The UK's Train Wreck of a Privatisation Policy

I took a holiday out to Cornwall in southwest England over the long weekend and travelled on the Great Western Railway, one of the most famous historic train lines in the world (built by Isambard Kingdom Brunel, its gradient is as flat as a billiard table).  I was shocked that the train company charged 88 pounds ($140) to go 180 miles (on a SuperSaver fare to boot!).  This compares to the 280 miles distance from London to Paris, for which the Eurostar charges only slightly more.  This is also despite the fact that the Eurostar has to go through the 5.8bn pound High Speed 1 rail line, the 5bn pound Channel Tunnel, and the 4bn LGV Nord line in France, whereas the Great Western Railway was completed by 1849 for the stretch that I was going on and surely fully depreciated now.  Oh, and the Eurostar goes twice as fast and uses trains where the outsides of the carriages don't look like they've been beaten into place by garage mechanics with mallets.

All this makes one wonder why it's so uncompetitive to take public transport to get somewhere in the UK, to the point where one can rent a car and drive for a cheaper price (even with gas costing $7/gallon).  Well, it goes back to the way the train lines were privatised in the first place and the subsequent rate increases which have been allowed.  The government agreed to fares increasing at an above cost of inflation.  This was part of the government's plan to shift the cost of transport more from taxpayers to fare payers.  Seems sensible enough on the surface, but then what's the point of privatising the railways in the first place then if you're just shifting costs from taxpayers to fare payers?  Plus private companies have to make a profit, so now you have an added cost to bear.  And as any UK taxpayer will tell you, taxes have gone up, not down, so you can't say that taxpayers have really benefited.

But really, what I don't think politicians understood is the impact of compounding fare increases at a rate greater than inflation.  As any long-term investor will tell you, the power of compounding has the greatest impact of any factor over the long-term.  The chart belows shows the impact of this compounding.  Basically, while inflation has a little more than doubled since 1987, rail and bus fares have gone up by 350%.

So the UK has most expensive fares overall in Europe, including Norway where I had a pizza for 24 pounds!  UK passengers are paying 1/3 more on an inflation adjusted basis than they used to.  A walk up fare costing 10 pounds in the UK would cost 7.1 pounds in Norway, 4.3 pounds in Spain and Germany, 2.4 pounds in France, and 1.8 pounds in Italy.  Now to be fair, average fair prices aren't as egregiously different, but you get the message.  And one really can't say that service has improved, trains at rush hour are up to 80% over capacity (a safety hazard?), and many of the train companies run fewer than half of their service on time.

By the way, why should fares be indexed to inflation in the first place?  Isn't the point of privatisation to improve productivity and efficiency, which would mean that prices should increase at less than inflation, i.e. more value for money so one is better off?  And what is a private operator's incentive to become more efficient if they are allowed to pass on ALL cost increases directly to fare payers?  The airline industry, which is one of major successes of privatisation, has barely raised prices since the late 1970s, not just on an inflation-adjusted basis but on an absolute basis as well (most of any price increase on airline tickets have come from higher airport charges, but that's for another day, another blog).  That means that rail and bus fares are now 3 times more expensive compared to airfares than in the 1980s!

My other major criticism is the privatisation process itself.  The government is also now awarding tenders for franchises to the highest bidder.  On the surface, this seems to make sense, but the result is that firms pay a large upfront fee to the government (this is basically a tax with no benefit to the consumer).  The firm then tries to pass on the costs to consumers; if it fails, the firm hands the franchise back to the government, at the cost of the taxpayer.

A couple of years ago, I was talking to the ex-head of a private equity firm, who acquired a major rail franchise during the privatisation process.  He said it was one of the most profitable deals they ever did.  Now a private equity firm is suppose to earn 20%+ returns, so you have to wonder what type of returns that they got if it's one of their best deals ever.  But if you're the government and you have a private equity firm which needs to earn 20%+ returns knocking on your door wanting to buy a rail franchise, doesn't that make you think that perhaps the prices you've set for fares may be a bit too high?  I posed that question to the guy, and he said what made the deal so great was that the fares were set as such a favourable level; they also bore virtually no risk and got all the upside.  I asked whether they needed to make the railway more efficient to generate their returns, to which he commented that there wasn't a need as they could pass the costs on to consumers.  That rail franchise happened to be the Great Western Railway!  So there is such a thing as a free lunch...it's called the UK government.

Japan's last chance saloon

Some coworkers and I had a discussion back in 2006 about which stock market would perform best over the coming years.  The others said Japan, because the market was extremely cheap relative to the other markets.  Ah, I agreed that Japan was cheap...but it was cheap for a reason.  As you can see, Japan's financial markets (as represented by the Nikkei stock index) have fallen off a cliff (was down over 80% at one point) since hitting its all time high back in 1990.  

The country went through an extreme financial bubble (at one point, the Imperial Palace was worth more than the state of California), and it never recovered from the subsequent collapse.  Japan had benefitted from an export driven economy which led to high productivity gains that fueled strong increases in GDP.  However, by the end of the 1980s, Japan had grown to be too large to support itself based on exports.  Living on exports is similar to a parasite-host relationship; if the parasite stays small the host can continue to support it, but it can kill the host if it grows too large, which is what was happening by the end of the 1980s.  But while the country had a dynamic export sector (though this was overtaken by other cheaper and more aggressive exporters like Korea and Taiwan, the by China), the rest of its economy was sclerotic.  The services sector was closed to outside competition, the agricultural sector was inefficient but had strong political clout, and the government was acting like a gravy train for special interests (especially farmers and the construction industry).  On top of this, Japan had benefited massively from a demographic boom in both overall population and working population, which substantially increased demand and output.  Unfortunately, this started to come to an end in the early 1990s.  What's worse, the country is now starting to go into a disastrous population decline which will halve the number of people by the end of this century.  This point is the crux of the problem for Japan.  The Black Plague was effectively the last time a major country lost such a significant proportion of its population (other than through war or famine), and it will be a very difficult uphill struggle for Japan's economy just to stay in place, much less grow.

Japan's government, with fairly strong finances throughout the 1970s and 1980s and backed by its people's massive personal savings, thought it could buy its way out of the early 1990s economic downturn.  As the OECD data below shows, gross government debt as a percentage of GDP tripled over the next two decades, but this still did not pull the economy out of its stagnation.  The government finally came to the realisation that the economic structure had to be reformed, but it was only during the term of Prime Minister Junichiro Koizumi (2001-2006) when the government actually had the guts to press through with reform.  The economy strengthened dramatically during the middle of the last decade as public confidence came back.

Unfortunately, Koizumi didn't stay long enough to see his reforms through, and the subsequent governments proved too weak to even prevent infighting, much less to push through reforms.  

Usually, the country which doesn't pursue reforms simply stagnates in low growth.  While stagnation isn't great, it also isn't the end of the world either, hence why things don't seem to be so bad when you walk through the streets of Tokyo.  The problem which makes the current situation unsustainable is the original issue, demographics.  To understand the scale of this demographic problem, one only has to take a look at the working population to dependents and to retired people ratios.  The number of workers to support each dependent is falling dramatically, and worse, most of that increase in dependents is retirees, who are typically more expensive for an economy than children (healthcare and pensions are more expensive than schools).

The country and its government is now running out of money to support this massive increase in retirement costs.  On the personal side, the Japanese use to save more than 20% of their incomes.  In a twist of circumstances, 2012 was the first year the Japanese had a negative savings rate, as they are now starting to draw down heavily on their savings for retirement.  On the government side, if we merely project the government's current fiscal deficits per year without adjusting for population changes, we see that the Japanese government will have a debt to GDP ratio of 400% by 2050 (blue line).  But that is only half the story, if we adjust for the population decline, the debt to GDP ratio goes up to well over 500% (see red line), and that doesn't take into account the increase in healthcare and pension costs from more retirees (likely the real figure is probably greater than 600%).  And here we're worrying about a Eurozone crisis where the likes of Greece don't even have 150% debt to GDP!  Japan without reforms is for intensive purposes is bust.  That's not a far-fetched prediction; it's a mathematical certainty.  The credit ratings agencies still give it an investment grade credit rating, but that's because the current debt will be paid off before the country goes bust.  But at some point investors won't trust the government to repay them, so what happens then?  The world has never experienced a default as big as Japan (not to mention that many other developed countries will be facing the same problems at the same time).

But there is a saving grace.  If inflation, currently negative, were to be 2% each year through 2050, then (as shown by the green line) government debt would only increase by a small percentage versus GDP.  All of the sudden the debt level looks a lot more sustainable, as inflation devalues the entire amount of existing debt, making any additional deficits that much more affordable.  This is essentially one of the pillars of Shinzo Abe's new economic policy.  Creating inflation by injecting a huge amount of money into the economic system should ignite a level of inflation, which would ease the debt burden on the country.  It also debases the currency, making the country's exports more attractive; the yen has lost a quarter of its value versus the US dollar since it became obvious that Abe would be elected, as shown below.

So there is a potential light at the end of the tunnel if Japan is able to reinflate its economy, but this optimism comes with a lot of scepticism.  Creating inflation but holding interest rates low destroys the value of savings (and Japan has one of the largest savings pools in the world), making it more difficult for savers to pay for their retirement.  The demographic burden still remains, and reducing the value of savings will significantly increase the hardship of retirees.

Japan has also long been one of the biggest DESTROYERS of financial wealth (though China may have exceeded it) as much of the economy (other than the multinational sector which has to compete globally) has allocated capital inefficiently.  Inflation alone doesn't solve this competitiveness and capital misallocation problem.  Significant reforms need to be made to the services, agricultural, and government sectors.  Quantitative easing is just the beginning, and frankly, it is the easy part.

Abe has the majority in the Diet (Japan's parliament) in order to pass reforms, but will he have the force of character to ram through changes against very entrenchment interests?  After all, the agricultural and construction sectors are some of the biggest backers of Abe's LDP party.  Unless Abe proves everyone wrong and becomes a Maggie Thatcher-type force of nature, the odds are desperately against him.  Whereas the UK is fairly centralised, which allows the head of government to push through reforms top-down, the Japanese government is very weak.  This can be attributed to the country's weak constitution, courtesy of United States (the US intentially implemented a constitution after World War II providing weak central authority to ensure a military dictatorship couldn't arise again).  This weakness is easily visible when one merely flies into Narita airport, Tokyo's international airport.  The northern runway at the airport is particularly short, as the government doesn't have the power to get one sole farmer holdout to sell his land in order to complete the runway.

So in order to pass the necessary reforms, Japan likely needs a new constitution.  This is not necessarily beyond the realm of possibility, but it'll require the Japanese people to pull together like they did in the aftermath of the devastation of World War II or the Fukushima earthquake.  But it's much more difficult now that people have more individual wealth and greater personal rights.  Likely the impetus will be a Greece-type of financial crisis situation...they won't have a choice.

More importantly, other countries, including the US, China, Korea, the UK, Russia, and Eurozone countries all have similar demographic problems, though most are not nearly as bad as Japan's.  It will mean a continuing debt problem coupled with economic stagnation, unless those countries can find ways to significantly increase productivity (which raises GDP and lowers the debt burden).  But it will require governments to take strong and decisive action to make this happen.  My bet is that the process of reform will come in stops and starts, with bitter political opposition at times leading to mini-crises.  We've always muddled our way through previous problems.  Let's hope we can muddle through this one as well.

Eurogroup and how to prevent a repeat of the Cyprus bailout debacle

Eurogroup sounds like a name for a rock band or a multidivisional conglomerate.  It is actually the grouping of Eurozone finance ministers, but perhaps it is appropriate to compare it to the other two given how dysfunctional its members work with each other.

In the case of Cyprus, the finance ministers in the Eurogroup ended up bickering over the details of how to save money in the bailout.  They first tried to do this by breaking two key principals in banking, one the guarantee on small depositors’ money (the government ensures that depositors always get their money back), and the other the seniority of depositors over bondholders and other claimants on the bank (depositors always get paid back before creditors do).  This needlessly caused panic amongst savers and hurt whatever trust and confidence is left in the banks (how can you trust the financial system if you don’t have confidence that your money is safe in your bank?).  The financial system inherently works on a system of confidence and trust.  Banks need confidence because they are lending out most of the deposits they take in; the bank by default does not have the ability to pay if all depositors suddenly want their money back, as is the case when they lose confidence.

So though the Eurogroup of ministers had to change their bailout proposal after protests (rightly so) from Cypriots, but they had already eroded confidence to such an extent that many depositors, not just Cypriot banks but elsewhere as well, will now withdraw money out of their banks and stuff it under a mattress (or elsewhere where it is not as economically productive).  Then Jeroen Djsselbloem, the Dutch finance minister and current head of the Eurogroup (his name sounds remarkably close to DimWitBloem in German), had the gumption to say that this new bailout plan can be the new template for how bailouts will work in the future.  He further compounded his faux-pas by saying that Luxembourg, Malta and other countries with big banking sectors should fix their problems too.  I guess no one bothering to tell him that the more he scares people in a financial crisis, the higher the costs of the bailout.   By trying to save a few pennies (the Cypriot bailout was only supposed to cost Eurozone countries EUR 10bn, which in the whole scheme of things is miniscule), the Eurogroup has now made the problem much worse.  Sure enough, the estimated costs of the Cypriot bailout has increased by EUR 6bn, simply because of the Eurogroup's idiotic actions.  They may have been right in their sentiments that creditors should bear losses in a bank bailout, but they should have done this in an orderly structure where everyone understands the process.  The Eurogroup is actually tasked with drawing up rules for orderly structuring bank recapitalisations, but has been taking its time with doing so, which makes one wonder why other people have to agree to its terms in haste while the Eurogroup doesn't have to abide by its own rules.

DimWitBloem also committed a potentially even bigger sin, repudiating his commitment to a common rescue fund for the Eurozone, once a Eurozone banking regulator is in place.  I actually have some sympathy for this point of view, but for a different reason.  The collective rescue fund and banking regulator is supposed to break the ability of governments to get their banks to support them (mainly by buying government bonds).  But knowing how EU countries always water down the regulations, I'm very skeptical that this tie can be broken under the proposed structure.  In fact, as it stands, EU regulations have already sown the seeds for another disaster.  Solvency 2 (new regulations for insurance companies and soon to apply to pension funds) gives government debt a risk weighting of 0% in those investors’ portfolios, i.e. government debt is deemed to be riskless!!!  Now, does anyone out there think that debt of the likes of Italy and Spain is riskless???  Nuts...  But my point is that the EU can't be trusted to get the rules right, so having a unified rescue fund will likely only cause weaker countries to find ways to dump their troubled assets into the rescue fund.  Also, banks tend to use the government bonds of their home country as a means to take care of simple cash needs.  So unless a Eurozone-wide government bond is issued, it will be effectively impossible to break the link between weak countries and their banks.  I, for one, am actually in favour of a Eurozone bond as long as it can be structured to be senior to each country's own bonds.  That way, governments can default on their own bonds without the significant destabilising effect on the rest of the Eurozone, as the default would be more contained and have a much smaller impact on the banking sector.  This is similar to how it is difficult for the US federal government to default but relatively easy for individual US states to do so (and they have done so in the past).

So the Eurogroup has been so dysfunctional in its actions that one has to wonder whether it is craven cowardice in facing up to reality or whether any of them know anything about economics and how a financial system works.  The lack of forward thinking is shocking.  Being reactionary is not a plan; it impairs the ability of the EU to make the necessary reforms to grow out of the current crisis.  The lack of a plan causes people to focus on nitpicking the bailout’s details rather than focusing on the greater goal.  A plan to recover from a debt-induced economic crisis is fairly straightforward; it has been done several times in the past (so what’s taking so long in figuring out what to do this time?).  It comes in three stages:

1) First, you must implement and explain the need for austerity.  This is not as what northern Eurozone countries such as the Netherlands and Germany demand, i.e. simply cutting spending.  Instead, it means explaining why the current system is not sustainable (overall spending needs to be shifted from consumption to more economically productive uses) and to chart an inevitable course for why change is needed.  People don’t like this idea but they get it.  Some will probably fight tooth and nail to keep their benefits, but overall, they see sense in the reasoning.  And you have to stick to the plan.  Maggie Thatcher said it best, “The lady is not for turning”.

2) But you have to give people an out.  This is step two.  You have to implement the changes needed to reform the system.  People have to know that there is a clear direction towards a brighter future, otherwise they won’t work for it.  Again referring back to Maggie Thatcher, she definitely changed people's attitudes towards entrepreneurship, aspiration and working to get ahead.  The UK is a much more dynamic culture that what it was before because of this.

3) But Thatcher only got it two thirds right.  There is a third step (and unfortunately, most reformers miss step three…Sweden is probably one of the better examples of how step three works). Generations of people are often left behind by reforms, e.g. coal miners by Thatcher, and they are never able to recover without help from the state.  Not everyone is an entrepreneur who's willing to risk their livelihoods in a competitive world...most people actually aren't, so the trick is to give them a bit of confidence but more importantly the skills and opportunities needed to adapt to the changed world.  Thatcher failed to do this, and the devastation to the economy in the north of the country (not to mention Tory prospects for being electorally competitive in these regions) was the result.  The current UK government has done stage one but has not done a good job moving on to step two, a growth plan which is necessary to make step one work, and hasn’t given much thought to a step three.  Unfortunately, the Eurogroup and Eurozone leaders are in even worse shape; they don’t seem to have a credible plan for even step one, much less the other two.

Note, people should not view the assistance with adjusting to reforms in step three as welfare.  It is a necessary investment to help the economy better adapt to changing market environments and should be quick and temporary.  The minute it becomes permanent, then it is merely a transfer of wealth from the economically productive to the unproductive.  The objective is to assist the unproductive to become productive again to support themselves, not to give them money in order to placate them that they are "getting their fair share".

Ideally, one should not take disproportionately more money from the economically productive to subsidise this process.  However, that just doesn't work in reality.  The economically productive are by definition generating more income, so in order to be able to pay for the adjustment programmes, it is necessary to get a greater contribution from them (e.g. Germany, Netherlands, the rich, etc).  But again, people need to get away from this mentality that these payments are to allow them "to get their fair share".  They are not.  It's just that this is the most efficient way of raising the funds for such programmes.  This is an important distinction that people need to set in their minds.

So the framework for a Eurozone recovery is fairly straightforward.  It is the same one used by Sweden to recover from its financial crisis in the 1990s and by Germany roughly 10 years ago when the country was highly uncompetitive.  But the advantage that those countries had was that they stopped talking and whining about the problem and got on with implementing the solutions.  In the present crisis, the EU countries which have already starting implementing reforms in a substantial way like Ireland, Latvia and Estonia, are already well on their way to recovery.  The problem with the rest of the Eurozone right now is that they are still having a bunch of useless discussions without a long-term plan.  So it's tough to see how the Eurozone is going to get itself out of the current malaise.  But everyone should know that the problem is the lack of political will, not the lack of a viable economic solution.  Maggie Thatcher, the Eurozone could use someone like you right now...

An Homage to (or Critique of) Margaret Thatcher, RIP

I'm always amazed how fast news organisations are able to get a complete programme out.  One minute I hear Maggie Thatcher had died, the next minute I'm watching an hour long biography on her.  She brings back childhood memories of the Thatcher/Reagan era of supply-side economics and fervent anti-communism.  I don't think one can speak her name without invoking strong opinions for or against her.  But what of her legacy?  Politically, she would have been a one-termer if Argentina hadn't invaded the Falklands in 1982...she was headed for defeat at the general elections, and the Argentines gave her a time-honored way to boost her poll ratings...start a war.  It didn't matter that the war showed that the British military was pretty bad at projecting power...they found out their ships couldn't defend themselves against enemy aircraft, and their bombers couldn't accurately hit their targets.  After suffering a thousand casualties (the Royal Marines were about the only service which really did their job right), the UK now have had the privilege of subsidising the 3000 residents of the Falklands every year for the past three decades in order to maintain its sovereignty.  The UK may have won the war, but one wonders whether it was a smart strategic decision for the long run.

In any case, Thatcher romped to a landslide in the elections and then decided to challenge the coal miners' power.  Frankly, Arthur Scargill and the coal miners had it coming.  Coal mining is a terrible working environment so you have to feel sympathy for them, but the miners had been holding the country hostage and caused the downfall of two prime ministers.  In this game, Thatcher was very much in her element.  The government forced the strike AFTER winter had passed, so most of the strike would occur when people wouldn't care as much...one would have to say that Scargill was an idiot to fall for this trap.  Many of the mines were unprofitable and the government forced their closure.  This economic premise I'm actually rather doubtful of.  According to classical economics, it is more efficient to close the mines, source coal from other countries, and get the existing workers into other employment.  But economists don't understand how these things work in practice.  Tied to one trade for all their lives, those workers were never going to be able to find other employment without help.  The government effectively destroyed the livelihoods of a generation of workers and a hosts of towns in blue collar England without providing some way for the workers to get back on their feet.

Instead, the UK had to fund their welfare costs and now also bear the cost of importing coal from other countries, not to mention the coal industry's decline significantly cut a competitive advantage of many industries in that region, causing a massive wipeout of much of British industry (though it wasn't that efficient or good in any case).  Industries need a nexus of skilled labour, resources, entrepreneurs, and capital.  Thatcher destroyed that, and the UK never recovered.  However, from a political point of view, it was definitely the right thing to do.  Government and business cannot always cater to the demands of labour; the 1970s lost the sense of balance between labour, business and government, and a cataclysmic shock was needed.  While GDP growth was still reasonable, high inflation was eroding the UK's competitiveness.

This drove unemployment to new highs during the 1980 and 1982 double recessions.

As you can see, both the inflation rate and the unemployment rate came down significantly during Thatcher's government.  But one has to wonder how much Thatcher had to do with this economic improvement.  The biggest change in the macroeconomic environment was the dramatic fall in commodity prices in the early 1980s and the use of high interest rates to squeeze out inflation.  This would likely have occurred regardless of the changes that Thatcher made (one could make a reasonable argument that Paul Volcker at the US Federal Reserve did more to help the economy than Thatcher).

Thatcher did cut UK government spending by privatising or deregulating several industries.  This cut government debt levels to post-war lows, and the UK enjoyed a prolonged growth period between 1982 and 2007 (other than the early 1990s recession).

But again, one has to wonder whether Thatcher's changes were for the better for the UK.  While the UK became a freer economy better tailored to the needs of consumers, without the income generated by strong industries, the economy resorted to private debt spending to generate economic growth (a liberalised financial sector also made it easier for people to borrow).  As you can see, private debt more than tripled as a percentage of GDP from the latter part of Thatcher's government.

Also, without a diversified economy of several industries, income inequality dramatically increased.

So while many people have substantially benefitted from Thatcher's changes, one has to wonder if the UK is better off on the whole.  Maggie Thatcher once stated that her greatest legacy was Tony Blair.  In the context, she meant that she was able to change economic and political thinking dramatically to the right, so that Labour under Blair had to move its policies (both economically and militarily) substantially to the right in order to be electable.  But I think the Blair comment is also appropriate in that the legacy is flawed in many ways (e.g. Iraq War, the global financial crisis).

The Cult of Kim Jong Un

I was writing a market commentary the other day and wanted to write about North Korea being a cockroach of a country, but seeing how the audience was going to be institutional investors, I thought better of it.  But realistically, I'm not sure what would be better description of the country.  Like a cockroach, North Korea's constantly making a general nuisance of itself (shelling other countries and kidnapping their citizens), eating your food (constantly blackmailing others to provide food aid), crapping all over the place (3 nuclear tests, selling drugs and nuclear technology to other countries, etc), and running away when a much bigger enemy comes along...plus it may survive a nuclear war...them and Twinkies.

I actually have higher hope for Kim Jong Un's regime, but not for the same reasons as most governments.  Many regimes and/or businesses last generations...the first one builds it, the second one perpetuates it, and the third one brings it all crashing down.  This is because the third generation doesn't understand the philosophy underpinning the original regime in the first place.  Kim Jong Un nor his generals were around during the Korean War, so they don't really understand what the nation was about as they didn't go through the experience.  Whereas Kim Jong Il, the father, still believed in the revolutionary zeal, the new regime is just a corrupt kleptocracy.  Kim Jong Un's wife seems to have a craving for designer handbags (just like how Imelda Marcos of the Philippines used to have 2000 pairs of shoes in her wardrobe).  There are Porsches wandering around the streets of Pyongyang when the country's doesn't even have enough fuel for farm tractors (one in four North Korean children has stunted growth from malnutrition).  Most staggering of all, at least for me, is that a good public sector job in North Korea pays about 3,000 won a month.  With the black market exchange rate of 8,000 won to the dollar, that's a monthly salary of about 40 cents!  Yet there are swanky bars and coffee shops in the country which are frequented by people in uniforms and coming in chaffeur-driven cars.  It reminds me of the end of George Orwell's Animal Farm..."all animals are equal, but some animals are more equal than others".  It's pretty obvious that these people don't follow the country's founder's, Kim Il Sung, ideals of solidarity of the proletariat.

The only way to ward off resentment and unrest is to create a foreign enemy to rally the people...cue the United States, always an easy bad guy to blame.  Hence North Korea's constant war footing and development of a cult around the leadership...it's not so much that they need to worry about a foreign invasion, they just have to pretend to their citizens that there is the threat of one.  The past aggressions are probably needed to create some war footage to show the local population...just like how Americans felt comforted that they were winning the war in Iraq and Afghanistan from footage of smart bombs hitting targets.

But then why does North Korea need nuclear weapons and what's the cause for the latest round of aggression?  The two questions go hand in hand.  The main issue is that North Korea does not produce enough to sustain itself, and China, on which North Korea almost solely relies for sustainance, voted for UN proposed financial sanctions for the first time early this year.  Such sanctions would hit the elite of North Korea the worst, and since it is the elite which has backed the regime, Kim Jong Un as a young ruler trying to assert his authority has to do something which will give the elite confidence that he will fight for them.  Kim Jong Un can deliver for his constituents either through the goodwill of other countries (in short supply these days) or through blackmail (hence the need to develop nuclear weapons).

The need to develop nuclear weapons is a real one, as North Korea as a conventional threat isn't much to speak of, despite its 1.1m person strong army.  The media definitely blows this out of proportion without understanding the circumstances.  Three-fourths of its forces are stationed within 60 miles of the DMZ, the demilitarized zone which separates it from South Korea.  While that may seem belligerent, it's because North Korea doesn't have enough fuel to get those troops to the border in case of war if those troops were located elsewhere.  The military doesn't have enough fuel to get to the southern part of South Korea, much less fight a war.  And the logistics of supplying them would be using farm animals, not trucks.  In 1950, it took UN forces two months to sweep across the entire Korean Peninsula, and they would have completely wiped out North Korea if the Chinese had not invaded.  That's the result with North Korea receiving military aid from both the Soviet Union and China.  Now that it's isolated and the US's modern weaponry, it's hard to imagine the North Korean army not collapsing within a few days.  Having worked at an American defence contractor before, I can tell you that the amount of shock and awe the US military can deliver on a conventional army is pretty overwhelming and impressive.  The North Korean troops will not know what's hit them.

Regardless of how delusional the North Koreans are, it's tough to imagine them not understanding this outcome, especially with Kim Jong Un having lived in the West.  So they need nuclear weapons to pose a threat.  Again, it's tough to see them actually using nuclear weapons offensively when the result would be their own obliteration.  But what they can do is use it as a defence.  They can shell South Korea without much repercussions, as the US/South Korea wouldn't want to start a nuclear war.  So the US and South Korea are more likely to cave in to their demands.  This is really what the North Koreans want...that the US and South Korea "surrender" to North Korea's demands, at least for the North Korean people's own consumption.  A face-saving way out and some aid will buy them off like it always does.

Unfortunately, this means that the situation keeps perpetuating.  Really, the only way to stop this run-around is to get China to do something about it, effectively treating North Korean transgressions as extensions of Chinese policy.  This would also have the positive effect of somewhat co-opting China's support of other notorious regimes, like Iran, Pakistan, Sudan, etc.  China's leaders are pragmatic, if rather slow moving, and they'll change if they think it's in their interest.  The trick is to push their buttons in a face-saving way.

Cyprus: An Exercise in Politicians' Logic

The debacle in Cyprus has been one of the most interesting and baffling exercises in politicians' logic in recent times.  It shows how much politicians are fans of round numbers, regardless of its practicality:

1) Germany said the euro zone should not lend more than EUR10bn to recapitalise Cyprus's banks, even though Cyprus needs about 50% more than that.

2) The IMF didn't want Cyprus's debt to GDP to rise above 100%, even though it's been above 100% for almost its entire time in the EU (and is currently at 140%), effectively defying basic arithmetic.

3) The president of Cyprus was adamant that the tax levied on big depositors (read Russian oligarchs and Greek tax dodgerds) shouldn't be more than 10%, even though it was their fast money coming into Cyprus's banking system which has caused the banking crisis in the first place.  

4) Senior bondholders lose nothing, even though depositors are supposed to be paid ahead of bondholders.

The number of Cypriots MPs voting for the bailout package?  Zero...  Go figure, you mean none of the MPs thought that the four criteria laid out above made sense?  What does this all mean?  Small depositors take a big hit for a problem that they didn't cause.  No wonder people are taking to the streets...I'd riot too if the government tried to do that to me!

Now if you're a Cypriot, things haven't been that bad until now.  GDP  growth was fairly strong until the financial crisis (see below data from Trading Economics); healthcare, tourism, shipping, and financial services have done well for the country.

Plus, though the country had high debt to GDP ratios historically (why did the EU let them join in the first place with a debt to GDP of 180%?!), it came down dramatically over the past decade until the financial crisis hit and the government had to bail out the banks.

On top of this, the banking problems weren't because of excessive borrowing locally, it was due to foreign deposits coming into the country which the banks then lent back out overseas.  Unfortunately, the banks chose Greece as a main destination for a lot of the cash...oops...  When the eurozone bailout of Greece forced losses on Greek government debtholders caused austerity which increased non-performing loans, this badly hit the Cypriot banks.  So one could view this bailout to be merely an extension of the Greece bailout.

To make it even more ridiculous, the country's central power plant was blown up by an explosion at the naval base next door in 2011.  Evidently, the navy didn't think it was a problem stored munitions next to the power plant!  So you have to feel for the average Cypriot on the street, who's wondering why they are getting robbed for something they didn't cause.

Now, before you start shedding tears for the Cypriots, they weren't exactly the epitomy of fiscal prudence either.  They've run a current account deficits as long as one can remember, i.e. they spend more than they earn.  Plus, you have to wonder what they were thinking letting their banking sector get to 13 times the size of their GDP!  Well, it's because they made a pretty good living off of all the foreign money which was coming in, even if they didn't realise it.

They also haven't exactly been model citizens of the EU.  There's a reason why Russians launder their money through Cyprus...because the country wants them to as long as it gets a cut.  They've also backed Russia against the will of the other EU nations...evidently Russia assassinating people using radiation poisoning wasn't enough to make them think about who they should get into bed with.  The EU and the United Nations also had an agreement to merge Northern Cyprus, occupied by the Turks since 1974, with the Republic of Cyprus, but Cyprus nixed the deal just to stick it to the Turkish Cypriots.  Now Cyprus is giving two fingers to the EU and trying to bargain with Russia in exchange for a naval base and potentially rights to gas fields which haven't been developed yet.  So it's not a surprise that the EU wants its pound of flesh from them.

This raises the question, does the EU really need to cave in to Cyprus for a more lenient deal?  I agree that it makes no sense to screw small depositors...it would be disastrous for confidence in the financial system if the EU goes back on its EUR 100,000 deposit guarantee.  But why not stick it to large depositors?  Would taxing Russian money launderers and Greek tax dodgers be a bad thing?  It certainly would be poetic justice to hit the people which have benefitted from the lax regulations and tax avoidance of the past two decades.

The ECB is worried about the effect on confidence in other weak Eurozone countries if they don't back Cyprus.  But is it really that much of a problem?  I don't think so.  In a banking crisis, regulators often let some banks go to the wall (either they refused to be helped or are beyond help) but state concretely which banks they will save.  As long as the ECB does this, there's no reason why they can't let Cyprus go bankrupt but back other nations.  It would certainly give people in say Italy a nice compact example of what happens when you don't take the EU bailout...you leave the Euro currency and suffer a bad devaluation, and you literally will lose half your saving deposits as the banks won't have the money to pay you back since no one is willing to lend to them.  It's not a pretty picture, but perhaps letting Cyprus go to the wall if they remain obstinate will give policymakers more credibility that the reforms they are demanding are necessary (though the austerity they are also asking for doesn't make a whole lot of sense right now).  Otherwise, the citizens of these countries will keep blaming someone else as the cause of their problems rather than face the reality that they can no longer live beyond their means.

Misunderstanding about the UK's Austerity Budget

Ahead of Chancellor George Osborne’s budget for 2013 which is supposed to come out on the 20^th, there has been a lot of criticism of the “austerity” being imposed by the government.  Many are calling for a change of direction; Nobel Laureate Paul Krugman said that the austerity drive is “deeply destructive.”  As a friend of mine noted (and rightly so), growth should be the main priority, so how can growth happen if the government is cutting back on spending?  However, this is only part of the story, so I wanted to put this all in prospective as most people are still of the wrong mentality.

First, government spending is still growing, as shown in the table below, so the government isn’t actually shrinking spending, only shrinking it as a percentage of GDP.

Second, even with the cutbacks, government spending as a percentage of GDP is still near the top of its historical range over the past 40 years (see table below)…hardly austerity.  The main problem is that the previous Labour government increased spending significantly as a percentage of GDP even though the UK was going through its best and longest growth period for the past 40 years.  They ran significant fiscal deficits during the good times, leaving nothing for the bad times.  They compounded this problem by financing a big part of the spending increase with taxes on the financial sector and encouraged the financial sector’s growth with “light touch” regulations and increased consumer indebtedness.  The Labour opposition are currently proposing more of the same, which has been shown to be detrimental to the economy.  So before people start running towards the Labour Party because they like what they hear, be careful…Ed Miliband and Ed Balls have the economic credibility of Argentina…or Venezuela.  Growth by borrowing is always easier than real growth via increasing economic productivity; this is a lesson learnt time and again in emerging market economic crises and being learnt now in the Eurozone and other developed market crises.

Third, the UK’s private sector debt has more than doubled as a percentage of GDP over the past 15 years, which is obviously unsustainable.  Basically, people have been spending beyond their means, and government spending, regardless of an austerity budget or not, isn’t going to change the fact that UK consumers will implode upon themselves if they continue this trend.  In this way, the austerity budget is useful in that it is as least forcing the debate of debt consolidation and spending within one’s own means.

These three reasons show that the government is right to sound the austerity alarm bell.  It’s not a matter of opinion; it’s a mathematical fact.  Anyone who tells you differently just simply doesn’t know what they are talking about.  But we come back to the question, how do you grow the economy if you have to cut back on borrowing and spending?  This is where the current Tory-Lib Dem government falls down on.  It has done a good job explaining the need for austerity in terms of consumption, but it doesn’t have a coherent strategy (or much of a strategy at all) for how you improve economic growth.  They hope that growth will come through confidence from austerity.  President Herbert Hoover in the US tried that during the Great Depression…it didn’t work too well to put it mildly.

There are generally three answers to this conundrum.

One is that the main way of truly increasing sustainable GDP growth is through improvements in productivity.  The UK economy, like other developed economies, is dominated by the service sector and by government (77% of the economy).  It should also be noted that these two sectors are notoriously the least productive in the economy (the table below provides an indication of how service sector productivity lags significantly).

As any foreigner will tell you, services in the UK are expensive, the quality is terrible, and the transport system is positively Third World.  There is a lot of scope for improving productivity here, and the government needs to have a plan to tackle inefficiencies in a wide variety of areas.

The second answer is devaluation of the pound sterling.  If your industries are generally uncompetitive, then making them cheaper will attract business.  This is what happened after the pound left the Exchange Rate Mechanism in 1992 and sharply devalued (see the graph below).  The UK economy, which had been held down by the imposition of high interest rates to defend an overvalued currency, recovered quickly after the devaluation (in fact, this was the last recession prior to the financial crisis).

However, benefitting from a devaluation is easier said than done.  The US and the Eurozone are weak and so are trying to devalue as well, while the many emerging market countries are purposely trying to hold their currencies down to prevent themselves from becoming uncompetitive.  Also, the UK has lost a significant portion of its export sector since the early 1990s, so the benefit of a devaluation will take time.  Still, the UK is doing a better job of devaluation than most (see graph below); the Bank of England has pushed the pounds to near the bottom of its trading range over the past 20 years.

Finally, government should cut back on consumer-related spending, but it doesn’t necessarily need to cut back on spending overall for the time being.  As shown in the graph below, UK government debt to GDP is high but not excessive compared to historical standards (though it should be noted that the prior periods had strong population growth which helped economic growth, something which is not likely in the near future).  Spending on investment which can increase productivity or economic capacity if done in the right areas, can be easily offset by the benefits.  The UK has significantly underinvested over the past 15 years (effectively living off of its past investments), part of the reason why the economy has difficulty growing and why inflation is high for a period of such slow growth.  So if the government maintained spending levels but redirected it from consumption to investment, then the economy should recover more strongly (though note, this stills means consumption spending on things like benefits, NHS, etc will need to go down as a percentage of GDP, so the message of austerity still rings true).

So the Tory-Lib Dem coalition are half right and half wrong in their economic policies (whereas the Labour Party are just completely wrong, but then, I can’t recall Labour’s economic policies ever being right after Clement Attlee’s government).  The government has rightly cut consumption spending, but it has not developed a strategy for improving investment spending and increasing productivity.  This is what George Osborne’s new budget should focus on.