V's and W's

The media and politicians are currently doing a lot of speculating about when the recession is going to end in the UK. The government are forecasting that the 2nd half of 2009 will feature growth followed by strong (above trend) growth next year and beyond.

This is known as a V-shaped recession. Short and sharp followed by a quick recovery. In this instance, it is also accompanied by a group of flying pigs and songs from Elvis on the moon...

There are various other recession patterns, a popular one being a W-shape. This has the initial fall followed by a false recovery and then a 2nd dip as the economy actually heals itself. The early 80's is a good example of a W (or double dip) recession. The 2nd dip is where the pain is really felt - higher unemployment, major cutbacks, etc. Oh, and minor things like rioting and crime rising!

I might be overly pessimistic, but I think a W-shaped recession is a nailed on certainty despite what most of the media say! The Sunday Telegraph's Liam Halligan honorably excepted. The UK has a bit of a conundrum to solve, namely:

1. Borrowing this year: approx £200bn (artificial stimulation of economy)
2. GDP: approx £1400bn
3. Increasing total debt (increased interest payments)
4. Need to cut spending in future years
5. 3 & 4 shrinks economy = recession

Note that the bank bailouts that everyone gets hot and bothered about are excluded from these numbers. That's even more borrowing to cripple our economy!

Looking at (1.), borrowed govt money now forms 10-15% of the total economy. The UK government takes in approximately £500bn in tax revenue, but is spending close to £700bn. As a guide, you would have to raise the basic rate of tax to 70p (from the current 22p) to balance this budget. What a balls-up! If you're not angry about this, then you should be...

The added problem is that the £200bn of extra stimulus does actually stimulate the 'real' (private sector) economy. So more than £200bn of the £1400bn GDP is linked to government debt. Let's say £300bn as an example. To balance the economy by cutting spending, GDP would have to drop 20% - which would be a horrendous depression.

We are stuck between a rock and a hard place. Raising taxes is not an attractive option - it becomes self-defeating after a while, failing to increase govt income. But at the same time, drastic cuts is not attractive as it would devastate the economy. There are no easy options...

What should we do? My simple answer is that we should not have come here in the first place. Dodging the question I know, but it is the fundamental point.

The UK/US dropped rates drastically in 2001 in the 'recession that never was'. We stimulated our way out of it by borrowing (and dropping rates drastically). But then we did not put the brakes on the boom that followed. We had chances to knock the boom on the head in 2003 and 2005 but chose not to do so. In doing this we just made the problem bigger. Now it is so big that we don't have a viable solution.

2005 made me angry at the time as it was such a missed opportunity. The UK dropped rates when we should have risen them (BoE Governor Mervyn King voted against the cut) - while the economy was doing a controlled slowdown. This made the boom worse and distorted the economy more. Consumer borrowing was £1100bn then - it is now £1470bn and will cause a lot more human misery. The public sector has had 2-3 more years of unnecessary growth. Unwinding that is going to be much messier in 2011 and beyond than it would have been if we had applied sensible thinking in 2006.

But we couldn't have predicted this all, I hear you say. Rubbish! It was painfully obvious that we were heading for the buffers from 2003 onwards. We just chose to look the other way because the value of our houses were going up and we were all getting rich quick...

We've had a major failing in leadership, particularly since 2001. Gordon Brown maintaining that public sector spending increases are the right thing in future just shows he does not get it at all. Maybe we should give him a 'V' of disapproval...

Dominoes...

Whilst the UK continues to pour more good money after bad, I noticed an article from arch-doomster Ambrose Evans-Pritchard (AEP) over the weekend about how the financial crisis is evolving in Europe.

I'm always wary of AEP's articles being factually biased. He seems to have an axe to grind on a number of fronts, with his favourite target of criticism being the Euro. But leaving aside the pros and cons of the currency at present, the bit that interested me was social unrest. His article mentioned riots in a number of countries over the past week, citing the example of Latvia.

Upon doing a search on it, it turns out it is true, but has been kept very quiet in the mainstream press. In the last week there has been rioting in a number of locations in eastern Europe. Generally, these are coming on the back of the introduction of austerity measures in countries that have run out of cash.

To my simple mind, rioting indicates people being surprised by a rapid downturn in events. In this instance, it seems to be young people realising that they have fewer opportunities 'to get on' in life. If circumstances change slowly, people adapt. They might become angry, but they won't riot. When things happen quickly, such as following say an IMF bailout, then rioting happens. (in the UK think Thatcher in the early 80's)

The key to avoiding trouble seems to be to put your house in order gradually, rather than having to be forced to cut spending by the global markets. Easier said than done.

Isn't it better to spray the cash around now and hope things get better in the future??!! (sarcastic smiley)

With limited 'real' cash around, the risk in the next year or so is for there to be an increasing number of sovereign defaults (countries running out of cash). What we are seeing now are the small countries being the first in line to take a spanking on the currency markets. The 'terrorists' in Iceland were the first to hit the buffers late last year. Now places like Greece, Latvia, Bulgaria and so on are following suit in a disorderly line. Even Ireland is on credit watch and could hit the buffers soon.

Then there are the big countries with spending problems. These include the likes of Spain, Italy and, dare I upset Gordon, the UK. These countries ran deficits in the good times and are now finding their government spending deficit is going out of control rapidly. Spain risks being the first to hit the buffers as unemployment is exploding at an incredible rate. They have also been running down their reserves, including almost all their gold, over the last few years. Now the kitty is empty...

The daddy of deficits (in value-terms) is the US of A. Last week, another $825bn of tax cuts and more spending was announced by Obama on top of a forecast overspend of $1.2+tr for 2009. Talk about pouring petrol onto the fire to help extinguish it! The mind boggles...

So, as the UK government commits potentially £100bn's to another bank bailout package, the dominoes continue to fall around Europe. Are we solving problems or making them worse?

'Quantitative easing'

In the last couple of weeks there has been an increasing number of drip-drip media stories about the Government considering the clever idea of printing money. But we can't call it 'printing money' as that is too crude, plus Joe Bloggs might be able to comprehend the consequences. No, the government prefer to refer to it as 'quantitative easing'.

I prefer the term printing money personally.

Today they've denied that they're going to do it in the near future (http://newsvote.bbc.co.uk/1/hi/business/7817063.stm) which, in the current double-speak world we live, means they are going to do it in the near future - possibly even this year.

Bad idea... Money printing has an inglorious history of catastrophic failure. Be it the schemes devised by John Law in the 1700's or the more recent examples of Weimar Germany in the 1920's, Argentina in the 1980's or the current disaster unfolding in Zimbabwe. It simply will never work as a solution.

That won't stop our government telling us that it is the 'right thing to do' in order to help 'hard working families'. 'Tough times call for tough decisions'. Borrowing another £100bn is a tough decision? Telling all government departments to trim their budgets by 15% to save £100bn sounds tougher (and braver) to me...

Our hand may well be forced by the bond markets. A lot of countries are trying to issue bonds this year when money is scarce. Germany has just struggled to offload £6bn of 10-year bonds(http://www.ft.com/cms/s/0/16c7ceba-dcbe-11dd-a2a9-000077b07658.html). What hope does the UK have with the £146bn of gilts we hope to foist on the market in 2009?

I think the treasury has a cunning plan! (in the Baldrick sense)

The race to the bottom

2009 should be a lively year in the currency markets with some major shake-outs and competitive devaluations.

The 'idea' is that a weak currency stimulates exports and helps pull an economy out of recession. On the other hand, a strong currency (boo hiss) would reduce exports and hence make a recession deeper and more prolonged.

So why have a strong currency? Errrm, maybe because you would be more wealthy as a nation! Goods would be cheaper, holidays would be cheaper, etc etc. What a horrible idea!

A strong currency is also associated with deflation for the same reason (cheaper things) whilst a weak currency is associated with inflation (more expensive things). Deflation makes debt seem bigger whilst inflation magics debt away.

The problem we have is that exporters (Germany, China, Japan) want a weak currency to keep their export markets strong and highly indebted countries (UK, US, Spain) also want a weak currency to inflate their debts.

And so we have a race to the bottom. Let's see who 'wins' in 2009...

Spending v Saving

This is one of the key questions the UK (& others) face over the next few years. At last, the tories have stuck their head above the parapet and suggested that we need to save as a nation rather than spend our way to oblivion (http://news.bbc.co.uk/1/hi/uk_politics/7810932.stm). So now there is clear air between the government and the opposition on this. About time too. Problem is that Joe Public is not yet mature enough to accept that saving may actually be a good idea.

A. The Case for Spending
The economy is stuffed if we collectively stop borrowing to spend. Since 2001, borrowing has been growing above trend and at accelerated rates. Approximate 'normal' levels have been:

1. Consumer borrowing has been increasing by £100+bn per year
2. Corporate borrowing by £50+bn
3. HMG borrowing by £30-50bn

If GDP is around £1400bn then the economy has been boosted by 10-20% due to borrowing. This explains the miracle economy in a nutshell.

The so-called 'credit crunch' in late-2007 choked off 1 and 2 many years after time should have been called on the debt party. However, I wouldn't call it a proper credit crunch until the net increases of these fall to close to zero. This only really started to happen in 2008 Q4.
The UK government are now trying to restore borrowing by using 3 to replace/finance 1 and 2. Hence the forecast budget deficits of £100-150bn over the next few years as we ride the brave new world of NuLabour Keynsian economics.
The theory goes that once that happens we can restore normality and we all live happily ever after. There will also be some lovely views of pigs flying along the skyline...

B. The Case for Saving
In sensible economies, it is normal to have a saving rate of 5-10%. This can take the form of pensions, cash, investment, etc. Putting aside money to boost the long-term economy (be it company investment, R&D, saving for a rainy day or pensions) is a good indicator for a nation.

Of late though, the usual suspects (UK, US, etc) have seen saving drop to 0% or even spend periods with negative savings rate. The maxim being "Live for today." This boosts economic growth in the short term but is madness long-term. History books show it to be lunacy and in this instance it will prove no different. So somehow we need to boost saving to build a stable economy in the future.

'Spending' is associated with the problem, 'Saving' with the solution. If we accept that long-term we need to move from 'Spending' back to 'Saving' how do we do it without the economy suffering a major contraction (aka depression)?

This is one of the major questions we have to find a solution to in order to heal the economy...