Buttonwood's notebook

THERE is an interesting debate among the analysts about the extent to which the ECB's programme of three year loans to European banks is being funnelled back into the government bond market. Whatever the truth of the matter (or the intentions of the ECB), the funding costs of Italy and Spain have fallen this year from the panicky levels of late 2011, and that can only be a good thing.

But the good news hasn't spread to Portugal, where the 10-year bond yield has gone above 14%. Remember that the official position is that the Greece private sector write-off will be a one-off; clearly the markets don't believe that. the lesson of Greece is that, the more official creditors get involved, the more the claims of privcate investors get subordinated, and the bigger their potential loss becomes.

Portugal's credit rating was downgraded two notches by S&P to BB, or junk bond status, which may mean that some investors aren't allowed to touch it. Of course, to the extent that cautious investors like insurance companies might be forced out of Portugal's debt, they might be replaced by risk-seeking investors (such as hedge funds) who would be attracted by the higher yield. However, such funds would want to insure themselves with a credit default swap (which currently indicate a 65% probability of default within the next five years, according to the FT).

But is it worth buying a CDS. After all, the EU authorities are going out of their way to make such swaps worthless, by engineering a Greek default that doesn't count as such under the terms of the CDS (because the deal is voluntary). By denying investors the ability to insuire themselves, the effect may be to cut off a potential source of bond demand.

The Portuguese government is pushing through labour market reforms but any boost to growth that such measures bring will take years to come though, time the country may not have. The EU could pass off one default as an aberration, but could it say the same about two?

ON Monday, your blogger took part in a BBC radio discussion involving Detlev Schlichter, the author of Paper Money Collapse: the Folly of Elastic Money and the Coming Monetary Breakdown. Mr Schlichter's argument will be familiar to fans of Ron Paul, although they are less often aired on this side of the Atlantic.

He writes that

It is simply a historic fact that commodity money has always provided a reasonably stable medium of exchange, while the entire history of state paper money has been an unmitigated disaster when judged on the basis of price level stability. Replacing inelastic commodity money with state-issued paper money has, affter some time, always resulted in rising inflation.

I am not entirely unsympathetic to this line of argument. The Chinese used paper money before abandoning it (just as the west was discovering the printing press). Monetary experiments in France under John Law and the Jacobins ended very badly (and very quickly). But one can easily flip the argument around. Nearly all societies did use metallic money but none now do. So one could say that all metallic money systems have been abandoned. The reason can be found in Mr Schlichter's argument; metallic money worked well in terms of delivering price stability but that is only one goal. What about growth and employment?

Fix the value of money and the burden of adjustment falls on other parts of the economy. Countries abandoned the gold standard in the 1930s because democratically-elected politicians found themselves unable to impose the kind of austerity required to maintain their gold reserves (the 1931 British Labour government balked at a 20% cut in unemployment benefit, for example). The economic historian, Barry Eichengreen, found that the earlier a country left the gold standard, the quicker its economy recovered. He also suggests, very plausibly, that it was easier to stick to the gold standard in the 19th century because many workers did not have the vote.

One can fix the value of your money internally, via a gold standard, or externally, via a fixed exchange rate. The Greeks chose the latter option by joining the euro. But now their voters are being asked to pay the price in terms of substantial austerity; in the old days, the Greeks would simply have devalued. Now, of course, over the long run a perpetual programme of devaluation will make a currency worthless. The point is that, neither fixing nor floating the currency is a panacea; countries still need to keep themselves competitive.

Not would a gold standard necessarily be fixed. The international version lasted from 1871 (when the newly-united Germany joined) only until 1914. Countries rejoined and dropped out in the 1920s and 1930s. The Bretton Woods system, devised in 1944, fixed exchange rates to the dollar and the dollar to gold. But countries could (and did) devalue, notably Britain in 1949 and 1967. If the US government declared that the future value of a dollar would be, say, one thousandth of a gold ounce, there would be nothing to stop a future government declaring the dollar to be worth one two-thousandth of an ounce. Ancient monarchs achieved the same feat by clipping coins or diluting the amount of gold and silver with copper or some other metal.

Now Mr Schlichter accepts this. He writes that

I don't think we should wish for the resurrection of the classical gold standard that collapsed in 1914. Although this system was the relatively best international monetary system we have had since the Industrial Revolution, it was still a government-managed, gold-anchored system. My hope is rather that from the ashes of the collapsed paper money system a monetary order arises that is, once again, based on the market's choice of a monetary medium and that is regulated entirely by market forces, by the free, voluntary and spontaneous interaction of the trading public and not by government dictate.

adding that

The state has to exit, once and for all, , the sphere of money and banking.

But a lot flows from this. What do do about the money that has already been created? Perhaps only reserve money and physical cash would be backed by gold or some other commodity, he suggests.

Some bank deposits from previous periods could still be allowed to remain uncovered while banks would be prohibited from issuing new uncovered deposits. If such a restriction on fractional-reserve banking were not to be enacted, then the state should in any case abandon all measures by which it supports and encourages these banking practices and socializes these risks.

The practical implications of this would surely be a severe restriction of credit (at a time when the economy is already weak) and that failed banks would be allowed to go bust. Now some might cheer at the latter prospect but would they really want it?  The state intervenes to rescue banks because politicians worry what will happen to confidence if banks fail. It is easy to say that consumers should assess the financial strength of their banks but will Aunt Agathas in Worthing (or Wichita) really be able to do so. The mid-19th century was something of a free-for-all in US banking and was marked by a lot of failures and frauds.

So going back to a gold standard is far from a simple act and would involve a whole lot of changes that might be far from palatable in a democratic society.

UPDATE: Sorry to add to a very long post but another thought occurred to me. Of all paper money systems ever devised, the vast majority are still in existence and haven't collapsed yet. One could argue that "all previous bipedal apes have become extinct" on the grounds that Neanderthals and australopithecus are no longer around. But that would ignore the 7 billion humans still walking around.

WHILE the big headlines over the weekend were about S&P's downgrades of European countries, the more worrying news came from Greece, where talks on a debt deal broke up. While I am not as negative as some on the agencies (their record on rating sovereign debt is pretty good), the market had already anticipated a downgrade of France, which has been paying a higher rate on its debt than Germany.

Greece's debt is a complex issue. Clearly, it must default to get its debt-to-GDP ratio down. But it also has a competitiveness problem that requires either a devaluation (not possible within the euro) or a fall in its costs (lower wages and thus a lower standard of living). Some of the pain of the latter option can be cushioned by subsidies from its fellow EU nations but they demand reforms in return. Many of those reforms are opposed by Greeks; it remains to be seen whether the technocratic government can push them though.

Of course, Greece has already had loans from the rest of the EU and this complicates matters further. The authorities are unwilling to see take any write-downs on their money. That puts all the burden on the private sector. Indeed, the more money lent by official bodies, the greater the write-down the private sector is forced to absorb if the Greek debt-to-GDP ratio is to fall significantly.

Throw in another twist. The authorities are obsessed (rather perversely in my view) with making the agreement voluntary so that the Greek deal is not classed as a default in terms of credit default swap market. That gives the creditors a bit more bargaining power. The banks appear likely to go along with whatever they're offered but the hedge funds are putting up more of a stink.

Talks between Greece and its private sector creditors are due to resume on Wednesday, January 18. Whereas a tentative deal was reached in October to write the debt down by 50%, a lot depends on the interest rate on the new debt. The lower the rate, the better for Greece but the bigger the hit (in present value terms) to the creditors. And then there are the knock-on effects. The EU has said that the Greek deal won't set a precedent for other nations. But, pull the other one. The EU has said a lot of stuff during this crisis and has backtracked many times. The bigger the write-off for Greece and the more aid (in terms of cheap finance), the more other nations will be encouraged to default and the greater the worries of creditors of other nations. That's why the Greek deal (or lack of it) is so crucial.

UPDATE: On the issue of the agencies being behind the curve, here is the result of an analysis by Gabriel Sterne at Exotix

We too have been repeatedly critical of troubled European sovereign ratings as the crisis has grown; we think they have been much too lenient! Our views are based on a simple but systematic assessment of the statistical relationship between sovereign ratings and spreads in EM and EA sovereigns. The analysis suggests the agencies rated troubled EA sovereigns 5-6 notches more favourably than do markets [as of 20 December].  Hence we continue to think that EA ratings are way behind the curve in terms of speed and size of downgrades.

JOHN Ralfe, the pensions consultant, made a good point in Monday's FT, when commenting about the closure of Shell's final salary pension scheme to new members. He wrote that

Defined benefit pensions face the fundamental problem that the perceived benefit to employees is always likely to be less than the real cost to
the employer, making them economically inefficient.

Given the choice of a £40,000 salary, with no pension, and a £30,000 salary with a £10,000 pension contribution, employees will almost always choose the former. Indeed the implication of Mr Ralfe's view is that they would take a £38,000 salary over the same package. It is as if the employer had arranged for the sink to deliver Evian, when employees would have been happy with plain old tap water.

This may be because employees underestimate the level of savings needed to generate a decent retirement income. And that underestimation may well be down to pension accounting which, for years, allowed employers to account for future investment returns, without accounting for the accompanying risk. This is still the case in the US. There is no evidence, for example, that employees react accordingly when they are switched into defined contribution schemes, where the employer pays in much less. What they should do is ramp up their personal contributions but they don't.

All this will only sink home when employees reach their 60s, want to retire, and realise there is little in their pension pot. As John Lennon sang "You don't know what you got until you lose it".

FURTHER to the latest column on hedge fund returns, Michael Edesess of Fair Advisors draws my attention to a fairly damning paper on the subject by Adam Aiken, Christopher Clifford and Jesse Ellis, three US academics. The paper tackles the problem of self-selection bias that can mark hedge fund indices (only the best funds choose to report) by looking at funds that have registered with the SEC (which requires them to report performance data). They can then compare the returns of those funds that report their numbers to the index providers.

Broadly speaking, there are two effects; first among funds that remain in commercial databases and second, in those that drop out. The authors look at the so-called alpha of funds (jargon for skill) that voluntarily report their numbers. This is a complex calculation since one has to know the portfolio allocation of managers; much of their return may be down to exposure to the S&P 500 or to corporate bonds and so would be classed as beta (simple market exposure that can be obtained at much lower costs elsewhere). Whereas, the managers that report to an index seem to show alpha of 3.5 percentage points, that is because they are the best performers. According to the authors

95% of a typical fund manager's measured skill can be explained by whether they report to a database

When things go wrong for a hedge fund, they tend to stop reporting their numbers to the commercial providers but they still have to report to the SEC. Almost half of all such funds still operate for two years after they stop reporting to the indices. Such funds produce returns that are more than 7 percentage points a year below those that continue to report to commercial providers. The authors conclude that

Our results indicate that when we exclude self-selected database funds, the average excess returns of hedge funds does not differ markedly from zero.

THE provision of three-year liquidity to European banks late in 2011 was seen as a vital means of support, given that the interbank market seemed to be freezing up again. But it was another signal of how central banks are taking a bigger and bigger role in the economy; as well as providing liquidity to banks, they are a source of demand for government bonds and the key providers of confidence to the equity market.

This blog has worried in the past about how central banks will ever exit from these positions. Few people seem to have agreed with me on this, although their reasons can seem spurious. For example, I have wonderd what will happen to bond markets when central banks sell the bond holdings acquired under QE. Some have responded that central banks will simply let the bonds mature. But this isn't an answer.

In any given year, some proportion of the existing bond stock matures and must be refinanced. The private sector must be willing to absorb the new supply and refinance the existing stock. To the extent the central bank doesn't roll it over, the private sector must add to its bond holdings. The cash effect is exactly the same as if the central bank had sold an equivalent amount of bonds. 

Anyway, the IMF held a conference on post-crisis policy last year. Looking through the papers (which will shortly be published in book form by MIT Press as In the Wake of the Crisis: Leading Economists Reassess Economic Policy), I was pleased to see that Joseph Stiglitz had focused on this point. He wrote that

If the government's purchase of bonds leads to higher prices for stocks and bonds, its later sales should lead to a lower price. If markets anticipate this, then knowing that in the future prices will be lower limits the rise of the prices today.

He adds that there are two significant adverse effects.

First, there will be large potential losses by the central bank. The fact that the central bank does not use mark-to-mark accounting does not make these losses any less real. Second, the attempt to hide these losses (to ensure that they are not recognized) may impede the conduct of monetary policy.

Mr Stiglitz points out that QE may have had further questionable effects. Money may have flowed to where the opportunities look most exciting, such as emerging markets, creating potential bubbles there. Secondly, QE seems to have been used as a means of competitive devaluation (of course, other people can play that game). And QE seems to have destroyed the private mortgage market and ensured that mortgage lending is now largely a government affair, via Fannie Mae and Freddie Mac.

PERHAPS the most controversial issue in international economics/politics at the moment is the effect of fiscal policy. Are governments that are pursuing austerity mindlessly driving their economies into recession, especially when the markets appear to be applying no pressure on them in the form of higher yields (case study: Britain)? What about governments with little choice to cut given the demands of markets and/or foreign creditors? And what about countries like America which has no difficulty financing itself but has long-term fiscal challenges?  

The debate is brought into sharp relief by Spain. In an eerie echo of Greece, a new government has taken office, only to announce that the current deficit is much wider than expected (8% of GDP as opposed to 6%). The new government has unveiled an austerity programme, including a public sector pay freeze, cuts in transport subsidies and increased income tax rates.

For Jamie Dannhauser at Lombard Street Research, these measures amount to

fiscal masochism. They will increase the economic pain and make it less, not more, likely that Spain returns to financial health in coming years.

The problem foreseen by Mr Dannhauser is a "down the plughole" issue. Fiscal austerity will cause demand, and thus GDP, to slump. The result will be lower tax revenues, little improvement in the deficit and a higher debt-to-GDP ratio than before.

Mr Dannhauser makes the common sense point that any fall in the government deficit must, by definition, be offset by a fall in the surplus of one of the other sectors of the economy - corporations, households and foreigners. The corporate sector has a weak balance sheet and will need to hoard cash, so it seems out. Spanish unemployment is high, house prices are under pressure and the savings rate is at its long-term average, so it is hard to see consumers going on a spending spree. Nor is it easy to see foreigners snapping up Spanish exports, given the state of the European economy.

These are very tricky issues, and there tends to be a high ideological content to the debate. Conservatives who dislike big government tend to deny that fiscal stimulus, in the form of higher spending, can work while attributing miraculous powers to tax cuts. Social democrats resist spending cuts as falling disproportionately on the poor, while suspecting that tax cuts benefit the rich.

A more pragmatic view is to assume that the effect of fiscal policy depends on the circumstances. A 2010 paper from academics at the LSE and the University of Maryland found that

the output effect of an increase in government consumption is larger in industrial than developing countries

the fiscal multiplier is relatively large in economies operating under predetermined (i.e. fixed) exchange rates but zero in economies operating under flexible exchange rates

fiscal multipliers in open economies are lower than in closed economies

fiscal multipliers in high-debt economies are also zero

Spain has an industrialised economy, operates under a fixed exchange rate and has a lower government debt-to-GDP ratio than many of its European partners (the private sector is another matter). That implies Spain's deficit might be propping up its economy (and thus fiscal contraction will do more damage). In contrast, Britain has a more open economy than Spain, a floating exchange rate and a higher debt-to-GDP ratio (although not excessively so). That implies austerity makes more sense in Britain since the fiscal multiplier should be lower.

Alas, the political debate never seems to get framed in these more nuanced terms.

THE new big hope of central banks is called macroprudential policy. During the boom, central banks used the fairly blunt instrument of interest rates as their main weapon. But since inflationary pressures were low, thanks to the deflationary shock stemming from China and eastern Europe, rates were kept low. This led to a splurge of asset-backed lending. Meanwhile, banks found easy ways to exploit the rules of the Basle accords - designed to ensure the system was well-capitalised. As a result, when mortgage-backed securities started to plunge in value in 2007, the banks were much less robust than was previously thought.

The Bank of England has set up a financial policy committee, which is just starting the arduous task of sorting out which principles it should follow and which policy buttons it can push. In a paper out today, it sets out its options. It starts by discussing the potential flaws in financial markets such as

incentive distortions which can, for example, arise from contracts that reward short-term performance excessively

informational distortions such as those linked to buyers doubting the quality of assets (adverse selection) or less than fully rational processing of information

co-ordination problems, where collective action, for example to step away from lending in a boom, may be in the interests of individual banks but there is no way to co-ordinate on this outcome

As the paper points out (and as Hyman Minsky famously noticed) there is a tendency for banks to get overexposed to risk in the upswing of a credit cycle. After all, it is the banks that are driving the cycle. As they become more confident about lending against assets, more funds are available to investors/speculators and asset prices rise, increasing the confidence of all involved. As a proportion of GDP, commercial lending to real estate doubled between 2002 and 2008. In the UK banking system, leverage (as measured by total assets to shareholders' claims) increased from 20:1 to 50:1 within a decade. Both measures ought to have caused alarm but nothing was done.

There is little new in this, as the paper recognizes. Credit cycles have nearly always been marked by lending against property. But property is an illiquid market and prices fall very sharply when the balance of supply and demand shifts, often wiping out of all of a bank's collateral. Meanwhile, the duration of bank funding was steadily falling, from an average maturity of 10 years in the early 1980s to four years by 2008 (the US followed a similar trajectory). This left the banks very vulnerable to a run on liquidity.

The FPC says the authorities have, in principle, three types of measure to deal with these risks.

those that affect the balance sheets of financial institutions

those that affect the terms and conditions of loans and other financial transactions

those that influence market structures

For example, balance sheet measures include maximum leverage ratios and liquidity buffers; the second group includes caps on loan-to-value ratios and minimum margins; the third includes requirements for disclosure to reduce uncertainty about the market exposure of individual banks, but also the use of central counterparties to clear trades.

The paper then conducts an excellent and clear-eyed assessment of the pros and cons of these measures, without coming to any definite conclusion (the paper is part of a consultation process). What is clear is that the authorities cannot rely on just one or two measures, esepcially given the proved willingness of banks to game the system. Of course, the authorities cannot prevent all future financial crises, but they can still be a lot more alert than they were in the early 2000s. The paper shows the FPC is making a good start.

Meanwhile, this blogger is off on a seasonal break. Merry Christmas (and Happy Hanukkah) to all readers; hope you have a great time. Santa has already delivered me a present in the form of this review.

THE grand bargain postulated before last week's summit - that the euro zone governments would agree a fiscal pact in return for the ECB buying lots of government bonds - hasn't quite happened. But perhaps it is being done via a different route.

The ECB did agree to lend money on extended terms to European banks, and relaxed its collateral rules. The move was generally welcomed as a sign that Europe was ready to stop a Lehman-type collapse resulting from the freeze in the interbank lending markets.

But euro zone leaders have been hinting quite broadly that the banks can take that money from the ECB at 1% and invest the proceeds in government bonds, and earn a very nice yield premium along the way. This is a sort of back door QE, or perhaps bank door QE is the better name for it. In the early 1990s, the Fed deliberately engineered an upward-sloping yield curve to allow US banks to rebuild their balance sheets after the savings & loan crisis; borrowing at 3% and investing in Treasury bonds at 6-7%.

There are some questions over whether banks will take this risk, given that they might have to mark to market any losses on their government bond holdings. And there is no sign yet that this bargain is having much of an effect on bond yields.

Of course, this bargain is on a cynical view, like two drowning men hanging on to each other; bankrupt banks supporting bankrupt governments. The taxpayer stands behind both, of course, but this kind of deal is designed to create an implicit commitment on the part of taxpayers without making the costs explicit to voters.

THE European Central Bank cut interest rates by a quarter of a point today, thus reversing all the increases made earlier in the year. Even at the time, those looked a mistake. But the rate change was widely expected; the real interest was in the statement.

Based on its regular economic and monetary analyses, the Governing Council decided to lower the key ECB interest rates by 25 basis points, following the 25 basis point decrease on 3 November 2011. Inflation is likely to stay above 2% for several months to come, before declining to below 2%. The intensified financial market tensions are continuing to dampen economic activity in the euro area and the outlook remains subject to high uncertainty and substantial downside risks. In such an environment, cost, wage and price pressures in the euro area should remain modest over the policy-relevant horizon. At the same time, the underlying pace of monetary expansion remains moderate. Overall, it is essential for monetary policy to maintain price stability over the medium term, thereby ensuring a firm anchoring of inflation expectations in the euro area in line with our aim of maintaining inflation rates below, but close to, 2% over the medium term. Such anchoring is a prerequisite for monetary policy to make its contribution towards supporting economic growth and job creation in the euro area.

In its continued efforts to support the liquidity situation of euro area banks, and following the coordinated central bank action on 30 November 2011 to provide liquidity to the global financial system, the Governing Council today also decided to adopt further non-standard measures. These measures should ensure enhanced access of the banking sector to liquidity and facilitate the functioning of the euro area money market. They are expected to support the provision of credit to households and non-financial corporations. In this context, the Governing Council decided:

First, to conduct two longer-term refinancing operations (LTROs) with a maturity of 36 months and the option of early repayment after one year. The operations will be conducted as fixed rate tender procedures with full allotment. The rate in these operations will be fixed at the average rate of the main refinancing operations over the life of the respective operation. Interest will be paid when the respective operation matures. The first operation will be allotted on 21 December 2011 and will replace the 12-month LTRO announced on 6 October 2011.

Second, to increase collateral availability by reducing the rating threshold for certain asset-backed securities (ABS). In addition to the ABS that are already eligible for Eurosystem operations, ABS having a second best rating of at least “single A” in the Eurosystem harmonised credit scale at issuance, and at all times subsequently, and the underlying assets of which comprise residential mortgages and loans to small and medium-sized enterprises, will be eligible for use as collateral in Eurosystem credit operations. Moreover, national central banks will be allowed, as a temporary solution, to accept as collateral additional performing credit claims (namely bank loans) that satisfy specific eligibility criteria. The responsibility entailed in the acceptance of such credit claims will be borne by the national central bank authorising their use. These measures will take effect as soon as the relevant legal acts have been published.

Third, to reduce the reserve ratio, which is currently 2%, to 1%. This will free up collateral and support money market activity. As a consequence of the full allotment policy applied in the ECB’s main refinancing operations and the way banks are using this option, the system of reserve requirements is not needed to the same extent as under normal circumstances to steer money market conditions. This measure will take effect as of the maintenance period starting on 18 January 2012.

Fourth, to discontinue for the time being, as of the maintenance period starting on 14 December 2011, the fine-tuning operations carried out on the last day of each maintenance period. This is a technical measure to support money market activity.

The key proposal here is in the "non-standard" financing of the banks. Many banks are struggling themselves in the money markets and had been tapping the ECB for 12 and 13 months money. Extending the facility out to three years gives them a lot more security, as does extending the range of collateral accepted. This would have seemed very bold moves five years ago and show the ECB is not as rigid as it is sometimes portrayed. The European banking system won't collapse for lack of liquidity.

What Mr Draghi didn't offer is a blank cheque for politicians attending the EU summit. He may well have reasoned that the more he promised in advance, the less pressure the politicians would feel. Instead, he reiterated his demands.

Turning to fiscal policies, all euro area governments urgently need to do their utmost to support fiscal sustainability in the euro area as a whole. A new fiscal compact, comprising a fundamental restatement of the fiscal rules together with the fiscal commitments that euro area governments have made, is the most important precondition for restoring the normal functioning of financial markets. Policy-makers need to correct excessive deficits and move to balanced budgets in the coming years by specifying and implementing the necessary adjustment measures. This will support public confidence in the soundness of policy actions and thus strengthen overall economic sentiment.

To accompany fiscal consolidation, the Governing Council has repeatedly called for bold and ambitious structural reforms. Going hand in hand, fiscal consolidation and structural reforms would strengthen confidence, growth prospects and job creation. Key reforms should be immediately carried out to help the euro area countries to improve competitiveness, increase the flexibility of their economies and enhance their longer-term growth potential. Labour market reforms should focus on removing rigidities and enhancing wage flexibility. Product market reforms should focus on fully opening up markets to increased competition.

It is a sad state of affairs that it seems European politicians will only reform themselves with a gun at their heads but there it is.

A HEADLINE on Bloomberg claims (in typical Bloomberg-ese) there was "No Lost Decade for S&P 500 as Big-Cap Bias Masks Rally". The idea is that, if you equally weight stocks, then they have risen 66% over the last decade.

That may be true and I have argued in the past that there's a lot of scope for alternative ways of weighting portfolios than market values. The Robert Arnott approach, which weights stocks by "fundamentals" like sales and dividends, avoids the peril of market-value weighting, which leads investors to allocate most money to those stocks that are most fashionable, and thus likely to be too expensive.

The problem with this approach is that, by definition, not all investors can follow it. If we all equally weighted stocks then, well, all stocks would be equally-weighted. As it is, many stocks are quite small and illiquid so are difficult for big managers to own. Take the Fidelity Magellan fund which had $100 billion at its peak; divided equally among 500 stocks, that would be $200 million per holding. For the smaller stocks, the fund would have 20% of the equity; as it got in and out, it would move the price substantially.    

The reason we use market cap-weighted stocks to measure the long-term performance of equities is that they represent the performance of the average investor, before costs. Ten years ago, investors were making big bets on tech stocks; they were wrong because they were overpaying. Indeed, the average mutual fund investor has done even worse than the index suggests; because investors chase hot mutual funds which, in turn, tend to own hot stocks.

So yes, equally-weighted funds are a neat idea (although since they've done so well in the recent past, they may underperform in the future). But they aren't what 99% of people own. For most equity investors, it was indeed a lost decade.

THERE has been a fair degree of Schadenfreude in Britain about the euro zone crisis. The UK didn't join the single currency (thank God!) and won't be required to fund the bailout (not our problem, mate!). But the euro zone remains Britain's biggest trading partner.

Over the last few weeks, both the Bank of England and the Office for Budget Responsibility have mentioned the risk of a euro break-up but said it was impossible to quantify its effect on the British economy. Given this is the single biggest risk out there, the reluctance to forecast has frustrated Danny Gabay, an economist at Fathom Consulting, who has made his own estimates. And they look bad. Very bad. He writes that

Our simulation implies that the impact of a disorderly euro break-up on the UK will be roughly half as bad again as the collapse of Lehman Brothers.The UK economy contracts by over 7% between now and 2013, assuming a euro default in early 2012.

Moreover in the absence of massive monetary easing to prevent sterling from rising by upwards of 35%, we see the UK slipping into deflation, which would make servicing its debt even harder. And you can forget those fiscal targets, In our simulation, the austerity measures are simply overwhelmed by the impact such a huge sovereign default event has on global bond yields. Even with austerity, we see UK bond yields rising above 10% by 2013.

Of course, the Bank of England could step in to avoid the outcome of deflation and higher bond yields by using more quantitative easing. How much more?

We estimate, using the Bank's own analysis of the impact its first £200 billion of QE had, it would require about £1 trillion of QE.

This would limit the size of the recession but at the cost of pushing inflation up to 8% by 2013, Fathom estimates. And it would leave the Bank of England owning the vast majority of government debt.