Rose tinted spectacles or optimism returning?

By Martin Skinner

I’d been building up to my blog last week on the assumption that more Quantitative Easing would be implemented and support for the banks would be effectively unlimited.  With these now in place it seems to me unlikely that we will suffer the severe double-dip that many are worrying about.  As last weeks’ comments show this isn’t a view shared by all – and it shouldn’t be expected to be; it is just my opinion based on information currently available and forecasting can be a mugs game these days.

Regardless, the news in the financial press is undeniably better now than it was 9 months ago and either my finding out I’m going to be a dad has given me rose tinted spectacles or optimism is returning to the City.

Looking back
Anatole Kaletsky used the example of the irresistible force and the immoveable object at the height of the crisis and argued that the willingness of governments and central bankers to use unlimited guarantees and in theory at least inject unlimited capital (£200bn so far) into the economy was the only way to reverse a classic run on the banks.  This was necessary because banks will rarely have enough money to pay all of their depositors out if confidence goes completely and they all want their money at the same time.

My argument now is that this tactic has succeeded – however it takes a while for markets to shift from ‘batten down the hatches’ to risking capital reserves on growth.  Understandable when you consider just how close we came to utter economic collapse.

Bosses optimism
In the Sunday Times last week John Waples reported on three top chief execs calling an end to the recession in the last week or so – Sir Stuart Rose at Marks & Spencer, Stephen Hester at RBS and Eric Daniels of Lloyds.

Tonight I went to a presentation by St James’s Place Wealth Management and the theme was very much that the returns offered by ‘riskier’ assets like equities, corporate bonds and property greatly outweighed the minimal returns offered by cash at 0.5% – and the expectation was that economic growth was likely to outperform expectations.  I agree.

What do you think is going to happen next year? And what do you think will be the 2010’s top performing asset classes?

In Other News
Some other great articles from the weekend press included:


Why is America gloomy when the news is good?

Irwin Stelzer

It has been a long time since the economic data have been flashing positive signals, and an equally long time since consumers, businessmen and occupants of the White House have been so gloomy. It’s worth considering why this disjunction of fact and perception is dominating the economic news.

Let’s start with the data. America’s economy grew at a 3.5% annual rate in the third quarter (preliminary figures). The Federal Reserve Bank’s survey of business conditions reports “either stabilisation or modest improvements in many sectors … reports of gains in economic activity generally outnumber declines . . .” There follow the usual warnings that improvements are from low levels and that setbacks remain possible, but the news is better than it has been for some time.

Economists at Bank of America Merrill Lynch agree: “Recent data point to … modestly higher overall growth.” As do those at Goldman Sachs, who might be driven to excessive exuberance by the size of their bonuses: “We remain convinced that the worst of the recession is behind us. The global economy has steadied itself and the current recovery is sustainable. While there certainly are some threats to the recovery, we assign a low probability to any one of them derailing US growth.”

Even the gloomier bunch at Coutts, who believe the global recovery remains fragile, admit that “the financial climate has improved markedly”. As indeed it has: dollar-denominated corporate bonds worth more than $1 trillion have been sold this year, a record.

Retail sales are showing some strength and although sales of new homes fell last month, inventories of unsold homes are well below their peak and sales of existing homes are up, as are prices. And an increasing amount of corporate news is quite good: IBM is so confident that business is picking up that it is stepping up purchases of its own shares; Verizon Wireless, in which Vodafone has a 45% stake, reports the highest increase in its customer base since 2005; and — most important — Caterpillar, the world’s largest maker of construction equipment, is signalling a revival of the manufacturing and construction sectors by rehiring some of the 34,000 workers it laid off.

None of this seems to matter to the psyches of the businessmen with whom I speak, the consumers about whom I read, or the White House. Businessmen tend to look further ahead than most participants in the economy — consumers worry about paying the rent or the mortgage next month, and politicians worry about tomorrow’s opinion polls. Company executives know that the profits picture is improving but they worry that much of the improvement comes from cost cutting rather than increased demand.

They are fearful that a new banking crisis will emerge. They see an administration and a Congress that are spending America into such deep debt that the dollar will continue to decline, forcing the Fed to raise interest rates to prevent a collapse of the currency.

Some executives expect the price of gold to double or triple in the next five years, interest rates to climb from their current level of close to zero to perhaps 8%, and taxes to soar to bring the deficit under control. They also believe President Barack Obama has no use for a market economy, preferring instead to turn over the management of the country to a series of “czars” who set bankers’ compensation, run the domestic automobile industry, will take over the healthcare sector, and now issue some 85% of the nation’s mortgages.

Small-business owners are more concerned about the administration’s emerging $1 trillion healthcare plan, which will drive up their costs, and with the new taxes that are aimed squarely at the income groups into which owners of small firms generally fall. So they won’t expand or hire.

Which is why the White House is so unhappy. The only indicator that matters to the president is jobs, jobs, jobs, about which he quizzes his staff every day. That’s another way of saying votes, votes, votes. The latest polls show that the portion of Americans approving Obama’s handling of the economy has dropped from 58% to 50% in the past six months, approval of his handling of the deficit is down from 49% to 40% and that 67% believe it is “not possible” that his healthcare plan will not add to the deficit. Nevertheless, the president remains personally popular. He would like to keep it that way and is considering a programme that would give tax credits to employers who add to their workforces.

Consumers are the third unhappy group, completing the gloomy business-political-consumer troika. Consumer confidence fell in October for the second consecutive month, no surprise given the weakness of the job market, and the reasonable fear of the vast majority of Americans who are satisfied with their healthcare insurance that the Obama plan will reduce their benefits and raise their premiums.

What is one to make of all of this? Last quarter’s return to growth should be sustainable in the near and even the medium term. Inventory building, increased exports resulting from the declining dollar, stimulus money that is only starting to hit the economy, and other spending created by a Congress eyeing the November elections will combine to provide a boost. In the longer run, however, the pessimism of the business community seems justified: the White House and Congress are dominated by politicians with little understanding of what makes an economy grow sustainably, and a devotion to spend-and-tax that bodes ill for the future of the dollar as a reserve currency, and for future generations who will have to pay the bills Obama will leave in his wake.

However, what politicians have created, other politicians can put asunder. The problems that have so many so gloomy are reversible. As Lawrence of Arabia tried to persuade his fatalistic Arab allies, “Nothing is written”. (Irwin Stelzer, The Sunday Times)

Three cheers for the death of old economics

The orthodox mathematical model took no account of reality. The new George Soros institute should bring back some sanity

Anatole Kaletsky

One of the few benign consequences of last year’s financial crisis was the exposure of modern economics as an emperor with no clothes. In February I argued that economists deserved as much blame as bankers, regulators and politicians. Quite a number of others, including Nobel laureate economists, made the same point that economics had to be urgently reinvented. These ideas have borne fruit much sooner than anyone expected with yesterday’s announcement of an Institute for New Economic Thought.
INET, funded with an initial commitment of $50 million from George Soros and backed by a phalanx of distinguished academic economists, could lead to a flowering of original thinking in a profession whose creativity has been stifled by the intellectual monopoly of orthodox academic funding bodies. It could promote a much more serious debate about what governments can and cannot do to regulate the market. Eventually it could re-create an academic discipline capable of explaining reality and offering useful advice to policymakers facing unexpected events.

The dirty little secret of modern economics is that the models created by central banks and governments to manage the economy say almost nothing about finance. Policymakers who turned to academic economists for guidance in last year’s crisis were told in effect: “The situation you are dealing with is impossible: our theories prove that it simply cannot exist.”

New economic thinking could have an important political impact. For economics is not just the desiccated study of abstract equations. It is the foundation of all politics in capitalist nations. As Keynes wrote: “Practical men who believe themselves to be quite exempt from any intellectual influence are usually the slaves of some defunct economist.”

The defunct economists today are the people who took control of the subject in the 1980s, with theories that closely coincided with the spirit of the Thatcher-Reagan revolution. Their three main ideas transformed the politics, as well as the economics, of the next 20 years. The first idea, known as “rational expectations”, maintained that capitalist economies with competitive labour markets do not need stabilising by governments.
The second idea — “efficient markets” — asserted that competitive finance always allocates resources in the most efficient way, reflecting all the best available information and forecasts about the future.

The third idea stated that economics, previously a largely descriptive study of human behaviour, had to become a branch of mathematics, using assumptions on human behaviour that were clear enough to be expressed in algebraic formulae. Economic problems that could not be analysed with mathematics were deemed unworthy of consideration.

Between them, these three ideas had huge political effects. “Rational”, “efficient” and mathematically inexorable economics seemed to legitimise whatever political results were decreed by markets: income inequalities, industrial dislocation, vast bonuses for top executives could all be presented as the impersonal result of scientific forces, rather than political issues.

Nobody seemed to notice that all this mathematical flummery left out the most crucial step of true science. Physics, chemistry and biology use mathematical models to draw conclusions that are then tested against reality. If reality contradicts these tests, then scientists reject the models. Today’s academic economics reverses this process: if models disagree with reality, it is reality that economists want to change.

It is not surprising that the whole scaffolding of theorems, models and computer simulations came crashing down, along with the towers of bad debt and bad policy it supported. Today’s academic approach prevented economists from thinking about a world that is, by its very nature, unpredictable and inconsistent — as Keynes and Hayek, at opposite ends of the political spectrum, both understood.

To gain a genuine understanding of unpredictable reality, some unorthodox economists may employ new mathematical techniques of non-linear dynamics and chaos theory. Others may revive the literary and anecdotal traditions of the great economists of the past, building on the work of sociologists, psychiatrists, historians and political scientists disdained by the present orthodoxy. INET will try to support these new schools of thought.

A good test of whether this venture proves successful will be to ask a simple question: Was Adam Smith an economist? Were Keynes or Hayek? By the standards of what is taught as economics today, the answer is “no”. They may have explained some of the deepest mysteries of human life: why the pursuit of individual self-interest increases the wealth of nations; why market economies suffer prolonged slumps; why central planning never works.

Yet Smith and Hayek produced no real mathematical models. Their eloquent writing lacked the “analytical rigour” demanded by modern economics. And none of them ever produced an econometric forecast. If any of these giants applied for a university job today, they would be laughed out of court and their written works would not have a chance of acceptance in The American Economic Review.

This is the mentality INET hopes to overcome. If the next generation of academic economists aspire to succeed Smith, Keynes and Hayek, rather than ineffectually aping Euclid, Newton and Einstein, then the venture will have been worthwhile. (Anatole Kaletsky, The Times)

Bank of England should release £30bn more in quantitative easing

David Smith: Economic Outlook

To QE or not to QE? It is the big question for the Bank of England’s monetary policy committee (MPC) this week, and it is a big question for the economy.
After those unexpectedly weak gross domestic product figures nine days ago, showing that officially the economy remains in recession, the onus is on the Bank to do more quantitative easing (QE) this week. Will it, and by how much?

The story so far is that the Bank has done £175 billion of quantitative easing: buying assets, mainly government bonds or gilts. The MPC, while not claiming it has solved everything, is upbeat about its effects.

David Miles, who joined in June, said recently: “I believe the evidence is that QE is having an impact and that it is relevant to economic conditions right across the country. And not just in financial markets in London, but in high streets and factories and homes throughout the UK.”

Kate Barker, another MPC member, said a few days ago that it had helped ease the recession in the housing market, thus supporting house prices.

I don’t suppose many people discuss quantitative easing before sitting down to watch EastEnders but if the Bank is right, they should. It is as important in its way as changes in interest rates and the guide on the Bank’s own website provides a simple explanation why.

The Bank, it says, “boosts the supply of money by purchasing assets like government and corporate bonds”, adding: “Instead of lowering Bank rate to increase the amount of money in the economy, the Bank supplies extra money directly. This does not involve printing more banknotes.

“Instead, the Bank pays for these assets by creating money electronically and crediting the accounts of the companies it bought the assets from. This extra money supports more spending in the economy.”

It goes on to say that this extra spending is necessary to get inflation back to its target — inflation is the Bank’s only target — but I suspect most people would rather see the economy boosted in a more straightforward way, such as getting unemployment down and preventing firms going bust.

The question is when the process should stop. Is £175 billion enough, or should the Bank go further? Let me first offer a guide to how the MPC would like us to think of its approach to policy, then offer my view.

There will come a time, though perhaps not for quite a while, when the Bank raises interest rates. At least some of the headlines that will accompany that announcement will be something like: “Worried Bank slams on the brakes”.

That is not, however, how the Bank would see it. Interest rates are very low, the lowest in the 315 years of the Bank’s existence. At 0.5%, Bank rate is a tenth of what I would regard as the modern-day norm, 5%.

So the way the Bank sees it is that as long as rates remain below 5%, then even if they are rising, monetary policy remains expansionary. So the right headline when, say, Bank rate goes up from 0.5% to 0.75%, would be: “Bank eases off the accelerator.”

The same applies, though in a slightly more complicated way, to quantitative easing. There are three ways any decision on interest rates can go: up, down or sideways.

There are also three ways this week’s decision on quantitative easing could go. The equivalent of a cut in rates would be announcing more easing, in other words more asset purchases.

Sticking with the existing £175 billion but not committing to any more would be like an interest rate “hold”.

An announcement that some of the gilts and other assets were to be sold back into the markets would be the equivalent of a rate hike, though it could still be argued that the policy would remain expansionary until they have all been sold back.

No such sell-off announcement will happen this week. The debate is about whether the Bank announces further easing or stops at what it has done so far.

It is of intense importance in the City, where the programme of asset purchases is seen to have helped lift markets (which the Bank acknowledges and welcomes). A halt would bring an immediate adverse reaction, most notably by pushing up the yields on gilts and corporate bonds.

It is also very important, if Miles and Barker are right, in high streets, factories, estate agents and homes up and down the country.

It matters too for the pound. The Bank’s aggressive easing programme has helped push sterling lower against other currencies though, as I shall try to explain, that might be a perverse reaction.

What will it be? MPC-watchers say October’s meeting offered few clues, merely putting off the decision until this month, when the existing programme runs out.

The shadow MPC, which operates under the auspices of the Institute of Economic Affairs, has been keen on quantitative easing from the start and thinks it would be a mistake to stop now.

Tim Congdon, one of its members, did an impassioned presentation at a recent meeting, arguing that Britain stood out in its policy response.

The easing programme had lifted growth in the money supply at a time when it was heading down worryingly in both the euro area and America. On his analysis, the currency markets should be concerned about recovery in Europe and America, not Britain.

A more cautious note is struck by Chris Williamson, chief economist at Markit, which produces the monthly purchasing managers’ surveys. He is convinced on the basis of these surveys that the economy has been recovering for some months.

The danger, he suggests, is that the Bank pumps in more money at a time when the economy does not need it, risking that the inflation already present in asset prices extends to other parts of the economy.

He has a point, which is why I think the Bank, which also has its doubts about the official statistics, needs to proceed with caution. It is too soon to stop the asset purchases altogether, not least because of the adverse reaction in markets that would result.

It is fair to argue, however, that the economy needs less of a boost than it did. At its peak, the Bank was doing £25 billion of easing a month. In August it slowed the monthly rate to £17 billion-£18 billion. I would slow it further, to perhaps £10 billion, implying that the Bank should announce a further £30 billion of purchases this week. Let’s see what it does.

PS: Many have written books on the credit crunch — I’m just putting the finishing touches to one — but not many people have written two. So I take my hat off to Graham Turner, founder of GFC Economics, for his second; No Way to Run an Economy.

He has always advocated dramatic policy measures to lift Britain and other economies out of the crisis and criticised policymakers for their timidity. His latest book is no exception.

Some think Britain and America have been irresponsible in allowing their budget deficits to rise too much. He argues that they should have been bolder in their fiscal stimulus efforts and allowed deficits to rise much more.

The parallel he draws is with wartime. During the second world war, America’s budget deficit rose to 28.1% of gross domestic product, while Britain’s was just behind at 26.1%. Debt and deficits fell sharply in peacetime, when full employment was re-established.

By “socialising” the banking industry’s losses, he argues, governments have been unable to offer a proper Keynesian response to the crisis. As you might expect, he is not optimistic about the outlook. (David Smith, Economic Outlook, The Sunday Times)

Why bankers love the people’s recession

David Smith, Robert Watts

The estate agent knew he had struck gold. He was showing an £8.5m flat in Belgravia, central London, last week to a client looking for the perfect bachelor pad. Sporting an expensively tailored suit and a Swiss watch, the 42-year-old banker had all the swagger of the boom years.
“The flat was immaculate, yet he wanted to rip it apart and do it up from scratch,” said Charles McDowell, who runs his own estate agency. “He said he wanted to throw an extra £1m at it, including installing a cinema room. People are scattering the cash again.”

Figures from Knight Frank, a top-end estate agent, show the number of City buyers as a proportion of applicants has grown to 38% — the highest since March last year.

“The bonus effect is only just beginning to be felt,” said Liam Bailey, head of residential research at the agency. “The hitherto weak £5m market has sparked into life.”

Vintage champagne is also flowing again at Coq d’Argent, near the Bank of England. For years a favourite of the Square Mile’s bankers, the wallets and belts of its clientele tightened when the credit crunch struck. That has changed.

“In the last few months we’ve seen more people happy to spend a few thousand pounds on wine with a meal,” said Sean Gavin, the general manager. “Even during the bad times champagne continued to flow, but there’s a good deal more vintage bottles being drunk now than a few months ago.”

The restaurant’s 48-page wine list offers bottles of 1982 Bollinger for £505. Those feeling more flush, or who prefer claret to champagne, can sample the 1982 Château Lafite Rothschild at £1,975.

It appears to be win-win in the City. Some bankers are benefiting from big bonuses and those who are not are benefiting from higher salaries. Every bank is hiring, according to headhunters. Jobs that were left vacant at the peak of the crisis are being filled again.

With bonuses under public scrutiny, basic salaries are being increased instead. Morgan Stanley has raised basic pay by 50% for its middle managers. Similar moves have been seen by Bank of America Merrill Lynch, UBS and Citigroup.

A former investment banker starting his own City firm said the “witch hunt” against bonuses had had perverse effects. “Those who are interested [in joining his firm] are demanding double the salaries of a year ago — largely because of this government hate campaign against bonuses,” he said. In many cases they were succeeding in getting the extra money.

The contrast with the wider economy could not be greater. On Friday grim official figures dashed hopes of an early end to Britain’s downturn. Instead they confirmed that the recession the bankers had caused is both deep and very long.

The 0.4% drop in GDP in the third quarter was the sixth fall in a row, making this the longest continuous slide since records began in the mid-1950s. The economy has shrunk by 6% since the spring of last year, putting the recession on a par with that of the first Thatcher downturn of the early 1980s.

The economic numbers are a severe blow for the government. Amid rising public anger, it now has to explain why the people who caused the recession appear to be the ones doing best out of it and what it intends to do about this perverse situation.

Last week the critics found a powerful champion in Mervyn King, the governor of the Bank of England. King makes what he describes as four “big” speeches a year. He chose his latest one — delivered in Edinburgh where both Royal Bank of Scotland and HBOS failed spectacularly — to deliver a broadside at the banks and the government.

“The sheer scale of support to the banking sector is breathtaking,” he told Scottish business dignitaries. “In the UK, in the form of direct or guaranteed loans and equity investment, it is not far short of £1 trillion (that is, £1,000 billion), close to two-thirds of the annual output of the entire economy.

“To paraphrase a great wartime leader, never in the field of financial endeavour has so much money been owed by so few to so many. And, one might add, so far with little real reform.”

While calling for further reforms to make the banking system safer, King will have been aware that one of the reasons the City is making money again is that it is benefiting from the action being taken by his organisation and other financial authorities.

The Bank’s programme of “quantitative easing” — effectively creating money — has lifted the price of the stocks and bonds the banks hold and trade. The Bank has spent £175 billion buying bonds with money created at the flick of a computer switch. As well as adding to bank reserves, this money has helped to fuel the surge in global stock markets in the past six months.

The huge volumes of debt issued by governments in an attempt to boost their flagging economies have also created windfall profits for banks. Governments pay the banks to act as salesmen to find buyers for their debt among the world’s pension funds, insurance companies and other national governments and central banks.

With dealing houses like Lehman Brothers and Bear Stearns out of the picture, and other banks crippled by the losses they suffered on sub-prime investments, there has been a big reduction in competition. That has allowed the surviving banks to charge higher fees.

They are also making money out of companies. The global downturn has forced some of the world’s biggest companies to restructure their finances. Globally, firms have raised about $700 billion (£430 billion) from investors. The banks earn fat fees on this business.

With this background the renewed row over bonuses is embarrassing for Alistair Darling, the chancellor, who last month struck a deal with Britain’s five biggest banks to limit their bonus payments this year. Shortly afterwards Lord Myners, a Treasury minister, came to a similar agreement with investment banks based in London.

The fear among ministers is that if they go too far, City firms will move to Switzerland or other countries, taking with them a portion of the estimated £70 billion that the financial services industry contributes to the exchequer every year.

Although the Treasury has denied plans for a windfall tax on the banks, the increase in the top rate of income tax to 50%, due next April, has already led to some hedge funds and other businesses deserting London.

Some believe the backlash against bankers’ bonuses has already gone too far. Yesterday the Duke of York caused controversy by saying bonuses were “minute” in the wider scheme of things.

Lord Griffiths of Fforestfach, vice-chairman of Goldman Sachs International and a former adviser to Margaret Thatcher, said last week that he was not ashamed of the bank’s bonuses and people should learn to “tolerate the inequality” implied by such payouts because they were for the greater good of the economy.

Such tolerance will be difficult to find among people who are struggling with their own finances as the wider economy remains in recession.

Critics will note that in America, which is instinctively averse to state intervention in financial markets, the government is proposing direct action to clamp down on the swollen salaries and bonuses of firms bailed out by the government.

Last week Kenneth Feinberg, President Obama’s “pay czar”, announced that the top 25 executives at the seven firms that received the most government help will, on average, have their total compensation cut in half this year. The cash portion of their salaries will be slashed on average by 90% and the rest will be replaced by shares that cannot be sold for years.

There are some in the British financial community who, like King, recognise the extent of the problem. The Financial Services Authority, the City regulator, is targeted for abolition by the Tories if they win power next year, but its chairman, Lord Turner, does not intend to leave without making his mark. The banks, he said last week, had a duty to build up capital as protection against future crises, not fritter their “exceptional, post-crisis profits” away in pay and bonuses.

“We will be talking to the banks as to whether those bonus pools they are making at the moment are compatible with the level of capital build-up that we believe is appropriate,” he said. “If it is not, we will be engaging in frank discussions with them.”

Frankness is the least an angry public will expect. In an article for today’s Sunday Times, David Cameron promises action against banks that channel profits into bonuses rather than new lending. “If that doesn’t happen, then we reserve the right to take action to ensure that it does, including through the tax system,” he writes.

Just as pressing a concern for the government is the state of the recession. Labour ministers were banking on positive news to give them a boost in the opinion polls. But while Japan, Germany and France came out of recession in the second quarter, and figures released this week are set to show that America did so in the third quarter, Britain has yet to escape.

Gordon Brown will once again be reminded of his claims that the country was better placed than others to weather the financial storm.

Although Darling has stuck to his script in recent months, insisting he expected the economy to recover only at the end of the year, the Treasury was bemused by the figures, which it had expected to be flat. So was the Bank of England, which had pencilled in a small rise.

The Tories yesterday made hay with the new figures. “There is now no confidence in Gordon Brown’s economic policies: he has no banking plan, no debt plan and no growth plan,” said George Osborne, the shadow chancellor. “The whole country is suffering from this lack of leadership.”

Vince Cable, for the Liberal Democrats, said Britain was suffering because of the failure to fix the banks and kickstart lending again. “For all that has been thrown at the economy to try to stimulate a recovery, it is clear that massive structural problems remain, particularly in the banking sector,” he said.

Although economists questioned the accuracy of the data — Goldman Sachs put out a research note on them headlined “Unbelievable. Literally” — they rekindled the political debate on the economy ahead of Darling’s pre-budget report, due in late November or early December.

The Treasury had hoped to present new projections for cutting the budget deficit, knowing that the economy was growing again. Now it will have to take the recovery on trust. (David Smith, Robert Watts, The Sunday Times)

Global economy has no substitute for falling dollar

Irwin Stelzer

Let’s see. The Chinese are cross because the falling dollar means the stacks of American IOUs they have in their vaults will be paid back in a devalued currency. The Americans are cross because the Chinese refuse to allow the renminbi to rise in value and this means goods made in Chinese factories will continue to displace made-in-America products, and provide jobs for Chinese rather than American workers. The Europeans are cross because the strong euro aborts the export growth on which they are depending to fuel their economic recovery. The British are cross because the weak pound makes it expensive to buy anything abroad, and suggests that a spurt of inflation is just around the corner. In short, everyone seems to be terribly unhappy with developments in the currency markets.
Well, not terribly. The Chinese might be unhappy that the dollar is declining in value, but are delighted that their policy of pegging the renminbi to the dollar is keeping their export machine humming — they need millions of new jobs to prevent their poor masses wondering whether some other form of political organisation might provide a better life. The Americans might be fearful that further declines in the dollar will dethrone it as the world’s reserve currency, but the Obama administration is hoping that a cheap dollar will make imports more expensive and exports more competitive, creating jobs. European exporters might be groaning about the growth-stifling effect of their high-flying currency, but eurocrats are secretly delighted that the euro is proving a source of strength in these difficult times.

Other players are also trying to cope with the falling dollar. Brazil has tried to stem the rise of its currency, which has appreciated more than 40% against the dollar since March — to no avail. Oil and other commodity producers are raising prices to make up for the declining value of each dollar they receive. But these are minor players compared with the geopolitical players who see an opportunity to replace the dollar as the currency in which the world does business, to cut America down to size — think China, Russia, Venezuela, Iran.

It is one thing to want to replace the dollar, quite another to find a suitable substitute. The renminbi cannot be the chosen currency so long as it is pegged to the dollar, for its value will move with the dollar. The rouble is not a candidate, since there is not enough of the currency around to handle the volume of world trade and, besides, it is not the sort of money on which you can rely to hold its value, especially if oil prices collapse. Which brings us to the euro.

As has been pointed out by Jean Pisani-Ferry, director of the Brussels-based Bruegel think tank, and Adam Posen, a fellow at the Peterson Institute for International Economics in Washington: “There is no sign of a move to the euro as a global currency. The share of dollars in global reserves remains almost three times that of the euro.”

The reasons for this failure of the euro to advance further as a global currency seem to be rooted in the failure of the EU to encourage economic growth and to develop better systems of economic governance. Talk about pricing oil in euros instead of dollars remains just that — talk. And in the recent crisis it was the Federal Reserve Board that was called on to provide currency to meet emergency needs for liquidity — that means dollars.

Still, doubts about the dollar’s future persist. Its recent decline may be consistent with its performance in previous currency cycles. And the drop might be due to a willingness by investors to take on more risk now that the recession seems to be ending, rather than to a lack of faith in the safety of the dollar. But investors remain worried that the dollar’s decline, so far acceptably gradual, will turn into a rout, perhaps not next year, but in 2011.

Ben Bernanke, Federal Reserve Board chairman, says that this can be avoided if two policy steps are taken. First, the American government must make “a clear commitment to substantially reduce federal deficits over time”. Second, Asian countries must boost domestic demand so that they don’t have to rely so heavily on exports to America, and allow their currencies to appreciate against the dollar so that the US trade deficit continues to fall as a percentage of American GDP.

What Bernanke did not say, perhaps because he was playing the discreet central banker, is that neither of these things is likely. The Obama administration has already pencilled in eye-watering deficits for a decade and more, and is in the process of adding perhaps another $1trillion to the US deficit by “reforming” healthcare — claims of savings are somewhere between delusions and lies. It will then turn its attention to the energy sector, and the subsidies required to fund its green revolution.

Meanwhile, the Chinese are unlikely to allow their currency to appreciate in value, and other Asian nations will continue to intervene to prevent their currencies from rising against both the dollar and renminbi. Trade imbalances will, therefore, persist.

Which puts the ball right back in the Fed’s court. Unless Bernanke drains liquidity from the financial system, and shrinks the Fed’s balance sheet by winding down $2 trillion in support programmes — and does so precisely when the recovery takes hold so as not to cause a relapse by moving too early — the dollar’s decline will accelerate, shattering confidence in its long-term value. One well-respected expert tells me that in two to five years the dollar will no longer be considered safe enough to be the currency in which the world does business. Its replacement: separate deals in local currencies — the Chinese paying for Brazil’s oil in renminbi, which the Brazilians use to purchase stuff made in China — and the International Monetary Fund’s drawing rights, bits of paper backed by a basket of currencies, including but not limited to the dollar. That would mark the end of an era which has seen world trade flourish and millions emerge from poverty. Sad. (Irwin Stelzer, The Sunday Times)

Deficit may undershoot despite GDP setback

David Smith

Shooting the messenger is never a good idea. Even so, on Friday the Treasury must have thought about getting up a posse and heading down the M4 to the Office for National Statistics in Newport.
Time and again in this recession, the ONS has come up with gloomier gross domestic product numbers than anybody expected. It did so again on Friday. The debate had been whether GDP would be flat or show a small rise. Government and opposition were gearing up for a political spat on what the end of recession meant.

The Bank of England’s monetary policy committee said in its minutes last week that GDP in the third quarter appeared to be in line with its August forecast, which was for a rise of nearly 0.2%.

Instead, we had a 0.4% fall on the quarter, making this the longest continuous period of falling GDP on record, though not yet the longest recession. The official statisticians have proved, at the very least, they are no propaganda machine. Other than that, we should treat these early estimates with a huge pinch of salt because they are so out of line with survey evidence.

In time the GDP figures will be revised but, when they are, it will not be news, merely of interest to number-crunchers. Meanwhile, we have seen some consequences of the weak numbers for sterling, which fell, and in expectations that the Bank will extend its programme of quantitative easing.

What about the public finances? Let me take you back to the recession’s start, and Alistair Darling’s first budget in April 2008. It included a forecast for public borrowing for 2009-10 of £38 billion, 2.5% of gross domestic product. The government’s net debt would remain below 40% of GDP, the official ceiling, through to 2013.

A year later, the picture was shockingly different. The borrowing forecast shot up to £175 billion, 12.4% of GDP. That’s right, borrowing equivalent to 10% of the economy, in a single year, added to Treasury projections in just 12 months. Debt, by the way, is now 59% of GDP and rising.

Treasury officials are working hard on the appetiser for Darling’s third budget, the pre-budget report (PBR), to be released in late November or early December.

It is very significant, not least because many feared another big upward revision of borrowing. That and the absence of new measures could have got the rating agencies sharpening their pencils to downgrade Britain’s AAA sovereign debt rating.

The numbers are not yet complete but the Treasury suggests things are broadly on track to meet the budget forecast. Dave Ramsden, its chief economist, set himself the goal in the budget of not having to revise the borrowing figures up again. It looks as if he may have succeeded.

At least one independent economist thinks the Treasury could go further. Karen Ward, UK economist at HSBC, has gone through the assumptions the Treasury used in doing its forecast in April.

Those assumptions, some of which have to be approved by the National Audit Office, were made at the time of deepest gloom, in March, when shares were low, the oil price was weak, and economists were at their gloomiest about unemployment.

Ward has gone through these assumptions one by one and concluded that there is a small pot of gold for the Treasury in them. The higher stock market, for example, should give the Treasury an extra £3.1 billion of revenue this year, the higher oil price £4.2 billion, lower-than-feared unemployment £1.8 billion, and so on.

The result is that she expects this year’s borrowing to be £153 billion, 10.8% of GDP, more than £20 billion below the Treasury’s forecast, with the improvement running through to future years. Under her projections, cumulative borrowing over the period from 2009-10 to 2013-14 will be £131 billion lower than the Treasury expects.

There are a couple of caveats. The first is that, as Ward points out, these only change the public finances “from appalling to merely very bad”. Most other independent economists still think, moreover, that the risks to borrowing are on the upside.

The second caveat is that I would not expect big revisions from the Treasury in the PBR in either direction. The important part of the borrowing story will not be known until the final months of the fiscal year — January, February and March. The Treasury would not want to revise down now only to have to revise up later.

Even so, the HSBC forecast reminds us it is too easy to fall into the trap of believing things can only ever get worse. The experience of the 1990s, when Britain moved from a budget deficit of 8% of GDP to a surplus of 0.5% in five years should be one that guides us through these dark days.

In the meantime, there is no shortage of ideas for getting the deficit down. My wish is that we should stop expressing every tax change in terms of how many pennies on income tax it would be equivalent to.

The National Institute of Economic and Social Research, for example, said last week that the government could raise the basic rate of income tax by 7p in the pound — which is not going to happen — or bring forward even more the raising of the state pension age, and to aim for 70.

I like the approach of Reform, the think tank, which identifies £31 billion of “middle-class” welfare, including child benefit, tax credits, maternity pay and the state pension, and say half these outlays should be cut immediately, whatever the squeals. Even if the public finances improve, these debates have a long way to run.

PS: How do you solve a problem like Mervyn? For many months intelligent people have been working hard on how to make banks more risk-averse and less prone to excesses. Then along comes the Bank of England governor.

The days of a gentle raising of the eyebrows are gone. These days, though he was in Edinburgh, Mervyn King used a Glasgow kiss, warning that moral hazard in the banking system is worse than ever and that there has been “little real reform” nationally or internationally.

Though speeches like this make great copy, they trouble me. Either King is showboating, which is entirely possible, or he is right out of the policy loop, which is worrying. We are in a pre-election limbo. If The Tories win and transfer banking regulation to the Bank, King would have the opportunity to mould the system, including a bank break-up, in the way he apparently wants. His fear may be that by then it would be too late.

I am not convinced by the argument that we need to break up banks. Britain has a heavily concentrated banking system — too few banks — but a better answer is competition, including international competition, and new entrants. Banks should be restricted from engaging in dangerous, “socially useless” activities, as Lord Turner of the Financial Services Authority suggests.

Paul Volcker, former chairman of the Federal Reserve, now head of Barack Obama’s economic recovery board, knows what he wants. Commercial banks receiving government guarantees should not own or sponsor hedge funds and private-equity funds and their proprietary trading — trading their own funds in the markets — should be restricted.

King, however, is vague. In Commons Treasury committee evidence earlier this year he said “narrow” banks would not work because people would favour riskier banks offering higher rates for savers. Even without explicit guarantees, no government would let millions lose their savings, which is true. If there is a King blueprint we have yet to see it. (David Smith, The Sunday Times)