Are markets bonkers?

La Bourse, Paris Shares in French banks have fallen amid concerns that France faces a credit downgrade

Are lenders to government, creditors of banks and investors in shares behaving in the kind of way that would guarantee them the kind of losses that presumably they would wish to avoid?

Are they completely bonkers, in other words?

I ask this question, because there is something of a paradox about investors' and creditors' current obsession with whether huge economies - the US, Italy, Spain and latterly France - will be able to repay all their debts.

The natural reaction of the governments of these countries, when they fear that it will become harder and more expensive for them to borrow, is to do what they think their creditors want - which is to introduce austerity measures, to reduce their respective deficits, the gap between what they spend and their tax revenues.

So Italy is accelerating plans to cut its deficit, the US is initiating a deficit-reduction plan for the first time since the crash of 2007-8 (albeit something of a messy one) and France is trying to make its deficit-cutting promises more credible (President Sarkozy last night gave his ministers a week to formulate new deficit-reduction measures).

Now here's the thing.

With economic growth in the developed Western economies so weak, these austerity measures are convincing investors and creditors (the same ones who don't want to lend to Italy and Spain, or different ones?) that the risk of a slide back into recession has become larger.

So guess what? They sell shares in companies that would be hurt most by recession, especially banks.

And some of them also start to wonder whether it's credible that Italy, Spain and so on will really be able to reduce their deficits, if an economic slowdown reduces what they receive in tax revenues.

Insurance hike

It is highly relevant in that context that the price which investors have to pay to insure their loans to Spain and Italy through the credit default swap market rose back to the kind of levels we saw before the European Central Bank started buying up Spanish and Italian government bonds.

And the cost to insure French government debt also rose sharply yesterday.

George Osborne On Thursday the chancellor will address MPs on the state of the UK economy

What that means is that creditors see the intrinsic risks of lending to these countries as elevated - and they fear the ECB buying of Italian and Spanish sovereign debt is an artificial and possibly unsustainable measure to reduce these countries' borrowing costs.

Against this backdrop, George Osborne is bound to argue today that the growing doubts about whether the US, Spain, Italy and latterly France can repay all their debts - which has been the backdrop to the rout on stock markets over the past 10 days - shows it is important that he should not waver from his deficit reduction measures, his austerity plan.

The chancellor will say that the UK has benefited greatly from lower borrowing costs as a result of the cuts, because it has retained its triple-A credit rating.

The problem for him - and the paradox of the current crisis, as I've pointed out - is that the austerity that is now being forced on other countries, like Italy, the US and France, means that the probability of the world sliding back into recession has increased.

So the shadow chancellor, Ed Balls, will argue that the chancellor's alleged inflexible determination to cut UK public spending increases the risk of a return to recession here.

This argument - whether the greater risk is countries unable to repay their debts or recession - is causing intense debate in politics and mayhem on markets.

Belief in banks

Gerard Lyons: "There is a risk of double dip recession elsewhere... So the most important thing is to try and ensure that confidence remains high."

Where it becomes a matter of life and death, in financial and economic terms, is in respect of its impact on banks and the banking system.

Because there is an inextricable link between creditors' confidence in big banks and creditors' confidence in the public finances of their respective home countries (see my post of last night for more on this).

The transmission mechanism between the perceived quality of sovereign debt and the perceived quality of bank debt goes like this.

First, all big banks benefit from an implicit guarantee from the governments of their domicile that they'll be bailed out in a crisis: it is the too-big-to-fail guarantee that George Osborne has asked the Independent Commission on Banking to find some way of weaning banks off (to an extent).

So the weaker the public finances of the government standing behind a bank, the less valuable is that too-big-to-fail guarantee - and the harder and more expensive it therefore becomes for that bank to borrow.

Given that the UK's banks are bigger relative to the size of the economy than those of any other country (except Switzerland), this link between a government's credit rating and the perceived strength of banks is one reason why the chancellor is so keen for the UK to keep its AAA rating.

Second, banks are encouraged by regulators to hold large stocks of government bonds, because these are seen as easily convertible into cash in a crisis.

But what is a safety buffer when public finances are in good shape becomes a source of serious weakness as and when the credit-worthiness of the issuers of those bonds, the borrowing governments, is challenged.

If in a worst case, as has happened for Greece, there is an agreement that the sovereign borrower won't pay back all it owes, there is a double whammy for banks.

They incur a loss that disproportionately reduces the capital they hold as a protection against losses on other loans, because under international banking rules they don't have to hold any capital in relation to their loans to alleged stronger economies.

Or to put it another way, if you are an investor who thinks that over the longer term there's a fair chance that a number of sovereign borrowers will fail to repay all they owe, then you would argue that the balance sheets of every big bank in Europe and the US are significantly weaker than the published figures show.

That is the background for the rout in Italian shares a week ago - and for the plunge in the shares of French banks yesterday. There has, inevitably, been contagion to UK bank shares.

Here's a chilling statistic: the share prices of Royal Bank of Scotland and Lloyds are more than 50% below what taxpayers paid for their huge stakes in these banks at the height of the banking crisis at the end of 2008.

PS. There has been a bounce in European shares this morning, following last night's slide on Wall Street. But given the volatility of the past fortnight, anyone who tells you they know where the market will close tonight is a fool or a knave.

Robert Peston Article written by Robert Peston Robert Peston Economics editor

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  • rate this

    Comment number 341.

    Banks do need to be weaned away, and in a big way. The economic ratings do not project the real pictures/strengths of the economies, because of their being mostly influenced by Banks, not giving enough perspective to the future prospects of other financial institutions (taking care of production and exports/imports) commandeering the long-term economic health. NEVER DEPEND TOO MUCH ON BANKS & GOLD

  • rate this

    Comment number 340.

    Are VIX calls or SPY puts a better hedge? This is the title of an article here:

    Options traders are betting on spreads after the market tanks, as now. Yesterday, 2.1million SPY calls, a bet on the S&P 500 index rising to a strke point. This is almost 1.4times the usual 4 week average. Casino market

  • rate this

    Comment number 339.

    It seems to me anyway, if we can all decide on something the Americans can run and develop right, all us other western countries should just pile a small fortune into that and then at least it's our fault as well if it goes wrong. I'm sure a million political, financial, mathematic degrees and Phd's across this hemishere can't really fail at making a few billion dollars or pounds over a few years.

  • rate this

    Comment number 338.

    Why don't Italy and Spain wait a bit before rushing to cut their behind the times deficits, invest in cutting US deficits instead and reap the return in a few years to cut their deficits cheaply. As well as reaping free knowledge of however the US plan to suceed. The UK could sit quite nicely in that equation standing by to help research, develop, improve, engine any new ideas for our own growth.

  • rate this

    Comment number 337.

    I reckon we have been short sold 1 Indian Test XI.

    Who can I sue?

  • rate this

    Comment number 336.

    332 Jaker

    Agree, pal.

    With ref to my 324, you should check out the banksters’ club-rules (stock-exchanges, ISDA, AIBD, etc) for the non-delivery of their ‘funny stuff’, all so ‘nice’ for themselves.

    No wonder short-selling got banned.

    In my country you do such a thing with a bag of rice, the law from tort-like breach of contract to a more criminal fraud charges may apply.

  • rate this

    Comment number 335.

    Robert E7
    2 Hours ago

    Does no-one have spellcheck?


    Do you wish to cross exaaamine the wicked wit ches of the west about the quality of baaat droppings in their poweshuns

  • rate this

    Comment number 334.

    37 No we should not take Bobs threats seriously mainly because we still permit banks and traders to rule the roost. It is no accident most of the toxic waste of the banking industry was routed through London and still us. We were the only fools stupid enough to let them.

  • rate this

    Comment number 333.

    323 WOTWIBAA+


    WE NEED VIOLINS on the streets of shaaame and everybody to be born agaaain after singing aaalong with ...

    THe only laaasting revolutionary change begins with rebirth

    "Fighting the system" meant being the same as the system as the looters demonstrated ...hardly revolutionary whaaat!

  • rate this

    Comment number 332.

    I am glad short selling has been banned in 4 countries, now the rest of Europe & the US should follow suit. These gits are the worst concoction in world markets & recently I wrote in a NYT blog that President Obama should hint on banning them, for up to six to eighteen months so as the 4 bigger ones can be investigated by the powers to be & if they're allowed to practice again should be regulated.

  • rate this

    Comment number 331.

    AAAfter i snap my fingers at the count of three you will all wake up from the wicked witches spell and sing along to the new european anthem



    errrrrr !



  • rate this

    Comment number 330.

    50 Years ago Europe was in ruins with the communists growllng at the gate ,now all it has to worry about is a pile of worthless paper which can be swept into a dustbin.

    Get real everybody ,its time to build heaven before the Maaayaaan calender clicks in again by default with another cycle of
    "weve been framed"
    Its time Europe was REBORN and rename"puff the magic dragon"
    link to follow

  • rate this

    Comment number 329.

    300 Jack if you believe that the Euro is finished them I'm afraid your bonkers. The deep depression will and probably has started in the US. % years ago I said that for the health of the UK economy we should decouple from the US and embrace our main market the Euro. If the Euro falls, the UK will follow it and be bankrupt in 3 months. The US is a ponzi scheme, forgotten Enron already?

  • rate this

    Comment number 328.

    298 I agree up to a point with your sentiments, but the bigger picture telss the story. The banks don not create wealth if you don't agree with me we have a problem.The banks manipulate debt by creating more debt to service the demands of the banks inexorable profit.
    Printing money does not create wealth, creating debt as in the fractional reserve scheme is fraudulent, only the banks gain.

  • rate this

    Comment number 327.



    it's no suprise to me that capitalism results in 'financial fantasy' with fiat currencies trying to 'bridge the gap' of subjective and absolute values - which is achieved by devaluing and debasing the currency making the citizen pay.

    ...the wealthy hvaing creamed off the surplus value.

    cannot understand why so many people struggle with that logic.

  • rate this

    Comment number 326.

    Does no-one have spellcheck?

  • rate this

    Comment number 325.



    It doesn't matter that it's too complicated to calculate (the absolute value) - the fact that you know there is one is all that matters. Any price defined by the market will be incorrect - when we have a recession the price (your subjective value) is forced severly back closer to it's absolute value (asset devaluation - i.e. a crash)

  • rate this

    Comment number 324.

    306 Aqua
    For shares and other ‘financial stuff’, there are the special rules and considerations available. You should see the redress available for non-delivery of these ‘special items’. Benign Local Stock Exchange rules, ISDA's for derivatives and AIBD's for bonds; will apply.
    Try doing that for a yacht or a bag of rice. Those banksters really know how to make it easy for themselves.

  • rate this

    Comment number 323.


    ...and for the second point - I think it's pretty well established that 'pricing risk' is a myth - otherwise these banks would have seen it coming.

    regardless of what you price in for risk - it still does not change the absolute value of the commodity, which is the value of the raw materials (shared - unless you can prove god gave you some!) and the labour used to refine it.

  • rate this

    Comment number 322.


    Sadly it's not even that clever - it's merely history repeating itself I'm afraid...


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