Winning Ugly - with Clegg

Barack Obama has confirmed that Nick Clegg is better looking than David Cameron and for the British voter both look pretty ugly at the moment!  With less than two years to run before the next general election it’s time for David Cameron to assess two things: Firstly will it be a good election to win; secondly if it is worth wining is majority government advisable?

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. 

I'm forever blowing bubbles

The soccer fans of West Ham United have sung the song ‘I’m forever blowing bubbles’ since God was a boy (or least since the mid 1920s) and whatever relevance it may have to inspiring sportsman has been lost in the mists of time.  The chorus of this American ballad goes;

I'm forever blowing bubbles,

Pretty bubbles in the air,

They fly so high,

Nearly reach the sky,

Then like my dreams,

They fade and die.

Fortune's always hiding,

I've looked everywhere,

I'm forever blowing bubbles,

Pretty bubbles in the air.

As with sports so with finance, the economic cycle is an endless treadmill of  precarious bubbles that ‘fade and die’.  The simple truth is that markets (people) are lazy, we are programmed to take the easy option, that’s evolution for you.  And this rubs off in the world of finance, we almost always lurch from one soft option to the next; in the last 15 years we have had the dotcom boom, the alchemy of algorithmic trading, the credit bubble and the addictive pleasures of QE.   In the good old days we had central bankers who would from time to time burst the bubble and insist that we get back to the serious business of controlling inflation and nurturing sustainable growth.  With deflationary pressure all around the Fed have been busy blowing bubbles not bursting them, but this is about to change.  

 In the last week the markets for both bonds and equities have been in full scale retreat, frightened by the smoke signals coming out of the Fed, which is pouring $85bn of new money into the US economy every month.  QE has had the effect of lowering interest rates and presumably nurturing some growth and new jobs.  All this has been achieved without stoking the fires of inflation but this can’t go on forever; in the short run negative real interest rates have a positive impact in the longer run (just ask the Japanese) worthless money kills ambition and productivity. It is therefore somewhat worrying that our Central bankers are now so cautious on the need to wind back QE and return to real money.  Probably more worrying is the fact that these self-same central bankers now believe that they should have a remit for ensuring high levels of employment and positive rates of growth rather than just managing the money supply and inflation.  News that the Fed will use QE until employment rates rise to 92.5% and to be in a world where employment should be the sole arbiter of interest rates and money supply is a madness of schizophrenic proportions.  Have we have forgotten all the important lessons of the of the 80s and 90s when we had raging inflation, high interest rates and low employment?  The world’s central bankers need to get back to their day jobs of managing inflation, otherwise more pretty bubbles will fade and die!

Obama's mad plan to arm the opposition in Syria

It’s been a busy week in the world of Middle Eastern politics, or more accurately it’s been a busy week in the world of Shia politics.  The Islamic world is not homogeneous, with a number of factions dating back to first days of the religion.  Today the intense rivalry between Islam's two big sects, the Sunni and the Shia, shapes the politics of the Islamic world. Recently a potent mix of religion and politics has sharpened the divide between Iran’s Shia government and the Gulf States, most of which have Sunni governments.  Things run pretty deep between the two sects as many Sunnis do not consider Shia to be proper Muslims. So what divides Sunni and Shia?  On the death, in 632, of Islam’s founder, the Prophet Muhammad; Arabs who followed him were split over who was the rightful heir to the prophet.  Abu Bakr, a friend of the Prophet and father of his wife Aisha had the majority backing and this sect became known as the Sunnis and today they make up 80% of Muslims. Others thought Muhammad’s family the rightful successors.  They claimed the Prophet had anointed Ali, his cousin and son-in-law—they became known as the Shia.   As time went on the religious beliefs of the two groups started to diverge.
Today the world’s 1.6 billion Muslims all agree that Allah is the only God and Muhammad his messenger. The Sunnis rely heavily on the practice of the Prophet and his teachings, the Shia see their Ayatollahs as reflections of God on earth. This has led Sunnis to accuse Shia of heresy, while Shia point to Sunni dogmatism.  Being the minority party the Shia have been careful not to be drawn into large scale conflict with the Sunni’s, although the Iran Iraq war in the 80s was an exception to this pragmatism. The "Shia Crescent" runs from Iran, through Syria to Hizbullah in Lebanon and is at the centre of much of the trouble in the region today.

Shia Muslim distribution 

While Syria has dominated the world news there has been an interesting development in Iran.  Hassan Rohani, Iran’s sole moderate candidate has won the presidential race.  It seems that the electorate in Iran is tired of the grinding of poverty that has characterised the rule of the departing premier Mahmoud Ahmadi-Nejad.   Mr Rohani is backed by two former presidents Akbar Hashemi Rafsanjani, a centrist, and Mohammad Khatami, and these reformist, both called on their supporters to vote for Mr Rohani and help the country distance itself from radicalism.  Mr Rohani has promised to establish a government that will save the country’s economy and help resolve its fractured relationship with the western world to ease international sanctions.  There are obvious concerns as many voters have bitter memories of the last elections in 2009 when they believe their votes were stolen by Mahmoud Ahmadi-Nejad, although the transition seems to be going smoothly.  Mr Rohani is not a true reformer but he has used the campaign to raise many concerns of the modernisers.
Meanwhile with unenviable timing President Barack Obama’s has decided to send unspecified “direct military support” to Syria’s Sunni rebels ramping up the stakes with Shia globally (The Assad Regime is Shia), just at the moment when moderates need encouragement in Iran.  The evidence that has been used to give cover for this active participation (use of poison gas) seems pretty thin and is strangely reminiscent of the ‘weapons of mass destruction’ ruse used in Iraq.  Despite the opportunities to further the moderates cause in Iran it seems that Obama wants to keep up the Presidential tradition of starting an unwinnable war, that has been in place since the time of Bill Clinton.
Sunni-Shia tensions became centre stage after the US-led invasion of Iraq in 2003 that catapulted the Shia majority in Iraq to power.   Iraq became a sectarian bloodbath, with Christian communities caught between Sunni and Shia bloodletting.  Syria is now in the same place and the last thing we need is for the USA to be taking sides.  Neutrality is particularly important as the sectarianism is the consequence not the cause of this conflict, which started as a civic uprising against the Assad family (part of the Arab Spring).  Obama is getting into very deep water as he will be directly attacking Hezbollah, Iran’s Lebanese proxy, as well as the Shia Islamist government of Nouri al-Maliki in Iraq.
What no one in the Pentagon can tell us is the impact this direct attack on the Shia world will have on neighboring states such as Turkey where the Sunni ruling party of Recep Tayyip Erdogan already have major issues with the minority Shia population that make up a fifth of the country’s population. Mr Obama is belatedly entering a very complex geo-religious drama and he would be well advised to leave well alone.

Bad Banks Good Business

Finally Stephen Hester, the CEO of RBS, has fallen on his sword.  The fact that he seems relaxed about this act of self destruction tells us quite a bit about the relationship between him and his owners (the HM’s Government).   It’s probable that Hester is a good banker, good enough to have turned around RBS and secured a return on investment for the tax payer.  Having inherited a bank with a balance sheet larger than the UK's economy and with over 250,000 employees he has been chipping away at the bad bits and selling non-core business to create something that resembles a stable universal bank.  The problem he has had is that he has been working work a government and the Bank of England who have absolutely no vision or plan for our Financial Services industry.
At the outset RBS should have been split into a nationalised Bad Bank, with all the most distressed loans and risky businesses under one roof and a Good Bank made up of the safer business.  Instead of this we have a part nationalised quite bad bank that is unable to perform its part in our financial infra-structure.  As a result lending is down and we are still months away from returning RBS to the private sector, this is distorting the market for financial services and holding back the recovery.

We need to protect our greatest economic asset - The City of London

It’s this total lack of planning and direction that marks out the coalition’s approach to our economy.  Cameron and Osborne had the advantage of watching labour screw up things between 2007 – 2010 and they should have had a very clear picture of how to turn things around.  Instead, like all weak administrations, they relied on a commission on banking (Vicker’s inquiry) to do their dirty work for them, this wasted two years and didn’t move the debate forward.  The central questions of the UK’s banking sector are quite simple and we just needed to make up our minds and get on with it.
Should Retail Banks be allowed to play the in the capital markets and be investment banks?  The answer to this is obvious. No!  There must be a reasonable number of retail banks in the UK who can support the market for deposits, transfers and loans.  They should access the capital market through Broker Dealers who do not have retail clients and they should be limited in the activities and products they can provide to corporate clients (businesses).
The second question is – should the capital adequacy rules be the same for Retail Banks and Investment Banks?  And the answer to this one is also obvious. No!  Retail banks don’t need the leverage or risk profile that investment banks might want, they should be extremely well capitalised with a high percentage of liquid assets (cash), this might be a ratio of 30%+ rather than the 17%+ target that the Basel 3 regulations envisage.  Investment banks need more rope and leverage and this inherent risk will be obvious to their sophisticated clients.
The third question relates to Private Equity businesses and their relationship to the banks.  It is a national disgrace that we have so few small and medium sized businesses that become global players and the way we fund business expansion is directly responsible for this.  Should we allow the short termism associated with Private Equity ownership to mar our industrial and services landscape in the way that it does today?  The leverage buy-out and the associated loss of productivity is killing off large swathes of our commercial infrastructure; companies as varied as Boots and Manchester United FC are unable to compete globally because greedy management and Venture capitalist have saddle the business in debt for the single purpose of personal wealth creation.   The tax laws need to be changed to ensure commercial logic rather than personal greed drive our private sector, it is a scandal the Boots has paid no corporation tax in the last 5 years despite making profits in excess of £5bn.
The fourth problem is the whole business of wealth management and the management of long-term savings. The great explosion of hedge funds and their incestuous relationship with the Prime Brokers (our largest investment banks) is another can of worms. There needs to be clear separation between the various types of asset managers and all of these must be separate from the dealer broker investment banks.  As consumers we should have a more distinct choice to reflect our varying risk appetites
We need to remember that the Financial services industry is our best and most productive sector.  We are the world’s leaders in finance innovation and London’s geographical position between the Far East and New York, combined with our language makes us the natural home for the finance capital of the world.  It is a scandal that the government has no plan or vision for the regulation, development of this core business, and this is symptomatic of their idle approach to structural change and recovery

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. 

Constructing a time for change

We have all become experts on the economics of recession, even my daughter can wax lyrical on about the benefits of quantitative easing and the need for fiscal measures to reduce government debt, but the big new thing is ‘structural change’.  The Greeks have been told to embrace it as have the French but what does this mean and how might it apply in the UK?

If any economy were to exist without government interference and regulation it might in theory be 100% efficient, but there would be unacceptable abuses of wealth and power that would lead to social and political instability that would create its own inefficiencies. So over the years governments and other organisations have layered legal frameworks over the way we all make, spend and invest money, this generally helps to regulate markets but over time creates unwanted complexity that distort markets and drives down efficiency.  Taxation is a great example of this, when the first legislated income tax were levied on the British in the 1799 no one could have envisaged the tangle of tax legislation that we have today, the current income tax rules stretch to 17,000 pages of legislation!  Every so often it becomes necessary to clear out unwanted or unnecessary legislation – this is one form of structural change.  The second type of structural change is the execution of an industrial policy or plan.  Nick Ridley famously said that the job of the Industry minister was to shut down the ministry, how wrong he was, reducing red tape and easing over regulation is important work but there needs to be a plan for our economy.

A tortuous route to recovery

In the UK, the last purge of regulation was in Margaret Thatcher’s time when whole industries we privatised, state owned housing was sold off and the City was deregulated.  We are need of a similar dose of medicine today, but where to start.  The coalition government has started to tackle Welfare and need to have a look at Health and Pension spending, and there seems a growing consensus in all political parties that nothing should be ‘off-limits’; even Ed Balls thinks we need a cap on Pension spending.  With so much to do the government should focus on only the most inefficient markets. 
Housing and construction is and obvious example of a market that has become grossly inefficient, where we still have inflated house prices and a lack of liquidity in the market.  The housing and property markets are hamstrung in two important ways.  Firstly accounting rules require that any property owned as an investment is valued regularly and these valuations are based on the recent letting prices, this means that landlords are incentivised to keep properties empty rather than rented out at lower prices. If one links this market distortion to the bureaucracy around ‘change of use’, (changing the use of a building from commercial office space to residential) we have a structural problem that means that many buildings are left empty and rents are inflated, which also drives up the overall cost of housing in the UK.  Deregulated the property industry to allow a free market in property value and ease the change of use criteria we could increase the rented market and bring house prices down generally.  This is an alternative to the lunacy of Tim Boles (the housing minister) and George Osborne who are intent on driving up house prices by making cheap credit available to new house buyers – many of who will be landlords and investors.  Rather than perpetuate the structural inefficiencies in this market we should deregulate to increase supply and competition; resolving these issues in our £5.2tn housing market would have untold benefits for the economy, including:

• Improved mobility of labour and a less pronounced north south divide
• Increase consumer spending as a % of national income
• Lower indebtedness (lower mortgages)
• Increased pension contributions

Hard Times - the need for structural change

Having already had a go at The Duchess of Cambridge Hilary Mantel recently struck a blow against another great British institution, Charles Dickens, her timing was impeccable as we in Britain still relies on Dickens for our economic guidance:

Annual income twenty pounds, annual expenditure nineteen nineteen six, result happiness. Annual income twenty pounds, annual expenditure twenty pounds ought and six, result misery

Mounting debt has been the cause of so much fun and subsequent misery is the West and particularly in the UK.  However, we have now had two months of uninterrupted good news on the economy, or rather we have had no really bad for two months.  The green shoots that I pointed at in December are now in plain view for all to see, but like a newly sown lawn there are still dangers ahead.  The chief threat is the overall level of debt and the threat of inflation and higher interest rates.  With negative real interest rates it’s possible to feel economically secure but if they were to rise to  5% how many governments, businesses and private individuals  would survive, this form of stress testing is deeply unfashionable as we all contemplate ‘free money’ for the nest 2-3 years.

So what are the numbers?  In the UK net debt is about 300% of GDP or about £7.5tn this is split quite equally in three areas - government debt, corporate debts (companies) and personal debt.  Added to this we have an enormous banking sector that is still in a very fragile state with poor liquidity and bloated balance sheets.  The important question is how much of this debt is distressed, or likely to default?  With notional interest rates of 0.5% and real interest rates at -2.5% many insolvent businesses and individuals can hang on in there but if real interest rates were to rise to 5% there would be real fall out.  It is the risk of this fall out that has encouraged George Osborne and the Bank of England to water down austerity and use monetary stimulus (QE) to keep the money supply up and interest rates down.  There is no doubt that the initial stages of the crisis were well handled by Alistair Darling and the emergency measures to bolster demand (cuts in VAT) and the massive injections of QE saved our banking sector and keep our weakened economy alive.  Since 2010 Osborne has pursued a very limited agenda of ‘austerity light’ balanced by more QE and the result is that we have survived but the big issues remain unresolved.  Overall debt is still way too high, structural changes to improve our competiveness have been focused on the one area where we don’t need growth, the already over priced housing market.  The good news is that over the last three years corporate and private debts have fallen from 232% of GDP to 208%.  We should expect this improvement in the private sector liquidity to continue at this gentle rate as most forecasters believe we have at least 2-3 years of low interest rates and low inflation.  The issue is that we will need 5-6 years of benign inflationary conditions to get back to a sensible ratio of debt to wealth (GDP).  On the debit side the Government has increased its own debt burden so much that this has more than compensated for the de-leveraging by families and private firms. General government debt has reached 90pc of GDP, up from 43.5pc when the crisis erupted in mid-2007.  And it seems that we are 3 or 4 years away from any significant reductions (where economic growth outstrips growth in government spending).

The up-shot of all of this is that we only have a few years to put in place the structural changes that the economy requires for us to be competitive before rising inflation and defaults kill off the recovery and pushes us back into depression.  The structural changes we need to consider would include:

1.     Deal with pension time bomb – increase  the retirement age and increase contributions
2.     Balance our economy with an industrial policy drives growth in the north of England and supports industries (other than finance) where we have shown that we can compete globally
3.     Simplifying tax to increase participation (reduce the black economy and tax avoidance)
4.     Improve the skills base of our young people and drive down unemployment for this group
5.     Improve our infra-structures – road, airports and rail networks
6.     Deregulate property industry to break the link between rents and values, which makes landlords happy to keep properties empty rather than occupied at lower rents.