Archives for April 2012

Dips or a Pancake – the UK economy

The UK does not have an official definition of a recession, so the media use the US definition of two consecutive quarters of negative growth in the size of the economy. Measuring the size of the economy is a hugely complex task that takes three to six months to do properly. However the markets and media are only interested in the first estimate that is produced about three weeks after the end of each quarter. Then they only look at the change of that result from the previous quarter – if the answer is less than zero then recessionary conditions are proclaimed, if between zero and one half of one per cent then it is sluggish growth and if above three-quarters of one per cent then Britain is booming. The margin between deep gloom and euphoria is amazingly small – when one adds to this the fact that the average size of error between the first estimate and the final figure is about 0.3%, then it is easy to see why instant newspaper headlines following quarterly GDP data can often turn out to be very misleading.

The first estimate recently published for Q1 2012 UK growth was -0.2%, this followed -0.3% for Q4 2011 and so satisfies the working definition of a recession; worse still because there had been such a poor recovery since the last recession, it can also be called a “double-dip” recession, adding further hyperbole to the headlines. There are at least 11 other EU nations who are also in recession with a few more still to report. For those who follow the detail, the surprise in the data came from construction spending, which had it been in line with expectations would have  brought growth up to +0.1% and prevented the headlines about recession. The National Statistics Office has for some time now had problems in accurately calculating construction spending and keeps changing how they measure it, and when one adds to that the fact that there is normally relatively little construction work done in winter and so substantial seasonal adjustments have to be  made to the data, but that this winter the weather was surprisingly good, then quite frankly nobody will know for some time what the correct numbers might be.

The last 6 quarterly reports have been -0.5%, +0.2%, -0.1%, +0.6%, -0.3%, -0.2% – the most sound conclusion that can be drawn from this is that for eighteen months the economy has been flat and growth has been zero. Within that the public sector has seen slightly negative growth (but only slightly, see here), the private sector has seen slightly positive growth (but not enough to stop unemployment rising) as at home consumers fear for their jobs and in the Eurozone, our largest export market, significant and painful austerity is being imposed. Additionally, loan growth is negative as consumers, companies and banks all seek to reduce their debts and hold more cash, rather than invest for the future.

This “flat as a pancake” picture is likely to continue, but the risks are much more skewed to a worse outcome than they are to a better one. At a zero rate of growth, the economy is very vulnerable to any external shock quickly sending it into recession, and western policymakers have very limited policy options available to mitigate any such shock. Fiscal deficits and debts are already too large and need to be brought lower and so provide no scope for fiscal stimulus, whilst monetary policy has rates close to zero and only further Quantitative Easing as a policy tool which is showing a clear pattern of diminishing returns, each time it gets deployed.

This UK government has only ever had a Plan A, and so is sticking firmly to it, mostly because there are no decent Plan Bs anyway, and has always relied on the rest of the global economy being in a reasonable state. However the pancake is better than the dips.

Democracy – the antidote to Eurozone austerity

Over the last twelve months of Eurozone crisis, the politicians in Europe have in the main been talking to each other rather than their electorates. In fact the conversations have involved Northern Europeans (mostly from Germany) telling Southern Europeans to slash government spending and find ways to collect more tax revenues and the Southern Europeans promising very solemnly that they have always intended to and will do so just as soon as they receive some extra money from the Northern Europeans. The voters have never been asked their opinion either in the North as to whether they want to commit funds to support those in the South, or in the South as to whether they want to go through with the austerity measures their politicians have agreed to. Over the next 18 months there are important votes in France, Greece, Holland and Germany, when the politicians will be courting votes and saying things that are odds with current policy settings.

It is said that in the French presidential elections, in the first round the French vote with their hearts and in the second round with their heads. Well, 30% of the electorate voted for the extreme left or the extreme right in the first round; both reject entirely the idea of deeper European integration and the economic policy of austerity. Further, the centrepiece of Francois Hollande’s platform is the rewriting of the fiscal compact set out in the new treaty to pursue a much more aggressive growth strategy and greater powers to the ECB to lend directly to countries. In this he is on a collision course with Angela Merkel and impact is likely to occur very soon after the May 6 run-off election. The received wisdom is that he will not seek dramatic change to what has already been agreed, and will be satisfied with language that has an aspiration for greater growth without meaningful measures – this would probably the best he would get from Merkel and Germany. The key though is that a clear majority of the French electorate rejected the current policies of austerity.

May 6 is also the date of the Greek general election. The technocrat Papademos who was put into power as the head of a coalition government of the 4 major parties in order to agree the terms and conditions of the Greek bailout, has completed his job and is stepping back to allow normal politics to resume. Northern Europe insisted that all 4 parties in the coalition individually signed up to the terms and conditions of the bailout, in order to prevent any backsliding after the agreement, but there are already problems. Recent polls indicate that 67% of Greeks want to stay in the euro but don’t want the austerity, which can be interpreted as wishful thinking, economic ignorance or that their politicians are allowing them to believe that such a choice exists. It is not clear that those 4 parties would command 50% of the seats in the new parliament, even if they could be persuaded. Already Venizelos, the head of the Socialist party has been floating the idea of Greece going back to the drachma as an alternative to austerity.

The Dutch too are struggling despite being seen as part of the Northern European bloc. The coalition government fell over the weekend because the far right party refused to accept the austerity measures necessary for the Netherlands to get their budget deficit in line with the Eurozone targets. An election now looks likely in Holland.

Once these elections are settled, attention will begin to shift to Germany’s election in September 2013. Here though the politics is reversed, what is popular with the Germans is the notion that the rest of Europe should engage in the austerity necessary to get their public finances in order as Germany has had to earlier this century, so that no further calls on the German purse are made from bankrupt Eurozone nations.

Exposure to the votes of their peoples is going to cause politicians to say and do things that make continued agreement on austerity and bailouts increasingly hard to do.

Spain – sliding down the Greece-y pole

A condensed version of the Greek tragedy in recent years: 1) A new government comes to power and finds that the true state of the public finances is much worse than the previous government admitted to. 2) They want to stay in the Eurozone because their people finally have a currency they trust, and so they solemnly promise their European partners that they will do whatever it takes to ensure this occurs. 3) An eye-wateringly aggressive fiscal austerity package is announced by the new government. 4) The sharp fall in expected public sector demand in the economy leads to a significant recession, unemployment rises sharply, welfare spending rises more than expected, tax revenues come in lower than expected and the fiscal deficit does not improve. 5) The government finds that foreigners no longer want to buy the debt it needs to sell in order to finance the deficit, so it forces its bank and insurance companies to buy the debt. 6) They are not keen despite high yields and so will only buy short-dated Treasury Bills of less than one year rather than bonds with longer maturities. 7) Yields on government bonds rise to levels at which it becomes impossible for the government to issue any more bonds and the deteriorating creditworthiness of the government debt means that the sovereign debt crisis is now also an existential crisis for the domestic banking sector. 8) The rest of Europe provides funds for a bailout, not to help out the distressed sovereign but to help out their own banking sectors who have massive exposures to both government and banks of the affected country. 9) This bailout from Europe comes with a price of even greater and more immediate austerity. 10) Youth unemployment soars to tragic levels as recession bites even deeper. 11) The country is bust.

Spain’s recent history is putting it on the same road to misery that Greece has travelled in recent years. 1, 2, 3 and 4 have already occurred and 5 is coming into sight, although Spain has taken advantage of the recent period of positive sentiment surrounding the ECB’s LTRO announcements to raise a good part of this year’s debt requirements. However 10-year yields of over 6% for an economy that is likely to show barely any nominal economic growth in the next few years, are not sustainable for very long, and foreign investors are likely not to want to commit more funds to Spain. The LTROs did however facilitate a move towards 6 as the 3-year fixed-rate financing allowed the Spanish banks to make arbitrage profits by buying debt with less than 3 years to maturity – the data suggest many Spanish banks did this.

Spain’s problems are different to Greece in two ways. First, whilst the initial Greek problem was a massive under-estimate of how much debt was owed by the government due to creative accounting, Spain’s problem is that the regional governments in the country have been busily running up debts which are seen effectively as debts of the national government, even though the national government has little political or financial control over the regions. Secondly much of the Spanish banking system has urgent solvency problems following the boom and bust in Spanish house prices over the last decade – the banks need more external capital and it probably has to be the government which has to supply it. The worse the austerity-induced recession, the lower house prices will fall, the worse is the solvency position of the Spanish banking system, and it becomes even more impossible for the Spanish economy to grow its way out of its problems. A move to 7 in Spain could happen faster than many think.

Moving to 8 – a bailout for Spain would be the critical moment for Europe. Greece, Ireland and Portugal together account for about 6% of the Eurozone economy, but Spain accounts for about 12%, so the scale of bailout assistance would triple. For Northern European countries this could well be a bailout too far.

As has always been the case since the crisis started, the solution depends on which of the 3 bad options Germany decides to opt for – either a full political and fiscal union, or inflation caused by the ECB printing money or Germany leaves the euro.

Coming soon – a real electoral debate about the US fiscal deficit and a weak 2013

Recent general election campaigns in fiscally-challenged countries such as the UK, Spain and France have been noticeable for their politicians’ reluctance to spell out specific measures that they would introduce to bring down the enormous fiscal deficits in these countries. The electoral success of the right-of-centre parties in the UK and Spain was however immediately followed by significant programmes of cutbacks to government spending as well as some tax increases.

It is now clear that the US Presidential election will be between Obama and Romney (who would have believed five years ago that a US election would be between an African-American and a Mormon). With Obama having presided over trillion dollar deficits throughout his term in office, how best to manage these deficits and the ensuing government debt will be the key battleground of the election campaign. The two candidates will argue from the two opposing economic and political traditions. Obama, the Keynesian, a believer in public spending acting as a stimulus to the economy to offset private sector deleveraging against Romney, the orthodox conservative, a believer in small government and balanced budgets. Obama wants to tax the richest 1% more and maintain government benefits to the poorest in society whilst Romney wishes to cut taxes, particularly for the wealth-creators, and cut all areas of government spending except for defence (in practice this means welfare  and health spending). It is only in America that Obama’s tax plans for the top 1% would be called “class warfare” and many would agree with that assessment.

Both men are highly intelligent, clear thinkers, who can produce very articulate presentations of their respective cases and let the American people then make an informed decision as to in which direction they want their country to go for the next four years. It could be democracy’s finest hour (or three months) although the history of recent elections tends to suggest that other rather more superficial issues will also get much attention.

The end of this year though is critical for US public finances, as both sides have put off all the difficult decisions regarding the budget until after the November election. If nothing changes between now and next January 1st then 2013 will see the expiry of the Bush tax cuts, which heavily benefit those whose income is high and generated from corporate dividends, and the Obama payroll tax cuts which benefit those in work. In addition, spending cuts affecting both defence and welfare in roughly equal measure are due to come into effect. If all these measures are allowed to come into being at one time the aggregate effect is likely to be to drive the US economy straight into recession. However no one expects all these measures actually to occur though – if Obama wins he will seek to reduce the welfare cuts and extend the payroll tax cuts and if Romney wins her will seek to reduce the defence cuts and extend the Bush tax cuts.

Financial markets do not appear to have these measures in focus just yet, or be paying attention to the fact that whoever wins there will be significant fiscal consolidation in 2013. They should be because Europe’s recent history demonstrates clearly that this consolidation, also known as austerity, necessarily involves reducing people’s disposable incomes, either because taxes are rising or because government spending is falling, and that this has to have an initial, deflationary effect on private sector demand. 2013 is very likely to be a pretty bad year for the US (and thus probably also for the world) economy. Markets tend to look 6 to 9 months ahead, so the next few weeks should see them begin to discount this weakness – this should be good for government bonds but less good for equities.

UK austerity and the UK economic miracle – some surprising data

The official data produced by the independent UK Office for Budget Responsibility supporting the recent Budget, showed up a surprising fact about UK government spending. The major focus of the Coalition Government since it came to power in 2010 has been the control of government spending and consequent reduction in the budget deficit from the £170bn (and 11% of GDP) it inherited from the previous government. Yet the official data show that in each of the two fiscal years that this government has been in office, current government spending has risen in real terms, that is to say after inflation has been accounted for, and that in a two year period when inflation has been permanently above the Bank of England’s 2% target due mainly to the increases in VAT, which are part of the deficit reduction strategy.

It could thus be argued that in the UK, austerity has not yet even begun. That would not be entirely fair, since the measure of current government expenditure excludes capital or investment spending by government. Investment projects are possibly the easier areas of government spending to cut quickly, and there have been large real reductions in non-current government spending. Further, some parts of current spending were permitted to grow in real terms – these were health spending and overseas aid. In addition the automatic economic stabilisers of rising welfare entitlements and rising interest costs on the national debt, have meant that economic weakness tends to boost current government expenditure. Most areas of government spending have seen austerity cuts (with many more to come over the next few years), but for real government spending as a whole, there has been no reduction.

In fact history suggests that such a goal is very difficult to achieve. Mrs Thatcher’s government from 1979 to 1990 did not manage to reduce real government spending, and since then it has risen every year. In nominal (actual cash) terms UK government spending has never fallen year-on-year since 1945..

For the government, the plans for current spending reductions in the next few years imply that the really hard (and unpopular) work only starts now. This may well affect their poll ratings significantly for the next year or two without a clear improvement in economic growth. For the Opposition Labour Party, their claim that the government has been cutting too far and too fast, and that a slower pace of cuts would be more effective do not stand up to any scrutiny as real government spending has not yet even started to fall.



HSBC compiled some fascinating data for economic growth amongst the major Western economies for the first decade of this century.

2001-2010 average annual % growth rate               Overall                              Per Capita

Japan                                                                                                0.8                                       1.6

UK                                                                                                      1.5                                         1.2

Germany                                                                                           0.8                                        0.8

US                                                                                                       1.6                                         0.7

France                                                                                                1.2                                         0.6


There are several surprises here, first Japan’s “lost” decade, the subject of many lectures from Americans and Europeans, is actually a demographic issue. Per capita growth in Japan was double that of the US and Germany and France – Japan has for some time been very aware of its ageing issues and has invested heavily in automation and robotics in order to boost its productivity. Secondly the strength of the US economy is also mostly about demographics – in this case both a younger population than the other countries, arguably reflecting a greater openness to immigration.  Finally the strong performance in both columns of the UK economy – a recent paper from Corry, Valero and Van Reenen confirms this strong  performance and attributes it to service sector productivity factors such as technology and regulation (though NOT banking regulation!). Perhaps history will judge Gordon Brown’s stewardship of the UK economy in this decade more favourably than current commentators.