Wednesday, 24 November 2010

Free for all in the eurozone?

In Autumn 2008, I attended a small public meeting entitled 'Sound Money'. I learned that for years the commercial banks had been getting away with literally printing money by issuing loans on the back of money they simply did not have.

On leaving the meeting, I was fired with the righteous indignation of the newly awakened and immediately wrote about the power and irresponsibility of such banks on an online forum. Instantly, I was seriously flamed by a professional banker, who insisted that talk of banks creating money out of thin air was total rubbish and I should get a grip on fractional reserve banking rather than spread such blatant ignorance.

Duly chastised, I studied fractional reserve banking. Banks did indeed maintain a relationship between the deposits they received and the money they lent out. But this relationship – the multiple of the amount held against the amount lent – had been stretching for years. And, given the additional practice of banks like Northern Rock of borrowing further sums in the international markets to lend to borrowers, it was little wonder a run on the bank soon resulted in that bank's collapse and others quickly realising they could no longer continue lending on such thin reserves.

Commercial banks, of course, are responsible for their own solvency – at least, up to the point where governments deem that allowing them to fail would undermine public trust in the financial system as a whole. It's at this point we get government bailouts: RBS and Lloyds in the UK and, rashly, a financial guarantee for the whole of the nation's commercial banking system by the government of the Republic of Ireland.

I am a little weary of reprising my eurosceptic credentials, but suffice to say, if Ireland was a truly sovereign country – that is, if it managed its own currency, the Irish Punt – it might have had some hope of staving off the swirling pirhanas of the bond markets for a little further time.The practice it would almost certainly have adopted is the same as that used by such illustrious independent nations as the UK and the USA. I speak of Quantitative Easing (QE), of course.

The advantages of managing your own Central Bank sadly have been much underestimated across the capitals of Europe. Not only do yet get to manipulate your own interest rates and exchange rates, you also get the opportunity to engage in QE. It is a trick that commercial banks – especially those that have stretched lending beyond their means unto insolvency – must desperately envy. For QE is that ultimate goal of both alchemist and banker: the ability to actually create money out of thin air.

QE has received a mixed press from economists. Some instantly recognise that it must be a recipe for stoking inflation. Others are more sanguine and judge it may be a harmless tool to stimulate an economy at a time of deflation. No-one, however, seems to have pointed the finger at the damage QE may yet inflict on the Eurozone currency.

For many months, the European Central Bank (ECB) has been supporting government deficits in Greece, Ireland, Portugal, Hungary and perhaps even Spain. Greece and Ireland have been receiving rolling handouts to keep their debt payments afloat. Now, a 'once-and-for-all' financial package has been arranged for Ireland, with the ECB at the core of the deal.

The ECB may not admit to following other central banks, but it too provides funds by engaging in QE: printing money. And the EU in Brussels is determined that such financial support must appear unequivocal if the integrity of the eurozone and even the EU is to survive.

But what has been the reaction of the bond markets to this latest Irish financial support? The answer is very little – in fact, they seem to be saying "is that all?". And can you blame them?

QE represents a bottomless pit of an ever-expanding money supply. If demanding 5% yield for investing in Irish government bonds brings this kind of guarantee, why not demand 6%...7%...8%? Such printed money is effectively free. Roll on the bond market calls in Portugal, Spain and Italy!

If my doubts about QE seem as naive as my understanding of fractional reserve banking, just ask yourself where, when and how will it end? The European financial institutions are becoming slaves to the markets. Each new bailout devalues the euro's credibility. The bond markets may not be satiated until they've escalated and extracted every cent the ECB is willing to issue to defend eurozone solidarity. If the euro survives it may be minus several members.

Even more importantly, if the global financial system is to survive with future credibility it might be time to consider what is really meant by "sound money". It surely can't mean just printing ever more money for the benefit of bond traders.

Friday, 19 November 2010

Lord Young Resigns

Lord Young's job at Central Office has been to mediate between government and industry and recommend regulatory improvements that can help British businesses succeed. Talking up the positive aspects of the financial environment in which our businesses now operate (though perhaps not strictly part of Lord Young's brief) is as important as any government initiatives for encouraging business investment and ultimately creating more jobs.

Lord Young's error, however, seems to have been to translate this wishfully positive view of Britain's business landscape into a description of the state of our population as a whole.

Statistics offered by the NIESR suggest that Lord Young's "Britons have never had it so good" assessment was not too far wrong. It was, nevertheless, about 12 months out. In fact, it was this time last year, despite the recession, that Britons really had never had it so good in terms of spendable income.

So could Lord Young's analysis be forgiven for being "within the margin of statistical error" over the lifetime of the recession? Unfortunately, this surprisingly rosiest period for the average Briton occurred under the management of the previous Labour government. For it was they, we will remember, who were desperate to delay necessary cost-cutting measures that might affect the well-being of the population – at least in advance of the general election.

Since that election, all has changed. The effects of tax rises, inflation and the beginning of public service job cuts have taken the edge off the unprecedentedly celebratory good times of 2009! And, of course, we have all known this must happen.

In the end, this unfortunate political incident leading to Lord Young's resignation is all about relative perceptions. Undoubtedly, GDP growth has resulted in the nation as a whole being better off during this last recession than those before, such as 1981 (when David Young was special adviser to the Dept of Industry and a year later Chairman of the Manpower Services Commission).

But that was then – this is now. Such memories do not serve today's 30 year-olds facing redundancy.

Nor do such comparisons serve a government needing to justify the severe measures required to correct the public finances.

The government's preferred message now is the need for a period of haircloth and ashes, in atonement for the financial excesses encouraged by the previous government. Woe betide anyone in government preaching that our immediate future might be relatively painless. It seems those bearing such embarrassing off-messages shall be hurriedly cast out.

It remains at least debatable whether it is Lord Young, or David Cameron, presenting us with a misleading impression of our present state of well-being. For example, we are certainly better off than than our Irish cousins.

Less debatable, unfortunately, is the sad political wisdom of Lord Armstrong when Cabinet Secretary that the prudent course is often to be economical with the truth.