The debt crisis – Pain Aversion – a Good basis for the country?

September 18th, 2010 by Jon Moulton

Jon Moulton of Better Capital LLP gave an engaging and thoughtful presentation to the Institute of Directors (IOD) at Moores Hotel on 17 September 2010.

Jon Moulton at the IOD seminar at Moores Hotel, St Peter Port ©RLLord (Click image to expand)

Mr Moulton began by looking at Guernsey’s situation.  He is very pleased with Guernsey but he highlighted the dilemma of Guernsey’s proximity to the European Union.  He asked “Is Guernsey in the EU or not?  Is Guernsey on its knees to Brussels or not?”  If Guernsey gave in to EU demands, which is what the EU wants, Guernsey wouldn’t need to exist.  If Guernsey sticks its heels in too much with the EU there won’t be any business left.  It will drift away.

Mr. Moulton emphasised Guernsey’s need to diversify and generate new business opportunities away from the financial services sector.  He stressed the need for good leadership and hoped Guernsey had it.  He then turned his attention to the UK.  Below is Mr. Moulton’s prepared presentation, which was interspersed with candid remarks and with humour.

We all know that the UK (and others too) and its citizens have lived for far too long with pleasurable consumption, and nice to have expenditures, being allowed to range well ahead of the ability to repay the debt that was being run up.

UK Government debt is burning away towards 100% of GDP and a lot more – perhaps twice that if you add in public pensions, PFI and bank support.

The UK reached a position last year where the Government was spending £4 for every £3 it raised in taxes.

Only two nations – Ireland and Iceland – managed to increase their debt relative to GDP faster than the UK in the last three years.

We are however far from alone – the Western world is generally overspending and over-indebted – and with lousy demographics too.  The USA will spend $1.40 for every dollar the Government raises this year.  Ireland, Greece, Portugal, Spain, Italy are all ropey in considerable measure.  The USA and the EU are all over-spending and most have lousy demographics.  Events outside our borders are a risk for our economy.  Stability seems unlikely.

Actually the debt binge has been going on for a long time – 20 years ago the total debt in the UK private sector ran at 150% of GDP that doubled to 300% some eight years ago and increased to 450% by 2010.  That level of debt is unprecedented outside of wartime.  Consumers and industrial companies roughly doubled their leverage in those 20 years whilst financials went up by a factor of around five times – albeit almost no-one can now really disentangle or define the debts of the financial sector as they trade in increasingly impenetrable derivatives and structured finance products.  “Regulators cannot understand funny bits of paper.”

Only 20 years ago the Government was spending less than its income. The State has risen steadily towards 50% of the economy – most history says 40% is about the limit.  Above this growth tends to slow and stop and things start going wrong.  Remarkably Mervyn King has been dispatched to the TUC to explain all this.

Then came 2008 and the structured finance and investment banking industries precipitated a major global financial collapse – Lehman Bros., RBOS, AIG, Bear Sterns, Northern Rock, even Alliance & Leicester fell over.

UK GDP fell by five or six percent in a year.  Unemployment went up painfully but surprisingly little from five percent to eight percent.

And we have suffered much less pain and failure than might have been expected in our economic system – company failures are at near 30 year lows (one sixth of 1992 figure) and housing repossessions are startlingly low given the financial shambles.  House prices have suffered little – indeed people with large mortgages on variable rates have seen a huge rise in their disposable incomes.

The economic pain has not been anything like as bad as we might have feared – or perhaps deserved – has it?

The reasons lying behind the remarkably low short term consequences of the debt orgy are mostly the result of policies designed to lower interest rates to levels not seen in 30 years in the UK.  You can manage a lot of debt if you pay next to no interest.  (The average UK interest rate over the last 30 years is eight percent.)  We printed money (lightly disguised and much obscured by the new name “quantitative easing”) and increased borrowing to avoid cutting government spending and to maintain low interest rates.

Simply we solved the difficulties of too much debt by using more debt and making that debt tolerable – at least for a short time.  Quite a few people have compared the process to treating heroin addiction with more heroin!  It is a good analogy.

These policies punished individual savers who saw their income slashed whilst those with reckless levels of personal lending were given a reprieve and a sharp rise in their disposable income.  The massive increase in Government borrowing enabled the current generation to live comfortably whilst leaving the burden to paying off the deficit to our children.

People buying annuities were hammered and borrowers were rewarded and protected.  Parents are fine but our children will struggle.

It is unarguable that by avoiding pain now we ensure that the future economy will be weaker and riskier.  It does not feel a very noble policy.

And the continuation of these policies seems increasingly likely as we try to protect our current excessive consumption.   The morality if terrible.

In the corporate world the very low failure rate is the consequence of very low interest rates, massive Government support – unlabeled but actually more quantitative easing – of businesses with unpaid taxes of some £30 billion plus propping up scores of thousands of enterprises, and a banking sector generally unwilling or unable to recognise losses.  Industrial debt runs at twice the level of the early 1990s recession.  That recession was only one third as deep as our recent one.  So if interest rates rise we should expect more failures than then – and corporate insolvencies then ran at six times today..

This lack of corporate casualties is not entirely good news – whilst short term it reduces job losses and the very real pain that involves – many enterprises that would normally have perished continue to trade.  Assets and people that are tied up in those hopeless businesses would do more good for the economy deployed elsewhere.

It is unlikely you will hear our politicians say it but actually we live in a time with an unhealthily low rate of corporate failure – try saving that to the Trade Unions!

In many ways these policies of low interest rates have protected the weak – and in some cases blameworthy – parts of the economic world.

Let us consider what has happened in the world of Banking – especially investment banking.  A combination of state guarantees, cheap and abundant funding from the public purse and a lack of resolute regulatory action has enabled incredibly risky business models to survive and even in parts revive.  The bonuses simply did not go away as we are led to believe that bankers cannot be found to work for anything less than a large multiple of the pay of anyone else.

Why did this happen?  Well in part simply an unwillingness to take the – huge – pain of more Bank failures during the crisis and now I fear an unwillingness to tackle a remaining looming threat to the structure of our financial world because of the definite immediate pain of restricting and dividing Banks into essential bits and the gambling piece.

The banking sector remains a very major threat.

Actually the issue is wider than Government finances – there is a more general issue.  We more generally reward short term performance and ignore long term consequences – professionals all lose their aura of professionalism as they value today’s fee over relationships and the old idea of Best Advice.  The transactional model is ascendant.  Relationships matter little.  Shame.

Many values of previous times have been dumped – a dodgy human’s record is readily overlooked nowadays if the bloke can deliver today.  A few recent political appointments come to mind.

The trouble with this is clearly seen in the kinds of byzantine transactions we have seen Goldman Sachs paying big fines for.  It seems that even the very highly paid Frenchman selling the handpicked structured heap of dodgy mortgage debt really did not understand it or care what happened to the buyers.  Those who dealt with Goldman Sachs had abundant reason to feel that the fees and bonuses were all that mattered – we should worry a lot that the newspapers struggle to find commentators – lawyers or accountants – to talk about Goldman Sachs because of their power and position in London.

Short termism obviously generates a bias against integrity.

This is pervasive in current society – we saw lots of silly pieces of headline grabbing public spending announced by, for example the ever lovable Lord Mandelson.  There was I fear no real expectation of anything noticeable ever being implemented.  Short term publicity gain was the achieved aim, and unaffordable costs and non-implementability happily ignored.

It was not easy to believe from their words that any of the parties in the last election actually were aware of the scale of public spending cuts that had to come.  David Cameron danced through the election campaign between the awful reality that he faced and his desire for election.  He will live long enough to regret the statement he made in January that “we are not talking about swingeing cuts.”

Those cuts will have to come and he knew it then.

Maggie Thatcher never actually cut public spending and the older souls present may remember the pain in her reign.  The current Government need-simply to stop debt rising further – to get the gap between spending and revenue down by £150 billion – say a 28% cut in spending if it is all to be done in spending cuts.  And given that the Coalition has said they will protect the NHS and International Aid actually the rest would have to drop about 35 percent.  The Coalition will need extraordinary courage and cohesion to get anywhere near this.

Even relatively mild cuts will be very difficult.  Trident, social workers, cancer drugs, school milk, nursing car, pensions …choosing where the pain is to be felt is a job I’m quite glad not to have to discharge.

And I suppose most of you are glad I’m not doing it too.  A massive drop in investment will hurt the economy and its prospects.  The Unions are visibly flexing their muscles in Manchester.  In the UK they may need to buy canned food, candles and other essentials for this winter – there’s a bad winter coming up with significant social unrest.

So what price a good short term economic recovery?

Is the FT’s Martin Wolf right to say “Any recovery is better than none”?

Should we carry on with a policy designed to simply reduce the rate of increase of the national debt in order to get a rapid recovery?

It is certain that highly indebted economies grow more slowly than less indebted ones.  Less wealth will be available in the future if there is more debt.

It is certain that every pound of debt put into the national balance sheet either has to be serviced, defaulted or inflated away.

It is certain that the levels of debt and deficits in the developed Western Economies are in historically high and largely uncharted territory – when creditors get to fear default or inflation interest rates will certainly rise.  And that would really hammer the highly leveraged UK economy.  Only the timing of this event is uncertain.  The probability will rise as the debt rises.

Our Government is currently talking quite toughly given that the two top men are former PR executives – not an area of business noted for pain tolerance or strategic thought – but its plans still mean continuing loading still further debt onto the next generation for the next few years and rely on low interest rates persisting, decent economic growth and stable international financial conditions to get close to an equality in spending and income in five years.

It must be right to fear that the Coalition will lack the necessary stomach and cohesion to grasp the nettle firmly.  Union opposition seems increasingly likely to be resolute.

It is certainly arguable that it would be better for the country to take more pain now and get the deficit down quicker.  Yes, it would mean more unemployment and business failure short term but it would provide a much better base for future growth. Resources would move from the public sector to the private sector quicker, and with a more sensibly balanced and less levered national economy, growth would return.

Actually it would be less risky and definitely a great deal more morally honest to cut the State quicker.  Our children do not deserve our debts.

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Mr. Moulton answered questions from the audience attending the IOD seminar.

He said that much of the growth in consumption was concentrated in very few people.  He called the income disparity particularly in Finance absolutely huge and ridiculous.  In the 1980s in a one thousand person company a CEO might earn eight times the salary of an average worker.  Today CEOs were earning up to 60 times the average amount of one of their employees.

Mr. Moulton said there was always the opportunity to make money in a bad economy.  Companies with new and good ideas would grow and there was the opportunity to make deals on distressed properties and companies.

He said that when people lose confidence in the currency inflation will return.  The price of gold has reached $1300 per ounce.  This is because of fear, he said.  He said there were lessons to be learned from history. Towards the end of the Roman Empire, the Romans debased their currency by substituting lead for silver in their coins and his led to a collapse in confidence.

He warned that more quantitative easing will bring “the explosion closer.”

History shows repeatedly that raising taxes isn’t very efficient at reducing deficits.  It is much better to cut spending and the earlier the better. The UK has just had its biggest trade deficit he said.

He said that Switzerland had the best European economy.  He didn’t think that university education necessarily helped the economy.  Only 28% of the Swiss population go to University.

He warned about US debt. He said that the USA has to raise three trillion dollars of external debt this year and they don’t know if they can do it.  Australia and Canada, on the other hand, are doing relatively well because they have little debt.  The USA will probably head towards protectionism.

The markets, he said, indicate that the EU has a ten percent chance of breaking up within the next 18 months.  He doesn’t know how the EU can hold together in the long term.

When asked about Guernsey economic condition he stressed Guernsey’s need to develop a new base for its economy and diversify away from financial services.  And he urged Guernsey not to follow the other economies and build up debt.

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