November Economic update 2011 The Euro Mess When Germany unied in 1990 it began a substantial transfer of income

from West to East. With typical German efciency, they put themselves through an economic boot camp. The SME sector underwent radical change, supported by the regional banks who were underwritten by the 16 regional Governments. Real wages fell as unions agreed to pay cuts. State benets were reduced, particularly for sickness and disability. Companies invested in R&D, new plant and equipment and apprenticeships. The result was a 20% drop in unit labour cost compared to the rest of the EU, and a rise in unemployment to 12.1% by 2005. This was the year Angela Merkel came into ofce. Meanwhile the club med countries became increasingly self-indulgent ( not Ireland it was individuals there) as their Governments found they could borrow at German rates of interest. This happened because the world markets were beginning to believe that German growing economic strength would underwrite the system. And French and German Banks who were short of capital, needed no capital to support Sovereign lending. Germany increased its exports to the fringe, and France, its biggest trading partner. France meanwhile hung onto German apron strings and fought against EU enlargement and the desire for greater competition by the Commission. France believed that Globalisation was a threat which needed to be managed, rather than an opportunity to be embraced. As the EU was enlarged, with British support, France lost power and inuence. The aging Europeans were enjoying a comfortable lifestyle, their companies asked Brussels to protect them from the Asian onslaught and in many areas they did. The French wished for more control of Brussels ( i.e. more protection). Last year, France was the only large EU country with a retirement age of 60. And the French, Belgians, Italians and the Polish all stop working in their late fties. See the charts on the next page. Angela Merkel is fond of saying that if the Euro fails then Europe fails. However if the Euro succeeds Europe is likely to fail anyway because the Euro was introduced on the back of two lies. The rst lie was that monetary union could exist without political union. The second lie was that Euro and Non-Euro countries could sustainably co-exist. This was based on the view that the EU is a club of clubs, all members share the single market, but otherwise coexist within a exible framework of labour laws, immigration, nancial regulation and bilateral agreements. In the last week of October 2011 European Leaders agreed to leverage the European Financial Stability Facility ( EFSF) boosting its lending potential from 300Bn Euros to 1.1 trillion Euros. This is the rst big step on the path of divergence between Euro and nonEuro members. It is the beginning of joint liability for Sovereign debt guarantees, thus paving the way for the creation of a Eurobond.
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If this happens the ECB will require each Euro member to solve their underlying structural problems. They will be required to harmonise their nancial sector, to co-ordinate their labour market rules and become more competitive. Eurozone level taxation will have to be introduced to ensure income is redistributed from North to South. Brussels will send economic policemen to oversee errant countries. But all these measures are diametrically opposed to the founding principles of the single market. A monetary union in trouble has very different needs than a club interested in free trade. The Euro members will ( under the inuence of France) decide that it was free trade which caused the imbalances in the rst place ( Germany and France are convinced it is nancial institutions based in London who are major contributors to the problem). The Eurozone will have to create a common nancial platform to ensure macroeconomic stability and the Eurobonds sell at a good price ( low interest rate). Non-members have no need for such structures and would resist strongly a regime run by and in the interests of the Eurozone. There are 10 such countries, they are smaller than the 17 Eurozone members and less homogeneous. The Lisbon treaty allowed member states in groups to enhance co-operation in selected policy areas. This will allow further divergence between Eurozone and non-Eurozone members. It could even allow non members to gang up on the core. Over the next ve years the microeconomic club will turn into a macroeconomic union. At which point Denmark, Sweden and the UK will have to decide whether they want to remain in a club with which they have increasingly less in common. The biggest failing of all is that the technocrats in Brussels believe that prosperity and growth derives from treaties and agreements. 70% of EU prosperity is created by rms employing less than 200 people, who day after day strive to create better products and services for their chosen customers. And yet to a man they will tell you that the biggest cost imposed on their enterprise comes from Brussels in the form of Health and Safety, Employment, and Harmonisation Reporting. The likely outcome Greece will leave the Euro within the next 18 months. The Greeks will force conversion of Eurodebt into Drachma. This will be a technical default. The Drachma will trade at a 60% discount to the Euro. This will impose losses on Greek businesses with overseas operations, but there will be much bigger gains as Greece becomes the no 1 tourist destination. The Greek Government will have to impose strict limits on cash and credit withdrawals to protect their banks, plus capital controls. Ination will rise to 15%, wages will not, so very quickly Greece takes the pain of a lack of competitiveness. Meanwhile Costas nds all his Villas fully booked, the sh he catches cost a little more to get ( fuel and spares for his boat), and he makes a fortune selling a bit
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of land to a plumber from Telford, attracted by cheap sunshine, and the new Ryanair routes from Birmingham City Airport. Within two years Greek GDP is growing at 3% . Savvy businessmen will be already asking the Greeks to pay for imports in Dollars, and probably cash upfront. The ruling Greek families who bought 10% of the London property market, will sell their house in London, buy drachma and then the assets of Greek state industries at knock down prices, thus ensuring that the market for in yer face Yachts booms. Meanwhile the German and French Governments ignore Brussels and put massive support behind their local banks who book big losses on Sovereign debt. And the Bank of England has to supply circa 150Bn to the London market as the Credit Default Swap issuers are required to pay up. Then what? In three years time France and Germany announce a Nordic Euro system, and a Clubmed Euro system. The latter will trade at a 30% discount to Nordic Euro. And Europe will become three clubs. Inner, fringe and outer. The outers, Denmark, Sweden and the UK will expand their trade to the East, where the money is! It will take this long because Brussels will resist it every step of the way. What does all this mean for the UK? The growth in our material standard of living depends on the growth in real wages, this in turn depends on the growth in productivity (except Directors of FT100 companies who have their own reward system). Productivity is measured as output per person per hour of work. For the UK it is usually 2.3% per annum, but since 2007 it has fallen by 2.6% per annum. It follows that real wages must fall by the same amount. And they are, ination at 5% and wages growing at 2.2% . But not if you are a FT100 Director, when your real earnings have increased by a staggering 70%. In the depth on the recession, the lowest bonus paid was 134% higher than in 2000. For the record, Directors always state that they are rewarded according to shareholder return. The evidence is against them. The overall reward to FT Directors has exceeded the growth in earnings per share by 640% since 2000. Source: Hansard. With the exception of FT 100 company Directors, real wages will remain depressed until productivity increases. It is worth noting that productivity is falling because SME owners are trying to hold on to employees for as long as they can afford to. This is a considerable social benet. The UK loss of productivity is reected in the falling value of Sterling ( 25% over the last 3 years). This allows us to adjust without nominal wage cuts, unlike Ireland where nominal wages have dropped 10%. The key question is over the value of Sterling given all that is happening in Euroland.
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In essence, Sterling will rise against the Clubmed Euro, and fall against the Nordic Euro. At a guess, 25% stronger against Clubmed, and 7% weaker against Nordic. UK Growth Prospects The chart is my best guess. I think a mild recession is 2012, followed by at line certainly until 2014. There will be some quarters when commentators will suggest the worst is over, then it will fall back again. The cause of this at line will be the lack of credit and money in Western economies. This in turn caused by the drive to compliance with Basel 3 by western Banks. We know from history that when banks need to make major adjustments to their balance sheets, economic growth is well below trend for 5-7 years. We are about to enter year 4, and next year the Governments austerity measures will be biting hard.

For any improvement on this the following needs to happen. Firstly earnings need to rise by 2% above ination. If not, then taxation needs to fall by 3% of incomes. If neither of these are possible we are left with credit needing to grow by 7% per annum ( currently it is shrinking by 3%). Fat chance. Interest rates will remain at 0.5% for certainly another two years. The mortgage rate will remain at an average of 4% providing the nation retains its AAA rating. The Bank of England forecast is on the next chart.

So far the actual has been at the lower end of their projections. This is because they dont have the behaviour of Banks in their model. As credit to all businesses continues to shrink we can expect a lot more asset purchases by the Bank. This process is called Quantitative easing. It is undertaken to prevent the money supply shrinking. Money supply shrinks when banks reduce their loan book, because they are required to reduce their leverage by the regulator. I expect George Osborne to announce his plan for credit easing in the Autumn Statement. This will involve the securitisation of SME loans for onward sale to the Bank of England. It is a neat way of directing new money to where it is needed most.

The chart below shows the relationship between money growth and nominal GDP growth.

The lag between money supply and nominal GDP is about a year. We need money supply to grow at 7% to produce nominal growth of 5%, split 2.5% real and 2.5% ination.
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The next chart shows the breakdown of lending. Literally!

And nally the prospects for the world.

The rest of the World It is clearly slowing down quickly, as the next chart shows. I guess the world will avoid another recession thanks to the East, but even they will be unable to avoid the consequences of the recession in the Eurozone next year. The USA is in no position to offset Europe, and China and Brazil have both slammed on the brakes over the past 9 months. It is all pretty much as expected given that the west still needs to reduce its debt.

Exchange Rates for 2012 Sterling-Dollar $1.60 Sterling-Euro 1.18 ( but very susceptible to any hint of a weakening of Osbornes resolve to deliver the plan. Euro-Dollar 1.25 Sterling-Yen 1.30 Ination UK 3.5% from February, dropping to 3% by year end. Euroland stable at 2.5% USA 3% UK House prices. Flat outside London, 3% growth central London
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Finally you will note that there is no mention of the USA. We await the retail data for Thanksgiving at the end of this month, then we can think through the USA outlook, I wouldnt be sanguine. Bur a lot more on the USA in February 2012. As this is the last update for 2011, I have repeated verbatim a letter sent to the New York Times. It was sent by an 86 year old lady to her Bank, and the recipient sent it to the paper. Dear Sir: I am writing to thank you for bouncing my check with which I endeavored to pay my plumber last month. By my calculations, three nanoseconds must have elapsed between his presenting the check and the arrival in my account of the funds needed to honor it. I refer, of course, to the automatic monthly deposit of my entire pension, an arrangement which, I admit, has been in place for only eight years. You are to be commended for seizing that brief window of opportunity, and also for debiting my account $30 by way of penalty for the inconvenience caused to your bank. My thankfulness springs from the manner in which this incident has caused me to rethink my errant nancial ways. I noticed that whereas I personally answer your telephone calls and letters, --- when I try to contact you, I am confronted by the impersonal, overcharging, pre-recorded, faceless entity which your bank has become. From now on, I, like you, choose only to deal with a esh-and-blood person. My mortgage and loan repayments will therefore and hereafter no longer be automatic, but will arrive at your bank, by check, addressed personally and condentially to an employee at your bank whom you must nominate. Be aware that it is an OFFENSE under the Postal Act for any other person to open such an envelope. Please nd attached an Application Contact which I require your chosen employee to complete. I am sorry it runs to eight pages, but in order that I know as much about him or her as your bank knows about me, there is no alternative. Please note that all copies of his or her medical history must be countersigned by a Notary Public, and the mandatory details of his/her nancial situation (income, debts, assets and liabilities) must be accompanied by documented proof. In due course, at MY convenience, I will issue your employee with a PIN number which he/she must quote in dealings with me. I regret that it cannot be shorter than 28 digits but, again, I have modeled it on the number of button presses required of me to access my account balance on your phone bank service. As they say, imitation is the sincerest form of attery. Let me level the playing eld even further. When you call me, press buttons as follows: IMMEDIATELY AFTER DIALING, PRESS THE STAR (*) BUTTON FOR ENGLISH
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#1. To make an appointment to see me #2. To query a missing payment. #3. To transfer the call to my living room in case I am there. #4 To transfer the call to my bedroom in case I am sleeping. #5. To transfer the call to my toilet in case I am attending to nature. #6. To transfer the call to my mobile phone if I am not at home. #7. To leave a message on my computer, a password to access my computer is required. Password will be communicated to you at a later date to that Authorized Contact mentioned earlier. #8. To return to the main menu and to listen to options 1 through 7. #9. To make a general complaint or inquiry. The contact will then be put on hold, pending the attention of my automated answering service. #10. This is a second reminder to press* for English. While this may, on occasion, involve a lengthy wait, uplifting music will play for the duration of the call. Regrettably, but again following your example, I must also levy an establishment fee to cover the setting up of this new arrangement. May I wish you a happy, if ever so slightly less prosperous New Year? Your Humble Client And remember: Don't make old People mad. We don't like being old in the rst place, so it doesn't take much to piss us off.

I hope you enjoyed this as much as I did! 2012 will more challenging than 2011, but at a time of rapid, discontinuous change there are always money making opportunities. I wish you well. Roger Martin-Fagg ( aged 63! ) Rmfagg@aol.com

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