DABERIAM LXIX

June 2012

To slightly change analogies from my previous thoughts, the slow motion European train crash continues to play out. Spain has at last acknowledged that its banking system is bankrupt. Anyone visiting Spain in the last two to three years has seen, particularly in the South, literally hundreds of acres of partially finished buildings that represent the bust in the property boom. It’s difficult to understand how anybody with a modicum of economic knowledge and a pair of eyes could conclude other than Spanish banks had unrecoverable debt measured in billions of Euro. It demonstrates the extraordinary ability of the massive bureaucracies of Brussels to live out a fantasy.

The complexity of the mechanisms that have been created to produce the appearance of a ‘U’ in EU is a key part of the problem. The often repeated observations from different quarters that the solution will require a partial break-up or serious political integration is also the observation that the lack of integration within the Union is a major part of the problem.

The Spanish banking crisis has, however, still failed to produce the acknowledgement that you cannot solve a black hole created by a portfolio of bad debts by lending more money to the banks. These debts have to be written off. The idea that the European debt crisis is different to the old Latin American debt crisis and the more recent Asian debt crisis is bizarre and irrational.

Debt destruction has to take place after a period of speculation financed by reckless lending. The power of the financial lobbies in Europe comes from the original need of Brussels to engineer a situation where the banking system created the appearance of growth and prosperity by excessive lending and was a key instrument in the pulling together of the final States that joined the Euro in the last ten years. The prosperity in Club Med and Ireland was, to a large extent, the result of massive building booms.

Respective governments clearly enjoyed the political kudos from the economic boom but the solution cannot come from governments themselves bailing out the banks. Historically, individual countries would have suffered banking defaults and debt and equity destruction, the IMF and other international organisations would have then helped Governments protect small depositors and re-capitalise their banking system. The machinery of Brussels is postponing the inevitable by moving the non-performing debt from bank balance sheets to government balance sheets and it is difficult to see how in the end this will not produce a situation where governments themselves will have to default. There seems to be a hope that a European government default can be avoided by producing some form of Euro Bond, substantially backed by Germany. If the mechanism for doing this had been in place five years ago, then it is likely that the banking system in certain countries could have been allowed to collapse and Euro instruments could have been used as part of the rescue. Today, so much has been squandered trying to use European central bank liquidity to avoid bank default that this proposition is probably a non-starter. Added to this the political unrest and confusion is making the formation of Europe-wide cohesive government policy nearly impossible.

This analysis is much over-simplified, but I think it covers the salient issues. The construction of Europe and the complexity created by the endless political compromises that were needed, probably means that a solution cannot be agreed until the crisis gets much worse – a frightening thought.

The European crisis is causing the centre of the economic world to shift from the Atlantic to the Pacific. The good news is that Asia continues its economic growth, albeit at a considerably slower pace than recent history. Continental America, North and South, also continue their steady if sub-optimal growth. Europe, a big customer for the rest of the world, has zero or negative growth which is having an impact on world trade as well as causing alarm and confusion in the world’s financial centres.

From a UK standpoint, Europe is a major problem from several different points of view. Not only is Europe a major trading partner, but UK banks have very considerable exposure to the European financial system. Added to this the European regulatory environment imposes enormous burdens on all aspects of the UK economy, burdens that our politicians and, in particular, civil servants seem unable to manage or resist in an efficient fashion.

On the lighter side, hopefully the success of the Jubilee celebrations will flow over into the equal success and economic boost during the Olympics. I do, however, have some misgivings about the chaotic situation that the Olympics will cause to travel in and around London. While I am hopeful that the Olympics will add some relief to the gloom, the economy faces severe headwinds from continuing incredibly complex regulation and ever increasing energy prices. It is unfortunate that the government as a coalition is unable to create coherent and joined-up policy. By its very nature a coalition is also unlikely to produce inspirational leadership.

In contrast to the UK’s predicament, it is worth noting and emphasising the unusual and new opportunities that there are in the USA. Wage increases have been lost for the past five to six years, compared with Europe, and there is above average unemployment in a relatively well skilled workforce. The banking sector, unlike Europe, has largely resolved its bad debt situation and is beginning to lend. In the last few months the property market has stabilised and indeed “building permits” are going from the decline line, through flat to rising. State governments are balancing their budgets and there are several examples of the electorate at the State level voting for candidates who propose reducing State pensions and employment. The presidential election in November will hopefully resolve the deadlock in Washington. All this by itself would auger well for an improved rate of recovery in the US.

The new wild card, however, is energy. The new technology that is enabling the exploitation of oil and gas reserves means that the US in the next few years could be self-sufficient in these areas. In the meantime the economy and industry in particular is benefitting from some of the lowest electricity prices and lowest gas prices in the world. A recipe for a new industrial revolution.

While the European crisis rumbles on, even if it is not resolved in the near future, I believe the rest of the world will a) get bored with worrying about it and b) markets will gradually take notice of the global economic recovery ex-Europe.