EU Watch: March 2013

http://www.goldmansachs.com/gsam/advisors/education/viewpoints_from_chairman/viewpoints-pdfs/q1_2013/3_1_13.pdf

From: Jim O'Neill
Sent: Friday, March 01, 2013 9:17 AM
To: gs-jims-views
Subject: Reform is not the Same Word as Austerity
Reform is not the Same Word as Austerity.
So you thought you’d escaped my Viewpoints already? Sorry, not so soon, but after April that relief will
arrive! Anyhow, as you will read below, I returned early in the week from 10 days in Chile, including a couple
in Argentina, just in time for the results of the Italian elections and the latest chapter in the US fiscal debacle.
The Italian Election Results.
I will be attending a well-known financial forum on the shores of Lake Como late next week, and in that
sense, post the uncertain outcome delivered by the Italian electorate, it will be interesting to hear the debate
at the forum (although I will be fresh from much bigger excitement at Old Trafford earlier in the week). For
now, I have three observations about the Italian election outcome. Firstly, perhaps somewhat oddly, I find
the outcome quite exciting because it seems to me for a country who’s GDP has basically not changed since
EMU started in 1999, something big needs to change. Maybe this election outcome and the peculiar mass
appeal of the Five Star movement could signal the start of something new? Secondly, for the established
elite of Italy and, crucially, the other ‘power centres’ of Europe, in particular Berlin and Frankfurt, these
results are pretty close to a nightmare. Indeed, it questions many aspects of the status quo, including the
widespread view in such circles that debt reduction for the sake of debt reduction is not only a worthy cause,
but one that is necessary to attract policy support. If such a consensus were open to change, they should
question this belief but I suspect it won’t come quickly or easily. Thirdly and linked to this, in my view, Italy’s
real problem is the absence of economic growth, which has caused debt to rise, and not the same problems
as some other problematic Euro-zone countries. Italy’s cyclically-adjusted fiscal position is actually in modest
surplus (see table below), which is better than virtually all other developed countries. I believe that tightening
fiscal policy for the sake of it with a vague aim of debt reduction is not a smart strategy. Italy needs to reform
its product and labour markets, boost nationwide productivity and reform. They also need German and ECB
support in order to stay in the EMU, and especially now, to stop a potentially fresh escalation of unnecessary
increases in bond yields. In Italy, reform doesn’t equate to austerity as their voters have just shown.
Other Europe News.
Importantly, the big surprise from the Italian elections comes against the other, more modest, but important
surprise of the past couple of weeks, which was the unexpected fall in the ‘flash’ composite Euro-zone PMIs
for February. After some hopes since late last year of a bottoming in the economic decline, this news
suggests it may have been temporary. Friday’s final manufacturing PMI for the Euro-zone confirmed some of
this weakness, with a fresh decline in both Italy and Spain, and ongoing weakness in France. These
negative figures more than offset Germany’s strength. Both this release and the Italian election outcome
suggest a fresh policy approach is necessary, but I doubt that is coming quickly.
One piece of positive news against all of this was the confirmation that the official Spanish deficit has
improved considerably in 2012, declining to 6.7% of GDP, from 9.0% the year before. Although slightly less
improved than their target of 6.3%, this is quite impressive in view of their severe cyclical challenges. Whether this will mean an improvement in the perception of the cyclically-adjusted fiscal position (again, see
table below) remains to be seen, but it is quite decent news.
Broader European News.
A couple of other more inspiring items caught my eye. Firstly, German Chancellor Merkel made some fresh
statements about welcoming Turkish desires for EU membership. I have long believed that for the EU to
thrive in the future this would be a great thing, so I see this as a welcome development. Whether this was
just a statement to help prepare for a brief trip to Turkey or not is harder to tell. Secondly, and in some ways
oddly, Polish policymakers still continue to talk about plans to join the Euro, which has reminded me of my
experiences from travelling to Eastern European countries in 2012. Seen from their eyes, the future of the
Euro remains in little doubt, as does their long-term desire to join.
Ongoing Fun and Games in the UK.
German comments welcoming Turkey’s admission into the EU and Polish comments on their plans to join
the Euro, may be considered issues from another planet to UK policymakers who in the past week have had
their own problems to focus on rather than the European question.
The perhaps inevitable loss of AAA credit rating from Moody’s should surely be seen as a negative verdict
on the UK coalition government’s economic policies, and consistent with this Viewpoint theme, reform is not
the same as austerity. The coalition seems committed to deficit reduction, and at the same time, intense
regulation and ongoing deleveraging of the financial sector. I read two interesting pieces that relate to both
this week, one from Anthony Hilton in the London Evening Standard on 26 February on the excessive
‘strangling of the economy by regulation’, and Martin Wolf in the Financial Times on 26 February on the
inappropriateness of fiscal tightening (The sad record of fiscal austerity). I think on one level, it is obviously
beneficial for the UK to ultimately have less leverage in the financial sector and less government debt.
However, to persist with both at the same time, will at best make domestic recovery tricky, and perhaps,
extremely difficult.
Against this background, the continued strength of UK employment data is quite remarkable, if accurate.
Whilst I was away, I came across an interesting report about regional employment trends that showed
especially strong recent increases in employment in the North East and similarly strong declines in
unemployment in Yorkshire and the West Midlands. These are all areas that one might have thought would
struggle against a background of restrained government spending. Therefore, to some extent, the UK
cyclical mysteries continue, including questions about data accuracy. A further angle to this peculiar story
comes from an early February special FT magazine story, which I kept a note of. The story focussed on an
Amazon distribution centre in a Midlands town that may be indicative of the supposed employment ‘puzzle’
suggesting a structure of rather low paid, flexible employees with little signs of a support system. Perhaps
this is the current reality for many, as unappealing as it may be.
To top it all off, in the past couple of weeks, the recent GDP estimates for the UK included the inevitable
upward revisions to some past data, suggesting that the post-crisis recovery was not quite as dire as
originally reported. Against that, the complete 2012 data we now have, shows weaknesses in net exports.
Although I am sceptical, assuming one can believe the UK trade data, this is not a positive outlook to add to
fiscal restraint and persistent anti-financial sector strategy.
At the time of writing, the latest UK manufacturing PMI was also surprisingly weak, adding to a picture of a
pretty shaky couple of weeks.
The US Reform Does Not Equate With Austerity Either.
As we end yet another period of Washington DC discussions on fiscal policy, this time with the sequester
about to hit, one has to focus on the opposite dilemma to much of Europe. The US seems unable and
maybe, even reluctant to reduce their underlying fiscal deficit. Or could it be that US politicians believe that
although the longer term structural dilemmas are large, it is much more important to boost a weaker than
desired recovery than excessively focusing on deficit reduction. Whether this is due to some perceived
wisdom or the benefits of being the world’s reserve currency is impossible to know, although it strikes me as
a better position to be in currently than the Euro area or the UK. Interestingly, most ongoing economic data
in the US, especially in the housing sector, continues to somewhat positively surprise which would certainly
support a view that the economy can cope with some fiscal tightening so long as it is modest. I also noticed
fresh positive reports about both the scale of increases in domestic US oil production and the reducing role played by imports.
Since I last published a Viewpoint, there has been some fresh fun and games about market views on Fed
policy. For the second consecutive meeting, markets were temporarily surprised by the release of Federal
Open Markets Committee (FOMC) minutes. In both instances, the minutes suggested some dissention to the
Fed leadership’s dovish stance on policy. After this latest round of concern, it hasn’t taken long for the
markets to react, helped by some quite clear repetition of Fed Chairman Ben Bernanke’s views. It is
beginning to emerge more and more clearly that the current Fed Chairman both encourages and tolerates
significant opposition to his own views, but his opinions on policy (probably supported by key allies, Dudley
and Yellen) tend to dominate what the Fed actually does.
The Yen and Currency Wars.
Since my last Viewpoint, Japanese policymakers have participated in a series of meetings. Following a G7
meeting and a G20 Finance Ministers meeting, the new Prime Minister, Abe, has survived a bilateral meeting
with US President Obama without having his policy criticised, as well as appointing key people to lead the
Bank of Japan with ex-Ministry of Finance stalwart, Kuroda, at the helm. During all of these events, the Yen
has oscillated, at times quite widely in the Y90-Y95 range, but not beyond. I am a bit torn about what may
happen next. On the one hand, the planned path of monetary policy seems now more clearly committed to a
true inflation ‘target’ as opposed to a vague ‘goal’ and this is essentially Yen bearish. Last November I
believed that this was likely, which is what persuaded me it was ‘the macro trade’ of Q1. It has been and
remains a big initiative and major shift. On the other hand, we now have all the new appointments in place
and they now have the rather ‘simple’ matter of delivery! Additionally, as a rather important Japanese
investor suggested to me this week, there is not much evidence of structural change to accompany those
planned monetary steps. This will perhaps continue to make domestic Japanese investors sceptical about
the longevity of the associated Yen weakness and the Nikkei strength.
China.
Not a good February for Chinese stocks after the stellar rally from November through to the end of January.
What is going on? Well, some key cyclical data has stopped accelerating, such as the PMI data, although at
this time of the year, it is harder than ever to interpret the Chinese data. If this were to be a true and fresh
deceleration, it would be cause for modest concern. However, it is probably a lot more to do with renewed
focus on possible policy steps about property prices, loose monetary conditions, and possibly higher
inflationary pressures. All of these strike me as modest concerns, and the very fact that Chinese
policymakers are so alert to containing fresh bubbles is, from a long-term perspective, probably a distinct
positive. It is difficult for me to believe that China has both genuine signs of fresh bubbles and inflation at the
same time as the economy slowing again. It might take until the March data releases for the evidence to be
clearer, which will not be published until April.
Chile, Argentina, Mexico and a Couple of Other Matters.
Except for my favourite topic, this leaves me with my impressions of Chile and Argentina and broader Latam.
This has been my debut in Chile, and I fell for it. Unfortunately we didn’t have the time to go far south or to
the desert, but we did experience Santiago, Valparaiso, the wine country and the spectacular lake and
volcano crossing of the Andes into Argentina. It was all lovely, and a sort of non Latin-American experience.
Many had advised us in advance that it would feel very European. While it did, it also felt quite a bit like New
York and LA, especially Santiago. As for Argentina, where I have been before, let’s just say it felt quite Latin,
unlike Chile. I left wanting to know the answers to the questions, “how does anywhere survive with 30%
inflation these days”, and “how come it is the only place I have visited in the planet in recent years where I
couldn’t get a roaming signal for my blackberry”, and “how come our bags got lost in transit”?
While in Santiago, I had a very interesting discussion about Chile and the rest of the continent with an
informed foreign observer, who was most bullish on Chile, as well as Colombia and Peru. He was not so
excited about elsewhere, with the exception of Mexico, and had a few highly sceptical observations to make
about Brazil.
Talking of Mexico, there was a very interesting FT interview with the head of Pemex on Thursday
highlighting the exciting potential reform of the domestic energy sector, which the new government is likely to
pursue. This is a key part of why so many people understandably are getting more and more excited about
Mexico (not forgetting Chicharito of course!). Coincidentally, I had a brief meeting with some Mexican policymakers on the same day, and amongst the many virtues they were extolling about the country, they
mentioned many anecdotes about accelerating Japanese auto and auto-parts plants moving there.
While I am on the topic of the FT, it was most interesting to read a “comment” article from a Deng Yuwen,
the Deputy Editor of the Study Times, which is the journal of the Chinese Central Party School. It suggested
that China should consider abandoning support for North Korea, and encourage unification. This is worth
watching because if this were reflective of a shift in official stance, this would be big, and positive news.
And lastly, India unveiled its latest budget on Thursday, with lots of tinkering and detail but nothing that
caught my eye. I was asked to be part of an Indian TV debate as it was unfolding. I suspect I upset them by
refusing, however, there was little in it that really captured my attention, and I believe India should start to be
much-bolder and include a more credible medium to long-term fiscal strategy, and as I have said on
numerous occasions, introduce a “proper” inflation target.
Football and Next Week.
Next Tuesday I will be in Manchester on “urgent business” for one of these ‘matches of the decade’. There
won’t be too much focus on austerity there, although for the loser, certainly reform!
Jim O’Neill
Chairman, Goldman Sachs Asset Management.
>>
Cyclically Adjusted Budget
Balances Across Developed
Countries
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