Abenomics, European Style

by Nouriel Roubini

NEW YORK – Two years ago, Shinzo Abe’s election as Japan’s prime minister led to the advent of “Abenomics,” a three-part plan to rescue the economy from a treadmill of stagnation and deflation. Abenomics’ three components – or “arrows” – comprise massive monetary stimulus in the form of quantitative and qualitative easing (QQE), including more credit for the private sector; a short-term fiscal stimulus, followed by consolidation to reduce deficits and make public debt sustainable; and structural reforms to strengthen the supply side and potential growth.

It now appears – based on European Central Bank President Mario Draghi’s recent Jackson Hole speech – that the ECB has a similar plan in store for the eurozone. The first element of “Draghinomics” is an acceleration of the structural reforms needed to boost the eurozone’s potential output growth. Progress on such vital reforms has been disappointing, with more effort made in some countries (Spain and Ireland, for example) and less in others (Italy and France, to cite just two).

But Draghi now recognizes that the eurozone’s slow, uneven, and anemic recovery reflects not only structural problems, but also cyclical factors that depend more on aggregate demand than on aggregate supply constraints. Thus, measures to increase demand are also necessary.

Here, then, is Draghinomics’ second arrow: to reduce the drag on growth from fiscal consolidation while maintaining lower deficits and greater debt sustainability. There is some flexibility in how fast the fiscal target can be achieved, especially now that a lot of front-loaded austerity has occurred and markets are less nervous about the sustainability of public debt. Moreover, while the eurozone periphery may need more consolidation, parts of the core – say, Germany – could pursue a temporary fiscal expansion (lower taxes and more public investment) to stimulate domestic demand and growth. And a eurozone-wide infrastructure-investment program could boost demand while reducing supply-side bottlenecks.

The third element of Draghinomics – similar to the QQE of Abenomics – will be quantitative and credit easing in the form of purchases of public bonds and measures to boost private-sector credit growth. Credit easing will start soon with targeted long-term refinancing operations (which provide subsidized liquidity to eurozone banks in exchange for faster growth in lending to the private sector). When regulatory constraints are overcome, the ECB will also begin purchasing private assets (essentially securitized bundles of banks’ new loans).

Now Draghi has signaled that, with the eurozone one or two shocks away from deflation, the inflation outlook may soon justify quantitative easing (QE) like that conducted by the US Federal Reserve, the Bank of Japan, and the Bank of England: outright large-scale purchases of eurozone members’ sovereign bonds. Indeed, it is likely that QE will begin by early 2015.

Quantitative and credit easing could affect the outlook for eurozone inflation and growth through several transmission channels. Shorter- and longer-term bond yields in core and periphery countries – and spreads in the periphery – may decline further, lowering the cost of capital for the public and private sectors. The value of the euro may fall, boosting competitiveness and net exports. Eurozone stock markets could rise, leading to positive wealth effects. Indeed, as the likelihood of QE has increased over this year, asset prices have already moved upward, as predicted.

These changes in asset prices – together with measures that increase private-sector credit growth – can boost aggregate demand and increase inflation expectations. One should also not discount the effect on “animal spirits” – consumer, business, and investor confidence – that a credible commitment by the ECB to deal with slow growth and low inflation may trigger.

Some more hawkish ECB officials worry that QE will lead to moral hazard by weakening governments’ commitment to austerity and structural reforms. But in a situation of near-deflation and near-recession, the ECB should do whatever is necessary, regardless of these risks.

Moreover, QE may actually reduce moral hazard. If QE and looser short-term fiscal policies boost demand, growth, and employment, governments may be more likely to implement politically painful structural reforms and long-term fiscal consolidation. Indeed, the social and political backlash against austerity and reform is stronger when there is no income or job growth.

Draghi correctly points out that QE would be ineffective unless governments implement faster supply side structural reforms and the right balance of short-term fiscal flexibility and medium-term austerity. In Japan, though QQE and short-term fiscal stimulus boosted growth and inflation in the short run, slow progress on the third arrow of structural reforms, along with the effects of the current fiscal consolidation, are now taking a toll on growth.

As in Japan, all three arrows of Draghinomics must be launched to ensure that the eurozone gradually returns to competitiveness, growth, job creation, and medium-term debt sustainability in the private and public sectors. By the end of this year, it is to be hoped, the ECB will start to do its part by implementing quantitative and credit easing.

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Currency Reform In Ancient Rome

by Peter Earle

Currency Reform In Ancient Rome

In the Western world, modern civilizations are often thought of in comparison to those of the ancient world. The Roman Empire is typically the first considered, and arguably the most natural reference point owing to its many achievements, complexity and durability. It stands in history, widely considered the high water mark of the ancient world; one against which contemporary political, economic and social questions can be posed. Much of the world is still living with the consequences of Roman policy choices in a very real sense, in matters ranging from the location of cities to commercial and legal practices to customs.

The global economic downturn of 2008, in particular its monetary facet, readily invites comparison between the troubles of the modern world and those of the Roman Empire; just as Western currencies have declined precipitously in value since their commodity backing was removed in stages starting roughly a century ago, Roman currencies were also troubled, and present a cautionary tale.

The Roman coin in use through most of the empire was the denarius, which demonstrated a persistent decline in value, starting from the time of transition from Republic to Empire, and continuing until its decimation during the Crisis of the Third Century AD. Although efforts by Diocletian taken after the monetary collapse are commonly associated with Roman economic reform, there were other efforts by earlier, lesser known emperors that suddenly and unexpectedly improved the silver content and value of the denarius. Firsthand accounts and archeological findings provide sufficient detail to allow examination of these short, if noteworthy, periods of voluntary restorative policies – and their architects.

While popular interest typically fixes on such well known emperors as Julius Caesar, Nero, and Augustus, I seek to direct attention toward four lesser known emperors who undertook the improvement of the denarius.  These initiatives essentially constitute rare, temporary episodes of qualitative tightening, in contrast to the more common – and, in recent history, ubiquitous – policy of quantitative easing. The reformers were Domitian, Pertinax, Macrinus, and Severus Alexander. A necessarily concise summary of each one’s initiatives follows, with a brief review of the circumstances surrounding their administration and decisions.

Domitian (September 81 AD – September 96 AD)

The first noteworthy Roman currency reformer was Domitian, son of Vespasian and brother of Titus. He ascended in 81 AD, inheriting the problems associated with his forbear’s costly projects. Vespasian had undertaken large scale construction projects he thought necessary to repair the damage to many structures during the civil wars that raged throughout the late Republic.  In addition, he paid lofty financial incentives to regime-supporting historical writers and awarded pensions of up to 1,000 gold coins annually to a coterie of court intellectuals. Titus, his son and successor, was known for the initiation of lavish and elaborate games as well as for recompensing individuals struck by unexpected natural disasters, including the eruption of the volcano Vesuvius, the Great Fire of Rome, and those affected by the outbreak of war in Britannia. Together, Titus and Vespasian committed vast resources to the construction of the Coliseum; and, consequently, during the 12 years of their emperorship, the silver content of the denarius was reduced from roughly 94% to 90% purity.

Despite that precedent, “Domitian was apparently very sensitive to the importance of capital and the benefits of stability derived from a credible and dependable money supply.”[1] Thus early in his reign, in a “dramatic and entirely unexpected” move that coincided with the end of hostilities in Britain and Chatti (Germany), he fired the Empire’s financial secretary. Historians speculate that this was either because the secretary considered Domitian’s plans to improve the currency quality “unwise” or because he’d allowed such “slackness to permeate the mint” in the first place.[2] Shortly thereafter, “in 82 – 84 AD Domitian improved the silver standard, and older coins averaging 88 to 92 percent silver were reminted into purer denarii (98 percent fine)”.[3]

However, Domitian’s currency improvement effort was short-lived due to renewed foreign warfare. Between 85 and 89, fighting in Africa, Dacia (Eastern Europe), and Chatti again broke out, such that the “purer coins had scarcely entered the marketplace when [he], in mid-85, pressed for money to pay war bills, again changed the standard, reducing it to 93 percent fine”.[4]

Domitian’s reign eventually devolved into tyranny and massive building projects echoing those of his brother and father, and culminated in a wealth confiscation edict so brutal that “it [became] fatal at th[e] time … to own a spacious house or an attractive property”.[5] In 96 AD, he was assassinated.

Pertinax (January 193 AD – March 193 AD)

For nearly a century after Domitian’s fall, the debasement of the denarius continued apace, and by 148 AD devaluations became ritually associated not only with the start of wars and public projects but with inaugural events and holidays as well.[6]

At the beginning of Domitian’s reign, money supply was 60% of what it had been in 40 [AD], and about 70% of this level at the end of his reign, a range maintained throughout the reigns of the Antonines, until, under Commodus, money supply reached 700-800% above [that] initial level.[7]

Commodus, whose twelve year regime saw among other things the re-introduction of Plebian Games – a pricey, nearly month-long festival of religion, art and sports – and an incredible expenditure of state funds in a massive, megalomaniacal campaign of self-indulgent iconography, was succeeded by Pertinax – a man of “propriety [and] economy” – whose 86-day rule starkly depicts the considerable risk that currency reformers undertook – and perhaps still do.

[O]n the day of his accession, he resigned over to his wife and son his whole private fortune, that they might have no pretense to solicit favors at the expense of the state. He refused to flatter the former with the title of Augusta, or to corrupt the inexperienced youth … by the rank of Caesar … g[iving] him no assured prospect of the throne[.][8]

In addition,

[h]e forbad his name to be inscribed on any part of the imperial domains, insisting that they belonged not to him, but to the public. He melted the silver statues which had been raised to Commodus … s[elling] all his concubines, horses, arms, and other instruments of pleasure. With the money thus raised, he abolished all the taxes which Commodus had imposed.[9]

On the heels of that, Pertinax “carried out an extraordinary … coinage reform that returned the denarius to the standard of Vespasian.”[10] It revalued the denarius from 74 to 87% silver by weight on new coins, several mintings of which were emblazoned with the motto “MENTI LAVDANDAE” (“noteworthy good sense”), and most significantly featured not his or another emperor’s visage but Ops, the Roman personification of wealth. In addition to this, Pertinax simultaneously embarked upon a fiscal rehabilitation program, the centerpiece of which were large budget cuts targeting the Roman military; he began by cancelling the customary bonus paid to soldiers by newly-seated emperors.

In a remarkably short of time, Pertinax gained “the love and esteem of his people.”[11] But his cuts to the military were deep and far reaching, and his urge to settle disputes with enemies rather than fight them out enraged the soldiery. “A hasty zeal to reform the corrupted state … proved fatal” for him. [12]. On the 86^th day of his rule, his personal guard betrayed him and mutinied, gathering at the imperial domicile. Though other guards urged him to safety, “instead of flying, he boldly addressed them” – and fell beneath their swords.[13] Rome’s “Age of Inflation” had thus begun.

Macrinus (April 217AD – June 218AD)

Gibbons describes Caracalla, who ruled for 19 years, as “the common enemy of mankind” for the incredible number of massacres and persecutions, as well as economic destruction, which occurred during his tenure.[14] He devalued the denarii from 1.81 grams of silver to 1.66 and introduced a new coin, the antoninianus: ostensibly a “double denarius” but actually weighing 2.6 grams of silver instead of the implied 3.3 grams. Additionally, he increased tax revenue by making all freemen in the Empire citizens and commissioned the construction of a number of massive, exorbitant bathhouses. And, most unsurprisingly, he raised the pay of the military, granted them new and expanded benefits, and launched a war against the Parthian Empire.

Macrinus, a member of Caracalla’s staff, became emperor after his assassination – to which, by some accounts, he was a co-conspirator. From the start, he made clear his concern with “prioritiz[ing] public faith over the generation of a sufficient amount of cash” for the Roman state.[15] During his short reign, he made the conscious choice to raise the purity rate of silver from Caracalla’s debased 1.66 grams of silver to above the level extant when Caracalla was installed – 1.82 grams – and demonstrated an inclination toward diplomacy versus combat. When the Persians challenged the Roman army, Macrinus “tried to make peace with the Persian king” and “s[ent] back [their] prisoners of war voluntarily.”[16] Consequently, he incurred the resentment of soldiers and further enraged them by introducing a pay system which paid them according to their rank and time-in-service.

In summary,

[t]he increased silver content was clearly beneficial for the state, as it would instill more confidence among its recipients and presumably still inflation … [but] the major problem, of course, was Macrinus’ attempt at military reform … [T]he army would not stand for a curtailment of privileges, even among new recruits. So while Macrinus’ plan was … fiscal responsibility in the state, the strength of the army was too great to allow for it … [and] paved the way for Macrinus’ downfall.[17]

Dissent soon erupted within the ranks and military forces, in a coup, elevated 15-year-old Elagabalus as the new emperor; a battle ensued between Elagabalus supporters and Macrinus loyalists. Macrinus’ forces were routed, and he was captured and executed.

Severus Alexander (March 222AD – March 235AD)

The new Emperor Elagabalus presided until his 18^th birthday, profoundly debasing the denarius and squandering monstrous sums from the public treasury. “No fouler…monster” wrote the poet Ausonius, “ever filled the imperial throne of Rome”.[18] After his assassination, his cousin Severus Alexander rose to power. And

[b]y the time that Alexander ascended the throne the question of the coinage, long acute, had become critical. Looking backwards one may see two centuries of fraud that the debasement of money had gradually but surely proceeded; in the future something little short of national bankruptcy awaited the Roman world unless measures were forthwith adopted to ward off [that] evil day.[19]

Yet in a different strategy from Domitian’s, Alexander initially reduced the silver content of the denarius from 1.41 grams to 1.30 grams, and some years later not only raised it back to the old standard, but far beyond that to 1.50 grams; a quality it had not seen in decades. He

restored the tarnished reputation of imperial money by improving the denarius and striking the first substantial numbers of brass sestertii and copper assees in a generation … they were well-engraved, struck on flans of traditional size and weight, and, as money, the equal of their more elegant ancestors.[20]

He reduced taxes and attempted through various means to end the “singular system of annihilating capital and ruining agriculture and industry [which] was so deeply rooted in the Roman administration”.[21] At the same time, though, he subsidized literature, art and science and socialized education.

When invaders from Gaul threatened the Empire, Severus Alexander attempted to buy them off rather than engage in a pitched, costly battle. This, once again, angered the legionnaires, who elevated General Maximinus as the new emperor. The military rebelled and, like Pertinax and Macrinus before him, Alexander Severus was executed.

Over the next three years, Maximinus doubled soldiers’ pay and waged nearly continual warfare. Taxes were raised, with tax-collectors empowered to commit acts of violence against delinquent or reluctant payers, as well as to summarily confiscate property for citizens in arrears.

Over the next five decades,

[e]mperors … debased the silver currency and raised taxes during what they perceived to be a temporary crisis, expecting windfalls of specie from victory, but war had changed from profitable conquest to a grim defense … The Roman world was treated to the spectacle of imperial mints annually churning out hundreds of millions of silver-clad antoninaniani by recycling coins but a few years old [which] removed older coins from circulation and destroyed public confidence in imperial moneys.[22]

Characteristic of all monetary collapses, as the denarius rapidly withered into a billon trinket Roman citizens developed odd, if essential, skills – the most noteworthy of which were extracting the thin silver coating from otherwise worthless coins and fluency in the social language of monetary failure: barter.

Epilogue

Comparing modern challenges and policy responses to those of remote times is an attractive but precarious enterprise: every generation, let alone culture and era, breathes a unique psychological oxygen. Nevertheless, in this case the exercise yields several potentially valuable insights.

First, what can we say about the reformers? Why did select figures, in an era admitting no formal economic theories and within which the interaction of supply and demand was attributed to superstitious causes or conspiracies, occasionally shore up their currency?

It is notable that all of the reform-minded emperors possessed germane backgrounds and experience: where the majority of Roman emperors had pre-ascension careers in politics or the military, Domitian grew up in a family known for banking; and despite the inglorious end of his incumbency (when maintaining power came to trump sense and experience) his initial

concern with finance, with a stable currency, and an awareness of reciprocity in business and trade dealings as demonstrated in instruments such as his Vine Edict, reflect his continuation of a tradition of financial sensibility, more in keeping with a business house, than with the traditions of [elites] valued by Senators and expected of Emperors.[23]

Most fascinatingly,

[w]hile still a Caesar, Domitian had published a work on coinage … which Pliny the Elder … had cited as a source.[24]

Macrinus was the first non-senatorial emperor, and had years of both financial training and experience; he served as the administrator of the massive Flaminian Road project. Later in his pre-political career, he was personally selected to manage the personal wealth of the imperial family under the emperors Caracalla and Geta. Pertinax had spent years in business as well as teaching, and his time as a merchant led him to the belief that “[e]conomy and industry … [were] the pure and genuine sources of wealth”[25]

Alexander Severus became emperor at 13. It is difficult to hypothesize as to what may have led him to enhance the denarii – and so strongly – but one may speculate that his closest advisors, his mother and grandmother, drew from years of experience in Roman booms and busts.

One also notes that each of the reformers came after particularly egregious debasers: Domitian after Vespasian and Titus; Pertinax after Commodus; Macrinus after Caracalla; and Severus Alexander after Elagabalus. It seems as if each deduced the connection between his predecessor’s profligate monetary (and, indeed, fiscal) policies and the consequent economic crisis, choosing to reverse the afflux.

Summarizing Macrinus’ efforts, but no doubt broadly applicable, is this synopsis:

The exact motivation … for coinage reform [efforts in the Roman Empire] is in general a little hazy … attempts at reforming the coinage standards could reflect the distrust that the … population had for the imperial currency … [a]nother possibility is that [the reformers] wanted to fit into a monetary tradition that was considered responsible … [or] felt a desire to distance themsel[ves] from the policies of [their] predecessor[s] … [as many] were a simple overturning of [prior emperors] destructive economic measures.[26]

In consummation, were these episodes in qualitative tightening successful? Obviously, brief respites in the systematic debasement of the denarius delayed the eventual, yet perhaps inevitable, monetary emergency. More analytically, though, one hint lies in the architectural analysis of lost, donated, and hoarded coins, in that

coins lost casually on sites are equivalent to small change lost today [in that] more were lost as their numbers mounted and purchasing value plunged due to debasements … [C]asual losses and hoards, then, can document shifts in patterns of circulation both within and beyond imperial frontiers.[27]

The number and constitution of coin hoards reveal the public propensity to forestall consumption (“saving”, in familiar parlance) or represent financial reserves hidden out of fear of future devaluations; in any event, they imply which coins were highly valued. Patterns of similar coins lost or donated, oppositely, suggest which in circulation were valued appreciably less. While both Pertinax and Macrinus ruled briefly, and their programs were quickly reversed by their successors, under both Domitian and Severus Alexander (who ruled for 15 and 13 years, respectively) the number of discovered, archeologically-dated coin hoards skyrocketed over those dated to their immediate predecessors: from 3 to 10 and 7 to 18; again, respectively. Similarly, coins of reduced quality are found with higher frequency at ritual offering sites (e.g., temples) and where losses were common (e.g., river crossing sites) than those of contemporary circulating issues with higher purity.[28]

But the most forbidding commonality is the thread of continuity running through the fates of the monetary reformers:

Emperors who improved the purity of the denarius, [notably] Pertinax in 193 [and] Macrinus in 217 … found themselves outbid for the loyalties of the army, and … went down in ignominious defeat.[29]

And so we return to the present day. Owing to the deep entrenchment of government in daily life and, consequently, the politically incendiary nature of entitlements, attempts to underpin the value of any currency with a commodity is likely to be met with considerable resistance from the diffuse and deep-seated institutions and social groups benefitting from fiat currency systems. And yet, for the first time in well over a century, the issue of what actually backs state-issued money has resurfaced as a political issue. Precious metals are seeing their greatest popular resurgence in decades, as, in tandem, interest in and usage of Bitcoin and other cryptocurrencies – precisely because of their irreproducibility and the consequent quantitative limitations – expands rapidly. This, perhaps, hints at a burgeoning shift in public awareness and sentiment, which may eventually translate to political pressure for a return to sound money, but real progress will likely be an uphill battle – with bouts of ‘sticker shock’ along the way. As historian William Warren Carlise wrote,

[a]ll through history we find that it is the reform, the return to sound money rather than the depreciation itself that first rouses popular discontent. It is only when the mass of the people learns that depreciations must be followed sooner or later by such remedies that they begin to entertain a salutary dread with regard to them.[30]

Perhaps the best conclusion that can be drawn from examining these instances is that in response to the familiar rhetorical query – “Are we going the way of the Romans?” – one can reply, truthfully: “No; they occasionally reformed their currency.”

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Ukrainian Coast Guard Attacked Near Russian Border, Some Killed

by zero hedge

A Ukraine military spokesman has confirmed that some sailors were killed and more injured when 2 Ukraine Coast Guard cutters came under attack by artillery from onshore near the village of Bezimenne (close to the Russian Border). This is believed to be the first such incident since the conflict began.

As Bloomberg reports,

Some killed when cutters attacked near village of Bezimenne near border w/ Russia, wounded are being transported to hospitals in Mariupol, Oleksiy Metasov, aide to Ukrainian lawmaker Yehor Firsov, comments by phone from Mariupol.

The naval cutter is reported to have been attacked by artillery from the shore.

Leonid Matyukhin, Ukraine military spokesman, says doesn’t recall similar attack since conflict started.

At around the 1:00 mark, the clip shows numerous aircraft approaching the burning ships...

Europe According to Draghi

by Jean Pisani-Ferry

PARIS – Central bankers are often proud to be boring. Not Mario Draghi. Two years ago, in July 2012, Draghi, the president of the European Central Bank, took everyone by surprise by announcing that he would do “whatever it takes” to save the euro. The effect was dramatic. This August, he used the annual gathering of top central bankers in Jackson Hole, Wyoming, to drop another bomb.

Draghi’s speech this time was more analytical but no less bold. First, he took a side in the ongoing debate about the appropriate policy response to the eurozone’s current stagnation. He emphasized that, along with structural reforms, support for aggregate demand is needed, and that the risk of doing too little in this respect clearly exceeded the risk of doing too much.

Second, he confirmed that the ECB was ready to do its part to boost aggregate demand, and mentioned asset purchases, or quantitative easing, as a necessary tool in a context in which inflation expectations have declined below the official 2% target.

Third, and to the surprise of most, Draghi added that there was scope for a more expansionary fiscal stance in the eurozone as a whole. For the first time, he expressed the view that the eurozone had suffered from the lower availability and effectiveness of fiscal policy relative to the United States, the United Kingdom, and Japan. He attributed this not to pre-existing high public debts, but to the fact that the ECB could not act as a backstop for government funding and spare fiscal authorities the loss of market confidence. Moreover, he called for a discussion among euro members of the eurozone’s overall fiscal stance.

Draghi broke three taboos at once. First, he based his reasoning on the heterodox notion of a policy mix combining monetary and fiscal measures. Second, he explicitly mentioned the aggregate fiscal stance, whereas Europe has always looked at the fiscal situation exclusively on a country-by-country basis. Third, his claim that preventing the ECB from acting as a lender of last resort imposes a high price – making governments vulnerable and reducing their fiscal space – contradicts the tenet that the central bank must not provide support to government borrowing.

The fact that Draghi chose to confront the orthodoxy at a moment when the ECB needs support for its own initiatives is indicative of his concern over the economic situation in the eurozone. His message is that the policy system as it currently works is not suited to the challenges that Europe faces, and that further policy and institutional changes are necessary.

The issue now is whether – and, if so, how – conceptual boldness will translate into policy action. There is less and less doubt regarding the benefits of outright asset purchases by the ECB. What was long regarded as too unconventional to be contemplated has gradually become a matter of consensus. It will be operationally difficult, because the ECB, unlike the Federal Reserve, cannot rely on a unified, liquid bond market, and its effectiveness remains uncertain. But it will most likely take place.

At the same time, there is little doubt that fiscal policy will fall short of Draghi’s wishes. There is no agreement in Europe on the concept of a common fiscal stance, and the backstop that the ECB could provide to sovereigns can be offered only to countries that commit themselves to a negotiated set of policies. Even this conditional support within the framework of the ECB’s so-called outright monetary transactions (OMT) program has been opposed by Germany’s Bundesbank and constitutional court.

Draghi’s initiative on this front should thus be interpreted not only as a call for action, but also – and perhaps even more so – as a call for reflection on the future approach to eurozone policymaking. The question is this: How can the eurozone define and implement a common fiscal policy without having a common budget?

International experience shows that voluntary coordination is of little help. What happened in 2009 was a rare exception; shocks like that which followed the Lehman Brothers bankruptcy – sudden, strongly adverse, and highly symmetric – come once in decades. At the time, all countries faced essentially the same issue, and all shared the same concern that the global economy could slide into a depression.

Europe’s problem today, though serious, is different: a significant subset of countries does not have fiscal space to act and would therefore be unable to support demand. And, though Germany is doing much better than anyone else and has fiscal space, it does not wish to use it to benefit its neighbors.

If joint fiscal action is to be undertaken, a specific mechanism would be needed to trigger it. One could think of a joint decision procedure that would, under certain conditions, require budget laws to be approved by the national parliament and a majority of partner countries (or the European Parliament).

Or one could think of a mechanism inspired by the “tradable deficits permits” imagined by Alessandra Casella of Columbia University. In this scenario, countries would be allocated a deficit permit consistent with the desired aggregate stance, but would be free to trade them; a country willing to post a lower deficit thus could cede its permit to another one willing to post a higher deficit. In this way, the aggregate stance could be achieved while accommodating national preferences.

Any mechanism of this sort raises a host of questions. But the fact that the official in charge of the euro is raising the issue indicates that the common currency’s architecture remains in flux.

A few months ago, the consensus was that the time for redesigning the euro had passed, and that the eurozone would have to live with the architecture inherited from its crisis-driven reforms. Not anymore. It may take time before agreement is reached and decisions are made, but the discussion is bound to resume. That is good news.

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Signs Of An Approaching Bear Market

by Mateo Blumer

Summary

• Stagnant wages and chronic underemployment will hurt US economic growth.
• Concerning debt levels and inflated asset prices are reminiscent of 2007.
• Post-Recession monetary easing has disproportionately benefited the rich, has failed to kick-start meaningful real economic growth.
• Geopolitical risk and US tax policy pose additional threats to US economy.

"The stock market has recovered so sharply for so long, you have to assume somewhere along the line we will get a significant correction. Where that is, I do not know." - Alan Greenspan, July 30, 2014

With all the volatility we've seen over the past few weeks and the possibility that we're nearing an inflection point, the bulls and bears are out in full force debating - and to some extent influencing - the future of the US stock market. Judging from the evidence being used to defend either side, the bears currently have a clear upper hand. Over the next five years, it is extremely unlikely that we will experience a bull market similar to the one we've just witnessed (from August 2009 to present). Based upon an examination of underlying economic conditions, trends and political realities, we can expect a significant market correction or full-on downturn in the years to come.

Let's start with the view from 40,000 feet. The graph below shows the performance of the S&P 500 (NYSEARCA:SPY), the Dow Jones Industrial Average (NYSEARCA:DIA), and the NASDAQ (NASDAQ:QQQ) over the past 5 years to date. For comparison, I've included a graph showing the previous five-year rally in US markets (using the same August-to-August timeframe), which took place from 2002-2007.

Major US Indices, August 2009-2014

Major US Indices, August 2002-2007

Despite the fact that the 2002-2007 rally (detailed in the second graph) conveniently begins at the end of the dot-com bubble and cuts off right before the Great Recession, the market rally we've witnessed over the past 5 years to date beats the previous rally by a pretty significant margin, for every index.

This comparison in no way proves that a bear market or market correction is coming. But it should make you wonder: have economic conditions over the past five years improved enough to justify such serious growth in asset prices? Where we are now, is the US positioned for the kind of economic growth that would sustain another five-year rally in the stock market?

Looking at the data, the answer is a resounding "No."

At any given time, there will be data that can used to support both bull and bear market hypotheses. Often times as we'll see, the exact same data point will be construed as positive AND negative, based on who's offering the analysis and what their overall thesis is. I've tried to compile what I consider to be some of the more salient points on either side of the argument:

Positive

- Aside from the volatility over the past few weeks, US markets have been demonstrating clear positive momentum. The NASDAQ, Dow Jones Industrial Average and S&P 500 indices each hit all-time highs in July 2014, well above the highs each had reached in 2007 prior to the recession.

- Overall, recent economic news in the US has been mostly positive. The US has been adding jobs lately, and although the 209,000 jobs added in July fell short of the projected 230,000 jobs expected, this represents the longest streak of 200,000+ jobs added since 1997. Job gains for May and June were revised upwards by a total of 15,000, to 229,000 and 298,000 respectively. Also positive was that most of July's job gains went to full-time workers, "partly reversing huge advances by part-time workers at the expense of full-time employees in June"

- Rapid employment gains have boosted consumer confidence, which hit a seven-year high in July

- The employment outlook therefore looks to be one of further robust job creation in the coming months, but with some moderation in the rate of job creation compared to the first half of the year. - Chris Williamson, chief economist at Markit

- Demand for commercial real estate loans is up, and net debt issuance of US non-financial sector has been climbing, hitting its highest level since its 2007 peak.

Analysis

The aforementioned statistics are relatively short-term in nature. This short-term perspective was a common characteristic among the most compelling and fact-rich bullish analyses I've been able to find. Of those facts and analyses that are longer term in nature - such as those looking at the stock market's historical performance - it seems that many of these are actually more compelling evidence to the contrary (i.e. markets have hit all-time highs, thus the chance of recession is low), or are attempting to distract from examination of current market realities by discussing investment philosophy.

Some examples of the latter that stood out to me: "Timing the market is a fool's errand" (article I Told you So!), and "studies have shown that the more frequent an investor checks their account balances, the more over time they dramatically underperform nearly every single part of the investable landscape" (in article The Greatest Mistake Investors Make). Talking about the shortcomings of active management - a legitimate idea with plenty of facts to defend it - is a pretty weak argument upon which to claim that a bear market is unlikely to occur.

It also stands out to me that, of the "Editor's pick" articles chosen in the past few weeks, the vast majority of those examining market outlook have either taken a bearish or cautious/neutral stance. This hardly constitutes evidence that the bears are right. But considering how articles that win this designation tend to be heavy on facts and references, specific knowledge, and novel but reasonable analysis, the fact that there weren't many market-bullish articles on this list over the past few weeks did seem to imply that there may have been a lack of such articles with strong factual analysis to back them up.

Negative

That being said, the legitimate case for a bear market comes not from weaknesses in the opponents' arguments, but from quality analysis of what we consider to be the most important facts. I believe a bear market is on the horizon for several reasons:

Major economies are showing signs of a slowdown:

- The Baltic Dry Index, often considered a leading indicator of future economic growth or contraction, has fallen 60% since the beginning of 2004; it currently sits at its lowest level of the year.

- Germany and Great Britain have seen industrial production and manufacturing (respectively) decline by 1.8% and 1.3% in May. In 2014, "the Chinese economy will grow at its slowest pace in years"

- The Bank of Japan (Japan's equivalent of the US Federal Reserve) has been buying its own market ETF to "boost the impact of its unprecedented easing" ("Bank of Japan Seen Buying Nikkei 400 ETF," Financial Post, July 10, 2014)

- Despite 88 companies being listed on the stock market in Q2 2014, the US contracted 2.9% in Q1 2014.

Stagnating wages and chronic unemployment threaten the US economy:

- Despite the increase in new jobs over the past few years, unemployment rose to 6.2% from 6.1% over the past quarter. The so-called under-employment rate (which includes discouraged workers who have given up looking for jobs, and part-time employees who prefer full time work as well as the unemployed) ticked up to 12.2% from 12.1%.

- Since the Great Recession, participation in the labor force has steadily declined, and despite recent economic growth, has actually reached new lows:

Inequality is Reaching its Highest Levels since 1928

- In 1982, the highest-earning 1% of families received 10.8% of all pretax income, while the bottom 90% received 64.7%

- In 2012, the top 1% received 22.5% of all pretax income, while the share going to the bottom 90% dropped to 49.6% (source)

- Since 2009, 95% of income gains went to the top 1% of earners

(click to enlarge)

In 2010:

- The richest 20% of Americans held 88.9% of the nation's wealth

- Top 1% wealthiest American households owned 35.4% of all U.S. Wealth (source)

- Richest 400 Americans together have more wealth than the poorest half of Americans combined (source)

- Before taxes and government transfers, America ranks 10th in the world in terms of income inequality. After taxes, it ranks 2nd in the world in income inequality. (source)

Uncertainty Regarding Geopolitical Crises Creates Potential Threats to Global Economy:

- Russia and Ukraine
- Israel and Gaza
- ISIS in Iraq
- Instability in Syria

US Tax Policy:

- Stopping corporate inversions "will make the US economy weaker," imposes big costs by discouraging investment (The Economist)

- America's corporate tax rate, at 35%, is the highest among the 34 members of OECD

Fed's Monetary Expansion:

- Since 2007, quantitative easing (printing money to buy bonds in order to keep interest rates low, with the goal of having cheap credit and stimulating demand and rising asset prices) has benefited Wall Street and the richest Americans disproportionately.

- "Motor force of Keynesian expansion is gone" (by which cheap credit and big interest rate cuts stimulate buying and spending, thus spurring overall economic growth). The expansion of US household debt - which is at 103% of household income - has come as a result primarily from massive student loan debts. As baby boomers retire, and start spending money rather than borrowing, this driver of Keynesian growth has nowhere to go but down. ("Don't Buy This Dip: The Fed is Not Your Friend")

- Same effect has been examined in England, where post-Recession QE has led to stock market gains, but benefiting disproportionately the rich, thus leading to rising levels of inequality ("Trickle-Up Monetary Policy?")

- "Factoring out the Fed's massive balance sheet expansion since its first big rate cut in August 2007 - that is, from $800 billion to $400 trillion - [US] real final sales have grown at less than 1% CAGR since then" ("Don't Buy This Dip: The Fed is Not Your Friend")

(click to enlarge)

Shiller Cyclically-Adjusted P/E Ratio is Creeping back up to Concerning Levels:

(click to enlarge)

Given the massive growth in US Federal debt, and the slowdown in US and global economic growth, valuations should be going lower, not higher.

Analysis

Overall, examination of big underlying problems - from the short-term indicators (like monthly jobs and production figures) to the longer-term trends (such as slowing growth and growing inequality) - there are several reasons why the US is likely to experience a bear market in the years to come. Not only does it seem as if the big stock market gains achieved over the past five years (and the resulting current valuations) may not be justified; many of the underlying problems are difficult to address, and currently show little or no sign of improving on their own (specifically, US inequality).

Although trying to time when this will happen is indeed a difficult task, we can prepare ourselves by moving assets out of equities and into assets that historically have a low correlation with the stock market (such as gold), and focusing on the sectors with the most reasonable valuations and long-term growth prospects. Here is an article that has some interesting examinations of the correlation between different asset classes (long-term Treasuries, Gold, Cash, High yield, and equity securities) during key times of market activity.

As an investment advisor personally, I am currently shifting assets away from equities, towards alternative investment opportunities in my hometown of Seattle, and in Austin, Texas. Working with people you know, and becoming intimately familiar with specific projects, allows for greater control and a higher level of confidence than, say, betting on the US real estate market as a whole. Looking at the fastest-growing US cities in search of such alternative investment opportunities, Seattle, WA, Austin, TX and Washington, D.C. are on my radar.

Since 1929, looking at average monthly returns in the stock market, we see that September is by far the worst-performing month of the year, with an average monthly return of -1.1%. This doesn't mean there will be a for sure pullback in September, but should get you thinking about what you might do if the market began showing signs of a correction, or full-on economic downturn. In times like these, it is so hard to predict when a bear market or market correction will take place, precisely because it's so hard to distinguish between human effects and market effects in terms of changes in stock prices. If everyone - from Wall Street to average Joe and everyone else in the world - decided to keep on buying stocks with confidence, and ignore reality, prices would rise indefinitely.

The bulls have one thing right: timing the market is notoriously difficult, and is usually only done successfully by those who have their finger on the pulse and have taken the time to understand the underlying economic realities. But it is far from impossible, especially when so many signs point to an impending bear market. Timing and shorting the market is different, it's more difficult than simply preparing for a bear market mentally, and from an investment standpoint logically. Far worse than trying to time the market and failing, is to ignore the economic realities and pretend like everything is OK and stocks have nowhere to go but up.

Source: Signs Of An Approaching Bear Market

Additional disclosure: Since July 2014 author holds net-short positions on certain market indices (SPY, RSP) using ETF-options spread positions (typically characterized by an equal ratio of "long" to "short" options positions) and through the use of similar futures options spreads. Author holds long positions on wide variety of individual stocks and sector ETFs.

See the original article >>

Does divergence of S&P 500 and treasury yields pose threat to equities?

By Matt Weller

After a dismal start to the month, the S&P 500 (CME:SPZ14) rallied to a record high last week and is nearing an important psychological resistance zone around 2,000.

If the index manages to break through this level, it should bode well for US stocks in the near-term. The strong performance of US stocks over the last couple of weeks can be attributed to easing geopolitical tensions, a strong earnings season and encouraging US economic data, which helped the market brush off mildly hawkish minutes from the Fed last week.

On the data front, the optimism surrounding the US labour market has been bolstered by strong US housing and manufacturing data. It’s worth pointing out that while the economic data out of the US has been broadly positive lately, it hasn’t materially changed the market’s perception on when the Fed will begin hiking interest rates. Thus, it’s supportive for US equity markets.

S&P 500 (white) and U.S. 10-year Treasury Yield:Source: FOREX.com, Bloomberg (Note: This chart may not represent prices offered by FOREX.com)

In the QE era, strong US economic figures can result in a negative reaction from U.S. stocks because it makes the market jittery about the prospect of higher rates. This time is different because the market’s expectations for monetary policy haven’t really been altered, despite the general feeling from the Fed’s July policy minutes that the doves are moving closer to becoming the minority.

At the same time, second-quarter earnings season has also helped to bolster investor sentiment. Of the 486 companies in the S&P 500 that have reported earnings at the time of writing, more than 75% of have topped analysts’ estimates. This bodes well for the index leading into a period of expected increased sales and revenue for many firms.

With the US earnings season almost over, the biggest threats to our bullish outlook may come in the form of increased geopolitical tension or a more-hawkish-than-expected Fed. As we pointed out earlier, the Fed’s latest meeting minutes were slightly more hawkish than the market was expecting, but the outlook for rates remains very data-dependant. In the event of strong growth and labour market indicators the Fed may elect to bring forward the beginning of its rate-tightening cycle. Yet, this won’t necessarily result in equity weakness; the Fed’s tightening cycle is likely to be gentle and measured, which makes it manageable.

At the time of writing, the market is eagerly awaiting a speech from Fed Chair Yellen in Jackson Hole, where she will talk about the labour market. The health of the jobs market is a crucial factor in determining when the Fed will begin hiking interest rates. July’s meeting minutes suggested that policymakers differ in their views of the labour market and how best to accurately assess its real health. Overall, despite the more hawkish minutes, the market largely expects Yellen to sound more dovish.

From a technical perspective, all eyes are on 2,000. This level represents a key psychological resistance zone for the S&P 500. A break here could extend the current rally even further into unknown territory. If the index is rejected by the aforementioned resistance zone it may head towards trend line support (see chart). A break of its upward trend would negate our overall bullish view of the S&P 500.

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The End of Tolerance and the New Populism

By Marina Prentoulis and Lasse Thomassen

Reflections on the 2014 local and European election results have heavily stressed the rise of the populist far right. Clearly they have emerged as a leading political force at home and abroad, but this is not the whole story.

UKIP, the French Front National and the Danish People’s Party have declared an end to tolerance of ‘the others’. This refers both to migrants and asylum seekers invading ‘our’ space, and the elites hidden in Brussels and Strasbourg governing without ‘our’ consent. Whether ethnic others or political and cultural elites, they are not part of ‘us’, and our intolerance of them is promoted as natural.

An anti-UKIP demonstration in Edinburgh, on May 9, 2014.

Seen from the mainstream and from the left, these parties capitalise on the anxieties experienced within communities increasingly subject to internal social diversity and external economic control. Although UKIP et al. present themselves as rebels against ‘establishment politics’, they are nothing more than its monstrous offspring. This is the same politics that has allowed democratic accountability and participatory citizenship to take the backseat as neo-liberal interests dominated Europe.

The old parties are clearly in crisis and losing electoral ground to new parties, right, centre and left. Concerned politicians of the mainstream parties are calling meetings to tackle the problem. In their minds, the challenge no doubt has little to do with them and the neo-liberal policies they have been backing. It is a challenge that has, for some time now, been dismissed as ‘populist’—a description which writes it down to the ignorance and fears of the ‘peoples’ of Europe.

Bridging the divides

The success of the radical left has drawn less attention, but there has been steady progress towards an alternative ‘populist’ discourse. Like the populism of the far right, the narrative of these groups is also intolerant of current political elites, and cast in the name of the peoples of Europe.

Mainstream politicians currently accord both the far right and the left the same label: Eurosceptics. But the new left populism that is slowly winning ground across Europe is rooted in different legacies and pursues a very different vision than the more successful far right. Whatever their success, one thing is sure: enough of traditional politics.

New parties, coalitions and movements are developing across Europe. In the south there is Syriza in Greece (26% of the vote in the EU elections); Izquierda Unida (9.9%) and Podemos (7.9%) in Spain; the Five Star Movement (21.2%) and L’Altra Europa con Tsipras in Italy (4.3%). To the north: Die Linke (7.4%) and Front de Gauche (6.3%) in Germany and France respectively.

The popular mobilizations that have followed the economic crisis in southern Europe contain a new (anti-)political discourse attacking the customs of representative politics. The Spanish indignados and Greek aganaktismenoi entertained the possibility of direct, participatory democracy through people’s assemblies. In Italy, the Five Star Movement brought into play the non-political, anti-establishment outsiders. Even in the UK, neo-liberal political and economic logic has been attacked by the Occupy movement and anti-austerity campaign groups.

Although these protests have now left the streets, their motives are still alive in the minds of European peoples. Political organisations on the left are trying to channel the indignation at every level from the local to the supranational.

In southern Europe particularly, the left has had to rethink its definitions of a ‘party’ and engage with grassroots networks that extend beyond traditional limits. Where the left was previously divided, it is uniting to form coalition parties which embrace the whole spectrum of socialist ideals.

Syriza in Greece emphasised not only the importance of electoral politics but also the creation of solidarity networks cutting across ideologies and social groups. The Izquierda Unida party in Spain has set aside fetishized issues to declare itself as a vehicle for social change coming from below—in response to the biggest surprise of the Spanish elections, Podemos, a non-party arising from the indignados movement. In Italy new party-coalitions, such as Sinistra, Ecologia e Libertà are forming. In France, the Parti de Gauche is broadening to become the electoral coalition Front de Gauche.

Vox populi

Two forms of populism, two forms of intolerance: one right, one left. While the far right has embraced the populist label, the left is sceptical. The two cannot share the same kind of populism, but it would be dangerous to cede its language to the right.

Where they speak in the name of the people as the ethnic nation, the left must articulate a different collective idea. What do ‘the people’ mean for the left? Against what is ‘the people’ set?

Where the far right is intolerant of difference, the left must embrace it; where the far right is reactionary and regressive, the left must be progressive; and where the far right complains about politicians, the left must complain about the political system. Switching from Cameron to Miliband to Farage does not make the political system more inclusive and participatory. This is where the new alternative forms of left politics can make a real change.

The left must not cede the populist voice to the right, but embrace it. It must do so not in fear of the other or in fear of change, but in the name of the people and against the political and economic elites. The left should embrace progress—things ought to precisely not be what they used to be.

Like populism, tolerance is no univocal idea. As the ‘end of tolerance’ gains ground, left-wing populism has a twofold objective. First, to stand firmly against the far-right populism. Second, to dispel the myth that politics must continue as it always has. People demand to be heard and their anxieties and grievances have to be taken seriously. A new left is taking shape, one that has been with these people in the streets of Europe.

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5 Things To Ponder

by Lance Roberts

The financial markets are set to wrap up the month with roughly a 3.5% gain, depending on where today's action ends, which is historically on the positive end of returns for the month. The histogram below shows the annual percentage change for the month of August. Since 1930, there have been a total of 47 positive months versus 38 negative (55% win ratio) with an average return of 1.47%. However, if we strip out the 37.7% gain in 1932, the one outlier, the average monthly return falls to just 1.04%.

Learn About Tableau

September's prospects improve a bit from August with the overall win ratio improving to 58.3%. However, unlike August there is bigger propensity of market declines of between 5-10%.

Learn About Tableau

With the Federal Reserve ending their support of the markets by October, and as discussed yesterday, corporate share buybacks on the decline; two of the biggest supports of asset prices over the last couple of years is fading. What does this mean for investors going forward? That is the subject of this Labor Day Edition of "5 Things To Ponder."

1) A Classic Warning For Investors by Michael Mackenzie via Financial Times

"A look at the growing and already large divergence between the S&P 500 and the 10-year government note yield illustrates how the two big US markets are not only not cheap, but are also sending conflicting messages.

Here, equities and bonds can probably prosper in the near term until economic data conclusively settles the issue. Only then will the huge divergence between the S&P and 10-year yields snap shut with serious repercussions for some investors."

2) The Fed Has Become The Fundamentals by Jeffrey Cooper via MinyanVille

"A bull market will always find the silver lining, no matter how insignificant. Mirror image of human emotions and hysteria." - Marc Eckelberry

"There is a notion out there that the bull market has a long way to go since there is no sign of elation, such as in the months leading up to the top in March 2000. Fear is driving the market, not greed. Equities are up out of lack of choice, not out of reason.

Ebullience has not been a hallmark of the advance at any point in the last 5.5 years. Does a grand top require a manic phase? The top floor can be reached by an escalator just as well as an elevator."

3) It's Time To Be Defensive, Very Defensive via ZeroHedge

"What is wrong with changing your mind because the facts change? But you have to be able to say why you changed your mind and how the facts changed." - Lee Iacocca

"It’s important to underline that major US investment houses, and certainly every single sales person I talk to, believe US is about to accelerate in growth not slow down. Q3 could be ok but the real damage will come in Q4 as the lead-lag factor of geopolitical risk, lack of reforms and excess global supply leads to low inflation. Despite recent Fed optimism about an exit strategy the fact remains that few institutions are worse than the Fed in projections as even its simple target goals show."

Read Also: The Bubble Of All Bubbles - European Bonds by EconMatters

4) Equity Markets Running On Fumes by Izabella Kamins via Financial Times

"It is widely accepted the Fed’s QE programme has inflated asset prices way above fundamental values (higher inequality being one unwelcome by-product). Andrew Lapthorne has identified the mechanism whereby QE, by shrinking the available stock of investable government bonds, has encouraged investors to instead gobble up other debt assets all along the risk spectrum. Companies issuing at low yields into this buying frenzy are doing what they always like doing with debt in the final throes of an economic cycle they issue cheap debt to buy expensive equity. Decent profit (cashflow growth) may be more than sufficient to cover capital expenditure and dividends, but a gargantuan funding gap emerges as companies also undertake their corporate finance zaitech activities (see chart below, Andrew also calculates that currently almost a third of all buybacks are to cover the expense of maturing management share options QE is indeed making the rich richer!)."

5) Get Ready For S&P 500 2150 by Mark Hulbert via WSJ MarketWatch

"This incredible bull market, which pushed the S&P 500 above 2,000 earlier this week, is still alive and well. By the end of the year, the benchmark index may rise to around 2,150, about 8% higher.

So says Sam Eisenstadt, who has more successfully called the stock market in recent years than almost every other market timer I can think of — including many who I have featured in this column.

Eisenstadt, for those of you who don’t know of him, is the former research director at Value Line Inc. Though he retired in 2009, after 63 years at that firm, he continues in retirement to update and refine a complex econometric model that generates six-month forecasts for the S&P 500."

Bonus Read: Because There Is An Extra Day This Weekend

The Greater The Stock Bubble, The Less Monetary Theory Holds by Jeffrey Snider via Alhambra Partners

"I think the full answer lies in monetarism not being a flow of “money” and funds but rather a corruption of expectations, and thus activity. The idea of “easy money” now spans not just some marginal speculators touring the contours of the pink sheets for grand slams, but rather it has taken hold of everyone from the should-be-conservative retirees looking to regain their balances from even two bubbles ago to corporate boardrooms looking to get paid as much as possible before reality closes in once more and the bottom falls out. In trying to gear marginal economic activity toward financial means, central banks have instead totally financialized the entire affair to the point that far too much psychology, and thus attendant flow, goes only in that direction. In other words, instead of enhancing marginal economic activity it directly suffocates it."

The Bubble is in Cash, Not Stocks…

By: Brad Thomas

We are repeatedly reminded by many so-called “experts” that the stock market is in a bubble, and that when central bank quantitative easing programs end stock markets will “crash.”

However, it would appear that the only bubble is people’s uncertainty of the future and their desire to hold large sums of cash. These high cash levels equate to a huge pool of marginal buyers, rather than sellers, for stocks and other “real” assets.

With more buyers than sellers the most likely next big move for stocks is up, not down. This will be the case until equity markets are overbought. Thus, until that time we should not concern ourselves with any material downside.

One of my guiding “mantras” is a quote from the famous value investor John B. Templeton:

Bull markets are born in pessimism, grow in skepticism, mature in optimism, and die in euphoria.

If one can simply identify where we are on this continuum then everything else falls in place! Yes, it does seem simple, but the hard part is interpreting the data and sentiment to discover where we are. In order to do this one needs to have been through a few market cycles to know what conditions of optimism and euphoria are all about.

I started trading in the mid 1980s and I have been through everything between now and then. Yes, it has been one hell of a ride. However, courtesy of this “journey” I know what optimism/euphoria is all about (thank the TMT bubble for that) and what all previous market tops had in common.

Contrary to popular belief the common trait wasn’t that they were expensive, rather it was that too many people owned stocks. Markets reach stages where they quite literally run out of buyers and that is when they are prone to significant downside movements.

So let’s have a look at a few indicators which will shed light on how the market is positioned – i.e. the “ratio of weak to strong hands”. Previous market tops were characterized by high levels of consumer confidence. Granted no one indicator is perfect and free of “noise”, however, it does seem that once the Conference Board Consumer Confidence Index reaches the 110 level the market is in danger of serious downside and investors should be very cautious of being over invested in stocks. Note where the index currently sits – right bang in “neutral” territory.

Yes, it is difficult to comprehend but, if consumer confidence is anything to go by, we are probably only half way through the current bull market! This may seem a wild assertion but it is backed up by what investors are doing with their savings.

When optimism is high people feel certain about the future and as a consequence they invest a high proportion of their savings in the stock market. High levels of fear/uncertainty or a lack of confidence is associated with a high proportion of peoples’ savings in cash or equivalents.

This week I couldn’t help but notice the following article in the Washington Post on 18 July:

The first paragraph of the article reads:

Americans are holding more cash in their bank accounts than they have at any other point over the last two decades, a new study found. The average checking account balance reached $4,436 at the end of last year, nearly double the average balance of $2,100 seen over the last 25 years, according to a new report from Moebs Services, an economic research firm. Prior to 2003, checking account balances pretty much hovered around $2,000, according to the report.

Cash levels more or less the highest in a generation! This isn’t “typically” the sort of condition that occurs anywhere near the end of an equity bull market! The same tone of this article was echoed by the following on Yahoo Finance on 21 July:

However one looks at it – cash is still a way more popular investment alternative than stocks:

Bankrate.com released the results of a new survey about how secure Americans feel about their personal finances compared with 12 months ago. According to the results, Americans overall chose cash as their favourite long-term investment. In fact, 1 in 4 Americans prefer cash investments for money they will not need for at least 10 years. Stocks came in third with 19% of the vote.

Nearly 40% of 18-29 year-olds say cash is their preferred way to invest money they don’t need for at least 10 years, despite the fact that the S&P 500 has gained 17% over the past year while the yield on cash investments is below 1%.

Getting back to Templeton’s quote “bull markets are born in pessimism, grow in skepticism, mature in optimism and die in euphoria” – if these articles and the Consumer Confidence index are anything to go by then we are nowhere near a condition of optimism perhaps at best we are still in skepticism!

Yes, it is very hard to comprehend this given that the S&P is up well over 100% in some 5 years but we should be very careful of jumping to the conclusion that the stock market and sentiment move in a lockstep or linear fashion. I think that many investors are under the mistaken belief that the performance of the stock market translates directly to sentiment.

You might be asking – how has the stock market managed to advance as dramatically as it has over the last 5 years? I think to a large extent this has been driven by corporate buybacks. Many companies have been aggressively buying back their own stocks over the last 5 years which has dramatically reduced the liquidity of stocks to trade. So with liquidity in shares being dramatically reduced it doesn’t take much in the way of buying pressure to push prices higher.

This leads us to a very interesting situation and looming disaster for those who aren’t invested in stocks! Consumers (who are ultimately the buyers of stocks) have the highest cash levels in a generation, combined with the liquidity of stocks that is probably the lowest in a generation and you have the recipe for the best is yet to come in the stock market. Yes, the rally in stocks is likely to continue for many months and the performance may well rival what we have seen over the last 5 years!

- Brad

See the original article >>

China’s Property Market: Policy Is the Real Risk

by Hayden Briscoe

Concerns about a possible collapse in China’s property market continue to grow. However, our research suggests that fundamentals are more robust than many think. The biggest danger lies in the potential for policy mistakes.

Investors are understandably worried about the headlines coming out of China’s property sector. Sales fell in July after having seemed to stabilize in June. For the first half of this year, sales nationally fell by 6.7% year over year, to RMB3 trillion (US$488.4 billion). That’s the first time such a steep fall has occurred since 2011.

We see three reasons for the sector’s slowdown. The main cause is China’s credit tightening, but there’s also the base effect created by extremely high sales in 2013 (a result of strong pent-up demand in 2012) and the country’s overall economic slowdown. Each of these stems from government policy. Credit expansion fueled demand for property in 2012—now, the government is rebalancing the economy so consumption will play a much bigger role alongside investment as a driver of growth.

To appreciate the impact of these policies on the property sector, it helps to consider its key fundamentals. Despite the decline in sales volumes, there has been no meaningful drop-off in property prices nationally. During the first six months of the year, the implied average selling price nationally fell by just 0.8%. But sales prices and volumes vary from project to project and city to city. On residential projects in Tier One cities such as Beijing, Shanghai, Guangzhou and Shenzhen, for example, price cuts of 5% to 10% can boost sales volumes literally overnight. Price cuts—even with steeper discounts—tend not to work in lower-tier cities.

This relationship explains why sales prices haven’t really moved. In Tier One cities, the number of properties being sold as a result of price discounting is too small to have much impact on national average sale prices. Developers in other cities aren’t lowering their prices because they know it won’t improve sales. Based on this evidence, if credit isn’t relaxed on mortgages, or if national prices don’t correct to stimulate demand for upgrades and investment, the physical market will likely consolidate further.

Oversupply is the main cause of concern for many people, but it’s not a nationwide issue, in our view. It’s particularly severe only in a few lower-tier cities (Display 1) and in the commercial property sector. On the national level, the supply-demand imbalance is manageable, and our research suggests that it can be resolved over the next two to three years, with demand underpinned by urbanization and, to an even greater extent, by people wishing to upgrade.

In the commercial property sector, oversupply is high—much higher than in the residential sector—and it has created images of ghost towns. While this could evolve into a bigger problem, commercial real estate accounts for a very small proportion of the overall property market (Display 2). This suggests that a crisis in commercial property is highly unlikely to destabilize the whole sector.

So, while there’s a supply-demand imbalance in the Chinese property market, it should be capable of resolving itself in the medium term, assuming a stable policy and credit environment. The key risk isn’t supply or demand, but the availability of short-term liquidity: Over the past few years, developers have been taking leverage from local governments’ balance sheets and adding it to their own. A severe shrinkage of bank and nonbank liquidity for the sector (most likely policy driven) would probably be the catalyst for a much larger correction. This, however, is not our base case scenario.

The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AllianceBernstein portfolio-management teams.

Hayden Briscoe is Director of Asia-Pacific Fixed Income and Jenny Zeng is a Research Analyst for Corporate Credit, both at AllianceBernstein.

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Scottish Independence

by Jim Walker

It’s NOT All about Pounds and Oil

“We shall not rebuild civilization on a large scale. It is no accident that on the whole there was more beauty and decency to be found in the life of small peoples, and that among the large ones there was more happiness and content in proportion as they had avoided the deadly blight of centralization. Least of all shall we preserve democracy or foster its growth if all the power and most of the important decisions rest with an organization far too big for the common man to survey or comprehend. Nowhere has democracy ever worked well without a great measure of local self-government, providing a school of political training for the people at large as much as for their future leaders. It is only where responsibility can be learned and practiced in affairs with which most people are familiar, where it is the awareness of one’s neighbor rather than some theoretical knowledge of the needs of other people which guides action, that the ordinary man can take a real part in public affairs because they concern the world he knows. Where the scope of the political measures becomes so large that the necessary knowledge is almost exclusively possessed by the bureaucracy, the creative impulses of the private person must flag. I believe that here the experience of the small countries like Holland and Switzerland contains much from which even the most fortunate larger countries like Great Britain can learn. We shall all be the gainers if we can create a world fit for small states to live in.”
Friedrich Hayek, The Road to Serfdom (1944), Chapter 15 (emphasis added)

Austrian economist and political philosopher Friedrich A. Hayek
(Photo credit: unknown)

“Much of the reclaimed sovereignty would be purely notional, and some would be the sovereign power to mess things up”
Bill Emmott (former editor of The Economist writing on Scottish independence), Financial Times Comment, 8 August 2014

When we are asked why we support Scottish independence our immediate answer is that it is time to for Scots to take responsibility for their own affairs, quit moaning and break the notion of dependency with which generations have grown up. We never think purely in terms of an economic calculation – whether independence would make Scots in general better or worse off by a few pounds. That is to misunderstand the whole rationale for independence.
We rarely try to explain to questioners that it is also in keeping with our whole philosophy of economics, politics and society. As we have noted in bold in the quote from Friedrich Hayek, one of the truly great observers of political economy and social philosophy, “it is the awareness of one’s neighbor rather than some theoretical knowledge of the needs of other people which guides action, that the ordinary man can take a real part in public affairs because they concern the world he knows.”
But equally – and this is the whole point – we agree with Bill Emmott: “…reclaimed sovereignty…would be the sovereign power to mess things up”. All countries have the right to make their own decisions even if that results in messing things up, at least in the first instance. In one of our country reports from 2013, Mongolia: Chaos In Action, we wrote that Mongolia, population of 2.9m, was a country in a hurry…

“…but, when combined with a traditional animosity towards foreigners, particularly Chinese and Russians, and the exuberance of Mongolian politics it is a backdrop which leads to lurches in policy positions as well as hasty decisions that produce more unintended consequences than results. In short, Mongolia’s economic immaturity is only matched by its political immaturity. It is a country in a hurry to go places but, like the traffic, it is stuck because of inadequate infrastructure, both physical and human. Not all resources are physical and, arguably, a country’s greatest resource is its people. That does not always go for its politicians and bureaucracy, as we are about to see.”

We likened Mongolia’s young, vibrant and chaotic democracy to a process of trial and error where hasty decisions were taken, often without thinking through the consequences, and then reversed a few months later. Having a small, concentrated population where political and economic policy decisions fed through quickly to the general public meant that the pressure to rectify mistakes was fast and intense.
We are not comparing Scotland to Mongolia. But we know one thing for sure though, Mongolians would fiercely defend their right to make those mistakes of their own accord. In fact, we know of no countries that we visit, or nations around the globe, that do not rejoice in the ability to make their own decisions and take responsibility for their own actions.
For example, we doubt if an independent Scottish government would voluntarily take the decision, as is the case today, to have the largest concentration of nuclear weapons in Europe stationed just 25 miles away from Glasgow, the country’s biggest center of population. Scottish independence is not all about economics.
But even if it were all about economics, the evidence is good that small units, such as Scotland, rank high in global terms. Figure 1 shows the 11 countries AAA-rated for sovereign debt by Fitch Ratings and their respective populations.

Standard & Poor’s ratings exclude Austria, the Netherlands and the United States from the AAA list but include Hong Kong (population 7.2m), Lichtenstein (37,000), Sweden (9.6m), Switzerland (8.0m) and the UK (63.9m). Moody’s includes the Isle of Man (87,000) and New Zealand (4.4m). It is otherwise the same as Fitch although it also rates Lichtenstein AAA.
In summary, if there is one thing you want to be in order to get AAA rated it is small. That fits much more closely with Hayek’s optimistic vision of the world than Emmott’s downbeat pessimism.

Eilean Donan Castle, Scotland
(Photo credit: unknown, via imgur.com)
Having said that, a number of large companies have voiced open concerns about Scottish independence and their own future, or at least some of their assets and investment if not the future of the company as a whole, in an independent Scotland. This has frightened many people away from the independence camp. These companies include multinationals such as BP and Shell and finance giants such as Standard Life and the Royal Bank of Scotland (both of which are headquartered in Scotland).
The American-born CEO of BP is on record as warning that Scottish independence represented a “question mark” for the firm because of the “uncertainty” that it involves (he was speaking in a personal capacity but that was never reported by the anti-independence media i.e., almost every single newspaper and broadcaster, in Scotland. BP’s Chairman, subsequently, was at pains to reaffirm the company’s investment schedule even in the wake of a ‘Yes’ vote).
But just think about the CEO’s comments for a moment. The head of a multinational oil company which has investments in countries like Russia, Indonesia and Egypt is kept awake at night by the prospect of Scottish independence. It would appear that Alex Salmond, who runs a perfectly competent, business friendly devolved government already, is scarier than Vladimir Putin, retrospective taxes and contractual changes in Indonesia and revolution and political upheaval in Egypt. Could something else be at play here?
Financial service company executives have talked about relocating from Scotland before even seeing what the financial services regime would be like after independence. Not a single thought for shareholders as regards the massive costs of relocation or for staff well-being and quality of life (the lifestyle in Edinburgh, we can assure you, is quite superb for well-paid financial services staff).
Their objections do not stack up but perhaps there is a different agenda: large corporations like to deal with large states. It is in these states that they can exert most behind-the-scenes influence on technocrats, regulators and civil servants (admittedly, some large companies have committed to investing more in Scotland regardless of the referendum outcome). Let us return to Hayek:

“Where the scope of the political measures becomes so large that the necessary knowledge is almost exclusively possessed by the bureaucracy, the creative impulses of the private person must flag.”

He could easily have added ‘and the interests and influence of the large corporation can be maximized’. In small countries the effort involved by large companies to buy relatively small influence is just too expensive. No wonder oil majors are wary of an independent Scotland and the prospect of a new North Sea tax regime; all the sunk lobbying costs from years of London activity would count for nothing. Likewise the influence the financial sector has on the Bank of England and other financial regulators. What these executives really mean is that Scottish independence would be inconvenient for them, regardless of the benefits (and costs) it might bring to everyone else.
But let us turn from the philosophical case for independence and concentrate on the economic issues which have become central to the referendum and outline our take on them.
To be continued tomorrow in Part 2: “The Currency – Sterling or Not?”
Dr. Jim Walker is the founder and chief economist of Asianomics Limited, an economic research and consultancy company formed in late 2007 and serving the fund management industry. He is also the owner of Forensic Asia, a bottom-up corporate research company which concentrates on financial stress and balance sheet health, and Chart Asia, a technical analysis unit which primarily focuses on trends in Asian stocks and markets. Prior to establishing Asianomics in December 2007 he was the chief economist at CLSA Asia-Pacific Markets. He joined CLSA in late 1991. Over the years Dr Jim achieved numerous ‘best economist’ rankings in the Asiamoney, Institutional Investor and Greenwich surveys of fund managers. Before coming to Asia, he worked in his native Scotland as a research fellow at the Fraser of Allander Institute for Research on the Scottish Economy, and then at The Royal Bank of Scotland’s Edinburgh headquarters. He holds a Bachelor of Arts Honours degree and a doctorate in economics from the University of Strathclyde, Glasgow.

The Currency – Sterling or Not?

For those of us living and working abroad, and especially in the world of finance, one of the most perplexing features of the debate on Scotland’s post-independence currency has been the misconception that somehow the successor state to the United Kingdom can stop Scotland using sterling as the medium of exchange. This has been the mantra repeated by leaders of all the major UK parties.
Sterling is a freely-convertible, internationally-traded currency. It shares those features with a limited number of other currencies – the US dollar, the euro, the Australian dollar, the Canadian dollar and the yen (to name most). As such, sterling is available to any country in the world as a transactions and reference currency. So, unless the UK successor state intends to make sterling non-convertible (with dire consequences for the City of London) we can safely say that ‘sterlingization’ is not only a viable option but an attractive one given Scotland’s strong trading relationship with other parts of the UK, and vice versa. In this sense, Scotland would be making the same choice as the independent Irish government did post-1923 (Ireland operated a currency board arrangement with sterling between 1927 and 1979).

PT: A 50 pound note issued in Scotland. Currently, Scottish banks have to deposit an equivalent amount with the Bank of England if they want to issue notes – about £3.6bn pound sterling notes issued in Scotland are in circulation at present.
(Image source: The Royal Bank of Scotland)
The question of the availability of sterling for use as the transactional currency in an independent Scotland is therefore clearly established. It would be up to an independent Scottish government only to make that choice.
The deeper question is whether or not Scotland and the rest of the UK should form an official currency union, as proposed by the Scottish government in its White Paper (Scotland’s Future – Your Guide to an Independent Scotland,).
This would involve having Scottish representation on the Monetary Policy Committee (MPC) of the Bank of England and would mean Scotland revoking its right to set monetary policy on its own (more of that below).
Apart from formalising the partnership arrangement between Scotland and the rest of the UK – as long-standing trading ties would dictate – this relationship would achieve one thing that current arrangements do not. It would ensure that the views and conditions in a part of the currency area that are not dominated by London would be heard at all MPC meetings.
The current MPC is made up entirely of staffers and external members based in London and the southeast of England bar one – the US academic Professor Kristin Forbes, who is based in Massachusetts. Unlike the US Federal Reserve’s Open Market Committee and the European Central Bank’s governing council, the Bank of England’s decision makers do not reflect regional Federal Reserves’ or member countries’ inputs nor is there any necessary input from economists or decision makers with a non-London-centric view. Scotland’s inclusion in a currency union would add balance to the monetary policy decision process which currently does not exist.
The proposal regarding a post-independence currency union is a clear, mature recognition on the part of the Yes campaign of the reality of current trading relations. It would make sense for both successor states to continue this relationship in order to facilitate trading ties. Those that suggest that Scotland would ‘not be allowed to use the pound’, apart from being technically wrong, show scant regard for safeguarding jobs and relations on both sides of the border.

Alternative Options

However, the political reality – whether it would be maintained after a Yes vote or not is a different question – is that the Unionist parties oppose formal currency union. (The fact that denying Scotland the use of a shared asset would call into question the Scottish government’s current commitment to taking on its share of the UK debt, the corresponding liability, has not been broached by the leaders of these parties.) There are plenty of alternative courses of action open to an independent Scotland.
The simplest alternative would be to adopt a sterling currency board – similar to the Hong Kong dollar’s relationship with the US dollar – at par. De facto the existing one-to-one currency relationship would continue although Scotland would have to establish its own monetary authority in Edinburgh and institutionalize rules around the functioning of the board. As to speed of implementation? Currency boards can be adopted overnight.
There would also be the possibility of Scotland applying for membership of the euro area – although given that system’s problems at the moment yet another member would not likely be welcomed with open arms – or simply establishing an independent currency. Denmark, Norway, New Zealand and Sweden all have independent, successful currencies despite two of them being members of the EU and the other two being resource-dominated economies.
This option is attractive to many nationalists and has merit in many respects. It would not be difficult to conceive although inevitably the exchange rate between the rest of the UK and Scotland would diverge, thus increasing transactions costs and disruption. As to which currency would strengthen relative to the other; that would remain to be seen – although with Scotland running a current account surplus and the rUK running a deficit, the odds would have to be on the Scots pound.
But it is important to admit that any ‘independent’ currency would be independent in name only. For a country that wishes to manage a fully-convertible currency, which Scotland would, it would mean coping with international capital flows and the domestic monetary consequences that these produce. New Zealand and the others we have mentioned do that very successfully but it is also true that the openness of the international economy reduces the flexibility of national exchange rate independence and monetary management around the globe. That reduces the flexibility of national exchange rate independence and monetary management around the globe. That is not an excuse or a rationale for the Scottish government’s currency union proposal; it is simply a fact.
As we  have just mentioned, one thing that even an independent currency would not do is give Scotland control over its monetary policy. Sad to say, in today’s world, that is an option that no longer fully exists for anyone – not even for supposedly capital-controlled China.

Monetary Policy – Recognizing Reality

Figure 2 shows the range of one year Treasury bill yields for ten of the eleven countries rated AAA by Fitch Ratings. Austria, Finland, Germany, Luxembourg and the Netherlands are all members of the euro zone. Yields in these countries are all close to zero. The only country in the group where interest rates are not depressed to extraordinary levels is Australia.

The thought that Scotland could set its own interest rates in its own currency in isolation from the rest of the world is naïve. China, one of the few countries that have attempted to run an independent monetary policy behind closed capital account doors, has ended up with a disastrously distorted industrial structure. That will become clear over the next few years as it undergoes its own version of an emerging market crisis.
The fact is that fully convertible currencies and indeed almost all currencies with an open capital account, are forced to adopt interest rates close to global norms. If they do not, the opportunity for disruptive and speculative capital flows is set in motion.
We have seen criticism from some quarters of the No campaign that the currency union arrangement would mean that mortgage rates in Scotland would be set by monetary policy made in London. These critics of Scottish independence seem unaware (or unwilling to admit) of the fact that monetary policy is not made in London anyway.
Mortgage rates, along with most official interest rates, are set internationally. UK monetary policy is almost exactly the same as that prevailing in the US, the euro zone and Japan. That is not an accident. There is no such thing as monetary independence, even for the Bank of England.
But back to mortgage rates. Yes, the majority of mortgages on offer would probably be linked to interest rates set by the Bank of England. But that is where Scottish independence and the increased financial sophistication that will accompany it would be able to provide more choice for Scottish citizens.
In Hong Kong it is possible to buy property with a traditional mortgage, a mortgage linked to Hong Kong interbank rate or a mortgage linked to a variety of currencies. All that matters in these various products is that banks appropriately price risk and customers are aware of the pros and cons of borrowing different products and in different currencies. Just because Scots at the moment have little or no access to products such as multi-currency accounts, foreign currency mortgages and interest rate swaps doesn’t mean that that will be the case in the future, especially in a vibrant, internationally-oriented independent environment.
The critics of Scottish mortgage rates being set in England needn’t worry. They will be set as they are today but, in an independent Scotland, what is on offer will be determined by the ingenuity of financial institutions and the appetite for new and varied mortgage products by the Scottish people.

Fiscal Policy – The Real Difference

That leaves fiscal policy as the real difference between an independent Scotland and the rest of the UK. But what a huge difference that can mean. This is where choice, responsibility and independence of mind and spirit enter the equation. As Austrians, we would probably make very different choices from those set out in Scotland’s Future but, there again, we would make very different choices from those made in the UK, the US, Europe and elsewhere. (At the same time, we believe that we would have more opportunity to influence these decisions in a smaller administrative unit than we do today.)
We have a philosophical problem with the Scottish government’s commitment to policies such as “free medical prescriptions”, “free university education” and the retention of public ownership of the Health Service. But our issue is with terminology and blind faith, not with the choices. In fact, these are good examples of the priorities that Scots in general espouse relative to the rest of the UK. Provision of medical treatment for all people in society, a commitment to education for the young and a functioning medical care system. These are all strongly supported public services in Scotland. As Hayek would put it, an awareness of what our neighbors want – who are we to argue?


Government provision of services is never “free”, however. Provision of these services means public expenditure cuts elsewhere – defense spending being one of the prime candidates for cutbacks (there is no reason for Scotland to have nuclear weapons or to maintain nuclear weapons bases). This probably goes a long way to explain the rather strange intervention of President Obama in the Scottish referendum debate when he declared his preference for the status quo. What he was really saying was, “we are happy with a nuclear submarine base near Glasgow because it suits us just fine.” (There is nothing which can explain the bizarre utterings of the Australian prime minister, Tony Abbott, when he urged a ‘No’ vote.)
Fiscal spending choices are a major attraction of an independent Scottish government and so too are fiscal revenue choices. Despite the popular (mis)conception of Scotland as a left-wing society the current Scottish government proposals include lowering the rate of corporation tax, rates relief for small businesses and halving of the air passenger duty (which would mean a reduction in costs for every passenger flying into Scotland of between GBP13-87). Currently air passenger duty is imposed centrally by the UK authorities in an effort to choke off demand for slots at London’s Heathrow Airport. Neither regional airports nor the Scottish Executive are allowed to vary the charge i.e., to compete.
In the area of oil and gas, much has been made of the drop-off in production which has taken place in the UK sector of the North Sea continental shelf. In the independence debate the UK Treasury and associated budget offices have used production declines – as well as questionable price assumptions – to show that Scotland would not be better off as an independent oil and gas-rich country (although the absurdity of that argument is simply beyond us). Suffice for us to say here that Professor Donald MacKay, an expert on the North Sea oil industry, has debunked the UK government’s case elsewhere.
But it is not just in official circles that information is distorted or suppressed. The existence of oil and gas deposits in the Clyde estuary has only recently come to light despite being known to the UK government for decades. Failure to exploit these important resources is entirely down to the existence of the nuclear submarine bases on the Clyde. Moreover, BP has had a major exploration success in the Clair field near Shetland. The company has shut down its exploration well and refuses to make an announcement – quite contrary to the norm in the industry – as to how many additional barrels this discovery is likely to produce in future years. However, even for a company extremely worried about the “uncertainty” of Scottish independence it has said that, “We intend to invest billions in the area in coming years.”

North Sea oil rigs off the coast of Scotland

(Photo via theguardian.com / Author unknown)

And what does the US Energy Information Administration (EIA) have to say about declining production in the UK sector?
“Since 2011, there have been a number of tax changes that affected production (or investment) in the United Kingdom Continental Shelf (UKCS), including the change in the rate of supplementary charge (an addition to the corporate tax) and the capping of relief for decommissioning costs at 20% of the supplementary charge. In addition, the tax rate for fields that are subject to petroleum revenue tax (PRT) increased to 81% of their profits (from the previous 75-percent rate), and fields that are not subject to PRT now pay a 62-percent tax (compared with the 50-percent rate in the past).
“As a result of the significant increases in taxes, the UKCS projects have become even less competitive. Increases in operating costs coupled with higher taxes have resulted in decreased investment in both brownfields and new exploration. Even without the increased taxes, operating costs in the UKCS were prohibitively high, exacerbated by the high decommissioning costs of old facilities, which also discourage investors.
“Almost immediately after the new tax rates were implemented, development on several start-ups was suspended, including Statoil's Mariner and Chevron's Bressay fields. In addition, Centrica launched a review of all of its exploration activities, as many projects were deemed uneconomical under the new rates. Given a nearly 16-percent decline in production following the implementation of the new tax rates, the UK government has introduced new incentives for producers to counter some of the increase in taxes.”
USEIA United Kingdom country analysis, Jul 14
A more imaginative tax regime with built-in production and exploration incentives – similar to that of Norway – would not be difficult to concoct. Maybe then BP and Shell – their lobbying investment notwithstanding – would be happy to stay in Scotland and invest much more. And with Trident cleared from the Clyde they could start making money and creating jobs in the west of Scotland too.

The Case Against

Too wee. Too poor. Too stupid. Too risky. In the run up to the referendum, these four charges are daily leveled against Scots who support independence. (Mr. Abbott has added the commentary that they are the enemies of freedom and justice – go figure.) Westminster politicians, their appointees who lead the Unionist parties in Scotland, the media (led by the BBC and the national press) and business people who should know better all trot out these banalities for why Scots should say ‘No’ on 18 September.
It would come as a great shock to our many friends in Denmark, New Zealand, Singapore and Austria that they are too small to be able to run themselves. It would be an even bigger surprise to Filipinos, Indonesians and Thais that they would be deemed far too poor to be able to run their own affairs.
And as for ‘too stupid’, just what have Scots been doing for the last 500 years? Lying in their beds or making a sprinkling of contributions to things like Economics (Adam Smith); Philosophy (David Hume); United States Navy (John Paul Jones); Penicillin (Alexander Fleming); Telephone (Alexander Graham Bell); Television (John Logie Baird); Steam engine (James Watt); Logarithms (John Napier); Electromagnetism (James Clerk Maxwell); Oil Refining (James Young); Ultrasound scanner (Ian Donald); Waterproof Macintosh – we needed that one (Charles Macintosh); Kirin Brewing Company (Thomas Blake Glover); Buick Motor Company (David Dunbar Buick); and many, many more.
A nation so rich in people, ideas and innovation can never be too wee, too poor and, least of all, too stupid to run its own affairs. Quite the contrary.

David Hume and Adam Smith – two famous Scottish thinkers of the Enlightenment

But the debate gets even worse. In many people’s eyes, it all comes down to a marginal decision about whether Scots would be better or worse off by a few hundred pounds a year were independence to be chosen. In other words, it is “too risky”. What we have tried to show above is that it is about much more than pounds and pence – especially since no-one can possibly tell what the actual outcome in pure economic terms will be. Moreover, for Scots who wish to retain the National Health Service in the public sector, a ‘No’ vote is the greatest risk given the current government’s privatization plans.
Worse still is the question of EU membership. The Scottish government fully supports Scotland’s continuing membership of the EU. The recently-elected president of the European Commission, Jean-Claude Juncker, has explicitly stated that a moratorium on new EU member states does not apply to Scotland. Maybe that is why David Cameron, the UK prime minister, was so opposed to his appointment. The biggest risk of all to the Scottish people is that they are forced to exit the European Union because of a vote to do so delivered by the rest of the UK in the next parliament, assuming Mr. Cameron wins again.
Independence economics will all be down to the decisions of an independent Scottish government and the Scottish people. The world is a risky place, economic policies and political decisions are there to be debated and who is to say, a priori, what is right or wrong, what is beneficial or costly? Every people sets its own priorities – for better or for worse. Ask the Mongolians. The debate on Scotland’s future is about taking responsibility, making decisions and contributing to the international community as best Scotland can. The list of names we set out a few paragraphs above certainly suggest that that is task Scots are fit to undertake.
In our view, it is about getting the balance right and making decisions that suit Scotland’s neighbors as well as Scotland itself. As Hayek argued in The Road to Serfdom, “We shall all be the gainers if we can create a world fit for small states to live in.”
Scots can meaningfully contribute to the creation of that world by voting ‘Yes’ next month.
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