Please don’t misunderstand me, I am a red-blooded capitalist. I always have been and always will be. I believe completely in free markets (business and financial). But even by my standards, things are going too far and somehow, a new breed of capitalism in financial markets needs to be found.

Why?

This quote is taken from EurActiv on the lead story on 29th November, “Ireland will contribute 17.5 billion euros of its own cash and pension reserves towards the bank rescue.”

Pension reserves, eh? When did that start???

And then in this story by EurActiv, “In November, Hungary and Bulgaria came up with very similar policies that embarrassed those attempting to provide an EU-wide solution to budget accounting of the cost of pension reform.” and “The move raised eyebrows in the Commission as both countries decided to nationalise their pre-funded pension schemes, thus reducing both public deficit and debt calculated by the Maastricht criteria“. EurActiv continues, “Although pension fund savings are private property, the Hungarian government pre-empted any constitutional remedies by amending the constitution, just a few days before announcing the plan.”

This all seems rather reminiscent of the misdeeds of Robert Maxwell prior to his death. What did Maxwell do? Its complicated, but in short, he used the reserves of the private pension plan of the Mirror Group to prop up the price of shares in the company. When he died / drowned off his yacht, the charade was exposed as only he seemed to know what was going on. The company then really started to struggle and as the share price collapsed, pensioners in the company scheme saw the majority of their pension fund vanish.

Parts of this are similar to the collapse of Enron in the United States. As Enron collapsed, most employees had used wages and bonuses to purchase equity in the company and it then transpired that the company pension scheme owned a very large amount of company stock. The share price had in part been propped up by the buying of the pension scheme.

These acts were considered to be illegal. Luckily for the rest of society, they caused retirement issues for thousands of people, rather than millions of people. But it seems as though the financial crisis is causing European governments to up the stakes.

We all know that the demographics of Europe suggest that funding the retirements of millions of people – as we all live longer – is becoming harder and harder. We also know that most state pension schemes are very similar to Ponzi Schemes in nature. The phrase ‘pension fund’ is often applied poorly to state schemes. The vast majority have no fund. All the money that comes in via social security payments, then goes out in the form of benefits.

But if those that have some form of fund start to prop up their economy with the money, are we moving into the government sponsored worlds of Maxwell and Enron? This cannot be a good thing for the majority of society, can it?

If these actions were illegal and ruinous on a much smaller scale, what makes sensible and educated people think that they will work when scaled up to a national or continental level?

Obviously, there are differences. Propping up a share price is different to propping up an economy, but it still sounds very much like a misuse of funds.

EU Blogger, Michael Berendt, in his recent post highlights a few of the potential social problems. And in content from earlier in 2010, the European Economic and Social Committee held an entire event to investigate the social costs of the financial crisis.

My real question then, relates to moral hazard and to the fundamental nature of the euro currency. At what point is enough enough? At what point is something not worth saving? At what point is the cost of saving bankers and investors not worth paying? Who is deciding who ought to be saved and why? At what point is the cost of saving the economy of a nation not worth paying?

Bearing in mind that I am an investor (and I own some shares in a bank!) this is hard for me to ask. But ask we must.

When is the juice no longer worth the squeeze?

As if this all was not bad enough, there are a number of very sensible financial people (the FT has been quite vocal on this for example), suggesting that the cost of servicing the interest bill for Greece is unsustainable and that they will default. It is a matter of when and not if. The cost to Ireland of servicing their IMF and EU bailout bills may also be unsupportable.

These bailouts might simply be bankrupting nations, slowly sucking the blood from them, whilst we wait for their total financial collapse (as suggested about Ireland by Wolfgang Munchau in the Irish Times here). This would be terrible.

Even worse, I don’t think I have yet spoken to anyone that believes that these bailouts will work in theory. If people don’t have even that basic faith, what must the hedge fund managers with their billions looking for ‘opportunity’ be thinking? They must be rubbing their hands with glee at the thought of the tens of billions in profits that they will make over the next few years. That is ‘our’ (and German!) money. Bonus time anyone?

The often excellent blog, The Baseline Scenario, writes of The Eurozone Endgame and four alternative scenarios, including, “Third, there is the thoughtful view of Willem Buiter – currently chief economist at Citigroup and still a brilliant critic of the global financial system. In a presentation circulating last week (not publicly available), he predicts “three or more sovereign defaults in the next five years.” His logic is impeccable – once it is easier to restructure debts, the temptation is to do exactly that; the market knows this and so brings everything forward in time.”

And the ever present Nouriel Roubini is reported by Reuters as saying, “(A bailout) happened in Greece. It happened in Ireland, and it’s going to happen in Portugal,” Roubini told a conference in the Czech capital. “The question is whether it could happen in Spain. The official funds are not sufficient for also bailing out Spain.”

Needless to say, the Portugese goverment is now expressing confidence in their economy in the hope of dispersing the blood that has already dripped into the water and started to attract the sharks.

This is, of course, manna from heaven for the eurosceptic press, such as the Daily Express in the UK who lead on their frontpage on Tuesday with, “A bail-out agreed by Chancellor George Osborne means Britain could have to find billions of pounds more to help Portugal and other debt-laden countries such as Spain and Belgium if their economies need to be rescued, as some experts are predicting.”

Are we witnessing the beginning of the end of the European political and social model? And the creation of new generations of financially underprivileged people across Europe? Are we thrusting the current generation into poverty in their retirement years?

Are banks really this important?

In case you don’t know, EUREKA is a network that helps to stimulate and foster new projects. Though they have many member nations (mostly European but also now including South Korea as of last year), the projects are chosen on merit – bottom up – rather than from a government level down.

The award ceremony last night highlighted the work of three projects and put a little glitz and glamour into the world of research and development. German TV business presenter Carola Ferstl provided some of the glitz and glamour, while the great and the good of the world of European innovation policy looked on.

First prize for this first ever Innovation Award was won by the catchily named ONOM@Topic+. Their project, lead by Gemalto of France, is leading the way in developing secure digital smartcards. These cards have many potential uses including payment and access to public transport systems, driving licences, medical records and biometric data and access to a wide range of public services.

It almost goes without saying that they have been addressing political issues and societal concerns whilst also working hard on the technological aspects. The project itself displays many of the benefits to firms in fast moving areas of the use of partnerships.

Jean-Pierre Tual, representing Gemalto, explained that the potential life-cycle of new products in their industry can be as low as two or three years. In such an environment, there is pressure to develop and roll out to market their products simultaneously.

As might be imagined, this puts real pressure on all involved to move and move quickly if their lead into the market is to be exploited and the investment in the project recouped.

Gemalto have actually used this product to move even further forwards it seems. Rather than simply bringing in a range of partners to assist in the R&D, they brought in their competitors as well. This has enabled them to develop a product that also now has industry and government support as being the industry standard.

They have been developing both product and business model on the fly. It is a very impressive achievement and they were clearly worthy winners.

The real question though, is how can more innovators and entrepreneurs be brought into the policy debate to help move issues forward in ways that benefit all? It goes without saying that they have much to do under intense time pressure.

At many of the policy related events in Brussels, it is clear that there are almost exclusively policy, government and lobbying professionals attending and few – if any – people that really innovate. Bringing these experts into the policy making arena in a positive manner seems to be the real challenge.

The problems with a bank tax are obvious though. Any country that has some semblance of a financial services industry, and chooses not to introduce such a tax, could easily be catapulted into the role of a new global financial centre. The massive sums of money at stake virtually guarantee this.

We often hear of the amazing sums of money being earned by the top hedge fund managers. The ‘poor’ ones only bring in a few million dollars each year. The ‘rich’ ones bring in hundreds of millions of dollars annually (some even earn into the billions per year!). In total, there are hundreds of billions of dollars in annual fees paid to hedge funds. If that is the case, and many of them deliver pretty average returns and so rely on their 2 to 3 percent annual management fee, then a global tax of (lets imagine) 0.5 percent, will be huge.

Who would want to avoid paying that???

Yep. Everyone.

And so the global financial centres could be crushed by the wrong tax legislation. That would prove to be terrible for London and New York. But possibly less bad for others (perhaps Singapore and Hong Kong for example). My thoughts on this subject in April can be found here.

So the risks are high and as France and Germany push ever harder for this, they risk turning the financial centres of the world upside down. Or perhaps that is the point?

However, much of the content of the conference was dominated by the role of markets and the financial crisis. Many of the speakers had the financial pitfalls in mind when they spoke about the problems being faced by poorer members of society. (For a definition, please click here – social exclusion .)

There was one speaker though, Josep Borrell, that addressed the issue much more concretely. Mr Borrell is former President of the European Parliament, so I think it is safe to presume he has some knowledge and insight to be applied.

He described the influence of the markets and how they are able to dictate policy to governments – albeit indirectly. This power to influence, by devaluing a currency when the financial policies of a government are not liked, is something that he called the “negation of democracy”.

He also highlighted the terrible inconsistency of large financial organisations and their market behaviour. The ability to punish governments in the financial markets by selling currencies down, having just needed a bailout, and using the bailout money to do it, shows the problems we have with markets currently.

If you would like to hear more, get it from the man himself. I asked him to elaborate:

As mentioned here, David Wright, Deputy Director of DG Internal Market and Services, is one of the most public voices right now on the direction the the EU is heading in. When it comes to hedge funds, capital requirements, OTC derivative reform, regulatory arbitrage and more, he is the person to listen to.

The interview is separated into two parts. In the first, Mr Wright discusses many of the elements of finance that need to be reformed.

In part 2, I ask about the prospects for increasing transparency and the influence of regulators in financial transactions…

The subject of ‘regulatory arbitrage’ and it’s implications was one of the key themes at Deutsche Bank’s event on 4th May about OTC derivatives in Brussels.

An overriding fear for legislators is that should the new rules be much delayed, on either side of the Atlantic, it will provide an opportunity for financiers to move their operations or trades to the location with the weakest rules. Even if this only happens for a temporary period, it may add further systemic weaknesses to an already weak global financial system.

Dr Swinburne was keen to point out that while the level of understanding in these complex financial instuments was growing rapidly in the CRIS Committee and that much progress had been made, it was still too early to tell what direction their policies would take. She warned participants that second guessing the outcome was pointless at this stage.

Emil Paulis, Director of Financial Services Policy and Financial Markets for DG Internal Market and Services at the European Commission, explained his expectation of the path ahead. Regulating OTC derivatives is clearly a feasomely complex area and since this regulation must start from virtually the ground up, many steps will attempt to bring these contracts in line with other asset classes.

These steps have three main themes. These are:

Counterparty Risk to include the use of the Capital Requirments Directive to help assess counterparty risks and pricing, for central clearing houses to oversee or authorise transactions.

Transparency so that as much information as is possible is available to let regulators and clients see the full terms of contracts. Questions were obviously raised about the competitive nature of these markets and the implications to business models of full disclosure and the usefulness of publishing contracts that are so complex that only those involved will fully understand them.

Increased standards of Market Integrity and the prevention of market abuse. It is likely that corporations using derivatives to hedge the risks in their business will receive exemptions, but for financial firms, the rules currently in place for other asset classes should be applied.

As a part of these measures, a – very – short public consultation process is planned. With the first releases due before the summer break, the revision of market abuse rules planned for the fourth quarter of 2010, and the problems of trying to match rules and progress with the United States, the OTC arena is due for fast and important changes.

There were many different perspectives discussed, but as you may imagine, financial services regulations were high on the list.

In the main, these regulations would be aimed at investment banks – rather than retail banks – but ultimately, these guys are major influencers in the stock markets of the world. Even if you happen to be a North American reader, this is important. The US and EU are doing their best to make their legislation comparable. The potential situations are therefore important to any and every investor.

One element that was raised repeatedly was that of stopping ‘regulatory arbitrage‘. In other words, trying to find ways to stop big banks and hedge funds from shopping around to take advantage of the most suitable legal locations. It seems that those at the top of the EU and US financial regulatory agencies believe that this ability to sidestep many rules and responsibilities added to the scale of the financial crisis. They are almost certainly correct.

Another element that ought to make us all worry, was highlighted by David Wright, DG MARKT from the European Commission. Governments around the world do not have the appetite to fix things if they go wrong a second time. In other words, if the structural problems are not resolved, those considered too big to fail will be left to fail. The actual phrase was, “I have it on good authority from very high-level officials in governments around that world that if this happens a second time, all bets are off!”

The sudden resumption in fat bonuses could come back to haunt investment bankers!

These issues have implications for the entire global financial system. Take heed. Think carefully about your personal investments and just how liquid and real they are. Numbers on a screen are just that, numbers on a screen. You can’t eat them if times are tough…

Whilst at the event I arranged an interview with a speaker. Eddy Wymeersch is Chairman of the Committee of European Securities Regulators. I asked him about short selling and the steps required if bankers are to become more responsible.

I have had the pleasure of meeting Ann on a number of occassions and I can attest to her knowledge and commitment to seeing Europe become the economy that many of us hope it can be.

Ann writes:

Greek default and the risk of contagion: Has the time finally come for Fiscal Sustainability?

What can I say? There isn’t a person I know who didn’t see the impending Greek default coming. It’s a country that has had no strategy for generating growth, unfunded pension liabilities en masse, a bloated, inefficient state sector, poor educational institutions, and an abysmal demographic outlook. For years, these developments could be softened by borrowing ever more and running up an unsustainable deficit, currently standing at 120% of GDP.

The only real surprise with what’s happening now is the speed with which events are unfolding and how visibly unprepared Europe is, despite the fact that experts have been warning that this would happen for years. It infuriates me that up until now fiscal sustainability has been the exclusive preoccupation of a handful of economists. I have argued for years that just as we taught citizens the need for environmental sustainability, the same can be done for fiscal sustainability. People deserve to know what happens when governments go on spending binges, driving up public debt and shouldering young people and future generations with the expense of today’s excesses. Just like no individual can permanently live beyond his or her means, no state can do so either. And you believe Argentina can’t happen in Europe? You better think again.

What is a mystery to me is why this looming and well-known threat was never communicated to a broader public; why this was never made an issue on par with environmental sustainability; why it had to remain the exclusive domain of academic economists, when the repercussions were so clearly to be felt by society-at-large.

Back in 2006, the Lisbon Council tried to kick off a fiscal sustainability initiative, attempting to broaden the widely accepted concept of sustainability to public finances. There was mild interest and encouragement from the European Commission’s DG Economic and Financial Affairs. We even got to host then-Economic Commissioner Almunia for a keynote speech but it was impossible to sustain any kind of momentum in the ensuing months in the absence of political leadership. None of the subsequent EU Presidencies or the European Commission highlighted the issue of unsustainable public finances in a concerted and ambitious manner. I guess after making the Stability and Growth Pact more “flexible” in 2005, ruining public finances was officially condoned and member states thought they could just go on with their reckless behaviour.

Reading some of my editorials from 2006, I feel angry and ashamed about the path of fiscal ruin that we in Europe subsequently embarked on, and which I back then warned of:

“The [Stability and Growth Pact] has utterly failed to explain to the average citizen the need for future-oriented budget priorities, fiscal discipline and long-term sustainability of public finances. The ultimate price for today’s lack of leadership will be borne by future generations, who – unless something is done now – will inherit a system so loaded with debt and so burdened by interest payments that political room to manoeuvre will be remembered as a luxury of the distant past.” (From ‘Europe must take an honest long-term fiscal view’, Financial Times, 6 November 2006)

“If Europe wants to be a responsible and respected global citizen again, as we were when we embraced and advanced the concept of environmental sustainability, we must urgently take action and kick off a second sustainability movement, one that will prepare our public finances and social security systems for the cataclysmic demographic changes on the horizon. How can we expect the world to listen to our calls for environmental sustainability while we squander the precious fiscal resources of our children and future generations? The time has come to abide by the values and principles we claim to possess.” (From ‘ Now What About Fiscal Sustainability?”, BusinessWeek, 22 November 2006)

Rather than feeling vindication because I knew this crisis would happen one day, I frankly feel anger and frustration at our policy makers and the economists who advise them. It is their closed-shop mentality – either trying to keep bad news from the public in the case of the former or simply believing that it’s not their job to communicate more broadly in the case of the latter – that is coming to haunt us now. Imagine if we had kept the threats of climate change to a closed, secluded group of decision makers and experts. What kind of public action and acceptance could we have expected? The people of Europe will now pay a heavy price for years of denial and acquiescence. And perhaps, just perhaps, we will see broader public movement towards fiscal sustainability after all. It is a pity that we were unable to do this in the mature, pro-active way that advanced democracies should be capable of, and that we are now faced instead with top-down, harsh austerity programmes that will impact our lives for years and decades to come.

- Today (28th April 2010) the Lisbon Council has released an e-brief about the financial situation and the actions required to rescue the situation. The paper has been written by Alessandro Leipold, economic adviser to the Lisbon Council and a former acting director of the European Department at the International Monetary Fund (IMF) and can be found here.

My thoughts are becoming more and more based on the economic realities of life. The regions with the strongest economies have strong financial centres. People go to these places to access capital to help their company grow.

But isn’t that changing? If New York is the global financial centre, why do they have all the debt? Aren’t they meant to have all the money? Perhaps that money comes from an economy that, you know, produces something???

In addition, the US is gathering an ever greater reputation as being the place where wealth is transferred from investor to manager (Enron, WorldCom, Madoff, lots of hedge funds) and where wealth is turned from useable capital into funny money (US$).

Then there are the regulations. Sarbanes Oxley anyone???

For my money, the future of New York as the global financial centre is limited. It might take years for this to change, or if the Dow Jones and dollar collapse, it might take weeks. Who knows?

If this supposition is correct – which I admit it might not be (read probably will never happen) – then where will the money go to? London? Frankfurt? Singapore? Tokyo? Hong Kong? Shanghai?

It is, for now at least, a pretty short list of choices.

This is why I find the many recent pronouncements of new European Commissioner Michel Barnier (in charge of financial services) to be slightly bonkers. He likes the idea of banning prop trading (investment banks trading on their own accounts), fine. He likes the idea of a banking tax, fine. He likes the idea of a tax on financial trades, fine.

But all of them together?

Individually, each idea may prove to be a step towards reigning in the mismanagement of money as we have seen in the last decade. As a group, they would be a mortal wound to the financial services industry in Europe. That would be a disaster. And it would be a disaster that would almost certainly make many funds, fund managers and their ilk to flee to a friendlier part of the world.

It would happen at a time when America and New York’s dominance is waning. Somewhere will benefit if New York perishes.

It seems unlikely that a new centre would be Shanghai, Beijing, Tokyo or Hong Kong. Either would need to use English far more than is currently the case. In Hong Kong’s case, the city would also need to be able to house an extra million or so people…

That narrows the list down a little doesn’t it! And if Barnier’s plans get to be launched, then perhaps Europe would be off the list as well.

I think the post itself is pretty self-explanatory.

The reason for posting is simply that I have been a questioner of the Euro for many years. Politically, it was a masterstroke. Pure genius. But economically, it has always seemed like a flawed idea to me – why (for example) Ireland, Latvia and Germany might need the same interest rate policy still isn’t clear to me after all this time, and I have been able to ask some very knowledgeable people that really ought to know the answer.

But despite my confusion as to it’s strength and validity, I don’t remember seeing anyone predict that the euro would ‘blow up’ probably within one month. Time will tell if this is correct. I would presume not, most things take longer than might be imagined. But who knows?

What do you think? Can the Euro survive Greece? If it does, can it survive Portugal, Ireland and Spain as well?