Does the Euro Have a Future?
The following is a transcript of a recent Fool U.K. Money Talk interview. You can listen to or download this podcast here.
David Kuo: This is Money Talk, the weekly investing podcast from The Motley Fool. I am David Kuo, and my guest today is an economist, a journalist, and a TV personality who was famously sacked in 2003 from the Institute of Directors, allegedly after pressure from the then-Labor government. My guest is Ruth Lea, and Ruth is director and economic advisor at Arbuthnot Banking Group, and Ruth is with me now. Welcome to Money Talk, Ruth.
Ruth: Well, I'm pleased to be here.
David: Now, we have lots to talk about, so I'm going to launch into my very first question, which is a very simple one. Why is the U.K. not growing? Weren't we promised at the last election that the U.K. was going to grow? -- and yet we have had nothing.
Ruth: I think that's true. Even in the last budget, we're still talking about nearly 2% growth for this year. It was strictly 1.7%. We'll be lucky now if we get 1%. The truth is, there's been hardly any growth in the economy since autumn last year. It's as if the economy's flatlining. It fell back in the fourth quarter of last year. It picked up a bit in the first quarter of this; very little growth in the second quarter; likely to be very little growth in the third and fourth quarters. The real problem is that all the components of demand, the demand that drives economies, are actually very depressed.
The big one, of course, is the consumer -- the household consumption is way down. It fell nearly 1% in the second quarter, that tells you something. Of course, what's happening to the consumer in this country is that they're squeezed, because inflation's running ahead of earnings growth; they had higher taxes; they've still got a big debt overhang from the pre-crisis situation. All these things are militating against a dynamic consumer growth. Then, when you look at the other components of demand, business investment -- well, that tends to lag rather than lead growth; you look at net exports, well look at our export markets -- what a mess they're in; and then of course our export markets are the U.S. and the eurozone. Last, but not least, of course, you have government spending, and what George Osborne, the chancellor, is trying to do is slightly pull back on government spending now, because we have such huge public sector deficits.
David: But didn't we know those three things when the election was actually in full flow? Didn't we know that the consumers were going to be spending less? Didn't we know that China was going to be slowing a little? And didn't we also know that government spending would not be as robust as it was in the past? So we knew that was going to happen, so why did they forecast growth in the region of 2%?
Ruth: Well, I think the truth was that they were looking at two components in particular, which I questioned at the time; I remember it very strongly, because I agree with you about the household consumption, I agree with you about general government consumption and public spending, in other words, but the two where they thought, or where the Office of Budget Responsibility thought there would be growth; in other words, if you're talking about business investment and you talk about net exports, those are the two that have really fallen down. Business investment, as I say, they've got this big business investment growth, and yet it doesn't lead recoveries.
Businesses don't do a lot of investing if they don't see growth ahead, and of course, what has happened with the corporate sector in this country is, they have raised a lot of funds on the capital markets, and they're sitting on them. They're not going to to spend -- they're sitting on the funds. When it comes to net exports, again I think there was the hope that there'd be a lot of growth in the eurozone, a lot of growth in the United States of America, and this would pull Britain's economy along, but the truth is, I think, that both those particular economic areas have performed much worse than we expected.
The United States is going through a very soft patch, there's very little growth there now. As for the eurozone, well, the power houses, in other words, France and Germany, grew well in the first half of this year, but now even they seem to be running out of steam, and of course, because, like Mrs. Merkel is insisting on fiscal retrenchment even in Germany, next year growth will be weak there as well. So in other words, I think the forecasters put far too much reliance on the fact that these particular blocks, if you like, these economic blocks, were going to do well, and they're not.
David: So what can the government do in order to promote faster growth here in the U.K.?
Ruth: Well, I think there are perhaps two aspects. One, of course, is still the scope for more monetary easing. Of course, you've just seen the Bank of England come up with another dose of quantitative easing, which is a pretty arcane sort of exercise; and the other one, which is the slow burn, quite honestly, is actually doing something about the supply side of the economy; trying to perhaps cut back on some of the taxation that acts as a disincentive to business activity. Of course, there's always the problem they're constrained by the public finances, but then again we have a crazy energy policy that just piles costs on top of businesses.
How stupid is that! But of course, they're trying to save the planet, but by trying to save the planet, they're wrecking an awful lot of manufacturing industry while they're at it, and of course we have a highly regulated labor market here. There's been a huge increase in employment regulations over the last 10 to 15 years, and if the government really got to grips with vested interests, they could do something about that, but I have a feeling they really don't want to.
David: So will cutting taxes help? If they were to cut, say, income tax and also corporation tax, will that help the economy grow?
Ruth: Well, I think it would certainly add to what I'd call the competitiveness of the business sector in the United Kingdom. Let's just take the city of London, for example, which of course is one of our major industries, even though it's under something of a cloud these days, but when I hear our politicians talk about shifting from the financial sector to manufacturing, I think, be careful what you wish for, because the city of London is terrifically important to the British economy.
It's a great generator of taxation, and it's a great generator of net exports. So be very, very careful, when you start bashing the city of London. But I don't think there's any doubt about it now, when you look at the various analyses of the competitiveness of London, which is actually still in the top spot, but London's competitiveness, it's edging away, it's leaching away. One of the reasons is actually because of our relatively high taxation. In other words, look at this, look at not just corporate taxes, but income tax as well, especially the top rate, and say, do we really need these taxes? -- because they are looking as though they're damaging one of our major, major industries.
David: But if you don't tax these industries that are making profits, how are we going to reduce the budget deficit? How are we going to pay down the national debt?
Ruth: Well, this is the hundred dollar question. I always talk about cakes, and it's one thing to say, we have a static cake, but the other thing is, if you want the cake to grow, then you have to provide the incentives. Part of the incentives are actually to cut back on taxation. For my money, I would like to see even further cuts in public spending. There's still an awful lot of fat in public spending in this country, and then we could bring down taxes as well. I think that would be far better in stimulating growth than what we've got at the moment. I mean, look at our aid budget -- you're talking about, what? Seven billion pounds to 9 billion pounds? An awful lot of it is wasted -- what is the point? If the government really got to grips with public spending, I think they could slice out another 10 billion pounds quite easily. Tax cuts -- 10 billion pounds, that would be helpful.
David: OK, so let's have a look at Germany now. We've done enough on the U.K. for the moment. Let's have a look at Germany. Germany makes things that people want to buy. They make beautiful cars, they have a good chemical industry; in fact, everything that Germany produces is in demand around the world. So why is Germany not growing?
Ruth: Germany, because it relies so much on exports, that when its markets begin to slow, then its economy begins to slow, and where are its big markets? -- the rest of the eurozone, not least the United Kingdom (we're not in the eurozone), the United States of America, and of course China. It looks as though even in China now there's some sign that the economy is slowing down. Of course, one thing about China is that it's a highly unbalanced economy. 50% of its GDP has been investment, and a lot of that has been enabled by German imports. So if that economy starts slowing down, then Germany's exports start slowing down, and that's trouble for Germany.
David: But if Germany can't grow, what chance have we got?
Ruth: Well, I think we have to look to other things. I'm not wholly desperately suicidally grim about Britain.
David: You could have fooled me!
Ruth: Germany is not the be and end all of British life, but I do think we have to accept the fact that if we are going to really have more growth in this country, then we have to improve our competitiveness. I've no doubt in my mind about that, and we've lost it; we've lost it over the last 10 to 15 years. I've talked about taxation, but it's all a regulatory burden as well. Of course, there's a lot of the rest of the world, even though, as I've just said, China's slowing and possibly India may be slowing as well, but nevertheless there are other export markets. For me, perhaps not just in the short term but in the medium and long term as well, Britain really has to gear its thinking toward a much more global reach than just being focused on Europe, which I think is a great mistake.
David: Now, earlier on, Ruth, you said we had to be very careful about throwing tomatoes at the finance industry. But it's not just the politicians that are throwing tomatoes at the finance industry. Recently we had the ratings agencies downgrade one of our U.K. banks, the Royal Bank of Scotland, but the Royal Bank of Scotland says it is one of the best capitalized banks in Europe, and yet the ratings agency said, we're not entirely sure. So who is telling the truth? -- is the Royal Bank of Scotland telling the truth? Or is the ratings agency -- do they know something that we don't?
Ruth: As I understood it with, I think it was Moody's, wasn't it?
David: It was.
Ruth: I think they downgraded several banks, and there were quite a few building societies as well, and some Portuguese banks, I think, at the same time. But I think their reason for doing it was that, if these banks or building societies got into trouble in the near future, they would not be bailed out by the British government.
David: Do you think so?
Ruth: Well, let's put it this way -- they're not telling us anything that we don't already know, because it's quite obvious to me, after the disaster of 2008 when we bailed out the Royal Bank of Scotland, the taxpayer bailed out the Royal Bank of Scotland, and of course Lloyds TSB (HBOS), that there are now things in place, the FSA, the Financial Services Authority, which is the financial regulatory authority in this country. They are getting all the major banks to look at something called recovery and resolution plans. In other words, if you get into trouble, matey, you have to get yourself out of trouble. This was agreed at a G20 meeting recently about these RRPs, as they're called, in addition to which we just had something called the Vickers report, which has also been talking about how banks, if they get into trouble, how they actually get themselves out of trouble. A lot of this is, the Vickers is actually talking about dividing the retail sector from the investment sector.
But more interesting for me, and this is where I think Moody's is really a bit behind the curve, if I may say so, is that the bond holders who have an interest in these banks will be obliged to take some of the losses if the banks get into trouble, and that is a huge development forward, because in the past they were always protected, and the taxpayer came marching to the rescue. Well, I think in future, that will not be the case. So to cut a very long story short, I think Moody's are telling us something that's not really very helpful at the time, and I don't think anybody really took too much notice of them, did they? -- I hope?
David: But the UK taxpayer already owns a huge chunk of Royal Bank of Scotland anyway.
David: So the fact that you've already bailed out 80% of the bank, what difference does it make if you're not going to bail out the other 20%?
Ruth: I just don't think they're saying anything that's terribly helpful or relevant, quite honestly, because putting RBS on one side, looking at the other banks, they are now, I know this as a fact, I know that they are under huge pressure to be able to insure themselves, if you like, if they get into big trouble. So they have to be prepared to have these regulatory recovery plans in place. So I think Moody's are just hopeless.
David:[he laughs] I think a lot of people would agree with you there! Now, I'd like to have a look at quantitative easing, if I may. The first thing really is, what are your views about quantitative easing, but before that, can you explain to our listeners, what exactly is quantitative easing?
Ruth: I think the way it worked in this country was that the Bank of England, the central bank, bought the best part of 200 billion pounds of gilts. They bought some corporate debt as well, but it was mainly gilts, and they bought it mainly from non-bank financial institutions, like insurance companies and pension funds. What they did was say, thank you very much -- we will buy 200 billion pounds of gilts, and here's 200 billion pounds of cash into your account, so that you can go away and buy lots of other goodies like corporate bonds and equities or whatever, or property or whatever, to stimulate more directly the economy.
David: Where did the money come from?
Ruth: Well, it was an electronic transfer.
David: From the Bank of England?
Ruth: It's called the magic of computers, and the magic of technology, and they literally would just transfer that.
David: But where did it come from?
Ruth: They just transferred it.
David: They just created it?
Ruth: The banks create these things. So they would just credit the deposit account, if you like, or the deposit of these particular businesses, these insurance funds or these pension funds.
David: So are people right to say that it was printing of money?
Ruth: Well no, it's not really printing of money, because of course the key thing then is, the insurance companies in question, they would go on to buy other assets, or indeed they'd just leave the money in their deposits. Interestingly too is that, when the Bank bought those gilts, they would actually credit the commercial bank of the insurance company with so-called reserves, or reserve deposits, and then that meant that the Bank, other things equal, could actually lend more money. But did that happen? -- well, no to some extent.
David: So it didn't work?
Ruth: Well, it did work to some extent, but it perhaps didn't work as some would hope. It worked in the sense that clearly these insurance firms and pension funds did go out to buy other assets, and the capital markets picked up quite a lot in 2009, and there was a lot of issuance, which was helpful. But because the commercial banks were so damaged by the crisis, they didn't lend money quite as perhaps some people would like them to have done, added to which, of course, because of the problems in the banks, they are now having to hold a great deal more capital, which also put restrictions on their lending. If you look at the Bank's analysis of quantitative easing, you'll see that this is what they expected. They didn't expect a great surge in lending because of the problems of the banks, but they did expect the capital markets to pick up, and, of course, they did expect that, because they'd bought so many of the gilts, the yields would drop, and they did. I mean, the bank estimates they dropped by about 100 basis points -- that's 1%, which is actually quite significant.
David: It's actually crippling pensioners at the moment.
Ruth: It is, and I was interested to see Mervyn King's response to all this last Thursday, when he announced a new wave of quantitative easing. The man is in a dilemma. Whatever he does, he's going to get criticized. He either tries to stimulate the general macro economy by more quantitative easing, and that's essentially what they're doing; or they try and keep interest rates up. You either try and pull interest rates down to stimulate the economy, but the knock-on effect is that, of course, it damages people who rely on those interest rates for their pensions and their income.
David: Because ultimately people who have been doing the right thing over the last 30, 40 years, saving for their retirement, saving for the day when they no longer want to work anymore, they are being clobbered at the moment, aren't they, by a wet fish?
Ruth: They are, and I'm one of them. Can I tell you that? My investments, well they've gone through the floor, and I'm an old age pensioner, you know, so you'll have to be frightfully respectful.
David: You look nothing like an old age pensioner to me, Ruth!
Ruth: And next year, my pension's all ready, and I'm waiting for another pension to come through next year, and it's been hammered, David. I look at it and think, Ruth -- don't go there. Just as George Osborne says, we're all in this together. An awful lot of people are being hurt at the moment, that's the brutal truth.
David: So what is the risk of quantitative easing? Some people say that inflation is an unintended consequence of quantitative easing. Is that likely?
Ruth: I think it's very unlikely, given the deflationary, and I use that word advisedly, pressures in the rest of the economy. There's hardly any growth, as we've already discussed. Unemployment is rising; earnings growth is very weak -- 2.5%, squeezing people's incomes. Under those circumstances, it's very hard to see that this would actually turn into a really inflationary problem. By the way, I was going to say that I think there's another agenda behind what the Bank of England is doing.
David: Oh, please do, yes -- please do tell us.
Ruth: Yeah, and I don't think it's a secret. It's not that I've been listening ... I'm not a fly on the wall, or anything! But I think they are very keen to try and get banks to capitalize more, because of the pressures on them. If they can stimulate the capital markets by doing what they're doing, by buying gilts up and then releasing, let's say, these insurance companies and pension funds to buy corporate bonds or whatever, or even invest in the banks, then I suspect that that's what they're interested in as well.
David: But that would only work if the banks were profitable? But if you're going to have banks that are deeply unprofitable, then who is going to actually invest in those banks?
Ruth: Well, I think banks probably on the whole, most of them are profitable, but more to the point, you invest in something at a price. If you thinks something's going to be, really going to make some very good returns, then you're prepared to buy at one price. If you think the returns are not so good, you buy at a different price, at a lower price. But I reckon that, if the insurance companies and the pension funds did have this cash in their deposit account, then they wouldn't be completely averse to the idea of investing our better-performing banks.
David: Now, let's have a look at Europe again, because Europe has its own idea of how to solve the crisis, their banking crisis and also the eurozone crisis, and it's something called the European Financial Stability Facility.
Ruth: Well, to date, of course, they've bailed out Ireland and Portugal, and of course there was an announcement made in July, or this decision was made in July, whereby not merely would they increase it to its maximum 440 billion euros, but also they'd give it more powers, so that it could actually be used in recapitalizing banks; it could be used in buying sovereign debt, and the like. But when I look at what the European politicians are doing at the moment, I think, to use that awful phrase, they're just kicking this can down the road, of the problems of the eurozone, because the eurozone is quintessentially completely dysfunctional. At the end of the day, I think there are only two or three options for it, but people don't really like discussing this at the moment. They prefer to talk about recapitalizing banks, etc, but this is just a chapter on the way to the denouement, whatever that might be.
The three options really are: full fiscal union, where you actually have a eurozone treasury, you have Eurozone bonds where you share all the risks, the sovereign debt; and you have the big fiscal transfer union from the richer countries to the poorer countries. But I think, given the reluctance of the northern countries, particularly Germany, but also the Netherlands and Finland and Austria, because these are really the creditor countries, I can't really see that happening. The alternative is perhaps that you might try and have a dual currency system, so you have a northern euro centering on Germany, and then you have a southern euro centering on Rome, or whatever; or I think bit by bit you have the progressive break-up of the thing.
So for me, you can talk about the EFSF, the European Financial Stability Facility, and you can talk about recapitalizing banks, and you can talk about letting Greece default, which they increasingly are doing, but these are just the early chapters in I think rather a sad saga. I don't know the final resolution of all this yet. I don't think anybody really does.
David: So is there any mechanism within Europe that would allow a country to leave? -- because many people have looked at Greece and said, do you know what? -- the chances of you ever repaying the debt that you owe to creditors is zero. So why are you going through all this austerity measure, when you might just as well default and say, let's take our ball home with us, because we're not really in this game at all?
Ruth: Well, I think the first thing is, people are expecting Greece to default, whether it stays in the euro or whether it doesn't. Can it leave? -- well technically, in the treaties, there is no exit from the euro, unless you leave the EU, as I understand it. But I have to say this, that the European politicians, when push comes to shove, are remarkably good at interpreting treaties so they can do what they want to do. So I think if push came to shove, and they said really, it would be better if Greece left and took on a new drachma or something, they'd find a way of doing that.
But when you come to this issue of, it's not worth the pain any more in Greece, because we know that they're having one austerity package piled on top of another austerity package; when GDP might fall 5, 6, 7% this year, it won't recover next year; and you see the riots and the protests in Athens, you get to the point where you're saying, well, politicians -- take note. What is happening now in the eurozone is intense pain by the people within the eurozone, and at some point I think you have to address that, and say that this can't go on. I remember some commentator saying that perhaps the future of the Eurozone may yet be decided on the streets of Athens, and I thought that was a very apposite remark, a very insightful remark, because that's really saying that, when push comes to shove, the people won't take any more. They won't take any more austerity.
David: So what about Angela Merkel and Nicolas Sarkozy, otherwise known as the Merkozy Twins? They reckon they have found a solution to the European problem. Can there ever be a solution for monetary union without fiscal union?
Ruth: I don't think so, because I hear people saying, oh, they're moving toward fiscal union, and they're talking more about rules and regulations to control economies, but this has been around a long time in the commission. So, more rules and regulations about, but your fiscal deficits? -- well, have we heard that one before? It was called the Stability and Growth Pact -- remember that one? Even rules and regulations about how big your trade surplus should be, or trade deficit should be, because of course another problem with the Eurozone is that a country like Germany, and I think the Netherlands too, they run big trade surpluses in the Eurozone, but other countries like Greece and Spain run huge deficits (I don't know what you do about that). But they're starting to talk about these rules and regulations -- this isn't what I call fiscal union, which really is a very much more profound thing, which I really do think politicians, nearly all the politicians within the eurozone, would baulk at.
David: So if you were to have full fiscal union, it would mean having one federal tax for everyone within Europe? Would Britain buy into that?
Ruth: Well, put it this way -- it would certainly mean, for the Eurozone, huge control over the individual member states' taxation-raising powers. I don't know whether it'd mean exactly the same tax rates, because of course these economies are very different, but it would mean that you'd be saying to Greece or Portugal or even to Germany itself that you have to raise so much tax, or you mustn't have a deficit of more than n% of GDP, or whatever. It'd mean huge control, and I suspect too it would mean huge control over the spending of these countries -- a terrific loss of economic sovereignty, and again, would that be acceptable to Italy? -- I don't know; I don't think so.
David: And who would be controlling the check book in that situation?
Ruth: Well of course, Germany would be the obvious choice. But this brings us on to another interesting thing, as I've seen this crisis unfold, is that this is meant to be concerning the whole of the eurozone, and, of course, the whole of the European Union, more generally. There are two bosses: there's the president of the commission, Mr. Barroso, and then there's the, I think it's the president of the European Council, who's Mr. Rompuy. Really, you could ask -- what are they doing in all this? They're taking a very second...
David: You get sound bites from them every now and again.
Ruth: Every so often, they sort of appear on the television, and tell people that it's really all terrific, and the European project is well on target for the new millennium, or whatever is it ... oh, I don't know. But they've been elbowed aside, which I think is very interesting. Who's calling the shots? Who do we really listen to, when we want to find out what these people may be trying to do? -- have Merkozy!
David: The Merkozy Twins, yes.
Ruth: Merkel and Sarkozy, and let's be honest, we know which is the most senior of the twins, don't we?
David: Who's wearing the trousers, you mean?
Ruth: Mrs. Merkel!
David: OK, now finally, I'd like to end on a positive note, if we can, and that is -- what is your outlook for the U.K. and Europe?
Ruth: My outlook, in the near term --
David: And try and make it cheerful!
Ruth: I can be nothing but really rather pessimistic.
David: Oh, no!
Ruth: I think the problem is that the Western economies generally have got to face up to the fact that the good times of the 1990s and even the early 2000s are but a distant memory. There are several things that are happening globally that are contributing to all this, not least of all the rise of the emerging markets, and the fact that they're running such big surpluses. Again the West on the whole, not Germany, are running such deficits; a big increase in commodity prices, which has meant that quite a lot of purchasing power to the West has gone to particularly the commodity producers, not least of all the oil producers. I just think the West has to wake up to the fact that probably their best days are over, if that doesn't sound too bad, and in addition to which, we've got a long way to get through the indebtedness that was built up in Western economies in the 2000s in the public sector (look at the United States), and indeed in the private sector. There's this huge overhang of debt, I think, which will take a lot of time to work through the system. Again Germany's perhaps a slight exception, but a lot of the other Western economies are in that position. Under those circumstances, as much as I would want to be optimistic and cheerful, I think it'd be misleading to your listeners to be anything but slightly more downbeat.
David: So where should people be looking for some kind of growth, then?
Ruth: I still think, even though I've made the comments about the Chinese economy slowing down, the emerging markets are still looking pretty strong. Of course, the commodity-producing countries, Australia, Canada, and indeed parts of Africa, they seem to be doing very well.
David: So if we had to learn a foreign language, which one would it be then, Ruth?
David:[he laughs] I can do that!
Ruth: So can Oi!
David: Well, thank you very much for coming in today, Ruth. It has been an enjoyable experience, even though it has been somewhat downbeat. Now, I try and find a quote to end each podcast, and I think I've found a suitable one for today. It comes from a lady called M. Kathleen Casey, who I think is a Canadian politician, and she said: "Pain is inevitable; suffering is optional."
Ruth: I agree.
David: So do I! Now, this has been Money Talk, I have been David Kuo, and my guest has been Ruth Lea, director and economic advisor at the Arbuthnot Banking Group. If you have a comment about today's show, please post it on the Money Talk Web page, which you can find at fool.co.uk/podcast. If you have a suggestion for future shows, please do email me at firstname.lastname@example.org. Until next week, g'day, mate!