Last night I saw a headline on the television news channel that I was watching and it said that Chancellor Merkel of Germany and President Sarkozy of France had called for “prompt action” on Ireland. This intrigued me as if you look at the institutions they set up back on May 10th of this year then with a response time at best of 3-4 weeks for one and 5-6 weeks for the other it made me wonder if they know what “prompt action” is. Perhaps this illustrates the difference between political and financial market timetables or more harshly perhaps it represents a known political tactic of calling for something you know will not be happening to hopefully avoid you being (rightly) blamed. It probably sounded good to their PR department. Tucked away if you look at the deeper implications of this is a theme of the Euro zone crisis since in began in the spring of this year which is that Europe’s politicians have felt all along that they can control events when in fact events have ended up controlling them. This leads to their continually being involved in short-term solutions to crises rather than getting ahead of events and setting a consistent long-term plan. In other words this represents a severe policy mistake as they have lacked any sort of realistic strategy just at the time one is most needed.
Axel Weber muddies the waters
In an interesting intervention Axel Weber who is the President of the German Bundesbank and a member of the European Central Bank said something yesterday which also was somewhat misleading. According to Bloomberg news he referred to the Euro zone shock and awe rescue fund
Seven hundred and fifty billion (Euros) should be enough to assure the markets………If not, it will have to be increased.
If we analyse this then Mr.Weber should know better than this. If we examine the 750 billion claim this as I have pointed out on the 25th of June and more recently on the 12th and 17th of November that the reality is that the real number due to weaknesses in the design of the package is more like 400 billion Euro’s perhaps 450 billion if it gets a following wind. To say that it will have to be increased again ignores fundamental problems. Firstly the money has to be raised on financial markets and these are the same straightened financial markets which are going to have to support a lot of borrowing over the next couple of years. The money is not given by governments they are in effect loaning their credit rating. Even so the implications of this borrowing as I shall discuss in a moment are hitting home. So governments may say no to this as Mr.Weber’s own government appears to have already done.
I wonder what Mr.Weber’s real intentions are with this speech. His past pronouncements have been much more in touch with reality than this and perhaps he was speaking to Europe’s politicians rather than us. If so his message is that their scheme is not big enough and I wonder what their response is.
Has there been any impact on Europe’s paymaster Germany?
If you consider that Europe’s rescue plans in essence involve borrowing a large amount of money on financial markets then you cannot avoid the conclusion that her ability to do this relies a lot on Germany as a paymaster/provider of a good quality credit rating. However as markets are forced to consider this it appears that there have been costs for Germany. In the euphoria after the announcement of more quantitative easing by the US central bank on November 3rd German ten-year bund yields dropped to 2.42%,whereas last night they closed at 2.71% for a rise of 0.29% in around 3 weeks. This of course coincides with the likelihood of Germany’s credit rating being used to help bailout some of the peripheral Euro zone nations.
Has this affected Ireland, Greece,Portugal and Spain?
There is an irony of this in that the government bonds of the peripheral Euro zone nations are often priced as a spread over those of Germany. Accordingly as German government bond yields rise so do those of the peripheral nations. I think the obvious link is that the likelihood of the shock and awe rescue mechanism being used has raised German bond interest rates which has led to a rise in Irish,Portuguese,Greek and Spanish government bond yields. Yes we now have it so far the rescue mechanism has made things worse for the suffering countries.
Ireland and her Gross National Product
The situation here continues to deteriorate. Irish ten-year government bond yields closed last night at 8.99% and her overall bond index fell to 80.75 from the previous close of 81.50. Apart from the previously mentioned dithering of Europe’s leaders there are other factors involved in these rises in yield.
As time has gone by I believe more investors have become aware of the difference between Gross Domestic Product and Gross National Product and the significance of this for Ireland.Even some economists have caught up! In a nutshell she can tax GNP but not GDP. Now if we take the Irish government’s own forecast for national debt which was for it to be 100% of GDP in 2014 and try to convert this into GNP we get 120/125%. This does not look so good and just as a reminder of yesterdays discussion the Irish government’s forecasts involved a very favourable growth forecast to get there.
Let me add something which also troubles me. We still have not got to the bottom of the problems in the Irish banking sector. It is not possible to say how much extra it will cost but we can be sure there will be some extra and maybe a lot extra. The Irish four-year plan assumes the state of the Irish banking sector to be as it was on the 30th of September. Unfortunately the inconvenient truth is that it has got worse since then and is likely to worsen as time goes by. If you put these facts and expectations into the Irish four-year plan the situation looks much worse than it has been presented to be.
The UK’s loan to Ireland
We have promised funds to Ireland although this is the Euro zone so it should not be a surprise that we still only have estimates for how much. Regular readers will know that I felt we should hold fire and wrote to the London Evening Standard and the Chancellor of the Exchequer to explain why. He has not replied. Not even a week later it looks even less likely that these loans will ever be repaid in full as Ireland cannot afford to on any reasonable forecast. Accordingly when we issue bonds to finance any bilateral loan they should be of longer rather than shorter term, the usual EU mantra of 3 years frankly just looks ever sillier in the face of reality.
The UK Economy
This week we saw that the Office of National Statistics confirmed that growth in the third quarter of 2010 was 0.8%. If we wish to feel good then let’s put it in the American annualised version so we are now at 3.2%! Indeed if we now recalculate the last half-year and annualise it we are up to 4%! Anyway returning to a more mundane reality growth so far in 2010 has been 2.4% in only 3 quarters of the year.
As we are a big trading partner for Ireland perhaps this will help her a little at this time but I would like you to keep this number in mind as I discuss the meeting between some members of our Monetary Policy Committee and the Treasury Select Committee from yesterday.
The Treasury Select Committee and the MPC
Here we saw some interesting thoughts and I believe that they were revealing. Let me combine two bits.
To date, growth has been a little stronger in 2010 than projected………..Earlier in the year, I had half expected by now to be withdrawing some of the exceptional monetary stimulus.
You might think that he might have been voting for a withdrawal as growth has been high and inflation has been over its target.But we also get a curious section on inflation.
Although the persistently high inflation out turns are basically due to factors that should have only a temporary effect, a rolling sequence of price level shocks is not easy to explain to the public or businesses. That is especially so when commodity prices, and so input prices, could easily continue to rise given robust growth in Asia. It is, therefore, absolutely vital for the MPC to be unwavering in our commitment to low and stable inflation over the medium term. Only if we maintain our credibility can we be effective in supporting the recovery of demand and activity.
Considering what has actually happened I guess many readers will be wondering what “unwavering in our commitment” and “credibility” mean to Mr.Tucker. Yet again we are back to the mantra of inflation being temporary but now the MPC is ignoring the fact that growth has been stronger than expected too. I get the feeling more and more that their forecasts are now to justify their existing policy rather than any real belief.
On the subject of inflation Mervyn King the Governor of the Bank of England spoke too and the emphasis is mine.
Over the past year, inflation has been high. At present it is 3.2%. The high outturns reflect a variety of factors that have pushed up on inflation in the short-term. The exchange rate depreciation has raised import prices significantly; there have been sharp increases in global commodity prices and sizeable changes to VAT. It is impossible to tell precisely how inflation would have behaved had these developments not happened. But it should not be surprising that their combined effect on inflation has been very large and persistent. It seems likely therefore that without the effect of these factors,inflation would have been significantly below the target over the past year. That is consistent with other evidence that spare capacity has been pushing down on inflationary pressure.
I have highlighted the first section because it is contradictory. The exchange rate depreciation took place mainly in 2007/08 and the effects have followed on. As we are now at the end of 2010 its effects are by no means the short-term claimed. Also the raising of import prices which followed was easily predictable although Mr.King failed to do so at the time. The second section highlights a common issue with policymakers as they love to exclude reasons for inflation rising from events. Satirists have already come up with inflation indices which ignore all price rises and indeed of course so did mathematicians a very long time ago when they discovered the number zero. I also notice the use of the word “persistent” in relation to inflation by Mr.King and wonder if he might spare the time to explain to us how this is consistent with his previous use of the word “temporary”.
If we deal with his last sentence I find it hard not to laugh out loud “evidence that spare capacity has been pushing down on inflationary pressure”.If you look at the UK’s situation where we have just come out of a severe recession our inflation has been surprisingly high not low. Also if I may help out Mr.Tucker with the common usage of language many of us use inflation rather than “a rolling sequence of price level shocks”.
Politics on the MPC
It is interesting that Adam Posen made clear that “more than just me and fewer than a majority” on the MPC had objected to Governor King’s support for the austerity programme of the coalition government. As a point of principle I agree. But there is a flaw here. The minute the MPC started on its programme of Quantitative Easing it lost its independence and became dependent at least in part on government. This is one of the reasons I have suggested that members of the MPC should in future be elected.
There was also some irony in discussing political interference to a committee composed of politicians!