Cyprus: An Exercise in Politicians' Logic

The debacle in Cyprus has been one of the most interesting and baffling exercises in politicians' logic in recent times.  It shows how much politicians are fans of round numbers, regardless of its practicality:

1) Germany said the euro zone should not lend more than EUR10bn to recapitalise Cyprus's banks, even though Cyprus needs about 50% more than that.

2) The IMF didn't want Cyprus's debt to GDP to rise above 100%, even though it's been above 100% for almost its entire time in the EU (and is currently at 140%), effectively defying basic arithmetic.

3) The president of Cyprus was adamant that the tax levied on big depositors (read Russian oligarchs and Greek tax dodgerds) shouldn't be more than 10%, even though it was their fast money coming into Cyprus's banking system which has caused the banking crisis in the first place.  

4) Senior bondholders lose nothing, even though depositors are supposed to be paid ahead of bondholders.

The number of Cypriots MPs voting for the bailout package?  Zero...  Go figure, you mean none of the MPs thought that the four criteria laid out above made sense?  What does this all mean?  Small depositors take a big hit for a problem that they didn't cause.  No wonder people are taking to the streets...I'd riot too if the government tried to do that to me!

Now if you're a Cypriot, things haven't been that bad until now.  GDP  growth was fairly strong until the financial crisis (see below data from Trading Economics); healthcare, tourism, shipping, and financial services have done well for the country.

Plus, though the country had high debt to GDP ratios historically (why did the EU let them join in the first place with a debt to GDP of 180%?!), it came down dramatically over the past decade until the financial crisis hit and the government had to bail out the banks.

On top of this, the banking problems weren't because of excessive borrowing locally, it was due to foreign deposits coming into the country which the banks then lent back out overseas.  Unfortunately, the banks chose Greece as a main destination for a lot of the cash...oops...  When the eurozone bailout of Greece forced losses on Greek government debtholders caused austerity which increased non-performing loans, this badly hit the Cypriot banks.  So one could view this bailout to be merely an extension of the Greece bailout.

To make it even more ridiculous, the country's central power plant was blown up by an explosion at the naval base next door in 2011.  Evidently, the navy didn't think it was a problem stored munitions next to the power plant!  So you have to feel for the average Cypriot on the street, who's wondering why they are getting robbed for something they didn't cause.

Now, before you start shedding tears for the Cypriots, they weren't exactly the epitomy of fiscal prudence either.  They've run a current account deficits as long as one can remember, i.e. they spend more than they earn.  Plus, you have to wonder what they were thinking letting their banking sector get to 13 times the size of their GDP!  Well, it's because they made a pretty good living off of all the foreign money which was coming in, even if they didn't realise it.

They also haven't exactly been model citizens of the EU.  There's a reason why Russians launder their money through Cyprus...because the country wants them to as long as it gets a cut.  They've also backed Russia against the will of the other EU nations...evidently Russia assassinating people using radiation poisoning wasn't enough to make them think about who they should get into bed with.  The EU and the United Nations also had an agreement to merge Northern Cyprus, occupied by the Turks since 1974, with the Republic of Cyprus, but Cyprus nixed the deal just to stick it to the Turkish Cypriots.  Now Cyprus is giving two fingers to the EU and trying to bargain with Russia in exchange for a naval base and potentially rights to gas fields which haven't been developed yet.  So it's not a surprise that the EU wants its pound of flesh from them.

This raises the question, does the EU really need to cave in to Cyprus for a more lenient deal?  I agree that it makes no sense to screw small depositors...it would be disastrous for confidence in the financial system if the EU goes back on its EUR 100,000 deposit guarantee.  But why not stick it to large depositors?  Would taxing Russian money launderers and Greek tax dodgers be a bad thing?  It certainly would be poetic justice to hit the people which have benefitted from the lax regulations and tax avoidance of the past two decades.

The ECB is worried about the effect on confidence in other weak Eurozone countries if they don't back Cyprus.  But is it really that much of a problem?  I don't think so.  In a banking crisis, regulators often let some banks go to the wall (either they refused to be helped or are beyond help) but state concretely which banks they will save.  As long as the ECB does this, there's no reason why they can't let Cyprus go bankrupt but back other nations.  It would certainly give people in say Italy a nice compact example of what happens when you don't take the EU bailout...you leave the Euro currency and suffer a bad devaluation, and you literally will lose half your saving deposits as the banks won't have the money to pay you back since no one is willing to lend to them.  It's not a pretty picture, but perhaps letting Cyprus go to the wall if they remain obstinate will give policymakers more credibility that the reforms they are demanding are necessary (though the austerity they are also asking for doesn't make a whole lot of sense right now).  Otherwise, the citizens of these countries will keep blaming someone else as the cause of their problems rather than face the reality that they can no longer live beyond their means.

Misunderstanding about the UK's Austerity Budget

Ahead of Chancellor George Osborne’s budget for 2013 which is supposed to come out on the 20^th, there has been a lot of criticism of the “austerity” being imposed by the government.  Many are calling for a change of direction; Nobel Laureate Paul Krugman said that the austerity drive is “deeply destructive.”  As a friend of mine noted (and rightly so), growth should be the main priority, so how can growth happen if the government is cutting back on spending?  However, this is only part of the story, so I wanted to put this all in prospective as most people are still of the wrong mentality.

First, government spending is still growing, as shown in the table below, so the government isn’t actually shrinking spending, only shrinking it as a percentage of GDP.

Second, even with the cutbacks, government spending as a percentage of GDP is still near the top of its historical range over the past 40 years (see table below)…hardly austerity.  The main problem is that the previous Labour government increased spending significantly as a percentage of GDP even though the UK was going through its best and longest growth period for the past 40 years.  They ran significant fiscal deficits during the good times, leaving nothing for the bad times.  They compounded this problem by financing a big part of the spending increase with taxes on the financial sector and encouraged the financial sector’s growth with “light touch” regulations and increased consumer indebtedness.  The Labour opposition are currently proposing more of the same, which has been shown to be detrimental to the economy.  So before people start running towards the Labour Party because they like what they hear, be careful…Ed Miliband and Ed Balls have the economic credibility of Argentina…or Venezuela.  Growth by borrowing is always easier than real growth via increasing economic productivity; this is a lesson learnt time and again in emerging market economic crises and being learnt now in the Eurozone and other developed market crises.

Third, the UK’s private sector debt has more than doubled as a percentage of GDP over the past 15 years, which is obviously unsustainable.  Basically, people have been spending beyond their means, and government spending, regardless of an austerity budget or not, isn’t going to change the fact that UK consumers will implode upon themselves if they continue this trend.  In this way, the austerity budget is useful in that it is as least forcing the debate of debt consolidation and spending within one’s own means.

These three reasons show that the government is right to sound the austerity alarm bell.  It’s not a matter of opinion; it’s a mathematical fact.  Anyone who tells you differently just simply doesn’t know what they are talking about.  But we come back to the question, how do you grow the economy if you have to cut back on borrowing and spending?  This is where the current Tory-Lib Dem government falls down on.  It has done a good job explaining the need for austerity in terms of consumption, but it doesn’t have a coherent strategy (or much of a strategy at all) for how you improve economic growth.  They hope that growth will come through confidence from austerity.  President Herbert Hoover in the US tried that during the Great Depression…it didn’t work too well to put it mildly.

There are generally three answers to this conundrum.

One is that the main way of truly increasing sustainable GDP growth is through improvements in productivity.  The UK economy, like other developed economies, is dominated by the service sector and by government (77% of the economy).  It should also be noted that these two sectors are notoriously the least productive in the economy (the table below provides an indication of how service sector productivity lags significantly).

As any foreigner will tell you, services in the UK are expensive, the quality is terrible, and the transport system is positively Third World.  There is a lot of scope for improving productivity here, and the government needs to have a plan to tackle inefficiencies in a wide variety of areas.

The second answer is devaluation of the pound sterling.  If your industries are generally uncompetitive, then making them cheaper will attract business.  This is what happened after the pound left the Exchange Rate Mechanism in 1992 and sharply devalued (see the graph below).  The UK economy, which had been held down by the imposition of high interest rates to defend an overvalued currency, recovered quickly after the devaluation (in fact, this was the last recession prior to the financial crisis).

However, benefitting from a devaluation is easier said than done.  The US and the Eurozone are weak and so are trying to devalue as well, while the many emerging market countries are purposely trying to hold their currencies down to prevent themselves from becoming uncompetitive.  Also, the UK has lost a significant portion of its export sector since the early 1990s, so the benefit of a devaluation will take time.  Still, the UK is doing a better job of devaluation than most (see graph below); the Bank of England has pushed the pounds to near the bottom of its trading range over the past 20 years.

Finally, government should cut back on consumer-related spending, but it doesn’t necessarily need to cut back on spending overall for the time being.  As shown in the graph below, UK government debt to GDP is high but not excessive compared to historical standards (though it should be noted that the prior periods had strong population growth which helped economic growth, something which is not likely in the near future).  Spending on investment which can increase productivity or economic capacity if done in the right areas, can be easily offset by the benefits.  The UK has significantly underinvested over the past 15 years (effectively living off of its past investments), part of the reason why the economy has difficulty growing and why inflation is high for a period of such slow growth.  So if the government maintained spending levels but redirected it from consumption to investment, then the economy should recover more strongly (though note, this stills means consumption spending on things like benefits, NHS, etc will need to go down as a percentage of GDP, so the message of austerity still rings true).

So the Tory-Lib Dem coalition are half right and half wrong in their economic policies (whereas the Labour Party are just completely wrong, but then, I can’t recall Labour’s economic policies ever being right after Clement Attlee’s government).  The government has rightly cut consumption spending, but it has not developed a strategy for improving investment spending and increasing productivity.  This is what George Osborne’s new budget should focus on.

Capping banker bonuses

CNN: Europe to cap bankers' bonuses

The EU has been on a rampage in introducing new rules to constrain the risk taking banks can do.  This one with capping banker bonuses at 2:1 versus salary has been in the works for a while.  I actually have sympathy for this one, though I figure the banks will find an easy enough way around this one.  At some point, the amount of bonuses some of these bankers receive just becomes funny money...they start blowing a few hundred thousand here, a few hundred thousand there...it's like a hip-hop star earning previously undreamt of amounts of money.  They don't know what to do with it and don't know how to value it, except unlike hip-hop stars, they tend tend to bankrupt their companies rather than themselves.

This is better than the other EU idea of paying bonuses in the form of bonds in the bank. That idea creates a situation where your average bankers's bonuses are decoupled from their own performance (usually, only the CEO and CFO of a bank can really have any sort of impact on a company's bonds). In which case, why pay a bonus in the first place if people don't think they can affect it and so don't value it? Obviously, there are a lot of people in favour of not paying bankers bonuses at all...that's a different conversation. But if you are going to pay a bonus, then it should be tied to performance properly, otherwise, people don't value it and it doesn't affect behaviour. It's better that they don't get a large portion of their bonuses until their investments are realised. That way, you prevent situations like all these subprime mortgages being issued. The employees wouldn't have gone for busted subprime if they knew their bonuses depended on it.

Disconnecting compensation from performance isn't just a financial services sector problem. A good example is with the public school system...teachers' salaries and pensions are disconnected from real performance, i.e. children's learning, so the schools are poor and the teachers push to reduce the standards on exams like the A levels so that they are made to look good even though it's to the detriment of the children. A friend of mine at Imperial College says most of her undergraduates' math skills wouldn't even be considered high school level in other countries, and Imperial's math programme doesn't accept students who haven't gotten Firsts with triple stars on their A levels...that's how dumb down the standards are now!

So how do you tie compensation to performance? So say the people working on the mortgage backed securities desks who caused the problems with subprime mortgages...their compensation should be based on how well those MBSs performed until maturity; they wouldn't have put dodgy subprime mortgages into the securities (or at least not to the extent that they did) if their bonuses would be affected...and that's something they have control over. Obviously, bonuses in financial services are high relative to other sectors, but the big issue that caused poor behaviour leading up to the financial crisis was that people were creating securities where the ultimate performance was years off but getting paid annually with no clawback. The banks should adopt more of the private equity carried interest model, where you have to wait until exiting investments before getting paid. It's been proven to address a large part of the problem (some private equity firms had difficulties, but none have gone bust).

For senior executives, they should be judged based on the things which have hurt banks the most in the past, i.e. asset-liability mismatch, poor credit quality, overleveraging, and mis-selling of financial products. It's not rocket science and it's nothing new; these are the 4 things which have caused ALL previous financial crises. For some reason, the regulators keep forgetting that.

One of my friends asked why politicians and regulators keep dropping the ball on this? My answer is "because they are susceptible to lobbying". Business is very good at convincing them that "this time it's different". Plus, the industry is pretty good at inventing new terms for the same thing over and over again in order to make things look sophisticated and justify why it should earn more. I find it amusing that many of the regulations the EU, UK and US are enacting now are the very ones they removed during the deregulation phase in the 1990s, when the bankers convinced the regulators that their sophisticated risk management systems meant the existing regulations were no longer necessary. The Glass-Steagall Act, the previous US regulation enacted after the 1929 crash, was working fine for years until it was revoked by the Graham-Leach-Bliley Act in 1999, only for most of the same provisions to be put back now by the Dodd-Frank Act. The UK, in some ways, is even worse. The British discovered after Big Bang deregulation that they could win financial markets business from other countries by offering more lax regulations. It's not surprising that it was the London-based units of Lehman Brothers and AIG which caused the downfall of their respective firms.

Really, I find the regulators make their lives (and everyone else's) too difficult with little benefit. Finance from a high level is pretty easy to understand. All regulators have to ask is:

1) Does this cause an asset-liability mismatch?
2) Does this reduce asset/liability quality?
3) Does this overleverage the company in a potentially unrecoverable way (regardless of the supposed "risk" level)?
4) Does this represent a mis-selling of what the financial product does, is overly complex or has higher costs than necessary?

You can basically eliminate all macroprudential financial regulation and replace them with these four questions. A Yes to any of them means the product shouldn't be allowed. It really is that simple...I'm willing to wager that there is no bad financial product out there that doesn't trigger a Yes to one of these questions.

Puzzled by the constant misunderstanding about quantitative easing

A friend of mine sent me this article (http://truth-out.org/news/item/14728-how-qe-could-save-the-economy-and-why-it-hasnt) about why quantitative easing hasn't worked.  It's written by someone who seems like he knows what she's talking about, but what she says is incorrect.  It led me to thinking, why is there so much misunderstanding about quantitative easing?

The reason central banks are doing quantitatively easing is that they, as they are set up right now, do not have the ability to pump money into the real economy, not that they are purposely trying to bail out their buddies at the banks.  There are two major reasons:

1) They do not have the organisational infrastructure to do so (no central bank has the ability to acertain the credit quality of individual borrowers, so they can't directly lend money to us, which would be the most effective way of  transferring money); and 

2) A finance-led economic crisis by definition means that the economy had too much debt, and given that banks create money by lending (i.e. you need an economy which is already overlevered to borrow more), they have a difficult time to push money onto people who are already overextended.  The banks wouldn't want to anyway, as they have to clean up their own loan books first, and why would they want to lend when the economy is in recession (so you cannot blame them for locking cash into reserves if they do not see economic activity picking up)?

The reason the central banks have been trying to help the banks is that that is what they understand.  They are trained to assist in the creation of more credit in order to get the economy going, and as they understand it, that means helping the banks.  As the banks are overlevered and have lots of bad debts, a powerful way of solving this problem is to increase profits.  More profits equal more balance sheet capacity to lend and to write off bad debts.  This works well but works slowly, usually taking several years in order to solve the banks' overleverage problems.  For Europe (which was more overlevered), you're probably looking at over a decade, whereas the US seems like it should more or less clean itself up within the next couple of years (it's already recovering but is being impaired by the incompetence in government, which is a different problem).

Given that the economy is too weak after the Great Recession to wait several years for a lending-led recovery, the central banks use quantitative easing to buy assets directly, either from banks or from tradeable markets.  This is what is causing asset prices to go up at the moment.  The central banks was to achieve three objectives with this:

1) Because the central bank traditionally helps create credit to stimulate the economy, they don't know very much about how to deal with the equity side (by equity, I mean people's actual net wealth).  By buying securities from people, they want to unlock the equity invested in those securities to channel it to other parts of the economy, thereby stimulating the economy;

2) Pushing up asset prices means that it is easier for banks to offload these securities and reduce their leverage to strengthen their balance sheets, improving their ability to lend; and

3) Pushing up asset prices hopefully improves sentiment, thereby getting people to start borrowing, investing, and spending again.

But as you can see, all of the above provide a basis for economic recovery, but none of them provides an actual catalyst for improving sentiment.  This is where Ben Bernanke's "helicopter" theory of throwing out money comes in (it's based on Keynes's idea of burying money for people to go find it to stimulate activity).  Giving money to people directly increases their net worth to spend or invest, so it's the fastest way to improve people's financial situations.  But no central bank has the capacity or the authority to give people money directly.  So that's why they fund government spending by buying Treasury bonds directly, so that the government can spend money or give people tax reductions to put more money into their pockets.  This is effective up to a point and is why it is wrong for governments to be pushing austerity when sentiment and people's financial capacity are so weak.  This in the mistake policymakers made that caused the Great Depression, hoping that restoring strength to the financial system and to government finances would improve sentiment.  But this process itself hurt sentiment so much that banks didn't want to lend and people didn't want to spend, putting the economy into a death spiral.

As I said, this process of central banks funding government spending works up to a point, and this is where the advocates of central banks funding unlimited government spending (similar to the post-World War II "Keynesian" model) are really wrong.  The money we have is an illusion; it's only because we place faith in it that is works.  What faith do you put in the money when the government is throwing it out of helicopters?  Equally, if the central bank wants to finance government debt to say 200% of GDP it has no problem with doing it, but what will people make of the worth of the money, especially if they aren't seeing the benefits directly?  Unfortunately, I have had difficulty getting people to understand this concept because people have faith in money until they don't.  The economic system works fine and is beneficial until people start questioning the value of the money itself, then all hell break loose, e.g. people had confidence in Greek bonds until they didn't.  When government debt is say 200% of GDP, regardless of whether the central bank owns it or not, people will likely suspect that the government will just keep printing more money to pay that off.  This is what happened in Germany during the Weimar Republic, when people lost faith in the currency and demanded more as compensation (causing massive inflation), so government had to print ever more money to keep up.

The biggest problem with this is that it results in a massive transfer of wealth from savers to debtors, since both debts and savings are devalued.  The rich will dump the currency and go elsewhere, while the government will usually step in to help the poor.  This leaves the middle class to take the brunt of the effect of currency devaluation.  And it dramatically impairs economic activity and productivity growth; why would you save money to invest rather than spend it immediately if the money is going to devalue?  It can be argued that it was the middle class's loss of confidence in the government which allowed the Nazis to come to power in Germany.

Going back to the issue of stimulating an economy, activity picks up when people 1) see value in investing, 2) see momentum in an economic recovery and want to jump on the bandwagon, and 3) feel secure enough in their finances to spend and consume.  If there's not at least one of these catalysts, then there is no recovery.  So it good that the central bank and the government pump money into the system 1) to arrest the decline and 2) to stimulate at least one of these catalysts.  Buying financial securities is only in indirect way of doing this, so the central bank cannot directly influence the catalyst themselves.

A better idea than getting people to borrow more is to have the central bank invest in the equity of projects and banks.  Why should the central bank not get the equity upside of projects if it is lowering interest rates and making it cheaper for these projects to be done?  This injects equity money into the part of the economy where it is most needed, i.e. in capital goods, which declines the most in a recession but accounts for much of the productivity improvements in an economy.  The trick is 1) to not replace or delay viable projects which could have been done by private or government entities in the first place, and 2) to make sure the projects themselves provide a necessary benefit to society given their cost (likely will need to partner with private investors or government on projects).  This injection should only occur in the down cycles in the overall economy when it is most needed, as it is obviously less efficient than a free economy would be under better circumstances, though it is significantly more efficient than throwing money out of a helicopter.

Central banks can also inject equity into banks to strengthen their balance sheets.  This would speed up the clean up of their balance sheets so that they are ready to make new loans more quickly.  The trick here is that the central bank's equity holdings will need to be politically independent, i.e. they shouldn't dictate where the banks should be lending.

Why don't the central banks participate in the equity of banks and projects?  The culprit is the people; they've been burned by poor government decisions in spending money in the past.  So there needs to be a preset framework for how these processes will function.  Also, this type of equity injections should only occur in a deep recession, i.e. only instances like the Great Depression or the Great Recession.  That way, the private and government sectors cannot usually count on the central bank to come bail them out, as this type of draconian measure is usually not needed for most recessions.

What are people thinking?

Over the past couple of months, I've been thinking to myself, "what are people thinking?"  I've got my retirement money invested in the FTSE 250 index to practise what I preach to small investors, that they should keep things simple by investing into the small/mid-cap indices when the economy is growing and investing into government bonds when they see a recession coming.  So you only need to make two decisions over an economic cycle of a few years...relatively straightforward...and should beat 90% of the "professional" financial advice out there.  As you can see, the strategy's done fairly well...I missed all losses from the entire financial crisis...though I didn't catch the bottom of the market and bought in much later, it didn't matter as I didn't lose money in the first place.

But what's caught my eye over the past couple of months is how the market is going up in a straight line.  Are things that rosy that people are willing to buy into equities with almost no volatility?  Evidently they are as money has been pouring into equities since the beginning of the year.  Amusingly, institutions such as pension funds are still discussing cutting equity exposure as they don't want the volatility.  Hopefully that haven't done that yet!  But does this mean that market perception about macroeconomic risks has changed?  I don't remember this smooth a ride since the financial crisis, and an eyeball look at past data shows that volatility was only this low back in spring of 2010, right before the Greek debt crisis started.

It's obvious where the risk to financial markets should come from, the Eurozone countries which are not reforming fast enough.  The European Central Bank buying the sovereign debt of Spain and Italy only gives them more time...not solve the problem.  I've been watching UniCredit (UCG), the weakest of the major banks in those two countries, and it's stock has come off about 20% from the high.

It's clear that the momentum behind the latest market rally is petering out, so is it going to come crashing down again and require another bailout or is something going to save it?  Spain looks pretty dire...PM Mariano Rajoy hasn't been able to implement many reforms, though to be fair, labour reforms are always the toughest.  Italy I think is the wild card.  Currently, Pier Luigi Bersani's centre-left coalition should win based on polls, but their lead has been decreasing.  If they win by a small margin and has to work with Mario Monti's coalition, I think the markets will be happy.  But how do you tell a centre-left coalition still with a lot of unreformed communists that they have to let go of their social and employment protections? I'm really sceptical that they are going to make things happen without having their arms twisted.  Perhaps we will see the market start to trade sideways more.  The central bankers have made hints that they may do more quantitative easing, but little of this seems to be channeling into the real economy, so the money goes where it is easiest to do so, the financial markets.  So the richest part of the population (who own the most amount of securities in the financial markets) benefits the most in the name of macroeconomic stability.  This isn't the way things are supposed to work, is it?

Starting from scratch

Enrico +Enrico Alvares suggested that I start a blog with my thoughts on the world.  Given that I write or say so much outside of the public domain, it's time that I say these things in public.  I think it will be a good way to learn from sharing my ideas and having the opportunity for others to critique them rather than only holding on to my beliefs without a sense of whether I'm on to something or whether I'm a nutcase.  I've never done something like this before, so I guess it'll be a trial by error.