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Sorry to paste such a long piece, but it's hidden here: http://market-ticker.denninger.net/ under Dec 2007 (and isn't that easy to find.)

This guy perfectly (to my mind) sums up what is happening in the financial systems of the world.

Basically, it's got very little to do with sub-prime, recession etc - these are just words used by the banks, economists and media to soften the truth - that our system of banking is corrupt and is out of control. Though this piece is not strictly about monolines, it demonstrates how the clever banks have sold trillions of dollars of worthless shit (backed by the monolines -phew!) to every pension, investment house, government body and even to themselves in a desperate attempt to stave off the inevitable. Although this author is American, I think we can safely assume this will be coming to our shores soon enough.

My apologies if it's been posted elsewhere on this site...I couldn't see it anywhere.

MONDAY, DECEMBER 3, 2007

The Money/Credit Cycle....

I'm going to "spend" my ticker today talking about something that you're not taught in school, yet is critical to understanding where we are - and where we're headed in the markets.

That is the money and credit cycle.

Let us think for a moment about what money really is. Gold is often called "real money", with the implication that other things used as money aren't "real".

Yet money, in the simplest (and most correct) definition is simply "a medium of exchange."

Through the years feathers, bones, foodstuffs and jewels have been used as money.

But - how is money created? Clearly, money must be controlled somehow, right? Otherwise you could walk over to your closest copier and run some off for yourself..... as much as you'd like. That would anger people, don't you think?

The first thing to get your mind around is that money, credit and debt are all interchangeable. In the world of economists these are known as "fungible" - that is, interchangeable without limit.

Today, when you go to the store and swipe your debit card, you are actually spending credit.

Let's say you walk into a restaurant and eat lunch. At the instant you order, you are in debt for $10 - the cost of the lunch. When you pay with your debit card, you settle that debt by moving $10 worth of credit from your account at the bank to the account at the restaurant.

So far so good.

But - where did the $10 you spent come from?

It was created through credit - that is, debt!

Let's start with a world where there is no money but some people own land. With land I can grow a crop to feed my family, but I first must acquire some seeds. Joe down the street has seeds, but he does not have land. We would both like to eat.

Therefore, I issue a debt to Joe in exchange for some seeds; I create money! I give him a promise to pay him part of my crop if he will give me some seed. He does; what he holds in his hands is, in fact, money. I have created it out of thin air by putting myself in debt.

Now what's the problem with that? Well, what happens to Joe if there is a drought? He has given up his seeds, but there is no crop! He loses. That's called risk.

Because of this risk, he will charge me "interest". That is, he wants somewhat more than the value of his seeds to cover the chance that I will in fact produce nothing with them.

And from this - risk - we sow the seeds of what ultimately causes headaches for the monetary system.

Let's say that today you wish to buy a car. You go into a bank and get them to agree to issue you a loan to buy that car. Let's say the loan is for $20,000. You sign a contract promising to pay back the $20,000 plus a rate of interest, which is charged so that the bank is covered for the risk that you won't pay them, and the value of the car at that time might not be as much as you owe. The car is the "security" for the loan - if you fail to pay, they will come and repossess it.

You now have $20,000 in your pocket, and you purchase the car. (We'll get back to how the $20,000 came to be in a minute.)

If these were the only two transactions in the world, you would soon recognize a serious problem - there is only $20,000 in money in the world, but you owe more than $20,000! The interest you must pay means that you somehow must acquire more money than exists in the world over the life of that loan in order to pay it back.

There is only one solution to this problem - the amount of money in the world must increase.

So the government will just print some more, right? After all, the can do anything they want.

Uh, no. If the government were to do that then the value of all the money currently in existence would go down by the exact amount that they printed. You could pay your debt but the bank would be in serious trouble because the money they got paid back with would not be worth as much as the money they gave you!

So where did the money come from?

It was created by the bank because some people trusted THEIR wealth to the bank to "hold" it for them - that is, they deposited some funds with the bank, and through the system of fractional reserve banking, the bank was thus able to "create" a certain amount of credit for each dollar on deposit.

If that system was short-circuited by a "raw printing" of money by the government, this would result in everyone "upstream" of you being hosed!

This of course is not acceptable to anyone (except you!) - the bank and auto manufacturer, along with the bank's depositors, specifically, would shortly say "no way!" and remove their funds from that system, choosing instead to do something else with it.

While many people believe that raw printing of currency is how governments respond to the need for "more money" or "more liquidity", with the exception of dictatorships this simply doesn't happen.

Instead, more money is created not through direct inflation, but rather through the pledging of more assets - that is, the creation of more credit/debt!

If the government wants to spend more it issues more debt (Treasury Bills/Bonds) which are then sold into the market - with interest attached. Due to fractional reserve banking once those bonds are purchased the funds can then be lent out at a multiple of the money received.

But wait a minute........

Isn't there a limit to this?

Ah, now there's the rub.

THERE IS!

See, there are only so many assets available to pledge. While human industry creates more over time - that is, we get better productivity through innovation and technology - there is a natural limit to the pledging of assets.

What's worse, the growth of money required to be able to meet interest and principal demand is an ever-increasing function. The "power" of compound rates of return is the damnation of compound interest, and in this case, its working against the system as a whole.

When the limit is reached - that is, there are insufficient remaining owners of credit-worthy assets who will (or can!) pledge them in return for more credit (money) being issued to them the system will fail and reset.

This is what happened in the 1930s.

It should have happened after the Tech Wreck in 2000.

But it did not, because when the velocity of money slowed precipitously in the tech wreck and Greenspan followed that velocity down by cutting Fed Funds to 1%, he managed to entice homeowners into pledging their HOUSES as collateral for yet another round of "reflation" in credit!

So the "reset" was avoided - for a while.

But - you saw what happened.

House prices exploded upwards as credit standards were thrown out and anyone who had a pulse qualified for a huge mortgage. The house was thought of as "security", making the loan cheap.

Or was it?

What did the mortgage companies and banks that made these loans know?

Well, what do you think they knew? They sold those loans off into the marketplace, keeping only a little - or none - of the risk for themselves.

Why?

Because they know what likely lies ahead - a monetary system "reset"!

This "last phase" marks a desperate reach for one more group of "suckers."

It is this phase which precedes the reset as debt merchants realize that they are in fact granting credit (creating money) to people who do not really qualify for it and have a high risk of default. As a consequence they will do everything in their power to collect as much of the "spread" (interest) as they are able, but lay off as much of the risk of the "reset" (default) as they can.

"Securitization" can be an element of misleading people into funding debt that will never be repaid because it allows yet another cycle of "credit reflation" while the risk is laid off on those unwitting market participants.

While "securitization" has its place in the credit cycle, when regulation is intentionally ducked by the government or worse, lending limits such as the existing "23A" exemptions are used like heroin given to an addict, the depth of the "reset" to come is grossly enhanced and the number of individuals and organizations that take the pain from the default cycle to come is significantly increased.

Unfortunately the ever-growing interest payment monster is now running into the hard reality that we're just about out of pledgable assets to put behind more credit.

WE ARE NOW FACING A "RESET" IN THE SYSTEM!

What happens in a "reset"?

The rate of credit creation slows precipitously as the list of assets that can be pledged dwindles down.

The interest and principal payments due on existing debt get close to and ultimately exceed the amount of money in the system, as the rate of credit (money) creation slows.

Those who detect this while they still have money pay off their debts, (correctly) deducing that a "reset" is about to take place - and that cash (assets) will have value, while debt will be a millstone that will drag you underwater.

Those who are unable to pay off their debts will find that a contracting credit (money) supply leaves them with insufficient funds to pay their debts. Debt defaults at a rapidly increasing rate.

The creditors (who granted the credit) will repossess the assets pledged for the debt in lieu of payment, while the debtors are financially destroyed.

The destruction of outstanding credit via default shrinks the money supply further, and we go back to #1.

This continues until equilibrium is reestablished, and the cycle begins anew.

Does this sounds kinda like what's going on?

It should - because it is.

Housing loans are defaulting. This is not "contained" to subprime and cannot be. As these loans default at a rate far beyond what was originally envisioned they contract the total amount of money in the system. This then forces defaults in other classes of debt - credit cards, automobiles, and various sorts of commercial credit as the money in the system is insufficient to service the debt that is owed.

This cycle will continue until equilibrium is restored. The depths to which we must go before equilibrium is reached, and exactly when it will initiate, is not possible to know in advance, but that we absolutely are going to undergo this process is known with certainty!

Creditors will end up with all the assets that are pledged on debts that default. Debtors will end up broke.

This is a natural cycle and cannot be prevented; it is an inherent and necessary function of any financial system which involves return for risk (commonly known as interest), and it is not possible to have a lending system that does not compensate for risk!

Whether you're on a gold standard or not is IMMATERIAL, whether there is a Federal Reserve is IMMATERIAL.

This is not taught in school, but it damn well should be.

WE ARE TALKING ABOUT BASIC MATHEMATICS HERE.

Mathematics is the only TRUE science AND IT DOES NOT LIE.

How do you deal with this as a PRUDENT individual?

Bluntly, you should avoid debt to the maximum extent possible, especially long-term debt, because it is not possible to predict exactly when a "reset" will occur - but that resets WILL happen is a mathematical certainty.

For most people, avoiding all debt is simply unreasonable. But when you start to live your life in such a fashion that you are financing your standard of living with long-term obligations you are at severe risk of being bankrupted outright when a "monetary reset" occurs - and odds are, there will be one at some point during each of our lifetimes.

Obviously, governments desire to prevent "resets", because they are terribly disruptive to the economy. They destroy those who have chosen to employ leverage in their financial lives, both corporate and personal, almost without exception. They contract GDP severely as the monetary velocity slows precipitously, and cause huge ramps in unemployment. In extreme cases they can lead to civil unrest or even radical changes in the form of government in a nation (e.g. the rise of Adolph Hitler), especially if the government mismanages the reset process or attempts to bail people out through "direct" monetary inflation.

By the way, before you believe that the government will simply "print money", should that be attempted (or some resemblance of it - e.g. government issues Ts, The Fed buys them and injects the money) the response in the market will be an instantaneous shutdown of private (and outside-US) buyers of debt, as the demand for yields will go parabolic to a degree that the government will be effectively priced out. Since the government needs debt market access to be able to continue to operate, this idea is a non-starter and the government knows it.

The sad reality is that each attempt to prevent a "reset" through meddling in the markets simply makes the ultimate event worse, as the amount of credit that must default to restore equilibrium ratchets higher with each new intervention.

We avoided the "Reset" in 2001/2003, but in doing so we insured that an even bigger one would occur.

Are we now in the beginning of the next "big" reset after the 1930s?

It is not possible to know until we are in the depths of it whether the snowball will gain enough momentum so that it smashes attempts at intervention. Once you can identify with certainty that a "reset" is underway it is too late to position yourself for it.

The risks of this event are now higher than they have been at any time in the previous 50 years.

To believe that we will avoid this event, you have to figure out where the next set of assets will come from that can be pledged for another cycle of credit relfation.

Without that new, unencumbered set of assets, the process of the monetary reset is assured.

No wonder they're all huddled together in Davos.

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Sorry to paste such a long piece, but it's hidden here: http://market-ticker.denninger.net/ under Dec 2007 (and isn't that easy to find.)

This guy perfectly (to my mind) sums up what is happening in the financial systems of the world.

(snip)

Fascinating stuff, but though he touches on the possibility of political upheaval, he doesn't go so far as to say that property rights can be reset along with everything else, i.e. when he says that debtors will be destroyed while creditors will end up with all the assets, if the reset includes a revolution then this is not necessarily the case.

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Fascinating stuff, but though he touches on the possibility of political upheaval, he doesn't go so far as to say that property rights can be reset along with everything else, i.e. when he says that debtors will be destroyed while creditors will end up with all the assets, if the reset includes a revolution then this is not necessarily the case.

this is the key: creditors will end up with the assets. These assets are actually liabilities on the banks balance sheets so must be sold.

Distribution of houses to savers will be the result, banks going bust the other.

Edited by Bloo Loo
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this is the key: creditors will end up with the assets. These assets are actually liabilities on the banks balance sheets so must be sold.

Distribution of houses to savers will be the result, banks going bust the other.

I think Huw has a point though; possession exists only by mutual consent and acceptance of the law. If a large enough percentage of the population are stripped of their possessions, then the system of law that alows this will probably break down.

Its like all the raves that the police failed to stop in the 90s, it is just not possible to enforce the law against the will of thousands.

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I think Huw has a point though; possession exists only by mutual consent and acceptance of the law. If a large enough percentage of the population are stripped of their possessions, then the system of law that alows this will probably break down.

Its like all the raves that the police failed to stop in the 90s, it is just not possible to enforce the law against the will of thousands.

ugh! soldiers on the streets?

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ugh! soldiers on the streets?

Be interesting to see. The army is overdeployed and anyway unenthusiastic about helping out this government. Those troops available might stand there, but I can't see much enthusiasm for breaking heads.

Ditto the police, who aren't really European-type paramilitaries, and who wouldn't be able to cope with anything more than localised outbreaks of civil unrest. Oh yeah, and they're not too keen on Clown Brown's gang either.

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Denninger is firmly in the deflationist camp and thinks that the goldbugs will be crucified as deflation takes hold. However he is an American and I don't think he gives enough weighting to the world picture, particularly the growth and inflation in countries such as China and Korea. Here in Europe there is also high inflation in the 'new' European countries, which is why Trichet is so obsessed with keeping inflation down. Our own government is also scared of inflation hence it is trying to make long term 2/3 year deals at low levels with the public sector. Everything the Fed is doing is to do try to avoid deflation which it fears could lead to a 1930s style depression. As an academic Bernanke blamed the depression on the Fed. He isn't going to do the same although the circumstances of credit bubble and unregulated markets are not unalike. Inflation can happen when asset values fall (how much would you pay for a house in Zimbabwe).

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Be interesting to see. The army is overdeployed and anyway unenthusiastic about helping out this government. Those troops available might stand there, but I can't see much enthusiasm for breaking heads.

Ditto the police, who aren't really European-type paramilitaries, and who wouldn't be able to cope with anything more than localised outbreaks of civil unrest. Oh yeah, and they're not too keen on Clown Brown's gang either.

I agree

Thatcher realised that the police and the army had to be kept onside, and even she couldn't keep a lid on civil unrest.

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Oh yes, they were. I'm not saying the police can't be violent when required. I'm saying that there aren't enough of them.

I had friends who were sent up to cover the miners strike (police). they left here with the attitude that they would be standing in lines just controlling fellow workers, but when a few got busted heads, it became a them and us battle.

Many left the Police after that as they felt they were being used as soldiers, rather than protectors of the community. I know some of you here wont beleive that, but I think most Police join up to help the public and dela with thugs on the streets, but get dissillusioned by the courts and do gooders who put them straight back on the streets.

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Economist article...

"Particular problems, like the monoline insurers, should be dealt with by particular remedies, not the warm bath of monetary policy. It is early days, but one choice for Mr Dinallo would be to corral their worst risks in a “bad bank”, leaving the rest intact—and more tightly regulated."

I think this would actually go some way to resolving wholesale meltdown....but it still means that without insurance the muni bonds rating would have to reflect the risk of the issuer going bust.

http://www.economist.com/opinion/displayst...ory_id=10566731

Sounds like NR2 except that the "bad bank" in the case of Northern Rock is The Bank of UK plc Taxpayers. Will it work, though? Sounds more like a delaying tactic; the bad risks may be coralled to prevent further infection and to allow new business to be written on a sounder basis, but they are still there. I suppose the powers-that-be are relying on the economy picking up and the music starting to play again. Just like Gordon Bean and NR. If HPC goes away, and NR's loan book turns out to be good collateral, then all is well. However, what if a recession has not been headed off - either in the US or the UK? Buying time will not have helped - it will just have delayed, and probably magnified, the inevitable.

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I think Huw has a point though; possession exists only by mutual consent and acceptance of the law. If a large enough percentage of the population are stripped of their possessions, then the system of law that alows this will probably break down.

Its like all the raves that the police failed to stop in the 90s, it is just not possible to enforce the law against the will of thousands.

If the government favors currant homeowners the banks will stop lending mortgages altogether. That should bring down prices sharpish.

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If the government favors currant homeowners the banks will stop lending mortgages altogether. That should bring down prices sharpish.

As long as they don't repeal squating rights everyone will have somewhere to live. :lol:

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From John Mauldin's Weekly E-Letter:

What Does the Fed Really Know?

I believe the monoline insurance companies like Ambac and MBIA are in worse shape than most realize, the counter-party risk in the $45 trillion Credit Default Swap market is much worse than we realize, and the exposure by various banks to their problems is much larger than currently understood. The Fed understands this, and realizes that they have been behind the curve but need to catch up. Let's go back and look at this quote from my letter just last week:

"If you are a bank or regulated entity, and you have mortgage-backed securities that have been written by a AAA monocline company, you can carry that debt on your books as AAA. But as the companies get downgraded, you have to write down the potential loss. Quoting from a recent note from Michael Lewitt:

" 'MBIA's total exposure to bonds backed by mortgages and CDOs was disclosed to be $30.6 billion, including $8.14 billion of holdings of CDO-squareds (CDOs that own other CDOs, or mortgages piled on top of mortgages, or, to quote Jeff Goldblum's character in Jurassic Park again, 'a big pile of s&*^'). MBIA was being priced as a weak CCC-rated credit when it issued its bonds last week; it is now being priced for a bankruptcy. MBIA's stock, which traded just under $68 per share last October, dropped another $3.50 this morning to under $10.00 per share.

" 'The bond insurers' business model is irreparably broken. In HCM's view, it will be all but impossible for these companies to raise capital at economic levels for the foreseeable future and certainly in enough time to work out of their current difficulties. The performance of MBIA's 14 percent bond issue will prove to have been the death knell for this business. The market needs to come to the realization that the so-called insurance that these companies were offering is not going to be there if it is needed. The fact that these companies were rated AAA in the first place will remain one of the great puzzles of modern finance for years to come.'

"You can bet that the $8 billion in CDO-squareds is gone. It is a matter of time. MBIA's market cap is about $1 billion [it is now at $1.74]. Current shareholders will be lucky if they only get diluted 75%."

Think this through. MBIA is still rated AAA. Ratings downgrades are just a matter of time. Banks that raised $72 billion to shore up capital depleted by subprime-related losses may require another $143 billion should credit rating firms downgrade bond insurers, according to analysts at Barclays Capital.

Banks will need at least $22 billion if bonds covered by insurers, led by MBIA Inc. and Ambac Assurance Corp., are cut one level from AAA, and six times more than that for downgrades by four steps to A, as Paul Fenner-Leitao wrote in a Barclays report published today. Barclays' estimates are based on banks holding as much as 75% of the $820 billion of structured securities guaranteed by bond insurers. (Source: Bloomberg)

The stocks of MBIA and Ambac have risen on speculation of take-overs or a rescue. But MBIA is going to have to cover that $8 billion of CDO squareds. With what cash? MBIA makes about $5 billion a year. It will take almost two years' earnings just to deal with the losses from CDO squareds. Not to mention the subprime mortgage exposure.

But what if the above-mentioned monolines are downgraded to junk, as was ACA when it could not raise capital? As the downgrades on various mortgage assets and the CDOs continue to increase, the ability of the monolines to deal with the problems is going to come under increasing question. The losses at major banks could be much worse than $122 billion if they are downgraded to the same junk level that ACA was.

And that is just the credit default swaps (CDSs) from the monolines. What about the trillions that are guaranteed by banks and hedge funds? There are a total of $45 trillion CDSs outstanding.

No one is really sure who owes what and to whom, and what is the risk that there may be no one to pay that CDS when it comes due? The entire mess is going to have to be unwound in the coming quarters. It may take a year or more.

I think the concern that there is the potential for a much worse credit crisis than we are currently experiencing is what is driving the Fed. They are looking at the problem from the inside, and realize that they simply have to engineer a much steeper yield curve to allow the banks to make enough profits so that they might be able to grow their way out of the crisis over time.

If I am wrong and the Fed was responding to the stock market, then we will likely not see a cut this next week. But if we get another 50-basis-point cut, as I think we will, then it means the Fed is responding to concerns about the credit crisis. And we will get another cut the next meeting and the next until we get down to 2% or below.

A 50-basis-point cut takes the rate to 3%. It they had cut the rate by 1.25% next week, the market would have collapsed. Better to do it in two leaps is what I think they are thinking. We will see. And it is not just the Fed that is concerned.

http://www.frontlinethoughts.com/pdf/mwo012508.pdf

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Interesting how quickly this has fed into other areas of the economy.

Who would have thought that problems in US bond insurance schemes would be effecting UK PFIs in less than a week !!!!

"AirTanker ditches PFI funding plan"

http://www.telegraph.co.uk/money/main.jhtm...irtanker126.xml

Edited to add IMHO the cost of credit is going to go through the roof.

Edited by lufc
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Interesting how quickly this has fed into other areas of the economy.

Who would have thought that problems in US bond insurance schemes would be effecting UK PFIs in less than a week !!!!

"AirTanker ditches PFI funding plan"

http://www.telegraph.co.uk/money/main.jhtm...irtanker126.xml

Edited to add IMHO the cost of credit is going to go through the roof.

Oh dear. You know i never understood the purpose of PFI, surely its cheaper and easier to issue some more Gilts. Oh I forgot that would make the budget deficit look worse wouldn't it Gordon? I say you should put PFI debt in the deficit. :lol: Another Labour rabbit hole!

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Oh dear. You know i never understood the purpose of PFI, surely its cheaper and easier to issue some more Gilts. Oh I forgot that would make the budget deficit look worse wouldn't it Gordon? I say you should put PFI debt in the deficit. :lol: Another Labour rabbit hole!

Invented by the Tories though :rolleyes:

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Interesting how quickly this has fed into other areas of the economy.

Who would have thought that problems in US bond insurance schemes would be effecting UK PFIs in less than a week !!!!

"AirTanker ditches PFI funding plan"

http://www.telegraph.co.uk/money/main.jhtm...irtanker126.xml

Edited to add IMHO the cost of credit is going to go through the roof.

Why on earth would a PFI scheme require bond insurance? How could a monoline insurer ever have had a higher credit rating than the UK government?

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I agree

Thatcher realised that the police and the army had to be kept onside, and even she couldn't keep a lid on civil unrest.

I heard on the radio a few days ago that when she entered office, Thatcher asked:

"how do I control inflation?"

The reply from humphrey was to

"pay the police and army more, you'll be needing them".

Don't know if it's true, but certainly , looking back she did need the police on side.

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How could a monoline insurer ever have had a higher credit rating than the UK government?

They don't and haven't. The reason PFI exists at all is to get the cost of the projects funded that way out of the public sector borrowing requirement so that GB can claim he's not breached his 'don't borrow more than 40% of GDP rule'. By having the money raised privately, it doesn't show up in the statistics although the interest on it turns up in annual government expenditure in the form of annual fees paid by the NHS et al to PFI suppliers. MBIA and other bond insurers were happy to insure these issues since it's clear, in reality, they are government backed. We should be thankful for small mercies I guess since it did at least reduce the costs for us taxpayers a bit (not by as much as if the government had issued the debt directly of course).

It's all a horrible con-trick and one of the reasons NuLabour may well go down in history as the most financially incompetent governments of all time.

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