Three Predictions for 2008

 28^th December 2007
The Malta Independent - Friday Wisdom

Planet Earth is about completing another cycle round the sun and those who are seeing it through are one year older and most of us are showing it. An additional wrinkle here, a louder ouch to pick a handkerchief from the floor and generally a creeping loss of agility and flexibility. Hopefully we are also one year wiser.

So is it wisdom or folly that in this last contribution for 2007 I propose to make three predictions for next year? The future is uncertain to all and one event could change the basis on which any predictions are made. However we cannot avoid trying to configure and prepare for the immediate future purely because of the possibility, big or small, of some fat tail event that would change the entire landscape.

So whether through wisdom or folly here are my predictions.

The safest bet is related to the Maltese property market. The supply/demand equation is changing so rapidly because of an over-supply in the pipeline that it is quite predictable, with limited risk of error, that the Maltese property market will cool down substantially in 2008 with certain sectors of the market where the supply/demand is way out of balance starting to show outright price reductions in the 10-15 per cent range.

Quality real estate tends to be less affected by such cycles due to more balanced demand-supply situation pulling on our attraction to foreign investors looking for a place in the sun. However, given that the real estate market has gone soft in most countries it is quite likely for the cooling down of the Malta property market to be felt across the board though in the first-time home buyer market it will be felt in a higher dimension than in the luxury market.

A prediction regarding the outcome of a general election is always risky and given that a week is a long time in politics any predictions will have to be made with great reservations. But how can anyone make predictions for 2008 and leave out the outcome of the general elections which will dominate the political calendar?

After 21 years of nearly uninterrupted tenure by a PN government I predict that by a hair or by a mile this time it will be Labour. There are innumerable satellite reasons why the majority can be expected to switch its political preference in 2008 but the core reason is the electorate’s fatigue with a PN government.

This could be unfair on Dr Gonzi who seems to score consistently higher than Dr Sant in any opinion survey involving a direct choice between the two leaders but this is not enough to overcome the swell of fatigue with his government. People wanted this change in 1996 and did not quite get it. After backing the old horse for another five years between 1998 and 2003 people were also ready for a change but Labour forced their hand by making them choose between it and the EU.

Now the fatigue has reached proportions that it could overcome any obstacle. The absence of any higher order issue, like the EU was in the 2003 general elections, leaves no visible obstacle in the way of fatigue to deliver what it should have delivered in 2003. Add to this that many people do not perceive that the promised EU spring has been delivered through EU membership and the price oppression causing loss of disposable income by high energy prices translating themselves into high surcharges on utility bills which were a core reason why Labour government met its untimely end in 1998, fatigue will have tail wind support to deliver a change of government come next election.

Which brings me to the third and last prediction, which is however dependent on and resulting from my second prediction of a Labour government being returned to power following the next general election. This prediction is that while political administrative power will change, the wide network of power spread across society, which has continually helped the PN to have a smooth time in government, will not change allegiance. The network of power found in the business community, in the ecclesiastical corridors, in the civil service, at the university, among the intelligentsia, in the white collar union organisations, in the media and wherever there is any power to be exercised will survive any election result.

This network of power outside politics, which did its best to help their PN ally in politics, will use their power to passively or actively obstruct a new Labour government. Let me take a silly but telling example. I am sure many would remember the hunger strikers camping outside Castille in 1997 purely because a Labour government did not revoke the building permit for Portomaso project issued under a PN administration. How many hunger strikes have there been since the PN were back in power in 1998?

Today it is almost laughable that anyone would dare thinking of protesting through hunger strike for anything in this totally insensitive society let alone to protest against the highest level piece of real estate development in the Mediterranean these last 10 years.

When the PN is in government they have total control as it is a political cell in a power network spread across society. The cells in such network feed on each other to restore power to any cell that temporarily loses it. When Labour is in power its power is purely political and will find headwind from the surviving power of the remaining cells who are eager to help the PN recover their lost power. Will it ever change? It would be a happy new year indeed if it were to do so in 2008 giving an enhanced meaning to true democracy.

From Goldilocks to Stagflation

21^st December 2007
The Malta Independent - Friday Wisdom

After a long period of benign inflation and relatively high economic growth it appears that quite unexpectedly the international economic landscape is changing to one where inflation is becoming a real threat, and growth is, at best, slowing.

The suddenness of the change in the economic landscape from goldilocks (not too hot – not too cold, with above trend growth and no increase in inflation) to stagflation (low growth accompanied by increasing inflation) goes beyond anything I can remember.

Until the start of last summer we were all singing praises to the wonders of globalisation. Emerging countries that embraced globalisation, in particular China, India and Brazil, were becoming an economic force to be reckoned with. Their development was creating an unbalanced demand for energy and base metals causing commodity prices to reach record levels in nominal terms.

Yet this increase in the price of energy and basic resources was not transmitting itself to inflationary impulses at the retail level of prices. The transfer of manufacturing activities to low cost emerging countries, particularly but not solely China, meant that in spite of higher input cost for the material and energy elements for manufacturing of consumables, the lower cost of labour and overheads more than compensated, meaning that the retail price of products on the shelves of the Walmarts and Tescos of this world was quite stable and quite often falling.

This globalisation process was on the other hand keeping in check the labour cost in developed countries given that the bargaining power of organised labour (unions) was weakened by the facility of employers to shift their shop to China et al if labour in the home country would get too expensive. This moderation in wage settlements was another reason for the benign consumer inflationary environment we have been having this century.

The low inflation readings were also aided by the methodology of measuring it. Central banks have a habit of reading inflation in two measures. The first is headline inflation which includes a wide spectrum of retail prices, including energy and food. But they mostly track and base their monetary policy decisions on the reading from the core measurement of inflation that eliminates from headline inflation the effect of price movements in food and energy on the pretext that these prices are too volatile to be addressed by monetary policy changes. By tracking the core inflation, central banks were not concerned about the immediate price movements caused by volatile energy and food but were mostly concerned to ensure that there is no transmission of second round inflation to the general price level of the economy.

It seems that suddenly the almost too good to be true economic scenario is falling apart. The obduracy of energy prices is forcing central banks to reconsider their neglect of headline inflation as it is becoming clear that high energy prices are not a passing phase and are unlikely to be compensated anytime soon by lower energy prices. Furthermore on top of stubbornly high energy prices, central banks must now take into account price rises of soft commodities, basic cereals like wheat, corn and barley, which could unleash a general price ripple increase in most food prices given that these cereals are not only irreplaceable ingredients for basic food products, as basic as our daily bread, but are also the basic ingredients for animal feed on which meat and dairy prices largely depend.

But it is not only a question of technical measurement of inflation. It is also that as China and India move up the development ladder their effect on inflation in the developed world is changing from benign to threatening. The costs of imports from these countries is increasing both as a result of rising domestic costs as well as a result of appreciation of their currency to reflect their enhanced economic status. Coming at a time when their internal development is continuing to make huge demands for energy, basic resources and soft commodities to feed an increasingly affluent consumer, high prices of energy and cereals mean that the inflation scenario in most developed countries is shifting.

Central banks would in normal circumstances have addressed such inflationary threats by tightening up their monetary policy, increase domestic interest rates to tame demand for imports and reducing cost pressures in the economy. The problem is central banks are currently having to fire-fight another more urgent problem caused by the sub-prime mortgage default problems in the US which demands lower not higher interest rates. Fighting inflation by tightening monetary policy will have to wait.

This gives rise to a serious risk of unmooring inflation expectations from their hitherto low levels. And it is well known that inflation expectations are self-fulfilling. Once consumers expect higher inflation this will realise itself as manufacturers and retailers gain pricing power and consumers demand higher wages to protect their real value.

This is the conundrum that will face unions in 2008 and beyond. Their benign wage demands so far were moored on low inflation expectations and higher value of their residential assets and financial investments. Workers were happy to moderate their wage demands if low inflation was helping to raise the value of their real estate and financial investments. The scenario is changing. Property prices worldwide are falling, financial investments are volatile, and expectations about inflation are worsening.

Can the unions keep their members’ trust if they persist in their benign wage settlements? And if unions become more demanding would this not force central banks to raise interest rates at a time when the economy needs looser monetary policy to cushion the external threats?

And if unions blow their top off and start demanding their full share, would this not give further impetus to inflation forcing employers to accelerate relocation to more friendly economic environment thus causing reversal in unemployment that has been steadily falling.

The conundrum that unions have to solve is whether they want to be flexibly part of the solution to restore goldilocks or whether they revert to their traditional narrow role and risk stagflation. The line between the two is very narrow but the economic outcome is widely different.

I wish my readers a peaceful Christmas full of the best things in life.

Betting Away Spending Power and Social Values

14^th December 2007
The Malta Independent - Friday Wisdom

I had clearly pointed out the risk to public morality of privatising the hitherto public lotto without taking precautions not to expose the general public, with an inherent Mediterranean cultural inclination for gambling, to an excessive temptation to spend a disproportionate part of disposal income on such human frivolities.

Writing in The Malta Independent on Sunday on 4 November 2001 I had asked: “what precautions are being taken to ensure that we do not end up with a gaming terminal in every street corner augmenting gaming and gambling far beyond the broad economic growth rate? Has the government calculated the social cost that a sudden surge in gaming would cause through forced recourse to usury and other criminal practices? Has anyone made any calculation of the economic costs of such sudden surge in gaming as expenditure gets shifted from other consumption with much more economically effective multiplier effect?”

Now we seem to have landed exactly where I had feared we would land. Ask anybody around you and he or she will tell of first hand experience of people who hardly earn enough to keep their body and soul together, who are scrounging to somehow live in the false hope of hitting the big Super Five jackpot.

We spend a handful in protecting our kids from vices such as drug and alcohol abuse. Our moral authorities, the Church included, do sterling work to educate the exposed sectors about the stark consequences of experimenting with core drugs and or their modern synthetic derivatives. Admirable people, to whom we shall remain eternally in debt, like those at Caritas, Appogg and similar organisations, dedicate their lives to redeem and rehabilitate those fragile among us who give in to the temptation to seek refuge in drugs or alcohol.

Even the State and the public sector spend a handful in supporting these NGOs through budgetary allocations, sponsorships or outright donations and in running a centre to give controlled drugs or methadone alternatives to those undergoing a rehabilitation programme involving a controlled withdrawal.

It is therefore quite paradoxical that gambling is not only legalised in controlled environments like casinos, but that we have opened it up to full exposure in practically every street of every town or village. We must be working on the false assumption that exposure to the abuse of gambling is morally less damaging then exposure to the abuse of drugs or alcohol.

I am surprised that Church authorities, who regularly find an opportunity to warn us of the great moral pain which would befall this country if we were ever start to consider giving up the privilege of being one of the only two countries in the world that outlaws divorce, has not expressed any reservation about the great destruction to family values being incurred by the undue exposure to gambling (gaming if you wish to be more polite) by overblown jackpot prizes which exploit human weakness to resist being drawn to the quick rich route which inevitably leads to financial and moral devastation.

Even our commercial community is being severely hit as retailers (and eventually wholesalers, importers or manufacturers further up in the delivery chain) complain that when the Super Five prize reaches jackpot proportions a significant portion of the disposable income normally spent on ordinary consumption, gets deflected to frivolous gambling.

A butcher confided to me that sale of meat in a Super Five jackpot week falls dramatically as presumably the reduced disposable income following the spend on the get-rich-quick illusion, forces housewives to feed their families on pasta with plain butter or hobz biz-zejt.

I think it is time for the authorities to take a fresh hard look at the situation before more damage is caused to family values which ultimately hurts society at large. As a simple first step the authorities should direct that the jackpot should once more be subject to a reasonable maximum figure and that any excess is shared by allocating 50 per cent for future prizes in subsequent weeks and 50 per cent to be donated to recognised NGOs who perform valuable social work on a non-profit basis.

Secondly, the authorities need to control the spread of gambling/gaming channels to avoid seeing gaming machines in coffee shops or other large retailers which should be kept clear of gambling terminals. Gambling terminals should only be allowed in recognised offices like lotto offices where the gambler goes purposely to gamble. There should not be a mix of gambling with anything else imaginable.

Thirdly, gambling of amounts beyond a certain limit should be made subject to more formal procedures. In the financial services sector we are expected to keep documentary evidence of identity with anyone we do business with even in the most ordinary course of business and we are expected to have a long nose to smell that we do not handle any money which could have been sourced from criminal activities. How can it be that people authorised to accept lotto/super five stakes are not obliged to keep identity records of people staking above a certain limit let alone satisfying themselves of the clean source of the funds being staked?

What you read so far is perfect reproduction of a contribution I published in The Malta Independent of Sunday on 11 December 2005. Nothing ever changes but dubious patterns start being formed of jackpots tending to accumulate to juicy proportions in the run-up to Christmas.

The government has to take a decision when the gaming licence comes up for renewal in the near future. The government’s responsibility to protect social values cannot be allowed to play second fiddle to the lucrative income government gets in taxes from gaming revenues. There must be also some control on gaming promotion and advertising. As advertising of tobacco has been practically abolished and advertising of alcohol is strongly regulated it is hardly understandable that advertising of gaming remains uncontrolled, creating a situation where the press, a clear beneficiary of such irresponsible liberalism, has a clear conflict of interest and a heavy feet to influence protection of social values.

Surcharge Surprise

 7^th December 2007
The Malta Independent - Friday Wisdom

You can tell politicians are panicking when they start contradicting themselves, while pretending to be a shining light of consistency. This is exactly what the minister responsible for national energy supplies did this week, when he announced that the surcharge on utility bills was being frozen at 50 per cent for the period up to June 2008 – even though it should have gone up to 97 per cent – if the full impact of market spot pricing were to be passed through to the consumer.

One can well remember how the same minister, upon the introduction of the surcharge mechanism, had insisted that this should gradually move to market prices and should be adjusted every two months to reflect such price movements with punctuality.

From an economic point of view, this what classical teachings dictate. Subsidies act as a barrier to careful use of expensive resources, and will delay the structural adjustment needed in consumption patterns to reflect the high cost of energy.

When the opposition came out with an electoral proposal that they would half the surcharge, the minister insisted on arguing that the opposition’s proposal was economically treacherous, and that the opposition was not explaining how this expensive measure would be funded. You might agree or disagree with the policy, but at least the minister was being consistent.

Suddenly it seems that political convenience needs to take priority over good economic husbandry, and the minister announced that the government will, in fact, be subsidising the surcharge to the tune of 40 per cent, costing taxpayers some Lm40 million. This, without any explanation of how the subsidy will be funded.

How can one claim consistency and continue to criticise the opposition’s policies, while simultaneously adopting broadly similar policies as those one is criticising?

Failure to explain funding for this sudden conversion from conservative economic doctrine to socially oriented measures for a short period of time, padding a few months on either side of the coming election date, leaves observers with a clear impression that this is more a matter of temporary convenience rather than deep conviction.

This may be politically savvy, but for the informed and objective voter, a small but growing minority, this is political deceit by a government shifting its policies to try to retain its grip on power.

We need to face facts that energy prices have gone up, and one way or another these have to be passed down the line to consumers, to ensure that consumption patterns adjust to the reality of the market. Policies should not be made to fit elections. Polices should be consistent and totally shorn of political convenience.

So, by all means grant exemption to social cases (that are proven by reliable means) from the surcharge. But why on earth should the state subsidise those who consume energy beyond what is considered reasonable, for a fair standard of living?

I fully agree that in line with social policy objective there should be subsidization across product lines. So it makes sense to keep butane gas sold in cylinders subsidised, as this is used for basic cooking and heating, and gives little scope for excessive consumption. There is scope for subsidising utility consumption on a quota per person basis, but anything above the quota should, not only be charged the full market rates, but should be loaded with an extra charge to finance subsidies given to low consumers.

Only such measures would force excessive consumers, with a high standard of living showing their high level of income and wealth, to economise on resources by switching to more sustainable sources like solar heating.

I would also argue that prices of fuel at the pump should cross-subsidise basic utility rates. While in many cases, uses of water and electricity up to a certain quota per person, is inelastic to price movements, as they merely serve basic needs; consumption of fuel bought at the pump is much more elastic to price movements and carries a better dose of discretionary use.

Only by allowing fuel at the pump to carry the full brunt of international pricing, can we promote more use of shared or public transport leading to better traffic management, and ultimately to a better environment.

If we continue to tailor such important policies merely to suit election and political convenience, then the electorate should not be amazed if after the election surcharge freeze we could have a post-election surcharge surprise.

Creativity Overdose

 30^th November 2007
The Malta Independent - Friday Wisdom

It is turning into a creativity overdose. The strategic plans published by both the government and the opposition for the development of the Valletta harbour and surrounding zone, is matching the anything-you-can-do-I-can-do-better game of promises about goodies to be dished out by each side if elected.

At least we are being told not only how to spend it, but also how to earn it. The problem, however, is that both parties are setting dead lines for execution which stretch well beyond the next legislature.

The PN puts the arrival date on their time line as 2015, meaning they need two legislatures to deliver, giving them almost uninterrupted tenure of office, stretching 28 years. Labour on the other hand give their dateline delivery year as 2020, meaning they would need three electoral terms to complete the project.

I have nothing against long-term planning. But in a fast changing world it is often of dubious value to make plans stretching so far into the future. The political parties would be more credible if they publish which elements of their plans will get priority for execution within the next legislature, as, after all, the electorate will choose a government for five years. No one should assume re-election down the line.

And of the greatest priority, I hope, would be a very promising initiative in Labour’s document about the City Gate bus terminus. Quoting verbatim this reads: “This project will also include the transfer underground of the City Gate bus terminus …creating a pedestrian area from the Malls Gardens right to the City centre”.

If we do anything, we have to do this project. The present bus terminus and surrounding kiosks are an insult to the World Heritage Site that is Valletta. Irrespective of whether the existing City Gate is appropriate or not for a walled city, what is certainly inappropriate is having its main pedestrian access point a perfectly organised confusion, with pedestrians criss-crossing among moving buses. The kiosks, with merchandise overflowing onto the pavement and often covered or protected by wind breakers – more appropriate for fields rather than for retailing outlets in a prime area – are a display of shabbiness and proof of poor standards.

I just returned from Salzburg where I could admire the cute wooden stalls erected in perfect order side by side to create a temporary Christmas Market in the city centre. For a market lasting a handful of weeks, Salzburg organises perfectly designed and uniform stalls. For kiosks being used day in day out in our City entrance, we have no power of persuasion or measures of discipline to impose a uniform and organised approach.

Less appealing is Labour’s proposal to develop the Royal Theatre site into an office building for financial services, to create a financial district in the area comprising the Stock Exchange and the Central Bank.
Valletta is appropriate to be a city for the citizen, not for business. A financial district attracting international business would have little inter-action with either the Stock Exchange or the Central Bank. More likely their interaction would be with MFSA as regulator, located on the Mriehel by pass.

It makes little sense to load further traffic and parking stress on Valletta, by adding business traffic to the private commercial attractions which draw huge crowds to Valletta each day. If we succeed in attracting business to form an international financial district, then its ideal location would be the site presently occupied by the Marsa power station, due to go out of business by 2015. On the SmartCity model it should be possible to attract PPP interest to develop this site and give a soul to the inner harbour area.

The Royal Theatre site ought to be developed into a project which meets the needs of the residents and tourists that daily throng in Valletta. Primarily for tourists, especially the cruise line visitors who are here for only a few hours and have no real opportunity to get to know us, it would be ideal if we could mount a visual display of our unique collection of prehistoric temples and cultural treasures there. The purpose would be to whet their appetite for a longer visit.

Rather than house complete government departments like the Inland Revenue, as Labour propose, this site should embody customer service points of the various government departments and national entities, giving us a single building where people can get a complete service without having to go from east to west and north to south. With Social Services department just across the road, a building servicing passports, ID cards, income tax enquiries and education department services would go a long way in offering a focused service point releasing many other buildings to house more appropriate cultural and commercial activities. I would even tolerate the housing of the parliament building here if it released precious space in the Presidential palace for more appropriate touristic and cultural uses.

Before spreading ourselves too thin in a multitude of projects stretching over several legislatures, we need to focus on the urgent work needed to give Valletta the pedestrian access it deserves and to render it a city for the people.

Cash Piles

23^rd November 2007
The Malta Independent - Friday Wisdom

We had two different types of cash piles in the news this week. The one closer to home was discussed at the general meeting for the shareholders of Maltacom plc, now officially renamed GO plc, where the shareholders rightfully queried the company executive what it plans to do the some thirty million liri of liquidity sitting in the company’s books for which there is no evident purpose.

Given the very low level of market price at which the shares of Maltacom have been trading on the Malta Stock Exchange, some 12 per cent below privatisation price on the sale of majority shareholding to TECOM which of itself was some 25 per cent below the last trading price before the announcement of the acquisition price, shareholders rightfully demanded why the executive should not put their money where their mouth is and start buying back the company’s own shares on the market. This would be a very powerful signal to the shareholders that the executive considers that the market is seriously undervaluing the company and could kick start fresh demand for the Company’s shares which would drive the price to a more realistic level.

Rather than accept such suggestion as a practical way of returning funds that the company does not need for its own development to its shareholders, the Chairman was reported as defending the holding of such excessive liquidity to finance overseas projects being eyed by the company.

I would not wish to enter into the merits of how appropriate it is for Maltacom to give priority to such foreign acquisitions over returning capital to shareholders as obviously I have no access to information on how attractive such foreign investments could be. However I know that there are not many acquisition targets with a price tag of thirty million liri. On top of that I feel that shareholders never invested in Maltacom to finance foreign acquisitions. Given that the majority shareholders ought to have no problem to finance their acquisitions themselves outside the Maltacom framework it is prudent to give Maltacom’s small shareholders the final say as to whether they want their executive to use the company’s excess liquidity to finance foreign acquisitions or to return capital to shareholders.

However this brings home another important point that I had raised at the time of the sale of a majority stake in Maltacom by government to Tecom. Given that the share price was arrived at on the basis of estimation of future operating cash flows from the core Malta operations rather than on the value of present assets, why did government not distribute the excess cash, surplus to operational requirement, to the shareholders (itself included) before the transfer to TECOM?

This is an enigma that was never satisfactorily explained or answered and together with the failure to transfer out of Maltacom the valuable Qawra land before sale to TECOM, makes this one and only privatisation under the Gonzi administration a failure. Whether it can be justified in a wider context on the basis of TECOM’s investments in Smart City remains to be seen even though the government had itself insisted that the two matters are not connected and each deal had to stand on its own two feet.

The other cash pile in the news is the foreign reserves in the hands of the oil exporters and emerging markets economies, including China, India, Russia and Brazil who among them are now holding 75 per cent of the global foreign exchange reserves. This is a far cry from the Asia crisis and Russia default of 1998 when such countries had very thin foreign exchange reserves to withstand the sudden outflow of hot money from their economies.

The US dollar keeps falling and comes within a whisker of a landmark of 1.50 for every Euro. The argument is being heard more insistently whether the USD still has the merits to remain the principal reserve currency of the world and the unit of account for pricing international commodities such as oil, metals and wheat amongst others.

As the US economy slows down under the weight of its housing crisis and seems to be moving closer towards the edge of a recession, the outlook for the USD, at least in the short term, remains poor. If the Federal Reserve has to cuts US interest rates still further to protect the economy from a recession, this will continue to devalue the external value of the USD and will give rise to continued concern to emerging economies about the wisdom of continuing to accumulate such USD amongst their foreign reserves.

With the Euro just about to celebrate its ninth year of existence its fate of becoming a reserve currency with comparable weight to the USD seems to be materialising much earlier than anyone could have imagined especially when just 5 year years ago the Euro was trading at some 80 cents for every USD. It has nearly doubled its value against the USD in just over five years.

The status of reserve currency brings much greater responsibility as well as considerable pain at the adoption stage as the rate tends to overshoot causing problems of competitiveness for domestic producers. But if this is accepted as a challenge of creative destruction, i.e. the replacement of non competitive units by new investment in higher value-added competitive units attracted by the reserve currency status, then the long term benefits from the switch the cash piles of emerging countries from USD to Euro could be enormous.

Lost Composure

16^th November 2007
The Malta Independent - Friday Wisdom

Ever since the Prime Minister decided not to go for a general election on this side of Christmas I perceive a certain loss of composure and self-confidence on the PN’s side diluting the boost they had received through the impact of the Budget novelties.

The decision to hold the election after the Euro changeover date should have been a sign of confidence by government in its ability to engineer a smooth changeover without any abnormal inflationary impulses due to the rounding up of prices upon conversion of the currency.

Yet government suddenly seems to have been gripped by fear that it has allowed itself hostage to fortune, as it is practically impossible to avoid some rounding up price pressures. Though insignificant in the grand scheme of things of how inflation is measured, such price pressures coming during an election campaign could be quite powerful points of criticism in the hands of the opposition and could very well prove a useful tool to discredit the image of a safe pair of hands that the PN wants to portray upon their leader.

Reality is that prices increase all the time. It is unrealistic to expect zero inflation and indeed such a hypothesis could be economically dangerous as it could tilt the economy into a depression, i.e. a general level of price reductions which would kill off demand in the economy as people will wait to buy tomorrow at a cheaper price what they can buy today at a higher price. The European Central Bank has an official inflation target of below but close to two per cent.

What must be avoided as much as possible is a widespread process of rounding up of prices as a direct result of the currency changeover. Government could have passed a law to prohibit price increases but given that we have a market economy and given the difficulty in policing and enforcing such law, government opted for something more effective and more practical. The voluntary agreements for price stability until March 2008 are not intended to ensure eternal price stability. They are merely intended to ensure that suppliers voluntarily bind themselves to keep prices stable over the currency change over period; to ensure that the consumer is given time to adjust to the new currency regime. Of course price increases after March 2008 are possible and indeed probable. But by then the consumer would know that these are price increases in the normal course of things and not price increases through abuse as a result of the currency changeover.

The best safeguard against price increases is free market competition and easily accessible information where the consumer can compare prices. After March 2008 we will have the same price policies based on the free market concept as we had in every March of recent years.

Government seems to have lost its confidence to explain such simple things and is somehow allowing the virtue of price stability agreements to be changed into a perceived vice of possible price increases after March 2008 without effectively explaining and defending its totally rational position.

Another sign of government losing its composure is the pitiful reply which the Prime Minister gave to a Super One journalist about the expected completion date for the Manwel Dimech bridge project. This project is celebrating its quccija these days.

It should have been completed by now, yet work is still proceeding on the St Julian’s Bay side of the bridge. The work on the Swieqi side has yet to start. The Prime Minister simply refused to be committed to a completion date for the project.

The obvious answer should have been that the contractor involved has been committed to finish the project by such and such a date and failure to do so would involve penalties which the government will invoke with rigour.

Yet the Prime Minister’s obstinate refusal to commit his government to a definite completion date shows he is not in control things and that is hardly typical of a safe pair of hands.

I have no idea what made the Prime Minister discard the idea of seeking a refreshed mandate on this side of Christmas.

Maybe the hope and expectation of a Christmas laden with feel-good factor, a smooth currency changeover and tangible result of budget – measures which will be included in the January pay slip – has persuaded the PN that it stands a better chance in February than in December.

They are possibly under-estimating the perceived, not necessarily the real, inflationary effect of the Euro and may be they are expecting lasting gratitude from the electorate for the economic boost families have been given by the Budget measures. Possibly the PN have under-estimated the reality that novelty wears out quickly and budget measures quickly solidify into a given and the electorate would be more impressed by fresh election campaign novelties rather than by yesterday’s news.

The PN could possibly soon regret their decision not to go for a 2007 election. On the other hand, they could find some comfort that their faux pas is well matched by Labour’s misplaced criticism of the quality of health services being provided at Mater Dei instead of focusing their criticism on the gross absence of value for money in this project.

Boring Bankers

9^th November 2007
The Malta Independent - Friday Wisdom

Central Bankers are generally very boring people. They have more independence than most other national organisations, an independence almost at par with that of judiciary outside Pakistan. They are tasked to keep the value of money stable but the only tool they have to do so is a very blunt one. Central banks are in charge of monetary policy which in simple language seeks to control the level of interest rates in the economy.

As the theory goes, if an economy is growing more than its potential, the excess demand will translate itself into rising prices so the Central Bank tightens monetary policy by raising interest rates to convince people to consume less and save more and thus bring back demand to within the economy’s potential. If on the other hand the economy is growing very slowly and below its potential causing excessive price stability or deflation through price reductions, central banks tend to lower interest rates to stimulate demand and kick start the economy.

Central banks get into a quagmire when they are faced with an economy with low real growth and high inflation as any attempt to stimulate the economy by lowering interest rates to stimulate demand could complicate an existing inflation problem. On the other hand, if they raise interest rates to address inflation they could throw a low growth economy into an outright recession.

When faced with such stark choices of conflicting objectives, central banks in developed economies that enjoy true independence from the executive are generally expected to give priority to the inflation objective. Quite often this would irk politicians whose objective time frames are generally as short as the date of the next elections. This is the reason why central banks cherish their independence which is the corner stone of the euro monetary system.

Changes in interest rates, unless of a draconian nature in the Paul Volcker style in the early 1980s, would only have an effect on the real economy with substantial time lag and this is why central bankers, boring as they may be, are expected to stay ahead of the economic curve and model their interest rates decisions to pre-empt problems rather than to address them. Otherwise interest rate changes decided today will have their real effect in 12 or 18 months down the road when the problems may have changed. So unless central banks stay ahead of the curve they could be prescribing a medicine unsuitable for the malady.

This could explain why for example presently there are people who query whether the US Federal Reserve is fuelling inflation by cutting interest rates too soon and by too much while others are arguing whether the European Central Bank is asphyxiating growth in Europe by not cutting interest rates and letting the Euro appreciate too much.

If central bankers are boring people, Maltese central bankers should be doubly so. They will no longer have monetary policy to administer as of 1 January and given that they have already lost banking regulation to the MFSA and exchange control to history, I sympathise with those who might think that our central bankers will be quite relaxed, outside their economic research department, as from next year and hard put to justify the use of their current resources, both human and physical.

So it is quite amazing that on the eve of joining the euro our Central Bank seems to have entered into an argument with the government about release of excessive foreign reserves to pay off part of the national debt. What’s more funny is that this duel is being made with the Times of Malta who are acting as an unofficial proxy for the government so that the latter avoids giving the impression that it is challenging the independence of the central bank.

Leaving technical issues aside, as these could be quite complicated, the crux is whether the excess reserves that are not required to cover the currency in circulation component under the new euro regime should continue to be administered by the Central Bank or released to government to pay off the national debt.

Those who argue that this will save us millions in interest servicing costs of the public debt seem to forget that this will be neutralised by lower profits by the central bank which in the end would flow back to the public exchequer. So we will lose on the swings what we gain on the roundabout.

Personally I would prefer to see these reserves stay with the Central Bank if for nothing for the avoidance of the possibility of giving this and future governments capacity to rebuild the public debt and still stay within the euro rules. On the other hand the Central Bank has to start practicing what they preach and explain what measures they would be taking to improve their efficiency given their reduced workload. They should also be more transparent about their performance in the management of foreign reserves.

Small fry investment services operators entrusted by their clients with portfolio management are under the new MiFID regime expected to report performance every quarter against a declared benchmark. Why should our professionals at the Central Bank avoid measuring their performance publicly against a benchmark given they are handling pretty high figures with several zeros behind the digits?

There is another enigma with the business of central banking. When things are going well central banks target their monetary policy to keep retail prices under control but take very little interest in asset price inflation. For example the Central Bank never pitched their interest rate policy to control the real estate price explosion of recent years. When things turn bad, as is happening presently in the US housing market which inevitably spills itself into the financial markets and possibly on the general economy, central banks start cutting interest rates aggressively in order to stabilise the economy and create a cushion for a soft landing.

But something is wrong somewhere. What applies to the downside should also apply to the upside which can only be done if central banks include asset price inflation in their monetary policy stance and if they have direct regulatory control over the markets not only in the banking sector but also on its periphery that contribute to asset price inflation or outright asset price bubbles. The whole regulatory regime needs to be re-engineered in the light of the 2007 experience.

Budget (non) Vision

2^nd November 2007
The Malta Independent - Friday Wisdom

 

If anything stands out clear from the budget debate it is that both the government and the opposition are on political trip of fiscal patchwork that sees no further than the next election. The short-termism is palpable.

To my point of view the objective of a budget ought to be the delivery of sound fiscal policy that stimulates operational efficiency and long-term sustainable economic growth to develop the economy to its full potential.

To achieve such objective a budget has to carry as proximate targets the need to keep marginal taxes low enough to stimulate economic activity and promote tax compliance by making it more economic than tax evasion. It also has to minimise transfer payments as these serve to bloat the government’s share of the economy and leads to inefficiencies as the government takes money from taxpayers with one hand and gives it back to same taxpayers with the other hand without adding value. It just adds inefficiencies as the government takes our taxes and gives us back part of our own money in children’s allowances.

The budget fails to generate such vision. It effectively does the opposite. Marginal tax rate is kept at 35 per cent, which is high by today’s standards when many competitor countries are working with flat tax rates at around 20 per cent or less. There is no vision to continue with the shift of fiscal impact from earnings to expenditure and instead leaves the economy to operate with marginal tax rates that are high enough to make evasion more economic than compliance.

Furthermore we continue with the social blasphemy in our fiscal laws where the fruit of labour is charged at a rate (35 per cent) higher than the fruit of capital (15 per cent in case of withholding tax application on investment income).

The opposition proposal to exempt overtime from income tax further complicates matters as it creates distortions in the composition of pay packages and discriminates against white collar middle income employees who are not paid overtime. It also discriminates against blue collar and junior white collar employees who in the absence of overtime opportunities at their main employment supplement their income through part-time jobs.

Our fiscal structure needs a total overhaul. It certainly can do without pre-election patchwork which puts some sugar on the front end and makes the long-term overhaul that much more difficult.

Our objectives should be twofold. To reduce marginal tax rates to the same level of the VAT rate so that we will have one common rate throughout the economy applicable to all marginal income, whatever its sources, and to all marginal expenditure. This rate will be low enough to make compliance more economic than evasion as the experience with withholding tax on investment income clearly indicates.

The second objective should be to reduce transfer payments so that the individual interacts with the government at only one point i.e. through taxation which could be positive or negative. The only other point of interaction would be in payment of contributory benefits like pensions the arrangements for which will remain intact.

Such a system would ensure that all government departments, with very few exceptions like justice, law enforcement, foreign affairs and the revenue departments, would operate on a strict commercial basis with as wide competition as possible to ensure maximum efficiency. The government would retract itself to become the enforcer of standards and consumer protection and will reduce its role even in delivery of services that can be delivered by market forces even in the field of infrastructure and maintenance, education and health.

This is not a vision that could be implemented through a single budget in a big bang method. But each budget has to make a contribution towards this destination. Regrettably the 2008 budget takes us in the opposite direction and proposals from the opposition do not help either.

We have lost our vision which needs to go much further than optimistic hopes of balancing the budget by 2010. We have to target growth, real growth at our maximum potential. We have to extend the limits of our potential and we have to economise on the use of resources by giving a huge impetus to efficiency by changing the way we do things around here. That which in MBA programmes is commonly referred to as the culture.

Electoral exigencies conditions politicians to fiscal patchwork. Let’s hope the newly elected government will focus of fiscal restructuring that deliveries the bacon over a medium term so that we can continue to earn an enhanced standard of living in a very competitive world.

You Can`t Handle the Truth

26^th October 2007
The Malta Independent - Friday Wisdom

This is what Jack Nicholson told Tom Cruise in the movie A few good men when Kaffee (Cruise) was interrogating Colonel Jessep (Nicholson) in a court marshal trial of two marines who obeyed orders to administer a code red (unofficial punishment) on a colleague who was not capable of physically performing up to the expectations of the colonel.

It is this quotation that sprung to my mind as I continued to dissect the budget for 2008. It feels that this government is telling us, the governed electorate, that we cannot handle the truth and that we have to be fed a few good lies and half truths in order not to get hurt by being tempted to elect Labour in government come next elections.

Let me start with the COLA increase of Lm1.50 which is Lm1 more than what should have been paid under the tri-partite COLA mechanism in operation since 1990. Would this have happened if this was not an election budget? And perhaps more importantly how sensible it is to continue with this out-dated system of legally enforced across the board COLA increases when we are entering the rigidity of a monetary union? We are giving up the economic tools of monetary, interest rate and exchange rate policies and government has pretty little room to manoeuvre within fiscal policy given its commitment to balance the budget by 2010.

As has been repeated ad nauseam, we can only remain globally competitive if we continue to restructure, and without the economic tools that will be sterilised by the monetary union, such restructuring has to take place directly in the real economy. But how can this happen if we continue to legislate across the board COLA increases totally unrelated to productivity? Or are we still thinking that monetary union is some free lunch?

Why can’t we be told the truth that in the context of a monetary union wage indexation, that is legally enforced irrespective of productivity, is a recipe for disaster? This is so especially when we are joining in the monetary union a currency that has become irrefutably and fundamentally overvalued against all major currencies, not least the US dollar, Japanese Yen and dollar pegged currencies of emerging countries in Asia and South America including China, India and Brazil.

How else are we being denied the truth we are presumed unable to handle? Consider this. Income tax revenue in 2006 was Lm598 million. Income tax revenue projected for 2008 is Lm728 million. An increase of Lm130 million in income tax revenue over two years when in each of these two years the government has increased tax allowances to the value of Lm12 million i.e. Lm24 million forfeited income tax revenue over two years. So added to the increase of Lm130 million, this is really a gross increase in the tax take of Lm154 million which is 26 per cent of the 2006 tax base.

Even the most optimistic “Supply Side” economist will question the realism of such an increase in the tax take when the economy is growing by less than four per cent per annum in real terms and six per cent per annum in nominal terms, which at best may explain about half the projected increase in the tax revenue. Where is the other half, a whopping Lm77 million coming from and what contingencies are being made in case this fails to realise itself?

We have been here before. Roll back your memory to another election budget for the year 1996 when the government again made very generous income tax concessions in expectation of substantial increase in indirect tax revenue through the then newly introduced VAT system. The expected increase in revenue from VAT proved to be overly optimistic and the result was a harrowing actual 1996 budget deficit which we continue to nurse till this very day. Now that we are seeing the budget deficit reduced to sustainable figures, the government, for pure electoral exigencies that have no place in good financial housekeeping, is again making optimistic assumptions for tax revenues to justify distributing the goodies before the bacon is delivered.

Is this 1996 all over again? 11 years ago to this very day a Labour government was elected to find that a projected budget of Lm32 million was in fact running in excess of Lm100 million without a single word of warning being uttered about it in the election campaign.

Is the government once again gambling the stability of public finances, gained the hard way over more than a decade of oppressive tax increases, for the sake of political convenience? Does this contain the unbelievably selfish argument that if this works the PN will be back in power with a five-year term to patch things up and if it does not work they will ensure that a new Labour government will find it tough going having to nurse public finances back to health and thus being unable to deliver on the many promises being made on the basis of inheriting a strong public finance situation?

I wrote this piece before I had the opportunity to examine the Opposition Leader’s criticism of the budget. Dr Sant once defended himself from some politically inconvenient truth I had mouthed saying that I tend to reason like a banker not a politician.

I don’t regret it and presumably that’s why I did not make a career in politics. But Labour is no less guilty of avoiding the economic truth. Too little too late may be politically convenient but economically it is a non-starter. It sounds not merely gambling but doubling the odds.

Can’t we be trusted to face the truth that it is too risky for our own good to upset public finance stability in the context of a monetary union rigidity and that tax credits should not be given before we are reasonably certain that the projected inflows will in fact materialise? Can’t we be trusted to handle the truth?

Budget in Different Contexts

19^th October 2007

The Malta Independent - Friday Wisdom

You really would have to struggle to try to analyse the budget for 2008 presented this week in parliament out of the immediate context of the impending general election. Out of 93 pages of the Budget speech booklet there is only one page that attempts to put this Budget in a longer term context until 2010. All the rest speaks of performance so far, performance expected till the end of this year and measures to be applicable for 2008.

With a general election due in all probability somewhere in February next year, it is politically compelling for government to tailor the budget with the election in mind. Measures announced have been costed as putting an additional Lm21 million in consumers’ pockets and they have clearly been designed to address the laments of wide and narrow sections of the electorate that have been breeding discontent and sending signals of their readiness to switch their vote.

A second round of tax band widening is clearly addressed to reduce the tax burden of the middle to high income families that have been hit in previous years through fiscal measures such as fringe benefits taxation. The granting of the full cost of living allowance to pensioners meets a demand they have been making year in year out for as long as I can remember. Extension of the benefits under the children’s allowance scheme rolls back restrictions which had been gradually introduced rendering the application of the children’s allowance very narrow. Through the announced measures it has been extensively widened. A middle income family of four could find itself better off by about Lm7 a week through the cumulative effect of the budget measures.

Other specific measures have more telescopic impact although collectively they amount to considerable feel good generation. Exemption or reduction of VAT on selective sports and cultural activities, tax exemption of subscription fees to children’s sports club, measures aimed to ease the hardship of sick and handicapped irrespective of means testing cost little but mean a lot to those who start benefiting there from.

How all these measures are being financed without new tax measures and while continuing to reduce the budget deficit could initially be mistaken for some classic example of supply side economics. This is the economic credo of those who maintain that lowering taxes does not necessarily lead to reduction of government revenue as the reduction in taxes could generate economic growth leading the application of lower tax rates on a wider base resulting in a larger tax take for the exchequer.

A closer look at the revenue side of the budget however shows this is hardly the case. Ordinary tax revenue is scheduled to increase by 5.3 per cent well above economic growth rate and evidently contains a measure of better enforcement. Recurrent expenditure, including all budget measures is scheduled to increase by 3.3 per cent indicating substantial freezing of government operational expenditure to allow room for the funding of the announced measures from the projected tax revenue growth.

What has largely gone unexplained is the increase of revised estimates of Income Tax revenue during the current year 2007 which is projected to exceed the original estimate by Lm30 million. This increase in 2007 additional income tax revenue can by itself finance all the measures announced in the budget for 2008.

Government has been very scant in explaining this growth of income tax revenue. One liner stating “additional revenue is expected on various taxes on income” is hardly sufficient to explain more than 12 per cent increase in income tax revenue in 2007 over 2006 which is more than three times normal economic growth and this at a time when tax allowances were given by way of widened tax bands.

More detailed explanation is merited lest we start suspecting that there is an artificial exercise of shifting revenues across yearly divides purely to strike a pre-determined bottom line figure.

In the comments I heard following the presentation of the budget, there has been little or no effort to give significance to the long term context of the Budget; how will it lead to higher economic growth so that we can continue to enjoy improved standard of living based on real earnings rather than debt.

Our economy has grown by 3.6 per cent which though better than the 3.2 per cent of previous year is still the lowest of the new EU countries with the exception of Hungary. We have grown because Europe, our main trading partner, has grown. There are no measures in the budget which can make us optimistic that we can accelerate our growth to the same tempo of other new entrants. On the contrary there is total disregard of problems facing loss of competitiveness of important manufacturing units that with the strengthening Euro versus the US dollar are being forced to consider relocating fully or partially to dollar based economies in the Far East.

Mandatory cost of living increases payable in advance could in fact accelerate the pace of such relocation. This COLA business has grossly outlived its purpose and needs scrapping sooner not later except for its effect on the minimum wage. The unions must regain their role of negotiating one increase across the board with each employer taking into account efficiency gains that vary from workplace to workplace. The COLA is indiscriminate in this regard and could send a few industries to their grave prematurely.

It is healthy that in the medium term budgetary figures till 2010 government is planning to reduce its recurring expenditure from the current 35.1% of GDP to 32.2% of GDP by 2010. It is not so healthy that government is freezing the capital vote at current level during all this time. We need to continue investing in our infrastructure to render our economic outfits more competitive to withstand the challenges of a strong Euro we have de facto already adopted.

Premature Exuberance

12^th October 2007
The Malta Independent - Friday Wisdom

As we enter the final stretch towards D-day for the adoption of the euro, I cannot help noticing a measure of premature exuberance, celebrating an achievement which has not yet been achieved and risking slip ups through over-confidence at the most crucial time of execution.

It is as if Italy started celebrating winning the FIFA World Cup 2006 two months before the event when they beat Holland 4-1 in a friendly encounter.

The euro adoption project does not consist solely or primarily of the administrative steps needed for its adoption. Indeed in the long run of things this will be a relatively minor part of the project.

This is not to say that the National Euro Changeover Committee has not done an excellent job in administering efficiently the change over process. The praise they have been showered with even from foreign authoritative sources is well deserved. Their job has been facilitated by the political consensus that has surrounded the project. This has permitted the NECC to brand it with a national imprint so necessary to obtain acceptance and cooperation from a very wide cross-section of the population.

But we should not deceive ourselves into believing that this is what the adoption of the euro is all about, and that the good work of the NECC is enough to guarantee the success of the project.

The real success or otherwise of the euro project can only be assessed and measured a posteriori after the actual adoption. There will be two tests that have yet to be overcome. The first one is to ensure that the changeover will not bring about any noticeable increase in prices, neither of a one-event nature and certainly not a spiral of price increases feeding on itself.

I don’t think that enough is being done to ensure that from an inflation point of view the NECC will live up to its motto that only the currency is changing but the underlying prices should remain, all things being equal, the same as if no currency changeover has happened. In a few words if a product was being sold at LM1 before the changeover it will be sold at EUR2.33 after the changeover and there will be no rounding up to 2.35, 2.40 or 2.50.

What else can be done in this regard? We need an intensive educational process of managing expectations of price stability. The consumer has to be trained to challenge price increases caused by the rounding off effect from currency changeover. The anchoring of such no price increase expectations has to be very deeply ingrained in the consumers. In business, merchants sell their products and services for the highest price consumers can take. If merchants perceive any readiness on the part of consumers to accept price increases due to the rounding effect of the currency changeover, rest assured that they will use this pricing power to the detriment of the consumer.

Next Monday is budget day. It is tempting for the government facing an election that will probably be held within two months after euro adoption, to score some political points by offering a financial one-off reward in advance for any price increases resulting from the changeover. What’s more effective to sway voters’ opinions than sending them a cheque in the post during an election campaign?

This will go diametrically opposed to the need to anchor expectations of no price increases and will practically give a license to merchants to round up prices on changeover.

I don’t agree with muted suggestions about imposing temporary price freeze. Apart from the extreme difficulty of policing such price freeze, the price increases will at best be postponed and not avoided. What is needed is correct and easily available information which consumers can use to their advantages in policing directly unjustified price increases. The voluntary price freeze agreements being signed with private sector operators are good and welcome in so far as they go. But who is going to ensure that they are honoured where it matters ie, at the retail end to the delivery chain?

In days of ICT revolution, it should be fairly easy to enforce dissemination of information by forcing retailers, wholesalers and importers to file an official price list with the NECC or Consumer Affairs office at the end of each month between October 2007 and March 2008. This information should be pasted up an on appropriate website where consumers can search by VAT Registration number shown on their fiscal receipt to know whether prices are being unfairly rounded up or indeed increased beforehand in anticipation of the currency changeover. Information is the best tool for consumers to protect themselves from price exploitation.

In the longer term, the success of the euro project will be measured by how much our economy remains competitive to export to the rest of the world and to attract foreign direct investment. Before we joined the ERM mechanism in May 2005, I had argued that we could suffer from loss of competitiveness by locking in at a rate which I perceived as fundamentally overvalued. Once the decision to lock in at just under 43 cents per euro was made I rested my case and worked for competitiveness to be achieved by restructuring in the real economy.

Two and a half years later and just on the D-day threshold, I am pleasantly surprised that our competitiveness has not suffered and that restructuring kept pace. There is no doubt that the euro project itself served as a catalyst for acceptance of an accelerated pace of re-structuring, but we should also thank our lucky stars that the world economy has been experiencing a very glamorous period of economic growth, not perceived likely in May 2005, which has eased the pain of restructuring and helped us to regain competitiveness without resorting to exchange rate adjustments.

The restructuring cannot be considered as having reached its destination on Euro D – day. It must continue relentlessly if we are to keep winning in a competitive world. With very limited or no room for manoeuvre in the monetary, exchange rate and fiscal policies, the restructuring has to be made in the real economy, where after all it is most effective.

This is no time for irrational or premature exuberance. It is time to focus more determinedly to the need to achieve a smooth price changeover without any inflationary impulses and to ensure that euro adoption will continue to be catalyst for accelerating the pace of restructuring.



   

Rock Sand and Confidence

5^th October 2007
The Malta Independent - Friday Wisdom

The Northern Rock is melting. Confidence had turned sand into a rock. Lack of confidence in the UK financial system is causing the rock to crumble back into sand. Soft confidence can do or undo what hard sledgehammer tactics fail to scratch.

This might be of little relevance to us in Malta given that we have a very solid and overly liquid banking system and there is not even a remote possibility of the inter-bank money markets seizing up as they did in UK. But given that we adopt a similar regulatory regime as that adopted in UK, it should interest us to watch and analyse how effectively this regulatory regime has performed when put to real test of financial stress.

In Malta, as in UK, there is separation between the monetary policy and financial stability oversight duties adopted by the Central Bank from the banking regulation duties adopted by the financial regulator (MFSA in Malta and FSA in UK) that actually licenses and regulates banks at the institution level.

The purpose of this separation was meant to ensure that the Central Bank is and is perceived to be totally autonomous in the conduct of monetary policy without being influenced by the stability of individual institutions.

How has it worked out in practice in the case of the Northern Rock crisis? Not very well I must say. With this first hand experience of how the system works when put to the stress test, it might just as well be that we need to review the whole structure of regulation, financial stability and monetary policy execution.

Northern Rock was a mutual building society that converted to commercial bank status being fully licensed and regulated by the FSA. Its business model involved operating as an important niche player in the UK mortgage market with very limited branch network for raising retail deposits and instead funding its mortgage loan book by short-term funding on the inter-bank markets and the wholesale commercial paper market.

No one has in any way accused Northern Rock that it has adopted irresponsible lending practices or that it is suffering any material deterioration of delinquency ratios of its loan book. On the contrary, regulators went on record stating that they are completely satisfied of the robustness of Northern Rock loan book and that the illiquidity problems have been caused by extraneous sources of systemic disturbance. Mortgage problems in the US and direct and indirect – as yet unquantified – exposure of some of the UK bank players to such problems and the general and sudden investors’ attitude shift from one of strong risk appetite to one of substantial risk aversion, forced the wholesale and inter-bank money markets to suddenly seize up.

Without the working of an efficient and liquid inter-bank market, the business model of Northern Rock went through the shredder. While the Bank of England was adopting a hands-off approach interpreting the problem as being specific to Northern Rock, depositors started lining up demanding instant return of their deposits.

The confidence foundation built over decades and decades of central banking tradition in acting as a lender of the last resort for preserving the integrity of the banking system was thrown out of the window in a couple of days by what appears to be lack of co-ordination between the FSA and the Bank of England. This lead to some under-estimation that Northern Rock was melting down due to a systemic freezing for reasons beyond its control and unconnected with their integrity of doing business.

Then when it was too late for confidence to escape unscathed there was a vault-face by the Bank of England. Not only did they suddenly give all the necessary credit lines and liquidity for Northern Rock to fund all the deposit drain in process but when this was not enough to reinstall confidence, they forced the Chancellor of the Exchequer to take the unprecedented step to guarantee all deposits of Northern Rock, and by implication of all banking institutions that might find themselves in its same position.

I dare suggest that this would not have happened if the Bank of England was directly responsible for licensing and regulation of individual institutions as the Bank of England would have had first hand ongoing experience of the problems of Northern Rock. It would have either not approved Northern Rock’s business model in the first place or would have provided liquidity more promptly without causing systemic seizing and without tarnishing the confidence foundation on which all of our financial systems are built.

Now with this first hand experience of how well or otherwise the new separation of duties between regulation and monetary policy has worked in practice, we can pass some judgement. Which is the more damaging? The risk of monetary policy execution being contaminated by the moral obligation to save a regulated institution or the risk of lack of coordination between the various regulatory players leading to a systemic failure causing the near collapse of licensed institution for reasons that are totally extraneous to their operations, causing hardship to individual depositors, leading to anxious queues outside branches right in the City which floats on financial confidence, and forcing the government to take on the obligation of the insurer of the last resort.

How are MFSA peer institutions in the euro area countries going to increase their coordination with the ECB to ensure that the Northern Rock experience in UK is not repeated unnecessarily in the euro area we are just about to join?