Financial markets: An air of confidence

Financial markets

An air of confidence

Jan 24th 2012, 11:38 by Buttonwood

THE equity markets have stated the year in fairly buoyant mood, with the S&P 500 now up almost 20% from the October lows. A better trend in US economic data has undoubtedly helped. But talking to investors in recent days, it seems the crucial factor has been Europe.

That might seem odd, given that many countries were downgraded by S&P and that the Greek restructuring deal has yet to reach agreement. But the ECB's willingness to lend money for three years to European banks has done two things. First, it has seemingly eliminated the prospects of a banking collapse, at least in the near term. Second, it may well have encouraged those banks to earn a turn by investing in government bonds, bringing down yields in Italy and Spain.

In turn, this may have encouraged US money market funds back into the region. According to Gerry Fowler at BNP Paribas,

Last week, US money market funds bought significant amounts of French and Spanish commercial paper. The value of notes issued by US banks with foreign parent companies increased by $6bn to $152bn. Notes issued by foreign domiciled banks rose $3bn to nearly £133bn.

It must also have helped that the European economic news has not been as bad as was feared; today's purchasing managers indices showed a rise above the 50 level. As I suggested in the New Year column, a New Year rally was very likely given the gloom that pervaded investors in late 2011. The question is how long it can last. the euro-zone deal that is being cooked - help for indebted countries in return for pledges of fiscal austerity - still seems likely to choke growth in the short term.

The problem with past examples of successful austerity programmes, such as Canada in the 1990s, is that they occurred in single countries (or in relatively small groups of countries). It is much harder when everyone is cutting at once. As Keith Wade, the chief economist at Schroders, puts it

The effects of co-ordinated fiscal consolidation by countries generating the majority of global GDP is likely to place a limit on world growth, absent a major technological innovation or policy transformation in the developed world.

The problem with reform programmes like those proposed by Italy's Mario Monti, necessary as they are in the long run, is that they don't do much for growth in the short term. It's another "I wouldn't start from here" issue. Just as we have accumulated debts, western economies tend to accumulate a whole lot of vested interests over the years, a problem well outlined in Mancur Olsen's The Rise and Decline of Nations, another book I've been reading. These vested interests - guilds, unions, producer cartels - can organise themselves to restrict entry to markets and inflate prices; the gains to cartel members are high, but the losses to non-members are small, since they are spread over a much larger population. Over time, however, the economy becomes like a barnacle-encrusted ship.

In short, these problems are greater than can be solved by the simple injection of liquidity into the banking systerm. Right now, however, investors are enjoying the sugar rush.

Readers' comments

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chernyshevsky Jan 25th 2012 0:09 GMT

I've seen numbers originating from think tanks being kicked around indicating that Italy could expand its economy by 8% in three years, with half of that growth coming in the first year, through liberalization of the professions. We will have to see. Clearly, the old modus operandi where parents hand down a license to a child cannot continue. Still, there's a strong attachment to the current system. I personally know people from such family businesses. I hope Monti has got the reforms lined in the correct order.

bampbs Jan 24th 2012 18:31 GMT

Austerity has to follow growth, or it will keep it from happening. Budget cuts must be keyed to economic recovery.

Doug Pascover Jan 24th 2012 16:44 GMT

Well just to run my mouth a little, I think it can be hoped that fiscal austerity is not secular in how it affects the economy. The public sector in the U.S. continues to shrink but growth is looking tol'able. My best recollection is that Thatcher achieved growth and austerity in the early 80s. If I were an EU creditor country, I might trade a little less austerity for a little more liberalization in the PIIGS but little by little that seems to be happening anyway.

Then again, what I just said looks like nonsense for the short term and probably is. At least they're removing therapy from a patient who might have been a little less sick than its symptoms.

dumaiu in reply to Doug Pascover Jan 24th 2012 20:34 GMT

I think Thatcher got out of debt by selling stuff off. It is harder when you have nothing left to sell.

You can't milk a dead cow. Growth will precede debt reduction - sooner or later.

It doesn't matter what targets central banks have for their policies; whichever gage you are watching, having a hand on the throttle is not a lot of use while indecisive politicians argue about how the rudder works.

Getting people into jobs is pointless if all you are doing is stopping other people getting into those same jobs.

You can't work your way out of debt working in zero-sum industries.

If everybody does QE it won't lead to devaluation (or do much else until confidence returns).

Macroeconomic policy is an enabling/disabling tool; macro doesn't make things happen. If you want to make things happen you have to make them happen.

Whew! I feel better for that!

iroquois5 Jan 24th 2012 14:43 GMT

Canada was lucky enough to clean its balance sheet during the internet boom when stock markets were exploding. Europe has to do so in the worst possible economic environment. That is probably why the EU is doomed: stagnation for years to come is the inevitable scenario.
Sooner or later «l’État providence» will slowly disappear in the euro zone as it did here.

Artemio Cruz Jan 24th 2012 14:28 GMT

I think the word "austerity" is in danger of being overused. For demand to pick up countries have to become more competitive. The Baltic countries have shown how to quickly restore competivity and by reversing some of their wage growth of the last decade. I'm not necessarily in favour of wholesale wage cuts but in the absence of devaluation it's the quickest route to improving the balance of payments and if people think that their job is secure even after a pay cut they are still likely to consume, ie. maintain confidence. This is definitely necessary for Greece which is just wholly uncompetitive and cannot rely even rely on a technocratic government with a parliament jostling ahead of fresh elections.

Spain and Italy will probably get away with reforms - liberalising the labour market and in Spain's case removing the gross electricity subsidies which are a huge disincentive to investment in newer, more efficient kit. I agree on the whole that such reforms must be greeted by a greater degree of support from the Commission and creditor governments: good will must shown and earned on both sides. Interestingly, the German "wise men" are arguing for some kind of mini-Eurobonds essentially for Italy and Spain as a way to insulate them from the bond markets before they are forced to go to a possibly chronically underfunded bailout fund. Of course, some kind of stick must go along with that carrot to stop them re-electing Berlusconi as soon as they think they are out of the woods.

One thing that I do think counts in Europe's favour is the relatively high degree of cohesion amongst the "educated elite"* - many of us have had extensive experience of life in other EU countries thanks to the extensive exchange programmes that have been running for a generation or more so that and the huge growth in single market trade and companies, Greece possibly excepted, there is less of a "them and us" culture than the media often portrays.

* I don't think that we necessarily consider ourselves as elite.

hedgefundguy Jan 24th 2012 13:33 GMT

These vested interests - guilds, unions, producer cartels - can organise themselves to restrict entry to markets and inflate prices; the gains to cartel members are high, but the losses to non-members are small, since they are spread over a much larger population.

Now where did I hear this line before?

Oh yes, securitization of mortgages and other debts.

That worked out well.

Regards

oneofthepeople Jan 24th 2012 12:45 GMT

"...organise themselves to restrict entry to markets and inflate prices..."

Restriction of competition does indeed lower efficiency. Add in peak oil/natural resources, challenging demographics, and capital misallocation due to wanton printing. This will take some time to fix.