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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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3. What caused the recession?

Many people are wondering quite how the current financial problems came about. The real underlying cause is inflation or more correctly hidden inflation brought about by the need of Western Governments to keep their economies moving forward. Inflation has been around as long as there have been currencies. Babylon and Ancient China had inflation. The Roman Empire suffered from terrible inflation and occasionally deflation. Europe went through serious inflation in the 16th and 17th Centuries when the Spanish found massive quantities of gold in the New World. The current problems have largely come around because the governments of the World were able to falsify their inflation data in the age of computers. It was easy to tell that the data was being falsified years ago because growth and inflation rates were striking uniform across the Western World. This is because the governments of the western nations were all trying to keep up with each other by playing the same game because they all have the same problem. Namely, that their populations are becoming increasingly less productive and the number of elderly and dependent people is increasing.

All the features of the UK economy in the last ten years, like a rapid increase in the value of the stock market and increasing house prices, are typical of an inflationary bubble. There was a lot of money in circulation and nowhere for it to go. Normally interest rates should have gone up in response to this trend but then the British Government and US Government committed the most astonishing act of financial mismanagement. Instead of raising interest rates to control inflation, they lowered them and then took all the controls off borrowing. Money was then spent on consumer goods and services and this was used to show that the Gross Domestic Product was rising. Some of the surplus cash was placing in property including land and buildings. Land and buildings fall outside GDP and are the wealth of the nation. Part of this national wealth was then transferred back into GDP in the process of executing the many deals that took place. Thirdly, all sorts of paper property like stocks, bonds, mortgages and savings accounts were used to soak up money. Various taxes on all the above headings meant that the State benefited yet again from unregulated inflation. The British Government thought that it had found the Holy Grail for driving an unproductive economy forward. Stoke inflation and get people to take the surplus cash out of circulation by putting it into the stock market and property. The policy worked well for ten years, then the falsehoods in the process manifested themselves, and now there is a major recession. The effect is exactly what economic theory suggests should happen so it can be of no surprise to any economist or central bank.

The Western World has been engaging in an inflation induced borrowing spree. Uncontrolled borrowing by the State and printing money are effectively the same thing. They both pull the economic system down because it is not money based on industry. Inflation over expands the aggregate load of debt to the point where it is out of proportion to the wealth of the nation. There is nothing new with governments using inflation to fund their activities. A pound today would have been worth a penny in 1900. Apart from a period between the First and Second World Wars inflation has been regularly used as a tool of the British Government.

There will be a considerable increase in the level of price inflation in 2010 as the pound has fallen dramatically in value since mid 2008. It will continue to fall even more in 2009 and 2010 as the underlying problems of the UK economy manifest themselves. If one puts a value of well over 2 trillion of new borrowing since Labour came to office it means that the money supply was being increased by well over 10% per annum compound rate for a decade.

It is important to remember that in 1930 a well paid industrial worker was earning 3 a week. By the 1970s this was 30 and today it is over 500. This means that between the 1930s and the 1970s the rate of increase in the salary compounded was 5.9% per annum but there was a war during that period. Between 1970 and 2008 the rate was about 7.7% per annum compound. A house that was worth 30,000 in 1978 was worth 180,000 in 2007. This gives an annual increase of 6.37% per annum compound. This is in contrast to an official interest rate of say 3 to 4% over the last 10 years. It is possible to do the same sort of calculations with food, energy and many other consumables. This therefore means that the 'inflation' figures provided by the British Government are patently untrue so the question has to be why anyone believes them and why the media reports them without questioning their accuracy.

The Labour Government took many controls off the financial management of the country when it took office but it was the election of George Bush that was the real turning point. In 2000 the dotcom bubble collapsed and there was a major adjustment in the stock market. The collapse of the dotcom bubble wiped over $5 trillion from the value of technology companies but it did not seem to have any great effect on the financial markets or the commercial world. There should have been a major recession in 2001 but it did not happen. The question then is why? The simple answer was that the US authorities started to print money. The US has run a massive balance of trade deficit for decades which means that it is always having to inflate its money supply so printing more bank notes is not a problem for them. The central banks in many other countries then started to emulate the US Government and so the process went around the World. In the age of instant communication if the US Government plays the inflation card then everyone has little option but to do the same. Similarly, if one major player starts to drop their interest rate then everyone else has to do the same otherwise they will get flooded with cash and the value of their currency will rise out of control.

In the last hundred years the economic systems of the World have become very refined and almost everyone in the West is now totally dependent upon other nations for the necessities of life so it is now impossible to escape imported inflation. There is always a tendency for money to flow from a country of surplus money or inflation to a country with no surplus money and so no inflation. In the age of electronic banking, inflation quickly equalises itself around the World. The constant outflow of dollars from the USA carries US inflation with it. America's export of dollars is an import to other countries. The USA has had a massive trade deficit for decades and has effectively been subsidised by those who hold or receive payment in a currency whose value is continuously being debased. This is a habit that other western countries have enthusiastically engaged in over the last decade with money being lent to developing countries, and given to countries like China and India in return for consumer goods.

Exporting cash is a wonderful way to export domestic inflation. It controls money inflation at home and distributes it abroad instead. If national payment deficits were to be contained within the country then the inflation would spring up at home and that would be serious. If foreigners who hold currency were to return the money to the country from which it came then price inflation would reappear in the country that exported it. One only has to look at the massive sums of money that the larger countries of the EU have lent to developing countries. In many cases it is close to the GDP of the country. Imagine what would happen if trillions of Euros were to be repatriated to the European Union in a short period. Now these countries are safe because the money is trapped outside their borders. Consider what would happen to the USA if China was to place all the dollars that it holds back into the US economy.

Central bankers have a system for recycling payment deficits so that they can go on generating inflation almost indefinitely throughout the World on the basis of recycled dollars. Every surplus dollar that is moved abroad generates an inflated number of say pounds from the Bank of England but then the BoE can then take the dollar and lend it back to the USA so that the surplus of dollars is as large as it was before. The same dollar can then be recycled as often as the central bankers want to recycle it back to the USA so generating money inflation around the World. Even in this recession the European Central Bank and the Bank of England have been lending dollars back to the USA so the practise continues during this recession

The stock market and the housing market have crashed. This has destroyed a large amount of inflated money. The fact that proves this, is the knowledge that house prices tripled in ten years, commercial property trebled in value and the stock market more than doubled all without there being any real commercial growth. The money had to come from somewhere and it certainly did not come from the industry of the British people or the European people or the American people. However using inflation to drive a service economy forward is like using nitrous oxide to get improved performance out of a petrol engine. Output rises dramatically but in the end the engine is seriously damaged or even destroyed.

At its simplest inflation can take one of two main forms. The most obvious is the rising cost of things that people want to buy. There is a natural feeling that this sort of inflation is caused by something which happens outside the country. Politicians can then pretend that this matter is outside their control. Then there is monetary inflation that is a voluntary act on the part of government to allow the existing amount of money in circulation to increase. When talking of inflation it is important to differentiate between price inflation and monetary inflation. When talking of price inflation it is necessary to identify true price inflation and not just odd items that are moving. If there is an increase in the price of essential items like food but a comparable decrease in the price of say fuel then overall there has not been true price inflation providing that the whole gambit of expenditure is covered. For most of us buying life's necessities is not a matter of choice. If we spend more on one thing than we used to then something else has to give way. The Civil Servants who are given the task of calculating 'inflation' are very careful to ensure that the totals that they calculate match the figures that their political masters require. The price of bread and milk at the supermarket might remain fairly low in a contrived scenario but it does not mean that the background level of inflation is low.

When a Government has a massive debt there are only three ways that it can reduce it. The first is to walk away from it. The second is to raise taxes and to pay it off. The third is to inflate and to dilute the debt. Of course, the problem with inflating is that it becomes an upward spiral. Each year there has to have more inflation than the year before just to stay in front of the game. Stopping the inflation cycle is very hard. Of course, one way to avoid hyperinflation is to have a high level of inflation and to convince the general public that inflation is in fact very low. Providing that the media can persuade the public that price inflation is low by focusing on the cost of a few staples and fuel then the underlying problems get overlooked. This is only possible if most of the materials consumed in the country are imported from low cost economies. Unfortunately, for the British people the level of propaganda today is higher than it has ever been in history. Almost every piece of data that is placed in the public domain has spin on it and few people have been trained to read through the spin and to consider the underlying social, political, and economic factors. The British Government is borrowing so much money now that it has no option but to inflate at an enormous rate. Soon the British electorate will see what real inflation is like.

There would be even more problems if there was deflation but this is highly unlikely as over half the GDP of the UK is now the responsibility of the State and destined to keep on rising. Deflation makes it possible for conventional monetary policy to deliver negative real interest rates. The faster the deflation the greater negative interest rates will be. The rising real value of debt as deflation increases becomes a lethal threat to any Government. In the US, the private sector gross debt has soared from 118 per cent of GDP in 1978 to 290 per cent in 2008. The people who have borrowed this money are gambling on inflation reducing the burden on them. Deflation would trigger a downward spiral of mass insolvency, falling demand and further deflation which is why the prospect of it causes so much fear. In other words, Western Governments have no choice but to keep on rewarding the profligate at the expense of the thrifty and to stoke inflation.

Deflation will never be a problem because once the interest rate hits zero Central Banks can print infinite quantities of money. Once inflation returns, after a period of deflation, the relevant Central Bank would have to sell assets into the market to mop up the excess money they printed to fight deflation. Similarly, the Government would have to reduce its deficit to a size that it can finance in the market. If this did not happen then deflation would swiftly turn into a high level of inflation. This will also happen if the debt was sold, in an attempt to cancel the monetary overhang if it is beyond the Government's ability to service the debt. Britain already lacks a credible currency and could in theory enter a deflationary cycle very soon were it not for the fact that the data prepared by the British Government is always heavily doctored, and the fact that the British Government will soon own all the banks. As a result, the printing presses will keep rolling and logic will be stood on its head for a little longer.

The excess money created by monetary inflation goes first into the capital markets and then to buy stock and bonds. In other words, it can be put into the capital markets or invested. This then forces up real values in the capital markets. It means that money that is in the capital market is taken out of the GDP figures. One man's monetary inflation is another man's capital gain. There is nothing new about what is happening with the world economy at the moment. It has all happened before. The only difference now it that computers cause more rapid swings and no longer can the official data be trusted.

Every time that there is a high level of inflation industrial stocks are favoured and go upwards in value while dividends go downwards. Stock prices go upwards until inflation levels off and then a stock market crash occurs. However, in the long term, ignoring their peak boom values, operations that have a tangible value still have worth after the inflation bubble is over. The stocks and shares of any business that is based on inflation are as worthless as bonds. Historically a country that has an overvalued currency because of inflation gives an artificial subsidy to service industries at the expense of export industries and other foreign sensitive industries. Unfortunately, inflation always tends to stimulate pointless activities and so a wasteful use of resources. Most growth during a period of high inflation is superficial. In other words for every spurious activity there is spurious investment waiting in the capital markets during a period of inflation. This is one reason why the collapse at the end of an inflationary bubble is so painful.

Most people in the UK have little interest in the stock market unlike the USA where many have their pensions invested in it. Most people believe that the stock market in some way reflects the commercial processes that are in train around the World. In reality, trading on the stock market is just gambling. Stock market speculation adds nothing to the wealth of any nation although it might improve the value of pension funds. When a government starts to use inflation in a time of low business activity the money has little to do and so it goes into the stock market. A rapidly rising stock market is a good indicator of monetary inflation which in turn is the precursor to price inflation. Commodity speculation is also linked with inflation. This is a phenomena that has also been very visible in the last couple of years. The stock market is always well patronised during a period of inflation. Without inflation the stock market can do very little. A boom in the stock market is a form of price inflation with the stock market just acting as a pressure valve. As the economic cycle advances some of the money in the stock market is drawn into creating business prosperity but most of it stays in the market as it is seen to be a certain way to create even more wealth. The stock market will always stop rising when inflation stops or is checked. When inflation runs away the price of stocks collapses back to their real value. This can mean that the real value of the stocks are decreasing even though their money value is still rising because of inflation. The FTSE 100 index more than doubled between 1995 and 2006 but this is in actual monetary values and does not take inflation into account. The current drop in say the FTSE 100 index has already taken it below the values that existed in the mid 1990s because of the devaluation of all the World's major currencies by 'inflation' over that period.

The main driver of a crash is fear. Confidence vanishes and no one feels sure that any business will survive so why buy the stocks. That is the situation that exists today. Most business growth in the last ten years has occurred because of borrowed money and an inflated money supply as the governments of the world printed ever more cash. However, the increased value placed on almost all major companies by the stock market in the last 10 years was out of balance with the new investment that was made in them or the increased productivity that they achieved. Soon the average value of stocks and shares will be back to the money value they had in 1995. These means a real value that is on a par with 1990 once inflation is taken into account. In the main this would be a fair value for many of them. This shows how dire the problems are for the Western World.

Published: January 2009