Sunday, 23 October 2011

Occupy What?

23rd October 2011
The Malta Independent on Sunday

It had to happen! The untold misery brought about by the recession caused by the financial turmoil that started in 2007/2008 and is still rambling on, inevitably motivated the anti-globalisation crowd, often rowdy, violent and detestable, to morph into a much more convincing and civilised ‘Occupy Wall Street’ movement. This has been exported internationally, with the ‘Wall Street’ bit in the title being adopted by different nations to parallel home symbols of financial excess.

While the ‘Wall Street’ brand is a powerful representation of capital markets which people can easily connect with, it is rather a misplaced target. It is the financial markets rather than the capital markets that have brought the world’s economy to its knees, and the financial markets are not traded on Wall Street but are mostly traded on the invisible inter-bank electronic markets.

What the protestors are probably promoting is not the physical occupation of New York’s Wall Street, London’s City, or Malta’s Castille, but really their banner is notionally ‘Occupy us’; give us a job; restore our human dignity; don’t let us pay for the excesses of greedy bankers who are still enjoying their multi-million dollar bonuses from transactions that eventually brought about the crisis; spread the adjustment pain more equitably; don’t let the banks, in spite of the damage they caused, to remain masters of the universe abusing their too big to fail status.

That something is wrong with the world financial order is best glimpsed from two odd facts.

Is it not strange that we are caught in a situation where the poor of the world are financing the excesses of the rich? China, India, Russia, Brazil, Indonesia and the like, with balance of payments surpluses, are the major holders of US Treasury securities, mortgage bonds and such like US securities. Logic would indicate that Third World countries where poverty is still prevalent and where the average per capita GDP is a mere fraction of the average US per capita GDP, would better employ their surpluses to develop their own economies rather than buy US debt.

However, logic does not always prevail. There is a limit to how fast emerging economies can develop without igniting damaging inflation. Economies have a limited absorption capacity for new investments particularly as one has to bear in mind that such investment is generally concentrated in major cities, forcing fragile population shifts from rural areas to urban city centres. There is a limit to how fast cities can grow to accommodate such shifts without creating social problems which would challenge the stability of the political structures.

Take China. Having millions over millions of rural undernourished peasants spread in the wilderness of greater China does not offer much challenge to the stability of China’s central command. However, having a few concentrated millions forced to live in inhuman conditions in city centres with dashed expectations of a much better life, can be a formidable challenge to the political stability of the regime. China thus can ill afford to have annual growth rates below eight per cent p.a, but will be hard put to push growth rates above 10 per cent p.a. without stoking property bubbles and inflation fires.

China is unable to allow its surpluses to seep into much higher consumption rates by its population because, inflation apart, this will of itself widen the income gap between the top echelons of society and the rest. This cannot sit too comfortably with stability for a communist regime. China is thus forced to park its surplus in US Treasuries and has become the US biggest creditor, to the extent that China loudly complains when the US, benignly or otherwise, neglects to protect the exchange value of its dollar.

The other odd symptom of the troubles plaguing the financial system is the remuneration realities in the financial sector and the rest of the economy. When a structural engineer designing bridges that add wealth and efficiency to the economy is paid less than 10 per cent of the remuneration package of a yuppie financial engineer who puts together financial products with strange names like MBS, CDO or CDS that few understand and which add little value to anyone but the bank designing them and selling them, then something must be wrong somewhere. So wrong that we have seen traditional economic powerhouses, like the US and UK with traditionally strong manufacturing bases, lose their productive strength through migration of their industries to cheaper locations resulting in dangerous concentration of their economies on the financial sector. In the end, the modern day poorly regulated financial sector produces nothing but short-term profits at the expense of long-term damage when the bubble bursts.

There is never an easy solution to problems that have accumulated over several years and when strong petrified imbalances have to be addressed through painful reversal of well-ingrained policies with many vested interests defending the status quo. And no one has yet come up with a feasible true solution to the current crisis.

We have been fire-fighting the crisis and in the process shifting the problem from one sector to the other rather than addressing issues at their true sources. We have seen governments coming to the rescue of financial institutions, exposing taxpayers money to risks without commensurate return; governments sinking to their ears in debt and having no room left to stimulate economies in distress in terms of classic Keynesian teachings. Government debt has in many instances reached unsustainable proportions raising doubt on their ability to service and repay their debts. This has shifted the problem back to the banks that hold on their balance sheets plenty of such sovereign debt, traditionally considered gilt-edged but now increasingly doubtful.

Where do we go from here, is the obvious question. World leaders seem unable to embrace the problem. The US is in political paralysis with the President and Congress unable to agree on a sensible economic policy. With elections due in 12 months’ time no party is in the mood to compromise and the election result is perceived as the ultimate resolution. In the EU there are too many leaders but no one is in overall charge. Emerging economies have a problem switching their economic model from export-led to one based on internal development and increased consumption. Supranational organisations like the IMF and the World Bank do not seem to have either the resources or the moral authority to knock heads around to orchestrate an international consensus for a co-ordinated approach towards a real solution. G-20s, G-8s or G-n’s over-promise but consistently under-deliver.

In the absence of some political strong and co-ordinated political leadership that can frame the problem in a language that people can understand, make proper exposition of the consequences if problems continue to be neglected, and orchestrate a co-ordinated solution that spreads the pain equitably among surplus and deficit countries, the only solution left would be a choice between a deep depression or a prolonged recession accompanied by inflation, which, over a number of years can work its way to making debt burdens more sustainable. In any event, the greatest burden will fall on the weakest.
Occupy Wall Street and similar movements are important to raise sensitivity about important issues but they never offer true solutions. Like similar popular movements, Occupy Wall Street and their like have a clear idea of what they do not want, but rarely have any clear ideas about what they actually want or how to achieve it

Alfred Mifsud

Sunday, 9 October 2011

Breaking a Circular Problem

9th October 2011
The Malta Independent on Sunday

Finally push has come to shove! As the Italians say: “Il nodo รจ arrivato al pettine”.

The financial crisis of 2008 and consequential recession was (is) not a normal recession – it was a balance sheet recession, not a cyclical one. In a cyclical recession, the financial sector remains strong and acts as the transmission mechanism for fiscal and monetary stimuli to pump prime the economy back to health.

This time, it is the financial sector that has caused the recession. Banks lost their capital through bad investments in overpriced property and property-related financial assets and, following the Lehman Bros. collapse, the US and UK governments had to intervene to recapitalise their banks to keep them afloat. The European Central Bank (ECB) is having to provide unlimited liquidity to EU banks to replace sources of wholesale inter-bank funding which are drying up.

After an initial stabilisation and some sort of recovery between mid-2009 and early 2011, it became evident that rather than having been resolved, the financial problem was transferred from the banks to the sovereigns. Governments had to incur huge debt burdens to support banks at the same time as fiscal revenues were experiencing severe reductions, resulting from reduced economic activities: lower taxable profits by banks and less revenue from property sales, as the real estate market collapsed.

Unable or wary of taking on more debt, the expiry of government stimuli support showed that, without such support, the economy started to stutter. This happened at a time when banks were coming under renewed stress due to ‘hidden losses’ on their balance sheets caused by their investments in government bonds, formerly considered “gilt-edged” but now turning doubtful as governments are having difficulty managing their debts.

So we now have a circular problem. Banks came under stress because of bad investments in property and property-related investment products. Governments came under stress when they had to save their banks. Banks came under stress again when the value of their government bonds turned doubtful.

Unless we break this vicious circle, the world will fall into a depression the like of which we have not seen in post-war history. And unless we break this circle, the Ricardian/Austrian economic school – which brought us to the source problem in the first place, with their laissez-faire policies of no, or light touch, regulation of banks and financial institutions – will be having both the first and the last laugh. They will have proved that government intervention has been ineffective in avoiding the recession and a great deal of resources would have been saved, had the market been allowed to bankrupt errant banks and errant investors.

In the eye of the storm there is the euro area. The recession has exposed the design flaws in the euro structure. Countries in depression are locked into a monetary union with a currency that is hugely overvalued for their domestic realities and consequently forced to go for internal devaluation (reductions in wages and entitlements) by austerity bone-shaking measures which, in their immediate impact, tend to crush the economy rather than strengthen it.

I sometimes wonder whether these design flaws were purposely meant to arrive at the point of crisis that we are at today. At times of acute crisis such as the present, the unthinkable becomes the choice of the lesser evil. Formerly, no go areas such as fiscal union, eurobonds, economic government and the like, which transfer a huge slice of sovereignty from individual states to a central government dominated by Germany and France, suddenly become not only possible but, for some countries in acute despair, a welcome solution.

Be what it is, the circular problem must be broken. Until we have restored health to EU banks, credit will not flow where it is needed for economic growth, and without an effective transmission mechanism, policy measures – be they monetary or fiscal – will prove ineffective. This means that banks have to be cleaned up. They have to market all their holdings of sovereign bonds and if that leaves them short of capital, they will have to be recapitalised. Once banks have enough capital, and once the value of their assets is no longer under suspicion by the market, then they can start being banks again, taking money from depositors and lending it to borrowers whose investments will help the economy grow sustainably.

Most EU governments have been hiding away from the inescapable need to recapitalise their banks by fooling themselves that they can restore confidence in the system by fiat rather than by sensible decisive measures. Isn’t it funny how, when she was the French Finance Minister, Mme Lagarde always insisted that French banks were generously capitalised and then no sooner had she put on her hat as managing director of the IMF, she changed course, stressing that it was imperative for European banks to be adequately recapitalised .

A perfect example of how politicians are often caught in a position where they cannot tell the truth – either because the truth would expose their nakedness or because they genuinely believe that people cannot handle the truth and that admitting the truth would depress optimism and enthusiasm for a solution.

Now that push has come to shove – with the forced rescue of Dexia by the French and Belgian government – everybody finally agrees on the need to recapitalise EU banks. Pretty soon, they will also agree that banks have to mark their sovereign debt holdings to market to establish the quantum of recapitalisation required and then, as part of the rescue of Greece and other countries in distress, the EU will also agree to debt exchange schemes offering banks a small profit on the written-down value of their sovereign holdings and sovereign borrowers, a substantial haircut on their debt obligations without going through the dirtiness of a forced default.

What the EU is continuing to shilly-shally about is who is going to fund the necessary recapitalisations. The general thinking is that this would be the European Financial Stability Facility, whose €400 billion resources could be leveraged to offer fire-power close to €2 trillion. This is a crazy idea. Leveraging at the centre to solve leverage problems at the periphery does not address risks, it concentrates them.

A solution has to be found through the mechanism of the ECB which is the only pan-EU institution that can operate autonomously with a speed that matches the market without having to depend on the slow democratic process of 17 member states each holding a veto. It would have been much more sensible for the EFSF funds to be used as capitalisation of the ECB to give it the fire-power to create an ECB-owned rescue/recapitalisation agency that could replicate the US TARP programme of 2008. The resources of such a fund would have been augmented by a 1:1 monetisation and by inviting contributions from other countries that have every interest in saving the euro, including the US, Japan, Switzerland, oil surplus countries and BRIC (Brazil, Russian, India and China) countries. This would have produced a genuine €2 trillion fund without crazy and dangerous leverage.

This week, Merkel and Sarkozy finally woke up to the fact that they cannot continue biting at the edges of the problem and must attack it at source in order to break the circle. Let us pray that they break it in the right way, as otherwise the circle will break them – and us.

Alfred Mifsud