The Richter Scale

The Confidence Fairy

noreply@blogger.com (Unknown) — Sun, 15 Feb 2015 19:07:00 GMT

George Osborne has presented himself as the “Iron Chancellor” willing and able to make the tough decisions required to see-through the Tories “long term economic plan”. With an Election 80 days away it’s time to assess his track record in this regard as he is now promising (with some glee) another 3 years of austerity, as he tries to achieve a budget surplus in by 2018. Osborne believes the winning narrative goes like this: Labour wrecked the economy, we inherited unsustainable debts, we then embarked on un-popular but necessary polices to restore confidence in the UK economy and bring down the deficit, these policies took time to work but supported by monetary policy (QE) the plan is now paying dividends. One would have to be a dumb fish to swallow this story hook line and sinker.

Taking the bait

Let’s rewind the clock to 2009 the year before the Coalition government came to power. 18 months after the financial crisis things were pretty black. The Labour government had bailed out two of the three major UK banks because of their unwise lending and derivative trading. Alistair Darling, the then Chancellor, had cut interest rates to 0.5% and reduced taxes on expenditure and as a results an enormous structural deficit opened-up. The deficit in the UK ballooned from 3% of GDP in 2007 – 08 to 11% in 2008-09 this added £120bn to the UK’s overall debt in one year. Due to our disproportionate exposure to the banking sector and soaring welfare bills, caused by Gordon Browns obsession with tax credits, Britain was the lamest duck of all the major economies “the sick man of Europe”. Things were pretty black at home and abroad there were genuine concerns that Greece would default and that other peripheral Euro-zone economies might follow suit – short term interest rates were rising and the UK was in the spotlight. Against this back-drop the election of May 2010 was fought in a febrile atmosphere. Whilst both major parties offered some form of austerity The Tories pandered to the fear that existed and won the election and (what they believed) was a mandate to sort out the public finances through austerity.
As with an historical analysis timing is everything and there are three specific milestones that need examination:

In the summer of 2010 were the Tories correct in their analysis of the problem and was austerity the first best option?
In 2011-12 should the Tories have changed to plan B when we were in danger of a double dip recession?
Was the recovery in 2013 unnecessarily delayed due austerity or was our recovery (earlier than other major economies) the direct result of government policy?

On point one it was pretty clear that in 2010 there were pretty awful scenarios that were a real danger to the UK economy, our credit rating was under watch, we had the biggest deficit in Europe and other countries, in less dire circumstances, where in danger of default – Ireland, Greece and Portugal. The great wealth and prosperity of the UK, built up since 1980, was at risk and there was a real danger that things could end badly. It was therefore important for the markets and business confidence (what Krugman dismissively call the confidence fairy) that the new government was seen to be tough on the deficit. There is no doubt that this worked, the ratings agencies lost interest for a time, business confidence and investment returned and private sector growth in 2010-11 more than compensated for the first round of public sector austerity.

On point two things are less clear cut. The main mistake the Tories made was to leave large sections of the overall budget out of the austerity plan (welfare and Health) this meant that the saving had to come from a some number of spending departments and this forced minister to cut the investment budget – many school build programmes were shelved, transport improvement were put on hold and so on. It is always easy to cut the capex budget but when falling demand is one of the main problems it should not have been the focus. This meant structural change was delayed and aggregate demand unnecessarily reduced. But we should also remember the Eurozone crisis rumbled on until Mario Draghi finally offered to” do whatever it takes” in July 2012. It was only at this point that long term interest rates started to fall across Europe and the specter of defaults on the continent faded away. So whether plan B should have been adopted in 2012 is probably a moot point. Up until the summer of 2012 economic catastrophe was still possible because of uncertainty in the Eurozone and by the autumn on 2012 Osborne had at any rate given up on is spending targets – and we were is a world of austerity-lite

On the third point it is fair to say that the way austerity was implemented was poor – cutting investment budgets and “ring fencing" major spending departments from the programme of cuts caused unnecessary pain. Having said that we were the first major economy to achieve “escape velocity”. Maybe we might be slightly better off but claims made by Paul Krugman and Simon Wren-Lewis that we are all £2,000-£1,500 worse off due to the Coalition government’s economic policy is hard to fathom.

The balance of argument hinges on the issue of confidence, the macroeconomic models used by academic economists made a good fist of most variables by they are unable to factor in the impact of confidence. If there had not been a willingness in 2010 to tackle our huge debt there is little doubt that domestic business and overseas investor confidence would have been knocked, this would have led to massive out-flows of money from the UK. The Coalition policy did at least restore confidence and this was indirectly responsible for recovery as in 2011-12 as the instability in Europe allowed a stable UK to draw in a very large of Foreign Direct Investment (FDI) - the main reason for recovery. So we should be thankful for the “confidence fairy” and broadly ignore the Keynesian revisionist s who, egged on by dubious Greek claims, are so loud in their assertion that austerity failed in the UK and elsewhere.

A Free Lunch for Europe

noreply@blogger.com (Unknown) — Sat, 7 Feb 2015 17:06:00 GMT

In three short years Angela Merkel has gone from being the Superwoman to the Boggiewoman of Europe. Having faced down the Euro crisis of 2011-12 she became the heroine of the hour – being fated around the world and the re-elected at home in 2014. Her unwavering commitment to securing the Euro based on secure fiscal framework has made her the Mistress of Austerity. It was she who enforced the bail-out process and the “Fiscal Pact” that accompanied the money.

Here's looking at you PIIGS

The recipients of the bail-out cash – Portugal, Spain, Cyprus, Ireland and Greece had to sign up to stringent terms associated with fiscal responsibility in order get the bail-out cash. These fiscal rules have been the great enforcer of austerity and were put in place at the insistence of Merkel and the German courts. "Fair enough" one might say - as Germany accounted for 27% of contributions to the bail-out fund, paying out 21.7bn euros in cash and providing guarantees worth a further 168.3bn euros and so the permanent bailout fund and its fiscal watch dog (Treaty on Stability, Coordination and Governance in the Economic and Monetary Union; or more plainly the Fiscal Stability Treaty) was born. You might say that there is no such thing as a free lunch!

The problem for most Europeans is that they actually believe that they are owed a free lunch – they feel that they have a right to Frau Markel’s cash and hard as it may seem I think they have a case. The problem for the Germans is that their over bearing and efficient manufacturing economy is the cause of the European problem – or much of it. Here is a chart that shows why.

A chart that tells an uncomfortable story for Angela Merkel

The chart (OECD data on trade performance) shows the balance of payments performance of various European countries in the period 1990 -2013, which covers nine years prior to the Euro and fourteen years of the Euro. It’s not easy to miss the inflection point. In 2000 there was a dramatic change in direction – Germany’s export performance greatly improved and the other most her European partners suffered as a result. Between 1990 and 1999 Germany had a manageable trade surplus of between $15-60bn almost immediately after joining the Euro Germany saw its trade surplus balloon to over $200bn annually. The detrimental effect this has had on the rest of Europe can be seen in the chart also - France and Italy, who had been running surpluses, went into deficit and for other less well developed economies the effects were much more catastrophic! The total advantage the Germans have gained from the Euro so far has been about $2.5tn – that’s a lot of zeroes! Now Greece wants to be cut some slack and Frau Merkel should remember that her economy has been exporting cars, pain and unemployment to the southern members of the EuroZone for the last 14 years and its time she got off the PIIGS back!

The solo becomes a duet

noreply@blogger.com (Unknown) — Thu, 5 Feb 2015 21:08:00 GMT

The world economy is a bit like my early love life – long periods or inactivity and boredom interspersed with rare flashes of excitement. Growing up in rural England with no Facebook, mobile phone, nor any natural ability to chat up girls made things pretty dull! The same is true of the world economy - one minute we are in a world of dull stagnation and deflation and the next we are in mortal danger, thanks to Greece.

The excitement of a good riot

Right now we have the Germans and the Greeks to thank for this (unwelcome) moment of excitement. The Germans don’t have the good manners to either extend or write off the ridiculously large Greeks debts and the Greeks don’t have the humility to take orders from the Troika any longer. But why should the imminent default of the world 43rd largest economy cause such a rumble. The default would add about $300bn of debt to other EuroZone members. Whilst $300bn is a lot of money it’s a drop in the ocean when compared to the overall debts in the developed world today – in fact it’s about 0.015% of the $200tn world's debt mountain.

The world’s debt can be categorised into four segments:

Government debts – the difference between government spending and receipts - funded selling government bonds to the banks
Financial debts – leverage held by banks
Corporate debts – Debts taken on by business funded by the banks
Personal debts – Debts taken on by private individuals and funded by the banks

How the debt stack up

The common denominator is the banks; the systemic risk in our financial system comes from the leverage that the banks took on in the years 2000-2008, to fund massive levels of loans and derivative trading of junk grade assets associated with the housing market – mortgage backed securities. The banks have been forced to deleverage over the last six years but there is still a huge amount of distressed debt in the system, Greek loans being a great example. The second problem is that Governments have added hugely to the overall level of debt – some of this is from bailing out the banks (the TARP programme and the bailouts of Lloyds and RBS in the UK) but most of the increase comes from straight over spending – funding programmes that they can’t afford. These two problems have meant that debt ratios in the developed economies have risen by 20 percentage points to 275pc of GDP since Lehmans went under – in other words the world is a more dangerous place than it was in the summer of 2008! The problem about the Greek debt crisis is that it will put a lot more stress on both Government debt and banking debt.

The Bank of international Settlements (BIS), the only bank to forecast the crash, tell us that in addition to the increasing debt ratio credit spreads have fallen to wafer-thin levels and 40pc of syndicated loans are to sub-investment grade (junk) borrowers, a higher ratio than in 2007, with even fewer protection covenants for creditors. Much of this credit boom has happened in the emerging markets who have succumbed to private credit booms of their own, partly as a spill-over from quantitative easing in the West. As the BIS say “Time and again, in both advanced and emerging market economies, seemingly strong bank balance sheets have turned out to mask unsuspected vulnerabilities that surface only after the financial boom has given way to bust.” This inability to deal with distressed debts is costing us dearly. Added to this pattern of serial forgiveness central banking policy has been easy during the up swings aggressively loose and persistently during busts. This induces a downward bias in interest rates and an upward bias in debt levels, which in turn makes it hard to raise rates without damaging the economy – a debt trap. If you look back of 30 years the level of interest rate required to create recovery has fallen from about 8% to today negative %. The BIS go on to tell us that as “private and public debts continue to grow, the economy fails to climb onto a stronger sustainable path, and monetary and fiscal policies run out of ammunition. Over time, policies lose their effectiveness and may end up fostering the very conditions they seek to prevent". We are obviously in a vicious circle.

There is now a unhelpful argument prevailing between the left and right. On the left the economic problems are seen as a liquidity trap, requiring governments and central banks to feed in more and more credit – quantitative easing and public expenditure. The BIS leads the charge on the debt trap side of the argument, which tells us that we need to continue the deleverage process to return to a world were banks are safe and interest rates are positive, but the BIS are a lone voice railing against the chant of all the main Central Banks. But there is something true and inspiring, like the perfect pitched voice of a single chorister, about their contrary take on the economic crisis – neatly summed up as - “There is something strange about fighting debt by incentivising more debt." But fear not the solo has become a duet as the most famous global management Consulting brand joins in on the side of debt reduction -

McKinsey’s survey of debt across 47 countries — illustrated in an FT interactive graphic — highlights how hopes that the turmoil of the past eight years would spur widespread “deleveraging” to safer levels of indebtedness were misplaced. McKinsey go on to say that “This calls into question basic assumptions about debt and deleveraging and the adequacy of tools available to manage debt and avoid future crises.” Hopefully the report will even up the debate among economists about what is an appropriate level of debt in an economy. McKinsey argues that high debt could constrain growth and create fresh financial vulnerabilities.

As the US and UK emerge from recession it is down to the Fed and the Bank of England to create a new order in which we “mend the roof while the sun is shining”. These two venerable institutions must take a lead in raising rates, enforcing a real deleverage to restoring the banking sector to health and finally blow away the house of card that has been built on credit and weak banks.

Forgive and Forget

noreply@blogger.com (Unknown) — Wed, 4 Feb 2015 10:12:00 GMT

The Greek crisis is about the only story being covered by the financial press. It’s the perfect seasonal pantomime not unlike Cinderella – a damsel in distress (Greece and its distressed debts) the drama of a tight deadline (Greece could run out of cash in March), comedy villains (the Trokia of the ECB, the European Commission and the IMF), a grumpy old maid (Angela Merkel) a handsome prince (Alexis Tsipras, the Greek prime minister, and his henchman Yanis Varoufakis, the finance minister). The only questions are; where is the Fairy Godmother who might save the damsel in distress and will there be a happy ending?

George and Yanis - could this be the start of a special relationship?

The problem for Greece is in identifying the fairy godmother. The parsimonious northern governments in the Eurozone will oppose anything that looks like a sell-out to extremists having already provided a substantial bail-out in 2010-11. The more profligate southern states have a different problem where the French, Italian and Spanish governments are strongly opposed to legitimising an anti-austerity, which would give credibility opposition parties like Podemos in Spain and the National Front in France. So if the fairy godmother is elusive maybe we need to understand the what the act of salvation might look like.

The overall size of the debt is high - €317bn,which amounts to 170% of GDP. These debts have maturities on average of 16 years. On the other side of the balance sheet the Trokia have asked Greece to run a fiscal surplus (excluding interest payments) of 4.5 per cent of GDP to keep the bail-out going - can anyone name a developed country that has run a fiscal surplus of 4.5 of GDP for 16 years.

The Greeks have been diligent in enforcing austerity to day and have achieved the primary fiscal surplus target but as some cost. The debt to GDP ratio has rocketed from 90% to over 170% in four years and a big chunk of this comes from the enormous decline in GDP. The Greece economy has shrunk by over 20%, that’s like losing London’s economy for the UK, imagine the trauma that would entail.

The new Greek government propose that they should be allowed to do three things:

Running a surplus of only 1.0 to 1.5 per cent, instead of the 4.5%. this would allow them to increase government spending by around 3% and given the very depressed state of the Greek economy, this may make sense.
Extending the maturity of their existing loans and having access to the continued bail-out programme. Extending the maturity of their loans. Whilst the Greeks have longer dated loans than other EU members (see the charts below taken from the FT) they are still by historical standards short term – extending the loan profile from 16 years to 30 years (the UK has only just finished paying off its debts from the First World War!!) they would be able to reduce the debt to GDP ratio to under 70% - a quite manageable number. Today Greece’s nominal interest spending in 2014 was 4.3 per cent of gross domestic product, less than Italy or Portugal and with a further extension of the maturity of loans this number could become very manageable.
Revise the structural reform programme to more closely reflect the politics of the new government – less privatisations, more public investment and so on. On the basis that they won a democratic election on this basis – this looks quite fair

The problem therefore seems to be political rather than economic. The Southern states have a problem - “How can the Spanish or Italian prime minister tell voters that Greece has a lower interest burden than we have, but we still need to give them debt forgiveness”. The Germans and French have a problem with anti-European parties that would “weaponise” any leniency to Greece on debt forgiveness.

So that leaves only one major economy in the EU that could broker a deal – enter stage right the Fairy Godmother – otherwise know to me and you as George Osborne!

Who is rigging the market now?

noreply@blogger.com (Unknown) — Sun, 18 Jan 2015 23:33:00 GMT

In the run up to the credit crunch the market manipulations perpetrated by the world’s largest investment banks are now well known to us. The banks rigged many of the important markets required for the global economy – proprietary trading held sway, credit and other derivative products were miss-sold, reference interest rates (Libor and others) were fixed and so it goes on. Fortunately for us governments around the globe and their central bankers have been on a mission to sort out these market abuses. The Wolves of Wall Street have been tamed by the Gnomes from Zurich, the ECB and the Fed – all very reassuring. That is until one looks closely at the market manipulation now being pushed through by Central Banks culminating in the completely unexpected decision of the Swiss National Bank (SNB) to remove the 1.20 floor on the Swiss franc against the Euro.

Anything the banks can do .....

As Gavyn Davies tells us this was “one of the biggest currency shocks since the collapse of the Bretton Woods system in 1971. The decision has been heavily criticised, both for its tactical handling of the foreign exchange market, and for the collapse of the centrepiece of its monetary strategy, without (apparently) any overriding cause. The credibility of a central bank that has traditionally been hugely respected by the markets has clearly been dented.”

Central banks have been having a field day saving the world from depression – first we had the huge credit stimulus (bank bail-outs) then rounds 1 and 2 of QE, followed by forward guidance and the big bazooka and more recently we have had the shenanigans around QE in the Eurozone, which prompted the move by the SNB.

Central Bankers assumed the mantle of superheroes in 2008 as they helped navigate the world economy through the wreckage created by the political decision to let Lehman Brothers go to the wall. They had a good start but more recently they seem to be losing the plot. The growing inertia around deflation and the legitimacy of QE in Europe have undermined the view that Central Bankers can do no wrong. The final straw was the move by the SNB, which creates some profound implications for the credibility of the wider market interventions by global central banks, on which asset prices currently depend. As part of the package the SNB has now set a negative interest rates on some deposit accounts of -0.75 per cent. If this proves effective, other central banks may follow suit. And, over time, that may take global bond yields further into negative territory and set asset prices soaring once again.

It is important to see that QE is also a market abuse as the processes effectively acts as a bail-in of indebted governments (through inflation and growth) by longer terms savers who have to rely on fixed income instruments. These savers are in fact middle class often low income families who pensions are being destroyed by QE the sole aim of which is to reduce long-term interest rates. Perverse isn't it that the very economist who propose the use of QE so vociferously are on the left of the political spectrum!

I guess the question is who’s market rigging has been the most damaging: the under-regulated investment banks or the over-zealous Central Banks. In 2009 the answer was pretty obvious but today it’s a tighter judgement call. The overly public ministrations of the Central Banks allow the market participants the opportunity to bet with the bank and this tacit and symbiotic relationship, where investment banks repair their balance sheets at the expense of national balance sheets (the tax payers) is starting to look pretty ugly. Over the last 5 years we have seen:

Bank bail-outs – government cash for banks
QE that pumps up asset prices to the great benefit of banks as they can bet on asset prices rising with no fear of market downturns
Negative real long term interest rates that have driven the bond markets higher and higher

These one way bets have allowed the Central Banks to re-capitalise the investment banks (at the expense of the tax payers) whilst providing a smokescreen of fair play. The move by the SNB was the first indication that this unholy alliance may be coming to an end, the surprise was somewhat welcome!

Demand for the old normal

noreply@blogger.com (Unknown) — Mon, 5 Jan 2015 19:56:00 GMT

For the last six years the developed world has been suffering from a chronic shortage of demand: demand for goods, demand and services, demand for investment. The need to deleverage personal, corporate and government debt has meant that there has been massive excess capacity and a huge shortfall in aggregate demand. This lack of demand has been driving up unemployment and driving down prices. All this has been complicated by the fact that we in the West are at the zero bound of interest rates this nasty cocktail has been characterised as secular stagnation. Over the last six years wages in all normal income groups have flat-lined and living standards will now be lower at the end of this economic cycle than they were in 2008 – this is extraordinary, almost unheard of in the developed world. Or is it? Thomas Piketty, the French Rock Star Economist (is that an oxymoron as the French have no rock stars?) would have us all believe that we are now returning to a more normal state of affairs, where vast pools of wealth lie idle in the hands of a financial elite and the rest of us jog along at a steady but uninspiring rate.

A French Rock Star??

The political response to this evaporation of demand has, in the main, been to further reduce demand by cutting government expenditure and regulating the banks so that they are unable to lend money to would be investors, a result of the new capital adequacy rules. All of this has added further to the massive reduction in demand! Some argue that it has been necessary, the hawks tell us that growth and prosperity can only return when the “deleverage” is complete and they held sway in the early days of the Great Recession. More recently the Keynesians, ably led by Larry Summers and Paul Krugman have implored governments to throw caution to the wind and pour money into this black hole of aggregate demand with increased government investments and spending (and debt). There is a lot of angst between these two groups the Keynesians believe that huge capacity has been wasted unnecessarily and the hawks point to austerity in the US, UK and Spain as proof that recovery can only come when debts have been reduced to a manageable level. Piketty, who only joined the fray in 2014 is offering a more dramatic approach, which although not evoking the guillotine would nevertheless murder the savings of super wealthy people.

Gavyn Davies, who sits right in the middle of these camps, believes that this shortfall in demand is going to become a thing of the past in the US. As consumer spending in the US and UK drives growth there will increasingly be a more nature balance between supply and demand. He tells us that “this will be a year in which excess capacity in the global economy will start to be absorbed”.

Gavyn's Chart

Add to this improving picture the recent drop in oil prices, that could add as much as 1% GDP growth to some developed economies, and we are at a tipping point. This is by no means true across the board, whilst the Anglo Saxon economies look likely to see capacity dwindle away, many developed economies in the EuroZone will still be in stagnation mode for a while. Mr Davies goes on to tell us that “Overall, then, economic performance in 2015 is likely to be a walk on the demand side. The supply side is showing no sign whatever of any improvement but, outside the US, that is still a long way from being the binding constraint on output”.

The question is, how will this play out in a highly globalised world? If, for arguments sake, demand becomes constrained in the US and UK during 2015 will these constraints manifest themselves in the normal way, through inflation and an up-tick in investment or will the threats that over-hang the rest of the world’s economies , of which deflation in the EuroZone is only one, mean that normal interactions might be suspended. Could inflation remain benign, investment weak and productivity low, as owners of capital continue to gravitate towards financial assets rather than new investments in productive capacity? Does the fact that so much wealth is now tied up in the hands of the old or very old mean that investment risk appetite is permanently damaged and that we have to, as Piketty tells us, tax these deal pools of wealth to get the money back into circulation

The answer to all this is almost certainly NO! I don’t have an equation that proves this but I don’t think I need one – normal service WILL BE RESUMED! Any way let’s hope so!

Crude benefits of falling oil prices

noreply@blogger.com (Unknown) — Tue, 30 Dec 2014 13:21:00 GMT

The ending of QE in the US and the fall in the price of oil from over $115 a barrel to under $60 a barrel were the defining economic events of 2014, but their consequences will not be felt until next year. The ending of QE in the autumn brought to an end the huge expansion of the US Federal Reserve’s balance sheet, since 2008 the Fed has pumped some $2.3tn of “new money” into the world economy which has had a wondrous effect on asset prices in all sorts of weird and wonderful places. London property prices have boomed, stocks in emerging markets reached new heights and bond prices sky rocketed as yields collapsed – also commodity prices boomed and oil was not left out of the party. Between 2009 and 2011 oil prices rose from $40 to $125 a barrel, driven by ever increasing demand from emerging markets and $1.9tn of US and UK QE. Following the boom in commodity prices between 2011 and 2013 prices stabilised at a high level before falling off a cliff in 2014.

The Crude Story

Why the price of oil has fallen is less important than its potential impacts – many believe it to be a supply side shock (increased production in the US due to the boom in fracking) or weaker demand from China and Europe as their economies struggle to grow. Whatever the reason the huge fall in the price of oil at this moment is highly fortuitous as it coincides with the end of QE. Halving of oil prices has the same impact as reducing interest rates by between 1- 0.75%, this is a massive stimulus (given we are at the "zero bound" of interest rates) for the developed world, as we are often net importers of oil and always huge consumers of the same. The IMF tell us that- The plunge in the price of oil represents a “shot in the arm” for the global economy which could boost overall world economic growth by between 0.3 and 0.8 per cent. So who will be the main beneficiaries?

Europe and Japan

For Europe the fall in the price of oil is a very welcome bonus when the politics of QE and German monetary loosening were becoming very difficult. Some are worried that falling oil prices will just add to the deflationary pressure that has building in the Eurozone, but this is wrong as lower costs of oil must help European competitiveness / productivity, which after all in is the main problem. A stimulus equivalent to a half point cut in interest rates must be very positive for the whole region. The question is will this be too little too late, as the Greek election may over shadow everything and if a new bailout is not agreed there may be a catastrophic event that even the falling price of oil cannot mask. In Japan, where Abenomics looks to be a busted flush, falling oil prices should be a positive in driving productivity, but will not help achieve the (meaningless) inflation targets set by the government. In Japan the level of public debt, anemic growth, depopulation and falling productivity make the oil price fall somewhat academic.

US and UK

The question for the US and the UK, who are at an advance stage of recovery, is whether the stimulus package will be enough to encourage central banks to raise interest rates. The consensus view is that both the Fed and the BoE will only start to raise rates in the second half of the year and then only very gradually. With both countries growing at around 3% and with real incomes starting to rise there will be increased pressure on the two Central banks to increase rates more quickly and more steeply. Lower oil prices will definitely bring forward the time table for high rates in both countries and this will have a substantial impact on the price of the dollar, which could potentially achieve parity with the Euro. A strong dollar should be good for the US's "relatively closed economy" but could be dangerous for Britain where our current account deficit is a major concern.

Emerging markets

In the emerging markets, where the ending of QE has in many cases been difficult is it difficult to see any good news. In the oil exporting countries like Russia, Nigeria, Brazil and Venezuela thinks could get very bad and currencies go into free fall and inflation spirals up with ever increasing interest rates. In the oil importing emerging markets the problem is that US monetary tightening will be mostly negative as it will force interest rates higher locally, when economic conditions may warrant lower rates. Also the increased cost of dollar borrowings, reckoned to be about $6tn in emerging markets, will weigh heavily on the developing world.

So the winners are likely to be the UK and the US who are at the most advance stage in the recovery cycle. They will benefit from the competitive advantage of lower prices and importantly the advantages of positive interest rates; that are a necessary component of a thriving economy where investment and innovation reap the greatest rewards.

Floating free from Germany

noreply@blogger.com (Unknown) — Thu, 27 Nov 2014 16:07:00 GMT

Mario Drahgi has called for more integration and “sweeping powers” for the ECB to control fiscal policies and efforts to reform the Eurozone's economy. Is this “joined-up” thinking is a throw-back to the darkest days of the Euro crisis, when it became obvious that there was lack of cohesion between member states? Or is this a power grab by the ECB, using the interminable recession, as an excuse to take control of a “fiscal and economic union”. Currently the ECB owns interest rates and sets budget targets (roundly ignored by all but Germany), in this new and enlightened world the EBC would like set tax rates and drive to through supply side reforms to drive productivity and competiveness.

Drahgi believes in the “importance of each country sticking to its commitments under the stability and growth pact “and that this should now be beyond debate”. He would like to go further by saying that in matter economic “sovereignty should be exercised jointly” – what a great line!! What are the things that could do with harmonisation?

1. Actual interest rates
2. Rates of business taxation
3. Minimum wages and hours of work
4. Actual spending limits (properly enforced)

Living in Harmony

There has certainly been a lost opportunity for the EZ member states to have coherent policies across the whole fiscal and monetary landscape and if more had been done in the first 10 years of the Euro’s life we might be in a better place than we are today. The great credit boom of 2002-08 might have been avoided, the huge government deficits might be lower and uneven competitiveness might be less of a problem – but none of this is at all certain. In the UK where we had absolute control of all the levers we still mucked things up badly – losing control of public spending and the current account.
The call for greater centralisation is the normal knee jerk reaction from bureaucrats when faced with any problem, but I am not sure that the timing is good – having missed the opportunity to have a more joined up economy what Europe needs now is less cohesion. The over-riding problem in Europe is lack of competitiveness in the Southern States (including France) compared to Germany and other northern European countries. The only way to sort this out is to have deflation in the South and Inflation in the North over a significant period (say 5 years), this will resolve structural imbalances that are causing so much pain. It is pretty obvious that Europe is too tightly coupled by the shared currency to achieve this structural change.

What is now required is a period where all Euro “currencies” float free against the German Euro for a fixed period and then re-join the single currency at more competitive rates, this would allow the EuroZone to avoid years of pain associated with the re-balance that is now a necessity. This organised revaluation would probably be linked to the ejection of certain “currencies” from the EuroZone where a longer term fix might be required. Without a strategy to re-balance in an orderly way the politics will become too painful and then anything might happen. Once those re-joining do rejoin the German Euro the new harmonising institutions and mechanisms should be in place to sustain a new single currency. The only alternative to this is for Germany to leave the Euro and leave the less productive and less prudent nations to sink gently into the abyss together - which is probably the first best option!

Winning the productivity race

noreply@blogger.com (Unknown) — Fri, 21 Nov 2014 08:41:00 GMT

Seven years on from the start of the Great Recession the slump looks set to go on and on. Even David Cameron who seldom mentions the economy was stirred this week to reinforce the message that - the worst may not be over.

Certainly, in the UK we have had some growth but we still have high levels of government debt and a crippling trade deficit and our main trading partner is in real trouble. It is now certain that the major economies in the developed world will never recover the lost demand that has opened up between actual GDP and the trend line established over the last 20 years. This puts us in new territory, as in every other recent recession the global economy has always been able to close gap in “temporary” lost demand during the expansion phase of the economic cycle. In real terms, people in virtually every developed country will be poorer at the end of this economic cycle than in 2007! This is a pretty stunning revelation – we have forgotten how to grow!

It’s pretty easy to agree that this recession was triggered by the financial crisis, which was caused by a loss in confidence in over-leveraged banks; that had greedily lent money to undeserving borrowers on an unimaginable scale. It quickly became clear that this accumulation of debt that can’t be honoured (distressed debts) was not just a banking problem as governments found their budget deficits spiraling out of all proportion as recession reduced income from taxes and raised expenditure.

The Great Recession is a consequence of aging populations and this deleverage: people, businesses, banks and governments have all been learning to live within their means and this has decimated aggregate demand. This austerity has had three important impacts on the real world economy, it has driven up unemployment, it has caused a drop in real incomes and it has devastated investment. The fall in employment and wages is terrible for those concerned, the scars will be deep but we know they can be healed. But the really worry is the lost investment as the wealthiest in society hang on to their money rather than invest in productive capacity and this results in decline in productivity.

Productivity is the most important building block in long term wealth creation – between 1990 and 2007 the UK increased productivity more than any other advanced economy, this had a wondrous effect on living standards; but since 2007 there has been a tragic decline in investment and this is despite negative real interest rates. In addition to the reduction in investment from both the private sector and the government to help meet austerity targets, The investments that have been have been made have been in existing assets like property and financial products rather than capital expenditure in projects that will improve productive capacity.

This significant drop in investment could normally be corrected by lower interest rates but we have, already, had to slash interest to zero in order to keep the lights on, so there is no way to further loosen of monetary conditions. If businesses are flush with cash won’t invest at current interest rates, what needs to change? There are only two courses of action open to us. We can wait for the deleverage to complete, which could take another year or two and would have a high cost in lost capacity and higher unemployment or we can try to bridge the investment gap by increasing government expenditure on capital projects, which will further increase public debts. Both approaches have associated risks, but for the most part I have supported the need for deleverage to run its course rather than add further to public spending and government debts. This is because higher government debt will put the brakes on private spending and investment; people and businesses are risk averse to economies flirting with default or very high long term interest rates. More recently I have been thinking that I may have got this wrong and that the real danger is the long-term loss of productive capacity caused by low investment. The consequences of low investment are plain to see already; falling wages, growing inequality, increasing migration, falling demand and lower growth. It is our number one duty to arrest this decline in investment and productivity – we need to think the unthinkable. The only way trigger up-tick in investment this is for Government to take the lead.

What is needed now is a significant re-balance away from government spending on services, that cost money but have no impact of productivity, into capital projects that can drive productivity and don’t weigh on future spending requirements. Government should not pick the projects, but should enable private companies to take centre stage building on those things where we already lead the world - Design, Research and Further Education, Communications and Finance. The building blocks would be:
1. Ensure future access to low costs energy / electricity
2. Secure the UK as Europe’s main transport hub to the rest of the world and improve links between London and other regions
3. Become the global leader in super-fast internet
4. Build an integrated research capability based on our leading companies and universities

These investments need to be funded by cuts to non-productive public services and matched by investment from the private sector partners. In the UK the government spends about £60bn a year on capital programmes against £600bn of total spending on day to day services (Welfare, Pensions, Health, etc.) rather than capital projects. By shifting the balance from a 9:1 split to a more sensible 8.5:1 split we would be able to create a £30bn investment fund, which if matched by private companies could see over £60bn being pumped into future productive capacity. Investment on this scale would help current aggregate demand as well as providing the boost to future productivity that is so urgently required. Finding a further 5% cut in government spending will require politicians to do the unthinkable but the consequences of doing nothing are even less palatable, we need prepare for a future in which the UK can win the productivity race.

What a hedgehog knows

noreply@blogger.com (Unknown) — Fri, 7 Nov 2014 09:09:00 GMT

When, in 1948, Mikhail Naimy wrote “The more elaborate his labyrinths, the further from the Sun his face” he was already living in a world that was being over-run by complexity. Most of the greatest insights in art and science since the end of the Second World War have been conceived in a dense soup of analysis. There will no more be simple insights that change the world – mastering the complexity is everything. The keen amateur who is able to think freely and creatively is no longer taken seriously; the potting shed had been replaced by the data centre such is the explosion of data and variables required to understand the problems we face. We are living in the age of the Fox (who knows many small things).
This up-tick in complexity is obvious in the world of macro-economics as the simple relationships between money, prices, capacity and rates of interest no longer seem to work. Also old certainties about productivity and wealth have been debunked – this is an uncomfortable world for the Hedgehog – (who only knows one big thing). Obvious problems create resolutions that can be faced with bravery, although tactics may vary we can unite behind a shared vision or oppose it full on. If the problem is too complex to articulate then there will be no solution only a vacuum.

Where are the hedgehogs

Mrs Thatcher’s plan to restore the UK’s productivity and competitiveness in the 80ies was “hedgehogesque”, we may not have enjoyed the process and it certainly divided the nation, but at least the approach was clear, no one was being deceived by the complexity. This honesty in execution made for a simple political narrative – you were either for or against and this polarisation was the key ingredient for her success. She was able to mobilise a “moral majority” against the vested interests of trade unions and state owned corporations to reshape our economy in five short but painful years. Clement Attlee was able to mobilise a different “moral majority” in 1948 when he, with breath taking efficiency, created the welfare state. Both of these politicians simplified the message and gained the high ground for long enough to make a difference – they both had to tackle a mass of complexity but all the public could see was a hedgehog.

The danger for today’s policy makers is that in large parts of the developed world most people hanker for the simplicity but those in power have been unable to articulate the how we resolve the complexities that we face. This loss of communication and trust between policy makers and their “moral majority” has created a dangerous vacuum where new hedgehogs appear that have no need for a “moral majority” they just need a majority. So in the UK we have the rise of distasteful and small minded parties like UKIP and the SNP who gnaw away at frailties and insecurities, creating a destructive nationalism based on a false interpretation of history. This narrowing of and hardening of attitudes is now a widespread phenomenon across Europe and in the US, where the recent mid-term election have returned an unusually large number of unreconstructed hedgehogs from the backwoods.

In the UK there are exactly seven months to go before the next election – just enough time for someone to stand up and articulate an alternative narrative. Our problems in the UK are not caused by immigrants and bureaucrats in Brussels, they come from our inability to afford the standard of living we aspire to. This gap between actual productivity and current living standards has created huge debts and can only be resolved by in two ways – further austerity or inflation to reduce living standards or a huge increase in private investment to drive productivity.

Time up for QE

noreply@blogger.com (Unknown) — Wed, 29 Oct 2014 14:37:00 GMT

No one really understands it and because of this opinions are all the more divided and intransigent. Despite this incoherence the market has understood enough to know that it drives asset prices and confidence in future prices. It is QE – quantitative easing.

Ben Bernanke - the Godfather of QE

QE is where Central Banks print themselves some money to buy bonds and other instruments from the banks, the idea is that this puts cash / liquidity into the economy increasing the money supply and making credit more freely available. Under “normal” conditions of growth (+2-3% annually)and inflation (around 2% annually) equilibrium this would drive up aggregate demand (growth) and inflation as the banks push this extra liquidity out into the market in the form of loans.

For more or less the whole recent period of QE, where the US, Japanese, European and UK central banks have poured $2tn of new money into the world economy, we have not had “normal” conditions as growth has been well below trend and inflation has also well below the targets set by governments. As a result it has been very difficult to measure the impact of this new liquidity. There are 10 of things that we can now say with some certainty:
1. QE did not create the wild inflation that many monetarist believed would result
2. QE reduced long-term real interest rates and borrowing has become cheaper.
3. QE created looser monetary policy over the past five years, without which the world economy would have delivered lower growth and higher unemployment overall
4. QE has made borrowing easier but the appetite for credit is waning
5. QE has helped sustain and increase asset prices
6. QE on its own did not solve the problem – we still have lower than trend economic growth, private investment is still at an historic low and Europe is flirting with deflation
7. QE may well have made things a little better than they might have been – the initial rounds certainly propped up a badly listing banking sector
8. QE may has made planet an even less equal society as owners of capital benefited from asset price rises and wages for labour have been depressed
9. QE has provided an endless source of fun for economist around the world
10. QE is a puzzle and the fun bit is about to start.

Even though we “know” all this stuff about the short term effects of QE what do we think will happen next? It may be most fruitful to look at this in a chronology.

Step 1 (now) – Asset prices globally will fall – stocks, bonds, property, wine – you name it prices will be falling for the next 6-12 months

Step 2 – As asset prices fall there will be a nasty sting in the tail for the banks that still harbour vast swathes of distressed debts. This will cause further tightening of credit markets and banks run up against the higher (new defined) thresholds for regulatory capital (cash and securities thy have to hold to support their loans and other trading)

Step 3 – This squeeze on capital in the banks will put a further break on growth and inflation. Unemployment will also rise and political institutions will come under pressure (the Eurozone will be under the spotlight again)

Step 4 – Just as it looks like the world will come to an end, low interest rates and cheap asset prices will create the conditions we need for recovery and recovery will come!

Solving Secular Stagnation

noreply@blogger.com (Unknown) — Wed, 15 Oct 2014 12:38:00 +0100

There is now a sense of gloom that pervades the corridors of power in the developed world, six years on from the Lehman Brothers' default and the ensuing “great recession” we are still in the economic dead-zone. In particular Europe is marred by low growth, high unemployment, falling prices and the worry is that this is the “new normal”. Most economist are satisfied that the problem is poor aggregate demand, caused by falling investment in both the private and public sectors combined with diminishing disposable income - wages have been flat for years. This malaise has been characterised as “Secular Stagnation” (SS), a term made famous by Larry Summers a former Head of the US Treasury department.

Larry Summers - feeling the torpor of Secular Stagnation

SS is a pervasive “liquidity trap”, which in turn has been described in Keynesian economics, as where injections of cash into the private banking system by a central bank fail to decrease interest rates and hence make monetary policy ineffective. SS can only happen when interest rates are “at the zero-bound” and are unable to fall further, resulting in a trap where interest rates are never low enough to stimulate demand. Also the monetary conditions that SS creates ; negative real interest rates and huge injections of new money into the system - Quantitative Easing (QE) creates a risk of bubbles in financial assets and huge amounts of money chase short term returns rather than long term investment opportunities - see chart 1.

Chart 1

There is little in the way of consensus on how we might resolve secular stagnation and break the liquidity trap; the worry is that Japan has been experiencing this condition for over 25 years – that’s a whole generation lost to low growth and falling incomes. It’s worth studying Japan in more detail as we don’t want to mirror their attempts at breaking the liquidity trap. In Japan in 1990 asset prices were stratospheric - NTT (the telecoms giant) was valued on the Nikkei at more than the entire London stock exchange, a joining fee to a smart golf club in Tokyo could costs around $1m. Their world had gone mad. Unsurprisingly there was a bust in 1990 and Japan has been on a downward spiral ever since. Over the next 25 year Japan has tried variations on one theme to resolve the issues of low growth - ultra loose monetary conditions. Interest rates have been suppressed, QE has been used to inject further liquidity but to no avail. More recently Abenomics has introduced massive public spending and sale tax rises into this cocktail, but there are still no signs of recovery!

The problems in Japan are complex with an aging population and low employment levels for Females but may also be failure to de-leverage (public debts are still very high) and this results in a switch from long term investment to the pursuit of short term yields; a direct result of ultra-loose monetary conditions. Japan has negative real interest rates, very high levels of personal saving combined with very low levels of investment in the productive economy combined with relatively high asset prices – this split in the economy between the real productive economy (low growth and fall demand) and the market for financial assets (rising asset prices) - see the chart 1.

The trap that Japanese policy makers have fallen into is that that over the last 25 years they have focused only on trying to increase aggregate demand in the real economy (Line R) and have ignored the needs to deal with over-priced assets (line A). This has had the effect of supressing aggregate demand further as high asset prices combined with wholesale indebtedness reduce confidence in long term investment in capital projects. Business will always prefer to hang on to their money than risk long term investment when there is the possibility of a bust or even a default – so investment will go overseas or wash around chasing short term gain in financial assets - demand will weaken further as in chart 2.

Chart 2

Learning from the Japanese experiments with QE and their ultra-loose monetary conditions over 25 years, should we modify our plan of attack on secular stagnation? Maybe the first step must be to deal with asset prices (line A) and de-leverage (reduce debts) by raising interest rates. This will result in short term pain including: loss of savings, rising unemployment, defaults and lower growth. Once the de-leverage is complete in both private sector and public sector confidence will slowly return (if supported by sensible public expenditure) and private investment in the productive economy will deliver the growth and prosperity we have become accustomed to. But if we don’t deal with the issues of de-leverage and unsustainable asset prices investment and growth will never return. It is interesting to note that the only policy option open to Japan that they haven’t tried is to increase interest rates and tighten monetary policy – a lesson for us in the West?

The IMF gives more poor advice

noreply@blogger.com (Unknown) — Wed, 8 Oct 2014 18:39:00 +0100

The IMF have made some interesting pronouncements over the last few years – having missed the credit crunch and the “great recession” that followed they at first endorsed the UKs plan A and then decried it just as it was starting to work – so we shouldn’t hold up too much hope that the Fund will have anything sensible to say on the matter of European recovery. No one was too interested when they published their World Economic Outlook, which is normally like a school report – “the UK could try harder”, “France needs to apply herself and complete home work on time” – you get the picture. But this time round it was a bit more specific and surprisingly so; normally the IMF is reasonably hawkish, looking to solve problems through monetary policy (what would expect, it’s a bank) but in this report the IMF suggest substantially increased public spending on infrastructure investment, and across much of the world. It asserts that when unemployment is high and interest rates are low, the benefits will be greater if investment is paid for by increased borrowing, rather than cutting other spending or raising taxes. Most interestingly, the IMF declares that good infrastructure investment will reduce rather than increase government debt burdens as public infrastructure investments pay for themselves. Confusingly the whole 44 page synopsis of the WEO highlights a number of risks to the world economy – political risk in Russia, property bubbles, shortages of natural gas, etc; but report hardly mentions the debts run up by governments and leverage in the banking system - convenient eh!

Christine Lagarde Head of the IMF points the way forward

In stark contrast and a world away from Washington, where the IMF is based, the Geneva based Centre for Economic Policy Research has published an interesting paper on the evils of debt and the world inability to do without leverage. The paper titled “Deleverage, What Deleverage” concludes that the world and the advanced world in particular is hooked on debt and tells us - “The world has not yet begun to de-lever and global debt ratios are breaking new highs. At the same time, in a poisonous combination, world underlying growth and inflation are also lower than previously expected, reducing global debt capacity”. In short hand – we have never been so indebted and low growth and deflation could make this extremely dangerous.
On one hand we have the IMF egged on by Larry Summers and Paul Krugman imploring governments to spend more to drive growth and inflation, whilst the CEPR point out that world debt is now over 200% of global GDP – and that despite the great recession and all that we have not started on the road to redemption.

Debts are generally higher in the advanced economies and likely to by weighted to public debt rather than private debt which is the main component in emerging markets. The chart below shows that government debts are still rising in the advanced economies some 5 years after the Lehman’s bust.

The basis for the IMF advice to the advanced economies to borrow more to fund “infrastructure” investments is - money is cheap and maybe labour is cheap and some countries have lousy infrastructure and Government debt is only 25% of the whole debt problem (total debts including financials are around 400% of GDP in the advanced economies) so what could go wrong. Well the problem is that investors generally aren’t Keynesian economists they tend to be hard-nosed people who prefer is see their savings dwindle rather than face a total loss due to a sovereign default. So there we have it; governments might try to simulate growth but borrowing to fund infrastructure projects but any small net benefit would be wiped out by the negative effect this will have on private borrowers (75% of all debt) they will be scared off and overall investment will plummet. So short of sending all rich people, bankers and business people on a Keynesian indoctrination we should start to de-leverage and and quickly confidence will return to the private sector who will have confidence in the markets that they are investing into. And if you want some proof for this the UK is an example of how this con trick can work. In 2013 just as the IMF suggested that plan A would not work (too much deleverage) there was a great in flow of overseas investment as confidence grew that we were serious about tackling debt and the rest is history!

Cutting Taxes and Axing Osborne

noreply@blogger.com (Unknown) — Mon, 6 Oct 2014 10:15:00 +0100

In 2010 the Tories had plan A, deficit reduction, and by and large the British public bought the idea, which was simple, “We have to cut the deficit because sky-high public debt will kill growth and investment and lead to long term depression”. Some of this proved to be wrong but enough of the narrative still works. In all polls that ask the question “who do you trust to manage the economy?” the Tories are in a comfortably lead. We Brits have a long memory and the Brown / Balls bubble will not be forgotten and more recently Ball’s idiotic call for a plan B made him the laughing stock of Westminster.

Despite the Tory’s hard talk on deficit reduction the reality is that progress has been hampered by the coalition’s bargaining (with the illiberal Lib Dems), which ring fenced welfare, the NHS and pensions from the ravages of austerity. Nearly all the cuts imposed in this Parliament have been born by spending departments that receive less 40% of the entire public sector budget. There have been some interesting results – less spending on police has reduce crime, less spending on “enterprise” has helped growth take off, lower spending on Europe has made Europe even less popular and a huge increase in international aid has seen our stock in the world fall dramatically!

This austerity ring fence means that we are only half way through the process of deficit reduction with more to come over the next five years, we are still adding £80bn to our national debt every year. The other major reason that the deficit has remained stubbornly high is that tax receipts have been anemic - As the chart below shows:

Since 2007 cumulative inflation in the UK has been 26% whilst tax receipts have risen only 7% so the real tax take has fallen by some 19%, a catastrophic decline! Why is this?
• In terms of share there has been a slight decline in income tax, this is because of a £10bn of tax cut (lower personal allowances) - the tax free allowance (what you earn before income tax kicks in) has increased from £6,000 to £10,000.
• Although there has been a big increase in employment this has been at the bottom end of the salary scale, where little or no tax is paid
• Companies systematically avoid taxes on profits

David Cameron has now set out his stall for the next election by focusing his Party on tax cuts for those on middle incomes! He needs to make this promise as the Tories, in this parliament, have funded much of their austerity programme by taxing middle income earners (their core vote) and there are now about 5 million people (up from 3 million in 2010) who pay tax at the 40% rate – in fact you only have to earn £31,000 a year to be a higher rate tax payer. The problem for Cameron is that this “promise” to raise the threshold from £31,000 to £50,000 will have to wait until the public finances are in surplus. As it will be impossible to convince anyone in the UK that higher borrowing to fund tax cuts for the "rich" is a good idea; so the Tories need to find a way of generating more tax revenues – while still reducing income tax! This creates a great opportunity to reassess the tax system in the UK, which is in bad need of modernisation, and to create some clear water between the Tories and all other Parties in the UK.

Standing in clear water - a liberal Democrat - without socks on!

To deliver their income tax cuts, without piling on more government, the Tories will need to deliver a wholesale review of our tax system in particular:
• They should replace corporation tax with a levy on companies that relates to turnover not profits, and turnover should mean all sales attributable to the UK market. This would force every company to make a contribution to the exchequer where ever they are domicile, forcing “unprofitable” companies to compete fairly with those that have to make a profit. As an example Amazon tell us that they do not trade at a profit in the UK and pay non corporation tax, but Amazon uses its vast financial resources to drive independent retailers (who have to make profits) to the wall. The overall level of this levy should raise about 10% of all taxes up from the current 8% but no great than the share raised from business in 2007.
• On income tax we need a simpler system that encourages work and enterprise but ensures that those who have been successful in the UK share their wealth appropriately. There should be two bands of tax only with a tax free allowance set at £12,000 (£1,000 a month). The lower rate should be at 20% up to £80,000 and above this the rate should rise to 40%. Tax on capital income (dividends and interest) should be at a standard rate of 30%. This reduce taxes on income to about 50% of all tax and would leave a gap in revenue of about 10% that be filled through cuts in government spending and an increase in VAT.
• An increase in taxes on expenditure (VAT) from 20% to 25% would plug the half the gap caused by income tax simplification. The good thing about raising sales taxes and reducing income taxes is that it gives consumers the choice of what to do with their money. One of the bi-products of this shift would incentives for savers, which has got to be good news as savings rates in the UK are amongst the lowest in Europe at about 5% of household income. In countries where sales taxes are higher - Sweden (25%), Norway (25%), Portugal (23%) and Belgium (21%) rates of saving are often double the UK rate.

The tight corner that that Cameron has painted himself into on tax may actually be good news as tax reform will be inevitable if he is to make good on his promise to reduce income tax and ensure that all companies pay a fair share. The only problem is that he will need to find a new Chancellor as George Osborne has shown no appetite for this type reform, content to tinker with the legacy handed to him by Gordon Brown.

Bonny Prince Alex

noreply@blogger.com (Unknown) — Mon, 15 Sep 2014 09:59:00 +0100

Prior to the union with England Scotland had a long and glorious tradition of following the wrong leader and creating the wrong alliances and this poor judgement eventually created the need for union with England 1706, when the Scottish Parliament voted by 106 votes to 69 for dependence. Since the Union there have also been a number of moments when the Scots have thrown their lot in with leaders (Bonny Prince Charlie for one) and alliances (The French) who offered more than they were able to deliver.

Queen Anne's floral badge of Union

Over the last three hundred years the people of these British Isles have managed to make an awkward four way marriage work. There have moments of hostility and open conflict (Irish independence) but there has also been peace and prosperity. This marriage of geographic necessity has enriched the world with so many important discoveries and insights; it is barely credible that such a small place could achieve such a creative and important contribution. Together we colonised about 25% of the globe and then handed this empire back. We gave the world it's global language and saved Europe three times from despots and tyrants. Together we have been in the right side of so many important alliances and civilising initiatives. We achieved more together than any of us had the right to expect.

Domestically we have been much more successful than many give us credit for. We have been one of, if not the most, successful economy over the last 200 years. If it had no been for our commitment to the two world wars and a misguided dalliance with socialism for 25 years we would be the richest country on planet by a country mile. In partnership we have built great institutions: the rule of law, the BBC, great universities, GMT, accounting standards, the codification of sport and the Jaffa Cake. We did all of this whilst maintaining a playful contempt for each other, which has been sustained by sporting rivalry. We even married each other and have, with open arms, invited the world to share our small group if Islands - we made multiculturalism work.

Scotland has a great identity and a clearly differentiated role in the world and to throw away the history and joint institutions we have built together would only be a sign of weakness and small mindedness, both if which are not characteristics one associates with the Scots.

So it is strange that Scotland is preparing to dump all this for some weird notion if independence - independence from what? The idea, that in this increasingly joined up world of global markets any nation can be independent is a sham. Who really sets interest rates, who really decided how much a government can borrow and who drives competitiveness - it's the market dummy! I have a number of practical worries for an independent Scotland, two of which stand out. Firstly, how will they be able to set up the tax collection infrastructure that the HMRC provides in eighteen months - without this they will be bust in a week. Secondly they will lose of economies of scale - they may not like the services the UK provides but without the economies of scale that 65m people provide , in the future these services will either be more expensive or worse. Scots can look forward to - terrible public TV, awful weather forecasts, a pathetic military, no foreign embassy in Washington and costly driving licences, and so the list goes on and on.

Listening to Alex Salmon over the weekend I was very struck by two things. Firstly, he seems to want to keep all the shared institutions that we jointly built (monarchy, the pound, the NHS) but he decries this heritage in the same breath. Secondly he seems only interested in being the captain of the ship and not in the safety of it's course ("we'll sort the currency issue out later on") . It's power he is after not independence and let's hope the Scots are not misled again by some self serving light weight. Based on the current opinion polls my only conclusion is that most Scots with any common sense are now living abroad - many of them go to my local pub!!

Germany's most important export is unemployment

noreply@blogger.com (Unknown) — Tue, 2 Sep 2014 18:52:00 +0100

Some time ago I posted a short piece entitled Austerity may be Wunderbar, the simple message in this blog was that Germany was the problem in the EuroZone not the solution. Having joined the Euro at a grossly undervalued rate the German economy has been on the PIIGS back for the last fifteen years. The net result of this competitiveness advantage was that in the years 1999-2008 German was able to re-boot its ailing economy by exporting cheaply to its European Partners where all control of credits markets had lapsed.

It's not just cars, but unemployment, that Germany exports

The Germans are are still winning but now they are exporting unemployment and deflation to the rest of the EZ. Paul Krugman sets out the history and today’s problem very nicely. He tells us - During the years when Germany was gaining competitiveness (1999-2005), euro area inflation was running at around 2 percent, and inflation in Southern Europe was running considerably higher. So Germany could gain competitiveness simply by having lowish inflation. But these days German inflation is only one percent, euro area inflation is lower, and the only way for Southern Europe to gain ground is to have zero or negative inflation:

This unfair deflationary pressure is driving demand (already on the floor) lower and makes it almost impossible for the southern countries in the EZ to make the appropriate adjustment. The argument Paul Krugman makes is that Europe (Germany specifically) needs is a good dose of inflation. This would allow southern Europe to lower prices compared to German and inflate their debts away at the same time- this would allow the PIIGS to devaluate against Germany over an extended period. To gain competitiveness against Germany the PIIGS need deflation of 1-2% a year relative to Germany and German inflation will not reach 3% any time soon. The problem is that the EZ is running out of time. As everyone knows there is not a cat in hell’s chance of Germany agreeing to raise domestic inflation to save the highly indebted and unproductive economies of southern Europe.

So what do the weaker economies in the EZ do? Politically, high unemployment, low growth and falling prices will force government to act sooner rather than later. With interest rates at the lower bound and Germany set against QE there is not much room for maneuver on the monetary side of the equation. The plan to use Blackrock (the US investment house) to design a new improved QE based on Asset Backed Securities (ABS) may just work but not unless it is accompanied with real structural reform. Next up is fiscal stimulus, which looks like a non-starter, as all government signed up to the Stability and Growth Pact –SGP, and debts already out of sight - Germany is probably the only country in the EZ able to increase public spending and it should do so now! This leaves supply-side reforms, which are deeply unpopular in all Europe and probably only saleable to the good people of Spain, Italy and France if they are backed by some massive reflation from the ECB.

Mario Draghi is trying to find a way through this mess that would see a trade-off between quantitative easing, structural reform from Spain, France and Italy and more public spending from Germany. Without the successful execution of this heady cocktail exit and devaluation is still the first best option for Greece, Italy, France, Spain Portugal and even Germany. Come on in all you short sellers!

Where no hawks dare to fly

noreply@blogger.com (Unknown) — Mon, 1 Sep 2014 09:01:00 +0100

The doves at the Fed led by the chief "cooer" Janet Yellen have found a new reason to keep interest rates at an historical low.

Not a hawk in sight

The latest buzz words are “Pent up wage deflation” and they provide an elaborate excuse for ultra loose monetary policy. The essence of the idea is that in the Great Recession of 2009-2011 the market rate for jobs fell appreciably but that because wages are "sticky" and actual wages remained flat. This stickiness of wages is a function organised labour (Trade unions), employee nervous to move jobs and employers who are reluctant to loose key staff.

A chart provide by Gavyn Davies at the FT summaries the model for "pent up wage deflation" much more coherently than I can explain.

The problem for the Fed and other central bankers is that the stickiness of wages is not uniform (the single line on GD's chart hides a range of possibilities) . In the public sector wages are very sticky and labour cost can only be reduced by lay-offs and natural wastage (not replacing retirees). In fact in the UK public sector incomes rose in the years 2009 - 2011, whist the private sector was in free fall. As an example of private sector wage unstickiness - in a partnership wages will always stay in line with performance as partners share profits, earning in Law firms fell heavily during the Great Recession and are still falling. Also in industries where earnings are impacted by variable commissions and bonuses wages are not at all sticky. As the chart below (from the Daily telegraph) illustrates wages are any thing but sticky in the UK's private sector.

The problem for central bankers is that the statistics they use for policy decisions are blunt national averages, which mask the actual behaviour of the economy. It is quite likely that in the US and the UK the productive economy has got some wage inflation but this is hidden by static wages in the public sector, which are still frozen to ensure that we can lower deficits in our public finances. In other sectors that are exposed to global competition (legal services) there will also be deflation - but these examples are not a function of demand shortfall and will not be corrected with negative real interest rates.

So we have the unhelpful situation that interest rates and other monetary policies are being judged against the unproductive economy rather than being targeted at the real economy that generates real jobs, wealth and growth. We are probably in a situation where the private sectors needs some tighten but this cannot happen until governments can afford to pay civil servants higher wages for doing the same work; given the state if public finances this won't be any time soon.

The big question is whether we should be making economic decisions based on the whole economy or whether we should focus on the parts of the economy we want to grow. If we need to shrink the State why should we be worried if wages are falling in the public sector. Anyway as we have already discussed interest rates will have little or no impact on public sector employment levels.
However, if we want our growth industries to remain competitive we must be alert to wage inflation in our productive economy an act appropriately.

Janet Yellen - barking up the wrong tree

noreply@blogger.com (Unknown) — Tue, 26 Aug 2014 11:51:00 +0100

Over the last 40 years (well up until 2008) the role of central bankers was pretty clear – keep inflation under control - and it’s no surprise that during the great inflationary period 1970-2000 monetarist held sway. Interest rates were raised, money supply was squeezed, unemployment rocketed (and then fell) and it was possible to pronounce the demise of Keynesian economics with complete certainty. The fun went out of economics - the “Great Moderation” proved that once and for all we were the masters of our own economic destiny. Then the credit crunch struck and the financial crisis kicked off which in turn led to the “Great Recession”, from which the developed world is still trying to escape.

By an almost unbelievable quirk of fate all the important Central Bankers in 2008 (Ben Bernanke, Mervyn King and Mario Draghi) were in fact all neo-Keynesians. The moment Lehman Bros went under the “Great Accommodation” began – interest rates were slashed, money was printed and taxes were cut to generate demand and public debt spiral upwards– and thank God they acted as they did. Miraculously depression was averted, growth returned and all looked to be set fair, until the realisation crept in that the huge government debts might spoil the party.
Since 2009 the economic consensus has fallen apart as bankers and pundits try to offer solutions to low growth, low productivity, spiraling debts and more recently the spectre of deflation. At the heart of this debate has been the interpretation of employment markets. Initially, Central Bankers in the US and UK linked their forward guidance on interest rates to falling levels of unemployment, there was unanimity that demand shortfall was the one and only problem. But as employment has risen without earnings growth or productivity improvements Mark Carney and Janet Yellen have been happy to move the goal posts so that a broader view of the employment market is now the driver for forward interest rates.
In her recent speech, at Jackson’s Hole, Janet Yellen was able to spread the suspicion that she can find an endless number of reasons for continuing with negative real interest rates.

Jackson Hole

The three she focused on were:
• Structural changes to the global employment market
• Nominal wage rigidity
• Depressed labour force participation
Without breaking into a sweat Ms Yellen was able to provide ample proof that these co-conspirators could only be dealt with by continuing the current “highly accommodative” policies. I guess if you believe that a shortfall in demand is the only problem we need to solve - then we might all jump to the same conclusion. However despite Yellen "evidence" there is a growing sense that Central Bankers are now barking up the wrong tree and that we are destined for years of pain if we continue with these ultra-dovish policies.
For me the question is whether we are addressing the problems in the right order or indeed whether we are addressing the right problem at all. Perhaps we have forgotten that “Great Recession” is the result, not of the “business cycle” which drives employment, but of market failure in financial markets. Over-leveraged Banks provided too many unsuitable loans to families and businesses, driving up asset prices and creating an unsustainable bubble in homes and other asset prices.
In the immediate aftermath of the credit crunch Central Banks applied the necessary liquidity into markets to save us from depression but they did not fix the problem of broken banks and sky high asset prices. The follow-on policies of QE, negative real interest rates and bank reform (Dodd Frank and Basel 3) have had the combined effect of:
• Leaving un-addressed the mountain of distressed debts – almost any business can service loans at today’s interest rates
• Squeezing liquidity out of the market for investment capital – Banks sit tight on over-priced assets and have no slack (due capital adequacy rules) for new loans
• Which in turn reduces investment in new technology driving up employment but suppressing wages
By addressing the business cycle without dealing with the unresolved issues created by the financial crisis the world’s central bankers are making the same mistake that the Japanese made in 1990. Rather than propping up asset prices and squeezing investment capital out of new ventures we need polices that have the opposite effect. This will be painful in the short term but it is the only way for us to avoid two lost decades that the Japanese economy has endured.

Central Bankers - from heroes to zeros

noreply@blogger.com (Unknown) — Thu, 7 Aug 2014 14:08:00 +0100

The Bank for International Settlements (BIS), the only institution to call the financial crisis in 2007, has weighed back into the macro economic debate in the last few days in its annual report. The report sets out a significant criticism on the current crop of central bankers, in essence the BIS lays the blames Yellen and Co for the falling: growth, demand and employment. The expansion of national balance sheets and negative real interest rates are now the problem not the solution. The Keynesian approach that all central bankers have followed is now coming under close scrutiny as the global economy struggles to gain economic momentum. The process of piling the "cart" with more and more debt means Central Bankers are running a huge risk as the road ahead may not be as smooth as the would like!

Let's hope there are no pot holes ahead

The BIS believed that the global economy has lost, for good, capacity and that the ultra-loose monetary policies pursued by the central banks is responsible for this wastage. The BIS is convinced that the long run ambivalence to debt, practiced by central banks, is the route-cause of this lost capacity; they contend that negative real interest rates and very loose credit terms have allowed governments, businesses and households to maintain very high levels of debt and that is squeezing the life out of the “productive” economy. Obviously Janet Yellen and her gang vehemently disagree.

The counter argument is that monetary easing has saved us from a full blown banking melt down and depression and it’s hard not to agree that in the early stages of the financial crisis the huge amount of liquidity pumped into the banking systems did save us from a complete catastrophe. Central Bankers were the heroes of the hour in 2008 but what is less clear is whether continued use of these measures (the US is still printing money and real interest rates are near zero everywhere) will restore normal service. Six years on from the financial crisis this are still pretty bad – the US is still stuttering with growth rates well below trend and in the Euro-zone things are really black – Italy is back in recession, France is close to its own triple dip and most of the PIIGS are still is the S**T. More worryingly deflation is a reality in many developed economies and debts are sure to rise because of this.

The BIS’s main contention is that central bankers have been too busy addressing the economic (output) cycle rather than addressing the financial cycle that is really killing us. This financial cycle has a longer frequency 20-30 years but importantly requires us to face up to our debt obligations (government, corporate and private). The BIS implores us to ensure a more symmetrical response across booms and busts. And it calls for moving away from debt as the main engine of growth. Otherwise, the risk is that instability will entrench itself in the global economy and room for policy manoeuvre will run out.

This is now clearly the case in Europe and Japan that a single failure could up-set the whole apple cart. The chart below show how little has been done to address indebtedness across the globe. The issue of negative interest rates and bloated balance sheets in governments, banks, other non-financial corporations and households means this creeping malaise that has become very difficult to shake off. The main symptoms BIS identify are:
• chronic shortfalls in aggregate demand.
• lose of skills caused by unemployed
• misallocations of credit and other resources (allocation of credit matters more than its aggregate amount - it is important that good borrowers obtain credit rather than bad ones)
• Dangerous impacts on asset prices and markets (bubbles)

Riding for a fall on a mountain of debt

Keeping their focus on the “Financial cycle” the BIS argue that there needs to be a fundamental repair of balance sheets; in any scenario where the cost of money is zero and prices are falling there can be no dynamism. Distressed debts weigh heavily on innovation and growth, owners of capital are unprepared to invest for the long term (who would if prices are falling) and consumers will pair back there spending. Demand must be weak. Importantly the BIS argue that over the long run and across the financial cycle Central banks should cease from their chosen path of borrowing in both the down and up-cycle -
“asymmetrical policies over successive business and financial cycles can impart a serious bias over time and run the risk of entrenching instability in the economy. Policy does not lean against the booms but eases aggressively and persistently during busts. This induces a downward bias in interest rates and an upward bias in debt levels, which in turn makes it hard to raise rates without damaging the economy – a debt trap”

The bad news is that the only way to escape the debt trap is to crystallize distressed debts and ensure and improved allocated of credit going forward. I have been arguing for some time that negative real interest rates for an extended period can only cause great damage, and the Japanese economy over the last 20 years is ample proof of this.

It may be worth reminding ourselves that the current up-swing in the business cycle (not the financial cycle) is due to end in 2017-18 – periods of expansion typically last 6-7 years. Unless we start repairing our balance sheets, reducing debts and increasing interest rates we will have absolutely no room for manoeuvre when the next down turn comes. Unsurprisingly the cadre of Central Bankers and Keynesian economist (see Gavyn Davies' blog) have screamed loud in protest – but they are howling in the against a wind of change that should sweep them away.

La Belle Époque - revisited

noreply@blogger.com (Unknown) — Tue, 5 Aug 2014 21:41:00 +0100

As we remember 1914 and the horrific shock that World War inflicted on Europe and the terrible waste of life the two World Wars inflicted it might also be sensible to recognise the economic shockwaves that these events triggered. The two World Wars and the depression that was sandwiched between them, changed everything economically. The old colonial powers lost their possessions and incomes from abroad; inflation was unleashed on the world as never before – destroying the inherited capital of the über- rich, labour organised and the world was changed. 1914 destroyed the La Belle Époque and changed almost everything!

By the '50s the old rich where on skid row!

There is now a body of opinion that warns us that the period 1910-2000 was in fact an anomaly. Thomas Piketty (The French Rock Star Economist) is clear that the long run data points to a future where developed economies are destined to have: low inflation, poor economic growth, stagnant populations and increasing share of capital owned by a very few. We used to think that the halcyon days from 1950 to the turn of the century were the norm and that we would continue to to see rising living standards and increasing equality.
The Great Recession of 2008-9 changed this consensus that within the business cycle we could expect prosperity and productivity to march ahead unencumbered. The global business cycle typically allows for about six years of “expansion” following a recession – the recent periods of “expansion” can be defined as 1983-1990, 1994-2000, 2002-2008 and it follows that the current “expansion” will last until 2017 and that we should be better off by the end of this cycle.
The reality is that if the next down turn comes in 2017 this period of expansion will leave many people worse off than when recession struck in 2008. The reasons for this are that growth has be anemic and that any expansion in national income (capital) has been soaked up by the a small number of the very rich – leaving the vast majority of us poorer and angry! But is Piketty’s analysis likely to hold water in the longer run – will secular stagnation and inequality be the name of the game?
As with any trend analysis the key is pick start and end dates that fit your prognosis – it’s important to do this before you start your research. Piketty has cleverly chosen his data sets to run from 1750 to 2000 - 250 years for which there is only really complete data for one fifth of the period. This unusual scoping of the data sets has allowed him to draw the conclusion that the natural state of affairs is where; growth is low, inflation is non-existent, population growth is stagnant, government debts are high and wealth is pooled into the hands of the very rich at the expense of others. This kind of near feudal state is apparently our lot in the long run. Considering the issue of capital consolidation alone and if one discounts the period for which there is really no data of sufficient quality (1750-1950)what one can see is that events (wars) and policy (fiscal initiatives) tend to dictate who gets what. To be clear, there is no inevitability for the continued unequal distribution of capital in the 21st Century.
The received wisdom (and government policies)for the last 25 years has been that growth can only generated by pandering to the greed of entrepreneurs – taxes on profits have been slashed, a blind eye has be turned to tax evasion, and wealth taxes have been ignored as countries compete to keep their investment dollars safe. This pandering to capital is the reason that the top 1% now own 35% of all wealth in the US and in the UK the top 1% own the same wealth as the bottom 55%! one might said that we have returned to la belle epoque!

You can have it all - but at the expense of those who work for you!

There is no doubt that there needs to be a redistribution of wealth from the owners of capital to those who provide the labour. Without this redistribution aggregate demand will fall, investment will dry up and stagnation may become the new reality. Turning the tide on Piketty’s nightmare vision of the future will require three components:
• Firstly, businesses taxes should be based not on profits (always easy to hide) but on sales and production. This approach combined with international efforts to raise taxes locally (where the business is transacted rather than where the business is domicile) will help enormously. Companies will have to pay higher rates of sales tax and pay higher rates of national insurance but no corporation tax. For example in the UK Amazon, Apple, Boots and Starbucks who avoid corporation tax in the UK would have to face higher rates of VAT on products they sell here and higher levels of National Insurance. This would also have the added benefit of leveling the competitive playing field making it easier for domestic businesses to compete with global rivals who avoid tax and use this advantage to buy market share.
• Second, we need encourage the wealthy to invest more productively rather than squirreling their wealth away in government bonds. This risk adverse investment approach has two impacts – it encourages Governments to run up big debts (they can always raise money at low rates) and takes productive capital out of the economy. The only way to achieve this is to have a more rigorous method of rating sovereign debt, with downgrade triggers invoked when indebtedness reaches certain levels. This would force governments to take their fiscal responsibly more seriously, reducing the size of the Sovereign bond market and driving capital into more productive investments.
• Thirdly, we need to take wages more seriously and encourage a high wage - high productivity economy. Minimum wages must be set at realistic levels that provide proper rewards for even to lowest paid. Without this where is the motivation to invest in productive technology? Also companies have a social duty to share profits sensible with employees and some employee ownership should be mandated – to recognise loyalty and contribution and this goes hand in hand to sensible company pension provisions. Companies who don't take their social responsibilities seriously should face one off fines to compensate their employees.

Employers will complain about the cost of doing business but there must be a re-balancing away from the owners of capital to those who do the hard work. Those on the far right will say that these measures amount to socialism that will drive business away from the UK - but this is nonsense! These changes could be implemented in a way that encourages business activity and to be clear there is no point in having a business friendly economy if all the rewards go to the business owners – business must provide a social good or it’s just a scam!

Believing in Secular Stagnation

noreply@blogger.com (Unknown) — Thu, 8 May 2014 09:13:00 +0100

Across the fault lines of Adam Smith and Keynes, those who take an interest in the global economy fall into two camps - those who are general optimistic about humankind’s instinctive ability to create wealth an prosperity and those who believe we are pre-disposed to muck (no typo) things up. You would think that those on the left are most agitated about market failures and the inefficiencies of capitalism - and many are, but social media exposes the truth that at least as many on the right are doomsayers. Every article in the press welcoming the signs and firm evidence of recovery in the UK is met with a barrage of comments from conservatives foretelling the end of the world – house bust, savings dearth, public debt ruin, balance of payments crisis and so it goes on!

Despite being on the right politically I have always been an optimist, we will prevail, the economy will right itself (no matter how badly George Osborne does) and we will return to rising living standards and wealth, health and happiness all around. But cracks are appearing in the mirror, doubts are creeping in and the “Black Dog” of Secular stagnation is starting to howl.

The Black Dog of Secular Stagnation

This sense of unease has not been sneaking up on me, no! Yesterday I was quite positive on the UK and global growth, certain in the knowledge that one could construct for a sustainable recovery and that the benefits of this recovery would “float most of the boats”. But yesterday is yesterday and today is Thursday. So what has changed?

Yesterday Paul Krugman (PK) posted a short piece, without a fanfare or any of the normal self-importance with three charts, which he said illustrated the dangers of secular stagnation. Secular stagnation is an old idea given fresh legs by PK and his mate Larry Summers (Ex-Secretary of the US Treasury under Clinton). Both have, eloquently if not convincingly, set out the premise that its possible for an economy (even at zero or negative real interest rates) to be unable to escape the liquidity trap – where aggregate demand suppressed by low growth, falling productivity and low investment will be unable to create the economic momentum to reach “escape velocity”. I had not seen any convincing of evidence for this awful scenario – that is until yesterday when I spotted this chart in PK’s post.

The chart plots real interest rates (Actual rates less inflation) in the long run across three and a half business cycles, between 1980 and today and it shows that in each subsequent cycle monetary policy has had to dig deeper to create growth. You will notice that this is simply expressed as a flat line across the business cycles – so in the cycle 1980 -1990 the average real interest rate was 4.5% and in last cycle it was just over 1.5% and in the current cycle the line will eventually be drawn at around -0.75%. This means that to sustain “normal” levels of growth we now need negative real interest rates, and no one knows how to deliver this – the last 20 years of Japanese economic history confirms this.

Let us suppose some brilliant mind (Mark Carney might do it) comes up with a set of proposal that create conditions where prolonged negative real interest rates can support decent rates of sustainable growth, that might be helpful and even necessary but it would turn the world up-side down. Here is a short list of unavoidable repercussions:

• There would be no middle class – no need or point in saving
• An aging population will have to keep working indefinitely
• There would be little no private investment in capital intensive businesses
• Governments would have to take sole responsibility for long term investment projects and public debt as a percent of GDP will have to rise even further
• The really rich will get proportionately richer as liquidity and leverage rule
• There would be a surge in self-employment, tax avoidance and rising public debts
• In short things could be pretty miserable!

There are now distinct signs that in Europe and the US that this economic rigor mortis has set in, whereas in the UK we look immune for now, but as secular stagnation strengthens its grip on the old world economies the contagion will spread to our shores eventually.

Let Them Eat Cake

noreply@blogger.com (Unknown) — Fri, 2 May 2014 02:30:00 +0100

The key to good economics is timing, Adam Smith was banging on about pins when pins where the last word in precision technology, Keynes was lucky to be at the height of his powers when the world needed him most and Milton Friedman took his bow when everyone had gotten bored of trying to make Keynes ‘General Theory' work. Enter stage right Thomas Piketty, who is also lucky to be making his pronouncements on inequality as a new gilded age dawns bright. Incidentally, one of the last gilded ages led to Equality, Fraternity and Liberty by way of the Guillotine so M. Piketty, a Frenchman, should be careful what he wishes for.

Exécution de Marie Antoinette 16 octobre 1793

Inequality is a malady that affects us all, miserable for those who have nothing, painful for those who have everything (the sense of unworthiness is soul destroying) and even worse for those who want everything but have very little. It reinforces the propensity to sin in a deadly way – greed (I want it), sloth (what do I do now that I’ve got so much) and envy (I want what you’ve got). This makes sensible debate all but impossible and it is likely to end in a bad way. There is some history here - Charles I followed by Cromwell, the age enlightenment followed by the French revolution, the roaring twenties by the depression and so on.

In contrast to these periods of excessive wealth concentration we have enjoyed a period where the middle classes have enjoyed a great improvement in living standards – from 1930 to 2000 we in the West lived through period when great wealth accumulation was based on meritocracy. Professionals all over the world increased their share of wealth substantially; well-off accountants and lawyers and doctors were able to climb the greasy pole to become really rich and the same was true for hard working artisans and successful managers. This progress of the middle classes was just rewards for their hard work and the acquisition of important skills, it seemed for a time that “the war for talent” would cement this progress and then three things happened. The Internet followed by leverage followed by recession!

The Internet is proving to be a major threat of the professional classes, who needs a consultant physician when you can look up your aches and pains on the web, who needs an accountant when you can file your tax return on line, who needs lawyer… well quite! We’re all professionals now and we have access to so much advise (much of it poor) that we don’t need any one to tell us what to do. In the same way small business owners have been crippled by this explosion in information access – who needs a travel agent, bookshop or insurance broker – and so it goes on. This loss a value that the middle classes have endured is likely to get worse before the younger generations figure out how to milk the system, as they surely will.

Secondly the middle classes have been ruined by leverage. It’s not controversial to say that the working classes have always been suppressed by leverage. Capital has been able to keep them in their place without too much effort since the dawn of time as most working class jobs are in capital intensive industries that thrive on job insecurity (manufacturing, mining, agriculture, etc). The middle classes were able to piggy back on this suppression, providing services to the capitalist and making good money in return. But today leverage is used not to build railways or ships and dig coal, no leverage is used as a means to asset strip the old fashioned economy.

Take a business like Boots the Chemist (we could pick a 1,000 others) that was the heart and soul of Nottingham, bought by an Italian Financier in 2007 the businesses head quarters was moved to Switzerland (with a number of off-shore entities in Luxembourg, Cayman and Gibraltar which “save” $1bn in tax a year), the old Head office in Nottingham has been devastated, the innovation of its pharmacy business has been destroyed, It pays little no corporation tax (On sales of over $22bn) and one man (who has no obvious talent) has basically stolen a great business because a couple of Private Equity firms (KKR for one) were keen to line their own pocket and put up the leveraged finance.

The business hasn’t got any better, the tax take has plummeted, the social good it provided to the good city of Nottingham has evaporated and one man has made off with £bns! The flow money from the real economy peopled by honest hard working to business owners who have no obvious talent is a cause of great injustice. No one minds the innovators like Dyson, Gates and Jobs making hay from brilliant ideas and designs but the manipulation of wealth through access to leverage is a commercial obscenity that needs to be atoned. The scar on humanity is made more livid by the fact that this enormous wealth is then handed down from generation to generation. It rude to say it but this activity is a form of larceny but its true.

If the advent of wild leverage wasn't bad enough the middle class have since been further penalised by the recession as governments have chosen to bail out their public spending deficits by collecting from those in work on middle incomes. The poor have no spare money to tax and the very rich sort their money away well out of reach so governments have squeezed the middle - and how they have squeezed.

Piketty (our timely French economist) suggests a concerted action by the largest economies to implement a global tax on accumulated wealth so this money can be recirculated into the real economy a kind of beefed-u inheritance tax. Five years ago this kind of idea would have been heralded as a communist mumbo jumbo, but how things have change and how well Piketty has timed his run! In fact, dealing with the excesses of private equity, the huge pools of “dead money” would be the best possible thing for capitalism – releasing £bns into the real economy where it can drive demand and grow real businesses owned by deserving entrepreneurs and hard working shareholders. It will be difficult for the squeezed middle to bounce back, but with a bit of help they will bounce back and then heads will roll!

Selling England by the Pound

noreply@blogger.com (Unknown) — Wed, 23 Apr 2014 22:47:00 +0100

The English are having a bad year, we are on the brink of losing our last meaningful colony and these storm blasted islands have endured the worst weather on record and we are only in April! Despite all this we are still standing and there remain three things that the English can be proud of:

Getting drunk and then fighting for their lives
Being polite and stand-offish
Having a weak currency

A Spaniard - what you find when you Google an image of a drunk English Gentleman!

The starkly contrasting social habits of the English are well documented but the relatively value of our currency has been brushed under the (garishly patterned) carpet by the long line of Keynesian and neo-Keynesian economist who believe that we will eventually take our place on the global top table of exporters if we continuously devalue our currency.

Against this backdrop, commentators and captains of industry have been warning against the inexorable rise of the Pound over the last 12 months. On a trade weighted basis – that is against a basket of currencies weighted accorded to the amount of trade there is with Britain – the pound has appreciated around 10 per cent in a year. Their whining is interesting as the currency was devalued by some 30% in 2009 in the wake of the credit crunch, but before the Euro crisis disabled our main competition. But let us not get too boggle-eyed about our currency’s recent past. Despite the great devaluations of 2009, 1994 and numerous other sinkings our currency (since 1990) has on average sat on or about $1.60 – okay so there have been some fluctuations but we seem to return quite effortlessly to this level of parity with the dollar.

So like the aggressiveness drunk the Pound quickly returns to its natural pre-disposition of being fair and politely - valued at around $1.60 - once exuberance and pessimism have worn off. And this is something we should learn rely on.
Sadly our exporters and their bankers have not worked out the derivative market well enough to be able to hedge forward on this likelihood. As a result they have be somewhat pathetic in building their export markets based on this fairly simple truth, which is that our economy has been one of the best performing economies of the last 200 years and this isn’t going to change anytime soon.
The interesting thing is that while our metal bashers can’t see this this stability foreign investor have no trouble is seeing that the UK is a (relatively) marvelously stable and reliable economy on which to bet their money.

So while our exports and manufacturing have been flat in the long-run (see the output chart above) we remain the favorite destination of hot global money! As the recent E&Y attractiveness survey highlights and our low cost of borrowing confirms. The issue for us is that money we attract is “hot” it doesn’t stay long and if it does it’s the magnetism of our London property market that is the biggest attraction.

Because of these inflows the markets don't seem to care about Britain's problem in paying its way in the world. This apparent ambivalence is explained by the fact that Foreigners are still willing to lend to Britain, and or buy British assets on the scale necessary to bridge the gap. This “get out of goal free card” has allowed us to squander longer-term export opportunities, whilst making the City of London rich on the in and out-flows of hot-money.

The best thing the government could do would be to offer (through the banks via macro-prudential measures) a long-term low cost hedge against currency fluctuations to domestic and foreign investors so that the real the benefits of our natural creativity and work ethic can be brought to bear – based on an exchange rate of roughly $1.60.

Float my boat?

noreply@blogger.com (Unknown) — Mon, 10 Mar 2014 19:27:00 GMT

The image of a rising tide lifting all the boats is a picture politicians like to paint – a fair recession and recovery, the reality maybe that the posh yachts and the scruff dinghies may be okay but the smartly kept but modest day boats may be stuck in the mud for a while yet!

Who will float my boat?

Five years after the Great Recession there is a sense that the world’s economy no longer adheres to normal rules, the tide is moving in a mysterious way. In a recession wages are meant to be sticky and as a result of this unemployment rises sharply as workesr price themselves out of the market. Following a recession, typically, productivity and wages pick-up quickly and eventually unemployment should fall. This time around rates of employment have remained quite high through the recession, wages and earnings have fallen sharply and productivity has not bounced back; so why?

One of the other major (and unexpected) differences in this recession has been that the pain has been greatest for the middle classes. Normally a recession hurts those at the bottom of the pile not those stuck in the middle. Wages for the middle classes have (contrary to Keynes’ General Theory) been proved to be un-sticky and middle incomes have fallen appreciably since 2007. This may well be the first warning shots of a new age in automation the so called “second machine age”. Typical middle income jobs in both public and private sectors are supposed to be replaced by technology – out with the book keepers in with new accounting software and so on. This explanation seems a bit thin to me and it’s more likely that pressure on the middle classes is a function of policy rather than technology innovation.

Initially, in developed countries the policy emphasis was on supporting the low paid and the owners of businesses – a kind of supply orientated approach. It was thought that tax breaks for the poorest in society and business friendly tax cuts would be the best mechanism to get people into work and trigger recovery.

In the UK the poor have done pretty well – the threshold below which no tax is paid has been raised by three thousand pounds since the Great Recession (from £6,475 in 2009 to £10,000 this year) and there is a school of thought that the government should raise this threshold again to £12,500. It is estimated that these increases in the personal allowance will result in 2.2 million people not having to pay tax on their income, while the cost to the Exchequer will be around £10 billion in 2013/14. The Coalition government feel that this approach supports their “tackling the deficit fairly” story.

The enormous cost of tax cuts for the poor has been met by the Coalition Government’s decision, in its first Budget, to increase the standard rate of VAT to 20% and to reduce the thresholds for basic and higher rates of tax. After allowances the 40% tax rate was £37,400 in 2009 and it’s now £32,010 a drop of over £5,000 without adding the effects of inflation. Whilst middle income earners have had some marginal benefits from higher allowances this has be out-weighed by the huge fall in the higher rate tax threshold. This devastation of the middle classes is now complete as those paying income tax at the higher rate (40%) has reached 4.4 million in the current tax year, that one in six – It was one in twenty a few years ago! So now middle income earners get taxed like the rich – the poor pay no tax and nor do the very wealthy! Some democracy

The world has certainly gone mad, when all income over £42,010 attracts taxes (income tax and national insurance) of over 50%. Middle income earners have also suffered from sales taxes, loss of child benefits, very high costs in transport and the loss of earning from saving (due to negative real interest rates). This policy of resolving the financial crisis and subsequent recession by attacking one section of society (about 5 million middle income earners) has been a true spectacular mistake by the Tory led coalition as these very same people are their core vote. Gordon Brown squandered £85bn of tax credits and welfare payments on his core vote between 2006 and 2010 (an electoral bribe more significant than anything Robert Mugabe has attempted). In contrast the current government have taxed the same amount of money from their core vote over this parliament!

It is obvious that the approach of bailing-out the country with money from a small number of middle income earners has been a huge mistake politically for the Tories, but more worryingly is may also prove to be a very poor economics. The average income in the “squeezed middle” fell from £37,900 to £32,600 between 2007 and 2012. Average direct taxes paid by them fell from £8,700 to £6,800 while indirect tax payments dropped from £6,400 to £6,000 (indicating a fall in consumption of around £8,000 per middle income wage earner). Imagine what rising interest rates (high mortgage payments) will do to this already squeezed middle and time is running out. George Osborne, having been saved by large in-flows of foreign direct investment, has one budget left to ensure the rising tide of recovery floats all the boats in the harbour.

A sticky mess for economists

noreply@blogger.com (Unknown) — Fri, 14 Feb 2014 22:13:00 GMT

I have spent a fair amount of my leisure time racing on sailing boats, where one becomes paranoid about wasting the wind, the tide or ones position on the water. This is in stark contrast to the rest of my life where waste is everywhere; I waste time in mindless meetings and commuting, I waste money on an over indulged family and some would argue that I am wasting my life away writing this blog! But all that is going to change; waste is out and utilisation is in – or so says the Governor of The Bank of England (BoE).

Having spent the last five years providing as much slack as possible to keep the banking system on its feet and the economy off its deathbed, there is now a new mood and doctrine. When Mark Carney arrived in the UK in July last year he promised us Forward Guidance on interest rates – he would hold rates at 0.5% until we achieved full employment. So like a seasoned skipper he turned the yacht downwind and let all her sails out. The economy (helped by a friendly gust of overseas investment) has picked up speed, employment rates have shot up and people are wondering when we will need to tighten things up. If we don’t tighten things up and the economic tail-winds pick-up we could get into a real mess.

He should have tightened up a bit earlier

But Mr Carney reckons there is still a spare capacity in the labour market and he is now telling us that until this capacity is utilised (about 1% of the economy) we will stay on this bearing – this may mean that we suddenly get over taken by a nasty gust (of inflation) and get dumped in the water but the Governor is not tacking quite yet. As he said we are on a good run “The recovery has gained momentum. Output is growing at the fastest rate since 2007, jobs are being created at the quickest pace since records began, and after four years above target the inflation the rate is back now at 2%”.

Since his first months as Governor there has been exceptionally strong jobs growth – almost half a million more people have found work since August – the unemployment rate has fallen much faster than anticipated to 7.1%, and is likely to reach the 7% anytime (the target rate for reviewing interest rates). But despite all this good news on employment and growth the BoE believe there is significant slack in the labour market, which will allow a lower level of unemployment with stable inflation. Mr Carney is break new ground by now confirming that he doesn’t like this wasted capacity and that we will keep rates lower for longer to eradicate the slack in the economy over the next two to three years.

This recovery has been good for the unemployed (who have found jobs) and for employers who have been able to retain and hire new staff at low rates. We don’t yet know if the recovery will be good for Mr Carney but the signs are okay - but the recovery it has not been so good for Keynesian economists. Much of Keynesian economics is based around the notion of sticky wages (the idea that employers have to sack staff rather than reduce their wages in recession). The idea that the Great Recession has proved that wage stickiness maybe a thing of the past doesn’t sound all that interesting does it? But it is probably the most important economic revelation of the last 30 years. The reason for this is that without proof for wage stickiness the whole General Theory is pretty much worthless and the Keynes’ General Theory is still the mainstream economic theory for the great and the good. Janet Yellen is a New Keynesian Economist and so are many of those in positions of authority over the global economy. So what’s the detail here?

In 2008/9 there was a steep rise in unemployment but it didn’t reflect the very sharp downturn in GDP and since the Great Recession economist have struggled to square the relatively high levels of employment with the very low levels of demand / growth. What is now becoming clear is that employers in the UK have used a number of devices to maintain work forces at lower costs. They have proved that wages don’t have to be sticky. Countless firms have: shortened hours of work, implemented wages freezes of 3-4 years, cut wages, introduced flexible contracts, sent people off on unpaid sabbaticals, cut all bonuses and commission (variable pay). Particularly in private sector white collar work places there is now a great deal of flexibility in wages. This means that employees have been able to reduce their costs to meet new levels of demand and price and this has helped keep employment rates high. The effect of this unsticky wage bombshell is that productivity (which should have been rising sharply) has fallen off quite badly – more people have been doing less work – and have been paid a lot less as well.

Keynes asserted that the reason for “involuntary” unemployment is that a nominal-wage reduction would not reduce “involuntary” unemployment. Furthermore he insisted that involuntary unemployment can only be eliminated by an increase in the price level, but not by a fall in wages wages. The UK economy may well have proved the great man wrong! - I paraphrased Paul Krugman who is pretty hot on all things Keynesian.

The ultimate proof for the un-sticky wage theory will be a rapid rise in productivity as the UK economy takes up the slack. If wages are sticky (as Keynes claimed) then we can expect very little in the way of improved productivity, but if he was wrong then the UK economy could be in for a very strong period of growth accompanied by low inflation. So this is a pretty exciting time in economics and if wage un-stickiness is proved then much of the accompanying General Theory will have to re-examined. If companies can now reduce costs without resorting to sacking employees; and on the other side of the cycle if companies can increase production significantly without direct investment we may well need some new economic models to keep track of all this.

Mr Carney has promised to serve a single five year term at the BoE but he has timed his run well, as he may well have the privilege of proving one of the pillars of modern economics is actually a rather sticky mess.