27th December 2014

Problems with the Euro

As anti-Euro parties are polling 50% in Italy what is the currencies future

An interesting article in The Observer this week documenting the decline in support for the Euro in Italy. It has reached a point where political parties favouring an exit are polling 50%. Mean will across the Adriatic there is the prospect of the radical Syriza gaining power in Greece which could lead to a Greek exit. All of a sudden the unthinkable is becoming a real possibility; the end of the Euro. It is not going to happen tomorrow but the longer the politics of austerity persist the more likely it becomes. Once one country exits and probably prosper then others will follow. Then who knows what the consequences will be especially with the euro as such a central part of the European project.

With hindsight its failure is rooted in a number of problems. As Britain's exit from the ERM in 1993, the precursor to the Euro, show economies do not grow at the same rate. This highlights the tensions that will occur if they are not removed by variable foreign exchange rates however these problems are magnified when a range of diverse economies are brought together. Generally the needs of an industrial economy will be different to those with a large agricultural or service sector. Normally easy money is required for industrial growth but elsewhere this will lead to asset inflation and this exemplified again by the difficulties Britain has had in finding an interest rate that promotes growth without overheating the housing market. Contrast this with setting an interest rate for Germany with that of the P.I.G.S. Portugal, Ireland, Greece and Spain. Nevertheless if one looks across the Atlantic to the USA these tensions seemed to be accommodated however there are a number of key differences between the currencies. Whilst the population of Eurozone exceeds that of the USA the euro has none of the benefits of world currency. The least significant of these is that it is not considered a safe haven in times of trouble but this is a reflection of greater problems. More importantly it is not the currency of choice for trading in commodities which continues to allow the rest of the world to subsidise the US economy; to obtain the currency to buy these commodities one has to sell goods in the US or a case of exchanging real wealth for tokens.

Secondly the Euro is the currency of a number of sovereign states whereas the dollar is that a single country. This means that that redistribution of income through taxes or other measure is more pronounced in the Eurozone even during times of difficulty. There are also historical differences. In the past banks were state institutions rather than federal and until comparatively recently interstate banking groups were banned. This had the effect of tying the lending institutions to the local economy which acted on as break on local asset inflation. However as the US has relaxed its banking laws so to has the problem of accommodating its divergent economies, cumulating in the crash of 2008. The problems of the Euro being a collective currency are made all the worse by Germany's historic neurosis over a strong currency. Being one of the stronger economies it was able to demand that the other countries adopt stricter controls such that it tried to model the rest of Europe in its own image. In hindsight this was bound to fail for the reasons given above however while there was strong demand for credit the world economy grew these conditions did not appear to be too onerous. With the collapse of demand and austerity the result is a shrinking economy. Keynes has fallen out of favour but the way in which to reverse this trend is for spending. In these times it is difficult justify it within a single country but the political setup of the Euro, with Germany seeing itself as the paymaster makes it almost impossible. Unsurprisingly the terms of the Euro agreement favour Germany, even in these times of austerity where the poor performance of the rest of the Eurozone has depressed the currency allowing German exports to remain competitive. But this now proves to be a short term fix as the even its own economy stagnates due to the shrinking of its export markets. The situation is made worst by European Central Bank's policy of keeping interest rates low. As there is unlikely to be any change in Germany opinion both public and governmental in the near future the contraction of the Eurozone will continue. This will almost certainly lead to at least one country leaving it.

Despite all these difficulties there are some merits to the Euro or the project would never have been embarked on. The ability to trade across the whole of the Eurozone without any transaction cost being one and removing price differentials is another. The argument has always been portrayed as a single currency or not but there is an alternative, a dual currency system. A euro would be legal alongside the national local currency but movement would be allowed between the two. Prices would be set in both currencies and there would also be bank accounts in each currency. People, companies and governments could pay, be paid or borrow in each as they choose. It brings together the advantages of a common trading currency but allowing governments the freedom to set monetary policy to suit their economy's needs. Of course this introduces complexity but there are many parts of the world were such informal systems exist without problems.

7th December 2014

The Autumn Statement's Real Message

As the dust settles from the Autumn Statement the real news is the prediction that for borrowing to be bought under control the state will have to shrink so that it is less than 35% of GDP by 2020. We are told that such a cut would transform the role of the state and has been welcomed by proponents of the small state. With health, education and aid protected this heaps the burden on other departments some of which are threaten with closure under these plans. But where will these further cuts be made. History suggests that large cuts like these are difficult to make, both Thatcher and Reagan tried and failed, and the omens are not good for the Chancellor as he has not even met his more modest challenge of removing the deficit. The military have been unable to recruit the reservists that are to replace the full timers. The prison system is showing signs of strain with increased disturbances. The justice system is starting snarl up due to the lack of legal aid. Roads are already in a state of poor repair and local councils are now struggling with their care responsibility that can only grow. The police have seemed to cope but is it wise to seek further reductions with so many uncertainties? There may be savings in Business or Energy Departments but these are the organisations that promote growth. Then there are the big ticket items like the replacement for Trident or HS2 but these too have their supporters.However it turns out that the government finances and the economy are in a worse state than this scenario would suggest because it is based on consumers taking on a lot more debt to continue the current boom. In fact for the government's plan to work it requires consumers to borrow at levels that were consider unsustainable in 2008. With mortgages lending falling this is unlikely even if there was an appetite for more borrowing. This highlights that the government's finances are not going to be cured by austerity alone.

This is a real crisis but you would not know it from the media, there is soviet feel to the news, GDP is up! Much like Pravda use to declare for tractor production. In both cases there may be truth in the individual statistics but they have a disconnect with greater reality. We can continue to delude ourselves while the rest of the world is still keen to supply us goods on tick but even that may come to end at some point. To put it simply the cause of many of our problem is that do not make enough. There has been a lot of talk about rebalancing the economy but it is still easier to make money from buying existing properties and until we address this dilemma we will neither fix the economy or the government's finances. We cannot expect 'the market' to sort it out as it is actual amplifying the forces involved so it will require government intervention. A first step will be to raise interest rates to more normal levels of 4% to 5%. This will reduce the price of a home for reasons explained elsewhere; it will increase the money supply and raise the level of inflation. All of which will beneficial for the current economy but even this may not be enough. We may need to raise capital gains tax and split away the investment part of bank from the retail side but that is for another blog. Such decisions will not be popular but if we carry on like this we may reach a position where will not be able to feed ourselves.

4th December 2014

The Chancellor's Autumn Statement Rabbit

As predicted by many commentators the Chancellor of the Exchequer left himself one rabbit to pull out of the hat for and that is the change to stamp duty. Whilst dressed as a reform to a tax it is more of a cynical attempt to prolong the housing boom that has been the driver of much of the growth in the UK economy. However despite allowing some to increase their deposit its effect is likely to be limited. The reason is that being that buying a house for most people has three components; borrowing costs; other costs such as taxes and surveys and the price of the house itself. The sum of these generally defines what is affordable. So as seen in the past a drop in interest rates or in this case stamp duty will see house prices quickly rise such that the overall cost remain much the same. However under the new banking rules lending is also based on affordability and the ability to repay so in all likelihood the number of people who will be able to afford to buy a home will also remain unchanged. This all come on a decline in the amounts advanced for mortgages and other lending with the exception credit cards. So as it is the interest repayments that lead to an increase in the money supply that in turn fuels growth we can expect GDP to fall back over the next quarter.

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