There is something rum going on in the financial economy. Those markets that are supposed to allocate capital to the people and places that can use it best are coming up with some rather peculiar results. Is this a transitory fever, or something more chronic?
In case you missed it, here’s a roundup of some recent news from the outer fringes of capitalism. Artist Damien Hirst sells some digital pink dots for $20 million, give or take. That figures. The cryptocurrency Bitcoin is heading towards $100,000 a piece. And why not? Digital kittens change hands for fortunes. Well come on, who doesn’t need a crypto-kitty or two?
Just a normal season in the new market economy then, where lines of binary code (purpose: yet to be determined) are the biggest investment craze since the last investment craze.
Oh, and what’s this? A large UK finance company and associated bank collapses and threatens thousands of jobs, with the taxpayer potentially on the hook for billions. Now that sounds…rather real, and rather bad.
Unlikely as it may seem, there is a thread that connects these seemingly disparate developments. It’s a thread that runs right through the economy not just of the UK but most of the Western world, a thread that connects ever more barmy investment propositions in the financial economy with the real world of factories and jobs in prosaic industries like steelmaking. The thread is spun by our long-running addiction to zero interest rates, and the increasingly crazy ‘hunt for returns’ that zero rates encourage.
To cut a long story short, central banks have been forcing down ‘real’ interest rates (that is, adjusted for inflation) to zero or less ever since the financial crisis. In late 2008 the Bank of England base rate was 4.5% (which was historically low). In early 2009 it was 0.5%. Today it is 0.1%: that’s actually a negative real rate (because inflation is closer to 1%).
Before we get on to why this ends up stoking a frenzy for digital kittens, let’s remind ourselves of how the interest rate trick works. Interest rates are supposed reflect the cost of capital. In ‘normal’ times the cost of capital is determined by what return the owners of capital are prepared to accept, with the reference point being demand for long-term government bonds. A central bank can dial its base rate or ‘policy rate’ up or down if it chooses, but over time it cannot fight the bond market. The bond market is boss.
Or was. Because that was before the central banks came up with a way to create artificial demand for bonds by the simple expedient of buying them. This was something invented in Japan after the dotcom crash, taken up by the US Federal Reserve in 2008 and quickly copied by the Bank of England and the European Central Bank. Known as ‘quantitative easing’ to its proponents and as ‘financial repression’ to its enemies, the bond-buying programme forces down long-term interest rates and floods new money into the financial economy. A lot of new money.
And yes, the money is ‘new’ because the central bank simply creates a credit on its balance sheet which it uses to buy the bonds. The bank doesn’t have to ‘borrow’ the money. It just invents it, allowing the government to effectively buy its own debt. And it works, so long as everyone has confidence in the system.
To hear the Bank of England tell it this is all great because the almost £1 trillion of bonds it has bought since 2009 have had the effect of “making it cheaper for households and businesses to borrow money – which encourages them to spend and invest”.
But invest in what? When policy is to crush interest rates to zero or below, suddenly there is less incentive to invest in the normal stuff like low-risk government and corporate debt. Why finance a few more machines or computers for a business when you can buy a blockchain token for Dragon the crypto-kitty (a character in an online game) for almost half a million dollars and maybe sell it for double the next week?
There has always been crazy money doing crazy things. But zero rates and quantitative easing have now been around for so long that crazy money is on the way to becoming the new normal. And the crazy stuff is seeping out of the financial pressure cooker and into the real economy.
And this is where we get to steelworks and trade finance.
Earlier in March one of the UK’s largest trade finance companies, Greensill Capital, collapsed and went into administration. It became immediately apparent that Greensill threatens to take a lot of other businesses down with it, including the GFG steel group that employs 5,000 workers in the UK, where it has 12 steelmaking sites, with more worldwide. Greensill was the main lender to GFG to the tune of about £5 billion, of which £1 billion or more is covered by UK government (ie, taxpayer) guarantees.
What happened at Greensill is still surrounded by a lot of smoke, but as administrators and accountants pick over the debris one thing is becoming obvious: the Greensill collapse is a case of zero interest rates at work in the real world.
Trade finance is an old business, but Greensill had a new take on it. Instead of just lending against trade invoices for a small premium, why not create an additional circular flow of cash by packaging up those loans as investments and selling them on to yield-starved investors? Preferably investors who would not take a very close look at the credit quality of those debts. And in the zero interest rate world, you can always find plenty of those investors.
One point of interest here is that these investments were not just bought by the world’s buccaneering risk-hungry super-rich, but also by staid outfits like German municipal authorities who could not resist the lure of fat returns in Credit Suisse’s $10 billion worth of Greensill-backed funds, when the alternative is negative interest in a German state bank.
If those investors had taken a close look at what they were buying they would have found all the classic signs of an overheated financial construct. They would have found a dizzy spiral of related-party transactions, companies that ‘lend’ to themselves and ‘borrow’ from themselves, proxies who ‘buy’ things they already own, all to create the impression of returns from a vacuum. If we ever thought those arrangements were confined to the self-referential world of digital art and the trade in encrypted mysterons then it’s time to think again.
The real cost of all this is yet to be counted. Greensill has collapsed. The future of many thousands of jobs in GFG and other companies that Greensill financed is uncertain. The trail of destruction extends worldwide, drawing in investment funds, global insurers, banks, governments and, of course, the poor saps who pay tax to them.
And this is only one case. So long as money costs virtually nothing and has nowhere rational to go, you can bet your last digital kitten that Greensill will not be the end of the story.
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