The Coming Debt Ceiling Crisis

“Failing to increase the debt limit would have catastrophic economic consequences. It would cause the government to default on its legal obligations. That would precipitate another financial crisis.”

--US Treasury

“I urge Congress to protect America's good credit and avoid the potentially catastrophic consequences of failing to act by increasing the debt limit in a timely fashion. Waiting until the last possible moment to act would risk financial market and economic damage that is completely avoidable and irresponsible to our investors and our country.”

--Jacob Lew, Sec. of the Treasury

“The Treasury has no room under the limit to increase total borrowing. If the debt limit is not increased before extraordinary measures are exhausted, the Treasury will not be authorized to issue additional debt that increases the amount outstanding. That restriction could lead to delays of payments for government activities and possibly a default on the government’s debt obligations. Which of the government’s various financial obligations would be paid and which would not would be determined by the Administration.”

--Congressional Budget Office

The House and the president are dead set on another debt ceiling drama. Both sides seem to want it.

Since the GOP controls the House, the debt ceiling is its principal tool to influence fiscal policy. The House is effectively controlled by the Tea Party which has a policy agenda that doesn’t match that of the Executive Branch. Another game of chicken, who will swerve first, global default, etc. etc. We’ve seen this movie a number of times. High drama, last minute deals, mutual denunciation.

This problem was caused by the founders’ decision to create co-equal branches of government which could be led by different political parties, known in France as cohabitation, and in America as gridlock. The founders were afraid of presidential kingship, on the mistaken idea that poor George III was a tyrant. The revolutionaries believed their own propaganda. Whatever Britain’s sins, they were not the fault of the king, but of the British legislature.

Conflict between the executive and the legislature began the day that George Washington left office. From that moment on, the battle has raged. Interestingly enough, the charter gives ultimate power to the the legislative branch: the right to impeach both the president and the vice president and install the House Speaker as president (a legal coup d'etat). But that has never happened, and is quite unlikely to happen this go-round.

The debt ceiling is a misinterpretation of the Constitution that causes artificial crises and hurts America’s credit. It was never meant to work the way it does today, and I am pretty sure that the Supreme Court would agree, if it were asked (paging Dr. Scalia). It is a legislative mythology, nothing more. The founders did not intend that the legislature could appropriate funds and then refuse to pay for them. But, because the ceiling is a useful weapon in the war between the branches, it is not going away. Obama should do his duty and litigate it, but he has decided not to do so, probably because he sees this "crisis" as a political opportunity. He has no interest in good governance as a desideratum.

Aside from the Constitutional nonsense, the debt ceiling is also a manufactured financial crisis. The Treasury implies that, when it hits the debt ceiling, the government must shut down and default on its debts. That is false.

The Treasury spends about $10B a day, and borrows at most $1 billion of that (and the daily borrow is declining sharply thanks to the Fiscal Cliff). When Treasury maxes out on its credit at the end of October, it will need to find $1B a day to meet payroll, fight wars, and send Grandma her check. When an American citizen is maxed out, he sells his motorcycle or his gun collection. That is all that the Treasury has to do. The Treasury very cleverly does not publish a balance sheet for the USA, but here are some of the known assets:

1. An enormous amount of financial assets that could be sold or repoed with the Fed.

2. Almost all of Alaska, including huge oil and mineral reserves.

3. Most of the American West, including huge oil and mineral reserves.

4. The GSA’s massive portfolio of commercial real estate.

5. Hundreds of redundant domestic military bases in some very expensive real estate markets. (The federal government gave away Governor’s Island in Downtown Manhattan, the Presidio in San Francisco, and is now giving away the Brooklyn Navy Yard. We can't pay our debts, but we can give away our crown jewels. Maybe T-bonds should have a general lien.)

6. The Strategic Petroleum Reserve.

7. Dulles and Reagan airports.

8. A big chunk of Puerto Rico.

9. The embassy in Tokyo.

10. Yellowstone.

And so on. By selling its unimaginable portfolio of real and financial assets, the US government could stay afloat forever without going above the current $16.7 trillion debt ceiling. The US government is the richest institution on earth; its wealth is in the quadrillions; it ain’t broke.

But, the US government doesn’t want to sell or repo assets to avoid a crisis. Just as the Tea Party wants a crisis to force a cut in spending, the Democrats want another shutdown to be blamed on the GOP, as it was in the Clinton-Gingrich showdown in 1996. Both sides want a rerun of that stupid movie.

An important point about Treasury securities: the Constitution obliges the president to protect the country’s credit. It does not oblige him to build bridges, to buy F-35 Lightnings or to aid the Syrian rebels. He is required to pay the country’s debts before he pays any other bills. That means that he would have to curtail or postpone discretionary spending, or sell assets. He cannot prioritize his personal wishlist over paying interest and principal on the federal debt. Should he do so, he should be removed from office. Arranging a default on the national debt and turning the US into a banana republic is, at least, a misdemeanor.

The Tea Party demands that Boehner use the debt ceiling as a weapon to: force a defunding of  Obamacare which is already law, budget cuts beyond the current sequester, comprehensive entitlement reform, and who knows what else (school prayer? a national Reagan holiday?). Boehner does not want to shut down the government, and he knows that Obama won't agree to the Tea Party’s ransom demands. Therefore, he has to figure out a deal that will satisfy both the Tea Party and the Democrats--two Venn diagrams that just don’t overlap. He has an impossible task. If I prayed, he'd have my prayers; if he wanted my advice, I'd tell him to quit and become a K-Street lobbyist like Trent Lott.

We will now have the pleasure of watching a rerun of the 1996 and 2011 crises, but with better fireworks. You may recall that after the last budget crisis, Boehner said he would never negotiate personally with Obama again. We’ll see if he is able to keep that promise in October.
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Comment by Vincent Truglia (http://www.clearandcandid.com):

Chris, although it is interesting to debate the origins of the constitution, the immediate problem at hand is the debt ceiling.  I would have to disagree that the XIV Amendment is any help in this instance.  Since its adoption in 1868, Congress has had the sole authority to authorize debt issuance.  In fact, prior to 1917, Congress had to approve every single security, including details such as maturity, interest rate, and the purpose for which the borrowing was required.

The exigencies of World War I made approving every single security practically impossible.  Congress, after considerable debate, approved the creation of a debt ceiling to streamline the process.  However, the reason they created the ceiling, instead of doing away with the approval requirement, is that many were worried that spending would eventually get out control.  As it turns out, we know that federal spending has indeed skyrocketed. Although, I have generally approved of most federal expenditures, I have to admit that the original concern was justified.

Since the very people who approved the XIV Amendment sat in Congress for many years, and in some cases, decades, it is hard to argue that they were misinterpreting its intent.  Since approving individual federal debt securities was the practice from 1868-1917, it would be hard for even the Supreme Court to make the argument that Congressional approval is not necessary.

In recent years, Bill Clinton has made the argument that “in an emergency” the President has the right to issue debt, even without Congressional approval.  Personally I think that too is a bit of a stretch.  To justify declaring an emergency, I would think that the US would first to have defaulted, if even for a day.  Also, I am still not sure under which constitutional provision such decrees could be authorized (short of war).

I do agree that we are going to have a big battle in Congress over the debt ceiling.  The Republican House leadership faces some tough decisions.  Tea Party supporters in the House know that are mainly in generally safe Republican districts.  They do not face re-election until 2014.  Why would they want to accommodate even the Republican leadership by supporting a debt ceiling rise? That would not play well in their districts.  Also, if they did, in the next election cycle, an even more radical far-right candidate would likely replace them as a result of well-funded primaries.

The dilemma for the Republican House leadership is that if they accommodate rational arguments for the US to avoid default, will they be soon replaced by less accommodating leadership, more aligned with the Tea Party?

The only dilemma Tea Party supporters in Congress face is if the US actually does default.  You and I know, that would cause chaos in world financial markets.  Voter outrage resulting from the consequences of such a default would likely cause the end of the Tea Party movement.  However, since many of them appear to be “true believers,” they might be willing to maintain principle over reason.  Human history is full of such examples.

As you know from my arguments elsewhere, barring a crisis, I see Republican majorities in the House for at least the next two election cycles.  In addition, given demographics at the national level, it will be difficult for a Republican candidate to win the presidency.  Democrats have won the popular vote in 5 of the last 6 presidential elections.  Even the structure of the Electoral College will continue to favor Democratic candidates.

My conclusion is that gridlock will only grow worse over time. At least until 2023, the US government does not face a fiscal crisis resulting from deficits.  By 2023, entitlement costs will start to rise significantly. Given that, why would Democrats want to bargain away anything fiscal over the next 10 years?

Although by any economic argument, the US government is a AAA credit, given that investors will likely have to face issues of the debt ceiling and potential default on an on-going basis. As a result, in my mind, the US is not really AAA. An investor in AAA-rated securities should have to worry about potential near-term defaults, even if those defaults are only temporary.

 

Chicago Needs A Big Bailout

A few years ago, Meredith Whitney predicted a blood bath in the US municipal bond market due to looming defaults. She may ultimately be vindicated but her timing was way off: muni prices rose steadily after the Crash until this year. Now they are falling for various reasons, including credit worries.

The list of distressed or troubled issuers continues to grow: Stockton, Vallejo, Detroit, Harrisburg, Chicago, Illinois, Birmingham, and others. The general storyline is a shrinking tax base in the face of rising retirement benefits. Not only are cash retirement expenses growing rapidly, they have been grossly understated in many cases. As the unfunded liability grows, the pressure rises to increase the level of annual contributions to a sustainable rate. This is a time when many states and cities are having conversations with “stakeholders”: creditors, guarantors, unions, retirees, about making adjustments.

There are a number of options for such situations: (1) higher taxes; (2) budget cuts; (3) pension reform; (4) “give-backs”; (5) bankruptcy and (6) a bailout from the state or the federal government. In many cases, especially in cities with a growing tax base, there is still plenty of room to make adjustments without the need for bailout or bankruptcy. California has appeared to right its ship with a big tax increase and the tax windfall from the Facebook IPO.

But in the more distressed cases, such as Detroit and Chicago, the time for adjustments has passed. Detroit is now bankrupt and seeking to default on its debt. Detroit is the poster child for muni credit risk, but it is an extreme example. It has huge debts and no tax base.

Chicago is the more interesting case. Chicago has been underfunding its pensions for years. So what’s new about that? What’s new is that, starting next year, they will have to increase their contribution by an amount that is very large in relation to the city’s budget. Reuters reports: "The city's pension payments are expected to grow from $480 million in 2014 to about $1 billion in 2015 and $1.1 billion in 2016, according to a financial analysis released by the mayor."

Here's what Moody’s says: “Had the city fully funded the required pension contribution in 2012, operating reserves would have been entirely depleted. To fully fund the plans’ annual required contribution, Chicago’s administration would need to nearly double the property tax levy, or enact commensurate expenditure reductions. We recognize the political implications and practical considerations that would accompany a tax hike of this magnitude. ”

How about that? Sounds like something big is about to happen.

Moody’s calculates Chicago’s unfunded pension liability at around $30B, and observes: “Chicago’s adjusted net pension liability is sizeable on a nominal basis and relative to the city’s operating budget. In 2012, the city’s ANPL was 8.0 times greater than the city’s operating revenues.”

Chicago would seem to be on the verge of a full-blown financial crisis. The only prediction I can make is that something will have to give. The pension liability is constitutionally protected, so that will not be a part of the solution. The city could raise taxes, which is inevitable (and required by law). The state could help out as well, except for one thing: Illinois has the same pension problem. It has the same A3 rating as Chicago. Moody’s: “The General Assembly's inability to steer the state off its current path toward fiscal distress demonstrates not only the magnitude of the state’s unfunded benefit liabilities, but also the legal and political hurdles to significant reforms.” So a bailout from Illinois doesn’t sound promising as a solution.

And then there’s the federal government. Back when Obama had the $900B stimulus money, he could have helped out (and indeed he did). But the stimulus is exhausted and the discretionary budget is sequestered. It should go without saying that Obama would love to bail out his hometown, now governed by his former chief of staff. Here it comes: “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.”

Unfortunately, Obama’s call for “new partnerships with some of the hardest-hit towns in America” does not echo very loudly at the House GOP caucus. It doesn’t appear at all on John Boehner’s to-do list. Chicago has very little representation on the red side of the aisle. No money from Uncle Sam unless the Dems win the midterms.

This drama will play out in Chicago, Springfield and DC over the next year. But back to Meredith Whitney: is there a Minsky Moment in store for the broader muni market? Well, there already is a Minsky Moment happening in Michigan, where a number of bond deals have had to be pulled. If Detroit gets away with defaulting on its GOs, that could impact the national market. The idea that debtholders are subordinated to government unions won’t go over well in the credit market. Credit spreads will widen, especially for “some of the hardest-hit towns in America”. They’re on their own.

Hollande Drives His Car Into Reality And Gets Totalled

“President Francois Hollande is banking on a turnaround in French unemployment by the end of the year. Not only that, he has upped the stakes by making it the top political priority of his Socialist government. "I will be judged on it," he told the nation in a Bastille Day television interview last month. ‘Politics is not magic,’ Hollande told the Bastille Day television cameras. ‘It is will.’”

--Reuters, Aug. 5, 2013

Francois Hollande is a well-meaning politician trying to create employment growth without an understanding of capitalism. His thinking proceeds from the socialist idea: the size of the economic pie is stagnant, but income and wealth redistribution can create jobs.

Hollande and his economics team believe that they can grow employment while cutting the government budget in the face of negligible growth. "Unemployment can start to ease by itself at a growth rate of around one percent," said Reuters' "government source".

Their plan: to create jobs by increasing the number of unproductive state employees and by “retraining” people who are lucky if they can read and write.

Reuters: “When French children return to school in September, they will be welcomed by an army of 30,000 new classroom minders and playground assistants in many cases taken straight from the dole queues. Such public sector posts are a category of jobs whose average duration will be doubled to 12 months. Add to these the so-called "jobs of the future" which the government will fund to help unqualified youths aged between 16 and 25 take up jobs in the health, charitable and other non-commercial sectors.”

That’s his plan. How is he planning to pay for this new serving  of government largesse? France has no fiscal room to increase spending, so this program will have to be paid for with new taxes or with magic. Most likely magic (or, should I say, “will”).

What is Hollande’s vision of the future for France? A society of classroom minders and playground assistants, plus subsidized jobs for the unqualified in the health, charitable and other non-commercial sectors. France will be a nation of social workers and the clients of social workers. The “engine of growth” will be ever-higher taxes on the rich.

What this man needs is an economic advisor who never studied economics at a European university, and who can explain the quantity theory to him in words that he can understand: “Mr. President, we surrendered our money policy to Germany fourteen years ago, and it is urgent that we get it back. Zero growth is killing our economy.”

Failing that, Hollande should read Irving Fisher:

“Unless some counteracting cause comes along to prevent the fall in the price level, a depression tends to continue, going deeper in a vicious spiral for many years. There is no tendency of the boat to stop tipping until it has capsized. Only after almost universal bankruptcy will the indebtedness cease to grow. This is the so-called ‘natural’ way out of a depression, via needless and cruel bankruptcy, unemployment, and starvation.”

Price Stability Is Killing Europe

“The ECB has the clear legal mandate to safeguard price stability. If the central bank were to print money in order to finance the budgets of countries in crisis, it would be unable to fulfil this mandate in the long term. This is because, in the longer term, using the printing press to finance governments leads to higher inflation. Such a monetary financing of governments in the euro area would inevitably jeopardise the euro as a stable currency.”

--Deutsche Bundesbank, “Questions about the sovereign debt crisis”, undated.

“The ECB lacks a coherent strategy for creating the monetary base required to sustain the money creation necessary for a growing economy. The ECB needs to overcome resistance to money creation caused by the link to the debt extinction of governments. The ECB needs to recognize that Europe’s problems are more than structural. It needs to stop using monetary policy as a lever for achieving structural changes and to end its contractionary policy.”

--Robert L. Hetzell,  senior economist, FRB of Richmond, “ECB Monetary Policy in the Recession”, July 2013

“The importance of technical competence in monetary policy has been proved repeatedly by central banks around the world. The quality of monetary policy depends critically on whether central bankers have a clear and nuanced understanding of policy making and inflation. Rather than worrying about inflation, central bankers should focus on reflating the economy.”

--Kenneth S. Rogoff, Harvard University, “The Federal Reserve in a Time For Doves”, August 2013

The ECB has a single mandate, price stability, which is tragic because price stability is killing Europe. Europe needs sustained 4-5% inflation if it is to recover from its five-year depression and reverse its rising debt ratios. But the ECB has defined price stability as inflation of less than 2%. And in addition, the ECB has ruled that a program of QE would violate the prohibition of “monetary financing”, i.e., deficit monetization. This suggests that the central bank can only buy the bonds of governments when they are running budget surpluses!

Achieving 4-5% inflation would require the ECB to buy something (the policy instrument). The normal policy instrument is government debt. Unfortunately, Brussels issues no debt for the ECB to buy. So the ECB is forced to use the bonds of eurozone governments as its policy instrument. But the ECB has defined the purchase of government bonds by the ECB as “monetary financing”. If buying eurozone government bonds is verboten, then the ECB has no policy instrument, as Hetzel points out.

The fact of the matter is that “monetary financing” is a legitimate monetary policy instrument in the pursuit of economic growth and full employment--even if the government in question is running a deficit, indeed, especially if the government is running a deficit, because inadequate growth causes deficits (and rising debt ratios).

So Europe has thrown up two roadblocks to European recovery: (1) zero inflation; and (2) no QE. Europe lacks a coherent monetary strategy, as Hetzel says.

ECB Announces Schedule For Next Banking Crisis

“The ECB will complete an assessment of top banks' assets early next year, a source familiar with the matter told Reuters on Thursday. The ECB is due to become the single supervisor for eurozone banks and before it takes up the task it plans to conduct an asset quality review as part of a broader balance sheet review of the region's largest banks.”

--Reuters, Aug. 1st, 2013

Europe plans to form a Eurozone Banking Union (EBU) next year. The plan provides for a Single Supervisor for big banks (the ECB), and for a Single Resolution Mechanism that would be able offer ESM assistance in failed bank resolutions. The ECB agreed to take on this thankless task on one condition: that sick banks must be resolved prior to EBU. In order to fulfill that condition, the ECB will supervise comprehensive portfolio reviews for the big banks. Unlike prior reviews which were macro and top-down, these reviews will be loan-by-loan, and will utilize third party professionals uncontaminated by local political pressures.

This situation is analogous to the nursing home agreeing to admit Grandma, so long as she can run a few laps around the track. The purpose of EBU is to break the credit linkage between Club Med governments and banks. The idea is that, once EBU is up and running, banks will be much less of a contingent liability for the governments and their debt ratios. But the plan assumes that the bad banks will be resolved now, before the linkage is broken.

There are two reasons why this plan won’t work:

1. If the reviews are honest, the recap bill will be in the hundreds of billions. By honest, I mean marking bond portfolios to market or assigning loss reserves against them. Plus the big real estate cover-up will have to end: no more refinancing with new money; no more accrual of unpaid interest; no more sanitizing toxic exposures by converting them into covered bonds. So, if the reviews are honest, and the price tags are dumped on the governments (or bondholders) the crisis will resume.

2. Even after EBU, the government credit linkage will remain because (1) the governments will still be expected to contribute in future resolutions; (2) the ESM is tiny in relation to the scale of the system; and (3) the SRM is predicated on depositor bail-ins which will destroy the banking systems, as it has in Cyprus.

Draghi is acutely aware of this problem, and he wants to know who is going to pay the big bill and how. Reuters:

“ECB President Mario Draghi has stressed several times that political leaders need to come up with a sufficient backstop before the ECB can embark on its asset quality review in order to cover potential capital shortfalls. So far, this issue is still not entirely solved.”

Not entirely solved? How about, entirely not solved.

Translating Draghi's Press Conference Into Truthspeak

I have read the transcript of Mario Draghi’s monthly press conference so you don’t have to. He made no big news, but there is always information. I enjoy reading the remarks of spokespeople for disastrous failures. I like to see how they phrase the fact that the wheels have come off the bus: “Your company had a tough time in 2012, and we expect another challenging year in 2013.”

Do you remember “Baghdad Bob”, the Iraqi minister of information during the American invasion? No matter how dire things got--such as having his ministry blown to bits--he was always upbeat and confident of victory. That’s who Mario Draghi is these days, "Frankfurt Fred".

Draghi is required to begin his pressers with a review of the telemetry on the eurozone’s economic and financial performance. Thus he has no choice but to concede that all of the dials are on zero, although that’s not how he says it. He never lies outright, but he plays games with words in a Clintonesque fashion. One must always remember that he is the smartest man in Europe.  He is very deft. This is what Draghi said today (brutally abridged, with my parenthetic translations into truth):

“Following a six-quarter economic contraction in the euro area,

[six quarters into the current depression]

recent confidence indicators based on survey data have shown some further improvement from low levels and tentatively confirm the expectation of a stabilisation in economic activity at low levels.

[The data suggest that the level of economic growth will rise from contraction to stagnation.]

At the same time, labour market conditions remain weak.

[At the same time, unemployment remains at crisis levels in the southern region of our country.]

The remaining necessary balance sheet adjustments in the public and private sectors will continue to weigh on economic activity.

[The catastrophic deleveraging in the public and private sectors will continue.]

Taking the appropriate medium-term perspective, underlying price pressures are expected to remain subdued, reflecting the broad-based weakness in aggregate demand and the modest pace of the recovery.

[Deflation will continue due to unexplained solar phenomena.]

Turning to the monetary analysis, underlying money and, in particular, credit growth remained subdued in June. Annual growth in broad money (M3) decreased in June to 2.3%, from 2.9% in May.

[The last thing that the eurozone needs right now is monetary stimulus.]

The annual rate of change of loans to the private sector weakened further. Weak loan dynamics continue to reflect primarily the current stage of the business cycle, heightened credit risk and the ongoing adjustment of financial and nonfinancial sector balance sheets.

[Credit contraction is continuing due to unexplained solar phenomena.]

In order to ensure an adequate transmission of monetary policy to the financing conditions in euro area countries, it is essential that the fragmentation of euro area credit markets declines further and that the resilience of banks is strengthened where needed.

[This whole euro thing is off unless someone can fix the Club Med banks PDQ.]

On credit growth, we have to acknowledge that underlying loan growth has remained subdued over recent quarters, and that this has been true for quite a time. We know that there are several reasons for this: first and foremost, weak economic demand, second, heightened credit risk and, third, continued deleveraging by households and enterprises.

[Credit contraction is understandable given the current level of solar activity.]

We are not at all oblivious to the fact that inflation in the medium term undershoots our objective of inflation that is close to, but below, 2%. The justification for this is the broad-based weakness in the economy and the subdued monetary and credit dynamics.

[Inflation is always low during depressions.]

If one accepts that the sole purpose of the ECB is price stability, and that widespread human misery is irrelevant to the workings of the ECB, and if one really believes that in his heart, then one can sleep at night. It’s kind of like being a crew member on the Enola Gay.

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. (http://research.stlouisfed.org/fred2/graph/?graph_id=131193&category_id=0)

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."

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*Bernanke: “Deflation:Making Sure It Doesn’t Happen Here”, http://www.federalreserve.gov/BOARDDOCS/SPEECHES/2002/20021121/default.htm

**Bernanke: “Japanese Monetary Policy: A Case Of Self-Induced Paralysis?”.

http://www.princeton.edu/~pkrugman/bernanke_paralysis.pdf

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.

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*“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.