A European-style tax?

Like it or not, there's only one way we're going to be able to pay for our ballooning deficit: a value-added tax.

By Shawn Tully, editor at large

Last Updated: December 2, 2008: 9:27 AM ET

NEW YORK (Fortune) -- It's highly possible, if not inevitable, that Americans will soon live under a radically different tax system - one that the pundits and politicians aren't talking about.

It's called a value-added tax, or VAT, and it's been used for decades to pay the bills and sustain the immense growth of governments around the world, from France to Mexico to Australia. Created in 1954 by a French economist, the VAT is the most potent, efficient machine for revenue generation yet invented.

And if there's one thing the U.S. government needs as the federal budget balloons, it's a ton of new revenue. "The bottom line is that the income tax cannot support the level of spending that's projected, something other countries faced years ago," said Roberton Williams of the Tax Policy Center, a non-partisan research institute. Today the VAT raises almost half of the total government revenue in France, and a similar share in most of the developed world.

The VAT is essentially a sales tax, except that it's charged at each stage in the development of a product instead of at the moment when the product is sold.

Take, for instance, a car with a sticker price of $30,000 and a value-added rate of 10%. Ford might buy its steel and other materials for $8,000 plus $800 in a VAT tax. A dealer then pays $25,000 plus a $2,500 tax for the finished vehicle. Ford takes an $800 credit for the tax it already paid and sends $1,700 to the government. A buyer then pays $30,000 for the SUV and $3,000 in taxes. The dealer collects the $3,000, takes a credit for the $2,500 worth of taxes already paid, and sends $500 to tax authorities. Ultimately, the government pockets $3,000, or 10% of the retail price of the car, in taxes.

The genius of the VAT is that, while the consumer pays it, the actual cash is mostly collected from producers before it reaches the retailer. Since the VAT is essentially a hidden charge embedded in the price of goods and services, raising the VAT doesn't arouse nearly the uproar caused by increasing income taxes.

The ease with which a VAT can be increased points to one of its big drawbacks: Governments see it as an easy way to pay for increased spending, which is a potential drag on economic growth.

Even so, the VAT would be better than the other likely alternative: A higher retail sales tax. If the national sales tax were raised to, say, 20%, consumers would cheat by paying cash to avoid it, and retailers would submit because they'd sell more goods by cutting the price 20%. With the VAT, every step of the manufacturing (and tax collection) process is documented.

Make no mistake: A VAT may be unavoidable in the United States. The reason is that spending is rising far faster than the revenue that can conceivably be generated by the current tax regime.

Keeping the budget afloat

Let's examine the numbers. Under our current tax system, receipts are projected to remain pretty flat, at about 18% to 20% of GDP, far into the future. But spending is slated to rise to 24% of GDP in 2030 and 28% in 2050, excluding interest on the federal debt. If taxes aren't increased enormously, future deficits, and the enormous borrowing they require, will swamp the budget with ruinous interest costs.

Today, the income tax raises around $1.1 trillion, or around 9% of GDP, with payroll and corporate taxes contributing the balance. The deficit now stands at around $580 billion, including the Social Security surplus that's helping to pay the bills. But that surplus is also rapidly disappearing. So to balance the budget, America would need to raise income taxes by 53%, assuming the other taxes remained at current rates.

The gap gets far larger in the future, chiefly due to rapidly rising costs of Medicare and Medicaid. To pay for those costs, we'd need to raise taxes by an extra 2% of GDP. That would require an additional $270 billion in income taxes.

All told, that's a total tax increase of $870 billion, or almost 80%. That's not including the estimated $240 billion cost of President-elect Barack Obama's healthcare plan through 2018.

The rub is that the fiscal pillar America has relied on since 1913 - the federal income tax - can't possibly support the looming new era of spending. All economists agree that when top income tax rates get too high, Americans will work, save and invest less. Tax collections would increase far more slowly than rates, and eventually level off completely.

The VAT may be the only answer. "We're moving towards European levels of spending," said Andrew Biggs, an economist at the American Enterprise Institute "If you go there, you need a more efficient way to raise revenue."

But the VAT, on top of encouraging bigger government budgets, has another problem: Middle class taxpayers would be hit harder by a VAT because they spend more of their income on goods like clothing and cars than high-earners. That's especially distressing to Obama and Democrats, who have pledged to make the tax system far more progressive by raising rates for the wealthiest Americans.

One partial solution would be to exempt staples such as food, gasoline or fuel oil from the VAT and impose extra-high charges on yachts and jewelry. To help middle-class taxpayers, the federal government could also send subsidies to tens of millions of taxpayers based on their incomes. The French, for example, mail checks to families depending on how many children they have.

But given the nature of politics, said Biggs, "the problem is that those rebates might be tied to some social agenda, not to making the system fair."

European governments have typically seen VAT hikes as an easy way to raise revenues during a recession. In some countries, government spending is more than 50% of national income. The results have been fiscal stability, but lackluster growth and a dearth of dynamism and entrepreneurship.

Given the budget numbers, the United States has already chosen a path of far bigger government. The trap has been set. It's unlikely America can escape without a VAT.

source:

http://money.cnn.com/2008/12/01/news/economy/tully_vat.fortune/?postversion=2008120206

China plays beggar thy neighbor

By Peter Navarro

The latest summit between the United States and Chinese officials graphically illustrates that China has learned to play two games from the West: hardball and beggar thy neighbor.

China's hardball approach is evident in the announcement by its major sovereign wealth fund that it will no longer invest in the US financial sector.

The stated reason for this provocative announcement, which was issued on the very eve of the economic summit, is that any such investments would be too risky.

"I don't dare to invest in financial institutions now," Lou Jiwei, chairman of China Investment Corp, said at a conference in Hong



Kong. "The policies of the developed nations on these institutions are not clear. Until they are clear, I don't dare to invest in them. What if they go bust? I will lose everything."

In fact, China's new policy represents both retaliation and a bargaining chip. The retaliatory part of the hardball message has been aimed directly at US Treasury Secretary Henry Paulson, who, much to the displeasure of the Chinese, continues to repeat his demand for Chinese currency reform. The bargaining-chip part is designed to reinforce just how weak the US position is in negotiations while leaving open the door to future investments by China's sovereign wealth fund if the US behaves itself.

As for the beggar thy neighbor, it has become clear over the past week that Chinese government officials intend to export their way out of the global economic crisis. This is all too readily apparent in the recent downward movements of the Chinese yuan relative to the dollar. Stripped of any rhetoric, this movement represents a "competitive devaluation" designed to boost Chinese exports to the US at the expense of both domestic US manufacturers and competing countries such as South Korea and Japan.

In fact, Chinese currency manipulation represents "beggar thy neighbor" on a grand scale. By grossly undervaluing the Chinese yuan relative to the US dollar over the past five years, China has grown its economy on the backs of American workers and helped to decimate the American manufacturing base. Today, it is almost impossible for American manufacturers to compete against their Chinese counterparts when the yuan is undervalued by 30% or more. Add to this an extensive array of illegal Chinese export subsidies, and it becomes easy to understand how China has been able to offshore so many American jobs to its own factories.
Under political pressure, China allowed the yuan to modestly appreciate relative to the dollar over the past year. However, despite this appreciation, the yuan still fell relative to the euro and other major currencies - in the process, significantly exacerbating China's trade imbalance with Europe.

It's not just the United States and Europe that China's currency manipulation hurts. Japan, South Korea and others of China's erstwhile competitors in Asia for export markets likewise lose competitive advantage. That's why China's latest devaluation of its currency could not come at a worse time for its Asian neighbors.

South Korea is experiencing an horrific currency crisis of its own, one that is in large part driven by the steep decline in its exports and a collateral slowing of its economy. The last thing South Korea needs right now is a competitive devaluation by China that further negatively impacts South Korean exports and puts more downward pressure on the won.

Japan is in exactly the same boat. This is a country that just a year ago finally got its head above the economic waters but now is sinking back into the recessionary, deflationary morass. China's devaluation likewise strikes hard at the ability of Japan to bounce back.

The ultimate big picture here is that China could play a very constructive role in the rebuilding of the global economy. With its huge foreign reserves, it could assist Asian neighbors like South Korea in their time of need. China could also use this time as a transition point for moving from an export-driven economy to one fueled by domestic consumption.

It is all too clear, however, that China has chosen to move in the opposite direction. This will not only further destabilize the global economy. It will also significantly strain relations with the United States. This is particularly true given the campaign promise of president-elect Barack Obama to crack down on Chinese mercantilism.

Peter Navarro is a professor at the Paul Merage School of Business, University of California-Irvine, a CNBC contributor, and author of The Coming China Wars. www.peternavarro.com

(Copyright 2008 Peter Navarro.)

source: atimes.com

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http://www.atimes.com/atimes/China_Business/JL09Cb01.html


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Canadian exporters' golden era may be over

Current account surplus to be commodities-bust casualty, economists say

Nov 29, 2008 04:30 AM

Ann Perry
business reporter

Canada's long-running era of current account surpluses could soon come to an end as the commodity bust drags down trade flows that helped propel the country's economy for years, economists warn.

The current account surplus, a broad measure of international trade that includes goods, services, investment income and other areas, shrank to $5.6 billion on a seasonally adjusted basis, down from an upwardly revised $8.2 billion in the second quarter, Statistics Canada reported yesterday.

The third-quarter figure was higher than economists had expected, and shows that Canada is still selling more to the rest of the world than it is buying.

But in a research note, CIBC World Markets economist Krishen Rangasamy said it would "likely be the last hurrah on our external balance," noting that skyrocketing commodity prices have more than made up for falling export volumes over the past five quarters.

"Now that (commodity prices) have come back to earth, and given that the global recession does not bode well for a recovery in real exports, a current account deficit looms for upcoming quarters," Rangasamy wrote.

The current account provides a reading on a country's capital flows as they relate to other countries. While a current account deficit in the short term is little cause for alarm, economists say persistent deficits can weigh on a country's currency and lead to increased debt levels.

The Canadian dollar has already sunk sharply this year as prices for important Canadian commodity exports such as oil, natural gas and metals have tumbled.

Canada has not run a current account deficit since the second quarter of 1999.

In an interview, Rangasamy said he expects the current account will dip into negative territory in the final quarter of this year. He also sees an $8.5 billion current account deficit for next year as a whole, although he thinks a recovery in commodity prices and global growth late next year will drive a surplus in the fourth quarter of 2009.

Douglas Porter, deputy chief economist at BMO Capital Markets, said in a research note that the current account will "struggle to stay in the black" in the fourth quarter of this year. He predicted a current account deficit of $10 billion or more in 2009.

In an interview, Porter said the third-quarter current account surplus showed "a healthy picture, but it's looking in the rear-view mirror because commodity prices peaked at the very start of the third quarter and then they've been sliding ever since."

Oil prices have plummeted more than 60 per cent since peaking around $147 (U.S.) in mid-July. Light, sweet crude closed down a penny yesterday at $54.43 (U.S.).

Porter also noted that "the amount of goods we're going to be able to sell to the United States is undoubtedly slowing rapidly with the sharp decline in U.S. sales."

That could have a significant impact on the current account since Canada exports many goods to the U.S. The third-quarter current account numbers showed the goods surplus shrank to $15.2 billion, from $16.2 billion in the previous quarter, as growth in imports outpaced growth in exports, Statistics Canada said. Canada's deficit in services narrowed by about $300 million, due largely to lower fees paid on securities transactions.

Meanwhile, the country's investment income deficit nearly doubled to $3.8 billion, driven by a drop in profits Canadian investors earned abroad.

On the face of it, a shrinking current account likely won't help the loonie recover from its recent slump against the U.S. dollar. Aside from tumbling commodity prices, the loonie has been dragged down by political uncertainty around Prime Minister Stephen Harper's minority government and the apparent collapse this week of the sale of BCE Inc. The Canadian dollar closed yesterday at 80.84 cents (U.S.), down 0.39 of a cent.

But Stewart Hall, an economist at HSBC Securities (Canada), said he isn't "overly worried from the standpoint of market perception."

"I think the currency market is looking more toward those emerging market economies that have a big demand to finance external liabilities as being really kind of the weak links of the currency market," he said, adding that Canada isn't viewed as "one of those weak links in the currency chain."

Porter also suggested a current account deficit wouldn't necessarily be the end of the world.

"There's nothing necessarily healthy or unhealthy about a (current account) surplus or a deficit in any given year. You have to take into account everything else that's going on," he said.

"But what's not healthy is a decade or two decades of deficits each and every year like we've seen in the U.S., whereas in Canada we've seen surpluses pretty steadily since the start of this decade, which indicates that Canada has been living within its means as a broad economy this decade."

source: thestar.com

link to the original post:
http://www.thestar.com/Business/article/545725


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Darling to slash VAT and spark Xmas spree

Alistair Darling will make a high-risk bid to lead Britain out of recession tomorrow, when he is expected to cut VAT and entice the British people to go on a pre-Christmas spending spree.

The move by the Chancellor and Gordon Brown won the support last night of Charles Clarke, one of the Prime Minister's most high-profile critics, a sign that the economic crisis is at last uniting Labour and focusing minds on the battle against the Tories. With high-street stores slashing prices to attract customers, Darling will offer help with his pre-Christmas price cut in an attempt to limit the collateral damage from the global financial crisis.

The cut is expected to see the rate drop from its current level of 17.5 per cent for at least a year - and possibly for as long as two years.

Last night, as Darling put the finishing touches to the most important financial statement of Labour's 11 years in government, there was speculation that he might slash the rate to 15 per cent, a move that would cost the government about £12.5bn a year.

Such a move, certain to be interpreted as evidence that Brown is preparing for a possible election next year, is seen by the Prime Minister as essential to help the economy ride out the severest economic downturn for generations.

Darling is also expected to announce an extension of the £2.7bn giveaway announced in the summer to buy off Labour rebels opposed to the abolition of the 10p income tax rate. The original rebate, worth £120 a year to basic rate taxpayers, was due to come to an end next April, but the Chancellor is likely to carry it over for at least another year. There could also be wider changes in personal tax allowances to take many low earners out of paying tax at all, as well as plans to speed up infrastructure projects to help salvage jobs in construction. In an interview with the Sunday Mirror, Darling today promises help for 'every household' so people can 'get through the difficult period'. He also promises support for householders with mortgages and those facing redundancy. 'Worried mortgage holders will get help and I shall do what I can to help those who lose their jobs.'

The public sector, he says, will be asked to spend less. 'In these difficult times the public sector will, like the rest of the country, be tightening its belt.'

There was also speculation that Darling could help motorists by postponing plans to increase vehicle excise duty on the most polluting cars.

With the financial markets nervously waiting to see how Brown and Darling intend to pay for the measures, the Prime Minister received a significant boost last night when Clarke, a former Home Secretary, finally buried the hatchet and lavished praise on his former political enemy over his handling of the economic crisis.

Ending one of the bitterest feuds at the top of the Labour party, and in a sign of how it is now united behind its leader, Clarke, who only in September called for Brown to shape up or quit, told The Observer that the Prime Minister had shown 'genuine economic and political leadership at a time when it was both desperately needed and difficult to do'. He said: 'It's been a real surprise to me but Gordon's economic self-confidence has made him more decisive on the political front.' The PM had listened to his critics and had 'earned the right to support'.

'I think that, since the Labour party conference, he has done really well in meeting the challenges of the world financial and economic crisis,' said Clarke. As a result, he said he felt Brown could lead Labour to a fourth consecutive general election victory.

'Winning the election, particularly in the marginal seats in the south east, remains a really tough call, but Labour is obviously back in the race and can do it.'

City economists said a VAT cut was 'psychologically attractive', as it would encourage people to spend when times were hard and could easily be withdrawn later.

The government's deficit will balloon to way above £100bn next year, but the Treasury hopes to reassure the City about the long-term health of the government's finances by announcing detailed plans to increase taxes and squeeze public spending, once the recession is over.

Britain's approach of plunging deeper into the red to pay for a short-term economic support package was echoed in the United States, when President-elect Barack Obama promised to save 2.5 million jobs with a two-year stimulus plan.

'There are no quick nor easy fixes for this crisis, which has been many years in the making, and it's likely to get worse before it gets better,' said Obama. 'But 20 January is our chance to begin anew, with a new direction, new ideas and new reforms that will create jobs and fuel long-term economic growth.'

In a speech to the CBI annual conference tomorrow, Brown will defend his own 'fiscal stimulus' plan, insisting that a 'new approach is now needed if we are to get through this unprecedented global financial recession with the least damage to Britain's long-term economic prospects'.

This weekend, the Conservative party launches a nationwide campaign aimed at highlighting its view that Brown's '£100bn borrowing binge' will mean higher taxes in the long run. Poster vans warning of a 'tax bombshell' - the same phrase the Tories successfully deployed against Labour in the 1992 general election campaign - are being used in London and in busy shopping areas across the country.

George Osborne, the shadow Chancellor, last night accused the Prime Minister of conning the electorate with tax cuts that would have to be paid back. 'Only the Tories will deliver lower taxes that last,' he said.

source: guardian.co.uk

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Bretton Woods II - five key points on the road to a new global financial deal

• guardian.co.uk, Friday November 14 2008 00.01 GMT
• The Guardian, Friday November 14 2008

John Maynard Keynes in 1944 at the UN International Monetary Conference in Bretton Woods, New Hampshire. The summit's agreement shaped with postwar economic effort. Photograph: Hulton Archive

International institutions

While the summit is almost certain not to create a new "Bretton Woods" system overnight, countries led by Britain and France want an enhanced role for the International Monetary Fund, to improve surveillance of complex financial markets and help prevent such excesses building up in future. They also favour increased funding for the IMF.

Gordon Brown made well-publicised efforts to persuade Gulf states to make large contributions to its coffers, while there is also pressure on China, and Japan has pledged $100bn of reserves.

The additional money would enable the IMF to finance more bail-outs to countries suffering runs on their currencies and banks.

The US is less keen on this because new streams of funding would dilute its voting rights within the Washington-based institution.

Similarly, the keenness of oil-rich Gulf states to contribute will be tested now that oil prices have more than halved from their summer peaks.

Global regulation

There is a widespread recognition that regulation of financial markets has been far too weak in recent years. Authorities have been increasingly aware of the excesses building up in such markets, like those for mortgage-backed securities, but have failed to increase regulation.

There is also, though, a recognition that too hasty regulation in response to a crisis, like that of the Sarbanes-Oxley Act brought in by the US Congress in 2002 in response to the Enron scandal (and designed to improve corporate responsibility and combat corporate and accounting fraud), could be counter-productive.

So, there will be discussion of a new global regulator that can force banks and hedge funds to be more transparent about their borrowings and their investment positions.

Such an organisation would force banks to hold greater capital cushions or make them pay bonuses in shares that would have to be held in a company for, say, five years, to make sure it was the longer-term interests of the shareholders that was the focus rather than the bankers' own short-term interests.

There is also discussion of a temporary suspension of "mark to market" accounting rules under which banks are required to report the current value of their assets at times when pricing those assets - such as sub-prime mortgages - is virtually impossible.

Recapitalisation of banks

This is already happening around the world, with most countries following the British model. The US government announced changes to its $700bn bail-out for its banking system on Wednesday, under which it will buy fewer toxic mortgage-backed securities from banks and instead recapitalise banks by buying shares.

This weekend's G20 meeting will discuss a possible response to the problem of banks running out of capital - which probably would be based on a Spanish-style system whereby banks have to hold a bigger capital cushion in good times, which they can draw upon in bad times.

Building such a system will not happen overnight but G20 leaders will probably commit themselves to such action. There is also likely to be discussion of new rules to simplify derivatives products and improve the transparency of the markets in which they are traded.

Fiscal/monetary policy

One aim of the G20 summit is to coordinate global action on interest rates in an effort to pump some life back into the world economy and avoid deflation, or falling prices.

Most governments have already begun to cut and many are also either embarking on, or considering, tax cuts or spending increases to help reflate countries' economies - especially as the impact of interest rate cuts in many economies is being hampered now by the poor availability of credit.

Brown is trying to lead globally coordinated tax cuts. But public deficits in Britain have grown so large in recent years that the country is one of the worst-placed of the main economies to afford a big fiscal giveaway.

New world order

Recent decades have been dominated by western industrialised nations grouped together under the banner of the Group of Seven, but the summit, this weekend, billed as G20, marks a significant shift.

Large-scale economies such as China, India and Brazil now have a place at the table and are demanding a much greater say in global economic oversight because they consider the old "Anglo-Saxon" free-market dogma to be dead.

Reflecting this shift, Brown has indicated that it could be possible to get an agreement on the Doha round of trade talks, which collapsed in Geneva earlier this year amid bitter recriminations between the US and India.

The French president, Nicolas Sarkozy, for his part, will use the summit to suggest that the days of the dollar as the world's reserve currency are over.

source: guardian uk


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Does a bigger boom imply a bigger bust?

Posted on Monday, November 10th, 2008

By bsetser

For the US housing sector – and the financial firms that financed the boom – a bigger boom meant a bigger bust. Home prices rose higher than before — and now are falling fast.

Shipping too. The Baltic dry index rose high on the back of Chinese demand. And recently it has fallen even faster than it rose.

The Baltic index tracks the cost of shipping bulk goods. But it is indicative of the broad contraction in global trade that is almost certainly now underway. No wonder that China is now pondering the risk that its export boom could turn into an export bust. Its export boom was comparable in scale to the United States housing boom. Perhaps bigger – as it also drew on demand fueled by Europe’s housing boom (and, until recently, the RMB’s large depreciation v the euro) as well as US demand.

Whatever the cause, China’s exports have grown steadily larger over the past few years. Indeed, as the following chart shows, it is almost impossible for words to do justice to the scale of China’s export boom.

Yes, the pace of nominal export growth has slowed recently. But that is largely the result of a bigger base – not any major slowdown. Real export growth has slowed more than nominal exports. But real export growth – despite the loud complaints of the textile sector – has remained positive so far this year. The basic story of this decade – at least until now — is of an enormous boom. There isn’t even much volatility.

Particularly relative to say the 1990s. Back then the pace of growth was generally slower and – as importantly — periods of rapid export growth were followed by periods of no growth. This shows up clearly in a chart that looks at the 12m change in exports (exports in the most recent 12ms – exports in the preceding 12ms).

In the 1990s, Chinese export growth looked rather cyclical. In this decade though exports basically just kept growing and growing.

That though is almost certainly changing. My measure of export growth picks up long-term trends, but not short-term changes. If CLSA’s purchasing managers’ survey is right, there is no little doubt that China’s manufacturing sector is heading toward a recession. Real export growth almost certainly will slow sharply in the fourth quarter.

And — as many have noted — there is a significant risk that domestic investment may slow along with exports. Some investment was directed at building up the export sector; even more likely went into China’s domestic property market. The scale of any slump in investment really matters. China’s investment boom was a bigger source of China’s growth this decade than China’s export boom.

China’s policy response is directionally right. A large domestically oriented stimulus is exactly what is needed. $585 billion is over 10% of China’s GDP – so it is large. At least it if it is really new money.

Unfortunately, as the FT’s Geoff Dyer notes, that isn’t clear yet. If the stimulus is mostly just funds that China would have spent in any case, its actual impact will be modest. But if it is real new money, it could be large enough to make a difference.

The big question though is whether it can be put into effect quickly enough to offset the likely downturn.

It isn’t totally inconceivable that the y/y increase in China’s exports could go from over $250 billion to something close to zero …

China’s financial sector doesn’t rely on financing from the international banking system. That leaves it in a better position than other emerging economies. On the other hand, China has relied more than most on external demand to support its growth – which is a problem in a global context when external demand is disappearing. Let’s hope China can reorient its economy quickly …

UPDATE: A superb leader on China from the FT.

This entry was posted on Monday, November 10th, 2008 at 1:14 am and is filed under China. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.

source: council on foreign relations (cfr.org)

http://blogs.cfr.org/setser/2008/11/10/does-a-bigger-boom-imply-a-bigger-bust/

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10 of the World’s Most Dramatic Financial Crises, and Their Lessons

Filed in archive Accounting, Economics, Finance, Government by Drea on September 24, 2008

Financial crises are consistent in one way, and one way only: They’re far more sexy when your neighbors are wearing them. When you suffer your own, runaway inflation becomes infuriating rather than exotic, and bogus bank scams go from intriguing to fist-clenching.

It’s all fine and well until it hits you squarely across the jaw. Which is what the people who run (or, more aptly, misguide) the United States have just done to the general population. For all the progress we’re making, a purple elephant might as well be running the show.

Which leads to a deeper question. Namely, does anyone run the show during a financial crisis? Is there any way to skip out of one as quickly as it enveloped you? Check out these ten nasty crises, and see for yourself:

10. Swedish Financial Crisis (1990-1994)

Cause: In 1985, Sweden deregulated its credit market, leading to a commercial property speculation bubble. Between 1990-94, the bubble burst, leaving 90% of the banking sector with massive losses, including all of Sweden’s largest banks.

Action: The government bailed out banks that looked like they could eventually survive the crisis, nationalizing two of them. It also extended a guarantee to those banks’ creditors, which kept consumer confidence up.

It let the banks destroyed by the crisis fail. Though the government took on bad assets worth about $9.9 billion, it was eventually able to recoup the losses through dividends and reselling assets from the nationalized banks. Stockholders were left empty-handed, but taxpayers didn’t have to foot the bailout bill.

Hear that, United States?

Moral of the story: Don’t save stockholders if you can save taxpayers. Investors, who take calculated risks by investing in the stock market, are in a position to bear losses with partial responsibility. Taxpayers, meanwhile, should not be punished for someone else’s oversights.

9. United States Savings and Loan Crisis (1980s-90s)

Cost: $160.1 billion ($124.6 billion taxpayer money) and 747 United States savings and loan associations.

Causes: Policy expert Bert Ely says old, incompetent policies were behind the mess.

Among them:

-The government picked S&L’s, traditionally funded by short-term deposits, to finance long-term, fixed-rate mortgages. Whenever short-term interest rates went up, S&Ls lost money on their long-term mortgages, leading to negative mortgage interest rate spreads.

-The S&L industry was subject a Depression-area regulation limiting the interest rates banks could pay on their deposits. To keep interest costs under control, S&Ls used funds from savers to cover home buyers, earning interest income on ten- to twenty-year-old fixed-rate mortgages through what Ely calls “maturity mismatching”.

-Restrictions on interest rates stuck S&Ls with rates below market value. Fannie Mae and Freddie Mac, which kept interest rates for homebuyers low, limited S&Ls’ profits–another reason they relied heavily on maturity mismatching to make a profit.

When Chairman of the Fed Paul Volcker restricted the dollar’s growth in the early ‘80s to combat stagflation, interest rates skyrocketed, and the S&L industry collapsed.

Action: The Financial Institutions Reform, Recovery, and Enforcement Act (1989), which created two new oversight agencies, a new insurance fund for thrifts, and a trust corporation to get rid of the zombie institutions that regulators had taken over. Additionally, Fannie Mae and Freddie Mac were given more responsibility in supporting mortgages for families in need.

Moral of the story: When the government puts impossible restrictions on a bank’s ability to make money, the bank finds a workaround to keep its bottom line working. When the Fed makes a change that blows the lid off the bank’s workaround, the whole system collapses.

8. Northern Rock Bailout (Great Britain, 2007)

Causes: Financial services expert Martin Upton says that when vast numbers of mortgage holders with bad credit in the United States defaulted on their loans, financial institutions around the world became cautious about lending one another money. After all, nobody was sure how much money their exposure to the US subprime crisis would lose them.

As a result, liquidity around the world went down, while interest rates went up. Unlike the United States, the Bank of England did not flood the markets with billions of dollars to get liquidity back up. Banks were, for the most part, on their own.

Enter Northern Rock. Northern Rock’s lucrative mortgage business (comprising about 40% of company assets), was located in a company in the (tax-sheltered) Channel Islands called Granite.

Granite was a charitable trust set up to benefit a Down’s Syndrome charity. However, Granite never donated any of its £45 billion of assets to the charity. Instead, it acted as a securitization vehicle, selling “asset-backed securities” to investors and replacing maturing mortgages with new ones.

When global liquidity dried up, Northern Rock couldn’t cover its money market borrowings. It asked the Bank of England for money in 2007, at which point the Tripartite Authority gave it emergency financial support.

After the bailout news hit, customers Martin Upton”>ran on the bank, withdrawing about £1 billion, or 5% of Northern Rock’s total bank deposits, in one day, and up to £2 billion by September 17. Bank shares to fell 72%.

The run tapered off after the British Government said it would guarantee all Northern Rock deposits. In January 2008, Northern Rock sold its lifetime home equity release mortgage portfolio to JP Morgan, using the £2.2 billion gained from the sale to pay off part of its Bank of England loan.

In February, the government announced that it adding Northern Rock’s liabilities to the country’s national debt, now pegged at 45% of GDP. It was thus nationalized.

Action: An internal report released in March 2008 cited inadequate government supervision during the Northern Rock crisis, but blamed the bank’s collapse on its senior management.

Moral of the story: Repackaging debt as assets in a fake nonprofit only works when the economy is going smoothly. Don’t build your entire business out of this practice and expect to survive.

7. Tulip Mania (The Netherlands, 1637)

Causes: The first speculative bubble on record revolved not around property or companies, but around tulip bulbs. After tulips were introduced by modern-day Turkey to Europe in the mid-1500s, people in the Netherlands grew especially fond of them, seeing them as a status symbol.

Tulips infected with a certain virus tended to develop spectacular colors, flames, and lines on their petals. These new varieties were given high-sounding names and coveted wildly by the population. In order to secure these fancy tulips in advance—tulips with the virus can take as long as 12 years to develop from seed to flower—a market developed around their trade.

Traders signed medieval futures contracts that guaranteed them tulips at the end of the season. Professional growers, meanwhile, were willing to pay more and more for the popular flowers. Some tulips were worth more than peoples’ annual wages.

In the 1630s, speculators, lured by tales of sudden riches, flooded the market. The Dutch government banned short selling of futures contracts several times in the 1600s to control the mania. It also created a formal market for purchase and sale of tulip futures, requiring traders to meet in taverns and pay a small fee for each trade.

Bulb prices climbed until early 1637, when tulip traders were no longer able to sell bulbs at inflated prices. Demand collapsed, leading to a drop in price. The tulip futures trade stopped.

Action: Tulip speculators went to the government for help. The government, in turn, permitted futures contracts to be voided with a 10% fee. Many futures holders voided their contracts, and bulb sellers were stuck with their inventory.

Moral of the story: People go crazy when they become convinced that they can get rich quickly. Even off a tulip bulb future.

6. Wall Street Crash of 1929

Cause: In the late 1920s, hundreds of thousands of investors contributed to a speculative bubble in the stock market. Many went into debt to purchase stock, resulting in more than $8.5 billion in debt throughout the nation—more money than was in circulation at the time.

When the market turned bearish on October 24, 1929, investors panicked, causing a massive selloff that tanked the stock markets and contributed to the Great Depression of the 1930s.

To demonstrate confidence in the market, the Rockefeller family and the heads of major banks bought large quantities of stock. This move didn’t stop the panic. During the week of October 24, the market lost a total of $30 billion, more than the United States had spent on World War I.

The stock market crashed caused businesses to close, mass layoffs, and a rash of bankruptcies. An international run on the dollar resulted in increased interest rates, driving out around 4,000 lenders.

Action: After an investigation, Congress passed the Glass-Steagall Act of 1933 (now repealed), mandating a separation between investment and commercial banks. They believed this would avert another dramatic panic sale. It didn’t—the Dow fell 22.6% in 1987—but, to date, the Great Depression that followed the 1929 crash hasn’t been repeated.

Moral of the story: Don’t panic. Many scholars now say that the 1929 crash didn’t cause the Great Depression, but certainly contributed to its severity. Public panic only makes situations worse than they already are.

5. The Japanese asset price bubble (1986-1990)

Causes: After World War II, Japan’s domestic policies encouraged people to save money. People put more money into banks, making it easier for companies to take out loans and lines of credit.

Using their new lines of credit, Japanese companies invested in capital resources, enabling them to produce goods more efficiently than international competitors. Japanese provided high-quality products at extremely competitive prices, becoming a major world economic power in the process.

At the same time, the yen steadily appreciated. Investors to make good money off financial markets. People used easy credit to develop property and buy homes, contributing to a speculative real estate bubble.

Real estate prices inflated, with some Tokyo properties selling at $139,000/square foot. Stocks prices seemed to have no ceiling at all. Reinvestment expanded the economy further. The Nikkei reached an all-time high of 38,957.44 in December of 1989.

Then, in the early 1990s, Japan’s bubble started to sink. Rather than a dramatic crash, real estate and stock values decreased slowly, leading to Japan’s “lost decade.” People started investing outside of the country; companies lost some of their competitive advantage internationally as a result. Low consumption rates coupled with lower output and employment meant steady deflation.

Action: The government lowered interest rates to practically nothing, which did nothing to encourage Japanese people to put money in the banks. The government subsidized banks and businesses on the brink of failure, effectively propping up zombie organizations with little visible benefit to the economy. The Yen carry trade became one of the main ways people made money off their investments.

In 2003, the Nikkei finally started climbing again.

Moral of the story: When bubbles grow, they’re wonderful in every way. When they sink—and they can sink, rather than popping—they can set the economy back more than a decade.

4. The .com bubble (1995-2000)

Cause: In the mid-1990s, a new type of business emerged: The .com, a company either based solely on the Web or servicing the Internet, its people, and its technology. When early .coms’ stock values shot skyward, venture capitalists jumped aboard en masse to finance Internet startups.

A .com’s lack of a viable business plan didn’t stop many VCs from throwing in money. Investors and startup executives assumed that once a .com had peoples’ attention, the money would come organically in the future.

Speculators jumped in, creating a market full of wildly overvalued startups. Lavish spending and astronomical publicity campaigns followed. .coms burned through their VC money, positive it would come back soon. Day trading became a relatively common way to make fast money.

In 2000, the NASDAQ began to trend downward, leading to what’s known as the .com bust.

Action: Though the government didn’t address .com startups or speculation, its policies and timing may have contributed to a loss of confidence. Between 1999-2000, the Fed increased interest rates six times in order to reign in the economy. Around the same time, a flurry of government investigations stalled corrupt business practices.

For example, around the same time the NASDAQ began its slide, Microsoft was declared a monopoly. Major telecommunications companies, such as MCI Worldcom, toppled under debt and management scandals. Regulators put the financial industry under fire for misleading investors during the .com boom. Famously, Enron collapsed after investigators uncovered an accounting scandal.

The Sarbanes-Oxley Act was passed in 2002, laying out far tougher transparency and accountability standards for public companies.

Moral of the story: The market, your favorite bipolar uncle, likes to celebrate wildly when he finds out about new technology. Just be sure to steer clear of him when his mania turns into prolonged, howling grief.

3. 1997 Asian Financial Crisis (1997-1999)

Causes: In the years leading up to the crisis, Southeast Asia was a hot international investment destination. ASEAN countries’ high short-term interest rates gave foreign investors favorable rates. Capital flooded into the region.

Asset prices increased, and growth rates in the early 1990s were as high as 12% of GDP, leading analysts to refer to the phenomenon as the “Asian Tigers” and “Asian Economic Miracle.”

At the same time, Thailand, South Korea, and Indonesia ran huge deficits. They borrowed quite a bit of money externally; keeping their own interest rates fixed encouraged this behavior. This left them vulnerable to changes in foreign markets.

In the early ‘90s, foreign investors turned away from Asia. Higher US interest rates valued the dollar up, which in turn made Southeast Asia’s exports less competitive (their currencies were pegged to the US dollar). Southeast Asian exports slowed in early 1996, fueled at least in part by China’s increased competitiveness in the export market.

What caused the crisis from here is subject to rampant debate. Some say that policies leading to large amounts of credit pushed up asset prices, which then collapsed, leading to massive debt defaults (kind of like the subprime crisis).

International investors panicked and withdrew credit. To keep the region attractive to foreign investors, ASEAN governments jacked up interest rates and bought up excess domestic money using foreign reserves. As a result, the governments’ central banks started running out of foreign reserves, while capital continued to drain from the region.

In 1997, Thailand’s government decided to float the baht, unleashing what’s now known as the Asian Financial Crisis. Regional currencies depreciated, meaning liabilities denominated in terms of foreign currency grew even more expensive in domestic terms. Entire economic sectors melted down, while people fell into poverty. Stock markets and currencies rapidly devalued. Politics destabilized, with executive resignations and an increase in extremist groups. The region seemed to melt down in the blink of an eye.

Actions: The International Monetary Fund created bailout packages dictating reforms in exchange for debt defaults. The reforms included cutting government spending, allowing banks to fail, raising interest rates, and becoming more transparent.

The IMF’s actions had questionable results, leading to a backlash against powerful international NGOs that continues today. Some say the crisis in Asia also contributed to the recent United States housing bubble.

Moral of the story: When things crash, rich people may interfere, offering money in exchange for an agenda. That doesn’t mean their agenda is right, or even useful. Moral #2: Financial meltdowns can happen at the speed of light.

2. Russian financial crisis (1998)

Causes: In 1993, the Russian government came up with inflation-free short-term treasury bills, known as GKOs, to finance the country’s deficit. GKOs were traded on currency exchanges. Though mostly state-owned, roughly 1/3 of funding came from foreign speculators, which they attracted through high interest rates. The government used proceeds from sales of new GKOs to pay off interest on matured bills—a classic Ponzi scheme.

In June 1997, looking to raise capital, the government increased GKO interest rates to 150%. By the beginning of 1998, GKO interest payments comprised more than half the federal government’s revenue. They became large domestic banks’ main source of revenue.

Meanwhile, the government owed workers roughly $12.5 billion in unpaid wages. It was also making more money from GKOs than from taxes. Investors lost confidence in the Russian government when they put all the pieces together, selling Russian securities and rubles. The Central Bank tried unsuccessfully to stabilize the ruble by spending an estimated $27 billion of its United States dollar reserves.

In August 1998, Russia’s markets collapsed. Investors, fearing a devaluation of the ruble and a debt default, panicked, leaving the market with a 65% drop in one day. As a result, several major banks closed, and inflation increased. It also eradicated the nascent middle class by eating through peoples’ bank savings.

Actions: The government cut spending on social- and municipal services. Fortunately, oil prices skyrocketed after 1999, facilitating a quick recovery.

Moral of the story: Don’t anger people while financing yourself with a Ponzi scheme. It ends up being much more expensive in the long run.

1. Argentine economic crisis (1999–2002)

Causes: Agentina had a history of volatility when the 1980s Latin American crisis struck. The import-dependent country was running low on US dollars, a currency that people were entitled to convert their pesos into if they felt like it (this was a “safe” option for many people).

The country also had a history of runaway inflation and associated loss of confidence in its currency. Meanwhile, the government spent lavishly on itself while ignoring the country’s crumbling industrial infrastructure.

In the 1980s, Mexico and Brazil, major Argentinian trade partners, suffered economic crises that spread through Latin America. Brazil’s real was devalued in 1999, hurting Argentine exports; at the same time, the dollar was revalued, delivering the Argentinian peso another blow.

In 1999, the country entered a 3-year recession. The government did not devalue the peso or unpeg it from the dollar, making the crisis worse.

The recession deepened. Investors ran on banks for dollars, which they then sent abroad for safety. In response, the government more or less froze everyone’s bank account.

Citizens protested in major cities, eventually starting fires and destroying property. Violence and fatalities ensued. In 2001, the government collapsed. People bartered for goods because they lacked cash. Business shut down. Many people eked out a living by scavenging cardboard for recycling plants.

Action: The government at first tried to set up a third currency between the peso and the dollar, but this failed. It then mandated that all dollars in banks be converted into pesos.

The exchange was left to float, leading the peso to depreciate. Exports became more competitive. The government tightened its tax policies, improved social welfare, encouraged business growth, and put reserve dollars up for sale on the market. As worldwide demand from Argentinian agricultural products increased, the country grew a trade surplus. It continues to struggle with inflation, however.

Moral of the story: Freezing bank accounts is a really bad idea.

source: businesspundit.com

Fort Lauderdale Blog & Real Estate News

Rory Vanucchi

RoryVanucchi@gmail.com

www.LasOlasLifestyles.com

www.FortLauderdaleLiving.net

Once Sizzling, China’s Economy Shows Rapid Signs of Fizzling

By DAVID BARBOZA
Published: November 6, 2008
SHANGHAI — Each new forecast of China’s economic fortunes predicts slower growth than the forecast that preceded it.

Just as China attained supercharged growth that astounded much of the world, it appears to be slowing more sharply and more quickly than anyone anticipated.
“It’s tough to be optimistic,” said Stephen Green, an economist at Standard Chartered Bank in Shanghai. “The three engines of growth — exports, investment and consumption — have all slowed down.”
The signs are so troubling that last week Prime Minister Wen Jiabao warned that this year would be “the worst in recent years for our economic development.”
A series of government reports released over the last few weeks indicated that China’s export juggernaut was moderating. Real estate construction projects are being suspended. Consumer confidence is in decline. And many factories in southern China are closing, putting tens of thousands of migrant laborers out of work.

Some Chinese companies have even reported that Christmas orders — which were supposed to be placed in late summer or early fall — were down 20 percent this year, as big retailers and toy marketers grew gloomy about the holiday season.
Until recently, many economists had insisted that China was insulated from the global financial crisis rippling through the United States and Europe, and that the Chinese Communist Party had the tools to keep the economy chugging along. But newly released data suggests that nearly every sector of the economy is slowing and credit is tightening in a nation that has grown accustomed to sizzling hot growth.
While few economists expect China to fall into recession, analysts are forecasting the worst growth in more than a decade, with the economy expected to expand by as little as 5.8 percent in the fourth quarter this year, down from about 11 percent in 2007.
Analysts worry that a sharp downturn could undermine the country’s already weakening investment climate and impair some of China’s biggest banks, which have bankrolled much of the boom.
Beijing worries that if growth slows to 8 percent or less, not enough jobs will be created in a country that is rapidly urbanizing — and that could lead to social unrest.
To prevent that, the government is preparing a large economic stimulus package, pushing new infrastructure projects, offering aid to exporters and searching for ways to prop up the nation’s severely depressed stock and real estate markets.
Less than six months ago, the government’s chief concerns were soaring inflation and an economy that was growing too fast.
Now, inventories are piling up around the country as domestic and foreign demand for Chinese goods slackens. In southern China, the government has had to step in to aid migrant workers after factory closures.

Indeed, when the Canton Trade Fair ended this week in the city of Guangzhou, orders at one of the biggest events for Chinese products were down significantly, and so were visitors, according to participants.
But it is not just export-oriented factories that are being hit. Companies that sell in China are also suffering because investment projects are being postponed and consumers are pulling back on major purchases.
After five years of growth over 10 percent, China’s growth rate has decelerated for five consecutive quarters, dropping from 12.6 percent in the second quarter of 2007 to about 9 percent the third quarter of this year.
That growth rate is still strong, but economists say the downturn began sharpening in the last two months. At many factories, large Christmas orders were canceled.
Earlier this week, the government announced that China’s purchase management index, which is used to measure the country’s economic performance, fell in October to its lowest level since it began compiling data in 2005, indicating that orders of all kinds had fallen sharply.
Auto sales in China have plummeted this year. Air travel is in decline. Property sales have dried up, and weakness in the property market is hitting the makers of steel, cement and glass.
“There is a nose dive in real estate construction in south China and east China, the two real estate boom areas,” said Yang Dongsen, a cement industry analyst at Merchant Securities. The real estate slowdown is expected to affect retail sales, which for the last few years had been lifted by new-home buyers purchasing appliances, decorations and other household goods.
It does not help that China’s stock markets have also collapsed, after a stunning rise in 2006 and 2007. Share prices in Hong Kong are down about 50 percent, and the Shanghai composite index has fallen 67 percent this year, wiping out nearly all the gains it had made in the previous two years.
Many economists say they believe that government stimulus packages will stabilize China’s economy and prevent an even steeper decline in growth, and that the economy could pick up steam by the second half of 2009.
Still, many economists say times have changed for a while.

“Don’t count on China to get back to double-digit growth for the next few years,” said Dong Tao, an economist at Credit Suisse in Hong Kong.
Keith Bradsher contributed reporting from Guangzhou. Chen Yang contributed research.

source: ny times


Rory Vanucchi
Fort Lauderdale Blog & Real Estate News
RoryVanucchi@gmail.com

www.LasOlasLifestyles.com
www.FortLauderdaleLiving.net

ECB Watch: Benchmark rate expected to fall to at least 2% by mid-2009

By Finfacts Team
Nov 7, 2008 - 7:56:12 AM

ECB Watch: Following the decision of the European Central Bank to cut its benchmark rate to 3.25% on Thursday, the rate is expected to fall to at least 2% by mid-2009.

If the rate falls to 2%, borrowers on trackers, will in particular gain.

As banks charge their customers about 1.25% above the ECB rate, depending on the type of mortgage.

Borrowers could gain a €400 reduction in monthly payments from the cuts that began in October.

A homeowner on a €300,000 tracker mortgage will benefit from a monthly repayment fall by €90 from Thursday's cut, in addition to the October cut, which also reduced the repayments by another €90.

The IMF expects the advanced economies to have their first full-year contraction in 2009 since 1945.

The reduction in mortgage costs should give the Government some courage to tackle the issue of public sector pay as private sector workers will in general get no rises and be at risk of unemployment.

The following is analyses on the rate outlook from 3 bank economists.

AIB economists led by Chief Economist John Beggs:

The ECB finally sees the light:

The European Central Bank cut rates by 0.5% today, bringing the total reduction in official rates in the eurozone to 1% in the past month.

It is hard to believe that the ECB hiked rates as recently as July. There has been a sea-change in its thinking on monetary policy since then, brought about by an abatement in inflationary pressures as oil prices collapsed and the eurozone economy hit recession, as well as worries about the deepening financial crisis.

It is clear that the ECB was not forward looking enough in terms of its monetary policy decisions in the earlier part of the year.

The summer rate hike stunned markets, given the worsening economic backdrop and fragility of the financial system. It contrasted with the policy easing of the Fed and BoE in H1 2008. The ECB, though, has been forced into a policy reversal and is now cutting interest rates rapidly to bring monetary policy more into line with economic realities.

The ECB did not attach much weight until recently to the turmoil in financial markets and its implication for the real economy.

While the ECB tried to distinguish between the operation of monetary policy for price stability purposes and money market operations, the lines became increasingly blurred. The rise in interbank rates and seizure in credit and money markets resulted in a sharp tightening of financial conditions that was completely inappropriate in an already weakening economy, increasing the risk of a deep and prolonged recession.

Neither did the ECB pay enough attention to leading indicators showing a sharp weakening in economic activity.

The latest readings from these indicators, in particular the PMI surveys and EC’s economic sentiment index, are truly awful. GDP contracted by 0.2% in Q2 and a decline of around 0.1% may have occurred in Q3. Leading indicators point to a marked fall in GDP in Q4. The eurozone economy, then, has been in decline for most of this year and the recession is likely to last until the middle of next year, judging by the continued downtrend in leading indicators.

With interbank rates still very high relative to official interest rates, it is quite clear that rapid and significant policy easing is required.

Three month interbank rates are still around 4.5% after today’s cut. Official rates need to be cut to very low levels to help bring down interbank rates, as has happened in the US. The ECB did consider cutting rates by 0.75% today. It was a missed opportunity for a bigger ECB rate cut as the BoE slashed rates by a whopping 1.5% today.

With inflation set to fall well below 2% next year, ECB President Mr Trichet hinted at his press conference today that further policy easing is on the cards, and another 0.5% rate cut seems likely in December.In the last cycle, ECB rates were eventually cut to a low of 2%. On that occasion, the economy managed to avoid recession. With the economy now in recession, inflation on the wane and interbank rates still elevated, ECB rates hould be cut to at least 2% in 2009.

Eurozone Economy In Recession

Eurozone GDP contracted by 0.2% in Q2 and data published since mid-year point to a continued deceleration in the pace of activity, indicating that the economy is in recession. The most recent data have been very weak, pointing to a marked contraction in GDP in Q4 and suggesting that the downturn in activity could last well into the middle of next year.

The EC’s economic sentiment index, a good lead indicator of economic growth, collapsed in October to 80.4 from 87.5 in September. This was the sharpest monthly fall on record and leaves the index at a 15 year low. The index has been in decline since mid-2007, when it stood at 111.6.

Meanwhile, the composite eurozone PMI fell to a record low of 43.6 in Octoberfrom 45.3 in September, well below its peak of 57.8 in June 2007. The October readings for both these indices, if sustained, point to a fall in GDP of around 0.3% in Q4. The contraction in GDP could be even greater if the indices continue to decline in the final two months of the year.

A marked fall is also evident in national surveys of business and consumer confidence, notably the Ifo index in Germany, INSEE surveys in France and ISAE index in Italy. The continuing sharp decline in these leading indicators in recent months is another sign that GDP growth is weakening further in the second half of 2008.

This is borne out by trends in manufacturing output and retail sales, which declined on an annual basis in July and August, and the marked slowdown in export growth over the summer.

The eurozone labour market has also weakened this year. The unemployment rate picked up to 7.5% in Q3 from 7.2% in the first quarter of the year. Employment rose by 0.2% in Q2 2008 compared to 0.5% a year earlier in Q2 2007. Survey data point to a continued weakening in labour market conditions. Meanwhile, inflation has started to ease, having picked up sharply earlier this year on the back of soaring food and energy prices. The CPI rate hit a historic high of 4% in July but had fallen to 3.2% by October following declines in commodity prices, especially oil. The CPI rate is set to continue on its downward path in the months ahead given the further fall in oil prices over the past month. The recession and rising unemployment will put downward pressure on core inflation. The CPI rate should decline to 2% next spring and 1% by next summer if the fall in oil prices in recent months proves sustained.

The growth in monetary aggregates is also decelerating. M3 grew by 8.6% y-o-y in September, down from 12.3% a year ago.

Growth in private sector credit slowed to 10% in September from close to 13% at end 2007.

Although declining, these growth rates are still elevated, but this may be because the current malfunctioning of credit markets puts greater reliance on banking finance, especially for corporates. Loan growth to households for example has slowed sharply to less than 4% y-o-y at this stage.

Overall, looking at the trend in the real economy, inflation and monetary aggregates, there seems little to stop the ECB from slashing interest rates to very low levels. Rates were cut to 2% in the last cycle. There is no reason why rates cannot be cut to this level again with inflation headed below 2% in 2009.

Simon Barry, Ulster Bank Capitals Markets:

ECB cuts by (only!) 0.50% as rates now headed to 2% or lower

ECB cut rates by another 0.50% today…
…this follows the 0.50% reduction in early October…
…so rates now stand at a two-year low of 3.25%, down from the recent peak of 4.25%...
…the ECB has never before cut rates by this much this quickly…
…though there was some disappointment that the cut wasn’t even bigger following the extraordinarily radical 1.5% cut from the Bank of England earlier today…
…a still highly fragile financial system and a rapidly deteriorating economic outlook provide the context for today’s move…
…while sharply lower oil prices also greatly help the outlook for inflation…
…further rate reductions are virtually certain in the period ahead including another 0.50% cut next month…
…rates now headed for previous low of 2%, maybe even lower

The ECB cut official interest rates in the euro zone by 0.5% today. Today’s move follows the 0.50% reduction announced as part of the co-ordinated global easing of interest rate policy on October 8th. ECB rates now stand at 3.25% - the lowest level in nearly two years – and down from the cycle peak of 4.25% reached in July.

The decision to cut rates was based on what Trichet referred to as the “alleviation of upside risks to price stability” – in other words an improved outlook for inflation. The improvement in the inflation picture has two clear drivers. First, the 60% drop in oil prices since July (from $147pb to $60 at present) will help produce a sharp decline in headline rates of inflation in the quarters ahead. Indeed, it looks as if HICP inflation (the ECB’s measure) could be as low as around 1.6% by next Summer, as the effect of lower oil and other commodity prices kicks in.

Second, incoming economic news, both from the euro area and the wider global economy, has been nothing short of horrendous of late. This week’s PMIs were a case in point. The October readings of both the manufacturing and services surveys hit new all-time record lows in the euro area, underlining how severe the loss in momentum has been in activity in recent months. Numbers out of Germany earlier today confirm the extreme weakness which is gripping the zone’s largest economy, with factory orders plummeting by a staggering 8% in the month of September alone – the biggest one-month fall since at least 1991. News from other major economies has also been exceptionally weak. Service and manufacturing PMIs from both the US and UK – two of the euro zone’s most important trading partners - have also collapsed in the past couple of months.

The weakness in domestic and external demand prospects featured prominently in Trichet’s statement. Notably, Trichet observed that the intensification and broadening of the financial market turmoil is likely to dampen global and euro area demand for “a rather protracted period of time”.

The global financial system has clearly been going through a period of unprecedented stress in recent weeks and months. But we can take at least some encouragement from the fact that the extreme distress in the capital markets, and the related pronounced weakness now affecting the major economies, continues to be met by an unprecedented response from policy-makers globally.

Today’s ECB move is another example of the determination of the authorities to prevent a catastrophic economic scenario. Since the ECB was formed in 1999, it has never cut rates by so much so quickly. At the beginning of the last interest rate cutting cycle in 2001, for example, it took the ECB four months to get rates down by 1%. This time they have done so in four weeks!

Today’s 0.50% move was in line with the prior expectations of most financial analysts. However, there was a palpable sense of disappointment in the markets at 12.45 when the ECB decision was announced following the extraordinarily radical 1.5% cut from the Bank of England earlier. The BoE’s decision was as laudable as it was audacious.

The ECB today missed an opportunity to deliver an even bolder move itself. But the sharp ongoing deterioration in the economic environment means that we shouldn’t have to wait much longer for the next instalment of policy easing. We expect another 0.50% cut at the December meeting, and rates look destined to get to the 2% low of the last cycle, if not even lower.

Austin Hughes, KBC Ireland - formerly IIB Bank:

• ECB cuts for the second time in less than a month.

• Rates likely to fall again in December as new forecasts will emphasise worrying scale of economic slowdown.

• Changed reality of much poorer global growth and continuing credit market turmoil argue for aggressive ECB easing.

• We think interest rates can fall to 2% in 2009 and possibly lower.

• Lower rates will offer some much needed support to the Irish economy.

As the European Central Bank had effectively pre-announced today’s rate cut, most market interest focussed on (1) the size of the rate reduction and (2) any pointers as to future policy easing.

On a day when the Bank of England delivered a dramatic 150 basis point reduction and the Swiss National Bank also surprised by announcing an intermeeting cut of 50 basis points, today’s ECB rate cut of 50 basis points may seem disappointing. Mr. Trichet did indicate that the ECB Governing Council had considered a 75 basis point reduction and also hinted that rates would fall again in December by saying that he ‘didn’t exclude that rates could fall again’. By emphasising that the December policy meeting was ‘an important rendezvous’ because of the availability of new ECB staff Economic projections, Mr. Trichet is clearly holding out the prospect of a further rate cut next month.

Why not cut by more?

We think there are at least three reasons why the ECB did not implement a bolder rate cut today. First of all, it appears at least some at the ECB still harbour residual concerns about the inflation outlook. In our comment on the co-ordinated rate cut of October 8, we highlighted the ECB’s continuing and seemingly misplaced concern about ‘second round effects in price and wage setting’. While Mr. Trichet acknowledged today that there has been ‘a further alleviation of upside risks to price stability’, the opening paragraph of the press statement also suggests the ECB believes ‘they have not disappeared completely’. This may reflect some differences of thinking within the Governing Council. It could also be that the ECB might be excessively concerned about the looming high profile pay deal in the German engineering sector. Some at the ECB may even feel that the global response to the current downturn threatens an eventual if distant rebound in price pressures. However, it is very difficult to square the ECB’s lingering worries about inflation with the relevant evidence emerging on the economic outlook of late.

A second argument for cutting less today and easing again in December is that it can be delivered next month against the backdrop of new ECB staff projections that will show notably poorer growth prospects and a weaker inflation trajectory. If the ECB had cut more aggressively today, the presentation of dismal forecasts next month without an appropriate policy response might have put the ECB in an uncomfortable situation Mr. Trichet is now in a position to deliver a further Christmas present in the shape of another easing on December 4^th.

Finally, it remains the case that the ECB has been very slow to recognise the scale of emerging downside risks to the Eurozone economy as well as the spill-over effect of the credit market turmoil on activity in the ‘real’ economy. Mr. Trichet emphasised today that circumstances had changed dramatically of late. However, the sharp slowdown evident in a broad range of Eurozone indicators since the middle of the year suggests a marked worsening of economic conditions that predates by some distance any impact from the failure of Lehman’s in September. Naively, the ECB seems to have believed that the Eurozone would be insulated from poorer economic conditions outside the single currency area. In addition, the judgement that ECB monetary policy and liquidity policy could be operated in entirely different directions for a prolonged period of time now looks fanciful. The implication of these errors is a slower policy response that may imply poorer Eurozone economic performance in 2009 than might have been the case as well as the possibility that ECB rates may need to fall further than if rates had been reduced earlier and not increased in July.

The ECB has fallen behind

Today’s decision by the ECB to cut policy rates by 50 basis points on the same day that the Bank of England cut rates by a massive 150 basis points underlines the relatively conservative nature of monetary policy in the Eurozone. Since the turmoil in markets began in August 2007, the US Federal Reserve has reduced it’s policy rates by 425 basis points, the Bank of England by 275 basis points and the ECB by just 75 basis points(two recent 50 basis point cuts preceded by July’s 25 basis point increase). Admittedly, Euro area rates were not initially as high as in these other economic zones but US policy rates are now far lower while UK rates are below their German counterparts for the first time since the middle of 1994. (Higher inflation, stronger growth and the greater importance of borrowing to the UK economy mean that UK policy rates have traditionally been higher than their continental European counterparts).

Of course it can be argued that the financial blow to the Eurozone economy is not nearly as severe as that to either the US and UK but we are now looking at the prospect of a severe global economic downturn that requires a forceful and speedy response.

History suggests an aggressive easing is likely

Faced with a sharp slowdown in growth and attendant downward pressure on inflation in 2001-2003, the ECB cut rates aggressively. That easing cycle lasted two years, encompassed 7 rate cuts and a fall in official rates of 275 basis points. Importantly, however, the ECB began it’s easing process a good deal quicker in the economic downswing. It is also the case that the current slowdown is likely to be a good deal more severe than it’s predecessor. Indeed, we now expect Euro area GDP to shrink by around 0.5% in 2009, the first full year decline in GDP since 1993 when activity shrank to 0.8%. Although the starting point for interest rates was notably higher in 1992, the German Bundesbank, effectively the Central Bank that ruled Europe at that time, reduced it’s key policy rates by 275 basis points in 1993. These comparisons argue the case for further sharp and speedy rate cuts even after today’s move.

Because (i) the global economy has been set on a sharply weakening path for some time (ii) evidence of a marked worsening of Eurozone economic conditions has been accumulating since the middle of the year and (iii) the financial market turmoil intensified sharply in September/October, we don’t think incremental changes to policy can be justified.

The ECB has now cut rates by 100 basis points in less than a month but we think further near term easing is likely. The current episode is more worrisome than the period surrounding the 9/11 terrorist attacks when the ECB reduced rates by 125 basis points in a little over a two month timeframe. As a result, we look for another 50 basis point cut in December and further easing through early 2009 that takes the main ECB refinancing rate down to 2 per cent by the middle of next year. The current economic downturn looks like being a good deal more severe than the slowdown that triggered the drop in ECB rates to 2.00% in 2003. We think the speed and extent to which money markets return to normality and the extent to which governments use fiscal policy to boost activity will determine whether a new all-time low will be seen in ECB rates in 2009.

What about Ireland?

The evidence of the KBC/ESRI Irish Consumer Sentiment Survey suggests that changes in interest rates are of critical importance to consumer confidence in Ireland. This is scarcely surprising. We estimate that every 1% drop in interest rates will boost the spending power of Irish personal borrowers by about €1.5 bio. Of course, there is some offset as personal savers will suffer a hit of about half this amount. However, as borrowers tend to have a higher propensity to spend then consumers, the prospective drop in interest rates alongside cheaper energy and food should provide some support to consumer spending in the coming year.

While it might appear that the Irish economy’s close relationship with interest rates is a relatively new one, history suggests otherwise. Periods of significant reduction in borrowing costs tend to be followed by stronger economic growth. Clearly, the sharp drop in interest rates that occurred in the late ‘80s contributed significantly to the subsequent economic upturn.

Similarly, lower rates coincided with an improvement in Irish economic fortunes in the aftermath of the currency crisis. The approach of EMU also saw growth accelerate as did the drop in borrowing costs between 2001 and 2003. This is not to say that interest rates are the key determinant of the performance of the Irish economy. However, a more favourable interest rate climate in 2009 may leave the outlook for growth a little less threatening than is now feared.

source: irish financial news

Rory Vanucchi

Fort Lauderdale Blog & Real Estate News

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