Predictions for 2012 and Beyond

8/3/2019 Predictions for 2012 and Beyond

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Predictions for 2012 and beyond

by Paul Emmerson, written 31st

Dec 2011

As befits the end of the year, Ive decided to make some predictions. Theyare macroeconomic in nature, and are prefaced with some thoughts on the

current political/economic situation as background. The article is written from a

UK perspective, but is of general interest.

First, a question: every year, where does the money for pensions, the health

service, education, etc come from? Taxes? Well, yes most does. But some

(around 25% every year in the UK) comes from borrowed money that we have to

pay back. The problem is that we arent paying all of it back, and both the

borrowed amount and the unpaid amount have been getting bigger and biggerevery year. Here are the figures: the current level of total UK government debt is

approximately one trillion pounds. Thats one thousand billion

(1,000,000,000,000). If there are 60 million people in the UK, thats 16,666 for

every man, woman and child.

What did all this money go? Figures for last year show the biggest areas are:

benefits & pensions, the health service and education:

Source:http://www.debtbombshell.com/uk-national-debt.htm
http://www.debtbombshell.com/uk-national-debt.htmhttp://www.debtbombshell.com/uk-national-debt.htmhttp://www.debtbombshell.com/uk-national-debt.htmhttp://www.debtbombshell.com/uk-national-debt.htm


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Two interesting points here. Please read these carefully:

Scandinavian countries have done this with centre-right (neo-liberal)governments over most of this period, and these same governments

have maintainedthe low income inequalities traditionally associated

with Scandinavia. Critics of free markets please note.

UK debt really exploded in 2007. That was the year Gordon Brownbecame prime minister and Alistair Darling became Chancellor of the

Exchequer. It was also the year of a big banking crisis, thats true. But the

graph shows government debt rising astronomically: from 44% at the

start of 2007 to 80% at the end of 2010. Thanks, Gordon and Alistair.

Someone will have to pay that and I suspect it wont be you.

Okaylets look at this government debt in a little more detail. Weve seen

that its growing, and weve seen that to pay it back we have to issue new debt. Is

that the end of the problem? No. Because every time the government issues a

new bond simply to repay an old bond, the interest rate that it has to pay on the

new bond is higher. Why? Because otherwise no-one would buy the new bond.

Would you lend to someone if you knew that they pay all their debts by borrowing

again from other people? You might, but only if they offered you very high

interest. For example, German 10-year bonds give you around 3% interest, but

Italian/Greek bonds give you 7%. Thats to compensate you for the risk that you

wont get your money back.

So, the Italian and Greek governments have to pay back the money theyborrow to run their countries plus give 7% interest to the lenders (the bond

holders). Where does that 7% interest come from? Well, there is only one place:

the countrys own internal tax receipts. And, of course, these fall in a recession. So

the government is left with less tax receipts for two reasons: less business activity

in a recession and higher payments to bond holders. Thats bad news. Where does

it get the extra money it needs to spend on benefits, pensions, health and

education? By issuing more bonds. Vicious circle. Its happening before your eyes.

What is the endgame? Various possible scenarios:1. Future generations pay. This is the default option that has been

happening for years. Continuing to issue new bonds to repay old bonds

does indeed kick the can down the road, but leads to slow, steady

decline. Big problem: demographics (and rising unemployment during

recession years) mean that fewer people are working and paying taxes.

So there are less tax receipts to repay the bonds not to mention to

fund the pensions of soon-to-be-retiring baby boomers (a huge

commitment coming just round the corner). The road along which the

can has been kicked is about to run out. Endgame. Irony: those on the

left who do not take deficit reduction seriously are guilty of anism


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every bit as big as sexism and racism: generationalism. The next

generation will have no options for the kind of society they want to

build: they will just be paying off Gordon and Alistairs rolled-over bonds.

2. Inflation. Central Banks can print boatloads of money in order to inflatethe currency and make it worthless. If Zimbabwe owes 1,000,000

zimbabwean dollars to bond holders, Mugabe can pay them back with a

single 1,000,000 dollar note that is worthless. Problem with this solution:

imports become very expensive. No Zimbabwean can afford an iPhone

while earning a salary in Zimbabwean dollars. In fact anything priced in

dollars, or euros, or yen, is just too expensive that includes energy and

imported food as well as consumer products. And of course no-one for a

generation will ever buy a Zimbabwean bond. So the government cant

invest in anything or make plans. By the way, the phrase quantitative

easing means printing money specifically to buy bonds. More QE iscoming, in the US, UK and EU.

3. Currency devaluation. In practical terms this is like #2 above, andcurrency devaluation and inflation are closely linked. By printing

Zimbabwean dollars, Mugabe makes his currency worth less. Previously

1 zimbabwean dollar = 1 US dollar. Now 10 zimbabwean dollars = 1 US

dollar. Mugabe can pay his bond holders the 1,000,000 zimbabwean

dollars he owes with his newly printed money, but to the bond holders

its only worth one tenth as much when they convert it into the US

dollars they need. And to the Zimbabwean in the street, the cost of an

imported iPhone goes up from 100 zimbabwean dollars to 1000

zimbabwean dollars. But this is indeed a solution, if you can stand the

pain of inflation. Its what the Argentines did in 2002 when they were in

a similar situation to the Greeks today, and its what some in Greece

offer as a solution now (although to devalue they would need to have

their own currency again, not euros).

4. Depression. What happens if there is less appetite on the part ofinvestors to buy bonds issued to repay previous bonds (because theprobability of not getting their money back is too high)? Answer: the

government is unable to borrow all the money it needs, and cant run

the country. Or it has to pay such high interest rates on the new bonds

to make them attractive that it bankrupts the Treasury. Hello Greece.

The warning signs are when a bond issue is undersubscribed, ie there

are not enough buyers. It just happened in Hungary a couple of weeks

agothey had to cancel their bond sale. Its going to happen more often.

It leads to a depression as government spending is cut (there is just no

more money available to pay teachers, doctors, pensions). Living

standards are adjusted downwards.


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5. Default. Instead of struggling over years under scenario #4 (depression),there is a more sudden resolution as a country just says: Nope, we cant

pay you back. Sorry. A partial default is already part of the Greek

solution. Problem: who are the institutions that are not paid back? Who

holds these bonds? Answer: European banks. So Barclays (and more

importantly their French and German equivalents) suddenly have muchsmaller assets on their balance sheets the bonds they own are now

worth much less. What does that mean? It means that they are unable

to lend money, as the money they are allowed to lend is determined by

the assets they have. If you have 100 in your pocket the regulator will

allow you to lend 10. But if you only have 20 in your pocket the

regulator wont allow you to lend 10. Banks being unable to lend to

companies and individuals means a depression.

And, as for the inflation and currency devaluation scenarios above,no-one buys a Portuguese or Irish bond for another ten years it is just

too risky. That means no money for the Portuguese and Irish

governments to run their country.

An obvious question now: is the financial sector to blame? The answer, to

my mind, is absolutely clear. Yesfor the 2007/2008 credit crunch crisis (mis-sold

mortgages, derivatives with ridiculous leverage, retail banks with risky investment

arms that werent separate, ratings agencies paid by the firms they were rating,

etc). But No for this one. This ongoing crisis is due to living beyond our means, and

goes back to the Central Banks response to the dot-com crash in 2000 (see later).

Lets look at the favourite four targets of the anti-finance movement, as identified

by many socialists and many European politicians looking for scapegoats:

Banks. Bailing out Northern Rock, RBS, Lloyds and HBOS in the 2007 crisiscost the taxpayer 37 billion (source:

http://news.bbc.co.uk/1/hi/business/7666570.stm), and that added to the national

debt by 3.7%. That was a disaster and the mismanagement of those banks

was a scandal. In return the government got a say in how these banks are

run, including bonus payments. These banks were too big to fail and thissituation must never be allowed to return. A badly run bank should be

allowed to go bust like any other company without putting ordinary

peoples money at risk. All political parties agree about this. But the fat cat

bankers who remain are working for banks that were not bailed out, and

they are paid by the banks own profits, no-one else. Yes, they should share

a (greater) burden during difficult times, as should all the super-rich, and a

one-time tax on bank profits might be a good idea.

But please dont scare the banks and fatcat bankers away from theCity. Finance accounts for 30% of the UKs tax receipts, and without the City

there would be 30% less money to spend on pensions, health and schools.
http://news.bbc.co.uk/1/hi/business/7666570.stmhttp://news.bbc.co.uk/1/hi/business/7666570.stmhttp://news.bbc.co.uk/1/hi/business/7666570.stm


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The City really is the goose that lays the golden egg for our welfare system.

If our finance sector goes to Switzerland and Singapore and Honk Kong,

then kiss the welfare state goodbye. Yes, the weight of finance in the UK

economy is very unhealthy but that calls for more of other kinds of

business, not less banking.

And those who think that increasing tax is a simple answer should

look carefully at this next chart. Its the Wikipedia list of tax revenue as % of

GDP, sorted by the (third) OECD data column. So highest tax countries at

top, lowest at bottom.


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Here we can see that UK companies and UK taxpayers pay a middling

contribution in comparison to other countries (34%). Some countries pay

more: Germany 37%, France 41%, Italy 43%, Sweden 46%. But some

countries pay less: Canada 31%, Switzerland 30%, Japan 28%, Australia 30%.

Theres no real message here, and some of the low-tax countries Canada,

Japan, Australia are ones we can admire for their low income inequalitiesand good social services. I think that tax rates are not very significant in this

crisis. Higher tax means more revenue for the government, but also scares

away some companies (meaning less tax revenues) and makes it more

difficult to start a business. I think the two effects approximately cancel

each other out.

Hedge funds. Hedge funds are speculators (half the time) who risk theirown money and no-one elses. Not a single hedge fund has ever contributed

a single penny to national debt. Hedge funds are just like any otherinvestment fund, except that they can also go short, ie bet that markets

will go down. In other words, they can make money in a falling market, not

just a rising market. A hedge fund that makes money by, for example,

shorting the euro is taking an informed guess that the euro is overvalued

and will go down in the future. They might be right or wrong, and might

make or lose money. Its their business. But criticizing them is nothing more

than shooting the messenger. They cannot move markets on their own.

And very important this for the other half of the time they

introduce massive stability into the system. They allow companies to hedge

risk, hence their name. For example, if you are a UK company who exports

to Europe and is paid in euros you might be worried about the euro falling

in value. It would reduce your profits and you would have to lay off workers.

If a hedge fund offers you a financial product that shorts the euro, then you

can make some money back if the euro falls offsetting your lower profits

from the less valuable euros you earned. This is hedging your risk, and it

adds stability and saves jobs.

And one final thing: without some players in the system able andwilling to go short, the risk of bubbles is much higher. Otherwise its in

everyones interest to just buy and keep buying (and never sell) because the

market can only go up. Thats a bubble.

Tax evasion. Of course all tax evasion must be stopped. Its a priority. Thecurrent crisis has thrown new light on this area, and the UK government has

responded with new proposals. But it wont make much difference. The

best figure I can find for annual UK tax evasion (by companies and

individuals) is 15 billion (15,000,000,000). So, total national debt is 1000billion and tax evasion is 15 billion. In other words if all tax evasion was

stopped tomorrow it would solve just 1.5% of our problems.


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Ratings agencies. In the 2007 crisis these were indeed a) hopelessly late inacting, and b) not independent. They were rightfully criticized. Now they are

doing a proper job, and for example downgrading US and French and

PIIGS bonds because it is more risky to own them. Thats their job: to rate

investments according to their risk, so that investors know. Once a

governments debt is downgraded by them, the government has to paybond holders a higher interest because of the higher risk of default. This

higher interest comes out of tax receipts, and there is less tax money

available for government spending. So politicians of countries with

downgraded debt are furious. But you cant criticize ratings agencies for

being asleep at the wheel in the last crisis and then complain when they

start to do their job properly now. Again, shooting the messenger.

The financial sector, and free markets, are just a convenient scapegoat for

this debt crisis. Be very wary of blaming them. If you reduce the weight of theprivate sector in the economy, and reduce GDP by making business harder to do,

then where are the taxes to pay for the welfare state? If you discourage

entrepreneurs, then where do new businesses and new tax receipts come from

in ten years time?

In fact debt crises have been happening regularly for 800 years, as Reinhart

and Rogoff have shown in This Time Is Different the most important book of the

decade. Cycles of boom and bust are driven by excess credit leading to debt and

default. They always have been and they always will be. The title is ironic

politicians always claim that this time is different, but it never is. Remember

Gordon Browns no more boom and bust? Remember Alan Greenspans

Goldilocks economy not too hot and not too cold? Raging against the way that

this crisis is wrecking peoples lives is like raging against the waxing and waning of

the moon. If you can come up with an economic system that generates wealth

without having economic cycles, then please do so. No one else in history has

managed it. Well, North Korea doesnt have cycles, thats true, but then it doesnt

have upturns either.

In fact the current crisis really began with the 2000 dot-com crash, but wedidnt feel it because of the actions of Central Banks (CBs) to recover from that

crash. CBs kept interest rates low in order to encourage borrowing and spending

and avert a recession. But they succeeded only in putting back the day of

reckoning, and making it worse. It was those artificially low interest rates that

caused individuals and governments to borrow too much and get into debt. Easy

money caused a succession of bubbles: in stocks, house prices, commodities. CBs

were the real villains of the piece. They should have let the economic cycle take its

course. History has shown it cant be tamed.

Its possible that downturns could in fact be made more bearable if

governments did what Keynes recommended: put money aside during the good


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times to offer support during the bad. But they never do they spend it all during

the good times. They dont put it aside for the bad times. They make hay while the

sun shines, in order to do whatever it was they came into politics to do, or just to

get re-elected. Their justification is that this time is different and bad times wont

return. Then when the downturn comes they try to enact the second half of

Keynes recipe spending to stimulate the economy without having the savedmoney to do it. They have to use more borrowed money to do it, the spending

doesnt work anyway, and the vicious cycle begins. The exception that proves the

rule here is the Scandinavian countries, which will surely weather the storm better

than others.

All this leads to my forecast for 2012 and beyond:

European Central Bank (ECB) will have to buy the bonds of PIIGScountries because no one else will, and without this support the euro

would collapse (which I dont expect). The ECB is currently not permittedto do this by its constitution, so lets see how they manage it. Germany

will have to supply much of the money to the ECB for it to do this, and

the German tax payers wont like it one bit.

German tax payers will demand something in exchange: the audit ofnational budgets by Brussels, to make sure that PIIGS countries and

others are not overspending. This means that PIIGS and other national

governments wont be able to set their own budgets in their own

parliaments. They wont be able to control levels of spending on health,education, etc, and they wont be able to decide tax levels. Brussels will

tell them at what age public sector workers can retire, and what level of

pensions they can give to the public sector. Politicians will be reduced to

the level of middle managers dividing up a diminishing cake amongst

hungry people. Expect massive civil unrest as PIIGS citizens accuse

Germans of making their recessions worse, of Germans trying to take

over Europe etc.

If the Germans turn round and say okay, you go it alone you

ungrateful so-and-sos, then game over for the EU and the euro. The

thing that most prevents the Germans from doing this right now is the

fact that a euro without PIIGS would be much stronger against other

currencies, and this would hurt German exports worldwide. In Europe

itself, the breakup of the euro would cause massive economic instability

and this also hurts German exports in its own backyard.

The civil unrest arising from enforced austerity will usher in left-leaninggovernments promising to protect workers living standards. They will

find that they are unable to act to do this (more spending by themmakes the situation worse). Papandreou is just the first socialist of many


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who are going to find this out. The resulting chaos will provide a

breeding ground for the far right (national socialists, defending the

interests of our people against Germans and bankers and free markets).

But I dont expect the far right to prevail (too many historical memories

and most people are too sensible). Instead there will be a long slow

decline in Europe as it readjusts to lower levels of public spending.

Green parties might do well. Make do and mend will become the orderof the day. The new austerity chimes well with the Green agenda of anti-

consumerism, of lower living standards to save the environment, etc.

And buying local is a nice gloss on economic nationalism. Buying local

products makes you feel okay about having a devalued currency that has

made imports expensive. But lower demand in rich countries combined

with local sourcing will put an end to the dreams of rising living

standards for the developing nations. In recent years thousands ofmillions of Chinese, Indians, Koreans, Mexicans, Brazilians and other

nationalities have finally risen out of poverty by selling into our markets.

That will stall. Expect the Green movement to be silent on this issue.

In the second half of year the bond and currency markets will realize thatUS debt is just as high as PIIGS debt. US debt and the $ will become the

new focus of attention for the markets. The US Federal Reserve is much

more likely to go down the route of inflation, money printing and

currency devaluation for historical reasons (Germans have a morbid

fear of inflation hyperinflation in Weimar Republic laying basis for

Hitler). So massive money printing of $ and associated devaluation of

$ coming for late 2012 into 2013 and 2014. This will be very good for

gold in the long-term.

The stock market could go either way. Its down for another six monthsfor sure. After that I dont know. If money printing, inflation and

currency devaluations rule the day, then the markets will rally along with

the rise in inflation. Historically markets always rise with inflation, for

two reasons:

1) Bonds hate inflation because bonds pay a fixed rate of interest.

You just spent 100 on German 10-year bonds and youre looking

forward to 3% interest plus your 100 back at the end. Thats not too

bad if you can only get 1% in cash at the bank. But now inflation is

starting: the 100 you get back will be worth much less in 10 years time,

and the 3% interest wont look so good if inflation is 4%. So you sell your

German government bonds. Across the world everyone else does the

same and money flows out of the bond markets and into the stockmarkets. The stock markets rise just for reasons of liquidity, nothing else.

Please remember that worldwide the bond markets are approximately


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ten times bigger than the stock markets. Read that last sentence again.

Its true.

2) A related point: rising stocks also act as a hedge against the

eroding value of cash at the bank.

However if inflation is not the outcome, and paying down the debtcombined with default rules the day, then stock markets are mostly

down with occasional sudden rallies for many years.

Short-term plays on the stock market when we get a (temporary?) lowthis year: Japan and Italy. Market sentiment cant get any worse here,

and that means a bottom. Fear and greed rule the markets, and fear can

overshoot on the downside as much as greed on the upside.

The recovery begins in 2020. By then debt is finally paid off or defaultedon or inflated away. A new phase of world economic growth andoptimism will resume. The race will be won by the low-debt,

demographically young, politically open, entrepreneurial, trading

economies with a well-educated workforce and flexible labour markets

and easy access to venture capital.

Be surprised as the United States once again does very well,

against all the conventional wisdom that the next century is Asias. Asia

will do very well in the future, for sure, but their easy growth is behind

them, and the big three have massive demographic problems (China,

Japan and Korea have ageing populations with exceptionally low

birthrates).

I think that when the depression is finally behind us the future growth stars

will be, in alphabetical order: Australia, Brazil, Canada, China, Denmark, Egypt,

Hong Kong, India, Indonesia, Iran (if theyve had a Persian Spring), Korea, Mexico

(if its not a failed narco-state), Philippines, Poland, Singapore, Sweden, Taiwan,

Turkey, United States and Vietnam. Of that list, I think the fastest growing in the

future (the new BRICs) will be Indonesia, Mexico and Turkey.

And for the UK? If we can reduce our debt (and keep it on a downward

path), and reduce our dependence on the financial sector, and make it easy to

start and grow companies, and improve our education and skills base (not easy

weve just had 3 terms of a Labour government committed exactly to that and Im

not sure its worked), then why not?

Happy New Year!

Paul Emmerson

31st

December 2011

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Predictions for 2012 and Beyond