Alasdair Macleod – 19 January 2010
The crisis in Greece has woken markets up to a serious problem, and it is not just Greece. Everyone knows that Greece is in trouble, and that Greece should never have been in the Euro in the first place. The common opinion is that Greece has sacrificed the flexibility of the drachma, and it would be better if it had not. The trouble is that even this wishful thinking represents an inflationary escape that as a remedy is far too late.
If Greece still had its drachma, no doubt it would have devalued, but then inflation would soon be accelerating as higher import prices kick in; and interest rates in nominal terms would be considerably higher, and rising, than they are today. Furthermore, the Greek banks would be in a greater mess as they would still have lent money in rapidly appreciating euros to the Balkan states and others, because the customers wanted low interest rates. No, devaluation would not have been a solution for Greece.
Greece’s problems are also a headache for the euro, because if Greece was somehow to leave the euro, the door would also be open for Spain, Portugal, Ireland and Italy, and that surely would threaten to end the euro as we know it. Faced with this the eurocrats in Brussels are more likely to give in and come up with some money to buy off Greece’s problems. But all this is schadenfreude for us, because even the UK’s budget deficit is running at about the same rate as Greece’s relative to GDP, with no sign of it coming down, other than in a Labour Chancellor’s forecast. The truth is that government finances everywhere are in crisis, with taxes falling and welfare costs rising.
It is particularly dangerous in this economic cycle, because governments are now standing behind their banks as well, promising to prevent their failure. In most cases, governments are therefore guaranteeing balance sheets whose size is a multiple of their respective GDPs, without the resources to do so. They hope that economic recovery will take hold, improving bank balance sheets and lending conditions, and eventually reduce public sector deficits. They believe that confidence, rather than facts, matter. This desired outcome is looking less likely by the day.
Governments, notably the UK and the US, are printing money to fund their deficits, because on a risk basis, treasuries and gilts are badly mispriced and cannot be easily sold. Instead, the UK has funded its entire budget deficit by printing money, an action likely to undermine international confidence further. In the US, the Fed has come up with an extraordinary proposal: it will act as a normal bank, taking deposits from commercial banks, separate from non-borrowed and excess reserves; it is not stated how these deposits will be used, but you do not have to be a cynic to conclude it will be leant to the government, bypassing bond markets[i]. It is actions such as these that are eroding the creditworthiness of even the largest governments.
The optimists don’t see it this way, but then they believe that government can recycle private sector money to the greater benefit of us all. The persistence of these Keynesian and monetarist hopes illustrates the reluctance of human nature to face reality.
This was precisely the position in 1931. Politicians and economists were confident the New Year would bring recovery. As it turned out, 1931 was the year Kredit Anstalt collapsed, having been the largest bank in Austria, indeed in Eastern Europe. Its troubles started in 1929, when Boden-Kredit Anstalt, which had over-extended its balance sheet, was forced into a merger with the stronger Oesteriechische-Kredit Anstalt, the arrangement being backed by government guarantees. New capital was provided by an international consortium of banks led by Rothschild’s Vienna office. However, in March 1931, the French banks demanded repayment of their short-term debts, precipitating Kredit Anstalt’s collapse and a global banking crisis.
Of course, history never repeats itself precisely, but is this not a template for the rescue of Bear Sterns? Or Bank of Scotland? Or Sachsen Landesbank? We will only know when the game has been played out. Having entered the New Year with high hopes, 1931 went down in history as “the tragic year”. Let us hope history does not repeat itself, but it is getting increasingly difficult to see how a rerun of the tragic year will be avoided.
[i] See the Fed’s press release. This is dressed up as the Fed planning to drain money from the banking system once economic recovery is under way. But with the Fed, you have to ask yourself the real motive, and in this case it is clear there is only one borrower of the deposits offered.