Montrose Journal Summer 10

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When we ask who has emerged best from the crisis it's important to remember that we can only talk relatively. The Great Recession which had its roots in the financial crisis starting in 2007 has left the whole world poorer. Millions of people have been thrown out of work and full employment will probably not come back to the advanced economies for many years. Great wealth has been destroyed. Some of that wealth was imaginary, the product of share and house prices out of line with the world in which they lived. But real wealth has been destroyed too. Factories have closed and will never re-open. Businesses which were built up over many years have been wiped out.

The downturn hasn't been uniform, but no one in the advanced world escaped.

So we need to remember that if we say that country A has done better than B or worse than some C, it's a bit like discussing whether France, Italy or England did best in the World Cup.

With that caveat in mind, who is best place now that the first fierce wave of the crisis has abated? To answer that we need to answer two questions.

What is the world environment going to be like over the next few years? What sort of economic structures will handle that best?

It's likely that advanced nations face low growth and very low inflation, possibly even outright deflation. If that's right, the countries best placed going forward are those with the greatest ability and will to counter the deflationary pressure and with a sound underlying structure. Without the policy will, bad actions might damage the economy unnecessarily. Without the sound structure, there is a limit to how much even the best policies can do.

So what sort of world do we have now? Everyone agrees that the economy has been dangerously unwell. But there are differences about the diagnosis just as different hospital specialists might disagree about what ails an individual.

Threats to a patient usually come in one of two forms. There are the acute ones, like accidents or illnesses such as pneumonia which build rapidly to a crisis at which point the patient dies or gets better. And there are the chronic illnesses like diabetes, which lead to a steady deterioration in the patient's life and well-being unless properly handled.

After a shaky start, policy makers in the west showed a lot of dynamism in presenting a united response to the crisis stage.

If it was just a crisis, then the patient ought to be encouraged to get back to normal. But chronic illness needs something more. Above all it requires a willingness to keep taking the medicine even though the symptoms have disappeared. In fact it requires a willingness to understand that it is because of the medicine that the symptoms have disappeared. Stop taking it and the symptoms will come back. There's a big risk too many people will forget that.

The policy battle which is now taking place is between those who think we had an acute crisis which has now passed, and those who fear the chronic disease.

Those who think the former have been winning the argument. The Bank for International Settlements (BIS), which groups all the central banks in the world, says the financial system is now out of the emergency room and in intensive care. Now the BIS says it is now time for the patient to get up, start exercising and for all the nurses and doctors to stop mollycoddling him

The "Emergency Room" theory of the crisis (let's call it "ER Theory") has gained ground in Europe. At a recent G20 meeting, the US was isolated in its calls for more fiscal measures to expand the economy. Instead, it had to accept that many countries are starting to tighten policy. Even in its own country, the Obama Administration seems unable to persuade Congress to take more action to stimulate the economy. Since the election of a new government, the UK is committed to a policy of drastic fiscal tightening over the years to come to 2014. In the Eurozone, the "Club Med" countries have all experienced milder versions of the crisis which gripped Greece and has forced that country to adopt draconian measures to cut spending and raise taxes.

Even in countries where bond markets show an extraordinary desire to buy government paper, like Germany, fiscal policy is tightening. All across the Eurozone, governments feel they have to preach austerity for themselves and severity towards their voters.

At the same time the "ER" Club of central banks, with the ECB at the head, have started gradually unwinding some of the special measures which they introduced to save the banking system. So both the fiscal and monetary measures which prevented the crisis becoming fatal have started being gradually withdrawn.

Underlying the ER theory is that most things were going fine until the crisis came along. A revolution in policy thought produced an extraordinary consensus on a set of beliefs. These were that Central Banks should be totally independent, should set interest rates to keep inflation low but not interfere on where banks lent the money, and also that governments should never run big deficits and should pay off the debt in good times. The central banks should nurture confidence in the markets by being as predictable as is consistent with steady inflation. In this theory, unemployment is a problem caused entirely by flaws in the labour market and no business of macro policy. Because trying to cut unemployment by easing policy would just lead to higher inflation. If mistakes were made by Central Banks, according to this view of the world, it was that they left interest rates too low for too long, thus encouraging bubbles and speculation.

Yet many of those policies need to be reviewed in the light of what has happened.

In the middle of this decade, Mervyn King of the Bank of England boasted of the success of central bank run monetary policy. "It's no coincidence," he said, that we had years of fast growth and low inflation once the bankers were allowed to get on with the job. No one seems to have asked him whether it is just coincidence that we've had two stock market bubbles, the worst recession since the war and the collapse of the banking system. Yet there is a strong case for making a link.

Cutting government deficits meant that interest rates had to be low to prevent the economy sliding into recession. Obsessed by the level of government borrowing, central bankers were wholly passive in the face of giant private borrowing. Low interest rates meant money flowed into assets such as housing or equities which formed bubbles. The hands off approach to what banks lent poured money into speculative sectors.

Even low inflation, the jewel in the crown of policy of the past 20 years, made the world vulnerable when the crisis came. Because it meant that Central Banks were already getting near the moment when interest rates were so low they could not go any lower.

Since real interest rates are nominal rates minus inflation, inflation at below zero means that real interest rates are always bound to be positive. In theory, Central Banks can deal with this by buying government bonds so that long term real interest rates stay low or at zero per cent. The Anglo-Saxons (the US Fed and the Bank of England) have actually done this. As a result the governments of those two countries have been able to run very big deficits without needing to pay higher interest rates for their borrowing. At the beginning of the decade, at the time of an earlier, milder crash in 2002, Ben Bernanke pointed out that this is the backstop which should prevent a repeat of what happened to the US economy in the 1930's.

Thus one crucial distinction is clear between Anglo-Saxon economies and the Eurozone. The Anglo-Saxons have been willing to take much more dramatic action to help the economy.

Partly this probably reflects their structure. The financial sector is much bigger in the UK and in the US than it is in the Eurozone. Banks in London and New York were much more heavily committed to the sorts of speculative activity which went disastrously wrong. But there was also a greater willingness to admit the scale of the financial problem than in the Eurozone. It's only now, 15 months after the US forced its banks to come clean and even longer after the UK banking sector was bailed out, that European banks are being asked to show similar openness.

But such thinking is anathema to the ECB, which thinks that the last thing it wants to see is government borrowing made easier. Although they have done some very timid technical intervention to improve liquidity in the markets hit by default fears, this is matched by action to take the money out of the system.

Eurozone economies thus have a central bank which appears by inclination to oppose the sort of measures which prevent deflation. It is not surprising that it says the risk of deflation does not exist. There are grounds for saying they are wrong.

A recent study by French economist Patrick Artus shows the problem.

If Europe grows at 1% a year in real terms (his estimate of underlying growth, which may be slightly pessimistic but is not absurd) and inflation is 1% (which seems very likely on current trends), then the nominal output of Europe will go up by 2% a year.

The lowest long-term rates in Europe are for German government boČnds. They are around 2.6%, down from 3.5% a year ago. Everyone else pays more.

So those with debts will have to pay more interest every year that the economy grows. In other words, the debt to gdp ratio, not just for governments but for borrowers as a whole, will rise steadily.

Unless of course private borrowers and governments both cut back on their debts buy spending less and saving more. But if they do that, the spending needed to expand the economy won't be there, so the recession will come back with renewed vengeance.

What could stop this? As a largely arithmetical exercise, Artus says (and he fully realises this is not going to happen) that governments could stop this deflation by enforcing a 20% pay increase everywhere, coupled with a 20% devaluation of the Euro to keep Eurozone exports competitive. In other words, target a drastic INCREASE in inflation through higher wages.

There is of course no chance of that policy being pursued. It would require the ECB to abandon its inflation target of just below 2%; need government interference in pay bargaining on a wholly unacceptable scale; and have enormous dislocative effects as some industries would be affected much more than others.

But suppose this does not happen.  It's not at all clear what stops the rising burden of debt (caused by the low nominal growth in gdp) from pushing Europe into a Japan-style deflation.

For Eurozone countries they have no way of opting out of this scenario. Some countries initially used aggressive fiscal easing to counter the problem, but the scope for that is being closed off by increasing calls for everyone to move back into balance.

The obvious sufferers in this are the countries of southern Europe, many of whom were only reluctantly admitted to the Euro in the first place and which have been steadily losing competitiveness. Ironically, if they were outside the Eurozone the tendency to high inflation which they have shown over the years would be a boon. They would find deflation easier to resist. But to do that and keep their current accounts manageable they would need to allow their currencies to depreciate. Eurozone membership prevents them from doing that. If it wants to, the UK can use its freedom of manoeuvre to respond to the deflation threat.

The chart shows the consequence. Those countries which are being forced to take the toughest measures (Spain and Ireland) were those most in danger of drifting into a deflationary spiral. Greece has probably joined them following the measures it has been forced to take in the wake of its crisis. Defenders of pursuing the current sort of policy have an answer to this. It is that everyone has to follow the German example, hold down wages, cut wage costs and become more competitive. This is the orthodoxy of European policy for the past 20 years. A long period of slow growth, high unemployment and government cuts in welfare programmes would all tend to force through the sorts of changes which this explanation of the situation relies on.

Defenders of pursuing the current sort of policy have an answer to this. It is that everyone has to follow the German example, hold down wages, cut wage costs and become more competitive. This is the orthodoxy of European policy for the past 20 years. A long period of slow growth, high unemployment and government cuts in welfare programmes would all tend to force through the sorts of changes which this explanation of the situation relies on.

Back when wage inflation was a major problem, forcing up prices to an unacceptable level, it was easy to see the macro sense in this. But high inflation is not the problem in the Eurozone economy now. The problem is that consumption is too low and lower wages and tighter fiscal policy both tends to reduce it. For example, all governments are cutting back on the generous pension schemes which they run.  As they do so, households have to save more for their old age, especially since for many the idea of staying in work until they are 68 is just a dream because there are no jobs.

There is no doubt that in Germany the economy has shown an ability to adapt and improve over the years. That improvement reflects the extraordinarily strong culture of the German corporate sector. Big companies like Siemens have kept their focus much more strongly than most of their counterparts elsewhere, distracted by takeovers and reorganisations. Apart from one or two disastrous flirtations by the car companies with overseas production (Mercedes buying Chrysler and being forced to sell; BMW buying Rover in the UK), the giant German corporations have kept a very strong sense of identity. The headquarters are spread around the country, often near the biggest manufacturing plant. Engineers usually play a leading role in the company rather than the finance department having all the say. It's this comparative simplicity compared to the Anglo-Saxon tradition of finance-led corporations which probably explains their success, not any better macroeconomic handing of the economy.

This is about as far as it is possible to get from the model in the UK and it highlights the UK's main area of weakness. London has always been a financial centre, but over the past 20 years its importance has grown enormously. Although providing relatively few jobs directly, financial institutions became the backbone of government tax raising and also contributed greatly to foreign currency earnings.

In a sense, the City took over the role which the North Sea oil played in the 1990's, pushing up the value of the pound and thus making British exports less competitive; but giving government the revenue to boost public employment. In the wake of the crisis, it seems unlikely that the tax revenue stream will recover to its previous level, which is one element behind the new government's attempts to cut public spending.

The weaker pound which has come about from a mix of lost currency earnings in the City and the fact that the UK is pursuing a looser monetary policy than the Eurozone will help British exporters. But it's hard to feel optimistic that this will on its own provide a big enough boost to prevent the UK sharing a pretty gloomy outlook with the rest of Europe.

Lacking the big industrial companies which lie at the heart of Germany's strength, the UK has become at best a place where firms set up local branches, be they US banks in Canary Wharf or Japanese car makers dotted around the landscape. The weaker pound will certainly help, as long as the vagaries of the foreign exchange market maintain it. And the Bank of England may be willing to do a new round of easing to boost the economy.

But the UK seems increasingly to share in the sense of defeatism about world growth which is spreading through governments. Everyone knows that growth looks slower than is needed to make a meaningful impact on unemployment. Everyone knows that slow growth is one of the things killing government finances.

Many but not all economists realise that something can be done about this. It would need a willingness to reject the voices of conventional good behaviour which dominated before the crisis and are back n the saddle again, apparently unfazed by the results of their earlier actions.

There is no sign that financial markets even have a scintilla of doubt about government debt overall. That is why bond yields are lower than at any time since the war. But fears that markets might have fears seem to be spreading paralysis.

Instead, governments everywhere seem to be concentrating on trying to prepare their populations to accept failure.

Like some of those truly atrocious matches at the latest World Cup (Japan 0 - Paraguay 0 sticks unpleasantly in the mind) everyone has decided that it's too risky to actually try to score a goal.  But unlike the World Cup, there is no rule that however bad both teams are, one of them must go through to the next round.

Instead, we are trapped in a malign version of Alice's Wonderland, where an evil Dodo has decided "nobody has won, and none must have prizes.'

The writer is a financial analyst and commentator

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