September 4, 2007

We mentioned to a friend that our favourite game at present is “Central Bank Strategy Watch”. It’s pretty simple: you try to figure out what each central bank should do, what you think they will do, who will go first, which one is your favourite. And how about some of the exciting sub-games: Interest Rate Tug of War where you can follow who is winning by watching the gap between the three and six month rates and the base rate; Policy U-Turn Tracking, with a fascinating episode in the UK by the Bank of England, which injected huge amounts of liquidity into the banking system and bailed out Northern Rock only one week after it said it wouldn’t consider doing anything of the sort. (Bank of England 0, Moral Hazard 1; or is that Bank of England 0, Moral Hazard 5 )

And for a really stimulating interactive module, how about “Come up with a Comprehensive Regulatory System”? This is where you take pen and paper (or a supercomputer) and try to divide responsibilities for banking system regulation, money creation, and interest rates between the different regulatory bodies in a country and see if they have any chance of coordinating in a crisis. So  you would have three in the UK: the FSA, Bank of England and Treasury. In the US, it is even more fun as responsibilities are split between the Federal Reserve (which has itself 1 2 regional Federal Reserve Boards), other federal bodies, state (yes, there are 50 of them) regulators, the Securities and Exchange Commission, etc. Try just naming them, much less figuring out what they should do and how they should interact. That sub-game should be especially sought after by insomniacs.

The trouble is that it is great fun coming up with the questions, and no fun answering them. Kennox Asset Management might not make millions of pounds from a sideline business releasing “CBSW: The Board Game”.

Our friend’s response was that we should get out more, and his favourite game is tennis. He has a good point.
Our failed board game aside, it is of incredible importance that the central banks get these issues right. Although central banks and governments do not create wealth (that is done by the private sector, i.e. companies and individuals), the central banks and governments create an environment where the private sector can flourish. A benign economic environment involves a sound banking system, reasonable taxes, a fair legal system and rules, an independent press, and so on. Creating this environment is no guarantee of prosperity, but getting it wrong will unquestionably act as an almighty brake on growth and progress.

Focussed on their obsession with short term inflation rates, central banks might be increasing the risk of a bigger disruption. There are two key issues for central banks that we’d like to look at here: backing the commercial banking system, and fiat money. (In reality, these two areas are so important to an economy that they are not covered by one entity but by some combination of the Comprehensive Regulatory System bunch mentioned above. For simplicity’s sake, let’s just call them the central banks, and leave the detail of the rest for the insomniacs.)

First, let’s look at the deposit-taking commercial banks. Banks are special. If a car or a pie manufacturer goes bust, it is unfortunate. Banks, on the other hand, fill an essential role in making sure credit gets to individuals and small companies that need it, i.e. recycling excess savings in an economy to productive means. It is always hard to find individuals or companies who are willing to sing the praises of the banks; the banks make huge amounts of money by giving us derisory rates of interest on our current accounts, and charging us fees for the pleasure. But, loved or not, make no mistake that having a strong banking system is essential for the workings of any economy. Banks have been at the centre of major economic crises throughout history – think of the turbulent history of the nineteenth century in the UK (there was a major crisis with banks failing about once a decade from the 1820’s onwards, including the run on the Overend and Gurney Bank in 1866, and the first bail out of Baring Bank in 1890); the role of fragmented and weak banks in the Great Depression in the 1930s; the role of banks in the Asian Crisis in 1998 and default by Russia that same year, to name just a few.

Banks have other characteristics that are special. Firstly, they are intricately entwined, so if one went bust, it massively increases the chances of the others going bust as well. Secondly, banks cannot stand a run on their deposits. Banks will return deposits often within a day, but often can’t get their money back from a loan for years. It’s called a maturity mismatch and it is a fact of life if you’re a banker. If a significant number of depositors all want their money back at the same time, the bank can’t call in its loans fast enough. Concern by depositors that the bank can’t come up with the funds encourages more depositors to come to withdraw their money, and the spiral continues. This started to happen in the UK at Northern Rock in mid- September.

So the Bank of England and the government at Westminster made an incredible move: they guaranteed all deposits at Northern Rock, and implied that they also guaranteed all deposits held by other banks in the UK. They did something extraordinary, and, we feel, unappreciated, by the general population – they nationalised deposits. They might well take away this guarantee, and they might well change their promise when it comes to actually defining what they meant in law. But, like the young shepherd in the fable, they have cried wolf.

Every generation tells their children never to make promises they can’t keep. (Which makes George W. Bush’s tax cuts and fiscal policy so fascinating. Take a look at almost any projection for when the baby boomers start to retire, and try to figure out how the US government can make those tax cuts permanent. It’s funny how rules that applied when you’re a child no longer apply when you’re older. We digress.) The Bank of England has made a promise it couldn’t keep it could never afford to support all the deposits in the UK, without triggering Zimbabwean levels of inflation (annual inflation in June was 7,251%, according to the Financial Times). Barclays has £250bn of deposits, Lloyds has close to £150bn, HBOS over £200bn, and RBS over £380bn. The government can’t make money like this appear from nowhere.

One of the first-tier UK banks going bust is very unlikely, but there is a very significant difference between unlikely and impossible. Who would have thought a couple of months ago that there would be a run on the 5th largest mortgage lender in the UK? Who, prior to September 2001, would have predicted the World Trade Center crashing to the ground?

Unlikely events do happen, and more regularly than the risk models and classic bell curves predict. Statisticians call it kurtosis, most other people call it history. If a big bank does run into trouble, that is exactly the time when a central bank is going to need all the credibility it can muster. Knowing that it has made a promise it cannot keep will not do much for its credibility.

Central banks are the lender of last resort. Last resort means when everything else goes wrong. Right now, we have high employment, low bad debts, strong global growth – it does not feel like we are at a time of desperate need. Imagine what it will be like if economic conditions get tougher. Imagine a recession, when unemployment is rising, corporate profitability is falling, bad debts are high and climbing, and the banks start to worry, not only about their growth, but possibly also about their solvency. The central banks have just nationalised deposits in the UK. What more will they do if things are really bad? They’ve played one of their strongest cards, a face card in the trump suit, if not the ace, early in the game. Let’s hope they don’t need it later on.

The second big issue for the central banks is their role as guardians of our confidence in money. We live in a world of fiat money, i.e. paper-based money backed only by a guarantee.

Over the course of economic history this arrangement is by far the exception, not the rule. (More normally over history, currencies were backed or pegged to a metal, most often gold and/or silver, and episodes off metallic standards were typified by instability and high inflation.)

Fiat currencies are enormously flexible and this makes a lot more sense than tying the economy and money supply to any metal, no matter how attractive it is. However, this system exists on confidence. There is absolutely no value in the pieces of paper unless people will exchange them for goods or services. Real trouble starts when people no longer want to exchange their good and services for pieces of paper. Remember what happened in the Weimar Republic where eventually it took a wheel barrel of paper money to buy groceries.

To avoid ever getting to this situation, governments, central banks, and the banks must do everything necessary to protect the confidence in fiat money. This is done by being responsible with promises, not spending more than you have, and not creating excess supply, i.e. not consistently creating more money than is needed. We feel that the central banks have not taken this responsibility seriously enough. Short term interest rates below 2% in the US from late 2002 to late 2004, the Greenspan put of 1998, the ballooning of reserves in countries such as China and the emerging markets (a sign of excess money), negative savings rates for governments and consumers, rising prices across all asset classes – these are all symptoms of a monetary system that is too loose.

The central banks are the guardians of our confidence in these pieces of paper. A central bank has three key tools: words, interest rates, and the printing presses. The central banks as a whole have pumped billions into the financial markets – the European Central Bank is reported to have injected €95bn in one day in August. The US Fed cut interest the federal funds rates by almost 10% from 5.25% to 4.75% on September 18th. And there’s no lack of talking, as you can tell when central bankers make the front page of newspapers. So, they are using all three tools quite liberally. As we said earlier, these are good times (high employment, good global growth and profits). The guardians of confidence must have some credibility to spare for when the times are really tough, for those rare but difficult events.

We’re not predicting the end of the world. We simply see risks out there that the future will not be anywhere as nice to investors as recent history. In the fund, we still hold a high percentage of cash which we are methodically investing as we find suitable lower risk opportunities. As well, we hold several companies which we believe will be resilient in difficult times. Debts.co.uk is a provider of solutions to overly indebted individuals. Swisscom is the telephone company in Switzerland, deriving most of its earnings in Swiss francs, a classic flight-to-quality currency which is backed by about a thousand tonnes of gold. Four out of our eleven holdings have cash on their balance sheets over 25% of their market value, and only two have debt over 5% of their market value. This type of company is the type that should weather even quite severe storms.

We’re desperately hoping that the global economy can remain resilient. Even the limited amount of reading of economic history that we’ve done lets us know that economic downturns cause large amounts of suffering. No one wishes for this. But not wanting something to happen is not the same as saying it won’t. Preparing yourself for eventualities remains the prudent option – don’t wait for a fire before testing your alarms. The risks to the global economy are much higher, and more imminent, at present than they have been in a long time. The central banks are not the solution to the problems that face the global economy, as that must come from the private sector, from individuals, from the market. But central banks have a key role to play, and an extremely difficult one. For all our sakes, let’s hope they have some firepower left for when they need it.

Authorised and regulated by the Financial Conduct Authority (FRN: 475658)
The Company is based in Scotland, UK with the above registered address (Registered Number: SC302037).

© Copyright 2022 Kennox Asset Management
chevron-down linkedin facebook pinterest youtube rss twitter instagram facebook-blank rss-blank linkedin-blank pinterest youtube twitter instagram