DABERIAM LXXXVIII

January 2015

My last comments in November were somewhat pessimistic, particularly with regard to Europe. This pessimism grows. It is now clear that the European Central Bank has finally capitulated to implementing so-called ‘Quantitative Easing’ (Q.E.). Q.E. has become a sort of ‘get out of jail free’ card. The public political debate about Q.E. has enabled European leaders to avoid addressing the primary issues that plague the Euro area, which are, firstly, the excessive debt of both government and the private sector, and secondly, excessive regulation, particularly of the labour markets, which paralyses entrepreneurial initiative.

The structural impediments to the regeneration of the European economies have not been addressed and the imbalances between northern and southern regions are continually ignored. Q.E. was a mechanism implemented by the Federal Reserve Bank in the US and the Bank of England in the UK in the aftermath of the financial crisis of 2008 to put liquidity into the banking system to stop it seizing up. It was extended to help drive down interest rates and finance government debt, while action was taken to reduce government spending in the case of the US.

Today in Europe, we are a long way from the original financial crisis and the problem is not liquidity in the banking system, it is the bureaucratic sclerosis that is gluing up the economy, as well as the fact that the private sector is unwilling to borrow as it is already over-geared. The ECB is embarking on Japanese style Q.E., where we have seen the banks flooded with cash which has had little impact on the economy, as the private sector already had too much debt and was unwilling to borrow. The implementation of Q.E. in Europe, owing to the fragmented nature of the economy, will it seems only apply to the ECB buying government debt from the banks, with some countries being excluded. This liquidity, owing to the Basle 3 rules etc., cannot in reality be lent on to the private sector to stimulate the economy.

We are in an “Alice in Wonderland” world where the primary issues remain unaddressed and there is a complete disconnect between the problem and the solution being proposed. To put it another way, the action being taken is not related to the problem and it is difficult not to be concerned that the result of Q.E. itself won’t create a crisis down the road. One unforeseeable consequence has already been the Swiss Central Bank giving up on trying to maintain the Euro/Swiss Franc exchange rate.

The effect of European Q.E. on the UK is also unpredictable and the elections in May are going to add increasing uncertainty in an already complicated world for British business. It is not practical to list the scenarios that could arise and we end up with a totally confused political picture where the best outcome is likely then to run us into a referendum on Europe, which will pour petrol on the economic uncertainty. The uncertainty is already discouraging individuals from spending - probably a good thing as personal debt is being paid down - but corporate capital investment is being hampered by the exceptionally confusing outlook.

The outlook from the USA, where I was over Christmas and the New Year, remains good. The decline in oil prices is definitely helping the economy, although it confuses the statistical reports as it is difficult to separate out the oil and gas industry, which obviously is suffering, from the general numbers. It can be seen, however, that the unemployment rate in the US continues to decline and wages are starting to rise. Investment in plant and machinery, capital expenditure, is gaining momentum and there is plenty of room for a huge increase. The average age of capital stock has risen from nineteen years in the ‘80s and ‘90s to some twenty-two years and it is interesting that the average age of motor-cars has risen from some 6½ years to 11+ years in the same period! From company surveys, it looks as though real GDP is going to break out of the 2 to 2½% range that we have seen in the last four years to a new high of 3 to 3½ %. Deflation in the US is basically good and comes from declining oil and gas prices and lower commodity prices. Confidence is likely to continue to increase with all the benefits that follow from that.

China, where I was last week, continues to do what is written, so to speak, “on the government can”. The economy is being slowed deliberately to get the excesses out of the property market. We are seeing house prices decline which will discourage some speculative building. However, residential property transactions are rising, particularly in the major cities, which should clear the excess fairly quickly. President Xi’s anti-corruption campaign is intensifying and is generally popular, and wages are rising. One company I visited said its direct labour costs had risen 30% in the last year, which indicates government policy is working. One of the outcomes of the government’s December economic policy conference was a re-emphasis on education and an improvement in the “social security” support systems. There was also an emphasis on improving agricultural productivity and land reform, as well as an emphasis on creating initiatives to encourage innovation and private company formation. These are significant reaffirmations of the reform process that was started by the present administration. While the government target for GDP is 7½ %, the economy would appear to be running at a slightly slower rate and could indeed slow down further but this should not be a concern. Even a 6½ to 7% growth rate is rapid for an economy that is now the size of China.

A view of the world must include a reference to the Ukraine. This unholy mess is potentially a major headwind for European stability and it is difficult to see how it can be resolved. Hopefully at the least it can be contained and possible discussions that are scheduled to take place between Russia, Hungary, Germany and Poland can find a way of stabilising what is turning into an ethnic conflict.

Luckily, Obama remains relatively quiet on the subject, although some of the Republican hotheads would appear to want to fan the flames and continue to talk about sanctions, which are painless for the US but very damaging for Germany.