Bond Outlook by bridport & cie, November 28 2012

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As the euro zone moves slowly federalisation, the question is how to fiscal achieve discipline for each member country. Decentralised à la USA, or centralised à la Germany.

As the euro zone continues its slow and painful advance to a federal structure, we have to look again at the issue of budgetary control. We had assumed that it must come from the centre, but that assumption is worthy of reappraisal in the light of a paper by Charles Wysplosz of the Graduate Institute, Geneva. He has compared and contrasted the German and US practices of fiscal discipline of the Laender and individual States, which he calls respectively the centralised and decentralised models. This issue is crucial for the euro zone.

 

Historical data show that the decentralised model has been more successful at keeping member budgets near balance. That success is very dependent on the credibility of the “no bailout” policy of the USA. It is not just a matter of policy, but of practice. The policy is already explicit in European Treaties, but honoured only in its breach.

 

Decentralised budgetary control addresses the biggest single problem of the euro zone – reluctance of its members to yield sovereignty and the associated democratic deficit – by leaving the individual member countries’ sovereignty intact. The problem now is how to reinstate a policy that has been so thoroughly flouted.

 

This author has just returned from a visit to Cambridge University to study the “Cambridge Phenomenon”. The city and university, roughly the size of Geneva, has 1,500 hi-tech companies employing 54,000 people. Components of its success include allowing the academics and researchers enormous freedom, adopting a policy of “open innovation”, encouraging interaction among academics, businesses large and small, and investors. The government is a facilitator and a source of competitively won funding, but not a controller. The key word for research and investment policy is “impact” (mainly on the UK economy).

 

Why this focus upon Cambridge? Because it epitomises the massive change that has taken place in UK thinking about economic management, and which manifests itself also in the appointment of Canadian Mark Carney as Governor of the Bank of England. He will not take over till Mervyn King steps down in June next year, but it would be surprising if the hand of his influence is not already felt. In macro-economic terms, the key issue is when quantitative easing will be permanently discontinued, or, since the current round is ending, whether, and for how long, will it be renewed. The other issue is that macro-economics alone cannot drive an economy; the micro-economics of business creation and investment are also essential. The contrast between French and British micro-economic policies can hardly be more apparent as the French government intervenes in the affairs of Peugeot and Arcelor.

 

Yet a major question remains unanswered. When is government justified in “saving” an individual company? The US Administration bailing out GM will lead to an overall cost to taxpayers of USD 14 billion (when the Federal Government finally unloads it shares) and is widely viewed as “justified”. Are Peugeot and Arcelor so different? Frankly, we do not know, but it gives food for thought.

 

Beware the widening of spreads on lower quality corporate bonds, which is likely to continue, even independently of when the fiscal cliff issue is ‘solved’.


Macro Focus

 

United States

 

Leading economic indicators rose in October at a slower pace (+0.2%.), as businesses, faced with the uncertainties of the “fiscal cliff” , held back on investment.

 

Consumer confidence was little changed at 82.7. Nevertheless holiday shopping totalled $59.1 billion, 13 % more than last year.

 

Mortgage rates dropped still further to an all-time low of 3.31% from 3.34%, for a 30-year fixed mortgage. Home prices rose 3.0% in the year ended in September, the most since July 2010.

 

Europe

 

Services and manufacturing output shrank for a tenth month in November, but only marginally (PMI composite index 45.8 compared with 45.7 in October).

 

The index of household confidence in the 17-nation euro area dropped to minus 26.9 from minus 25.7 in October. However German business confidence rose in November, and even French industrial confidence climbed from 85, the lowest in more than three years, to 88 after Hollande unveiled a payroll tax cut for businesses that will go into effect next year.

 

United Kingdom

 

GDP rose 1 % in Q3 over Q1, but the budget deficit widened in October as government spending grew and the economic slowdown hit tax revenues from companies. The shortfall was £8.6 billion pounds compared with £5.9 billion pounds a year earlier.

 

Switzerland

 

The consumption indicator rose to 1.31 points from a revised 1.04 points in September as new car registrations more than compensated for weaker business activity in the retail sector.