Benjamin Graham said that in the short term the market is a voting machine, but in the longer term it is a weighing machine. It seems to me that the markets are in a voting mood at the moment. The liquidity provided by central banks has driven up asset prices over the past couple of months, so that equity markets are at six months highs.

If you have read Gordon Pepper’s book, The Liquidity Theory of Asset Prices, this shouldn’t be a huge surprise. When the ECB joined the Fed and BoE at the liquidity party through its LTRO, it was the signal investors had been waiting for. The threat of a Dexia style funding crisis was largely removed, so the excess liquidity sloshing around in the system could seek out risk assets with a degree of confidence.

The ECB has taken off the Trichet hair shirt and Draghi has donned his party shirt. While solvency concerns remain and structural problems in the eurozone persist, in the short term, who cares? The crisis can has been given another boot down the road.

With European economies either in recession or close to recession, there is little or no demand for credit from the real economy, so the liquidity creation of central banks flows into asset markets. The initial beneficiary was fixed interest markets, but with near term tail risk removed, equity markets have taken up the baton.

Investors are voting with their money, regardless of the cyclical negatives. Fund managers cannot be left behind. Those with high cash positions are risking their careers, so capitulation is the name of the game. Without a shock event, this process has further to run, although the “easy” money has already been made.

Equity markets look cheap relative to bonds (except bonds might be expensive). However, that is predicated on top of the cycle earnings making PEs look cheaper than the underlying reality. We’ve already seen some flickers of disappointment and distress in the corporate world.  These are just the first pebbles but the avalanche of downgrades may not come for a while. The process of corporate profit margins peaking typically takes longer than the bears anticipate, lulling the bulls into a false sense of security.

The weighing machine will not be operational until the cycle turns. The excess liquidity will have to be destroyed somehow. This will either be through inflation, where the value of each monetary unit depreciates relative to physical assets. Alternatively, a portion of the money created gets incinerated by defaults and bad debts, which tends to be deflationary.

The eurozone appears to be set up for a deflationary outcome. The collapsing domestic demand outside the core is profoundly deflationary and the ECB’s liquidity operations are unlikely to turn the tide. In the US and UK, an inflationary denouement is possible, but the weakening eurozone economy and early signs of stuttering growth in China may see a period of disinflation or even mild deflation first.

If the Fed and BoE decide deflation is the dominant force they will push monetary policy to the limits to fend it off. Ultimately they could set off an inflationary surge, wrong footing investors. Markets extract the maximum pain from the maximum number of people. What would cause the maximum pain would be deflation, where investors sell real assets and load up on bonds, followed by an episode of inflation, destroying the real value of said bonds.

Ultimately the value of assets will need to be weighed. The cash flows attaching to both bonds and equities will have to be measured by a proper yard stick. There is no doubt that discount rates are too low and that low discount rates have boosted asset prices.

Sovereign bond yields in “safe” countries (i.e. US, Germany, UK), where there is little default risk, have been pushed to levels unthinkable just a few years ago. Risk free rates are exceptionally low. These will rise at some stage either because growth returns or inflations rears its ugly head. When this happens, asset markets will get caned.

However, I feel this is still some way off. I can’t see the deleveraging phase of the global economy lasting much less than another five years, so it may not be until near the end of this decade that the scales are recalibrated.

In the mean time, some wealth will be destroyed through recession, deflation and default. We could even see falling equity markets again when recession cuts into corporate profit margins. Fiscal consolidation and government spending cuts are also negative for corporate profit margins.

Central banks are scared witless that a further collapse in asset prices will set in motion another debt liquidation spiral. They are right to fear this, but the aggregate level of corporate profits and tax revenues are inadequate to support the current level of all asset prices (equities, corporate and government bonds) at a sensible discount rate. Something will have to give. Either defaults will reduce the principal and interest costs or inflation will have to erode the real value of the principal and interest payable.

One way or another the scales will show that the current level of asset prices is too high in real terms. They have to fall either in nominal terms or the real value has to be eroded by inflation. As for the day of judgement, who knows, but sooner or later it will come.

While I do think that executive pay if far too high, I’m not sure I would put Hester in that class. Let’s not forget that RBS was a basket case when he took over with a balance sheet 1.7 times the size of the UK economy. At least he has now trimmed that so it is the same size as the UK economy!

The share price of RBS is well below the government’s cost price, but bank share prices in general are well down. To make this the basis for a rewards for failure argument is at best disingenuous and at worst downright deceitful. It seems to me that Hester is doing a good job of rescuing RBS. This requires a lot of skill and fortitude. Not any Tom, Dick or Harry can do it.

Not only does the Labour faux indignation disgust me, but the lack of support from the current government is particularly spineless. They have avoided any responsibility by claiming (rightly) that Hester’s remuneration is a matter for the board, him and the terms of his contract. However, they have expressed a wish that he doesn’t take his bonus. Power without responsibility.

Quite frankly, why would anyone take a job like this again? The politicians who appoint you, don’t have the decency to stand up and defend you, even though they set your contract and beg you to take the job. Not only that, any succeeding administration doesn’t have the guts to abide by a legal contract. No wonder we’re in a mess.

When Harold Macmillan was when asked what was most likely to blow governments off course, he replied “events, dear boy, events”. Both politics and economics, by their very nature are unpredictable. Unlike the physical sciences, cause and effect can be both mean reverting and reflexive. The cross over point is not always obvious and events are unpredictable.

I’ve not written anything over the past two weeks, not because nothing has happened, but because there has been little insight to pass on. At the end of last year, it looked like we were seeing the demise of the eurozone, but the ECB’s LTRO seems to have postponed the denouement.

While the LTRO does not solve the solvency crisis of banks and sovereigns, it has bought some time. How much is still open to question. A Greek default in March could open the floodgates. Equally, there has been ample time to arranged contingencies.

Containing any spill over into Portugal will be a severe test to eurozone policy makers, but they can’t say they haven’t been warned. The LTRO should contain the short-term liquidity strains in the eurozone bank sector. With so much liquidity being placed at the ECB, despite a negative spread, most banks will have secured themselves against all but a severe run. For those brave enough, the carry trade on sovereign bonds provides an opportunity to rebuild some capital.

We seem to have returned to a “wait and see” period in markets. Asset prices have yet again been buoyed by monetary pump priming by central banks, but the real economy can’t use (or doesn’t want to) use the credit provided, so it goes into asset markets. While there is the latent threat of inflation, it does appear that the global economy, especially the West, is in a true liquidity trap.

At these times, it is best to return to what we do know rather than speculate about events, that by their very nature, are unpredictable in timing and magnitude. What we do know is that there are two fixed points in the global economy that are causing severe distortions.

The first is the renminbi peg. This has caused the problems for both the Chinese and US economies. Put simply, it has caused over consumption, low savings, and investment in the US and the opposite in China. The trade and capital imbalances are an out-working of this. Arguably, it has also caused higher unemployment in the US.

There are some positive signs that other economic mechanisms, mainly high inflation in China, are bringing about a rebalancing. The real effective exchange rate of the renminbi is appreciating through the substantially higher rate of inflation in China. This seems to be having the effect of rebalancing trade. The trade surplus, although volatile, is declining.

China would be more sensible to allow the exchange rate to appreciate to offset these inflationary pressures rather than allow high inflation. By maintaining its crawling peg, monetary conditions are red hot and are producing severe distortions within the economy. My guess is that the Chinese are afraid to allow too much appreciation because the corporate sector operates on thin profit margins. A bust in the corporate sector allied to the over extended position of the banks to the real estate sector would wreak havoc in the banks.

However, it is impossible to know when the chickens will come home to roost in China. The problems of an overheated real estate market, hidden debts in the municipalities, over investment, financial repression, low share of GDP taken by wages and corruption are well known and rehearsed. National statistics are so unreliable that a bust could be occurring long before it’s recognised by outsiders. Nevertheless, the rebalancing that appears to be happening between the US and China makes me a bit more relaxed, although still wary.

The other fixed point is the eurozone. The competitive divergence and the accompanying trade and capital imbalances are now a frequent topic for debate in the quality press. Anyone and everyone by now should know the underlying cause of the crisis. What is lacking is recognition by the political elite. Germany is trotting out the same austerity prescription, seemingly not understanding that the only way the the south can repay its debts to the north is for the trade surplus of the north to become a trade deficit.

In a fixed currency regime, this can only be achieved by the north (i.e. Germany) indulging in a massive domestic demand stimulus, a credit boom and tolerating significantly higher rate of inflation than the overall eurozone. It will also have to come to terms with a trade deficit. The matching offsetting capital flows can then be used to pay down the debts owed by the south.

For every trade surplus, there must be a trade deficit. For every creditor, there must be a debtor. This is not economic theory, it is economic fact. German politicians either don’t understand or don’t want to understand. Until the disease is correctly diagnosed, there can be no cure. Sadly, that is where we are in the euro crisis.

How will it play out? No-one knows for sure. It could easily drag on for another two years, but I suspect the crunch will come sooner. Should a Greek default cause a unstoppable cascade to Portugal spreading to Ireland, Spain and Italy, then the game will be over. However, this seems too obvious.

The French elections could be another catalyst. Hollande will be very different to Sarkozy. Germany will be less likely to tolerate a Hollande view of Europe. The fiscal pact has already run into some legal sand traps. It will be dead if the Socialists win in France. The next German federal elections in 2013 will start to enter the political calculus as this year develops.

In my view, Italy is the elephant in the room. It has a completely technocratic government with no democratic mandate. As the unpopularity of the previous regime fades over time and the austerity measures bite, Italians are likely to question the legitimacy of the government. Civil unrest is a distinct possibility. Berlusconi is biding his time and waiting for a chance of revenge. Because Italy runs a primary budget surplus, it could exit it the euro and function in a way that Greece cannot.

I do wonder whether, when push comes to shove, Germany will really go for full fiscal union. Regaining the Deutschemark will look an increasingly attractive option. The banking system will need to be recapitalised, but it will anyway whatever happens. Better to do that with a strong currency. German exports will suffer, but perhaps not as badly as anticipated as German industry tends to be high value added and somewhat price insensitive. German consumers would get a huge boost in relative purchasing power, which would be politically popular. Personally, I believe a German exit is the least disruptive option.

If the eurozone breaks up, many pundits have forecast the end of the world. I take the opposite view. Dislocation will be severe but the changes in currency and competitive parities would unleash a strong rebalancing mechanism which could be the foundation for a decade of growth. At the moment the eurozone is a depression and deflation monster. Get rid of it and we could be surprised at the strength of a recovery in Europe.

]]> http://lemmingscanteachnothing.wordpress.com/2012/01/29/events-dear-boy/feed/ 0 blogpackinglight http://lemmingscanteachnothing.wordpress.com/2012/01/12/the-tragicomedy-continues-part-2/ http://lemmingscanteachnothing.wordpress.com/2012/01/12/the-tragicomedy-continues-part-2/#comments Thu, 12 Jan 2012 08:46:22 +0000 Robin http://lemmingscanteachnothing.wordpress.com/?p=1307 Continue reading →]]> So the proposed EU treaty to impose greater fiscal discipline will allow countries to temporarily deviate from the rules “in case of an unusual event” or in “periods of severe economic downturn.” It will also restrict the powers of the European Court of Justice. This is becoming more and more of a farce. Will Sarkozy’s trousers fall down at the next press conference or Merkel do a Judy Finnigan? After all the fuss, it seems that Cameron has largely got his way and the single market is untouched. I suppose we are getting to a stage where the EU leaders no longer have any credibility to lose.

While the odd couple agree on the Financial Transactions Tax, before Merkel reveals that she may not be able to persuade the Bundestag to pass the legislation, markets are screaming “crisis”. Investors are paying Germany to look after their money with a negative yield on the latest bill auction, ditrusting the banks to keep it safe. Unicredit is on the verge on imploding. The Greek banks are bleeding deposits. The latest German GDP figures look great year-on-year but dire quarter-on-quarter. Quite frankly I wouldn’t trust this lot to run a sweet shop.

So after a brief respite over Christmas and New Year, we get the resumption of the eurozone tragicomedy. How many Merkel/Sarkozy summits have we had over the past eighteen months? I’ve lost count. Carla must be worried that there’s something else going on.

Sarkozy and Merkel bring to mind that great put down by Abba Eban. They never miss an opportunity to miss an opportunity. You have to laugh that this has been labelled a “summit for growth” when the first initiative that emerges is a Financial Transaction Tax.

It was interesting to read yesterday of the Ernst & Young study that suggested that instead of raising €37bn of revenue, imposing the tax would result in a fall in tax revenue of €116bn when the secondary effects of lower GDP growth and decline in financial transactions are taken into account. The EU’s own figures suggest that GDP would be lowered by around 1.75 percentage points.

Is Sarkozy on drugs? How can a summit aimed at boosting growth come up with a measure that actually reduces growth? The problem with the political classes in Europe is they are not only economically illiterate but are positively delusional. It might be funny if it were not so serious.

There will be no solution to the eurozone problems until the elite recognise the underlying causes. As I and others have rehearsed, the root cause of the eurozone crisis is the trade and capital flow imbalances that have resulted from the shifts of competitiveness within the single currency zone.

These imbalances became self reinforcing for an extended period of time, causing a credit boom and higher inflation in the periphery together with rising trade deficits. To finance these deficits, capital flowed to the periphery, mainly from Germany, with the concomitant accumulation of debt.

For most countries the accumulation of debt was in the private sector (Greece being the notable exception). However, the credit crisis saw much of this migrate to the public sector, either explicitly (like Ireland) or implicitly through the accumulation of sovereign debt by the banking system.

Excessive fiscal deficits are the symptoms of the disease rather than the disease itself. The proposed tightening of fiscal rules is bound to fail as it doesn’t get to the root cause. Indeed it is likely to make things worse as it will reduce growth and increase credit defaults.

The policies that need to be pursued to rescue the eurozone never seem to make it on to the agenda. The correct policy prescription for recovery and growth is very simple. Germany needs to expand domestic demand aggressively, accept higher inflation and run a trade deficit with the rest of the eurozone.

This is the only way that the periphery can hope to repay its debts to Germany. By definition, the periphery has to run a trade surplus with Germany. The offsetting capital flow back to Germany would allow the repayment of accumulated liabilities to the German banking system.

The only way that the periphery can run a trade surplus with Germany is for German domestic demand to expand more rapidly than overall demand in the eurozone. This will entail two features that are likely to be unacceptable to German politicians and public. Namely, inflation will have to be higher than the eurozone average and domestic borrowing will have to expand.

This always supposes that the periphery has the goods and services that Germany will want to buy. Other than tourism, it is quite difficult to see what large economic sector might achieve this turnaround rapidly.

The only alternative way to achieve a resolution is to have a massive semi permanent fiscal transfer from Germany to the weaker countries. Mr Cameron has been roundly attacked for daring to speak this unpalatable truth.

Quite frankly, none of this is particularly new, but until these painful truths are addressed, there can be no solution. If the politicians can’t come up with the goods, then the market will force the solution.

The danger signs are coming thick and fast. The collapse in the Unicredit share price might presage a total collapse. Once banks lose credibility in the market, the end can come surprisingly quickly. Unicredit must be close to implosion, especially with its exposure to CEE and the potential domino effect of Hungary. Dodgy legacy loans from German real estate are also a concern.

The failure of the ECB’s LTRO is also a worrying feature. Nearly all of the liquidity appears to have been placed back with the ECB on overnight deposit. At least this provides some liquidity buffer but the increasingly scarcity of good quality collateral makes you wonder how long this game can go on.

Source: Zero Hedge

There was a really scary chart in the FT last week from Soc. Gen., showing the collapse of the money multiplier. Monetary policy has become largely ineffectual and the banking system is seizing up.

The only way to reverse this is to reduce the risk premiums in the sovereign bond market. The ECB will have to go “all in” and backstop sovereign bonds. The only reason yields are low in the US and UK is that investors know that they will get their money back. The ECB will have to do the same, however unpalatable that is to the Germans.

At the moment, it is difficult to see the politicians arriving at a solution. Their analysis and narrative of the crisis is not just wrong, it is delusional. Even if they adopt the correct analysis, the solutions may prove to be politically and culturally unacceptable to Germany.

Germany will have to weigh the cost of supporting the euro against the cost of its disintegration. The disintegration of the euro would bankrupt its banking system. Assuming a rise in the “new DM”, its export industry would also suffer a sharp contraction.

History teaches that in a credit bust, in the short-term, it is the debtors who suffer, but in the longer-term, it is usually the creditors who suffer most. In the 1930s, it was most notably the US and to a lesser extent France. To avoid the possibility of a Great Depression in Europe, Germany will need a complete change of mindset and embrace the profligacy of inflation and debt. Anything less will spell disaster for Europe and Germany itself.

]]> http://lemmingscanteachnothing.wordpress.com/2012/01/10/the-tragicomedy-continues/feed/ 0 blogpackinglight ECB Deposit Facility Usage.jpg money multiplier http://lemmingscanteachnothing.wordpress.com/2012/01/04/the-real-cause-of-the-crisis/ http://lemmingscanteachnothing.wordpress.com/2012/01/04/the-real-cause-of-the-crisis/#comments Wed, 04 Jan 2012 08:42:13 +0000 Robin http://lemmingscanteachnothing.wordpress.com/?p=1292 Continue reading →]]>

Many column inches have been written about the causes of the Global Financial Crisis that we are still suffering from. Precious few have been devoted to the psychology of the crisis. As many friends and former colleagues will know, I’ve become increasingly convinced that the root cause of the crisis has been the increasing influence on the financial system by psychopaths in senior positions in many companies. Perhaps psychopaths is too emotive a word as it has connotations of brutal murderers. Perhaps sociopaths is a better description. These are egocentric people who appear to have no conscience or social empathy.

My epiphany came from watching a programme on psychopaths on the BBC last year. While it dealt mainly with criminal psychopaths, especially murderers, it also touched on the financial sector. It contained a staggering throw away line that there are four times as many psychopaths in senior business positions as the rest of society (4% vs. 1%). The survey appeared to have been conducted in the financial sector but wasn’t specific.

During my 30 years of working in the financial sector, I have had the misfortune to cross paths with a number of sociopaths (let’s be polite). Twice in my career, this caused me to change jobs. Over the years, and especially from the mid 1990s onwards, it became increasingly clear to me that the general level of ethics and morality was declining in the financial world. Whether this was just a reflection of the decline in moral standards in society in general is difficult to know. However, it also became more apparent that an increasing number of senior people in management positions were showing characteristics of egocentricity, excessive greed and callousness.

This became increasingly obvious when I was working at Flemings and was a major reason for leaving. Working for a smaller firm, for a while, I sidestepped these malign influences. However, changes in ownership and management saw the same influences emerging.

The sociopathic tendencies of senior management are rife in financial institutions. Who can doubt that Fred Goodwin, Angelo Mozillo or Dick Fuld have sociopathic characters? Even now, the behaviour or people like Jamie Dimon or Bob Diamond make you sit up and wonder whether they are on the same planet as the rest of us.

The big question is whether we can ever hope to get out of this financial mess without getting rid of the sociopaths at the top. Unfortunately this means not just in the financial world, but the political world as well. Many of the egotistical and amoral traits that we see in the financial sector are mirrored in the political world. Perhaps we need psychometric testing on senior managers and politicians to stop our financial and political systems being corrupted. Have the SEC or FSA considered this? I doubt it. It’s too controversial, but hiding from the facts won’t bring the cure.

It’s time for a radical re-think of the way manage our financial system and possibly our political one as well. At least in politics we can vote them out. In business there is a significant lack of accountability, most obvious in the scandal of excessive executive pay. Human beings and their actions were the real cause of the crisis. The recklessness and risk seeking of a few has wrought pain and misery for many. I put it to you that until we root out these malefactors, we won’t cure the malady that afflicts our financial system and the wider body politic.

The catalyst for this article was a post on Zero Hedge from a contributor who has been thinking along similar lines. It’s well worth a read.

If  you are interested in psychopaths in business, then I recommend reading “Snakes in Suits” by Paul Babiak

Today, I want to look at the so-called Robin Hood Tax or Financial Transactions Tax (FTT). In economic circles, this is also known as the Tobin Tax, after the economist who first proposed it. Initially it was proposed as a transaction tax on foreign currency deals to dampen volatility and deter speculation. Later this idea was extended to other financial transactions.

The fact that it has been dubbed the Robin Hood Tax gives it a spurious legitimacy as it implies that it applies to the rich and benefits the poor. At best this is disingenuous and at worst deception. It is also worth bearing in mind the standard “economic” tests for a good tax. It must be fair, easy to collect, difficult to avoid or evade, transparent (i.e. obvious to the payer) and not produce perverse effects. The FTT fails in almost every respect.

1. Easy to collect but easy to avoid. Adding a percentage to a financial transaction is not technically difficult but unless every tax jurisdiction in the world adopts a uniform FTT, transactions will migrate to lowest tax or tax free jurisdictions. This is because financial transaction are electronic and can be executed almost anywhere. It is extremely difficult to force transactions to be made in a location. In a sense this makes it difficult to collect as well. The only exception is property transactions, for obvious reasons, which is why property taxes tend to be high in most countries.
2. Makes financial regulation more difficult and increases the risks in the financial system. If transactions are driven away from the “home” jurisdiction, then efficient regulation becomes much more difficult. One of the lessons of the financial crisis is that regulation was deficient and uncoordinated. A FTT would probably make it worse and risks would accumulate hidden away from regulators.
3. The customer always pays. Proponents always seem to claim that somehow it is the banks that will pay. The sad reality is that it always the customer who pays. The banks will always pass on the costs either explicitly or implicitly. Almost always, this will be hidden from the customer who will be charged a gross price for a product without the underlying costs broken down.
4. The goals of deterring speculation and raising revenue are irreconcilable. The more successful a tax is in deterring transactions, the lower the revenue generated.
5. A FTT never raises anywhere near the revenues projected. Allied to the previous point, experience suggests that a FTT often raises a small fraction of the hypothetical revenue. The best example is Sweden in 1984, which imposed a FTT and saw bond market volumes decline by 85% within one week. The tax raised 3% of the projected revenues and eventually was abolished.
6. Doesn’t deter speculation anyway. For example, stamp duty on property has never prevented property bubbles. There are much better ways of deterring speculation, for example through margin requirements.
7. Raises transaction costs and reduces liquidity. A FTT is often pitched at a very small percentage of the face value of a transaction but this is deceptive. It widens the gap between buying and selling an instrument (technically the bid/offer spread). In many cases this spread is tiny so even a small percentage tax has a huge impact on trading costs and negatively impacts liquidity (because it is more expensive to trade). For example on a Eurodollar futures contract of $1m, a 0.02% FTT increases the cost of trading from $13 to over $400. This might not seem much, but it would dramatically decrease trading and liquidity. Before you say that this might be a “good” thing, futures were not a cause of the financial crisis and are a vital ingredient of the commercial world helping producers and manufacturers hedge all kinds of currency and commodity exposures.
8. Reducing liquidity raises volatility. Anyone involved in markets knows this. A FTT, which is designed to dampen volatility, is likely to have the reverse effect by lowering liquidity.
9. Reduce asset prices by raising the cost of capital. It has the same effect as raising interest rates. Asset prices fall. Who cares? It’s only the rich that suffer. Well, no, actually anyone who has any saving does. If you have a funded pension or a life policy or indeed any savings that are linked to asset prices you will be worse off. Unfortunately the real impact is usually worse on those with modest savings than those with large savings. The wealthy have a sizeable cushion of excess savings in contrast to poorer citizens to whom every penny is important. Raising the cost of capital also deters investment and growth in the economy.
10. Reduces growth and raises unemployment. Allied to the above, slower growth usually raises unemployment. On figures produced by the European Commission, the proposed FTT would reduce long-term growth by 1.75% and increase unemployment by just under 500,000 in the EU.
11. Favours public sector pensions over private sector pensions. Because private sector pensions are funded and dependent on asset values, any decline due to a FTT would have a detrimental impact on pension values. Public pensions generally are unfunded and so unaffected by asset values, hence public sector workers would be protected at the expense of private sector ones.

That’s quite a long list and I could include some more technical reasons, but you get the idea. It is not surprising that FTT taxes are rare and often repealed. They are ineffective and have perverse effects. It is a reflection of the economic illiteracy of Merkel, Sarkozy and Barroso that they have persisted with this idea long after countries like the US have rejected it. It certainly won’t work unless it is adopted globally and even then has significant drawbacks.

From a purely UK perspective, it is estimated that an EU FTT would raise approximately 80% of its revenues from London. It would wipe out the derivatives market in the UK and cost £25.5bn. Ask yourself whether Merkel or Sarkozy would agree to an additional tax on Mercedes or Citroen cars. Further you might question Sarkozy’s motives when not long ago he was trying to woo HSBC to relocate its HQ to Paris with tax incentives.

Lastly, even interest groups as wide apart on the spectrum as the IMF and the Socialist Worker have admitted that a FTT is unworkable.

]]> http://lemmingscanteachnothing.wordpress.com/2011/12/12/skewering-the-robin-hood-tax/feed/ 1 blogpackinglight http://lemmingscanteachnothing.wordpress.com/2011/11/29/how-bad-will-it-be/ http://lemmingscanteachnothing.wordpress.com/2011/11/29/how-bad-will-it-be/#comments Tue, 29 Nov 2011 08:54:51 +0000 Robin http://lemmingscanteachnothing.wordpress.com/?p=1272 Continue reading →]]> Gradually everyone is inching towards the probability that the eurozone will break up. How bad will this be? We’ve had various studies having a stab at the economic cost. Naturally some forecast draconian falls and the end of civilisation in Western Europe, even war. I liked Gideon Rachman’s article today, suggesting that there’s a good chance that it won’t be as bad as the alarmists are saying. Of course the political elite in Europe have a vested interest in painting a dire picture. Scare tactics are the oldest ploy in the political playbook.

I think we can rule out war. What’s the point and who gains from it? There’s no powerful casus belli. Sure we could see the rise of nationalism and political extremism, but I can’t see a war.

Redenomination of euros into national currencies poses huge logistical and economic problems, but, in the end, are they insurmountable? My answer is no, they are not. The biggest headache is how to deal with the banking systems. I guess some kind of recapitalisation and bad bank strategy, perhaps with new banks being built out of the old is the way it will have to go.

No doubt the short-term will be awful, with all sorts of unexpected problems and an arbitrary redistribution of wealth. However, the longer-term could be a lot brighter:

1. Debt forgiveness in one form or another has to happen before the European economy can grow vigorously again. This will happen in a euro breakup.
2. Trade and capital flow imbalances can be addressed with flexible currencies. This is at the root of the eurozone problems, so the removal of this problem would be unequivocably a good thing.
3. Competitiveness will be restored to the periphery. This is not just in a eurozone context, but a global context. A fall in the currencies of the periphery would unleash an export boom and help these countries trade their way out of their problems.
4. The breakup of the euro could meaningfully erode the power of the European Commission, which is holding back European growth with its over-regulation.
5. While there would be a sharp fall in GDP, growth thereafter could be quite strong. This was the experience after the gold standard was abandoned in the 1930s. The table below shows how countries in the 1930s showed a strong recovery after they abandoned gold. As I have argued before, the closest parallel with the 1930s is the rigidities of the gold standard and the eurozone.

The best thing for Europe would be the end of the eurozone, preferably a managed breakup over the Christmas period. In the short-term there would be a severe drop in GDP, just through the dislocation of the banking system and broader economy. However, I believe that the European economy would prove more resilient that the doomsayers predict and that, with the restraints removed, growth over the remainder of the decade will be a lot stronger, albeit from a lower base.

Today we saw two very bad pieces of news. First was the new order data for industry in Europe, which was dire. Secondly, we had the failure of a bond auction in Germany. Perversely, these both might be good news. The new order data means that a recession is almost certain in Europe. This means that the ECB will have the excuse to cut interest rates and loosen the monetary spigots. In Germany, industrialists are going to start to put pressure on the politicians to switch from austerity to stimulus and to shift from fear of moral hazard to monetary flexibility.

The failure of the German bond auction is a pivotal event, in my view, as it shows the crisis is beginning to impact the core. We’ve already seen spreads widen in the “satellite” core (Austria, Belgium, Finland, Netherlands), but for Germany to have problems selling its debt is a real shaker. This is not to say that the politicians will come up with a solution, but the market is forcing the pace and Merkel is getting nailed for her lack of decisive action.

Inevitably, it is impossible to say where this leads, but the game is coming to boiling point and something will have to give. Will Merkel and Draghi blink? If they don’t, the markets will push them over the edge, especially with shut down of private sector funding for the eurozone banking sector. The pressure is now so extreme that both Merkel and Draghi will be forced to capitulate. If they do, then the short-term relief rally could be powerful. I can’t see the underlying problems being addressed, but traders might get an early Christmas present. Who would want to be a fund manager in this environment?

I’ve been quiet on this blog, in contrast to markets and economies. To be honest, I’ve been watching the unfolding drama with horror. Even in my worst nightmares, I didn’t think the politicos could make quite such a hash. It’s all been so obvious. Back in February 2009, I wrote a note called “Depression Lite”, where I looked at the parallels between the Great Depression and the credit crunch. In it, I suggested that the closest parallel was between the eurozone and the straightjacket of the gold standard. To quote:

“If currencies cannot float, then the adjustment process will need to be by other mechanisms. By widening government bond spreads within the Eurozone against German government bonds, markets are beginning to raise interest rates against several countries, increasing their cost of funding. However, there are really only three ways that these imbalances can be rectified ultimately.

Germany could indulge in a massive domestic demand stimulus that would help the deficit countries to export their way out of their problems. Under the gold standard, this is exactly what Germany would have been forced to do, by expanding its money supply and increasing economic growth, sucking in more imports. It is extremely unlikely that Germany would follow this policy option.

There are two other policy options. The deficit countries could have a very severe recession in the hope that the elasticity of imports is greater than the elasticity of exports. Alternatively, wages could be cut to restore competitiveness. Cutting wages would be an extremely difficult policy move for governments to execute. Therefore, it is likely that the deficit countries will face an extended period of contraction or low growth and restructuring to restore competitiveness. It is also likely that this will be accompanied by a high level of unemployment as shedding labour will be the principal avenue open to corporates to reduce cost bases.“

It’s just been so obvious. No amount of austerity is going to work, in fact it is self-defeating. I’m just in despair over the whole thing. I’m glad I’ve retired.

What is really worrying me at a deeper level is the breakdown of trust in markets and in political systems:

1. The interbank market in Europe has virtually ceased to exist. Banks are funding themselves from the ECB’s nipple. US, Asian and UK banks are slashing their exposures. Will this mistrust spread beyond the eurozone? CDS spreads are widening for US and UK banks. Deposits runs are happening in Greece and Italy and likely to spread. Why should depositors trust either the banks or the ECB, if the ECB refuses to be lender of last resort? At least in the US and UK, you know you’ll get your money back because the Fed or BoE will print it.
2. MF Global looks like a huge case of fraud and a breakdown of regulatory oversight. If $1.2bn really has gone missing, then Mr. Corzine could be wearing orange overalls soon. Just as worrying is how the NY Fed only recently allowed MF to be a primary broker. Also what were the various regulatory bodies doing, especially the SEC and the CFTC? Can anyone trust a broker any more? It will be interesting to see whether end customers start to avoid the futures markets.
3. The unintended consequence of the eurozone finessing the Greek default so that it is not a credit event is that many are now questioning whether CDS contracts are worth the paper they are written on. If hedges turn out not to be hedges, then a huge layer of leverage will have to be unwound. In the long run, strangling the CDS market might be a good thing, but there’s a time and a place and now is not the time or the place.
4. The imposition of technocratic governments is a hugely risky ploy. Sure, in the short-term, the dysfunctional governments of Greece and Italy may improve but their democratic legitimacy is called into question. Will the populaces really stand for seemingly endless austerity being imposed on them? The fundamental contract between people and government has been ruptured. The people will revolt. Now they can blame foreign interference rather than taking responsibility for themselves.

We are in for a horrible crisis over the next 12 months or so. Christmas could be a time when there is an extended bank holiday in the eurozone as panicked depositors try to get their cash out. I think it’s that serious. Don’t forget in the US in 1933, the banks were closed for a week to sort out the mess.

We are in for the mother of all resets. A lot of debt will default. A lot of banks will go bust. Unfortunately, most of our policymakers have their heads in the sand.

The good news is that if the euro blows apart (and hopefully the renminbi peg gets blown up in the backwash), it will, eventually, set the scene for a spectacular rebound in growth. When you look at major crises that entail severe falls in output and bankruptcies (Asia and Argentina, to name just two), a couple of years after the dust has settled, economies enjoy a very strong recovery. If the current whole rotten edifice gets blown away in the next year or so along with the attendant rigidities, then there must be some hope that by 2013 or 2014, we might see a decent recovery. The depths will have to be plumbed first. Let’s hope the social and political fallout doesn’t short circuit the process.

I’ve refrained from further comment on the eurozone recently as the quality papers have done a good job. We are near the end of the road. Either the ECB becomes a true lender of last resort or there are some serious fiscal transfers or it’s game over. The next few weeks will tell. Whatever happens, the dithering has locked in a recession for Europe. Well done the politicos. Another fine mess you’ve got us into.

Fixed exchange rate regimes are probably the most pernicious and damaging economic constructs of the past hundred-odd years. Initially they always seem attractive. They provide stability and certainty. Often they restore confidence, shattered by a previous crisis. However, every single time they end in another crisis or catastrophe. They are like a cancer. At first they seem benign, but as they mature, they infect the whole economic body and ultimately cause a catastrophic collapse.

While the gold standard prior to World War I is seen by some as some kind of halcyon era of prosperity and stability, for many countries it was not. For instance, the US struggled to maintain confidence in its committment to gold, especially in the absence of a central bank. It suffered numerous runs on both its gold reserves and its banks. Real economic activity and employment suffered huge swings and there were a number of very deep recessions and one depression. It was not just the US, many countries suffered similar experiences. The pre-war gold standard was hardly an advert for a fixed exchange rate.

If the gold standard prior to the First World War, was a flawed system, then the return to gold after the war was possibly even worse. There’s no need here to go into the whys and wherefores of the Great Depression, but it is hardly controversial to pin a significant amount of the blame on to rigidities that the gold standard introduced to the economic system. A major cause of the depression was “cheating” by the Bank of France which refused to stimulate the money supply in line with an influx of gold. This caused a shortage of gold at the end of the 1920s and beginning of the 1930s which led to severe downward pressure on the money supplies of the UK, Germany and to some extent the US. In 1931, this led to the UK abandoning the gold standard. The start of the economic recovery of every nation in the 1930s can be traced to the time that it abandoned the gold standard and the fixed exchange rate system.

After the Second World War, the world went back to a fixed exchange rate system, this time based on the dollar but ultimately on the dollar’s convertibility into gold. As with all fixed exchange rate mechanisms, it started well in the immediate post-war recovery. However, soon cracks started to appear. With the dollar being used as a reserve currency, dollar shortages were a frequent problem, especially for countries in Europe, none more so than the UK. Draining of dollar reserves often led to stop/start economic policies and economic volatility. Towards the end of the 1960s and early 1970s, the strains started to tell on the dollar. In 1971, Nixon ended dollar convertibility into gold (partly because the French demanded gold for their dollars!) and the era of global fixed exchange rates came to an end.

The next major attempt at fixing exchange rates was the European Exchange Rate Mechanism (ERM). Introduced in 1979, the ERM was semi fixed to start with and various realignments were carried out periodically. The ERM is famous for the ignominious departure of the UK in 1992, sterling having lasted less than two years in the mechanism. In 1993, the bands for the French Franc had to be widened, but the ERM did provide an increasing level of stability for the core European currencies, leading to the establishment of the ECU and finally the Euro. The example of the UK provided a warning that even large, highly developed economies might be incompatible with a fixed exchange rate mechanism. However, those warnings were ignored. The success of the late stage ERM and early euro may have been due, in part, to the illusion of the “Great Moderation”, which engendered all sorts of risk toleration.

However, there was another warning of the dangers of fixed exchange rates before the end of the 1990s in the shape of the Asian Crisis. Asian countries had pursued a dirty fixed exchange rate policy against the dollar since the early part of the decade. Many countries ran balance of payments deficits and saw speculative investment bubbles. Excessive dollar liabilities built up, putting strains on maintaining currency parities. You know the rest of the story. One by one, countries were forced off the dollar peg and savage recessions ensued. It wasn’t just Asia, Argentina went even further and instituted a currency board from 1991. The peg to dollar finally collapsed in 2002, having suffered a huge economic crisis, the shock waves of which are still being felt today.

You would have thought with all the evidence suggesting that fixed exchange rates are almost impossible to manage for an extended period of time and that they cause enormous economic dislocation and hardship both prior and post abandonment, that the architects of the eurozone might have been a bit more cautious and careful in their construction of the single currency. But, no, the apparatchiks know best. Fatally, they failed to have any mechanism to deal with the inevitable trade and capital flow imbalances or shifts in competitiveness. Unlike almost any other currency in the world, there was no true lender of last resort. Criminally, they allowed Germany and France to flout the rules almost at the outset, undermining any respect for a rules based system on public sector borrowing. I could go on, but, by now you know the picture.

In the context of a 100% failure rate for fixed exchange rate currency mechanisms, is it surprising that we are seeing the failure of the euro? Given the gut wrenching adjustments being imposed on countries by unelected bureaucrats, what is the likelihood of some kind of uprising? Are we surprised that the eurozone is on the cusp of a depression?

Some times the failure of exchange rate policies can work for good. Arguably, the Asian Crisis had a positive outcome both economically and politically. Equally, the outcome can be darker. The rise of fascism and Hitler owed much to impact of the Great Depression on Germany. For most of the post-war period, Europe has been a model of liberal democracy, but this is now increasingly under threat. On the one hand, unelected bureaucrats in Brussels are usurping power and sovereignty. On the other hand, there is an undercurrent of popular unrest which could morph into a nationalist backlash. It is possible that the breakup of the eurozone will bring a more democratic European Union, but it would be foolish to bet on it. History shows that, more often than not, economic and social crises provide a platform for extremists to grab power.

]]> http://lemmingscanteachnothing.wordpress.com/2011/11/09/the-cancer-of-fixed-exchange-rate-regimes/feed/ 0 blogpackinglight Cancer.jpg http://lemmingscanteachnothing.wordpress.com/2011/11/07/historical-parallels-with-19th-century-us/ http://lemmingscanteachnothing.wordpress.com/2011/11/07/historical-parallels-with-19th-century-us/#comments Mon, 07 Nov 2011 08:46:50 +0000 Robin http://lemmingscanteachnothing.wordpress.com/?p=1228 Continue reading →]]> If you got a couple of minutes, it’s worth reading this short article at VOX on the parallels between the eurozone crisis and the US banking system in the 19th century. It’s not just the imbalances that doom the eurozone to failure but the lack of a proper mechanism for co-insurance of the banking system and the inability of the ECB to act as lender of last resort. The current arrangements are a recipe for runs on the banking sector. Watch out!

“Those who don’t know history are destined to repeat it.” Edmund Burke