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As soon as the money supply was checked house prices had to fall
and there had to be a recession. If property prices collapse
so will the UK banking sector.

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4. Government Debt

The British Government was servicing a large debt a year ago. Now this debt is even larger and will get even bigger particularly if the British Government is going to absorb the still undisclosed debts that have yet to come out of the financial sector and to shore up key businesses. A large number of British businesses will go into liquidation in the next couple of years even if the banking sector does make money available to them. This means a dramatically falling amount of tax income from the private sector that will be badly mauled in the next few years particularly as many companies, particularly those in developing countries, dump inventory to survive. The markets are still going downwards, businesses are going downhill yet tax and inflation will have to go forever upward. At the end of 2008 the Government's monthly tax income fell by 7% from the year before and its expenditure rose by almost the same amount. In 2009 and 2010 the situation will only get worse. This is an enormous change to accommodate in an economy where inflation is the only tool left to raise revenue for the Government.

The creation of government debt is always accompanied by an increase in the money supply. A large government bond issue would drive interest rates up if it had to compete with private borrowers for a static supply of credit capital and no government wants to pay high interest rates. In the current crisis the British Government has driven interest rates right down with no reference to logic but this means that providing it can still sell gilts, even with a low rate of return, it can walk away from a large part of its liabilities. Of course, this will mean that pension funds will be further damaged but the most important function of private pension funds is to enable the State to fulfil its commitments. The difficulties will appear when foreign investors become reluctant to stay with the pound particularly after its loss in value in the middle of 2008. This means that they, and others like them, will be very unwilling to lend money until they can see that they will not be abused again in the same way. Many other leading currencies such as the Dollar and the Yen have also been set at artificially low levels. This means that money will tend to flow to the Euro so driving its value upwards until the ECB is obliged to follow the lead of the other major currencies.

As long as the Government can sell its debt it can use debt to restrain the inflationary effect of its excessive spending and money creation. If faith in the money wealth of a nation is lost then the restraining effect of government debt is lost. At that point the Government's debt will serve to fuel inflation. In other words government debt, which holds down inflation with credible debt, amplifies inflation when the credibility is lost. This is the danger of the British Government's current enormous liabilities. It is starting to look unsustainable. The faith of the money markets in the British economy is falling rapidly.

The British Government has undertaken to inject capital into the banking sector but if house prices continue to fall and if businesses suffer still further then the British Government will have to take over the banking sector. The banks will be left intact so that the outstanding debts that now belong to the Government, can be paid back. The reality is that the value of homes will probably drop back to the level of 1995 or even 1990 and much of this loss will belong to the banks. The question then is where the British Government will find the hundreds of billions of pounds that will be needed to meet these additional obligations. The answer has to be that it will just print more money to replace that which is lost. Of course the individuals and companies who have lost the money will still be liable for these losses so widespread bankruptcy and liquidation will be the outcome for many. The Government must be hoping that with luck it will be able to acquire the banks' assets on the cheap.

The total amount of Government debt has to be controlled and this can is done by inflation, bankruptcies or a property crash. This is where the UK economy is at now. Productive businesses have been going out of business at a frightening rate over the last 20 years. This will only get worse in the next three years. Historically the way that business operated was to make money with goods, labour and machinery. However, in the last ten years many realised that that it is possible to make money with money and to avoid the effort of actually having to do something productive. During a period of inflation production is abandoned in favour of business activity and people of lower ability undertake what production is left when, in fact, the most skilled managers are required to maintain productive momentum. Most British companies, that once produced something themselves, are now become little more than importers in total or in part.

When looking for the reason for inflation it is necessary to ask who is the biggest debtor and which organisation has the largest long-term liabilities and of course the answer is the State. The British Government has historically doubled the number of pounds in circulation every 15 years. This means that monetary inflation has been at a background rate of about 5% up to the time that Labour took office. Monetary inflation therefore can never have been just 2 or 3 % as the British Government is always claiming. Finding out how much new paper money goes into circulation each year is very hard and now that so much money exists electronically the quantum is almost impossible to determine. In the last ten years, in current terms, even this amount of inflation would have the effect of giving the Government over 50 billion pounds of invisible 'tax' every year to keep it operating as well as serving to reduce its long term debt by the same amount. This is why deflation is such a frightening prospect for the British Government, but as it is able to falsify the data even if there were to be deflation no one would ever know about it. Of course, deflation is very unlikely to happen in the UK because the printing presses will be running hard over the next few years. The number of people that are dependent on the State increases each year so putting this new money into circulation will not be difficult.

Until the very end of an inflationary cycle borrowers always make huge profits because lenders almost never fail to underestimate the damage that inflation is causing them, particularly as most of them believe and act on the data provided by the State. There is a simple rule - always beware of being a creditor when the State is a big debtor. Foreign holders of Sterling have sustained massive loses during the last half of 2008 because the value of the currency plunged so far so fast. However allowing the value of a currency to drop is a good way for the State to reduce its debt it needs to borrow from outside the country. As soon as a Central Bank hints that it is going to speed up the printing presses flight from the currency always ensues. Recent statements from Gordon Brown and Alistair Darling about the UK spending its way out of recession had to mean that the printing presses were about to speed up and the fall in the value of the pound was entirely predictable. The process accelerates ever faster when the currency starts to lose its value in an uncontrolled way, as the pound did in 2008. The problem can also occur when a country is burdened with a huge mountain of domestic and foreign debt. Creditors know that a strong burst of inflation would solve many problems in the US and the UK and so they are wary of getting involved with the Dollar or the Pound if there is a better alternative.

It is important to remember that 85% of many people's wages are ultimately taken in tax. If the price of all the imported goods consumed by the average person rises by 10% then this only means a real increase of 1.5% in the actual cost but when taxation is added back the increase goes back to 10% in the shop. The important thing for the State is that 85% of this 10% increase goes to the State. As a result every time the price of goods increase the Government gets ever more money for doing nothing. At the moment the Government is taking on ever more debt which means that the State component of the GDP is increasing and the more the Government benefits from inflation. This effect also means that all those who work for the State or whom are dependent on the State are benefitting from the current recession because prices are falling very fast. It is only those who work in the vulnerable parts of the private sector who are suffering. Of course, when the retail sector levels out at the bottom of the recession those who are sponsored by the State will have this benefit taken away and will be less than happy when prices surge up again.

Published: January 2009