Monday, October 31, 2011

Today's links

1--Another reason the Fed might buy MBS, FT Alphaville


Excerpt: In his speech two weeks ago, Bernanke explained the evolving intellectual framework of central banking after the crisis, and specifically explained the increasing importance of monitoring financial stability along with its traditional responsibility for monetary policy. The details remain to be worked out, obviously, but buying MBS would seem a way to address both goals.

And speaking of those European banks….

Separately, anecdotes of European banks deleveraging dollar-denominated assets – such as mortgage securities – have proliferated. Should this trend continue, it would be most convenient to have the Federal Reserve positioned as a ready buyer of MBS, as well as Treasuries.

Convenient indeed, and too much of a coincidence not to at least mention. Just something to keep in mind next week…

2--Furious Greeks lampoon German 'overlords' as Nazis with picture of Merkel dressed as an SS guard, Daily Mail

Excerpt: Street poster depicts German Chancellor wearing a swastika armband bearing the EU stars logo on the outside...

Greeks angry at the fate of the euro are comparing the German government with the Nazis who occupied the country in the Second World War.

Newspaper cartoons have presented modern-day German officials dressed in Nazi uniform, and a street poster depicts Chancellor Angela Merkel dressed as an officer in Hitler’s regime accompanied with the words: ‘Public nuisance.’

She wears a swastika armband bearing the EU stars logo on the outside...

Opposition parties blasted the landmark agreement, with conservatives warning it condemned the country to ‘nine more years of collapse and poverty’.

But it is the fury of ordinary Greeks which is raising eyebrows.

Greek government officials who agreed to the belt-tightening moves have been portrayed in cartoons giving the Nazi ‘Sieg Heil’ salute.

And German visitors flocking to ancient tourist sites are being met with a hostile welcome from some Greeks.

3--Why No Action on Jobs?, Jared Bernstein, On The Economy

Excerpt: Why, you may be wondering, do politicians refuse to take the necessary fiscal steps to dislodge the unemployment rate from its elevated perch of 9.1%? Why, to the contrary, do they seem if anything intent on austerity measure that will push it in the wrong direction?

I can think of three reasons:

1) They want the President to fail;

2) They don’t believe fiscal measures will work;

3) They irrationally fear a higher budget deficit, even temporarily.

Re 1, what can anyone say? If you’re will to throw the economy under the bus to gain political advantage, you, not the millions hurt by your actions, should be the one who loses their job.

Re 2, I’ve got more sympathy for you. Folks have a hard time accepting counterfactuals—the idea that things would have been worse absent the Recovery Act. But the evidence is at this point pretty plain to see: here, where the economy improved while the Recovery Act was in place and stumbled as fiscal stimulus come off too soon, in the UK, where austerity is clearly stifling growth, and in southern Europe as well.

Re 3, it can’t be emphasized enough that temporary spending measures, even large one, are not what drive the long-term debt problem. Note how the Recovery Act—all $800 billion of it—adds nothing to the growth of the debt/GDP ratio starting around now. The culprit there would be the Bush tax cuts—it’s the permanent spending, not the temporary stuff that whacks you here.

I’m all for laying the groundwork to get on a sustainable budget path once the private sector is back in the business of creating jobs for people here in America. For now, the question regarding budget deficits should be: are they large enough to help pick up the slack until that moment arrives? (chart shows effects of Bush tax cuts)

4--Draghi to slip Trojan-style into ECB hot seat, Reuters

Excerpt: It bears a certain similarity to the Trojan horse story.

While the ECB’s staff are off enjoying a public holiday on Tuesday –which by the way no one else in Frankfurt will get– Mario Draghi will slip unnoticed into the bank and make himself comfortable in the president’s chair recently vacated by Jean-Claude Trichet.

While the covert changeover could never have been planned, it may end up being like Trichet was never there. The baguettes and coq au vin in the canteen may mysteriously turn into pizza and spaghetti in time for lunch on Wednesday when everyone else is back in the office, and that might be that.

Draghi has been careful to stay out of Trichet’s way in the final weeks of the Frenchman’s leadership. While new ECB board members usually turn up a few weeks early to get their feet under the table, there has been no sign of Mario on Kaiserstrasse yet. And ECB insiders say are no clearer now how life will be under the Italian than they were months ago when he was given the job.

The objective, to avoid any confusion about who is in charge at the central bank at such an important phase of the crisis, is probably a sensible one. But you can’t help thinking that behind Trichet’s back, everybody must have been checking with Draghi before committing the ECB to anything that might not have been to his taste.

5--Brussels Decisions 'Will Exacerbate the Crisis', Der Speigel

Excerpt: The euro-zone, it would seem, has managed to convince investors that it might be on the path to solving the common currency area's debt problems after all. In addition to the Greek debt haircut, the 17 euro-zone members also agreed on a requirement that European banks increase their core capital ratios to 9 percent, a move that will, it is hoped, help buffer them against the hefty write downs of Greek debt that some will have to swallow.

In addition, the EFSF is to be boosted, transforming the fund with a current lending capacity of €440 billion into one with firepower worth €1 trillion. At that size, it is hoped, investors will no longer be overly concerned about investing in euro-zone sovereign bonds, particularly those from larger area economies like Italy and Spain.

Still, despite the apparent investor euphoria over the deal, there are, for the moment, precious few details about how exactly the new EFSF fund will work. There are two competing models -- one involving an insurance scheme guaranteeing a portion of investments in euro-zone sovereign bonds against loss and another envisioning the creation of an investment fund to attract money from outside the euro zone. But euro-zone leaders won't be making a final decision until November.

'Several Additional Steps'

"The complete lack of details out of the European summit doesn't give investors a great sense of comfort," Fredrik Nerbrand, global head of asset allocation for HSBC, told Reuters....

The left-leaning daily Die Tageszeitung writes:

"Above all, €1 trillion simply won't cut it, because not even €2 trillion would be enough. The crisis now has a life of its own and has eaten its way into the heart of the euro zone. A real inability of Europe's debt-laden countries to pay back the money they owe would mean mass panic among financial investors. Meanwhile, Italy and even France are seen as potential candidates for insolvency, which is absurd. The countries possess two of the world's strongest economies."

"The euro crisis will only be over when the euro has become a normal currency like the yen, the dollar or the pound. This includes a European Central Bank able to buy up government bonds, much like the Bank of England routinely does."

"Such a solution remains distant, however. Chancellor Merkel continues to rely on state-level solutions like the so-called 'debt brake.' Each country is to tighten its purse strings in order to calm the financial markets. No one even talks about the alternative: that rich people could pay more taxes. The prescribed cuts will deepen the recession, which in turn produces deficits and sends investors into a whole new cycle of panic. The decisions from Brussels weren't harmless -- they will exacerbate the crisis rather than solve it."...

Would the markets still be reacting with such euphoria if the technical details of the 'voluntary' debt haircut were understood? How much in risk premiums will investors demand for government bonds that are only partially guaranteed by the EFSF? And then there is still Greece, this country without a business model, which is expected to reduce its debts down to 120 percent of its gross domestic product by 2020. It remains questionable as to whether this still enormous mountain of debt will be more manageable for the country (or more acceptable for the capital markets). But without stronger growth -- probably also fueled by EU aid -- this goal remains fiction."...

"Berlin is especially proud of the fact that the European Central Bank (ECB) is to be left out of the rescue of the highly indebted nations. This promise will be difficult to keep, at least in the short-term. As long as the EFSF is not yet fully functioning with sufficient 'firepower' at its command, the ECB will still have to jump in as the 'lender of the last resort.' Designated ECB President Mario Draghi knows that, and therefore deliberately left the door open to further buying up of government bonds."

6--German Constitutional Court Halts Special Euro Panel, Der Speigel

Excerpt: Germany's highest court has issued a temporary injunction banning the work of a new panel convened by the country's parliament to quickly green-light decisions on disbursement of taxpayer funds through the euro bailout program. The decision could lead to further delays in German decision-making in efforts to rescue the beleaguered common currency.

Germany's Federal Constitutional Court on Friday expressed doubts about the legality of a new panel of lawmakers set up by the German parliament to reach quick decisions on the release of funds from the euro bailout mechanism, the European Financial Stability Facility (EFSF). The court issued a temporary injunction banning the nine-person committee in the Bundestag from taking any decisions on the EFSF's deployment of German taxpayer money.

The special committee was recently created in order to be able to provide a quick green light for EFSF aid in especially urgent situations in which it wouldn't be feasible to put the issue up for a vote before the full parliament. The decision from the court, located in Karlsruhe, could also slow down Bundestag approval of the further application of German credit guarantees within the scope of the euro backstop fund....

'The Bundestag Cannot Be Replaced'

But the SPD members are contesting the law. "The Bundestag cannot be replaced by a nine-member committee on such important issues," Schulz told SPIEGEL ONLINE. Schulz argues that, at a minimum, the Bundestag's budget committee should be included in all decisions.

7--Euro Bailout Failure, 5 Ducats

Excerpt: Have so many ever been so enthusiastic over a plan to beg, borrow, and steal $1.5 trillion?

•Beg - Weaker European banks will have to raise over $100 billion in capital.

•Borrow - Eurozone will borrow $1.4 trillion to bailout future sovereign and bank defaults.

•Steal - Private investors lose 50% of their Greek bonds' face value (ok, "steal" is a bit strong).

Begging, borrowing, and stealing doesn't usually instill confidence. And it shouldn't. Piece by piece, here's why...

Greek bond 50% haircut:

1.Greek bonds held by the ECB and IMF don't get a haircut, so the Greek gov't didn't get half of all of their debt cut - only part of it. They still owe much more than 50%.

2.Greece's economy is still shrinking and it still runs a trade deficit, so they will continue to run a gov't budget deficit. They are going to default again.

3.The bank trade group agreed to the 50% cut as voluntary so that it wouldn't trigger a CDS default, but their decision doesn't bind the actual bond investors, and some probably won't volunteer.

4.The best reason to volunteer now is so that you haven't shot your wad early, before Greece defaults again, when you might get a bigger payout.

5.Nobody knows what the interest rate and term of the restructured bonds will be. Assume it will be very low and very long, so that the present value of the bonds will be much less than 50%. Looking for volunteers? (in truth there isn't that much Greek CDS out there).

Banks Raise Capital:

1.The rule was created so that it scarcely touches German and French banks, funny how that works since they negotiated the deal.

2.Italian banks have to raise a lot of capital, but do private investors want to put money in banks in a stagnant economy, with a government that probably can't bail them out?

3.The goal is to hit a target capital as a percentage of assets. Instead of raising capital, they could sell assets - particularly the good ones that will sell for a high price, which leaves them with the crummy assets and makes the bank weaker in the long run.

4.A scarcity of bank capital will cause banks to lend less and lend more conservatively, which will contrain economic growth and ultimately make it harder for banks and governments to pay back their debt.

5.If banks sell many of their assets, and lend less, then that will generally lower the price of European assets and further undermine bank solvency.

6.If the value of sovereign bonds is used to determine bank capital adequacy, why would a bank now buy Italian and Spanish bonds that have a greater risk of falling in value? Sovereign bonds are now risky to banks even if they don't default.

Borrow €1.0 trillion ($1.4 trillion):

1.€1 trillion equals 45% of China's foreign reserves, but China's reserves aren't in Euro cash, but mostly in US Treasury and Agency debt. And although these are very liquid assets, you can't sell $1.4 trillion of anything without driving down your price a lot (unless the Fed wants to buy it).

2.No nation will guarantee the €1 trillion debt, Germany explicitly will not.

3.Germany demanded that the ECB would not guarantee the debt either.

4.The Euro Emergency Stability Fund will take the first loss before any of the €1.0 in debt defaults, but the EFSF is backed by credit risks such as Italy and Spain, who are more likely to default than lend in an emergency.

5.Borrowing €1.0 trillion from China will increase demand for the Euro, causing it to rally and make the Eurozone trade deficit worse.

6.If the money is lent from within the Eurozone, then you are removing money that would otherwise be lent to someone else, which may constrain economic growth.

7.If the €1.0 debt is perceived as safer than some individual Eurozone members, then individual Eurozone members may not be able to sell their own bonds to refinance their debt - which means that they would be forced to tap the leveraged emergency fund.

8--European Bank Debt-Guarantee Proposals May Struggle to Thaw Funding Market, Bloomberg

Excerpt: European banks, which need to refinance more than $1 trillion of debt next year, may struggle to fund themselves until policy makers follow through on a pledge to guarantee their bond sales.

European Union leaders promised this week to “urgently” look at ways to guarantee bank debt in a bid to thaw funding markets frozen by the sovereign debt crisis. Lenders have found it hard to sell bonds for the past two years and have increasingly turned to the European Central Bank for unlimited short-term emergency financing.

“The biggest problem at the moment is that banks haven’t been able to fund themselves,” said David Moss, who helps manage about 8.5 billion euros ($12 billion) at F&C Asset Management Plc in London. “If banks can’t fund themselves, they’ll struggle to exist.”

ECB Funding

The extra yield investors demand to hold banks’ senior bonds instead of benchmark government debt soared to a record 360 basis points on Oct. 4, according to Barclays Capital’s Euro Aggregate Banking Senior Index. The spread has since narrowed to 315 basis points, still almost double its average of 178 basis points for the past four years.

Banks that have been unable to tap the bond markets are likely to become more reliant on the ECB for funding. When the Frankfurt-based central bank revived a tool last used at the end of 2009 to ease money-market tensions on Oct. 26, 181 banks borrowed a total of 56.9 billion euros for 12 months. The identities of the borrowers weren’t disclosed.

European governments including France, Spain, the U.K. and Germany guaranteed some bonds issued by their banks to reassure investors after the collapse of Lehman Brothers Holdings Inc. in September 2008. In May 2010, the EU ended the program when it said banks that relied on the pledges would face a review of their long-term viability.

U.S. Program

In the U.S., the Temporary Liquidity Guarantee Program allowed banks to issue bonds with backing from the FDIC for as long as three years. Borrowers paid a fee of 0.5 percent to guarantee debt due in six months or less, 0.75 percent for debt going out one year, or 1 percent for longer-dated maturities, according to terms on the agency’s website. More than 85 percent of U.S. banks participated in the program, including JPMorgan Chase & Co.

About 66 banks had issued $231 billion of FDIC-guaranteed debt as of Aug. 31, according to the FDIC. Sheila Bair, the agency’s former chairman, told Congress in November 2008 that in the month following introduction of the program, “we have seen bank funding rates moderate significantly.”

For the European guarantee to work, it would need to be provided by a pan-European body such as the European Investment Bank, said Philippe Bodereau, head of credit research at Pacific Investment Management Co.

9--Greece at its limit, The Street light Blog

Excerpt: (written before Thursday's agreement) The Greek parliament just passed the previously agreed-to package of tax increases and spending cuts. But I am willing to bet that it is the very last round of austerity measures that Greece will be able to enact. Here are excerpts from Gavin Hewitt's gripping column from yesterday:

Athens erupts over austerity cuts

Athens was expecting violence. The expectation of it hung in the air. It is all people have spoken of in recent days. Even tourist hotels some distance from the parliament were boarding up. As a 48-hour general strike took hold shopkeepers were hammering in place steel shutters. The fear that emerged in hushed conversations was that there could be serious casualties. Such is the rage, the frustration that has built over months.

...I joined some students heading for the parliament. They are outraged that schools have a shortage of books. One young man said to me that he was not prepared to see decades of social progress sacrificed to satisfy the European Union and the IMF. Some waved banners with Che Guevara's picture. Then the column stopped, and from the left marched builders, arms linked, carrying poles with red flags on top. They walked with purpose. They have seen the construction industry collapse.

Then metal workers and teachers. It seemed at times as if the whole city was on the move. ...Marches and skirmishes soon became running battles across the capital But the numbers kept coming; great rivers of protesters.

...And with the marchers came young men and women in black hoods and masks. They began tearing at a wire fence that the police had slung across the road at the side of the parliament.

When eventually the police lost patience and fired the first tear gas grenade, the sound echoed across Syntagma Square and the crowd cheered.

There is a sense here that this is the key battle if spending cuts and wage increases are to be defeated.

Then skirmishes became running battles. Some of the anarchists had petrol bombs that snaked through the air falling around the riot police. They replied with volleys of tear gas and stun grenades.

...Europe's leaders had insisted that in exchange for bailing Greece out, it had to slash its deficit. The Greek foreign minister told me on Tuesday that no European country had ever tried such cuts in such a short space of time.

But seeing the vast numbers on the street, the government ministries occupied, the violence, it has to be asked whether Greece can impose these new austerity measures.

And if it can't, will the EU and IMF go ahead with the next tranche of bailout money. The so-called troika (the EU, IMF, the ECB) is delivering its report this week. Without the next 8bn euros ($11bn; £7bn) Greece will be unable to pay its bills within weeks.

But the mood has hardened here. There is less fear of default.

The finance minister said on Wednesday that "what the country is going through is really tragic".

Greece will continue to miss the deficit targets set by the troika. The ECB can continue to demand that Greece raise taxes and cut spending by even more, but further austerity-punishment will not help. At some point very soon Germany is going to have to make a simple decision: does it, for its own self-interest, come up with the money needed to fix this crisis, irrespective of what's happening in Greece; or does it say no, and elevate the crisis by an order of magnitude. I wish I had confidence in the answer.

10--The Mysterious Drop in the Saving Rate, CEPR

Excerpt: The NYT told readers that the saving rate has fallen sharply in recent months, registering just 3.6 percent in September, down from rates of more than 5.0 percent earlier in the year. (In the pre-bubble era, the saving rate averaged more than 8.0 percent.)

The main reason for this decline was likely erratic income data. There are often erratic movements in these numbers that cannot be explained by actual developments in the economy. In the four months from January to May, a period in which the GDP data show the economy was barely growing, wage earnings reportedly increased at a 3.9 percent annual rate. By contrast, in the four months from May to September the data show that wage earnings rose at just a 0.4 percent annual rate even though the economy grew at a 2.5 percent rate in the third quarter.

This sort of sharp slowdown in wage earnings is not plausible in an economy where growth was actually accelerating. It is more likely that wages were understated in September and indeed the whole third quarter, which means that income growth would be stronger and that the savings rate would be higher.

It is also worth noting that some of the story here reflects the timing of car purchases. Car sales were depressed in the second quarter because os shortages related to the earthquake/tsunami in Japan. The third quarter sales were strong as manufacturers had big sales incentives to make up for lost ground.

11--Income Excluding Government Transfers Drops Again, WSJ

Excerpt: The economy’s third-quarter growth spurt has many economists saying the U.S. dodged the recession bullet. Not so fast, says at least one dissenter.

Yes, consumers and businesses are spending more, Thursday’s report on gross domestic product showed. But look deeper, especially at Friday’s data on household income, and the picture is more troubling, and indeed could point to a looming recession, says economist David Rosenberg of Gluskin Sheff & Associates Inc.

Even though consumer spending makes up most economic activity, Mr. Rosenberg argues the focus should be on income rather than spending in determining the health of the economy. And in that regard, the data don’t look good.

The main category to consider is “real personal earnings less government transfers,” Mr. Rosenberg says. Essentially, that’s income minus Social Security, Medicare, unemployment insurance and other government aid. What’s left is the bulk of consumer income Americans are actually earning.

The “real personal earnings less government transfers” category is among the host of indicators the National Bureau of Economic Research tracks in determining business cycles.

Friday’s Commerce Department report shows that personal income indicator has declined for three consecutive months — at a 2% annual rate. In the past, such steep drops in that category have been followed, three-quarters of the time, by a recession, according to Mr. Rosenberg’s research.

So while consumers boosted spending in the third quarter, they pulled it off by dipping into their savings and spending government dollars, not by earning more money at work. Mr. Rosenberg says stagnant wages, plunging consumer confidence, and low expectations for wage growth are a recipe for a dramatic drop in consumer spending in coming months.

“Absent the decline in the savings rate, consumer spending in real terms would have actually contracted over the past three months,” Mr. Rosenberg says. That won’t hold for long, he says. “Unless income picks up, I would expect spending to contract over the next several months,” Mr. Rosenberg says

12--The Spending-Income Shortfall, WSJ

Excerpt: A boost in consumer spending is largely what fueled the 2.5% growth in GDP in the third quarter. But the spending boost wasn’t accompanied by a similar increase in income, according to new data Friday by the Commerce Department. In September, for example, disposable personal income — the money left over after taxes and other payments to the government — edged up just 0.2% from a year earlier, when adjusted for inflation. Meanwhile, inflation-adjusted consumer spending jumped by 2.2% from September 2010. The report suggests that Americans are dipping into savings, rather than relying on higher wages, in order to boost spending, a trend that economists say is not sustainable in the long term. (See chart)

Friday, October 28, 2011

Weekend links

1--To forgive is divine, Credit Writedowns

Excerpt: This is to say we do not think the European agreement ends the debt crisis and there will be the need for an other emergency summit in the not-to-distant future. Exaggerated growth forecasts and inflated privatization revenue projections will require additional adjustments going forward. The agreements in principle still needs the details to be worked out, but the broad outline is less than the shock and awe that would rebuild the lost credibility. At least twice earlier this year, European officials said they would present a comprehensive solution and finally put some closure on the debt crisis. At least twice this year they have failed and we are not confident that the third time is a charm.

The 50% haircut to private sector Greek bond holders is unlikely to be the last. Even by their own admission, the Greece's debt to GDP will be 120% in 2020. That is twice the Stability and Growth pact cap of 60%. That is simply not a sustainable solution.

Ironically the ECB purchases of Greek bonds and its refusal to accept a haircut means that the private sector has to take a bigger haircut to reduce Greece's overall debt burden. The market does not know how much Greek bonds the ECB owns. The guesstimate 70-75 bln euros. That is roughly 20% of Greece debt that will not be lowered. It is as if the Federal Reserve carried it Maiden Lane assets at face value not market value.

2--Another Bear Market Trap, Credit Writedowns

Excerpt: The EU itself in its release calls the plan a "broad agreement" to increase bank reserves. We would emphasize the word "broad." Banks would be recapitalized subject to the approval of a number of policies still to be determined. It intends to broaden the rescue fund to a trillion Euros, ask Greek bondholders to take a haircut of at least 50% and force the banks to recapitalize by June 30th. How all of this is going to happen remains unclear. And the haircuts apply only to Greek debt. The hope is that the markets would gain enough confidence to ring-fence Spain and Italy from following in Greece's footsteps. The markets have bought the story so far, but how long that feeling lasts is highly uncertain, particularly in view of the violent nature of recent trading.

As for the U.S. economy, although we've seen a small recent bump following the summer debt-ceiling circus, the economy remains in the doldrums. Consumer confidence remains near all-time lows as a result of the weak labor market. Consumer spending has improved somewhat lately, but only because households lowered their savings rates. Personal income is still scraping along the bottom. Core capital goods expenditures were up, but surveys indicate the business investment may slow in coming months. Confidence in the small business sector is still at historical lows. Recent unwanted inventory accumulation may also point to a coming slowdown in production. Housing is scraping along the bottom and may drop even more as the foreclosure backlog comes on to the market.

The economic sectors that have shown some recent improvement are generally coincident or lagging indicators while leading indicators appear to be showing some weakness. The ECRI Weekly Leading Indicator is at levels indicating a recession ahead. This indicator has a good record of predicting past recessions and has never forecast one that didn't occur. If this prediction is accurate, we will be going into a recession in such a fragile economic environment that we would expect any recession to be severe. Some of the statistics are; 9.1% unemployment, 22% of homeowners underwater, about 5 million homes in inventory or shadow inventory, home prices continuing to decline, and debt (all sectors) at historically high levels.

3--The Creeping Eurozone Credit Crunch, Credit Writedowns

Excerpt: Here’s a very informative chart via Morgan Stanley showing the deterioration in the Eurozone’s key credit indicators. Banks will no doubt sell assets, at least in part, as a way to meet their required capital targets. (See charts)

4--Foreigners Sell Second Largest Amount Of US Bonds Ever In Past Week, Record $93 Billion In US Paper Sold In Past 2 Months, zero hedge

Excerpt: According to today's update in the H.4.1, the total amount of securities held in the custodial account for foreign official and international accounts just plunged by $20 billion, of which $19 billion was attributable solely to Treasurys: the second largest weekly dumb ever. And since this total number includes both Treasurys, which are used for political purposes, as well as Agency securities, which don't really serve much in terms of a diplomatic statement but are great at shoring up liquidity, one can assume that the relentless selling in all types of US paper has had one purpose only: to generate capital. As the third chart shows, that amount is substantial: in the last 8 weeks foreigners have sold a unprecedented $93 billion across the custodial account bringing it to $3.392 trillion, the lowest since March 2011! So the next time someone asks where European banks are finding emergency liquidity now that commercial paper, money market and Libor Markets are all dead, you will have the answer.

5--China on ‘Bigger, Faster Treadmill’: Chanos, Bloomberg

Excerpt: China is on “a bigger and faster treadmill” than ever as a slowdown in the property market has already started, said Jim Chanos, president and founder of $6 billion hedge fund Kynikos Associates Ltd.

“The Chinese are beginning to realize that property prices can go down as well as up and this is going to be a very, very troubling development for the Chinese property market,” said Chanos in an interview from Singapore with Susan Li on Bloomberg Television today.

China’s home prices gained in fewer than half of the 70 cities monitored by the government in September for a second month as sales eased after government curbs this year to keep housing affordable and prevent an asset bubble. ...

Real estate transactions in September, October, in the tier-one, two and three cities the firm tracks are down 40 percent to 60 percent year on year, said Chanos, who had predicted the market may crash as early as 2010.

“The property slowdown or worse has started,” he said. “The question is how is it resolved.”

6--The Euro Area Precedent for Policy Failure, The Wilder View

Excerpt: Last weekend, a leaked Troika report (Troika = ECB + EC + IMF) revealed that European policy makers now comprehend that the Greek policy prescription is not working (bold by yours truly):

The growth and fiscal policy adjustments assumed under the program individually have precedent in other countries’ experience, but experience to date under the program suggests that Greece will not be able to set a new precedent by realizing at the same time and from very weak initial conditions a large internal devaluation, fiscal adjustment, and privatization program.

Rob Parenteau and Marshall Auerback sum up the implications of this point (1 A.):

On the first page of the document is not only a pretty open and blatant admission that expansionary fiscal consolidation (EFC) has proven to be a contradiction in terms, at least in Greece, but there is also a serious policy incompatibility problem, at least over the intermediate term horizon, with efforts at internal devaluation (ID) – that is, attempting nominal domestic private income deflation in order to improve trade prospects when one has a fixed exchange rate constraint.

I agree with Rob and Marshall – the grand plan does not work. Greece will (of course) not be able to set a new precedent of public sector and private sector deleveraging amid weakening external demand and a fixed exchange rate. However, I’d like to focus here on the ‘precedent in other countries’ experience’. What precedent?...

Finally, I leave you with a potent illustration of what not to do when it comes to fiscal austerity: Portugal vs. France.

(chart) Portugal was doing all right – better than France, even – until they ran into 2010 financial stability problems that forced the government to start ‘cutting’. Portugal started to contract in Q4 2010, applied for funding in April 2011, and contracted thereafter. Economic Intelligence Unit sees Portugal contracting throughout 2012 (no link). The Euro area prescription for austerity is tantamount to economic collapse amid a fixed exchange rate and meager global growth prospects.

The EA policy plan for fiscal austerity is setting a precedent, all right, a precedent for policy failure.

7--Could be worse, Econbrowser

Excerpt: The Bureau of Economic Analysis reported today that U.S. real GDP grew at an annual rate of 2.5% during the third quarter of 2011. That's below the average postwar growth rate of 3.2% and well below the 4.3% growth for an average expansion quarter. Even so, it's better than any of the previous 3 quarters, and better than many analysts had been expecting when the quarter began in July....

The growth in 2011:Q3 GDP was led by solid consumer spending and encouraging strength in business purchases of equipment and software, with the latter contributing 1.2 percentage points to the 2.5% total all by itself. An investment- and net export-led recovery would be the ideal scenario, if it can continue. Inventory cutbacks subtracted 1.1%, which means that real final sales registered an encouraging 3.6% annual growth rate and suggests that fourth-quarter GDP growth could be better than the third. Housing remains stuck in its own depression, but since there's no quarter-to-quarter change, it's making no contribution, positive or negative, to the observed GDP growth rates. And no, the chart below has not mistakenly omitted the government sector's contribution to third-quarter growth-- the slight increase in federal defense spending was exactly offset by cuts in other categories of federal, state, and local spending, for a net contribution from this sector of exactly zero. (charts)

8--What are those Italian bonds telling us?, Pragmatic Capitalism

Excerpt: Equity markets are rightfully celebrating the fact that, in the near-term, a full blown banking crisis with private sector contagion has been avoided. But we shouldn’t get too far ahead of ourselves here. An interesting development in response to this Euro package is the Italian bond market. The bond vigilantes are shrugging their shoulders at this. As you can see in the chart below, yields on the 10 year Italian bond initially fell, but have since recovered all of their lost ground since the announcement last night. What’s going on here? Why are the equity markets responding so favorably while the bond market barely budges? I think the message from the Italian bond market is quite clear – this is not a real solution to the Euro crisis. Equity markets are more hyperbolic and looking at the near-term. One is saying, “the coast is clear for now” while the other market is saying “there is much work to be done here”.

Bond vigilantes in Greece have already learned the lesson from this crisis. The ECB’s current strategy cannot stop yields from surging in the case of worsening budgets. If the ECB wants to control the yields on these periphery debts they need to set the rate and be a willing buyer in any size at that rate. This would be a step towards fiscal union and unfortunately, the Germans won’t have that. They’d rather backstop their banks, impose austerity and hope that this crisis resolves itself. Wishful thinking if you ask me and the Italian bond vigilantes seem to agree.

The Italians have made bold targets for the coming months. It’s eerily reminiscent of the targets the Greeks have been setting for years now. Can they grow their economy during a balance sheet recession while the government sector contracts? The math says no and talk is cheap. The Greek experiment confirms this. Italian bond markets are shrugging their shoulders at this plan. While it may be a step in the right direction, it is by no means a real fix. The question now is how long before the bond vigilantes get impatient and force the EMU leaders into truly bold action?

9--Student Loans, Social Security and Debts You Carry for Life, Rortybomb

Excerpt: According to the Project on Student Debt, the average debt load for graduating seniors in 1996, when this law was passed, was $12,750. Now it is over $23,200. Also note that, post-1991 and upheld by the Supreme Court in 2005 as it regards Social Security payments, student loan collection has no statute of limitations. This is one of the very few kinds of debts without such limitations. As this site puts it, ”Creditors and debt collectors have a limited time window in which to sue debtors for nonpayment of credit card bills… In most states, the statute of limitations period on debts is between three and 10 years.” But in this case, the Department of Education notes, ”[b]y virtue of section 484A(a) of the Higher Education Act, statute of limitations of no kind now limits Department’s or the guaranty agency’s ability to file suit, enforce judgments, initiate offsets, or other actions, to collect a defaulted student loan.”

It is impossible to discharge bad debts in this system under our normal mechanism for handling bad debts — bankruptcy. When delinquencies happen — say when you graduate into a recession that elites refuse to fix — you get thrown into the fee-churning world of private debt collection. This world was memorably described by law professor Ronald Mann as a “sweat box” of fees and other ways of increasing the total debt owed. With fees churning, there’s no date after which creditors can no longer go after your student loan payment, and they can even go after the baseline measure society has created to prevent poverty in old age.

Now with all this in mind, let’s quickly examine the New York Fed’s recent release of its Quarterly Report on Consumer Credit, specifically this delinquency data: (Chart)

Student loan delinquencies look to be slowly increasing over time, while credit cards and mortgages go up and down. On the flip side of this dynamic is the amount of loans being “charged off” by private institutions. These are loans that will never be fully replayed, and a cost-benefit analysis tells the lender that it is no longer worth trying to collect the full amount. These are tough estimates to get, but Karen Dynan of the Brookings Institute has one estimate in her “Household Deleveraging and the Economic Recovery”:

As credit card and housing debt become unbearable, there’s a point at which they get written down. That point is too high, but because of various laws regarding debt collection that shift the strategy and potential end results between the actors, there’s a logic to it. As far as I can tell, there’s simply no equivalent chart, or even logic, for student loans. Because of legal choices we’ve made in how to set up this relationship, it stays forever, is virtually impossible to discharge under hardship, churns fees when it goes bad, and creditors can get to anything, including Social Security, to get it repaid. Meanwhile, we have a Great Depression-like event that is throwing college graduates into a labor market that is far too weak.

Thursday, October 27, 2011

Today's links

Today's quote: "Leverage can have different economic functions, but in these cases it simply disguises a lack of money." Wolfgang Munchau


1--Europe's crisis may end up in a violent blow up; interview with James Galbraith, Daily Ticker
Excerpt: (Video--Euro endgame)

2--Overwhelming Majority--Merkel Wins Parliament Vote on Fund Leveraging; Der Speigel

Excerpt: The German parliament has voted in favor of the controversial leveraging of the euro rescue fund by a large majority, with 503 out of 596 members of parliament backing the motion, 89 opposing it and four abstaining. The outcome is expected to strengthen Chancellor Angela Merkel at a summit on the debt crisis in Brussels on Wednesday night.

German Chancellor Angela Merkel won strong backing as expected for the planned leveraging of the euro rescue fund in a parliamentary vote on Wednesday.

Of 596 votes cast, 503 members of parliament voted in favor of the motion, with 89 no votes and four abstentions. The motion had cross-party backing from the parties in Merkel's coalition and from the opposition Social Democrats and Greens.

The leveraging, intended to boost the firepower of the €440 billion rescue fund, is part of a package of measures designed to tackle the debt crisis and protect the single currency. Other steps are expected to include a Greek debt cut of up to 60 percent and a plan to recapitalize European banks to shield them from the resulting writedowns of their bond holdings.
The vote is expected to strengthen Merkel's position in summit talks in Brussels on Wednesday night.

3--Europe's non solution, Credit Writedowns

Excerpt: But the eurozone’s chief policy makers continue to ignore this fundamental point and therefore, steadfastly avoid utilizing the one institution – the European Central Bank – which has the capacity to create unlimited euros, and therefore provides the only credible backstop to markets which continue to query the solvency of individual nation states within the euro zone. The ECB is so loath for everybody to agree on a Greek default, on the grounds that they bear "the loss" even though it is a notional accounting loss that has no bearing on their ability to create euros until the cows come home. By contrast, when you get national governments funding the European Financial Stability Fund (EFSF), then it does ultimately threaten the credit ratings of France and Germany once the markets begin to call their bluff on how far they're prepared to go to support this political fig-leaf called the EFSF. And because NONE of these countries is sovereign in respect to their currency (they USE the euro, but they don't ISSUE it), it expands the potential insolvency problem, taking Germany down along with the rest.

The market pressures are most acute today in respect of Greece, but the broader concern is that speculators will eventually look toward the bigger PIIGS, such as Italy, and this is where the issue of the European Financial Stability Fund’s structural weaknesses come into play.

Let’s not get bogged down in numbers. The EFSF could have 440 billion euros behind, 1 trillion, 2 trillion, even 10 trillion euros, but it all comes back to the funding sources. The French are right: it makes no sense to implement this program without the backstop of the ECB, which is the only entity that could make any guarantees credible, by virtue of its ability to create unlimited quantities of euros.

Both the leading policy makers within the euro zone and market participants continue to conflate two distinct, but related issues: that of national solvency and insufficient aggregate demand. Policy makers want the ECB to do both, but in fact, the ECB is only required to deal with the solvency issue. When you do that in a credible way, then you get the capital markets re-opened and you give countries a better chance to fund themselves again via the capital markets. It means you do not actually need several trillion dollars, because you have a credible backstop in place – a central bank that can create literally trillions of euros via keyboard strokes and thereby address the markets’ concerns about national solvency. At this point, the bonds of the various nation states become less distressed and the corresponding need for massive banking recapitalization goes away.

4--The ECB: Unwilling Saviour, The Street Light blog

Excerpt: The ECB is really the only institution that can establish a backstop in eurozone sovereign debt markets that is completely credible. This would be especially effective if the ECB targeted an interest rate for Spanish and Italian bonds rather than a quantity of intervention, as I've suggested previously.

But there's another reason that it would be appropriate for the ECB to be at the heart of the solution. In a recent paper (pdf) Paul DeGrauwe points out that an essential ingredient to the crisis is the fact that the adoption of the euro meant that sovereign nations in the eurozone could no longer borrow in their own currency. As he puts it, "in this sense member countries of a monetary union are downgraded to the status of emerging economies." The difficulty this creates is that since the central banks of these countries can no longer provide unlimited domestic currency liquidity to the government, default becomes a possibility in a way that it was not before euro adoption.

The solution to this flaw in the system is to have the new, joint central bank -- the ECB -- take up the role that individual central banks previously had of ensuring that their own government would never have to default on domestic currency debt simply due to liquidity problems. If the ECB were to assume that role today, default would be completely taken off the table as an option for investors to worry about in the markets for Spanish and Italian debt, which would guarantee that this crisis could no longer spin out of control as it is currently threatening to do.

Regardless of whether European leaders agree use the ECB as the immediate solution to the crisis, I would argue that if the eurozone is to survive in the long run, the ECB is going to have to be explicitly granted the authority -- and indeed the responsibility -- for doing just that. If they want to have a common currency and all of its benefits, the eurozone countries need to accept the drawbacks that come with it. And one of those drawbacks is that the ECB will have to not just be the guardian of the eurozone's inflation rate, but will also have to be an effective guardian of Europe's financial system, even at the potential cost of slightly higher inflation during certain limited episodes.

5--Leaked Greek bailout document:

Expansionary fiscal consolidation has failed,
Credit Writedowns
Excerpt: Below is the leaked Greek bailout document that everyone has been talking about. Yesterday, the Financial Times wrote:

Greece’s economy has deteriorated so severely in the last three months that international lenders would have to find €252bn in bail-out loans through the end of the decade unless Greek bondholders are forced to accept severe cuts in their debt repayments.

The dire analysis, contained in a “strictly confidential” report by international lenders and obtained by the Financial Times, is more than double the €109bn in European Union and International Monetary Fund aid agreed just three months ago.

-EU looks at 60% haircuts for Greek debt - FT.com

Here is my understanding of what the Troika analysis demonstrates about the European Sovereign Debt Crisis. We have embedded the document at the bottom of this post.

This leaked Troika "debt sustainability analysis" submitted to the EU Summit yesterday will no doubt be a part of the deliberations in the Greek debt restructuring proposals to be hammered out by Oct. 26th.

Point 1. A. on the first page is a pretty open and blatant admission that expansionary fiscal consolidation (EFC) has proven to be a contradiction in terms, at least in Greece. Moreover, there is a serious policy incompatibility problem, at least over the intermediate term horizon, with efforts at internal devaluation (ID) - that is, attempting nominal domestic private income deflation in order to improve trade prospects when one has a fixed exchange rate constraint.

This latter point is further amplified in the "stress test" scenario discussed on the bottom of page 5, which I think we all know is soon to become the Troika's base case scenario. They stop short of recognizing that their demands and the actions they have imposed on Greek policymakers are setting off a Fisher debt deflation implosion of the Greek economy.

But clearly, the EFC policy is rupturing any semblance of a social contract, and ripping the social fabric to shreds as well.

6--Felix Zulauf: "The die is cast", The Big Picture
Excerpt:

• We are on a spiral caused by mass credit creation, excessive borrowing, reckless spending, and a enormous credit crisis. The end result is inevitable, and most likely unavoidable.

• There will be yet another bailout in the US and QE3 (or more) — but not until the situation gets much worse; That refers to both the market and the economy.

• Of all the currencies in thew world, the US Dollar is the least ugly. That says less about the Greenback than it does about the Euro and Yen.

• The Eurozone was problematic since its inception. You cannot have a monetary union but not simultaneous fiscal union.

• Watch for rising populism in response to economic turmoil. It is already happening in Europe, and will eventually come to the US.

• The political situation in Europe is unlikely to improve until the crisis is much worse. The same is likely true in the US.

7--Philip Pilkington: My European Nightmare – An Infernal Hurricane Gathers?, Naked Capitalism

Excerpt: Here is the key point though: the report essentially states that the current austerity measures are going to butcher the Greek economy. Even if haircuts are taken – and even if these work in bringing down the debt load, which is a big ‘if’ – the Greek economy is assumed to be in for two decades of sluggish growth. (Once again, I’ll point out that, as far as I can see, even this pessimistic report remains too optimistic in this regard).

That leads to the obvious question: do the Eurocrats know all this? Before it was always implicitly assumed that they did not. It was assumed that they were simply deluded about economic recovery in the periphery; not bloody-minded about the implications of austerity. But now we have to question this narrative.

Hence, my nightmare becomes ever more real. What this report suggests is that the Eurocrats know well what they are doing. They are imposing destructive austerity measures – and, let us be frank, pointless asset-stripping drives – on the periphery knowing full well what effect these are going to have.

So, why are they doing this? Well, in light of current evidence we should raise the unpleasant question: is there not the chance that this is really a cynical power-grab? The elites in the core countries have found their political status boosted immeasurably by the present crisis. They will moan that this crisis is awful, of course, but secretly they must know that it is upping their political profile immeasurably and putting them in important decision-making positions.

And so, what if we are moving into a situation where the Eurocrats establish an iron-grip on the periphery through financing arrangements that essentially allow them full control over the imposition of highly destructive economic policies?

Here’s how I see this nightmare scenario unfolding:

Firstly, it is becoming increasingly recognised – most notably by the French and the IMF – that, in order for the Eurozone financial system to regain a modicum of stability, the ECB must step in and back the EFSF. In essence, the ECB must become a sort of unofficial ‘Lender of Last Resort’. If this situation comes about, the Eurocrats will have the ‘unlimited firepower’ – that is, the ECB’s ability to issue currency – with which they can essentially control the bond markets.

If the Eurocrats find themselves in this position they may well opt to keep the periphery bond markets on life support while continuing to insist on austerity… all the while, fully acknowledging – as laid out above in the secret document – what this austerity will mean in real terms: perpetual and unending suffering in the periphery.

Thus the Eurocrisis will be a financial crisis no more. Instead what we will have is the core countries tightening the vice of austerity on the imploding periphery. As can clearly be seen from the projections in the document discussed above, there will be no endgame here and this situation will carry on indefinitely....

the document leaked from within the structures of Europower strongly suggests that the Eurocrats know exactly what they are imposing on the periphery. This further indicates that, come hell or high water, they are going to stick to their guns regarding austerity. Assuming that this state of affairs is not going to last for two decades or more, the game-change is then sure to come from within the periphery countries.

Last time we saw such austerity policies being forcibly imposed on a country within Europe – I refer, of course, to the debt extractions that took place after WWI – we got Hitler. Greece, of course, is far too small a country to produce a Hitler. But that is not to say that it could not produce something a little smaller, but for that, no less dangerous to the Greek people. A Pinochet, for example.

8--Dear bondholders, you are invited to…Ft Alphaville

Excerpt: ...The full statement from the euro summit is out.

The details begin on page 4 and, as reported, private Greece bondholders are “invited” to take a 50 per cent haircut, while the official sector will contribute up to €30bn. This is expected to take the debt:GDP ratio of Greece to 120 per cent by 2020. There’s also agreement to leverage the EFSF up to four or five times, with both the bond insurance and the SPV options being accepted.

First, the haircuts:

The Private Sector Involvement (PSI) has a vital role in establishing the sustainability of the Greek debt. Therefore we welcome the current discussion between Greece and its private investors to find a solution for a deeper PSI. Together with an ambitious reform programmefor the Greek economy, the PSI should secure the decline of the Greek debt to GDP ratio with an objective of reaching 120% by 2020. To this end we invite Greece, private investors and all parties concerned to develop a voluntary bond exchange with a nominal discount of 50% on notional Greek debt held by private investors. The Euro zone Member States would contribute to the PSI package up to 30 bn euro. On that basis, the official sector stands ready to provide additional programme financing of up to 100 bn euro until 2014, including the required recapitalisation of Greek banks. The new programme should be agreed by the end of 2011 and the exchange of bonds should be implemented at the beginning of 2012. We call on the IMF to continue to contribute to the financing of the new Greek programme.
In terms of leveraging the EFSF:

19. We agree on two basic options to leverage the resources of the EFSF:

• providing credit enhancement to new debt issued by Member States, thus reducing thefunding cost. Purchasing this risk insurance would be offered to private investors as an option when buying bonds in the primary market;

• maximising the funding arrangements of the EFSF with a combination of resources from private and public financial institutions and investors, which can be arranged through Special Purpose Vehicles. This will enlarge the amount of resources available to extend loans, for bank recapitalization and for buying bonds in the primary and secondary markets.
20. The EFSF will have the flexibility to use these two options simultaneously, deploying them depending on the specific objective pursued and on market circumstances. The leverage effect of each option will vary, depending on their specific features and market conditions, but could be up to four or five.

9--Vital Signs: Consumer Confidence Tumbles, WSJ

Excerpt: Americans’ outlook became more downbeat this month. In October, an index of consumer confidence fell to 39.8 — the lowest level since March 2009 — from 46.4 in September. It isn’t clear if the drop reflects a worsening economy or if consumers’ bleaker outlook will incline them to spend less. Indeed, the survey the index is based on showed that in October, more people said they planned on buying a major appliance than in September. (See chart)

Wednesday, October 26, 2011

Today's links

1-Euro roundup, Wall Street Journal

Excerpt: With European Union leaders heading from one pivotal summit to another, intense negotiations are underway to hammer out details on a plan to stem the euro debt crisis, including a sweeping recapitalization of European banks, a bigger bailout fund and a substantial restructuring of Greece’s debt. EU and euro-zone leaders are meeting again on Wednesday to finalize a deal after laying out the foundations for a bank recapitalization plan and leveraging of the European Financial Stability Facility at meetings Sunday.

Pressure is mounting on euro-zone leaders to deliver a convincing plan before G-20 leaders meet Nov. 3-4. The situation is fluid due to the complex nature of negotiations, meaning timetables are still be susceptible to change. EU finance ministers are likely to meet ahead of the summit, while the German Parliament has also scheduled a critical debate for Wednesday to approve any changes to the EFSF’s role. There are now two options for the EFSF on the table, which could be combined. One is an insurance plan that foresees the fund’s setting aside a pool of money that could be used to offset part of any losses suffered by purchasers of the debt of weak countries, such as Italy. The other would be to create a special, separate fund, which would raise money from private investors and others, like sovereign-wealth funds, to buy debt of weak countries. The EFSF would also participate in the fund–but would suffer the first losses. The scale of write-downs on Greek debt as part of a second bailout agreement for the country are also still being finalized. The range of a write-down under discussion is between 40% and 60%, with Germany at the high end and France at the low.

2--European Banks Warn of Credit Drought, Bloomberg

Excerpt: European banks say they have to cut assets to help satisfy a government push to boost capital faster than planned to insulate them against the sovereign debt crisis. That may trigger a credit crunch for companies and consumers throughout the 17-nation euro zone, helping to push its economy into recession, say Citigroup Inc. and Deutsche Bank AG analysts.

Leaders meet today in Brussels to approve a plan to increase lenders’ capital by about 100 billion euros ($139 billion). Banks say they will more likely achieve the new requirements by shrinking rather than raising cash from shareholders, a scenario they want to avoid partly because their share prices have fallen 30 percent this year....

Banks are more important to the European economy than they are in the U.S., according Bank of America Corp. economist Laurence Boone. She calculates that loans to the private sector totaled 145 percent of gross domestic product in 2007, more than double that of the U.S., where companies rely more on stock and bond markets for capital.

James Ferguson, head of strategy at Arbuthnot Securities Ltd. in London, draws parallels between Europe’s current situation and the credit crunches suffered in recent decades by Japan, the U.S. and the U.K.

“History shows that bank recapitalizations provide the catalyst for the credit crunch,” he said in an Oct. 20 note. “Japan learned this in 1998, and the U.S. and the U.K. in 2008. Continental Europe’s lesson starts now.”

Banks across Europe have announced they will trim more than 775 billion euros from their balance sheets in the next two years to reduce short-term funding needs and achieve the 9 percent in regulatory capital required by the Basel Committee on Banking Supervision ahead of schedule, according to data compiled by Bloomberg. They may be required by policy makers today to meet this ratio by the end of June, two people with knowledge of the talks said....

Deutsche Bank CEO Josef Ackermann, 63, who said on Oct. 13 that banks may be forced to restrict lending “due to possible debt haircuts in the euro zone.”

Regulators say the risk of reduced lending is worth taking in light of a bigger concern about the banks’ ability to find short-term funding on the markets at a time when investors are questioning their sovereign debt holdings....

“The banks need to deleverage, but if they choose to deleverage by cutting assets not by raising equity then it will have negative consequences for the economy,” Simon Maughan, head of sales at MF Global Holdings Ltd. in London. “It’s much better to force a deleveraging through more equity even if that means it has to be forcibly injected in the banks.”

3--On political dysfunction in Europe, Naked Capitalism

Excerpt:...Fiscal consolidation is not expansionary. Moreover, it increases deficits due to the increase in spending on fiscal stabilisers and the decrease in tax receipts – that is unless the cuts are extremely large. There is zero chance that Greece will make its targets. I don’t expect Portugal, Italy, Ireland or Spain to meet their targets either, especially given the incipient double dip we are witnessing.

As the Germans are likely to see their fiscal trajectory deteriorate markedly in this environment due to the anaemic domestic demand and dependence on exports, their willingness to fund bailouts will evaporate. The political calculus may turn to topping up capital at underfunded German banks. Greece, at a minimum, will default. Indeed, without the ECB’s assistance Italy would default – that’s the real Armageddon scenario because no amount of recapitalisation would prevent a deep depression. Stark’s resignation increases the chances that just this will occur....

On the fourth topic of Germany having its fill of bailouts and moving to recapitalisation, that is definitely what is happening here. But Italy is the real problem for the Germans. Politically, there is no appetite to bail out the Italians. As I said above, “without the ECB’s assistance Italy would default – that’s the real Armageddon scenario because no amount of recapitalisation would prevent a deep depression.” The ECB is going to have to monetise Italian debt or a deep Depression is coming. There is no other choice. Silvio Berlusconi recognizes this and said as much yesterday. However, the ECB needs movement on the reform front first. The question is whether the reforms happen before the bank sector implodes and sovereign yields in Italy and Belgium spike. If they don’t, there will be contagion into the real economy and the recession in the euro zone will deepen.

Yes, I still think the euro zone is coming apart at the seams.

4--Chart of the Day: US Income Growth 1979-2007, Credit Writedowns

Excerpt: (Must see chart)

The CBO writes:

From 1979 to 2007, real (inflation-adjusted) average household income, measured after government transfers and federal taxes, grew by 62 percent. That growth was not equal across the income distribution: Income after government transfers and federal taxes (denoted as after-tax income) for households at the higher end of the income scale rose much more rapidly than income for households in the middle and at the lower end of the income scale.

In a study prepared at the request of the Chairman and former Ranking Member of the Senate Committee on Finance, CBO examines the trends in the distribution of household income between 1979 and 2007. (Those endpoints allow comparisons between periods of similar overall economic activity.)

After-Tax Income Grew More for the Highest-Income Households

CBO finds that between 1979 and 2007:

--For the 1 percent of the population with the highest income, average real after-tax household income grew by 275 percent (see figure below).
--For others in the 20 percent of the population with the highest income, average real after-tax household income grew by 65 percent.
--For the 60 percent of the population in the middle of the income scale, the growth in average real after-tax household income was just under 40 percent.
--For the 20 percent of the population with the lowest income, the growth in average real after-tax household income was about 18 percent.
[…]

Market Income Shifted Toward Higher-Income Households

The major reason for the growing unevenness in the distribution of after-tax income was an increase in the concentration of market income—income measured before government transfers and taxes—in favor of higher-income households. Specifically, over the 1979 to 2007 period, the highest income quintile’s share of market income increased from 50 percent to 60 percent (see figure below), while the share of market income for every other quintile declined. In fact, the distribution of market income became more unequal almost continuously between 1979 and 2007 except during the recessions in 1990–1991 and 2001.

5--It's consumer spending, stupid, New York Times

Excerpt: AS an economic historian who has been studying American capitalism for 35 years, I’m going to let you in on the best-kept secret of the last century: private investment — that is, using business profits to increase productivity and output — doesn’t actually drive economic growth. Consumer debt and government spending do. Private investment isn’t even necessary to promote growth.

Between 1900 and 2000, real gross domestic product per capita (the output of goods and services per person) grew more than 600 percent. Meanwhile, net business investment declined 70 percent as a share of G.D.P. What’s more, in 1900 almost all investment came from the private sector — from companies, not from government — whereas in 2000, most investment was either from government spending (out of tax revenues) or “residential investment,” which means consumer spending on housing, rather than business expenditure on plants, equipment and labor.

In other words, over the course of the last century, net business investment atrophied while G.D.P. per capita increased spectacularly. And the source of that growth? Increased consumer spending, coupled with and amplified by government outlays.

The architects of the Reagan revolution tried to reverse these trends as a cure for the stagflation of the 1970s, but couldn’t. In fact, private or business investment kept declining in the ’80s and after. Peter G. Peterson, a former commerce secretary, complained that real growth after 1982 — after President Ronald Reagan cut corporate tax rates — coincided with “by far the weakest net investment effort in our postwar history.”

President George W. Bush’s tax cuts had similar effects between 2001 and 2007: real growth in the absence of new investment. According to the Organization for Economic Cooperation and Development, retained corporate earnings that remain uninvested are now close to 8 percent of G.D.P., a staggering sum in view of the unemployment crisis we face.

So corporate profits do not drive economic growth — they’re just restless sums of surplus capital, ready to flood speculative markets at home and abroad. In the 1920s, they inflated the stock market bubble, and then caused the Great Crash. Since the Reagan revolution, these superfluous profits have fed corporate mergers and takeovers, driven the dot-com craze, financed the “shadow banking” system of hedge funds and securitized investment vehicles, fueled monetary meltdowns in every hemisphere and inflated the housing bubble.

Why, then, do so many Americans support cutting taxes on corporate profits while insisting that thrift is the cure for what ails the rest of us, as individuals and a nation? Why have the 99 percent looked to the 1 percent for leadership when it comes to our economic future?...

Consumer spending is not only the key to economic recovery in the short term; it’s also necessary for balanced growth in the long term. If our goal is to repair our damaged economy, we should bank on consumer culture — and that entails a redistribution of income away from profits toward wages, enabled by tax policy and enforced by government spending. (The increased trade deficit that might result should not deter us, since a large portion of manufactured imports come from American-owned multinational corporations that operate overseas.)

We don’t need the traders and the C.E.O.’s and the analysts — the 1 percent — to collect and manage our savings. Instead, we consumers need to save less and spend more in the name of a better future.

6--The Demand Doctor, John Cassidy, The New Yorker

Excerpt:...In “The General Theory,” Keynes took aim at this view of the world. His central insight was that the economy was driven not by prices but by what he called “effective demand”—the over-all level of demand for goods and services, whether cars or meals in fancy restaurants. If car manufacturers perceived that the demand for their products was lagging, they wouldn’t hire new workers, however low wages fell. If a restaurateur had vacant tables night after night, he would have no incentive to borrow money and open a new venture, even if his bank was offering him cheap loans. In such a situation, the economy could easily remain stuck in a rut, until some outside agency—the government was Keynes’s favored candidate—intervened and spurred spending. Only then would private businesses be emboldened to expand production and hire workers.

Nasar, in her capacious and absorbing book, makes the key point well:

What made the General Theory so radical was Keynes’s proof that it was possible for a free market economy to settle into states in which workers and machines remained idle for prolonged periods of time. . . . The only way to revive business confidence and get the private sector spending again was by cutting taxes and letting business and individuals keep more of their income so they could spend it. Or, better yet, having the government spend more money directly, since that would guarantee that 100 percent of it would be spent rather than saved. If the private sector couldn’t or wouldn’t spend, the government would have to do it. For Keynes, the government had to be prepared to act as the spender of last resort, just as the central bank acted as the lender of last resort....

In the course of his career, Keynes advocated tax cuts and interest-rate cuts, but he didn’t limit himself to those measures. During the nineteen-twenties, when the unemployment rate reached double figures, and British monetary policy was hamstrung by the gold standard, Keynes called for additional spending on public housing, roadworks, and other civic projects. “Let us be up and doing, using our idle resources to increase our wealth,” he wrote in 1928. “With men and plants unemployed, it is ridiculous to say that we cannot afford these new developments. It is precisely with these plants and these men that we shall afford them.”...

In the summer of 1931, the government made deep spending cuts, intending to restore confidence in government finances. Keynes warned that the effect would be to worsen the slump, throwing more people out of work. He said that budget deficits were a by-product of recessions, and that they served a useful purpose: “For Government borrowing of one kind or another is nature’s remedy, so to speak, for preventing business losses from being, in so severe a slump as the present one, so great as to bring production altogether to a standstill.”...

It is a complete mistake to believe that there is a dilemma between schemes for increasing employment and schemes for balancing the Budget,” Keynes wrote. “There is no possibility of balancing the Budget except by increasing the national income, which is much the same thing as increasing employment.”...

A wartime economy may present a special case, but a recent working paper published by the National Bureau of Economic Research looked at data going back to 1980 and found that government investments in infrastructure and civic projects had a multiplier of 1.8—pretty close to Keynes’s estimate.

So why didn’t the Obama Administration’s 2009 stimulus package usher in a true recovery? Keynes would have pointed out that, with households and firms intent on paying down debts and building up their savings in the aftermath of a credit binge, large-scale deficit spending is needed merely to prevent a recession from turning into a depression. With interest rates already close to zero, Keynes would have argued that the economy was stuck in a “liquidity trap,” greatly limiting the Federal Reserve’s scope for further action. He would also have noted that the stimulus was—especially compared with the devastation it meant to address—rather small: equivalent to less than two per cent of G.D.P. a year for three years. Even this overstates its magnitude, given that much of the increase in federal spending was offset by budget cuts at the state and local levels. In its totality, government spending didn’t increase much at all. Between 2007 and the first half of this year, it rose by about three per cent in real dollars...

The recent slowdown in the U.S. economy occurred just as Obama’s 2009 stimulus package was running dry. The U.K. economy provides an even more striking case study. As in this country, the authorities reacted to the 2008 financial crisis by cutting interest rates, boosting public expenditure, and allowing the budget deficit to rise sharply. In 2009 and in the first part of 2010, the economy began to recover. But since the middle of last year, when the Conservative-Liberal coalition announced substantial budget cuts to balance the budget, growth has virtually disappeared. “The reason the current strategy will fail was succinctly stated by John Maynard Keynes,” Robert Skidelsky and the economist Felix Martin wrote in the Financial Times recently. “Growth depends on aggregate demand. If you reduce aggregate demand, you reduce growth.”...

Yet Keynes was anything but a spendthrift. When deficits and debts reached historically high levels, he believed, it was necessary to spell out how they would be reduced in the long term. As Backhouse and Bateman observe in their timely and provocative reappraisal, Keynes never said that deficits don’t matter (the lesson that Dick Cheney reportedly drew from President Reagan). He believed not only that large-scale deficit spending should be confined to recessions, when business investment was unusually curtailed, but that it should be directed mainly toward long-term capital projects that eventually would pay for themselves. When some of his followers, by way of postwar planning, advocated using tax cuts and deficit spending to “fine-tune” the economy on an ongoing basis, Keynes struck a note of caution. “If serious unemployment does develop, deficit financing is absolutely certain to happen, and I should like to keep free to object hereafter to the more objectionable forms of it,” he wrote....

Even his great intellectual contribution—the notion that economies can remain in an “equilibrium” state with mass unemployment—defies easy explanation. How exactly does it come about? Not simply because, as textbooks often suggest, prices and wages get “stuck,” maybe as a result of union contracts. Keynes was convinced that, even if wages and prices are flexible, the economy could remain mired...

7--Examining Keynes’ Letters to Franklin Roosevelt, Rortybomb

Excerpt: Keynes also noted that getting the housing market straightened out is one of the best ways to handle the Depression. “Housing is by far the best aid to recovery because of the large and continuing scale of potential demand; because of the wide geographical distribution of this demand; and because the sources of its finance are largely independent of the Stock Exchanges.” Getting the housing market right is also an uphill battle for our recession and administration....

Since we are looking at Keynes’ letters to President Roosevelt, let’s look at his 1933 open letter to FDR, published in the New York Times. Among other recommendations, he advises the new administration to do two things on the domestic front (my bold):

If you were to ask me what I would suggest in concrete terms for the immediate future, I would reply thus… In the field of domestic policy, I put in the forefront, for the reasons given above, a large volume of Loan-expenditures under Government auspices. It is beyond my province to choose particular objects of expenditure. But preference should be given to those which can be made to mature quickly on a large scale, as for example the rehabilitation of the physical condition of the railroads… You can at least feel sure that the country will be better enriched by such projects than by the involuntary idleness of millions.

I put in the second place the maintenance of cheap and abundant credit and in particular the reduction of the long-term rates of interest. The turn of the tide in great Britain is largely attributable to the reduction in the long-term rate of interest which ensued on the success of the conversion of the War Loan. This was deliberately engineered by means of the open-market policy of the Bank of England. I see no reason why you should not reduce the rate of interest on your long-term Government Bonds to 2½ per cent or less with favourable repercussions on the whole bond market, if only the Federal Reserve System would replace its present holdings of short-dated Treasury issues by purchasing long-dated issues in exchange. Such a policy might become effective in the course of a few months, and I attach great importance to it.....

His first suggestion constitutes fiscal stimulus. But his second suggestion is urging the Federal Reserve to replace its short-term bonds with long-term bonds to bring down the rates on the long-term bonds — just like Operation Twist! Equally interesting, instead of naming an amount of Treasuries to buy, like $800 billion or $2 trillion, Keynes says to hit a specific rate. The Federal Reserve can either set a rate or an amount, and we’ve been doing QE through setting purchase amounts. Maybe this other way that he suggests, having QE set a target for long-term rates, is a better way of doing QE? He’s a pretty smart fellow.

Monday, October 24, 2011

Today's links

1--There's a hole in the bucket, Paul Krugman, New York Times

Excerpt: The torments of the euro would be funny if they weren’t so tragic. At this point the urgent need is for a big Panzerfaust — a bailout fund big enough to head off a self-fulfilling liquidity crisis for Italy. But such a fund would be backed by the credit of the euro area’s remaining AAA governments, basically Germany and France — yet at this point the euro situation has deteriorated sufficiently that taking on another commitment would undermine French credit. There’s a hole in the bucket, and every attempt to fix that hole ends up being stymied because, well, there’s a hole in the bucket.

The answer to the whole conundrum is to back the rescue, not with French guarantees, but with the power of the printing press — to put the ECB behind the effort. But the ECB won’t and maybe can’t (under current rules) do that.

And meanwhile, austerity programs are leading to severe slumps in Greece and elsewhere. Who could have imagined that?

What a tragedy. A rich, productive continent, which has produced arguably the most decent societies in human history, is tearing itself apart because its elite insisted on embarking on a dubious monetary project, and now can’t bring itself to take the steps necessary to give that project a chance of working.

2--Number of the Week: GDP 6.7% Below Potential, WSJ

Excerpt: 6.7%: The gap between U.S. GDP and its potential.

It looks as if, despite everything, gross domestic product picked up in the third quarter, easing fears that the U.S. was on the cusp of another recession. But that doesn’t mean the economy is anywhere near where it needs to be.

Economists expect Thursday’s GDP report from the Commerce Department will show the economy grew at a 2.7% annual rate in the third quarter. That would still leave economic output 6.7% below what the Congressional Budget Office estimates its potential is. In other words, in a world where employment and economic activity were as high as they could be without the economy running into inflationary trouble, the U.S. would be producing about $900 billion more in goods and services a year than it is now.

Experts quibble about exactly where potential GDP is these days, and that’s especially true in light of all the damage the economy has suffered. Companies have invested less on new plants and equipment, unemployed workers’ skills have eroded, and some people have exited the work force for good — all things that have likely lowered the economy’s potential. But even so, everyone agrees it is still much, much higher than we're getting now.

3--Recovery before reform, Robert Skidelsky, Project Syndicate

Excerpt:The financial crisis that started in 2007 shrunk the world economy by 6% in two years, doubling unemployment. Its proximate cause was predatory bank lending, so people are naturally angry and want heads and bonuses to roll – a sentiment captured by the current worldwide protests against “Wall Street.”

The banks, however, are not just part of the problem, but an essential part of the solution. The same institutions that caused the crisis must help to solve it, by starting to lend again. With global demand flagging, the priority has to be recovery, without abandoning the goal of reform – a difficult line to tread politically....

Glass-Steagall aimed to prevent commercial banks from gambling with their depositors’ money by mandating the institutional separation of retail and investment banking. The result was 65 years of relative financial stability. In what economists later called the “repressed” financial system, retail banks fulfilled the necessary function of financial intermediation without taking on suicidal risks, while the government kept aggregate demand high enough to maintain a full-employment level of investment.

4--‘Tread Lightly in Stocks’ as TED Spread Widens: Chart of the Day, Bloomberg

Excerpt: Investors ought to “tread lightly in stocks” because credit markets have yet to show the kind of optimism that lifted share prices this month, according to Gina Martin Adams, a Wells Fargo & Co. strategist.

The CHART OF THE DAY highlights an indicator that Martin Adams used to draw her conclusion: the TED spread, or the gap between what financial companies and the U.S. government have to pay for three-month loans. The chart compares the spread with the Standard & Poor’s 500 Index since 2009.

During the first two weeks of October, the differential widened by four basis points, or 0.04 percentage point. The S&P 500, in contrast, recorded its biggest two-week gain since July 2009 by climbing 8.2 percent.

“Credit markets have not confirmed the positive tone of equities,” Martin Adams, who is based in New York, wrote in the report. That’s “usually a warning sign worth noting.”

From the end of July through the end of last week, the TED spread more than doubled to 39.5 basis points. The gap tends to widen as concern about credit risk increases, and vice versa.

5--U.S. Economy Trapped by Its Circle of Strife, WSJ

Excerpt: Bursts of enthusiasm aren't uncommon in bear markets. But they should be watched with caution.

Consider Japan. Just when the nation's stock market finally seemed to have stabilized, in the fall of 1991, another downdraft began.

The Nikkei 225 index, already down 35% from its December 1989 peak, went on to drop another 35% by the following summer. But even that wasn't the bottom. Nor was the next low in mid-1995. Nor the following one in late 1998.

The Nikkei, in fact, didn't bottom until it reached 7607 in April 2003. The 80% decline took 13 years to fully play out. And just when the deflation finally appeared to be over, the global financial crisis hit and pushed stocks to a fresh low again.

There are many important differences between Japan's experience and the U.S. today. But both instances, along with the Great Depression, are classic examples of credit booms turned bust. These are fundamentally different from garden-variety recessions and expansions triggered by inventory or demand shocks.

They are supercycles in terms of both time frame and scope. They are marked by asset-price bubbles that, upon reversal, trigger financial crises as the banking system struggles to stay afloat. And importantly, these financial crises tend to occur at the start—not end—of the debt-shedding process that can take years or even decades fully to play out.

6--Workers Lose Pricing Power, WSJ

Excerpt: Competition drives down prices. This is as true in the labor market as with any other marketplace.


Labor Department figures out Tuesday showed the number of U.S. job openings fell in August for the first time in four months, to about 3.1 million. At the same time, the number of unemployed rose to nearly 14 million. In other words, there were roughly 4.6 job seekers for every opening in August, up from 4.3 in July.

Little wonder that the average hourly earnings of workers declined during the month. In fact, intense competition for jobs is a key reason why U.S. incomes broadly are under so much pressure. There were never more than three job seekers per opening even during the worst of the last jobless recovery. That figure shot as high as seven during the worst of the recession in 2009. Today, it has yet to recover to anything like the average of two seekers per opening during the expansion of 2004-07.

This helps explain the sharp recent worsening of U.S. household finances—and sentiment. A study by two former Census officials released Monday showed that in real terms, the annual income of the typical U.S. household has fallen from $55,309 in December 2007 to $49,909 as of June, a drop just shy of 10%. This is partly because of the higher unemployment rate. Even for households headed by a full-time worker, however, median income has fallen by more than 5%.

And as Credit Suisse economist Henry Mo points out, even if all U.S. job vacancies were filled overnight, nearly 11 million workers would still be unemployed—and that doesn't include the nine million working part-time who would prefer full-time work and the 1.2 million who have given up looking altogether. Although the pace of layoffs has slowed, there simply aren't enough new positions to go around. In fact, separate Labor Department figures show the average number of people employed by new firms has been on a downward trend for two decades.

Given all this, deflationary pressure on incomes is likely to persist. While that helps companies control costs, it will also constrain consumer spending. That is because prices of certain household necessities, like food and gas, haven't been deflationary enough. The global commodity market is much tighter than the U.S. labor market. This, unfortunately, is the new normal.

7--Greek haircuts and Greek myths — the details, FT Alphaville

Excerpt:s ...FT Alphaville has also taken a look at “Greece: Debt Sustainability Analysis”, an assessment prepared by European Commission economists for discussion on Friday among European finance ministers.

The headline: it suggests private bondholders will be pushed to take 50 or 60 per cent haircuts.....

The assessment shows that debt will remain high for the entire forecast horizon. While it would decline at a slow rate given heavy official support at low interest rates (through the EFSF as agreed at the July 21 Summit), this trajectory is not robust to a range of shocks. Making debt sustainable will require an ambitious combination of official support and private sector involvement (PSI). Even with much stronger PSI, large official sector support would be needed for an extended period. In this sense, ultimately sustainability depends on the strength of the official sector commitment to Greece....


Making Greek debt sustainable requires an appropriate combination of new official support on generous terms and additional debt relief from private creditors: · Large, long-term, and sufficiently generous official support will be necessary for Greece to remain current on its debt service payments and to facilitate a declining debt trajectory.....

Under the assumptions used, the time required to get back to market could be significant, generating a potential need for additional official financing ranging up to €440 billion (i.e. under the worst case of the scenarios studied here, the faster macro adjustment shock)....

The results show that debt can be brought to just above120 percent of GDP by end-2020 if 50 percent discounts are applied. Given still-delayed market access, large scale additional official financing requirements would remain, estimated at some €114 billion (under the market access assumptions used). To get the debt down further would require a larger private sector contribution (for instance, to reduce debt below 110 percent of GDP by 2020 would require a face value reduction of at least 60 percent and/or more concessional official sector financing terms). Additional official financing requirements could be reduced to an estimated €109 billion in this instance. Of course, it must be noted that the estimated costs to the official sector exclude any contagion-related costs....

Depressing, sure — but also necessary and achievable, though it’ll still take more than what’s in this document.

For what the report doesn’t seem to cover is — unsurpisingly — the role of official creditors. As UBS economists noted earlier this week, even 50 or 60 per cent haircuts won’t be enough. A 110-120 per cent debt to GDP by 2020 (as suggested in the scenario) remains highly dangerous.

Indeed, there appears to be concern, to put it lightly, at the ECB about the scenarios used in the report. Scenarios that get a little close to home, perhaps. Here’s an interesting footnote to the last quoted paragraph:

The ECB does not agree with the inclusion of these illustrative scenarios concerning a deeper PSI in this report.
Because, as FT Alphaville’s Joseph Cotterill adds in an email to us, “either the official creditors take haircuts too (ha!) OR they’ll be discussing 90-100 per cent private haircuts soon enough.”

8--More on that looming crunch de crédit, FT Alphaville

Excerpt: The looming European credit crunch may not be the first thing on European leaders’ minds this weekend, but it’s coming, at least according to Citigroup....

The ECB, of course, announced on 6 October that it was reintroducing longer-term refinancing operations (LTROs), but that won’t be enough to stop a downward spiral of asset shedding, capital raising, loan contraction and reduced growth, suggests Citi.

From the note, emphasis ours:

Banks to shrink their balance sheets to replenish their capital buffers...

We suspect that the flow of loans to the private sector (see Figure 5) will be reduced to a trickle, as it was in the six quarters ending in Q1 2010...

We believe that unless investors’ perception of risk related to bank debt diminishes significantly over the next few months, a larger net proportion of banks will tighten lending standards and the supply of loans will decline. The magnitude of the resulting credit squeeze will be determined by the extent to which this phenomenon is concomitant to a contraction in demand....

Compared to the consensus, we are pessimistic about the ability of the euro area to grow in 2012, not only because we do not expect a solution to be found at the Euro summit that will solve the crisis, but also because we fear that the deterioration in macro leading indicators has further to run. We expect a mild recession in 2012, with negative quarterly GDP growth from Q4 2011 to Q3 2012. While most core countries might avoid a technical recession, we believe that the size of the fiscal tightening effort in financially-supported countries will lead to a sizeable fall in economic activity in those countries, hence dragging down the Euro zone aggregate.

9--Deck Chairs, Titanic, Paul Krugman, New York Times

Excerpt: OK, yes, European banks do need more capital. But their problems are a symptom of the underlying sovereign debt problem, which can only be resolved, if at all, with ECB lending AND a commitment to reflate. Without that, the losses on sovereign debt will blow right through any amount of newly raised bank capital.

So when I read

Europe’s big banks will be forced to find €108bn ($150bn) of fresh capital over the next six to nine months under a deal to strengthen the banking system agreed by European Union finance ministers.
I think, this is a band-aid — and one that’s going to be applied gradually, over six to nine months! — when the patient is at risk of dying in a few weeks from damage to his internal organs.