January 30, 2012
Water into wine? I think not.
Rather than talk about who went ‘mad borrowing’ last week, let’s focus on why it happened, because I want to explain what is happening right now in the financial markets. I would also like to make the point that central banks are becoming – yet again – instruments of leverage, rather than guardians of prudence. This looks good now, but will cause more problems in the years ahead.
In the past few weeks, the world’s central banks, led by the Fed and the ECB, have opened the floodgates with cheap money. This is driving up everything from European bond markets to commodities and stocks that, last year, people wouldn’t touch with a barge pole.
The reason for the mad borrowing is that money is now cheaper than ever. In our boom, the maddest borrower wasn’t the Irish citizen, but the Irish banking system. In the case of the two biggest banks, they doubled their borrowing in three years. It took Bank of Ireland over 100 years to borrow â‚¬60 billion (from depositors); it doubled that in three years (by borrowing from German, French and British banks).
Why did our banks do this? Because they could, because they were allowed to and because they thought they could make a fortune doing it.
When money is made available cheaply, it is borrowed. This sets off an endemically short-term cycle, where the game is to buy whatever asset is moving upwards sharply. The trick is to sell before everyone else.
When the rate of interest is forced down to excessively low levels, the incentive to save disappears because the returns to savings are minimal and the incentive to borrow increases dramatically. We are
seeing this carry-on now in global markets.
Politically, the result of all this will boost significantly Barack Obama’s chances of being re-elected as US president. Research in the US shows that one of the key determinants for presidents getting re-elected is the direction of the economy in the six months leading up to election day. For example, Ronald Reagan won re-election in November 1984 when unemployment was at 7.4 per cent. This was the same rate as when he was elected the first time four years earlier.
Unemployment had been much higher during his term, but he wasn’t punished for that. What counted was the economy on the day. Obama might be similarly lucky if the economy moves in the right direction, at the right time.
Of course, the president is being helped enormously by the Fed’s promise last Wednesday to keep interest rates below the rate of inflation for the next few years. Interest rates below inflation means that people in America will be punished for saving. They will lose money if they save, in real terms. Their savings will be eroded by higher prices. Taking their cue from the Federal Reserve, global funds are borrowing and placing bets with the borrowed money on the world’s stock markets.
The same is happening in Europe. In mid-December, the ECB, under pressure from Nicolas Sarkozy, decided to fund the banks of Europe and give them the wherewithal to buy government bonds. The ECB is making â‚¬450 billion available to the banks at 1 per cent. With this they are buying bonds yielding 5 per cent or higher. This is bringing down yields.
This is what the NTMA was playing at last Wednesday. The NTMA was using money borrowed by the bust Irish banks at 1 per cent from the ECB to lend on to the insolvent Irish government. The manoeuvre gives a “carry trade” of a free 5 per cent to the banks. This is the financial equivalent of turning water into wine. But, unlike in Cana, someone has to pick up the bar bill.
You see, this is great for the banks because they can rebuild their balance sheets with the free money. But when you follow the money, you see who pays. You do, of course, yet again.
Let’s follow the money and explain the cash-for-trash scheme in Europe. The banks have managed to give the ECB dreadful collateral and, in return, the ECB gives them real money for 1 per cent, which they then lend to the government at 6 per cent. But someone has to pay the money back. And that is you.
So not only did the banks destroy a generation by borrowing and lending hand over fist, but they have their claws in the next generation by loan-sharking to the government which will use this money to pay today’s bills while giving the tab to the next generation.
Let’s see if all this is sustainable.
First off, are European countries more creditworthy this week than they were last week? Without growth, the answer must be no.
But even more pressing is whether this immediate growth in the western world can inflate another bubble, even for a short while, at a time when it is supposed to be deleveraging (paying money back) not leveraging (borrowing yet more).
Last week, there was a lot of talk about deleveraging. McKinsey Global came out with a widely cited report on deleveraging. It’s well worth a gander, if only for the chart on Ireland’s position.
In the report, the point is made that all western countries will have to go through a prolonged period of paying back debt. McKinsey believes that we are only at the start of this process. But, in fact,
if you examine the data, we have not even got there yet.
Look at the chart. It shows the gross government debt of the major OECD countries. As you can see, the government debts of the western countries are rising rapidly. This is because the private sector paysÂ money back and saves – which it has been doing since the crash – as the government has been taking up the slack. If the governments were not borrowing, the collapse in the economies would be even greater.
(2011-2014 OECD forecast)
So the process of deleveraging is only just beginning.
This means that the short-term boost to stocks and bonds can only be just that. These market rallies, which are real and can allow people to make money if you are clever and get your timing right, should be treated carefully.
As the Canadian economist David Rosenberg – one of the best in the business – stated: “These rallies should be rented, not owned.” Succinct, don’t you think?
Longer term, this age of deleveraging will come to dominate our world. When the magic spell of bubble stock and bond rallies wears off again, the underlying position of too much debt and not enough growth will reassert itself.
Yes, the water was turned into wine for one night only. Next day, we are left with a hangover. No miracle.