Tag Archives: PIIGS

19th February 2012: Greece And The Godfather Are Gaming The “Prisoners Of Debt”

Quote of the Day:

I’m gonna make him an offer he can’t refuse.

Don Corleone – aka The Godfather


Macro Overview

The Fable Of Football

  • Readers will be familiar with the Vadar, a small island state with its own “independent” central bank. This is an interesting story which occurred a while back in the prison-system of the small, isolated nation. There was only one prison on Vadar, but it was getting over-crowded and more costly to police. That is until the Vodor prison guards, aptly nick-named, “Storm-Troopers” devised and interesting little plan.
  • The prison guards would regularly hold sporting fixtures against inmates. The most popular of which was (American) Football. It was popular because it allowed highly-charged, full-physical contact between inmates and guards, sometimes with gruesome consequences. It was a fantastic gladiatorial spectator sport and soon it was drawing huge crowds from the paying public. All proceeds would go towards upkeep of the prison and new prison facilities – everyone was a winner.
  • The rivalry got more intense and the games got fiercer. The prison guards realized that the inmates were taking things very seriously and began to restrict their training times to gain the upper hand. While the prisoners felt slightly cheated, they accepted. Consequently, the guards would win almost every game, but the rivalry remained strong and a huge drop in inmate crime was observed, as it was a welcome distraction and new focus for the convicts.
  • The games were officiated by a qualified referee with the dubious name of Ramio Repus. He also administrated all the funds and match-proceeds for games and ensured that they were fairly allocated to prison facilities for both guards and prisoners alike.
  • Of course, the prisoners were initially wary of him, but as more and more games were played their confidence grew that he was indeed a fair and sporting man who stuck strictly to “the rules of the game”. Indeed, he would become an essential part of the Vadarian judicial system, for he was the one and only man highly respected by both the prison guards and the prisoners: he was practically criminological priesthood.
  • There was chatter on the streets and alleyways of Vadar that Ramio Repus had unfathomable political clout and even of him becoming the next Mayor of Vadar…

The Game-Changer

  • But, as the final game of the winter approached, there were mutterings in the canteen and whispers in the courtyard… a few rumors were circling. Something was afoot. You see there was more than just pride as stake; both prisoners and guards had been placing bets on their respective teams to win – the prisoners by “gangster proxy”, of course – and the stakes were the highest they’d every been, some prison guards putting their future earnings for the remainder of the entire year down. Of course, there was only one major bookmaker who could be trusted: Ramio Repus. To ensure complete security and confidence, he held all bets in an escrow account.
  • What is important to understand is how much of this system was based on Trust. In fact, the beauty of the system was that it was a trust based-harmony.
  • However… against form and all the odds, the inmates won the game convincingly… that’s where things started to fall apart.
  • The gangsters and prisoners who had bet on the game were, by their right, due a huge windfall in winnings. But it emerged that some of the prison guards would go broke in the process – in fact, a lot of them would. The officiator, Raimo Repus adjudicated that: “for the survival of the system as a whole”, it would be impossible for a mass-bankruptcy of prison guards, there would have to be some form of settlement agreed.
  • The prisoners didn’t want to lend the guards any more money, they just wanted to settle for what cash they could. But there was a complication. It became apparent that the, supposedly neutral, officiator Raimo Repus had invested in the game too… he’d bet on the Prison Guards to win. In fact… he was by far and away the biggest gambler in the game.
  • The guards told prisoners and gangsters that they would only given them only a fraction of their winnings and, even then, they would have to sign a disclaimer protecting the prison guards from a class-action law-suit. The prisoners were repulsed by this… “aren’t we supposed to be the f***ing criminals, not you?” Hissed one of the furious inmates at national television camera. The following week, prison management informed the prisoners that they “set prison rules”, not the prisoners. This did not go down well – prisoners revolted, burning down the entire East Wing of the prison. Crime rates inside and outside of the prison spiked horrifically.
  • Ramio Repus’ star was falling too, but still had some credibility left and he used that to decree that the money he personally owed would be conveniently written off by the escrow account because his bets were all null and void. To add insult to injury, he vowed to help the indebted prison-guards honor as much of their obligations as they could, but he would do this by selling the assets for the prison bought with game-revenues…
  • The stand-off prisoners and guards has never been under more tension. Guards are frequently called in for aggressive zero tolerance action against prison gangs, who now appear to be united against the authority of the guards. The very fabric of trust in the entire judicial system is now under much more strain than it ever was.
  • Outside the prison, hit-squads and criminal cells of livid gangsters are running riot – prison is no longer a deterrent it is a call to join their suffering comrades-in-arms. Off-duty guards have received death threats against themselves and their families. One guard was executed in a nightclub while out with his colleagues, another guard, who did not even participate in any betting syndicates for religious reasons, was beaten to a pulp in broad daylight… the streets are a war-zone.
  • There is chatter on the streets and alleyways of Vadar that Ramio Repus had unfathomable clout in the criminal underworld and even of him actually being the biggest gangster in Vadar …

Exercising Trust

  • I won’t insult your intelligence any more, dear reader. This is not a true story, nor is it even accurate. It is just an exercise in the power and fragility of trust. Vadar does not really exist and the characters are made up.
  • But they do have representation in our world. The prisoners are the Greek bondholders, for example – “prisoners of debt”. The prison guards are the Greek Government… As for Ramio Repus? Why, an anagram of  “Super Mario”, of course.

Friend or Foe?


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7th December 2011: Immaculate Conception Of A New Superpower. Forget China, Get Ready For: The “Germanic States of Europe”


Quote of the Day:

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.

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24th November 2011: The Eurozone Endgame is Nigh: “Treaty Change” – At Last A Substantive Debate


Light At The End of the "Euro-Tunnel" ?

Quote of the Day:

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 specific actions 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.

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.

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22st November 2011: Why The Germans Understandably Hate Inflation

Sweeping up Bank Notes – When Cash Becomes Trash

Quote of the Day:

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:
  1. 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.
  2. 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.

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14th November 2011: Brokeback EU Introduces “Hair of the Dog Political Policy”

Globalization of The Brokeback Economy

Quote of the Day:

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.

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8th September 2011 – European Confederation – TIPSTER’s “European Consolidation Treaty”

Rethinking the Stability and Growth Pact

Quote of the Day:

Fragmentation of the Euro would incur political costs. Europe’s “soft power” influence internationally would cease (as the concept of “Europe” as an integrated polity becomes meaningless). It is also worth observing that almost no modern fiat currency monetary unions have broken up without some form of authoritarian or military government, or civil war.

Stephane Deo, Paul Donovan, Larry Hatheway – UBS Economist Team.

Macro Overview

  • War? YIKES!! I’ve always been a fan of Paul Donovan, back in 2008/2009 he and David Rosenberg were pretty much the only mainstream Street economists playing down the inflation threat to treasuries. Discouraging investors from dumping US Treasuries – he felt there was always going to be support for prices. A highly contentious and contrarian call at the time, but it doesn’t look so bad now does it?
  • Here’s UBS’s latest report – of which I’m sure Paul is a large part: Euro-break up – the consequences. It is creating such a stir around the World I’ve had to include a link to it (courtesy of Paul Kedrosky’s blog site). As a hard-wired skeptic I’m not 100% sure about the credibility of the message, though: “don’t break up the Euro or we’ll all descend into financial chaos and civil war”. Indeed, ZeroHedge take a more satirical line to it in their comment, Bring out your Dead, quoting extensively from UBS’s piece:

“Were a stronger country such as Germany to leave the Euro, the consequences would include corporate default, recapitalisation of the banking system and collapse of international trade. If Germany were to leave, we believe the cost to be around EUR6,000 to EUR8,000 for every German adult and child in the first year, and a range of EUR3,500 to EUR4,500 per person per year thereafter. That is the equivalent of 20% to 25% of GDP in the first year. ” It also would mean the end of UBS, but we digress. Where it gets even more scary is when UBS, like many other banks to come, succumbs to the Mutual Assured Destruction trope made so popular by ole’ Hank Paulson : “The economic cost is, in many ways, the least of the concerns investors should have about a break-up. Fragmentation of the Euro would incur political costs. Europe’s “soft power” influence internationally would cease (as the concept of “Europe” as an integrated polity becomes meaningless). It is also worth observing that almost no modern fiat currency monetary unions have broken up without some form of authoritarian or military government, or civil war.” So you see: save the euro for the children, so we can avoid all out war (and UBS can continue to exist). The scariest thing, however, by far, is that for this report to have been issued, it means that Germany is now actively considering dumping the euro.

  • I think the UBS report sensationalizes the scenario a little as it implies that a Euro would be allowed to “freely collapse” in an uncontrolled manner – I simply cannot see this happening under any scenario unless we see parabolic escalation of geopolitical tensions withinEurope. So yeah, if we have a war, then the probability of war is high! In fact, one thing I agree with ZeroHedge on is the most concerning thing about the report is the fact UBS felt it necessary to issue it at all. What does this say about the fragility of the Eurozone – or indeed the fragility of UBS?
  • That said the detail of the report highlights the probabilistic outcome for the Eurozone, in my opinion. Most people talk either of the Eurozone muddling through under its current form with the Germans reluctantly agreeing to provide huge contributions (either by Eurobonds or through EFSF) where as others think that the Euro will simply disintegrate.
  • 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”.
  • Remember as I mentioned in another comment the old Treaty and SGP had the two main criteria for convergence:

…Member States were required to do stick to the following two fundamental economic criteria:

  1. Deficits of less than 3% to GDP
  2. Debt to GDP of less than 60%
  • The Eurozone Consolidation Treaty would be an evolution of this where:
    • The absolute targets (level 2 criteria) are revised to more realistic levels in this crisis:
      • Deficits less than 5%
      • Debt to GDP less than 100%
    • Additional confederative oversight – structured into the Treaty. Where, if deficits approach the level 1 criteria of: 4% or Debt 80% of GDP then the following occur:
      • Government must seek approval from other 17 member states before executing the fiscal budget. Voting is weighted pro-rata among members according to size of economy (a measure of GDP)* or risk collectively enforced austerity (loss of independent political power).
      • The member state immediately loses its confederative voting rights in the event of level 1 criteria being triggered.
    • These initial targets are then ratcheted back to closer to their original levels over 5 years after 2013.
      • LEVEL 1: 2.5% GDP Deficits, 55% Debt to GDP
      • LEVEL 2: 3% GDP Deficits, 60% Debt to GDP


  • These measures would act as a severe deterrent for member states to stray beyond their fiscal responsibilities toward convergence.
  • The political structure would literally force member states to take an active and political interest in each others fiscal agenda. Much more coherence and collectivism within the Eurozone.
  • There would be collective responsibility among member governments for failing Euro members.
  • Greater cultural and social cohesion between populations.
  • Greater credibility to the Euro and fiscal union of the Eurozone.
  • Greater independence of the ECB as this would purely be inter-state legislation.

* I put GDP weightings although this could be contentious. But it’s my view that, if, during a Sovereign debt crisis, member states are expected to contribute towards bailouts (EFSF) with pro-rata weightings in accordance with their GDP, then they should be awarded confederative voting rights in this respect too. This could be made into a more sophisticated weighting (e.g. I personally favour (GDP – Debt) measure which would place significant additional encouragement towards the convergence of fiscal prudence. If you get your sovereign balance sheet in order, you’ll get more regional confederative powers.

  • Listen, lots of flaws with what I’ve just suggested, perhaps it’s too complicated or too rigid or just too politically unrealistic… but it’s just a suggestion. A new European Consolidation Treaty along these lines may just work. Let’s face it, there are many positive things about a currency union in Europe– in fact Stephane Collignon of The Guardian came up with an interesting alternative solution yesterday which has many similarities with mine.

I therefore propose to abolish the SGP and to replace it by a new framework with the following features:

1. A European macroeconomic framework law is voted every year under theLisbontreaty art. 294 on the ordinary legislative procedure, which determines what the appropriate aggregate fiscal deficit is for the euro area as a whole. This law takes into account the economic environment, growth and employment, the accumulated debt levels, and the world business cycle. The macroeconomic framework law replaces the rigid deficit limits of the SGP, which were never kept, and establishes a framework with greater (vertical) flexibility that an efficient macroeconomic policy in a single currency area requires.

2. The European commission then issues deficit permits against the authorised amount of the aggregate deficit.

3. These deficit permits are allocated to member states according to their GDP shares. Modifications according to the relative debt ratios (above or below 60%) are possible.

4. Deficit permits are transferable. If one member state needs to borrow more, it can obtain additional permits from other member states that do not use them. The transfer could be subject to deals between governments in the European council, or one could set up a market where deficits are traded like pollution permits. The transfer mechanism allows for the necessary horizontal flexibility that responds to asymmetric shock in member states.

5. A banking regulation that prohibits financial institutions from lending or helping raise euros for public authorities unless the borrower can present the equivalent amount of deficit permits. In other words, member states’ capacity to issue debt is controlled at source; no need for complicated bureaucratic surveillance and punishment mechanisms.

  • The point I’m trying to make is that Europefaces a political problem – there are political solutions.

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24th June 2011 – The Art of Political Deception, Part 2 (a) – The Rational Objectivism of the Fed’s Debasement of Cash (and rebutting the Uncertainty vs Volatility conventionality)

The Art of Political Deception, Part 2 (a) – The Rational Objectivism of the Fed’s Debasement of Cash (and rebutting the Uncertainty vs Volatility conventionality)

The New Determinant of Market Volatility

It’s always worth starting with a bit of humor – I just love that cartoon. I used to have it pinned to my desk in Hong Kong to serve as a reminder of just how debased equity market volatility was from fundamentals and how sensitive price movement had become to top-down macro events, regulation and centralized (fiscal or monetary) policies.

Right, let’s start by defining the major challenges with a series of poignant questions which are concerning the market today (in no particular order).

More Questions than Answers

  1. Why is the Fed hesitant to even mention QE3?
  2. How could a handful of small economies, like Portugal, Greece and Ireland create such huge global systemic risk, not only to the break up of Europe but even to the demise of the US Economy?
  3. Why has the Dollar fallen so far and why might that trend be reversing at this point?
  4. Why have commodities risen so much and why might that trend be reversing at this point?
  5. Why is China experiencing the double-whammy headwind of rising inflation and slowing growth and why are they getting increasingly irritated with American Monetary policy?
  6. With all the uncertainty in the World, why has realized volatility been so low and still at a discount to implied volatilities (as measured by VIX, for example) which, incidentally, are also bizarrely low? Why might that trend, too, reverse in the near future?
The VIX - relatively suppressed levels of implied volatility.

Source: Bloomberg. The VIX implied volatility index.

The answers to all of these questions are not as challenging as they first seem. In fact, we can distill all these riddles into a conundrum:

        • The key question: what is Money?

Identifying Some Important Observations

Let’s start with some simple bullet points.


A. Capital – I define very broadly as anything which has value to more than one person. If I have a watermelon, that is a form of capital. If I have knowledge on how to do a great foot massage, that is a form of capital. Of course knowledge on foot massage is not a great form of money because it has pretty poor “exchange qualities”.

B. Money – I define money the way most people do. It is a form of “capital” which can be used as a medium of exchange and a good store of value. So a watermelon is not a bad form of money but it’s not as good as, say, a piece of gold or silver or even coal.

C. Sterilization – This is the manipulation of a money or currency relative to other forms of money or currency. For example, to weaken its “exchange rate” in order to decrease the costs of export (often exporting deflation) or increase the costs of imports (often importing inflation).


D. “Inflation is always and everywhere a monetary phenomenon.” — Milton Friedman

E. One more point to make, which is opinion, based on observation. The effectiveness of Monetary Policy is not merely affected by the politics associated with Fiscal Policy – it is dependent on it.

Monetary Policy and Fiscal Politics go hand-in-hand

Political Punchbag

Let’s start with Observation E. The markets are concerned about the cohesion of the Eurozone for one primary reason: it is exceptionally difficult to manage monetary policy over an economy with incoherent fiscal (political) policies and objectives. Monetary policy is inherently linked to politics and fiscal policy – current fractures within the European system are clear evidence of this.

This circumstance is not limited to the Eurozone. In fact, on a more granular level, QE and Obamanomics (and even the timing of policy announcements) are unequivocally inter-twined. I have written extensively about the linkages and the politicization of the Fed. Indeed, the institution itself is openly partial to its own set of political objectives. While admittedly sounding a little stroppy, Peter Diamond’s rant in the NY Times, after not getting nominated as a Fed Governor, offered a fascinating expose of just how politically convoluted the Fed is – as was the analysis of Morgan Stanley Asia CEO and Chief Economist, Stephen Roach, when interviewed with Bloomberg’s Tom Keene:

ROACH: …I’m very disturbed to have read Peter
Diamond’s withdrawal from the –

KEENE: Well, I wanted to bring that up, yes.

ROACH: I mean here’s a guy who knows as much about the labor market as any living economist in the United States today and yet is a victim to a sort of political sabotage of his nomination to serve on the Board of Governors at the Fed.

KEENE: Have you seen this before? Is it – where the Republicans are pushing back because the Democrats pushed back before? Have you ever observed something like the challenges to the Noble Laureate Diamond?

ROACH: Look, I’ve been going around this track for a long time and the polarization, the disfunctionality of our political process in Washington right now is in a league of
its own right now. And I think it’s a real tragedy for the need to get talent into running the government at all levels. I don’t know anybody who wants to subject themselves to this

There is no sensational conspiracy theory here. It is obvious that, no matter how far you go to secure the independence of a Central Bank, monetary policy will always be effectively joined at the hip to the pantomime of partisan politics.

So that’s it!

Contradicting Chairmen

OK perhaps that’s a bit cryptic, so let’s identify some dots for us to connect. As I said in my last comment, I was pleasantly surprised by Charlie Rose’s interview with Greenspan – I actually agreed with more than 50% of what Greenspan said!

On inflation, Greenspan said he did not know of a

…single economist or member of government who isn’t worried about this issue…

So what is inflation? Is it the rise of food and energy etc, asks Charlie Rose?

…no, it comes from basically the issue of a very large amount of liquidity in the system…

Greenspan then quoted his good friend, the late Milton Friedman (Observation D) in his interview. This is not insightful to you, dear reader, I’ve written most extensively about the perils of inflation in many comments and how we can perceive it from a simplistic monetary standpoint.

Hmmm… but wait a minute. The dots are not connecting here at all, are they? Almost all commodities are denominated in the World’s Reserve Currency, the US Dollar, and Bernanke is the guy who controls the supply of US Dollars. But, wait, didn’t Bernanke say, only a few days ago in Atlanta, his policies were not really attributable to the rise in commodity prices? The Milton Friedman/Greenspan thesis of inflation appears to be in direct contradiction to Bernanke’s defense.

But let’s move on…

Revisiting the key question: what is money?

This is the question which holds the answer to everything. To keep it simple (and save me re-writing it!) let me highlight a reply-comment I made to a blog article on the issue of inflation and the definition of money (Definition B and Observation D):

I tend not to look at the shorter term moves but briefly, Gold is up almost 300% over 10 years and the dollar fiat-to-fiat index is unchanged. That puts a line through Bernanke’s story.

By far the most economically important trading commodities to the World, though, are oil, Nat Gas (and, increasingly the most common food products) partly because of their political relevance and partly because the trading supply are very good proxies for the actual supply available (just my opinion).

Why the Dollar collapse directly affects commodity prices is firstly because it is the denomination, the World’s reserve currency. The second reason harks back to how we define capital (my definition is simply anything which is of more utility to more than one person) and how we define money. In my opinion a form of capital which:
a) acts as a good exchange medium, and
b) a good store of capital value.

Which means almost everything is a form of money. The Dollar has been a very efficient money compared to say a lump of coal because it is unmatched in (a). However, by exploding its Monetary Base it is losing value relative to the lump of coal (b) due to uncertainty over the sheer supply supply.

I find it useful to ask not how many dollars I can use to buy a lump of coal but rather how many lumps of coal I can use to buy a dollar. If I know that the dollar supply is exploding, it is quite logical to deduce that the dollar (and indeed other inflated fiats) is trash so I’d like many more of them for my lump of coal – hence the dollar drops in value compared to commodities. I believe it is that fundamentally simple. to Bernanke;s quip last week:

“…implying that the dollar’s decline can explain, at most, only a small part of the rise in oil and other commodity”,

I say: “The dollar’s decline does not explain the risk in commodities – the dollar’s decline IS the rise in commodities.”

This is why we see strategic decisions by China, Russia, India and many other large growing economies to diversify out of pseudo fiat trash and into Gold and Silver, why they are using massive surpluses to aggressively massive pursue resource related projects and pander diplomatically to resource-based governments in Australia, South East Asia, Brazil… even as politically risky as Africa, Mongolia, Iraq, Iran and Russia. This is why the timing of China’s latest introverted infrastructure-specific boom is poignant. This is why capital continues to flow into this sector despite the state of the global economy. It also helps to understand the meteoric rise in “collaborative consumption”.

There is a move towards resource investment directly related to the uncertainty and sheer size of ensuing dollar supply dynamic. Fiat cash is still an asset, but who would want any asset class whose supply is being overtly exploded beyond any comprehension? I wouldn’t, I’d look to get out in any way I could and if that meant exchanging it for a farm or a coal field, I’d do it.

A Lesson from Japan

During Japan’s “Lost Generation”, they tried everything to fight deflation, but they could not find the monetary escape velocity from, the gravitational pull of what economist Richard Koo coined, a Balance Sheet Recession.

You see, simplistically, there are three types of debtors in an economy: corporations (including banks), individuals/consumers and governments. In Japan, the banks, government and even large corporations piled on huge amounts of debt which foundered the subsequent debt-deflation death spiral. Only Mrs Watanabe, the Japanese consumer, kept herself well capitalized, she saved a heap of cash and so could weather the deflation storm for decades (remember cash alone appreciates in a deflationary environment). No matter how low interest rates got, because, in part, monetary uncertainty was so high, dear old Mrs Watanabe could not be shaken out of her consumption coma. She was a risk-hater. As all debtor types are linked in an economy, it mattered not how well capitalized the banks and companies were to become, their consumers (and therefore customers) were simply not driving the top line, so the inflation transmission system stalled. Japanese corporations reverted to simply using liquidity to repair their balance sheets – in some cases, ultimately to near impeccable credit standards.

This weak link in the transmission mechanism of inflation, however, meant that monetary base was not manifesting into broad-based money supply and velocity – money was just being stored “somewhere in the system” – to paraphrase Greenspan.

History never repeats itself, they say, but it often rhymes. America faces an uncannily similar predicament today although a couple of the the cast of debtors have swapped roles. Once again the banks are in trouble and government “stimuli” are racking up huge deficits, but here, in the US, the large corporations are in great health and it is the consumers who are riddled with debt. Never-the-less, the broad effect is remarkably similar to the situation in Japan. The boardrooms of American corporations face the same level of apprehension about leveraging their balance sheets as Mrs Watanabe did 20 years ago. El-Erian and the PIMCO boys refer to this, symptom of Balance Sheet Recessions, eloquently as: having “the wallet but not the will”.

The Paradoxical Effect of Uncertainty on Underlying Volatility

In this interview, Greenspan concurrently implied that corporations were hoarding cash and cash-equivalents because they were disinclined to invest in longer term projects due to the uncertain unintended consequences of centralized policy and interventions into the market place (otherwise known, sometimes incorrectly, as economic “stimulus”).

In normal times, debt can be good. In normal times hoarding cash can be dangerous, as it limits an organisation’s ability to innovate and grow ahead of its competitors. But these are not normal times. Generally speaking, corporate executives are interested in two things: exploiting highly specific growth areas of the business (e.g. emerging market demand) and, more importantly, survival. Companies with more cash on the balance sheets are in a better position to weather downturns, they have better credit ratings and so can borrow cheaply even during times of great uncertainty. As a direct consequence of this focus of the business and lower leverage, their profitability is more predictable and their earnings (and therefore stock prices) become less volatile.

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.

The inherent flaws of applying rational objectivism to the markets

Greenspan also said something in his interview which struck a chord with me. He made a concession which I think most people missed. That was that large groups of people (including the markets) did not always make rational decisions, but rather they made “systematic” ones. After all rationality is in the perception of the beholder. Remember this admission came from an ardent disciple of the philosophy of Rational Objectivism.

Thus, in a time-constrained environment, it is at times more important to understand the pattern of human behavior than to attempt to justify it. We can neither rationalize nor claim to understand everything the market does at any point in time. There is a healthy helping of humility in this acceptance. I can’t believe I’m saying this, but: well put, Alan, the market is wiser than us both and today you and I must eat our humble pie.

Next comment we’ll summarize and, in one fell swoop, put a nail through each one of those questions which are troubling the market today.


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