Sunday, 21 November 2010

Another Domino Falls

Ireland has eventually faced reality and formally asked for financial support from the IMF and EU. It was only a matter of time. It looks like they will get 15 Billion Euros to go to the State, and 80 billion Euros to go to bailing out the banks, or around 100 billion Euros in total. Most of this will probably come from the 750 billion Euro EFSF set up in the Spring, when the sovereign debt crisis erupted around Greece. Ireland is now the second domino to fall, and the hope of the EU is that this will provide a firebreak to prevent the next domino in the chain Portugal from falling. It seems a vain hope.

As I pointed out a couple of years ago when the Financial Meltdown began Where We're Going,

“The problem that could arise given the scale is that the same causes of breakdown of trust and relations between Banks, which led to the Crunch could simply be transferred to the relations between States now acting as banks. We have already seen that to some extent. It was seen over the actions of the Dutch, Belgian and Luxembourg governments over Fortis. It was seen in the scramble for advantage when Ireland stepped in to guarantee all Bank deposits, threatening a stampede out of deposits in other EU countries. Most classically, it has been seen in the conflict between Britain and Iceland over deposits in Icelandic banks, and which was reminiscent of the 1970’s Cod War. It is certainly the case that some of these banks such as UBS of Switzerland have Balance Sheets bigger than the GDP of their host nations.”

We now have a zero-sum game in much of the global economy. Traders rarely make single bets. They usually work on the basis of what are called "paired trades". That is if the risk/reward ration for one thing has improved whereas for something else it has worsened, then they buy the former, and "pair" this trade by selling the latter. In that way, gains are maximised, and losses minimised. When Northern Rock was nationalised, it became one of the safest places to put your money, because all of its deposits were now guaranteed by the State. When Greece was bailed out, and its need to go to the Capital Markets pushed down the road, by its bail-out, the focus was shifted to the next country that lacked that facility – Ireland. Capital began to flow out of Ireland to the extent of 23 billion Euros, and was likely to increase. Depending on the nature of that settlement, pressure will be relieved from Ireland and be transferred to Portugal. It seems likely that this same procedure will be played out again, and then next in line will be Spain. If I were a Bond Trader, then as soon as it became obvious that Ireland was to be bailed-out last week, I would have been selling Portuguese debt across the yield curve, and possibly Irish Debt at the Longer end, and buying Irish debt at the short end of the curve i.e. Bonds due to mature in the next couple of years. The reason is simple. With the bail-out, Ireland will have no need to go to the market for the next couple of years. That alone means the Supply of short-dated Irish Bonds will fall, and the price will rise accordingly. Moreover, the bail-out means that there is no possibility of default on those short-dated bonds, meaning the risk has disappeared, and with it the risk premium on them. By contrast, Portuguese Bonds have become relatively more risky at all maturities. If the EU has to cover the lending to Greece, and Ireland through the EFSF, by borrowing istelf, then this debt coming to market at some point, will be very secure, and if I were a Bond Trader I might want to keep some reserves to pick up that debt. Finally, having seen that if the Bonds of a country are trashed enough the EU will come in to bail-out that country, thereby removing the growing risk that bondholders were feeling - particularly after Merkel's comments - then there is a massive incentive for Bond Markets to trash the next country in line, in order to force the EU to come in, and back-stop that risk.

I would expect that next week we will start to see already that the spread on Irish Bonds will narrow, and on Portuguese Bonds they will widen.
But, none of this provides any real solution, in fact, it compounds it. We have had 750 billion set aside in the EFSF, we have had a large chunk of that set aside for Greece, now we have another 100 billion set aside for Ireland, the figure for Portugal is likely to be a similar amount. The trouble is, a hundred billion here, and another hundred billion there, before you know it, you're talking about serious money! And that serious money is being drained from one pot only to temporarily fill another. The real solution is not to rob Peter to pay Paul, but to create more value in total. The trouble is that creating more value in the context of an economy needs an approach that is rather more sophisticated than the attempt to apply the principles of running an household budget that the Tories and the Right-Wing Populists want to use.

There are two basic things required. Firstly, the debts have to be monetised. In other words, the EU, just as with the UK and the US (the US has already been doing this with QE), has to print money to pay the creditors. Households can't do that without risking being sent to gaol for forgery, or passing a false instrument. But, printing money itself is not a solution. Paper Money itself is not Value, it is only a representative of Value contained in the Money Commodity – usually Gold - which itself can only circulate as value within the economy to the extent that it can exchange with equivalents. That is, real value is created by increasing the quantity and value of commodities circulating in the economy, more cars, TV's, machines and so on. In a Capitalist economy that only happens when the Capitalists believe they can make profits from doing so, a basic condition for which is that there is adequate demand for those commodities. The only point of the money printing is to work towards this latter requirement. By clearing the debts in the short term, it provides the basis for Money and Credit to circulate in the economy. But, that will only happen if people are confident to spend on consumer goods, which in turn creates confidence for firms to invest. At the moment that is unlikely because Governments like the Tories or their equivalents such as the Tea Party in the US, have scared the shit out of people with their narrative about how bad the situation is, how imminently devastating the deficit is, and how much pain people will have to suffer with Cuts and job losses as a response. The exact opposite is required, and without it, the consequences could be far worse than the picture the Liberal-Tories have been painting.

The fiscal stimulus that the last Labour Government had implemented was beginning to have the desired effect. Unemployment had not risen as much as the pundits were predicting, people were not being thrown out of their houses, and so on. Growth in the economy had started to increase, and as a result the deficit was actually lower than had been anticipated as taxes were higher and welfare payments lower. The same effect could be seen from the fiscal stimulus introduced in the US, in Brazil, in China, and elsewhere. What was actually required was a continuation of that fiscal underpinning of the economy to allow it to gain strength. Then the measures could be put in place to ensure that fiscal responsibility was restored under the more benign conditions of economic growth, and further measures could be introduced to encourage investment in those areas which offer the greatest potential for future development and competition.

What is standing in the way of that is right-wing ideological dogma. As I quoted recently a right-wing commentator in the US summed it up when he was discussing the demands of US Big Business for socialised Healthcare, and the resistance such a rational solution faced:

“The bigger hurdle may be stereotypes. Business's sensible drive to get Uncle Sam to take on more of the health burden will run into the nihilistic (but potent) "big government" rhetoric of the GOP--plus the party's delusion that we can keep federal taxes at 17% to 18% of GDP as the boomers retire. If Republican pols want to help Republican CEOs solve their biggest problems, this caricature of a political philosophy will have to give way to something more grown-up.”

Matt Miller in Fortune

The problem is that popular opinion is rather like an oil tanker, it does not turn on a sixpence. Years of neo-liberal propaganda have conditioned people into the belief that the State is bad, that there has to be balanced budgets and so on. Politicians such as those Miller is referring to, who have to get elected, cannot simply come out and change course if they want to get elected. The example of what has happened to Obama, is a clear illustration of what happens when they do.

As a consequence the domino's are likely to continue to fall, and each one will create a more deafening thud as it lands than did the last.

No comments: