It’s one thing to read an apocalyptic alarm from, say, a blogger or a newsletter writer. It’s quite another to see it coming from an analyst at a large institution, in this case AIG.
Bernard Connolly is deeply critical of central banks, not just of their recent actions but also of their very existence, and thinks they have gone from bad to worse with their devotion to inflation targeting. Connolly believes the monetary authorities have gotten themselves in a fix where they lack good options, but he sees raising rates now as the worst move they could make.
An interesting aspect of this piece, particularly for US readers, is Connolly’s observations about the politics of ECB chief Trichet’s moves. He argues that Trichet has gone beyond his mandate, perhaps to force action from the G8.
While I am not certain I agree fully with Connolly’s analysis, I do think the Fed has cut too deeply, too fast. As much as it would be better for rates to be higher, I’m not certain if we can get from A to B right now. The financial system is a mess. For instance, banks for some time have been well behind on foreclosures; it appears this is by design, so as not to alarm the public and shareholders. Similarly, the Bank of England says banks are hoarding cash, another sign of fragility. The Fed somehow hoped that banks would recapitalize in this window of improved market conditions, but they haven’t to even remotely the degree necessary, and the losses in the pipeline are probably worse than the Fed has been willing to admit to itself.
As much as I don’t like coddling banks, my sense is things are far more precarious than they appear. I’d rather see the Fed sit tight for three or four months and see if demand destruction due to high oil prices and a cut in subsidies in developing countries (particularly China, which has said it will lower supports and may take action after the Olympics) puts some downward pressure on oil prices.
Regardless of whether you agree with Connolly’s views, I recommend him for his fresh perspective and trenchant writing style.
We have lost count of how many notes we have, in the past few years, written with some reference to a crisis of capitalism. Tragically, that crisis is now upon us, and the pace of unravelling seems to be accelerating. The next highly foreseeable development is that there will be a worldwide crimping of central bank independence as the political process increasingly sees — rightly or wrongly, but in our view largely rightly — central banks as having fouled up.
The yob culture of Britain’s streets seems to have spread to several of the central banks. Those banks are behaving like gangs of brutish, feral fifteen-year-olds who egg each other on, claiming “respect”, by knocking down elderly passers-by and kicking the life out of them. So far, governments have reacted…by saying that we have to let these young people express themselves. But the tide may be turning…
The ultimate fons et origo of the present mess is, arguably, the very existence of central banks, for that existence is a token of a decision taken by society, in virtually all countries, that financial risk must be at least to some extent socialised and that central banks are necessary to prevent or alleviate financial crises. Moral hazard is thus inherent in all, or virtually all, our societies. But the proximate reason for the mess, ironically enough, is that central banks have reinterpreted their mission, largely perversely, and have fallen prey to the totemism of inflation targeting. That totemism is essentially imposing on the world a version of Bundesbank philosophy that is proving highly malignant in the moral-hazard-ridden but innovative and, in most circumstances, beneficial financial system we actually have…
One implication worth stressing from the very outset is that while Trichet told us all last week that he will, if he is allowed to get away with it, impose 1930s-like conditions in the euro-area cads, the Fed has, in its recent pronouncements, come close to saying that it is prepared to impose some aspects of 1930s conditions — and not least a stock market crash — on the US. And while Trichet can argue that he is only doing what the politicians have, through the treaty, told him to do, however stupid or destructive that may be, the Fed will have only itself to blame…. In our note of a month ago, “The Fed: Damned If It Does and Damned If It Doesn’t?”, we argued that while the vicious circle posited by Fisher might well exist, another, and more dangerous, vicious circle would be created if the Fed were to give the impression of being constrained by the dollar…
But who has won the argument in and about the ECB? Our understanding is that Trichet sprang his announcement on surprised ECB Council members at the real Council meeting — the dinner on the Wednesday evening preceding the formal meeting2. We further understand that even those who welcomed Trichet’s announcement — such as Weber — were taken aback by it (though not as taken aback as banks’ exotic rate structures desks, which were ripped up and torn into shreds by the sudden reversal of the shape of the euro curve; one presumes that Trichet did not anticipate the wild movements in the curve, for those movements were very unwelcome from the point view of a global financial system which in some ways looks even more vulnerable than before the Bear Stearns rescue). Many others were appalled by it. Significantly, it seems the Irish said (as we suggested last Friday) they could accept Trichet’s decision, but not this month — in other words, not until after today’s referendum.
Implicitly, what Trichet did at his press conference was something along the lines of, “Forget anything you thought you knew about the euro: it is from now on going to be a hard, Germanic currency. The ECB is the Bundesbank and the euro is the DEM. The value of the euro and the level of interest rates will be no more affected by the fact that countries such a Spain, Portugal, Greece, Ireland and Italy are members of the euro zone than were the dollar and US rates affected by the fact that at various
times countries such as Nicaragua were dollarised.” If Trichet were allowed to get away with that, the status of the euro would be radically transformed. Even more important, Trichet was in effect announcing a coup d’état in EMU. The question of whether the euro would be hard or soft, and whether the ECB would respond to conditions in the area as a whole, to conditions in weak countries or to conditions only in Germany – at bottom, the question of whether France or Germany would
predominate in EMU – was the subject of many years of detailed – and, it has to be said, inconclusive – political discussion and negotiation, though admittedly not politically accountable discussion and negotiation. Now Trichet, a jumped-up civil servant, though admittedly the high priest of the caste of civil servants, or at least of énarques, appears to be saying, “I don’t care about all that: This question is not being decided by my personal diktat, and my decision is in favour of Germany.”
Will Trichet be allowed to get away with it? Does he want to get away with it (recall our suggestion made last Friday that Trichet, who is known to have been worrying about divergence within the euro area for the past couple of years, may in effect have decided to force the politicians to make the decisions about the future of EMU before an uncontrollable economic and financial crisis develops, knowing as he must that the ECB cannot resolve the problems and contradictions now so clearly exposed within it). The stakes are now very high indeed. Lagarde’s implication that the G8 would force Trichet to change his mind represents a very considerable upping of the ante. If the ECB goes ahead and hikes, Lagarde (and Sarkozy) will look foolish. If that were to happen, the rumours that have been swirling for some months, to the effect that Sarkozy might threaten Merkel that France could withdraw from monetary union, might begin to have some substance. But if Trichet backs
down, he will have made a political — though entirely unaccountable — forum, the G8, the arbiter of ECB policy. ECB independence will be gone. Thus the G8 is shaping up to be potentially as climactic as the famous Bath Ecofin meeting of September 1992. Then, the pressures on Schlesinger, and his reaction to them, precipitated the ERM crisis.
What might the line-up at the G8 be? The belief in the market that the US government and the Fed were disconcerted and discommoded by Trichet’s announcement seems credible. For what that announcement did, coming immediately after Bernanke’s comments on the dollar (to which we shall return in Part 2 of this note), was potentially to re-create the conditions of the summer and early autumn of 1987. Then, the market perception that the Fed would be obliged by the Louvre Agreement to support the dollar, by following Bundesbank rate moves, was very definitely a factor ccontributing to
the Wall Street Crash of October of that year (true, the US stock market had gone parabolic in the months preceding the 1987 crash and was thus very vulnerable; but the factors of vulnerability now, though different from those of 1987, are very considerable; more obviously, the parabolic variable recently has been the oil price — a sharp fall in that price would reduce equity vulnerability, but, as noted earlier, we defer substantive discussion of the oil/inflation/dollar/rates/stocks nexus to Part 2).
We suspect that the US, or at least the US government side, will want to make it clear to Trichet (or perhaps in reality to Weber) that it will not look kindly on any attempt by the ECB,…. to push up not just euro rates but dollar rates. Equally clearly, the Italians will side with the French. So, too, will the British government, which has troubles of its own with the turbulent monetary priest of Threadneedle Street. The Canadian government, too, will not wish to endorse an ECB role as global rate-setter. The Japanese — including, we suspect, the BoJ – will have been aghast at what one can consider the collective loutishness of some of the other major central banks. So Trichet and the Germans may well be isolated.
That said, we cannot predict the G8 outcome with any confidence whatsoever. But Lagarde has ensured that its outcome — whichever way it goes – could be dramatic. The politicians will strike back against the central banks, whether at Osaka or later. The central banks (again with the exception of the BoJ, for reasons we hope to develop in a subsequent note) have, in putting the entire global economic and financial system at risk in pursuit of “respect”, over-reached themselves.
Note that this was published prior to the G8 meeting this weekend. The public pronouncements seemed very tame, so it does not appear that the backlash that Connolly hoped for took place.