Category: Blog

    Today the Leaders of the Euro zone should be meeting to sort out their position ahead of another week when the markets can test their approach to country debt. Instead, they are keeping their disagreements to the beach and to the odd phone call.

            My best advice to them is to split up the Euro zone before it does more damage. That is not their view, so the following agenda sets out the minimum they need to consider and decide to keep their zone going.

         The Agenda should include:

1. Progress to proper supervision of spending and borrowing levels in each member state, with revised credible plans for those borrowing too much.

2. Treaty changes and legislation needed to legalise transfers and enforced supervision of budgets.

3. The role of the ECB in buying in bonds that have deviated too far from the average borrowing rate, and the scale of the operations needed to do this. Is further share subscription to the ECB needed?

4. The role of the ECB in supervising member states commercial banks. How will the lender of last resort facilities operate at a time of stress?

5. The size, scope and use of the European Financial Stabilisation Mechanism and fund.

6. What use will be made of Euro bonds issued in the name of the Euro authorities?

7. The likely future extent of transfers needed from the richer to the poorer parts of the Union.

8. Who will speak for Euroland and ensure the communication of a strong, consistent and plausible message based on these decisions?

                There is no need for the UK and other non Euro members planning to remain outside the scheme to be at this meeting. The Uk should send a message wishing them success in their deliberations, and reminding them that the UK will want a looser arrangement with the emerging Euroland central government as its price for agreement to all this, to be negotiated as soon as Euroland has these decisions in place.

         It would of course be sensible to discuss first if they want to carry on inflicting so much economic and pain and cost on the zone, or if it might be better to drop some members out now whilst they still can. There seems no wish to even discuss this.

               Markets have been in the limelight because they have simultaneously decided there will be too little growth ahead to sustain the massive debts the west has built up. The spend now pay later model followed by the US, and  much of Euroland, only works if enough of the money is spent wisely on productive investments which can pay the interest and repay the capital in due course. If public and private sectors borrow to spend too much on current consumption, eventually lenders  ask “How can you afford to pay us back?”

            The immediate triggers of this phase of the crisis were twofold. In the US the politicians were at war over whether to limit future  US borrowings. Republicans blame the President. He allowed markets to think the US might not pay the interest on all its debt if he did not get his way. Suddenly American bonds, the gold standard of government loans, were in doubt. He did  not point out that if the debt ceiling were kept too low for spending he could cut other spending whilst paying the interest from taxes. Democrats blame the Tea party. They say if the Tea party group had not made a big issue out of whether the US could afford to carry on borrowing, the markets would not have got into a spin. The debt was affordable, they say, until the Tea party said it was not.

              On the other side of the Atlantic a more serious crisis was ready to explode. In the EU the politicians did not alarm markets by a serious row about an important issue – how much should a country borrow?  They upset markets by an even more damaging  row over which countries might default or reschedule their debts, and over whether the Euro scheme could be trusted to manage “sovereign” or country  borrowing in any responsible way. As newspapers have been saying, the crisis this week in the EU has been where is the leadership? Who speaks for the Eurozone? When will there be any sensible answers to some fundamental questions about the conduct of monetary and state borrowing policy? The US had too many political voices over the last few weeks for the comfort of the markets . Euroland was inaudible. The US did debate a crucial issue – how much debt is wise? She did come to some kind of an answer. Euroland did not debate how to control her wayward members and did not come to an answer.

              In the US the sovereign was split by a family row between the Congress and the President, whilst in the EU there  is a continuing row over whether there is a Euro sovereign at all.

                 When markets are in a herd like emotional spasm, be it bearish or bullish, it requires the authorities to be clear, firm, and to boss the markets. Over the last week the Euro  authorities did too little too late, and came across as out of touch, indecisive and worried sick. It is not a good combination. Yesterday at the Euro news conference a range of financial journalists asked a range of crucial and well based questions. There were answers to practically  none.

                 We do not know when the latest fund to prop the Euro will be fully established and ratified. We do not know if they will expand it in case it is needed to intervene for Italy and Spain. We cannot be sure  how serious the ECB is about buying in bonds of Euro countries the market no longer trusts. We do not know when the EU will complete its plans to put in stronger economic governance to curb and control the deficits of the wayward members. We do not know how much extra if anything German and French taxpayers will put in to help the poorer countries. We do not know if there are plans to borrow much more on the Euro credit card, to lend on to individual countries that cannot afford the rates they have to pay now to borrow directly.

               What the markets now know is there will be slower growth ahead in both the US and Europe. The weight of debts on both sides of the Atlantic is too great. Debt needs limiting. Some debts need paying off. This will slow economies down whilst the debt is controlled. Share markets partly fell to discount slower growth.

              The most worrying feature of the crisis is the return of fears about banks. As predicted here, the Regulators set up this crisis by their response to the last one. They instructed banks to hold much more cash and reserve in the form of government bonds. They saw these bonds as risk free. Now the markets are saying many of these country bonds have fallen substantially in price. This has meant large losses for the banks holding Greek or Portuguese or Irish debt. As the individual  bond markets collapse, so the bank shares plunge. As the shares plunge markets become more suspicious about the weaker banks. Some of the European banks have been through falls in assets and share prices larger than  anything assumed in the most recent stress tests. Now the only way the weakest  banks can be kept functioning is through the plentiful supply of cash from the Central Bank.

            During the week US, German and UK government bonds did well compared to most of the rest. The strain was taken by Italian and  Spanish government bonds, by bank shares and by general equities.

               UK bonds have had a good period because the government has been crystal clear in its commitment to deficit reduction in all that it has said. It now needs to deliver the figures to show the policy is being successfully implemented. I would be happier if the UK was taking stronger action to control the government overhead and  less desirable spending.

               US bonds have benefitted from rumours that the US might print some more money to buy more of them up, given the new weakness in the economy. There has also been some relief that a deal was stitched together, and that action is now envisaged to cut future spending. The US has to negotiate the downgrade of its credit rating, and then to deliver better borrowing numbers in the months ahead.

                Germany deserves a strong credit rating for herself, but will increasingly be questioned if she accepts the need to underwrite or subsidise the large deficits elsewhere in the Euro zone. Socialising the Euro risk between all members will help Greece and Portugal  but impose new costs on Germany.

             “The flight to quality” is itself a risky strategy in a western world where there is too much debt, too many imports, and not enough exports. The west has to get better at earning its living in a very competitive world. Cutting the borrowings is not an easy task. It is  task that cannot now be avoided. Too many western countries have got used to borrowing 10% of their National Income each year through some combination of private and public sector borrowing. Increasingly the borrowing is public sector, as the private sector takes the painful steps to rebuild its overstretched balance sheet.  The markets are merely stating the obvious when they say governments cannot carry on like that.

             It wasn’t just ill chosen words by Euro leaders which triggered the Stock market crash. It was also a series of figures which pointed to a slowing of world growth in the US and elsewhere.

              Many in markets have long understood that many western countries have been living on too much debt. The Credit Crunch shifted some of that debt from the private sector and banks, to the governments, in a desperate attempt to keep things going “as normal”. Now on both sides of the Atlantic people are questioning how much longer western countries can carry on spending on overdraft, before the costs of servicing the debts become too great to keep it all going.

             There remains a fundamental imbalance in world economies that we have often discussed on  this site. The emerging market economies have been expanding rapidly. They make an ever more astonishing array of goods, providing world markets with high quality products at affordable prices for the west. They are building large surpluses based on export, and lending money to the west to allow it to continue to buy their goods.

               The western economies, with a few exceptions, are borrowing large sums to be able to consume more than they earn. Much of this borrowing and spending is now done in  the public sector following the C redit Crunch. They export too little, import too much, and delay adjustments by flexing the credit card.

               Neither side of this imbalance is healthy, but the debtor nations are in the weaker position. They have the more vulnerable living standards, maintained by too much borrowing. They either have to export much more, or cut back. The Emerging market economies now have the option of making and selling more to themselves, as the West reins back on its own consumption when it can no longer borrow so much.

             The West has been in the business of trying to delay or avoid the adjustment, by switching from excessive private sector to heavy public sector borrowing. If growth now slows too much the west’s ability to borrow is damaged. Lenders will see tax revenues disappointing, and borrowing levels forced up above the government plans. At a certain point, as has happened for several EU countries already, markets effectively say they will lend no more, forcing more drastic measures on a reluctant country.

            The messages for the UK are simple. The UK must distance itself as much as posssbile from the Euro crash. It must argue for less EU law and costs for the UK as we agree to whatever Euroland wants to do to try to keep itself going. The UK government has to do more to attract and stimulate business investment and activity here, and has to intensify its efforts to cut public borrowing. All overborrowed sovereigns will come under this spotlight, so the UK has to show solid achievement in deficit reduction to back up its plan to get the deficit down in the next four years. If revenue disappoints through slower world growth, it just means the government has to be better at controlling costs. It needs a productivity revolution in the public services.

              We few who wrote and spoke strongly against the Euro in the 1990s did so because we thought it could not work. We thought it would make people poorer, destroying jobs and output.

             In the two books I wrote I stressed

1. They wanted countries to join which were nowhere near ready to join on their own sensible criteria. The high borrowing, inflation and devaluation prone countries were not  compatible with Germany.

2. The Euro area authorities  had insufficient political control over spending, tax and borrowing when they needed to stop countries free riding by borrowing too much.

3. They would find out that belonging to a single currency meant they were sharing the bank account with the neighbours. It implied the neighbours would pick up excessive bills. The neighbours would be dragged into paying more tax and sending more transfer payments to the weaker parts of the union.

           So it is proving. Yesterday Mr Barroso helped trigger a world market crisis by saying the contagion from Greece, Portugal, Ireland and Cyprus was now spreading to Italy and Spain. Markets had been warning this could happen.  It was altogether more serious when Mr Barroso himself said it is happening. Mr Trichet at the European Central Bank followed up by saying the Bank is in the business of buying bad bonds from stressed countries. That led people to ask why were the bonds still so weak, and how much buying could the Bank plausibly do?

           Why did two such senior Euro figures make such unhelpful statements?  In the case of Mr Barroso it may be that he was so concentrating on the audience of the member states that he forgot the impact his words could have on everyone else. Or it is possible that he wanted such an impact, because he is trying to get the member states to do something when they would rather forget the problems between meetings. Mr Barroso wants the EU states to complete the ratification of new rules for the bail out funds, and wants the Euro area to intervene more rapidly and with convincing sums of money behind it.  Mrs Merkel’s people expressed their displeasure at Mr Barroso re-opening this issue.

Mr Trichet may simply have run out of any answers which could reassure investors. He would be damned if he said he was not going to intervene, and damned if he said he would. If he ruled out intervention it was a further sign that Euroland was not yet grown up, that it did  not yet  recognise the need to restore some balance to its troubled debt markets. If he said he would intervene it highlighted the lack of financial firepower of the zone to sort out Italy and Spain on top of the four countries already recognised as debtors of the system.

            So what are the options from here? Each time we review them there is a predictably bigger mess to sort out.

             I still advise the Eurozone to undergo an orderly break up.It is the least bad option. If they had pushed Greece and Portugal out a year ago they  might have been able to contain the pressures. Now it is more difficult  to keep Spain and Italy in.

                They of course will not want to do that. They are more likely to move more rapdily towards a stronger European economic government. That is probably why Mr Barroso said and wrote what he did this week.

                 It is getting a bit late for that. Such a Euro sovereign will need to impose credible limits on how much member states can spend and borrow in the common currency immediately. It will need to work with an active European Central Bank, buying in debt of the weak states, issuing its own Euro debts, and printing more Euros to meet obligations and inflate away some of the liabilities. It will have to follow something  more like the US policy.

                This US  policy itself is not proving to be a huge success, but it is the current Establishment orthodoxy.

                How likely is all this? My guess is Euroland will do too little too late again. The main politicians and Parliaments are all on holiday. Mr Barroso will find it difficult to get them assembled and to persuade them to take action. As the full costs of keeping this system afloat are revealed Germany will find it more difficult to sell it  to the German people. The weak countries have to be made more credit worthy. That means the strong countries have to subsidise them one way or another. That in turn means the strong countries have to become less credit worthy. There may be limits to how far public opinion in the stronger countries  will allow that to happen.

            Most of the debate about the government’s strategy has concentrated on the possibility that they are “cutting too fast and too far”. Few worry that spending is still increasing in cash terms, and may prove difficult to finance.

            The government plans to borrow an extra £485 billion over five years, if all goes well.  It might not.

            It is quite possible that growth rates will be lower than the forecasts. We have seen that the OBR had to revise its growth forecast down at the time of Budget 2 compared to Budget 1 from the Coalition. Many think it will need to revise it down again for the current year. Mr Chote of the OBR has now  said as much. My worries have always been more about years 3-5, when the forecast assumes well above trend and well above  past average  growth, sustained for three years. If this does not come about, tax revenues will not surge as advertised.

               When I last reviewed the position I suggested moderately that the government might experience £25 billion less tax revenue, and incur £25 billion more spending over the next four years than planned. This would take total additional borrowing up to £535 billion, well ahead of total UK state debt in 2004.  After all, there was more than £30 billion of slippage in total deficit reduction for the Parliament between Budgets One and Two. As the world economy enters the doldrums, as the US slows and emerging economies seek to cool down, it is possible the global growth prospects will be worse than expected, leading to a further shortfall in revenues.

               I would have preferred the government to have imposed a freeze in public spending in the first year, instead of allowing a 5.3% increase un current spending.  That would have have lopped more than £16o billion off the borrowing over the full five years, giving the government more leeway. I would have pencilled in larger cash increases in spending for the second half of the Parliament than currently allowed, leaving extra total borrowing still well down on the government’s plan .

                    I would have imposed a strong control to use natural wastage in all but front line public service roles, to cut staff numbers more rapidly without the need for redundancy payments. This would yield good savings for the second half of the period. As my recent PQs have started to illustrate, the government has been hiring as well as firing.

                       My advice to the government today is to seek to bring in  total public spending  this year with a lower rate of increase than in the budget. More savings compared to budget this year can be multiplied by four to achieve good savings on the amount of extra borrowing over the complete Parliament. It would also leave more of a cushion in case revenues disappoint, or in case extra spending is needed in crucial areas in 2013-15, as may well  be the case.  It would still be a good idea to use most of the natural wastage available in administration and non core services.

                       In recent months the government has rightly highlighted the very favourable low borrowing rates it has achieved by talking about serious deficit reduction. In order to extend and protect those low borrowing rates, the government needs to show its deficit reduction strategy is hitting the targets. That requires more to go right, both in controlling spending and in faster growth of revenues. The danger of the strategy is not that they have cut public spending too much, but that they are still spending more than the country can afford. Markets can change their minds. It is important not to give them a reason to do so.

                In the US the markets are not appeased by the unsurprising decision of the an Administration  that it will after all be able to pay the interest. They knew the President was just playing dangerous politics.  The markets are now looking at the plan to curb the deficit, and are not overly impressed. As US growth falters, so the deficit looms larger. The US remains on the watch list for a downgrade.

                In Italy and Spain markets are once again becoming sceptical. Can Italy easily roll over its large stock of debt as it comes due? Can Spain bring its revenue and spending closer together to cut the amount of extra debt it needs?

                  These two are back in the glaring spotlight of bond market criticism. The EU bail out pot is big enough for Greece and Cyprus, but it would be very stretched by even a partial rescue for these two large countries. The Euro debt crisis rumbles on. The Euro needs a sovereign to run its economy, pay the bills  and put proper discipline into the public accounts.

          During the run up to the  Coalition budget I argued that increasing the CGT rate would not  yield more revenue. Some Lib Dems wanted the rate raised to 40% or even 50%. The Chancelllor listened to the arguments, and decided on 28%. He said in his Budget speech that any higher rate was likely to lead to lower revenues. He had accepted the Laffer curve argument, the argument that if you raise the rate too high fewer gains are taken, and fewer rich companies and people come here or venture money here to make gains.

           So far so good, you might say. The only problem is, I do not believe that 28% is the optimum rate for CGT. History and past experience suggests revenues are maximised at rates below 20%. Maybe Labour was right in choosing 18% as a good rate for CGT. The Treasury, I was told, was pretty sure 28% was the optimum rate, the magic level at which revenue was maximised.

            Imagine my surprise, therefore, when I looked at the detail of the Treasury and OBR’s own forecasts following the Budget. There quite clearly shown, is a fall of £500 million or 15% in CGT receipts next year compared with this. It takes more than a year for the full effects of a new CGT rate to come in, given the lags in selling the assets, reporting the gains and then paying the tax. So the official forecasters themselves accept that 28% is not an optimum rate . They reckon the higher rate will cost the Treasury £500 million of lost revenue in the first full year. If the rate stayed the same, there presumably would have been no such drop off in tax revenue, given the fact that the economy is forecast to grow and company and London property asset values are likely to rise.  

              The government needs more revenue to meet  its large spending requirements. It cannot afford the £500 million CGT revenue drop next year. So why not take the rate back down to the Labour level, a level likely to increase the receipts? The way to tax the rich more, is to set competitive rates which attracts them here and gets them paying tax in the first place.

               The same is probably true of the new higher rate of Income Tax. Throughout most of its period in office Labour wisely stuck with the Conservative’s top rate of Income Tax of 40%. When first set, this was a very competitive rate which attracted businesses to the Uk with high earning employees. In more recent years many other countries have lowered their top Income Tax rates, making the UK less enticing. The increase to 50% has done damage and is doing damage. It is probably losing the UK revenue. Again, the government should want to tax the rich more by setting a competitive rate. If they reverted to the old cross  party 40% top rate they could well raise more revenue.

             Such reductions, though restoring Labour rates of tax and bringing in more revenue, would doubtless be attacked as helping the rich by the Labour opposition. No amount of explaining  that the aim is make the rich pay more will assuage them. So the Coalition could at the same time take more people out of tax at the other end of the income scale. It could also renew or extend its Council Tax freeze, as this tax hits lower income families hard if they are not on benefits.

             The government should also look at the impact business rates are having. Empty property rates can tip a business over the edge. The present level of business rates is part of the problem on the High Streets, where retailers find it difficult to cover all their costs from current levels of trading.

                        The government needs to tailor a package of tax cuts which help recovery and support business, without costing too much lost revenue. In some cases the tax “cuts” are a no brainer, as they should yield extra revenue.

              When the Indian Captain withdrew his appeal, allowing Ian Bell to return to the crease to bat some more, he did a fine thing. In this world of lawyers, rules, and fighting over every detail and advantage, it was a magnanimous and popular gesture.

               Ian Bell was out. He had been given out by the Umpire. He only had himself to blame, as he had not checked whether  the ball was out of play and  the over concluded.  The law said his innings was over.

                 Watching the replays it was also clear Ian Bell had grounded his bat in the crease, completing his run. He had then started to walk off for tea. The two England batsmen were not attempting a further run. In the spirit of the game Ian Bell was not run out, because he was not trying to complete a run.

                   Given the state of the game and the brilliance of Bell’s batting, it was the triumph of the spirit of cricket. It subsequently turned out that England won easily. No-one can say India threw it away with this gesture. At the time no-one knew how well England would bowl, and there was still everything to play for. It was a genuine sacrifice made by India which can make us all feel better about human nature.

             The debate about the right level of public spending needs to be put into the context of how much tax politicians think they can impose. If you look at the last fifty years figures, you will see that no government, Labour, Conservative, Labour/Liberal or Coalition has ever tried to impose taxes higher than 38.7% of GDP. That high level was reached in one year, under Margaret Thatcher, when she was trying to bring an inherited deficit under control.

            Labour governments have been careful  about tax levels   – or, in  other words, Labour have spent more based on borrowing, and subsequently Conservative governments have put up taxes to pay for all the extra spending their predeccesors built into the budgets. In the 1970s Labour taxed at 34-35% of GDP. The incoming Conservative government had to increase taxes to pay the bills and curb the deficit, as well as cutting the rate of increase in the spending.  In the 1990s and early 2000s Labour taxed at 35-37% of GDP. The incoming Coalition government has had to raise taxes to cut the inherited deficit.

             The Conservatives had got taxes down to 32% by 1973-4, to a low of  32.3% in 1993-4 and to 34.6% in 1996-7 . The Coalition government proposes to keep taxes at the highest levels of the last fifty years for the five year Parliament. The Plan envisages tax rising to 38.5% of GDP by 2014-15.  Labour does not recommend any significant increase in current tax levels. Its bigger bank tax is a matter of a few billion, whilst Labour opposes the VAT increase which raises more than the larger bank levy.

             I think the politicians show wisdom in these decisions. I do not think the UK does want taxes above 38.7% of GDP. Politicians should therefore plan their spending based around a sustainable level of revenue of around 36% of GDP, the level achieved under Labour. Indeed, there is evidence that the UK economy has performed best when tax revenue is below 36% of GDP, as in the 1990s following ERM exit, and in 2002-5.

           It follows from this that unless you  now think the UK could and should go from the conventional level of tax to say 45% of GDP going in tax, current spending levels are unsustainable. This year the Red Book forecasts spending at 46% of GDP, miles above the sustainable tax level.

              These figures are all in real terms expressed as a proportion of output, because that is the way the Treasury chooses to present them. In cash terms, every year has seen increased taxes. Inflation has often eroded the value of allowances and offsets. People pay tax on the inflationary element in income and gains. Over this Parliament tax is scheduled to rise by 2% of GDP, but by a massive £172 billion a year, comparing Year 5 with the last Labour year. That shows the impact of inflation and growth on tax revenues.

                 Tomorrow we will look at how within that suggested total of GDP that the government can take, revenues can be maximised and economic damage minimised. Higher tax rates do not always yield higher revenues. Politics can get in the way of revenue maximising tax rates.