March 12, 2012
Now there we were, thinking that financial markets didn’t like defaults. In fact, we were warned that if we were to do something as dastardly as not pay Anglo unsecured creditors, the sky would fall in. This line has been followed by our state as if it were gospel.
Yet on Friday, we see that not only is it not gospel, it is nonsense. The financial markets didn’t sell off, but rallied enthusiastically after the news that Greece had defaulted spectacularly on sovereign debt, not bank debt. So the markets that lent Greece money rallied on the news that Greece wasn’t going to pay the money back.
The largest sovereign default ever – and the only one in a developed country in 60 years – was embraced by the financial markets. In fact, for what it’s worth, the Greek stock market rallied too.
So what does this tell us?
It tells us that financial markets have no memory. They move on. It also means that when something becomes inevitable, sensible people accept it and make provisions. The fact that the default was not orderly or chaotic makes no real difference. Only weeks ago, creditors of Greece were saying that they wouldn’t accept default (as if they had a choice).
Yet by Friday, 95 per cent of all creditors said that they would accept losing half their capital.
The other 5 per cent, let’s call them ‘rouge creditors’, who won’t accept the deal and want all their money back, risk getting nothing.
So what happened to the so-called vindictive financial markets, and what they would do to Greece if Greece defaulted? They rolled over. And what about the ATMs? Remember the notion that the ATMs wouldn’t work if bondholders didn’t get paid? Well, ATMs worked just fine in Athens on Friday evening.
More significant has been the U-turn by the troika. A few months ago, the EU view was that no default could be contemplated yet, on Friday, even the so-called hard-line Wolfgang SchÃŒuble, German finance minister, called the deal an “historic opportunity for the country”.
So what we are seeing is a U-turn in attitudes as events overtake the big players. The biggest enemy of dogmatic positions are rarely other ideas, but events and the march of time. As Greece contracted and contracted, the idea that it could pay its debts evaporated.
The new reality is one that we have been arguing here in this column all along, which can be summed up by the idea that you never make a balance sheet better with more debt – you make it better with less debt.
Now what does all this mean for us in Ireland, as we move forward?
It means that we, too, will get a debt deal on banking debt, not just the promissory note. The question is whether we are best to go for it now or wait for something much bigger down the road.
Let me explain what I am on about when I say “much bigger down the road”.
At the moment, the central banks of the world are responding to this mega-debt crisis and the consequent de-leveraging that we are witnessing everywhere with lower and lower interest rates. Interest rates are as near to zero as possible. In the US, the Federal Reserve said that it would keep rates as low as necessary. In fact, last Tuesday, when Fed chairman Ben Bernanke suggested he might not give all the free money the market wanted, there was a sell-off in the markets the next day. This was followed by a report on Thursday that the Fed would indeed provide more liquidity and, guess what, the markets rallied on Thursday afternoon.
The Bank of Japan, the Bank of England and the ECB are all at the same game. We are in the Year of the Central Bank, where the only action is what policy makers are doing.
They are injecting as much liquidity as necessary because the banks are in a very fragile position. Even the much-maligned stress tests of European banks show that banks need over â‚¬150 billion of capital right now. Banks can get this by either selling assets or raising equity. Given that they don’t want to do the former and can’t do the latter, the central banks have stepped in as lender of last resort.
Now, let’s get a handle on how much money we are talking about.
Over the last three and a half years, Britain, Europe, Japan and the US have boosted their central bank balance sheets to $8.76 trillion, and pumped out that much new money into the banking system.
The central banks have opened the discount window and taken in all sorts of collateral and, in return, given out this cash.
Today, the balance sheet of the ECB is 30 per cent of eurozone GDP. The figure for the Federal Reserve is 17 per cent and the Bank of England 18 per cent. This is an increase without historical precedent or parallel in peace time. Under these circumstances, we may say that the economy is ‘recovering’ – as we have been hearing in the US – but it lacks real meaning because we are so awash with central bank cash and credit.
Now here’s the rub. What goes in must come out. As all this cash finds its way ultimately into asset prices and inflation, the central banks will have to take it back out of the system because they can’t countenance mass inflation.
So what will they do?
The will raise interest rates rapidly and maybe much more rapidly than we expect.
Last week, I was lucky enough to hear 87-year-old Paul Volker speak at a conference. As he got up on stage, I thought to myself that when this guy was head of the Federal Reserve, after a bout of inflation he raised interest rates to 20 per cent to purge the system. Last week, the same short-term rates in the US were 0.2 per cent.
Could the greatest monetary splurge in human history be followed by a Volker-style whiplash in interest rates, the likes of which we haven’t seen in a generation?
The answer is yes, but maybe not to the same magnitude seen in the early 1980s. But it could happen if inflation took off, forcing the central banks to reverse their policy of the past three years.
What would happen here, if real interest rates in Europe went up to 5 per cent to choke off inflation? After all, don’t forget that savers in Germany would benefit from this. Here would be chaos, mass default, bank failure and another credit crunch, but this time on a much greater scale.
A whiplash in interest rates is not remote, in fact, it is quite likely. Given the fragility of our banks, the state of their mortgage books and the fact that people can’t take any hikes in interest rates, the lesson from Greece is that we’d better position ourselves for higher – not lower – interest rates.
At least we now know for sure, creditors will do a deal because events will overtake them. The centre doesn’t hold and the world quickly moves on to the next paradigm.