Wednesday, May 2, 2012

Politicians can stay irrational longer than you can be right.


Market player/commentators like Charles Biderman, Hugh Hendry, and Kyle Bass have each at different times made rational, clear assessments of the solvency problems facing Europe. Each essentially agree that Eurozone governments, in particular the PIIGS, will not be able to balance their books or grow sufficiently to pay down their debts. Nor will they be able to maintain stable market prices for their populations, their levels of welfare spending, or in some cases, their social order while remaining in the common currency.

To use one of Hendry's elegant oversimplifications, the Euro is akin to the gold standard because Germany will not allow member countries to inflate away their debts by debasing the Euro currency. This makes debt payment and deficit reduction zero-sum for Euro economies, as compared to the US (and Canada), who can literally increase the money supply though printing, and then pay with that.

Keynes is said to have uttered the maxim, "Markets can remain irrational longer than you can remain solvent." This meant that even if you had a sound investment system that must inevitably succeed at some point, there was no way of knowing precisely when that point might occur, and you would likely go bankrupt if you waited for your circumstances to transpire. 

However, I would adapt this to say that, "politicians can stay irrational longer than you can stay  right."


Politicians are not stupid. In fact, the calculus that guides their behaviour is something of a black art. It would be foolish to underestimate them. What financial commentators have missed is that the financial crisis is primarily a political crisis now, meaning that the solutions will not be fiscal, monetary or economic - they will be rather crassly, even viciously, political.

Leaders know that the doomsayers are probably right. Some PIIGS will default, some countries will be caused to leave the Euro, metals will go through the roof (if briefly), there will be unrest, brinksmanship and possibly war, or at least the threat of it. But what politicians appear understand better than bankers and hedge fund managers is that someone is going to get it in the neck. And we can pretty much bet it won't be the leaders or their coalitions.

They have seen what has happened in Greece and Italy with democratic governments being suspended in favour of German-appointed receivers (e.g. the Troika). Does anyone really think that political animals, who have lived their entire professional lives trading on cunning, deceit, betrayal, attrition and patronage, would be undone over a matter of fiscal principle? It seems rather unlikely.

No, the reason we have not seen substantive changes in policy in Europe, and why countries have been kicking the debt-can down the road in what seemed like a futile way (remember bailing out Greece?) - is that until a sufficient amount of blame can be laid at the feet of some losing constituency - to borrow from former Citi CEO Chuck Prince, the music will play and the players must dance.

Politicians will keep dancing until the consequences of the inevitable can be placed on the shoulders of their critics, or anyone else who stands to benefit by being correct about their failure. The difference between politics and business is that leaders don't need to be right, they just have to outlive their rivals. The hedge funds and Co. really are the smartest guys in the room, and they are so clever they have elevated themselves to minor political players, who are given the opportunity to take potshots at presidents and politically appointed central bankers. Their story is heroic, but it ends badly for them.

Just ask anyone in a union or the public sector about what they think about "rich people." Add the actual poor and there is already an angry mob braying for the blood of bankers. Politically, governments are the only thing standing between the mob and anyone who knows the difference between "less" and "fewer".  In a truly severe crisis with significant unrest, it is far less likely that bond holders will be negotiating terms of re-payment than they will be bargaining with authorities over whether they will be allowed to escape. With or without their assets. 

The real question political parties are asking themselves now is not how they will unwind debt, how they will pay pensions, employees, or creditors. The question they are working on is, when it comes down - who will be holding the bag? The debt message is wrapped up in a bunch of different financial instruments, obligations and flows and is for now too complex to pin on any one patsy. Some people think that the election of Francois Hollande in France would suggest that a bloc of indignant countries might elect similar governments who could get together and stiff Germany, but since Germany consumes most of their exports, it's not that simple.

The patsy in this case must be from parties who are not among the key influentials keeping these governments in power.

In the short term, plausible targets will likely include "the rich", whose wealth will be taxed and their assets expropriated to be used as collateral for more debt, or just sold off. Foreign investment dries up for a bit, but it comes back in less than eight years, or two election cycles. Britain did this after the second world war with often unpayable land taxes that allowed the government to seize estates that had been in families for centuries. These are now the charming "Upstairs Downstairs" theme parks operated by the National Trust. It will be popular, and do almost nothing to solve their spending  problems, but it will set the stage for the next phase, and keep governments from falling.

"Foreigners" are a useful scapegoat because they can't organize and vote, with "gypsies" running a close second. Popular resentment of Russian and other Eastern European money will bolster support for capital controls that prevent people from getting their savings out of the country. Anglo-saxons being a close third in France, and the Med. Appeals to patriotism and being "all in this together" will be a fine pretext for other forms of financial repression. These will be designed less to target specific groups, and intended primarily to just seal the exits.

During the 2007-2008 crisis, in response to "speculators" governments got together and banned "short selling", which is the financial way of saying you think a stock or an asset is worth less than is being asked. Calling a bluff, in essence. Hendry said recently something about short selling being the way people say the emperor is naked. He's right. To conceal the harm of extreme policies, and possibly to fix or manipulate prices for basic commodities like fuel and food, governments will interfere with market based price discovery. It would be done under the aegis of protecting the people from speculators, and some of them may even believe in it, but fundamentally it is to ensure that the state can secure the supply of basic goods and rewards for the minority of people who could overrun it.

Of course, this begs the question in regard to how that could be a bad thing. Reasonable people would hope that their government would intervene to ensure people still had food and gas during a crisis, that's what they paid taxes for. Indeed, if one is a part of the coalition that keeps the government in power, then certainly, this is a good thing. The big question now is the matter of who we can expect this new coalition to include to weather the crisis.

What financial types and a lot of commentators seem to forget is that hyperinflation works. It allows a leader to keep rewards going to the coalition that keeps him in power, and as an alternative to simply not paying police and soldiers, it keeps outbursts of civil unrest manageable. There are many losers in hyperinflation, but the leadership coalition is not among them. 

 Reducing rewards to the entire coalition (e.g. cutting public paycheques, pensions, and clawing back wages)  risks them turning on the leader. By simply reducing the size of the coalition the government must reward, it can stay in power with the resources available. As one possible example, universities, both as a public cost centre and a source of unrest, could be closed for the duration of a political crisis, placing academia outside a reduced coalition. Alternately, keeping students enfranchised with hyperinflated dollars may also keep them from rioting. It could go a lot of ways, but the point is that when the coalition shrinks, some people will be left out of it.

 Greece has sidestepped its dubiously reliable tax collectors by collecting property taxes through utility companies, allowing it to cut the those collectors out of the coalition. It is worth examining whether one will be a part of a crisis coalition (or likely to be cut out of it) before coming to any conclusions about one's support for radical financial repression.  Many people who are socially enfranchised now may be surprised to find that they will cease to be so, in spite of their loyal service, work, low pay, seniority, etc.

The absurd logic of racism becomes a factor when, regardless of what an individuals personal convictions may be, if there is sufficient benefit to denouncing their neighbours, people can be relied upon to do it. It's a bleak assessment, and depending on the country, it may not fall on ethnic lines. Conceivable targets in Europe could include capitalists, sociopaths, financiers, chancers, profiteers, toffs, aristocrats, fascists, survivalist/libertarians, hoarders, racists (ironically), tax dodgers, Islamic bankers, criminals etc.

If a person can secure their position in the coalition by denouncing others, it has the effect of both making the effective coalition smaller and easier to reward using now-scarce resources. To the leader intent on keeping power, this is win-win. Having citizens politically cannibalize one another appears to be fairly common in the lead-up to and throughout a polarizing political or debt crisis, as it prevents the formation of formidable opposition. Personal security in such a situation has less to do with one's assets than with correct credentials and alliances.

However, internal purges will not change the circumstances that lead up to the crisis, and so they will require external scapegoats. Switzerland is probably a bit anxious right now.  While it seems unlikely that anyone would actually annex it, if French, Italian or German troops marched on Zurich and demanded their accounts or gold, it's not clear who would be obligated to come to its rescue, since it's not a member of NATO. Eh, but who knows?

If all this sounds paranoid, cynical and extreme, this is a blog, we're not negotiating treaties here. The point is, where certain hedge fund managers have it wrong is in this: if the leaders they have antagonized survive politically, they will keep the music playing and everyone dancing until they are sure that the only seats left are for themselves and their coalitions.

Then it won't matter that they danced like idiots and that we laughed at them for it, because when the music stops, one can be sure that they will be the ones with the seats.

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