The Continental Model

In New York and London the financial industry jobs have vanished and government solvency along with them. The New York City and State governments face extended years of multi-billion dollar deficits. Britain has the lowest interest rates ever set by the Bank of England in its 315 year history.

Britain and America bet heavily on the financial services economy. The bet has not turned out well. The failed investment house Shearson Lehman might as well represent an entire banking sector that has disappeared overnight. Has the economic bet on services left the British and American economies less able to weather the recession? Are economies which retained a much larger portion of their manufacturing industries more resilient?

Over the past 30 years the American and British economies have traded their manufacturing jobs for work in all types of services. The banks, investment houses and hedge funds of London and New York were only the best known of an entire services sector that came to dominate both economies. Services tend to be knowledge intensive businesses, better able to take advantage of the information revolution and its efficiencies. The older labor intensive manufacturing industries were moved to low wage countries, often by the original American or British firms. Countless manufacturing jobs from England and the United States were moved to China, India, Malaysia and other emerging market countries as their firms sought greater efficiency and profits from lower costs.

The economic model practiced in the United States and Britain is often criticized on the continent and in the European Monetary Union (EMU) for its willingness to tolerate economic dislocation and unemployment in pursuit of efficiency, flexibility and productivity. It is called the Anglo-Saxon model for its supposed rapacious tendencies, with little protection or concern for workers or those displaced by its creative ferment. The term Anglo-Saxon recalls the tribes who conquered England and the ‘civilized’ Romanized Britons in the fifth century. The centralized French and German economic systems are the spiritual descendants of that Roman Imperial model.

Germany France and Italy have been more solicitous of their homegrown manufacturing firms. Fewer jobs have been moved overseas by their industrial companies. But has this autarkic tendency helped preserve jobs and consumer demand within the EMU market and its individual countries? Will it help them weather the recession?

The worldwide recession struck employment first and hardest in the financial sector. But this crisis is no respecter of economic model or good intentions. It has hit the euro area’s three largest economic forcefully, despite their more extensive manufacturing base.

Industrial output in the EMU was negative in eight of the ten months to November last year. In Germany output fell at an annualized rate of 15.1% in the three months to November; in France the drop was 14.5%; in Italy 19.5%. Unemployment is rising, from 7.2% at the beginning of 2008 to 7.8% in November the last month for which statistics are available. It will go higher in 2009.

Consumption is falling worldwide. Britain and the United, the main export markets for European manufacturers are in a consumer recession. Emerging markets too are buying less and investing less in their own productive capacity. The demand for capital goods is down around the globe.

In the Eurozone the recession is also being felt in restrained consumption. The saving rate in the EMU is higher than in the Anglo-Saxon economies but rising unemployment and the air of pervasive gloom is keeping consumer out of the stores. European consumer confidence is at record lows. And the negative outlook is affecting services as well; the December Services Purchasing Managers Index registered a record low. Services are not going to rescue the Eurozone economy.

The slowdown is driving government deficits higher around the globe and Europe is again no exception. The budgets of the smaller EMU countries are already under stress. Standard and Poor’s, the rating agency, has already downgraded Spain’s and Greece’s credit rating and put Portugal and Ireland under review. Germany officials have said they expect their deficit to be over the Maastricht 3% limit before recovery takes hold.

The European manufacturing sector, larger and to some degree more protected than the US and British versions has proven to be no refuge from the destructive forces of the recession and the financial crisis.

The ECB has been guilty of similar miscalculation. Until President Trichet’s admission last July that economic growth was far slower than expected the bank had maintained a standoffish attitude to the credit crisis. It had preferred to believe that the crisis was the product of lax US regulation and overheated housing markets. Surprisingly enough the ECB comments before the January 15th 50 basis point cuts had been hinting at a rate pause. The decline in the euro prior to the cut was clear evidence market skepticism for the ECB hints.

Once again events have overtaken EMU and ECB official expectations. The protected EMU industrial model has not saved European jobs. It has not sustained consumption or consumer spending. Trichet has all but promised a rate cut in March. This time the markets will take him at his word.

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A Less than Sterling Analysis

The British Pound Sterling has suffered more from the financial crisis and recession than any other major currency. From its high point of just over 2.1100 in November 2007 to its Friday close at 1.3812 the Sterling has lost 35% of its worth against the US Dollar. It has sustained similar losses against the Yen, 51%, the Euro 44%, and the Swiss Franc 36%. In comparison the Euro has declined only 19% against the Dollar, 32.1% versus the Japanese Yen, and 11% against the Swiss Franc; the Australian Dollar has lost 33% against the US dollar, and 46% against the Yen; the Canadian Dollar has fallen 26% against the American Dollar and 43% against the Yen but gained 9% against the Euro; and the Swiss Franc has dropped 20% against he US Dollar and 27% against the Yen while gaining the above 11% against the Euro. With the exception of the Yen crosses which were the beneficiary of the funding based carry trade and whose destruction in a welter of deleveraging repatriation and capital flight is a story apart from the general market, the Sterling has forfeited more value than any other industrial world currency. The immediate economic and interest rate prospects can account for a large part of the market disenchantment with the Pound. But there are also secondary concerns, the British sovereign debt outlook, the health of the banking system, the pending election and even the trading history of the Pound, which although not as quantifiable as interest rates or GDP add considerably to a Sterling trader's worries. Unfortunately for the British public and the government not one major criterion is positive for the Pound. The Bank of England (BOE) has been more forthcoming about the condition of the economy and more aggressive in reducing rates to meet circumstances than its counterpart across the channel, the European Central Bank (ECB). But it has lagged far behind the American Federal Reserve. Though the current BOE 1.5% repo rate may be an historic low across more years of existence than any other central bank, it is very likely that rates will move even lower in the immediate future. The BOE does not have the anti-inflation mandate of the ECB or the institutional credibility of the Bundesbank. Mervyn King the Governor of the bank may warn the market of the dangers of ultra low rates but in the end he will take the bank down the same path as the US Federal Reserve. Aside from other considerations the British economy will have suffered from the delay. Gross National Product in the United Kingdom plunged 1.5% in the last three months of 2008. It was the largest economic contraction since 1980. The British housing market has experienced a credit fueled real estate boom like the US and is mired in oversupply, falling prices and bankrupt mortgage lenders. Unemployment is at 6.1% the highest since 1997, claims jumped 77,900 in December and consumer spending and confidence are sinking. Industrial and manufacturing outputs were down 6.9% and 7.4% respectively on the year in November. The British banking system is not as diverse as that of the United States and is centered on a few large institutions. The Royal Bank of Scotland is one of those key institutions and the government now has a 70% stake in ownership. While wholesale nationalization of the banking sector is not contemplated nor spoken of by the government, as more banks come to depend on government rescue funds the result is a nationalized industry, in fact if not in declaration. Financial services accounts for a large part of the British economy. A government controlled banking industry will be neither as profitable nor as expansionist when the recession finally ends as it would have been under private stewardship. The difference for the British economy will be fewer jobs in a less productive financial sector for years to come. Standard and Poor’s reaffirmed the British AAA rating on January 13th but the longer term prospects are still questionable. The government has assumed many of the liquidity problems of the banking system. In so doing the government has vastly expanded its debt and risk burdens. If markets continue to fall analysts and the rating agencies will posit more bank recapitalizations and more private sector debt on the government books. Spain, Ireland and Greece have already had their ratings reduced and they have the benefit of belonging to the united European currency. In the newly stringent rating agencies, concern for British debt rations will weigh far more heavily than consideration for government funding costs or British chagrin. Gordon Brown's Labour Party is trailing badly in the polls. The deciding factor in the US election may have been the state of the US economy and the financial market blowup in September and October. Prior to that intensification of the financial crisis the two candidates, Barack Obama and John McCain, were essentially tied. The lesson will not have been lost on Mr. Brown. Nothing determines an election in a democracy like the state of the domestic economy. Market suspicion has to be that the Brown government will do whatever it can to prop up the economy before the election, including lower rates, massive fiscal stimulus spending, and quantitative easing when rates have reached a nadir. Nothing that will help the Labour cause and the economy will support the Pound. Every measure can be justified by the need to rescue the economy from recession or worse. If the Pound is sacrificed in the attempt so be it. Finally, trading historians will remember George Soros and the European Exchange Rate Mechanism (ERM). In the fall of 1992 Mr. Soros bet that the Conservative Government of John Major would be unable to maintain the Pound within the trading band of the ERM. The currency markets believed Mr. Soros and joined in the most famous currency raid in history. The Sterling was forced out of the ERM and the Conservative Administration’s reputation for fiscal competence was shattered. Today there is no ERM and no central bank trying to hold back the weight of the currency markets. But currency traders still hunt in packs and they are stalking the Pound Sterling. FX Solutions, LLC