The Crime of '11

When the US became a federal republic in 1789, it found itself in a bad spot financially. The Continental Congress had financed the war with paper money, which caused Weimar-style inflation. The paper (“Continental dollars”) was bought up by speculators hoping for redemption in coin. From our nation’s founding until 1933 (Civil War aside), the dollar was pegged to gold at $20 an ounce. Continentals traded for pennies.

Most officials thought that sticking it to the speculators would be necessary and prudent. Hamilton, the Treasury Secretary, was an Anglophile who understood that England had defeated France because it was a good credit and France was not. The Rothschilds bought British bonds; they shuddered at France’s paper (and they made a nice profits whenever the UK won).

Hamilton believed that the US would be like Britain and not like the rest of the world: we would be a sound credit. No defaults.  He redeemed all of the Continentals in gold.

The US has had many credit events since “redemption”: States have defaulted and repudiated their debts; the entire South defaulted and the US repudiated the Confederacy's debts; we issued paper currency during the Civil War (but redeemed it all in gold); we broke the gold clauses in our bonds in 1933 when FDR temporarily took us off gold; and we went off gold entirely in 1971; dollar “Silver Certificates” were with drawn form circulation unredeemed. But the US never ever failed to repay its Treasury bonds on time and in full, if you define “in full” as legal tender and not gold.

So, what was the result? The result was that by mid-20th cenury, the dollar and the Treasury bond became the dominant instruments in the world, the reference for value, the world’s reserve currency (you sell us Toyotas, we give you low-yield paper), and the image of stability and safety. Switzerland with liquid markets.

This is ultimately about brand management (and trust). Warren Buffett said that it takes years to build a reputation and seconds to destroy it. Would Coke put polluted water in its sodas? Would Toyota remove the brake pads from its cars? Would Boeing disable the control surfaces on the Dreamliner? No. But the US, which has built the most important financial brand in world history, the Treasury bond, is about to default. This really takes the cake for stupidity.

We are witnessing is the result of the ideological sorting out of the political parties. In the 1950s, this issue would have been resolved with phone calls from Ike to Speaker Sam Rayburn and Majority Leader LBJ. Rayburn and Johnson were both conservative Texas Democrats, now a forgotten species. The divide between Pelosi and Cantor appears simply unbridgeable. The last time we were in this position was 1861. That didn’t play out well either.
And by the way, default is unconstitutional. If I were the President I would pay my debts no matter what Congress does. Congress can impeach him, but the Senate won't convict. Frankly, I'd impeach him if he didn't override Congress.

The creditworthiness of the United States

Credit belongs only to the most enlightened and best governed nations.
--Daniel Webster

There are a four considerations: (1) will the USA keep its AAA, (2) will it default, (3) what are the possible consequences, and (4) what is the longer-term outlook.

The AAA rating is now on a very short leash: the agencies are saying that the US must agree a deal NOW, and agree a credible debt/GDP trajectory that is consistent with the highest sovereign rating. (These parameters have been published.)

While I could argue that the agencies should leave the AAA alone (because the US is still a very high grade credit), they have no big incentive to treat the USA any different from any other OECD sovereign. So I would expect them to downgrade the US next week or the week after, if no deal is reached. It’s silly to downgrade a bond issuer after it has defaulted. Not much predictive power there!

Additionally, given the CBO’s adjusted medium-term debt trajectory forecast, legislative gridlock (with or without a default) suggests that the US is moving from what I would call Aaa1 to Aaa2, in the direction of Aa1. It’s just simple arithmetic.

However it is important to observe that there are two kinds of countries: those that borrow in their own currency, and those that don't; the latter would be the entire eurozone. Every other OECD country finances itself in the same currency that it prints. (And please don't tell me that euros are domestic currency, except for perhaps Germany).

Printing presses are useful in debt crises. The Fed is the US’s lender of last resort, it has unlimited resources, and a big incentive to help. US default is much less likely than it is for countries that commit the original sin of funding themselves in foreign currency (the eurozone).

Given the digging of trenches on Capitol Hill, the US is at real risk of a technical default which, while it would make the US look like a banana republic run by clowns, would not fundamentally change the country’s underlying credit parameters. Treasuries would still be the best and most liquid bonds in the world. (When Moody’s took Japan to A2 in 1998, it had no impact on JGB yields.)

While a default would be a major dislocation, I don't expect Treasury yields to move dramatically in the event of a temporary default. Institutional investors, banks and central banks will have to scramble to change their investment guidelines. The longer this  standoff lasts, the worse it gets (it becomes less technical and more real). It will be a big blow to confidence, upon which rests the $50 trillion of debt outstanding globally.

The impending Eurozone crisis makes global investors want dollars (and gold, yen and Swiss francs), so I just don't see huge currency/bond dislocations because the temporary default would be technical and not not real. The expected loss of a defaulted US Treasury bond comes very close to zero.

What matters most is not a temporary default, but rather a failure to address the CBO's (adjusted) medium term debt trajectory forecasts. If the Democrats insist on no entitlement reform, and the Republicans insist on no revenue enhancement, the CBO forecasts will materialize, and the the US will face a major crisis in the next decade.

Additionally, as Moody’s points out, when a country defaults and does not adopt reforms to prevent such an event from ever happening again, it doesn’t smell like a AAA, even if the expected loss remains miniscule. Household FICO scores reflect not only repayment but punctuality.

What is happening in Washington today is unworthy of the issuer of the world’s reserve currency.  It is deeply irresponsible. As J.P.Morgan observed, “Collateral is no substitute for character”. Serious countries do not default on their debt due to partisan budget battles. Alexander Hamilton would move to Canada if he were alive today.

Parliamentary democracies do not face this problem. It is a major constitutional problem for the US. (And it is absurd for Congress to appropriate trillions in spending and then deny the Treasury the ability to finance it.)

We don't need anymore shocks. Lehman and the PIIGS are enough. Modern finance is founded on leverage and confidence, and I do not wish to live through a rapid deleveraging of the global economy (1930-34). There is a growing view that modern finance (1980-2011) is a huge Ponzi scheme funded by debt that cannot be repaid without big inflation. I don't subscribe to this view, so long as central banks are prepared to manage the deleveraging without catastrophic deflation (1930-1933).

It is particularly unfortunate that this rodeo in D.C. is occurring at a time when confidence in the eurozone it at an all-time low. National problems can become global problems when they are coincident.

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.