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It has been a rollercoaster ride in financial markets this week, though it looks like equity markets will go into the bank holiday weekend on a fairly positive note. Meltdown has been avoided though at the start of the week markets were in a nervous mood. The eurozone crisis has not been resolved and doubts about the health of the eurozone banking system persist. The likelihood of a banking crisis is high and I believe this will force M. Trichet and his colleagues at the ECB to follow Mr. Bernanke's copybook and adopt full-blown quantitative easing. In my view, this happens sooner rather than later. In addition, a restructuring of Greek debt seems inevitable and, in my opinion, the sooner they get on with it the better. There is no point in ‘extend and pretend’.

As far as sterling is concerned, it is still on the sidelines and has not been in focus. If anything, with the spotlight on the euro, the pound has started to stabilise. UK economic prospects still remain uncertain and a full-blown economic recovery is some way off. In the meantime, it is all about the budget and, if the government can put up some convincing measures to tackle the deficit without wrecking the economy, then I think the markets might look at the pound more favourably.

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Markets rebounded but there is still plenty of uncertainty. Worries about the health of the European banking sector persist and have overtaken Greece as the main focus. This has the smell of the Lehman crisis about it, given the unclear exposures of various banks to ‘club med’ debt. At least there is a template for dealing with these types of problems – the Fed in the end managed to stabilise the American banking system. Now the ECB needs to do the same. The problem is the lack of coordination and absence of a central fiscal authority. This could turn out to be very messy, given the problems in recapitalising European banks that are in trouble. In addition, M Trichet needs to implement outright quantitative easing and, until that happens, the markets will remain volatile.

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After last week’s volatility in the financial markets, the focus at the start of this week is the new Chancellor’s announcement of £6 billion spending cuts as he starts to address the UK’s budget deficit. £6 billion is a relatively small amount in relation to the overall scale of spending but at least it is a start in the right direction. The trick is to avoid eurozone-style ‘slash and burn’ budget policies which inadvertently fail to get the deficit on the right track because the medicine ends up killing the patient. The proper thing to do is to encourage growth in the economy and generate enough jobs and activity that tax revenues start rising again. That doesn’t mean you put tax rates up. In fact, income tax rates are high enough and at the top end have probably reached their limit in terms of impacting on competitiveness, etc.

The markets will be watching UK budget developments closely but I think the new administration understands the importance of making progress here, in which case I am not expecting any disasters from a market point of view. I am less sanguine about the prospects for the eurozone where the debt crisis has still not been properly resolved. For sure, the recent bail-out took care of funding difficulties over the medium-term but it did not address problems relating to solvency and any seemingly inevitable debt restructuring for countries like Greece. Likewise, European banks are still vulnerable and funding problems are still an issue. Spain’s central bank had to take over a small regional bank at the weekend but problems in the regional banking sector are widespread following the real estate bust in Spain. This is likely to be a problem area for some time.

As far as sterling is concerned, it is a little steadier on the exchanges as I write despite the best efforts of the BA unions. Last week, sterling got caught up in the wash, so to speak, as the euro made a new low against the dollar for the year. Against the US dollar, sterling is close to the 1.4500 level which is just a few big figures above last week’s lows. The action was more to do with the euro but other currencies like the Swiss franc were also in the spotlight as the Swiss central bank intervened to try and prevent strength in their own currency. In the run-up to G7 and G20 meetings in June, currency market volatility might start to settle down.

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More carnage! Global stockmarkets took another battering yesterday as investors fretted about a double-dip recession, today’s vote in the German Bundestag on the Greek bail-out and general concern about uncoordinated policy responses to the financial crisis. Essentially, everything that has gone up in the markets is now going down and everything that has gone down is now going up. This is typical as investors run for cover and unwind positions. You get a ‘flight to liquidity’ and a ‘flight to safety’, so investors put their funds in US and German bonds and flee emerging markets, cash-in any profits they have made in the stock market and bale out of long positions in commodities (that have been on a rip over the past year or so). Perversely, currencies like the yen and Swiss franc go up but this is because leveraged investors like hedge funds who have borrowed in these low yielding currencies are forced by the meltdown to repay their borrowings. Why has the euro gone up (admittedly a minor recovery against the dollar so far)? It is only because traders are unwinding record short positions in the euro and record long positions in the dollar. I do not expect any recovery to be sustained and a longer-term decline in the euro looks probable given all the problems in the eurozone.

So what happens next? Markets will remain jittery until there is a better policy response from the G7 and G20. Stockmarket crashes tend to concentrate the minds of policymakers so don’t be surprised if we see plans/measures to help soothe investor confidence. The S&P index is already about 11% off its April high and the 20% threshold for a bear market is around the 970 level (the S&P index closed at 1,071 last night). Typically, stockmarket corrections since last March have been of the order of 5-10% so the current meltdown is testing the boundary. Bears will know that the Chinese and Spanish equity markets are down 20% plus, year-to-date. Will US and UK equity markets follow? The FTSE 100 index has held up well when all is said and done and, as I write, it is ‘only’ off 6% for the year. Of course, if you are an international investor exposed to the UK market, the weakness in sterling makes that a loss of nearly 17%! The US markets have also held up relatively well and are down 3-4% since the beginning of the year. My guess is that policymakers will come up with the goods and, for the eurozone, this looks like putting in place an orderly restructuring of Greek debt. If they do the right thing and admit to the obvious, there is a good chance that we might see a trading low in the markets soon. It is best to get on with sorting the problem out rather than sending good money after bad. As far as sterling is concerned, short positions are being unwound which is why you have had recent volatility. This morning’s economic data, though, is not particularly encouraging. Government borrowing was £10 billion in April and underscores the need for early resolution. Mortgage approvals also dipped while data for private sector investment for Q1 is 30% down on a year ago. All in all, the UK economic situation is still fragile which won’t be helped by the global financial market volatility at the moment. Let’s hope for a silver lining in the clouds.

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Market volatility persists in the aftermath of the German decision to ban naked short selling. However, is there a glimmer of hope amidst all the gloom and doom that has hit markets in the past few weeks and months? The S&P index (the US equity bell-weather) has now ‘mean-reverted’ to its 200-day moving average at around the 1,100 level. Also I am told that the percentage of oversold stocks in the S&P index is at its highest since March 2009. Would I want to be short here? Not really. Risk-reward does not look that attractive. In addition, the Swiss National Bank intervened in the EURCHF exchange rate yesterday in order to prevent further appreciation in the Swiss franc. There is evidence that the recent strength in the Swiss franc reflects investors taking their money out of eurozone banks (Angela Merkel kindly provided a list of German banks this week that you should avoid!) and putting their money into Swiss banks. FX intervention alerted currency markets to the possibility of more general intervention in the euro, though Mr Juncker, head of the eurogroup of finance ministers, rules out FX intervention. Well, given the scale of short positions in the euro and its minor recovery, it looks as though Mr Juncker might have a reprieve for now. However, he may have to eat his words at some stage because I doubt the eurozone debt crisis is over.

Fiscal contraction not just in the eurozone but globally could easily dent the prospects for the recovery in the global economy being sustained. Indeed, a tightening of fiscal policy will almost certainly reduce the pace of growth. The markets understand this which is why commodity currencies like the Australian dollar (which are a play on China/global growth) have come off sharply of late. This means that the major central banks will have to keep rates lower for longer and the release last night of the minutes of the Federal Reserve meeting at end-April suggest no change in their accommodative position. I guess this all applies to the Bank of England as well, despite the disappointing inflation figures this week. This morning’s retail sales figures rose a measly 0.3% in April, though the March numbers were revised up. The Nationwide’s expectations index for the next six months fell to the lowest since August. We all know that tax increases and spending cuts are just around the corner so there is no reason to loosen our belts yet. Sterling is still in the doldrums against the major currencies at the moment and slightly sidelined as the markets focus more on the euro and the US dollar…and the possibility of some relief in the stockmarket.

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The main news today is the German ban on ‘naked short selling’ of credit default swaps, eurozone government bonds and ten banking stocks. There is no truth in the rumour that Angela Merkel is going to ban World Cup teams from scoring against Germany. The German measures have been met with a big ‘thumbs down’ from the markets, as you might expect. Stopping the markets from working does not resolve the eurozone’s serious economic problems. However, there is a long-standing mindset amongst eurozone policymakers that it is all the fault of speculators (most of whom obviously reside in London). Most of the academic studies I have seen with regard to the impact of bans on short sales conclude that they have negative consequences. Note that when the SEC banned shorting financials at the time of the Lehman crisis in September 2008 this did not prevent a further decline in the S&P index.

Martin Wolf in this morning’s FT has written a good piece (click here) which points the finger at private sector spending volatility (courtesy of ECB interest rate policy) that generated a boom and bust in the eurozone. He thinks fiscal austerity will make the situation worse and that a restructuring of Greek debt is inevitable. Certainly, the German ban will reduce the attractiveness of eurozone financial assets to international investors as policymakers retreat into their bunker. The euro is clearly a casualty and has lost ground since the German announcement. Further weakness is likely which will probably end up in FX intervention as the EU tries to close off currency speculators. Ultimately, the imposition of capital controls cannot be ruled out.

Where does this leave sterling? Our new Chancellor has not challenged EU plans to regulate hedge funds and the risk is of further regulation that dampens the longer-term prospects for the City as a thriving financial market. However, sterling is not the eurozone and might benefit from the pressure on the euro. The US dollar has (so far) been the main recipient of ‘flight to safety’ flows but an enveloping euro currency crisis will likely elicit co-ordinated FX intervention if the euro slide continues. The next few days and weeks will prove interesting.

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The main story this morning is the news of a unexpected rise in the UK inflation rate to 3.7% in April from 3.4%. Core CPI inflation edged up to 3.1% and for those with long memories, RPIX – Retail Price Inflation less mortgage interest payments (which was the official inflation target until December 2003) – jumped to 5.4% from 4.8%. Whatever measure you prefer, there is no doubt that inflation is starting to become a problem. The Bank of England’s (BoE) 2% inflation target is looking increasingly redundant, especially since the BoE has a consistent reputation of under-estimating the inflation out-turn. In addition, the UK is looking as though it has become lumbered with ‘stagflation’ as well as being the only major economy with such a high inflation rate. Of course, some of the inflation increase reflects government tax measures and the inflation rate will only rise further if proposals to increase VAT are implemented.

Previous weakness in sterling has also contributed to the pick-up in inflation and I wonder whether the BoE might change its tune towards the exchange rate. Previously, the BoE has been quite relaxed about weakness in the exchange rate as they saw it as helping to rebalance the economy as well as providing stimulus (even though our main export markets in the eurozone are growing at a sluggish rate). My guess is that the rise in inflation will make the BoE less inclined to talk the pound down. However, the BoE do face a dilemma with regard to monetary policy. Increasing quantitative easing now looks as though it is off the agenda but, similarly, any increase in interest rates to dampen inflation would have a deadly effect alongside the expected tightening of fiscal policy. This leaves the option of a stronger pound as the only mechanism to help dampen inflation pressures. However, the only way they can get the pound up is through talking it up and/or signalling that an expansion of QE is not on the cards. Sentiment and positioning towards the pound has been extreme so there is the possibility of a revival here. It might not be huge but it could be that the period of extensive declines in sterling might be behind us.

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George Osborne isn’t wasting any time and has announced this morning that the UK Budget will be held on 22 June. He also announced that Sir Alan Budd will head up the new fiscal watchdog. Sir Alan is a hugely influential and credible figure, but his first job will surely be to look into the alleged spending splurge by Labour Ministers in the last days of office. I have said before that Britain faces a serious challenge with regards to fiscal policy which will involve tax increases and spending cuts over the medium term. The IMF notes that Britain has the largest structural deficit of any of the major economies and one of the measures that the IMF recommends is an increase in VAT.

In the meantime, the markets look messy and uncertain. It was only a week ago that the EU and IMF announced with great fanfare their $1 trillion bail-out package. By the end of last week, it had all gone horribly wrong with global stockmarkets on the slide and the euro plummeting in the FX market. Mr Trichet, in a recent interview, is trying to put a brave face on things and convince the Germans that he hasn’t gone soft on inflation but I am not sure anyone believes him. European banks are under pressure and the whole thing is reminiscent of the freeze up in money markets after the Lehman crisis when banks wouldn’t lend to one another because of a loss of confidence. In addition, both the US and the eurozone are on a mission to tighten regulations on banks, hedge funds and the financial industry more generally. Bank stocks are under pressure and the outlook for the financial industry looks grim.

But back to currencies. The slide in the euro is creating global market volatility and uncertainty. In my experience, when this sort of thing happens you can bet your bottom euro that FX intervention is not far away. I note that traders’ positioning is now at extremes with record long positions in the US dollar and record short positions in the euro. I wouldn’t mind betting that FX intervention is on the cards and that, before this month is out, we will have seen intervention trigger a sharp turnaround in market positioning. What went down will go up and what went up will go down. For technical buffs, the euro has now made a 50% retracement (since the beginning of 1999). Typically, such moves can halt there (1.21) or extend to a 61.8% retracement which is 1.12. We shall see. For sterling/dollar over the same time period, what does stand out on the long-term chart is that lows of 1.35-1.37 have marked the floor in sterling and we are not far from that “floor” at the moment.

If I am right, sterling will get some indirect benefit from intervention. Sterling-dollar made a low of 1.4252 this morning (1.4417 as I write) and there are record short positions in sterling as well. Likewise, sterling/yen is looking overstretched on the downside (low was 130.00 on 7th May) and low this morning was 131.04. So, there is the possibility of a short-term comeback for the pound. There is plenty of economic data this week that will give markets plenty to chew on, especially the CPI data on Tuesday, MPC minutes on Wednesday and retail sales data on Thursday as well as what will be fairly awful public sector borrowing numbers on Friday.

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Investors remain nervous and, despite the EU/IMF bail-out, there are worries that some eurozone governments won’t be able to push through the required budget measures without damaging the prospects for economic growth or creating the conditions for an increase in social and political discontent. Governments could easily fall in this situation. It is no surprise that the euro continues to weaken and this morning is testing the 1.2500 level against the US dollar and the 0.85 level against sterling. Further weakness in the euro looks likely and if the descent in the currency becomes ‘disorderly’ it would be no surprise if the ECB intervened in the currency market to try and support the euro. I doubt whether such intervention would be successful as the ECB can’t raise interest rates to back up intervention and I doubt whether the Americans are much interested. The level of the euro at the moment is a long way from the record lows just above 0.70 in EURUSD back in 2001 when there was joint FX intervention which did succeed in putting a floor under the euro.

All of this potentially increases the volatility in financial markets in the months ahead and I have to say that I am worried that this could all culminate in a stock-market crash late summer/early autumn. Worries about debt crises are not just limited to the eurozone. The US and the UK are in the same boat. This week saw the US monthly budget deficit post the largest April deficit on record. America’s national debt now amounts to $13 trillion (see their ‘debt clock’ here). This is a global problem which will ultimately result in debt restructuring and default and, ultimately, inflation as debt is monetised by the central banks. This could bring about extraordinary changes to the international monetary system and its institutions and conceivably bring about massive changes in the currency system.

As far as sterling is concerned, Danny Blanchflower (ex-MPC member) in his latest interview that is doing the rounds today continues to be sceptical about the prospects for the UK economy and thinks the Bank of England (BoE) will have to remain accommodative for some time. When I met him a few months ago he was particularly negative about the UK housing market and the prospects for sterling. He thinks that aggressive tightening in fiscal policy is the wrong thing to do at the moment and thinks that it is imperative to secure sustainable economic growth. Certainly, sterling has lost ground against the dollar over the last day or so which wasn’t helped by downbeat comments from Mervyn King about the global financial crisis. The Inflation Report also featured upward revisions to UK inflation forecasts but it looks as though the BoE will keep interest rates lower for longer. A tighter fiscal policy and looser monetary policy is traditionally a recipe for a weaker currency from a fundamental point of view. Low interest rates of themselves don’t necessarily mean a weak currency. Witness the strength in the low yielding yen and Swiss franc at the moment. But unlike the ECB and the BoE, their central bank balance sheets have not expanded as fast. The Fed has completed its quantitative easing programme and is looking to unwind its balance sheet thereby providing some support to the US dollar which has enjoyed a good run since the beginning of this year.

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The Bank of England Governor, Mervyn King, gave his blessing to the new coalition government’s budget proposals but warned “we are still halfway through the world’s worst financial crisis ever”. If that is the case then you can expect an extended period of low interest rates and perhaps another increase in the bank’s quantitative easing programme. The new government’s budget details are still vague at the moment though the influential and respected Institute for Fiscal Studies (IFS) has made a good summary of the state of play so far (click here).

Early ‘horse trading’ on tax policies has begun though, with the Conservatives shelving plans to raise the inheritance tax threshold as well as dropping plans to reverse Labour’s increase in employees NI contributions. In exchange, the Liberal Democrats will use the revenue to increase personal income tax allowances to £10,000 and CGT on non-business assets is increased. The government is looking to push through £6 billion worth of spending cuts this year and it will be hoping that the UK economy continues to recover. Any setback in the economy will make it difficult push these measures through. Yesterday’s Inflation Report highlighted higher inflation projections out to the third quarter of 2011. The official projection for Q2 this year is now 3.3% compared to 2.8% in February. It is worth noting that the Bank of England’s inflation forecasts have tended to under-estimate the actual inflation outcome, so the Bank may have to contend with higher inflation during the course of this year. I mentioned in yesterday’s blog that a weaker pound has been largely responsible for the UK’s higher inflation rate. I also mentioned that a loose money/tight fiscal policy combination is traditionally a recipe for a weaker currency.

So far, the response in the currency markets to the new UK government has been muted. Indeed, since the beginning of this year, sterling has not moved much against the G10 currencies with the exception of the Japanese yen and US dollar which have both been very strong. There are still reverberations from the eurozone debt crisis and last week’s slide in global stock-markets. On balance, this has tended to favour the US dollar as the safe-haven currency even though America has budget problems of its own. The monthly budget numbers out of the US published last night reported an $83 billion deficit for the month which was the largest April deficit on record. There is no doubt that worries about sovereign debt crises on a global basis are not going to go away. Debt restructuring, debt default and debt monetisation are set to remain the main themes for financial markets in the longer term. In the meantime, the euro remains weak and this morning it continued its decline against the major currencies.

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Thankfully what nearly looked like a political disaster with a Lab-LibDem coalition has been avoided. The Conservative-LibDem coalition is being well-received in the financial markets with sterling a little firmer against the US dollar and the FTSE100 index making a minor move into positive territory. Initial soundings about tax reductions and tax relief look encouraging but the main event will be the next budget where the markets will eagerly await proposals for tackling the budget deficit. In the interim, the markets may well give the new administration the benefit of the doubt so some good news at least following last week’s global market turmoil.

There was also good news yesterday with the release of the industrial production data which reported a 2% gain in the month. Signs that the UK economy is starting to build a better base for economic recovery are accumulating. This morning’s unemployment numbers for Q1 showed an increase of 53,000, taking the unemployment rate to 8.0% from 7.8%. That was on an ILO basis whereas the claimant count for April reported a monthly fall of 27,000. A bit of a mixed picture for sure but for what it’s worth I am encountering anecdotal evidence that people who had been casualties of the 2008 and 2009 recession are now beginning to secure employment.

Better news on the economy does not necessarily mean that the Bank of England is about to raise interest rates. That would be a mistake, in my view, as it could easily choke off economic recovery. If anything, the Bank of England needs to set off a tighter fiscal policy with a period of low interest rates. One of the problems that the Bank of England faces is the rise in inflation. After all, this is their exclusive mandate – to ensure stable inflation. A large part of the rise in UK inflation can be attributed to the previous decline in sterling which pushes up import prices, petrol prices and producer input costs (now running at a double-digit rate). It may be that the Bank of England is in favour of a lower level in the exchange rate as part of a rebalancing process. Given the weakness in the UK’s main export markets (i.e., the eurozone), a weaker pound does not actually do a great deal to stimulate UK exports. There simply is not the demand from Europe. This morning’s GDP data for the eurozone area featured a 0.2% increase in Q1 which is not what you would call healthy, though it is better than actually being negative I suppose. But I do wonder whether the Bank of England might start to change its tune on the exchange rate. A stronger pound would help contain inflation as well as deferring any pressure for a rise in interest rates.

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Markets roared yesterday in response to the $1 trillion EU/IMF bail-out package, though there has been a much more considered response in the Asian markets and at the European open this morning. It is also worth noting that China’s equity markets have now lost 20% year-to-date which means it is in bear market territory. This is a worrying sign for global equity market investors and suggests that it might be a mistake to believe that massive injections of liquidity and yet another bail-out can work its magic by pushing prices of risk assets ever higher. Is there any ammunition left for policy makers to bail out the next financial crisis? And has the EU just simply delayed an inevitable day of reckoning that will involve debt restructuring, default and debt monetisation? I think you can guess where I stand on all of this. It is difficult to see how this is constructive for the euro. The ECB has done a U-turn in buying government bonds and in the process has ripped up the rule book as enshrined in the Maastricht Treaty. When push comes to shove, I guess rules are made to be broken. And push has come to shove as the eurozone debt crisis threatened a re-run of the global market meltdown in 2008. To some degree the ECB has had its independence undermined and its reputation tarnished. Whatever the semantics coming out of Frankfurt, the ECB has adopted quantitative easing (at a time when the Fed is unwinding quantitative easing). The problem is that sterilising bond purchases (i.e., draining the liquidity arising from the cash for bond swap) only ensures that eurozone money supply growth continues to contract. This is a recipe for economic slump and deflation.

Missing from all the hoopla surrounding the EU bail-out is the adverse impact that the draconian cuts in eurozone budgets will have on economic growth. Ireland is the template for ‘slash and burn’ fiscal policies. The Irish economy has contracted by 20% and a similar fate may be in store for many eurozone economies. The slump in growth has actually increased Ireland’s budget deficit and debt/GDP ratio. The same process will likely happen to the rest of the eurozone and the $1 trillion will have gone up in smoke. Longer-term, real money investors will be concerned that debt monetisation just undermines the euro as a store of value and investment currency. So do not be surprised by further weakness in the euro.

UK politics have taken an unexpected twist with the prospect of a Lab-Lib Dem coalition. The Wall Street Journal this morning calls this a “coalition of the absurd”. It is certainly a coalition of losers. I agree with ex-cabinet minister Dr John Reid who was interviewed by Sky TV last night that this simply shows no respect for the voters’ wishes and will backfire on both Labour and the Liberal Democrats. International investors will certainly be puzzled that the mother of parliamentary democracies is behaving in this way. In addition, the risk of a snap election in these circumstances delays any prospect of a credible budget programme being implemented. This can easily unsettle UK markets. So far, sterling is holding up reasonably well against the major currencies, but political uncertainty is always a recipe for unwanted volatility.

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Well the EU have come out with all guns blazing after last week's moves in financial markets created wider contagion and a slide in equity markets. What the EU has basically come up with is a €500 billion support package bolstered by an extra €60 billion from the IMF. Even Mr Trichet and his colleagues at the ECB have bowed to the inevitable and adopted quantitative easing (QE) in order to stop a fully-fledged banking crisis. In addition, the Fed has re-opened currency swap lines in order to meet the demand for dollars from European banks – otherwise we would be treated to a possible repeat of a Lehmans-style crisis.

Financial markets have responded positively first thing with Asian markets recovering, and this should continue with European markets following along. While the package is massive and designed to convince the markets that policymakers mean business, I can't help being wary about the market’s ‘knee-jerk’ reaction. We await more details and specifics, but it just shows me how deeply flawed the eurozone system is and how deep the trouble that various countries and banks have got themselves into. As far as the euro is concerned, I would be cautious too. QE plus an uber-accommodative ECB means a super-loose monetary policy. Fiscal policy on the other hand is super-tight, which can only keep economic growth low and unemployment high. I mean, look at the Bank of England who implemented QE very early on and took interest rates to zero. It has taken a very long time to revive bank lending/credit as well as to generate any sort of meaningful recovery. In the process, sterling has been one of the weaker performing currencies.

Which brings us to the UK election. After all the meetings and talk over the weekend, it looks as though a deal between the Conservatives and Lib Dems will be arrived at and announced today. It might well be a ‘formal alliance’ with seats in the Cabinet for the Lib Dems. There might also be a fixed-term period for Parliamemnt to prevent the Conservatives calling a snap election. I am not sure what the markets will make of this, or what the next Budget might look like, or what the new government's position on joining the euro might be (surely not?!). So, clear as mud for now though, hopefully, early clarity and a credible commitment to tackling the national finances would certainly bolster sentiment towards sterling.

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The financial markets end the week in a tail-spin as widening contagion smashes investor risk appetite (the sharpest intraday point drop in the Dow since 1987 happened last night). To add insult to injury, the results of the UK General Election point to a hung parliament with the Conservatives as the largest party. At the time of writing it does not look great and all kinds of weird and wonderful political scenarios can appear out of the blue. A constitutional stand-off is the last thing we need. A Lab-Lib pact would be a painful reminder for those of who experienced all that before and does not provide any encouragement at all that Britain's budget deficit will get back on track anytime soon. In addition, the markets are suspicious that Lab-Lib policies would mean more taxes and more red tape – as if we haven't enough of all of that already. No wonder sterling got hit last night with the sterling/dollar exchange rate dropping to 1.46.

In addition, equities got hammered last night as the markets continue to take a negative view of the widening contagion in the eurozone debt markets and the threat of a European banking crisis. The ECB's meeting yesterday was a big disappointment with the ECB looking like it is behind the curve. M Trichet has physically aged (he probably needs some Grecian 2000 for that white hair…) and the ECB is clearly in its bunker. No new measures, no policy action (no General Steiner - click here), no recognition that the eurozone debt crisis appears to be spiralling out of control. Angela Merkel, the German Chancellor, added to the bunker mentality by blaming it all on speculators.

We have seen all this before where European policymakers look for a scapegoat to blame rather than blaming themselves for a set of inappropriate and unsustainable fiscal policies. Back during the ERM crisis of 1992 an ECB governor publicly threatened to have the kneecaps of yours truly removed for having the temerity to suggest a devaluation of the currency was imminent. In Ireland, the Catholic Church accused ERM doomsters of being heretics and threatened them with excommunication…just as well I am Church of Scotland. Policymakers in denial and in their bunker are a classic sign that things are falling apart. The reality is that Greece is bust. Athens is in flames and, despite what M Trichet said yesterday, Portugal is in the same boat as Greece and the name of that boat is the good ship Titanic. Spain and Ireland are fellow passengers. Debt restructuring, default and the possible break-up of the monetary union are now very realistic scenarios. All of these economies have to recognise that by joining monetary union they gave up their sovereignty and unlike the US and UK do not have the sovereign power to print money, issue debt and devalue their currency as a way of extricating themselves out of the mess (by the way, why can't Greece slash its military budget from 5% of GDP to more normal levels and slash tax exemptions for certain parts of Greek industry?).

Given all the panic and mayhem in financial markets this week, the G7 and EU leaders are having a teleconference today. The Bank of Japan has already injected $22 billion of liquidity into the system this morning. Investors are scrambling for safe havens (like the US dollar, yen and gold – $2000 here we come?). Investors and traders will likely square up positions in the very near-term just in case there is either FX intervention (capital controls cannot be ruled out in a very extreme situation), the Fed providing currency swap lines as they did in the Lehman's crisis to alleviate funding pressures for banks and/or some other measures designed to plug the eurozone ‘black hole’. I can't think what those measures might be or whether they would have any credibility, but injections of (more) liquidity look like the best bet. All financial crises have a way of resolving themselves eventually. It is not always continual gloom and doom but a ‘defining moment’ is required to put confidence back into the markets and, as they say, opportunity always comes out of chaos. Stay tuned.

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No sign that the eurozone debt crisis is abating and contagion is just not spreading to the rest of Club Med but it is also weighing on financial markets generally. Some equity markets are posting year-to-date declines varying from around 1% for our own FTSE100 index to 15% down for the Shanghai Composite (remember all those bullish investment stories about China?). In the currency markets, the euro is on the slide as investors fear that Greece has no alternative but to default. Deaths in Athens just highlight the absence of a social and political consensus in pushing through draconian fiscal measures. Certainly, some sort of debt restructuring seems inevitable but Nobel Prize-winning Professor Paul Krugman thinks that Greece will have to leave the euro if it wants to have any chance of getting its slump-hit economy back to normal. The ECB holds its regular policy meeting today and, amidst the eurozone’s debt crisis, this could be the most important ECB meeting since the inception of monetary union. Events have tended to leave the ECB behind, putting a question mark over the ECB’s independence. The ECB has also been forced to do U-turns over providing liquidity and suspending eligibility requirements for Greek bonds. Some are questioning the credibility of the ECB and its ability to be at the forefront of tackling the crisis. More U-turns are likely I think, with the end-game being monetisation of debt i.e., quantitative easing, regardless of so-called ‘legal’ prohibitions in EU treaties. Market worries that all of this will get worse before it gets better are reflected in further weakness of the euro in the currency market. We are not at the stage where the ECB will intervene to stop the slide. It would be better if the ECB took advantage of today’s policy meeting to convince the markets that it is indeed seriously considering a variety of options to tackle the debt crisis and impending banking crisis.

As far as sterling is concerned, today is the day insofar as a possible change of government is concerned. Tonight’s exit poll (10pm) will give a better idea of the outcome. A hung parliament is not a good scenario for the markets, but a clear mandate (326 seats needed for a majority) might make the doomsters have a rethink. Professor Niall Ferguson is undoubtedly gloomy and in the latest edition of the Spectator magazine he writes that the UK will need the IMF for a bail-out. I am not convinced about that myself, though there is no getting away from the fact that the UK has the worst structural deficit of any major economy (as a percentage of GDP) at just over 10%. This is the major economic issue facing the new government and early action by a new Chancellor would be a big plus. It would also stymie talk of further declines in sterling which is a fairly popular expectation with some City economists. Sterling is not in the same boat as the euro and, on a trade-weighted basis, sterling has avoided sharp declines over the past month or so and I mentioned in yesterday’s blog that foreign investors have been significant buyers of UK government securities. This suggests that foreign investors have a brighter view of sterling’s prospects than some City economists.

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The Greek debt crisis takes yet another turn for the worst with the markets giving the ‘thumbs down’ to the EU/IMF funding package. Rather than shutting the markets up, so to speak, the EU and IMF have opened up the proverbial can of worms. Contagion within the eurozone is spreading and the markets are taking the view that the EU and IMF simply don’t have the capacity (and the Germans any further willingness) to bail out Portugal or Spain who are currently in the firing line. In addition, the ECB, which is certainly not a latter day Bundesbank, could easily monetise the debt of the Club Med economies after effectively doing the same for Greece. This is ultimately a recipe for higher inflation at some stage so it is not surprising to see the euro continuing to weaken with a fall through the 1.3000 level against the US dollar yesterday.

To some extent the decline in the euro is weighing on the sterling rate against the US dollar as the dollar is the beneficiary of the latest round of risk aversion. Stockmarkets are going through another correction at the moment which could amount to 5%-10% before it’s over. Remember that any sign of market nervousness just means that interest rates will stay lower for longer. Of course, all will be revealed on the UK election quite soon and recent polls are encouraging for the Conservatives. The immediate job must be to get our budget deficit back on track with measures that won’t derail the economic recovery. It is too early in the economic cycle to think about putting taxes up. Indeed, the medium-term objective has to be to cut taxes and red tape; best to put pressure on spending (public sector wages and headcount) but to avoid slashing public sector investment.

If a new government can do this, then there is a better chance of securing sustainable economic growth. There are plenty of sterling bears out there who think that a currency depreciation is required to rebalance the economy (a view still favoured by the Bank of England) and others who think a further decline in sterling is required to cure the UK’s trade deficit and/or compensate for the UK’s high budget deficit. Recent data is more encouraging as it seems foreign investors have been buyers of gilts in the recent month or so with net purchases amounting to £28 billion (February and March) which compares to £24 billion for all of 2009. Some of this might have been a flight to safety from the Greek debt crisis, but it also suggests that foreign investors are more sanguine about UK budget prospects. In addition, foreigners have been active in prime areas of the UK housing market and again – although there are plenty of gloomy predictions of UK house prices doing the rounds – my guess is that this pessimism is wide of the mark. Maybe the same might be true for the exchange rate.

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Well, it’s election week. YouGov, the opinion pollster who predicted the last election result to within a seat, is predicting that the Conservatives will win 300 seats – just short of the 326 required to form an overall majority. However, in recent polls there has been a slight firming of support towards the Conservatives while the “Clegg factor” might be wearing thin. All will be revealed on Thursday night and Friday morning. I have said before that a hung parliament is just a recipe for the usual political back-stabbing and infighting which is not what the economy needs right now. However, a working majority for the Conservatives would be well received in the City, especially if an emergency budget and the setting-up of a fiscal commission was part of the new government’s policy measures.

Interestingly, opinion polls suggest that UK voters have not fully digested the implications of Britain’s poor fiscal position. This is probably not surprising, given that politicians from all parties have dodged answering the critical questions of how they would resolve Britain’s debt problem. The fact is that the UK has one of the worst structural budget deficits (nearly 8% of GDP) according to the IMF, who also argue that the UK requires one of the biggest fiscal adjustments of the major economies. For sure, we need to get the UK economy strong first. ‘Slash and burn’ fiscal policies – as practised in Ireland and (now) Greece – are a recipe for economic implosion and deflation. However, the markets do not have the patience to wait for the economy to recover without evidence that the government is taking early action to cut the debt (not helped by the way that the UK is on the hook for £1 billion as part of its IMF contribution to bailing out Greece). Admittedly, our debt/GDP ratio at 70% is nowhere near as bad as Greece (that even after the EU/IMF bail-out will end up with a debt/GDP ratio of 140%). Spain and Portugal are next in the spotlight, I think, but the EU/IMF might not have the cash to bail these economies out. The ECB has just changed the rules in accepting Greek bonds as collateral funding for eurozone banks and at some stage might have to be the buyer of last resort for all ‘Club Med’ bonds. No wonder the euro has weakened against the US dollar since the EU/IMF announcement.

But it’s not just UK government debt that is a problem. The McKinsey Global Institute has noted that at 160% our private sector debt as a percentage of GDP is one of the highest in the major economies. This means that, ideally, UK consumers should be saving more, spending less and repaying debt. We shall see. On the other side of the pond, American consumers (who are in the same boat) seem to be spending more at the expense of saving less. It makes me wonder whether the 3% plus GDP growth for the first quarter reported last Friday for the US economy is sustainable. Either way, the new UK government has no choice but to tighten fiscal policy. Remember that this year we are the only economy apart from Argentina that has not implemented any fiscal stimulus. Little wonder that the UK economy is dragging its feet in terms of recovery. I was very interested in Bill Martin’s report on the UK economy (click here) that was alluded to by David Smith in his Sunday Times column (click here). Bill argues that a lot of the ‘good times’ in the UK economy in previous years was mainly attributable to bubbles in housing and equities and I have to say that I agree with him.

As far as the Bank of England is concerned, if fiscal policy has to be tightened then it is best to keep interest rates lower for longer. This is good news for the UK housing market and it was encouraging to see a pick-up in mortgage approvals in this morning’s data. Sterling? Well some think a further depreciation is required given that even in a recession we are running a trade deficit. However, given the slump in the eurozone (our main export market), it’s not clear that a depreciation in sterling would help exports. If anything it might worsen the inflation outlook and producer input price inflation is running at a double-digit pace already. Short term, there is a real possibility that the doomsters and gloomsters are confounded. If Mr Cameron wins comfortably and then does the right thing on fiscal policy (which I think he can) then who knows? Sterling might well enjoy a revival.

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