Another Euro Crisis

We may all breath easier. The crisis is over. In Brussels yesterday the leaders of the 27 agreed to save Greece from the jaws of the bond market.

On the other hand the real Euro crisis is only just beginning. Germany has signalled its price for the Greek rescue: the EU must be able to expel errant members from the Eurozone. A way is sought to revoke the irrevocable union.

A new treaty will be needed and there is little appetite for that in European capitals. Still, Ms Merkel is pushing for it and the compromise language in the summit conclusions opens the door to treaty revision.

The root of the next euro crisis lies in the change made to the German constitution last year which requires a balanced budget. While Greece and Spain and Portugal are pushed to deflate their way to German levels of competitiveness, Germany will be deflating its way to a budget balance. That is why Germany wants to make an emergency exit available.

Until now we expected the borders of the Eurozone to extend to the east. It seems more likely that the southern border will retreat northwards.

Ruskin's Critique of Capitalism

An interesting article in today's FT quotes John Ruskin on the idea that the role of a business is the provision of goods:

“it is no more [the merchant’s] function to get profit for himself out of that provision than it is a clergyman’s function to get his stipend.”

It expresses something I have been trying to say. The purpose of a business is to provide a product or a service; "to provide for the nation" in Ruskin's words. The dominant idea of our time is that the purpose of a business is to generate shareholder value. The job of an executive in any business, whether it makes software or cleans offices or whatever, is to maximise the profit returned to shareholders.

John Kay, says something along these lines in The Truth About Markets. He claims that the idea that profit is the objective and business the means is wrong; doing business is the objective and profit the motive. (I'll check the quote when I get a chance).

This is on my mind because I'm wondering about what happens when the owners of firms no longer have control of them and the only measure of a firm's behaviour is its return on equity. I'll write more on this soon.

Obama Crosses the Line

A clear dividing line: some want to reform banking regulation, others want to reform the banks.

Yesterday the US administration crossed from regulatory tinkering to real reform. In Britain it is Mervyn King and Lord Turner, rather than the government, who want banks tamed.

The "Volcker rule" means that banks which take deposits will not be allowed into the Casino - an excellent first step.

Some institutions will try to escape by giving up their status as banks. Goldman Sachs and Morgan Stanley only became bank holding companies during the crisis. It is not politically possible for them to escape government rules. Obama's goal is to cut back financial firms to a scale where they can not threaten the stability of the system. He will need some version of the quack principle- if it quacks like a duck it is a duck.

I would like to see more. The authorities - possibly the Fed - should have powers to limit leverage (that is the total amount financial firms borrow) and certain types of derivatives should be banned.

Much of the commentary will be on the politics. Is this Obama's response to the defeat in Massachusetts? I think not; look at the cover of last week's Economist when it called for Obama to come out fighting. The FT had something similar this week.

Will Britain follow suit? I think so; fear of the City of London losing out to other financial centres has held the government back. Britain can adopt the same rules as apply in New York and push them through the EU so that they apply equally in Frankfurt.

Economics or B*ll*cks?

The pound has risen to a four-month high against the euro, after higher than expected UK inflation raised the prospect of interest rate rises, says the BBC.

Is that economics or is it bollocks?

Yes you are right. In economics higher inflation pushes a currency down not up. I previously told a little story to explain why that is. So why is the BBC talking bollocks?

Well inflation figures were higher yesterday and the pound did rise against the euro so perhaps lazy journalism put the two together. Coincidence doesn't mean one thing caused the other. In fact the euro fell against the dollar as well, so maybe the pound's rise has more to do with the economic news from euroland where Greece seems to be struggling at present.

Perhaps currency traders do care more about interest rates than economic fundamentals and so they did push up the pound as the story says. It is possible; day-to-day market movements are not explicable by economists. On the other hand, the rise in inflation is a blip caused by unusually low prices a year ago. The bank is not about to raise interest rates. Surely, even currency traders can work that out.

Update 20h00

Now the BBC says:
Euro falls against dollar and pound
The euro has hit a five-month low against the dollar as continuing concerns about the Greek economy weigh heavily on the currency.

That is a little more plausible. Incidentaly the latest inflation figures for euroland are up....

Megabankers Megabucks

How did it happen that a group of people have persuaded themselves that they should each be paid millions each year? How did they persuade their employers to pay in one year more than most of us can earn in a lifetime? Why did the non-executive directors or the remuneration committees or external regulators or the owners of the firms or the press not shout "Hold on; this can't be right"?

The proverbial Martian analysing earthling society would conclude that the work of bankers and "traders" must make the greatest contribution to human happiness and well being. Why else would we reward them so highly?

Not so long ago a bank's chief executive was paid about the same as a top civil servant or the CEO of any other public company. Since then, their remuneration has blasted off skyward dragging up the pay of other CEOs in its wake. Perhaps if we understood the mechanism by which this distortion arose we could throw the machine into reverse.

Employers didn't call a halt because it was the people in charge of the banks who were boosting their take home. Economists call this the agency problem - mangers running a company for their own benefit rather than the owners' benefit.

Non-executive directors didn't because they were taken in by the argument that pay had to be "competitive". Their responsibility was to look to the interest of the company on whose board they sat. The problem of pay inflation however was systemic. If other banks were paying more then the each bank had to up its offer to keep its best staff. As the old song says, they were only playing leapfrog.

The same problem affected remuneration committees who felt they had to pay more or the top talent would desert to a competitor. The committees were also made up of the same sort of people who were benefiting from the acceleration in top pay.

This is a perfect example of each doing what is individually rational but the outcome is collectively irrational, a kind of market failure. If no bank offered to inflate salaries, where would they desert to? (Actually they could have gone to private equity and hedge funds. Controlling them is another issue, but in my view there would be plenty of able people left to run the banks and in retrospect they couldn't have done a worse job.)

What about the banks' owners, the shareholders? If you held shares in one bank then you might be influenced by the competitiveness argument. Modern capitalism isn't like that. Most shares are held by institutions - pension funds, insurance companies and mutual funds - all of whom diversify their holdings and so can escape the narrow view. Sadly, institutions do not take their responsibilities as owners seriously. If they don't like what a company does they rarely put pressure on the board or raise issues at shareholders meetings. At best they quietly sell their holding. This is a major failing. Institutions look after the savings of people like you and me and should look after our interests.

Now would be a good time to cut bankers' pay. They are not in much of a position to move to a competitor or set up a new hedge fund. Government could do it - government should step in to deal with market failures. It would work best if governments acted together and so could resist banks' threats to relocate to less regulated environments.

Fund mangers could do it too, and probably more effectively. We should put pressure on fund managers to use their shareholdings to stop bankers helping themselves to the profits which would otherwise go to boost your pension, your life assurance policy, your ISA or other nest-egg investments.

So far the people running the investment institutions have got off lightly.