Feb 21st 2012, 13:52 by Buttonwood
AFTER another all-night summit, a deal between Greece and the troika (the EU, ECB and the IMF) has finally been reached. It involves the expected combination of measures - a private sector write-down, more loans from the EU in return for austerity measures and enhanced monitoring of Greek compliance. After all that effort, Greece will still have a debt-to-GDP ratio of 120%, which looks more than it can afford.
Markets have duly been unimpressed today, although of course a deal may have been priced in. But the FT story about a confidential paper on Greek finances only illustrates that this is a short-term fix and that further bailouts will be necessary.
It is hard to find an analyst who is impressed with the deal. First, there is the issue of overoptimistic forecasts. Lombard Street Research writes that
The troika assumes that the new austerity policies will improve the Greek public finances but have only a modest impact on economic growth. In their baseline scenario, GDP is expected to contract by just over 4% in 2012 and then stabilise in 2013 before growing robustly (at over 2% pa) thereafter. This, of course, is ludicrous and runs counter to all the evidence accumulated over the past couple of years.
This is probably the last Greek bailout we will see, but not for the reasons the authorities are claiming. Neither the Greeks nor the EU will have the patience for another round of negotiations once this latest package unravels.
David Owen at Jefferies points to the alternative forecast in the leaked report which sees the debt/GDP ratio in 2020 at 159% and comments that
the assumptions which feed into this are not particularly onerous - marginally weaker growth, slightly slower fiscal adjustment and less rapid pace of asset sales. And so from this leaked document comes a damning sentence which really sums up what the markets should take away from today: "With debt ratios so high in the next decade, smaller shocks would produce unsustainable dynamics, leaving the programme highly accident-prone."
And what kind of precedent does this set for other European bailouts? At M&G, fund manager Richard Woolnough notes bitterly that
The (deal) ensures that the private sector will suffer a real loss while the public sector (national European central banks and the ECB) will not suffer any losses. Central banks have this privileged position as they are prepared to provide further finance to Greece (akin to a rescue rights issue diluting existing shareholders). Of course, it is not in the politicians' interests for the central banks to bear any losses as a result of lending to Greece and of course it is the politicians that set the legal and regulatory framework. Not only can politicians change the goal posts, they can change the ball you are playing with. Politicians, and the authorities, are exercising their embedded power.
This deal will cause the private sector to suffer a disproportionate level of losses both in absolute and relative terms to the public sector. This punishes the private sector investor in Greek debt relative to the private speculator who was short Greek debt
Finally, there is the issue of whether Greek politicians can really impose this deal on their electorate. At Capital Economics, Jennifer McKeown predicts that
with the recession thwarting debt reduction efforts and public outrage growing, we still see Greece leaving the euro-zone before the year is out.
Feb 20th 2012, 16:05 by Buttonwood
WHILE Greece continues to inch its way towards a deal with its EU partners, the creditors of a much-larger debtor, the US government, appear to be untroubled. Ten-year Treasury bonds still yield just 2%. But the issue of how the US addresses its long-term fiscal problems is, as yet, unresolved. A series of papers from the Mercatus Centre at George Mason University in Washington DC, called “Tipping Point Scenarios and Crash Dynamics” attempts to address the issue. The academics seem to agree that the long-term position is unsustainable – that not all of the promises made by the government will be met. But in terms of the actual outcome, you pays your money and takes your choice.
Peter Wallison takes the (fairly widespread) view that a government with debt denominated in its own currency and with access to the printing press will not default on its debt. But he can still envisage a crisis in which repeated failure by politicians to tackle the debt burden means that investors eventually conclude that the debt will be inflated away. This will lead to a weaker dollar, higher prices for commodities and other real assets and a wage-price spiral. Foreign creditors may only be willing to lend to the US in renminbi, rather than dollars. Such a crisis will finally push Washington into putting its finances in order.
Garett Jones thinks that neither outright default nor inflation is likely, in paper because the markets would see such an outcome coming and push interest rates up to prohibitive levels. Furthermore, Americans will be able to see the messy state of Europe and will resolve to avoid the same outcome. Thus a massive deficit-cutting deal will be achieved although Mr Jones thinks this is more likely under the Democrats than the Republicans, because of the latter’s anti-tax philosophy.
Bondholders, concerned about principal, not principle, will see the GOP as the key political barrier to repayment.
In contrast, Arnold Kling argues that neither Democrats nor Republicans will be willing to compromise because of the effect on their electoral prospects. However, a negotiated default would bring in the IMF to broker a deal, which would inevitably involve both tax rises and spending cuts.
The external guidelines would give both (parties) political cover to vote for compromises that would otherwise anger their bases.
Perhaps the most provocative paper comes from Jeffrey Rogers Hummel who reasons that default is virtually inevitable because a)federal tax revenue will never consistently rise much above 20% of GDP, b)politicians have little incentive to come up with the requisite expenditure cuts in time and c)monetary expansion and its accompanying inflation will no more be able to close the fiscal gap than would an excise tax on chewing gum. Most controversially, he argues that
The long-term consequences (of default), both economic and political, could be beneficial, and the more complete the repudiation, the greater the benefits.
Why does he take this view? Once allows for the Treasuries owned by the Fed, the trust funds and foreigners, total default could cost the US private sector about $4 trillion. In contrast, the fall in the stockmarket from 2007 to 2008 cost around $10 trillion. In compensation, however, the US taxpayer would no longer have to service the debt; their future liabilities would be lower.
If Ricardian equivalence holds even approximately, then the decline in the value of Treasuries should be mostly offset by an eventual rise in the total value of both privately issued assets, such as shares of stock and corporate bonds, and expected future wage income.
I am not so sure about this. If the US government defaults, most US borrowers will surely face higher borrowing costs especially as the banks are relying on an explicit and implicit guarantee from the government on their liabilities. Mr Hummel refers to the relatively short-lived effects of widespread defaults in the 1840s (after a canal-building boom). While I am all in favour of learning from history, the financial system was rather less sophisticated (and less leveraged) at that point.
But Mr Hummel doesn’t stop there. The 1840s defaults were followed by greater fiscal discipline at the state level. Default would also be a good thing, he argues since government would be forced to renege on its social security and Medicare promises.
Reliance upon these government promises constitutes a particularly egregious form of fiscal illusion….The best way to alleviate future suffering is to repeatedly and emphatically warn the American people that these programs will go under. The more accurately people anticipate this inevitable outcome, the better prepared they will be.
So there are your choices. Default on the debt in real terms via inflation, default in nominal terms or break the promises made to future benefit recipients. Not an appealing menu but an indication of the likely political battles over the next 10-20 years.
Feb 14th 2012, 15:30 by Buttonwood
SO Moody's has accompanied downgrades of several European nations by putting the UK on negative outlook. Some will doubtless argue that this is a nonsense, as they did when S&P downgraded the US in August; a country with access to the printing press and that has issued debt in its own currency cannot default. The UK is also relatively immune to a funding squeeze; the average maturity of its debt is almost 14 years.
However, the UK does have one problem with inflating the debt away. Almost a quarter of the debt in issue is in the form of inflation-linked bonds. Now the government could try and change the inflation measure (the tactic they have used to reduce the burden of inflation-linked public sector pensions). But a lot of the debt was issued under terms that give investors protection were the UK government to try such a trick (some of the longer-dated debt has no such protection).
A further problem for the UK is that it does not have the advantages of the US; sterling is not the world's premier reserve currency and the Chinese do not have to own gilts as part of their exchange rate policy. Were the country to regain the reputation it had in the 1970s as a serial devaluer, gilt yields would surely be significantly higher.
The political implications are interesting. The British government is not saying that the agency is wrong or biased, as is a regular complaint on continental Europe. George Osborne merely said that
It was a reality check for the whole political system that Britain has to deal with its debts, that we can't waver in the path of dealing with our debts
For the opposition, Ed Balls drew the opposite conclusion arguing that the government was trying to cut the deficit too fast and thus damaging growth. While it is very hard to find anything in the Moody's statement that supports his view, Mr Balls may have the best of the political argument. The government has said austerity was needed to reassure the markets; the implication of the Moody's statement is that they are not reassured.
Analyst reaction has shown little surprise at the move. At RBS, Richard Barwell wrote that
We have consistently argued that the United Kingdom's safe haven status is not warranted by fundamentals. Moody's ratings action – putting the UK on negative outlook – recognises that reality.
It would be rash to assume that the Chancellor will always be willing and able to administer another dose of austerity medicine in response to bad news on the state of the public finances. Unfortunately, the Chancellor is likely to come under the most pressure to buckle at the worst possible moment – in a recession when the public finances are deteriorating for cyclical and potentially structural reasons.
While at Royal Bank of Canada, Sam Hill wrote that
Previously we've highlighted that of all the risks to the UK's triple-A rating the most significant is that of repetitively disappointing, low growth which leads ratings agencies to conclude with enough confidence that the UK is heading down a path that fails to stabilise public debt levels. The revisions to the growth outlook published by the OBR at last November's Autumn Statement, shown in the chart below, represented a significant deterioration to that outlook and hence the consequences for fiscal sustainability
In short, the UK is heading to the same destination as its European neighbours, it is just approaching the outcome by a more circuitous route. Creditors will not be repaid in full in real terms; i.e. they can only be repaid in depreciated currency.
UPDATE: In terms of outright default, Richard Woolnough of M&G points out that the probability of an AAA rates issuer defaulting within 10 years is 0.04%. The probability of an AA-rated issuer defaulting is just 0.55%. So it makes very little difference.
Feb 10th 2012, 13:23 by Buttonwood | DALLAS
THE running conflict between creditors and democracies reached a new stage with the battle over Greek debt. The EU is demanding that Greek leaders add €325m of cuts, pass the rules through Parliament and that all three main party leaders commit to the deal so that they cannot renege after the next election. This might not be sufficient. As David Zervos of Jefferies points out, Pasok (the former governing party) is on 8% in the polls. Three parties well to the left of Pasok have more than 42% support; New Democracy, the centre right party has 31%.Mr Zervos writes that
So what do Papademos' letters of intent, endorsed by the 3 party leaders, really mean? Absolutely nothing! Of course the EU leaders are not stupid, and they understand that after April elections the Greeks will very likely not stand up to any agreement. And they want to protect their €100b check. That is why they have proposed an "escrow" account for bailout monies (maybe they should have called it a UTMA account). It is also why they are asking for the party leaders to bind themselves, via written commitments, to adhere to the agreement after April. Last year Samaras balked at such a letter, and the deal still went through. This time who knows. And in the end who cares. An election tomorrow or in April could easily produce a New Left/KKE/SYRIZA coalition government. You think KKE will sign something for the Germans?? Ha!!! There would be no letters, no commitments - just a bunch of left wing anti-establishment types thumbing their noses at the north.
There is, surely, a fundamental difference between lending money to a household, a company and a government - and a difference that makes the characterisation of the latter as risk-free as rather odd. Heads of families cannot tell creditors that "Sorry, we've had a vote. I would pay you back but was outvoted by the wife and kids." In the middle ages, lending to monarchs was the ruin of many bankers; the French even executed some creditors. A debor who can change the laws is a risky beast.
We can argue that voters have the right to renounce debts taken out in their name. But they also have to accept that it is hard to compel creditors to lend to them (foreign creditors, at any rate).
Meanwhile, the fall in French industrial production illustrates the mountain facing Nicolas Sarkozy as he campaigns for re-election. If he falls, he will add to a long list of countries that have changed administration since the debt crisis started - the US, UK, Spain, Portugal, Greece, Italy, Denmark, Romania, etc. The big exception is Angela Merkel but she heads a creditor nation.
Feb 9th 2012, 22:54 by Buttonwood/DALLAS
TRAVELLING round America one can only be struck by the vibrancy of the media market. Yes, we can all shudder at the wilder shockjocking, but there seems to be plenty of intelligent programming around if you know where to find it. Last night, I found myself on the talk show of the venerable Milt Rosenberg in Chicago, together with Ann Lee, an academic, who has rather bravely launched a book called What the US can learn from China, calling for a less hostile approach towards the rising Asian power. It was a 2 hour discussion (albeit with a number of commercial breaks). There is NPR, of course, and intelligent podcasts too; there were some smart questions on both Invisible Hands and Planet Money. The phone-ins are more daunting; one caller raised the subject of internet pornography in public libraries which was a bit off-topic for your blogger.
Sad though it is to see newspapers in decline, the richness of this online and on-air information does rather make up for the decline in readership. After all, if you were in a one-paper town in, say, the 1970s, your news was filtered through one source. Now you have the potential for a much more diverse range of views; albeit that people seem to seek out those sources that confirm their own biases.
Alas, I managed my own bit of dumbing down. Apparently on NPR, I said that Nixon went off the gold standard in the 1970s when of course, what actually happened was that the dollar went off the link to gold (under Bretton Woods). Of course, I know that; I've just written 100,000 words on the subject and brain freeze or jet lag set in. Apologies. The point, however, remains the same. This was a new experiment in monetary history in which there was no longer any metallic link, however diluted. It has been followed by a vast expansion of debt, a number of asset bubbles, a huge boom in capital flows and in trading volume and the surge to prominence of the financial sector. It is impossible to imagine the same thing happening under Bretton Woods or under the classical gold standard period (1871-1914). (There was globalisation in this period, of course, but it was more marked in trade than in capital movements.)_
The danger now is that Europe, in particular, is struggling to pay off its debts, given its slow-growing, ageing economy. And that is a roundabout way of linking to this week's column which is about the lump of labour fallacy and why it won't help if we baby boomers take early retirement.
Feb 9th 2012, 11:15 by Buttonwood
READING the daily headlines on Greece, a lot of historical parallels come to mind - notably the situation of Britain in 1931. Then a minority Labour government was told by a committee, headed by a City grandee Sir George May, that it needed to make public spending cuts in order to keep on the gold standard. What stuck in the craw of the cabinet was a demand to cut unemployment benefit by 20%. The government fell to be replaced by a broadly-based (but Conservative-dominated) coalition; it eventually gave up on the gold standard. Britain never returned to it. In the mythology of the Labour party, this was a "bankers' ramp" (or racket) that brought down a government.
Greece, of course, has already replaced its Socailist prime minister with a new government headed by an unelected central banker. Even he, however, depends on support from the main parties. There is just a limit on how much pain politicians will impose on voters at the behest of (often foreign) creditors.
Of course, when Britain did leave the gold standard, the results were much less damaging than the bankers feared; indeed, many economists think the move set the country on the path to recovery. It seems less likely that the same could be said if Greece left the euro; its banks and corporate sector wouild be faced with bankruptcy (their debts would still be in euros but their revenues in devalued drachmas). They would still need aid from their EU partners. However, there is an element of mutually assured destruction about this; the contagion effects on Portugal, Spain and Italy might be huge. That suggests in the long run Greece will default not just to private sector creditors but to official creditors as well; and the rest of Europe will have to lump it.
Feb 8th 2012, 12:46 by Buttonwood
ONE of the most remarkable things about the modern economy is how quickly we have got used to rates of near-zero per cent. This is unprecedented in history. The Bank of England did not cut rates below 2% for 300 years and the old saying was "John Bull will stand many things but not 2 per cent". Savers want some return on their money.
Now of course the Fed has indicated that rates may stay at this level until 2014. But what will be the impact? In a Wall Street Journal piece yesterday, Charles Schwab argued that
the Fed's actions, rather than helping, are having the perverse effect of destroying the confidence of businesses and individuals to invest and the willingness of banks to loan to anyone but those whose credit is so strong they don't need loans
Meanwhile Bill Gross of Pimco writes on Ft.com that "zero-based money risks trapping recovery" arguing that the Fed has driven rates too low
A flat yield curve is a disincentive for lenders to extend intermediate or long-term credit unless there is sufficient downside room for yields to fall and bond prices to rise, resulting in capital gain opportunities.
It is an interesting argument. I've suggested before that, for anyone saving for retirement, the logical response to low rates is to save more, not less. The pot needed to generate a given income is higher and the expected return on your savings is lower so it takes more work to get there.
But what if the Fed took Mr Schwab's advice and pushed up rates? The economy has not delevered much, even in the US. Higher rates would lead to more defaults and the potential return of the downward spiral of 2008 with debtors selling assets, pushing down prices and hurting confidence even further. This is a classic "I wouldn't start from here" problem and one has to have some sympathy for central bankers, even though (in my view) they dropped the ball during the boom.
Feb 3rd 2012, 16:11 by Buttonwood
AS this blog has been negative on the economic outlook, it is only right to admit that today's numbers look very good indeed. First the non-farm payrolls jumped 243,000 and the unemployment rate fell to 8.3%. I was half-expecting a disappointing number given the evidence that seasonal adjustment had boosted the December figures (BCA Research pointed out that 42,000 of the announced gains came from the couriers and messengers category). and there might still be distortions. Neil Dutta of Bank of America Merrill Lynch noted that
One interesting wrinkle in today's data is the fact that the number of employees reported "not at work due to bad weather" totaled 206,000. The average for January going back five years was roughly 420,000. That could make today's number look somewhat stronger than it otherwise would be.
Nevertheless, it seems less likely that the non-farm payrolls are out of kilter given the other data. The services ISM data showed a jump to 56.8, including a rise in the employment measure. There was also a rise in factory orders. Good news for equities (and for President Obama's re-election hopes).
To dampen the mood a little, the much-promised Greek debt deal has still not been finalised and Greek media are reporting that Lucas Papademos, the technocrat prime minister, is having make-or-break talks with the opposition leaders over wage cuts needed to appease the creditors. Vague talk is going round of a resignation threat but this may be a negotiating tactic.
My worry remains that central banks have kept the economy propped up via liquidity transfusions, such as the ECB's three year loans to banks, but the net effect of this is to create asset markets and banks that are dependent on long-term support from the authorities, an unhealthy development. But if any country can pull out of the debt trap, it is surely America with its better demography than Europe and the advantage of the global reserve currency and most liquid bond markets.
A trip to the US over the next two weeks should give me a more detailed view but it will mean blog posts may be less frequent. (Part of the visit is book-related and for those who might be interested, Bloomberg published an extract today.)
Feb 2nd 2012, 17:06 by Buttonwood
A SHARP point from the monthly note of the Bank Credit Analyst (always one of the best research reads). The writers agree that the ECB's LTRO loans have stopped the possibility of a dangerous bank run in the euro zone. To have confidence in money, citizens need to be reassured that the government stands behind the banks. But
such a backstop can only be credible if there are no doubts about the government's solvency. The problem in Europe is that deposit insurance schemes are administered at the national level. That is where the ECB comes in. While it would never admit it, through a rather circuitous route. the ECB has now assumed a role comparable to the US Federal Deposit Insurance Corporation (FDIC)
It's understandable in the circumstances but not what those who set up the ECB had in mind.
Feb 2nd 2012, 14:14 by Buttonwood
AN intriguing note from Simon Smith at fxpro deals with the position of the ECB regarding the Greek bonds it holds. As is well known, private sector creditors are negotiating a haircut of 65-70% but official creditors, including the ECB, are refusing to take a loss. Mr Smith summarises the ECB's position
Firstly, its purchases were made primarily for monetary policy purposes and as such should not be seen in the same light as private sector purchases based on credit considerations. Secondly, and more crucially, the ECB views taking a loss on its holdings as breaking the constraint under which it operates regarding the monetary financing of deficits.
If the ECB is successful in maintaining its position, then it will make a profit when the bonds are held to maturity, since they were bought well below face value. As Mr Smith writes
It all comes down to the fact that the ECB is sitting on around €40bln or so of Greek government bonds, bought since the start of its securities buying program (SMP) back in 2010. We don't know exactly how many it holds or their maturities. That said, some rough back-of-the-envelope calculations suggest that it could make somewhere between €20-25bln if all were held to maturity (and with no haircut).
When banks are planning to hold government bonds to maturity, they can put them on their books at face value, not the market price. So the ECB could recongise that profit and award its staff a bonus. There are around 1,500 staff and, assuming a bonus pool of 40% of profits, that's a bonus of €5m-€7m each. Frankfurt property prices will rocket.
It's not going to happen, of course; the ECB might well lose money elsewhere and any profits go to shareholders, not the staff. (Mind you, it will be embarassing if Germany makes a few billion out of a Greek default). But it's a nice illustration of the strange world we have entered; see our recent piece on how the Fed has made almost as much money as the rest of the US banking system.
Feb 1st 2012, 13:02 by Buttonwood
THE issue that intrigues me most at the moment is the effect of the financial crisis on the workings of democracy, neatly illustrated this week by the FT story about the idea of an EU commissioner to oversee Greek budget plans. This is quite a complex area. If you want to borrow money, you have to convince someone - a private sector creditor or an official creditor - to lend you money. They thus need to be confident you can pay it back. This amounts to an implicit, rather than an explicit, veto on budget policies.
More broadly, however, there is the issue of how good democracies are at making complex decisions. The British system has an (almost) independent judiciary, a system that works to limit the arbitrary power of government over the individual. "Be you ever so high, the law is above you" Lord Denning proclaimed. The American judiciary is the third branch of government, although some judges are elected and Supreme Court nominees have to run the Congressional gauntlet. There is an underlying idea that judges can protect the rights of minorities, even if the majority of voters might prefer a different outcome.
Over the last 30 years or so, there has been general acceptance that central banks should make interest rate decisions independently of the whims of politicians, who might be tempted to adjust interest rates in accordance with the electoral cycle. This consensus might be breaking down if the views of Republican party leaders in the US are anything to go by. But for the moment, the power of these banks is extraordinary, given the scale of their intervention in government bond markets.
The debt crisis shifts the focus to fiscal policy. It is possible to separate this field into two. At one level, a government might face a restriction on its overall deficit (that was the idea of the Stability and Growth pact), rather as individual US states have balanced budget rules. It is harder to swallow the idea that voters should not be allowed to set the composition of the tax and spending policies that make up the budget. But of course, it has been suggested; for example, there was a lot of pressure on Ireland to increase its corporation tax rate in return for EU aid.
This leads on to the question of whether voters are sufficiently well-informed about the decisions they are taking. In a previous post, I discussed Brian Caplan's book The myth of the rational voter. What was interesting about the book, in my view, was that voters who were generally ignorant of the basic political structure (how many senators per state, for example) tended to have different economic views from those who were well informed (Caplan did control this finding for voter income). But some might dismiss his view as a right-wing economist complaining that normal people don't think like right wing economists. (It is surely more complex than that. If voters think the budget deficit can be eliminated by scrapping foreign aid, they ought to know that such aid is a very small part of spending.)
So it was interesting to read Democracy under attack; how the media distort policy and politics by Malcolm Dean who, as a former Guardian writer, would have little sympathy with Mr Caplan. His main worry is that the British papers tend to distort the facts and thus mislead voters on social policy. On crime rates he cites a survey that shows
people who were the best informed had the least anxiety about crime; those who were most ill informed were the most anxious.
On social spending, a 2002/03 British survey found that
the public believed 44% of social security spending went on the unemployed when it was, in fact, only 6% and 13% on one-parent families when it was less than 1%. Few recognised the biggest beneficiaries were pensioners, accounting for over 50%.
In another field, the public attitude towards asylum seekers has been affected by the hostility of a large section of the press, which have combined the ludicrous (asylum seekers eat the Queen's swans) to the plain nasty ("Shut out this scum" was one News of the World headline).
Again, the reason why this issue is so difficult is that, at a time of austerity, the public may support the slashing of benefits to minority groups, even though the effect on the deficit may be small and the hardship caused may be great. The answer is not, I hasten to add, to pass decision-making to EU commissioners in Brussels. The tough part is to try and make sure that voters, many of whom are uninterested in politics, are as well informed as possible about the issues being decided.
Jan 30th 2012, 12:04 by Buttonwood
THE battle over RBS CEO Stephen Hester's pay has absorbed an awful lot of weekend press and media in Britain - one might call it a bout of Hesteria. Mr Hester has sensibly backed away from his bonus, since the position of "banking public enemy" is not one to be relished - ask Sir Fred Goodwin.
There is a defence to be made of the bonus. Mr Hester did not create the mess at RBS; he is clearing it up. If he can remodel RBS and return it to the private sector, he will have delivered value to the taxpayer that could be in billions - in other words, more than a thousand times his bonus. If he walks away from the job, the public might lose a lot more than the £1m (in shares, not cash) that he was due to receive. By all accounts, he is a good manager and has made a decent fist of shrinking RBS's giant balance sheet.
Politically, however, the problem is that Mr Hester is working for a (largely) state-owned company at a time when other public sector employees are suffering a wage freeze, benefits are being cut and so on. It is very difficult to argue that "we are all in the same boat" if one state employee is being handed a luxury yacht. Doubtless, there are many teachers, doctors and nurses who are doing a fantastic job but they won't get a bonus either.
Many of us might feel that, if Mr Hester struggles to make ends meet on his £1.2m basic salary (plus £420,000 pension contribution), that we would be willing to do the job for say £1.1 million. This is not quite as ridiculous an idea as it sounds; clearly, if the average person were employed as a brain surgeon, electrical engineer or a footballer, their inadequacy would be quickly exposed.
But a bank CEO's worth is rather harder to judge. Clearly we can see examples of executives that have got it wrong, by overpaying for acquisitions or by recklessly leveraging the bank's balance sheet. A previous post highlighted an excellent speech from Andrew Haldane at the Bank of England; he pointed out that bank CEO pay correlated very well with return on equity, but very poorly with return on capital. Gearing up the company proved very lucrative for them in the boom, but disastrous for everyone else in the bust.
Take another example; market share. We all appreciated Steve Jobs' genius in creating new products and increasing Apple's share of spend on electronic devices. But if a bank increases market share, that may simply be a sign it is taking too many risks; that was the case of New Century in the US subprime market and Northern Rock in UK mortgages.
Perhaps, then, the best bank CEO would be someone who says No to the expansion plans of his subordinates and who has a decent amount of respect for the economic cycle. That same person would not be motivated by getting rich quick. So it's quite possible there might be a few people around who could do the job for £1.1m.
UPDATE: I should have added a point (featured in this week's column) that relates to executives being rewarded with stock. The more stock an executive owns (and thus the wealthier he is) the more likely he is to gear up the group's balance sheet and overpay for acquisitions. The finding seems counter-intuitive but wealth seems to breed overconfidence.
Jan 27th 2012, 15:54 by Buttonwood
PATRICK Artus, the chief economist at Natixis, was telling me how Spanish exports were booming so I thought it was worth looking up the data. With austerity on the menu in many countries, the hope is that export growth can compensate for sluggish domestic demand. Of course, since the biggest export market for many European nations is other EU nations, this might seem a lost cause. But at least, there was a general export increase last year.
Top marks to Estonia. The performance of Greece may seem surprising given that it has a huge current account deficit. My colleague who is just back from the country tells me Greek tourism has been doing well, in part because of the political turmoil in Egypt, a rival destination and in part because Israelis are heading for Greece rather than Turkey. Malta and Cyprus may be benefiting from similar effects.
Spain is doing very well on this score and a lot better than France. Ireland's bottom ranking is misleading; it had an export boom rather earlier than the rest and has recorded current account surpluses in three of the last five quarters.
Jan 27th 2012, 9:13 by Buttonwood
WHILE Italy and Spain are enjoying a welcome breather from debt pressures, Portugal is still under the cosh. Two-year yields were 16.1% yesterday and five-year yields were 20.8%. It all looks like an ominous replay of Greece's problems. The strategists at Rabobank comment this morning that
Portugal’s ongoing weakness, however, acts as a reminder that contagion is spreading and that aggressive liquidity provisioning serves to obscure its symptoms rather than address the illness itself.
The ever-thoughtful Jim Reid at Deutsche Bank comments that
There are more market concerns that Portugal could be the next Greece and the original EU78bn loan package may not be enough given the economic and fiscal slippage. At a very high level we do see certain parallels between the two. DB European economists expect the Portuguese economy to contract 2.9% this year in real terms which is not far off the -3% real GDP contraction estimated in Greece. Portugal's budget deficit is estimated to be 6.4% of GDP in 2012 versus 6.6% in Greece.
Meanwhile, the latest row in Greece concerns whether official creditors should take a write-down. This is a classic problem of form over substance. Clearly, Greece won't be able to service its debts over the long run, even after it defaults to the private sector (whatever the deal is called, failing to repay 65-70% of what you owe is a default). Other countries could send transfer payments to Greece over an extended period, or the debts could be written down. Since the other EU nations stand behind the ECB and the EFSF, this amounts to the same thing in the end. It would be plain silly if a deal broke down because of an argument about how, not whether, Greece gets subsidized.
Jan 26th 2012, 10:07 by Buttonwood
SO THE Federal Reserve has indicated that it will need to keep interest rates low until late 2014 (rather than 2013). Should that really be the cause for an equity market rebound, as occurred last night?
Otherwise intelligent people tend to reason as follows. The price of a stock should equal the discounted value of future cashflows. If the discount rate is lower, then the present value is higher (one heard this argument a lot during the dotcom bubble). This is true if other things are equal. But other things aren't equal. Why is the Fed keeping rates low for so long? Clearly, it is worried about the economic outlook and has lowered its expectation from "moderate" to "modest" growth. These crisis levels of interest rates are needed for a very extended period, just like Japan. Given that background, it makes sense for future profits expectations to be reduced, leaving the present value of equities unchanged.
There are other explanations for the rally. The Fed did for the first time set an inflation target. While this was an unremarkable 2% (which most people figured was the Fed's aim), the actual measure was for the deflator of personal consumption expenditure, not for the consumer price index. Since the PCE deflator has tended to rise more slowly than CPI (thanks to house prices), the effect could be to increase inflation expectations. To the extent that markets were worried about deflation, that might be a reason for equities to rally.
However, there is not a lot of evidence that markets are worried about deflation. The breakeven inflation rates on index-linked bonds over the next 10 and 20 years are 2.1-2.2%, pretty much the Goldilocks rate - not too high or low.
Then there is the obverse of the argument in the second paragraph. Perhaps investors were worried about a double dip recession in the US and believe the Fed action will avoid such an outcome. But that is not what economists are forecasting and the S&P 500 has rallied around 20% from its October low, in part because the US economy appears to be strengthening.
What about more subtle arguments? The Fed could just be wrong about the economic outlook, and could be committing itself to keeping monetary policy too lax in an expanding economy. Well there was no sign of concern from the bond market; Treasury bond yields fell after the statement. In any case, if the Fed were to drop the ball on inflation, investors should demand a higher dividend yield in compensation implying a fall in share prices, not a rise.
My suspicion is that the key part of the statement was the Fed's hint at a further round of quantitative easing. Like junkies needing a further hit, investors are desperate for central banks to buy more assets. Just like junkies, however, they may find that they need bigger and bigger doses to achieve relief.
UPATE: A small aside on this issue. What is the future for money market funds under this scenario? With yields this low, investors can hardly be offered a decent return after fees. Surely many funds will be wound up before 2014.
Jan 25th 2012, 18:25 by Buttonwood
PUT aside your worries about the financial markets and the euro-zone economy for a moment. Consider what Steven Pinker, in his magnificent new book The Better Angels of Our Nature, describes as "the most significant and least appreciated development in the history of our species" - the decline of violence.
It may be that, when you first consider the idea, you experience a visceral rejection of the concept (that was my instant reaction). Wasn't the 20th century incredibly violent? What about the Holocaust or Mao's famine? But Mr Pinker builds his case, logically and convincingly, over 700 pages.
Jan 25th 2012, 12:34 by Buttonwood
FIGURES released today show that the UK economy contracted 0.2% in the fourth quarter of 2011, with many people predicting a further decline in the current three months. That would meet the technical definition of a recession and would not be good news for the government's austerity strategy.
So what's to blame? The temptation will be to look at Europe so it's unfortunate that Germany's Ifo survey, also released today, shows the third consecutive rise. Britain may export a lot to Europe but so does Germany, which is performing a lot better.
So is it all down to cuts? The public finance numbers were published on Tuesday and showed that current expenditure in the first eight months of this year was £6.7 billion higher than in the previous financial year. Admittedly, that was down to higher interest spending and benefits; other spending was down. But, of course, in Keynesian terms, people who receive social benefits are likely to spend most of their income and thus bolster demand. In terms of closing the deficit, tax revenue seems to have contributed more; in the first eight months of the financial year, revenues were £18.1 billion higher than in the previous year, a tightening of more than 1% of GDP. It was the VAT rise that did it.
Jan 24th 2012, 11:38 by Buttonwood
THE equity markets have stated the year in fairly buoyant mood, with the S&P 500 now up almost 20% from the October lows. A better trend in US economic data has undoubtedly helped. But talking to investors in recent days, it seems the crucial factor has been Europe.
That might seem odd, given that many countries were downgraded by S&P and that the Greek restructuring deal has yet to reach agreement. But the ECB's willingness to lend money for three years to European banks has done two things. First, it has seemingly eliminated the prospects of a banking collapse, at least in the near term. Second, it may well have encouraged those banks to earn a turn by investing in government bonds, bringing down yields in Italy and Spain.
In turn, this may have encouraged US money market funds back into the region. According to Gerry Fowler at BNP Paribas,
Last week, US money market funds bought significant amounts of French and Spanish commercial paper. The value of notes issued by US banks with foreign parent companies increased by $6bn to $152bn. Notes issued by foreign domiciled banks rose $3bn to nearly £133bn.
It must also have helped that the European economic news has not been as bad as was feared; today's purchasing managers indices showed a rise above the 50 level. As I suggested in the New Year column, a New Year rally was very likely given the gloom that pervaded investors in late 2011. The question is how long it can last. the euro-zone deal that is being cooked - help for indebted countries in return for pledges of fiscal austerity - still seems likely to choke growth in the short term.
The problem with past examples of successful austerity programmes, such as Canada in the 1990s, is that they occurred in single countries (or in relatively small groups of countries). It is much harder when everyone is cutting at once. As Keith Wade, the chief economist at Schroders, puts it
The effects of co-ordinated fiscal consolidation by countries generating the majority of global GDP is likely to place a limit on world growth, absent a major technological innovation or policy transformation in the developed world.
The problem with reform programmes like those proposed by Italy's Mario Monti, necessary as they are in the long run, is that they don't do much for growth in the short term. It's another "I wouldn't start from here" issue. Just as we have accumulated debts, western economies tend to accumulate a whole lot of vested interests over the years, a problem well outlined in Mancur Olsen's The Rise and Decline of Nations, another book I've been reading. These vested interests - guilds, unions, producer cartels - can organise themselves to restrict entry to markets and inflate prices; the gains to cartel members are high, but the losses to non-members are small, since they are spread over a much larger population. Over time, however, the economy becomes like a barnacle-encrusted ship.
In short, these problems are greater than can be solved by the simple injection of liquidity into the banking systerm. Right now, however, investors are enjoying the sugar rush.
Jan 23rd 2012, 14:00 by Buttonwood
HAVING posted before on the seemingly inevitable nomination of Mitt Romney, I thought I'd better check up on the betting on Iowa's electronic markets. In the wake of the Gingrich resurgence in South Carolina, there has been a slight fall in confidence about the Romney candidacy but at a price of 73.4, he is still the overwhelming favourite. As you can see, only Gingrich of the other candidates has a real price. There is no sign that a "white knight" candidate, like Jeb Bush, will emerge.
Incidentally, the markets also seem more confident than they were in September that President Obama will be re-elected, perhaps because of the Republican in-fighting. At the moment, it's about a 57%-43% split (that's not a forecast of the vote shares, it;s a winner take all market. a bet on Obama means staking $57 to get $100.)
Jan 20th 2012, 17:04 by Buttonwood
THERE is an interesting debate among the analysts about the extent to which the ECB's programme of three year loans to European banks is being funnelled back into the government bond market. Whatever the truth of the matter (or the intentions of the ECB), the funding costs of Italy and Spain have fallen this year from the panicky levels of late 2011, and that can only be a good thing.
But the good news hasn't spread to Portugal, where the 10-year bond yield has gone above 14%. Remember that the official position is that the Greece private sector write-off will be a one-off; clearly the markets don't believe that. the lesson of Greece is that, the more official creditors get involved, the more the claims of privcate investors get subordinated, and the bigger their potential loss becomes.
Portugal's credit rating was downgraded two notches by S&P to BB, or junk bond status, which may mean that some investors aren't allowed to touch it. Of course, to the extent that cautious investors like insurance companies might be forced out of Portugal's debt, they might be replaced by risk-seeking investors (such as hedge funds) who would be attracted by the higher yield. However, such funds would want to insure themselves with a credit default swap (which currently indicate a 65% probability of default within the next five years, according to the FT).
But is it worth buying a CDS. After all, the EU authorities are going out of their way to make such swaps worthless, by engineering a Greek default that doesn't count as such under the terms of the CDS (because the deal is voluntary). By denying investors the ability to insuire themselves, the effect may be to cut off a potential source of bond demand.
The Portuguese government is pushing through labour market reforms but any boost to growth that such measures bring will take years to come though, time the country may not have. The EU could pass off one default as an aberration, but could it say the same about two?
Jan 19th 2012, 14:15 by Buttonwood
ONE of the joys of reading widely is that you can come across interesting ideas that make you think again. (I've been reading Steven Pinker's brilliant new book on violence which I want to blog about when I've finished it.) But another book I've come across is The Myth of the Rational Voter: Why Democracies Choose Bad Policies by Brian Caplan which was written back in 2007.
The idea is not original, although it is far from universally accepted. It takes time and effort to become informed about public policies. The chances of any individual's vote influencing an election outcome is virtually zero. Therefore it's not worth voters taking the time to make a judgment; they are "rationally irrational". As Mr Caplan points out, for most people a belief system that denies the theory of evolution or postulates that the world was created 6000 years ago, has little negative consequences on their daily lives; they can still function as a motor mechanic or shop for groceries. As a Republican Presidential candidate, indeed, such beliefs are positively beneficial. So people believe what they want to believe unless forced to change their minds by some event in their lives (not likely when it comes to evolution*).
Now economists don't like the idea of people being irrational, although it seems self-evident to mere history graduates. And even if they are irrational, wouldn't their irrationalities cancel each other out? Efficient market theorists take a similar line; stupid investors are just random noise, smart investors bring prices in line with fundamentals. But Mr Caplan shows that voters have systematic biases in one direction.
Indeed, there are some interesting polls which show the problem. About half of Americans do not know that each state has two senators and three-quarters do not know the length of their terms. Around 40% cannot name either of their senators. More importantly these "ignorant" voters have different opinions than informed voters (ie. those who do know the political basics). The ignorant voters have a series of biases - anti-market, anti-foreigners, an inclination to pessimism and what Caplan calls a make-work bias, being against economic changes that boost prosperity but threaten jobs in the short-term. (Some may struggle with this last one, but without efficiency gains in the economy, we'd all still be working on the farm.)
Now one could say this is an economist's bias; members of the profession like people who think like them. But it's not just stuff like free trade, A poll by the Kaiser Family Foundation in the mid-1990s showed that 41% of Americans thought that foreign aid was one of the two biggest items of federal expenditure; its actual share of the budget was just 1.2%. The biggest single item of expenditure was actually social security (pensions). But only 14% of Americans placed it in the top two.
There is no reason to suppose that Americans are any different from anyone else in this respect; they just have more opinion surveys. But it does show the difficulty for democracies in coping with the aftermath of the credit boom. Public policy decisions were difficult enough when economies were booming; it is even harder when we are sharing out the pain. It helps explain why Greece and Italy have turned to technocrats.
* Except for MRSA patients, perhaps. How did the staphylococcus aureus become methicillin resistant? Ah yes, they must have been intelligently designed as a kind of afterthought; a product relaunch of creation.
Jan 18th 2012, 14:04 by Buttonwood
ON Monday, your blogger took part in a BBC radio discussion involving Detlev Schlichter, the author of Paper Money Collapse: the Folly of Elastic Money and the Coming Monetary Breakdown. Mr Schlichter's argument will be familiar to fans of Ron Paul, although they are less often aired on this side of the Atlantic.
He writes that
It is simply a historic fact that commodity money has always provided a reasonably stable medium of exchange, while the entire history of state paper money has been an unmitigated disaster when judged on the basis of price level stability. Replacing inelastic commodity money with state-issued paper money has, affter some time, always resulted in rising inflation.
I am not entirely unsympathetic to this line of argument. The Chinese used paper money before abandoning it (just as the west was discovering the printing press). Monetary experiments in France under John Law and the Jacobins ended very badly (and very quickly). But one can easily flip the argument around. Nearly all societies did use metallic money but none now do. So one could say that all metallic money systems have been abandoned. The reason can be found in Mr Schlichter's argument; metallic money worked well in terms of delivering price stability but that is only one goal. What about growth and employment?
Fix the value of money and the burden of adjustment falls on other parts of the economy. Countries abandoned the gold standard in the 1930s because democratically-elected politicians found themselves unable to impose the kind of austerity required to maintain their gold reserves (the 1931 British Labour government balked at a 20% cut in unemployment benefit, for example). The economic historian, Barry Eichengreen, found that the earlier a country left the gold standard, the quicker its economy recovered. He also suggests, very plausibly, that it was easier to stick to the gold standard in the 19th century because many workers did not have the vote.
One can fix the value of your money internally, via a gold standard, or externally, via a fixed exchange rate. The Greeks chose the latter option by joining the euro. But now their voters are being asked to pay the price in terms of substantial austerity; in the old days, the Greeks would simply have devalued. Now, of course, over the long run a perpetual programme of devaluation will make a currency worthless. The point is that, neither fixing nor floating the currency is a panacea; countries still need to keep themselves competitive.
Not would a gold standard necessarily be fixed. The international version lasted from 1871 (when the newly-united Germany joined) only until 1914. Countries rejoined and dropped out in the 1920s and 1930s. The Bretton Woods system, devised in 1944, fixed exchange rates to the dollar and the dollar to gold. But countries could (and did) devalue, notably Britain in 1949 and 1967. If the US government declared that the future value of a dollar would be, say, one thousandth of a gold ounce, there would be nothing to stop a future government declaring the dollar to be worth one two-thousandth of an ounce. Ancient monarchs achieved the same feat by clipping coins or diluting the amount of gold and silver with copper or some other metal.
Now Mr Schlichter accepts this. He writes that
I don't think we should wish for the resurrection of the classical gold standard that collapsed in 1914. Although this system was the relatively best international monetary system we have had since the Industrial Revolution, it was still a government-managed, gold-anchored system. My hope is rather that from the ashes of the collapsed paper money system a monetary order arises that is, once again, based on the market's choice of a monetary medium and that is regulated entirely by market forces, by the free, voluntary and spontaneous interaction of the trading public and not by government dictate.
adding that
The state has to exit, once and for all, , the sphere of money and banking.
But a lot flows from this. What do do about the money that has already been created? Perhaps only reserve money and physical cash would be backed by gold or some other commodity, he suggests.
Some bank deposits from previous periods could still be allowed to remain uncovered while banks would be prohibited from issuing new uncovered deposits. If such a restriction on fractional-reserve banking were not to be enacted, then the state should in any case abandon all measures by which it supports and encourages these banking practices and socializes these risks.
The practical implications of this would surely be a severe restriction of credit (at a time when the economy is already weak) and that failed banks would be allowed to go bust. Now some might cheer at the latter prospect but would they really want it? The state intervenes to rescue banks because politicians worry what will happen to confidence if banks fail. It is easy to say that consumers should assess the financial strength of their banks but will Aunt Agathas in Worthing (or Wichita) really be able to do so. The mid-19th century was something of a free-for-all in US banking and was marked by a lot of failures and frauds.
So going back to a gold standard is far from a simple act and would involve a whole lot of changes that might be far from palatable in a democratic society.
UPDATE: Sorry to add to a very long post but another thought occurred to me. Of all paper money systems ever devised, the vast majority are still in existence and haven't collapsed yet. One could argue that "all previous bipedal apes have become extinct" on the grounds that Neanderthals and australopithecus are no longer around. But that would ignore the 7 billion humans still walking around.
Jan 17th 2012, 10:29 by Buttonwood
THE European Union is still talking about a financial transactions tax. Now I'm not in favour of it since it would simply drive a lot of business offshore (and it seems, at heart, an intrinsically anti-British move since the UK has the largest financial sector).
But the consultancy Oliver Wyman has produced a report on the issue and its arguments cause a certain degree of reflection - although not in the way that the authors intended. The report says that the tax will
directly increase transaction cost for all transactions by 3-7 times and by up to 18 times for the most liquid part of the market
adding that
Prior studies have shown that as much as 90% of the additional tax burden on financial institutions is generally passed on to end users. Non-bank financial institutions such as pension funds, insurers and asset managers will be particularly hit
It is a fair point that hedge funds can move to avoid the tax but pension funds and insurance companies can't. But Wyman adds a bit that sticks in the craw somewhat. The levy will
inefficiently tax the economy, as raising €1 of tax will likely cost the economy more than €1 given the indirect costs associated with reduced volume and more fragmented liquidity.
What bothers me about all this is that it seems to consider the financial transactions tax in isolation. Many EU countries are in deficit; the alternative to a financial transactions tax might be taxes on income (reducing incentives to work harder), taxes on sales (distorting spending decisions and bearing more heavily on the poor), taxes on business (which will also get passed through to consumers) and so on. One should look at the tax from the point of the view of the beneficiary of the pension fund; they may prefer to see a tax on transactions rather than a rise in VAT. A test of the "economic efficiency" of a transactions tax needs to be a bit broader.
A second issue is that much evidence shows that active managers underperform the indices; the trading costs that those managers incur are passed on to clients. So if a transactions tax prompts fund managers to trade less, or prompts clients to switch to lower cost index funds, investors may not suffer that much.
A third issue is that liquidity is a means to an end, not an end in itself. The purpose of the stock market is to allow companies to raise money so they can invest in new plant etc, and for savers to be able to allocate capital efficiently (i.e. to the companies with the best prospects). It is not clear that trading every millisecond serves that purpose. The function of the foreign exchange market is to make it easier for companies to trade and for capital to flow to the best international destinations; again it is not clear that the average currency holding period of 31 seconds (according to Andrew Lapthorne of SocGen) serves that purpose.
Now all of the above objections are trumped by the territoriality issue; the financial transactions tax should be simply renamed the Let's give a present to Wall Street and Singapore levy. But if we could devise a global tax system, it is not clear that financial transactions should enjoy their current privileged position.
Jan 16th 2012, 13:55 by Buttonwood
WHILE the big headlines over the weekend were about S&P's downgrades of European countries, the more worrying news came from Greece, where talks on a debt deal broke up. While I am not as negative as some on the agencies (their record on rating sovereign debt is pretty good), the market had already anticipated a downgrade of France, which has been paying a higher rate on its debt than Germany.
Greece's debt is a complex issue. Clearly, it must default to get its debt-to-GDP ratio down. But it also has a competitiveness problem that requires either a devaluation (not possible within the euro) or a fall in its costs (lower wages and thus a lower standard of living). Some of the pain of the latter option can be cushioned by subsidies from its fellow EU nations but they demand reforms in return. Many of those reforms are opposed by Greeks; it remains to be seen whether the technocratic government can push them though.
Of course, Greece has already had loans from the rest of the EU and this complicates matters further. The authorities are unwilling to see take any write-downs on their money. That puts all the burden on the private sector. Indeed, the more money lent by official bodies, the greater the write-down the private sector is forced to absorb if the Greek debt-to-GDP ratio is to fall significantly.
Throw in another twist. The authorities are obsessed (rather perversely in my view) with making the agreement voluntary so that the Greek deal is not classed as a default in terms of credit default swap market. That gives the creditors a bit more bargaining power. The banks appear likely to go along with whatever they're offered but the hedge funds are putting up more of a stink.
Talks between Greece and its private sector creditors are due to resume on Wednesday, January 18. Whereas a tentative deal was reached in October to write the debt down by 50%, a lot depends on the interest rate on the new debt. The lower the rate, the better for Greece but the bigger the hit (in present value terms) to the creditors. And then there are the knock-on effects. The EU has said that the Greek deal won't set a precedent for other nations. But, pull the other one. The EU has said a lot of stuff during this crisis and has backtracked many times. The bigger the write-off for Greece and the more aid (in terms of cheap finance), the more other nations will be encouraged to default and the greater the worries of creditors of other nations. That's why the Greek deal (or lack of it) is so crucial.
UPDATE: On the issue of the agencies being behind the curve, here is the result of an analysis by Gabriel Sterne at Exotix
We too have been repeatedly critical of troubled European sovereign ratings as the crisis has grown; we think they have been much too lenient! Our views are based on a simple but systematic assessment of the statistical relationship between sovereign ratings and spreads in EM and EA sovereigns. The analysis suggests the agencies rated troubled EA sovereigns 5-6 notches more favourably than do markets [as of 20 December]. Hence we continue to think that EA ratings are way behind the curve in terms of speed and size of downgrades.
Jan 11th 2012, 17:37 by Buttonwood
JUST back from Societe Generale's annual strategy seminar, held in the west end. As usual it was packed; as usual it was a jolly affair (considering the gloomy message) with Albert Edwards wearing a floral shirt that he may well have acquired in the 1970s.
As always, it was a thought-provoking event, and not confined to Albert's normal pro-bonds, anti-equities message. Indeed, Albert accepts that bonds are a poor medium-to-long term investment but thinks we have another deflationary shock to go first. "2012: The Final Year of Pain and Disappointment" was the title of the event. His general case, which he has manfully maintained for around 15 years, is that we are in an "ice age" in which equities get de-rated and bonds do well, as has been the case in Japan.
The surprise message for investors is that he feels the US is on the brink of another recession, despite the recent signs of optimism in the data (the non-farm payrolls, for example). The recent temporary boost to consumption is down to a fall in the household savings ratio, which he thinks is not sustainable. He cites the views of other forecasters such as the Economic Cycle Research Institute and John Hussman that a recession is on the way, and points to other confirming data such as the recent weakness in commodity prices.
Dylan Grice took a more philosophical view, pointing out the limits of our knowledge. Historians have had 1600 years to work out the reasons for the fall of the Roman empire and still don't agree; economists still debate the causes of the Great Depression. He produced two lovely quotes, the first from Lao Tzu
Those who have knowledge don't predict. Those who predict don't have knowledge.
And the second from J K Galbraith
There are two types of forecasters; those who don't know and those who don't know they don't know
From this standpoint, the confidence of central bankers in their ability to forecast is quite astonishing. He cites Ben Bernanke who, when asked what degree of confidence he had in his ability to control inflation said "100 per cent". This was the same man who asked about the chances of a US house price decline in 2005 said
It's a pretty unlikely possibility. We've never had a decline in house prices on a nationwide basis.
and then, when house prices were falling, said in 2007 that
the impact on the broader economy and financial markets of the problems in the subprime market seems likely to be contained
Dylan thinks that 30-year inflation breakevens at 2% are significantly underpriced.
Andrew Lapthorne is the quant guy on the team. he had a number of interesting graphs, including one that showed the combined yield of a global balanced portfolio (50% equity, 40% government bonds, 5% cash and 5% corporate bonds) was now 3%. With total expense ratios on many mutual funds around 2% (and hedge funds charging 2 and 20), that doesn't leave much left for clients. Another graph was on pensions. If you look at the numbers, S&P 500 companies are expecting 10% returns from equities (after costs!). But a poll by Duke University found that chief financial officers median forecast for equity returns was just 6%; in effect, they didn't believe their own accounts.
As for share buy-backs, companies are hopeless about timing. At what moment in the last 15 years did S&P 500 companies devote the maximum proportion of their cashflow to share buybacks? The answer is early 2008 just before the market tanked. In 2009, when valuations were depressed, they used only a small proportion of their cashflow on buying back shares.
On a more encouraging note, Andrew found that more and more stocks were passing valuation tests at the moment. The only other time since 1989 whan such bargains were around was in early 2009.
The final speaker was Edward Chancellor from GMO, and a noted historian of financial crises. He pointed out that many of the signs of bubbles - an uncritically assumed growth story, overconfidence in the authorities, rapid credit expansion, an investment boom - are currently present in China.
In this blog, our Buttonwood columnist grapples with the ever-changing financial markets and the motley crew who earn their living by attempting to master them. The blog is named after the 1792 agreement that regulated the informal brokerage conducted under a buttonwood tree on Wall Street.
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