Monday, 19 December 2011

The Inevitability of the Euro’s Demise

I don’t know why David Cameron prevented any future accord on fiscal discipline being incorporated into a revised European Union treaty at the last European summit. Whether he saw something in its provisions that was potentially damaging to the United Kingdom, or whether he was simply trying avoid a potentially catastrophic split in his own party, he alone would be able to tell us. What I do know, however, is that this question is completely irrelevant.

Nor is this simply because those who are currently trying to make political capital out of his decision, arguing that Britain will now become isolated in Europe, are quite clearly being disingenuous. For not only do they know that there are bound to be other countries, outside the Eurozone, which will not sign up to the treaty – countries like Hungary, which has already stated that it will have nothing to do with any treaty that requires tax harmonisation – they are also aware – because they are made of the same stuff – that the vast majority of politicians who rise to be heads of governments are nothing if not pragmatic. They do what is in their interest. And if it is in their interest to continue doing business with Britain, they are not going to cut off their noses to spite their face. After all, the Eurozone exports more goods and services to the UK than to any other country in the world.

It is not primarily for this reason, however, that I say that all this politicking is irrelevant, but rather because, even if an intergovernmental agreement on fiscal union is eventually signed by the Eurozone members, I do not believe that it will not have any effect.

I say this for three reasons. Firstly, there is too little provision in what has so far been agreed to counter the immediate threat of member government insolvency. It is why yields on Eurozone bonds have continued to rise, and why the credit rating agencies are threatening a wholesale downgrading of Europe’s credit status. Secondly, although the new fiscal rules may prevent Europe ever getting into this mess again, it will be many years before some member states are able to reduce their annual deficit to just 3% of GDP and even longer before they are able to get their accumulated national debt down to 60%. In the case of Greece, for instance, it is unlikely to happen before 2025. Thirdly, and more importantly, however, is the fact that there is nothing in any of the drafts of the treaty so far put forward to tackle the Eurozone’s most serious underlying problem, which is not primarily a lack of fiscal disciple, or even the lack of competitiveness among some of its member states, but rather the variability in competitiveness across the monetary union.

One can see this variability most clearly in the per capita GDP of the member states, as shown in Table 1. The figures are those from in 2010.

Member States
GDP Euro Millions
Population Millions
GDP per Capita (PPP)
GDP per Capita (Nominal)
PPP as % of European Average
Eurozone Average
Table 1: Per Capita GDP per Eurozone Member State in 2010

For those unfamiliar with this kind of analysis, you will notice that the table has two columns of ‘per capita’ data: one labelled ‘Nominal’, the other ‘PPP’. The first is simply the country's GDP divided by the population. GDP, however, is measured in terms of local pricing. In rich countries, where prices are high, GDP will therefore be exaggerated. In poor countries, where prices are low, GDP will appear to be lower than it actually is. To overcome this distortion, we therefore introduce PPP, 'Purchasing Power Parity', which uses average prices from across the entire sample to give us a more accurate comparison.

Unfortunately, this does not help us resolve inaccuracies in the underlying data, and most readers will have already spotted at least one rather glaring anomaly in the above figures, which appear to show Ireland as having the third largest per capita GDP in the Eurozone. This, however, is due to the fact that when the table was compiled, Ireland’s actual figures for 2010 were not yet available. The figures included are therefore the forecast figures from 2009, which even at that point were almost certainly over-optimistic. The important point, however, is that even if we mentally downgrade the Irish data, and ignore the figures for Luxembourg, which has a micro-economy all of its own, it is still absolutely clear that the Eurozone encompasses member states with wide variations in productivity and hence competitiveness. 

Having accepted this, the question you still may be asking, however, is why this is a bad thing. The answer is that, within a monetary union, these variations have a polarising effect, exaggerating them over time and actually making them worse. This is because the value of a currency is indirectly related to the performance of the economy it represents. The factors determining this value may be vague, numerous and complex, ranging from market demand to speculators’ expectations, but in the end it all comes down to how well the economy is doing. In the case of a monetary union, however, the currency represents the aggregated economy of the union as a whole – both its strong parts and its weak parts. It represents, that is, the average performance across the entire community. As a result, the stronger parts will find themselves operating with a currency which is undervalued with respect to their own performance, while the weaker parts will be burdened with one that is overvalued. The strong parts, as a consequence, will find that their exports are that much more competitive in international markets, and will become even stronger as a result, while the weak parts will find that their exports are overpriced and will therefore become even weaker.

We can see this in the difference between Germany and Greece. While Germany has clearly benefited from an undervalued Euro, making its  luxury cars even better value around the world, the only thing which Greece exports is overpriced olive oil. This is not to say, of course, that an undervalued currency is the only reason for Germany’s success. Its focus on high-end manufacturing and its long-term approach to investment have had a lot to do with it. But an undervalued currency has certainly been a factor, just as an overvalued currency has been a factor in Greece’s steady deterioration. 

The problem is further exacerbated by the fact that once this polarisation has started, it is very hard to stop it, not least because other factors then kick in. With poor economic performance in the weaker parts of the union, unemployment inevitably rises, tax receipts drop, public expenditure increases, and a budgetary deficit develops. If the union also facilitates freedom of moment, the brightest and best young people from the poorer areas then start migrating to the richer ones. The richer areas thus reap the benefit of their talents while the poorer areas are further impoverished. 

In fact, this is a phenomenon we can also see happening within national economies. In Britain, for instance, we have something called the north/south divide, which is the result of more than half a century of such polarisation. It primary cause was the loss of heavy industries and manufacturing from the north during the post-war years. The problem has been made much worse, however, by the fact that although its labour costs are generally much lower than in the south, the north-east, in particular, has had to try to rebuild its economy while operating with a currency which more accurately reflects the increasingly successful service based industries of London and the south-east. As a result, it has acquired an almost permanent disadvantage, which successive British governments have tried to overcome, largely by throwing tax-payers’ money at the problem through such institutions as regional development funds. All these palliative measures have actually achieved, however, is the creation of an economy which is almost totally dependent on government subsidies and hand-outs.

Indeed, in many ways, the European Union has done exactly the same thing, channelling grants and subsidies to its less advantaged member states, in order to try to overcome the disparities. Infrastructure projects, in particular, have been used a mechanism for redistribution. Drive down any major road in Spain or Portugal and you’ll see a signed telling you that it was financed by the EU. This, however, is no way to build a sustainable economy, which needs to grow organically from within itself. If you also lock these grant-assisted peripheral states into a monetary union, which then makes their goods and services permanently uncompetitive on international markets, you finally have a recipe for the kind of disaster that is now unfolding in Greece.

So what is to be done? For Greece, there is only one answer. It has to leave the Eurozone. It will, of course, be difficult. When they return to the Drachma, the Greeks will almost certainly see their currency fall in value by at least 30% against the Euro. This will mean that imports from other countries will be 30% more expensive. However, Greek exports will become 30% cheaper. So will Greek holidays. They will be able to start rebuilding their tourist industry. With lower labour costs, multinational companies will start investing there. It will take time, but eventually Greece will be able to rebuild its economy, and this time on a firmer foundation.

But what about the bigger picture? What happens to the Eurozone once Greece has left? The answer is, I’m afraid, ‘More of the same!’ For what applies to Greece today, will eventually apply to all those countries with per capita GDPs less than the Eurozone average. Once polarisation has set in, relative to Germany and the Benelux group, they will all steadily become less and less competitive.

It is why some economists believe that the Eurozone will eventually break into two, with a northern, richer grouping, and a southern, poorer grouping. This, however – or so I believe – is to misunderstand the inexorability of the polarisation to which variations in competitiveness across a monetary union give rise. For even though, with two monetary unions in play, the variations may be smaller, the same economic principles apply, and polarisation will still occur. In the northern grouping, for instance, the country that would be would most disadvantaged is France. By remaining in a monetary union with Germany and the Benelux countries, its economy would get weaker and weaker. It is almost certainly one of the reasons President Sarkozy is so desperate not have any of the Eurozone member states leave.

Not as desperate as Angela Merkel, however. For if all the weaker economies in the Eurozone were to return to their original currencies, leaving just Germany and the Benelux countries to form a Eurozone core, the value of the Euro against other currencies, would very probably rise by somewhere between 20% and 30%. This would mean that Mercedes and BMWs sold around the world would go up in price by between 20% and 30%, and the dent in sales would almost certainly be considerable. Factories throughout the motor supply industry in German would have to lay off workers; unemployment would rise; tax receipts would fall; a budgetary deficit would open up; and so on and so on.

The question you will be asking, of course, if Angela Merkel knows all this – as she surely must –why is she trying to sustain a situation which she must also know is unsustainable. As a politician, however, the question is really what else can she do? To preside over the demise of the Euro, and be responsible for the worst calamity to hit the German economy since the second world war, is simply unthinkable. She therefore has no choice but hang on and fight a rearguard action for as long as she can. The truth is, however, that eventually the whole house of cards must collapse. And there is nothings she or anyone else can do about it.

Monday, 5 December 2011

The Problem with UK Public Sector Pensions

The problem with UK public sector pensions is that they are a Ponzi scheme, and were more or less identified as such in the report by the Public Sector Pensions Commission published in July 2010. The reason for this is that, unlike private or personal pension plans, where the contributions of employees and their employers are invested in individual, ring-fenced, and gradually accumulating pots of money, in the case of public sector pensions no such separate and identifiable funds are ever established or built up. Instead, the pensions of today’s public sector retirees are paid directly out of the contributions made by current public sector workers: a system or model which continually requires the recruitment of new contributors to underpin the pyramid, and which, when applied in a related financial sector, earned Bernie Madoff a sentence of life imprisonment.

Of course, Bernie Madoff knew what he was doing; whereas it is possible that those who originally devised our public sector pension schemes may not have seen the dangers. For during the first few years, when there were yet very few public sector pensioners and a growing number of public sector workers, most of the schemes would have almost certainly been in surplus. From the point of view of the treasury, in fact, employee contributions would simply have been regarded as an additional form of tax: a helpful source of revenue which would have continued to grow throughout the 60s and 70s as health and education and other public services continued to expand. The trouble is that all those people who entered public service during this period of rapid public sector growth are now of pensionable age; and with us all living much longer, the pensions they are receiving far exceed the contributions being made by their successors. As a result, the bulk of these pensions are now having to be paid by the rest of us, out of general taxation.

How much we are actually paying can be seen in Figure 1, which is based on data provided in the above-mentioned 2010 report, and which can be found in PDF format at

Figure 1: Growth in Public Sector Pension Deficit

In the report, the numbers are actually presented in a way that is slightly more complicated than this, in that part of the deficit is notionally deemed to be made up by the employer. This, however, is a polite fiction. For while the ‘employer contributions’ deducted from the NHS budget, for instance, may relate to the numbers of staff currently employed, they are actually used to pay the pensions of doctors and nurses who have already retired. This also explains why these notional ‘employer contributions’ have become so disproportionate. In the case of civil servants, for instance, the ‘employee’ contribution is just 3%, while the contributions of the various government departments to which they are assigned has risen to a massive 24%. This, however, is merely a way of disguising the current account deficit. And even then, additional monies are still having to be paid directly out of the treasury.

What is even more important, however, is the fact that, as one can see from the above graph, the deficit is steadily growing: from £11.4 billion in 2003/04 to an estimated £17.95 billion in 2010/11. That is an average annual increase of 4.6%. And the question we therefore have to ask is how big this funding gap is likely to get.

Unfortunately, there doesn’t seem to be anyone who actually knows the answer to this question. Or if they do, they’re not telling us. Nor is it all that easy to work it out. For the only figures available which even touch upon this issue are for the total public liability as it stood at the point at which the liability was measured. That is to say that they tell us how much we would be contractually obligated to pay present and future public sector pensioners if the schemes to which they belong were otherwise suspended, with no further contractual obligations being incurred. They do not tell how much these contractual obligations will continue to grow as the schemes themselves go forward. In this sense they are not forecasts; merely statements of account. They are also snapshots, taken at a single moment in time, which are almost immediately out of date. Indeed, the most recent such snapshot I have so far been able to find – included in the above mentioned report – is an estimate of what the total liability stood at as of 31st March 2010, when it was believed to be £1.176 trillion. Since then, however, it will have already grown substantially.

Not that we are going to be asked to pay this off over night, of course. As in the case of treachery bonds – which, in the light of this £1.176 trillion, constitute only our second largest category of public debt – the pension liability is spread over a fairly large number of years. Unfortunately, the Public Sector Pensions Commission’s report doesn’t tell us how many. Nor does it give us a profile of how the liability will be discharged on an annual basis. All we can say for sure, therefore, is that it won’t be linear. For although the liability, as presented in the 2010 snapshot, takes into account not only current pensioners, but all those who are currently building up an entitlement – including those who have only just started on this process – as already stated, it measures their entitlement as it stands today, not as it will stand at the end of their working lives. If we were to create an annualised payment profile for the £1.176 trillion current liability, therefore, it would probably look something like Figure 2.

Figure 2: Annualised Public Sector Pension Liability as it stood on 31st March 2010

As you can see, this profile has a fairly long tail. This is because the people who will still be receiving pensions in the 2080s are those who would have only just started work when the snapshot was taken. It is their entitlement at that point, therefore, rather than the entitlement they will eventually build up, that the snapshot reflects. In reality, however, most of these people will go on to receive full pensions, and far from tailing off, the liability will therefore continue to grow. In fact, it is unlikely even to peek during this time frame. For even if the number of people retiring on public sector pensions were to remain constant – rather than continue to rise as is currently the case – the increase in life expectancy – and hence the number of years each pensioner draws a pension – would ensure that the cost continued to rise. In order for the liability merely to plateau, therefore, the number of people retiring on public sector pensions would have to fall. This, however, would mean that the number of people working in the public sector would also have to be reduced, which, of course, would have the further effect of reducing contributions. Like all pyramid selling schemes, in the end it is simply unsustainable.

Given the generous nature of public sector pensions, and the fact that they are being paid for by tax-payers who, for the most part, cannot afford such pensions for themselves, it is also  indefensible.

Of course, apologists for the system will argue than rather than reducing public sector pensions or making them less generous, private sector pensions ought to be brought up to the level of the public sector. This, however, is economic fantasy. Most, if not all, companies which created final salary pension schemes during the 1950s, copying the public sector model, have now abandoned them, or have gone out of business, partly as a consequence. One of the reasons the previous government couldn’t save MG Rover, for instance, was that no one wanted to buy a company with such a huge pension liability. We therefore have to accept that the only way we can provide pensions for ourselves is by saving money into a pension fund, out of which an annuity can eventually be bought. The problem is that, even with contributions from one’s employer, there is a practical limit to how big a pension fund most of us can build.

Assuming an average return on investment of 7% per annum, for instance, someone on average pay, who had a pension plan in which both he and his employer had paid in 5% of his salary per year for the last thirty years, would now have a fund worth £167,000. If we take a fairly typical annuity purchase rate of £5,972 for every £100,000 invested, this would give the average retiree a pension of £9,973 per annum at the age of 65.
To demonstrate how unfair public sector pensions are, someone on an identical salary in the public sector would get a pension of more than double this, and at the age of 60 rather 65. To get an equivalent pension, in fact, the person in the private sector, together with his employer, would have to make a combined contribution of 21% of his salary per year. For the vest majority of people in this country, therefore, this is simply not possible. Yet it is this majority – the 22.9 million people who work in the private sector – who are paying for the public sector pensions of the privileged minority.

What is truly remarkable, however, is that when public sector workers went on strike last week to protest against the government’s proposed reforms, the majority of people – between 63% and 68% depending on which opinion poll you read – actually supported them. It is another example, in fact, of what I have referred to in the past as the strangely inverted political culture we have in this country: one which tacitly assumes that the Labour Party and the trade unions, like latter day Robin Hoods, are on the side of ordinary working people, while the Conservative Party, like the wicked Sheriff of Nottingham, is a bunch of callous, uncaring tyrants, determined to grind poor public sector workers into the dirt. What makes this perennial caricature even less apposite on this occasion, however, is how moderate the proposed reforms clearly are.

I say this because the one thing the government is certainly not proposing to do is put an end to the real underlying problem of public sector pensions: their fundamental pyramid structure. For that would mean placing the notional contributions of both employer and employee into real pension funds. While still having to meet the contractual obligations of existing pensions, this would mean that they would not be able offset current pension payments with these notional contributions, thus widening the pension deficit and further adding to overall borrowing. Over time, they would also have to augment or consolidate these new pension funds with the contributions that should have been paid into them in the past, along with the interest they would also have been earning. The cost would be astronomic. All the government is actually proposing, therefore, is to (a) bring the retirement age for public sector pensions into line with the state pension age – which, reducing the number of public sector pensioners at any one, would relieve some of the burden in the medium to long term – and (b) increase present employee contributions by 3%, thus reducing the current pension deficit.

The fact that it is this latter proposal which has caused the greatest resentment, however, is a clear indication of how entangled in deception and delusion the current situation has become. For most public sector workers almost certainly know that their so-called contributions are not actually contributing to their future pensions. They know that they are simply an additional tax, which they have every right to suspect the government is merely levying in order to reduce the overall fiscal deficit. On the other hand, they refuse to accept the corollary of this: that their pensions are entirely paid for out of taxation, most of which is collected from other people. The problem is that while both sides, for various reasons, continue to maintain these polite fictions, it is difficult to see how the dispute can be resolved.

There is also another reason why we need to stop deceiving ourselves and face up to the truth. For the world economic order which, for last thirty years, enabled the mature western democracies to consume more than they produced, spend more than they earned, and pay for it all on tick, is coming to an end. In 2008, the bubble finally burst. Public sector pensions were both a symptom and a contributor to what was wrong with our economy throughout this thirty year period. If we go on arguing about them from entrenched political positions which are no longer relevant, we are not going to solve the problems. The western democracies that will come through this crisis most intact will be those that stop deluding themselves, face up to the truth and start finding new ways to live, work, and structure their economies to meet the challenges of the 21st century. Reliving the political battles of the post-war period will not do that. We need fresh thinking and a fresh approach, based on economic reality. For if we fail, our children and grandchildren will be paying the price for decades to come.