The UK Election and the European Crisis

Well, I am sure that nobody can have missed the fact that the UK has a hung parliament. I read several articles before the result that suggested that a hung parliament has been 'factored in' to the price of gilts and sterling, but it seems that this was not the case with severe market jitters following the election results. The jitters seem to have revolved around whether the Conservatives would be able to form the government, and the concerns are about the early versus later cuts to spending. I also wonder whether the markets have been counting on the notion that the Conservatives have been lying about the degree of the proposed cuts, and have expected the cuts to be deeper than those outlined in the Conservative manifesto.

The news that the Conservative and Liberal leaders are urgently trying to find a mutual position before Monday is being reported as being driven by a desire to have an agreed framework in place before the markets open on Monday. Such is the fragility of confidence in the UK economy. However, a recent report suggests that the Conservatives and Liberal Democrats are struggling to meet the deadline (update - there will be no deal before Monday).

The problem of the UK's hung parliament could not have come at a worse time. I have, over recent months, been noting the gradual loss of confidence in the UK economy, and the risks to the European economy, all of which are resultant from massive deficit spending. The result of the increasing concerns in the markets are now taking the whole world economy to the edge of crisis. Any review of the finance pages of any serious media outlet report the same nervousness and fragility of confidence. The violent plunge of stock markets is just one symptom:

U.S. stocks fell the most in 14 months, erasing the Standard & Poor’s 500 Index’s 2010 advance, as concern Greece’s debt crisis is spreading and the most volatile trading in 23 years sent the gauge down 6.3 percent.

Waves of electronic selling helped push the Dow Jones Industrial Average down as much as 9.2 percent on May 6, the biggest drop since the Crash of 1987, before paring losses. Industrial and materials companies in the S&P 500 fell at least 7.9 percent as all 10 industry groups declined.

There is increasing talk of further problems of contagion in Europe, though this should be re-described in the more accurate phrase of improved diagnosis of problem economies. The following is just one example of the concerns being expressed:

‘Nuclear Implosion’

The “unwinding became a nuclear ‘implosion’ of sorts as the carry trade became a true burden on the shoulders of the global equity market,” Dennis Gartman, a Suffolk, Virginia- based economist and hedge-fund manager, said in his daily Gartman Letter on May 7. “It was indeed a ‘perfect storm’ of unwinding of risk and the strange creation of fully fledged panic.”

The Dow Jones Industrial Average plunged by almost 1,000 points in intraday trading on May 6 as waves of computerized trading exacerbated declines. For the week the gauge declined 5.7 percent, while the Standard & Poor’s 500 fell 6.4 percent.

The euro yesterday traded as low as $1.2586 in New York before jumping to $1.2747, near its $1.2798 high for the day. Speculation that the ECB would offer “a large credit facility” to European banks sparked the gains, said Richard Franulovich, a senior currency strategist at Westpac Banking Corp. in New York.

The risks to the European banking system of an ongoing sovereign debt crisis can not be understated. As several analysts have noted, the risk of sovereign default by EU countries is heavily concentrated within the European banking system. The risks of defaults extend far and wide but, yet again, the risks are potentially going to be absorbed by European sovereign states. In particular, we have the extraordinary situation in which a European stabilisation fund is being proposed, which will see already indebted (and some already dangerously so) countries having to borrow yet more money to lend to countries that are apparently in worse condition than themselves:

The proposal, tabled by Nicolas Sarkozy in an emergency meeting late on Friday night, will involve the creation of a €60bn "European stabilisation mechanism" designed to provide bail-out support for countries which may face similar strain to Greece in the coming months.

It is thought to be focused particularly on Spain and Portugal, both of whose leaders fear an assault by "bond vigilantes" in the market who have scented weakness within the eurozone. The plan will have fiscal implication for all European Union countries, including the UK. The key element is an extension of an existing bail-out package, already used to support Hungary and Latvia.

This involves extending an already-existing Lisbon Treaty clause originally designed to provide cash for economies hit by natural disasters. Under this, the European Commission will borrow directly from markets, with its own finances guaranteed by EU nations – something which would leave the UK public finances exposed if a country fails to repay the loan. It could also impact the UK's credit rating.

Whilst I have avoided and rejected the use of the word contagion, within such proposals we do finally have a mechanism of contagion; just as the bank crisis was shifted into sovereign risk (contagion), here we have the potential to spread the problems of one sovereign to another. Whilst any new borrowing that these solutions generate may not be the cause of a sovereign crisis, they may end up as a significant contributory factor. Unsurprisingly, the Liberal Democrats and Conservatives appear to be keen to avoid any connection with this deal, and can later leave the blame with the Labour government:

Representatives from either party were unwilling to comment last night. The plan, which was only expected to be entirely finalised by lunchtime today, in time for the ministers’ arrival in the Belgian capital, must be completed in time for markets opening on Monday morning, according to Mr Sarkozy.

It is no wonder that they are unwilling to comment, when they are in the process of discussing how to address the UK's own fiscal black hole. However, were they in a position to negotiate, they would be just as likely to agree to participation in the fund - after all, they may need the same support in the future, and to not contribute now may put future support at risk.

Alongside the brewing crisis, there is the usual talk of 'speculators', and 'bond vigilantes'. Whilst some will profit from the turmoil, the underlying driver of the turmoil is not speculation but the fear of investors for the security of their investments. Those investors will include pension funds and other investments that are aggregations of individual savings. The idea that this crisis might be the fault of 'the markets' is laughable and allows the politicians and policymakers a way of absolving them from responsibility. The cause of the crisis is clearly in the hands of the policymakers and politicians of sovereign states who have borrowed recklessly. Without such reckless borrowing, the markets would have no reason to shun the bonds of the at risk countries.

Alongside the European crisis, there has been the retreat to the illusory safety of the US, with treasuries as the big winners:

Treasuries surged, with 10-year note yields registering the biggest two-week drop since December 2008, as concern that Europe’s debt crisis will spread beyond Greece sent investors to the safety of U.S. government debt. Thirty-year year bonds gained for a fifth straight week, the longest winning streak since the collapse of global credit markets at the end of 2008 drove yields to record lows. The jump in demand comes as the Treasury is scheduled to sell $78 billion in notes and bonds next week.

Regular readers will know that I have suggested that, as crisis escalates, there would be a market swing towards the US as a safe haven. I will repeat the analogy I made a long time ago; as the investors flee the bear in the woods, they will flee into a cave for safety, not realising that the bear actually lives in the cave. If looking at the drivers of the crisis in Europe, it is possible to see similar problems afflicting the US. The flight to the supposed safety of the US will allow the US to plod forward for a little longer, seeming to confirm the wisdom of investor decisions, but the underlying poor position of the US economy will eventually lead to a US crisis. The reserve currency status of the $US will only allow the US a breathing space, but will not allow the US to continue down the current path.

Overall, what we are starting to see is the potential for the crisis to escalate. The UK is in limbo, with markets ever more nervous about the state of the UK economy. Alongside the UK, the crisis in Europe looks to be accelerating, and is even threatening the destruction of the Euro. The risks of a major crisis are increasing with each day that goes by. Confidence is hanging on a thread, and there is no way to guess the way in which markets will jump. When markets are so jittery, it is quite possible that any single news event might trigger a panic, and with that panic, if it takes hold, the world economy could plunge.

This kind of situation always brings to mind the cartoons of Wile Coyote and Roadrunner. As Wile runs of the cliff, his legs keep on pumping and he appears to defy gravity. Then, as he looks down, and he realises there is no support, he plunges downwards. Whilst it was possible to defy gravity for a while, in the end gravity pulls him down. The big question that we face in the coming weeks is whether the markets will look down, and see that they have actually run off the cliff. I have no idea whether this might happen, but the chances seem to be increasing day-by-day.

We are living through interesting, and very worrying times.

Financing UK Government Debt - The Problems are Starting

I have a comment on my last posting, in which an anonymous poster very kindly provided a link to an article in the Financial Times. I quote from the start of the article as follows:

'The UK and Italy struggled to sell bonds on Thursday in a fresh sign of the difficulties governments are facing because of the debt needed for economic stimulus packages and bank recapitalisations.

The two bond auctions saw both governments forced to pay higher yields to attract investors and Italy scaled back the amount on offer.

Analysts say it is an “ominous” warning that debt raising is likely to become even tougher in the coming months if problems are emerging so soon after government announcements to increase issuance. A record of more than €1,000bn ($1,290bn) of debt is expected to be issued in Europe next year.'

Long term readers will know that I suggested the government would be hitting problems of default about now (as long as six months ago). I have continued in this view, and that means that my prediction was for the default to happen now. However, as you will note from the FT article, we are still at the warning shots stage. The move from warning shots to outright panic is difficult to predict, so it could be an immediate collapse, or might take a while yet.

Meanwhile, as government is going on a borrowing binge, it is worthwhile noting that this has severe knock on effects in the economy, as the government is competing with investment in private business. I discussed the problems that are caused in the wider economy in an article here, but thought it worth mentioning again as I have not discussed the subject for a long time.
If I have my history of economics right (please correct me if I am wrong), I believe that government borrowing (in the modern sense) was started to finance the Napoleonic wars. Regardless of the original purpose it has now become a very bad habit, and one that should really be prevented, by a constitutional constraint if necessary. For the moment, it appears that the problem is about to be addressed by the creditors to the UK, but better the country never got into the problems in the first place.

On a different but related subject, I was catching up on my reading yesterday, and managed to plough my way through the Economist magazine. In an article they discuss the re-ordering of the world financial system, the so called 'Bretton Woods 2'. It makes very depressing reading, as they are proposing that the solution to all of the difficulties is more regulation, and with the wisdom of hindsight criticise the Basel Banking accords (Wikipedia gives a good introduction with Basel 1 here, and Basel 2 here). Again, those who are regular readers will know that I have long 'fingered' the Basel Accords and government interventions as major contributors to the financial crisis. Essentially, the regulation in the banking system created huge distortions in the market whilst giving a false sense of security in the banking system (I discuss this in detail here).

The reason why I mention this is that the lesson being learned from the banking crisis is completely wrong. Instead of accepting that it was the regulation of the banking system that was the problem, the consensus is increasingly that it was the wrong regulation, and that more and closer regulation is the answer. Essentially, the consensus view is that it is possible to take the risk out of banking which, when you think about it, is a very odd idea. The nature of banks is that they lend to individuals, governments and businesses, and some individuals and some businesses do better than others. By nature, whenever a bank lends money, they take a risk.

Now, if we look at Basel accords, they are founded on the idea that different classes of assets have different levels of risk. This means that, for example, a UK issued bond would normally be viewed as low risk, such that banks will be encouraged to lend to the UK government, such that they maintained a balanced risk portfolio. Now, I would suggest that you stop and think about that for a moment.....

We have a system of regulation that encourages banks to lend to a government? Governments are not a productive asset class. They do not do anything to generate concrete wealth. They provide some services, which might be seen as productive activity, but they do not generate income from that activity, they just farm tax from their populace to pay for it. It is a fine distinction. For example, if we go to a restaurant, we pay the restaurant for the service of cooking our food for us. If we pay tax to the government it provides the service of health care. The real difference here is that when the restaurant borrows money, it does so with an expected return, and the restaurant owner/s are risking their own money. On the other hand, when a government borrows money, it is risking the money of the population at large and the money of businesses, with no way of calculating the return on what is borrowed. Furthermore, the business and individuals have no choice but to have the government risk their money for them.

Despite the use of word 'investment' by politicians, this is not the role of government, as their role is spending the money of other people.

So here we have a regulatory system, that encourages banks to lend to government. If they are lending to government, they have less capital to lend into productive activities that actually generate the revenue necessary for government to function. It is rather odd when you think about it.

However, there is something even more disturbing about the whole system of regulation. An inherent part of the system is prescience. Apparently, it is possible to know the future of different classes of investment. For example, the Bank for International Settlements can apparently see the future and determine what is risk and what is not, and national regulators do then do the fine detail of what they will accept as safe or unsafe investments. Amazingly, these very clever people have an insight on risk, and can determine what is a risk and what is not. They must be very clever indeed.

The trouble is that, UK government debt has long been seen as very low risk, but we are now seeing that it is actually very high risk. The trouble is that, over the last 12 months, all kinds of 'safe' investments have proven to be unsafe. Essentially, what you have is a system in which lots of apparently very clever people can supposedly determine where risk resides. However, as experience is telling us, they have absolutely no idea where risk resides.

So now we come to the answer that is being proposed. More clever people will now sit down and re-determine how risk should be calculated, having learned lots of lessons from the recent crisis. All of these very clever people will get together, and once again will strain themselves to see the future, and determine what the future might be. But the trouble is, that is what they did before.....

Essentially, there is no escaping the fact that the world is a complex place, the world is unpredictable, and individuals are fallible and make wrong decisions. No amount of regulation of the banking system will change this. There is no reason to believe that the people who determine the particular risk of asset class have any better grasp of the risk inherent in that class than the holder of that asset - the banks themselves. The simple fact is that, what was safe yesterday, can become unsafe the next day. No one individual, or group of individuals, is infallible, so why should they be able to determine risk?

As such we come back to the start, and have to say that, whenever we deposit money in a bank, we are taking a risk that the bank will lose that money. We need to accept that risk, because we make that risk with possible trade-off that the bank will invest the money and increase our wealth. However, any idea that this can be guaranteed is just foolish, and no amount of regulation will make that guarantee. All such regulation serves to do is create a false confidence, and thereby encourages systemic risk.

What we have now seen is that such guarantees are worthless and, as a result, we have governments having to accept liability for their former guarantees of the safety of the system. However, it is not government that picks up the tab for that guarantee, but every individual and business within the country. In other words, there is a system in which people apparently know better than banks where the risk of those banks reside, they then say that if the bank follows their rules, they will guarantee that all the money invested in those banks is safe, and they make that guarantee with the money of tax payers.

When you think about it, it is a completely absurd idea. However, lots of very clever people all think this is a great idea, and persuade us all that governments offering guarantees (based upon their mystical knowledge of future risk) using our money is a good thing.

Note 1: Thank you all for the comments on energy policy, which were interesting and challenging. I had an interesting comment from HYDROGENPHILE (his caps), who suggested that hydrogen is the answer to storage of energy. This is presumably based upon the use of fuel cells, which are an interesting emerging technology that I have followed for some while. However, until the switch to a hydrogen energy economy is made, this does not address the problem of the here and now. In other words, the switch to a hydrogen economy needs to be made before the investments in energy provision that relies on that switch is undertaken.