Blame the speculator, shoot the messenger: habits of the trapped politician

Sergio Bruno makes much of the recent rise in the cost of borrowing for the Italian government, blaming speculation for the disruption to public finances. But investors have every reason to be worried, and it is in our interest that they act on these worries
Michael Bullen
23 September 2011
In view of the frequency at which "speculators" are accused of destabilising markets (for example in the contributions by Sergio Bruno, here and here) it is perhaps opportune to assess the extent to which speculation has occurred in the Euro sovereign debt crisis, to understand better the potential negative and positive impacts, and in particular to consider this within the context of government bond market reversals within the Eurozone in recent months.

It is important firstly to draw a clear distinction between legal and illegal activities. "Speculation" and "manipulating markets" are frequently assumed to be one and the same: however, "speculation" is a legal risk activity that does not guarantee monetary gain or even return of the principal sum. Indeed, by most definitions, investing in stock markets can be seen as speculation. "Manipulating markets", on the other hand, is an illegal activity for which significant penalties exist in the EU and elsewhere. (Unless, of course, you are a government entity: for example, OPEC exists with the specific object of manipulating oil markets.)

During times of economic disruption the finger of accusation is often pointed at "speculators". The volatility of government bond markets in the Eurozone in the last couple of years or so have proved to be no exception; but the only investigation into alleged speculative attacks in that time that I am aware of was by Bafin, the German financial regulator, into allegations that speculators were ramping Greek derivative markets causing government bond prices to fall. Bafin later reported that they were not able to find evidence supporting the allegations. 

My feeling is that those pointing the accusing finger are frequently guilty of confusing the activities of investors with those of speculators; or at least of using the terms "investor" and "speculator" as interchangeable, according to how it suits them at the time. Government bonds are typically bought by banks, institutional investors (pension funds, insurance companies etc) private investors and other longer term investors. Sovereign funds are big investors in some government bond markets though are likely to have only limited holdings in peripheral European bonds. Government bonds tend to be viewed as relatively low risk investments and, once bought, commonly do not see the light of day until their redemption, which can be up to 50 years from the date of issuance. 

In other words, this is not "hot money". Nonetheless, investors will subject these assets to the same scrutiny subjected to other investment classes: much as Keynes once said, "when the facts change, I change my mind", investors also reserve the right to change their minds when circumstances change. What may look a good investment one week may look very different a few years - or even weeks - later and investors will act accordingly. Indeed, to the extent that the bond holders are banks, they are required by regulation to re-assess the value of their investments as part of  "mark to market" measures of capital adequacy.

An investor may sell a bond position for all sorts of reasons - perhaps because it has attained a certain pre-set profit target - or a short-seller may act because they think that a market is exhibiting signs of being over-bought in the near term. This behaviour brings liquidity to markets - in this case allowing buyers with different views or objectives into the market -  and assists in the prevention of potential price bubbles, which occur precisely when people do not readily sell when the actual value of the asset suggests they ought to have done.

Many of us pay contributions into pension or other investment funds. Managers of those funds are answerable to us, their clients. If the clients do not like the investment returns, they can remove their pension monies and place them elsewhere. Thus, pension funds are focused on investment returns and it is in everyone's interests that this should be the case: the alternative is that our future pensions will suffer.

Institutional and other investors do not buy government bonds as a "special favour" to governments. They buy them for their investment attributes, which will include dividend, credit quality and date of maturity. In the good times, governments are pleased when investors acquire their nation's bonds: it provides funding for their activities, helps to ensure deep and liquid markets and politicians can bask in the reflected confidence that investors place in their nation. The corollary is that, in the bad times, the lack of confidence reflected by falling bond prices causes unwelcome light to be shone onto the actions of politicians and into the deepest recesses of their integrity; the inevitable response is for politicians to blame "speculators". However, investors are merely doing their jobs, managing pension funds for their clients.

Lack of confidence in a market can lead to prolonged periods of falling prices (or, in the case of bonds, rising interest rates) as information and opinions are shared from desk to desk. Investors have also learned from long, bitter experience to "let the trend be your friend" and that those who panic first usually lose the least. This may be characterised negatively as a "herd instinct", though in the animal kingdom it is a tried and tested way of avoiding being picked off by predators. In mitigation of investors, they do not like being picked off by predators either.

In the case of Greece it is likely that some investors wish they had followed the herd, let the trend be their friend or panicked a lot earlier, as the initial trickle of negative rumours developed into a torrent of unfortunate facts. Early sellers, reacting to ill-defined changes in sentiment, were vindicated by subsequent disclosures. One may plausibly argue that investors were "conned" into buying bonds by a culture of dishonesty and deception among the political elite which deliberately obscured the true picture of national accounts and that, had investors known the real facts, they would not have invested in the first place: that as those facts became known, they revised their investment decisions and chose to reduce their exposures to Greece. Much of the time, when investors sell they are not seeking to profit but rather to limit losses. In those circumstance, why would anyone want, or expect, much less demand, that they do anything different? 

Of course, accusations of "speculation" are not confined to government bonds. In recent weeks several European governments have banned short-selling of financial shares, hoping to limit volatility - typically of the "downward" variety - in stock markets. This was caused by investors becoming increasingly nervous at the very large holdings many European banks have in Greek and other government bonds. At the end of 2010 German and French banks alone held approximately £25bn in Greek government bonds, on top of a perhaps even greater amount loaned to Greek households and corporations. With expectations growing for losses on those holdings, who would blame those banks for wishing to reduce their exposures by selling or hedging some government bonds? Who would blame investors in banks affected from wishing to switch to alternate investments? Why would anyone expect them to do otherwise?

A ban on short selling of several financial stocks was introduced in the UK in 2008 for much the same reasons and lifted some months later. Rumours had abounded earlier in the year of market manipulation in HBOS stock. Certainly, foreign and UK hedge funds were identified as having short positions: however, a subsequent FSA investigation revealed no attempts at price manipulation. Moreover, the UK banks that went bust, were bailed out or nationalised (however you wish to characterise it) did so not because they were ganged-up on by nasty speculators but because of bad management and unsustainable business models compounded by inadequate legislation policed by an ineffective regulator. Which is not to say that, in certain exceptional circumstances, a ban on short selling may not be a sensible policy for the near term: just don't expect it to have any fundamental impact on likely outcomes, except perhaps in delaying them slightly.

In much the same way, are speculators currently responsible for the parlous state of Greek finances? No, that accolade belongs to the politicians who cooked the books for so long. Are speculators responsible for the failing finances of other Eurozone states, such as Italy? No, that accolade again belongs with politicians who not only built unsustainable debt burdens in the first place, but later conspired with politicians elsewhere to enable Italy and other states to enter the Eurozone without ever coming close to meeting the Maastricht Treaty requirements. European politicians had learned over time that electorates tend to vote for politicians that spend money but against politicians who tax. The solution they arrived at was to spend the cash but to defer the cost for future generations to pay: in certain cases, the solution involved spending the money but hiding the cost, again for future generations to pay. Either way, those subsequent generations have now arrived and are demanding changes.

Politicians viewed membership of the Eurozone, with its low interest rates, strong currency and ostensibly strict fiscal rules as a long term solution that would enable them to support state expenditures at low cost. After resorting to financial trickery to enter, once in the zone they abandoned all pretence at meeting terms designed to enhance ongoing stability: even Germany and France, originally strong proponents of the terms of the Treaty, failed to meet provisions in one or more years. The Council of Ministers failed to enforce the rules and no state has yet been fined for failing to comply with them. Moreover, several Eurozone states failed to use the cheaper funding costs as an opportunity to reform, or perhaps even to repay debt, and economic growth subsequently plummeted. Countries such as Portugal and Italy have seen precious little growth in 10 years. Investors like to see at least some effort being made to ensure sustainability of debt; one may also argue that continued reliance on subsidies in some nations contributed to a lack of urgency in seeking competitive reforms. Low growth and high debt, especially if heading in the wrong direction, is a toxic mix and it should be no surprise to anyone, after 10 years or more, that investors are demanding ever higher premia from some states in return for lending them more money.

Some politicians and analysts urge that, far from public debts being of such a size that they must be addressed now, the only solution to the crisis is that they must be increased still further. Some analysts have  proposed the printing of money at a European level, as if likely resultant inflation would not lead to even more pronounced bond market convulsions. Meanwhile, investors and voters, in particular those of the younger generations, are left wondering: if fiscal laxity and irresponsibility are what led to this problem in the first place, how are we to believe that more of the same is the answer now? 

Politicians do not find it within themselves to shoulder the blame for systemic failures within the Eurozone; for them, "speculators" remain a favoured whipping boy. Nonetheless, politicians will remain dependent on investors for funding until such time as they discover an alternative to government bonds and, even in the event that a long term viable alternative were to be found, it is unlikely that politicians would find themselves released from the burden of being answerable to markets for long. It seems to me that markets have done no more, with European sovereign debt, than to reflect the risks of default and inflation that the actions of politicians have created.

So what should politicans do now? They must rise to the challenge the economic circumstances present and, in my view, be a little more creative than the typical cut public services/increase taxation response seen thus far. Heavily-indebted nations need to come to terms with the reality that both tax rises and expenditure cuts must take place. However, it is the mix of cuts and taxes that may need to change, particularly with respect to taxes. Different measures will be appropriate for different countries, but Italy, in particular, seems relatively well placed to weather the crisis if the political will is there. Italy is a very wealthy nation that happens to have high public debts: however, Italians also have high levels of domestic savings and per capita income is impressive, more or less in line with that of the UK and distributed relatively evenly. It has been mooted in recent days that Italy should consider the introduction of a wealth tax and my feeling is that the proposed imposition of a one-off wealth tax should be taken seriously: returning Italian public debt to sub-100% of GDP would make a significant difference to investor confidence and anecdotal evidence suggests that Italians may be open to this, as part of broader fiscal reforms. In particular, it is difficult to envisage an alternative that will not alienate younger generations, perhaps encouraging them to try their luck elsewhere and further compounding Italian fiscal woes. Whether Italian politicians could be trusted, post-wealth tax, not to return to the bad old days of high public deficits requiring additional future wealth taxes is another matter. It is up to Italy's politicians to convince savers and investors of their reformed ways.

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