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.

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.

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. 

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.

A new currency war?

To students of the Great Depression, the current discussion about a currency war should come as no surprise. In the ‘30s, the world had a fixed exchange rate system, based on a US-centered gold standard. It made it obvious for all that a series of competitive devaluations were taking place as countries turned their attention to exports as a way of boosting domestic growth.


This time around it is a bit different. We do not have a global fixed exchange rate. We have dollar, we have the euro, and the yen. Until the outbreak of the crisis, we also had two currency blocs, the Euro and the US dollar bloc. By the latter I refer to the fact that a number of South American and in particular Asian exporters unilaterally kept their currencies largely stable against the dollar.

We are now in a situation where competitive devaluations are off the table, since there is no fixed exchange rate system. This has opened the floodgates for something far more insidious, quiet and discrete manipulation of the currencies. And there is a sneaking feeling that the US of A is actually the main culprit. The US allegedly want to weaken the dollar in order to redress the huge hole in the trade balance. Doing this is so not kosher.

It is very easy to come to that conclusion when looking at the weakening of the USD since in the past months. Several currencies have appreciated significantly against the USD. I talk about the euro, the ASEAN currencies, the yen. And even the Chinese yuan also increased a bit. For all practical purposes the implicit dollar bloc has gone and the USA appear to be exporting its economic trouble to everybody else.

It always makes good headlines to accuse somebody else of currency manipulation. US lawmakers are specialists in that discipline as they pound the Chinese in order to obtain a significant appreciation of the CHY.

I am sure that everybody in the US economic policy circles welcomes a weaker USD. It was the same in Euroland in the first half of the year. But I am equally sure that the current dollar depreciation is the result of what I described in my previous post. Namely the current situation of the USA being caught in a liquidity trap.

There is a near universal expectation that the Federal Reserve will resume its asset purchasing programme within weeks. Such a program increases reserves in the banking system, but so far it does not lead to an increase in the money stock. Banks do not lend money and consumers and businesses do not borrow. Banks have a tendency to increase deposits at the central banks in that situation. It could however also happen that they help finance investments in securities. In other words, the main consequence is to inflate the value of financial assets.

To the extent that investments are not made exclusively in dollar-denominated assets, this liquidity flow will tend to weaken the dollar and to drive up assets in the “host” countries. In other words, the side effect of the US monetary policy is to drive the dollar down and financial assets upwards, also outside the USA.

Obviously, there is nobody complaining about the asset inflation, since it is supposed to lead to consumers feeling better and increasing demand. Eventually, that is.

But the falling dollar is obviously provoking a lot of politicians in other countries, from China to Brazil. A lot of noise is now audible and it is fully understandable. The weakening dollar makes US exports more competitive. The country that triggered the financial crisis through a disastrous combination of private and public sector deficits, a debt explosion and a terminally weak regulatory regime are now trying to export their way out of the crisis. At least according to the critics. I am sure that US policy makers would prefer to be in a situation where they could indeed push a string – using the monetary policy to get the economy growing faster.

Eventually the US economy will pull out of the liquidity trap, but nobody knows the timing of this. In the meantime the trends in the financial markets will continue, no matter how contradictory they are.

And in the meantime, we can all marvel at the best manipulators in town, the Chinese. Following months of increasing pressure from the Western World, the crawling peg regime from the pre-crisis years was reinstated. Not that CNY has moved a lot against the USD. But the change came virtually at the same moment as the USD began to weaken against the EUR and the JPY. So the net effect has been a weakening of the CNY in trade-weighted terms. Not bad for presumed novices in the noble art of waging a currency war.

Helicopter Ben getting ready for take-off? He ought to

Back in the ‘80s, then-US Fed Governor Paul Volcker used some serious weapons to quell inflationary expectations in the US. Interest rates were hiked to a point where the economy went into recession, excess capacity was established and a veritable press blitz focused on the need to stop inflation. At the same time, like-minded governments in the Western world gave the same message and such a thing as inflation indexing was killed in most countries. And it worked. Over a couple of years, inflation and inflationary expectations were falling rapidly and they have remained on a falling trend ever since.

Now that deflation – or at least disinflation – is a very real possibility, the game is to create some inflationary expectations, hoping it will feed through the economy. The reason is the same as fighting excessive inflation, namely that inflation as well as deflation leads to sub-optimal economic decisions.

The question is how to boost inflationary expectations, and it is not quite as easy as one would expect. Monetarists have told us that inflation is essentially a monetary phenomenon – “too much money chasing too few goods”. But that is clearly not the case now. With excess capacity nearing 10 per cent of GDP in several large countries, including the US, and monetary policy not leading to credit growth, inflationary pressures are totally absent. No matter how much money Federal Reserve and other central banks have pushed into the banking sector, most of it has remained with the banks, deposited at the central bank. It has not led to an increase in credit, and the main effect has been to salvage the banking sector and to recapitalise it by stealth.

Economic textbooks prescribe increased public spending that directly creates demand. With governments across the Western world moving to reduce public sector deficits, this solution is not exactly on the agenda. So rumours abound that now the central banks, led by Fed, are about to introduce another round of asset purchases, also known as “Quantitative Easing”. Which is again supposed to increase the money stock.

It probably won’t work this time either. The rumours have created some minor moves in the financial markets, though. The break-even inflation rate between T-bonds and US Inflation-indexed bonds, known as TIPS, has increased to 2.20 per cent. It means that if US inflation over the coming 10 years is 2.2 per cent, an investor will receive the same real return on a TIPS as on a normal government bond. 2.2 per cent is obviously higher than Fed’s assumed inflation target of 2 percent. Thus the situation receives quite some attention in the financial press.

But bond dealers do not create inflation expectations out there in the real economy. Such technicalities have nothing to do with how the average consumer perceives of the world. He/she begins to expect inflation once everyday goods and services begin to increase. We need the price of homes, groceries, haircuts, child care and so on to increase before inflation becomes tangible. At this moment in time it appears that only food prices are going up.

So I am very sceptical that Fed’s attempts at creating inflationary expectations through intervention in the financial markets will work. Fed Chief Ben Bernanke (unfairly) earned the nickname “Helicopter Ben” when in 2002 he quoted the monetary economist Milton Friedman’s recipe on how to stop deflation: Drop money from a helicopter. In the same speech Bernanke went on to describe the monetary policy as it is being implemented right now.

The problem is only that as long as Fed buys T-bonds off the private sector, including the banks, essentially it turns some private sector savings into cash. If the cash is not spent, it will not increase demand. Friedman saw clearly that the cash money had to be aimed at people who would spend it.

Maybe Ben should begin to look for his pilot helmet and get himself ready for that helicopter drop.

A sweet sport ... followed by?

Renowned Fed hawks believe it is necessary to expand and extend the Quantitative Easing programs in the US. Bank of Japan is doing it already. Bank of England is being strongly recommended by business leaders to do the same. And in continental Europe it is all quiet. I must admit that some of what I hear makes me rather apprehensive. Apparently there are strong worries that the current slow growth phase will last long enough to spur deflation. And deflation is the thing we do not want. At all!


In the past months we have seen some broad trends: Stronger stock markets, strong bond markets, weaker dollar, weaker yen, Stronger EUR, stronger EM currencies and EM stock markets. Market risk indicators are coming down. Credit spreads are falling.

Plainly, some of it does not make sense. I am afraid that we are setting ourselves up for a new round of market turmoil, maybe even at the level of what we experienced in May.

Since the outset of the crisis, the central banks have worked to reflate, and the asset prices have indeed recovered much of the lost ground. The loss of paper wealth should not be a major obstacle to growth. But now we have arrived at another critical junction. It is marked by a slew of new growth forecasts for 2011 from various institutions – they all represent downward revisions of growth forecasts.

The Great Recession was triggered by a huge increase in debt, mainly by households in the Western world. Households are now involved in a gigantic cleaning up of their own balance sheets. Meanwhile, the sharp recession undermined government revenue, leading to huge government deficits. Governments are now cutting back on expenditure and increasing tax revenue to fill the coffers.

Some had hoped for business investment to step in as a driver. But in terms of volume, investments do not match neither consumption nor public spending. And we have already seen an inventory rebuilding. New business investment is being delayed as final demand appears sluggish.

It means that attention turns to the original purpose of monetary policy, namely to stimulate the economy. But we are in a “liquidity trap” where pouring more money into the economy has very little effect on economic activity, since banks to not increase lending. As Keynes would have put it, we are trying to push on a string.

Several central banks have taken the step of introducing Quantitative Easing. Instead of massaging the money market they buy securities (various bonds) directly in the market, pushing money into the pockets of banks and other corporations. But the question is whether that has any effect on the economy. If we look at traditional measures, there are no significant signs that it is actually moving the economy forward. So what happens is quite simply that the reflation of the financial assets takes another step forward.

It all looks like a replay of the events following Internet bubble. This time it is not different. It is more of the same, just on a grander scale. Stocks move up, bond yields fall, commodities prices increase. We are in a liquidity driven sweet spot. It all goes well until it becomes clear that the underlying reality does not correspond to the current market perceptions.

Given that the stock markets have not yet taken to heart that growth will be slow because of the ongoing attempts to repair public and household balance sheets, this is where things may go wrong, maybe sometime in 2011. Until then, the markets look set to have quite a good time.