A shock further contraction in UK economic growth gives the Bank of England an even bigger policy dilemma and on election day an economic policy for Ireland

This morning voters in the Irish Republic will take to the ballot box and cast their votes in a general election. After the economic “perfect storm” that has hit their country they do need a change and I hope that it will show that the ballot box as well as the gun and revolution can lead to fundamental change. As we stand in spite of the “rescue” from the EU/ECB/IMF then Ireland looks insolvent as she goes forward. Her government bond market has if anything deteriorated since the date the “rescue” was announced. As I type this her ten-year government bond yield is 9.46% which we can compare with seriously troubled but unrescued Portugal at 7.64% or the UK at 3.72%. If you compare the relative situations then it is plainly unfair that Ireland has a rate 6% higher than that of the UK as there are as many similarities as differences. Regular readers will be aware that I often argue that the shorter end of the maturity spectrum also gives us insight into a country’s finances and here we find a bond maturing in April 2013 which yields 8.03% which to my mind has even worse implications than the ten-year yield. For those to whom this is unfamiliar you can learn a lot from what is called a yield curve but my point here is that the revealing part is the gap between the official central bank rate (1%) and a yield of 8.03%. Thus in two years the gap is over 7%!

What does this mean for the Euro zones concept of a rescue?

It means that the “rescue” is not far off an utter failure. If we look again we see that to April 2013 investors want a yield of 8.03% when repayment is in effect guaranteed by the rescue plan. Behind the rescue plan we have the European Central Bank, the European Union and the International Monetary Fund. As they are willing to loan money to Ireland at around 6% (it was announced at 5.8% but rates have risen since then) I am surprised that more commentators have not raised this point. If it was perceived to be a success then Irish government bond yields should have headed towards 6%. In fact they have headed away from it!

We are back to the theme that you cannot solve a solvency problem with liquidity and until Europe’s leaders cotton onto this point there will be little improvement in Ireland’s fortunes. Also please remember that these higher bond yields for Ireland come in spite of the fact that the European Central Bank has been willing to buy these bonds to support the market and could do so again. Accordingly we do not know what the fair market price is and we can put another chalk mark on the scoreboard of false markets created by central banks. I regularly argue that such intervention is mostly beyond their abilities and skills and yet again we can see that in the words of the song there are “more questions than answers”. Sadly we seem likely to get more of this type of intervention rather than less as many central bankers appear unaware of the damage they are doing. When I read the speech of David Miles who is on the UK Monetary Policy Committee I was struck by the image of a man who felt that events happened to him and yet in terms of UK history the Bank of England has been extraordinarily interventionist. I doubt whether he appreciates the irony of this or the fact that the events he feels he is suffering from may be “feedback” from his own actions, if we look for a song for central bankers may I suggest the lyric, “Reality was once a friend of mine”.

What can Ireland do to escape her apparent fate?

In my opinion the “rescue” needs to change from being a rescue for Europe’s banking system to a rescue for Ireland. At the moment Ireland’s taxpayers are in effect taking the strain of not only bailing out her own banking system but propping up that of banks from around Europe. They could be helped by the following measures.

1. There has been a lot of debate over the fate of senior and subordinated bondholders in Ireland’s banks. These were supposed to bear some of the risk of banking but so far have not done so. Some help can be found here as there are approximately 21 billion Euros of such assets. One way of helping Ireland would be to write these down to zero if necessary. After all if we do not write them down after the sort of collapse that has happened to Ireland’s banking system when would we?

2. The interest-rate charged on the rescue package should be reduced from the current level of around 6%. When the “shock and awe” package was originally mooted and before it turned into the (incompetently designed) European Financial Stability Facility there was talk that it would make loans at an interest-rate of 4.5%. It would be better if it returned to such a philosophy. It would save Ireland some money and stop the obvious prospect which in the end is bound to happen of Irish minds focusing on someone making a profit from her misery as many Euro zone countries raise money much more cheaply than this.

3. Once the situation of Ireland’s banks become fully clear then there will need to be a debt “haircut” in addition to the above measures. Ordinarily I would recommend starting with this but I am not sure that issues such as potential derivatives losses have been fully accounted for and in addition Ireland’s housing market remains a problem. As “haircuts” are something which should happen only once then it is wise to wait although I would suspect I am not the only one wondering why information has been withheld. For example the latest accounts from the bad-bank NAMA have sat on Ireland’s Finance Ministers desk for some time now.


The solution is not easy and it will cause pain around Europe’s banks. Frankly I believe that this is the real reason why such measures have not been applied as we have seen another example of the can being kicked down the road. The essential problem of this strategy for Ireland is that the road is long and the can cannot be kicked far enough. The more cynical amongst you probably suspect that Europe’s politicians only want to kick the can beyond their own elections!

One factor that cannot now be undone is the fact that via its Securities Markets Programme the ECB has bought some 77 billion Euros of peripheral government debt of which a reasonable amount will be Irish. Accordingly banks have been able to remove loss making positions from their balance sheets onto the balance sheet of the ECB. Shareholders have transferred losses to Europe’s taxpayers. Since the programme started prices have fallen in some areas heavily so shareholders should be grateful and taxpayers should be made aware of what is being done in their name.

Those who wonder how banks are paying bonuses  again might like to reread the last paragraph. It comes under the theme of privatisation of profits and socialisation of losses! Whilst there are various ways that governments are supporting banks in this way I regularly see politician’s claiming that they are against “the banks” and want to punish them. Those particularly concerned about this topic might like to ask their member of the European Parliament what their voting record is in this area and what objections they have made…….

A shock as UK economic growth in the fourth quarter of 2010 is revised down rather than up

When the figures for the flash estimate for Uk economic growth in the last quarter of 2010 were announced they caused something of a media and political storm. The report of negative growth of 0.5% was definitely not expected. If you recall the National Institute for Economic and Social Research which releases its own estimate some ten days earlier agreed with the 0.5 bit but without the minus sign! The debate had settled down with most economists expecting an upwards revision today. However this is what we have received from the Office for National Statistics.

Gross domestic product contracted by 0.6 per cent in the fourth quarter of 2010, revised down from the previously estimated fall of 0.5 per cent. GDP in the fourth quarter of 2010 is now 1.5 per cent higher than the fourth quarter of 2009.

So there is something of a shock effect in the numbers being revised down and not up. If we look for some perspective on this opening statement we get the further bad news that this means our economic growth was only 1.5% on the year. I take no pleasure from the fact that it brings it back in line with my original estimate for the year, I was happy to be wrong as we need every scrap of growth we can get.

Why were the numbers revised down?

Output of the production industries was revised down from 0.9 per cent to 0.7 per cent growth in the latest quarter. Output in the service industries was revised down to a fall of 0.7 per cent in the latest quarter from a fall of 0.5 per cent reported in the preliminary estimate. The decline this quarter was driven by a fall in business services of 1.1 per cent, together with a fall of 1.4 per cent in transport, storage and communications services.


Government final consumption expenditure rose by 0.7 per cent and is now 1.2 per cent higher than the fourth quarter of 2009.

What does this mean?

One of the themes of this blog has been that there is a danger of stagflation for the United Kingdom. As our reported economic growth for 2010 as a whole is now 1.5% and inflation ended the year with inflation at 3.7% or 4.8% depending whether you use CPI or RPI it would appear that this may well be the reality of our situation. I still believe that in the end these growth figures will be revised higher. For example the NIESR figures I referred to above suggested that in the quarter to end January the UK economy only contracted by 0.1% and as they update their figures with the official ones then they still offer a much more optimistic picture (I did speak to them on this and it is slightly confusing but if you stick with the original NIESR figures you get a more optimistic figure, they only use their own monthly estimate and then update with the ONS ones).

A bigger problem for the Bank of England

These figures reminded me of a section from the most recent Monetary Policy Committee’s minutes which I quoted yesterday.

Nominal domestic demand had increased by 6.8% in the four quarters to Q3, accompanied by nominal consumption growth of 6.3%, in part reflecting the VAT increase in January 2010. These were both above their average growth rates for the decade before 2007.

My point is that if nominal domestic demand is surging at a rate shown above and yet real economic growth is turning negative then the gap will be filled by inflation. If you look at problem you can clearly see that inflation from this source is not something that the Bank of England can blame on external factors and the clue is in the word domestic. Yet again we see a sign of possible pent-up inflationary pressure…..


16 thoughts on “A shock further contraction in UK economic growth gives the Bank of England an even bigger policy dilemma and on election day an economic policy for Ireland

  1. Hi Shaun
    In reference to your Irish solutions, I wonder what the simulated effect would be of effective sovereign default / haircutting on the wholesale funding costs of UK, EU and global banks at a time when they are weaning themselves off public support, confronting diminishing returns on equity ( through captial regulation) and are all struggling to lengthen the maturity of their long term funding by persuading unleveraged investors to buy their debt.

    Are you not worried about a default event causing another shock wave on the level of 2008 ?

    • Hi Shire
      Some 20 years ago I was part of a team that had as one of our specialisations Japan her markets and her economy. Indeed I was based in Tokyo for part of 1990.The way her banking sector was measured was relative to the outright level of the Nikkei stock index and the original story was that it was under-water at 24,000. As the market plummeted this story changed to 22k,20k,18k,16k and 14k! At this point I will step slightly aside to ask if official narrative changes are familiar.. Anyway my main point is that we have adopted a similar strategy combining the apocryphal ostrich position with denial that is in effect a repetition of this. Their “lost decade” now stretches for 20 years. And the Nikkei is under 11,000.

      As I feel that Japan still has a lot to do going forwards I feel that we are taking the wrong choice. Accordingly I think that it is better to have reform now and in certain respects begin again.

    • Hi Geraint and welcome to my blog

      Yes I do and I understand that many will think I am proposing a solution which may add to the problems facing us so let me try to explain at least part of my thoughts. Firstly it is by no means a cure but it is part of a solution I believe for the following reasons.

      1. I discuss a range of interest rates because although many only discuss shorter-dated ones ( if you take it literally the MPC only controls overnight rates). Accordingly for me I might raise rates at the shorter end to hopefully help prevent rises in longer-term ones.I discuss longer-dated interest-rates in my articles regularly and find that they are rarely reported on in the mainstream media which is disappointing because they are at least as important as the base rate.

      2. The credibility of the MPC would have been improved rather than reduced.

      3. I would combine it with a campaign against the way that many interest rates faced by consumers and businesses have no relationship to it. For example I feel that banks are being allowed to profiteer at this time.This might mean that for some rates would fall, for some borrowers I hope it would. A side effect would be to reduce bank profits (and bonuses) some of which are being earned too easily.

      4. It would rebalance the situation to some degree between savers and investors.

      5. The borrowing situation has been distorted with those on longer-term tracker mortgages in great shape financially whereas those who want one now may not get one at all. It would help here

      6. Money markets would function more efficiently as we move out of what Keynes called the liquidity trap.

      7. It would help end us having an emergency interest-rate when we are no longer in an emergency.

      8. It would aid a rebalancing between savers and debtors.

      9. As more information emerges about our banking sector I get more and more convinced that not only do real problems remain but that they have returned to the same behaviour. To my mind this weeks figures from our banks evidence that. So as I have already replied to Shire I would start to reform the banks now to change course for the UK.

      So it would be part of a step by step strategy and if you look at events since I proposed it at the end of 2009 I feel that inflation trends (which I expected) and economic growth trends (which have been higher than I expected) have backed it up. It would require other things such as reform of our banks which I often call for. Instead they get bailed out again and again.

      But it would not help with oil or commodity price rises in themselves…….. There is, in my view, no magic bullet merely that some choices are better than others.

      Apologies by the way if you are not new as the name seems familiar….The system flags up new email addresses but I know that people often have more than one.

  2. Just one comment on the MPC and inflation. In reading the latest MPC minutes I see reference to the usual drivers of inflation, but I noticed another one added : companies rebuilding margins. I think this might be worth analysis and might tell us something important about where we are now and the output gap theory?

  3. Hi Shaun,

    Great articles and the honesty is great. I read from Elliott Wave Int that the key rate on 10 year bonds was 8% – once a country hits the 8% figure out comes the cap for a bailout, if this is true then at what point (how many countries going bust) does the ECB run out of bailout money and simply lets them fail?
    Also I’m a private trader and wondered if you could email me your rates.


    • Hi Andrew,welcome to my part of the blogosphere and thanks for the compliment.

      As to a key number I can see why an organisation like Elliot Wave might wish to choose such a number. It conceptually links to the idea of technical analysis.

      There are others such as 4.5% over the German bund which gets you to a similar ish 7.6/7.7%.

      However there are dangers in such an approach as you are assuming that history repeats itself. Whilst it often does in the Euro zone it may not forever and the rest of the world hopefully has learnt something.

      Other factors to consider are in my opinion.

      Affordability: Here we have the total amount of debt relative to economic output, the current fiscal deficit and projections for it and usually the most important number is not only current growth but likely growth

      The overall bond market: The ten-year is only a benchmark and as I wrote today the shorter end does really matter here. In effect it is a numerical representation of what investors are willing to back with their money and in the shorter time periods it mostly reflects policy credibility…

      As to the ECB I have argued before that if it were a private bank it would be insolvent and since then the situation has only got worse so the idea of it running out of money really depends now on political will. I believe that this is a reason behind Axel Weber’s departure.

      I will reply to the other part privately.

    • Hi Ian

      i think that whilst there is a theory it has turned out to be much weaker than they expected. A bit like gravity which as it is keeping me on my chair as I type this seems very strong but i gather it is around ten to the power of forty weaker than the strong nuclear force….. Perhaps I have been watching too many physiscs documentaries but the point of stronger forces applies here!

      Also a true Keynesian realises that Keynesian polices have a time period or life span….

  4. Great Blog Shaun, I’m a non-economist (so apologies if my question is stupid) who has been reading your blog for just over a year but never commented before.

    Can I ask, you have mentioned a number of times now that the long term government bond yields of the Portuguese and Irish governments in particular are likely to leave them insolvent.

    Is there a historic defined rate which would likely render them insolvent? Is it that once you pass e.g. 7% on a 10-year bond you run into difficulty? Or is it just that there is an increase in the probability of running into difficulty meeting payment demands?


    • Hi Owen

      Welcome to my part of the blogosphere and thanks for the compliment.

      As to your question I wouldnt worry about seeming stupid many so-called experts publish a lot of misinformation on this front in my opinion. I have answered a question from Andrew below which gives my view on the main factors to consider. Once you have read that the hopefully the next bit makes sense!

      National debt levels are rising partly because fiscal deficits have been high sadly this has usually come with low growth and because of banking sector weakness low growth prospects. Not a good mix and this is why interest-rates which were affordable in the past are not so now. So in this sense history is not that good a guide and we need newer benchmarks. In my career the UK has had much higher interest-rates but not with the mix I have described….

      So if we talk of 7% as a magic number I think we are making a mistake as in my opinion the 6% level of the “rescue” for Ireland leaves her insolvent too…..

  5. Hi notayesmanseconomics.
    Excellent blog. And I agree about Japanese pork lunchboxes.
    You say “Once the situation of Ireland’s banks become fully clear ” and this worries me because if there is more bad news to come then it is well hidden. Nobody thinks Ireland has turned a corner, but many believe (or are being led to believe) the Bank problem has shown itself in all its terror.
    Then again, maybe a straw to tip the issue from “rescue” to help might be a god thing.

    • Hi Thomas
      Thanks for the compliment and welcome to my blog. As to tonkatsu I am a fan and I enjoyed much of the variety that Japanese food has to offer when I was there except I am not much of a raw fish fan so Sushi was not to my liking!

      As to the banks there is more to come. It is not clear to me that NAMA has been totally transparent and I remember the Anglo-Irish Chairman giving a speech saying that the bailout needed to be much larger leading to speculation of derivatives losses….As to the property market it has fallen so much it is hard to say what will happen next.

  6. Hi, thanks for the blog.

    In the Irish solution you mention the figure €21 billion – I’m not clear on this: does it refer to the unsecured debt held by the banks (proposal is to write it off), or the value of the banks’ outstanding bonds?

    On the UK, Evans Pritchard is warning against base rate rises:


    I agree with him, that commodities price rises are a muted rerun of 2008 and it would be folly to combat this speculation with rises. Yet your view on UK inflation having to fill the gap is a bit worrying.

    I read somewhere that the government is postponing legislation for reform of the banks until 2013, when Mervyn surrenders his crown.

    • Hi Stephen
      Thanks for the compliment and welcome to my part of the blogosphere.
      The Euro 21 billion refers to an estimate of total existing senior and subordinated bank debt for Ireland.

      As to the UK I have been arguing the case for an interest-rate rise since I started this blog back in November 2009…..

      As to bank reform it is likely to always be one of two things. 1. Cant be done because the banks are in no shape to take it or 2. Not necessary because they are obviously doing so well and this time it is different…I would have done it immediately after the credit crunch but as it has not been then I could only start now and I would if gievn a chance.

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