Wednesday, July 31, 2013

The FOMC Votes For Recession

The FOMC issued its monthly statement today. It reads a lot like the ECB’s monthly statements: it begins with the admission that the economy is still stuck in a ditch, and then says that it will continue to do what it has been doing for the past five years. The committee has its foot way down on that gas pedal, but the speedometer still reads zero.

Here is the latest telemetry:

Nominal growth: 2.9%

Real growth: 1.4%

Unemployed: 7.6%

Underemployed: 14%

Core inflation: 1.1%

M2 growth: 6.8%

Divisia M4 growth: 2.3%

10-year yield: 2.5%

(Growth rates are percent change from year ago, not annualized quarterly rates.)

The US economy is running at stall speed. Historically, nominal growth below 3% has led to negative real growth. The Federal Reserve’s monetary stance is contractionary, despite whatever Bernanke says. Inflation at 1.1%  is 30% lower than when Bernanke was sounding the deflation alarm* a decade ago. (

This is what Bernanke said about the BoJ in 1999 (I have bolded the good stuff):
“I will argue here that, to the contrary, there is much that the Bank of Japan, in cooperation with other government agencies, could do to help promote economic recovery in Japan. Most of my arguments will not be new to the policy board and staff of the BOJ, which of course has discussed these questions extensively. However, their responses, when not confused or inconsistent, have generally relied on various technical or legal objections—-objections which, I will argue, could be overcome if the will to do so existed. My objective here is not to score academic debating points. Rather it is to try in a straightforward way to make the case that, far from being powerless, the Bank of Japan could achieve a great deal if it were willing to abandon its excessive caution and its defensive response to criticism...There is compelling evidence that the Japanese economy is suffering from an aggregate demand deficiency. If monetary policy could deliver increased nominal spending, some of the difficult structural problems that Japan faces would no longer seem so difficult.”**
I hope that Janet Yellen hasn't been drinking Kool-Aid from the same defeatist fountain as Ben Bernanke. The unemployed can't take another five years of complacent nonfeasance. As Bernanke taught us, the only way to stimulate aggregate demand at the zero-bound is with inflation. What this country needs is 4% inflation.

Now, for an insight into the Alice-in-Wonderland mentality of the FOMC hawks, here is Governor George’s dissent from today’s statement:
Voting against the action was Esther L. George, who was concerned that the continued high level of monetary accommodation increased the risks of future economic and financial imbalances and, over time, could cause an increase in long-term inflation expectations.
George is the president of the KC Fed:

"Ms. George joined the Bank in 1982 and served as a commissioned bank examiner until 1995, when she was named to the Bank's official staff. She has held numerous leadership positions at the Bank within its research support, public affairs, and human resources functions. She served as first vice president of the Bank from August 2009 until her appointment as president."

*Bernanke: “Deflation:Making Sure It Doesn’t Happen Here”,
**Bernanke: “Japanese Monetary Policy: A Case Of Self-Induced Paralysis?”.

The Eurozone Crisis Through The Eyes Of Hyman Minsky

“Over a period in which the econ­omy does well, views about accept­able debt struc­ture change.  In the deal-making that goes on between banks, invest­ment bankers, and busi­ness­men, the accept­able amount of debt to use in financ­ing var­i­ous types of activ­ity and posi­tions increases. This increase in the weight of debt financ­ing raises the mar­ket price of capital-assets and increases invest­ment. As this con­tin­ues, the econ­omy is trans­formed into a boom econ­omy.  The ten­dency to trans­form doing well into a spec­u­la­tive investment boom is the basic insta­bil­ity in a cap­i­tal­ist econ­omy.
“Each new instru­ment and expanded use of old instru­ments increases the amount of financ­ing that is avail­able and that can be used for financ­ing activ­ity. Increased avail­abil­ity of finance bids up the prices of assets and this leads to increases in invest­ment.
“Units which engage in spec­u­la­tive finance depend upon the nor­mal func­tion­ing of finan­cial mar­kets. In par­tic­u­lar, spec­u­la­tive units must con­tin­u­ously refi­nance their posi­tions.
“The views as to accept­able lia­bil­ity struc­tures are sub­jec­tive, and a short­fall of cash receipts rel­a­tive to cash pay­ment com­mit­ments any­where in the econ­omy can lead to quick and wide reval­u­a­tions of desired and accept­able finan­cial struc­tures. Whereas exper­i­men­ta­tion with extend­ing debt struc­tures can go on for years and is a process of grad­ual test­ing of the lim­its of the mar­ket, the reval­u­a­tion of accept­able debt struc­tures, when any­thing goes wrong, can be quite sud­den and quick.
“In addi­tion to hedge and spec­u­la­tive finance we can dis­tin­guish Ponzi finance—a sit­u­a­tion in which cash pay­ments com­mit­ments on debt are met by increas­ing the amount of debt out­stand­ing. High and ris­ing inter­est rates can force hedge financ­ing units into spec­u­la­tive financ­ing and spec­u­la­tive financing units into Ponzi financ­ing. Ponzi financ­ing units can­not carry on too long.
“Feed­backs from revealed finan­cial weak­ness of some units affects the will­ing­ness of bankers and busi­ness­men to debt finance a wide vari­ety of orga­ni­za­tions. Unless off­set by gov­ern­ment spend­ing, the decline in invest­ment that fol­lows from a reluc­tance to finance leads to a decline in prof­its and in the abil­ity to sus­tain debt. Quite sud­denly a panic can develop as pres­sure to lower debt ratios increases.”

--Excerpts from Minsky’s “The Finan­cial Insta­bil­ity Hypoth­e­sis: An Inter­pre­ta­tion of Keynes and an Alter­na­tive to Stan­dard The­ory”, Chal­lenge, March-April 1977, pp. 20–27. [source: Steve Keen’s DebtWatch].

Minsky’s model for the economy was informed by Irving Fisher’s Debt-Deflation Theory. They both offered models of the economy in which finance plays a dominant role (as opposed to, say, fiscal or monetary policy). In explaining crises and depressions, monetarists point to the money supply, Keynesians point to the government’s fiscal stance, and Fisher/Minsky point to the credit markets.

I don’t think that is necessary or correct to take an exclusivist stance in this debate. There is plenty of room for each of these theories to contribute to our understanding of economic cycles. Only angry academic economists feel constrained to argue for exclusive theoretic supremacy.

The eurozone debt crisis is a modern phenomenon in which all three theories contribute explanatory power: (1) fiscal: the Troika’s austerity program is depressing aggregate demand; (2) monetary: the ECB’s deflation policy has ensured that neither NGDP nor RGDP can grow, and that the real value of debt rises; and (3) credit: the steady withdrawal of credit from the private sector has thrown an anchor around the peripheral’s necks. Indebtedness grows while the economy shrinks. The harder they try to balance the budget, the higher the level of unemployment, misery and debt. Debt rises while NGDP declines (the “denominator problem”).

Back story: The eurozone periphery experienced a period of high confidence and low credit spreads following the introduction of monetary union. The bankable investment horizon was now much bigger; lending opportunities abounded. Cross-border lending was now domestic lending. Emerging economies became developed economies overnight. The opportunities to lend and invest were almost limitless. All bets were winning bets.

Euro euphoria permitted higher leverage for banks, companies and governments than prior to EMU. Higher leverage bid up asset values: an asset is worth what a bank will lend against it. Stocks, property, bonds: all rose on the tidal wave of rising debt. As Minsky would say, finance in peripheral Europe went from being self-liquidating, to being speculative, to being ponzied. Principal could be rolled over again and again, while interest was paid with new borrowing. Trichet declared that EMU was raising living standards; the euro project was a success; convergence would continue on the path to “ever deeper union”.

This revery ended in the fall of 2009, when Greece revealed that it had been cooking its books for years. Market psychology changed overnight: credits that had appeared eminently bankable and marketable were now suspect. “The reval­u­a­tion of accept­able debt struc­tures, when any­thing goes wrong, can be quite sud­den.” Government, corporate and bank credit ratios that had looked OK now looked toxic. The debt markets began to look for other dodgy credits, and discovered the PIIGS.  It was discovered that these countries were running big deficits, were piling up debt, and had bloated, unwieldy and opaque banking systems. Most of them had one or more big banks that no one wanted any exposure to. They looked scary.

In a monetary union, capital movement is unconstrained. It may take years to flow in, but it can leave in a couple of weeks. Capital movements are electronic; capital flight requires a key-stroke, or a committee meeting followed by a keystroke. Overnight, the whole world lowered its concentration limits for peripheral Europe: “Let’s take our clients’ exposure down from 30% to 10%; give the traders a few months to bring it down, but I want it brought down this year. The clients are nervous, especially about X, Y and Z.” Asset managers assured their clients and banks assured their boards that they were reducing their exposure to the PIIGS.

When your nation’s entire balance sheet is funded in foreign currency, capital outflow and the closing of the debt market are hard constraints. Whining won’t help. The only way to obtain wiggle-room is to beg from Germany, which is what Greece, Ireland and Portugal have had to do. Spain is next, but the Germans have bailout fatigue.

And that has led to the strange world into which the eurozone is heading today: a world where no sovereign or bank, no matter how big, is too big to fail. There will no safety net for bondholders, creditors or depositors. Governments are free to repudiate their debts, and banks to repudiate their deposits.

Ponzi schemes never end well. The eurozone’s ponzi scheme has ended. There is no more money flowing in, while debts continue to mature, interest has to be paid, deposits have to be redeemed, and pensions need to be paid--in euros, not funny money.

Germany has solved this problem by saying that everyone who participated in the eurozone ponzi scheme should have known better and should now “contribute” to the resolution. Debt is not debt; it’s a risk asset. Creditors are now expected to become willing or unwilling participants in a “fair and just” resolution of their debtor’s debts.

Trichet’s statement that default by a eurozone sovereign was “unthinkable” and “not under discussion” was rendered inoperable, as Ron Zeigler used to say. Now, it is not only “thinkable”, it is official policy. Sophisticated investors  should have known that, when Trichet said that it was “unthinkable”, his fingers were crossed. That’s the kind of thing that sophisticated investors should know: when the president of the ECB makes a policy statement, just insert “not”, or “I’m kidding, of course”.

So, now,  the flood waters are beginning to inundate the PIIGS. Their banks have started to fail, and their governments have begun to engage in “PSI” which means “repudiation” in Eurospeak. What’s going to happen to all those bloated and insolvent banks that dot the Mediterranean landscape? Who is going to write those checks?

Germany believes that it has established the Siegfried Line on its southern borders. The colonies can be sacrificed without endangering the Homeland. Germany should read a book*: I mean really, a virus which can kill your neighbors can kill you too. Once the word gets out that German banks are stuffed to the gills with all sorts of foreign and domestic dreck, and that they too may default on their bonds and deposits, the German banks may experience their very own Minsky Moment. I ask you, is there one solvent bank in Germany, or France? Which one? They disclose very little, and previous stress tests have been shown to be cheap lipstick. How can any counterparty really know anything about Commerz or Deustche? They certainly didn’t know much about Depfa or Hypo or WestLB.

People shouldn’t light fires in their own neighborhoods. Does anyone in Germany remember Danatbank**? Schadenfreude is not the best policy for financial stability.

*“Can It Happen Again?”, Hyman Minsky, 1982. The hardcover sells for $1,400 on Amazon.
**The collapse of Danatbank on July 13, 1931, triggered a loss of confidence in the German banking system, and produced  a wave of withdrawals from all other German banks, beginning the German Banking Crisis, which led to deflation, depression and political chaos.

Tuesday, July 30, 2013

A Look Inside Obama's "Better Bargain For The Middle Class"

The president has announced that, for the remainder of his presidency, he will focus on the economy in general, and the middle class in particular. He announced his new economic plan, “A Better Bargain For The Middle Class”, in a speech last week. His plan is the banner story on the White House website.

I would like to analyze the president’s plan. I’d like to boil it down to a series of explicit policy proposals that we can discuss from the perspective of economics.

So what is the plan?  From what I could find on the WH’s Better Bargain website (, there is no document aside from the transcripts of his recent speeches. Everything on the Better Bargain website is a video, with the exception of the speech transcripts. There is no policy document that you can click on and download.

It would appear that the president is devoting a considerable portion of his energy to pushing a plan which has not yet been written down, even as a one-page term-sheet. Presumably he will dribble out further details as time passes. The only mention of the Better Bargain on the House Minority Leader’s website is a blurb endorsing it, with no details or legislation mentioned. There is no mention of it at all on the website of the House Democratic Caucus. They evidently haven’t gotten the memo about the president’s plan for the rest of his presidency.

So, it appears that  the content of the president’s economic plan is available only from the text of his speeches, which I have now dutifully read and which is not an enjoyable way to spend a morning. An informed citizen of a free republic shouldn’t have to do this. I shouldn’t have had to spend an entire morning making notes on the transcripts of the president’s speeches in order to find out what his showcased economic plan consists of. We'll have to pass it to find out what's in it.

The president can devote the rest of his term to the advancement of his plan, but he can’t spend a couple of days writing it down on a piece of paper so citizens (and  legislators) might discuss it. His “communications strategy” does not seem to include communication. It isn’t as if economic growth and unemployment are minor issues in a country where 14% of the labor force is unemployed or underemployed. A little seriousness is required on this subject.

As an aside, I would observe that the White House website is remarkably content-free, and is more like the website for a consumer products company: lots of pictures, videos, and slogans, but no text. Take a look for yourself:
Is it just that the White House’s communications strategy is content-free, or is it that the White House policy operation is content-free?

So now to the “plan”. The president begins by describing the problem that his plan is intended to solve:
"Trends that have been eroding middle-class security for decades – technology that makes some jobs obsolete, global competition that makes others moveable, growing inequality and the policies that perpetuate it – all these things still exist, and in some ways, the recession made them worse. Reversing these trends must be Washington’s highest priority." 

The president’s plan to reverse these secular trends consists of ten points (as best as I could tell):
1. Jobs.
2. Education
3. Homeownership
4. Health care
5. Retirement.
6. Urban renewal
7. Minimum wage
8. Fiscal policy
9. Tax reform
10. Immigration
Is this the correct list? Have I left anything out? If I have, maybe the White House policy staff will publish a correct list.
Below are the plan’s details, as outlined by the president in Galesburg and on the radio:
1. Jobs
"We’re going to create strategies to make sure that good jobs in wind and solar and natural gas that are lowering costs and, at the same time, reducing dangerous carbon pollution happen right here in the United States."
"I’m going to push new initiatives to help more manufacturers bring more jobs back to the United States." 
"We’re going to continue to focus on strategies to make sure our tax code rewards companies that are not shipping jobs overseas, but creating jobs right here in the United States of America.
"I’m going to be pushing to open more manufacturing innovation institutes that turn regions left behind by global competition into global centers of cutting-edge jobs.
2. Education
I’m going to keep pushing to make high-quality preschool available for every 4-year-old in America.  
We’ve already begun meeting with business leaders and tech entrepreneurs and innovative educators to identify the best ideas for redesigning our high schools so that they teach the skills required for a high-tech economy.  
I’ve asked Congress to start a Community College to Career initiative, so that workers can earn the skills that high-tech jobs demand without leaving their hometown.  
I’m going to use the power of my office over the next few months to highlight a topic that’s straining the budgets of just about every American family -- and that’s the soaring cost of higher education.  I will lay out an aggressive strategy to shake up the system, tackle rising costs, and improve value for middle-class students and their families.  
3. Home Ownership
I’ve asked Congress to pass a really good, bipartisan idea: to give every homeowner the chance to refinance their mortgage while rates are still low.
4. Health Care
I'm going to keep focusing on health care because middle-class families and small business owners deserve the security of knowing that neither an accident or an illness is going to threaten the dreams that you’ve worked a lifetime to build.
If you’re one of the 85 percent of Americans who already have health insurance, you have new benefits and better protections than you did before:  free checkups, mammograms, discounted medicines if you're on Medicare; no lifetime limits; insurance companies will have to cover you and charge you the same rates as everybody else, even if you have a preexisting condition.

5. Retirement
So as we work to reform our tax code, we should find new ways to make it easier for workers to put away money, and free middle-class families from the fear that they won't be able to retire.  

6. Urban Renewal
We need a new push to rebuild rundown neighborhoods.  We need new partnerships with some of the hardest-hit towns in America to get them back on their feet.  
7. Minimum Wage
Because no one who works full-time in America should have to live in poverty, I am going to keep making the case that we need to raise the minimum wage.
8.Fiscal Policy
Repealing Obamacare and cutting spending is not an economic plan.
9.Tax Reform
If you’re interested in tax reform that closes corporate loopholes and gives working families a better deal, I’m ready to work.
10. Immigration Reform
Economists show that immigration reform makes undocumented workers pay their full share of taxes, and that actually shores up the Social Security system for years.  So we should get that done.
I can’t resist asking: did someone at the White House find a file called Postwar Democratic Party Slogans? Good jobs, better education, home ownership, affordable health care, a secure retirement, urban renewal, higher minimum wage, a fairer tax system...Who made up this list? More likely an historian or a focus-group guru than an economist. I can assure you that if Larry Summers or Christina Romer or Austin Goolsbee had been asked to design this plan, it would have been much more credible and actionable, and more consistent with the laws of economics.
A real economist (as opposed to Gene Sperling) would say that the best way to strengthen the middle class would be a plan to increase real per-capita disposable income, which after four years of recovery, is growing at 0.0%.
A long term plan to increase household income would be achieved by:
1.  Supply-side reforms such as lower taxes and a lower regulatory burden on employers.
2. Demand management via stimulative monetary policy, such as nominal targeting.
3. A plan to force the education unions to ensure that all kids graduate from high school, and that all high school graduates can read, write, balance a checkbook and and complete a tax return.
4. A plan to reduce the cost of healthcare by allowing the healthcare business to operate as a free market in which doctors and hospitals compete on price.
5. A plan to reduce the cost of unskilled labor (e.g., the minimum wage, the employer mandate, the payroll tax) in order to allow the unskilled to be able to compete in the labor market. Right now, the full price of an unskilled worker is significantly higher than his productivity. McDonald’s has already begun automating its restaurants.
6. A plan to reduce the bloated cost structure of the higher education industry and make it possible for a middle-income parent to be able to send her kids to college without going broke.
7. A tax code that rewards work and thrift, which which does not penalize success, and which does not discourage investment.
8. A plan to increase credit creation by ending the War On Banks, such that instead of paying billion-dollar fines for crimes real or imagined, banks can rebuild their balance sheets and start to make more loans to households and businesses. Economic growth cannot occur without credit growth, and credit growth cannot occur without bank profitability. You can't eat your bankers and have them too.
Everything that I have proposed above is a non-starter at the House Democratic Caucus. (Here is their economic plan: No one on the left is serious about growth or unemployment. And no one on the right understand these issues either.

Friday, July 26, 2013

Detroit And The Rule Of Empathy

Investors and borrowers were rankled that Thursday's bankruptcy filing was expected to hit bondholders of some of the city's general-obligation debt following a proposal by Detroit's emergency manager, Kevyn Orr, to rank these bonds alongside other unsecured debt. Some investors expressed surprise that the city could slash the general-obligation bonds' value, as they are backed by Detroit tax revenue and payments are guaranteed by the Michigan Constitution. "I understand the strategy of trying to break out from the [unsecured creditor] herd and say, 'I'm different,' " Mr. Orr said. "But, from our perspective, unsecured creditors share in the unsecured creditor pool." Michigan Gov. Rick Snyder also said that these bondholders should have recognized the risks they were taking when they bought the bonds. "These are sophisticated buyers….This is not your couple living out in the Midwest going through the mortgage crisis," he said.
--WSJ, July 26, 2013
Michigan governor Rick Snyder believes that Detroit’s bondholders should have recognized the risk that, in banana republics, contractual obligations are unenforceable. He also believes that sophisticated investors should be subordinated because, well, because they’re sophisticated, and probably rich as well. If Mom and Dad owned the bonds, that would be different because Mom and Dad didn’t know that they were living in a banana republic when they bought the bonds. And Mom and dad aren’t rich.
Of course, Michiganders already know how worthless bond indentures can be: they are not enforceable if the company in question employs a lot of Democratic autoworkers. Employees come before bondholders, everyone knows that. We’ve already seen this movie in California, where the public sector unions have trumped GO bondholders in Stockton and elsewhere. Pensions are sacred, while bond indentures are so yesterday. And anyway, bondholders are rich.

You may recall that the incumbent president once said that, in choosing a Supreme Court justice, he wanted a judge with empathy. Not a commitment to the rule of law, but empathy. An empathetic judge will always rule on behalf of the weaker party, irrespective of the facts in the case. An empathetic judge will put his finger on the scales of justice in favor of the poor, the sick and the elderly. In other words, an empathetic judge is not blind like the famous statue, but rather has big open eyes and stares empathetically at the plaintiff or the defendant or the pensioner.
There is nothing inherently wrong with replacing the Rule of Law with the Rule of Empathy. France did that a long time ago, and they’re still chugging along. But it does require that, going forward, bond investors must appreciate that they have no contractual rights, and that they shouldn’t waste their time reading the covenants. In America today, a GO bond is just as good as a Czarist war bond.

Thursday, July 25, 2013

Cyprus: Victim Of German Imperialism

"We anticipate the banking resolution mechanism for the Cypriot banking sector to result in a significant downsizing of banks' activities and therefore to severely affect the economic performance of the island from 2013 onwards.  We expect an acceleration in the contraction of the Cypriot economy in 2013, with a negative real growth rate in the low double-digits and no return to positive growth before 2016. Our view is further supported by the negative feedback loop that expenditure cuts may have on the economy given the importance of public services, hence potentially challenging future consensus on fiscal strategy. We note that large uncertainties remain regarding the magnitude of further recapitalization needs for the financial sector given the expected sharp deterioration in the operating environment which will erode asset quality, as well as the behavioural responses of all economic actors to the shocks experienced by the financial sector (including risks of financial disruption related to the timing and approach for lifting of capital controls). In light of all the downside risks and the limited number of upsides, we view Cyprus as likely to default again in the coming years, as reflected by the rating level and negative outlook. Although it is not its central scenario, Moody's also sees a material risk of a Cypriot exit from the euro area which is captured in the Caa2 country ceiling. As a result of the immediate downsizing of the banking sector and the expected spillovers to rest of the economy, especially in terms of weakened consumer and investor confidence, we forecast that the economy will contract by 12% this year and another 6.4% next year."

--Moody’s, 15 July 2013

The purpose of EMU is to reduce the occupied states to penury in order to make them more like Germany, or Ethiopia. Ultimately the question is is: how low can per capita income decline until “Europe” becomes a dirty word, and “liberty” becomes the popular desideratum. Cyprus is the laboratory of this experiment, along with Greece and Portugal. Here is the experiment: How many people must eat out of garbage cans before the euro elites understand that EMU is destroying lives.

It must be pleasing to be ingesting a nice Brussels dinner while discussing how subhuman the  Cypiots are, and how they must be “taught a valuable lesson”. That was how Stalin felt about the “rich peasants” of the Ukraine: surplus empty mouths to feed. Wouldn’t the world be a better place without so many peasants?

Perhaps, in a perfect world, Cypriots wouldn’t exist, like the kulaks and the Crimean Tatars.  All Cypriots do is enable Russian plutocrats. Why should they exist? Liquidate them. Indeed, liquidate all of the parasite states of the Eurozone.

So we now know that the purpose of EMU is not to enrich the vassal states, but to occupy them and to make them penurious colonies of the hegemon. Peripheral Europe is Germany’s Latin America. But there is a crucial difference: the US has not forced its Latin American colonies to join the dollar zone. Latin America, despite its colonial status, retains monetary sovereignty. Aside from the Bolshevik laboratories of Argentina and Venezuela, Latin America is outperforming its colonial parents. Portugal and Spain should have monetary union with Brazil and Mexico, instead of Finland and Germany.

What Germany is doing to Cyprus is a crime. The Germans lack empathy and revel in schadenfreude. That’s sick. Germans cannot learn.

Wednesday, July 24, 2013

The Outlook For Euthanasia In The Eurozone

Today, Moody’s said this about the non-performing loans of Spanish banks: “Spanish banks’ reported NPLs understate asset quality challenges, and negatively affect their ability to generate earnings...Such a high level of problem exposures pressures banks to set aside sufficient provisions at a time when low interest rates are negatively affecting net interest margins. As a consequence, a growing number of banks risk becoming increasingly vulnerable.” (Moody’s Credit Outlook, July 25, 2013)
And here is what an ECB board member said recently:
“Any [failed bank] solution which does not imply an outright bailout seems to take creditors and markets by surprise. This will need to change. I would say that after the events of Cyprus, markets should be convinced that Europe is serious and committed to bailing in and thus ending the bailout culture.” (Benoît Cœuré, May 23, 2013)
Europe has decided to form a “banking union” for the eurozone, which will centralize bank regulation and failed-bank resolution under the ECB. Under the scheme, bank failures will be handled in a standardized manner as prescribed by European law (not national law). Pursuant to the new policy, big banks will no longer be too big to fail. Instead, insolvent banks--no matter how systemically important--will be forced to default on their unsecured bonds and uninsured deposits. Mr. Coeure avers that “This will provide the right incentives to financial market participants and minimise public costs and economic disruption.”
Did you hear that? Europe believes that large bank failures will minimize economic disruption. Compared to what--thermonuclear war? Why didn’t somebody tell Hank Paulson this when he was wasting billions rescuing the US financial system? Apparently the TARP was unnecessary.
The ECB stated in its opinion on the European Commission’s Bank Recovery and Resolution Directive: “…all financial institutions should be allowed to fail in an orderly manner, safeguarding the stability of the financial system as a whole”.
You need to read that twice in order to understand it. What the ECB said is that if banks are allowed to fail in an orderly manner, this will safeguard the stability of the financial system as a whole. I will repeat: so long as large European banks default on their debts and deposits in an orderly manner, the financial system will remain stable. This is insanity. The poster child for this philosophy is Cyprus, where the financial system is not only stable but actually frozen--and quite a bit smaller as well. Cyprus is the laboratory in which the world will learn if a country can have an economy without M1. Another benefit of EMU.

The ECB knows how rotten Club Med’s banks are, and is understandably loathe to become a hospice for dying banks (and dying banking systems). Consequently, it has insisted that all large banks undergo a thorough asset quality review before coming under its supervision. That way, any necessary euthanasia would occur prior to the Banking Union. Depositors have no idea how these insolvent banks will be resolved: will it be like Dexia, or like Cyprus Popular Bank? Total bailout, or total default on everything? (Here’s a hint: keep your money in the Lutheran banking systems.)

The ECB’s scheme assumes that its examiners will be shown all the bad loans and will be able to assign realistic loss provisions (e.g., 100%). So far in this saga, this  has not happened. The earlier eurozone stress tests were cosmetic window-dressing for the gullible public. Having spent my lifetime listening to insolvent banks explain to me in excruciating detail how extremely solvent they were, I distrust such exercises. Insolvent bankers lie to their examiners, their regulators, their boards, their wives and themselves. When a bank fails, the only question is: will the resolution cost be a multiple of its equity or its assets?

I have compiled a list of the kind of big eurozone banks most unlikely to survive an honest portfolio review. The tool that I have used is Moody’s European bank deposit ratings. The deposit ratings come close enough to highlighting Europe’s most troubled names, because the rating uplift for official support is generally limited.

Below is my list:
Cyprus Popular Bank: C
Bank of Cyprus: Ca
Allied Irish: Caa3
National Bank of Greece: Caa2
Monte dei Paschi: B2
Espiritu Santo: B2
Bankia: B1
Bco. Popular: Ba3
Caixa Geral: Ba3
Bco. Populare Milano Ba3
Deutsche Pfandbrief Bank: Baa3
Dexia: Baa2
Commerz: Baa1

I’m sure I have missed a few other basket cases (Credit Foncier, HSH Nordbank?). But this is a representative list of the kind of banks that are supposed to enter the European Banking Union as solvent deposit-taking institutions that won’t default on their deposits unless, as in the case of the Cyprus banks, they already have.

The big debate in Brussels right now is between Germany, with a stable of dead banks it wants to bail out with its own money, and Club Med, with a stable of dead banks it wants Germany to bail out with German money. Germany’s proposal is that Germany should be able to bail out German depositors with German money, but that Germany should not have to bail out anyone else’s deposits. German depositors are safe, Greek depositors are speculators who should move their money to Germany. Now that's a banking union!

Tuesday, July 16, 2013

The Lehman Resurrection Act of 2013

Senators Elizabeth Warren (D-MA), John McCain (R-AZ), Maria Cantwell (D-WA), and Angus King (I-ME) today will introduce the 21st Century Glass-Steagall Act, a modern version of the Banking Act of 1933 (Glass-Steagall) that reduces risk for the American taxpayer in the financial system and decreases the likelihood of future financial crises.

The legislation introduced today would separate traditional banks that have savings and checking accounts and are insured by the Federal Deposit Insurance Corporation from riskier financial institutions that offer services such as investment banking, insurance, swaps dealing, and hedge fund and private equity activities.
Warren: “The 21st Century Glass-Steagall Act will reestablish a wall between commercial and investment banking.”
McCain:"Since core provisions of the Glass-Steagall Act were repealed in 1999, shattering the wall dividing commercial banks and investment banks, a culture of dangerous greed and excessive risk-taking has taken root in the banking world,"
King: “While recent efforts at financial sector regulatory reform attempt to address the ‘too big to fail' phenomenon, Congress must take additional steps to see that American taxpayers aren't again faced with having to bail out big Wall Street institutions while Main Street suffers. While the 21st Century Glass-Steagall Act is not the silver bullet to end ‘too big to fail,' the legislation's re-establishment of clear separations between retail and investment banking, as well as its restrictions on banking activities, will limit government guarantees to insured depository institutions and provide strong protections against the spillover effects should a financial institution fail."
--Excerpted from the sponsors’ press release, July 11, 2013
One of the principal lessons of the financial crisis is that the standalone Wall Street dealer firm is an nonviable business model. The reason is that dealer firms lack core deposit funding and their short-term funding is highly confidence-sensitive, even their secured funding. They need core deposits and/or access to the Discount Window.
Had the Fed not granted Goldman Sachs and Morgan Stanley Fed membership and window access in October of 2008, they would have faced liquidity crises. Goldman and Morgan Stanley, like Lehman, Merrill and Bear, were standalone Wall Street dealer firms. Ditto Citigroup Securities or whatever its nom du jour is at the moment. Indeed, the investment banking units of all US banks would become standalone self-funding Wall Street dealers under the Warren Act.
The Warren Act would expel all of Wall Street from Fed membership, and cast them out into funding darkness. Expulsion would be an immediate death sentence for Wall Street firms. They would get low ratings and be unable to fund themselves in any market. Sayonara to Wall Street. Sayonara to the US debt and equity capital markets. Sayonara to capitalism as we know it.
It is noteworthy but unsurprising that neither of New York's senators are cosponsors of the Warren Act. Should it pass, New York City would become Detroit, and New York State would become Michigan.
It would be interesting to try to run a $16T economy with $55T of debt without a capital market. Who needs all that debt anyway? We could weed out the weak.

Tuesday, July 9, 2013

Germany’s Libertarian Vision For Europe

One is tempted, indeed one is required,  to begin a discussion about Germany’s eurozone  financial policy by introducing the word hypocrisy.  Such a discussion should explain how even the smallest German sparkasse or dry cleaner is TBTF, how bankruptcy law is not the most lucrative profession in Germany, and how there are no German vulture funds. Germany is the homeland of not only TBTF but also of Too Small To Fail. In Germany, all corporations are above average, and all dry cleaners are national champions.

All nationalities are hypocrites in one way or another. It is normal to preach one thing and practice another. But nonetheless, I must observe that Germany is dispensing a medicine in the eurozone that it has never taken itself.

This is the German prescription:
1. Eurozone governments should be allowed to default on their debt, and there should be no implied guarantee from the eurozone.
2. Eurozone banks should be allowed to default on their debt and deposits, and there should be be no implied guarantee from the eurozone.

Well, I mean, come on. I suppose that in some sort of laboratory those theories could be tested. But in the real world, in pathetic Europe? To have the banks fail and the governments default is a bit, how do you say, risky? Please remind me of the libertarian utopia where such things have occurred and revolution did not ensue.

The German idea of turning Europe into a laboratory of libertarian economics would be more credible if Germany had ever tried even the smallest experiment somewhere in Germany. You know, such as allowing Depfa or WestLB or Hypo or Berlin or the Saarland to default. But, as we know, all German entities are TGTF, Too German to Fail. Deutschland is not a country for failures, only successes!

I can certainly sympathize with the German view. I feel the same way about Citigroup, BofA, California, Rhode Island and Illinois. I would love to see them go bankrupt and sink beneath the waves, while listening to the screams of their creditors and employees. What normal person wouldn't?

But if I were the head guy in one of the Club Med colonies, I would not sit quietly, stewing in my own juices, while my people starved.

Germany wants the big Spanish and Italian banks to fail and default on their deposits. Germany wants the Club Med governments to fail and default on their bonds. Germany wants Southern Europe to eat grass. Which is understandable--that’s how I feel about Illinois and California.  But I don’t think that schadenfreude is the appropriate basis for national financial policy. Call me weak and “caring”, but I don’t really enjoy seeing educated people begging in the streets and eating out of dumpsters. It's not good for capitalism.

Germany doesn’t care about the kids in Southern Europe. Germany only cares about German kids, which is perfectly rational. (What did anyone do for starving German kids in 1946?)  But you can’t construct a country on the basis of schadenfreude. Either Germany must allow the South to control eurozone monetary policy, or she should exit the eurozone. Having a hard-money hegemon running the eurozone is destroying not only the “European Idea” but also the lives of millions of innocent Europeans. That is not in Germany’s long-term interest.