December 16, 2007

Financial markets struggle as banks keep passing the parcel

Posted in Banks · 12 comments ·

Worrying events in the US, added to an already paranoid financial sector following the sub-prime crisis, have left market traders in a state of anxiety.

In July 1998, the International Monetary Fund (IMF) issued a $10 billion loan to Russia to assist the delinquent Yeltsin government, as a result of an economic crisis that had been building for months.

Gullible market players took this loan as a sign that the corner had been turned. They contended that such intervention could only stabilise things. In contrast, I got a call that morning from an old market hand, who had seen it all before, who told me: ‘‘David, sell everything, this is your last chance.” He was on the money. Russia defaulted three weeks later.

There was an eerily similar reaction in world financial markets to concerted intervention by the world’s central banks last week. The banks, worried that this credit crunch is not easing, pledged to inject money into the system to try and bring down interest rates.

Normally, such a sign of official muscle would be enough to steady nerves, but these are not normal times. The opposite occurred. Investors regard the central banks’ intervention as either a sign of panic or a sign that the balance sheets of banks are much ropier than even the most pessimistic bear had imagined. As a result, the intervention prompted a sell-off, confirming the suspicion that we are not out of the woods yet, by any means.

As we noted a few weeks back, the watchword in the banking world is ‘guilty until proven innocent’. Everyone knows that there is more horrible sub-prime and other derivative-related crud on the balance sheets of some large banks, but because the banks have been evasive, no one knows for sure where the toxic stuff is.

So the essential lubricant of the financial system – liquidity – has dried up, because trust has evaporated. You lend to people you trust and, if you don’t trust them anymore, you demand a higher risk premium for the pleasure of lending them cash. This ephemeral quality – trust – is what the central banks are trying to resuscitate.

So, the financial markets arena has become a large game of pass the parcel. No bank wants to be the one that lends to the other bank with the huge sub-prime losses. The banks are desperately trying to pretend that they trust each other, while at the same time minimising the potential risk of any inter-bank loan, by trying to lay off that risk to someone else.

When everyone was confident, there were lots of banks happy to ensure that the system of loans, repackaged loans and syndicated loans worked well. But now, the chain has broken, and the central banks are finding that trust is an expensive and elusive commodity.

There can be little doubt that this crisis will pass, but the question is when. Last week, another unpleasant visitor made itself at home. In the US, the epicentre of the problem, the data on inflation is worrying.

Not only is inflation rising, but the financial market knows that, with this rise, the central banks will not cut interest rates indefinitely. This is the catch-22 situation in which the global economy finds itself. After ten years of a boom, inflation is rising, productivity falling and the bad loans of yesterday are being exposed.

Last Thursday, producer price inflation data in the US revealed that producer prices in November rose at the fastest monthly rate since 1973. (This is the sort of stuff economists are trained to look at, so bear with the nerd in me.)

American producer prices – the prices manufacturers pay each other for materials – are now rising at 7.2 per cent year-on-year. This is very worrying. Worse still, the pace of inflation has picked up dramatically in the past three months.

Since the credit crunch began, if we drill deeper, we will see that American inflation is rising by an annualised 22.6 per cent.

Since August, prices for what the Americans call ‘‘crude materials for further processing’’ have risen at an annualised rate of 42 per cent – now that’s what you call inflation.

And it’s getting worse. Last month, import prices in the US, reflecting the fall in the dollar, rose by close to 10 per cent, compared with this time last year. This is the fastest growth in import prices since the 1980s.Lastmonth, the ratio of industries reporting higher prices relative to those reporting lower prices was 19 to none.

So, the US has a significant inflation problem, posing a dilemma for the central banks. How long can they continue to help the banking system without jeopardising their core objective of keeping prices down? The Fed is trapped – and the markets know this. On top of this, the US jobs market is slowing down at a frightening rate. More Americans are now unemployed than at any time in the past three years.

Taken together, the reason the financial markets are spooked is that the central banks are intervening in something that they don’t seem to understand. Take the European Central Bank. How can it – being so obsessed with inflation – credibly continue to inject money into the system on the day that European inflation hit its highest rate in six years?

These inconsistencies have undermined the central banks’ efforts and, as a result, the more they act, the greater the sense of market panic. Sometimes power is best exercised with a threat, rather than with execution.

So a bit like the halfhearted stamp duty moves in our budget (which will not work), maybe the best thing the authorities can do is stand back and, like the Rolling Stones album of 1969, Let it Bleed. Ironically, the opening track on that album – released this week 38 years ago — is Gimme Shelter, which may well be all the financial markets want for Christmas.

  1. VincentH

    Is it likely that there will be enough money, to destroy Tara, when this little reflux is over.

    And ’tis only a fool that has a problem with inflation, it is a real part of the market. Where as you have here and in the US, a control of the cost of labour with the infusion of people from outside of the nominally closed market, shit like this will happen. The same thing is occuring in the UK, but there there is people with the belief that around London they are safe. This from the rep of the con’ party the other evening on the BBC. idiots
    Ah, money to be made, one way or the other.

    what is it that the little people sang, HI Ho, HI HO,’tis off to work we go.
    Silver linings, and ….

    RENTS/income, from land/property need to be stabilised, and the only way to do this is with the Law. Income from whatever is based on borrowing, which is based on a stable labour source. Which is based on stable costs. A hyper property market, just taps the arm of the juggler. therefore a fucked up property market for first timers without deposit.
    It is time to call the subprime what it is on this side, the first time buyer.

  2. o


    have been waiitng for a while to see the Pope’s Children doco…thx for posting them up here.

    On the downside…my heart really sank watching the series. I really despair.
    What have we given away?…is it the inevitable downside of “modernisation” or just that we have sold our souls and the very DNA fabric that made us once a great people – not perhaps in terms of material wealth – but in art, literature, big ideas (Burke, Wilde, Joyce, Yeats, Collins), the aesthetic, the mystic, the dream and all the other intangibles that makes us human and more. Is it no longer fashionable in Ireland to “dream out loud”.

    Really, really, really depressing.

  3. Donal

    The celtic tiger was nothing more than a curse….

    Ireland sold its soul for wealth and as it is often said “The Devil is owed his due” and we’re going to have pay for it and beg God for mercy afterwards.

    What we need is a cultural revival and the diaspora can actually help with this one, we need to “dream out loud” again

  4. John

    Check out this little graph of GDP versus credit growth. Ireland is the most extreme example and presumably one of the most exposed.
    Credit growth in Ireland is the highest in the developed world. Credit has been growing on average seven percentage points faster than GDP.

    The Irish didn’t sell their soul it was sold for them and a handsome profit was made by the mercantile class. Not the first time this has occurred in Irish history. Just as an interesting aside, look out for a book entitles “Who Owns The World”. Written by an Irish author and studied the ownership of all countries of the world. It points out that a huge swathe of the globe is held in a very small number of hands. In Europe they are receiving huge tax free subsidies from the EU approximately 37 billion euro annually. The prince of Wales and and other European nobility being the major recipients.
    The Queen of England officially owns all lands under her domain absolutely, her subjects are merely feudal occupiers under medieval laws which remain on statute and have been further reinstated as recently as 2002 in the UK. Where does that leave Ireland one might wonder. Well following independence from England the lands of Ireland were taken back from the queen and given to the people of Ireland!!!. Not quite, we too are just feudal serfs occupying lands owned entirely by the state?, whatever that is meant to be. An Irish person who sweats their guts out to pay a mortgage for an inflated piece of property does not really own it, nice eh. Now maybe I’m the last to find this out but Irish freehold is not freehold, you don’t own the land you merely occupy it. So the Irish state replaced the queen as the landowner, we too recognise the same medieval feudal land laws. Hence compulsory purchase and the soon to be reinstated land rates, probably under some environmental provision. The author gave a talk in the Royal Society last year and recounted meeting with an Irish Minister of State who informed him that he should keep this information down because it could cause all sorts of trouble. Really? I doubt it the Paddies are too stoned on Coke to realise. Sorry but my grandfather fought in 1916 and independence to liberate Irish lands for the Irish people and this slight of hand is how they were rewarded. Disgraceful!!. Check the facts folks if you feel a little sceptical. Kevin Cahill is the author and here is a link to his speech.

  5. Anne Osborne

    The problem is pretty well known by now: too much reckless lending and borrowing, high personal and corporate over-indebtedness, not enough saving and investing. Price inflation – always a consequence of the inflation of the money supply – is now eating into spending power and savings and jobs are increasingly at risk. Unfortunately, the combination of more expensive (and scarce) credit and rising unemployment is the perfect recipe for faster falling house prices. Hang onto your seats, it’s going to get even more bumpy out there in the land of the Irish amateur landlord and FTB with a fixed rate loan that’s due to be reset this coming year. Since not even all the efforts of all the central banks in the westernised world cannot put the corporate Humpty Dumpty back together again – surely it’s time that some straight talking happens. If you have massive debts, stop digging. Start paying it off; stop buying stuff you don’t need with money you don’t have. Sell your ugly little buy-to-let – if you can – now, and take whatever capital growth it produces, or cut your loss now. Ditto the pricey SUV. Buy a bike. If David, who saw all this coming long ago, and other economists, who are finally opening their eyes to the staglation that a debt tsunami always brings in its wake, are even half correct, chances are that property prices are going down in value for the next few years. So will corporate profits. Start saving. Start investing. Do like the Sage of Omaha: “Close the doors. Be fearful when others are greedy. Be greedy when others are fearful.” Think of ways to earn more money, and to live with less.

  6. Donal

    No matter how much money is poured into “loosening up” the credit crunch…..

    that money will never be seen again!

    Ireland is going to fall at the first hurdle for how much money we’ve borrowed and squandered, so will the rest of europe.

    God knows how bad it will affect America and other states like Australia & Japan.

    I think new jobs created for immigration are in trouble and those who bought their house for 10 to 20 times their salary!

  7. stephen flynn

    Hi David,

    Regarding the above article.
    Couple of questions i have if you would be so kind as to take the time to answer.
    You seem to suggest that the market reaction after the Fed’s announcements on a 25
    basis point cut in the discount rate was down to fear created by the intervention
    Was it not the case that the markets had convinced themselves that
    a 50 or even 75 basis point cut was likely and in turn priced such a cut in
    the days and weeks prior to the fed announcement. Also David with regard to
    your comment referring to the “let it bleed” song by the rolling stones, is
    that to suggest that recession would be preferable to high inflation caused by the
    bailing out of the banks over dodgy lending? Is the route cause of
    inflation currently down to restricted supply of key soft commodities and energy
    which will continue to be the case for the foreseeable future.Should Goverment
    policy try to intervene in such matters of supply inelasitcity and rising
    demand? I would look forward to your comments. Forgive me if my
    understanding of economics is some what patchy as i have only begun to learn about the
    markets recently. I use a subscription provided by David Fuller which is quite
    good. I am currently quite heavily waited towards the emerging market themes via Austraila, India, Mining shares and also in the agricultural sector through fertilizer companies and commodities such as wheat all fo which i trade via spread betting. Hence when i read “‘‘David, sell everything, this is your last chance.” He was on the money. Russia defaulted three weeks later.” alarm bells started to ring.

    Any ways thanks for your time David.

    Kind Regards


  8. Im no economist, particularly when I get lost trying to comprehend the labrynthine world of investment banks 1000 ways to repackage all kind of bad/dodgy debts and sell them on to each other as “financial instruments” or whatever. It is naked greed, garnished with folly, which has thrown the international financial system into near meltdown.Why do governments not regulate this madness better?
    The system of big investment funds being able to “borrow shares” and then gamble against them, is one example of why there can never be stability in stock markets.

  9. Lonnely Expat


    you don’t have to be an economist to comprehend. Of course banks like to make profits, just as everyone else does. Of course they are being burned, just like everyone else is. Why do governments not regulate this madness? They try. They eventually burn, just like everyone else does. Who settles the bill? You and I, just like everyone else does.

    Corollary: You will pay, just like every—

  10. Barry

    I was wondering when the discussion would turn to ‘regulating the banks’ and it didn’t take long for the usual answer – govts cannot/will not do it, because they (the banks) have too much power in the modern economy. Even in the 1930s this was the case and it led to Hitler and he didn’t sort it!!

    My question is, why don’t govts let one of the banks go to the wall?? I simply don’t understand why for example the UK hasn’t let Northern Rock go, they are not under any political pressure such as an election, they could spin it as ‘pour encourager les autres’ and it would frighten the bejaysus out of the banking community. It couldn’t cost more than the £40bn it has already caused them to commit. Anyway it is likely they’ll have to nationalise it and that will cost more.

    Perhaps David you could write us a piece on letting one go??? Of course it may be against your free market principles….??

    Bye, Barry

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