naked capitalism

Edward Harrison here.

We seem to be moving forward with this discussion on monetary policy, banking, and reserves. Things seemed to be veering wildly off track but I have seen a huge number of good comments in the last 24 hours. Now, John Carney does a good job of summarising some of the initial forays in this back and forth that started between Steve Keen and Paul Krugman but that has since branched out. I am going to try my hand at framing the discussion here in order to weed out a lot of the extraneous stuff. Where there are mistakes, I will fix them accordingly as they are pointed out. I think this is pretty important, so please pay attention to this one.

The comments from the last post I wrote and from a follow on post by Tom Hickey at Mike Norman’s blog got at the heart of the debate and so I will try to characterise what was said.

Framing

We have been living in a world predominated by floating exchange rates and currency non-convertibility for forty years now. Nevertheless, most of economics world seems to take a fixed exchange rate, Bretton Woods, or gold standard view of money and banking. In that world, as Warren Mosler quipped, bank lending is reserve constrained with the interest rate an endogenous variable via bank competition for reserves.

I put it this way in December [emphasis added]:

In the old gold convertible system, the central bank had to jack up rates to prevent an outflow of gold. Interest rates were the release valve. But in those old days, only by adjusting the gold peg i.e. depreciating the currency, could countries under attack get away with low rates once the vigilantes were on to them. That’s what happened during the Great Depression. Once the conversion was broken, the currency depreciated and depression lessened immediately.

Today the release valve is always the currency because there is no gold tether. So the currency gives way, not interest rates.

-Bond vigilantes and the currency relief valve

What this in effect means for the domestic banking system is that in a nonconvertible floating exchange rate system, lending is not reserve constrained as banks can create reserves by making a loan that creates a deposit. Any one institution can always borrow reserves from other banks or from the Fed itself if it finds itself short of reserves (See this BIS paper from 2010 for further discussion).

The US government, as monopoly issuer of its own sovereign currency, has given the Fed monopoly power in the market for base money. The Fed then exercises this monopoly power by targeting the overnight rate for money, the fed funds rate. That is to say, the Fed targets a rate or a price, not a quantity. Almost all modern central banks of today operate with explicit interest rate targets, allowing the overnight rate to fluctuate within a range. Any monopolist can only control either price or quantity, not both. Now, central banks could target something else like reserves to transmit monetary policy into the economy; and they have done in the past. The Fed targeted reserves from 1979-1982. What the Fed found was that it had only a controlling influence on base money because targeting the monetary base meant volatility in interest rates (see this 2004 ECB paper for further discussion). But, more importantly, because bank loans create deposits that actually need reserves to maintain the integrity of the payments system, the Fed is forced to supply them according to its legal mandate.

In short, reserves are about helping set interest rates, not about pyramiding money on a reserve base.

Under present institutional arrangements, the Fed Funds rate is dependent on the Fed’s supplying the required amount of reserves at any given reserve ratio to keep the interest rate at its target or within its target band.  The Fed can’t target a rate unless it supplies banks with all the reserves that the banks need to make loans at that rate. This means that central banks must be committed to supplying as many reserves as banks want/need in accordance with the lending that they do subject to their capital constraints. Failure to supply the reserves means failure to hit the interest rate target. So in practice, if a banking system as a whole is at the reserve limit, central banks always increase the level of reserves desired by the system in order to maintain the interest rate. Not doing so means at once that the Fed cannot hit its target or that transactions fail as the payments system breaks down.

In sum: In a nonconvertible. floating exchange rate system, the amount of credit in the system is determined by the risk-reward calculations of banks in granting loans and the demand for those loans. Banks are not reserve constrained. They are capital constrained. Financial institutions grant credit based on the capital they have to deal with losses associated with that activity.

I don’t think anything I wrote is particularly controversial for those with banking and money as their primary economic discipline or area of study. But if you read textbooks like the one I got in business school by Glenn Hubbard, you find sentences like "The monetary base sometimes is called high-powered money because a given amount of base allows creation of a multiple amount of money" (p. 420, Money, the Financial System and the Economy, Hubbard, 1995). This suggests that the banks in fact are pyramiding credit/money creation on the back of reserves when this is not the case. I checked my intro college economics textbook by Baumol and Blinder from 1985 and it’s exactly the same kind of stuff. The reality is that banks are not reserve-constrained because the Fed must supply reserves to back loans already granted. Only if and when the Fed decides to raise the fed funds rate to curtail credit growth will reserves be constrained. And they will be demand-constrained, not supply-constrained.

Central Bank Flexibility – tactics, strategy, and policy

Given that framing above, the question everyone is asking is whether any of that matters over the long-term. Here’s how I explained Nick Rowe’s objection to the concept of endogenous money:

I think the real difference between what Nick Rowe is saying and what people like Scott Fullwiler and Steve Keen are saying is that Nick believes over the medium-term, central bank interest rate policy is endogenous. What I think Nick means is that Scott Fullwiler’s view is reasonably clear and straightforward in his view that central monetary policy is exogenous but that it only matters over a short-term time horizon because central bank interest rate policy adjusts endogenously over the medium-term to commercial bank and other economic variables such that it is really endogenous rather than exogenous.

Further, I think Nick Rowe is saying that it creates an expectation of central bank interest rate policy merely by announcing its target rate and the market moves to accommodate that target, knowing the central bank is the monopoly supplier of reserves. In that sense the central bank has control. But what he seems to suggest is that the central bank policy rate cannot be determined independent of macroeconomic variables (like inflation specifically) and that central bank may be forced to change policy based on these, making it possible to treat the central bank policy rate as medium-term endogenous.

Nick Rowe says my view of his previous commentary is fairly accurate. Scott Fullwiler doesn’t like the terms short- and medium-term. He would rather see us talk about Fed tactics, strategy and policy.

Scott frames it this way (with minor edits for readability):

1. Tactics – can the central bank directly target reserve balances, monetary base, etc?
2. Strategy – what sort of rules/discretion balance does the central bank follow in adjusting the target it has set tactically. How often? How big of an adjustment each time? By what criteria?
3. Policy – How does the macro economy work and what role can or should the central bank play in stabilizing it?

Scott goes on to say that:

The debate between Krugman/Keen once it got to issues related to the money multiplier and loanable funds was about tactics–can banks individually or collectively create loans without regard to deposits or reserve balances? This is closely linked to an understanding of what banks are/do and hence Krugman’s view that they didn’t need to be included since inserting them didn’t change how one should view the money multiplier or loanable funds models. This is where I jumped in, because Krugman in my view was completely wrong on these points.

But Krugman’s reply to me, and Rowe’s post, brought in strategy and policy–”the central bank must change the interest rate target by adjusting to events and expectations” which is about how the central bank should adjust its target (strategy) within the context of how the macroeconomy works and interacts with monetary policy (policy)…

The MMT view is that we need to understand how the tactics work to inform our strategy and even our understanding of how the economy works. Krugman tried to suggest understanding the tactics is irrelevant to these two. This is a very significant distinction between the approaches.

Further, in MMT, we keep these three (tactics, strategy, policy) separate when we discuss them. Neoclassicals generally don’t–so, when I say the central bank must set an interest rate target (tactics) but can move that target wherever it wants (the possibilities for strategy), Nick says no the cb must set a target that responds to the economy and thus must be endogenous (strategy in the context of view of macroeconomy). We end up talking past each other as I have not invoked yet at all how central banks “should” set strategy with regard to how the macroeconomy works. While we will disagree on the latter, in our view jumping to that without clarifying and setting a common language for tactics and strategy complicates the discussion unnecessarily.

This is progress.

Translation: we agree on the basics here but semantically there are differences. 

• MMT’ers believe the central bank, as monopoly supplier of reserves has monopoly power and therefore full discretion to act as an exogenous actor.
• Nick Rowe says a central bank must set a target that responds iteratively to the economic variables like inflation and thus must be endogenous as a overarching strategy in the context of a macroeconomy).

I think that’s where we stand.

My Conclusions

• We have been living in a world of floating exchange rates and currency non-convertibility but the economics world very often – and wrongly – takes a Bretton Woods view of money and banking.
• The Bretton Woods world is one in which bank lending is reserve constrained with the interest rate an endogenous variable via bank competition for reserves.
• In a nonconvertible floating exchange rate system, lending is not reserve constrained (over the short-term) as banks can create reserves by making a loan that creates a deposit. Any one institution can always borrow reserves from other banks or from the Fed itself if it finds itself short of reserves. If a banking system as a whole is at the reserve limit, central banks always increase the level of reserves desired by the system in order to maintain the interest rate.
• But questions remain about what a central bank can target and to what effect and as to the discretion a central bank has in adjusting any target it has set "tactically". Some say that over the long-term a central bank must respond iteratively to macro economic variables. Others believe the central bank has full discretion to set policy as an exogenous actor.
• My question is whether the above suggests banks MUST be including in any realistic economic model for it to have predictive power even in more extreme economic circumstances like the ones that existed during the great credit bubble. The Great Financial Crisis would suggest yes. yet, many in the economics field resist this notion. Hopefully, we can get more answers on this question as a result of this post.

One more post today, this time on Europe. I wrote this outline for Italy in November before the ECB’s Italian job. I didn’t and still don’t see an Italian exit or default as a baseline. However, a Greek exit for the eurozone has been my baseline for a number of months. Citigroup’s Willem Buiter has talked a lot about this recently. He and his colleagues call it "Grexit". Business Insider’s Simone Foxman has a good synopsis of that view.

Here’s how I see it happening, based on my Italian default post.

1. Plan. The Greek government can plan for a redenomination into New Drachma in secret that takes advantage of the Greek law jurisdiction over their sovereign debt obligations.
2. Law. “Euroization” would remain in place and the euro would continue as the currency of physical payment. However, New Drachma would become the national currency, pegged at 340.75, exactly the same rate as the Drachma was fixed on 19 June 2000 and converted into euros on 1 January 2002. All debt under Greek law would be redenominated into New Drachma at the 340.75 New Drachma exchange rate peg. This would effectively bring us back to 31 December 2001 for Greece.
3. Taxes. The government would announce that henceforth it will tax exclusively in New Drachma. All municipal governments would be required by law to tax in New Drachma. 
4. Banks. Like the Argentines before them, the Greek government would convert all euro bank accounts legally into New Drachma. The systems would process as if it were euros because of the fixed peg, but legally the money would be New Drachma. This would make the Greek economy “euroized” but make the banking system redenominated into New Drachma.
5. Retail. Retailers, all sellers of Greek goods, would then be forced to return to the double accounting treatment of pre-2002 whereby they denominate all transactions in both Drachma and Euros. Again, the paper money would be euros and each euro would initially be worth 340.75 New Drachma. The electronic money would legally be New Drachma, even while the systems said euro.
6. Float. On day one, immediately after redominating, the Greek government would drop the 340.75 New Drachma exchange rate peg and float the new Drachma as a freely floating currency. From that day forward, foreign currency adjustments would need to be made between euro and New Drachma.
7. Physical currency. New Drachma would be printed by the Bank of Greece and introduced to replace euros.

When the present government loses re-election in a few months, the new government will have difficult decisions to make. One of these will be whether to rescind the austerity deal now being hammered out. If they do not accept the deal, Greece must then exit the euro zone.

P.S. – Two posts todat at Credit Writedowns outline the social mood in pictures and video in Greece right now. My take: these deflationary policies mean that nationalism is coming back, just as it came back in the 1930s because a shrinking pie produces an us versus them mentality. See here and here.

Edward Harrison here. I was reading Yves’ excellent post on The Top Twelve Reasons Why You Should Hate the Mortgage Settlement and I thought about a post I wrote a year ago on what this was all about. I am re-posting this post verbatim below but I just want to say a few words first.

Clearly, the Obama Administration is positioning itself for the 2012 general election. The goal is to do the right things and say just enough to make the Administration’s policies appear successful. The messaging is designed to build up a base from which to contrast Obama from the eventual Republican nominee in order to get out the vote. I doubt seriously that Obama’s people want any of these mortgage fraud initiatives to have teeth. After all, the President is going for the Super PAC money.

This is kabuki theater for the masses. it is designed to give those people inclined to vote for a Democrat a reason to do so in November, nothing more.

Original post from 8 Mar 2011 below

Yves Smith wrote a post this morning highlighting the $20 billion mortgage settlement the Obama Administration, the banks and the State Attorneys General are hashing out. Her conclusion is that this is this is a Bailout as Reward for Institutionalized Fraud. Read the post. It is quite good.

Here is my take.

The Administration has now moved into re-election mode. Uppermost in their mind is the need to demonstrate that they have taken the right policy steps on the economy all along. And this means making the recovery stick.

-Obama’s economic agenda for re-election, Nov 2010

What that means is that there will be no foreclosure moratoria, and certainly no ‘fat cats on Wall Street‘ rhetoric. The Obama Administration is looking to cultivate a pro-business profile. This is why erstwhile Obama-basher and GE CEO Jeff Immelt has been brought on side as well. That’s also why Obama has brought Bill Daley into the tent as Chief of Staff. Call it the Jamie Dimon comeback – that’s what I am calling it. Call it whatever you like. The fact is the old Obama Administration already set policy early in 2009 and the new Obama Administration now has to defend it if the President wants to be re-elected, which he clearly does.

So, of course they are going to push for a mortgage settlement. As with the Goldman case this past summer, the number is eye-poppingly large enough to throw a bone to the anti-Wall Street crowd but small enough that it doesn’t jeopardize the still fragile US financial system. Bankers can continue business as usual. And that is the goal, of course. Remember Tim Geithner’s statement about the Administration’s needing to do "deeply unpopular, deeply hard to understand" things to right the economic ship?

I watched exceptionally capable people just get killed in the court of public opinion as they defended those policies on the Hill. This is a necessary part of the office, certainly in financial crises. I think this really says something important about the president, not about me. The test is whether you have people willing to do the things that are deeply unpopular, deeply hard to understand, knowing that they’re necessary to do and better than the alternatives.

More than ever, Tim Geithner runs the show for economic policy. He is the last man standing of the Old Obama team. Volcker, Summers, Orszag, and Romer are all gone. So Geithner’s vision of bailouts and settlements is the one that carries the most weight.

What is Geithner saying with his policies?

• The financial system was on the verge of collapse. We all know that now – about US banks and European ones too. Fed Chair Ben Bernanke has said so as has Bank of England head Mervyn King. The WikiLeaks cables affirmed systemic insolvency as the real issue most demonstrably.
• When presented with a choice of Japan or Sweden as the model for crisis resolution, the US felt the Japan banking crisis response was the best historical precedent. It is still unclear whether this was a political or an economic decision.
• The most difficult political aspect of the banking crisis response was socialising bank losses. All banking crisis bailouts involve some form of loss socialisation and this is a policy which citizens find abhorrent. That’s what Geithner meant most directly about ‘deeply unpopular, deeply hard to understand’.
• Using pro-inflationary monetary policy and fiscal stimulus, the U.S. can put this crisis in the rear view mirror. Low interest rates and a steep yield curve combined with bailouts, stress tests, dividend reductions and private capital will allow time to heal all wounds. That is the Geithner view.
• Once the system is healthy again, it should expand. The reason you need to bail the banks out is that they have expansion opportunities abroad. As emerging markets develop more sophisticated financial markets, the Treasury secretary believes American banks are well positioned to profit. American finance can’t profit if you break up the banks.

I would argue that Tim Geithner believes we are almost at that final stage where the banks are now healthy enough to get bigger and take share in emerging markets. His view is that a more robust regulatory environment will keep things in check and prevent another financial crisis.

I hope this helps to explain why the Obama Administration is keen to get this $20 billion mortgage settlement done. The prevailing view in the Administration is that the U.S. is in a fragile but sustainable recovery. With emerging markets leading the economic recovery and U.S. banks on sounder footing, now is the time to resume the expansion of U.S. financial services. I should also add that given the balance sheet recession in the U.S., the only way banks can expand is via an expansion abroad.

I strongly disagree with this vision of America’s future economic development. But this is the road we are on.

This came in overnight via the FT.

China’s economy expanded 8.9 per cent in the fourth quarter of last year, extending a slowdown that began at the start of 2011 and is expected to continue into 2012.

That’s a full percentage lower than Q1 2011. So clearly the Chinese economy has slowed in reaction to both global slowing and the Chinese authorities’ attempts to cool asset and price inflation. Here’s the thing though:

The gradual slowdown led most analysts to conclude that Beijing has managed to engineer a “soft landing”, as price increases have fallen back from a peak of 6.5 per cent in July to 4.1 per cent in December.

Is that the right analysis? And why?

Many other analysts are also predicting a sharper slowdown in the coming months.

“We expect GDP growth to slow more markedly in the first quarter due to the sharp investment slowdown under way,” economists at Citi said in a note.

JPMorgan expects economic growth to slow to 7.6 per cent from a year earlier in the first quarter of 2012, driven down in part by declining exports to the EU and Japan.

But a deceleration has long been expected – the question has been whether it will be gradual or a hard landing.

Jim O’Neill is saying Chinese GDP numbers are “a blow for the hard landing guys” whereas analysts like Patrick Chovanec are taking the other side.

Poll below

Based on the voting on this poll so far, I see this as a major economic issue where there is no consensus. I think the outcome will be a driving force of stock and bond market valuations globally by the second half of the year.

Source: Financial Times

P.S. – To give you a sense of how China bulls see this, the World bank says China can grow 8pc annually for two decades. Update: Also see my post from last which asks: Has Anyone Noticed The Mammoth Shifts in Chinese Economic Policy? We are now on the backside of the initial burst of Chinese economic policy changes. Now it has to be about domestic consumption.

Edward Harrison here. Happy New Year to Naked Capitalism readers. You’ve probably seen this from early in the morning: Germany printed a negative GDP growth number for Q4. Here’s what I said earlier today at Credit Writedowns about this news.

As I predicted in a message to Credit Writedowns Pro subscribers on Monday, statistics have shown that the German economy has finally succumbed to the deflationary economic policy of the euro zone.

Germany showed first signs of feeling the pain from the euro zone’s debt crisis as the economy shrank in the last three month of 2011, despite outperforming its peers for main part of the year thanks to strong domestic demand and exports.

Gross domestic product (GDP) grew 3.0 percent in 2011, preliminary Federal Statistics Office data showed on Wednesday, below the previous year’s growth rate of 3.7 percent — the fastest since reunification — and in line with a Reuters poll estimate.

But GDP contracted by around 0.25 percent in the fourth quarter of 2011, an official from the Statistics Office added.

"Germany cannot isolate itself so easily from tensions within the euro zone. In addition the export sector is facing a difficult period given the fall in global demand," said Joerg Zeuner, chief economist at VP Bank.

I have been sounding the alarm bell since summer as this is something I said as early as March 2010 would eventually happen when the sovereign debt crisis became acute. Spain [and Italy]’s debt woes and Germany’s intransigence lead to double dip. That’s because Q1 will also be negative for the German economy, according to predictions from German market economists. So much for expansionary fiscal contraction.

The eurozone is in a recession right now. And it is the banking sector where downside risk lies. I stick by wrote in early October at the New York Times:

All indications are that Europe is already in a double-dip recession…The sovereign debt crisis and the fiscal consolidation implemented to deal with it have taken their toll.

None of the current signals indicate the situation will improve without policy support.

[...]

One would not be overstating the case in drawing parallels to the fateful events in 1931 that spread from the Austrian bank Credit Anstalt to the rest of the European banking system and into the U.S., creating bank runs and depression. Until the banks take substantially more credit write-downs and recapitalize, this crisis will continue and get worse.

All of the risk is to the downside here in my view. Will the US also double dip? What about China’s faltering housing and stock markets –can they prevent a hard landing? And what will this mean for investors?

I intend to address all of that today in this week’s newsletter on protecting your wealth in a world of recurring crisis and downside risk. I will have a lot more to say about the situations in Europe, the US, China, India and Brazil as well as on oil and Iran there. (Note: as I started the newsletter last Thursday and publish weekly, I will be on a six day schedule for a bit to push the publish date back toward the beginning of the week.)

Sign up is here for monthly or yearly subscriptions.

Source: Reuters

Also see: German negative yields as harbinger of deflation at FT Alphaville.

P.S. – This was Hans-Werner Sinn in September: “no, no, no, no, no, no, I don’t see a recession for Germany”. Are the chickens coming home to roost in the core or is this just a blip?

Edward Harrison here.

The post by Randall Wray below is an interesting one because it points out how the world has changed since the end of the gold standard and why the sovereign debt crisis is centered in the euro zone.

While I have an Austrian bias overall, for me, MMT is the best way to think about nonconvertible floating exchange rate systems as distinct from fixed exchange rate, currency board, pegged and convertible systems. The difference is policy space and what I would call the bond vigilante relief valve. In the old gold convertible system, the Central Bank had to jack up rates to prevent an outflow of gold.

In the old days, only by adjusting the gold peg could countries under attack get away with low rates once the vigilantes were on to them. That’s what happened during the Great Depression. Once the conversion was broken, the currency depreciated and depression lessened immediately.

Today the release valve is the currency because there is no gold tether. So the currency gives way, not interest rates. And to the degree that interest rates would increase, the Central Bank can print. The currency revulsion question then is always currency depreciation, inflation and even hyperinflation (when and under what preconditions) not interest rate spikes.

Sovereigns with significant foreign currency liabilities face the same issues – as we saw in Iceland in 2008. In the Russia and Argentina defaults last decade, those countries had foreign currency liabilities and a currency peg. This was the problem. It’s different for nonconvertible floating exchange rate currencies issued by a sovereign with no foreign currency obligations.

Where the bond vigilante story is usually flawed is in thinking that the bond vigilantes have power. Shorting government bonds when the central bank is politically aligned with the Treasury is a sure-fire way to lose lots of money. The consolidated government’s balance sheet consists of IOU liabilities that it can manufacture in infinite quantities. Why would anyone think they can win that game? It’s like my writing Yves IOUs for blog points. Maybe I write more than I can ever cover her for. But I create the points. I can always create more. if I write too many, their value depreciates.

The Europeans are currency users with a Central Bank that is not politically aligned. This is a very different institutional arrangement to the US. The Fed can ‘financially repress’ all it wants. They control rates. Long-term, the result will be currency depreciation relative to other CB’s not repressing. But if everyone is engaged in financial repression i.e forcing negative real interest rates across the curve – and I think they all will be – then clearly its only hard currency that wins: gold, land, etc. After an initial bond vigilante run, Bill Gross has got religion on this too.

Paul Krugman gets it too. I didn’t always think this was the case. But now Krugman is way out in front on this one as Randy attests in the post below.

From an investing standpoint you have to get this one right. The bond vigilante paradigm has been false in Japan and now in the US as well. If you had seen rates in Japan at 2% and shorted them saying they would come up, you would have lost your shirt. Conversely, if one uses the currency sovereignty paradigm, the short-JGBs trade is one that one would have avoided.

What a cautious investors should do is shun repressed assets and seek next best alternatives in similar assets classes or in different currencies – corporate over government bonds, Canadian over US, etc. Indonesia, for example is an opportunity.

One last note: Bill Gross had a good piece in the FT about what I have dubbed ‘permanent zero’. He called it the ugly side of ultra-cheap money. I think he’s onto something that worries me as well. It’s the same sort of thing we saw in Japan and it means, critically, that when the economy hits recession, the yield curve flattens even more and banks get savaged by this while the asset side of their balance sheet falls apart. They are then forced to sell good assets to delever and that causes a negative spiral. For the US, the next recession will be like this – and it will be nasty for risk assets as a result.

That’s my piece. Randall Wray’s post is below.

This post first appeared at "Great Leap Forward”, Randall Wray’s EconoMonitor blog.

As Mae Moore says, “It’s a Funny World” (2002). Let’s try to make sense of two news reports. Help me if you can.

1. Republicans reject the payroll tax holiday because it does not go far enough. To complicate matters, the Senate has already gone on its Xmas holiday and is refusing to come back. That leaves the Republicans in a bit of a pickle—they are going to raise taxes on the average American by $1000 per year because they refuse to support a 2 month holiday extension.

Right. Congress wants its long holiday from work, but does not want to give Americans a holiday from paying a regressive tax—the payroll tax—that for the bottom 70% of American workers takes away more income than the Federal Income tax. It is a job killer, too—as it raises the cost of employing Americans over the cost of employing workers just about anywhere on earth (few other countries tax work and employment the way we do—our payroll tax makes American workers more than 12% more expensive). So Republicans want to take away the payroll tax holiday and kill jobs.

That is a rather nice election strategy. And it is bad enough that they’re mainly running clowns for President. With the exception of Ron Paul, is there any serious candidate in the running? No, I didn’t think so. What, they actually WANT President Obama for 4 more years? Why? To continue to bail-out Wall Street? To continue to look the other way while banksters trash the economy?

Apparently the Republicans are hold-outs because they want two noxious additions to the payroll tax holiday legislation. First, they want an environment-killing Keystone pipeline—so they want that linked to the extension of the payroll tax holiday. The wording they prefer forces the President to forego any reasoned analysis of the wisdom of the pipeline by rushing a decision within 60 days. Second, they want to end the extended unemployment compensation benefits—to kill any jobs that the payroll tax holiday created. Right. We’ve been too kind to the environment and to the workers who lost their jobs because of Wall Street’s excesses, so let’s take away the payroll tax holiday and kill as many jobs as we can.

The logic escapes me. Extending the payroll tax holiday while reducing the time unemployed workers can collect benefits is a zero sum game. Do Republicans really want to fiddle while the economy slips into Great Depression 2.0? Yes they do. They see that as a win-win. They’ll run some Bozo the Clown, lose the election, and then stick Obama with the coming depression. And they hope to also stick him with an environmental nightmare to hasten the end of life as we know it.

Oh, sure, there will be life after Keystone. You’ve seen some of the science fiction movies that attempt to divine it. I’d put my money on the dystopian Mad Max or A Boy and His Dog. I expect that is a future that many of the current Republican candidates would embrace: one with insignificant, ineffectual governmental constraint on unbridled pursuit of macho self-interest. Newt! It’s your party platform.

2. The World Discovers Modern Money Theory. Who wuddavthought? The problem with the Euro is that formerly sovereign nations gave up their currencies to adopt a foreign currency called the Euro. Now, MMT followers have been saying that since the Euro was proposed. It was a system designed to fail, and like all systems designed to fail the only question was when. We now know the “when” is January 2012—when the Euro banks fail and Italy leaves the union.

But we were ignored for a decade and a half, while economists and policymakers celebrated the glorious “Union”. Heck, the union was so great that the EMU invited every Tom, Dick, and Harry nation to join up. They added nations with wages and living standards that were barely above subsistence level—indeed, nations that were willing to reduce living standards below subsistence if only they could join and reap the supposed benefits of joining the most dysfunctional empire ever constructed.

And they let Germany add cheap workers within its eastern half and then extend its reach to those low cost new additions as it came to account for 75% to 80% of all European exports. There has never been any international arrangement, anywhere, at any time in human history, that so-favored a nation. And when things went predictably bad for all of Germany’s neighbors, Germany pointed its finger at its victims and insisted that they were at fault for Germany’s success. No more porridge for them!

As evidence that the world is coming around (finally) to the MMT view, take a look at Dean Baker’s excellent piece.

Now here’s the ironic thing. It seems to have been none other than Paul Krugman who made it safe for others to adopt MMT. He shined his headlights on the obvious: the reason why interest rates on government debt are not exploding in countries like Japan, the US, and the UK is because they issue their own currencies.

Japan is the champion nation in terms of budget deficits and government debt relative to GDP. Many have long argued (wrongly) that this is because holders happen to have addresses in Japan. Nonsense. A sovereign government that issues its own currency makes interest payments on its debt in exactly the same manner whether the holder has an address at the South Pole or on Mars: a keystroke to a savings deposit at the central bank. What matters is whether the country issues its own currency.

That is why the little spat between the UK and France—with France insisting that credit agencies ought to down-grade the UK before they downgrade France—is so silly. France can have a debt ratio under 15% of GDP and still be forced to default. The UK can have a debt ratio above Japan’s 200% and still face no chance of involuntary default. That is the beauty and utility of issuing your own currency. France is a currency user and its fate depends on Germany—which is busy sucking up every spare Euro it can lay its greedy hands on. France is no better off than the panhandler on the street corner begging for pocket change—a user of currency, not an issuer.

So, Krugman shined the headlights on the difference between a currency issuer and a currency user. It is now time for everyone to follow Dean Baker—to look for the car keys under those MMT headlights.

3. Olly Olly Oxen Free: it is safe to come out of the dark. A sovereign government faces no financial constraints. We can have payroll tax holiday extensions and unemployment benefit extension. Heck why don’t we go whole-hog and actually create jobs for the unemployed? We need 25 million of them. We can afford them. All we need to do is to find useful things for them to do. That ain’t hard.

“The Conservative belief that there is some law of nature which prevents men from being employed, that it is “rash” to employ men, and that it is financially ‘sound’ to maintain a tenth of the population in idleness for an indefinite period, is crazily improbable – the sort of thing which no man could believe who had not had his head fuddled with nonsense for years and years… Our main task, therefore, will be to confirm the reader’s instinct that what seems sensible is sensible, and what seems nonsense is nonsense. We shall try to show him that the conclusion, that if new forms of employment are offered more men will be employed, is as obvious as it sounds and contains no hidden snags; that to set unemployed men to work on useful tasks does what it appears to do, namely, increases the national wealth; and that the notion, that we shall, for intricate reasons, ruin ourselves financially if we use this means to increase our well-being, is what it looks like – a bogy.” –John Maynard Keynes 1972, 90-92

Here are a few code words that you will often see in economic writing followed by their true meaning. The code word is a dog whistle. It acts like an emotional marker only for those attuned to the underlying ‘moral’ issues implied by the code. While you may agree with the logical framework behind the code word, the purpose in using the code is to influence emotion instead of logic. When I talk about ‘economics as a morality play’ this is what I am referring to.

Politics is not the only place where you will hear dog whistles.

The code is in parentheses – which others may hear, but much more faintly.

• PIGS/PIIGS = the eurozone periphery aka Portugal, Italy, Greece and Spain and sometimes including Ireland (who are shameful debtors too lazy to work hard to actually pay for the things they buy, looking to free-ride on the euro zone)
• Technocrat = unelected (and therefore illegitimate) policy maker (from elite institutions isolated from the mainstream and middle classes) who works behind the scenes to assist elected officials because of their prior policy experience (and connections to power)
• Big Government = (statist and freedom-crushing) activist government policy (used to increase the size and scope of government to redistribute wealth illegitimately by government confiscation)
• Bankster = (contemptible) high level financial services executive (who acts like a mob boss Gangster in ripping off ordinary folks as popularised in recent history by libertarian Murray Rothbard in Right Wing Populism in 1992 but now used more widely)
• Anschluss economics = (repugnant) economic power play to force another society into a specific economic model (usually done by Germany, harkening back to the Third Reich and the German attempt to dominate Europe militarily)
• Hippie = (unreasonable and dangerous) Occupy Wall Street protester (dressed like counter-culture and treasonous types from the 1960s and 1970s with no agenda due to economic ignorance)
• Deficit terrorist = someone who sees fiscal deficit as a negative aka a deficit hawk (who acts like a terrorist in forcing pro-cyclical cuts that disproportionately affect the poor, middle and working classes because of uninformed economic views)
• Trickle down economics = (bogus) supply-side economics that reduces regulation and lowers income taxes and capital gains taxes (in order to give kleptocrats a free hand in stealing legally)
• Oligarchs = (deceitful and grasping) bankers and corporations who have a dominant role in society (and who act as unelected policy makers, because they bribe and lobby government, pushing policies that favour themselves)
• Elites = those (untrustworthy) who have either attended what is considered a highly regarded educational institution or work in what is considered a well regarded corporation and who are in a policy making or policy influencing role (but who live in an ivory tower separated from reality that sets them apart ordinary people and gives them the ability to make bad policy decisions which only serve to enrich themselves and others from their caste)

All of these terms are morality plays used to influence emotion rather than speak from a voice of reason. Whenever you see them, you should ALWAYS be suspicious regardless of context or source.

I will update this list over time as I think of more words. So refer back to it here at Credit Writedowns.

Note: This post was supposed to be a quick and dirty list. But I have added the paragraphs below to the original post only at Credit Writedowns and Naked Capitalism due to some very useful suggestions from readers. Further updates will be at Credit Writedowns going forward.

Since economics has become a hot topic with the financial crisis, a lot of people who aren’t economic gurus have a great interest in the topic. I think that’s great. The reality is that there is a code in the economics world just as there is in any profession. For example, in real estate, an agent might say a house is a "must see" or has a "lovely interior" when advertising it. That’s code for "this house looks better on the inside so I have to tell you that or I can’t sell it." In education, a teacher might call a pre-school or primary school student "active" in an evaluation form because they know they must use neutral terminology. But this might be code for "disruptive" or "has an attention deficit".

The intent of this post is to make more plain what is meant by these hidden codes so that anyone can understand why the code is being used instead of the true message. My point is not to say that emotion or morality is illegitimate in economics, although it should be clear I lean toward rational argument given the unconscious use of a code word ‘morality play’, which was pointed out by a reader. After all, economics is a social science, and hence not objective; it is not a science as some of its practitioners wished it were; it’s not just about numbers but about social values, ethics and political judgments that are not the same for all people. Every economic policy has ethical and moral dimensions and is therefore not objective. Sometimes economists act like economics is a science; it is not – and their telling you it is like science is either deception or self-deception.

I believe you as a reader should always be on the lookout for loaded words that inflame emotions and code and jargon that masks deceptive intent. Sometimes the code is justified like when banks use ‘robosigners’ to process mortgage applications or when banks get a ‘bailout’ when they are clearly insolvent or when banks commit ‘errors’ in trying to evict people from their home. I say these are the kind of things that should make you angry; you should get worked up about it. Yves Smith and Michael Hudson are masters of using language to evoke emotion – and they make strong arguments. However, a lot of times, the code is used just to divert from a reasoned argument exactly because that argument is weak and must rely on emotion to have appeal. I say you should always do a double take when the code is employed to check whether it is a justifiable use or a cover for something else.

One more thing: occupying the neutral center is not always a great thing. The word ‘bipartisan’ is code for a reason. A lot of times, you have to take sides since economics is a social science and not objective. There is nothing wrong with that, especially because this is a once-in-a-lifetime crisis with key issues on the table. I take sides all the time, but I am trying to flag it when I do so you know it instead of trying to act like my analysis is always neutral. Sometimes I do so unconsciously though and you should be alert to code as a sign that I have done.

P.S. – I try to avoid these words. But they are insidious. Sometimes they creep in. (As I say above, the truth is that sometimes these words are legitimate. So sometimes I consciously use them to evoke the thinking in the code words, although less and less now. Sometimes they just come out – unconsciously. Bailout and morality play are the added words below I most use. You as a reader, though, should never give a free pass to anyone though. Always remember the code is suspicious.)

P.P.S. – the dog whistle is supposed to have one meaning that some can hear but that others can not hear at all or more faintly. It is supposed to be a ‘secret’ language that can be used in public discourse between like-minded people without offending anyone. So it makes sense to add in words that seem more neutral/non-pejorative but are really code. And so the ‘code’ is what is heard by advocates of the logic behind the dog whistle as opposed to what those opposed to that logic might hear. Many of the terms above are ‘loaded’ i.e. carry negative associations and therefore a bit obvious to be good dog whistles. The ones below are often more neutral sounding but are code nonetheless.

Also see Kantoos referring to the increased moralising in the Euro debt crisis.

Updates

• Morality play = an (inappropriate) appeal to philosophy and emotion and morality in an economic or political argument (that is illegitimate because morality is bad or at least shouldn’t be a prevailing policy concern and because logic is always superior to emotion as a way of getting a response)
• Free market = society (worthy of emulation and) guided by deregulated and desupervised economic policy (which is a good thing because freedom connotes choice and choice is good)
• Job creators = (praiseworthy) individuals that hire or organisations where people work (and should therefore be seen as most responsible for creating jobs and given leeway by regulators, the media and society in general to do as they please)
• Reform = (good) change that requires significant economic adjustments to implicit social contracts (toward the prevailing economic orthodoxy which includes lower taxes, free markets, and less regulation and should be viewed as positive because reform is viewed as such regardless of the impact on different groups)
• Moral hazard = a (bad) policy choice which gives someone, some institution or some group within society a break (which they don’t deserve and therefore encourages them to free-ride and mooch off of society)
• Class warfare = (bad) economic and political policy used to divide people (and pin the blame all on one political group and their allies to gain an unfair political advantage)
• Wage inflation = (negative) rise in wage rates (that will lead to cost-push inflation and eventually to higher consumer prices unless stopped)
• Bailout = (an illegitimate) provision of liquidity to forestall bankruptcy (because the recipient is bankrupt and not just temporarily lacking funds, making the financial aid a form of welfare)
• Bipartisan = (what everyone should see as a legitimate) policy approach which mainstream economists and policy makers of different political leaning have endorsed (making this effort better than more partisan ideas.
• Extremist/left-wing/right-wing = (dangerous and contemptible) economic ideas which can be considered outside the mainstream (and should therefore be considered illegitimate)
• Printing money = (hyperinflationary) economic policy in which the central bank buys existing private sector financial assets for reserves it creates for the that purpose (and which will eventually destroy the value of the currency)

Cross-posted from Credit Writedowns

There is a flurry of activity going on in Euroland this weekend. I have a number of stories up on different proposals in the offing. Clearly, European policy makers have got religion about saving the euro. Expect some kind of announcement soon.

According to Austrian daily Der Standard, Italy is to receive a 600 billion euro bailout courtesy of the IMF. Note: the article has what I assume to be a typo, referring to 600 million euros instead of 600 billion. I have fixed that in the translation below. Also note that the ultimate source of this information is La Stampa, an Italian daily newspaper.

Translation from German:

According to a media report, the International Monetary Fund (IMF) is preparing an assistance program with a capacity of up to 600 billion euros for heavily indebted Italy. Appropriate credit could be awarded for a period of twelve to 18 months in order to stabilize the financial situation of the country, reported the Italian newspaper "La Stampa " on Sunday, citing an IMF official. With interest rates between four and six percent, it would be much cheaper than current two-and five-year bonds with interest rates of more than seven percent.

Funding still uncertain

According to the report, the IMF may not be able to cope with the auxiliary loans from its current funding, and so different options would be considered for funding. Thus, for example, payment by the European Central Bank (ECB) is in conversation, which the IMF could guarantee. With the assumption of ECB aid under IMF control, Germany, which rejects a stronger involvement of the ECB in euro rescues and presses for the greatest possible independence of the central bank, should also be reassured, the newspaper quoted an IMF representative.

The European Union and the ECB had recently sent experts to Rome to examine Italian public finances. The IMF also wants to send their own auditors. In Italy, the debt burden is about 1.9 trillion euros. Additionally, the country is currently suffering from weak economic growth. This has led to worries in financial markets in recent weeks that Italy, like Greece, Ireland and Portugal before it, may need financial assistance. The new Prime Minister Mario Monti is under strong pressure to cut costs to make up for the failings of his retired predecessor Silvio Berlusconi.

Source: IWF bereitet 600-Millionen-Euro-Hilfsplan für Italien vor – Der Standard

Also see:

• Franco-German secret negotiations for new euro contract
• Officially Eurobonds are taboo but behind the scenes nothing has been ruled out
• Juergen Stark explains ECB opposition to monetisation is not about inflation
• Foreign news: Belgium gets austerity, EU prepares for Eurobonds, Netherlands says breakup inevitable, Spain to get IMF bailout

All of the articles above are from just this weekend and point to serious damage control now ongoing in Euroland. I doubt whether any of these proposals is an effective long-term solution. But, this is what’s on offer. Boxed in by the ever-worsening sovereign debt crisis, the Franco-German euro zone axis is trying to formulate a policy that both adheres to the German economic orthodoxy without worsening the crisis any further.

But, the damage is done to the real economy. Dithering will lead to recession in the euro zone, Switzerland and the UK at a minimum, according to recent economist projections.

MMT fans: Also note that, while I see an independent central bank as a good thing like Juergen Stark in the article above, top MMT scholars like Mosler and Wray do not. They call for the Fed to be abolished with its role conducted out of the Treasury.

This post originally appeared on Credit Writedowns

Editorial note: this article is neither a policy recommendation or a prediction. Rather, this articles looks to outline one potential outcome of the current policy choices in the European sovereign debt crisis, building upon the discussion from three recent articles “Deflationary crisis responses”, “Predicting the future of policy making”, and “Why France will be forced out of the eurozone”.

One week ago today, I was running through Italian default scenarios because the policy choices in the sovereign debt crisis have narrowed with most of the risk being on the downside. At the time, I asked “Could Italy unilaterally exit the euro zone and redenominated euro debts at par into a new Lira currency to forestall the default? Perhaps. That is something to consider at a later date. For now, here’s what will happen if Italy defaults.”

That later date is now. So let’s get cracking on what would bring about a unilateral Italian exit and how it could be accomplished.

Nationalism and “Beggar Thy Neighbour” economic policy

Let me quote something as a jumping off point which applies here that I wrote nearly three years ago about Ireland and what I correctly predicted would be a banking crisis.

Ireland must threaten to leave now if it wants to maximize any EU help it expects to receive, before the scope of other EU banking crises become apparent.  Weakness in the financial sector has infected all of the Eurozone members. I have mentioned that Austria has a weak banking system (see posts here and here). But, there is even growing evidence that Germany too has a fragile banking system.  To be clear: this is an ‘every nation for itself’ strategy pitting Eurozone members against each other, where those nations savvy enough to request help sooner are likely to benefit at the expense of others. The question is whether the Germans would go along with this.  If they do not, tensions will rise and that will change the calculus for Portugal, Italy, Ireland, Greece, and Spain. I don’t have a view on this as yet because the situation is still evolving.  However, I lean toward believing the Eurozone will remain intact even while individual nations or banking systems collapse.

As events occur in Eurozone banking, I will keep you abreast on developments.

-The Eurozone and the spectre of banking collapse, Feb 2009

When the chips are down, an us versus them mentality starts to seep into policy choices. What happens is that significant economic downturns create economic distress that causes people to circle the wagons. One day, it’s boom time; all is well and we are full of hope for the future. We are minding our business, working hard, tending to our families and enjoying life. The next thing you know, the economy is in a deep slump; we or some of our neighbours are jobless, penniless… and angry. What caused this? Who caused this?

When times are tough, people start looking for someone to blame. And usually it is not the In-group which gets the blame; it’s usually “them”: out-groups like minorities, immigrants and foreigners. Dylan Grice calls this “in-group bias” and predicts the following:

The historic and psychological evidence clearly links economic dislocation with the scapegoating of out-groups and, of course, the eurozone edifice stands increasingly lonely and tall as a lightning rod for the latter. I believe the likelihood is that over the course of the next decade or so, the trend will be towards greater fiscal problems and greater economic problems. I believe these problems will increase the temperature of debates about whose fault it all is, and that as the conclusion to these debates becomes more polarized they will play into the hands of nationalist, anti-immigrant and increasingly, anti-euro sentiment.

If the downturn is protracted enough and deep enough, this us versus them mentality spreads into the mainstream at the political and national level. And we see economic nationalism, an ‘every nation for itself’ strategy enter mainstream politics. That’s what World War I, the Great Depression and World War II were all about. So I expect no different here with the sovereign debt crisis if policy choices point mostly to downside scenarios.

The saving grace highlighted in the Irish example above is that it really does take longer for these things to play out than one expects. I was talking about the European banking crisis in early 2009 and here it is late in 2011. So that tells me, with the right leaders and right policy choices, none of these downside scenarios is automatic. They may be likely, but there is reason to hope and exhort leaders to prevent calamity.

The Current Situation in Euroland

Unfortunately, these last three years have been largely wasted. Instead of bank recapitalisation, credit writedowns and rebalancing in the euro zone, we have seen self-serving and one-sided morality tales of sinful fiscal profligacy and creditor-centric policy solutions that are wholly inadequate to fix the institutional deficits of the euro zone. This morality tale is really a fairy tale. Spain is the perfect example of a country that never should have joined the euro zone. It had a fiscal surplus right through to 2007 and still has better numbers on debt than Germany. The last of the three articles upon which this discussion is built, the excerpt I posted last night by Philip Whyte and Simon Tilford, is magnificent in laying these unfortunate circumstances.

The question then is what now? How do the Europeans escape this roach motel of an economic prison they have constructed while still respecting the laws of the existing unworkable institutional structure? No one wants a free for all.

We see now that Italy will default without the central bank acting as a lender of last resort. And Italy’s default would trigger a cascade of interconnected bank runs default and Depression as did the insolvency of Creditanstalt in 1931. German policy makers are aware of this. The Irish Times has written how Merkel’s pragmatic allies offer hope of new outlook whereby the euro zone evolves toward a more integrated fiscal union with penalties for free riders and an exit clause for those that can’t make it. Germany is moving fast to implement this solution.

Alas, this is a flawed project for two reasons. First, trying to make the ‘sinners’ of the eurozone periphery more Germanic fails to understand the dynamics of intra-European capital and current account balances. Put crassly, the euro zone is one giant vendor financing scheme. You can’t have Germany and Spain both running current account surpluses with each other at the same time. The imbalances will continue.

Second, Policy makers have run out of time. They caused this problem by dithering; we wouldn’t be here if they had cut the cord early on. I still think the ECB will move eventually. But it will be too late; the debt deflation will have already set in, aided and abetted by a growth-crushing fiscal policy strait jacket that in the last month has moved from the periphery to France, Italy and Austria as contagion has spread.

The Italian Job

Even so, the ECB may not move at all. And therefore, we must run through the various worst-case policy remedies available and think about which one could be chosen.

What about a unilateral exit from the euro zone? I ran through the exit scenario a year ago and it looked bleak, one reason I saw it as unlikely at the time. But things have deteriorated and so the best alternative to a negotiated agreement for policy makers in Italy may well be exit.

So I have been thinking about this and have come up with an outline plan. The plan is based on how countries exited the gold standard during the Great Depression. I have said many times that the euro is like gold.

The euro has acted as an internal gold standard to euro zone members in that it prevents governments from printing money and devaluing to escape economic hardship and it ensures that large fiscal imbalances cannot be sustained and eventually lead to crisis.

I like to think of the Euro as gold and the Euro countries as having implicitly retained their national currencies with a fixed rate to the Euro. If you recall, that actually was the setup when the countries pegged their currencies to the ECU before Euro money was introduced.

So the euro area countries can de-peg like the gold standard countries did and unwind the euro structure by running the “euroization” process in reverse. Here’s how one could do it.

1. Plan. The Italian government can plan for a redenomination into New Lira in secret that takes advantage of the Italian law jurisdiction over their sovereign debt obligations.
2. Law. “Euroization” would remain in place and the euro would continue as the currency of physical payment. However, New Lira would become the national currency, pegged at 1,936.27, exactly the same rate as the Lira was fixed on 31 December 1998 and converted into euros on 1 January 2002. All debt under Italian law would be redenominated into New Lira at the 1,936.27 New Lira exchange rate peg. This would effectively bring us back to 31 December 2001 for Italy.
3. Taxes. The government would announce that henceforth it will tax exclusively in New Lira. All municipal governments would be required by law to tax in New Lira. 
4. Banks. Like the Argentines before them, the Italian government would convert all euro bank accounts legally into New Lira. The systems would process as if it were euros because of the fixed peg, but legally the money would be New Lira. This would make the Italian economy “euroized” but make the banking system redenominated into New Lira.
5. Retail. Retailers, all sellers of Italian goods, would then be forced to return to the double accounting treatment of pre-2002 whereby they denominate all transactions in both Lira and Euros. Again, the paper money would be euros and each euro would initially be worth 1,936.27 New Lira. The electronic money would legally be New Lira, even while the systems said euro.
6. Float. On day one, immediately after redominating, the Italian government would drop the 1,936.27 New Lira exchange rate peg and float the new Lira as a freely floating currency. From that day forward, foreign currency adjustments would need to be made between euro and New Lira.
7. Physical currency. New Lira would be printed by the Bank of Italy and introduced to replace euros.

The hard part is about capital flight, inflation and the cost of retooling the systems for New Lira. But this is all a one time cost. Warren Mosler wrote up a plan like this for Greece that Randall Wray featured here last week. In his scenario, euro bank deposits remain as euros and existing euro denominated debt would remain in euros as well.

Repercussions

Staying in the zone. The political repercussions of a redomination would be huge. Although I have talked about this as a eurozone exit, it could be just a redomination, meaning that the New Lira would depreciate and Italy could fully re-euroize the economy without leaving the euro zone. Since we’re running through scenarios, we should consider this outcome, as countries in the Depression did eventually re-peg to gold via the Bretton Woods currency regime. But I think the impetus here is to escape the euro and the persistent current account deficits as well as to escape the anti-growth policies of the euro zone that have caused Italian sovereign debt levels to spike. Moreover, it is unlikely that the German plan of fiscal oversight, penalties and exclusion would solve Italy’s fundamental problems of low growth and eroding uncompetitiveness in a currency with an elevated value.

Inflation. This would be mitigated by the taxation policy which would give the new currency value. But we see how Iceland has battled inflation in the wake of a large currency depreciation. In some ways you could consider this a one-time standard of living adjustment. But the adjustment will be severe since markets tend to overshoot to the downside. It’s not clear how low a New Lira would sink, and so inflation would be a big problem.

Bank solvency. This was the biggest issue to begin with. The redomination solves Italian bank solvency since all their accounts would be in New Lira. But this solution heaps all of the burden of adjustment onto foreign lenders via the exchange rate adjustment. German, Dutch and French banks would be insolvent if the New Lira lost a lot of value as they would be repaid in depreciated currency. I think this point highlights what I have been saying about apportioning losses in a creditor-friendly way. The foreign lenders have used the fact that the euro is one zone to lend cross-border and increase their return on equity. They bear some of the responsibility for the credit growth in the periphery. The foreign currency losses they would take from a New Lira demonstrates this.

National Solvency. That problem would be solved. The burden of adjustment would then fall to the exchange rate.

Contagion. Clearly, an Italian exit would break apart the euro zone. All of the countries now on the hot seat would consider redominating as well. Once a euro exit takes place, it would be a mad rush to follow. In France in particular, politicians would be desperate to redenominate and depreciate the currency in order to escape the foreign currency losses. Thus would begin a currency way via competitive currency devaluation.

In conclusion, a unilateral exit would be a devastating event for Italy and the euro zone. Inflation would be high but bank and national solvency issues would recede. If the exit were done under these nationalistic pre-conditions of redomination, most of the adjustment burden would fall on foreign creditors. Italy would become export competitive again and could focus on economic growth strategies instead of ones of fiscal adjustment. The benefit of this particular plan is that it can be implemented quite quickly.

Just as during the Great Depression, those countries that left the gold standard first saw the earliest return to economic growth. I would expect the same to be true here again for the euro area countries today.

Cross-posted from Credit Writedowns

Marshall Auerback was on Fox Business last week talking about the European sovereign debt crisis. He said he is very concerned not just about the national solvency problem in the euro zone but also about the debt deflationary policy remedies now being implemented across the whole of the euro zone. He notes grimly, “the more you deflate these economies, the bigger the public debt problem is going to become.”

The deflationary impact of fiscal tightening after the deficit ‘Supercommittee’ failure will only begin to hit the United States in a major way beginning in 2012.

Video below

Cross-posted from Credit Writedowns

The most important debate of our lifetimes is now ongoing. For many, the answer will be existential. First, the question: Should the ECB “write the check’ for the euro area national governments? In thinking about the answer to this all-important question, I prefer to shift the focus by changing the verb “should” to “will”.

Answering this slightly different question is much more important than answering the first question for you as an investor, a business person and as a worker. If the ECB writes the check, the economic and market outcomes are vastly different than if they do not. Your personal outlook as an investor, business person or worker will change dramatically for decades to come based upon this one policy choice and how well-prepared for it you are. The right question to ask then is: Will the ECB “write the check’ for the euro area national governments?

To date, my answer to this question has been yes. See, for example, my thoughts on why questioning Italy’s solvency leads inevitably to monetisation and why Investors will buy Italian bonds after ECB monetisation. But what if the ECB doesn’t write the check? What if the ECB let’s Italy default, what then?

Here’s my thinking on that score.

Italian death spiral

Let me start off with what I have previously written from two posts from November 7th.

The euro zone periphery was a sideshow. This stuff with Italy is the real deal. With yields at 6.7% and rising, it’s game over for the euro zone. The extend and pretend stuff ain’t gonna work.

And if you are an investor, this is the moment of truth. Everything – every asset class – depends on how the euro zone performs in the Italian Job. There are only two outcomes, here. If Italy blows up, a Depression is upon us; banks would be insolvent, CDS triggers would implode the system, bank runs would begin, stock markets would crash, and you will would see sovereign debt yields go to unbelievable lows for nations with a lender of last resort. If Italy survives, I would expect a monster rally in periphery debt, stock markets, and bank shares and a selloff in CDS at the minimum. However, the euro zone is already in recession so that rally will not be sustained.

Forget about Berlusconi and austerity in Italy. That’s a sideshow too. Austerity is not going to bring Italian yields back down. These days are over, folks.

Here’s the real problem: Italy needs to run a primary budget surplus (excluding interest payments) of about 5 percent of GDP, merely to keep its debt ratio constant at present yields. That’s never going to happen. So the yields for Italian bonds must come down or Italy is insolvent. More than that, a stressed Italy means a stressed euro zone and a deepening recession with all of the attendant ills that means: Ireland would suddenly start missing deficit targets for example. Bank shares would be under stress, triggering more Dexia’s. So even if Italy limps along at 7 percent yields, we will see a nasty double dip recession and bank failures. And we know that yields will rise. Last November, we were discussing Ireland in the same way with its yields at these levels. Soon, the yield went to 9% and Ireland was forced into a bailout – one that Italy is to big to give.

So we are definitely facing a real financial Armageddon scenario here.

-Italy! Italy! Italy!

Here’s what I am saying.

1. Italy needs to run a primary budget surplus (excluding interest payments) of about 5 percent of GDP, merely to keep its debt ratio constant at present yields. It won’t ever be able to do so.
2. Therefore, yields for Italian bonds must come down or Italy is insolvent as it must roll over 300 billion euros of debt in the next year alone.
3. Austerity is not going to bring Italian yields back down. First, Italian solvency is now in question and weak hands will sell. Moreover, investors in all sovereign debt now fear that they are unhedged due to the Greek non-default plan worked out in Brussels last month. As Marshall Auerback told me, any money manager with fiduciary responsibility cannot buy Italian debt or any other euro member sovereign debt after this plan.

Conclusion: Italy will face a liquidity-induced insolvency without central bank intervention. Investors will sell Italian bonds and yields will rise as the liquidity crisis becomes a self-fulfilling spiral: higher yields begetting worsening macro fundamentals leading to higher default risk and therefore even higher yields.

Soft depression

I believe the global economy is in a cyclical upturn within a larger depression. Two years ago, I wrote:

… all countries which issue the vast majority of debt in their own currency (U.S, Eurozone, U.K., Switzerland, Japan) will inflate. They will print as much money as they can reasonably get away with. While the economy is in an upswing, this will create a false boom, predicated on asset price increases. This will be a huge bonus for hard assets like gold, platinum or silver. However, when the prop of government spending is taken away, the global economy will relapse into recession.

-Credit Writedowns, Oct 2009

Last week I wrote that this is “a soft depression scenario where the countries with a true lender of last resort can backstop without problems.” The problem, however is that the ECB is not a true lender of last resort as we are now seeing.

Should the ECB go all-in or not? There aren’t a lot of options. No one is going to buy Italian bonds at a low yield without a backstop, irrespective of austerity now that the insolvency genie is out of the bottle. With a backstop, some people will. An Italian default equals the insolvency of the Italian banking system. An Italian default means massive losses for German and Dutch banks and beyond. Any scenario in which there is an Italian default leads to a Depression with a capital ‘D’. The question is a political one and, hence, unpredictable. The Germans (and Dutch) either allow the backstop or face Depression. It’s as simple as that.

-Italy’s debt woes and Germany’s intransigence lead to Depression

Outlining the Armageddon scenario

This is the crucial piece in understanding how to protect yourself in the event the ECB decides to not act as a lender of last resort for the euro area national governments. This is a true Armageddon and Depression scenario.

The reason no real alternative to the ECB’s acting as a lender of last resort is offered by hawkish types is because the alternative is economic collapse – and recognising this is not politically palatable. We know that Italy will default without the central bank based on the analysis above. Italy’s default would trigger a cascade of interconnected bank runs default and Depression as did the insolvency of Creditanstalt in 1931. Could Italy unilaterally exit the euro zone and redominate euro debts at par into a new Lira currency to forestall the default? Perhaps. That is something to consider at a later date. For now, here’s what will happen if Italy defaults.

1. Credit event: An Italian default would be a credit event, meaning it could not occur under the voluntary arrangement which the EU is trying to force through for Greece because Italy is simply too large for banks to willingly take the writedowns needed to deal with its insolvency. Doing so would render many financial institutions insolvent. Even in the Greek case, I doubt whether they will get enough participation from the private sector to meaningfully reduce the Greek sovereign debt load. So, an Italian default would be uncontrolled and immediately crystallise losses that must run through the balance sheets of everyone holding their bonds.
2. Italian bank run: Once Italy defaults, Italian banks would be insolvent as a result of these losses since they are the largest holders of Italian sovereign debt. Given the 10 billion euro writedown at Unicredit just yesterday, we can see these banks are already weak. Therefore, we should anticipate wholesale bank runs in Italy beyond just the weakest banks.
3. Spain and Slovenia insolvency: Other weaker sovereign creditors within the euro area without IMF funds would come under heavy selling pressure. This includes Spain and Slovenia first but would also include Belgium later and perhaps Austria due to its bank exposure to Eastern Europe. Spain’s yields have already crossed 6% and Slovenia’s have already crossed 7%. These governments would default as well then, cascading the losses onto their banking systems. Defaults here would lead to domestic bank insolvency and bank runs as in Italy. Countries like Ireland, Portugal and Greece would want to default in order to escape the suffocating strictures of austerity given the now untenable solvency path that a deep Depression would cause. Likely, these countries would default as well. Analysts like Sean Egan estimate eventual losses in Greece will be 90%. In the Italian default scenario, these losses would crystallise overnight.
4. Contagion into Eastern Europe: Unicredit’s losses included significant writedowns in Eastern Europe and Central Asia (Ukraine and Kazakhstan). One area of contagion could be to other banks with exposure to weak economies elsewhere in Eastern Europe like Hungary and Slovenia. Greek, German and Austrian banks would be most vulnerable because of exposure to central Europe and the Balkans. Hungary, already under threat of a sovereign downgrade to junk, amidst a record decrease in the Forint/Euro exchange rate, would suffer contagion. the currency would come under heavy selling pressure. Other weaker sovereign debtors would be affected as well.
5. Euro bank insolvency: Other debtors with significant exposure to Italy would suffer huge writedowns. Core bank exposure to Italian debt an order of magnitude larger than periphery combined. Financial institutions with exposure could be recapitalised by the state, however. The questions here for the likes of Germany, France and the Netherlands are a) how explicit a backstop will these banks get? would bond holders take losses; b) how would this affect the sovereign debt level and credit rating? c) how would this lack of capital affect credit availability and economic growth?
6. Credit default swaps: As an Italian default would be a credit event, it would trigger credit default swaps, many of which were sold by American financial institutions. Would these institutions pay out? Could they? How would Italian losses affect their capital base? The same questions for euro countries become applicable here as well as American banks could be recapitalised by the state. (Will Americans allow another bailout?): a) how explicit a backstop will these banks get? would bond holders take losses; b) how would this affect American sovereign debt level and credit rating? c) how would this lack of capital affect credit availability and economic growth in the US?

There are a lot of other potential areas where this could go like capital controls, civil unrest, eurozone breakup, government coups, etc, etc. All of that is speculation. But above are the six parts I see as a sure thing: credit event, Italian bank run, Spain and Slovenia insolvency, contagion into Eastern Europe, some euro bank insolvencies and credit default swap triggers. Clearly, this would mean an economic downturn of at least the magnitude of the Great Depression.

I also tend to think contagion will spread throughout the eurozone until it breaks apart – and we do see yields rising right across the euro zone, today in France, Austria and even the Netherlands:

This is a rolling crisis wave through the eurozone infecting more countries, closer and closer to the core. As Marshall wrote recently, this is a structural problem. All of the euro zone countries face liquidity constraints and all of them will eventually succumb to the rolling wave of yield spikes one by one until we get a systemic solution: full monetisation and union or break up.

-Felix Zulauf on the inevitability of further crisis in Europe, July 2011

Protecting your wealth

Hedging against this outcome means preparing for black swan scenarios in stocks, government bonds, currencies, commodities and precious metals. This is a world of unpredictable policy paths that will certainly involve civil unrest, government repression and economic nationalism, but may also involve competitive currency devaluations, currency controls, and trade wars.

My view is that such a scenario will mean significant dead weight economic loss due to debt deflation dynamics. Economic output would decline significantly, as would stocks and high-yield debt. Commodity prices would also decline. But depending on the policy response of governments, bonds and precious metals are wildcards.

Governments like Norway’s are protected because of low debt and rich natural resources. On the other hand, governments like Australia’s and Canada’s are exposed because of significant household sector indebtedness and high property valuation. In essence, there is nowhere to hide in the sovereign bond area. As a foreign investor in sovereign debt, you want to know where the currency and the interest rate are going and neither is foreseeable in this train of events.

If governments try to inflate their way out, precious metals might be a good safe haven, although paper gold presents a problem of reliability and physical gold is subject to confiscation. On the farmland front, as Jim Grant testifies, yields are already very low, so you have to wonder how much upside there is to that trade. Obviously, in a world of financial repression and competitive currency depreciation, those investments won’t necessarily lose value.

Highly rated corporate bonds and high quality dividend paying stocks may well be the best safe havens.

Those are my thoughts on what an Italian default would mean. The overall thrust of the arguments here is that a default would be economically catastrophic and put into play a lot of outlier scenarios. The potential for large losses would be significant, and, therefore it pays to think about how to protect your wealth in such an environment, given that serious policy makers believe letting Italy default is a justifiable policy choice.

P.S. – after I wrote this post, I noticed a piece by David McWilliams, a well-known Irish economist, which ran through an Irish euro exit scenario like the one I had speculated about for Italy above. See my article highlighting McWilliams main points here.

Cross-posted from Credit Writedowns. Follow me on Twitter at edwardnh for more credit crisis coverage.

Disclaimer: This piece on the impact of Italy’s potential insolvency on the sovereign debt crisis is not an advocacy piece. It is supposed to be an actionable prediction of what I see as likely to occur. That said, see link at the bottom for the other side of that trade.

Michael Pettis liked my recent piece on vendor financing in the euro zone. The key point he wrote me – and which he reiterated just the other day – is that bad policies in “the surplus as well as in the deficit countries are at the root of the trade and capital inflow imbalances to which this crisis is the response” I agree with his contention that it is pointless to insist on adjustments only in the deficit countries.

That said, Michael agreed, however, that the euro crisis is not just a liquidity crisis. The European Sovereign Debt Crisis is a solvency crisis too. Countries like Italy are simply not going to be able to grow their way out of the problem. Everyone is recognizing this now. Until Italy was at the heart of the crisis, we could all delude ourselves that this crisis could be met with crushing levels of austerity in the periphery, even if that forced the economies there into depression. If Spain’s debt woes and Germany’s intransigence lead to double dip, then Italy’s debt woes and Germany’s intransigence lead to a Depression (with a capital ‘D’).

So, how the heck do we get out of this morass? My argument has been that with the central bank as a lender of last resort, solvency is meaningless for a government borrowing in a currency its central bank creates. In a nonconvertible floating exchange rate world, the adjustment mechanism is the exchange rate, not the interest rate. The last twenty years in Japan tell us that.

Translation:

… all countries which issue the vast majority of debt in their own currency (U.S, Eurozone, U.K., Switzerland, Japan) will inflate. They will print as much money as they can reasonably get away with. While the economy is in an upswing, this will create a false boom, predicated on asset price increases. This will be a huge bonus for hard assets like gold, platinum or silver. However, when the prop of government spending is taken away, the global economy will relapse into recession.

-Credit Writedowns, Oct 2009

That’s a soft depression scenario where the countries with a true lender of last resort can backstop without problems. In the euro zone, the ECB is not a lender of last resort… yet. And so the solvency issue cannot be postponed, monetised or inflated away and comes to a head. In fact, had the ECB been allowed to intervene as a lender of last resort earlier when just Greece was on the line in March 2010, we wouldn’t be here at all. Since then, the ECB has intervened only as a quid pro quo for more economy-deflating austerity, making things worse. And when they have bought periphery bonds they have been timid to prevent the currency-weakening moral hazard of ‘fiscal profligacy’. Credible lenders of last resort use price, not quantity signals. Everything in the sovereign debt crisis that has transpired since March 2010 is directly attributable to the ECB’s not acting as a lender of last resort.

As for Italy’s solvency, here’s what we know: Italian government debt is almost 120 percent of GDP. Since Italy pays over 6% for two-year money, rolling over debt contracted at favourable yields in 2008 or 2009 becomes excruciatingly onerous. Slow growth Italy’s debt to GDP spirals higher and higher at these levels. At German yield levels, Italy can sustain its growth indefinitely because it has a primary surplus already. I covered a lot of the ground in my last three posts Why questioning Italy’s solvency leads inevitably to monetisation, Why Investors will buy Italian bonds after ECB monetisation and Italy! Italy! Italy!

Here’s the thing: distinguishing between insolvency and illiquidity is a tricky subject because liquidity crises are the market’s way of shaking out the insolvent. Liquidity crises are always solvency crises. The question is about determining which debtor will not be able to repay future principle and interest in a world of incomplete information. If the questionable debtors are large enough, this leads to panic and a wider liquidity crisis that stresses the balance sheets of everyone, including the insolvent debtors. Indeed, the insolvent almost always are shaken out and bankrupted by this process (or are bailed out by government). The problem is that the shake out process kills a lot of other debtors too. If the crisis is large enough, a Depression results.

So, we are now faced with a question: Should the ECB go all-in or not? There aren’t a lot of options. No one is going to buy Italian bonds at a low yield without a backstop, irrespective of austerity now that the insolvency genie is out of the bottle. With a backstop, some people will. An Italian default equals the insolvency of the Italian banking system. An Italian default means massive losses for German and Dutch banks and beyond. Any scenario in which there is an Italian default leads to a Depression with a capital ‘D’. The question is a political one and, hence, unpredictable. The Germans (and Dutch) either allow the backstop or face Depression. It’s as simple as that.

P.S. – Angela Merkel has a damn good poker face though. I think this could be why.

Cross-posted from Credit Writedowns. Follow me on Twitter at edwardnh for more credit crisis coverage.

Disclaimer: This piece on the impact of Italy’s potential insolvency on the sovereign debt crisis is not an advocacy piece. It is supposed to be an actionable prediction of what I see as likely to occur.

Last week we witnessed a flight to quality within the euro zone government bond market. The yield on 10-year German government bonds dropped a record 35 points last week. German 10-year bonds now yield 1.82 percent. Meanwhile, the yield on 10-year Italian government bonds continues to rise, last quoted by Bloomberg at 6.37%, a record 455 basis points higher than German government bonds.

Clearly, Italy is now the biggest focal point of the European sovereign debt crisis. And, make no bones about, while the immediate concern for Italy is liquidity, at heart the European Sovereign Debt Crisis is a solvency crisis. Let’s take a look at Italy to see why.

The “Complete Strategy”

On October 26th, the EU announced to great fanfare that it had hammered out a “complete strategy” to deal with the ever-widening European sovereign debt crisis. The text of summit statement showed three pillars upon which this strategy rested.

1. Sustainable public finances and structural reforms for growth: “The European Union must improve its growth and employment outlook, as outlined in the growth agenda agreed by the European Council on 23 October 2011… All Member States of the euro area are fully determined to continue their policy of fiscal consolidation and structural reforms.”

2. Stabilisation mechanisms: “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 the funding cost…; 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.”

3. Banking system package: “There is broad agreement on requiring a significantly higher capital ratio of 9 % of the highest quality capital and after accounting for market valuation of sovereign debt exposures… Banks should first use private sources of capital, including through restructuring and conversion of debt to equity instruments. Banks should be subject to constraints regarding the distribution of dividends and bonus payments until the target has been attained. If necessary, national governments should provide support , and if this support is not available, recapitalisation should be funded via a loan from the EFSF in the case of Eurozone countries.”

The first of three pillars addresses solvency of euro area national governments while the second addresses liquidity. The third addresses both the liquidity and solvency of euro area banks. But will this solve Italy’s problems?

Italy

Italy’s problem is this: Italian government debt is almost 120 percent of GDP, behind only Greece within the euro area. Meanwhile, Italy pays 6.5% for its long-term debt. If interest rates were to remain at current levels for an extended period, Italy would need to run a primary budget surplus (excluding interest payments) of about 5 percent of GDP, merely to keep its debt ratio constant.

As a reminder, the plan is to have Greece’s private sector creditors reduce their claims enough to get Greece to this level, which the EU is calling sustainable. My suspicion is that the 120% debt target for Greece is largely a function of not wanting to suggest that Italy’s debt levels are too high.

How can Italy get out of this trap?

Lower interest rates: The plan presented by the EU was to relieve Italy of its interest rate burden by leveraging the European bailout facility, the EFSF. In order to do this, the Europeans need a “combination of resources from private and public financial institutions and investors”. We know that European banks are undercapitalised and European countries are in the midst of a sovereign debt crisis. So no funds are going to be forthcoming there. The United States is having its own fiscal battles and cannot take the lead. That leaves the biggest developing countries, China, Brazil and India and oil rich sovereigns to bail out the Europeans. The Chinese have already said they are not going to get involved and the amount of resources Europe can get from elsewhere is not nearly enough to backstop Italian government debt, the third largest government debt load in the world unless the Europeans are relying on aliens to fund them. So this pillar of the three-legged stool is broken – at least for an economy the size of Italy’s.

Growth: Given the fact that Italy has one of the lowest ratios of births to deaths in the world, it also has a rapidly aging society, which limits potential economic growth. Even if domestic GDP expands by a wildly optimistic 2 percent per year – it has expanded less than one percent over the last decade – you would need 3% growth from exports in order to stabilise the debt to GDP ratio at 120% at prevailing interest rates. That is never going to happen. So this leg too is bust.

Austerity: The Europeans are pushing Italy to make structural reform. But the Italian government has been unable to make these reforms. Prime Minister Berlusconi priorities seem to be elsewhere and his government is weak; likely the government will collapse. Even so, Italy’s labour minister Maurizio Sacconi warns that rushing through the labour market reforms which the EU demands risks creating the preconditions for a wave of terrorism. Wow. Do you really think, the Italian government, which seemed to have a different governing coalition almost every year for most of the post World War II era, is going to be able to push these kinds of draconian reforms through? And I haven’t even mentioned budget or public pension cuts.

The Italians don’t have a leg to stand on.

Monetisation

This approach is the easiest and therefore a very likely outcome. Let me frame what I think the issues are and how to go about it. Note, this is not an advocacy piece so I am framing what could occur more than what I would recommend.

The monetisation scenario ostensibly involves an attempt to separate liquidity from solvency issues by using the currency creator’s power to stand behind debt obligations with a potentially unlimited supply of liquidity. This is the traditional lender of last resort role that a central bank is expected to play. For example, the Fed played this role in buying up financial assets during the crisis in 2008 and 2009. Of course, it did so recklessly by buying up dodgy assets at inflated prices instead of good assets at penalty prices so as to discriminate between the illiquid and the insolvent.

Now that the credit crisis has moved on to sovereign debt, the central bank can play this role with sovereign debt as well. The best way to accomplish this task would be to start buying enormous quantities of sovereign debt, inducing a huge shift in the price/interest rate of those assets. Only afterwards, the ECB would announce that it was prepared to supply unlimited liquidity to stand behind these assets at specific target interest rates and would do so at the most inconvenient moments for speculators wishing to make a quick euro. (Update: see comments of a similar nature after this was written from Willem Buiter at the bottom.)

The point would be twofold:

1. Market participants would understand that the ECB had unlimited means to back up threats with action, the stress clearly on the word unlimited.
2. Market participants would understand that the ECB intended to penalise speculators by targeting them with its unlimited liquidity.

As Willem Buiter first mentioned last November, the ECB will not risk its anti-inflationary credibility to monetise the debt of smaller euro zone countries like Greece or Ireland. This is why they were forced to take a bailout. On the other hand, it could be a possibility for Spain because Spain is simply too large to bail out in the way that Greece and Ireland were bailed out.

The immediate impact of this kind of action would be a rise in the euro-denominated gold and silver price, currency depreciation more generally, and increased inflation expectations. So this is a beggar thy neighbour economic policy – competitive currency devaluation, if you will.

-Three options for the euro zone: monetisation, default, or break-up, Nov 2011

I wrote these paragraphs one year ago and I see nothing that has occurred since then which makes me want to change anything. In fact, the events of the past year make me think this is all the more likely. Italy was not a factor then; it was Spain which was the problem. Italy has the third largest government bond market in the world. In July, I also mentioned that Italy owes German banks 116 Billion euros. If Italy were to default, the result would be financial Armageddon and a major worldwide Depression, perhaps one worse than the Great Depression. The Germans know this. And as I outlined above, the route to a sustainable solvency path that leads to liquidity for Italy is blocked at every path. Italy will continue to pay a huge premium for its debt. The only way to ensure Italy’s medium-term solvency is to have it borrow in a currency whose creator is credibly committed to creating an unlimited supply of money in order to backstop Italy’s debt if necessary.

At present, the ECB is buying just enough bonds to send a message to Spain and Italy that they need to live up to their austerity quid pro quo or else the ECB will stop buying. The ECB wants to prevent ‘free riders’ from making the euro a weak currency. But, let’s be clear, a currency with “no lender of the last resort” was a ridiculous concept from the start. The crisis we are witnessing now was always going to happen. As much as the ECB resists it now, they have limited choices: monetise or face a global economic collapse. The longer they wait, the worse it will get.

This post was the first in a series on Italy that I began on Sunday. Read the second on the second on Why Investors will buy Italian bonds after ECB monetisation. I will have more today or tomorrow.

Cross-posted from Credit Writedowns. Follow me on Twitter at edwardnh for more credit crisis coverage.

Here’s an interpretation of the euro zone I have been meaning to discuss. I touched on it in the update to my post on how austerity in Europe works. In a fixed exchange rate environment like the euro area, you don’t have currency fluctuation issues. So persistent current account imbalances as we see within the euro zone are really a form of vendor financing. I am familiar with the perils of vendor financing having witnessed the Telecom bubble of the late 1990s go bust, wiping out the major source of revenue in the European high yield market in which I worked. Here’s an article from right around the bust that gives you a positive spin on how how vendor financing worked in telecoms.

Aerie is just one of the 45 vendor financing deals Nortel has on its books. As such, it offers a glimpse into a battle the big telecommunications equipment makers — notably Nortel, Lucent (LU) and Cisco (CSCO) — are rushing to join: picking up more of the financing slack for the very companies that buy their equipment.

Islands in the Stream

While Nortel is certainly knee-deep in the lending business, rival Lucent is the true champion of vendor financing. Lucent has been saying "yes" ever since it hit the ground four years ago, to the tune of $7 billion in financing commitments, more than double Nortel’s $3.1 billion. (Nortel has $1.4 billion in actual loans outstanding to buyers of its equipment; Lucent, $1.6 billion.)

Cisco, in order to compete with the incumbent telecom equipment makers, says it has beenincreasing its vendor financing activities through its banking arm, Cisco Capital. Cisco has so far promised $2.4 billion in loans to its customers. (Cisco’s loans outstanding amount to $600 million.)

Equipment makers derive several advantages from so-called vendor financing arrangements, the terms of which often remain under wraps. Namely, they gain relationships with potentially lucrative customers and revenue that will look good on the next financial statement.

Vendor financing works successfully as long as the lender makes sure the customer can pay back the loans. In the telecoms arena, the whole sector cratered and these loans were an albatross around the necks of the likes of Nortel and Lucent. Not only did firms like Nortel lose huge revenue streams, they also had to write off massive amounts of capital from dud loans they had made to customers during the bubble. It’s as if most of the revenue Nortel and Cisco were booking in 1998 or 1999 was phantom revenue, maintained artificially by their channel stuffing and vendor financing of customers. Eventually Nortel went bankrupt.

And so it is in Europe as well. The lurid Telegraph story about German-made Porsches bought in Greece shows you an extreme example of how this works. The reality is you can’t have Germany and Spain both running current account surpluses with each other at the same time. Unless the euro zone as a whole runs a current account surplus as large as Germany and the Netherlands, then you are automatically going to have a sort of vendor financing relationship going.

The euro area did have a good-sized trade surplus through 2005 – not as large as the one that Germany and the Netherlands had, but sizable. This all unravelled starting in 2005 (chart below via tradingeconomics.com). That would have been the time for German banks and companies to pull in their horns and restrict credit to the periphery.

So, if Germany or the Netherlands wanted to be the export juggernaut and run a massive current account surplus, this had intra-EU ramifications. The most important is that Germany’s or the Netherlands’ current account surplus matched current account deficits in Spain, Portugal, and Greece. That’s how it works. You sell more to me than I do to you and I get more cash than you do. There are always two sides to every transaction (chart from the FT below).

The large euro-area internal current account imbalances should be seen as a form of vendor financing, whereby the creditors, principally Germany, forward their customers, the debtors, trade finance in order to sell their wares. Germany’s aging society meant slow growth. So German companies have looked abroad for growth, just as the Japanese have done in their aging society. Taken in aggregate, this means persistent current account surpluses which are a fancy way of saying vendor financing at the national level.

German banks were at it too, by the way. German retail banking is a low margin business and credit growth is weak. So the German banks loaded up on foreign assets, making loans abroad. German banks were very active in Ireland and Spain during the housing bubbles there, for example.

So, one way to look at the sovereign debt crisis is a complicated form of vendor financing. German banks have been particularly aggressive in seeking returns abroad and now the chickens are coming home to roost.

By Philip Pilkington, a journalist and writer living in Dublin, Ireland

In waking a tiger, use a long stick.

– Mao Tse-tung

Well, it looks like it could finally be happening. The Chinese housing bubble could well be bursting right before our eyes.

The bubble has long been present for all to see, with news reports popping up earlier this year about ‘ghost cities’ and ‘ghost malls’. Indeed, it’s been so visible and so well observed that even the mainstream media picked up on it. That’s right, folks… you heard me right: the mainstream media picked up on it! God, it must be serious!

People have been calling the bursting of this bubble for a while now. But this is the first real indication I’ve seen that this particular house of cards – excuse the pun – is beginning to topple.

On Sunday Gordon G. Chang over at Forbes noted:

“Residential property prices are in freefall in China as developers race to meet revenue targets for the year in a quickly deteriorating market.  The country’s largest builders began discounting homes in Shanghai, Beijing, and Shenzhen in recent weeks, and the trend has now spread to second- and third-tier cities such as Hangzhou, Hefei, and Chongqing.  In Chongqing, for instance, Hong Kong-based Hutchison Whampoa cut asking prices 32% at its Cape Coral project.  “The price war has begun,” said Alan Chiang Sheung-lai of property consultant DTZ to the South China Morning Post.”

Conservative estimates say that property prices in China will fall by 10% next year, while some, such as Cao Jianhai of the Chinese Academy of Social Sciences, see potential price falls of 50%.

So, why did this bubble inflate and what will be the consequences if it deflates?

Dude, where’s my communism?

We could look at the superficial reasons as to why the bubble inflated – you know, the usual non-story of low interest rates and a boom in bank lending. But this is not the root cause – it never is. The real underlying cause is the same as that of the financial bubbles that have plagued our fair Western lands: income inequality.

When the rich stockpile money in bank accounts they often get a bit bored. They then get weary of tiresome productive investments and look around for a bubble to inflate. Property is the name of the game these days.

A 2008 World Bank report says it all. Not only is income inequality rising, but people in the urban centres are seeing their incomes rise much faster than people from the rural areas. You can see all these dynamics on the chart below which is taken from the same paper.

As we can see, the difference between urban and rural incomes rose sharply as China’s economic growth took off. In addition to this those on the coast saw their incomes rise substantially faster than those that live inland. This geographical dispersion of wealth likely exacerbated underlying trends, ensuring that wealth was concentrated in certain geographical centres that would then become hotspots for property speculation.

The bubble got a boost in 2008 when the Western finance-o-sphere melted down from… erm… another housing bubble. In response to flagging demand from the West, the Chinese government initiated a humongous stimulus package of $586bn. This stimulus kept the property market intact, together with the robustness of the Chinese economy.

But it looks like it’s all over now. How sad.

Is the housing bubble a paper tiger?

So, what happens when this thing falls apart? Worst case scenario: we get total meltdown. The Chinese banks would probably hit the wall, the economy would fall apart and China would finally have to deal with all those disgruntled and underpaid workers that have, until now, been off the streets only because they have crappy jobs.

In addition to all that domestic nastiness, the current commodities bubble would probably deflate and the Australian mining sector would grind to a halt – finishing off one of the only remaining English-speaking economies worth a damn. (There would also probably be a knock-on effect in that the Aussie property market would finally implode as well).

Not very pleasant, huh?

Well, the doomsayers are probably going to be a little peeved because in all likelihood the bursting of the Chinese property bubble will likely prove a paper tiger.

You see, we in the West seem to think that a financial crisis – and crises related to the extension of excessive credit – must be catastrophic for the real economy. But this is not so. If there is a strong government in place that operates under its own sovereign currency and has no childish qualms about increasing deficit spending, then pretty much any financial-ish crisis can be deficit-spent into oblivion.

As Bill Mitchell put it the other day in an excellent post about Western doomsday fantasies surrounding China:

“The Chinese government is the currency issuer and they demonstrated during the early stages of the crisis that they know exactly what they are doing with respect to using that monetary supremacy to maintain growth as one component of spending collapses.”

That says it all really. If the property bubble collapses, the Chinese government can simply extend and expand the already existing government construction projects. Hell for the environment, of course, but not so much for the Chinese worker. They can boost this with New Deal-style direct government works projects if they so wish. In fact, they can do pretty much anything they want to boost domestic employment and demand because they don’t have the likes of John Boehn-head cock-blocking them every time they try to get anything done.

This will probably provoke inflationary pressures, but given the choice between widespread unemployment – ‘unemployment’ being Chinese for ‘social unrest’ – the government will likely start to ignore it. Indeed, they will probably come to realise, if they haven’t already, that their inflation problems are likely due in large part to income inequality. This will spur them on to create the domestic consumption base that they sorely need. And if it doesn’t the inflation itself might just do the work for them in the coming decades.

Either way, the money currently be splurged on property will find its way into the domestic consumption base and into investing in productive capacity that supplies this base. The Chinese government can either do this directly through redistributive taxation policies or the inflation will take care of it by eroding the value of the upper-classes hoardings… erm… I mean ‘savings’. I’d favour the former, but if ignorance (and power-plays) win out the latter will suffice in the medium-to-long run. Just ask Latin America!

Yes, the property bubble in China looks like its bursting. But no, this will probably not prove to be a catastrophe. Instead, we in the West are going to get schooled once again, when our Eastern ‘comrades’ show us just how to run an advanced capitalist economy. History, eh? It’s just one big irony.