Words ought to be a little wild, for they are the assault of thoughts on the unthinking
- J.M. Keynes

Wednesday, 28 November 2012

The European Gravy Train


The EU gravy train is on a slippery slope due to Greece on the tracks. After the interest rate concession so magnanimously granted to Greece, everyone thinks that they are entitled to the same. Expansión reports that Luis De Guindos informed parliament that Spain will pay an interest rate of lower than 1% for its bank bailout. This is exceedingly generous for loans with an average maturity of 12.5 years (according to the EFSF) because Germany currently funds itself at 1.47% for 11 years (Jan-24 bund) to say nothing of an SPV backed by dodgy guarantees which was unable to issue even3 year bonds (and where guarantors accounting for a third of the guarantee themselves need a bailout to say nothing of the exploding baguette scenario).
Most likely Mr De Guindos is in a parallel universe to the EU’s parallel universe. As the translated Expansión article states (emphasis mine on the Freudian translation) “In June, when it announced the ransom demand for banking, Brussels said that this loan would have an interest of between 3% and 4%.” The parallel universe explanation fits best given that an interest rate below cost of funding would be a fiscal transfer which is illegal.
A little further west, his counterpart in Lisbon told his parliament that Portugal (and Ireland) will benefit from conditions offered to Greece. Quite ironical after all the chants of ‘we are not Greece’ and ‘Greece is a special case’. At least he is not in a parallel universe yet. His misplaced optimism stems from his belief in a 'principle of equal treatment' established in the European summit in July 2011. Somehow this principle is not mentioned in Barroso’s post-summit statement or in the statement by the heads of state. (As an aside, the part of the statement on Greece is quite interesting as it shows how EU is satisfying Einstein’s definition of insanity). The only sentence of peripheral relevance is “The EFSF lending rates and maturities we agreed upon for Greece will be applied also for Portugal and Ireland.” From this to assume that any and all Greek concessions made in future will also apply equally is a willing suspension of rationality.    
At least the Irish are more realistic as per the Department of Finance spokesman quoted in Irish Independent “Last night was about Greece, not Ireland and there was no discussion on extending the conditions or concessions agreed for Greece to Ireland.” Still they are also looking for concessions from the gravy train. If someone deserves a break it is the Irish since they have the greatest chance of coming out of their self-inflicted pain but unfortunately Europe doesn’t work that way. And that is why the gravy train cannot to see the light since they have constructed a never ending tunnel for themselves.

Tuesday, 27 November 2012

Eurogroup Statement in Parallel Universe


No surprise that the can has been kicked down the road (Eurogroup statement on Greece). But I’d definitely like to know what were they drinking before coming up with the “agreement”. Here is proof that parallel universes described by String theory exist. They seem to be very happy and optimistic places but somehow I can't get my brane around them.

After all the verbiage about strong confidence in Greece, the salient features of the latest grand plan are:

  1. Maturity extension for both bilateral and EFSF loans by 15 years and interest deferral on EFSF loans by 10 years. Genius. This solves the problem in one neat stroke. If there are no payments due then there is no chance of default.
  2. Lenders redirect SMP profits to a segregated account which is then used to pay them back. Was the ghost of Arthur Andersen in the advisory panel?
  3. Lowering interest rates on Greek Loan Facility (GLF) (bilateral loans provided in the first bailout) by 1%. The catch being that “Member States under a full financial assistance programme are not required to participate in the lowering of the GLF interest rates”. Spain and Italy account for 31% of the €52.9bn GLF with the former lending €6.5bn and the latter lending €9.8bn. So as soon as Rajoy and Monti take the poisoned OMT chalice, a third of the interest rate subsidy vaporises.
  4. Lowering guarantee fee costs paid on EFSF loans by 10bps. Rounding error.
Even these “benefits” will only accrue only if
  1. Greeks behave themselves. (“the above-mentioned benefits of initiatives by euro area Member States would accrue to Greece in a phased manner and conditional upon a strong implementation by the country of the agreed reform measures in the programme period as well as in the post-programme surveillance period.”)
  2. National parliaments ratify the agreement without a hitch.
  3. A grand plan to transfer taxpayer money from across Europe and the world to private creditors is elucidated (the IMF has learnt nothing from its Argentinean fiasco). At least there is a ceiling for the tender price (“tender or exchange prices are expected to be no higher than those at close on Friday 23 November 2012”).
The ridiculousness of the debt-GDP targets is obvious. From a debt-GDP of 175% in 2016, Greece is supposed to achieve a debt-GDP “substantially” lower than 110% in 2022. This requires an average annual growth in excess of 8% assuming no change in debt. Greece hasn’t achieved that kind of growth since 1996 (prior data is not maintained by Eurostat). The highest average annual growth it achieved in a consecutive 6-year period was 4.28% from 2001-2006. And this was when the global credit boom and Euro-convergence trade were at their zenith. Assuming this growth rate is miraculously achieved again, debt has to decrease by an average of 3.5% per annum. This implies primary surpluses in excess of 10.5% as interest payments currently consume about 7% of Greek GDP. Interest rate subsidies will have to lower that figure to 0 and assume the best ever primary surplus which Greece ran in 2000 is repeated not once but 6 times in a row. Truly heroic assumptions. We await the next meeting.

Monday, 26 November 2012

Thoughts on Catalan Election Result


One has to feel sorry for Arthur Mas, the pro-independence Catalan leader. In September he seized upon the vote-winning idea of Catalan independence with the implicit subtext that all economic problems would magically vanish upon its arrival. Until recently it looked as if he would get an absolute majority and a great lift in popularity, status and bargaining position. Instead everyone won but him.
Ironically voters found the idea of independence so alluring that they voted for more radical pro-independence parties than Mas’s CiU. As the FT reports, CiU which had 62 seats in the previous parliament crashed to 50 seats when once it was projected to achieve an absolute majority of 68 in a 135 seat parliament. The biggest amongst the more radical separatist parties, Esquerra Republicana (ER), more than doubled its seats in the Catalan parliament (21 from 10). Together with the CiU, pro-independence parties now control 87 of the 135 seats in parliament.
This more radical pro-independence parliament is likely to have more serious repercussions than a parliament with a CiU majority especially as the record high turnout of 69.56% (compared to 58.78% in 2010) shows a clear mandate for independence. Mas probably opened Pandora’s box hoping to find a cure for his plummeting popularity due to forced austerity. Frozen from capital markets with €42bn in debt and clinging on to emergency credit lifelines from Spain he desperately needed to up his bargaining power. Unfortunately, he unleashed the evil of populism.
The result itself is not surprising since it is part of the process of growing extremism which is underway to a greater or lesser extent in all of Europe. However, it presents Spain with a Catch-22 situation. To do nothing would increase resentment and further fuel the shift towards the radical pro-independence parties. To appease Catalonia will set a precedent for other Spanish regions who are surely watching the performance of the independence card. Given the propensity of politicians to steal from the future and shore up the present, the likely scenario is for Rajoy and Spain to do nothing and rebuff all Catalan demands. This is a relatively easy approach since constitutionally Catalonia has little power and the central government can always handle strikes and demonstrations with a little tear-gas. Also, taking a hardline stance makes Rajoy appear strong and keeps the economic trainwreck on the rails for sometime longer.
Of course the eventual denouement is going to be far worse but that is always someone else’s problem.

Wednesday, 21 November 2012

Say what the struggle hath availeth (Part-II)



The second plank of improving primary balances on which the Economist’s Euro-optimism rests is also as shaky as the first. (NB: Primary balance is the difference between government revenue and expenditure before interest on debt). Although primary balances in the periphery are improving and Italy has returned to surplus, it is not yet cause for cheer. Indebtedness is still increasing as Graph 1 shows.
Graph 1








Source: Eurostat

Primary balance is only one part of the picture and a surplus is necessary but not sufficient to prevent debt from spiralling out of control. Despite a primary surplus, debt can still increase if the interest paid on debt increases more than in proportion (as explained in the box below).
Assume debt at start of year = D
Average interest rate            = R
Therefore, total interest bill   = D*R
If primary surplus               = P
Then, Net change in debt     = D*R – P
For stable debt:                R = P/D = Sustainable funding rate
For decreasing debt:         R < P/D
Condition for debt spiral:   R > P/D 

The deteriorating fiscal situation has not been kind to peripheral yields. As Graph 2 shows average 10-year yields have been north of 5% since the middle of last year for all peripherals (and longer for Greece, Ireland and Portugal).
Graph 2







Source: Eurostat

Short-end rates are lower but still not low enough to allow debt sustainability (Table 1). Either primary deficits improve massively or bond yields reduce dramatically (even going negative for peripherals). Neither seems likely as self-defeating austerity precludes the former and the latter is impossible even with OMT. The situation is fairly dire for Portugal and Greece since neither has ever achieved the required primary surplus in the last 12 years. Italy and France are the closest to realising the required primary surplus. However, as debt piles up in the interim the moving target may prove elusive especially if maturing lower interest rate debt is replaced by debt with higher interest. This trend is already in play and can be discerned by the declining capability to service interest as seen by the increase in ratio of interest payments to revenue (Graph 3 below).

Table 1: OMT is not enough
Country
Current 2Y Yield
2011 Data

Primary surplus reqd. if avg. interest paid equals 2Y yield
Primary Surplus (P)
P/D (Sustainable funding rate)
Germany
0.00%
1.8%
2.24%
0.00%
France
0.11%
-2.6%
-3.02%
0.09%
Ireland
1.95%
-10.0%
-9.40%
2.07%
Italy
2.25%
1.0%
0.83%
2.72%
Spain
3.17%
-7.0%
-10.10%
2.19%
Portugal
4.89%
-0.4%
-0.37%
5.29%
Greece
4.20%*
-2.3%
-1.35%
7.17%
Note: Greek yields are for 3-month T-bills
Source: Bloomberg, Eurostat, Author’s calculations

Graph 3 







Source: Eurostat          

In short, primary surpluses are just a milestone in the never-ending road to debt-sustainability at the end of the rainbow. All the summits, confidence-boosting press conferences, back-slapping solidarity and grand plans have failed to stem higher debt, higher interest rates (despite unusually loose monetary policy) and lower interest service ability in peripheral nations.

Tuesday, 20 November 2012

Say what the struggle hath availeth (Part I)


The recent issue of the Economist had a moderately optimistic piece on peripheral economies restructuring and becoming more competitive. The twin planks on which this assessment was based were improved primary budget balance and current account balance. The article even started with a heart-warming story of Spain shipping cars to China for the first time. 

Alas, peering under the bonnet reveals that the peripheral engine is still shot. Looking at the trade deficit with four major EU trade partners shows that there is one clear winner and it is not in the periphery. (Trade deficit which covers goods is a better indicator of competitiveness which is all about making and selling “stuff” - see footnote).

First spot the country with improved terms of trade with China.










Source: Eurostat

Then see if it is the same country which has massively improved its terms of trade with India too.










Source: Eurostat

Surely the world’s consumer of last resort, the US will be different. Um…no.









Source: Eurostat

So with which country have the peripherals improved their terms of trade? The answer is the country whose motor is shot even more than Europe’s – Japan. But even here you have to look closely to see the improvement.









Source: Eurostat

Combining all the above, it is clear that Germany is powering ahead, Ireland is steadily improving, Spain has stabilised but stalled and Italy and France are losing steam with the latter in worse shape. The Economist was right about exploding baguettes.















Footnote: Services covers traditional items, such as travel and transportation and items, such as communications, financial and computer services, royalties and license fees, and many types of other business services. Looking only at goods also strips out services rendered purely for tax optimisation purposes which skew balances for countries like Ireland.

Friday, 16 November 2012

This Time is Different


Poring over history shows that nothing is different. In that sense, the current US recovery is following a familiar pattern as shown by Reinhart and Rogoff. However, historical schadenfreude does not ease present pain. Habituated to quick recoveries, Americans are shocked at the sluggishness of the current one. It is certainly different from all the post World War II recoveries as Graph 1, 2 & 3 show.

Graph 1: Number of years taken to surpass pre-recession per-capita GDP peak











Source: Conference Board Total Economy Database™

Graph 2: Real GDP growth following recessionary trough (rebased to 100 at start)











Source: U.S. Bureau of Economic Analysis

Graph 3: Unemployment rate following recessionary trough











Source: U.S. Bureau of Labour Statistics

Despite it being a big issue in the recent presidential election, there is very little that presidents or even central bankers can do. Despite the copious amounts of ammunition expended by Bernanke & Co. economic forces created by the financial and housing bust are holding back a swift recovery as they always have. In fact, the weakness of the recovery in face of the strength of Bernanke’s attack is concerning. Apart from the obvious ineffectiveness of monetary easing in face of a liquidity trap (something I have been banging on about for some time, for example this and this) it is storing up problems for later.

Bernanke has floored the accelerator yet the car refuses to move. The Fed funds rate is the lowest it has ever been both on a nominal and real basis (Graphs 4 & 5). The steepest yield curves in a recovery are providing further impetus to bank profits and helping them rebuild their balance sheet (Graphs 6 & 7). However, industrial recovery is average at best (Graph 8) with capacity utilisation woefully low (Graph 9).

Graph 4: Fed funds rate following recessionary trough











Source: Federal Reserve

Graph 5: Real Fed funds rate following recessionary trough










Source: Federal Reserve

Graph 6: Yield differential between 10Y and 2Y UST following recessionary trough










Source: Federal Reserve

Graph 7: Yield differential between 10Y and 5Y UST following recessionary trough










Source: Federal Reserve

Graph 8: Industrial Production Index following recessionary trough











Source: Federal Reserve

Graph 9: Capacity utilisation following recessionary trough










Source: Federal Reserve

A more circumspect US consumer is one of the main reasons for the slow recovery. Growth in both consumer credit and real personal consumption expenditure has been the slowest since the 1950s (despite record low rates). This is shown in graphs 10 and 11. This is because the consumer is still weighed down by his debt binge during the Greenspan era (Graph 12 – blue line following the 1991 recession and orange line following the 2001 recession). Bernanke’s low rates policy has not encouraged more borrowing but it has made this debt burden easier to bear (Graph 13).

Graph 10: Consumer Credit following recessionary trough (rebased to 100 at start)










Source: Federal Reserve

Graph 11: Real personal consumption expenditure index following recessionary trough









Source: U.S. Bureau of Economic Analysis

Graph 12: Consumer debt / GDP ratio following recessionary trough









Source: Federal Reserve, U.S. Bureau of Economic Analysis

Graph 13: Financial Obligations Ratio (FOR) following recessionary trough










Source: Federal Reserve
Note: FOR includes Mortgage payments, Consumer debt, Auto lease, Rent, Home Insurance and Property Tax

Moribund consumer finances are being compounded by idiotic austerity. Failure to reduce government debt during booms has now come back to haunt policymakers. With the worst post-war debt/GDP ratio (Graph 14) it is no surprise that real government consumption expenditure is declining (Graph 15). Even without the fiscal cliff, the government is retarding recovery.

Graph 14: Debt/GDP ratio following recessionary trough








Source: U.S. Bureau of Economic Analysis, www.treasurydirect.gov

Graph 15: Real government consumption expenditures and gross investment index following trough (rebased to 100 at start)









Source: U.S. Bureau of Economic Analysis  

These economic facts in addition to ideological battles have hamstrung the fiscal response to the crisis. Therefore a sharp upturn is unlikely and the investor has to adapt to these “different” circumstances. The script is familiar within the US. Slow growth and muted corporate earnings are likely to cause equity price revaluation, a process which has already started. Amidst this backdrop easy monetary policy is unlikely to be reversed which means that the hunt for yield will continue. At some point, equities will need to be bought and fixed income sold, but that point is not here yet.

Globally the picture is more interesting. The die is case for anaemic global growth with consequent problems for export-dominated economies. The US was the global economic engine pulling out other nations from their recessions. Recovery occurred relatively swiftly from the Latin American crisis, Tequila crisis, East Asian crisis, Russian crisis and the dotcom bust because the US consumer and the economy kept chugging along. Now the situation has changed. Neither can the US bestow largesse (as was the case in Latin America and Mexico) nor can it continue to consume bric-a-bracs made by other nations at the same pace. Moreover, with Europe mired in crisis and China’s lopsided development showing signs of strain there is no one to supplant the consumer of last resort.

This is especially bad for Europe which has staked its resurgence on the twin planks of austerity and export-led growth. The first has demonstrably failed. The second is about to fail. In addition, with the presidential election over, the imperative to keep the farce running by throwing money through the IMF is no longer there. It is now a question of when the dominoes fall.

Surprisingly, the gloomy environment favours the dollar despite the Fed’s best efforts to cheapen it. The US economy will continue to outperform given its size (in area, resources and population) and resilience. Europe’s woes and Chinese wobbles will only enhance the allure of the dollar as a safe haven (the Yen is not a safe haven, Swiss have tied themselves to the European mast and the Australian dollar is a commodity play in a slowing economy).

This time may be different but ultimately there is no difference in the importance of USA to the global economy and its global standing.

Tuesday, 13 November 2012

History of the World in One Graph









Source: Angus Maddison
Note: GDP is expressed in Geary-Khamis 1990 dollars therefore proportions are based on PPP not on absolute nominal figures. This better links GDP to living standards.


Pre-1700
Primarily agrarian economies where economic might was based on extent of fertile land and size of population. Not surprisingly, China and India with 50% of the world’s population were behemoths accounting for more than half of the world economy.

1700-1820
Industrial revolution started in the mid-18th century in UK. The rapid increase in prosperity of UK relative to Europe is reflected in the sharp rise in the share of UK to Western Europe’s GDP from 15% in 1700 to 26% in 1820. The precipitous decline in India’s GDP followed the decline of the Mughal empire after the death of Aurangzeb in 1707. It led to political fragmentation, internecine warfare and the rise of the rapacious East India Company.

1820-1870
Post-Napoleonic era and the rise of nationalism in Europe. Industrialisation arrived alongside and led to a spike in Europe’s share of world GDP. The hunt for colonies gained importance and became easier due to technological progress. China’s stagnant economy couldn’t withstand the assault (First Opium War was in 1840) and followed India’s decline. The US also started to catch up post independence utilising its large landmass, increasing population and benefits of industrialisation.

1870-1900
The zenith of imperial Europe and British Raj with roughly 13% of world’s population accounting for 32% of world GDP. By now, western Europe had also caught up with the UK after German unification and industrialisation (as seen by the static share of UK in Europe’s GDP). Tsarist Russia was left far behind, which may have had a bearing on the things to come.

1900-1913
UK-German rivalry and an arms race began as the German economy challenged and finally overtook UK around 1908. The balance of power shifted as can be seen by the first ever decline in UK’s share of European GDP since 1500. The seeds of the Great War were probably sown. On the other side of the world, the US continued to move upwards. Lack of industrialisation and colonialism meant India and China were poor farmers in an urban society.

1913-1950
Europe destroyed itself through two wars and the consequent transfer of wealth to the US (along with US's natural development) led to the latter overtaking the former. Communism, the wars and Stalin’s mismanagement didn’t help Russia and its satellites to progress greatly. Their share of world GDP only went up slightly post 1950 and peaked around the 1960s.

Thursday, 8 November 2012

The Brave New World of Credit Trading Machines


If the decline in the trading volume was not enough, credit traders must now face up to their obsolescence. The brave new world is here and pithily captured by FT Alphaville’s headline “Culled UBS traders replaced with algos”.  

The incessant march of technology cannot be halted and it was only a matter of time until the machines forced their way into the OTC-trading bastion. Moreover, two developments have greatly accelerated the rise of the machines. First, the credit crash exposed the myth of the alpha generating trader. What many banks considered superior trading ability was largely found to be some variant of a leveraged carry trade. Second, post-crisis regulation pushed for greater transparency, squeezed profit margins and increased capital requirements on trading positions. The pre-crash business model of taking enormous (albeit hidden) risk with borrowed money is no longer tenable. The new object is to match buyers and sellers, taking a cut from both without risking much capital. In this, machines are cheaper and faster than humans as demonstrated by the domination of HFT algorithms in equity markets.

Large desks manned by scores of highly paid traders and salespeople were anachronistic especially in commoditised OTC credit products. When a client wishes to trade a particular bond or CDS, price is usually the only determinant for a trade. In the process, there is no value added by salespeople who take the client’s call, relay the message to the trader and relay back a response. The value added by a trader is only realised when the bond/CDS position is closed out through an offsetting trade. This can be negative if the market moves against the position in the interim (Therefore traders demand a margin to compensate for this risk and hope to convert it into actual added value). The level of competition in the market impacts the margin and thus the value realised by the trading operation. The example below makes it clearer.

Consider a buyer of bond A, who wishes to pay $99 for it. Unknown to him a seller B is ready to sell at $98. Now if there is only one bank who knows both the buyer and seller then it can make $1 profit by buying from B at $98 and selling to A at $99. However, if after buying from B, some news causes A to revise his bid to $97 then the actual value added is negative $1. Therefore the less time that elapses between the two offsetting transactions, the better it is for the bank. Now presence of another bank which also knows A and B will reduce the margin demanded due to each bank’s incentive to win the trade by undercutting the other. Not only does it reduce their realised profit from $1 but it also increases the potential loss. If a bank buys at $98.5 hoping to sell to A for $99 but news leads to a revised bid of $97 then the loss is $1.5 not $1 as it would have been earlier.

Before the crash, excluding the innumerable smaller firms, there were more than 20 large banks all clamouring for the same business. The obvious result was zero margins in market-making. These were supposed to be compensated through proprietary trading which is no longer an option.

To make money in market-making requires maximising the speed of trade execution to avoid being undercut and minimising the delay in closing out trading positions to reduce the risk of deleterious market moves. This is exactly how HFT algorithms operate in equity markets and even though the implementation might differ, there is no reason why market-making fundamentals should differ for OTC credit markets. Electronic platforms which enhance the speed of trade execution have already been adopted by most banks. They obviate the need to maintain an expensive army of salespeople whose main job is to intermediate between clients and traders. It enables the bank to focus on the few salespeople who actually add value. This is a move towards corporate banking type relationships where a few people have extensive and strong relationships with a firm's senior managers ensuring that they at least get asked when there is business to be done. The next logical step is disbandment of the expensive army of traders which the introduction of algorithms integrated with electronic platforms would enable. This would result in lower bid-offer spread (i.e. advertised margin) and quicker post-trade price adjustment. Consequently the probability of capturing client trades would go up reducing the delay in offsetting trading positions. Human traders will still be needed but as in sales, far fewer than earlier and of a higher calibre than average.

The gloom over employment following the UBS cull is justified since not only is banking undergoing a structural change but artificial intelligence is fast replacing human intelligence. However there is no need to start the search for John Connor. A chosen few will still be needed by banks. More importantly for those who have real talent there is nothing to fear from a rise of the machines. Even though machines have an edge in market-making, long-term trading or investment is a multidimensional field where human intelligence beats artificial intelligence hands down. Ask a computer to compute the probability of eventual Greek default and how best to express that view and chances are that a blue screen will pop up. Opportunities abound in the current market and the financial turmoil has led to a general thinning of ranks (leveraged coin tossers and momentum chasers are dying out) which has made pricing anomalies more numerous, longer lived and more profitable. Even better, the rise of the machines means that execution becomes easier and cheaper. So raise a toast to the machines and follow the one consistent and proven winning strategy: that of using the machines to one’s advantage. 

Saturday, 3 November 2012

The Rhyming of History


“If there is ever another war in Europe, it will come out of some damned silly thing in the Balkans.” 
– Otto von Bismarck

An incident in one of the Balkan countries which should have been settled without much fuss grew rapidly malignant and engulfed the entire continent. This was the assassination of Archduke Franz Ferdinand which led to the Great War. Although one would be justified in thinking that it also applies to the current state of affairs. A €20bn cheque to Greece at the beginning of 2010 with behind the scenes conditionality might have settled matters. Unfortunately elections in North-Rhine Westphalia along with typical EU bureaucratic swiftness led to characteristic delay in decision making. By the time the first inept rescue was mounted, the fire had spread.

Despite two bailouts, one restructuring and numerous masterplans, not only is Greece in worse shape but it is still at the exit door. A Greek exit may have lost its horror for those ensconced in a bubble of sanguinity but they are deluding themselves. Just as before 1914 when massive instability was hidden behind a façade of economic and political stability, today’s quiescent markets are covering an increasingly unstable equilibrium.

The oft-repeated refrain is that the European elite will never allow a Greek bankruptcy and exit. All their actions so far lend credence to this hypothesis. This belief has been further strengthened with every red line that has been erased in the misplaced hope that reality will match rosy forecasts. Now, once again a fudge is being created to allow a loan repayment extension and the disbursement of the next €31.5bn aid tranche. This is familiar to the refrain leading up to 1914. It was thought that civilised nations which are economically interlinked can never go to war. Each incident which heightened tensions and made the Great War more probable was dismissed on the belief that the irrationality of mutual destruction could never prevail. No less a person than Winston Churchill thought “…It is too foolish, too fantastic to be thought of in the twentieth century...No, it is nothing. No one would do such things. Civilization has climbed above such perils. The interdependence of nations in trade and traffic, the sense of public law, the Hague Convention, Liberal principles, the Labour Party, high finance, Christian charity, common sense have rendered such nightmares impossible.” One can hear the echoes in the reassuring pronouncements of European leaders today.

More importantly the argument of never allowing a Greek bankruptcy and exit looks at only one side of the problem. In a marriage either party can file for divorce. Of course the EU leaders want to make it work and are trying their best, but the Greeks don’t seem to be so keen on what they perceive as an abusive relationship. Support for anti-bailout parties is growing (including worryingly for extremist parties such as Golden Dawn) and even the coalition government is about to fall apart. Fanning the flames is the non-binding ruling by the Greek Court of Audiors that pension reform is unconstitutional. Despite EU elite’s best efforts, Greece can unilaterally decide to exit (i.e. implode). The argument that the majority’s preference for the Euro over the Drachma will prevent such an occurrence is hogwash. History is full of cases of unofficial and official dollarization preceding and succeeding default. Greece can still use the Euro even if it is not in the Eurozone.

Another worrying similarity with 1914 is the inability of leaders to understand the consequences of a trigger event and their gross underestimation of eventual impact. Until the declaration of war diplomats thought that the dispute between Serbia and Austria-Hungary could be contained. Once war was declared in August, all sides thought it would be a fairly short affair likely to be over by Christmas. Kaiser Wilhelm II famously told German troops in August 1914 that they would be back home before the leaves fall from the trees. A disorderly Greek default and exit would not be an isolated event. First, it would destroy the credibility of the European elite which has already risked immense amounts of economic and political capital by successive Greek bailouts. Second, it would likely lead to contagion as both markets and citizens wonder who is next. Third, it would inflict large losses on official institutions and European partners making further bailouts difficult if not impossible.

The argument that a Greek exit would actually lead to austerity relaxation and unlimited bailouts just as Lehman’s failure triggered a surge of monetary and fiscal support is wrong. First, the EU is not the US and hence the speed of decision making cannot be the same. Second and more importantly, political positions which have been taken and conveyed to voters have solidified over the course of the crisis. Each concession wrangled out at summits has increased bitterness and entrenched positions. North and South Europe are more polarised than they were before it all started in 2010. Therefore a sudden change of direction is unlikely. Just as alliances and political stances of countries pre-1914 made a catastrophe inevitable, so too will current irrational politics contribute to a cataclysm. Finally, the post-Lehman financial sector bailout has generated a tremendous backlash from ordinary citizens. A corrupt elite has been seen to be favoured as the recipient of bailout money. As pro-EU opinion ebbs away in countries like Germany a multiple sovereign bailout to “save the system” is unlikely to fly. This is especially so since public opinion in the donor Northern European countries is shaped by the caricature of the “lazy” southerner. If the latest fracas over the EU budget is anything to go by, countries aren’t going to sign blank cheques when their own economies are on the ropes.

No one thought war was possible in 1914 with the result that the yield on British 2.5% consols (perpetual debt with 2.5% interest p.a) in July 1914 was 3.34%. War and subsequent inflation saw prices more than double destroying investor capital on a massive scale. Similarly the current market isn’t pricing in the probability of an EU meltdown even as we move closer with the Greek car about to take a wrong turn.