Failing states and strangled economies

Jul 7, 2022·Alasdair Macleod

Fickle markets have stopped worrying about inflation and begun to worry about recession. Both the financial establishment and investors seem incapable of understanding that it is not either one or the other, but both together.

Behind the inevitable crisis which is now emerging is a lack of understanding that it is not supply chain failures, or an evil President of Russia that have caused our current predicament, but our previous monetary excesses. And to add to our troubles we have elected a weak political class incapable of even preserving a scintilla of moral standards. In addition to the re-education required of our leaders, it renders a resolution of the developing credit and currency crisis virtually impossible.

We face a downturn of exceptional destruction in the bank credit cycle, even rivalling that of the 1930s. With today’s fiat currencies and governments determined to bail out everyone from the consequences of their actions, we have a global systemic and currency crisis without the wise heads required to steer us through it. 

The lessons from history are clear. Currencies and the entire credit system are staring collapse in the face, which will ensure the impoverishment of nearly everyone. These are the conditions which lead to calls for strong leadership, for leaders willing to ride roughshod over vested interests. A different form of socialism will be called for instead of free markets. These are the conditions that led Germany, Italy, and Spain in the 1920s into fascist dictatorships.

To understand and hopefully avoid these dangers, it is time to reprise Hayek’s “The Road to Serfdom”, and to understand that if nations are not steered wisely through the forthcoming financial hurricane, the long run political consequences will also be dire.

The decline and fall of the West

We are seeing, perhaps, a rerun of Rome’s multi-century decline ourselves, but our socio-economic decline is progressing at a far quicker pace. Though there have been some examples of old-fashioned barbarity in our wider spheres of influence, we are not so much driven by a Nero or a Caligula, but by the absence of statesmen, denial of capitalism, and the promotion of wishy-washy socialism. Our decline is evidenced in the erosion of our work ethic, hate of capitalism, and a widespread belief in entitlement for which the state is expected to provide. It threatens to be a terminal decline in established morality based on Judeo-Christian values.

Politicians are aiding and abetting the trend by refusing to address it. They even refuse to stand up for established definitions of gender. Presumably, they don’t want to encourage hate mail from a very vociferous but miniscule minority — anything for an easy life. But creeping anti-morality has adverse consequences. Government departments now have “diversity advisers”, and other woke police, and are bound through regulations to adhere to their irrelevant strictures. Universities are riddled with woke nonsense, and no one in authority has the authority to stop it. History is being rewritten to include new biases, political correctness being more important than historical facts.

It infects business. Publishers and filmmakers are raking in money from the Harry Potter series but refuse to acknowledge the author whose only crime was to point out that a woman is a woman, and a man is a man. 

It is symptomatic of moral decline, leading to societal breakdown, and a political system incapable of dealing with adverse headwinds. This baloney is indicative of a deep malaise affecting all Western nations. I take as an example the moral decline of the UK, because that is where I live. I ask readers elsewhere to compare their experience with that of Britain, and I’m sure they will see similarities. 

Today it is a far cry from what was expected at the UK’s general election in December 2019. A Conservative government was elected on a free market manifesto. Brexit was to be done and Britain was to be unshackled from the EU customs area. Freeports were to spring up as centres of excellence. Britain had a prosperous future to look forward to as an entrepôt. Bureaucratic wastage was to be eliminated and the civil service to be made more focused upon outcomes. A bonfire of EU regulations was to be lit. With the Johnson government having collapsed this morning, he is not being rejected due to his failure to deliver on his manifesto, and a replacement administration is likely to be no better.

It is easy to blame the Conservative government’s change of heart about free markets on the unexpected diversion by the covid pandemic. But that has passed, and we see no signs of the earlier manifesto pledges being respected. If anything, being able to exercise even greater power over its population has gone to ministers’ heads. Instead, the British government has been grandstanding, first on climate change, and more recently on something which has very little to do with UK citizens and made their lives even more difficult thanks to sanctions — the war in Ukraine. Anything other than addressing the issues upon which the government was elected was the policy. Instead of responsibly managing the burden of the state upon its people, it is far easier for a government to throw money at day-to-day problems.

The reality behind government spending is it rarely achieves its intended objective, making things worse not better. As Milton Friedman famously quipped, if the government oversaw the Sahara, there’d be a shortage of sand. 

The largest sinkhole for state spending is the UK’s national health system, and every crisis demands more money, more regulation and more bureaucracy. The reasons doctors are leaving the profession are not just stress and burnout. Public heath doctors “are buried in vaccination programmes, time-consuming and impersonal remote consultations, overwhelming bureaucracy, and failing management”.[i] And what applies to doctors applies to nursing staff as well.

These are professionals who joined the health service with a sense of vocation, only to find all their altruism driven out of them under the supervision of highly paid administrators and bureaucrats. A combination of lack of staff, high sickness levels of those employed, low morale, and stultifying bureaucracy is leading to a systemic breakdown. The government’s response is reminiscent of Nero: where he debased the coinage to pay his bills, today’s sterling is debased for a similar purpose. Debased currency is fed into the National Health Service along with additional bureaucracy to administer it.

Not only is the state failing the common man, but it has become an impossibly costly burden upon him. It is a failing state. The problem is common to all other nations whose populations believe the state exists to provide them with a living and free services.

The mistake of underappreciating economic evolution

In early 2020. the world stopped as governments mutually agreed to lockdown their populations completely in response to the covid pandemic. All but the most basic of economic activities were to cease. With further lockdowns, it was not until eighteen months passed that these restrictions on human activity gradually ended — though some restrictions remain in place and China still shuts down whole cities in response to minor outbreaks of the virus.

Governments everywhere appear to have assumed that after lockdowns everything would just return to normal, where it had left off. They acted as if human activity had been cryogenically suspended. Besides the teething troubles of returning to normal, no account had been taken of the change in the attitudes of ordinary people. Many of them didn’t want to return to work, and where they could, often opted for early retirement. Others decided they could continue to work from home for a far less stressful life than the daily commute and are refusing to return to their offices. Some reflected that those long hours for pay that fails to keep pace with rising prices were not worth turning up for. Covid lockdowns seem to have got workers facing the drudgery of earning a living anew to just jack it in.

To the frustration of government economists, economies have not returned to where they were when locked down as they had hoped. Nothing was in the right place: shipping containers, foreign production, domestic labour. Working from their computer models, they failed to understand that it is human desires, which are at the root of all demand, and they don’t stop evolving. And apart from the inevitable supply disruptions, an economy after prolonged lockdowns is bound to be materially different from before.

Supply chains remain disrupted, and shortages have replaced a previous abundance. Hire car firms illustrate this point. Before lockdowns, operators obtained fleets of unsold cars at substantial price discounts, and now have to pay full retail prices for cars, if they are available which often, they are not. With all other costs of running a car hire business, it means that hire car rates in the US have doubled, and according to The Guardian (30 May), the price of car hire in Tenerife booked for August has risen by 220% over August 2021.

Despite the evidence, governments still insist that these are temporary difficulties, which will disappear in time and that normality will return. Government economists feel no need to revise their expectations that the disruption of rising prices will pass. It’s just taking a bit longer than they expected for us to conform with their computer models.

This line of thinking has been seen before. Karl Wirth, the German Chancellor in 1922 along with his cabinet colleagues, the Reichsbank, parliament and the press all denied any connection between soaring prices and the paper mark’s debasement.[ii] We look back on those times with utter disbelief at the German establishment’s naivety. 

This wilful ignorance was not confined to Germany during its hyperinflation. Today, it is common groupthink across all Western nations. And like the German establishment’s naivety at that time, we fail to recognise the root cause of our own inflation-driven problems today.

Monetary boom and bust

In early 2020, global stockmarkets were collapsing ahead of covid lockdowns. The same day that the UK locked down, under the cover of an emergency response to the covid crisis the Fed reduced its funds rate to zero and began quantitative easing of $120bn every month. In the name of preserving market confidence, it was the biggest rescue package ever seen. In the face of business activity stopping entirely over much of the US economy, commercial banks extended emergency overdraft facilities, spiking bank credit at the same time as the Fed began injecting unprecedented amounts of credit into the financial economy through QE. Wall Street, at least, was rescued.

But the expansion of bank deposits in the US, which is the other side of bank credit, is now reversing, as Figure 1 shows.

 The black line is the six-month moving average of monthly changes in bank deposits. Changes in the monthly rate, in feint blue, are extremely volatile making a trend hard to discern. The moving average gives a clearer picture. Considering that the 15% increase over the four months following February 2020 is now fully reversed, the current withdrawal of credit from the US economy is more devastating than it at first appears.

We can easily explain the sharp increase in bank lending when covid lockdowns first commenced. Like the rest of us, banks were unprepared for this sudden disruption to commerce. The effect on businesses was catastrophic for their cash-flows, and consequently their overdrafts soared. Understandably, the collective response from bankers was to accommodate the demand for credit because the alternative would have tested their own solvency.

In banking terms, this is revolving credit, a temporary stopgap available for businesses to draw down upon. It is likely to be revolving credit which is now being withdrawn as bankers lean on borrowers by reducing their overdraft facilities.

For some businesses, bank credit had been supplemented by financial support from the Federal Government. The Government’s deficit soared, and from the beginning of fiscal 2020 to date, it has totalled over $6 trillion. It is a measure of how inflationary financing has dwarfed changes in bank credit so far, dramatic though the latter has become.

The developing trend for bank credit will be of mounting concern for the monetary authorities, who will be acutely aware that bank credit makes up the vast bulk of circulating media. Central bank currency liabilities to the public in the form of banknotes represents under 12% of broad money supply. The rest, in the form of bank deposits, is the counterpart of bank credit. If bank credit declines, bank deposits contract as well. Bank credit is that part of the monetary iceberg under the surface which is not seen.

Because the reduction of bank credit is reflected in a reduction of deposits, broad money supply will decline. But so far, we have not considered the addition to bank credit from QE, which until recently has been accumulating at the rate of $120bn per month.

The effect of QE is to create matching bank deposit balances in the form of reserves at the Fed. On their creation, these balances match deposits at the commercial banks in favour of the institutions, mainly pension funds and insurance companies, which have sold their US Treasuries and agency bonds to the Fed. Since March 2020, QE has totalled about $3 trillion.

So, why is it that these balances have not been reflected in a discernible increase in the level of bank deposits? Well, perhaps they have. Since March 2020, the level of bank deposits has increased by $3.28 trillion. This is close to the figure injected into institutions’ bank deposits by the Fed’s QE. But if the increase in bank deposits since March 2020 was entirely due to the Fed’s QE, then there must have been minimal expansion in bank lending to other depositors.

This is obviously not true. So, we now have a mystery of missing deposits from QE. They appear to have already been driven from public circulation (and therefore the money supply statistics), ending up on the Fed’s balance sheet in the form of reverse repos (RRPs), currently standing at about $2 trillion. If this is where Fed’s inflation of deposit money has ended up, we appear to have resolved the mystery. 


Why this is so is not entirely clear. When the Fed funds rate was zero, commercial banks were unable to take on large deposit balances and pay interest, so there was a reason why they ended up at the Fed, which paid ten basis points at that time. With increases in the Fed’s fund rate, money market rates have risen providing a deposit alternative at the commercial banks, yet RRP balances have continued to rise. 

A possible message from this is that liquidity in the economy is already excessive, and a repeat of the Fed’s reflationary policies of March 2020 could simply end up driving the RRP balances even higher. That being the case, renewed QE seems unlikely to be a solution for declining bank deposits and therefore bank credit on the other side of bank balance sheets.

Alternatively, it could be argued that the financial system in general is using use the RRP facility to obtain short-term high-quality collateral. If this is the case, it suggests there is a system-wide lack of balance sheet space, which could be resolved through bank credit contraction. However, with increasing amounts of Treasury stock being issued, and now with sovereign governments also reducing their holdings, there should be no shortage of this collateral for financial purposes. 

With respect to changes in bank credit, it is vital to understand that economic growth or recession are no more than changes in the sum of currency and bank credit employed in the overall economy. Increasingly, some bank credit is deployed in non-GDP activities, such as dealing in financial assets. But putting that to one side for the moment, a recession is simply a contraction of bank credit withdrawn from GDP-qualifying activities, assuming the central bank does not reduce its note issue. That commonly described growth and recession are measures of economic progress or regression is just an assumption that credit is always used productively, which is obviously untrue. It is a huge but all too common a mistake to confuse the two.

The relationship between changes in bank credit and the consequence for economic activity makes downturns in bank credit a reliable advance indication of the withdrawal of credit from economic activity. That these conditions are currently in the pipeline was confirmed by Jamie Dimon of JPMorgan Chase in a speech at a banking conference in New York early in June, when he upgraded his description of economic conditions from storm force to resembling a hurricane. It was the clearest indication of bank lending conditions deteriorating that we could possibly have from the US’s most powerful banker. And we are now seeing confirmation in a growing list of corporations issuing profit warnings.

Where Dimon goes, all the other bankers will follow. And this is what the chart of bank deposits in Figure 1 above is now indicating. But not all bank credit ends up financing economic, as opposed to purely financial activities. The US economy has progressively become more financial since the Glass-Steagall Act was eroded and then finally repealed in 1999, which prohibited commercial banks from investment banking. Consequently, we can only speculate as to whether bank credit contraction is undermining Wall Street more than Main Street. That its contraction is affecting financial asset activities is supported by the evidence in Figure 2, of margin credit for financial speculation.


Presumably, the trend for the withdrawal of credit is continuing, the last figures available being for May. But so far, it represents less than $200bn compared with total bank credit outstanding of about $18 trillion — a relatively trivial amount. Furthermore, an unknown quantity of the credit in financial activities will have come from shadow banking, not recorded in bank credit statistics.

But financing made available for brokerage accounts, which is what Figure 2 represents, is only a small part of the financial credit picture. There is hedge fund leverage to consider as well as part of a widespread funding of derivative positions. And there is the funding of banks’ own trading books. As financial asset values decline, which is the inevitable consequence of the liquidation of financial collateral, these in turn are likely to decay.

Whatever might be happening on Wall Street, forward profit guidance from US corporations confirms that a substantial slowdown in economic activity is taking place. Commercial banks will be aware that this is the case from their own intelligence. And given the jump in circulating credit due to lockdowns, they will now be concerned about a heightened risk of non-performing loans. And with the operational gearing with respect to shareholders capital, the pressure on bank executives to call in loans where they can is obviously mounting.

That being so, we can explain the bear market in financial assets and a developing recession in the broader US economy. Bearing in mind that GDP numbers are only a reflection of the quantity of currency and credit in circulation, the dynamics behind bank credit contraction can be expected to warrant that the recession will be deep. And the withdrawal of bank credit also leads to selling off financial assets, not least of liquid collateral held by the banks against loans of all sorts. The unwinding of long-term bull markets in bonds and equities appears to have a long way to go yet.

It should be added that the difficulties facing the US commercial banks are considerably less significant than those facing their confrères in other jurisdictions. Ratios of assets to shareholders’ equity, and therefore the likelihood of systemic failure are particularly high in both Japan and the Eurozone. When the US banking system sneezes, these financial systems could simply collapse.

A slump does not cure inflation

It is not just weakness in equity markets, but an examination of the trend in bank credit also tells us that a cyclical downturn is evolving. We can see that the forces behind a credit contraction are arguably more powerful than anything since the 1930s. Furthermore, the existence of over $2 trillion in reverse repos indicates that it is unlikely to be simply cured by a repeat of the Fed’s actions to rescue the US banking and financial system in March 2020 under the cover of the covid pandemic.

We have also noted the naivety of today’s establishment over the consequences of the rapid expansion of the quantity of currency and credit, and its repetition of establishment beliefs concerning the reasons for the paper mark’s collapse in Germany in 1922. To that we can add the misguided belief that recession and inflation are mutually exclusive.

And anyone examining the economic conditions of past fiat money inflations will be aware that monetary debasement might make the statistics look good in the short-term, but they always lead to wealth destruction. Far from recession and inflation being mutually exclusive, they are like Siamese twins joined at the hip.

The realisation in financial markets that economies face a significant downturn has diverted investors’ attention from declining purchasing powers for currencies. This is a gross error. Anyone thinking realistically about the economic outlook can see that governments and central banks will suppress interest rates anew and cause credit to be injected into both financial markets and the wider economy in attempts to avert a bank credit crisis. Whatever the detail, these measures will lead to a step up in the rate of government debt creation and the debasement of their fiat currencies will accelerate as faith in them is bound to evaporate.

It is therefore a ludicrous error to think that the problem is no longer one of inflation, and instead to blame events, such as supply chain disruptions and Russia’s aggression in the Ukraine, as the main reason that producer and consumer prices are rising.

Currency and credit will continue to be created, but to less effect. Just as the German establishment in 1922 could not conceive of stopping the printing presses, major currencies in the West are set to be similarly debauched. The entire global banking system will have to be underwritten by central banks — an operation fraught with failure and unintended consequences. But what should also concern us are the consequences for society, already divided between a silent majority and a small but increasing minority of woke individuals who seek no less than the destruction of capitalism and who expect the state to give them a living instead of earning it for themselves.

As we are seeing only this week, the stability of democratic governments is fragile. The UK’s Prime Minister has been ejected from office. The excuses for his removal are not the real crisis: it was his inability to carry out the changes his constituents expected. Mistakes have undoubtedly been made, but would any other elected representative of the people been able to steer the nation towards capitalistic free markets? Can any replacement achieve a better outcome?

In the coming months we will find that food prices rise substantially, exacerbated by sanctions against Russia and the Ukrainian conflict. That will happen anyway, but so that people can afford to pay higher prices for food and energy, the currency and credit to enable them to do so will be produced without them having to cut back on other consumer items and services. The effect will be to accelerate rising prices not just for food and energy, but for everything else as well.

Ordinary workers already find that their wages fail to keep up with rising living costs, and social disruption from strike actions will intensify. Unless by some miracle the process is halted, the middle classes will lose everything, and are likely to blame everyone and everything but monetary debasement. The lessons from the past tell us that it will not just be the collapse of currencies we face, but the collapse of society itself.

We can see how political extremism will emerge from these conditions, with increasing calls for strong leadership. Someone with dictatorial powers to restore law and order. Someone with a different type of socialism. It will be fertile ground for fascism. It will take extraordinary luck if intellectually informed statesmen emerge to steer society away from this outcome. 

The reality of our predicaments is that we face a repeat of Rome’s decline and fall from Nero to Diocletian, but at a hyper-driven speed. 

[i] Quoted from a letter by two doctors to The Daily Telegraph 4 July.

[ii] See When Money Dies by Adam Fergusson


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