Archives for March 2012

Pro-growth policies at a time of fiscal austerity

In both the UK and Europe, commentators have become increasingly vocal about the need to combine the necessary fiscal austerity with policies designed to boost economic growth. They are correct to stress that the easiest method to reduce budget deficits is for private sector growth to boost tax receipts – the problem is how to combine demand growth in the private sector with the necessary control of demand in the public sector and the options are very restricted. Every pound or euro of public spending that is reduced as part of an austerity package is a pound or euro less of somebody’s income – this is why the savage austerity imposed on Greece, Ireland and Portugal (equivalent to 3% or more of GDP in a single year for several years) has led to recession as huge swathes of final demand were removed from the economy and business and consumer confidence collapsed. The UK is aiming to reduce its budget deficit only by about 1% pa, similar in fact to the pace of deficit reduction it achieved in the early 80s, and so far has avoided the severe recession seen in other European countries that had to make much sharper retrenchments of their government spending.

Monetary policy is the obvious starting point for pro-growth policies when fiscal policy has to be tightened. However interest rates have effectively already been cut as far as is meaningful, and the UK’s Quantitative Easing and the ECB’s trillion euro LTROs have meant a great deal of money has already been created in both the UK and Europe. The danger with these policies is that it is similar to filling a balloon with water – the balloon expands as water is added with no impact on its surroundings, until no more water can be contained and then the balloon bursts and drenches everything around it – there is very little impact on the economy from printing the extra money until it reaches a critical point and the money pours into the real economy creating inflation.

The IMF’s standard pro-growth policy used in conjunction with fiscal austerity for countries in need of support has always been a (large) devaluation. This provides a kick-start to the private sector which boosts export demand for its products at a time when the domestic market is struggling. Sadly for those countries inside the Eurozone, they voluntarily gave up the possibility of using this policy when they joined the single currency.

Politicians on the right of the political spectrum argue that lower tax rates increase the incentives to make money, and that this leads to growth and thus higher total tax revenues – and they point to point to the 1980s as evidence of this. It is true that there is an (unknown) optimum tax rate that yields the most tax; in the 80s marginal tax rates were very high (and probably above the optimum rate) and their reduction did spark more growth and higher revenues. However today’s marginal tax rates are much lower than then (and likely to be near or possibly already below the optimum rate), and it is not clear that it would have a very significant effect on growth today.

Increasing the efficiency of the economy by reducing bureaucracy and regulation is another policy often claimed to improve growth prospects. Certainly these impose costs and constrain the ability of business people to do more business. Reducing these requirements will boost growth in the long term but not necessarily in the short term. And in today’s society some degree of regulation is considered desirable (eg in healthcare and financial services) in order to protect consumers, so there is a need to distinguish between “good” and “bad” regulation and bureaucracy.

Infrastructure spending is generally viewed as a pro-growth policy since it creates jobs in the short term and boosts economic efficiency in the longer term. The problem for fiscally constrained economies is that the returns to this investment are very long term and so make the short term budget deficit even worse. There is however one option for the UK that would help to boost growth in the short term and that would be for the government to build directly or else to subsidise building a large number of new homes. The UK suffers from a shortage of housing, resulting in high rents and high house prices. Houses can be built and sold on for a profit reasonably quickly, leaving a small positive effect on public finances, providing jobs for thousands of construction workers and by boosting supply will tend to reduce the high rents and house prices which consume so much of the UK’s income.

The tectonic plates are moving beneath the Japanese markets

For many investors Japan has become a market they have felt happy to ignore for some time now. It can be argued that nothing has happened in the Japanese economy over the last 20 years as nominal GDP growth has been essentially zero over the period, although this disguises real growth of about 1% per annum offset by deflation of a similar amount. The budget deficit has been allowed to run at very high levels as the private sector has chosen to run a large financial surplus and moved from being very highly geared in 1990 to now having substantial net cash on its balance sheet. These deficits have been almost entirely financed by Japanese institutions, content to own JGBs yielding 1% or less, because the deflation still gave them reasonable real returns. The yen has benefited from these real returns, the continued trade surplus and the lack of enthusiasm displayed by the Bank of Japan to engage seriously in Quantitative Easing, in sharp contrast to the Central Banks in the other Western economies. The Nikkei stock market index fell more than 80% from its 39000 peak at the end of 1989 to its October 2008 low.

As with the devastating earthquake that did so much damage to Japan last year, so the tectonic plates beneath the Japanese financial markets now seem to be moving.

The nuclear disaster at Fukushima has led to almost all of Japan’s nuclear electricity plants being closed down over the last year. This in turn has resulted in a shortage of domestically produced electricity and a strong rise in Japanese energy imports, to the extent that the long-acclaimed trade surplus has now turned into a deficit, removing one of the key props to a strong yen.

The demand and supply picture of the JGB market which for so long has seen a balance between the enormous supply from the large budget deficit and the heavy demand for bonds from domestic financial institutions is in danger of deteriorating as the aging of the population is reaching a critical point where net inflows of contributions into pension funds are now more than offset by payments of pensions to those who have retired. The largest pension fund, the Government Pension Fund has now reached this position, so that the core investor in JGBs for many decades is now a net seller and will remain so for many decades to come. The budget situation remains dire, normal expenditure of Y90 tr for fiscal 2012, revenues of only Y42 tr leaving a deficit of Y48tr ($600bn) before a further Y3.8tr of earthquake reconstruction expenditure. Annual debt interest of Y22tr is over half of tax revenues. Austerity moves to curtail the budget deficit are likely to send the economy back into recession and so attention has turned to the Bank of Japan and its historic determination to avoid unconventional monetary policies as the only route left to ease the situation.

With the retirement of BoJ Governor Shirakawa later this year, the vacancy for his successor has created a Monetary Policy Committee more amenable to carrying out the government’s wishes. February saw a new turn in Japanese monetary policy as the BoJ announced a firm inflation target of 1% and an intention to overcome deflation, to which end it announced a Y10tr increase in Quantitative Easing. It is committed to further such moves until its inflation goal is in sight.

Financial market movements in recent weeks indicate that this as a significant move. The Japanese bond markets are no longer pricing in deflation, the yen has fallen sharply and broken its long term uptrend against the other major currencies and the Japanese equity market has broken its 5 year downtrend. The Second Section of the Tokyo Stock Exchange where the smaller domestic Japanese companies are traded has risen every trading day for 6 weeks, beating the 1975 record which marked a new bull market from the late 1974 lows. Such market action is rare and typically indicates that all the potential sellers have sold their positions. Japanese markets should not be ignored – important changes are occurring – sell JGBs, buy the equity market and hedge the currency.

Just what do you get for a trillion euros?

A trillion is a seriously large number. Counting E500 notes at the rate of one per second, it takes a lifetime (63 1/2 years to be more exact) to get to one trillion euros.  In two operations over 10 weeks, under the new leadership of Mario Draghi,  the ECB lent this much to the European banking system at a fixed rate of 1% for a term of 3 years and backed by much weaker collateral requirements than it has historically permitted.

The net new liquidity provided to the banking system is about half of this, the other half reflecting the expiry of other ECB lending facilities which these operations have replaced. Balances held at the ECB by the banking system have risen by about E500bn over the same time period. So for now the ECB has lent money to the banks at 1% and the banks have re-deposited it with the ECB at 0.25%. The banks however have about E750bn of bond issues maturing in 2012, and so they now have a far less pressing need to borrow in the financial markets to refinance these maturing bonds – it was this huge refinancing requirement which, at the end of last year, had brought fear to the markets of another 2008 event in which the banking system froze and plunged the world into  a savage recession.

So Mr Draghi is credited with finding a solution to the eurozone’s banking liquidity crisis which threatened markets last November and December. In response the bonds and equities of banks have risen sharply and pushed up the prices of securities all over the world in 2012. In particular sovereign bond yields in Italy and Spain have fallen sharply as investors expected that many eurozone banks would use the new liquidity at 1% to buy these sovereign bonds offering much higher yields. The numbers suggests that this has not actually happened, or at least not yet, but the prevention of a crisis has pushed prices higher anyway as confidence has returned.

A full 3 cheers for Mr Draghi is not appropriate though. First, financial markets have read this operation as the European equivalent of Quantitative Easing and this together with the stated desire of Central Banks in the US, the UK, Japan and Switzerland to print more of their own currencies, has sent the gold price rising sharply as well. This has terrified the German Bundesbank which has also realised that in effect these operations have meant that the ECB has acted as lender of last resort, a role it has historically not seen as part of its remit. Further the ECB’s willingness to accept much less secure forms of collateral for this lending, because some of the weaker banks were running out of secure collateral means that the ECB itself could become theoretically insolvent in a further crisis. German support for monetary union as a result of the recent steps, is clearly weakening both amongst the people and politicians and within the Bundesbank.

Secondly, this may not do much to boost the public sentiment towards banks because it seems unlikely that much, if any, of this money will find its way into the real economy via higher lending. Instead it is likely that banks will use it to make an arbitrage profit – some UK banks have already announced that they will not be paying bonuses to their staff based on such profits, indicating that this is the strategy they will adopt for this money.. In addition, in 3 years time, this huge amount of money is due to be repaid – this could create liquidity problems for the banking system all over again. Although the ECB will be likely to be able to manage this over time, withdrawing liquidity from the system nearly always has negative effects on the real economy.

The most serious concern is that although dealing with bank liquidity issues these operations do very little for the bank solvency problems that beset so many banks within the eurozone. Lending them new money is not the same thing as providing the much-needed new capital which can then be used to offset the substantial bad losses that still need to be written off. In fact, this trillion euros has merely created even more debt in an effort to solve the problems caused by too much debt, and since this new money is owed to the ECB who demand priority over all other creditors, all other creditors have implicitly been diluted!