To provide a bit more context for the French government bond spreads discussed in the last post, the chart below shows the 5-year spreads to German bonds for a few more European countries.

With spreads over 4300 basis points (43%), the chart is dominated by Greece, so here is the chart again with Greece removed.

As you can see in both charts, while French spreads are certainly heading north, they have a long way to go.

For those who have spotted the break in the line for Ireland, my data source seems to be missing 2010 data. I am looking into that and will update the casts if I plug the gaps.

Data source: Bloomberg.

Changes of leadership in both Greece and Italy were initially well-received by markets, but investors are getting nervous again. Attention is shifting to France, and French government bonds seem to be on the nose. The chart below shows the “spread” between French and German 5-year government bonds. Measured in basis points (1/100th of 1%), the spread is the difference between the yields on the respective bonds and it has now reached 183 basis points.

Given that yields on 5-year government bonds are only 0.95%, that is a big difference. Investors are demanding almost double the rate of interest on a French bond offered by a German bond if they are to take on the risk that France is not able to repay its debt in 5 years’ time.

Unlike France, the United Kingdom is lucky enough to have its own currency and the spread between UK and German government bonds is only 10 basis points. More on that in a future post.

Data source: Bloomberg.

Yes I am back. I know it has been a while. What can I say? I have been quite busy!

One of the things taking up my time during the week was preparing for and then giving a talk for the Q-Group on operational risk capital modelling. It sounds arcane, I know, but there was one exciting part: I had the opportunity to try out the simulated laser pointer that you can create by pressing your finger on the screen of the iPad during a Keynote presentation.

Since regulators expect banks to use their capital models to quantify 1 in 1,000 year losses, I slipped a reference in my presentation to the Italian bank Monte dei Paschi di Siena which, having been founded in 1472, is a mere 539 years old. The somewhat oblique point was that no-one should take these models too seriously.

Monte dei Paschi di Siena

It was an ironic twist that evening that this was headline on the front page of the Wall Street Journal website:

It seems that Monte dei Paschi di Siena was one of a number of banks suffering as a result of the European sovereign debt crisis and it makes an interesting case study of the challenges of the business of banking.

Back in the original days of the global financial crisis, the banks that got into the most trouble were the ones with significant exposure to “toxic assets” (US mortgages, mortgage-backed securities and their ilk). Once people started to worry about these toxic assets, the problem was that no-one really knew how much exposure any given bank had to these assets and so no-one wanted to lend to anyone else. Since many banks (including Australian banks) rely on wholesale debt markets (i.e. they borrow money from big institutional investors around the world like pension funds), this became a problem for everyone.

Back then you might have thought that a regional bank like Monte dei Paschi di Siena would be fairly immune to what was going on, but it got off to a bad start in the crisis by acquiring another bank, Banca Antonveneta in 2007. In retrospect (and even at the time in the eyes of some analysts), it paid too much and over-extended itself at the wrong time. Within a couple of years, its capital buffers had become so thin that it was forced to turn to the Italian government for a capital injection and also cut its dividend payments right back in an attempt to rebuild. This was painful for Siena because, in a peculiarity of Italian banking, the majority shareholder of Monte dei Paschi di Siena is a charitable foundation, originally established in the 1990s for the express purpose of acquiring the bank when banks across the country were being privatised. This foundation makes donations to all sorts of public groups across the city of Siena and, with the dividend cut, the donations stopped too.

To make matters worse, the bank is a large holder of Italian government bonds, which have not been performing particularly well of late. With a capital base of €7.1 billion (figure as at April 2011), it held €32.5 billion (figure as at December 2010) in Italian government bonds and so any decline in value of Italian government bonds put pressure on the bank’s capital. In mid-2011, in the face of the European debt crisis, the bank decided it needed to further bolster its capital position. But the foundation did not want to lose its majority share-holding, so the foundation turned to JPMorgan and Goldman Sachs (aka the vampire squid) to borrow money to buy new shares issued by the bank. Unfortunately the loans were secured by shares and as the share price continued to fall, the foundation had to hand over more shares to its lenders. If things do not improve, the foundation is likely to be forced to sell more shares, ultimately losing its majority stake in the bank. The foundation, which once made around €250 million a year in donations to the city, is not looking likely to be able to contribute nearly as much to the public good in the future.

Will this venerable bank be the first to survive for 1,000 years? It has not failed yet, but the immediate future still looks rather shaky.

Kweku Adoboli managed to cost UBS over $2 billion with his rogue trading, and has now cost chief executive Oswald Grübel his job. While this time the buck stopped at the top, it is more than can be said for many previous rogue trading cases. Grübel was called out of retirement to take the helm of UBS as it faced the global financial crisis, so perhaps a return to retirement was an easier choice than it would have been for the chief executives of Société Générale, NAB*, Allied Irish and other past victims of rogue traders.

But what has surprised me about this latest rogue trading incident is reactions like this one from the Economist:

For UBS and its shareholders, the immediate questions should be why it was still vulnerable to this sort of alleged manipulation more than three years after Mr Kerviel’s [the Société Générale rogue trader] loss.

Of course banks are aware of the risk of rogue trading, but it does not mean that protecting themselves against this risk is a simple matter. Trading businesses are complex, with many interconnected computer systems, some old, some new, most dealing with transactions in real time. It is a case of asymmetric warfare: the bank has to defend itself against every possible attack, but the rogue trader only has to find a single point of weakness. The UBS loss may be another reminder for banks of just how much an insider can cost them, but I am confident that there will be another spectacular rogue trading case within the next five years.

Little wonder then that Sir John Vickers, in his report on UK banking, has recommended that banks should “ring-fence” their investment banking operations (including financial markets trading businesses) from their retail and commercial banking arms. The idea is that, while governments will always want to protect the financial system that is so central to their economy, tax-payers should not end up on the hook for losses arising from risky investment banking activity.

Banking regulators around the world have been intently pursuing ideas like this over the last couple of years and the Adoboli case will only add to their determination to impose some form of “recovery and resolution” framework on banks. Before this work is complete, I would not be too surprised if UBS have spun off their investment banking arm. It is becoming all a bit much for Swiss shareholders to cope with.

* UPDATE: My memory served me poorly: the CEO of NAB, Frank Cicutto, did in fact resign after their FX trading fraud.

Ever since Standard & Poor’s downgraded the US government from AAA to AA+ I have been drawn into debates about the risks posed by growing US government debt. Ever since reading the book Mistakes Were Made by Carol Tavris and Elliot Aronson I have been fascinated by cognitive dissonance and as my debt debates kept following the same pattern I became convinced the explanation for this pattern lay in cognitive dissonance. Coincidentally, I then read a post by Bill Mitchell discussing a paper by Adam Kessler analysing the views of mainstream economists in terms of cognitive dissonance.

For those as yet unfamiliar with the concept of cognitive dissonance, it refers to the discomfort people feel when faced with conflicting information. The brain tends to react to cognitive dissonance by quickly eliminating the conflict and restoring consonance.

One of many examples of cognitive dissonance in Mistakes Were Made arises when people with prejudices are presented with evidence that contradicts their prejudices. Tavris and Aronson quote Gordon Allport, who wrote The Nature of Prejudice over fifty years ago. Allport illustrated a typical pattern of dissonance-blocking in the following dialogue:

Mr. X: The trouble with Jews is that they only take care of their own group.

Mr. Y: But the record of the Community Chest campaign shows that they give more generously, in proportion to their numbers, to the general charities of the community, than do non-Jews.

Mr X: That shows that they are always trying to buy favor and intrude into Christian affairs. They think of nothing but money; that is why there are so many Jewish bankers.

Mr Y: But a recent study shows that the percentage of Jews in the banking business is negligible, far smaller than the percentage of non-Jews.

Mr X: That’s just it: they don’t go in for respectable businesses; they are only in the movie business or run night clubs.

Time and time again Mr X. shakes off contradictions to his prejudice with a non-sequitur, responding with a completely unrelated argument in support of his prejudices. My conversations about US debt have been eerily similar:

Me: This Standard & Poor’s downgrade is a bit silly. The US has got past the farce of the debt-ceiling and, unless they choose to default next time they run up against that ceiling, their debt is much safer than euro sovereign debt from the likes of Greece and Ireland.

Mr. Z:  But they’ve just kicked the can down the road. Unless they do something about their deficits and cut all their entitlement spending, they are basically bankrupt.

Me: But the US government is effectively the monopoly issuer of US dollars and all their debt is denominated in US dollars: they cannot run out. So, they never have to default, unless their crazy politicians choose to.

Mr Z: Oh, sure, they can fire up the printing presses and simply print money, but that will always be inflationary.

Me: What about Japan? They ran deficits and their government debt has been growing for years and that hasn’t led to inflation. In fact, they could do with a bit of inflation, but have been unable to generate it. Government deficits will only be inflationary if the government is spending at the same time as the private sector and is overheating aggregate demand.

Mr Z: But Japan has been a basket-case for years, no-one would want the US to end up like Japan!

See the similarity? Almost every time I try to make the point that countries which control their own fiat free-floating currencies and only borrow in that currency (such as the US, UK, Australia, Canada and Japan) can never be forced to default on their debt, the conversation quickly veers away to inflation, Japan and anything but the central point. That’s cognitive dissonance for you.

I recently enjoyed lunch with a group of former colleagues. At one point, the conversation turned to the Australian dollar, a natural enough topic for a bunch of finance types. Someone observed that the Aussie is the 5th most actively traded currency in the world, which is impressive since Australia is certainly not the 5th largest economy in the world (that honour currently goes to France).

Thinking about Australian dollar punching above its weight led me to wonder which country had the most actively traded currency relative to the size of its economy. A quick vote around the lunch table came up with four candidates: the Australian dollar, the New Zealand dollar (which is much beloved by hedge funds), the Swiss franc and the Norwegian krone. The most popular choice among these was the Australian dollar. I was wavering between the New Zealand dollar and the Norwegian krone, but none of us knew the answer. That meant only one thing: a Stubborn Mule post would ensue to settle the bet.

Starting with turnover in the chart below, it is no surprise that the US dollar is by far the most actively traded currency. Not only is the United States the largest economy in the world, but an enormous amount of international trade is conducted in US dollars, and sellers and buyers have to transact in the currency markets to convert US dollars to and from their local currency.

Top 10 Currencies by Turnover (2010)

There are a number of reasons the Australian dollar is traded as much as it is. Our higher interest rates attract many into the carry trade (borrowing in low interest rate currencies, investing in higher interest rate currencies and hoping that the currency you are buying does not collapse). As a very commodity-driven country, many international investors see investing in Australia as a proxy for investing in commodities and, more particularly, jumping onto the China growth band-wagon. For many investors, simply buying the Australian dollar is cheaper and easier than investing in our stock-market.

But back to our bet. Only one of the assembled diners picked the Swiss franc, but it turns out to be at the top of the league table. With a GDP in 2010 of US$500 billion, there was average of $253 billion traded in Swiss francs every day in April 2010!

I have never made a close study of the Swiss franc, so I would be very interested in hearing any theories people may have as to why it is so heavily traded.

Next in the list is New Zealand, so my instincts were right there (let’s not mention the fact that I also tipped the Norwegian krone which came in a disappointing 11th place). Interestingly, third and fourth place, the Hong Kong and Singapore dollar respectively, did not even make it into our short list. And it turns out that the Australian dollar ranks 5th not only in terms of outright turnover, but also in turnover relative to economy size.

Top 10 Currencies by Daily Turnover relative to Annual GDP (2010)

If you are interested in exploring the league table further, the table below has all of the data.

Data sources
Currency turnover: Bank for International Settlements (BIS)
GDP: CIA World Fact Book (official exchange rates)

The IMF has been busy of late, what with their attempts to stave off European sovereign defaults and shenanigans of its erstwhile managing director, Dominic Strauss-Kahn. I have been busy too (for rather different reasons I hasten to add) and so it has taken me a while to get to looking at the IMF’s most recent World Economic Outlook (WEO) report, which was released back in April.

The WEO is prepared twice a year and, whatever one’s views of the merits of the economic ideas of the IMF and their role on the world stage, the report provides a rich source of data and includes both historical data and five-year forecasts.

I was interested to compare the effect of the global financial crisis on the most challenged euro nations, the so-called “PIIGS”, Portugal, Ireland, Italy, Greece and Spain, to a few other countries. To account for differences in population and currencies, I chose Gross Domestic Product per capita expressed in US dollars as the measure for this comparison*. Even so, care needs to be taken in interpreting the results. Exchange rates do introduce a fair degree of volatility as is evident in the chart below: the trajectory of US GDP per capita is quite steady, although the downward dip over recent years is clearly evident, while the paths for every other country wiggle up and down with the vagaries of currency markets. Nevertheless, it is striking to see the IMF projecting that Australia will dramatically outpace the other countries in this group, thanks to the combination of a resources boom and escaping relatively unscathed from the financial crisis of the last few years. I should point out that, while taking the gold medal in this group, Australia is not the overall winner in the IMF 2016 forecast stakes. That honor goes to the small nation of Luxembourg, and Qatar is not far behind.

History and IMF forecasts of GDP per capita (in US$)

An alternative approach that seeks to eliminate exchange rate effects is to work in local currencies and make these comparable by scaling to a common base at some point in the past. Somewhat arbitrarily, I have chosen to base this comparison on 1996, which gives a 20 year span including the forecasts out to 2016. This time I have used inflation adjusted figures**. Interestingly, this approach sees Ireland coming out on top, which reflects the strength of their economic boom over the period immediately up to the start of the crisis.

History and IMF forecasts of GDP per capita (local currency index)

This chart shows even more clearly how unaffected Australia was by the financial crisis compared to other countries. Once again, these results should be treated with caution. Any comparison like this will be very dependent on the year chosen to base the indices. If only I had chosen the year 2000, Australia would be in the lead again!

* This is the IMF series NGDPDPC.
** This is the IMF series NGDPRPC, rebased to 100 in 1996.

It has been reported that Greece is considering leaving the euro and re-establishing its own currency*.

More than a year ago, I argued that being part of the euro seriously exacerbated Greece’s economic woes, and for the reasons given there, I do think that re-establishing sovereignty over its currency is in Greece’s interests in the long run. Nevertheless, it would be a painful process exiting the monetary union.

To begin with, there are all sorts of practical complexities. The switch to the euro was an enormous project, years in the planning and to switch back would require major logistical and systems changes for banks and businesses across the country. Mind you, the work involved may act as a stimulus to employment! The other challenge, is that Greece still has significant quantities of public and private debt denominated in euro. Inevitably, there would be defaults and restructuring of this debt. That, combined with the fact that the new currency would be launched by a country known around the world to be in dire economic straits, would result in ongoing weakness of the new currency. While a weak currency would have some advantages, making Greece’s exports far more competitive than they have any hope of being while the country retains the euro, imports would become very expensive and there would be significant inflationary pressure. The problems Iceland has faced since its default provide a useful comparison, although Greece does have the advantage of a broader domestic production base.

So, while an exit from the euro would be an unpleasant experience, it is probably just the medicine that patient requires.

* Thanks to @magpie for drawing this article to my attention.

The debt rating agency Standard and Poor’s (S&P) has placed their rating of the US on negative outlook. What this means is that they are giving advance warning that they may downgrade their rating of the US from its current AAA level (the highest possible rating). Their actions were motivated by concern about “very large budget deficits and rising government indebtedness”.

To me this shows that S&P do not have a good enough understanding of macroeconomics to be in the business of providing sovereign ratings. How can I doubt such an experienced and reputable organisation as S&P? Well, keep in mind that this is the same agency which maintained investment grade ratings for the likes of Bear Stearns, Lehman Brothers and AIG right up to the point where these firms were on the brink of collapse (while it was only Lehman that actually failed, that was only because the other two were bailed out). Likewise, it is the same agency which assigned investment grade ratings to sub-prime CDOs and other structured securities many of which only ended up returning cents in the dollar to investors during the global financial crisis.

Of course many commentators are very nervous about the growth in US government debt (notably, the bond market seems far more sanguine) and typically assert, with little justification, that growing government debt will lead inevitably to one or more of:

• a failure of the government to be able to meet its debt obligations,
• rising inflation as the government seeks to deflate away its debt (and interest rates will rise in anticipation of this future inflation), and
• a collapse of the currency as the government seeks to devalue its way out of the problem.

Before considering how likely these consequences really are, it is important to emphasise that while there is a widespread tendency to label all of these as a form of “default” by the government it is only the first of the three, a failure of the government to make its payment obligations, that the S&P rating reflects.

In fact, I do not consider any of the three consequences above to be inevitable. The quick and easy counter is to point to Japan. As its government debt swelled to 100% of gross domestic product (GDP) and beyond, it never missed a payment, would have loved to generate a bit of inflation but consistently failed year after year and, while its currency has its ups and downs, the Yen remains one of the world’s solid currencies. While I certainly do not think that the US should aspire to repeat Japan’s experience over the last couple of decades (I would hope for a better recovery for them), this point should at least dent the simplistic assumption that default, inflation or currency collapse follow rising government debt as night follows day.

Since it is only a true default that is relevant for the S&P rating, it is worth considering more specifically how likely it is that the US government will be unable to honour its debt obligations. Regular readers of the blog will know that I regularly make the point at the heart of the “modern monetary theory” school of macroeconomics, namely that in a country where the government is the monopoly issuer of a free-floating currency, the government cannot run out of money. If your reaction to that is “of course they can print money, but that would be inflationary!”, ask yourself why that did not happen in Japan and then remind yourself that even if it did happen, it is not relevant to the S&P rating.

There is one important caveat to this monopoly issuer of the currency argument. While it certainly establishes that the US government will never be forced to default on its debt, it is still possible that it could choose to default. This choice could come about in a dysfunctional kind of way since the US imposes various constraints on itself, in particularly a congress legislated ceiling on the level of debt the government may issue. So it is possible that a failure of congress to agree to loosen these self-imposed constraints could end up engineering a default. Now that is a more subtle scenario than the one that S&P is worried about, but since it is possible, it is worth considering how serious debt-servicing is becoming for the US government. To make a comparison over time meaningful, I will take the usual approach of looking at the numbers as a proportion of GDP. Taking the lead from a recent Business Insider piece*, the chart below shows US government interest payments as a share of GDP rather than the outright size of the debt. This has the advantage of taking interest rates into account as well: even if your debt is large, it is easier to meet your payment obligations if interest rates are low than if they are high.

US federal government interest payments as a share of GDP

So the interest servicing position of the US government has actually improved of late and is certainly much better than it was in the 1980s and 1990s. So why is S&P reacting now? I would say it is because timing is not their strong suit (and they do not really understand what they are doing). Ahh, you say, but what happens when interest rates start going up? Since the US Federal Reserve controls short-term interest rates and of late, through its Quantitative Easing programs, has been playing around with longer-term interest rates as well, the US government is in a somewhat better position than a typical home-borrower, and interest rates will only start to rise once economic activity picks up again. Then the magic of automatic stabilisers come into play: tax receipts will rise as companies make more profit and more people are back at work, and unemployment benefits and other government expenditure will drop and the growth of government debt will slow or reverse.

So, there is no need for panic. Once again, the rating agencies are showing that we should not be paying too much attention to them. After all, as they all repeatedly said in hearings in the wake of the financial crisis, their ratings are just “opinions” and not always very useful ones at that.

Data Source: Federal Reserve of St Louis (“FRED” database).

* As Bill Mitchell, @ramanan and others have noted the Business Insider chart, while looking much the same as my chart, has the scale of the vertical axis out by a factor 10.