Europe faces its Minsky Moment

In 1933, Irving Fisher published his seminal “Debt-Deflation Theory of Great Depressions”. His theory was that over-indebtedness will ultimately lead to liquidation. Debt liquidation leads to distress selling and to a contraction of deposit currency as bank balance sheets shrink, leading to falling prices. As prices fall, the vicious cycle continues because even though prices are falling, indebtedness does not. Deflation makes debt bigger. (That’s Greece we’re talking about.)

Milton Friedman, Ben Bernanke and Barry Eichengreen (along with most other students of monetary policy) agree with Fisher’s theory. In fact, it’s so difficult to refute that it’s become an axiom.

Which brings us to 2011. What is the economic phenomenon that has characterized the past 29 years (i.e., since the crash of ‘82)? One word: leverage, ever growing leverage. Leverage at banks, shadow banks, mortgages, mortgage-backed securities and their derivatives and, of course, governments of all shapes and sizes.

Leverage is inherently evil because it increases financial fragility. If a financial institution has 4% equity and its assets decline in value by 4.1%, it is insolvent. Leverage exposes debtors to creditor confidence. Borrowers default when and only when no one will lend to them anymore.

Creditor confidence is not modelable. It is purely a matter of  group psychology: “I’d better get out now because I see people heading for the exits”. It is unpredictable. Who could have imagined that Goldman Sachs, AIG and GE would lose creditor confidence in 2008?

There are only three ways out of over-indebtedness and a loss of creditor confidence: bailout, default or (in the case of governments) inflation.

As we speak, private sector creditors have lost confidence in Greece, Portugal and Ireland (governments and banks). They are living on life support from the troika (EU/IMF/ECB). They are small and manageable. But the loss of confidence is now spreading to Spain (government and banks) and to eurozone banks exposed to the diseased sovereigns and their banks.

In 2008, the contagion was confined to major banks active in the mortgage, RMBS and CDO markets, which the central banks funded and the governments recapitalized. Today, the contagion appears to be spreading to the entire eurozone banking system. The eurozone banking system is too big to fail and too big to bailout, unless the ECB has the guts to step up to the plate (which is, by the way, its job).

The Germans have talked tough about the need to liquidate failing non-German banks. Let’s see how they feel about liquidating the Landesbanken or Deutsche Bank.

Europe is facing its greatest challenge since 1939. Will it take extraordinary measures to maintain financial stability, or will it be sauve qui peut?

The eurozone is shuddering

The risk of a catastrophic financial accident is as high as it was in 2008. Eurozone bank risk spreads are rising as investors take flight, while the yield on one month Treasury bills is now below zero. Even though the troika (EU/IMF/ECB) is moving forward with Greece’s bailout, investors are seeking cover anyway. Thus Greece doesn’t have to default for there to be a eurozone financial crisis.

If Spain, Portugal and Eire (governments and banks) lose market access, they will have to reschedule (default) because the troika doesn’t have enough money to rescue them all, along with Greece.

This scenario would be more like the cascading worldwide defaults of 1931 than 2008. One would have to imagine that the wealth destruction in such a scenario would be unprecedented.

Can such a scenario be contained to the Eurozone, or could contagion spread to other developed markets? I can’t see how other European banks won’t be affected to some extent, but they benefit from borrowing in domestic currency, which their central banks can print. I would not expect that non-European banks and governments would be affected, because they all borrow in their own domestic currencies.

Such a scenario would pose an unprecedented challenge to the ECB, which would have to make some very hard choices in order to maintain financial stability (i.e., taking on trilllons of exposure to eurozone banks, presumably with government guarantees of questionable value).

None of this would be happening were it not for the incredibly stupid idea of a monetary union of a hodgepodge of economies based on a geographic concept. The lesson learned during 1931-33 will now have to be relearned: only domestically issued fiat money can prevent deflation and defaults. No country should ever adopt a foreign currency as its own: If you can’t print it, don’t borrow in it. (And no central bank in the world can print gold, so forget about that “solution”.)

The breakup of the eurozone is such a black swan that its ultimate ramifications fall into the Rumsfeldian “unknown unknowns”. I’d have to say long-term bullish, but short term frightening.

Greek default looms

Previously I had predicted that Greece would default within six months. It is now evident that I was a tad over-optimistic. Default will occur considerably sooner than that.

First of all, Germany won’t mount another bailout unless Greece embraces reform and unless bondholders take some pain. Far from embracing reform, the Greeks are rioting and the government is falling. (Video footage of violent riots has become one of Greece’s fastest growing exports.)

It will be difficult to form a unity government committed to reform, because the opposition would rather renegotiate the bailout that Greece got a year ago, which will not be music to German ears. The Greek plan is to demand a new bailout while defaulting on the prior one. Angela will not be amused.

Greece cannot commit to reform because the people won’t accept it. Germany can’t agree to a bailout unless Greece commits to reform. The ECB, Greece’s largest creditor, refuses to participate in any debt reprofiling, which Merkel demands.

Therefore, Greece will soon run out of money to pay its maturing liabilities and will therefore default, along with its banking system which will collapse.

In my opinion, Greece has no choice but to default, exit the eurozone and redenominate its currency and its debt.

The consequent losses to European banks will be large. This would set up another Lehman event, in which the interbank markets freeze. The ECB will be the provider  of liquidity, until the losses are sorted out and the banks are recapitalized.

The Fed will have to step up liquidity operations as well, as in 2008. This will be a deflationary event and may require QE3. Real possibility of a double dip in the 3rd quarter.

Greek default this summer: implications

Greece is within six months of utter and irreversible collapse. Her electorate will not accept the German castor oil plan. She has the choice of balancing her budget under a German rifle corps, or defaulting and balancing her budget anyway (deadbeats can’t borrow).

By September, she will be in default in the worst possible way. Greece is not Argentina, she is Egypt, or Congo. There will be nothing orderly or lawful about her default. Her banks will succumb, her creditors will be left penniless, the ECB will no longer remember her name, and her tax revenues will drift towards zero. She will be a humanitarian basket case, except for the fact that Europe will be unsympathetic to Marxist defaulters. Maybe UNICEF will step in.

Once Greece sinks beneath the waves, Europe will have to come up with a jerry-rigged central funding scheme to keep the fires of hell away from Ireland, Portugal, and the other dodgy credits. Good luck on that. I would expect the worst for Eire and Lisbon.

How many times does the world have to learn that ungovernable Third World countries should not peg their currencies to anything of real external value? Isn’t that the lesson of Latin America, East Asia and, now, the golden Teutonic paradise of euroland?

The Anglosphere is lucky that (aside from Eire) neither UK, US, CAN, AU or NZ have chained ourselves to this catastrophe.  We’ll get the blowback, but not another Depression.

Investment implications? No idea, aside from bullish for $ and gold.

Europe must plan for a Greek defult now

Greece has not been compliant with the terms of its rescue loan. The Germans are balking at a second rescue. I really don’t see what will prevent an attempted restructuring. Credit spreads are in the stratosphere.

Greece’s debt lacks a collective action clause, so that it cannot negotiate with its creditors the way a company can. However, because Greece is not subject to a court, it can restructure unilaterally. However, I would expect that it would seek to negotiate the terms of the restructure with the ECB, the IMF and the EFSF.

Greece has lost access to the capital market. Restructuring will be another nail in that coffin. A negotiated restructure will mean that Greece will be saddled with a mountain of debt and no hope for market access. This means that Europe (the EFSF) will have to finance Greece’s budget deficit. The terms for such loans will be draconian because Europe will want the budget balanced rapidly. Thus, failure to comply with the first rescue’s conditions will only result in worse conditions.

Greece also has the nuclear option: default and repudiation. Since the capital markets will remain closed, and the European spigot rapidly turned off, Greece would have to balance its budget while still owing an amount in excess of its GDP. What is the incentive to honor its debts if there is no reward? Germany is not going to invade if Greece defaults. We have already seen repudiation in Latin America (about 100 times over two centuries).

In the end, either France and Germany cough up a lot of money, or else Greece defaults and repudiates some or all of its debt. They can’t pay it and they won’t pay it. The Greek electorate will not willingly put itself through what Romania went through in the 1980s.

In my opinion, now is the time for Europe to forget its “stability” delusions and start thinking about how to manage a Greek default. This will require another bank recapitalization and, in order to keep the interbank market open, another bank guarantee scheme. The ECB will have to put aside its dreams of a rate hike, and instead launch a massive liquidity infusion.

Europe must also decide what to do about Ireland. Ireland’s debt exceeds its debt capacity.

A German official said that a Greek default will have a market impact an order of magnitude greater than Lehman in 2008. That depends entirely on how well the authorities handle it. If it is bigger than Lehman, the ECB and the EU will have to up their game considerably. Right now they are in denial and unprepared.

Will Portugal be the first domino?

At present there are three eurozone members who have lost the ability to access the private capital market: Greece, Ireland and Portugal. Greece and Ireland have agreed to drastic austerity in exchange for access to the European Financial Stability Facility (and the IMF and ECB).

The Portuguese government has been attempting to perform fiscal surgery on itself without a bailout. Today the Portuguese parliament rejected the government’s austerity plan; the government has resigned; and there will be an election.

A bailout appears to be inevitable. But the EFSF/IMF scheme requires drastic austerity along the lines that have just been rejected. The new government and parliament will be faced with a choice between drastic austerity or default (resulting in even more drastic austerity). There is no “Get Out of Jail” option.

I would expect the ECB to keep Portugal on life-support while a new government is elected and formed. But unless Portugal requests a bailout on Draconian terms, there will be no bailout and Portugal will descent into the abyss.

It is possible that the Europeans will blink and keep shovelling euros into the Portuguese treasury despite uncontrolled budget deficits, but I can’t see Angela Merkel keeping her government together under such circumstances; the German people are already very angry about the EFSF.

Also, the EFSF may demand that bondholders agree to rescheduling and/or take a haircut. This would foreclose market access for a long time, forcing the eurozone to refinance all of Portugal’s maturing debt, a political impossibility.

The only way that Portugal can prevent economic collpase while remaining in the eurozone is to swallow the austerity pill and become a ward of the eurozone for the foreseeable future. Can any free people vote for drastic long-term austerity? The Baltics did, but for the euro peripherals, I am skeptical.

It is unclear how long the Greek and Irish peoples can tolerate a repeat of the Great Depression.

The threat of inflation

Headline news today: “Core producer prices rise at fastest rate in two years”.

Market reaction: “This may force the Fed to reconsider its position that inflation is not a serious threat this year,” said Michael Woolfolk, analyst at BNY Mellon Global Markets. “While the Fed can brush aside upside surprises to headline inflation, it cannot as easily brush aside upside surprises to core inflation.” (FT)

Now, some perspective. Core PPI grew at an annual rate of 1.6% in January. During the recession the PPI was in deep deflationary territory, falling from 205 to 170 (17%). Since the Fed began to the money supply, PPI has “recovered” into very low single-digit growth.

However, all measures of inflation are currently under 2%: CPI, core CPI, PPI, and core PPI. Core CPI has not been this low since the New Frontier. There is no reason for the Fed to reconsider its position that inflation is not a serious threat this year. The Fed continues to undershoot its inflation and employment targets.

The good news is that, due to quantitative easing, the money supply (M2) has begun to grow again at a comfortable (and non-inflationary) annual rate of 5%. We are in recovery, and monetary velocity has begun to rise modestly (1%). The combination of 3% real growth (let’s hope) and 2% inflation would get nominal GDP growth up to 5% (from minus territory in 2009). 6% would be better, but I will settle for 5%.

The impending departure of the hawkish Kevin Warsh from the Board of Governors and the FOMC is a good thing, in the sense that hopefully the president will nominate a more dovish governor who would be more supportive of Bernanke’s efforts to grow nominal GDP. Hopefully, Warsh won’t start testifying before Ron’s Paul’s committee about the danger of inflation.

Please note that, in all the debate about the US’s growing debt/GDP ratio, a missing fact is that one of the best ways to stabilize this number while the US is still in AAA territory is to grow nominal GDP. Growing our way out of debt is much less frightening than defaulting our way out of it. That was one thing that both Ronald Reagan and Bill Clinton understood.

ECB halts bond purchases: Why?

Reuters:
The European Central Bank bought no government bonds for the first time since October last week, reflecting growing market confidence that policymakers are
getting on top of the euro zone debt crisis.

Analysts said the ECB's move was a reflection of the better
debt market conditions and its hopes that Europe's rescue fund,
the European Financial Stability Fund, would take over its
uneasy role of debt buyer of last resort.

"It further reinforces Trichet statements that the ECB is
present in the market commensurate to the strains they see. The
ECB has clearly looked at the situation and decided that the
situation is not as pronounced as it was last month," said RBS
economist Nick Matthews.

"It is also occurring against a backdrop where the ECB
appears to be supporting an enhanced role for the EFSF which
could see the EFSF becoming the vehicle to buy bonds rather than
the ECB."

Here is my take on what may actually be happening. There has been a tug-of-war between the ECB and Germany over the size and scope of the EFSF. The ECB does not want to become the de facto bailout fund for the peripheral eurozone members.

It may be that this decision to stop buying government bonds is political and not financial. This is the best way for the ECB to pressure the European Commission to make the EFSF more credible, in that hope that markets will calm down, or in the hope that the bonds that the ECB has bought don’t go bad.

We will see if I am correct pretty quickly.

Sovereign credit risk: Eurozone, Japan, US, UK

There is a lot of confusion in the financial media (aside from Martin Wolf at the FT) about sovereign credit dynamics. Below is my short precis of sovereign credit risk factors:

1. Fiscal trajectory
This involves forecasting three variables: government revenue, government expense, and nominal GDP. GR - GE = fiscal deficit. Add forecast annual deficits to outstanding debt, and measure against both revenue and GDP. (The debt to revenue ratio is the more critical.) Another useful ratio is interest/revenue.

There are some scary fiscal trajectories out there, especially Japan, Greece and Ireland, which appear to be unsustainable without massive fiscal consolidation coupled with rapid GDP growth: an unlikely scenario. The US has a bad trajectory as well.

2. Debt capacity
Debt capacity is a country’s maximum sustainable debt level in relation to GDP or government revenue. Sustainable means without “debt restructuring”. There are many factors which influence this measure, such as the depth of the domestic capital market, whether the country has a fiat (printable) currency or, much worse, a currency (e.g., the euro) which it cannot print. Also important is social cohesion, the perceived legitimacy of the government (compare Finland with Egypt), and the overall level of development. Examples of high debt capacity are the UK after WW2, and Japan today. By this measure, Ireland is in much better shape than Greece. The Irish pay taxes, have a small public sector, and don’t riot much (the riots were in the North).

3. Market access
Market access is the ability of the country to refinance in the debt markets, as well as the ability of the banking system to remain funded and liquid. Here again, it helps to have a deep capital market and a fiat currency (under a fiat currency, the banks are always liquid). In the eurozone, only Germany, France and perhaps Italy have deep domestic capital markets, but they do not have a fiat currency. Japan, with the worst debt ratios in world history, has excellent market access due to its huge domestic savings glut. It can issue bonds at amazingly low yields. The banks buy the bonds and the population funds the banks.

4. External support
Greece and Ireland have lost market access. They are being kept afloat by the ECB (which discretely buys governmnt bonds and lends to banks) and by the EFSF which acts as a lender of last resort to member states. Therefore, in these two cases, the central issue is no longer the underlying fundamentals (fiscal trajectory and debt capacity) but rather the political decision-making concerning external support.

This is why the ECB is at war with the European Commission. The ECB does not see itself as the eurozone’s bailout fund (just as the Fed has little interest in buying California bonds). But the Commission has so far refused to establish a large, credible bailout mechanism for the peripherals, because Germany doesn’t want to be the eurozone’s de facto bailout fund either.

UK
How does the UK look in this prism? It has an unsustainable fiscal trajectory as the PM and the Chancellor will happily inform you. It appears to have more runway on debt capacity, so long as the Coalition is seen to have a credible deficit reduction plan (the plan is credible, but will the Coalition hold together?). It is extremely lucky (i.e., smart, thanks to the unsung Gordon Brown) that it did not adopt the euro. Britain can grow its money supply with complete autonomy, and can let the pound depreciate to regain competitiveness. The UK’s big problem is that it has a services economy, not an export economy, and devaluation does not really make the City of London more competitive.

Market access is good unless there is a breakdown of the Coalition, which is unlikely. Should the Coalition lose its majority due to fiscal disagreements, confidence in sterling and gilts could hit a wall, and bond yields would add a default risk premium.

US
Here again, the fiscal trajectory is unsustainable over the next decade (according to the Congressional Budget Office). The US is entering a potentially catastrophic demographic shift, not with a surplus, but with a very high deficit. As the boomers retire, the costs of MediCare and SocSec will create a major structural imbalance. It’s actually quite frightening, considering the difficulties of a meaningful budget compromise. Can Harry Reid and John Boehner agree on anything? (The UK has a significant constitutional advantage in that the Government always commands a majority in the House.)

US debt capacity? Quite a bit of runway left,  judging by the the Japan-like Treasury yields demanded by investors. Ditto for market access; Treasury auctions are going very smoothly, and the Fed is doing its part with $600B of QE2.

External support? That would be Asia (Japan and China), which buy Treasuries with their current account surpluses. No evidence of a problem there.



Conclusion
So, my judgement would be that Greece and Ireland must default, the UK is at risk unless the Government keeps its majority, and the US is also at long-term risk if the GOP and the Democrats cannot agree this year on a plan for fiscal consolidation.

The China-US summit

The People’s Bank is in a real bind. Central banks have mandates. The PBC’s dual mandates are difficult to achieve: parity with the dollar and growth without high inflation. Maintaining dollar parity requires the PBC to invest China’s enormous current account surplus in dollars (otherwise, the yuan would rise in dollar terms). The PBC requires exporters to sell their dollars to the bank in exchange for yuan.

As the PBC’s balance sheet expands, so does the money supply and thus inflationary pressures. The PBC is seeking to dampen inflation by curbing bank lending and raising interest rates. The PBC could also fight inflation by allowing the yuan to appreciate, but that it out of the question. Export growth trumps inflation. The PBC’s policies have been very successful. China’s growth and prosperity since 1979 have been remarkable.

But now the PBC and the government have two problems (besides inflation). One is that China is under increasing pressure from the G-20 to allow the yuan to rise. The other is that China is concerned that the value of it’s ~$3 trillion dollar nest egg is threatened by the US’s massive deficits and by QE2, which China believes represents a stealth devaluation.

Yesterday, President Hu made two somewhat contradictory statements (in a written Q&A with the Journal) which highlight his dilemma. First, he said the the dollar’s hegemonic status is obsolete. Then, in the same statement, he said that US monetary policy “has a major impact on global liquidity and capital flows and therefore, the liquidity of the U.S. dollar should be kept at a reasonable and stable level”.

In 2009, the PBC called for a new synthetic reserve currency regime. France has made similar statements. But there is nothing stopping the PBC or the ECB from buying SDRs or diversifying their reserve portfolios.

As I pointed out in my most recent post, I expected the PBC to buy euro-denominated government bonds, and indeed it did so last week in the Spanish and Portuguese auctions. But it is one thing to buy euros and another to stop buying dollars.

The ECB could diversify away from dollars and buy yen, won, sterling, the A$, the C$, etc. But that would be symbolic. Monetary policy on the ECB’s scale cannot be conducted with illiquid, boutique currencies. Buying yuan bonds is out of the question due to China’s exchange controls.

So the PBC and the ECB are exposed to both the US credit risk (still AAA!), and devaluation. And I don’t see that there is much to do about it, other than jawboning the Fed and the Treasury, which hasn’t worked.

President Hu’s summit with President Obama will be highly scripted, and I don’t expect anything major to come out of it.