Gifts to Greece

My first thought this morning was to write about the so-called UK drought again. Maybe I’ll post something on that later.

Then I had a strong urge to comment on the absurdly excessive punishment of Lewis Hamilton (a 5 place penalty or inadmission of his final run – moreorless equivalent punishments – would have been appropriate) after an error by his team in qualifying for today’s Spanish GP. I’d hardly call myself an expert on the sport, but a previous foray into F1 commentary attracted a good deal of attention.

Instead I’m going to channel my annoyance at the spoiling of what might have vaguely resembled a sporting event in Barcelona towards the Greeks.

All I want to convey is one simple point, that the Greek people have benefited hugely from the international loans on which they have already partially defaulted and look increasingly like failing to repay in their entirety.

We haven’t invented this thing we call money just for fun. Money allows resources to be allocated. If you borrow it, spend it and fail to repay the loan, you have acquired or consumed resources that could have been used by someone else. Take the Athens metro railway and all the other billions worth of infrastructure to support the 2004 Olympic Games. How was that funded? I’ll hazard a guess. Borrowed money, at least in part. And what will happen to all that capital investment when Greece defaults? It’ll still be there. These assets will remain in existence indefinitely for the benefit of the Greek people. To the extent they haven’t been paid for, they’ve effectively been stolen from the rest of the world.

Some loans may be riskier than others, because that’s how the world is, but, unlike equity investments, loans are designed to be repaid. Financial disruption – on a global scale over the last 5 years – arises when debts are not repaid. So, because of the knock-on effects, Greece’s default is worse than theft! The entire EU has been plunged into recession in large part because of the need for the financial system to prepare for possible Greek default. Instead of using capital to support new lending, banks have been writing down Greek (and other) debt and taking actual losses.

Obviously we’re just reaping what was sown when Greece and other European sovereigns borrowed unsustainably. The question is how to prevent repeats of this cycle of behaviour?

Let’s mull over that question for a minute. What is the popular conception of what’s going on?

I think it was Arthur Smith I heard on the radio yesterday saying the Greeks should be let off their debts because “it’s not the fault” of those protesting. In what sense is that, Arthur? Are you perhaps saying the average Greek took no executive decisions regarding the nation’s finances? Clearly true. But isn’t a large part of the problem that they haven’t paid and continue not to pay their taxes? What do you think is fairer, that every Greek homeowner should pay a special tax (they’re refusing) or that you and I should find the money?

And isn’t a large part of the problem the Greek public-sector? What do you think is fairer, that Greek workers should take whatever pay cuts it takes to balance the books (as has happened elsewhere in Europe, such as in Estonia – now growing again – Latvia and Lithuania) or that you and I should find the money?

Many non-wealthy Greeks must also be culpable of wilfully participating in a cash economy, benefiting from lower prices for services whilst complicit in tax avoidance. What do you think is fairer, that the Greeks start paying taxes commensurate with their public spending like people in most other countries, or that you and I should find the money?

But the really interesting point is that Greece is a democracy. They’ve chosen their own government since the ousting of the colonels in the 1970s. Collectively, then, they’ve repeatedly elected politicians, at least some of which have overspent, undertaxed and cooked the books, or appointed officials to do so on their behalf. Clearly, collectively, the Greeks have benefited from this behaviour. I’m intrigued, Arthur, whether you’re suggesting that, collectively, the Greek people are also not responsible for the situation they find themselves in.

That’s probably enough. After all, Arthur is a national treasure, practically the new Queen Mother, and perhaps a little fragile. Maybe he just didn’t think. Maybe, like the QM, he inhabits a world where decisions are made by waving a magic wand. Maybe, like the QM, he lives in a world where one need take no responsibility for one’s finances.

I also caught a snippet this morning of someone on the Andrew Marr Show invoking the precedent of Argentina. That great and honourable country, that upstanding, exemplary member of the international community most recently defaulted on their debts about a decade ago. And it’s been great for their economy! Who’d have thought it? It’d be great for my personal finances if I went out and bought a house, a car, new furnishings and white goods, new shoes, clothes and so on and then didn’t bother paying for them. I’m sure I’d feel pretty well off for a few years too.

Let’s pick on someone else. Arianna Huffington writes in the NYT:

“Yes, the Greeks acted irresponsibly before the economic collapse — the same way my father had acted irresponsibly in his private and professional life. But that is not reason to punish the children, to destroy their future as part of a remedy for a past for which they bear no responsibility.”

What Arianna is saying – for some reason “bleeding heart liberal” is the outmoded phrase that comes to mind – is a little more sophisticated than Arthur Smith’s indignant genialism. We have to draw a line, she says, to protect the innocent. Though, I can’t help pointing out yet again, these “innocent” are nevertheless beneficiaries of the misappropriated funds spent in Greece over the last decade or so. Perhaps they’ll remember that every time they hop on Athens’ shiny new metro trains.

The fear gripping financial markets – and contributing to the unnecessary economic hardship and suffering of innocent little children currently taking place in, say, the UK – is that other countries will follow Arianna’s line of reasoning too. Why shouldn’t Ireland, Spain, Portugal and even Italy say “don’t punish the children”? Having elected profligate, irresponsible governments that have given them what they wanted – low taxes, high spending – why won’t they now elect governments to satisfy their new desire for debt writeoff with some kind of moral justification (right wing nationalist or left wing anti-capitalist – take your pick, or, hey, what the hell, you can even pick both!).

If we want financial stability – quite possibly a good thing, I suggest, in light of the 1930s, just as a for example – then debts have to be repaid. And sovereign debts would be a good start.

So how can the international community protect itself against freeloaders? Against those countries who run up debts, fail to collect enough tax and then, in the words of the song about the girl next door and the bathroom floor, plead “It Wasn’t Me”?

Here’s my suggestion. Many of the countries that default are serial offenders. There’s something deeply ingrained, in their DNA if you like, that leads them to spend too much and collect too little tax. So cut them off from international finance for long enough for them to lose thir habits. This would be simple to implement. The financial services industry is highly regulated (all that effort’s been really effective, hasn’t it?). Regulators in responsible countries (say the UK, the US, the EU apart from Greece) could simply demand that no financial institution or its subsidiaries (maybe even no company) lends at all to a government that has defaulted on sovereign debt over the last 50 years – or maybe even more. Or, crucially, to any institution in that country dependent on its government, such as a bank or a company.

Since holding the currency of the defaulted country would constitute lending, all investment in defaulted countries would have to be funded locally in their own currency. Imports would require foreign currency that would have to be acquired beforehand by local institutions or individuals, i.e. by selling goods and services as exports (or small amounts of currency to tourists and other visitors). No publicly funded export credit guarantees would be available to UK companies, for example. In effect, such countries would be forbidden from running a trade deficit.

Such a measure would do two things. It would financially quarantine serial defaulters for a time longer than short-term market memory currently manages (defaulters tend to return to the international markets within a decade). And it would give non-defaulters pause for thought.

Don’t Backslide on Greece!

You know there’s serious trouble when the Economist runs a two-page editorial, in this case proposing “how to save the euro”.

The Economist agrees with most observers that the problem boils down to how to deal with Greece.

Let’s recap.  Greece, a serial defaulter, essentially fiddled the books to understate its debt in order to be admitted to the euro club, hoping for more economic stability.  Then the financial crisis came, and, as the saying goes, the tide went out and the Greeks were seen to be wearing no trunks.  Not only that, there was an Aegean tsunami on the horizon. Luckily, the Germans had grabbed the deck-chairs so the Greeks aren’t on their own.

What are the Greeks, the Germans and the eurocrats (not to mention the IMF) to do?

What baffles me is the current hysteria from all quarters. Decisive action is not required, as for example, George Osborne insists. The Greek debt is a long-term problem which requires a long-term solution. “Decisive action” implies some kind of quick fix. “Decisive action” is the last thing we need.

In fact, I can see things that can be done to mitigate the situation – economic stimulus measures in the less-indebted eurozone, other European (that includes the UK, Mr Osborne) and other global economies – but I simply can’t see how the central problem could be handled any better than it already is. If that’s not what the markets want to hear then the markets will just have to get over themselves. Some problems just have to be lived with.

Let’s consider the alternatives (I’ve previously written about this on Martin Wolf’s blog at the FT, but I can’t even access that right now, as I terminated my FT subscription in protest at them trying to jack up the price).

1. Greece exits the euro and devalues
This would be catastrophic, at least in the short-term. The Economist discusses the possibility and quotes an estimate that such a step would cost Greece 40-50% of its GDP in the first year (though this seems to assume they leave the EU as well). The trouble is, the “mother of all financial crises” that would result would not be confined to Greece. French and other eurozone banks would take a massive hit, with all kinds of knock-on effects. Even if the initial shock could be contained without seriously recessionary consequences for the remaining eurozone countries, it would simply be a case of “who’s next?” – Ireland, Portugal, Spain, Italy, Belgium, France…

2. Greece devalues within the euro
This is the straw that many are now clinging to, including the Economist, but in fact it’s almost as bad as option 1.

First, there’s the moral argument. Why should the beneficiaries of excessive Greek borrowing be forgiven their debts? Greek taxpayers (or non-payers, by all accounts) would escape paying taxes equivalent to the nation’s long-term spending; all Greeks would have benefited from public services that they haven’t fully paid for; Greek public sector workers would have been paid more than the nation could actually afford – the list is endless. The point is, although different Greek constituencies would no doubt blame each other, the entire nation is complicit, though pre-school children can legitimately claim not to have been in a position to influence matters overmuch.

Second, if Greece is let off a large chunk of its debt, why wouldn’t other countries demand the same? Why should the Portuguese, Spanish, Italians, Irish, French and Belgians suffer tax rises and cuts to their public services if Greek debt is simply written down?

Third, and critically, there’s the problem that a Greek default within the euro doesn’t actually solve the underlying problem. It does something about the debt, but not the deficit. If Greek debt is (say) halved from around 140% of GDP to around 70%, they will still not be credit-worthy, because they’d still be running a deficit. There would still be a need for the IMF, EU and ECB troika to help the Greek government somehow bring revenue and expenditure into line. There’d still be a need for wealthy Greeks to pay more taxes, the Greek public sector to spend less and its economy somehow to grow. In the meantime there’d still be a need for someone to lend euros to Greece.

A Greek default within the euro would simply not have the usual effect of sovereign defaults because it would not be accompanied by devaluation.

In fact, the main effect of Greek default within the euro would be for the Greeks to say “thank you very much”. There’d still be a big hit on eurozone banks (including the Greek ones which would need to be recapitalised from somewhere, and not to mention the ECB), although not the automatic loss from lending to the Greek private sector that would occur in the case of option 1 (when devaluation would make it more difficult, to say the least, for Greek companies to service euro-denominated debt).

Now, it seems to me the troika must recognise this. If I was them I’d demand the budget reforms before allowing any kind of Greek default. In particular, the possibility of Greece having to leave the euro needs to be still on the table. In fact, it wouldn’t surprise me if there hasn’t been a nod and a wink to the off-message officials and politicians (usually German) who regularly float this possibility.

It seems the next payment to Greece is being put off to the last possible moment, even though stumping up is much better for everyone than the alternatives. What puzzles me is that the markets don’t recognise that this brinkmanship is a necessary part of the strategy of forcing Greece to balance its budget in the long-term.

What the Greeks should really be worrying about is the possibility that they haven’t resolved their fiscal problems by the time the rest of the eurozone has recovered (and in particular the banking sector has rebuilt its capital) sufficiently to withstand a Greek default, euro exit and devaluation. Then the eurocrats might just decide to throw them to the wolves.

Still, I wouldn’t rule out a collective loss of nerve and a Greek default within the euro. We’d have to muddle through somehow. If there’s a double-dip, there’s a double-dip – maybe that’s now the least we can expect; if there are further sovereign defaults, the sun will still come up the next morning; if we do end up calling it the Second Great Depression or a Lost Decade, life will still go on. As I said, some problems just have to be lived with.

Dissecting a Wolf, a Bean and a Vulcan

I see John Redwood was up bright and early this morning, blogging away.  At 6:34am he posted that:

“…the [cuts] strategy has worked, bringing interest rates on government borrowing down and seeing off a possible Greek or Irish style borrowing crisis.”

Well, maybe.  But there’s an alternative explanation which would chill the former Minister’s blue blood.  I would have thought traders would pay a lot of attention to the interest rate desired by a central bank able to use QE to drive down yields to whatever level it desires.  FT Alphaville suggests that the Fed, at least, might decide to simply target long-term interest rates rather than apply a specific amount of QE.  Not a market to short just now, I would have thought.  Much safer to bully the Portuguese.

For the record, I can’t help a nasty feeling about all this QE.  The danger is letting inflation catch up with us.  A bit of inflation right now would be a jolly good way to get rid of all that negative equity.  But if inflation expectations sneak up on us the Old Lady would be compelled to sell off her QE bonds at a loss to soak up excess cash.  And it would suddenly make new government debt rather expensive.

Still, there don’t seem to be any better ideas out there.  And the clear and present danger, as pointed out by Posen, does seem to be a Japanese style “lost decade”.

But it was what the Vulcan did next that really amused me.  He was on the Today programme this morning absolutely fulminating that the Deputy Governor of the Bank of England, Charlie Bean, had suggested that if savers spent some of their money it might benefit the economy.   Redwood apparently believes that: “We are all collectively embarked on cutting the mortgage and putting some more money into savings and pensions.”  Yes, “all”.  How does that work, John?  Where does this money come from?  The same magical mystery place as bank interest apparently, since the former stalking horse also lectures us that: “Consumers might spend more if they got a better return on their savings and had more savings income” and that: “As house prices fall, people become more alarmed by the level of the mortgage.”

Um, doesn’t one person’s savings income come from another person’s mortgage interest payment?  And won’t house prices fall even further and people become even more alarmed if their monthly mortgage payments rise?

What on Earth does the Member for Wokingham think the economy is?  Maybe on Vulcan there are some different principles, but in this part of the Milky Way it’s generally considered that the more money circulates in return for goods and services, the healthier the economy is.  Yes, John, money has to circulate.  We can’t all stuff our mattresses with it.

Another getting their knickers in a twist over all this is our old friend Martin Wolf over at the FT.  If he feels the Coalition’s cuts agenda is dangerous I suggest we listen.  And this morning Wolf’s teeth were dripping the blood of the IMF, who (much to the delight of Grant “Anyone for Rugger?” Schapps on Question Time yesterday evening) have dared to endorse the new government’s spending plans.

Personally I think there’s a good chance the whole cuts debate is redundant as – just like in a household – it’s not always that easy to cut back on your spending.

But what really surprised me this week was a rare slip by Wolf.  He wrote that:

“The [policy strategy] of slashing the fiscal deficit while the private sector tries to slash its debt suffers from a fallacy of composition: it is impossible for all sectors of the economy [i.e. the public and private sectors] to spend less than income at the same time.”

This is simply incorrect. There is no “fallacy of composition”. The creditors are all private sector, so it is entirely possible for both public and private sector debts to be paid down simultaneously. It’s not the balance between the sectors that matters; it’s what happens within the private sector that’s important. Simply put, to decrease total debt, there needs to be an increase in financial equality (though not necessarily in living standards, since public spending reductions affect the rich financially and the poor non-financially).

Strangely, whilst my first contribution to the debate appeared immediately, my second comment which began by succinctly pointing out Wolf’s error failed to appear on the FT for a couple of days (then appeared twice).  I have little tolerance for this sort of thing.  It seems to me that the mainstream media who have coopted much of the blogosphere debate have a responsibility to allow debate to actually proceed and make sure their technology works reliably.  I was going to have a good whinge.  Now I suppose I’ll have to give the FT the benefit of the doubt.  Must have been a glitch.

There’s a really big issue here, though.

It’s becoming more and more apparent that the big picture is that inequality is more than just bad for us Spirit(Level)ually – it’s also bad for the economy.  Robert Reich has apparently explained this in Aftershock which I was just about to order when I realised I had his Supercapitalism on my shelf.  Unread.  Not any more though, so I’m off to see who can rush me Aftershock (2-3 weeks say Amazon, tsk).

On Climate, and Causes in Complex Systems

Why do so many travellers, such as those marooned by the Eyjafjallalokull ash cloud, invoke a panic response on finding they can’t leave a foreign land? I remember that when I was on a memorable trip to Albania in, if I recollect correctly, 1996, our group was playing leapfrog, as it were, with another minibus full of tourists, along a road to the coast. When we stopped – often – for a passenger to relieve the symptoms of one or other of the local stomach-bugs, the other bus passed us, only for us to see them stopped by the roadside a few minutes later. Eventually we pulled up beside them to chat. It turned out that Albania’s borders were shut, in the hope of trapping whoever had blown up the Tirana police-chief. The other group were cutting their trip short. So illogical. We simply carried on with our holiday. [I drafted this a few days ago, but, since then, I've heard, Radio 4's Today programme is discussing the psychology - and even genetics - of the have-to-get-home phenomenon, right now!].

It beats me why so many people spent thousands of euros hiring cars to drive across Europe. Surely staying until the ash alert blew over would have been both cheaper and less stressful.

Whatever they did, though, even those who have spent the last week hitch-hiking from Athens to Calais abroad cannot fail to have heard that, apparently, global warming will lead to more volcanic eruptions.

Is this something we should worry about?

In short, no.

Volcanoes and ice ages

The scare seems to be based on a study of the end of the last ice age:

“Huybers and Langmuir spliced two databases of volcanic eruptions worldwide over the last 40,000 years.

Eruption levels stayed low until around 12,000 years ago, then suddenly they suddenly shot up. The melting ice released so much pressure that the newly liberated volcanoes erupted at up to six times their normal rate, the researchers estimated.

The inferno lasted for 5,000 years and could have pumped enough CO2 into the atmosphere to raise concentrations between 40 and 50 parts per million, the researchers estimate. Changes in ocean chemistry probably released the rest.”

I love the eruption levels “suddenly” shooting up “suddenly”!

Now, a couple of kilometres of ice over a volcano is one thing. It’s reasonable to suppose that would prevent the pressure in a magma chamber that would otherwise have caused an eruption from doing so.

But melting a kilometre or so of ice takes quite some time. And besides, since the last ice age, there aren’t so many ice-sheets left. Worst case, in a few centuries, perhaps, we could feel the effects of some pent-up volcanic activity.

In the meantime, the worst that could happen is that some eruptions are brought forward by a few years.

The hype around the volcano scare exploits our innate difficulty in conceiving long periods of time. It also resonates with research a while back which noted more eruptions at certain times of year. The suggestion was that particular weather conditions – changes in pressure – around volcanoes, could set them off.

This triggering is an entirely different kettle of fish.

Volcanoes and the weather or short-term climate change

Consider a simple model of volcanic eruptions as the sudden release of something we might call “pressure” that builds up over time. Let’s suppose that the main cause of the build-up of “pressure” is geological. Let’s also assume that the weather can cause seasonal variations in pressure. In this model, eruptions will occur when the total pressure crosses some threshold, as in the following diagram:

Because I’m lazy, and Powerpoint is a step back from pen and paper (and reverting to that and scanning is a hassle right now), I’ve shown the total pressure (dotted line) as the sum of the geological pressure and seasonal variations for the first eruption only, but hopefully you get the idea.

It’s not very usual for volcanoes to erupt every 3-5 years, of course – 50 years or so might be more usual – and in real life every eruption is different.

Hopefully, though, it’s fairly easy to see that eruptions are much more likely in this system during the period when the seasonal effect tends to increase pressure. Over this period the total pressure (dotted line) increases much faster than when the seasonal effect is to decrease pressure.

In fact – and hold this thought – if the rate of increase in pressure due to short-term variability is faster than the long slow build-up of pressure, then eruptions, according to this simple model, will always occur during the short-term upswing in pressure.

My proposition is that it is very easy to exaggerate the effect of the seasonal cycle as a “cause” of eruptions. It is merely a trigger.

You can also see that, if, say, the seasonal pressure changes – a gradual trend on top of the annual fluctuations, perhaps, or an increase in amplitude of the cycle – it will not have a large effect on the frequency of eruptions over a long period. The periodicity of the system will still be driven by geological processes. The weather is a secondary driver in this system.

Now, if you didn’t know that volcanic eruptions are caused by a build-up of “pressure” underground, you might hypothesise that they’re caused by weather conditions. You might collect a lot of data and calculate correlation coefficients to “prove” your theory. You might even argue convincingly that, because we know what causes the weather, the weather must cause volcanic eruptions rather than vice versa and furthermore, it is not the case that both the weather and volcanic eruptions are caused by a third factor.

But you’d be wrong.

Could this mistake happen in other circumstances, though?

Solar cycles and the AMO

That old chestnut, solar cycles, surfaced yet again in New scientist a week or two ago. The claim is that there’s a “compelling link between solar activity and winter temperatures in northern Europe.”

Well, maybe there is.

But anyone who’s stayed awake this far will realise that it’s not enough to determine a correlation between solar cycles and weather patterns. Maybe the solar cycle does trigger a change from one state of the AMO (Atlantic Multidecadal Oscillation) to another. But that doesn’t make it the sole or even the main cause of the variability.

To recap, I first explored the idea of the AMO when I became concerned that the emphasis being put on shrinking Arctic ice as an indicator of global warming (GW) could backfire if the shrinkage reverses. My first post on the topic was therefore titled: Spin Snow, Not Sea Ice, the AMO Is Real!. Back then, I noted that the AMO cycle – likely to be variable in length, especially now we have the extra GW complication – tends to be of the order of 60 years or so, with the previous cooling phase lasting from the 1940s to the 1970s. Maybe we’re entering another one.

That first post suggested a mechanism for the AMO, which I discussed a little more in my second post on the topic, Why the AMO Overshoots. So I won’t repeat myself today.

Later, in 1740 And All That I looked at a historical example of a sudden switch from mild to cold winters in NW Europe. The weather pattern that leads to cold winters might be termed an “anti-monsoon”, as I first discussed back in January in Snow Madness and the North-West European Anti-Monsoon.

Two other posts Ice Pie and Ice Sickle explore aspects of the AMO.

The basic argument in all these posts is that the natural cycle – the AMO – is characterised by a set of feedbacks. Positive feedbacks – perhaps including the effect of lying snow, as considered in That Snow Calculation – produce distinct warming (Arctic ice melt) and cooling (Arctic ice recovery) phases. Negative feedbacks cause one phase to flip to the other. But the exact timing of the tipping-point may be caused by external triggers.

My proposition is that by the end of warming phase of the AMO, the seas (especially the Arctic and the North Atlantic) are relatively warm compared to the land. Any sudden cooling event could trigger a flip to the cooling phase, because the land cools quicker than the ocean, so would become relatively even colder.

Possible sudden cooling events are volcanic eruptions or the change to a cooling phase of the solar cycle, as discussed previously for the case of 1740.

A critical point is that the sunspot cycle is much shorter than the AMO (see AMO discussion and graphs in my first post on the subject):

NASA graph of yearly sunspot numbers

The sunspot cycle indicates the total irradiance from the sun, and the rate of variation is comparable to that of other causes such as GW:

IPCC Fig 2.16 recent changes in solar irradiance

Further Implications

Not too many scientists claim volcanic eruptions are “caused”, as opposed to triggered, by variation in the weather or by climate change. Most understand that only over the sort of long timescale that is needed to melt an ice-sheet would the frequency of eruptions change.

But far more common is the explanation of apparent climate cycles – such as the AMO – by variations in solar output. In cases such as this, it is necessary to do more than just prove a correlation. The causal mechanism needs to be clear and must be shown to be quantitatively sufficient to explain the observed phenomena.

Considerable care is required whenever attempting to explain the “causes” of complex system behaviour.

The need to distinguish between triggers and underlying causes of cyclic behaviour also applies elsewhere in the climate system. Furthermore, the distinction between triggers and underlying causes may become blurred – both may be of similar magnitude, creating a resonant system. In particular, over longer timescales than so far discussed, the Milankovitch cycles are not enough alone to explain the ice age cycle. Perhaps they resonate with another cycle internal to the climate system.

In other domains too, it is not possible to assume that the “cause” in a complex system is just that which is evident on the surface. The lax lending practices and cheap money that are held to have caused the credit crisis may just be one part of a deeper, more complex cycle of optimism, deregulation, increased trade and globalisation on one hand and retrenchment and nationalism on the other.

Lloyds Rights Issue complexity: Um, why don’t we just change the rules?

The upcoming Lloyds rights issue is in fact quite simple. They are giving shareholders the right to buy ~50p worth of new shares for each of the currently existing shares they hold. The new shares will be offered at a discount, but their price has not yet been set, so, obviously, you cannot yet determine how many new shares you can buy. But you’ve been told, albeit somewhat cryptically, what you need to know right now: if you want to take up your rights, you’re going to need to find 50p for each share you own when the rights issue process starts on 20th November. [Summary paragraph added 8:45am 4/11/09].

But is it just me or is the organisation and presentation of this rights issue more complicated than it needs to be? [Reworded 8:45am 4/11/09].

I quote in full section 10 of Lloyds’ announcement of its rights issue:

“10 Share Subdivision

Under the Companies Act, it is not permissible for a company to issue shares at a discount to their nominal value, which, in respect of the Existing Ordinary Shares is currently 25 pence per share. It is proposed that the Company carries out the Share Subdivision which will reduce the nominal value to 10 pence per share. This provides the Company and the Joint Bookrunners with greater certainty that the Issue Price will be able to be set at a 38 per cent. to 42 per cent. discount to TERP [the Theoretical Ex-rights Price, which itself depends on the number of new shares being issued, so a bit of algebra is needed to determine the issue price for 38-40% discount based on the current trading price of the existing shares] irrespective of market conditions. The Board believes that the Share Subdivision also provides the Company access to the best available underwriting structure and terms. Although no decision has currently been made as to the Issue Price, in no circumstances will the Issue Price be below 15 pence. As noted in paragraph 8 of this letter, the Issue Price is expected to be announced on 24 November 2009, two days before the General Meeting. The Proposals are conditional on, amongst other things, the completion of the Share Subdivision.

It is proposed that, pursuant to the Share Subdivision, each existing Ordinary Share of 25 pence in issue at the close of business on the date of the General Meeting will be subdivided into one ordinary share of 10 pence in the capital of the Company (a “10p Ordinary Share”) and one deferred share of 15 pence in the capital of the company (a “Deferred Share”). The purpose of the issue of Deferred Shares is to ensure that the reduction in the nominal value of the Ordinary Shares does not result in a reduction in the capital of the Company.

Each Ordinary Shareholder’s proportionate interest in the Company’s issued ordinary share capital will remain unchanged as a result of the Share Subdivision. Aside from the change in nominal value, the rights attaching to 10p Ordinary Shares (including voting and dividend rights and rights on a return of capital) will be identical in all respects to those of existing Ordinary Shares. No new share certificates will be issued in respect of the 10p Ordinary Shares as existing share certificates for existing Ordinary Shares will remain valid in respect of the same number of 10p Ordinary Shares arising from the Share Subdivision. The number of Ordinary Shares of the Company listed on the Official List and admitted to trading on the London Stock Exchange’s main market for listed securities shall not change as a result of the Share Subdivision. The Share Subdivision will not affect the Group’s or the Company’s net assets. Consequently, the market price of a 10p Ordinary Share immediately after completion of the Share Subdivision should, theoretically, be the same as the market price of an Ordinary Share immediately prior to the Share Subdivision.

In addition, it is proposed that, pursuant to the Share Subdivision and as required by Article 3.1.4(i) of the Articles of Association, each existing Limited Voting Share of 25 pence in issue at the close of business on the date of the General Meeting will be subdivided into one limited voting share of 10 pence (a “10p Limited Voting Share”) and one Deferred Share. Aside from the change in nominal value, the rights attaching to 10p Limited Voting Shares will be identical in all respects to those of existing Limited Voting Shares. No new share certificates will be issued in respect of the 10p Limited Voting Shares as existing share certificates for existing Limited Voting Shares will remain valid in respect of the same number of 10p Limited Voting Shares arising from the Share Subdivision.

The Deferred Shares created on the Share Subdivision becoming effective will have no voting or dividend rights and, on a return of capital on a winding up of the Company, will have the right to receive the amount paid up thereon only after Ordinary Shareholders have received, in aggregate, any amounts paid up thereon plus £10 million per Ordinary Share.

No share certificates will be issued in respect of the Deferred Shares, nor will CREST accounts of shareholders be credited in respect of any entitlement to Deferred Shares, nor will they be admitted to the Official List or to trading on the London Stock Exchange or any other investment exchange. The Deferred Shares shall not be transferable at any time, other than with the prior written consent of the Directors. The rights attaching to, and restrictions upon, the Deferred Shares are set out in Resolution 6.

At the appropriate time, the Company may repurchase the Deferred Shares, make an application to the High Court for the Deferred Shares to be cancelled, or cancel, or seek the surrender of the Deferred Shares using such other lawful means as the Directors may determine.”

Got that? You’ll be tested on it later!

In fact, all section 10 says is that to get round some stupid rule, and in case Lloyds shares fall before the rights issue completes, we’re all going to be issued with “deferred shares”. These are totally worthless. I just hope they don’t actually show on my trading account, cluttering up the screen and statements.

Frankly, who cares about the nominal value of shares? And, if the rule that companies can’t issue new shares at below the nominal value of existing shares is so easily circumvented, does it really have any point? Maybe the law could simply be changed to add “unless approved at an AGM”.

I’d rather the army of accountants and company lawyers running large companies were employed making sure the business doesn’t screw up, not worrying about worthless deferred shares. Someone was obviously paid to write the paragraph that ensures the deferred shares are worthless. On the other hand, maybe it was worth it for the amusement value. I like it so much I’ll quote it again, this time with a bit of emphasis:

“The Deferred Shares created on the Share Subdivision becoming effective will have no voting or dividend rights and, on a return of capital on a winding up of the Company, will have the right to receive the amount paid up thereon only after Ordinary Shareholders have received, in aggregate, any amounts paid up thereon plus £10 million per Ordinary Share.”

Perhaps they should index that £10 million to RPI. We might experience hyperinflation.

Lloyds is also waiting till the last minute before telling us what the issue price of the new shares will be, in case the short-sellers get their teeth into the situation. Actually I don’t care very much. What I want to know is how much I’m going to have to put in for each share I own. Then I can calculate the total amount I need to find. Shareholders are being asked for about 50p per share they own at the record date for the issue (20th November), calculated by dividing the amount to be raised (£13.5bn) by the number of shares in circulation at the moment (just over 27bn, a number which won’t change materially over the next couple of weeks). Lloyds’ announcement could easily have included the exact amount as a headline (I haven’t read all 200,000 pages of the documents they’ve issued today).

Rights issues remain dysfunctional as I explored here, here and here around 18 months ago (when HBoS was passing a hat around, ironically enough). All that’s been done is to try to speed the rights issue process up, which introduces new problems: the regulators haven’t speeded up the process of moving money about, and the post, for obvious reasons, is even less reliable right now (let’s hope we can all exercise our rights online or by telephone, eh?). As I said in my previous posts on this topic, it must be possible to devise a way of raising funds from shareholders that isn’t vulnerable to attack by short-sellers. Such a scheme would surely save on underwriting fees, for starters. Lloyds will only raise £13bn net from its £13.5bn rights issue. I can live with putting money into basically sound companies that need it, but it sticks in the craw that so much disappears in transaction costs (and in this case, a windfall tax in all but name). Especially when I’m not going to get any dividends for another 2 years!

The Great Carry Trade III: Nouriel Roubini Frets about US and a bit on Japan

When I used to frequent the Internet Chess Club they’d often use a message something like: “A hush descends as Grandmaster So-and-so enters the room.” Well, I feel the same reaction should greet Professor Nouriel Roubini’s entry into the discussion of the Great Carry Trade. It’s worth hanging on the Professor’s every word…

Roubini notes that:

“…while the US and global economy have begun a modest recovery, asset prices have gone through the roof since March in a major and synchronised rally. While asset prices were falling sharply in 2008, when the dollar was rallying, they have recovered sharply since March while the dollar is tanking. Risky asset prices have risen too much, too soon and too fast compared with macroeconomic fundamentals.

So what is behind this massive rally? Certainly it has been helped by a wave of liquidity from near-zero interest rates and quantitative easing. But a more important factor fuelling this asset bubble is the weakness of the US dollar, driven by the mother of all carry trades. The US dollar has become the major funding currency of carry trades…”

Roubini, characteristically, worries most about the unwinding of the dollar carry trade.

I don’t know, I think there is a wrinkle here, which is that the US dollar can’t actually depreciate, not fully, anyway, because of China’s dollar peg. Therefore it hasn’t got so far to snap back in a panic. Sure, there can be some unwinding if the market suddenly perceives emerging markets to have become overvalued, more risky or growth less certain. This damping of the dollar’s movement makes dollar-funded carry trades less risky than they would be otherwise. This is not good, because it will allow bubbles to inflate even more than would otherwise be the case.

Roubini writes as if carry trading investors are making a currency gain by borrowing dollars, over and above emerging currency and other market movements. That’s only true if your accounting currency is neither dollars, nor, say, sterling, which is hardly appreciating nor going to appreciate against the dollar (and also appears to meet the criteria for a carry-trade funding currency). In fact, it’s only really true if your investors want euros or possibly yen at the end of the day, though one wonders why they don’t just borrow in those currencies to reduce the risk, if they believe a flight to safety would favour the dollar.

Since the dollar’s decline is primarily taking place against the euro, it follows, incidentally, that as I argued last time, the next phase of the game will be characterised by a eurozone trade deficit as well as a US and (not that it’s very significant to the rest of the world) a UK one.

Martin Wolf worries – to a very deferential Tech Ticker audience – that eventual US rate rises will have a dramatic effect. Sure. But – since interest rates do most of their work in curbing inflation through their effect on the foreign exchange rate – that simply means they won’t have to rise very much, doesn’t it? Of course, this will help to fuel further borrowing in US…

It might be worth comparing the dollar carry trade to the yen carry trade. The crucial difference is that the yen carry trade was/is inherently risky, because the yen has, for decades, been undervalued, given Japan’s persistent trade surplus (increasing again in 2009).

But we are in a fairly unusual situation of a reserve currency doomed to eventual decline: we can borrow cheaply in dollars because of its reserve status, but, as its status as a reserve currency diminishes, it will be seen to be fundamentally overvalued because of its trade position and the vast overhang of dollars already in foreign hands. So borrowing in dollars is something of a one-way bet – you don’t have to worry that your fortune has the Ponzi quality of depending on everyone else continuing to want to borrow in dollars. The dollar isn’t going to snap back up – notwithstanding a temporary recovery during the next major crisis – because its value is already being held up by central banks wanting to buy them. Rather, the dollar’s value can be expected to decline over time as it is replaced (by a mix) as the world’s reserve currency. Compared to the yen carry trade the dollar carry trade is a bargain, risk-wise. No wonder emerging market equities are breaking records!

Ambrose Evans-Pritchard is always an entertaining read. He writes today that the next crisis could be a Japanese default. But Japan’s trade surplus must make this unlikely. All they’ve got to do is divert some of Japan’s private savings to the public purse. Maybe a little easier said than done, of course, but there’s still plenty of scope. Of course, if they let their national debt rise from 2 to say 3 times GDP, it could start to get tricky to service…

Meanwhile, Peter Tasker worries about an asset bubble bursting in China. This seems closer to the mark. He compares China to Japan and notes that:

“If China continues to follow the Japanese template, the end of the dollar peg will be the trigger event [for the "final manic stage" of the bubble], setting off a Godzilla-sized credit binge.”

There also seem to me to be similarities with the Great Crash of 1929. We are in a fairly unusual situation of a reserve currency doomed to eventual decline, but it is not a unique situation. Didn’t the UK coming off the gold standard in 1925 convince investors that the dollar was the place to be? Blaming Churchill (who took the decision) is wrong-headed. The problem was that the peg existed in the first place, not that we came off it. It might be hitting the ground that does the damage, but the problem is trying to float in the air in the first place.

It seems to me the sooner China appreciates its currency the less painful it will be for everyone. Especially as, the longer Chinese economic growth exceeds that elsewhere, the bigger the relative size of its economy and the greater the imbalance caused by the undervaluation of its currency against the dollar. As I said when I started trying to get my head round all this, currency pegs are a very bad idea indeed. You may be able to market the buck, but you can’t buck the market.

The Grandmother Of All Stealth Taxes

As the nights were drawing in this time last year I detailed how the UK’s “bailout” of the banks is in fact the Mother Of All Stealth Taxes. Well, I underestimated the greed of our politicians.

In March this year the government had obviously not yet done a good enough job of convincing the world’s speculators that the UK financial system was safe. They therefore proposed an insurance scheme in case Lloyds’ losses on specific assets (some £260bn worth, mostly commercial property and mostly acquired when Lloyds took over HBoS) amounted to more than £25bn. For this insurance scheme Lloyds would be required to pay a notional amount of £15.6bn in shares as I described at the time.

I say the amount is notional, because no-one knows what the shares would have been worth in the future. Presumably existing shareholders think the shares are worth more than their current price or they would sell them. Furthermore, the price of the shares granted for the insurance scheme was set when the bank was in difficulty. Since pre-emption rights of existing shareholders (i.e. their right to buy shares on the same terms as the new investment in the bank) were not respected we have no way of knowing how many would have bought shares on the same terms as the UK’s Treasury was offering.

Since Lloyds would have to incur losses of £(25+15.6) = £40bn or so before it even broke even on the deal, their executives started looking into ways to make themselves strong enough to insure themselves against these potential losses. The situation is not straightforward, but Lloyds’ management must have considered that they could manage the assets to incur less than £40bn in losses.

Lloyds now believes it can raise enough money by selling new shares to existing shareholders and issuing some bonds (mandatorily convertible to shares in certain circumstances, I gather) to insure itself, which is, after all, a large part of what banks do.

But as is being widely reported, the Government is demanding a £2.5bn break fee. This has no logical justification whatsoever.

The febrile media reaction to the banks is typified by Dan Roberts in the Guardian. His commentary begins:

“Another day, another few billion pounds of our money is on its way to cheer up Britain’s banks. Today it was the turn of Lloyds to stick its hand out – indicating it wants an estimated £5bn to support its latest restructuring wheeze.”

and which descends into complete incoherence by the end:

“All in all, it’s like taking out house insurance during a fire, refusing to pay for it once the fire is out and sending the insurance company a bill for a new sprinkler system. The real irony is that behind all the complexity, the APS and this associated exit strategy boil down to something very recognisable to bankers by now: a credit derivative, the most toxic yet invented.”

In actual fact a capital raising by Lloyds is a welcome simplification of what looked like becoming a labyrinthinely complex relationship with the UK government. It’s not the role of the taxpayer to guarantee the dodgy property loans Lloyds inherited when it took over HBoS – when, we shouldn’t forget, the bank’s executives were denied the right to conduct thorough due diligence on behalf of Lloyds’ shareholders – so Lloyds raising capital itself so that it is strong enough to bear the potential losses of the assets now on its books represents a return to normality which pundits like Roberts should be welcoming.

What Roberts seems to object to is the government’s participation in the rights issue. But this is what happens when you’re a shareholder. The government will be better off compared to underwriting the losses on a £250bn dodgy loan portfolio. The cost to the Treasury of keeping its/our shareholding to 43% will be around £5bn whereas they could otherwise have had to pay out, we have to assume, perhaps somewhere around £25bn in insurance in return for increasing their holding in Lloyds from 43% to 62% according to calculations done back in March. Let’s be generous and assume ~20% of Lloyds raises £15bn when the taxpayers’ stake is eventually sold (valuing the whole bank at £75bn). Even then the taxpayer is at least £25bn – £5bn – £15bn = £5bn better off under the rights issue plan than writing the APS insurance, assuming £25bn losses, after excess.

The reader may ask why a deal being done at all. The answer is that obviously Lloyds’ management think they can keep losses somewhat lower, but the Treasury surely has to take a more cautious view – note that because of moral hazard, the level of losses could depend on whether or not they’re insured by the Treasury! Since the sensational news has just come through this morning that RBS is to exit the scheme as well, I suspect that all involved – particularly in government – have realised that the scheme is in fact unworkable. It distorts the two banks’ incentives so much that it is impossible for them to do their job of managing the bad debts.

But what of this £2.5bn fee? There are two sorts of justification. One is that the government “saved” Lloyds by proposing the APS. But if the government had done nothing either the whole banking system would have collapsed in March or the banks would have faced down the short-selling speculators and recovered (as Barclays did, its shares having risen 6-fold since then). I would have thought it was part of the normal responsibility of government paid for by all our taxes, not an optional extra, to ensure the existence of an orderly banking system.

Then there is the financial justification. Roberts suggests in his fire insurance analogy that:

“The catch here is that we haven’t been paid yet for providing this insurance when it was needed most (ie, during the crisis) and are having to haggle to get the premium paid retrospectively.”

For what the government deserves another £2.5bn (making them at least £7.5bn better off than before this latest deal) is not exactly clear. The point is the insurance scheme had a £25bn excess and was to run for 5 years, so Roberts’ fire insurance analogy is inappropriate – the insurance policy would have had to pay out nothing for at least the first couple of years. Logically, if there’s going to be a fee of this kind it should be offset against losses and writedowns to date against a scaled-back excess of ~£5bn, i.e. a fifth of £25bn, since about one of the 5 years will have passed since what I understand to be the baseline for the insurance policy of last December by the time the Lloyds fund-raising is complete. Furthermore, the FT this morning provides details of RBS’s losses to date on assets that would have entered the APS. I don’t know where such data for Lloyds could be found, but they are likely to be comparable. RBS has already absorbed losses of £23bn! Even if we take a figure of £15bn for Lloyds, then the loss after the excess is £10bn. The government pays 90%, so owe Lloyds £9bn. Fine. We’ll offset the £2.5bn against that amount!

The £2.5bn break fee is just an opportunistic tax, ultimately falling largely on UK pension funds. There’s no financial justification for this amount.

Lloyds shareholders are likely to be understandably aggrieved that the fee is much higher than the figure of £1-1.5bn that has been touted in the media for some time now. There has to be the suspicion that the government’s negotiators have ramped the price at the last minute. If so, this reeks – I would have thought government had a duty of fairness.

With another £13bn from a rights issue, Lloyds shares are in total worth around £40bn, tops, right now, so £2.5bn represents an arbitrary tax of at least (2.5/40)*100 = 6.25%. There is still an upside, but it’s not looking stellar. I gave a guesstimate earlier that, with a fair wind, Lloyds may eventually be worth £75bn or about double the value shares are currently trading at. But this might not be for 5-10 years. A lot of investors are going to consider that they can much more easily double their money in a “global return to growth” scenario by investing it in emerging markets – where the political risks these days seem no worse – instead of in the UK. Does the government want that to happen? Especially as they may want to sell a lot of bank shares in a few years!

I have owned Lloyds shares since I worked for the bank in the early 1990s. When I was given a few shares as part of my remuneration, I certainly wasn’t warned that the government would levy arbitrary taxes whenever the country’s finances hit a patch of turbulence.

The Great Carry Trade II: more on the Problem of China

Yesterday I explained why I consider that we’re in the midst of an era that could be termed the Great Imbalance. I go along with the the view apparently held by Nouriel Roubini that the so-called “Great Moderation” – the period of low inflation – is/was a mirage.

The point is that there is more than one tectonic shift taking place: low inflation has been caused, not by monetary conditions alone, but primarily by a historic reduction in the power of labour to raise wages and hence prices. Inequality is rising, full employment in developed countries is a half-forgotten phenomenon, jobs move around the world as part of globalisation; whereas the disruption of this supposedly happy state of affairs is caused by, well, trade imbalances.

A year ago I reported how the FT’s Martin Wolf had put his finger on the button (in fact, he’s written an entire book on the topic). Today I open my FT and see the argument outlined again, this time by Martin Feldstein in a piece titled “Why the renminbi has to rise to address imbalances”.

Feldstein argues that the US must increase household savings and China must increase domestic demand and “exchange rates must also adjust”. But this logical relationship is wrong. Exchange rates are the driver here. If the renminbi is allowed to rise against the dollar, American household savings and Chinese demand will adjust automatically.

Feldstein correctly notes that in the next phase of the Great Imbalance the euro will be drawn into the fray. The renminbi has dragged the dollar down. We’re going to start to see imports from Germany substituted by domestic Chinese (and American) products. (Europe will likely blame protectionism, and if they retaliate that would be a self-fulfilling diagnosis). Of course it will all be explained as due to the development of China, things they’re doing right that we’re doing wrong. The low dollar will be easily explained as a shift away from the dollar as a reserve currency since China will naturally hold more euros – a counterpart of its trade surplus with the region. But in fact all this will be the result of misaligned currency exchange rates!

Perhaps we should ask ourselves why China follows this policy when India does not. One problem India may avoid but China must face in the future is the sustainability of their industry. It’s all very well making things cheaply in external money terms, but we also have to consider whether they are being made efficiently in terms of physical real-world resources: labour, energy, the cost to the environment and so on. If these are being systematically mispriced – and it’s difficult to see how they could not be – then there will eventually be a reckoning, a crisis in China and a Great Rebalancing.

At the risk of oversimplifying, the difference with Japan, perhaps, is that, through successful industrial policies, Japan achieved export-led growth more by greater efficiency (such as quality) compared to the competition. This was sustainable even in the era when Japan was popularly termed “the Land of the Rising Yen”.

Feldstein’s conclusion is that:

“Fortunately, the Chinese economy is expanding rapidly and its growth is becoming less dependent on exports. When it has the confidence to allow the renminbi to rise, we will be on the path to reduced global imbalances.”

I don’t know. I think they need to start now, or maybe not to be starting from here at all. It seems to me that, in the real world, economic shifts are marked by destructive crises. We’ve probably got a few years before the wheels come off again. Or, if governments use the time wisely, maybe the train can yet be switched to a level track. Interesting times.

The Great Carry Trade

I was much taken by one of Larry Elliott’s pieces for the Guardian a couple of weeks back. Larry identified several eras: the Great Depression; the Great Compression, the period of strong growth and increasing equality after WWII; and the Great Moderation, the period of low inflation from the late 1990s to the early 2000s. We’re just ending the Great Recession (as this term was overused to describe 19th century episodes, I prefer “the Great Crunch”, which I think has a more modern flavour, but let’s go with Larry’s nomenclature today). I’d like to add to the mix the Great Inflation of the 1970s and 1980s. The question Larry asks is: What now? The Great Escape?

I’d like to argue that we’re likely to enter a period that we might call “the Great Imbalance”, reserving, on second thoughts, the title I’ve chosen – “the Great Carry Trade” – for the underlying cause. In fact, you could argue that the Great Moderation and the Great Recession are merely episodes in the history of the Great Imbalance.

Let’s first consider the causes of some of these various eras. Here’s my simplification of some complex phenomena:

• The Great Depression is so-called because growth stagnated in large part because of a breakdown in trade.

• After WWII trade resumed, but crucially without the Soviet Union and satellites, China and India. Larry’s Great Compression resulted from the growth in this era, together with, crucially, greater bargaining power on the part of workers, as collective bargaining reached its apogee. This combined with a squeeze on that critical resource, oil, to produce the Great Inflation.

• In 1989 the Berlin Wall came down. China and India have since become global players. This has locked in the reduction in workers’ power that occurred when unemployment resulted from the Great Inflation, permitting rapid non-inflationary growth – the Great Moderation.

Now, Larry writes that:

“One feature of the Great Moderation was the build-up in debt that allowed consumers in the US and Britain not just to live beyond their means, but to mop up the excess output from the low-cost factories in Asia. Debt is now being paid back, and it will continue to be paid back as the monetary and fiscal authorities withdraw the emergency stimulus packages of the past 12 months.”

But I’d argue that, far from “the build-up in debt” being a “feature” of the Great Moderation, it is a result of the fundamental cause of the Great Imbalance, that is of the Great Carry Trade.  And the Great Imbalance is not over, because international debt is not, in fact, being “paid back”.  And the Great Carry Trade itself has a cause: the false idol of export-led growth.

Larry also suggests that:

“The Great Moderation … could only be temporary, since its reliance on levels of debt that were only sustainable provided asset bubbles continued to inflate meant we were buying stability today at the expense of instability tomorrow. As such, Alan Greenspan created a housing bubble out of the wreckage of the dotcom bubble, thus disguising the structural problems in the US economy.”

I disagree: the cause of the Great Moderation phase of the Great Imbalance was not the debt, but globalisation. Larry is also writing in the UK, which somehow sidestepped a recession after the dotcom crash, so perhaps sees more stability than Stateside commentators. Regardless, I suggest that the conditions are already in place for the next bubble, because the underlying imbalance has not been addressed.

Larry titled his piece “Eastern promise holds little hope for west”. But why should this be? Growth based on trade is mutual – it’s not a zero-sum game. If I buy Chinese toys for pounds, the only way to zero out the transaction is for British products to be purchased with those pounds. The cash acts as a store of value. That’s the point of it.

But what’s happened is that the pounds and dollars used to purchase goods from China and other countries following a similar strategy has not been spent on imports from UK or US. The ramifications seem no less serious now than when I wrote nearly a year ago. Since then there’ve been a few developments:

• The worst recession for a generation.
• A fall in the value of the dollar (and pound) against the euro.
• A massive recovery in emerging markets in particular, fuelled by investment flows.

But no change in the value of the renminbi against the dollar.

So what’s going to happen?

Let’s consider trade first.  The eurozone was until recently in rough trade balance.  Now, though, the US trade imbalance with China (and others), which is an inevitable result of the currency pegs, will be shared by the eurozone.  Additionally, the eurozone will see a deteriorating trade position against the US (and UK).  In short, the next phase of the Great Imbalance will see the addition of Europe to the debtor countries.  This is inevitable with current policies.

But there’s another feature of what’s going on which leads me to highlight the Great Carry Trade.  Investors – ironically as a result of articles like Larry Elliott’s – see the big opportunities as in the developing countries.  What was a minor part of portfolios is becoming mainstream, egged on by the investment industry.

Why do I talk about a “carry trade”? Well, the effect of investment in higher-yielding currencies is – whether or not one organisation carries out all parts of the transaction – borrowing in the low-yielding currency (the dollar or pound, say) at low interest rates to lend (or invest) in a high-yielding currency (such as the rouble or renminbi).

A key point is that all the dollars or pounds invested come straight back. Think about it: to invest in China, you (or an intermediary) have to sell your dollars to a bank to buy the local currency. These dollars are then available to lend on the international money markets, depressing dollar interest rates. The carry trade is self-fuelling, reinforcing the trade imbalance.

With free-floating currencies, the capital flows will eventually force up the currency of the destination country, and investors will no longer see the opportunities they did. There’ll be some kind of correction, quite possibly an “emerging market crisis”.

But with pegged countries there are fewer ways out. Obviously there is a possibility of investor confidence becoming undermined and an asset (e.g. stock market) bubble bursting, but failing that, either inflation could occur or the currency peg could break. But both of these tend to help the foreign investor, by increasing the value of their assets. The pegging country is likely to find itself in a policy straight-jacket. Increasing interest rates to cool the economy simply encourages the carry-trade. Hinting at appreciation, or a limited appreciation, of the currency is likewise a red rag to a bull. They could try to directly control the capital flows, like Brazil did recently, or try to manage asset values directly. But such policies are difficult to implement. All very unsatisfactory.

I can only conclude that unless emerging market currency pegs are abandoned we will simply have a repeat of recent history, with a slightly different flavour.

Much depends on what happens in the deficit countries. Current policies suggest that governments will try to rein back on their borrowing. That leaves even more potential for bubbles in the property and the corporate capital (equity and bond) markets.

It now seems to me that in the UK, at least, property prices will resume their upward path. This will be driven not by low-income owner-occupiers, and maybe not even by the recent type of buy-to-let investor. Rather corporates will invest, which will increase construction rates (because such investors require large numbers of properties), which will help fuel the economy, sucking in more imports, of course. Foreign buyers will also continue to stoke the market, particularly in London. Interest rate increases to choke this off will have limited impact as they will tend to push up the pound, encouraging the very imports and capital flows that are fuelling the Great Imbalance.

In an even world, investment flows into UK equity and bond markets should, over time, exactly counterbalance flows out. But we live in an uneven world. Furthermore, when capital returns to the UK (or US) it has had the risk taken out of it. Companies, just as in the dotcom boom, will, even when raising equity is possible, still over-leverage.

Where the next gasket blows is anybody’s guess. Remember, excessive capital flows will once again be a global phenomenon. Governments will try to shore things up, but will simply have not enough thumbs to stick in all the dykes that could burst.

Mad Mortgage Rules – and Miles Brignall

Jay Rayner’s review of the Eastside Inn in today’s Observer magazine includes an unforgettable comment about its owner, “chef Bjorn van der Horst, who has the name of a porn star and the palate of an angel.” My partner wondered how Rayner comes up with something like that. I suspect it’s not that difficult – though it is a very good line – if all you have to do for a living is stuff your face and write about it.

Because clearly the restaurant reviewer has not been keeping up with the London Evening Standard newspaper (“the ES”). Rayner expresses surprise that fewer London restaurants have not “gone to the wall”. He goes on: “according to Harden’s, a fine restaurant guide in so many ways, London closures have actually been slightly down over the past year, at just 64 – the lowest rate since 2000. Openings are up 9%.” But a few weeks ago the ES revealed that because so many of the sorts of people who patronise upmarket eateries have had a mortgage windfall, takings have survived the downturn.

The point is that many mortgages have reverted (from a fixed rate) to banks’ standard variable rates (SVRs) which in many cases are tied to the Bank of England’s base rate. Tracker mortgages are again tied to the base rate.

Presumably the Guardian’s Miles Brignall is either not a gastronome or is simply insufferably smug, so has not accompanied Jay Rayner on any of his restaurant trips. If he had, Jay would be well aware of how Brignall has an interest-only mortgage, for which the monthly payments have decreased from almost £900 to £150.

In what must rank as one of the most irresponsible pieces of financial journalism I’ve ever seen, the Guardian ran a short piece by Brignall in Saturday’s Money section, perhaps to provide “balance” to a report on the FSA’s proposals to discourage interest-only mortgages.

Journalists often introduce “balance” when in fact there is no widely-held alternative position. The classic example is climate change. Approximately 999 out of 1,000 scientists working in the field broadly accepts the consensus view of the warming effects of human greenhouse gas emissions. But the crackpot 1000th all too often gets a platform. Result: the public believes there is a fundamental debate when in fact there is no such thing.

The FSA pointed out that (1) if someone takes out an interest-only mortgage when they could not afford a repayment mortgage for the same amount then they are likely to have a problem paying the principal at the end of the term of the mortgage and (2) it would be a good idea for people taking on interest-only mortgages to demonstrate that they have an investment vehicle for paying off the principal, e.g. an endowment policy. Such endowments were of course very popular back in the 1980s.

What the FSA says is very sensible.

But Miles Brignall appears to have committed both the cardinal sins. He writes that:

“By going interest-only, nice houses with gardens (well, vegetable-growing area) suddenly became affordable – all for the same monthly repayment had we gone for a smaller home, with a tiny garden – but funded with a repayment mortgage.”

And Brignall’s scheme for paying back his mortgage? Arbitrage:

“The pay rate on our mortgage is 1.24% – courtesy of the Bank of England – and yet I’m getting 3.01% on my Manchester Building Society Isa. You don’t need to be Mervyn King to know that that’s a good state of affairs.”

This is absolutely nuts. It is a pure cock-up that mortgage rates are lower than the rates paid on consumer deposits. The banks simply did not expect the Bank of England’s base rate to go down to 0.5%. Stupid. What the banks should have done, and will do in future is tie all mortgages to LIBOR – the cost of money in the interbank market – so this situation will not recur.

In bailing out mortgagees and other borrowers in general, by reducing interest rates dramatically, the Bank (the Bank with a capital “B” refers to the Bank of England) has, likely unintentionally, given a massive windfall to hundreds of thousands of borrowers with these daft mortgages for which the payments can drop to virtually nothing. A lot of them are spending their fortunate gains in restaurants, so we haven’t had a shake-out to separate the decent restaurants from the salmonella-factories.

From the Bank’s pov (point of view) reducing the rate so low doesn’r make sense in the long-term. Since in future fewer commercial rates will refer to the base rate, the Bank has got its powder wet.

—

The other recommendation by the FSA is less sensible. They want to ban self-certification mortgages. These have pretty much disappeared already, but the FSA seems to be keen to lock the self-employed and those with irregular income out of the mortgage market altogether.

All this will do is move the problem. Those unable to pay a mortgage would be unable to pay private rent either, so landlords would find themselves in difficulty.

This observation set me thinking. Here’s my suggestion. Mortgages should simply be provided to those who, regardless of their employment situation, can demonstrate that they have been able to pay a comparable private rent. This wouldn’t apply to everyone – some may live with their parents or pay a very low rent in a shared house while saving a deposit, for example – but would help a lot of people get on the housing ladder. Some legislation would be required – but the private rented sector is under review anyway – to require landlords to provide receipts for all rent paid in full. This would be good news for landlords as the need to collect such receipts would give a further incentive for tenants to keep up with the rent. Certified receipts would likely prove more useful than references for tenants seeking to move to new rented accommodation, but they would also demonstrate that a potential mortgagee can afford a certain level of mortgage payments. This would translate to a given size of mortgage. Mortgage lenders would require proof of rent payment for a number of years (at least 2 or 3) – this might vary for different offerings (e.g. depending on the deposit the buyer is able to put down). Some slack would be required. There are a few extra costs (e.g. maintenance and insurance) which property owners have to pay but tenants don’t. The big problem, though, is that interest rates can increase (and mortgages may be at “teaser” rates, liable to revert in the future to a higher rate, such as the lender’s SVR), causing difficulties for mortgage holders, so the government (or perhaps an independent regulator) would have to advise the rate for which affordable payments should be calculated, which may be somewhat above the market rate at any particular time.

An example is in order. Let’s say someone has been paying £1200pcm in rent for a few years. A lender might then assume they could pay a mortgage of £1050 a month to allow for other homeowner expenses. They may also allow for future interest rate rises, so accept the application only for mortgages requiring monthly repayments of £900. Got it?

What we’re trying to do is establish what outgoings a mortgagee can afford, so it is much more logical to establish what outgoings they have been able to afford in the past than to simply examine their income.

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Postscript: Miles Brignall’s mortgage

Miles lets on that he’s paying 1.24% interest at the moment and that this works out at £150 pcm, or 12*150 = £1800 pa. Therefore on a house he tells us is worth £390K (or is that what he paid for it?) the mortgage is (100/1.24)*£1800 = ~£145,000. From a lender’s pov, £245K equity (reasonably plausible if, say, they bought their previous flat in the mid 1990s – they might have taken out a mortgage back then of well under £100K, with even less than that outstanding 3 years ago) is reasonable security, so they’re not the ones likely to get their fingers burnt.

Miles was paying “almost” £900 pcm before rates started tumbling or 6 times as much as at present. He may have paid off some of the mortgage, but at £250 a month for at most 3 years, not very much (no more than £9,000). This means his rate was getting on for 6*1.24 or over 7% (check: 900*12/154,000 = ~7%. Quite expensive, it seems to me.

How the rate has dropped by ~5.75% is difficult to explain, as base rates haven’t fallen that much (they were 4.75% in late 2006, rising to 5.75% in late 2007). Maybe the “almost £900″ was a reasonable bit less and the £150 is rounded up (or perhaps includes a fixed amount – e.g. insurance of some kind) or maybe he’s paid off a bit more than I’ve reckoned.

Anyway, most worryingly, Miles says he is only putting £250 a month into a savings account, so he’s getting used to having £400 extra to spend each month (£400 comes from the £900 mortgage payments less £150 he’s paying now, less the £250). I hope Mrs B doesn’t get too used to all those meals out!

Be very clear: the reason Brignall was able to obtain a mortgage on a £390K property was not because of the affordability of the monthly payments – it was because he had so much equity the lender didn’t consider him much of a risk. It’s the same as the logic behind sub-prime lending when banks thought they couldn’t make a loss because the value of the property would rise. Miles can presumably afford even £900 a month, but, in fact, he’s described exactly the sort of lending which concerns the FSA because it is in the interest (no pun intended!) of the lenders and not necessarily of the borrowers.

Someone with an interest-only mortgage like Brignall’s who couldn’t afford £900 each month could easily find their debts gradually increasing over time, as they were forced to put other spending on credit cards or take out personal loans.