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

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

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

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’.

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

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

Tackling the slump: Money for something | The Economist

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

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

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

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

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

An Unholy Trinity

Few would disagree with the view that the economies of the world are in turmoil. The news this summer has been dominated by the twin sovereign debt crises of the Eurozone and the US. The case of Europe is well rehearsed. The Eurozone has become a monetary union without an effective mechanism to deliver fiscal co-ordination. As a result, the weaker economies have been allowed to borrow beyond a prudent level with very little adverse consequences. Equally, the Euro provided a vehicle whereby the stronger Eurozone economies 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.

Equally, 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 fiscal stimulus and Federal debt has come under the spotlight. The key fiscal 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+.

It could be argued that both of these crises have been exacerbated by weak political systems, and that political reform needs to underpin any effective recovery strategy. This is what we know about already. It has our attention. As a futurist, however, I am intrigued and concerned by what I don’t know. What are the factors that we are overlooking and which may appear important in the future? There are two other major issues that have attracted far less attention – mainly because they are a lot less pressing at the moment – the financial position of the US States and the fragility of the Asian banking system.

Our focus in North America this year has been with the US Federal debt. Another sovereign debt crisis currently developing concerns the finances of the US States. The position of the States reflects the Federal position in that effective deficit reduction is blocked by special interest groups, who obstruct both spending reductions and tax increases. As a result, the levels of State debt have risen considerably in recent years. This is fine, as long as lenders are willing to finance the deficit spending. If the reserve currency status of the US Dollar is weakened, then an immediate impact for the US States is likely to be an increase in the cost of borrowing and a greater unwillingness to lend to them. If the weaker US States were to experience probing by the markets at the levels that the weaker Eurozone nations have experienced this year, then it is likely that the consequences would result in a significant disruption to the US financial system. This vulnerability and the risk of the downside has not been factored into many current economic forecasts. It is possible that US Federal debt could be downgraded even further because of the parlous condition of State finances.

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. The size of trade deficits between China and both the Eurozone and the US rather argues against this case. Hopes for an export led recovery in Europe and the US both require an appreciation of the Chinese currency. This has happened to a certain extent – mainly as a device for the Chinese government to keep inflation in check – but nowhere near the degree needed to do the job effectively. The Chinese government continues to manage the exchange rate in a way that minimises the possibility of internal unrest rather than to alleviate recessionary conditions in Europe and North America. This is not set to change.

Monetary conditions within China now require a tightening. Effective action will take 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 in any case. In either situation, a wobble in the Chinese banking system would have major global consequences. The risk of an event of this type has not been factored into many economic forecasts, which assumes ‘business as usual’ in China.

We are of the view that there are three systemic weaknesses in the global monetary system at present – in the Eurozone there is the possibility of disintegration, in the US there is the risk of ineffective debt reduction programmes at both the State and Federal level, and in Asia there is the risk of financial implosion caused by non-performing loans within the financial system. Together, they provide an ‘Unholy Trinity’ of problems facing the world economy. Their resolution requires a degree of political leadership that doesn’t appear evident at the moment, and a degree of consensus building at both the national and international level. To date, that co-operation has been lacking as the various parties have been unwilling to lay aside their narrow interests for a greater common good. For that reason, we are of the opinion that the current economic outlook is likely to be a lot rougher than it otherwise needs to be.

© The European Futures Observatory 2011

The Output Gap In Pictures

This is a really useful chart because it shows a comparative estimate of the output gaps of various countries. In a previous post, we calculated the US Output Gap to be about 10%. Interestingly enough, this is a figure that The Economist has independently arrived at. What is of concern is the UK Output Gap, which is estimated at about 13%. We feel that this is a bit high, not because economic activity is greater than estimated, but because we feel that economic potential has been severely eroded by the recession.

To be frank, what we mean is that there are now youngsters who will never work because they haven’t developed the habit of working in their formative years. This is the human cost of recession – blighted lives. It is a legacy that far too many politicians forget about until social turbulence moves from being an abstract concept to being disorder on the streets.

© The European Futures Observatory 2011

http://eufo.blogspot.com/2011/08/risk-of-inflation.html

http://www.economist.com/node/21526392

The Risk Of Inflation

How close are we to seeing a bout of prolonged inflation in the US? This might seem an idle question, but it is one that has quite important consequences for the US economy in the medium term. The Federal Reserve has, over the past couple of years, undertaken a major monetary expansion to support the US financial sector. It has done so though a policy of historically low interest rates - which it has signalled will continue to 2013 - and a policy of quantitative easing - which has injected about $2.3 trn into the economy. To those of the monetarist persuasion, a roaring inflation is just around the corner.

This might not be the case. A monetary expansion might be a necessary condition for an inflation, but it is not a sufficient condition on its own. A monetary expansion also has to work with a combination of the right supply and demand conditions to produce an inflation. For us, the key question is whether or not those conditions prevail at the moment. There is no doubt that prices are rising on the supply side. In particular, food prices, heating costs, and transportation costs are pushing up prices on the supply side. And yet this cost push is not igniting the flames of an inflation on the demand side. Rather than seek higher wage settlements, consumers are accepting a reduction in their living standards instead. This is because a sluggish economy has had the effect of dampening down demand for goods and services. Companies are absorbing rising input costs for fear that end user price rises would drive away their customers.

In terms of economics, we are seeing a muted demand response to the monetary expansion owing to the size of the ‘output gap’. The output gap is the difference between what GDP currently is and what GDP could have been if the recession had not occurred. Using US Bureau of Economic Analysis figures (which are expressed in 2005 constant dollars), we estimate the output gap to be in the region of $1.5 trn. This is probably an overstatement of the gap because the recession is likely to have forced a number of economic participants out of the jobs market completely. Put another way, it implies that the US economy could grow up to about 10% this year before experiencing a profound number of inflationary pressures.

Of course, the risk of inflation might be low now, but it does remain in the medium term. Should the US economy return to anything like the trend growth path, then prices will harden and wage settlements are likely to start to creep up. We expect that the US politicians will allow inflation to take hold for a while. After all, the two ways to reduce the impact of the US Federal debt pile are economic growth and inflation. If the two are combined at the same time, then so much the better. However, it is easier to start a prairie fire than to put it out, and the prospect of an inflation being created deliberately for a short term gain may well come to be seen as politically irresponsible. For the moment, though, the risk of inflation seems to be quite low.

© The European Futures Observatory 2011

Joining The Dots

Sometimes, a bit of foresight is not what is wanted. As I was watching the riots in London, I was reminded of a piece that I wrote in 2008 about society moving from NICEY (the Non-Inflationary Continuously Expanding Years) to NASTY (the Non-Accelerating Socially Turbulent Years). The point is a simple one. When the economy is doing well, most improvements trickle down into most parts of society, and economics comes to dominate politics. When things are not going well in the economy, the pain is rarely shared equally, and politics become dominated by the social impacts of where the pain is felt. There was an element of this in the recent rioting in the UK.

The recent disorder in the UK, however, is not a game changer. We are currently about a week on from the disorder. The streets have been cleaned up, many businesses affected are operating again, and many of the offenders have been identified, arrested, and have made an appearance in court. In 2008, we were more concerned about the potential for unrest in China, which we felt would be a game changer. That is probably why it hasn’t happened. There are still bouts of unrest in the western provinces of Xinjian and Tibet, but nothing so far has threatened the stability and authority of the Chinese government. For this we are grateful.

Looking to the future, the risk of disorder remains, right across the world. We still rather imperiously divide the disorder into that we like, such as that in Libya, and that which we dislike, such as that in Bahrain. The root causes of the discontent – poverty, lack of opportunities, and sheer boredom – still remain. Until the world economy starts to grow again, this risk of disorder is unlikely to abate.

Those of us watching the future need to be mindful of this in our work.

© The European Futures Observatory 2011

http://eufo.blogspot.com/2008/11/from-nicey-to-nasty.html