Sunday, 28 August 2011

When Confidence Goes

The Malta Independent on Sunday

Those who left on holiday at the end of June and return to their desk in September will find a different economic world they have to grapple with.

The world economy is in much worse shape than it was only a few weeks ago. Economic growth in the second quarter has slowed sharply and forecasts for the rest of 2011 and 2012 have been scaled back in all areas especially America and Europe. Even countries in the emerging world, which had kept the world economy going after the 2008 financial crisis, are now cutting down their growth forecast under the weight of measures to control inflation. Global share prices have dropped by some 15 per cent since end June and consumer confidence has slumped. Major corporations, rather than investing their cash hoards in innovation and new production facilities, in the absence of perceived growth in global demand, are buying back their own shares in the market at discounted prices or making acquisitions. None of this augurs well for future growth.

In the space of a few weeks, confidence about a steady even if slow recovery has given way to fears of a double dip recession. Confidence grows in small steps like going up a slow moving escalator. When it goes, it plummets quickly, like falling down a lift shaft.

Why this sudden change in sentiment` The answer to such question cannot be a single event. For some time it is mostly guesswork and educated hunches, rather than scientifically proven cause-effect dynamics. However, there is no doubt that the tragic earthquake and tsunami in Japan of last March may have been a trigger to set in motion a series of events that played on each other to reinforce a negative change in overall sentiment.

These dramatic events caused the disruption of the supply chain and loss of efficiency in production on a global scale. This came at a time when the Libyan crisis was peaking, causing loss of supply of high quality crude oil which forced oil prices to escalate as much as 20 per cent in a short time just when economic sentiment was already wounded by the Japan events. This double blow was followed by economic statistics which started to flow out in the beginning of July showing that economic GDP figures for the first quarter had been over-estimated, that expectations for second quarter were even lower, that job growth in the US had fallen off dramatically in May and June, that orders for new machinery had slowed down and that consumer sentiment had turned pessimistic.

In circumstances like these, Keynesian economics would argue in favour of additional fiscal stimulus on the part of governments. However, governments are suffering from fatigue of stimulus following the 2008 crisis and their debt situation does not permit much room for further stimulus which would demand increase public borrowing at a time when the bonds markets and rating agencies are showing increased concerns on the debt sustainability of the US, Japan and various European countries, both on the periphery as well as in the core of the euro area.

Such concerns kept the market under stress during July, but that was a sideshow compared to what happened in August when the markets normally take a nap while most operators go to the beach. Not this year! The trigger point was the unthinkable downgrade of the US credit status by S & P on 5 August following the political shenanigans in the US Congress for agreeing a last minute deal to raise the US debt limit without which the US would have defaulted on its debt. A new criterion was brought into the rating agencies dictionary. It was no longer the ability to repay debts, something that is never in doubt in the US, which enjoys reserve currency status; it was about the political willingness to repay such debt. The light-hearted manner in which the Republicans in Congress, held in bondage by the newly elected Tea Party right-wing faction, were prepared to accept default by the US Treasury not to sacrifice their credo for a smaller government, shocked confidence and made many other forms of formerly unthinkable matters no longer unthinkable.

Among such unthinkable matters was the implosion of the euro monetary system. This is no longer unthinkable and possibly it is no longer improbable. European politicians, handicapped as they are by the need to solve a Europe-wide problem but being accountable only to their domestic electorate on whom they depend both for democratic legitimacy as well as for re-election, have proved no match to the speed of the market which is driving contagion from the peripheral countries in genuine distress to core countries like Italy, Spain and France whose distress is only due to the psychological effects of contagion.

In circumstances like these, the major burden for saving the world from slipping into a prolonged recession or an outright depression rests with Central Banks. Freed from democratic responsibilities towards their constituents and enjoying autonomy in their operating structures, Central Banks can move with a speed matching the markets. Just as in the good times Central Banks are expected to take the punchbowl away when the party is getting too hot, in these hard times it is the responsibility of Central Banks to neutralise the political necessity to administer austerity in a low or no growth environment by loosening their monetary policy. The Federal Reserve in the US and the Bank of England have understood this by keeping their interest rates at near zero levels for a very long time and by undertaking various rounds of monetary easing (creating money by buying bonds on the market).

The ECB, moulded as it is in the Bundesbank tradition and influenced by its location in Frankfurt, has still to show that it understands the need to loosen monetary policy to the degree required by present circumstances. The mandate to be responsible solely for inflation does not help but the ECB would be failing its mandate if it allows the euro system to collapse or the euro area as a whole to fall into depression. Two interest rate increases in the first half of this year were therefore unhelpful if not downright detrimental. Some call such measures as crazily out of touch with what is happening on the ground around them in the economic terrain for which the ECB is responsible.

The underlying problem in the euro area is that many banks are zombies. They are only alive because they have been permitted to value their holdings of sovereign debts at a price unrealistically detached from their official market price. The market has considered the stress tests that have avoided this anomaly as being unreliable.

The ECB should take the bull by the horns and insist that EU regulators force banks to value their sovereign holdings at their true market price. This will mean that the equity cushion of many banks will be wiped out. So be it! To retain stability and confidence in the system the ECB should create a Euro Bank Recapitalisation Super Fund (EBRSF) – a European equivalent of the US TARP, which because of the EU structure cannot be a fiscal initiative like in the US – to recapitalise as necessary all euro banks that lose capital through the mark-to-market stress test. That is the only stress the market will accept.

As the ECB itself is now a holder of such sovereign debt, it may have to recapitalise itself as well.

In better times, the EBRSF will re-privatise its holdings of the equity acquired in euro banks through the recapitalisation process. It will refund the credit from the ECB and like the TARP experience in the US will not cost the taxpayer a single cent.

It is time for the ECB to bypass the politicians and let them play the games they know best in their quest to preserve power. The ECB has the ability to save the euro, which bears the signature of its president, through determined, imaginative and creative measures to address the existential problem that it is facing. It needs to show that with the ability it also has the will.

Friday, 19 August 2011

Limited Menu to Save the Euro

19th August 2011
The Malta Independent

“ Some countries have clearly run out of time and space to resolve their sovereign debt problems voluntarily.   But the single-minded focus on austerity to the detriment of sustaining growth, and the unwillingness of policy makers to see the Eurozone sovereign crisis as a regional systemic issue except through gritted teeth, if at all, are damaging to its survival chances.  …..  To be fair, the proposals agreed by European leaders on 21st July did make some progress, but can now be seen as part of a continuum of too little too late.”                                                  
  George Magnus – Economist 16.08.2011

George Magnus was one of the few economist who predicted the financial crisis of 2008.  This quote was pronounced on  the same date the Chancellor Merkel and President Sarkozy ( now jointly referred to as Merkozy) faced a press conference following their meeting in Paris and announced, to the dismay of the financial world,  that their plan to save the Euro is to introduce a financial transaction tax ( Tobin tax).
Anyone with a modicum of financial knowledge ought to know that a financial transaction tax can only be introduced if there is a G20 agreement for its global adoption.  The chances of this happening are zilch.   Even agreement about within the EU is unlikely given that the UK will oppose it  perceiving  it as a veiled attempt by Frankfurt and Paris to challenge London’s international financial eminence.

Finding a lasting solution for the Euro monetary system takes much more then dreaming the impossible and pretending that Germany and France have a moral authority to impose their views  on the whole EU and indeed on the whole world. 

The menu for a Euro solution has now narrowed down to three as shown in the accompanying diagram namely:

·          Increasing the fire power of the EFSF/ESM , the EU rescue mechanism.  Current resources are just about what is required for bailing out Greece, Ireland and Portugal but surely not enough should Italy and Spain need any bailout.
·          Issue of Common Eurobonds to replace the individual sovereign bonds.
·          ECB adopting what I refer to as Defensive Monetisation.

At the Paris conference Merkozy rejected outright the first two options and did not mention the third option at all.

There are good reasons why Merkozy ruled out a bigger rescue fund and the issue of a common Eurobond.   The first is only a short term solution without addressing the underlying problem that  too much austerity and too little growth       is no way to solve the debt problems of Euro countries in distress.   The second will find no political support for approval by the 17 Euro countries’ parliaments without it being framed within a restructuring of the whole edifice including the creation of a common fiscal policy and the creation of a common Euro Treasury which in itself is a red-line no go area for some Euro countries. In the present situation it would be putting the cart before the horse.

That basically leaves the last option of Defensive Monetisation as the only real option left to save the Euro.   The reason why Merkozy could appear relaxed at their press conference is because the ECB has now taken over the politicians’ fiscal role and has stabilised the markets by using its money creating properties to buy sovereign bonds of Italy and Spain on top of past interventions to support the sovereign borrowings of Greece, Ireland and Portugal.

The ECB is now the sovereign lender of the last resort for a big chunk of the Euro area.    So far the official line of the ECB is that this lending  to the sovereigns will not be monetised as the creation of money created through buying sovereign bonds on the secondary market will be neutralised by drawing back liquidity from the money markets.     Given its huge and increasing volume it is doubtful whether the ECB can fully neutralise such money creation at a time when it has to expand its liquidity programmes to keep  liquid banks in Euro distress countries.    Without  such liquidity support  at a time when such banks are losing domestic deposits and are finding difficulty to raise funding on the wholesale markets, many Euro area banks would implode.

I would argue that not only the ECB will not be able to neutralise money creation in this magnitude, but that it should not even try to.   The ECB is the only institution that can keep the markets steady as it can match the market speed through its autonomy which gives its manoeuvrability that is not available to political structures.       

The ECB is the only real entity that can practically save the Euro and address the underlying problems which are destabilising it, whilst concurrently honouring its mandate for price and financial markets stability.

The underlying problem is that many banks in the Euro area are zombies.    They are only alive because they have been permitted to value their holdings of sovereign debts at a price unrealistically detached from their official market price.    Stress tests that have avoided this anomaly have been considered by the market as unreliable.   Equity values of most financial institutions exposed to such sovereign risk continue in their downward trajectory.

The ECB should take the bull by the horns and insist that EU regulators force banks to value their sovereign holdings at their true market price.  This will mean that the equity cushion of many banks will be wiped out.   So be it!   To retain stability and confidence in the system the ECB should create a Euro Bank Recapitalisation Super Fund (EBRSF)         - a European equivalent of the US TARP which because of the EU structure cannot be a fiscal initiative like in the US – to recapitalise as necessary all Euro banks who lose capital through the  mark-to-market stress test.   That is the only stress the market will accept.

Once the problem of loss of confidence in banks  gets addressed,  banks will  become real banks again not zombies.   Credit will start flowing again.    Furthermore banks would be sitting on a portfolio of discounted sovereign bonds that can be converted by a market exchange offer into new debt for the sovereigns concerned who in the process can see a big slice knocked off their official public debt level.

A market driven exercise of debt reduction and banks driving credit again will be the essential ingredients to frame adjustment austerity programmes in a context of growth,  stimulating adherence and acceptance for austerity as a necessary if bitter medicine to straddle back to economic health.

Pain of adjustments would be spread beyond the citizens of the countries in distress making the adjustment more equitable and bearable.  Given that many sovereign bond holdings are cross-border, the pain gets shared with shareholders of foreign banks exposed to distressed bond holdings.   When things go bad it is normal for lenders and borrowers to share the pain.   In the process the claim that the EU’s rescue programmes are meant to rescue their banks not the countries in distress gets also addressed.

In good time the EBRSF will re-privatise its holdings of the equity acquired in Euro banks through the recapitalisation process.   It will refund the credit from the ECB and like the TARP experience in the US will not cost the taxpayer a single cent.

It is time for the ECB to bypass the politicians and let them to play the games they know best in their quest to preserve power.   The ECB has the ability to save the Euro, which bears the signature of its President, through determined, imaginative and creative measures to address the existential problem that it is facing.   It needs to show that with the ability it also has the will.

Alfred Mifsud

Sunday, 14 August 2011

Pavlov`s Dog and the Euro

The Malta Independent on Sunday

Pavlov’s discovery of classical conditioning remains one of the most important in psychology’s history. In addition to forming the basis of what would become behavioural psychology, the conditioning process remains important today for numerous applications, including behavioural modification and mental health treatment.

In his digestive research, Pavlov and his assistants would introduce dogs to a variety of edible and non-edible items and measure the saliva production that the items produced. Salivation, he noted, is a reflexive process. It occurs automatically in response to a specific stimulus and is not under conscious control. However, Pavlov noted that dogs would often begin salivating in the absence of food and smell. Pavlov set out to provoke a conditioned response to a previously neutral stimulus. A particular acoustic was chosen to be the neutral stimulus. The dogs would first be exposed to the chosen sound and then the food was immediately presented.

After several conditioning trials, Pavlov noted that the dogs began to salivate after hearing the acoustic stimulus. A previously neutral stimulus changed to a conditioned stimulus that then provoked a conditioned response (salivation).

The financial markets behaved like Pavlov’s dogs last Monday, the first time they opened for business after, on the previous Friday evening, rating agency Standard and Poor’s (S&P) took the unprecedented step of downgrading the sovereign credit status of the United States from AAA to AA+.

Credit Rating of AA+ is still a very strong accreditation, but it is not AAA. It was previously unthinkable that the USA, the most advanced economy in the world and in control of the world’s reserve currency which investors were willing to lend back to the US Treasury for 30 years at less than four per cent, could somehow be deprived of its AAA status. The thinking was that if the USA is not AAA than no one else is.

The unthinkable however had gradually been becoming less and less unthinkable as the US Congress danced close to the edge of the precipice before finding a last minute dirty compromise to raise the US debt legal ceiling. S&P explained that while the USA could still be considered AAA regarding its ability to repay its debts, the shameful and laborious way the debt ceiling was raised created nascent doubts about America’s willingness to pay its debt, especially if the extreme Tea Party right wing branch of the Republicans were to increase its hostage bond on the US legislative process.

On Monday morning, the markets across the world argued that if the US had been downgraded nothing else remained unthinkable, not the breakdown of the euro, not the bankruptcy of other strategically important financial institutions, not even a double dip recession or outright depression, especially as governments had run out of resources to continue supporting the recovery through additional fiscal stimuli. As a result, investors suddenly and without further analysis went into risk aversion mode and sold off shares and bonds to park money into cash, gold and US Treasuries. Yes, like Pavlov’s dogs, investors had been trained to park their funds into US Treasuries whenever anything happened that triggered risk aversion. It was however comical that the downgrade of US credit that triggered the risk aversion forced investors to rush like headless chickens into the same US Treasuries that had just been downgraded.

This could be tragically serious beyond its comical surface. The message that nothing remains unthinkable is forcing financial capital markets into a sudden and spurious meltdown in values. This adversely affects consumers’ confidence, economic tempo, and investment plans. Suddenly, a slow but fragile economic recovery turns into a self-fulfilling recession turning the spurious into real loss of value. In this context, the euro debt problems shift from serious to life threatening. Solution to the euro debt problems largely depends on recovery of economic growth so the austerity measures can be alleviated by some hope of sustainability and return to normalcy. In the context of a double dip recession, the austerity burden becomes unbearable.

It is clear that while the US credit downgrade on 5 August triggered the current turmoil, the ultimate source is also shared by the inability of EU political leaders to get ahead of the market curve and take the hard political decisions needed to force the market to look at the EU as a whole unit rather than judge it by its weakest links.

Some weeks ago I was in favour of our contributing, as a still solid link in the EU chain, our fair share for the Greek bailout. Given developments since, I am changing my opinion. Unless EU leaders get themselves ahead of the markets, piecemeal bailouts will ultimately mean there will be more members in the rescue ward than rescuer members. Contagion will make sure that is a given.

Contagion can only be stemmed by a ‘shock and awe’ solution. This comes in two versions. Either a massive increase in the size of the rescue fund with contributions from sources outside the EU including China, USA and oil exporters; or a major political change in the EU set up permitting the issue of EU-wide Eurobonds on the credit status of the whole euro area rather than on the credit status of the individual components. Such a decision will obviously be the precursor of an eventual economic union, including a fiscal union that will be only one step short of a full political union.

In the absence of either of these measures, the euro system is doomed and will blow out probably sooner rather than later. So, without one of these two measures, I feel entitled to reverse my opinion and counsel against further contributions to bailout without one of these two measures being included in the package alongside the austerity for members seeking rescue.

Big changes in the EU only happen at five minutes to midnight when a strong crisis would be knocking at the door. Unfortunately, that’s the way the EU works. But we cannot continue behaving like Pavlov’s dog in the face of serial demands for bailouts.