European Bank Accounting Is A Joke

On Sunday, Europe introduced the “Cyprus Doctrine”, which says that uninsured deposits are risk assets and that uninsured depositors are “investors”. The deposit claim has been transformed into a capital instrument. Henceforth, holders of uninsured deposits in European banks are supposed to do their homework, and make sure that they are not investing in uncreditworthy banks.

Connoisseurs of European bank regulation may recall that market discipline was one of the original “Basel Pillars” along with prudential supervision and capital adequacy. And now market discipline exists as a real pillar. Advocates of free markets and financial deregulation should applaud the introduction of the Cyprus Doctrine. (I would call it the “Dijsselbloem Doctrine” if I could spell or pronounce it. The Dutch need SpellCheck.) Indeed, the anti-regulation WSJ is just thrilled with the Cyprus Doctrine: “This is a useful lesson in the limits of government guarantees and a welcome blow against moral hazard”.

Banks won’t need to be regulated anymore because they are outside the safety net. Instead, depositors will police the banking system, rewarding the strong and punishing the weak. Bad banks will be weeded out; we will have fewer but better banks. Taxpayers and legislators will no longer need to  pay attention to the industry. Banks can be set free.

There is only one problem with European “depositor discipline”: European bank accounting and disclosure is a joke. There is little relationship between a European bank’s creditworthiness and its financial reporting. Both dead Cyprus banks were solvent according to their latest financials, and both passed the European Banking Authority’s 2011 stress test. I think that both Bankia and Banca MPS passed as well: I think everyone passed. The stress test was a joke. It was calibrated to pass everyone. All European banks are created equal--until they fail.

How are depositors supposed to be able to know where to put their money? You might think they could use bank ratings, but most European banks aren’t rated by Moody’s or anyone else. And Moody’s is not clairvoyant; it has to use the same bogus financial disclosure as everyone else. Bank executives seldom blurt out the fact that they are insolvent. Insolvent banks lie about their asset quality to anyone who will listen. They certainly lied to me when I was in the business. I found that one of the best sources of information about insolvent banks was market rumor and anecdote. Not actionable information, but more useful than the lies the banks told.

If you don’t believe that insolvent banks lie about their condition, read the annual report for any one of the banks which have had to be bailed out in the past few years. Not one of them said that they were insolvent, or that their loan portfolio was full of holes, or that their CDOs were mismarked, or that they were becoming illiquid. And I would add that European bank regulators act as advocates for their banks. They take criticism of their banks personally. Are these regulators now supposed to issue press releases pointing out which of their banks are no good and should be avoided at all costs?

I can’t help making one other observation that will make me sound arrogant. I have been a bank analyst since 1978. I have been following bank regulation for 35 years. Although I may be demented, I remember the lessons of those 35 years, the most important of which is that bank deposits make up most of the money supply and, as such, are contingent liabilities of the central bank. If you screw around with bank deposits, you are screwing around with the money supply which drives nominal growth. You can’t introduce depositor discipline while expecting economic growth. It’s one or the other.

The Eurozone Introduces "Depositor Discipline"

"If there is a risk in a bank, our first question should be 'Okay, what are you in the bank going to do about that? What can you do to recapitalise yourself?'. If the bank can't do it, then we'll talk to the shareholders and the bondholders, we'll ask them to contribute in recapitalising the bank, and if necessary the uninsured deposit holders."

---Jeroen Dijsselbloem, Dutch finance minister

"In a normal market economy an investor always has a risk of losing money. That's why I think it's fair and right, and also part of a normal market economy, that owners of a bank, investors, and biggest depositors - who can be seen as investors - take their own responsibility, in one way or another."

-- Jyrki Katainen, Finnish prime minister

So the Dutchman with the unspellable name, who is currently the head of the committee of eurozone finance ministers, has announced that no bank in the eurozone, no matter how important,  is TBTF. How this must warm the hearts of the Righteous. “We told those Levantines: No more of our good clean Protestant money will go toward paying for your sinful ways. Let your dirty depositors pay.” You know how good it feels for them to say that.

It has been interesting watching the northerners writhe in agony as they have had to write checks to the peripherals. Every time they have rescued a bankrupt bank, they have said “This is the last time: from now on, creditors and depositors will contribute.” But until now they never actually allowed that to happen. Now, not only do we see the junior creditors of Bankia being hit, we also see depositors in the big Cypriot banks being whacked. A breakthrough.

It is easy to destroy someone else’s economy. The IMF has done it a number of times. But when it comes to one’s own economy, one is more cautious. The northerners talk the talk when it isn’t their banks, but they have never walked the walk themselves. They bailed out all of their banks, big and small, during the crisis. In fact, they have been bailing out banks for years as a matter of routine.

The Germans have been the worst. They have rescued the landesbanks so many times that even the French got angry. WestLB? I don’t have enough fingers to count the number of its bailouts. WestLB has been magical in the way that every mark or euro poured into it has vaporized into the atmosphere, again and again. Where did it all go?

The French don’t let any bank fail, not even nonsystemic dinosaurs like Credit Foncier. They run a convoy system that’s as tight as Japan’s. Large banks don’t fail in Europe, and small banks almost never do either.

So now the north wants to introduce “depositor discipline”. Depositors are now “investors” who bear responsibility for investigating the soundness (and morals) of the bank and the country in which they “invest” their deposits. Well, you can bet that from now on they will do just that. That means two things: (1) big depositors will look at the sovereign credit ratings of the country where they have deposits; and (2) they will look at the ratings of the banks where they deposit their money.

And now, since eurozone banks are no longer TBTF, those bank ratings are going to go down. This is what Moody’s has to say on the subject: “The authorities’ apparent willingness to accept the risk of contagion suggests that the landscape is shifting to the detriment of senior bank creditors in support scenarios”. So institutional depositors will now have to make sure that their money is placed with highly-rated banks in highly-rated countries. Second-class will no longer suffice. That is, unless they are prepared to “invest” in the resolution of the banks where they deposit their money. The eurozone is now a depositor’s minefield.

It just so happens that both France and Germany still have some weak banks which could serve as guinea pigs for this new policy. Germany has some dodgy landesbanks (Bayern, HSH Nordbanken, Bremer) which would be fascinating to see resolved. France also has some interesting names: Dexia, Credit Foncier, Credit Immobilier, Natixis, BPCE. Will these be wound up at a loss to their senior bondholders and depositors? So far, no bank issuer of pfandbriefe has ever been allowed to fail. Will that change? Will the legal robustness of pfandbriefe finally get tested in a bank failure? This new policy opens so many analytical doors.

Will we, as avid spectators, get to see the spectacle of large French and German banks defaulting on their bonds and deposits? Sadly, no. That’s only for the Levantines.

Bank Fraud In The Eurozone

It is quite evident that the scale of the Cypriot banks’ insolvency far exceeds their holdings of defaulted Greek government bonds. It appears that a very high proportion of their other assets are worthless also (although you wouldn’t know it by reading their audited financials). The phenomenon of horrific loan quality has characterized the eurozone banking crisis (sort of a truism, I guess). Notable examples have been Anglo-Irish in Ireland,  Bankia in Spain, Banca MPS in Italy, and now the Cypriot disaster. In each of these cases, the loan write-downs have been very large in percentage terms. When half of your loan book is bad, you are more than merely insolvent, you are suspiciously insolvent.

The general European reaction to this phenomenon has been “poor underwriting” and “real estate bubble”. You don’t hear enough about “bank fraud”. It’s worth remembering that for every large defaulted loan there is a rich borrower who is very possibly a crook. I recall a finance minister explaining that his country’s new president was honest because he had published the names of defaulted borrowers and was pursuing them for collection. Living in an anglosaxon country, I had always just assumed that banks pursued defaulted borrowers (at least outside of Texas). The finance minister explained that, in his country, banks had never pursued defaulted borrowers because they were all related or connected (also known as generals) . The new president was scrapping  that tradition. (Note: that president and his finance minister are long gone and I am sure that things are back to business as usual in their famously corrupt country.)

In Japan, after the real estate bubble collapsed, foreign entrepreneurs bought bad loans on the theory that they could foreclose, and then re-lease or resell the properties at market rates. These foreigners did not count on the fact that the Yakuza were the borrowers/owners/occupants, and disliked loan collectors.  

Bad loans, corruption and borrower fraud are peas in a pod. This certainly applies to Club Med. Billions of euros have “disappeared”, only they didn’t disappear--they are just in someone else’s bank account. I’m not denying that Club Med is dotted with half-built properties of every description: I’ve seen them myself. Not all the money went from one pocket to another--but a lot of it did. A lot of bad loans were made to “connected” borrowers, probably most of them. The tale of Bankia in Spain is particularly sordid, worse than Texas at its worst.

In the US, when the government was forced to pay off the liabilities of the entire bankrupt Savings & Loan industry, it took over their loans, foreclosed on the borrowers, seized their assets and then sold them to the public within two years (via the Resolution Trust Corporation). As far as I know, the whole operation was clean and above-board, and the government was able to recoup billions in the process. Not enough of the fraudsters went to jail, but they did have to give back their assets.

I don’t see any evidence of this happening in Europe. In the case of Bankia, the government intends to hold onto its bad loans for years. An uncollected loan is an outright gift to the borrower, and Bankia’s borrowers are well-connected. In the case of Banca MPS, I’m sure that we will also start hearing hair-raising tales of corruption, and very little about loan collection.

What we are witnessing in European banking today is a saga of bad assets carried as good assets, bogus accounting, hopeless insolvency, and billions in uncollected bad loans. A good definition of a Third World country is one in which bank loans are made but not collected. My gut tells me that Club Med fits  that definition.

Europe's Newest Currency: The Nonconvertible Euro

“Today the Cypriot parliament will vote on capital controls allowing authorities to restrict noncash transactions, curtail check cashing, limit withdrawals and to even convert current accounts into fixed-term deposits when banks reopen on Tuesday... There have also been discussions over eurozone-enforced controls on Cyprus, including freezes on savings and a requirement that all bank transfers are approved by a central bank, Handelsblatt reported today.”

---today’s Telegraph

The Cyprus resolution that is being cobbled together this weekend would involve a haircut on uninsured deposits and banking sector consolidation in exchange for the troika’s recapitalization of what’s left of the banking system. This would permit the ECB to continue to fund the remaining Cypriot banks, allowing them to continue to function in euro without have to redenominate. Cyprus would not default on its government debt and would remain in the eurozone.

There would also presumably be a new austerity package for the government involving the usual “impossible” and “unthinkable” reforms. In theory, the government and legislature will capitulate completely to the troika’s entire list of demands.

This plan is supposed to put the Cypriot crisis to bed for the medium-term.

In addition to the haircutting of uninsured deposits, it appears that remaining uninsured (and insured?) deposits while remaining “whole” will not be unfrozen and will be not be convertible into real euros. As the Telegraph reports above, the Cypriot euro will remain subject to currency restrictions including even the possibility of forced conversion into longer-term instruments.

Cyprus will have a nonconvertible currency for some period of time until something even worse happens: redenomination back into pounds. There will be a powerful incentive for capital flight before that happens.

As any Argentine or Venezuelan will tell you, when you can’t wire your money to Miami, you fill your suitcase and fly it there. Will Cyprus try to prevent the physical movement of large quantities of cash from Cyprus to anywhere else (Israel, Lebanon, or even Northern Cyprus, which is literally across the street)? Perhaps Cypriots will try to exchange euro notes in Cyprus for convertible rubles in Russia. The Argentines and Venezuelans will need to establish a school in Limassol for “Living With A Nonconvertible Currency”.

Will a parallel currency market develop for Cyprus euros at a discount to convertible euros abroad? I presume that that will happen. Business must go on, and payments must be made. We should also see the underinvoicing of exports and the overinvoicing of imports, as is normal for blocked currencies.

And where will rich Cypriots want to park their money? My guess would be as far from the EU as possible, such as Dubai. Their natural depository is London, but that might not be safe from their government’s clutches. Similarly, it will be safer to keep cash in anonymous safe-deposit boxes, rather than in bank accounts which can be more easily identified and confiscated.

Of course, the development of the Cypriot currency system is monumentally unimportant to the rest of us. But it may serve as a wake-up call to Greeks, Portuguese and other residents of Club Med who are relying on Europe’s promise that depository confiscation and/or currency controls will never happen there. They know those promises mean nothing. The holders of Club Med government bonds know that they can be defaulted upon (Greece), and the holders of Club Med bank deposits know that they can be frozen and/or haircut. Soon they may learn that a euro can go from being convertible to being nonconvertible to being another currency altogether. Ask any Latin American.

Will Germany Turn Europe Into Latin America?

The headline in today's Journal is "Merkel's Hard Line, Vilified In Nicosia, Cheers Germany". Some quotes:

"Cyprus lives off a banking sector with low taxes and lax regulation that is completely out of whack. As a result, Cyprus is insolvent and no one outside of Cyprus is responsible for that…We've taken measures in all countries to protect ourselves against contagion effects."

--Wolfgang Schaueble, Finance Minister

"Merkel has nothing to lose in Cyprus."

--Ulrike Guerot, European Council on Foreign Relations

Germany is happy about the Cyrpus banking crisis because it will punish Cypriot sinfulness. I guess the sin is that the eurozone is no place for an offshore banking center/tax haven, which is debatable. But that decision should have been made before Cyprus was admitted into the eurozone. Now its banks have EUR 50 or 60 billion in euro-denominated deposits which Germany wants it to default on. The Journal says that "one reason that Berlin is taking such a hard line on Cyprus now is that it sees the country's crisis as a unique opportunity to end its reliance on tax refugees". This is punishing shoplifting with the death penalty.

Germans are very skilled at making things and being thrifty. They are economically admirable in every way except one: they have never accepted modern capital markets. They have resisted anglosaxon capitalism for forty years, and they still don't accept it. Germany (like France) believes in intermediated financial markets which can be controlled by the authorities in order to ensure financial stability. They don't trust independent market actors like hedge funds, US investment banks or rating agencies. You can make an argument that they are right, but it's way too late. They lost that battle and global finance is now substantially anglosaxonized.

A large percentage of European capital flows today are disintermediated, especially cross-border. And anyway, foreign banks are no more controllable than hedge funds. The creation of the eurozone by itself substantially reduced the power of national authorities. Consequently, the European capital market is now more powerful than the European national authorities. Germany doesn't like this for good reasons, but it is a fact that she can't change. Causing Cyprus to default is not a good way to deal with this issue.

So where's the black swan here? What did everyone miss? The markets knew that the Cyprus banks were insolvent because of Greece’s default. They knew that Cyprus had billions in offshore deposits. They knew that the Cypriot political system (like Greece's) is politically incapable of accepting any form of IMF-style austerity. Everyone has known  about this witches' brew. But, everyone figured,  the Cyprus problem is a rounding-error, and Europe always manages to kick the can down the road. It’ll get fixed. That’s certainly what I’ve been predicting.

What we didn't know was that Germany wants a crisis in Cyprus. Germany wants Cyprus to default on its bank deposits. That wasn’t understood until now. That’s the black swan. In retrospect, we can see the explanation: bailout fatigue on the part of the thrifty German people; the desire to disallow the enabling of tax evasion by a eurozone member; and outspoken distaste for the Russian kleptocracy. But the truly dangerous part of the German rationale is the mistaken opinion that a Cyprus banking collapse is manageable. This is the same stupid complacency that led to Lehman.

A Cypriot banking collapse will have unpredictable consequences; it’s a shot in the dark. It will inevitably create contagion--maybe not immediately, but eventually. Credit committees work on schedules. If Cyprus goes, risk limits for southern Europe will be reduced. Investments, deposits and capital flows will be redirected. Southern European banks will lose deposits not just from foreigners, but also from domestic investors and corporations.

A deposit freeze affects every bank, not just the weak. A Spanish millionaire is no safer in Banco Santander's headquarters office in Madrid than in the tiny caja down the street. Remember: if Cyprus blows up, Cypriots with deposits in foreign banks will not be affected. The key is getting your money out of the country.

This is a classic Latin American banking discussion. I’ve sat through scores of them. Southern Europe is at risk of going back to a Latin American-style financial system. Latin American depositors instinctively understand that you must keep your company's money and your family's wealth in a hard-currency deposit in a big bank in a strong country. Southern Europeans used to know this: it was called a numbered Swiss bank account. They are relearning this lesson. Let me be clear about what is happening here: we already have within the eurozone billions of nonconvertible euros. That’s a word you haven’t heard lately, unless you live in Venezuela or Cuba.

The West has spent the last sixty years building an institutional framework to allow global trade and capital flows. This has meant the dismantling of currency controls, capital controls, trade barriers and barriers to foreign investment. As this structure has been built, lessons have been learned: Don't lend or borrow foreign currency. Don't build up short-term foreign debt. Capital inflows can go both ways. The eurozone was supposed to be an enhancement to the globalization of finance. It was supposed to do for the eurozone what the dollar zone has done for the Americans.

If eurozone bank deposits now become subject to sovereign risk, that will reverse the whole process. No one can be that reckless, and the Germans aren't supposed to be reckless. They are what economists call "a serious country". Let's hope they stick to that tradition.

A Brief Note on Deposit Freezes

Deposit freezes almost never end well. They are imposed during banking crises in order to stop bank runs. Unless the reason for the lack of depositor confidence is removed or the deposits are rescheduled, the run will resume when the freeze ends. The only way to end a freeze without default is to restore confidence with a guarantee from a  creditworthy guarantor backed by unlimited resources. Unlimited resources means a printing press.* There is only one such entity in the eurozone, the ECB, or the ESM backstopped by the ECB. There is no evidence that anyone is even discussing such a resolution. Germany wants a default.

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*The US ended its deposit freeze in 1933 by forcing many banks to default and then guaranteeing the rest. Millions of innocent people lost their savings.

Europe Has A Week To Prevent Another Lehman

Cypriot banks are closed, all bank deposits are frozen including the Russian government’s, and there is no obvious way to unfreeze them. Russia is becoming very annoyed. The ECB has given Cyprus until Monday to agree to a bank recap. Otherwise it says that it will withdraw emergency liquidity and the Cypriot banking system will collapse. A Cypriot banking collapse would be a Lehman Event.

Since there are no real deadlines in Euroland, this is most likely feint by the ECB to force Europe to step up. One solution might be for the ESM to guarantee the ECB’s exposure pending a bailout agreement. The ECB isn’t allowed to lend to insolvent banks.

Europe is finally realizing that a Cypriot banking collapse would pose a systemic risk to the eurozone. The Telegraph:

“Jeroen Dijsselbloem, the Dutch finance minister who chairs meetings of eurozone ministers, warned that Cyprus poses a "systemic risk" to Europe's economy and banking sector, meaning a bank meltdown there could plunge other European countries into a new crisis. "In the present situation I think there is definitely a systemic risk and I think the unrest of the last couple of days has proven this, unfortunately," he said.” (03.21.13)

A Cypriot banking collapse would lead to a general pull-back of deposits in Club Med banks (including Italy) by foreign and domestic institutional depositors. The risk in these countries is not that an individual bank will fail, but rather that all deposits will be frozen and rescheduled and/or redenominated. This means that the entire country must be redlined, not just weak banks. Domestic institutional creditors are as much at risk as foreigners.

The finance ministers have reportedly started to discuss capital controls as a way to prevent contagion from a Cyprus collapse to the rest of Club Med. What could this mean in practice? Are they really contemplating capital controls for the Club Med countries? This would violate a whole lot of laws, and would mean the effective end of the eurozone as a single monetary zone. (The US and and a number of other countries use the US dollar as their currency, but they are not a single monetary zone.)

If capital controls are imposed in any of the Club Med countries, they will have to be imposed on many of them, because of the risk that they will be imposed later. Capital controls in an economy like Italy would be a financial event similar to Austria in 1931.

Unless a Cypriot banking collapse is averted, it will be another Lehman Event, perhaps even a Minsky Moment. In retrospect, none of the reasons for allowing Austria’s banks to default in 1931 were very persuasive. None of Hank Paulson’s reasons for allowing Lehman to go bankrupt are persuasive. And none of the reasons being given for Cyprus to go under are persuasive either. The cost of a cleanup from Cyprus would be a multiple of the cost of buying the entire country.

Ultimately, this is a problem that land squarely on Merkel’s desk. Only she (and Schaueble) have the power to force (permit) a resolution. I am confident that this is being made clear to her as we speak (by Medvedev and others). Personalities matter in financial crises. At this juncture, it is very unfortunate that Tim Geithner has left the scene. Right now, the only authoritative American voice in Europe is Ben Bernanke, who isn’t allowed to make policy recommendations.

The world has about a week to prevent the Cyprus crisis from infecting southern Europe. If it fails, the market impact will be quite remarkable.

Europe's Latest Monetary Experiment

Cyprus's new finance minister ruled out a haircut on bank deposits to ease a financial bailout. "Really and categorically - and this doesn't only apply in the case of Cyprus but for the world over and the eurozone - there really couldn't be a more stupid idea." 
--Reuters, March 1st, 2013

“The European Central Bank is pressing Cyprus to legislate a universal levy on bank deposits before international financial markets open on Monday...Cyprus gave way after the ECB threatened to push the island into a disorderly default by withdrawing liquidity support for Laiki, its second-largest bank, on Tuesday.”
FT, March 17th, 2013

"The move to take a percentage of deposits, which could raise almost 6 billion euros, must be ratified by parliament, where no party has a majority. If it fails to do so, President Nicos Anastasiades has warned, Cyprus's two largest banks will collapse."

--Reuters, March 17th, 2013

Like many people, I enjoy monetary experiments. Usually these occur in Latin America, where unorthodox monetary ideas are being tried all the time. But we now have a new laboratory for monetary innovation: the eurozone. This weekend, Europe ordered Cyprus to haircut bank deposits, thus transforming them from money (M2) into a loss-absorbing instrument. That's innovative. This could be the Next Big Thing in monetary policy: the transformation of deposits into bank capital and/or government revenue. Cyprus is the ECB’s new laboratory for monetary policy, a kind of EuroDisney. I trust that Mario Draghi is enjoying this experiment as much as the rest of us.

Now we have two Draghi Doctrines: (1) "Growth is irrelevant to the conduct of monetary policy"; and (2) "Bank deposits are risk assets". Mr. Draghi is always thinking up new ideas.

A bank deposit in Euroland (or at least in southern Euroland) is no longer money. Instead, it's a speculative zero-coupon instrument. (Note that deposits in branches of foreign or solvent domestic banks are also subject to this confiscation; bank solvency is irrelevant.) I can’t over-emphasize how innovative this decision is. 

Outside of Euroland, bank deposits are considered money and, as such, as a contingent liability of the central bank. The ECB has just transformed what had been money into a risk asset. The Fed did this same thing in 1931, and it didn’t work out well: the money supply flowed into mattresses. Going forward, only the truly patriotic will keep their money on deposit in Club Med banks.

When depositors lose confidence, they redeem their deposits in cash or move them to banks beyond the reach of the government. Consequently, deposit withdrawals cause M2 to decline by the money multiplier, which causes deflation. This underlines the nonsense of the assertion that the eurozone is a “single monetary area”. What’s the outlook for Greek or Portuguese M2 growth in 2013, Mr. Draghi? The euro has now been balkanized into a set of defective national currencies.

In the three year saga of the European sovereign debt crisis, we have been told by the authorities that (1) default by a eurozone sovereign was “unthinkable”, and (2) that a deposit haircut would be a “stupid idea”. Well guess what: Greece has defaulted on its bonds, and Cyprus has haircut its deposits. What will be Europe’s next experiment?

N.B.: Cypriot bank deposits are now frozen indefinitely by order of the Central Bank, but you wouldn't know it by looking at its website. Still a secret, I guess.

Stocks Will Go Higher As Reflation Gains Credibility

In mid-December (“2013: The Year Of Printing Money”),  I predicted that QE3 would prove to be highly bullish for the stock market. I wrote:
"Assuming that the Fed implements QE3 as announced on Wednesday, I expect to see the Dow around 15,000 next Christmas. This is because the Fed’s balance sheet should grow by $1 trillion next year, a 36% increase over where it is now. By yearend, I expect nominal GDP growth to have accelerated from its current 4% to a level closer to 5%. I am therefore bullish about both economic growth and equity prices."

Since I wrote that statement, the Dow has risen by over 1,100 points, or 8.5%. Over the same time period, the Fed’s balance sheet has grown by $240 billion or 9%*. As the Fed’s balance sheet has grown since December, the stock market has steadily risen. I don’t think this is mere happenstance; I think it is cause and effect. The stock market did not rise just because the Fed bought more bonds; it rose because the market has become convinced that the Fed intends to fulfill its statutory mandate by buying bonds until unemployment has declined to a normal level. In other words, the market has begun to believe that the Fed’s promise of an employment target might be credible and not merely a nice gesture.

Last year, the employment target had little credibility because a number of FOMC members had expressed reservations about such a radical policy (unlimited open-ended bond buying). Some members expressed doubts about the unlimited horizon for the program, suggesting that it could be stopped at any time. If the new policy had been credible, the market would have reacted when it was announced in early September. In fact, it did not even react when the Fed began buying bonds after its announcement. It only reacted when the scale of bond buying became material and began to appear in the monetary base in January.

I think it is important to keep the scale of what is happening in perspective. The drive-by commentariat (on both the right and left) continue to believe that the Fed is buying bonds on a massive scale. They believe this because it would be too much trouble to dig up the actual data. Under the Fed’s “reckless” and “inflationary” QE3, the monetary base has been growing in the single digits (after not growing at all for 18 months), and the money supply (M2) has been growing at the same moderate pace. The news is not that the Fed’s balance sheet is growing rapidly; the news is that the Fed’s balance sheet has finally begun to grow. Under five years of QE, the money supply has never grown faster than 11% and has averaged in the mid single digits. Under QE, core CPI has never exceeded 2.5% and has averaged substantially below the 2% target. And yet the TV economists are still debating whether “the economy is on crack” and “how we can get off of our addiction” to monetary stimulus.

One thing that puzzles me is the rather disingenuous way that Bernanke is trying to sell QE3 to Congress and the public. He says that he is buying bonds in order to lower long-term interest rates and support the mortgage market. This sounds plausible and sensible, but it just isn’t true. Bernanke is buying bonds to raise inflation expectations and thus bond yields.

One need only consult Bernanke’s own writings to know that the purpose of QE is to raise inflation expectations and bond yields. That is because the only way to lower real interest rates in an ultra-low rate environment is by raising inflation expectations. The Fed needs to convince the markets that it is sincerely committed to fulfilling its full employment mandate, even if it means exceeding its inflation target.

This is what Bernanke told the Japanese ten years ago, when he advocated price-level targeting for Japan:
"Inflation above zero will be needed if real interest rates in Japan are to be negative for a period, as many observers think is necessary for full recovery...
A period of reflation would provide a boost to profits and help to break the deflationary psychology among the public, which would be positive factors for asset prices as well...
Price-level targeting, as opposed to more conventional inflation targeting, requires a short-term inflation rate that is higher than the long-term inflation objective."

What Bernanke said ten years ago still applies: a successful reflation policy requires changing inflation expectations. If QE3 is to succeed, bond yields must rise to reflect the expectation that inflation will be higher than the level embedded in today’s yields.

Unfortunately, we’re not there yet. Reflation has not gained credibility in the bond market, as the 10-year rate remain stuck below 2%. The market does not believe that the new policy is for real. It believes that the minute unemployment ticks down, the money spigot will be turned off.

Bernanke is now struggling to convince the markets that he means what he says and that he has the votes on the FOMC to pursue QE3 until unemployment comes down to a significantly lower level. In my view, this will require an additional one percent of inflation. As the current pace of QE continues, we should start to see higher inflation by the end of Spring. Bad for bonds, but very bullish for equities.

In December, I predicted a 15,000 Dow by yearend. My current view is that we will get to 15,000 by mid-summer.

Note to bondholders:

If I am right and Bernanke succeeds in raising inflation expectations, you are about to be clobbered. You may believe that QE is your friend, but it isn't. As long as the monetary base grows, you will be fighting the Fed, and the Fed will win. Get out now while you still have your shirt on. You will never see rates this low again.

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*See data: http://research.stlouisfed.org/fredgraph.png?g=gcv

The Sequester Is Fiscal Theater, Not Fiscal Policy

The US faces a fiscal crisis due to the demographic implications of healthcare, social security and public-sector pensions. Over the next decade, as the postwar generation leaves the workforce and begins to draw upon government resources for healthcare and pensions, these budget items will grow rapidly at the federal, state and local level. Without drastic and politically unpalatable reform, these expenses will consume government budgets, leaving no room for government services and activities. The consequences will be high structural deficits, and an exhaustion of national debt capacity.

The run-up to the demographic crisis should have been preceded by a strengthening of the national finances in order to leave some debt capacity for the problem. Instead, the country has been running large deficits since as a result of the Great Recession. Federal debt held by the public has grown from $5 trillion in 2007 to $11 trillion today. The ratio of debt held by the public to GDP has risen from below 40% in 2007 to almost 80% today. Without a drastic change in course, the CBO predicts that ten years from now the ratio will climb to 90%, the highest level in postwar history.

Here is the budget arithmetic: GDP has been growing at 4% in nominal terms since the Crash, while federal debt has been growing at 12% over that period (post-crash). The debt is growing 8% faster than GDP, hence the steadily rising Debt/GDP ratio. The deficit represents 30% of federal spending.

Stabilizing (or reversing) the country’s debt ratios will require a major reduction in overall spending, entitlement reform, and substantially higher taxes on the middle class. All of these measures are included in Simpson-Bowles, but that plan is an unpopular orphan. Republicans won’t discuss taxes or global adventurism, and Democrats won’t discuss entitlements or welfare.

Therefore, there will be no fiscal reform, the deficit will remain large (and will grow as Medicare grows), and the fiscal problem will go from being difficult to fix to being beyond fixing. The likelihood of a fix is becoming very low.

Today's children will inherit a country at maximum debt capacity, like Japan is today. While we now enjoy the luxuries of low taxes and high spending, today's  children will not. The pleasures that we receive from spending their money will not be commensurate with the financial squeeze that they will face. The ultimate issue is one of intergenerational morality, or rather immorality.

To avert the coming crisis will require two things: (1) immediate fiscal consolidation; and (2) reform of the nation's healthcare and pension systems. The current state of play in Washington indicates that neither is politically possible. There is no political consensus for lower spending, higher taxes and drastic programmatic reforms. The overall consensus is for low taxes,  a high level of spending, and unreformed entitlements. Both the Simpson-Bowles and Ryan plans were dead on arrival, and no one wants to discuss them.

All of the "deficit reduction" measures taken by the administration and Congress since the crash (including the sequester and its “massive cuts”) have had little  impact on the 10-year fiscal outlook*.

The problem is not only that there is no consensus for reform, but also that the door for reform has almost closed. Too many baby boomers have entered the land of perpetual leisure, and too few have the inclination to die. They won't die for decades, they will vote, and there will be more of them than there will be working taxpayers. To the retired, Medicare and Social Security are Holy Sacraments.

I have argued in the past that a principal cause of the fiscal problem is inadequate inflation and inadequate nominal growth, and this remains my view. Higher inflation would reduce the deficit and flatten the trajectory of the debt ratios. It could also be used to partially erase the debt. But inflation these days seems about as popular as Medicare reform. It's not being debated (not even at the FOMC), and the world would probably explode in flames if the CPI ever went above 4%. So that simple solution is off the table, leaving debt accumulation as the likely alternative.

In the context of the looming fiscal crisis, the sequester is small potatoes**. It only affects a small part of the budget in a small way. I happen to like the sequester from a policy perspective, because it cuts defense by a meaningful number, which is good policy if, like me, you are uncomfortable with gold-plated overseas adventurism. Using fiscal policy to “limit the mission” is a good tactic. I also like the cuts to the bloated non-defense budget as well. Any cut is a good cut if your goal is limited government. But the sequester is political theater rather than real fiscal policy. Simpson-Bowles is real policy, as is the Ryan Plan. But they are not being debated.

*The Budget Outlook, CBO, 04 Mar 13.

http://www.cbo.gov/sites/default/files/cbofiles/attachments/Presentation_NABE-3-4-13.pdf

**The Budget Control Act of 2011
The BCA specifies automatic procedures to reduce both discretionary and mandatory spending during the coming decade. Those automatic reductions will take the form of equal cuts (in dollar terms) in funding for defense and nondefense programs in fiscal years 2013 through 2021. Under the BCA, the automatic enforcement procedures will reduce budgetary resources for defense programs by $492 billion over the 2013–2021 period. By CBO’s estimate, the automatic enforcement procedures will reduce discretionary defense resources by about 10% in 2013 and reduce the caps on defense appropriations by lesser amounts thereafter, declining to 8.5% in 2021. By CBO’s estimate, the automatic enforcement will reduce nondefense funding (excluding Medicare) by about 8% in 2013 and by declining percentages thereafter, falling to a low of 5.4% in 2021.

The European Kool-Aid Machine Is Still Working

Despite the drumbeat of defeatism from English-speaking economists, and despite three years of disappointing economic results, the Eurozone persists in the execution of its original "Plan A", adopted three years ago:
1. Balance eurozone government budgets by raising taxes and reducing expenditure.
2. Improve external competitiveness with internal deflation and market reforms.
3. Stabilize debt ratios through fiscal consolidation and the (eventual) resumption of economic growth.
4. Prevent speculative attacks and restore market access with credible long-term policies, backstopped by the ECB and the ESM.
5. Remove "exit risk" by the ECB's pledge to buy government bonds in the event of stress.

Now is an opportune moment to assess where "Plan A" stands with respect to probability of ultimate success. At present, all of the troubled countries (except Cyprus) are either in compliance with Troika agreements, or are otherwise implementing (or pretending to implement) fiscal consolidation and structural reform.

The bond market's reaction to progress to date has been positive, with yields declining and limited issuance resuming for a number of peripheral countries. The ESM has not had to make new loans (besides Greece), and the ECB has not had to intervene in the bond market. In the hierarchy of world crises, Europe appears to be moving to the back-burner, outside the spotlight of daily headlines and TV news bulletins.

Is there anything wrong with this picture? Yes, it's completely delusional. The eurozone's financial arithmetic continues to head inexorably in the wrong direction. 

The ECB's zero growth policy (ZGP) is slowly bankrupting the peripherals as their debt grows while their economies and government revenues shrink. The political pressure gauge is the unemployment rate, which has already entered the critical "red" zone for some of the peripherals. The human cost of the ZGP is immense and has not yet fully manifested itself in the political process. Zonal unemployment is now 12%, and zonal GDP is shrinking (yes, the whole zone).

But this is not an acknowledged problem for the eurozone, because employment is not an ECB mandate. Unemployment and growth are irrelevant to the European assessment of the success of Plan A. As far as the ECB is concerned, Plan A is a big success.

Let's agree for the sake of simplicity that the central problem for the eurozone is the growing risk of peripheral government bankruptcy, and that the best index of government solvency is the level and trajectory of the Debt/GDP ratio. This ratio can be forecast as follows: Debt + projected fiscal deficits + bank recapitalizations - debt write-offs = future Debt. GDP + nominal growth = future GDP.

What do we see? We see D continuing to rise due to declining government revenue and inflexible government expense, resulting in large and persistent fiscal deficits. On top of these operating deficits is the cost of unending banking system recapitalizations due to government and private-sector defaults. We see flat nominal GDP growth due to low inflation, lack of export competitiveness and inadequate domestic demand, exacerbated by fiscal austerity. 

Thus, D continues to rise while nominal GDP is stagnant (and shrinking in real terms). All measures of government creditworthiness have steadily declined since 2007. Credit ratings are being pushed out of investment grade as new risk thresholds are breached. (In Europeland, sovereign downgrades are irresponsible, unwarranted, and strongly discouraged.)

Other than further debt forgiveness by unhappy creditor governments and institutions (see: Bundestag), there is nothing visible on the horizon to reverse this process of government insolvency as manifested by the upward slope of the D/GDP ratio. The ECB remains satisfied with ZGP, and studiously ignores its enormous human and economic costs.

The current debate within the ECB governing council is not how to stimulate growth and bring down unemployment, but rather how to exit from further stimulus, since the crisis is over. The perversity of such thinking is remarkable in its indifference to evidence of failure. How much contrary data will it take to prove to the Germans that shrinking economies don't repay debt? (They have a selective memory about German history during the 1920s.)

This year, the eurozone disaster must inevitably grow from a purely economic crisis into a political one as well. The peripheral governments face multi-year depressions and their social safety nets and their "social models" are becoming badly frayed. 

Most of the peripheral countries are politically immature with fragile institutional legitimacy. Most of them have undergone multiple regime changes over the past century and few of them have been successfully democratic for longer than a few generations. Few of them have weathered a protracted depression under a democratic regime. Each country has a political inflection point, which will be reached as depression continues. Greece and Cyprus are already politically fragile.

The peripheral states are being stress-tested both economically and politically by the ECB's zero growth policy. As long as the ECB persists in running this sadistic contest, the odds of political failure will steadily increase, and may already be irreversible for certain countries. Europe is not Japan; it is much worse.