Tuesday, November 29, 2011

The Downwards Spiral: the UK

The headlines; the UK economy is sliding and government borrowing is not going to meet projections:

The Government is set to borrow £111 billion more over the next five years than previously expected, with borrowing peaking at £127 billion this year before declining to £53 billion by 2015/16.
The Office for Budget Responsibility (OBR) has now issued its latest review, and it makes interesting reading. Perhaps the most worrying aspect of the whole thing is that there is an assumption that (by some miracle) the Euro will somehow muddle through. This is from 'Economic Outlook', 1.16:

On the assumption that the euro area struggles through its current difficulties, we expect the economy to gain momentum gradually through next year. But the headline measure of GDP is likely to be broadly flat until the second half, partly due to various one-off factors. Consistent with this profile, we have revised down our central forecast for year-on-year GDP growth to 0.7 per cent in 2012, compared to the 1.2 per cent average forecast among external analysts.
And this is section 1.21:

Our central forecast assumes that the euro area finds a way through the current crisis and that policymakers eventually find a solution that delivers sovereign debt sustainability. A more disorderly outcome is clearly possible. This poses a significant downside risk to the central forecast, but one that cannot be quantified in a meaningful way given the numerous ways in which it might unfold.
There is an important point to note here. The central forecast assumes that there will be a Euro solution. It is hard to match this forecast with the events that are taking place. As we have seen over the past few weeks, the descent into crisis is accelerating, not slowing for the Euro. For example, today we have a headline that Italy has had to pay over 7% on ten year bonds at the latest auction. Last week a German bond auction was a worrying dud. Whilst there are arguments about the cause, it is still indicative of a wider 'loss of faith' in the Euro. In a recent post, I showed a diagram of risk exposures to sovereign debt crises, and the UK was just one of the countries with a heavy exposure to European sovereign debt defaults (also, see OBR report p.63 for details). And, of course, Europe is a key element in the UK's international trade.

Bearing in mind that the OBR forecast overall is therefore probably a work of fantasy, there are some interesting elements in the report. The OBR has belatedly started to recognise something that regular readers of the blog will already know; that the UK's problems are deeper than previously realised. This is a neat summary from the Wall Street Journal:

The OBR said the output gap--the difference between what the economy can potentially produce and what it is producing--is smaller than previously thought, reducing it to -2.7% for 2011 from the -3.9% estimated in March. This means that more of the deficit is structural, making Osborne's goal of eliminating it more challenging.
Regular readers will know that I have little time for the notion of the 'output gap', and have argued that it ignores the underlying structure of the UK economy that is based upon ongoing growing debt fuelled consumption. These figures are a finding of what should have been obvious, but the figures still flatter the situation. There are large sectors of the economy that are still largely distorted to service consumption based upon debt, and these are only just starting to contract.

The final point I want to pull from the OBR is the useful analysis of consumer disposable income, confidence and spending. The big picture is that consumers are not pulling out their wallets, and there is little prospect of doing so for a while yet. This should come as no surprise in light of rising unemployment in combination with  low wage growth versus inflation. The situation is just going to get worse, and this will lever the economy down, as the sectors of the economy that service consumer spending shrink back, and in turn this increases unemployment.

All in all, even without a Euro crisis, the UK economy was likely to be hit very hard as the government sought to reign in growth in borrowing. Also, it must be remembered that this dire economic outlook is set against a backdrop in which government borrowing levels are still outrageously high. So-called austerity still means supporting the economy through a huge stimulus from the government, and a stimulus that is funded by borrowed money (borrowing that is secured against future taxpayer income). Even using the OBR's optimistic forecasts, and bearing in mind that the off-balance sheet obligations are not included, the national debt will grow from 67% of GDP to 78%. However, I do not like these circular understandings of debt ratios. The net debt forecast is £bn; 2010-11 = 905, 2011-12=1044, 2012-13=1182, 2013-4=1300. This does not look very austere to me.

Some newer readers might be surprised at the word 'stimulus' used above. However, what else can we call such huge government borrowing (or rather taxpayer borrowing facilitated - signed for on behalf of taxpayers by the government). It is a massive stimulus to the economy but, despite this (and low interest rate) stimulus, there is only one way ahead for activity in the UK economy; it will shrink. The structural problems in the UK economy were built up as a result of years of debt-fuelled consumption, the government filled the gap in growth in debt based consumption, and is now trying to reverse this course. On top of this, there is the crisis in the Euro zone. The only direction the economy can go is down; there are no sources of economic growth. This is from Tullet Prebon's Dr. Tim Morgan, commenting on the autumn statement (distibuted by email):
The real problem which confronts the UK is that the economy has been skewed by a bubble-decade of private borrowing and public spending, a decade for which Osborne’s predecessors must shoulder most of the blame. Interest rates were kept too low, individuals ramped up their borrowing on the basis of unsustainable property price escalation, and the previous government spent not just up to, but far beyond, a boom whose real bubble nature it completely misunderstood. 
This is precisely correct. The fundamental problem is this. The UK is borrowing gargantuan amounts of money in the face of almost certain economic contraction. As such, it is borrowing ever more money with reduced prospects for income to service the borrowing in the future. It is not really as complicated as many would like to propose. Something must give. In recent times, the bond markets have been relatively kindly to the UK, but it can only be a matter of time before they start to work out the contradictions in the UK economy, or start to see the contradictions playing out in the statistics. The OBR's blated recognition of the structural nature of the deficit is just the start. The OBR have yet to recognise quite how terrible the situation is.

In a recent post, I discussed the way in which governments would piecemeal address the problems in their economy - a small cut here, an adjustment there. The only way out of the mess is for governments to confront the underlying problem that they simply cannot afford to continue spending on what I called 'luxuries'. The only route out, however painful is to have a medium term target of zero borrowing, however painful that might be. As it is, this is what I said for the countries that were debt laden:

As it is, each country that faces crisis will no doubt continue to nibble at the luxuries. As they do so, they will fail to address necessity versus luxury, and the crisis will continue as each nibble fails to achieve stability, and thereby forces a new nibble at yet another luxury. It is the way that Greece has gone, and the way ahead for the other overly indebted countries. Nibbling into oblivion. 
This is the current state of the UK. For all of George Osborne's good intention, he is nibbling in the face of a catastrophic downward spiral. It is not enough, and this will become apparent over time. Right now there may still be time to determine what is an absolute necessity and what has to be consigned to luxury. As it is, as Greece found out, if no action is taken soon enough, others may  well make that determination for the UK.

Note: Thanks for the comments on recent posts. One question that came up was to ask how a Euro break-up might develop, and what consequences. I have been giving a lot of thought to this, and the problem I am confronted with is this; any break up of the Euro would be an event that start a period of 'chaos'. By this, I mean that we cannot predict either government or market reactions to this kind of event in the short term, as there will be some kind of panic resulting from the crisis. The short term reactions will largely determine the nature of the medium term actions, so prediction is simply not possible. I can only say that in both the short and medium term (five years out), it will not be good.

In light of this, and the potential complexity of the situation, without even having comparable situation to draw upon, I am ever more puzzled at the confident assertions of those who predict x, y or z. Just for a start, think of the possibilities for core Euro zones versus complete break-up. What will finally determine the end game? What will Germany do if Greece defaults, or Spain, or Italy? What will France do, and how will that interact with Germany's approach. What about the ECB - will it ride to the rescue in the face of conflagration? Will that save the Euro, or just delay the day of reckoning? There are endless scenarios, and it seems that predicting one type of outcome would be extremely difficult. However, with the number of predictions out there, perhaps someone will get it right?

Tuesday, November 22, 2011

US Banks and the Euro Crisis

In a post a short just over two weeks ago, I suggested that the response to the European sovereign debt crisis was in part being influenced by the 'too big to fail' banks, including the large US banks exposed to European debt. As the European crisis lurches forwards, the exposure of the too big to fail banks is starting to see the light of day. For example, the following is a graphic from EconMatters on Business Insider, originally from the New York Times:

From NYT, Oct 23, 2011

It's  great visual illustration of the linkages between the different debtors, though the colour scheme is extremely questionable. The concern has now become concrete, with the following from Reuters:

The U.S. Federal Reserve plans to stress test six large U.S. banks against a hypothetical market shock, including a deterioration of the European debt crisis, as part of an annual review of bank health.
The Fed said it will publish next year the results of the tests for six banks that have large trading operations: Bank of America (BAC.N), Citigroup (C.N), Goldman Sachs (GS.N), JPMorgan Chase (JPM.N), Morgan Stanley (MS.N) and Wells Fargo (WFC.N).

"They are clearly worried about the issue of Europe," said Nancy Bush, a longtime bank analyst and contributing editor at SNL Financial. "In a time of risk aversion and concern, you need transparency."
The Fed said its global market shock test for those banks will be generally based on price and rate movements that occurred in the second half of 2008, and also on "potential sharp market price movements in European sovereign and financial sectors."
Meanwhile, as the Independent newspaper points out, the 'technocrats' and leaders of Europe are being recruited from the alumni of the too big to fail banks:

The ascension of Mario Monti to the Italian prime ministership is remarkable for more reasons than it is possible to count. By replacing the scandal-surfing Silvio Berlusconi, Italy has dislodged the undislodgeable. By imposing rule by unelected technocrats, it has suspended the normal rules of democracy, and maybe democracy itself. And by putting a senior adviser at Goldman Sachs in charge of a Western nation, it has taken to new heights the political power of an investment bank that you might have thought was prohibitively politically toxic.

This is the most remarkable thing of all: a giant leap forward for, or perhaps even the successful culmination of, the Goldman Sachs Project.
It is not just Mr Monti. The European Central Bank, another crucial player in the sovereign debt drama, is under ex-Goldman management, and the investment bank's alumni hold sway in the corridors of power in almost every European nation, as they have done in the US throughout the financial crisis. Until Wednesday, the International Monetary Fund's European division was also run by a Goldman man, Antonio Borges, who just resigned for personal reasons.
Even before the upheaval in Italy, there was no sign of Goldman Sachs living down its nickname as "the Vampire Squid", and now that its tentacles reach to the top of the eurozone, sceptical voices are raising questions over its influence. The political decisions taken in the coming weeks will determine if the eurozone can and will pay its debts – and Goldman's interests are intricately tied up with the answer to that question.

I suggest reading the complete article. As for the stress tests of the too big to fail, the one point of confidence that we might have about such tests is that they will seek to reassure, rather than really test.  The pressure being laid on the Eurozone by both the US and UK are no doubt at least partially driven by the impact of both the direct and indirect exposures of the major banks in these countries. As I pointed out in the earlier post, it seemed odd that the bailout of Greece was being arranged to avoid triggering Credit Default Swaps, which would risk spreading the pain of default into the too big to fail banks. This is my conclusion to the previous post on default exposure:

It is a certainty that central banks and the regulators in the US and Europe have a good idea about the concentrations of risk in the system, and they are no doubt briefing and driving the policy of politicians. This is all so opaque, and one can only suspect that the avoidance of triggering CDSs is yet again about 'too big to fail'. In other words, the world is being moved again by policy to protect large financial institutions and the 'investment-grade global banks' are investment grade only because they are backstopped by governments and central banks.Is this not shabby? 

It is all looking ever more shabby.