Is “Europe” more important than democracy or the rule of law?

The desperation of Europe’s leaders to protect their banking systems from the effects of the sovereign debt crisis is leading to startling decisions and actions which call into question their commitment to the principles of democracy and the rule of law.

Last year Merkel and Sarkozy made it clear that Europe required Italy and Greece to install technocratic leaders in order to force through the austerity and structural reform measures that Europe deemed necessary if it was to consider continuing to support these countries through their financial crises. When the previous Greek Prime Minister suggested holding a referendum on adopting austerity measures last November, he was told in no uncertain terms by Germany and France that this was unacceptable. European referenda have a nasty habit of delivering results that the political elites do not like.

Then last week, Wolfgang Schauble proposed that Greece should postpone its general election due in April and extend the life of  its technocratic government. The sub-text was very clearly that Germany feared an inappropriate result that might lead a new Greek government to renegotiate the terms of the E130bn bailout after it had been agreed and Europe had committed substantial sums of money. From the rulings of the German Constitutional Court in recent years, it is quite clear that if anyone tried to push the Germans in similar ways, the reaction regarding the primacy of German sovereignty and democracy would have been extremely forthright. To a great extent these demands resemble the power battles between debtors and creditors in a failed company, where the creditors can take full control of a company’s assets when it cannot meet its obligations, but countries are not companies and voters are not shareholders that are automatically disenfranchised upon bankruptcy.

Perhaps even more worrying is the ECB’s action to ensure that it has greater rights than any other owner of  equivalent securities in the financial markets. By demanding that its Greek government bond holdings be converted into other bonds that will have priority over all other Greek debts, a few weeks ahead of a plan that will see all other Greek government bond holders lose approximately two-thirds of the value of their holdings in a “voluntary” haircut, the ECB is at the very least flouting financial market convention that all holders of a security should be treated equally. At its worst interpretation, in a situation where there will be limited assets to repay the debts, it can be construed as theft.

Worse still is the implication for any other sovereign European bonds that happen to be owned by the ECB. The greater the ECB ownership, the worse-off are all other private holders of other European debt as their rights to repayment now rank below those of the ECB (in credit markets this is known as subordination). Thus the creditworthiness of all European debt in which the ECB has a stake has been even further reduced. This is likely make it more expensive for these issuers (Portugal, Ireland, Italy and Spain) to raise money for a very long time to come. Future sovereign crises are now in danger of setting off vicious cycles of ECB intervention buying sovereign debt in the secondary market leading to private sector investors selling down their positions as they become less creditworthy so worsening the crisis.

To be sure there are no easy choices in solving  the euro sovereign debt crisis, but the longer term costs of some of the solutions that are being called for and implemented may well be far higher than currently understood.

PS – it also appears that Greece’s creditors will take over the national  gold reserves too.

Rising income inequality – why is it happening?

The early 1980s marked major lows in income inequality in both the US and the UK, and has since risen steadily back to the previous peaks seen in the late 1920s – there has been a particular acceleration since in the 21st century. In the US today, the top 10% earn 50% of all income, and the top 1% earn 20% of all income. In the UK the figures are only a little less unequal. The Davos forum’s 2012 report recently cited income inequality as a global risk for the first time.

In economic terms, the reasons for this increasing inequality lie in the differing forces affecting the demand and supply of low or averagely-skilled workers and highly-skilled workers. At the lower-skilled end of the labour market, there has been an explosion of supply, China and India are estimated to have tripled the number of people in the world seeking industrial jobs – the world market price for such labour has thus come under enormous downward pressure. This is not just in low-tech, assembly manufacturing, but, given the strong emphasis put on education in both these societies, increasingly too in higher-skilled manufacturing and with the rise of the internet, in service sector roles where brain matters more than brawn. India produces 3 million graduates a year, most with good English and strong IT skills, for whom $20,000 is a very attractive salary. This factor, more than anything else, explains why the median real wage in the US is unchanged over 40 years – the standard of living in the US has risen only because more members of the household are working. As real wages have stagnated, it follows that company profits have seen most of the benefits of economic growth in recent decades.

These higher profits have enabled company executives at the top end of the labour market to receive very much higher pay – generally determined by board members who are senior executives at other companies. This has been compounded by two further factors. First, globalisation has enabled successful companies in one country to expand much more easily internationally – the complexity of managing such businesses and the skills required by executives have increased substantially. In addition companies with greater revenues and profits generally pay better. The second is technology and the “winner-take-all” nature of many new industries as the virtual world places enormous premia on the benefits of networking effects. For example, people use Facebook and Twitter rather than any competitors because they already have so many users, and so their dominance over competitors mushrooms. In addition the rise of information technology has greatly reduced the need for many “middle-management” functions in companies, jobs which provided a career ladder for many of the “averagely-skilled” in previous times.

Thus this rising trend in income inequality has been led by global economic forces. Does this matter? Well – the answer is income inequality matters if society thinks it matters, and it may now be getting to that stage. The recent phenomenon of the Occupy movement around the world in recent months, claiming to represent the bottom 99% suggests that this trend is reaching socially unacceptable levels. From an economic perspective, the natural human tendency to create the best opportunities for one’s children, when combined with greater inequality of outcome, tends to create much greater inequality of opportunity for future generations. This does damage the economic potential of a nation.

In the same way that global economic forces have led to rising income inequality, those forces may also make it difficult to address by redistribution away from the richest. The richest (both individuals and large companies) have always been able to afford better tax lawyers than governments, and with many of them being internationally mobile, they are able to choose where they earn their money and incur tax liabilities. 2012 looks likely to be the year when the debate over income inequality comes to a head in the US Presidential elections with Obama determined to campaign on the notion of taxing millionaires more to reduce the deficit, and the Republicans determined to reduce the deficit solely through spending cuts. This is likely (absent foreign crises) to be the key issue in the forthcoming campaign.

Elections and political transitions in 2012 – January 2012

This year brings elections or organised transitions in political leadership in Russia, the US, China and France. Such periods can lead to unpredictability in economic policy ahead of these transitions as current leaders seek to avoid bad news in order either to win the election or to go out on a high. Similarly the period immediately after an election or leadership transition is usually one where the leader has most political capital and will generally seek to execute his or her most vital or most cherished policies. These may not necessarily be those policies which are most appropriate in an economic sense but are the most appropriate in a political sense. With so many transitions in such important nations this year, the scope for good politics to triumph over good economics is very large.

The US election is now underway with the Republican primaries firing the starting gun. The two parties are ideologically further apart than at any time in living memory (the phrase “class warfare” is being used a lot), and the Democrat President is unable to get the Republican Congress to agree to anything he wants to do. This year policy is in limbo, US politicians are unlikely to agree on doing anything  with regard to economic policy – this is understood and to some extent accepted by the markets, but action must be taken in 2013 to start reducing the fiscal deficit and the candidates are unlikely to reveal to the electorate just how bad things will need to be in terms of spending cuts or tax increases. In addition, upcoming elections require all candidates to stand up very strongly for American interests in any international dispute – in trade matters this can easily spill over into protectionist policies to “safeguard American jobs”.

In China, a new generation of leaders will come to power just before the US election – at the top level there will be no shocks but there is much manoeuvring still going on for the next level down, who will form the leadership team in five years time. Chinese officials will struggle to allow or tolerate “bad” economic news, and any further weakness of the type seen in recent months may well generate another dramatic stimulus response of the sort seen in early 2009. In foreign and trade policy also, it will be important for the Chinese to be seen to be stoutly defending their interests to safeguard Chinese jobs.

France is the most interesting story with its May Presidential elections. First it means that Sarkozy cannot allow anyone to leave the euro before the elections, because all his efforts over the last two years to “save the euro” would have visibly failed – therefore more summits and buying of time with new initiatives is very likely. However were he to remain President (unlikely from the current opinion polls), he would never have to face the French voters again – he could afford to try to be a European statesman and actually may be prepared to adopt a more German solution to the euro crisis, even at the expense of traditional French interests. By contrast markets might get a nasty shock were his main challenger Francois Hollande to win the Presidency. He is a fairly unreconstructed socialist, and would have few political soulmates in Europe, and has already declared that the current policies of austerity and institutional change to force countries into more restrictive fiscal policies are unacceptable to him. It is difficult to see Angela Merkel willing to give much of the ground that Hollande would require in order for France and Germany to continue to lead the efforts to save the euro. Either way the French election looks likely to be absolutely pivotal in determining which way the euro crisis gets resolved.

Amidst all this, the UK looks to be a rather stable place. The coalition looks set to soldier on – the Liberals cannot afford to leave since the ensuing election would see them almost wiped out, whilst Cameron benefits from pursuing the economic policies that he believes is necessary but seeing the blame laid on the Liberals. The economic policy of steady austerity has been set for the next few years and no change will be considered until much closer to the planned 2015 election. For Cameron, current economic policy is both economically and politically appropriate and he stands in a place that many of his fellow world leaders would wish to be.