Wednesday, June 30, 2010


When banks hit the rocks like ships caught in horrendous storms and governments have to send out the lifeboats and tugboats and the populace and shops are fearing for loss of jobs as trade suffers, and salvage operators circle like vultures, we are told that there are three questions potential investors in banks need to ask.
How much liquid capital is the sector going to need to refloat and stay afloat?
What will regulation do to normal EXPECTED earnings and borrowing and lending costs?
How is the economy when there is a drought in financing; should we fear deflation, another recession e.g. in EU and Euro Area, fall in world trade hurting China, Germany especially, asset bubble-burst recession in PR China, emerging market countries running higher deficits, world growth stuttering, etc? Tidbits from the Group of 20 meeting, stress tests by banks, and what is being called Basel III new regulations for banks to build up larger buffer reserves to cover unexpected shocks (e.g. double-dip recession) and the US Congressional bill for financial reform (agreed without special tax levy on US banks of $19bn)and similar developments in Europe, may partially answer the first two questions. What is not answered by anyone convincingly is how the banks may be anchor-dragging on economic recovery because they continue to shrink their loan books. The truth is that many banks remain beached and the lending tide to refloat them and for them to refloat stangnating business remain out.One has to wonder at the gall of banks such as the UK clearers who can say to Government boldly and on television that they are approving over 80% of business loan requests especially to small firms, when Bank of England survey data shows the figure is only 40%. Senior loan officers in several banks tell me the true figure is much below that, in fact banks are refusing 80% of loan requests! Are our bank managements knowingly telling lies or just ignorant of what is going on underneath them, or relying (as they often do) on some number that some bankers casually quote about a period of time long past and parrotting it as if still current because it sounds good. I suspect the latter.In the USA, if this was the case Congress would erupt in anger, but nothing like that anger is so far occurring in among UK legislators, matters being left to Vince Cable leading an enquiry tour of the banks and the new Banking Commission enquiry. The HoC Treasury Select Cmte voted in (not appointed) may take a stronger line than hitherto. They could do no better than ask me for the facts. UK legislators are respectful toward banks even though the banks are not important sources of political campaign money. In the USA where firms can now donate any amount of money and it is an election year, legislators will still get very angry about the banks because this has strong public appeal, but may blunt their swords as in the banking reform bill. How much banks can rely on bribery or PR lobbying is therefore quite complicated. How much firepower can any sector have that remains underwater and in hock to government? For example, what should our politicians be thinking about the stark facts (among many I have collected) that German banks lend 16% of all non-financial customer loans to small firms, US banks lend 10%, while UK banks (domestically, including foreign-owned banks in UK) lend only 1.5% of all customer loans to small firms? Let us not forget that small firms employ half roughly of all private sector employees i.e. 40% of national totals.
Governments, G20, EU, NGOs and various policy pundits, journalists and economic forecasters are torn between how urgently they want banks to cushion themselves with generous amounts of reserve capital and wanting banks to pump-prime recovery by boosting lending to key sectors such as small firms, manufacturing and business generally.
In 'credit-boom' economies like UK and Spain and Greece there is also some pressure on banks also to resume mortgage and property development lending even if this will not help narrow trade and payments deficits. Central banks in Spain and Greece will resist this, but the UK is uncertain given the continuing housing shortage.
Governments are also committed to no more banking shipwrecks. But banks are making way in stormy seas, some more powerfully than others, but all are variously interdependent, netyworked. Shipping, for example, is transport, a transmission mechanism like banks, exposed on the ocean waves of the world economy, but dependent not on their own power so much as on the tides, currents, and world economic system. It is not part of regular business management thinking, however, to see firms as part of the global system, but only as succeeding or failing by whatever they do for themselves. This is only half of the truth. The other half is what banks, governments, business science and poltiics have most difficulty coming to terms with. Why because there are too many variables for them to compute, and they do not have the geostationery guidance systems yet to make sense of all of that. We should not be surprised therefore when "every man for himself" is the repeated kneejerk response to systemic panic.Those fearing another bout of embarassing losses among banks as they unwind their Credit Crunch spaghetti of inter-linkages, and start to count up realised losses after recoveries and collateral disposals, want banks to hold enough tier one capital to withstand another financial crisis as big as the last one. It is actually similar to requiring banks to carry enough water to refloat themselves like ships off the rocks, or like BP must have enough capital to pay all damages and clean-up costs of the Gulf of Mexico disaster. Yes, but what is the next Credit Crunch is more like ships in a desebanks to refloat off the reefs without government support. In my view this is foolish thinking for two reasons:
1. banks would have to hold three times minimum regulatory capital i.e. 24% ratio to risk-weighted assets, and
2. government bailing out of banks is very cost efficient and over the medium term profitable to taxpayers.Credit Crunch was like ships suddenly finding themselves in extreme ebb tides straned in a desert of all liquidity sources dried up so that they could not refinance their funding gaps and stock markets withd more negative liquidity (shorting and panic selling) than positive liquidity (long term investors). Government had to step in and water the desert or dig channels and drag the hulks back to sea. Authorities (of all kinds), however, are now urgently keen to see governments disengage from bank aid-packages and to sell stakes in banks as soon as possible, to return all matters to private markets, and this against a background of a Greek Chorus chanting "let banks fail, no more moral hazards" (including some banks such as Banco Santander and HSBC and others' related views). The idea is that when assets are underwater banks should have enough compressed gas in their recovery balloons to lift the sunken wrecks back to the surface for repair and recovery. My three times regulatory capital estimate was recently confirmed by the FT commenting, "For months now banks have been worried because if “support” includes all benefits from implicit taxpayer guarantees – for example the ability to generate a high return on equity from excessive leverage and a lower cost of capital – banks would require more than three times today’s level of equity capital to compensate, according to some studies." (i.e. mine.)
But if support simply means covering losses, US banks have tier one capital to cover gross losses up to $1,200bn. Yes, but then they must rapidly replace that capital or they are insolvent. Net losses, would be half this or less, but they take a few years to confirm i.e. $1.2tn gross capital replacement that become $600bn net. In Europe the figures are similar but larger i.e. $2tn and $1tn.
Many may argue this thinking is too lax. But if new Basel capital adequacy standards eventually follow the G20’s lead, a big worry for potential investors, banks will require half as much again in liquidity reserves. How do they do this? They have to sell off some operating units, non-core assets, asset management and insurance, and reduce their own portfolio capital for trading. In my view this is taking defensive thinking too far and too abstractly. The general concern is to stop banks building up asset bubbles again. This is a symptom and in some sense what always has to happen anyway. It is more vital to consider the matter less abstractly and more in terms of how banks are risk diversified. Banking has gone too far in containerisation to only see the portfolio boxes and loans in the abstract and not what is inside the portfolios, inside the many same shape containers.In my view it is far more important that banks rebalance their loan portfolios so that they are much better risk diversified across all sectors of the economies where they operate. In export led economies like Germany and China banks lend two third to business, directly and indirectly (via loans to other financial firms), while in credit-boom economies banks are lending more than two thirds to mortgages and property. These extreme biases lie at the heart of extreme imbalances in the world that were the ultimate original cause of the Credit Crunch.
Market analysts are incapable of looking at the macroeconomic picture. It is above their pay rate. They are tasked to be obsessed with how big a dent to banks' net interest income profits in the short to medium term that financial reform may make? It is impossible to know for sure; the answer is certainly less than feared, but analysts have to come up with some numbers. Hardly a day goes by when some analysts from a bank or fund management does not call me to ask the same question “what will the impact of “Basel III” new regulatory requirements on banks’ profits?
One big last-minute change to the Congress's derivative legislation, for example, allows banks to keep trading interest rate and currency swaps in-house (81% of swaps by gross notional value according to BIS). Another change relaxed the expected restriction, slightly, on banks’ lending and investment in private equity and hedge funds: US banks may expose 3% ratio to tier one capital to AI and Hedge funds.
A bigger question is whether big banks may yet be split between traditional retail and investment wholesale banking? Canada plays a key role here as an example where banks avoided the worst of the Credit Crunch despite having also ended their Glass-Steagal type division between retail and investment banking at the same time as US and UK, which to many observers is like the difference between merchant ships and navy vessels. Implementation periods for implementing new capital reserve build-ups have also been stretched out and important definitions – such as the language around proprietary trading – still leave room for manoeuvre, just as there also remain foggy fudging of fair value, stress tests and other issues in Basel II and IFRS.
In all, analysts reckon normalised earnings per share could be anywhere between about 5 and 15% lower for universal banks in the USA, and 10-15% lower for the brokers such as Goldman Sachs and JP Morgan, with mid-single digit declines for regional and trust banks. This will be similar if applied in Europe. All that changes however if the Euro Area falls apart, if there is an EU recession and if Far East markets, especially China, and emerging markets go into a tailspin.
Forget the charges such as the surprise recoiling from applying a $19bn fee to offset the cost of the new US bill, or Bank Stabilisation Funds in Europe and other bank taxes – investors will look through one-offs for valuation purposes. The most important reforms are the move to trade and clear derivatives on-exchange, the possible death of certain swap desks, and the ultimate re-definition of proprietary trading in terms of limits as well as accounting under IFRS, and the debasement in Europe of ratings agencies. These and related matters could yet contain some shock surprises. But the potential for damage to shareholders is limited in the case of long term investors. The problem is that short term profit hunters, brokers, “day traders” and stock-shorters continue to dominate as can be seen in market volatility. Even if these regulations pull down net profits by 20%, compensation would only have to fall by a tenth to match the decline. This assumes the recent relationship between revenues and profits stays about the same and 40% of operating revenues continue to be paid to employees, including bonuses. And it excludes the inevitable impacts in the finance sector of new tradable instruments.
Other factors that analysts are blind-sided by include the need of all banks to modernize (replace not upgrade) their general ledger systems and to incorporate a new generation of risk accounting systems. Naming no names, the current state of banks’ back office systems, GLs and risk engines is appalling. Many banks lack systems for risk accounting of loan collateral, some have only a dozen or less credit risk counterparty types, or less than 20 major GL headings, or subjective intuitive ratio inserted here there and everywhere. No banks are free of bug fixes that generate more system bugs, or, for example, account numbers that may be the same for different customers in different branches, and all big banks have complex networking of systems between tottering opaque legacy systems, outdated versions, impossible to scale up, historical data breaks between systems, held together with duck tape and chewing gum and new ones that lack modular design or have impossible interfaces and on and on. The cost of replacing system in any big bank runs into $billions and by the time they are implemented, assuming efficient, experienced professional teams are available, they will be out of date.If stress tests applied to banks’ accounting systems, both cash accounting and risk accounting, as Basel II proscribes, they would almost all fail. It is a great irony that regulation requires certifying and externally validating everything, yet computer systems that in the end are what express and safeguard everyone’s finance, are not required to be certified. Auditors ought to be doing this, but of course cannot and would not do so thoroughly. Therefore, there should be regulatory supervisor agencies set up specifically to audit banks’ financial computing systems.
According to a Credit Suisse analysis, a team I admire above many others, the estimated impacts of the new so-called Basel III proposals are very material for European banks. The revisions will reduce tier 1 capital to 2.6% and require €600bn- €1,000bn of new capital for European banks to comply with minimum capital proposals. That assessment seems harsh, but is caveated by taking existing data and not assessing the impacts over time, over say 3-5 years. The liquidity provisions will require €3,500bn-€5,500bn of new long term funding. This I also find to be several times too large, but must bow to the fact that my view is intuitive wheras CS has done the math. Finally, the impact on European bank earnings is estimated at €250bn (equivalent to 37% of 2012 earnings), with a drop in return on equity of 4% to 5%.
Interesting then that in the UK and elsewhere there are many groups hovering in the wings anxious to cherry-pick banking assets and to buy existing banks, parts of them, or set up new ones. Maybe they are the only long term investors making an impact on the banking sector; not the short-term bonus-motivated current generation of bankers.

Tuesday, June 22, 2010


The first thing I liked is the return to a traditional plain dark red cover for the budget report, hopefully meaning no more New Labour PR spin, but that would be a revolution in politics.
In his speech Chancellor Osborne rose several notches in everyone's estimation, as did Harriet Harman too, labour's acting leader, in one of the best opposition responses to a government budget for years, which balanced excoriating attack whilst welcoming some of the Coalition's measures.
The Budget Report begins, "The British economy has become unbalanced. It has been too reliant on growth from a limited number of sectors and regions. Overcoming these challenges will require a new model of economic growth built on saving, investment and enterprise instead of debt. This Budget is the first step in transforming the economy and paving the way for sustainable, private sector led growth, balanced across regions and industries." This is wonderful for being the first statement in a long time on economic policy in our party politics that looks round the corner past the question of government finances and talks about more than just supply-side notions, or am I being over-hopeful? The June Budget report does state that the UK private sector has become the most indebted country in the world at five times GDP (or ten times higher than government) and a graphic is supplied to show this.But, this is hyperbole because the information ignores the other side of the account of what the rest of the world owes back to UK banks and other factors such as the quality of collateral offered to banks by domestic borrowers etc., all of which would show a small net surplus. The point should be that lending and borrowing are not necessarily signs of anything unless you look at both sides of the balance sheets.
The June Budget Report instead of doing that says "Between 2002 and 2007 there was a near tripling of UK bank balance sheets and the UK financial system had become one of the most highly leveraged in the world, more so than the US. As a result, the UK was particularly vulnerable to financial instability and was hit hard by the financial crisis. The loss of confidence and withdrawal of credit that followed precipitated the deepest and longest recession since the Second World War: output fell by more than 6 per cent." This is nonsense on several counts. "The UK" was not highly "leveraged" in terms of the references above, and the fall in output was exceeded by other countries such as Germany, which was not at all "highly leveraged" in the sense implied above. More such guff follows including quoting the ratings agency Fitch & Co. who make errant assumptions about 'public sector' when they mean 'central government' and are no better than newspapers at in depth analysis - another set of jokers in my view, playing with fire. I can show that if the Bank of England was counted within the public sector then the extreme opposite is true that the UK was massively reducing its net debt position in both 2008 and 2009 to the lowest in the OECD!
The Budget report discusses UK competitiveness, but this is interpreted in tax competitive terms. Hence there is a clear plan to lower corporation tax significantly and introduce other measnures to retain and attract investment.
The fact of the matter, to be absolutely clear about this, and so on, in my view the UK economy's problems lie elsewhere, mainly in extreme imbalance in UK bank lending of 70% to mortgages and property, only 1.5% to small firms (who employ half of all private sector jobs) and only 23% to business that is not related to property and only 5% of all lending is to UK industry making tradable goods on whom we rely for a fifth of our economy and most of our exports! That the UK is the 7th biggest manufacturer in the world and not far further down the league table is no thanks to UK banks! These are the issues that government has to address in "rebalancing" the economy to compete in the world. German banks lend ten times more to domestic industry and small firms than UK banks. UK banks lend more to foreign industry in foreign countries than to businesses in the UK.
Like its predecessor the Coalition is keen to improve funding access for small and medium sized firms, but I doubt it understand the scale required to compete, for example, with Germany or China, in banking lending available to SMEs. The measures it discusses might increase funding for SMEs by about £1bn or 2.5% when 100 times this is required to grow over the medium term.
We have to look hard at the fact that the UK was a leading credit-boom economy alongside USA, not an export-led growth economy like Germany or China, which is not good idea either. The OBR forecasts predict a surprisingly significant improvement in the UK trade balance, partly due to the weaker pound but at the same time continuing deterioration in the balance of payments? Also, the forecast expects employment to continue growing and unemployment falling, which counters Labour's fear of double-dip recession and half a million job losses with 25% cuts over time in central government departments. The forecasts expect the contributions to growth of business investment and improving trade balance to exceed household spending's contribution to growth. The June Budget report shows this graph of economic growth to show the historically steepest fall of any post-WW2 recession, as if most shocking. The UK performance was in good company. It mattered little if one was an export led surplus or credit boom deficit country, all fell together in 2008.I do wish that mandarins and politicians would have the temerity not to exploit partial facts and do more to discuss the global picture.
In case anyone thinks there is a pragmatism at work in the Budget Statement in place of merely the 'make government smaller' kneejerk Conservatism, there is a page 1 in the budget statement: "Reducing the deficit is a necessary precondition for sustained economic growth", which is purist rhetoric that makes no actual macro-economic sense except to signal the balance of the coalition's conservative stance. It is good politics, however, when most people have a grossly exaggerated idea of the size of government in the economy. Figures of 40-60% are bandied about as cast-iron fact when the true figure is only 20% and best not get too much smaller than that! UK government sector has always for example during the twentieth century been smaller as a % share of the economy than in the USA, but most people would imagine the opposite to have been true!
The Office for Budget Responsibility (OBR), in its pre-Budget forecast stated that "without further action to tackle the deficit":
•• public sector net borrowing would remain at 4% ratio to GDP in 5 years time,having
been above 5% for 6 consecutive years, unprecedented in the post-war period;
(This is so; the Maastricht criteria of a maxima of 3% ratio to GDP and 60% national debt were based on long run UK experience - don't tell the other signatories in the EU. But 4% would be a good result and actually is an exaggeration because OBR took no account of one third of Government Debt held by government itself or the income and sales revenue to be gained when disengaging from interventions that saved the banks!)
•• the structural deficit would be 2.8%/GDP in 2014-15, while the structural current
deficit would be 1.6% and national debt would still be rising in 2014-15 to 74.4%/GDP, with annual debt interest reaching £67bn in that year. (But those are only the gross figures, and could easily be greatly reduced by deploying the government's financial assets that balance the other side of the account- more later).
The fiscal consolidation that is additional on that planned by Labour is shown in the following table: The Government states that its mandate is to achieve "cyclically adjusted current balance by the end of the rolling five-year forecast period" (2015-16). That is a very welcome statement, much more sensible than the idea of totally eliminating the structural deficit.
The plan is for £40bn deficit reduction (4/5 by spending cuts, 1/5 by higher tax rates), which sounds ok, representing 7% of the budget and only 3%/GDP. But, this is on top of budget balancing plans inherited from the outgoing government's March Budget. The June Budget plus plans the Government inherited represent a total consolidation of £113bn by by 2014-15 and £128bn by 2015-16, of which £99bn per year
comes from spending reductions and £29bn per year from net tax increases. Over 5 years this amounts to about £460bn and to about 15% lower government spending that will make the government, according to Conservative commentators, shrink by one quarter in financial terms by the end of a full government term. The liklihood of this being accomplished is not high given the strong possibility of a Euro Area and EU recession soon when the government will have to cyclical adjust its spending upwards again. Actually public spending does not fall:The spending increases approach 5% and debt interest falls modestly. These values are within rounding errors of inflation, interest rates and other factors. Therefore, arguably, there is something of a joke here in ratio to the almost hysterical banter about debnt and deficit in the election politicking. Marshall McLuhan quipped that behind every joke lies a grievance. Looking at the figures they do not appear too different from the inherited projections. In a stable democracy stability in handover of government is important. The projected differences for the year 2010-11 in my view are within error margins and not as yet cause for alarm. The Coalition Government cannot be accused of playing fast and loose with the inherited projections and the differences do little more than reflect a slightly faster economic recovery than forecast. Here are Labour's projections.The big moves that are possible in public sector finances from unwinding government support for the banks will not happen for another year.
What is on the Treasury butcher's block?
1. earlier than planned spending cuts, but actually not much
2. cut structural deficit to zero within 5 years but subject to cyclical factors
3. spending cuts building up to £120+ billions = c. 15% of government budget.
Labour had spending efficiency savings in mind of about £80bn over 5 years plus £100bn of asset sales not counting shares in the banks etc. But,someone in HMT or OBR must know that to cut the deficit by £100 requires a £128 spending cut, while a £100 spending increase generates £28 in directly related taxes plus £12 in same year indirectly and another £20-£30 over the next 3 years depending on the line items and £20 leaves the economy to pay for imports. The Budget forecasts expect about £450bn in spending cuts and higher tax revenue, but a net £115bn higher spending, which is a 20% restructuring of government finances over 5 years.
In my view any government can and should legitimately seek to achieve that degree of policy flexibility if politics is to have any meaning.
What I dislike has been the electioneering rhetoric, much of it false or empty:
- UK heading for highest national debt ratio in EU or G20 or merely highest debt
- Public finances in a mess; largest borrowing requirement in UK history; debt interest costing as much as Defence or Police (£41bn) and some say about to exceed Education
- Tax burden for future generations (unspecified - decades or a century?)
- UK 48% or more than 50% or in some regions 60% and 70% of the economy, of GDP etc.!
- Government unproductively too big etc. £90bn hidden black hole etc.
My arguments:
The hysteria about public finances is normal in election campaigns; same plank that got Labour elected in '97 when it unrealistically accused the Major Government of over-borrowing and no one batted back to ask what Labour would have borrowed had it been in power to reflate out of the recession in the early 1990s.
The hysteria is also important to holding the coalition parties in government together on a predominantly Conservative financial agends albeit one that assumes if only the government finances are in balance then everything else in the economy will be ok and enterprise freed to grow?
But, the truth is that public finances are not in a mess, not compared to private sector debts at three times government's (not counting banks' foreign assets & liabilities at 8 times governemnt gross debt and that matters not a jot as much as the confidence required for UK banks to competitively borrow five times as much as government this year to refresh their funding gaps.
The Public Sector's net position in financial assets is very solid e.g. 1/3 of national debt is owned by government and could be cancelled by fiat or sold off without increasing the national debt. 1/3 of debt interest is paid by government to itself. And after debt interest is taxed net interest cost is only half the gross budget figure. Last year, QE buying in gov. bonds exceeded new borrowing by £30bn = actual net negative government borrowing!
The structural deficit cannot be reduced to zero because it includes £100bn national savings, currency in circulation, and because banks, insurers and pension funds need an annual supply of new gilts for investment and capital reserve purposes (recent auction were four time over-subscribed). banks especially need a handsome supply or they will be buying foreign government bonds instead in large quantities.
National debt heading for £900bn is offset by off-budget items such as £240bn of the debt owned in gov. accounts, £50bn bank shares, £30bn financial assets in public sector enterprises, £30bn reserves, c. £500bn bank assets swapped for £260bn gov. paper = £140bn surplus (off balance sheet), and a stock of other assets conservatively calculated that roughly match or exceed the total of the national debt.
The budget deficit is narrowing with recovery faster than expected, leaving the 'structural deficit' calculated to persist in 'normal' years, of about £70bn - though this seems high. But given this is for necessary capital investment (and actually Osborne in his speech all but said that Brown's Golden Rule lives on). But in rebalancing the economy, Osborne is cutting public sector capital investment when capital investment in the UK is one of the lowest in the G20 and it needs serious rethinking. Serious attention should be given to measures to ensure UK banks lend far more to business and far less for property and mortgages. The governmen plans to discuss with banks the regional distribution of their lending and to SMEs. This should extend to a lot more, in the ontext of to what exten the UK must be less credit-boom led and more export-led, especially concerning long term lending to business sectors.
The money markets have the UK, Euro and Euro countries they hope cornered like a highway robber having stopped the stagecoach and is levelling pistols and demanding gold watches. The markets are presuming everyone is more scared than wise to them and unable to call their bluff. I would call their bluff.
In UK (and US too) the profit from off balance sheet bank bail-outs (replacing private sources of profitable funding gap finance) alone can recover half of budget deficits over the 5 year medium term. The tax rake-back on the other half over recovery to higher growth plus small doses of inflation will see budgets 'normalised'. There will be no perceptible burden on 'future generations' and the borrowing and off balance sheet financing is in any case more tax-cost effective than higher tax rates.
The OBR forecasts expect residential property values to grow much more slowly than in past years and for commercial property values to recover significantly faster. This suggests that the OBR expects there will be a significant shift in bank lending including property development and mortgage lending from households to business. The basis for believing this would be interesting to enquire into.The Coalition government believes that private enterprise will grow more with the budget redaction. Labour's view is that the economic cake risks being made smaller not larger by shrinking the state and that half a million jobs will be at risk. Spending is now projected to fall from 48% ratio to GDP to 40% by 2015-16 and receipts are projected to rise from 37% to 39% ratio to GDP. Cyclically adjusted
public sector borrowing will be reduced by 8.4% to 0.3% ratio to GDP in 2015-16. This is based on the following GDP forecast.

In conclusion my point is that balancing or normalising the budgets and debt positions are only a matter of time once the hysteria about public finances has calmed down. A quarter of all the budget consolidation (£110bn) over 5 years is expected from lower government capital investment and asset sales. It is my expectation that considerably more can be done and that should also be done to sustain a much higher level of capital investment. There may be an element however of battening down the hatches in anticipation of a Euro Area recession or prolonged low growth?
For the Euro Area fiscal problems are rather different. In part this is because all Euro Area national central banks gave away theo money market activities to the ECB and have much less flexibility than the UK, such as when calling on the ECB for responses on a scale commiserate with the UK and USA. The UK can roll over £100bn of treasury bills off budget, while that is not feasible for Euro Area members except indirectly via complicated negotiation with ECB, which is in any case not set up to assist with state governments' financing.
Therefore, Euro Area states' banking sector funding support interventions had to be 'on budget' and this is essentially the Greek and Irish problem, but others too, including Germany where the banks are extremely vulnerable to falling business profits causing loan losses and vulnerable to disappearing net interest income becauser the banks lent 60% of all loans to industry.
The EU and Euro Area have much bigger problems to solve in determining how to reform the Euro system as they head into serious trade winds that should propel them soon into a year long recession!

Thursday, June 10, 2010


In our general election it became axiomatic that the state of the economy and public sector finances were one and the same. It was surely curious that parties, media and it seemed the general voters did not have stomach for debating the financial crisis, recession and world economy. This would have suited the Labour Party, but the political rhetoric could not stretch to these matters to make them party political, although the Conservatives did their very best to blame it all on Labour, and the Liberal Democrats were happy to plant their flags somewhere inbetween but not shy away from bemoaning the state of public finances, which was essentially the Conservative agenda.
It is poetic justice that labour is ousted from power by the same accusations it levelled at the Conservatives in 1989, live by the sword, die... etc. Many people are understandably cynical and see whatever government does as at best oil on troubled waters and likely failure to stem the pollution a la BP. Now that the dust has settled and we have a coalition in government, which is I think a positive outcome insofar as it was long overdue for the Liberal democrats to be blooded with power in central government. I doubt I will see a Labour Government in power again during my working life and I will not be surprised never to see one party with an overall majority in power again in my lifetime. That is nothing compared to the generations some wags speculate it will take to undo the financial consequences of recent years as if it will impoverish all innocents unbearably.The general public is full to brimming with anxieties showered on them by election politics. Central to this is their grappling with what national debt and budget deficits actually are. Decades of refinement to determine what is in or out of the numbers, what is consolidated off balance sheet, what is in the Maastricht Criteria or not, and so on have not made it easy even for experienced economists to be "absolutely clear" as politicians like to say when presaging their fuzzy remarks.
What the politicians say is not cast-iron clear and what they actually know for certain to believe we cannot be sure.
Politics is myth-making as well as reality-checking. Some of it is long term ideology, some short term so-called "hard choices" that appear counter-intuitive to what parties are supposed to stand for.
To take a few examples of what everyone, or the great majority, have been led to believe as essential facts:
- government is half of the economy and employs over half of those in jobs, a view gained from wrongly describing all of the government budget as a % of national income
- government is under 25% of the economy and employs 20% of people with jobs including many who are not full-time but merely part-time jobs
- the fast-growing national debt is an egregious burden on future generations
- that is hard to prove rhetoric; easier to prove the opposite, to show that borrowing is more productive and less of a burden than taxes, and far less than private sector debt, and easiest to argue, technically, the burden on 'future generations' will be imperceptible to them, if a view that most would deem politically too benign to be creditable
- government borrowing is unsustainable, added to which the government has vowed to eliminate the 'structural deficit' that is the bulk of borrowing that is not caused by the effect of recession causing tax revenues to fall below trend
- truth it that eliminating all government borrowing is unsustainable because banks, insurers, pension and life funds and other long term investors need a steady supply as a matter of law as well as prudence, and government needs to make long term investment that should not be entirely a burden to current years' taxpayers
- government is too big / national debt is £14,000 per man, woman and child and growing to £22,000 / if we shrink government and get debt and borrowing down or eliminated then everyone is better off etc.- no, a third of the national debt is owed by government to itself and could actually be cancelled by government fiat, and government has nearly as much again as the national debt in financial assets, but anyway private sector debt at £66,000 per man, woman and child should be considered a more compelling matter, not counting £120,000 owed to foreigners per UK man, woman and child by UK banks. These are silly ratios because in each case banks foreign balance sheets, the domestic private sector and the government all have balancing assets, liquid and property that more than balance the books. Why therefore, except for political reasons, are we so centrally obsessed by government finance; there is more to the state of the economy than that.
- everything government spends and taxes is our money and we (taxpayers) own the debt and deficit
- no, nearly 30% (28%)of tax revenue is taxation exerted on government spending; it is actually not possible to draw lines between private/public and taxpayers/ government to define our economy as if government is made less then private and the whole economy will be worth more; government is not outside our economy or on another planet!
- if we technically could have netted the buying in by government of government debt and counted the value of public enterprise balances and shareholdings bought in the banks out of fees for asset swaps there would have been zero net borrowing by government in the last two years - years when gross government borrowing was trumpeted as the highest ever in history etc.!
- government spending has to be cut urgently and front line services may not be immune, and we will all feel the effects of government spending cuts!
- no, we won't all feel it, and much of it happens anyway, and there are big items that can be cut or encashed without any obvious pain to the general public; life does not always have to progress through 'hard choices'!
What are these items? There are typically £15bn a year efficiency savings not counting all kinds of savings here to spend more there that is regularly part of all departments, agencies, services and enterprises, £20bn asset sales, £15bn public enterprise profits, and not forgetting £45bn in bank shares and many £billions in profits from asset swaps and charges to the banks, offset by benign factors such as steady growth in national savings premium bonds, cash in circulation, foreign currency reserves, and much else.
Compared alone to banks that are selling assets and cost-cutting and needing to re-borrow £hundreds of billions, plus other private sector recycling of borrowings, the government's accounts and financial balances are in reality much less worrisome.
The financial markets don't know any more about all this than others, but like politicians it is there job to stir the pot and test opportunities to trade on uncertainty as they have been doing very successfully with Greece and other 'sovereign debt' politics shaking the Euro. But, this was predictable because it always happens after recessions when governments have to shoulder the burdens of economic recovery.
Does it matter if government cuts spending sooner than later. yes, maybe, but only because the differences are very small and fragile between national income growth rates subject to the intricacies of how these are estimated, and defined for accounting purposes, and need to be just enough to at least bolster confidence compared to slightly lower rates of growth where all can appear doom and gloom. Recovery is both real and psychological, about confidence for the near term future as much as about actual cash-flow and debt management.
Government is steering a political path between the psychology of recovery and its economic underpinnings. They have to talk the talk but may not need really to walk the walk, not all the way. We can bemoan the duplicity of politics and politicians but thank god for them too otherwise who is there to control the panic?