Economics

Haircuts on the horizon

And so the pain goes on. European bank shares fell sharply last week as news of an €80bn-€90bn (£68bn-£76bn) bail-out for Ireland sparked fears that senior creditors of Irish banks could soon be forced to accept losses.

Such concerns were particularly acute among investors in the UK and Germany – exposed to €110bn and €102bn of Irish bank debt respectively. The third-most exposed country, incidentally, is the United States.

The centre of the turbulence on Europe’s financial markets shifted last week, though, to Spain and Portugal, causing their governments’ borrowing costs to soar. The reason is that the rescue package being finalised between Dublin, the European Union and the International Monetary Fund may impose “haircuts” on all those who leant money to banks in the Republic – not just the “junior creditors”.

Continue reading at The Telegraph.

Economics

Is this the beginning of the end of the Eurozone?

Could the endgame of this “Greek tragedy” be a eurozone break-up? The single currency’s supporters maintain such an outcome is mere mythology. Greece accounts for only 3pc of the 16 member states’ combined GDP, they say, and has lower debts than some of the banks bailed-out during “sub-prime”. A loan of €20bn (£17.5bn) would do the trick, we’re told. That’s less than the British government injected into either Lloyds or the Royal Bank of Scotland.

Such analysis sounds vaguely plausible. But its naïve and politically dishonest. Then again, the single currency was built on political dishonesty. That’s because, at the heart of the eurozone project there was always a fundamental contradiction – one the architects of monetary union never dared to address. Now its being highlighted for them, whether they like it or not.

While the European Central Bank controls eurozone interest rates and the money supply, the size of each country’s fiscal deficit results from the spending and taxation decisions of its own sovereign government. How can you enforce collective fiscal discipline in a currency union of individual sovereign states, each answerable to their own electorate? The truthful answer is you can’t – not unless you subjugate the autonomy of democratically-elected politicians and, by proxy, their voters.

Voters don’t like that. Neither, do politicians. Faced with a choice between seriously annoying their own voters and seriously annoying the ECB, the most ardently “pro-European” lawmakers, even those with years of Brussels trough-nuzzling under their belt, will always side with their own. That’s why the eurozone will ultimately break-up – whether Greece is bailed-out or not.

The eurocrats blame “speculators” for the single currency’s woes. That’s a bit like sailors blaming the sea. The eurozone is ultimately doomed because, in the end, economic logic wins and the will of each country’s electorate bursts through. This current Greek saga won’t end the eurozone – but future historians will identify it, perhaps, as the beginning of the end.

Many have said it’s hardly surprising that Greece – with its history of financial profligacy and capital flight – has emerged as the eurozone’s Achilles heel. A more germane observation is that, while fiscally wayward, Greece is also the birthplace of democracy. If the Greek population wants to get upset, throw out its elected politicians and reject austerity, it must be allowed to do so. I think they’d be mad, but it must be their choice.

If Berlin and Brussels try to impose their own view on Greece and the “cuts” come from outside, the situation will become incendiary. Protests will turn into fully-blown riots. Greece will endure very serious social unrest. Deep-seated rivalries and suspicions between countries will be re-ignited. And for what?

Greece is running a budget deficit of 12.7pc of GDP. The real number could be 15pc or more as Greek politicians have lied for years about the extent of their country’s liabilities. They’re not the first European leaders to do so and they won’t be the last. But Greece was, almost uniquely, assisted in its fiscal cover-up by Brussels – with the usual “convergence criteria” being bent to allow Greek euro entry.

As recently as September 2008, the euro seemed to be going well, despite the massive variation between member states. The five-year Greek credit default swap spread was less than 50 basis points. In other words, buying insurance against Greece reneging on its sovereign debt cost only slightly more than insuring German government bonds. Those, such as this columnist, who continued to warn that the eurozone was “dangerous and inherently unstable” were dismissed as cranks, xenophobes or worse.

Then sub-prime hit in earnest. Insuring against Greek default suddenly became a lot more expensive, the CDS spread rising six-fold in eight weeks. The same risk measure is now around 400 basis points, the cost of insuring against Greek default no less than 20 times higher than it was in January 2008. Default risks are growing in Portugal and Spain too, the eurozone’s fourth biggest economy.

The problem is that default dangers in Greece – where €20bn of debt falls due in April and May – are making creditors think twice about lending to other cash-strapped governments. Even if Greece avoids default, this latest crisis means governments everywhere will have to pay more for their finance, which in turn will push up borrowing costs for everyone – right across the eurozone and beyond, including in the UK. This is so-called “contagion”.

The Greek government has been desperately trying to convince the rest of the world – the Germans in particular – that it will keep its promise to reduce the deficit in its still-shrinking economy to 8.7pc of GDP next year and less than 3pc by 2012. Yet this would amount to the most severe fiscal contraction in the history of modern Europe. It simply won’t happen.

The reality is that Greece has two choices – both disastrous for the eurozone. One is to default, leave the euro and re-establish the drachma at a rate low enough to stimulate exports and growth. To write this is heresy. But with general strikes now in the offing, and the Greek public-sector unions resurgent, such a scenario is possible.

For years, the ECB has set rates low to suit France and Germany. This has made life difficult, causing dangerous debt bubbles, in smaller and more inflation-prone eurozone members. Were Greece to take the exit route, the governments of several other single currency members would come under intense pressure to do the same. The eurozone’s vital cohesion would be seriously undermined. Its ultimate break-up – or, at least shrinkage to a Franco-German rump – would only be a matter of time.

The other, more likely, option is that Greece accepts a German-led bail-out and “muddles through”. But even that would spark an eventual eurozone split. On extending assistance, Berlin and Brussels would talk tough and Greece would promise to behave. Anything less wouldn’t be tolerated by German voters. After the horrors of inter-war hyperinflation, Germany has spent more than 50 years building policy credibility. Backing a Greek bail-out would be a massive step – the first time in decades Germany has departed from its fiscal and monetary hard line.

Yet the German government will do it. Refusing to bail-out Greece would risk being labelled “bad Europeans” – something anathema to Germany’s post-war elite. Berlin also has a massive financial stake in the euro’s status as the world’s second most-used reserve currency.

Although Greece will be presented as a one-off, a “very exceptional” case, once that line has been crossed there is no going back. Other eurozone countries will want a bail-out. Why should Portuguese, Estonian or Spanish workers endure austerity and unemployment, while those in Greece were spared? Why them and not us? If big banks can compete for bail-outs, walking the line of “moral hazard”, political leaders will do so too. A Greek rescue by the Germans would spark repeated bail-outs.

In the end, voters in the big eurozone economies, faced with their own fiscal problems will say enough is enough. Europe’s monetary union will collapse, just like every other currency union in the history of man. The exception is America – yet the US, as the eurocrats hate to acknowledge, had been through a century and a half of political union before the Federal Reserve was founded in 1913.

That’s the key difference. America is a political union, with a system of explicit inter-regional fiscal transfers, and the eurozone isn’t. That’s why the single currency will ultimately split and be exposed as what it is – a triumph of European hubris and political vanity over unavoidable economic logic.

Economics

The Sub-Prime Debacle – What Will Future Historians Say?

Liam Halligan has kindly agreed to publication of the transcript of his address to the Cobden Centre/Libertarian Alliance dinner on 30 September 2009.

INTRODUCTION

Thank you for asking me to address this meeting of the Libertarian Alliance. I’m most grateful to Tim Evans for arranging this evening and for inviting me along. I’m Liam Halligan – Chief Economist at Prosperity Capital Management. I also write a weekly economics column in The Sunday Telegraph – and have done for the last six years or so. I’m happy to be here – and I hope you find my contribution substantive and worthwhile, even if what I’m about to say, I admit, is unlikely to be a bundle of laughs.

For I intend to discuss the somewhat uncomfortable question of how future historians will look back on the period we’re currently living through. How will the sub-prime debacle be judged, ten or twenty years hence?

Now, consider this quotation. Then consider where and when it was written.

“There is growing recognition that the dispersion of credit risk by banks to a broader and more diverse group of investors … has helped make the banking and overall financial system more resilient …”

“The improved resilience may be seen in fewer bank failures and more consistent credit provision. Consequently the commercial banks may be less vulnerable today to credit or economic shocks”.

That was written by the International Monetary Fund, in their flagship publication – The Global Stability Report. The date of publication was April 2006. Just three years ago – but, as we all know, in terms of what’s happened since then, it’s been a very long three years indeed.

I cite the IMF’s report with the benefit of hindsight, of course, and not in an attempt to be smug. My Sunday Telegraph column first foresaw “a US recession soon” and “serious turbulence on financial markets across the world” in January 2007 – caused by the bursting of “a liquidity bubble”, itself pumped up by the growing use of derivatives”1.

My point is that when the IMF wrote what it did the previous April, I didn’t violently object. Almost nobody did. If I’m honest, the dangers of sub-prime only crystallised in my mind in early 2007 because of a speech given at Davos by Zhu Min – an official from China’s Central Bank. “There is money everywhere,” he said. “You can get liquidity from the market every second, for anything. That means people are investing in assets with no idea of the risks they are taking”. Wise words. How alarming we only fully understand their implications in retrospect.

The main point I want to make here today isn’t that the Western establishment’s view, and resulting policy actions, were wrong in April 2006 – when the IMF published the Global Stability Report that it’s now so easy to pick to pieces. That’s obvious.

My point isn’t that the establishment’s view and policies remained wrong when the likes of Zhu Min – and some Western economists too – where issuing stark warnings in early 2007.

My point is that the Western establishment’s view remains wrong, even today, and what we’re doing to tackle this crisis – this massive, systemic threat not only to our economic and social stability, but to the West’s entire claim to global dominance – what we’re doing to tackle this problem is making our predicament far, far worse.

That’s the point I believe will cause future historians to wince, when they come to examine this sub-prime debacle … that what we’re currently doing will do nothing to help us escape this crisis and is, in fact, sowing the seeds of the next financial meltdown which may not be long in coming.

Future historians will be aghast at the extent to which our current, wild policy stance is also shouldering our children and grandchildren with ever more debt – as if the demographic realities of our ageing Western societies weren’t enough of a fiscal burden already.

This economic trauma has been of our own making. There was no external oil embargo, no trade union militancy, no all-consuming war. Sub-prime was a problem we caused – the Western financial and political elite. Future historians will condemn us for it. But they will condemn us even more, in my view, for how we’re now responding to the crisis, for the self-destructive nature of the current policy consensus. Quantitative easing. Zombie banks. And, in the pipeline, inflating away our debts. Have we learnt nothing?

But future historians will say something else too. They’ll judge what sub-prime meant for Western hegemony. For in my view this crisis has ENDANGERED, and our limp-wristed response is now SQUANDERING, the Western world’s long-standing role as the bed-rock of global finance, along with all the material advantages, influence and claim to leadership that role brings.

Compare our spiralling debt and deficit levels, our now meagre reserves, our money printing antics with the growing strength, stability and confidence of the emerging giants of the East. This is another clear trend that I believe future historians will identify – how the sub-prime debacle, and the related loss of confidence in Western institutions and markets – accelerated and accentuated an already on-going shift in commercial and financial prowess from the large Western economies such as our own to the fast-growing emerging markets.

WHAT THE WEST SHOULD DO

So, what should the Western world do? Cast your mind back to last April’s G20 conference – when Gordon Brown, in his own words, “saved the world”

“Today’s decisions, won’t solve this crisis immediately,” said our so-called leader. “But we’ve begun the process by which it will be solved”.

It is on reading these words that future historians will wince. Brown’s words, the glitz surrounding the G20 summit, and the related relief-rally on global markets, amounts to pure escapism.

Because there is nothing in the language of the London summit communiqué, or the subsequent Pittsburgh summit communiqué, or in any of the political utterances from any of our mainstream politicians that amounts to anything other than vague platitudes. There is nothing that Brown has said, or Osborne, or – heaven help us – Nick Clegg – that even begins to describe, let alone address, the scale of the problem we face. Future historians will surely reach for the prozac.

We’ll get “a stronger regulatory framework for the future financial sector”, we’ve been told. But there isn’t even the prospect of a debate on resurrecting “Glass-Steagall” – the Depression-era firewall that, for almost sixty years, prevented investment banks, for the most part, from recklessly gambling with taxpayer-backed deposits.

Yet since those measures were swept away in the 1980s and 90s, the world has lurched from crisis to crisis. Politicians are petrified, though, of re-building that crucial barrier, constructed during the early 30s after the last almighty credit bubble burst, lest they annoy the money-men and jeopardise future campaign finance.

The G20 has “an unshakeable commitment to work together to restore jobs and growth”. Really? So how about finally agreeing a new over-arching trade liberalization agreement? The “Doha round” has been stalled for almost eight years. If ever we needed a global trade round, it’s now.

If the big G20 players were serious about global recovery they’d have done a deal on trade at either London or Pittsburgh, taking out an insurance policy against the rising tide of protectionism. But so fixated are they by parochial domestic interests and pork-barrel politics, so unwilling to stand up and make the often uncomfortable but palpably necessary arguments for free trade at this pivotal point in history that they pledged only to “prepare for a conclusion to the Doha round”. How woolly can you get?

And then, on top of this cowardice, comes the biggest mistake of all – the wildly expansionary fiscal and monetary policies that have been unleashed in response to this sub-prime fiasco. In my view, and the view of almost every non-journalistic, non-Westminster village, non-Whitehall, financially literate person I know, the recent rebirth of Keynesianism, and the rash of debt-financed “stimulus packages” has done enormous harm to the Western world’s reputation for sound financial management, to our ability to eventually grow out of this crisis, to our future debt-service costs and, ultimately, to our all important credit-ratings.

“We used to think you could spend your way out of recession by boosting government spending but I tell you now, in all candour, that option no longer exists.”

So said a beleaguered Jim Callaghan to the Labour party conference in 1976.

“And in so far as it did exist, it only worked on each occasion by injecting a bigger dose of inflation into the economy, followed by higher unemployment as the next step”.

The lesson that Prime Minister Callaghan learnt 33 years ago was hard won. The UK was deeply indebted and, of course, had famously gone “cap in hand” to the IMF. And yet, we’re now far more deeply indebted. The UK is heading for a fiscal deficit that, even on growth assumptions that have been torn apart by independent observers, is twice as high as that shouldered in the mid-1970s.

Yet in the UK, and US too, our leaders show absolutely no sign of understanding of the lessons of history, of grasping that Keynesian fiscal boosts don’t work. The Western world, already weakened by huge deficits and spiralling debts, has reacted to this crisis by taking on even more debt. Our leaders have taken the line of least resistance – handing-out money to various interest groups, tearing up the fiscal rules. Media commentators and academia have done nothing to stop them, barely raising a whimper.

Yet the lessons of history are undeniable – debt-financed “pump-priming” is ultimately self-destructive – not least in countries that already have high debts and fragile currencies.

Rather than head-line grabbing fiscal boosts, Western leaders should be grabbing their banking industry by the scruff of the neck – forcing it to come clean about the extent of it losses, so thawing our frozen credit markets, and getting our economies moving again. Until we do, the Western world will keep haemorrhaging jobs and foreclosures will keep rising – as credit-worthy firms and households are denied access to vital working capital.

We need to tackle the entrenched vested interests that caused this ghastly episode, and which are doing everything they can to milk it for all it is worth. Simon Johnson, the former chief economist of the IMF, wrote a staggering article in the May edition of Atlantic magazine. “The finance industry has effectively captured our government,” he observed. “Recovery will fail unless we break the financial oligarchy that is blocking essential reform”.

Future historians will praise Johnson not for his insight – because what he is saying is obvious – but for his courage. Johnson has displayed the bravery needed to point to the madness of the current policy consensus. He is almost the only top-ranking economist to do so. Yet what he is saying is little more than common sense.

Why are we keeping fundamentally insolvent banks alive? That’s what future historians will ask. What happened to Schumpeter’s creative destruction? Yes, I know Lehman caused a collective nervous break-down – but that wasn’t because it happened, but that it happened in such a random, disorderly way. The markets think Lehman, in particular, was allowed to collapse not because it was any more insolvent than any other number of Wall Street institutions. They feel Lehman collapsed because the US Treasury Secretary at the time, among others, had a personal dislike for Lehman’s Chief Executive.

That’s the point – there wasn’t and isn’t any hard information about the state of each of our major banks. So informed, objective analysis of which banks are solvent and which aren’t is impossible. Given this information vacuum, there is only rumour and innuendo. And where there is a vacuum, the markets assume the worst – not least the inter bank market.

That’s why we need full disclosure. The numbers will be ghastly. Bank shareholders – rightly, I’m afraid – will lose their shirts. Perhaps next time they’ll take more notice of how companies they own are being run, rather than simply banking the dividends and ogling at the capital gains as balance sheet leverage is cranked-up. Bond-holders, too, will also take a haircut. But, under a credible threat of bankruptcy, many will be convinced of the wisdom of swapping their debt for new equity, so allowing genuinely viable banks to recapitalise themselves from within.

Of course governments must take systemic risk seriously. But shareholders should still face the consequences of the choices they’ve made. The state, should, in extremis, protect bond-holders up to some level – but only those in fundamentally solvent banks. And, crucially, banks should be legally forced to “fully disclose” and then “write-down” their potential sub-prime losses BEFORE any further taxpayer-funded recapitalisation.

The Swedes took this hard-headed approach during their early 1990s banking crisis – more pain now, but much better in the medium and long-run. The US and UK have adopted instead the head-in-the-sand Japanese-style variant – creating our very own zombie banks which are technically alive (allowing well-connected banking executives, for now, to save face and keep their jobs) but which are commercially dead and a drain on society given the weight of their toxic debts – not to mention the absolutely enormous moral hazard represented by their on-going existence.

“Quantitative easing” may sound like a clever way out. But the rest of the world is watching, alarmed at the inflationary fires we are stoking, mindful that our currencies are now extremely vulnerable, dubious – given these inflation and currency dangers, to say nothing of default risk – about buying any more of our debt. The music, at some point, will stop. That moment could soon be upon us.

So, we need a wholesale banking sector “shake-out” – despite the hard truths that will involve us facing. We need to re-instate Glass-Steagall – so commercial and investment banking are separated once more, preventing taxpayer-backed deposits from being levered-up and reckless-gambled.

We need legally-binding counter-cyclical reserve requirements – giving central banks the ability to rein in credit at the top of the cycle, and keep a close eye on leverage.

Saying all this is the easy bit. Doing it is tough. But at the moment, we’re not even saying it – admitting to ourselves that we have to change, that the party is over, that we need to exercise restraint.

And meanwhile, the world is shifting around us – in a way that is also hardly discussed now but will be the stuff of the broad analytical brush strokes that future historians will paint when this period is picked over, and the history of sub-prime is written.

WEST TO EAST

By early August 2007, seven months after I wrote the Sunday Telegraph column I referred to earlier, “sub-prime” burst from the business pages and into the mainstream. Global markets lurched, as Main Street was introduced to terms such as collateralised debt obligation and credit default swap.

That August, coming up for two years ago now, I wrote that the credit crunch was a “pivotal moment in the history of global capitalism”2.

Readers were asked to contrast the major Western economies – “squandering their role as the bedrock of global finance” – with “the relative stability of the emerging giants of the East”. The indebted Western world, I suggested two years ago, “is now far more vulnerable to financial meltdown than many of the nations we so recently used to deride”.

The likes of Brazil, Russia, India and China, I argued – with their huge reserves – were “better placed to deal with a global crisis than their Western counterparts”.

After all, back then these four so-called BRIC economies held between them two-fifths of the world’s total currency reserves. And now they hold half. The G7, minus Japan, holds a mere 6pc of total global reserves. And in a world stalked by the danger of systemic meltdown, reserves amount to power. On that basis, after the last decade of the West’s debt-fuelled over-consumption, using money leant to us by the East, the balance of power has firmly shifted.

Consider the contrast between the relative indebtedness of firms and households in the G7 compared to those in the emerging giants. In the US, UK and Japan, total personal, commercial and state debts easily exceed 250pc of GDP. In Brazil and India, the figure is less than 100pc. In Russia, it’s under 50pc. So the big EMs face much lower debt-service costs over the next few years, as the Western world “de-leverages”. They’ll be able to channel their resources into growth, rather than debt-service.

These were the reasons why I concluded, back in August 2007, that “when sentiments improve and investors’ risk-appetites return, there could well be a flight to quality – but away from the West and towards the economic powerhouses of tomorrow”.

So far this year, the world’s top-ten performing stock markets are all emerging markets. China’s main share index has gained 52pc since the start of 2009. Russian stocks are up 99pc and Brazilian shares 114pc. Meanwhile, the FTSE 100 and Dow Jones have managed only 20pc year-to-date rises, despite massive pump-priming, QE and a desperate attempt by the authorities to keep assets prices buoyant. And what happens when our state-sponsored sugar rush fades.

When future historians ponder the sub-prime debacle, this could be seen as the moment when the large emerging markets truly entered the financial mainstream. This has been happening for some time but this sub-prime fiasco is now accelerating and accentuating that trend.

One reason is that these nascent capitalist economies will grow faster for the foreseeable future, and from a lower base, than their “credit-crunched” Western rivals. The developed world will contract 3.3pc this year, says the IMF, with the EMs grow 3.4pc. The relative gap is vast next year too – with the West set to manage only 1.1pc growth (some hope) and the Eastern upstarts expanding 5.6pc.

As the threat of Western sovereign defaults rise, and our Keynesian boosts wither and die, investors will increasingly seek-out surplus countries rather than deficit countries. We now live in a world, of course, of huge Eastern surpluses and fast-expanding Western deficits.

So the emerging markets will grow much faster, and they have big surpluses. They’re less indebted, as I’ve said. In many such countries, firms have also financed their expansion not from debt, but retained earnings. Again, this means they’re well-placed to thrive – not least in relative terms – during this era of global deleveraging, a reality that investors are now starting to notice.

On top of all that, the West’s response to “sub-prime” – not just more debts, but “money printing” – also means serious inflation is now in the pipeline. The major Western currencies are being debased – the pound, in particular.

All these factors are generating interest in relatively simple, “tangible” investments in commodity-rich emerging markets, as asset-managers eschew the complex, derivative-driven strategies that have ruled the roost in recent years but have now ended in tears.

In 2007, the emerging markets accounted for half of global growth. Last year, as sub-prime hit the Western world, these nascent capitalist powers were home to three quarters of all global growth. In 2009, barring a late surge in Luxembourg or Switzerland in the fourth quarter, the emerging markets will account for ALL of global growth. And it won’t be long, at this rate, before they account for more than half the world’s total stock of GDP.

Yet these dynamic economies, despite their massive capital requirements, still play host to less than a fifth of the world’s portfolio investments. This anomaly is unsustainable. So, ultimately, it will not be sustained.

Yes, these markets can be challenging. But who could possibly say, after sub-prime, that’s not now equally true of the West – or even more so? Certainly, the big emerging markets have run better macro-economic and regulatory policies in recent years than their Western counter-parts so, to use a term de nos jours, can now point to superior “macro-prudential” management – alongside all their other advantages in terms of labour costs, productivity gains, market size and so on ….

That’s why, in my view, future historians will identify sub-prime as the moment when global capital flows shifted irrevocably … and that, when the smoke has clear, the Western banks have restructured and the stress tests come and gone, that will be the most important historic implication of sub-prime – as I said, the acceleration and accentuation of the re-balancing of the global economy away from the West and towards the East, along with all that that means in terms of the Western world’s hegemony.

Ultimately, sub-prime could help usher in a more stable global equilibrium – with activity, capital and influence spread more evenly between West and East. I certainly hope so. But that’s something else future historians will have to contest.

Because, in the here and now, the West’s political and regulatory system – driven by the prevailing commercial philosophies of the US and UK – has been found desperately wanting. We’re lurching from day to day in denial – unable to even admit the seriousness of the policy response required, let alone begin grappling with the technical, administrative, legal and ultimately political difficulties that surround its implementation.

THANK YOU

  1. “It could be downhill all the way after Davos”, Sunday Telegraph, Business p.4, 28.01.07 []
  2. This crisis is by no means over yet”, Sunday Telegraph, p.23, 19.08.07 []