The agreement between European nations overnight is of some considerable significance for the shape of the capital markets in the longer term. I have always been sceptical that the Euro will “collapse” in the way many have predicted, not because I see anything particularly wrong in the logic — yes, there are all sorts of cul de sacs in the finances and in Europe’s banking system that seem to point to disaster — but because financial crises do not really happen that way. They are usually surprises, not something that evolves over two or three years. That was certainly the case with the GFC, and is usually the case. The very nature of markets is to surprise, because those traders who drive the market make money out of doing the unexpected.
But what I think we are now seeing is the beginnings of a new three part financial world: the English language, deregulated, approach to finance, the European managed approach to finance and the Asian approach to finance that is largely predicated on ignoring the cost of capital and subordinating finance to political and social ends. I suspect there will also be three powerful currencies emerge: the greenback, the euro and the yuan.
Global capital is seen as a homogenous development, but to a large extent it has been an English speaking phenomenon over the last decade or two. The huge transaction volumes coming out of London and New York attest to that. The English language approach to money, since the de-regulatory push of Reagan and Thatcher, has been a prosecution of a fundamental absurdity: that money, which is rules, can be deregulated. Capital can “flow freely” as if it is water. This liquid should not be impeded by barriers if it is to reach its equilibrium point of maximum efficiency. It is rubbish, of course, but metaphors are extremely powerful, especially bad metaphors. Then the whole thing was scientised: the rules were manipulated by highly numerate rocket scientists (often literally out of NASA) who took the basic rules of money and created a massive edifice of meta rules: rules, based on rules based on rules. CDOs, CDSs, interest rate swaps, volatility indexes and now micro second high speed trading. It is this folly that is at the source of the recent crises. Not government profligacy, although that is certainly real and is unsustainable in some parts of the world.
Europe and Europe’s banks have been swept along with this tidal wave, but Europe’s financial history is much more about conventional banking and conventional bonds. There is not even much of a history of share market capital in Europe, the bourses are comparatively small. Let alone all the meta money nonsense that has brought their banks to their knees. It is far more likely that they will revert to what they know: simple forms of debt and attempts to manage state profligacy in the southern countries. Meta money can only survive through the use of massive amounts of leverage because the margins are so small. It can be killed by small taxes, which take out those tiny margins. The Europeans’ interest in such taxes — and Britain’s rejection of them – is a symptom of the difference in attitude between European and English-speaking perspectives. London was actually the leader in those massive volumes of meta money transactions in the lead up to the GFC, it is a big part of the UK economy.
Asia has a very different attitude. The region doesn’t really believe in the cost of capital at all. This was seen graphically in the implosion of Japan and the ridiculous asset valuations that were never going to give a realistic return (at the time it was praised as the long term perspective of the Japanese, but in fact it was just a lack of interest in the discipline of capitalism). The same pattern of thinking can also be seen in China’s property bubble, and the extremely high levels of investment, which will also struggle to provide a proper return.
So we will have three approaches to money: the English speaking method of making returns from returns from returns from returns. The European approach of meeting the cost of capital by making returns mainly from debt. And the Asian approach of not worrying what the returns are. The first will cause many more crises, it is a game of Russian roulette with the monetary system. The second will be mired in low growth, because the underlying demographics are poor. The third will probably move in big cycles of excess and correction, much as we are seeing in Japan. It is not much of a prospect, but it is perhaps preferable to letting the purveyors of meta money run rampant playing Russian roulette with the world financial system, as has been the case of the last decade and a half. And at least some diversity affords the system with a little protection: some redundancy when money itself is put under stress.