naked capitalism

Yves here. Notice how someone in the officialdom actually said “There is no alternative”. Nothing like being explicit.

By Delusional Economics, who is horrified at the state of economic commentary in Australia and is determined to cleanse the daily flow of vested interests propaganda to produce a balanced counterpoint. Cross posted from MacroBusiness.

Overnight, Greek Leftist leader, Alexis Tsipras, gave up on his attempts, or at least pretence of them, to form government. The gauntlet has now been handed to PASOK leader, Evangelos Venizelos, who again has 3 days to attempt the same.

Given that New Democracy, Venizelos’s potential coalition partner, has already failed to create a workable coalition it is doubtful PASOK will succeed. Neither Tsipras or Samaras used their fully allocated time suggesting there is little point dragging out talks as no comprises could be reached.

Greece appears to be heading back towards an interim technocrat government and new elections unless the Greek President is able to muster a workable coalition in the coming days. New elections may bring new alliances, but it is yet to be seen what the new political strategies will appear after the demolition of the centrist parties.

Overnight the EFSF board agreed to make an additional payment to Greece in order to keep it technically solvent for a few more weeks:

After a conference call, the board of the European Financial Stability Facility, the 700 billion euro bailout fund administered by the 17 countries that use the euro, agreed to make the scheduled payment, which will allow Greece to meet near-term bond redemptions and other obligations.

An initial 4.2 billion euros will be paid on Thursday, while the remaining 1 billion will be paid out later, “depending on the financing needs of Greece,” a statement said.

It said the remaining 1 billion was not needed before June.

This may appear as a back down but realistically it is just a payment in order for Greece to hand the money back again. Greece has approximately €3 billion worth of bonds held by the ECB maturing this month and also the non-greek law PSI bonds to sort out. This is very much a case of drip feeding money in order to protect greater Europe from the contagion of a default.

In the meantime the rhetoric from outside of Greece has ramped up a notch with European Central Bank Executive Board member Joerg Asmussen quoted as saying:

Greece has to be aware that there is no alternative to the agreed consolidation program if it wants to remain a member of the euro zone

The ECB currently holds €40 billion of Greek bonds and its banks have €140bn in repos. In that regard Mr Asmussen appears to be having an argument with a loaded gun, and this has very much turned into a game of chicken.

But members of the ECB aren’t alone in publicly announcing Greece’s choice. Until recently, speaking of a Greek departure from the Euro was completely out of bounds. But, as Bloomberg reports, the economic and political realities of the situation appear to have changed all of that:

From the monetary fortress of the European Central Bank to the pro-European duchy of Luxembourg, policy makers are beginning to air their doubts that Greece can stay in the euro.

Post-election tumult in Athens has put the once-taboo subject of an exit from the 17-country currency union on the agenda, lifting the veil on possible scenario planning afoot behind the scenes.

“If Greece decides not to stay in the euro zone, we cannot force Greece,” German Finance Minister Wolfgang Schaeuble said at a conference sponsored by German broadcaster WDR in Brussels today. “They will decide whether to stay in the euro zone or not.”

After 386 billion euros ($499 billion) in aid pledges for Greece, Ireland and Portugal, 214 billion euros in ECB bond purchases and another trillion euros in low-interest loans for banks, plus 17 high-level crisis summits, Greece’s political chaos thrust Europe into a perilous new phase.

The world is witnessing an “important moment in European Union history, a moment of crisis,” EU President Herman Van Rompuy said in Brussels on the 62nd anniversary of the declaration by Robert Schuman, then France’s foreign minister, that launched postwar European integration.

Let’s hope there is some form of compromise on both sides, but at this point in time it is very hard to say what is going to happen either way.

Greece, however, wasn’t the only problem overnight. Spain once again came to the fore as its 10 year bond yields rose 4.02% to reach 6.078%. Meanwhile the Spanish stock market indicator, the IBEX 35, closed down 2.77% overnight which took it back to levels not seen since October 2003 and it now sits lower than it did at the height of the GFC:

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Overnight rumours of plans to attempt to bolster the banking system, including huge jumps in capital requirements, hit the news wires:

Spain plans to partly nationalize BFA- Bankia group as Prime Minister Mariano Rajoy tries to restore investor confidence with his second overhaul of lenders in three months, a government official said.

The government will become the largest shareholder in the bank that has the biggest Spanish asset base, said the official, who declined to be named because the plan hasn’t been announced.

It’s also working on a plan to force banks to set aside more provisions on real estate loans that are still healthy, said a person familiar with the situation, who also declined to be identified. The rules, to be approved on May 11, will increase provisions on the loans to about 30 percent from 7 percent, creating an additional buffer of about 30 billion euros ($39 billion), the person said.

Rajoy, who said for the first time this week he may use public money to shore up banks, is trying to restore trust in the financial system without overburdening public finances.

As I have explained previously, Spain’s major economic issue the loss of private sector wealth from over exposure to a deflating housing bubble which, in the absence of a major push in counter cyclical fiscal policy, is leading to a surge in bad debts in the banking system.

Spanish house prices accelerated downwards in April with the YoY falls hitting 12.5%. The accumulative falls since the peak are now 29.8%

With asset devaluations like that it is very difficult to see how the Spanish taxpayer is going to stay unencumbered under any new plan.

By Philip Pilkington, a writer and journalist based in Dublin, Ireland. You can follow him on Twitter at @pilkingtonphil

Fairytales and nursery rhymes are quite popular among the economists. Economists and economic commentators will couch magical thinking in rational sounding phrases — but that doesn’t stop it from being hokum. Some within the profession attack these juvenile tendencies. Paul Krugman, for example, has often lambasted the idea, fostered by some of his colleagues, that the current crisis is due to a lack of confidence among investors. In a flash of irony he labeled this idea that of the ‘confidence fairy‘.

Of course, Krugman is absolutely right; the idea that a lack of confidence is responsible for the current crisis is a fairytale pure and simple. Our current economic problems are caused by a lack of aggregate demand. Investors are absolutely right to lack confidence at this moment in time because, just like in the 1930s, there is no rational reason to invest more because the population lacks the adequate purchasing power to consume more goods and services. Matias Vernengo over at the excellent Naked Keynesianism blog provides a classic quote from Roosevelt’s Fed chairman Marriner Eccles that summarises the situation well:

Confidence itself is not a cause [of economic depression]. It is the effect of things already in motion. What passed as a ‘lack of confidence’ crisis was really nothing more than an investor’s recognition of the fact that new plant facilities were not needed at the time.

Pretty straightforward point, but powerful nonetheless. And I think Krugman and other ISLM-Keynesians would broadly agree with it. That is, peculiarly, until they start talking about inflation targeting.

Proponents of inflation targeting claim that if the central bank sets a higher inflation target investors will react to this by, well, investing more. Krugman sums it up:

If the Fed were to raise its target for inflation — and if investors believed in the new target — expected inflation over the medium term, say the next 10 years, would be higher… [and] higher expected inflation would aid an economy up against the zero lower bound, because it would help persuade investors and businesses alike that sitting on cash is a bad idea.

Now, is it just me or does it appear that Krugman has just smuggled the confidence fairy in through the backdoor? Read that passage again carefully. The ‘idea’ here is to trick investors into investing by scaring them into thinking that the Fed will allow inflation to rise higher than it currently is.

Really? Come on. Does Krugman really believe investors are this stupid? Does he really think that they make their investment decisions based on what some central banker says is the target rate of inflation? Sure, the commentariat are eating this garbage up — the usually sharp crew over at FT Alphaville provided a glowing account of why the inflation-confidence fairy should be unleashed from its bottle — but when it comes to putting your money where your mouth is, are smart people really going to buy into this idiocy?

Short answer: no. Krugman and others treat investors like children. But investors — real investors who provide funds for new goods and services — are not children. Instead, they will continue to look at the economic fundamentals when making investment decisions. And if there is simply not enough demand for goods and services they will not make investments aimed at creating more goods and services. Duh! It really is quite obvious.

Now, the financial investment community might well react to this hocus pocus — but that is an altogether different thing. This is not because paper-shufflers are stupider than their entrepreneurial and corporate counterparts, but because they are concerned with perceptions and fairytales — it is largely upon these that their business rests. They do react irrationally to news simply because they think that their peers might react irrationally to the same news. The financial community is, in many ways, a hall of mirrors with everyone trying to guess everyone elses’ reaction to announcements and news. But just because the financial community may react to a higher inflation target by no means entails that their money will end up funding goods and services that increase employment in the real economy.

If you actually look at how the financial community reacts to unorthodox announcements by the central bank the reality — as opposed to what abstractions like the ISLM will lead you to believe — is much different. The likely outcome of such an announcement in the present economic environment is obvious given that we now have four years of experience with these sorts of pseudo-policies: financiers will move their funds into so-called ‘inflation hedges’ like gold, silver and other commodities. What’s more, if the central bank manages to scare them sufficiently they may even move their funds out of government bonds and into these ‘hedges’. This will lead to increased upward pressure on the interest rate at which governments borrow which will, in turn, give the austerity brigade even more of a mandate to cut government spending and engage in other sorts of economic vandalism.

Unfortunately, Krugman and others will likely continue to publish their fairytales and recite their bedtime stories. Why? Because, to put it somewhat bluntly, it gives them something to do. It gives them something to talk about that makes them appear as if they have some specialised knowledge that only a select few Very Sophisticated People understand and have access to. It also gives them the assurance that their abstract models actually tell them something — something a priori and mysterious — about the real world that cannot be gleaned by simply observing empirical reality. In short, it gives them a power to fascinate the general public and policymakers and lull them to sleep. But of course this is exactly the same power of fascination that the parent exerts over the child at bedtime by telling them of faraway lands; of witches and of warlocks; of goblins and… of fairies.

By Satyajit Das, derivatives expert and the author of Extreme Money: The Masters of the Universe and the Cult of Risk Traders, Guns & Money: Knowns and Unknowns in the Dazzling World of Derivatives – Revised Edition (2006 and 2010). Jointly posted with Roubini Global Economics

The half-life of solutions to Europe’s debt problem is getting ever shorter.

Recent hopes have relied on the ostensible success of the European Central Bank’s (“ECB”) LTRO – Long Term Refinancing Operation, more appropriately termed the Lourdes Treatment and Resuscitation Option. In December 2011 and February 2012, the ECB offered unlimited financing to European banks at 1% for 3 years, replacing a previous 13-month program. Banks drew over Euro 1 trillion under the facility – €489 billion in the first round and €529.5 billion in the second. Participation amongst European banks was widespread, especially in the second round where around 800 banks used the facility.

The funds borrowed were used to purchase government bonds, retire or repay existing more expensive borrowings and surplus funds were redeposited with the ECB. The first entailed banks borrowing at 1% purchasing higher yielding sovereign debt, such as Spanish and Italian bonds that paid 5-6%. This allowed banks to earn profits from an officially sanctioned carry trade – known as the Sarko trade after the French President.

The LTRO provided finance for both beleaguered sovereigns and banks, which need to raise around €1.9 trillion in 2012. It helped reduce interest rates for countries like Spain and Italy. It also helped banks covertly build-up capital, via the profits earned through the spread between the cost of ECB borrowings and the return available on sovereign bonds.

The LTRO was very clever, effectively monetising debt (printing money) without breaching European Treaties or the ECB’s charter.

The sheer weight of money – at one €500 note per second it would take 63 ½ years count €1 trillion- proved successful. Financial market sentiment was overwhelmingly positive feeding a large rally in global stock markets and other risky assets.

As subsequent events have exposed, there were always reasons to be cautious.

The LTRO facility is for 3 years. It assumes that the conditions will normalise within that period. It is not clear what happens if that is not the case.

Economist Walter Bagehot advised that in a crisis central banks should lend freely but at a penalty rate and secured by good collateral. The ECB does not appear to have quite understood Bagehot’s commandment. The rate is below market rates, amounting to a subsidy to banks. The ECB and Euro-Zone central banks have loosened standards, agreeing to lend against all manner of collateral. In effect, the ECB is now functioning as a financial institution, assuming significant credit and interest rate risks on its loans.

If the European Financial Stability Fund (“EFSF”) was a Collateralised Debt Obligation, the ECB increasingly resembles a highly leveraged bank.

The ECB balance sheet is now around €3 trillion, an increase of about 30 percent just since Mario Draghi took office in November 2012. It is supported by it own capital (scheduled to increase to €10 billion) and the capital of Euro-Zone central banks (€80 billion). This equates to a leverage of around 38 times.

Critically, the LTRO cannot address fundamental issues.

It does not reduce the level of debt in problem countries, merely finances them in the short-run. Europe is relying on its austerity program to reduce debt. As Greece demonstrated and Ireland, Portugal, Spain and Italy are demonstrating, massive fiscal tightening when combined with private sector reduction in debt merely puts the economy into recession. As public finance deteriorate rather than improve, it results in an increase not decrease in public debt.

Ultimately, it may be necessary to go Greek. Debt restructuring may be needed to achieve the required reduction in the public borrowings for many countries. Interestingly, financial markets price the risk of a Spanish debt restructuring at around 30-35%.

The LTRO does not improve the cost or availability of funding for the relevant countries beyond an immediate short term fix..

Government bond purchases financed by the LTRO artificially decreased the interest rates for countries, such as Spain and Italy. Unless additional rounds of LTRO are offered, interest rates are likely to return to market levels.

The real increase in liquidity available to support sovereign borrowings was lower than €1 trillion. Perhaps only one third of the LTRO loans and maybe as little as €115 billion were directed to this purpose. Banks used the bulk of funds to repay their own borrowings. As debt becomes due for repayment through the year, banks may need to sell sovereign bonds purchased with the funds drawn under the LTRO. Unless market conditions normalise and banks regain access to normal funding quickly, this will place increasing pressure on sovereign funding and its cost.

With European countries facing heavy refinancing programs in 2012 and beyond, the ability to raise funds at reasonable rates remains important. Existing bailout programs assume countries like Portugal and Ireland will be able to resume financing in money markets normally from 2013.

Events complicate the ongoing commercial financing of European banks and sovereigns. The need for collateral to support ECB funding makes other investors de facto subordinated lenders, reducing their willingness to lend or increasing the cost. In the Greek restructuring, European Central Banks and official institutions were exempted by retrospective legislation from loss while other investors suffered 75% writedowns. This has reduced investor willingness to finance countries considered troubled.

European banks already have large exposures to sovereign debt, which has increased since the start of the LTRO. Spanish banks are thought to have purchased around €90 billion, a jump of around 26% to €220 billion. Italian banks are thought to have purchased €50 billion, a jump of 31% to €270 billion.

Similar rise in government bond holding have occurred in Portugal and Ireland. As interest rates on these bonds have increased, buyers now have large unrealised mark-to-market losses on these holdings.

As with the sovereigns, the LTRO does not solve the longer term problems of the solvency or funding of the banks, which now remain heavily dependent on the largesse of the central banks. It is government sponsored Ponzi scheme where weak banks are supporting weak sovereigns who in turn are standing behind the banks – a process which can be best described as two drowning people clinging to each other for mutual support.

The LTRO has not materially increased the supply of credit to individual and businesses. The money is being used by banks to finance themselves as they reduce borrowings by selling off assets to reduce dependence on volatile funding markets. The LTRO does little to promote desperately needed economic growth in the Euro-Zone.

The initial euphoria faded as a number of concerns re-emerged, manifesting themselves in the form of increasing rates on Spanish and Italian debt which now hover around the key level of 6.00% per annum.

Increasingly poor economic growth figures from Europe pointed to a lack of growth and progress on debt reduction.

Attempts to reduce Spain’s deficit has proved problematic. Both Spain and Italy have deferred balancing their budget in the face of a deteriorating economic outlook. It is unclear which markets fear most -Spain and Italy not achieving its targets through savage spending cuts resulting in higher debt or achieving its target putting their economies into an even deeper recession and increasing debt.

The difficulties faced by Spanish Prime Minister Mariano Rajoy and Italian Prime Minister Mario Monti implementing labour reforms have highlighted the resistance to structural change. Increasing protests in many countries point to the political difficulty in implementing the agreed austerity measures.

The problems of the banking system have resurfaced. Spanish bank bad and doubtful debts have increased, as the Iberian property bubble deflates.

Increased reliance by Spanish and Italian banks on financing from central banks has heightened concern. Spanish bank borrowings from the ECB increased to over €300 billion in March from €170 billion in February. Lending to Spanish banks now accounts for nearly 30% of total ECB lending. Italian banks have also been heavy borrowers, a reminder of the linkage between banks and their sovereigns.

Reluctance to increase the inadequate European firewall sufficiently to deal with potential problems means policy options are limited. At around €500 billion in available funds, the bailout fund is short of the €1 trillion sought by the International Monetary Fund and G-20 or €2-3 trillion thought necessary by financial markets. German leaders have repeated their unwillingness to increase the fund to the necessary size, arguing, probably correctly, that no firewall will be adequate.

Poorly judged and ill-timed comments by ECB President Draghi about the absence of need for further LTRO funding and planning for an exit drew attention to the fragility of the position and ongoing risks. The comments were driven by Bundesbank unease at the ECB’s policy. The market reaction forced Mario Draghi to retract comments about an early exit from emergency funding. As rates continued to rise, Benoit Coeure, the French ECB board member, promoted a new round of direct purchases of Spanish bonds to reduce yields.

The failure of the LTRO to decisively solve European problems is unsurprising. Confidential analyses prepared by European Union officials and distributed to ministers meeting at the Copenhagen meeting in March 2012 concluded that the €1 trillion in loans was a “reprieve”, rather than a solution.

Rather than take the time afforded to move on other fronts, European leaders reverted to type. Spanish Finance Minister Luis de Guindos opined that: “We are convinced that Spain will no longer be a problem, especially for the Spanish, but also for the European Union”. It was eerily reminiscent of his predecessor Elena Salgado who almost exactly one year earlier on 11 April 2011 said: “I do not see any risk of contagion. We are totally out of this”. The optimism was echoed by French President Nicolas Sarkozy who was confident that the Euro-Zone had “turned the page”. Italian Prime Minster Mario Monti stated that the “financial aspect” of the crisis had ended.

The European debt crisis is not over. Fundamental problems – debt levels, trade imbalances, problems of the banking sectors, required structural reforms, employment and economic growth – remain.

Beyond the German favoured remedy of asphyxiating austerity to either cure or kill the patient, Europe is rapidly running out of ideas and time to deal with the issues. As the real economy stalls and debt problems continue, the most likely policy actions may come from the ECB – an interest rate cut to near zero and further liquidity support, perhaps even full-scale quantitative easing. Bailout funds may be channelled to recapitalise Spanish banks, as means of helping Spain without resort to a full-blown bailout package.

It is doubtful whether any of these steps will work.

European politicians and citizens want a quick return to a period Spaniards now refer to as cuando pensábamos que éramos ricos which translated into “when we thought we were rich”. Official policies and action are focused on deferring rather than dealing with the problem. Unfortunately, that means the inevitability of meeting the same problem somewhere down the road.

John Maynard Keynes observed in The Economic Consequences of the Peace that each action designed to bring closure to one crisis sows the seeds of greater economic, political and social problems. Europe is living the truth of that statement one day at a time.

By Marshall Auerback, a hedge fund manager and portfolio strategist. Cross posted from New Economic Perspectives

Nearly one Spaniard in four is unemployed, according to data released on Friday, as the country’s economic and financial predicament prompted a government minister to talk of a “crisis of enormous proportions”.The data from the National Statistics Institute showed 367,000 people lost their jobs in the first three months of the year. At this pace, Spanish job losses are equivalent to 1 million per month in the United States. That means more than 5.6m Spaniards or 24.4 per cent of the workforce are unemployed, close to a record high set in 1994.

Spain has become the new Greece. Actually, in many respects Spain is now worse than Greece. The Spanish unemployment rate is already so high and unlike Athens, Madrid has made no headway in reducing its public debt levels (whereas the Greeks are close to running a primary fiscal surplus at which point they could leave and turn the problem back on to Brussels). Moreover, Spain has a huge private debt burden that is twice that of Greece.

Although I have warned on these pages before that Spain’s austerity program was leading the country to disaster, my reaction to this economic catastrophe has been one of amazement. Just take a look at this employment data

Spain First Quarter Unemployment: Summary (Table)
2012-04-27 07:00:00.13 GMT

Yet, until now Rajoy Administration has been saying that the marginal decline in GDP estimated by the Bank of Spain for the first quarter was exaggerating economic weakness. Now we have the spectacle of the Spanish government suggesting that the Bank of Spain estimate of a .4% decline in Q1 Spanish GDP is too pessimistic. But in light of these numbers, what kind of GDP decline should one realistically expect when employment falls two percent non annualized in a quarter? At least a four percent annualized decline. more likely much higher. Yet who is talking discussing that as a real possibility in Brussels? Nobody. Everybody remains asleep at the wheel.

For years, the Spanish GDP figures have been hard to square with the underlying collapse in industrial production and rise in unemployment, both of which were more realistically reflecting the scale of the country’s collapse into depression.

When I said a few months ago that the Spanish government was lying about their numbers, I was attacked by a few Spanish readers of this blog, who claimed I was a nefarious hedge fund manager, likely loaded up to the gills with CDSs on Spanish debt who was trying to foment panic. For the record, I have never bought a credit default swap in my life. If anything, I was trying to foment panic because I was horrified by the new ultra austerity stance adopted by the recently elected Rajoy Administration.

Now consider the reality: the economy is crashing, hence the unemployment rate rise. Yet German Chancellor Angela Merkel and the ECB President, Mario Draghi, continue to insist that one can have both fiscal restriction and a lower domestic price level despite the fact that Spain has a non financial private debt to GDP ratio of 230%.

Interestingly enough, Dutch levels of private debt to GDP are even higher, at 249%, the highest in Europe. By contrast, the Italians still have net household savings. So who are the real “profligates” in Europe?.

Those who embrace these ruinous austerity policies will soon be seeing the experiencing much the same kinds of conditions as the Spanish (albeit from less depressed levels) including the moralistic Dutch, whose finance minister has been a crusader in favour of even harsher fiscal rules than those embodied in the Stability and Growth Pact.We have also recently witnessed a big surprise decline in the German consumer confidence index last week as well as a collapse in an Italian retailing sentiment index. The austerity disease is intensifying the crisis, even in the core.

It is inconceivable to me that Super Mario Draghi won’t be changing his tune soon, in spite of what he and the Merkel government are now saying for public consumption. To continue with this present course will not only precipitate a collapse of the euro, but a political collapse across Europe.

There is no question that larger deficits are needed to support aggregate demand at desired levels. However, as all of us who have contributed to this blog have long noted, the problem is the national governments are currently like US states and as such are revenue constrained because they are USERS, rather than ISSUERS of the currency (as opposed to, say, Canada or the US, both of which are sovereign issuers of their own currency).

So relaxing the deficit limits without some kind of ECB funding guarantees can cause markets to abstain from funding the national governments, which creates a solvency crisis of the kind we are experiencing today. Said another way, without the ECB the euro members are currently deep into ‘Ponzi’, as my friend, Warren Mosler has described it. In reality, they have all been in ‘Ponzi” since day one. But it took a crisis of the magnitude of 2008 to make this manifest for the markets.

At some level, the ECB understands that, as it always”writes the cheque” when a systemic crisis pushes the system to the brink. It can be no other way, as it is the sole issuer of the euro. But for the most part, Europe’s policy making elites remain in denial, as they continue to turn away from the one entity that could address the insolvency issue.

And let’s be clear once and for all. The US government does not face the same kind of crisis as the Spanish, the Greeks, the Dutch or even the Germans. The US government has expanded its public debt ratio considerably in recent years but yields remain low and when the ratings agencies downgraded their assessment of the US sovereign debt the demand for it rose. Whither the so-called “bond market vigilantes”?

The Euro governments are in a different camp altogether. All those who actually understand that the member governments are using a foreign currency and thus are not at all like Japan, the US or the UK governments, appreciate that their is default risk attached to the paper issued from the EMU governments.

They also appreciate that with the non-elected eurocrats of Brussels insisting on a decade or more of austerity and implementing fiscal rules that these would ensure a crisis every time there has been a serious downturn in aggregate demand. And with that, the risk of default with government debt has risen. That is what we are seeing today across the euro zone. And in Spain it is writ large.

The mainstream austerity line is trapping Spain (as well, as Greece, Portugal, Italy, Ireland and soon the core of the euro zone) in a dangerous downward spiral of lost income and increased unemployment. I still think Francois Hollande’s likely election could well change the political dynamics in the euro zone, even though he generally buys into the mainstream neo-liberal euro line. Hollande is an “austerity lite” character, as opposed to being a genuine reflationist. But even he cannot be oblivious to the looming political and social dangers which await France, if he continues to pursue the policies embraced by the current President, Nicolas Sarkozy.

So far, Brussels has not let facts get in the way of a good neo-liberal theory, but it’s getting increasingly hard to ignore this emerging horror show.

By Daniel Alpert, the founding Managing Partner of Westwood Capital. Cross posted from EconoMonitor

This past Sunday, Paul Krugman penned a screed in the New York Times Magazine (entitled, somewhat unflatteringly in my opinion, “Earth to Ben Bernanke”) that expanded on the content of an ongoing debate in the economics blogosphere over the contents of the mind of Federal Reserve Board Chairman Ben Bernanke.

Professor Krugman has posited for months now that Bernanke has come up short in failing to follow his own prescription for post-bubble, debt-deflationary economies (namely, that of Japan, which the Chairman wrote about as an academic a dozen years ago). In essence, Professor Bernanke’s view was to push both monetary and fiscal stimulus to the point at which it would generate above-natural rates of inflation for a period of time sufficient for such economies to reflate and discount the indebtedness accumulated during credit bubbles.

In the course of Krugman’s commentary he has pushed the notion that Bernanke is either politically intimidated by the right, fearful of uncontrolled inflation, or possessed of a shy personality that is vulnerable to peer pressure within the FOMC (Paul…seriously?).

While some of what is in Ben Bernanke’s mind may be made more clear with tomorrow’s FOMC meeting announcement, in the meantime allow me to rise to Chairman Bernanke’s defense and suggest to Professor Krugman, as I have in the past, a different – yet still quite Keynesian – explanation for our Fed chairman’s current point of view (and in doing so give Paul a piece of my own mind, as I doubt Ben will rise to the bait himself).

Ben Bernanke is neither overly “shy” or out of touch with the world, as Professor Krugman would have us believe. To the contrary, I believe the Chairman has correctly assessed the limitations of extraordinary monetary intervention at the zero-bound (short term interest rates at or near zero) and comprehends a present inability of the U.S. economy to generate the sustainable inflation that the professor correctly notes would help us out of our debt-deflationary slump.

I am sure that Professor Krugman agrees that the Great Recession and its sluggish aftermath saw a mammoth decline in aggregate demand. But if present levels of aggregate demand are insufficient to revive our economy, such demand must be insufficient relative to something else. And in this case – seen from a global perspective – that something else is the global aggregate supply of labor, productive capacity and, yes, even capital. Much of this excess supply can be traced to the historically sudden emergence of the post-socialist nations into the global market economy – which nations are characterized by extremely low wages relative to those of the developed world.

As a result of the foregoing, wages in the U.S. and other areas of the developed world are unable to “track” (that is, to follow along with, even on a lagging basis) the type of inflation resulting from the ocean of liquidity that quantitative and credit easing policy of the Fed, the ECB and the Bank of Japan has produced – generally speaking, inflation in highly tradable commodities and financial assets. No wage growth (because of the dampening effect of excess emerging market labor, always standing by to work cheaply where it can compete with endogenous U.S., European or Japanese labor)…no sustainable inflation. As a result, high levels of inflation tend to collapse economic activity, as limited per capita wages are shunted to oil and food, rather than to more expansionary forms of consumption.

Extraordinary monetary measures will remain a critical weapon in fighting the deflationary pressures that result from our continuing debt overhang and global wage imbalances. But I am afraid – as I believe Chairman Bernanke may well be – that attempts at “reflating-to-recover” are, in the end, somewhat counterproductive under present circumstances.

By Delusional Economics, who is horrified at the state of economic commentary in Australia and is determined to cleanse the daily flow of vested interests propaganda to produce a balanced counterpoint. Cross posted from MacroBusiness.

So it appears, at least in the short term, that the ECB’s LTRO effect is starting to wear off as markets finally catch up on the story of the underlying economy’s of periphery Europe:

Euro zone bond markets Thursday received their first jolt since the Greek debt exchange was clinched earlier this month as Italian and Spanish bond yields soared with investors rushing to book profits ahead of the end of first quarter of 2012.

The sell-off in Italian debt pushed yields to their highest levels in a month, evaporating the gains made since the second of the European Central Bank’s three-year liquidity operations in February, where the ECB poured more than a half a trillion euros into the financial system. Italy had distanced itself from Spain in bond markets in recent weeks but Thursday’s rout sparked nervousness across financial markets and served a reminder that the crisis in the euro zone is far from over.

As I have been explaining over the last few weeks there is renewed market focus on Spain because it is becoming apparent that its economy continues to weaken. Overnight there have been nation wide strikes protesting against labour reforms and spending cuts. Spain’s economy contains massive private sector debt created by a now failed housing market, but Spain’s economy is also tightly coupled with Portugal which is another area of concern:

Portugal’s central bank said the economy will contract more than previously forecast in 2012 and won’t grow next year as consumer spending drops and export growth eases.

Gross domestic product will fall 3.4 percent this year after declining 1.6 percent in 2011, the Bank of Portugal said today in its spring economic bulletin. In January, the bank forecast GDP would decrease 3.1 percent in 2012, also a bigger drop than previously estimated, and predicted that the economy would expand 0.3 percent in 2013.

“The risks surrounding the current projection point to more unfavorable economic-activity developments,” the Lisbon- based central bank said in a statement. “These risks stem to a large extent from external-driven factors, in particular related to the sovereign-debt crisis in the euro area, which may constrain external-demand developments.”

Prime Minister Pedro Passos Coelho is cutting spending and raising taxes to meet the terms of a 78 billion-euro ($104 billion) aid plan from the European Union and the International Monetary Fund. As the country’s borrowing costs surged, Portugal followed Greece and Ireland last April in seeking a bailout and now plans to return to bond markets in 2013.

Surely none of this is a surprise to anyone, as I have stated previously this should be a totally expected outcome. However, to add to the downside Moody’s cut the ratings of some Portugese banks:

Moody’s investors service has downgraded four Portuguese banks debt and deposit ratings by one notch, aligning their ratings at the same level or one notch below the ratings of the Portuguese government, which was downgraded to Ba3 from Ba2 on 13 February 2012. All ratings have a negative outlook.

According to the rating agency: “While none of these pressures are new, they continue to mount against the backdrop of the ongoing euro debt crisis. Positively, Moody’s recognises the supportive stance toward the Portuguese banking system by its government and the euro area authorities including the ECB. However, Moody’s has concluded that this supportive stance does not fully offset the aforementioned negative drivers.”

Sometimes, however, I get the feeling that presenting economic statistics to people really doesn’t give them an appreciation what is actually happening in these economies. For that I think you need the human story, unfortunately that too is fairly tragic:

Overnight Moritz Kraemer, head of sovereign ratings at Standard & Poor’s, also expressed “>some opinions on Greece that, although not unexpected, certainly isn’t helping the mood:

There may be “down the road, I’m not predicting today when, another restructuring of the outstanding debt,” he said at an event in London late on Wednesday. “At that time maybe the official creditors need to come into the boat.”

Speaking at the same event at the London School of Economics, Poul Thomsen, the IMF mission chief to Greece, said while the country has made an “aggressive” fiscal adjustment, it will take at least a decade to fully complete the country’s restructuring.

To Copenhagen then, where it appears the Eurozone finance ministers will be doing as I expected:

A draft agreement prepared for the finance ministers’ meetings reveals a plan to retain the €240bn (£200bn) rump of the European Financial Stability Fund (EFSF) until next year.

The move boosts the available bail-out funds to €740bn from this summer but falls far short of the €1 trillion firewall that international leaders have been calling for.

It marks a concession from Germany but is unlikely to stem fears over the advancing debt crisis, particularly in Spain.

On Thursday night Germany’s finance minister, Wolfgang Schaeuble, said the fund would be further boosted to €800bn, with help from the International Monetary Fund (IMF). He dismissed fears of countries leaving the eurozone as “nonsense”, and said that Spain must implement labour reforms or Europe would “never succeed” in solving the debt crisis.

Still, happy to be surprised on the upside, but it looks increasingly doubtful at this stage. The more things change, the more they stay the same.

By Delusional Economics, who is horrified at the state of economic commentary in Australia and is determined to cleanse the daily flow of vested interests propaganda to produce a balanced counterpoint. Cross posted from MacroBusiness.

Back in November last year I posted on my confusion over the jubilation shown by the citizens of Spain as they elected Mariano Rajoy as their new political leader. Mr Rajoy’s strategy during the election campaign was to say very little about what he was actually intending to do to address his country’s financial problems, preferring to simply let the incumbent party fall on its own sword so that he could take the reins. It became obvious soon after the election that, despite his party’s best efforts to dodge questions, the intention was simply to continue with even more austerity.

Since that post I have continually warned that although Spain is obviously a different country to Greece in regards to how its problems have manifested, it still faces significant macroeconomic challenges that were not being correctly reflected in the bond market.

…. Spain which I consider to be the major unrecognised problem. The country has seen its yields tumble since December on the back of the ECB’s 3-year LTRO but there hasn’t been anything in the economic metrics of the country to support such action. Spain has 23% unemployment and still rising, the banking system is under-capitalised and still has unknown exposure to the country’s housing market collapse. On top of that the rising unemployment rates is pushing up bad loans in the banking system to 7.4%, a 17-year high, and is still rising.

As I mentioned this week, since I made those comments bad loans have risen further , house prices have continued to fall and the government’s debt position has worsened.

So it should come as little surprise to MacroBusiness readers that overnight the bank of Spain announced that the country has now fallen back into recession:

Spain’s economy is suffering its second recession since 2009, the Bank of Spain said, obstructing the government’s efforts to reorder public finances as it prepares the budget for this year.

“The most recent information for the start of 2012 confirms the prolongation of the contraction in output in the first quarter of this year,” the Madrid-based central bank said in its monthly bulletin today.

Spain’s gross domestic product declined 0.3 percent in the fourth quarter of last year, less than two years after emerging from the last recession. Prime Minister Mariano Rajoy will present his 2012 budget on March 30, amid growing pressure from investors and European peers to rein in the deficit, which was 8.5 percent of GDP last year.

And so, once again, we see failings of economic logic creeping back into Europe. The reason that Spain’s economy is suffering is because the government sector is attempting to de-leverage in the face of the same behaviour from the private sector after the collapse of the Spanish housing market. You can obviously point to all sort of things that happened in the past and claim they never should have been allowed to occur. Where were the bank regulators? the macro-prudential oversight ? the fiscal policy in order to push against the housing bubble?. All good questions, but none of them change the fact that the Spanish economy is demonstrating its current behaviour because of the government sectors attempt to lower its deficit.

As I have explained previously in terms of national income, a country with a long running current account deficit has been borrowing goods and services from the rest of the world. In order to support this one, or both, of the non-external sectors of the economy will have expanding debt positions and due to this the economy tends to restructure around consumption over investment and production. Because the external sector is a net drain on capital from the country, the government and/or private sector must continually expand their debt in order to maintain economic growth.

In many cases this debt accumulation leads to asset bubbles, because the expanding debt drives asset prices which attracts speculation and in doing so accelerates the external borrowing. This in turn drives up national income, which in turn drives higher prices and further speculation. In the EuroZone, if either sector’s debt is accumulating faster than its income then at some point in the future a limit will be reached and the rate of debt accumulation will fall. This leads to falling asset prices and national income, which ultimately leads to a crisis as accumulated debts start to sour.

This is what we have seen in Spain. The private sector accumulated large debts on the back foreign capital inflows leading to a housing bubble. This bubble has since collapsed leaving the private sector in a position of significant wealth loss and indebtedness, the banking system holding significant and growing levels of bad debts and the economy structured around the delivery of a failed industry.

Prices for Spanish homes fell 3.4 percent in the first quarter from the previous three months as the euro area’s fourth-largest economy shrank and reduced mortgage lending crimped demand, according to Idealista.com.

Sellers cut asking prices for existing homes by an average of 2.9 percent in Barcelona, 1.9 percent in Madrid and 2.2 percent in Valencia, Idealista, Spain’s largest property website, said in an e-mailed statement today.

“Prices have continued to fall due to difficulty in obtaining mortgage financing,” said Fernando Encinar, co- founder of Idealista. “Legislation passed by the government in February to push banks to provision for real estate will result in similar declines over the remaining quarters of the year.”

Prime Minister Mariano Rajoy is battling to turn around a slump in the real-estate industry. His government forecasts an economic contraction of 1.7 percent this year that will push Spain’s unemployment rate, the European Union’s highest, to 24.3 percent. The government passed a decree in February forcing Spanish banks to make deeper provisions for losses linked to real estate in an effort to push down prices and boost sales.

The growing unemployment is leading to a slowing of industrial production, which means that even though the country is importing less it also appears to be exporting less. Combine this with the interest payments on borrowings from the rest of the world and at this point Spain continues to run a current account deficit which, in the most basic terms, means Spain is still paying others more than it is being paid back. That is, the external sector is still in deficit.

So with the external sector in this state and the private sector unable and/or unwilling to take on additional debt as it attempt to mend its balance sheet after an ‘asset shock’, the only sector left to provide for the short fall in national income is the government sector. If it fails to do so then the economy will continue to shrink until a new balance is found between the sectors at some lower national income, and therefore GDP.

It may appear logical to you that this must occur, and I don’t totally disagree, but that doesn’t change the fact that under these circumstances there is simply no way that the private sector will be able to continue to make payments on the debts it has accumulated during the period of significantly higher income. This is a major unaddressed issue.

This is why we continue to see a rise in bad and doubtful debts in the Spanish banking system which, under direction from the Government, banks continue to merge.

Spain’s biggest bank in terms of assets has been created after CaixaBank bought Banca Civica for 977m euros ($1.3bn, £817m). The government has amended laws to encourage mergers between banks, many of which collapsed following the bursting of the property bubble.

Banca Civica itself was formed by combining four troubled “cajas”, or regional savings banks. The merged bank will have 14 million customers.

CaixaBank will have 342bn euros in combined assets, deposits of 179bn euros and loans totalling 231bn euros, the bank said. The CaixaBank deal will be completed by the third quarter and will generate cost savings and other benefits of 540m euros by 2014.

The problem is that, apart from economies of scale, merging banks doesn’t actually help that much because impaired assets don’t suddenly disappear. The other issue is that Spanish banks have been large users of the ECB’s 3 year LTRO facility which means they have continued to load up their balance sheets with their own countries sovereign debt in order to participate in the carry trade.

It is quite possible, as I explained above, that the LTRO was masking the true value of those sovereign bonds and that Spanish banks have made a terrible decision by making those purchases. Here are the current 10 year yields for Spanish government bonds, courtesy of Bloomberg:

If yields continue to rise, and I see no reason to discount this possibility, then Spanish banks are eventually going to have to front-up more capital to cover those ECB loans. Where exactly is this going to come from?

And so I am starting to get a bit of deja vu.

The eurozone’s public debt crisis is not over despite calmer financial markets this year, the OECD said on Tuesday, with a warning that the bloc’s banks remain weak, debt levels are still rising and fiscal targets are far from assured.

As the eurozone heads into its second slump in just three years, the Organization for Economic Co-operation and Development (OECD) said the 17-nation area needed ambitious economic reforms and there could be no room for complacency.

“Market confidence in euro area sovereign debt is fragile,” the Paris-based economic think tank said in a report on the state of the eurozone’s health. “The outlook for growth is unusually uncertain and depends critically on the resolution of the sovereign debt crisis,” it said.

….

OECD chief Angel Gurria has called for “the mother of all firewalls” – some 1 trillion euros – but finance ministers look more likely to agree to a level nearer 700 billion euros.

I’m sure we’ve been here before.

By Daniel Alpert, the founding Managing Partner of Westwood Capital. Cross posted from EconoMonitor

Alright, got your attention. But the headline above is not offered merely by way of titillation, as a former partner of mine would say—it has the added advantage of being true.

As many of you who frequent this space already know, I have been tracking the rates of change in the 3 month moving averages of U.S. consumer credit outstanding and retail sales since a piece we did on the subject in November of 2010. We look at aggregate consumer credit (and not merely the revolving portion more commonly associated with retail activity) because we believe that term loan borrowing—where available (chiefly student loans and autos)—frees up cash for consumption. Another way of viewing this is that transportation and education are not truly elective purchases and not leveraging those purchases would otherwise reduce overall consumption.

What the numbers tell us today (as illustrated in the below graph) is that, as of January 2012, the growth rate in all forms of consumer credit on a 3 month average basis grew at a rate greater than at any time during the credit bubble. Moreover, at $2.495 trillion, outstanding consumer credit stands a 97% of its peak of $2.576 trillion in August of 2008. Deleveraging, my friends, this is not.

Yesterday the Consumer Financial Protection Board reported that student loans alone likely moved past the $1 trillion milepost at year end. This not only acts as a present danger, but will reduce consumption years into the future as the present cohort of students enter their prime consuming years “pre-burdened” by indebtedness. Normally, we would rely on post-recession rapid growth to reverse the situation, but in an oversupplied, demand-impaired global economy GDP growth proves elusive.

While aggregate payrolls are up 4.6% YoY since February 2011, as 2 million net jobs were created over the past year, this has come at the expense of declining real wages and pretty flat (up 1.8% YoY) nominal wages. So the income/expense hole for many workers has become wider, and even the newly employed and re-employed are coming on in such low wage categories that when you subtract foregone transfer payments (unemployment and other benefits) their net additional income (and the contribution thereof to consumption/GDP) hasn’t risen all that much.

As we all sit here in our liquidity-bloated, but still over-leveraged, developed world economies, wondering if this year’s rendezvous with recovery will be the real thing – I offer the follow three thoughts with regard to the below graphic (click to enlarge):

• Are we once again entering a zone similar to the period immediately prior to the Great Recession in which consumer borrowing also grew rapidly more and more of the new borrowing was applied to debt service instead of new consumption? Watching retail sales trends over coming months should be instructive in this regard.
• The crash in the housing market has left us with $873 billion in Home Equity Line of Credit balances (at Q4 2011) owed by consumers, most of which is no longer collateralized by home value. While borrowers may be making payments (many at vastly reduced rates of interest giver the floating rate nature of those loans), I would put forward the argument that as a practical matter unsecured consumer debt in the U.S. is actually well over $3 trillion.
• We are programmed by past cyclical phenomena to look at consumer credit expansion after a recession as being a positive – heralding the arrival of the “confidence fairy” who the more supply-focused in the macroeconomic establishment view as the critical element to a recovery. There is no doubt that there is an element of this in the expansion illustrated below but, like so many things about the present secular crisis, that is surely not the driving force when a substantial portion of the increased indebtedness is applied to making ends meet, rather than triggered by optimism about the future.

By Delusional Economics, who is horrified at the state of economic commentary in Australia and is determined to cleanse the daily flow of vested interests propaganda to produce a balanced counterpoint. Cross posted from MacroBusiness.

Anyone who has been following my European commentary for any length of time will know that I have been running a number of risk themes on Europe due to what I consider to be misguided and one-sided policy which will ultimately be counterproductive.

These themes come under the major trend that I see in the Eurozone:

.. Periphery nations weakening, France in the middle, Germany outperforming, but the whole ship slowly sinking.

This analysis is based on the sectoral view of the European periphery which I explained on Monday in a discussion of the Australian economy:

As we have seen from nations like Greece and Portugal, a country with a long running current account deficit and a private sector with a desire – or no choice to save (austerity) – has significant problems trying to reach a government surplus. Once you understand that the external sector and the private sector are a net drain on national income it isn’t hard to see the problem. Under these circumstances there is simply no room left in the economy for savings in the government sector and attempts to reach government surpluses become counter-productive as this simply accelerates the decline.

If a country’s current account deficit is structural ( I’ll explain this later ) then these efforts are very dangerous because this can easily develop into a damaging feedback loop. The loss of income through the external sector leads to a loss of income in the private sector, this then drives the stronger desire to save, meaning government revenues fall further. This inevitably leads to calls for higher taxes, which once again drain income from the private sector … and around we go. The result of this dynamic is a rise in unemployment, therefore national production and income, meaning once again the government sectors revenue decline while private sector spending and investment fall further.

And the story is the same if you look at this from the perspective of national income. A country with a long running current account deficit has been borrowing goods and services from the rest of the world. In order to support this the non-external sectors of the economy will have expanding debt positions and due to this an economy structured around consumption over production. Because the external sector is a net drain on capital from the country, the government and/or private sector must continually expand their debt in order to maintain economic growth.

In many cases this debt accumulation leads to asset bubbles, because the expanding debt drives asset prices which attracts speculation and in doing so accelerates the external borrowing. This in turn drives up national income, which in turn drives higher prices and further speculation. If a sector’s debt is accumulating faster than its income then at some point in the future a limit will be reached and the rate of debt accumulation will fall. This leads to falling asset prices and national income, which ultimately leads to a crisis as accumulated debts start to sour.

This is what we have seen across the European periphery, although the debt has accumulated in different sectors of the economy across different countries. Ultimately, however, once a European country falls into crisis the debt has ended up in the government sector, even if it didn’t start there, because Europe has chosen to keep banks alive at all costs. This ideology, however, is the major issue with the “Austerity” plan.

After a financial crisis the private sector tends to have lost significant amounts of wealth which leads to both the loss of demand for, and ability to support new borrowing. The debts to the rest of the world still exist which tends to mean the external sector is still in deficit even with lower demand for imported goods. This means that in order for the nation’s income to remain at the previous level the government sector must go into deficit to offset the fall in private sector credit creation. If this does not occur then the economy will shrink until a new balance is found between the sectors, which basically means the economy will try to find equilibrium at some lower national income, and therefore GDP.

This is the sort of deflationary policy that Europe is endeavouring to implement in the European periphery. There is just one BIG problem. At a lower national income the country has no ability to service the debts that it accumulated on its previous income, yet that is what Europe expects to occur. This is simply delusional, because it is a mathematical impossibility and in trying to break these basic laws of arithmetic Europe is slowly destroying the economies of the European periphery which will, in turn, bring down the stronger economies.

Which brings me to last night’s Flash PMI data.

Flash Germany Composite Output Index(1) at 51.4 (53.2 in February), 3-month low.
Flash Germany Services Activity Index(2) at 51.8 (52.8 in February), 4-month low.
Flash Germany Manufacturing PMI(3) at 48.1 (50.2 in February), 4-month low.
Flash Germany Manufacturing Output Index(4) at 50.5 (53.9 in February), 3-month low.
Flash France Composite Output Index(1) falls to 49.0 (50.2 in February), 4-month low
Flash France Services Activity Index(2) remains unchanged at 50.0
Flash France Manufacturing PMI(3) drops to 47.6 (50.0 in February), 4-month low
Flash France Manufacturing Output Index(4) declines to 47.0 (50.8 in February), 7-month low
Flash Eurozone PMI Composite Output Index(1) at 48.7 (49.3 in February). 3-month low.
Flash Eurozone Services PMI Activity Index(2) at 48.7 (48.8 in February). 4-month low.
Flash Eurozone Manufacturing PMI (3) at 47.7 (49.0 in February). 3-month low.
Flash Eurozone Manufacturing PMI Output Index(4) at 48.8 (50.3 in February). 3-month low

And so you can see that the major theme continues. Stemming from that major theme ,and associated analysis, I have had some major expectations.

1. That Portugal would follow Greece.

This now appears to be occurring in ernest:

Portugal’s core public deficit nearly tripled in the first two months of 2012, showing a deepening economic slump is denting tax collection and stoking concerns the country may miss its budget targets and follow Greece in requiring more rescue funds.

The gap widened to 799 million euros ($1.06 billion) from 274 million euros a year earlier, when the deficit had slumped by more than 70 percent, the finance ministry’s budget office said on Tuesday.

2. Spain was a large unrecognised problem that would return to the spot light:

The country has seen its yields tumble since December on the back of the ECB’s 3-year LTRO but there hasn’t been anything in the economic metrics of the country to support such action. Spain has 23% unemployment and still rising, the banking system is under-capitalised and still has unknown exposure to the country’s housing market collapse. On top of that the rising unemployment rates is pushing up bad loans in the banking system to 7.4%, a 17-year high, and they are still rising.

Since I made that statement bad loans have risen further, house prices have continued to fall and the government’s debt position has worsened.

3. Italy could grow out of its economic slump but was unlikely to owing to history, structure and demographics:

The real problem in Italy is that its economy has been stagnant for nearly the entire decade. According to the IMF, among all countries in the world between 2000-2010 Italy only grew faster than Haiti and Zimbabwe. In 2010, Italian GDP was only 2.5% higher than in 2000. This problem is actually made worse by the fact that this is such a long term trend. Italy’s per-capita GDP growth was 5.4% in the 1950s, 5.1% in the 1960s, 3.1% in the 1970s, 2.2% in the 1980s and 1.4% in the 1990s. Since the new millennium the country has hardly moved forward and if we extrapolate out that trend Italy will spend the next decade in contraction.

On top of stalling growth, Italy has a demographics issue. With a debt to GDP ratio at 120% along with a population with a median age of approximately 45 Italy really does look like the Japan of Europe. The only problem is Japan is competitive, runs a trade surplus and is sovereign in its own currency. Italy has none of these things.

The latest stats from Italy appear to show that the economy continues to weaken and GDP continues on its long running downward trend.

4. Although the ECB’s emergency response to the crisis may have averted the crisis in the short term, it is likely to lead to a zombification of the periphery banking system and therefore add to the downward pressure on periphery economies.

The jury is still out on this one because we need to wait for the ECB’s Quarterly bank lending survey to get the results. This was noted by FTAlphaville overnight:

The effectiveness of the LTROs, and other extraordinary operations of the ECB, can at the moment be judged by some metrics (and general sentiment) positively. However, it seems a bit rash to call them an “unquestionable” success until the liquidity is actually shown to improve bank funding markets, and ultimately land in the real economy.

So we will just have to wait and see on that one. Overnight we also saw news that Ireland, the strongest of the periphery in terms of export potential, fell back into recession due to falling trade volumes.

In total, it is fairly clear to me that Europe’s troubles are far from over because the area continues to meet my predictions. That, however, didn’t stop Mario Draghi from trying to convince the world otherwise:

European Central Bank President Mario Draghi has said the worst of the eurozone crisis is over. In an interview with Germany’s Bild newspaper, he said the situation in Europe was “stabilising”.

Mr Draghi also said that some economic data, including inflation and budget deficits, showed that Europe was doing better than the United States.

The European crisis and the associated delusional rolls on.

By Satyajit Das, derivatives expert and the author of Extreme Money: The Masters of the Universe and the Cult of Risk Traders, Guns & Money: Knowns and Unknowns in the Dazzling World of Derivatives – Revised Edition (2006 and 2010)

The re-emergence of China has dominated recent economic and political discourse. The Chinese economy is forecast to expand by around 60% in the period between 2007 and 2012, compared to around 3% for developed economies. While China’s rise is important, its drivers are frequently misunderstood and poorly analysed.

China’s economic structure is deeply flawed and fragile. The Chinese growth story may be ending. As an old Chinese proverb, probably apocryphal, holds: “There is no feast that does not come to an end.”

Good Times, Desperate times…

Prior to the global financial crisis, China’s impact was mostly in manufacturing, especially consumer goods, and demand for commodities. With its large, low cost labour force China became the world’s manufacturing centre of choice, exporting around 50% of its output. This helped reduce inflation, lowering living costs throughout the world.

China also emerged as a large purchaser of commodities. It is now the largest purchaser of iron ore and other nonferrous metals. It is also one of the biggest purchasers of cotton and soybeans.

Between 1990 and 2010, China’s share of world coal consumption increased from 24% to 50%, in part driving a doubling of coal prices. In the same period, China’s share of world oil consumption increased from 3% to 10%, contributing to a 233% increase in oil prices.

Chinese savings and foreign exchange reserves (totalling over $3.2 trillion) were a major source of capital for financing developed countries, especially governments. China exported savings of around $400 billion each year, helping reduce interest rates in the US by as much as 1.00% per annum. Its role as an exporter of capital flows is surprising given China’s average income per capita is around $4,000, well below that of the US and Europe.

Following the GFC, China’s role became even more important. China, together with some of the other BRIC countries such as India and Brazil, contributed a large portion of global growth in 2010 and 2011.

As Western governments ran up large budget deficits in an effort to maintain economic growth, the ability to borrow from China, especially its large foreign exchange reserves, became important. Most recently, the European Union (“EU”) and the International Monetary Fund (“IMF”) sought the financial support of China to resolve the European debt crisis.

The country’s increasing importance and foreign praise has led to Chinese hubris. The 30 July 2009 editorial in the English language People’s Daily, an official publication, boasted that China, under the leadership of the Chinese Communist Party (“CCP”), had coped successfully with the financial crisis, earning worldwide attention: “High-level figures from the western political and economic spheres … envy China’s superb performance … as well as “China’s spirit”– the kind of solid, unbreakable “Great Wall” at heart to ward off the financial crisis.”

Lock and Load….

In the first phase of the GFC, China was badly hit, with growth slowing and lay-offs of 20-25 million migrant workers in export based Guangdong province alone. Like governments throughout the world, China responded with massive monetary and fiscal stimulus.

In late 2008, China announced a fiscal stimulus package of Renminbi 4 trillion (about $600 billion) over 2 years. The fiscal measures were modest equating to a budget deficit around 2.2%. The major response was via the large policy banks, which are majority government owned and controlled.

The banks were directed to extend credit and finance infrastructure projects on a large scale. If additional credit growth over and above normal lending is taken into account, then the Chinese government’s stimulus totalled around 15% of gross domestic product (“GDP”), amongst the largest in the world.

New lending by Chinese banks in 2009 and 2010 was around 40% of GDP. New bank loans in 2009 and 2010 totalled around $1.1-1.4 trillion, an increase from $740 billion in 2008. Total outstanding loans in the economy have jumped by nearly 50 per cent over the past two years.

Around 90% of this lending was directed towards investment in building, plant, machinery and infrastructure by State Owned Enterprises (“SOE”). In 2010, China allocated over $2.6 trillion to investment expenditure – the highest proportion of GDP of any major economy in the world. According to the World Bank, almost all of China’s growth since 2008 has come from “government influenced expenditure”.

The Short of It…

China’s use of rapid growth in credit to restart growth has increased the volume of credit outstanding to 130-140% of GDP and as much as 160-170% when off balance sheet lending is included.

In the 1990s, a similar increase in the growth of lending resulted in sharp increase in bad debts. The biggest state-owned Chinese banks were insolvent, requiring government bailouts that cost around 40% of GDP, only ending in 2004.

The current loans have financed, in the main, property and infrastructure projects. Increased lending created asset bubbles in property and shares (both now unwinding). It is doubtful whether the cash flows from the investments will be sufficient to cover all the debt, increasing non-performing loans in the banking system. Governor of the central bank -People’s Bank of China (“PBOC”), Zhou Xiaochuan observed candidly that the large credit flows “pose bank lending quality risks”.

With characteristic hyperbole and an eye for media attention, James Chanos, a hedge-fund investor argues that China is “Dubai times 1,000 or worse”. Predictions of a financial and banking collapse are overstated. Property loans are conservatively structured and also the government has a variety of policy tools to manage problems.

Predictably, in February 2012, the Chinese government instructed its banks to roll-over $1.7 trillion of loans to local governments, to avoid the risk of default. It was tacit recognition that the loans were at risk and may not be able to be repaid on schedule. There was lip service to the fact that Chinese banking regulators would check to ensure that the loans were capable of being repaid. Having already borrowed from the playbook of Western governments to resuscitate the Chinese economy from the GFC, Beijing now adopted “extend and pretend” strategies, deferring the day of reckoning on the loans.

As China analysts, such as Michael Pettis, a professor of finance at Guanghua School of Management at Peking University, have observed the bad debts will absorb significant financial resources and restrict domestic consumption.

The government will recapitalise of the banking system by lowering deposit costs and ensuring a wide spread between their borrowing and lending rates.

The Chinese government and PBOC will continue to keep interest rates low, negative in real terms after adjustment for inflation. Low interest rates will make it easier for borrowers to meet repayments. Low or negative real returns entail writing down the loan principal in economic terms while maintaining its nominal value. The banks effectively pass this cost onto depositors in the form of low or negative returns on their savings. Given few alternative investment opportunities, savers have to accept this or take speculative positions in other assets like property.

The PBOC will ensure a wide spread between the bank’s deposit and lending rates, probably around 1.5-2.5% higher than normal. This increases bank profitability and helps build up the bank’s capital base.

Just like the Japanese after the collapse of the bubble, Chinese householders will be forced to pay for the restitutions of their insolvent banks. Savers will pay a disguised tax – low deposit interest rates and high borrowing rates. In effect, the bailout will entail a large transfer of wealth and income from households to other parts of the economy, amounting to several percentage points of GDP.

This will reduce wealth but also slow consumption growth, at a time when external demand for Chinese products and Chinese trade surpluses is decreasing.

The Long of It…

The long term effects of this debt fund investment boom are more complex. Revenues from many projects will be insufficient to cover the borrowing or generate adequate financial returns.
Over-investment in non-productive, low return projects will ultimately reduce growth.

The bulk of investment has been by SOEs in government-backed infrastructure projects – the tiegong­ji (meaning “iron rooster”), a homonym for the Chinese words for rail, roads and airports.

The Ministry for railways is planning investments of around $300 billion, adding 20,000 kilometres (“Kms”) of rail track to the existing network of 80,000 Kms. China’s rail network will become the second-longest in the world behind the US, overtaking India.

China is also having a love affair with super fast train. Undeterred by accidents and the high cost, further expansion of the high speed rail network is under way. A new service between the southern cities of Guangzhou and Shenzhen travels at 380 kilometres per hour (KPH) nearly halving the travel time to 35 minutes. CSR Corp, China’s biggest train maker, has plans for a super train capable of 500 KPH.

China is constructing around 12,000 Kms of new expressways at a cost of over $100 billion. China road network of over 60,000 Kms of high-speed roads is only slightly less than the 75,000 Kms in the US. China is planning to expand the high-speed road network to 180,000 Kms even though China has only around 40 million passenger vehicles compared to 230 million in the US.

There is a spate of new airports and expansions of capacity at existing facilities. Jiaxing in eastern Zhejiang province is converting a military landing strip into a commercial airport at a cost of around $50 million. The town is only one hour’s drive on brand new expressways from three of China’s busiest international airports in Shanghai and Hangzhou. There are also plans for a high-speed rail line connecting Shanghai and Hangzhou.

While some of the investment is productive, the need for rapid ramp up has meant that an unknown amount is unproductive.

In Hunan, local authorities tore down portions of a modern flyway and used the stimulus funding to rebuild it. Stories of ghost cities, such as the empty newly-built city of Ordos, Zhengzhou New District, Dantu and the orange area to the north-east of the Xinyang, abound. There are ghost shopping malls in many cities.

Based on estimates from electricity meter readings, there are more than 60 million empty apartments and houses in urban areas of China. Many of the properties were purchased by people speculating on rising property prices.

Crowing Roosters or Eating Crow….

Analysts, such as Pivot Capital Management, argue that the efficiency of Chinese investment has fallen. One measure is the incremental capital-output ratio (“ICOR”), calculated as annual investment divided by the annual increase in GDP. China’s ICOR has more than doubled since the 1980s and 1990s, reflecting the marginal nature of new investment. Harvard University’s Dwight Perkins of Harvard argues that China’s ICOR rose from 3.7 in the 1990s to 4.25 in the 2000s. Other researchers suggest that it now takes around $6-8 of debt to create $1 of Chinese GDP, up from around $1-2 around 20 years ago. In the US, it took $4-5 of debt to create $1 of GDP just before the GFC. This is consistent with declining investment returns.

Sino-philes dismiss the lack of efficiency arguing that the decline was because of falls in the growth rate due to the collapse of global demand. This assumes that global demand will rebound strongly increasing the returns from these investments.

Sino-philes also argue that the investments in infrastructure will produce long term economic benefits and returns from increased productivity. They point to the fact that few investment programs of social infrastructure are profitable. They point to the mid-19th century boom in investment in railways in Western countries, which generated economic benefits, but few made an adequate financial return with many going bankrupt. They also argue that China lacks necessary infrastructure.

China has six of the world’s ten longest bridges and the world’s fastest train. But 40% of villages lack paved road providing access to the nearest market town. The real issue is whether the specific projects are appropriate.

High-speed rail lines in China may increase social return, improving the quality of life for the average Chinese if they are wealthy enough to afford to use them. But the financial return on capital invested in these projects will be low.

While super-fast trains are appealing to politicians and demagogues proclaiming superiority of Chinese technical proficiency, investment in improving ordinary train lines, rural roads, safety and more flexible pricing structures may yield higher economic benefits.

Ironically, given the motivation of the plan to increase employment opportunities, this capital-intensive state investment has created relatively few jobs. Instead, the programs, which are overseen by the Chinese Communist Party (“CCP”), have been used to achieve political objectives.

Over Building…

China’s investment boom may also be exacerbating industrial overcapacity. The greater portion of investment has been in infrastructure, rather than manufacturing.

A 2009 report prepared for the European Chamber of Commerce outlines the over-capacity. In its analysis of six major sectors, the report identified the following capacity utilisation rates: steel 72%; aluminium 67%; cement 78%; chemicals 80%; refining 85%; and, wind power 70%.

In 2008, China’s steel capacity was 660 million tons against demand of 470m tons but the difference is similar to the European Union’s total steel output or the combined output of Japan and Korea. China’s excess in cement is larger than the total consumption of the US, Japan & India. Yet China continues to add capacity.

If China be unable to absorb this new capacity domestically, then it might seek to increase exports, in order to maintain production and growth. This would increase a global supply glut. To the extent that Chinese growth is driven by such spending on unproductive investments, it is both wasteful and ultimately economically destructive.

The government’s response highlights the severity of China’s problems of late 2008 and early 2009. China’s economy, especially its export sectors, experienced a large external demand shock, stemming from rare synchronous recessions in the developed world. Beijing deployed massive resources to restore growth to counter the economic and social impact of the slowdown.

The unsound foundations of Chinese economic and financial strength have been largely ignored. But then all food tastes good to the starving man.

NOTE Part II is here.

Yves here. This post from MacroBusiness provides a good point of departure, and I’ll provide some comments further down.

By Sell on News, a global macro equities analyst. Cross posted from MacroBusiness

A little known fact about John Maynard Keynes, detailed in Jane Gleeson-White’s book “Double Entry” is that he was responsible for the development of national economic statistics and that he expected them to be aggregated only on a temporary basis.

It was being done for the war effort, and would, he reasoned, not be necessary afterwards. This certainly puts “Keynesianism” in a different perspective, and poses the intriguing question: where would we be without economic statistics?

The Economist recently had a leader “Don’t Lie to Me Argentina” in which it accused Argentina of some kind of unforgivable treachery for politicising its economic statistics. As if economic statistics aren’t political in their very nature (a heavy bias towards capital and against labour, for instance).

So in contrast to H&H [a fellow MacroBusiness blogger], who enthuses that without economic data we are “naked, bereft of meaning” I wish to present a very different perspective. I wish to briefly examine what it would mean not to have economic statistics. Here are a few implications, I submit:

1. We would have to stop being lazy in the way we construct meaning and do the work of creating meaning ourselves.
The worship of economic statistics encourages a certain passivity of mind because it presents us with a picture ready made that we can then seek to interpret. Trouble is, that picture is heavily biased. Imagine, for instance, if it included unpaid housework as was proposed in Keynes’ time? Economics just presents transactions and makes little distinction between good transactions and bad ones.

A natural disaster, for instance, is generally thought to be bad, but in statistical terms it is not because typically the reconstruction creates a lot of economic activity (witness the Japanese growth figures post Fukushima). What happens is that transactions are not seen as a reflection of reality; rather reality has to be fitted into the transactions. “We all must change our behaviour because GDP is not growing fast enough, or productivity is not improving enough”.

2. We would embrace a broader sense of meaning, one that did not involve just what can be measured.
Most economic growth statistics measure the exchange of consumer goods, because it is easy. Much harder to measure assets, because they are not continually transacted — that was why the asset bubbles in America were ignored for so long, because they are hard to measure – and harder again to measure long term infrastructure investment. It is impossible to measure culture, yet culture is essential to well being. Indeed, well being is not really measured, and when they have tried to use broader measures it is generally found that life has improved little despite the economic growth.

3. We would not have a financial/economics sector purporting to understand what they do not understand.
For example, the “inter-relationships” between various economic indicators (such as Friedmanites v Keynesianism). This is for the most part an intellectual fraud. There are the obvious conclusions – you can’t spend more than you own, for instance – that derive from housekeeping (that being the etymology of economics). But anything beyond that is either unknowable or a circular argument (for instance Friedman’s maxim inflation is always and everywhere a monetary phenomenon is a tautology dressed up as insight).

4. We would have a greater sense of how we can impel affairs as thinking creatures with free will, rather than being pushed about by the “economic system”.
There is a reason why economists are so poor at anticipating the future. Economic statistics are always retrospective and tell us little about what people are going to do – and it is what people DO that shapes the future. Of course the past will shape what people do, but it does not determine it. Money is a social construct and transactions are social arrangements. They are subject to individual and collective will, not the logic of a mathematical system.

5. We would not have the giant casino that is amusingly referred to as the global capital markets.
The use of algorithms, which poses deep dangers to the system, is only possible because of the blizzard of data and statistics. That is exactly what is being codified and manipulated. Intriguingly, one of the geeks made an interesting comment, saying that a 2-3% variation, which makes all the difference in GDP statistics between acceptable growth and recession is all but inevitable in his geek world. he could not understand why it is considered so significant. But that is our world, dominated by economic statistics.

So there are five reasons why we would probably be a lot better without all that data. Far from being naked, bereft of meaning, I would suggest we could put on some decent clothes and find some more substantial, dare I say it, real meaning.

Yves here. While I would come up with a different list of implications, I’ve long been struck with the fetishization of numbers, particularly when all numbers are not created equal. Transaction data, say the price at which a particular stock traded at for a specific order, is a hard number. But the overwhelming majority of economic statistics are “soft” in that they are constructions, and statisticians care a great deal about consistency over time. That is useful up to a point. The procedures that produce consistency mean that if the measurement fails to capture or underweights an issue that is becoming increasingly prominent, it will have obtained consistency at the expense of representativeness (the notorious non-farm payrolls “birth-death adjustment” is a classic of this type). And the caliber of official statistics had decayed due to reduced staffing thanks to budget cuts.

I wrote about some of the problematic behaviors that result from the propensity to give quantitative information, no matter how poor it may actually be, great weight, in an article, “Management’s Great Addiction.” One the symptoms, and it takes place way too often, is when people rely unduly on a single or very few metrics to analyze a complex phenomenon (think of the use of VAR to measure firm wide risk!). If you must measure to get a grip on a complicated situation, use more rather fewer views in (provided you don’t go for more just to have more but can find pretty reliable measures of different, important aspects of a complex situation).

And perhaps the most important habit to adopt is to be aware of the limits of your knowledge.

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

Recently the mainstream press have done some rather interesting coverage of Modern Monetary Theory (MMT). Particularly good was the Washington Post’s attempt to spell out the key differences between Modern Monetary Theory and standard post-war Keynesianism.

In their piece on MMT, the Post rightly pointed out that after the war there were two distinct brands of Keynesianism. One came down from Keynes himself through his students at Cambridge; the other was essentially invented by the American economist John Hicks and came to dominate academia after the war.

In the coming days we will probably see many commentators expressing confusion over the differences between the two types of Keynesianism. And while there are many threads that one could follow to try to draw what is a very real distinction between the two approaches, we will concern ourselves here with Hick’s old ISLM model and the liquidity trap interpretation of Keynes’ argument.

Hopefully following this thread will tease out some of the differences between the two approaches (differences which Hicks conceded when he rejected his own interpretation of Keynes later in his life). Key among these will be: the post-Keynesian protest in trying to fit Keynes into some engineering diagram straitjacket; the post-Keynesian focus on actual business psychology; the rejection of the so-called ‘loanable funds’ theory; and the post-Keynesian scepticism as to monetary policy.

From the Mists of Time

First, the liquidity trap itself. Keynes deduced it – like he deduced so many other things – but it was only an endnote to a chapter entitled ‘The Psychological and Business Incentives to Liquidity’ in his General Theory of Employment, Money and Interest. The passage in the original – remarkably difficult to find given the muddle surrounding the liquidity trap today – is as follows:

“There is the possibility, for the reasons discussed above, that, after the rate of interest has fallen to a certain level, liquidity-preference may become virtually absolute in the sense that almost everyone prefers cash to holding a debt which yields so low a rate of interest. In this event the monetary authority would have lost effective control over the rate of interest. But whilst this limiting case might become practically important in future, I know of no example of it hitherto. Indeed, owing to the unwillingness of most monetary authorities to deal boldly in debts of long term, there has not been much opportunity for a test. Moreover, if such a situation were to arise, it would mean that the public authority itself could borrow through the banking system on an unlimited scale at a nominal rate of interest.

This passage was seized upon by Hicks and other monetary policy enthusiasts as the nodal point of Keynes’ theory of an economy out of whack. While we won’t get too deep into the details, these economists thought that it was under these specific circumstances that active government fiscal policy was necessary. Yes, some of these ‘ISLMic Keynesians’ would probably have broadly supported the use of fiscal policy even when the economy was not mired in the dreaded liquidity trap, but their theoretical underpinnings for such a recommendation were weak, self-contradictory (having to do with so-called ‘rigidities’ which were otherwise ruled out in their models) and, dare I say, born of naked political motivation.

Keynes, on the other hand, clearly advocated fiscal policy measures even though, in his own words “whilst this limiting case [of the liquidity trap] might become practically important in future, I know of no example of it hitherto”. Here was a man who never saw a so-called liquidity trap in his life, yet whose theory led him to advocate fiscal policy in a manner that he understood to be wholly consistent with logic. In Chapter 12 of the General Theory entitled ‘The State of Long-Term Expectations’ he wrote:

For my own part I am now somewhat sceptical of the success of a merely monetary policy directed towards influencing the rate of interest. I expect to see the State, which is in a position to calculate the marginal efficiency of capital-goods on long views and on the basis of the general social advantage, taking an ever greater responsibility for directly organizing investment; since it seems likely that the fluctuations in the market estimation of the marginal efficiency of different types of capital, calculated on the principles I have described above, will be too great to be offset by any practicable changes in the rate of interest.

Clearly Keynes was sceptical of monetary policy despite the fact that he had never seen a so-called liquidity trap. His analysis – which was not Hicks’ ISLM model – led him to conclude that monetary policy was too weak a tool to manage a capitalist economy. He was right of course; as a means to stimulate growth monetary policy is probably, to a large extent, voodoo – a conjuring trick summoned out of dust to tweak the animal spirits of investors in the good times. And the reason it is still appealed to by the ISLMists? Because without it their criss-crossing totem falls apart and they are once again led to think in terms of business psychology and the real world.

Moving back to our little history, Keynes’ liquidity trap argument was not loved by all and sundry. The British economist Arthur Cecil Pigou, who had received something of a clawing in Keynes’ General Theory, was convinced that even if an economy entered a liquidity trap the self-equilibrating forces of The Market would ensure that everything would return to normal eventually. Pigou thought that if competition were allowed to work its magic wages and prices would fall. This fall in prices would mean that already existing money would become worth more in real terms, so consumption would increase and the economy would exit the liquidity trap as GDP grew – this became known as the ‘Pigou effect’.

Pigou’s argument was rather dim. It did not, for example, take into account the distributional impacts of the real money boost provided by the deflation together with the disproportionate propensity to consume among the different income classes. Nor did it consider the fact that when people see a general decline in prices they might hold back purchases in the hope of more declines, thus reinforcing the deflation spiral. And then there was another, rather enormous problem that was pointed out by the great Polish economist Michal Kalecki: put simply, that the real levels of debt would rise as prices and income fell:

The adjustment required would increase catastrophically the real value of debts, and would consequently lead to wholesale bankruptcy and a ‘confidence crisis’.

While the deflation might – we emphasise the word ‘might’ – encourage those who held money to consume, it would cast debtors deep underwater and massively increase bankruptcies. Kalecki’s point had, of course, already been stated in theoretical form a few years before by Irving Fischer in his ‘The Debt Deflation Theory of Great Depressions’ – especially in this now famous passage. But, of course, such theories are not equilibrium theories and so Pigou could never have accepted them.

Pigou was largely ignored by the new Keynesian orthodoxy. This new orthodoxy, who were otherwise ISLMists to the core, also tended to broadly ignore the liquidity trap argument. Partially this was because they had, like Keynes, never seen such a thing; but partially too because fiscal policy was, due to contemporary government policy, the economic fashion of the day – and if economists are good at nothing else they are quite brilliant at following intellectual fashions.

The New ISLMists

Moving on to recent history – one in which the fashion is undoubtedly monetary policy – the most popular advocate of the ‘liquidity trap’ argument today is Paul Krugman. Krugman had long been familiar with what he thinks to be a liquidity trap problem because of his study of Japan, which went through similar problems to those currently being experienced by the US and the UK after their housing and stock bubbles blew up in 1991.

Krugman is, of course, an avid ISLMist. But prior to this he thought that Pigou’s argument had some merit:

If you really want to know, I had initially believed that the ‘Pigou effect’ might play an important role in the discussion, and needed the intertemporal model to convince myself that it did not.

From his initial Pigovian ideas, Krugman has since moved onto the ISLM model. Although Krugman does recognise that government fiscal stimulus should be used aggressively in the current downturn he understands this only in terms of the ISLM. This leads him not only to fundamentally misunderstand the nature of the problem, but also to call for negative real interest rates. He recommends that in lieu of adequate fiscal policy the central bank should try to scare people into thinking that inflation is just around the corner. This is a rehash of the arguments he put forward in relation to Japan:

[M]onetary policy therefore cannot get the economy to full employment unless the central bank can convince the public that the future inflation rate will be sufficiently high to permit that negative real interest rate… [And] an economy which is in a liquidity trap is an economy that as currently constituted needs expected inflation… (My emphasis)

Negative real interest rates – which essentially mean trying to blackmail savers into investing by threatening to inflate away their savings – are a dubious tactic for number of reasons, none of which can be appreciated from within the ISLM model.

I wrote about some of the potential problems of this approach on this site recently. Put simply, because the ISLMists rely on a toy model with intersecting lines to determine investment behaviour, they cannot even begin to try to think in terms of investor psychology – which is precisely the type of thing that Keynes, plugged into the real world as he was, was interested in. The ISLM model implicitly models robot that, lo and behold, act in their investments as if they were reading the results of an ISLM model. (Tautology, much?). This leads the ISLMists to completely ignore the perverse effects that certain policies may have upon the psychology of the investor. Their ISLM robots only move in one direction when pushed – in the real world investors can go in any number of directions.

Related to this is that by scaring the hell out of investors that inflation is around the corner they may seek to hedge against the perceived threat to their money savings and they may do so by hedging in commodities. This can cause any number of economic problems.

The most obvious of such anomalies in the current situation is gold, the market for which is in an obvious bubble. Now the gold bubble will have few effects on the real economy except for leaving a few convinced gold bugs with ashes in their hands when the whole thing burns – but there are other commodities markets that certainly do have effects on the real economy when they inflate. As former International Petroleum Exchange director Chris Cook argued on this site recently, oil and other commodities markets are probably being inflated right now due to investors hedging against feared inflation. Ironically enough, this produces the feared inflation by raising energy and other prices which in turn push up the CPI.

This is not the first time these issues have been raised. Hedge fund manager Mike Masters, MMT economist Randy Wray and Commodity Futures Trading Commission commissioner Bart Chilton have all noted that massive amounts of money looking for a ‘safe haven’ might be inflating bubbles across the commodities markets and raising prices for consumers.

Of course, the model-obsessed ISLMists will truck out their criss-crossing totems once more to ‘prove’ that supply and demand in the oil and other markets cannot be tampered with by hedgers and speculators (presumably they would say the same about the gold market, although it would take quite a twisted mind to explain why the ‘real’ demand for gold has more than doubled since the financial crisis). Harking back to undergraduate level economic models is a weak move and would, I think, be laughed at by real world investors who are nowhere so naïve about commodity markets.

ISLMists would, as usual, be better off reading Keynes himself who in his Treatise on Money spelled out the possibility of what he called ‘commodity inflation’. But alas, they probably will not. After all investors piling out of dollars and into commodities to hedge against inflation in the current environment doesn’t look like how their ISLM robots should be acting during a so-called liquidity trap. And when models are worshiped like totems it is reality that is to be ignored rather than an anomalous reading recognised for what it is.

Death of the Loanable Funds Doctrine

In truth the liquidity trap argument is basically meaningless in how it relates to a modern economy with a modern banking system. This is because, as followers of Keynes and his students have now known for over 30 years, the amount of money in a modern economy is determined by the demand for said money and not its supply. This is a key difference between the standard ISLM Keynesians and the post-Keynesians which should be stressed as much as possible.

The only control that central banks have over the supply of money is through the exogenously determined interest rate which, as everyone knows, is set through open market operations (OMOs). This means that if we whip up a model the supply function of money will be represented by a horizontal line, indicating the infinite elasticity of the supply of money. One of Keynes’ most eminent students, Nicholas Kaldor, put it as such:

The supply of money is infinitely elastic – or rather it cannot be distinguished from the demand for money.

We won’t get into the reasons that this is the case as they are quite complex, but the reader can consult the mounds of theoretical and empirical material that has accumulated over the past few decades in Post-Keynesian circles. Instead let us see what consequences such an argument has for those that adhere to the liquidity trap theory.

Any good ISLMist will tell you that if the supply for money is indeed infinitely elastic then the Holy Model is truly cooked and the liquidity trap theory burns up with it. Why? Because if we plot a horizontal line representing the supply of money (LM) across the ISLM model we will see that the investment-saving function (IS) is then always moving along a horizontal line which, in the standard ISLM model, only occurs when a liquidity trap is hit.

Monetary economist Marc Lavoie sums it up rather well in his book Foundations of Post-Keynesian Economic Analysis:

In a theory of endogenous credit money, the role attributed to liquidity preference by the earlier neoclassical Keynesians loses its significance. The preference of the public for holding money does not play any role, either in the determination of the rate of interest or in that of employment.

This means that the liquidity trap argument is reduced to being a rather bland statement about the fact that interest rates are not leading to increased confidence rather than a fancy modelled theory about how investment is determined. The reason that the ISLM turns up such boring results when confronted with the endogenous theory of money is because the ISLM model itself is reductionist and faulty.

Indeed, those researching and theorising in the tradition of Keynes have come very far from the old liquidity trap arguments and the ISLM doctrines. But the mainstream, with their collective head buried in a model, remain painfully unaware.

Refocusing the Issues

While it would take us rather too far off topic to go into any detail on where economic commentators should be looking for the causes of the current stagnation, a few comments should be made in passing because these subtle theoretical differences have enormous real world consequences.

First of all, the world around us is not as the old models would have it. Where the models might expect mild deflation we have persistent but mild inflation and this even with unemployment at high levels. This inflation, as alluded to above, is in part due to the very policy choices by economists who apply pseudo-Keynesian models to analyse the world around them. Before they are to understand a single thing beyond the ends of their noses, economic analysts have to stop abstracting so violently away from the real world and seriously ask themselves why their models come up lacking when confronted with the facts.

Secondly, and tied to this, models like the ISLM are reductionist in the extreme and should be thrown out immediately. Not only do they fail to integrate many aspects of Keynes’ own analysis (as was later recognised by the creator of the ISLM himself), but they essentially fall apart when confronted with certain important realities of our modern world – especially those realities that have to do with credit and the real processes of credit creation in modern economies.

I will no doubt be chastised for not supplying a replacement for the ISLM. This is a ridiculous criticism to be made of a short essay focused on the liquidity trap. But there are mounds of real Keynesian research and theory out there for the interested reader to explore. As for a replacement for the ISLM… frankly, the model should never have existed and should anything resembling it ever come into existence again it should be immediately thrown out.

Economists need to become more flexible – and flexibility is not built into these models. (Nor are they built into their supposedly more ‘sophisticated’ but equally reductionist DSGE cousins). These models are constructed in a manner that excludes contradiction, especially empirical contradiction, and so they lead to ignorance and prejudice rather than to new discoveries. The models also, as we never tire of pointing out, allow their adherents to avoid thinking about how economic agents might react in psychological terms. This was a key aspect of Keynes’ analysis and one that gave it such power.

The models are like calculators in that they add up the limited variables inputted neatly but allow us a handy excuse to stop thinking – and given sufficient ‘training’ in these models the user will inevitably become something of a calculator himself.

As for the liquidity trap? When it was invented it was nothing but a footnote that its author brushed aside. Today it is a fad theory that explains away the pressing need to take a good hard look at what is going on around us. Confine the bloody thing to the dustbin of history where it belongs!

Yves here. In case you managed to miss it, there is supposedly an agreement for Greece to get €130 billion. But then we learn that Greece will still need more dough if it meets its target of reducing government debt to GDP to 120% by 2020 (and why is debt to GDP of 120% seen as sustainable then when it is not seen as sustainable now? And leaked documents further note that Greece might not meet its targets (duh!) and its debt to GDP could instead by 160% of GDP, which would require bailouts of nearly twice the amount now contemplated. And “discussions” are continuing in Brussels into the early morning, which says this deal is about as done as the US mortgage settlement.

By Satyajit Das, derivatives expert and the author of Extreme Money: The Masters of the Universe and the Cult of Risk Traders, Guns & Money: Knowns and Unknowns in the Dazzling World of Derivatives – Revised Edition (2006 and 2010)

The Greek Prime Minister spoke of a choice between “austerity” and “disorder”. He got both, as the Greek Parliament based the European Union (“EU”) agreed to severe budget cuts and outside rioters protested the plan.

In great dramas, sub-plots support the main story. The story of “hairshirts” (the Greek economic plan) and “haircuts” (the writedown of Greek debt or PSI – Private Sector Involvement) are little more an intriguing side show in the broader European debt crisis.

With Greece increasingly doomed, the real significance of the negotiations is that they provide a template for future European sovereign restructurings. No one buys the oft-stated European leaders’ position that Greece’s position is unique or exceptional. Portugal is first in the line of fire, with the Irish, Spanish and Italians watching anxiously.

In July 2011, the Institute of International Finance (“IIF”), a lobby group representing major banks and investors, proposed a complex plan entailing investors suffering a loss of around 21% on the value of their Greek bond holdings. On 27 October 2011, banks and investors were “invited” to accept a 50% write down under threat of larger losses if they did not agree. The write-down was structured as a “voluntary” exchange of maturing Greek bonds for new bonds, to avoid triggering credit default swaps (“CDS”) contracts, a form of credit insurance.

Greece has around Euro 350 billion in debt including Euro 70 billion in bailout loans and around Euro 80 billion in bonds held by the European Central Bank (“ECB”). A 50% haircut of the remaining Euro 200 billion equated to reduction of Euro 100 billion. As around Euro 85 billion is held by Greek banks and pension funds, the reduction of Euro 100 billion was less than 30% of outstanding debt, as only private investors are covered and bonds held by official institutions such as the ECB are excluded.

Following protracted negotiations, the Greek government has agreed on a new austerity package. The bond exchange is likely to proceed with bond holders’ writing off 53.5%, equating to losses of over 70-75%.

The Troika – the European Union (“EU”), European Central Bank (“ECB”), the International Monetary Fund (“IMF”) – needs to reduce the level of Greek debt to a “sustainable” 120% of gross domestic product (“GDP”) by 2020. The bond deal and the latest budget cuts are designed to achieve this paving the way for a second financing package for Greece to enabling Greece to repay a Euro 14.5 billion bond on 20 March 2012. Deterioration in Greece’s finances required the bigger writedowns and greater budget cuts.

But even the greater austerity and larger losses to lenders will probably leave Greek debt above the target level, requiring delicate financial engineering to at least cosmetically reach the target. In the end, the fancy footwork yielded an irrelevant 120.5% of GDP.
The 120% level is largely meaningless, being a political construct designed to avoid drawing unwelcome attention to Italy whose debt levels are around this level.

There is no certainty that the agreement reached can be implemented. The IIF represents around 50% of banks and investors.

Investors with Greek bonds naturally want to minimise losses. Investors who have hedged by reinsuring the Greek bonds prefer default to a voluntary restructuring, allowing them to trigger their insurance and cover losses. Hedge funds who bought into Greek bonds, at prices around 30%, want a result which gives them a profit.

The deeper losses will increase resistance to the deal, especially from hedge funds who may prefer to take their chances in a default.

One option is to unilaterally insert collective action clauses (“CACs”) into existing bond contracts, allowing a supermajority of lenders to bind the minority.

A complicating factor is the ECB’s refusal to take losses. With direct holdings of Greek bonds of Euro 40 billion as well as additional loans to banks secured over Greek bonds, the ECB’s capital of Euro 5 billion (scheduled to increase to Euro 10 billion) is insufficient to absorb losses. As the CAC would force the ECB to share in losses, a special arrangement will exempt them from the effects of any CAC to the further detriment of already resistant private lenders.

The special treatment of the ECB means that commercial lenders are effectively subordinated to official lenders, a position which has been avoided to date. Given that after any restructuring, the bulk of its debt will be held by official lenders, such as the ECB and IMF, it is unlikely that Greece will be able to return to financial markets for a long time, which probably in reality was always the case. But this will discourage commercial investment in risky European debt, such as that of Portugal, Ireland, Spain and Italy, adding to the contagion pressures.

Any agreement is also likely to face legal challenges from lenders, which would complicate proceedings.

Another complication is the extremely tight timetable that must be followed to ensure the arrangements are implemented in time. There is little margin for error.

If the new agreement cannot be implemented, then the Troika could extend the necessary money to meet the March maturity and continue negotiations, although this would be difficult. Alternatively, they could arrange an orderly default. Another outcome is that Greece unilaterally declares a debt moratorium and leaves the Euro.

Voluntary or involuntary default, large voluntary losses, and/or CACs all increase the risk that credit insurance contracts may be triggered with increased threat of contagion.
This agreement is unlikely to be the definitive resolution everyone seeks.

Greece has consistently failed to meet economic forecasts. Despite measures by the Greek government, debt continues to increase. According to the EU statistics office, Greece’s debt reached 159.1% of GDP in the third quarter of 2011, up from 138.8% a year earlier and 154.7% in the previous quarter.

Greece may get through the March 2012 maturity but the arbitrary 120% debt to GDP ratio, the best case under the plan, is unsustainable, even in the unlikely case that it is met. The Greek economy, which has been in recession for years, shrank by 7% in later part of 2011. Budget revenues for January 2012 fell 7% from the same time last year, a fall of Euro 1 billion. This compares to a budget target for an 8.9% annual increase. Value-added tax receipts decreased by 18.7% in the same period compared to January 2011.

Greece’s financial position will deteriorate and it will miss key milestones – debt levels, budget deficits, growth, asset sales and structural reforms. The projected reductions in debt are based on optimistic assumption of growth which are unrealistic given the severity of the income cuts and shrinkage in government spending.

With elections due in April 2012, government support for the austerity plan cannot be assumed, in face of a serious recession and increasing social unrest.

A similar pattern is already evident in Portugal, Spain and Italy with debt, budget and growth targets, largely unrealistic, being missed. Popular resistance to reforms and austerity is also predictably rising. Prime Minister Maria Monti has made it clear that Italy cannot take more austerity, which has barely started to be implemented.

Even if the Greek “rescue” is agreed, the Euro-zone still need to finalise the Euro 500 billion rescue system by April 2012’s IMF meetings. The fund is designed to create the much vaunted firewall to prevent Euro-Zone instability from spreading.

There are suggestions that the size of the bailout fund could be increased. But Germany, Finland and the Netherlands, the only remaining AAA rated members of the Euro-Zone, are reluctant to increase their commitments. The credit ratings downgrade of many other member nations, including France and Austria, has increasingly highlighted the risks of increasing their exposure.

The IMF is trying to marshal additional funds from members to support a European bailout. At the World Economic Forum, IMF head Christine Lagarde said that she was attending “with my little bag, to actually collect a bit of money”.

Following direct approaches by Lagarde, China and Japan have mouthed platitudes about “help”. Any support has been made conditional upon the Euro-Zone members increasing their commitments, in the knowledge that it is presently unlikely. Tellingly, China Investment Corp (“CIC”), the country’s sovereign wealth fund, and influential Chinese central bankers have rejected suggestions of purchasing European government debt. One official stating that: “We may be poor, but we aren’t stupid”.

The US has ruled out contributions, though is shouting encouragement from the sidelines. The US Congress still hasn’t approved the previous round of additional IMF commitments.

Everyone knows the amount of money available is insufficient to deal with the problems.
History suggests that a write-down of debt for distressed borrowers is frequently followed by others.

The entire trajectory of discussions, plans and negotiations largely ignores Greece. There is no longer any pretence of “assisting” Greece. It is about ensuring that German and French banks minimise their losses. It is probable that no funds will be released to Greece but rather placed in a special account from where it will be used to meet the country’s debt obligations.

Germany and the Netherlands has suggested that the EU assume control of Greek finances and elections be suspended in favour of a technocratic government, having the confidence of Berlin, Paris and Brussels. In the end, the communique required Greece to pass a humiliating law giving priority to debt repayment over other government obligation. The Trioka will establish a permanent presence in Greece to oversee the process. The loss of Greece’s sovereignty has not been well received, at least in Athens.

Subplots connect main plots in thematic terms or provide minor diversions or comic relief. The light relief in this instance come from a group of hedge funds who have threatened to take action in the European Court of Human Rights alleging that Greece has violated bondholders “rights”.

In the end, Greece may live to default another day. Other embattled European nations will be scrutinising the Athenian sub-plot extremely closely as to clues as to their future as they await the battles that lie ahead.

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

More pension funds are getting their act together and calling the British government on their dodgy pseudo-stimulative policies. The British pension provider Saga has released an excellent counterargument to the recent round of QE announced by Bank of England governor, Mervyn King (an argument that we have been pushing for some time).

Saga are seething and you would guess that pension recipients are no less enraged because the effects that QE is having on pension funds appears to be quite devastating. Dr. Ros Altmann, Director-General of Saga, made the following statement which will resonate with many:

The Bank of England has consistently ignored the dreadful damage that its QE policy has inflicted on anyone coming up to retirement. During 2012, record numbers of people will reach age 65 and many will need to buy an annuity. Around half a million annuities are sold each year and, since 2008, annuity rates have fallen by about 25%, most of which is due to the effect of QE. That means over a million pensioners will be permanently poorer for the rest of their lives, as they have bought an annuity at rates that have been artificially depressed by the Bank of England.

What’s more annuity rates – that is, the rate at which pensioners draw down income – has dropped significantly:

Annuity rates have plunged, meaning the people’s hard-earned pension savings are not giving them the pension income they could have achieved even just a few months ago.

That means less spending power in the pockets of pensioners; and that, in turn, means less demand in the economy.

Back in 1995 British pensioners were offered a new, more risky but potentially more profitable option called an ‘income drawdown’. Helen Pow at the Daily Telegraph explains the income drawdown as follows:

Income drawdown allows people to take an income from their pension savings while leaving it invested in the stock market. It is an alternative to an annuity – which involves you handing over your pension savings to an insurance company in exchange for a guaranteed annual income for the rest of your life.

But even going down this route – which is far more risky than buying annuities – won’t allow Grandma and Gramps to avoid the ravages of QE. Saga again:

If they decide not to buy the annuity but go into income drawdown instead, they will also be hit by QE because they amount of income they are allowed to take out of their pension fund is determined by the Government Actuary Department’s (GAD) rates, which are themselves based on gilt yields.

Which makes perfect sense because, as Helen Pow explains:

Typically these [income drawdown] funds are invested in a combination of shares, cash and fixed-interest investments such as bonds and gilts.

Simply put: QE programs hurt pensioners big time – and the more QE they pump in, the more they damage pension funds. Indeed, back in October James Kirkup at The Daily Telegraph reported that the last round of QE sapped money from pensioners to the equivalent of around £3,750 a head. That’s a big chunk of change.

Saga have largely come to the same conclusion as we have on the Quantitative Easing programs being run by the UK and the US:

There have to be more intelligent ways of using newly created money that would more directly stimulate the economy, rather than resulting in millions of poorer pensioners for years to come and company pension schemes draining much-needed resources from their sponsors. Indeed it would be better to just drop pound notes from helicopters and let people spend them, than buying gilts and seeing the money disappear into bank balance sheets while worsening pensioner prospects.

John Maynard Keynes couldn’t have put it better himself. Of course, there are better ways to distribute newly issued money to people; you could employ them, for example, or you could cut taxes massively. But Saga’s main point stands. QE is dodgy policy and real stimulus is needed urgently.

Thankfully, with companies like Saga getting the word out through press releases, this phenomenon is no longer just confined to FOMC meetings. Increasingly it is coming into the public eye.

Saga are also right not to point their guns at Mervyn King and other central bankers; they’re doing the best they can given the circumstances in this regard. The real problem are the stubborn and intractable governments in the US and the UK who, despite having their own currency and hence extremely low interest rates, simply refuse to engage in real stimulus policies.

Spending policy in these countries is being run by economic vandals and so, with these thugs on her case, it’s no surprise that Grandma is too scared to take a trip down to the local shop and engage in some good old-fashioned economic-stimulating consumption.

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

While I was writing on the unsustainability of the haircut deals yesterday, the peripheral bond markets in Europe rallied. My argument was that when other countries started getting uppity and demanding haircuts, European government bond investors would slowly but surely come to realise that they were the ones on the end of the hook and that politicians didn’t give a damn about them. This would eventually result in their piling out of the bond markets, sending yields into the stratosphere. The ECB would then be forced to step in and buy up bonds in the secondary market – or perhaps do something even more responsible, who knows?

And indeed, as the Greek deal began to solidify, Ireland quickly joined the queue:

Ireland would see any European Central Bank contribution to the restructuring of Greek debt as a precedent that would boost Dublin’s efforts to ease the burden of its own sovereign debt, the country’s finance minister said on Wednesday.

In the meantime, however, the markets for peripheral company and bank debt rallied – and rallied rather hard at that. The FT reports:

For all the uncertainty over Greece, Europe’s bond markets have been rallying strongly. Now the ‘risk on’ sentiment has spilled over into markets for company and bank debt, with investors snapping up a wave of bond issues from Italy, Ireland and Spain.

Of course, this isn’t the European government bond markets; this is just company and bank debt. And we can’t expect investors get nervous until they start seeing governments in countries like Portugal rattle the cage and demand a haircut. But still, some explanation is surely needed.

Is it that these investors are stupid? Well, we should never assume stupidity when easy moneymaking might be involved. And that, of course, is precisely what’s happening here. Per the FT:

Bankers say that the European Central Bank’s €489bn injection of much-needed liquidity through a three-year loan programme into Europe’s financial system not only provided unlimited and cheap funds to the region’s banks but helped to lure cash-rich investors back into the public bond markets, and those of so-called peripheral eurozone nations in particular.

Sorry, what? Let’s hear that again:

Torsten Elling, co-head of the European rates syndicate team at Barclays Capital, says that the ECB’s so-called longer-term refinancing operation has convinced investors to look at higher-yielding assets again. “The door is open for covered and senior unsecured bond issues in the periphery. There’s definitely demand from investors and that’s been driven by the LTRO.”

Aha! Of course! It’s the ECB bailout that is facilitating this bond market rally. Investors grab the LTRO funds and bang them into high-risk assets, while at the same time investors are told that they’re going to get burned in the Greek bond market.

Naked they came from their mothers’ womb, and naked they shall depart. The Troika gave and the Troika has taken away; may the name of the Troika be praised!

Yesterday I claimed that the Eurocrats had not thought their strategy through; I said that they had not considered how bond markets would react when more haircuts became inevitable and began to be demanded by other countries. Was I wrong? Is there indeed a master plan? Is the LTRO the mechanism by which this master plan is launched?

No. I don’t think so. The LTRO bailout fund will not stem the tide in this regard. The key problem is that this is not a liquidity crisis, but a solvency crisis. And it is not a solvency crisis in the typical sense, but a solvency crisis of a group of sovereign states that don’t use their own currencies.

The LTRO cannot make up for the fact that countries such as Ireland and Portugal do not issue their own currency and are being starved for funds by their de facto central bank, the ECB. This is for the simple fact that, as a BCA Research reports said recently (via WSJ blog):

The ECB’s LTROs can solve the banks’ refinancing needs for the next few years if they choose to take advantage. [But] the LTROs’ effect on peripheral sovereign debt is only indirect and is subject to the banks’ fickle appetite for risk.

The LTRO then, has a few functions. The most obvious is to keep the banking system operating while the Eurocrats continue to spit fire on the economies of the periphery and, in doing so, greatly increase the risk on these very banks’ holdings of sovereign debt. Tied to this, the Eurocrats can walk daily into the same room as the bankers and the financiers and not get shouted at for ruining their portfolios. Oh, it’s a wonderful life!

Yet people would be misled if they thought that this was, at heart, a nefarious banker-driven scheme. No, the bankers are being kept wriggling on the hook like everyone else. They’re just being fed rather well.

At heart this is, as it always has been, a political problem. And it must be said that, disgusting and ruthless though it all is, those that are pulling the strings are doing a rather good job at balancing all those political forces – like the bankers and the financiers – that might have the power to actually hold them accountable for their destructive and reckless actions.

But the situation remains a house of cards. And once other peripheral countries, squeezed hard in the vise of austerity, begin to demand the haircuts that are all but inevitable, those same bankers and financiers will look back to Greek default and remember just how important their interests really are relative to the naked political desires of those in power.