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Why it isn't just a matter of confidence
Aug. 7th, 2011 04:45 pmI was explaining the nuts and bolts of the current financial crisis to my mum yesterday. It went like this:
That, in a nutshell, explains why this isn't a matter of loss of confidence. The loss of confidence is based on the very real realization that the money isn't there. And it's the fact that the money isn't there that will cause the problem, not a minor niggling doubt about Greece's inability to pay. Indeed, if it was just a matter of confidence, as someone suggested on Five Live this morring, then we could just bring in Derren Brown to solve the problem by saying:
I think that the most interesting news last week was that Bank of New York Mellon had started charging to hold big cash deposits. There's quite a lot of technical stuff at play here (unlimited FDIC compensation -- although depositors might wonder at whether that became less reliable on Friday night following the US downgrade by S&P -- the fact that BNYM has to pay for that protection, and the added capital burden if you get huge cash inflows) but the nub of the matter is that there's a huge flight to short-short-tem liquidity. I suspect some Money market funds (e.g., my liquid Charles Schwab holding is not in "cash", but in a "Money Market fund") have been moving shedloads of short-term assets into cash. That could well mean that what was a derisory interest rate (0.01%) on such funds could actually become negative.
This is an interesting scenario. Obviously the "base rate" can't be less than zero, but when you think about it, it can. Because you have to keep any money you borrow from the government somehwere. So if you can borrow at minus 0.5%, but it costs you 1% a year to hold cash, or indeed anything risk-free and fungible, then a negative base rate actually doesn't look as impossible as everyone has said it is. It is, indeed, all relative.
++++++
The US downgrade was not the seismic event some people seem to be claiming (could be famous last words there if Monday morning brings some kind of financial apocalypse). But one obvious implication is that there will be a move of at least some funds to those countries that remain 'AAA'. One of those is Germany, and the yield on the German bund will fall again tomorrow -- thus widening the spread between German and Spanish/Italian bonds even if the latter do not get cheaper. But another of those countries is, yes, the UK. We were put on negative watch in the wake of the 2008 meltdown, but that was removed last year and our rating was affirmed because, the rating agencies said, our fiscal approach was responsible and indicated that we were probably one of the safer countries now when it came to sovereign debt.
Thus the downgrade of the US could have a beneficial knock-on effect for the UK, since we will be able to borrow money relatively more cheaply than otherwise we would have been able to do. It should also be positive for sterling, both vs the dollar and vs the euro.
That in itself is an unusual scenario. The sterling, as a semi-euro currency, has for the past few years been a half-proxy for the euro (looked at from the dollar point of view) and a half-proxy for the dollar (looked at from a euro point of view). So if either of those currencies moved sharply, sterling would move less sharply in the same direction relative to the 'other' currency. This link only occasionaly gets broken, but next week could be one of those weeks, as the euro and the dollar compete in the world's ugliest currency contest. Jeez, no wonder the Swiss are fed up to the back-teeth with the whole thing (a quick look at the CHF/USD rate will give a graphic illustration of why).
But the mess in the US is, I think, as nothing to the mess in Europe. Olly Rehn said on Friday that the slowness with which the EU had been moving when coping with the crises that are now coming at an ever increasing pace (it's only just over a fortnight since the "historic" meeting of the EU leaders) was "a price that you have to pay for being a collection of 17 democracies". Yeah, well, that price might turn out to be fiscal collapse.
As has been observed, if the strategy over the past 50 years of the EEC has been to create crises that force greater fiscal and political union, then one might say that "things are on track". But things are different this time. The consensus of ruling politicians is getting subverted from below. And I think that the chances of getting an EFSF of €2trn is approsimately 10% at best. And since many of the countries technically won't be able to approve and increase before October anyway, by that time it might all be academic. Make no mistake about it, this week is an important one for Italy and Spain. If their yields start moving up to 7%, real panic will set in (the people who lent their ten grands will start to worry that perhaps their money has actually been spunked away rather than used wisely -- and with good reason, because it has been. If that happens, then all of the political "expressions of wish" won't make bugger-all difference.
My knowledge of financial history isn't brilliant, but I'm somewhat reminded of the situation with Jewish financiers in the distant past. Kings borrowed from them because they needed the money to stay in power. But as time went on, they borrowed more and more (the Jewish financial community continued to lend because to refuse so to do would have had other, more unfortunate consequences for their community as a whole). Eventually what tended to happen was that the whole debt was ripped up and the Jewish community got it in the neck anyway. Then the King ran out of funds again and this time had no-one to borrow more funds from, and he got it in the neck as well.
Things are not so simple these days for our modern "kings", because the "lenders" are, in the final analysis, us (plus the Chinese). It's our pension funds, our banking deposits, our cash holdings. To rip up the obligations and say "fuck off, we aren't paying", would generate a Dr Who like feedback temporal panic vortex and make it plain how insolvent we really are. Well, that would not be good news for the political establishments in the developed world. And we aren't talking about political parties here or governments. We are talking about systems.
And that is the unspoken fear of Merkel, Sarkozy, Cameron and Osborne. Some of the thickos (e.g., Cable, Hague) are holding the line of "problems in a distant land of no concern to us", but this is delusional. The economy is too global.
So the leaders of the world's leading democracies are coming to realize that this is not just a financial crisis that they are looking at; it's not just a financial crisis that could lead to a political crisis; what it is is a systemic financial crisis that could well lead to a systemic political crisis -- one where systems, rather than governments, fail. And this is no idle fear. This kind of thing has happened many times in history, and some kind of financial fuck-up has frequently been at the heart of it. In this sense, one wonders if Germany has, for the past 50 years, been fighting the wrong war. For them, the absolute be-all and end-all has been the suppression of inflation, because, they think, that is what led to the Nazis taking over. But suppose the suppression of inflation is just another version of that carnival game (mentioned here before) where you hit one pop-up mole down, only for another one to appear elsewhere? Suppose the hyper-inflation was not a cause, but a symptom? Suppose the underlying cause was (in a way, as Hitler said) the Treaty of Versailles? The economic austerity impinged on a country that had no way of getting out of it. Ring any bells?
Yep, Germany wants to do to Greece precisely what the French wanted to do to Germany in 1919. And the IMF is backing them.
In terms of economics, this goes beyond Keynes and Hayek. New tools, as it were, are needed. My fear is that such tools may be incompatible with democracy as we know it. State capitalism (a la China?) or, worse, possibly some kind of refined Stalinist economics ('refined' in the sense that Windows 3.0 was a refined version of Windows 1.0 -- one that vaguely works).
Europe and the US has shown that the price for democracy is "muddling through" with fudged compromises. Indeed, the EU seems to actually AIM for fudged compromises. But eventually reality peeks through, and the markets are that reality. The politicians can blame the banks, the speculators, as much as they like. But they can only deny the reality of the situation for a finite amount of time. The only debate now is whether the end will be nasty and brutal, or some kind of gradual slide. My guess is that it will be the latter, and that it will be some relatively minor event, (a baby black swan, as it were) that will cause the really massive market meltdown. It will be at that point that all of us savers will suddenly realize that we only have about half what we thought we had. Time for gold sovereigns under the bed, indeed. That or a thousand acres of land and a crash course in self-sufficiency.
___________
Postscript. The more I look at this and the more I assume that the European leadership is thinking roughly along the same lines, the more likely it seems to me that eurobonds will be the (temporary) answer, if only because this is just about the only way to kick the famous metaphorical can down the road for more than a few weeks.
But there's a race against time here and, once again, the danger is that the crisis will run ahead of what would be a solution now, but might not be a solution come November.
The "plus" for the eurobond is that it is a bit more fiscal/political unity by the back door (by which I do not mean that I am in favour of this, although actually I am, but that fiscal/political unity is the aim of a significant number of people within the financial and economic and political communities -- so this would indeed "calm the markets").
The only players that would want to say no for political reasons (Ireland, Greece, the others on the periphery) don't really have much bargaining power at the moment, while those who might want to object for economic reasons (the taxpayers of the solvent EU members) might be "bought off" with some flowery language and the judicious use of Derren Brown.
___________
"Suppose you lent me ten thousand quid, and I paid you forty quid a month in interest. Now, I'm a fairly reliable chap, and I pay the interest every month, so, in your books, you put your "wealth" down as including that ten thousand quid, and your "income" as including the forty quid a month that I pay you.
Now, what you don't know, because I haven't told you, is that I bought HMV shares with that money you lent me, and those HMV shares have tanked. And to be honest, they haven't got a snowball's chance in hell of getting back to where they were when I bought them, which means that you haven't got a snowball's chance in hell of getting back your ten grand.
If you think of you as the banking system, and me as Greece, and HMV shares as the Greek public sector, you've got a rough idea of the situation. You might THINK that you have that ten grand, but in fact you haven't. And, not only that (to extend the metaphor), but the mortgage company to whom you might owe money is aware of your situation, even if you aren't. So forget any chance of getting a larger loan. Indeed, they might start asking for their money back. Which you might think is very unfair. But look at it from their point of view. 'fairness', doesn't come into it. They have their own depositors to worry about."
That, in a nutshell, explains why this isn't a matter of loss of confidence. The loss of confidence is based on the very real realization that the money isn't there. And it's the fact that the money isn't there that will cause the problem, not a minor niggling doubt about Greece's inability to pay. Indeed, if it was just a matter of confidence, as someone suggested on Five Live this morring, then we could just bring in Derren Brown to solve the problem by saying:
"Look into my eyes, look into my eyes. Everything is going to be okay. And one-two-three, you're back in the room".
I think that the most interesting news last week was that Bank of New York Mellon had started charging to hold big cash deposits. There's quite a lot of technical stuff at play here (unlimited FDIC compensation -- although depositors might wonder at whether that became less reliable on Friday night following the US downgrade by S&P -- the fact that BNYM has to pay for that protection, and the added capital burden if you get huge cash inflows) but the nub of the matter is that there's a huge flight to short-short-tem liquidity. I suspect some Money market funds (e.g., my liquid Charles Schwab holding is not in "cash", but in a "Money Market fund") have been moving shedloads of short-term assets into cash. That could well mean that what was a derisory interest rate (0.01%) on such funds could actually become negative.
This is an interesting scenario. Obviously the "base rate" can't be less than zero, but when you think about it, it can. Because you have to keep any money you borrow from the government somehwere. So if you can borrow at minus 0.5%, but it costs you 1% a year to hold cash, or indeed anything risk-free and fungible, then a negative base rate actually doesn't look as impossible as everyone has said it is. It is, indeed, all relative.
++++++
The US downgrade was not the seismic event some people seem to be claiming (could be famous last words there if Monday morning brings some kind of financial apocalypse). But one obvious implication is that there will be a move of at least some funds to those countries that remain 'AAA'. One of those is Germany, and the yield on the German bund will fall again tomorrow -- thus widening the spread between German and Spanish/Italian bonds even if the latter do not get cheaper. But another of those countries is, yes, the UK. We were put on negative watch in the wake of the 2008 meltdown, but that was removed last year and our rating was affirmed because, the rating agencies said, our fiscal approach was responsible and indicated that we were probably one of the safer countries now when it came to sovereign debt.
Thus the downgrade of the US could have a beneficial knock-on effect for the UK, since we will be able to borrow money relatively more cheaply than otherwise we would have been able to do. It should also be positive for sterling, both vs the dollar and vs the euro.
That in itself is an unusual scenario. The sterling, as a semi-euro currency, has for the past few years been a half-proxy for the euro (looked at from the dollar point of view) and a half-proxy for the dollar (looked at from a euro point of view). So if either of those currencies moved sharply, sterling would move less sharply in the same direction relative to the 'other' currency. This link only occasionaly gets broken, but next week could be one of those weeks, as the euro and the dollar compete in the world's ugliest currency contest. Jeez, no wonder the Swiss are fed up to the back-teeth with the whole thing (a quick look at the CHF/USD rate will give a graphic illustration of why).
But the mess in the US is, I think, as nothing to the mess in Europe. Olly Rehn said on Friday that the slowness with which the EU had been moving when coping with the crises that are now coming at an ever increasing pace (it's only just over a fortnight since the "historic" meeting of the EU leaders) was "a price that you have to pay for being a collection of 17 democracies". Yeah, well, that price might turn out to be fiscal collapse.
As has been observed, if the strategy over the past 50 years of the EEC has been to create crises that force greater fiscal and political union, then one might say that "things are on track". But things are different this time. The consensus of ruling politicians is getting subverted from below. And I think that the chances of getting an EFSF of €2trn is approsimately 10% at best. And since many of the countries technically won't be able to approve and increase before October anyway, by that time it might all be academic. Make no mistake about it, this week is an important one for Italy and Spain. If their yields start moving up to 7%, real panic will set in (the people who lent their ten grands will start to worry that perhaps their money has actually been spunked away rather than used wisely -- and with good reason, because it has been. If that happens, then all of the political "expressions of wish" won't make bugger-all difference.
My knowledge of financial history isn't brilliant, but I'm somewhat reminded of the situation with Jewish financiers in the distant past. Kings borrowed from them because they needed the money to stay in power. But as time went on, they borrowed more and more (the Jewish financial community continued to lend because to refuse so to do would have had other, more unfortunate consequences for their community as a whole). Eventually what tended to happen was that the whole debt was ripped up and the Jewish community got it in the neck anyway. Then the King ran out of funds again and this time had no-one to borrow more funds from, and he got it in the neck as well.
Things are not so simple these days for our modern "kings", because the "lenders" are, in the final analysis, us (plus the Chinese). It's our pension funds, our banking deposits, our cash holdings. To rip up the obligations and say "fuck off, we aren't paying", would generate a Dr Who like feedback temporal panic vortex and make it plain how insolvent we really are. Well, that would not be good news for the political establishments in the developed world. And we aren't talking about political parties here or governments. We are talking about systems.
And that is the unspoken fear of Merkel, Sarkozy, Cameron and Osborne. Some of the thickos (e.g., Cable, Hague) are holding the line of "problems in a distant land of no concern to us", but this is delusional. The economy is too global.
So the leaders of the world's leading democracies are coming to realize that this is not just a financial crisis that they are looking at; it's not just a financial crisis that could lead to a political crisis; what it is is a systemic financial crisis that could well lead to a systemic political crisis -- one where systems, rather than governments, fail. And this is no idle fear. This kind of thing has happened many times in history, and some kind of financial fuck-up has frequently been at the heart of it. In this sense, one wonders if Germany has, for the past 50 years, been fighting the wrong war. For them, the absolute be-all and end-all has been the suppression of inflation, because, they think, that is what led to the Nazis taking over. But suppose the suppression of inflation is just another version of that carnival game (mentioned here before) where you hit one pop-up mole down, only for another one to appear elsewhere? Suppose the hyper-inflation was not a cause, but a symptom? Suppose the underlying cause was (in a way, as Hitler said) the Treaty of Versailles? The economic austerity impinged on a country that had no way of getting out of it. Ring any bells?
Yep, Germany wants to do to Greece precisely what the French wanted to do to Germany in 1919. And the IMF is backing them.
In terms of economics, this goes beyond Keynes and Hayek. New tools, as it were, are needed. My fear is that such tools may be incompatible with democracy as we know it. State capitalism (a la China?) or, worse, possibly some kind of refined Stalinist economics ('refined' in the sense that Windows 3.0 was a refined version of Windows 1.0 -- one that vaguely works).
Europe and the US has shown that the price for democracy is "muddling through" with fudged compromises. Indeed, the EU seems to actually AIM for fudged compromises. But eventually reality peeks through, and the markets are that reality. The politicians can blame the banks, the speculators, as much as they like. But they can only deny the reality of the situation for a finite amount of time. The only debate now is whether the end will be nasty and brutal, or some kind of gradual slide. My guess is that it will be the latter, and that it will be some relatively minor event, (a baby black swan, as it were) that will cause the really massive market meltdown. It will be at that point that all of us savers will suddenly realize that we only have about half what we thought we had. Time for gold sovereigns under the bed, indeed. That or a thousand acres of land and a crash course in self-sufficiency.
___________
Postscript. The more I look at this and the more I assume that the European leadership is thinking roughly along the same lines, the more likely it seems to me that eurobonds will be the (temporary) answer, if only because this is just about the only way to kick the famous metaphorical can down the road for more than a few weeks.
But there's a race against time here and, once again, the danger is that the crisis will run ahead of what would be a solution now, but might not be a solution come November.
The "plus" for the eurobond is that it is a bit more fiscal/political unity by the back door (by which I do not mean that I am in favour of this, although actually I am, but that fiscal/political unity is the aim of a significant number of people within the financial and economic and political communities -- so this would indeed "calm the markets").
The only players that would want to say no for political reasons (Ireland, Greece, the others on the periphery) don't really have much bargaining power at the moment, while those who might want to object for economic reasons (the taxpayers of the solvent EU members) might be "bought off" with some flowery language and the judicious use of Derren Brown.
___________
