Another great picture

A picture is worth a thousand words

Standby for collapse

I’m away for the next three days. On past form, that means a market collapse. You have been warned.  😉

Disruptive technology

Books and music. It would be difficult to imagine life without them, especially when you are retired, like me. In many ways, books and their production have undergone little change over the past few hundred years. Printing has become better and faster, but books are still ink on a page. The publishing world too has seem little fundamental change. All this is changing with the introduction of e-readers, especially Kindle. The latest £89 version is very tempting. Once you’ve bought a Kindle, you are tied into Amazon. Not only are Amazon attacking the consumption end of the market but they are starting to recruit authors directly, bypassing publishers. The model could end up benefiting both Amazon and authors. Publishers could get crucified in the same way record companies have been. Will this limit choice? Is Amazon about to become a virtual monopoly?

The music world has already been turned upside down by the digital revolution and record labels have struggled to adapt. iTunes has been fabulously successful, but its position is being challenged by online streaming. Rhapsody/Napster, Spotify and now Deezer are making land grabs. The winner might take all. Streaming all the music you want to a computer and/or a mobile device could mean the end of purchasing music. Instead music will be rented.

I’ve been using Napster for a while and am impressed, especially with its mobile integration. It’s also ideal for the rest of the family. The one downside has been the low bit rate. Although its ok on a proper HiFi, it’s noticeably less atmospheric than a CD (all mine are ripped to a server and distributed wirelessly to my two systems). Spotify introduced a 320kbs service but then blotted it copybook by requiring a Facebook account. Deezer, a French “Spotify”, with a larger subscriber base, has just launched in the UK with a 320kbs offering. For £4.99 a month you can stream all the music you want via a computer/Sonos network and for £9.99 you can add a mobile device with the ability to listen offline.

I’ve had a trial subscription to Deezer and I’m very impressed. 320kbs is not far short of CD quality. I can’t see myself buying any more CDs of music that’s on Deezer. Unfortunately the library is not as extensive as Napster, but, hopefully, that will improve over time. Also classical music is not well represented. Nevertheless, if you want a streaming service, Deezer is worth checking out. The proliferation of these services is going to crater CD sales even more. It’s also going to stuff online MP3 sales through the likes of iTunes. Apple need to launch a streaming version of iTunes or they will suffer a severe erosion of market position. As we have seen with many technology companies, the landscape changes rapidly. What looks like a strong position one minute turns to dust the next. Where is Yahoo now?

You keep missing the point

I’ll say it again. Unless the surplus countries (i.e. Germany) boost domestic demand and have higher inflation, the stressed eurozone countries are doomed to a long and painful depression and risk the breakdown of social order. It also means that aggregate demand in the eurozone will be weak, further imperilling both sovereigns and banks. This is not economic theory, it is reality. It beggars belief that this has not even been mentioned in the crisis talks. It is the single most important policy issue and yet there is a deafening silence. Roger Bootle has written about it today. The markets will force the solution, which is likely to be the eventual breakup of the euro. Sticking plaster solutions will not cure the patient. That’s it, I’m finished commenting on the euro for the moment, it’s all too depressing.

Jeremy gets it too

Read the last sentence of Jeremy Warner’s article. What’ s the least bad policy option? Germany won’t do it, so the euro is doomed to fail. I love the picture that goes with the article. It’s worth a caption competition!

The big bazooka

The Eurozone’s version of a bazooka

So the bank recap fund is going to be €80bn according to the FT. I can’t see the market wearing that. The solvency of the banks needs to be put beyond doubt and that’s not big enough. Yet again the Eurozone incremental approach is just leading us over a cliff. These guys couldn’t run a sweet shop.

Maybe they’ll read Martin Wolf

Today’s FT. Will they listen to Martin Wolf? Don’t hold your breath.

Now Merv has said it (again)

You would have thought that the politicians might have got the message by now. It’s the imbalances, stupid! This is not a new observation from Merv (or anyone else, come to that). Unless global imbalances addressed, the global economy is in for a rough time. The two major imbalances are within the Eurozone (the most difficult to solve) and between Asia (esp. China) and the US. It really beggars belief that there is no plan to address these. It makes me very gloomy.

George agrees

George Magnus of UBS highlights the issue of imbalances in the Eurozone, as I did yesterday and lack of policy initiatives to solve them. Of course he does it in a more erudite and elegant way than me, highlighting the issues of fiscal integration and the problems of the German constitution. The cures for the Eurozone crisis look to be beyond the abilities of the politicians to deliver, so we will be in for another “tin hats on” phase in markets soon. You can read George’s piece here on Scribd.

It just won’t work

Whatever plan Merkozy come up with, it’s not going to work unless Germany has a massive domestic stimulus and higher inflation. Anything else won’t solve the imbalances of trade, capital flows and competitiveness. It’s simple economics. How can the stressed countries repay their debt to Germany (and the North) if they don’t achieve a trade surplus with their creditors? How can they regain competitiveness if their inflation rates are higher than Germany? These are very basic questions that Merkel in particular and German politicians in general are ignoring and hoping that they will go away. Until they recognise these fundamental imbalances and the part the Germany has to play, the Eurozone will just stagger from crisis to crisis, even if the EFSF is dramatically increased in size. European leaders (including Mr. Cameron incidentally) need to take Economics 101.

Small businesses to the rescue?

It’s always interesting to look out for things that don’t fit the prevailing view. Most non-Wall Street onlookers, including me, think that the US is either in recession or slipping into one. However, JP Morgan reported strong loan growth in the SME market. Indeed, it was the one real bright spot in their results. That seems at odds with the US going into recession. It is possible that cash flows are being squeezed so companies have resorted to borrowing.

As a cross check, the National Federation of Independent Businesses Survey was out this week. Overall, the survey remains quite downbeat. However, the headline optimism index ticked up. While the level is still abysmal for a “recovery”, the change in direction may be significant. On the other hand it could just be a blip. To have any confidence this needs to follow through over the next few surveys.

Source: NFIB

The changes within the index are also instructive. It is encouraging that small businesses believe that economic conditions are likely to improve and that sales will move higher. Of course this might be an anticipation of the Christmas effect. I shall be keeping an eye on the next few NFIB surveys and bank results to see whether they are indicators of better growth in the US. It is possible that the US will flirt with recession rather than having a full-blown recession. My best guess at the moment is an extended period of very low growth, flipping between negative and positive QoQ growth.

Source: NFIB

What’s the best ownership structure for banks?

It might seem arcane to raise this in the midst of the most serious banking crisis seen in Europe since the 1930s. However, the front page article in today’s FT highlights the inherent conflict of interest between the narrow responsibility of the owners and managers of most of the banks and their wider responsibilities to society. Mr Barroso is correct in stating that the banks do need extra capital but, also correctly, the banks state that they could improve their capital ratios by shrinking their balance sheets. Clearly, this would be a disaster economically and arguably, the banks are cutting off their noses to spite their faces. If all banks act in the same way, then asset prices will collapse and ALL banks will become insolvent.

While this threat is obviously a negotiating ploy, it does raise the question of whether the public joint stock (PJS) ownership structure of banks is against the public interest. It raises a further question as to whether it is also against the interests of most employees. The fundamental problem of PJS ownership is that at the top of the economic cycle it encourages excessive leverage and risk taking, while at the bottom of the cycle the banks (at best) exacerbate the downturn by squeezing credit and at worst require a public sector bail out. This is pro-cyclical behaviour is supposed to be countered by regulation. However, the banking sector tends to “capture” regulators in the upswing of a cycle so the appropriate counter-cyclical measures are either watered down or absent altogether. Even the Bank of Spain with its counter-cyclical provision policy couldn’t stop excessive risk taking in the Spanish banking sector, particularly in the Cajas.

Arguably, a PJS structure is also detrimental to the interests of the majority of those working in a bank. The ownership structure effectively means that there is little effective oversight of management. Shareholders rarely have any real influence over the board and management. The information the board receives is filtered by management, so effective oversight is difficult. Management effectively have a free rein. However, their compensation is driven by “shareholder returns”, so maximising return on equity is a key objective. Management are also incentivised by stock options. This means increasing the bank’s balance sheet leverage as far as possible and squeezing the cost base as much as possible.

For the ordinary worker in the bank, the rewards for success tend to meagre. So in the upswing, bonuses for the majority of the workers are modest and the majority of the rewards accrue to senior management. There is also a constant corrosive pressure to maximise revenue and milk customers for all they are worth, hence, the miselling and mortgage underwriting scandals we have seen recently. In a downturn, managements seek to cut costs aggressively. To maintain their own bonuses, they sack junior staff aggressively. For instance, Bank of America recently announced 30,000 redundancies, but they were in the mainstream bank with few in the areas that have caused them all the problems. Head we win tails, you lose. Is it surprising that we see an increasingly poor quality of service from banks?

What are the alternatives? There are three other ownership structures to consider: privately owned joint stock (POJS), co-operative and public sector ownership. POJS banks share some of the characteristics of  PJS banks, but there are significant differences. Because they are privately owned, shareholder oversight is stronger and owners tend to take a longer-term, more holistic view of the enterprise. Limited access to capital tends to make them more risk-averse and more cautious over growth. These sound like good things. However, a banking sector that was completely privately owned might produce low growth as access to credit would be quite restricted. Large privately owned banks might gain excessive political influence, as they have in some developing countries.

A co-operative structure has some attractions. It appears more democratic and could lead to a better balancing of the interests of all stakeholders. However, in countries like Italy, co-operative banks have become dysfunctional as weak oversight has led to capture by special interest groups and politicians. They also have limited access to capital. Finally, public ownership might be attractive. It removes the conflict between the privatisation of profit and the socialisation of losses that has dogged the current system. However, the history of public sector banks is not a happy one, with politicians using their influence to pervert the provision of credit.

The current system has evolved over the last century and seems to be the best amongst a bad bunch. It seems that the only way the banking chimera can be brought under control is by strict and enlightened regulation. Unfortunately, it is difficult to see that happening. the European Banking Authority has already lost credibility. US banking regulation is still a mess. In the UK we are in transitioning to oversight by the Bank of England. I see little recognition or policy directed at resolving the inherently divergent  interests between bank managements and public policy.

Regulators really need to get a grip on this and bring it into the public arena for debate. For too long bank managements have been unaccountable to the wider polity for their actions. Balancing commercial freedom with public benefit will not be easy to achieve, but unless we try, we are in danger of increasing political friction, public outrage and an endless loop of crises.

From the blogs

A couple of interesting things from today’s blogs:

Chinese capital goods weakness

In John Mauldin’s “Outside the box” there is a piece from Gavekal on Asia. What interested me was the observation that excavator sales had fallen, suggesting that capital goods demand has weakened. This has to be bad news for Germany and maybe this is what we are seeing feeding through to weaker German manufacturing orders. If demand for capital goods in China (and Asia) is weakening where will Germany export to? In the rest of Europe, demand  is weak, especially with credit tight. The US is in a similar position. According to the bulls, strong German growth is supposed to pull Europe with it. My view is that Germany is highly cyclical and dependent on external demand. Its gearing to exporting capital goods suggests to me that German growth will disappoint over the next 1-2 years, spelling further problems for the eurozone.

Erste’s woes

Golem XIV gives us a piece on Erste’s “shock” writedowns. The obvious read through is to Unicredit (oh dear!), Intesa, Raiffeisen and KBC. Further grief in CEE will heap more stress on Italy and Belgium, just when they don’t need it. If the politicians and eurocrats don’t go nuclear with a huge bank recapitalisation scheme, they will have lost their chance to get ahead of the crisis. I don’t think they will get a second chance. Part of Erste’s problems cam from writing CDS. As part of the recap scheme, there should be a massive audit on CDS exposures and a huge compression trade. Controversially, I think that Europe should reform any further writing or buying of CDS. There will be howls of outrage, but the opacity of CDS are a cancer in the system. Firstly, they should all go through a clearing house. Secondly, they should only be purchased as true hedges on existing positions. Thirdly, banks writing them should put up capital or reserves as insurance companies do for insurance contracts. Fourthly, rewards and bonuses related to these contracts should only be paid at the end of a contract when the true profitability (or otherwise) is known. Only by getting a grip on the CDS market will counterparty uncertainty be reduced significantly.

A skim through last week’s data

Not so gloomy in the US

Economic indicators were a bit more upbeat last week in the US. The important ISM surveys were a bit more positive than expected, especially the manufacturing survey. The headline number beat expectations, although new orders and inventories were a bit weak. The non-manufacturing index was broadly unchanged, indicating weak growth rather than recession. Car sales, construction and semi conductor billings all showed some positive signs. At the end of the week, the non-farm payrolls surprised on the upside. However, the Challenger jobs survey suggested that employment numbers may weaken again with cuts in financial sector and military personnel. Overall, indicators seem to be suggesting anaemic growth at the moment rather than outright recession, but the forward indicators still look a bit ominous.

 Europe staring down the barrel

The eurozone crisis continues to exert its malign influence on European economies. There was little to cheer about in any releases last week. Spanish lending figures were very weak, illustrating the squeeze in European banking sectors. German manufacturing orders fell for the second month is a row and industrial production was down month-on-month. Government finance numbers from France and Spain were poor, illustrating the pressure on fiscal policy.

 Banking crisis ratchets up

The news that Dexia was in trouble and likely to broken up caused jitters at the end of the week. At least the ECB has thrown a lifeline to banks by significantly extending their liquidity support. The supply of unlimited 12 month liquidity should help some of the short-term funding pressures. It also seems likely that there will be a significant recapitalisation of stressed banks either through government funds or the EFSF. If handled well, this ought to calm financial tensions significantly and provide some breathing space to discuss other policy initiatives.