The Eastern Connection

There are times when the future simply unfolds in front of us, and this is one of those times. Three recent stories help to highlight that future. First, we learned on Sunday that RBS - a 282 year old bank in the UK - was subject to record losses that would result in making the company vulnerable to vulture funds (see story). Second, the losses turned out to be in line with those leaked to the press at the weekend (see story). And finally, by coincidence, there happens to be a delegation from China that is in Europe to buy distressed assets (see story).

In this one sequence we can see two major trends into the future. the first trend is the shift in the locus of the world economy eastwards. The mechanism by which China will establish itself as a major power will be through the purchase of European and American assets. In recent years, there has been resistance to this. The resistance will melt away in the face of the choice of either domestic redundancies or foreign ownership.

The second major trend is that of realignment in the economies of the world. Bottom feeding does serve a useful purpose in redistributing assets from those who don't know how to use them into the hands of those who do (see post). This periodic 'creative destruction' is an essential part of renewal. It is the capacity for renewal that make capitalism such a resiliant system.

In terms of where we are in the cycle of renewal, the appearance of bottom feeders and vulture funds is quite positive. It shows that the system is working and that we are once again moving forward.

Three cheers for that!

Bottom Feeding, Shopkeepers, and VAT

We recently wrote about the process of bottom feeding as a natural part of the prelude to economic recovery (see post). It well be the case that the retail sector has been engaged in this activity itself over the question of VAT (a form of sales tax imposed in all EU nations, but at different national rates).

As part of the fiscal stimulus to the UK economy, the Government reduced VAT from 17.5% to 15% for the period 1st December 2008 to 31st December 2009. Ordinarily, we would expect this to lead to a reduction in UK consumer prices. However, it now transpires that a good portion of the UK retail sector has failed to pass on this reduction in VAT (see report). Instead of passing on the reduction in VAT, about a third of all retailers have retained the tax reduction to shore up their balance sheets.

How so? In the UK, retail stores tend to work to the 'price point'. For example, £9.99 is a popular price point. Prior to 1st December, of the £9.99 paid by the customer, the company would have kept £8.50 and remitted to the government £1.49.

When VAT was reduced to 15%, the company had a choice. It could have lowered it's price to £9.77, retained it's cut of £8.50, and remitted to the government only £1.27. Alternatively, the retailer could have retained the price point of £9.99, increased the amount retained to £8.69, and remitted £1.30 to the government. This, it appears, is what many retailers have chosen to do.

The turnover of the retailer has increased by 2.23% courtesy of the tax change, as has the government, who receives an additional 3p for each £10.00 spent at the till. If that isn't an example of bottom feeding, then what is?

Our Friends In The North

To date, our view of the recession has been dominated by its economic impact. It is also changing the shape of global geopolitics and we need to be mindful of this. One area in which there could be profound geopolitical realignment is in the Arctic. The Arctic is an area which doesn’t normally attract a great deal of attention, but which has an enormous potential to dominate geopolitics over the next decade.

We are probably all aware that the Arctic ice cap is melting, at an increasingly accelerating rate. By 2020 the degradation of the ice cap is likely to be sufficient for the Arctic to be open to sea traffic for most of the year. There are two key shipping routes. Heading north through the Bering Sea, if you turn left across the northern coast of Russia, you would be following the Northern Route between East Asia and Europe. The Northern Route should reduce the shipping time between Japan, China, and Korea to Europe by about three weeks. Had you turned right at the Bering Sea and followed the northern coast of Canada, you would have followed the North Western Route between East Asia and the East Coast of the US. The North Western Route is likely to reduce the shipping time between Japan, China, and Korea to the East Coast of the US by about three weeks.

Two key advantages of these northerly shipping routes is that they by-pass the pirate infested waters of South East Asia and East Africa, and they also diminish the importance of the strategic bottlenecks of the Suez Canal and the Panama Canal. In terms of operation, owing to a thinner ice sheet, the Northern Route is likely to be open appreciably sooner than the North Western Route.

As the ice recedes, the energy and mineral deposits of the Arctic will become more open to extraction. The present economic recession has lessened the imperative of extracting these deposits but, as the global economy moves into recovery over the next decade, the issue of mineral rights is likely to dominate the agenda again. The problem is that there are no settled international borders to the North Pole. The issue is further complicated by the Lomonosov Ridge, to which Russia claims ownership.

At present, there are six nations with an interest in the Arctic. We like to measure the weight of this interest in terms of ‘Degrees of Influence’, which are determined by the ‘slice’ of the Arctic controlled by them. The six nations, and their degrees of influence, are: Russia (160°), Canada (85°), US (30°), Greenland (35°), Norway (35°), and Iceland (15°). This pattern is changing due to the current financial crisis.

The viability of Iceland as an independent sovereign nation has been called into question after the collapse of the Icelandic banking system. Already Russia has provided a bailout of €4bn. It is likely that these funds have strings attached, possibly in terms of Arctic mineral rights and possibly in terms of the use of former NATO airbases (see report). However, the Russian funding is unlikely to be sufficient. A more permanent solution is likely to be EU membership for Iceland, which is currently being fast tracked (see report). This rather changes the complexion of things.

One of the interesting consequences of the current financial crisis is the potential it has for strengthening the Federalist case in Europe. The direction is towards a tighter and more co-ordinated foreign policy for Europe, with a tightening of the institutional framework to give it substance. As the recession grips, Greenland and Norway are reviewing the exact nature of their independent foreign policies. If this trend were to gain hold, then, by 2020, the complexion of the Arctic could well change to Russia (160°), Canada (85°), EU (85°), and US (30°) in terms of degrees of influence.

We are not suggesting that this will happen. What we are suggesting is that the scenarios regarding the Arctic, which rely upon six nations as the basis for the scenarios, might need to be reviewed for the possibility of consolidation of the European interest in the Arctic. This consolidation would be the direct consequence of the recession.

© The European Futures Observatory 2009

Bottom Feeding

It's Saturday and I have spent the day bottom feeding.

In an ecosystem, a good balance of creatures will have a number of bottom feeders - those animals whose job it is to clean up the debris and waste in the ecosystem to allow for renewed growth within the system. Worms, ants, wasps, they all perform this vital function. They clean up the environment by removing waste in the ecosystem.

Exactly the same occurs in an economy. As companies cease trading, their assets are disposed of by the liquidators and administrators. In the current recession, we have seen a number of retail operations go into administration - usually with a great fanfare of job losses - only to come out of administration as the core business has been disposed of as a going concern. Funnily enough, there is little fanfare about the jobs saved - good news doesn't sell newspapers.

In recent weeks, we have seen Whittards come out of administration with 1,000 jobs saved (see report) and Adams has come out of administration with 1,900 jobs saved (see report). The bottom feeders in this process go under a sexier name - they are value investors. For some time, value investors have been buying in the stock market. The headlines surrounding Warren Buffet - possibly the most famous value investor - is a testament to this.

And now we see that value purchasers are returning to the High Street. January UK retail sales were up as shoppers took advantage of deep discounting by stores (see report). In this respect, we joined the trend today. We needed a new bed for our spare room, and managed to buy a bed normally costing £600 for £300.

We have wanted a new TV for some time, and we managed to buy one previously costing £450 for £370. Strangely enough, the TV that we bought was on sale for £350 two weeks ago. Perhaps there is a message that we ought to heed? Are retailers discounting less as people return to the stores?

This leads on to the key question. If we are seeing value investors purchasing assets for pennies on the pound, if we are seeing price sensitive consumers return to the High Street, then are we seeing the bottom of the recession start to emerge? Perhaps Baroness Vadera was right when she said that she could see a few green shoots of recovery (see report)?

For my part, I am now going to watch Ipswich Town thrash QPR on my new telly!

More On Audit ...

I see a pattern emerging.

First we have a Ponzi scheme. It doesn't matter what the content of the scheme is, it needs to be just credible enough to part people from their money through a possible - but highly improbable - investment scheme. You then create a money funnel where the receipts from later entrants go to fund the payments to earlier entrants, who may not want cash anyway as they can be persuaded to let their paper gains ride on the casino.

You may attract the attention from whistleblowers along the way. If they are external, then that's just sour grapes from incompetent competitors, if they are internal, then get rid of them. You will need accounts to lodge with the regulators, so a compliant auditor would also be helpful. And so the money goes around until it crashes to a halt - a crash caused by the collapse of the property market or the stock market, perhaps? And then the scheme comes into the open.

This business model fits the scheme of Bernie Madoff (see report), it may well fit the scheme of Allen Stanford (see report), and it has an unbearable likeness to the case of HBoS described in a previous post (see post). In the latest case to hit the headlines - that of Stanford International Bank - it appears that we have internal warnings that served as resignation letters and a small firm of auditors who gave SIB an unqualified audit opinion (see report). this all hightens the need for the reform of the audit community.

However, it is easy to blame others and we need to confess our own culpability. The fraudster needs the victim (I believe that they are called the 'Marks'). If we all were less willing to believe the improbable, it would be more difficult to perpetrate the fraud. If we all gave up trying to find an 'edge', then it would be difficult to sell high risk schemes. If we all said that what we had was enough - to become satisficers rather than maximisers - then these schemes would never gain sufficient momentum to grow.

On my part, I groaned when I read that the auditor of Stanford International Bank qualifies where I did, albeit 15 years earlier.

Made In China

China has an image problem.

Chinese manufacturing has come to be synonymous with cheap and of poor quality. The latest example of Chinese quality control is the Test Wicket at the Sir Viv Richards ground in Antigua. For those who don't follow cricket, the West Indies are hosting England in a series of test matches. Last Friday the second test match was abandoned because the outfield started to break up, making play dangerous (see report).

As we are told by The Times:

"The Sir Vivian Richards Stadium, built for the World Cup with money from the Chinese Government, has had a chequered history"

Quite! We have written before about our scepticism over the widely made claim that China is becoming the world's economic superpower (see post). Recent events do nothing to allay our scepticism. If China is to achieve it's industrial destiny, then it must move up the value chain by producing goods of a quality than it has so far.

At a different tangent, we are told that China is using it's soft power to create influence in places such as Africa through the construction of infrastructure projects. For example, it was recently announced that Angola is to receive a $1 billion makeover for the African Nations Cup (a soccer tournament) in 2010. The Shanghai Urban Construction Group is to build four stadia for the tournament (see report).

One wonders if these stadia will be built according to Chinese construction standards (pretty poor) or Angolan construction standards (even worse). We can also speculate about the long term goodwill created if the constructions need to be replaced after a few years.

If the stadia in Angola are on the same level as the Sir Viv Richards stadium, then we can expect the goodwill to be pretty short lived. That particular project is in need of rebuilding after only two years.

Inflation Again

Following up on our previous post on inflation (see post), the question of fuel poverty seems to have worked its way into our thoughts for the medium term. In the UK, fuel poverty is defined as a situation where fuel costs take up more than 10% of total household disposable income.

It is estimated that 5.4 million people in the UK suffer from fuel poverty. To alleviate this situation, the government has funded a programme of initiatives to alleviate fuel poverty - mainly through grants distributed by Warm Front, a body set up specifically for this purpose. It is estimated that 3.1 million people in fuel poverty are eligible for a Warm Front grant, but only 1.8 million people have taken up that funding.

Why? Part of the problem seems to be the funding model. Warm Front will only fund the contractors it chooses to undertake the work. Leaving aside the question of value for money - which is a big question because there are allegations of contractors padding the cost of their work to inflate the price - there is also the issue of the householder being liable for the cost above the grant ceiling, which, in some cases, amounts to thousands of pounds. This seems like a scheme to exacerbate fuel poverty!

In a recent report (see report) the scheme has been charged with not being fit for purpose. This suggests that fuel poverty is likely to be with us for some time to come. An interesting point will come in the near future. The costing mechanism for domestic fuel is related to RPI. As RPI moves negative, will domestic fuel bills fall? If they don't, then this aspect of the Age of Scarcity will only become more acute in the recovery, when it comes.

A Pig In A Poke

“Why won’t the banks resume lending?” is a cry frequently heard at the moment. As it happens, it is not exactly an accurate cry because the banks are still lending, it is just that the volume of lending has reduced, albeit reduced greatly. In the UK, this, in part, is explained by the disappearance of foreign owned banks lending into the British economy. For example, the Icelandic banks and the Irish banks have, by and large, withdrawn to their home territories, thus reducing the lending capacity within the British economy. There is, however, another factor at play that will become significant in the longer term.

When considering a loan application, bankers apply two key principles of lending – does the borrower have the ability to repay the loan and to service the debt, and what security can the borrower offer to cover the lender’s position if events turn out worse than planned. These areas, in recent years, have broken down. Indeed, one could argue that it is the malfunctioning of these basic principles that has undermined confidence in the whole financial system

The ability to service the debt and repay the loan is generally determined by the accounts presented by the borrower to the lender. In recent years, in the domestic mortgage market, we had seen the growth in ‘self-certification’ mortgages. These are mortgages underwritten by the statement of the borrower that they had told the truth in their statement of income on the loan application. Needless to say, there was a certain degree of exaggeration of income in this process. That didn’t matter to the average lender. In a strong housing market, the increase in property prices would underwrite the veracity of the income statement through the collateral of the property. As the property market has stuttered and fallen, these mortgages have been withdrawn. Self-certification mortgages are now rare birds.

Instead, lenders now resort to the accounting history of the prospective borrowers. This is not without hazard. In the background, there is a debate quietly raging between ‘Principle Based’ accounts – mainly used in the UK and Europe – and ‘Rules Based’ accounts – mainly used in the US. Rules based accounting had been gaining the upper hand until the case of Enron. The Enron accounts had satisfied the rules based accounting principles, but not the principle based accounting rules. This difference between the two is one of those obscure and arcane accounting issues that are likely to dominate our world in the next decade.

On Friday, the Lloyds Banking Group lost a third of its share value because the board of Lloyds did not fully grasp this point (see report). Lloyds had previously been lent on by the UK authorities to absorb HBoS, a large UK mortgage bank that had pretensions to become a more general corporate lender but failed to do so. It appears that the board of Lloyds relied upon a set of accounts produced by HBoS, and had not conducted full due diligence in pricing the merger. Laying aside the wisdom of this, the veracity of the accounts is worth considering.

From Parliamentary evidence last week (see report) it seems that the Head of Risk at HBoS at the time warned the Board that he felt that the bank was taking excessive risks in their lending. His reward – according to his version of events – was to be made redundant. He wrote to the audit committee, who then asked the auditors to investigate. The auditors investigated the claim, and found that the claims were unfounded. Three years later the bank went bust. What is called into question is the role of the auditors in the production of the accounts.

If lenders are to rely upon accounts, those accounts must provide a true and fair statement of the financial position of the entity. There are now calls for reform of the audit process. In particular, three reforms come to mind. First, there is the issue of the automatic rotation of auditors every three to five years to prevent the development of a cosy relationship between the auditors and the management upon whom they are auditing. Second, there is the issue of limited auditor liability. At present there are moves to cap auditor liability for mis-statements on the face of accounts. This trend is likely to be reversed. And thirdly, there is the issue of Chinese Walls within audit firms. Many allege these not to exist. To assure the probity in the production of accounts, there is likely to be a trend towards the banning of audit firms providing consultancy services to those entities that they audit. These trends could well come to dominate the corporate landscape in the coming decade.

When we return to the original question, one of the reasons that the banks are restricting their lending is because they cannot quite trust the accounts that are put in front of them. As the recession bites and asset values fall, the valuation of collateral is likely to become a key issue and the independence of the accounting profession is central to this. It would seem that the world needs the accounting profession to become a bit more disagreeable in producing accounts over the next decade or so. Once confidence in financial statements returns, a more general business confidence will follow.

If not, the business of lending is likely to remain a bit like buying a pig in a poke. You will not be sure of what you are getting in a transaction, which will serve to keep credit conditions tighter than they otherwise would have been.

© The European Futures Observatory 2009

Post-Moderns In The Making?

In a recent post, we stated that the British Commonwealth provides an example of what a community of nations mkight look like (see post). I am now reminded that it is not the only one. I was tidying up some notes the other day and I came across this graphic:

It would appear that The Commonwealth is the largest community group, but is not the only one. There is also an Islamic community, a Francophone community, and a Portuguese speaking community. All of these have, as a base, a common element that could help to form a community of nations. Perhaps this is one way in which the Post-modern world will emerge?

Unemployment In January

The UK jobless figures for January were published yesterday. Apparently, the UK unemployed rise by 73,800 in January and unemployment now stands at 1.97 million (see report). As we stated in our previous post (see post), whilst this is a tragedy in itself, it is not sufficient to move the total jobless to 3 million in 2009.

We are now seeing that forecasters are starting to express the view that the recession is likely to be longer and deeper than had originally been anticipated. Even the Bank of England gave that warning yesterday (see report). GDP growth is now forecast to contract by 4% between 2008 and 2009 whereas it had previously been forecast to shrink by 3%. It is also forecast that there will be a quick recovery in 2010 - more on that in another post.

One thing that strikes me is that the recession is rather pock-marked in its effect. Retail and wholesale have been badly affected, and this is widespread across the UK. Financial services have been affected, although not as badly as thought, and the impact has been felt in London and South East England. One sector affected heavily is the car manufacturing sector, which is focussed on the West Midlands. Things seem pretty bad there.

In a special report on Newsnight (accessed here), we were able to see just how hard the recession is biting in the West Midlands. As the auto industry is clustered in that region, so is the economic pain. Whilst it is obviously inequitable that the pain is concentrated in one region, it does imply that the regions where the pain isn't being felt so much (such as East Anglia) are doing relatively well.

Finally, the report also highlighted aniother reason why unemployment might not hit 3 million. In this recession, there is a distinct move towards short time working so that employers can retain their skilled production teams. This underemployment does not show up in the official statistics, but it does cause concern that the recovery may, at first, appear to be jobless as the slack of underemployment is taken up.

We still take the view that we are on target for unemployment to reach 2.5 million in 2009 rather than 3 million. Let us hope that we are right and the pessimists are wrong.

Time For Tea?

Further to our post on Icarus visiting Europe (see post), we came across an interesting graphic in The Economist:

The map show the locations of the areas of disruption, which seemed to have fallen into three categories: oil refineries, fossil fuel power stations, and nuclear power stations. It is interesting to note that, despite the general slump in UK construction, these three areas are presently enjoying something of a boom.

An interesting question is why it is that the contractors found it necessary to bring in non-UK labour to undertake the contracts. Apparently, it is better to use Italian and Portuguese labour not because they are necessarily cheaper than UK labour, but because they are more productive.

Labour productivity on the job is broadly comparable - after all, the time differences to lay a brick are unlikely to differ that widely. However, the problem is the amount of time actually spent on the job. It would seem that the UK workers were striking because they have tea breaks and their continental colleagues do not.

A winter of discontent, strikes over tea breaks, it's almost like a replay of the 1970s. This is bound to have inflationary consequnces a little way down the line.

Is Ireland A Pig?

In a recent post (see post) we introduced the idea of the Mediterranean Economies, which are sometimes unkindly known as the PIGS (Portugal, Italy, Greece, and Spain). We are now starting to see Ireland being associated with this group (now called the 'PIIGS'). The case for the inclusion of Ireland in this group can be summarised in this graphic:

As the Irish economy has gone into recession, it has started to exhibit the characteristics of a Mediterranean economy (high perceived political risk, potential downgrading of sovereign debt, fiscal crisis, expanded PSBR).

However, for the Irish economy to become a full PIG, it needs to exhibit the characteristics of a Mediterranean economy on the upside (low rate of job creation, low rate of poverty elimination). In recent times, the Irish economy has been quite good at job creation on the upside, which is why it was classed as an Anglo-Saxon economy.

If it remains so, then perhaps it is a bit premature to call it a PIG. It would remain the only Anglo-Saxon in the Euro zone.

The Humming Engine Of Inflation

At a recent meeting I was asked about inflationary forces present in the current economy. The question took me aback a little because most conversations about the economy at present tend to focus on an absence of liquidity, the threat of unemployment, and the significant reductions in world trade from which we are currently suffering. The short and easy answer to the question about inflation would have been that there are few inflationary pressures at the moment. To the contrary, the problem might be one of deflation rather than inflation. This, however, would have been the wrong answer.

There is currently a situation of contango in the global oil markets – an inverted price curve where the future price of oil is higher than the current price of oil. For example, the spot price of oil is currently about $40 a barrel and the 5 year price of oil is currently about $80 a barrel. If we have a discount rate of, say, 5%, the 5 year price should be about $32 a barrel (i.e. something costing $40 in 2014 has a present value of $32). This presages a steep rise in the price of fuel in the coming years. Looking at the question the other way around, a 5 year price of $80 a barrel now implies a spot price of $102 in 2014, at a 5% discount rate. In many ways, this takes on an aspect of Peak Oil – a point at which the oil will be worth more in the ground than in use, but it also serves as a reminder that inflation is a feature with which we will have to deal in the medium term.

This thinking has been reinforced in other areas recently. Since the meeting, I have been noticing petrol prices at the pump. Over the last four weeks, petrol has increased in price by 1p per litre per week, from 82.9p per litre to 86.9p per litre. This may partially reflect increased demand for oil products over the recent cold snap, but what is significant is that the price of petrol has increased by 5%, almost un-noticed, in a month. This increase may or may not fall back again. However, if our hypothesis is correct, it may indicate that recession induced price drops may have found their bottom.

Just as I was mulling this over, we received our January gas bill (for domestic natural gas). This quarter, the bill was £576, which I thought was rather a steep increase. Looking back, our January gas bills were £306 in 2005, £339 in 2006, and £430 in 2007. At this point, we restructured our household heating to use alternative sources – electricity powered radiators and a log fire – so that our 2008 bill came down to £342. This year, we are using fewer cubic metres of gas, but our bill rose by 68%. I see a pattern emerging.

We previously wrote about some of the long term pressures in the global economy that were helping to drive long term inflation (see post). These pressures haven’t gone away. The UN estimates global population to have been about 6 billion in 2000, and forecasts the global population to be about 8 billion in 2025. That’s an awful lot of additional people to feed. It is small wonder that the pressure on global food prices is upwards. These extra people all need to be economically active, which is placing pressure on limited supplies of energy resources. Together, food and energy inflation are likely to be a dominant feature of our longer term future, irrespective of how loose the markets are presently.

Of course, we have not mentioned the third element of the possible global inflation – water – because, in the West, we tend to take our water for granted. If the alarmists are right and the quest for drinking water causes displacement of populations and outright conflict (it has been suggested that the incursion into the Lebanon by Israel in 2006 was about who should dominate the Litani watershed – the first ‘Water War’ of the century), then the ‘price’ of that commodity is bound to increase and to have a second order effect on inflation in the West.

This brings us back to our model of scarcity for the first half of this century. Where are the inflationary pressures? In the FEW – Food, Energy, and Water. Actually, I would add minerals to that list, but it doesn’t then have such a catchy name. Whilst the short term pressure on these prices is downwards, the longer term outlook is a little more worrying. Just to make matters worse, the monetary authorities around the world are pumping liquidity into the financial system. If they do not mop it up just as quickly when the recovery starts, then they may well be fuelling the next inflation.

Whilst not driving forward at the moment, the engine of inflation is still humming away in the background.

© The European Futures Observatory 2009

China, One Year On

About a year ago, we wrote about the tightening labour market in China (see post). At that point, there was speculation about whether or not the process of globalisation could continue if China were to exhaust its seemingly unlimited supply of cheap labour.

How things can change in a year! We are now told that 20 million workers in China are to be laid off over the New Year break (see story). This number makes me suspicious. Last year, we were told that 20 million workers would not return after the New Year break. This year we are told that there are 20 million fewer jobs to come back to. The symmetry of this number makes me curious.

Notwithstanding that, there could well be a real problem in the offing. It has often been said that the Chinese economy needs to generate GDP growth of 8% in order to ensure rising living standards to offset the dislocations of a RIPE (Rapidly Industrialising Poor Economy) nation. this year, GDP growth is set to be below this number. According to the model, there may well be social unrest that could lead to major changes.

In terms of our scanning, we should look for evidence of this disruption. It has the potential to lead to the dissolution of China as we presently perceive it. Of course, it also may not. After all, a lot can change in a year.

Sand In The Gears

There are many of us in the UK who are completely mystified by the concept of 'military discipline' as it appears to be practised in the US.

In a recent post (see post), we gave three cheers to President Obama for the return to 'soft power'. He had, we were told, signed an order that the military tribunals in Guantanamo Bay were to be halted. It now transpires that a colonel in the camp has decided to ignore that order (see story), which calls into question the ability of the Commander-In-Chief to ensure that his orders are obeyed. To whom do the US military answer?

A predominant UK view of US forces is best summarised, if very unkindly and incorrectly, in 'Yes, Prime Minister' as:

"Apparently the American troops in Germany are all so drug-ridden that they don't know which side they're on anyway."

This is a prejudice that is hard to shake off, particularly now it transpires that the US will continue to outsource its torture through the process of rendition (see story). From outside of the US, it appears that the US military and intelligence services are out of control, and this is bound to make it harder for President Obama to gather support for his foreign policy.

Icarus Visits Europe

We wrote in a previous post about the ‘Icarus Effect’ – those economies that have risen the highest and the fastest in recent years that have the potential to fall the furthest and hardest in the downturn (see post). This week, it has been the fate of Europe to experience some of the more disruptive consequences of the downturn. In France, a general strike gave way to rioting against the prospect of falling living standards (see report), in Spain there were protests against unemployment (see report), in Latvia there was rioting against the terms of the IMF bailout (see story), in the UK refinery workers are striking against the use of foreign labour (see report), and Iceland may be fast tracked into the EU – and the Euro – as the country starts to cease operating as a sovereign entity (see story). In order to make sense of this, we need a framework through which we can interpret events as they unfold.

We are quite convinced by the categorisation of the European economies by the Bruegel Institute in Brussels (see web site). Their research indicates that Europe can usefully be categorised as having four styles of economy:
1. The Mediterraneans (Greece, Spain, Italy).
2. The Continentals (France, Belgium, Germany).
3. The Anglo-Saxons (UK, Ireland).
4. The Nordics (Denmark, Sweden, Finland, Netherlands).
These classifications are based upon how the economies behave rather than their geographical location. As a reference point, the US would be classified as an Anglo-Saxon economy. The Mediterraneans are sometimes referred to, unkindly, as the PIGS Economies (Portugal, Italy, Greece, and Spain).

It is an interesting exercise to cast the A8 (the eight EU accession states from 2004 – Estonia, Latvia, Lithuania, Poland, Slovakia, Slovenia, Cyprus, and Malta) in terms of the more established Bruegel categories. The Eastern European members of the A8 have tended to be more influenced by the Anglo-Saxon agenda of privatisation and flat taxes than any of the other European models. In the current downturn, this leaves these economies rather vulnerable. They will suffer the loss of living standards without a fully developed social welfare system to mitigate it.

Iceland is, perhaps, the most interesting case. Traditionally, Iceland would be cast as a Nordic economy – very unimaginative and very solid. In recent years, Iceland has moved from being a Nordic Economy to being more of an Anglo-Saxon economy by liberalising its banking system and accumulating large leveraged positions. In doing so, it has become a microcosm of how the recession might play out. Financial collapse in Iceland has been rapidly followed by the collapse of the Icelandic real economy. This has led to political instability, with the fall of the Icelandic government this week. The escape route for the nation is now to accept the pooled sovereignty of the EU, which has all sorts of geo-political implications.

An alternative would be for the Icelandic people to revert to an inward focus. To retain as much independence as they have today, which is highly prized in Icelandic society, the nation would have to become far more self-sufficient than it is today. The Icelandic currency has depreciated to a point where it is effectively valueless, Icelandic trade has dropped away significantly; tax revenues are set to fall, and just at the point where pressure on government spending is rising. If foreigners are reluctant to fund the Icelandic PSBR because of the devalued currency, then the only thing that the Icelandic government can do is to tighten its belt until it really hurts.

This highlights the danger of being where we find ourselves. The popular reaction during a downturn is to rail against foreign companies, foreign staff, foreign finance, and so on. A good number of protests in Europe at the moment are specifically directed against the involvement of ‘foreigners’ in the domestic economy. To their credit, European politicians have resisted calls for protectionist measures. We can only hope that they stay on course. Already the US has shown an alarming sign of protectionism through the ‘Buy American’ clause in the financial stimulus package. This assertion of nationalist sentiment is dangerous because it is confrontational and invites retaliation, which is in nobody’s interest. In a trade war, we are all the losers.

Although Icarus has visited Europe this week, let us hope that we can avoid his fate by overcoming the dangers that we face.


© The European Futures Observatory 2009

The Clouds Gather

We wrote last year about the New Nationalism (see post) as the force that would diminish the process of Globalisation. Two recent events have brought the New Nationalism into a sharp focus.

First, the new US Secretary to the Treasury has accused China of manipulating its currency against the dollar (see article). This talk is both silly and dangerous. It is silly because any financial relationship of the scale that is being discussed involves the voluntary actions of countless thousands of people. China is only able to maintain a soft peg against the dollar because the Federal authorities have a seemingly insatiable appetite for borrowing Chinese funds. Had the US raised taxes in the period 2004-07, had the US authorities tightened monetary policy, the appetite for Chinese funds would have been more limited.

The statement is dangerous because it is confrontational at a time when the premium has to be on co-operation of all nations. Who, does Secretary Geithner think, is going to lend the Federal government the funds it needs to finance the fiscal stimulus? The only nation in the world with those sums available is the Chinese government. In a rare, but candid, interview for The Atlantic (see article), Gao Xiqing - who controls $US200 billion of the Chinese Sovereign Wealth Fund in the US - warned the Federal government to "be nice to the countries that lend you money". In the UK we call this biting the hand that feeds you.

The second event that causes concern is the requirement that only US steel and iron is used on infrastructure projects financed by the bailout package (see article). Ignoring the obvious points of silliness - in a globalised world, what exactly is a 'US company' - this provision is dangerous to the extreme. The great fear is that we are starting to head towards the naive protectionism that made the Great Depression so 'great'.

We have also been here before. When George Bush came to office, he imposed punitive tariffs on foreign steel with the result that US consumers of steel had to pay more than necessary for their steel. The matter was resolved through the WTO in favous of the EU, and Bush only relented when faced with the prospect of legally imposed punitive tariffs on Foridian Orange Juice (remember Jeb Bush?).

The fear across the world is that we have yet another US President who will not honour international obligations (the WTO rules on state support), who acts unilaterally, and who acts with disregard to the interests of his close allies. In a recent post, we asked where the change was (see post). This is still a valid question.

We take the view that the clouds are definitely gathering, and that the storm could strike sometime this year. This is not a good time to have a novice at the helm of the ship of state.

© The European Futures Observatory 2009

The Penny Starts To Drop

Poor President Obama. The shine seems to be coming off his his Presidency after only a week. In a previous post (see post) we commented upon the impossibility of the task that he has set himself. This theme was taken up by The Economist this week (see article). It would appear that the strategy of seeming to please as many as possible on the way into office has created a problem of failing to please so many when in office.

I was out for a meeting this afternoon. As I drove home I managed to pick up a bit of the debate on the fiscal stimulus in Congress. Should the stimulus work through tax cuts? Should it work through increased Federal spending? If so, on infrastructure projects? Or on welfare projects? There certainly seemed to be a good deal to argue about. And yet, the supporters of each of these positions appeared to believe that the candidate Obama had promised support to their pet projects. President Obama appeared to be letting them down.

I think that is the basis of my Obamascepticism. He appears to have promised so many mutually exclusive entitlements to so many groups that he can only fail to deliver. And that is only within the US!

On To 3 Million?

One economic indicator that we are following closely this year is the UK unemployment figure. This is important for a number of reasons. First, it gives an idea of the pressure on government spending to rise. It lets us gauge how hard the recession is biting. Second, it provides an early warning of the direction in which tax revenues are heading. The unemployed tend to have less to spend, so VAT receipts, followed after a while by Corporation Tax receipts and Schedule D Income Tax receipts, fall away as unemployment rises. Together these give us an indication of where the PSBR is going - and how readily the Government will be able to repay its borrowing.

The figures published last week (see article) indicated that unemployment had risen by 77,900 in December. This is a real tragedy to each of the individuals who make up this statistic, and we would not want to downplay any of the suffering that they are now going through. However, in a previous post (see post) we suggested that, in order for unemployment to reach 3 million by the end of 2009, the figures would have to increase by 100,000 a month.

The good news is that we are on course for unemployment of about 2.5 million by the end of 2009. The bad news is that the rate of increase is accelerating. Prior to December, unemployment was rising at about 45,000 a month. It is now on its way to doubling that rate of increase, which is worrying.

The implication is that the stock of debt incurred through the rising PSBR is increasing as well. Perhaps it may be beyond 2017 before it is paid off?

And Germany Too ...

In a recent post (see post) we discussed the affordability of the UK fiscal stimulus. At the time, the German Finance Minister - Peer Steinbrück - was dismissive of the policy. He saw it as a means of buying our way out of recession, which it is, and of which he disapproved.

It's funny how events catch up with us. We now find that the German Federal authorities plan exactly the same stimulus (see article). Of course, we could talk about the correctness of the arguments for the fiscal stimulus, but a more telling point is likely to be the German economy falling in an election year.

We need to remind ourselves that fiscal policy is all about politics and not economics. Sometimes we lose sight of that point.

The Velvet Glove And The Iron Fist

One of the changes that we are to see in Washington is the United States starting to use its ‘soft power’ again. During the Bush administration, the US relied almost exclusively on ‘hard power’, which came to be equated with the use of force. As the sole superpower, without a military peer in the world, the Neo-Con agenda calculated that American policy could be forced upon an unwilling world because nobody would dare to deny them.

This strategy proved to be muddle headed on two counts. First, it did not account for asymmetric warfare. A small group of determined individuals could obtain military victories over much larger nations. The way in which the Madrid bombings knocked Spain out of the ‘Coalition of the Willing’ gives evidence of this. Secondly, Political Philosophy 101 teaches us that might is not right unless it has a backing of legitimacy. This was almost totally lacking in the Bush Doctrine, as the absence of legitimacy degenerated to include embracing illegal acts such as torture and arbitrary detention. To his enormous credit, the first foreign policy act of President Obama was to halt the kangaroo courts – military tribunals, if you like - in Guantanamo Bay, and his second was to order the closure of the camp within a year. It may prove difficult to achieve this, but it has certainly sent a signal that the US intends to seek the moral high ground – the epicentre of its soft power – in the years to come.

But what does that mean for the longer term? Two recent articles have laid out the basis of a model that explores this issue. In an article for Foreign Affairs (see article), Anne-Marie Slaughter asserts that we are in a transition period moving away from a world of hierarchies and towards a world of networks. In many ways, this is quite a reasonable supposition. Ms Slaughter then goes on to argue that the US is uniquely advantaged to benefit from the growth of networks owing to the number of immigrant diasporas living in America. The point is well made, but taken too far. Europe also has a large number of immigrant communities from as wide a range of origins as the US. There is no reason why these communities could not network European influence in exactly the same way as is suggested for American influence.

To a certain extent, the infrastructure for this already exists. I was once asked how a small, open economy such as Australia could compete and have a voice in a world of giants. I took the view then, as I still do, that the Commonwealth provides an infrastructure that could be used, very much in a way similar to the EU, to allow smaller nations to have a greater voice in the international arena. Of course, it would need to be a different Commonwealth to the one that we have now, but the basic architecture is there. One possible future would be for Europe to put its colonial heritage to use in developing this network of nations. It also offers the US the opportunity to develop within the framework of these networks, or parallel to them.

Of course, the world in which these networks are operating is in the process of changing. The second article, in Foreign Policy (see article), argues that the certainties by which the US provided leadership for the West over the past fifty years are changing. Since World War II, international discourse has been bounded by five certainties:
1. That peace is better than war.
2. That benign hegemony is better than a balance of power.
3. That capitalism is better than socialism.
4. That democracy is better than dictatorship.
5. That western culture is better than all the rest.
The move from a world of hierarchies to a world of networks is calling into question all of these certainties. Even the belief in capitalism as a means of organising an economy is now seriously in question.

There is a lot to commend this view of the world and if President Obama is to reassert American influence in the world, he will need to convince the American public of the case. President Obama campaigned on a promise of change, but now leads a society that is likely to be resistant to change. For example, in the case of climate change, for the US to achieve the reductions in carbon emissions in accordance with the Kyoto protocols, we have calculated that petrol (gas) would have to be in the region of $19.00 a gallon. All of the evidence of the past two or three years suggests that this is an unacceptable position for the American public. More to the point, will the rest of the world cede the moral high ground to a nation that persistently fails to meet its international obligations?

This may prove to be something of a dilemma for President Obama in the years to come. His desire for the US to follow one path may increasingly be bounded by his political inability to implement what needs to be done. The domestic agenda may constrain the foreign agenda significantly. This is one metric by which the decline of the US could be measured – how the US President is unable to act internationally because of domestic considerations. If this becomes obvious, then we will know that the American unipolar moment has ended.

Perhaps the velvet glove may not fit the iron fist.

© The European Futures Observatory 2009

Icarus Is In The Air!

A little while ago we posted a piece on The Icarus Effect, speculating that as the BRIC economies have soared the greatest in the past few years, so they will fall the furthest and hardest during the present downturn (see post). The Economist recently presented two cases that support this contention.

The first article was about a company called Smart Union in China (see article). During the upswing, Smart Union was something of a success story. It included a tale of rags to riches for Tony Wu, who built a toy manufacturing empire from nothing in 1995 to a HK$53mn IPO in 2006. In 2007, sales topped HK$1bn. However, it appears that the company overtraded. Rising costs - particularly labour costs - squeezed profit margins, the weakness of the balance sheet pushed the company into costly credit arrangements for working capital, and a flood led to HK$65mn stock being written off. This led the company to cease trading.

The second case is about Satyam Computer Services (see article). Satyam, India's fourth largest software and services firm, seems to be a victim of crony capitalism. It is a company that is tightly controlled by a small number of family members. One of the family members has confessed that the company balance sheet is more of a work of fiction than fact. A reported cash pile of US$1bn on the balance sheet does not, in fact, exist. This story has a little way to run, but it does highlight the downside and how it is likely to play out.

Operating in the BRIC economies has a number of difficulties for western companies. BRIC companies are often inexperienced and under-capitalised, as in the case of Smart Union. They also operate in an environment where internal financial controls, transparency, accountability, and audit independence are weak or non-existent, as in the case of Satyan. It is a small wonder that capital is flying back from the BRIC nations to a more safe haven - Europe and North America.

If globalisation is to proceed as fast as it has in the past, then there needs to be a harmonisation in the development and implementation of the rules surrounding accounting practice, corporate governance, and audit reporting. If not, the BRIC economies will always be junior players.

© The European Futures Observatory 2009

Chalk One Up For The Awkward Squad

In a recent post (see post) we reflected that the group who will prove troublesome to President Obama is already taking form. One of the problems that President Obama faces is the ability to galvanise the European nations to follow an American agenda. It was put to me recently that "Europe is no longer willing to have its wars declared in Washington".

Whilst Europe would broadly support the objectives of the President, when it actually comes to committing troops, it is a different story. Germany is well known for not being willing to commit more troops to Afghanistan. It now appears that France is unwilling to commit further troops to Afghanistan (see report).

This causes a problem for the new President because it keeps the US committed to an expensive overseas engagement at a time when America might like to scale back its commitment. Perhaps the honeymoon is coming to an end?

How Long? How Deep?

Our previous post on unemployment (see post) asked if we are getting the right picture from the statistics that we have available to us. The theme of uncertainty about the duration and length of the incipient recession was taken up in an article in The Economist (see article) that reported on the recent AEA Conference in San Francisco.

It would seem that the dismal scientists are being quite dismal about the prospects for the US economy over the next few years. Part of this would reflect a reluctance to adopt an aggressive fiscal policy to resolve the matter, and part of this would reflect the structural changes that the US is currently undergoing.

We feel that America is likely to have a longer and harder recession than other members of the OECD. It has delayed effective action later than other nations, it is suffering from a structural realignment of the economy, and it is slow to grasp the 'New Normal'. In this respect, the economists at the AEA might be right.

America At The Crossroads

All eyes turn to Washington this week for the inauguration of President Obama. In winning the election, he has done much to impress. The campaign has set all sorts of records for fundraising, galvanising grass roots support, mobilising the popular vote, and taking on the vested interests in Washington. It is so fitting that the Senator from Illinois will become the first Afro-American President of the United States. At this point, it might be helpful to take stock about why this Presidency in particular is likely to be pivotal in the story of America.

President Obama will inherit two sets of problems – the US economy and the position of the US in the world. The US economy is in a dire position. As the global economy moves into recession, there is evidence to suggest that the US economy is one of the hardest hit in the OECD group of nations. It has not benefited from the fiscal stimuli that other economies are starting to feel. Much of the benefit of the financial bail-outs has been devoted to shoring up the balance sheets of the banking sector rather than getting the economy working again. There is a great deal of anger in the US about the way in which Wall Street has been bailed out and Main Street has been left to its own devices.

This erosion of trust, and its consequential impact on confidence, is the first thing that the new President will have to tackle in his fiscal stimulus. Even if the US has a ‘good recession’, there are a number of longer term adverse factors that will start to arise during this Presidency. Last year the first Boomers reached retirement age. The numbers achieving this status over the next four years will rise dramatically, and even more will join their ranks should President Obama be re-elected in 2012. There are likely to be a number of very unhappy voters in the next few years. The financial crisis has severely reduced the value of the Boomers retirement accounts at exactly the wrong time for them. As a generation, the Boomers have been led to expect a comfortable retirement, but the prospects are not favourable for this outcome.

In addition to that, the expectation of medical entitlements has risen just at the point where the demands on the system are likely to take it towards breaking point. The health and retirement entitlements in the Federal Budget are likely to place it under considerable pressure in the coming years. Healthcare reform has been a central promise of the Presidential campaign. However, the realties of office, combined with the entrenchment of vested interests, lead us to think that major reform could well take longer than a single Presidential term and that the pressure of growing entitlements will cause the federal deficit to grow during this Presidency.

Of course, the US does not face these problems in isolation. They are a common set of problems experienced across the OECD. It is unlikely that any one nation – even the US – will be able to solve these problems in isolation. This is where the position of the US in the world might start to be problematical. The ‘awkward squad’ are already forming. The Financial Times reports that Germany and France have warned President Obama that the EU intends to set the agenda for reform at the G20 in April (see article).

In a different article the FT also reports that the Saudis have reduced oil production by an amount greater than the amount agreed at OPEC in an effort to force up the price of oil (see article). This is significant because the Wall Street Journal reported an estimate that oil at $80 a barrel gave the US economy a stimulus of $275 billion (see article). One way of interpreting this news is that the covert stimulus of $150 billion given by the Saudis to the Bush Presidency – by holding oil at $40 a barrel instead of the target $75 a barrel – is not going to be given to the Obama Presidency. Indeed, one consequence of filling the State Department with people sympathetic to the pro-Israel lobby is likely to be that the Arab members of OPEC are unlikely to be greatly sympathetic to the plight of the US economy.

This interplay between global geopolitics and the global economy is likely to dominate the next Presidency. In Afghanistan, the US would like to see greater NATO involvement and a commitment of more European troops. The European refusniks – led by Germany – are unlikely to respond to this call. In turn, this circumscribes any attempt to reduce the cost to the Federal budget of overseas engagements. We seem to be at a time where two certainties of the past have become very uncertain.

For the last twenty years we have relied on the certainty that market capitalism is the best way to arrange our affairs, and that the US would take the lead in making market capitalism work. Events of the past two years have demonstrated that market capitalism, as a system, has its deep flaws. In dealing with these flaws, the economies of the world are heading towards a more socialised arrangement – market socialism, if you like. In this, the US does not have a great deal of authority, Europe does.

Equally, recent events are starting to show that the US is not the unchallenged superpower that it once was. A new order is emerging. Authority is seeping away from nation states towards supra-national bodies. Even the UN is finding a revitalised role in this new order. Of the nation states, the emerging powers now want a greater say in the organisation of global affairs. The G7, then the G8, is now the G20 to include the reality of the development of India, China, and the other emerging economies. Whereas once the US could dominate such groups, now it cannot. A different conversation has arisen that few in the US have yet to hear.

And so we find America at a crossroads. President Obama has much promise in finding the right path. It is in all our interests that he doesn’t take a wrong turn.

© The European Futures Observatory 2009