When the Music Stops23rd June 2013
Every time I raise sincere doubts, they have a habit of coming to pass, and to do so pretty quickly. I’m not claiming a track record here, and I’d rather be right about good news, but lets aim to keep the run of fortune running. Having called the trouble in Cyprus (see here) a few weeks before it happened, a fortnight ago I blogged that “…the big debate over inflation versus deflation is not yet concluded, and the powers that be may simply have done a great job of sustaining the unsustainable for a little longer”.
Cue last week’s apparently sudden collapse in stock markets. To be fair they have been weak for a month now, but the real damage occurred last week. The carnage in share prices has been led by Spain’s Latibex Index of South American securities, down 20% over the last month, with Japan’s Nikkei down 15%, Italy’s FTSE MIB and Hong Kong’s Hang Seng down 13%, and markets from Netherlands, Portugal, France, Spain, Germany and Belgium and the UK’s FTSE 100 all down close to 10%, and the US around 5% down. Much of this has apparently been triggered by China and the US talking about the end of “easy money”.
Cue headlines suddenly proclaiming the weakness of the banking system, and at last some fundamental questions starting (at a very superficial level) to be posed in the media about our monetary systems. Perhaps the best headline is an article today in the FT: “The best spending cut of all? Shut down the Treasury”!
So what has caused this change in approach? Well, markets are moved by mood. Few people are prepared to stick their necks out when everything is going swimmingly to point out that the fundamentals really don’t justify such euphoria, as more and more are sucked into the vortex of irrational exuberance. Exuberance is catching, as is the madness of crowds, particularly when supported by rampant credit creation. But then the mood changes, because there are too few left in the crowd to be converted. With no fresh fodder to feed the exuberance, it becomes far more likely that some will change their mind, creating a sudden dash for the exit. These social moods – socionomics – control so many aspects of the economy, stockmarkets and even cycles in magazine headlines and musical taste. Yes, musical taste; one of the greatest proponents of social mood, Robert Pretcher, has modelled the evolution and success of the Beatles albums against the stock market, and the results are compelling.
What these cycles demonstrate is that however Governments and Central Bankers seek to act like King Canute in holding back the tide, the tide will do it’s thing. The market is king. The strange thing is that the all-encompassing state has educated most people to be mistrustful and suspicious of the market, even though the market exists to proffer the best range and quality of goods and services at the best prices, and with the most convenience to the end user. The market aims to satisfy our necessities and indulgences, because, as the principles within Austrian Economics make clear, the economy is made up of individuals making individual decisions. What the market is not going to respond well to is powerful individuals and groups thinking they can manipulate events, from interest rates to social mood, because in the end it catches up with them – and us.
On the down dips social mood can become ugly, as “taking profits” turns to contagion. The bottom is marked by despair, but that is the dark before the dawn, as there are not enough people remaining to turn to despair, and so the only way is up. Now I have no way of predicting what will occur in the future, or when, and they used to burn witches at the stake, so lets stay safe and stick to examining the fundamentals … but just be aware that fundamentals don’t necessarily move the markets – in fact contrary to general understanding, the markets may well move the fundamentals!
The last few years in search of “recovery” have seen the state impose its will on money creation to an unprecedented degree. The aim has been to prevent an unprecedented squeeze in the supply of credit as banks sought to de-risk and shrink their balance sheets. What we have actually seen is a monstrous distortion of the economy as interest rates were driven to close to zero, whilst banks struggled to write-down debts against inadequate profits, and boost their balance sheets with government debt, much of which is un-repayable: In states which do not control their own currencies, like Greece and Cyprus, we have seen this default only too well. In states that do control their own currencies we have seen the erosion of value through inflation.
For now, bank liquidity has for now been satisfied by central banks acting as lender of last resort, but the banking system remains, in the main, as insolvent as it was before. UK and Swiss banks are being called upon to raise fresh capital as regulators start to understand the stupidity of their regulations to date, and the extent to which bank assets are risk-weighted and leveraged. Don’t blame the banks – they create the money under our monetary system which is determined by the state, and upon which the state depends for its taxation and redistribution model. And the states have been busy weakening banks further by stuffing their balance sheets full of state debt.
We are told that the next batch of Eurozone bank stress tests won’t be until 2014, but those done in the past proved laughable, as they were swiftly revised and much higher bail-outs followed. In the UK whether our banks require £26 billion or not (as recently announced by the Prudential Regulation Authority), it is certain that the provisioning and/or write-off of lending will take many more years to complete. Where bailouts are necessary we have seen the future, through Cyprus, and now at the Co-op, as bail-ins become the new norm.
In the case of Cyprus, a botched bail-in has resulted in severe distress, with the Cypriot President now asking for the bail-in and wind-up process to be unwound. The first bail-in of all depositors taking a modest hit might have worked (if accompanied by appropriate longer-term structural economic change, including a fresh currency), but it involved modest pain to too many voters. So it morphed to a far more severe hit for larger account holders and businesses, many of whom were left with no working capital to continue their operations, or to pay their suppliers, resulting in the failure of many other businesses, creating massive job losses, and to cap it all they stuck with the Euro.
In the case of the Co-op (whose black hole was identified at £1.5 billion), there is much that is unclear about the rescue decided upon over last weekend, although the details won’t be announced until October! But bonds are being converted to equity, whilst the shareholder (the wider Co-op Group) appears to have escaped relatively undamaged. Whatever happened to the old certainties of shareholders taking the hit before bondholders?
As foretold in another of my blogs (here) the game has changed. Bail-ins will be decided in an arbitrary and political manner that leaves little room for convention or justice.
So what to look out for?
China’s central bank is currently not supporting its banks with sufficient liquidity despite surging interbank short-term interest rates. The Bank of International Settlements (which very few have heard of, but which is one of the most critical global institutions) is saying that Central Banks must end their bond-buying (QE). In Europe the European Stability Mechanism could devote Euros60billion to more bail-outs, saying the rest will have to come from national governments (how?) or bail-ins of investors and depositors (far more likely).
It used to be the case that if the US sneezed, the rest of the world caught a cold … I wonder what happens when China and Europe sneeze together?