DABERIAM LXXXII

March 2014

My last note mentioned the Ukraine situation as being exceedingly dangerous.  The country dissolved into chaos that had partly come about as a result of the EU offering to let them join, and then encouraging dissent when the President had vetoed the idea.  From the Russian point of view, they could never let Ukraine, and in particular Crimea, join the EU as this would have affected their major economic and political interests.

The West’s response to the military take-over of Crimea has been slow and confused, partly because of the lack of political cohesion in Europe and, more importantly, the north European and British dependence on Russian gas.  Germany is particularly vulnerable as between 30 and 40% of its gas comes from Russia, and if Mrs Merkel implements her plan to shut down their nuclear capacity, Germany would, to all intents and purposes, be totally dependent on Russian energy.  

It is worth remembering that some 9% of British gas also comes from Russia and British energy policy, tilted towards heavily subsidising unreliable supplies of alternative energy, means that the UK will become more dependent on the European pipelines.  The other unfortunate by-product of the situation is that the West’s response is likely to drive Russia into closer alliance with China - probably not a politically sensible strategy. Europe desperately needs time and stability to heal its economic problems and it certainly doesn’t need to precipitate an energy crisis, something a malevolent Russia could do easily.

While the US response has been slightly more cohesive, the rest of the world takes full notice of the fact that while the US government is offering desperately needed financial help to the new Government of the Ukraine, political infighting in Washington has so far held this up.  Hopefully, from an economic point of view, the Ukraine situation will settle down into a quieter stalemate in spite of all of this. 

China’s own domestic economic restructuring continues according to plan.  The stress in the banking system is precipitating bankruptcies as the government damps down the secondary and tertiary banking sector.  The by-product of these banking problems is the release of large amounts of commodities, particularly copper, back onto the market, which has been used as security for bank loans and speculation.  Asia in general is suffering form the Chinese slow-down but most countries seem to be adjusting quite well.

The US, on the other hand, is developing rapidly.  It really can’t be mentioned too often that an economy that has cheap energy, a good supply of relatively well educated labour and generally an entrepreneurial spirit, is likely to grow.  The repatriation of manufacturing is picking up at a rate that will increase, US productivity continues to grow at a rapid rate in spite of the lack of capital investment; the only real headwind is bureaucracy, which has grown rapidly under President Obama.  For example the Obamacare programme is imposing confusion and an “employer penalty” that encourages companies to reduce their full time workforce and discourages small companies from growing to more than fifty employees.  Also the chaotic tax system with an IRS tax code that runs to more than 71,000 pages, and a high corporation tax level of 40%, makes investing in tax saving techniques in many instances more profitable than productive capital expenditure.  Overall, however, the tailwinds far exceed the headwinds.

The elephant in the room for Europe and the US is, however, Government debt coupled with artificially low interest rates being engineered by central banks.  Low interest rates rob savers and pensioners to the benefit of government and borrowers.  Regulatory requirements are also pushing pension funds and insurance companies into buying Government debt.  This is creating an exceedingly dangerous bubble as, at some point (probably in spite of the efforts of central banks), interest rates will rise.

Today, you can say that the most dangerous investment is so-called “safe” AAA Bonds.  Put simply, someone holding a 20-year Government Bond is virtually guaranteed to make a major loss when interest rates rise and will anyway lose money as inflation gnaws away at purchasing power.

On a more parochial note, it is worth, unusually for me, congratulating the British Chancellor.  The recent budget was a masterpiece of political balancing. With very little to give away, an appearance was created of doing good things, apart from the political gaff of reducing bingo tax and crowing about it. His repealing of the requirement of pensioners to buy annuities was courageous and innovative. He did, however, hugely help house purchasers which, while politically popular, only drives up the cost of housing, as it was not coupled with any initiative to improve the supply.  House building in the UK is faced with major planning issues that slow down the development of house building projects for years.

With spring in the air, we should be seeing economies improve, albeit at different rates.  It is certainly likely that those in work and businesses will put the foot on the accelerator.