Monday, 29 November 2010

Moral Hazard receives another boost

I have a great deal of sympathy for the German Chancellor Merkel’s stated project of “maintaining the primacy of policy over the markets”. This wish has led Germany to underwrite the giant European attempt at salvaging the Euro zone from collapsing under the speculation against government debt issued by Greece, Ireland, Portugal, Spain, and soon Belgium.

I am, however, afraid that the chosen method is making things worse. By effectively guaranteeing government debt from various EU member countries, Germany effectively tells the speculators that there is no problem in holding the debt of those countries. It is possible to operate in the bond markets without having to factor in the risk that the issuer will go bankrupt. Merkel is not alone in underwriting certain kinds of market behaviour.

Since the creation of the US Federal Reserve it has been the practice that if economic trouble was brewing in the US markets, FED would simply open the monetary spigots and the crisis would go away somehow. Currently, it is known as the “Bernanke Put”, a free insurance against capital losses. When the bank sector was effectively insolvent, it was bailed out by the US government with few conditions attached. The people who through monumental greed and incompetence had created the crisis, are mostly still holding on to their handsomely paid jobs. And they pay each other silly bonuses.

Having learnt the lesson that if they behave stupidly, they will receive generous help to get themselves out of trouble, they are now back to their old ways. By underwriting fully the debt of European sovereign borrowers, Merkel and her political allies are exactly supporting the behaviour they want to stop. If there is no real risk of loss, gambling against the troubled countries become a pastime, where you just have to adapt your strategies to the short term trends. Real caution is not called for.

For every rescue package put together, moral hazard becomes more and more engrained in the working of the financial markets. More and more money can participate in the speculative runs, making such runs more and more difficult to handle.

Ms Merkel has the common sense of believing that lending money should be a risky business. If a lender does not check the quality of the borrower, there is a risk of losing money. But when she had the guts to say it out loud, she was met by a storm of protest from the financial markets and their political backers: Never should there be any risk of losing moneys lent to a sovereign. The prices of Irish debt plummeted and Ms Merkel was rapidly forced to issue a calming message that it was only something she meant from 2013, when the current rescue system is to be replaced by something more permanent.

It still baffles me that the Swedish bank rescue action from 1991-92 has inspired so few of today’s politicians. Sweden’s banking problems were in every way as serious as the problems seen now (with the exception of the global systemic risk if we do not get out of the trouble).

In brief, the Swedish package saw management and shareholders of failing banks wiped out, banks were nationalised (i.e. integrated in the government balances) for a while, essential services were continued, banks were restructured, recapitalised, and sold. Bad loans were floated in the market with a temporary guarantee. The operation was quick and efficient – not the least because the government obtained full insight into the loan books. The whole action was run in a perfectly capitalist way: If you screw up, you lose your shirt. Such straight forward action was never taken in this crisis.

Now politicians are afraid of taking on the ever-larger banks, whose lobbying activities are based on huge resources. Politicians allow banks to obfuscate and hide the real magnitude of the problems. It all ends up being more expensive to the taxpayers than necessary. And when somebody – even with Ms Merkels position of strength – has the nerve to tell a few obvious truths, they are forced to beat a hasty retreat by a howl of protest from the banking sector.

I am afraid we are in for a very, very long time of trouble. So far it is becoming increasing clear that because of the attempts to “maintain the primacy of policy” the markets are being given a golden opportunity to speculate against the governments. Obviously, the influence of the bank sector lobbyists continues to grow. The markets strengthen their primacy over politics with every timid step aiming at reducing their influence.

Monday, 22 November 2010

The Irish bail-out teaches us a lesson about EU

The bail-out package for Ireland is the story of a pre-announced disaster. First the Irish allowed their economy to become a hedge fund, allowing the banks to grow their balances to levels disproportionate with the size of the economy – just like Iceland. Just like Iceland, the Celtic Tiger dreamt of having invented a new economic model of debt-fuelled hyper growth. They had not.

At the same time, they decided to attract foreign direct investments by lowering tax rates to levels that have been a thorn in the side of larger EU countries. As the crisis struck, they made a colossal mistake by guaranteeing all deposits in the Irish banks. As the scale of the losses in the banks began to become clear, it dawned upon most observers able to do simple sums that honouring that guarantee would lead to budget cuts so severe that social unrest could be the consequence.

The reaction from the corporate and financial sector was predictable. Yields on Irish government debt soared and companies withdrew billions form the Irish banks. As the cost of refinancing government debt increased, it became clear that the real cost of servicing the debt would surpass the growth rate of the Irish economy, catching the Republic in a debt trap.

The situation was compounded by German Chancellor Merkel’s untimely – but essentially correct – remark that when things go badly, it is not only the borrowers that should be punished. The lenders should also take a haircut if they had not assessed the quality of the borrower properly, which should be the responsibility of any lender. That remark gave a further push to the borrowing costs, and may seen in retrospect have been the event that finally pushed the Irish over the edge. They would have gone there anyway, but it might have taken longer time.

Now that the Irish have formally asked the EU and the IMF for a “contingent loan”, i.e. an overdraft facility, we are told that granting the facility was in order to protect the Euro zone.  Maybe it would be a good idea to remember that German and French banks hold large swathes of Irish debt, and would obviously have been badly hit in case of an Irish default. They are now saved from that ignominy.

All of this is just another episode in the ongoing saga of greed, incompetence, and cynicism that is the story of the European debt crisis. At every twist in the road, Moral Hazard becomes more engrained and acceptable as a business concept.

If there is any lesson to be learned from the Greek and the Irish bailout, it is that EU is slowly waking up to the fact that the common currency was launched for political reasons essentially without the support of rules and institutions required to secure the survival of the Euro zone.

In the weeks before the bailout it became clear that some of the wrangling had more to do with the future of the EU than with Ireland. Germany (again) suggested that the EU should be given far more power to control and influence the budgets of the individual member countries. This would mean a transfer of sovereignty to the EU commission and France would have none of that.

The differing positions could well be understood on the basis of economic logic. Germany has no problems transferring economic decision power to the commission, knowing full well, that the German economic strength will continue to give the Federal Republic a strong say in Europe’s fiscal affairs.
France, on the other hand, has for ages used German economic strength to project her own global aspirations. Obviously, the new assertiveness of Germany is a threat to that position, and France will for that reason resist any transfer of economic decision power to the Commission.

For now, France won the battle. Germany backed down and accepted that the procedure for dealing with bail-outs will continue to be led by politicians instead of bureaucrats. But make no mistake. The Germans are getting sharper and more precise than we are used to. In the words of German finance minister Schäuble, pretending that things can continue like they have worked in the past decade, implies a lot of wishful thinking. When Ireland has faded from the headlines, the issue of making the Eurozone work will be the most important for the future of the EU.

Wednesday, 17 November 2010

Chinese food price

The recent weeks have given us all a clear impression that the US is losing global influence on all fronts, and in particular on the economic scene. There is nothing strange about it. An economic textbook from my days at university put it clearly: A country running a steady current account deficit will sooner or later lose room for manoeuvring.
By running a persistent deficit, the US is now inextricably linked to its largest creditor, China. For a long time, China would be influenced by whatever the US decided. But now, China’s economic decisions will gradually have an influence on the US. Already now, China’s decisions concerning her currency reserve have the potential to influence the USD and US interest rates.  By implication, it affects the rest of us.
I have written about China’s problems that derive from the peg to the dollar. So far, China has profited enormously from that peg in terms of export. The flip side of the coin is a huge inflow of liquidity that China’s immature financial system cannot really cope with.

This inflow has given rise to a strong inflation in certain types of assets in China – mainly in property – but has so far not given rise to general consumer price inflation. China’s monetary authorities have tried to limit the financing of building projects, and using selective capital controls. It has cooled the economy somewhat but has not of course not resolved the real problem, namely the growth in the money stock resulting from the export surplus.

China’s Consumer Price Inflation is estimated to be in the region of 4% and ought not to be a course for real worry. But the food subcomponent is rising at a rate of 10% per year, and that is a course for concern. So much so that China is about to introduce selective price controls. A technique that has been tried on many occasions in the West. But it has never worked anywhere. It merely postpones inflation, it does not remove it.

The main reason that the Chinese government is targeting food inflation is straightforward. Despite the economic boom in the south and the east of the country, there are still large parts of the population in the North and the West that are eking out a living not much higher than the bare subsistence minimum. Authorities in Beijing rightly fears that if the inflation in food prices continue, it could lead to social unrest. Fears of social unrest remain one of the most powerful drivers of the Chinese leadership and has been so for several decades. Back in the 1970’s it was one of the drivers of the economic reform policy introduced by Deng Hsiao-Ping. After the Tien An Minh massacre it became clear that the crackdown on protesters had been severe as the authorities feared it could spread.

My guess is that the announced selective price controls and initiatives against food price speculation will have a temporary effect, but as long as the current account surplus remains capital inflows will continue unabated.

Only a change in the exchange rate policy will mean a real difference, and it will come at some point in time.
When China decides to take steps toward floating the Yuan, it will have a dramatic impact on the financing of the US current account deficit, and that will affect us all. While not many of us bide out time studying Chinese food prices, it is more important to us than you would think. 

Wednesday, 3 November 2010

US Elections – bad for Obama, positive for risk assets

The US mid-term elections ended largely as opinion polls had predicted. Republicans took the House of Representatives, Democrats kept the Senate. Given the influence of the anarchistic right-wing movement, the “Tea Party”, there is little reason to believe that the Republicans will co-operate with President Obama and the Democrats to solve the deep economic problems besetting the US. Instead, two years of further obstruction is likely.

Just like the Republican party (correctly) gambled on the economy not having recovered by 2010, the next Republican gamble appears to be that by simply doing nothing, the economy will have recovered somewhat by 2012. The election strategy will probably then be to claim having “saved” the US economy.

As a stark reminder of the seriousness of the economic situation, IMF and ILO yesterday released a study telling that since 2007, USA has suffered 25 percent of the job losses recorded globally.

For the financial markets, the consequences are likely to be the following:

No major economic initiatives will be forthcoming from President or Congress. 48 out of 50 US states are in deep economic trouble. No economic stimulus will be forthcoming from neither federal, state, nor local governments. Instead, budget cuts are likely to happen by default as spending programs expire and are not replaced.

This leaves Federal Reserve as the only institution holding the rope. Monetary easing is the only viable economic instrument available for a foreseeable future. Hence, the QE2 should be in the bag, and my guess is that it will come in two tranches of 500bn USD each.

As we have stated earlier, it will continue the ongoing inflation in risk assets, mainly stocks, commodities, gold, silver and tradable energy. The only question is how far it will run. No end in sight so far.

USD will remain under downward pressure until the US consumer demand begins to pick up in a substantial way.

Bond yields will remain under downward pressure from a combination of continued deflationary pressures and purchasing programmes from the US Fed/Treasury.

So-called inflationary expectations – which are in reality just a relative price between small-volume inflation bonds (TIPS) and big volume T-bonds - will point upwards but will have no real economic effect.

US corporations will continue to be hugely profitable in spite of unsatisfactory top lines. There will be a river of ink telling that it translates directly into higher stock prices. Wrong argument, but right conclusion. Instead we are looking for an increase in bank lending to private equity firms, looking for financing for leveraged take-overs. It has not started yet.

US policy makers stand pat and will have to play a waiting game. They are waiting for US consumers to finish the repair of their badly stretched balance sheets. As known from previous episodes of this kind throughout history, it takes years. The US consumer is 2-2.5 years into this cycle. There may be another 4 years to go.

Growth will be slower than trend growth in the time to come, and it is unlikely that the US Output Gap will have closed by 2012. Consumer Price Inflation remains unlikely.

Fortunately, things are looking better almost everywhere else.