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It is not just the Euro. Southern Europe faces a major structural crisis

It is not just the Euro.  Southern Europe faces a major structural crisis

Major shocks to social and economic systems ruthlessly expose weaknesses which can be contained in more normal times.  When the price of oil quadrupled in 1973/74, the different levels of resilience in the labour markets of Western Europe were quickly revealed.  Inflation initially rose sharply everywhere.  By 1976, it had fallen to 4 per cent in Germany, but was still 14 per cent in the UK.  German workers realised that the oil price rise was out of the control of their own government.  Demanding bigger money wage increases would be self defeating.  It took the deep recession of the early 1980s, when unemployment rose to 3 million, and the defeat of the miners to bring British inflation back under control.

In the same way, the financial crisis of 2007 to 2009 uncovered deep structural faults in most of the economies of Southern Europe.   The recovery in the UK took a long time to get hold, and it was only really in 2013 that we began to get over the shock.  But GDP here is now 6 per cent higher than it was at the start of 2008, when output began to contract.  In contrast, in Spain GDP is now 5 per cent lower than it was nearly eight years ago, and Portuguese output is 6 per cent lower. In Italy, the fall in GDP is as much as 9 per cent.  So between 2008 and 2015, a dramatic gap of 15 per cent has opened up between the levels of GDP in the UK and Italy.

Membership of the Euro does not help.  But there are much more fundamental issues.  A fascinating paper by Gianluigi Pelloni and Marco Savioli in the latest issue of the Economic Affairs journal focuses on why Italy is doing so badly.  A crucial reason is that Italy has a high level of corruption.  Transparency International ranks the countries of the world on this measure.  The least corrupt is Denmark.  Germany and the UK come into the charts at 12 and 14 respectively.  Italy is at number 69, along with Greece, Romania and Senegal.

Italy has suffered from a lack of restructuring of production.  The products in which Italy specialises are very similar to those of twenty years ago.  And the economy continues to be populated by vast numbers of tiny firms, specialising in commodities with low technological content in both the manufacturing and service sectors.

There are many barriers to both innovation and expansion.  For example, access to credit is difficult and complex, as a 2013 World Bank study highlights.  Start up costs are high.  The average number of years of tertiary education in the population aged over 25 is only half that of France, Germany and the UK, so the workforce is less capable of dealing with technological advances.

Pelloni and Savioli do detect some positive signs in sectors such as chemicals, food and pharmaceuticals.  But mere tinkering will not be enough.  Drastic reforms are needed to deal with the structural weaknesses exposed by the financial crisis.

As published in City Am on Wednesday 25th November

Images: Euro by Images Money licensed under CC BY 2.0

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Keynesians are wrong: Cutting public spending can boost economic growth

Keynesians are wrong: Cutting public spending can boost economic growth

The key aim of George Osborne’s economic policy has been to eliminate the financial deficit of the public sector.  The main way of trying to achieve has been to squeeze public spending.  The orthodox economic textbooks maintain that this withdraws demand from the economy, and so leads to the growth rate being slower than it would otherwise be.

But can contractionary fiscal policy of this kind actually expand the economy?  At first sight, it seems something of a contradiction, the concept that spending less might cause higher growth.  An oxymoron, one might say – where I am using the word in its regular sense and not referring to those Greeks who voted ‘no’ in the referendum.   The very idea provokes howls of derision and outrage, from leading Keynesians such as Stiglitz and Krugman downwards.

Yet we have been here before.  In early 1981, the UK economy had moved into a deep recession, comparable in size to that which we experienced during the financial crisis.  In the budget of March of that year, the then Chancellor, Geoffrey Howe, cut the financial deficit by 1.5 per cent of GDP, or some £20 billion in today’s prices.  This prompted no fewer than 364 university economists to write to the Times in protest, explaining that the policy was completely misguided and would only serve to prolong the recession.  In fact, the economy began to recover during 1981, and posted a healthy growth rate of 2.2 per cent in 1982, followed by a boom rate of 3.9 per cent in 1983.

One swallow does not make a summer.  Is there any other evidence?  Tim Congdon, in a recent article in the journal Economic Affairs, claims that since the 1980s, ‘expansionary fiscal contractions’ have been the norm rather than the exception both in the UK and the US.  Keynesian support for fiscal activism is, he argues, unsupported by a large body of recent evidence.  To cite just one example, Congdon points to the substantial fiscal tightening under the Conservatives from 1994 and initially continued by Gordon Brown until 2000.  Over this period, the UK economy grew rapidly.

There are good theoretical reasons for thinking that cutting the government deficit could stimulate rather than contract the economy.  The classic paper was written by Robert Barro of Harvard as long ago as 1974.  Its rather mysterious title, ‘Are government bonds net wealth?’, has not prevented it from becoming one of the most cited papers in the whole of economics.  Barro, who was subsequently awarded the Nobel Prize for work such as this in macroeconomics, essentially argued that a nation cannot make itself better off by increasing its public debt. More recently, the work of the Italian economist Alberto Alesina, now also based at Harvard, has been influential in policy making circles in the European Commission and European Central Bank.

The simple view that more government spending boosts the economy appears to make common sense.   The opposing views are more subtle and complex.  But it is the latter which at present have the upper hand.

As published in City AM on Wednesday 12th August 2015

Image: “George Osborne 0482am” by alltogetherfool is licensed under CC BY 2.0

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Supply side success is a cure for the drug of deficit finance

Supply side success is a cure for the drug of deficit finance

George Osborne’s plan to run financial surpluses and use them to pay off government debt has been met with the usual set of whinges and whines, mainly from academic economists funded by the taxpayer. Of course, their arguments are based purely on what they believe to be the intellectual merits of their case.  One of the more prominent names is David Blanchflower, once a Gordon Brown favourite on the Monetary Policy Committee, who at least is based in a private university in America. Blanchflower predicted that coalition policy after the 2010 election would lead to 4 million, and possibly even 5 million, unemployed. The actual figure now is 1.8 million. Still, economic forecasting is a notoriously difficult exercise.

It is clearly very difficult for a certain kind of economist to grasp the fact that an economy can prosper whilst at the same time the government balances the books. The two decades after the Second World War were probably the most successful in the entire history of the UK as an industrial economy, stretching back to the late 18th century. From the late 1940s to 1964, real GDP grew at an annual average rate of 3.5 per cent. Today, relatively few economists believe that we can sustain an annual growth of more than 2.5 per cent. And each additional one percentage point extra on GDP represents the best part of £2 billion worth of extra output.

Over this period, successive governments added virtually nothing to the size of government debt. In some years the government ran a surplus, and in others a deficit. But cumulatively, these more or less cancelled out. At the same time, low but persistent inflation eroded the value of the outstanding stock of debt, so that as a percentage of GDP, government debt declined sharply over these 20 years. Of course, fiscal prudence did not by itself cause the strong economic performance. Indeed, rapid growth leads to a growing flow of receipts from taxation, which makes it easier for a government to behave responsibly.

The key point is that the 1950s and early 1960s were very favourable to sustained growth driven by the supply side of the economy, by companies incentivised by the prospect of profit. The controls and restrictions imposed of necessity during the war had largely been lifted by the time the post-war socialist government under Attlee lost office in 1951.  Living standards has been ruthlessly squeezed during the war in order to divert resources into the armed forces. So there was a massive pent up demand for new consumer goods. Companies had been unable to invest during the war, so they wanted to build up their stocks of capital equipment rapidly. The net result was a prolonged boom, driven by the supply side, and enhanced by the renewed opening up of world trade.

Economic theory suggests strongly that longer term growth is driven by the supply side, by investment and innovation. If Osborne can create a climate in which these flourish, he will simply not need the drug of deficit finance.

As published in City AM on Wednesday 17th June 2015

Image: Piccadilly Circus c1960 by David Howard under license CC BY 2.0

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Bribing the electorate: new rules of the game thanks to zero inflation

Bribing the electorate: new rules of the game thanks to zero inflation

The temptation to believe in the concept of a free lunch is one which has proved irresistible to numerous governments through the ages. Henry VIII, for example, has seized popular imagination once again through the brilliant portrayal of him by Damian Lewis in Wolf Hall. Bluff King Hal is the nickname often associated with the King. But to his subjects, especially towards the end of his reign, he was more usually called Old Coppernose. He debased the silver coinage with so much copper that, when the coins were used, the copper shone through the flimsy cover of silver onto his portrait.

The Office for Budget Responsibility has recently produced an excellent little document which shows how post-war governments in the UK have indulged themselves in the modern equivalent of coinage debasement. The dry title is ‘A brief guide to the UK public finances’, but it contains fascinating material.

Since 1948, British governments have run deficits on the public finances in 54 out of the 66 financial years.  In the most recent four decades, surpluses have been registered on only five occasions.

It all started off so well. The post-war Labour government of Clement Attlee was heavily interventionist, nationalising the mines, socialising health care in the NHS. But it was a model of fiscal rectitude. It ran a surplus in every single year until its defeat in 1951, including what is by far the largest post-war surplus in 1948 itself, amounting to nearly 5 per cent of GDP – getting on for £100 billion in today’s terms.  The Conservatives carried on in the same way. From 1948 until the election of the next Labour government in 1964, public sector surpluses and deficits more or less cancelled each other out over time.

This is exactly how it was meant to be. Keynesianism, as it was originally conceived, required the government to run deficits when the economy was slowing down, to boost demand, but to offset these by surpluses in the good times. But since 1964, the cumulative size of the annual deficits comes to no less than 160 per cent of GDP. A nice little earner with which to bribe electorates.

Governments have got away with it thanks to inflation. The bonds they issue to finance deficits are denominated in money terms. When they mature, they simply pay back the face value, regardless of what has happened to prices in the meantime. Even with only 3 per cent inflation, prices double in just 23 years. And this doubling halves the real value of debt issued at the time.

The zero inflation world in which we now live changes the rules of the game. Any debt which is sold to finance public sector deficits will have to be repaid for real. Both George Osborne and Ed Balls are smart enough to understand this. The same cannot necessarily be said for many of their senior colleagues. And the biggest task is to convince the electorate, especially in the subsidised areas, that their living standards from now on will depend upon their productivity. No more free lunches.

As published in City Am on 22nd April 2015

Image: dice another day by topher76 under license CC BY 2.0

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Everything is crystal clear with hindsight

Are government bonds risky? This question arose a year ago, during a meeting with my bank. I wanted a low risk portfolio, but they noted that I did not want to hold UK government bonds. Whether it was the regulator who was insisting, or whether it was the way the bank was interpreting some Delphic pronouncement of the regulator, was not quite clear. But I could not be in both categories. Bonds were deemed low risk. So if I wanted to continue not to have bonds, my risk profile would have to change.

I did not doubt for a moment the financial probity of the British government. They were not about to default on the debt. But, at the time, long dated bonds yielded just under 2 per cent. At some point, the yield would rise, and I would be left with a capital loss. In the event, yields have recently risen, almost reaching 3 per cent on the 10 years. So a low risk portfolio would have landed me with a nice capital loss of some one third of the initial value of the portfolio. The outcome would have been very similar with US government bonds.

Looking around the world, a year ago there were many opportunities to incur large capital losses by buying government bonds. In Switzerland, the yield on 10 year bonds was just 0.60 per cent and is now, 1.10 per cent, implying a capital loss at present of almost 50 per cent. Even in Germany and its economic extensions of Austria and the Netherlands, rates have risen to give a loss of some 20 per cent on average.

Paradoxically, several economies where there has been genuine doubt about the financial stability of the government have generated very favourable outcomes for bondholders. In Portugal, yields have fallen from 8.6 per cent to 7.2 per cent, a nice capital gain of 20 per cent. In Spain, the increase in value has been one third. The stellar performer is Greece, where anyone willing to buy Greek bonds a year ago would have doubled his or her money.

Of course, all this is with the benefit of hindsight, when everything is clear. But why not? A paper recently published in Nature, one of the top two scientific journals in the world, claimed that a return of 320 per cent could have been made by trading the Dow Jones 2007-2012 using a strategy based on the number of times the word ‘debt’ appeared in the financial press. But both the rule and the trading strategy were all worked out after the event. It is perhaps not surprising that a return of 318 per cent could have been made if the words ‘colour’ or ‘restaurant’ had been used instead of debt.

Many regulators seem to inhabit this world of certainty, where everything can be known and someone is at fault if losses are made.  The real world is just not like this.  A year ago, I was lucky. Maybe I won’t be next time!

As published in City Am on Wednesday 25th September 2013

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No free lunch. Defaults today mean less jam tomorrow

Potential defaults in the Euro zone have been in the news again. In Portugal, the ruling coalition parties and the main opposition Socialists have been unable to agree on a European Union-led bailout plan after days of talks. Yields on the country’s 10 year bonds have approached 7 per cent, compared to the 1.5 per cent in Germany. There has been some improvement this week on the news that an early general election has been avoided, but yields still remain over 6 per cent.

Even more dramatically, the city of Detroit has become the largest American city to file for bankruptcy. Just as in the case of the Mediterranean countries, the public sector workers had been provided with much too generous wage and pension levels for much too long. The unfunded liabilities in the public pension funds of the city are estimated to be $3.5 billion. There is currently a major legal wrangle about whether the pensioners have a constitutional entitlement to their income. If they are, and the rest of America has to bail the funds out, they can feel fortunate that they live in a monetary union which works, namely the USA. Countries such as Greece and Portugal struggle for every cent of bail out money in the teeth of German reluctance to pay.

But does it matter? Does it matter if a public administration defaults on its debts, either in full or obliges bondholders to take a haircut? Economic research had until very recently contained a paradox in its answers to these questions.

International finance theory predicts that sovereign defaults lead to higher subsequent borrowing costs. They can even lead to the full exclusion of a country from international capital markets. All this seems very sensible and rational. A default today should reduce trust in the creditworthiness of the institution in the future.

The problem was that a large body of empirical research suggested that support for the theory was, at best, weak, and in many studies non-existent. An influential 1989 paper by Jeremy Bulow and Kenneth Rogoff – he of Reinhart and Rogoff fame – concluded that ‘debts which are forgiven will be forgotten’. More generally, the consensus in the empirical academic literature was that not only do defaulting countries not face higher borrowing costs in the future, but they regain access to credit within a couple of years.

So why not just do it and default? Here at last seems to be the answer. A comprehensive piece of work in the latest issue of the American Economic Association’s  Macroeconomics finally provides powerful evidence to support the theory. Juan Cruces and Christoph Trebesch construct the first complete database of investor losses in all restructurings with foreign banks and bondholders from 1970 until 2010, covering 180 cases in 68 countries. They show that restructurings involving higher haircuts are associated with significantly higher subsequent bond yield spreads, even 7 years after a default, and longer periods of capital market exclusion. There really is no free lunch.  Defaults give rise to significant future costs.

As published in City AM on Wednesday 24th July


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