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Economic Update October 2012

In recent weeks I have talked to a broad range of intelligent individuals about the UK and Global situation. There is an underlying common thread: people don't really understand what is going on and therefore are swayed by opinion formers wether they be the media or some economist or other claiming to know cause, effect and solution. There is an assumption that the leaders of industry, banking and commerce must know what is going on and a Phd holding economist will certainly know. And yet those who run a business, instinctively know that business conditions are shifting rapidly and they will succeed if they respond quickly to what is now called the new reality. A period of rapid change always produces new income generating activities for those who can make it happen. In this update I am going to repeat a great deal of the thinking I have shared with you in recent years, because in our daily lives we tend to forget which is driving what. A market economy A market economy is where human beings exchange goods and services priced in local currency. The exchange is goods and services for money. Money is in two forms: legal tender i.e. notes and coin and electronic digits which are always a claim on a bank account somewhere in the world. In rural India 80% of the exchange uses legal tender. In the UK it is 5%. In the USA it is 10% Electronic digits are transferred by an instruction from a card holder, or less frequently a cheque. The legal tender is created by the central bank on demand from the commercial banks. Please note that Quantitative Easing doesn't increase the amount of legal tender, but it does increase the amount of electronic money, and if this new money flows between people in exchange then there is a material impact. Electronic money is created when a bank decides to make a loan. A retail banker has to manage three conflicting objectives constantly. These are: liquidity, solvency and profitability. There is always a trade off between profitability and the other

two. A highly liquid bank with lots of capital as a proportion of its balance sheet will not be very profitable unless it has been granted monopoly rights. A typical UK building society will not be very profitable because it will be liquid and solvent. Liquid means be able to convert electronic digits into legal tender on demand. Solvent means having sufficient retained profits to cover any bad debts incurred by risky lending. As a general rule highly profitable loans are illiquid and have a higher probability of going wrong. As a general rule any bank with bad debts under 2% of it's balance sheet would be considered ok. Until the crash of 2008 it was assumed that markets in aggregate priced risk correctly and that market participants were for the most part rational i.e. they weighed up the cost and benefit of participation in a market and then took an objective decision based on the facts. All the major banks created risk management models based on this and used probability theory to model what if situations. As did the regulators of banks. If more money comes into an economy then a number of things begin to happen. If there are businesses with spare capacity then they will respond to higher customer demand by increasing supply. Prices generally do not rise but volume does. Increased volume means higher money flows to the individual firm and usually higher total wages paid out and absolute profits earned. The same will happen to the suppliers to the firm. In this way the flow of new money causes an expansion in real goods and services, not their selling price. This is called economic growth and it is evidenced by an increase in real GDP . Assuming it continues for a number of years people will be better off in real terms. Please note the rate of growth has to be higher than the rate of growth in the population for this to be the case. I have just returned from a two week stay in India. In the thirty years since my last visit the changes are dramatic. The tractor has replaced the buffalo ( and manual labour), motorcycles and small cars have replaced the bicycle, the rural homes are now brick with tiled roofs ( instead of dried dung and mud with reeds or bamboo for roofs.) I talked to people about the Tata Nano the cheapest car in the world: it will not be a success because any mechnical dianostics require a laptop and software, rural India doesn’t have repair centres with such devices. They also don’t like the fuel tank being in the front! The locals say the Nano will be a fun second car for middle classes who cannot afford an Evoque, which everyone aspires to.

Almost everyone has a mobile phone and is talking on it. A street musician had the latest Nokia tucked under his Kilim, as he played a mournful chant for passers by. In small villages the women still line up at the village pump to collect clean water, then carry it home to their house where they switch on the TV fed by a satellite dish on the roof. She will have the choice of 18 Indian channels including a range of shopping channels. The money for this will come from family members who will be in the nearby city labouring at a daily rate of £5 ( about 450 Rs) Cooking is done on subsidised LPG stoves, the traditional cow dung stove declining in use. India has a better Internet system than the UK and yet most houses in the City have water supply only on alternate days and no sewage disposal apart from the local river. India is growing at between 5 and 8 percent a year due to micro credit schemes in the villages and mortgage lending for the ballooning middle classes in the cities. In Delhi to meet the housing shortage the government supplied low cost housing on a means tested basis. The new occupants then used this asset to get a loan to build a second house which they rent out. If the rate of growth in money spending exceeds the growth in real capacity the result will always be inflation. At this point the central bank raises interest rates to reduce the demand for loans and hence the creation of electronic money. This is what has happened in India over the past two years. Summary The growth of an economy depends on new money being created by banks and spent by people on a range of goods and services produced by commercial enterprises. In Europe and the UK insufficient money is being created by banks to enable existing capacity to be fully utilised. The creation of new capacity stalls. The workforce becomes unor underemployed. The flow of spending is below normal, as you can see in the graph below for the UK.

During uncertain times there is a natural tendency to hoard money. This reduces flow further. There is also an expectation that the price of fixed assets must fall and then there will be bargains to be had. This is particularly so after a period of prolonged asset price inflation. Unfortunately there is a destructive feedback loop here. When a bank creates a new loan it naturally looks for security. This is usually a fixed asset. If asset prices are falling the risk of lending is rising and the the riskiness of existing loans is increased. So if individuals hoard money, the banks do not lend it on, nor do the banks create new money. In the UK money creation in just 2.6% a year cf with 7% which is the normal rate. How do we break out of this? There is a deficiency of demand due to insufficient bank lending plus money hoarding. To tax one part of society and distribute to another is not an economic solution. To increase Government spending financed by new loans from the central bank is an option, but the spend should not finance current consumption i.e. through social welfare schemes. It should be spent to improve the nations' ability to compete in the future and increase current consumption as a side effect.

The RMF recovery plan. Fully nationalise RBS and rebrand it the UK Bank for Reconstruction: UKBR. The existing shareholders get bought out at market price. The investment bank division only does infrastructure financing, all casino activities are forbidden. The funding for the bank is existing depositors who are offered a higher rate of interest on savings accounts than the market ( Barclays etal would be forced to compete) The focus of the retail bank will be SME's and mortgages. Max loan 75% of valuation, and 3.5x joint incomes. For SME's lending against sales ledger and the quality of the owner should be a feature as well as against fixed assets. The bank would be expected to lend to housing associations that were well managed. A 5% default rate should be accepted. The cost of this would be a transfer from taxpayers. The EU will object to this, but we tell them to get lost. This would put a bomb under the existing private sector banks and drive the pace of change. Long term funding for UKBR would be bond issues, their AAA rating would guarantee a reduction in money hoarding and a liquid secondary market as the B of E would accept them for cash.

The bank would have a supervisory board above the executive board ( as in Germany) consisting of small business representatives, the Bank of England, Treasury and three unelected members from the House of Lords ( Alan Sugar?)

Will it happen? No because UK banks are so intertwined with the political class and they have spent years getting bigger to reduce the level of competition. Plan B Reduce basic rate of income tax by 5p at a cost of 27Bn, simultaneously freeze all Government benefits for the next three years. Show all taxpayers where their money is being spent with quarterly updates by email, adverts in the Sun etc. Gradually phase out all subsidies business reliefs etc and reduce tax in line.

Launch national infrastructure fund with fixed rate on interest payable. Bond to be sold at lottery ticket booths, Tesco, etc. Admin costs to be under 10%, and funds supplied to local authorities etc but only for investment not welfare. The fund to be managed by UKBR . If the tax cut produces a mini boom, slow it down by increasing VAT and split vat on bills to show which part goes to which Government activity. I would also consider local sales taxes, this would encourage spending flows to lower taxed areas as happens in the USA.

Meanwhile we have a national debate on the size and role of Government and the distinction between funded welfare benefits such as state pensions ( where the worker contributes throughout his working life) and state hand outs. On Sept 29 2012 the Economist wrote a leading article ‘Heading out of the Storm’. The thrust of their piece was that because employment was holding up, money incomes are rising, and because inflation is falling, real incomes are rising. All this plus pent up demand drive the economy forwards. The Economist suggests that this will unlock the liquidity held by companies turning it into capital spending. They suggest that the funding for lending scheme launched in July should increase bank lending, so all in all conditions are improving. I am naturally optimistic but I think the Economist is on a wing and a prayer with this view. If we take July retail sales by value, they were up 1.5% on a year earlier, inflation over the same period is up 2.9%, so the volume is down by 1.4%. August was a better month, value up 3% on a year earlier, so adjusted for inflation up 0.1%. The historical growth rate for retail sales in volume terms is 3-4% per annum. The graph below shows how volumes have performed since 2008. Most of the value increase is due to price rises.

I agree that replacement spending will be a growing driver of consumer durable goods, as things wear out, but I do not see much evidence that the stock of consumer goods is increasing. On household incomes the position is as follows: actual payments including bonuses rose 1.5% and settlements were at 1.8%

And inflation adjusted incomes and consumption is:

I fail to see green shoots in this data. And 70% of the public sector spending cuts are yet to materialise.

So what about the level of employment? The employment rate is the percentage of those aged between 16 and 64 who are currently in paid work. It is 71%, an increase of 0.4% since the beginning of the year. A greater proportion are working but they are earning less because many of the newly employed are part time or self employed. Median income fell 3.1% last year, and real earnings have fallen 7.1% since 2010. The only bright light is the chart below: in response to shortages, the amount paid to skilled workers should begin to rise.

The historic quarterly growth rate for real GDP is 0.6%, I do not think we will get close to this until 2016. On the next page you can see recent performance, I think next year we will see a flat economy with real GDP growing by 0.4%. This is because the global economy is slowing down rapidly.

The Global Outlook and it’s impact on the UK

Look at the charts on the next page.The figures in parentheses is the share of UK exports to the country. Europe is still the most important market, and it will be in recession throughout 2013.

The Central Banks continue life support. The recent QE announcements in the USA are indicative of the pessimistic outlook. The Fed intends to create $60Bn a month until further notice. The Bank of England will do more as well. The ECB is the winner ! All this new money will enable western banks to become Basle three compliant, boost bond and equity prices, but not boost the supply of credit for mortgages and SME’s.

The Euro OK so Greece is still a member, so my previous forecast of a Grexit is wrong. They will leave but I am not guessing when! Since my last update the announcement by the ECB that they will buy sovereign bonds has averted the euro collapse for the time being and rendered my last forecast wrong. The ECB has not solved the problem, just delayed the day of reckoning. The Eurocrats are busy designing a new system of banking supervision which will prevent a future euroland banking crisis ( perhaps) but it doesn’t fix the core problem which is European banks are undercapitalised and at risk from sovereign debt default. They are currently busy changing the composition of their assets:reducing the

amount of illiquid SME lending and increasing their holding of bonds. The consequence is a credit crunch. View the graph on the next page.

What should the periphery states in the Eurozone do? Ideally leave the Euro and devalue. If this is not an option because of misplaced political commitment to the single currency then the following needs to be done. The OECD has conducted research into 30 rich countries over the period from 1985 to 2008 to discover what, if any, policy measures are best adopted when a currency is overvalued relative to domestic costs of production. Their conclusions are as follows: If the economy is depressed then labour market reforms do not work very well, they should be undertaken when the economy is growing.

In a depressed economy the most effective approach is to promote more competition in network industries such as telecoms,transport and electricity. The result is more jobs as new entrant firms gear up to compete. But the banking system must be working normally for the new entrants to get financed. Any structural changes take 5 years to make an economic impact. Shifting the burden of tax from income to expenditure is shown to get more women employed and the impact is quick. Reducing job protection measures for regular staff results in more employment of women and young people. But weakening the position of temporary workers hurts employment in both the short and the long run. The overall conclusion is as follows: 1 do not pursue further austerity 2 fix the banking system 3 shake up product markets by encouraging new entrants 4 reduce employment protection for regular staff 5 increase protection for temporary workers 6 shift the tax burden from income to expenditure Leave sweeping labour market reforms until the economy has begun to grow again, then make the changes and wait five years for the full effect to come through. Given a 5 year election cycle major labour market reform is unlikely as politicians are reluctant to take on vested interests. It is worth noting that Germany overhauled its labour market from 2000 and by 2004 was reaping the benefits. To illustrate: in 2009 Fiat’s five biggest assembly plants in Italy produced 650,000 cars using 22,000 workers. Their single plant in Poland produced 600,000 cars with 6,100 workers each earning a third less than the Italians. Today Fiat operates at 40% of capacity. The UK with it’s more flexible labour market and a competitive currency operates at 90%. In Europe 30 of 98 assembly plants are operating below 70%, not BMW or Mercedes who have price insensitive exports to Asia. Removing one redundant car worker can cost up to 200,000 euros. ( source FT) The European response is cash for clunkers schemes and wage subsidies. All this suggest to me that Southern Europe can expect little or no growth for another 5 years with steady increases in unemployment. Unless of course they leave the euro which I still think is the best option in the longer run.

Roger Martin-Fagg October 4 2012

PS if you are a regular reader then you will note that I mostly repeat myself using the most recent data. If you think it boring, just imagine what it’s like for me, writing this stuff!!!