Transcript for Alasdair Macleod
Chris Martenson: Welcome to another ChrisMartenson.com podcast. I am your host, of course, Chris Martenson. Today, we have the good fortune of speaking with Alasdair Macleod, publisher of FinanceandEconomics.org and a recently-introduced contributing editor to ChrisMartenson.com. I had the pleasure of meeting Alasdair for the first time in Madrid, Spain when he interviewed me. So, we get to turn the tables here today and return the favor.
Then we went out – he and I – to several extended meals over the next few days, when I was over there in Spain, and I was really impressed with his ability to understand and articulate what’s happening at the macroeconomic level globally. And, given his vantage point from Europe, I’m keen on discussing his latest observations of where we are with the situation over there. The European sovereign debt crisis has been muted somewhat in the news lately, but it is by no means resolved. It poses perhaps the greatest single risk today to global financial markets.
As we ponder which event might progress from the outside in to stir up another round of financial disruption, we’d do well to keep Europe in sharp focus. Alasdair, a pleasure to have you.
Alasdair Macleod: Chris, it’s very, very nice to speak to you again.
Chris Martenson: Wonderful. Can you give our listeners a quick sketch of your background, please?
Alasdair Macleod: Yes, certainly. I started off at the late age of about 21 in the stock market. And I became a stockbroker, a member of the London Stock Exchange. I became senior partner of my firm at the grand age of about 29. Since then, I’ve not only been stockbroking, but also I’ve managed funds, I’ve been a director of a bank, I’ve done consultancy work for a wide range of financial services companies. I come at it from that end rather than having gone to university, got a degree in economics, had to unlearn everything, and then start again. So, I do have the advantage that I’ve been a practical economist in adverted commerce as part of what I’ve been doing since my early 20s.
Chris Martenson: That sets you very, very apart from your average central bank member, I would suggest.
Alasdair Macleod: It certainly does, and I learned very early on that governments in particular, central banks also, really have very, very little clue of what goes on in the market. It varies, and some central banks are better than others. But, generally, you know things are driven by political considerations rather than economic considerations, and that creates a certain tension in the markets.
Chris Martenson: That’s a really important point, which I hope to unravel here now. You recently penned an excellent overview to the European credit crisis to our readers on ChrisMartenson.com. But for those who have yet to read it, can you summarize quickly for us how things got to this state?
Alasdair Macleod: The history of this particular case goes back to the beginning of the euro, the birth of the euro. You could argue it goes way back to the last war really when the European iron and steel federation got together. The idea being if you got desperate countries in Europe together politically, then they wouldn’t fight each other in the future. That gradually evolved over time to the point where they decided to go for the common currency – the euro – and that came in 1999. But ahead of that, the countries had to converge their economies so that they could stick together. Part of that convergence was for the European Monetary Union, whereby the various currencies would be stuck in a channel and managed so that they would work alongside each other. That was meant to bring economic stability.
The other aspect of it was that these countries had to get economic convergence, and that meant things like levels of debt had to be within certain parameters, budget deficits had to be less than three percent. So, as you may imagine, before the euro convergence – which was 1997 – the countries going into euro at that time had fiddled the books quite a lot in order to qualify. And so, we had a lot of issues like off-balance-sheet stuff which really dates all the way back to 1997, even though the euro came in 1999.
Since then, virtually all the countries – with the exception of Luxembourg and, I think, Finland – have breached rules by having too large a level of public sector debt or indeed having too large a level of budget deficit. The result of that is that instead of being fined, it was all just generally ignored. Once the euro got going, of course, that de-risked it, from the bank’s point of view, because they could then lend to countries like Spain or Italy – Greece joined later, so after they joined, Greece.
Knowing that the rate of interest, let’s just say, on a bond, the German government bonds, it would be, say, 3%. And, therefore, given the whole system had a sort of guarantee, rather like a Fannie Mae guarantee from the overall European Union, you could effectively borrow at rates which equated to German government bond yields and lend it out to the Italians or the Spanish or the Greeks or the Portuguese for a spread of two or three percent. You geared it up through fractional reserve banking. It was money for old rope.
The result was that there was a huge great sea of bank credit created in the wake of the invention of the euro, even though the ECB itself ran a relatively tight monetary ship. So, it was really a sea of credit, and that inevitably ended up with property bubbles quite similar to the one you had in the United States. And when that burst, of course, the whole thing started falling apart. Of course, when the private sector starts going wrong and the banks come under huge great pressure, inevitably, governments are asked to take up the running and guarantee the banks. That’s roughly where we got to, I think, in 2009.
Since then, the crisis has been playing out, because it is quite obvious that the weaker countries cannot support all this debt and implied off-balance-sheet debt in the form of bank debt, various guarantees to nationalized industries, and so on and so forth. So it’s good ole crisis, which has got a lot of lengthy mixture that we’re familiar with in the United States and in the UK, and perhaps even in Japan. But, I think the reason it’s become so much more obvious in Europe is because the individual national banks can’t resort to quantitative easing to pay their government’s bills. They actually have to go and borrow it. It’s sort of like we’ve got to go to the bank manager and convince the bank manager. And, that is proving very, very tough.
That’s roughly where we are. I don’t know if that gives you enough of an overview, Chris?
Chris Martenson: That was an excellent summary. I just recently interviewed Bill Black – former regulator over here in the States – and he said that the seeds of the subprime crisis were really just sown-in regulatory failures that allowed certain behaviors to go forward. So I am going to tie this in by suggesting that back in 1997, then in 1999 when the union was coming together forming and the euro was birthed, there were certain, let’s say, structural conditions that were in play, right? Everybody had to sort of fit within these parameters, but they were allowed to fudge, in essence. I believe even Goldman Sachs got caught – I don’t know what the summary of that was – but they were caught helping Greece hide certain debts off-book so that their deficit ratios would look better than they actually were.
Alasdair Macleod: Absolutely true, yes. That’s right.
Chris Martenson: I’d like to hear more about that in a minute. But, what I am getting at here is that this was almost designed to fail, in the sense that when you put in a structure that allows nation states to cheat and then gain access to cheap credit, what happens next really shouldn’t surprise anybody, should it?
Alasdair Macleod: I agree with you entirely. I don’t think I would say it was designed to fail. It was like a design with not enough attention being paid to how it would actually work going forward. The reason for this is quite simple. You had all the politicians from the different countries all beating their own national political drum. Meanwhile, you have the umbrella of the European Union, which everybody pays lip service to. But again, they were pursuing the domestic agendas rather than working together at the European level. So, it was never really going to work effectively. The politics of it were too divisive for the system to survive. I think that’s the way I would put it.
Chris Martenson: I agree. Maybe I could have spoken more clearly. When I said designed to fail, it wasn’t that people designed it saying yeah this is going to fail. But, in its design there were certainly risks of failure embedded.
Alasdair Macleod: Exactly. It demands the same thing effectively.
Chris Martenson: It does, if we’re being adults about this and can learn from past experience. So what I am really interested then in the political differences. You mentioned one. There’s an extraordinary difference in how this all plays out, because the local or regional banks, as they were cannot just quantitative ease on their own. I mean, Greece is certainly stuck with us. We contrast what’s happening in Greece today with what’s happening in Iceland, which did have the ability to ease or to base its currency as a means of rectifying the imbalances. But Greece doesn’t have that opportunity.
So, here we are, and I’d like if you could to explain some of the politics that are involved in how the maneuvering happens or where it leads to types of sclerosis that prevent activities from happening that ought to be happening. But there’s a very different political flavor and tenor, obviously, to what’s happening with the ECB and in the member states in the EU, as compared to what’s happening in Japan or in the United States.
Alasdair Macleod: I think the overriding characteristic of politics in Europe is the shape of the parliaments. They are horseshoe-shaped. By that, I mean that you’ve got different degrees of opinion amongst generally disparate parties. Therefore, governments are generally formed by coalition. What this means is that a dominant party who needs a smaller party to come on board will get that party on board by effectively bribing them. And it’s not actually bribing the individual politicians, which is the sort of thing that’s happening in Greece. The bribes would be in the form of, okay, well, we will introduce this tax or that tax, which suits your political platform.
So, you have this sort of constant shuffling of trying to appease by bribes. And the bribes are all paid effectively either out of taxes, or, in the old days before the Euro, as inflation. Once the euro came in, if you need to raise some money to buy off a political party, then that was quite easy. It would be the BNP or the Italian equivalent or the Spanish equivalent would come up with the money one way or the other to help government in its efforts.
So on the domestic level, you do have this sort of political theme, which is fundamentally dishonest in the way it works. I don’t mean that as a criticism of the individuals. The individuals and their behavior, I think, is secondary to it. The order of events is that if you’ve got a bad system, then you end up with bad people, and that’s the way around it has really happened in Europe.
At the European Union level, that has been a different problem. That has separate parliaments, as your listeners are undoubtedly aware. That is the most extraordinary fudge. It’s part of the year in Strasbourg and part of the year in Brussels. At great, great cost – the whole of the political machine migrates backwards and forwards. This is an example of a sort of political compromise that you get in the founding of an institution like the European Union. What the European Union does is it has an unelected body, then commissioners who will propose perspective legislation or regulation, and then that is brought to the parliament. The parliament either endorses it or throws it out. In practice, what happens is that parliament endorses it. It has become, therefore, a huge great machine for the production of regulations.
But, I don’t know – 9,000 regulations; I’ve heard that figure since they started. It wouldn’t surprise me if it was even doubled that. The result is, Europe has become a place where a business can only operate if it’s a friend of the government, if it manages to work its way around the taxes, if it manages to work its way around national prejudices, even though those are not meant to be there because the idea of the European Union is free trade. Alternatively, it’s got to be able to comply with an absolutely extraordinary raft of anti-competitive regulations.
So, the whole system has really become pretty inefficient and works very much against free markets. So, the only thing that has really been keeping it going – as I said – since the euro came in was the expansion of bank credit. Of course that’s the other aspect of it. The banks are really political. They’re very much in the hands of the politicians and the politicians are very much in the bank’s pockets. It might be familiar to your listeners in other jurisdictions as well.
Chris Martenson: Yes, we recognize that theme very well. So, here’s what I’m interested in: This EU body has member representation. I want to understand the practical reality. Let’s imagine I’m Spain for the moment. I am Rajoy and I have this extraordinary funding need. I maybe need a hundred billion euros to get through the next funding cycle. How do I go about getting that? Is this an act of lobbying that happens at the EU level? Tell me the process.
Alasdair Macleod: Well, there are two sorts of funding. There’s a sort of funding which the EU can help with. That is, regional substance, in one form or another. So, you’ve got EU-funded infrastructure projects. That is about as far as the EU can really go. They spend most of their time demolishing markets rather than facilitating them. It’s really predominantly a machine for the production of regulations – all obviously with the best intent, but very much with a political incentive in it as well.
A very good example of this is that the EU constantly tries to knock London as a financial center off its perch. I think they are rather miffed, for the real markets dealing in euros happens to be based in London rather than anywhere in Europe, like Frankfurt or Paris or wherever. And London keeps on trying to fight a rear-guard action to stop this type of regulation. And, to a degree, they succeed. But you can see that the tensions are there the whole time. The other sort of funding which is a major source of funding for a country like Spain is really through the bond markets and also through the banks. The two things are obviously inextricably linked, because most of the lending to the Spanish government tends to come from the Spanish banks.
If you go back to pre-crisis, particularly before the credit crisis of 2007-2008, the banks all around Europe were lending money to countries like Spain. As I said earlier, they were picking up on the interest rate differential between the bond yields in Germany and the bond yields in Spain. The fact that they are only 1-2% different just basically meant that all the bank did was it geared it up even more so that it was effectively doing a reverse repo. It would gear up that 1-2% differential and walk away with 20% per annum for doing nothing. It really was money for old rope. Of course, countries like Spain became completely dependent on financing of this sort.
Chris Martenson: All right, so I am Spain, and I’m obviously relying on the bond market. Obviously I’ve spent wildly beyond my means for a period of time. It was credit, and like all good credit bubbles, they come to an end. As the Austrians say, your choices include either the voluntary abandonment of your credit cycle or the destruction of your currency. Neither of those actually seem to be an option for Spain. They seem to be struck in some sort of a nether world in this moment. So they have to rely on the bond market.
One of the things that certainly become quite obvious is that the ECB is stepping in the bond markets, quite often routinely. They’ve got the Italian options and also the open market, Spanish options and open market. In your estimation, if we were to speculate a bit, are there people in the ECB who are tasked with watching these bond markets? And do you think they have marching orders, as it were, to maintain price levels and/or market stability and liquidity?
Alasdair Macleod: Well, the ECB obviously watches the bond markets extremely closely. I think, if I can just take a step back in your analysis, the ECB really has one overriding problem. That is in the context that individual nations are effectively standing behind their banks. The ECB has an overall responsibility for the European banking system. Therefore, its primary focus is to keep the banking system from hitting a banking crisis. So, that’s the basis behind all these long-term financing, the LTRO financing, which is, I think, run to nearly a trillion euros now. That is to support the banks.
But what the banks are doing is, they take some of that capital and they put it aside because they’ve got their own bond redemptions which they’ve got to meet on their own balance sheet and they can’t see who is going to lend them the money at this stage. They’ve also got deposits walking out of the door and going to other banks within the euro system. So they need to reserve something back from there. But once they’ve made that estimation, they have something left over which they can lend to their governments.
So, it was never the intention of the ECB to bail out the governments. But what we did see, obviously, since you referred to, the yields of the bonds for the Spanish government and the Italian government fell really quite sharply as these long-term financing operations were put in place by the ECB suggesting there was bigger leakage going into financing those governments. Now that is over, the yields are beginning to rise again. But, I think that if the ECB is going to succeed in this mandate of supporting the banking system and stopping that falling over, it really cannot bail out the governments as well.
So, it’s gotten so it’s stuck, in a sense. It’s got to concentrate on what it’s got to do. But, equally, if the governments get into real difficulties, it’s going to make it even more difficult for the ECB to stop certain parts of the European banking system [from] failing. They are damned if they do and damned if they don’t. Now, I think under Trichet, who was the previous chairman of the ECB or president of the ECB, he took quite a hard line. He recognized quite clearly that he has to keep the banking system going and he’s not going to make money available for the government.
Now, when he retired, I think Draghi has taken the softer line. He has condoned – if I can put it that way – two things: Firstly, national banks’ lending to their governments and taking money up to three years maturity from the ECB in order to do so. That is sort of a temporary fix for governments in difficulty. The second thing is that he’s turned a blind eye to the imbalances that have built up in the national central banks, into banking settlement systems – which is called TARGET.
I haven’t referred to this in this in this interview, but this is actually very important, because at the moment it has built up huge imbalances, which explain why the bank runs that we’ve seen in Greece in particular, Spain, Portugal, and Italy have not produced the sort of bank-run crisis on the surface, which we are familiar with. The reason for it is the way the settlement system works. So, if I can just explain this to you, Chris, for your listeners?
Chris Martenson: Please do, yes.
Alasdair Macleod: It’s slightly technical, but I’ll try to keep it as simple as possible. Let us assume that a tour operator in Greece wants to order some Mercedes buses. He will buy those buses from Mercedes Benz in Stuttgart, which is fine. He will pay Mercedes Benz in Stuttgart. Now, in the process, what he has done is he has taken the euros away from the Greek economy and moved them into the German economy. This is balanced by the national central banks. And, in this case, the national bank of Greece will issue sufficient euros to replace the ones that have left the country. So, there is no net monetary effect.
The Bundesbank will withdraw euros from circulation for the same reason – to keep the level of euros in Germany stable, notwithstanding the fact that Mercedes has manage to get a hold a whole load of euros as a consequence of selling buses to Greece. Now, within the books of the central banks, this is balanced out by a loan that appears in their books to the effect that the Bundesbank has a loan due to it for those euros from the Bank of Greece. Then, the Bank of Greece’s books, it has an obligation, a loan, to pay the Bundesbank. So that balances out. Now, the effect is that an imbalance arises across the central banks – in this case, the cost of the buses – and suddenly you’ve got money owed by Greece to the Bundesbank.
Now normally, over time you would expect these things to balance out, because capital flows will be going one way while trade flows go the other way. But, since you also have not only the trade flows going whichever way they go, but you have capital flight, this has led to a huge rate imbalance across the national central bank’s books. And it’s got to the point now where I think the most recent figures for the Bundesbank indicates that it is owed getting on toward $700 billion euros by the other national central banks. Obviously, this is not just Greece. It’s Greece. It’s Portugal. It’s Ireland. It’s Spain. It’s Italy. It’s France. And so on and so forth.
The only central banks which have loans out to them on a net basis – and remember, this is a net basis because it’s a complete sort of settlement system we’re talking about – are the Bundesbank, you’ve got the Netherlands Central Bank and also Luxembourg. I think Finland just about in balance, but that is it. So, the reason that the system hasn’t fallen over is because the ECB has turned a blind eye to this development. These are the sort of problems that we have in the background.
None of us would have known about this if it hadn’t been through a research paper that was produced by the IFO Institute, in Munich I think it is, going into this sort of very arcane boring subject. It has now become quite an issue in Germany. The German people are beginning to think, now hold on a minute. Our central bank here is owed a heck of a lot of money by all these other central banks. Are they ever going to be repaid? So you can see this is now becoming politicized.
That’s sort of roughly where we are on where the central banks are and what they’re trying to do. What I would contend is that if the ECB tried to get into the business of supporting government finances as well, or overtly supporting government finances, then I think it wouldn’t be very quick before it would be “game over” for the euro. But so far, they are resisting that. They are doing it under the counter.
Chris Martenson: Great, I want to talk about that a little bit later. Right now I am interested in maybe six months ago, I am guessing here, the BBC had this really nice interactive chart which was a circle and it showed these arrow flows of who-owed-who-what. You don’t have to click around the circle very many times to see that with Ireland owing all these countries, and then Spain owing all these countries, and the U.S. owing all these countries, that everybody owes everybody.
Alasdair Macleod: More than that, Chris, it’s the private sector banking system that owes these things. So for example, you’ve got French banks owning Spanish bonds, and Spanish banks owning Irish bonds, and German banks owning Irish bonds, and so on. It’s really government bonds being held within the private sector banking system.
Chris Martenson: Right, and you just described a second device in this target system which sounds to me like a current account imbalance, but within a single currency. So a sort of official set of imbalances exist. Fundamentally, this was a predicament of insolvency and, of course, predictably; the ECB has a mandate to protect a banking system. The way you do that is you provide liquidity. They’ve done that in ample amounts. But liquidity and solvency are two very different concepts, usually. So, here we are at this moment where if you have a mental image, maybe it’s of fingers being put into a dike with leaks coming out. So, they’re limping along.
But, at the fundamental level in terms of what really needs to happen, there’s some sort of an adjustment process that has to happen. So, step forward, it turns out that a number of countries are being rather unwillingly – I would suggest nudged – towards the idea of austerity, Greece being the first candidate or victim, and Spain pretty far along that trail. Of course, lo and behold, it turns out austerity in the time of excessive government expenditures leads to economic contraction, which only adds another set of pressures to an outstanding pile of debt and indebtedness.
So, taking all of this into account, seeing where we are in this landscape, what if there was going to be some sort of resolution to this that was going to work, what would that look like? Is it austerity? Is it just more printing? What, if any, resolution exists here?
Alasdair Macleod: I like your use of the little word “if.” The problem I am afraid is even more complex and deeper than we had discussed so far. There is one big element of this which nobody had addressed because they don’t understand it. If you’re an Austrian economist, you will understand it. If you not, you won’t. And because governments are populated by economists who are not Austrian, then they don’t understand it and they won’t understand it.
That is this: If you try and measure an economy by GDP, all you are measuring at the end of the day is the amount of money in the economy. It is not a measure of economic progress. It’s a very, very important point. And, the reason it is relevant is that so long as you say we need GDP to not fall – which is roughly what we’re talking about as far as the problem that the officials see; they don’t want the economy to fall because it threatens taxes and all the rest of it – if they’re measuring it by GDP, then they are using the wrong metric to come up with any solution. Does that make sense?
Chris Martenson: Well, it does because one of the things I’ve harped on continuously is that with GDP, if a country goes deeper and deeper into debt to fund itself, GDP only measures the so-called economic activity that happens as a result. It doesn’t measure the offsetting debt. If you strip out the debt effect, you will find that many economies have actually in fact not been growing rather at all. And, so we’re measuring something that is illusory because it provides a gain when it’s there, but it’s going to do the opposite when it’s not there.
Alasdair Macleod: Yeah, it is, in effect, no more than an accounting identity. Now we’re in the real world and we’re trying to seek a solution to the problem. You don’t do that by concentrating on an accounting identity. This is the point that nobody in the system seems to understand. So far as I am aware, nobody is yet discussing, but this is why I think virtually anything they do is almost certain to fail. Now, if we take a step back, the one thing that is wrong with the European Union – and most of the other advanced nations by the way; it’s not just them – is the size of government. There is a myth that government can intervene and improve things. It can’t.
As you rightly point out, one side that isn’t looked at is that government spends money on subsidizing this industry. You know, whatever…paying out welfare and so on and so forth, but that money’s got to come from somewhere. Is it being taking away from the productive economy and being injected into something less productive or not productive at all? They’re destroying savings and therefore the ability of an economy to actually progress itself.
So, at the accounting identify level, governments can do this and actually push up GDP because GDP incorporates government spending at cost in the provision of services and all the rest of it. That is part of GDP. So, if government increases its spending, GDP goes up. You rightly say, it excludes the other side, and that is where does the money actually come from?
So, we actually do have a huge problem in understanding what the problem is and therefore how to resolve it. I think that the consequence of that is that the crises is likely to drag out a lot longer than it would otherwise because they are bound to resist the obvious and that is to cut government spending. You really need to slash it the whole way across the board. So, they will resist that because – the economist will tell them, and by this I mean the near capital economists – that if you cut spending across the board, then you’re going to cut GDP, which means that your tax take is going to go down and you’re just going to make the problem worse. Unless you print money to offset it, you’re going to create a huge great deflation. But actually, what they need to do is to cut the government spending, remove the distortions from the economy so that the economy can actually recover itself.
Now, you mentioned Iceland earlier. I think you know that what the currency did is a slightly separate thing from what happened in Iceland itself. The government hadn’t resorted to do anything. It couldn’t interfere. It stood back and everybody understood, We’ve got a problem. It’s a huge great problem. Somehow we’ve got to look after ourselves. We can’t expect the government to pay our welfare, pay for this, pay for that. We’ve got to look after ourselves.
They’ve done that and the result is the economy has turned around. That is what we need to happen in Europe. But they are going to resist that process till the politicians’ dying days, and that is really the problem. They are now getting in the way of the solution.
Chris Martenson: So, what you’ve described is really that there was a sort of a structural risk that was embedded into this entire construct starting back in 1997. It was exploited for temporal gain, and it worked really well while it worked as long as the pie was expanding and nobody was looking too carefully at the mounting imbalances as it chugged along beautifully. Everybody was getting rich on their Spanish villas going up in price almost daily. This whole thing was bound to work until mathematically it couldn’t work. Leaving out of this story the impact of rising energy cost, which is a big component I usually weave in at this moment, just all on its own this was bound to have a mathematical problem. It has encountered that mathematical sort of limit, as it were. Obviously it could have limped along further, but for one set of reasons or another, it ended.
And instead of saying Wow, that’s over. How did we go wrong? Where should we repair this? The very natural systemic response is to perpetuate the status quo of let’s get this through the next quarter, let’s get it through the next election cycle, let’s see if we can keep the bond markets alive another week – whatever those things are that we’re all looking at. So you painted a picture for me of a whole lot of very well meaning, very interested people who are diligently applying the wrong solutions to the incorrect diagnosis.
Alasdair Macleod: I think you have summed it up extremely well.
Chris Martenson: Well, thank you for that. So, with that excellent summary, I want to end this part of the interview, and we’re going to move on to Part II for the enrolled members. I want to get in that part very specifically what the key risks are, what the scenarios might look like as this plays out because it has more room to play out here, and I want to talk about specifically what individuals can do in that circumstance, specifically for those of us who live in Europe who are listening to this, and as well, maybe generally around the globe.
So, with that ending, can you tell people who are interested in following you more closely, besides the articles you write for Chris Martenson.com, where would they do that?
Alasdair Macleod: Well, I have a website, which is financeandeconomics.org. I also write for Gold Money. I go around and speak at various conferences and so on and so forth. But my writings can be found really on those two sites. I tend to put the longer articles on financeandeconomics.org. Gold Money’s clients like a sort of 500-word thing. I try on that one to do a fairly straightforward subject, because 500 words doesn’t give you a lot to develop something which could really be understood. But those are the two sites where you would generally find me.
Chris Martenson: Wonderful. Well, this is Chris Martenson. We’ve been talking with Alasdair Macleod. You can find out more either on PeakProsperity.com or financeandeconomics.org.