Is There A Chance For a "European Spring"?

“Mr Tajani said the crisis is compounded by the tight monetary policy of the European Central Bank, which has failed to alleviate a serious credit crunch for small firms. ‘We need a real central bank, like the US Federal Reserve or the Bank of England, willing to promote growth,’ he said, in an unusually blunt criticism of a fellow EU institution.

Guy Verhofstadt, leader of the European liberals, said it is time to broaden the ECB mandate to include growth, warning that the eurozone is at risk of chronic stagnation and a ‘Japanese winter’ unless the central bank goes beyond short-term measures.”

--Ambrose Evans-Pritchard, Daily Telegraph, Sept. 8th, 2013

A little background: Antonio Tajani, the EU commissioner for industry, is an Italian politician close to Berlusconi which in eurospeak makes him a “liberal”. (In Europe, liberal means capitalist.) Guy Verhofstadt, a former prime minister of Belgium, heads the liberal faction in the European Parliament. He is touted as the next president of the European Commission. It sounds like both of them are reflationists.

I wrote previously that, if an uprising ever comes in the eurozone, it would have to come from the left, except for the fact that the European left doesn’t understand monetarism. Maybe I was wrong. Not about the left being ignorant of monetarism, but about the right's embrace of deflation. There are now stirrings of reflationism on the right, which is potentially good news for unemployed and/or starving Europeans. If the right starts openly pushing against austerity and deflation, I have little doubt that the left will jump on the bandwagon. The left has never had its heart in Austrian economics.

The Social Democrats’ problem has been their desire to maintain credibility as a responsible governing party, and to be seen as as willing to make “hard choices” even if it hurts workers. The socialists’ ignorance of monetarism has left socialists such as Francois Hollande with the false choice between austerity and utter collapse. In the US, respected left-wing economists such as Paul Krugman and Joseph Stiglitz can call for fiscal and monetary stimulus with impunity, but there is no such freedom on the left in Europe. In today’s Social Democracy, to advocate inflation is a personality disorder, or crypto-communism. Wealth confiscation, government defaults, bank failures: yes! Reflation: no. Eat your gruel.

It looks like the eventual leadership of the revolution against austerity and deflation will come from the right. Perhaps this is not so surprising, considering that Sarkozy, Berlusconi and Rajoy have criticized the “hard euro” policy in the past, and that the new head of the BofE is a closet inflationist. Hard currency is not a tradition in Latin Europe, nor in Anglo Europe.

The challenge for Europe is whether these murmurs can be forged into an outright revolt, as opposed to banter at the kaffeeklatsch. Europe needs a statesman like William Jennings Bryan who understands economics and can forcefully articulate the need for a revolution before it is too late.

But I think it is already too late or, rather, that the cause is hopeless. Let me explain why:

1. Fear of Germany

Europe has an irrational fear of alienating Germany. Aside from the small matter of 20th century history, the fear emanates from the fear of being “cut off” from the German Treasury. In other words, the fear of not getting bailed out. What is irrational about this fear is that Germany has already decided to cut off the rest of Europe. Weidmann's "No Bail-Out Principle" means no bailouts.

2. The Single Mandate

It will be difficult for the revolutionaries to get control of the ECB as long as its mandate is unchanged. To change the mandate  will require treaty revision, which is next to impossible so long as Germany is in the EU. It is true that, if the  ECB board were to vote to reflate, that could be an end-run around the mandate, but Germany would object.

3. ECB Independence

Even if the reflationists win political control of the EU, that does not change the independence of the central bank. New governments could appoint doves to the ECB board, but that would take years. At present, board members are prohibited from taking direction from their home-country governments. They do not represent their home countries, unless they are German.

While I would like to convince myself that there could be a light at the end of the eurozone tunnel, I really doubt it. It will take a lot more than a few off-hand comments to the Telegraph to make a revolution. It is deeply ironic that the Italian left succeeded in destroying Berlusconi, the only man who could have saved Italy from becoming Greece. And ditto for France, which rejected a right-wing reflationist (Sarkozy) in favor of a left-wing austerian (Hollande).

I'm not going to hold my breath waiting waiting for a European Spring.

The Cyprus Experiment: Part II

Money doesn’t matter. The real economy exists independently of the money supply. An economy can grow in the midst of deflation. The world economy could be conducted using a single penny.

These are interesting, if stupid, hypotheses. But God hasn’t given us laboratories to test them. He has given us no “play economies” where we can turn the dials and see what happens--except Cyprus! God gave us one play economy where human suffering doesn’t matter. We can conduct whatever sadistic experiments we want without consequence, outside of heaven. Cypriots aren’t really people, they are economic pawns, ants.

So, the geniuses in Brussels and Frankfurt decided to perform an experiment on Cyprus: they cut its money supply by 30% to see what would happen. Hoover did that in the early thirties, but not in one day. Even he didn’t have the sang froid to do that. One minute Cyprus has 70B in bank deposits, the next minute it had 50B. Shazam! Cool!

That happened a couple of months ago, so it’s early days. It will take a year to see if Cypriot school children are actually eating out of garbage cans, which would be a coincident indicator of policy failure (or evidence of successful structural reform?).

Because Cyprus is situated between Saturn and Uranus, its economic telemetry is delayed by about six months. The eurozone is balkanized when it comes to the quality, timeliness and reliability of economic statistics. Maybe at some point we will begin to get transmissions about the post-nuclear Cyprus economy.

Well, here’s a hint: it won’t be pretty. The good news is that the Cyprus is the “Israel of the Hellenesphere”, and they are highly resourceful.  Most Cypriots are running at least three businesses in Cyprus, plus a few restaurants and dry cleaners in London. But nobody, no matter how smart,  can thrive in the midst of a massive decline in the money supply. The unemployment rate in Cyprus one year from now will be 20%, which will take a toll on almost everyone.

This experiment will play out the way that pouring gasoline on an ant colony would play out: not too good.

Draghi's Satanic Mandate

“Q: Is the ECB reflecting on the fact that, with high debt and countries coming out weak from recession, a mid-term inflation target is not enough to get out of the crisis; and that there are some economists who suggest that you should also link it to unemployment, as the Federal Reserve System does?

“Draghi: The answer to the question is pretty straightforward. Our mandate talks about price stability and that is our objective: price stability in the medium term.”

--ECB press conference, Sept. 5th, 2013

What is the object of economic policy in general, and of monetary policy in particular? Wouldn’t you say prosperity, or wealth-creation, or an employed workforce, or an economy operating at full potential? Economic policies in modern capitalist countries are supposed to create the conditions for sustainable long-term growth, as opposed to civil war or revolution.

In the US, this is a matter of law. The Full Employment Acts of 1946 and 1978 require the federal government to "promote maximum employment, production, and purchasing power." They provide the Fed with its dual mandate. Given what happened in the US during the ‘thirties, it is understandable that Congress decided to outlaw another depression. And the law has worked. Because of it, the US hasn’t experienced a Second Great Depression.

In the US, there is almost no debate concerning the objects of monetary policy. All economists, whether on the left or right, are supportive of the dual mandate. It is not a topic of debate. How could anyone seriously argue that high unemployment and low growth are desirable?

As we know all too well, Europe decided that, instead of outlawing depression, it would outlaw inflation. Or, to put it less charitably, Europe made a very stupid  policy decision, which is that price stability alone would create the necessary conditions for prosperity. In other words, a full employment mandate is unnecessary because price stability will create full employment.

What is amazing is that even though the ECB has successfully delivered price stability from the day of its founding, for some reason full employment has not resulted. Whatever could be wrong?  What is wrong is that it is impossible to have 4% real growth in a context of 1% nominal growth. Nominal growth sets a ceiling for real growth, since deflation and growth go together like arsenic and good health.

Does Mario Draghi believe that 1% inflation will address the eurozone’s 12% unemployment, or its spiralling government debt ratios, or its banks’ toxic loan portfolios? No, he doesn’t. Let me give you my take on Draghi: he’s the Clint Eastwood character in those 1970s spaghetti westerns. He’s a hired gun. He was hired to deliver price stability, and that’s what he’s delivering. He wasn’t hired to deliver full employment; if you want that you’ll have to amend his contract and pay him extra.

If Draghi were to mention the European depression at a board meeting, the Germans would shout him down. Or perhaps I should say, when Draghi mentions the depression at board meetings, the Germans shout him down. He has mentally compartmentalized his job description, such that he feels no pangs of guilt when he reads about people eating out of trash bins. The sin is not his; it is Europe’s. 

If Draghi had written the ECB charter, it would have included full employment. But he didn’t, so like Eastwood, he just hangs ‘em high.

Europe Is About To Get Worse

Thesis: The eurozone depression is about to accelerate because credit growth has turned sharply negative.

Can an economy grow when credit is contracting? I really don’t think so. Credit growth in Zonal Europe is now sharply negative. Here are the stats as of June, courtesy of the excellent Market Daily Report:

EZ: (3.5%)

Ger: (6.3%)

Fr: (1.1%)

Belg: (3.0%)

Neth: (1.0%)

Aus: (5.6%)

Fin: (4.4%)

It: (0%)

Sp: (9.3%)

Ire: (13.2%)

Gr: (20.4%)

P: (4.7%)

Cyp: (17.0%)

[URL: http://mdbriefing.com/eurozone-credit.shtml]

A plot of EZ credit would look like the trajectory of an airplane which takes off, achieves cruising altitude, and then runs out of fuel: a scarey parabola. The inflection point, or Minsky Moment, occurred this winter. Something happened which resulted in a decline in zonal credit; I don’t know what it was.

But now zonal credit is declining--not the growth rate, but the actual stock. A credit contraction always and everywhere results in negative economic growth. I don’t see how the eurozone can avoid an acceleration of the double-dip recession that began at the beginning of 2012. I’ll be honest: I expect zonal credit to contract for the next decade. It will take at least that long for the European banking system to digest its Matterhorn of toxic waste. The banks will have to simultaneously charge-off bad loans, mark government bonds to market and raise capital--in the face of declining core profitability. This is the definition of a debt-deflation depression.

May I remind you of the eurozone’s official strategy: (1) weak banks should be allowed to fail; (2) weak governments should be allowed to default. This predicts that the weak zonal governments (the PIIGS) will default, and that the weak zonal banks (of which there are many) will be allowed to default on their bonds and deposits. That’s a death-spiral: market prices will decline, especially the price of labor, while the real value of debt will rise. A repeat of the whole 1930-33 thing, which we know all about.

It is almost as if the entire product of the economics profession since 1933 has been erased. We have learned nothing. We will once again experiment with liquidationism. Prices fall and real debt grows until it is extinguished via default. Why not do it again? Maybe it will turn out differently this time. Perhaps the laws of economics will suspend themselves for the benefit of the European unemployed. Maybe this time starving people won’t turn to political extremism. I am reminded of Christopher Hitchen’s aphorism: The connection between cruelty and stupidity is very close.

My advice: Keep your eye on the DMB’s eurozone credit growth statistic. Should it continue to decline, as I predict, we will enter Phase III of the eurocrisis. I would not own any security denominated in euro.

Stocks Are Safe!

Thesis: The current high equity risk premium is not a result of QE. Bond yields are low because of low inflation, and equity valuations are low because of post-Lehman stress syndrome. The  stock market offers value at today’s prices.

For those who wish to understand the stock market, I would recommend NYU Professor Aswath Damodaran’s website: http://pages.stern.nyu.edu/~adamodar and his blog: http://aswathdamodaran.blogspot.com. Damodaran is the guru of equity valuation, and unlike the equity strategists on Wall Street, his work is available to the public. To my knowledge, no Wall Street firm publishes its estimate of the Equity Risk Premium (ERP) on a regular basis. I think this is because they want to keep this information close to their chest. Fernando Duarte at the NY Fed also does valuable work on the ERP. I am hoping that, at some point, he introduces a regular data series. That would give us two estimates.

A brief primer on the ERP:

PE ratios are meaningless except in the context of the interest rate. To make it clearer, consider the reciprocal of the PE, the earnings yield. When bond yields are high, the market will demand a high earnings yield. When bond yields are low, as they are now, the market will accept a lower earnings yield. So when people say that the current ~15x PE on the S&P is “high”, they neglect to remember that the PE on the 10-year Treasury is near an all-time high at around 36x. In 1981, the PE on the 10-year was around 7x, which was a steal. (Data: WSJ:http://online.wsj.com/mdc/public/page/2_3021-peyield.html?mod=mdc_uss_pglnk, FRED: http://research.stlouisfed.org/fred2/ .)

The bear view today is that the ERP is artificially high because bond yields are artificially low, due to QE. The bears expect that as QE tapers, bond yields will rise and the ERP (and stock prices) will fall. Many investors expect bond yields to return to “normal”, meaning 4% or so, once the Fed stops buying bonds.

Thus we come to the subject of the outlook for bond yields. Here’s my view: I do not expect bond yields to return to “normal” anytime soon. Bond yields reflect inflation expectations, and I don’t see inflation anywhere on the horizon. Money growth remains stuck at 7% despite QE, inflation is bouncing around 1%, and nominal growth at 2.8% is dangerously weak (FRED). Further withdrawal of monetary stimulus is unlikely to raise the rate of  inflation or of inflation expectations. Monetary policy, as it is practiced by the FOMC, is broken and unlikely to be fixed anytime soon (unless the president appoints Scott Sumner to head the Fed).

Therefore, I expect bond yields to remain very low, and the ERP to remain high. When the ERP reverts to mean, stock prices will be “fully priced” and the investment horizon will be very bleak indeed. Damodaran calculates the current ERP at 5.5%, which is an unprecedented multiple of the risk-free rate. We are being paid almost 6% for taking “equity risk”. That makes stocks a safe investment at today’s prices.

Why is the ERP so high? Because of post-Lehman PTSD. Investors are still afraid of another crash. That is our opportunity to buy. Stocks climb a wall of fear. The simplest way to play the market is by buying it (SPY), or by buying an index with alpha, such as PKW. Given my outlook for inflation, I would avoid precious metals such as GLD.

Limited Surgical Sanitary War

[Author’s note: I try to keep this blog focused on finance and economics. However, since my country is on the verge of yet another elective war, I hope that readers will indulge my desire to comment.]

“Saddam poses no imminent and direct threat to the United States, or to his neighbors, the Iraqi economy is in shambles, the Iraqi military is a fraction of its former strength and, in concert with the international community, he can be contained until, in the way of all petty dictators, he falls away into the dustbin of history.

--Barack Obama, 2002

“The constitutional powers of the President as Commander-in-Chief to introduce United States Armed Forces into hostilities, or into situations where imminent involvement in hostilities is clearly indicated by the circumstances, are exercised only pursuant to (1) a declaration of war, (2) specific statutory authorization, or (3) a national emergency created by attack upon the United States, its territories or possessions, or its armed forces.”

--War Powers Resolution of 1973

There is a civil war going on in Syria. On the one side, you have the Assad regime which is supported by Iran, Russia and China. On the other, you have the rebels who are supported by the Gulf States and al Qaeda. The US has decided that it prefers the bloodthirsty al-Qaeda rebels to the bloodthirsty Assad regime.

The US is on the verge of declaring war on Syria on the basis of the “Rwanda Doctrine” that requires US military intervention in foreign civil wars for “humanitarian” reasons. So far under this doctrine, the US has attacked six countries: Somalia, Yugoslavia, Afghanistan, Iraq, and Libya. President Obama wants to add Syria to this list of humanitarian triumphs. Maybe he will win another Peace Prize.

Obama’s plan is to rain missiles and bombs onto “military targets”, and to avoid, as much as possible, schools, hospitals and the Chinese embassy. Since this is a humanitarian mission, the US will only use humanitarian bombs and missiles, so no one will be hurt.

War is an important foreign policy decision, for any state. It seems to me that, in considering attacking a foreign country, the US should consider three criteria: (1) international law; (2) American law; and (3) the Powell Doctrine. In my judgement, Syria fulfills none of these criteria.

International Law

The US is signatory to a list of treaties, from the Hague Convention to the Kellogg-Briand Pact, to the UN Charter, which prohibit states from attacking each other. Signatories are allowed to respond if attacked, but Syria has never attacked the US. Indeed, only seventy years ago, the US government expressed rather strong opinions about foreign attacks on its military bases, such as Pearl Harbor. There is nothing in international law which permits attacks on foreign countries without a UN resolution, which Obama doesn’t have. The fact that the UK and France also want to attack Syria is entirely irrelevant. The formation of an “alliance of the willing” is illegal without UN sanction.

American Law

From the founding until 1898, it was well understood by both the executive and the legislature that war was only justified in the event of an attack. The wars against Tripoli, Britain, and Mexico were all justified on the basis of foreign military aggression. It is true that the war with Spain was justified on humanitarian grounds, but it was an act of naked imperialism, something not contemplated by the founders. The War Powers Act only permits the president to attack a foreign country without Congressional authorization in the event of an attack on the US, which hasn’t happened. Bombing countries at the president’s discretion is illegal under US law.

The Powell Doctrine

The Powell Doctrine is not based in law, but rather in national interest, which should also be an important criterion in foreign policy. The Powell Doctrine represents General Powell’s conclusions regarding the Korean and Vietnam Wars.

Here it is (source Wiki):

The Powell Doctrine states that a list of questions all have to be answered affirmatively before military action is taken by the United States:

1. Is a vital national security interest threatened?
2. Do we have a clear attainable objective?
3. Have the risks and costs been fully and frankly analyzed?
4. Have all other non-violent policy means been fully exhausted?
5. Is there a plausible exit strategy to avoid endless entanglement?
6. Have the consequences of our action been fully considered?
7. Is the action supported by the American people?
8. Do we have genuine broad international support?

By my calculus, Syria meets only one of Powell's eight conditions:

1. National security threat?

Syria poses no threat to US national security.

2. Clear attainable objective?

It is certainly not clear to me how dropping bombs on Syria will transform it into a thriving democracy at peace with Israel.

3. Risks and costs analyzed?

If so, the analysis has not been made public. I would observe that Russia might have a negative reaction to an attack on its ally, with unknowable consequences. Has Obama discussed this with Putin?

4. Diplomacy exhausted?

Yes.

5. Exit strategy?

No. You cannot accomplish regime change or pacification from the air. Nor can you destroy nerve-gas canisters from the air.

6. Consequences fully considered?

I really doubt it.

7. Supported by the American people?

No, only 9% favor an attack.

8. Broad international support?

Not from the UN Security Council, where both Russia and China strongly object to an attack on a member state. Both consider such actions to be hegemonist and illegal.

It appears that Obama has replaced the Colin Powell Doctrine with the Samantha Power Doctrine which gives America the right (indeed the obligation) to invade or attack any country whose internal policies it disagrees with--but only if they are small and weak, and preferably if they are Arab. Kim Jong-Un can sleep tonight.

Is The Dollar's Reserve Currency Status At Risk?

A friend sent me the following email:

“Chris, how concerned are you about the US losing global reserve currency status in the foreseeable future?  Have you ever heard of Stansberry Research?   This guy predicts US monetary and fiscal policy (massive debt, cheap money, etc.) is already causing flight from US dollars around the world.  As the trend continues, the day will come when we’re no longer the reserve currency, and there will be a massive inflationary shock to US economy with enormous erosion in incomes, asset values, etc.  He advises investments in gold, silver and non-US based assets.  He lays out a well-reasoned, fact-based analysis.  Very interesting.  Do you have a take on this?”

Yes, I do have a take on Stansberry’s opinion. I don’t agree with it. It is built on false premises and faulty analysis.

The false premise is that “US monetary and fiscal policy (massive debt, cheap money, etc.) is already causing flight from US dollars around the world.” It’s not. The dollar remains by far the leader in international reserves: almost three times bigger than the euro ($3.8T vs $1.4T). Here's the link: http://www.imf.org/external/np/sta/cofer/eng/

America’s debt is not yet "massive", Treasuries are Aaa (unlike Japanese, French and British government bonds), and dollar credit is not cheap in real terms. America remains a very attractive place for foreign money. Furthermore, East Asia has nowhere else to invest their reserves. No other bond market is deep enough, except for Japan, and everyone is full up on JGBs. (What do you think the ECB uses as its reserve asset?)

In order to intervene effectively in the FX market, central banks need to own large quantities of assets that are liquid, safe and stable in value. This means foreign government debt. No other government security in the world can compete with Treasuries. Remember, the reserve asset must have a liquid market at all times. That’s Treasuries, and nothing else. Remember: neither the ECB nor the EU issue bonds. Euro-denominated government bonds are issued by the member states of which Germany is the benchmark.

Stansberry says that, when the world wakes up to the worthlessness of the dollar, there will be a massive inflationary shock to the US economy. Now that’s really dumb. If the world should ever dump the dollar, the shock will be deflationary, not inflationary. A dramatic rise in bond yields is deflationary and will produce a monetary, economic and fiscal convulsion. Yes, the Fed can offset this with inflation, but that is a counter policy. Rising real interest rates are inherently deflationary.

Why do you suppose that when  there is a financial crisis, the world's central banks ask the Fed for dollar swap lines? Because their banks are indebted in dollars, which they can’t print. The dollar is the currency of global finance; it has no competition.

Furthermore, a factoid that the gold community tries not to mention is that the dollar has appreciated for the past two years while gold has depreciated. If there is a run, it is from gold into dollars. How liquid do you suppose the bullion market is, when you need $30 billion on a moment’s notice?

Who are the competitors of US Treasuries? Basically, JGBs, gilts and Bunds. JGBs yield nothing, and the Bund and gilt markets are not big enough for the conduct of major monetary operations. When the BoJ or the PBoC want to intervene in the FX markets, they use Treasuries, not Bunds or gilts or gold. Both the euro and the yen are, today, story paper. Central banks don’t buy story paper (not even in Latin America). The almighty dollar is still the almighty dollar, with a growing economy, low inflation, and a rapidly declining fiscal deficit. There is no alternative.

The IMF: Fountain Of Bad Advice

“The day will come when this period of exceptionally loose monetary policy, both conventional and unconventional, must end. In the long-term it is clear that exit will involve phasing out, and ultimately reversing all of these policies.”

--Christine Lagarde, Managing Director, IMF, Aug. 23rd, 2013

It is the IMF’s position that:

1. Monetary policy has been exceptionally loose for the past five years.

2. That this monetary stimulus has provided “breathing space” for the accomplishment of structural and fiscal reform.

3. That, in the long run, it is the reforms that are important, while the unconventional monetary policies must be brought to an end.

4. That central banks will need to cease providing loose money, and will have to manage the risks associated with “exit”.

Each of these statements is completely wrong, and on many levels.

First of all, there is no evidence that monetary policy has been loose since Lehman. Money growth since the crash has averaged in the mid-single digits for the US, the UK and the EZ, and in the low single digits for Japan. Not only is such growth not rapid, it is a bit low by the measures of the past thirty years. Should you look at a graph of money growth since the crash for the major economies, you will see no evidence of exceptional looseness. Further, if money policy were exceptionally loose, wouldn’t we be seeing inflation? Inflation in the major economies is near an all-time low. The statistical evidence is that money policy has been overly restrictive since the crash, so there is nothing to exit from.

Secondly, rapid money growth would indeed have provided breathing space for reforms that improved competitiveness. But rapid money growth did not occur. Instead, the IMF has forced the PIIGS to perform surgery on themselves in the middle of a depression, thus producing high unemployment. You can’t breathe when you’re drowning.

Thirdly, the prioritization of structural reform over nominal growth is utterly misguided. The world’s problem is the output gap caused by inadequate aggregate demand, not labor market rigidities or budget deficits. Policies that create unemployment hurt aggregate demand. What the world needs right now is an end to structural reform and budget austerity until growth returns to a more normal level. Reform and austerity are killing the patient.

Fourth, it is fallacious to say that monetary stimulus must be brought to an end when it has not been tried. Since there is nothing to “exit”, there are no risks to manage. The risks emanate from the deliberate continuation of restrictive monetary and fiscal policies resulting in inadequate demand. The IMF has the gall to talk about the risk of inflation when the real and present danger is deflation.

The principal risk facing the world economy today is the market’s realization that the monetary authorities lack the ability to stimulate aggregate demand because they falsely believe that they are already providing stimulus--indeed too much stimulus. That means a future of ultra-low inflation, inadequate demand, and a growing output gap. It also means ongoing fiscal pressure as debt rises while government revenue stalls.

Ms. Lagarde says that thinking about global economic and financial stability is the IMF’s raison d'être. That’s a lot of money the world is spending for bad advice.

Market Discipline Requires Honest Accounting

Yesterday I wrote about the iffy credit outlook for Dexia. Today I’d like to write about Dexia as an example of the quality and usefulness of European bank accounting for investors and creditors.

Here are Dexia’s reported earnings for the past seven years (billions in euro):

2006: 2.7

2007: 2.5

2008: (3.3)

2009: 1.0

2010: .7

2011: (11.6)

2012: (2.9)

1H13: (.9)

Notice anything odd? Dexia reported profits of 723M at yearend 2010, only to be followed by a loss of 11.6B in 2011. Think about that: Dexia’s management and auditors signed off on the 2010 financial statements in March of 2011 and presented them to Dexia’s shareholders in May of 2011, only to report a loss of (oops!) 11.6B for 2011.  The same saga was true in March of 2008, when management reported a 2.5B profit for 2007, only to report a 3.3B loss for 2008.

How can management report a profit in the same year that it is heading towards a massive loss? Is that incompetence, or legerdemain?

It is one thing to “manage” the reporting of massive credit losses so that they bleed out over a multi-year period. That enables a bank to match its credit expense with its operating income. Everyone does that, or tries to. But it is quite another to punctuate the recognition of catastrophic losses with periods of reported profitability. Wouldn’t an honest bank consume that supposed profitability with an addition to reserves? If you’re going to lose 12B euro, you might just put that 723M into the provision, as “an overabundance of caution”.

And it isn’t just Dexia. Banca MPS in Italy is the same story: it reported a 946M “profit” for 2010, followed by a 4.7B loss for 2011. Shouldn’t that 964M “profit” have been added to reserves, given what followed?

Why does it matter whether bank financial reporting is truthful?  For three reasons: (1) shareholders; (2) bondholders; and (3) depositors. Shareholder bought the shares of these banks in 2007 for high prices, only now to find that they are worth a few cents. Retail investors bought the subordinated debt of the cajas that now constitute Bankia, only to be wiped out. And finally depositors, such as those with deposits in the two largest Cypriot banks, who have been wiped out substantially if not totally.

It is now European policy that depositors are expected to take losses because they “contributed” to the problem. They “contributed” to the problem by irresponsibly placing their deposits with insolvent banks. Had they been responsible, they would have known that these banks’ financial statements were fictitious.

Market discipline depends on honest financial reporting. As long as European bank managements can decide whether to make or lose money in a given accounting period, shareholders and creditors will be stumbling in the dark.

That means that it is only a matter of time until another credit event reveals to depositors in Club Med banks that they have made a big mistake. Can you imagine that Daimler or Siemens or Nestle are likely to leave a lot of money on deposit at Banca MPS or Banco Espiritu Santo for more than about ten seconds?