- Laurence Copeland is a professor of finance at Cardiff University Business School and a co-author of “Verdict on the Crash” published by the Institute of Economic Affairs. The opinions expressed are his own. -

“Lilies that fester smell far worse than weeds” Shakespeare, Sonnet No. 94

The Bard’s words sum up one of two reasons why the Attorney General, Baroness Scotland, ought to resign in response to being fined 5000 pounds for employing an illegal immigrant in her home. We have a right to expect nothing but the highest standards from any government officer, especially the country’s top legal officer.

However, the lilies-that-fester issue is not the only one involved here. Although this case may not look to most people as serious as many of the scandals of recent years, it has an additional dimension which is absent from run-of-the-mill cases of ministers (or judges or senior policemen) caught exceeding the speed limit or cruising a red-light district.

Just look at the excuses being wheeled out on behalf of the Baroness. They all amount to saying that the law as it currently stands makes demands on prospective employers that are so bureaucratic, time-consuming and complex that nobody should be surprised if even the Attorney-General, with all the resources at her disposal, gets it wrong.

If this is the case, it is an appalling state of affairs, and, far from strengthening the defence, actually makes the case for her departure unanswerable. After all, it may be possible to argue that the average person cannot be expected to conduct a thorough investigation of the residence status of every child-minder, window-cleaner or gardener they employ (though, if this is conceded, 5000 pounds might sound like an unjustly harsh penalty for anyone earning less than the Attorney-General!).

But can the same defence be mounted for the head of the country’s legal profession, given that she is not only a member of the government, and as such ought to take her fair share of the responsibility for creating this bureaucratic nightmare, but that she is also reported to have had a hand in drafting the law?

One would expect her to carry a more than equal share of the blame for intervention in the labour market in a form that is a deterrent (or, insofar as a fine may be unavoidable, a tax) on employment, as well as an affront to democracy, since it puts  ordinary folk (and apparently even the Attorney General) in a situation where it is well-nigh impossible for them to operate within the law. (Nor ought it to be any defence, however true, to say that there are many other legal minefields strewn in the path of the innocent citizen.)

In other words, far from being an argument in her defence, the fact that an employer’s obligations under the law are so onerous is actually an indictment of Lady Scotland’s performance as a minister, and an additional reason to demand her resignation. The fact that she has fallen foul of her own law is simply poetic justice, or as Shakespeare put it, she is hoist with her own petard.

- Laurence Copeland is a professor of finance at Cardiff University Business School and a co-author of “Verdict on the Crash” published by the Institute of Economic Affairs. The opinions expressed are his own. -

There is so much talk of a new regulatory framework for the financial sector, anyone would think it was an important issue.

Unfortunately, it is almost irrelevant, for the simple reason that, however sophisticated the new regime, experience shows it will be bypassed and/or captured by banks of one kind or another, possibly by novel types of institution invented specially for the purpose.

This is true even in the unlikely event that the whole world – with the possible exception of North Korea – embraces the new regulations and enforces them with vigour.

The only type of intervention which has a hope in hell of success is one based on size. As Mervyn King has said, when a bank is TBTF (Too Big To Fail), it is just too big.

What is needed is breakup along functional (and, where necessary, geographic) lines, separating the boring but essential utility business of deposit-taking and payment-transfer from the exciting risk-taking of investment banking. A once-and-for-all breakup would have to be followed by continual monitoring, to ensure that takeovers and mergers did not breach the size limit and take us back to the TBTF dilemma.

The aim should be straightforward. If banks were cut down to manageable size, the taxpayer’s liability could be limited to deposit insurance alone. Banks could be allowed to fail in the same way as firms in other industries and would no longer be able to hold Governments or central banks to ransom, as they have repeatedly done in the last twenty or thirty years.

Moreover, break-ups would bring other benefits. Without an implicit taxpayer guarantee, there would be more incentive for institutional shareholders to insist on responsible management behaviour and to impose remuneration packages consistent with it. This mechanism of shareholder vigilance, which failed totally in the run-up to the current crisis, in my view offers the best hope for the long term. By their shameful passivity, institutional shareholders must carry a major share of the responsibility for the existing mess, and everything should be done to shame them into activism in future.

Will breaking up the banks eliminate systemic risk altogether? Of course not. But it will mean that the world economy will no longer be hostage to the irresponsible behaviour of a handful of bankers consciously pushing the banking system to the limit, or, as has recently been confirmed in accounts of the demise of Lehman Brothers, indulging in brinkmanship with the authorities.

The difficulty is how to get from here to there. As I said in an earlier blog, we need governments too big to be captured, and it is now plain that they exist neither in Washington nor in London. Predictably, the UK Government has shown no stomach whatever for the fight, even though it effectively owns two of the country‘s largest banks. It is a catastrophic error – one is reminded of the first Gulf War, when, with Saddam Hussein at their mercy, the Allies fell back on technicalities to justify leaving him in power.

It would be ridiculous to compare the evil of tyranny with the excesses of bankers, but in pure monetary terms the current crisis has already cost several times as much as the two Gulf Wars added together. Yet not only are Western Governments running away from confronting the banks, they appear determined to take on almost anyone else involved in finance. In particular, the EU’s hostility to so-called Alternative Investments (hedge funds and private equity) is, if anything, likely to make institutional investors as a whole even more reluctant to intervene than they were before.

As ever, it seems there is no situation so bad that our endlessly creative politicians cannot make it worse.

- Laurence Copeland is a professor of finance at Cardiff University Business School and a co-author of “Verdict on the Crash” published by the Institute of Economic Affairs. The opinions expressed are his own. -

As the G20 ministers gather for their meeting this week, there should be no doubt about the item at the top of the agenda: the re-entry problem. At what point should the expansionary monetary and fiscal policy of the past year be reversed? And, if the answer is “not yet”, how soon does the re-entry plan need to be announced?

Since nobody is quite sure how much of the current worldwide economic recovery is a direct or indirect result of the various stimulus packages, quantitative easing, cash-for-junk-vehicles and cash-for-junk-bond schemes, it follows that nobody can be sure whether or when it is safe to reverse the fiscal expansion.

But leaving it too late to retrench will hand the decision over to the bond markets. They will be looking for reassurance from the major debtor countries that both versions of the default scenario can be ruled out.

An outright default, probably camouflaged as debt renegotiation rather than repudiation, becomes politically more acceptable than the package of expenditure cuts and tax rises needed to carry on with repayments.

A more likely scenario sees the lenders repaid in devalued currency, as the debtor country achieves the same outcome by printing money so as to generate inflation –- an option always open to any country whose debts are denominated in its own currency (i.e. not to Eurozone members).

So far, the markets have given the United Kingdom and the United States the benefit of the doubt, trusting them to come up with a plan gradually to cut their spending over the next few years.

But how long before their patience is exhausted? The numbers are frightening even by the standards we have got used to bandying about during this crisis.

On the federal government’s own optimistic projections, the U.S. deficit will be around 12 percent of GDP this year, and will still be around percentof GDP ten years from now, by which time the national debt will have grown to over $9 trillion, or more than 75 percent of GDP, compared to just over 40 percent today.

For the UK, the projections are of the same order of size relative to the economy –- and based on assumptions every bit as optimistic.

Faced with numbers unprecedented in peace time, the danger is that the markets may start to doubt the resolve of either America or Britain or both. At that point, holders of UK and U.S. gilts could decide to dump their vast holdings, driving their price down and their yield up –- in effect, demanding compensation for their prospective default losses.

The cost of insuring against default on UK government debt in the credit default swap market is already over one half of one percent, an improvement over the last few months, but still more than double the comparable figure for France or Germany.

Ironically, the very fact that so many Americans are voicing their disquiet about government borrowing is one reason to be sanguine about the outlook for U.S. bonds and consequently for the dollar, though it is still hard to visualise a turnaround in the public finances on a scale sufficient to preserve the dollar’s long term status as the world’s reserve currency.

As far as the UK is concerned, there is virtually no prospect of any serious attempt to address the problem this side of the election, so the burden will fall entirely on the post-election administration. If, at any time in the next twelve months, Labour manages to recover in the polls to the point where a minority Government becomes a serious possibility, the gilt market could panic amid a flight from sterling.

Against this background, the key player at G20 will be China. Its leadership realised some time ago that its massive dollar reserves represent a $2 trillion hostage to U.S. political will, a costly error for which they will be thankful they do not have to face the wrath of the electorate.

If dumping its massive holdings of US Treasury bonds drove the dollar down by 30 percent, the cost to China would be about $600 billion, which nowadays sounds like small change. So far, the ultra-cautious Chinese leadership has been deterred by fears about the impact of a less competitive RMB (renminbi) on its exports, but at some point the prospect of replacing the dollar as the number one reserve currency might just prove too tempting to resist.

- Laurence Copeland is a professor of finance at Cardiff University Business School and a co-author of “Verdict on the Crash” published by the Institute of Economic Affairs. The opinions expressed are his own. -

Before the credit crunch, we had what I called a Prozac market. Investors on both sides of the Atlantic seemed to be in denial, as irrational as the people who end up in the bankruptcy court because for years they have kept on smiling while the bills piled up unopened.

Last Fall, reality caught up in the shape of the worst banking crisis in history, and we have now had to mortgage our earnings for decades to come in order to bail out the banks. Not surprisingly, by mid-March this year, the Dow had fallen by well over 50 percent from its peak level at the start of October 2007, and the FTSE by nearly as much. In the last three months, however, the FTSE has risen by 20 percent and the Dow by nearly 30 percent. What has happened to justify the recovery?

The best that can be said is that there have been signs that the economic situation is deteriorating more slowly than in the second half of last year.

For example, the fall in house prices may be slowing. But in both UK and the U.S., they remain a long way above their long run levels by most yardsticks. Moreover, in the early 1990s, after the last British house price bubble popped, it took almost a decade for prices to recover, against a background of far higher inflation and a much more robust economy than today – and of course without an accompanying banking collapse.

Insofar as the construction industry is concerned, any increase in demand from the residential sector is likely to be overshadowed by continuing weakness in commercial real estate and, in the UK particularly, brutal cuts in public sector capital expenditure.

For the foreseeable future, the UK and U.S. governments, households and much of the corporate sector will be forced by record levels of debt to rein in their spending. Long term bond yields are already above 4 percent. Insuring against the risk of default costs 39 basis points for U.S. government debt, 80 points for UK gilts, and 300 or 400 points for a number of major multinationals, which clearly indicates that some financial markets have few illusions about the future.

Pricing equities usually involves a comparison of historic dividend yields with long term interest rates. Unfortunately, in crisis conditions, past levels of earnings (and hence of dividends) are no guide to the future. As government and consumers begin to repay their debts, they will both have to cut spending, or at least prevent it growing at anything like the rate seen in the last few years.

Ideally, the slack would be taken up by export demand. But with world trade in the doldrums, it is hard to imagine the UK and U.S. can export their way out of recession.

I can only visualise two possible exits from this impasse. Either the future involves years of Japan-style deflation, high unemployment and stagnant output. More likely, Anglo-Saxon electorates will opt for monetary expansion, inflation and devaluation, implying a de facto default – which is exactly the outcome being priced by the CDS insurance premia mentioned earlier.

Neither scenario is attractive for equity markets. Add to all this the danger of another round in the banking crisis (possibly involving the European banks), thinly-veiled threats from China to dump their dollars, long term problems which have not gone away, like global warming, pensions and health care……if the market was on Prozac last time, it must be on Ecstasy now.

So what should investors do? My own choice would be a mix of two components:

1. Corporate debt and/or equity of low-leverage companies in “safe” industries: pharmaceuticals and healthcare, food processors, utilities, etc.

2. Conventional and index-linked gilts in pounds, dollars and euros.

Of course, if you think governments are going to default on their debts, rather than inflate them away over the next decade or two, you need to buy gold……and a gun might be useful too.

- Laurence Copeland is a professor of finance at Cardiff University Business School and a co-author of “Verdict on the Crash” published by the Institute of Economic Affairs. The opinions expressed are his own. -

The unending saga of MPs’ expenses has to be seen in perspective. Of all the dishonest things that politicians do, inflating their expenses is about the least damaging. At their worst, they lie to us whenever they think it politic to do so and knowingly favour policies which suit their own interests rather than those of the country. How can this happen? After all, in a democracy the interests of government are supposed to be aligned with those of the electorate, aren’t they?

It might work if we were all rational, but alas, we are not. Only too often, we want the best of both worlds. Nobody is offering us endless sunshine with no hosepipe bans. But there are always politicians prepared to tell us we can have low taxes without reducing government spending, longer sentences without overcrowded jails, near-total job security without high unemployment (the French are especially keen on this), and so on. Why do democratic politicians repeatedly make these promises which they know to be impossible? And why do we keep believing them, election after election, in spite of the repeated failure of politicians to deliver the impossible?

The question is as topical now as ever. In spite of their frightening levels of indebtedness, neither the UK nor the U.S. government has yet said how it proposes to pay off debts in the future – in fact, Gordon Brown is adamant that spending will carry on more or less unaffected. Yet surely voters on both sides of the Atlantic can see that at some point they will have to pay higher taxes and/or accept substantial cuts in Government spending? If so, why do politicians persist with the charade?

The answer lies, I believe, in the nature of the competitive process through which politicians appeal to the electorate. Suppose 80 percent of the electorate know that a choice has to be made – we cannot have both spending and lower taxes. If, say, half of these “informed” voters favour lower taxes and cuts in government spending if necessary, it is fair to assume they also predominantly support the right wing party (Conservative or Republican, for example). Similarly, the other informed segment of the electorate prefer higher taxes and will overwhelmingly vote Labour or Democrat.

Now it is axiomatic that a two party system is a battle for the centre ground, inhabited by the floating voter. In the example here, it is a fight for the 20 percent of the electorate who either still cling to the hope that we can have the best of both worlds or, possibly, who know we cannot, but nonetheless cannot face the decision (and who may have the same attitude to their own credit card bills). In order to capture their votes, politicians must continue to offer pipe dreams. If they can include a reassuring wink to their own side (“when the crunch comes we’ll do the right thing”), so much the better.

At some point, the process must come to an end, as more and more voters realise the truth – that neither they, nor the Government can go on borrowing indefinitely. The game is over when, either the segment of the electorate still in denial has dwindled into insignificance, or maybe when politicians risk alienating their own supporters by the patent dishonesty of their pitch. If the reports are to be believed, Prime Minister Gordon Brown thinks we are still some way from this point, while Chancellor Alistair Darling begs to differ.

- Laurence Copeland is a professor of finance at Cardiff University Business School and a co-author of “Verdict on the Crash” published by the Institute of Economic Affairs. The opinions expressed are his own. -

We could see it coming, couldn’t we? Those gigantic over-leveraged hedge funds were bound to come crashing down, as their massive bets turned sour, forcing them to default on their bank loans and bringing the banking system to its knees.

Except that it never happened. Instead, the system was destroyed by the greed and incompetence of the insiders, including some of the most blue-blooded investment and commercial banks in the world. Highly regulated as they were said to be, they were allowed in every country except Spain simply to move their riskiest investments off balance sheet, where they were free to bet the bank on investments in the notoriously toxic mortgage-backed securities.

Note the absence of hedge funds and private equity - Alternative Investment Funds or AIF’s - from this story.

Nonetheless, with proposals to impose new reporting requirements and controls on management, the EU is concentrating its regulatory fire on the dog that didn’t bark, with the clear intention of reducing the competitiveness of AIF’s and tying the hands of their managers (with a side swipe at the offshore financial centres where many are legally domiciled).

Since the only investors in this type of fund are high net worth individuals and institutions like pension funds, insurance companies and mutual funds who ought to be capable of looking after their own interests, official concern can only be justified if there is a potential threat to the banking system – something which you might have thought would have been best left to the banks to monitor. The fact that the EU feels the need to make these proposals amounts to a vote of no confidence in bank managements.

Now confidence in bankers may, understandably, be as low these days as in MPs. But are there any better grounds for trusting regulators who allowed the crisis to occur under their very noses? If regulators have indeed now learned the lessons of the crisis, should they not concentrate on applying them to the banks in their charge?

Ironically, hedge funds do remain problematic. First, pre-crisis academic research had already shown hedge fund managers to be incapable on average of earning high enough returns, even in a bull market, to justify their high fees. The crisis offered them a golden opportunity – which they have mostly missed - to show that they could make good on their promise to shield investors from losses in a bear market.

Second, AIF’s should carry some of the blame for the crisis, but their sin was one of omission, not commission. As major players, they could have done far more to rein in empire-building bank managements. For example, instead of short selling RBS to prevent its catastrophic purchase of ABN AMRO, they sold too little and too late – when RBS was already beyond recall. Moreover, they could have used their voting power far earlier to insist on remuneration packages for executives that were properly aligned with shareholders’ interests. Instead, by their inaction they endorsed management decisions either explicitly or by default.

But then this last is an accusation which could have been directed at any of the traditional investment vehicles – mutual funds, insurance companies, pension funds etc – though this fact is apparently of no concern to EU Commissioners, fixated as they are on their vendetta against the “locusts”.

- Laurence Copeland is a professor of finance at Cardiff University Business School. The opinions expressed are his own. -

Is the crisis over yet?

In the last 3 months, the Dow and the FTSE have each risen by about 25 percent, the Standard & Poor’s 500 by a third. House prices appear to be stabilising in the UK. Stress-tested and backed by seemingly unlimited government funding, the banks are lending again (if only to each other), so that 1-month libor is down to only 0.3 percent.

In the Far East, the Chinese economy may be growing again, and even Japan may have pulled out of its nosedive. The oil price has recovered from its lows.

Is there any reason to doubt that the worst is past?

No reason whatever, except the following (in ascending order of gravity):

1. As unemployment increases, defaults on credit card debt are certain to rise, reducing the banks’ ability and willingness to lend to consumers.

2. Even if the residential property market has stabilised, commercial property prices appear to be in free fall, leading to further contraction in the construction sector, more bad debts and knock-on effects on employment and investment in the broader economy.

3. The consensus view is that bank stress tests, in the U.S. at least, were based on optimistic assumptions about the depth and duration of the real estate slump.

4. In order to spare U.S. and UK taxpayers, the bailout burden has been piled on to the bond markets, which have so far proved willing to finance the massive increase in the national debt of the two countries at a cost of only 3.75 percent on 10-year Government debt in UK and 3.5 percent in U.S., which is remarkable considering that both countries appear to be heading for a debt-to-GDP ratio of 100 percent or more.

However, in addition to the recent threat by S&P to downgrade UK gilts, the spread on credit default swaps is an even clearer warning: it costs 86 b.p. to insure against a British government default, and 44 b.p. for the U.S. (compared to only about 40 b.p. for France, Germany or Japan). Outright default by Britain or the U.S. is, in my view, highly improbable.

By far the most likely outcome in the medium term is inflation, or default by stealth. This is how Britain paid the bill for World War Two and the U.S. for Vietnam. So far, however, the bond markets appear to trust the politicians to come up with a plan to pay off these debts. But they will not wait forever.

At some point, they could well take fright and try to dump UK or U.S. government debt, forcing yields up to cripplingly high levels, with disastrous consequences for the real economy.

5. Who are these bondholders anyway? A significant proportion are institutions or governments of countries which, unlike Britain and the U.S., save rather than consume, and hence have balance of payments surpluses, notably the Gulf States, Japan and, most important, China. How long will their patience last? They are locked into their massive accumulation of dollar assets, unable to exit without realising enormous capital losses. But if they decide to stop throwing good money after bad, the outcome could be a dramatic rise in interest rates and a calamitous fall in the value of the Dollar, a final convulsion in this long devastating crisis.

None of these disasters is inevitable. But if you think the worst is over, ask yourself: why is the price of gold - traditionally seen as a safe haven in times of economic turmoil - rising again?