The Pace Quickens

We are all starting to feel the impact of China on our daily lives. For example, the ‘China Price’ is rising, which means that we are feeling its effect in falling disposable incomes (through higher inflation). It does not mean, however, that all is lost. One beneficial effect of the China effect is that the government of China can now look to Europe for investments and purchases. Purchases help European exports, but, more significantly, Chinese investments are providing a prop to the Euro at just the time that it is needed.

Of course, good news for Europe is bad news for the US. As Euro denominated bonds become the choice of Chinese investors, so they are moving away from investments denominated in US Dollars. This will give the fed a refinancing headache in the near future. As it does so, the geopolitical decline of the US will be shown in a more stark light, counterbalanced by the stark rise of China.

To this extent, the pace of change will appear to quicken.

© The European Futures Observatory 2011
BBC News - China's Hu Jintao: Currency system is 'product of past'
Charlemagne: Mr China goes shopping | The Economist

Business As Usual?

One of our contentions is that the financial economy and the real economy each run to a different rhythm. At times when both of the economies are synchronised, tremendous gains are made. When they are out of step, then problems arise. Our current economic difficulties originated in a hic-cup in the financial economy. There was an edifice of credit given too easily to people who were patently unable to repay the loans (what Will Hutton calls the ‘Ponzi Economy’), regulators who were unwilling to regulate this lending, and  a financial sector driven by greed and personal enrichment to expand this lending beyond safe limits. All of this came tumbling down when the financial economy hit a speed bump.

It was by no means certain that the contagion in the financial economy would need to spread into the real economy. After all, the bursting of the ‘Dot.com Bubble’ only had mildly recessional implications. However, a combination of a poor and tardy policy response – particularly in the US – allowed the contagion to bleed from the financial economy into the real economy. And here we are, where we are – the worst recession since the 1930s.

The financial economy and the real economy are still out of step. Across the OECD, unemployment remains high, there is still a relatively large debt overhang in the public and household sectors, and the output gap remains higher than previously experienced. All of this suggests that the real economy needs further fiscal and monetary stimulation. The financial economy, on the other hand, has largely recovered from where it was during the credit crunch. Credit is flowing again - albeit at much reduced trading volumes - the financial system has been shored up, bank profits have returned, and even large bonuses are back on the agenda of bankers. The danger, as the financiers see it, is the nascent inflation that could result from the recent monetary expansion. The financial economy needs interest rates to be increased as part of a monetary contraction.

In many respects, this reflects a desire to return to ‘business as usual’. Of course, if I were an investment banker, I would see the logic behind returning to stellar salaries as quickly as possible. However, the policy of ‘business as usual’ implies that we continue to make the mistakes that put us into recession to begin with. This suggests that the financial economy has yet to come to terms with the paradigm shift that the recession has caused.

For example, the conventional wisdom that proved to be unwise in 2008 states that if inflation is building, then interest rates should be increased and monetary policy should be contracted. If the MPC were to follow the suggestion of Andrew Sentance to increase interest rates, would it work? We think not. The main inflationary pressures that we are currently experiencing are structural in nature caused by rising food, energy, and commodity prices. Raising interest rates may cause Sterling to appreciate a little (or it may not), taking the pressure off those food, energy, and commodity prices denominated in US Dollars, but the impact on global food, energy, and commodity prices is likely to be negligible. UK interest rates would have to rise very far in order to have an impact on global commodity prices.

Instead, such a policy is likely to do severe damage the real economy. Low inflation rates and a low value of Sterling, which fell by between 20% to 25% in the period 2007-10, have stimulated the UK manufacturing sector that exports to Europe, the US, the Middle East, and the Far East – i.e. those economies based around the Euro and the US Dollar. Whilst the cost of imported materials have risen, this is unlikely to lead to a domestic inflationary spiral because of the sheer size of the output gap. There is too much slack in the economy, particularly with the public sector redundancies starting later this year, for inflation to get out of hand.

And this is the point at which we arrive. If it is UK policy to nurture the exporting manufacturing sector, then interest rates need to be held low for some time to come, despite the occurrence of structural inflation. If, on the other hand, interest rates are raised, then it signals a surrender to the financial economy and a return to ‘business as usual’.

If this occurs, the we ought not to complain too much about bankers bonuses. After all, that is part and parcel of our economic policy.

© The European Futures Observatory 2011

BBC News - UK interest rates remain at 0.5%

The Economist | The outlook for exports: Trade winds

A Chinese Endgame.

The rise of China over the past couple of decades has been quite relentless. Year after year the Chinese economy has grown, year after year Chinese commercial influence has expanded. Sino-sceptics point to the apparently rigged exchange rate between the Yuan and the US Dollar as the source of China’s financial might – the origins of the huge currency reserves – which has un-balanced the world economy.

The US would like China to allow the appreciation of the Yuan faster than it is currently appreciating. The Chinese government is reluctant to do so, fearing the political consequences of a slowing in the growth machine. However, this does create another problem in its wake. A high Yuan may help Chinese employment, but it also hinders the attempts of the Chinese government to keep a lid on domestic inflation.

China imports many of its raw materials. The weight of Chinese purchases in global markets has given rise to demand led price inflation for those resources – from food to metals to oil. This is starting to push an inflationary spiral in China. Normally, governments would counter an inflationary spiral by raising interest rates and allowing the exchange rate of the currency to appreciate. This policy has effectively been discarded.

The policy is to do nothing. Normally this is not a bad option, but in this case it might not be. If inflation takes root, then it could become as equally destabilising as rising unemployment. The prospect of an impoverished middle class is just as unattractive as the prospect of an unemployed middle class. However, this fuse is burning slowly. We are unlikely to see great change in the near term, but in the longer term this is a problem that will have to be dealt with.

In the meantime, we should note that the “China Price” is rising.

© The European Futures Observatory 2011
Price rises in China: Inflated fears | The Economist

Happy New Year

It’s about this time when many forward looking pundits outline their views on how the year ahead will shape up. These forecasts are not always very accurate – the example of the forecasts of UK unemployment at 3 million at the start of 2009 come to mind – because they turn out to be an expression of hopes and fears rather than a serious examination of the forces and trends that will dominate the year ahead. I try to avoid making predictions because it is too easy to be wrong. Flying cars and robot house servants come to mind of examples where the speculations of futurists have been wrongly taken for predictions of the future. Instead, I try to consider what the forces are that will shape an emergent future – to look at possible futures rather than predicted futures. We are currently working on a project that examines the forces that are likely to shape the coming decade. As this is the forward looking time of year, we thought that we would share these observations.

We have identified five key trends that we think will shape the coming decade. These are quite broad trends – almost mega-trends, if you like – and are likely to have a substantial impact upon how we live through the coming decade. The five trends are:

1. The Great Re-Balancing Act: There is much of the global economy that is unbalanced – Asian savings, North American and European debt, the levels of household indebtedness, the imbalance between the public and private sectors, productivity differentials, and so on. These imbalances are unsustainable in the long term. The re-balancing of the global economy is likely to dominate the next decade in various shapes and forms.

2. The Reform Of Big Brother: The public sector in Europe and North America has grown substantially over the past couple of decades. It is set to grow even further as the Boomers move into retirement, through the expansion of spending on retirement benefits and age related healthcare costs. At the same time, the prospect of muted recovery will act as a constraining factor to the tax base. As public finances are squeezed, reform will become inevitable and is likely to feature as a trend in the next decade.

3. The New Enlightenment: Our public infrastructure reflects a set of institutions that arose out of The Enlightenment. There are those who believe that this institutional infrastructure is inadequate for modern society. Some look to reform the existing infrastructure, whilst others look to establish new institutions. This is given a sharper edge by the need to reform the public sector, and is likely to be a feature of the coming decade.

4. The New Nationalism: Over the next decade, the best part of a billion souls will be added to the population of the world. This will place acute stress upon all sorts of resources that could result in their prices rising considerably. The traditional response of nations to such stress is to retreat into a nationalist cocoon, a feature likely to be made worse by a muted recovery in the global economy. If so, then the process of globalisation may stutter in the coming decade, with all sorts of consequences.

5. The Icarus Effect: Prior to the global recession, a number of economies were growing and developing at a rapid pace. As recession hit, the growth trajectory of all economies dipped. Some economies have bounced back from that dip (e.g. China), whilst other economies have simply hit the ground (e.g. Ireland). As this trend unfolds further, it is likely to be affected by the re-balancing of the global economy, which could call into question whether this is really the ‘Asian Century’.

None of these trends is set in stone. Events may occur that lead to sharp discontinuities in the trends – we only have to look back 10 years to see what a discontinuity 9-11 was. However, they do provide a useful device by which we can examine current events from a long term perspective. In doing so, we need to be sceptical about our work. Whilst the trends seem to be evident now, they may become less evident as time goes by, as new trends emerge. We see the trend identification as a road map looking into the future, a map that should help us to see where we are going.

Of course, we also need to remember that all maps become out of date over time.

© The European Futures Observatory 2011

Spooking The Horses

There are times when a well intended policy can actually make matters worse. It seems to me that the European Stability Mechanism may be just one such policy. It is designed to ensure that the financial markets are operated in an orderly fashion in the face of one member of the Euro coming under pressure, but they may serve to de-stabilise the markets by being open to undue political pressure.

In future crises, the EU will require the crisis stricken member of the Euro to force losses on the existing bondholders before a bail out package would be approved. In the future, in the face of the certainty of a loss, what will those bondholders do? My guess is that they will dump the crisis stricken bonds at exactly the time when the Euro member state would want them bought. What will prospective buyers do? Sit on their hands until the price of the debt stops falling. As bond prices are the inverse to interest rates, of course rates are likely to rise.

However, as greater risk has been introduced to the system, it is quite likely that the system will become more volatile. Just as we want to quiet the horses, there go the politicians spooking them again. At least this will give rise to some good shorting opportunities in the medium term!

© The European Futures Observatory 2010
BBC News - EU to target private lenders in future bail-outs

The Geopolitics Of Scarcity

As we start to look at the onset of scarcity, all sorts of second and third order consequences start to emerge. One such consequence is how the impact of food scarcity could undermine the authority of the Chinese Government.

The model is quite simple. A combination of globalisation and a fixed exchange rate have allowed China to develop into a manufacturing powerhouse on a global scale. This has raised millions of Chinese families out of poverty (60 million families a year – that’s a huge number). As incomes have risen, so have dietary expectations. Chinese families expect to eat more regularly, with more food, and with a higher protein content than they have in the past. All of this puts pressure on global food markets.

However, China is also a poor nation, a feature of which being that expenditure on food is a high percentage of household disposable income. As food prices rise, they have a more immediate effect on households than they would, say, in ‘Western’ economies. This is the basis for discontent, which may lead to unrest. The last time food prices rose quickly, there were outbreaks of unrest in Tibet and Xin-Jiang provinces, as the rising cost of food exacerbated an existing set of grievances.

One way in which the Chinese government could reduce the impact of rising food prices could be to allow the Yuan to rise faster than it is currently rising against other currencies. However, this policy has the risk of slowing China’s export growth, which has been the basis for prosperity so far. It would also mark a shift in China’s commercial policy away from export-led growth and towards domestic consumption-led growth, a potentially destabilising feature within the Chinese economy.

That none of this has happened suggests that the growth of Chinese exports will remain strong, that inflation will continue to be an issue, that the global financial imbalances will continue to grow, and that food prices will continue to rise. There will come a point where all of this reaches a climax and profound and sudden change will come. We are still of the view that such changes will originate in western China, and it is to there that we are looking for clues.

© The European Futures Observatory 2010
BBC News - China sees inflation jump to 5.1%, a 28-month high
BBC News - Chinese exports jump unexpectedly amid inflation fears

Finding An Alternative

The Senkaku Islands, as they are known in Japan – in China they are known as the Diaoyu Islands, are a group of unproductive volcanic rocks lying in the East China Sea. They are only remarkable because both China and Japan – and Taiwan too, for that matter – claim ownership of the rocks. If there weren’t deposits of oil shale in the island chain, then it is quite likely that their ownership would not be disputed.

At present, Japan controls the islands and recently asserted its control by seizing a Chinese trawler, allegedly fishing illegally in the disputed waters. China responded by cutting off the supply of Rare Earth Elements to Japan. The price of REEs has risen considerably in recent weeks as Japan seeks alternative sources (China controls 97% of the global production of REEs). This is very much a scarcity story.

What is interesting is the Japanese response to scarcity. The rising price of REEs has led to greater economy in their use. There has been a boost to the technologies of resource economies so that less REEs are used per unit of output (an increase in ‘resource productivity’). There has also been a race to diversify supply away from China to other areas where REEs could be found. A rising price makes more marginal deposits commercially viable. There has, finally, been a boost to the mineral salvage industry to recover REEs from discarded electrical equipment.

In many ways, this is the response that we would expect to any incipient scarcity. Perhaps this is the answer to Peak Oil?

© The European Futures Observatory 2010

BBC News - Japan seeks new options on rare earths

A Prelude To Scarcity

In recent days, there has been quite a lot of interest in the issue of long term scarcities. This is an area upon which we have been working for over a year now – longer if we include the work on the Post-Scarcity World – and it seems to be an area that is coming into fashion. The argument for scarcity is well rehearsed. In 2000 there were 6 billion souls on the planet. By 2050 the mid-estimate of the UN is that there will be 9 billion people. Balanced against this increase in potential demand for resources is the view that we are coming to the point of peak production for many resources, thus potentially restricting their supply. The result of this clash of rising demand against falling supply will be an ‘Age Of Scarcity’.

Of course, the transition to the Age Of Scarcity is not likely to be discontinuous. We are likely to drift into a position of scarcity over a number of years, with, every now and then, a prelude of what is to come. We would argue that this is what is happening with food prices. After a long period of falling food prices in real terms, from 1980 to about 2002, food prices appear to have started to rise on a long term trend. This trend, underpinned by growing demand in the emerging economies and by modest improvements in crop yields, looks set to continue for some time to come.

Every now and then, a combination of natural disasters, the impact of climate change, the impact of trade nationalism, and so on, serves to tighten the markets a bit. It happened in 2008, and is again happening in 2010. To this extent, we are witnessing over a small period of time what may well happen over a longer time frame. We are witnessing a prelude to scarcity.

© The European Futures Observatory 2010

The Economist food-price index: Malthusian mouthfuls | The Economist

How Rich Are The Poor?

My son is currently living in Taiwan, so stories about Taiwan naturally catch my attention at the moment. There was a story in The Economist about how Taiwan is on the verge of becoming richer than Japan. The counter-intuitive nature of that comment really did catch my attention.

The Economist is quoting IMF figures when it states that the GDP per head of Taiwan is set to be $34.7K this year, against $33.8K for Japan. However, once we start to drill into the figures a different picture emerges. The Dollars used are not real Dollars but ‘PPP Dollars’ (Purchasing Power Parity Dollars). PPP Dollars are an artificial construct that attempts to weight income in terms of the cost of living across countries. The Japanese figure is discounted more heavily than the Taiwanese figure because Japan has a much higher cost of living. However, the adjusted figures do suggest that Taiwan has a better standard of living than Japan, which fits in with the impression that my son creates.

Does this matter? In a sense it doesn’t. These figures a a bit arbitrary and the PPP weightings are something of a guesstimate rather than an accurate measurement. However, there are times when it is important. According to some measures, China will move from the third largest economy in the world to overtake Japan as the second largest economy in the world this year. What we lose in this statistic is exactly how poor China is. The ranking of number two is a volume effect (well over a billion Chinese citizens) rather than an income effect. According to the IMF again, but for 2009 instead of 2010, China ranks 99th for GDPO per head in PPP Dollars (Taiwan ranks 37th and Japan ranks 17th).

Which is the rich country and which is the poor? China could be seen as a rich nation – the second largest economy in the world – whilst at the same time being one of the poorest - 99th in terms of GDP per capita. We haven’t quite come to grips with this dichotomy as yet, and some would say that this will be one of the future challenges that we face.

© The European Futures Observatory 2010

Taiwan and Japan: X not V | The Economist

The Luck Of The Irish

The case of Ireland and its present difficulties does pose a few questions that have a much longer perspective. If the Euro experiment were ever to work, then there would need to be a great degree of monetary co-ordination, along with a fair amount of fiscal co-ordination. The establishment of the ECB has, by and large, achieved monetary co-ordination. It was the role of the Stability and Growth Pact to harmonise fiscal policy by limiting budget deficits to 3% of GDP and public debt to 60% of GDP. The failure of the Stability and Growth Pact, almost from inception lies at the heart of Ireland’s present difficulties.

In recent years, Ireland has based its ‘Celtic Tiger’ credentials on a policy of the competitive reduction of Corporation Tax. Businesses, particularly UK businesses, have responded by relocating in the low tax environment. That now appears to have been something of a mistake. Now that the Irish bubble has burst, the nations bailing out Ireland – the victims of competitive tax policies – have a say in the future management of the Irish economy. Just as the Greek bailout is predicated by the reduction of public spending to more sustainable levels, so an Irish bailout is likely to be predicated by the raising of taxes to more sustainable levels.

This is of tremendous significance because it would imply the loss of Irish fiscal sovereignty. The Irish government has gambled on a low tax Tiger Economy and has lost and now it has to pay the price accordingly.

© The European Futures Observatory 2010

Hamish McRae: Sovereign defaults in the eurozone are inevitable

X Marks The Spot

When we last wrote about Mr Osborne’s Gamble (that fiscal tightening and monetary loosening will bring us out of recession), we left the issue of politics on one side. If the Gamble fails to work in an adequate time frame, we are unlikely to be able to leave politics out of the equation because this will be the arena in which the consequences of failure will be felt, as President Obama found to his cost this week. It is interesting that the political arena in the UK has experienced a significant long term change this year through the generational rebalancing of British politics.

Over the course of this year, Mr Brown has been replaced by Mr Miliband as leader of the Labour Party and Mr Clegg has moved from obscurity to Deputy Prime Minister on behalf of the Liberal Democrats. There has been no change in the leadership of the Conservative Party. The one thing that all of the current party leaders have in common is that they belong to Generation X, and that they have replaced Baby Boomers as party leaders. We have already felt some of the consequences of this, but far more are to come.

To recap on generations, the Baby Boomers in the UK represent a generational cohort that has almost been a golden generation. They grew up in the rising prosperity in the 1950s, they provided the flower power generation of the 1960s, they benefitted from the great housing inflation of the 1970s and 1980s, and they are currently starting to retire on gold plated pension schemes. They are self-absorbed, self-indulgent, and spoilt.

The children of the Boomers – Generation X – have experienced a different life pattern. They grew up in a world of strikes and three day weeks, of stagflation, of youth unemployment in the Thatcher years, and of a struggle to get onto the housing ladder. They are the original punk generation who have lived a life of low paid and insecure jobs, and who have learned to get by through making the best of a bad job. This ability to muddle through is what the Xers are bringing to the leadership roles into which they are now moving.

One of the great attributes of the Xers is their pragmatism, and this is starting to show though in politics. For example, the Liberal Democrats gave a clear promise in their manifesto not to increase VAT (a UK sales tax). Within weeks of attaining power, that undertaking had been abandoned because of expediency as part of a more general fiscal tightening. Again, each Lib-Dem MP signed a written pledge not to increase Student Tuition Fees. Again, within weeks of attaining power that pledge was abandoned in the name of fiscal pragmatism. The Boomers accuse the Xers of not keeping their word, which they haven’t. However, this does not prick the Xer conscience because the situation warranted this change of heart.

When we take this thinking to Mr Osborne’s Gamble, we can speculate that if the gamble doesn’t pay off, then the policy will be changed – in short order – to a policy that does work. The most likely candidate would be that the fiscal tightening will not be tightened as hard as originally planned. There are lots of areas in which the policy can be reversed. Many of the spending cuts will adversely affect the Boomers, who are now flowing into the ranks of the retired.

As these parts of the public sector are cut back, the Boomers will howl with rage like children who have had their toys taken from them. For example, there was an absolute furore when it was suggested that free bus passes for all retirees – irrespective of their wealth or income – be removed. The Boomer sense of entitlement was outraged at this suggestion, which was made in the cause of saving public spending. There is likely to be more of this in the near future, particularly as local government works out which areas of the public sector to retreat from. Politically, it would be tempting for an Xer Chancellor of the Exchequer to buy Boomer votes by not pruning so hard if the gamble fails to work as planned.

To our view, this gives shape to Plan B. Renewed Quantitative Easing will provide an early warning signal of the gamble not paying off. If things continue to worsen, then the pragmatic aspect of the present government is likely to come into play to allow for some fiscal easing as well, possibly by spending a bit more on the ageing Boomers.

In this respect, we are fortunate to be surrounded by pragmatic Xers because the last thing we need right now are doctrinaire politicians.

© The European Futures Observatory 2010

The Pace Of Change

We live in a world that demands things to be done instantly. President Obama has just been punished for not taking the US economy out of the worst recession in recent history in less than two years. When I offer the opinion that the recovery could well take the rest of this decade, I am usually met with sheer disbelief. We want everything done now, and we expect that in others.

Of course, not all in the world march to that tune. The issue of political reform in China is one case in hand. There is much pressure from the west – principally the US, but also the European nations as well – for China to reform its political institutions. China replies that it is, but at a pace of gradual reform rather than at breakneck speed. Exactly how far things have moved can be seen in John Humphrys’ report for the BBC.

In a 30 year retrospective, Mr Humphrys reports on how much has been achieved in one generation. By comparison with 1980, China is a much more open, tolerant and pluralist society. By western standards there is still a long way to go, but perhaps the cause for political reform might be helped more by congratulating the Chinese government for what it has achieved rather than berating it for what it has yet to achieve?

Sometimes we should be a bit more tolerant ourselves.

© The European Futures Observatory 2010 

BBC News - Humphrys: 'I was wrong about China'

Is America The New Weimar?

I am currently reading Keynes' "Essays In Persuasion". I have read the first section, which is about the question of Germany's reparations after World War I. The victorious Allies, in the Treaty of Versailles, saddled the new German Republic with an enormous war reparation, which far exceeded the ability of the German economy to stand the repayments. 

We all know the story of how that led, indirectly, to the great Weimar inflation, the destruction of middle class savings, and the rise of Hitler. What is less well known is the pattern of inter-Allied debt, and how the insistance upon strict settlement of those debts made both a German default and the rise of Hitler almost inevitable. If there ever was a case of 'penny wise and pound foolish', then this was it.

As I read about Keynes' view on this, I couldn't help but make the comparison between Weimar Germany and contemporary America. Both superpowers of their day, both suffering from an aggressive and war like foreign policy, both in hock to a set of foreign creditors. Germany had recently lost a war, and one could argue that America is currently in the process of losing one.

Following the analogy, that would imply that the US will face a crisis in servicing its debt on the near future. I believe this to be the case. One can suspect that the US will be unable to repay the debt that it is incurring. If so, then are we just around the corner from a large bout of inflation? The hyper-inflation of the 1920s wiped out most of the Weimar debt. Will the same occur for the US in this decade?

© The European Futures Observatory 2010



Essays in Persuasion

The Chinese Keynesians

BBC News - China wealth fund urges US to spend on infrastructure

This is such an interesting story. It would appear that the China Investment Corporation wants the US Federal Government to spend $1 trillion on infrastructure investments over the next five years. The stated purpose of this spending would be job creation. What I find interesting is the implicit money-go-round: Washington hires workers, who spend their salaries on Chinese products, which provides money to the CIC, who then lend the trade surpluses to Washington to hire workers. There is a nice symmetry to this and it is a classic Keynesian case for public works.

What is also interesting is the tacit rejection of Quantitative Easing as a way to reduce the number of jobless. In many respects, this is something of a false comparison. QE is very much a Keynesian approach to monetary policy and is a necessary condition for a fiscal stimulus to work. The use of QE without further fiscal stimuli is, as yet, an untried policy, the results of which we have yet to see. This is Osborne’s Gamble.

However, I do find it interesting that a Communist body is advocating the use of a Keynesian approach to support a markect based Capitalist economy. The irony here is great.

© The European Futures Observatory 2010

Mr Bernanke’s Gamble

Events are unfolding that could lead us interesting times. The US corollary to Mr Osborne’s gamble is a gamble by Mr Bernanke – of equal intent, but with far greater magnitude – to kick start the American economy. This is something of an untried experiment, to combine fiscal tightening with monetary easing in order to fine tune the economy, and we have yet to see how well it will go. There is a real danger of diminishing returns (QE2 will yield less stimulus per £ or $ injected) that may render the medicine unhelpful. More fiscal stimulus would do the trick, but there is little appetite for this at present.

The fears of QE2 inducing a bout of inflation still seem to be far fetched. That could be an effect, but the output gap is absolutely huge in the US. Economists might talk about the ‘output gap’ in an impersonal way, but in the US, ‘output gap’ means people living in cars, people without healthcare, people who have to give up their education. Perhaps economists, who are in no position to talk about moral hazard, ought to give some thought to the consequences of their trade a bit more?

© The European Futures Observatory 2010

America's economy: Not by monetary policy alone | The Economist

Anyone For Tea?

The forthcoming mid-term elections have taken on the hue of a referendum on the popularity of President Obama. A mere two years ago, the President was billed as a new and dynamic political force in America. His rally cry was ‘Hope’, his exhortation ‘Yes, we can.’ And yet, the programme seems to have come off the boil. ‘Hope’ now turns out to be ‘Hype’ and, in an unguarded moment on a TV show recently, he now says ‘Yes, we can. But, …’ If the polls are anywhere near to being correct, the President’s party is facing a substantial defeat in the voting next week. As an outsider looking in, I am interested in why America has fallen out of love with Obama? Why is it that his opponents are so hostile towards him? What exactly is driving the extreme views of the Tea Party opponents to the President?

I guess that the single word answer is ‘recession’. America is experiencing a recession that is at the worse end of the OECD experience, and this is exposing some of the fractures within American society. However, we like to take a longer view of these fractures in seeking an explanation.

According to Edward Luce of the FT, “the annual incomes of the bottom 90 per cent of US families have been essentially flat since 1973 – having risen by only 10 per cent in real terms over the past 37 years”. This is quite an interesting statistic because it also explains so much. If income has flatlined in this period, and living standards have been increasing, then how has the American Dream been paid for? By an increase in household debt. It would appear that American consumers have been borrowing to improve their living standards. A good part of this increase in debt was underwritten by a boom in the housing market, as households used their mortgages as credit cards.

Of course, there is nothing inherently unstable about this money-go-round until the music stops. Once that occurs, then everyone wants to ditch the parcel rather than being left with a dud asset. As the credit crunch – essentially a financial phenomenon – bled into the real economy, the resulting recession has had two important consequences. First, there is an acute shortage of credit to finance further expansion of consumer expenditure (more on this later), and second, there arises unemployment at sufficient volumes that the servicing of existing debt is called into question.

This is compounded by the composition of the borrowers. Many of those who have borrowed to finance their lifestyles are of the Boomer generation, and one thing that characterises the Boomers is their deep sense of entitlement. We now have a situation where a generational cohort, who are accustomed to being treated like spoilt children, have had their toys taken away from them. They are angry. They are angry enough to form Tea Party groups. They are angry enough to call into question whether their own President is American. They are angry enough to give credence to extremists such as Glenn Beck. And they may just be angry enough to vote into office someone like Christine O’Donnell, who is manifestly unfit for office.

It could be quite easy for Europeans to become smug over the discomfort of America. However, just an element of deep thought stops this train of thought. It is the angry, white, lower middle class who are giving electoral backing to the Neo-Nazi parties in the UK. It is the respectable burghers who are giving electoral support to the anti-Islamic parties in the Netherlands. It is the middle class establishment who are behind the hounding of the Roma in France and Italy. There are angry middle class voters across the developed world at the moment.

This is likely to be a feature of our near future. If recovery is sluggish (the best case scenario) or if recession makes a re-appearance (the worst case scenario), it is unlikely that middle class household balance sheets will be repaired quickly. In the past, the world has waited for American households to start borrowing to finance their consumption, thus kick-starting the world economy. This is unlikely to happen for some time – American households are simply too maxed out. This suggests that middle class anger will remain for some time to come, which will make our politics just a little more xenophobic and our economies just a little less globalised.

We call this trend the ‘New Nationalism’.

© The European Futures Observatory 2010

FT.com / Reportage - The crisis of middle-class America

On the Way Down: The Erosion of America's Middle Class - SPIEGEL ONLINE

BBC News - Number of Americans living in poverty 'increases by 4m'

Glenn Beck Leads Religious Rally at Lincoln Memorial - NYTimes.com

BBC News - Profile: Christine O'Donnell, Delaware Senate candidate

Growing Number of Americans Say Obama is a Muslim: Pew Research Center

Ageing Europe

We often hear the argument that, over the next decade or two, the European economy is likely to come off the boil owing to the ageing of the population of Europe. This is, and always has been, stuff and nonsense. The forecast only makes sense if everything stays the same. Of course, it doesn’t.

To start with, the enlargement of the EU has brought into Europe tens of millions of young workers from Bulgaria and Romania – they will make an appearance in the European jobs market from 2014 onwards. Then there are the tens of millions of young Turks whose hopes are pinned to Turkish accession. And then, on top of that, there are tens of millions of youngsters in North Africa, who are awaiting the spread of Europe across the Mediterranean. All of these will swell the European workforce.

Of course, there are those who do not want to see an enlarged EU. Their answer to the impending labour crisis is to enlarge the workforce organically – mainly by raising the age at which Europeans retire. It is in this context that the recent raising of the French retirement age can be viewed. France is lukewarm about Turkish accession to the EU, which implies that French workers will have to retire later as a consequence.

© The European Futures Observatory 2010
BBC News - Q&A: French strikes over pension reforms

Ever Increasing Union

It is often argued that the fragmentation of the EU at the national level is one of the handicaps that is preventing Europe from achieving its full commercial destiny. The cause of integration is seen to be at the heart of the European project, which is why infrastructure projects take such prominence. During the industrial revolution, rail provided an integrating force, but at the national level. Rail is now set to provide an integrating force at the European level. The link between London and Cologne is really quite important – Cologne is the rail hub that opens Scandinavia, The Baltic, and Eastern Europe to traffic from Western Europe. I am sure that the Franco-German tiff will be resolved. They usually are. What excites me is the prospect of the pan-European service being available from 2013.

Of course, all this is saying is that I am a rail fan rather than a fan of flying. Guilty as charged!

© The European Futures Observatory 2010

A Franco-German train tiff: Ils ne passeront pas | The Economist

Bush III

So much for the hope create by Obama’s election. In one way, he is behaving like the third Bush. On coming to office, there was a solemn promise to close Guantanamo Bay within a year. That deadline came and passed. He is still pursuing with the Military Tribunals – a judicial black hole where ‘normal’ trial rights are suspended, where public reporting is suspended, where evidence based upon hearsay, coercion, and torture is admissible. There are those who argue that the pursuit of the military tribunals is a war crime in itself!

We now have the case of Omar Khadr. A young man from Canada who was coerced into a confession by the threat of being gang raped to death has now entered into a plea bargain with his US prosecutors. If he pleads guilty, which he has, he will be eligible to serve any remaining time in his native Canada. It is hard to see which injustice cries the loudest.

Is it the extraction of a confession under duress? Is it a plea bargain where a guilty plea brings a much lighter sentence? Is it his complete abandonment by Canada?

I have never thought highly of Obama – to me he is just another US President of the same mould, more hype than hope, perhaps – but I did used to think highly of Canada. I’m less inclined to do so now.

© The European Futures Observatory 2010
BBC News - Canadian militant pleads guilty at Guantanamo tribunal

Productivity–vs- Competency

The public sector is pulling back in the expectation that the private sector will expand to fill the gap in terms of services and social care. The reasoning behind this is that the private sector has a higher labour productivity than the public sector. Normally it does. However, nothing is without cost. Higher productivity in private sector basically means that the job is done cheaper than the public sector could do it. We tend to think in terms of public sector waste (one source of productivity loss), but we should also think in terms of private sector incompetency (one source of productivity gain). One way in which higher productivity is delivered is through cutting corners in staff costs – usually by not training staff adequately to do the job.

The case of the poor man who was left brain dead by incompetent private sector agency staff who were not trained adequately for their outsourced public sector role provides a taste of what is to come in the next few years. It would be a shame if the cost savings from the outsourced social and health services were simply absorbed into higher lawyers fees resulting from the level of incompetence (and negligence) derived from swapping productivity for competence.

© The European Futures Observatory 2010
BBC News - Tetraplegic man's life support 'turned off by mistake'

Globalisation Fast Tracked

The recent meeting of G20 Finance Ministers has actually achieved something worthy and tangible. In a bid to avoid a looming trade and currency war between the surplus and the deficit nations, the G20 Finance Ministers have agreed to rebalance the voting rights at the IMF. This may sound a bit arcane, but it does have a tangible impact. If globalisation is to continue as it has in the recent past, if we are to avoid a retreat into economic nationalism, then the global economy has to be rebalanced, which includes reform of the institutions, such as the IMF, that direct the global economy.

The detail of the reforms is interesting. 6% of the voting rights will be passed from European nations and given to the emerging economies. This reflects the change in global economic power. However, the US still retains 17% of voting rights, thus giving it a de facto veto over all decisions (an 85% majority is needed for decision-making). I wonder how long that will last? I guess that the loss of the US veto would suggest that the Dollar would no longer be the global reserve currency. I can see that coming, but not just yet.

© The European Futures Observatory 2010

G-20 Leaders Pledge to Avoid Currency War - NYTimes.com

BBC News - G20 summit agrees to reform IMF

When The Well Runs Dry

What is the structural weakness in the US economy? Some might point to the flight of manufacturing, some might point to duff mortgages, but I would point to the parlous finances of the various States Governments. A recent article in The Economist considers the impact of retiring Boomers (along with their sense of entitlement), State finances, and the lack of funding for State pension schemes. Apparently, 7 out of 50 States will have exhausted their pension assets by 2020, and half will have run out of money by 2027. The impact of this on the State tax revenues makes even more interesting reading. It would seem that current employees are working under an illusion that the promises made are affordable, whereas they quite possibly are not, as the following table suggests.

Of course, the bond markets will intervene well before this scenario occurs, but it does suggest that, towards the end of this decade, a crisis in State funding – along the lines of the crisis in the Eurozone – will befall the Dollar.

Ooops … it looks as if we can’t afford to retire!

© The European Futures Observatory 2010

American states' pension funds: A gold-plated burden | The Economist

Mr Osborne’s Gamble

The news in the UK this week has been dominated by the Comprehensive Spending Review. This is the first attempt within the OECD to match financial planning with the rhetoric of deficit reduction. There is much that still has to come out of the review, but the broad shape of the deficit reduction can now be discerned.

To start with, there has been the decision to place a far greater reliance upon cuts in public spending than tax increases to eliminate the deficit. In measures previously announced, about £20 bn tax increases will start to have an effect in the current fiscal year. Of those, the greater proportion will be increases in taxes on consumption rather than on income and savings. A ratio of 4:1 (£4 in spending cuts for every additional £1 raised in taxes) is a bit unusual. Normally we would expect a ratio of 3:1.

The Chancellor of the Exchequer (our quaint title for our Finance Minister) announced about £80 bn in spending cuts. Whilst all departments will face some degree of financial restraint, the bulk of the spending reductions have been directed to the welfare budget (the old and the poor) and spending on local public services (social care, local education, the police, libraries, and climate resilience). Leaving on one side whether the politics of these makes sense, the objective of the cuts is to enhance our future prosperity and the more pressing question is whether or not the policy will work.

In a paper delivered to the Post Keynesian Study Group at the University of Cambridge, Victoria Chick presented evidence to suggest that for every 1% reduction of government expenditure as a percentage of GDP, there would be a corresponding rise of 0.6% in the level of public debt as a percentage of GDP. The mechanism by which this happens is quite obvious. As government expenditure falls, employment levels fall (over 80% of public expenditure is on salaries). As employment levels fall, income tax receipts fall and unemployment benefit payments increase, leading to an increase in the deficit. We can see why the government’s own Office for Budget Responsibility have warned that there is a 40% chance that more deficit reduction measures will be needed in the near future.

Of course, this begs the question of how the deficit reduction plan is supposed to work. The workings all hinge around expectations. If, it is supposed, the public were to believe that the policy would work, and that they see as credible a permanent reduction in taxes, then they would increase their consumption expenditures accordingly. The private sector – having been crowded out by the public sector – would then increase to satisfy this demand, triggering further growth. The key to this plan is an improvement in household and business confidence. Unfortunately, recent evidence points in the opposite direction. Businesses are confident that their sales will fall as public sector workers are made redundant. Households are confident that a better use of their resources is to build their precautionary balances, and so the savings rate rises.

And this is Mr Osborne’s Gamble. He has bet that the recovery in household and business confidence will trigger growth at a rate to offset the deflationary impact of public sector redundancies. The Chancellor estimated that just under half a million public employees would be displaced by 2014-15. However, there will also be a knock on effect in the private sector. The OBR estimates that a further half million private sector jobs will be lost as a direct result of the spending reductions (much of the public sector is currently delivered by the private sector). If we add to that the half million jobs lost since the onset of recession, for the plan to work, the private sector will need to create at least one and a half million jobs within four years. The Treasury calculates that the private sector has the capacity to create two million jobs in this time frame. However, having the capacity to create jobs is one thing and actually creating them is another.

We shall see how Mr Osborne’s Gamble plays out. If he is right, then we will have a muted recovery for half a decade. If he is wrong, we may well have a muted recovery for at least a decade. Either way, when I look at scenarios with a ten year horizon, I will need to look for the assumptions about Mr Osborne’s Gamble. This will take on a greater significance with an international dimension when it is recalled that the UK is the first actor in OECD to detail the cuts. As other economies in Europe follow suit, so the process will gather momentum internationally.

The position of the US is more interesting than usual. At present, the White House is disinclined towards fiscal tightening. However, if the polls are correct and the Tea Party candidates rise to prominence in the Mid-Term Elections, then deficit reduction plans will take a more central role in the US. However, that is a story best left for another week.

© The European Futures Observatory 2010

QE2?

As we stand on the verge of the second round of Quantitative Easing (QE2), the twin questions of how it works and what it achieves remain to be answered. Some have attempted to answer the question in terms of orthodox economics. These answers have failed - mainly because the assumptions upon which QE is based are quite alien to orthodox economics. In orthodox economics, if you flood an economy with liquidity, then inflation will follow. That has happened to a minor extent, but nowhere near as much as has been previously suggested. Instead, we are experiencing a relatively mild recession (for now). This is explained in QE terms by the output gap - the difference between what we can produce and what we are actually producing. With an output gap in excess of 10%, monetary easing can still go quite some way before conditions in the real economy start to become inflationary.

QE is also being used to fine tune the economy. I rather suapect this to be something of a blunt instrument. The policy of fiscal tightening and monetary loosening is novel, but I do fear that the tightening might be overdone. For example, for Mr Osborne's plans to work, the private sector needs to generate something like a million jobs in the next four years in order to soak up that half million recently unemployed during the recession and the half million displaced public sector workers created in the recent spending review. This seems like a tall order at a time when GDP growth will be, at best, muted. A million jobs over the decade might be a more reasonable prospect.

Which brings us to Faisal Islam. His article for Prospect Magazine rather reflects conventional thinking. Stuck in the grip of a neo-classical base for his economics, he fails to grasp the key points of QE. In my view, this reflects the failure of economics more than anything else. Perhaps what we need is a new economics?

The Great Money Mystery – Prospect Magazine « Prospect Magazine

© The European Futures Observatory 2010

US inquiry into China rare earth shipments

Is this a story about the 'Age of Scarcity', or is it a story about the locus of Geo-politics shifting eastwards, or is it a story about the New Nationalism? The truth is, that it is all of them at once. Futurists have a knack of describing trends and scenarios as if they were separate and discrete views of the future. For analysis, it is better to assume that they are. In practice though, reality is a bit more messy. Many trends and scenarios inter-act with each other and need to be disentangled. The story of Rare Earth Elements is one such case in hand.

BBC News - US inquiry into China rare earth shipments

© The European Futures Observatory 2010