With a second bailout of a Belgian bank in as many days, a guarantee from the Irish Government to underwrite their banking system for two years and the swirl of debate and interpretation of yesterday’s shock move in Congress reverberating around us, I have found myself pondering two key issues facing the market at the moment. The first concerns the nature of money and the second concerns the nature of politicians. The former must have changed, while the latter remains as obdurate as ever.The word “unprecedented” has been used so often this year, referring to Central Bank actions, that it has lost so much of its power that it is almost a cliché now. I don’t have the exact figures to hand (sorry not enough time to do proper research today!), but hundreds of billions worth of global currencies have been pumped into the financial system. One question which has been absent from a lot of commentary is exactly where has all this money come from?
How exactly is the Belgian Government suddenly able to bail out two banks? How can the Irish Government afford to underwrite banks, which have to be on thin ice (especially given the state of the Irish property market)? How can the British Government afford to take over Bradford and Bingley? Most critically how on Earth can the USA afford the $700 billion bailout, especially given the amount of Dollars they have already pumped in?!
Historically money was tied to some form of underlying base product or commodity. Traditional economic models state that increased money supply must lead to inflation. Governments’ primary source of revenue is through taxation. Printing money to “solve” economic problems has usually created even bigger problems, notably hyper-inflation. Hyper-inflation leads to destruction of currencies, which suppresses economic activity and usually ends in a violent correction.
OK so I am over-simplifying things, but have things changed so much that these basic principles do not hold true anymore?
No doubt there are those that will tell you that past performance only serves as a guide and future performance should not be judged on it. After all modern money is electronic. It can be whizzed around the World at the press of a button. It is a system of exchange, based on confidence that your counter-party in any transaction will honour the agreement and that Central Banks are there to underwrite the transaction.
While we have experienced massive, social, technological and economic change in the last 30 years, the confidence the system is based on is potentially its most serious structural flaw. What happens if confidence evaporates?
The simple answer is no-one knows.
If historical precedent is anything to go by then the implications are horrendous. We could see a total collapse of the financial system, which takes generations to overcome.
If, however, we have made a break with history then the outlook might actually be a lot more positive. While we could well see a short-term serious retrenchment, which will be painful, the modern economy might well be able to heal itself in an unprecedented (sorry!) manner. I actually have a lot of faith in modern people. We are better educated and informed than any generation that has lived before us. We have incredible technology at our disposal and live in generally liberal, positive, stable democracies. Power (military, political or economic) is not concentrated in ways it has been in the past. While the US is certainly the World Leader, in relative terms this position is not as significant as it has been in the past.
What I am less confident about is the inflationary outlook. I need more time to understand this, but intuitively a lot of what has been done this year to solve the Credit Crisis feels wrong.
So what does this mean for the rest of the week?
The more I think about it, the less in favour of the bailout I am. By letting banks, who deserve it, go to the wall the US Government will be taking a massive risk. However given the level of financial support they seem able to give the economy I believe that their energies could be better targeted elsewhere. Wall Street executives really do deserve what should be coming to them.
If the bailout does go through, I fear that it will be doomed to fail as it has got off to such a bad start. For a confidence raising initiative, it does not inspire much assurance such is the level of resistance to it.
However I still think it will pass, although it will be interesting to see what happens in the next two days. I need to see the re-worked version of the plan, but I think the shockwave of yesterday’s equity sell-off is bound to have had an impact. While this morning’s rally might have lessened the affect, it is still bound to be influencing the agenda. The dire state of money markets must also be playing very heavily on US lawmakers’ minds.
Of course there is one factor, which we do need to remain aware of. Throughout this period of great change, there will remain one constant – the self-interest of politicians. I caught one item on the radio this morning that said that out of roughly 145 US Congress seats, which are marginal, only 8 members voted for the bill! Given how unpopular the bailout seems to be with the US public and with an election looming we really shouldn’t discount political expedience halting the entire process.
I am staying out of the market today.