Floating free from Germany

Mario Drahgi has called for more integration and “sweeping powers” for the ECB to control fiscal policies and efforts to reform the Eurozone's economy. Is this “joined-up” thinking is a throw-back to the darkest days of the Euro crisis, when it became obvious that there was lack of cohesion between member states?  Or is this a power grab by the ECB, using the interminable recession, as an excuse to take control of a “fiscal and economic union”.  Currently the ECB owns interest rates and sets budget targets (roundly ignored by all but Germany), in this new and enlightened world the EBC would like set tax rates and drive to through supply side reforms to drive productivity and competiveness.

Drahgi believes in the “importance of each country sticking to its commitments under the stability and growth pact “and that this should now be beyond debate”.  He would like to go further by saying that in matter economic “sovereignty should be exercised jointly” – what a great line!!  What are the things that could do with harmonisation?

1. Actual interest rates
2. Rates of business taxation
3. Minimum wages and hours of work
4. Actual spending limits (properly enforced)

Living in Harmony

Time up for QE

No one really understands it and because of this opinions are all the more divided and intransigent. Despite this incoherence the market has understood enough to know that it drives asset prices and confidence in future prices.  It is QE – quantitative easing.

Ben Bernanke - the Godfather of QE

QE is where Central Banks print themselves some money to buy bonds and other instruments from the banks, the idea is that this puts cash / liquidity into the economy increasing the money supply and making credit more freely available.  Under “normal” conditions of growth (+2-3% annually)and inflation (around 2% annually) equilibrium this would drive up aggregate demand (growth)  and inflation as the banks push this extra liquidity out into the market in the form of loans.

Germany's most important export is unemployment

Some time ago I posted a short piece entitled Austerity may be Wunderbar, the simple message in this blog was that Germany was the problem in the EuroZone not the solution.  Having joined the Euro at a grossly undervalued rate the German economy has been on the PIIGS back for the last fifteen years.  The net result of this competitiveness advantage was that in the years 1999-2008 German was able to re-boot its ailing economy by exporting cheaply to its European Partners where all control of credits markets had lapsed.  

It's not just cars, but unemployment, that Germany exports

Where no hawks dare to fly

The doves at the Fed led by the chief "cooer" Janet Yellen have found a new reason to keep interest rates at an historical low.

Not a hawk in sight

The latest buzz words are “Pent up wage deflation” and they provide an elaborate excuse for ultra loose monetary policy. The essence of the idea is that in the Great Recession of 2009-2011 the market rate for jobs fell appreciably but that because wages are "sticky" and actual wages remained flat. This stickiness of wages is a function organised labour (Trade unions), employee nervous to move jobs and employers who are reluctant to loose key staff.

Janet Yellen - barking up the wrong tree

Over the last 40 years (well up until 2008) the role of central bankers was pretty clear – keep inflation under control - and it’s no surprise that during the great inflationary period 1970-2000 monetarist held sway.  Interest rates were raised, money supply was squeezed, unemployment rocketed (and then fell) and it was possible to pronounce the demise of Keynesian economics with complete certainty.  The fun went out of economics - the “Great Moderation” proved that once and for all we were the masters of our own economic destiny.  Then the credit crunch struck and the financial crisis kicked off which in turn led to the “Great Recession”, from which the developed world is still trying to escape.

La Belle Époque - revisited

As we remember 1914 and the horrific shock that World War inflicted on Europe and the terrible waste of life the two World Wars inflicted it might also be sensible to recognise the economic shockwaves that these events triggered.  The two World Wars and the depression that was sandwiched between them, changed everything economically.  The old colonial powers lost their possessions and incomes from abroad; inflation was unleashed on the world as never before – destroying the inherited capital of the über- rich, labour organised and the world was changed. 1914 destroyed the La Belle Époque and changed almost everything!

By the '50s the old rich where on skid row!

Life "Sans Gaz"

The great and the good of the economics world have been debating the possibility of growth without bubbles.  Larry Summers and other commentators have proposed that the dynamic growth enjoyed by the West between 1994 and 2008 was due to a stream of bubbles (dotcom, the euro, the credit boom and commodities) that kept growth rates artificially high.  Without a stream of future bubbles the developed world may not be able to grow at a rate that improves living standards.  Fortunately human being are well adapted to bubble recognition  (it occurs when the capital gain an investor expects over time is much greater than the potential change in interest rates in that same time period) and once one person has spotted a bubble we all dive in!
Stripping out these instances of temporary and unsustainable exuberance we are left will a pretty anemic performance in global GDP growth.  The inability to grow without market bubbles providing the fuel to the global engine has been coined secular stagnation – low growth, high debts, falling prices and high unemployment.

Here's to the next bubble

Before we all throw in the towel,  it's possible that the champagne that has been on ice for five years is about to pop its cork in a shower of new bubbles – the housing market is building up a head of steam in a number of key markets – parts of the US, the UK, Germany and parts of Scandinavia. In other markets there is still a considerable over hang in supply (Spain, Ireland, Greece and parts of the US) and the pain that investors and lenders have been through ought be burned into their collective consciousness.

Where have all the bubbles gone

The UK economy may be in the midst of a stellar year in which growth has returned, most unexpectedly, but there are special circumstances that have benefited us.  Elsewhere in the developed world, we face a persistent economic stagnation. Across the developed world employment rates are low, wages and disposable income are depressed; real interest are still negative; government debt is staggeringly high and rising; companies and individuals prefer to hoard cash than invest and to cap it all it looks like deflation is now stalking the planet. 

Despite extraordinary efforts by the world’s central bankers in the aftermath of the Lehman’s default, which has included the massive increase of liquidity (QE) and negative real interest rates, five years on the outlook is pretty poor.  Larry Summers re-coined the term secular stagnation to characterise the economic landscape and went on to float the idea that the west has grown on the back of asset bubbles for the last 20 years (Property, DotCom, Emerging markets, Sub-prime, etc) and that any return to pre-2008 levels of growth will demand some new bubble to help us along.  Larry Summers suggests the level of real interest rates required to generate full employment might be, say, -2 or -3 per cent.  More practically bankers in both the Fed and the ECB are now contemplating negative interest rates on short term money they hold over-night as a way of stimulating demand.  

Where have all the bubbles gone

The world's economy is off-balance

Economists around the world are dusting themselves off after a bruising few years of terrible forecasts, messed up assumptions and missed diagnosis.Whether you have been on the Rogoff / Reinhart or Krugman side of the argument there are red faces all around. The simple problem is that economies are not meant to behave in the way they are.  We have got to a point where old models (classical, Keynesian or monetarist) don’t work and excuses just don’t wash.  The problem is that after five years of negative realinterest rates the world’s economy has been unable to return to “historic trend” levels of growth – we are still bumping along the bottom.  Most economists believe that interest rates can be set to create a sustainable equilibrium in the economy where growth, employment and inflation can be held in a positive balance.  The absence of the interest rate equilibrium after years of interest rates set near or at the lower bound of zero raises the question as to what the alternatives are to negative real interest rates might be?  Larry Summers the former Secretary of the Treasury of the United States made  an important speech on this subject a couple of weeks ago.



Larry Summers - tired of waiting for the recovery

Austerity may be wunderbar

Five years on from the tsunami of the Lehman’s default and subsequent recession it’s probably a good moment to assess the relative merits of the monetary and fiscal strategies that developed countries have deployed to reboot their economies.  There have been a range of initiatives that have been tried but the “standout” response has been austerity, which can also be derived as a noun – austerian and there is even an antonym – Krugman!

Living it up - throwing a light on living standards

Since 2009 the UK has been in a liquidity trap, where depressed consumer spending has contributed to an overall shortage in demand.  This demand shortfall played its part in creating the “flatlining” economy that Ed Balls was so fond of.

We won't remember them!

The main reason for this lack of demand has been the squeeze on private sector pay and living standards, this squeeze has been vicious and this is because disposable income is “marginal”.  A wage earner on average income of £37,000 only has about £15,000 of disposable income a year after paying for taxes, housing costs, utilities and transport.  Since 2008 pay increases have been less than 2% a year and prices have increased at 3.5%.  Five years of real earnings decline at 1.5% annually means a reduction of £2,600 or a whopping 17% of disposable income. This squeeze was combined with a rise in the saving rate, as Britons have lowered their debt-to-income ratios.  

Bernanke Vernacular

Ben Bernanke the Chairman of the Federal Reserve Bank has been on quite a journey since 2007, having saved the world after the Lehman's default he has nursed the US economy back to health quicker than anyone would have dared to hope.  The soon to be retiring Chairman of the Fed  warned us this week that over the next year he would start tapering off the amount of money the Fed pours into quantitative easing, which is currently running at $85bn a month.  This effectively signals the end of ‘near zero’ interest rates in the US and around the world. 

My Word! My Bonds!

The early signs of recovery were visible in December but after a few months of bumping along the bottom we now have some more consistent evidence that the economy is moving forwards, rather than sideways.  Our service sector (63% of the economy) is leading the way and even construction (7%) and manufacturing (11%) are making a contribution.  The problem of indebtedness still overhangs us like a thunder cloud threatening to rain on our parade.  The overall level of debt is frightening in itself (over 300% of GDP if we include all government and private debt)  but it’s the possibility of rising inflation and interest rates that really terrifies commentators.  At a 0.5% base rate we can certainly manage the problem at base rates of 5% things will be very different.  The one certainty is that rates will rise in the medium term – and this one-way bet is now reflected in an increasingly jittery bond market. 

Weaning ourselves off negative real interest rates is going to be painful but the earlier we start the more manageable the pain will be.  If we remain in the cloud-cuckoo land of negative real interest rates we will be at the whim of the markets but if we can be brave and set our own agenda we might well become a safe haven for a global bond market in distress.  At some point bond prices will start to fall and yields and interest rates will rise, the tipping point is not far off and fickle markets could turn this natural evolution into a full blown bear market for bonds, with an unprecedented sell off which would drive up interest rates dramatically.  Britain has one small advantage in that we are emerging from recession about a year in front of the Eurozone our main export market and we are better placed to deal with some increase in interest rates that our main competition. By implementing a small increase in interest rates now we could secure low interest rates of the longer term as the bond market doubt about the level of sovereign debt mount.

There are obvious risks to this approach, would marginally higher interest rates slow economic activity and therefore drive up government expenditure on benefits?  Also the treat to Sterling and the impact of reduced imports but this would be countered by the deflationary impact on imports.  These are serious concern but the pale into insignificance when weighed against the more cataclysmic option of being at the mercy of a dying bond market

The arrival of Mark Carney at the Bank of England gives us an excuse the look afresh at our options and I hope he will be brave and take a contrarian view of the world and our place in it. 

Abenomics on the ragged edge

Economist around the world watch Japan with baited breath, there is much at stake for the both sides of the argument, The Keynesian wing have their fingers tightly crossed hoping that Abenomics will finally  be the solution to kick starting the world third largest economy, that has been moribund for years. Others on the monetarist wing believe that it will end in tears, and it looks like the markets are voting in favour of the monetarist.

Abenomics is in fact a sort of con-trick, the Bank of Japan (BoJ) is trying to break a deflationary cycle but massive doses of Quantitative Easing (QE) alongside a huge increase in government spending on capital projects.  It is hoped that these two levers will prize economic growth out of an economy that has been going sideways for 20 years.   What everyone knows, is that the moment inflation resurfaces and growth returns, the BoJ will return to a more prudent approach.  This highly transparent strategy has now turned into a game of cat and mouse between the BoJ and the markets.  This week bond yields rose (higher interest rates expected), stock prices fell and the yen rose a little against the dollar last week.  Paul Krugman argues that higher bond yields, a weaker stock market and a stronger exchange rate are all in response to a tighter monetary policy than the one now promised (a broken promise).  The markets don’t believe the Haruhiko Kuroda the new governor at the BoJ is going to be as mad as he says he will be!  The big questions are:

1. Will the markets believe that the policy to risk all for 2% inflation is real or just a short term con-trick 

2. Will interest rates remain lower enough to see this policy through
3. Will the fourth arrow of increase sales taxes to fund the capital spend programme actually be delivered

It’s difficult to believe that the BoJ will be utterly reckless for much longer, everyone knows that Mr Kuroda is trying a form of blind man’s bluff.  The markets will take a medium term view so this promise ‘to be reckless for a little while’ doesn’t cut much ice.  

A further difficulty is that the whole plan depends on low interest rates, to force down the value of the Yen (supporting export growth) and to drive up consumer spending in Japan.  But low interest rates are going to be dependent on the level and expectation of government debt, which already unsustainably high.  If interest rates rise then the need slash capital spending would create a very swift about turn in policy and this is what the markets believe will happen – this could become one-way bet.  

In addition to the interest rate time bomb another problem is that Abenomics has weaken the Japanese banking sector, which is now sitting on Y821tn ($8tn) of government bonds (the result of government debt and QE) and the bottom is falling out of this market.  This is making it very difficult for the Banks to lend money to new and growing businesses.   

The net result of all of this is that Shinzo Abe is on a tightrope above a shark infested river.  He needs to tread a fine line between a credible reflationary policy and need for low interest rates to manage the crippling public debt.  He might just totter across the ravine and receive a hero’s welcome but my money is on him ending up in the torrent with the short sellers enjoying a tasty lunch. 

To QE or not to QE that is the question

I have just moved jobs and this has prompted me to think about the challenges that Mark Carney the in-coming Governor of the Bank of England (BoE), will face.  He arrives with stellar credentials and a reputation as one of the world most expert central bankers.  He became the central banker for his own country Canada in 2008 and has taken credit for Canada’s OK performance since the financial meltdown following Lehman’s failure in the summer of 2008. He has used a mixture of monetary measures to help the Canadian economy recover, quantitative easing, and monetary tightening have both been deployed more readily than in other economies. 

Mark Carney - Magician or Muppet?

His arrival in Threadneedle Street  is vitally important for the British chancellor, George Osborne, who has run out of ideas for getting our economy growing again

Mr carney must be wishing that he had been appointed a little earlier as the BoE as the current governor has already blown £375bn on quantitative easing – but the firepower may be drying up.  The main issues he faces are:

1.      Springing the liquidity trap in private consumption and getting the banks lending again
2.      Managing inflation that has be stubbornly high unlike in japan and other advanced    economies where deflation is a major concern
3.      Re-structuring the banks and dealing with the debt over hand in the private equity business
4.      Implementing a new regulatory regime for the banks without killing off this vital sector

     Getting the economy to grow after 5 years of flat lining, with other major economies using QE and monetary policy to improve competitiveness (currency devaluation) we need action that supports the real economy.  

For some time the markets have been convinced that more monetary activism is on the way and this has had the pound plunging, along with yields on UK government bonds. Abenomics  being unleashed by Haruhiko Kuroda, the new Bank of Japan governor, have only stirred expectations of exceptionally aggressive easing with Mr Carney in charge.

Last week Mr Carney acknowledged on that the UK was one of the economies which the International Monetary Fund has said is in “crisis”. Like any in-coming manager he will want to paint the current situation as black as possible; so having talked the UK economy down what room for manoeuvre will Mark Carney have?

He created excitement in December when he mooted the idea that central banks could set targets for the overall size of the economy, or nominal gross domestic product, rather than inflation. But in the budgets Mr Osborne opted for relatively minor changes to the Bank of England’s remit as he kept the 2 per cent inflation target but clarified that policy makers could prioritise growth, provided inflation remained under control.  Economists called the new remit a “damp squib” after all the hype.

So what might change?

     One area of policy that will clearly change under Mr Carney is what is known in central bank speak as “forward guidance”. The idea is that private consumers make spending decision their view on forward interest rates,  if they believe interest rates will remain at ultra-low levels for an extended period they may be less inclined to save. Under Mr Carney’s stewardship, the Bank of Canada became the first central bank in the Group of Seven leading industrialised nations to promise to keep interest rates low a long way into the future. The US Federal Reserve has since gone further, committing to keep interest rates low until unemployment falls below 6.5 per cent. With the UK’s poor record on inflation such a commitment might be more difficult

     He may well consider more quantitative easing, but after our £375bn binge he maybe less include or able to continue the asset purchase scheme.  He could however be a little more radical than the current regime at the BoE and contemplate more structural measures.  He could look at more proactive restructuring of RBS and Lloyds Banking group and some of the private equity funds.  The UK economy is suffering from a large number of zombie companies weighed down by debt but hanging on due to ultra low interest rates.  Rather than raise interest rates, which would damage the housing market and consumers Mr Carney could insist the banks take more proactive steps to restructure debts that will never be paid off.  This might cause some short term unemployment pain but a clear out of Zombie companies would clear the way for more vibrant private sector growth.  Any return to large scale QE and continued negative real interest rates would be a firm signal that both the government and the Bank of England think that bank creditors (savers) should continue pick up the tab for the wild over spending between 2000-2009.    

     Mr Carney could also build on the Funding for Lending Scheme (FFLS), unveiled by the Treasury and the Bank of England last summer, has had some success in easing borrowing constraints on would-be homeowners. But, while conditions in the mortgage market have improved, lending to small and medium sized businesses remains constrained.  Revamping Funding for Lending is an easy win for Mr Carney, who indicated this year that he was willing to use the scheme to boost credit creation.  The problem with FFLS is that it is essentially a mechanism for civil servants to pick winners - a role they are very badly suited to.

If I was in his shoes I would consider a contrary approach, which would mean raising interest rates.  The medicine of ultra-low interest rates in the advanced world has proved a failure in Japan over 10 -15 years and has not worked in the US, UK or Europe in the last 5 years.  Where aging populations comprise a substantial part of the total private consumption and where companies turn cash into share buy backs low interest rates are a killer blow.  We need to move to a world where there are real positive interest rates on 2-3% rather than the current negative real interest rates.  This would also have the benefit of dealing with Zombie companies and force the banks to restructure quickly.  There would definitely be more pain in the short term but we surely benefit in the medium term with a more dynamic and health real economy.

Measure for measure

The Daily Telegraph is agonising over the huge question that all major (well run) economies are facing - namely why is employment growing when growth is so poor.

http://www.telegraph.co.uk/finance/comment/jeremy-warner/9863483/No-one-really-understands-whats-going-on-in-our-economy.html

The real problem here is about the measures - when the global economy is expanding, it's probably a good idea to keep an eye on inflation as an indicator of monetary growth.  When debt is the problem (government, private and banking) we need other objectives. Should we not be measuring the reduction in the levels of these debts?  And these measures should be absolute not as a % of GDP (which measures growth).   It seems to me that growth is an erroneous expectation, whilst we are downsizing the size of:  our state, the banks and private debts.   In fact  GDP flat-lining could rationalised as good news.  The ineptitude of this Government is to have set goals to shrink the economy but still expect to be judged on GDP growth!

The other major major problem with keeping a focus on these growth orientated measures is that we end up penalising the very people we should be supporting  - SAVERS!  

The united policy of both UK governments since the credit crunch (Gordon Brown's and David Cameron's) have been to pay for the years of largess by stealing the hard earned savers of the middle classes.  Policies of increases taxation on savers and QE, which keeps interest rates low are both death to savers.  This approach can be blamed on the fact that they focus on the wrong measures - if they were able to see that growth is unlikely when you need to reduce debt they would be rewarding savings.  The natural consequence of this is that they would be squeezing the life out of zombie companies and over borrowed individuals who are killing our economy, which would give new life to those who can create the green shoots of recovery 

The fuse has been lit

We have had a relatively benign run on inflation in the UK and the West generally since the credit crunch. Since 2008 deflationary pressures have been enormous as Governments slash spending and the private sector continues to pile up cash surpluses, so the outlook should be set fair. This is reinforced by the stunning turn-around in the US energy situation (US imports of oil down to the lowest level for 25 years) and the resulting flattening of oil prices.

 
But the first storm clouds are bubbling up. In the emerging BRIC economies the spectre of inflation is now casting its shadow, bad news from Brazil and China this week confirms this picture. The over-use of quantitative easing to balance spending cuts in the West and some massive stimulus packages (Japanese prime minister Shinzo Abe unveiled a Y10.3tn $116bn package yesterday) may be about to throw some lighter fuel on the fire. In the US Kansas City Fed Reserve President Esther George warned that the Fed's near-zero interest-rate policy could spark inflation.

 
Central bankers are under so much political pressure to target growth rather that maintaining a prudent approach to inflation and this could be a very expensive mistake.


Japan
http://www.ft.com/cms/s/0/a165b562-5b92-11e2-9d4c-00144feab49a.html#axzz2HUZoq0EM

Brazil
http://www.ft.com/cms/s/0/7c9c40de-5b79-11e2-9d4c-00144feab49a.html#axzz2HUZoq0EM

China
http://www.bloomberg.com/news/2013-01-11/china-dec-inflation-2-5-exceeding-economists-est-.html