- >> Portuguese $ denominated debt of T years may be priced at 6%, German $ denominated debt of years may be priced at 1%.
- >> There is a 5% differential due to creditworthiness disparity.
- >> But Portuguese EURO denominated debt of T years may be priced at 7%, German EURO debt of T years may be priced at 0.75%.
- >> There is now a 6.25% differential… WHY?
- >> Because of the issue of convertibility … investors are putting a premium on the break up of the Euro… they don’t want Euro-denominated Portuguese debt for fear that upon break up of Euro (or splintering/temporary exit of Portugal) they may end up with debt denominated in Portuguese Escudos … or some native equivalent.
Tag Archives: Monetary Policy
Quote of the Day:
The drugs don’t work…, they just make you worse…
- 2 days ago I said we were all cyclical beings born into a cyclical world. Our very behaviour is not only responsive to cyclicality, billions of years of evolution have actually made us, indeed all life-forms, dependent on cyclicality.
- 1 day ago I said that both economists and quantum physicists are ignorant. The only difference is that a quantum physicist recognizes the limitation of his knowledge – an economist does not.
- Hey, by the way, if you want to think about the limitations of quantum physics watch this clip, WARNING: this made me feel very small.
- I digress… and perhaps that was a little harsh on our esteemed academic class – I do know some very humble economists… but not many. However, the thought I wish to convey is that even the smartest of our academic gurus can only work within the constraints of the human mind and its ability to interpret. There are many things we can “understand”, but what does it mean to understand? We have many answers … but there are many, many more questions to which there are no answers. It’s the same in economics and finance – sometimes we should be humble enough to say: we do not know and therefore we do not have a solution to this problem.
Don’t Listen To The Smart Guys
- But moving on. For all these economic wizards advising our political elite, they did not stop the Japanese from stagnating for a generation, they have not managed to halt the train-wreck in Europe and they’re failing to de-odorize the stench of a stagnant workforce, gangrene growth and a rotting housing market in the US. They all have many complicated theories, most of which I’m too stupid to understand. So I revert to what all ignorant people revert to: common sense.
- Both expansionary/Keynesian and austere/Austrian policies have not worked thus far and there are many instances in which they have not worked in the past. Do the proponents of each doctrine humbly admit they’re wrong? No… of course they don’t. I don’t think they ever will. Instead, they all stare blankly for a moment and then stamp their feet and, red-faced, hiss the same response: “No! NO! It didn’t work because you did not do ENOUGH of it!!” Austerity in Spain/Britain did not work because we did not do enough of it. Stimulus in Japan/US did not work because we did not do enough of it!
- Right. That’s because your education is based on theories which are largely empirical – economics is, I’m afraid, largely an observational science, not a pioneering one. The ideas of policy makers and their so-called Nobel Prize winning wiz kids are not based on hard fool-proof theory nor are they pragmatic within the political and historical context.
- If someone tells me they can design a solar powered helicopter which works in the dark and it turns out they cannot, then their concept is flawed because their theories did not take into account all the practical considerations and the context of the experiment (because, that was what it was, let’s face it). “But, but, wait…. in theory there’s enough moonlight, I just didn’t think of the weight of the…” aaah… forget it mate… just admit you were wrong… and I was a fool for believing you.
- If someone tells me they can revive the economy by either spending more or with more austerity and it turns out they cannot, then I’m a fool for believing them and their concept is flawed because their theories did not take into account all the practical considerations and the context of the experiment (because that was what it was, let’s face it). “But, but, wait…. in theory we can revive the economy, Congress is in gridlock! Young Greeks are on the streets! The banks won’t lend!” … aaah… forget it mate… just admit you were wrong and I was a fool for believing you.
The Drugs Don’t Work
- So here’s an experiment I have tried many times and come to only one conclusion. If you drink many pints of Belgian beer… you’re gonna have a hangover. There ain’t much you can do about it… yeah I’ve tried all the techniques. Like drinking a pint of water before you go to bed only to see it re-emerge with startling ferocity. Eating a kebab at 3 in the morning on your way home… … … only to see it re-emerge with startling ferocity. I’ve tried the old alka-seltzer too… same result – fizzy and ferocious. The drugs don’t work… they just make you worse. How about hair-of-the-dog? Yeah right – its barf will be louder than its bite. So look, if you’ve done such a monumental job of screwing your guts up by downing copious amounts of booze in a single night, there ain’t much you can do about it the morning after the night before … you just have to get through it… somehow.
- Here’s a novel thought. Policy makers of a by-gone era prostituted economic HIV and now economically, we’re at a place for which there is no practical cure. There is no magic remedy for the disease we have spent the last 20 years getting ourselves into. As ZeroHedge put it today: By Incentivizing Debt, We’ve Guaranteed Debt Serfdom and Stagnation. We just have to deal with it – austerity won’t work it just makes it worse. Stimulus won’t work – it just makes it worse. We were all present at the orgy and had our noses in the punch-bowl, scoffing like swine at a trough for so long we didn’t realize how much we were screwing up our intestinal organs… now we have a hangover, a big hangover… and we just have to get through it.
- We’ve strayed beyond the limitations of our theoretical responses from our limited theoreticians. The drugs don’t work, they just make you worse.
Quote of the Day:
Each thing is of like form from everlasting and comes round again in its cycle.
Marcus Aurelius – 161 to 180 AD
The Inevitability Of Cyclicality
- So, as I commented yesterday, last weekend my herb garden was the source of my ponderings. We are cyclical animals, born into a cyclical world. The circular movements of the planets create cycles which we see so often that we are not even aware that we move effortlessly in synchrony with them. What is interesting is that most of these movements which define our very lives, our existence, our entire experience of this thing we call “life” is this… they are all circular in nature. The Earth itself is a 3 dimensional circle – a sphere. It “spins” on an axis, so every one of us is experiencing a circular spin towards and away from the sun (the sun rising and setting). In turn, the Moon circles the Earth and the Earth circles the sun. We call this observation of a circular motion from a singularity a cycle.
- Here is an interesting thought, life has existed on Earth for about 4 billion years – give or take a hundred million or so years. So think about it, every aspect of every living thing that has ever existed on Earth has had to adapt to these cycles (in fact, everything that has ever lived in this universe, actually). The day and night, the rotation to the sun and sidereal days, the axial tilt and seasonal cycles, the moon and tides and its lunar cycles.
- As a consequence we have adopted our own cycles: emotional cycles, energy cycles, menstrual cycles, economic cycles and perhaps the biggest cycle of all – the cycle of life. For, just like parsley seeds I planted today, life is born into a cyclical world and before it perishes it reproduces offspring and another life enters the clock we live on… it is the cycle of life and we, like every other form of life on this planet are by definition cyclical organisms. It is part of our blood, our DNA, through billions of years it has been etched into our skin, hard-coded into our brain, it’s in the substance of our bones and the very existence of our soul. Not only do we depend on cyclicality, we embrace it… for it is life, we love the pattern of cyclicality, we embrace the concept of consistent and repetitive change (which is all that a cycle is). We are cyclical beings, born into a cyclical world – not only do we expect cyclicality. We live for it, we thrive on it… it is the very substance of what makes us living beings.
Economists And Other Ignorant Academics
- Greenspan-worshippers praise “the Maestro” for trying to suppress the cyclicality of the economy, for trying to iron out the volatility in the markets. I say he’s a fool for doing so, not only is this (as we have seen) impossible, it is actually counter productive in the long run. And THAT ladies and gentlemen, is how planting marjoram in my herb garden, is related to capital markets and monetary economics – through the medium of astro-economics!
- Greenspan was the original sinner, let’s not forget what damage his monetary ambivalence has done. This is not an argument about Keynesianism and Austrian Economics, it is about common sense. If indebtedness is allowed to propagate through an economic system unchecked it does not dispel the rules of cyclicality. The “economic energy” in the system remains the same, it merely alters the frequency and the magnitude of the cycle – both on the upside AND the downside.
- It’s been a long enough reading session. But next time let’s talk about how ignorant we all are – especially the smart people like quantum physicists (no that’s not oxymoronic) and especially the so-called smart economists. I’m not clever, but I admit it. The best quantum physicists are, by their own admission, ignorant – indeed the only difference between an economist and a quantum physicist is that the economist is generally less humble – economists think they have the answers to everything, at least physicists accept that they don’t.
Quote of the Day:
What begins as a temporary program of providing liquidity becomes a permanent program of printing money needed in order for the system to merely function.
The First Thing I Noticed When I Got Back
- Apologies to readers for the “radio silence”, I’ve been away for 3 weeks inHong Kong. As usual, there are, of course, a few things to report from my observations in the East. Some of them may surprise you, but let’s leave that for another day.
- The thing I noticed as soon as I logged in to check my blog statistics was that the articles I had written a long time ago on Greece (in an attempt to simplify the explanation of how Greeks had gotten themselves into a debt trap) had generated a lot of renewed attention. It’s surprising because I wrote these two articles a year ago and yet readers clearly think it has relevance today… the sad truth is that it does. Here we are 3 years into Greece’s woes and the same old problem persists with the Eurozone now bracing itself for “GREXIT” – the exit of one of its members, Greece, from the Monetary Union.
- I turns out the word “solidarity” may have a different meaning when it’s vented from a European politicians mouth. If the Greeks exit they take not just themselves but also the credibility of all Eurozone politicians. Who’s gonna believe Van Rompuy or Merkel or Rajoy when they say that “Portugual/Ireland/Spain [insert your favorite peripheral nation here] will definitely not exit the Eurozone”?
- For those of you that care, here are the two articles, apologies for the gross simplifications, the articles are intended to be soft humor, not condescending in any way.
- The Greek Sovereign Debt Crisis, Part 1 – Thomas The Tank Engine Economies
- The Greek Sovereign Debt Crisis, Part 2 – The Greek Tragedy
- In the first article I quoted Chris Martenson’s piece Death by Debt. This is a great article, I suggest you read it – it too was written a year ago but still has relevance today.
Death By A Million Debts
- You see, I have old fashioned principles. I believe that if one is in debt to someone else, one only has two options: repayment or default. It’s really that simple.
- There are those who believe that government debts (in particular Treasuries) do not need to be repaid, the laws of logic are corrupted, bent and therefore rendered mute, in these special cases. They believe that debts can be magically printed out of existence. If this is the case then, by definition, they are not debts, they are something else … and the market will eventually treat them accordingly; assigning the relevant risk premium to both the debt instruments and/or the paper currency in which they are denominated.
- For now, though, let us go along with the charade and simply understand the risks the Feds around the globe are undertaking on our behalf… the markets are down, even inflation is a little softer, even oil has come off the highs… so what are the headlines du jour? More QE of course! QE in the UK, QE in the US, QE in Europe, QE in Japan… QE forever! If we all print those suckers fast enough nobody will owe anybody anything and everything will be better…
- But look around you; everything is not better is it? Although suffering may be drawn out over a longer time to reduce the visible impact, the tragic reality is that everything will not be better, most of us will suffer terribly under this monetary overkill. A small proportion of the victims will suffer and understand the root of this suffering … and a smaller proportion still will know root causes and have the fortitude to do something about it.
- I leave you once again with Chris Martenson’s quote:
What begins as a temporary program of providing liquidity becomes a permanent program of printing money needed in order for the system to merely function.
Quote of the Day:
They [Arsenal] have a replay against Chelsea and if they win it they would face a semi-final three days before playing us in the league. But then they did say they were going to win the Treble, didn’t they? It’s squeaky bum time and we’ve got the experience now to cope.
Sir Alex Ferguson – Manchester United Manager
Did Meagan Hit The Bulls-eye (of the storm)?
- You gotta give credit where it is due. Meagan Greene looked a little crazy when she wrote about the Eurozone crisis back in March (I had an excerpt in my Tonsillitis Economy piece) a time when all seemed to be rosy. Stocks were hitting new highs, credit spreads and borrowing costs of European nations were closing in on new lows. Was that really the right time to be saying: “hey don’t be fooled – this is just the eye of the storm”?
- Well, for a while Meagan looked like a rather lonely kill-joy but these days she’s looking pretty smart, huh? The reality is, as Meagan correctly alludes to, nothing has really been “solved” at all in Europe.
- As I wrote about way back in 2011, an all encompassing solution would involve three types of action:
- Short Term Relief – Extreme action at the ECB
- Medium Term Security – a direct and heavy participation of tax-payers at the core of Europe (EFSF and ESM)
- Long Term Structure – Treaty Change at the heart of Eurozone political structure.
- While, under Super Mario, the ECB is has literally exploded onto the scene with Euro-note-firing big monetary bazookas and Treaty Change happened as I anticipated about way back in September 2011, the medium term leg of the stool (a direct and heavy participation from the taxpayers at the core) has largely gone missing.
- Here is Meagan’s excerpt again:
The third way the troika has tried to buy time is with a so-called firewall consisting of EU bailout funds and bilateral loans to the IMF. This is designed to take Italy and Spain out of the markets for a few years should they face unsustainably high borrowing costs. The hope is that these countries would be able to implement structural reforms and see those reforms boost growth by the time a return to the markets is required.
But for the firewall to work both its EU and IMF elements must be large enough. This is far from guaranteed, and failure on this point could trigger a massive escalation of the crisis. On the EU side of the firewall, there are currently two funds in place, the European Financial Stability Facility (EFSF), which has around 250 billion euros in available funding, and the 500 billion euro European Stability Mechanism (ESM). The former is due to replace the ESM in June 2012, but the only way to amass enough funds to cover Italy and Spain’s financing needs for a few years is to run the EFSF and ESM concurrently. However, German Chancellor Angela Merkel remains — for now, at least — vehemently opposed to this idea. Similarly on the IMF side, many countries have indicated their reluctance to contribute to a firewall until the Eurozone devotes more of its own collective resources to solving its crisis.
Figure 2: Composition of the Firewall vs. Financing Costs for the PIIGS (€, billions)
* Note; the trajectory of the bottom row (Total Cumulative PIIGS Financing Needs) on Meagan’s table.
The Third Leg Of The Eurozone Solution Stool Is Largely Missing
- The medium term leg of this three-legged stool is essential because it connects the superficial short term remedies (money-printing) to their long term objectives (full political unity). The absence of this essentially adhesive part leave the project with a soft underbelly, prone to attack. Until investors have a comfort level that this Eurozone experiment is succeeding, they will always err towards putting pressure on the peripheral Eurozone economies via the markets.
- Simplistically speaking, German taxpayers, and others at the core, need to put their hands in their pocket if they truly want the Euro-dream to succeed, but, so far, investors feel that this essential part of the plan is falling well short of what is needed.
- The Eurozone politicians (bless them) have tried every trick in the book to polish this turd including: creating new shells under the impression that they are well-capitalized funds, turning the bailout fund into a Giant CDO and begging the Chinese. But we kinda know… you can’t really polish a turd.
- In hoping that massive ECB stimulus (in my opinion, a short term solution) is continually repeated ad nauseum for a period long enough to bridge over the medium term to give time to the long term adjustments of real, integrated fiscal consolidation (Confederative Treaty Change) to gain traction is a real long shot, and, in my opinion a very risky strategy.
- Aside from the political nightmare of Eurozone fiscal and political collaboration (right now this is a goal post moving further away from Europe with time, not getting closer) there are real risks to inflation here and (more poignantly) to the credibility of the ECB as it reaches further and further beyond its rather purist, single mandate.
- Much has happened in the last few months. Let’s not underestimate the progress that has been made to-date. The Treaties have been worked out with alarming efficiency, the ECB is ready to inflate with Mario’s gleefully hovering over the “PRINT” button. Also, despite the fact that the ECB turned the entire Eurozone debt market into a retroactively risky, pseudo CDO-like minefield, Greece has finally defaulted and the process is in the latter stages of workout.
- But rest assured, the future of the Eurozone is still in the balance – this ain’t over yet. In fact, as Meagan Greene implies and as Manchester United manager, Sir Alex Ferguson would say: the “squeaky bum time” in Europe may be ahead of us, not behind us.
Quote of the Day:
… you threaten my people with slavery and death.
Oh I’ve chosen my words carefully, Persian, perhaps you should have done the same…
THIS IS SPARTA!
King Leonidas – in the Film 300
The New Old Currencies Of Choice
- When Sen Ron Paul quizzed Ben Bernanke about the monetary properties of Gold as a currency, Bernanke flatly refused to accept that Gold was a currency – see my comment last summer. In his mind, the only reason we talk about Gold as money today was tradition. Bernanke was wrong, Gold is a form of money, it always has been, in fact I’d go as far to say that almost everything is a form of money, but Gold has particularly good attributes.
- A few days ago, I wrote a piece called The Emerging Gold Standard which made references to how Iran was trying to circumnavigate trade sanctions by settling oil trades in Gold. The article also referenced my piece on The Marco Polo Connection, where I speculated that China’s interest in “bailing out” Italy was largely gold related (China has a huge desire for the yellow metal and Italy has the largest Gold-to-GDP ratio).
- Today we hear rumors of the EU having Greece by the Golden Balls in the latest bailout deal – see Zerohedge piece on this. As scavenging eyes examine and sniff at the carcass of another failing state they no longer salivate over paper promises. They want something tangible… “give me oil …or gold”. The World of Finance welcomes new old currencies.
Spartans Will Be Slaves
- Well 2.5 millenia is a long time in the scheme of politics I suppose. There was a time when Greek leaders refused to let their people be slaves. Today things are different; their Gold is seized, their Government is subordinate to higher authorities, their economic prosperity is deemed expendable by leaders in other countries. To add insult to injury, sticking with ZeroHedge – they run an article with the title: The Colonization Begins: Germany May Send 160 Tax Collectors To Greece.
- Welcome to the Currency Wars of the 21st century. When a nation feels aggrieved it no longer sends soldiers to burn rape and pillage the region, it sends tax collectors and demands Gold in return. So I suppose 2.5 millenia is a long time in the scheme of politics – things can change in that time.
- The ink has not even dried on this new agreement and already we see EU politicians acknowledging that Greece may need a third bailout.
- Finally, a really cool video on ZeroHedge explaining Greece’s debt enslavement to Europe with reference to the LTRO “cash for trash” scheme. Something which I wrote about in my comment: LTRO = Lying To Restore Order. You have to watch this vid…
- I’m not going to comment on the markets really today. I’m only going to show a Chart of the Day – GOLD (of course). In my view this is not so much a euphoric rise in popularity of the metal per se, it is a representation of the lack of faith in paper promises.
Chart of the Day
Quote of the Day:
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
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)?