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

Monday, 12 September 2011

Has The Giant Stumbled?

The US has had a poor year to date. The American recovery started to run out of steam in the spring, the second round of Quantitative Easing ended in the first half of the year, and the question of Federal debt has come under the spotlight. The key debt issue was the raising of the Federal debt limit. Eventually, a temporary compromise solution was found, but the process of reaching this compromise has demonstrated the polarised nature of American politics and has weakened considerably the position of President Obama. It was for this reason that the US credit rating was downgraded from AAA to AA+.

The long term consequences of this downgrade have yet to emerge, but there are three factors to be aware of as we move into the future. First, could we take this as the opening move in the US Dollar losing its status as the global reserve currency? It is not quite a ‘Suez Moment’, but has the potential to start the process by which one emerges. How America would respond to these events is uncertain, but the world needs certainty right now, not more uncertainty. Second, the cost of borrowing in America is likely to rise in the long term, thus muting the economic recovery – which is already weak. It means that the world can no longer rely upon the American consumer to generate a recovery. Exactly where we should look for this engine of growth has yet to become clear. Thirdly, the political intransigence in America makes effective US Federal debt reduction appear even more remote. One political grouping will veto all tax rises. Another group will veto reductions in defence spending. And a further grouping will veto spending reductions on healthcare and welfare spending. It is not helpful for America to have a polarised and intransigent political system, but that is exactly what it has.

The political classes in the US are rather hoping that growth in the economy will move them out of the difficulties which they now face. With growth, overall tax revenues will rise, leaving the spending commitments much more affordable than they presently are. The question then is whether or not a presumption of growth is reasonable. In assessing this question we need to consider the point at which we are starting. The US has been hit hard by the recession. According to the US Bureau of Economic Analysis, GDP (which it measures in 2005 constant dollars, a practice which we shall continue) fell by about 6% between 2007 and 2009. During this time, US unemployment roughly doubled from abut 5% to about 10%. A recovery has been under way, but the level of GDP is still below the 2007 level and unemployment remains about the 9% level. The growth there has been is well below trend.

More worryingly, this growth has been achieved with the benefits of a $1.2 trn fiscal stimulus and two bouts of quantitative easing to the tune of $2.3 trn. The prop of quantitative easing has now been removed for the moment. Some of the temporary fiscal stimuli are also now coming to the end of their mandate. On top of this, the agreement to raise the debt ceiling institutionalised further cuts in federal spending of between $2.1 trn and $2.4 trn, depending upon whether a consensus is reached about where spending cuts and tax increases are to be incurred. Either way, the public sector support for the US economy is likely to become much reduced this year. It is for this reason that a softening of the US economy looks likely, and a double dip recession is not exactly off the agenda.

In the longer term, US politicians are relying upon the private sector to generate the growth needed to jump start the economy. This is unlikely to come through US exports – the overseas customers of US firms are likely to be facing the pinch just as much as US consumers. A weakening dollar may provide some relief to US exporters, but not at the levels needed to revitalise the economy. Both the private household sector and the private corporate sector are currently looking to repair their balance sheets, which has led to some poor consumption and investment figures. As households retrench, so will the corporate sector, as the prospects for future profits become even more limited. If there ever was a case for a fiscal intervention, now would be it.

Which brings us back to the political malaise in Washington. One of the interesting things about the American Constitution is that it is the product of conscious design. It hasn’t evolved and fallen together as the British Constitution has, but was actually designed in a way that checks and balances would prevent too great an accumulation of power. It was, however, based on a presumption of a willingness to compromise, and that willingness has been lacking in recent months. To an outsider, it seems as if the political system has been hijacked by extremists who would willingly destroy their country rather than reach an accommodation with those who do not share their view. If the extremists fare well in the elections next year, then we can expect the US economy to show sluggish growth for the rest of this decade. A modicum of common sense is a necessary, but not sufficient, condition for an American recovery.

It is possible to design a fiscal stimulus that does not increase the US federal deficit. For example, renewing the mandate to extend unemployment cover, to be paid for by a tax on the idle balances of the rich or a levy on tax-payer funded banking profits is not beyond the scope of most governments. By definition, the taxes would be levied on dead money and given to those who are most likely to spend them. If the idea of giving money away sounds too socialistic, then the unemployed could be asked to work for their benefits on a myriad of socially useful, but commercially unattractive, projects. Surprisingly, this is exactly what the financial community is looking for – a credible deficit reduction plan that enhances growth.

There is the possibility that if America does not find this way internally, then it may be enforced by an external authority. The Chinese Government – a principal creditor of the US – has already expressed its displeasure at recent events in Washington. There is evidence to suggest that China has fallen out of love with US T-Bills and is currently diversifying into other currencies. If this were to become a more clearly defined trend, then the prospect of rising interest rates in the US would be a very unwelcome turn of affairs. It is within the gift of China to force the issue through the bond markets and it is important for the political classes in America not to have the issue forced. Again, Washington needs a credible deficit reduction plan that enhances growth. We fear that if this is not achieved, the the AAA  status may not be regained, and the US may even be downgraded further.

This is not to say that the future for the US economy is all bleak. It is entirely possible for the US to enter into a virtuous circle by resuming a growth path. However, to do so will require very skilled political leadership, and that is what we are looking for when we review American economic prospects in the medium term.

© The European Futures Observatory 2011

Wednesday, 7 September 2011

How Deep Are A Gnome’s Pockets?

Harold Wilson once famously railed against Swiss bankers – who he dubbed the ‘Gnomes of Zurich’ – when he felt that they were unfairly driving down the value of the Pound. How things have changed. Bankers other than the Swiss variety have recently been depositing their funds in Swiss Francs as a result of the uncertainty over the Euro and the US Dollar. The Swiss Franc has been seen as a ‘safe haven’ currency, which attracts large volumes of liquid funds when the financial environment seems excessively risky. The result of this has been to drive up the value of the Swiss Franc, causing the Swiss Central Bank to worry about the deflationary and recessionary consequences of a general deflation.

What to do? The traditional response would be to reduce interest rates, to make the Swiss Franc less attractive to overseas investors. The problem is that Swiss interest rates are, like those elsewhere, virtually at rock bottom. If the Swiss authorities could persuade others to raise their interest rates, then Swiss rates could fall in relative terms. The problem is that there is no great appetite for to help Switzerland in the international community. Other nations feel that they have who have too many problems of their own to co-operate with Switzerland.

That leaves managing the external rate of the Franc as the only option open to the Swiss authorities. The only tool that they have are open market interventions. If Switzerland had a regime of strict exchange controls, then managing the external rate would be much easier. It would also destroy the Swiss banking industry, which relies upon funds freely flowing into their coffers. Market intervention is a costly business. It is reported that the Swiss National Bank (SNB) has lost SwFr 10 bn already this year on defending the currency. Now that the markets sense a vulnerability – one that is possibly unsustainable – there is an incentive to bet against the Swiss Franc until the SNB runs out of money.

It is at this point that we shall see exactly how deep are the pockets of a gnome.

© The European Futures Observatory 2011

Switzerland abandons floating exchange rate in dramatic 'currency war' twist

Swiss move to make its safe-haven less attractive

Swiss gloves come off in battle over value of franc

Monday, 5 September 2011

A Sick Old Man?

The economic case against Europe is well rehearsed. The longer term case against Europe is one of demographics. The population of Europe is ageing, and, if nothing changes to the contrary, the dependency ratio of workers to non-workers is likely to fall to the point where a severe shortfall of workers (and their tax receipts) occurs. So far, the discussion has focused upon reducing the fiscal impact of an ageing population, without considering other remedial measures that could be taken.
In the short term, the Eurozone has become a monetary union without an effective mechanism to deliver fiscal co-ordination. As a result, the weaker economies of Portugal, Ireland, Greece, and Spain have been allowed to borrow way beyond a prudent level with very little adverse consequences. Equally, the Euro provided a vehicle whereby the stronger Eurozone economies – particularly those of Germany and the Benelux nations – could power ahead faster than they otherwise would have done. An imbalance was created between the stronger and weaker Eurozone economies that has now become unsustainable.
The present situation in Europe needs greater fiscal discipline on the part of the weaker Eurozone economies and a greater fiscal transfer system on the part of the stronger Eurozone economies. Over the course of the summer, we have been inching towards this solution. We can hope that the process will continue, but perhaps with greater speed than we have seen to date. Interestingly, this could have two important long term consequences. First, we could see an inner core to the EU that has a high degree of monetary and fiscal integration – the ‘two speed Europe’. Second, that inner core could emerge as quite a strong economic force in the global economy, particularly when compared to America. After all, the Eurozone as an economic unit has a GDP to rival that of the US, the Eurozone is more of a trading force in the world economy, and, despite all of the adverse comment in the press, the Eurozone as a whole has a lower debt to GDP ratio than the US. A more integrated European economy would be a welcome result from the present malaise.
For this to happen, a number of institutional innovations need to be devised. Presently, Europe is relying upon the ECB to purchase the sovereign bonds of the Eurozone nations – a form of European wide quantitative easing. It is difficult to see how this could go on into the long term without the re-capitalisation of the ECB (the ECB has reserves of about €0.5 trn, whilst some commentators suggest that €1.5 trn to €2.0 trn might be needed to effectively stabilise the Euro). There is a case for such restructuring to be accompanied by the issuance of Euro-Bonds. In effect, this would create a fiscal union to parallel the monetary union within the Eurozone. It could, if constructed properly, actually force the weaker Eurozone nations to adopt greater levels of fiscal discipline. For example, if the issuance of Euro-Bonds were to be limited to the Stability and Growth Pact limit of 60% of GDP – an idea first floated by the Bruegel Institute – with the excess being raised under the present conditions, then it would allow nations such as Greece to have about half the sovereign debt guaranteed by the collective Eurozone nations, with about a further half to be raised under the credit-worthiness of Greece as a sovereign nation. As things currently stand, this is a move expected by the bond markets but resisted by the national politicians of the stronger Eurozone nations at the behest of their voters.
This disparity between market expectations and the willingness of politicians to act is nudging events along the course outlined above. The last final step – the issuance of Euro-Bonds – is looking ever more likely if the Euro is to remain as a currency. If the threshold of Euro-Bond issuance is not crossed, then it is difficult to see how the Euro would remain as a currency. If Euro-Bonds were to be issued, then the Eurozone would be free to concentrate upon the fiscal impact of ageing European populations. Much of this discussion has been the result of straight line thinking. It has been concerned with the shrinking of the tax base and the expansion of the welfare base. This approach, however, might be a bit premature.
Across Europe, governments have been taking steps to make their future pensioned populations less of a fiscal burden. Retirement ages have been increased, contributions to retirement schemes have been increased, and less generous entitlements have been devised. All of which act to lessen the impact of future pension spending upon the public purse. The argument about the dependency ratio is also unlikely to ring true. When faced with labour scarcities, Europe has traditionally imported labour,  rather than relying upon the natural growth rate of the population. This helps to maintain the tax base. It can be achieved in one of two ways – the first is to increase the number of young people in the EU through the accession of nations with relatively young demographic profiles. The case of Turkey is one to watch in this area. The second way of increasing the number of young workers is to attract them as ‘guest workers’ through schemes such as the ‘Blue Card Scheme’. This may well inform EU policy towards North Africa in the near future. Together, the redefining of retirement combined with an influx of young workers are likely to reduce the fiscal impact of an ageing population.
In all of this discussion we must remember that it is entirely possible that the Euro could still collapse. Equally, we must not under-estimate the political will to keep it afloat. That political desire to keep the Euro afloat is nudging the Eurozone towards a closer fiscal union to match the current monetary union. As a result, Europe of the future could become much stronger commercially than it is today. At that point, those EU nations that are outside the Eurozone, such as the UK and Denmark, may come to regret the decision to stay out.
© The European Futures Observatory 2011