Why would you trust a politician?

I wouldn’t blame Stephen Hester if he decided to resign. For Ed Miliband and Ed Balls to attack Hester over his remuneration is the height of hypocrisy. They were both members of the government that employed Hester and set the terms of his contract. Not only that, he was persuaded by Gordon Brown to take the job for the public good and take a remuneration package that was lower than the current market rate.

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.

Events, dear boy

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.

The tragicomedy continues part 2

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.

The tragicomedy continues

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.

The real cause of the crisis

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