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July’13 Newsletter: Asset Bubbles Become Policy Bubbles

Leaders, institutions and markets are all looking for guidance to get out of the present crisis. Government confidence is at stake, institutions’ credibility is jeopardized and banking is close to fraud and collusion.

Leaders looking for a compass

In the first phase of the current financial crisis, most political leaders and experts claimed that banks must be rescued whatever the cost. But as the years slip by, this rhetoric has weakened. The crisis has now triggered power shifts in at least 10 of the 17 eurozone nations (Greece, Ireland, Italy, Portugal, Spain, Slovenia, Slovakia, Netherlands, France, Cyprus). Nearly all governments are now coalitions. Just as the splits in public votes show confusion, so the decision making of coalitions seems increasingly weak, with all looking for a policy bandwagon upon which to jump, or for means to prevent them becoming the next Cyprus.

Throughout this decline in government confidence, the official spin has consisted in believing that expansionary monetary policy combined with bank bailouts and the assumed (but not agreed) future banking union will see EU nations return to growth and national debts brought under control.

These hopes have not been fulfilled. In fact, evidence of the absence of growth appears every month in the inexorably upwards ratcheting eurozone unemployment figures which in May increased by another 0.1% to 12.1%.

The last countries witnessing to this lack of political direction are Bulgaria and Portugal. Bulgaria’s previous government collapsed in April over concerns that its then government had too cosy a relationship with foreign monopolies. The ensuing elections saw a coalition led by the centre left party of Plamen Oresharski, but it is now in deep trouble over corruption suspicions. The country’s President, Rosen Plevneliev, strongly hinted July 6 that further elections might be held to quell the now daily protests in Sofia.

Just as Bulgaria’s titular head has recently had to work overtime, so has Portugal’s. We previously commented on several countries’ efforts to step back from “austerity”, by offering future structural reforms. By the start of July, the policy of “austerity” had become so discredited that Portugal’s Foreign Minister was happy to resign July 2 precisely because the new Finance Minister – Maria Luis Albuquerque – supports ‘austerity’, defined as complying with the previously agreed bailout programme terms. President Anibal Cavaco Silva seems to have kept the coalition alive, but increasingly on ECB life support. Yet, nobody knows how long that support might last. In a word, and ironically, Lisbon has become vulnerable because it is officially “on aid” (it is the object of a bailout programme) and, therefore, it is denied access to the ECB’s Outright Monetary Transactions (sovereign bond buying) capabilities.

As a result, fears that the incumbent government coalition would break up led to yields on its ten year bonds soaring from 5.67% (May 2013) to 8%, and the yield would certainly have climbed higher but for the intervention of the ECB, which announced it would buy bonds, if necessary.

President Silva’s efforts in keeping the coalition alive are crucial, since a stable leadership is required to honour what was promised in exchange for the bailout programme. Nonetheless, the news is unambiguous. Portugal will need a second bailout to avoid default, and the second bailout will of course raise further questions. For example, one can expect further doubts about the credibility of the European institutions who crafted the 2011 bailout (€ 78 bn). Moreover, we shall be bombarded by a new wave of discussions on whether Portugal can ever recover inside the euro, and whether the best course is to go back to its own currency, possibly after dafaulting

Institutions looking for credibility

Another institution with credibility questions is the Bank of England, in the news because on July 1 Mark Carney replaced Mervyn King as Governor. King was regarded as increasingly eccentric and unapologetic. His apothegms such as in 2010 “Of the many ways of organising banking, the worst is the one we have today” suggest a regulator who does not accept responsibility for his actions. The Bank’s more respected directors, such as Andy Haldane, are deeply worried. In a June 11th appearance before a UK Parliamentary scrutiny committee, Haldane hit the UK headlines by claiming that the government bond bubble was now the biggest threat to UK financial stability; this statement was followed by the remarkable admission that we (central banks) “have intentionally created the biggest bond bubble in history”.

What difference can Mark Carney make? Finance Minister Osborne is optimistic, frequently describing him as “the greatest central banker of his generation”. Time will tell.

Markets looking for consistent monetary policy

The relative calmness in markets until last April was seen as evidence that the co-ordinated policies of central banks had been working. Investors knew that with the Fed buying €85 billion of assets per month (split half treasuries, half mortgage securities), and with the ECB threatening to unleash “unlimited” firepower in the form of OMT (Outright Monetary Transactions) and bond buying, running short positions could be both risky and expensive.

With the benefit of hindsight, it now appears that the calmness of markets from September to April perhaps did not reflect confidence in consensus policy solutions, but rather the fear of betting against central banks. Put differently, there was a genuine belief at the Fed that their policies will work, and at some point soon interest rates can start to be “normalised”. American investors have become wary, though; and now look to the yield on the 10 year Treasury bond – 1.61% in April, 2.61% in early Juy — for evidence of normalisation. On this side of the ocean, Europeans wait to see the end of the American story, but do not seem to have a story on their own. Hence the volatiliy experienced during the past few weeks, which might actually increase, should inflationary pressures rise and generate new headaches for central bankers.

Not surprisingly, investors jump when any glitches appear in the co-ordinated consensus policies of Bernanke, Carney, Draghi and others. Portugal is a good example and it blindsided many operators: Just as the Fed was encouraging discussion on reduction in liquidity, the ECB was forced to accentuate its liquidity injection powers and had to recommit to low interest rates for the foreseeable future, in order to avert immediate problems.

The banking problem, which seems to be particularly troublesome in Europe, adds to the simmering tensions and deserves close scrutiny. It is not only a problem of leadership and vision. It is getting closer and closer to a question of fraud and possibly collusion. On June 23, recorded conversations between senior Anglo Irish bankers about the way the central bank was lured into the bank’s 08 bailout were released in the public domain. When the crisis erupted, a figure of €7bn was initially presented to the central bank as sufficient. The tapes, however, reveal that this number was produced disingenuously; small enough to hook the central bank into the strategy of rescue by managers who knew the figure was nowhere near enough. Irish taxpayers were infuriated to learn from the tapes that when pressed on the calculation of the €7bn number, the bank’s head of retail banking boasted on the tape that he had picked it “out of my a**”.

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