In some ways, observing the economic upheavals of the last couple of years has been a little like watching a car crash in slow motion – very slow motion. And as May gives way to June, the crash reaches news heights.

Spain has had its credit rating downgraded, this time by Fitch, from AAA to + AA. The ECB has warned that there’s around 195 billion worth of debt sitting in the balance sheets of Eurozone banks that is set to go bad. The Centre for Economics and Business Research has said that Greece has no other option but to exit the euro and default on its debt. Meanwhile, fears of a crash in China’s housing bubble are growing, and in the UK, the removal of HIPs is already providing strong evidence of a shift in the housing market which could spark off big falls. Meanwhile, the Dow suffered its worst May in 70 years.

But maybe we are not seeing a slow-motion car crash at all. What we are witnessing may ultimately prove to be good news, but perhaps what we are really seeing is something akin to a slow-motion visit to the dentist who is extracting some nasty teeth without the use of an effective anaesthetic. Once the tooth is gone, things will be better, but, boy, is it hurting.

Here are a couple of points you should bear in mind before you go any further. Look beneath the economic crisis and you should be salivating over how strong the economic prospects are. Globalisation is creating wealth at an extraordinary rate. In countries such as China and India we are moving closer to a day when poverty is all but eradicated. Globally, capacity based on existing levels of capital is greater today than ever before. Globalisation means that countries have been able to focus on what they are good at, and as a result productivity levels are rising fast. Secondly, there’s technological advance. Put globalisation and new technology together and we see the prospects for a golden age of prosperity. There is nothing illusory about this potential. The global economy’s capacity for producing goods and services is rising.

It is a tad ironic that we suffer from such a nasty crisis at such a time of opportunity.

Where the view here is unusial is that we would argue that the crisis of today is actually being caused by all this new potential. Furthermore, we would say it was like this in the 1930s. Never forget that the Great Depression followed an unprecedented 50-year period of technical innovation.

It is possible that the big crises, like the one we are going through now, are caused because we become victims of success. Rapid progress can create upheaval in the short run.

This is what has happened so far.

During the noughties we seemed to be on the verge of enjoying the best period of economic growth ever. The UK went for 16 years without recession, and the global economy expanded at an extraordinary pace. But we also saw the emergence of global imbalances.

These imbalances manifested themselves in the form of some countries seeing a massive trade surplus; others, an equally massive deficit. But we also saw the ascendance of capital over labour. Corporate profits took an ever higher share of GDP, wages a smaller share. As a result, household discretionary disposable income did not rise as fast as growth. See Did globalisation cause the economic crisis?

So what happens if productivity is rising, but demand is not keeping pace? Answer, you get recession.

During the noughties, however, consumer spending was kept high via consumer debt. Savings from surplus countries and the corporate world meant that the money markets were flooded with cash, and interest rates fell – at one point the long-term rate of interest was lower than the rate set by central banks. (This is known as inversion of the yield curve, something Alan Greenspan called a ‘conundrum’. In fact, there was no conundrum; the low interest rates set by the markets were caused by a savings glut.)

Low interest rates and the easy availability of money led to housing bubbles, which made consumers feel wealthier, and so they spent more, even though the growth in their earnings was not that impressive at all. The advent of mortgage securitisation was a symptom of the times, not a cause of today’s crisis.

That is why it is simplistic to say we have a debt crisis. What we really have is a crisis in the distribution of the fruits of globalisation and new technology.

The credit crunch represented stage two in the story. House prices had reached levels which even in times of easy money were ridiculous. Curiously, the great housing crash began in the US, where prices were much cheaper relative to income than elsewhere.

The savagery of stage two was diminished by banking bailouts, rock bottom interest rates, fiscal stimulus and quantitative easing. But none of these measures helped to deal with the underlying problem of how the fruits of growth were not being effectively distributed.

The housing crisis and the resentment of bankers are both symptoms of these problems. As is the social unrest that seems to be accompanying fiscal cutbacks.

The new UK government wants to see the Bank of England take into account house price inflation when setting interest rates. This debate is also a manifestation of the same underlying problems.

The euro crisis is an extra issue. The formation of the single currency added to the problems of imbalances.

In the UK, we suffered from what has become known as the Dutch Disease, from the time when North Sea oil pushed up the price of the Dutch guilder, making the rest of the economy uncompetitive.
In the UK it was the City which pushed up sterling, making life almost impossible for manufacturers.
But, now, the cheaper pound is an important factor in the realignment of the UK economy, and a small factor in the realignment of the global economy.

But it is not enough. It is hard to see how Greece has any alternative but to exit the euro and then default. The only other option would be for the rest of the euro countries to accept that Greece is a basket case and just throw money at it, ad infinitum.

But if Greece leaves the euro and defaults, it is hard to see how Spain, Portugal and the rest can avoid a similar fate.

If the real underlying problem of the global economy is that the fruits of growth are not being distributed, then it is clear that one possible consequence will be default by those in debt.

Stage three in the crisis may be the point we are now getting to. In this stage we are likely to see debt default. In the UK and Spain, and maybe France, we are likely to see a continuation of the housing crisis that went into sudden reverse in 2009. There are already signs this has begun in the UK. According to estate agent Countrywide, there has been a sharp rise in new properties coming onto the market following the government’s announcement that it was scrapping HIPs with immediate effect.

In the US house prices are still falling. The level of stock of property for sale is consistent with sharp falls in prices. The removal of the tax credit on mortgages can only exacerbate the problem. Although US house prices are cheap relative to income, there are disturbing similarities between the US housing market now, and the Japanese market in the early 1990s.

In China, fears of a bursting in the housing bubble are growing. According to Bloomberg: “Dollar bonds sold by China real estate companies this year are the worst performers among Asian non-financial corporate debt,” meaning markets are becoming increasingly concerned over a possible bursting of the Chinese housing bubble. In an interview in the FT, Li Daokui, an economics professor who is a member of China’s central bank’s rate setting committee, said: “The housing market problem in China is actually much, much more fundamental, much bigger than the housing market problem in the US and UK before your financial crisis … It is more than a bubble problem.” He also said: “When prices go up, many people, especially young people, become very anxious … It is a social problem.”

Mr Li also said China needs to allow gradual appreciation of the yuan.

A rising yuan may be essential for China to avoid inflation and continuation of the inflation of a housing bubble.

The beginning of the end of crisis will only occur once we see a more expensive yuan and German currency, and a cheaper dollar, sterling and cheaper currencies for the PIIGS. But that on its own won’t be enough. The visit to the economic dentist will only end when we see a change in the way GDP cake is divided.

The above article is a follow up to the piece below, written on 27 January

The UK economy, peeking behind the economic wallpaper

In the final quarter of 2009 the UK managed a passable impersonation of a drunk staggering out of the Inn of Deep Recession. We are out of recession, but only by the skin of our teeth. Will the drunk be able to manage the long walk home?

Then there’s Bill Gross, he knows a thing or two about investing. Among the various accolades thrown at him is the description as the most successful bond trader of his generation.  And this is what he had to say about the UK, or in particular about UK government bonds: “The UK is a must to avoid. Its gilts are resting on a bed of nitroglycerine.”

Then there’s the IMF. It is in report mode at the moment. Late January is the time of the year when the International Monetary Fund makes its economists work. There’s its World Economic Outlook survey – that wasn’t too bad. Then there’s its Global Financial Stability Report – that wasn’t so pretty.

Then there’s Japan; the economy of the rising sun has suffered a nasty blow.

It is time to take stock. Some are saying there’s a double dip recession on its way for the UK. And yet others have predicted a new boom time for the UK.

Churchill once said: “If you get two economists in the room you get two opinions. Unless one of them is Lord Keynes, in which case you get three opinions.”

Well, right now it seems that, if anything, there are more different points of view than there are economists.  Opinions on the economy are like those gondolas you see in Venice that Monty Python once referred to.  They are everywhere.
The bed of “nitroglycerine.”

And to begin, let’s take another look at what that nitroglycerine man, Bill Gross, had to say.
In Pimco’s February newsletter to its investors, Bill Gross said:

“Having survived due to a steady two-trillion-dollar-plus dose of government ‘Red Bull,’ Adderall, or simply strong black coffee, the global private sector is now expected by some to detox and resume a normal cyclical schedule where animal spirits and the willingness to take risk move front and centre. But there is a problem. While corporations may be heading in that direction due to steep yield curves and government check writing that have partially repaired their balance sheets, their consumer customers remain fully levered and undercapitalised with little hope of escaping rehab as long as unemployment and underemployment remain at 10-20 per cent levels worldwide…”

He added: “The true legacy of banking crises is greater public indebtedness, far beyond the direct headline costs of bailout packages. On average a country’s outstanding debt nearly doubles within three years following the crisis.” He continued: “The aftermath of banking crises is associated with an average increase of seven percentage points in the unemployment rate, which remains elevated for five years…Once a country’s public debt exceeds 90 per cent of GDP, its economic growth rate slows by 1 per cent.”

Finally, comes the killer: “Of all of the developed countries, three broad fixed-income observations stand out: 1) given enough liquidity and current yields I would prefer to invest money in Canada. Its conservative banks never did participate in the housing crisis and it moved toward and stayed closer to fiscal balance than any other country, 2) Germany is the safest, most liquid sovereign alternative, although its leadership and the EU’s potential stance toward bailouts of Greece and Ireland must be watched. Think AIG and GMAC and you have a similar comparative predicament, and 3) the UK is a must to avoid. Its Gilts are resting on a bed of nitroglycerine. High debt with the potential to devalue its currency present high risks for bond investors.”

What the stats say

According to the ONS, the UK expanded by a trifling 0.3 per cent in the final quarter of last year. Manufacturing managed a 0.4 per cent recovery, services 0.1 per cent, while agriculture contracted by 1 per cent and energy supply by 3.3 per cent.

The 0.4 per cent recovery in manufacturing was disappointing. Thanks to the turning inventory cycle, economies around the world that rely heavily on manufacturing have been enjoying robust expansion. The UK may only boast a relatively small manufacturing sector, but why is it that even in what’s left of the sector, and despite the cheap pound, the recovery was so lacklustre? The normally reliable Purchasing Managers indices from CIPS/Markit suggested manufacturing was recovering strongly. The headline index tracking services has been above the long-run average for three months now. And yet the services sector growth rate was tiny.

Maybe when the ONS revises its data, it will be revised upwards, and by quite a bit. Maybe the fact that ONS data was so much at odds with the survey evidence suggests that the official data is simply too low. It does seem that in the past, ONS preliminary estimates of growth underestimated the strength of the downturn going into a recession, and therefore got revised downwards, and underestimated the strength of recovery coming out. So there has to be a good chance the ONS figures paint a picture that is worse than reality. But, equally, it is possible that the ONS will eventually downgrade its figures, and then we will find that the UK was in fact still in recession during the final few months of the last decade.

The glass is half empty

It is ridiculously easy to present a case to suggest the UK is heading for far worse times. Unemployment may not have risen to the extent that many feared, but the fact is the relatively modest rises in unemployment were paid for by workers accepting lower pay increases, even decreases, and working fewer hours. According to the Chartered Institute of Personnel, no less than two thirds of people who were made redundant were paid 28 per cent less money when they finally found a new job.  See Jobs: flexibility has changed the rules  

In a survey carried out by Bloomberg in which investors were asked to say if they were more or less optimistic about certain economies, the UK came out bottom. See Investors give UK thumbs down as US enjoys best quarter in four years.

It is clear that tax will rise, hitting our disposable income levels hard. Recently, Verdict Research predicted that the amount of money we have left over after paying key bills will be less in 2013 than today. See: We will be worse off in 2013 says report  

Then there’s the rate of interest. The low cost of borrowing is surely the main reason why house prices are picking up at the moment.  But how long will rates stay low? It has been argued here before that thanks to the impending retirement of the baby boomers, savings will increase and this will act to keep interest rates low.  But it’s a complicated world, and who knows what’s around the corner. Should inflation start rising again, or should the UK’s debt level lead to a crash in sterling, interest rates may be forced upwards quite rapidly. This would be catastrophic.

Consumer affordability will also be stretched by rising raw material costs, energy, and perhaps food. 

It is also clear that the government will have to make cuts. The inevitable result of this will be job losses.

The big impending problem lurking for the UK, however, is baby boomer retirement. The fact is, the UK has run up huge debts during a period in which we should have been saving for the time when the size of the working population starts falling relative to the size of the retired population. Now that reality has dawned on many that their house does not make for a reliable pension, we will surely see a sharp rise in savings.  This will suck demand out of the economy. Those baby boomers who have an inadequate amount stashed away are set to feel the financial consequences of this.

No wonder many are warning the UK could be about to experience a Japanese style lost decade.

And by the way, the Japanese lost decade has been going on for twenty years now.

Sovereign default

Although this column has argued a UK government debt default is unlikely, it remains a possibility.

Whenever economists try to defend the UK’s level of fiscal debt, they often point to Japan, where debt is much higher.  On January 26, Japan’s credit rating was downgraded by Standard and Poor’s from AA to –AA. Okay, Japan’s credit rating was at this level for much of the noughties (between 2002 and 2007).  But it is a worrying trend. There are some important points about Japan.  Japan’s massive level of debt has in part been affordable because Japanese consumers have been saving with such gusto. The money they saved found its way into government bonds. In other words, Japanese fiscal debt is simply the other side of a coin which says massive Japanese savings.   In the UK we don’t have that underlying strength.  There is another point about Japan. Its population is ageing to an even greater extent than the European population.  It is far from certain that the Japanese government will be able to continue to fund its enormous debts when the working population starts shrinking

So to the argument that UK fiscal debt is affordable because it is affordable in Japan, here are two arguments back. Firstly, Japan is different because consumers save more. Secondly, the Japanese story is not over. Just because she has managed debt so far it doesn’t mean she will be able to do so in the future.

Returning to Bill Gross, in his newsletter which waxed lyrical about nitroglycerine, he also talked about a ring of fire. The fire surrounding countries with big debts, which includes France, Italy, Japan, Spain, the US and good old Blighty.

On the other hand, much of the UK’s government debt is held in bonds that are several years away from maturity, and therefore the UK will have less problem funding existing debt than other highly indebted nations.

Capital Economics, by the way, reckons 2010 will be the year of gilts. It has a contrary view on how markets will react to any halt in quantitative easing. While most reckon that as monetary policy is tightened, the result will be lower demand for government debt, Capital Economics reckons the opposite will occur. It says investors will turn from risk, ditch equities and rush for safety. Traditionally, a flight from risk means gilts surge in price, meaning their yield falls. 

Perversely, then, it reckons that as quantitative easing is reversed, the cost of funding government debt may fall.

 Fiscal Deficit: Darling sides with the Tories, and the media divide grows

And is the UK bust?

The US 

Recent data on the US economy says she is booming.  Annualised growth in Q4 was an impressive 5.7 per cent.

On the other hand, US Consumer Confidence, as measured by the Conference Board, is low.

There are plenty of those who fear a double dip recession in the US.    Then again, US productivity is rising at an extraordinary pace. If the US can find a way of maintaining this rise in productivity when employment starts to rise, it will have managed something quite special. Technological advances mean that this is quite possible.

See Krugman warns of US double dip – but for different reason from the other doomsters

Another crisis

In its financial stability report, the IMF warned that: “Even though some bank capital has been raised, substantial additional capital may be needed to support the recovery of credit and sustain economic growth under expected new Basel capital adequacy standards.”

More alarmingly, a recent report from the World Economics Forum (that’s the organisers of Davos) warned that there are several risks of another major crisis. It said: “Fiscal crises and unemployment, underinvestment in infrastructure and chronic disease are identified as the pivotal areas of risk over the next years.”
See Risk of meltdown II has not gone away

Economic forecasting

 Let’s face it, the economic forecasts have not had a good recession. Galbratih once said: “The only benefit of economic forecasting is that it makes astrology look respectable.” But, just for the fun of it, let’s take a quick look at the latest projections from the IMF.

It reckons the UK will expand by 1.3 per cent this year, and by 2.7 per cent next. In fact, it has forecast a higher growth rate for Britain in 2010 than for the euro area. It has Spain still in recession. But for the G7 economies, however, the IMF has the UK languishing in bottom place.

On the other hand, for 2011, the IMF has the UK outdoing all G7 economies with the exception of Canada

It expects China to expand by 10 per cent this year and by 9.7 per cent next; India, by 7.7 and 7.8 per cent; Brazil by 4.7 and 3.7 per cent; and Russia by 2.6 and 3.4 per cent.

Of all the economies mentioned in the report, Spain is expected to be the last to leave recession.   It also expects Spain to be the worst performing economy, and the euro area in general to see a growth rate of just 1.6 per cent next year.

The UK’s opportunity

But Goldman Sachs is more optimistic about the UK

But Goldman Sachs is more optimistic about the UK.
Goldman Sachs’ star economist, Jim O’Neill, reckons the British economy will expand by 3.4 per cent in 2010, compared to a growth rate of just 2.4 per cent in the US and 1.9 per cent in the Eurozone.

The reasoning behind his prediction is not rocket science. The UK’s growth will be born of the cheap pound. Of course the dollar has fallen too, but not as steeply as the pound, which has dropped from an exchange rate of approaching $2.1 to the pound a couple of years ago, to just $1.61 at the time writing. (Although for much of last year the pound was even cheaper against the greenback.)

The UK’s big opportunities come on three fronts.

Firstly there’s the cheap pound. This will surely lead to greater exports, eventually.

Then there’s the City. What with Barack Obama hitting bankers even harder than Alistair Darling, it seems a City exodus is being avoided.  Once globalisation gets back on course, the City could grow to a size that even dwarfs its current level. The government needs to find a way of ensuring a City recovery benefits the wider economy. The dangers to this are twofold. Firstly, the popular backlash against bankers could ultimately destroy what could become our golden goose. Secondly, a City recovery could push the value of the pound back up, killing an export-led recovery.

The final opportunity for the UK lies in bio-tech.  This is one of the few industries where the UK does lead the world, and it happens to be an industry with massive potential. Recent advances in genetic science could translate into extraordinary opportunity for this sector.

For more articles covering this see:

The next decade, why hope lurks at bottom of Pandora’s Box of ills

UK to lead developed world recovery

And for the demographic threat, see

The demographic punch