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Mory Doré’s column

Politics and financial markets: misunderstandings that are not new

Small point into the complex and tumultuous relations, misunderstood, between financial markets and politics. In these troubled times where the markets are supposedly expecting clear answers from politics and where at the same time, the same markets are accused of destabilizing economic policies, Mory Doré intends to put some order in these proceedings

Article also available in : English EN | français FR

1. POLITICS THAT NEVER ACCEPT THE MARKETS SANCTION

We will not rewrite history, but when even the politicians are so quick to make the process of financial markets and come to forget that they are involved, whatever their political camp, who simply delegate their economic policies to those same markets in the early 1980s in the English speaking world and from the mid-1980s in mainland Europe. That is the famous 3D period: Deregulation, Decompartmentalization.

At that time, everyone swears by the benefits of the market economy. They are facilitators of financing the economy in the disintermediation of the relationship between lender and borrower, and they especially can absorb without great difficulty public waste financing (in better words, the public debt liveliness and financing as in France with the involvement of banks -SVT - primary dealers in monthly Treasury auctions of government securities).

The need to continue to fund waste and excess debt of the states has often led to bubbles which extreme risks were deliberately minimized (and yet, everyone is now discovering that a loan of a state of the OECD countries can be a risky asset).

So we have it easy to reprehend today the alleged madness of the markets because after all, why the markets would only be allowed to buy treasury bonds issues and not selling them when they believe, wrongly or rightly, that fiscal policies applied are as ineffective as expensive. This type of inconsequence from politics is also seen today in the trial focused on rating agencies: They are always wrong they downgrade your rating and are flattered when they maintain or enhance your rating. That said, I am far from being a defender of the rating agencies for at least two reasons.

  • First, they are greedy and not objective. The subprime crisis has shown their complacency due to their status as judge and jury regarding the rating of complex structures issues: better yet, they rated the securities and the more they were written , more commissions were given to the agencies.
  • Another credibility gap, their timing often inappropriate. Or degradation of some signatures are too late then posing the question of the usefulness of utility agencies, or on the contrary these degradations occur "too early" during the finances consolidation plan of the issuer, which has the effect of being self-fulfilling by damaging the creditworthiness of the downgraded entity by higher interest rates induced.

2. MISCOMPREHENSIONS AND MISUNDERSTANDINGS BETWENN POLITICS AND FINANCIAL MARKETS

In fact politicians and more often central bankers do not always understand very well the market (there is still evidence today). They think in fact that one can solve a crisis with selective interventions which have certainly their uses but does not address real problems that are causing the crisis. These interventions take many forms depending on the type of crisis observed

  • In foreign exchange crisis, it may be for a central bank to issue its own currency for sale on the market if it considers the currency is overvalued (we see how the Swiss National Bank and Bank of Japan are struggling to fight against the supposed overvaluation of their currencies in this way)
  • During a bond market crash or during an explosion of public deficits, there may be direct or indirect monetization of government debt, where in this case the central bank purchases government securities, or also the establishment of unusual conditions for banks to invest heavily in public debt securities. We think about quantitative easing in particular, initiated by the FED and the BOE (Bank of England), the easing of the eligibility criteria in tenders offers of the ECB or the recent purchases of Spanish and Italian debt by the same ECB
  • In bond market crash and/or equities, it may be traditional flexibility of monetary policy through interest rate cuts
  • In the midst of market functioning, we may notice(and it is almost the case without interruption since the summer of 2007) securities allocation through large liquid bid from the central bank to remedy the malfunctions of the interbank market (in more usual terms, issues in the short-term repo market for financial institutions, either because they are reluctant to lend in the interbank market, or because investors subscribe to fewer certificates of deposits issued by banks)

As we said, all this must be undertaken and if they are necessary conditions for the resolution of crises, this does not in any way make sufficient conditions. Structural resolution of crisis presupposes that a number of conditions are met. Of these, include: a return of sustainable confidence among economic agents and investors; structural changes in the behavior of economic agents; credible and smart economic policies, that is to say policies that favor at the same time growth and disciplined management of public finances; long-term structural reform aimed at increasing the economy productivity

If we look at the three strongest crises of these past twelve years, we will notice that we have been able to solve them or, if not yet the case, we will solve them by putting together or in part the conditions described above:

- We remember the stock market crisis of the early 2000s with the overvaluation of stock prices of TMT (Tech-Media-Telecom) companies. It was necessary for these companies to carry out a significant downward adjustment of their debt and leverage to ensure that conditions to exit the crisis are met. Actions initiated by governments and central banks would not have been enough

- We also remember, closer to us, the subprime crisis on US households badly indebted in 2004-2006. The complexity of this crisis was exacerbated by the distribution of structured products backed by these loans, to investors around the world. That created an unprecedented crisis of securitization with impressive contagion effects. Again, the actions initiated by governments and central banks have not met the expectations. In addition, the resolution of this crisis have been achieved only by transferring risks to other economic actors. Indeed, the housing debts with low credit quality, handled by retail banks were almost entirely securitized, ie transferred to investments banks. We know the aftermath, these investment banks were able to pass through these claims to global investors (banks and insurance companies among the biggest investors) because of mismanagement in financial engineering and significant leverage. The subprime crisis has therefore ostensibly ended when the states have recapitalized many institutions threatened with bankruptcy or, at best, highly damaged in terms of equity.

- the subprime housing crisis was finally dead and was about to become the subprime sovereign crisis. Since the end of 2009, we are witnessing a new debt crisis, that of some sovereign states of the euro zone and their insolvency as the growth led in the past by debt is no longer possible (see Ireland and Spain); the crisis of public finances of some states previously considered to be solid in their structures, like the United Kingdom, France and the United States is now latent.

3. IT WILL BE UNDERSTOOD THAT POLITICS MUST CREATE THE CONDITIONS FOR GROWTH AND DEBT REDUCTION..IT IS USELESS TO ADVOCATE WEAK MEASURES TO PLEASE THE MARKETS IN THE SHORT-TERM.

When the politics will understand that measures to please the markets systematically are both ridiculous and do not mean anything (they should read this carefully as the writer of these lines served for over 20 years various positions and activities in direct contact with financial markets). Besides, who to please ? The markets are not an abstract creature, or an omniscient custodian of the optimal allocation of resources. markets consist of a range of participants with constraints, objectives, time horizons and different regulations: trader, arbitragist, institutional investor, bank treasurer, ALM manager, central bank, hedge fund, asset manager, structurer.

Politics need to understand that markets are essentially hypocrites and do not really know what they want (when we know the heterogeneity of market participants, we understand better the reasons. Do not be impressed by their called messages and requirements)

A few demonstrations of what we say

Today, fiscal virtue is required, so that the deficits of the most fragile countries of the Euro zone must be reduced drastically, without saying that such practices would maintain would maintain the self-recession; we know that at the same time if these fiscal imbalances were reduced severely, then the peripheral countries might suffer further attacks on their public debts, the financial markets stating the fact that these policies reduce growth and thus cannot help in the deficit reduction purpose. what better message to politics: whatever you do, the markets will punish you. All this to say that we must therefore address issues otherwise (we will come back and see how)

This hypocrisy and versatility of the markets have been noticed several times before, and current political and economical leaders in France and Europe who were in business during the 1990s (there are many) should remember. Here is what I wrote in early 1995 as part of the weekly markets outlook for institutional and corporate clients of the financial institution for which I was working at the time.

It is still remarkable that the four crises of the Franc and EMS have all one thing in common: Europe (doubts about European integration, doubts about the Euro...). Without repeating the Anglo-Saxon theory of conspiracy, we can still ask whether the foreign exchange market (driven by some "powerful" British banks) does not prevent the mission of European integration.

  • Yesterday, the foreign exchange market was attacking the Economic and Monetary Union (EMU) under the pretext that some countries weakened their social fabric and reinforced unemployment by sticking to the Bundesbank monetary policy. Hence the pseudo theories of the time by which the rate cuts would strengthen the currencies through the promotion of growth. A prevailing view was born.
  • Today, the foreign exchange market continues to charge the EMU stating, this time, that some countries do not follow enough the German example and its fiscal virtue. Hence the today pseudo theories on government deficits and their devaluation effect on the currency. A new prevailing opinion appears.

Of course today I could have written these lines I wrote in other contexts back in March 1995. In fact, there are many aspects in common with the market hypocrisy noticed today (and as a professional market participants, I have never accepted this behavior). There are also similarities with today sovereign debt crisis. The removal of currency risk with the creation of the Euro, has unfortunately led to less attention regarding fiscal discipline in countries that already have external deficits. The increase in external debt of countries with deficits in the euro zone(roughly the famous PIIGS) was naturally facilitated by the disappearance of currency risk. Until the markets the markets had understood that some of these countries had entered a solvency crisis and not a liquidity crisis. History repeats itself unfortunately and the sovereign debt crisis in the 2010s replaced the EMS currency crisis of the 1990s. Having been involved as a professional in both crises (and all those which have existed between these two periods), I would say that the origins and explanations are similar

  • 20 years ago, it was unsustainable for the fight against the German inflation born of German reunification in 1990 and the fight against endemic unemployment in the French and southern Europe economies to coexist.
  • Today it impossible to use both the model of economic industrial specialization of Northern Europe and Southern Europe (including France) based on non tradable services, often resulting over time to rising external surplus for the northern countries and deficits for those in the South. This clearly means, beyond all politicians rhetoric and beyond declarations of intent, that without strong institutional changes on the fiscal and political, the euro zone is likely to implode.

4. WHAT THE POLITICS SHOULD DO

Again I will use what I wrote in my weekly market notes in March 1995 (at this time I was both in charge of derivatives trading and market analysis, for my employer).

We will remember that the foreign exchange market, in 1993, attacked the currencies of countries deemed not proactive in the fight against unemployment and in promoting growth. Forget the market "social virtues" of 1994 as the currencies of countries attacked were those judged to be too deliberate and not enough disciplined in budgetary matters. It is likely that before the end of the year1995, the foreign exchange market make a synthesis between its requirements of 1993 and those of 1994, ie that the currencies of countries that combine efficiently social and fiscal policy will be rewarded

Combine efficiently an ambitious social policy and a rigorous fiscal policy, that is actually what the politics should focus on. If the markets are convinced that politicians are able to create the conditions for economic growth and social development in an environment where finances are well-balanced with a rigorous management of public funds, then any speculative attack will have no credibility and will stillborn. I want to say to the politics : because the markets don’t really know what they want, it is your responsibility to set up economic policies that create value for all economic actors (employees, consumers, investors...): Proactive economic policy, coherent, credible, with the goal to achieve potential growth); Intelligent sharing of valued-added; fiscal discipline for operating expenses and fiscal activism for capital expenditures, flexible monetary and exchange rate policy...

Let’s come back on the four solutions that we identified in recent articles on the crisis of sovereign debt

- Solution 1 : Policies to enhance potential growth (long-term solutions); it is the real good solution

-  Solution 2 : establishment of a true fiscal federalism with eh pooling of national debts and the establishment of Eurobonds listings program (politically difficult for Germany). It’s an easy solution that is now presented as a panacea and naturally supported by many politicians and economists. The idea is : As the Euro zone is globally solvent, creating a European agency in charge of programs for refinancing needs for all countries in the euro zone, replacing the 17 national debt issuers will be the best way to break the destabilizing speculation...Oh; and how would the agency miraculously solve the problems of fiscal solvency of some states and the inability for them to raise their economies potential growth ?

- Solution 3 : Debt restructurings or partial defaults (trying to avoid systemic risks and drawing on successful examples in emerging countries since 1998 : Russia, Argentina, Uruguay, Ecuador), this can only be effective if we get involve a bit more the private creditors because we have to end with this devastating unforeseen moral that has disempowered many generations of investors (I’m in a pretty good position for no longer being able to withstand this type of behavior based on the fact there will always be a buyer or lender of last resort - systemic risk forces )

- Solution 4 : Temporary exit - with the risk that the temporary period lasts drags on - from the euro zone for some countries : depreciation of the new national currency, inflation tax to reduce the debt (electorally rewarding, but economically suicidal).This is obviously the worst solution, since the political and social consequences of such events would be dramatic.

If we had to rank these solutions, we would choose in order of decreasing preference: solution 1 obviously, solution 3 subject to conditions discussed, solution 2 (which can be improved if one chooses a pooling close to the German standards of fiscal management and not a lax pooling); in last, of course, solution 4

The message of the former president of the European Commission, Jacques Delors, who recently estimated that the Euro and the European Union were " on the Brink" clearly favors the solution 2. Basically, he said "that the success of Europe, economically, is based on a triangle: the competition that stimulates, cooperation that strengthens, and solidarity that unites. We must move into action. Because if we do not, the markets will keep doubting".

We would have preferred hearing before 1999 all those people with solutions today. Also in the context of the weekly note about the financial markets outlook, this is what I wrote in January 1995 on the successful conditions of the EMU (Economic Monetary Union) establishment.

We end our last week telex citing the pitfalls in which governments with their economic policies are trapped in.

  • Central Bank Diktat
  • Markets Diktat
  • and Rating Agencies Diktat

Also many European governments might be tempted to believe or to make believe that the rapid implementation of the single currency would be the best way to avoid this triple diktat. Although this acceleration may seem very effective and attractive and even though we support the implementation of the European Economic and Monetary Union, we are wary of illusions. And, more specifically, the illusion that the single currency would solve everything. Let me explain

a/ Assuming that 8 of the 15 countries forming the EMU meet the convergence criteria within 2 years - highly unrealistic assumption - they would still have to met them sustainably. Otherwise, the single currency would cause serious social and political imbalances in some countries of the Union.

b/ In fact, a single currency monetary zone assuming a fixed exchange rate, with identical nominal interest rates and perfect freedom of capital flow, the only macroeconomic adjustments available for economic policies would be the budget and the inflation rate. Let’s imagine for a moment that this monetary union is made

  • What would happen if suddenly a member of the Union was subject to public finances more damaged than the other states ? Well this country would have to rise its real interest rates to achieve the deficit financing (that is to say , to lower drastically its inflation rate as it would have no freedom to act on the nominal interest rates, become "mutual"); This would frankly lead to a deflationary economic policy with all the consequences of instability from a social point and also from a political point of view
  • What would happen if suddenly a member of the Union, for internal reasons , was subject to inflationary pressures ? This would mean that real interest rates would fall and therefore the capital invested in that country would flee. This would be forced to reduce drastically trade and budget imbalances. At the risk again to disrupt the social equilibrium of the nation through a policy of public expenditure compression

c/ We observe, the fact to be aware that if the EMU countries will be willing to merger their currencies into a single one in 1997 or in 1999 is a wrong debate. The key is whether the convergence criteria met by individual countries will be sustained or not. What would have happened to a monetary union between France and some other European countries in 1991 (which them met criteria for debt, budget deficit and inflation) reeling from the 1993 recession ? we therefore see that beyond the criteria convergence set by the Maastricht Treaty, it would probably make sense to integrate qualitative and social criteria.

From there stating that the failure of the European monetary construction was a foregone conclusion, there is one step that we would not cross. One must know, however that other factors weakening the euro zone have existed for 12 years : heterogeneity of sectoral structures of economies, not offset by a fiscal federalism and a real common fiscal policy; a consistency of short-term interest rates (logic in a monetary area) but that led to maintain a too low cost of money between 1999 and 2006 in some countries that had established their growth model on housing speculation (see Spain and Ireland); as well, a lack of risk premium on long -term rates for some countries despite a softening in fiscal and tax discipline (but in this case ,we must blame the market myopia)

Mory Doré , August 2011

Article also available in : English EN | français FR

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Mory Doré’s column About the author

Financial market professional active on various fields for more than 20 years, Mory Doré is a key advisor of his company on portfolio and risk management for various financial institutions. In addition, he is also a trainer, teacher and (...)

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