Inflation in a Toothpaste Tube

 

24^th April 2009

The Malta Independent - Friday Wisdom

Ironing out inflation from the economy is often like pushing on a sealed toothpaste tube.

For all the concern which central banks routinely express in their fight against inflation they know that the economy can only grow stably if there is a small degree of inflation. Given that economy is a very dynamic system, if there is no inflation there grows the risk of falling into a deflation spiral which is much more feared.

Generally an inflation level up to three per cent p.a. is considered ideal. The European Central Bank, known as typically more conservative in the old Bundesbank tradition, has an express inflation target of below but close to two per cent. Inflation at this level is considered necessary to oil economic growth within a context of reasonable price stability. Investment is stimulated as stable macro-economics make visibility of demand more predictable. Investors become more willing to undertake debt to finance investment with the comfort of predictable demand for the goods produced from their investment and with the assistance from inflation in lessening gradually the burden of the debt. Savers on the other hand are not deterred as the erosion from inflation is unobtrusive, while consumers are encouraged to take on personal credit to augment demand beyond what is affordable from normal incomes.

Inflation is of two kinds. The one that is most generally referred to is inflation at the retail price level, meaning inflation of the goods and services bought regularly for consumption purposes. However there is also asset price inflation, meaning inflation in prices of assets that we normally buy for investment purposes, especially real estate and financial investments.

Central banks have so far tended to focus on the former type of inflation i.e. retail price inflation. But if the current financial turmoil is delivering a lesson, it is that the dynamics of the economy are such that going forward central banks will find it inadvisable if not dangerous to ignore asset price inflation in their execution of monetary policy. The economy is a wholesome affair, and ironing out inflation in one place could simply be transferring it to another. Hence the analogy of pushing on a sealed toothpaste tube!

The economic history of the last forty years shows alternating period of general price inflation which when controlled merely shifts to asset price inflation. The massive retail price inflation caused by the oil shocks of the seventies was addressed by tight momentary policy and high real interest rates which threw the economy in a stagflation recession throughout most of the eighties and early nineties.

When retail inflation was brought under control through recession-induced reduction of demand and through increasing supplies resulting from efficiency gains of the evolving IT technology, inflation merely showed up as asset price bubbles in the financial capital markets leading to the technology bubble which burst in 2000 and 2001. When this was overcome through accommodative monetary policy and retail inflation was rendered even milder through the increase in supply as China started being integrated in the global economy after its joining the WTO in 2000, inflation showed up as real estate bubble in the US and other countries like UK, Spain and Ireland.

The real estate bubble burst in 2008. China’s accumulating huge balance of payments surpluses became too weighty in ironing out retail inflation from the sealed toothpaste tube. The pressure building up in the real estate sector blew the tube apart and presently we have toothpaste all over the place.

This is the analogy of the financial turmoil with governments being constrained to perform massive interventions to put the toothpaste back in the repaired tube before the economy gets dragged into a deflationary environment.

Putting toothpaste back in its tube is never easy but there should be little doubt that given the massive size of government interventions the world will succeed in avoiding a depression and will gradually return to a normalised demand and gradually start creating inflation again.

This scenario is very distant from present reality where world trade is collapsing; OECD global output is expected to contract 4.3 per cent during this year, and OECD unemployment is seen rising to 9.9 per cent next year (unemployment being a lagging indicator). The output gap is just too big to start envisaging a quick return to retail inflation and this after a sharp correction in asset prices which has caused unquestionable asset price deflation in real estate and equity and corporate bond markets.

Yet there is no doubt in my mind that if we are to avoid a depression or a prolonged recession, we have to create inflation and this will come quicker than we can presently envisage for two reasons. Firstly there is going to be considerable reduction in supply capacity as corporate restructuring and bankruptcies will wipe away whole swathes of supply capacity. Secondly exporting economies like Germany, Japan and not least China will be forced to reduce their export supply capacity and re-direct it towards their domestic markets.

Asset prices have a long way to go before they start absorbing inflation pressures so inevitably inflation will show up across the board in retail price indices. This will be assisted by major shifts in the exchange values of the major currencies with currencies of deficit countries like the US falling substantially against currencies of surplus countries like Japan, China and to some extent Europe.

The massive size of debts being undertaken by governments needs exchange rate adjustments to ease the burden and to some extent this has already happened in case of Sterling for the UK.

This week I spent a soul inspiring few days at the Salzburg Global Seminar sharing these experiences with renowned central bankers, professors from major universities and economic institutions, representatives of the financial media and many peers from all over the world but with substantial representation from Asia.

Having heard such a wide cross section of views I realise more and more how important it is for central banks and principal world Treasuries to put the toothpaste back into the tube, and to avoid for the future exerting acute pressure on any particular spot in the tube by allowing structural macro-economic imbalances.

Abolish Donations

19^th April 2009

The Malta Independent on Sunday

You would not expect a PN candidate for the MEP elections to make the case for more transparency in political party financing as a platform for his election bid. The PN has done pretty nothing to implement the very limited and insufficient measures proposed in the Galdes Report to bring some order to this very obscure corner of our political reality. And MEPs have often come in for criticism about the perks attached to their jobs. which entitlements are often shrouded in obscurity.

Yet, Alan Deidun, a PN MEP candidate, wrote as follows in The Times this week (extract):

“Party funding: Publish those names!”

“Local parties have been solicited to publish the names of their financers for donkey’s years now, to no avail.

“A threshold could be introduced to weed out from the list the non-commercial entities contributing insignificant financial sums, to avoid disclosing the identity of all the John Citizens out there and thus maintain the popular party-funding mechanisms.”

“All political parties should implement the recommendations of the Galdes Commission, concerning political party financing, so that Maltese citizens can get to know where loyalties actually lie. Codes of conduct and guidelines on ethical behaviour have been issued for candidates contesting the impending European Parliament elections – it’s high time that the same guidelines are issued for the political parties themselves.

“It’s been often mooted that the construction industry is the real kitty behind both parties – the time is ripe to confirm or dispel such a hypothesis.”

I have touched on this subject quite often in my writings. It is clear that there is inertia from our political parties, which seem happy with the status quo. This is incomprehensible especially from Labour’s side. The PN has been in government for a generation. From its position of power it had, and still has, every opportunity to maximise resources to gain advantage over Labour. And availability of resources does make a difference. Election campaigns, especially if professionally run, do not come cheap.

Why Labour have not shown much enthusiasm for addressing this scourge is more difficult to fathom. Could it be that expectations that it would soon be its turn in government tempered Labour’s determination to force change as it (wrongly) assumed that it would soon be its turn to cash in from tenure of power?

In truth, the new Labour leader has included this matter in the agenda of the parliamentary select committee that is exploring and reporting on ways to improve the workings of democracy. However, months are rolling by and we have yet pretty little to show for it except some sole initiative by some low ranking party official making a half-hearted appeal to bring the country into the 21st century in so far as party financing is concerned.

Our democracy can never be considered as working effectively unless we dispel the theory of “‘he who pays the piper plays the tune” by revolutionising the way our political parties finance themselves.

To my mind there is only one way that gives a fair chance for this to be achieved. Abolish all kinds of political donations. All means all, from telethon collections to private donations. Political parties are the major instruments through which democracy is exercised and it is fair and just that the State, which benefits so much from the workings of a proper democracy, takes direct responsibility for political party financing. This will achieve maximum transparency as State funding will be controlled by and accounted to the National Audit Office, which will report its findings to Parliament on a regular basis.Any threshold, below which any donations would go unreported, even if low, will be a sure invitation for donations to be structured below such threshold to escape reporting. So to avoid this risk and the arbitrariness of fixing the level of such a threshold, there simply must be no threshold.

Any threshold, below which any donations would go unreported, even if low, will be a sure invitation for donations to be structured below such threshold to escape reporting. So to avoid this risk and the arbitrariness of fixing the level of such a threshold, there simply must be no threshold.

All donations must be abolished and the political parties’ only source of income other than State financing would be the normal fees paid by registered members. No lotteries, no collections, no fund-raising activities!

Free from the headaches of struggling to find the means to finance their operations, the political parties should focus on their core business, i.e. that of being political parties. Political parties should not be media companies, travel agents, or communication services providers. What sense does it make to pursue a process where, after the government, having divested through privatisation most of its operational functions, we see political parties expanding their activities into such same operational functions? If political parties are allowed to perform, directly or through subsidiaries, any such commercial activities, it would be an quite easy to obtain donations under the guise of commercial payments to escape the limitations that may be set for direct financing rules. So any reform involving party financing must compulsorily include control over the activities of commercially operating subsidiaries, and the best control is total abolishment.

Such a revolutionary approach would bring into question the parties’ access to mass media. We must be quite unique in having the two main political parties operating their own radio and television mass media. With the benefit of having 17 years’ experience where political parties own and control their own mass media, we can draw conclusions whether this has helped the proper working of democracy, whether this has served to polarise the electorate or has aided the electorate to be better informed with a cross section of views from the different political factions.

The time has come for this 17-year experiment to be re-thought. While the fact that political parties need access to the media is unquestionable, the need for them to own and control their own media is much less evident. The growth of electronic means of communication reduces the need for the traditional mass media, and the Broadcasting Authority should provide political parties balanced access to such media without the need for direct ownership.

This country cannot continue to be conditioned by party-owned media to live five-year-long election campaigns. There is time for politics in the run up to an election but there is time for a normal life away from political pressure and coloured perceptions in the years between an election. During these in between years our people must be entertained and educated to have the analytical skills to make a positive objective choice when they exercise their ultimate democratic right through the ballot box.

Addressing the party-financing scourge must be a priority objective if we are to have a democracy that truly works. It has been left purposely on the back burner for far too long. It is time to bring it to the forefront in a serious way, which includes the total abolition of political donations.

Pensions Black Hole

17^th April 2009

The Malta Independent - Friday Wisdom

If the government were a commercial organisation it would be unquestionably bankrupt. We always knew that our pay-as-you-go pension system is a huge burden on future governments who will find it progressively harder to maintain it. Longevity will explode entitlement payments whereas contributions will fail to keep pace as the economically active will grow at a much slower pace, if at all, than those claiming entitlements. However no one had ever put a number on it.

Now at last someone has. A Eurostat/ECB task force is undertaking a project to arrive at a statistical measurement of the assets and liabilities of pension schemes of EU member states. Malta took part in the pilot study for calendar years 2006 and 2007 and the result is mind boggling.

Our pension system has no assets as it goes completely unfunded. It has only liabilities to fund future payments of current pensioners from the contributions of those currently economically active and, in case of any shortfall, to fund this from the consolidated fund.

If Malta were a commercial company the auditors would insist on showing a liability in its balance sheet reflecting the current value of such future obligations using best estimates regarding longevity, inflation, economic growth and making a subjective judgement on the rate with which to discount future obligations to their present value.

It is this theoretical liability that was calculated by the Eurostat/ECB project team and it represents the current value of pensions to be paid in future on the basis of accrued pension rights without taking into consideration the future contributions of current workers or the accrual of new pension rights to such workers. In short if we were switching to a fully funded pension system this liability would have to be put up in cash by the pension sponsor as part of the switch.

The liability was estimated at e14.3 billion equivalent to 264.2 per cent of the GDP. No commercial company could survive and remain financially stable if it had to recognise in its books a pension liability equivalent to 264 per cent of its internal value-added.

But government is no commercial company. It has no obligation to include such liability in its financial statements although Eurostat and the ECB seem minded to include it in a revised version of the national accounts of EU countries to distinguish those who like us are fully exposed to such obligations from others who have full or partial funding mechanism in place.

Government can change the rules of the game in a way that a commercial company would find it hard if not impossible to do. For example the project team calculated that by raising the statutory pension age from 61 to 65 in the period between 2014 to 2023 pension liabilities reduced by seven per cent of the GDP. To contain such obligations within manageable proportions, governments will in future have to consider further extension of the pension age, higher contributions from the economically active or some freeze on the pension entitlements. They will also have to create economic growth to increase the activity rate among females which is still among the lowest in the EU.

It is possible that in the long term the problem could take care of itself if, as I expect, the present concept of retiring on pension will gradually disappear. Longevity will make current pension arrangements unsustainable or irrelevant in quantum terms thus forcing people to continue working indefinitely for as long as their health permits. As work will be much more brain intensive, requiring little or no physical effort and offering flexibility on the location where employee services have to be imparted (most employees will be able to work from their own home without having to attend the office regularly) working until death could well be the norm fifty years down the road. It will not be punitive. It may well be fun and the only way to keep up a comfortable lifestyle for forty or fifty years beyond current retirement age.

So while shocking at face value, the quantification of the black hole in our pension obligations need not force us to despair. We have long known that as the baby boomers retire, the pension system will come under severe stress and failure of politicians to take, admittedly, harsh decision to reform it, will by default lead to the gradual irrelevance of the whole public pension structure.

Of much more immediate worrying stuff is the return for the months of January and February 2009 of government’s financial situation. The bottom line deficit has deteriorated by a harrowing 40 per cent even though government slowed down capital expenditure funding and in the process “saved” (probably postponed is a more appropriate definition) e15 million. Government revenue is down 12 per cent with sharp drops in all principal revenue sources except for social security contributions. Customs and Excise is down 29 per cent, VAT down three per cent and Income Tax down seven per cent. That social security contributions kept up fits within the theory that unemployment is always a lagging indicator of economic performance.

If there was any doubt that in the first quarter our economy went into a deep recession one now needs little further proof. The recession forces government budget to behave counter-cyclically even if government has not projected accordingly. The recession chops ordinary revenue as economic activity retreats and it forces expenditure to increase as social protection payments kick in through unemployment benefits and other incentives to protect the economy from falling deeper into a recession.

Government refused to prepare a budget taking into account the reality of the recession affecting our major trading partners. The 2009 budget is being rendered irrelevant by the unfolding events and at this rate government will have a lot of explaining to do for its obstinacy in refusing to look at the recession in the eye and to budget accordingly. The real outturn is showing that the budget for 2009 was built of hope rather than realistic expectations.

And we have not hit bottom yet. We will probably hit bottom this summer when a failed tourist season will shock the many who normally benefit from tourism instant powers of multiplication. Government will have adopted the EU’s proposed additional 2 per cent stimulus by default rather than by plan.

   

Resurrection

5^th April 2009
The Malta Independent On Sunday

This is the week where death leads to resurrection. I don’t mean to be religious but I take the pitch to refer to the resurrection of two types going on around us in the material world, one on the local scene and the other in the international arena.

This country installed a new President of the Republic yesterday. Dr George Abela, who less than a year ago contested the leadership of the Labour Party and was the delegates’ second choice for the post, was anointed President by a wide parliamentary majority. The decision was also hailed by a broad cross-section of the electorate, as evidenced from media reports and the general feel of street and cocktail party chatter.

While President Abela comes from Labour stables, which in itself is a refreshing change following four consecutive presidents that came directly from the PN parliamentary high echelons, he is respected for holding moderate opinions and for holding his ground well when all around him are losing their head.

Following the leak of his nomination with consensus between the Prime Minister and the Leader of the Opposition, his approval by Parliament was just a matter of simple procedure. Yet it was interesting to see who among the great majority would show dissent to Abela’s nomination, either by voting against it, by abstaining or through discretionary absence.

The discretionary absence of PN MP Pullicino Orlando was quite expected, as the gentleman seems on a mission to send regular reminders to his own government that they depend on his vote to sustain parliamentary majority, and reinforces such reminders by disobeying his Whip on issues that do not threaten his government’s survival.

What was more interesting however was to note whether there would be any dissentions from Labour’s parliamentary crop. In fact there were three absences. One MP made a public statement that his absence was purely accidental due to another concurrent media engagement that could not be postponed. The other two made no comments leaving one to deduce safely that their absence was a wilful show of disapproval of Dr Abela’s nomination.

It is no coincidence therefore that the two open Labour dissenters were the former Labour leader and the former deputy leader who, with Dr Abela as the other Labour deputy leader, engineered in 1996 the only real Labour victory at the general election in the last 33 years.

This act symbolises all that was wrong with Labour since the pre-mature crash out of government in 1998 until its third consecutive general election defeat last year, eventually leading to the election of the current young Labour leader in a shift that reflects a generational change.

How Dr Alfred Sant and Dr George Vella found it appropriate to continue expressing their bitterness at their former colleague who has been elected to the dignitary post of President rather than rejoice that one from their ranks, irrespective of past differences, has been chosen to a post of high moral authority which Labour has not occupied since the days of Agatha Barbara, only proves their incompetence to lead; it proves why, since Dr Abela’s departure from the leadership trio in the summer of 1998, Sant and Vella became dysfunctional leaders leading the party to one defeat after another.

This is a great opportunity for Labour to resurrect itself under Joseph Muscat who can now work not simply to chip away the failed legacy he inherited from Dr Sant and Dr Vella, but to peel off layer after layer of it till he brings the party in good shape to become the people’s choice at the next general election where it really matters.

Dr Sant and Dr Vella this week, yet again, gave another demonstration that where it most matters they put their personal ambitions ahead of the party’s collective interest. This was a time to let bygones be bygones. In any event, time has amply proved that they were in the wrong and Dr Abela was in the right. Yet rather than suppress their personal bitterness leading to false pride, they yet again chose to put obstacles in the way of the new leadership and made an implied statement that they regret nothing they did in bringing Labour to the verge of extinction.

Just as in 1998, Sant and Vella betrayed Labour’s interest by forcing a quick early election rather than conduct behind the scenes negotiations to explore in a more calm and serene matter how to protect the electoral mandate gained less than two years earlier; just as in 2003 Sant and Vella rode roughshod over internal pressure to disengage the EU issue from a general election and render it a separate issue to be decided by a binding referendum; just as in 2008, Sant stayed on as leader and Vella stayed on as main spokesman for EU affairs even when it was clear to all that they were the biggest asset in the PN’s hands to depict Labour as an alternative that could not be trusted to make most of our new EU reality. Yet again this week they both proved that even from their opposition backbenches they still think that they and only they are right and the rest of the party, new leadership included, is wrong.

Sant and Vella should do the party and themselves a favour and give up their parliamentary seats to permit the new leader to bring in more forward looking Young Turks who can better guarantee success for Labour than the bitterness still harboured by Sant and Vella in their spirits. Their legacy is written and will not be changed. They are the main architects of Labour’s lost decade between 1998-2008. They cannot be part of Labour’s resurrection.

The G20 meeting held in London this week promises to be a resurrection for the world economy, which went into a tailspin since the bankruptcy of Lehman Brothers last September. From stones thrown at the house of a disgraced banker in Scotland, from workers “bossnapping” in France, from 90 per cent retrospective taxation in Washington, from the rich of the world creating a heads-I-win-tails-you-lose capitalism, there emerged from the G20 an air where the rich and poor of the world can work together to build a fairer system, keeping world trade flowing and giving access to resources to the poor nations, and hopefully leading to the conclusion of the Doha round of negotiations at the WTO giving better access for the poor to sell their wares in the markets of the rich.

There is a long way to go to translate the G20 objectives into a practical action programme. However, it seems that world leaders have read the history of the 1930 depression and decided that the risk of going down that route forced them into a spirit of collaboration, which had not been evident under the Bush administration.

May this be the true beginning of a sustainable resurrection of a fairer world economic and regulatory system!

Gaffe or Great (G20)

3^rd April 2009

The Malta Independent - Friday Wisdom

Miracles can happen! The world needs one if the great expectations for a meaningful solution to the economic woes that have thrown the world into a sudden deep recession, potentially a depression, is to emerge from the meeting of the 20 leading high-income and main emerging countries in London this week.

I am writing this piece on the eve on the summit but it will be published on the morrow. The London meeting of Thursday, 2 April could surprise us through down to the wire compromises leading to co-ordinated global approach to address a global crisis.

However the soundings from the main participants in the run up to the meeting, discounted as they have to be for their usual overdose of posturing, leave little room for optimism about reaching the great compromise.

The G-20 leaders seemed to be talking at each other, rather than to each other, with an air of misplaced superiority, arrogantly implying perfect knowledge about what needs to be done to achieve their home-spun silver bullet solution. They sounded like a football team without a coach and without a captain, lacking a coordinated game plan, and trying to force their view of the world on each other.

Some players proclaim they mean to play a game of defensive containment. Others proclaim an all out attack tactic. The rest mean to occupy the middle ground. Each grouping seems to be hoping that once the game starts the others will fall in line with magic coordination behind their preferred objective. In such circumstances confusion is more likely than co-ordination, irrespective of the wishful verbosity of any final communiqué to paper over the evident unbridgeable cracks.

It must not be so! There are long-term objectives on which it is easy to agree. Every country inside or outside the G20 would not disagree about the urgent need to re-design the world financial system and ensure a better regulatory regime to guard against a re-occurrence of such financial distress. This regulation must not only tighten on the already regulated banks, but must include other financial institutions which operate, so far largely unregulated, in the shadow banking system, including investment banks, hedge funds, private equity funds, credit rating agencies and tax havens.

There is no problem in agreeing that measures must be taken to ensure that banks and financial institutions that are too big to be allowed to fail, are not allowed to take risks that could involve taxpayers in expensive rescue operations. The current paradox where profits are privatised and losses are socialised cannot form a sound basis for a lasting solution. It will inevitably bring taxpayers out on the streets to protest the raw deal they are getting, and if it persists, democracy would roll-over to bring into power populists with dangerously too narrow view of the world.

However the Franco/German tandem is making a poor show pretending that current problems can be resolved by implementing tighter regulation to avoid a recurrence. When the house is burning the priority has to be on putting out the fire rather than writing a new fire safety code.

The EU has not been helped by the arrogant comments of the Czech presidency that the US (and UK) stimulus plans are a sure way to hell. This is not only disrespectful to fellow member UK, and to the new US President who has inherited these problems from the previous administration; it is also short on economic savoire-faire.

What the Czech presidency could have said without being offensive and shaming itself, is that the US type of fiscal stimulus plans solution is not suitable for general application across the EU. With the economies of the US and the UK being overly dependent on internal consumption for growth, it is obvious that consumption stimulus plans have to be part of the solution to their economic malaise. Such solutions are clearly less suitable for economies whose growth depends on export demand and who already have in place counter-cyclical social systems that kick in automatically to increase government expenditure through unemployment benefits and other social payments to those who are directly hit by the recession.

The Chinese, who together with Germany and Japan are the largest surplus countries, are caught in contradiction. They criticise the US for stimulating domestic demand as this risks diluting the long term external value of the US dollar, potentially damaging the value of their vast accumulation of foreign reserves largely denominated in US dollars, and could revalue their own currency making their exports less competitive. On the other hand they want to preserve their export dominance and still wish for the rest of the world to continue buying their excess supply.

How can China, together with Japan and Germany for that matter, not realise that their structural surpluses are the ultimate cause of the structural imbalances that led to the crisis? How can they continue to resist grand scale stimulation of domestic demand in order to dismantle their structural surpluses through trade and not merely through recycle financing?

If the G20 is to achieve anything substantial it must meet four objectives and prioritise them in the following sequence. Firstly it should condemn and where applicable reverse all measure of protectionism creating barriers to free trade. Such protectionism would hurt mostly the poorest countries that are not represented at the G20.

Secondly they must agree to a substantial, very substantial, increase in the resources of the International Monetary Fund (IMF) so that it can aid the poor countries that are unjustly affected by the crisis.

Then they must agree a substantial stimulus of domestic demand by the surplus countries to address chronic disequilibria and shift global demand to countries with greater capacity to borrow rather than continue to rely on countries that in reality need to rebuild their domestic savings to address their chronic deficits.

Lastly they must appoint a wide-ranging committee of experts to recommend the necessary changes for a more effective and globally co-ordinated financial regulation.

Anything short of this will require another G20 meeting in the near future.