1.
The
Global financial crisis and its impact on the UK, Europe and Global economy
2.
Demographic
shifts in Europe, urbanisation and growth (GDP) of the key emerging (BRIC) economies
The
financial crisis
Economic
turmoil in Europe, debt management activity across Western economies and the resulting
impact on the Global financial system has pre-occupied the news media over the
last year. There is no respite for political leaders and the focus in the
European Union, as elsewhere, is to identify how best the Euro zone can support
debt laden Greece and other Euro-zone members caught up in the developing
crisis of confidence.
It’s
hard to imagine any modern day commercial enterprise being able to survive with
the current levels of indebtedness of key Western economies - where almost all G7
members have greater than 90% debt to GDP, some considerably more than 100% of
GDP - and this despite the existing constraints on Euro zone signatory
compliance with the Maastricht Treaty.
It’s now
widely recognised that if World leaders are going to address the Global
economic crisis, they will need to resist making short term gestures that ultimately
make things worse. In large part the measures taken to resolve the banking
crisis in 2008, in isolation of implementing other changes, have contributed to
the economic crisis in Europe and the US today. A crisis fueled by sovereign debt,
investor confidence (lack of), Globalisation and negative/stagnant economic
growth.
What
are the issues in Europe, and how are these globally relevant?
The most
pressing issues relate to the challenge of how to:
·
reduce
massive budget deficits without depressing the Global economy and creating
social turmoil
·
avoid
the break up of the Euro zone
·
stem
the crisis of market confidence in a State’s ability to repay its debt
·
maintain
solvency and liquidity in the banking system in the face of wide scale debt default
·
stimulate
economic growth, increase employment, maintain an effective regulatory
environment for business and finance in the future, and
·
balance
the benefits of a free-market model of capitalism with social-equality and global
competitiveness
The
scale of the unfolding problem is unimaginable. Even after writing down half of
its Sovereign debt, Greece still can’t shoulder the burden of its bond yield and
reduce its debt. Further write-downs are unavoidable since the financial burden
is simply bigger than the failing Greek economy can support in any meaningful
timescale, and regardless of other challenges. This situation has pushed up
bond yields and created market volatility that will eventually force Greece out
of the Euro zone, cause it to default on its debts, and create financial stress
to the European banks exposed to its bonds. Even though this eventuality is widely
anticipated, it will still create turmoil in the global banking system and further
impact economic growth.
Worse
still, Italy (three times the combined size of Greece, Portugal and Spain) is also
under tremendous pressure, with Sovereign debt an eye watering 120% of GDP, or
1.9 trillion Euros. The consequence of Italy defaulting on its debt is
unthinkable. French, German and UK banks collectively hold about €400 billion of
Italian bonds. Failure would threaten their solvency and cause a seismic shock
to the World banking system. With volatile market sentiment, Italy’s bond yield
has repeatedly burst through the critical 7% threshold, where annual interest
payments are a staggering 350 billion Euros, or approximately 40% of GDP.
Italy’s yields remain highly sensitive to general market sentiment.
Repeated
effort across Europe to address the situation has had little lasting impact. On
each occasion, initial improvements in market confidence quickly dissipate, as
the challenges of developing a solution quickly enough to make a difference are
understood. Neither is there agreement about approach. Currently there are two
schools of thought; neither is devoid of its issues –
1.
Austerity
measures – budget management.
Problem
- convincing large populations to support decades of increased taxes and severe
austerity measures will not pass smoothly. Resistance is already significant as
resentment of deep-rooted economic inequalities, and widespread frustration
with the political class boil over. Athens and other European capitals burned
throughout the summer of 2011. More unrest is inevitable as the full impact of
austerity is realised. No wonder the UK Government is making early
preparations, spawning news headlines like “More
Metropolitan Police to be trained in baton rounds”, [BBC News].
2.
Economic
growth – Keynesian style state intervention injecting cash into the economy by
infrastructure investment
Problem
– this requires already indebted governments to borrow more and assumes that
the money will be widely distributed so as to stimulate economic activity
In this
heady climate of crisis resolution, maintaining liquidity in financial systems and
executing the budget deficit reduction activity needed to recover market confidence
are foremost on the agenda of political and financial leaders – acutely aware that
what needs to be done to save their economies will be deeply divisive and damage
their future political ambitions.
This
sets the scene for the economic maelstrom heading our way should: credit rating
agencies continue to downgrade ratings of key European economies, investors
flee Sovereign bonds, bond yields escalate to unsustainable levels, contagion
sweep through the banking system causing money circulation and credit to dry
up, the global economy sink further into recession creating mass unemployment,
and/or widespread social unrest in populations with little to look forward to for
generations to come.
Is
there a fix?
Some
believe the solvency and liquidity issues can be addressed if the Central Banks
print enough new money - as they did in 2008 with the onset of the banking
crisis, and as the US Federal Reserve has been doing ever since. There are two
flavours of this, ‘Credit Easing’ and
‘Quantitative Easing’ (QE). In the
former, the Central Banks print money and lend it to banks at preferential
interest rates hoping that this will increase lending between banks and
therefore stimulate money flow. In the latter Central banks print money simply
to increase the amount of cash circulating in the financial markets thereby
increasing liquidity and solvency. Unfortunately there are problems associated
with both, as the Germans are keenly aware. When Germany last printed money to
stimulate its economy, the resulting hyperinflation was so severe the economy
collapsed and created the circumstances that gifted Hitler his political
platform. It’s therefore unlikely Angela Merkel will support substantive QE in
the Euro zone - unless it is to negate financial catastrophe for Germany itself.
Printing
money may provide short-term relief to: easing pressure on liquidity, supporting
banks exposed to default, buying time to allow debt reduction plans to gain
traction, and perhaps helping to calm volatility in financial markets. Beyond
this, it causes other unwelcome problems, like: severe inflation, currency
exchange issues, loss of international competitiveness, and spiralling trade
deficits.
If
Governments are already having difficulty servicing and repaying their debts,
the situation will only get worse as the global economy deteriorates impacting
tax revenues, should investors flee bond markets and borrowing costs escalate. QE
certainly won’t solve the problem of how Europe (and the US) got into this situation.
There
is another issue. As new money is printed to keep financial institutions
stressed by debt default, solvent, this money accumulates in bank vaults – thereby
removing it from circulation. This is because banks exposed to debt default, or
the risk of it, are forced to strengthen their balance sheets to cushion
against losses - by increasing capital reserves. That’s why QE by Central Banks
in 2008 didn’t negate the problems we have today. QE isn’t a solution to the
problem of debt, it’s a solution to the problem of solvency and liquidity.
Therefore, if the is the only tool used, the underlying issues will continue
unabated and require ever increasing amounts of cash with diminishing economic
benefit.
There is
little good news on the horizon. Euro zone economies will not avoid depressing
growth in GDP while implementing austerity measures. Nor are they likely to be
able to make adequate progress in reducing debt sufficient to satisfy the
markets because the head winds are already too strong, and accumulating. Nor will
they avoid (credit) rating downgrades and increased bond yields, or avoid challenges
raising funds in future. Implementation of austerity measures will be hampered
by a severe decline in social cohesion arising from the combination of budget
cuts, loss of social benefits, and tax increases. Sooner or later, Greece will default
on its debts and this will trigger similar failures with Portugal, Spain,
Italy, Ireland and France. Thereafter the impact will wash through the Global
financial system creating a spiral of increasing debt, decreasing money supply,
increasing bond yields, inflation, and interest rates.
In
fact, the rules that apply to an individual are the same for a nation state. If
you can’t afford to service your debt and reduce it over time, you have to
restructure it – or go bankrupt. Its not clear how seriously this is being
discussed. The solution is almost too complex to be practical:-
·
Wholesale
debt restructuring and/or write down of sovereign debt
·
Widespread
exchange rate adjustment and devaluation
·
QE
to maintain the banking system
·
Structural
reforms to enable a balanced budget
·
Economic stimuli
Demographic
shifts, urbanisation and growth in the E7
As if
the financial crisis wasn’t problematic enough, there are underlying tensions
that will further hinder growth, and therefore debt reduction efforts, beyond
the immediate Sovereign debt and budget management challenges: -
· Firstly, although the Global
population is set to increase to 9.3 billion by 2050, most of this growth is
taking place in emerging economies – Brazil, China, India... In contrast, populations
in Europe are in decline. Result - reducing consumption, reducing tax revenues
and stagnant economic growth (GDP).
· Secondly, the populations of
Europe are ageing, due to increasing life expectancy and reduced birth rates.
This creates long-term difficulty for European economies. Result - fewer taxpayers
entering the workforce, declining tax revenues, reduced consumption and
increased public sector spending on social welfare and health care systems (or
dramatically reduced benefits with budget cuts).
· Thirdly, offsetting declining
populations across Europe’s stagnating economy, China will add around 400
million new, relatively affluent consumers to its existing urban population of
500 million. India is forecast to add about 300 million new consumers to its
urban population. The impact of these changes to Global trade is significant.
Currently the world’s seven largest emerging economies (E7) are about 20% of the
size of the seven largest economies (G7) in terms of market exchange rates
(MER), and 75% of the size in terms of purchasing power parity (PPP). By 2050 the
picture completely changes and the current E7 will be 25% larger than the G7 in
terms of MER, and 75% larger in terms of PPP. G7 economies are already being
marginalised and the impact will create a structural shift as commercial enterprise
realigns its distribution model with the new centres of trade. Although there
may be some short to medium term relief with increased exports from the West to
the East, this will be temporary and the shift in the main centres of trade
will result in dramatic migration of jobs (from West to East) resulting in
extensive job loss in all sectors except those that must be distributed
locally. Result - declining tax revenues from reductions in the workforce and
from corporations migrating to more efficient tax jurisdictions, increasing
social welfare costs putting pressure on budgets, increased balance of trade
deficits.
· Finally, dramatically reduced
western economies will result in dramatically reduced financial markets and it’s
probable that large corporations will relocate to overseas bourses. Prada is a
recent high profile example, re-listing on the Hang Seng in Hong Kong. Result -
severe impact on tax revenues for economies (like the UK) who are reliant on
the financial service sector. David Cameron recently said that London (The
City) was constantly under attack from overseas exchanges - trying to poach
companies and the best City brains away from the UK. Unfortunately the tide is
running against him.
These
issues create significant (additional_ challenges for Europe since a drastically
reduced and aging population will create economic stagnation and increase
pressure on public finances. Add to this the economic power shift from West to
East, creating a migration of capital and jobs, and you have the makings of a
perfect storm for Europe and the USA.
European
corporations will hold their share of the global market but as time goes by many
will re-align their business models, relocating their operations and even relisting
on Asian bourses. In this scenario, one could imagine a radically different
FTSE Index compared to the one we have today. Investors are unlikely to place
their money in the shrinking, stagnating economies of Europe in preference to
the rapidly growing BRIC economies where the returns are greater. The economic
crisis in Europe will force portfolio evaluations and we will soon be hearing
reports of investment funds re-balancing their investments.
Politicians
can’t solve these economic problems without restructuring their economies and finding
new ways to balance budgets against a back-drop of declining commercial
activity, reducing tax revenues, and increasing pressure on social-welfare
support. Restructuring and re-balancing an economy takes a long time.
Re-educating a significant welfare dependent society and re-aligning its sense
of entitlement is a long and traumatic process.
These
scenarios are bleak and their impact will be felt across continental Europe and
North America for decades. The European Union will fail and its unclear what
will follow – disparate nation states with sovereign currencies and
protectionism, or a new accord.
It’s a
harrowing thought that while people are locked into the current financial
system – banking, credit, mortgages, wealth management, property, etc - there
will need to be something like a 50% reduction in living standards in order for
Western economies to compete with those in the east.
