Monday, November 28, 2011

Tough Choices for UK Economy

Many are saying it’s a difficult to time to be a chancellor. This is certainly true, but it’s also difficult time to be a saver (negative real interest rate of -4.5%) or difficult to be an average worker (biggest fall in real incomes – 3.5% since Great Depression.)

It’s not great news if you’re a public sector worker who faces wage freezes and a higher retirement age. It’s undoubtedly hardest for the 3 million unemployed

The OBR may predict growth of 1% in 2012 for UK, but most analysts would choose something closer to 0%.

This prolonged period of slow / negative growth is manifested in record levels of unemployment, especially amongst the youth unemployed. This kind of negative output gap cries out for fiscal stimulus – higher government spending and lower taxes.

But, the UK’s budget deficit is still very high and despite the overly-enthusiastic spending cuts – the deficit is falling at a disappointingly slow rate. (The disappointing deficit reduction caused in part by the fall in GDP caused by the spending cuts themselves)

Historical UK debt as % of GDP might not look so bad. But, with the Euro crisis getting worse almost every day, markets are keenly watching any sign of government debt weakness. It is true the UK’s monetary and exchange rate independence gives us more room for maneuver than Euro members, who are stuck in a perilous deflationary spiral. But, in the current climate, even the bravest Keynesian may baulk at the scale of fiscal expansion necessary to catch up all the lost output.

A sensible solution would be to pursue some short-term infrastructure projects to create some demand, and at least some sense of urgency for growth. To reassure markets, the government could try target long-term fiscal strengthening measures which don’t harm short-run economic growth. Raising pension age, is one way to reduce the structural debt, without cost of short-term unemployment. But, raising pension age has incurred a huge public sector strike. It seems there is no popular way to increase growth and reduce debt.

At least, the UK has an independent Central Bank able to consider the wider public interest and not just the threat of inflation in northern Europe (i.e. Germany) Quantitative easing is far from perfect - banks sit on most of this extra cash, it’s unfair e.t.c. But, I still feel it is better than nothing. At least, we have some monetary stimulus amongst all the other dire news and global deflationary pressures. The Bank of England may have incurred wrath of savers this year, but they've done a big favour to hopes of recovery (and the government)

Another plus, is that the UK has avoided the bond market turmoil of the Eurozone. But, it’s not a time to feel smug for staying outside the Euro. Whether we like or not, a large proportion of our exports (60%) go to Europe. If Europe is dragged into a deep depression (which is increasingly likely, despite all the non-reassuring promises to the contrary), it will harm our prospects. When you have growth forecast of 0% a recession in your main trading partner is bad news.

The government made a mistake in cutting spending so hard on coming to power. To some extent they are perpetuators of their own misfortune. Their recent growth package gives the impression of being political spin, brought out almost as an after-thought.

Yet, they inherited a difficult economic climate, and events in Europe and abroad are largely out of their control. Like so many times, since 2007, we keep saying ‘well I guess it could have been much worse’

Yet, despite their obvious mistakes, and the inequity of the bank bailouts, I have mixed feelings about the upcoming public sector strikes. We can’t afford the luxury of bankrupting the country just so we can help workers gain 35 + years of state pensions. No matter how much we would like to retire at 65, there are unfortunately, more pressing priorities.


Friday, November 18, 2011

Difference Between the EU and Euro

I often find people talk of the European Union and the Euro (single currency) as interchangeable ideas. Recently, the German leader Angela Merkel stated defending the Euro was essential for maintaining the post war gains of the European Union. The new Italian new 'technocrat' leader Mario Monti warned that a breakup of the Euro would bring its users "back to the 1950s." - (before the creation of EEC.) Yet, arguably, the European Union would be a lot stronger without the Euro or at least the Euro in a very different format.

The Ideal of European Integration

The post war development of Europe is one of humanity's great achievements. We went from a conflict perpetually at war, to a continent at peace (with the odd exception in the Balkans). The European Economic Community, for all its failings helped foster greater ideals of integration. With free trade throughout the European Union we benefited from a golden age of economic growth, low unemployment and prosperity. Whatever bureaucratic failings may occur in the EU, I will always remain a broad supporter of this ideal of bringing European countries together.

The Euro Is Not Aiding European Harmony and Prosperity.

The problem is that European leaders felt having a single currency (the Euro) was a natural extension of this ideal of economic and political integration. Southern European economies were particularly keen to gain the benefits of being tied to the German economy. (Italy was one of strongest supporters of Euro). Countries felt joining the Euro would be an easy ticket to low interest rates, low inflation and high economic growth. (in fact the opposite has occurred).

The EU were so keen to go ahead with the single currency that their own 'Maastricht Criteria' were pushed aside to let everyone join. (In 2000, the UK was actually one of few countries who met Maastricht Criteria, though we decided not to join). In the case of Greece the decision to ignore these criteria would prove most damaging.

The problem with the Euro is that it is fundamentally flawed, and because of these fundamental flaws it has an in built deflationary bias which is promoting low growth, high unemployment and increasing division between the different regions in the EU.

Fundamental Flaws of the Euro

  1. No Lender of Last Resort. This means liquidity crisis come quickly and with great force. It is why Greece, Ireland, Portugal, Italy, Spain (and more to come) have see such a devastating rise in borrowing costs. If the UK had been in the Euro, the same would have happened to us. Problems of Euro in recession
  2. Uncompetitive Countries. Countries in the south of Europe have seen a rise in inflation relative to Germany. This has left them uncompetitive, leading to lower exports and lower growth. But, because they are in the Euro, they can't devalue to restore competitiveness. They are left with sluggish growth.
  3. Austerity. The response to the EU debt crisis has been to push spending cuts on country. No matter how steep the spending cuts, these have singularly failed to reassure bond markets. Bond yields have continued to rise regardless. THe only thing spending cuts have achieved is to push the south of Europe into a potentially damaging recession, lower tax revenues and higher debt to GDP. IN response the European bureaucrats and leaders shout 'more austerity'. The outcome is unemployment, recession and greater disharmony.
  4. Not an Optimal Currency Area - geographical immobilities
  5. No real fiscal union - only grudging promises of help
More: Problems of the Euro.
  • The Germans don't want to bailout southern countries who have run up large budget deficits.
  • The south don't want to be stuck in a deflationary trap.
Both, are right. It shouldn't be like this. With the single currency and common monetary policy, we only have a recipe for falling living standards and increased social division. This doesn't help Europe. It is the Euro and the failings of the ECB which is threatening the stability of Europe.


Wednesday, November 16, 2011

Is France Next Bond Crisis?

Despite similar public sector debt to Germany France (85% of GDP) is at risk of becoming the next target for bond investors, as sellers push the interest rate on French debt up.

In the real world, investors are selling all Eurobonds apart from Germany. France is looking like the next target for a panic sell off.

The ECB adamantly refuse to act as lender of last resort. As Rome burns, the ECB watch their inflation targets. But, if they don't intervene what will stop the Euro crisis? - ECB and Money Creation

One Year Bond Yields - Spread v Germany and France Bond Yields

French National Debt

  • debt
  • In Nov. 2011, French national debt stands at 1.7 trillion Euros - 85% of GDP.
    • Forecast for end of 2012 is 90% of GDP.
    • France's budget deficit is 5.8% of GDP
  • France National Debt
  • Spiegel online


Tuesday, November 15, 2011

Inflating Away Our Debt

Inflation reduces the value of money. This reduces the real value of your debt and also the real value of your savings. Therefore periods of high inflation tend to be good news for borrowers, but bad for savers. This is particularly the case if we have high inflation during a period of very low interest rates.

Inflation and Interest Rates since 1900

In periods where inflation is higher than interest rates, savers are losing out.

UK 2011

From one perspective, it is curious that with inflation of 5%, investors are very willing to buy UK bonds pushing interest rates down to 2.2% on 10 year bonds (Nov, 2011). What this means is that investors prefer to hold bonds with a negative real interest rate rather than use their funds to invest in other areas.

The good news for the UK is that with inflation of 5%, we are effectively 'inflating' away part of our debt. With inflation it is much easier to reduce your debt to GDP ratio.

Simple Example Showing Affect of Inflation on Debt.
  • Suppose government borrow £1,000bn and nominal GDP is £1,000bn.
  • Supposed tax revenues = £400bn (40% of GDP)
  • The debt to GDP ratio is 100%.
  • Suppose then we have inflation of 100%, and the level of former debt stays at £1,000bn.
  • Because of inflation, nominal GDP increases to £2,000bn.
  • The debt to GDP ratio will fall to 50%
  • Also, if tax rates stay the same, tax revenue will increase to £800bn, making it easier to meet debt interest payments.
This scenario, is bad news for savers who see a real fall in the value of their savings. In the above case, savers will see the value of their bonds fall by 50%. This kind of inflation is effectively a partial default.

But, for the government and borrowers, it is a 'lucky' event which makes the task of debt reduction easier. However, if a country gains a reputation for having 'unexpected inflation' it will become more difficult to sell future debt. It means in the future bond investors will demand higher interest rates to compensate for risk. - There are only so many times you can get away with 'inflating away your debt'

Usually, the threat of inflation would push up bond yields as investors don't want to have this kind of negative interest rate. However, at the moment, pension funds don't want to invest in the stock market or invest in long term capital investment. They only want the security of government bonds. Therefore, in the current liquidity trap, the government can take advantage of borrowing at low interest rates.

Also, part of the reason that investors are willing to buy bonds at such low interest rates, is that they really do expect inflation to fall next year. The current inflation of 5% in 2011 is due to temporary factors such as higher taxes and impact of devaluation. Because markets expect inflation to fall next year, they are more willing to hold UK bonds.

Also, markets fear UK growth will be very low. This risk of a second recession means that the stock market and other investments are still unattractive. Pension funds would rather have the security of bonds rather than risk putting money elsewhere.

Bond yields have also benefited from
  • The governments stringent spending cuts.
  • UK yields have also been helped by having a lender of last resort (unlike Italy).

Inflation Unfair on Savers

Inflation invariably reduces real wealth of savers. Many pressure groups representing savers argue for immediate action to protect the value of their savings i.e. higher interest rates to reduce inflation and increase real interest rates.

However, the government and Central Bank have to weigh up the different costs.

It is unfortunate the middle classes see a small fall in the value of their savings. However, arguably it would be a much bigger cost to society, if higher interest rates pushed economy back into recession and a significant rise in unemployment.

Low interest rates reduce living standards, but it is not comparable to the reduction in living standards from unemployment and a prolonged recession.

Savers Also need Economic Growth

Savers are getting such a poor deal because of feeble prospects over economic growth. If the economy recovered with strong economic growth, pension funds would have the confidence to invest in shares and capital investment. They wouldn't feel tied to buying bonds with negative real interest rates.

Therefore, although it is unfortunate savers have negative real interest rates, it is definitely not in their interest to have a sudden rise in interest rates which pushes the economy back into recession.


Friday, November 11, 2011

Options for the Eurozone and Euro

The EU gives the impression of stumbling through the crisis. There is an attempt to deal with issues as they come up, without tackling the fundamental issues underlying the crisis.

In particular, in response to rising bond yields, there is a rush to try to reduce budget deficits and reassure markets. But, this approach is not working. It is not working because:
  1. It doesn't address the underlying lack of competitiveness and misaligned exchange rates in southern Europe.
  2. It doesn't tackle the need to promote growth in GDP, which will help reduce Debt to GDP ratios.
  3. It doesn't reassure markets there will be no liquidity crisis - because there is still no lender of last resort.
See more detail on: Euro Debt Crisis Explained

Options for the Eurozone

1. Internal Devalution, Austerity, Weak bailouts

The current option pursued by the European Union is to
  • Reduce spending as much as possible to reduce budget deficits.
  • Rely on internal devaluation (lower labour costs to restore competitiveness for the Southern economies)
  • Implement structural reforms to restore competitiveness, although these tend to be vague.
  • Offer a grudging and weak kind of bailout (i.e. the EFSF is guaranteed by countries like, er Italy)
The problem of this is that:
  1. This is causing lower growth and falling tax revenues. Therefore, markets don't see how the likes of Italy are going to reduce their debt to GDP ratios.
  2. Despite austerity measures markets still don't confidence in buying Italian debt because of the fears of recession, and also there is no lender of last resort.
  3. The process of restoring competitiveness through this internal devaluation is very slow.
If the EU stick to this, we will get prolonged economic stagnation and a serious recession in the south of Europe. There will be a perpetual need to cut spending and try and reduce budget deficits. Internal devaluation may eventually restore some kind of competitiveness (Ireland has been more successful than other) and help promote some kind of economic recovery, but it will take a long time and cause very high levels of unemployment and instability. There will also be persistent pressure from the bond markets. Whether the Euro can surviving bailing out stagnant economies the size of Italy during a decade of economic stagnation is highly debatable.

2. Change the Role of the ECB

At the moment, the ECB seems only interested in preventing the non-existing inflationary threat. The ECB could be reformed to:
  • Act as lender of last resort. Buy government bonds without hesitation and give markets confidence.
  • Target a higher inflation rate (perhaps as likely as Berlusconi being made an honorary member of the Women's Institute) But, the ECB at least have to see the need to target growth, even at the risk of some higher inflation.
3. Break up of the Euro

Concentrate the Euro on only a small group of northern economies who have actually shown a degree of economic harmonisation (Germany, France, Belgium, Netherlands e.t.c). Countries who leave the Euro should honour current contracts in Euros, but new contracts should be based on their own currency (new Lira, New Drachma) These new currencies will significantly devalue. This has both costs and benefits.
  • The rapid devaluation will restore competitiveness enabling an increase in export demand
  • The devaluation would probably cause capital flight as investors seek safe havens in the 'strong Euro' and away from the south.
  • The fragmentation of the Euro could cause great turmoil in the EU. However, it may still be a better alternative than the prolonged recession likely with current policies.

4. Fiscal Union

The other option is to go for broke and have a complete fiscal union. i.e. there would be no Italian bonds, no German bonds, only Euro bonds. This would prevent contagion for weak countries. It would reduce interest rates enabling a more ordered austerity program. It should give better chances for growth.

However, it opens a range of other issues.
  • Can the EU impose a degree of fiscal discipline on countries with poor track records.
  • Will German taxpayers be willing to bite paying for Italian profligacy.
  • Is fiscal union enough? It still doesn't promote competitiveness and economic growth.

Tuesday, November 8, 2011

Economic Problems of Italy

Italy is facing a economic serious crisis with bond yields rising close to 7%. They also face the prospect of recession and slow growth in the coming years.

Bond Yields on UK, Italian and German Debt

Firstly, there is a significant difference between Greece and Italy. Greece was fundamentally bankrupt. It's budget deficit, and public sector debt was too large for it to cope. A debt restructuring was inevitable.

Italy is actually running a primary budget surplus (this means if we exclude the cost of interest payments on its debt, Italy has a 'primary' budget surplus - very different to the UK) Italy doesn't have the highest public sector net debt in the EU either.

source: FT

Italy's fiscal deficit is lower than many other countries.

It seems bizarre a country with a primary budget surplus can be facing a liquidity crisis that Italy is.

Reasons for Italian Crisis

Recession. Austerity packages (spending cuts) and fears about the prospects of the Eurozone have precipitated a fall in consumer spending and economic growth in Italy. It is forecast Italy will remain in recession in 2012 and 2013. This negative growth will lead to a fall in tax revenues and higher government spending on unemployment benefits. Markets don't want to buy Italian debt because of fears over lack of economic growth will make it very difficult to reduce their debt to GDP ratio.

Poor Growth Record

Due to a combination of political instability, corruption and poor productivity growth, Italy has developed a poor track record of economic growth in past two decades.

source: economist

Long Term Debt.

Though Italy's budget deficit (annual deficit) is quite low, public sector debt is over 110% of GDP, which is giving cause for concern. The problem is that it is quite difficult to reduce this debt / GDP ratio given - how much they spend on interest payments, and the poor prospects for GDP Growth.

Ageing Population.

The long term debt problem is not helped by Italy's ageing population. This will reduce income tax revenues and require greater commitment to state pensions over the next few years. Italy has one of the lowest birth rates in the world.

Fundamental Uncompetitiveness

Since joining the Euro, Italy has seen its relative competitiveness decline. Labour costs have risen 40% compared to Germany; this has contributed to a 70% fall in direct investment since 2007. Like Greece and Portugal, Italy can't devalue so it is left with uncompetitive exports. This uncompetitiveness leads to lower economic growth and more pressure on debt/GDP ratio.

No Lender of Last Resort

Italy is not bankrupt, but it may experience a liquidity crisis (it may be unable to 'roll over its debt' i.e. sell enough bonds to meet current budget requirements in short term). This liquidity shortage should be quite a small risk. But, because there is no lender of last resort for Italy (i.e. ECB will not buy Italian bonds to roll over debt) Markets find Italian debt much less appealing. If there was a guaranteed lender of last resort, Italian bond yields would be much lower. People would have much more confidence in holding Italian debt. However, because there are fears over liquidity shortages this has pushed up bond yields; this increase in bond yields has increased the cost of servicing Italy's debt


Italy suffers from:
  • Having wrong exchange rate. They have lost competitiveness and can't devalue leading to lower growth
  • Monetary policy is too tight for Italian economy.
  • There is no lender of last resort.
  • EU austerity measures (spending cuts) are forcing Italy back into recession leading to a predicted slump in tax revenues. This is making markets nervous about future prospects for Italy.
  • There seem no practical solutions to returning to strong growth. Again the only medicine seems to be 'spending cuts' and internal devaluation. But, this will be a long drawn out process.
  • Political instability. Lack of strong cohesive government makes markets more nervous to hold Italian debt.
Similarities between Italy and Greece.
Both countries:
  • Share decline in competitiveness
  • Would benefit from devaluation, but in Euro can't
  • Are experiencing high unemployment and economic stagnation
  • Must regret being in the Euro.

Saturday, November 5, 2011

Is the UK like Greece and Italy?

With all the turmoil in the Euro, how likely is the UK to face similar debt crisis as Greece, Italy, Spain and Ireland?

On some measures there is a disturbing similarity.

Public sector debt as % of GDP


Facts on European debt crisis

    Annual Budget Deficit
  • The UK's budget deficit is one of highest in EU (after Greece and Ireland's 2010 budget deficit)
  • The UK economy is very closely linked to the Eurozone; if Europe enters a recession, this is likely to adversely affect the UK economy.
  • Despite recent growth figures there are signs that the UK economy is stuck in an economic slowdown.
However, I don't think we need to fear becoming the next Greece, Ireland or Italy. This is why
  • Bank of England is willing to act as lender of last resort - buying bonds in a liquidity shortage. Markets have greater faith in countries who have independent Central Bank who is is willing to buy government bonds. If Italy experiences temporary difficulties in selling government debt, there is no Central Bank to step in. They have to go through the whole rigmorole of going to the EU asking for loan. But, this loan usually involves interminable political wranglings. Understandably, markets fear there is no mechanism to deal with liquidity shortages. Therefore, investors are less willing to hold debt held by Eurozone economies.
Bond yields have stayed low in UK
    • euro

    Bond yields on EU Debt

  • Low Interest Payments. UK Debt interest payments are manageable at only around 3% of GDP (£48bn)
  • Longer debt maturity. The UK has a higher % of debt denominated on bonds with long maturity (e.g. greater than 10 years) therefore there is less pressure to sell new bonds.
  • Historical national debt. As a % of GDP, UK public sector debt has been higher in the past. (National debt facts)
  • Spending Cuts. Markets have been reassured government is committed to reducing structural deficit.
  • Greater Flexibility. The UK has greater flexibility than Eurozone economies. Whilst the UK government cut spending leading to unemployment and lower demand, at least UK Central Bank have been able to pursue quantitative easing to provide some monetary stimulus. Also, the UK has benefited from the depreciation in sterling which helps to boost domestic demand.
It doesn't mean the UK economy is safe. The debt to GDP ratio will only improve when the UK economy returns to its long run trend rate of growth. However, it would require a very sharp deterioration in the UK economy for us to face the challenges facing some of the Euro member countries.