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It’s one of those rare days when one feels just the teeniest bit sorry for HMG.  It is being criticised by a group of 16 know-it-all “economists” for its plans to accelerate public works programmes in order to try to spend the UK’s way out of recession.  Admittedly there is a germ of theoretical truth in the accusation.  In a static economy a big increase in central government spending can “crowd out” private sector investment as it sucks in a disproportionate amount of resources and cash.  It gets worse if a government tries to pay for this spending by raising taxes.  However, HMG has been vilified, and rightly so, for suggestions that it might sit back and do nothing at all.  But for these “economists” to centre their criticism on the assertion that HMG will not pick the right sectors to support utterly misses the point.  They should be embarrassed for trying to call themselves “economists”.  Not only does any spending have to be better than nothing, history shows us that it decidedly is.  Just look at the US’s New Deal after the last global credit crunch and collapse in equity markets. 

These “economists” would make far better use of their time if, rather than sniping at anything the government tries to do, they offered some help where it is most needed.  This does not have to be a static economy.  There is no reason why the private sector would not play too, if only the banks would release some of the billions of pounds they have been given in the form of fresh, affordable loans.  The banks’ gross selfishness is a far more corrosive force for bad.  They are doing precisely what Hoover and his Treasury Secretary Mellon did in 1929.  Look where that got the world.  (But who employs most of these “economists”?  Why, the banks of course.)  Besides, given the antique condition of much of the UK’s lamentable infrastructure, the benefits of any major government spending programme will be felt far beyond the navigation of the current recession.

But a really far-sighted government would be looking beyond just keeping the capital’s brickies and sparks in jobs by boosting work on Crossrail or the Olympic Village.  It should be addressing one critical issue which has made the current recession worse than it would otherwise have needed to be.  Greater energy independence would have left the UK far less exposed to the inflationary effects of a soaring oil price.  And that would have given the Monetary Policy Committee far greater latitude to pursue a more accommodative monetary policy.  With some of the best sites for alternative energy sources such as wave and wind power in the world, it is a scandal that the private sector has not stepped up to the plate.  To misquote John F Kennedy, we should choose to do these things not because they are easy, but because they are hard.  We need them if a re-run of the current mess in a few years’ time.

It’s rarely a good idea to stand in front of a stampeding herd of elephants with an upturned hand.  But it is utterly astonishing that the media, and apparently the markets too, have been quite so slow to understand that a recession was inevitable.  In the UK the Monetary Policy Committee has been telling us for months, if not years, that the fight to contain inflation would demand slower growth.  And what is going to happen to that outlook when the domestic and global banking system then looks poised to do a Chernobyl?  Anyone with an ounce of brain (not necessarily a required qualification in Canary Wharf admittedly) could see for a long time what was likely to happen.  Of course, the media loves this.  In the absence of a nice new juicy war or major natural disaster, there is lots of material to talk about when we’re heading into recession.  Plenty of “human interest” stories for the mawkish, sadistic audiences of today who think that Big Brother is quality television.

To attribute another 6%-ish fall in the Nikkei today to “blind panic” is not quite as lightweight as it sounds.  Share prices are still being moved to a large extent by the unthinking “join the dots” black boxes of “sophisticated” fund managers.  Substitute data mining for hard, rational, independent thought and this is what you get when you feed rubbish in at one end.  One of the most serious failings of these black boxes is their reliance on consensus forecasts for company earnings, or worse, a simple extrapolation of what has gone before.  This is completely hopeless when the machine has gone straight from sixth gear into reverse.  While companies may be clinging to the vain hope that their earnings won’t suffer as recession bites, market strategists are looking, quite sensibly, far further down the road.  The consequence is that, in Europe, a consensus forecast for a 10% rise in FY09 earnings is on its way to being revised down to a 40% fall, and with only a snail-like recovery after that.

Don’t dwell for too long on what OPEC’s attempts to keep the oil price up by cutting production, or the need to compensate for the disastrous fall in the value of defined-contribution pension schemes, or alarming new evidence that inflationary wage expectations aren’t dead after all, might do for this trend.  It is a fact of life that valuations contract once it has become clear that earnings are on a downward trend.  Valuations don’t expand again until there are convincing reasons for believing that earnings are about to resume an upward trend.  Sadly, we’re simply not there yet.  This is not to say that all possible investments deserve to be tarred with the same brush.  But sensible selectivity is required here.  There’s nothing to be gained (rather, a lot to be lost) by being exposed to companies most likely to suffer in a major economic downturn of the sort for which we are headed.  When the black boxes update their data and capture that fact, what has been picked out today from the wreckage will do nicely tomorrow.

Japanese investors will have an interesting take on whether Western markets have reached the bottom.  Having seen their financial system start to implode about sixteen years before ours, the Nikkei is now roughly 82% below its all-time high, and that’s about eight years after its banking crisis was “solved” and its economy returned to “growth”.

If the best measure of efforts to solve the global financial crisis were the TV coverage world leaders have been grabbing for themsleves in the last few days, by now we’d be well on the way to recovery.  Unfortunately, the best thing that could be said about Junior’s 0800hrs performance on Saturday, for which the visibly exhausted suits were required to present themselves at White House by 0645hrs if they wanted to clear the security checks in time for the photo shoot, was that the markets were shut at the time.  They couldn’t respond to an almost complete lack of content.  The world has come to a sorry state when it is almost better to wish that the leader of the biggest economic force should be at home in Texas chopping logs rather than opening his big yap.

But read between the lines and the glimmers of hope are starting to multiply.  This is not to guarantee that they will succeed, but it has to be better than having no glimmers at all, as was the case about a week ago.  There are media reports that finance ministers refused to sign up to official statements until they included some real content.  There are indications that even Hank Paulson, Wall Street’s friend, realises that the best chance of a fix is to nationalise Wall Street.  And the quality end of the media is ramping up its mission to inform increasingly anxious and betrayed electorates, the better to exert pressure on our political leaders.

One way or the other it is all over for the banks now.  If the latest initiatives fail, then the Great Depression is going to look like a walk in the park.  Modern society can no more do without a functioning banking system than it can without mains electricity.  If the initiatives are to succeed, then the banks have to cede control to those wishing the best for society at large rather than for banks’ executives and shareholders.  There is no excuse for not lending.  It is disgraceful that, in a week which has seen 0.5% taken off the base rates of the countries which matter, Sterling LIBOR ended the week up 0.76%.  Everything else – recapitalisations, liquidity injections, base rate cuts – is pointless if the banks don’t lend.

Sadly, for each set of positives steps that are taken, another batch of negatives is ready and waiting.  The weekend press makes much of the unimaginably large amount of credit default swaps which have reached maturity in the last few days.  One commentator estimates that the recovered value of Lehman’s CDSs has been perhaps as little as 8%, which leaves the system nursing a theoretical loss of – wait for it – US$414bn on this counterparty alone.  That is not covered by either the Paulson Plan or Prudence’s Package.

So where does it come from?  To a certain extent the banking industry sits on both sides of these deals.  For every loser there is a winner, and it is not impossible occasionally to find them under the same employer’s roof.  At times like these – when the bankruptcy of the loser could bring the whole system down – might it not be correct to tell the winners that they can’t collect?  It’s not as though they would be worse off as a result, just not better-off.

Here too the system has been at serious fault and needs a radical overhaul with far tighter regulation.  Ordinary people can’t take their house insurance policy along to a bank and use it as collateral to borrow a far bigger sum of money, which they then use to buy another house, which then needs a house insurance policy, which they take to a different bank, etc. etc.  Where is the sense in letting the banks do so themselves?  The columnist Will Hutton estimates that Barclays and RBS have each built up mad pyramids like this of CDSs to the value – and this is each mind you – of US$2.4tr, which is more than the UK’s GDP.  If we get through this, such lunacy can never be allowed to happen again.  Alan Greenspan has an awful, awful lot to answer for in encouraging the deregulated development of the derivatives market.

But a few brave bargain-hunters are now beginning to appear.  Sir Philip Green is sniffing around the twitching corpse that was Baugur’s UK retail empire.  Big oil companies have dividend yields nudging towards 10% as the wider market collapses and will need the oil price to fall an awful lot further not to be able to afford to maintain such a payout.  Share prices are, sadly, falling far faster than real underlying asset values in non-financial sectors.  But market sentiment has been criminally slow to come to terms with the fact that the global economy always had been heading for recession, let alone that the recession is now going to be much deeper and longer.  While it is darkest before dawn, it is so dark out there right now that we can’t see the watch to tell whether it’s 0600hrs or 0100hrs.  Time to try to borrow someone’s torch.

Prudence is not usually the motorist’s friend.  When he was Chancellor he hi-jacked the environmental element of the fuel duty escalator in a blatant revenue-generating exercise.  The odd penny on a litre of fuel every year was going to have to be repeated for a few decades before we were going to abandon our obsession with the motor car and take to public transport, but it was a lovely little earner for the Treasury.  Instead, US foreign policy, speculative “investors” and militant groups dotted around key oil-producing areas did the environmental trick for him in a far shorter period of time.  But the oil price has collapsed since the July spike and Prudence is now calling upon the oil industry to share the benefits.  Well he might, because for as long as we don’t drive our cars the Treasury isn’t getting enough fuel duty and VAT on fuel sales.  HMG needs the cash and consumers need any break they can get in these cash-strapped times.  Prudence has got a point.  Taking 10^th October 2005 as a starting point (because it’s exactly three years ago and makes the sums easy), the Sterling price of the short-dated gasoline futures contract is just 4.3% higher, but the price of a litre of unleaded is up 45.3%.  Doubtless the petrol companies will tell us that it’s all about smoothing prices, insulating us form the very peaks but not always sharing the troughs.  Nice try boys, but it won’t wash.  At its lowest point in the last three years (18^th January 2007), the gasoline future had fallen 34.0%, but at that date pump prices were 18.7% higher.  At the peak (11^th July 2008) virtually all of the futures price (up 72.4%) had been passed on at the pump (up 65.3%).  If the futures price is only 4.3% up over three years, would the oil companies like to explain why a litre of unleaded does not cost 2005’s 75p/litre plus 4.3% plus whatever duty might be expected to have been chucked on top?

This one is choice.  A survey conducted by the World Economic Forum puts the US in 40^th place in the list of strongest banking systems, behind economic powerhouses like Malta (10^th), Namibia (17^th), Estonia (25^th) and Senegal (33^rd).  The US is then followed by Lithuania, Peru, El Salvador and – wait for it – the UK.  How are the mighty fallen!

If Asia’s markets this morning are any guide, the UK and Europe are not going to be striking out on an independent course after last night’s 7.3% collapse on Wall Street.  At the time of writing, the Nikkei may be off its worst for the day, but it’s still down 7.6%.  To what do we attribute this fresh bout of nerves?  And can anything be done about it?

First suspect up is the removal in the US of the ban on short selling.  This doesn’t wash.  US bank stocks have collapsed even while the ban was in place.  If a company is rubbish, investors will have no hesitation in dumping the “underlying”.  Replacing the ban wouldn’t achieve anything.  So no joy there then.

Next up is a fresh panic in the US about the true state of the “rescued” US financial system.  The market has been digesting Paulson’s remark two days ago that banks could yet fail.  Insurers, whose difficulties were not explicitly addressed by The Plan, are now in the sights too.  And Paulson has woken up to the fact that a UK-style state recapitalisation of the banks is not such a bad idea after all, even though it wasn’t invented in the great US of A.  It would have helped if this had been in the original script, as it has re-introduced anxieties that shouldn’t be there.

But most damaging is how the illness is now spreading out across the wider market and to a broader class of investor.  The prospect of recession wiped about one-third off the value of General Motors.  Speculation abounds that it may be beaten into the bankruptcy courts by Ford.  Panicked reactions both, but understandable when US new car sales in 2009 look set to fall by about a fifth and only the Japanese make the sorts of cars for which there is still a demand.

As for professional investors, Robert Tchenguiz provides a good illustration of the second-stage effects at work.  He is a big customer of the failed Icelandic bank Kaupthing.  When his lender found itself facing the grim reaper, it began to call in its loans, perfectly prepared to throw its customers to the wolves if that is what it would take to keep itself in business.  As a result Tchenguiz finds himself having to dump big chunks of his tottering empire, for example Mitchells and Butlers, at whatever price he can get.

Less spectacularly (or vicariously), but perhaps more insidious, falls in share prices now seem to be triggering covenants which mandate positions to be reduced or sold outright.  Sadly, this increase in selling pressure does nothing to remedy the initial problem.

Ironically, however, this mechanistic reaction does offer a glimmer of hope.  The big index funds are constantly comparing actual with target weights.  Even though they are “index” funds, these two weights are not always the same thing.  Like Martinis, index funds can have a “twist”.  And being big, achieving that “twist” can translate into some big transactions.  With markets falling as they are, that is now more likely to be achieved through purchases to top-up on stocks that have been battered.  Index funds tend, sadly, to be indifferent to what a company may really be worth, but right now this could help

Secondly, with the luxury of a few hours in which to think rather than just panic, what should now be taking place is a comprehensive re-assessment by the big institutions of companies’ fundamentals.  Many will doubtless have changed for the worse.  With recession now inevitable and of uncertain duration, there are whole chinks of the market which should be off limits even though they are apparently “cheap”.  And anyway cheapness needs a whole new definition, as it not now based on what prevailed in the market’s boom times as much as on what will pass for acceptable over the next couple of years.  One vital difference there is that there is going to be nothing like as much spare cash around to drive prices up.  Valuations come down and recovery doesn’t happen overnight.  “A prescription for some patience tablets please Doctor.”

Yesterday’s markets displayed an unaccustomed level of reality.  In falling more than 3% – relatively small beer by the standards of recent volatility and apparently not that much to worry about any more – Wall Street is telling us that it is not that confident that The Plan will get through the House of Representatives before the weekend.  In this morning’s early trading Asia does not seem inclined to oppose that view.  The point is not that a deal won’t get done.  It has to, otherwise the Great Depression is going to look like the Last Night of the Proms.  It is that the compromises required of banks, and their long-term implications for “the Anglo-Saxon business model”, will be drastic and severe.  Furthermore, if McCain couldn’t read the three-page version and agree with its contents in the run-up to last week’s rejection, politicians aren’t going to have approved every element of the 451-page Mark Two version by today.  It was always hopelessly unrealistic to expect that a compromise acceptable to all parties could be achieved in so short a time.  Nothing much short of Sweden’s 1990s nationalisation of its banking system is really likely to prove an affordable, credible, effective and enduring “fix”.  But this is America, the Home of the Quick Buck.  “Me” comes first.  For example, two politicians only gave their support to a vote on The Plan when an amendment to remove excise duty on children’s wooden arrows had been added to the package.  This will save archery makers in the politicians’ home state a princely US$200,000 a year.  Like that was worth putting the whole country at risk for.  While the haggling continues and uncertainty persists, markets are slowly learning that it pays to have a general tendency to err on the side of caution.  The next question becomes to ask how high could markets go when a deal is struck and how long could the euphoria last?  Even though short-selling is banned, enough traders and investors are apparently content to sell real stock that closing out “clothed” short positions can still lead to sharp rises when the broker dealers put the squeeze on.  But another cause for deep concern is now inexorably rearing its ugly head.  We now find ourselves at the start of an extended settlement period for a big chink of credit default swaps contracts.  These are the instruments used by investors to protect themselves against counterparty risk.  Sharp rises in their price tends to signal the imminent demise of the insured risk, such as Lehman Brothers.  If the insured risk does go under, the counterparty is supposed to receive a big insurance payout by way of compensation.  But who funds that payout?  Lehman’s alone is estimated to have run up a potential bill for the writers of its CDSs of as much as US$350bn.  And it is far from being the only counterparty to have been in trouble of late.  To put this in context, the entire Plan is (so far) “only” being priced at US$700bn.  And this probably assumes that banks do get their CDSs honoured in full rather than being defaulted on.  Remember what happened when Lloyds names had to write cheques instead of cashing them?  This is just the teensiest bit bigger than that. ECB president Jean-Claude Trichet summarised what the UK needs to see before there is a real chance of lower interest rates here.  Eurozone inflation fell from 3.8% to 3.6% in September and yet rates were left on hold at 4.5%.  In other words, real interest rates are +0.65%.  In the UK they are +0.30% and, unless inflation has abated here in the last month too, real rates could soon be going negative even without the need for a base rate cut.  The key part of Trichet’s speech was that he said Eurozone inflation risks had not disappeared.  He needs both a lower heading number and confidence that the risks are on a clear downward trend.  November’s Quarterly Inflation Report will tell us which, if either, of those boxes the UK has ticked.

Paulson has proved that he was right about one thing all along.  A failed deal is worse than no deal at all.  This was why the US authorities had refrained from interference until ten days ago.  Confidence would best be restored by leaving the market to sort its own problems out, with occasional official nudges such as Bear Stearns, Merrill Lynch, Fannie Mae, Freddie Mac,….. Well, obviously, not.  What Paulson has got horribly wrong is that the Goldman Sachs negotiation techniques, which earned him his estimated US$700m personal fortune, do not work when it comes to bullying politicians up for re-election.  “But this, or you’re dead meat” is likely to achieve precisely the opposite result.  And so, sadly, it has proved. Taking a leaf straight from Junior’s “Inturnashnul deeplomasi fer dummees” Paulson failed dismally to establish even a tentative consensus before the real horse trading got started.  And there was no Plan B for when Plan A crashed and burned.  As America isn’t Iraq (yet) he couldn’t then do what he wanted to all along anyway. But there’s delicious irony in the breakdown of yesterday’s vote in the House of Representatives.  60% of Democrats, possessed of sufficient intelligence to understand the economic consequences of failing to come up with some sort of deal, voted in favour.  60% of Republicans, far more concerned to protect the rights of the American way of doing business (and banks’ CEO megasalaries) voted against, one describing the deal bizarrely as “a cow patty topped with a marshmallow”.  (If the issues involved weren’t so serious, we should all be screaming with laughter at the fact that four of the nineteen Congressmen from Junior’s home state of Texas voted against!) Intuitively the voting split should have been the other way around.  With elections looming, the Republicans would have been better served by presenting a united front.  Even if they had somehow been responsible for the current mess, they had an answer of sorts and the will to carry it out.  Meanwhile the Democrats would have been doing what any decent UK Tory Opposition (sic) would do, picking holes in the plan but offering no better ideas of their own. In all the horror of Wall Street recording its biggest-ever one-day fall in absolute terms (7% is not the biggest one-day percentage fall by a long shot) we should remind ourselves that it is not all over yet.  The market is only back to where it was before The Plan was unveiled.  A few more banks have joined the list of “the disappeared”, Wachovia being gobbled up yesterday by Citigroup for example.  But we now have a much better idea of what will fly and what won’t. Republicans trying to pin the blame on a very punchy speech by the Democrat House Speaker Nancy Pelosi have instead done a brilliant job of highlighting this.  Voters are simply not going to hand US banks a blank cheque (for they definitely will come back for more) and leave them to get on with it unsupervised.  Voters are not going to pass up the opportunity to impose far tighter regulation on a greedy, self-serving and immoral industry which has brought them (but not the industry’s executives) to the brink of financial ruin.  Sooner or later a deal will get done.  But for each near-miss that is experienced in the process, the banks’ freedom of action for the future will become more constrained.  When a deal is struck the banks will have another Thursday September 18^th, after which they’re going to be out in the wilderness for a very long time. While politicians on Capitol Hill haggle over a solution for banks’ toxic “assets”, monetary authorities around the world continue to appear powerless to solve an equally pressing problem.  How to make banks lends to each other once more?  Because there’s precious little point tidying up one side of the balance sheet if the other then remains static.  Unfortunately, that is exactly what is happening at the moment.  Tens of billions of dollars daily are being injected by way of new liquidity, yet it all seems to soak away into the sands.  Figures from the Bank of England yesterday showed that only £143m of new mortgages were issued last month.  This was a 98% y/y fall.  Where is all the liquidity going?  And rates being paid by borrowers who can find a deal are still going up. Injecting liquidity eases the pressure on banks which have decided to rely too heavily on the frozen interbank market.  That is a good thing, because otherwise they would be going bust.  But it serves no positive purpose sitting there idle.  Nor is there any point (even if inflation rates permitted it – which they don’t) of cutting interest rates.  It is the unwillingness of banks to lend to each other that is pushing interbank rates up, not an “excessive” base rate.  The time has come to get tough on how the liquidity is then used. One draconian answer might go like this.  Banks can already apply for emergency funding by offering qualifying collateral (on ever looser standards) which incur a “haircut” so that a bit of pain focuses the mind better.  They then get more liquidity than current arrangements allow, but a chunk of this must be immediately recycled into new mortgages or corporate lending or the whole amount is withdrawn.  The banks get more than they say they really need and the poor punter finally sees something coming out of the other end of this chronically constipated beast.  Once normal operating conditions are restored, the facility is withdrawn.  Mind you, it might just be easier to nationalise this sorry mess altogether and have done.  Because, quite frankly, it just does not work.  What faith can any of us have in an industry which moans about its problems yet complains when it is asked to pay to insure its customers’ deposits?

Have we now heard the name Ken Rogoff had in mind when on August 19^th he warned “We’re not just going to see mid-sized banks go under in the next few months, we’re going to see a whopper”?  (See Daily 090820.)  Which category does Lehman or Merrill Lynch fall into?  And AIG isn’t even a bank.  Yesterday’s trio of horrors tell us that the rules of the game have changed and not for the better.

Firstly, moral hazard is not completely dead after all.  A few months ago the consensus would have been that Lehman, or any other of Wall Street’s big names, would be rescued in these circumstances.  Banks should be allowed to take bigger and ever loonier bets and, if they went wrong, the taxpayer would bail them out.  Shareholders would have the value of their investments protected and executives would keep both their jobs and their huge bonuses.  The unfairness of this has always been obvious, but the consequences of failure were deemed too awful to contemplate.

Not any more they’re not, although we will return later to the question of whether we have the full list of unintended consequences.  There is a sense in which Lehman is a victimless crime in a way that Northern Rock would not have been.  Lehman is not a major deposit-taking institution, with thousands or ordinary people exposed to the risk of losing their life savings.  Its customers, both companies and individuals, are instead supposed to be both financially sophisticated and sufficiently well-off to understand the risks associated with Lehman’s products and services and to take the hit when things go wrong.

But what is telling here is that no institution, either domestic or foreign, was prepared to step up to the plate to snap up this “bargain opportunity” and that this time the federal government was not prepared to guarantee the buyer’s risk in doing so.  This is very different from Bear Stearns, where JP Morgan Chase effectively received a multi-billion cheque to keep the rescue job out of the US Treasury’s “in” tray.  The Korea Development Corporation had spent weeks looking over Lehman’s books, but still couldn’t come up with a number that made acceptable financial sense.  Bank of America had been teed up in the media most of last week as the home-grown saviour.  Even Barclays had been put forward as a buyer, which made even less sense than its lucky escape from buying ABN Amro.  In other words, the precedent has now been set that the US authorities have a clear idea of banks which are “worth” saving.  If we look at Lehman’s characteristics we will now have a far better idea of the names which will also be allowed to fail when they get into too deep waters.

By contrast, Bank of America was lined up pretty quickly to launch a US$50bn rescue of Merrill Lynch.  This speed is alarming and does not inspire confidence.  Officially, top-level contact between the two banks only began on Saturday.  BofA’s technocrats may think they’re very bright, but can they really have analysed the target to the n^th degree in so short a time?  Remember, it is Merrill that, with each succeeding set of quarterly results and in full and ghastly, but private, knowledge of its own “book”, has had to resort to ever dafter self-help measures, such as lending buyers the money to buy its own assets at huge mark-downs.  BofA’s CEO Ken Lewis has also famously gone on record as saying he had no idea how anyone could make money out of investment banking, yet here he is buying one of the biggest operators.  Was he wrong then (no, given the write-offs these boys have been making) or is he wrong now?  There is truly grim hubris in Lewis’ statement that “This is the strategic opportunity of a lifetime…..  to create the premier financial services company in the world.”  It really is no surprise that this brilliant (not) strategic step by Lewis wiped 15% off the value of his company yesterday.  There is a very real chance that he will not obtain the necessary shareholder approval to proceed with the deal if this is how his initiative continues to be rewarded.  So, unintended consequence number one: being helpful causes you more harm than good.  Will all potential rescuers want that?

The second major point is that, now the boil has been lanced, the rot is spreading fast.  With their customary skill in anticipating the problems that lie ahead, the debt-rating agencies have finally cut their views on the world’s largest insurer AIG.  The company had been hoping to cobble together up to US$40bn in fresh capital to try to keep its operation on an even keel, but has only been able to squeeze US$20bn in support from the New York state insurance regulators.  If this is what happens to the big guys, what chance for the little people?  This is the second unintended consequence and where things could get really messy.  It is bad enough that the investment banks have been writing off billions in ill-advised “investment strategies”.  Most of these things were insured, but the policies were then either used as collateral against further bright ideas or traded around for profit.  Bankruptcies like Lehman or rescues like Merrill Lynch will only add to the mountain of “assets” that have to find a buyer.  There will be more calls of the insurance which supposedly protected them, just AIG is less able to meet its obligations.  Don’t forget that most of these “assets” are based on the US housing market, which isn’t going up.  Basically, what happens to the casino when the banker, as well as all the punters, manages to go bust?

The last (for now) major point is the impact upon money markets.  Even before AIG suffered its rating cuts yesterday, US overnight interbank interest rates were three times the Fed funds rate with which they are supposed to be in virtual alignment.  Cutting interest rates, as many observers believe the Fed will do again today, is completely and utterly pointless when the banks themselves won’t play the game.  If they hadn’t realised it before the disappearance of Lehman and Merrill, the banks that still survive this morning now know what risk really is.  It really doesn’t matter how low Fed funds goes if you don’t trust the counterparty.  Which is probably why ten US banks clubbed together yesterday to pledge a US$70bn self-help rescue kitty should any of them find themselves short of cash.  Each of the ten is entitled to draw down one-third of the fund.  Do the sums.  Haven’t these people learned anything at all?  What happens when they all ask to draw on their one-third entitlement?  Who stumps up the extra US$163bn?  Which brings us to the last (again, for now only) unintended consequence.  It may have taken almost exactly a year, but Deutsche Bank’s CEO Josef Ackermann has been completely vindicated in his call that everyone should have come clean about their true positions.  Now there is nowhere to hide.  Whether it is the liquidators trying to realise such assets as they can, or rescuers dumping their acquired toxic waste before it fatally contaminates their own balance sheets, this stuff has got to go and at any price possible.  The insurers will be called upon to play their part.  Bottom line: there will be much less money in the system to go around, seriously handicapping any attempt at economic recovery.  If there ever had been any mileage in the glib proposition that the credit crunch would soon be over and that things would return to normal, there certainly isn’t now.

Yesterday’s bloodbath in equity markets came in two phases.  In neither case is there reason to believe that the causes will be temporary.  In neither case should the reaction have been a surprise.  In neither case should we think we’ve seen the end of the story. Europe started the day already alert to the fact that the Bank of England had begun to rumble ominously about the approaching end to the Special Liquidity Scheme.  No-one, sadly probably not even the Bank, knows just what the banks have done with the tens of billions thrown at them, beyond the grim fact that it is certainly not filtering down to the companies and households where it is most desperately needed.  (Cutting interest rates wouldn’t alter that, whatever the “doves” might hope.)  Similarly, no-one knows how the banks intend to survive when the lifeboat is hauled back up in to the boathouse.  Scrabbling around for funds to meet the financial year-end accounting sleight-of-hand is going to be an unedifying spectacle at best.  Time for a few more “final” rights issues, or a fire-sale disposal of assets? So, markets sprinted for cover when European Central Bank President Jean-Claude Trichet announced that he would be clamping down on what the ECB has regarded as deliberate abuses of its liquidity operations.  One example quoted was that of Macquarie Bank, that well-known European institution (not), which had thrown together a bunch of securitised Australian car loans and somehow managed to pass this off as qualifying for ECB liquidity support.  How?!  The details of what the ECB will be doing are arcane and technical, but the gist of it is that the cost of accessing extra liquidity will rise sharply as the rules on qualifying collateral are tightened and the size of “haircuts” on that collateral increased.  The drive for greater transparency continues too, with penalties to be imposed on collateral which has been “valued” using proprietary models rather than the open market. Two broad explanations are being offered for this tougher ECB stance.  Firstly, it is still far from happy with the “value” of the toxic waste being put up as collateral.  Secondly, as a consequence of the first there is no visibility as to how long it will take to clear up this mess, so resources need to be doled out more gradually.  Together these mean that the banks are going to have to take much more responsibility, and financial pain, for a mess that they alone created.  Stick all this against a background of a Pan-European economy which is grinding to a halt, which raises the potential incidence of corporate defaults, and housing markets showing all the aerodynamic qualities of a brick (sic), and a very large dose of whacky baccy is then needed to rustle up a bull case for financials.  How could anyone sensible ever have thought that this was going to get cleared up overnight? The second blow came for the other side of The Pond, where weak August retail sales figures and an unexpected rise in jobless claims reminded traders that the US is not out of recession yet.  Indeed, the President of the San Francisco Federal Reserve went on record as saying that things have got to get even worse before they get better.  This was something of an exercise of stating the “bleeding obvious”, but it would appear that somebody had to say it, so Ms. Janet Yellen duly provided a concise summary.  The US financial system is fragile, as witnessed by the highly uncertain future of the foundation stones that are Fannie Mae and Freddie Mac.  Several private sector “shoes” could yet drop, with the likes of Lehman Brothers scrabbling desperately around to find a rescuer.  Elevated measures of affordability and a glut of unsold stock mean that the housing market is still headed south.  And the market for US exports is rapidly closing for business as overseas growth slows and the US dollar strengthens.  Other than that, it’s all hunky dory.  What’s not to understand?  There is no pill to pop for a quick fix and there never has been. 

Against all this carnage, Unilever’s decision to appoint an outsider as the new CEO was a welcome breath of fresh air.  Unilever has made a tradition of developing its talent from within, preferring evolution to revolution.  As a result, while it has rarely managed to generate much excitement, it has not got hearts beating faster with panic that often either.  Now, however, it appears that it is time for a change.  Unilever has picked Paul Polman, recently passed over for the top job at Nestlé and who previously spent most of his career at Proctor and Gamble, over the heads of four high-quality internal candidates.  The company says that Polman will not be attending this month’s strategic review conference, suggesting that he will simply continue to oversee the initiatives put in place by his predecessor.  Even if that should be true, the least we can expect is that the strategy will be executed with the flair traditionally associated with his rather more exciting and successful previous employers.

The latest UK car sales may have set us up for an Office of National Statistics-style bit of data confusion in a month’s time.  August’s new registrations fell 18.6% y/y, prompting the Society of Motor Manufacturers and Traders to become the latest special interest group to plead for direct government support.  Quoth the SMMT, “[Industry] is concerned by the reluctance of consumers to commit to major purchases.”  Well, duh!  But given the truly barking UK obsession with demonstrating the new-ness of its cars via what goes on the number plate, could it not just be that cash-strapped buyers are pushing their August purchases out in to September?  As some dribbling acolyte of Jeremy Clarkson might put it, “I’m not so poor that I can’t afford a new car at all, but I’m not going to buy one which will be ‘old’ just a month after I’ve bought it.”  Don’t be the least bit surprised if this month’s “boom” number is greeted with wild enthusiasm as “proof” that the recession is over.  Unfortunately, as October’s numbers will subsequently show, the trend in this industry is unremittingly down.

Let’s see if we’ve got this straight.  The idea of financial markets is that they are supposed to be efficient processors of all available information and anticipate where the trend is headed.  How then do we make sense of yesterday’s surge on Wall Street, and the slavish imitation of European equity markets, to news that US CY08Q2 GDP growth had been revised up from last month’s government estimate of 1.9% to a whopping 3.3%?  Being way better than the 2.7% figure the “analysts” had been expecting, it had to mean that there is going to be no recession, didn’t it?  Well, actually no, at least not yet.  Let’s not dwell too long on the cynical interpretation that Junior’s mob might have been clever enough to imitate the sneaky tactic beloved of embattled corporate CEOs.  “Low-ball” your forecasts and the market will love you when you beat them.  Let’s not even be that picky about whether US official statistics have a better track record for accuracy than the UK Office for National Statistics.  Rather let’s look at why the GDP number had been as good as it (apparently) has and ask if it can be sustained.  

The first component of the number latched onto gratefully by the bulls is US export growth.  A 13.2% annualised rate was much better than CY08Q1’s 9.2%, but it was apparently built upon the weakness of the US dollar and strong demand in export markets.  What has happened to the US dollar so far in CY08Q3 and where is the market now expecting it to go?  It has got, and is expected to continue to get, stronger.  What is happening to growth rates in economies to which the US exports?  They are slowing down.  What do these two factors taken together mean for potential US export growth going forward?  We foreigners have less spare cash to buy US exports even if the new-found strength of the US dollar had not sent their prices up.  Future export growth isn’t going to be as good.

Next, we are asked to believe that US consumption growth has been unexpectedly strong.  Well, that may, or may not, be true.  The conclusion sits at odds with survey data on retail sales, savings intentions and consumer sentiment.  But given what had been thrown at the problem in the way of income tax rebates, it would have been bitterly disappointing if there had been no positive effect at all.  Unfortunately for the bulls, there is no immediate prospect of another consumption-boosting tax cut any time soon.  Why should there be, if US Inc. is now on the path to economic recovery?

Finally, if recession really has been avoided and the US is back in growth mode, what is going to happen to monetary policy?  With the Fed funds rate at 2%, real US interest rates are -3.6%.  That’s not what you need if your economy really is growing at over 3% and has an inflation rate approaching 6%.  And when interest rates go up, what happens to consumption and housing?

Objectively and dispassionately, it seems wrong for markets to have reacted as they did.  The US may be further into its recession than Europe and Asia, but it still isn’t seeing the sort of recovery in housing, investment or credit that would flag the start of a meaningful recovery.  As for the UK and Europe, have dealers been paying no attention at all to publications from the Bank of England and the European Central Bank?  Get used to it: we are headed for recession.  Hanging on to yesterday’s gains is going to require more than just a dose of bullish hot air if the force of gravity is to be resisted.

  Look too at some of the micro data on US Inc. that emerged yesterday.  The retailer Sears saw FY08Q2 sales fall 4% and earnings fall 62%.  Perhaps it’s just the recipients of tax rebates shop more often at Sam’s Club than K-Mart?  Actually, they do, but the number still doesn’t increase confidence that the GDP data is flawless.  Computer maker Dell’s earnings for the same period fell 17%.  Greater use of “bricks and mortar” retail and an aggressive pricing policy (but have you tried pricing what a working Dell PC would cost, compared with the advertised “price”?) hit the gross margin hard, offsetting the positive effect of 11% sales volume growth.  But what is worrying is the company’s observation that recent dollar strength is now hurting sales, because of which it refused to issue “guidance” for either the current quarter or the full year.  What kind of “visibility” of earnings or expression of confidence in the future is that?  The Financial Times has calculated that Merrill Lynch’s credit crunch losses over the last eighteen months are now equivalent to about one-quarter of all the (inflation-adjusted) profits it has earned in its 36-year life as public company.  And the write-off game isn’t over yet.  No surprise then to learn that the Bank of China is so inspired by the quality of the US financial system that it has reduced its exposure to the “safe” and “guaranteed” paper issued by Fannie Mae and Freddie Mac by 25% in just the last two months.  If countries running huge trade surpluses decline to recycle that money by subsidising the US government and households, then the entire model is in serious trouble.  So much for sovereign wealth funds. 

For the second month in a row the CBI’s survey of the UK retail sector has resulted in a record low reading, with 46% of retailers reporting a y/y fall in sales.  One of the wettest Augusts on record didn’t help, but the CBI also puts a chunk of the blame in the slowdown in the housing market.  On which point, the Nationwide’s latest house price survey showed a 1.9% fall m/m, a 10.5% fall y/y and, for those with seriously masochistic tendencies, a 17% fall in the annualised q/q figure.  Those of a nervous disposition should under no circumstances read today’s Lex column in the FT.  This correctly identifies “ludicrous earlier valuations, a shift in buyer psychology, and credit withdrawal by lenders” as the causes of the collapse to date.  But which of these has now been laid to rest?  Finally, yesterday’s note commented on LibDem proposals to try to stabilise the housing market.  Hey presto – one day later and the package has rematerialised as official Labour Party policy.  What a bunch of spineless wasters!  Can’t they generate new ideas on their own?

We only have a few hours to wait for the first official reasons, contained within the Quarterly Inflation Report, for why the Monetary Policy Committee did not raise rates in front of yesterday’s horrible inflation numbers.  CPI rose from 3.8% to 4.4% and RPI from 4.6% to 5.0%.  The official CIP target is supposed to be 2%, yet the market is talking already about 5% next month.

The most likely explanation is that the QIR will describe a new deterioration in growth prospects to accompany the awful inflation picture.  This would give the MPC more confidence that economic slowdown should eventually be enough to bring inflationary pressures under control, because companies struggling to stay in business will find it hard to pass on price increases and will not be in a position to afford inflation-busting wage increases.  July unemployment data, also due out later today, will show how far that proposition hold true.

However, that reasoning looks questionable for two reasons.  Firstly, the MPC itself has always warned of the asymmetry that results from leaving inflation unchecked for too long.  Failure to act promptly only leads later to much tighter policy than needed to be the case, making any recession far deeper.  Secondly, the MPC has also talked sternly in recent months about the need to contain inflationary expectations.  How have they been contained when the consensus for August’s number is already 5%?

Admittedly there have been very sharp changes recently in the prices of some components in the overall inflation basket.  The oil price fell about 11% over July (and more this month to date) and returned roughly to the level that prevailing at the end of May.  Retailers are now finally starting to pass this fall on in the shape of lower pump prices, which will bring some respite from the crushing trend of increases seen over the last year.  But utility bills have seen huge price rises this month that will negate any benefit from lower fuel costs, with similar rises threatened for January.  There is optimistic talk that basic food prices are falling, but we’re not yet eating bread made from this year’s wheat harvest and bakers don’t price on a “last-in first-out” basis.  The proof of that particular pudding will be in the eating.

When we see the minutes of last month’s rate-setting meeting we will know, without any possibility of doubt, how the MPC decided to interpret yesterday’s inflation number in the context of the QIR’s forecast of long-term trends.  It is very, very hard to see how votes in favour of a cut will have gone up, unless those who join the Blanchflower camp want to achieve a similar lack of credibility.  With numbers like these, saying that inflation is under control has about as much plausibility as arguing that Gordon Brown will win the next general election.  Rather, how many new “hawks” will there be?

One new slant comes to mind however.  As consumers we are told that we notice most the price increases of items we buy frequently and which we might pay for in cash, like food and fuel.  (Although filling up with fuel these days usually requires one to present the deeds of one’s house as collateral to protect the petrol station against default on the credit card.)  Put a different way, we listen most to what we heard last.  Understanding and submitting to any change in policy is easier if the groundwork has been done first – “Interest rates are going up because…..”.  But the timing of that change is also important.  If the wage negotiation cycle has a peak, it is roughly at the calendar year end.  By October, when world harvests are in and we have a better idea of whether the trend in the oil price over the last three weeks has been sustained, there will be greater confidence in the validity of forecasts for inflation and growth.  But, and this is the important bit, any rise in rates which may by then have proved necessary will be a fresh memory in wage negotiators’ minds on both sides of the table.  Employers will know with painful clarity what they can afford.  Unions won’t be trying to demand compensation for a July rate rise as a cost-of-living increase when the price of victory is fewer jobs.

Sadly, this story has a nasty sting in the tail.  Economic theory tells us that countries with an inflation problem experience a deteriorating exchange rate, because of poor relative purchasing power and inadequate real rates of interest (especially when monetary policy is visibly too weak).  This is happening to Sterling now.  Yesterday it hit a six-month low against the Euro and a two-year low against the dollar.  What do we need in this country to pay for oil?  Or cars?  Or TVs?  Or…..

At long, long last we have a piece of fundamentally good news.  Unfortunately, this story is both too complex for the whitesocks to understand and won’t be reflected in events today, so markets have all but ignored it.  Nevertheless, if it comes off, this stands to be one of the most significant developments the global financial market is likely to experience for decades.  Better still, it is one that will go a very long way to ensuring that it is many years before we experience again what we have been going through over the last year (and will have to continue to endure for a year or more yet).

The news in question is the publication in the US of a report into the credit crunch by the Counterparty Risk Management Policy Group, led by Gerald Corrigan, former head of the Federal Reserve Bank of New York and managing director of Goldman Sachs.  This is not a repeat of the piece of limp flannel served up in the UK last week under the title of the Crosby Report.  For one thing, a raft of leading US banks have given the report and its conclusions their public support.  And those conclusions are striking.

Banks are voluntarily accepting tougher regulatory oversight and a deliberate restriction of their opportunities for growth in order to take risk out of the system.  Just compare this with the UK where Sir James Crosby only just resisted the bullying of our banks to plead for even larger state handouts to boost their coffers with no reciprocal concessions.  In the US, “sophisticated investors” will no longer be allowed to buy complex structured financial products unless they can demonstrate an ability and willingness to monitor what they are buying into.  Private clients can forget about this game altogether unless they are billionaires or above.  Banks will voluntarily submit to far tighter accounting treatment of structured products and transparent disclosure of “assets” that may still reside off balance sheet.  Risk-testing will be realistic and with reference to unthinkable catastrophes, rather than the less threatening exceptions to the daily grind that were favoured until 2007.  Bankers’ pay deals should no longer allow “patterns of behaviour and allocations of resources” which threaten “the basic goal of financial stability”.

In theory, all this makes a repeat of the present credit crunch far more difficult to take place.  Accounting policies will make it harder for banks to dream up “exotics”, there will be fewer customers to sell them to, risk-testing will ask really tough questions (and demand answers) and the whole thing will be transparent.  In other words, the problem will never grow as big again and we will know at-a-glance how big it could be.

But it is the size and lingering uncertainty about the present crisis which will prevent us from deriving any immediate benefit from this report.  It is not just reasons of “administrative complexity” that are preventing banks from signing up for tighter accounting and regulatory standards before 2010.  Do so earlier and the unspoken truth about just how bad things are will be laid bare for all to see and flee from in terror.  The banks will also need at least that long to identify and clear up what remains of today’s mess.  That is not a cost-free exercise.  Nor is the creation of the institutions – such as a grown-up clearing house for derivative products – which will be required to service the proposed new regime.  And, as usual in anything involving lawyers, the devil will be in the detail of any final agreement between the parties involved.  Lastly, the banks’ potential to make money on the same scale as in the run-up to August 2007 has gone, taking with it a big chunk of their future valuations.  But that’s a small price to pay in order to try to avoid the greed of a few supposedly intelligent men in suits from dragging down the entire global economy.  Mr. Corrigan deserves our thanks.