Elite have us living in a fool’s paradise

Her trusted field marshal, and her lover at the time, Prince Gregory Potemkin, organised a series of mobile villages to appear as soon as the imperial barge, stuffed with innocent and gullible foreign dignitaries, came into view.

When the riverbank came within earshot, the villagers would break into a spontaneous, sycophantic chorus of praise for the Empress, giving the perplexed foreigners the impression that not only had Russia pacified Ukraine, it had also managed to win over the local peasantry, which was no mean feat in the 18th century.

As soon as the imperial barge turned the corner the villagers would dismantle their villages and rebuild them overnight further downstream, with a view to performing the same malarkey the following day.

This continued each day for over two weeks. The overwhelmed foreign dignitaries then reported back to Berlin, Paris and London on the marvel of the Russian conquest and pacification of Ukraine. Thus was born the ”Potemkin village approach to economic and political progress.

Over the years, the Russians have perfected this approach of half-truths, misinformation, disingenuous analysis and obfuscation. Russian governments perfected the art of identifying culprits on whom to pin the blame for their own failings: Jews, Poles, profiteers, priests, intellectuals, kulaks, enemies of the revolution and so on.

Typically, if there is a problem, a few culprits are rounded on and grandiose decrees are announced to fight the evil, whether it is economic, social or political.

Along with the entirely ”made up triumphs of the five-year plans, the Soviets deployed the Potemkin tactic to pretend that they were more powerful than they actually were.

The West believed the Potemkin villages and that is why no one foresaw the overnight implosion of the Soviet Union, despite the billions spent on so-called ”intelligence. Although there are good arguments to suggest that even if the CIA doubted Russian strength it wasn’t in their interest to tell the truth because the US government would have cut the defence budget if the other superpower was nothing but a Potemkin village with inter-continental ballistic weapons.

This week, I thought of Potemkin villages, not just because Ukraine and Crimea are in the news, but because of what is happening to our government’s favourite indicator of economic success: the Irish bond rate.

As this column has been pointing out until it is blue in the face, the fall in Irish bond yields is because of European Central Bank president Mario Draghi’s promise to ultimately buy peripheral bonds if he has to in order to prevent another euro debt crisis. This is not only the case with Ireland, it applies for most of the eurozone from Greece to Italy, Portugal, Spain and even France.

The game that Draghi is playing is nothing more than lending money to bust banks that lend this money to bust governments.

This pushes down bond yields and pushes up bond values, implying that the balance sheet of the banks looks better and the credit worthiness of the governments also looks better, but nothing has changed in reality.

It is a sleight of hand, which temporarily makes the banks look a bit more stable and temporarily makes the government look more robust.

For the banks, this temporary increase in the asset side of the balance sheet works wonders ahead of a stress test. Passing the stress test is dependent on having enough capital. However there is really no such thing as a quantum of bank capital.

Bank capital – the new target for the ECB – is actually a residual, not a target. It is what falls out when you subtract a bank’s liabilities from a bank’s assets. Therefore, anything that raises asset values (such as government debt on the asset side) and anything that reduces liabilities (such as loads of bad loans, which haven’t been written down properly as is the case in Ireland, on the liability side) will raise bank capital. As you can see, not only is bank capital a moving target, dependent on other bits of jiggery pokery but the lads on the inside can also influence bank capital.

The bankers could overstate assets and underestimate liabilities to boost the capital in order to pass the stress test. Do you think such a thing is beyond these guys?

Yet in the real economy this week we saw that GDP – the government’s preferred figure when it is going the right way – actually fell in 2013. Also we learned that inflation, as measured by the CSO, is actually falling too. Of course, the government brushed off the fall in GDP because it doesn’t suit them and hardly commented on the inflation rate.

If the rate of inflation is falling at a time of unresolved debts, it means that the debt burden will actually rise not fall. If the price you charge for your goods that you sell is falling, it means your income is falling and if the legacy debts from the boom are not falling or being written down, your debt burden is rising.

This is exactly what is happening here in Ireland as the debt burden creeps ever upwards which means more risk, while the bond yield falls, which means less risk. One of these things has to be wrong, they can’t be both right!

In the domestic economy we’ve seen modest falls in unemployment indicating some demand out there and retail sales have been stronger. However, Ireland is now a cash economy. There is no credit and with no credit, projects – even very good ones – don’t get financed and there is no vibrancy.

In such an environment where the cake isn’t getting any bigger but is actually getting smaller, the insiders (those with a stake and influence on both the left and the right) move to ensure that they get their share. Meanwhile, the outsiders (those without a stake, influence or ”pull) remain shut out, surviving day to day.

All the while the elite, the state, the ECB, the EU, the institutional bond market and much of the media, focus on the fall in bond yields and the exit from the bailout; these are the Potemkin villages of the 21st century. Like the Russians of old, we are so concerned about deceiving others that we end up deceiving ourselves.

David McWilliams writes daily on international economics and finance at www.globalmacro360.com

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