Tuesday, November 23, 2010

Property, the Banking system and the end game for the Euro

The fundamental problem of Europe is not the Euro.

The fundamental problem is the economic structure of most of the European economies. The standard model of these economies has been to pay for today's bills with cheques drawn against the future. Instead of saving up for things today and acquiring them later, we have chosen to acquire them today and pay for them in the future. To a degree, it has worked: the levels of average prosperity in the present day would stagger most of our forefathers. Yet, there has always been a critical piece of small print: growth needed to continue, and not just economic growth, but population growth too, so that the costs were painless enough for the next generation to carry.

Yet about 40 years ago, the oil shocks created inflation that was not the result of economic collapse or war, but for several years was a normal part of business. In the face of this, real assets, especially property, held their value in real terms, but looked like they were appreciating sharply in nominal terms. Property became more and more popular, and banks began to prefer not only lending to property purchasers, but also lending against property to finance other asset purchases. All the time the central banks, trying to "even out" the cycle, provided excess liquidity in the downturn, while failing to tighten sufficiently in the upturn. Since this helped to erode money as a store of value, property began to look like a one-way bet.

At more or less the same time, we lost sight of another basic issue. People began to retire earlier and earlier, believing that the inflated asset-largely property- values that supported this decision were normal. Even as life expectancy increased into the eighties, people began to stop working in their mid fifties. The time a pension had to cover went from a few years to several decades. The cheques we were drawing against the future grew ever larger.

It was not just in the private sector that saving became a dirty word: States too began to hand out increasingly extravagant welfare packages: for millions of people, it was not economic to work. Skills rotted, and both Western Europe and the USA acquired a burden of the unemployable unemployed who nonetheless made a substantial call on the public purse.

Then over the course of the last decade bankers began to securitise their loans, that is to package them for sale to third parties. In doing so they also packaged the asset that the loans applied to. These asset-backed securities (ABS) were supposed to be safe because of the value of the collateral bound up within their structures. It is the mistake that bankers always make: that taking collateral against a loan gives them "security".

It was a long time coming, but the property bubble finally burst. The result was not merely the failure those of banks most directly involved in property, but also those banks exposed to the ABS market- which in practice meant pretty much all of them.

The impact in Europe was twofold. Those countries most exposed to property: the UK, Ireland and Spain saw large parts of their banking system evaporate. Domestic rescue plans were initiated and guarantees were issued. Meanwhile those countries with large state debts based on an unaffordable welfare state found that their access to the capital markets closed. Populations to pay for the welfare are generally falling- and resistance to immigration is making the problem even worse.

At first it was the poorly structured economies that fared worse: Greece was forced to address its long term deficit. However, the absolute breakdown of the Irish property market increased Irish government liabilities to several times the Irish GDP. The deficit yawned to over 30% of GDP.

At this point the anti Euro crew will argue that had the Irish been able to devalue their currency, then the crisis would have been resolved, because the bubble would have burst far sooner if the demand for Punt, as opposed to Euro, assets had reflected the smaller size of the Irish economy alone versus the Eurozone as a whole. Furthermore, the Irish could have mitigated the crisis, as the UK has done, by devaluing their currency.

Mitigated, perhaps, but as the experience of the UK, which can devalue its currency, shows it is certainly not solved.

As I have argued repeatedly on this blog, devaluation is only ever a temporary solution, and if it is used- as it has been in the UK- simply to avoid painful structural adjustment then it ends up permanently reducing the economic potential of the entire economy as people simply build in higher inflationary expectations. Arguably the reason for the instability in the Eurozone's periphery is a function of the fact Germany- the core Euro economy- has been undergoing a long and difficult restructuring, and has emerged extremely competitive, indeed too competitive for the other unrestructured economies to cope with.

Now the breakdown of the property based savings and welfare system is creating a second meltdown: not only a meltdown of the banking system, but also of the states that have issued guarantees to that banking system.

It is a meltdown that will lead to sovereign defaults, and not just in Europe. The policy of competitive devaluation can not work where China- the worlds largest surplus economy and the worlds manufacturing base- maintains its own artificially low currency level. Without the unlikely prospect of a dramatic Chinese revaluation, even the breakup of the Eurozone and drastic devaluation by the most insolvent economies will not solve anything. The Germans will remain efficient, the Chinese will remain efficient and investors will be more fearful than ever about the prospects of the ex-Euro countries.

The only solution is to do what the Baltic states have done: make a drastic cut in costs by an "internal devaluation", in the case of the Baltic by around 25%. That means wages fall by 30% and house prices by 50%, and the overall level of costs by about 15%. The Balts did in last year. The Greeks propose to do half as much over five years, the Irish by 15%- not 25%- over 3 years.

Not enough, and the result is that these Euro-delinquents will require a rescue that is beyond the ability of the rest of the Eurozone to finance. A debt default is therefore now very likely. Only this is where we can criticise the ECB and the European Council: we still do not understand how such a default will be handled.

But after the inevitable default happens, we are in a whole new ball game, and no one knows what happens then. One thing is for sure, very few of my generation and none of the following one will be retiring from work at 55.

The age of austerity that looms before us is set to be measured in decades rather than years.

10 comments:

Lord Blagger said...

Then over the course of the last decade bankers began to securitise their loans, that is to package them for sale to third parties. In doing so they also packaged the asset that the loans applied to. These asset-backed securities (ABS) were supposed to be safe because of the value of the collateral bound up within their structures. It is the mistake that bankers always make: that taking collateral against a loan gives them "security".

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You've got this bit wrong.

There is nothing wrong with securitisation. Bundling up loans, selling them to investors, and earning a fee for managing them is a perfectly good thing to do. There is small issue about compliance. Namely, do the loans being sold meet the criteria that the bankers say they do.

So lets take NR. What would have happened if they had securitised their loans? Nothing. They would still be here. The investors in the bonds take the hit. They wouldn't have had a funding problem.

What's the problem then? Well the banks sold off their risk, but then the management let another department buy it back and start trading it. In most cases the risky stuff.

What the solution going forward? It's securitisation. Creation of bad banks by splitting off the good parts. Then the government sells off the good bits for cash, offsets the profits against the losses at the bad banks. The reason is that the good parts can start loaning again

Lord Blagger said...

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Cicero said...

Well yes, I agree, but my point is that it is not the securitisation that is the issue, it is the collateral (i.e. the taking of Security), which were the assets that back the ABS market. These were of course largely mortgages. These were based on property values inflated by poor quality credits entering the market- a phenomenon that began in the US (which does not allow recourse to the borrower, once the collateral is returned) and which spread to the UK, which does allow mortgagors recourse to the borrower. The banks that bought US ABS instruments were killed, and the UK particularly bad. So the poor collateral became a virus across the whole market. The risk was very mispriced.

Lord Blagger said...

The banks that bought US ABS instruments were killed

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This is the point. It's not securitisation that is the issue.

The problem is they offloaded the risk, property exposure and funding exposure when they securitised. That is a good thing.

They then bought the risk back, which is plain stupid.

Cicero said...

I am not disagreeing with you- it is that the banks thought that collateralising risk eliminated it: it did not, indeed never does.

Lord Blagger said...

Collaterialising risk eliminates their risk, unless they buy it back.

It passes the risk to someone else.

It is what they should have done. Securitise and get rid of the risk and the funding issues.

ie. When the interbank market dried up, NR went bust because it couldn't fund. If it had securitised, it wouldn't have needed to fund, and there would not have been a run.

wallybynature said...

i enjoy this blog when i pass by and i agree largely with your post above as i suspect dan hannan would. you eloquently make the case that the euro cannot work because of the major differences between the national economies. in some ways you are arguing against the premise you make in the hannan post.
is the solution for the euro for germany to exit until all the other countries have improved so they can come back in again.
i am fearful because the ec in trying to save itself may ruin us all. i will be still working if i make 80 and look forward to it.

Lord Blagger said...

i will be still working if i make 80 and look forward to it.

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If you want to, fine. However many don't.

I did a little calculation the other day. Median wage is 25K a year. What would have happened if a median worker had had their National insurance in the FTSE and not 'invested' with the government.

They would retire on an joint like, RPI linked retirement income of 21,000 pounds a year.

Instead they have 5,000, now linked to CPI not RPI, and not even fully joint life.

So when people say the stock market is risky, ask them if they would prefer the risky 21,000 a year, or the not risk 5,000 a year.

Pensions and government debts are an even bigger mess than the Euro

wallybynature said...

interesting post.
i fear that the govt is too addicted to our ni ever to allow those that have stomach for risk to invest in the ftse.
i agree about debts and pensions except their true horror although beginning to show now will take more time to come to the top of the agenda than the present playout of the euro's travails.
it is not a good time to be old now and will be far worse in the future. but that is not just economic as families seem to care less and less for their own.

Lord Blagger said...

Well think about it. To replicate the current pension would just take 1/4 of NI going into a fund.

If you can divert 1/2, people are much better off in retirement.

Plus the added benefit of growth, which gives the government what it really needs. Growth in taxes. Growth itself doesn't help the govenment. It's only an increasing tax revenue that works.

However, I think its a bust. I don't think they can cut, until they are forced to. That for many is too late.

So you need insurance, and that's a lot of very heavy saving.