“To be, or not to be, that is the question,

Whether ’tis nobler in the mind to suffer

The slings and arrows of outrageous fortune,

Or to take arms against a sea of troubles,

And by opposing end them.”  Hamlet, Act III, Scene 1.

It seems, after nearly 30 years of deregulated markets, that we face a sea of troubles ourselves. An extreme global debt deleveraging is upon us, the numbers too outrageous to even consider. Not only have we consumed beyond our means, we have mortgaged our future. Whereas once credit was difficult to come by and banks conservative in their lending (can you pay this back?), the brave new world brought us access to unlimited treasures, all paid for on a credit system, which had limited restraint.

As financial models became more complex and debt could be packaged, securitised and sold off, all sense of restraint was lost. Who owed whom was lost in a parallel universe of metaphor: swap, hedge, collateral, obligation, repurchase. Repaying principal and interest, in the old fashioned sense was put to one side. Can you afford the interest? Don’t worry about the principal, that will pay itself off as the price rises! Can’t afford the interest? Don’t worry, we’ll lend that to you as well, or have a holiday (from interest that is….keeps charging but pay it some other time). Tick, tock, tick, tock.

Maybe Hamlet wasn’t as crazy as he sounded.

As I explained in a previous post on the Euro, deleveraging debt is a painful process. As debts are written off, the money supply contracts, causing a contraction in the general economy. This creates a spiral where demand for new credit drops and this causes further losses to business, resulting in more job losses and so on. Traditionally, this has been dealt with by the lowering of interest rates, which hopefully stimulate demand for credit and reduce interest burdens. Sadly, this doesn’t work until the overhanging debt has been cleared out, by which time unemployment has risen and economic output has contracted to severe levels.

The road to austerity is a self-fulfilling process. Clearing the debt mountain will take many years and, perhaps, like Japan, it could be a decade or more. During that time people will be unemployed, machines will sit idle and resources will be untouched. In the 1930s governments stood back, waiting for the miracle of the market. None came. That is not a road we want to travel down.

As the shadow banking system starts to fall apart, it is time to plan and look forward to building a stable and local supply of money to see us through the hard times. Continuing to rely on overseas capital and ever increasing borrowing is a road to ruin. Our gross debt will hit $90 billion  by 2016, according to Treasury forecasts. The government talks of returning to surplus by 2015 but that is very optimistic. Even then we will still carry this debt for many years to come.

So is printing new money and spending it directly into the economy a better idea? I talked about this in a recent interview with Kim Hill and Radio NZ National, which you can catch here.

RadioNZ National Kim Hill interview

I have had an incredible amount of positive feedback since the interview and, interestingly, from a very wide range of people. There were a few comments about “funny money”, including a little pop from Nevil Gibson at the NBR. My answer to that is if you think this is funny money, try explaining the nearly $4 trillion that’s been used to buy debt off US banks! The feedback has confirmed the following: that there needs to be a clearer explanation on how the money creation process actually works (even though the RB has published on this here), that inflation needs to be better understood and that people are extremely concerned about the way the financial system is structured. We will be working on producing a simpler explanation to those issues.

In the meantime, around the world, there is a lot of new work being undertaken around the quantitative easing process and how that is not really working. Sushil Wadhwani (Goldman Sachs and MPC member in the UK) and economist (and former colleague of mine) Michael Dicks have looked at more direct interventions into the economy, noting that QE is a very roundabout way of trying to stimulate an economy. They look at directing lending to companies from the central bank and, more interestingly, at simply giving households a voucher to spend. You can read the brief paper here. Their proposals are in the right direction but do not go far enough. Nouriel Roubini recently wrote that direct spending on new infrastructure in the US would be much more useful than simply buying toxic bonds off failing banks.

What’s clear is that more and more economists and policy analysts are realising that QE is a sop to the banks, boosting their balance sheets and stock prices, at the expense of the taxpayer. Clearly this is a misallocation (and perhaps misappropriation) of taxpayer funds. Furthermore, even with trillions of $ of QE, there has been no inflationary effects at all. This is important to note when considering the direct injection of new money, as we have proposed, for the Christchurch rebuild.

As I noted in this recent piece for ChangeNZ, as long as there is surplus labour and resources, there will be no inflationary effects from new money. This has been confirmed from business sources, who note the economy is limping along at between 33-50% of capacity. So there is little concern over the direct effects of the new money in raising prices. The indirect effects through the banking system are also likely to be minimal, given a very low demand for credit across the economy. Indeed, with debt deleveraging in full swing, we are likely to see further reductions in debt, offsetting any new potential demand for credit. Still, credit numbers will need to be watched carefully and, at the same time, it’s important to note that the amount we are suggesting is only $5 billion. Ultimately the goal is a strong and locally managed financial system with price stability. That is something we have not had, despite the continuing myth of a central bank induced low inflationary environment. The time is right to consider an alternative way forward.

Perhaps we should leave the final words to Hamlet, as we ponder the road ahead:

“The undiscovered country, from whose bourn

No traveller returns, puzzles the will,

And makes us rather bear those ills we have,

Than fly to others that we know not of?

Thus conscience does make cowards of us all,

And thus the native hue of resolution

Is sicklied o’er, with the pale cast of thought,

And enterprises of great pitch and moment

With this regard their currents turn awry,

And lose the name of action..…”

 

 

 

 

 

 

 

The pressure is really on now for the Euro leaders (Germany and France) to come up with a permanent solution for the fiscal disaster that is the Eurozone. They have few options open to them and none of them are palatable to many. However, with the enormous burden of sovereign debt hanging over the Euro, they must make a move sooner rather than later or risk a complete blow up in the Eurozone debt markets which will lead to severe contagion a la 2008 meltdown in credit markets.

So what are the options?

1) One solution, which further develops the Euro project, is for full fiscal integration. This would be a major step and involve the Euro authorities taking over the management of individual countries fiscal responsibilities, outstanding debts and all future decision making over taxation and borrowing. It’s an ultimately surrender of financial sovereignty for all countries in the Eurozone. As with EU membership, this would favour the economically weaker countries as their borrowing rates would fall. Sadly for some, like Germany, their borrowing rates would rise, as there would be one single Eurobond, financed at an average rate of all the countries combined. It would most certainly be lower than the average rates now but still above where the most creditworthy (if there is such a thing) pay. The chances of this happening are slim to none, even though Merkel and Sarkozy have discussed moves in this direction. Behind this idea sits the possibility of a fully fledged Eurozone Government, the fear of many Euro-sceptics over the years. The reality is that this proposal can only work if there is a USE - United States of Europe.

It’s very hard to see this getting past voters in any country unless there is a financial meltdown of apocalyptic scale at which point “emergency measures may be justified” to coin a favorite term of “shock doctrine” watchers. For an amusing fictional account of how things may turn out, read this gem of a story “Berlin gets ready to leave the Euro”. Merkel’s electoral setback is hardly likely to shift matters forward.

2) The middle ground is for some of the weaker countries to leave the Euro and re-create their old currencies. These would be set initially at a rate which would enable some form of devaluation to help their export markets recover. This would entail quite a tricky transition process, both legal and financial, and the sheer mess it would cause logistically is enough to put many off, notwithstanding the theoretical attractiveness of a clean cut. The debt picture would be less fun: it’s hard to imagine anything less than a complete default if there was no further support from the EFSF . ANy debt denominated in local currency would face exorbitant rates meaning, in reality, those countries would not be able to borrow money. In effect, any country leaving the euro would result in default and an inability to raise money. The outcome of this would be complete financial chaos……initially. However, as with Iceland, it could lead to a complete restructuring of their economy at a completely new level.

In some ways this situation parallels that of some clients I have as a budget advisor. Some come with simple problems: a need to budget better, clear debt, sort out messy financial positions. However, some come with debts that are not possible to restructure in any way. They simply have no chance of ever repaying them, barring a lottery win. In these situations, they have been allowed to take on more debt than they can possibly service and often they have depreciating assets against an outstanding debt (a car for example). They are usually finished off by the compounding interest. It’s clear in these cases that lenders have been very, very sloppy. Often, as with professional investors, the search for yield or the desire to sell a loan overrides a proper analysis of the risk profile. This is how people end up with a debt mountain.

Insolvency is, sadly, the only answer. Life after insolvency is a, in current market parlance, an austere one. But it’s not the end of the world….life goes on. However, for the lender, it is a total loss…..though in many cases the debt has been packaged up and sold off, down the debt collection food chain.

Sovereign debt is no exception. Sure some countries can sell as much as they like (the US and Japan for example) but for others, with less collateral (whether in the form of private savings, trade surpluses or simply a reserve currency), there is a limit. Those limits have been breached and there is simply no way out. As I say to some clients: spend less, earn more or default.

This leads us nicely to:

3) Muddling along and trying to keep things as they are. This has been the course charted for the last few years: bank bailouts, sovereign bailouts and major cuts in public spending. This is akin to bailing out a sinking ship with water removed from one area whilst it pours in from another. As with option 1) there has been a reluctance to take action that would create some long term obligations for the major Eurozone underwriters (mainly Germany but also France to some extent). So funds have been created for special purposes to buy the sovereign debt of stressed countries. This has worked in part but again the markets can do the sums and see that they don’t add up.

At fault here, as usual, are the lenders. They have been happy to buy up sovereign debt on the basis that it’s too big to fail (TBTF) and that rates were attractive given the implicit support from the Eurozone. Why buy German Bunds when you can buy Greek paper at a much better yield? The market is supposed to be the restraint on government borrowing, knowing when to demand higher yields and when to say no more. But the post-EMU convergence desire for yield at any cost remains core to the investment approach of many. EMU was a big fudge to start with: how on earth did Greece, Italy and the other laggards suddenly reduce their budget deficits to 3%? It was all too tidy because it was always a political rather than economic project.

So governments spent too much and were able to borrow freely to support this. Investors were unconcerned knowing ultimately, it’s all underwritten by someone. The numbers now are too big and if underwriting as in option 1) is not the chosen path then the muddling along will have to involve some serious haircuts (read: partial defaults) in order for the system to continue to function. And why not? Investors have made poor decisions and have to pay the price. So why the reluctance to proceed down this route?

Well here’s where we get to the crux of the matter. European banks, and others, have invested heavily in sovereign bonds. If we see partial defaults or major restructuring then banks will be in trouble again and we will be back to 2008 in a flash. The reality is though that banks should have been allowed to fail back then with investors taking their losses as would be expected in a market system. Bailing out the banks in Europe and the US, whilst making no real reforms, has simply multiplied the problem and led us to where we are now.

At some point, the loss has to be taken by the investors and not the public.

It’s clear that none of the 3 options are palatable. But as I say to my budget clients, that’s the whole point. They never are. Debt is a miserable beast at best and when it climbs all over you there is no easy way out.

The Euro was always a pet project of Germany and France, a chance to unite Europe and create a powerhouse to rival the US and the ASEAN block. It was a project birthed from centuries of conflict and huge loss of life. Europe’s leaders stand at a crossroads. No path is easy to take: to go forward would see the European Project move towards its eventual conclusion, a true European Union. To go sideways means and end to the dream and a system in tatters.

The former is most unpopular, the latter a financial disaster. There really is no room for soft solutions here. It could be the end of the dream or the start of  a new future. Either way there are hard times ahead.

So finally Gekko is back. Last night I had the pleasure of seeing Wall Street 2: Money Never Sleeps. It doesn’t disappoint. It pushes all the right buttons and manages to communicate the current situation with reasonable clarity. I will be interested to see how the person in the street views it.

I enjoyed the quick hello from Charlie Sheen as Bud Fox and Oliver Stone made a few cameos himself. The plot was fairly straightforward but the message of the film was stark: the system is untenable and has been seriously abused. Sure Gekko used to buy companies and strip them down and sell them on: the ultimate art of financial efficiency and productivity improvement. But now it’s about financial engineering which has nothing to do with the business itself.

As Gekko notes in a speech to a group of students and alumni, the share of GDP generated by financial services got as high as 40%………it used to be around 7%.

This orgy of financial speculation has left our global economies in tatters and we rush to pick up the pieces. Blame lies all around so that shouldn’t be our focus (they lent it, you spent it!) but the ramifications are very serious. We know well that the global financial system nearly collapsed and after trillions of dollars in bail outs and stimulus, it still looks very shaky. Payback will be painful.

The new “Bud Fox” character, carrying the torch for alternative energy, asks the “bad guy” what his number is, how much it would take for him to walk away from the business. His answer: “more”. It’s become nothing more than ego, a game as Gekko would describe it. Ultimately it’s a loss of understanding and values. The disconnect between the financial markets and the real world has grown so wide that a chasm has been created, a big black monetary hole which is dragging us all in. This film has much more impact than Mike Moore’s recent treatise on capitalism because it paints a truer picture: the excess, the egos, the glamour….and the frailties of us all.

Susan Sarandon has a neat role as a nurse turned real estate speculator. She painfully encapsulates the shift from real, productive work to speculation on house prices. Needless to say she comes a cropper.

The bail outs continue and moral hazard is everywhere. Is Gekko redeemed? Not really. He’s more human but the guy still loves the game and is happy to play even under the new rules. The trillion dollar question for the audience is simple: will the rules be changed?

Don’t hold your breath.

So Basel III is finally with us…….phew……can’t wait for Basel IV. I’m not sure about a fifth one as that really would be a joke too far but then again if we can have a Rocky and Rambo V why not Basel V? We will really be up the creek when that one comes out. Is this one likely to change anything? No one seems to think so but then again 2 years ago I said the same thing about Basel II!!

It all comes down to leverage which now is well understood. The new capital requirements simply squeeze poorly capitalised banks a bit harder but really make sod all difference to the underlying problem which as we all know is excess credit creation. This credit creation is also known as money supply expansion. Are credit and money the same thing? well yes and no. When you get a new loan from the bank, you have received credit. This credit appears as money in your bank account and can be converted (though usually ins’t) into note and coin. But here’s the nub. Whilst money, the the form of note and coin, cannot be destroyed (ok you could burn it), when you pay back your loan that money is cancelled…in a puff of smoke. It only existed in your imagination. Of course that same “money” can be relent but new credit can always be created as long as there is enough “equity” in the bank…….come in Tier 1 capital and other assorted IOUs.

For example, the money supply in New Zealand has contracted by nearly $10bln in the period from Feb 09 to Jul 10. That’s why there’s no money in the economy……it’s goneski. But if we dealt in real money it would never disappear; once it was created it stayed in circulation or under your bed but it could not be destroyed.

The ability of banks to inflate and deflate the economy is still very much theirs with central banks acting like the lunatics they are by playing important games with their interest rates. They haven’t quite worked out the mess they made over the last 15 years by focusing on inflation and forgetting about asset prices, leverage and moral free speculation.

Gareth Morgan notes this in his take on it but again misses the real point, as does Basel 1,2 and 3 (and probably 4 and 5). It is the quality of money supplied into an economy that is the most important aspect of the economy. Copious amounts of speculative credit has blown out the “real” economy creating a mess which could take decades to unwind.

But we need to address this sooner or later….otherwise we will get the same maneuvering again ………or is it the same manuva?

Time for a book review.

I’ve just finished Michael Lewis’s “The Big Short”. It’s an amazing book, not just because it informs us of the road to the subprime mess but he creates a story around the protagonists. He also manages to expose the whole wretched mess, the fictionalisation of risk and yield laid bare. He introduces us to the main players in the debacle through the eyes of a few weird and wonderful players who worked out that something was terribly wrong and bet against it. These colourful characters expose the whole damn scheme as nothing more than a paper pyramid.

As Lewis sums up the Collateralized Debt Obligation (CDO) on page 73:

“The CDO was, in effect, a credit laundering service for the residents of Lower Middle Class America. For Wall Street it was a machine that turned lead into gold”.

Simply put a CDO was a collection (a tower) of subprime loans that had miraculously transformed from junk status to triple A (AAA) credit and therefore it was investible by major funds (referred to in the book as dopey Germans).

So what was the short? Well on one hand you had investors who sold insurance on these debts defaulting. They believed (incorrectly) that it could never happen and therefore they were picking up free money. The shorters realised the were getting amazing odds on the loans defaulting and piled in.

At the bottom of this was an average person with no money and a big mortgage, usually 100% or more. Any fall in the price of their property would immediately put them in a default position. Yes it was a giant pyramid scheme. The real laugh is that even the guys going short didn’t really understand what it was they were shorting so opaque was the structure and process.

I recommend the book very highly. It’s a gripping read and manageable for the layperson.

You’re left wondering how the bankers got away with it. The answer given by the bankers (well laid out in Sorkin’s book) was that they were too big to fail.

This sets us up nicely for the next round.

P.S.

Today the SEC is launching a case against ICP Asset management for their role in handling CDO investments. Along with the case against Goldman Sachs we can expect more companies to be investigated for their role in this financial fraud. It will also be interesting to see when the rating agencies themselves will come under review. They were the ones who gave the AAA blessing to these products they really knew very little about. Makes you wonder about the whole darn shooting match!

It’s taken me a long time to get round to this post. My eyes have been glued to the train wreck that is European fiscal management. Who could forget the financial gymnastics performed by many EU wanna-bees prior to EMU integration. 3% budget deficit….no problem said Greece….we have some very good accountants in Athens.

So the chickens have finally come home. And now the Euro project is in harms way. Or is this just the next stage in complete sovereign consilience? It’s fiscal consolidation or that’s the end of the road.

The real problem, if you look hard enough under the falling limbs of the EU forest, is simply debt and its modern bedfellow, leverage. The financial binge of the last decade, built upon market deregulation in the 80s, has simply finished. Apres le binge, le deluge as they might say in Paris. A bad hangover is one thing but watching bankers get on the big white telephone is no fun at all.

The debt binge primarily was brought about not so much by low interest rates (though that helped) but by the belief that capital gain was guaranteed. Stocks always go up in the long run, property always goes up in the long run…..don’t worry about income, just borrow as much as you can and buy an asset. These financial assets have become a magnet for all investors and, naturally, sellers of investment products. I wonder how many people are holding derivative products which allow them to catch the upside of the stock market with no risk unless the market falls 50%….oops. Certainly Mr Buffet has a few of those.

The return to a time when people invested in companies based on their fundamental performance and bought houses to live in is long overdue. That people cannot afford to buy a home is without doubt the result of excessive lending by banks over the last 30 years. This is the root cause of the problem. Banks have actually created the inflation we have seen in financial assets….unearned income to be exact. That asset price inflation has seen real wages fall heavily over the years consigning the average wage earner or those unable to access leveraged credit to a lifetime of renting and debt.

The maths of excessive leverage is the simple maths of compound interest….compounded.

As Paul Volcker noted in this recent piece,

“There was one great growth industry. Private debt relative to GDP nearly tripled in thirty years. Credit default swaps, invented little more than a decade ago, soared at their peak to a $60 trillion market, exceeding by a large multiple the amount of the underlying credits potentially hedged against default.”

The bottom line is very simple: we have spent our GDP already….for many years hence.

Now it’s payback time. The payback process could take many forms: bankruptcy, forced asset sales or a slow descent back to a normalized level of activity - actually living within our means. Stripping away the financial sector so it works for people and business rather than conspiring against them will be the first requirement: not so much regulation as reengineering.

Whichever route we take it will be a painful adjustment made worse by the fact that those who are in charge are actually responsible for perpetuating the current system or refusing to question and change it.