Archives for February 2012

The Super Mario Brothers – changing European politics

Last November saw the two Marios, Draghi and Monti, take on key positions within the Eurozone; Mario Draghi as President of the ECB succeeding Jean-Claude Trichet and Mario Monti succeeding the Silvio Berlusconi as Prime Minister of Italy. Both were appointed rather than being democratically elected but importantly both are hugely experienced within European politics and highly regarded and trusted by their peers. Both have moved fast to create change in their respective areas and together can be seen to be challenging the old power balance within the eurozone away from a Franco-German dominated politics towards a more truly European version.

November was also the period of greatest intensity in the sovereign debt crisis, when Italian 10 year government bond yields exceeded 7%, threatening a global banking and financial markets disaster. Mr Draghi acted decisively in December, cutting the ECB’s key interest rate and then announcing a new policy of Long Term Repurchase Operations, offering unlimited liquidity to Eurozone banks for a 3 year period at only 1%. This new policy has turned out to a marvellous euro-fudge. To German-minded Central Bankers a LTRO is not equivalent to the Anglo-Saxon policy of Quantitative Easing (aka printing money) that they loathe so vehemently, but is a liquidity-management tool which Central Bankers would be expected to deploy at times of crisis. The liquidity is merely lent to the banking system on the basis of collateral, it is not the creation or printing of new money. However (a) the scale of the operation, being unlimited, (b) the long time period involved, prior to this the ECB had never offered such facilities for longer than 1 year and then only in the darkest days of the 2008-09 crisis, and (c) the 1% rate, a zero premium to the official rate and thus creating no stigma for a weak bank being forced to pay higher rates for emergency liquidity, all meant that the short-term effects of this policy are remarkably similar to those of a policy of Quantitative Easing. The financial markets have certainly responded in such a fashion as the dangers of a eurozone banking crisis have receded.

Mr. Monti was effectively installed by Merkel and Sarkozy after they forced the departure of Berlusconi. Despite having enormous wealth and a population and an economy equivalent in size to France, the lack of growth in the Italian economy and its enormous level of national debt meant that it was seen as the weakest of the large European economies. Monti earned his stripes as the EU Competition Commissioner, taking on and defeating both Microsoft and Hewlett Packard in well-publicised battles over their monopoly powers. He has surprised many with the speed and ambition of the fiscal and economic changes he has forced through the Italian parliament, taking on many of the protected special interest groups which benefit from rigidities in the regulatory system. He is clearly aiming at delivering the significant structural reform to the Italian economy which is so badly needed and which Berlusconi failed to deliver.

Having gained credibility with his actions within Italy, Monti has used the fact that Merkel likes and listens to him to argue with Germany about its single-minded focus on austerity as the only tool to restoring the European economy. In recent weeks the tone of German thoughts on the European economy has changed towards the need for greater pro-growth policies. Italy now has a seat at the top table when these matters are discussed.

Sarkozy and France appear to be the losers in this power shift. Sarkozy was very quick to ensure that he maintained a French presence at the top of the IMF by getting Christine Lagarde to replace Dominique Strauss-Khan, but that has cost him a key voice within Europe, where she was well regarded but it has not really helped in terms of getting the IMF to be pro-Europe. It is noticeable how much quieter Sarkozy has been since Monti’s arrival at the top table. This may reflect his domestic political weakness – he faces re-election in May and with current polls suggesting he is set to lose, he has been forced to ask Merkel to campaign for him in France. The Franco-German axis in Europe which has dominated European politics for the last few years is breaking down as Germany is now the clear leader and then below are a newly-weakened France and a newly-strengthened Italy. A greater Southern Europe perspective is just beginning to have an effect on the way in which Europe is now being run.

Is “Europe” more important than democracy or the rule of law?

The desperation of Europe’s leaders to protect their banking systems from the effects of the sovereign debt crisis is leading to startling decisions and actions which call into question their commitment to the principles of democracy and the rule of law.

Last year Merkel and Sarkozy made it clear that Europe required Italy and Greece to install technocratic leaders in order to force through the austerity and structural reform measures that Europe deemed necessary if it was to consider continuing to support these countries through their financial crises. When the previous Greek Prime Minister suggested holding a referendum on adopting austerity measures last November, he was told in no uncertain terms by Germany and France that this was unacceptable. European referenda have a nasty habit of delivering results that the political elites do not like.

Then last week, Wolfgang Schauble proposed that Greece should postpone its general election due in April and extend the life of  its technocratic government. The sub-text was very clearly that Germany feared an inappropriate result that might lead a new Greek government to renegotiate the terms of the E130bn bailout after it had been agreed and Europe had committed substantial sums of money. From the rulings of the German Constitutional Court in recent years, it is quite clear that if anyone tried to push the Germans in similar ways, the reaction regarding the primacy of German sovereignty and democracy would have been extremely forthright. To a great extent these demands resemble the power battles between debtors and creditors in a failed company, where the creditors can take full control of a company’s assets when it cannot meet its obligations, but countries are not companies and voters are not shareholders that are automatically disenfranchised upon bankruptcy.

Perhaps even more worrying is the ECB’s action to ensure that it has greater rights than any other owner of  equivalent securities in the financial markets. By demanding that its Greek government bond holdings be converted into other bonds that will have priority over all other Greek debts, a few weeks ahead of a plan that will see all other Greek government bond holders lose approximately two-thirds of the value of their holdings in a “voluntary” haircut, the ECB is at the very least flouting financial market convention that all holders of a security should be treated equally. At its worst interpretation, in a situation where there will be limited assets to repay the debts, it can be construed as theft.

Worse still is the implication for any other sovereign European bonds that happen to be owned by the ECB. The greater the ECB ownership, the worse-off are all other private holders of other European debt as their rights to repayment now rank below those of the ECB (in credit markets this is known as subordination). Thus the creditworthiness of all European debt in which the ECB has a stake has been even further reduced. This is likely make it more expensive for these issuers (Portugal, Ireland, Italy and Spain) to raise money for a very long time to come. Future sovereign crises are now in danger of setting off vicious cycles of ECB intervention buying sovereign debt in the secondary market leading to private sector investors selling down their positions as they become less creditworthy so worsening the crisis.

To be sure there are no easy choices in solving  the euro sovereign debt crisis, but the longer term costs of some of the solutions that are being called for and implemented may well be far higher than currently understood.

PS – it also appears that Greece’s creditors will take over the national  gold reserves too.

Reasons to be happy – if you own gold!

Gold is money whose supply is not decided at the whim of human leaders. Annual gold production is about 1.5% of the total amount of gold in existence, so it is the demand for gold which determines its price. In contrast the major paper monies of the world, the dollar, euro, yen, pound  and Swiss franc all have Central Banks whose job it is to determine how much of their currencies to be created. Before the crisis, the rate of increase of supply of a currency was kept roughly in line with the nominal growth rate of their economy, somewhere around the 3-6% per annum range. However in recent times, this has gone out of the window. The policies of Quantitative Easing seen in Japan, the US and the UK in the last few years have massively expanded the amount of money in their financial systems. In Switzerland, in response to the massive appreciation of the exchange rate, the Central Bank has made public on several occasions its intention to create unlimited amounts of Swiss francs in order to prevent further appreciation. The ECB (with its Germanic bias) has indicated that it would never a policy of Quantitative Easing, but within weeks of taking office as President, Mario Draghi announced 2 Long Term Repurchase Operations, which permit European banks to borrow unlimited amounts of money for 3 years at 1% and encouraged all banks to make full use of this facility – a policy which has similar short-term effects as QE. The supply of paper money across the Western world has increased sharply in recent years and the rhetoric of those in charge implies that they remain very happy to continue that policy for years to come if they feel it necessary.

Interest rates are very low. Gold brings no income return, and so tends to perform poorly when the income return on other assets is high. Today the opportunity cost of owning gold is very low since the return on other assets is so low. In addition, such low rates of interest tend to occur at times of low or tough rates of inflation and …

Gold is the best hedge against inflation. Recent analysis by Credit Suisse looking at the performance of different asset classes in times of rising inflation over the last 100 years, showed that gold delivered the best correlation to rising inflation. A relatively new asset class that might also do this is inflation-linked bonds, however were the inflation to be substantial the amount that would have to be repaid by governments would rise significantly and could cause a sovereign debt crisis. Gold is no one’s liability, unlike inflation-linked bonds, and in that sense remains the best inflation hedge.

Gold is a great hedge against political uncertainty. The Arab Spring has brought enormous political instability into the Middle East. One of gold’s huge advantages over other tangible assets is it very high value to weight ratio – and this fact has meant it is very portable. If a rapid departure from home suddenly becomes necessary, the most convenient medium for taking your wealth with you is gold.

Gold is an indicator of wealth. Through the centuries in both China and India (representing one-third of today’s global population), gold has been the first port of call for household savings. However from 1952-2002, Chinese individuals could not buy gold. Indian per capita consumption is over twice that of China, so the Chinese still have some catching up to do. At a national level, the reserves of many Asian countries have historically been held in dollars with very little held in gold (in sharp contrast to the Western Central Banks which have always maintained very high weightings in gold).

There are about 5 billion ounces of gold in the world and about 7 billion people alive today – that is about $1250 or £800 worth of gold for each person. Do you have your share?


PS Note too that Greece’s credxitors were quick to ensure that they can seize Greek gold.

Is Quantitative Easing reaching its sell-by date?

Nearly 3 years ago the Federal Reserve and the Bank of England, having taken interest rates to  just about zero but still believing that they needed to make policy even easier, announced a new policy of Quantitative Easing (QE) as their preferred route to help their economies recover. Recovery did followed, although in keeping with previous post banking crisis environments, this recovery has been weak and inconsistent. This unconventional policy was pursued because the conventional interest rate tool had reached its physical limits and with fiscal debt and deficits so high, so too had fiscal stimulus as a policy. The unconventional policy, QE, was the only thing left.

There are good grounds now for believing that the QE approach adopted to date is also approaching sensible limits. In the UK, the Bank of England will shortly own over a third of all UK government bonds outstanding – amazing as it might appear with a  trillion pound national debt which has doubled in just 4 years, there is potentially a shortage of government bonds. This is due to new, post-crisis rules on capital adequacy for both banks and insurance companies which drive these institutions towards holding many more government bonds. With many gilts also held as the underpinning of pensioner annuity payments, a continued steady reduction in the budget deficit could mean that there are simply not enough gilts available to be bought if the Bank judged that much more QE was necessary

In the US the enormous market in mortgage bonds issued by what are effectively government entities makes this less of a problem than in the UK, but it was very noticeable that the second round of QE in the US in 2010/11 resulted in a surge in commodity prices, including gold, which pushed up inflation in the US, reduced disposable income and contributed to a weakening economy, as opposed to the economic stimulus that was intended.

So if further Quantitative Easing of monetary may now be either not implementable or counterproductive, then what can the Central Banks do if they decide that their economies require further stimulus. Both the Bank of Japan and Bernanke have previously suggested that a further tool that could be deployed is for the Central Bank to buy equities in the secondary market and so push up equity prices. Terrific for shares and all those executives with share options, but it is not clear that this then leads onto companies raising new equity finance in order to invest which is the rationale for such a policy.

The problem for all monetary policy approaches post a banking crisis is that there are two economies, a financial economy which requires reliquefication, recapitalisation and write-offs of bad assets and a real economy which cannot gain finance from the financial economy and produce growth until the financial economy is cleansed and functioning again. In economic jargon, the monetary transmission mechanism from financial sector to real economy is broken and so QE although in theory a logical policy, in practice only gets adopted when things are so bad that it will not work.

The aggressive Quantitative Easing solution, which Central Banks have not yet adopted is “helicopter money”. This is where the government prints new money and drops it out of helicopters (or via tax cuts and higher welfare payments) into the real economy. This is very likely to work in boosting the economy in the short term (people have more money in their pockets and so go out and spend some of it), but it will not be long before there is an inflation problem. This is clearly an economic policy beset with risk and the reason that Central Banks prefer to work through the financial system, even though it does not function well – in Zimbabwe this policy led ultimately to the printing of Z$100 trillion notes.

Quantitative Easing is near its sell-by date – something different will be tried next, and whatever that policy is, it will mean more government interference in the economy and more (long term) inflation. Stay long of gold!

Rising income inequality – why is it happening?

The early 1980s marked major lows in income inequality in both the US and the UK, and has since risen steadily back to the previous peaks seen in the late 1920s – there has been a particular acceleration since in the 21st century. In the US today, the top 10% earn 50% of all income, and the top 1% earn 20% of all income. In the UK the figures are only a little less unequal. The Davos forum’s 2012 report recently cited income inequality as a global risk for the first time.

In economic terms, the reasons for this increasing inequality lie in the differing forces affecting the demand and supply of low or averagely-skilled workers and highly-skilled workers. At the lower-skilled end of the labour market, there has been an explosion of supply, China and India are estimated to have tripled the number of people in the world seeking industrial jobs – the world market price for such labour has thus come under enormous downward pressure. This is not just in low-tech, assembly manufacturing, but, given the strong emphasis put on education in both these societies, increasingly too in higher-skilled manufacturing and with the rise of the internet, in service sector roles where brain matters more than brawn. India produces 3 million graduates a year, most with good English and strong IT skills, for whom $20,000 is a very attractive salary. This factor, more than anything else, explains why the median real wage in the US is unchanged over 40 years – the standard of living in the US has risen only because more members of the household are working. As real wages have stagnated, it follows that company profits have seen most of the benefits of economic growth in recent decades.

These higher profits have enabled company executives at the top end of the labour market to receive very much higher pay – generally determined by board members who are senior executives at other companies. This has been compounded by two further factors. First, globalisation has enabled successful companies in one country to expand much more easily internationally – the complexity of managing such businesses and the skills required by executives have increased substantially. In addition companies with greater revenues and profits generally pay better. The second is technology and the “winner-take-all” nature of many new industries as the virtual world places enormous premia on the benefits of networking effects. For example, people use Facebook and Twitter rather than any competitors because they already have so many users, and so their dominance over competitors mushrooms. In addition the rise of information technology has greatly reduced the need for many “middle-management” functions in companies, jobs which provided a career ladder for many of the “averagely-skilled” in previous times.

Thus this rising trend in income inequality has been led by global economic forces. Does this matter? Well – the answer is income inequality matters if society thinks it matters, and it may now be getting to that stage. The recent phenomenon of the Occupy movement around the world in recent months, claiming to represent the bottom 99% suggests that this trend is reaching socially unacceptable levels. From an economic perspective, the natural human tendency to create the best opportunities for one’s children, when combined with greater inequality of outcome, tends to create much greater inequality of opportunity for future generations. This does damage the economic potential of a nation.

In the same way that global economic forces have led to rising income inequality, those forces may also make it difficult to address by redistribution away from the richest. The richest (both individuals and large companies) have always been able to afford better tax lawyers than governments, and with many of them being internationally mobile, they are able to choose where they earn their money and incur tax liabilities. 2012 looks likely to be the year when the debate over income inequality comes to a head in the US Presidential elections with Obama determined to campaign on the notion of taxing millionaires more to reduce the deficit, and the Republicans determined to reduce the deficit solely through spending cuts. This is likely (absent foreign crises) to be the key issue in the forthcoming campaign.