A national debt, if it is not excessive, will be to us a national blessing.
Alexander Hamilton
Macro Overview
TIPSTER’s Completed Sovereign Bond Auction Calendar
Look, dear reader, I’ve done all the hard work for you… just watch my blog site and set your mental alerts. We are heading into a really important period for sovereign’s and their debt auctions will be on many investors’ watch lists and item #1 in their minds. So watch this space.
In my last Market Nightshift article I showed you how I ranked the significance of each country with respect to the importance of their auctions to the global economic outlook. This is highly subjective (and proprietary) work from me and there are obviously huge assumptions and caveats. For example I’m not even taking into account the size of the auctions or indeed the term of the note being issued. All I have done to filter the auctions down is choose the countries I think most important to the health of the global economy and then subsequently weed out any Bill auctions (paper under 1 year) on the (very) loose assumption that it will be very easy to raise short term capital and investors probably favour rolling down the curve for a given yield. Then I’ve calibrated the variables to come up with an index ranking of each country.
Ranking the “importance” of a country with respect to its auction is not a simple task though. For example, we should obviously look at the debt/deficit projections and debt to GDP levels, relate this to economic growth and come up with a ranking based on this. But the main issue is that Eurozone members with fiscal autonomy are not masters of their own monetary destiny, so Eurozone members must be “penalized” in this respect. Also, there is the contagion aspect; only countries too big to fail will be truly hazardous to the global economy. The larger the countries output (it is assumed) the more “infectious” it is to global conditions. So what I found in my rankings was that Italy and Spain were by far the countries of greatest concern. They tick all the boxes: high debt (in Italy’s case), high deficit projection (in Spain’s case), anemic growth, Eurozone members both of whom are big enough to bring down the entire Eurozone (and therefore the Global Economy). Watch out also for France, Belgium and the UK though!
The Two Most Important Charts Of The Month
Anyway, I’ve used data from providers such as Bloomberg on the dates of the various auctions coming up and also made some assumptions on when auctions would take place when the data was not available. Here are the two charts you need to follow – I’ll update these weekly and broadcast them, I’ve done all the hard work, you just need follow this blog.
Chart 1 – a 6-month view of the relevant auction (weeks) and scaled by my factors mentioned above and in the article I referred to.
Significant Auction Calendar – Weekly (click to enlarge)
Chart 2 – a 3-week view of the relevant auction (days) and scaled by the factors mentioned above and in the article I referred to.
Significant Auction Calendar – Daily (click to enlarge)
I’m not recommending to buy or sell anything, I’m just saying that these auctions should be of primary importance to people. Notice that this week is a HUGE week for auctions with both Spain and Italy with big auctions coming up. Notice also that for the next 3 weeks it appears Thursdays will be big days for sovereign debt watchers.
The level of concern that we have about what is going on in Europe is absolutely huge. We receive evidence all over the markets these days that the pricing for the potential of a Eurozone break-up is distinctly non-zero – contrary to everything that is said by policy-makers and by central bankers.
Michael Platt – CEO
Macro Overview
Positive Themes for 2012
There are many things to be positive about in 2012 for investors.
The corrections in asset prices have obviously left securities at more tempting levels than than they were before.
European leaders have not found a solution yet, but they have made huge strides towards achieving, at least an avenue towards a solution.
Central bankers are not only ready to throw the kitchen sink at the problem, they are acting in concert and with cohesion. While the effectiveness of these measures is questionable, the symbolism is there for all to see; central bankers will not sit on the sidelines if the markets hit self destruct. Of course, economists of the Austrian school would say the Feds are not allowing the economy to self construct, rather than self destruct. But, whatever your economic persuasion, this collectively expansionary central bank posture is supportive of asset prices in the short to medium term.
There has been an up-tick in economic data (especially growth, jobs and ISM out of the US) in the last few weeks.
Inflation in sensitive, emerging growth drivers such as China and Brazil is subsiding.
Volatility, as measured by the VIX, for example, has subsided significantly – options are priced much lower than they were only a couple of months ago.
Risks And Opportunities for 2012
Wherever there is risk there is opportunity and wherever there is opportunity there is risk. Without being too specific, here are some themes, risks and potential black swans to watch out for in 2012. Let me just list a few things I’ve been thinking about over Christmas.
Macro Themes:
The Extinction of Triple A rating – see comment from Part 1 on 2nd Jan 2012. Look in particular at the refinancing profiles the Eurozone faces – which was in my Chart of the Day in that article. But ZeroHedge point out that 2012 is going to be a rather monumental year for debt refinancing in the World with a whopping $8 Trillion coming due – see my Chart of the Day for debt profile of G7. The bond markets can only digest so much – can you spell PIIGS in the Python?
Global Inflation – Economic “Monetary Global Warming” – see comment from Part 2 on 3rd Jan 2012
China Economic Transitional Control (soft versus hard landing). My prediction here is that it will be managed as a soft landing, but a “landing” never-the-less and landings rarely happen without a bump or two. Expect tails for investment in the Greater China to remain fat and continue the trend they started in 2011. Expect defaults to be contained (not systemic/contagious) credit-based investments in Greater China will be an increasingly dangerous minefield to navigate – rising frequency/default rates and uncharted workout/recovery rates.
Property Prices. Two prominent property markets at very different stages of their cycle. In the largest economy in the World, America, inventory overhang is still heavy but towards the end of the year look out for signs of property prices bottoming out. In the largest population in the World, China, look out for signs of a treacherous bear market in property – especially at the mid to high end residential.
Election and Politics. Start with the obvious, the Republican primaries are heating up in a big way. Then there will be almost no respite as this momentum will feed directly into the general election frenzy. This sets the backdrop for the politicization of the investment horizon. Expect some assertive rhetoric directed towards sensitive issues such as Iran/Israel, China and, of course, the domestic economy/deficits/regulation. See comment from 1st Jan – Politics Will Dominate. Layered on top of this backdrop are the, rather tense, Russian Presidential elections (March), the French Elections (1st Round in April, second round in May). Note that Sarkozy is already throwing his political weight around, first with unapologetic finger pointing at Britain and then with very aggressive rhetoric towards aggressive rhetoric towards Syria. Finally add in the small issues of the 12th 5-year plan and a complete leadership overhaul in China’s Communist Party leadership and a US presidential election in November! There is literally no time to catch your breath – the markets will watch these events and the policy rhetoric leading up to them very carefully.
Potential Black Swans:
Eurozone: still the biggest black swan out there. Eurozone break-up will be very painful and is currently represented as a distinctly “non-zero” probability by the markets – as Michael Platt points out. There are rumours that Spain may already need to tap the EFSF. A fund created by Europe to save Europe which already faces a downgrade from AAA in lock-step with France – you couldn’t make this stuff up! European politicians may have bought some time but they haven’t bought much, the bond markets will soon call for detail on Treaty Change progression and a fiscal reform timetable with specific deliverables.
Political Surprises. Take your pick: French election unveiling unexpected Euro-skepticism. Putin getting “overthrown” before he’s even re-elected. Ron Paul emerges as a viable front-runner in the Republican Primaries (I will not get drawn into a political argument but suffice it to say, the market is not pricing this probability in with mainstream media dubbing him the unelectable candidate).
Return-Free-Risk Instead of Risk-Free-Return. Markets are determined by sentiment – even the most liquid bond markets are no different. A sharp sell off in one of the major bond markets (for example Treasuries or even Japanese Government Bonds) will have huge repercussions to the global economy.
Geopolitical. How strong are North Korea’s Kim Jong Eun’s relationships with the remaining political cronies of his father? How much authority does he command over military leaders? How will its relationship with its sole ally, China, evolve? We’re about to find out in 2012! The unpredictable regime has already started lashing out at its neighbour to the East. Don’t be duped into thinking that Iran has been contained either – the sanctions are having effect and the threats of a war in the Straits of Hormuz are empty… for now. But there is deep anger simmering beneath the surface and Ayatolla Khamenei rattles sabers primarily to distract from a very desperate and unstable political structure and an increasingly agitated Iranian public. This situation is far from stable. Elsewhere the Arab Spring shows little sign of abating with Syria on the brink of civil war and Egypt facing a tense transition to democracy.
This is your last chance, after this there is no turning back.
You take the blue pill, the story ends, you wake up in your bed and believe whatever you want to believe.
You take the red pill, you stay in Wonderland and I show you how deep the rabbit hole goes.
Remember… all I’m offering is the truth… nothing more.
Morpheus – visionary leader in the film The Matrix
Macro Overview
Presenting A Backdrop To The Motion
I like this devil’s advocate game, let’s put forward a motion we are ambivalent about and then try and argue its case:
Is Germany positioning itself for a European deflationary depression?
Firstly, let’s make one thing clear, I have no definitive opinion on this, it is not a statement – it is just a question. But let’s take a step back and examine the backdrop to this. For years and years I had been writing about the then impending Western debt bubble, indeed, I started writing about it long before the bubble actually burst. Of course, we know what happened and, since then, much of this bad consumer debt has settled on the balance sheets of the financial sector and much of this debt as been subsequently transferred to sovereign balances. Debt is not magicked away – it can only be shuffled around until it is either paid or defaulted upon.
More recently, in January 2008 (before the crisis hit) I wrote that the only real option for Bernanke and that was what I called “Hair of The Dog Monetary Policy” – to force feed us more of the very same poison which had made us sick in the first place. Inflation was the “lesser of two every evil, evils”, I wrote. He’d have to cut rates and ease monetary policy so drastically to keep the credit lines open and then to try to inflate his way out of the problem. Using a variety of ingenious methods (aka Quantitative Easing), that’s basically what he did.
In any normal environment this would be extremely risky, if not foolhardy, monetary strategy – never mind social consequences of letting the inflationary predator off the leash, what about the moral hazard? So why was I so convinced that Bernanke would fly his helicopter right in the face of moral hazard and print like a mad man? There are many reasons to be honest: the relative politicization of the Fed and its lack of “Monetary Dominance”, the unknown quantity of the Zero bound of interest rates (the Fed has the tools to fight inflation but not deflation). But the most fundamental reason is not always the easiest to explain – it arises from the cultural consequences of restructuring (defaulting on) this mountain of debt which was crippling the economy.
Debt doesn’t go away, the debtor must either pay or default – it’s that simple. To cut a long story short, just like Japan in the 1980’s, Western societies had racked up too much debt. Unlike Japan, where much of the initial debt leverage emanated from the corporate sector (and then the banking and public debt), The West, after the Enron disaster, had raised corporate balance sheets to much higher standards under the Sarbanes-Oxley act of 2002. So corporations were actually in good shape (thank goodness for Enron), heading into the crisis. Instead a debt bubble in The West originated on consumer balance sheets. With direct encouragement from central bankers (the original sinners – see my comment: Greenspan prostituted economic HIV), consumer debt in Anglo-American economies was exploding to a size that would dwarf even the Japanese debt bubble of the 1980’s.
Racing Cars and Fiscal Policy
I remember a track day with in a two-seater Formula Jaguar (see photo above – a truly terrifying car!) where I would repeatedly spin off-track on the chicane. The instructor (in the other seat) told me I had two options: either brake harder and slow right down or (his way) put your foot on the gas and get enough speed so that the down-force from the aerodynamics stick you harder to the tarmac. On the next lap, he took the controls and showed me his way … I don’t remember much but I remember I closed my eyes and screamed like a little girl. But, to my amazement, not only did we stay on the track we cut a massive chunk out of my personal best lap time.
When debt rises in an uncontrolled manner, there is an political inflexion point, an economic chicane, if you like, which it must be dealt with. Status quo is simply not an option – otherwise we’d continue to spin off track. But there is a “choice” for policy makers, and my opinion is that this choice is determined more by cultural aspects of a society than by the apparent logic of economic mathematics. Indeed this cultural divergence is part of the reason why a, fiscally harmonized, EU is such an ambitious project. Let’s look at the two options at the economic chicane (excuse my over-simplification):
Option 1 is to simply stop spending when we approach the economic chicane, cut the debts, slash the deficits and take the pain up front. In motor racing terms, this is the “braking option” – in terms of economic “acceleration” it’s a U-turn in policy velocity – towards deceleration. Philosophically it’s bluntly Darwinian, constructive destruction, some would argue: the strong will survive, the weak will die, then we move on. This solution tends to be favored by a school of economists who think the best way for debt to be “worked out” is primarily through clean, hard default – not by relying on the flawed models of monetarists. This tends to induce, initially, a deflationary outcome as capital is sucked from the system violently. This school of economics is actually a Germanic cultural trait – in fact the school originated from the old Austrian Empire – the “Austrian School of Economics”.
Option 2 is to spend more to increase growth and let growth and inflation work its magic on the economy by implicitly reducing the relative value of the debt by increasing the value of everything else (aka “soft default”). This, like my instructor, is the “foot on the gas” option to attacking the chicane and this solution tends to be favoured by Modern Monetary Theorists and Keynesians. This tends to induce, initially, an inflationary outcome as capital is typically forcefully infected into the system and, as Keynes himself said; “inflation is always and everywhere a monetary phenomenon”. While the Austrian school emanated from “core Europe” (popularized by French, German and Austrian economists), John Maynard Keynes was very much an Anglo Saxon and his political approach to economic management is the framework for much of the Anglo-American (whether Democrat or Republican) economic model and thus monetary response to the crisis.
Am I reading too much into the origins of these two schools of thought? Perhaps … but I really do think that history and cultural issues play a strong part in understanding why different societies are more comfortable enduring one option over the other when they hit the economic chicane of debt-led insolvency.
How does all this play into Europe’s debt crisis? Is Germany really positioning itself for a European deflationary depression?
This is an absurd, if not alien concept to many – who on Earth would want deflation in this environment? Well that’s an interesting question which we’ll try to answer. It’s not an easy question as I think the answers lie in the cultural and historical aspects of each society – as “The Union” that is the new, incredibly culturally diverse, 26-member cast of Europe, is finding this out the hard way.
Well… lets continue…
Cultural Attitudes To Debt Play A Huge Role In Differentiating Between Remedial Policies
Right, so when debt levels reach a certain point there is a pretty horrific economic inflexion point – it’s a bit of a “red pill / blue bill moment” that the lead character, Neo, faced in the movie “the Matrix”.
In terms of fiscal options, I likened it to a chicane on a race track where the driver either has the option of braking and slowing right down or accelerating and hoping the aerodynamics of the car keep him on the road. Kyle Bass puts it slightly differently, he uses the “fork in the road” concept – hey, pick your favourite analogy. But listen carefully to what Bass says in this video after about 5min 30 seconds [emphasis mine].
So this is a belief commonly held by most central bankers and academians who, as you know, unfortunately run many of these countries. They believe that when you get to this proverbial “fork in the road” (and this fork in the road means that there are two options that you believe that you have: one is default and one of them is inflation… and you believe that these options are mutually exclusive of one another).
When you sail into the zone of insolvency, when your debts get to become many multiples of your revenue. This is something we spend a lot of our time thinking about. When you attempt to inflate yourself out of this problem and your debts are already more than 5, 6, 7 times your revenue, you put yourself into this position where inflation causes the default.
So, in many of these nations, inflation is not an option (and I know your show isn’t long enough) but when you talk about the ECB monetizing all of these debts I think that doesn’t change any of the spending, number one. And what you’ve seen coming out of the Bundesbank and many places in Germany is: that doesn’t change the behaviour of the participants whatsoever – in fact it might encourage their continuing behaviour of the profligacy that’s riddled throughout Southern Europe.
I believe the ECB knows one thing: they have to print money. Whether it’s the ECB or the 17 various central banks at the periphery… they don’t have the money to recap their banks.
So your question should be: do they print before they default or after they default (or both) … and in my opinion they have to just print afterwards, because the number they are going to have to print is so large and that they know this going in…
I know I’ve commented on this video before, you have to watch it – I have watched the second part many times and Kyle Bass’s comments are just intellectual gold dust, in my opinion. It was this interview and a couple of others (which I will show you below) which initially sparked my train of thought on the subject of Germany and the inflation vs deflation pill-choice.
Let’s look at a couple of other poignant comments which were made in the last few days. The first comes from legendary hedge fund manager, Michael Platt – it speaks to the simple arithmetic of the European sovereign debt crisis. In his view, an inflexion point is coming and, as Kyle Bass inferred, there is actually very little authorities can do to prevent it, they can only prepare for the for the type of carnage they wish to endure first. Listen up…
Platt manages one of the biggest hedge funds in the World ($30 billion) and he doesn’t hold any punches. Diving in with both feet he says:
We sort of distill it down to one essential fact that we continue to focus on at BlueCrest Capital Management. That is that, if you look at the debt of, say, Italy, with a debt of 120% of GDP which is increasing at a real rate of 5% (where they have to fund these days) and you look at the GDP, which is now is forecast declining at 0.5% of GDP… arithmetically their debt is going to blow up.
Absolutely it’s about the cultural and political divide. The reality is, there is no willingness within the Eurozone to share wealth. In the United States, money flows between different areas: if California is having a very difficult time the rest of the States will transfer money to California. This is not the case in Europe; there is no willingness to transfer money across the boundaries in a long term and sustainable way.
Lastly I’d like to introduce you to one more interview which continued along the same thought trail this week, it’s a Bloomberg interview with Niall Ferguson, here. And this is the quote I was particularly intrigues by:
The problem here is in Berlin, it’s not a European problem it’s a German problem and the fact of the matter is, the Germans remain more worried about 1923 (i.e. inflation) than about 1931 (i.e. depression) – which is remarkable when you consider what the consequences were for Germany.
You see where I’m going with this don’t you, dear reader? There is a subtle, common theme in all these comments which, I feel, is worth expanding on. Bass, Platt and Ferguson all agree that there is a huge economic inflexion point coming (or, indeed is happening as we speak) and that there is very little policy-makers can do, but make the preparations in ways they feel are most protective to their (highly divergent) societies. The choices they make are largely dependent on cultural issues – Platt remarked directly on this – but Ferguson and Kyle also implied this by drawing attention to the “choice” between invoking inflation (first) or deflation (first).
Red Pill Deflation Or Blue Pill Inflation? That Is Question
To those (e.g. Americans) brought up in a society built almost exclusively upon Modern Monetary Theory, where ubiquitous and extremely “efficient” credit extension is responsible for much higher levels of consumer debt, it is obvious what needs to be done at this inflexion point: INFLATE FIRST, ASK QUESTIONS LATER! Indeed, perhaps Bernanke’s most famous speech was: Deflation Making Sure “It” Doesn’t Happen Here.
Indeed, while Japan has tried to inflate its way out of deflation, it’s quite telling that they were not nearly as pre-emptive or aggressive at the beginning of the deflationary slump. Many (Western Economists) believe this to be a blatant mistake, a “school-boy error” of Monetary Policy. Perhaps it was… or perhaps, collectively Japanese society actually objectively “chose” deflation first and then later tried to inflate their way out of the deflationary debt spiral. Some would say this was a complete disaster, but I’d offer a little more respect for what I believe was actually a cultural choice. It is worth noting that while the economic numbers look horrific to an Anglo-American, Japanese society did not disintegrate into chaos, Japanese unemployment barely rose above 5%, Japanese standards of living and life expectancies continued to rise during this “lost decade”. Deflation did not wreck Japanese society, it only certified it. Could you imagine such a response from American society, faced with a generation of recession and deflation? I think not. This is very much a cultural issue.
There are many reasons why Anglo-Americans were always going to chose to inflate their way out of this crisis.
First, there is a financial argument for this. Due to the massive levels of debt from a (so-called) efficient and extremely loose financial policy, deflation would almost certainly plunge Anglo-American economies straight into deep recession and probably depression. Remember the gargantuan levels of consumer debt in Modern Monetary Theorist economies – the principal value of these debts grow in real terms if inflation is negative. So deflation only exacerbates high levels of this massive mountain of consumer debt – that’s a disaster.
Secondly, a political argument. Because debt is largely held at the consumer level, politicians will always do what is in the interests of the consumer (i.e. their electorate) if they wish to remain in power. Moral hazard plays second fiddle to ensuring that voter debt-burden is softened and votes are protected.
Thirdly, a cultural argument. Democratically diverse and heterogeneous societies with extremely open and liberal media and civil rights culture, like American and the UK are, by design, less stable. In fact, some would say the instability in a political sense, ensures greater long term stability, as societal flaws are exposed very quickly ensuring a faster politically-led evolution. This notion sounds a little flimsy because it is, it’s a psychological equilibrium based heavily on confidence. In a deflationary downturn, confidence evaporates and, the inherent exposed instabilities, which are normally encouraged and embraced by these societies, turn on the economy and obliterate business sentiment, crippling the country into a depression.
But Germany is not an Anglo-American society with a Anglo-American values and an Anglo-American economic model. As I’ve written about before (see my comment: Why The Germans Understandably Hate Inflation) and as Ferguson alluded to in his quote above, the Germans appear to be more petrified of inflation than they are of deflation. Yet for Americans and Brits (who dominate the financial media, let’s face it) to opposite is true.
In many respects Germany is very much more like Japan than it is like America. In fact the cultural similarities between two very different countries are quite striking: socialist democracies, with a general consumer propensity to save rather than borrow, changes the political dynamic considerably and sets the tone for their societal traits. Also relatively cohesive, homogeneous societies with wealth uniformity (a huge middle class) and a ultimate respect and pride for, what I will call, “personal honour, structure and discipline” plays a significant part in their cultural identity. It is no surprise that they both possess the two best education systems in the G7 for Science and Maths and consequently home to the two most sophisticated manufacturing, engineering and export industries.
In this cultural dynamic, deflation is not the monster it is portrayed as in the Anglo-American media. To start with, it is politically less destabilizing in a society which embraces a culture of consumer saving over consumer credit. Indeed the personal wealth of a, saving-rich, populous increases with deflation and, in a more culturally cohesive society with more uniform wealth distribution (both have by far the lowest GINI coefficient of the G7), the prospect of societal disintegration is more applicable to inflation than deflation. Also note that, there is a structural industrial cushion for nations whose economy is absolutely dominated by sophisticated manufacturing exports as wage deflation provides a significant boost to domestic industry via reduction of labour cost on a relative basis.
What Choice Does This Leave Germany With Today?
The bottom line is, if you ask an American or a Brit what the single worst economic period was for their country in the last 100 years, almost unilaterally, the response would be: The (Deflationary) Great Depression of the 1930’s. If you ask a German I’m not sure you get the same answer. I think a German would say: The Hyperinflation of the 1920’s. That’s the psychological difference between Britain and Germany, between David Cameron and “Merkozy”, between the BoE and the ECB, between the US and Japan. Of course, I’m simplifying everything greatly (and I apologize for this) and the economic idiosyncrasies are very different, but their economic positioning and their collective divergent abilities to endure different economic hardships are almost entirely cultural.
Where does this leave us today? Well, it’s not entirely obvious that Germany wants to do everything its power to avoid a Deflationary Depression (that’s an understatement) – this has come to the distress of many highly vocal American and British pundits who think that Germany and the ECB are, quite simply, idiotic not to print the heck out of the Euro. That’s a culturally and politically naïve simplification, I think.
So let’s look at the historic facts: the last time Germany tried to aggressively inflate its way out of a debt trap, disastrous Hyper-inflation ensued, soon followed by a huge Deflationary Depression anyway (oh yeah… and don’t forget the most far-reaching World War in the history of mankind). That’s not a great benchmark. The current facts are that Germany has made it clear that:
The ECB will have a German design – its mandate will be to control inflation and inflation only.
There will be absolutely no participation on the part of the ECB to print money or directly monetize.
It is no secret that the Germans have long been making significant preparations for Euro-wide defaults.
Kyle Bass may be right. The choice is less a case of simply, “do you want inflation or deflation” but rather:
do you want inflation first (and then run the risk of trying to deal with a potential deflationary reaction to default later), or,
do want deflation and default up front (and then try to inflate and grow out of this, potentially chronic, depression later)?
The answer in the UK and the US is, without hesitation: “#1 please” – it’s just how we deal wit this, it’s part of our culture. I know this is a controversial thing to say, but, given both the actions and rhetoric I am observing from Germany, given the cultural and historic backdrop of Central Europe… I’m not sure they would give the same answer.. and, to be honest, in their cultural and historical context, I’m not sure they are wrong to do so. After all, from a cultural perspective, who are we to tell the Germans what is best for their country?
If you attempt to confiscate the savings of your populous after you’ve sold them bonds to the tune of 227% of GDP you’re going to have a very difficult social scenario on your hands. We’re going to look back at this in two or three years from now and we’re going to say: if you took the time to understand their balance sheet and their income statement as a country, it’s the single most obvious thing I’ve ever seen in my adult life. The reasoning I hear from the other side: we keep finding one or two reasons why they might be able to hang on for a little longer and clearly that’s not an investable theme…
Kyle Bass (onJapan)
Macro Overview
Eeerie Silence In The Corridors Of Brussels
It’s easy to tell when someone’s being really naughty in our house: it falls eerily silent.
That said this is far from victorious, all that has happened is a potential path has been cleared toward as solution – Merkel and Sarkozy deserve credit for that part, at least. Whether the European political elite take the right path from here is an entirely different matter – perhaps another time we will examine the potential pitfalls and legislative landmines that EU politicians will have to circumnavigate to make sure this incisive rhetoric is effectively manifested in a fair and transparent political structure which all EU members can feel happy about.
It’s all very well France and Germany uniting to cut out Britain and ensure their dominance in the region but will they now do the right thing by the other 15 states in the Eurozone and the other 24 states in the “new EU”? That’s a monumental question and the questions within the new EU will only become harder.
This was supposed to be one of many steps The Union (I don’t know what else to call it) had to take. As I’ve alluded to before, the EU needs to concurrently implement long, medium and short term solutions to fixing their cancer. In many ways they have taken the hardest decision over Treaty Change, but it would be just like Europe to let egotistical politics get in the way of a good solution. Note, Sarkozy has an election coming in a few months and a black eye for Cameron is not a trophy you can plaster on your campaign bus.
So no news is bad news in Europe at the moment. After “Merkozy” pulled the trigger to release their euphoric silver bullet, the microphones fell silent. No more clarity or definition or specifics, not even passionate resounding speeches by the main leaders to their domestic electorates – who all wait with bated breath and twitchy sphincters to hear what their government has signed them up for. It’s left the market thinking that there may indeed be devils in the details.
Make no mistake, Cameron’s approach was poor, even naive, and I’ve already aired this. He could have left with significantly more friends in Europe and still implicitly played the veto card. But history will judge whether this new Germanic States of Europe would ever have been a good thing for the British to be part of.
Kyle Bass Puts China’s “Infinite” Reserves Into Perspective
Great quote from Bass, above. Well I have to say, Bass makes an incredibly logical argument as to whether Japanese Government Bonds are the best looking short in the World. I agree with his logic for shorting Japan… I just daren’t. My appetite has not really changed much since I wrote: I ain’t shorting JGBs ‘til they stop the road works at Roppongi – but I will avoid them.
But Bass’ view on China strikes a few more chords. This is what I wrote a few months ago about the so-called Chinese trump card that is supposed to be able to underwrite the World-economy.
It is not easy to get good access to default rates in China but the FT reports that yields on loans to developers are hitting 20%+, suggesting that “developers are losing access to funding”. My guess default rates will rise exponentially over the next 2 years – if they are not doing so already.
Never-the-less, we hear many reassurances that non-performing loans (NPLs) in China are “contained”, but where have we heard that before and how on earth is it possible to quantify a risk which, as Pettis correctly asserts, by it’s very nature we cannot see? The NPLs we are currently able to observe in China are but the tip of a rather imposing iceberg.
Some of my friends in closer dialogue with Greater China businesses think that magnitude of bank losses due to NPLs may be greater than book equity of the banking sector as a baseline case. Don’t ask what the worst case scenario is, it’s too horrific to put into print.
Bass, while admitting China is an “enigma” to him, he makes some interesting comments on Chinese banking sector too…
In the last two years China has grown their banking sector (their banking assets) 50% of Chinese GDP two years in a row. That’s analogous to the US lending $14.5 Trillion into our economy in two years. One thing I’m fairly certain of: if we lent $14.5 Trillion into our economy in the last two years, we would grow at more then 8%. So I think it’s very important to think about China’s FX reserves (that everyone points to as being the piggy bank for the World at now $3.5 Tillion) … but it’s important to understand that Chinese non-performing loans in the banking sector are right around 1.5%. Historically they’ve been 19%. So if you have 13.5/14 Trillion (call it) dollars worth of assets in your banks and your non-performing loans go back to what’s normal in China you can do some quick maths and realize that you could end up losing almost $3 Trillion and that magical pot of money that sits in China goes away…
Interestingly, Kyle Bass has no real view on China though, recognizing (correctly) that China can keep the game going for a lot longer if it wishes to. While Hugh Hendry may have profited from short-China plays, big China bears like Chanos need to be aware that if there is one market which can remain irrational longer than you can remain solvent – it is China.
But sino-pessimism aside let’s be sure, China is pretty much the only large economy which actually possesses any sort of wiggle-room in fiscal and monetary policy. My view is that China can use what economic fire power it has to rotate its economy towards a more service-based, consumption-based economy as part of its 12th 5 year plan – which I have commented about. Be sure about one thing though, even if trend growth in China remains robust, this process will not be seamless and smooth – volatility in Asian assets is here to stay and with it the fat-tails of default, scandal, fraud and other terrors of the black-swan variety.
Enough talk from me: just listen to Bass for yourself, courtesy of BNN links:
Angela Merkel: Only political solutions can resolve the situation… A breakthrough can only happen if we are ready to change our treaties.
STRATFOR: Translation: Expect to give up some political sovereignty if you want to share in Germany’s wealth.
Macro Overview
On The EU Poker Table Merkel Plays Her Hand Beautifully
Christmas started with the “immaculate conception” – Mary, pregnant with Jesus, rode all the way to Bethlehem to give birth to Jesus. Conception is an interesting concept – after all, conception is always “immaculate”. We should not be surprised by this, but we always are.
Consider this: could Angela Merkel and her CDU Party be playing their EU hand beautifully? Many theoreticians and economists make the mistake of looking at the EU through a “lens of logic”. This could not be further from the reality. In a political shake-up as violent as this, self-interests, horse-trading and power-plays dominate and economic logic takes a back seat. Like shifty characters at a high-stakes poker table, EU leaders size each other up as they pore over the political hands they’ve been dealt … and some are playing their hand with much adeptness.
Consider this: Germans have always been paranoid about inflation. But are they really as paranoid today as they are making out? Is the average German truly petrified of inflation in the midst of a (deflationary) global slump, (deflationary) debt crisis and lurching violently into a (deflationary) pan-European recession? It would be awfully clever of Merkel’s CDU to suggest that they indeed are still vehement inflation hawks (and indeed some are). But, by publicly over-blowing this risk, Merkel’s CDU have irrefutable leverage over other states (like France and the Southern Europeans) to acquire what it has truly wanted since the dawn of the European experiment.
Consider this: Germany has never taken its eyes off the prize. A Germanic Central Bank was a significant milestone for Germany in the context of the Euro, but, in this final chess game, Germany recognizes it as merely a sacrificial pawn. Merkel, the longest serving leader of a G8 country, is no mug – indeed Sarkozy is a political lap-dog by comparison. She may be happy to throw her lap-dog a political bone and trade a Germanic Central Bank for the ultimate prize: a Germanic European Constitution. A supra-national political body which, incidentally, would command a strategic force (economically, geographically, militarily, politically) more powerful than anything we’ve ever seen.
Puppy dog Sarkozy can return home with is superficially triumphant bone of a temporarily flexible monetary victory to his gargantuan domestic banking problem. But Merkel returns with the ultimate prize, an entire continent governed by a Germanic political infrastructure molded under a Germanic ideology. All this and, unlike the World Wars of last century, without firing a single bullet.
Smart moves Angela, using the ECB chess-piece (no peripheral-friendly monetary solutions without German-friendly political reform) you’ve maneuvered Germany to a position where is effectively holds the other EU states over a barrel…now, for the “greater good” of the Eurozone, here comes the treaty change.
The World has been fixated with preparing itself for the collapse of the Eurozone and the Euro and all the geopolitical ramifications this would bring. Instead, this Christmas the World may have to prepare itself to welcome the conception of a new Superpower from the most unlikeliest of places… and all the geopolitical ramifications this would bring.
With freedom comes some unpredictable fluctuation. This is one of life’s packages: there is no freedom without noise – and no stability without volatility.
Nicholas Taleb and Mark Blyth
Macro Overview
Tail Risk In China
A while ago I wrote about the tail-risks in China (Prepare for the Dragon’s Fat Tail Risk). But this was a hard concept to convey. On this piece I expressed a concern specifically on the Chinese property sector and since then the trade has largely played out. Chinese Real Estate risk assets have significantly underperforming global markets and their peers on an annualized basis – even as most of the turmoil has emanated, not from China, but from Europe!
Why should we be worried about a risk we cannot observe and which is not statistically likely to happen? Of course, the reason we should pay attention to them is because of the magnitude of the consequence if they do happen (for the same reason, I still have a smoke alarm in my house, I still wear a seat belt in my car, for example). It is also worth paying extreme attention to the tail risks in specific asset classes or regions when probabilistically it appears the, still statistically small, tail risks may be inflating (fat-tails).
The Black Swans of Investment
Understanding tail risk:
The critical issue in both cases is the artificial suppression of volatility – the ups and downs of life – in the name of stability. It is both misguided and dangerous to push unobserved risks further into the statistical tails of the probability “tail risks” to disappear from policymakers’ fields of observation.
That quote [emphasis mine] was from a quite brilliant piece – The Black Swan of Cairo by Taleb and Blyth. While, in this case, they relate economic black swans to political uprisings there is a more obvious relationship between economic black swans and investment performance. You could substitute the word “policymakers” for “portfolio managers” and it would fit just nicely. This is what I was alluding to with my piece on China’s Fat Tail-Risk. But it should be noted that tail-risks can remain apparently dormant for a very long time. Many of the investors who were short sub prime CDOs could not handle the elongated and binary pay-off and bailed well before the trade finally came good.
So this is one of the things people have difficulty understanding about tail risks. Tail risks are invisible by definition, they do not exist, until the moment they do… then they are all and everything that exists. In a complex system tail-risks often start small and then propagate through the interdependence of a highly complex lattice of relationships in a manner which is difficult to predict or quantify. Who would have thought that the ripple effects sub prime mortgages in America would eventually lead to the murder of Colonel Gaddafi or riots in Athens or Treaty Change in Europe? Two years ago Greek debt collapse was a tail risk, 5 years ago sub prime CDOs presented a tail risk to the financial centre. But they are not any more, now they are front and centre risks – they went from being “unknown unknowns” to “known knowns” in an instant.
The reality is we are complicated creatures, we live in an interdependent and “complex” world and yet we try to apply logic or “linearity” to govern it and suppress, contain or “control” the chaos (the natural volatility and cyclicality of life). Many years ago I was writing about this and many thought that it was a little “weird” to suggest that volatility, cyclicality and recessions were “good” for us because they helped us build robust defense mechanisms towards uncertainty. This is true of corporations too, even Greenspan eventually recognized this and I wrote about it in a comment (rebutting the Uncertainty vs Volatility conventionality). Here I (and the Maestro himself) suggested that the very action of trying to contain volatility/cyclicality in a complex world may succeed only in producing more volatility in the future. It is worth thinking of China’s centrally controlled economy in this light.
Of course the reverse is also true, the systems have a habit of self-correcting – it’s hardwired into our natural quest for survival. So, as uncertainty in a complex world arises, people, corporations, all entities interested in self-preservation, build up massive defense mechanisms to counteract the uncertainty… which eventually suppresses the volatility again… and so the sustainable, self-healing cycle continues. Cyclicality and uncertainty is not only in our blood, we need it to survive – it is oxygen for the spirit. This is what I wrote in that piece:
The Paradoxical Effect of Uncertainty on Underlying Volatility
I admit, I have been wrong on the issue myself up until this point. Instead, I now challenge the conventional wisdom that uncertainty causes volatility. Every action deserves a reaction, perhaps even an over-reaction. In extremely uncertain times, large corporations, which are highly sensitive to market sentiment, regulation and macro policy, react by hunkering down to core business and swamping their balance sheets with cash. In doing so they counteract external volatility with internal shock-absorbers on their balance sheet. Consequently. the volatility of their share prices get suppressed and can significantly underperform the volatility of other asset classes (say commodities) and other facets of the economy. For example, small businesses (which actually account for 60% of the US economy) may experience a very different environment and may have extremely high levels of volatility – just look at the unemployment numbers! But of course this environmental volatility may at times fly under the radar of the market for a simple reason – we can only trade the volatility of the extremely big companies. Indices like the VIX only relate to the biggest (most conservatively positioned) multinational businesses.
We are starting to see the effects of the Fed’s extreme monetary policy and it does not always directly lead to increased Money Supply on Main Street. Rather, one may observe the effects of an explosive monetary base in commodity prices, in stock prices, on the balance sheets of banks and on the balance sheets of corporations.
The macro-economic uncertainty is directly correlated to the uncertainty level inside the boardroom of a company. But the correlation between this and the volatility of stock prices is very inconsistent and, at times, completely uncorrelated. Paradoxically, more certainty over the economic, fiscal and monetary outlook may lead to more, not less, volatility in the markets. As Mrs Watanabe starts to splash the cash and Western Corporations see the opportunity to compete by taking more longer term risk onto their respective balance sheets.
I’ve suggested over the years that investors indeed everybody needs to embrace a certain level of uncertainty and with it a certain level of volatility and cyclicality – even recession. We need volatility to ensure stability. But this was a controversial view point at the time, after all Greenspan, the Maestro, was eliminating volatility from our lives, he was suppressing cyclicality of the business cycle with his “Greenspan Put”. This is what I wrote in a comment (Bernanke and the Butterfly) a few years ago (well before the Sub Prime Crisis).
It’s worth reminding ourselves that it is not the Fed’s job to prevent recession, it is to manage long term inflation (and therefore present inflation expectations) and nurture long term employment and with it economic growth. I hear talk of recession now as if it were something we should never have to experience, ever. Perhaps this was Greenspan’s vision, a safety net for failing, weak and inefficient businesses. Nobody should be allowed to suffer the consequences of the natural business cycle. But yet this form of Financial Socialism has a tendency to expunge the natural existence of, what I call, the “darwinistic alpha” normally prevalent in a purer capitalist system, thus the notion of “creative creation with creative destruction”, becomes compromised.
I really encourage you to read The Black Swan of Cairo, but here are a few choice quotes from it:
Complex systems that have artificially suppressed volatility tend to become extremely fragile, wile at the same time exhibiting no visible risks. In fact they tend to be too calm and exhibit minimal variability as silent risks accumulate beneath the surface. Although the stated intention of political leaders and economic policymakers is to stabilize the system by inhibiting fluctuations, the result tends to be the opposite. These artificially constrained systems become prone to “Black Swans” – that is, they become extremely vulnerable to large-scale events that lie far from the statistical norm and were largely unpredictable to a given set of observers.
Just as robust economic system is one that encourages early failures (the concepts of “fail small” and “fail fast), the U.S.government should stop supporting dictatorial regimes for the sake of pseudostability and instead allow political noise to rise to the surface. Making an economy robust in the face of business swings requires allowing risk to be visible: the same is true in politics.
Putatively independent central bankers fell into the same trap. During the 1990’s, the U.S. Federal Reserve Chair Alan Greenspan wanted to iron out the economic cycle’s booms and busts, and he sought to control economic swings with interest-rate reductions at the slightest sign of a downward tick in the economic data. Furthermore, he adapted his economic policy to guarantee bank rescues, with implicit promises of a backstop – the now infamous “Greenspan put,” These policies proved to have grave delayed side effects.Washingtonstabilized the market with bailouts and by allowing certain companies to grow “too big to fail.” Because policy makers believed it was better to do something than to do nothing, they felt obligated to heal the economy rather than wait and see if it healed on its own.
With [Chancellor Angela] Merkel, we will soon make proposals on modifying the treaties to prevent countries from diverging in the budgetary, economic and fiscal areas…
Nicholas Sarkozy – French President
Macro Overview
12 weeks is a long time in this market. But 12 weeks ago I remember explicitly stating that the way to solve this Eurozone crisis was to change the very fabric of the glue holding it together… namely CHANGE THE TREATIES that were agreed long ago (Maastricht Treaty, Stability and Growth Pact, EU Treaty)… I’ve since referred to this many times in my comments. Here is a quote:
They’re missing the most obvious solution in my opinion which is what Donovan calls the confederation of Europe. I’ll go one stage further and say I think the best solution would be to reform the Maastricht Treaty and Stability and Growth Pact. Let’s call it “The Eurozone Consolidation Treaty”.
Then I set aside specificactions which would change the treaties should be changed – namely to STRUCTURALLY enforce more fiscal discipline and economic management of the region (not leaving it to vague “guidelines”) where automatic punitive measures come into play for countries which do not adhere to the limits.
At the time this was regarded as politically impossible, outlandish, perhaps even fool-hardy, insane, idiotic… right?
OK… I now forward you the headline in Reuters just hitting the tape…
French President Nicholas Sarkozy has embraced a German campaign for treaty change that could give European authorities intrusive powers to intervene in the national budgets of countries sharing the euro currency.
France and Germany will soon propose amendments to the European Union treaty in response to the bloc’s sovereign debt crisis, Sarkozy said on Tuesday.
“With (Chancellor Angela) Merkel, we will soon make proposals on modifying the treaties to prevent countries from diverging in the budgetary, economic and fiscal areas,” he told an Asian forum in Paris.
“We will do everything not just to defend Europe but also to consolidate it.”
That’s right, you know where you heard it first, dear reader, and I believe we may have entered the end game here. It’s been a long time coming but I actually see light at the end of the euro-tunnel – especially if Germany and France revamp the EFSF with something tangible.
The Dollar has rallied hard since I called an end to my bearish stance which was great, but it may be time to resume the Dollar short again and perhaps even buy Euros again (!?). But first let’s see how all this pans out – it’s only a headline so far and much more needs to happen. But, in my opinion, EU leaders may have at least just cleared the path for a relevant debate and, who knows, perhaps even some action towards a sensible solution.
There is no way it will work, at least not for a longer period — because, of course, following massive buying … as a political solution to this crisis, after a while people would realize that what is on the European Central Bank’s books has to be recapitalized by someone,
Angela Merkel – speaking on ECB participation
Macro Overview
Why the Germans Hate Inflationary Policies
It’s not hard to see where German hatred of inflationary policies come from. WWII arose out of hyper-inflation in the Weimar Republic which saw Germany at the epicenter of the most expansive war in the history of mankind.
Remember, Germany is a massive and growing exporter outside of Europe and, as the European consumer hits the skids, this is only likely to increase as a proportion of total exports. ECB money-printing would likely lower the exchange value of the Euro boosting their exports. The fact that Germany campaigns against ECB participation gives you an idea of just how petrified they are of unruly inflation expectations.
If you look at the chart below it shows how the Paper Deutsche Mark rose against the Gold Mark from 1 to 1 Trillion in the six years from 1918 to 1924 – quite a remarkable feat. Imagine how disruptive this is on a highly productive economy like Germany’s. This is a chart engrained onto the soul of every German – they are not going there again.
German Hyper-Inflation
Why the Germans Hate ECB Monetization
Well, monetization is inflationary policy, so it stands to reason, why they’d hate it doesn’t it? True, but so many historians and pro-print pundits point to the fact that WWII was caused primarily by the oppressiveness of the Versailles Treaty in the aftermath of the first World War. But this misses the point, the economic reality was that, for whatever reason, there was a sovereign debt problem in Europe (and debt takes many guises). The Germans felt they had no alternative but to inflate their way out of this debt and the rest, as they say, is history.
Since the painful aftermath of the Second World War, Germany’s Bundesbank has been modeled on a strict mandate of price stability and, under this resolute stewardship of inflation, the German economy has indeed flourished. The ECB is a central bank crafted (correctly in my view) in the same mold of this stoic, uncompromising Bundesbank. With monetary authority over a wide variety of cultures it was even more imperative that the ECB had a simple, pure mandate, unpolluted by political influence, untainted by conflict. Employment distractions and a bias towards monetization and money-printing are highly charged political hot-potatoes for any central bank, never mind a supra-national central bank, to contend with.
Why the Germans Will Not Tolerate Even A Temporary Direct ECB Participation
This was really well explained in a WSJ Blog yesterday. A typical modern western central bank can print the heck out of its fiat paper currency and can simultaneously cohesively suppress inflation statistics while making the argument that, as soon as inflation “appears”, they’ll be extremely pro-active in reversing the inflationary policies. But, ironically, the ECB is actually more inherently righteous than this as, due to its structure, it finds this argument is much more difficult convey.
Firstly because, once the bank loses sight or control of inflation, within a culturally broad region of independent fiscal authorities, the dispersion of inflation risk increases greatly. Some cultures within the Eurozone could be in outright deflation (periphery) while other parts are getting cooked by rampant inflation (Germany).
Secondly, and more importantly, the ECB (arguably the last bastion of supra-national credibility within the EU) immediately loses credibility by overtly stepping over the strict mandate line enforced on it. Additionally, if the ECB makes the decision to monetize peripheral debt, it must do so assertively and with a communicated long term objective (we’ve already seen that the market does not buy half-measures, and the market will test the ECBs resolve on anything like this). By making a heavy and almost indefinite commitment to purchase peripheral debt, the inflationary effects will be felt in Germanyalmost immediately and the Euro will probably tank – exasperating the problem. The ECB and the whole of Europe would then have a gargantuan problem. As German inflation careers out of control, the ECB, having just vaporized most of its credibility, must:
Continue with its monetization until peripheral economies are safely out of their debt trap – meanwhile the most productive economy in the Eurozone will have hit the self-destruct button. Good luck managing the fallout from that.
If it tries a U-turn and begins a sudden tightening policy, what little credibility it has, will finally desert it – you now have a central bank with no credibility trying to fight runaway inflation in what was the old Weimar Republic. Good luck managing the fallout from that.
Sympathy For The Germans (For a Change)
I have criticized the way Germany has positioned itself forcefully within the Eurozone and I’ve noted how they have benefited from the weaker Euro and I’ve criticized them for actually being the protagonists who discredited the fiscal framework of the Stability and Growth Pact in the first place (see the excerpt from the Guardian in this piece).
That said; I do sympathize with their argument with respect to inflationary monetary policies. Not only is there inherent moral hazard to money printing in general, ECB direct involvement with sovereign debt purchases will likely expose more, not less, flaws within the Eurozone framework. I believe treaty change, as I’ve commented on many times (see here for suggestions I made long before it was on the tip of Merkel’s tongue) to be imperative if the Eurozone is to survive. This is because it is fiscal accountability and the very foundations upon which the EU was constructed are the root causes of many of the fractures within the Eurozone.
Germany is as much to blame as all the other countries for this crisis, as I said in my piece Brokeback Europe:
…there is little fiscal discipline within the EU and therefore little credibility. This is not an opportunity to point nationalistic fingers; this is a fault within the constitutional framework itself. The EU was a collective creation, this gaping policy hole is a collective, European mistake.
But just because Germany is as much at fault as every other nation, does not mean we should ignore their suggestions for a solution. The southern European states should accept that direct participation by the ECB in the debt markets is out of the question, they should grant Germany this but in return they should demand that German taxpayers put up a significant amount of collateral into the EFSF to draw a line under this once and for all. That is where the negotiation process should be – at the moment Europeans are arguing about which argument they want to have! We’re a long way from finding and implementing a solution, it would seem.
Ennis Del Mar: If you can’t fix it, Jack, you gotta stand it. Jack Twist: For how long? Ennis Del Mar: For as long as we can ride it. There ain’t no reins on this one.
Script from Brokeback Mountain
Macro Overview
The European Dream
Like all pivotal societal achievements, the European Union started as nothing more than an idea, an idea which became a dream, a dream which became a reality. But dreaming is easy, implementing dreams is harder – dreams in design often become nightmares in development.
Of course, we all know immigrants in America had a dream a couple of centuries ago and the ideals of this dream were effectively drafted into print in the American Constitution. A document so powerful that, over two hundred years later, Americans today still abide by its principles religiously.
But Europe is not a country. It is a continent, a continent with many diverse national identities. So a federal constitution is out of the question, instead, the European ideals were drafted in a series of broad confederal treaties. The Eurozone was going to operate under a Monetary Union, that part was clear, but if these treaties were to be effective they needed to be strict, clear and extremely well-disciplined, especially with respect to:
Fiscal discipline
Monetary discipline
Anything other than this would open up festering wounds of national and cultural divisions that the EU was effectively trying to incrementally overwhelm with a new sense of continental identity in Europe. This was the New European Dream.
The two items; fiscal and monetary union, were covered quite clearly in the Maastricht Treaty, Stability and Growth Pact and the EU Treaty. Paper promises are all well and good, but (as we have learnt from the balance of fiat currencies versus hard currencies of late – look at Gold prices) they have little intrinsic value – they must be backed up with a demonstrable record of discipline and credibility.
Discipline and Credibility of Fiscal Union in the European Constitution
Well, I’m not going to repeat myself, but, to cut a long story short: there is little fiscal discipline within the EU and therefore little credibility. This is not an opportunity to point nationalistic fingers; this is a fault within the constitutional framework itself. The EU was a collective creation, this gaping policy hole is a collective, European mistake.
Firstly, it is practically impossible for any supra-national agent (or any other entity) to objectively enforce any form of fiscal discipline of any weight on any government or regional fiscal body. Instead, the framework is a wishy-washy set of “guidelines” which, highly partisan, domestically-motivated political interests are expected to follow in good faith. It took a global recession to uncover the hidden fractures of this faith-based cohesion but, let’s be clear: right from the start, there were serious design flaws in the constitutional framework.
A Debt-to-GDP ratio of more than 60% (the supposed limit of the Maastricht Treaty “convergence criteria”) does not suddenly appear overnight. It is important to understand that excessive debts and bloated deficits had been running in many European states for many years before the Sub Prime Crisis was just a twinkle in a Goldman Sachs Structured Products Salesman’s eye.
I went through these fundamental problems in more detail in a comment I made: European Confederation – TIPSTER’s “European Consolidation Treaty”. Here I exposed the flaws of the current agreement and suggested ways in which this could be improved greatly to manage fiscal accountability. This is what I would call: political risk management. I’m a risk manager and the first rule of risk management is: make sure one is always aware of the risks one is taking – the rest is just a matter of calibration. Burying one’s head in the sand and praying is not an effective risk-management strategy – not with an investment mandate, not with a political mandate.
In conclusion, the secret is out: EU is broken, it was broken from the start and it does not need a patch, it needs a complete fix from first principles. Notice, I’m not at all implying that the Europeans cannot implement their dream. I’m implying that, without a serious overhaul of the very fabric upon which the Eurozone is built upon, fiscal fractures within the EU will not go away, they will resurface again and again.
Discipline and Credibility of Monetary Union in the European Constitution
So we understand how woefully insufficient the framework of fiscal union was – basically a disaster waiting to happen. But now we turn to the other part: monetary union and the discipline and credibility associated with it. Pretty simple, huh? A common currency, a single central bank with an extremely tight mandate: PRICE STABILITY ABOVE ALL ELSE. That should make this an open and shut case, right?
Well, try telling that to a German. The idea was, while the fiscal union part could be mercifully viewed as “work in progress”, the monetary union was supposed to be dependable, stoic, strict, unwavering and… well, yes, Germanic. There is a lot of talk about how “German” the ECB is and indeed there is ongoing debate about whether it should become more German in the future.
A simple mandate of price stability (around 2%, if you will, no more thanks) would ensure that the ECB does not get entangled in matters of fiscal politicization and NO DIRECT MONEY PRINTING AND CERTAINLY NO MONETIZATION OF DEBT! Inflation is a prevalent predator in Europe, we know all too well where that has led Europe in the past. In fact, here is a little excerpt from the EU Treaty, Title VII, article 101 (yes, I read it, sad but true):
Article 101
1. Overdraft facilities or any other type of credit facility with the ECB or with the central banks of the Member States (hereinafter referred to as ‘national central banks’) in favour of Community institutions or bodies, central governments, regional, local or other public authorities, other bodies governed by public law, or public undertakings of Member States shall be prohibited, as shall the purchase directly from them by the ECB or national central banks of debt instruments.
Remember this is effectively part of a pretty clear transcript of what is the European equivalent of The Constitution. I’m not debating what the ECB should do. I’m simply expressing the consequences with respect to the credibility of the entire Eurozone dream if they do not adhere to Article 101. In fact the Germans, who have built their economy on the forthrightness of European Monetary Policy, have, quite simply, vetoed any notion of ECB peripheral debt monetization. Just in case you were in any doubt about the German position, the German Central Banker and head of the Deutsche Bundesbank recently said:
appropriation of monetary policy for fiscal policy purposes must come to an end.
Pretty blunt, pretty clear, pretty honest, pretty… well… German. ECB executive board member, Jurgen Stark remarked that the ECB can never become lender of last resort. So German monetarists are in close agreement about their stance. But they are not politicians, I think rift between the Euro-friendly German politicians and monetarists will intensify in the near future – as both seek to assert their case to the German public.
It’s quite clear that, despite the “progress” made last week in Greece and Italy, Europe’s problems are only just beginning. It’s all very well putting an economist in charge of the country but it solves neither the societal nor political problems at the root.
Short Term and Long Term Remedies: Print First, Ask Questions Later…
Believe it or not, there are still many solutions available to Europe – including temporary break-up/sabbaticals, revision of the treaties (as discussed above) and even collateralizing the EFSF with something less flakey than a mangy dingo with fungal skin condition. But I have now taken to calling the potential fixes “remedies” and not “solutions” because, honestly, if there was political will to see the solutions through, they should have happened by now. Preventatives and cures are being ignored, so the best we can hope for is hair of the dog and some pain-killers.
Of course, there is the possibility of just ignoring the German monetarists and printing money (as everyone outside Europe seems to want them to do). Careful what you wish for, that’s what I say. Not only will a significantly weaker Euro obliterate any green shoots of manufacturing recovery in America and Asia (can you imagine if the highly competitive German exporters effectively get a 10-20% subsidy on their exports with respect to their $-based competitors in China and the US), but the sheer volume of fiat trash in the global financial system will have second-round effects on global inflation pressures and, dare I say it, geo-political tension – starting with Germany (do we really want to go there?) By the way, for “growth recession” see: political upheaval, social unrest and extreme investment risk.
But perhaps Niall Ferguson, is right and European politicians will continue to talk tough on their discipline toward EU treaties but will, in actual fact, endeavor to undermine it, the credibility of their constitution and the ECB, engaging in Quantitative Easing “by stealth” (is there any other form?). Indeed, another prominent Harvard professor, Ken Rogoff, too thinks that the ECB will buckle under pressure and crank up the QE printing press. As ever with European politicians, it is more important to watch what they do, not what they say.
Deception is a rather skeptical view of European politics but we should be used to this by now, there are any number of facilities “the Feds” have to disguise what they are actually doing – stealing wealth from prudent savers and lower to middle class families to prop up the rich and imprudent. America uses spaghetti-like complexity of “shell-games” to hide the true extent of their currency debasement. But, as usual, the magnitude of the fall-out to the questions of credibility and discipline, political forthrightness, moral hazard and equitability will be kicked down the road… and the price for that deception and procrastination will be that the risks associated with the answers to those questions will become evermore elevated.
We’ve spoken before about hair of the dog monetary policy. Welcome to hair of the dog political policy. But if large populations of Europeans are at odds with each other over the mechanics of a resolution, when this severe bout of Euro-sclerosis eventually comes to an end, it’s hard to see how it will end gracefully.
According to Greek legend, Leda (pictured above) was raped by Zeus in the guise of a swan. Their consummation resulted in the birth of two eggs – one of which was Helen (the beautiful Helen of Troy).
Today we ask the question: was modern-day Greece economically raped by a “black swan event” – or is this a convenient myth to disguise the inconvenient truth?
Quote of the Day:
Come senators, congressmen
Please heed the call
Don’t stand in the doorway
Don’t block up the hall
For he that gets hurt
Will be he who has stalled
There’s a battle outside
And it is ragin’
It’ll soon shake your windows
And rattle your walls
For the times they are a-changin’.
Bob Dylan – Poet
Macro Overview
A Pig in a Python Creates a Bit of Indigestion
Italy is a PIIG the Python Can’t Swallow
Berlusconi was the Italian “Teflon Don”; seemingly nothing could touch him. Until now, that is. The current crisis is making a mockery of political and economic traditionalists alike. The Teflon-Don, Gordon Brown, Papa-G, many others and a very large chunk of investors are heaped onto a growing pile of carcasses of intelligent people who, perhaps understandably, could not grasp the sheer ferocity of change underfoot. If your train of thought is still bound by the parameters of the, relatively benign, decades preceding 2008, then you’re cruizin’ for a bruizin’, pal. The times are a-changin’ and they’re a-changin’ at breakneck speed.
Italy’s plight presents a new challenge to the members of the European Council, not that they needed one! In fact, Greece has taken a back seat in the press for all the wrong reasons, as far asEurope is concerned.Greece is an economic minnow compared to it’s Italian neighbor. Italy’s debt is over 4 times the size of Greece’s and its economy and banking sector are significantly larger and (perhaps more importantly) much more integrated with Europe’s political core, namely France. Put simply, for Europe and the EFSF, Italy is a PIIG the python cannot swallow.
While the markets concentrate on Italian yields (up around 7%) and the maturity profile of Italian government debt (hundreds of billions coming due in the next few months), I look at the CDS 2s-10s or “steepness” of the credit curve. The term structure of CDS) for Italian debt has flattened significantly and even turned negative recently (see below). Here are some examples of countries in and around Europewith negative credit term structures:
Iceland
Ireland
Portugal
Greece
Hmmm… that’s hardly an illustrious group of gold-standard economies is it?
Italian Credit Steepness, 2s-10s (Source: Bloomberg)
It’s the political uncertainty that the markets do not like. However this works out, the Italian elite must come to a compromise. In the political arena that is the EU, if you compromise domestically you are compromised internationally. Strong leaderships with secure domestic majorities will have much more political leverage as the fiscal austerity debate rages on. Where have seen heard this power-drain before? Greece!
Read My Lips: Greece is not a political “black swan”
Although the dynamics are very different, holistically, Italy faces the same problem that Greece does: externally forced austerity clashing with domestic confrontation and resistance.
Which brings us to the question of the cause of the EU market contagion: I’m not going to defend peripheral profligacy, but if Greece’s problems are all its own making, is it pure coincidence that we are seeing the same issue with Italy – a core member of the Eurozone and the 8th largest economy in the World?! Perhaps we should entertain the thought that there is something structurally wrong with the design and development of the entire EU economic system itself.
Of course, it is easier on the mind if we conjure an evil scapegoat to vent upon. When my soccer team (The Mighty Spurs) concedes a goal, I blame the defense and goalkeeper immediately, but it’s not always that simple is it? Indeed, I alluded to this in a piece (Greek Mutiny!) I wrote recently:
Remember, this is not a Greek political problem temporarily embodied in Europe –this is a mutation of Euro-sclerosis: a European problem which is, just temporarily, embodied in Greek politics.
Today we know this form of Euro-sclerosis, an ideological confrontation, is now as much an Italian condition as it is Greek, how many more will succumb to the affliction before the penny drops that:
The EFSF, even under its new guise, is fundamentally over-hyped and under-funded. It needs to be collateralized with something harder than a flakey politician’s promise in order to deliver an effective response from the market. Simple as this: showmethemoney. (See my article on reasons why).
The current political framework of the EU is structurally inadequate. (See my article on reasons why with suggestions – not necessarily for a cure but on the remedial approach, at least).
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The Famous Leaning Tower of Pisa
The Leaning Tower of Euro
All this begs the question – if this is not all Greece’s/Italy’s/Portugal’s/Ireland’s fault, just who is to blame? The answer, I’m afraid, is a cop-out: everybody in Europe is to blame. That’s the definition of a “union”, when things go bad there is a collective responsibility. Perhaps we’ve forgotten that.
It starts of course with the fundamentals. When you erect a building, you’d better be sure the foundations are exactly level. It’s not so bad for a one or two storey house if you’re out by a couple of millimeters, but if you keep adding floors the weaknesses are stressed and become exaggerated – over time it ends up looking something like the Leaning Tower of Pisa
Now, over the last few years, the EU has collectively been adding member states with more exuberance than Harry Rednapp (is on signing new players for The Mighty Spurs) on transfer deadline day. Thus any small blemish on the foundations of a structure, built initially for a closer group of core nations, would be amplified at the periphery. As we added more peripheral stress to the original framework, the flaws are amplified.
But let’s be clear, I’m not saying that the fundamental issue is that the EU has too many member states. Rather, the problem is that the initial foundations of the structure were flawed and was thus was always going to be incapable of dealing with extreme stress loaded upon it – however those stresses may occur.
Let me finish with a couple of excerpts. Last night I was reading some economic papers in bed and I came across two very different authors, with very different backgrounds, writing about two different topics.
Michael Pettis, the Professor at PekingUniversity, on why China should not bail out Europe: Germany Must Do It, Not China.
These pieces are very different but for one brief instant they converge and cross paths. It’s all very well, I suppose (and I recommend you read these pieces for very different reasons), but I’m always intrigued when two very different perspectives converge on a common theme. Let’s take a look:
As political horizons get shorter (in a crisis, governments tend to be unstable), leaders choose short-term fixes at the expense of medium-term solutions. Since they are unlikely to be in office to benefit from the medium-term improvement, they discount its effect at much higher rates than they discount short-term policies. The result is that the crisis gets worse, not better.
. . . . . . . . .
So how do we explain the European crisis? One theory is that the European crisis was caused by the moral turpitude and spendthrift habits of lazy Europeans along the periphery, in sharp contrast to the hard-working and thrifty countries of the center. According to this theory it is unfair to demand that Germans clean up the mess.
If you believe this theory, you are going to have to explain what happened in 2000 that turned thrifty Italians, French and Irish into spendthrifts, and that turned ordinary Greeks, Portuguese and Spaniards into even worse spendthrifts. You will also have to explain why spendthrift Germans in the 1990s suddenly morphed into the stolid, thrifty creatures of legend.
An alternative theory is that the imbalances were caused by internal policies – perhaps the creation of the euro and the gearing of monetary policy to German needs at the expense of the periphery? – which led to the severe internal imbalances. These imbalances created employment growth in the countries that suppressed consumption, and forced the countries that didn’t to choose between debt and unemployment. Of course since the latter countries had no control over monetary policy, the choice was largely made for them by the ECB with its excessively lowinterest rates, and their debt levels surged.
I find this alternative theory a lot easier to understand, and if it is true it places responsibility for saving the euro squarely in Germany’s hands. The only way to save the euro (and incidentally to prevent Germany’s banks from being forced to absorb huge losses on peripheral European debt) is for Germanyto spur consumption and investment enough to reverse the current account surplus. Only this will allow peripheral Europe to grow and to earn the euros needed to repay the debt.
National identity was as deeply embedded in Europe as elsewhere, and historical differences were compounded by historical resentments, particularly those aimed toward Germany. The real solution to European wars was the creation of a European nation, but that was simply impossible. The European Union tried to solve the problem by retaining both national identity and national regimes. Simultaneously, a broader European identity was conceived based on a set of principles, and above all, on the idea of a single European economy binding together disparate nations. The reasoning was that if the European Union provided the foundation for European prosperity, then the continued existence of nations in Europe would not challenge the European Union. Perhaps, over time, this would see a decline of particular nationalisms in favor of a European identity. This assumed that prosperity would cause national identity and tensions to subside. If that were true, then it would work. But there is more to Europe politically speaking than an enhanced trading area, and the economics of Europe are hardly homogeneous.
Germany and the Periphery
The German economy was designed to be export-based. Its industrial plant outstrips domestic consumption; it must therefore export to prosper. A free trade zone built around the world’s second-largest exporter by definition will create tremendous pressures on emerging economies seeking to grow through their own exports. The European free trade zone thus systematically undermined the ability of the European periphery to develop because of the presence of an export-dependent economy that both penetrated linked economies and prevented their development.
. . . . . . . . .
In short, the European project is failing at precisely the point that it had been attempting to solve — nationalism. The ability of leaders to make deals depends on authority that is slipping away. The public has not yet clearly defined the alternatives, but that process is under way. It is similar to what is happening in the United States with one definitive exception: In the United States, the tension between mass and elite does not threaten to disintegrate the republic. In Europe, it does.
Europe’s Sub Prime Crisis
Unbalanced, and reckless monetary policies in the US created imbalances in the, normally, scrupulous credit markets which spawned localized (in consumer and housing) credit and debt bubbles – which eventually grew so large they posed systemic risk via contagion in the financial system.
Equally, unbalanced and reckless political policies in the EU collective created imbalances in the credit markets which spawned localized (at the peripheral states) credit and debt bubbles – which eventually grew so large they posed systemic risk via contagion in the financial system.
I’m not going to go as far as Pettis in blaming the Germans for Europe’s predicament, it is has collective failings. But I’m also not going to blame only the goalkeeper, if The Mighty Spurs lose a game because he dropped the ball… well… that’s my intention anyway – we’ll see what happens next match!
29th January 2012: Economic Growth In the UK Poised For Capitulation - Small Businesses On The Breadline http://t.co/bWYLErVehttp://tinyurl.com/ygsw24d1 day ago
26th January 2012: Bye Bye “Merkozy” Hello “Merkeron” - Hit Sarkozy Fire An Economic Bazooka Or Hurl A Political Boo… http://t.co/0IeMVsHkhttp://tinyurl.com/ygsw24d4 days ago
The author works in the finance industry and has interactions with Funds, Investment Banks and Advisors in the Alternative Investment industry.
Conflicts of interest may exist.
