Archives for July 2012

The Olympics Opening Ceremony – an Economic History musical

If all Economic History lectures had as much music, dance, costumes and extraordinary set design as the Olympic Opening Ceremony, the world would surely be awash in Economics graduates.

Danny Boyle’s extravaganza took the world through 400 years of British economic development to the delight it seems of most of the world. The criticisms from some, particularly from Asia, were that for the most part it looked back rather than looked forward, portraying a Great Britain secure and confident in its past but with little to say about its future.

It began with an 18th century agrarian idyll filled with sheep, rain and maypole dancing (football and cricket were also represented – reminding the world that Britain invented sport). Most of the population were then employed in the agricultural sector or provided services to the agricultural sector and lived in villages. Life, (and the economy), was fairly straightforward and an individual’s wealth came from ownership of the land.

It moved dramatically into the Industrial Revolution and 19th century life. The forging of the Olympic rings highlighted the nature of work in many factories of the time – hot, noisy, dangerous, and making things out of metal that changed the way people lived. The jobs in this economy were in factories which coalesced around towns and conurbations and so the population began its long term move into an urban setting. New wealth began to be created by and accrue to industrialists and entrepreneurs.

The lengthy section devoted to the National Health Service which according to Nigel Lawson (Chancellor to Mrs Thatcher) is “the closest thing the British have to a religion”, highlighted the 20th century’s change in the structure of the economy away from manufacturing towards services and in particular State service provision. Since World War 2, governments have steadily increased the levels of taxation in the economy and used the revenue together with a lot of government borrowing to provide services such as universal education, health care and social care. People moved from towns into cities Over time there have been proportionately far fewer people employed in manufacturing industry and far more people employed in these key State services. Wealth creation during this period tended to accrue to those in financial services who developed expertise in minimising tax payments and in developing financial markets in order to finance government borrowing.

The final (21st century) section focussed on technology and its dramatic effect on our lives particularly in the areas of connectedness and communication, to the delight of the younger generation. However Danny Boyle was not able to provide the answers to two key and rather difficult questions – what to do about State deficits and debts now that they have reached such enormous levels and which economic sector will provide the jobs to employ a large number of our workers in the future, if the size of the State has found its limits? The movement towards greater connectedness does not appear to be creating many jobs, merely a need for bandwidth and servers, and other high-employment service industries such as retailing are moving online rapidly.

The West is thus entering a third period of economic transition, this time moving away from a traditional service led economy. What it is moving towards is still very unclear however. The worst case would be that governments decide to collect together large numbers of unemployed young people and seek a  military use for them (which effectively was the solution found at the end of the 1930s). The eventual answer  should be known by the time London hosts its 4th Olympic Games.



This time IS different for equity markets

Observant investors over the last 30 years should be looking at the current markets and thinking that an opportunity to buy into equity markets may be at hand. Following some inflation fears in 2010 and 2011, inflation across the world has declined markedly in 2012 and looks set to decline further to levels below the targets that Central Banks have set. Further, economic growth is slowing markedly and has now become a greater economic and political risk than inflation. Policymakers’ focus has clearly shifted from concerns about inflation to concerns about growth. Historically this shift in focus (1982, 1988, 1992, 1998, 2002 and 2009 saw similar shifts) has been a clear BUY signal for equity markets – in today’s conditions this is further supported by very low valuations on equities.

In these previous cycles, the shift in policymaker focus led to substantial policy easing, principally via lower interest rates, which boosted consumer disposable income, boosted consumer confidence and encouraged demand for mortgages for house purchases.  This led consumer demand as a whole and thus an economic recovery. Equity markets rallied as they foresaw this pattern of events.

Sadly, however, this time is different. Policymakers certainly wish to boost demand by policy easing but the key differences this time around are (i) interest rates are essentially at zero and cannot be cut meaningfully, (ii) government deficit and debt levels have reached levels that terrify even the politicians and so fiscal policy has been neutered, (iii) the financial system is so badly damaged from its period of excess up until 2007 that it is no position to start lending again despite heavy political pressure, (iv) consumers now feel that in aggregate they allowed their debt levels to rise too sharply and wish to lower them and (v) consumer confidence in their economic future has been so badly damaged that many do not wish to borrow anyway.

The only policy stimulus open to governments and Central Banks is further Quantitative Easing (“QE”) or money printing. So far all the extra money that has been created has remained in the financial system and not found its way into the real economy – this is not to say that QE has been useless; it has not.  Indeed the financial system and the Western economies would be in a far worse state today if there had been no QE.  In addition, the long-running Euro saga has meant that the Eurozone has had to adopt very restrictive fiscal policies in an attempt for the weaker governments to maintain support from the markets and from the stronger Euro members, making the Eurozone economy much weaker than it needed to have been.

So this time, the usual cycle of policy easing leading to consumer recovery and thus economic recovery together with improving equity markets is unlikely to occur.  It is true that equity markets are cheap by historical comparison, and this should limit the downside potential for equity markets in the absence of a severe recession which would damage earnings. However, equities lack the usual reasons for investors to buy them, and so upside potential is also limited until some shock or crisis leads to a radically different policy approach.


A three dimensional view of UK financial services – regulation, price and trust

Prior to the Thatcher government’s move to deregulate the industry, UK financial services were characterised by heavy regulation, high prices and confined to a relatively small group of people who were considered specialists. Thus, you could only get a mortgage from an institution that you had been saving with for some time and where you passed an interview with the manager – then you paid the rate of interest that they said. Those wishing to save had two choices; either buy an insurance bond of some description from a salesman where the commissions and investment performance were not visible, or go to a stockbroker who would make investments for you in shares by trading with his friend on the floor of the Stock Exchange called a jobber, and then charge you a fixed, and large, commission. In summary there was a high level of regulation, prices were high but there was also a high degree of trust from the consumers of financial services towards the providers, some of which could be attributed to consumer ignorance, but bank managers and stockbrokers had a high social standing then.

The deregulation of the financial markets began in earnest in the 1980s, most famously with the “Big Bang” of 1986, blowing open the restrictive practices of the UK securities markets and allowing the banks to own and operate securities companies. A boom in house prices and the sale of council houses saw greater demand for mortgages and many more entrants into the mortgage market, which became a low-margin product used to sell a much higher-margin endowment or savings scheme to repay the capital at the end of the term. The unit trust market expanded on the back of this new demand, a bull market was well underway and suddenly everyone wanted product to supply this new demand for long term savings. As the bull market of the 1980s led into the bull market of the 1990s, more and more investment products came out and business models evolved from providing good advice to clients towards delivering sales targets. As the level of regulation declined, competition increased and pricing fell – the performance of the products was good but there was a decline in the level of trust between financial advisers and their clients, as a “product-push” mentality developed.

The post-bubble bear market from 2000 to 2003, saw US interest rates cut to 1% and a new bull market in housing. Financial innovation in securitised and derivative markets dominated by the major banks and a massive increase in financial sector gearing meant that profits from advising clients well became puny compared with the profits that could be generated by the banks from their trading books in these areas. Regulation came to be seen as inimical to innovation and capitalism itself. The bursting of this bubble that has been witnessed over the last 5 years has produced terrible returns for investors and demonstrated that very low levels of regulation, even though combined with relatively low pricing, has come at the cost of a total breakdown in trust between financial institutions and their clients.

What is needed in the next phase of history for the UK financial services sector, is a combination of 1) heavier regulation, particularly over institutions in the investment banking markets and the inherent conflicts of interest they contain; 2) the costs of this regulation  not  falling upon the ultimate purchaser of financial services and 3) new business models that are able to rebuild the trust that needs to exist in the financial services sector between an advisor and his client.

The financial services industry has to get back to a situation where the client is assured that the only interest of his adviser is to give him the best personal, financial advice. To work at its best this means advice needs to be on a fixed fee basis rather than remuneration tied to the purchase of particular products or other services. This may be revolutionary but its time has come.

Eurozone poker – Monti calls Merkel’s bluff

At last week’s EU summit, Mr Monti refused to agree to anything until Germany made a key concession. He wanted the bailout monies for the Spanish banking system not to be structured as debt of the Spanish government.  In the end, Mrs Merkel gave in although this will not occur until a European banking supervisor has been established for the Eurozone banking system.

This concession is hugely significant in terms of a principle to which Germany has long held fast, in that it appears to contravene the Maastricht “no bailout” clause – recapitalising a banking system requires equity capital not debt capital. Europe will now use its emergency funds to inject new equity into the Spanish banks. This cannot be portrayed as emergency lending to fellow European sovereigns as all previous rescue loans have been. Providing equity capital to bankrupt institutions is inherently a far riskier proposition than lending to a sovereign state, and so it is impossible now to maintain the facade that German taxpayer money is not being put at risk.

As time moves on, Germany and others will find themselves facing the classic sunk cost problem – if more money is required to keep these banks afloat, then the capital provider feels under greater pressure to do so, to avoid writing off the previous investment. This is the first step down a slippery slope – the second step will come when a more rigorous and independent audit reveals that Spain’s banks require far more than the E62bn currently mooted in order to recapitalise. Next Ireland and Greece have already made clear that they want to get (retroactively) the same terms as Spain for their banking recapitalisations, and finally the Italian and French banks will be looking enviously at the cheap equity capital Spanish banks have now secured.

Mrs. Merkel does have a cooling-off period though. The principle has been conceded subject to agreement within 6 months of a new European banking supervisor. This leaves many vital areas of disagreement over details and, probably, ratification in all 27 EU states. Key areas still to be resolved are which banks fall under the direct supervision of the European regulator, what will  be the role of the current national banking supervisors, and most importantly of all, who has responsibility for deposit guarantee insurance. It would seem obvious that any deposit guarantee scheme would have to fall under the auspices of the European banking regulator, but it is not clear where the money would come from. Most politicians do not wish to provide their own taxpayers money to bail out bank depositors in other countries – instead they are hoping it will be funded by the banking system itself via a Financial Transactions Tax. In the long term this may be a viable solution, but in the short term the fund would be empty for several years and the potential demands on it huge given the fragility of European banks.

One further factor which should not be ignored is that in September 2013, Mrs Merkel faces re-election. Should she concede too much to the rest of Europe over the next 12 months, she faces huge domestic political problems. There is talk that a possible way out of her dilemmas is for Germany to hold a referendum on whether it should continue to support its European partners to enable them to remain in the single currency. German public opinion is currently split on this and such a referendum would leave European financial markets paralysed until the matter was resolved.

The markets have rallied strongly on the abandonment of the Maastricht “no-bailout” clause, and the first move towards more integrated European institutions. However history suggests that there are many more late-night summits and games of brinkmanship to come while negotiating the details of what has been only agreed in principle. Investors can afford to wait and see before concluding that Europe is solving its problems.