Of all the developments in financial markets last week, surely the most telling came out of Germany. Berlin successfully auctioned off â‚¬4.173 billion worth of two-year notes at a negative yield of 0.06 per cent.
This means that investors are actually paying the German government to lend it money. This gives substance to the expression that the “return of capital is the new return on capital”. In other words, getting your money back is as good as it gets these days.
This happened at the same time as the financial markets gave up on Spain. Despite the fact that the eurozone bailout for Spanish banks was sanctioned last week, the markets are fleeing Spain and its bond yields ended the week above 7 per cent.
The reason 7 per cent is important is that, as the yield moves above that mark, the chance of the bonds being downgraded increases. Now the average bond investor – think a typical pension fund – doesn’t like risk. It doesn’t see the higher return as an opportunity to make more money, it sees the higher return as tantamount to higher risk. Based on the return of capital, rather than the return on capital idea, these guys don’t like risk, but more than that they are debarred from taking risks.
If a sovereign bond is downgraded, many bond funds are prevented from holding them because their legal structure explicitly says they can only hold AAA assets or something similar. So the risk for Spain, as it heads past 7 per cent, is that its bread and butter supporters will fall away. This seems highly likely in the weeks ahead.
All of which makes a mockery of the notion of a successful monetary union when one big country is being paid to hold other people’s money and another big country, Spain, is being squeezed.
Obviously the background noise to all this are the shapes being thrown in Brussels by the Finns, Dutch and Germans about the extent of “peripheraid” that they face. Peripheraid is the likely permanent infusions of money from the north of Europe to the south and west for years to come.
But it is important to gain a bit of altitude from the machinations of European politics to see what is happening. The issue is not so much about what is happening, but why.
Look around the world and you see yields on all major bond markets falling rapidly. This means that investors think the deleveraging cycle is nowhere near over, and a combination of no inflation and hardly any growth is going to predominate.
So how do we square this with the knowledge that the central banks of the world have rarely printed more money? Surely inflation must take off. After all, in the US there are entire political movements based on the end of the dollar or the prospects of an inflationary explosion – and the notion that the Federal Reserve is some sort of anti-patriotic conspiracy to impoverish the average, hard-working American through inflation.
But as Irish-American commentator Bill Bonner noted last week: “The ultra-low yield on the ten-year T-note is a polite ‘FU’ to inflationistas everywhere, and a bet on a continuing and painful deflationary deleveraging cycle.”
This cycle is most evident in Ireland, where huge debts inherited in the boom are fixed while after-tax income is falling for many – and has been eliminated completely for those who have lost their jobs. If, in addition, companies are cutting their prices to compete, they face the situation where their revenues are falling but their debts are fixed.
If they move to improve their balance sheet by selling an asset, this makes sense so long as no one else does this too. But as we see with the case of Spanish bonds, if everyone sells at the same time, you get the paradox of deleveraging. This is where what is good for the individual is not good for the collective. If we all decide to sell, the price of assets falls more, and the very process of trying to improve the balance sheet actually makes it worse.
We can see this deflationary cycle very clearly when we see the fall in money supply relative to GDP in major economies. When there is loads of credit around, the money supply expands relative to GDP; it leads the cycle and where it goes, the economy will follow.
Now in the US in particular we are seeing a collapse in money supply relative to GDP. This means that, despite the central banks making loads of money available to the banks, these banks are not lending this money out.
In economics, this is termed the decline in the velocity of money. It also means that monetary policy worldwide isn’t working because there is a liquidity trap. People and companies are still paying debt, they don’t want to borrow and banks are still dealing with bad debts, so they don’t want to lend.
All this means is that, for the global economy to grow, some big shift in demand has to occur. More and more, it is looking as if the governments are going to have to engineer demand.
I know that this is unpalatable to many who believe that the governments are already big enough and create waste. I have some sympathy with that view, but the only other way the crisis is going to be fixed, in Europe at least, is for the ECB to buy up all the debt of Spain with money that it prints. Can you imagine this being accepted by the Germans or the increasingly belligerent Finns?
Looking at historically low bond yields and capital flight from the periphery, as well as the liquidity trap everywhere and the paradox of deleveraging, I am at a loss as to how growth will be kick-started otherwise.