Sometimes my predictions are proven correct

Avid readers may recall that in early February, I said how I thought a bailout of the PIGS should work:

The EU (not the eurozone) establishes an entity called something like the Federal Solidarity Fund. The FSF would be capitalized by the member states with government bonds and callable capital using a formula based on GDP (like other international financial institutions). 

The capitalization would be sufficient to get the FSF a bond rating of AAA from the three agencies, which have established standards for rating such institutions.

The FSF would then issue debt to fund its loan book. Such bonds would be eligible for purchase or rediscount at the ECB. Borrowers would have to submit to IMF-style conditionality, including an amortization schedule. Conditionality should be sufficiently onerous that accessing such funding would be a last resort. 

There is no reason why the ECB should not be a big purchaser of  FSF bonds. The ECB has an EUR1.7 trillion balance sheet, with plenty of marketable assets that could be sold to offset FSF funding. 

The critical constraint is sufficient capital to maintain the AAA rating while having sufficient funding to meet the needs of needy states. 

Well, that's just about what was announced by the European Commission on May 9th:

We have decided to establish a European stabilization mechanism. The mechanism is based on Article 122.2 of the Treaty and an intergovernmental agreement of euro area Member States. Its activation is subject to strong conditionality, in the context of a joint EU/IMF support, and will be on terms and conditions similar to the IMF.

Article 122.2 of the Treaty foresees financial support for Member States in difficulties caused by exceptional circumstances beyond Member States' control. We are facing such exceptional circumstance today and the mechanism will stay in place as long as needed to safeguard financial stability. A volume of up to 60 billion euro is foreseen and activation is subject to strong conditionality, in the context of a joint EU/IMF support, and will be on terms and conditions similar to the IMF. The mechanism will operate without prejudice to the existing facility providing medium term financial assistance for non euro area Member States' balance of payments.

In addition, euro area Member States stand ready to complement such resources through a Special Purpose Vehicle that is guaranteed on a pro rata basis by participating Member States in a coordinated manner and that will expire after three years, respecting their national constitutional requirements, up to a volume of 440 billion euros. The IMF will participate in financing arrangements and is expected to provide at least half as much as the EU contribution through its usual facilities in line with the recent European programs.

Unfortunately, the the fund has not been set up yet, Greek bond yields are rising again, and the markets are not calmed. It is hard to be optimistic.

Six reasons to be bearish

I'm still quite bearish on the outlook for US economic growth. Here are my reasons:

1. Monetary Policy

Most of the monetary aggregates are flat, meaning that the spigots at the Fed are either set to "off" or "trickle". The FOMC hawks are still pushing for a contractionary policy, and the compromise is stasis. It is true that the real funds rate is negative, but less than the Taylor Rule or Scott Sumner would suggest.

2. Credit Creation

Bank credit growth is 0%, and C&I loan growth is negative 20% year-on-year. Consumer and small business credit remain restricted. The doubling of the Fed's balance sheet has been accompanied by a contraction in credit. It would appear that Congress' War on Banks is working: they have gone on strike. You can't increase capital standards, tighten accounting and liquidity rules, tax bank balance sheets and expect there to be no real-world impact. The economy simply can't recover without a resumption of credit creation.

3. Nominal GDP Growth

NGDP growth is hovering around 3%, which is the lowest that it has been since Eisenhower. Real GDP is important, but nominal GDP is more important: we spend money, not real money. Bernanke believes that the Fed can target nominal GDP growth, but he isn't doing it because he doesn't have the votes. It will be interesting to see if Obama will nominate a dove to replace Don Kohn (a moderate dove). I nominate Scott Sumner.

4. Fiscal Policy

Next January taxes will go up sharply due to the expiration of the Bush tax cuts. Starting next year we will have a recession trifecta: no monetary stimulus, contractionary fiscal policy, and negative private sector credit growth.

5. Europe

All of the European countries have embarked upon a path of fiscal consolidation (which is worrying Tim Geithner). Greece will be in crisis by this time next year. It's bridge loan will have been consumed, it's debt levels will be higher, and it's NGDP will be lower. Very unlikely that it will have market access under those circumstances. It's only options are a bigger bailout or redenomination and default. This will not restore confidence in the rest of the PIGS or in the eurozone's banks. Global growth will be challenged, as will confidence overall.

6. China

China's credit bubble will have to slow or contract. The People's Bank is very worried about the situation. China's growth will slow.

Hard to be bullish, although I am usually wrong and I hope so in this case. Maybe it's already discounted in the markets, but remember that the Dow peaked in Sept '07, after the credit bubble had begun to collapse. 

The tragedy of mark-to-market

Steve Forbes lays out the case against mark-to-market:

An economic version of the bubonic plague is ready to reemerge: mark-to-market accounting. This rule was the principal reason that the financial disaster of 2007--09 threatened to destroy our financial system. The system could have survived the losses from subprime mortgages and other unsound exotic transactions--though there would have been substantial casualties among players--just as we survived the raft of bad Latin American and commercial real estate loans in the 1980s and early 1990s.

In effect, mark-to-market accounting rules forced financial institutions to value securities for capital purposes as though they were day-trading accounts. Traditionally, an asset was held at book value for regulatory capital purposes unless it was disposed of or became impaired. In 2007 that standard was overturned by the Financial Accounting Standards Board (FASB). When panic set in regulators and auditors forced banks and insurers to write down the values of assets to absurdly low levels that weren't even remotely justified by their cash flows. Forbes columnist and noted economist Brian Wesbury explained in his book It's Not as Bad as You Think: Why Capitalism Trumps Fear and the Economy Will Thrive (John Wiley & Sons) that if mark-to-market had been in effect during our last big banking crisis some two decades ago the largest commercial banks in the country would have been destroyed. Those institutions had Latin American loans equivalent to 260% of their capital. On a mark-to-market basis those loans would have fetched barely ten cents on the dollar.

Mark-to-market is like being told to mark down the value of your house to a price that it will fetch within the next 24 hours. An absurdly destructive concept. But it explains why the massive losses financial institutions took were mostly book losses and not actual cash losses on bad paper.

Mark-to-market accounting was banned in 1938 because it was contributing to financial distress during the Great Depression. In March 2009 Congress forced a change: The FASB would allow cash flow accounting to be used when markets were illiquid. Overnight the terrible bear market ended, and the credit system came back to life. Remember all the angst over what to do about the banks' toxic assets? All those stress tests? When mark-to-market accounting was amended the toxic assets crisis disappeared as banks were able to deal with assets in an orderly fashion.

Yet, incredibly, the FASB--with the passive connivance of the SEC, the FDIC and others--is set to bring back mark-to-market accounting with a vengeance. This time all loans, not just securities, will be subject to these so-called fair-value rules. The immediate impact will be to crush small businesses. As Wesbury and his colleague Robert Stein observed in a June Forbes.com column: "There is no real market for [individual] bank loans. How does a trader in New York know what price to bid for a loan to a dry cleaner in Burlington, Iowa? In fact, the minute a bank makes a loan to a local small business it will be forced to write down the value because no one else will pay 100 cents on the dollar for that loan, especially in times of economic stress. … When markets freeze up financial institutions must use prices that do not reflect actual cash flow."

It's no surprise that the accounting industry is lobbying hard for this catastrophic change. With a pre-Depression-era mentality of businessmen who thought protectionism would make them richer by stifling foreign competition, many auditors today are salivating at the fees they'll collect from the mammoth, laborious procedures necessary to "evaluate" millions of individual loans. But just as protectionism led to the Smoot-Hawley Tariff, which triggered a global depression, which, in turn, devastated "protected" businesses and others here and around the world, this supertoxic mark-to-market concept will severely stifle job creation and economic growth. We will enter into perpetual recession punctuated by brief spurts of growth.

Greek debt crisis caused by foreign banks

First Greece hires banks to help it hide debt, then, when it is caught, it threatens to sue its enablers. Only in Greece can a drunk sue his bartender. 

From the AP:

In Athens, Greek Prime Minister George Papandreou said he is not ruling out taking legal action against U.S. investment banks for their role in creating the spiraling Greek debt crisis.

"I wouldn't rule out" going after the U.S. banks, he said in a CNN interview aired Sunday.

They also blame bank economists for telling the truth about Greek default risk:
The government and many Greeks have blamed international banks for fanning the flames of the debt crisis with comments about Greece's likely default.

The new government in Westminster

Well, I am relieved that Nick Clegg and the LibDems could not make a deal with Labour and have instead agreed to form a coalition with David Cameron and the Tories. This is good news for Britain, but probably bad news for the Tories. 

They have inherited a government with falling revenue, rising expenses and a high debt load. They are going to have to bring the deficit back into the low single digits in order to stabilize the debt-to-GDP ratio. Given the presence of the LibDems in the government (and possibly at the Treasury), this will be accomplished by raising taxes as well as expense control. It's hard to see how this will make the government popular. 

The UK's principal problem is its overdependence on the City of London (the financial services industry), which is shrinking in size due to the 2008 panic and subsequent woes. Financial reform may be necessary, but killing the City is killing the egg-laying goose. 

We will learn more this week about the cabinet and policies of the new government.

Framing the Greek problem

From Thaler's Corner on Seeking Alpha three days ago:

Let's not kid ourselves. The European Monetary Zone is on the brink of implosion, along with the European Union, the Schengen area and everything else that goes with it.

The situation on eurozone peripheral nation debt markets is grim.

Investors who must sell debt instruments as a result of credit agency downgrades are not finding any buyers.

Aside from any Austro-liquidationist monetary theory, if we are to maintain the "E" in ECB, the latter must absolutely launch a massive and transparent European government bond purchse programme (Shock and Awe).

The state bureaucrats presently sitting on the ECB Governors Council will never dare to approve such a solution without firm orders from their government leaders.

Sarkozy and Merkel are meeting today in Brussels and have summoned Mr. Trichet to attend.

No European leader should want to be stuck with the sort of historical stain left by Andrew Mellon, US Treasury Secretary from 1921 to 1932 :

• ‘Liquidate labor, liquidate stocks, liquidate the farmers, liquidate real estate’.
• ‘It will purge the rottenness out of the system. High costs of living and high living will come down. People will work harder, live a more moral life.’
• ‘Values will be adjusted, and enterprising people will pick up the wrecks from less competent people’.

We will see soon enough.

Best of luck to everyone.

The UK: A coalition of evil

Wow. The UK is really heading up a fetid creek without a paddle. 

We are looking at a (likely) Lib-Lab coalition government with an unpopular and lame-duck PM. Could this be any worse? Yes it can. 

First of all, a Lib-Lab coalition is still short of a majority, so they would have to make unholy deals with the Scottish and Welsh national parties, which are very left and have their hands out for tips. Their condition for signing on is "funding guarantees" for their dependent regions--at a time when the government's top priority must be fiscal consolidation. 

But wait, there's more. Because Brown has said that he will step down as leader of the Labour Party, that means that the next PM will have to be elected by Labour's electoral college. The  Labour electoral college is made up of three parts, each carrying equal weight: lawmakers, labor unions and party members. 

So in the midst of a fiscal crisis, we are looking at a government including an enormous amount of regional and left-wing baggage, and a PM chosen by the labor unions. This means higher taxes and more socialism at a time that the country is staring into a fiscal abyss.

And, as part of the Lib-Lab deal, Labour has agreed to change the 300-hundred year old electoral system from single-member constituencies to proportional representation. The represents the Italianization (or Israelization) of the UK. 

We can look forward to unending government "crises" every time that some obscure party leaves the government. The government will be hostage to its smallest coalition partners (like Likud's dependence on ultra-right wing religious parties). 

Oh, and another thing: bringing in SNP and Plaid Cymru is a UK suicide pact. The closer the UK gets to regional autonomy subsidized by English taxpayers, the closer England will get to demanding its own devolution. It's only a matter of time until England demands equal rights and elects its own parliament, which is the beginning of the end of the United Kingdom.

What a mess. Looks bad for sterling, FTSE, and above all, gilts.

Europe blinks

The EU stared apocalypse in the face yesterday...and blinked. This weekend's summit represents policy turnarounds on three major issues.

One, the ECB has agreed (undoubtedly under pressure) to monetize government debt (by buying in the secondary market, but it has nonetheless lost its virginity). Such a policy was not contemplated when the ECB was established. 

This is a hugely positive step, because it represents a capitulation by the no-bailout hawks to the save-the eurozone doves. (Note that this does not represent a change in monetary policy, because the ECB will sterilize any such purchases.)  Because the ECB has unlimited resources in euros (because it prints them), it represents a highly credible source of stabilization.

Two, the eurozone has transformed itself from a currency union into a federal state, with the creation of an EMF guaranteed by EZ members on a pro rata basis. The size of the fund (EUR 500B) is sufficient to be credible, if consummated.

Three, the EU has made the IMF a full partner by inducing it to offer a backstop of EUR 250B, and thus letting it into the zone and giving it power to impose conditionality, as it is already doing with Greece. 

Will this work? Right now we're looking at a PowerPoint presentation rather than a treaty; there are many blanks to be filled in and many i's to dot and t's to cross. 

Some questions:

1. Will all member states agree (non-ez states must agree to release the EU contingency fund)? Will this fly with the German Constitutional Court?

2. The plan is for the EMF to issue bonds guaranteed on a pro rata basis, not on a joint and several basis. These bonds will be difficult to rate. You have an underlying credit that looks pretty bad, and then guarantees from countries with different ratings. Doesn't look AAA to me. Or will the ECB buy them without ratings?

3. Greece looks like a bad credit. If it defaults, will Ireland, Portugal and Spain have to pay up? What if they don't, or can't?


4. What happens when Greece misses its fiscal targets, as it will?

I think that this rescue will successfully postpone an explosion, but will not result in a permanent solution. 

Instead of allowing Greece to escape the eurozone and devalue its way out of its problems, this scheme will instead allow Greece to add further to its debt burden, making it increasingly insolvent, while degrading the creditworthiness of its creditors. 

Trichet is going to bankrupt the Eurozone

Europe has a choice: the ECB buys government (i.e., Greek) bonds, or, alternatively, allows the hopeless states to get off the train and return to monetary sovereignty. The problem is  this: Greece will, not get off the train and will choose default, which means that the other  PIIGS are facing the apocolypse. Buy canned goods,  decorate  your bomb shelter,  and get out of euros.

Trichet suggests action on bonds would be last resort

THE EUROPEAN Central Bank is under growing pressure to take fresh action to stem a widening crisis of confidence in euro zone government debt, though it remains likely for now to stop short of buying bonds.

Markets punished the euro and bonds on the weak periphery of the zone after ECB president Jean-Claude Trichet said central bankers did not even discuss at its Thursday meeting what analysts have dubbed “the nuclear option”. Market conditions may not so far be bad enough to convince the ECB to take that controversial step.

Instead, the ECB’s next steps could include reinstating 12-month loans for banks at fixed interest rates, lending US dollars again, or announcing a blanket waiver of its collateral rules for all euro zone sovereign debt in money market operations.

“Market expectations certainly are that the ECB will do something, that the governments would take too long to do something or they are not willing, not able,” said Fortis economist Nick Kounis. “Therefore the ECB, which has more flexibility, should jump into that vacuum.”

The difficulty which euro zone governments had in negotiating their €110 billion bailout of Greece suggests they cannot be counted upon to agree on fast, concerted action to prevent credit jitters from spreading through global markets. That may leave the ECB as the only European institution with the ability to intervene effectively in the widening crisis.

Mr Trichet will meet other top central bankers at the Bank for International Settlements (BIS) in Basel this weekend, an excellent opportunity to discuss any co-ordinated liquidity action.

There is a precedent: central bankers from Europe and North America agreed in principle on joint liquidity injections at the November 2007 BIS meeting, and actually conducted those injections a month later.

European central banks have let currency swap lines with the US Federal Reserve lapse, but these could be restarted at any time.

The ECB held a conference call with commercial banks yesterday to gauge the state of money markets.

“It is a possibility for the US Fed and the ECB to do this specific market measure in just a few hours because it is just reinstalling something that was there before,” said one money market desk head who participated in the call.

Economists said the ECB would likely hold the option of buying bonds in reserve until it had exhausted more conventional ways of flooding markets with cash.

“They are most likely to do if there is a further panic on the market and we see a further increase in the LIBOR/OIS spreads and interbank confidence for lending does subside – then I think the ECB will be the only institution that will try and calm markets down,” said Kenneth Broux from Lloyds TSB.

Many say that anything short of government bond purchases may fail to calm the markets.

EU rules prohibit the ECB from buying government bonds from the primary market, but this would not be a show-stopper.

“You have this ‘no monetary financing’, but you are allowed to buy in the secondary market, so what’s the difference?” an official involved in European banking supervision told Reuters. “Buying in the secondary market, you take the pressure, and so you push people in the primary market.”

Analysts have estimated the ECB might buy some €200 to €300 billion of bonds, about 20 to 30 per cent of estimated annual new issuance in the euro zone.

Its covered bond programme was comparatively larger, comprising about 60 per cent of new issues at the time. But some analysts say the ECB would sacrifice credibility as an inflation fighter if it bought government bonds, potentially affecting inflation expectations.

This probably explains Mr Trichet’s uncompromising tone on Thursday.

Socialist logic

So let me get this straight: Congress proposes anti-Wall Street legislation, the stock market falls by hundreds of points, and that shows that we need more anti-market legislation. Welcome to 1934.

Senators say volatility makes case for regulation

US senators advocating stricter limits on banks and tougher regulation of markets used Thursday’s volatility to demand more sweeping reforms as the financial regulatory bill edged towards a vote.

Ted Kaufman, the Democratic senator from Delaware, said the sell-off in the S&P 500 supported his case that high-speed trading needed more regulation and banks needed more limits on their activities and size.

He told the Financial Times that he would try to introduce a proposal requiring the Securities and Exchange Commission to report on high frequency trading “much sooner” than they were due to.

“Until today,” he said, he was struggling to get traction on the issue with other senators.

In addition to new proposals directly aimed at high-frequency trading, Mr Kaufman said Congress should support his amendment to put size caps on deposit-taking banks. “Banks should not be involved in high-risk/high-return proposals . . . There’s a potential for a meltdown and [then] you’ve got a commercial bank in the crosshairs.”

Mr Kaufman’s pet cause appeared to be gathering ground in Congress as the market panic filtered through to the Senate floor. “I have become a believer,” said Mark Warner, a Democrat from Virginia. “Everything in my gut says he’s on to something here.

“I think there was a warning sign shot across the bow today,” Mr Warner added. “As we deal with financial re-regulation, if we don’t make sure this is part of the mix, I think we’re not acting appropriately.” The market moves overshadowed a series of amendments, including a failed Republican move to loosen the power of a proposed Consumer Financial Protection Bureau and a bipartisan effort to introduce a sweeping audit of the Federal Reserve.

A frantic mobilisation of Fed officials helped modify the audit amendment, which was proposed by Bernie Sanders, the independent senator from Vermont. Eventually, in an attempt to secure passage Mr Sanders agreed to keep a ring-fence around monetary policy, shielding it from congressional audits.

A vote on the amendment, which was one of several areas of regulatory reform that has concerned the Fed, was held up last night as Democrats struggled to corral their members on the Senate floor.

Earlier senators approved an amendment that would force bigger banks such as Citigroup to pay more to insure deposits, while cutting the cost for smaller institutions.

A host of other proposed changes, ranging from capping interest rates on credit cards to reintroducing the prohibition on commercial banks owning an investment bank, will be considered in the next few days.

Judd Gregg, the Republican senator from New Hampshire, predicted that the bill was now certain to pass but he hoped to make changes, including removing a provision that would force banks to spin off their derivatives trading desks.

The Democrats hope that a final vote can take place next week but Republicans warned that they intended to take as much time as they needed to consider hundreds of amendments, potentially prolonging the process.