Disclaimer: For the first time in two and years of blogging I have been driven to swearing in a blog post. Apologies but I lack the words to express what’s happening.
A short post but there really isn’t a great deal to say.
We have falling equity prices, falling commodity prices, record low bond yields across UK, Germany and the US and the worst hit shares are financials (where rumors of problems in the European banking system are once again circulating) and those most exposed to global growth.
This is a growth scare – and a big one.
And George Osborne is still taking comfort in low yields on government debt and declaring Britain a ‘safe haven’.
I’m afraid a bond yield of 2.3% on 10 year UK government debt isn’t the market saying ‘well done you, nice deficit reduction plan you’ve got there mate’ it’s the market screaming ‘for Christ’s sake, everything is fucked and we’re terrified about vanishing growth’.
Markets, as we know, can be irrationally optimistic but they can of course also be irrationally pessimistic. Let’s hope that’s what’s happening now.
In the past nine months theUKeconomy has grown by 0.2%,Belgiummeanwhile has grown by 2.2% – a very healthy performance. In the second quarter of this year it racked up quarterly growth of 0.7% – putting it near the top of the Eurozone growth league.
What’s the secret of the small state’s recent faster growth?
Oddly enough, the answer appears to be its lack of functioning government.
But before the small state libertarians open the champagne – the connection isn’t the one they might expect and hope for.
It’s not that the lack of an intrusive, interfering government has set the forces of enterprise free – instead the political paralysis afflicting Belgium has meant that, unlike most Euro-area governments, it has not embarked on an austerity drive.
As the FT reports the of absence of austerity (and the fact that Belgian salaries and pensions are indexed to inflation) is providing a boost to growth.
Belgium can’t avoid austerity forever, public debt to GDP stands at over 100% (much higher than the UK) but in the short to medium term it is certainly outperforming its neighbours. The FT quotes a perplexed economist from ING:
“In the case of public spending, the short-term gain is paradoxical. It makes it more and more clear that we will have to undertake deeper austerity measures in the future.”
I don’t think this is paradoxical at all – nor do I agree that an effective short term stimulus now necessarily means deeper austerity later. As Christine Lagarde argued yesterday, the right policy mix for most states is a short term stimulus to get growth moving coupled with a medium to long term programme to balance the budget.
Belgium, in the absence of a functioning government, lacks the ability to commit to a credible medium term plan – hence the recent market pressure on its bond yields, but in the short term its current policy mix is certainly generating growth – as of result of which the government’s deficit narrowed from 4.6% of GDP in 2010 to an estimated 4.0% this year (according to the IMF’s Fiscal Monitor).
Christine Lagarde, the new IMF director, has written an important article for the FT today. Tellingly it is entitled ‘Don’t Let the Fiscal Brakes Stall Global Recovery’.
The essential points are (i) that markets worry about growth as well as deficits and (ii) that states ‘that are not under market pressure’ and have room for expansion should be looking at slower tightening and/or additional fiscal measures to help growth in the short term.
She is basically arguing for the same postion as IMF’s Chief Economist did last year – the appropriate policy action now by Finance Ministry’s is for short term stimulus coupled with creditable (and meaningful) medium term fiscal tightening.
What is interesting is that her argument explicitly accepts that spending cuts mean lower growth & higher unemployment – something the government (and its cheer leaders) have occasionally denied.
As she notes – markets worry about high deficits BUT they also worry about low or negative growth.
The question then becomes what is the right balance. As I wrote earlier this year:
The Government claim that cutting the debt will lead to ‘expansionary fiscal contraction’ and a ‘rebalancing of the economy towards net exports and investment’. This is unlikely to be correct, the evidence (see this post for example on recent IMF work) suggests that austerity policies lead to weaker growth – especially if interest rates are already low or cannot fall further. I’d have much more time for Osborne if he acknowledged that the cuts will hurt growth but argued that not cutting as fast and deep as he plans would risk a loss of market confidence and problems funding the debt. That’s a justifiable and reasonable position to hold.
We face a trade-off between cutting and hence harming the economy and not cutting and hence risking a loss of bond market confidence. The real debate, away from the shouty world of Westminster, is about the balance of risks.
Taken together I think the UK’s low stock of debt, the low interest rates it attracts and the debt profile outlined above more than offset the high deficit. I think the risk of cutting as fast and deep as the Government intends is far worse than the risk of a loss of confidence. I certainly don’t say that there is no chance the markets would lose faith in a British government that’s adopted a different approach, I just think the balance of risks points towards a less extreme and more growth friendly fiscal package.
It’s nice when the Director of the IMF agrees with you.
It is now fairly widely acknowledged that the British recovery has stalled in 2011. Whilst Britain may yet avoid a double dip recession growth looks set to be sluggish.
Given the more pessimistic outlook it is important that policy makers are clear about the reasons for this slow down, otherwise we risk a misguided policy response.
George Osborne is relatively clear that the slower growth profile of theUKeconomy, and the reasons that 2011 growth may well miss the OBR forecasts, is because of a more troubled global outlook – the debt standoff in the United Statesand the ongoing Eurocrisis in particular.
The left meanwhile are mainly focussed on the impact of austerity.
Both answers risk missing the point – what is killing the UK recovery is actually falling real wages.
Each month he Treasury publishes a compilation of independent forecasters views on the UK economy. The table below shows the median forecast from back in January (when optimistic observers expected growth of 2.0%) and the most recent forecasts from July, when the estimate had fallen to just 1.3%.
For completeness sake I have also included the OBR’s own numbers.
Whilst there has been a lot of attention (rightly) paid to the falling headline number, I have seen less comment on the make up of that falling growth forecast.
The first thing to notice is that since January independent forecasters have revised up their export growth forecast and revised down their import forecast (as a result of domestic weakness meaning less imports). The end result is that the contribution of net trade to GDP growth was expected to be 0.5% in January but is now expected to be 1.3%. In other words – for all George Osborne’s talk of global headwinds hitting growth independent forecasters now expect Britain’s export performance to be better than they did in January. A questionable assumption maybe – but weaker external is not a fact explaining the downgrades to the growth forecast.
What has caused growth to be revised down is dramatic collapse in domestic demand forecasts from an expected 1.5% contribution to growth in January to just 0.1% now.
The chart below demonstrates this:
What has caused this collapse in domestic demand? A huge fall in private consumption forecasts from expected growth of 1.2% in January to an expected contraction of 0.3% in July.
Whilst the government has talked up exports and investment for the past year and the opposition has focused on spending cuts, the consumer outlook has become dire.
Why has consumer spending been revised down so heavily?
A substantial part of the answer can be found in falling real wages. Back in January independent forecasters expected RPI inflation to be 4.0% in 2011 and average earnings to grow 2.6%, implying real wages would fall by 1.4%. They now forecast RPI of 5.3% and average earnings growth of 2.5%. Real wages are now expected to fall by 2.8% – double the estimate of January.
Because of this consumption estimates have been radically revised down and GDP with it.
If one wants an answer to why the recovery is faltering, one would do well to start looking at real wages – an area policy makers haven’t spent anywhere near enough time talking about.
Is ECB intervention in the Italian and Spanish bond markets working?
Since Monday the ECB has been buying Spanish and Italian debt in the secondary market aiming to drive down the yields and hence ensure that both countries can afford to borrow from the debt markets.
The yields on both countries’ debt had increased sharply in the preceding fortnight (post-the latest Eurozone crisis summit) in a pattern which has become strangely familiar over the past year – the yield hits 6%, the country denies there is a problem, it hits 6.5%, more denials and suddenly it is at 7% and a ‘bailout’ is being arranged.
Whilst Ireland, Portugal and Greece represent 4.5% of EU GDP between them, Spain is 8.7% alone and Italy is 12.7%. They are too big to fail - but also possibly too big to bailout.
If Italy and/or Spain were to require a bailout they would obviously not be able to participate in the EFSF – at which point the increased costs to France (in particular) would become perhaps insurmountable. In other words if one of these two go, the whole crisis coping mechanism goes with it. (Not to mention the fall out in the banking sector).
So – back to the original question, is the ECB intervention working?
But in the CDS market (credit default insurance) a different picture emerges – one of continuing and rising concern for Spain and Italy.
If the markets were genuinely reassured we would expect CDS rates and bond yields to fall together. As CDS rates (where, crucially the ECB is not intervening) are continuing to rise this looks like entirely artificial price moves in the bond market caused by the ECB acting as buyer of last resort.
The question becomes – what happens when the ECB stops buying? The answer may be a swift return in bond yields to uncomfortably high levels.
So – why can’t the ECB just continue buying? Well it could. But it would soon own a substantial proportion of outstanding Italian and Spanish government debt – something which Northern European tax payers are unlikely to be happy about and a situation which may be sustainable. What will it do to confidence if an international central bank (with no power of taxation) is standing behind a substantial segment of the debt of two major economies?
Once more it looks like the Eurozone’s ‘solution’ is just an attempt to buy time – let’s hope they use this time well.
The past few weeks have seen a vicious equity market sell off which now seems to have paused, huge swings in the European peripheral bond market and major falls in commodity markets (outside of gold) all accompanied by rising volatility.
It seems fair to conclude that uncertainty has risen and that this will probably impact on firms’ investment decisions and consumers’ spending patterns.
Drawing on work by Ben Bernanke (from a long forgotten 1983 paper) Nicolas Bloom (assistant professor of economics at Stanford) has a succinct and highly recommended post up at Vox, which aims to forecast how this increase in uncertainty will impact the economy.
Based on my research, I predict another short, sharp contraction in late 2011 of about 1%, with a rebound in spring 2012. This research looks at the average impact of the previous 16 uncertainty shocks to predict the impact of future shocks. Typically these leads to reductions of growth of about 2% immediately after the shock, with a recovery about six months later once uncertainty subsides.
(With a hat-tip to regular commentator Luis Enrique)
Last week myself and Maurice Glasman had an 800 word op-ed in the FT.
The first half focussed on the failures of the British economy over the past twenty years – how financial dominance has led to a narrow tax base, little real investment, low productivity (once one removes excessive risk taking) and a lack of real, private sector growth & jobs in the regions.
The second half looked at some lessons that might be learned from Germany– in terms of banking reform, vocational training and corporate governance.
Denis MacShane and Aditya Chakrabortty have both responded. Whilst both have fair critiques and raise very useful points, I do feel that their central objections to the article, in some ways, misunderstand the point – which is possibly due to the limitations of us covering so much ground in 800 words.
MacShane lists 10 differences between Britain and Germany whilst Chakrabortty’s critique is two pronged – that the ‘German model’ we wrote of no longer really exists and that what remains contains many objectionable elements.
Both note how German wages have declined in recent years – something I have written about myself. However this phenomenon, whilst not desirable, is global (and also present in the UK).
MacShane notes that the UK outperformed Germany between 1998 and 2008. On that point I’m not so sure – subtract the effects of an unsustainable credit bubble from UK growth and the picture isn’t so rosey.
Both MacShane and Chakrabortty nopte that we can’t import the German model wholesale into the UK. MacShane writes that:
to wish Britain were more like Germany without acknowledging that there are massive differences between politics, history, society, law, unions and economic culture makes a good FT column but is not serious political economics
Whilst Chakrabortty notes that:
Germany isn’t a cut-out-and-keep model of how to manage a sound, socially just economy. We need to think a bit harder
Both are very fair points. But as the original article stated:
we should re-examine the lessons to be learnt from the German social market economy
‘Re-examine the lessons to be learnt’ in training, financial reform and corporate governance does not mean ‘entirely adopt every element of the German Political Economy’.
Back in the early twentieth century, during the debate on Tariff Reform, Joseph Chamberlain was keen to learn lessons form the Germany of that time.
The Liberal response, headed by Lloyd George has a rhetorical attack on all elements of the German system nd a claim that the Conservatives wanted to introduce it all. Lloyd George argued that ‘German tariffs mean German militarism’ and that the Tories would introduce ‘Black (rye) beard and horse meat sausages’.
As I wrote back in March:
There is certainly a lot to learn from Germany but, as ever, things are more nuanced than they seem.
Speaking personally I am quite attracted to many elements of German’s economic model, although not all of it. I am also not keen on horse meat sausages.
I learned quite a few things during four and half years working directly in financial markets, three of them are worth stating right now; the first causality of market turmoil is usually a sense of perspective, when market news is leading the main bulletins the story has probably moved on and, finally, markets rarely fall in a straight line.
In this spirit I thought it might be worth trying to provide some realistic and non-panglossian quick market commentary.
At the time of writing the markets are performing reasonably well, all things considered – the bond markets are behaving themselves; the equity market falls are limited. Apocalypse seems to have been averted, or at the very least postponed. That said, as we saw on Friday, markets can gyrate wildly during the day.
There’s a tendency, given the rapid availability of information, to assume that important market moves happen in hours and days – and sometimes they do – late 2008 being an excellent example.
But more often they move in weeks and months. The credit crunch began in August 2007 with the seizing up of the credit markets (although the first clues maybe came in June 2007 with the failure of two Bear Sterns hedge funds), Northern Rock failed in September 2007, central banks co-ordinated rate cuts in January 2008 as equity markets crashed, Bear Sterns failed in March 2008, worries developed throughout the summer of that year, Freddie May and Fannie Mac ran into serious problems in August and Lehman’s happened in September. The resulting market implosion bottomed out in March 2009.
It took a long time to play though and during that time there were many false dawns and (long-ish) periods of calm and market rallies.
That all said, I also remember the February 2007 market panic after the Chinese index fell 10% and the May 2006 commodity-led correction – both of which were contained although felt worrying at the time.
The current market problems feel more like 2008 than 2007 or 2006 but we can’t be absolutely sure.
Despite all of the drama of the past week equity markets remain well above the level of a year ago, let alone above the Q1 2009 lows. This suggests that things aren’t quite as bad as the headlines imply – but also that any fall could go a lot further.
After the major falls last week, we should expect some sort of bounce. The usual pattern of a market fall is two steps down, one step up – not a straight descent.
Just looking at the Eurozone, the US and the UK– where exactly are we?
In Europe– the central problem of underperforming PIIGS economies unable to devalue remains unresolved. The ECB’s intervention today is having the desired effects of driving down yields on Spanish and Italian bonds. But it won’t stop the underlying rot of low growth and an explosive path of debt build-up and nor will it provide much relief from the effects of tough austerity which is strangling growth. More importantly, the real question is how long will it work for? How much money is the (still-divided) ECB prepared to commit to holding down PIIGS bond yields? We can expect the market to test this commitment in the coming days. In the medium term is a situation in which the ECB is the only real buyer of Spanish and Italian debt unsustainable?
In the US the major falls came before the downgrade. A downgrade by one rating agency is unhelpful but not a disaster. US yields are still low. The real issue is not the debt burden but the faltering economy. The driver of the markets in the medium term will be the real economy.
In the UK the issue is similar – horribly low growth and the risk of a double-dip.
In the short term things look better today – but nothing is happening to resolve the fundamental problems of low growth.
Gilliam Tett today in the FT makes for alarming reading pointing out the worrying parallel between what is unfolding inEurope and what happened in theUS in 2008.
One point in particular strikes me as being crucial – the continued reliance of banks of short term funding. Which leaves them exposed to rapid moves in short term market rates – a la 2007/08 and now 2011.
I’m not denying that many Eurozone banks face a solvency crisis but in the coming days a liquidity crisis could have a wide spread impact on all banks in Eurozone – and indeed beyond, the poor results from Lloyds & RBS leave them looking exposed.
The news that BNY Mellon (a large US bank) is now charging to hold large deposits (actual nominal negative interest rates) is especially alarming. It suggests to me that the reports of US banks and money market funds pulling cash fromEurope and holding in theUS are true.
Some US banks risk being flooded with cash whilst Eurozone ones are starved.
Watching the inter-bank lending rates in the next few days will be crucial.
This really does remind us of the importance of liquidity regimes – something George Osborne reportedly wants to scale back in the UK.
A very quick ‘major economy’ round up.
The Eurozone crisis is getting worse. Spanish and Italian bond yields are at Euro-era highs and the market is increasingly focussed on worries about the Italian banks.
The divergence can also been seen in the spread between French and German bonds hitting a Euro-era high.
In the US, the debt deal may have passed, but a bad manufacturing PMI and awful consumer spending numbers have revived fears of a double dip recession.
As investors flee to safe havens, we risk round two in the ‘currency war’ as Switzerland attempts to devalue the Swiss Franc which has been driven by its ‘safe haven’ status.
Against this backdrop governments from London to Washington to Berlin are committed to cutting government spending and austerity.
What is now worrying me is that we may be verge on a major financial crisis – one not based on ‘too big too fail’ banks on but ‘too big to save’ Eurozone states – and unlike in 2008 there is little evidence of intra-government cooperation and no appetite amongst policy makers for a stimulus programme.