The Euro shows why the Pound is hurt

The Greek crisis continues to develop. After the implosion in their public finances which was revealed after they stopped faking the numbers, the markets have taken fright at the scale of the problems in Athens. So far so unsurprising: Greek public finances have been weak or very weak for decades. However, there is now a strict discipline that Athens must adhere to: membership of the Euro. Instead of printing money and getting out of trouble by devaluing the Drachma, the Greek government must now impose tight fiscal discipline, despite the grim outlook for economic growth.

Many Anglo-Saxon commentators do not believe that the Greek government: beset with strong Unions and a poisonous legacy of corruption will be able to do so. Several others do not think that they should even try. The problem is that without cutting the deficit, the country faces a stark choice: either fail to repay their debts- i.e. to default- or to abandon the Euro altogether. The Anti-Euro cheerleaders are hopeful that Greece will choose the latter road, and that the single currency will be crippled as a result.

The problem is that introducing a new Drachma would be creating a literally worthless currency- it would have little resources and less confidence to back it. Greek businesses would probably be unwilling to be paid in New Drachmas, and the Euro would continue in general circulation. There would be a real risk that Greece would enter hyper-inflation in the new currency and create crippling economic damage for itself. There really is no alternative but for Greece to continue to use the single currency- so the focus is now on trying to plug the hole in the economy and create some kind of international bail-out. In that sense, Greece is probably "too small to fail". The Greek economy is a relatively small part of the Eurozone and co-ordination between the ECB, the IMF and World Bank should be able to give the Greek government enough breathing space to start the process of reordering their public finances.

The problem will become far more serious if other Eurozone economies begin to suffer the Greek meltdown: and the huge instability in the markets last week shows that fears are gathering around Spain. Spain is a significant part of the Eurozone, and any rescue would require the real commitment of Germany in order to happen- and the mood music in Berlin suggests that there is a limit to German patience and understanding.

The reasons why Germans are imposing limits are not hard to see. Germany, over the past decade, has imposed upon itself a large scale structural reform of the labour market: it has been a difficult and at times painful process. However the Club Med states have not imposed such structural changes: in the name of social cohesiveness, jobs became permanent but unemployment rocketed. The productivity of Germany improved dramatically, but that of Italy, Spain or Greece fell dramatically. The Germans learned the lesson that the fixed currency demands much greater flexibility in every other area of the economy. The Greeks and the Spanish did not learn that lesson- and now the burden of that failure is crushing the life out of their state budgets at a time of general economic gloom.

However, the smugness of many British commentators is ill founded. "Look" they say "how lucky we are not to be members of the Euro, because we too could have been in the same position as Greece- and unable to devalue our currency". Yet the fact is that our much vaunted "currency flexibility" is as much a curse as a blessing. Leaving aside the morality of whether governments should be allowed to debauch the value of the currency it issues, the fact is that even the 30% fall in Sterling has not been enough to avoid the longest and deepest recession in the developed world. Despite maintaining an independent currency, the British economy has massively lost competitiveness- and for the same reasons as Spain and Greece. We have created a massive state sector of startling inefficiency, and after the fall of our largest industry- banking and finance- Britain has very limited competitive advantage. The national debt has doubled in two years, the deficit- at around 16%- is actually worse than Greece. The fact is that even while the devaluation of Sterling has reduced the impact of our folly- the UK is on the road to ruin, independent currency or not.

The Greek and the Spanish crisis is not about the impact of the single currency, it is about a failure to implement necessary economic and strategic reform. It is about a failure to deal with huge pension deficits in an ageing population, it is about a failure to diversify the economy and to create a more flexible micro-economic environment. Whether or not the single currency survives is really beside the point: the fact is that these changes have been delayed too long, and therein lies the root of the problem.

As for the UK? Well almost all of the same questions apply. The failure to address pensions has destroyed the competitiveness of the British Economy: British Airways being the most obvious example. The massive increase in the power of the state, and the expansion of state economic activity to the levels of East Germany is beyond the long term capacity of the State to finance. Placing so many of our best brains into the accounting and City underlines the lack of diversity of our own economy- and looks way too much like putting all our eggs in one basket.

In my view- however reluctantly- the Germans will try to steady the Euro ship. The price will be high: make the necessary reforms or else leave the single currency. The so-called PIIGS states have little option but to comply: indeed Ireland already has done so.

As for Britain? We have given ourselves a breathing space at the expense of a third of our nominal wealth. Unless we address our structural weaknesses and wean ourselves from our dependence on the state sector, then the outlook is very bleak indeed. Higher inflation, lower competitiveness, and continued decline.

In the end the crisis of 2010 is not a currency crisis- it is a fundamental economic crisis. Without truly addressing our deficit and the imbalances that caused it: being "tough on the deficit and tough on the causes of the deficit", then the value of the Pound versus the Euro will continue to drain away. We have gained an advantage from possessing an independent currency- the breathing space to reform. The price is that unless we use that breathing space to enact radical restructuring across the economy we will be permanently poorer, and clutching a currency that no one trusts or uses.

Tory Wobbles

it has been a pretty ho-hum week for David Cameron. Despite a good performance on Prime Minister's question time, he has had to consider a swathe of polls all showing Labour support up, and the Conservatives down. Many Conservative commentators are coming out of the woodwork to give advice to Mr. Cameron- and the chorus has increased in intensity with every percentage point the Tory lead falls. Amongst the various voices trying to steady the ship, there is a growing voice of simple perplexity: "how", they think, "can the Tory lead be in danger, when Labour has so manifestly failed?" Benedict Brogan's piece in the Telegraph this morning is a classic of the breed.

And of course he is right: Labour has failed, and the voters are indeed heartily sick of Gordon Brown. But that is not the same as saying a Conservative victory is inevitable, or even desirable.

Fraser Nelson in the Times, I think, comes quite close to explaining why. He points out that winning office and winning power are two different things. A successful Prime Minister has a clear and usually radical agenda from the very beginning. The problem that Nelson identifies- and I have blogged about this before- is that the Conservative front bench are so focused on winning the election that they have adopted Labour nostrums wholesale and have been far to timid in voicing a clear vision for what they would do in office, should they win. Touting a one billion pound spending cut is a bat squeak compared to the roar of a one hundred and sixty billion pound deficit- and claiming such a pin prick as a "radical solution" is simply ridiculous.

Nor is David Cameron winning any plaudits for his vision of political reform. This morning he writes, reiterating his opposition to electoral reform - and of course he is right to oppose the cheap Labour chicanery on the issue. However his own vision is scarcely more coherent - the root of the problem of expenses and all the rest of it, is that the majority of our MPs represent "safe seats": they can not be held accountable. Without a full scale programme of constitutional reform, including voting reform, the political gap between the governed and the governors will continue to grow, even if there are 10% fewer Members of Parliament. You could argue that political reform is the unfinished business of the Thatcherite reforms: she was prepared to open any market to greater competition, sweeping away swathes of Spanish practices- sometimes even too radically- but the one place she failed to introduce any reforms at all to, was the political system- with malevolent consequences that are now obvious.

So Fraser Nelson is right, in a sense, the Conservatives are in great danger of being too timid, not only too timid to win power, but if the polls fall further even too timid to win office either. But I think that he is probably wrong to hope for change from a Conservative leadership that is too comfortable- even self satisfied- to understand that the state of the country is now bringing us to a crossroads where all choices have serious consequences and all solutions must be radical.

In a sense a new political front is opening up: a clear gap between the statists- of all parties- and the radicals. I am a classical Liberal, but recognise that there are liberals in other parties too. I think that if we do indeed have an inconclusive election then it will be important for radicals across the current political spectrum to reach out to each other and forge a common agenda.

For me, failing to "trust the people" has led to the nanny state agenda and a huge and more sinister reduction in personal freedom to the benefit of the big state. Labour is set to increase the power of the state even further, but the Conservative leadership too is ducking the issue. They have, as Fraser Nelson points out, taken on too much of the syntax of New Labour to be able to challenge the system in the radical way that it requires.

While my own party too needs to be more clearly explicit about the reduction in the power of the state that we want to see, at least the Liberal Democrats have put forward policies that understand the need to cut drastically the spending programmes currently under way. Indeed we have even cut policy commitments that are dear to our hearts, because we know that there is no point- the money simply isn't available.

What I would say to liberals in the Conservative Party is that it is not enough to speak fitly or be silent wisely. It is absurd that radicals now have to look to John Redwood for leadership- and a reflection of just how marginalised the liberal voice has become, that there are no others willing to speak out.

If Fraser Nelson and those like him are disappointed now, I fear that they will be utterly disillusioned after a year of any Conservative government. Only real, radical reform can address the political and economic crisis that our country faces- and the timidity of the Cameroons is simply not enough.

While I understand the feeling that speaking out now might be seen as damaging the prospects of the party within weeks of the election, the fact is that those prospects are in the balance because of a failure to speak out earlier. Fortune favours the bold, not the timid, which is why the Conservative commentariat is rightly concerned about the way things look as we stand on the brink of a decisive general election.

Speaking from beyond the grave..

Well, as deathbed conversions go, the sincerity of Labour's move to promote electoral reform is a pretty cynical exercise. Even David Cameron was able to mock at today's Prime Minister's Question Time.

I think as Liberal Democrats we can hold ourselves back from the not-particularly-appetising morsel of AV- which is not necessarily fairer than First-Past-the-Post, and is anyway considerably more closed, since it relies on Party lists.

A Single Transferable Vote (STV) in multi-member constituencies is what the Lib Dems want: since it retains constituency links, is not reliant on lists, allows non party figures to be elected and allows the voters to chose between candidates of the same party, rather than having party hacks foisted on them willy-nilly. It is the fairest and most open electoral system and will actually produce a Parliament that reflects how people vote.

After being strung along by Blair and now Brown, I don't think any of us are in the mood to offer Labour any support for their half baked, crooked little scheme.

Alistair Carmichael was suitably scathing: Beware of dying governments bearing gifts of electoral reform, but I don't think this is a dying government, I think that at today's Prime Ministers Question Time he was actually speaking from beyond the political grave.

The message is clear: if people want to reform our political system, they should vote for the party that consistently advocates political reform -the Liberal Democrats- and not for a government that treats electoral reform as a way to try to save their own miserable skins.

Sure David Cameron does not support political reform, but, guess what? Neither does Gordon Brown. All that has happened is that a pathetic, cowardly and miserable government has yet again demonstrated why the cynical politics of Blair, Brown and Mandelson have long since passed their sell-by date.

UK Housing: waiting for the fall

The new year seems to give rise to new economic forecasts, as people try to guess what the next few months will hold. Now we are into February, the game seems to be correcting previous forecasts, and so it has been going with UK house prices. This hardy perennial of boring dinner parties seems to be a particular focus right now, and yet it is clear that all is not well. The latest forecasts seem to show that the British economy will recover and that house prices will recover even more quickly. Except that House prices have not actually fallen too much in the first place. The latest (revised) forecast from CEBR is that house prices will rise a further 6% over the course of 2010. If so, then that is a potentially very dangerous number.

An average salary in the UK is, depending on how you measure it, just under £30,000 a year before taxes. The average property price is roughly £130,000. This represents an earnings: house price ratio of roughly 4.3x. This in itself is quite a high ratio historically, and even allowing for savings and previous equity, it also implies a high level of average mortgage debt. This is particularly true recently, because of the high levels of loan:value that banks were prepared to offer on mortgages over the past decade.

However, such large debts are still supportable on an average income if interest rates remain low. Over the course of 2008 and 2009, interest rates fell dramatically, with the result that the "affordability" of homes increased dramatically, that is to say the proportion of income used to fund mortgage debt fell sharply, as interest rates touched bottom. The result has been that many households have actually found themselves dramatically better off despite the severity of the crisis.

On the back of this, commentators are now predicting that the general economic recovery will indeed bring a more vigorous housing market. It could certainly be the case that there will be a short term spike in house prices, because there is clearly a low level of current supply. The reasons for this are complex, but amongst others, there is the fact that many are now locked into low fixed mortgages that they would have to re-peg upwards were they to move house, which is a strong incentive not to move at all.

Nevertheless there are several constraints on the UK housing market which I believe make the current optimism irrelevant. The first is that although the UK state debt has increased massively: from roughly £450 billion to roughly £900 billion over the course of the past two and a half years, this is dwarfed by the over £4.6 trillion of total British indebtedness. Household debt is a multiple of the government number. While it is true that there was a certain amount of de-leveraging of personal debt, with a sharp reduction of credit card debt being seen in the early part of the crisis, the c. 10% increase in house prices over 2009 has cancelled this out, and indeed the lower interest rates are now fuelling personal expenditure too: and the result is a sharp acceleration personal debt (and not co-incidentally in UK inflation too).

The British are returning to their bad old profligate ways. But why does this matter? The answer lies in revisiting the total debt number: roughly £4.6 trillion. This is a debt to GDP ratio of 466%. In the developed world, only Japan has a higher debt:GDP ratio (roughly 470%). The United States has roughly 300%, while Germany's debt: GDP is roughly 280%. The level of British debt is very high overall, and with the government deficit for 2010 now forecast to be over £120 billion- a higher percentage deficit than Greece- the UK is also increasing its level of debt at a faster rate than virtually any other developed economy.

The Bank of England has dramatically increased the money supply, through its quantitative easing programme and the government has run huge deficits, both policies designed to stimulate economic activity. Both policies have clear implications for the British currency: the Pound. The government will have to undertake a large programme of Gilt issuance- issuing new government bonds- and there is a finite level of demand for this paper. The amount of money the government needs to borrow is so large that they are going to have to offer higher interest rates in order get investors to buy Gilts. The problem is that with inflation already headed over 3%, the level of interest rates needed simply to ensure demand from investors will need to be at least 5%.

Which brings us back to the housing market. If we remember that the average Bank of England base rate- the benchmark interest rate in the British economy- since it was founded in 1694 is 5%, then the idea of talking about "affordability" when we see base rate at 0.5% and mortgage rates of only around 3-4% is very dangerous. The -incidentally unregulated- estate agency business has a clear interest in talking up prices. It has worked: housing prices have in real terms more than doubled and on some measures nearly quadrupled since 1975. The ratio between average salary and average house price is currently close to an all time high. Total indebtedness is also at an unsustainable level. All of this comes at a time when the interest rate cycle is set for a steep tightening.

On top of all of this is that, despite the fiscal stimulus, despite the dramatic fall in Sterling, from €1.40=£1.00 to €1.14=£1.00, the British economy is losing jobs. Glaxo is axing 4,000 jobs in the UK, Bosch nearly 1000 and there will be indeterminate job losses from the sale of Cadbury to Kraft. These are jobs in sectors that should have benefited from the fall of the Pound. All of these job losses come before the rise in rates that will be needed to be able to sell the amount of UK government debt that is coming onto the market over the course of 2010 and 2011. Higher rates and fewer jobs are not good for the fundamentals of the UK housing market.

So, at a fundamental level, it seems clear that there should be fall in house prices. My best guess is that about a 20% fall is justified by the fundamentals. However, the short term technical spike - lack of supply- could keep prices rising for a while. In addition Mr. Cameron now echoes Mr. Brown in saying that cuts in government expenditure will be more gentle than he had previously thought. To me that means unemployment may be lower, but that inflation will be higher. Usually that would mean interest rates rising, but the Bank of England has delayed its hike in rates.

I think that means that the policy makers are therefore relaxed about Sterling falling further. However I think it is a tightrope walk between trying to maintain economic stimulus and not letting inflation cause a meltdown in the currency and an emergency interest rate rise. I think the record of policy makers in avoiding these crises is very poor.

I therefore think there is going to need to be an emergency tightening -possibly even before the general election, particularly if the hung Parliament scenarios become common currency. The impact of a return to rates above 5% will show the current observers of the UK housing market to be living in a fools paradise. British Households did not pay down their debts while they had the chance- they inflated the housing market instead. The consequences will be dire.

So, as the punters adjust their views of the UK in the light of the January numbers. I do not: I still see a fundamental crisis in UK home ownership and a serious instability in Sterling. The effect on living standards, especially when combined with higher taxes to fund the bloated government sector is going to be bad. The only issue it seems to me is going to be the timing: and that I cannot judge just yet.

A failure of Ambition?

As always when coming to France, I am struck by the deliberate way the state has invested in infrastructure. It is not just that their Railways work so well, which is -frankly- a standing rebuke to Britain, the country that invented them, it is also the way in which grands projets reflect a vision of France. It may seem sometimes an overblown, perhaps even bombastic, vision to a more cynical Anglo-Saxon eye, but it does unquestionably reflect an ambition for France.

In a country half as densely populated as the UK- especially its South-East corner- it is obviously easier to build straight high speed rail lines or such huge statements as the Millau viaduct in France. However there is also a far greater will to do so. In Britain we spend billions on invalidity benefit and call it "investing in people"; in France they genuinely do "invest" in infrastructure. It is an investment that allows the French to travel across the country in 2-3 hours. To live in Mid France and still work in Paris: the equivalent of living in Sheffield and working in London, with only a one hour travelling time between the two. By contrast, it takes hours to simply cross London. There are no high speed RER trains in London, which make travelling in Paris so much faster. Cross Rail, which would be RER 40 years later, remains a distant dream, while in Paris there are already 7 or 8 RER lines.

The British economy is choking under the weight of the need to concentrate so much in London and South East England because it takes to long or is too expensive to travel if one is based outside that region. Paris and the Ile-de-France have far fewer problems because of the vision and the ambition that they showed in fixing up their infrastructure. Sure, not all of it works: the Mitterand Library is a poorly built, ugly shambles. Yet still one can not fault the idea. The Nimby-ism and catastrophically expensive real estate market in the UK are impoverishing the whole country.

And there is no-one to even start the national debate about what we must do.

Darling's Double Dip Disaster

The UK has released the latest GDP numbers: on 40% of the data, the statistics show that the British economy finally returned to growth... of 0.1%. The consensus forecast was for 0.4%, so there is no doubt that these growth numbers are disappointing, and there is still the scope for them to be revised downwards. Meanwhile next months numbers are likely to be worse, given the slowdown in retail spending that the increase in VAT is likely to bring about.

So it may be that the British economy has not even come out of recession, and even if it has, it may go back into negative territory at the next data point.

This comes despite the fact that the British government is continuing to run a double digit deficit; A deficit that is not sustainable and which must be reduced sharply. The fact is that those who are seeking to put a positive gloss on the situation of the British economy are missing the point: the country has still not escaped from its fool's paradise where property is always a one way bet and that it is legitimate to borrow as much as possible at today's "low rates" in order to get on the property escalator for the future.

However, the rapid increase in inflation is not just a function of base effects: the whole structure of the British economy is now paying the price for the devaluation of Sterling over the past two years. The Bank of England is signalling that it will not increase rates even if the inflation numbers over the next two quarters are worse than expected. The Bank is trying to avoid the blame for tipping the economy back into recession by raising rates too soon.

Yet all that is happening is that the low rate environment is keeping the UK housing market at an unsustainable peak. The imbalances of the British economy can not be corrected while House Prices are 20% above any sustainable level. As CQS observes in their latest briefing: the outlook is for considerable turbulence in the UK economy.

The risk that the Bank of England runs be keeping rates low is that the erosion of Sterling that high inflation causes becomes a collapse in confidence in the currency.

As I have noted before, the choice is stark: either keep rates low and risk a Sterling collapse or increase them and trigger a house price fall, with a risk of further problems in the banking sector. For the time being, the market believes that the Bank of England will have to raise rates quite soon. If they are disappointed then there is a real risk that the Pound becomes permanently dislocated from its previous trading range and drops to parity with the Euro, or even below.

There is a certain amount of patience still in the market, because the expectation is that a new government will take effective action against the deficit, but the UK is running out of road. If, despite the massive deficit spending, the double dip actually happens, then the policy choices are all very unpleasant indeed. The government after the next election may find that it has to make pro-cyclical cuts in government expenditure even though the economy has returned to recession. Under those circumstances the longest recession since 1945 which we have supposedly just emerged from will look like a phony recession: the impact of Great Recession II will involve the painful restructuring that the Brown government tried to avoid and it will be all the worse for having been delayed. The imbalances in Housing may finally be addressed, but the consequences for millions of mortgage payers will not be pretty.

So, it is not a wonder that there are growing mutterings about the outlook for the British economy over the next few years: and those mutterings could become a roar quite soon. The day of reckoning will come very soon unless there is real leadership at the Treasury and the Bank of England.

A chill wind

Tonight in Tallinn is set to be one of the coldest nights so far: minus 24 Celsius.

In fact it has not been above -14 for a while now. Personally I prefer it like this than when it is around freezing point, because there is no damp in the air, so it feels drier. Not to mention the fact that every day has begun with a beautiful clear sunrise and with the sun on the frost, the days are bright and cheerful.

We have some snow forecast in the middle of next week, but I will be back for a few days in London and Paris, so hopefully will miss this and the -6 associated with snow.

It is certainly true that you adjust your frame of reference quite quickly: once upon a time I would have considered -6 to be quite cold!

However, despite the cold, there have been three separate reports today that confirm that Estonia is on track to enter the Eurozone on January 1st 2011. It looks like we have finally struggled through our economic winter. Christmas tourism is up sharply on this time last year. The economy is out of recession. Finally, the place is looking up.

Meanwhile I shall go cross country skiing tomorrow in the bright sunshine. The chill wind is blowing this country some good.

Glass-Steagall Redux

President Barack Obama is in a mean mood. Furious that his Democrats were unable to hold one of the safest seats in the Senate, he allocates at least some of the blame for this on the large bonuses that the Wall St. bankers paid themselves in the middle of the election campaign. In the battle between America's Main Street and Wall Street- the votes are largely on Main Street.

Yesterday the President made his move: He has announced that he intended to restrict the ability of banks to use their own capital to take positions in the market, so-called proprietary trading. This is not exactly reimposing the highly restrictive Glass-Steagall Act, but it is being seen as a serious attempt to bring the bankers under control.

So serious, in fact, that the markets have fallen sharply in response. However, despite the approving noises made by George Osborne this morning, it will be quite difficult to enact these restrictions. The German model of Allfinanz or French Bancassurance is explicitly based on the ability of deposit takers to trade on markets. However, the way in which these institutions trade is rather different from the Anglo-Saxon model. Even still, the intervention by President Obama will be exceptionally difficult to enact internationally- even with the support of "Squeeky" Osborne.

I think Mr. Obama's challenge to the banks will be resisted tooth and nail. The resistance will come not only from the bankers themselves, but also from Europeans and Asians who have operated under different financial models.

President Obama, facing defeat on his health care proposals in Congress as the result of the Massachusetts special election, may find that he is picking up an even more difficult battle.