Tuesday, 20 December 2011

The Entrepreneurial Community

It is commonly held that the main generator of jobs and prosperity is the small business sector. One of the problems that we face in the UK is that ‘small’ is defined in such a way that it covers 99% of all UK businesses. A much better definition would focus on the life stage of the SME rather than its turnover and its asset size. When viewed this way, SMEs fall into two distinct categories – those whose purpose is to grow into a substantial business (and thus create jobs) and those whose purpose is to provide a stable and comfortable income to the owners (our SME survey found this to be the larger category of SME). Public policy has recently encouraged both categories of SME, whereas it might be focussed on the former rather than the latter category in future years.

The Entrepreneurial Community takes responsibility for bringing to market the ideas of the Creative Community. The two appear to go together in tandem, and that a healthy Creative Community is a pre-requisite for a healthy Entrepreneurial Community. However, this is a necessary but not sufficient condition. We need to consider what else is needed to turn a healthy Creative Community into a healthy Entrepreneurial Community. Our survey of SMEs suggested that most SMEs are set up in Suffolk because it is a nice place to live, and that their greatest handicap is the lack of a mature business community. It was seen that this is the one factor that needs to change if Suffolk is to develop a thriving SME sector.

Given the anticipated onset of peak oil, climate change, and resource scarcity, we need to be mindful of the steps that the Entrepreneurial Community can undertake in order to give itself a degree of resilience to these anticipated problems. Indeed, we can reframe the issues to consider them as future opportunities yet to be exploited. As always, it is a case of what action can be taken today in order to help us face the future.

A key to resilience would be the encouragement of SMEs that were located in the Support Economy – the part of the Service Sector that focuses upon the provision of services that are tailored to the higher needs of the individual. This could be done through a series of initiatives, including the development of high speed IT interconnectivity links, the encouragement of off-line business networking, the development of a working culture that celebrates diversity, creativity and innovation, and the establishment of a series of creative hubs that connect the creative hotspots within Suffolk.

The absence of a well developed business community within Suffolk may not necessarily prove to be a handicap in the next two decades. Part of the charm of Suffolk is that the Industrial Revolution passed it by. However, if it is to retain that charm, it must ensure that the Sixth Wave – the technology to address scarcity - does not.

© The European Futures Observatory 2011

Thursday, 15 December 2011

A Happy New Year? Not Likely!

This is the time of year when pundits pull out their reviews of the year past and their appraisals of the year to come. Normally I find that sort of exercise uninteresting. 2012, however is something of an exception. Many of us are aware that an old Mayan Calendar seemed to indicate the end of the world in 2012. We have very little truck with this, but we are aware of a number of fundamental changes that are likely to come to a head in 2012. As always, the story about the future has its roots in the recent past.

Many observers have failed to notice that a new Credit Crunch - CC2.0, if you like – has started. It originated in Europe in July 2011, and has been progressively worsening over the course of the autumn. The cost of inter-bank lending has quintupled between July and December 2011, and has reached a point where European banks are starting to cease lending to each other. The main impact, so far, has been felt at the more peripheral edges of the EU. Whereas, for example, five years ago it was common for Hungarian households to take out a Euro denominated mortgage from an Austrian bank, nowadays that avenue of finance has dried up. Whilst this creates a precarious position, given a high degree of skill on the part of the monetary authorities, it ought not to have tragic consequences.

What would really start things moving would be a run on a bank. Looking at the fragility of the global banking system, a number of weak spots do stand out. For example, the Cypriot banking system is in an exceptionally precarious position. Between 2008 and 2011, Cypriot banks took deposits from the Black Sea Basin that are over five times the Cypriot GDP. This money was then, by and large, invested in Greek Sovereign Debt (Cyprus has an exposure to Greek Sovereign Debt amounting to 160% of GDP). If we take a probabilistic view of the CDS market, then we can arrive at the conclusion that the markets are factoring in a 100% chance of a Greek default within the next five years. Should those depositors from the Black Sea Basin take fright at that prospect and withdraw their funds from Cyprus, it is hard to see how the Cypriot financial system would survive. This, or a number of similar situations, would then provide a test of credibility for the European Central Bank.

To date, the ECB has struggled in its role. We are of the opinion that tightening monetary policy early in 2011, and then having to loosen it again later in the year, was ill considered. The problem is that the political constraints placed upon the ECB prevent it from acting as a central bank. It isn’t able to act as a lender of the last resort and it doesn’t have the capacity to raise adequate funds in the currency that it is supposed to govern. In all fairness, this is partly a consequence of a lack of fiscal cohesion within the Eurozone rather than an inherent fault with the ECB. Nonetheless, it means that, should pressure be placed upon liquidity within the Eurozone, it does not have the capacity to adequately deal with the problem. If the ECB were to seek to deal with a liquidity crisis through a bout of Quantitative Easing (which, constitutionally it has ruled out), we calculate that it would now need access to about €1.5 trillion to €2.0 trillion. The funds that it currently has (about €0.5 trillion) are not sufficient to do the job.

It is easy in the UK to adopt a certain Schadenfreude about the situation in Europe, but a few moments contemplation of the second and third order effects of a European liquidity crisis soon takes the smile off our face. The UK banks have collectively lent German and French banks €1 trillion, who have then lent that money forward to the peripheral sovereigns – mainly Italy and Greece. A similar situation applies to the US banking sector (although American banks have been pulling back from Europe late in 2011), who in turn have received much of their liquidity from the Far East. The world is still as interconnected as it was in 2008 and the transmission of pain will be equally as quick.

Our opening position for 2012 is not a good one at all. It is entirely possible that a miracle will occur – that governments which have recently been acting in a self-centred and narrow minded way will suddenly see the case for co-operation and generosity as a way out of the current mess – but we will assume that the national interests will still prevail and that co-operation will remain limited. That acts to draw up a bleak picture for 2012. We have an extremely fragile monetary system, most fiscal systems are over-stretched, and growth is virtually absent within the world economy. Some may point to the Far East – particularly China – as a source of vitality, but we are of a different opinion. The prospect for growth in China is likely to fall below the threshold needed to maintain internal order, and, with a change in government scheduled for 2012, this may top the Chinese agenda for much of the year. To make matters worse, there are early signs that the Chinese property bubble is bursting. If that were to be the case in any significant way, then Europe would not be the only source of monetary contagion in the global monetary system in 2012.

It would be foolhardy for us to suggest exactly how things are likely to turn out in 2012 because there are so many variable factors that could have a large impact on the year. We could almost characterise 2012 as the year of the ‘Wild Cards’ (low probability, high impact events which result in systemic chaos). However, we can point to some of the issues that may dominate. One such issue is the number of elections that are due for the year. Elections are scheduled in Germany, France, and the US, which does not auger well for economic growth. We ought not to expect bold and courageous policy initiatives this year, even in the face of an acute need for them. If we are very lucky, then we will see the continued burning down of the long fuse that is the debt overhang in the developed world. This provides something of a boundary for what we can expect in 2012. If we are really lucky, and barring any truly silly policy mistakes, then a good result for 2012 will be to continue to bump along the bottom.

There is also a reasonable chance of the anticipated recession developing into a full blown recession. One of the great policy achievements in 2008-09 was the co-ordinated and timely intervention of the G20 nations to prevent recession turning into depression. These factors are absent in 2012. The ability of governments to use the lever of fiscal expansion is far more constrained now than it was then, both politically and financially. The G20 has been captured by the austerity agenda, and it would be a very brave politician to run against this conventional wisdom at the moment. Of course, courage in the face of impending elections is rarely seen. However, the longer term consequences of the austerity agenda have yet to be played out, and may start to become evident in 2012. We have already seen disruption on the streets of European and North American cities. This may well become more violent as time goes on.

We have already seen the suspension of democratic institutions in Europe. How this works out in terms of legitimacy and sovereignty have yet to be seen, but we may well see the start of this process in 2012. For example, the Greek austerity plan is not the product of the Greek democratic process, it is an agenda forced upon the Greek people by their German and French banking creditors. When the Greek Prime Minister suggested that the people be given a voice in the austerity plans, he was forced out of office and replaced by a technocrat with no democratic mandate at all. This has weakened the legitimacy of the Greek government. Our correspondents in Greece suggest that the country is starting to become ungovernable. For example, the absence of a democratic legitimacy means that it is now viewed as acceptable in Greece if citizens don’t pay their taxes. After all, these are taxes imposed by German banks. 2012 has the potential for being a year where civil defiance tops the political agenda.

And this is if things go well! At the other end of our expectations, there is a reasonable possibility of a financial implosion, the consequences of which could be catastrophic. Of the four weak spots in the global financial system (the Eurozone, the US Federal deficit, the US States deficits, and the Chinese banking system), two are showing signs of rapid movement to a critical position. If the Chinese banking system were to suffer acute stress, then it is reasonable to expect the repatriation of part of the Chinese trade surpluses that are currently parked in US Treasury Bonds. This is definitely dark scenario territory. In some of the darker scenarios that we have been working on this year – particularly those based upon the break up of the Eurozone – the immediate loss of output is somewhere between 8% to 10% of global GDP. This quite rapidly becomes a world of deflation and social disorder. As we have mentioned before, in November 2008 as it happens, NICEY (Non-Inflationary Continuously Expanding Years) has become NASTY (Non-Accelerating Socially Turbulent Years), and the prospect of a financial implosion is very nasty indeed. 

2012 is likely to be a very dangerous year. But what of beyond that? Assuming that the Mayans were wrong, and that 2013 follows on from 2012, what hope can we have for the future? We are quite pessimistic about this decade. The debt overhang, sluggish growth, and institutional reform are all going to take a number of years to unwind. In 2009, we thought that the UK debt overhang could be resolved by 2018. We are a bit more bearish now – owing to the fiscal policy mistakes that are currently being made – and we can argue quite well that the debt overhang may be with us some time longer. We are of the view that we are currently in a phase of what Schumpeter called ‘creative destruction’ and what the followers of Kondratiev would refer to as the ‘long winter’. As sure as night follow day, so does spring follow winter.

We are starting to see the commencement of the Sixth Wave of technological advance. This doesn’t have shape or form at the moment, but we take the view that it is likely to coalesce around the technologies of scarcity. At some point further down the line in this decade, the results of the monetary loosening that we are currently experiencing will transform itself into rising prices. Prices of what? We are of the view that the prices of base resources – Food, Energy, and Water - are likely to rise. We have already seen some evidence of this during the period 2006-2009. This is the stimulus that is needed to trigger the Sixth Wave. We are of the view that, just as the great wage inflation of the 1970s provided the trigger for the labour saving technologies of the Fifth Wave (the ICT revolution), so a great resource inflation around 2020 will stimulate investment in resource conservation technologies during the next decade. This investment boom is likely to be the source of the economic growth that is needed to fully address the debt overhang and to provide the new jobs that will soak up the unemployed pool of labour.

Good policy can bring forward this vision just as much as poor policy can defer it. We are of the view that authorities can now, even in an era of austerity, start to prepare for this future by building the infrastructure for it. This need not be physical infrastructure and it need not cost a great deal of money. It could be fostering connections within a community, it could be inspiring the aspirations within a community, or it could be raising the intellectual base of a community through educational and social initiatives. The physical infrastructure is likely to be built in response to the creation of a social infrastructure, using whatever resources that are to hand. After all, it only takes an internet connection to organise a Tweetup. It is our hope for 2012 that we shall see many more of these low cost, high impact initiatives.

2012 is unlikely to be a prosperous year. However, the Law of Undulation has not been abolished, and from our present lows we should aspire for future highs. It is in our hands to sow the seeds of our future prosperity in 2012, and we invite everyone reading this to join us in doing so.

© The European Futures Observatory 2011

Tuesday, 15 November 2011

The Creative Community

It is our belief that if a community wants to foster local, organic, economic growth, then it needs to establish a local creative community within it. The thinking behind this is that economic growth in a knowledge based economy is generated through the process of creative capital accumulation. This happens when the creative processes add to our stock of knowledge. This is enhanced if creative people live near to each other and are able to work and network with each other through the formation of a creative cluster.

The role of the policy makers is to encourage the formation of a creative cluster. This can be done by developing a community that is diverse, tolerant, and open. A community that lacks vision, which finds itself trapped in the past, and where vested interests thwart change is unlikely to develop sufficient a creative presence to achieve lift-off. A core of about 10% of the workforce needs to be engaged in creative occupations in order to achieve the critical mass whereby creative agents coalesce into larger economic entities.

It would seem that it is important for policy makers to develop an area as a great place to live. Creative agents tend to be very demanding for arts, cultural, and recreational facilities. There also needs to be a ‘bootstrap’- possibly a university or a science park - to enhance the creation of intellectual property. The bootstrap acts as a source of technology, talent, and social tolerance. Finally, policy makers need to focus on creating the right ‘people climate’ – policies that are people centred.

Suffolk has a mixed record in these areas. It is a great place to live. It has a number of world class facilities, such as Newmarket (billed as the home of horse racing), which has spun out a number of world class businesses (Tattersalls of Newmarket is considered as one of the leading bloodstock agencies in the world). However, Suffolk does lack a bootstrap. The establishment of UCS is a promising start, but UCS does not confer its own degrees and lacks a significant research centre. Other attempts to establish research led business parks have not met with any degree of success. In many ways, that reflects the composition of the county. Suffolk is dominated by conservative and suburban lifestyles and lacks a Bohemian population of any significance.

In many respects, this bounds what needs to be done over the next twenty years. Within that time frame, it is possible that a significantly creative population could be encouraged, perhaps through the establishment of a series of intellectual and cultural events. These new residents could be persuaded to work in newly established creative clusters, which have been nurtured by the local authority.

This is the key uncertainty that the creative community faces. Is there scope to encourage sufficient members of the creative class to locate in Suffolk? If they can be enticed, then regeneration will follow. If they can’t, then Suffolk will continue to perform below par.

© The European Futures Observatory 2011

Thursday, 10 November 2011

A Right Royal Jelly

I had the good fortune to be invited to the first ‘Suffolk Jelly’ this week. It was organised by Suffolk Digital and hosted at the Eastern Enterprise Hub. I wasn’t quite sure what it was about, so I thought that I would go along to find out. I am very glad that I did because I found it to be a very worthwhile event. In trying to describe the event, I think that it was set in two halves. In one half was an office space which those attending could use for the day. I think that was the idea covered in the report in the local press. However, for me, I didn’t find that format at all helpful – I have a number of offices already.
My interest was aroused and inspired by the second half of the offering – the soap box section. This was a room dedicated to the attendees who were encouraged to present on any subject they liked. Most presentations were made by people telling the audience what they did. It was a bit hit and miss as to whether the subject was of interest, but it was important for allowing the presenters a bit of live practice at making a pitch. Some presentations were a bit more speculative, told the audience what the presenter hoped to do and asked for comment and feedback. This worked really well and provided the sort of feedback that one rarely obtains. My offering for the day was a short piece on why futures matter (or, more correctly, why ‘business as usual’ is not an option). The Q&A turned into a conversation about business model flexibility and adaptability. The whole ethos of the day felt a bit like those ‘Skunk Works’ sessions that some of us attended in previous lives.
What I found most interesting about the day was the opportunity that it afforded to build creative capacity within Suffolk. There are currently a large number of creative agents based in the county, but without a node around which to coalesce. The Jelly format seems ideal for delivering this. For example, I saw presentations by Jamie Riddell (basically a trend spotter/ cool hunter), Andrew Walker (whose line is data analytics), and Steve Butterworth (whose cause of citizen journalism is all about picking the story out of masses of raw data). To my mind, there is scope for these three individual agents to work collaboratively to bring to market a combined offering that would be larger than what they could achieve on their own.
And that is the challenge of building a creative community. There is more to it than simply joining the creative hotspots. Those connections need to amount to something larger than the individual parts. The first Suffolk Jelly may not have achieved that because there remains a great deal to be done. However, it was a very valuable first step in the right direction.
Click Here for details of the Jelly.
Click Here for press coverage of the event.
© The European Futures Observatory 2011

Saturday, 5 November 2011

The Many and the FEW

The whole premise of our ‘Communities of the Future’ project is based upon two assumptions. The first is that, by 2025, global population will have increased from its 2000 level of 6 billion to a new level of 8 billion. These are ‘the Many’. This is a mid-range estimate, and there is a likelihood that population could be higher or lower than that figure. However, for the purposes of the project we shall assume that the mid-range figure will be more or less correct.

One of the implications of this rapid population growth is that we shall need to grow more food. In doing so, we shall use more energy and we shall use far more water. The second assumption is that the supply of these resources is either fixed or growing at a rate that is slower than the growth in demand for these resources. For our purposes, we shall assume that the growth in demand far outstrips the growth in the supply of resources, giving rise to a period of acute scarcity. These scarcities are likely to be further exacerbated by the impact of climate change and peak oil.

In the period to 2030, we do not envisage a substantial change away from the reliance upon the price mechanism as a means of allocating scarce resources. There is a case for a more formal rationing system for key resources – such as electricity – towards the end of the period, but we do not feel that a consideration of a fundamental change in the current distributional system is warranted.

In which case, the era - as we see it - will be one of high prices for basic commodities. This is likely to cause a certain degree of social stress, as we see the incidence of fuel poverty rising and we see the possibility dietary standards declining. However, it does create an incentive for the construction of social technologies to counter this. We feel that people are likely to become more communal and sharing in their lifestyles, as a means of coping with the problems that they face. The challenge to social enterprises will be to create the institutional structures to deliver a more sharing way of living.

Initially, high prices for basic commodities will act as a brake upon commerce (this is the ‘income effect’). The high cost of inputs is likely to reduce the levels of economic activity for the first part of the period under review. However, this will also create a commercial opportunity for those creative enough to find it. The initial shock of rising prices is likely to stimulate ways of using resources more effectively (the ‘substitution effect’), and those entrepreneurs who unlock the substitution effect are set to do very well.

Ultimately, the relative high price and scarcity of resources will stimulate investment in resource saving technologies. We see these as starting to have an effect towards 2030. This investment is likely to act as a stimulus to economic growth – ‘green’ economic growth!

© The European Futures Observatory 2011

Click Here for more information about the ‘Communities of the Future’ project.

Click Here for more information about the session ‘The Many and the FEW’.

Monday, 3 October 2011

China To The Rescue?

There are those who take the view that the emerging Asian economies – especially that of China - might prove to be the salvation of Europe and America. This view rather neglects the unfortunate fact that the Asian economies – especially that of China – have problems of their own and it may not be entirely convenient for them to act as a rescuer to western economies. China, in particular, is suffering from an economy that is in danger of overheating. Inflation is rising and an awkward looking property bubble is forming on mainland China. Asking the government of China to add to that inflation seems to be unrealistic at best.
The size of trade deficits between China and both the Eurozone and the US has allowed the exchange rate to be used as a vehicle of monetary tightening. There has, in recent months, been a slow appreciation of the Chinese currency against the US Dollar and, to a lesser extent, the Euro. The main motive for this appreciation has been to act as a check upon domestic inflation within China rather than to act as a device to stimulate demand for American and European goods. However, the degree of appreciation has been nowhere near the levels needed to provide a stimulus for the sluggish Western economies. The Chinese government continues to manage the exchange rate in a way that minimises the possibility of internal unrest, which means that all changes are slow and deliberate. This is not set to change.
Monetary conditions within China now require a tightening. However, this policy also requires a great degree of finesse. The exact quantity of non-performing loans in the Chinese monetary system is unknown, but is thought to be much higher than in Europe, the US, and even Japan. Some estimates suggest that the degree of non-performing loans could be as high as a third of the assets on the balance sheets of Chinese banks. If the monetary authorities tighten too hard, this could expose the volume of these non-performing loans at exactly the wrong time, triggering a Chinese banking crisis. If the monetary authorities are lax in their tightening, then they might not deal effectively with the inflation that is weakening the Chinese banking system to begin with. In either case, a wobble in the Chinese banking system would have major global consequences.
It is worth considering how and why such a wobble might take place. In recent years, Chinese local authorities have been forming large numbers of joint ventures with the private sector bodies. A principal objective of the joint ventures has been to buy and develop property, especially throughout the eastern seaboard of China. The joint ventures have received preferential access to banking funds – often controlled or heavily influenced by the local authorities – to finance the investments. The allocation of capital has not always been on the strictest of commercial considerations. Not all of the loans made are fully performing. It would appear that, over this summer, the number of defaults in the Chinese banking system have started to rise.
We can expect this process to continue. As the Yuan continues to appreciate, as interest rates continue to rise, and as banking reserve ratios continue to creep up, the availability of new finance in China will diminish. This will have the effect of reducing demand in the property sector, which will lead to property prices softening. If panic sets in, as happened in 2009, prices could fall quite sharply to expose the weakness of many property funding arrangements. In itself, this will not readily transmit into the monetary system. One possible response by the Chinese central bank could be to ease credit in the face of a property bust. However, a consequence of that policy would be to rekindle the inflationary forces that are currently being dampened down. If, as is more likely, the monetary tightening were to continue, even in the face of a weakening property sector, the problem could easily transmit from the property sector into the financial sector.
If the property sector were to crash, it is likely that many property investors would also liquidate their stock holdings to cover their property losses, as far as they could. We could almost say that this is happening already. Since 2009, the Chinese economy has grown by over 9% per annum, whilst the stock exchange is trading at broadly comparable levels in nominal terms. If we factor inflation into the picture, then it is true to say that the stock exchange has witnessed negative real growth between 2009 and 2011. This partly reflects the flight of capital from China to the relative safe haven of the US (the Dow Jones Index is up by 20% over the same period, even allowing for a bad summer in 2011), but it also reflects the liquidation of stock holdings to cover losses in the property market.
At present, the effects of all of this have been fairly mild. There is a reasonable risk that such an event could become substantial. In April 2011, Fitch warned that it was changing its stance on Chinese local currency denominated debt from ‘Stable’ to ‘Negative’. The debt currently has an AA- rating, but could well be downgraded in the near future. If it were to happen, then the repercussions would be felt well beyond China. A run on the Chinese banking system could be accommodated by the Bank of China, but not without recourse to the repatriation of holdings of overseas debt that it owns. It is not unreasonable to conceive of a run on Chinese banks leading to a run on the American banking system in fairly short order. Beyond that, the contagion would spread to the global banking system quite rapidly.
At the moment, few observers have factored into their calculations the possibility of a renewed financial crisis originating in Asia. We feel that they ought to. There is a reasonable chance of financial instability emanating from the region, and we feel that the current view that Asia will rescue the European and North American economies is nothing more than fanciful.

© The European Futures Observatory 2011

Monday, 26 September 2011

Time For QE2?

Despite Project Merlin, it would appear that there is a problem with the UK banks lending to UK non-financial corporations. The graph indicates that, since 2009, lending has been negative in absolute terms. If we factor in an inflation rate in the region of 5%, then lending in real terms has been negative since about 2008.

The policy of quantitative easing, where the Bank of England injected £200 bn into the monetary system, lowered interest rates to an effective nominal rate of about -2.5% in nominal terms and stimulated GDP by about 1.5% to 2%. This was a great success. It meant that we suffered a recession instead of an economic slump. However, it was also something of a blunt instrument in that much of the injection did not make it to the real economy. The policy also diverted cash from one idle pool of money (the gilts market) into another (the stock market). It is no accident that the FTSE 100 share index rose by 50% during the period in which the Bank of England made its purchases.

That, of course, does not mean that the policy would continue to work if it were to be repeated. For the policy to work, there needs to be a more direct link between bond purchases and bank lending. The proposal for QE2 to but bank bonds rather than gilts might go some way to address that problem. It would be a way to give Project Merlin some teeth. There is the possibility of some capital loss on the part of the Bank of England, but given the levels of profit made during the onset of the credit crunch, these do not need to be substantial.

If monetary policy is to be the chosen route - and I have to say that a fiscal stimulus aimed at low income families would be more preferable - then a monetary easing directed at small business is unlikely to do much harm. It may even help to boost growth a bit.

© The European Futures Observatory 2011

Sunday, 25 September 2011

Not Quite The Whole Truth

This is a curious example of a story not quite telling the whole truth. We are told that "Britain's banks, moreover, are not among the most exposed to Greek debt. " That part is true. But it is not the whole truth. French and German banks hold about two thirds of the Greek sovereign debt. Any action to prop up Greece, is also action to prop up the French and German banking systems - a point missed by many French and German voters.

However, from where did the French and German banks get the money to buy Greek sovereign debt? It is the case that British banks lent the French and German banking system over €1 trn. Any pain felt by French and German banks will be quickly transmitted to the UK banking system. From this, we ought to deduce two conclusions. First, nobody can afford to be smug about the pain of others. We are all in this together. Second, any politician who claims that the cost to their constituency of a Greek failure would be minimal either knows the truth and is not telling it, or doesn't know the truth and really ought to.

© The European Futures Observatory 2011

£1.75 trillion deal to save the euro - Telegraph

Wednesday, 21 September 2011

Who Will Look After Little Brother?

One potential debt crisis that has escaped our attention so far this year is that of the US States. An interesting feature of the American political system is that the political sub-units – the US States – enjoy a greater deal of fiscal freedom than many political sub-units elsewhere in the developed world. Whilst US State governments follow a more integrated monetary policy, which tends to reflect a national agenda, they also have the ability to pursue a more independent fiscal policy.

To this extent, the US system is comparable to the Eurozone. We must not follow the analogy too far because the American States are different to the Eurozone nations in that they have more of a common heritage, a common language, and a tradition of openness within a broader economy than the EU has yet to develop. And yet, we cannot but help to think in terms of California having a GDP similar to Italy, or Wisconsin the size of Ireland, and so on. It is instructive to do so when considering the issue of potential monetary instability.

The average fiscal deficit to GDP ratio in the Eurozone is about 4.2%. This average hides a wide dispersion of results, from a Greek deficit of about 10.0% of GDP to a German deficit of about 1.7% of GDP. The situation in America is slightly different. The estimate for US Federal debt is about 9.0%, which is in the ball park in comparison with some of the Eurozone nations. However, the average State debt is about 16.5% of State GDP, which is a figure that makes Greece appear to be fiscally prudent. There is some debate about the accuracy of these figures (State GDP is very hard to measure in a fluid and open economy such as the US), and we have to remember that there is also a political agenda to their estimation. Additionally, there is also a greater deal of dispersion around this mean, from Wyoming (with a deficit of about 6% of State GDP) to Massachusetts (with a deficit of about 25% of State GDP).

If we believe that the US State deficits and the US Federal deficit are additive, that would imply total public debt in the US of about 25%. This seems rather large to us, and suggests that an element of double counting has crept into the estimations. Nonetheless, we are comfortable with the conclusion that US States deficits are worse than those of the Eurozone nations, and that there is a greater variation of experience with the deficits of the US States. All of this remains hidden by the US Dollar being the world reserve currency. Just as the weaker Eurozone nations have hidden behind the collective strength of the Euro, so the US States have hidden behind the US Dollar being the world reserve currency. This has kept down the cost of borrowing for US States and has made funds more readily available than the fiscal environment would otherwise have offered without this feature.

Looking into the future, one wonders how long this will last. If the US credit rating suffers further deterioration, then there may well come a point where the position of the US States is re-evaluated in the bond markets. Just as the more vulnerable Eurozone nations have suffered the scrutiny of the bond markets, so could the weaker US States, such as Michigan or California. If that were to happen, then rather unfortunate consequences could result. In thinking about what could happen next, we have found the case of the near bankruptcy of New York City in the 1970s to be instructive.

The relative fiscal independence of the US States means just that – they are responsible for themselves. If their finances were to come under pressure, then there is no automatic mechanism whereby the Federal government would have to bail them out. If the Federal government took a position of moral hazard – that those who made the mess have to clear it up – then it is quite likely that the State governments would respond by increasing revenues (charges as well as taxes) wherever possible, along with the more likely policy of cutting back expenditure very hard. Even today, it is not entirely unknown for the staff in some States to be paid in IOUs, which are redeemed for cash by a credit union or bank. We could well see a lot more of this. It is at this point that one of the great strengths of the US economy becomes one of its weaknesses.

Although there is some migration between nations in the EU, by and large, European populations are having to bear fiscal austerity. The tax base is relatively stable and the pain of spending cuts is simply endured. This is not so in the US. Given the open nature of the US economy, given the fluidity of its labour market, and given the relative homogeneity of the population, it is far easier to move house. Often to a different State. It is relatively easy to move from fiscally imprudent New York to fiscally prudent Connecticut – you would simply be moving further up the commuter line. This feature creates an instability to the State finances. It is generally the case that the tax base is highly mobile (and will pack up and leave if taxes are seen as too high), whilst the spending base tends to be immobile. The tax base moves out, whilst the spending base stays put. For a State under pressure, this will make the situation worse.

In this future, if it came to pass, the Federal government would have to bail out the State, much as it eventually had to with New York City in the 1970s. Not because it has to, but because it is in its interest to do so. The cost of such bail outs would be truly staggering, and we can see why the Federal government is reluctant to contemplate it. This completes the circle, because a failure to contemplate the downside of the finances of the US States may well lead to a further downgrading of the US by the ratings agencies.

Most visions of the financial future do not account for adequately the inherent instability that the US State finances could contribute to the global monetary system. We feel that this is a mistake. We fear that the realisation of this weakness could lead to a sudden correction in valuations that itself could become a destabilising factor. Then we will all be wondering who will look after the little brother.


© The European Futures Observatory 2011