Sunday, June 26, 2011

Europe faces its Minsky Moment

In 1933, Irving Fisher published his seminal “Debt-Deflation Theory of Great Depressions”. His theory was that over-indebtedness will ultimately lead to liquidation. Debt liquidation leads to distress selling and to a contraction of deposit currency as bank balance sheets shrink, leading to falling prices. As prices fall, the vicious cycle continues because even though prices are falling, indebtedness does not. Deflation makes debt bigger. (That’s Greece we’re talking about.)

Milton Friedman, Ben Bernanke and Barry Eichengreen (along with most other students of monetary policy) agree with Fisher’s theory. In fact, it’s so difficult to refute that it’s become an axiom.

Which brings us to 2011. What is the economic phenomenon that has characterized the past 29 years (i.e., since the crash of ‘82)? One word: leverage, ever growing leverage. Leverage at banks, shadow banks, mortgages, mortgage-backed securities and their derivatives and, of course, governments of all shapes and sizes.

Leverage is inherently evil because it increases financial fragility. If a financial institution has 4% equity and its assets decline in value by 4.1%, it is insolvent. Leverage exposes debtors to creditor confidence. Borrowers default when and only when no one will lend to them anymore.

Creditor confidence is not modelable. It is purely a matter of  group psychology: “I’d better get out now because I see people heading for the exits”. It is unpredictable. Who could have imagined that Goldman Sachs, AIG and GE would lose creditor confidence in 2008?

There are only three ways out of over-indebtedness and a loss of creditor confidence: bailout, default or (in the case of governments) inflation.

As we speak, private sector creditors have lost confidence in Greece, Portugal and Ireland (governments and banks). They are living on life support from the troika (EU/IMF/ECB). They are small and manageable. But the loss of confidence is now spreading to Spain (government and banks) and to eurozone banks exposed to the diseased sovereigns and their banks.

In 2008, the contagion was confined to major banks active in the mortgage, RMBS and CDO markets, which the central banks funded and the governments recapitalized. Today, the contagion appears to be spreading to the entire eurozone banking system. The eurozone banking system is too big to fail and too big to bailout, unless the ECB has the guts to step up to the plate (which is, by the way, its job).

The Germans have talked tough about the need to liquidate failing non-German banks. Let’s see how they feel about liquidating the Landesbanken or Deutsche Bank.

Europe is facing its greatest challenge since 1939. Will it take extraordinary measures to maintain financial stability, or will it be sauve qui peut?

Saturday, June 25, 2011

The eurozone is shuddering

The risk of a catastrophic financial accident is as high as it was in 2008. Eurozone bank risk spreads are rising as investors take flight, while the yield on one month Treasury bills is now below zero. Even though the troika (EU/IMF/ECB) is moving forward with Greece’s bailout, investors are seeking cover anyway. Thus Greece doesn’t have to default for there to be a eurozone financial crisis.

If Spain, Portugal and Eire (governments and banks) lose market access, they will have to reschedule (default) because the troika doesn’t have enough money to rescue them all, along with Greece.

This scenario would be more like the cascading worldwide defaults of 1931 than 2008. One would have to imagine that the wealth destruction in such a scenario would be unprecedented.

Can such a scenario be contained to the Eurozone, or could contagion spread to other developed markets? I can’t see how other European banks won’t be affected to some extent, but they benefit from borrowing in domestic currency, which their central banks can print. I would not expect that non-European banks and governments would be affected, because they all borrow in their own domestic currencies.

Such a scenario would pose an unprecedented challenge to the ECB, which would have to make some very hard choices in order to maintain financial stability (i.e., taking on trilllons of exposure to eurozone banks, presumably with government guarantees of questionable value).

None of this would be happening were it not for the incredibly stupid idea of a monetary union of a hodgepodge of economies based on a geographic concept. The lesson learned during 1931-33 will now have to be relearned: only domestically issued fiat money can prevent deflation and defaults. No country should ever adopt a foreign currency as its own: If you can’t print it, don’t borrow in it. (And no central bank in the world can print gold, so forget about that “solution”.)

The breakup of the eurozone is such a black swan that its ultimate ramifications fall into the Rumsfeldian “unknown unknowns”. I’d have to say long-term bullish, but short term frightening.

Thursday, June 16, 2011

Greek default looms

Previously I had predicted that Greece would default within six months. It is now evident that I was a tad over-optimistic. Default will occur considerably sooner than that.

First of all, Germany won’t mount another bailout unless Greece embraces reform and unless bondholders take some pain. Far from embracing reform, the Greeks are rioting and the government is falling. (Video footage of violent riots has become one of Greece’s fastest growing exports.)

It will be difficult to form a unity government committed to reform, because the opposition would rather renegotiate the bailout that Greece got a year ago, which will not be music to German ears. The Greek plan is to demand a new bailout while defaulting on the prior one. Angela will not be amused.

Greece cannot commit to reform because the people won’t accept it. Germany can’t agree to a bailout unless Greece commits to reform. The ECB, Greece’s largest creditor, refuses to participate in any debt reprofiling, which Merkel demands.

Therefore, Greece will soon run out of money to pay its maturing liabilities and will therefore default, along with its banking system which will collapse.

In my opinion, Greece has no choice but to default, exit the eurozone and redenominate its currency and its debt.

The consequent losses to European banks will be large. This would set up another Lehman event, in which the interbank markets freeze. The ECB will be the provider  of liquidity, until the losses are sorted out and the banks are recapitalized.

The Fed will have to step up liquidity operations as well, as in 2008. This will be a deflationary event and may require QE3. Real possibility of a double dip in the 3rd quarter.

Wednesday, June 1, 2011

Greek default this summer: implications

Greece is within six months of utter and irreversible collapse. Her electorate will not accept the German castor oil plan. She has the choice of balancing her budget under a German rifle corps, or defaulting and balancing her budget anyway (deadbeats can’t borrow).

By September, she will be in default in the worst possible way. Greece is not Argentina, she is Egypt, or Congo. There will be nothing orderly or lawful about her default. Her banks will succumb, her creditors will be left penniless, the ECB will no longer remember her name, and her tax revenues will drift towards zero. She will be a humanitarian basket case, except for the fact that Europe will be unsympathetic to Marxist defaulters. Maybe UNICEF will step in.

Once Greece sinks beneath the waves, Europe will have to come up with a jerry-rigged central funding scheme to keep the fires of hell away from Ireland, Portugal, and the other dodgy credits. Good luck on that. I would expect the worst for Eire and Lisbon.

How many times does the world have to learn that ungovernable Third World countries should not peg their currencies to anything of real external value? Isn’t that the lesson of Latin America, East Asia and, now, the golden Teutonic paradise of euroland?

The Anglosphere is lucky that (aside from Eire) neither UK, US, CAN, AU or NZ have chained ourselves to this catastrophe.  We’ll get the blowback, but not another Depression.

Investment implications? No idea, aside from bullish for $ and gold.