Short decaffeinated skinny soya latte for me, and hold the whipped cream.

In response a group of Medical practitioners wrote a letter to the Observer titled “It’s simplistic to blame bad health on ‘recklessness’”. The argument goes that the broader framework of social, economic and environmental factors lead individuals to act in a particular way – people are not making entirely conscious choices about leading the “reckless” lives that they do. Much, if not all of the health behavioural patterns are a consequence of the framework that they live in.

To that end this group argues that “GPs should be directing their energy towards creating a climate in which the easy and realistic choices for people are also the healthy choices”. For example – not being exposed to other people’s smoke was dramatically affected by passing legislation. Other possibilities could include the regulation of fast-food outlets, cheap alcohol sales and advertising.

Addressing these issues is surely part and parcel of addressing the moral hazard issues relating to an individual’s health: the ultimate goal is to encourage people to take a more responsible approach to their own health, without a reliance on the taxpayer funding the NHS to sponsor treatment for the ailments that afflict individuals who act irresponsibly. The basic idea being that we don’t have a situation where “you screwed up, have a lollipop…by the way that lollipop was paid for by that tee-totaller running the marathon over there.”

Within the financial world, moral hazard discussions like this have become more prevalent over the past couple of years. The “heads I win tails you lose” notion of government backed banks led to assymetric pay-offs between traders, shareholders, creditors and taxpayers (in that order). Sorting out some of these complexities will be the goal of policymakers and regulators for years to come.

Where moral hazard issues are particularly galling are when they seem so blatantly constructed. When I worked at Lehman Brothers one of my clients was looking around the world for sovereign backed bonds to invest in – i.e. government or government backed bonds, where as long as taxes were being paid you will get paid your coupon. Part of the reason for their desire to invest in these types of assets was because, as a bank, they received a low “risk-weighting” under the Basle bank capital regulations for these investments, which in effect allowed them to easily leverage their return. Leverage was the key to getting as high a return on equity as possible.

At the time investing in French government bonds made no sense because this bank’s cost of borrowing was higher than that of the French government. At the same time this bank wanted to get some “French exposure” to diversify their portfolio, i.e. so it wasn’t all US municipal debt or Greek based debt, for example.

The French government, as it turned out, in their efforts to support their own companies over international competitors had established a very strange tax concept which allowed failing French companies a form of tax relief. In most other countries across Europe capital gains tax in profitable years can be offset against capital losses in other years – but the premise is that you have to have some capital gains to offset the tax benefit of capital losses.

In France they ditched this idea, and allowed these failing French companies to roll-up their capital losses and sell these to a profitable company, or a bank, who would pay the failing company an upfront sum for the tax credits – thereby effectively getting further investment in these failing companies, ultimately paid for by the French taxpayer.

By buying these tax credits and restructuring them, we were able to create bonds where the recourse was now to the French government; i.e. exactly the sort of risk that the investor wanted, and at a much higher interest rate than the French government was paying on its Treasury bonds. It was unbelievable that the French government had wilfully created this moral hazard.

This example is a small one, by comparison to the huge sovereign moral hazard that we are seeing in relation to Greece currently. Ambrose Evans-Pritchard blogged in the Telegraph this week about how “It pays to riot in Europe”. On Wednesday the Irish government’s debt rating was downgraded by the rating agency S&P to AA-. As of today the cost of borrowing for 10 years rose to 5.48% or “near 8% in real terms once deflation is factored in.”

Yet Greece is able to borrow from the EU at 5% and from the IMF at a staggered rate far below that. These were the terms of the €110bn bail-out.

To add insult to injury Ireland is actually subsidising this farce as it meets its share of the bail-out fund. Ireland’s pre-emptive and widely applauded austerity budget provoked no rioting or threats of terrorism, just a desperate realisation that times are going to be tough.

Whether it’s a healthcare debate or an economic one, getting someone to (metaphorically) stop smoking is going to be tricky if the benefits of continuing to smoke outweigh the merits of stopping. As it happens Greece tops the worldwide list for per capita annual cigarette consumption – not just in Europe – but worldwide, at a staggering 3,017 per adult per year. Why am I not surprised.

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The range and quality of the hardware that we are equipped with is substantial – 12.8 million Britons have smartphones for example – up 81% on a year ago. As the England cricketer Graeme Swann pointed out on his Twitter page this week: “Playing with my new iPad. Can’t believe the kids of today have this technology. When I was young it was all conkers and skipping ropes…”

And he’s younger than me. It was footballs and Panini football stickers for me, which were easily more appealing than Pac-man on the Commodore 64.

Times have most certainly changed. I recall from my mother who told me about a letter that my dad wrote to her in the early stages of their courtship. My Dad, who has fairly illegible handwriting at the best of times, was detailing a tale of how a crow had hit the windscreen of his car en route from Dublin to Belfast; a relatively minor incident for him, less so for the crow.

Unfortunately the word crow in the letter looked like the ‘r’ was missing, suggesting to my mother that a quite larger, bovine creature had hit the windscreen. She had to assume that Dad was OK on the basis that he was writing the letter, but was still quite concerned. Without access to immediate communication – a text or mobile phone call for example – mum was forced to wait. She wrote a letter back asking whether the impact of the cow had done any major damage to the car, or to my father.

All very amusing, and a situation far removed from anything we face today. Last week I was kayaking with some buddies around the remote Saint Anna archipelago off Sweden; self sufficient for 5 days pitching camp each day on different islands and rarely seeing other souls; yet we were never disconnected in a communications sense – full mobile reception allowed for text messages and the odd phone call to my wife to let her know of our whereabouts and how we were getting on.

The effect of permanently being online, so to speak, is comforting in this sense, but not necessarily ubiquitously good for the brain. A recent book by Nicholas Carr called The Shallows reflects on how the internet is changing the way we think, read and remember. His line of discussion is that our deepening dependence on networking technology is indeed changing not only the way we think, but also the structure of our brains. Who bothers to write down or memorise detailed information any more, for example, when they know that Google will always retrieve it if it’s needed again?

The only telephone numbers I know off by heart are my wife’s mobile, my own, and an old telephone number for a house in Dublin that we lived in when I was a child. That’s great perhaps, because it frees up more processing capacity, in the small leftover part of my brain.

As a Guardian editorial on Carr’s book points out: “It’s easy to dismiss Carr’s concern as just the latest episode of the moral panic that always accompanies the arrival of new communications technology. People fretted about printing, photography, the telephone and television in analogous ways. It even bothered Plato, who argued that the technology of writing would destroy the art of remembering.”

I quite agree. I’m pretty excited about the changes the internet and network permanence bring, but it is important to acknowledge where we are likely to have brain deficiencies (!) as a consequence. I’m sure our memories will get worse, because they are less tested – just like a golfer who doesn’t practice loses his ‘feel’. Another area where we are likely to become weaker is in the area of original thought, and the capacity of an individual to truly reflect deeply, without interference. Network permanence and information overload just get in the way.

Interestingly Bill Gates, the Godfather of the networked world, has always committed to a twice annual reading retreat. He spends seven days alone, twice a year, at a waterfront cottage in a secret location that he reaches by helicopter. There, he ponders the future of technology and the Internet. Through the enforced isolation he believes he is able to analyse the bigger picture with greater clarity.

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What has been the best investment the British government has made during the last 10 years? Investments in education, the health service, roads, the Olympics? All almost undeniably noble efforts, but from a purely financial perspective the investments into banks at the peak of the financial crisis look like a decent contender. In one of the most optimistic predictions so far, the Centre for Economics and Business Research said taxpayers could make £19bn from the government’s two main stakes, in RBS and Lloyds, with the assumption that the share prices will rise along with GDP. Recent results would suggest that this is a reasonable proposition.

The value of these stakes currently stands at close to £67bn, based on today’s share prices, which is actually a relatively meagre gain of about 6% on the initial investments. Undoubtedly the potential value could be considerably higher as these stock market valuations reflect the desire of the government to sell their stakes at the first possible opportunity – the consequence of a motivated and large seller in any market is that the price is likely to stay relatively low.

This raises certain questions that many people have asked throughout the past almost 3 years – August 9^th 2007 was the official 1^st day of the credit crisis when BNP Paribas announced the halting of redemptions on 2 funds that it could no longer value: What role do governments have in banking; not-at-all, temporary or permanent? Why sell if these are undervalued investments? And more specifically is it a good idea to look to sell all now, and re-privatise, particularly if those private buyers are likely to be foreign and with no specific interest in the volume of loans to UK residents, only the profitability of those loans.

Recent history shows no real answer to these questions. Some would argue that banks should always be private sector financed, and driven solely by returns to shareholders and other stakeholders. Others (with German, French and even US precedents) would say that banking is a utility, that it should be provided to a large extent by the state – much like our roads, most of our healthcare and our schools.

The Landesbanken in Germany were formed as semi-state owned banks aimed solely at financing the heartbeat of the economy, the Mittelstand – small to medium sized largely family-run industrial businesses. Similarly, after the Second World War, the French State decided to “put banks and credit to work for national reconstruction.” Shares in the four leading French retail banks were transferred to the French government on 1^st January 1946. Banque National de Paris was only re-privatised in 1993, and 17% of its shares are still held by the government – not because of a specific bailout, but because of a desire by the state to hold influence over how credit extends into the domestic economy.

State involvement in banking isn’t limited to what the US government would call “socialist” Western European economies. The US Government Sponsored Enterprises (GSEs) like Fannie Mae and Freddie Mac are effectively banks created by the government to enhance the flow of credit to targeted sectors of the economy, such as domestic agriculture, home finance and education.

The residential mortgage borrowing sector is by far the largest of these – GSEs hold approximately $5 trillion worth of mortgages.

Many would say that this willingness to lend ‘uncommercially’ led to the creation of the subprime crisis, and the credit and general financial crisis that followed. Because of this state interference the capital markets stopped working in their most original sense, and funds were flowing for political rather than economic reasons.

Worryingly, the GSEs remain prevalent, and in some cases are the only funder for parts of the US mortgage market – if their power was diminished then you really would see which borrowers have been “swimming naked” in the US housing market.

As with the vast majority of things that I write about, the real answer to whether banks should be publicly or privately funded, is somewhere between “it depends” and “I don’t know”. Broadly speaking I would side, typically, in favour of a market based solution – the private sector knows best, but it’s not as simple as that in this case. Banks are so complex that many are too big to fail – so their failure would be catastrophic for more than just their stakeholders.

As Jeremy Warner points out in the Telegraph: “Critics point to the success of Germany’s Mittelstand…as a classic example of the benefits of socially directed banking. But in truth, the export success of German manufacturers has little to do with not-for-profit, state owned banking. In fact, the crisis exposed some of Germany’s regional Landesbanken as even more reckless in their trading and lending practices than their bonus driven, Anglo-Saxon counterparts. Rather, it is to do with Germany’s high savings rate.”

This problem would have been the same whether or not the banks had been nationalised. But in the UKs case it would have been an exceptionally bad use of £120 billion of taxpayers’ money to abandon all hope of getting it back again in pursuit of some kind of not-for-profit, “politically directed utopia of freely available credit” – the performance of Fannie Mae and Freddie Mac is testament to that.

Perhaps the lesson of the UK example is that there should be cyclical involvement in banking by the state. Leave the profit motive in place, and let the banks operate on that basis, but look to pick out investment opportunities as they arise out of volatile periods; i.e. save the banks when necessary (as in 2007-2008), but make sure that those investments are done at prices that make economic sense for the taxpayer. But then again that may be an assumption of competence that goes too far.

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Dear Tony,

I see the Russians have put a space vehicle on the moon. Is there any chance of a better bus service in Bristol?”

Progress, it seems, has never served everyone equally.

This week’s Wikileaks saga involving the release by this controversial website of over 90,000 classified documents similarly serves different agendas in unequal ways. Liberals will applaud this idea of progress – the Information Age is working – while criticism will come from those who believe secrecy fosters national security.

Throughout history control of communication and information has been crucial to political control. The Catholic church in it’s early days maintained power because it was run by clerks who were literate – the Heresy Act of 1401 made it a criminal offence for a lay person to read the Bible. If anybody had an opportunity to study it, they could and probably would have challenged the authority of the Pope, rightly or wrongly.

The power of the priesthood eventually came up against the secular power of the king, for fairly base reasons, and so Henry VIII nationalised the Church; the Anglican Church then exercised its new power by telling the faithful that God wanted the king to be king. At the time church attendance was compulsory, so with few alternative information channels available, it acted as a powerful instrument of control.

The Royal Mail was established in 1660 by Charles II motivated in part, it is believed, by his desire to open his subjects’ letters to find out if they were doing anything that might threaten his authority. The ability of the CIA or MI5 to open our emails is undoubted, but certainly more of a time consuming activity given that an estimated 247 billion emails are sent every day around the world.

Luke Hansard, who gave his name to the reporting of parliament, was initially imprisoned for publishing its proceedings. Some courageous advocates for civil liberties and the freedom of the press have campaigned against restrictions – such as the Official Secrets Act – which prevent the public from knowing what governments are doing, while governments want to know what everyone else is doing.

With the growth of radio, and then TV, the Conservative British government of the day made broadcasting a public industry for the same reason that Henry VIII had taken over the Church. The BBC was, and to some extent still is, a public service for the passage of the right information into the heads of the British public.

The United States recognised the potential and importance of controlling information globally. When Bill Clinton was in the White House, the Pentagon issued a document called “Full Spectrum Dominance”, which stated that the US intended to establish control in space, land, sea, air and information, of which information was the most important.

The latest Wikileaks download alters any notion of the US government maintaining so-called full spectrum dominance. Many will cheer at this notion. Exposing facts must surely be in the interest of all, yet on the flip-side, for all of human history controlling information has been a central tenet of governance – sometimes for devious means, and sometimes in my view, for sound reasons. If the Official Secrets Act had not existed I’m sure that the D-Day landings may have transpired very differently.

In a recent TED talk, Julian Assange – the Wikileaks founder – openly talks about how a document his website released exposing the corruption of Kenya’s last leader, Daniel Arup Moi, materially affected the outcome of the most recent elections. He celebrates this – as do many of his advocates around the world. In principal so do I.

What concerns me, however, is that his approach to forcing change is like shoving a screwdriver into the spokes of a moving bicycle. It might be the right thing to do (exposing the information, not sticking the screwdriver into the wheel), but handling the short-term consequences isn’t straight-forward, and may be even more destructive for many than the status quo. There were 90,000 classified documents exposed on Wikileaks last week, adding to a total of over 1 million documents posted. As individuals we cannot possibly engage with all or even any of this ‘original’ material.

We will rely on soundbites from media commentators to help form our view of this information. Those soundbites will understandably focus on the shocking and not the mundane. More information is not universally helpful – it is good when we are capable of processing the key points – yet the scale of information that the Information Age is throwing at us in such an exponential fashion is too much for the lay person to digest and process in a complete way.

“A little learning is a dangerous thing; drink deep, or taste not the Pierian spring: there shallow draughts intoxicate the brain, and drinking largely sobers us again.” Alexander Pope, An Essay on Criticism, 1709

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Under the old driving regulations in Ireland there was no ‘points’ system for speeding related offences – it was a purely financial based fines system. In old money, pre-Euro, it was around £30 punts, and latterly 50 euros for anything but obscene speeding offences. No wonder Ireland has had one of the worst records in Europe for driving accidents (

Back in the late 1990s, our university golf team used to travel throughout Ireland playing matches against local clubs and so the odd speeding fine was picked up – once even by yours truly. Surprising, not least because I didn’t think the clapped out Ford Fiesta I was driving had the ability to pass the 70mph mark. I think I must have been going down a very large hill. I hasten to add that once was enough as £30 would have covered a fair amount of my monthly budget. In my case, it was a sufficient sum to act as a deterrent.

On the flip side, one of the members of the golf team was a mature student who in his own understated way had “made a few quid” out of a technology company he had set-up and sold before the dot.com boom imploded. He drove an Alfa Romeo and a seat in his car on the way to golf matches was a prized position – you travelled in style and got to your destination quickly; very quickly at times. In one journey to Lahinch on the west coast he was stopped three times for speeding. I sat in the front passenger seat on this journey and handed him his cheque book from the glove compartment each time for him to pay his fine direct to the Garda (police officer) who had stopped him. Five minutes later he was back cruising along at Mach 1, truly undeterred.

Fines act as deterrents to different people in different ways, but what was clear was that the Irish driving system didn’t work for our flush friend.

I was reminded of this tale this week while reading about the SEC settlement in its fraud suit against Goldman Sachs, relating to the creation and distribution of the Abacus transaction. The settlement ($550 million) marks the steepest penalty ever doled out by the regulator against a Wall Street institution. As the FT pointed out, the settlement may as well have been for $550 – if past performance is anything to go by Goldman’s trading desks will have made up the half billion dollars by the end of next week. For them it is the equivalent of opening the glove compartment, taking the cheque book out and writing a quick, relatively painless cheque to the market’s equivalent of the Garda.

While this may sound cynical, it is to be expected: $550mm is equivalent to 1.2% of Goldman’s 2009 revenues – or 3 days worth of revenues. Alternatively, it’s 3.4% of its annual compensation bill; that’s a $34,000 reduction per $1,000,000 bonus payout, which isn’t exactly going to throw you off your stride. For further context:

1) The fiscal 2010 federal deficit in the US is currently projected at roughly $1.2 trillion. Goldman’s $300 million will lower it by only about 1/25th of one percent.

2) The UK treasury took in twice the amount — £600 million — by imposing a bonus tax.

3) The funding gap in the UK’s public sector pensions is estimated at around £1.2 trillion. The $100mm (roughly £65mm) the mostly state owned RBS will receive in this settlement is 0.0000065% of this figure.

In this particular case, however, the funds will be distributed between the so-called “victims” – a German bank called IKB and the Royal Bank of Scotland, who assumed an $850mm position in the Abacus transaction when it acquired ABN Amro. Both of these self confessed ‘professional’ investors showed an unhealthy level of incompetence in both this transaction and in the other activities in the run-up to the credit crunch. It’s hard to believe that they deserve the $550mm worth of funds from Goldman more than the US or European taxpayer. Anyway, that’s another story in the ever increasing moral hazard saga of this financial crisis.

This penalty is symbolic, and it mainly appears to show the weakness of the SEC’s legal case – which is different from it’s ethical case. As with the financial regulation bill in the US, the financial services sector was braced for something truly painful, and should now feel mightily relieved, which is a case of a regulatory opportunity missed.

That said, the SEC will also try to make examples of other banks – it needs to justify all the hiring for its new ’structured and new products’ unit. Banks are still risky and will be fined for the same practices, but insufficiently so to make any great difference to operating practices. It will be the equivalent of stopping the Alfa Romeo for 10 minutes to pull the cheque book out of the glove compartment. Plus ça change, plus c’est la même chose.

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Formal scenario planning for companies got going in the 1970s, presumably with the rise of management consulting businesses.  Though oil prices had remained stable since World War II, leaders at Royal Dutch Shell worried that disruptive change could happen with severe adverse effects on their business.  Among the disruptive events they feared was a sudden increase in the price of oil caused by the emergence of the Organization of Petroleum Exporting Countries (OPEC) cartel.

The Yom Kippur War of 1973 strengthened Arab opinion against “the West”. Furious at the emergency re-supply effort that had enabled Israel to withstand Egyptian and Syrian forces, the Arab world imposed the 1973 oil embargo against the United States and Western Europe and as a consequence oil prices shot up dramatically.

Many oil companies struggled with the effects of the new competitive dynamics.  Shell on the other hand thrived.  They had prepared a plan – a scenario plan – for what they would do as these circumstances unfolded, and they implemented their plan while others were just gathering to deliberate on their next actions.

I had lunch with my Dad in London last week and he talked about how BP, who were a client of his, regularly (twice yearly) used to run intense “disaster recovery” situations for their senior management – this was back in the 1990s. These situations would be set-up with actors and the whole movie industry paraphernalia, and would be an institutionalised part of senior management’s diaries. We presumed that given the recent deepwater drilling shocker, and Tony Hayward’s foot-in-mouth media soundbites, that these sessions must have fallen in their importance or by the way-side completely.

In one of these trial scenarios there was a simulated explosion at a refinery pipe on the south coast of England which had left an unspecified number of BP workers dead, and as it turned out at a later briefing session, a primary school in danger from further explosions. My Dad’s client, who had been part of this scenario response, told him that things had gone very well until he got into a lift while taking a break. He had started chatting to someone about how they were getting on and told this person that solving the primary school issue was going to be a tricky public relations tester. The lady in the lift, who was an actress, then told him that she was a reporter for the Daily Mail and that his little insight would be tomorrow’s front page news.

His lesson for the real disaster situation had been learned – be careful who you speak to at all times. All painfully real and as a consequence very effective management training because of the seriousness with which the scenario was taken.

Before Lehman Brothers collapsed in late 2008 its risk management teams would have been performing scenario analysis of a kind on a daily basis. Aside from the daily Value at Risk metrics for calculating the daily potential losses across its balance sheet, they had disaster recovery plans in place ever since the World Trade Center attacks in 2001. These plans would ensure business continuity in the event of another such incident – crucial in a trading business where hundreds of millions of dollars are at risk on a day-to-day basis.

One of the fundamental issues with many of the theoretical “what ifs” that many organisations, like Lehman, test themselves with is that too many “what ifs” are dismissed as so unlikely as to be worthless in their testing. If senior management at Lehman had been tested with the questions: What if housing prices fall by 15% year on year? What if money markets suddenly seize up, so that interbank liquidity is virtually nil? What if a AAA rated counter party suddenly declares massive fraud and goes into bankruptcy proceedings?

In the middle of 2007 all of these questions would have been dismissed as “six sigma” events, i.e. so unlikely as to not be worthwhile thinking about as there was no statistical precedent. With hindsight, I’m sure there are many people who wished they had prepared answers to these questions, and put a framework in place to deal with such unlikely probabilities. Even if they had merely asked the questions then the answers would have made them better at considering the direction the business should be taken.

Our systems are never as resilient as we would like to think they are.

The latest budding failure in the scenario planning world is developing around the stress tests that are being imposed on 91 of Europe’s biggest banks. As a recent Credit Suisse report noted: “We doubt that stress tests would be announced if they were going to disappoint the market.”

Stress-tests are the Catch-22 of banking supervision. Their purpose is to demonstrate that banks are safe. To do so, the tests must be rigorous. Yet because their purpose is to bolster confidence, their rigour is bound to be doubted. Unless the tests reveal that the banks are in a terrible mess. In that case, the stringency of the tests would be proven, but the primary mission of reassurance would have failed horribly.

The tests apparently don’t look at the what would happen if Greece defaulted, nor if there was a liquidity breakdown in the interbank markets as a consequence. Yet these are two scenarios that the markets perceive to be highly probable.

The trick is, as with the folks at Royal Dutch Shell in the 1970s, to do your stress testing early and often. For the European banking system this is all coming too late – the answers will be either too unpleasant or too unrealistic to be of any great use.

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People writing on the economic crisis (or any topic for that matter) do so for different reasons. Forming a practical response to the factors that caused the crisis would tend to fall well down the list of reasons for journalists putting pen to paper, or hand to keyboard. To deal in practical realities is akin to hard work. Where journalists and commentators have an advantage over policy makers is that they can live in an idealistic world, separated from the practicalities of implementing any of the ‘fixes’ that ailed the economic system in the past.

It’s easy to say that the trade imbalances between China and the US that developed over the past 15 years were a key cause of the financial crisis, without ever having to really discuss how things could have or should have been different in practical terms. Similarly, analysts can point to the situation, for example, that banks like Lehman Brothers being close to 50 times leveraged against their capital was a blatant failure on the part of regulators, shareholders and the bank’s misaligned management team. Likewise, the securitisation market, which allowed banks and other financial institutions to shift mortgages, credit card debts and the like off balance sheet was a key tool in the armoury of banks as they looked to window dress their regulatory capital position. It was also the key tool in allowing the huge expansion of credit between 2000 and 2007.

All of the above has been written about in countless articles, so in a sense it is the ‘accepted wisdom’. Yet, when it comes to mapping political responses to this analysis it’s clear that the practical issues of reforming the structure of financial markets are sufficiently difficult that much of the accepted wisdom is being by-passed in favour of pragmatic deferral – what I’m choosing to call ‘the fudge factor’.

As a case in point – it is broadly recognised that serious structural changes are required to the rules for bank capital. Journalists suggest that banks clearly need more of the stuff, as did many policymakers at the recent G20 meeting in Toronto; politicians on the other hand want them to lend more – and central banks, whose liquidity lifelines have kept the sector ticking over, now want to withdraw that support. It’s not easy to manage each of those concerns simultaneously – forcing banks to raise more capital and getting them to lend more don’t necessarily go hand-in-hand.

With the pressure on to raise cash and free up balance sheets, banks are now looking to revisit an old favourite of the pre-crisis era. Securitised products, which many commentators point to as being central to the financial crisis, are seemingly back on the agenda. Many central banks and governments are hoping that a ‘new form’ of more transparent securitised products can help address the issue of undercapitalised banks and lack of credit simultaneously, even though we all accept that such a thought process allowed us to get into a mess in the first place. The ‘accepted wisdom’ goes out of the window when short-term practicality is at stake.

In the first seven years of the past decade the securitisation sector expanded at an amazing pace, providing an ever increasing proportion of the credit which fuelled western growth. By mid-2007, for example, upwards of $8,000bn worth of assets were securitised – ie funded in these markets – which represented more than half of all credit creation in some sectors.

But since the onset of the financial crisis, these markets have collapsed. Last year, for example, just $4bn worth of collateralised debt obligations were sold, compared with $520bn in 2006. In Europe, about €30bn of securitised bonds have been sold this year, compared with more than €500bn before the crisis.

So far, few non-bankers have really noticed this collapse, largely because governments have stepped into the breach, papering over the massive funding hole. In the US, for example, the Federal Reserve has bought $1,250bn of mortgage-backed securities. In Europe, the Bank of England and ECB have gobbled up mortgage-backed bonds, and other securitised assets, via repo deals. Before 2007, eurozone banks sold more than 95 per cent of their securitised products to private sector investors; now it is under 5 per cent – with the rest going mostly to the ECB.

The crucial question is: how long will this pattern continue? Unsurprisingly, all western central banks are deeply uncomfortable about the fact that they have replaced, or become, the securitisation buyer. They are understandably looking for exit strategies and urging the banking industry to restart the securitisation machine. Against that backdrop governments are demanding that banks they own or part-own should lend more. Furthermore, financial journalists continue to point out the role that securitisation played in the financial crisis developing in the first place. Everybody can’t be right at the same time.

In 2007, when securitisation bankers were tucking in to the champagne, a large source of the demand for securitised bonds came from quasi “invented” buyers – that is, banks and bank-funded vehicles that were developing investment strategies to take advantage of regulatory and rating agency loopholes, fuelled by artificially cheap loans.

Cheap funding has since vanished and governments are determined to close all those loopholes. As a result, those invented buyers have disappeared. So how can we have a situation where we find a new funder (other than government) for the $8 trillion worth of funding that has disappeared and where banks are better capitalised leading to a safer financial system?

The fundamental answer is that pursuing these tasks simultaneously isn’t possible. Nor is it possible for journalists to blindly utter the mantra that securitisation is bad, bank capital is insufficient and that we need more credit available to our businesses, and think that if we follow each of those paths that things will work out economically.

That leaves G20 leaders with an unpalatable choice: either the government continues to replace the securitisation market indefinitely, to maintain credit growth, or it must adjust to a world where credit is far more rationed and costly. That first option is hated by most central bankers. However, the second is disliked by most politicians.

If you want to understand what could happen to global growth, then understanding what is happening in securitisation now – or more specifically what is not – is hugely important. Who is going to fill that funding gap for the long term, and what will the economic ramifications be? Without that financing where will global demand come from? We are fudging our way through at the moment, pretending that things will work out for the best.

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By the time Osborne had finished speaking the purchasing power of the pound in my pocket had (by foreign exchange market standards) rocketed northwards past $1.50, and yields on gilts (the interest rate of UK debt) had fallen considerably – and for those in the bond and currency markets the UK was suddenly a considerably happier place.

In cliched footballing speak (you’ll be hearing plenty of that as the excuses mount this week): At the end of the day, the lad Osborne gave 110% and you can’t ask any more than that. Fair play to the lad.

But what lies beyond this austerity? And are the bond and currency markets right to be sanguine?

This week’s blog could be kept very simple – and I could just say “no they aren’t” – that cutting spending and raising taxes is not a panacea for all that ails the UK (or many European countries). I should probably write a few more lines though to fill this out a bit.

The rate at which bond markets can make debt servicing unsustainable is rapid and having their backing is crucial when you have a deficit as large as the UK does. It is that issue which has been rightly addressed in this Budget. But over time big structural changes are required: The only meaningful way in which the UK Exchequer can pay off its debts is through increased tax revenues from an increasingly competitive and productive private sector – GDP growth needs to be trending upwards from the current 2.1% annualised projection. Achieving that, unfortunately, is considerably harder than pursuing austerity in public spending.

This aspect of solving the UK’s problems, albeit seemingly quite simple, is not widely commented on in the financial press, or political circles. The vast majority of discussion at the moment revolves around the timings of fiscal austerity.

In this debate, in one corner stand the “growth now” camp, who argue that expansion is a pre-requisite to service a country’s debts sustainably. Without it tax receipts implode, investment is turned away, and meeting future debt payments is harder. This camp is adamantly against Europe’s shift towards austerity, questions Tuesday’s tough UK budget, and urges countries like Germany to adopt expansionary policies. Some advocate additional fiscal stimulus even for high deficit countries, like the US.

On the other side of this debate stand the “austerity now” gang. They point to worsening sovereign debt ratings, in particular to the fact that (despite Europe’s rescue package) Greek and Spanish debt risk is back to worryingly high levels. Furthermore this group are concerned a coming sell-off in equity and corporate bond markets will deter new investments and exacerbate many countries’ debt problems. For this camp, the US request that others postpone fiscal adjustment is irresponsible. Instead, they want budget cuts to lower risk premiums and stave off disruptive debt restructurings.

In that debate, I’m firmly with the cut now approach on the basis that the rug can be pulled out from under you by bond markets if you don’t have a credible financial plan in place, and that cutting now is always easier than later. In the end, however, both camps are somewhat right and somewhat wrong.

Mohamed El-Erian – a big man in the bond world as Chief Investment Officer of PIMCO, seems to have been one of the few people that I’ve read to really clarify the issues at stake. Politicians across Europe should take note, not least because of the size of their sovereign debts held by PIMCO. In his Op-Ed in the FT this week “Beyond the false growth versus austerity debate”, he points out that austerity or fiscal expansion is only part of the process for remedying a large budget deficit – but of itself is insufficient.

“As a general rule industrial countries need to adopt both fiscal adjustment and higher medium-term growth as twin policy goals. The balance between the two will vary. Some, like Greece, need immediate fiscal retrenchment. Others, like Germany, the US and Japan have more room for manoeuvre. But no one should pursue just one of these objectives.”

For a country such as the UK, once we have accepted the need for fiscal austerity, the fundamental question is where does the ‘higher medium term growth’ come from? It’s when you pose this question that bond and currency markets should retain the right to be considerably concerned.

From a policy perspective it’s not clear what the strategy is; I can’t think of a single politician who has spoken coherently on the issue of where private sector growth really comes from. There have been various promises of past and current governments to address the need to bring back manufacturing competitiveness for the UK – once the powerhouse of economic growth. In reality this is hard to do – very high tech manufacturing does have a place in the UK’s high margin economy, but car production and the like are now genuinely low tech and are right to be outsourced to China, or elsewhere, where monthly incomes of production plant employees are closer to $200 a month rather than $3000.

So how can the UK be competitive in high tech manufacturing, bio-technology, green technology and the nano sciences – all of the high end, high margin industries that are used as buzz words by policy makers? If it is to be the case that the UK is creating truly world class companies who employ lots of people and pay lots of tax then it will not come about by accident.

The UK does not have vast natural resources (or virtually any for that matter) like Norway or Canada, nor does it have endless supplies of cheap labour, like India or China. What it does have is lots of relatively well educated people – that is the main resource; the UK’s source of a competitive advantage.

Developing that resource through a more strategically orientated approach to 3rd level education has to be a critical part of addressing the “structural deficit”. It’s no accident that the likes of Silicon Valley has produced companies like Apple and Oracle – world leaders in designing high tech software. These companies appear because of the links between venture capital and the best of what is happening in departments at Stanford, MIT and Harvard.

In Ireland, I’m optimistic when I understand that one the main reasons Intel has invested so much there, and created so many jobs, is because the nano-sciences department at my old university (Trinity College) is producing a stream of truly exceptional people in that field. The department is ranked number 2 in the world, on a budget that is approximately 1,000th of the size of the number 1 ranked University for that subject in the world. For a high cost, high margin, open economy like Ireland it is these successes that need to be copied and replicated.

The same goes for the UK, or else austerity may not be merely temporary.

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He sees the “rise of the rest”—the growth of countries like China, India, Brazil, Russia, and many others—as the great story of our time, and one that will reshape the world. Certainly, when economists focus on the means by which we will pull ourselves away from a global recession, it is the “emerging” countries that are described as our saviours. Their growing middle classes are the new engine rooms of global growth which will compensate for the overpaid or work-shy economies of the “old” world.

The tallest buildings, biggest dams, largest-selling movies, and most advanced cell phones are all being built outside the US or Europe. This economic growth is producing political confidence, national pride, and with it many potential international problems as we manage the transition from ‘old’ to ‘new’ world order.

At this very moment we observe trading relations between China and the US being tested in new ways – David is becoming Goliath – and the once impregnable negotiating position of the US has been significantly weakened. The US still retains a significant advantage over the rest of the world as the largest GDP growth contributor, with almost 25% of global GDP, and as the controller of the world’s reserve currency. But as Zakaria points out, there is a gradual erosion taking place.

Ironically the US led push for more open international trade and freer movement of capital has empowered countries like China and India to create export led economic growth – and with China’s trend growth rate having pushed towards double digits for the past decade, it won’t take long for the world’s most populous country to become the economic powerhouse it should be. PWC has predicted that the Chinese economy could be as large as the US by as early as 2020.

What does it mean to live in a truly global era? While the changes we are seeing are bound to produce international conflicts – hopefully of a non-violent nature – the benefits of a globalised world are extensive.

At a micro level the internet age and open capital markets make a powerful combination. I received an email last week from a group called Kiva, who I’ve mentioned before in this blog. They operate a micro finance lending business from the UK targeted at small business development in emerging countries. The email was in relation to my portion ($25) of a $675 loan to a lady called Patience Johnbull who lives in Delta State, Nigeria. She runs a bread making operation, and was looking for a loan in order to expand her enterprise.

The power of the internet is clearly demonstrated by the fact that I can be connected (and hopefully helpful) to a lady I will probably never meet, in a part of the world I’m unlikely to visit anytime soon.

The content of the email was as follows:

Patience Johnbull in Nigeria (Activity: Food Market)

You Loaned: $25.00

Newly Repaid: $3.13

Total Repaid So Far: $12.50 (50.00% of your loan)

Repayment Status: Paying back on time

View loan profile at:

http://www.kiva.org/lend/166553?_te=ru

To me this represents the best form of venture capitalism there is. The difference between this loan working and not doesn’t matter much to me – it’s a punt; a true ‘venture’. At the other end, I’m sure it makes a world of a difference for Patience Johnbull to achieve her worthy ambitions, but fundamentally it is not charity. In the globalised world that we live in Patience is competing for capital against entrepreneurs of different types all over the world. She is demonstrating that she is good enough in that competition and I’m glad she has the chance to better her situation for herself and her family.

In great contrast – across the so-called Western world we are entering what is being termed by the Financial Times as the Age of Austerity. The UK is about to embark on cut backs in public spending that are virtually unprecedented. There will be undoubted recrimination amongst those who lose out. These countries simply cannot afford to sponsor, in what I would term a charitable fashion, the bloated public sectors that are now disproportionate to the size and growth rates of the private sectors that support them. We all want to have better healthcare, roads, childcare and the like – but as Patience Johnbull knows living in Nigeria – the state can’t necessarily afford to pay for it.

As Fareed Zakaria pointed out in the Post American World the next 20-30 years in the world economy will not be about the decline of the fortunes of those in first world countries like the US and the UK, but more about the “rise of the rest”.

I take a great deal of heart about the idea of people like Patience Johnbull being empowered to make a difference in their own worlds, and as the sort of people who will help emerging economies grow their way out of poverty. In the context of their existence I have little sympathy for the relative austerity that is going to be deposited upon the West. The austerity period will hopefully focus the minds of those affected that our previous standard of living shouldn’t be taken for granted.

We are in competition. Check out www.kiva.org and see some of who we’re up against.

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Of the 25 economists who took part in the survey, 12 predicted that the euro would not survive in its current form over this Parliamentary term, compared with eight who thought it would. Five said that they didn’t know.

I’m not sure if brain surgeons were allowed to be as diverging in their views that things would pan out as well for those going under the knife. Such are the luxuries of the world of the economist – it tends not to be remembered whether you were right or wrong, but more how confidently you state your claim. It’s lucky for them that there’s nothing important at stake – it’s only money.

Anyway – the potential ‘death of the Euro’ is only one of a number of interesting conclusions from this survey, including some thoughts about the prospects for inflation or deflation in the UK, where again there is plenty of variety in the views expressed. On balance the economists see inflation as the more likely danger, as the government looks to erode the value of huge debt pile it owes. I would tend to agree.

This topic, although it sounds pretty dull – whether prices will go up or down and by how much – really is at the epicentre of all that is going to guide the world’s economic success or failure over the coming years.

The report card for the global policy response to this economic crisis is broadly a case of so far so good. Policymakers have had the ability to pump liquidity into the financial system to stimulate economic activity without causing significant inflation, and to do it in sufficient size that the risk of deflation has been minimised.

The task of maintaining this so-called Goldilocks situation is getting trickier and trickier, however, and the proverbial can hit the fan very quickly if policy-makers start to make a mess of it.

Divergence of opinion between economists on this issue is genuinely understandable. After the mini-inflation scare following the ECB’s bailout plans for Europe, we seem to be having a deflation scare. Prices may be sneakily rising in the UK, but Spain is now in outright deflation (exclude energy and food, and prices are falling) and core inflation across Europe and the US is very low. In Ireland prices have recorded falls for 17 consecutive months.

The fact is that the substantial money-printing across the world has not yet brought us proper inflation simply because the mechanism for passing it on isn’t working very well: the world’s banks are too busy repairing their balance sheets to lend it out. European banks own so much of the sovereign debts of other struggling European countries, some on the brink of default, that the prospect of maintaining or increasing lending rates has to be a difficult one to contemplate. The increasing Libor rate – the rate at which banks lend to each other – is testament to these concerns.

But there is nothing like deflation to bring on hyperinflation: governments desperate to prop up prices and economies, despite being broke, print reams of money – money that eventually enters the market in a rush, flipping deflation to inflation almost instantaneously.

The Weimar government in Germany in the early 1930s is a good example – the huge reparation payments demanded by foreign governments after German defeat in the First World War led to deflation for a period of time as economic demand dried up domestically. This rapidly flipped to hyperinflation as printing money became the best way to ‘afford’ reparation payments, in the absence of sufficient tax receipts from a struggling domestic base. The government soon collapsed and paved the way for the far right views of the Nazi party to be broadly supported, and we all know that particular episode of history didn’t end too well.

While the economists in the Telegraph survey are on balance in the inflationary rather than deflationary camp, there is still a significant minority who don’t follow this view. With prices already edging down, substantial excess capacity in the system, and the Eurozone about to withdraw large amounts of demand from the world economic system as lean times bite, it is reasonable to worry that a Japanese-style deflation is in the the Western world’s future.

If this is the case, it is hard to reverse: knowing that prices are declining, consumers defer purchases, which causes prices to fall further, which in turn causes consumers to keep their wallets and purses zipped. This death spiral resulted in Japan’s so-called ‘lost decade’.

On the flip side; with many governments running huge deficits, while simultaneously printing money, we may have an inflationary spiral, with the value of the dollar declining, savers devastated, and interest rates soaring as investors demand higher and higher rates for their money, knowing they will be repaid in dollars with reduced purchasing power. In that context the flight to gold seems to be a pretty sound strategy as it’s widely accepted as a hedge against inflation.

Or, if you prefer your inflation to be of the imported variety, the tale of woe is along these lines: The declining euro, headed towards parity with the dollar, will limit US exporting capacity. The US will ‘import’ a financial crisis, as its banks take big losses on sovereign debt and on loans to Greek and other enterprises. Already, banks are hoarding money, and companies have decided to rein in borrowing, given the uncertainties in credit markets.

There are sound arguments for the occurrence of either inflation or deflation. My bet is on a period where we teeter on the brink of deflation as excess capacity builds up across the global economic system. Policy-makers will continue to do all they can to ensure that deflation doesn’t become widespread; quantitative easing, low interest rates etc., and we will run the gauntlet of a sudden flip into hyperinflation. Over a reasonable time period (5-10 years) I think managing to avoid significant inflation is very unlikely.

Like most economists, I am almost sure that this will be the case. That is to say that I am 20% certain.

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