Investors go mad (again)

Euro logo at ECB headquarters in Frankfurt The ECB is still cutting the cost of money

As I mentioned a few weeks ago, not everyone at the Bank of England shares Mark Carney's professed view that bubbling property is the gravest threat to financial stability and the sustainability of the recovery.

There was no ranking of dangers by Andy Haldane, the Bank's top economics boffin, in a speech delivered in restorative Scarborough last night, but he did share some serious anxieties about overheated financial markets.

And he warned that the Bank of England might have to exercise its more sweeping powers to damp down the speculation, lest it prove dangerous to banks and their ability to create essential credit.

So where are these risks manifesting themselves?

Well, in general, the prices of bonds and shares are very high and volatility is low. Which implies that investors have become a little myopic, a little unconscious of economic reality.

And as Haldane says, this is eerily reminiscent of conditions before the great Crash of 2007-08.

Here is one example he gave: the implied cost of borrowing for Spain and Italy for five years, which is close to the average maturity of their debt, is now lower than the cost of borrowing for the same period for the US and the UK.

This is shown by the yield on five-year government bonds, which is 1.33% for Spain, 1.44% for Italy, 1.65% for the US and 2.02% for the United Kingdom.

Now it was not long ago when Spain and Italy were close to catastrophe: there were legitimate fears of default on the poisonously intertwined debts of their respective banks and governments, bringing the Armageddon risk that such an earthquake could fracture the entire eurozone.

Are the debts of Spain and Italy now solid, glittering gold?

Errr, no.

Their economies, banks and public finances are a long long way from rude health.

Nor are the structural flaws in the eurozone anywhere near fixed: a course of steroids has been administered to banks by the European Central Bank; there is a little more pooling of countries' resources for bailouts; but the economic and political union widely seen as necessary to put monetary union on unbreakable foundations remains elusive.

In other words, the risk of default by Spain and Italy is significantly greater than for the UK and US.

So it seems little short of insane that investors are saying, in the price they pay to buy Spanish and Italian debts, that Spain and Italy are more creditworthy than the US and UK - both of which are enjoying the kind of economic recoveries that most of the eurozone would kill for.

To be clear, central banks themselves are partly responsible for Spanish and Italian bonds being so expensive (low yields or implied interest rates on bonds are the corollary of high prices).

The European Central Bank is still cutting the cost of money, whereas the US Federal Reserve and Bank of England are both on very gentle trajectories to increase interest rates.

But even if central banks are responsible for having made credit so cheap in recent years, with all the almost-free money they've created since the financial crisis of 2007-08, it takes two to tango.

And it is therefore reckless lending and investing by financial institutions - from banks to hedge funds - that has been pushing asset prices up to vertiginously high levels.

Which brings the risk that asset prices will tumble, at some inconvenient moment, wreaking serious harm to these financial institutions - and their ability to finance the economic activity crucial to our prosperity.

That is why Haldane says it may soon be time for the Bank of England to unleash what he calls "the rumble of thunder", or one of the weapons of the godlike central bank, to rebuke lenders and investors, and alter their behaviour.

This could take a number of forms. It could come as a public admonition to banks not to stock up on pricey bonds.

Or it could be the pioneering use by the Bank's young Financial Policy Committee of its so-called macroprudential powers to force banks to hold more capital to absorb potential losses on particular classes of overvalued assets.

Or the FPC could instruct banks to hold more loss absorbing capital across the board of their activities, by activating the so-called counter-cyclical buffer.

Or, if all else fails to dampen the potentially lethal exuberance, the Monetary Policy Committee could raise interest rates.

Which is, as Haldane says, the last line of defence.

But what matters is that interest rates are now seen as a defence against madness in financial markets, in a way that they weren't in the boom boom years of Greenspan and King.

Robert Peston Article written by Robert Peston Robert Peston Economics editor

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  • rate this

    Comment number 158.

    157. John_from_Hendon

    All well and good but how do we get to this ideal state of house multiples without one almighty crash which is likely to take much of the banking system down too.

    Or is this fiscal Armageddon needed in your view?

    Regarding your grandfather my mother bought her first house in the 1950s as a brand new primary school teacher for about £200. Not sure this helps us now.

  • rate this

    Comment number 157.

    156.alan "no bubble" but..

    Prices in 2008 were even then at a far too high multiple of regional average pay.

    We need property at a 3 to 4 times the average regional pay - not some fanciful "affordable" level - anything above this is an economy crushing bubble.

    One of my grandfathers paid just one eight of his income for family housing throughout his life (died in 1960) (I have his accounts)

  • rate this

    Comment number 156.

    I think the so-called "asset bubble" is exaggerated.
    In many parts of the UK -excepting London - house prices are still below their 2008 level in nominal terms and substantially below in real terms.
    Similarly with the FT100 index.
    It still hasn't breached its previous 1999 peak.
    If it were the same level now in real terms the index would be about 12,000 rather than about 6,800.

  • rate this

    Comment number 155.

    I'm getting fed up with moaning about immigrants and muslims on BBC
    & yes there are too many foreign and local trades going through foolishly

  • rate this

    Comment number 154.

    It is not just investors that are going mad.
    They re being egged on by central banks:

    Is it really in central banks remit to purchase equities?

    What is going on?

    Do they know/suspect something we don't?

  • rate this

    Comment number 153.

    Look at the Caixa's, the irresponsible lending caused so much of the problems. They now seem to want bailing out even further despite forced mergers. This is a decade plus problem to come, if you've been to Spain recently, look at all the unfinished developments. Why would anyone look to live in an unfinished ghost town, often overlooking the motorways ?
    Oh and don't mention corrupt politicians...

  • rate this

    Comment number 152.

    131. All for All
    11 HOURS AGO
    JfH @122
    must rise"

    When affordable?

    In rich-led revolt against 'tax & spend' .....


    Not sure I agree with the substance of all you say but I must record here what a superb comment it was. So much expressed so lucidly and so interestingly. First rate prose style.

  • rate this

    Comment number 151.

    The sole purpose of this government has been to keep kicking the can as hard as they can with our money, and to ensure nobody in the City gets prosecuted for 2007/8. If they can kick it past 2015 then they will be able to retire with the loot and blame whatever govt gets elected - because the catastrophe has been obviously on the way for six years.

    Meantime the plunder goes on unabated.

  • Comment number 150.

    This comment was removed because the moderators found it broke the house rules. Explain.

  • rate this

    Comment number 149.

    144. Up2snuff

    "tertiary banking crisis"

    Could you give an example of a Tertiary Bank, maybe name the "major bank", and give a broad outline of what was done to save it?

    Asking a lot in 400 words but I'm really interested!

  • rate this

    Comment number 148.

    Out of pure curiosity, John from Hendon is consistent in advocating a) Higher interest rates and b) Joining the Euro. If we did b) then interest rates would be very low, stay there for a long time and we couldn't change them if we wanted to. So if given the choice would John pick a) or b) ?

  • rate this

    Comment number 147.

    Business all normal.

    We have a property bubble.

    And a tech bubble.

    Set to burst.

    Before or after the election however?
    My money is after the election.
    Since notwithstanding the world cup we deserve and must keep the feel good factor going.
    We are truly mugs... ..

  • rate this

    Comment number 146.

    Under the pressure of the EU , Spain and Italy have pushed economics reforms far more than UK. If we consider current account and trade deficit ( actually trade surplus for Italy ) , they have achived smashing results and defenitely the UK are the one who are following.

    A part of arrogance I cannot see any reason for mr. Peston to be under the impression that the UK debt is so rock solid.

  • rate this

    Comment number 145.

    JfH @138
    "an economic perversion"

    Comment @131 was in retrospect.

    My question - my suspicion - that interest rates might be used not just 'in economic purity' (to moderate investment risk-taking & wage-demands, at risk of growing faster than productivity & supply), but 'for advantage': to those with capital against those needing credit, to those with forecast, foreknowledge, or ability to sway.

  • rate this

    Comment number 144.

    142.Knut Knutsen
    We had a banking crash in 1973-5.
    And we ended up playing cards by torchlight.
    The bank crisis was totally Govt inspired back then & power cuts, unconnected to the tertiary banking crisis came later due to industrial action.

    After that a major bank failed & was secretly rescued by the Bank of England & a Governor who were really sharp & acted in the right way at the right time.

  • rate this

    Comment number 143.

    @139 JStG
    Another change that should be made, imv, is when any taxpayer money goes to private businesses, it should be in return for equity in that business. Having privatised State businesses over 3 decades it is absurd, obscene & just plain wrong that 'public' £s should continue to be the investment foundation for private profits.

    This equity could then form a sovereign wealth fund for the UK.

  • rate this

    Comment number 142.

    We had a banking crash in 1973-5.

    Interest rates rose to 13%, Housing prices collapsed, and in the middle of it all the World Stock Market crashed. Inflation, lax regulation, and poor Government all played a part.

    And we ended up playing cards by torchlight.

    But it was a long, long time ago.

  • rate this

    Comment number 141.

    @137 Michael, is right, once you factor in expected inflation it looks very different.
    A crude example, if we subtract the most recent inflation figures UK 1.5%, EZ 0.5% from the yields quoted in the article.
    UK 2.02% - 1.5% = 0.502%
    Italy 1.44% - 0.5% = 0.94%
    There are other factors to consider, but allowing for inflation helps to clarify the risk/reward.

  • rate this

    Comment number 140.

    We have a housing bubble, Spain and Italy do not, their market where allowed to sink. If we have a property collapse our banks will be insolvent once again. So then why are we a better bet than them?

  • rate this

    Comment number 139.

    Rates should be fixed, at a sensible rate. Then when action is needed to cool booms or boosts in recessions taxation should be the thing varied. Makes much more sense. High tax in booms or rising prices, wages, any inflation at all, and lower in bad times. Governments required to put aside taxes for the bad time too. Eight percent min fixed legal minimum.


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