The Shepherd's Bush Blog has asked the famous financial commentator Siegfried Line to outline the dynamics of the present financial threats to all those in Shepherd's Bush and the rest of the world. Here is his analysis:
You ask "what is going on in the world?". The answer is that we are in the middle of a financial and political crisis. In general everyone has too much debt, both private individuals and states (sovereign debt) but finding a way out is proving to be difficult because:
1. The destruction of assets resulting from the 2008/9 financial crisis has reduced productivity in western economies and this has reduced the tax take. Consequently governments cannot sustain the spending of previous years without building up a lot of debt (usually borrowed in government bonds or Sovereigns)
1b. A lot of states (almost all western states) have chosen to reduce their spending (fiscal discipline) this has reduced economic activity and reduced taxes further. Conseqauently the state debts are not reduced as had been hoped. This has been made worse because a large number of states have decided to do this at the same time so trade and economic activity is further depressed. (ie it looks although Keynes was right, in a period of economic recession one needs to stimulate the economy not retrench by reducing government spending - this is a rerun of the 1930s when Hoover in the US and a Tory/Liberal coalition (!) in the UK, introduced harsh fiscal measures to deal with government deficits after the depression. The result was their economies did not recover until World War II !! ie after 1939)
2. The Eurozone has particularly serious problems.
2a.The structural problem at the heart of the Euro project is that, unlike in the US, there is no fiscal union. This means that different Eurozone members have different fiscal regimes (tax and spend) and these differences cause strains in difficult times. The most obvious problem in Greece is the very poor ability of the state to collect tax which is bound to create problems. Although the US is divided into states with different laws there is a common tax regime and much spending (eg defence and health) is determined in Washington. The US $ is consequently very sound despite the economic recession.
2b The lack of fiscal union is exacerbated in states like Greece, Italy, Ireland and Spain because of what might be called their financial culture. In the past when there were economic recessions these countries devalued their currencies thus making their goods cheaper to export, encouraging their purchase and so stimulating their economies. BUT because they are now members of the Eurozone they cannot devalue so instead the only way out is fiscal ferocity, ie vast cuts in government spending and steep rises in taxes. Again this is a downward spiral: it reduces economic activity, causes a rise in unemployment and impoverishes the people. Again there is a reduction in tax take so the deficits do not go away. This has happened in Greece. It is a similar situation to that which caused the UK to abandon the Gold Standard in 1931.
2c. National governments within the Eurozone should have encouraged Greece to carry out an orderly default on Greek bonds which would have reduced the debt burden and the spiral of decline. They have not done this (or have only done so in a very minor way) because their banks hold large quantities of Greek bonds so it would be bad for banks as they would have to write down billions of Euros on their books (ie admit the value of the bonds was nil). So the EU actions so far have been called a bank bailout rather than a bailout of governments issuing the bonds. (This is because the 21% "haircut" the banks would suffer under current plans - the PSI - is much less than the losses they would suffer if they sold the bonds for their present value on the open market). This failure of robust action by the Eurozone governments has led to a loss of confidence in peripheral countries bonds.
2d. Overall the Eurozone can easily pay off Greek debt because core countries Germany, Netherlands, Finland, Denmark are so productive and in positive balance. So if there was a Eurobond this could be used to finance all the countries of the Eurozone. However the "core" countries are becoming more nationalistic and do not want to fund Greeks who they regard as lazy, corrupt and spending all day on the beach and the Germans contrast this with the incredible reconstruction of their country since 1945. This is important because attitudes are returning to those earlier in the 20th Century (or indeed as someone in the FT pointed out to the peace of Westphalia in 1648 which reduced the influence of the Roman Church giving way to nationalism). Nationalism in turn led to the horrors of the Second World War which was so awful idealists decided it should never happen again and their answer was European Union. Chancellor Merkel holds the key but has elections in the next year and is afraid of alienating her electorate. For a Eurobond the interest rate would be higher than that issued by the German government so would be negative for the Germans but is otherwise generally regarded as the simplest effective measure that should be taken to shore up the bond markets of the peripheral countries.
2e. The ECB (European Central Bank) has purchased bonds of vulnerable countries so their prices rise and yields drop and this has given some support but much more is needed especially if Spain, Portugal and Italy become further involved..
2e. The ECB (European Central Bank) has purchased bonds of vulnerable countries so their prices rise and yields drop and this has given some support but much more is needed especially if Spain, Portugal and Italy become further involved..
2f. Greece could leave the Eurozone but it would be very disruptive and probably more disruptive than a default. Greek banks would crash as would the economy as a flight of capital out of the country took place.The biggest risk is that financial markets would in these circumstances sell the bonds of other peripheral Eurozone countries (Italy, Spain, Portugal, Ireland) Selling the bonds means that interest rates rise in these countries putting even greater pressure on these countries to finance the day to day working of government but also raising interest rates for companies and individuals trying to borrow money to pursue projects that would enhance growth. So again the result would be a depression in economic activity a decline in taxes raised and greater overall deficits.
If the strains on peripheral countries became too great and their bond yields all rose to intolerable levels the Euro might have to be abandoned which would lead to a mega financial crisis with unpredictable outcomes. This is because the Euro is woven into the material of the international financial system. An enourmous amount of unwinding would have to occur. The new currency of the core countries, or a rump core countries would shoot up as capital fled to the core making trade difficult for these countries. I think the destruction of the Euro is unlikely because the effects would be so dire. On the other hand I would be more hopeful if the Eurozone ministers and parliaments would show some sign that they are capable of getting their act together. Given the problems the Eurozone governments are having mastering the situation there must remain a substantial risk that we will experience the worst financial crisis since the bursting of the South Sea Bubble.
3. Problems with Weak Banks.
3a. There is some 6,300 million of Sovereign Eurozone debt about half of which is potentially suspect if full blown crisis were to occur. Much of this is held by Eurozone and other banks. Further banks are at risk if they have lent to holders of doubtful Sovereign debt so there is a problem of contagion.
3b. Many Eurozone banks are weak on reserves and risk collapsing if Sovereigns started defaulting. Supporting the banks is thus a key secondary problem of the crisis but one through which the general public might first experience the crisis as runs on banks started and some collapsed denying retail depositors their funds.
4. The US has problems of its own, mostly a stalled economy interlinked with a drastic and continuing fall in house prices which has sapped consumer confidence. As it is the world's economic power house this alarms people. The big fall in the markets on Wednesday and Thursday 21st September was triggered by the US Federal Reserve bringing in further US bond buying of long term bonds to keep interest rates as low as possible. It seems the accompanying justification painted such a dire picture of the US economy that it may have been the trigger - but there was a lot of bad news about and a lot of tension in markets so I think it was just the excuse to sell...! The Fed should have printed more US $ to ward of deflation but seems to have been cowed by the right wing of Congress (T party etc) one of whose members called Federal Reserve actions on QE "Treasonous".
5. To a large extent these are political crises. The politicians in Eurozone cannot agree on what action to take and are dithering and do not seem to know what to do and this makes things worse as market confidence in the Eurozone bonds is further undermined. The vile politics in US Congress is also a problem for the US where the Republicans seem determined to push their view and seem to have abandoned compromise regardless of the consequences.
Overall there is a real danger of a spiral of declining productivity and rising debt - a debt trap. Individuals are also trying to pay down debt so are not consuming so this causes economic slow down too.
I do not know where all this will end but it does not look good. The only good thing about things being really bad is that it ups the pressure on our political classes to do something about it so their is a positive feed back mechanism there.
Siegfried Line, Sunday 25 September 2011. Riechen, Kreis Sinsheim, Germany.
