The USA, Russia and the EU.

The recent Helsinki summit between Trump and Putin has set the cat amongst the pigeons in diplomatic circles. Trump’s desire to ‘get along’ with Putin and Russia has been declared treasonous by many former American diplomats. The Europeans are feeling somewhat left out in the cold faced with threats to the NATO alliance, rising tariffs on exports to the US and outright contempt by many US politicians. What should they do in these circumstances? Why not do something really radical and heretical like getting into bed with the Russians? Before one is accused of treason for advocating a liaison the West’s traditional enemy, think of it like this. The world has changed in the last 30 years from a bipolar one of the West dominated by the USA against the communist East dominated by the Soviet Union into a multipolar one. We still have the USA as the world’s dominant power. Rising fast is China which has not only a rapidly growing economy but 4X the population of the US. We have Europe, which has a larger economy than the US but a fragmented political system. Finally we have Russia, the remnant of the old Soviet Union and the world’s biggest country by land mass. The thing to remember about Russia is that its economy is not that large, ranking only 11th in the world nor is its population at 145m that great, a bit over 40% of that of the USA and a tenth of China’s. What makes Russia great is its landmass and its history not just that of the Soviet Union but the old Russian Empire of the Romanovs. She wants to remain a major power in world politics but is constrained by the relative size of her economy. To succeed as a major power, she can no longer rely on might but instead she needs to be a nimble operator, as recognised by her current president, Vladimir Putin. In many respects Putin has played this game well with successes in Syria and the alleged interference in domestic US politics. Other escapades have proved to be less successful, for example the Ukraine where Russian backed separatists have stalled. This has proved costly for Russia because of Western sanctions and illustrates Russian weakness, which remains the economy. This shows why Russia may be open to a deal. Russia remains overly dependent on energy and has failed to diversify its economy. Capital continues to flow out of the country. The removal of sanctions and greater integration into the European economy would make Russian respectable again and would be a big boost for the Russia economy. This is important for Russian political ambitions which inevitably cost money. The downside for Russia would have to be admission of guilt for previous sins such as the downing of the Malaysian Airlines plane and restrictions on meddling in the affairs in Europe. There would be several benefits for Europe. As with Russia, the obvious one is the economic benefits that would accrue to Europe with increased trade. In addition, there should be a reduction of tensions in the Eastern Europe, particularly in the Balkans. It also might make it easier to tackle corruption in Eastern Europe. The third benefit would be a demonstration of independence from the US. It may be that NATO is indeed finished and Europe needs to start thinking seriously about its future security independently of the US. It would be a demonstration of European integration and clout. There are many reasons why such a deal is highly unlikely. Mr Putin is undoubtedly enjoying playing with Mr Trump and may consider Europe not worth the trouble. The Europeans may think that Mr Trump will not be in the White House for much longer and normal service will be resumed shortly. Could Europe trust Mr Putin not to renege on any agreement after a short period by causing trouble say in the Baltic States or the Balkans? Any agreement would have to allow the Ukraine to fall back within Russian orbit which would be a major betrayal. Another issue would be that if the Americans have the clout to deny Europe any flexibility with Iran, they have the clout to deny any independent deal with Russia. Finally of course the Americans might realise that treating the Europeans with contempt might not be in their best interests. All these are valid points and there may be many other objections. But there is no harm in exploring the issue and one never knows.

Italy

I am finding it rather difficult to know what to make of the recent Italian bond volatility except that it is a bit of a storm in a political tea-cup. The decline of established political parties and the corresponding rise of so-called ‘populist’ parties needs to be put into context. Whatever the rhetoric about leaving the euro-zone, the euro itself remains more popular amongst Europeans than the EU. There is little desire to return to national currencies and if Greece can remain within the euro (at considerable cost to the Greeks), why should not Italy? It is hard to see what about the Five Star Movement and the Northern League would gain from actually giving up the euro, particularly the Northern League whose strength is derived from a region that has done tolerably well out of the EU. Joining the Eurozone was probably not the wisest decision the Italians have ever made but leaving would be equally unwise. All that said should not disguise the serious issues outstanding to help monetary union work better, primarily some form of banking union, greater risk sharing between countries and a more expansive fiscal policy by Germany. Italy itself needs to address its banking sector and the bad loans therein. I see little reason but to expect more of the same, Italy to remain within the Eurozone but with a struggling economy and with bond yields at a substantial premium to those of Germany.

Global growth

Global growth. The IMF has recently released its world growth projections alongside its April world economic outlook. It paints a tolerably optimistic outlook with expected growth of just under 4%pa for the period 2017/19. This compares favourably with 3.4%pa for the previous 5 years 2012/16. The driver behind this improvement has been the OECD countries where growth is forecast to rise from 1.7% to 2.3%pa whereas developing countries’ growth will remain at around 4.8%pa over the whole 2012/19 period. The IMF gives two reasons for the improvement; the first is a rise in investment spending and the second is an increase in trade volumes. It is worth putting this in context. Global growth has averaged 3.7% since 1970, (implying a doubling every 19 years), so what the world is currently experiencing is in line with the long run trend. This might come as a surprise to some who think of current growth rates as being poor. What has happened is two-fold. The first is the rebalancing of growth away from the rich countries of the OECD to Asia and China in particular. The second is that we have been conditioned by the GFC of 2007/08 and the relatively weak recovery afterwards to think that the current situation is dire. In fact, global growth was weaker in the 1980s and 1990s than it has been since the millennium. Things however are changing. The emergence of China as an economic super-power has helped sustain global growth since 2000. But growth rates of over 10% are unsustainable and Chinese growth is likely to settle down at around 5% or less with consumption rather than investment and exports as the driving force. This means that China will be source of demand rather than supply. The second factor is that the recovery in OECD countries since the GFR was driven by an ultra-loose monetary policy in preference to using fiscal policy. This is ending, most notably in the United States. Here, the Federal Reserve has raised rates and is reducing the size of its balance sheet. The Administration under Trump has significantly loosened fiscal policy by disguising it as tax reform. This leads to a third factor. The US Administration wants to reduce the American trade deficit using a combination of threats and tariffs but its monetary and fiscal policies will have the opposite effect. This wrong mix of policy will lead to a higher deficit which could lead to more tariffs and so to a break-up of the old liberal world trade order. In the short run, the gradual tightening of monetary conditions could cause some turbulence. American policy should lead to a stronger dollar, which is always bad news for emerging markets. We have already seen this in Argentina and Turkey. Corporate spreads are widening a bit which could put pressure on high yield investments. There is still quite a lot of bad debt hidden away on bank balance sheets most notably in Italy. The travails of Deutsche Bank demonstrate just how much bank restructuring in Europe has lagged the US. The good news is that inflation remains on the low side albeit rising commodity prices and a stronger dollar will have an impact. As always, we live in interesting times; matters are never quite as bad as they seem but Donald Trump will do his best to make them so, and whatever you do, don’t share his self-serving optimism.

Prospect Magazine and economics

Prospect Magazine and economics. Prospect Magazine recently invited a number of economists to opine on the state of their discipline and what in their view single measure needs to be addressed. The state of macroeconomics remains dire with macroeconomists having largely failed to anticipate the Great Recession and struggled to come up with solutions to the problems created in the post GR period. In no particular order, starting with Martin Wolf of the FT, he bemoans the state of the discipline and its reliance on encouraging debt and high property prices to boost demand. Larry Summers, ex US Treasury Secretary wants us to get to grips with economic cycles and Brad deLong of University of California thinks we are running out of options to deal with the next downswing. Jim O’Neill once of Goldman Sachs wants us to learn from China whose macro-economic management seems to be better than ours. Barry Eichengreen of Columbia University wants us to focus more on employment. Jagdish Bhagwati, also of Columbia University wants us to defend the benefits of free trade and globalisation. Robert Gordon of Northwestern University bemoans the failure of technology to have any impact on productivity. And Ruth Lea thinks we are all hopeless at forecasting. Adair Turner wants us to clip property’s wings (not just bricks and mortar but intellectual property as well) based on the rising rent from such property is leading to increased inequality. He could perhaps have added that gearing up lending on property led to much of the financial sector’s problems in 2007/08 and in previous recessions, e.g. the S&L crisis in the late 80s. What all these prognoses do is focus on is the real economy, and yet the crisis of 2007/08 was a financial crisis. The economics profession has been good at modelling the real economy and, more debatably, the financial economy but hopeless at merging the two. The only economist who has come close to it was the late Hyman Minsky yet he remains outside the mainstream of the profession. Tim Congdon of the Institute of International Monetary Research wants us to study how the banking sector interacts with real economy, a vital first step. Ann Petifor of Policy Research in Macroeconomics argues that there can never be a market in money. It has always been assumed that it is governments that print money yet recent monetary thinking suggests that it is banks that create money. This is what Mervyn King calls financial alchemy, the liabilities of the banks being money which is liquid but the assets being long-term loans which are not. The asset/liability mismatch of the banking sector is the cause of much of our problems. John Kay takes this a stage further. Bankers are rewarded by taking as much risk as possible and model their operations accordingly. In normal times, the models work but occasionally they don’t and when they don’t, disaster beckons as happened in 2007/08. He calls this ‘radical uncertainty’ (as does Mervyn King) and accepting this will radically undermine much of modern finance theory, for the better. Tinkering with regulation will not work as the regulators failed miserably in the run up to the GFR. Personally I do not think the problem lies with the ‘real’ economy but our failure to come to grips with the banking sector. Deposit insurance ensures a substantial implicit subsidy to banks. Banks have been forced to substantially increase their capital base which is no bad thing, but we still have no real idea how much capital banks should have. In order to make a return on expensive equity, they have every incentive to gear their balance sheets and to run rings around regulators. But the political will to radically reform the structure of the banking sector is largely gone as the GFR becomes a distant memory. And anyway, why worry as Deidre McCloskey of the University of Illinois says, economic development is a positive sum game and our economies continue to deliver.

Regulation. There is a dilemma with regard to regulation of the financial sector. In principle, regulation should be a set of rules that governs behaviour in the financial sector, that states what behaviour is acceptable and what is not and what is legal and what is illegal. All this should be done independently of the economic cycle but in practice that is not what happens. It is best described by Warren Buffet’s statement that it is only when the tide goes out that we can see who is swimming naked. In other words, it is only during a financial crisis that regulatory weaknesses are revealed, and this leads to cries for more and better regulation. When the economy turns up again, there are demands for the relaxation of those regulations. This rather suggests that the flow and ebb of regulatory pressures may unintention-ally be part of the problem. This is the conclusion of an interesting paper by IMF economist Jihad Dagher called ‘Regulatory Cycles: Revisiting the Political Economy of Financial Crises’ which explores this subject in considerable detail. He notes that there is a definite correlation between economic upswings and periods of deregulation and suggests that regulation implementation is pro-cyclical rather contra-cyclical. In other words, it is all about the timing of regulation and its implementation makes the problem worse, not better. It is difficult to know how to escape this inbuilt pro-cyclicality of regulation. It would be a very brave politician to stand up at the bottom of financial crisis and say that we should relax banks’ capital requirements and not tighten them. In 2009, it was clear that the banking sector had been operating with too little capital for quite some time and the regulators were rightly castigated for missing this. But it is equally clear that forcing banks to build up their equity capital base since then has contributed to the weakness of the recovery. It is equally clear that now that we have a strong recovery kicking in, now is not the time to relax regulatory pressures. But with the current occupant of the White House showing little or no understanding of economics, it is unlikely that anything will change.

UK economic growth. I distinctly remember a BBC Question Time programme just before the Brexit vote in which it was claimed that Europe did not matter for the UK economy because it was low growth and the UK needed to open itself up to high growth countries elsewhere in the world. This claim always struck me as odd. For a start, what matters is the volume of trade with between two economies not their overall relative growth rates. Geography matters when it comes to trade. Secondly what matters again is the solvency of the country one is trading with - can it pay its bills? And finally, no evidence has been produced to demonstrate that the UK's membership of the EU was hindering its trade with non EU countries. In fact, most high growth economies would rather deal with the EU than a UK outside the EU; after all, the EU is much the bigger market. The next thing that has puzzled me is that if the claim was true, namely the UK economy would boom once freed of its EU shackles, one would have expected sterling to have risen post the vote to leave the EU. Instead it has fallen, by 15% on a trade weighted basis, to August last year but it has recovered 1/3rd of that fall since then partly reflecting dollar weakness. Brexiteers have made much of the Remainers claim that the UK economy would crash if the UK voted to leave the EU. That of course did not happen; what happened instead was the fall in sterling. It was the currency that took the strain of the vote, not the economy. Finally much has been made of the UK's better than expected economic growth since the Brexit vote. This, however, is not because of Brexit but because world economic growth has improved and most particularly EU growth has recovered substantially. The lie of the Brexiteers' position can be seen by comparing the UK's growth rate relative to that of Europe. In 2015 it exceeded that of Europe by 20% (2.4% v 2.0%), in 2017 it was 62% of Europe (1.5% v 2.4%) with a similar outcome forecast for 2018. It seems to me self evident that the UK economy has suffered because of the Brexit vote and the uncertainties over the UK's position vis-a-vis the European Single Market. Whatever the potential merits of Brexit (and there will be some), there will be substantial short run costs. These will be alleviated to a certain extent by the cheapness of the currency and a booming global economy. In conclusion, it is the short run costs that matter and are visible; any potential merits of Brexit are simply pie in the sky.

Carillon Carillon’s bankruptcy is a seminal event but possibly not for the reasons that many think. It certainly does not prove that privatisation doesn’t work and indeed the notion is absurd. Private companies go bankrupt all the time. Equally absurd is the idea that reliance on Government contracts is a recipe for success. Another absurd idea is that Carillon’s demise represents private gain, public loss. Carillon’s shareholders will be wiped out, most of the bonds’ value will be lost and the banks will take a huge hit. There is no shortage of private sector loss. Whether there is a public loss is debateable. Carillon quite clearly did not make money out of its Government contracts so one could argue that it was the Government that was exploiting Carillon rather than the other way round. There is obviously a debate to be had about the role of the private sector in providing a myriad of public services but Carillon’s bankruptcy does not shed any light on that. Privatisation was an exercise in risk transfer from the government to the private sector; Carillon took that risk and failed. The questions that Carillon’s bankruptcy raise are rather different. The first question is over the role of the auditors, KPMG who seem to have completely missed the fragility of Carillon’s finances, and if they didn’t, why didn’t they raise questions. The increase in regulation over auditing, audit reports, audit committees etc does not seem to have worked. Company reports get longer and longer and more complex as a result of this regulation but it seems the net result is that it is more difficult to assess a company’s financial position not less. The second question is the old one of corporate responsibility when directors and senior management are paid huge salaries and bonuses but can still walk away with the money even when things go completely awry. This is the private gain that gets the man in the street so angry and quite rightly so. The third question is what the Government was doing in all this, seemingly awarding new contracts to Carillon in the vain hope they might solve Carillon’s cash flow problems. I call this ‘Micawberment’ rather than government. What conclusions do we draw from this? There will be increased pressure on the auditing profession without actually changing much. Governments will continue to govern but will do a lousy job of it as always. We might, and should, make some progress in holding directors and senior management accountable albeit not much progress has been made. The real lesson is a more general one. Companies go bankrupt all the time and there is nothing that Governments or any-one else can or should do about it. It is called risk and there is no escaping it.