Thursday, November 10, 2011

Wanted: Debt officers and institutions able to enforce debt settlements across countries....

Wanted: Debt officers and institutions able to enforce debt settlements across countries....

One hundred and fifteen years ago, on May 26, 1896, the Dow Jones Industrial Average, an index of a few companies, was first published. Charles H Dow, the driving force behind it, predicted that these companies, specializing in coal, copper, steel, flour, sugar, needles, wire nails, hay, glue and, for a light touch, whiskey, would shape the great industries of the future. Perhaps not a very good prediction, but it certainly beats those by any of today's astrologers - macro-economists, I mean.

Now that bond markets signal to many countries that if they continue with their present fiscal and regulatory policies, there is a high chance they may default, it is the right moment to look at the stock markets, bond, currency and derivative markets around the world - and take stock. Just what exactly can these markets achieve - and what it is that they cannot achieve under the present international arrangements? More important: what type of institutions do we need both to enforce debt settlements and, perhaps more important, to prevent governments from spending and borrowing too much?

Economists and academics of finance have long argued that stock markets perform two primary functions: to help the investment of savings and to help raise capital for growing companies, although famed investor Warren Buffet once said that: "As far as I am concerned, the stock market doesn't exist. It is there only as a reference to see if anybody is offering to do anything foolish."

His observation captures the nature of stock and bond markets, thought capturing it does not necessarily mean that it is easy to make money from such accurate perception - as Mr Buffet's own performance over the last 13 years shows. In US terms, his Berkshire-Hathaway investment company made roughly 1% per year; if you were Canadian or Australian and did not hedge, you would have lost about 1% per year over this period.

At all times, managements of companies commit mistakes. Someone must discover them. To make such discoveries requires dedicated detective work. It includes reading through annual reports, footnotes included; comparing one company's management and internal organization with others'; having a broader vision where society is heading; evaluating what demands are of a more permanent nature and which ones are of a more temporary one.

Just as there are few entrepreneurs with vision who do not adhere to herd instincts, there are only few good financial detectives who can do a better job than numerous others in evaluating companies not by their market value, not by articles in the media, but by judging the respective managements' ability to solve problems.

Mr Buffet's and other good financial detectives' intervention and redirection of savings is, indeed, one of the ways in which stock and bond prices are adjusted, correcting others' mispricing. In other instances, the introduction of a financial innovation brings about the adjustment of stock and bond prices - whether it is high-yield bonds, derivatives, credit default swaps and so forth.

As the discovery of mispricing takes time - consider how many years elapsed between identifying the problems in the US real estate sector, and being able to act upon it - some stocks and bonds would be traded at "foolish" prices, either too low or too high. Such periods are of limited duration - though that may mean years. Mr Buffet is thus quite right: financial markets main role is that they help speed up identifying mispricing and signaling that solutions must be found.

However, the way from accurate identification toward taking positions to making money from such actions is not obvious. It takes time for management and boards to react, and unless there is a decent takeover market, management and boards can take their sweet time - even if the process did not involve politics. The Ancient World struggled with the question of "guarding the guardians - accountably", and so does our world, not yet solved in the domestic takeover markets and certainly not in the international ones to which I now turn.

It is one thing for the markets to identify, with some serious delay (as the problems were well known for a while), that Europe's extended welfare states, drastically changing demographics, large black markets in Club Med countries, cannot go on for much longer. By now bond markets signal the problem.

However, in contrast to takeovers of private companies, the "takeover" solutions that the world practiced a century ago to enforce payments of debts across countries, and prevent governments from getting over-extended - do not exist today. This is one main source of today's "instability of the international financial infrastructure". Let's go down memory lanes to see what those internationally acceptable practices were and to see in what directions we must search for solutions.

Between 1900 and 1930, the US enforced an international "debt-payment" - OK, let's call it "diplomacy". For example, in 1913, the US made a deal inducing Guatemala to pay interest on its defaulted debts. In 1923, the US State Department proposed reforms to Colombia's banking system, tax collection, and public administration. Colombia passed these reforms - with US officials staying on as employees of the Colombian government. In 1926, Peru appointed Americans to head the customs service as a condition for a loan, and Bolivia accepted US advisers to monitor its finances.

The US also arranged loans, backed by debtor countries' pledges to give the US the right to take over tariff collection in case of default, which it did in the Dominican Republic in 1905, Cuba in 1906 (as part of what today would be defined as "imperialism") and many other Latin American countries throughout 1929.

A loan in 1926 to Costa Rica actually had a clause that allowed the US to take over Costa Rica’s domestic tax collection should it default. (Of course, you might need not just military force to make such clauses credible - but domestic willingness and backing to enforce it within the US.) More peaceful contractual agreements were signed with Honduras in 1926, which required the country to impose a 3% export tax as collateral. The enforcement was peaceful: he National City Bank of New York Exporters was the exclusive seller of the stamp.

The United States did use its military to prevent instability when governments in some countries defaulted. It intervened in Cuba, the Dominican Republic, Haiti, Honduras, Nicaragua, and Panama. In some of these, the United States took over the administration when local governments collapsed. The United States ran Cuba from 1906 through 1909, in 1912, and from 1917 to 1922; Haiti from 1915 through 1934, and the Dominican Republic from 1916 through 1924.

The Great Depression brought this US-sustained debt-settlement-induced world to an end. No alternative has been found since. With the US now much weakened, its capital markets reputation in tatters, and Europe in disarray - facing problems that neither central bank policies nor financial engineering strategies can solve - the present volatile state of affairs will go on until an international agreement is reached to re-create the institutions needed for not just enforcing the settlements of debts, but prevent countries from profligacy.

These institutions, though, must be far more than present-day International Monetary Fund, misguided by academic fads (with its economists advocating 4-5% inflation for years), Bruxelles-type bureaucracies, new committees for "financial stability", international courts (suits against "sovereign" countries not honoring their debts over the last few decades had zero consequences). We require institutions with clout to enforce clauses in contracts.

How will the eventual new world look like with institutions able to enforce debt settlements across countries - and, more important, having institutions to prevent national governments from overspending and taking on too much debt - I do not know, though anticipating such problems I had published potential solutions almost two decades ago. The historical precedents suggest that without a re-invention of international debt-settlement arrangements the intense volatility we face today will go on.....

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