He told CNNMoney: “If we had to invest our $1.1 trillion somewhere and we didn’t like the U.S., where could we go? Canada and Australia are in decent shape. Germany has been okay but is starting to get infected by Europe’s troubles. Overall, the U.S. is still the clearest pond in the forest.”

So what’s next for the economy? He said: “Our investment committee has sketched out four possible scenarios. Scenario A is that the global economy rebounds back to past levels of high growth. B is just a decent rebound. C is that new normal – half-sized growth. And D is deflation, debt, destruction. I’d say we’re at a C – right now. We believe in the new normal, but what we’re seeing in Europe puts the minus on that C grade.”

And what does that mean for investors? “Instead of 10 per cent returns for stocks, look for five or so. And instead of the past 20 years’ returns on bonds, which are actually better than stocks – close to double digits – it’s 4 per cent going forward.”

Okay, that’s all very dandy, but what does it mean?

Well, if equities will see a return of 5 per cent, bonds even less, all those baby boomers worrying about their retirement are in a right royal mess.

Roger Bootle calls it “Money for Nothing”. The idea that you can become rich just by seeing your assets go up with the market. So property owners and equity investors make money just because property and equities are moving north. Those days are gone.

Think about it from a home-ownership point of view. Supposing you earn an average of £30,000 a year over your working life (at current prices), and you pay, say, a third of that in tax and NICs, and you work for 40 years. This means you earn £800,000. Now, assume you need a pension worth £500,000 just to fund a very basic retirement, and live in a house worth £300,000, which you have paid for in full when you retire. With zero house price growth and zero pension growth, and zero interest rates, this means every penny you earned would have paid for your pension and your home. Or to put it another way, you will have starved to death.

Money for nothing has funded the economy for the last half a century. If Gross is right about future returns for investors, then how on earth will baby boomers afford their retirement? And how on earth will non home-owners be able to afford to buy?

Cheaper houses and a longer working life are the only possible solutions. Either that, or somehow we need faster growth.

And that’s why technology and innovation are so important. See: The two words economists forget

Europe is in debt, and so are the US and Japan. Every country in the world wants a cheap currency. The euro is sure to collapse, so are the dollar, sterling and the yen. In the race to the bottom, a gold medal awaits investors who spot the inevitable chance.

No wonder gold is riding so high. It passed its all-time high a few weeks ago, and has hovered around that price ever since.

Then there’s quantitative easing – with central banks printing money so fast, there is only one possible outcome. Let’s put it this way; the supply of money is growing, the supply of gold is fixed. Ergo, gold will rise some more.

Then there is the popularity of gold as jewellery in countries such as India and the Middle East. As their economies expand, so does demand for gold.

Gold also has a peculiar property that makes it an ideal conductor of electricity, meaning it appears in minute quantities in some semi-conductors.

There is only one way that yellow oil can go. Just as black gold is going up, yellow oil will do so, too.

It is just that …

Investors are under an illusion. The savings fundamentalists have cast a spell. They tell us the problem with the world today is too much debt, that inflation – nay, hyper-inflation – is inevitable, and gold will keep going up.

The property fundamentalists said something similar in the noughties.

But both sets of fundamentals are wrong.

Wealth that accrues from growth in property and gold prices is being fed by a bubble. For the lucky ones who get the timing right, their own individual wealth can rise enormously. For the economy as a whole, the effect is at best neutral, and at worst disastrous.

Property rose too high in price during the noughties because property speculators saw it as safe. Banks saw it as safe. Derivative traders saw it as safe. And the public, who in some ways themselves had become property speculators, saw it as safe.

So our spare money was invested in a resource that could not create wealth. Under different circumstances the result would have been deep recession. If savings are not invested in productive sectors, then demand will lag behind potential supply. Instead, consumers borrowed against the extra wealth they had gained via rising property prices, and spent.

It has become fashionable to blame today’s crisis on our indulging lifestyles and people’s belief they could live beyond their means. In fact this is not how it was at all. People believed their spending was affordable, because they expected their house to go on rising in value.

It was not reckless spending that caused the crisis, it was reckless saving – on a global scale.

And now property is crashing, with money heading towards government bonds. We all know the risk in that, which is why many believe gold will be next.

But the untold story of the global economy is the end of growth in the broad money supply. Contraction in the global broad money supply is imminent.

Gold investors are suffering under the same illusion that struck property investors.

Bubble surfing is an unpredictable sport, getting the timing right is hard, and requires luck.  So far, many property investors think they managed precisely that – although they may be too hasty in drawing this conclusion, and the story is not yet over.

Gold investors are playing the same game, and they may get away with it if they can judge the timing to buy and sell right.

Isaac Newton thought he could do that, too, but when the South Sea Bubble crashed he lost a fortune.

Just remember, when investors decide en masse to turn to property and gold as safe havens from economic turbulence, their actions can create the very turbulence they feared. But in the way they learnt that in times when demand is lower than capacity, property prices can crash, the same lesson may yet apply to gold.

Where are the surplus countries to cut their wealth? Forget the euro, and sterling. The dollar may be enjoying its last hurrah. China absolutely does not want the yuan to fill that role. That leaves a certain yellow metal.

According to the FT, Saudi Arabia’s reserves of gold are twice the size we previously thought.

The pink ’un said evidence is pointing to “the revival of bullion as part of emerging economies’ official reserves.”

The snag with gold is this. If the money supply is determined by the amount of gold in existence, then growth can stall permanently. Innovation can be suffocated. The rich stay rich, the poor stay poor. For centuries, while gold made up the money supply the world changed at a snail’s pace. There are some who say this was a good thing. But they are fooling themselves. In the days when gold was money, poverty, mass starvation and misery were the staple diet for all but the ruling classes across the world.

The discovery of gold in the New World by the Spanish led to a rush in the growth of the money supply which led to inflation and killed Spain’s economic dominance. But the same discovery of gold in the New World funded the industrial revolution in the US.

In short, during the days when gold ruled, economic growth was determined by how busy were the gold miners.

Now bring the debate more up to date.

During the late 1990s and the noughties, the global savings glut ultimately meant money found its way into property. Property owners borrowed against rising asset prices, so economic collapse was avoided. The bubble burst.

Then money found its way into government bonds. Governments used rising bond prices to fund their borrowing, and economic collapse was avoided.

If the bond bubble bursts, gold may be next.

And that could be curtains for the economy.

Only if measures are taken to deal with the savings glut, can the underlying problem be fixed.

Groundless

Groundless – such a simple word. It is of course a word that could be applied to government debt, although we tend to use the more racy version – bottomless. But on this occasion the ‘G’ word had a soothing effect. Would China dump the euro and throw its massive pile of reserves at Uncle Sam? Earlier in the week markets had leapt onto rumour and sold, fearing that China was indeed about to leave the Eurozone to itself, and the UK too, leaving their governments scratching their head wondering how they were going to fund all their borrowing. And then China’s State Administration of Foreign Exchange came along and made its statements. The fears were ‘groundless’ it said, and up went the markets.

The statement continued: “China has always firmly supported the EU integration process. We support the European Union and the International Monetary Fund package of financial stability measures being taken. Europe has been, and will be one of the major markets for investing China’s exchange reserves.”
The FTSE 100 was up 157 points, the Dow up 284. It was a good day for markets after a pretty horrible couple of weeks.

Mind you, if it really is true that we came perilously close to another Lehman Brothers type disaster earlier this month, then doesn’t that tell us the global economy is still very fragile? Given this, one has to question why markets are as high as they are. Sure, they have dropped back this year, but remember that last year saw markets boom. By October 2008 the FTSE 100 was below 4,000. Last night it closed at 5,195. One can’t help but conclude market optimism is groundless.

Money has to go somewhere

Then again, money has to go somewhere. China is sitting on this mountain of cash. Every time Mr Chinaman sells a product to Ms Europe, somewhere in the banking system we see an exchange of euros and yuan. If the markets were left to their own accord, the end result would of course be a slighter more expensive yuan. But China’s government doesn’t want that. It keeps the yuan cheap and so our Chinese exporter gets lots of yuan for his products. All these yuan could lead to inflation, so the Chinese government soaks them up by issuing bills, leading to its coffers brimming over with money. Money it has no choice but to throw at the foreign exchanges. Earlier this year all the talk was that the US was going down, and how worried China was about the future of the dollar and US fiscal debt. There was even speculation that the dollar could lose its status as the world’s favourite currency, maybe to the euro. So it is all a tad ironic that all of a sudden the big fear is that China is set to ditch the euro and just invest in dollars.

There is only one long-term solution for China, and that would be to let the yuan appreciate. This of course would mean she would have less money and both the Eurozone and US would struggle to raise all the money they need. But then again, as a consequence of a rising yuan, European and US exports to China should rise, and as a result US and Europe would expand at a faster rate and their borrowing requirement should fall. At least that’s the theory.

Scanning the Internet, there is no shortage of economists who remain positive. And yet the latest bizarre twist to the financial tremors is that the Spanish banking sector is in danger. Let’s run that one past you again. During the banking crisis of 2008/09 we were told banks should have done things the Spanish way. Spain was held up as a paragon of what a good banking sector should be like. And now it seems to be suffering from just the kind of problems that descended on the US and UK in the autumn of 2008.

Libor is back in the news, that’s the rate at which banks lend to each other. It is not quite like the bad days of 2008/09, but it’s looking nasty again.

And yet much of the economic data that hit the streets yesterday was quite good. There was good news on the UK’s performance in Q1, with the ONS changing its estimate of growth. There was really good news from the US on consumers. But then again, news on the US housing market was worrisome.
Click here for: Stock markets: is it like 2008, or just a case of springtime nerves?

The pain in Spain comes out of the drains

Should Greece default?

Punish savings

Good news lurks in latest economic data

Ian Harwood, who is the chief economist at Evolution Securities said: “Corporate profits are improving, and companies have lots of cash. Both theory and experience suggests that these conditions can be expected to lead to higher investment spending and employment. And, crucially, this seems to be exactly what is beginning to happen.” He added that he didn’t think that even the fiscal tightening would be enough to delay the recovery.

Goldman Sachs’s talismanic chief economist Jim O’Neill said: “Our main conclusion is that, while it is true that European Monetary Union is undergoing a severe crisis, especially following the co-ordinated policy response, this is not likely to be a source of global financial market contagion, nor is it likely to be the source of a major renewed European economic downturn.”

So far the FTSE 100 is down 11 per cent this month. It is down 15 per cent from 20 April, which saw the year high, and 8.8 per cent since 1 January.

These are steep falls, but the drops are not high enough yet to justify the description of ‘market crash’. The falls we have seen so far could just about fall into the category one might refer to as ‘seasonal blip’. But then again, only just. If falls continue, then we move into alarming territory.

The comment made by Ian Harwood about rising corporate profits seems odd. As has been pointed out here on several occasions of late, corporate profits may be the problem. Companies are saving, and in the process demand is being sucked from the economy, and money is flowing into any form of government bonds which the markets see as safe.

Perversely at a time when sovereign debt is mounting across the world, the yield on UK, US and German bonds is falling. The yield on UK government ten-year bonds has dropped from 3.92 per cent on 10 May to 3.47 per cent at midnight yesterday.

This is the great irony of the sovereign debt crisis. As worries over government debt grow, markets become anxious to pump more money than ever into government debt. This backs up a point made here often enough. It is not sovereign debt that is the problem. Rather, it is market enthusiasm to lend to governments. If money stopped flowing into government bonds, and instead funded more investment and consumer spending, growth would rise and governments would not need to borrow so heavily.

This is why deflation and not inflation is the real danger. As Albert Edwards, who is a strategist at Société Générale, told the Guardian: “The US and Eurozone now stand on the edge of a deflationary precipice.”

Click here for:

The pain in Spain comes out of the drains

Should Greece default?

Punish savings

Good news lurks in latest economic data

If you have a nasty cold, and you take some miracle drug that masks the symptoms so you can go out and play in the sun, what happens when the effects of the drug wear off? Answer: you feel even worse. If you are in debt, and you borrow money to pay off your debt, what happens? Answer: you end up in even more debt. Back in September 2008, and then again in early 2009, it seemed as if capitalism itself was toppling. Some might say “good thing too,” but quite clearly the after effects of a banking collapse would have been misery. The great banking bailout that followed was hugely controversial, but probably meant we avoided an economic catastrophe on a scale that… well, you don’t want to go there. Suffice it to say that things would have been very nasty.

And now, 18 months on, it seems to be happening all over again. It would appear that the banking bailout was no more than a sticky plaster placed in haste over a gaping wound. And now the infection has spread. The symptoms were masked and now they have returned, if anything, worse than before. Media headlines have started talking about a return of the Great Depression.

So what is going on this time? Is it really that bad, and what’s the way out?

The prediction

Back in 2006 Ann Pettifor penned a book called “The Coming First World Debt Crisis”. The book’s main hypothesis was that up until that point we had only seen debt crises inflict the developing world, or even the undeveloped world. The author suggested that the developed world would be next, and the result would be a catastrophe on a scale we could barely conceive of. She reckoned the fundamental cause of the crisis that was about to develop, was what has commonly been referred to as ‘fiat money’, that’s this idea that the money supply is really determined by banks and their lending.

The author of this article read the book, but found himself getting annoyed by the conspiracy theory aspect of the fiat money debate. It seems the problem, according to the high priestess of the fiat money conspiracy, lies with banks, which supposedly are making money at the expense of everyone else, and relying on us borrowing more and more, and getting further and further into debt, to fund their massive profits.

Of course, four years on, it would appear the book was prescient indeed. Banks are certainly unpopular, and have been blamed for creating the economic crisis of our times. But we are not sure that the diagnosis of the problem is right.

There are so many predictions out there that the laws of statistics say some of these predictions will be right. But that does not make their authors some latter day Cassandra. Just because the prediction was right, it does not mean the theory behind the prediction was right. Astrologers amongst the Incas had predicted the end of their civilization. They were right. Does that prove astrology can foretell the future, or does it simply tell us something else? Perhaps the Incas were so convinced their astrologers were right, that when the Spanish arrived they made little effort to resist the conquest because they thought it would be pointless, and thus the prophecy became self-fulfilling.

The real point here is to beware of looking at all the theories predicting doom before the credit crisis happened, and of then heaping too much praise upon the authors.

The crisis

The latest reason for markets panicking is that they are fearing that governments are enacting austerity drives too quickly. Yes, that’s right. After spending an age telling us they were worried about fiscal debt, now markets are worried it is being reduced too fast. Of course, this panic comes on top of Germany’s ban on naked short-selling, which comes on top of the bourgeoning fears over Spain and Portugal, which come on top of the Greek economic tragedy, which comes on top of the banking crisis, which comes on top of the credit crunch, which comes on top of mortgage securitisation, which comes on top of the idea that house prices always go up.

This time it may be different

But before you dismiss ideas such as the banking bailout, and the EU bailout of Greece and Co., and say you can’t solve a debt crisis by lending more money, just remember there is a precedent for dealing with debt by borrowing more. During the 1930s, governments did what common sense said they should. They made cutbacks, and they encouraged thrift. And the depression got deeper. Then the Second World War came along and they had no choice but to borrow; the depression ended, and the global economy embarked on its best ever period of economic growth, which lasted right up to 1973. At the beginning of the UK’s golden period of economic growth, fiscal debt was 250 per cent of GDP. A quarter of a century later the average Brit was enjoying an income that was around twice the level at the beginning of the period.

You see, high government debt does not automatically mean low growth to follow.

Professors Reinhart and Rogoff have published a book called “This time it is different”. They have looked through the ages and found an incredibly high correlation between government debt and economic crisis. The title of their book is meant to be ironic. It never is different.

And yet the post Second World War experience shows this is not so. You can say most serious car crashes occur when the driver is going too fast. That does not mean that when cars are driven fast there is nearly always a serious car crash. Most people who go bust have previously got into big debt. This does not mean all people who get into big debt go bust.

Sure, economic crises are often preceded by a fiscal debt crisis. But high fiscal debt does not always lead to crisis.

Bizarrely, the yield on UK, US and German ten-year bonds has fallen over the last week or two. Investors have been rushing to safety, pouring their money into the safest assets they can think of. And those assets are government bonds. Economics is like that that. It throws up strange results, and is not always common sense. Behaviour that is right for individuals can be wrong for an economy.

China joins the panic

Did you know that between January and February this year the Eurozone imported no less than 27.9bn euros worth of stuff from China. It was the region’s biggest import market. Yet exports came to just 12.6bn euros. For the EU 27, imports from China were 37.6bn euros. Exports were 15bn euros.

But that only masks the problem. A much more serious problem relates to the flow of trade within the EU, with German surpluses with the rest of the region meaning that by definition the rest of the EU has a massive deficit with Germany.

And just as the falling pound has been seen as good news by those who want to see the UK export its way forward, the falling euro is now being seen as good. Earlier this week, John Lipsky, the Deputy Director at the IMF told Bloomberg that: “The current level of the euro does not appear to pose problems.” He said: “The euro is rather close to what we would consider equilibrium value after an extended period at which it traded above that value.” Charles Wyplosz from the Graduate Institute of International and Development Studies in Geneva told the Chinese Xinhua news agency that the falling euro is a “godsend”.

In fact, while the deficit between Europe and China is way too big, there are signs that it is closing. Exports from the EU to China rose 47 per cent over the last year, whereas imports fell 2 per cent.

According to the FT, Asian exporters are becoming extremely anxious or ‘rattled’ over the plight of the euro. The pink ’un paraphrased Tom Albanese, Chief Executive of Rio Tinto, saying: “The European crisis is the greatest current risk to China’s growth.”

As you may know from several articles written here covering this point, China dealt with the crisis by boosting internal investment, possibly creating a new bubble and perhaps pushing up the global price of oil and other commodities. But she still enjoyed massive exports to the EU and US. China’s policies were short-sighted and are now rebounding on her. It may seem appealing to sell to, but not buy from, one’s main customers, but if this policy ultimately means your customers run out of money, then this policy can backfire. In business, all sides of a deal must gain.

At least the falling euro suggests Europe’s problems are seeing a partial fix, but the problem of trade flow within the EU is no closer to a solution. And Germany’s response to the Greek crisis shows she has no intention of doing her bit to boost demand within the EU.

Enter Venter and synthetic life

But maybe there is more to this crisis than just global imbalances.

The 1930s depression was odd, because back in 1929 most investors were extremely optimistic. And they had good reason. The previous half-century had seen unprecedented innovation. The problem in the 1930s was that the money supply contracted just at that point that innovation had created unprecedented potential. Industry could produce more for less labour input, and yet demand was falling.

It is like that today, too. In the US, productivity has been rising at an extraordinary pace.

And now we have Craig Venter. In the penultimate paragraph of the last article written in this column in 2009, it was said: “And by the way, watch genetic science over 2010, and prepare for announcements that will stun the world.”

Well, this morning, Craig Venter happened. The famous genetic scientist claims to have created a synthetic life form. Actually, he hasn’t done that at all. If you change some chips inside your computer, have you created a new computer or modified an existing one? Well, this analogy is fairly close to the ‘has Venter created synthetic life?’ debate.

But frankly, this debate is academic. What Venter is doing is truly stunning. It seems we are close to seeing synthetic life forms that can suck up waste and carbon dioxide, and create fuel. Algae may yet become the new oil. Cures for cancer and heart disease beckon. This may seem like hype, but it isn’t. What is going on in genetic science right now is probably the most significant scientific advance ever seen.

Of course there are doubters, just as there were doubters when Copernicus said the Earth went around the Sun, or Darwin said life had evolved. And there are dangers, too. If the credit crunch has taught us anything, it should be the importance of regulation, and just as bankers can get it wrong, so can scientists.

Are we victims of scientists?

But just as the period before the 1930s was one of extraordinary innovation, the period we are going through now is, too. But just like the 1930s, this creates the problem that demand may lag behind capacity. That was the problem in the 1930s, and it is the problem today.

And that brings us back to fiat money and the debt crisis. Debt is affordable if as a result of that debt we are able to produce more goods and services. And right now, the world’s ability to produce goods and services is without precedent. But to meet this new potential we need growing demand. Without this extra demand, we get deflation and depression.

In the latest version of Robin Hood, the English King, Richard the Lionheart, asked the Robin Hood character played by Russell Crowe a question about the wisdom of his crusade. He asked Crowe for the truth, and so the archer replied, but telling his king things that he didn’t want to hear, and as a result Crowe found himself in the stocks. Sometimes telling the truth can be a bad idea.

You may know from your history, but stories of kings, emperors and Caesars are littered with accounts of messengers being punished for bringing bad news. The cruel leaders may have got away with it at the time, but history has not been kind to those despots through the ages.

Yesterday, that’s what Angela Merkel did. She shot the messenger. But this time around we didn’t need to await the unravelling of the ages before her deed was seen for what it was. Markets immediately pounced, ravaging Germany for daring to blame them for telling unpalatable truths.

You could say that the likes of Ms Merkel and Mr Sarkozy don’t like hedge funds. But then that would be like saying Genghis Khan was responsible for a few deaths. The duo who sit centre stage in the Eurozone hate hedge funds with a vengeance.

But dislike of hedge funds is only a part of the story. They don’t like speculators much either. Before the days when he was a shareholder in Goldman Sachs, Warren Buffett once said “derivatives were weapons of mass finical destruction”. Well, no doubt Sarkozy and Merkel share those sentiments, only maybe magnified several times over.

But yesterday Ms Merkel banned what’s called naked short-selling and speculation on government bonds. This of course was a massive problem for short-sellers, as they found the economic nudist beach they were lazing on had become of interest to the morality police. They had to rush indoors and throw on the first clothes they could find, not wanting, as it were, to offend the German chancellor with their nakedness.

Jibes about emperors with no clothes aside, naked short-selling hasn’t really got anything to do with fashion, rather it relates to selling shares you don’t own. Speculators get the blame over and over again. George Soros was vilified in 1992 for nakedly- (or short) selling sterling (not a pretty picture). But these days it is generally felt Mr Soros did the UK a favour because he hastened our departure from that horrible period of ERM membership.

The truth is, markets only sell, or short stocks, if they have a good reason to do so. Short-selling is the markets’ way of allowing for risk. Robert Shiller, the highly acclaimed US economist, reckons the housing market needs a more active derivatives market, because that way we are less likely to see the absurd booms we saw in the mid noughties.

The truth is, naked-selling and bond speculation are simply ways of getting the news quicker. And of late, these speculators have been akin to the messengers of old, bringing the great king news he didn’t want to hear.

A statement from the German government said that the practices that have been banned “could have led to significant disadvantages for financial markets and have threatened the stability of the entire financial system”.

Bloomberg quoted Brian Yelvington, Head of Fixed-income Strategy at Knight Libertas LLC, as saying: “The market sees an inadequate policy such as this as an act of desperation and a refusal to address the fundamental problems at hand.”

But if markets can’t short or speculate with bonds, they are going to reduce risk somehow. So they sold equities, with the Dax falling sharply this morning. They sold the euro too, with the currency falling sharply yesterday. Just bear in mind it had already been falling steeply beforehand, so yesterday’s selling came on top of previous selling.

The Telegraph quoted one trader as saying: “Without the two-way flow the German market is likely to become utterly dysfunctional.”

Sterling was down against the dollar too, although its fall was nowhere near as steep as the decline in the euro.

It seems that markets have reacted to the German announcement by seeing the US as the safest place for their money. Even China has begun buying US Treasury bills again. As for the UK, well, the yield on UK ten-year government bonds fell to 3.68 per cent this morning, from 3.75 per cent last night. That’s a sharp fall in yield, or rise in price, within just a few hours.

Take some comfort from the fall in UK yields. This suggests that the markets are now seeing the UK as a relatively safe haven. Ironically, Germany’s move may make it easier for the UK government to fund its debt.

And so what lessons can we learn? Well, it is quite simple really. Kings who shot their messengers were normally kings who suffered defeat. The Ancient Greek playwright Sophocles once wrote: “No one loves the messenger who brings bad news.”

In Henry IV, part 2, Shakespeare wrote:
“Yet, for all this, say not that Percy’s dead.
I see a strange confession in thine eye:
Thou shakest thy head and hold’st it fear or sin
To speak a truth. If he be slain, say so;
The tongue offends not that reports his death:
And he doth sin that doth belie the dead,
Not he which says the dead is not alive.
Yet the first bringer of unwelcome news
Hath but a losing office, and his tongue
Sounds ever after as a sullen bell.”

It seems, then, that Ms Merkel saw the markets like a sullen bell, but in reality the move may ultimately mean Ms Merkel herself dwells in a losing office.

Markets crash, but computer glitch provides partial explanation

At one point yesterday the Dow Jones was down a stunning 998.5 points, or 9.2 per cent, the biggest one-day drop since 1987, before staging a comeback. For a while it seemed the US stock market crash could actually eclipse news of the election in the UK media. (On second thoughts, maybe not, it seems not even the Second Coming or an invasion by Martians could have managed that feat.) But the Dow finally ended the day a mere 346 points down, a big fall of course, in fact it was the biggest one-day drop since that momentous of all months, September 2008, but even so it was a trivial drop compared to the day’s earlier losses.

But it seems the big falls were largely explained by technical glitches. Many of the trading systems are programmed to automatically sell if stocks fall by a certain amount. Yesterday was a day of extreme volatility, and for a while certain stocks had fallen quite steeply. This triggered off automatic selling, exacerbating the fall. At one point shares in Procter and Gamble were down by a stunning 37 per cent. On its own this fall made up 172 points of the day’s losses. Yet the stock finished the day just 2 per cent down on the opening price.

But while much of the falls can be explained by quirks in the trading systems, the drops nevertheless showed how pensive markets are.

Banking crisis 2?

The wounds of September 2008, when Lehman Brothers went bust, have not healed, and markets are terrified that the Greek contagion could spread. Even if Greece was to default, the disaster would not be on the same scale as the Lehman Brothers collapse. But many are drawing parallels between Greece and Bear Stearns, the bank which was rescued before the Lehman Brothers collapse. Greek rioters have made clear their disquiet over the impending austerity drive. The risk of default remains high. Markets fear that Greece is simply unable/unwilling to make the necessary cuts, and these fears alone are creating further worries that Spain, Portugal and the rest of the motley crew will follow Greece into sovereign debt hell.

Moody’s, the credit ratings agency, rubbed salt into the wound. It warned that “the banking systems of Portugal, Spain, but also Ireland, the UK and Italy are increasingly moving into the focus of the markets.” The Moody’s note stated: “Each of these countries’ banking systems faces different challenges of different magnitudes, but… risk could dilute these differences and impose very real, common threats on all of them.”

Fears of another banking crisis sent shockwaves through markets across the globe, with bank stocks falling steeply yesterday, and this time the falls had nothing to do with technical hitches.

UK stuck between rock and hard place

As for the UK, Moody’s made a ‘stuck between a rock and a hard place comment,’ saying: “The UK is in a difficult position: if it were to tighten fiscal conditions too quickly, then this could lead to further asset quality challenges in the banking system, potentially choking off economic recovery… Alternatively, if the UK did not tighten fiscal conditions soon and credibly enough, then the financial flexibility of the sovereign may diminish as market opinion may move against the UK.”

Blame the messenger

Earlier this week, the EU Commission seemed to suggest the real problem with the economy was the rating agencies themselves. José Manuel Barroso said of the credit ratings agencies: “Deficiencies in their working methods has led to ratings being too cyclical, too reliant on the general market mood rather than on fundamentals – regardless of whether market mood is too optimistic or too pessimistic.” He may have a point. Or maybe instead this is all about European sensibilities and hating to have US companies pointing out their shortcomings. Markets can be irrational, but they can also be rather effective at pointing out errors. They messed up during the build up to the credit crisis, but it does not necessarily follow they are messing up now. A few days earlier in the week Michel Barnier, the European commissioner in charge of an overhaul of financial services, said: “There are not enough ratings agencies, not enough competition and not enough diversity. Why should there not be an agency that is more European than those that exist today?” And then he left one big question hanging: should an alternative European agency be state or privately owned?

Merkel warns of threat to EU

Meanwhile, in Germany Angela Merkel made no effort to mince her words.
While the Greeks hate the terms of the rescue package which they see as being far too tough, the Germans feel the Greek bailout is too soft. But Ms Merkel told the German parliament: “This is about nothing less than the future of Europe… and with it the future of Germany in Europe.” Her warning continued: “We are at a crossroads… There is no alternative to the planned aid for Greece, we want to secure the financial stability of the euro area. It must come, in order to fend off a chain reaction in the European and international financial system.”

Strong words, but frankly the German ‘will it, won’t it’ rescue of Greece has an element of farce about it. Every few days we are told a Greek deal has been agreed. But when you keep presenting the same information as if it is news, one can’t help feeling confused. How many times does the EU need to announce its rescue of Greece? No wonder markets are so spooked.

Playing the fiddle

Earlier this week The Telegraph ran a piece suggesting the IMF would be unable to afford a Greek style rescue for other countries if the contagion spread to Spain, Portugal, Italy and, horror of horrors, the UK. If these countries were to enjoy an IMF bailout of the same scale relative to their IMF quota as Greece, then the IMF would have to find around $1 trillion. This would surely be impossible.

No wonder rumours are circulating that the European Central Bank will have to go nuclear and take a leaf out of the Fed and Bank of England books and print money. But yesterday the European Central Bank’s President Jean-Claude Trichet said: “We did not discuss the matter. I have nothing more to say on it.”

But markets are not convinced. Mythology says the Emperor Nero played the fiddle while Rome burnt, but in fact this is not true, and he did all he could to deal with Rome’s fire. Mr Trichet may talk the talk of doing nothing, but inside he must surely be feeling quite different.

Nuclear monetary option

This has inevitably led to further talk that the only solution to the debt crisis will ultimately be via governments inflating their way out of difficulty – the hyperinflation bogey is back on commentators’ minds. But we still stick to the view that globally we are seeing demand lag way below potential supply. There is enormous slack in the global economy. This is nothing like the 1970s, when supply was stretched wafer thin. The real danger for central banks lies in the threat of pushing up asset prices. Indeed, central banks have said they want to achieve this, because rising asset prices will lead to rising demand. But there is a danger of seeing the twin evils of falling High Street prices but rising asset prices.

The truth is, however, that the net effect of massive levels of global savings is that money is flowing into safe havens, namely US government debt. A perverse effect of the global savings glut is that while US fiscal debt is soaring, so is demand for US government bonds. The underlying problem of global demand not keeping pace with global rises in potential supply has not gone away, and until this problem is fixed, we will lurch from one crisis to the next.

Well, maybe. The truth is, the price of oil, China’s house prices, China’s trade deficit, and the hopes for the UK to boom again are all connected. The snag is, it is hard to tell whether we are on a treadmill of blood, sweat and tears which will lead to success, or if it is just a crushing bench press of pain.

Oil is hovering in the $86 to $87 region at the moment. That’s high, but still a lot short of the level we reached in 2008. But the price of petrol for British drivers is at an all-time high. Yesterday, the average price of petrol hit 120p, passing the previous high of 119.7p from July 2008. The cheap pound is part of the explanation, but is not the only cause. Back in July 2008, oil was trading for around $145, which at the then exchange rate worked out at £73 a barrel. Today, the dollar price of oil is cheaper, but the dollar is more expensive to the pound, making the sterling price £56. So if oil, even after allowing for the fall in sterling, is cheaper per barrel, why is petrol for consumers more?

Another major factor pushing on petrol prices in the UK is refinery capacity. At the moment, regardless of how much oil OPEC and Co. pump out, we don’t have the capacity to then refine it all.

Presumably this particular problem will be fixed eventually.

But the truth is, back in 2008, oil was surely a major factor sparking off the economic recession. And if black gold continues to rise, then that could suck growth out of the global economy.

On the other hand, the counter view argues that oil is a bubble. That it is being inflated by an unsustainable Chinese investment boom, and that in any case, much of the growth in the developed world which is pushing on oil is down to a temporary turn in the inventory cycle. So, oil may well fall back in price later this year.

Talking of China, the celebrated fund manager James Chanos has said China’s property market is on a “treadmill to hell”. Setting aside points about treadmills being literally the road to nowhere, “treadmill to hell” is surely an oxymoron. Treadmills are the epitome of hell anyway, so to say you are on a treadmill to that unpleasant world is like saying hell is the road to hell.

Anyway, semantics aside, it is possible to over egg the Chinese property bubble thing. Sure, China’s house prices are surging, but so its average income. At the moment house price growth in China is outstripping growth income, but just bear in mind that should Chinese house prices fall by, say, 10 per cent, while income rises by 10 per cent, then the average price to average income ratio would have fallen by around 20 per cent. Given these underlying fundamentals in China, a full blown crash seems unlikely.

Perhaps the real story on China at the moment is the growing expectation that she had a trade deficit in March. It is not that China’s exports aren’t rising at an impressive rate; they are, it is just that imports are thought to have expanded even more rapidly.

So does this mean that China is set to become a great importer?
Well, the general feeling is that we won’t see another deficit in China for a while and that much of the increase in imports was actually down to the surging prices of commodities.

Even so, the fact is that of the Eurozone’s top ten trading partners, China was the only region that actually imported more from the region in 2009 than from the year before. The Eurozone trade deficit with China shrunk from £119bn in 2008 to £90bn last year.

Bit by bit, China is becoming an importer as well as an exporter.

As for the UK, the recent fall in sterling has made the British economy a lot more competitive. Capital Economics, for example, says “the UK is just as competitive against Germany as it was a decade ago – or indeed three decades ago. And it is significantly more competitive, compared to the position ten years ago, against other European countries such as France, Greece and Ireland.”

But Britain’s problem is that too much of its trade is with its neighbours and with the US. The UK sells more to Ireland than it does to China.

So Britain is perhaps selling to the wrong countries. It is exporting to countries that are in an even bigger economic mess.

So, it is no good the British labour force being willing to sweat away in new factories, building on the foundation of a cheap pound. First, the UK has to push its sales to China and India and the rest of the emerging gang a lot harder.

At the moment, China is importing commodities. That is why the Australian economy is doing well. Commodities are going from Down Under to the other side of the Great Wall. But, should China find a way of channelling more spending into consumption, and less into bubble-like investment, then a side effect of this may well be cheaper oil.

Meanwhile, US Treasury Secretary Tim Geithner is off to China at the moment. The feeling out there is that some kind of deal to let the yuan appreciate is in the offing.

Chinese consumption, it seems, is the key. It will create a more balanced Chinese economy, it may well led to cheaper oil, and more Chinese imports, which in turn will feed into the export markets in the West.