September 28, 2011
Did you notice something strange over the past two days about the financial markets? The European stock markets actually rallied on the rumour that Greece would be allowed a “ring-fenced” default.
Now consider this again because the ‘official’ position of the Irish and the European political elite is that any default on anything by anyone would be a disaster, leading to huge capital flight and massive financial carnage.
If this is true, how come markets in the past two days have given precisely the opposite signal?
According to the latest financial market move, default actually calms things down for investors. It seems that it makes sense to face up to the reality that a country like Greece — or indeed a ‘bank’ like Anglo — has no money and therefore must default. If you prevent this basic capitalist process from happening (whereby investors pay for their mistakes), you spook the entire system.
If you doubt this, consider the graph. This graph shows the risk perceived by banks in Europe and how they will lend to other banks. The entire banking system is kept liquid by interbank lending, whereby banks lend to each other. Think about it. You go into the bank today and deposit money, but if that money is not lent out to someone else today, the bank will end the day with a surplus of funds in its safe. It makes sense for your bank to lend this surplus money to another bank, which may have lent out too much today. This is how the system works.
But what happens if banks don’t trust each other because they are worried about what is on the balance sheets of the banks they are lending to and think that maybe the bank won’t be able to pay them back? In such an unusual case, the rate of interest goes up on the interbank lending to cover the lending bank for the risk that the borrowing bank is borrowing precisely because it is running out of money.
Look at the chart above. It shows you what happened to the perceptions of risk in the European banking system in the past few weeks. It has skyrocketed. Interestingly, you can see that in the run-up to the Lehman crisis, the perceived risk increased enormously. Then it settled down after the Lehman default and collapse. It is important to see that this happened after the Lehman default.
Things calmed down and even during the various Greek, Irish and Portuguese crises last year, there was a sense that things would settle.
Now the idea that a massive debt crisis in Europe is brewing and there is no leadership to deal with it has sent this risk between banks through the roof again.
The only way this can come down is through a default in Greece and obviously in other countries that can’t pay their way. As the market reaction yesterday showed, if we default on old debts and put in place a fund to make sure it doesn’t happen again, then we can all look to the future. This is the basis of all bankruptcy procedures — old creditors who made the mistake get roasted, new ones get the gravy.
But the politicians won’t accept this logic, why? Why are the political establishment and the financial markets signaling two polar opposite outcomes to one debt crisis?
The reason is that the political establishment is worried about prestige and how the power of Europe might be perceived in the wake of a default in Greece.
Obviously, it doesn’t look good, short-term, if a country in supposedly the richest part of the world defaults. Nor does it look good for a part of the world, which has historically been important and is vying with the US as the best of the old superpowers, to have a delinquent country in its inner circle. So this is about political prestige.
Even if prestige makes the European balance sheet worse — because propping up lenders to bankrupt banks or indeed bankrupt countries is the ultimate ‘dead money’ — it appears that many political leaders want this option. Once you pay it, you get absolutely nothing back but, so the argument goes, ‘serious’ countries don’t default.
The markets, on the other hand, worry about future return, not past prestige. Financial markets have no memory. They are driven by the opportunity tomorrow rather than by recrimination for yesterday. What happened, happened and move on.
This is why a decision by a country (like Ireland) to pay all its bank debts, makes the country riskier, not less risky. The lesson we have to take from the European financial markets of the past two days is quite simple: if Mr Noonan walked away from paying the next tranche of Anglo bondholders, the market in Ireland would rally.
This is because every time we pay â‚¬700m to Anglo bondholders, it is dead money. This spending will not raise the productivity of Ireland in the future as it would do had the money been spent on schools.
In fact, it will retard productivity growth because it will have to be paid by higher taxes in the next generation. Yesterday, we saw what the markets think of this type of financial nihilism — they penalise it. This is why Ireland is locked out of the bond markets.
We need a massive change at the highest level in Europe to rescue the situation and this demands facing up to the world as it is, not the world as we would like it to be.
This generation of European leaders makes German Field Marshall Paul von Hindenburg, Neville Chamberlain and even Bertie Ahern look decisive. We are reminded of Henry Kiss-inger’s rebuke: “When I want to talk to Europe, who do I call?”
In the face of crisis, the Continent’s position has been denial. First it was the dithering EU Commission suggesting everything is going to be alright, then we had Angela Merkel stating that Greece wouldn’t be allowed to default and now we have the leaks, made real by injudicious comments from the Americans on Monday, that at the heart of the solution to Europe’s debt-problem will be some sort of ring-fenced default in Greece.
Expect the Greeks to be allowed to default in some form in the next few days. Then this leaves open the following logical question: if Greece can default on its debts, why not the Irish banks on their bondholders? Like certain others, they haven’t gone away, you know. This would save us tens of billions of euro. After all, the ECB is on the hook in Greece, and it is also on the hook here. What is good for the Grecian goose must also be good for the Celtic gander.