Saturday, May 8, 2010

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.


  1. A hedge fund manager on Newsnight the other night said that the banks are being revealed as insolvent again, as they were in 2008. If a second round of bank bail-outs is not possible, what will happen then?

  2. Lemming: A good question. The banks probably never moved out of insolvency, as the insolvency was hidden through new accounting rules, which I detailed a long time ago.

    What will happen next? It may be that we are going to see an impetus towards the printing presses turning again, but I am not sure that the markets will accept this. I am not sure there is much more that can be done to support this crumbling structure, but perhaps there may be a few last attempts. This seems to be the policy in Europe at the moment, but I am not convinced it can delay the crisis for long.

  3. Always remember that the UK cannot become insolvent. The Bank of England can always redeem Sterling bonds with fresh cash if requred.

    All that can really happen is that Sterling can depreciate. However that is all relative to the other currencies around.

    Deficit spending isn't causing inflation at present, so it is less of a problem than the market would like the government to believe.

  4. I think it is time for the UKgov to realise that it does not need to issue debt as a sovereign government with monopoly of currency issue. Essentially, the UKgov needs to support the UK demand by spending - not by supporting banks or trying to run at a surplus. Secondly, the EUgov or whatever you want to call it, needs to reorganise itself along similar lines. The ECB should be put in a position that it supplies the funds to each government in a similar way to if they were sovereign with their own currencies - so that each government can maintain aggregate demand with appropriate spending. Again the ECB should issue no debt. If this cannot be engineered then the Euro must be dismantled since it is fundamentally flawed. If governments finally realise that the government debt monkey is an unnecessary burden, then we can forget about national solvency and concentrate on fixing banking solvency, by having proper regulation, limits on bonuses, firing and jailing etc etc.

  5. There is an imporant development on the Eurozone crisis:

    Since ECB is sterilising the purchases of government debt, it is not quite QE, however:

  6. The ECB, EU and USA are throwing everything including the kitchen sink at the problem (usual solution to debt crisis from PTB - throw more debt at the problem and hope the problem goes away)

    10 May 2010 - ECB decides on measures to address severe tensions in financial markets

    1.To conduct interventions in the euro area public and private debt securities markets to ensure depth and liquidity in those market segments which are dysfunctional... The scope of the interventions will be determined by the Governing Council... the statement of the euro area governments that they “will take all measures needed to meet [their] fiscal targets this year and the years ahead in line with excessive deficit procedures” ... to accelerate fiscal consolidation and ensure the sustainability of their public finances.
    specific operations will be conducted to re-absorb the liquidity injected through the Securities Markets Programme.
    2.To adopt a fixed-rate tender procedure with full allotment in the regular 3-month longer-term refinancing operations (LTROs) to be allotted on 26 May and on 30 June 2010.
    3. To conduct a 6-month LTRO with full allotment on 12 May 2010, at a rate which will be fixed at the average minimum bid rate of the main refinancing operations (MROs) over the life of this operation.
    4.To reactivate, in coordination with other central banks, the temporary liquidity swap lines with the Federal Reserve, and resume US dollar liquidity-providing operations at terms of 7 and 84 days. These operations will take the form of repurchase operations against ECB-eligible collateral and will be carried out as fixed rate tenders with full allotment. The first operation will be carried out on 11 May 2010.

    UK forced to bail out Euro.

    All 27 EU finance ministers have been summoned to Brussels on Sunday to sign up to a “European stabilisation mechanism. Britain will be unable to veto this as it will be put through under the “qualified majority voting” system.

    Euro-zone leaders are attempting to get round objections from countries such as Britain by invoking Article 122 of the Lisbon Treaty, intended to enable a collective response to natural disasters. This does not need unanimous agreement.

    So 750bn Euros.including off balance sheet entities like SPV's, US swaps and forced lending. Unsurprisingly markets and bonds have reacted favourably. But with reports of central banks buying Government bonds and that several countries have to borrow just so they can lend to the euro, how long it can last is hard to tell.

    Ambrose Evans-Pritchard believes "A European state is being created before our eyes."

  7. Josiah Stamp's GhostMay 10, 2010 at 5:48 AM

    "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."

    Why are the financial markets holding a gun to the head of the UK? Someone reminds me who REALLY runs this country?

  8. "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."

    I think that Krugman used that same metaphor some years ago...

  9. "Why are the financial markets holding a gun to the head of the UK? Someone reminds me who REALLY runs this country?"

    The government really runs the country and it has chosen to do so over the last few years by borrowing too much money from other people. Those people make no claim to want to run the country, but they do want to protect their own position. If their position appears to be in jeopardy they will react accordingly.

    It is a chicken-home-roost juxtaposition situation.

    The only one at fault and the only one to blame is the person who borrowed money he could not repay. His nametag might say "government" rather than "Fred Bloggs" and his address might be Downing Street rather than Acacia Avenue, but over-borrowing is over-borrowing and it carries a price.

  10. Bailout not convincing markets.

    Euro Erases Gains as Bailout Optimism Ebbs; Stocks, Copper Drop

    “Markets realized quickly that this crisis won’t be cured by adding liquidity, no matter how big it is,”
    “The structural problems of the euro zone will persist. I’m not surprised at all the euro is losing strength again.”

    Accelerating inflation may prompt policy makers in China, the world’s third-largest economy, to tighten lending controls as the European Union’s bailout plan forces nations including Greece, Spain and Portugal to increase taxes and rein in public spending. Greece may have its credit rating lowered to junk within the next month, Moody’s Investors Service said yesterday, citing the country’s “dismal” economic prospects.

    ‘Multiyear Contractions’

    The euro fell 0.5 percent, after yesterday gaining 0.3 percent. It reached $1.2529 on May 6, the weakest level since January 2009. Against the yen, the currency today dropped 1.3 percent to 117.73.

    Every “fix” is accompanied by “an adjustment in the real economy,” Stephen Roach, chairman of Morgan Stanley Asia Ltd., said late yesterday in an interview on Bloomberg Radio with Tom Keene. “We saw that in Asia in the late ‘90’s, we saw that in the U.S. in ‘08, ‘09, and we’re going to see that in Europe, certainly in the peripheral countries, with significant multiyear contractions in the years ahead.”

    Volatility in the markets to be expected as the world takes in the scale of the bailout and QE. I do not expect the inflation wary Germans to like this however, no matter how "sterilised" the QE ends up being.

  11. If it didn't look like financial armageddon enough before - it does now.

    Perhaps it really will take a huge event to wake people up? I despair.

  12. An anarchist's perspective on the Greek crisis:

  13. Curse you, gravity. You win again.

  14. Bit more info on the swaps and bond purchases

    Oh and gold went to all time high on day Gordon Brown resigned :)

  15. Seems Britain hasn't agreed to bailout Europe, and Euro officials are being snotty and saying they won't bailout us.

    Officials from both euro and non-euro countries said Britain should not ask for help if it runs into trouble because it had not signed up to a £378 billion support fund.

    French, Swedish and many Brussels officials have predicted that it is only a matter of time before Sterling is hit by the same market turbulence that came close to destroying the euro at the weekend.

    Jean-Pierre Jouyet, a former French Europe minister and the current chairman of France's financial services authority, yesterday predicted only "God would help" a rudderless Britain after it snubbed its euro zone neighbours.

    Denninger has a good rant about this.



  17. "Deficit spending isn't causing nflation
    at present"
    For a few reasons, Neil Wilson. They are the following:

    1. because The UK is amid a recession, which is deflationary by nature.
    2. The UK has not reached the proscribed debt to GDP ratio where government debt has an obvious effect on economic activity.

    "just as the bank crisis was shifted into
    sovereign risk (contagion), "

    In other words, the finance sector was able to sucessfully move its negative balance to the public sector. This was commonly referred in the media as a series of "bail-outs". Absorbing the finance sector's losses is bankrupting the public sector faster than had the public sector declined to "save" the financial sector. It's unclear as to why was it only the developed countries that became involved in these "bail-outs" if the global financial system was truely at stake.

    The United Arab Emirates bailed out its banks but only because it tied its economy too closely to the bloated finance sector of the developed world. Dubai got in trouble because they tried to imitate the economies of New York and London too closely which was very stupid of them, but at least they aren't garanteeing investors of anything.Or so they say. They have the wealth (oil) to do so and even they are being cautious.

    But still, it makes one wonder what compelled them to start building very lavish and exquisite real estate properties for rich people that don't exist?

  18. Labour hid ‘scorched earth’ debts worth billions

    "THE government last night accused Labour of pursuing a “scorched earth policy” before the general election, leaving behind billions of pounds of previously hidden spending commitments.

    The newly discovered Whitehall “black holes” could force even more severe public spending cuts, or higher tax rises, ministers fear.

    Vince Cable, the business secretary, said: “I fear that a lot of bad news about the public finances has been hidden and stored up for the new government. The skeletons are starting to fall out of the cupboard.”

    The new cabinet has been discovering previously unknown contracts and uncosted spending commitments left by their spendthrift predecessors.

    “There are some worrying early signs that numbers left by the outgoing government may not add up,” said Francis Maude, the Cabinet Office minister.

    David Willetts, the universities minister, claimed that Labour had left behind “not so much an in-tray as a minefield”.

    The disclosures come as George Osborne, the chancellor, prepares this week to reveal details of an initial £6 billion of cuts to help plug the hole in the £163 billion deficit. A full emergency budget next month will see some departmental budgets being slashed by up to 25% as well as tax rises, including a possible hike in Vat."

    Shades of what happened in Greece when the new government disclosed the true size of the deficit?

    Even if it doesn't cause the same sort of problems, austerity measures are likely to be the hot topic of conversation for a while.

  19. I felt fear for the first time on Friday as the markets resumed their descent. It made me think that whatever has been or will be thrown at the problems, the inevitable will eventually happen. The fear is not knowing what the inevitable is, but it does not take much imagination to see what follows a descent into poverty.
    And I am someone who has is out of the casino, with long-term views. God knows what the bulls are feeling now. Once the fear takes hold, the market feedback frenzy will cause havoc.
    Has anyone else felt like this, or was I being (temporarily) Chicken Little?

  20. Pop-quiz for fun:

    Scenario: Imagine that your life savings are in an offshore euro account (Isle of Man) whose parent company is a top-3 UK banking group. In light of the current brink-teetering of the Eurozone and UK economies and in light of everything this blog has been saying for ages, do you consider your savings to be safe & secure? Or do you ....

    A) Move all the euros to a German bank, reasoning that Germany is likely to be a bit more of a survivor if unthinkable things happen to the EUR / Eurozone), or

    B) move it into the bear's cave (your USD account) quickly before the EUR/USD rate gets any worse, since you were planning to take a year off to study in the US next year anyway, or

    C) stuff it into swiss francs or your aunt's account in Australia, or

    D) spend it on stuff since your friend says it'll be worthless by this time next year. Party like it's 2099.

  21. Cynicus,

    I'm a bit late onto this topic so you might not read this comment but I'd like to know your opinion on this
    Your predictions of a dollar collapse are seeming less likely since everyone else is collapsing first. If the dollar collapses last then we'll all be back in balance again.

    On another note, being not at all literate in the world of big finance, why is it not possible for each of the countries in trouble to look through their debt positions and trade them back to each other and cancel them out i.e. Greece owes UK £6bn, UK owes Greece £5bn - therefore just call it quits as Greece ows UK £1bn. I've just cut the Greek deficit by £5bn - woohoo.

  22. Cynicus what do you think about the theory that nothing now can save us. As is being made clear the austerity measures - that you seem to support are causing deflationary problems on a massive scale in the countries they are being used in. This means the markets are jittery about possible double dips and jittery about Greece entering a horrible recessionary scenario.

    So it seems we are damned if we cut and damned if we dont. And what is worse - default or ten years of depression - which is what some commentators think Greece now faces.

    Also what do you think to the US move on the IMF lending to the Euro and the German move to stop naked short selling?

    Interesting times.

    Suzy Smith


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