Friday, 11 February 2011

Inflation And Interest Rates On The Rise

Over the last week, or so I've been noticing that interest rates are on the rise. The yield on the UK 10 Year Gilt has rising by around a quarter of a percentage point, rising from around 3.6% to 3.88% the other day. Its not the only interest rate that has been rising. Interest rates in Ireland have been rising again, and today CNBC is reporting that Moody's have downgraded six Irish Banks' creditworthiness as uncertainty mounts surrounding the outcome of the Irish General Election.
In addition, Paul Mason reports on his blog that yields on Portuguese Bonds have spiked above 7%, causing the ECB to have to rush in to buy Portuguese Bonds. The crisis in the European Financial System is far from over, and what the situation in Ireland and Portugal is showing is that rather than austerity measures being a solution to this problem, they are making it worse.
Ireland's economy is tanking making it more difficult to repay debt out of growth. Portugal, which never ran up a massive deficit has problems rather because it economy cannot grow enough to cover the debt it does have. Paul Mason writes,

“the biggest challenge is that they import more than they export. Industries are being devastated by the triple whammy of recession, falling public sector demand and the underlying shift of low-value production away form places like this into Asia.”

But, the European financial system is not made up of national systems. It is a single entity with Banks and Financial Institutions in once country having massive stakes in the Banks and Financial Institutions of the others. The Authorities have tried to paper over the cracks in the hope of being able to somehow muddle through. That was the purpose of the sham Bank “Stress Tests” of last year, which gave nearly all Banks a clean bill of health only weeks before the Irish banks collapsed!
Even the fact, that the ECB is intervening in the Portuguese debt markets to buy its Bonds affects the rest of the European Financial system, because it insists on sterilising any such money printing by taking money out of the system elsewhere i.e. out of the banking system in Germany, France, Italy, Spain etc. That in itself acts to raise interest rates in those countries. The real solution, as I said last year when the crisis first erupted, is for the EU to issue its own Bonds as any other State does. In that way, each country be it Ireland or Germany is able to borrow at the same rate, which is as it should be in a Monetary Union.
But, the EU cannot do that, because political wrangling for advantage between the different countries, prevents it. As Paul Mason writes,

“The big decisions about this country's future will be taken in Brussels now. WHat the markets were betting on, yesterday, is that Brussels will - as is now traditional in the choreography of EU sovereign debt woe - fail to act decisively, or agree a clear way forward.”

Its probably more correct to say that they will act eventually, but too late, with the consequence that the action will have to be more dramatic, and more costly than it need have been had they acted promptly. One thing that might eventually prompt that is, in fact, what is happening in North Africa.
Everyone talked previously about how passive the Egyptian people were. That was until they were not. As Paul Mason comments, and what anyone who has been to Portugal knows, the Portuguese people are an extremely polite, and friendly people. But, they are also the people who in 1974, rose up in a Revolution to overthrow the fascist dictatorship of Salazar, and who established Workers Councils over large parts of the country.
Given the strong links between Southern Europe and North Africa both in terms of trade, and in terms of history, and population movement, it seems unlikely that the events in North Africa will not find their expression also in Southern Europe, especially under conditions of widespread social unrest based on similar grievances, in Greece, Spain and Portugal. Moreover, if Portugal were to play the Tunisia in this scenario, then its much larger neighbour – Spain – could play the role of Egypt. Spain has had considerable economic growth in the last 20 years. Like Egypt, that has led to the growth of a large Middle Class, and population of well-educated young people. But youth unemployment in Spain stands at an incredible 40%!!! Adult unemployment stands at a Depression level 20%.
And, like Ireland, and Portugal, the austerity measures introduced by the Spanish Government are making things worse, undermining the possibility of escaping its low growth and recessionary economy as a means of repaying its debts. And unlike Portugal, Spain DOES have large debts.

As I've reported previously there are tremendous other frictions in Spain, such as the various regional antagonisms, such as that from the more prosperous Catalunyan region, who are seeking autonomy or independence as a means of escaping the burdens of supporting the other regions. And like its smaller neighbour, its only just over 30 years ago that Spain too was under the heel of a fascist dictatorship. The EU participated in the intervention into the former Yugoslavia partly in order to ensure some form of stability on its borders.
It is inconceivable that the EU, or more particularly the Northern European core of the EU, would not act eventually to prevent a descent into chaos within its own borders. The French and Germans will hold on and negotiate until the last minute to extract the greatest possible advantage, probably some time towards the end of this year, or beginning of next, as the crisis mounts, it will impose or get agreement on some form of fiscal and political union that meets its demands, and will then begin to issue EU Bonds, and reflate the European economy. In the meantime things will be interesting to say the least.

Another reason those interest rates are rising is because both the Euro and the Pound have been falling in value. That does not concern Germany, whose exports have benefited greatly, which is one reason the German economy is booming.
But, for those economies like Portugal and Britain, which have Trade Deficits, a falling currency, whilst helping exports – which is why UK Manufacturing has done recently well in recent months – also has the effect of increasing the cost of its imports. The UK Government has trumpeted the rise in manufacturing exports, but has said nothing about the fact that this rise has been largely wiped out by the increase in Imports.

And data out today for the UK, shows the effect of that. Coming just a day after the Bank of England yet again failed to act to rein in escalating inflation, data showed that the Input Costs for British Manufacturing rose a staggering annual rate of 13.4% pa. In January, as the BBC, reports.
Those costs feed through into the output costs of manufacturing industry, which rose 4.8%. This means that these prices, which will not yet be in the Consumer price data are coming along into that index in coming months, adding to the existing increases due to VAT, food price rises, and rapid increases in the costs of energy.
The BBC quotes Alan Clarke, economist at BNP Paribas, who said that it looked like inflation was becoming "engrained", adding: "It reinforces the case for higher rates." In fact, the rising Bond Yields are an indication that whatever the Bank of England decides, interest rates are going up, and going up because the market – the Bond Vigilantes – has decided that inflation is rising, and the Liberal-Tory austerity agenda is not going to make paying off the debt easier. It will be yet another example of where a key part of the Government's argument will have been blown apart. It argued that it had to bring in austerity to reduce these interest rates, and now interest rates are higher than when it came into office and are rising, whereas in May they were falling!!!

The consequences of the rising inflation and interest rates are clear. Wages are failing to keep pace with inflation, which is a key part of the Liberal-Tory agenda to boost profits, but at a time when a massive deflationary hit to the economy is going to be felt as a result of the reduction in Public Spending, and when households have been trying to rebuild their Balance Sheets by paying down debt, the result can only be a significant reduction in Aggregate demand, impacting heavily on the sales of private businesses, and their profits.
Rather than boosting profits, its likely to have the opposite effect. In addition, this hit to households disposable income will come at a time when they will be facing both higher taxes, and other costs resulting from the Cuts. And, adding to the reduction in demand is the effect of a depressed housing market. Recent figures show that demand is once more slumping for houses, mortgage issuance is declining, confidence according to the Nationwide is plummeting, and prices are still at bubble levels 4 times their inflation adjusted long term average!!!
The Wealth Effect demonstrates that as people's wealth, such as that tied up in their house, declines this causes them to adjust their spending downwards because they feel less well off, and because they feel the need to save more to rebuild their assets. Falling house prices will inevitably feed into this downward recessionary spiral over the coming months.

And, the consequences of all this are already being felt. In another interview on CNBC this morning, Ray Bolger of Mortgage Brokers John Charcoal, reported that Fixed Rate Mortgages had basically disappeared in the UK for anything more than 5 years. There was one still available he said with Yorkshire Building Society with a rate of 4.9%, but that would likely be gone by Monday. This is a direct result of those rising Bond Yields, which push up the costs for Banks and Building Societies to raise funds to lend.

As inflation continues to mount, and assets such as houses and shares, whose values have bubbled up due to excessive paper money being printed, its no wonder that Gold is increasingly seen returning to fill its role as real money.
Not only is the experiment, began in Dubai last year, of introducing machines that dispense small gold bars, spreading to other countries, but one London Clearing Hose is now considering accepting Gold As Collateral.


keith said...

thought provoking piece.

I was having an argument recently on another site with some neo-liberals who were claiming, a la Friedman, that balance of trade deficits no longer matter despite one of them actually pointing to the decline in savings over the past 10 years as funding the deficit (along with the huge increase in indebtedness), he couldn't actually see what would happen when the money runs out.

However, do you know of any good reading from a marxist perspective on trade and deficits. It does seem to be a bit untheorised (I've read Marx on it but then there's the whole question of fiat money).

In the long run, the austerity measures will most probably lead to another debt bubble – people will have to buy things and with less money will turn to credit. Another reason for why austerity isn't a good policy.

Boffy said...


I should know some Marxist material on Trade and Deficits, because International Economics was one of the specialist subjects I studied for my degree. But, to be honest I can't think of anything that stands out. However, it was 30 years ago. Marx had intended to include it in his larger work, but died before he got to it.

Most Marxist analysis is in terms of Imperialism, and how trade is structured by it - though I would take issue with much of that theory, which was absed on false premises largely from Stalinism, and things such as Centre-Periphery relations, and Dependency Theory. A Good critique of that in my opinion is Bill Warren's "Imperialism, Pioneer of Capitalism".

I have written several pieces here, and reproduced some of the stuff I wrote in the 1980's on "The New International Division of Labour" and so on.

I don't know if you are a member of the Conference of Socialist Economists, but I'd guess if you looked in their Catalogue, you'd find several articles. The other main source, though not a Marxist I can think of would probably be Joan Robinson.

But, you have given me an idea for a series of posts!

On the do deficits matter issue I think Joan Robinson made the interesting observation that there is a big difference between an economy that runs up a trade deficit to invest i.e. buying in Capital equipment and so on, and one that runs up a deficit to consume. Asian Tigers in the 80's/90's an example of the former, the US an example of the latter.