Greece, Ireland, Portugal and Spain have received rescue packages during recent months and the latest Cyprus bailout is still comparatively small compared with these previous rescues. However, Cyprus is a more complex rescue for several reasons. One factor here is the apparent large Russian influence and suspicion (especially in northern European creditor countries) that Cyprus is a conduit for illicit Russian money (which is denied by Cyprus).

The basic problem is that Cyprus has a broken banking system. Fuelled by Russian deposits, the Cypriot banking system is around 8 times bigger than the corresponding Cyprus GDP. It is also a highly concentrated system – the three largest commercial banks are five times bigger than GDP. The banks have experienced big losses on their holdings of Greek government debt and in their own financial dealings within Greece. It is reckoned that banks in Cyprus need up to €10bn in order to recapitalise.

The proposed rescue package in total is €17bn. This is a massive burden (it is around 95 per cent of Cypriot GDP) on a small economy. In order to mitigate its impact, a levy has been proposed on bank deposits -  6.75 per cent on deposits under €100,000 and 9.9 per cent on deposits over €100,000. Cyprus is currently in a state of extreme financial emergency.

The proposed levy on bank deposits has attracted a great deal of criticism and concern.  This levy was apparently demanded by a Germany-led group of creditor countries.  A primary objective is to reduce the cost of the bailout from €17bn.

There is an argument that deposits over €100,000 (so-called ‘wholesale depositos’) might be potentially subject to such a levy. They are typically above the ceiling for deposit protection (or deposit insurance) schemes and these deposits are held by more sophisticated (and wealthier) customers. The economic argument runs that these kinds of depositors (and those who invest in bank capital debt or bonds) have the skills and should be required to help discipline banking behaviour. They receive higher rates of bank interest and, therefore, they should be part of the overall ‘market disciplining’ of banks.

But even with this kind of depositor (and capital bondholder), there is a countervailing economic argument. This is that only bank regulators have the kind of detailed and often complex banking information needed to detect and discipline banking behaviour. Even bank regulators are often hard pushed to detect, quantify and police banking behaviour.

A related economic argument is that if these kinds of bank depositors and bondholders lose confidence in regulators and the banks, they will seek to take their funds out of the banking system. If this kind of behaviour spreads, it becomes a ‘contagion’ that can quickly mutate into a bank run when all bank depositors and creditors withdraw their funds. In modern globalised and highly integrated financial markets, these kinds of bank runs can spread quickly across national frontiers.

On balance, though, there is a stronger case that wholesale depositors and capital bondholders should be part of the overall market discipline process. Retail depositors, on the other hand, cannot be expected to have the skills and knowledge to assess bank soundness.

For bank deposits covered by the deposit protection (or deposit insurance) scheme, deposits under €100,000 (so-called ‘retail deposits’), the present proposals have no support from historical experiences.  Indeed, banking history supports the economic dangers of this kind of proposed deposit levy on Cyprus. It is quite simply, an economic bungle. Unless shelved, it raises the specture of bank runs and a wider contagion beyond Cyprus to other EU countries who may need a similar kind of rescue package. So how does banking history support this view that retail deposits at least should never be subject to this kind of levy?

The most dramatic and formative experiences of what can happen and go wrong (and produce unintended consequences) is that of US experiences in the ‘Great Crash’ of the late 1920s and 1930s. This was a period of ‘laissez faire’ economics – the prevailing economic philosophy was that if banks had got themselves over-exposed in their lending and investing, then it was not the role of the State and taxpayers to bail them out. The result of this kind of thinking was the famous ‘bank holiday’ of 1933 when the US banking system effectively collapsed and was closed down for a week.

These US experiences were a fundamental reminder that banks (whether we like it or not) are ‘different’. From these experiences came important bank stabilising moves like the famous Glass-Steagall Act (which separated investment banking from retail banking); the principles of modern central banking (the central bank has to act as ‘lender of last resort’ when the banking system comes under liquidity pressure); risk-based capital adequacy rules; and deposit insurance.

These moves recognised that all banking systems are underpinned fundamentally by depositor confidence. In carrying out their important economic role of borrowing short and lending longer, banks are always exposed to liquidity risk. This latter risk is mitigated to the extent that it is underpinned fundamentally by the confidence that depositors have that they can always draw down their deposits when needed. So long as this belief exists, depositors do not have an incentive to run on their banks.  Under these conditions, contagion risk (the risk of a bank run spreading to otherwise healthy banks) is minimised and the probability of a systemic risk (a generalised bank run) is much reduced.

To some extent, the maintenance of this confidence is a kind of ‘illusion’.  It is an illusion to the extent that even the healthiest banks could not meet a serious run by their depositors without central bank liquidity help (as ‘the ‘lender of last resort’)

Within this apparatus of confidence maintenance, deposit insurance plays a fundamental role that is borne out by banking history, especially US experiences. Insuring retail deposits up to a set figure (like €100,000) acts as a disincentive for a depositor to run on a bank.  In this sense, deposit insurance is itself a kind of unique kind of insurance – effectively, deposit insurance exists to help prevent the event insured against.

The new, proposed levy on Cyprus bank deposits, especially for those up to €100,000 (the retail deposits) ignores the lessons of banking history. The levy breeches deposit insurance protection and opens up wider questions on the kind of protection that retail depositors can expect. Leaving aside the legal and moral questions raised by such a levy, it is bad economics.

Political and punitive aims have dominated good economic sense. Even if such a levy could be economically justified, it would need to be related to the risk exposure assumed by each bank.  In short, the more risky a bank, the higher the levy should be.  But even here the retail depositor (rather than bank shareholders, senior bank management, the national bank regulator and the eurozone bank regulatory authority) is still being punished for the sins of others.

Cyprus banking is broke and Cyprus needs to be rescued. But the proposed bank deposit levy on retail deposits is a mistake, a bungle. The potential wider impact of this move on confidence in the eurozone banking system and wider EU banking could be calamitous. Cyprus has rejected this scheme and now has to come up (and quickly) with a more acceptable proposal, which may involve a more direct Russian role.

Professor Ted Gardener                  

The UK is not the only big country to have been downgraded.  Both the US and France have been downgraded to this second tier during the past two years.

Rating agencies have themselves been downgraded during recent years.  They suffered a bad press in the build-up to the financial crisis (that started in 2007) because of the high and improper ratings they assigned to paper which turned into ‘toxic assets’.  The latter were central to the combination of events, the ‘bubble’ that subsequently mutated into the worst financial crisis in modern history. As a result, major investors no longer automatically respond to these kinds of credit rating changes in the way that they did before the crisis.

Nevertheless, this downgrade is clearly not good news!  It was predicted and the reasons for it are well-known, but it does have some impact on the economic credibility of the UK government’s present plans to fire up the economy.  It is particularly discouraging to Mr Osborne’s (the UK Chancellor) tough austerity measures and the apparent impact that these are having on borrowing (via reduced tax revenues and increased welfare spending).  Maintaining Britain’s triple-A rating was an important part of the present UK Government’s election manifesto.

The immediate impact on the markets of the downgrade has been surprisingly little.  Sterling did fall a bit, but gift yields also fell (as investors concern increased over the recent Italian election results).  Both in the UK and wider financial markets, the downgrade did not apparently cause more than a flutter.  Share prices on March 5 soared to levels not experienced since before the financial crisis.

Nevertheless, as sterling weakened during the last days of February (fuelled largely by concerns about high inflation and low growth), the downgrade added to these kinds of pressures.  Sterling is currently the weakest major currency of 2013.

So, the downgrade is not a calamity by and of itself, but is has certainly added to the pressures on sterling and Britain’s struggle to fire up a sustainable economic recovery.  In this context, there are wider and more fundamental economic problems (like the present Eurozone recession) faced by many other countries.  There are some apparent ‘green shoots’ appearing in the UK economy and the recent downgrade confirms the many economic challenges that have to be addressed in order to achieve a sustainable recovery.  In this respect, the UK is not alone.

Mr Osborne may need to re-think some of his austerity plans and bank lending still has to recover.  The latest figures on bank (lack of) lending to small businesses are disturbing and disappointing. The Chancellor’s Budget on March 20 will be interesting.

Professor Ted Gardener  

It takes a considerable time to change a banking culture and this is now a major challenge. There is a widespread view that many aspects of the pre-crisis (the crisis  that started in 2007) culture need to be reformed. A core issue in all of these talks and proposals is the importance of  re-professionalising bank management and the core economic importance of bank lending. UK and wider global economic recovery requires bank lending to lead and this needed growth in lending has to be sustained.

A particular UK (and in several other European countries) problem is the apparent dearth of bank lending to smaller businesses. There is growing evidence in the UK that this is just not a demand-side problem – that is, a lack of demand for this kind of bank lending by creditworthy customers. There is a growing volume of cases where smaller firms are apparently being refused bank credit at any price. At the same time, many banks may impose such stringent conditions on borrowers that many firms are discouraged from even asking for a loan.

There have been many strong attempts in the UK during recent years to increase (even start!) the bank credit flow to smaller firms. The most important of these include

-          The Enterprise Finance Guarantee scheme which gave banks a Government guarantee of 75% of their loans to smaller businesses. This appeared to be a big move since it substantially reduces the risk to banks who make such loans (the banks argue that one of the reasons why lending to smaller businesses is more problematic is because these kinds of loans are inherently more risky)

-          In 2011, the much vaunted ‘Project Merlin’was an agreement between the biggest lenders and the Treasury to provide £190bn of new lending to businesses

-          Project Merlin was followed by the Loan Guarantee Scheme that used Government guarantees to help reduce the cost of bank borrowing from markets.

But none of these have succeeded to date in getting the needed credit to smaller businesses.

The latest such scheme was launched in August, 2012 – the Funding for Lending Scheme (FLS). Under FLS, banks can borrow at cheap rates from the Bank of England to fund their lending. The initial objective is to provide around £70bn to lenders to support low-cost business loans and cheaper mortgages.

There are several grounds for greater optimism about this latest initiative. For one thing, it is on a bigger scale than earlier initiatives and it can be expanded if needed. Bank borrowing costs did fall during the second half of 2012 and US experience has shown that these kinds of reductions can help stimulate bank business lending. FLS has already helped to stimulate a UK property revival as the banks compete more strongly to offer the cheapest mortgages. Large business firms also seem to have benefitted.

So far, though, the smaller firms have still not seen increased bank credit flow resulting from FLS. It appears that lenders continue to operate a separate set of lending rules for small firms. Despite FLS, bank lending interest rates, fees and commissions have not fallen for smaller firms. Small firms continue to be starved of bank credit.

One solution (strongly advocated by Vince Cable and others) is a return to ‘old style’ banking where local bank managers were more prominent. Cable argues that that the kind of bank culture that helped to fuel the crisis downgraded banks’ branch-based business lending and these lending skills were effectively lost. The big banking bonuses were not paid to branch-based lenders, but more to investment banking and capital markets staff. As a result, more talented staff have been incentivised to move into these higher rewarding areas of banking.

Another proposal is that a proportion of FLS-based funding should be set aside specifically for small businesses. There are also calls for a greater public scrutiny of where and how banks are lending, especially to smaller firms.

This apparent bank ‘credit gap’ for smaller firms is not just a UK phenomenon (although it does appear to be a particularly serious issue for the UK). Banks and bank lending in many European countries are effectively shrinking.  Banks are under strong, post-crisis pressure from regulators, creditors, shareholders and other key stakeholders to re-configure themselves into safer and yet more profitable institutions.

In the face of these wider economic forces, other market solutions to produce needed credit begin to appear.  In particular, the entry of foreign banks into the  domestic market, non-bank finance companies and other new lending platforms begin  to assume a greater prominence.  These needed ‘innovations’ seek to take advantage of the apparent shrinkage of bank lending and the apparent unwillingness (for whatever reason) of the banks to do anything about it. Crowdfunding in all its forms, for example, is fast emerging as a real threat to traditional bank lending.

It is still early days, but time is fast running out in the sense that a growing, legitimate credit demand has to be satisfied in some way. Unless the banks respond to the apparent growing ‘credit gap’ for small businesses, the market is increasingly likely to produce a more viable and efficient solution. The best Government response is to make sure that this innovation process is not impeded, but is rather encouraged.

Professor Ted Gardener                                                                     

The UK economy is not alone in experiencing recent bad GDP news. The US economy also shrank (by 0.1 %) in the last quarter of 2012 after 13 consecutive quarters of growth. Other major economies (including China, Japan and Germany) are also struggling to meet earlier, more buoyant economic growth expectations. Despite the apparent outbreak of ‘positive contagion’ in some important financial markets, the peripheral Eurozone economies are also still fragile at best.

The latest GDP figures, then, are a cautionary reminder that there is still a big hill to climb for economic recovery to become strong and sustained.  No one would deny that. Nevertheless, the real UK economic scenario and prospects are more complex than that apparently revealed by the latest GDP data alone.

A snapshot of one set of data cannot capture the full economic picture and developing trends. For one thing, recent UK employment data look much more buoyant and seem at odds with GDP data looked at in isolation of other key factors. Construction, house property prices and business optimism surveys all seem reflective of a  more buoyant economic scenario.

Investor optimism and the recent strong performance of the FTSE 100 are also important economic indicators. Although this stock market performance does not again appear consistent with the UK’s underlying economic performance of recent months (if you go by GDP data alone), it is reflective of other, perhaps even more fundamental economic drivers. In particular, it reflects growing economic confidence.

The early 2013 FTSE 100 index recorded higher values than those in the run-up to the collapse of Lehman Brothers in 2008. This suggests that the market is increasingly downgrading the imminent threat of a severe downward spike in the global economy. In short, the post-crisis ‘hangover’ in financial markets may be drawing to a close.

A recent report by the LSE (London School of Economics) Growth Commission (summarised in greater detail in The Sunday Times, February 3, 2013) emphasised the many advantages that that the UK has in approaching its future. These many ‘assets’ include its flexible labour markets, a world-class university system  and important sector strengths, with cutting-edge firms in key manufacturing and services sectors.

This report points out that during the past 30 years the GDP per capita in the UK has risen more quickly than in its advanced- country competitors (including France, Germany and the US). The report de-emphasises the ‘myth’ that most of this performance is attributable to the financial city of London (although financial services and London’s position as one of the major international financial centres are UK strengths). They also criticise the apparent UK trait of self–criticism and disparaging success potential (the several ‘doom and gloom’ scenarios that characterised some of the build-up to the highly successful London Olympics are a good example of this UK trait).

The LSE report makes many proposals for generating growth via infrastructure, innovation, education and skills. These include inter alia a new business bank and a National Growth Council. It is emphasised that a great deal needs to be done in order to capitalise on the UK’s many considerable strengths and to tackle effectively its weaknesses. The many challenges that lie ahead are not downgraded. But the report emphasises that with the right policies, the UK has the necessary assets to look ahead with confidence.

So ‘mixed messages’ on the UK economic recovery. On balance, though, there are developing grounds for more optimism. There are also good reasons for believing that the UK has the assets to move forward with growing confidence, so long as the right policies are enacted.

No time for complacency and no time for ‘doom and gloom’ either. A good time to think more carefully about what the markets are signalling?

Professor Ted Gardener           

The following table shows the data used in this periodic survey by The Economist of house-price indicators.

The Economist house-price indicators

This survey shows a differentiated pattern of post-crisis house price movements around the world.  Generally, these data  show an increasingly positive picture of house price recovery in the US (up 4.3% compared with last year) contrasted with the struggling economies around the eurozone periphery – like Italy (-4.0% year-on-year), Ireland (-5.7%) and Spain (-9.3%).  Spain recorded the biggest annual house price fall (at -9.3%), whilst Hong Kong (21.8%) topped the table on house price rises.

This survey uses two additional measures that focus on house valuations.  The first is a house price-to-rents ratio (roughly analogous to the P/E (price to earnings) ratio used in valuing equities.  The second measure used is the ratio of the long-run average house price to disposable income per person, which The Economist use as a proxy for ‘fair value’.

The house price- to -rents ratio (third column of The Economist table above) reveals a very large range of valuations.  Canada tops the table with a remarkable overvaluation of 78%, whilst Japan at the opposite end of this range has a 37% undervaluation.

US house prices were still falling in the last survey, but they are now rising (by 4.3% on a year-on-year basis).  US houses are still 7% undervalued on the basis of prices- to-rents and they are presently 20% below ‘fair value’ based on the price-to-income ratio.  On balance, the US house price recovery (helped by US monetary policy) now looks positive and sustainable.

The European picture is more complex and diverse, where the peripheral eurozone economies continue to struggle.  Spain has the most adverse data of this eurozone periphery group, with house price overvaluations on both measures of 19% and 21%.  France has the highest EU overvaluations on both measures at 50% and 35%.  Whilst unemployment is comparatively high in both Spain and France, French banks are generally stronger at this time.

Germany is an EU anomaly with its small house prices rise (2.7%) over the past year and undervaluations (-17%) on both the price-to-rents and ‘fair value’ measures.  A big factor with Germany was that it did not experience the kind of pre-crisis house price boom of other major economies.  One worry for Germany, though, is that some observers argue that it could be heading for a property bubble.  Prices in big German cities (like Berlin, Cologne, Munich and Hamburg) now appear to be rising steeply (The Economist, November 24, 2012).

The British data show a small year-on-year house price fall (of -0.9%) and an overvaluation of 21% and 12% on the two valuation ratios.  The Economist suggests that the British market may be doing somewhat better than these ‘still-stretched’ valuations may suggest.  There are two reasons for this view.  One is that the British market does not suffer the glut of ‘ghost towns’ of empty homes in countries like Spain and Ireland.  Secondly, the latest Bank of England survey of lending conditions suggests that mortgage finance is now more available than at any time since the financial crisis.  According to another recently produced index (Frank/Markit House Price Sentiment Index) discussed in a Glenigan (22^nd January) report, UK homeowners believed that the value of their properties continued to decline during January 2013 (the 31^st consecutive fall according to this measure).

Another recent survey (by Glenigan) reveals that the UK private residential sector was one of the most buoyant for the construction industry in 2012.  Glenigan survey data show that 2012 project starts were consistently above 2011 levels, with a surge of construction awards in the third quarter of 2012.  This confirms other survey data that the market heated up as 2012 drew to a close.  Nevertheless, British house building figures are still approaching an historic low.

The UK property market is itself highly diverse, with many regions having significantly different post-crisis experiences.  London had only a small, one year dip in response to the financial crisis.  A significant issue for the UK is that its property prices are still significantly above (up to 18%) the OECD average.  This, in turn, impacts on many other costs and overall has an adverse effect on UK economic competitiveness.

The UK supply shortage of housing and the banks’ apparent reluctance to lend (albeit beginning to lessen during recent weeks) has meant that the average age of unassisted (by family and other means) first-time buyers is now 33 years, an all-time high (according to the UK Council of Mortgage Lenders).  This has helped to prompt another new and major initiative by the UK Government.

Under new proposals, developers will be able to convert office buildings into residential blocks of flats without first obtaining the permission of councils.  This move is a radical change in the UK planning system.  The aim is to accelerate the availability of new homes. An immediate outcome is likely to be a wave of conversions in central London where residential property values have rocketed during recent years. These changes will not apply to shops or warehouses.  The City of London (which strongly opposed the new system) has also been promised an exemption.

All in all, a pretty diverse picture on global house prices. Global economic recovery will be influenced strongly by state of the housing market. On balance, the signs are at least mildly positive (albeit still cautionary) on the trajectory of prices and valuations in some major economies like the US and Germany. Nevertheless, several housing markets are still struggling with post-crisis hangovers.

Professor Ted Gardener                                                                     

But it is probably too soon to be excessively optimistic about these developing ‘good news’ stories.  To be sure, the euro did manage to survive into 2013 and Greece has not exited (and ‘Grexit’ odds have reduced markedly).  Indeed, Greece (like Ireland and Portugal) seems to be on the economic mend.

There are lots of other ‘good news’ indicators during recent months.  Reductions in government bond yields have attracted most recent attention as a real positive signal of strengthening market optimism.  The fall in the interest rate on Spanish ten-year government bonds to below 5% on January 10 was the lowest for many months.  Italian debt interest rates have also reduced recently.  At the same time, big banks in Italy and Spain have become more able to sell long-term debt.  Banks in the Eurozone are also likely to reduce their dependence on the financing lifeline extended by the ECB’s long-term refinancing operations.

Recent investor optimism has been prompted by several factors.  Probably the biggest single boost to optimism has been the assurances by Mario Draghi that the ECB will do ‘whatever it takes’ to save the euro.  The resultant increased bond market optimism, in turn, helps to facilitate better government financing and improved financial health.  These potential knock-on effects help to support the alleged emergence of a ‘positive contagion’.

Nevertheless, The Economist (December 22, 2012 and January 19, 2013) cautions against excessive optimism that the eurozone crisis is over.  The need for greater Eurozone fiscal integration, a stronger banking union across the eurozone and continuing structure change to combat competitive asymmetries within the Eurozone are amongst the key challenges that remain important in solving the crisis.  A strong long-term plan is still needed to save and sustain the euro.

The Economist points out that although confidence in bond markets is now being seen as a key turning point, this could be misleading. There are other possible explanations for some of these apparent positive ‘vital signs’. There is a worry, for example, that the connections between weak banks and governments may have strengthened during recent months. The economic scenario within the Eurozone is also still weak (indeed, ‘grim’ in The Economist’s words).

A real worry is that the present apparent market optimism may deflect politicians from addressing the needed policy actions for a sustainable solution to the crisis.  It is not yet party time for the Eurozone crisis, but the New Year has at least started on a more positive note.

Professor Ted Gardener

The expression ‘fiscal cliff’ (first used in the US in February 2012) describes a toxic combination of reduced US public spending and a squeeze on incomes. If the Obama and Boehner agreement reached over the Christmas period had not happened, around $600 billion of previously agreed tax rises and spending cuts would have hit US households and businesses from the start of January, 2013.

Global stock markets recorded a strong upward surge in response to the news of this agreement, which had developed into a kind of ‘cliff-hanger’. Superimposed on developments like the continuing  Eurozone problems, weakened economic prospects in Europe and the recent slowdown in the Chinese economy (the present annual rate of growth of 7.4% is the weakest since 2009), falling over the US fiscal cliff at the start of 2013 would have added another major ‘dampener’ to global economic recovery.

For now, though, falling over the fiscal cliff has been temporarily (for just a few weeks) averted.  But the fundamental debt management problem remains unresolved in the US economy going forward. The 11^th hour Obama/Boehner agreement and the respective political wrangling and compromise that characterised it are worryingly similar to how Eurozone politicians have gone about tackling the continuing problems of the euro.  US politicians and economists have not been slow to voice their criticisms of this European approach, this ‘euro style’, to problem solving!

The result is a ‘patched up’ solution, a kind of ‘quick fix’. In effect, this latest US deal has just postponed for a very short period (60 days) the previously agreed automatic spending cuts or (better still) a more fundamental attack on the underlying massive debt problem.

Except for Japan, the US has the largest structural budget deficit in the rich world. Unlike the Eurozone countries, though, the US has not yet instituted needed reforms like raising the retirement ages and rationalising pensions. So when these kinds of needed policies are eventually instituted, their impact on the US (and wider global) economy will be that much more harsh and painful.

The Economist (January 5, 2013) is very critical of this latest US ‘patch up’ policy approach to avoid falling over the fiscal cliff. It comments that: ‘It leaves in place significant short-term fiscal tightening, while doing almost nothing to arrest the escalating national debt in the long term’.  In more critical vein they suggest that: ‘And while the West’s foremost democracy stays paralysed, China is making decisions and forging ahead’.

The inevitable conclusion is that this Obama/Boehner agreement will do nothing for the US’s image of global leadership in economic management. Like European politicians in handling the problems of the Eurozone, attacking the fundamental problem (rather than the immediate symptoms) has been merely postponed. Partisan politics have apparently dominated over the kind of economic policies needed to tackle the real problem.

An unintended consequence of this kind of approach is that it also serves to exacerbate global economic uncertainty. This, in turn, helps to dampen the apparent growing signs of economic recovery.  A stronger and more sustained economic recovery would also be a big help in itself for handling these serious debt management challenges.

Not the best of starts to improved and sustainable global economic recovery in 2013. It is to be hoped that the US will now get down to tackling its fundamental debt problem in the weeks ahead.  Sound economic management needs to dominate party politics. The US must not get hooked on a ‘euro style’ approach to policy formulation.

Professor Ted Gardener                           

Eurozone problems remain probably the single biggest challenge to global economic recovery and its sustainability.  Most observers seem to agree that the imminent dangers of a euro collapse have passed for the moment at least. But several core challenges remain and have to be addressed strongly.

Within the Eurozone, many of the so-called peripheral economies (like Ireland, Portugal and Spain) have made strong progress towards resolving the Eurozone crisis with their structural reforms and austerity programmes.  Others (especially Greece) are still at the start of this painful process; although Italy has embraced the reforms, progress is still comparatively slow.  Necessary moves are being made towards a Eurozone banking union (an important contribution towards resolving the Eurozone crisis) with the ECB as the main supervisor, but much remains to be done.

Nevertheless, economic growth in the Eurozone periphery economies is still a major problem.  The economic divide (in terms of GDP and unemployment) between the periphery and the core continues to grow. In 2013 the European Commission expects the Eurozone’s GDP to grow by just 0.1% (after a 0.4% decline this year).  Germany’s GDP growth is expected to be 0.8% (same as this year), but GDP will fall in peripheral countries like Spain, Portugal, Italy and Greece.  These same kinds of forecast divergences also obtain for unemployment, another key economic indicator.

UK economic recovery, on the other hand, is presently looking stronger than expected as it moves out of its apparent ‘double-dip’ recession.  However, the Governor of the Bank of England has warned that the UK recovery will be a slow one that extends over the next two years at least.

US economic recovery is important since the US is still a major ‘engine’ or ‘driver’ for many other economies around the world.  The US economy grew by an impressive 2% in the third quarter of this year, significantly better than anticipated. This was the 13^th consecutive quarter of US economic expansion. However, the US is still struggling to avert its so-called ‘fiscal cliff’ – US tax increases on the middle classes as a policy response to this threat could substantially reduce consumer spending (needed to help sustain economic recovery) next year.

Up until recently, it was useful to think about the global economy comprising the Brics (Brazil, Russia, India, China and South Africa) and the ‘sicks’.  The Brics generally (led by China, the third largest economy in the world) grew strongly, but the ‘sicks’ (mainly the US and EU) struggled to achieve and sustain economic growth.

This ‘model’ is not so robust these days.  For one thing, the Brics are not decoupled from the problems of other major economies, like the Eurozone crisis.  Another issue is that the Brics have recently encountered their own problems, including political corruption; political challenges and economic changes (Financial Times, October 9).

For the first time in a decade, China’s economic growth this year will not make 8%.  Important factors have been reducing demand from Western economies (reflecting their weak economic recoveries), a slowdown in the rate of increase in the Chinese labour force and a rise in Chinese wages.  A slowdown in Chinese economic growth has a knock-on impact on other Brics (especially India, Brazil and South Africa).

Growth in India, the other new Asian giant economy, has also dropped.  India’s growth pre-crisis topped 9%, but it is now just over 5%.  The blackout during the summer of 2012 (which affected around 600m people) was a reminder of India’s infrastructure fragility.  At the same time, political and economic reforms have also slowed.

The Economist recently (November 10) explored what it called ‘Asia’s great moderation’.  The ‘Great Moderation’ was a term used to describe the US and many of the Western economies during the build-up to the financial crisis of  2007-2009.  This was a period characterised by low interest rates, easy borrowing and strong economic growth.  The Economist explores whether this kind of lable now describes many Asian economies and why this might be a worry for the global economy.

Another cautionary ‘snapshot’ is that Japan’s GDP shrank by 0.9% in the third quarter.  This has added to global concern.  Japan is still one of the world’s largest economies and these latest GDP figures could signal  the country slipping back into recession.

On a more positive note is the recent economic rise of Mexico, the next candidate to join the ‘Brics club’..? In a recent (November 24) ‘Special Report’, The Economist points out that Mexico’s economy outgrew Brazil last year and is expected  to grow twice as fast this year.

These ‘snapshots’ of recent developments, then, do not produce a conclusive picture of optimism or pessimism.  There is good and bad (and much middling) news.  On balance, the world economy is still at a dangerous place with many threats to be met. Nevertheless, there is enough good (and middling) news to be hopeful that a more sustainable economic recovery is now possible and is more apparent.

Professor Ted Gardener                                                                        

A recent headline in The Economist magazine (November 17) for an article on progress in the Eurozone was ‘More and more and not enough’.  This seems an apt summary of where resolving the Eurozone crisis is at present and where it might go.

A great deal of restructuring has already been undertaken in Europe’s peripheral economies, which are the worst-hit by the crisis.  Growth in exports and strongly reducing current account deficits by Portugal, Ireland and Spain, for example, have been impressive.  Budget deficits have also been reducing, together with labour costs, and competitiveness has been increasing.  Greece, for the present though, remains effectively insolvent.

Despite the reassuring trends in Portugal, Ireland, Spain and (up to a point) Italy, much remains to be done.  These southern European economies are around half-way through the needed adjustment process, with Greece considerably further back along this trajectory.

If the euro crisis is to be resolved, the competitive divide that opened up when the Eurozone was launched between the creditor countries of northern Europe and the debtor countries of the south has to be closed.  In practice, this means that concerted strong action is needed from these core northern European economies as well.

There have been many positive moves in this direction, especially by Ireland.  Reduced budget deficits and improving current-account deficits are examples of these.  A particularly important development has been the announcement (in July) by Mario Draghi, Head of the European Central Bank (ECB), that he would do ‘whatever it takes’ to save the euro.  This steadied financial markets and reduced escalating bond (borrowing) yields.  Competitiveness indicators (except in Italy) also appear to be rising in many southern European countries.

However, a major problem is that these reforms and apparent gains in structural reform are taking place alongside a lack of economic growth.  This is especially marked in the Eurozone peripheral economies, but even the stronger economies (like Germany) are apparently slowing down.  A major issue is that the austerity programmes (though they may be badly needed) are not consistent with quickly firing up economic growth.

This implies that northern Eurozone economies (like Germany) also need to engage in some structural reforms in order to help produce the growth needed in the southern Eurozone countries.  Another major issue is that the banking and financial systems differ markedly in the northern and southern economies.  Bank borrowing, for example, is more expressive and often much less available in southern Eurozone countries.  These north v south differences are reflective of the close linkages between the banks and weak government finances (and banks holding ‘risky’ government bonds) in many southern countries.

This can only be corrected by strengthening private investor confidence outside of these southern countries in order to make financing easier.  An important move in this direction is the creation of a Eurozone banking union.  This would take responsibility for supervising banks away from national governments (and therefore, weaken the potential link between imprudent banking and weakening government finances).

However, the latest proposals for a Eurozone banking union apparently leave a lot to be desired.  The proposal is for the ECB to be the main European bank supervisor.  But there are already objections (from Germany) to the ECB supervising all banks in Europe.  Another issue is the apparent lack of a common ‘resolution fund’ to tackle bank failures and the  required  deposit insurance scheme to help prevent (reduce the probability of) runs on banks.

In this respect, The Economist (November 17) comments that ‘The Eurozone needs a banking union, but this isn’t it’.  The Economist argues that the very survival of the Eurozone may well rest on its ability to forge a banking union.  On the latest proposals to do this they conclude: ‘Shortcuts that fudge questions of accountability and dodge a genuine pooling of risk make matters even worse’.  Strong words indeed that do not augur well.

Although the imminent threat of a collapse in the euro appear to have receded (for the moment, at least), big hills still need to be climbed.  These include:

• Continuation of the structural reforms and austerity programmes in the southern and so-called peripheral economies.
• The firing up of economic growth in the southern Eurozone economies, which implies some needed structural reform (to stimulate more demand) by the northern economies as well.
• Restoration of confidence in southern countries’ banking and financial systems.
• To this end, development of a banking union with a common supra-national banking supervisory authority is essential.

But there is another time-bomb at the heart of Europe, France, who has just lost its highly prized Moody’s triple-A credit rating.  The Economist (November 17) warns that France has to reform in order to meet the challenges of an increasingly uncompetitive corporate sector and an enlarged government living beyond it means.  Unless this is done decisively and soon, the markets will lose confidence in France.  It could well be France (rather than Italy, Spain or Greece) that ultimately decides whether the euro will live or die.

Professor Ted Gardener                                                                                 

There are many reasons for these shifts in global positioning.  US economic recovery has generally been stronger than that of Europe. Although the UK economy is now beginning to show a stronger recovery than has been anticipated, there is still a big hill to climb. The Governor of the Bank of England has warned that Britain’s economic recovery is likely to be slow and extend well into the next 2-3 years at least before stronger and more sustainable growth appears.  At the same time, the Eurozone crisis remains a threat, especially to Europe. The continued strong growth of the Asian economies has also fuelled a strong demand for financial services, which in turn has boosted the growth of Hong Kong and Singapore.  All of these kinds of developments have conspired against London holding on to its top spot as the world’s leading financial centre.

Although, London’s loss of dominance is partly a result of a ‘shift to the east’, there are many other reasons.  In my recent (March 2012) blog London Besieged – Time To Get Real other threats to London’s global position were also discussed, including the tougher blanket immigration rules (which make it more difficult for talented individuals to come into the UK and the City).

The City and financial services have been one of the UK’s most successful industries.  The export surplus (foreign earnings) from the City and related services (like accountancy and legal) make up over 3 percent of GDP.  The City is a major export earner and one of the UK’s most successful industries.  The CEBR’s chief executive (Douglas MacWilliams) cautions on London losing its global top spot:

‘Much of this shift is inevitable as a result of the world’s changing economic geography.  But we have accelerated the shift through over regulation, penal taxation and banker bashing’.

Any ‘avoidable actions’ that weaken London’s global positioning do not appear to be good policy? The apparent national predilection for self-deprecation and ‘witch hunts’ are manna for Britain’s competitors in a ‘news sensitive’ industry, like financial services.

David Cameron, the British Prime Minister, used his annual speech (November 12) at the Lord Mayor’s Banquet in London to warn about the growing threats to some of the UK’s important economic sectors (like finance and defence).  He warned that those who ‘trash the banks would end up trashing Britain’.  Mr Cameron emphasised that pursuit of a modern industrial strategy should not mean being anti-finance.  He agreed that big mistakes have been made within the financial sector and in its regulation, and these have to be corrected.  He said

‘I say recognise the enormous strength and potential of our financial sector; regulate it properly and get behind it’.

He emphasised that Britain now faces a ‘moment of reckoning’ as new economies across the globe expand.

More than ever before in its modern history, the UK must play to its strengths in the developing global economy.  New competitors and new forms of competition need to be met from a position of strength and growing confidence as potential opportunities. Turning these kinds of threats into opportunities has to be facilitated and encouraged.  This is something that London and UK financial services have historically excelled at doing. A strong and innovative financial services industry, with the City at its apex, are necessary conditions for economic success in this new, ever more competitive and aggressive world order.

Professor Ted Gardener