All I Want for Christmas is . . . Eu 489.2 bn

That's the demand for three-year money by 523 Eurozone banks that has just been satisfied by the ECB, lending at its average benchmark rate (currently 1%), accepting as collateral paper including Spanish and Italian bonds.

How much is Eu489.2bn?

For the ECB, it's equivalent to:

• 55.4% of the total Euro note issue;
• 73.6% of the gross amount of its previously outstanding gross lending to Eurozone credit institutions;
• It is twice the previously outstanding net lending to Eurozone credit institutions.
• It is six times the ECB's outstanding capital, and 20% of its previously total balance sheet.

For the banks, it is worth:

• 54% of the banks' total net foreign assets
• 11.8% of gross foreign liabilities
• 4.5% of the deposit base
• 21 months of new lending to the private sector at current rates
• 15 months of new deposits from the private sector at current rates.
• 2.1x the Eu230 bn of bank bonds that mature during 1Q2012.
• Probably slightly more than three quarters of the Eu600bn+ in bank bonds maturing during 2012.

For the economy of the Eurozone, it is equivalent to:

• 3.15x Ireland's annual GDP
• 2.84x Portugal's annual GDP
• 2.19x Greece's annual GDP
• 46% of Spain's annual GDP
• 31% of Italy's annual GDP

So Happy Christmas, I guess.

Banking Systems - Still All For One, I'm Afraid

Whatever 2012 may bring, no-one can claim that disasters in the Eurozone and its banking system could strike like lightening out of a clear blue sky. We have all had plenty of time to get habituated to the idea that somehow, somewhere Princip will stumble upon his Archduke. Consequently, major financial centres and their regulators, not to mention Europe's banks and their ex-Euro counterparties have had plenty of time to prepare for disaster. I have tracked how this has materially altered balance sheets of foreign banks in London and New York.

The hope therefore is that given such a lengthy warning period, if and when the Eurozone's financial system really begins to implode, other parts of the world's financial systems will prove to be more robustly insulated from the damage than they were when Lehman went down. But are they?

Every day I dutifully track the CDS market for 5yr bank bonds in the Eurozone, the US and Asia, as a reasonable proxy for perceptions of systemic risk in these financial systems. If US and Asian financial systems have been busy insulating themselves from Eurogeddon successfully, then the linkage between rising risks in the Euro banking system, and rising risks in these other banking systems should be diminishing.

We can measure whether this is true by looking at how the correlations between movements in Eurozone banking system CDS rates and those in the US and Asia have developed over the year. Here's the chart, showing the development of 30-day correlation coefficients between daily movements in the underlying CDSs.

Man, I'd have loved this chart to be different. However, like it or not, we end the year with no sign that the market believes that either US or Asian banking systems have made any significant progress in insulating themselves from Euro-risk. In fact, the correlations are at or near their all-time highs.

Sorry about that.

PS. The de-coupling between Eurozone and US systems in June this year was the consequence of developments on both sides of the Atlantic. The Eurozone saw what was then the biggest and most decisive meeting to protect the Euro – at the time these meetings had more credibility than they now enjoy. On the other side of the Atlantic, we had various developments in the stand-off in how/if to continue funding the Federal government.

Shocks and Surprises, Week Ending December 16th

Although the week's dataflow delivered more positive surprises than negative shocks, we'll start with the shocks, because potentially the most worrying almost managed to slip by undetected, a triumph of camouflage.

It's not as if China's monthly monetary data isn't widely watched, but most commentary on November's data dwelt on the relative strength of new bank lending (up 562.2bn yuan on the month) and the modesty of the slowdown in M2 (12.7% in November, vs 12.9% in October). In my opinion, they should have spent more time thinking about the 'shock' fall in growth of M1 7.8%, slowing still further from the 8.4% recorded in October. There is a ready explanation for both the weakness of M1 and the relative resilience of M2, which notices that inflation has retreated, and urges that inflation-related liquidity preference (M1/M2) has similarly retreated. The only problem with this explanation is that it's wrong (as one could also tell from the surprising strength of the previous week's retail sales numbers – up 17.3% YoY). Rather, what's happening is that China's M2 numbers since October have been newly bolstered by the inclusion of deposits from China's Housing Provident Fund – a mandatory forced savings scheme in which the size of new deposits are tied to the size of wages. M2 numbers are staying within range of expectations only because of these forced savings.

In fact, the M1 numbers almost certainly tell the right story – a story of deteriorating private liquidity and cashflows. Even with these forced savings included in the story, for the second month in a row, China's banks gave out substantially more new loans than they took in new deposits. Since the end of September, China's banks have extended 1.148tr yuan in new loans, but have taken in only 100bn yuan of new deposits (including the forced savings). To be clear, this is not just some seasonal effect showing up in the data – it's a genuine deterioration in private sector liquidity. Lucky, then, that the central bank can offset it by cutting reserve ratios.

The week's positive surprises continue to be discovered in the relative health of the world's industrial economy, which so far is almost managing to shrug off the appalling dangers European politicians seem keen to subject their citizens to in order to 'save the Euro'.

It no longer completely surprises that the more timely surveys of industrial conditions in the US show sharp improvements. This week, the Empire State Manufacturing index delivered its best reading since May, and the Philadelphia Fed Survey gave the strongest reading since April. In both cases, the improvements were driven by a sharp uptick in new orders. Nor is it beyond comprehension that Japan's machine tool orders managed a sequential jump which was 1.1 SDs above seasonal historic trends – as we've pointed out elsewhere, the minutiae of recent trade and output data has already showed the resilience of capex spending globally.

But it is a surprise that Europe's manufacturers are surviving better than expected: this week the Eurozone Composite PMI, the Eurozone Manufacturing PMI, the Eurozone Services PMI, and (separately) manufacturing and services PMIs for both Germany and France all arrived stronger than consensus had expected. True, only German and French services PMI readings managed to crawl over the expansion/contraction reading of 50 – but outside those readings, the pace of contraction was less than expected. Similarly, the 3.5% YoY fall in new car registrations in the EU25 actually hid a sequential rise of 2.4% MoM – which was 1.1SDs above seasonal historic trends.

It would, of course, be misleading to ignore the fact that the hardest of data – which also arrives systematically later than most survey data – was generally worse than expected. In the US, industrial production fell 0.4% MoM and retail sales rose only 0.2% MoM in November. In the Eurozone, industrial production grew only 1.3% YoY during October, China's Leading Index declined by 0.1% MoM – the first sequential fall since Dec 2010. This latter indicator is particularly badly-named – how can a short-term 'leading indicator' be doing its job properly if October's 'leading indicator' is delivered two weeks after the hard release of economic data for November?  

Trade Data vs 'The New Great Depression'

On the day that Christine Lagarde warns that the world may be tipped back to a new 1930s-style Great Depression, it's worth pointing out that it's not happening so far. We have almost all the data now for November, and so far not only is the slowdown nothing like what happened at the end of 2008, but it's less dramatic even than the slowdown which accompanied the near-recession of 2000-2001.

In fact, NE Asia's exports showed positive sequential momentum in November, as did G3 imports in October (both the latest data).

(True, Christine Lagarde's analysis carries all the knowledge and authority of economics and finance which you'd expect from a French socialist labour lawyer. It's a shame that when she speaks, you never know whether its the French politician, the labour lawyer, or the judgement of the IMF that's coming out. Still, if you will appoint completely unqualified people to important jobs, you can't be surprised when they discredit the institution upon which they have been foisted.) 

The hinge of world trade remains the link between Western import demand (US, Eurozone, and Japan) and NE Asia's exports (China, Japan, Korea, Taiwan). Plenty of lucrative careers have been sustained maintaining that these two will or are decoupling, but so far they haven't and you shouldn't be holding your breath. In the three months to October, for example, G3 imports grew 17.2% YoY whilst NE Asia's exports were up, er, 15.6%. Were I to plot the 6m sequential momentum of these two against each other, you'd barely be able to see daylight between them.

Now let's look at the dynamics of G3 imports a little more closely. In October, in dollar terms, G3 imports rose 14.9% YoY (US up 12.9%, Eurozone up 13.2%, Japan up 26%), and the rise of 2.1% MoM was 0.3 Sds above what one would normally expect in October. The six-month moving average of that momentum reading shows a reading 0.08 SDs from historic trends – ie, virtually no deviation whatsoever. (By the way, it is not weakness in the dollar generating these YoY movements: the dollar was down only 1.1% YoY against the SDR in October.)  

Clearly, this is a less buoyant picture of momentum than we've experienced during the last couple of years. But it remains well within the range of 'normal', and miles away from the experience of 2008/09. I put a lot of emphasis on those momentum readings, because they express fundamental changes in direction sooner and more accurately than YoY readings. Compare what's happening now with what happened in the run-up to the end of 2008: the lurch down may eventually materialize, but it hasn't yet.

Now consider what's in that trade data already. Here's what I wrote about the data-flow last week, in Shocks and Surprises, Week Ending December 9^th. “When we extract the detail from this mass of data, we confront a paradox:

• on the one hand there's a very sharp contraction in the trade in intermediate goods, which bodes ill for the short-term industrial output,
• on the other hand, the demand for capital goods is, so far, undiminished, which suggests that capex plans, and therefore expectations of how the industrial cycle will develop over the medium and longer term, are unchanged, and rather bullish.”

The point at which companies stop buying intermediate goods, is precisely when we should see the most abrupt short-term collapse in trade numbers. It should be happening right now.

So let's look at November's exports from NE Asia: we have the full data for China, Korea and Taiwan, and we have numbers for the first 20 days of the month for Japan). There's no denying the data is patchy and volatile: China's exports were up 13.8% YoY as were Korea's but Taiwan's export growth slumped to 1.3%, whilst Japan's (probably) rose 6.1%. Part of this – particularly Taiwan's problem, for example – are the result of specific sectoral weaknesses. But overall, the slowdown that's happening so far more resembles 2000/01 than 2008/09.  

The danger, of course, is that I'm being complacent – that I'm the man flying past the 31^st floor window murmuring 'well, it's all right so far.' After all, European politicians seem bent on subjecting the continent to the Euro for as long as possible, which virtually ensures the period before its failure will be one without significant European economic growth, and the period after its failure will be to some extent chaotic.

(See Mohamed El-Erian's excellent summary of the dynamics of the crisis, in Foreign Policy.) 

But there are two reasons why even this outcome is likely to result in a milder downturn for world trade than currently seems likely. First, we are still starting from a very low base: G3 imports fell 28% in 2009 (12m to October 09), and the recovery of 2010 still left them 15% lower than in 2008. In the 12 months to October 2011 G3 imports were only 1% higher than they were in the same period in 2008. Second, whilst the collapse of Lehmans really was a surprise, the travails of the Eurozone most emphatically are not. Probably the only people in the world who don't know how, ultimately, this will have to end are Europe's politicians. It seems inevitable that eventually even they may have their moment of enlightenment – at which point, the very least we can expect is that the European Central Bank may discover an appetite for preserving the financial system rather than its virtue. Meanwhile, as I have tracked many times, the world's biggest financial centres (New York, London) have quarantined Eurozone banks as best they can. That quarantining can never be perfect, but we can certainly expect it's getting better with every working day.

So what matters is timing. If the breakup of the Eurozone can somehow be fended off until 2013, the ensuing chaos may have less of an impact than if it happens next week. Moreover, the trade data that's staying within normal bounds now may continue to do so throughout 2012.

Global Capital Demographics

Yesterday I wrote about how in the Eurozone, where there is by definition little room for competitive flexibility in labour markets, and none in currency rates, one of the few remaining keys to comparative advantage is in the relative age of a country's capital stock. Thus, now that Germany has quietly been renewing and modernising its capital stock over the last couple of years whilst France and the Netherlands (as competitors) have been letting theirs quietly age, its comparative advantage within the Eurozone is only likely to widen.

But what's happening in the rest of the world: how do the demographic trends in capital stock work out in the US and NE Asia, as well as the Eurozone? Can we learn anything about the shifts of global comparative advantage from this, with all the potential for adjustments for pricing adjustments in labour and currency markets that implies? (I am, incidentally, absolutely aware that this is a long way from the last word on this issue – a complete analysis would also have to take in growth of capital stock, labour productivity, terms of trade and currency fluctuations. I am concentrating on this issue of the demography of capital because it's usually tends not to surface on economists screens.)

Let's start with NE Asia, where we can see very different trends emerging throughout the last 20 years, which we can interpret.

Starting with Japan, we can see that the implosion of the bubble economy in 1990 led to a long period where Japan hung back on re-investment and let its capital stock age. This period lasted for a full decade, so that by 2000, the average age of capital stock had risen to 4.16 year, from a low of 3.41 years in 1991. That was about as old as Japan's capital stock got, but it was not until around 2005 that corporate Japan began quietly to reinvest and renew – a modest trend which was halted in its tracks, and reversed, by the global financial crisis in 2008/09. Right now, Japan's capital stock is once again about 4.1 years old on average – the oldest in NE Asia.

The contrast with China is, of course no accident: rather, that contrast represents the impact of Japanese industry relocating and expanding out of Japan and into China. The investment cycles generated by China's financial system prior to Zhu Rongji's reforms were wild affairs, as the swings in the average age of its capital suggests. However, the last ten years has seen a combination of enormous and sustained investment, which has left China with the fastest growing, but also youngest capital stock in NE Asia. The capital demographics of South Korea and Taiwan bear the imprints of, respectively the 1997/98 financial crises for Korea, and the post-2001 political/diplomatic deterioration for Taiwan. South Korea's aggressive currency depreciation in 2008/09 bought the room for, among other things, an attempt to rejuvenate its capital stock.

Over time, as economic weight in NE Asia has shifted dramatically to China, so it is China's investment spending which has gradually come to be the swing factor in the demographics of NE Asia's capital. I have weighted these demographics by a moving three-year average nominal GDPs to generate a demographic for NE Asia as a whole. This shows that the age of the region's capital stock has remained roughly stable at around 3.6 years since 2008. Here's how it compares with what's happened in the US and the Eurozone.

This is a really dramatic demonstration of how comparative advantage is likely to have shifted over the last decade. In 2000, the US had by far the youngest capital stock, whilst NE Asia was still aged by the combination of Japan's irrecoverable bubble economy, and the 1997/98 financial crises. We can infer that Europe's capital stock was older than that of the US, but younger than NE Asia's. In 2011, the situation has reversed very dramatically: now NE Asia's capital stock is by far the youngest; the US's is by far the eldest (and older than it has ever experienced), whilst Europe's capital stock, too, is old and still aging at an unprecedented pace.

Grounds for NE Asian triumphalism? Perhaps. But take another look at the second chart. Doesn't the current US/NE Asian situation look rather like the beginning of the 1990s – the last time that America was generally considered down and out?   

Who's Got the Newest Euro-Kit?

It doesn't seem like a rash assumption that in 2012 there is more likely to be a shortage of demand than supply for most goods and services in the Eurozone. Who sort of company, and what sort of country, does that suit best?

The standard answer – and it's not wrong – is that in these circumstances, operating margins get squeezed, and consequently the winner will be the one who can maximise asset turns. Any company (or country) which has been investing heavily on the expectation of maintaining operating margins is going to be profoundly disappointed and possibly financial threatened.

But the standard argument misses one crucial point: the company/country that's been investing most heavily recently may have a larger stock of capital on which it must raise asset turns, but it will also have the newest stock of capital equipment. And if the world is one in which labour markets are sticky (wages difficult to cut, employees difficult to fire) and fx rates similarly sticky, the later the generation of equipment, the better. In cases where there are few other avenues of comparative advantage, arming your workers with the newest generation of equipment could be the difference between competitive success and failure.

The caveats that this will prove most important in countries with sticky labour markets and no room for currency fluctuations directs our attention immediately to countries within the Eurozone. Of the large Eurozone economies, neither Italy nor Spain is likely to be a position to respond to deteriorating market conditions with anything more than lunges for survival. But we need not assume that Germany, France and the Netherlands will necessarily be in survival-only mode. So which has the newest capital stock?

We can estimate the average age of capital stock by by extending my usual technique of depreciating all fixed capital spending over a ten year period. When we do, this is what we find.

This chart tells us something rather important: whilst Germany still has, on average, just about the oldest capital stock of these three countries, the difference – which is an important element of comparative advantage – has narrowed dramatically since the financial crisis. As of September, the estimated average age of Germany's capital stock was 3.89 years, now virtually indistinguishable from its Netherlands neighbour, but only very slightly older than France's average 3.83 years. During the pre-crisis years of 2005-2008, the age gap between Germany and France averaged 0.32 years, and the age gap between Germany and the Netherlands averaged 0.19 years. What's more, these are necessarily slow-moving trends, and it's very likely that when the final data for 2011 is published, we'll find Germany has newer capital stock than the Netherlands. By the middle of 2012 we should expect it to have a newer capital stock than France.

This represents a structural sea-change in comparative advantage within the Eurozone, in Germany's favour. Having deflated its way back to competitive equality, those same forces are now entrenching a new comparative advantage. It is extremely difficult to see how France and the Netherlands can be expected to recoup the ground they are losing right now, except by developing competitively flexible labour markets. Let me put this in plain language: we should expect the growth differentials between Germany and even its financially-confident neighbours to widen from here in a way simply not seen since the introduction of the Euro. German economic dominance over the Eurozone will grow inexorably.  

Germans! Fugues and Strettos

Actually, my principle area of expertise isn't economics, it's music. And as a musician, it's always been clear that the Germans are Europe's most talented nation, and by quite a distance. It is possible to craft an alternative to holy trinity of Bach, Beethoven and Brahms, but as soon as you try, you find you're still speaking German, even if you're in fact in Austria (Mozart, Schubert, Wagner, Mahler?).

Let's not deny other nations their very considerable moments: God smiled upon France when he gave her Debussy and Ravel; he scowled on England when he cut down Purcell so soon, and silenced Howells before he had even really got into full swing. We will always sing with Italy, a nation that squeezes a whole opera into its national anthem. We can let Hungary off for Liszt (blame France!) since they also produced Bartok. And so on. But alone, Germany is irreplaceable.

Why? It's certainly not a distinctively German ear for song: who would sit through Fidelio if they had an Italian alternative? Nor is it being particularly open to flights of improvisation: unlike their jokes, you really ought to laugh at German jazz. It isn't exquisite sensitivity to mood: 'Prelude de l'apres midi d'un faune' morphs alarmingly into 'Auftag der nach Mittag eines Fauns' – it's a crime, isn't it?

But what German music displays time after time, throughout the ages, is an extraordinary understanding and command of order – its necessity for structure, its complexity and simplicity. Understanding (and almost always sticking with) the rules allows German music to work simultaneously in horizontal and vertical dimensions, simultaneously on a micro and macro time-scale. It's unique: Bach can do the trick in a minute, Wagner can stretch it to hours (days even). German music isn't constrained by the demands of order – time after time it is liberated by it.

Perhaps the epitome of the German approach to music is the fugue – a piece structured around the harmonic interplay of voices all using the same musical fragment in all possible ways (straight ahead, upside-down, back-to-front), yet somehow cohering. Obviously, the more voices, the more difficult a trick this is to pull off – it's far easier to write (and play) a three part fugue than a five-parter. But that's not all, it's technically possible to do it with more than one tune at a time – a double, or triple fugue. At this point it gets seriously complicated.

Then it gets worse. At the epicentre of a fugue, we meet the stretto, in which all the fragments concatenate, yet somehow what emerges from this pile-up is music. As a pianist responsible for all the voices at once, things can get seriously weird. I had been playing a Bach five part double fugue for months, and it was drilled into my muscle memory. Then one day, I decided to really take a good analytical look at the eight bars of stretto. Armed with a pencil and patience I got to work. What I discovered over the next half hour was so intricate, so extraordinary, so impossibly demanding, that when I went back to the piano, I found myself physically quite unable to play it. Rather, when I got to the stretto, my brain was overwhelmed by the monstrous and monomanical complexity it was encountering. Utterly preoccupied, my brain paralysed my fingers – I was quite literally fugueing.

And so back to today. Or rather, to the German approach to the Euro-crisis. The German analysis of the underlying problem of the Eurozone being one of fiscal discipline isn't entirely wrong. But Germany's fugal concentration on it is. Actually, they've been fugueing for more than a year now. Last week, saw the first attempt at a 26-part stretto on the theme of fiscal discipline, facilitated by explicitly-written rules. If achieved, it would be a thing of wonder all by itself – a thing, actually, of beauty. But long before we get there,it will cause paralysis and breakdown. What Germany's policymakers should bear in mind is that, mighty as Bach's fugues are, he was sufficiently wise to know that to work, even the best fugue needs its Prelude of diverse and complementary material.  

Shocks and Surprises, Week Ending December 9th

This was the week that we got a close look at most of the world's industrial sectors. We've had monthly trade data from China (and Taiwan), from the US, and from Germany (and Britain). And we've had industrial output data from much of Europe, China, as well as various readings of factory orders.

When we extract the detail from this mass of data, we confront a paradox:

• on the one hand there's a very sharp contraction in the trade in intermediate goods, which bodes ill for the short-term industrial output,
• on the other hand, the demand for capital goods is, so far, undiminished, which suggests that capex plans, and therefore expectations of how the industrial cycle will develop over the medium and longer term, are unchanged, and rather bullish.

As a generalization, industry worldwide is bracing itself for a short-term demand shock, but still tooling up aggressively for expansion.

We shall start with the US, where both exports and imports fell MoM in October (by 0.8% and 1.0% respectively) , but the trade deficit (US$43.5bn) was much as expected. It's the details that matter: exports of capital goods rose 1.1%, but industrial supplies fell 3%. And it was the same story for imports: capital goods rose 2.7%, but industrial supplies fell 5.5%.

And it wasn't just happening in the US. Germany's factory orders, which 5.2% MoM – massively higher than anyone expected – mainly because orders for capital goods jumped 7.8% MoM, whilst orders for intermediates rose only 2%

We had negative industrial production shocks from the UK (down 1.7% YoY) and Spain (down 4% YoY), and both each case, what was doing the damage was a collapse in production of intermediate goods: in the UK machinery rose 2.5% MoM, but intermediates fell 1.1%. In Spain, output of capital goods fell 1.3% YoY, but intermediates fell 5.5% YoY. Italy's industrial production fell 4.2% YoY, though the pattern was less clear (capital goods fell 1.5%, intermediates fell only 0.2%).

In Asia, we had two confirmations of this pattern. First, in Taiwan, which produced negative shocks for both exports (up only 1.3% YoY), and imports (down 10.4% YoY), we saw a sharp fall in imports of of minerals (down 6.1% YoY), and chemicals (down 18.5%).

Second, at first glance the 6.9% MoM fall in machinery orders from Japan, which was well below the level of expectations, immediately suggests a broad fall in demand for capital goods. But in fact, the deterioration was confined to domestic orders, and in particular demand from non-manufacturers (down 7.3% MoM). In fact, export orders for Japan's machinery were up 1.6% MoM – a bounce-back from a very weak September sequential.

Beyond that, the data offered no conclusive evidence of a sharp slowdown in global trade. True, Germany's trade data was worse than expected, with exports down 3.6% MoM, and imports down 1% MoM. But it's failing demand from the the Eurozone that's pulling down the numbers: exports to the eurozone fell 0.4% YoY, but rose 3.1% YoY to other Europeans, and 8.3% elsewhere. And it's the same story with imports: imports from the Eurozone rose 6.1% YoY, but 10.2% from elsewhere in Europe, and 10.9% YoY from elsewhere.

And in China, readings for both exports (up 13.8% YoY) and imports (up 22.1% YoY) in November were just about within the (extremely optimistic) range of expectations. In MoM terms, both exports and imports were higher by a full standard deviation or more from what one would expect from seasonalized historic trends. I count this, then as a significant surprise. The surprising strength in exports was built on sequential strength in exports to the US (up 17% YoY) and Asean (up 21.5%), whilst exports to the EU, HK, and Japan were merely in-line with trends.

The second major data event of the week was, of course, the monthly raft of news from China. This provided more pleasant surprises than nasty shocks, and isn't likely to persuade Chinese authorities to alter whatever plans they already had in mind. In addition to the surprisingly strong trade numbers, retail sales rose 17.3% YoY, confounding expectations by some distance. At the same time, CPI inflation surprised by retreating to 4.2% YoY (from 5.5% in October), and PPI fell to 2.7% YoY (from 5% ) to its lowest reading since December 2009. The only negative shock in the data was the retreat in urban fixed asset investment, which slowed to 24.5% in the year to November, from 24.9% in the year to October. Industrial production growth slowed to 12.4% YoY (from 13.2% in October) – a slowdown in YoY which was no surprise, since it reflected a MoM change entirely in line with historic seasonal patterns.  

Continent Cut Off! Return of the Belgian Dentist?

On the basis of what's publicly available, in the early hours of this morning in Brussels, something became unquestionably clear: France and Germany care more about taxing and regulating the City of London than preserving the European Union. Something else became clear: that Britain's political leaders consider avoiding such taxes and regulations as it expects to be advanced from Brussels as being more important than preserving its position in the European Union.

Therefore, unless things change, we must expect that the Eurozone-et-al will attempt to impose burdensome financial regulations and taxes on its financial sectors; and second, that Britain will reject these taxes and regulations, at virtually any cost. The divorce is coming, and it will be over money.

Expect things to become even more stupid, wasteful and vain. Once Eurozone-et-al's technocrats get a taste for financial repression, will they know how to stop? After all, they have governments and banks to refinance against a backdrop of near-zero nominal growth, and financial repression always delivers results in the short term, no matter what the longer-term conseqeuences. Which tools of financial repression will be off-limits? Limits on alternative investments? - already passed the European Parliament in October. Widening reserve ratios? - the attempt to pre-empt Basel III is already on its way. Withholding taxes popping up everywhere? Limits on deposit rates and bond yields?

Back on this side of the Channel, the response by the City to Britain being chased from the EU will be to toughen its act as Europe's offshore financial centre. Since almost by definition London's more lightly-taxes and lightly-regulated fee structure is likely to undercut those onshore burdened by the EU's taxes and regulations, it's an inevitable role. That being so, we have to at least ask whether the remaining members of the EU would also finally have to burden themselves with capital controls in order to break free of London's gravitational pull.

But would capital controls work anyway? Put it another way: what sort of economic, financial and regulatory circumstances would be conducive to the growth of what might be called a Euro-EuroMarket in London. Take a step back and recall the circumstances behind the birth of the Eurodollar and Euro-Deutschemark bond markets between the 1960s and 1980s.

The birth of the Eurodollar bond market relied on the collision between long-maturing financial imbalances and what were seen at the time as urgent political/financial imperatives. On the one side, the post-War period saw a build-up of dollars earned and held offshore, as a result of several factors:

• the accumulation of offshore dollar balances, encouraged by 'Regulation Q' – a cap dollar interest rates offered by US bank;
• the fear that dollar accounts held in the US might be frozen in response to balance of payments pressures;
• sizeable outward direct investment by US multinational companies; and
• a series of US current account deficits, which had the effect of internationalizing the dollar.

The automatic and logical response was that European holders of  dollars got used to buying dollar-bonds issued by European companies in New York.

And that's what was happening until urgent US political/financial imperatives drove the business offshore. Persistent balance of payment pressures (the flow which built the stock of overseas dollar liquidity), led to an attempt, in 1963, to stop foreigners raising dollar capital in New York. The means chosen was the Interest Equalization Tax, which was designed to raise by 1% the effective annual cost to foreigners of borrowing in the US. This was augmented by an attempt to years later to engineer a Voluntary Restraint Progam on FDI by US companies, by discouraging US banks fro making anything but short-term loans to international borrowers. By 1968, this had morphed into mandatory restrictions on FDI. Faced with these tax and regulatory pressures, the foreign US bond market simply moved to London, and the Eurodollar market was born.

The birth of the Euro-DM market was slightly different. With W Germany running persistent current account surpluses, Germany could at first afford to take a relatively relaxed view of foreigners raising money on their capital markets, since this capital outflow at least eased the upward pressure on the DM. However, there was the simple matter of tax, and when in 1964 W Germany introduced a withholding tax on German bonds, non-German investors discovered a real appetite for DM bonds raised, tax free, in London rather than Frankfurt. This was the famous tax-dodging 'Belgian dentist' at work, hoarding his bearer-bonds.

You'll notice that none of these circumstances lasted – indeed after the collapse of the Bretton Woods arrangements in 1972, the US restrictions withered away naturally. However, by that time, the Eurobond market was sufficiently established in London to perpetuate itself. Then came the 1980s, when the combination of falling bond yields and global financial liberalization did the rest.

It's strange to revisit this world of financial repression and imagine that Eurozone-et-al might be heading back there.

However, for London, two circumstances which bred the Euromarkets look to be settling into place. First, of course, the likelihood of Eurozone-et-al financial repression creating arbitrage opportunities; second, there is also a massive pool of offshore Euros available – and my guess is that offshore pool will balloon exponentially within hours of plans to tax onshore Euros being unveiled. And, of course, there are also urgent financial/political pressures now at work to bend Euro capital markets to the will of European governments. 

Third, for most of the last five years, the Eurozone has run modest current account deficits. The logic of German inspired endless austerity is for these deficits to be reversed, and sharply. For as long as this attempt lasts (and the Euro looks to have an immediate future), the corollary is that there will be no shortage of foreign issuers wishing/needing to issue Euro-Euro bonds. The more so if government-and-banking-system refinancing crowds out other onshore corporate issuers.

Finally, on a personal note: I firmly believe that London is invincible – it is the unexampled global city with so many diverse dimensions that it effortlessly reshapes itself for the eyes of every visitor. It has no equal today, having never been successfully copied or replicated. Personally, I also think it's dirty, expensive, difficult and dangerous, and when it's cornered it'll fight like the mongrel dog it is. What sort of idiots would pick a fight with it?

Shocks and Surprises, Week Ending December 2nd

• Labour, housing, confidence all surprising positively in the US;
• Sharp monetary slowdown finally shows up in the Eurozone;
• Bad PMIs for China, but is this shocking? Broader NE Asia dataflow suggests ambivalence;
• Japan's capex crumbles and unemployment soars, but production, retail sales and wages surprise positively.

A series of positive surprises in the US from labour and housing markets, and also from consumer confidence, suggests we can expect some upwards revision of economists' growth forecasts for 4Q11 and 1Q 12 (currently consensus stands at 2.3% and 1.9% respectively). The biggest headline was the completely unexpected fall in the unemployment ratio in November from 9% to 8.6%. This major surprise was due entirely to the fact that the rate of firing has fallen sharply (from 5.2% to 4.9%), whilst the ratios for job leavers, for re-entrants and for new hires were all unchanged. We'd had a hint that numbers might be stronger than expected earlier in the week, when the ADP survey sprang a similar surprise, reporting a rise of 206,000 during November, very nearly double the rise in October, and the strongest reading since December 2010.

The news from housing markets remains choppy, but we have reached the stage where the weight of surprisingly good news is beginning to outweigh the shocking bad stuff. This week, for example, discovered a 10.4% MoM jump in pending home sales (ie, sales where the contract has been signed but not completed). This was the strongest reading since November 2010, and completely unexpected: sales in the Midwest popped 24.1% MoM, and the Northeast (the most depressed market) jumped 17.7%. But whilst volumes may be in remission, it's still not clear what's happening to pricing: the US House Price index showed a rise of 0.9% (which no economist had expected), but the S&P Case Shiller 20 Cities price index showed a fall of 3.6% YoY (which was even worse than economists had forecast).

Finally in the US, consumer confidence also appears to be rebounding: with the index for November rising to 56, from 40.9 in the previous month. This was the most cheerful assessment for five months, reflecting sharp improvements in the view of both the current and likely future economic situation.

The picture I've painted here is quite brightly positive. But of course, the week's news washed up a shore-drift of consensus-confirming and  minor negative data shocks. Remember, I'm concentrating here only on the data which really stood out.

And for that reason, when we shift to the Eurozone, there's a swathe of data which tells a story of an economy under siege: labour market indicators, business climate and confidence surveys , PMIs for the Eurozone, for Germany and France individually, consumer spending indicators for France, industrial sales for the UK: they all consistently paint a picture of the European economy slowing fast. But very few of them stand out as being exceptionally better or worse than we had expected. But two readings did stand out this week.

First, Germany's retail sales, excluding autos, were far stronger than expected, rising 0.7% MoM, with exceptionally strong spending on clothes/shoes (up 7.8% MoM), and autos (up 3.8%). Should we really be surprised that the German consumer remains in good health? After all, though financial catastrophe may stalk southern Europe and threatened the financial architecture of the continent, Germany's unemployment ratio in November fell to 6.9% from a previous 7%.

Second, though, and probably far more important, the European Central Bank reported – for the first time during the ongoing crisis – really sharp slowdowns in monetary aggregates during October. M2 slowed from 2.5% YoY in September to 2% YoY in October, implying a sequential slowdown 1.75 SDs below seasonalized historic trends; M3 growth slowed from 3% YoY to 2.6% YoY, implying a slowdown of 1.8 SDs below seasonalized historic trends. The problem here is that we also know that Eurozone monetary velocity is absolutely flat. By implication, nominal GDP growth in the Eurozone must have very nearly stopped by now. There is a message for the ECB here: 'Sie mussen Zinssenkung'. (It's the only language they understand.)

China's contribution to the global central-bank effort to forestall the collapse of Eurozone banks was for the People's Bank of China to cut its reserve requirement ratio on China's banks by 50bps to 21% (for large banks). This was announced two hours before the rest of the world's major central banks cut 50bps from dollar-funding costs. The slight asynchronicity was enough to feed speculation that PBOC was reacting to the deterioration in China's own economic data. The focus was on China's Manufacturing PMI for November, which fell to 49 from 50.4 (which was worse than the range of expectations) and the HSBC/Markit Manufacturing PMI, which fell to 47.7 from 51. This was joined on Saturday by a sharp fall in China's Non-manufacturing PMI to 49.7 from 57.7. In short, the surveys tells us that China is now slowing, and more sharply in November than in October.

But is this actually a shock? I ask because the week brought a mass of hard data (ie, non-survey data) from the rest of NE Asia, almost all of which came in as expected: South Korean exports and industrial production and service industry output, Taiwan leading and coincident indexes (and Taiwan's Manufacturing PMI for that matter). In addition, Hong Kong's retail sales surprised on the upside in both value and volume measures (up 23.1% YOY and 15% YoY respectively), as did South Korea's trade surplus (thanks to strong exports, primarily to the US).

Adding Japan to the mix extends the feeling that the data on NE Asian growth is no worse than ambivalent. This last week brought upside surprises on retail sales (up 1.9% YoY), on industrial production (up 2.4% MoM, mainly thanks to rising output of transport equipment, and machinery); and even cash earnings (up 0.1% YoY). On the other hand, we also had two negative shocks. First, capital spending fell 9.8% YoY in 3Q: this is best seen as further delayed and intensified J-curve effect from a sharper revaluation of the yen even than followed the Plaza Accord in the late 1980s. Most likely Japan's capex loss is likely to be China's FDI gain. Second, the unemployment ratio jumped unexpectedly from 4.1% to 4.5% (even as wages surprised on the upside). This is a mirror image of what we saw this week in the US, when unemployment fell, but so did wages.  

Flow Essentials - Hidden Strengths, Hidden Vulnerabilities

Today I (finally) publish my Flow Essentials for 3Q, taking in the bulk of the developed economies: US, the Eurozone, China and Japan. This booklet charts the ratios I believe to be fundamental to understanding how an economy is performing, and what implications that growth has for the financial system. The charts look at:

• returns on capital, and growth of capital stock;
• changes in real labour productivity, and growth of employment
• changes in terms of trade
• movements in leverage, and changes in the net foreign asset/liability position of the banking system
• size and movement of private sector savings surplus/deficit
• changes in monetary velocity and liquidity preference.

Those of you who spend time analysing equities will recognize a deep affinity between this form of macroeconomic analysis and Dupont analysis. You should also recognize the concern with cashflow. You can download it here:

Flow Essentials: The Big Beasts 3Q11

Is there a Big Message for the world economy here? Superficially, the answer is 'yes, the world economy is in better shape than it usually seems.' First, return on capital is rising everywhere, except post-tsunami Japan. In the case of the US it is rising very sharply. Second, with the exception of China, there's very little in the way of growth of capital stock, so the risks to asset-turns based earnings are fundamentally still tilted towards the upside. By which I mean that continued topline growth is likely to do more good for the bottom line than a slowdown in growth is likely to do damage. Third, every major economy is running a significant private sector savings surplus: the US at 4.3%; the Eurozone at 4.9%; China at 4.2%; and Japan at 9%. Everywhere except Japan these surpluses are falling steadily – this is fuel for continued growth in private domestic demand.

Rising ROC and falling savings surpluses everywhere! Why, then, are we worried? The problem is that the flip-side of these large private sectors surpluses and almost equally large public sector budget deficits. Were this not the case, these big economies would all be producing far more than they are consuming, and deflation would be rife. (Or, more likely, profits would dry).

Worse, there is almost an economic identity in which the large private sector savings surpluses – or at least the part of those surpluses which are represented by profits - are conditional on those public sector deficits. In those parts of the world in which the underlying public sector debts are so huge as to require fiscal deficits to be pruned or reversed, there's a very predictable threat to profits growth, and therefore to the investment cycle.

We guess at this instinctively, but we can also demonstrate it at a macroeconomic level. Take two national accounting identities:

Y = C[onsumption] + I[nvestment] + G[ovt spending] + eX[ports] minus iM[ports], and

Y = W[ages] + P[rofits] = T[axes] + O[ther income]

and solve for Profits:

Profits = (C-W) + I + (G-T) + (X-M) - O

Now lets use that to look at the relative breakdown of profits from three major sources

1. Consumption minus Wages
2. Government spending minus Taxes
3. Exports minus Imports.

First, look at Japan.  

As you can see, the macroeconomic attribution of Japanese profits in the aftermath of the financial crisis of 2008/09 is very different, and crucially, very much more dependent on continued fiscal deficits, than before it. In 2007-08, Japan's profits were finally no longer principally dependent public sector largesse – rather, the profits were coming from the spread between consumption and wages, and to a lesser extent, net exports. During 2010 and 2011 that all changed, and we're back to the old state-dependent structure. Moreover, the situation has been exacerbated by the continued collapse in Japan's terms of trade, so net exports barely make a contribution any longer.

Now, take a look at how the US picture has changed (I've smoothed to 5yr averages here. In this case it reveals a pattern otherwise difficult eyeball, owing to its volatility).

Each line has a story to tell. First, the top line is stagnant: it looks as if the proportion of profits generated by the surplus of consumption minus wages finally plateaued in 2Q08 at the onset of the financial crisis. There is no sign that this is about to rise higher. Second, and most obviously, the proportion of profits attributable to the fiscal deficit has risen from a low of around 5% in 2002 to an all-time high of 25% now, and it continues to rise sharply. This is the 'corporate welfare' one reads about, and it is the single biggest factor behind rising profits right now. And finally, since the financial crisis the modest closing of the trade deficit has offset the peaking of the consumption-wages profit element.

This type of analysis shows plainly enough what is at risk during coming year: that the scramble to close fiscal deficits, whether made voluntarily or under pressure from markets, will make a sharper impact on profits, returns on capital, private sector savings surpluses (cashflows) and the investment cycle than is immediately obvious. Just another way of saying: price equities on the basis of unexpected earnings volatility.  

Bernanke Locks Down Sarajevo

On Monday someone asked me the right question: 'So just how does it end?'. And, being the right question, I was stuck for an answer. 'I don't know, but eventually Princip will run into the Archduke.'

Most of you will know the reference: it was Gavrilo Princip's assassination of Archduke Ferdinand of Austria in Sarajevo in 1914 which triggered the explosive set of mutually-dependent alliances and relationships and tumbled Europe into all-consuming war. Could it have been otherwise? Hefty precautions had been made in Sarajevo for the visiting Archduke's visit, and an 'official' attempt on his life by Princip's co-conspirators had failed in the day, when the thrown bomb bounced off the his car's bonnet). Shaken but alive, the Archduke later abandoned his schedule in order to visit the bomb's survivors. On the way there, fatefully, his driver took a wrong turning, delivering the Archduke to the street where Princip was resting up in a deli, recovering his nerves. Whilst the Archduke's driver realized his mistake, Princip realized his date with destiny. How unlucky was that? Despite everything, the Archduke met his Princip.

My reading of yesterday's announcement of a coordinated commitment to abundant dollar-funding is the equivalent of Ben Bernanke putting Sarajevo on lock-down. The end of the Euro won't be triggered by a lack of dollar liquidity at Eurozone banks – at least not on Bernanke's watch. The Archduke may yet meet his Princip, but it won't be right here, right now. Hence the globally-coordinated cutting of interest rates by 50bps on dollar liquidity swaps by the Fed and the central banks of England, Japan, Switzerland, the Eurozone and Canada.

Actually, though, as I've been tracking for months now, foreign banks' US$ positions are probably the least of their very considerable worries. The latest data from the Fed shows that foreign banks operating in the US have built up a net dollar asset position of US$265 bn directly attributable to loans or deposits from their related foreign offices – and this represents a net improvement of US$672 bn during the last 12 months. In London too Eurozone banks have been careful to ensure they're running net long positions in both sterling (in September they had a net sterling asset position of £1.7bn, reversing a net £32.7bn short sterling position in Sept 2010), and in other fx (a net long position of £21.95bn, reversing a net short of £21.28bn in Sept 2010).

At a consolidated level, the Eurozone's banks look in good shape in terms of their external balances: they report a net external asset position of Eu905.2 bn at end-October.

But balance sheets are one thing, liquidity mismatches another. What matters is the pace at which these banks' fx liabilities are shrinking. And here the picture is sobering. Even at a consolidated level, gross external liabilities owed by Eurozone banks are down 7.3% YoY in October, having contracted by Eu327bn during the previous 12 months, of which the majority has left during the last six months. Over in New York, the deposit base of all foreign banks has contracted by US$182bn over the last year – that's a fall of 17.2%. In London, Eurozone banks have seen their foreign currency deposits fall by 12.6%, or by £124bn, in the year to September – and since their Euro deposits fell by only 5% during that period, we can be pretty certain it's the dollars that have left.

Remember, deposits are meant to be the 'sticky' part of a bank's liabilities. If they are leaving, one shudders to imagine how quickly other more mobile foreign liabilities are leaving.

Since we have established that these banks also have net long dollar positions, the central banks' cheap liquidity swaps should provide a way of presenting that rout as orderly, buying time to wind down the dollar assets without triggering economic meltdown.

As for its contribution to defusing the Euro Doomsday Machine – it does nothing for that.