Month: November 2010

          When the European political classes put their expensive spin doctors behind the need for a bail out, there were two assumptions behind  what they said. Firstly, a bail out for Ireland would stop contagion to anywhere else. Secondly, a bail out for Ireland would help solve Ireland’s problems. It is difficult to understand why they believed either of these two things.

           They already knew that a bail out for Greece to stop contagion had not worked. Barely seven months after the Greek crisis we were deep into the Irish crisis. If they watched the markets they would have known that the markets were already putting pressure on Portugal as well. As the crisis is all about a country’s ability to borrow and the price it has to pay to borrow, they should watch the government debt markets. Yesterday the price of borrowing for these countries rose again, despite the bail out.

          Prior to the Irish loan Ireland could borrow in the markets at close to 8% for ten year money. It  now has to pay  over 9%. Portugal had to pay around 6% but   now has to offer over 7%. Greece still has to pay almost 12% despite its bail out on May 2nd. Yesterday even Germany experienced rising costs to borrow, with its rate going up to 2.7% from 2.5% a few days ago. There is no evidence in these rates that bail outs appease the markets. Indeed, it looks as if one bail out just eggs the market participants on to demand a bail out for another troubled sovereign.

          These rates for Greece and Ireland imply something far worse. If you thought that these governments would pay all the interest on time and repay the amount of the loan in full when stated, and still remain in the Euro, it would be sensible to sell German bonds and buy Greek or Irish ones. You would make so much more in the same common currency with “similar” sovereign risk. Over ten years you would earn a sum greater  than 90% more of your initial  investment  in extra  income on your Greek bonds than German ones.  Clearly by a big majority investors do not expect the countries under pressure to be able to meet all their obligations in full, or they expect them to leave the Euro at some point. The defenders of the Euro have a lot of work to do to reassure people and bond markets  that Greece and Ireland will honour all their debts, so that Greece and Ireland can settle back to borrowing at something closer to German rates of interest. I hasten to add I am offering no investment advice on these matters on this site.

            So why don’t  enough people believe the loan packages for Greece and Ireland will solve their problems?  They must fear that the remedy of cuts in spending  and higher taxes will not allow the economies to grow quickly enough to curb unemployment with all the cost and waste that brings, or to allow the deficit to reduce quickly enough through more buoyant tax revenues. They must be worrying that these countries could get into a vicious circle of more cuts, less tax revenue, more cuts, less tax revenue. With interest rates as high as they are the country will find an increasing proportion  of its public spending absorbed on paying interest charges, leading to the need for further cuts in other spending to try to balance the books.

             What would work better? Leaving the Euro would be the simplest solution for distressed countries, allowing them to devalue against Germany and make themselves more competitive again more quickly without so many direct wage cuts. They would still need to control their deficits by spending curbs and growing the tax revenues, as the UK and US have to do with their own floating currencies. They would have more scope to settle the pace of these changes for themselves, and to set tax rates and regulatory burdens that were attractive to enterprise and capable of fostering the faster growth in output they need.

          The little discussed issue is why the European Central Bank chose this moment to demand a reduction in its support to Irish banks and their refinancing by the impecunious Irish state.The loan we are all being asked to contribute to is basically a loan to refinance the borrowings Irish banks have been making from the ECB. Couldn’t the ECB have carried on lending enough for a bit longer, and in  private worked out a faster and better plan for tackling the problems of the Irish banks with those banks and the Irish government?  Such a solution might not have spooked the bond markets as much as their chosen course. If they go on upsetting the  bond markets as they have been doing, they might find it makes solving their currency and debt problems more difficult, not easier. In this case, careless talk costs money. Lots of money.

Dear Shareholder,

                  I am writing to reassure that all is going well with your company’s strategy. A few shareholders have asked me to explain what is going on in our  Irish subsidiary.  Let me confirm that we have every intention of supporting our Irish company, and are engaged in helpful talks with them so that in future it can be organised in a sound way. We need to ensure that local management follows Group policy and observes all the wise controls on borrowing, spending and revenue collection that have been so successful in our core areas of operation.

                   There is absolutely no question of us wanting to change the Irish management. As in all our subsidiaries, the choice of management is a locally determined matter and should stay so.  We have found that they now understand fully the position, and wish to work with us to resolve it as quickly as possible. They realise that they cannot allow their overdraft from the Group banking subsidiary to build up at the rate it was growing, and want to seek longer term proper financing facilities. They also value Head Office assistance in  tackling the losses in their banking division. We will of course work positively with whoever local  election chooses  when the management falls due for re-election to the local Board.

                  Some have said that the Irish company’s low pricing policy in corporate markets was one of the ingredients in their past fast growth phase. We beg to differ. We think all subsidiaries should set realistic prices, and should not be seeking to undercut other group companies. We do think higher prices and charges  are an integral part of a successful solution to their trading problems.

                  Some have also argued that the Irish company needs to set its prices in a different currency to the Group currency, to allow for softer pricing. This is another variant of the mistaken notion that profitable  trading comes from trading down. We will assist with more training on how to run a successful operation with firm prices using  our ever popular   “Never knowingly undercutting” philosophy.

                  We wish to spread best practice around the Group more successfully. Our German subsidiary has an excellent record at controlling its borrowings. It has recently come up with imaginative proposals for controlling loans in all subsidiaries. It recommends that each subsidiary should remain resp0nsible for raising its own money in the Group currency, but that each loan agreement should have clauses that require the lender to accept less interest and capital repayment if the subsidiary concerned is unable to meet all the payments. This way will avoid other  Group subsidiaries having to assist in providing cash for the loan repayments for a subsidiary which has spent too much and earned too little.   This seems to me to be an excellent discipline, and I look forward to agreement to introduce it soon.

             I would also like to express my thanks to Group companies that do not share our common bank account at the moment for nonetheless being so helpful in assisting our Irish subsidiary. It shows the true spirit of solidarity for which our Group is rightly famous. We now need  to ensure all other Group companies have learned the lessons, and will take immediate and strong action to rein in their spending.

               I give notice to all speculators that we will not stand idly by and watch them trying to make money by weakening us collectively. We are currently looking again at what legal actions we can take to stop them selling our debt short, or failing to appreciate the underlying strength and health of our trading position.

              As always, we are grateful to all our subsidiaries which are trading well for their continued contributions to cover the central overheads. At times like these the value of a strong Head Office is so clear to all.

Yours sincerely

Chairman.

                      Yesterday Parliament was asked to debate the 5 Year Parliament Bill. Some of my colleagues felt strongly that this piece of legislation was wrong, tampering with a tried and tested system for keeping a successful government or Parliament for up to 5 years, but allowing an election to be held earlier if need arose or if the Prime Minister wished. The government said its proposal preserved the right of Parliament to dismiss a government through a simple majority No Confidence vote as at present, but allowed the Parliament to continue to see if a new government could be formed.

               I did not get worked up about it in the way some did. After all, a Parliament could tire of the 5 Year Parliament Act and repeal it by a simple majority. A Parliament can still vote for a General Election under the Bill, although it needs a weighted majority, and there can still be a General Election if no new governemnt can be formed after a Vote of No Confidence.

               The sooner Parliament finishes all this business fiddling with the constitution and gets on to the serious business of reforming public services and shaping an economic policy that will deliver the growth we need, the better.

            A couple of days after the EU cobbles together a package of loans to arrest the Euro crisis, Portugal calls a national strike against the austerity measures that are a central feature of the Euro project for an overborrowed country in the zone. It could scarcely be worse timing for the Euro’s cheer leaders. The markets did not like their package earlier this week, marking Irish, Greek, Portuguese and Spanish government bonds down. They will like political disccontent with the core policy of budget deficit reduction even less.

              So why isn’t it working? The origins of the current stresses and strains lie in the way the Euro  was set up. They created the federal institutions, a Central Bank, a single currency, a single market, and a lot of common law codes. They did not offer a single language for an informed European political debate or a fully operational single labour market. They did not put in place sufficient transfer payments from richer to poorer areas. They did not back up the need for proper controls over how much each country could borrow with a binding central budget to limit the overall totals of Euro denominated sovereign debt.

               Now, belatedly, they are trying to impose a new discipline on member states, to curb their appetite for more borrowing in the common currency. It is a bad time in the economic cycle to do so, when unemployment is high and electorates are worried about wage and salary cuts and spending cuts. Their critics may be right in saying in some cases if the cuts are too big without a good private sector recovery the cuts can make the problem worse. The UK can benefit from its devaluation of sterling and the private sector recovery now underway. Greece does not seem to be able to do the same without a devaluation.

                 The idea that loan packages for Euro members in trouble on their  own will solve the problem is foolish. If most or all the loan comes from EU members, it just adds to the balance sheet and deficit strains in the healthier member states. They can take those strainms for one or two small states, but cannot afford the strains for other larger countries  on top.

                    The Euro is imposing exactly the same kind of economic torture on the peripheral countries as the ERM imposed on some members when they tried that. When the UK left the ERM economic recovery followed swiftly. The problem with the Euro is that it is an ERM that countries cannot get out of. That is what makes this rolling Euro crisis a tragedy. It is the triumph of politics over commonsense. There is more bad news to come, as there are apparently no limits to the pain they will inflict in the name of the single currency. People in underperforming Euroland economies are goign to have to get used to pay cuts and job losses as a necessary price to pay forsharign a bank account with the neighbours. Electorates of western Europe are n ot sufficiently enamoured of the political union to want to pay higher taxes to send sufficient money to countries and regions that cannot compete successfully at the common exchange rate. So the only answer offered is more cuts.

A number of  contributors to this site have said it is too easy for companies to bring in overseas employees from outside the EU  to fill lower paid jobs which locals could easily do. Yesterday we were told that in future a company has to be paying the individual concerned £40,000 plus to qualify for an inter company transfer for a year or more. Are you all happy with this change?

                     Yesterday was one of those days in the Commons when you need to count the spoons. The two front benches were in complete agreement about the need to lend money to Ireland. They did not seem to mind that we do not know how much, at what interest rate or for what purpose or against what security. The European political classes have decided it is time to make Ireland borrow in public with some strings attached, after months of Irish banks borrowing in private from the European Central Bank. There was no explanation of why now is the time to switch from the one kind of funding to another, or why now is the time to drag the weaknesses of the Euro and some of its member states so prominently into the headlines.

                When the main political parties agree it is often wrong. They all agreed that the Exchange Rate Mechanism would give the UK a “golden scenario”. Instead it gave us the predictable boom and bust. Labour and Conservative agreed about the wars in Afghanistan and Iraq. Now they agree that because we export a lot to Ireland it must be in the UK’s national interest to lend Ireland money, without stating the terms or the purpose.

               Numerous MPs raised worries or pressed for some proper information to inform  a decision. Why would the Irish bail out be more successful than the Greek one? Would the Irish bail out be the last Euroland one?  Why does the UK have to help fund a Euroland problem?  Couldn’t the Euro area handle this issue itself? What interest rate will we charge? What will the conditions be? As Ireland will face an IMF type package of spending cuts and tax increases, how will it work as she cannot at the same time devalue, a normal part of an IMF package? If overborrowing is the problem, how does borrowing more help? Why don’t the Irish banks sell more assets?

                   The official soundbites got in the way of sensible exploration of these issues. If you did not support the bail out you were thought to be unrealistic, turning your back on the problem. Parliament in this mood does not do subtlety and cannot examine more than one possible solution.

                            Meanwhile the markets did not suddenly think lending to Ireland a good proposition and pile into Irish bonds. UK and US shares tried to rally then fell. The politicians would be wise to watch the markets more carefully, and listen to what critics of their bail out scheme are saying about the future of the Euro and the need for a better economic policy.  Then they might understand   the force of the argument that troubled Euro countries need a work out more than they need a bail out. The attention should go into how you recreate stable banks and sustainable public finances in countries which cannot compete worldwide easily at current levels of the Euro.  I fear this bail out is not the sudden resolution of the Euro’s problems, nor the complete solution to Ireland’s difficulties.

                       Given that the suffering countries seem to want to stay in the Euro they have to accept it means a sharp reduction in their costs of production to compete alongside Germany. That could be done by a breathtaking leap in productivity, or has to be done by reducing costs generally in  painful way. The UK and US have done it less visibly by devaluation.

             On 2 May 2010 the EU and IMF agreed a large bail out for Greece.  Mr Barroso, the EU President of the Commission heralded this with the words “The eurozone is certainly regaining confidence. Our fundamentals are certainly good”. The Head of the European Central Bank, Mr Trichet, said the package “helps to restore confidence and safeguard financial stability in the euro area”.  The Austrian Finance Minister told us  it “send a clear signal to the markets that Europe is able” to handle the crisis and “minimise the risk” of its spreading. Mrs Merkel said it would mean all other Euro states “will do all they can to avoid this themselves.”

Seven months later we have the same type of crisis in Ireland. The Irish government was pushed into a rescue, probably because the European Central Bank was no longer prepared to make money available to Irish banks on the scale needed. The nervousness created in the Irish bond markets by the criticisms of Ireland’s financial position from its partners in the EU did not help. Much of the rescue package is likely to take the form of a refinancing, shifting the risk of the Irish banks away from the ECB towards the Irish state and the countries lending Ireland the money.

Will this bail out be the last? Have the European authorities now done enough? The danger is that the very public way Ireland was pushed into this bail out and refinancing of the debts could one day apply to another EU state. Markets have got the message that if they push hard enough they can force action, and some EU officials seem to think making more of the national debts EU wide obligations is a good thing, the way to go, as it brings more EU control over the budgets.

The strategy can only work if at the same time someone solves the underlying problems. They are two fold. The first is many EU states spend too much and collect too little in tax revenue. They need faster growth to make bringing these two figures into balance easier. Will they get faster growth from the policy mix favoured by the EU and IMF?  The inability to devalue within the Euro removes one of the normal ways heavily indebted and less competitive states sort out their problems. Euro states have to do it by cutting wages and cutting public spending, which is tough and difficult to do in democracy.

                 The second is there are still weak banks within the EU area guaranteed by states that are themselves short of money. These banks need to be wound down or sold on to new owners with longer pockets. Keeping them as expensive pensioners of the state is not a good solution. The sooner state supported banks are reduced to sustainable businesses, the better. Governments have pledged to protect depositors, but there is no such need to protect all the bad business and businesses within these banks.

               There has been a sudden surpising worry by some that the VAT rise in the UK in January will reduce growth next year. The official confirmation of this from the OBR should not be a great or new revelation.The point is the growth rate is unsustainable given the very  high level of borrowing, so if you do not bring the deficit down you could end up with a far worse outcome.  Of course a material tax rise  cuts what people can spend on other things. It is part of the price of trying to reduce  the inherited unacceptably high deficit. Whether you cut the deficit  by tax rises or by spending cuts, forecasters will say it  will reduce the growth rate of activity.Forecasters rarely offer you the alternative forecast, to show you what would happen if you do not tackle the deficit and you enter a Greek style crisis.

            The case for doing it has always been that if you do not cut the deficit, the deficit may damage the economy more  and overwhelm us all. If the UK lost the confidence of world markets as overborrowed Greece and Ireland have done, much bigger cuts and tax rises would  be forced on us. Cutting the deficit is a necessary policy to prevent a worse economic outturn.If you keep a deficit which is too high interest rates are forced up, making many worse off. If your deficit loses you the confidence of the world’s money lenders the government could be forced to cut much more from public spending, as Greece and Ireland have discovered.

            Some tax rises can be self defeating. VAT is probably the least bad tax option. Hiking the rates of CGT, Income Tax and profits tax might result in less revenue being collected. It is all too easy to put people off enterprise. You can drive them or their profits and earnings abroad very quickly. Higher rates of Income Tax and CGT are more damaging to tax revenues and the rate of business investment and growth than higher VAT.

             Ireland is being lectured by her Euroland partners that she should increase her Corporation Tax rate to cut her deficit more. It is now popular to claim that all of Ireland’s real economic achievement prior to 2007 was false, and that all the policies which brought that about were wrong. It is true that in the later stages of Ireland’s great period of growth poor banking regulation led to too much credit, driving asset prices too high. It is also true that belonging to  the Euro kept interest rates and the exchange rate at too easy a level for too long, making a credit explosion more likely.  That  has now replaced that with an exchange rate that is too high, limiting Ireland’s capacity to export her way out of debt. Not all the achieveement prior to 2007 was false, as a visit to Dublin will testify.

       The cuts in Corporation Tax were an excellent  policy, which did enormous good to Ireland. The low tax rate brought in many more international businesses, and with them much more revenue. Raising the rate too far from here could lose Ireland that advantage and could cut their revenues in the medium term, making the deficit worse. There is already a substantial outflow of people from Ireland seeking better oportunities elsewhere. An outflow of companies would add to the trouble.

                The UK’s strategy for cutting its deficit over four years has always relied on a large increase in tax revenue. Total public spending goes up every year over the next four years in cash terms, despite some difficult cuts in some areas. There is strong growth in spending on Overseas Aid and  the EU, increased pension payments, and small real growth in Health and schools. By 2014-15 current  spending will be up by £92billion compared to last year, and tax revenue is forecast to be a massive £176 billion higher.

          A higher rate of VAT is part of the that forecast. The OBR does not think the VAT increase so worrying that it stops growth. Most of the increase in tax revenue  is expected to come from economic growth. That it makes it doubly important the rest of tax policy is geared to promoting growth. The Irish debate over Corporation Tax is instructive for us. Ireland’s Corporation Tax revenue surged after the cut the rate. The sooner the UK cuts her rate the better. The government has said it will laser in on measures to promote growth. That will require a substantial business freedom element to Mr Clegg’s Freedom  bill soon. Further reductions in  tax rates on earning and investing, on working and enterprise, would also help, and could increase the revenues.

            I have had all too many calls asking me whether I think David Young’s comments were true, or had in them grains of truth. I think the wisest thing he said was that his remarks were inaccurate and insensitive. He made a fulsome apology and the world should move on. Anyone can make a mistake. It does not  mean most Conservatives think as he did in his off the cuff remarks.

            We have just lived through the worst recession since the 1930s. Many people in private industry and commerce lost jobs, or went on to short time, or took a pay cut during the intense part of the downturn. It was not a great time for them. Millions of savers have seen their savings income from deposit and bond interest slashed, as we live through an era of low official and savings interest rates. Many people do not have tracker mortgages, and have been paying mortgage rates well above base rate. Now it is the turn of those in the public sector to experience pay freezes, productivity raising reorganisations, and reduction of back office headcounts.

                The current high rate of UK inflation, low wage growth and devalued pound inherited from the previous government are squeezing disposable incomes. Some of the spending measures in areas which are being cut are difficult choices which the government has made.

            Sometimes truth is stranger than fiction. Who would have thought the Euro authorities would by their words undermine their own creature, the Euro? It has been a bad week for advocates of the single currency.

            As it is a political project, this will not worry its supporters unduly. They see this as a useful opportunity to press for more political powers over the economies of Euroland. They may have started the Euro by placing the cart of monetary union before the horse of political union, but they are now in the market for a suitable animal to take the project on.

             We should keep our eye on the European Central Bank. It seems to have been growing Eurobank worries which led to the pressure on Ireland to do more about its banks. In recent months the Bank has been allowed to buy in member states bonds, but there is still an argument about whether it should print money to do so.

            Some will want the ECB to behave more like the Fed and the Bank of England, and will be pleased if in future it buys in more bonds and allows the single currency to drift down against other major trading currencies to ease the adjustment of peripheral Euroland. Others will want the Bank to remain tough, and require more EU  powers over member states budgets so the countries need to borrow less and the Euro stays strong.

             It would be wise if the ECB and the EU regulators made sure of the strength of Portuguese and Spanish banks before markets start to test out those two countries more. The EU, Euroland and the IMF may be able to afford Greek and Irish bail outs, but Spain is a much larger country. We do not need a phase three of the Euro crisis. Just putting together a package for Ireland does not guarantee peace thereafter. Every member state and all major banks within Euroland have to pass muster and be seen to do so. You could reach the point where the sums the stronger countries have to find to help the weaker are too great for the stronger members as well. In the end a debt crisis can only be overcome by working through the debts, minimising the bad ones, and writing them off against profits or new capital.