DABERIAM LX

February 2011

As January goes, so does the rest of the year. Excuses by Central Banks abound, but it’s beginning to dawn on everyone that inflation is here and serious. The Bank of England has yet again to explain that it was caused by exceptional circumstances. The models have long ceased to work and have been disconnected from the real world for probably ten years. The steady and low inflation rates that Mr Brown was so proud of in the mid noughties were to a large extent due to our ability to import Asian consumer goods. The Bank of England models basically ignored this and after the recession have been used to justify forecast low inflation on the basis that there is unemployment and industrial capacity so prices cannot go up! Here again the reality has been ignored. Asian prices are rising rapidly and are brought on by rising food prices and wages. Spare modern manufacturing capacity in the UK is very limited and, as anyone in the manufacturing sector knows, there is a tremendous shortage of skilled labour.

While the film industry in the UK has been achieving stunning success, I doubt whether this can be linked to the enormous output of students with degrees in media studies and art, and certainly these subjects have limited use in industry.

Everyone who goes shopping knows that prices for virtually everything have been rising inexorably for the last two years or more, and it is now beginning to be the focus of attention in the Press. Whether the Bank of England or European Central Bank can do anything about it is another matter, but at least they look as though they are no longer in total denial.

The extraordinary rise in GDP of the Chinese economy, recently overtaking Japan for second place after the USA, means that an ever larger percentage of the billion-plus people in China are able to escape from a bowl of rice a day to the delights of meat. However, the stress on the world’s food supplies that this is causing will drive up food prices for some time to come. Meat production requires an enormous amount of grain or equivalent and increasing grain production not only requires land but is being curtailed by the shortages of water that have been developing around the world for some time. Also, Asian prosperity is putting increasing stress on the supply of raw materials from coal to copper. The huge building programmes in China require cabling and steel and will use ever increasing amounts of electricity.

The West, with its current surplus of Central Bank generated liquidity, is adding to the pressure on commodity prices as “investors” bid for the commodities to hold as investments. There is another reason for being nervous of inflation - hugely indebted western national and local governments will not be unhappy with inflation, for the time being, as it reduces their indebtedness. Western Central Banks are also under great pressure to keep interest rates down, again to take the pressure of governments.

It is still going to be a two or three speed world for some time as the enormous imbalances built up over the last seven or eight years are reduced. The pain of unemployment is likely to continue for some time and the burden of inflation will fall on the savings of the ageing baby boomers. The downward trend of interest rates is being reversed and those holding fixed interest paper will be surprised, not only by the loss in purchasing power of their ‘safe’ bonds, but the loss in nominal values incurred as interest rates rise. The western decline in prosperity will impact severely the middle class elements of society who are not protected by inflation-proof government pensions.

The unrest in the North African States would appear largely to be caused by the impact of the rise in food prices and the pressure on the educated population, and could possibly spill over into Europe. The call for democratic representation is really more of an indication of unhappiness and a way of expressing the frustration of a rising population of well-educated young in the governments that have not delivered the promise of prosperity.

Having said all the above, the world’s economy is rapidly recovering from the financial train-wreck of 2008/9. The dislocations in world trade caused by the breakdown of international trade finance are slowly recovering. The breakdown in world trade has of course left wreckage in its wake. Air and shipping transport facilities have been moth-balled or scrapped and there is currently a shortage of capacity, pushing up global freight rates. While this is pushing up prices of Asian product, it is also making it more attractive for manufacturing companies to bring production back from Asia. The effects of this are already being seen in America where the Government is incentivising the re-building of the country’s manufacturing base by giving 100% capital allowances for new machinery and reducing the tax on employment. The policy in the UK, unfortunately, has so far been exactly the opposite. In spite of this, UK manufacturing is recovering well in its export markets.

Europe on the whole is neutral, with German machine tool industry going into high-gear but the hangover of property booms and debt bubbles still have to be paid off in Mediterranean Europe. In particular it is difficult to see how countries such as Greece can survive – they will in the end have to reschedule their borrowing, i.e. ‘default’ – but this event is relatively widely anticipated. What happens in Spain, Italy, Portugal and Ireland is difficult to anticipate as the interlocking relationships of the banks is hard to determine. It must also be remembered that France and Germany will have to decide to what extent they are prepared to support their southern neighbours and calculate the political cost to the present parties in power.

Britain is in a strange state, almost suspended animation. The Government is doing the right thing in hacking into the debt mountain and trying hard to deal with the legacy of what amounts to a corrupt financial administration. The difficulty facing Cameron and Osborne has been made more problematic by their coalition partners. Added to this, having to impose such draconian cuts inevitably results in upsetting many vested interests who have lived off the largesse of the government; also it is inevitable that mistakes of detail will be made or created by those opposed to the cuts for political or self-interested reasons. Libraries and woodlands come to mind, really very minor savings but hugely emotional subjects around which ‘Middle England’ can rally. The Prime Minister’s and the Chancellor’s courage will be tested and it can only be hoped that the economy starts to recover in a general fashion in good time for the next election. One of the good and interesting by-products of all this change is that the large and impressive cadre of new MPs are learning about the sand in the works and the frustration caused by the bureaucracy. Hopefully, this will encourage Members of Parliament to be less inclined to legislate on the hoof and think harder about the consequences of the proliferation of often conflicting laws that they load on the private sector!

All in all, the right things seem to be happening and growth and economic recovery is well on the way. While the pain of paying for the past failures of financial regulation and profligate government expenditure has to be borne, at least the indicators have switched to the right direction and we should see a returning level of optimism.

Damon de Laszlo
February 2011