The behaviour of markets this year has confounded expectations. It is useful to step back and view the landscape from a high level as daily market monitoring can lead to myopia and inability to distinguish between noise and signal. It is also useful to avoid over reliance on established or sophisticated financial or economic models particularly when a simple one will suffice. To understand the present it is necessary to understand the past. It is hoped that with this we might have some idea what the future might look like.

The crisis of 2008 while manifesting itself in the space of 6 months was the culmination of a much longer term phenomenon. For reasons dealt with elsewhere, debt, both public and private, was allowed to accumulate to levels which were no longer sustainable. It is not clear when the point of unsustainability was reached, but this problem began to be discovered by the market in mid 2007 accelerating to panic by the end of 2008. It was the reaction of investors attempting to shed direct or indirect exposure to this unpayable debt that led to acute market volatility and the demise of Bear Stearns, Merrill Lynch, AIG, Lehman Brothers and Northern Rock among others.

In order to maintain the functioning of the financial system, the payments system and the nexus between savings and investment, regulators and governments in their wisdom chose to bail out the system. To restore confidence, it was necessary to transform and transfer this unpayable quantum of debt from private to public balance sheets to signal adequate support for these assets or to remove them from scrutiny and analysis.

Debt can be reduced in a finite number of ways. It can be paid down, reorganized or defaulted upon. Given the size of debt in the global economy none of these was a viable short term option. It was necessary therefore to transfer such debt from institutions with credit risk to institutions where credit risk was academic, mostly arising from their ability to print money to satisfy their liabilities. Sovereign balance sheets.

One flaw in this strategy is where a sovereign is unable or unwilling to monetize debt, such as the Eurozone where monetary policy has been abdicated to a common central bank over which no single country in the union has unilateral or arbitrary control. The symptoms are plain to see.

All other central banks will likely continue to monetize the debt that their governments have assumed on behalf of credit risky holders. Even so, even the US has faced a credit rating downgrade. New and more creative ways of transforming and transferring the massive stock of debt needs to be found. Time can be bought if current holders of debt repackage the debt so as to assume first loss risk while seeking less indebted investors to provide senior funding. The devil is in the details as the European Financial Stability Facility’s initial plan to do this was rebuffed by potential senior funding providers.

The prosperity of this planet in the last few decades has been financed by debt. The calculation of GDP does not account for debt creation and therefore includes future output. This is an error. Be that as it may it is an accounting standard that our species has generally accepted. By this metric therefore, since the world collectively seeks to reduce its debt, global GDP growth must slow down and depending on the rate of debt reduction, may be negative. This result holds for the closed system as a whole.

Failure to recognize this or indeed a stark recognition of this will likely lead individual regions or nations to attempt to grow their economies at prior rates regardless. If the world’s total debt is to be reduced, debt must be redistributed and locally somewhere, it must increase. A case in point is China’s attempt to maintain growth while its single channel of growth, exports, collapsed in the wake of a severe dearth of trade finance and retrenching US consumers, which resulted in substantial credit creation. Beggar thy neighbour policies are likely to rise. Incipient signs of this are unilateral currency interventions by the Swiss National Bank and the Bank of Japan and the exchange of rhetoric between the US and China over the value of the RMB. Periods of slow economic growth or contraction can be contentious ones. As domestic demand slows and government finances are burdened by excessive debt the natural tendency is to attempt to export. Not all countries in a closed system can have a net positive trade balance. The likelihood of contentious and hostile trade policies is elevated. Currencies are likely to be co-opted as instruments of trade mercantilism.

The large scale transformation and transfer of debt or credit risk can potentially be contentious as well. During the third comprehensive plan for the Eurozone where a haircut of 50% was proposed on Greek sovereign debt, ISDA regarded this as a voluntary exchange and therefore not a credit event. This has raised questions as to the probity of ISDA. Consider also a situation where defaults in one region impact that region’s banks but where these banks have transferred their credit risk to another region through the use of credit default swaps triggering contagion. How willing will the authorities of one region be in providing relief directly or indirectly to another region at a time when fiscal austerity looms over most developed nations’ public finances?

A less apparent theme is the failure of the principal-agent relationship. This relationship is never perfect and its imperfections typically come under scrutiny in recessions. The last time this was examined was in the 2001 Dotcom bubble where stock options rewarded management for success without appropriate penalties for failure. There is a wider manifestation of this problem. The most visible is in the banking system, especially because they required bailouts paid for from public funds. Banks serve several functions, among which are safe custody of depositors’ assets, and a safe and efficient transmission between savings and investment. As management remuneration is asymmetrical, it is possible to earn a positive bonus but not a negative one, excessive risk taking and cavalier stewardship arose which culminated in the financial crisis of 2008. As a result the trust has been broken between banks and depositors.

A similar lack of trust has arisen between people and their governments. The troubles in Middle East North Africa which began earlier this year have not abated. Even in democratic and apparently democratic regimes, election results are equivocal and represent a lack of clear mandate to any government. Governments are agents to their people who are the principals. As stewards of their welfare the rise of income and wealth inequality is an indictment of their performance. Gini coefficients have risen in Communist, Socialist and Capitalist countries alike. High rates of inflation in the developing world are potentially destabilizing and investors may underestimate the priority of price stability in agrarian societies. Debt monetization is fundamentally inflationary adding to the complexity of policy that faces governments.

There is no new crisis, only the ripples and aftershocks of the first one in 2008. Time is what is required for the global economy to heal itself. Patience unfortunately is lacking. The result may be interim solutions which defer inefficiencies and imbalances but do not dissipate or address them. Unfortunately, for me, I have no answers and am only an observer in these dramatic proceedings.

Stuff that’s least expected to happen:

About the Euro, Congratulations are in order as its impossible to present the least likely scenario since the Europeans have got themselves into a position where anything can happen. Consensus seems to be Greece exiting the Euro, everyone else staying, Germany and France agree to closer fiscal union, the ECB being happy with this and printing their merry way into inflationary heaven. Next most likely is that the Europeans simply delay and delay and never come to any credible solution over their problem and the market throws its arms in the air and walks away. Bond yields from Germany to Greece spike and the ECB is forced into debt monetization. Least likely is Europeans miscalculating how much slack they have, some bank somewhere has lied on their stress test and defaults. The ECB steps in to bail them out but its too late because the market is doing a runner on a whole swathe of European banks. In a queueless run, cash is simply wired out of the European banking system and a whole bunch of banks become public property. The sovereigns are faced with a huge bailout bill which only more worthless paper can finance so the Euro goes into free fall and we have stagflation in Europe. Highly unlikely. The Euro breaks up but the European Union holds together. Mass nationalizations, some defaults, 7 years of famine, but a stronger more robust more efficient economy without the artificial self inflicted encumbrance of a common currency. European brands and intellectual property thrive and the region becomes an export engine of growth. Now that’s what I call unlikely.

The US economy seems to be in a recovery. It has been an export led recovery and likely to persist as long as Europe doesn’t deteriorate too much further. The USD needs to be weak for this to continue. Consensus is that the recovery will take hold but that it never really accelerates and we get a period of slow growth. The long shot scenario is that the muted recovery gets the housing market going. With the amount of leverage in housing, if there is the slightest recovery, with the Fed holding rates down across the yield curve and possibly buying more mortgage debt, banks may start lending to home equity again which would lead to a credit fuelled boom. Unfortunately this will likely store up more problems for the future but we are not looking that far ahead. Another low probability scenario is that the current recovery is merely a lagged indirect effect of China’s infrastructure binge on resources boosting the resource rich Americas which form the US’s largest export markets and that China falters and the US economy sags back into a mire of recession and divisive politics. The Fed defaults to QE mode and the whole US economy sinks into a Japan Lost Decades scenario. Unlikely. Thin. Surely not.

China has been driving the world economy for the last 3 years on the back of its resource consumption so it is important to understand what’s going to happen there. Consensus has been that China will successfully engineer a soft landing by which is meant lower inflation, circa 4%, with growth stable above 8%, widely regarded as the number that will absorb the annual cohorts joining the labour force. Until the last 2 weeks China had been tightening monetary policy and restricting credit creation to dampen asset price inflation and excess capacity accumulation in selected industries. With inflation numbers showing clear signs of slowing China has been able to lower reserve ratio requirements on their banks in a sign that either policy has worked or the economy is weaker than expected. The low probability event is that the official numbers have been fictional and the shadow banking system’s debt has accumulated to breaking point, the structured credit vehicles are unable to refinance themselves and there is a sudden need for a backstop provider of credit, the central government, which puts their balance sheets into Grecian territory. The employment numbers turn out to be a lot weaker than published, held up by the counting of the unpaid and employed who have been waiting for paychecks for months, and things come to a head during the Chinese New Year when businesses fail to reopen. Very unlikely. Lehman likelihood unlikely.

Not to be morbid but we haven’t had some serious global scale fisticuffs in a long time. In the last 30 years we have had plenty, and having plenty always makes everyone happy and less likely to have fisticuffs. The poor are less likely to complain about income inequality, the oppressed are less likely to complain about not having a voice, the rich are less likely to complain about taxes, exporters are less likely to complain about tariffs, etc etc etc. Unfortunately, the plenty that we had was mostly borrowed from the future. And that future, unfortunately is today, and the bailiffs are at the door. Suddenly nobody is as accommodating as they used to be. And what of the progress of the last 5 decades? Arm someone whether it be with arms or intellect and when the going gets tough, they will eventually attack you with your own weapons. When the going gets tough, suddenly democratic elections are more closely fought, votes more equally divided, tempers more easily frayed, and dissatisfaction abounds. Fisticuffs? Unlikely, if you are given to the traditional analytical tools of having nothing but a ruler and a penchant for extapolation. Bloody unlikely.

Economic model. Before the fall of communism we in the ‘free world’ were pretty clear in our minds that capitalism was the ‘right’ model. Its easy to identify the right model when one has a negative example. Its not so easy when one loses one’s foil. Without a nemesis capitalism has veered into uncharted territory. Our efforts to save the financial system in 2008 and our ongoing efforts to keep the ship on an even keel have led to interesting socialist fixes. Yet so dire are circumstances that our entire attention is focused on dealing with symptoms rather than root causes that we have compromised our philosophy and live from day to day. What model might emerge fro
m these crises? This is really hard to see.

The Euro must fall. If the Euro is to be saved, and if there is not to be some messy bank default with a side order of contagion, the ECB will be engaged in debt monetization very soon. All the Germans are seeking before they will let loose the printing presses is some assurance that they will not be forever subsidizing the siesta in the Southern provinces of Europe. They should rest assured that they will not, not forever anyway. History has shown that the Fates are fair, if a little perverted. The day will come when Germany will be the one in need of some slack. In fact, what the Germans plan to do to the PIIGS is what the Allies did to the old Weimar Republic that forced it into depression.

This week will be the fourth time the Euro group meet to formulate a comprehensive plan for the Euro. I don’t see what else they can pull out of the hat. What are the hard constraints? Well, the Eurozone needs to find some 3 trillion EUR to recapitalize the banking system. They need to find this from somewhere, either by borrowing it from some unsuspecting developing nation or by printing it. Earning it is ideal but that could take decades and these chaps have a few days left. That leaves printing it. But the Germans have conditions which they want met before they will allow the ECB to print.

Note that the ECB has already primed its printing presses. All Mario Draghi is waiting for is the go ahead from Angela and then its happy days. The only risk is that the German conditions are not met. So what are these conditions? They have not been clearly specified but you can bet on a stronger form of the Maastricht Criteria embedded in the EU Treaty. Well that’s a relief then. These criteria were pretty much violated by every member of the Euro including Germany.

However, it is now so crucial that the ECB be allowed to monetize debt that there will likely be brinksmanship and a grubby political bargain in the establishment of Maastricht II. Angela’s hand is not as strong as one might imagine.

When the printing presses start to roll, you can bet that the Euro will be on a path of weakness. Just like the USD. But knowing how rational investors behave, that weakness is likely to be prefaced by a sharp spike up for no good reason.

There is no economic rationale for Europe having a common currency. The USD works in the US because there is a common treasury on top of the state governments and Federal taxes and benefits unite the US. Also, labor mobility is high, and the national identity is at least as strong as the state or regional identity.

Any economist of basic competence would have struggled to find an economic rationale for the Euro. Yet it went ahead 12 years ago as a work in progress with a weak or incipient form of fiscal alignment if not union in the form of the Maastricht criteria. It was recognized by the European leaders of the day that Maastricht was but a first step towards a closer fiscal union which would be necessary if the Euro were to survive. As it turned Maastricht was breached by every member including Germany and was allowed to lapse in 2010, probably when it was clear to all that fiscal union was a bridge too far.

While the Euro makes no economic sense, we have to realize that it was the product of political and not economic will. When Euro notes and coins were initially introduced, those who lived in Europe will recall the rise in inflation which was foreseen by many economists in the day, but who unfortunately were shouted down by the politicians. Beware the politicians and the loud. Human beings are susceptible to decibels and smart suits, and less accepting of logic unless it is suitably embellished by a silver or a forked tongue.

Pity the Germans. Since they were locked out of the embryonic European Union immediately following World War II they have paid dearly to be part of the Europe they once tried to conquer. And so with the implementation of the Euro sovereignty over monetary policy was transferred from the Bundesbank to the ECB. This came as a second blow to Germany which was only a few years into absorbing the East German economy and in need of a weaker currency and lower interest rates. Instead the Germans got chronic unemployment and higher inflation. This was the bargain for inclusion into the Euro club.

More than memories of the Great War, the Weimar Republic, World War II, more than a Teutonic tendency to eschew indebtedness and to require its repayment all else be damned, more than all this is the more recent memory of the price of Euro membership to Germany some twenty years ago, a price which Southern Europe seeks now not to pay. This is hard for the German to understand or bear. Germany is being asked again to pay.

More immediately and more topically, France and Germany are working desperately to avert a crisis in the Eurozone. Each has paid a price to have the Euro and are now likely to throw good money after bad to save a currency union which has no economic underpinnings. If it did, the world would have a single currency. Europe needs the Euro as much as Asia needs a common currency. While the risks to a Euro break up are high, the immediate damage in its wake to the banking system is too much to contemplate and so it is expected that some compromise solution will be hammered out which will allow the ECB to begin monetizing sovereign debt. The Germans will only allow this if there is a binding framework for centralized fiscal management of the Union and its members. A partial union has not worked, perhaps a more complete one might. This is misguided.

Fiscal union is only necessary to maintain monetary union. It is predicated on the logic of monetary union which is flawed. Be that as it may, fiscal union will indeed allow the Euro to survive. But years hence as countries look back to their subjugation to both a European Central Bank and possibly a European Central Treasury, how will they judge their investment? A central fiscal planner suffers from the same illogic as a central monetary planner. Countries in Europe will at different times require different fiscal policy. What is profligate for one may be thrifty for another. We give up efficiency for no good reason.

The sum of outcomes of separate individual optimizations is greater than or equal to the optimization of a sum of outcomes. This is a mathematical truism that is clearly overlooked by anyone seeking monetary or fiscal union.

The future is a wonderful place. Because you can borrow from it.

Nobody really owns a house, not normal people anyway. They only rent it. They either rent it from a landlord or they rent it from a bank, through something called a mortgage. Some landlords actually rent their real estate from the bank and then sublet it to some hapless tenant. Renting from a landlord is less risky. Renting from a bank means that you are likely to either make a colossal amount of money if property prices rise, as they have in places like Hong Kong or Singapore, or you might lose more than everything including your pet cat, if property prices slump, as in places like Florida or Nevada.

But you don’t really have a choice. Cheap housing doesn’t really exist in cities where the jobs are. Jobs are only available where expensive real estate is on hand to relieve you of your hard earned wages. Cheap real estate is only available where jobs are cruelly scarce.

So it makes sense to be a landlord or homeowner, but only if property prices are rising or if you don’t have to rent your real estate from a bank.

A long time ago you would buy a house with a mortgage and would have had a good chance of paying off this mortgage before having to move into a pine box carried by six of your best friends. There was a point in time when the bank would hand you back the keys and the deeds to the property. These days you’re more likely to refinance and rollover your mortgage and home equity debt until a point in time when you handed the keys to the house over to the bank or the bailiffs. It is a sad state of affairs, and it is not exclusively American or Western.

Debt is not bad. It enables and it facilitates. Problems arise when we start taking it for granted and lose sight of the obligations to repay it. So ingrained is debt and how it is regarded that it has become a cultural phenomenon.

Whereas debt used to be a good thing that allowed you to enjoy something today which you envisaged being able and willing to pay for in the future, today debt is just something that allows you to enjoy something today, period. The obligation and the ability to repay has been relegated to a mere irritation.

Soon households began to repay credit card debt with other credit cards, cycling their debit balances whenever they came due. This practice while initially frowned upon has become standard practice for even high grade corporate issuers and indeed has been turned into an art form by sovereign issuers. It seems today that even sovereign bonds are PIKs (Payment In Kind bonds, kinda like junk, usually worse.)

So ingrained in our society has this practice been that it is the de facto financing mechanism for buying cars in the UK from a Toyota to a Porsche. White Bentleys with mirrored glass tend to be paid for in used hundred dollar bills with non sequential serial numbers in patent croc carryalls borne by big men in dark suits…

Installment plans can be found for everything from luxury watches to designer clothes. Store credit cards continue to be dealt out by croupiers in the basement of Harrods or the fifth floor of Harvey Nichols. And everyone seems happy to rent their clothes, cars, mobile phones and iPads.

All we need is time. It will be better tomorrow. This time next year we’ll be rich.

Pensions. A defined benefit pension defies the concept of responsibility and quite frankly is naïve. A defined contribution pension is fairer and more practical. Even that, however, can be gamed. If the trustee of a defined contribution scheme exposes the scheme to credit risk in a conflicted or cavalier fashion, what recourse is there? What preventive or preemptive action can be taken? Some of the arguments and proposed solutions to pension underfunding have an unmistakable kleptocratic logic to them. ‘Raise the pension age’ really means don’t pay the old codgers so soon and let’s see if we get lucky and some of them die. ‘There’s no problem, they have home equity’ really means, let them eat cake, they seem to have money anyway, how dare they take back what they’ve paid into over the last 40 years. Countenancing an arithmetic that involves an arbitrary and mandatory cash transfer between generations is institutionalized theft. Besides, pensions discourage discretionary saving, and a misplaced belief in the promises of companies and states. Ultimately, we are on our own and if you don’t believe that then trust your pension, your bank, your banker, your accountant, your member of parliament, prime minister, president, generalissimo et al.

I would honestly like to know what happens when a corporate or a state is no longer able to meet its pension liabilities. An employee provides their services on 30 day credit to their employer and on 30 year credit to their employee pension fund. What happens when companies just cannot hire anymore? What does that say for the structure of business organization? Already the British public sector workers have woken up to the fact that their easy ride has run away.

The human race is great at depleting things. Just as we deplete all the stuff in the ground that powers our planes, trains and automobiles, and holds up our glass and steel towers, we deplete our future leaving a massive burden of debt.

This is a consequence of living beyond our means and getting ahead of ourselves. Yes it makes sense to borrow to buy today what we can pay for tomorrow. But it is not alright to borrow to consume today and expect future generations to pay for it. There are limits to profligacy and we have stepped well over the limit. We laugh at the thrift and inefficiency of some of the more backward nations, nations from whom the Europeans now hope to obtain a loan, and then have discovered to their surprise and dismay that these nations actually have some sophisticated underwriting standards. They actually expect to be repaid in money that’s worth something in cold hard stuff.

Chapter 11 is good in that it allows companies to get back on track to profitability. Personal bankruptcy gives people a second chance to rebuild what has been lost, or spent. But safety nets have two sides, one that saves and another that encourages irresponsible behaviour.

Another broad phenomenon has been the fall of communism and the lack of a counterbalancing force to capitalism. Without a dual, capitalism has evolved in a perverted way. Where once the system would reward and punish decisions in equal measure, the type of capitalism practiced today rewards but does not punish. At least it tries at each turn to bail out investors, to entrench management, to enrich the powerful. How can the price signal work if its distribution is deliberately skewed to the upside? The system attempts to blunt the punishment to inefficient resource allocation and poor decisions. The spectre of moral hazard hangs above every market and economy, holding policy and governments hostage to the concept of ‘too big too fail.’ Without an alternative regime, a competing model, there is no incentive to refine, improve or keep the capitalist model honest. Even the communists have adopted capitalism, albeit without democracy. This unbridled form may be even more cutthroat than the original model where minority rights actually meant something, instead of being swept away in a torrent of economic growth.

The perversions of capitalism have led to excessive debt without the recognition of responsibility and hence an absence of a credible long term solution, also moral hazard writ large which have policymakers doing what the market wants, and price distortions the result of asymmetrical efforts to support special interests. These make the current trajectory of economic development u
nsustainable and unstable.

Already the degree of intervention in markets and the economy has reached unprecedented levels. Central banks have bloated their balance sheets monetizing debt issued to finance Keynesian fiscal policies. Fictional bank stress tests are applied to signal strength where there is weakness. Regulators require more conservative practices from banks while governments require credit profligacy. Central banks extend credit to one another in a kaleidoscope of capital they hope no one can trace or fathom. And accounting standards have developed, or degenerated, depending on your point of view, to the point that they can no longer be considered generally accepted.

Something has to give and suddenly the future is not so wonderful a place. Because we’ve borrowed the living daylights out of it.