Friday, 28 October 2011

Magical thinking in Euro Wonderland

After a tense few days, EU leadership have finally come up with a draft proposal for easing Greece's debt problems, recapitalising banks and helping other debt distressed countries to finance their debt more easily. The full text of the EU leadership's statement is here (downloadable pdf).

The devil will be in the detail, of course, which is pretty sketchy at the moment. But my initial impression of the report is that it contains far too much magical thinking. External agents will apparently willingly provide money to distressed Eurocountries when the ECB won't; growth will somehow appear in highly-indebted countries despite severe spending cuts and lack of inward investment; countries with uncompetitive business sectors and large trade deficits will somehow balance their budgets. And financial conjuring tricks will create the amount of money the report says will be available. How these will work in practice remains to be seen.

Media interest in this report has focused on three areas:

- Greek debt restructuring
- bank recapitalisation
- the "big bazooka": use of the EFSF to provide financial assistance to debt-distressed Eurocountries and if necessary to provide capital to insolvent banks

According to Gavyn Davies in the FT, all three of these are inadequate. I'm afraid I have to agree.

1. Greek writedown.

Gavyn Davies says:

"The 50 per cent haircut on private debt passes the litmus test, but there has been no participation by the official sector. The effect is to reduce the Greek debt ratio from 152 per cent of GDP in 2020 to 120 per cent, assuming that all of the Greek fiscal restructuring can be implemented in the meantime (which seems highly improbable). These debt figures are higher than expected, and may well prove unsustainable once again. So the Greek headache has not been definitively solved, and probably will not be until there is a significant write-down of official debt."

The proposed Greek debt writedown involves private creditors only. Once again, public creditors - notably the ECB - have got off scot free. Quite apart from the fact that this is unfair to private creditors, it also means that the writedown is far smaller than it needs to be to make any significant dent in Greece's debt mountain.  The ECB should now acknowledge that it must write down the value of its Greek collateral.

Greece is now in partial default and it remains to be seen whether ISDA will declare a credit event. So far it seems they won’t because banks did actually agree to the 50% haircut.

2. Bank recapitalisation

I've commented already that the 9% capital requirement might not be quite what it seems. Gavyn Davies is lukewarm:

The litmus test said that €300bn of recaps would be impressive, while €100bn would be skimpy. Predictably, the summit has chosen the skimpy end, at €106bn. This will only be enough if the rest of the package, designed to calm the sovereign debt markets, is highly successful.  Clearly, European leaders were worried about the possible effects of making excessively onerous capital demands on the banks, given they were threatening to lever their loan books in order to hit the new capital ratios. Regulators have been told to ensure that this does not happen.

But there is a glimmer of light:

.....there appears to be an intention to introduce a new EMU-wide guarantee scheme which will help banks to secure unsecured medium term funding. This could be a very important step towards restoring confidence in the banks...."

3. The "big bazooka"

The supposed extra 1tn euros available to distressed sovereigns and undercapitalised banks through the EFSF facility is fictional.  Gavyn Davies says:

"It is important to be clear that this does not involve bringing any new money from the eurozone itself to bear on the problem. At most, it involves a subsidy of about €200-250bn (which was already committed in existing EFSF guarantees) from the stronger members of the eurozone to attract new investors into the market for Italian and Spanish bonds......it amounts to 8 per cent of the outstanding debt of these two countries, which may not prove compelling. Talk of a trillion of new money, apparently conjured out of thin air by financial engineering, is inherently misleading....."

So the EFSF will be leveraged, not funded. Exactly how that will work is yet to be disclosed, but the idea seems to be that there will be some combination of taxpayer guarantees from member states to insure bondholders against default (some sort of CDS insurance, I suppose), plus hopefully some actual funds from external sources such as the IMF and China. The IMF probably will cooperate but it is unclear (to me, at any rate) what the incentive would be for China to provide money to the EFSF rather than investing directly in Eurozone countries. I wouldn't have thought that propping up distressed sovereigns without any real prospect of even recovering the investment any time soon would be particularly attractive to them.

It remains to be seen whether banks can raise the necessary capital from private sources. If not, then it seems the EFSF can be tapped for this as well. How far is 1 trillion euros expected to stretch?

At this point the media lose interest. But actually there is much more to this report, and the implications of it are far-reaching. These are the matters that the media are not discussing - and should be:

1. The provisions of the European Semester regarding economic coordination between member states are to be fully adopted. That means the European Commission will review national budgets before they are implemented to ensure compliance with the Stability and Growth Pact.

2. Despite the statement that the Eurozone is "committed to growth", there are no measures whatsoever to promote economic growth in the debt distressed countries. Instead, the Eurozone is still adhering to its ridiculous austerity agenda, which will only serve to drive those countries further into recession and eventually drag the rest of the Eurozone down too. Concerns have now been expressed about this from around the world.  Because of this, reduction of Greek debt to 120% by 2020 looks extremely unlikely and further default and restructuring seems inevitable.

3. Countries in deficit reduction programmes will be supervised by the European Commission to ensure they comply with the economic (i.e. austerity) measures imposed on them as the price for their bailouts.  This supervision is to be introduced immediately for Greece. But economic supervision of Greece is not accepted by its population and is likely to be fiercely resisted, especially as it is certain to involve even harsher cuts and austerity. There is no democratic mandate for this provision in the EU statement as far as I can see.

4, Legislative commitment to balanced budgets "in accordance with provisions of the Stability and Growth pact" is now required from all member states. But for deficit countries to achieve this they need inward investment and exports. Germany and the Netherlands therefore should invest invest their trade surpluses in their European neighbours and encourage domestic spending to attract imports. There is NO discussion of the large trade imbalances between the Eurozone countries and no commitment from either country to increase inward investment in deficit countries. And both Germany and the Netherlands have large fiscal surpluses. The Stability and Growth pact limits deficits to no more than 3% of GDP but imposes no limit on surpluses - so "balanced budget" doesn't quite mean that, does it? Are Germany and the Netherlands going to adopt expansionary fiscal policies to reduce those surpluses despite the lack of incentive to do so? Or are EU leaders so economically illiterate that they don't realise that fiscal tightening in deficit countries must be accompanied by fiscal expansion in the surplus countries or the whole area will end up in recession?

Financially, all this proposal does is kick the can down the road for a bit longer. But I’m very concerned by the authoritarian tone of many of the pronouncements in the report.

For me the really striking feature of this report was the evident intention to use the opportunity created by near-collapse of the Euro to push forward the "cause" of the single currency. New measures to promote fiscal convergence are principally aimed at further embedding the Euro, not sorting out the very real economic problems that Eurocountries face. The EU leadership are not really interested in fixing what is wrong with the Euro model as it is at present. They are buying themselves time to move the Eurozone further towards the model they really want - full political and economic union.

If you read the statement in this light, suddenly everything makes sense. Eurozone leaders believe that eventual political and economic union is not only possible, it is inevitable and will be achieved within a short timespan. Wave the magic wand of European unity and - hey presto - Wonderland will be restored.

So there is no need to provide adequate funding to the EFSF, no need for more than minimum Greek debt relief, no need to do anything to relieve the real economic tensions in the Eurozone. The only thing that matters is the austerity measures that they believe will turn all Eurocountries into mini-Germanys. And any country that can't or won't implement those measures obviously hasn't sufficiently bought into the Euro project so must be coerced with economic supervision and - eventually -with sanctions. Never mind the cost in economic ruin and human distress. Never mind whether the people of the country concerned support those measures. They will be imposed by an unelected, unaccountable outpost of the European Commission residing within the errant country and with carte blanche to override the elected government's decisions regarding the conduct of their economy.  Furthermore, ALL countries in the Eurozone will now have to consult the Council of Ministers before implementing economic policies mandated by their electorates.

I don't oppose the aim of political and economic union in the Eurozone. Far from it. In my view full political and economic union is the only way the single currency can survive. But it must be achieved with the full knowledge and consent of the PEOPLE of the Eurozone. Using this crisis to force through far-reaching changes designed to move the Eurocountries towards such a union by undermining national democracy smacks of Shock Doctrine.

Behind the mask of economic aid to debt-distressed countries lies a very real attack on democracy. This statement is deeply disturbing and to me abhorrent.

Wednesday, 26 October 2011

That 9% bank capital requirement may not be quite what it seems

From the FT this evening (26th October 2011):

Is the European bank recapitalisation a done deal? Not if you ask the Germans and Spanish. A broad agreement on raising the capital bar for banks has been announced this evening. But some technical details — that make a big difference to some banks – have been left open.

Berlin and Madrid are mounting a last-ditch bid to lower the bar by allowing a broader range of capital to be used as part of the “temporary buffer”. German and Spanish banks in particular will have a lot more work to do to reach the new, 9 per cent core tier one capital ratio if they are not allowed to count some hybrid forms of capital.

This is reopening a highly-charged (and tremendously technical) debate that overshadowed the European Banking Authority stress tests last summer. After a long fight, the EBA overruled the Germans and Spanish and imposed a relatively narrow definition of capital that excluded so-called convertible debt.

This time around, there is a chance there will be a little more leeway. European officials insist that the capital criteria will largely match that used in the summer stress test. But even some small tweaks could make a big difference. Some banks’ core tier one capital would rise by 1 or 2 per cent, if the hybrid capital were accepted. Morgan Stanley reckon that, under this scenario, the capital shortfall could be as low as €50bn-€90bn.

None of this was clarified in the European leaders’ statement this evening. But eventually the details will emerge. Will the market be impressed?

For those who don't know, so-called "hybrid instruments" are securities that have the characteristics of both debt and equity. Convertible instruments, probably the most common form, are debt securities (bonds) that have a provision in the terms of the contract that allow them to be converted into shares under certain circumstances, such as heavy losses or insolvency of the holder. This is important, because if a company or bank suffers serious losses shareholders' funds are first in line to take the hit after retained earnings. Bonds, which are in effect loans, have to be paid back if there are sufficient realisable assets. So if a company or bank fails, shareholders will lose their investment, whereas bondholders will expect to receive some or all of their money back.

Tier 1 capital, for banks, traditionally consists of shareholders' capital and retained earnings - so is the most loss-absorbent type of capital. The EU's definition of capital assigns convertibles to Tier 2, which is only called on if Tier 1 capital has been wiped out. This is what the debate is about. The 9% requirement is for Tier 1 capital only, but  Germany and Spain allow convertibles to count in Tier 1 capital.

It all depends to what extent these hybrid instruments can be relied on to convert to equity and therefore absorb losses. And that hangs on the terms of the contracts. I foresee a lot of work for corporate lawyers sorting this one out.

Tuesday, 25 October 2011

The cold hard truth

On Friday 21st October 2011, a group of economists working for the so-called Troika produced a devastating report. This report was leaked to the press, notably the FT, which promptly produced an article analysing it, and the BBC. Paul Mason, BBC Newsnight's economics editor, gave a 10-point analysis of the report on Twitter which I reproduce here. And the Telegraph released the full text of the report the following day.

European politicians have been fighting ever since. Germany's Merkel and France's Sarkozy had an argument loud enough to be heard in the EU concert hall. The Belgian finance minister left early and refused to attend the press conference. Merkel and Sarkozy jointly turned on Italy's Berlusconi, demanding that he implement fiscal reforms he has so far failed to deliver. And Sarkozy slapped down the UK's Cameron when he complained about the lack of any credible resolution plan for the Eurocrisis.

Entertaining though the politicians' antics are, they arise from a terrible truth. The bailout plan they came up with on July 21st was totally and completely inadequate. Everyone knew this, of course. But the politicians didn't want to admit it. Because actually they haven't the faintest idea what to do.

This crisis reminds me of the "bird within a bird within a bird" roasts that pretentious restaurants like to offer. On the face of it, it is a sovereign debt crisis in the poorer countries of the Eurozone, now extending to richer but highly indebted nations such as Italy. The German official story goes that these countries have borrowed far more than they can afford so must take the pain of massive reductions in their bloated public sectors in order to reduce their debt and return to competitiveness.  This story, and its accompanying denigration of people in the debtor countries as "lazy" and "profligate" despite considerable evidence to the contrary, is now so widely believed that it is difficult to counter it. It has become an article of faith.

But cut through the sovereign debt crisis and you find a bird of a different feather. Regular readers of my blog will know that almost everything I write has banking in it somewhere, and this post is no exception. If Greek debt had been entirely held by its own banks, it could have defaulted long ago - nationalised its banks, wiped its debts, started again. But its debt was held by giant foreign banks, systemically interconnected, crucial to their countries' economies and seriously short of capital and liquidity. The countries to whom those banks "belong" have waged a systematic campaign of disinformation to prevent the world realising that the Greek (and Portuguese, and Spanish, and Italian) sovereign debt crisis is also (and has always been) a BANKING crisis and the main suspects are French and German banks.

Every cent that has gone to "bail out" Greece has been paid straight to banks. Greece has not been "bailed out" at all. Far from it - it has been asset-stripped and its people impoverished to enable it to make some contribution to meeting its creditors' demands. Furthermore, those creditors have demanded severe fiscal austerity as the price of this "bailout".  I say "those creditors" because the principal agents of those demands are the French and German governments whose banks are at risk - plus the IMF, representing more distant financial interests. The Greek economy is now in deep recession.  But the creditors are demanding even harsher austerity measures, despite the appalling consequences for the people of Greece  .

Demanding severe austerity from a country in recession looks like madness, not only for the country itself but also for its creditors, since it makes it even less likely that it will be able to pay its debts. But there is a reason why the creditor nations have insisted on this apparently idiotic course of action. To them, there is no other choice.

Here's why. Were Greece a currency-issuing sovereign state, it could say "up yours" to its external creditors, default on its debts, nationalise its banks, devalue its currency and impose capital controls. The ensuing economic adjustment would be painful, but at least Greece would be controlling its own future. But it can't do this - because it is a member of the Euro.  In effect it has adopted a foreign currency as its national currency. Yes, the Bank of Greece is one of the central banks that supports the European Central Bank (ECB), which is responsible for determining Eurozone monetary policy. But historically the ECB has pursued monetary policies that suit the larger, richer nations, particularly Germany, and are disastrous for the smaller, poorer nations. It is still doing so now: it raised interest rates despite mounting evidence of impending recession throughout the distressed debtor countries, thus making their problems worse. This would be fine if there was a commitment within the Eurozone that stronger countries would support weaker ones with fiscal transfers. But there is no such commitment - in fact it is specifically ruled out in the treaty directives. Nor have the convergence criteria defined in the European Stability and Growth pact ever been adhered to: the 60% debt limit was exceeded for several years by - France and Germany. Convergence criteria that are so widely flouted are pointless, and for creditor countries to blame Greece and others for failing to adhere to them is rank hypocrisy.

When a nation has no control of its currency, it has no control of monetary policy. The only means it has of solving economic problems are fiscal ones. If it is over-indebted, it must increase tax income and/or cut public spending. That means tax rises, sales of state-owned assets, wage cuts, benefit cuts, pension cuts, public sector job cuts. This is the "austerity" that is demanded of Greece and others. The reason why Eurozone creditor nations have demanded such austerity is that they see no other way that preserves the Euro. The only other alternative is for Greece to leave the Euro - and the fear is that other debt distressed nations would then follow.

But fiscal austerity in recession-hit countries doesn't work, does it? Greece's problems have got worse, not better. Its deficit is increasing, not decreasing. There is no prospect of it returning to economic health for at least a decade, if ever, if current policies continue. And this is the cold hard truth that Eurozone leaders are now facing. The policies they have pursued have turned a small sovereign default into a potential continent-wide debt crisis and banking collapse. And they have no other policies to offer.

So the politicians argue among themselves about exactly how much of a loss the private sector should "voluntarily" accept on Greek debt. Germany, whose taxpayers stand to take the biggest hit if Greece defaults, wants a 60% haircut. France, whose taxpayers will have to bail out its under-capitalised banks, can't afford won't accept anything more than 40%. Both of them are furious with (and terrified of) Italy, which owes far too much even for Germany to bail out. And the ever-so-virtuous UK is just seriously irritating. Why should Eurozone politicians care about the impact on them? They didn't join the Euro, after all, and they've scotched every bright idea that the Eurozone whizzkids have come up with for extracting more money from their bloated financial sector to help with the Euro blues.

It's all so much hot air. Every country is fighting for its own survival now. The figleaf of European union has finally fallen off and the fundamental misconception of the Euro project is evident for all the world to see.  THERE IS NO UNITY. The only possible future for the Euro lay in fiscal and political union - the creation of a "United States of Europe". But there can be no political union while politicians pursue the interests of their own countries at the expense of the rest. And without political union there can be no fiscal union - given what has happened with monetary policy, is any Eurozone country really going to give up its tax raising powers to Brussels?

The Euro is doomed. Exactly how it will break up remains to be seen - perhaps Greece and other debtor nations will leave or be expelled, perhaps Germany will reinstate Deutschmarks, perhaps it will split along North-South lines (the so-called "2-speed Euro"). But break up it will, and really the sooner this happens the better for all concerned. Trying to preserve it at all costs has already wrecked Greece's economy and threatens to ruin the rest as well.  I'm not pretending that a Euro breakup will be easy. It won't - it will be exceedingly painful and very, very messy. But I don't see how it can be avoided.

Greece's economic decline has gone too far now for an orderly default with maybe a 60% haircut to be sufficient. What is required is comprehensive debt forgiveness and economic aid, not more loans. It would be difficult enough for this to be achieved even within a more accommodating Eurozone. But in the present political climate I don't see how a sufficient aid package can be put together. The political will simply doesn't seem to be there. Eurozone politicians will no doubt kick around some numbers and come up with yet more ever-so-clever ways of leveraging fictional money to bail out banks and pay creditors without doing anything to relieve the debt burden or restore Greece's economy. It won't achieve anything and it won't fool anyone.

Greece is dying before our eyes and its only hope now is default, exit from the Euro and international economic aid. Others are queuing up to take its place as Eurozone basket case. Portugal, Spain, Italy.....even France is now on the hook for a possible credit rating downgrade because of the weakness of its banks. And Germany, that powerhouse economy, will soon feel the effects of the economic demise of the countries it has come to rely on as its main export market.

The Eurozone is heading into the mother of all recessions, and it will be entirely of its own making.  But the consequences of its folly will be felt throughout the world.

Reality strikes the EU at last?

Paul Mason's Twitter feed, Friday 21st October 2011

I am tweeting a series of quotes from the Troika Debt Sustainability Assessment. They say Greek debt peaks at 186% of GDP evn with 21 J deal

Troika report basically says current Greek debt dynamic entirely reliant on massive haircut AND total support from EU/IMF

Troika: "Making Greek debt sustainable requires an appropriate combination of new official support on generous terms and additional debt relief from private creditors

The Trokia's logic is to say: without help Greece gonna need E359bn bailout. With 50% haircut it needs E220bn - from p7 of Troika doc

Troika; however they also moot a 60% haircut - this brings official financing down to 216bn

OK to recap. Some insiders now saying my doc is not Troika but ECB+. However: debt dynamics only sustanable with haircut + further bailout.

Okay - now I have gotten thru the basics of the doc I will analyse and do an orderly twitter splurge. From 1 to 10

1) A debt analysis sent out to EU leaders says Greece may need 50-60% debt forgiveness (ie haircut) to maintain bailout as agreed...

2) Even with 50% haircut on Greek debt, says the doc, Greece going to need bigger bailout

3) It says debt to GDP could peak at 186% without a massive haircut, and remain unsustainable for a decade

4) It also models a very deep, frontloaded adjustment, with slump plus low privatisation receipts

5) Greece "a turn for the worse, with the economy adjusting through recession + related wage-price channels, rthr thn structural reform"

6) "Even with much stronger PSI, large official sector support would be needed for an extended period."

7) Some are saying this is a "positioning document" pinged late Friday into EU inboxes to freak them out. I would not know

8) It certainly places 50-60% haircut on agenda. That then impacts on bank solvency in N Europe

9) Bleakest part of DSA is its view that Greek economy is not undergoing structural impovement, just internal collapse

10) Hard to see the story standing up that Greece can grow its way out with 21% haircut, if this assessment is accepted.

Monday, 17 October 2011

Banks and bird food

It seems appropriate that the "Occupy London" protest currently going on should base itself on the steps of St. Paul's Cathedral.

Devotees of Disney films will of course have watched the classic "Mary Poppins". Featured in that film is an old lady who sells bags of bird food on the steps of St. Paul's. Mary Poppins, nanny to the Banks children whose father works at a dusty old bank close to those steps, sings of the plight of the birds and their desperate need for food. At tuppence a bag, the food is just the right price for a rich but neglected child to buy with his pocket money.

I've long thought that it's not the birds that are hungry, but the old lady who is selling bird food in order to earn enough money to live. Juxtaposed in the film are ostentatious wealth, represented by the bank, and grinding poverty, represented by the bird lady. Michael Banks, the younger child, must choose what to do with his pocket money. Should he put it in the bank, or should he buy bird food?

In fact Michael's decision is taken out of his hands. The bank seizes his money against his will. When he protests, other customers of the bank misunderstand, and all start to remove their money, causing a run on the bank. But in the film there is no government to step in and rescue the bank. It is forced to close its doors and suspend business.

It seems to me that the dilemma that our government has faced, and still faces, is the same as that faced by Michael Banks. Do we concentrate our resources on supporting banks and financial markets? Or do we allow them to fail, and instead concentrate on supporting the poor and the needy?

So far government has opted to support banks while cutting support to the poor and needy. It has done so, in my opinion, because of a misguided belief that failing to provide money to banks would endanger the economy, and a second equally misguided belief that supporting the vulnerable costs money that the public purse cannot afford. Banks may not have physically seized government money - although some would argue that they have - but by talking up the dangers of bank failure and convincing politicians of their overriding need for support at all costs, they have ensured that they have first call on public money. The people of the UK get what is left over after the demands of banks and financial markets have been met. And even that is cut to the bone because financial markets actually don't like governments spending money to support the poor and needy. Never mind that the needs of people aren't met. Plentiful risk-free securities supported by AAA credit ratings are all that matters, it seems.

In the film, the outcome of the bank's attempt to seize Michael's money is literally laughable. When the money is eventually donated to the now-broke bank along with a joke, the proprietor dies laughing, forcing a  change in ownership and fundamental reform of management.  We, too, need a change in ownership and fundamental reform of our banks. Some people see this being achieved through full nationalisation and state control. I would personally prefer to see it happen by allowing banks that have become too big and too rigid to fail, so that new forms of banking can develop in their place. It may be that some combination of nationalisation and bank failure will be required, depending on the size and significance of the bank. But even nationalised banks I think should suffer a sea-change - be broken up and sold on in bits to competitors and new entrants.  And we should aim to remove all forms of government support from banks in the longer term.

The question of the bird lady remains unresolved. We don't know what happens to her.  But really, she shouldn't exist. No elderly person should be forced to sell bird food (or anything else, for that matter) in order to survive. The diversion of political energy and public resources to the financial sector in the last few years, coupled with an unpleasant and illogical economic ideology, has meant that safety nets have been reduced, and we still do not have a satisfactory solution to the lack of funding of pensions, both state and private. It seems to me that supporting the poor, the sick and the old is the first duty of government in a civilised society, not the last. Let's get our priorities right.

In the film, Mary Poppins makes it very clear where her heart is, in her impassioned song "Feed the birds". I know where my heart is.

Saturday, 8 October 2011

The fear that paralyses

One evening back in June 2011, four people were discussing on Twitter the possibility of a second global financial crisis. They had been having similar conversations most evenings for several weeks. Now, anyone who knows Twitter will realise that tagging in three people to tweets all the time doesn't leave much room for comment. So those four people created a hashtag to enable them to discuss more easily using a TweetChat application.  That hashtag is the now-famous #gfc2 - Global Financial Crisis 2.0

I was one of those four people.  And in my post Black Thursday, on 5th August 2011, I told the world that the second Global Financial Crisis had started.

Since then, global markets have crashed again and again, banks and sovereigns have suffered ratings downgrades, yields on the debt of countries perceived as being "risky" have soared - together with CDS spreads.  Countries have introduced a range of monetary and fiscal measures to attempt to stabilise the financial system and reduce the market perception of risk, often causing considerable pain to their own people in the process and wrecking any prospect of economic growth in the foreseeable future. The interbank markets are nearly frozen and banks have become dependent for funding on central bank liquidity. Investors have progressively moved funds to "safe havens" such as government-insured deposit accounts, government bonds from countries perceived as "safe", traditional "safe haven" currencies such as the Swiss franc and Japanese yen - and for those investors that are actually banks, the safest of all safe havens, central bank deposit accounts.

In the last week there has been the first failure of a major bank since 2008. Dexia's failure caused panic in the marketplace, and although the immediate announcement of a rescue package by France and Belgium did much to calm investor fears to start with, subsequent squabbling over the spoils spooked them again. This is against the background of an abject failure of European leadership to come up with any sensible plan for resolving the sovereign debt crisis that now threatens to bring down the entire European banking system and with it, possibly, the global financial system. That failure underlies last night's credit rating downgrades of Italy and Spain by the credit rating agency Fitch.  Fitch raised concerns about Italy's debt level and the strength of its banks - but FT Alphaville and Zerohedge both pinned the reason for Italy's market woes on the ineptitude of its politicians, especially Berlusconi who seems to be becoming something of an international joke.  The reason for Spain's downgrade is less clear, but Fitch's statement suggests that the main issues are the weakness of Spain's economy in the light of general failure of the Eurozone to sort out its problems.

The UK is not immune to political ineptitude either.  On Monday the Chancellor, George Osborne, announced measures to improve corporate finance which in effect would reduce the Bank of England to the status of an SPV, enabling the Treasury to hide its largesse off balance sheet while keeping the notional risk. Not surprisingly the Bank was having none of it: when it recommenced Quantitative Easing on Thursday it adamantly refused to buy corporate bonds, leaving Osborne with only half a policy. Meanwhile the Prime Minister's speech had to be hastily rewritten after its suggestion that people should "pay off their credit cards" was leaked to the press. Economists everywhere pointed out that this would fatally undermine the government's austerity programme: unless there is a vast increase in exports, which is highly unlikely given that the imploding EU is still the UK's largest export market, concurrent public and private sector deleveraging makes growth impossible. "Is Cameron promoting zero growth?" they said.  The trouble is, he was right - and everyone knows it. The private sector really is deleveraging - fast - and the government's austerity programme really is the wrong medicine now. Even the IMF - not known for its support of Keynsian stimulus programmes - has suggested that maybe fiscal consolidation needs to be done a little more gently. But Osborne has staked his political reputation on this austerity programme. However wrong it is, he isn't going to give it up easily.

Yesterday Moody's announced the downgrade of 12 UK banks and building societies, citing the removal or reduction of government support for banking following the publication of the Vickers report on bank reform. Immediately after the announcement there was panic among bank depositors evident in comments on, for example, the Guardian's comment pages. This was dangerous as it could have led to a run on these banks and building societies. Sudden uncontrolled bank runs are a sure-fire way of bringing down even well-run banks. Moody's was not suggesting that these banks were in danger of failure, or that depositors' funds were at risk: in fact five of the downgraded institutions actually had their "standalone" ratings - the real measure of their creditworthiness - upgraded as part of Moody's review. So there was NO reason for depositors to panic.

But according to some commentators, there was. At least one blog, and commentators on twitter, suggested that the government would not honour FSCS deposit insurance in the event of bank or building society failure. This is dangerous nonsense. Even in the event of catastrophic bank failure - and there is at present no reason to believe that is about to happen - the UK government can if necessary print the money to compensate depositors.  I don't know if these commentators realised (or cared) that their words could spook depositors into removing their money from these financial institutions. The one I read has for some time been promoting the idea that all banks are about to fail, in support of his argument that total nationalisation of the entire banking system is the only solution. So maybe uncontrolled runs would suit him - after all, that would bring about the catastrophic bank failure he has been predicting.

If there is one lesson to be learned from the past four years, it is that the theory of "rational expectations" that underlies neoliberal economics does not fit the reality of people's behaviour.  Investors, depositors, politicians, bankers - none of them are fully rational. Yes, when times are good and markets are behaving as expected, their decisions are probably close to rational. But when every day brings more bad news and disaster seems to loom, emotion governs decision-making at every level and panic reigns. This is where we are now. So we have depositors removing money from government-insured deposit accounts because they've read a scaremongering blog. We have investors removing money from funds domiciled in the EU even though the actual assets are invested worldwide. We have banks refusing to lend to each other.  We have central banks providing money to investors who simply hoard it in safe havens instead of using it constructively to generate new business growth. And above all, we have politicians kicking difficult decisions down the road to the next election, knowing full well that after that it will be someone else's problem. The global financial crisis is in reality a global political crisis.

You see, people whose careers and livelihoods depend on promoting a particular set of policies, or a particular political line, don't make pragmatic decisions based on the best interests of the people they serve, if by doing so they have to admit they are wrong. People who are making money by managing other people's money, or manipulating opinion, don't always do so in the best interests of their customers, if their jobs are on the line.  And above all, when people are scared, common sense goes out of the window and disaster scenarios abound.  Fear stalks the streets and paralyses all constructive thinking and activity. Whole economies come to a standstill.  Doom and gloom prophecies come to pass just because people have believed in them.

Fear is probably our biggest enemy at the moment. It prevents us solving problems and reinforces existing patterns of behaviour that make matters worse.

Yes, the economic prospects in most Western nations are dismal. Yes, the Eurozone is falling apart.  Yes, the global financial system is at risk. Yes, some of our banks may well fail - although I personally don't think all of them will.  But none of these are reasons to panic.  We may well have a global financial crisis. We don't have a global disaster. Let's not create one.

Instead, let's call upon politicians to work together constructively to resolve this ghastly mess. Suspend party political differences, stop scoring points and be prepared to adjust policies to achieve workable solutions. Only this way can fear be conquered and the real economic difficulties we face be addressed.

Friday, 7 October 2011

Downgrade, what downgrade?

This morning, the credit rating agency Moody's downgraded 12 UK banks and building societies. Understandably, people have been asking whether this means that these financial institutions are unsafe, and whether the overall credit rating for the UK is in danger - even though S&P, another credit rating agency, affirmed the UK's AAA rating only two days ago.

The statement from Moody's makes it clear that the reason for the downgrade is the expectation of less support from government for these financial institutions: 

"...announcements made, as well as actions already taken by UK authorities have significantly reduced the predictability of support over the medium to long-term."

Moody's still expect some support from government for the large systemically-important banks such as Lloyds TSB and RBS, although they believe that even this may be withdrawn in the medium to long-term, so the ratings for these banks are on negative watch.  But their view is that smaller institutions such as the Co-op Bank and smaller building societies would simply be allowed to fail in a crisis.  I am slightly surprised by the two-notch downgrade of RBS, since it is 84% government-owned. Would the government really fail to provide support to a bank in which it has a controlling interest?

The driver for this downgrade must surely be the Independent Commission on Banking's report. As I've commented in a previous post, the aim of the recommendations in this report is to allow banks to fail safely. Personally I think that the recommendations actually fall short of meeting this objective. But the fact that the government has accepted those recommendations is a clear signal that support for banks can no longer be taken for granted. A further consideration would be the fact that the Government allowed Southsea Bank to fail in June 2011.

It is quite wrong to view this downgrade as in any way reflecting on the viability of these financial institutions. In fact even the term "downgrade" is misleading. What Moody's has done is assess the commercial creditworthiness of these institutions in the absence (or reduced level) of government support and assign an appropriate rating. It's an adjustment to a more realistic level, not a downgrade as such.  It does not indicate any danger to these institutions - in fact their new commercial ratings are generally pretty good. Nor is there any danger to small depositors: deposits in all financial institutions are insured by the FSCS up to £85K.

What this adjustment will do, however, is raise the cost of capital and funding for these banks, which may find its way through into higher fees and charges, and possibly higher interest rates on lending. Not especially good news for bank customers. 

Finally, this adjustment in no way reflects on the creditworthiness of the UK itself. In fact as Moody's now clearly believes the UK government is quite happy to throw smaller banks and building societies to the wolves instead of bailing them out, and may think twice before throwing money at larger banks too, it may be more willing to maintain the UK's AAA rating.