The Wisdom of Walter Bagehot

Readers of The Economist will already be familar with the name Bagehot, it being the title for their UK-focused regular column. I suspect fewer will have read anything by the man after whom it is named.

I recently had cause to browse Lombard Street: A Description of the Money Market (a free online copy can be found at Project Gutenberg). Written in 1873, in the aftermath of a banking crisis (Lombard Street is in the City of London, and used in this context to refer to the global banking system), it’s a remarkably prescient view of our current situation, and one worth citing from directly. I will not provide much further commentary as his quoted words are self-explanatory both in their description of the problem and the least-worst solution. I’ve also kept any modifications to the absolute minimum required to retain comprehension on stitching the quotes together.

The briefest and truest way of describing Lombard Street is to say that it is by far the greatest combination of economical power and economical delicacy that the world has even seen. Of the greatness of the power there will be no doubt. Money is economical power. But very few persons are aware how much greater than the ready balance is the floating loan-fund which can be lent to anyone or for any purpose.

A million in the hands of a single banker is a great power; he can at once lend it where he will, and borrowers can come to him, because they know or believe that he has it. But the same sum scattered in tens and fifties through a whole nation is no power at all: no one knows where to find it or whom to ask for it. Concentration of money in banks, though not the sole cause, is the principal cause which has made the Money Market so exceedingly rich.

It is a luxury which has never been enjoyed with even comparable equality before.

But in exact proportion to the power of this system is its delicacy. Only our familiarity blinds us to the marvellous nature of the system. There never was so much borrowed money collected in the world. If any large fraction of that money really was demanded, our banking system and our industrial system too would be in great danger. The amount of cash-in-hand is so exceedingly small that a bystander almost trembles when he compares its minuteness with the immensity of the credit which rests upon it.

We do not always manage it with discretion. There is the astounding instance of Overend, Gurney, and Co. to the contrary. Ten years ago that house stood next to the Bank of England in the City of London; it was better known abroad than any similar firm known, perhaps, better than any purely English firm. The partners had great estates, which had mostly been made in the business. They still derived an immense income from it. Yet in six years they lost all their own wealth, sold the business to the company, and then lost a large part of the company’s capital. And these losses were made in a manner so reckless and so foolish, that one would think a child who had lent money in the City of London would have lent it better. After this example, we must not confide too surely in long-established credit, or in firmly-rooted traditions of business. We must examine the system on which these great masses of money are manipulated, and assure ourselves that it is safe and right.

Ordinarily discredit does not at first settle on any particular bank, still less does it at first concentrate itself on the bank or banks holding the principal cash reserve. These banks are almost sure to be those in best credit, or they would not be in that position, and, having the reserve, they are likely to look stronger and seem stronger than any others. At first, incipient panic amounts to a kind of vague conversation: Is A. B. as good as he used to be? Has not C. D. lost money? and a thousand such questions. And every day, as a panic grows, this floating suspicion becomes both more intense and more diffused; it attacks more persons; and attacks them all more virulently than at first. All men of experience, therefore, try to strengthen themselves in the early stage of a panic [by limiting credit].

A panic, in a word, is a species of neuralgia; you must not starve it. The holders of the cash reserve must be ready not only to keep it for their own liabilities, but to advance it most freely for the liabilities of others. They must lend to merchants, to minor bankers, to ‘this man and that man,’ whenever the security is good. In wild periods of alarm, one failure makes many, and the best way to prevent the derivative failures is to arrest the primary failure which causes them.

There should be a clear understanding between the Central Bank and the public that, since the Bank hold out ultimate banking reserve, they will recognise and act on the obligations which this implies; that they will replenish it in times of foreign demand as fully, and lend it in times of internal panic as freely and readily, as plain principles of banking require.

We should also look at the rest of our banking system and try to reduce the demands on the Bank as much as we can. The central machinery being inevitably frail, we should carefully and as much as possible diminish the strain upon it.

It may be said that the reserve in the central bank will not be enough for all such loans. If that be so, it must fail. But lending is, nevertheless, its best expedient. This is the method of making its money go the farthest, and of enabling it to get through the panic if anything will so enable it. Making no loans as we have seen will ruin the country; making large loans and stopping, as we have also seen, will ruin it. The only safe plan for the Bank is the brave plan, to lend in a panic on every kind of current security, or every sort on which money is ordinarily and usually lent. This policy may not save the Bank [and the country]; but if it do not, nothing will save it.

Bagehot went on to describe the importance of central bank lending at a premium to the pre-crisis rate & to lend against collateral, both to ensure moral hazard remained. The US Federal Reserve, The Bank of England, the Bank of Japan and even China’s central bank have all read & understood Bagehot and turned on the money tap to keep the global system from seizing up entirely and so utterly destroying the quality of life of billions of people. The European Central Bank likely also understands it, given its participation in the 30th November 2011 central bank agreement to increase dollar liquidity. Unfortunately, it is currently prevented from acting further due the legal limitations placed on it by, primarily, the Germans in terms of using one of a central bank’s greatest assets: printing money to permit that liquidity flow and devalue currency, even at the cost of inflation.

As we begin to see the cautious outlines of a potential “grand bargain” on lending involving the IMF, the world’s major central banks, the BRICS, and Eurozone fiscal policy union, let’s hope they haven’t left it too late…

Italy. Or, How Markets Got Their Groove Back.

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Two Eurozone governments toppled in almost as many days. First Prime Minister Papandreou of Greece was forced to resign, and at time of typing we hear that Prime Minister Berlusconi of Italy is finally throwing in the towel. The common factor? Despite bluster, both eventually kow-towed to capital markets.

Markets are much misunderstood & maligned. They are either perceived as Machiavellian, plotting complex geopolitical outcomes from the shadows, or as irrational, disregarding long-term economic fundamentals in favour of short-term risk-taking. Markets are a reflection of the sum of a large number of disparate actions. As such, they are subject to the emotional temperature of those making deals. Fearful traders make for volatile markets.

Since the global financial crisis first hit in late 2007, those traders realised en-masse that something had gone dreadfully wrong. The complexity of some of the financial vehicles, especially in securities markets, led to an inability to accurately price risks. Accurate pricing of risk is an essential of any market, from the man on the street choosing how much a used car is worth, to an investment bank deciding what a trillion-dollar collateralised debt is worth.

That inability to price risk shook confidence in the entire financial system, with results we’re all familiar with. Far from being Machiavellian geniuses, traders are all too human. They became extremely fearful to trade with, well, anyone. They lost the ability to gauge what was worth investing in and what was not, and in their fear desperately turned to politicians and governments to solve the problem.

There is something subtly different in the air this week. The repeated failure of those politicians to restore confidence, most especially in the eurozone but also in the USA, has caused something to snap. Market have gone from childlike fear to doing their basic job: pricing in risk. The cost of Italian government debt rose to near-unsustainable levels on the back of prolonged shilly-shallying by the Berlusconi government, prompting his slow-motion fall.

This is a restoration of moral hazard in markets for which we should all be very grateful, as it is the first sign in over four years of a return to some degree of normality in how markets are supposed to work, as abnormal and dramatic as the events themselves are. Unpopular as they currently are, markets are our least-worst way of judging monetary value. There is something potentially cathartic and empowering about their net actions this past week, which may encourage sustainability and further progress in the months to come.

Governments, beware.

Emperor’s Clothes – The Sad Symmetry of Gaddafi & the Eurozone

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With the death of Gaddafi, a morally bankrupt institution propped up by a flamboyant facade is gone. I look at the festering Euro crisis and wonder if the same will be true of an equally bankrupt Eurozone, also founded on grandiose empty visions.

The French and Germans still can’t agree what to do, so have kicked the can another few days down the road by announcing a further summit by the middle of next week. In the meantime, tense markets have time to think up new fears about the potential solutions, thus undermining the likelihood that the solutions will work. The failure of the Eurozone politicians to fix their system reveals not just the longstanding structural problems that I have blogged about before, but also their fundamental inability to grasp market psychology.

Markets adore certainty and clear boundaries. This is not surprising, as they are essentially the sum total of a large number of individual actions and most individuals also adore certainty and clear boundaries. This is all the more so when they are afraid. They regress to an immature and emotionally-volatile state in search of a parental authority figure, prone to overreaction and counter-productive action in the meantime.

European politicians view markets as either an evil speculatory force, or a rational price-setting mechanism. They are neither. They do not have an overall agenda, but merely respond in aggregated, mob-like fashion to events.

American and British politicians tend to intuitively understand this emotional aspect to markets in a way that the Europeans do not. More importantly, they sense the importance of working with that aspect rather than trying to argue against it. This underpins the suggestion that Europe pull out the “big bazooka” (to quote British Prime Minister David Cameron, echoed by US Treasury Secretary Tim Geithner); to over-compensate for the problems the Euro is having. This would finally get ahead of the investor anxiety curve.

I hope I am wrong, if only for the benefit of my portfolio. I hope that the Eurozone politicians finally come up with a decisive, comprehensive and convincing plan to address the structural problems the Euro has. But I fear they will prevaricate their way into a disaster.

Gaddafi was reported to have been found in possession of a golden gun. The Eurozone must be wishing for such a valuable asset…

Related articles

• Slow train to eurozone rescue (bbc.co.uk)
• Eurozone Latest: Banks Will Only Be Made to Raise 100 Billion Euro in Capital (blogs.wsj.com)
• £250,000 get-out-of-the-euro prize (independent.co.uk)
• Update: ECB Stark: Warn Against Greek PSI, Eurozone Exit (forexlive.com)

Rebuilding Greece

As global markets rise on the hope that the Eurozone may finally be mustering the courage to grasp the political nettle of the problems generated by a single monetary policy but multiple fiscal polices, it seems appropriate to post this photograph of the Parthenon being rebuilt. Taken during a recent break I enjoyed in Athens & the Ionian island of Kefalonia, the imagery of the Parthenon gradually being reconstructed, reversing the damage caused by years of neglect, resonates neatly with the wider challenge faced by the Greeks.

This was my first visit to Greece in many decades, and much has changed. Despite its current woes, it is undoubtedly a richer and more sophisticated country than I remembered. It has benefited from the influx of funds brought about by EU membership and the cheap borrowing costs it initially experienced as a Eurozone member. The debt has caught up with it and my personal opinion is that all the current austerity measures & bailouts are simply buying time to manage a more definitive restructing of the debt in due course. Call it a default if you prefer, for that is what it will be in effect, but it will be done in a contained way once the rest of the Eurozone has finally erected sufficient economic defences to calm any subsequent financial concern.

Greece itself faces a long period of reconstruction. It is a proud country, with a glorious past (some aspects of which I intend to blog about soon) but it must realise that many of its current problems are of its own making. Poor tax collection, profligate spending and overgenerous public sector conditions are an unsustainable and toxic mix.

I witnessed first-hand the anger and sorrow that the population are feeling. From large protest marches watched over by riot police, to individual stories of woe such as the young museum worker who hadn’t been paid in four months, Greece is struggling to transition. The risk is of an increasingly angry population causing severe unrest requiring military intervention, and a subsequent coup. This may seem outlandish speculation but it is only a few decades since Greece was under military rule. With the current political class widely reviled, it may not take much more pressure for the public to permit a coup.

The following images of the Parthenon show more of the restoration work taking place. I hope the Greeks can manage to rebuild their country with equal care.

Euro Farce

The Eurozone remains en route to implosion. But it’s a slow-motion train wreck.

I first blogged about this almost exactly one year ago, and again last November; I doubt today’s post will be my last. I won’t rehash the detail from those posts, but reading them in light of ongoing events proves their points.

Eurozone central bankers and politicians have consistently failed to definitively address the fundamental structural economic flaw generated by a unified monetary policy and nationally disparate fiscal policies.

That’s because there is no way to address this mismatch, short of unifying fiscal policy to a much greater degree than stronger countries’ economies (and voters) are prepared to accept. Or breaking up the monetary union, which Euro politicians and central bankers refuse to accept.

Paul Mason, BBC Newsnight’s economics editor, is just one of many journalists now publicly discussing scenarios previously considered verboten. His idea of Euro bonds would be one way of addressing the structural problem, but fails the litmus test, as I doubt it would be palatable to German voters. His final point, quoted below, paraphrases one I made in my earlier articles:

Whether we hit the barriers of political unacceptability or a market attempt to take down the ECB first is a question everybody hopes we never have to answer, but markets have staged attacks on central banks before.

Where I differ from his perspective, is that I hope the question is answered, and soon.

What is needed is clarity and finality, not ongoing slow-motion crisis and farce. Euro currency fragmentation will be intensely painful, but as with a sticking plaster, it’s best to act decisively to limit the overall agony. It’s been over a year since this crisis started, and the hope then was that temporising measures would buy enough time for economies to recover, and that growth would be enough to disguise the underlying problem. If it had happened, it would have worked.

It hasn’t happened, because what Greece, Ireland, Portugal (and Spain and Italy) desperately need in order to grow is rapid and major currency devaluation relative to other world currencies, to make their economies competitive again. They cannot get sufficient devaluation within the Euro, as the relative economic strength of the northern Eurozone countries keeps the currency as a whole moderately attractive internationally. It is falling in value somewhat, despite that, but not nearly enough to save the periphery. The ECB’s recent interest rate hike simply underlines how monumentally destructive the Euro is proving to the peripheral economies, not to mention their citizens.

Solving the problem demands decisive political action to either break up the Euro, or drive the Eurozone significantly towards  fiscal union. Forgive my scepticism but I doubt we’ll get either. Just more muddling through with temporary bailouts and other weak measures. In short, keeping fingers crossed, hoping it buys enough time for natural growth to kick in, and praying the market is too stupid to see what’s going on in the meantime.

Hmm, good luck with that…!

Euro Crisis: Domino Rally meets High Stakes Poker

Ireland has now followed Greece’s example in accepting a bailout after acknowledging that it cannot continue propping up its failed “economic miracle”. This does not surprise me, and in fact I discussed the intrinsic problems of Euro earlier this year.

More detail can be found in that article, but the crux of my opinion is that currency/monetary union without fiscal union – and inevitable full political union – is completely unsustainable. The market will always identify countries of relative economic weakness within the Eurozone. When these countries had their own currency, they could allow the currency to weaken to compensate for that weakness, as well as setting an interest rate suitable to their own peculiar conditions. Being part of the Euro, they lose this flexibility as the Eurozone interest rate will always be set to favour the Eurozone as a whole (de facto the large economies of France and Germany) while still being unable to benefit from the perceived fiscal stability of those larger countries in the bond market.

There are only a handful of routes out of this structural crisis:

1. Blind luck/bluffing – this is the route the EU is currently desperately pursuing. They hope that by successively bailing out bankrupt peripheral countries, and so displaying confidence in the Euro system, they can ride out the storm, allowing the wider economy to recover in time to prevent a catastrophic collapse. Economically this is very risky, as contagion has already spread from Greece to Ireland and Portugal is next in the firing line. If Portugal falls, the much larger Spanish economy will be next in the domino rally and its economy is too large for a bailout without bankrupting the entire Eurozone. This first option is however politically the easiest option, requiring little more than inertia, and so is the EU’s preferred strategy.
2. Full fiscal (& political) union – if this occured, the financial problem would be solved at a stroke. It would be the equivalent of the USA being able to absorb a downturn in one state by relying on its overall country-wide credit rating. While this makes financial sense, it is politically impossible to do quickly, and so is not a realistic option. There is also the question of whether the general public of the Eurozone countries would wish it, but EU governments have historically worried little about this, so we can consider their potential resistance a mere trifle.
3. Break up the Euro into two zones, with two floating currencies – This allows quarantining of the weak peripheral Euro economies from the strong core. There would be a weak currency for the peripheral economies and a second, stronger one for the core economies. Over time, countries would be able to migrate from the weak currency to the strong one, once their economies truly stabilised. The EU would hate this option, as it would mark a significant reverse in overall EU project. There is also the question of whether it would work financially, as the weaker zone may simply bankrupt itself anyway and still come crawling for a bailout from the stronger zone.
4. Expel weak countries from the Euro - this would force them to revert to their national currencies. This would serve to separate the weaker economies in a more drastic way than option 3. It would have many of the same political and financial drawbacks, but would probably be seen as more financially credible, as well as providing a genuine incentive for high-spending debt-ridden peripheral Euro countries to finally curb their state spending.

It is difficult to see the future clearly, but my hunch is that if option 1 continues to be followed, Portugal will end up accepting a bailout within months. To use a bit of poker terminology, we will then be in a heads-up, all-in situation with Spain. If the markets call the EU’s bluff, and Spain is unable to finance itself, the bailout costs will cripple the EU for a generation and the sustainability of the Euro will be seriously questioned. Chances are, it would collapse.

If Spain holds the line, these questions may still be raised, but the financial imperative will be removed and the EU will continue to drift towards greater political integration, solving the longer term economic problem at the expense of national sovereignty.

Chancellor George Osborne declared earlier today, in justifying the UK’s loan to Ireland despite his long-standing scepticism of the Euro, that “I told you is not much of an economic policy“. This is true, but those of us who have shared his Euroscepticism and foresaw the problems of monetary union without fiscal/political union, will still be feeling regret that others did not see the situation in the same light. Incidentally, the drivers of the EU integration project have always recognised the need for both, though they have tried to downplay it for fear of scaring national electorates.

We’re entering the endgame. The future of the Euro hangs in the balance. Personally, as the UK remains outside the Eurozone and this mess will ensure we stay out of it for years to come, I don’t really care what the outcome is, as long as the decisions are made swiftly and with conviction. We’ll still be affected here in the UK regardless of Euro membership, of course; the Eurozone is a key trading partner. But as we’re outside the Eurozone, the damage can at least be minimised and absorbed nationally.

I just want certainty, one way or another; the current death of a thousand cuts is not good for the market.

Related Articles

• Ireland’s huge bailout brings the country only brief respite (guardian.co.uk)
• IMF and EU bail out Ireland amid fears of Eurozone contagion (guardian.co.uk)
• IRELAND BAILOUT: Government in crisis after coalition partner calls for election (dailymail.co.uk)

What next for the Euro and EU?

The recent financial difficulties within the Eurozone have highlighted a central conflict in the whole project: monetary union without political union is inherently unstable and unsustainable.

The reasons for this are fairly self-evident but worth reiterating briefly:

• a single currency naturally requires a single interest rate across the Eurozone
• each country within the Eurozone has its own individual strengths and weaknesses
• each country therefore has its own theoretical optimal interest rate for its own economy
• but the single eurozone interest rate is set for the best economic benefit of the eurozone as a whole, which means it will benefit some countries, be neutral to others, and detrimental to some others
• the economic interests of the whole eurozone will naturally be more closely aligned to the benefit of the largest economies, since they contribute the most to it
• the smaller and worse-managed economies will thus tend to suffer more in the long term than the largest, due to their being the economies whose own theoretical optimal interest rate is further from the ECB’s rate
• this will magnify the discrepancies between the best and worst economies over time
• this is only resolved by allowing rich countries to bail out or otherwise subsidy poorer countries when need arises
• this is politically and economically damaging for all the countries concerned
• the wider instability affects the regional and global economy due to the Eurozone’s size
• the only way to neuter the political fallout in the long term is to transfer the primary political allegiance of citizens within the Eurozone to the zone as a whole, rather than to the individual countries within it. A parallel: there isn’t all that much surprise or fuss when the Federal Reserve sets rates for the USA as a whole rather than for the benefit of the individual states. The reason is the core identity of most Americans is to the USA (alongside their identity to their state). Similarly, to make the European Central Bank’s monetary policy decisions, and the potential fallout from them, truly politically acceptable to Eurozone citizens as a whole, citizens must learn to love the Eurozone as well as their national identities.
• One obvious way of doing this is deeper and more complete political union between the states. It’s worth noting en passant that the USA required a Civil War to really settle that dilemma.

Supporters of a federal EU have always known that a stable and deep monetary union requires a stable and deep political union. Indeed, many have often been very open about economic union being a necessary but insufficient waypoint en route to a federal state. Those who wish their national governments to consider the interests of their nation state as its primary concern will be more sceptical of the benefits of such a political union. Paradoxically, the current crisis may well lead to a deepening of ties within the Eurozone, making closer monetary and political union more likely due to the severity of the financial impact on member states.

The arguments are finely balanced in some respects, and it does boil down to a prognostication on the future, which will always be filled with uncertainity and personal opinion. There is no doubt that there are financial benefits to being part of a large economic and political union. There is also no doubt that one of the consequences of such a federal state is a ceding of some national sovereignity and national interest to the federation. It is also true that the EU as a whole is significantly more left-wing in economic policy than the UK, and if we were part of a federal state, the centre of gravity of the union as a whole would pull the UK towards that direction due to the aforementioneded ceding of power. I feel that would be damaging to the UK economy, and its citizens.

The decision as to whether to pursue such a course is a judgement should be whether the net national benefit of union outweighs the net national benefit to remaining more separate.

Personally, I am relieved the UK remained out of the Euro. That’s not to say the UK can live in splendid isolation; we have a globalised economy and the eurozone is a major trading partner, so we should hope their system stabilises and work with the rest of the EU where we can to do so. And we should support further free trade measures within the zone and around the world. But my judgement is that the net national benefit is in continuing to remain out of the zone, at least for the medium-long term. I’m also relieved that this opinion (although perhaps not that line of reasoning!) is shared by a solid majority of the population and the current government.