Wednesday, November 14, 2012

Greece: The Troika Needs To Dump The IMF

Well, the Greek mess is still unresolved. The ECB has been stepping on Greece’s oxygen tube to force the Greeks to capitulate to all of the Troika’s demands, in exchange for another EUR 30 billion. The government has complied by jamming through compliant legislation (at great political cost). But that is not enough to unlock the Troika’s money box.

Europe, for reasons that are unclear to me, won’t keep the money pumps going unless the IMF is on board as a full participant. The IMF says that Greece’s debt trajectory is unsustainable, the understatement of the century. The IMF wants Greece’s official debt to be reduced to a sustainable level. (Greece’s private bondholders have already been whacked). In other words, the challenge is not only finding a way to come up with more money, but also persuading somebody to forgive debt at the same time. The IMF and the ECB can’t forgive debt, and the Germans refuse to forgive debt.

It would seem to me that the simplest solution would be to leave the IMF behind, and just lend Greece the EUR 30 billion from the ESM. Clearly no one really cares whether or not Greece's debt situation is sustainable. But for whatever reason, Europe wants to keep the IMF on board. Therefore, Europe (the EFSF/ESM) will have to write down its claims on Greece. Merkel and Schaueble say no to this because they wish to maintain the illusion that the German taxpayer is lending and not donating to the Greeks (who chose not to pay taxes).

We’ve been through so many Greek crises before that it is hard to get too excited about this one. In every case in the past, the geniuses in Brussels have come up with a way to prevent the Pandora’s Box of an uncontrolled Grexit. Now they have a simple choice: either kick the can down the road for another six months, or come up with Plan B for a controlled, non-catastrophic Grexit.

As I have discussed before, the IMF cannot be “fixed” by Europe because Europe doesn’t control it. The US (Obama and Boehner) has to agree to whatever Lagarde wants to do. That suggests to me that if Europe wants to forestall Grexit, she will have to jettison the IMF and change the Troika into a Duo.

If it were up to me, I would be moving toward Plan B, with a fully developed plan to allow Grexit while feedingthe Greek people and preventing a European banking crisis. If the Germans would allow the ESM to recapitalize banks directly, this could be accomplished without exacerbating the sovereign debt crisis.

Wednesday, November 7, 2012

Obama's Re-election: The Bright Side

As a believer in free markets and limited government, it is dispiriting to see the American people (50% of them anyway) choose European social democracy. However, there is a silver lining to the black cloud of Obama’s re-election: some of the Democratic party's policy positions are good. Obama is a mitigated disaster, and we can take some comfort in that.

Social Issues

First, the Democrats are more liberal--read libertarian--on the social issues. They do not want to revisit the criminalization of abortion, which would be a disaster for all concerned (I know: my godfather was on the NYPD abortion squad). The Democrats are generally more supportive of an enlightened drug policy, as opposed to the current prohibition that keeps the drug cartels, the prison guards and the DEA in business, and which is turning Mexico into a failed state which exports its illiterate peasantry. 

I wish the Democrats had the guts to advocate drug policy reform, but they don’t, probably because of the prison unions and other corrupt influences. It would be a great day for liberty if some future president could zero out the DEA and all of its infantry, weaponry and foreign adventurism. Forgive me for pointing out that the DEA is also 100% unconstitutional.

Monetary Policy

Second, the Democrats understand monetary policy much better than do the Republicans. It is an indisputable fact that the GOP is opposed to QE and to the reappointment of Bernanke as Fed chairman. The GOP is the party of hard money and flirtation with the gold standard. The US will never be able to correct its debt trajectory as long as it pursues European-style deflation. Growth is the only way to balance the budget and to grow the denominator of the D/GDP ratio. I have much more confidence in Obama’s choices for Fed governors than Romney’s. I hope that Obama reappoints Bernanke or a a man of similar excellence.

Foreign Policy

Third, Democratic foreign policy is much less imperialist than the Republicans'. The Republicans enjoy America's superpower status and seek to rule the world. The Republican party managed to start two disastrous wars in a part of the world where American troops should never be deployed, and where our strategic interests are debatable. Certainly, we have failed to achieve whatever our strategic objectives might have been. That is, unless our strategic objectives were to make Iraq an islamic republic, to endanger the oil kingdoms, and to give the stone-age Afghans better rifles. That we achieved. 

Obama’s “no boots” policy with respect to Libya and Syria has been prudent. I do blame him for stupidly overthrowing Mubarak and Qadaffi, but the GOP was no wiser. The GOP has a preference for intervention and elective wars which appears incorrigible. Obama is less likely to go to war with Iran than Romney, and he will be better positioned to rein in Netanyahu.

Defense Policy

Fourth, the Democrats are much less in thrall to the military-industrial complex than are the Republicans. The Pentagon is a  parasitical growth that manages to suck $600 billion out of the American taxpayer every year. That needs to be reduced. 

But the scandal is not so much the waste and corruption as it is the perverse incentive to seek out military conflict and imaginary enemies. The US military to this day remains equipped to fight a conventional land, sea and air war against the Soviet Union, which hasn't existed for twenty years. What are we planning to do with all of those carrier battle groups? Why are we spending $600 billion on the F-35 fighter? What or who are our hunter-killer submarines pursuing? Why are we provoking the Chinese with new bases in their backyard? I have little confidence in Obama’s ability to get control of the “defense community”, but even less when it comes to the GOP.


I certainly do not mean to suggest that the foregoing “silver lining” can adequately compensate for the corrosive crypto-marxism of the Obama regime. In my opinion, antimarxism is the highest form of political morality, while marxism and all of its malign offshoots is inherently evil and destructive of liberty. The marxism at the core of the Democratic ideology is indeed evil, but not all of the party’s policy positions are incorrect. Let’s take comfort in that.

Sunday, November 4, 2012

The Fiscal Cliff: There Is No Alternative

The US is in the midst of a fiscal crisis caused by the combination of reduced revenue due to the 2008-09 recession and increased expense caused by the 2008 fiscal stimulus bill. Federal debt held by the public has grown from $5 trillion in 2007 to $11 trillion today. The ratio of debt held by the public to GDP has risen from below 40% in 2007 to almost 80% today. Without a drastic change in course, the CBO predicts that ten years from now the ratio will climb to 90%, the highest level in postwar history (and utterly inconsistent with the AAA credit rating criteria of Moody’s and S&P).

There is no need to rehash the debate about whether President Obama or Speaker Boehner was responsible for the failure to reach a bipartisan “grand compromise” in the summer of 2011 during the debt ceiling crisis. In my opinion, Obama and Boehner were close, but both of them got too far out ahead of their House caucuses. Pelosi and Cantor each killed the deal: Pelosi, because it included Medicare reform, and Cantor, because it included a tax increase. What we got instead was the Budget Control Act of 2011. 

The BCA provided that if Congress failed to adopt the Simpson-Bowles fiscal consolidation plan, automatic expense sequestration would occur in calendar 2013. In addition, the deal to extend the Bush tax cuts was set expire in 2013. This combination of automatic cuts plus an automatic tax increase is the much-feared “fiscal cliff” that hits the US budget and economy two months from now, unless Congress decides differently.

The Budget Control Act of 2011
The BCA specifies automatic procedures to reduce both discretionary and mandatory spending during the coming decade. Those automatic reductions will take the form of equal cuts (in dollar terms) in funding for defense and nondefense programs in fiscal years 2013 through 2021. 

Under the BCA, the automatic enforcement procedures will reduce budgetary resources for defense programs by $492 billion over the 2013–2021 period. By CBO’s estimate, the automatic enforcement procedures will reduce discretionary defense resources by about 10% in 2013 and reduce the caps on defense appropriations by lesser amounts thereafter, declining to 8.5% in 2021. By CBO’s estimate, the automatic enforcement will reduce nondefense funding (excluding Medicare) by about 8% in 2013 and by declining percentages thereafter, falling to a low of 5.4% in 2021.

The Fiscal Cliff Is Necessary
In my opinion, the massive deficits of the past five years are neither moral nor prudent. The American people can be analogized to wealthy parents who, having spent all of their children’s inheritance, have also mortgaged their house and taken out a huge loan in the name of their descendants. We have spent trillions of dollars for partying on our children’s credit card. We have not only run deficits in recessions, we have run deficits during growth years. We have demonstrated a bipartisan inability to keep our fiscal house in order that keeps getting worse. This has already cost the US its AAA from S&P and will cost it Moody’s AAA as well, unless something like the fiscal cliff is allowed to occur.

I have no confidence that Congress can reach a lame-duck deal that will rein in our large and unaffordable deficits. I think that the only way to move toward fiscal discipline is to jump off the fiscal cliff in January. The CBO says that the economic impact would be a mild recession in 2013, followed by resumed growth. That strikes me as a very small price to pay for cutting the deficit in half, limiting future deficits, bringing down the debt ratio over the next decade, re-establishing the AAA ratings and laying the foundation for future prosperity.

There are aspects of the fiscal cliff that will have to be fixed, such as Medicare reimbursement, but aside from that I think that we can live with it as it is. It will ding defense and other discretionary spending, which is necessary in my view, especially given our inability to reform Medicare. And the CBO forecast includes no assumptions concerning any possible offsetting monetary stimulus from the Fed.

The following discussion of the “fiscal cliff” reflects the CBO’s latest ten-year budget outlook, published in August.

The federal budget deficit for fiscal year 2012 (ending 9.30) will total $1.1 trillion marking the fourth year in a row with a deficit of more than $1 trillion, or 7.3% of GDP.  Federal debt held by the public will reach 73% of GDP—the highest level since 1950 and about twice the 36% of GDP that it measured at the end of 2007.

The Fiscal Cliff Scenario
Substantial changes to tax and spending policies (the “fiscal cliff”) are scheduled to take effect in January 2013:
>Expiration of the Bush tax cuts;
>Sharp reductions in Medicare reimbursement rates;
>Automatic enforcement procedures (“sequestration”) to restrain discretionary and mandatory domestic and defense spending;
>Expiration of emergency unemployment benefits and of the  reduction of 2%  in the payroll tax rate

With those and other policy changes contained in the fiscal cliff, the deficit will shrink to an estimated $641 billion in fiscal year 2013 (or 4% of GDP), almost $500 billion less than the deficit in 2012.

Under the CBO’s “fiscal cliff” scenario (FCS), budget deficits are projected to continue to shrink—to 2.4% of GDP in 2014 and to 0.9% by 2022. With deficits small relative to the size of the economy, debt held by the public is projected to drop relative to GDP—from about 77%  in 2014 to about 58% in 2022 (which would be consistent with AAA bond ratings).

Most of the projected decline in the deficit occurs because revenues are set to rise considerably—from 16% of GDP in 2012 to 20% in 2014 and 21% in 2022. Between 2012 and 2014 alone, revenues in CBO’s “fiscal cliff” scenario shoot up by one-quarter as a share of GDP.

Outlays, by contrast, are projected to be a smaller share of GDP in 2022 under the FCS (22%) than they are in 2012 (23%). Discretionary spending is projected to decline relative to GDP throughout the next 10 years because of the caps on discretionary funding under the FCS. By CBO’s estimate, discretionary spending will fall to 6% of GDP by 2022—the lowest level in at least 50 years.

The Alternative Fiscal Scenario
To illustrate the consequences of possible legislative changes to the FCS, the CBO produced an alternative fiscal scenario (AFS) that incorporates the following assumptions: that all expiring tax provisions are extended indefinitely (except the payroll tax reduction in effect in calendar years 2011 and 2012); that the AMT is indexed for inflation after 2011; that Medicare’s payment rates for physicians’ services are held constant at their current level; and that the automatic spending reductions required by the Budget Control Act, which are set to take effect in January 2013, do not occur (although the law’s original caps on discretionary appropriations are assumed to remain in place).

That set of alternative policies (the AFS) would lead to budgetary and economic outcomes that would differ significantly, both in the near term and in later years, from those in the “fiscal cliff” scenario. In 2013, the deficit would total $1.0 trillion, almost $400 billion (or 2.5% of GDP) more than the deficit projected to occur under current law.

Under the AFS, deficits over the 2014–2022 period would be much higher than those projected under the FCS, averaging about 5% of GDP rather than 1%. Revenues would remain below 19% of GDP throughout that period, and outlays would rise to more than 24%. Debt held by the public would climb to 90% of GDP by 2022— higher than at any time since shortly after World War II.

The Economy Under The Fiscal Cliff Scenario
Under the FCS, the deficit will shrink to an estimated $641 billion in fiscal year 2013 (or 4% of GDP), almost $500 billion less than the shortfall in 2012. The CBO forecasts that such fiscal tightening will lead to economic conditions in 2013 that will probably be considered a recession, with real GDP declining by 0.5% between the fourth quarter of 2012 and the fourth quarter of 2013 and the unemployment rate rising to about 9% in the second half of calendar year 2013.

Under the FCS, as the economy adjusts to a lower path for budget deficits, real GDP is projected to begin growing again in late 2013. The pace of economic expansion will average 4.3% from 2014 through 2017, CBO projects. As economic growth picks up, the unemployment rate is projected to decline to 8.4% in the fourth quarter of 2014 and to 5.7% by the fourth quarter of 2017.

The Economy Under The Alternative Fiscal Scenario
The AFS would lead to budgetary and economic outcomes that would differ significantly, both in the near term and in later years, from those in the FCS. In 2013, the deficit would total $1.0 trillion, almost $400 billion (or 2.5% of GDP) more than the deficit projected to occur under the FCS. The economy would be stronger in 2013: real GDP would grow by 1.7% between the fourth quarter of 2012 and the fourth quarter of 2013, and the unemployment rate would be about 8% by the end of 2013, CBO projects.

Under the AFS, real GDP would be higher in the first few years of the projection period than under the FCS, and the unemployment rate would be lower. 

However, the persistence of large budget deficits and rapidly escalating federal debt would hinder national saving and investment, thus reducing GDP and income relative to the levels that would occur with smaller deficits. The economy would grow more slowly over the 2018–2022 period than under the FCS, and interest rates would be higher. Ultimately, the CBO concludes, the AFS would lead to a level of federal debt that would be unsustainable from both a budgetary and an economic perspective.

So, my conclusion is that the alternative to the fiscal cliff is not a better-crafted but equally effective inflection in the debt trajectory, but rather no such inflection. The choice is thus between the fiscal cliff and ultimate ruin. Unfortunately, I expect the outcome to be much closer to the AFS than to the FCS, and ruin it will be.

Friday, November 2, 2012

Both Greece And Cyprus Must Capitulate Next Week

It now appears that when the German finance minister said on Wednesday that Cyprus had not engaged in substantive negotiations and had missed the deadline for a November deal, he was making an honest observation but was not speaking officially.  The word out of the Troika is that long-distance negotiations continue but with no progress. The parties are far apart and do not appear to be budging. The issues are labor law and privatization. Both issues are non-negotiable for both sides.

Cyprus is publicly begging the Troika to come back to Nicosia for more "negotiations"; the Troika's failure to return suggests that there is nothing to talk about until Cyprus gives in and agrees to what the Troika has “proposed”. As Schaueble intended, the Cypriots have become extremely nervous, but have yet to agree. They really should not call his bluff because, even if they somehow win Round One, he will make sure they lose in the end if not sooner. One can only imagine the level of his, shall we say, frustration with their attitude.

Schaueble said that nothing substantive had been accomplished, which is true. For Cyprus to meet the deadline for the Nov. 12th eurozone finance minister meeting, she will have to capitulate to the Troika on all issues this week. I think that Schaueble’s statement was calculated as a stark warning to both Cyprus and Greece that these are not as much negotiations as they are ultimata, and that Europe isn’t going to blink. The marxist parties in both countries must choose between capitulation or default.

In Greece, the wicket is just as sticky. There are three problems: (1) parliament must pass the labor reform demanded by the Troika, which it may not be able to do; (2) the labor law may be declared unconstitutional;  (3) the Troika will have to come up with an additional EUR 40 billion in new loans; and (4) the additional money and time have blown a hole in the IMF’s required debt stabilization plan, requiring a debt reduction scheme to offset the new debt.

Both Greece and Cyprus are scheduled to run out of money by the end of this month, so there really is a short deadline for the conclusion of "negotiations". The next two weeks should be action-packed as (1) Greek and Cypriot politicians realize that they are no longer negotiating and pass the required legislation; (2) their bailout plans are rapidly cobbled together for the ministerial meeting on the 12th; and (3) the financing issues are resolved. Only after the plans have been approved by the Troika and the eurozone will the small matter of German and Finnish parliamentary approval have be addressed (or cleverly finessed).

Thursday, November 1, 2012

Did Germany Just Throw Cyprus Overboard?

“Cyprus! Who cares about Cyprus?” you say. Well, you need to start paying attention now.

To recap for the inattentive: Cyprus (full-fledged member of the eurozone and current president of the EU) needs an emergency bailout because its banks are insolvent and it is running a very large and rapidly growing budget deficit. Its finances are out of control. It has no market access and its bonds are rated close to default. The banks are temporarily living off of liquidity support from the ECB, but the ECB isn’t supposed to lend to insolvent banks, so that cannot continue for much longer.

Cyprus applied to Europe for aid in June. The Troika visited Nicosia and proposed an austerity and reform plan on July 25th. The Eurogroup made it crystal clear that, for the Cyprus bailout to be considered this year, it had to be wrapped up and ready for the eurozone finance minister’s scheduled meeting on Nov. 12th. The Cyprus government, after waiting for two months, announced in October that it had rejected the Troika’s proposals and “invited” the Troika to return to discuss its counter-proposal. (Please see my post, “Cyprus Tells The Troika To Take A Walk”, Oct. 1st, 2012.) The Troika has not yet returned, and may never return.

From the Cypriot perspective, this was supposed to be a negotiation: the Troika proposes, Cyprus “rejects” and counter-proposes, the Troika returns, and then a compromise is reached. However, it appears that Cyprus may have overplayed its hand.

Instead of saying “thank you for these constructive proposals, let us work with you to make them better”, the Cypriots inexplicably decided to raise the Red Banner and to cast its negotiations with the Troika in the context of the international class struggle. Frankly, in describing the stupidity of this move, words escape me. Were the Workers of the World really supposed to rise up and defend the 13th month salary and the COLA?

Communist President Christofias informed Europe that he would defy the Troika’s demand to rein in wages and asked the other parties to support his position. “I’m certainly ready to take to the streets with the workers,” he reportedly said. A delegate from his party told the international communist party conference in Brussels that “we will not accept terms that will abolish working peoples’ gains and sell off for pittance public property to big capital.”

Since rejecting the Troika’s proposals, the government has been “calling on” it to return to Nicosia for “further negotiations”, since the Nov. 12th deadline was rapidly approaching. But today is November 1st, and Christofias and his FM are still waiting by the phone. They say that the Troika will arrive any day now, or maybe next week.

As readers know, it has been my view that Europe will hold its nose and write the check for Cyprus because because exit from the eurozone is “unthinkable” and “impermissable” (especially for the country which is the current president of Europe).

But now, right out of the clear blue sky, German finance minister Wolfgang Schaueble told the media this morning that Cyprus has missed the November deadline, and that the next opportunity to apply would be next year.

As everyone and his brother knows, Cyprus will run out of money long before then. That suggests that Schaueble, meaning Merkel, meaning Germany, meaning Europe has decided to throw Cyprus overboard. Can this be true? We’ll undoubtedly know more tomorrow, but I doubt that Schaueble was misquoted. I think we should assume that he meant precisely what he said.

I see three reasons for this shocker: (1) Europe is furious at Cyprus and can’t stomach their communist arrogance; (2) Cyprus really has missed the Nov. 12th application deadline; and (3) even if Cyprus had met the deadline, their application would have been DOA in the Bundestag. Failure to apply on time makes it easier to reject Cyprus’ application.

The larger question is: Does this mean that Merkel can’t get the Greek bailout through the Bundestag? If so, that means we are facing another Lehman event, since I am aware of no plan for an orderly Greek exit. Grexit, in my opinion, will include default, repudiation and redenomination. That’s a Black Swan, no matter how many times it has been mooted before.

Is this the assassination of the Archduke Ferdinand? I sure hope not!