Predictions for 2012 and beyond by Paul Emmerson, written 31st Dec 2011

As befits the end of the year, Ive decided to make some predictions. They are macroeconomic in nature, and are prefaced with some thoughts on the current political/economic situation as background. The article is written from a UK perspective, but is of general interest. First, a question: every year, where does the money for pensions, the health service, education, etc come from? Taxes? Well, yes most does. But some (around 25% every year in the UK) comes from borrowed money that we have to pay back. The problem is that we arent paying all of it back, and both the borrowed amount and the unpaid amount have been getting bigger and bigger every year. Here are the figures: the current level of total UK government debt is approximately one trillion pounds. Thats one thousand billion (1,000,000,000,000). If there are 60 million people in the UK, thats 16,666 for every man, woman and child. What did all this money go? Figures for last year show the biggest areas are: benefits & pensions, the health service and education:

Source: http://www.debtbombshell.com/uk-national-debt.htm

Read the first sentence of the first paragraph in the box above one more time. Now read it again.Were living beyond our means. This is how we continue to live in never-never land: The government issues a 10-year bond: it borrows the money from lenders (bond holders), uses it as per the table above, and after 10 years repays the bond holders with interest. What happens if the government cant repay at the end of the 10 years? Simple. It issues another 10-year bond to make the repayment on the old one. This is called rolling over the debt. Whenever a PIIGS (Portugal, Italy, Ireland, Greece, Spain) country has debt to roll over its a big thing on the markets: will they find buyers for the new debt? So the government (the country) slowly gets deeper and deeper in debt. We take on new debt to service the old debt. Now then, it would (in theory) be possible to reduce government debt every year if some of the old debt, and all of the interest, was paid for out of the taxes that comes from growth in the economy. But that doesnt happen. Except in Scandinavia. Heres a graph that backs up the point about Scandinavia. It shows government debt as a % of GDP for Denmark and Sweden (blue and mustard lines, debt slowly decreasing) compared to the UK, Germany and France (red, green and purple lines, debt slowly increasing). It covers the last 15 years.

Two interesting points here. Please read these carefully: Scandinavian countries have done this with centre-right (neo-liberal) governments over most of this period, and these same governments have maintained the low income inequalities traditionally associated with Scandinavia. Critics of free markets please note. UK debt really exploded in 2007. That was the year Gordon Brown became prime minister and Alistair Darling became Chancellor of the Exchequer. It was also the year of a big banking crisis, thats true. But the graph shows government debt rising astronomically: from 44% at the start of 2007 to 80% at the end of 2010. Thanks, Gordon and Alistair. Someone will have to pay that and I suspect it wont be you. Okay lets look at this government debt in a little more detail. Weve seen that its growing, and weve seen that to pay it back we have to issue new debt. Is that the end of the problem? No. Because every time the government issues a new bond simply to repay an old bond, the interest rate that it has to pay on the new bond is higher. Why? Because otherwise no-one would buy the new bond. Would you lend to someone if you knew that they pay all their debts by borrowing again from other people? You might, but only if they offered you very high interest. For example, German 10-year bonds give you around 3% interest, but Italian/Greek bonds give you 7%. Thats to compensate you for the risk that you wont get your money back. So, the Italian and Greek governments have to pay back the money they borrow to run their countries plus give 7% interest to the lenders (the bond holders). Where does that 7% interest come from? Well, there is only one place: the countrys own internal tax receipts. And, of course, these fall in a recession. So the government is left with less tax receipts for two reasons: less business activity in a recession and higher payments to bond holders. Thats bad news. Where does it get the extra money it needs to spend on benefits, pensions, health and education? By issuing more bonds. Vicious circle. Its happening before your eyes. What is the endgame? Various possible scenarios: 1. Future generations pay. This is the default option that has been happening for years. Continuing to issue new bonds to repay old bonds does indeed kick the can down the road, but leads to slow, steady decline. Big problem: demographics (and rising unemployment during recession years) mean that fewer people are working and paying taxes. So there are less tax receipts to repay the bonds not to mention to fund the pensions of soon-to-be-retiring baby boomers (a huge commitment coming just round the corner). The road along which the can has been kicked is about to run out. Endgame. Irony: those on the left who do not take deficit reduction seriously are guilty of an ism

every bit as big as sexism and racism: generationalism. The next generation will have no options for the kind of society they want to build: they will just be paying off Gordon and Alistairs rolled-over bonds. 2. Inflation. Central Banks can print boatloads of money in order to inflate the currency and make it worthless. If Zimbabwe owes 1,000,000 zimbabwean dollars to bond holders, Mugabe can pay them back with a single 1,000,000 dollar note that is worthless. Problem with this solution: imports become very expensive. No Zimbabwean can afford an iPhone while earning a salary in Zimbabwean dollars. In fact anything priced in dollars, or euros, or yen, is just too expensive that includes energy and imported food as well as consumer products. And of course no-one for a generation will ever buy a Zimbabwean bond. So the government cant invest in anything or make plans. By the way, the phrase quantitative easing means printing money specifically to buy bonds. More QE is coming, in the US, UK and EU. 3. Currency devaluation. In practical terms this is like #2 above, and currency devaluation and inflation are closely linked. By printing Zimbabwean dollars, Mugabe makes his currency worth less. Previously 1 zimbabwean dollar = 1 US dollar. Now 10 zimbabwean dollars = 1 US dollar. Mugabe can pay his bond holders the 1,000,000 zimbabwean dollars he owes with his newly printed money, but to the bond holders its only worth one tenth as much when they convert it into the US dollars they need. And to the Zimbabwean in the street, the cost of an imported iPhone goes up from 100 zimbabwean dollars to 1000 zimbabwean dollars. But this is indeed a solution, if you can stand the pain of inflation. Its what the Argentines did in 2002 when they were in a similar situation to the Greeks today, and its what some in Greece offer as a solution now (although to devalue they would need to have their own currency again, not euros). 4. Depression. What happens if there is less appetite on the part of investors to buy bonds issued to repay previous bonds (because the probability of not getting their money back is too high)? Answer: the government is unable to borrow all the money it needs, and cant run the country. Or it has to pay such high interest rates on the new bonds to make them attractive that it bankrupts the Treasury. Hello Greece. The warning signs are when a bond issue is undersubscribed, ie there are not enough buyers. It just happened in Hungary a couple of weeks ago they had to cancel their bond sale. Its going to happen more often. It leads to a depression as government spending is cut (there is just no more money available to pay teachers, doctors, pensions). Living standards are adjusted downwards.

5. Default. Instead of struggling over years under scenario #4 (depression), there is a more sudden resolution as a country just says: Nope, we cant pay you back. Sorry. A partial default is already part of the Greek solution. Problem: who are the institutions that are not paid back? Who holds these bonds? Answer: European banks. So Barclays (and more importantly their French and German equivalents) suddenly have much smaller assets on their balance sheets the bonds they own are now worth much less. What does that mean? It means that they are unable to lend money, as the money they are allowed to lend is determined by the assets they have. If you have 100 in your pocket the regulator will allow you to lend 10. But if you only have 20 in your pocket the regulator wont allow you to lend 10. Banks being unable to lend to companies and individuals means a depression. And, as for the inflation and currency devaluation scenarios above, no-one buys a Portuguese or Irish bond for another ten years it is just too risky. That means no money for the Portuguese and Irish governments to run their country. An obvious question now: is the financial sector to blame? The answer, to my mind, is absolutely clear. Yes for the 2007/2008 credit crunch crisis (mis-sold mortgages, derivatives with ridiculous leverage, retail banks with risky investment arms that werent separate, ratings agencies paid by the firms they were rating, etc). But No for this one. This ongoing crisis is due to living beyond our means, and goes back to the Central Banks response to the dot-com crash in 2000 (see later). Lets look at the favourite four targets of the anti-finance movement, as identified by many socialists and many European politicians looking for scapegoats: Banks. Bailing out Northern Rock, RBS, Lloyds and HBOS in the 2007 crisis cost the taxpayer 37 billion (source: http://news.bbc.co.uk/1/hi/business/7666570.stm), and that added to the national debt by 3.7%. That was a disaster and the mismanagement of those banks was a scandal. In return the government got a say in how these banks are run, including bonus payments. These banks were too big to fail and this situation must never be allowed to return. A badly run bank should be allowed to go bust like any other company without putting ordinary peoples money at risk. All political parties agree about this. But the fat cat bankers who remain are working for banks that were not bailed out, and they are paid by the banks own profits, no-one else. Yes, they should share a (greater) burden during difficult times, as should all the super-rich, and a one-time tax on bank profits might be a good idea. But please dont scare the banks and fatcat bankers away from the City. Finance accounts for 30% of the UKs tax receipts, and without the City there would be 30% less money to spend on pensions, health and schools.

The City really is the goose that lays the golden egg for our welfare system. If our finance sector goes to Switzerland and Singapore and Honk Kong, then kiss the welfare state goodbye. Yes, the weight of finance in the UK economy is very unhealthy but that calls for more of other kinds of business, not less banking. And those who think that increasing tax is a simple answer should look carefully at this next chart. Its the Wikipedia list of tax revenue as % of GDP, sorted by the (third) OECD data column. So highest tax countries at top, lowest at bottom.

Here we can see that UK companies and UK taxpayers pay a middling contribution in comparison to other countries (34%). Some countries pay more: Germany 37%, France 41%, Italy 43%, Sweden 46%. But some countries pay less: Canada 31%, Switzerland 30%, Japan 28%, Australia 30%. Theres no real message here, and some of the low-tax countries Canada, Japan, Australia are ones we can admire for their low income inequalities and good social services. I think that tax rates are not very significant in this crisis. Higher tax means more revenue for the government, but also scares away some companies (meaning less tax revenues) and makes it more difficult to start a business. I think the two effects approximately cancel each other out. Hedge funds. Hedge funds are speculators (half the time) who risk their own money and no-one elses. Not a single hedge fund has ever contributed a single penny to national debt. Hedge funds are just like any other investment fund, except that they can also go short, ie bet that markets will go down. In other words, they can make money in a falling market, not just a rising market. A hedge fund that makes money by, for example, shorting the euro is taking an informed guess that the euro is overvalued and will go down in the future. They might be right or wrong, and might make or lose money. Its their business. But criticizing them is nothing more than shooting the messenger. They cannot move markets on their own. And very important this for the other half of the time they introduce massive stability into the system. They allow companies to hedge risk, hence their name. For example, if you are a UK company who exports to Europe and is paid in euros you might be worried about the euro falling in value. It would reduce your profits and you would have to lay off workers. If a hedge fund offers you a financial product that shorts the euro, then you can make some money back if the euro falls offsetting your lower profits from the less valuable euros you earned. This is hedging your risk, and it adds stability and saves jobs. And one final thing: without some players in the system able and willing to go short, the risk of bubbles is much higher. Otherwise its in everyones interest to just buy and keep buying (and never sell) because the market can only go up. Thats a bubble. Tax evasion. Of course all tax evasion must be stopped. Its a priority. The current crisis has thrown new light on this area, and the UK government has responded with new proposals. But it wont make much difference. The best figure I can find for annual UK tax evasion (by companies and individuals) is 15 billion (15,000,000,000). So, total national debt is 1000 billion and tax evasion is 15 billion. In other words if all tax evasion was stopped tomorrow it would solve just 1.5% of our problems.

 Ratings agencies. In the 2007 crisis these were indeed a) hopelessly late in acting, and b) not independent. They were rightfully criticized. Now they are doing a proper job, and for example downgrading US and French and PIIGS bonds because it is more risky to own them. Thats their job: to rate investments according to their risk, so that investors know. Once a governments debt is downgraded by them, the government has to pay bond holders a higher interest because of the higher risk of default. This higher interest comes out of tax receipts, and there is less tax money available for government spending. So politicians of countries with downgraded debt are furious. But you cant criticize ratings agencies for being asleep at the wheel in the last crisis and then complain when they start to do their job properly now. Again, shooting the messenger. The financial sector, and free markets, are just a convenient scapegoat for this debt crisis. Be very wary of blaming them. If you reduce the weight of the private sector in the economy, and reduce GDP by making business harder to do, then where are the taxes to pay for the welfare state? If you discourage entrepreneurs, then where do new businesses and new tax receipts come from in ten years time? In fact debt crises have been happening regularly for 800 years, as Reinhart and Rogoff have shown in This Time Is Different the most important book of the decade. Cycles of boom and bust are driven by excess credit leading to debt and default. They always have been and they always will be. The title is ironic politicians always claim that this time is different, but it never is. Remember Gordon Browns no more boom and bust? Remember Alan Greenspans Goldilocks economy not too hot and not too cold? Raging against the way that this crisis is wrecking peoples lives is like raging against the waxing and waning of the moon. If you can come up with an economic system that generates wealth without having economic cycles, then please do so. No one else in history has managed it. Well, North Korea doesnt have cycles, thats true, but then it doesnt have upturns either. In fact the current crisis really began with the 2000 dot-com crash, but we didnt feel it because of the actions of Central Banks (CBs) to recover from that crash. CBs kept interest rates low in order to encourage borrowing and spending and avert a recession. But they succeeded only in putting back the day of reckoning, and making it worse. It was those artificially low interest rates that caused individuals and governments to borrow too much and get into debt. Easy money caused a succession of bubbles: in stocks, house prices, commodities. CBs were the real villains of the piece. They should have let the economic cycle take its course. History has shown it cant be tamed. Its possible that downturns could in fact be made more bearable if governments did what Keynes recommended: put money aside during the good

times to offer support during the bad. But they never do they spend it all during the good times. They dont put it aside for the bad times. They make hay while the sun shines, in order to do whatever it was they came into politics to do, or just to get re-elected. Their justification is that this time is different and bad times wont return. Then when the downturn comes they try to enact the second half of Keynes recipe spending to stimulate the economy without having the saved money to do it. They have to use more borrowed money to do it, the spending doesnt work anyway, and the vicious cycle begins. The exception that proves the rule here is the Scandinavian countries, which will surely weather the storm better than others. All this leads to my forecast for 2012 and beyond: European Central Bank (ECB) will have to buy the bonds of PIIGS countries because no one else will, and without this support the euro would collapse (which I dont expect). The ECB is currently not permitted to do this by its constitution, so lets see how they manage it. Germany will have to supply much of the money to the ECB for it to do this, and the German tax payers wont like it one bit. German tax payers will demand something in exchange: the audit of national budgets by Brussels, to make sure that PIIGS countries and others are not overspending. This means that PIIGS and other national governments wont be able to set their own budgets in their own parliaments. They wont be able to control levels of spending on health, education, etc, and they wont be able to decide tax levels. Brussels will tell them at what age public sector workers can retire, and what level of pensions they can give to the public sector. Politicians will be reduced to the level of middle managers dividing up a diminishing cake amongst hungry people. Expect massive civil unrest as PIIGS citizens accuse Germans of making their recessions worse, of Germans trying to take over Europe etc. If the Germans turn round and say okay, you go it alone you ungrateful so-and-sos, then game over for the EU and the euro. The thing that most prevents the Germans from doing this right now is the fact that a euro without PIIGS would be much stronger against other currencies, and this would hurt German exports worldwide. In Europe itself, the breakup of the euro would cause massive economic instability and this also hurts German exports in its own backyard. The civil unrest arising from enforced austerity will usher in left-leaning governments promising to protect workers living standards. They will find that they are unable to act to do this (more spending by them makes the situation worse). Papandreou is just the first socialist of many

who are going to find this out. The resulting chaos will provide a breeding ground for the far right (national socialists, defending the interests of our people against Germans and bankers and free markets). But I dont expect the far right to prevail (too many historical memories and most people are too sensible). Instead there will be a long slow decline in Europe as it readjusts to lower levels of public spending. Green parties might do well. Make do and mend will become the order of the day. The new austerity chimes well with the Green agenda of anticonsumerism, of lower living standards to save the environment, etc. And buying local is a nice gloss on economic nationalism. Buying local products makes you feel okay about having a devalued currency that has made imports expensive. But lower demand in rich countries combined with local sourcing will put an end to the dreams of rising living standards for the developing nations. In recent years thousands of millions of Chinese, Indians, Koreans, Mexicans, Brazilians and other nationalities have finally risen out of poverty by selling into our markets. That will stall. Expect the Green movement to be silent on this issue. In the second half of year the bond and currency markets will realize that US debt is just as high as PIIGS debt. US debt and the $ will become the new focus of attention for the markets. The US Federal Reserve is much more likely to go down the route of inflation, money printing and currency devaluation for historical reasons (Germans have a morbid fear of inflation hyperinflation in Weimar Republic laying basis for Hitler). So massive money printing of $ and associated devaluation of $ coming for late 2012 into 2013 and 2014. This will be very good for gold in the long-term. The stock market could go either way. Its down for another six months for sure. After that I dont know. If money printing, inflation and currency devaluations rule the day, then the markets will rally along with the rise in inflation. Historically markets always rise with inflation, for two reasons: 1) Bonds hate inflation because bonds pay a fixed rate of interest. You just spent 100 on German 10-year bonds and youre looking forward to 3% interest plus your 100 back at the end. Thats not too bad if you can only get 1% in cash at the bank. But now inflation is starting: the 100 you get back will be worth much less in 10 years time, and the 3% interest wont look so good if inflation is 4%. So you sell your German government bonds. Across the world everyone else does the same and money flows out of the bond markets and into the stock markets. The stock markets rise just for reasons of liquidity, nothing else. Please remember that worldwide the bond markets are approximately

ten times bigger than the stock markets. Read that last sentence again. Its true. 2) A related point: rising stocks also act as a hedge against the eroding value of cash at the bank. However if inflation is not the outcome, and paying down the debt combined with default rules the day, then stock markets are mostly down with occasional sudden rallies for many years. Short-term plays on the stock market when we get a (temporary?) low this year: Japan and Italy. Market sentiment cant get any worse here, and that means a bottom. Fear and greed rule the markets, and fear can overshoot on the downside as much as greed on the upside. The recovery begins in 2020. By then debt is finally paid off or defaulted on or inflated away. A new phase of world economic growth and optimism will resume. The race will be won by the low-debt, demographically young, politically open, entrepreneurial, trading economies with a well-educated workforce and flexible labour markets and easy access to venture capital. Be surprised as the United States once again does very well, against all the conventional wisdom that the next century is Asias. Asia will do very well in the future, for sure, but their easy growth is behind them, and the big three have massive demographic problems (China, Japan and Korea have ageing populations with exceptionally low birthrates). I think that when the depression is finally behind us the future growth stars will be, in alphabetical order: Australia, Brazil, Canada, China, Denmark, Egypt, Hong Kong, India, Indonesia, Iran (if theyve had a Persian Spring), Korea, Mexico (if its not a failed narco-state), Philippines, Poland, Singapore, Sweden, Taiwan, Turkey, United States and Vietnam. Of that list, I think the fastest growing in the future (the new BRICs) will be Indonesia, Mexico and Turkey. And for the UK? If we can reduce our debt (and keep it on a downward path), and reduce our dependence on the financial sector, and make it easy to start and grow companies, and improve our education and skills base (not easy weve just had 3 terms of a Labour government committed exactly to that and Im not sure its worked), then why not? Happy New Year! Paul Emmerson 31st December 2011