DABERIAM XC

April 2015

While the UK is in the grip, or should I say, smokescreen of the election campaign, it has become apparent to me that politics and economics have become detached.  The lack of leadership of the two major parties and the paucity of political philosophy from both has allowed, even encouraged, a proliferation of parties led by “characters”!

The problem for politicians is the inability of economists to explain coherently the slow recovery from the 2007-8 financial crisis.  Economic models, with all their beauty and complexity, manage to cram historic data into a formula, a process that is mathematically fascinating but useless as a tool for prediction.  Most of the crises prior to 2007-8 were related to inflation and in some cases specifically triggered as a result of oil price rises.  The arrival of the 21^st Century saw the end of inflationary pressures. The finance sector’s lobbying and the diminished memory of the financial bubbles that burst in the 1930s encouraged politicians to roll back the regulation of the banking and financial sector in London and New York.  This set in train an explosion of financial instruments and debt.   The left leaning governments in the US and UK were happy to take advantage of easy money and gave up any pretence of controlling expenditure.

Individuals and the corporate sector became heavily over-borrowed and the natural result of the crisis and the experience of individuals in the private sector and companies was to “learn” and reduce their borrowing.  The searing experience of private individuals and company managements of being over-indebted was learnt and no amount of interest rate reduction is likely to tempt those with this experience to “go there again”. 

From an academic point of view, Japan was and still is a perfect example – they have remained since 2000 some of the most highly borrowed people in the world, only temporarily eclipsed by the US between 2006 and 2010, but reducing interest rates and pumping money into the economy has not encouraged the Japanese people to borrow any further.  The government, on the other hand, using the cloak of economics, continues to borrow and run up huge deficits.

The US,  interestingly, dealt with the liquidity problems of the financial crisis quickly and effectively through quantative easing, private sector debt and write-offs, particularly in the property market, bankruptcies in the corporate sector and a government that by accident, to a large extent the result of political gridlock and constitutional requirements, was forced to reduce its expenditure,  The post crisis recovery by the US, while not remarkable, has been steady and the luck of being able to exploit their energy resources has helped.

Europe and the UK have not been a success story.  The advantage that the UK had is that at least the Bank of England was able to act and had a supportive government.  A further advantage in retrospect was that the banking crisis, which one has to remember started in London with Northern Rock, had a much bigger impact on UK politicians than it did in Europe.

The EU, and Germany in particular, for a considerable time felt little need to act and there was a certain smugness about the good standing of European banks compared with the blow-ups in London and New York.  QE in the UK was belatedly brought in, ostensibly to provide liquidity to the banking system but in fact it turned into a method of funding the government’s deficit and avoiding, at least for the first few years, the need for a clampdown on government expenditure.  While QE in America certainly had an impact on banking liquidity, it did little to encourage economic recovery until a large amount of debt had been written down.  What happens in the UK will very much depend on the shape of the next government.  For the country to recover further, confidence in the business sector to increase capital expenditure and invest in plant and machinery will be a critical factor.  It’s unlikely that the private sector, as I have said, will be tempted to borrow and squander money, in particular, as the younger generation is suffering from a bubble in house prices. This particular bubble, induced by cheap mortgages, government grants and the inability of house builders to get timely planning permission is, as they say, a train crash waiting to happen.

Europe is a completely different story.  The ECB with its German leaning management and fragmented financial authority has been unable to act.  The bureaucracy of the EU lacks legislative cohesion and any political leadership. As with all bureaucracies when left to themselves, no action is the preferred course and when action is forced it is likely to adopt some historic collective comfort zone that relates to some previous problem, “fighting the last war”.  This has been seen in the so called European QE which is a bizarre transaction whereby the ECB buys a trillion Euros of government debt on a pro-rata basis, driving interest rates into negative territory.  The ECB’s actions will have no effect on the real economy except to potentially bankrupt pension funds and threaten the insurance industry.  Conflicting regulations make it difficult for banks to lend to industry, even if they wanted to borrow, while requiring banks, the pensions and insurance industries to hold large amounts of debt with a leaning towards government debt, to the huge detriment of savers, and current and future pensioners.

The other elephant in this room is the fact that when interest rates rise, the depreciation in the Bonds will be dramatic, if not catastrophic, to the holders.  The economic and political consensus is that QE suits governments as it enables them to avoid dealing with the structural problems of Europe and their own excessive expenditure.  The civil servants and bureaucrats have got control of the purse strings!

Certainly America is on a steady course and recovering economic strength.  Europe is definitely very worrying and Asia, led by China, seems for the moment to run steadily, albeit at a slower rate of growth.