Terry Smith Straight Talking

BBC World Service, 24 February 2012

This morning I was interviewed on BBC World Service regarding the future shape of Europe. To put this in context, the French employers’ association, supported by The President of Medef's Ile de France region, and head of the French association of female business leaders, Marie-Christine Oghly, said it wants full political union. During my discussion I explained why such a union would undoubtedly make the situation worse.

You can listen to the full interview here (starting at 6mins 10 seconds) and a transcript of my discussion is below.

ED BUTLER (Presenter): Germany’s chancellor, Angela Merkel, has supported the idea of further European integration.  She’s demanded the strengthening of Brussels’ oversight of national budgets.  And many business leaders have in the past seen a federal European superstate as the only logical conclusion of monetary union.  But since the latest crisis, those who already had misgivings about the creation of the euro and deeper union, feel that their position has been reinforced.  One of those is Terry Smith, chief executive of his own brokerage and fund management firm, one of Britain’s richest investors, and a man who reckons it’s a time to draw a line under what he calls the “European experiment”.

TERRY SMITH: It’s tempting in the crisis that we’ve had for the last few years, and particularly the eurozone crisis, that, for a number of people, when asked what the solution is, to say “more Europe”.  I rather suspect, though, that it’s highly probably that the answer is “less Europe”, because if you look for the majority of Europe – not just France, but I would include France in this comment. For the majority of countries in Europe, their membership of, certainly the currency union portion of Europe, has really been quite a problem for them.  It’s impossible, really – for Greece, certainly, Portugal, probably Spain, some of Italy, and France and Ireland – to live in a currency union with Germany, so a political union would probably make that worse.

ED BUTLER: But surely the problems of Greece arose because it wasn’t in this single political union, you could argue. If it had been, all of the accounting issues that people have talked about, all of that, that sense of Greece trading off the wealth of the northern states would not have been possible in the…

TERRY SMITH: It’s certainly true insofar as if  you’re going to have a single currency and make it work, I don’t think you can do it without political union, because in the end you have to have a single authority that guarantees the debt, and that single authority can only guarantee the debt by raising taxes.  So I think you’re right about that.  However, I would disagree that if Greece, or indeed any of the other peripheral countries which are struggling, had been in this currency union and it had a political union, it would all be all right.  I think you’re missing another bit that would have to occur for that all to be all right, which is you’d have to have the political union and the single authority to do the taxing and guarantee the debts and so on, but there’s one other thing everybody would have to accept: forever, there would be transfer payments from the rich nations – primarily Germany but also Holland and Finland – to the poorer countries.

ED BUTLER: But the paradigm of the United States, which is often talked about, isn’t it, in the context of United States of Europe, United States of America…

TERRY SMITH: Yes.

ED BUTLER: …the Americans have a great tradition of upping sticks and moving stake when things don’t work, and perhaps that’s part of the problem in Europe that we’re too cemented in our little cultural zones, and if there were that single entity, we would somehow feel freer, as workers, as businesses, to move around.

TERRY SMITH: The parallels with America don’t entirely work.  Bear in mind America basically is a country which is pretty much single language.  It’s a country where, other than the American Civil War, there hasn’t been any conflict on that continent since foundation, basically; whereas you haven’t got to go very far into Europe to find the states of Europe warring with each other.  I mean, part of the problem in the German/Greece situation now is their history.  And so it’s not quite that simple.  Engineering what you see in America would probably require some of the things that you had in America to build that.  America did have a civil war before this was accepted.

ED BUTLER: True.  But Terry aren’t you speaking here as a British-based financer and investor who will look at the eurozone and know that you’re not part of it, you’re not of it, you’re not in there.  If you were in France, if you were in Germany, would you not feel a strong sense of, “look, we have two choices. One is disintegration – which is a total nightmare – and the other is integration, which gives us some glimmer of hope”?

TERRY SMITH: I look at it as a businessman who does business in 24 countries around the world, and I spend a lot of time living outside the UK and looking at it from the perspective of America or Singapore or Zurich or wherever else I happen to be at that time.  So I don’t think I’m purely UK-centred.  When you say “if I were in that situation, wouldn’t I want this integration”, I think that the French probably want it because with it they’re in a great deal of trouble.  France has got a current account deficit which has been growing continuously since 2004.  It’s got unemployment over 10%, it’s got the highest minimum wage rate in Europe, it’s got the biggest exposure amongst its banks to the eurozone debt, and 56%/57% of the French economy is a state economy.  France is in a mess if it gets cut loose from all this. 

ED BUTLER: Right.  But if it wants to get bailed out by the Germans…

TERRY SMITH: I can understand why, but that doesn’t necessarily mean that it’s good for all the states of Europe just because it’s good for France – or indeed for the remainder of the world – to have this happen.  Just to go back to an earlier point, you said disintegration, it would be a nightmare.  I think that’s accepted wisdom, but again, I think accepted wisdom is an oxymoron.  It may be that actually disintegration is better than trying to hold together something which shouldn’t be held together.  And I would doubt that those countries around the periphery, including France… I very much doubt if those countries can survive in a union with Germany.

ED BUTLER: Are you betting on Europe’s future?

TERRY SMITH: I’d have a bet on Europe’s future.  I would bet that Greece is going to leave the euro.  And I would bet that it’s highly likely that then Portugal will leave the euro.  And I think it’s then reasonably questionable whether or not Spain and Italy can survive… certainly the south of Italy has got all of the characteristics of the other peripheral countries.  And I think the final frontier of this is France.  France, in this crisis, has been seen at the top table dispensing justice alongside Germany but France’s financial characteristics are far closer to the peripheral countries that are in trouble than it is to Germany.

 

Is Occupy right?

Last night I gave the Worshipful Company of World Traders' 25th annual Tacitus lecture at Guildhall in London. The title I chose must have come as a shock to some in the audience: Is Occupy right?

You may find it unlikely that I would sympathise with the Occupy movement. I am a supporter of the market economy, small government and I’m a climate change sceptic so it might not obvious that I would entertain the possibility there was merit in Occupy's cause.

Apart from a lack of a clear goal it is easy to pour scorn on Occupy as a sort of “Swampy does capital for financial markets”, or to focus on the lack of hygiene in some cases or the “champagne socialist” nature of protesters who are busy drinking frappuccinos whilst communicating on their iPads and protesting about inequality.

It is so very easy to knock. Easy, but I observed perhaps not right to do so before trying to understand what drove them and what actions they should be seeking to achieve.

You can view and download my full speech (see below) in which I discuss what I believe is wrong about the way in which financial markets have operated including the separation of retail banking from investment banking, securitisation (which should be banned), Big Bang, the bonus culture, fund management and performance fees, and the EU.

BBC Radio 4 World at One Programme, 01 February 2012

Today I was interviewed on Radio 4’s World at One regarding Fred Goodwin being stripped of his knighthood.  We had a lively debate about whether it was right to take his honour away - I think not - and whether other people should have their honours stripped from them. The BBC interviewer pointed out to listeners that the RBS chairman did not receive his knighthood for services to banking and by implication it would not be appropriate for him to be treated in the same manner as Fred Goodwin. I did not have the time to point out that Anthony Blunt received his knighthood for services to art yet was stripped of it for spying. One person that clearly does stand out for scrutiny is Alan Greenspan.

You can listen to my interview here (commences at 20 minutes 55 seconds) and a full transcript is below.

SHAUN LEY: Presenter
Well, Terry Smith is chief executive of Tullett Prebon, a money broker and Fundsmith, a fund management company.  He’s in the City now. Welcome to the programme.
What do you make of the decision to strip Fred Goodwin of his knighthood?

TERRY SMITH: Chief Executive, Tullett Prebon and Fundsmith
I think it’s deplorable.  He’s now been bracketed with traitors, dictators and convicted fraudsters.  If he did something wrong, I’d like to see some proceedings against him – civil or regulatory – and then if he is found to have done something wrong, strip him then but at the moment it looks like a deplorable, political willingness to go along with the sort of morals of a lynch mob.

SHAUN LEY:
But honours are discretionary: there’s no real criteria for rewarding them.  Why should there be any specific criteria for taking them away?  If they’re given by politicians why not allow politicians in response to public opinion, to strip them from those who’ve received them?

TERRY SMITH:
We could do that if people wish.  It would be a break with the way that this has been done in the past, of course – that’s not necessarily a bad thing – but historically, as I say, traitors, dictators and convicted fraudsters have been it so this is a complete change.  If we are going to strip them at discretion for failing though, I would like to suggest to you that the Buckingham Palace probably need a rather large cupboard for returns, because if everybody who fails has to hand back their honours there’ll be a lot.  If we take the specific case of Fred Goodwin, he didn’t make his decisions alone.  The chairman of his board and his board helped him – the chairman, by the way, was Sir Tom McKillop – and he’s in the regulated, highly regulated banking industry where the FSA basically approved what he was doing and that was chaired at the time by Sir Callum McCarthy.  So I presume if we’re going down that route, there will be a lot of other people rather than this lone individual singled out.

SEAN LEY:
I suppose I should say, just in passing, that Tom McKillop’s knighthood was for services to the pharmaceutical industry before he went to banking but I think your point is well made. 

TERRY SMITH:
Who cares what it was for?

SHAUN LEY:
Fair enough and on that basis, are you concerned that this might have an impact on the City, on the attractiveness of Britain for business, particularly this idea perhaps if you fail, which a lot of people do in business, even people who are subsequently successful, you’re going to get punished for it?

TERRY SMITH:
Yes, I think the only way to absolutely guarantee that you won’t fail, is not to try in the first place.  I think it will have a bad effect on people and I think people who either aspire to receive honours for whatever reason in their career, or those who like Stephen Hester, have taken on a job in the public sector who see that something that they were contractually received is taken away for political reasons, must surely think twice about ever taking something on like this again.  But going back to an earlier point: if we are going to take honours away from people because of their mistakes, could I suggest another one that should obviously be called into question?

SHAUN LEY:
Go on, briefly.

TERRY SMITH:
How about the 2002 honorary knighthood given to Alan Greenspan, the chairman of the Federal Reserve and the citation was “ for his contribution to global economic stability”.  I’ll believe that people are not on a witch hunt for a single man when they proceed against Alan Greenspan and strip him of his knighthood.

SHAUN LEY:
OK, Mr Terry Smith in the City: thanks very much for joining us.

Michael O'Leary on the EU

This presentation by Michael O’Leary in Brussels to the EU is worth 15 minutes of your time. It is ostensibly about airlines but he also offers some insight into the EU:

http://www.youtube.com/watch?v=p4HYSsrlcq8&feature=player_embedded

Cameron's veto was consistent with history

There was a wonderful letter in the FT yesterday from a Mr Shenkman. He has clearly got a better grasp of history than those who have claimed that David Cameron’s veto of changes to the Lisbon Treaty and the UK’s alleged isolation as a result is in some way a reversal of British foreign policy towards the Continent.
 
I have a strong interest in history as I have a first class honours degree in the subject and in my view Mr Shenkman is right. For hundreds of years Britain’s successful policy with regard to the Continent has been to ally with the weaker powers to prevent a single power dominating the Continent. This which would have been to our detriment as an island off the coast of mainland Europe whose prosperity has depended upon trade with the wider world.
 
This policy was implemented during the Napoleonic Wars when the successful military intervention of Nelson and Wellington prevented the Continental System from being imposed upon Europe, and again in the twentieth century with two world wars fought against Germany.
 
There may no longer be a military dimension to the current problems in Europe (although I think we should hesitate before dismissing that possibility given the historic instability of south east Europe). There is, however, little doubt that the Eurozone has been used as an instrument for Germany to dominate the Continent through productive might and David Cameron’s veto is consistent with the aims of centuries of successful British policy on Europe which it would be foolish to abandon.

 

Financial Times, Letters to the Editor
Long tradition of holding other powers in check
From Mr Gregory Shenkman.

Sir, Perhaps the history I studied at Cambridge was different to that absorbed some years later by Jonathan Powell at Oxford (“Cameron has betrayed 200 years of history”, December 12). Mr Powell suggests....

Read the full text at http://www.ft.com/cms/s/0/9f1ca328-1c4c-11e1-af09-00144feabdc0.html#axzz1gJnGZzdi

 

(Those of you without a subscription can access a limited number of articles each month via FT.com's free registration.)

Isolation Hysteria and the IMF

I am frankly amazed by the outpouring of hysteria from some politicians and the media on the subject of David Cameron’s use of the veto over changes to the Lisbon Treaty.

To listen to some in politics and the media bemoaning what they claim is the resulting ‘isolation’ of the UK you would think that the UK should accede to any request from the EU in order to avoid this fate. Why? The Euro, which these proposed changes were designed to support, has been a predictable disaster for almost all the countries involved other than Germany.

It is also worth bearing in mind that many of these commentators-such as Ken Clarke and Michael Heseltine- were vociferous supporters of us joining the Euro. Indeed, Michael Hesletine thinks we still should-an unusual case of trying to join a sinking ship. Had we done so, we too would now be bankrupt and quite possibly governed by an unelected official appointed by the EU, as Greece and Italy are. These commentators were wrong when they wanted us to join, so why should we listen to them now?

We should now move onto redefine and renegotiate our relationship with or within the EU, starting with the question “What do we get for the£50m per day we send to Brussels?”. If we do not get what we want, we should accept that the UK’s future, like its past, success will lie in being an open economy servicing and trading with nations with which it has historic connections in the Americas, Asia, Africa and Europe.

One aspect of the “deal” at last week’s EU summit puzzled me. It was seeing Christine Lagarde, the Managing Director of the IMF (a Frenchwoman-her predecessor being maybe not coincidentally a Frenchman) proudly announce that the EU countries (other than Britain’s) central banks were going to make loans to the IMF of €200 billion. This might seem counter intuitive-how can countries which are to put it mildly short of money make a loan to someone else? Of course the answer is that the funds would be loaned to the IMF for it to loan back to the Eurozone.

That is obviously a circular piece of none too subtle legerdemain, but the hope was that other countries would join them with additional funding. This hope was rather dashed when the Canadians immediately announced that they has no interest in subscribing funds to rescue the ‘rich continent’ of Europe. Sensible people the Canadians: they dragged themselves back from being a basket case in 1994 with spending cuts which restored a budget surplus and have not experienced a banking crisis. They also just announced withdrawal from the Kyoto protocol on climate change. Following the refusal of China to take part in such nonsense despite the myriad rumours, I can only assume that this latest leg to the circular Ponzi scheme that is now the Eurozone is a non starter.

BBC Radio 4 Today Programme – Eurozone downgrade warning a ‘statement of the blindingly obvious’

This morning I was interviewed on the Today Programme about the decision late last night by Standard and Poor's to review the credit standing of 15 eurozone countries including Germany and France.

Evan Davis opened the interview by asking, ‘how important do you think the Standard and Poor’s declaration is?’

To which I responded, ‘it’s not terribly important in itself. It’s a statement of the blindingly obvious in many respects. The idea that many of the eurozone countries, possible all of them, might be less able to service their debts than people had thought historically strikes me as fairly obvious.’

You can listen to the full interview here.

The full transcript of the interview is below.

EVAN DAVIS: Presenter
Well, yesterday was an extraordinary one, even by the high standards of the ongoing eurozone crisis. On the one side there was a glimpse of a possible solution to the immediate crisis as a compromise between France and Germany was agreed. Maybe that would pave the way to the European Central Bank easing up on its policy. Then, with impeccably bad timing, came the bombshell announcement from the credit ratings agency, Standard & Poor’s, that the debt of every member of the eurozone was being looked at for a possible downgrade; not every member, in fact, Greece and Cyprus, who are already very lowly rated, were exempt. Well, S&P is one of several private organisations that make a living out of rating the security of different governments’ debt; even Germany might go down, they said, France might go down two notches on their scale. Well, obviously, Standard & Poor’s don’t have any particular inside information, they’re just another group of analysts making their own assessment but they are a group who, for good reason or bad, are taken very seriously. We’ll discuss the implications of it, and that French/German agreement, in a few moments, but let’s just get Robert Peston to explain the significance of the Standard & Poor’s review.
Robert, what’s the significance of the Standard & Poor’s review

ROBERT PESTON: Business Editor
Well, I mean, you know, whether eurozone leaders like it or not, investors still take what credit rating agencies say about governments’ ability to repay their debts, seriously, and actually that authority of credit rating agencies is built into the system, because central banks, for example, when they’re lending to banks they actually use credit ratings to determine what kind of assets they take from banks as collateral. So what credit rating agencies say… and in the case of Standard & Poor’s, it’s not actually their analysis that I think people will regard as particularly controversial. We know that banks have been finding it increasingly difficult – that’s eurozone banks - have been finding it increasingly difficult to borrow, we know that governments like Italy and Spain have been finding it increasingly hard to borrow. And we’ve also witnessed how difficult it’s been for the eurozone to come up with solutions to these very serious financial difficulties. And, therefore, the analysis that underpins the downgrading is one I think that many people would accept. It is the timing, as you say, of them that is quite so shocking and explosive, coming as it does midway through what many would regard as make or break negotiations to try and solve these problems.

EVAN DAVIS:
Well, they didn’t mention the… I didn’t see in the bits I read of Standard & Poor’s mention, this French/German agreement. Now does the French/German agreement change the picture so significantly that Standard & Poor’s are out-of-date before they’ve even been published?

ROBERT PESTON:
Well, not yet Evan, because the French/German agreement is only one step along the way to reform; the other eurozone members have to sign up for it. And anyway, we haven’t yet seen all the detail of what the French and the Germans want in respect of limiting the ability of eurozone members to spend and borrow recklessly. We’ll only have a sense of how credible that plan is towards the end of the week, and actually if history is any guide, it may… what we may get at the end of the week is simply more broad brush statements by eurozone leaders, it may be weeks before we have the fine print, and it’s the fine print of these agreements that we now know from bitter experience which determines whether in the end these rescue proposals will actually work, and so far, over the past 18 months, the eurozone governments have rather let us down, given us, you know, wonderful hope on the basis of the thrust of what they’ve been saying and then we’ve seen the fine print we’ve thought, “well, actually, there’s rather less to all of this than we hoped”.

EVAN DAVIS:
Robert, thank you very much indeed. Well, let’s talk through this with Ngaire Woods who’s Dean of Oxford University’s Blavatnik School of Government, and with Terry Smith, a veteran City commentator, Chief Executive of Tullett Prebon and Fundsmith.
Good morning to you both.

TERRY SMITH: Chief Executive, Tullett Prebon and Fundsmith
Good morning.

NGAIRE WOODS: Dean of Oxford University’s Blavatnik School of Government
Good morning.

EVAN DAVIS:
Terry Smith, how important do you think that Standard & Poor’s declaration is?

TERRY SMITH:
It’s not terribly important in itself. I’d agree with Robert Peston’s comments, basically. It’s a statement of the blindingly obvious in many respects. The idea that many of the eurozone countries, possibly all of them, might be less able to service their debts than people had thought historically, strikes me as fairly obvious.

EVAN DAVIS:
Yeah. It’s annoying in the timing, though, isn’t it? There they are, trying to get everything together for Friday and then suddenly this thing is dropped and it’s humiliating saying Germany is going to be downgraded, essentially France, two notches.

TERRY SMITH:
Well, no, I don’t think the timing is particularly bad. If you remember, during the credit crisis, one of the great things levelled against the rating agencies was that they weren’t independent enough. So I think when they start behaving independently it’s a bit remiss to start complaining about them. And I think they’re absolutely right in what they’re saying. One of the great things in this situation is that France appears alongside Germany as one of the, sort of, financially stable, dispensing the way in which this crisis will be handled. If you look at France’s finances they have far more in common with the countries in the periphery than they do with Germany.

EVAN DAVIS:
Well, hang on, the debt level’s no higher than ours; it’s just because of the banks. It’s only because their banks will be infected by what goes on.

TERRY SMITH:
I don’t want to say ‘just because of the banks’, because if the banks need recapitalisation I think the debt level will soar, and there seems little doubt that they will need recapitalisation.

EVAN DAVIS:
OK. Well, give us a reason why Germany should be downgraded then?

TERRY SMITH:
Germany is the one that actually in the end will end up risking its credit for the remainder of the zone, if it goes down the path which is currently being outlined. So Germany doesn’t have the resources to support the whole of this. That’s why.

EVAN DAVIS:
OK. Well, look, let’s focus a bit more on this French/German agreement and ask this question, as to whether that somehow makes Standard & Poor’s a bit out-of-date. Ngaire Woods, I don’t know whether you think, what we saw yesterday – and the markets reacted very optimistically to it – what we saw was a glimpse of a solution.

NGAIRE WOODS:
No… I think there’s a political logic to the French/German agreement, which is that neither Merkel nor Sarkozy want to be seen as writing a blank cheque to all of Europe’s debtors. Of course that’s what the markets would like them to do but that’s not what they want to do. But what they’ve put in chain is a very long process, it’s going to take years for that treaty to be ratified and it’s going to have to be ratified in countries which are deflating fast, where people are losing 35%, 40% of their income and being expected to vote in favour of the euro. So I think it’s going to be a very contested process that will send many more shivers through the markets. And what the markets are looking at – and this is what Standard & Poor’s is saying, and I very much agree with Terry – is that they want to know how it is that Italy and other debtors are going to refinance several hundred billion euros of government debt over the next four or five months, and they can’t understand why the French and Germans are sitting, you know, designing their summerhouse while their house is burning around them.

EVAN DAVIS:
But isn’t the answer to that: that if they design a nice summerhouse the ECB will come in and sort it all out next year? But the ECB aren’t going to do that until they’ve got the cover of a proper structure being designed for dealing with the insolvency issues down the road.

NGAIRE WOODS:
Well, I think the other issue, though, is that for every step that governments like Italy and Greece and Ireland are trying to take to move forward, by cutting government expenditure, they’re risking sliding two steps backwards because they’re not growing. And debt, of course, depends not just on how much you owe and how much you’re spending, but also on how much you’re earning and how much you’re growing. And what the markets are looking at is a situation where, although governments might be making strenuous efforts, the growth prospects are looking more and more pessimistic. So they want to know, you know - the numerator and the denominator – ‘what’s going to happen to the debt and what’s going to happen to growth?’. And I think that’s what the eurozone leaders haven’t delivered on yet.

EVAN DAVIS:
Right. So in a way, we’re saying they haven‘t solved the immediate problem, because that would still rely on the ECB coming in. We haven’t solved necessarily the long-term problem, which is this growth austerity nightmare that there’s only a limit to how much austerity is going to work. Do you agree with that analysis, Terry Smith?

TERRY SMITH:
Yes, I do agree with the analysis. But I would pick up on one thing. We’ve seen, literally, countless summers here, and we’ve seen pronouncements of agreements - and it’s quite true this is a long process and it’s quite true we haven’t seen the details - but even if it all came to pass – and I must say the odds, looking at history, are against it – the idea that the ECB would then be able to buy bonds and that’s a solution, I’m afraid is farcical, because what you’re talking about is the central bank for these countries buying bonds that the countries are issuing. If you’re spending more than your income – and these countries are going to be spending more than their income for the foreseeable future – you need to be able to sell these bonds to some outside third party that’s got money. And for that to happen you’d need to convince them - as we’ve already heard - that your economies are competitive and that they’re able to grow. And I just don’t see how most of the peripheral countries, and France, can grow within the straitjacket of the euro. In fact, the whole point about these proposals, is putting in place things that will probably prevent their growth for quite some time.

My comment in The Times

The Times today ran my comment on the perilous state of Western economies and the difficult but very necessary realities we have to face in order to navigate our way out of this economic storm.

Here is my article in full:

The Times, 11th August 2011

Deeper cuts: the only way out of this storm

No one, not even the NHS, can escape the painful truth that we're living beyond our means

If we in Britain want to develop the right policies to get us out of our current economic mess, we first need to face up to the cold hard reality that for the past 30 years we have simply been living way above our means.

The West has been outcompeted by the rise of manufacturing and service industries in the developing world. Software programmers in India and Chinese factory workers are willing to work for much less than their Western counterparts. The West's population has been greying as the baby-boomers pass into old age and advances in medical care have lengthened our lives, increasing the cost of pensions and medical services.

Rather than face the decline in living standards that these fundamental changes entail, we continued to spend so that our standard of living was maintained. More innovative ways were found for people to borrow more and for banks to lend more. Savings ratios dropped to negligible levels — in the UK from 11.7 per cent of incomes in 1992 to 2.0 per cent by 2008. The size of the public sector swelled to make up for private sector job losses and governments ran deficits as this expansion inflated their costs beyond their tax revenues.

This borrowing binge created a housing bubble here, in the US and elsewhere. The "solution" to the banking crisis that broke in 2007-08 when this bubble burst has been for governments to provide capital and liquidity to banks and to guarantee their liabilities. In so doing, Western government finances already in deficit have become unsustainable.

In the UK, government debt is at about 75 per cent of GDP. But if public sector pension liabilities are included, the UK's debt to GDP ratio would rise to 155 per cent. If the private finance initiative is included and the guarantees given to the banking sector were ever called upon, it would rise to more than 240 per cent.

The situation in the US is worse, with federal debt at 96 per cent of GDP rising to 390 per cent if social security and Medicare liabilities are included. The problem for the US is not political wrangling over the so-called debt ceiling. It is that the US budget deficit has risen continuously since the crisis began and there is no credible plan to check its rise. As in the UK, the spending "reduction" plan relies not upon any actual cuts but upon heroic assumptions about growth that are clearly without foundation in reality.

The eurozone suffers from this same general problem, but it is exacerbated Income taxes will need to be cut: it's the surest way to growth by the single currency. The entry of the peripheral countries into the currency led markets to assume that the credit risk on euro debt issued by them was roughly the same as that of Germany. This bizarre assumption led to the borrowing costs of these countries falling toward those of Germany. Faced with this, these countries went on an orgy of spending, racking up huge government debts. Property prices were inflated, public sector jobs increased, pensions were guaranteed at early retirement ages, and, in some cases, this was coupled with the national pastime of tax evasion.

The consequence has been the bailouts of Ireland, Greece and Portugal, with Italy and Spain now facing a similar prospect.

But politicians continue to deny the painful reality that we have been living beyond our means. So we will probably have more so-called quantitative easing (QE). But "printing money" to fund these growing deficits rather misses the point: if you are spending more than your income, at some point you need to get someone who has money to lend it to you or accept that your currency will be devalued.

Conventional policy responses, such as cutting interest rates to increase demand, are not working. For the past three years, UK rates have been at their lowest level since 1694. Yet despite record low rates, huge government deficits and QE, the economies of the West are still stuttering. Only yesterday the Bank of England cut its growth forecast with Mervyn King saying "the imbalances in the world economy are still not being properly tackled and the burden of debt is still there."

Tuesday's announcement that US interest rates are expected to remain close to zero until 2013 was greeted with relief by the markets. But these long periods of low rates tell you how bad the crisis is. They are not a solution: look at the Japanese experience of the past two decades.

What is needed is an entirely different approach. Public spending needs to be cut more deeply until finances are sound once again. There can be no sacred cows: the NHS and Medicare cannot be exempt. Public sector pension entitlements will have to be cut back — the amounts and the indexation will have to come down and the retirement ages will have to go up. Personal income taxes and payroll taxes will need to be cut. This is the surest way to engender growth and higher employment.

Interest rates need to be raised to boost the incentives to savers and encourage banks to lend. It may depress the housing market, but in the long ran that is a good thing. The national obsession with home ownership in the UK, Ireland and the US has done us no good. Houses are unproductive assets and cannot be exported. It is no coincidence that in the soundest economy in Europe — Germany — more than half the population rents its housing.

All this will cause a great deal of pain. But that is inevitable given the situation we are in. It reminds me of the advice in a manual on seamanship. "Perhaps the worst plight of a vessel is to be caught in a gale on a lee shore. In this connection the following... rules should be observed:

1. Never allow your vessel to be found in such a predicament..."

Terry Smith is chief executive of Tullett Prebon and of Fundsmith.

The Brown Bottom

With the gold price hitting new nominal highs I thought it was a good moment to remind ourselves about the consequences of Gordon Brown’s sale of much of the UK’s gold reserves.

In 1999-2002 he sold 395 metric tons of gold at an average price of $275 an ounce. Today the price stands at $1749 an ounce. No wonder Brown’s sale on the gold price charts is known as The Brown Bottom. He also gave notice to the market that the sales would take place, thereby giving market participants every opportunity to drive the price down in advance.

Here are my calculations of the value which would have accrued if we still held the gold today:

	Sold then	Value now
	99 - 02	2011
Quantity sold tons	395	395
Average price $/oz	$275	$1,700
Sum realised US$m	$3,477	$21,492
Exchange rate avge.	$1.52	$1.63
Sum realised £m	£2,287	£13,185

The 2012 Olympics are estimated to cost some £9billion, so we could have paid for the Olympics with the amount of value he surrendered and had over £2billion in change left.

As of December 2010, estimated gold reserves were as follows:

US	8,133 tons
Germany	3,401 tons
Italy	2,452 tons
France	2,435 tons
UK	315 tons

The impact of the man’s stupidity is breathtaking.

 

Accelerated Stock Repurchases

This week there was a new development in the share buyback mass shareholder value destruction exercise which has gripped American companies and has some following in the UK.

To date this year Citigroup reckons that  in the US market there have been 26 Accelerated Share Repurchases or ASRs totalling $8.5bn.

What happens in an ASR is that the company does the whole or a significant proportion of a share buy-back programme in a single transaction with an investment bank or a small group of banks rather than executing the programme over an extended period in line with volumes traded in the market. The investment bank(s) makes a short sale to the company and borrows the stock it delivers to the company.

Of course, at some point the investment bank will need to purchase stock to cover it’s short position and enable it to return the borrowed stock to the stock lender(s). Investment banks are not noted for doing something for nothing and certainly not taking on short positions just to assists companies. After all, share buy-backs can generate share price rises at least in the short-term and indeed part of the raison d’etre for Accelerated Share Repurchases is to trigger a bigger short-term boost to share prices. No sane organisation would go short of shares faced with that likelihood. So the company is required to give the investment bank an agreement to cover any losses it incurs in purchasing the shares to cover the short.

In an 118.8m share ASR which IBM did in May 2007 it paid an initial price of $105.18 per share for the shares purchased from the investments banks’ short sales totalling $12.5bn, and then another $2.95 per share or a total of $351m to cover the higher price of $108.13 at which the banks eventually closed their shorts.

One of the rules that I have found in business life is that when management is doing something they really don’t want examined they use polite euphemisms to camouflage the reality of the situation. Thus, the payments by IBM to the banks are termed ‘adjustments’ in its accounts not “extra costs” or even “losses”.

This is a truly amazing thing for a company to do. I have previously contended (“Share Buybacks: Friend or Foe?” Fundsmith, April 2011) that many companies seem to pay little or no apparent heed to the implied returns from share repurchases or even the price at which they buy-back shares. With an ASR they literally have no idea at what price they are repurchasing them. They have in effect agreed to write a blank cheque to the investment bank to cover the cost of eventually purchasing the shares.  How can this be acceptable? Surely all but the most stupid management must accept the contention that the price at which shares are repurchased has some bearing on whether the repurchase creates or destroys value for remaining shareholders. What this implies about managements lack of understanding and/or care about shareholder value seems to me to amount to malfeasance.

Add to that the fact an ASR gives investment banks even more ways to take money from the unfortunate shareholders of these companies. No doubt there is commission and a bid-offer spread on the short sale, then interest on the stock borrow and prime brokerage fees for arranging it, then further commission and bid-offer spreads on the ultimate purchases. Who knows, maybe some of these companies are actually daft enough to pay an advisory fee for the investments banks’ advice on ASRs. It’s a field day for the investment bankers who, let’s remind ourselves, are engaging in a risk free trade. Let’s also not forget that they earn precisely zero from that other totally acceptable means of distributing cash: dividends.