The Sick Man of Europe plus other global maladies

What's caught my eye this week including Labour's joyless honeymoon, shrinking British kids, the Fed's momentous decision, Berlin's banking blunder, and the battle for the Global South

Photo by insung yoon on Unsplash

1. Joyless Honeymoon

This week’s Labour conference in Liverpool is clearly not going to be quite the celebration that the party might have been anticipating. After the loveless landslide has come the joyless honeymoon. It is easy to dismiss rows about ministers accepting freebies from donors and whether the prime minister’s chief of staff deserves to be paid more than the prime minister (but less than some permanent secretaries as tittle-tattle fuelled by a hostile right-wing media that has been quite clearly determined to destroy the new government since the day it took office. Just nine weeks into a five year parliament, it is certainly hard to believe that the question of who paid for the prime minister’s spectacles is of any lasting political significance.

Nonetheless, there are two reasons why this tittle-tattle cannot be so easily dismissed. The first is that at least some of these negative stories, particularly relating to Sue Gray, are being fed by briefings from ministers, advisers, civil servants and Labour party staff. That suggests both a lack of political grip in the centre and a swift return to the kind of factionalism that has historically been a problem for past Labour governments. The fact that The Observer has published a poll today showing that Sir Keir Starmer’s approval rating has fallen to minus 26, one point lower than Rishi Sunak, shows that the negative media campaign is having an impact, and is bound to dent both the prime minister’s confidence and his authority.

But these rows are also filling a media vacuum in the media where debate about policy should be. It is striking that more than two months into the new government, the most eye-catching policy initiative has been a decision to scrap the winter fuel allowance from pensioners which emerged without warning or consultation and carried all the hallmarks of a panic measure. I wrote a couple of week’s ago that it was becoming clear that the election had come too early for Labour - that while it was well prepared for campaigning, it was not prepared for government. That is apparent in the number of difficult issues it has kicked into the long grass while it awaits the outcome of reviews - for example, on defence, pensions, social care - as well as Starmer’s less than sure-footed approach to his reset of EU relations, reflected in his short-sighted dismissal out of hand of the EU’s proposal of a youth mobility scheme.

Now it is faced with having to develop policy while in government, a hard enough task under any circumstances, but even more so with a fractious party and hostile media to contend with. No doubt Labour will try to flesh out some policy detail in Liverpool this week. But the real test will come with the Budget on October 30. The challenge facing Rachel Reeves is clear enough: there is now a wide consensus that behind many of Britain’s economic challenges lies a chronic lack of investment over many decades. Her task is to find the money to make one or two bold bets on areas where significant public investment can substantially move the dial on long-term productivity.

Most of that money will have to come from new taxes, given the current level of Britain’s public debt which needs to be kept on a sustainable footing. But to the extent that some of it may be able to come from extra borrowing as a result of tweaks to the fiscal rules, it will be vital that Reeves adopts some measure to convince voters and the markets that this increased borrowing will indeed be used to fund productive investment. The best way to do this, as consistently advocated by Wealth of Nations, is to adopt a new target to increase net worth over the life of the parliament.

On that score, I was disappointed this week to see that an otherwise excellent House of Lords Economics Committee report into the sustainability of the national debt included a very positive endorsement of net worth on the basis of evidence provided by a number of witnesses, only to rule it out of its final recommendations in a single paragraph, apparently on the basis of the evidence of a single witness. The argument offered was that net worth would lack credibility because it could be easily fudged, with current spending, for example on teachers, rebadged as investment.

This betrays a complete misunderstanding of the net worth approach. The problem of loose definitions was exactly what led to the discrediting of Gordon Brown’s much-vaunted Golden Rule, whereby he promised only to borrow to invest over the course of an economic cycle. This is the model that Reeves currently seems minded to adopt. But the advantage of net worth is that it is based on robust internationally recognised accounting standards which are much harder to fudge. Crucially, the transparency that would come with adopting those accounting standards as the key tool of financial management throughout the public sector would bring the added advantage of increased accountability and thus productivity, which is what the British state needs.

2. Sick Man of Europe

There’s no question in my mind where much of that investment should go. Earlier this month, Lord Darzi’s report into the National Health Service revealed a £37 billion capital spending gap over the past decade relative to what other peer countries have invested in their health systems. Last week, a new report by the Institute for Public Policy Research laid bear the consequences of that under-investment. It found that among G7 countries, only America ranks lower on life expectancy, obesity and avoidable mortality, while only Italy ranks lower on health spending. All this has significant implications for the economy.

Labour supply: We find that 900,000 workers were missing from work due to sickness – compared to what we would have otherwise expected on prepandemic trends – at the end of 2023. Economic inactivity due to sickness could breach 4 million by the end of the parliament, if post-pandemic trends continue.

Productivity: People with one or multiple health conditions are as much as twice as likely to take sick days or experience lower productivity due to working through sickness. Productivity impact of sickness is linked to to poor job design, work culture or financial means to take sick days when they are needed.

Public finances: Poor health means avoidable expenditure in the NHS and welfare system, and lower tax receipts (as fewer people are in work). We find that the 900,000 missing workers due to sickness (above) mean a loss of an estimated £5 billion in tax receipts per year, and that better population health could save the NHS £18 billion per year by the mid-2030s

Meanwhile what really caught my eye this week were these two charts in this piece in The Conversation by Danny Dorling, Professor of Geography at Oxford University, which really highlights the scale of the crisis facing Britain. The first chart shows that on standardised United Nations measures, Britain has faced a sharper rise in the numbers of children living in poverty than anywhere else in the world. Indeed, Dorling says that the bottom fifth of Britons are now poorer than the bottom fifth of much of Eastern Europe. The second chart, astonishingly, shows that British children are getting shorter. The average heigh of five year-old boys has been declining since 2010, a phenomenon which Dorling attributes to austerity and poverty.

How on earth could we have let this happen? Britain owes the founding of its welfare state in part to a panic at the turn of the last century over the health of the nation, when it emerged that a third of young men were not fit enough for military service. But after a century of progress, Britain is in every sense becoming the sick man of Europe and the health of the nation is once again a cause for alarm. I agree with the IPPR: Starmer should elevate not just fixing the NHS but improving public health as one of his government’s core national missions.

3. Momentous Times

The big financial news of last week was the decision by the US Federal Reserve to cut its main interest rate by half a percentage point to between 4.75 and 5 per cent. Indeed, The Economist even called the decision momentous. I suppose the the first interest rate cut since inflation took off in 2021 might have seemed momentous to a trade with millions of dollars riding on it, or an American homeowner or business hoping to refinance a mortgage or loan. But for the rest of us, a cut in US interest rates had seemed long overdue given that inflation has already fallen back to 2.5 per cent and unemployment has risen by one percentage point over the last year.

The only question was whether the cut would be a quarter or a half percentage point. In opting for a half, the challenge facing the Fed was to convince the market that it was acting boldly to ensure the US government doesn’t fall into recession rather than because it fears that it already is. Given that the stock market soared to new highs and bond yields remained steady, it would seem that Fed chairman Jay Powell pulled off this rhetorical feat with aplomb. Now the debate moves on to how far rates can fall without triggering another upswing in inflation. For a succinct explanation of the various arguments, I recommend this typically insightful post by Marco Annunziata.

But events in the US should not distract our attention from far more momentous developments elsewhere, notably in China. As John Authers noted in his Points of Return newsletter for Bloomberg, Beijing’s sputtering growth is drawing comparison to Japan’s classic slump since the 1990s — Japanification. The latest Bank of America fund manager survey shows that investors are currently pretty gloomy about China’s growth prospects:

Indeed, China’s situation could be even worse than that of Japan.

China now has all the symptoms of a “balance-sheet recession”: a protracted period of deflation, property market declines, and a debt overhang. And, just as in Japan, this has followed an amazing period of growth. What would it take to escape the quagmire? Barclays Plc researchers argue that China faces a unique set of challenges, which in some instances make it worse off than Japan — population decline, housing troubles, an even more pronounced slump.

The problem with a balance sheet recession is that there is not much policymakers can do about it. Cutting interest rates doesn’t help much because households are too indebted to revive the economy by spending more. As Authers notes, household debt has more than doubled in the past decade, reaching 143% of disposable income in 2021 before stabilizing. Meanwhile 96 per cent of savings are locked up in time deposits, with anecdotal evidence suggesting households prefer maturities of up to five years to lock in higher long-term rates.

Besides as I noted here, the Chinese authorities have in any case been doing the opposite: punishing regional banks for selling Yuan bonds in an attempt to push UP bond yields, most likely as part of an attempt to avoid any further weakening of the Yuan. What the markets want to see is a comprehensive fiscal stimulus to try to boost domestic consumption and ward off deflation. But there is no sign that Beijing is planning the bazooka that would reassure investors. The danger is that it will simply double down on its export-led growth strategy, dumping its surplus output onto world markets, thereby raising global trade tensions.

Meanwhile, as Authers says, a Chinese cloud hangs over the global economy:

It has taken Japan about three decades to escape the economic slump. The asset value destroyed by property’s downturn is estimated at $9 trillion, twice the size of China’s equity market cap. The Chinese stock market meanwhile is looking alarmingly like Japan’s. There’s no quick fix. The experience of Japan and the US indicates it can take at least a decade to bring private-sector leverage down.

4. The Italian Job

The most enjoyable financial story of the week may yet turn out to be one of the most consequential. The way in which Andrea Orcel, the chief executive of UniCredit, was able to snap up a large offer of shares in Commerzbank from the German government at a discount to the market price seemingly without the German government being aware is a fine piece of deal-making that has resulted in many red faces in Berlin and caused a real political headache for the German government.

Berlin had put 4.5 per cent of the shares in Commerzbank as part of its ongoing efforts to sell off a holding in the previously troubled lender acquired after the global financial crisis. But rather than the shares going to ordinary institutional shareholders, Orcel spotted an opportunity to add to Unicredit’s existing 4.5 per cent stake, thereby putting himself the Italian banking giant in prize position to launch a full bid for Commerzbank. Orcel claims he thought UniCredit’s bid was welcome, while Berlin claims it was blindsided by UniCredit’s actions. Craig Coben, a veteran Bank of America dealmaker, had a good write up of the blame game in the FT.

But there is a serious point at stake in this saga. It is now over a decade since the eurozone, in response to its debt crisis, rightly decided to create a banking union. But so far it remains a banking union in little more than a regulatory union. The European Central Bank, which was established as the single supervisor for eurozone banks, has brought stability to the sector, but as I explained in this post, it is the stability of the graveyard. What is needed is a substantial consolidation of the banking sector to cut costs, boost profitability and support more risk-taking. Yet the market remains deeply fragmented along national lines. The cross-border banking mergers that banking union was supposed to unleash have barely happened.

That is what makes UniCredit’s move so potentially significant. Will Berlin allow the Italian bank to buy the whole of Commerzbank, as it seems it would like to do? The political opposition already inside Germany, not least from unions who fear big job losses, is intense. For the German government, to allow such an important piece of the country’s financial system, the biggest lender to the Mittelstand companies that are the backbone of the economy, would be a bitter pill to swallow. Yet that is the logic of both the single currency, single market and banking union that Germany has signed up to. It is hard to see on what reasonable grounds it could refuse.

Hard on the heels of the Draghi report into how to restore Europe’s competitiveness, which highlighted the urgent need to deepen financial integration to boost investment across the bloc, UniCredit has laid down a vital test of Germany’s commitment to Europe. The early signs are that is a test that Berlin it likely to fail.

5. Trading Places

The United Nations General Assembly takes place this week, when world leaders gather in New York for several days of frenetic diplomatic activity. The single most salient fact underlying these meetings is that the West is losing the global south. That partly reflects anger in many countries at what they perceive as western hypocrisy and double standards in their support of Ukraine but not of Gaza, which has some increasingly to side with Russia, and over deepening economic relations with China. The Economist has this good long read on the state of play, but these two paragraphs for me stood out in terms of highlighting the situation facing the West:

America has belatedly woken up to competition with China for support in the global south amid signs that sentiment is shifting. An opinion survey of 31 countries, conducted for The Economist by GlobeScan, found strong support for Ukraine in many of them. But respondents in India, Indonesia, Vietnam, Egypt and Saudi Arabia sided more with Russia. The survey also found strong support for American leadership in the world, though places like Turkey, Egypt and Saudi Arabia leaned towards China.

A separate annual survey of elite opinion in South-East Asia, by the iseas-Yusof Ishak Institute in Singapore, for the first time recorded a majority saying that if asked to choose between America and China, they would side with China in a crisis. Western diplomats say it has become harder to meet senior figures in Muslim-majority countries such as Malaysia and Indonesia. Some in America’s Congress worry the damage to America’s standing is becoming irreparable, though they also think showing loyalty to an embattled ally will reassure friends worldwide.

Reviving Western relations with the Global South should be one of the defining geopolitical challenges of both the next American president and the new European Commission. As I noted a couple of weeks ago, this piece in Foreign Affairs by Brian Deese, one of Kamala Harris’s advisers, calling for a new Marshall Plan for Clean Energy sent an encouraging signal that a Harris presidency at least might think creatively about how to engage with developing countries.

It is easy to spot problems with Deese’s plan, not least that China currently has better and cheaper clean energy technologies. But the key problem may be one that Deese identified himself: the inflexibility of US financial aid.

Officials in foreign capitals joke that the United States shows up with a 100-page list of conditions, whereas China shows up with a blank check. The United States’ current financing authorities are constrained by byzantine rules that block U.S. investment that could advance its national interests.

If anything, EU rules are even more onerous. Meanwhile Environmental, Social and Governance rules can be a formidable obstacle to private sector investment in many emerging market countries. The West rightly wants to project its values. But Russia offers regimes security and China offers them lucrative commercial deals with few questions asked. It is hard to compete with that.

Meawhile the broader question is what is even the point of the UN, given that it is currently unable to play any mediating role in the two biggest conflicts in the world right now in Gaza and Ukraine, and that one of the five permanent members of the Security Council is in brazen breach of the UN Charter, with the active connivance of another. For a good discussion of these issues and a rather optimistic view of what should be done about them, this podcast interview between the FT’s Gideon Rachman and UN General Secretary Antonio Guterres is worth a listen.