The Great Debate UK

from The Great Debate:

Britain’s austerity experiment is faltering

It was the Welsh sage Alan Watkins who remarked that a budget that looked good the day it was delivered to the British Parliament was sure to look terrible a week later, and vice versa. The avalanche of new information dumped by the Treasury is simply too much to grasp at a single sitting, and governments tend to bury bad news in a welter of statistics. And so it proved with finance minister George Osborne’s budget served up last week.

The immediate headlines stressed that rich Brits would pay less income tax – down from 50 percent to 45 percent – but it only took a day before even traditional Conservative cheerleaders like the Daily Mail were condemning Osborne for funding tax breaks for bankers and billionaires by stealing from those living in retirement. The paper’s cover screamed: “Osborne picks the pockets of pensioners.”

Osborne insists he is sticking to his “Plan A” to reduce the public deficit by sharply cutting state spending by 25 percent over the five-year parliament and imposing severe austerity. Because he believes his “Plan A” is on target, all he needed was a touch on the tiller. He therefore designed his budget to be fiscally neutral – that is, for every tax cut there was a corresponding tax increase. He put up tobacco and alcohol duties and sliced a little off corporation tax.

Osborne’s broader economic experiment, however, is fast faltering. If it were a drug trial, doctors would be urgently taking patients off the snake oil and feeding them the placebo. In 2010, he inherited from Gordon Brown’s Labour government a fast-rising recovery in economic growth, but now, after two years, GDP is headed south, and Britain is teetering on the edge of a government-inspired double-dip recession. In the last quarter of last year, GDP shrank by 0.3 percent.

As predicted, “Plan A” is not working. The number of jobless is 2.67 million (8.4 percent) and rising, the highest rate for 17 years, and the cost of paying the unemployed to do nothing is soaring. Inflation is running at 3.7 percent. Most galling of all, no doubt, for Cameron and Osborne, who were rushed into taking drastic measures when Bank of England Governor Mervyn King spooked them into believing the markets would punish them if they did not tackle the deficit right away, the rating agencies Moody's and Fitch have warned that notwithstanding the debt-reduction efforts, Britain could soon lose its AAA status.

Far from spurring the British economy to greater things, the Cameron coalition’s slash-and-scrimp policies have moved the government sector even deeper into debt. According to the latest Treasury figures, in February the current budget deficit rose to £11.1 billion. Borrowing rose to £15.2 billion. And the net public debt was £995 billion, or 63.1 percent of GDP. Critically for the coalition, even by the Treasury’s optimistic estimates, public-sector net debt as a percentage of GDP will continue to rise for another two years, maxing out at 76.3 percent just in time for Cameron to call a general election.

Debt reduction and austerity may be popular with the financial markets and Austrian economists, but British voters are fast beginning to tire of hard times. Cameron’s cry of “We’re all in this together” sounds a little hollow when he and his multimillionaire colleagues, such as Osborne – 23 of the 29 members of the Cabinet are worth more than $1.6 million – are so conspicuously not consuming the gruel they are feeding the rest of the nation. Cameron took five expensive high-profile family holidays last year, four of them abroad, all dutifully recorded in detail by Fleet Street’s finest.

from The Great Debate:

How the Industrial Revolution created modern debt

This is an excerpt from Paper Promises: Debt, Money and the New World Order, published this week by PublicAffairs.

Consumers have always borrowed money from friends, neighbors and relatives. Merchants would not exist without credit; the habit of making debts on a “slate” in the local butcher or greengrocer was still common in the middle of the twentieth century. But the local merchant would normally offer credit only to a known, local customer; serial defaulters, or those deemed to be untrustworthy, would be refused business. In David Copperfield, Mr. Micawber’s failure to repay merchants required him to cadge off his friends.

But the modern idea of widespread consumer credit (in the form of national lenders, credit cards, etc.) really dates to the Industrial Age. A peasant’s income is unlikely to grow over the long term; at best, it will be highly variable, with bumper harvests in good years giving the peasant sufficient income to pay off debt incurred in bad years. But two or three bad harvests in a row could be ruinous.

This point illustrates a wider truth. The granting of a loan requires both the creditor and the debtor to be confident that the latter’s income will grow sufficiently to repay the debt. Think of a retailer that sells a washing machine, or television, in installments. Clearly the customer does not have the money now; otherwise he or she would pay upfront. Moreover, the overall bill, including interest, will be greater than the cash price. So the debtor must be confident that he will stay in employment to pay the larger sum. In addition, he or she will probably be confident that their future income will rise so as to offset the additional interest. A growing economy makes that calculation all the more likely. The Industrial Revolution changed the pattern of human civilization. It allowed economic growth to expand at a much faster rate than ever seen before. This was probably down to the use of carbon-based fuels (wood, coal and, eventually, oil) to power technologies to replace human and animal labor. This resulted in a substantial increase in productivity.

Think of an economy as a business with inputs and outputs. An agrarian economy is often dubbed a subsistence economy; it takes all the energy of the workers (and their livestock) to produce the food necessary to live. A bull may plow a field, and reduce the effort of the farmer, but it takes a lot of land to feed the bull. The economy (business) does not produce a profit. Carbon-fuelled machines transform the situation. Initially, man naturally exploited those fuels that were easiest to reach; chopping down trees, getting coal nearest the surface and so on. So the output, in terms of goods and energy produced, was much greater than the effort put in.

The movement of people from the land to the new industrial cities also required an agrarian revolution. Those remaining on the land had now to produce a surplus, enough to feed the industrial workers as well as themselves. Fortunately, this happened, thanks to the consolidation of smallholdings, new farm machinery, crop rotation and a host of other small reforms. In turn, these improvements allowed the population to grow.

So we now had economic growth and population growth. The next stage emerged as workers gathered in factories. Initially, the conditions were terrible – long hours, low pay (albeit better than a farm laborer’s income) and non-existent safety standards. In the crowded towns, sanitation was poor, disease spread quickly and life expectancy was severely restricted. But factories made a big difference in that they grouped workers together and made it easier for them to organize in their own interest. That was very difficult for geographically dispersed agricultural workers. Steadily over the nineteenth century, trade unions grew in membership and workers flexed their muscles through strikes. Governments started to recognize their power and buy them off. Bismarck, a hard-headed pragmatist, introduced old-age pensions in Germany as a way of recruiting worker support for the Hohenzollern monarchy.

Capitalism and democracy under threat from euro zone crisis

By Laurence Copeland. The author is a professor of finance at Cardiff University Business School. The opinions expressed are his own.

It takes quite a lot to make me feel sorry for politicians, especially the European variety, but I must say that Nicholas Sarkozy and particularly Angela Merkel have a right to be livid at the news that the Greek government now proposes to hold a referendum on whether they will agree to be given another gigantic dollop of aid. Having only reached agreement (of a very vague kind) at last week’s summit in the early hours of the morning, you can imagine how the French and German leaders must have felt when they discovered that their marathon negotiating sessions may all have been in vain. It seems the Greeks are now too wary of foreigners bearing gifts to accept their largesse without weeks or months of prior deliberation and debate.

The acceptance of the referendum proposal is apparently not a foregone conclusion, which is just as well, since it is plainly insane.

First, consider the wording of the referendum question. Opinion polls appear to show that Greeks remain keen on staying in the EU (and maybe even in the euro zone), so as things stand at the moment the outcome could be a majority in favour of rejecting the deal, but staying in the EU.  But is this option still open to Greece? If not, the Greek government could end up with a mandate to follow a road that is already clearly blocked.

To pre-empt this scenario would require some sort of clear statement from Brussels about whether they would be willing to allow Greece to stay in the euro zone and/or EU if it rejected the latest round of austerity measures.

Even supposing the details of the referendum are sorted out, what then? How long is all this supposed to take? The vote could hardly go ahead before mid-January at the earliest. What on earth does Mr Papandreou think will be happening in the markets in the meantime?  Does he think they will simply sit on their hands and wait patiently for Greek democracy to grind through the gears?

In reality, the momentum of this crisis is so inexorable that you can be quite sure that the deal currently on offer will have become totally irrelevant by the time any referendum is held, if the offer hasn’t anyway been withdrawn by the time you read this.

Is there such a thing as a real safe haven?

By Kathleen Brooks. The opinions expressed are her own.

There are traditional relationships that the financial markets respect. For example, when the markets are tanking the world wants to own safe havens like the yen, the Swiss franc, U.S. debt and gold. If volatility spikes investors go into auto-mode and are almost pre-programmed to purchase these asset classes.

But just how safe are the safe havens? Both the Japanese and Swiss authorities intervened to limit the appreciation of their currencies in recent days. The Swiss National Bank (SNB) did so first by slashing interest rates and announcing a new QE program to flood the economy with money to try and put downward pressure on the franc. The Bank of Japan (BOJ) embarked on something similar, but they directly intervened and sold yen in the markets.

While some people will question the timing of the move, there can be no doubt that the Japanese and Swiss authorities don’t appreciate having currencies that are safe havens and will do all they can to try and break this association. The result has been volatility. The euro had rallied to record lows versus the Swiss franc before bouncing on news about the SNB. But once the dust settled investors went right back to doing what they have been told: buy yen and Swiss francs during market turbulence.

The essence of a safe haven should be stability. It needs to act in a predictable way during times of panic. However, the SNB and BOJ have turned this on its head. They are willing to fight the prevailing trend even if it means throwing good money after bad. But although the Swiss franc and the yen are both likely to keep their status for now, political risk for both currencies has surged higher.

So what about gold? It is considered the ultimate safe haven by some since it is not controlled by any government or central bank so there is no intervention risk. While that is technically true there are a couple of reasons why gold may not be as safe as everyone thinks it is. Firstly, it is traded on an exchange and that comes with its own set of risks. Margin calls can change if prices fall by a certain amount, also, as we saw last week, some investors are forced to sell gold and other “safe” assets to cover margin calls elsewhere, which means the price may not always react as you expect it to.

The ultimate safe haven is U.S. debt. The markets may be panicking about high levels of U.S. debt but they buy more of it. This argument is totally illogical but it is true. The reason why is that the U.S. debt market is the most liquid in the world. When investors get nervous they want something they can sell out of in an instant. Emerging markets may have stable debt levels; however their capital markets are far less developed than Treasuries. If you want to sell in a hurry you might find that there are no willing buyers and you are forced to hold on to it. This is what investors’ fear, so they flock to American markets not because they believe the U.S. debt problem is any better now than it was when the debt ceiling debate nearly caused a default, but because of its liquidity.

from Breakingviews:

Plunging markets reflect ugly political paralysis

By Agnes T. Crane The author is a Reuters Breakingviews columnist. The opinions expressed are her own.

Thursday's market plunge reflects, as much as anything, an ugly political paralysis. This phenomenon, rather than any particular headline, seems to have freaked out investors, sending U.S. stocks down around 4 percent at one point, Treasury yields below 2.5 percent, oil under $90 a barrel and even gold off 0.5 percent. Politicians' brinksmanship in Europe and the United States makes for great theater, but it has done little to resolve what most troubles the global economy: too much debt and no clear plan to pay it off.

Take Uncle Sam. Some lawmakers seemed willing to risk a self-inflicted catastrophic default. Yet the last minute agreement did nothing to address the long-term healthcare and Social Security burden -- by far the biggest danger to the nation's finances longer-term. The $2.4 trillion in hoped-for but nebulous spending cuts falls short of the $4 trillion needed to stabilize the U.S. debt-to-GDP ratio. And the deal ensures that the clearly slowing pace of economic growth can't be tackled with fiscal stimulus.

Europe, meanwhile, still looks lost in the weeds of its much more real and immediate debt crisis. The region has been trying to set things right for nearly two years since Greece's oversized debt load first appeared in the market's crosshairs. A series of EU-wide rescue packages may have been political achievements of sorts, but their failure to address the problem fully has left peripheral nations vulnerable to bond market sharks, with Italy the latest to feel their bite. Calls for a bigger European rescue fund and the European Central Bank's decision to intervene in markets again show the political classes floundering.

Predictably, many investors are holding out hope that central banks will ride to the rescue, as they have for the last four years, with further monetary stimulus. But it's no surprise their limited tools are no longer right for the job. Flooding the market with more cheap money surely can't be the right fix when the Bank of New York, for one, is now charging big depositors a fee to park cash in its vaults.

What's needed is a genuine effort to reduce debt, not just delay repayment one more time, as with the latest Greek bailout. Unfortunately that means making unpalatable choices, like opting for austerity and even tax hikes, at least temporarily. While the West's leaders instead flail and fudge the numbers, it's no wonder if investors lose faith.

U.S. debt downgrade: Who cares?

By Laurence Copeland. The opinions expressed are his own.

As I write this blog, it looks as though the U.S. Congress is going to pass a bill raising the debt ceiling and making modest cuts in Federal Government spending over the coming years. Although it is, quite rightly, being presented as a somewhat hollow victory for the forces of reason, there is one extremely puzzling aspect of the crisis.

It is being reported on all sides that the credit rating agencies may well downgrade U.S. sovereign debt in spite of this “happy ending” – indeed, Egan-Jones, one of the smaller agencies, cut its rating of U.S. debt some weeks ago, and there is much talk of Moody’s and S&P following suit in the very near future.

This is all rather puzzling. After all, a credit rating is an assessment of how reliably lenders can count on the borrowers repaying their dollar loans (principal plus interest) in full and on time.  Now the only scenario I can imagine in which the U.S. Treasury fails to meet its legal obligations to its creditors is one in which the Congress blocks a rise in the debt ceiling explicitly so as to bring about a default – and even then it would presumably require the collaboration of the executive because, as many people have pointed out in the current cliffhanger, even if further borrowing is impossible, U.S. tax revenues are far greater than the cost of servicing the debt.

In other words, the Administration can always pay its legal debts – it is only about to run out of money on August 2nd, in the sense that tax revenues are insufficient to cover legally required payments to Uncle Sam’s creditors plus hundreds of billions of dollars of other commitments which the federal Government is politically (and no doubt to a great extent morally), but not legally bound to pay, such as: social security payments, purchases (unless already ordered), wages to civil servants without contract, and so on and so forth. It can delay most of those payments without contravening criminal or civil law, and in most cases can walk away from its commitments altogether with no legal penalty, though of course the outcome might be politically or socially explosive.

In short, whichever way you tell the story, as far as I can tell, default by the USA (or indeed by Britain) could only occur as a result of a conscious political decision to do just that. By contrast, all the forecasts are that Greece will have no choice in the matter. The distinction, as I have pointed out before, is that while Greece’s debts are in a “foreign” currency – it has no right to print euros – the Fed or Bank of England can print as many dollars or pounds as it takes to repay their debts. In the process, of course, the domestic and foreign purchasing power of their currencies will be devastated, but they will have discharged their legal debts. As far as America is concerned, with the exception of a relatively small quantity of so-called TIPS (Treasury Inflation Protected Securities), U.S. bondholders have what economists call a purely nominal claim i.e. one that is denominated in current dollars, not dollars of constant purchasing power. By lending to the USA, they have given a hostage to fortune, a risk which, if they were wise, ought to have been reflected in the yield they demanded before buying the bonds in the first place.

All of which does nothing to resolve the original puzzle, because however dishonest, disreputable or unethical one may think is this scenario, “backdoor default”, as Mark Calabria of the Cato Institute has called it, does not qualify as a default in the sense relevant to the a country’s credit rating, nor (I assume) does it count as a credit event for the purposes of credit default swaps, the main instrument for insuring investors against default by bond issuers.

Another day, another crisis

By Laurence Copeland. The opinions expressed are his own.

Here we go again – the same sickening feeling, as stock markets reel amid a flight to “safety”. For months, there have been worries about contagion from the Greek imbroglio, and now the nightmare seems to be coming true, as one after another the weak European economies are put to the sword.

First came Greece and Ireland, then Portugal, now it’s the big league – Spain and, even bigger, Italy (and don’t forget Belgium, an accident waiting to happen for many years now, not very important in pure economic terms, but psychologically significant as the home of the whole sorry euro disaster).

In the table below, you can see how much Governments were being forced to pay for borrowing on the markets yesterday (July 11). The rates quoted for Greece, Portugal and Ireland imply that borrowing in the bond markets is for all practical purposes out of the question for those countries, as that has been the case for some months past, but the new development is that Italy and Spain are now being forced to pay 6 percent for 10-year loans, a premium of more than 3 percent compared to Germany.

from The Great Debate:

Five ways to correct the Greek debt crisis

By Mohamed El-Erian This piece is the English version of the one that appeared in Handelsblatt. The opinions expressed are his own.

Not a day goes by without a flood of comments on Greece and its debt problems. They seem to come from everywhere. Some are later denied while others are left to stand, accompanied by a continuous string of worrisome data. In the process, even greater disorder is gaining hold of the country’s debt markets, with credit spreads exploding in an ever more alarming fashion.

There is a risk that all this could serve to confuse rather than illuminate the key issues that should be on the radar screen of many, whether they are policymakers or normal citizens. I can think of five such issues.

First, there is a good reason why Europe’s current approach to Greece's problems has not worked well. Indeed, many, including me, believe it will not work any better going forward. Meanwhile, the costs and risks are growing exponentially.

Despite a year of large sacrifices on the part of Greek society and exceptional financial support from neighbors, Greece is still very far from regaining economic and financial stability. Output continues to collapse, unemployment is rising, the budget deficit remains alarming, and the already excessive debt burden is increasing further.

As a result, the country is no closer to re-establishing normal access to the global financial markets. New investors prefer to wait on the sideline, thereby starving the country of fresh capital. Meanwhile, doubtful liabilities are increasingly being transferred from creditors, who knew they were taking risks in lending to Greece (rather, for example, than buy German debt at a lower interest rates), to Greek and European tax payers as well as to the balance sheets of public organizations.

Second, the time has come to urgently recalibrate the EU/ECB/IMF approach to solving Greek’s debt crisis. This must start with an open recognition that an insufficient number of the original key objectives of the Greek adjustment program have been realized and, going forward, even fewer stand any realistic chance of being realized under the current approach. As a result, the country will not be able to harvest gains from the courageous steps taken to improve the efficiency and functioning of the public sector. Indeed, it could be forced to reverse them.

The U.S.’s big, fat political debt problem

By Kathleen Brooks

The U.S. has practically zero chance of solving its debt problem in the foreseeable future while politicians line up to contest the 2012 Presidential elections.

We have already heard President Obama lay out his partisan cards. He called for Congress to come up with a plan to trim $4 trillion from the U.S. deficit in the next 12 years. His favoured way to do this: end tax cuts for the rich – a well versed refrain from Democrats throughout the ages.

Ironically it was Obama who extended these tax cuts – for everyone – at the end of 2010, which arguably has contributed to the U.S. becoming the only G10 nation to have a rising budget deficit this year, according to the IMF.

The tax question obviously goaded the Republicans and the Speaker of the House of Representatives John Boehner immediately responded by saying that tax hikes were a non-starter. He argued that the U.S.’s fiscal problems were not down to a lack of revenue, but due to unbridled spending coming out of Washington. So there we have it: deadlock before we have even got started.

The wrangle over funding the 2011 budget that nearly closed the U.S. government earlier this month came down to an ideological fight between left and right, with those on the far right demanding cuts to programmes that didn’t support their ideology such as abortion programmes.

This highlights the level of detail and depth of discussion that will be held over the coming weeks and months to make even more radical cuts than those proposed for this year’s budget. Middle ground is virtually non-existent in Washington right now so a failure to come up with a credible deficit reduction plan in time for President Obama’s June deadline is looking increasingly more likely.

What to make of the U.S. resurgence

-Kathleen Brooks is research director at forex.com. The opinions expressed are her own.-

Back in the summer, things in the U.S. were so dire that the Fed had to step in to the breach and boost the economy with a $600 billion cash injection. This was only formally announced in November, yet within two months the outlook for the U.S. economy has brightened markedly. The dollar has had a flying start to the year and appreciated more than 2 per cent against the other major currencies.

But is this reversal in fortunes too good to be true and can the huge juggernaut of the U.S. economy really turn around this quickly?

The chief reason for the boost in investor sentiment, particularly towards the dollar, is the uptick in some of the major U.S. economic indicators. The widely watched ISM surveys have jumped in recent months and there are positive signs that the recovery that was noticeable in the manufacturing sector of the U.S. economy is now spreading to the much larger services sector. Investment houses rushed to revise higher their growth forecasts at the end of last year after President Obama agreed to a two-year extension of the Bush tax cuts. All of a sudden the U.S. economy was hitting the headlines again for all of the right reasons, and after giving the dollar a wide berth for most of the second half of 2010 investors are once again happy to own the greenback.

The U.S.’s economic outlook is even brighter when it is compared to its western counterparts. The euro zone and the UK face a year of tax hikes and austerity measures designed to reign in budget deficits, which should keep a lid on growth. Already at the start of the year we have seen the UK services sector slip back into contraction and Europe’s core economies are leaving the weaker peripheral nations in their wake when it comes to the growth stakes. In the last months of 2010 investors were willing to support the euro on the back of a bright outlook for the core economies, but not so in 2011 – the motto seems to have changed for investors to one of “the euro zone is only as strong as its weakest members”, which at the moment means it is extremely weak. So part of the dollar’s attraction is relative: at the moment its future is brighter than its neighbours’.

But, the U.S. is far from out of the woods itself and investors could be accused of lowering their standards. Jobs growth is mediocre at best and it will take many more months of 100,000 per month job creation to bring down the unemployment rate to a level more acceptable to the Federal Reserve. This doesn’t suggest the U.S. is in rude health. Due to these headwinds, we don’t think that the U.S. growth path will follow a straight line. But if we get another economic hiatus like the one last summer, will the Fed be able to provide another round of quantitative easing? Probably not that easily.

So while the near-term outlook for the U.S. economy is one of gathering momentum lending support to the dollar, the very policy measures that are supporting growth now will hurt it later. Quantitative easing and the extension of the Bush tax cuts are only exacerbating the U.S.’s unfathomably large debt mountain – at last count it stood at $14 trillion. The U.S. needs to sort out its debt problems at both a federal and state level (California has a budget gap this year of more than $20 billion). This means a lower dollar for the long term and higher inflation to try and erode the debt load.