Yves here. It’s not very nice to engage in an economic death watch of sorts, particularly when the underlying disease looks likely to spread. But who will go critical first? Is the rapidly accelerating political crisis in the UK a sign that the sceptered isles will be first to enter the economic ICU?
Many commentators have discussed the near-certainty of de-industrialization of Germany due to high energy costs and how the loss of revenues and jobs would propagate rapidly through its economy and then to the rest of the EU, since Germany is a major driver of EU activity. Credit Suisse analyst Zoltan Pozsar wrote in late August that $2 trillion in German value added depended on $20 billion of cheap Russian gas.
The last two months have featured stories of Germany companies suspending operations or cutting production, from stainless steel to aluminum to papermaking to chemicals, and that list is not complete.
The EU is engaged in yet another rearranging-deck-chairs-on-the-Titanic exercise of trying to come up with gas price caps. Gazprom has already said that’s a no go. From RT:
Plans to set a price cap on Russian gas sales, which are currently being considered by Western leaders, would cause supplies to be halted, according to Gazprom CEO Alexey Miller.
“We rely on the contracts that have been signed. A unilateral decision of the kind is, of course, a violation of essential terms of the agreements which would lead to a termination of supplies,” Miller said on Sunday in an interview with Russia 1 TV.
It’s not clear why any other gas suppliers whose customers contracted for spot or other variable prices should go along either. The EU is trying to solve this problem by calling the cap something else. From Reuters:
The latest draft conclusions showed that the leaders would agree to “explore a temporary dynamic price corridor” on natural gas until an alternative EU gas price benchmark is in place.
Belgium, Greece, Italy and Poland want a price corridor for wholesale transactions, which would mean a price range with a central value below the market price.
The draft said the leaders would also “explore a temporary EU framework to cap the price of gas in electricity generation at a level that helps bring down electricity prices without … leading to overall increased gas consumption.”
Now there are bad design elements in the European electricity scheme that likely does to some degree lead to price distortions on the upside. However, the EU is facing a chronic gas shortage. It not only will have trouble getting through the winter, but its supply woes will continue in 2023 and will be even worse next winter unless Europe kisses and makes up with Russia, which seems impossible at this juncture.
Yet instead of focusing on the necessity of rationing, the European Commission is dithering with the fantasy of technocratic fixes, which is likely to result in disruptive, unplanned rationing in the form of blackouts.
Italy, Europe’s other industrial engine, is also a heavy user of Russian gas, but the business press has yet to focus as intently on its developing tsuris.
The reason for the long-winded German detour is to suggest, despite Germany having a poor prognosis, that the UK might hit the acute phase sooner.
In particular, the UK entered this crisis in weaker condition than major EU countries thanks to Brexit. And Brexit is also exacerbating inflation. From Euronews in July:
In June, a study by the CER’s Deputy Director John Springford examined the economic cost of the UK’s departure from the EU so far, setting out to disentangle it from that of COVID-19….
His “sobering” conclusion is that in the final quarter of 2021, GDP (gross domestic product) was 5.2% smaller, investment 13.7% lower, and goods trade 13.6% lower than what they would have been had the UK remained in the EU.
“The UK had a particularly deep recession in 2020, but it ended COVID restrictions sooner than many of its peers, thanks in part to starting its vaccination campaign early in 2021. That should have made its recovery from COVID faster than other countries, not slower,” he says.
“It should trouble Labour and the Conservatives that the economy is lagging so far behind its peers.”….
….another report from June noted a decline in some aspects of Britain’s trade with both EU and non-EU countries that was “not explained by changes in the pattern of global trade during the pandemic”….
Inflation figures from the Office for National Statistics (ONS) published in June put the UK’s rate at 9.1%, as measured by the consumer prices index. The figure for the eurozone in May was 8.1%, before rising to 8.6% in June according to Eurostat data.
Yet inflation in the UK is worse than in other high-income economies, as the Peterson Institute for International Economics noted in a report in May. This is despite the fact that Britain and its neighbours have suffered the same economic shocks from Russia’s war on Ukraine and soaring energy prices.
“Brexit has amplified the inflationary impact of a simultaneous common shock,” the institute says.
The fact that the UK imports a lot of food and is structurally vulnerable to a triple crisis (a simultaneous currency, banking and fiscal crisis a la Iceland) by virtue of being a small open economy with an outsized banking sector does not help.
If you read Richard Murphy’s post below, it’s not hard to see that his erstwhile suggestions will help only at the margin. In particular, he appears not to appreciate that investing in renewables will do nothing to alleviate the energy shortfall bearing down on the UK now, and is unlikely to have much impact before (optimistically) 2024. Similarly, letting the pound fall will increase the price of food and energy imports. And if any big financial players have significant net dollar or Euro liabilities, a further decline in sterling could put them in distress.
And while we are comparing the severity of the UK’s and Germany’s pathologies, let us also consider a warning from Pozsar that doesn’t appear to have gotten as much attention as his conclusion about the economic leverage of Russian gas:
More broadly, the three “moments” of reckoning we discussed above mean that
global supply chains, whether they produce military or civilian goods, are facing
a Minsky Moment – a Real Minsky Moment. Paul McCulley’s term referred to
the implosion of the long-intermediation chains of the shadow banking system
that marked the onset of the Great Financial Crisis. Today, we are witnessing
the implosion of the long-intermediation chains of the globalized world order:
masks, baby formula, chips, missiles, and artillery shells, for now. The triggers
aren’t a lack of liquidity and capital in the banking and shadow banking systems,
but a lack of inventory and protection in the globalized production system,
in which we design at home and manage from home, but source, produce, and
ship everything from abroad, where commodities, factories, and fleets of ships
are dominated by states – Russia and China – that are in conflict with the West.
Inventory for supply chains is what liquidity is for banks. In 2007-08, big banks
ran on “just-in-time” liquidity: the dominant form of liquidity was market liquidity,
for which you could always sell assets into a deep market without moving prices,
so you did not have to have liquidity reserves at the central bank. Similarly,
big corporations today run “just-in-time” supply chains for which they assume that
they can always source what they need without moving the price. But not really:
the U.S. military has to wait a little bit as Raytheon “will take a little while”;
Taiwan and Saudi Arabia have to wait as well until the conflict in Ukraine is over;
and if your washing machine broke recently, you’ll have to wait a bit too until
defense contractors are done buying them up to rip chips out to make missiles.
We’re borrowing from “here” to make things “there”. Do you remember the
three units of Minsky? Hedge units can cover their payments from their incomes.
Speculative units have to borrow to be able to make payments. And Ponzi units
can make their payments only if they sell some of their assets and are thus the
most exposed to rising interest rates. As our chip examples demonstrate,
Minsky would classify our military supply chains as “speculative” units at best,
which are exposed to a further escalation of geopolitical tensions that could
easily turn them into Ponzi supply chains. We can also apply Minsky’s framework
in Europe, where Germany can’t cover its payments without Russian gas and
the government is asking citizens to conserve energy to leave more for industry…
Protection by Pax Americana for global supply chains is what capital is for banks.
In 2007-08, big banks didn’t have enough capital to deal with systemic events,
because they were Too Big to Fail. The assumption was that the state will bail
them out. The state did provide a bailout, but at a cost, which was Basel III…
Today, the assumption among investors is that globalization is Too Big to Fail…
…but globalization is not a bank in need of a bailout. It’s in need of a hegemon
to maintain order. The systemic event is someone challenging the hegemon,
and today, Russia and China are challenging the U.S. hegemon. For the
current world order and its trade arrangements and network of global supply chains
to survive the challenge, the challenge must be squashed quickly and decisively,
in the spirit of the Powell Doctrine. But Ukraine and Taiwan aren’t Kuwait,
Russia and China aren’t Iraq, and Top Gun 2 isn’t the same movie as Top Gun.
With that context, it becomes even clearer why any remedies for the woes afflicting the UK, Europe, and eventually the US will not come quickly, if at all.
By Richard Murphy, a chartered accountant and a political economist. He has been described by the Guardian newspaper as an “anti-poverty campaigner and tax expert”. He is Professor of Practice in International Political Economy at City University, London and Director of Tax Research UK. He is a non-executive director of Cambridge Econometrics. He is a member of the Progressive Economy Forum. Originally published at Tax Research UK
I am posting this thread on Twitter this morning:
We all know Truss has made a mess of her premiership, and will leave the UK in a parlous state. But what does that mean for the economy and whoever succeeds her both now and after a general election? A thread….
[Please note that this is a long thread. If it appears to stop mid-flow please click on the last Tweet you can see and the next section should appear.]
Let me ignore how we got in the mess we are in. Instead let me address the issues that we face. They are:
– Energy prices that remain out of control
– High, and still increasing interest rates
– Low pay rises
– Pressure on stretched government services
You could add in other issues, like ongoing war and the UK’s crisis being exceptional to that in other counties. You could also mention Brexit, quite appropriately. Whatever is in the list, the issues look to be big.
That is the correct conclusion. So too was the reaction to Truss’s mini-budget correct. Major tax cuts and regulatory reform were, at this moment, wholly inappropriate. Truss got just about everything wrong.
Leave that aside though. What are the consequences of the position we are in, because these have yet to all be seen, and so need to be explained. I stress, what I am suggesting is things are nowhere near as bad as yet as they are going to be.
First, high inflation rates compared to lower wage rate increases meant that households were always going to be facing an economic crisis this winter.
Apart from well focussed energy price interventions (and the one we are getting is poorly focused) there is little the government can do about energy price increases, excepting three things.
One of those is reform to the way energy is priced in the UK. The energy price cap being introduced is a poor way to achieve that goal, but better than nothing.
The second is to impose a bigger windfall tax. Nothing has yet been said about this, which is bizarre.
Third, the quickest to deliver and cheapest forms of alternative energy supply need to be focussed on: Truss has done the exact opposite by ignoring wind and solar and focussing on nuclear and gas. This was straightforwardly wrong by her and needs to change.
There is, then, ample opportunity for an improved energy policy for opponents or a successor to Truss to exploit. Having such a policy would massively help tackle the crisis we are in.
Inflation is a harder issue to tackle. The Bank of England is suggesting interest rate rises to tackle this. Their logic is that UK households have too much to spend and so interest rates must rise to crush their spending power.
The problem with this is it is not true. Households already have too little to spend in most cases, with that likely to get worse without any help from the Bank of England. The fundamental assumption that the BoE makes is wrong in that case.
The only other excuse the BoE has for raising rates is to match the US Fed and its rate increases. This is no argument though. The Fed is intent on crashing the US economy. Why copy it? Why not say a falling pound is a price worth paying in that case?
Tackling inflation is a task not within the reach of government except by energy price controls in that case. `That has to be admitted. In the current environment not everything can be controlled. Inflation might be the one to let go.
That makes sense when the alternative is a full blown mortgage crisis as a result of increasing interest rates when increasing those rates will have no impact on energy or food prices, which are set very largely outside the UK at present.
Let’s turn to that mortgage crisis. As I have been saying for many months, and which others have now caught up with, the average likely increase is around £500 a month. Rent rises are also likely as landlords have mortgages.
This level of increase is unaffordable. Most households have nothing like that margin for error in their budgets. Whether they should have been allowed to borrow the sums they did in that case is now irrelevant. Excessive loans were permitted, and are commonplace.
This crisis has the capacity to make the energy price crisis look like small beer. People will be unable to pay, in their millions. That spills over into a homelessness crisis if they evicted, and into a house price crisis as they sell under pressure.
There will then be the negative equity trap to deal with, as people have mortgages bigger than the values of their homes. Those who lived through the early nineties know the personal tragedies this resulted in.
And we also have the makings of a banking crisis, potentially. I know banks are better capitalised now. And I know there are stress tests. I am not, however, wholly reassured by the reassurances of those who say all will be OK.
The debt crisis to come will hit households, intolerably. It will hit banks hard. Let’s not pretend there will be no victims.
The answer to this is, of course, to stop the Bank of England imposing unnecessary interest rate increases. Sure, the pound will fall and inflation will stay higher for longer. But what is more important? Inflation or 5 million bankrupt households? Does the question need asking?
If the Bank does not agree then they should be told. My problem is I cannot see any Tory doing that, and right now Labour is saying nothing about it either. We may get these interest increases as a result. Mortgage rates of 7% may happen.
What then? Three likely things matter most. The first is that households will stop spending on anything but food, energy and mortgages or rents. There will be a massive fall in demand in the rest of the economy.
Second, as a result of that fall in demand whilst facing their own increased energy and interest costs many businesses will go bust and unemployment will increase, dramatically.
Third, government revenues will fall. Fewer people in work guarantees that. Spending more on energy food and mortgages and rent with almost no VAT due on any of them also guarantees that. So tax revenues will be hit, and benefit costs will increase, substantially.
The result of this is recession, plus a big government deficit at the same time. By the time this happens the measures the government can take are limited. They will have to keep people alive: beyond that their scope for action will be small. That will be how bad things will be.
This is the wholly predictable consequence of current actions. So what should be done?
First, stop interest rate rises. They are the easiest and quickest route to calamity, so they must be stopped. Yes, we will be out of step with all but Japan by doing this, but someone has to say recession is no way out of this crisis: it will only make it worse.
Second, do QE now to cover the cost of the energy crisis. This crisis is as serious as Covid: QE has to be used. That will take the immediate pressure off interest rates.
Third, accept inflation. And allow inflationary pay rises. They’re not great. They are much better than millions out of work.
Fourth, reform energy policy.
Fifth, there must be tax increases to balance QE. These must come from the wealthiest alone. I have explained such a programme many times before.
Sixth, consider price controls. We already have them on energy and in some regulated sectors. They now need to be used to squeeze price of essentials. At present they tend to be heavily inflationary. That needs to be reversed.
Seventh, reconsider Bank of England independence. It makes no sense when the result is their current plan to crash the economy.
Eighth, seek international support for low-interest rates. They are essential. They will also save most developing countries from crisis. They can’t afford their debts now.
Ninth, increase energy cooperation, worldwide. Sustainability will require it anyway.
Tenth, pray. In this situation we might all need to do so.
Will that work? Possibly. But what can be said with certainty is that this programme will deliver a lot more hope than the current route to Armageddon on which this government is set and which Labour is not opposing.
We cannot afford interest rate hikes. They must not happen. Recession, homelessness and domestic devastation are prices not worth paying for an anti-inflation policy that is itself doomed to failure. This is the biggest issue in economics now.
The trouble is that the Bank of England think they can do what they want right now after the debacles of the last few weeks. Somehow they have to be stopped. I just wish I knew who was going to do it.