Sun 20 May, 2012
How does one get a Harvard Business School case study made after them? Why by being constantly ahead of the curve, with the right trade, and being mocked by the same "access journalism and excel free" mainstream media which pushed subprime toxic grenades to anyone who listened, only to be proven correct time after time. In other words, by being Kyle Bass: the same Kyle Bass who lost money month after month on his Subprime short (full slide deck here), only to see it all made back, and then some... quite a bit of some. Because it is not by following the herd that one makes the killer trades: it is by standing against it and by waiting for conventional wisdom (in this case that Japan's debt load is somehow sustainable - it isn't, but the kneejerk response still is one to treat JGB's as a flight to safety - this only works until it no longer does and the same math that had doomed the euro over a decade ago is finally grasped by all). Yes: he has lost 60% on his Japanese short fund since inception: so what? All it takes is one millisecond of Malcom Gladwellian insight and the formerly offerless market goes bidless. And that -60% is transformed to +XXXX.YY. Perhaps once the market takes long, hard look at the underlying reality of what the chart below implies, and that unlike in the US, where two-thirds of all financial liabilities are mopped up by the shadow banking system which provides an unregulated inflation buffer (there is a reason why the European bank system is 3x bigger than the US - the balance is made up of the 100% unregulated shadow banking liabilities most of which are held off the books!), Japan just does not have one.
(As a total tangent, we are always fascinated when "pundits" come up with "economic" theories explaining what they have absolutely no understanding of: namely the subversive role of shadow banking with its $20 trillion in assets which allows infinite asset rehypothecation, which more than any other three letter economic theory that has no bearing in practical reality, is the sole reason why Treasurys are a Giffen good... for now.)
Either way, below is the complete Harvard Business School presentation on Kyle Bass, on Heyman Capital and on the Japan Short ber, which we hope will put to rest some of the prevalent disinformation floating around.
Earlier we wrote about why the Kyle Bass Japan trade was misguided, and we cited some unconfirmed numbers from ValueWalk, indicating that his Japan Macro Opportunities Master Fund had lost a staggering 29% in April.
A reader has sent us a copy of his performance update May 3.
From the report...
JMOMF Tranche H
January 2012 -7.89%
February 2012 +6.84%
March 2012 +2.13%
April 2012 -29.32%
Year to date 2012 -28.96%
Inception to date -60.77%
Click here for more on Kyle Bass's bad trade >
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Facebook's lead banker, Morgan Stanley, appears to have bought a huge amount of Facebook stock on Friday to try to stop the price from falling below the IPO price.
If Morgan bought all the shares sold near $38 in the final 20 minutes of trading, Reuters calculates, the firm might now be the owner of 50 million shares--or $2 billion--of Facebook stock.
And if Facebook stock threatens to break through the IPO price of $38 again on Monday, Morgan Stanley will probably buy a whole lot more.
Importantly, no one really has any idea how much Facebook stock Morgan has on its books, if any. The firm could have shorted a huge amount of stock earlier in the day--selling shares it didn't own--only to pile up "dry powder" buy shares if and when the stock threatened to break the IPO price. So, Morgan may not actually own any Facebook stock. It even conceivably could be net SHORT Facebook stock. But given the intensity of the selling pressure at the end of Friday, it seems likely that the firm owns some.
Meanwhile, Reuters says Morgan Stanley earned 38% of the overall IPO fees for placing the deal, a share that amounted to $67 million.
So, if Morgan Stanley ends up owning a bit more of Facebook, the stock would only need to drop by a dollar or two to wipe out Morgan's share of the IPO fees.
So, everyone who hates Wall Street now has something to cheer for!
The lower Facebook goes, the more money Morgan Stanley will lose.
And if the firm really does have 50+ million shares, the losses could get big quickly.
(Okay, not "big," at least not in Wall Street terms. Stocks are so safe relative to derivatives that Facebook would have to go to zero for the loss to be BIG. But Morgan could certainly lose several hundred million dollars.)
(This, by the way, is another reason the whining and umbrage about Facebook's small IPO "pop" is ridiculous--if Facebook's stock keeps dropping, it's the company's banker that's going to really take it on the chin.)
SEE ALSO: Facebook's Banker Bought A Huge Amount Of Stock To Keep Price Above IPO Level
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I wish I could have been a fly on the wall at the G8 summit at Camp David this weekend. The final communiqué from the global big shots talks about keeping Greece in the Euro and a shift away from austerity and a move towards growth oriented policies. Forget the Happy Talk, I want to know what they were really saying.
Obama must be praying for a miracle with the other members of the G8. If we get a “Grexit”, there will be months of turmoil in the global capital markets before the dust settles. The last thing the Big O wants to have is a recession in Europe that infects the USA with lower growth and higher unemployment when Americans are going to the polls in six months. For the same reason, Obama needs Japan to keep QEing and spending money it does not have.
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Obama may be a slave to what happens outside of our borders during the period prior to the election, but those same foreign leaders are completely at the mercy of the USA and the next President after the election. It won’t matter what the UK, Germany, France or Japan does with stimulus in their countries; what’s on the table in the USA will overwhelm any of those efforts.
The USA is months (220 days) away from initiating fiscal policies that will trigger a recession in the US that will be at least as severe as that experienced in 2008. With the rest of the world already teetering on recession, America is set to push the global economy right into the tank. The non-US members of the G8 are well aware of these facts. They must be crapping in their pants at the prospects.
I think those concerns are completely justified. Any foreign leader who is banking on the hopes that America will end its political stalemate and put forward a credible economic plan that puts the US and global economies on a better footing is a fool. If you want proof of just how far away viable compromises are, consider some legislation put forward by Republican leaders this week.
House Representative “Buck” McKeon (R.Ca) runs the powerful Armed Services Committee. He has come up with a fiscal 2013 spending plan for the military. The CBO looked at H.R. 4310, so did the White House. It’s a joke.
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$637 billion! That’s a lot of loot for a country that’s tapped out. This is not a compromise. This is an insult. The following chart shows that the 2013-spending plan proposed by Republicans has no reduction from the historic highs of the past few years.
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What does the White House have to say about H.R. 4310?
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When it comes to military spending, the Republicans want to bust the law that led to the increase in the debt limit. They propose legislation that would renege on the deal that they fought for last summer. The fight over the debt limit brought the economy and the markets to its knees. It cost the USA its AAA. And now the Republicans propose to kiss it away.
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Obama had lunch with House Speaker Boehner last week to discuss the political impasse and the critical issues the country faces. To make it look like B&O are just a couple of regular guys they went for a bite to a local sandwich shop. I’m thinking there must have been 300 Secret Service types outside. There is nothing regular about these guys. Did the “deciders” at the hoagie shop agree on anything? Not a chance.
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There is a near zero chance for America to address the fiscal cliff that is coming on Jan 1 before the election. I think there is also a zero chance that it will get resolved in the six-weeks following the vote. Those G8 leaders have every reason to be worried. So should the markets.
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When JPMorgan first announced that its CIO office had blundered into a huge trading loss, the number was pegged at $2 billion, though the company said it could go higher.
Then the loss was reported to be $3 billion.
And now....
$5 billion or more?
The nation's largest bank has said publicly that its losses on the trades have surpassed $2 billion, and people familiar with the matter have said they could over time reach $5 billion.
But the losses could be even bigger if the company sells its positions into a market that has turned against its positions, some traders say. Improvements in the markets could slice the bank's losses.
So the basic issue seems to be: Unwind now and stomach large losses, or wait and hope that things improve.
Either way, it's clear that JPMorgan has a live and active problem on its hands.
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Just checking in on Jeff Gundlach's famous long natural gas/short Apple trade.
It's still been on a ridiculous run since he announced it, gaining nearly another 3% just on Friday.
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Christopher Wood of CLSA has a tidy sumup of the Greece situation in the latest version of his GREED & Fear note.
GREED & fear was asked this past week what were the possibilities that stock markets have seen their highs for the year? Four weeks ago GREED & fear had put the odds at “as high as 35%” (see GREED & fear – Fine lines, 19 April 2012). They are now at least 50% and probably higher, with the potential trigger of a rally from likely lower levels the policy response that will come sooner or later from Bernanke and Draghi if the deflationary action intensifies, as is likely.
It is likely because the Greek election is still one month away with the polls scheduled for 17 June. This is a long time in the markets. With the far-left Syriza party leader Alexis Tsipras seemingly intent on abandoning Greece’s latest debt restructuring deal, and also still seemingly leading in the opinion polls, the issue will be whether the electorate can be convinced by the two mainstream parties, New Democracy and Pasok, that voting against debt restructuring and staying in the euro is not an option.
That is also the message being sent by German spokesmen, including Financial Minister Wolfgang Schäuble. Still it is not quite as simple as that. Germans love order and Berlin will be as concerned as everyone else, if not more so, about the potential chaos triggered by a Greek exit. This is why a potential Syriza-led government would have more room to negotiate than is commonly supposed. Still a total refusal by Athens to compromise in any way would leave Berlin and Brussels with little option but to let Greece go. Meanwhile, the main threat ahead of the June poll is deposit outflows from the Greek banks as everyone starts to hoard physical euro.
Thus, The Guardian reported yesterday that Greek savers have withdrawn €3bn from banks in the 10 days since the 6 May election. Greek private sector deposits had fallen by 17%YoY or €34bn to €171bn as at the end of March.
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The next tranche of Greek aid remains up in the air, and tax collections (surprise!) running vastly below expectations, so Greece is urgently trying to come up with a solution to fund itself as it sees its cash pile rapidly dwindling.
Ekathimerini has a good report on the situation:
The public coffers are seen running dry at the end of June, but this will depend on two key factors. First, revenue collection: In the first 10 days of May, inflows were about 15 percent lower than projected but there are fears that the slide may reach 50 percent. The GAO will have a picture for the first 20 days on May 23, while the last three days of the month are considered crucial, when 1.5 billion euros of the month’s budgeted total of 3.6 billion are expected to flow in.
Second, whether the IMF and EFSF installments are disbursed: This is not certain, as the decision will be purely political for both providers and evidently partly linked to political developments. Earlier this month the eurozone approved a disbursement 1 billion short of the 5 billion euros that were expected.
Some of the options:
- Suspending various tax credits and rebates.
- Cuts in payments to the social security fund.
- Other trimming of grants to state agencies (a move which has been done before, and bought the country a few months actually).
- Not paying Greece's contribution to the EFSF.
- Raiding the fund designed for bank recapitalization.
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White House photographer David Souza has done it again.
From The White House flickr:
Prime Minister David Cameron of the United Kingdom, President Barack Obama, Chancellor Angela Merkel of Germany, José Manuel Barroso, President of the European Commission, and others watch the overtime shootout of the Chelsea vs. Bayern Munich Champions League final, in the Laurel Cabin conference room during the G8 Summit at Camp David, Md., May 19, 2012. (Official White House Photo by Pete Souza)
Seeing as Bayern Munich lost the shootout, we hope Angela Merkel isn't gong to push for double austerity out of some sense of revenge.
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Kyle Bass was one of the handful of hedge funders who made a fortune betting against housing during the subprime bust, and since then he's been stalking his next big "career trade."
For years now, his big target has been Japan, a country with a debt-to-GDP ratio of over 200% and a shrinking/aging population. He's convinced that it's only a matter of time before the country implodes in a massive sovereign debt crisis that sends bond yields soaring, while the yen becomes worth less than confetti.
Back in early 2010, there was a story about how he took out a mortgage in yen, because he was so sure that it was going to implode, thus meaning he'd get his house for free.
Well, it hasn't exactly worked out that way he planned (yet).
Since the beginning of 2010, the exchange has gone from about 92 yen against the dollar to just 80. Kyle Bass's mortgage has gotten way more expensive.
Of course, the mortgage was probably all for show, a clever marketing move that's augmented his regular media and conference appearances where he touts the big end-of-Japan trade.
Here's how he described Japan in a letter last December:
Madoff's scheme collapsed for one primary reason -- he had more investors exiting his scheme than entering. As soon as this happened it was over. According to this most recent census, the Japanese population peaked within the last few years at 127.9 million and has since lost 3 million. Japan has one of the most homogeneous -- and some might even call it xenophobic -- societies of any developed nation in the world. It is no secret that there is no love lost between the Japanese and their neighbors, and therefore, immigration is an unlikely answer to a dwindling populace.
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It is indisputable that Japan has the worst on balance sheet debt burden in the world (roughly 229% of GDP).
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The European debt crisis will simply act as an accelerant to the Japanese situation as it will most likely change the qualitative thoughts of JGB investors. We believe that the sequence of events is set to begin in the new few months.
So basically he thinks it's a giant Ponzi scheme, and that it's only a matter of time before the market "wakes up", smells the coffee, and the whole thing implodes.
But not only has his mortgage gotten more expensive, per the chart above, his fund seems to be doing very badly.
According to the website ValueWalk, citing sources, his fund lost 29% of its value in April, and has really been getting clobbered since inception. We haven't been able to confirm the losses, though a trader we talked to thinks the numbers pass the smell test, given how Bass has structured his trades, and given the performance of said instruments (a series of currency and bond derivatives designed to profit in a Japanese demise), over the past year.
But still, the general thinking on Bass is that he's not wrong, he's just early. After all: 229% debt to GDP!
Back in April, Harvard Business School actually did a case study on the trade and basically said just that: Japan may not blow up imminently, but it's only a matter of time before it will.
Of course, there are two problems with that.
1) Kyle Bass's fund may not have years and years worth of investor cash to burn through while waiting around.
2) The entire premise of the trade might be wrong, and it will never happen.
The second reason -- that the premise is totally screwed up and that Japan will never implode -- is what we're going to focus on here.
It's worth nothing that for years people have been making this bet. Kyle Bass is the latest to step in front of what's been dubbed "The widowmaker", so-called because of the number of investors who have gotten pummeled trying to short JGBs (Japanese Government Bonds).
But hey, just because something hasn't worked int he past, it doesn't mean that it won't work at some point in the future. Bass is hoping that he got the timing right, and what gives him hope in the timing is that we've seen the first sovereign blowups in Europe, and that that will cascade into sovereign blowups elsewhere, and when people see the country with the worst debt-to-GDP in the world, they will pounce.
The problem is that the analysis is totally simplistic and incorrect.
To start, debt-to-GDP (which is the number that in Bass' mind really damns Japan) is a lousy measure of anything. It's flawed right from the get-go, given that it's measuring a stock (total debt) to a flow (a country's national income for the year).
But beyond that, debt-to-GDP just doesn't tell you anything about interest rate risk or credit risk.
We pointed out in this chart that for major economies, there's actually a slight negative correlation between debt-to-GDP and yield on the national 10-year bond.
In the US, it's well known that rates have gotten lower and lower while the national debt has blown through the roof.
So right off the bat, trying to bet against a country based on its debt-to-GDP is a losing idea.
But still, people are convinced that for the US and Japan, it's just a matter of time.
In Japan, the story that bears like Bass tell themselves is that Japan has a huge well of domestic savings, and that those savings go into Japanese Government Bonds, but that now that Japan is running a trade deficit, those savings are getting depleted, and the country will need to look for outside borrowers, and those borrowers won't be eager to lend to Japan at the pathetic 0.83% rate on the Japanese 10-year, and that when those foreign borrowers demand market rates, Japan will blow up because there's just SO much debt that an increase in rates will wreck the country's public finances.
But this too is nonsense.
There's no connection between rate sustainability and domestic/foreign borrowing.
For example, in the US, the amount of debt held by foreigners has exploded over the last few decades, but it hasn't created any upward pressure on rates.
And it's well known that the majority of Italy's public debt is held domestically, but that hasn't prevented the country from teetering on the brink of crisis.
So the whole foreign/domestic borrowing thing is a canard, although it does warrant the question of why it doesn't matter. After all, it does seem logically like it should be problematic that Japan would have to borrow more and more from abroad.
Here's how to think about it...
Foreign ownership of debt is not a function of the country going cap in hand all around the world, looking for investors to buy their bonds. It's a function of trade. When a country runs a trade deficit, it basically means it's spending more on goods from the rest of the world, than the rest of the world is spending on goods from said country.
So it stands to reason that if Japan is buying a lot from the rest of the world, then there are a lot of yen floating around the world: More yen wind up in places like China, the Mideast, the US, Europe, etc.
What happens to those yen? Well, some will get spent on other things, but in the end, they'll all wind up in bank accounts somewhere, and somehow they'll find their way into a Japanese Government Bond, so that the holder of said yen might get some yield. Now theoretically if someone had a bunch of yen, they might prefer to buy German bonds or US bonds, and that's fine, but then there's another private holder of yen who has to make a decision about where they're going to place their currency. Eventually, that currency will find its way home, and the cycle is complete.
This is the key idea that Bass is missing, and why his trade is never going to pay off. For a country that borrows in its own currency, government spending finances borrowing! If Japan spends 100 billion yen on something, that's 100 billion yen out there in the world that will eventually wind up in a financial institution, where ultimately 100 billion yen worth of JGB will be purchased. It's the same with the US of course, and it's this idea that Bill Gross didn't get when he famously asked: Who will buy our debt after QE2 runs out? It caused him to get crushed on the Treasury boom of 2011.
But what about Europe?
The problem in Europe is that the cycle is broken. When the Spanish government spends money, that money doesn't necessarily end up in bank accounts where the money will be paired with Spanish debt. Instead, a lot of it leaks to bank accounts in Germany, where it goes to buying German debt. Or maybe it goes into French debt. Spanish government spending doesn't help finance Spanish government debts.
This is why Richard Koo's modest proposal to save the Eurozone is to ban countries from selling sovereign debt to anyone that's not domestic, so that the cycle of spending and borrowing would stay domestic.
Europe's problem really isn't about sovereign debt. It's about the fact that countries don't have their own currencies, and are thus totally flawed.
It's fun to look at a chart like this, showing that only Japan has more debt than Greece, and to conclude that it's going to implode, but extrapolating from Europe to anywhere else, where countries borrow in their own currencies, and have their own central banks, is a recaipe for disaster.
No doubt Kyle Bass will keep pumping his Japan trade for awhile, but the logic is badly flawed, and it is never going to pay off for him.
SEE ALSO: The costliest mistake in all of economics >
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Monthly data reported in the last week was mixed, due to revisions in the prior month's data. Retail sales were up, just barely. There was no consumer inflation. Housing permits fell sharply, but only because the prior month's numbers were revised even more sharply higher. This caused the Index of Leading indicators to record a slight decline. Housing sales are in a definite uptrend. Industrial production rose strongly, but less so taking into the negative revision to the prior month. Regional manufacturing reports were mixed with NYS up strongly, and Philly in contraction.
The high frequency weekly indicators this week, with one exception, were neutral to positive as the Oil choke collar disengages due to the now-annual ritual of late spring Europanic.
Let's start with the exception. Rail traffic was mixed again this week. The American Association of Railroadsreported a -1.3% decrease in total traffic YoY, or -8,100 cars. Non-intermodal traffic was down by -15,200 cars, or -5.2% YoY. Excluding coal, this traffic was up 5,800 cars. Ethanol-related grain shipments were also off, as were chemicals, metals, and scrap. Intermodal traffic was up 7,100 carloads, or +3.1%. Railfax's graph of YoY traffic continued to show that the YoY improvement in hauling of cyclically sensitive materials remains strong. Oddly, it remains baseline, non-cyclical shipments that are declining, and declining ever more sharply.
Housing was mixed but at slightly higher recent levels:
The Mortgage Bankers' Association reported that the seasonally adjusted Purchase Index fell -2.4% from the prior week, and was down slightly, -1.0% YoY. The Refinance Index jumped 13.0% with record low mortgage rates. This index continues to be near the upper end of its 2 year generally flat range.
The Federal Reserve Bank's weekly H8 report of real estate loans, which had been negative YoY for 4 years, turned positive over one month ago. This week, real estate loans held at commercial banks was flat w/w, and their YoY comparison declined -0.1% to +0.9%. On a seasonally adjusted basis, these bottomed in September and remain up +1.6%.
YoY weekly median asking house prices from 54 metropolitan areas at Housing Tracker were up +2.4% from a year ago. YoY asking prices have been positive now for almost 6 months. Median current list prices are now higher than at any point last year. Either this indicator will turn, or the Case-Shiller repeat sales index is likely to turn within the next several months. I do not see how the divergence between the two can continue much longer.
Employment related indicators were also neutral to positive:
The Department of Labor reported that Initial jobless claims rose 2,000 to 370,000 last week. The four week average fell 4000 to 375,000. It seems more likely that in April we saw a quirk of seasonality rather than a more ominous sign.
The Daily Treasury Statement for the first 13 days of May showed $87.7 vs. $95.6 B for April 2011. This has everything to do with the month starting on a Tuesday rather than a Monday. Compare Monday through Wednesday in the equivalent period and this year is $4.0 B ahead of last year. For the last 20 reporting days (4 x each day of the week), $132.7 B was collected vs. $129.6 B a year ago, an increase of $3.1 B, or +2.4%. This reverses last week's decline, but is still a weak advance.
The American Staffing Association Index remained at 93 for the third week. It remains two to three points below the all time records from 2006 and 2007 for this week of the year.
Same Store Sales continue to be solidly positive.
The ICSC reported that same store sales for the week ending May 12 fell -0.8% w/w, but were up +4.5% YoY.Johnson Redbook reported a 3.7% YoY gain. Shoppertrak reported a gain of 12.0% YoY after last week's YoY decline of -2.7%. The 14 day average of Gallup daily consumer spending turned positive again this week at $71 vs. $68 in the equivalent period last year.
Money supply was mixed:
M1 fell -1.5% last week, and also fell -0.6% month over month. Its YoY level increased to +16.5%, so Real M1is up 14.2%. YoY. M2 was flat for the week, and was up +0.4% month over month. Its YoY advance rose slightly to +9.6%, so Real M2 increased to +7.3%. Real money supply indicators continue to be strong positives on a YoY basis, although they have had a far more subdued advance since September of last year.
Bond prices rose and credit spreads were flat:
Weekly BAA commercial bond rates fell .07% to 5.08%. Yields on 10 year treasury bonds also fell .07% to 1.88%. The credit spread between the two remained even at 3.20%. Strongly falling bond yields mean that fear of deflation is strong. Spreads have been widening for the last month until this week.
Finally, the energy choke collar is disengaging:
Gasoline prices fell for the fourth straight week, down another .04 to $3.75. Oil fell almost $5 this week, $96.13 to $91.48. Oil prices are now below the point where they can be expected to exert a constricting influence on the economy. Since gasoline prices follow with a lag, we can expect gasoline to fall to that point in about a month as well. The 4 week average of Gasoline usage, at 8692 M gallons vs. 8864 M a year ago, was off -1.9%. For the week, 8971 M gallons were used vs. 9048 M a year ago, for a decline of -0.9%. Gasoline usage is moving to parity with the reduced levels that began to be established one year ago.
Turning now to high frequency indicators for the global economy:
The TED spread remained at 0.390, near the bottom of its recent 3 month range. This index remains slightly below its 2010 peak. The one month LIBOR rose slightly to 0.240. It is well below its 12 month peak set 3 months ago, remains below its 2010 peak, and has returned to its typical background reading of the last 3 years.
The Baltic Dry Index rose slightly from 1138 to 1141. It is about 1/3 of the way back from its February 52 week low of 670 to its October 52 week high of 2173. The Harpex Shipping Index rose another 5 points from 440 to 445 in the last week, and is up 70 from its February low of 375.
Finally, the JoC ECRI industrial commodities index fell sharply for the second week in a row, from 122.82 to 120.25. This indicator appears to have more value as a measure of the global economy as a whole than the US economy.
When the US is in a recession, that doesn't mean that every single state's economy is contracting. Texas or Washington state might be doing well, for example. The sharp declines in the JoC ECRI index and treasury bond yields seem to be all about Europanic. The global economy as a whole might be slipping into contraction thanks largely to austerian stupidity in Europe (but note that global shipping rates appear to have bottomed).
But when we look at the up to the moment indicators for the US, we see a slow improvement in housing, refinancing of mortgages at lower rates, consumer purchases remaining strong, payroll taxes modestly improving, the Oil choke collar loosening, and both industrial and retail consumers of energy focusing like lasers on efficiency. On the other hand, rail traffic is an actual drag, even if there are very good reasons for the decline that are longer-term economic positives. In short, the US economic expansion appears intact.
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Here's a radical new idea from former Deutsche Bank Chief Economist and current Senior Advisor Thomas Mayer, based on the facts that a) Greeks don't want to leave the euro and b) they also don't want to continue with the Troika bailout programs as they are currently constituted.
All of the talk to date has been of a binary option for the eurozone between a cooperative Greek government that gets to stay in the euro and a non-cooperative one (presumably led by the likes of Syriza boss Alexis Tsipras) having to exit the euro.
But maybe there's a third option, just because the stakes are so high here. The rest of the eurozone doesn't want to see a Greek exit because of the potential for other countries following suit (whether they contemplate leaving as well or experience similar runs on bank deposits), which would be disastrous.
What would that middle ground look like? According to Mayer, the Troika could decide on "a partial stop in financial assistance, with continuing support for debt service needs and the Greek banking sector but no further support for the financing of the government’s primary expenses."
Thus, the "Geuro" is born:
Assuming that the Greek government is unable to quickly balance its primary budget, a plausible response of the government to the shortage of euro cash as a result of the end of financial transfers would be to issue debtor notes (IoUs) to its creditors, promising payment as soon as fresh euro cash would become available. As creditors lacking euro cash would have to use the IoUs to settle their own bills, these instruments would assume the role of a parallel currency (let’s call it Geuro).
The Geuro would probably quickly be used in most domestic transactions. For the purchase of essential imports, Geuros would have to be exchanged against euros, most likely at a hefty discount of 50% or more. Since an increasing number of domestic goods, services and wages would be paid in devalued Geuros, the export sector could reduce its prices in euro and regain competitiveness against foreign suppliers. The exchange rate of the Geuro relative to the euro would be determined by the primary budget gap of the government that is being filled by Geuro issuance. Political pressure could build for more prudent policies as Greek residents saw their terms of trade decline.
This plan comes with strings attached: Europe would have to completely take over the Greek banks to avoid even greater capital shortfalls. However, Hooper points out that consensus is quickly building around this idea as necessary for any reasonable stability plan going forward anyways.
So, Greece gets what they need under the "Geuro" plan: a recapitalized banking system and internal devaluation to increase competitiveness and hopefully spur growth.
The icing on the cake is the exit strategy. Mayer:
Greece could formally remain in EMU, execute the exchange rate devaluation necessary to regain international competitiveness, and in the future decide for itself through issuance of Geuros, whether and over what time span it would want to return to a hard currency that is stable against the euro. It could eventually even return completely to the euro by repurchasing Geuros against euros.
Is the Geuro the elegant solution Europe has been waiting for? Troika, are you listening?
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Normally I don’t like to write about European prospects in the midst of a very rough patch in the market because in that case there isn’t much I can say that isn’t already being said. I find it more useful to wait for those recurring periods in which the markets recover and optimism rises. Still, given the conjunction of political uncertainty in Beijing, low Chinese growth numbers, and another round of deteriorating circumstances in Europe, I will spend most of this issue of the newsletter trying to outline the possible paths countries like Spain must face.
For several years I have been saying that Spain would leave the euro and restructure its external debt. I should say that I specify Spain because it is the country in which I was born and grew up, and so it is also the country I know best. When I say Spain, however, I really mean all the peripheral European countries that, like Spain, are uncompetitive, have high debt levels, and suffer from low savings rates that had been forced down in the past decade to dangerous levels.
Spain had a stronger fiscal position and healthier bank balance sheets than many of its peers when the crisis began, so any argument that applies to Spain is likely to apply more forcefully to its peers. As an aside I will add that France is for me the dividing line between countries that will be forced into devaluation and restructuring and those that won’t – in my opinion France could go either way and we will get a much better sense of this in the first year of Hollande’s presidency.
There are two reasons why I was and am fairly sure that Spain cannot stay in the euro (or, which amounts to the same thing, that Germany will leave the euro instead of Spain). The first has to do with the logic of Spain’s balance of payments position, and the second has to do with the internal dynamics that drive the process of financial crisis.
To address the first, I would start by noting that thanks to excessively loose monetary policies driven primarily by German needs over the past decade, Spain has made itself wholly uncompetitive in the global markets and in so doing has run large current account deficits for nearly the entire past decade. Its fundamental problem, in other words, has been the process by which its savings rate has collapsed, its cost structure forced up, its debt levels soared, and a great deal of investment directed into projects, mostly real estate, that were not economically viable. As I have discussed often enough in previous issues of this newsletter, I think all of these problems are related and are the automatic consequences of the same set of policy distortions implemented in Spain and in Germany.
Until Spain reverses its savings and consumption balance and drives down its current account deficit into surplus, which is what a reversal of these distortions would imply, it should be pretty clear that Spain will continue struggling with growth and will continue to see debt levels rise unsustainably. But the balance of payments mechanism imposes pretty clear constraints on the process of adjustment. In that sense there are really only three ways Spain can regain competitiveness sufficiently to raise savings and reverse the current account:
- Germany and the other core countries can take steps to reverse the policies that led to the European crisis. They can cut consumption and income taxes sharply in order to reduce domestic savings and increase domestic consumption. These would lead to a reversal of the German trade surpluses and higher inflation in Germany, the combination of which would allow Spain to reverse its trade deficit and regain competitiveness via lower inflation relative to that of Germany and a weaker euro.
- Spain can force austerity and tolerate high unemployment for many more years as wages are slowly pushed down and pricing excesses are ground away. It can also take measures to reduce costs by making it easier to start businesses, reducing business taxes, and by improving infrastructure, but these latter provide too little relief except over a very long period, especially given the difficulty Spain will face in financing infrastructure and reducing taxes.
- Spain can leave the euro and devalue. This would leave it with a problem of euro-denominated debt, whose value would soar relative to GDP denominated in a weakening currency. In that case Spain would almost certainly be forced to halt debt payments and restructure its debt.
I want to stress that these are, practically speaking, the only three ways for Spain to regain competitiveness. There are other ways that could in theory also work, but they are too unlikely to consider. One could assume for example that the rest of the non-European world – most importantly the US, China and Japan – take steps to stimulate their domestic economies sufficiently to force up consumption and run in the aggregate large and growing trade deficits. These deficits, whose counterpart would be a very large European trade surplus, would then bail out the whole eurozone by generating GDP growth rates that exceed the debt refinancing rates.
I think most of my readers will however agree that this is pretty unlikely. The rest of the world is also struggling with growth and in no hurry to run large trade deficits. Another possibility is that we suddenly see a rapid and dramatic move towards full fiscal union in Europe, in which sovereignty, for all practical purposes, is fully transferred to Brussels (or Berlin). But that probably won’t happen either – the rise of nationalism throughout Europe has made this always-unlikely prospect even less likely.
So we are left largely with these three ways of allowing Spain to regain a cost structure that makes it competitive and allows it to amortize its debt while growing. Anyone who rules out two of the three ways listed above must automatically imply that Spain will follow the third way. So which will it be?
Humpty Dumpty economics
The first way is for Germany to reverse its surplus and begin running large deficits. This is by far the best way, but I think it is very unlikely. Berlin has made no indication that it is prepared to do what would be necessary for it to run large deficits and, on the contrary, it is even talking about the need for more austerity.
In part this is because Germany has a potentially huge debt problem on its balance sheet. As a consequence of its consumption-repressing policies during the decade before the crisis, Germany’s domestic savings rate was forced up to much higher than it otherwise would have been and Germany has had to export the excess capital. Not surprisingly, given European monetary dynamics, this capital has been exported largely to the rest of Europe in order to fund the current account deficits of peripheral Europe that corresponded to the surpluses Germany so badly needed to grow.
It did this not by accumulating euro reserves, which it could not do anyway, but rather by accumulating loans to peripheral Europe through the banking system. As a result of all of these loans, Germany is rightly terrified that a wave of defaults in Europe will cause its own banking system to require a state bailout if it is not to collapse, and so it does not want to cut taxes and reduce savings because it believes (wrongly) that austerity will make it easier to protect its creditworthiness.
But German’s anti-consumption policies are leading it towards a debt problem in the same way that similar US policies in the late 1920s created an American debt crisis during the next decade. In that light I thought this very illuminating quote from then-presidential candidate Franklin Delano Roosevelt might be apposite:
A puzzled, somewhat skeptical Alice asked the Republican leadership some simple questions:
“Will not the printing and selling of more stocks and bonds the building of new plants and the increase of efficiency produce more goods than we can buy?”
“No,” shouted Humpty Dumpty, “the more we produce the more we can buy.”
“What if we produce a surplus?”
“Oh, we can sell it to foreign consumers.”
“How can the foreigners pay for it?”
“Why, we will lend them the money.”
“I see,” said little Alice, “they will buy our surplus with our money. Of course these foreigners will pay us back by selling us their goods.”
“Oh not at all, “said Humpty Dumpty. “We set up a high wall called the tariff.”
“And,” said Alice at last, “how will the foreigners pay off these loans?”
“That is easy, said Humpty Dumpty. “Did you ever hear of a moratorium?”
And so alas, my friends, we have reached the heart of the magic formula of 1928.
Humpty Dumpty’s grasp of the balance of payments, it turns out, is no more naïve than that of many European policymakers, and I suppose Germany will follow the historical precedent set by the US – and so many other countries that confuse trade surpluses with moral vigor. By refusing to take steps that seem on the surface to undermine its creditworthiness, Berlin will only ensure the debt moratorium that will probably demolish its creditworthiness anyway.
And of course without a major reversal of German’s current account position the balance of payments constraint absolutely prevents net repayments from peripheral Europe. This game will go on as long as the core countries continue financing the periphery, but once they finally stop, the peripheral countries will almost certainly default or restructure their debt.
To take a brief detour before returning to discussing the three paths Spain can take, I think Berlin is betting that if they can prolong the crisis long enough, while pretending that the problem is one of liquidity, not solvency, they can recapitalize the German (and other European) banks to the point where they eventually are able to recognize the obvious and take the losses. This was, after all, the strategy followed by the US during the LDC Crisis of the 1980s, when it waited until 1989, seven or eight years after the crisis began, to arrange the first formal debt forgiveness (the Mexican Brady Bond). During that time a steep yield curve engineered by the Fed allowed the US banks to earn sufficient profits to recapitalize themselves to the point where they could finally formally recognize what had long been obvious.
There are at least two reasons however why this strategy won’t work for the European banks. First, the hole in the European banks’ balance sheets dwarves the equivalent hole in the balance sheets of the American banks during the LDC crisis. It would take them much longer then seven or eight years to fix the problem.
Second, postponing resolution of the debt crisis is extremely painful for the debtor countries, who have to bear the full brunt of the adjustment that both debtor and creditor countries really need to make together. This reduces maneuvering space for Europe because the political system in Europe is less able than that of Latin America during the 1980s to accommodate this very painful process. Well-functioning democracies, after all, make it harder for bankers and elites to force the cost of the adjustment onto the middle and working classes.
Can Spain adjust by itself?
This is also the reason why Spain cannot follow the second of the three paths described above. The second path requires that Spain bear the full brunt of the economic adjustment, which in reality Spain and Germany should bear together. Spanish voters, however, will not permit (and rightly so) that Madrid force such economic pain on its citizens in the name of an ideal of “responsible behavior” (i.e. remaining within the euro) that is both mistaken and extremely painful.
The adjustment will require that Spanish wages and prices are forced down substantially until Spain can reverse the higher price differential relative to Germany from which it suffers. Figuring out how to do this is not very hard – we have plenty of historical precedents upon which to draw. To simplify substantially, there are basically two things that have to happen in order to force a relative decline in prices. First, unemployment must remain very high for many years so that wages either decline, or rise by less than inflation and relative productivity growth. This is pretty straightforward.
Second, there must be some way to deal with the real increase in the domestic debt burden. Why? Because there are two ways relative prices can be forced down, and both of these result in a real increase in the debt burden. First, high inflation in Germany can exceed lower Spanish inflation, and second, Spain can deflate. In both cases the real cost of debt must increase substantially – in the former case because high German inflation will force up euro interest rates so that Spain’s refinancing cost will exceed its domestic growth rate, and in the latter case because deflation automatically increases the real debt burden.
How will we deal with the rising debt burden? Typically we do so by confiscating the wealth of small and medium enterprises or by confiscating the savings of the middle classes, and usually we do both.
So for Spain to adjust we need both very high unemployment for many years and we need to undermine the middle classes. Any policy that requires an enormous and unfair burden on both the workers and the middle classes is unlikely to be rewarded at the polling booths.
The huge unpopularity of the newly elected Prime Minister Mariano Rajoy, in that context, should not be a surprise. I wrote last year just after the election that this would happen, although I thought it would take a year or two before the population really turned on him and made it impossible for him to govern. But Spaniards, from business leaders down to workers, are furious at the Rajoy government and this anger will continue until either the two major parties eject those of their leaders who continue to demand that Spain behave in a “responsible” way, or harder line extremist parties replace the two parties themselves.
I place the word “responsible” in quotation marks not because I am opposed to responsible behavior but rather because the attempt to tighten the budget and impose austerity in the name of remaining on the euro is being presented as the “responsible” thing to do. It is, however, no more responsible than the policies France used in the 1920s to revalue the franc to pre-War parity, which were also sold to the French public as the “responsible” thing to do.
In both cases (and in many other deluded attempts to protect hopelessly overvalued currencies underpinned by rising eternal debt), policymakers did not understand that their policies were guaranteed to fail and were based on a misunderstanding of the causes of the underlying crisis. The responsible thing to do is to acknowledge that the euro is indefensible and that Germany’s refusal to share the adjustment burden, after it absorbed most of the benefits of the mismanaged monetary position it imposed on the rest of Europe, means that Spain will be forced to take on far more than its share of the cost.
But whether or not everyone agrees with my analysis of what really is “responsible” behavior, I think it most people will agree that, rightly or wrongly, Spanish voters are unlikely to accept high unemployment and an assault of middle class savings for many years without rebelling at the polls. Spain simply cannot accept the full burden of adjustment.
This means that the first two of the three paths I listed above cannot be followed. If I am right, we are automatically left with the third. Spain (and by extension many other countries) must leave the euro. It will be very painful and chaotic for them to abandon the euro, but the sooner they do it the less painful it will be.
The death spiral
I said at the beginning of this newsletter that there were two reasons why I was certain Spain would leave the euro, the first of which has to do with the logic of Spain’s balance of payments position and the second with the internal dynamics that drive the process of financial crisis why I was certain that Spain would leave the euro. To address the second, I think Spain will leave the euro because it seems to me that the country has already started on the self-reinforcing downward spiral that leads to a crisis, and there is no one big enough to reverse the spiral.
How does this process work? It turns out that it is pretty straightforward, and occurs during every one of the sovereign financial crises we have seen in modern history. When a sufficient level of doubt arises about sovereign credibility, all the major economic stakeholders in that country begin to change their behavior in ways that exacerbate the problem of credibility.
Of course as credibility is eroded, this further exacerbates the behavior of these stakeholders. In that case bankruptcy comes, as Hemingway is reported to have said, at first slowly, and then all of a sudden, as the country moves slowly at first and then rapidly towards a breakdown in its debt capacity.
What is key to understanding the process is to see that stakeholders will behave for perfectly rational reasons in ways that politicians and moralists will decry as wholly irrational. Rather however than respond to appeals that they stop behaving irrationally, stakeholders will continue making conditions worse by their behavior as they respond the distorted incentives created by the erosion of sovereign credibility. To do otherwise would almost surely expose them to disaster.
To summarize what the self-destructive and automatic behavior of the stakeholders is likely to be, it is worth identifying some of the major stakeholders and to suggest how they typically react to a rise in the sovereign’s default risk:
- Private creditors. As Spain’s credibility deteriorates, private creditors will demand higher yields on their loans to Spain even as they change the form of their lending to reduce their own risk, for example by shortening maturities. This has a double impact on making conditions worse. First, higher interest rates mean that debt rises more quickly than it otherwise would. Second, shorter maturities and other changes in the loan structure mean greater balance sheet fragility and a rising probability of default.
- Official lenders. As they are forced into providing liquidity facilities, official creditors typically demand and receive seniority. This of course increases the riskiness for other lenders and creditors by pushing risk downwards, and so worsens balance sheet fragility and increases private sector reluctance to lend.
- Depositors. As the probability rises that Spain will leave the euro, and that bank deposits will be frozen and redenominated in the weaker currency before any abandonment of the euro is announced, depositors respond rationally by taking money out of the banking system. As they do, banks are forced to contract lending, to increase balance sheet liquidity, and to reduce risk, all of which act as a drag on economic growth.
- Workers. Rising unemployment and the prospects for an unequal sharing of the burden of adjustment cause unions to become increasingly militant and to engage more often in various forms of industrial action, which, by raising uncertainty and costs for businesses, force them to cut output and employment.
- Small and medium businesses. One of the sectors most likely to be penalized in a debt crisis is the small and medium enterprise sector. Owners of small and medium businesses know that they are vulnerable during a crisis to an expropriation of their wealth through taxes, price and wage controls, and other forms of indirect expropriation. They try to forestall this by disinvesting, cutting back on expenses, and taking money out of the country.
- Political leaders. As time horizons shorten and politics becomes increasingly radicalized, policymakers shift their behavior in ways that reduce credibility further, increase business uncertainty, and raise national antagonisms.
It is important to recognize the almost wholly mechanical nature of credit deterioration once a country is caught in this kind of spiral. Deteriorating creditworthiness forces stakeholders to adjust. Their adjustment causes debt to rise and/or growth to slow, thus eroding creditworthiness further.
The combination of these and other actions by stakeholders, in other words, can’t help but reduce GDP growth, increase debt, and increase the fragility of the balance sheet, all of which of course undermines credibility further, so reinforcing the suboptimal behavior of stakeholders. All of the exhortations by politicians, the church, public intellectuals, bankers, etc. – and there will be many – that stakeholders put personal self-interest aside and act in the best interests of the nation will be useless. Slowing this behavior is not enough. It must be reversed.
But how can it be reversed? No one is big enough credibly to guarantee the creditworthiness of all the afflicted countries, and without a credible guarantee the downward spiral will occur, more or less quickly, until it is clearly unstoppable.
Only connect…
It is pretty clear that all of this is already happening in Spain and it is also pretty clear that every few months when the government announces the latest batch of economic and debt data, these numbers always turn out to be worse than expected and much worse than originally projected, which is, ironically, exactly what we should expect under the circumstances. Here is an article from Saturday’s Financial Times that shows just how bad it is:
Nearly one Spaniard in four is unemployed, according to data released on Friday, as the country’s economic and financial predicament prompted a government minister to talk of a “crisis of enormous proportions”. The data from the National Statistics Institute showed 367,000 people lost their jobs in the first three months of the year. That means more than 5.6m Spaniards or 24.4 per cent of the workforce are unemployed, close to a record high set in 1994.
The data, which follow a sovereign credit rating downgrade, prompted José Manuel García-Margallo, foreign minister, to say that they were “terrible for everyone and terrible for the government”. He compared the European Union to the doomed liner Titanic, saying that passengers would be saved only if all worked together to find a solution.
It is interesting that Garcia-Magallo is openly discussing the possibility of the “passengers” not being saved. Usually in the beginning of a sovereign debt crisis we spend an unfortunately long time in which policymakers insist that the market is overreacting to bad news and that the problem – inevitably a short-term problem driven largely by illiquidity – can be resolved with patience and hard work. There is no discussion of contingency plans because the contingency is unimaginable.
At some point however it becomes possible at least to acknowledge formally that policymakers might be forced into the contingency. Once this happens, the debate becomes much more intelligent and the resolution of the crisis is speeded up. I have no idea if we have reached that stage in Spain, but in that light I found an article last month, by Ambrose Evans-Pritchard of the Telegraph, both very worrying and, at the same time, comforting. In the article he says:
Articles calling for Spain to withdraw from EMU – or at least exploring the idea – are no longer rare. They are appearing every day.
…What is striking is the response on the comment threads of such pieces. My impression over the last month is that a large bloc of informed Spanish opinion has reached the conclusion that EMU is dysfunctional, and increasingly destructive for Spain. Many posters seem extremely well-informed, using terminology such as “debt-traps”, “internal devaluations”, and “relative unit labour costs”.
Many point the finger directly at Germany, correctly stating that Berlin seems to think it can lock in a current account surplus with Club Med in perpetuity. Clearly, such as an arrangement is mathematically impossible within a currency union – unless Germany is willing to offset the surplus with flows of money for ever, either through fiscal transfers or loans or investment. These flows have been cut off.
Opinion is divided, of course. The pro-euro camp is still a majority. But the smothering conformity of past years has been obliterated.
As recently as six months ago one didn’t discuss in polite company in Madrid the possibility that Spain would leave the euro and restructure its debt. The prospect was unthinkable and like many unthinkable things it could not be discussed.
This made it very unlikely that anyone except the radical parties of the left or right would be able to control the discussion and of course this was likely to lead to a more disorderly resolution. But now perhaps things have changed. If responsible policymakers, advisors, the press, and public intellectuals are indeed discussing and debating the future of the euro now, I am pretty sure that a real and open debate about Spain’s prospects will quickly move the consensus towards abandoning the euro.
And that is why the article is comforting. The historical precedents suggest that typically policymakers postpone the decision to reverse the monetary straightjacket for as long as they can, and in the process they erect barriers towards such a reversal in the name of shoring up credibility. These barriers work by increasing the cost of a policy reversal, and the point of this is to improve credibility in investors’ eyes by increasing the cost of “misbehavior” by policymakers.
Mexico did this for example in 1994 when, in order to convince an increasingly skeptical investor base that the central bank would not devalue the peso against the dollar, the Ministry of Finance shifted its domestic borrowing from peso-denominated funding to dollar-denominated funding, which of course would increase the debt-servicing cost of a devaluation for the government. Unfortunately, when policy is reversed anyway, as was the case in Mexico in 1994, the cost indeed ends up being much higher, and it takes longer for the economy to recover. In that sense the sooner Spain prepares for an abandonment of the euro the less painful it will be.
But of course it won’t be painless. Whenever an analyst predicts that Spain will soon leave the euro he is almost always countered by someone who earnestly explains that Spain cannot leave the euro because the process will be too painful. In 1993-94 of curse we were told that this was why Mexico could not possibly devalue, and in 2000 and 2001 this was why Argentina could not possibly break the currency board. It would have been too painful to devalue.
But of course Mexico and Argentina both did devalue and, yes, it was a very painful experience but they did it because the alternative was worse. And likewise while it is true that Spain cannot leave the euro without experiencing a very painful process, the point is not that anyone is arguing that Spain should willingly and irrationally choose to endure pain. Spain will leave the euro because the alternative is worse.
This is an abbreviated version of the newsletter that went out last week. Academics, journalists, and government and NGO officials who want to subscribe to the newsletter should write to me at chinfinpettis@yahoo.com, stating your affiliation, please. Investors who want to buy a subscription should write to me, also at that address.
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Sat 19 May, 2012
Submitted by Chris Martenson
Alasdair Macleod: All Roads In Europe Lead To Gold
This week we bring back Alasdair Macleod, publisher of Finance and economics.org, because, as he puts it "every horror that we discussed last time we spoke is coming about". Especially scary since our previous conversation with him was less than three weeks ago...
Today's interview continues building on his excellent synopsis from last month that detailed the origins of the Eurozone crisis. The fundamental shortcomings warned of at the Euro's creation in 1997, combined with the excessive sovereign debts run up since then, have finally expressed themselves at a scale too large to be contained any longer.
Today, Alasdair details in-depth the huge and serious challenges facing Greece and the major Eurozone countries, and the likely impacts of the fast-dwindling options left remaining.
He sees no happy ending to this story, no outcome in which serious pain and permanent behavior change can be avoided. And for those looking for shelter from the unfolding economic storm, he sees few options besides the precious metals (which he believes are severely under priced at the moment):
Greece
The Greek situation is entirely predictable: when you force enormous pressures on an economy and try and raise taxes from the private sector -- a private sector which isn’t used to paying taxes because usually they find away around it -- you start cutting pensions, you start cutting this, cutting that, and the people revolt. They haven’t a clue what they are doing, but we get the revolt nonetheless. It looks like nobody there can form a government; and it looks like there will be another election probably in June. That won’t resolve anything unless by some miracle, some sense gets knocked into people’s heads.
The other thing, which nobody has mentioned, is that there are about 90 billion dollars in derivative contracts involved in the Greek economy. This is not just government, but also local governments and towns and cities and all the rest of it. The counterparties to this $90 billion must be getting a bit worried about that, I would think because that looks as if it will default.
The people who have been most active in getting these derivative contracts going over time have been people like Deutsche Bank, Goldman Sachs and I suppose JP Morgan -- so you can see the problems aren’t just limited to the government and some unfortunate Greek citizens who are caught in the middle of this.
We are looking at potentially up to ninety billion dollars worth of derivatives which one side of those transactions is going to default. One side: it is not a balanced figure is it? I don’t know that it is necessarily as bad as that, but it is a problem that needs to be dealt with, addressed and contained. I think what they have to do as much as possible, is to try to work for a sensible outcome in this, which probably will involve Greece leaving the Eurozone, but maybe obtaining help from the ECB to set up a currency board. The reason I say that is that I think for Greece to return to the drachma would be complete destruction. You would have a situation where people who owe money in Euros would still owe money in Euros. If the Greek government tried to change that by law, for starts, that could only apply to loans taken out in Euros in Greece; whereas a lot of these have been taken out in Euros elsewhere in the European Union. In any event, I think if they tried to do a law on this, it would be a retroactive, which would be open to legal challenge.
Meanwhile, if you have deposits in a Greek bank, you can be sure the Greek government would say we are going to re-designate those into New Drachmas, which would impoverish the depositors. When it comes to trade, I think everybody would just stay well clear. To go back to a New Drachma, I think is the most destructive path Greece can have. Now, they could do that on the basis that, if the European Union wanted to make an example of Greece, then this is a way in which they could just let them go hang. The importance of that would be that the situation for Greece should be so bad that no other member of the Eurozone would contemplate leaving the Eurozone. That is a possibility. But I think that is less likely than coming to terms in such a way to give Greece an exit. But if they do get an exit, again, they’ve got to have an exit in such a way that it hurts enough and anybody else who wants to take that exit would see, well it is actually probably more painful than staying where we are. It is a very difficult balance to achieve.
The people who will do this, I don’t believe are the politicians. It would have to be the sensible people in the ECB and perhaps some of the more backroom boys who could put together some sort of face-saving mechanism without this becoming too much of a political hot potato. It is very, very tricky, it really is, and quite honestly, the way political governance has been going in Europe, the chances of them getting some sort of orderly withdraw in the interest of continuing relationships, et cetera, I think are actually probably slim. That is what we are up against: this is not easy. There is no precedence for this at all and I know that lots and lots of people are saying it has got to return to the Drachma; I just think that a New Drachma would collapse almost immediately. I think that a currency board in the Euro is actually a more sensible result given where we are.
France
France is a mess. They have outstanding debt of 1.3 Trillion Euros, something like that. Their debt/GDP is around about 85-90% going on a hundred quite rapidly. That is a very liquid and nasty situation. Unemployment is running close to ten percent.
It is almost impossible to employ anyone in France because the taxes are so high. Do you know the total tax that you pay as an employer, more than doubles the salary that you pay an individual? This is absolute craziness, but it is been like that in France forever and a day. The result is an awful lot of the market is black market.
Spain & Italy
Spain is a worse situation. Government debt alone is just under a trillion. A trillion dollars equivalent, I should say, and that is a lot of money. That is a lot of money. Italy is over two trillion dollars. That really is a very, very big one, so this contagion must not be allowed to happen.
Germany
Their economy is performing reasonably well, but it is not performing well because they are doing well for Europe; they are doing well because they are selling the most cars, machine tools and everything else to China, to Brazil, to Russia. Africa’s a great growth area. Europe, as far as Germany is concerned is dead. Which of course brings us on another question; that is why should Germany continue to support all these bust Europeans? There is a sort of conscience if you like about the last two world wars, but there is going to come a point where that wears pretty thin I would have thought. The trouble is that it is all very well, everyone turning around and saying, Germany has to help. Actually, what they are saying is that Germany’s citizens should give up their savings, their hard won savings to rescue a project, which is obviously dead or deceased. I think Germany really should bust out as soon as possible and I am sure that there are an increasing number of businessmen and bankers in Germany who are beginning to feel that way.
On Gold
People who have gold or silver, I think actually had a very rough ride over the last couple of months. A lot of them are wondering what on Earth is going on because every time you get good news, gold seems to rally along with equities, but every time there’s bad news and gold actually should be giving you some protection, it goes down the swanny.
I think the problem there is that the whole system is run by people who went to college and were taught keynesian economics. In my day, when I first went into the stock market and I enjoyed that first bull market in gold when it went from thirty-five bucks to eight-fifty, the traders and investment managers were all practical people. They all cut their teeth, all learned their trade the hard way. Some of them had degrees in college, but generally it would have been something like classics or history or something like that. If they got a degree in economics, they probably would have left because they never would have understood it in those days. But now it has changed. Everybody who is employed has a degree and if they are anything to do with investment strategy, or the investment business, it is all economics degrees. So they have been brainwashed in the keynesian thing. This sort of neoclassical approach where gold is yesterday’s story, paper money is the future. They really do believe it and it is the opinions of these people who drive the markets in the short term.
The result is that gold and silver have become very, very seriously mispriced. I don’t think I have seen a stretch like this as I can remember; by stretch, the difference between perhaps where it should be. We must be careful not to tell the market what the price should be, but it is so underpriced at a time of enormous systemic stress, that I think when gold and silver snap back into a more sensible, logical valuation relationship with the markets, the move actually could be very, very sharp and quite large. If gold ran up through the $2,000 level very quickly, which I think is a very strong possibility, because it is been held down so much, that could bring other problems. The central banks, who might have sold gold and not told us about it will find that they are embarrassed. I think also the bullion banks in London who operate a fractional reserve system with gold, exactly the same way as to do with any paper currency, will be hurt very, very badly on the run. Any shorts in the futures market equally could be hurt very, very badly. We have a situation, where there is a potential for a huge run in gold and I personally wouldn’t be surprised to see it.
Click the play button below to listen to Chris' interview with Alasdair Macleod (48m:07s):
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Today, the G8 came, saw, and wrote down a bunch of meaningless promises on paper as it does every several months (spoiler alert: more printing). They also posed for photos, such as this one. We leave it up to readers to provide the context.
Before You Write Off This Threat … Read This
Russian Prime Minister Dmitry Medvedev said that if the U.S. invades the sovereignty of countries like Syria or Iran, it could lead to nuclear war. And see this.
Russia and China have previously stated that an attack on Iran would be considered a direct threat to their national security.
And Iran and Syria have had a mutual defense pact for years. China and Russia might also defend Syria if it is attacked. So an attack on Syria could draw Iran into the war … followed by China and Russia.
The House approved a resolution Thursday preventing containment as a method of making sure that Iran does not obtain nuclear weapons, rejecting:
any policy that would rely on efforts to contain a nuclear weapons-capable Iran.
The next day, the House authorized the use of force against Iran to keep it from developing nukes.
Of course, while the Middle Eastern wars are mainly driven by oil (and perhaps protecting the dollar) – and while real conservatives are anti-war- many in the U.S. military view the wars as a literal crusade, and see Islam itself as their mortal enemy.
For example, Wired reported last week:
The U.S. military taught its future leaders that a “total war” against the world’s 1.4 billion Muslims would be necessary to protect America from Islamic terrorists, according to documents obtained by Danger Room. Among the options considered for that conflict: using the lessons of “Hiroshima” to wipe out whole cities at once, targeting the “civilian population wherever necessary.”
If this sounds nuts, remember that millions of evangelical Christians want to start WWIII to speed the “second coming” … and atheist Neocons and Neolibs are using religion to rile them up to justify war against Iran.
And Professor Michel Chossudovsky documents that the U.S. is so enamored with nuclear weapons that it has authorized low-level field commanders to use them in the heat of battle in their sole discretion … without any approval from civilian leaders.
What could possibly go wrong?
Latest comment from David Kotok at Cumberland Advisors deserves your attention. -- Chris
May 19, 2012
This is an open letter in response to legislation recently passed in the US House of Representatives. The behavior of Representative Harold Rogers, Chairman of the House Appropriations Committee, has made the front page of The New York Times, describing the $17,000 drip pan for Black Hawk helicopters that is earmarked for his district in Kentucky.
The US House of Representatives, that includes his leadership, has passed Bill H.R. 5326. This legislation decimates the statistical agencies that support the entire fabric of business investment, policy-making, and decision-making in the United States.
This action speaks volumes concerning the failure in Congressional accountability to review this legislation thoroughly and the abysmal behavior of Congressional leadership to permit it to pass. This threatens the economic recovery and long-term growth trend of the United States.
Below is a copy of a letter sent to the membership of the National Association for Business Economics (NABE). It recounts the important elements of the legislation that must be opposed. It also gives the appropriate number and reference in the US Senate version. It contains sample text which citizens can use to send letters, emails or telephone calls when it comes to lobbying on their behalf.
We are asking all who read our list serve to use this information, publicize it to others, and to stress to those in Congress that while we support some of their efforts in fiscal discipline, we do not support the emasculation of the agencies mentioned and the destruction of the statistical base that is essential to the ongoing business and investment climate in the United States.
I discussed this legislation with Bob Parker, Former Chief Statistician of the Bureau of Economic Analysis and the Government Accountability Office. Bob is a good friend and colleague in several economist organizations where we are both active. He is the most skilled professional I know.
Bob said that this legislation would "eliminate the economic census. That means no more bench-marking of key indicators such as retail sales, service receipts, manufacturers shipments and orders, trade inventories, industrial production index, etc."
So dear reader, this legislation can really cost and hurt you. Please act now while damage can be mitigated.
Thank you.
Dear NABE Members and Friends:
Last week, we alerted you that the U.S. House of Representatives was considering an appropriations bill for Commerce, Justice, Science, and Related Agencies (H.R. 5326) that would drastically reduce funding for the Census Bureau and make participation in the American Community Survey voluntary. Thanks to the many NABE members and other data users who contacted their representatives to try to prevent this action. Regrettably, the legislation ultimately passed the House along party lines and was much more damaging than originally proposed. In its current form, H.R. 5326 will "devastate" the nation's economic statistics.
Specifically, the legislation will:
Terminate the American Community Survey;
Cancel the 2012 Economic Census; and
Halt development of cost-saving measures for the decennial census.
NEXT STEPS:
The Senate is expected to take up its own FY2013 Commerce, Justice, Science, and related agencies appropriations bill shortly. The Senate and House versions of the bill will then presumably be addressed by a conference committee comprised of members of both bodies.
HOW YOU CAN HELP:
Call or email your senators and representative today to tell them why you value the Economic Census and the American Community Survey. You can use this sample letter below:
Dear :
I am writing to express my concern over passage of H.R. 5326 by the U.S. House of Representatives, which would drastically cut funding for the U.S. Census Bureau and eliminate the Economic Census and the American Community Survey (ACS) - two of the most important tools we have for understanding the U.S. economy.
These programs are critically important to businesses, policymakers, and government agencies which use the data to make informed decisions and plan for the future. The increased uncertainty accompanying the loss of these data will most certainly result in more missed opportunities and waste for businesses and misallocation of resources by policymakers and government agencies. I urge you to ensure that the Census Bureau receives adequate funding to continue these vital programs.
How are Economic Census data used?
By the federal government as an input to calculate elements of key economic indicators, such as economic growth (GDP), prices, and productivity;
By retailers in evaluating whether to expand into new market geographies;
By economic development commissions in attracting new businesses to their areas; and
By companies to benchmark performance against industry averages
How are ACS data used?
By corporations to examine workforce characteristics of neighborhoods to determine optimal locations for new factories or sales centers;
By homebuilders looking to tailor new subdivisions to surrounding neighborhoods based on income, family size and existing home values; and
By municipal governments in planning to meet the educational, safety and housing needs of their citizens.
The information we glean from the Economic Census and the ACS increases our understanding of current economic conditions and reduces uncertainty, allowing businesses and policymakers to make well-informed, efficient decisions. If we eliminate these programs, we are choosing to "fly blind," an alarming proposition in these challenging economic times. Again, I urge you that you vote to ensure adequate funding for both the ACS and the Economic Census.
Sincerely,
David R. Kotok, Chairman and Chief Investment Officer
CHICAGO (MarketWatch) -- Kentucky Derby winner I'll Have Another won the Preakness Stakes Saturday at Pimlico Race Course in Maryland, giving him a shot to become the first Triple Crown winner in 34 years. As in the Derby two weeks ago, I'll Have Another ran down front-running Bodemeister to prevail by a head at the wire. Creative Cause finished third. I'll Have Another was the second betting choice in the race at 3-1; Bodemeister went off at 8-5. There has not been a Triple Crown winner since Affirmed in 1978. Eleven horses have completed the Derby-Preakness double since then only to fall in the Belmont Stakes, the longest race in the series at 1 1/2 miles. Big Brown was the most recent to miss the feat in 2008. This year's Belmont will be run Saturday June 9.
Market Pulse Stories are Rapid-fire, short news bursts on stocks and markets as they move. Visit MarketWatch.com for more information on this news.
"Had I right, for my own benefit, to inflict this curse upon everlasting generations? I had before been moved by the sophisms of the being I had created; I had been struck senseless by his fiendish threats; but now, for the first time, the wickedness of my promise burst upon me; I shuddered to think that future ages might curse me as their pest, whose selfishness had not hesitated to buy its own peace at the price, perhaps, of the existence of the whole human race."
– The musings of Dr. Frankenstein about his creation of a monster, in Mary Shelley's 1818 novel, Frankenstein
And later the monster answers:
"Shall each man," cried he, "find a wife for his bosom, and each beast have his mate, and I be alone? I had feelings of affection, and they were requited by detestation and scorn. Man! You may hate, but beware! Your hours will pass in dread and misery, and soon the bolt will fall which must ravish from you your happiness forever. Are you to be happy while I grovel in the intensity of my wretchedness? You can blast my other passions, but revenge remains – revenge, henceforth dearer than light or food! I may die, but first you, my tyrant and tormentor, shall curse the sun that gazes on your misery. Beware, for I am fearless and therefore powerful. I will watch with the wiliness of a snake, that I may sting with its venom. Man, you shall repent of the injuries you inflict."
In the classic novel by Mary Shelley (written when she was just 19!), she writes about a young doctor (the Frankenstein of the title) who defies nature and creates an ungainly monster, piecing together parts that were not designed to fit each other. Even though he gives the creature life, it eventually turns on him and his family. The unhappy monster, which develops into quite the rationalizing being, demands that Dr. Frankenstein create a female version of himself so they can flee civilization and find happiness. When Dr. Frankenstein decides not to follow through on his initial promise to do so (thus the first quote), the monster seeks revenge. It does not end happily.
The European Monetary Union was a triumph of hope over reason, pieced together from very dissimilar countries which, while sharing common borders, have very different cultures and economies. That it would eventually face an existential crisis was foretold by numerous critics at the time of its creation. The euro has never been a real currency. It was and still is an experiment, fashioned and shaped by a generation with noble ideas and vision, but tied together by an unworkable structure. Can its foundation be reworked into a solid structure? Or will natural centrifugal forces pull it apart? The difficulties that are faced are somewhat akin to fixing the engine of a jet plane while it is flying at 30,000 feet.
In today's letter we explore the options that the eurozone faces in order to stay together, and what it all means for some of the countries involved. While I have written for a very long time about the probability of Greece exiting the eurozone, the actuality is fraught with risk, not just for Europe but for the world economy. What happens in the next few months will impact us all for a very long time. Indeed, this is one of those years, as Lenin noted, when decades happen. There is a lot to cover, and in future weeks we will go into more detail, but today let's just step back and see if we can get the larger picture.
There Is No Easy Grexit
The term du jour for the possible exit of Greece from the eurozone is “Grexit.” It is a rather ugly sounding word for what will be an ugly process if it happens. A Grexit has several serious implications. (I wonder how the Chinese translators will render Grexit.)
The first is the risk of contagion. When Bear Stearns went bankrupt, the immediate question by the market was not how much did we lose, but who is next? As it turned out, it was Lehman. The rest is history. But it was a recent lesson that is still quite vivid in the memory of traders and investors.
Grexit calls into question the very existence of the European Monetary Union. Is it a union from which there may be no exit, an “all for one and one for all” union, or is it a club that one can choose to belong to or to leave? Certainly, it’s a club that offers very distinct privileges, but also one that imposes very high costs on both the member who leaves and the members who stay, who must pick up the bar tab of the fleeing member.
There are those who argue that there is no treaty provision that allows for the exit of a member of the eurozone. Therefore, under the rules, you simply can’t leave. That is a nice concept in theory, but each member of the eurozone still thinks of itself as a sovereign country with full rights of self-determination, including the right to be self-destructive.
It is kind of like telling South Carolina in 1861 that there is no provision in the US Constitution for a state to secede from the Union. South Carolina and ten other states soon decided they did indeed have that right, and the bloodiest war in US history was fought over that question. People who think they are part of a sovereign country tend to be jealous of that idea and resist any suggestion that there may be limits on their sovereignty. And while no one thinks that the rest of the eurozone would resort to any sort of coercive action, the manner in which Greece is allowed to leave (or pushed out the door) is of the utmost importance.
The “Troika” (the European Commission [EC], the International Monetary Fund [IMF], and the European Central Bank [ECB]) has set up budgetary expectations for Greece as a condition of getting loans to pay their current operating expenses. These conditions require Greece to reduce its deficit and balance its budget by cutting government spending and raising taxes, and by actually collecting the taxes that have not been paid. This idea of not spending more than you take in taxes is called austerity by its critics and simple common sense by its proponents.
But the program has resulted in 25% unemployment (50% among youth) and a deep five-year recession, with the likelihood of another 7% dip just this year alone. (Question: How long does a recession have to last until it becomes a depression? Recessions typically last at most two years in developed countries.) Government workers are losing their jobs, and profits are severely down, as are tax receipts.
Greeks recently voted overwhelmingly for parties that want to reject the austerity program in one way or another. It was an almost complete reversal of the margins that the two previously dominant parties tended to get. Those parties agreed on the need to accept the austerity measures, in order to be able to continue selling bonds to European governmental institutions (and the IMF), since the private bond market for Greece had simply ceased to exist, except for relatively small trades by speculators buying bonds that others were forced to sell.
And the government entities represented by the Troika wanted some assurance that Greece would not continue to run huge deficits, but would at some point in the future be able to return to the private bond market. That meant that there had to be a balanced budget. Otherwise, Europe would be funding Greece for decades, which would not sit well with European voters.
Even so, because of the very real pain caused by the austerity measures, Greek voters pushed back and resoundingly voted out the parties that had agreed to the measures. Because so many small parties with such different views garnered votes, there was no way to form a majority government, and so there will be another election June 17. The recent vote notwithstanding, opinion polls show more than 75 percent of Greek voters want to stay in the euro.
There is no way to know what will happen next month; the polls change every few days. And the Greek economy may be in much worse shape by June 17. The government is running out of money to pay its day-to-day bills. We are not talking just your basic police, fire, military, and other government-worker salaries, though those are very much at risk.
The austerity deal requires that Greece actually collect taxes that are owed. One of these is the property tax, which evidently almost no one paid. And some bureaucrat got the “bright” idea (pardon the pun) to collect the tax by adding it to people’s electric bills. People tended to pay their electric bills – the power was shut off if you didn’t. However, that didn’t work out so well. This from the Financial Times:
“The government had hoped to raise €1.7bn-€2bn from the levy in the fourth quarter of last year. But a massive unions-led civil disobedience movement against this ‘injustice’ scuppered that and a ruling that it was illegal to disconnect people’s electricity supply for non-payment sent the collection rate even lower. However, the memorandum of understanding with the IMF-EU signed in March demands that Athens collects a range of back taxes, such as the property tax from 2009 which was essentially never collected. So it will be interesting to see how the Troika reacts to these most recent developments. Ironically, the scale of non-payment means that the PPC itself (the power company) has run out of money. Last month it needed a €250m liquidity injection from the government so as to avert a nation-wide energy supply meltdown. So even less of the already-too-small pot of tax revenues is going to the government. The PPC has until end of June to find new sources of funding. It seems unlikely that people who stopped paying power bills last year are suddenly going to start now. While EU-IMF funding is still forthcoming, the overwhelming support for the anti-bailout parties as Greece heads for new elections next month puts an obvious question mark over future assistance. But the PCC experience suggests we really could be moving towards the IOU stage of this crisis as liquidity issues bite.”
So let’s get this straight. Now the government is running out of money and the power company can’t collect enough to pay its bills because Greeks simply aren’t made to pay, so the government has to subsidize the power company with money it doesn’t have.
The party that leads in various polls is called Syriza. A youngish firebrand has convinced many Greeks that the austerity program must stop but that Europe should and will continue funding them. Let’s take this straight from the Wall Street Journal:
“ATHENS—The head of Greece’s radical left party says there is little chance that Europe will cut off funding to the country, and if it does, Greece will repudiate its debts.
“In an interview, Alexis Tsipras, the 37-year-old head of the Coalition of the Radical Left, also known as Syriza, warns that financial collapse in Greece would drag down the rest of the euro zone. Instead, he says, Europe must consider a more growth-oriented policy to arrest Greece’s spiraling recession and address what he calls a growing ‘humanitarian crisis’ facing the country.
” ‘Our first choice is to convince our European partners that, in their own interest, financing must not be stopped,’ Tsipras said in an interview with The Wall Street Journal Thursday. ‘If we can’t convince them—because we don’t have the intention to take unilateral action—but if they proceed with unilateral action on their side, in other words they cut off our funding, then we will be forced to stop paying our creditors, to go to a suspension in payments to our creditors.’
“According to recent opinion polls, Tsipras’ party is poised to win the most votes in repeat elections next month, bettering its surprise, second-place finish in an inconclusive May 6 vote that left no party or coalition with enough seats in parliament to form a government.”
Call me skeptical, but I fail to see how a young man who has never been at a negotiating table with any of the Troika (and who has apparently never talked with a German banker) can think he can hold Europe hostage.
“Tsipras says that, if push comes to shove, Greece can manage on its own. By not paying its debts, the country will have enough cash to pay its workers and retirees. He also proposes cuts in defense spending, cracking down on waste and corruption, and tackling widespread tax evasion by the rich.”
While such a platform might qualify him to run for US president, I somehow don’t see it convincing anyone that Greece is on a path to a balanced budget. Especially when he wants to quash the austerity programs that were agreed to, in order to secure the last round of funding.
A Rational Bank Run
The entire issue is made worse by the fact that there is a very real run on Greek banks. The FT reports that €5 billion has left Greek banks in just the last two weeks, some 3% of the total remaining deposits, by my calculation. As Mervyn King, the governor of the Bank of England noted during the Northern Rock crisis, “Once a bank run has started, it is rational to join in.”
The more that Greek citizens feel it is possible that Greece will leave the euro, the more likely they are to pull their money from Greek banks and send it abroad. Everyone in Greece is reading about the bank run, and the lines at the banks next week will be longer than the ones this week. And in today’s world there is no need to stand in line. The bank run can be entirely executed by computer. You simply open an account in another country and wire the money out.
That means the very cash that is needed by businesses small and large is fleeing the country. There is little investment in equipment or services, beyond what is absolutely necessary. Forget about getting a small-business loan at a bank. The ECB has already said it cannot continue to fund four Greek banks (talk about yelling fire in a crowded theater!), although those banks can get funded by the Greek central bank, which can get money from the ECB.
The primary resource that is needed to create growth is confidence, and that is in short supply in Greece. And if you’re in another country and thinking about investing in Greece, it makes sense to wait and see what will happen. Maybe prices of things you want to buy will be much more attractive if the banking system collapses. A few months after the collapse, someone will get around to selling the assets and loans of the banks, which may be in drachmas at the time, so your euros or dollars will go a LOT farther. Distressed loans and a currency revaluation? That smells like opportunity.
When Argentina collapsed, last decade, those who went in with cash were able to get some very good properties and deals. I could go down a list of such potential opportunities, but they will be there. At least Greek beaches are not going to be taken away. While it has been 25 years since I was there, I still remember how beautiful they were. There is a reason tourism in Greece is 20% of the economy. And that will be there no matter what currency Greece uses.
I said it was important how Europe deals with Greece, whether it stays in the euro or leaves. If Europe gives in to the demands for more money without a real plan for a path to a balanced budget, then they are sending a message to the voters of Spain, Portugal, Italy, and Ireland. Ireland goes to the polls in a few weeks. Spain already has Greek-like 25% unemployment. The frustration that Spain and the other countries feel with their own austerities is very real and getting worse, and the Troika knows it.
That is the reality that Greece faces. If they vote to stop the austerity, it is likely that Europe will simply not fund their loans. If Greece is not going to pay anyway, why not just pay off the loans or write them off? The thinking will be, “Why give them more money to spend when they are not living up to the agreements? These things can’t be negotiated with every new government. There has to be some continuity.”
But staying in the euro does not solve Greece’s most significant problem. Greece has a serious trade deficit. Its workers are not as productive as those in the core of Europe, and relative wages need to come down. And while that is easy to say in the abstract economic world, it is hard to do in the real world. What Greek worker thinks he is overpaid by 30% relative to a German worker? Try and sell that in Athens.
But that is the judgment of the market. And until the trade imbalance is solved, there will be no lasting solution to the Greek crisis. The imbalance will either be solved by a swift change of currency and a revaluation of the new drachma or a slow, tortuous process that could result in more than a decade of recessions and slow growth, with chronic high unemployment.
Greek Fatigue
Europe is visibly getting weary of dealing with Greece. Just as Hank Paulson eventually gave up trying to convince Dick Fuld to accept a rescue of Lehman Brothers on realistic terms, Europe may grow tired of being only one election away from yet another Greek crisis. And while Greeks may be tired of austerity, and they are, they have not yet come to the realization that the rest of Europe may not be willing to let them live as they want.
Greece will not be kicked out of the euro, but it is entirely possible and even likely that their funding will dry up without a continued austerity program. And that will eventually push voters to demand a government that promises them a return to their own currency. “How could it be worse?” they will think. But for a year or so it will get worse. Then it will get better. But the changes will be severe.
The Alligator of Bank Runs
If and when Greece exits the euro, the ECB must be prepared to step in with massive funding of peripheral-country banks and sovereign debt. That is not within their charter today; but when the euro is at total risk, that is the only way to save it.
As the joke goes, it is hard to remember that the original project was to drain the swamp when you are up to your neck in alligators. The “alligator” that will immediately face Europe after a Greek exit is bank runs in Spain and Italy. There must be the creation of a European-wide institution to insure deposits, in order to stop bank runs. Inexplicably, Europe does not have the equivalent of an FDIC, but if they are to survive they’d better get one.
Further, a Greek exit will mean even more defaults and losses, not only on Greek government debt but on their private debt as well. I know, the law says the contracts are in euros, not drachmas. But the Greek government will pass a law that says all debt owed by Greek citizens will be paid in drachmas, or something to that effect. And Greek citizens have to obey the law, don’t they? Exactly who are you going to send to repossess my property (car, home, equipment, etc.)? As we kids used to say when someone wanted to make us do something, “Yeah? You and what army?”
Businesses will get very concerned about doing business with citizens of a country that might leave the euro. If Greece is allowed to set a precedent by leaving, there must be clear rules for the reconciliation of contracts.
And there must be a massive show of support for Spanish and Italian sovereign debt, to convince the market that Germany and the other core countries are serious. We are talking multiple trillions of euros will be needed, if the interest rates on Spanish and Italian debt are not kept in check. That may mean the ECB will have to monetize debt for a time. Or they can change the rules and allow the European Stability Mechanism (ESM) to function as a bank, which would essentially allow the ESM to borrow from the ECB a relatively unlimited amount of capital (just 20 times leverage of €400 billion is a LOT of euros). That should buy all the time needed.
And then they have to deal with the whole fiscal union concept. As so many people said at the beginning of the euro experiment, you can’t have a real monetary union without a fiscal union. But that is a story for another letter.
So, let’s sum up. Greece will either have to continue with austerity to get any more money or leave the euro. The latter is more likely at some point, because sooner or later the voters will elect a government that will make that choice. And it may happen quite soon.
Right now, it would be difficult for the eurozone to guarantee Spanish bank deposits, for instance, and not guarantee Greek deposits. I suppose they could cook up a reason, but it would not be seen as the right thing to do in polite circles. And if a run on Spanish banks happens while waiting for Greece to make up its mind? What then? That will be a crisis on steroids.
Europe is going to either have to abandon the idea of a complete monetary union and let some nations go, or it is going to have to print massive amounts of money. Most likely it would be the ECB that turns on the presses, although making the ESM a bank could be an option if things get really bad. It all depends on how badly the Germans want to keep the euro together and what they will pay for doing so. Right now, the polls say they will do whatever it takes, even if they don’t like it. If inflation gets to 4-5%, then let’s ask the question again.
And I know some of you are thinking, how can he be talking trillions? Easy. Greece’s commitments alone to various European entities (the ECB, their portion of the ESM, EIB, etc.) run to about €500 billion. Add to that what private contract losses would be. Then realize that Greece is quite small compared to Spain or Italy. Yes, I know, Italy and Spain are not Greece; but the bond market is getting nervous. Spanish yields spiked to 6.5% at one point this week. The eurozone must commit to keeping peripheral interest rates low while countries struggle to get their budgets under control. That will not happen overnight, nor will it be cheap. It may cost Europe trillions. As in, more money than anyone can wrap their head around.
(Sidebar: I’m thinking the ECB is going to cut rates shortly.)
And the rest of the world had better hope they get it right. European banks are almost three times larger than US banks and finance much of world trade. A weakened European banking system is not good for anyone. Yes, emerging-market banks, private banks (hedge funds and sovereign funds), and even US banks can step in and, over time, make up the difference. Bu the operative words are “over time.” Building up the institutional infrastructure to finance global trade has taken decades. It wouldn’t take that long to do it again, but it would not be just a year. There could be large disruptions.
And that is not to mention European consumers and their imports, which would suffer in a prolonged European recession. Which would of course affects world trade and global GDP.
European leaders have given us an experiment called the euro. Will it be like Frankenstein’s monster and turn on them? Have they defied the natural order of Europe, or tamed the beast that raged for a thousand years? Have they created something that mankind will dearly wish they hadn’t, and suffer for their hubris?
Or will the euro yet become a Hercules, capable of performing astounding feats for the greater good? We are at the critical moment of the experiment, when the results are not yet clear but everyone can see that we won’t have to wait much longer.
Who Gets the Old Maid?
A popular card game for children is called Old Maid, which is played with a deck with an extra queen. The cards are dealt and the players trying to match their cards (a 3 with another 3, or a king with another king, for instance) until they can play all their cards. And of course you must trade cards with other players. When one person has no cards left, whoever has the Old Maid (the solitary queen) loses. There is some strategy involved, as if you have the Old Maid early, you might not pass it until close to the end, so it cannot come back to you.
Which brings to mind the balance sheet of the ECB, and leads to some rather dark thoughts. If Greece leaves, then at best the ECB will only get drachmas in return for the euros on the Greek account. IF Greece decides to pay anything at all. (My bet is that if they do pay, there will be strings attached that say the ECB must hold the drachmas for a very long time, so as not to hurt the currency.)
OK, but that increases every remaining eurozone member’s commitment by around 2.5% of the remaining balance. And then what if Portugal or Spain leaves? Or, heaven forbid, Italy? Your commitment just grew by a rather large amount. Not to mention your portion of the ESM, EFSF, EIB, etc.
On the way to a Nash equilibrium, the players all try and anticipate the moves and rationale of the other players, plus what their levels of pain tolerance will be. And then they adjust their own positions.
At what point does it occur to the voters of a country that they are taking on more debt than they can bear? How much European solidarity is really there? Is there an unlimited amount of pain that can be tolerated? I rather think there is a limit; we just don’t know what it is, or even if we could ever conceivably get there.
At what point does a country decide it does not want to be stuck with the Old Maid? Will Greece be allowed to walk away from its commitments? And if it tries, what will be the consequences? I know there is no mechanism for any of this, but someone had better be doing some serious planning around it, because you can bet a lot of investors are privately calculating how things will play out. This can all be handled, if you decide to deal with the issues openly.
So what am I worried about? We all know that developed countries do not default on their sovereign debts: the banking regulators of Europe have told us so. And if you can’t trust a banking regulator to know what he’s doing, then who can you trust?
Atlanta, New York, Philadelphia, Italy, and Singapore
I leave for Atlanta Tuesday and get back Thursday morning. I am then home for a whole ten days before I take off to New York for a meeting and then on to Philadelphia for the CMG Advisor Forum with my good friend Steve Blumenthal. He has assembled an outstanding group of speakers. Details to follow, but if you are an investment advisor you should consider coming. You can call CMG at 610-989-9090.
I have a few other events on the calendar, but the next big trip will our third-annual vacation to Tuscany. I do love Tuscany and am looking forward to seeing friends and relaxing a little bit. Then in July I will be going to Singapore for a speaking engagement, and will try and see more of that country. I really liked it when I went earlier this year.
And speaking of Frankenstein, I think Mary Shelley wrote the first true science-fiction novel, creating a whole new genre of literature. She took what was known as science (or at least scientific lore) and extrapolated into the realm of “what if,” giving us a tale that called into open discussion the nature of life and existence. And to do that while still a teenager? When today our students write papers in English classes that leave us wondering about what we allow to pass for literacy in our educational system?
This has come to mind while watching a YouTube video about my friend David Brin’s new book which, almost 200 years after Mary Shelley, deals with the very same issues, but with a very modern twist and cutting-edge science. The book is titled simply Existence, and it will be out in June. A Science Fiction Hall of Fame writer, David weaves a great story while making us think about the purpose of life. You can see the video (about 4 minutes) at http://youtu.be/cn6GqxeOvn4
It is once again time to hit the send button. It is early Saturday morning and I need to get some rest to prepare for another action-packed week of trying to figure out the ontological meaning of the existential angst in Europe that is caused by the dilemma of Greece. Or, in layman’s terms, “What the hell are they thinking?”
Have a great week.
Your happy to be existing at very this moment in time analyst,
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May 19 (Bloomberg) -- Morgan Stanley, the lead underwriter in Facebook Inc.’s initial public offering, stands to take a hit from a stock market debut that stoked disappointment among investors in the largest social network.
The bank stepped in to prop up the stock from dipping below its $38 IPO price yesterday, said people with knowledge of the matter, who asked not to be identified because the purchases were private. Morgan Stanley, based in New York, was the only underwriter among Facebook’s 33 banks with the responsibility to support the shares, the people said.
Underwriters “are acting like the cavalry to keep this thing going up,” Eric Jackson, founder of Ironfire Capital LLC, said in an interview on Bloomberg Television’s “Street Smart.” “They’re not going to be here a week from now, two weeks from now, a few months from now. It does suggest that there are going to be some rocky waters ahead.”
Days before the sale, Facebook and Morgan Stanley decided to bump the offering price range to one with $36 as a midpoint to persuade the company’s backers to sell more of their stock, one of the people said. Facebook and the bankers knew pre-IPO investors were willing to sell more, though not at the initial midpoint range of $31.50 a share, the person said. Goldman Sachs Group Inc. and Accel Partners were among backers that decided to sell additional shares in the IPO.
The IPO price, at the top of the increased range, prevented a first-day pop in the shares, which advanced 23 cents to $38.23 yesterday.
“It does indicate that investors are conscious of the risk, that the revenue model is still unproven, that operating costs are high and rising,” said Brian Wieser, an analyst at Pivotal Research Group LLC with a $30 price target on Facebook. “Those factors are weighing on the investors. The stock is greatly overvalued.”
Crossed Quotes
The debut was also marred by glitches at the Nasdaq Stock Market, where initial pricing of the first transaction was pushed back by a half-hour amid delays in trade confirmations, crossed quotes and signs that orders were mishandled.
Facebook executives and bankers met on May 17 to discuss the final IPO price, people familiar with the matter said. Among the underwriters, Morgan Stanley was the main bank handling pricing, the people said. Some co-managers of the offering advised Morgan Stanley against expanding the sale and price range because their clients’ demand didn’t support the move, two people said.
Pen Pendleton, a spokesman for Morgan Stanley, declined to comment. Jonathan Thaw, a spokesman for Menlo Park-based Facebook, declined to comment.
Market Value
Facebook raised $16 billion in the IPO selling 421.2 million shares on May 17, valuing the company at $104.2 billion. The offering price gave Facebook a market capitalization almost double the $60 billion United Parcel Service Inc., previously the biggest company to complete an IPO, was valued at when it went public in 1999, according to data compiled by Bloomberg and Dealogic.
That means Facebook bankers will split about $176 million for managing the social-networking company’s initial public offering after accepting a lower-than-average fee of about 1.1 percent. The biggest share of IPO fees typically goes to the lead underwriter on the deal, though the cost of propping up the stock in the first day of trading could potentially outweigh any underwriting fees generated from the sale.
Key Bankers
Dan Simkowitz, Morgan Stanley’s chairman of global capital markets, was one of the main bankers on the offering, said a person familiar with the matter. He also helped run General Motors Co.’s 2010 IPO that raised $18.1 billion.
Michael Grimes, global co-head of technology investment banking at Morgan Stanley, also played a key role. He introduced Facebook executives to investors at a lunch meeting last week in Palo Alto, California, part of a road show to pitch the deal to prospective buyers. Grimes became acquainted with Facebook Chief Operating Officer Sheryl Sandberg when he handled the IPO for Google Inc., her former employer. He meets regularly with investors in search of the next promising startup and is an avid consumer of his clients’ products.
Sandberg recused herself from picking bankers for Facebook’s IPO because she had relationships with several banks from her previous job at Google, one person said.
Facebook Chief Financial Officer David Ebersman was the point person on the deal, starting with the selection of the lead bankers, one person said. Sandberg and Chief Executive Officer Mark Zuckerberg were involved in major decisions throughout the process, the person said.
The performance may hurt the entire IPO market in the short term, people said. Some technology companies considering initial offerings are readjusting timing and valuations based on the day’s events, one of the people said.
“I know a bubble when I see one,” Bill Gross, Pacific Investment Management Co.’s co-chief investment officer, wrote about Facebook in a posting on Twitter.
--With assistance from Ari Levy, Brian Womack and Douglas Macmillan in San Francisco, and Sarah Frier and Michael J. Moore in New York. Editors: Jennifer Sondag, Tom Giles
To contact the reporters on this story: Serena Saitto in New York at ssaitto@bloomberg.net; Jeffrey McCracken in New York at jmccracken3@bloomberg.net
To contact the editor responsible for this story: Tom Giles at tgiles5@bloomberg.net
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Nassim Nicholas Taleb, author of Fooled By Randomness and The Black Swan (not the Aronofsky movie), was on the BBC's Newsnight with Emily Maitlis to discuss the multi-billion JP Morgan trading disaster.
One of the most vocal critics of the value-at-risk (VaR) risk metric, Taleb was deeply critical of the risk management practices being employed by the world's largest banks.
"We've known since 1998 that tools they use to manage their risk don't work," said Taleb referring to JP Morgan's use of VaR. "They are using the wrong tools. It's not a fluke."
By Taleb's estimation, "JP Morgan has 10 times to 15 times the risk of a regular hedge fund"
He believes more regulation was not the answer because "derivatives traders can game regulation."
Rather, he thinks banks should structure compensation so that traders should take a bigger hit if they deliver large losses. Furthermore, he argued that banks should get out of the trading business, be run like utilities, and just make plain vanilla loans.
To this the Maitlis suggested Taleb was an idealist. This irked Taleb, who exploded with this rant:
"I'm not an idealist. I'm someone who doesn't want to be paying $14 million for this lady Ina Drew, which is more than John Gotti, the mafiosi god. I don't want to keep paying her all this money for taking risks."
Here's the whole interview. Maitlis calls Taleb an idealist at the 5:55 mark.
SEE ALSO: A Complete Guide To JP Morgan's Trading Fiasco >
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Via BNONews, here's the G8 statement on boosting growth and the Greek situation.
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Our imperative is to promote growth and jobs.
The global economic recovery shows signs of promise, but significant headwinds persist.
Against this background, we commit to take all necessary steps to strengthen and reinvigorate our economies and combat financial stresses, recognizing that the right measures are not the same for each of us.
We welcome the ongoing discussion in Europe on how to generate growth, while maintaining a firm commitment to implement fiscal consolidation to be assessed on a structural basis. We agree on the importance of a strong and cohesive Eurozone for global stability and recovery, and we affirm our interest in Greece remaining in the Eurozone while respecting its commitments. We all have an interest in the success of specific measures to strengthen the resilience of the Eurozone and growth in Europe. We support Euro Area Leaders’ resolve to address the strains in the Eurozone in a credible and timely manner and in a manner that fosters confidence, stability and growth.
We agree that all of our governments need to take actions to boost confidence and nurture recovery including reforms to raise productivity, growth and demand within a sustainable, credible and non-inflationary macroeconomic framework. We commit to fiscal responsibility and, in this context, we support sound and sustainable fiscal consolidation policies that take into account countries’ evolving economic conditions and underpin confidence and economic recovery.
To raise productivity and growth potential in our economies, we support structural reforms, and investments in education and in modern infrastructure, as appropriate. Investment initiatives can be financed using a range of mechanisms, including leveraging the private sector. Sound financial measures, to which we are committed, should build stronger systems over time while not choking off near-term credit growth. We commit to promote investment to underpin demand, including support for small businesses and public-private partnerships.
Robust international trade, investment and market integration are key drivers of strong sustainable and balanced growth. We underscore the importance of open markets and a fair, strong, rules-based trading system. We will honor our commitment to refrain from protectionist measures, protect investments and pursue bilateral, plurilateral, and multilateral efforts, consistent with and supportive of the WTO framework, to reduce barriers to trade and investment and maintain open markets. We call on the broader international community to do likewise. Recognizing that unnecessary differences and overly burdensome regulatory standards serve as significant barriers to trade, we support efforts towards regulatory coherence and better alignment of standards to further promote trade and growth.
Given the importance of intellectual property rights (IPR) to stimulating job and economic growth, we affirm the significance of high standards for IPR protection and enforcement, including through international legal instruments and mutual assistance agreements, as well as through government procurement processes, private-sector voluntary codes of best practices, and enhanced customs cooperation, while promoting the free flow of information. To protect public health and consumer safety, we also commit to exchange information on rogue internet pharmacy sites in accordance with national law and share best practices on combating counterfeit medical products.
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This isn't going to be a popular thing to say, but it needs to be said. So here goes...
All this whining and umbrage about Facebook's IPO is ridiculous.
When are people who voluntarily speculate on stocks finally going to take responsibility for their decisions?
Never, apparently.
On Thursday, Facebook priced its IPO at $38.
On Friday, the stock opened at $42, a 10% jump, and spent most of the day trading above $40. Then, thanks to heavy support from the company's bankers, the stock closed just above $38.
In other words, even after the sharp selling at end of the day, Facebook IPO buyers were better off than they had been the day before. And if they were among those who took the abundant opportunity throughout the day to sell stock above $40, they locked in a nice overnight gain.
But to hear people bitch, you'd think they'd been swindled out of their life savings.
The New York Post captured the prevailing sentiment perfectly:
ZUCKERS!
They were Mark Zuckerberg’s cash cows.
Hordes of everyday New Yorkers played the fool yesterday to Wall Street fat cats and Facebook insiders, who used a bloated stock price to milk them of billions of dollars during an overhyped IPO.
With a $38-a-share price tag and forecasts for a 10 percent jump, mom-and-pop investors blindly bought in with dreams of instant riches that never came true.
Meanwhile, the social network’s hoodie-wearing CEO finished the day with a net worth of $19.25 billion. The average Facebook employee saw their on-paper wealth shoot up to $2.9 million.
Wow, sounds horrible.
And what happened, exactly?
Apparently, IPO buyers got less free money than they expected to.
The hope, presumably, was that--no matter where Facebook's IPO priced--the enormous demand from suckers would cause the stock to "pop" when it started trading--thus allowing the shrewd IPO buyers to flip their shares at a profit only hours after buying them.
Of course, that's exactly what the IPO buyers were given a chance to do. For about 4 hours yesterday, the IPO buyers could have locked in an instant 5%-10% gain. But apparently this wasn't the 50%+ gain they were looking for.
Well, it's time for people to grow up.
The $38 that Facebook IPO buyers voluntarily paid for the stock--emphasis on voluntarily--was already an extremely rich price for a company with decelerating revenue and only ~$0.35 of earnings last year. The only way these buyers were going to get a big "pop" from that price was if other investors seeking the same instant riches were even more aggressive and reckless than they were.
And it turned out that those even-more-aggressive-and-reckless traders stayed home.
So Facebook IPO buyers only got their 10% instant gain.
And a lot of them, apparently, did not take the opportunity to lock in that gain. Instead, they held on to the stock, either hoping that it would trade higher (likely), or because they are actually long-term investors.
And now, with the stock looking as though it will crash through the underwriters' support and the IPO price on Monday, the IPO buyers are blaming their decision to hold onto it on Facebook, too.
So, what exactly were you looking for, folks?
Even more free money?
Just for pressing "buy"?
In what other normal universe would you ever expect that?
Facebook could not have been clearer about how it was going to emphasize the long-term at the expense of the short-term, and that's exactly what it did in choosing its IPO price. Facebook now has a lot more cash at its disposal than it would have if it had lowballed the IPO just to give buyers a "pop." That cash is valuable to the company, and it will help the company create more value over the long-term.
In the weeks leading up to the IPO, moreover, many analysts screamed from the rooftops that Facebook's stock seemed extremely expensive. We even went to far as to call it "muppet bait."
And when the stock opened on Friday at merely an extremely expensive price, instead of a ludicrous one, we were relieved. Because it meant that millions of investors weren't buying it at absurd prices in the after-market... and thereby setting themselves up to get creamed when the hype faded.
But apparently those who did buy the IPO were expecting to get something for nothing. (And not just "something." They were expecting to get a lot for nothing.)
And when they didn't, they started taking their frustrations out on Facebook.
Trading stocks is a risky business. Perhaps it's time for those who voluntarily choose to do it to acknowledge that.
SEE ALSO: And Now, If Facebook's Bankers Can't Hold The IPO Price, The Stock Will Crash To The Low $30s
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When you're putting together your investment thesis on natural gas, are you taking into account what the Chinese truckers are saying? Now you can. Piper Jaffray just asked exactly 51 of these guys what they thought about the viability of natural gas as a fuel source in the Chinese trucking industry.
Here are the results of the survey:
Here's the deal, though: all of those truckers that don't see a future for natural gas say it's either because a) natural gas engines just aren't powerful enough or b) the necessary infrastructure isn't there.
With that in mind, here is Piper Jaffray's bonus stock pick for you: WPRT.
This is why:
This [survey] is positive news for WPRT, since the company's high pressure direct injection (HPDI) technology offers torque that matches the performance of traditional diesel engines. A lack of fueling infrastructure was the second most oft-cited reason for skepticism, with 44% of truckers mentioning this as a major hurdle. Presumably, if the Chinese government rolls out the infrastructure and WPRT rolls out the engines, many truckers will start migrating toward natural gas trucks.
That takes care of 90 percent of the naysayers. Could turn into an interesting natural gas play.
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Warren Buffett offered some dismissive words on higher education in a conversation with MBA students last month (notes provided by Market Folly).
Here's what he said when asked about the student loan bubble::
The best education you can get is investing in yourself. But this doesn’t always mean college or university. I have two degrees but I don’t have them on my wall, in fact I don’t even know where they are.
I used to be afraid of public speaking, and I realized that I have to do that someday. I do have one diploma I display from Dale Carnegie’s Public Speaking Course and it only cost me $100.
Thus, I don’t think college is for everyone, one benefit is that it gives you a button. In fact none of my three kids graduated from college.
John Mellor did research on group of students for a project. One group was sent to the beach while the other studied at university. Their results are not that different. It’s always about consistent improvement of your abilities.
You should always ask yourself, “does this have any value to me?” I did go to university because of the expectations of my parents.
Buffett himself earned a Bachelor of Science in business administration at the University of Nebraska-Lincoln and a Master of Science in economics from Columbia Business School.
His children have had successful careers despite not graduating from college, with his son Howard making a career in business and politics, his son Peter becoming a composer, and his daughter Susy being active in philanthropy.
Buffett also discussed advice for kids, insight on getting rich and why he would never live in New York.
Don't miss: Robert Reich says new college grads are "f*cked" >
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Deutsche Bank's Joe LaVorgna is still not ready to push the panic button on the economy.
In his latest macro note, he homes in on what is likely causing GDP to drag:
Services spending.
"Weakness in services spending has been unprecedented: the data show spending actually fell during the last recession. This is something that never happened before. Moreover, spending on services remains depressed, rising just 1.4% in inflation-adjusted terms over the past year."
Where is this noise coming from? LaVorgna says housing — in particular, rents and utilities. "Housing-related spending needs to turn up if the overall trend in consumption and by default real GDP is going to improve, as we continue to believe it will," he writes.
The sources of that belief are climbing rents and warming weather:
"We expect housing rents, which account for about 84% of spending on housing and utilities-related services, to continue to rise in lagged response to a new cyclical low in the residential vacancy rate...Moreover, housing rents should also get a lift from higher household formations, a function of an improving labor market."
...
"We expect a return to more normal weather patterns to lift household utility usage, and should the summer months produce above average temperatures, electricity usage should rise commensurately, adding a further lift to measured consumption."
The one caveat in this trend, LaVorgna believes, is that while inflation will moderate through the rest of year, there will be a concurrent "troubling uptrend in core inflation—driven predominantly by services—which will be taking place beneath the surface."
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The New York Post is pulling no punches this morning.
Here's an excerpt from today's cover story:
They were Mark Zuckerberg’s cash cows.
Hordes of everyday New Yorkers played the fool yesterday to Wall Street fat cats and Facebook insiders, who used a bloated stock price to milk them of billions of dollars during an overhyped IPO.
With a $38-a-share price tag and forecasts for a 10 percent jump, mom-and-pop investors blindly bought in with dreams of instant riches that never came true.
Meanwhile, the social network’s hoodie-wearing CEO finished the day with a net worth of $19.25 billion. The average Facebook employee saw their on-paper wealth shoot up to $2.9 million.
Reporters Georgett Roberts, Josh Saul, and Jeane Macintosh interview experts and new investors, who respond to yesterday's lackluster IPO.
Read the whole story at NYPost.com.
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