Monday, October 31, 2011

Smoke on the Horizon?

A very quick post as I have had a rather odd email from a reader of the blog. I have taken out the identifying elements, but the email is as follows:

Just thought I would tell you about a letter I received on Friday from my bank,

I run a small business and bank with Santander in the UK.
The letter was to find out how big our business is.
They are creating a data base containing all small businesses eligible for the deposit protection scheme.

Smoke on the horizon?
This is some of the recent news on Santander, starting with:

Chief Executive Officer Alfredo Saenz told investors last month it may take three years for profit to “return to normal” in the face of mounting Spanish defaults and weakening earnings in the U.K. and Brazil. Santander expects to “approximately” match 2010 profit this year, he said today. The bank said it could reach a core capital ratio of 10 percent by June 2012, exceeding European requirements, without selling new shares and while maintaining its dividend policy.
“In Spain, I’m still a bit scared about the real-estate market because I still have the impression that there are more losses to come out there,” said Peter Braendle, who helps manage about $60 billion, including Santander shares, at Swisscanto Asset Management in Zurich. “Fortunately, Spain is only one side of the Santander story because they have a diversified business.”
And from the FT:

Retail and corporate customers withdrew £2.5bn of deposits from the UK arm of Santander in the third quarter of this year after the bank changed its funding strategy. Santander said it had moved to shift its funding mix away from expensive deposits by cutting interest rates on some accounts as it had been able to access cheaper financing elsewhere.
 And the UKPA:

Santander UK said it had also overhauled its customer complaints process, recruited 1,100 customer facing staff and relocated its call centres back in the UK to improve its service.
The bank admitted it still had more to do to improve customer service to levels of satisfaction in other areas of the bank. The group was the UK's third most complained about bank behind Barclays and Lloyds in the first half of the year.
The group is in discussions to buy more than 300 branches from RBS, which will add 30,000 small and medium-sized enterprise (SME) customers, which would take its share of the market to 9% from 4%. The deal is expected to complete towards the end of 2012.

 And the BBC;

The bank said it would increase its Tier 1 capital level to 9.2% by June 2012, which would bring it in line with criteria set by the European Banking Authority.
Smoke on the horizon? The most interesting part is that Santander has been losing customer deposits, and the bank's version of this is that the use of wholesale funding is a choice. This from the Financial Post:

Spain’s banks face a massive spike in their funding needs next year at a time when a credit crunch on wholesale markets and calls to increase provisioning against toxic property assets has made the sector’s liquidity a crucial concern.
Around 130 billion euros ($174 billion) of Spanish bank debt will come to maturity next year, according to Thomson Reuters figures. Many banks took on three-year, government-guaranteed debt in 2008, making up a large chunk of the borrowing.
but later in the same article:

Banco Santander SA, Spain’s biggest bank and one of the best-capitalised in Europe, issued up to 7.5 billion euros of three-month to 18-month commercial paper in September, paying between 3 percent and 3.75 percent depending on maturity.
On the covered bond side, bankers expect markets to stay closed for the foreseeable future unless a European-wide solution is introduced to deal with the sovereign debt issue.
In June, Santander struggled to place a 1 billion euro five-year covered bond, backed by a pool of loans the bank had made to regional governments across Spain.

Smoke on the horizon? You could read these articles many ways (if you read the complete articles, the picture is even less clear), but one thing that is certain is that any Spanish bank going to the wholesale funding markets is going to be treated with, at the very least, some caution. It seems odd that they might choose to opt out of the retail and corporate deposit markets in the current environment, regardless of how competitive they might claim those markets to be. It is also notable that in the environment that they are being squeezed two ways, with requirements for larger capital buffers, and facing a difficult market for raising capital. On the other hand, the letter in the email just seems odd, and might therefore be a badly timed administrative requirement, and the bank on a spending spree buying up RBS branches (but with access to deposits)?

I don't have time to go into more depth on this, as it is just an off-the-cuff article in response to the email, but I would certainly be concerned if my bank was in the Santander stable, regardless of the issue of the letter described in the email. I'll leave you to make up your own minds.

Thursday, October 27, 2011

The Price of Unskilled Labour

Bearing in mind the ongoing chaos in Europe, and other major stories, I am guessing that this post might appear a little odd. It relates to a single story, which is the problem of recruiting labour for farm work in Alabama. I do not know the agricultural sector well, let alone the sector in the US, and I therefore add this as a caveat for my discussion and my conclusions. However, I think it is worthwhile plunging on as (even if there are specifics that might confound my case) I think the principles still apply. I will quote the start of the story at some length:

Alabama farmers are facing a labor crisis because of the state's new immigration law as both legal and undocumented migrant workers have fled the state since the strict new rules went into effect last month.
So far, piecemeal efforts to match the unemployed or work release inmates to farm jobs are not panning out, and farmers are asking state lawmakers to do something before the spring planting season.

Farmer Guiseppe Peturis has a small operation — growing mostly vegetables on his family's 20-acre farm in Belforest, Ala. — and selling them on the corner in front of his house. His retail business has suffered since he appeared on the local news saying Alabamians don't want to do hard farm work.

Peturis says he's a Republican, but is no fan of Republican Gov. Robert Bentley's plan to get jobs for out-of-work Alabamians by passing the nation's toughest immigration law. Among other things, it calls for police to detain suspects if there's reasonable suspicion they are in the country illegally.

Peturis says he's tried to hire through the state unemployment office before, but didn't have much success.
"Two of them left in 30 minutes; didn't even tell us they [were] going to leave," Peturis says. "One worked an hour and says it was too hard on his back."
There are many ways to approach this simple story. One approach would be to note that the local workers are simply too lazy to do hard work, despite horrendous levels of unemployment in the US. From this, we could present a story of lazy rich country workers who think that the world owes them a living, who are not willing to get on with work, but would choose living on hand-outs rather than doing hard work. It is a tempting approach, and was my first reaction to the story.

However, I then thought back to a time when I finished my degree and had some time to fill between starting my first job. I needed money to tide me over and worked for a little while as a building labourer. I discovered the meaning of hard physical work. I can safely assume that working as a labourer on building sites remains just as hard. I also note that there is not the same kind of discussion of the necessity for immigrant labour to allow the building trade to continue. I also remember that, when I chose the labouring job, I chose it because it paid considerably more than, for example, bar work.

When I thought about this story, it occurred to me that perhaps the real problem is that the pay being offered is simply too low for the level of hard physical work that is required. The farmers have become used to being able to pay low wages to immigrant workers, and have not accepted that they must simply pay more for local workers. This means that the farmers costs must go up, and that means higher food prices. However, set against that, the demand for government hand outs would be reduced with the resultant drop in unemployment and there would be more tax paid to the government.

Nevertheless, there is an element of the first approach to the story that remains. It is that presumably unemployed people are choosing hand outs over working for low wages which they do not think compensate them for the demands of the work.

Although this story at first seems to be straightforward, it is actually discussing some of the complexities of trying to understand the real operation of an economy. The availability of migrant labour has seemingly allowed farmers to pay lower wages than local people would accept. This in turn has impacted upon the cost structure of agriculture, such that the expectations for the prices asked by farmers are, in part, determined by this cost structure. I do not know the details of the Alabama law that is referred to in the story, but it seems that Alabama has 'gone it alone' with regards to cracking down on migrant labour. This in turn leaves the Alabama farmers with a problem with their costs in relation to the competition.

The real problem therefore is not that Alabama has restricted access to migrant workers, but that it has acted alone. I suggested earlier that Alabama farmers had not accepted that they must pay more, but it is probably a case of them being unable to pay more without making a loss. The real question is to ask what would happen if migrant labour were to disappear across the whole of the US? If this were undertaken, if migrant labour was unavailable, the story from Alabama suggests that the wages for agricultural labour would have to rise to compensate for the hard work involved. This would lead to inflation in food prices, and therefore lead to a rise in the broad measure of inflation, and a fall in unemployment.

However, there are other potential consequences that might confound this scenario. For some kinds of produce, there is the potential for competition from other countries. Would the increase in costs in the US agricultural sector then lead to an increase in imports of produce? If so, it might be that, in paying higher wages to the local workers, the farmers would still face competition and might lose in that competition.

The real question here is about the cost of labour in the US. The problem is that, where there is potential for competition for imports, the cost of labour really matters. The problem is that, if labour is a large element of the input of a good or service, then the low cost countries are likely to win in competition. The agricultural sector has survived competition by importing relatively low cost labour i.e. labour that is willing to work for lower wages than local labour. The result of this is that there is cheaper food, but higher unemployment. Remove the immigrant labour, and agricultural wages will rise, and unemployment will be reduced. However, this might take place at the cost of certain sectors of agriculture going out of business, with a negative impact upon the balance of trade, and possibly a negative impact upon unemployment to offset the positive gains. 

As I said, this appears to be a simple story, and simple narratives could be wrapped around the story. However, it illustrates some of the problems in a world economy where there is greater competition between unskilled labour, even if it is not always obvious that the competition exists. There are some elements in this story which much of economic theory does not really capture, such as the idea that people think that there is a fair price for hard physical labour, rather than a market price determined by supply and demand. The supply of unskilled labour is large, with any unemployed person who is not disabled able to do the work. Nevertheless, it seems that this labour has a sense of a 'fair' price for this kind of hard physical labour so that, even though there is an oversupply of labour, the price of that labour must rise in order to access that pool of labour. Supply and demand does not explain this.

What appears to sit underneath the entire story is the cost of labour. I have made a case in this blog that the massive input of labour into the world economy has created what I have termed hyper-competition.  However, it appears that the story about the Alabama farmers appears to be an illustration of how the oversupply of labour is creating a situation of hyper-competition, at least in some agricultural sectors. The curiosity is the response of the unemployed US people, who simply think it is unfair to be paid so little for such hard work. As much as it would be nice to be paid higher wages, is it possible/realistic? Is it confronting the reality of the situation of hyper-competition? Can the US afford to keep people so many people unemployed? If my take on this story is correct (and again I highlight the caveat), then the story is a hard illustration of the problems that have come with the growth in the world labour force.

Saturday, October 22, 2011

The Wheels are Falling off....

Oh dear, oh dear. Is the the grand project about to come to a crashing end? The EU and Euro have never looked as fragile as at this moment in time. However, there is a caveat; there is still a strong determination to hold the project together. The question is whether determination is enough in the face of the conflicting interests of very differently positioned EU members and in face of the storm that is now assaulting the EU and Euro.

I will not cite any of the news on the ongoing problems, as just about all the media are talking about the same problems; the fracture between the French and German positions, the IMF's reluctance to provide further bailouts for Greece without banks taking a major 'haircut' on Greek bond holdings, the growing resentment of the 'bailees', the proposals for a true financial union.Then there are the problems of the banks that are exposed to the risks of multiple sovereign defaults.

For all of the determination of politicians to save the grand project, it seems that the prospects for the EU and Euro to crumble are increasing. Of course, the former does not create certainty on the latter. However, if the Euro does crumble, will the political drive survive the recriminations that will follow? It seems unlikely but, again, it would be unwise to underestimate the determination of those who support the grand project. The EU as an institution will fight for survival in the face of any storm, and still has support of many politicians throughout the EU.

You will note here that the questions resolve around politics rather than economics, but now the economics are driving the politics. This is, in some respects, a reversal on the foundations of the EU and Euro in which politics drove the economics.

For the moment, I would like to just speculate on the scenario that there is no final resolution (which seems likely) which satisfies the financial markets. If this is the case, the crisis will hit hard. The reason is very simple - it is not just Greece that is overextended; it is not the only country that is unable to pay back the money that has been borrowed. I have long talked of the fallacy of GDP, that it includes activity that is derived from borrowed money, and in particular includes overseas borrowing. The way that GDP is measured sees increased borrowing from overseas creating activity in the borrower's market, and this gives the illusion of 'economic growth'. At present, for example in Greece, the economy is contracting even with borrowed money creating activity in the economy, and that is a signal for the state of the other 'at risk' economies.

There are some really fundamental points to consider here. The first is to return to a theme of this blog. Countries are unable to borrow money of themselves; they can only borrow and spend money on behalf of the tax base. As such, whether people or businesses, the ultimate borrower is the taxpayer. Some economists delineate public and private debt, as if they were different. However, public debt is in the end private debt as it is taxpayers that must repay the debt, not the government. The government just serves as the legal entity that signs for the debt, and then acts as a conduit for the repayment and distribution of taxpayer debt.

When we consider the position of Greece, or any of the other 'at risk' economies, it is apparent why the crisis is taking place. There are two possible purposes of borrowing and these are 'borrowing for consumption now', and 'borrowing for investment'. For the latter, provided the investment increases productive activity, it is generally a good thing to borrow money. I say generally, as this is not always the case, and this is where it becomes rather tricky to explain the problem. For example, investment in a restaurant will result in productive activities of 'making good food' or 'making convenient food' and so forth. It appears that it is a good investment. The problem arises when the investment is based upon a mistaken assumption about the real number of potential customers and the real underlying spending power of those customers.

If many people are reliant on borrowing for 'consumption now' as a determinant of their ability to spend in the restaurant, then there is a potential problem in the future. It is actually a double-whammy. If the people are reliant on borrowing to increase their spending power to be able to afford the restaurant, there must come a point at which they can no longer borrow, as they must be progressively accumulating debt, and that means that their debt to income ratio will be moving towards a negative. As such, at some point, they must switch from borrowing to repayment. At this point, they no longer have the borrowed money to provide the spending power to go to the restaurant, but also will have less money to spend on other things that they would have been able to buy, if they were not repaying debt. This is the double-whammy.

Now, if we return to so-called government debt, and remember that this is the debt of all taxpayers, then it becomes apparent that, when governments borrow, they are increasing the spending power of each taxpayer, but at the future cost of the double-whammy. If we think of our restaurants, the investment in these appears to be an investment in productive capacity, but in reality it is investment in over-capacity in relation to the underlying size of the market. Borrowing for 'consumption now' by both individuals and government has encouraged the development of capacity with a finite life. Meanwhile, those parts of the economy that, without the borrowing, might have been sustainable, get hit by the double-whammy. Not only can the taxpayers now not afford x, they can also no longer afford y, as they are now paying for the borrowing for 'consumption now'.

If we add in the accumulation of so-called private debt, or debt to which an individual has personally consented and has a personal repayment obligation, then it is possible to see how an economy can become distorted in creating capacity that is, in the long term, unsustainable, and which distorts activity and investment into over-capacity.

Now, we need to think of an individual German worker, for example working in a car factory. Our German worker is productive and helps in creating value in assembling cars. He takes home a wage, spends some of his wages, but also saves some of those wages. There are many ways of saving money but, for simplicity, let's say that he places the money in a pension fund. Included in the portfolio of the pension's investment fund are Greek bonds. Those bonds have gone to the Greek government, which spends the borrowed money in the Greek economy. This input of money from Germany increases activity in the economy, and will allow, for example, more Greek people to have the spending power to buy a German car. This in turn encourages an increase in capacity in the German car factory where our German worker is an assembly worker.

If we think of the way the system is working, it is as follows; in aggregate, lots of German workers are lending lots of money into the Greek economy. This allows the people to consume more German goods and services. In the financial industry, they say that this creates assets for the German worker, but those assets are actually debt obligations from (in the broad) Greece. They are only assets if Greece is willing to return the value of the asset plus interest. The problem is that Greece as a whole has been borrowing for 'consumption now', and even borrowing for investment was in many cases just supporting investment which was supported by borrowed money for 'consumption now'. The financial institutions that claimed they were buying assets with our German workers' savings were in fact primarily providing money for 'consumption now' for the people of Greece. The deal with 'consumption now' borrowing is that it must be matched (and exceeded because of interest) in the future by the double-whammy of less consumption, unless there are increases in productivity.

This is not to say that all of the borrowing in Greece was for 'consumption now', but the parlous state of the Greek economy is suggestive that this was a major proportion of the usage of borrowed money.

Squarely in the middle of this, we have the banks that lent the money. On their books, they have so-called assets. These are of course, obligations for x to pay debt. My intention here is not to go into the complexities of fractional reserve banking which I will leave to one side. However, some of the 'assets' purchased are not funded by inherently speculative use of savings, but by deposits which the banks must return on demand. If a debtor fails to repay debt, then the asset is in fact a liability. If enough debtors refuse or unable to pay, the bank will have greater liabilities than assets. It is bust, and all the depositors lose. In addition, those who gave the banks money for speculation will lose money (e.g. pension funds).

Staying with the Greece and Germany example, the problem is that Greece does not accept the double-whammy, and to do so would see a massive drop in the living standards of people in Greece. They simply do not want to pay back the debt to Germany. In some cases, in the case of 'private debt', there is simply nothing left to pay the debt back with; some of the sectors of the economy supported with borrowing for 'consumption now' are collapsing. The overcapacity supported by 'consumption now' is disappearing and with it 'assets' are disappearing. In the meantime, in Germany, for example where our car assembly worker works, over-capacity starts appearing as demand for German cars in Greece declines. Whilst it is possible that this capacity might be directed to other markets, what happens when other markets (e.g. Spain) see similar declines? How much over-capacity is there in Germany?

The really massive problem boils down to this. Money has been lent into supporting 'consumption now', and this money was lent without ever really considering how the consumption now might be paid back. In part, this was down to the flattery of GDP figures, but also due to banking regulations that pronounced that certain types of debt were safe. The problem is that there is nothing left to recover when debt is used for 'consumption now'. For example, the cars purchased with borrowed money are literally consumed over time (I use a physical entity such as a car for simplicity, but I hope that you can see the same point with services). Unless the Greeks now produce things of equivalent value to repay the Germans, massively reducing their own consumption in the process, the loss must take place. Unless of course, the Greek economy has an overnight miracle of productivity growth....

Then there are the savings of the Germans. If Greece does not meet its obligations, then the savings that have been poured into so-called Greek 'assets' will disappear. Even if governments borrow (from where?) to support the banks/other countries, the problem is that they are borrowing on behalf of tax-payers in order to protect those same tax-payers from losing money on their own savings. They do not lose their savings now, but they still have to effectively repurchase the same savings through the tax system. It comes back to the idea that governments can borrow on their own account. They cannot.

At this stage, I would like you to take a pause for thought. I would like you to think this through for yourself, as it puts a whole new context around the pantomime taking place amongst the governments of Europe. The tax-payers of Europe are borrowing money to bail out the losses on their own savings? Every Euro used by government to fill the hole of losses creates an exact equivalent of a Euro + interest obligation from tax payers on the borrowing. It is, of course, an absurdity. As there is nothing but tax-payers to repay the debt, it can only be a redistribution of the losses. And whoever lends the money to fill the hole from the bad debt, will want interest for their lending. Tax-payers bailing out themselves?  Or, here is a thought, is it that the taxpayer money is being used to save the banks?

I am, of course, simplifying overall. I have just focused on Greece and Germany, and excluded all the other actors throughout much of the discussion. However, when considering the big picture, we can see similar networks of relationships between individuals, economies, banks, governments etc. In the end, it is all about borrowing for 'consumption now', without the ability of the over-consumers to repay their borrowing. Meanwhile governments claim that they can save the day, but they have absolutely no resources of their own to use to save the day. They only have their tax-base to fall back upon, so that they are using tax-payer money to save the same tax-payers (or banks) from financial loss. The interesting part of all of this is that, if you listen to the news, you would think that it is governments, not tax-payers who are borrowing the money to 'save the EU' or 'save the Euro', or save the 'at risk' countries. In summary, the whole pantomime is simply madness.

Friday, October 7, 2011

More QE, More Bank Bailouts....

I have several unfinished posts sitting awaiting attention. If I am completely honest, I am now overwhelmed with the number of subjects that I would dearly like to discuss, and am therefore procrastinating. China, the EU, the US, the UK, the banking industry and so forth; all facing, or potentially facing, crises. The magic wands of policy makers are now firmly bouncing off reality. Also, I have had an ongoing niggle, which is that it appears that the Economist magazine may have plagiarised the thesis that I have developed as an explanation for the world economic crisis. I will start with this subject, then give some comments on the current state of play in some stories of interest.

Has the Economist Magazine Plagiarised Cynicus Economicus?

According to, plagiarism is:

the unauthorized use or close imitation of the language and thoughts of another author and the representation of them as one's own original work, as by not crediting the author: It is said that he plagiarized Thoreau's plagiarism of a line written by Montaigne. appropriation, infringement, piracy, counterfeiting; theft, borrowing, cribbing, passing off.
The key part in the definition is that of imitation of thoughts without crediting the original author. As a longstanding reader of the Economist, I was interested to see that they recently had a special report on the world economy (link here to the introduction of the 18 page special report). On reading the report, I started out thinking things like 'good, they have finally understood this', but as I continued reading, it seemed that the structure of the report was based around my thesis for why we are in an economic crisis.There are several potential sources of the explanation for the economic crisis which may have been plagiarised, and I have listed them below:

Copy One on Huliq is a piece titled 'Underlying Economic Crisis Caused Financial Crisis', and appears to now be unavailable. This is perhaps the most comprehensive of the discussions, but is no longer available. Another version can be found in TFR magazine here, another version on the blog here, and another version again on the blog here. In addition, there are references and discussions of the thesis throughout the blog, and it informs much of what I write throughout the blog. The TFR version is a short introduction, but you will also find references to the ideas as far back as 2008, and see the development of the ideas behind the thesis from the early days of the blog. In addition to having very similar views to the above articles, the report is littered with other ideas that just happen to be exactly the views/theories/perspectives expressed in this blog.

The Economist special report has several elements which, up until now, I have never seen discussed elsewhere, and it seems unlikely that, by coincidence, they would all appear in the same place at the same time. I have listed just a few of the commonalities:

  • The financial crisis was caused by an underlying economic crisis - the savings of the East pouring into the Western banking system, rather than the financial crisis causing the economic crisis.
  • The massive input of labour into the world economy, alongside bottlenecks in the supply of commodities.
  • The massive demand for commodities (in relation to the above), as the emerging economies develop infrastructure.
There are many other similarities. Of course, the devil is in the detail. The Economist report is 18 pages in the hard copy version, so there is considerable detail in the special report which is different from the blog. There are some areas where the ideas of this blog and the Economist article diverge. For example, they do not follow my thesis about the world economy to the logical conclusion of the  hyper-competition and zero sum game. This would not fit with the editorial policy of the Economist, and I would be interested to see how the special issue was edited. However, even these ideas are partially visible in the special report.

Whilst it is flattering to see your own ideas reproduced, it is also beholden on those using the ideas to give credit for them to the appropriate source. The Economist typically gives credit to academic authors that they use in their articles, but perhaps the ideas of a 'mere blogger' are not considered as a source that might be given credit. Of course, it is always possible that, by coincidence, the Economist authors have simply seen the logic of the arguments of this blog for themselves. It is also possible that I am overstating the similarities, but I do not think so. Reading the special report, I was very clear in my mind that there was an uncanny similarity with many of the ideas of this blog. I would be interested to hear the views of the longstanding readers of this blog; do you think that they have plagiarised, or do you think that I am over-stating the similarities?

On a more positive note, at least the ideas are getting 'out there' into the mainstream.....

The Bank of England Printing Money Again.......

It comes as no surprise to that the Bank of England (BoE) is again embarking on money printing, otherwise know as quantitative easing. The CPI is at 4.5% and the RPI is at 5.2%, so inflation is marching upwards. This is what the BoE Monetary Policy Committee report has to say on inflation in their minutes for the September meeting:

The Committee’s view remained that the most likely near-term path for inflation was for a temporary rise to a peak of over 5% before the year end, in part reflecting announced utility price changes. Inflation was then expected to fall back sharply in the first part of 2012, with the impact of the change in VAT dropping out of the twelve-month comparison contributing around 1 percentage point to the fall.
It is really quite extraordinary. We have now heard about forthcoming falls in inflation for so long now that the BoE has no credibility on this issue whatsoever. Even more amusing is the letter to the Chancellor, which the BoE must write (yet again) for exceeding their 2% inflation target:

At its meeting today [the MPC] judged that, in order to keep inflation on track to meet the 2% target over the medium term, its programme of asset purchases should be increased to a total of 275 billion [...].
Yes, that's right; yet again, inflationary policy will be put in place even while inflation is rising, and whilst inflation is again missing the inflation target by a large margin, and yet again the medium term will sort it out. As I pointed out in a recent post, even the BoE has acknowledged the inflationary impact of QE. There are also some disingenuous moments in the letter, such as the discussion of 'domestic' measures of inflation indicating that inflation will 'contained'. However, the letter says nothing about international inflationary pressures; it's as if the economy of the UK is like the geography of the country, a financial island with no influence from the rest of the world economy.

Returning to the MPC minutes, they acknowledge that the fall in the value of sterling was responsible for the inflation (which has been the argument of this blog for a long while, but which the BoE did not factor into past calculations),and it also appears that there are varying views on more money printing. The one certainty I have about the nature of the debates in the MPC (not those that are published) is that the real reason for money printing is nothing to do with inflation. There are several possible reasons for the policy (1) They really believe that the economy needs to be 'stimulated' (2) They want to hold down the value of sterling, or see even greater falls (3) They want to pre-empt risks of the current positive sentiment in bond markets to the UK turning negative - a sort of insurance policy to ensure that gilt auctions have a buyer. As I discussed in my last post, the current state of policy chaos around the world, with potential for full blown currency war, seems to provide a rationale for the policy, but I would dearly love to hear how this is discussed behind closed doors.

Unsurprisingly, the Conservative party is now behind the measure as the general malaise in the UK economy deepens. Perhaps the most interesting aspect of George Osborne's endorsement of the policy is his repeated emphasis on the independence of the decision of the BoE. This brings to mind that he protests too much....

Coverage of the policy has been mixed. Alen Mattich at the Wall Street Journal argues that the BoE is engaged in ongoing policy mistakes, with this as just a further error in a catalogue of errors.  He worries, quite rightly, that the BoE is highlighting the risks of deflation, ignoring the risks of inflation, and is over-confident in the ability to tame inflation if it takes off. David Blanchflower, a former insider, says the following:

Concerns such as those expressed by Ros Altman – that QE2 is "another throw of the policy dice which could damage pensions, impoverish pensioners and increase risk in all financial markets" – have been raised. Mervyn King has responded to these criticisms and I agree with him: not doing QE would push us back into recession at a time when output is slowing and fiscal policy is tightening. Rising unemployment, falling incomes and slowing output would just be worse. So QE2 is not perfect but doing nothing is worse.
On the other hand, we have a commentary from a Conservative MEP in the Telegraph suggesting that:

According to the BBC, the Bank of England has decided to 'inject a further £75 billion into the economy'. Who knew it was that easy? I mean, why not inject £500 billion? Or a trillion? By the BBC's logic, it would surely make us the wealthiest nation on Earth.

I can't believe I'm having to write this, but nothing new will be manufactured, invented or developed  as the result of this monetary splurge, no services offered, no businesses founded. Rather, the money already in circulation – the money in your bank account, in your purse, under your mattress – will be worth less. The government, in other words, is helping itself to your savings – and, in doing so, is damaging productivity, disincentivising work and weakening the competitiveness of the British economy.

Perhaps the most interesting aspect of the commentary is that the MEP goes on to discuss QE in terms that would be used by Austrian Economists, such as counterfeiting. I say this is interesting, as it seems that Austrian economics appears to be reaching into the thinking of UK politicians, and this is the first time I have seen thinking so explicitly rooted in Austrian economic thought.

My own view is that I am against printing money in principle but, as I discussed recently, with increasingly extreme policy around the world, it may be necessary to react to the policy of others with extreme policy. This is why I would like to hear what is going on behind closed doors. If the policy makers are working against the extreme policy of other states, then perhaps, just perhaps, there might be some justification for this very high risk policy. However, I have never seen a justification for money printing that might overall justify the risks and damage that money printing might do. On the other hand, in the current climate of chaos in the world economy (of which the BoE QE policy is just another contributory element), it becomes ever more impossible to see how policies might this state of chaos, it seems that there are no clear answers.

The European Crisis

As the readers of this blog are mostly very well read individuals, I am sure that you will have heard about the latest ratings agency downgrades. This from the Wall Street Journal:

A pair of ratings downgrades sent the euro tumbling by more than a cent within an hour on Friday, bringing a jolting end to what had would have been the third-straight daily gain for the European currency versus the dollar.

When Fitch Ratings announced around midday in New York that it had cut its ratings on both Italy and Spain, it put a spotlight on the risks swirling around the third- and fourth-largest economies in the 17-member euro zone. If the downgrades further complicate those countries' capacity to borrow, it will likely raise fears that they will be unable to withstand a bout of "contagion" in their debt markets if, as many expect, Greece defaults on its debt in the weeks ahead.
The Italy downgrade wasn't a major surprise, as both Standard & Poor's and Moody's Investors Service had recently cut Italy's sovereign ratings. But Fitch's action on Spain came out of the blue. It hadn't put either country's rating under review.
The response from investors was swift. Having bid the euro higher through much of the day, when it was propelled by healthy U.S. jobs data and indications that European officials are becoming more willing to take aggressive crisis-fighting action, they rushed to buy dollars. Having been above $1.35 before noon, the euro was trading at $1.3390 at 1pm EDT, where it more or less spent the rest of the day.

The complexity of the mess of the Euro area almost defies explanation as it encompasses the European banking system, the US banking system, the politics of individual countries, and the economics of a failed monetary union, past and present regulation, and the ratings agencies. Add in a dollop of media madness, and you have a situation of almost unbelievable complexity.

Starting with the politics...we have a situation in which electorates threaten punishment of politicians for their actions. In the case of the potential rescuers, such as Germany, there is the unwillingness of the electorate to bail out the 'profligate' nations. In the case of those in need of rescue, there is the unwillingness of the electorate to be 'dictated' to by the rescuers. Then there are the politicians who are determined to rescue the grand European project in the face of the electorate, and the others who fear the consequences of a banking meltdown in the face of sovereign default (or who are basing their own positions in both perspectives).

The essential problem is that there is such heavy exposure in the European banking system to defaults on sovereign debt in the at risk states. This exposure can be laid firmly at the door of the Basel Banking Accords (see here for an extended discussion from 2008, but still applicable as an explanation), which set up a system in which European sovereign debt was considered to be 'safe', and where European banks were themselves considered to be 'safe'. In consideration of bank capital adequacy ratios, this encouraged the holding of this 'safe' debt. In Basel II, the ratings agencies were also placed firmly into the mix, with their central role in determining capital adequacy ratios based upon their ratings systems for assets, where their ratings determined what assets the banks should hold. Movements in the ratings then determines the solvency of the banks. The problems is that the ratings agencies might be described as useless in that they are reactive, rather than predictive. By the time that they react, the assets are already held by the bank as 'safe' and then become unsafe. With that 'unsafe' designation, the banks must then shore up their balance sheets....

What we now have is a situation in which banks are now sitting on a pile of 'safe' assets that are now 'unsafe'. It is all down to the idiocy of regulations from a bunch of supposedly smart people who actually thought that they could determine future risk. They didn't get the idea that, just by creating a system in which assets were deemed as 'safe', they would become 'unsafe'. As soon as an asset is declared as safe, thought and calculation, and the regulatory system itself creates an incentive to the over-issuance of the assets in question. It also relies upon organisations and individuals who are able to see into the future, analyse the complexity of macro and micro economics and so forth.

Throw a dysfunctional economic union into this mix, and it is no real surprise that there is now a massive crisis brewing. The problem is this. If the at risk states default on their debt, much of the European banking system will go down in a thunderous crash. With that crash, the very electorates that are determined not to support the bailouts of the at risk states will find that, with the collapse of the European financial system, their savings and pensions will be decimated. The alternative is that they pay for the bailouts, one way or another, through the tax system. In the case of countries like France, just to add to the toxic mix, there is the possibility of over-extending their own credit, and thereby risking their own sovereign debt position. The countries doing the bailouts risk creating contagion through the bailout process itself.

So where does the US banking system slot into this system, and why the pressure on the EU to sort out a massive bailout? This from Robert Reich:

That’s where Wall Street comes in. Big Wall Street banks have lent German and French banks a bundle.
The Street’s total exposure to the euro zone totals about $2.7 trillion. Its exposure to to France and Germany accounts for nearly half the total.
And it’s not just Wall Street’s loans to German and French banks that are worrisome. Wall Street has also insured or bet on all sorts of derivatives emanating from Europe – on energy, currency, interest rates, and foreign exchange swaps. If a German or French bank goes down, the ripple effects are incalculable.
Get it? Follow the money: If Greece goes down, investors start fleeing Ireland, Spain, Italy, and Portugal as well. All of this sends big French and German banks reeling. If one of these banks collapses, or show signs of major strain, Wall Street is in big trouble. Possibly even bigger trouble than it was in after Lehman Brothers went down.

Again, look to the regulatory framework that saw, for example, a German bank as 'safe' and EU sovereign debt as being 'safe'. Indeed, OECD banks in general were 'safe'. And so banks could leverage up without negatively impacting their capital adequacy ratios....leaving themselves ever more exposed to the point in time when 'safe' became 'unsafe'. Thus we have the multitudes of cross exposure of banks to banks, with derivatives exposures as a further ratchet.

The end result of this is a problem so profound that there really is no resolution. The scale of the problem means that it is impossible to do anything but delay the inevitable disaster. The politicians cannot undo the structure that they played a part in creating. It is simply too late. The only point I think I have not covered is the media madness. For this, exhibit A is Ambrose Evans Pritchard*, who has issued ever more hysterical commentaries, which are screaming that 'SOMETHING MUST BE DONE'. He is not alone, but is an exemplar. He offers the correct diagnosis (in some respects, but not with regards to underlying causation) that there is a horrendous crisis, but fails to see that there is nothing to be done other than delay the crisis. This is from a fairly recent sub-head from his column:

Europe, the G20, and the global authorities have one last chance to contain the EMU debt crisis with a nuclear solution or abdicate responsibility and watch as the world slides into depression, endangering the benign but fragile order that has taken shape over the last three decades.

Perhaps there is some undiscovered genius who can put Humpty Dumpty back together again, but at the moment, all the kings' horses and all the kings' men cannot put.....and that is the problem.

* I actually really like to read his columns, as he is a fantastic source of information (and I use this often), but most of his analysis is (to say the least) problematic.

Note: I was going to throw the new Basel framework into the mix, but this is already an over-long post....Apologies for the lack of posting but I have been horrendously busy.....