Business • Confidence drains away
THE BEAR’S LAIR
Confidence drains away
By Martin Hutchinson
The continual stream of bad news coming out of Europe is causing a withdrawal of investor confidence in the bonds of several European countries, very reminiscent of the draining confidence in housing-related bonds in 2007-08. Thus there seems to be an increasing likelihood of an extreme scenario in which confidence disappears and insolvency events occur that were previously unthinkable.
Such a collapse in confidence would almost certainly produce a global depression of 1930s magnitude. It’s also pretty clear from the 2008 experience that the authorities have little idea of how to prevent this or of what to do when it happens.
This can be easily demonstrated by examining the authorities’ behavior in 2008. In monetary policy, Ben Bernanke’s Federal
Reserve and the Bank of England both violated Walter Bagehot’s famous dictum that in a crisis the central bank should make money readily available against first class security at a very high rate.
The purpose of doing this, as Bagehot and his contemporaries well knew, was to prevent a liquidity crisis that might destroy confidence and cause banks to be forced into liquidation unnecessarily, while at the same time providing a strong incentive for the banking system to get its house in order, foreclosing on loans with poor security, liquidating positions even at a loss and freeing up the banks’ balance sheets for future opportunities.
If the banks took large but not fatal losses in doing this, so much the better; it would prevent them from overextending themselves so foolishly in the future, sharply discouraging future bubbles.
In 2008 in both the United States and Europe and again earlier this year in Europe, the world’s central banks recklessly disregarded this dictum and instead lent large amounts of money at very low rates. The result was that banks piled back into risky assets, buying mortgage debt in the US after the housing market had collapsed (thereby profiting from the artificially steep yield curve gap between low short-term rates and higher medium term rates).
In Europe this year, Italian and Spanish banks bought more of their countries’ government bonds, thereby recklessly overloading their balance sheets still further and weakening at a crucial moment what should have been a ferocious budget pruning in both countries.
Given the ability to postpone pain, the Italian government of Mario Monti, installed illegitimately by Brussels, wimped out on the necessary labor law changes. The mostly admirable Spanish government of Mariano Rajoy trimmed the national budget adequately but failed to bring the grossly overspending provinces to their senses.
As well as reckless lending at excessively low rates, 2008 saw the creation of the Troubled Asset Relief Program (TARP). Like the cheap loans, this saw government taking an utterly irresponsible attitude towards public money and demonstrating a complete lack of forethought as to what the bailout should achieve. Indeed, in its first incarnation, TARP would have had taxpayers buying the most toxic housing assets from the banking system at prices determined by the banking system; it would thus have guaranteed humongous losses for taxpayers and achieved little.
With the massive liquidity injections from the Federal Reserve, no bank bailout should have been necessary. At worst, Citigroup, Merrill Lynch and Washington Mutual might have failed because being overleveraged and heavily concentrated in the most worthless assets they would have lacked sufficient collateral for a Fed loan program that was run in an appropriate manner. AIG would undoubtedly have failed and would have deserved to do so because of its grossly inappropriate activity in the gimcrack credit default swap market.
However other banks would have rescued themselves through Fed emergency funding, with Wells Fargo buying Wachovia at a knockdown price and Bank of America surviving, in spite of its catastrophic previous purchase of Countrywide, because it would only have had its own bad assets to deal with and not those of Merrill Lynch.
The result would have been a very nasty recession, a sharp contraction of credit, and a further lurch downwards in house prices that would have achieved 2012′s depressed and market-stabilizing price levels three years early. The recovery from recession would however have been robust, as it was for example in 1920-21, which saw a similar period of mass liquidation after the overextended bubble caused by World War I.
Even if a bailout had been undertaken, TARP’s principles were precisely the reverse of those that should have been used. Instead of making TARP capital injections compulsory, they should have been voluntary. TARP as it was implemented cast a shadow over the credibility of the entire US banking system, as well as encouraging assets and business to flow even further towards the largest banks, which were thought "too big to fail".
A voluntary TARP, on the other hand, in which banks took only those capital injections that they felt truly necessary, would have allowed those banks that could survive without TARP, including many of the larger regionals, to gain additional credibility and lower market funding costs through doing so.
As for AIG, it should indeed have been treated as a special case, being forced to default altogether, thus ensuring that the wholly unsound credit default swap market involved several of the world’s largest banks in painful losses, strangling its further growth. Holders of genuine AIG insurance policies might have had to wait for their money, as did holders of assets in the defaulting Reserve Primary Fund, but they would have received most if not all of their legitimate claims in the end.
Enough of history. We are currently in the eurozone faced with a repeat of 2007′s mortgage market collapse, only on a larger scale, potentially involving the public debt of not only Greece and Portugal (Ireland appears to have rescued itself) but Spain, Italy and France, all countries so large as to be impossible to bail out.
Just as in 2007-08, investor confidence drained from mortgage bonds of all kinds, even though some of them eventually proved of high quality, so today investor confidence is draining from a number of European countries whose prospects are very different.
Should the authorities continue pouring money into the market without the necessary structural reforms taking place, we will eventually experience another September 2008, with the defaulters being countries rather than banks (though their defaults will cause several banks to default as well). In detail:
In Greece, a further default is inevitable, whether or not the country remains part of the euro. The deflation required in order to force the witless Greeks back to living standards that are sustainable – about a third of their 2008 opulence – is simply too great if Greece remains part of the euro, and the debt Greece has already acquired, even after the write-offs already taken, is too great to be repaid from collapsing drachmas. Greece must exit from the euro; the market has already priced this in, and the principal objective should be to force it out as quickly and in as orderly a manner as possible, without pouring additional resources down the Greek rat-hole. Those resources will be needed elsewhere.
Spain, on the other hand, is in trouble almost entirely because of investor confidence. Its budget is well under control and its debt is moderate. What’s more, its real estate problems were confined to the smaller banks (Bankia being an amalgamation thereof). Its problem now is that it is a decentralized polity, and its provincial governments did not adopt austerity quickly enough and are now cut off from the market. If Spain were isolated, its problems could be solved with a moderate-sized bailout; as it is, it may very well have to leave the euro although a full debt default remains unlikely. Rationally, Spain has by no means the most difficult problem to solve, but market confidence in it has almost entirely departed.
Italy has considerably worse problems than Spain, in terms of its debt level, and much less capability to solve them. If the EU were going to impose a new government undemocratically, it had to ensure its government would take the actions needed. As it is, Monti has wimped out in face of Italy’s public sector unions, and Italy’s budget and debt problems are getting worse, not better.
Furthermore, Italy must have an election next March (or lose democratic legitimacy altogether). At that election, it now seems the electorate will be offered three alternatives: further pointless austerity with Monti, a clean departure from the euro followed by an assault on union privileges with Silvio Berlusconi or an outright debt default with Beppe Grillo. Two out of three of these alternatives would lead to debt default, while all three would probably lead to departure from the euro, since under Monti the bailouts would get too great for the German people to stand.
Finally, France is currently not in investors’ sights, with its 10-year bonds yielding 2.2% rather than 6-7% as in the case of Spain and Italy. Here investors are being irrationally optimistic in not panicking. The new French government has introduced a 75% tax rate, plus a swingeing wealth tax, and has reversed most of the very modest fiscal reforms introduced by the previous government.
France’s budget and debt position are both worse than Spain’s, and the new measures will drive wealth out of the country, cause economic decline and thereby worsen France’s debt and budget problems substantially. When investors figure this out, probably toward the end of this year, there will be hell to pay – the French economy is far too big, and French economic policy far too bad, for any bailout to be feasible.
There are thus at least two major confidence destroyers in France and Italy beyond the current problem children of Greece and Spain. Just as with the successive bankruptcies/liquidation rescues of Northern Rock, Bear Stearns, Fannie Mae/Freddie Mac, WaMu, Lehman Brothers, Wachovia and AIG in 2007-08, successive events will deal hammer blows to investor confidence, eventually drying it up altogether. No amount of further "liquidity support" and bailouts will prevent this; the amounts of money involved in the case of Italy and France are simply too great.
Doom is not inevitable. If the euro breaks up, each national currency can find its own level, and national monies can be printed as necessary to fund debt service and government deficits. Inevitably, some countries, probably Greece and France, will overdo the injections of liquidity from their central banks and experience a Weimar Republic-type inflation episode, followed by a partial default on their debt. But that, and the sharp decline in living standards that it will produce, will be purely their problem.
In Italy (probably) and Spain (almost certainly) sufficient discipline will be maintained that the crisis will be solved without default and without further outside intervention. Globally, the break-up of the euro will cause a short-lived downturn, but the new strength in Germany, Finland, the Netherlands and elsewhere, their economies finally freed from the need to bail out their weak sisters, will quickly restore global growth.
In 2008, much subsequent economic malaise could have been solved by the authorities applying the principles of Adam Smith and Walter Bagehot. The same principles can now be applied in the eurozone, and the collapse of investor confidence stopped in its tracks. To adapt a famous Maynard Keynes aphorism, all it will take is the euthanasia of the bureaucrat.
Statistics: Posted by yoda — Wed Aug 01, 2012 1:48 pm
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