Economic Update July 2011 Europe and the Euro As many of us stated right from the start, the

Eurozone economic model has some fundamental flaws. The recent fiscal and financial crisis confirms that the model is unworkable. The model is this. In a single currency system a country with lower productivity than the average should experience falling wages and prices. This lower cost base encourages inward investment from other members of the system which over time restores productivity, and wages and prices rise to the average. What has actually happened is the lower productivity countries increased their wages and prices faster than the systems average, enabling them to purchase more, better value imports from the more efficient members of the system ( but sell less to other members of the system). This created growing current account and fiscal deficits, which were financed by the banks of the whole system at low interest rates because there was no currency risk, and because no core tier one capital is required to support sovereign lending. This lending boosted the systems money supply and inflation in the low productivity countries. 90% of the money supply in the Eurozone doesnt exist in tangible form. It sits in the liabilities side of commercial banks balance sheets as deposits. In the Eurozone, any bank deposit is equivalent to any other within the system, unless a bank is on the verge of collapse, in which case its euro bank deposit is not the same as a Deutche Bank deposit. When it became clear to the commercial banks that there is such a thing as sovereign risk and that this debt may have to be written down against scarce capital, their willingness to lend evaporated, leaving it to the Central Banks to supply liquidity. The European Central Banks have been creating massive amounts of new electronic money to keep banks afloat. The borrowing banks offer Government bonds as collateral. So the deficit countries are being financed by the central banks from within the system. The Bundesbank is the dominant creditor. Indeed the combined deficits of Ireland, Greece,Portugal and Spain, are matched by the increase in the assets of the central banks since 2008. The Bundesbank has created 325Bn Euro deposits since 2008. A Greek default will create losses for central banks which will have to be covered by the taxpayer. So the fiscal transfers explicitly forbidden in the Euro set up rules at the request of Germany, will actually happen. The German taxpayer will be bailing out the Greek Government via their central bank.This backdoor method of financing debtor countries is political dynamite. The options are stark indeed. The ECB could refuse to lend against defaulting country debt, this would cause the collapse of some French and German commercial banks, and a run on the Eurozone banking system. This would be the end of the Euro as we know it. So either the Euro system is dismantled or it moves to a fully integrated system where Brussels has direct tax raising powers and the mandate to transfer tax receipts from strong to weak. Assuming the latter is not going to happen, we can consider the options. 1 The ECB continues to lend, thus financing the deficits of the fringe countries and through the back door ensuring fiscal transfers take place. 2 Greece leaves the Euro, and the new drachma trades at around 40% discount, imposing large paper losses on wealth held in Greece. It will be very disruptive for a time, and then because Greek sunshine will again be a bargain, economic growth will resume as we flock to Greece for a cheap holiday. All Greek Government bonds would be forcibly re-denominated in the new Drachma, and the interest paid in the same. This is what would be called a credit event and it would trigger large payments to banks who have insured their Greek debt using credit default swaps, UK Banks are major underwriters of these. This will cause a minor banking crisis within Europe, and a few banks will need Government equity. 1

3 Greece will join with Spain, Portugal, Ireland and Italy to form the Med Euro, probably managed by the Italian Central Bank. This will trade at a 30% discount to the remaining Nord Euro. And it will cause big losses for PIGS government bond holders. But growth will resume. The Germans may not be too keen on this because their exports to the Med Euro would immediately become 30% dearer. However imports would be 30% cheaper which would allow German consumers to buy more such goods and let them enjoy much cheaper holidays, just as they did when they has the D mark. Nord Euro interest rates would be around 4%, Med Euro rates between 6 and 7%. Sterling would rise against the MedE and fall against the NordE. 4 Germany leaves the Euro, and it drops 30% in value.

The Greeks are not stupid; already 20% of domestic bank deposits have been moved off-shore, some of it into London property where above 1million prices have risen by nearly 7% in the first six months of this year. Greek Banks hold 40bn of their Government debt on their books. This is 180% of their core tier 1 capital. In the event of a default, they would be all insolvent, and would need to be recapitalised, but who by? I, just like the authorities have no idea. They are already excluded from wholesale markets, and have to get their liquidity from the ECB ( 100Bn outstanding by the end of May). But the ECB has said it will refuse to accept Greek debt as collateral should a default be declared. Greece is insolvent. To become solvent it would need to run a budget surplus of 7.5% of GDP by 2015. The maximum possible is 2.5%. Assuming 2.5% can be achieved, without a restructuring of debt, the ratio of debt to GDP would rise from the current 140% to 400% by 2050. There has to be a restructuring( a polite term for default) this would require that Greek bonds be reduced to 20% of face value.This would cost 140Bn Euros. Portugal and Ireland would follow, which would cost another 200Bn. The charge would be to the ECB, the banks and their shareholders. In total 5% of Eurozone GDP. My opinion is that Greece should leave the Euro and default. The new head of the IASB which oversee accounting standards is throwing banks a lifeline, for when the Greeks default. He proposes that banks will be able to write off bonds by discounting the expected income stream using the original not the current rate of interest. This is a massive help to the banks. If a bank bought Greek debt at a 5% yield, it can use that as the discount rate instead of the current market rate which is 20%. This is yet another example of how institutional arrangements are being made ready for the default, and to reduce the contagion. The IMF undertook a post mortem following the Argentinian debt crisis in 2001. The parallels with the Greek situation are uncanny. The IMF concluded: when debt dynamics are clearly unsustainable, the IMF should not provide its financing. To the extent that such financing helps stave off a needed debt restructuring, it only compounds the ultimate cost of that restructuring A pan-European banking sector stress test has just been published, but apparently the banks are not being forced to model the impact of any sovereign debt default. So, unsurprisingly almost all passed except for a few small Spanish Building Societies, a couple of Greek banks (!), an Austrian Bank. No UK banks failed, but Barclays Core tier one capital drops from 10% to 7%. The press are suggesting Italy is in trouble and could go the same way, I think not. Most Italian debt is held by Italians. Italian households have the lowest personal debt in Europe ( one of the outcomes of a large cash economy). And Italian Banks are mostly well capitalised. However a Medeuro would help Italy a lot, so I guess they would be willing members.

The USA At the time of writing Congress is deadlocked over the debt ceiling. The Democrats want to raise taxes, the Republicans want to cut Federal spending. 2

Unless there is a change in policy, by 2020 Federal debt will be 100% of GDP. ( Greece is currently 147%!) When a recession happens, Government spending in mature economies rises automatically due to Automatic Stabilisers. Social support spending increases sharply and tax receipts fall, the cyclical deficit rises, thus dampening the effect of a collapse in private sector spending. In the USA these stabilisers are weak, so discretionary Government spending has to do the heavy lifting. But the USA has a federal system; the 50 State Governments are expected to balance their budgets regardless of the cycle. This means the Federal stimulus has to be that much larger. This is what Obama did in 2009, and the Republicans wish to constrain such action in the future. If we assume that the majority of Republicans own capital either directly or via equities, they have done very nicely out of the stimulus. Unfortunately the workers have not. Since 2009 profits are up $528Bn, wages up only $168Bn ( source: the Economist). The workers think the stimulus has failed and one can see why.

So how should the Federal Government proceed in order to prevent the deficit from going exponential ? 1 A federal sales tax. This is a tax on spending not income. 2 Abolish tax relief on borrowing: in a recession people pay down debt and this increases their tax bill, and in a credit fueled boom, the more they borrow the less tax they pay. Madness, and pro-cyclical ie makes the boom bigger and the recession deeper. 3 Federal retraining grants, which would be merged with unemployment insurance, so if someone loses their job, they have automatic access to retraining funds. There would huge resistance to this from the Republicans, but it makes economic sense, whereas more Quantitative easing does not because the new money has not been lent to SMEs, instead it has created overpriced commodities and equities. S&P rose 30% between August 26 2010 the date QE 2 was announced, and April this year. QE 2 ends at the end of June 2011. The unemployment rate is unchanged at 9.5% The Fed stimulus has not increased the amount of credit available to US business and households, and the velocity of money is falling again.

US Banks are changing the structure of the asset side of their balance sheet to conform to the Basel three requirement for greater liquidity. This means more bonds and less SME credit and mortgages. This requirement applies to all Banks, and is the dominant reason why real economic growth is so elusive in the West. 4

The Global Situation As I keep pointing out, we are not going thorough a normal cycle, instead we are experiencing a contained depression caused by a prolonged period of private sector deleveraging. I will simply reiterate the core problem. If we add all the balance sheets of the world together we would get zero. So if we take each country; those running large surpluses eg China, Germany, Brazil, can only do so if the UK, the USA, and Greece run deficits. Looking at the world as a whole, it is the high income countries who are in deficit ( not Germany) and the middle income who are in surplus. So high income countires need to save more and middle income countries spend more. In high income countries, private debt need to be reduced. There are four ways in which this can be done: repayment, default, higher real incomes, and inflation. And a fifth way which must be considered: a huge debt bonfire where we just write it off and start again. Repayment means spending less than ones income, and it shows up as an increase in the savings ratio. In the first quarter of 2011, US households and business were running surpluses. The USA has a current deficit with the rest of the world, so the rest of the world is spending less than its income, and the Federal Government is consequently picking up the difference. Here comes the rub, all Governments in deficit countries have announced they intend to reduce their debt. So somebody somewhere must be willing to reduce their surplus. It is unlikely to be Western households, so it will have to be Western businesses. Business can do it in two ways: either a surge in investment spending or a reduction in retained earnings. The former will be adjustment via growth, the latter via a slump. The outcome will be a combination of the two which translates into low or no growth for the next few years in the West.

The UK outlook in more detail. We will get the second quarter GDP figures at the end of August. The expenditure survey is likley to show a 3% growth in nominal spending. The GDP deflator is calculated at 3%, thus the official view will be the economy has stalled, showing no growth, but no double dip, but it will be a very close call. You will recall that growth is expected to come from an increase in capital spending, and net exports. Net exports helped in the first quarter ( without them, there would have been only 0.2% growth), but for the second quarter, although exports rose, imports rose by more, increasing the current account deficit. Larger companies have increased their capital spend, see chart below, but a lot more is required.

Households are really beginning to suffer the effects of fuel and food price inflaton, so the outlook for non food retail is poor. The following charts show why.

The private sector has been increasing earnings at 1.6%, the public sector at 2.2%.

UK earnings growth flat at 2%.

Inflation is running at 5%, so real income before tax is falling by 3%. Unless households reduce their debt repayments, and or draw on real savings, consumption spending excluding food will fall by 5% in real terms for the rest of this year.

The UK inflation rate

The consequence of the last two graphs is this: In May retail sales volumes were up just 0.2%, and value up 3.8%, on a year earlier. But 1.1% down on April. The graph is retail sales volume. June figures are likely to be no better. Normal growth is 3-4% yoy. The only way non-food retail can go for the remainder of this year, is down.

UK retail sales 2011

UK retail sales volume is essentially flat so far this year.

The chart shows that UK companies as a whole have continued to increase their surplus, the offset is an increase in the Governments deficit. Households, having reduced their surplus, are now increasing it again. Our deficit with the rest of the world has increased. As has been stated before, the Government has a business plan which requires the purple line to move to minus 2.5% by 2015, most of the adjustment will have to come from Companies, ideally by paying all employees 7% backdated to Jan 1 2011. This would boost real incomes and final sales, and govt tax receipts. This will not happen, so the next best thing would be a surge in investment on innovation and people development, which will raise productivity and the underlying growth rate. This needs to do the heavy lifting. If it doesnt happen then the surplus of companies will fall because of much lower than expected sales.

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The outlook for the UK remains poor to very poor. It will take more time than forecasters expect for our economy to adjust from domestic consumption and public sector spending led to exports and investment spending led.The majority of consumers outside London will continue to feel less wealthy, and income constained as the adjustment continues. In the UK between 2000 and 2007 retail sales volumes rose 33%, but real disposable income by only 15%. So during this period of steadily increasing houseprices, remortgaging plus credit extension allowed the UK to live beyond its means. House prices in real terms will continue to fall, in nominal terms remain flat. Remember the price of a house is primarily driven by willingness and ability to pay, which in turn is driven by income and the multiple of it which can be borrowed, plus the expectation of which way the price will go in the near future.

The path of interest rates over the next few years. The correct rate of interest, when banks are operating normally, is the real growth rate plus 2.5%. So for the UK over the last 40 years this means 5%. Higher rates will be often in place because money supply is growing too fast, and this is drving up domestic prices. Rates lower than this will because inflation is below the target level of 2%. Many people think that UK rates should rise. They should not. The reason is simple, banks are contracting the asset side of their balance sheet, this destroys money, so without QE the UK money supply would be contracting. When this is happening, the rate of interest ceases to be a lever which will influence money supply. If UK interest rates were raised, inflation would GO UP. Housing costs are 25% of the RPI, so a 1% rise in interest rates would increase infaltion by 0.25%. And there would be another recession. As I have said before, today the UK inflation rate is the consequence of a 25% devaluation of sterling, plus commodity and food price inflation. It is most certainly not due to excessive wage awards, or excess money supply. The biggest risk to the UK is stagflation, which is low or no growth but an inflation rate at 4%. The Bank of England will keep base rate at 0.5% until this time next year. If by then money growth is still sub 2%, they will continue with 0.5%. However in three years from now, monetary growth should be restored ( because the banks will have rebuilt their balance sheets by then), and rates will rise quickly towards 4%. 11

The ECB has raised rates again because of strong export led growth in Germany, which is nearly a third of the Eurozone. As Trichet has pointed out, the PIGS are small fringe economies, and he has to worry about the core of Europe, even so, Eurozone money supply growth in no higher than the UK, so its a surprising move. Further evidence of the problem of one size fits all, and why in the end the system will unfold.

Exchange Rates In the short run exchange rates are determined by interest rate, exchange rate, and inflation rate differentials. On this basis, the dollar and sterling should weaken against the Euro and Asian currencies. However periodically political risk dominates. I think we are entering such a phase with the Euro. The politics is becoming crucial with Germany continuing to try to exert some discipline, whilst the PIGS continue to emphasise that their debt is a European problem requiring a European ( ie German) solution. So we should expect bigger swings than normal in the value of the Euro against the main currencies. Then we have the US debt ceiling which need to be raised protem, otherwise the US Federal Government will not meet its wage bill in August and also pay interest on its debt. Its worth noting that during the time it has taken you to read this update, the US has borrowed another $6million! And yet relative to Euroland, the USA may be considered to be more stable. So best guess: -$ range 1.40-1.65 -Euro range 1-1.20 $-Euro range 0.65-0.75

Roger Martin-Fagg July 18 2011 Rmfagg@aol.com

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