Winners and losers from the credit crunch

August 2008

As I travelled up to Scotland in 1997 with Gordon Brown to speak at a Labour Party event about a month before New Labour’s landslide victory in May 1997, he asked me whether I would make the Bank of England independent. I said on reflection I would probably not, as I would not trust the money men in the City with the economy.

He has never listened to my advice since either.

I believe it is in fact a good idea to take the printing of money away from politicians with an independent Central Bank, as long as this is not a total surrender of economic policy to an un-elected body. But, unfortunately, that state of affairs is more or less what we have today. As Labour felt the need to counteract its former image of the “tax and spend” party, it delegated its responsibility for macro-economic affairs largely to the Bank of England and the Monetary Policy Committee.

No-one had any interest in admitting in the following years that lower inflation measured by the Retail Price Index (RPI) was not brought about by any action they took – let alone the fact that the Bank had become independent. The internationally benign inflation scenario was caused by the opening of Eastern Europe after the collapse of the Soviet empire and of the Asian and South American markets through the GATT free trade agreements. All this caused an enormous surge of low-cost traded goods and services outstripping any normal demand.

This is what is called globalisation and it is the true reason for low inflation in the last decade. Global issues will also be at the root of higher inflation in the future, whatever the Central Banks do or don’t do.

Central Banks’ influence over inflation through varying interest rates has no direct effect on the price of oil, gas, wheat, rice or copper.

Central Banks still believe that, even if they cannot influence “international inflation”, they can at least influence second-round “home-grown inflation”, brought about by subsequent wage rises. That concept makes little sense: consumers who are already hit by commodity and energy price rises are doubly handicapped by higher mortgage costs. Far from bringing wage induced inflation down, such interest rate increases strengthen the likelihood of trade unions launching strikes for more money, wherever the chances of success are best, namely where employers can’t set up businesses in cheap countries. I predict that the public sector will become a battlefield over such action in due course.

Interest rate hikes in such an environment can have an indirect effect through influencing exchange rates and thus easing or worsening the effects of “international inflation” in local terms. While the rising oil price has had a direct effect on US consumers, the appreciation of the Euro and sterling appreciation against the dollar have cushioned the impact on the UK and the rest of Europe.

Central bankers are meanwhile clinging to the belief in their omnipotence. The Anglo-Saxon Central Banks in particular failed miserably during the last decade, as they could have curtailed the exuberance of the private household credit explosion in time by killing off the excesses of home-made asset inflation in the housing market.

Alan Greenspan has a lot to answer for. As a Republican with a Republican in the White House, he probably felt obliged to support the apparent economic miracle of uninterrupted growth. He was also a Wall Street banker and supported his clan in their incredible amassing of wealth and the contamination of the world’s financial services industries through the highly debatable selling of trailer park mortgages. He and many of his admirers believed he was infallible.

On this side of the Atlantic a Labour chancellor and his main advisor watched the US miracle unfold and bought into it hook, line and sinker. The philosophy was: Who needs manufacturing and the smokestack industries of “Old Europe”, when one can have the City with its vibrant financial services? 

Had the United Kingdom become a member of EMU and adopted the Euro, would things have been different? I doubt it. The examples of Ireland and Spain show that home-made asset price inflation and private household debt surges were not tackled in time. They are paying for it now and are causing strains across the EMU area.

The so-called “one size fits all” policy of a common interest rate throughout the EMU zone did nothing to prevent it, and indeed was one of the main causes of this outcome. The Irish and Spanish  governments stood idly by, hoodwinked by relatively low inflation and bathing in the sunshine of an economy growing faster than that of its neighbours. They could of course have taken appropriate fiscal action, smothered the excesses of the boom and stored budgetary proceeds for a rainy day – but, in typically short term politicians’ fashion, they did not do so.

The Maastricht target of curtailing new government debt to a maximum of 3% of Gross Domestic Product was a typical German demand, as the underlying assumption is clearly that governments’ excesses can bring about inflation. It was wrong in two ways. First it did not take into account of the fact that private household debt increases could have a similar inflationary effect. Second, the Maastricht procedures did not foresee that inflation would be (temporarily) extinguished by globalisation.

In the UK in 11 years under Labour private household debt has increased from £500 bn to £1.4 trn. The increase can be broadly split into mortgage debt of around £750 bn and credit card and other household debt of £150 bn. It is fair to assume that about a third of the mortgage increase has gone into consumption – from holidays to cars and new kitchens – in other words £250 bn of the £750 bn. When this is added to the £150 bn other debt increase, it is clear that, in the UK over the last 11 years, the astonishing sum of £400bn has been channelled into consumption purely financed by credit - around  2% of GDP annually.

In previous – pre-globalisation – times that would have resulted in huge inflation; because of the influence of globalisation,  it has now resulted in huge imports and a catastrophic balance of payments deficit. On a much larger scale, that has been what has been happening in the US, too.

The disappointing side-effect of all this is that the hoped-for “trickle down” from the rich to the poorer has not taken place. Instead the income and wealth gap has widened under the Republicans in the US and under Labour in the UK. As over a million £20-per-hour industrial jobs were replaced by 2 million service sector jobs at £7.50 per hour, the worse-off members of society made up their income shortfalls with credit card and mortgage debt. Now that this has become more difficult, the high streets face a blood bath. Income redistribution is not just a social necessity but also an economic one. There is at least one piece of good news: imports will decrease substantially.

Germany alongside other  core EMU states with relatively stable house prices, broadly intact manufacturing industries and healthy saving rates has much less to fear from the credit crunch that the UK and US. So the tide has turned again.

The productivity riddle

Much has been made of America’s superior productivity levels – 20% ahead of Germany and France and over 30% ahead of Britain’s dismal record despite Gordon Brown’s various attempts of boosting it. 

In the past I have always accepted this story. It appeared to be so plausible, as America’s single market of nearly 300 million people offers such huge advantages of scale. Looking, however, at the continuously deteriorating US trade performance one starts to wonder. 

How can one bring a $ 750 bn trade gap (about 7% of GDP) in line with the highest productivity in the world? As the manufacturing sector has shrunk as in Britain to somewhere just north of 15% of GDP, it means that nearly 40% of US manufacturing industries have been displaced by the trade gap.

Apart from “stars” like Microsoft, H&P, Boeing and others there must have been a lot of “dogs” falling by the wayside. The great economist Schumpeter hailed the process of weeding out under-performing companies as the great invigorator of capitalism, but I doubt whether he had it quite on this scale in mind.  

This trade gap is not just with the low-priced countries of the Far East; it is growing significantly with Europe in spite of the dollar’s fall against the Euro. In 1998 the US trade gap was $ 247 bn and the Euro averaged 0.88 dollar – it stands at present at 1.38 - a 57% devaluation of the dollar during which time the overall trade gap has trebled. 

This brings me to the second point of the riddle. How is productivity measured? It can’t just be that it is national output divided by the number of people working in a country and then, for international comparison, the exchange rate between countries is applied? I doubt it, as the devaluation of the dollar would have eaten up any productivity gain over the last decade. So what artificial exchange rates and other fiddle factor are being used here? Are the roughly 12 million “illegals” and their grey output taken in to account?  

There are lies, big lies and statistics. We know that. The real riddle is of course, why the US and for that matter the UK are under-performing so badly in the world markets of traded goods, whilst they have such envious job creation records in the service sector as compared, for instance, with Germany.

The answer seems to lie in three main areas:

Firstly, in a truly globalised economy there is little room for monopolistic or even oligopolistic market structures – there are simply too many players. So money goes where the pickings are easiest – just look at British banking and retailing.

Secondly, to survive in global competition, companies have to invest long-term in products and export markets – there are few fast buck wins to be made here.

Thirdly, the supply of cheap credit has replaced the old-fashioned save-first and spend-later and has let to booms in consumption and asset inflation feeding off each other.

All three have worked hand in hand, as the huge growth in financial services has shown. All three have led to significant economic growth with enormous imbalances worldwide and at home. Is it sustainable? I don’t think so.

If anybody else can come up with some better or additional reasons or comments on the above, I would like to hear from them. 

 

Only finance matters

Forty years ago I was parachuted into Britain by my German employer Jungheinrich to give the thriving British forklift truck industry a run for its money. In 1967 Britain’s forkers exported 40% of their trucks and importers held a miserly 12% market share. The pound stood at DM 10.80. Our prices were high but our quality was good. We starting selling against the Brits – and were hit by the first devaluation of the Pound, got kicked back, started again and then the next devaluation happened. After seven years of hard work and more currency adjustments, our market share had crept up to an unsatisfactory 2%, the company considered sacking me and closing the operation down. Our British competitors defended their turf well.

Then the miracle of North Sea oil production started to get under way, the pound strengthened, Britain enjoyed a boom and we doubled our market share in three consecutive years. So did our foreign competitors. From the mid 1970s onwards oil production displaced manufactured goods output virtually one to one.

Those days are long gone now. Despite being a small net exporter of oil, Britain’s balance of trade is a shocker and the current account deficit, which takes into account the services sector, was in the red in April alone by £3.5 bn. As a sign of the attrition facing the manufacturing sector, Jungheinrich bought the last surviving British forklift maker out of receivership in 1994; but in 2005 the company threw in the towel and moved production to Germany.

Where is the pound today? By previous measures it would have disappeared by now. But no – although it reached its lowest point against the then DM at around 2.20 (around €1.10 in new money) by 1994, it has since been rising towards €1.50 and has been stuck there for the last six years – against a steadily worsening trade performance.

What is the reason for this phenomenon?  It seems that today only finance matters - interest rate differential and spread betting on purchase managers’ indices, housing start-ups, unemployment date etc govern exchange rate movements, not manufacturing or trade. The real world has become irrelevant, for the moment at least.

For those interested in the subject I recommend Dan Atkinson’s excellent book “Fantasy Island”. Although he writes for The Mail on Sunday, he has a good grip on the issues. And unfortunately I have to admit that I agree with his conclusions.  

 

The negative balance of Britain’s fractured families