Thursday, May 19, 2011

Today's links

1--IMF says Greece must "reinvigorate" reform drive, Reuters

Excerpt: The IMF warned Greece on Wednesday that it would fail to shore up its finances unless it redoubled reform efforts, and euro zone officials dismissed suggestions that a mild debt restructuring might help.

European finance ministers broke a taboo this week by acknowledging for the first time that some form of restructuring might be required to ease Greece's debt burden, which at 150 percent of annual output is among the highest in the world.

Some have said that private creditors could be asked, on a voluntary basis, to accept later repayment of their Greek debt but ministers have also made clear that their first priority is ensuring Prime Minister George Papandreou's government steps up reforms.

"The program will not remain on track without a determined reinvigoration of structural reforms in the coming months," Poul Thomsen, an International Monetary Fund envoy who arrived in Athens last week to assess its progress in meeting fiscal targets linked to its European Union/IMF bailout.

2--Could Greece be the next Lehman Brothers? Yes – and potentially even worse, Guardian

Excerpt: If Athens reneged on its debts it would shatter the markets' confidence in the eurozone project...

It was less than three years ago that the failure of Lehman Brothers sent tremors through the global financial system, threatening the existence of every major bank and triggering the most severe economic crisis since the Great Depression. As Europe's policy elite met for fresh crisis talks today, the dark fear that haunted everyone around the table was this: if the bankruptcy of a middling-sized Wall Street investment bank with no retail customers could have such dire consequences, what would happen if the Greeks decide they have had enough and renege on their debts?

Could Greece, in other words, be the new Lehmans? Given the structure of modern financial markets, with their chains of derivative trades and their pyramids of debt, there is only one answer. Greece could certainly be the next Lehmans. The likelihood that a Greek default would pose a threat to the future of the eurozone as well as to the health of the world economy means it has the potential to be worse than Lehmans. Much worse....

It was also clear from the outset that the structure of monetary union would result in struggling countries being subjected to deflationary policies. Since the eurozone is not a sovereign state there is no formal mechanism for transferring resources from rich parts of the monetary union to the poor parts. Nor, given language barriers and bureaucratic impediments, is it easy for someone made unemployed in Athens to get a job in Amsterdam. Instead those countries seeking to match Germany's hyper-competitive economy have to cut costs, through stringent curbs on wage increases and fiscal austerity.

3--Richard Koo Explains Why An Unwind Of QE2, With Nothing To Replace It, Could Lead To The Biggest Depression Yet, zero hedge

Excerpt: So what are the actual problems inherent in QE2? Mr. Bernanke has stated from the beginning that QE2 would not lead to an increase in the US money supply.

If so, why did the Fed carry out QE2? The simple answer is that it believed QE2 would result in a portfolio rebalancing effect. The portfolio rebalancing effect can be described as follows. When the Fed buys a specific asset (in this case, longer-term Treasury securities), the price of that asset rises. That prompts private investors to re-direct their funds to other assets, which leads to a corresponding increase in the price of those assets.

Private-sector sentiment may improve as asset prices rise, and if that prompts businesses and households to spend more money, the economy may improve. In effect, the Fed hopes that quantitative easing will lift the economy via the wealth effect. Inasmuch as the balance sheet recession was triggered by a drop in asset prices, monetary policy that serves to support asset prices may also help pull the economy out of the balance sheet recession.

Reasons for divergence of liquidity supply and money supply

The decline in private-sector credit in the US and the UK is attributable to both the unwillingness of banks to lend and the unwillingness of the private sector to borrow. The two factors are rooted in balance sheet problems and are indications that both countries remain in balance sheet recessions.

When a bubble collapses, the value of assets drops, leaving only the corresponding liabilities on the balance sheets of businesses and households. To fix their “underwater” balance sheets, companies and individuals do whatever they can to pay down debt and avoid borrowing new money even though interest rates have fallen to zero. Banks, for their part, are not interested in lending to overly indebted companies or individuals, and often have their own balance sheet problems. With no borrowers or lenders, the deposit-growth process described above stops functioning altogether.

US banks now appear slightly more willing to lend money, although that is not the case in the UK. In neither country, however, are there any signs of greater willingness to borrow among businesses and households.

Unable to buy more government bonds or private-sector debt, investors have few places to turn

In the hope of producing a portfolio rebalancing effect, Chairman Bernanke declared that the Fed would purchase $600bn in longer-term Treasury securities between November 2010 and June 2011. This was roughly equivalent to all expected Treasury debt issuance during this period.

From a macroeconomic standpoint, these purchases of government debt meant that—in aggregate—private-sector financial institutions would be unable to increase their purchases of US Treasury securities, because all of the growth in Treasury issuance would be absorbed by the Fed.

The fact that US businesses and households were rushing to repair balance sheets by deleveraging meant that—again, viewed in aggregate—private investors would be unable to increase their purchases of private-sector debt.

With the private sector no longer borrowing and all new issues of government debt being absorbed by the Fed, US institutions found themselves with few investment options.

So funds found their way to equities and commodities

The only remaining destinations for these funds were equities, commodities, and real estate. Real estate had just been through a bubble and remained characterized by heavy uncertainty. In commercial real estate, for example, banks—at the request of US authorities—are engaging in a policy of “pretend and extend” and offering loans to borrowers whose debt they would never roll over under ordinary circumstances. That means that current prices do not accurately reflect true market prices. Housing prices, meanwhile, resumed falling late in 2010.

UK house prices have been falling since mid-2010, and the Halifax House Price Index dropped 1.4% in April 2011 alone (the decline was 3.7% on a y-y basis).

The only remaining options for private-sector investors have been stocks and commodities. That, in my opinion, is why both markets have surged since the announcement of QE2.

And the conclusion:

QE2 was Bernanke’s big gamble

When the situation is viewed in this light, we come to the realization that Mr. Bernanke’s QE2 was in fact a major gamble. It was a gamble in the sense that the Fed tried to raise share prices with QE2. If the wealth effect resulting from those higher prices led to improvements in the economy, the higher asset prices would ultimately be supported by higher real demand, thereby demonstrating that prices were not in a bubble.

However, I cannot help but feel that the portfolio rebalancing argument was putting the cart before the horse, in the sense that it is ordinarily a stronger real economy that leads to higher asset prices, and not the other way around.

It might be possible to sustain the portfolio rebalancing effect for some time if conditions were such that investors were totally oblivious to DCF values. But with market participants paying close attention to DCF values, any delay in the economic recovery will naturally bring about a correction in market prices, thereby causing the portfolio rebalancing effect to disappear.

4--Princeton grad works at video store, CNN Money

Excerpt: Brittney Winters graduated from Princeton in 2009, expecting to use her double major in French and Spanish to get a teaching job. But aside from some freelance tutoring, the jobs she's been able to find -- waitress, public relations and video store clerk -- have all been outside her fields of study.

"The degree I have isn't obviously marketable," she said. "I don't regret what I studied. If I was going to spend four years and God knows how much money, I might as well study something I like."

She's looking at going back to graduate school to get a masters in English, hoping that when she completes the program she'll find a better job market waiting for her.

5--Is REW the new MEW? (Retirement Equity Withdrawal), Calculated Risk

Excerpt: Reader "Soylent Green is People" asks if Retirement Equity Withdrawal is replacing Mortgage Equity Withdrawal (MEW) for those in need?

Borrowing from retirement accounts has definitely increased. From CNBC two weeks ago: More Americans Raiding Retirement Funds Early

... 19 percent of Americans — including 17 percent of full-time workers — have been compelled to take money from their retirement savings in the last year to cover urgent financial needs, the Financial Security Index found.

And from a new study by Aon Hewitt: Leakage of Participants’ DC Assets: How Loans, Withdrawals, and Cashouts Are Eroding Retirement Income Note: "DC" is Defined Contribution - like a 401(k) plan.

As of year-end 2010, nearly 28% of active participants had a loan outstanding, which is a record high. Nearly 14% of participants initiated new loans during 2010, slightly higher than previous years. The average balance of the outstanding amount was $7,860, which represented 21% of these participants’ total plan assets.

Hmmm ... $7,860 is 21% of total assets? That means the average total balance is less than $40,000 for participants who borrow from a DC plan.

6--Patting Themselves on the Back?, Tim Duy, Economist's View

Excerpt: The yield on 10-year Treasuries has slipped back to just a hair over 3% - despite the fact that the US has hit its legal "debt ceiling." The fresh reversal in yields appears to be further evidence against the ongoing hard-money fears that the combination of quantitative easing, deficit spending, and a falling dollar are sure to spell inflationary doom. As Paul Krugman likes to quip, the bond market vigilantes remain invisible.

From a monetary policy perspective, the behavior of the Treasury market would suggest that it may be too early to tap on the policy breaks....

By this measure, inflation expectations have come off their peaks in recent weeks. Further evidence that bond market vigilantes were getting ahead of themselves? Or evidence that the Fed did what “needed” to be done – throttle back on monetary policy to keep expectations under control?

In other words, I can see where some Fed officials could make the case that financial markets are simply responding positively to good, old-fashioned monetary austerity. The implications for policy are straightforward; officials could pat themselves on the back for a job well done, rather than worry that the move toward tighter money was once again premature.

From my perspective, recent market activity has followed a standard playbook – the advent of QE2 pushed market participants into the obvious trades. Long equities and commodities and short dollar. Trades that worked because they were balanced on a kernel of truth. Global economic activity did firm, and interest rate differentials should be dollar negative. At the same time, there was always a risk the trades would overextend and collapse, either under their own weight because the Fed took away part of the story. Perhaps it's been a little of both, with at least energy prices clearly sapping US growth and the Fed calling it quits on quantitative easing. What is left? An economy that is growing yet remains mired at a suboptimal level relative to potential output. Very similar to what we had before QE2 – an economic roundtrip to somewhere that is at least within sight of another lost decade for US job growth.

7--IMF’s Predatory Policies Likely to Continue with New Leadership, Marshall Auerback, New Deal 2.0

Excerpt: Most mainstream economists have not recognized that changes in the government sector balance will have (opposite) consequences for the nongovernment sector balance. This is not a theory but a simple accounting identity based on double-entry bookkeeping. The ECB doesn’t seem to get this; nor do the Germans; nor does the IMF. But it’s very simple (and being amply demonstrated in the current travails of the euro zone): When the government sector goes into deficit, the shortfall equals the additional private sector saving (or reduction of private sector deficit), plus additional net imports.

By adopting the euro, both Greece and Ireland abandoned the option of allowing their currency to depreciate as a means of improving its current account stance. Without this option, it is hard to imagine how either country could boost its exports, which is the only way either can escape their debt traps, given the inability to conduct an independent fiscal policy. Austerity of the kind advocated by Strauss-Kahn and his market fundamentalistas at the Fund damages private expectations (encouraging risk averse spending patterns and more saving) and directly reduces aggregate demand. The only thing that drives output, income and employment growth is spending, which is precisely what the IMF’s programs are designed to frustrate. That its destructive policy mixes have hitherto been coated in the honey-sweet words of a former French Socialist Finance Minister, does not make them any easier to swallow.

It’s the institution that’s the problem, no matter who takes over from Strauss-Kahn, whose future public career is almost certainly shredded regardless of the ultimate outcome of this particular case. Expecting the Fund to change is akin to painting a leopard black, and thinking that this will change its predatory behavior.

8--Human Development and Wealth Distribution, Dominique Strauss-Kahn, IMF

Excerpt: "....Adam Smith—one of the founders of modern economics—recognized clearly that a poor distribution of wealth could undermine the free market system, noting that: “The disposition to admire, and almost to worship, the rich and the powerful and…neglect persons of poor and mean condition…is the great and most universal cause of the corruption of our moral sentiments.”

This was over 250 years ago. In today’s world, these problems are magnified under the lens of globalization....globalization also had a dark side. Lurking behind it was a large and growing chasm between rich and poor—especially within countries. An inequitable distribution of wealth can wear down the social fabric. More unequal countries have worse social indicators, a poorer human development record, and higher degrees of economic insecurity and anxiety. In too many countries, inequality increased and real wages stagnated—failing to keep up with productivity—over the past few decades. Ominously, inequality in the United States was back at its pre-Great Depression levels on the eve of the crisis....

Inequality may have actually stoked (an) unsustainable model. In countries like the United States, borrowing seemed to allow ordinary people to share in the rising prosperity. Like the Great Depression before it, the Great Recession was preceded by an increase in the income share of the rich, a growing financial sector, and a major rise in debt.... the unbalanced pattern of growth had a variety of causes, but we would be foolish to ignore the distribution of wealth....

We stand on the threshold of a new era. We cannot turn our back on openness and globalization, but we need a new globalization for a new world—a globalization with a human face, where people come first, and where growth and equity always go together....

What are the practical implications of this?

First and foremost, we need to rebalance global growth....The surplus countries must shift from an external to an internal growth engine, relying more on domestic demand, and letting the middle classes come into their own. Stronger social safety nets and investment in infrastructure will support this rebalancing....There must be a shift away from the culture of risk and recklessness, to put the banks back in the service of the real economy.... An immediate task is to end the scourge of unemployment....Progressive taxation can also promote equity through redistribution, and this should be encouraged....


Let me conclude briefly. Before he died this summer, the British historian Tony Judt made a passionate plea for policymakers to pay far more attention to the damaging effects of inequality. “Inequality is corrosive” he wrote, “it rots societies from within…it illustrates and exacerbates the loss of social cohesion…the pathology of the age and the greatest threat to the health of any democracy.”

9--Hedge-fund leverage down, but exposure up, Marketwatch

Excerpt: Hedge-fund leverage is down, but equity managers have the highest stock-market exposure in four years, according to two industry reports released Tuesday.

Average standard leverage decreased across all strategies from 1.27 to 1.10 times investment capital in the past year, according to Chicago-based Hedge Fund Research Inc.

Meanwhile, average margin to equity declined to 16.98% from 17.13% year over year, HFR said.

The percentage of funds that do not usually use leverage climbed to about one-third of the industry — an increase of 4% from last year, HFR also noted.

Leverage is the use of borrowed money to magnify investments. The strategy is an integral part of the way hedge funds are run, but too much leverage can increase losses and sometimes lead to fund blow-ups.

Falling leverage suggests the $2 trillion hedge-fund industry is taking on less risk. However, another report Tuesday suggests the opposite.
Stock exposure

Long-short equity hedge funds increased their stock-market exposure to about 58% net long from roughly 53% last week, according to the latest edition of Bank of America Merrill Lynch’s Hedge Fund Monitor.

That’s the highest market exposure since 2007, before the global financial crisis crushed share prices in 2008 and left the hedge-fund industry with record losses, according to BofA Merrill Lynch.

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