BIS Quarterly Review (December 2019) and Repo Markets

The December 2019 BIS Quarterly Review is out and it includes some very interesting articles.

There is one on the evolution of OTC interest rate markets.  Given these are an indicator of market volatility, the research is important, because the turnover of interest rate derivatives has increased for a variety of reasons; some of which are the changing structure of the market.

Collateral is king in the euro repo market.  Repo markets provide liquidity, but the euro repo market has seen activity which indicates investors are seeking particular securities rather than just liquidity and the availability and price of those particular securities has become a factor in the euro repo market.

One article receiving a lot of attention is one on the September stress in the U.S. dollar repo market

Italian Mini-BOTs Would Be Liability Swaps

In the last two weeks there has been a flurry of economic/financial writing about the Italian proposal for a parallel currency in the form of mini-BOTs by an Italian Lega politician, Claudio Borghi, who, as a former Deutsche Bank person, should understand the implications of a parallel currency deployment and who has been quite vocal in his desire to exit the euro.  Since Italy is the third largest economy in the eurozone, the impact would be significant unlike Greece.

Most of the writing has been monetarily critical --- concentrating on perceived debt increase to unsustainable levels and legality.  Papadia and Roth have tried to review the competing viewpoints through existing literature, but they omit the earlier 2015 Andresen and Parenteau electronic TAN proposal, which was the basis of the Varoufakis plan via Galbraith.  Papadia and Roth would have us believe the paper form would be better than the electronic form, because it would be less likely to be used criminally.  In fact, the electronic form is even less like currency, less expensive and simpler to implement, and not subject to counterfeiting.  Papadia and Roth make a good listing of what makes currency and what makes a security.  In their conclusions, they worry about the mini-Bot enabling an

Some Links from Week of 2/25 -- 3/3/2019

I do weekly research in economics and finance with the links available by subscription (contact me).  Here are a few of the approximately twelve pages for the past week.  The links are of interest and worthy of thought.  They do not reflect whether I agree with them or not.

Prospects for inflation in a high pressure economy -- Hooper, Mishkin, Sufi

Inflation Risks and Expectations

Fed Balance Sheet News

Future of Fed Balance Sheet - Quarles

What can we learn from the NY Fed's inflation gauge -- Tim Duy

 U.S. Economic Outlook and Fed Monetary Policy -- Clarida

Did the yield curve flip? -- SF Fed

Are Normal Yield Curves actually Normal?

20 Years of the eurozone

Public Debt through the years -- Eichengreen

Kraft Heinz exposes the corporate debt problem

Italy's Debt and the Spread

Italy's Carige bank faces 630 million euro capital gap 

What if the problem of the EU turns out to be Germany and its banks

Risky Retirement Business -- Carmen Reinhart

How imperfect knowledge shapes financial markets

Temporary price level targeting -- Bernanke

News and Central Bank Growth Forecasts

Bank of England reads the Guardian

Governments bears responsibility for income inequality and the tools to reduce it

Conversation with Emmanuel Saez


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Turkey is Harvesting the Risks of Its Foreign Denominated Debt

Noah Smith has hit the nail on the head when he writes that Turkey's currency crisis is the direct result, as many emerging nations have experienced, of issuing debt denominated in foreign currencies rather than its own currency.

It is just bad economics for any nation to issue debt in a foreign currency.  I wrote about this in relation to Argentina in 2010 and Argentina still, today, has the problems associated with foreign

Watch for Eonia Year End Spikes

In the last two days of November, the Eonia, which is the one day Euribor rate, spiked 6.1% and 6%, which is very unusual.  Bloomberg gave, as an explanation, that the National Bank of Greece had excess liquidity of 450 million euro which it loaned in the last two days of November to peers in its country, but would that cause two days of 6% spikes?  Was something else going on with eurozone bank liquidity?

The two regional Italian banks Carige and Creval have been struggling for additional funding, along with four other small Italian banks, to meet the ECB balance sheet liquidity rules and lower allowable NPLs (non-performing loans).  But any month end liquidity needs would have been relatively small.  However, new ECB bad loan rules will become effective January 1, 2018 despite significant opposition, particularly from Italy.  This will put additional pressure on Italian banks, because, while eurozone banks as a whole have 5% NPLs, Italian banks have 15% of that 5%.  The final compromise is to enforce the new NPL rules on a bank by bank basis, whatever that means.

Meanwhile, on 18 November Monte dei Praschi di Sienna, had to put $671 million (569.4 million euro) in reserve, before its new reorganization board meets for the first time in December, which

Douglas L. Campbell on "Breaking Badly: The Currency Union Effect on Trade"

Douglas Campbell has written a very interesting paper on the effects currency unions have on trade in which the analysis of the data comes to different conclusions than current economic literature.  He explains the paper in his blog post and his concerns that the paper will never be published, because he is going up against big names in the profession.  Basically, his paper tests whether omitted variables in past studies affect the analysis of a large data set.  He looks at each major currency union including the eurozone and appropriate control groups and finds according to the papers abstract: "As several European countries debate entering, or exiting, the Euro, a key policy question is how much currency

Is Federal Reserve and ECB Monetary Policy Coordination Practical?

Brad Setzer has an interesting post on central bank monetary coordination based on Lael Brainard's recent speech.  I am not convinced the issue is so much correcting "imbalances" or the supply of high quality government bonds in the eurozone.  If eurozone banks are keeping deposits at the ECB at a negative 40 basis points charge, what does that say about the balance sheets of those banks?  The ECB does not publish excess reserve data on a monthly or weekly basis; therefore, we have no timely means to track stock and flows.  Additionally, the ECB Asset Purchase Program is providing bank liquidity, but its operation has created excess liquidity in some surplus countries where the liquidity is less needed and regulatory balance sheet problems in other countries where banks need to hold on to

Waiting for Godot or Does Anyone Really Know What Is Going on with eurozone Banks?

I have been researching eurozone banks excess reserves and repo availability for a few weeks trying to work my way through muddled commentary and sort the reality from the assumptions and found myself questioning what I know.  In doing so, I have misstated to others what I am thinking and even the data, facts, and issues about which I am concerned.  Sometimes it is best to just stand back and look for the string that pulls the material together.

I have yet to write that article which will address whether eurozone banking rules to promote solvency of banks is creating a liquidity problem, because  the eurozone banking resolution authorities seem to have so badly mismanaged the Banco Popular resolution to the point of intensifying a bank run despite monitoring bank liquidity on a daily and hourly basis.

Banco Popular was Spain's 6th largest bank having been in existence since the early 20thCentury and one of the more profitable banks until about 2016.  In February 2017, it announced it had a 3.b billion euro loss on asset writedowns and Non Performing Loan sales while maintaining it still had more than sufficient quality assets on its balance sheet.

By the end of May and first days of June reports were circulating that Banco Popular had received only 3.5 billion euro on 40 billion euro collateral rather than the 9.5 billion euro it had expected one month previously and had applied to the Bank of Spain for liquidity support receiving only 10%

U.S. Term Premia and U.S. Economy

An economics/financial writer recently expressed surprise that U.S. five year term premia nearly matches U.S. 5 year breakeven inflation.  To me, it seemed obvious, in this low interest, low growth economy, that the above would be true.  In 2015, Bernanke commented on how low term premia appears to be holding down  interest rates.  In the March 2017 New York Federal Reserve Bank Snapshot of the U. S. Economy, on page 14, you can see the term premia of the U.S. Treasury ten year nearly matches the 5-10 year inflation risk premia.  This is what one would expect in a period of low growth, no significantly surprising political instability in the world, and no financial instability.

I find nothing wrong in my disagreement with the writer, because he pointed to data, expressed his opinions, and ended up asking questions.  The fact that I disagreed caused me, as is my habit, to look and see if I was right or wrong.

Here is a good compilation of how the New York Federal Reserve Bank calculates term premia how it has been used and evaluated.

I have, in the past, pointed readers to the New York Federal Reserve Bank U. S. Economy in a Snapshot monthly report.  Put it in your bookmarks to review monthly. 

In New York Federal Reserve's analysis of the last 15 bond market sell offs, it immediately struck me that the last sell off in July 2013 was consistent with the Cyprus "banking" crisis.  As a country which is a member of the EMU and uses the euro as its currency, Cyprus saw its banks closed, deposits seized or taxed to fund a bailout, and monetary capital controls imposed to keep money in the country.  The bailout terms, banks resolution, and capital controls were imposed on Cyprus, a sovereign nation, by the EMU.

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Are ECB Target2 Balances Ever Risky?

Izabella Kaminska is a very talented and intelligent writer for FTAlphaville and I try to read everything she writes, because she makes you think.  I will continue to read what she writes.  When she wrote yesterday that ECB Target2 balances are a big deal, I was thrown for a loop and wondering what am I missing.  I even reached out to another financial and economic professional for a give and take discussion.

Kaminska cites the March BIS Quarterly which shows that Target2 balances have substantially increased as the result of the Asset Purchase Program but CDS spreads have remained stable.  She then concludes that the capital flight during the 2012 Greek crisis was a big deal which resulted in Target2 balances increasing and creating "financing" by Target2 credit National Central Banks, such as the Bundesbank in Germany.  She also concludes this was a failure of the transmission mechanism and cites a paper on the old Soviet Union's International Investment Bank in an attempt to draw a comparison of flows and a failure of the transmission mechanism.

I have written about Target2 twice in 2015 (here and here) and discussed it with economic and financial professional in the United states and other countries.  Additionally, as I have previously cited, Whelan published an excellent paper on Target2 and how it works in 2012.

I am going to try to keep this simple.

The stable CDS spreads with increasing Target2 balances show the Asset Purchase Program is working.  In fact Footnote 3 in the BIS March Quarterly cites the BIS November 2016 Quarterly which states, "The ensuing upward trend in TARGET balances largely reflects the settlement of these cross-border transactions by central banks and, therefore, does not signal renewed stress in financial markets."

Target2 credit balances are money created by the ECB and not by financing from the credit National Central Banks.  National Central Banks are only liable for losses at the ECB to the extent of their Capital Key ratio, which with Germany is 17.9973%.  With respect to the APP, National Central Banks are only exposed to 20% of any APP losses which would be distributed according to the NCB's Capital Key ratio. 

With respect to the study on the Soviet Union's International Investment Bank, its failure was from pricing, industrial capacity, governmental policy, access to international markets, and a weak Soviet ruble unsuitable for international trade.  It is an interesting study of a failure of the transmission mechanism.  However, the ECB and Target2 during 2012 demonstrates the success of a transmission mechanism.  While the ECB balance sheet shows spikes in 2012 and currently, they are from two different causes and both speak to the maintenance of financial stability. 

The IIB transferable ruble loans to Soviet Block countries creating foreign currency denominated debt for those countries has some similarity to every eurozone country having its debt in a foreign currency (euro), but the eurozone is a monetary union (without a fiscal transfer mechanism) with a central bank (ECB) exercising monetary policy.

When would Target2 levels constitute a risk?  Any risk to Target2 would be a risk to the eurozone itself.  This is why arguments against Target2 have been arguments against the credibility of the euro as a currency and attempts to argue the euro is on its way to a currency crisis.  While I have long maintained the euro is treading towards a currency crisis, the crisis is dependent on growing political risk fed by a defective monetary union without a fiscal transfer mechanism which uses destructive austerity to compensate and only creates negative economic growth, more unsustainable debt, and a growing eruption of political unrest which is swelling to possible political risks in Italy and France. 

People are suffering.  Greece, which is already at depression economic levels, is again facing demands for more destructive austerity from the EMU and has never recovered from the EMU enforced coup in 2012 or the monetary warfare waged by the ECB in 2015.  Spain has had a temporary government for so long it may have forgotten how a real democratic parliament functions.  Spanish and Italian banks need support.  Portugal was allowed to keep its government on condition it did what the EMU wanted.  Cyprus had its citizens bank deposits taken away from them. It is no surprise people are unhappy.  And nobody really wants to ask how strong German banks, not just the large international banks (like Deutsche Bank and Commerzbank) but the national, savings, and landes banks really are, particularly since Germany has resisted including all its banks in ECB stress tests.

How serious would the political risk have to be?  If you look at the CDS spreads of 2003 euro bonds and 2014 (which have CAC provisions) bonds, you can see the increased political risk with the spreads between the two doubling to 40 basis points.  This perceived political risk ignores the possibility of an eurozone country actually exiting the EMU, changing its countries bond laws and abrogating CAC's, and redenominating its debt from the euro to its own fiat currency.  Just using Target2 balances as a base example, it is easy to see that if Greece and Portugal both left the EMU, the EMU could easily survive with its monetary credibility tarnished.  However, if Spain and Italy left and defaulted on Target2 and redenominated euro debt, it would create a significant loss and change in remaining eurozone countries Capital Key ratio.  Even if France left, it would create a significant change in remaining countries Capital Key ratio and create damaged euro credibility.  A currency depends on its credibility to survive.

Could the eurozone survive as a monetary union without Spain and Italy if they defaulted on Target2 and redenominated their euro debt?

The political risks are growing and they are not supportive of democracy. 


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Economy & Market week ended 12/25/2010

Here is a draft post from 2010 early 2011 which did not get published in which the dysfunctionality of  the eurozone was so obvious and yet so ignored today.

For a Holiday week, a tremendous amount of information flowed and we are going to cover the eurozone, Ireland, Germany, bonds, the euro, other countries like the UK, China, the new tax bill in the U.S., the mortgage mess, austerity in U.S. municipalities and States, unemployment, sectoral balances, the effect of home prices on small business, and the market and investing.  You should find this material pertinent and thought provoking.

Michael Hudson in discussing how financial interests determine sovereign policy argues that bankers are getting politicians to siphon off public money bail bankers out of their mistakes at the expense of capital formation and living standards.  Latvia is an example of how the economy has been subjected for the purposes of bankers just as if it has been militarily defeated and occupied.  Germany is serving its bankers and not the people; Germany needs to adopt more progressive tax and financial policies.  Hudson sees the current crisis as a sovereign crisis --- who is in charge and responsible for taking care of the citizens --- not a true debt crisis.  Banks should be forced to realistically value assets and debts on their books.  There is no need to wreak economies with financial asset stripping.  Debt needs to be restructured with the help of a progressive tax and a true central bank which can help finance governments.  He wants to see taxes shifted back on to land and resource rent as well as financial and capital gains.  He wants to de-privatize basic utilities and natural monopolies to take control from rentiers and prevent Europe from being turned into a tollbooth economy.

Edward Harrison acknowledges that eurozone internal devaluation and austerity is not a politically sustainable solution and there are only three possible outcomes in his opinion: monetization, default. or breakup.  Charles Wyplosz sees the problem as a lack of alternative options planning allowing decisive action, because the ECB has been consistently late to help.  Wyplosz remains concerned about debt and possible default.  He sees six questions which need to be addressed: can eurozone member nations face down the markets, is there a strategy for avoiding defaults, is there a plan to organize defaults if they occur, can a first defaulter be ringed to avoid contagion, if sovereign default is a possibility should banks also need to fail, and is ECB independence threatened by its need for more capital?  Daniel Gros finds the debate in the eurozone over the structure and financing of a stability mechanism self-defeating and likely to promote a festering situation which does not solve the lack of growth in the countries affected and the increasing costs to refinance with rising interest rates.  Geoffrey Underhill sees the problem as fully understood from the beginning of the euro as a lack of federalism.  The eurozone needs to act as a federal union consistent with the primacy of Germany as established by the structural formation of the euro and the ECB needs to proved guarantees to the "provinces" "... and adequate internal resource transfers to compensate for the fully predictable adjustment asymmetries in the absence of intra-Eurozone devaluations."

Is Germany, in demanding at the European Summit that "... there would be no fiscal transfers to troubled economies, and that the best way forward is further fiscal consolidation, along with plans for the private sector to share in any losses after a sovereign default", acting in its best interests?  Gavyn Davies believes Germany is not acting in its best interests.  There is a "damaging effect of a permanent increase in the interest rate spread of 1 per cent over Germany fully offsets the beneficial effects of reducing the budget deficit by 1 per cent of GDP for the troubled EU economies."  He believes the strategy emerging from the Summit will not work and the stronger EU economies could make a big difference by providing the weaker economies with liquidity in the form of lower interest rates.  Davies uses a recent paper by Lupton and Mackie to demonstrated the arithmetic to show Germany cannot continue to assert its creditor nation policies which will not reward these weaker nations and demands they suffer the sanctions befitting their debt and not place German banks on the precipice of shared suffering in sovereign default by any one of these weaker nations.

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Kicking euro IED Down the Road & Global economy: Radio Appearance July 7, 2012

In a radio appearance on Saturday Session with Bishop on July 7, 2012, we talked about how the eurozone is no longer kicking a can down the road but it is kicking an IED down the road and when it explodes it will have global repercussions.

We discussed the Libor scandal and the banks involved.

We discussed US unemployment and how the Fed's warning on the "fiscal cliff" is not just about revenue but the need of the government to spend if continuing high unemployment is to be lowered.

We discussed how the Fed minutes from the preceding month which would come out in the week of July 9th would not show any inclination towards QE3 and would show concern about the potential economic impact of the eurozone currency crisis blowing up and the continuing threat of US fiscal contraction (the need for government to spend to address the unemployment problem).  And we were right on as the minutes show.  The Fed FOMC meeting statement in July continued its reluctance to do anything which might place it in a political cross fire during an election year.

Here is Part 1 of the interview.

Here is Part 2 of the interview.

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Radio Interview 2/25/2012: Greek Bailout, Europe, and Federal Reserve QE3

We were interviewed on Saturday Session with Bishop about Greece and the proposed bailout and how it forces Greece to relinquish its sovereignty.  The details of the proposed bailout, which would include new restrictive laws, more pension reductions and spending cuts, the prohibition against any Greek political action contrary to the bailout, and the requirement to make debt payments before any public spending in Greece would be allowed, and the need for resolution prior to March 20th, which is the date on which Greece must pay maturing debt.  Greece is already in technical default.  We discussed the imposed austerity programs and how they are making Greece's economy even more unsustainable.  We discussed how Greece will inevitably face the choice of default within the euro or default with abandonment of the euro which is a choice between economic slavery as a colony of the eurozone (Germany) with foreign EU/ECB technocrats running the Greek government or the harsh new beginning of freedom with a new sovereign currency which could devalue up to 80% after a fixed exchange from the euro to the new currency and the redenomination of  all Greek public and private debt into the new currency and the possibility of economic growth.

While it may appear that the United States has decoupled from the developing storm of Europe, the consequences of a currency union without a fiscal transfer mechanism, recession in Europe, eventual Greek default, and the pressure on European banks and other eurozone peripheral countries will have global consequences on financial liquidity and the world economy including the United states and China.

We also went over the minutes of the last Federal Reserve Open Market Committee (FOMC) meeting in which most members are not inclined to initiate a QE3 unless disinflation reasserts itself and economic growth weakens in the future.

An MP3 of the interview is here.  The European situation and the tragedy of Greece have been unfolding in very predictable and obvious fashion for a few months.  Even Wolfgang Munchau has finally acknowledged that Greece needs to default.

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Blogging, Clients, and the Impending European Implosion

In the first week of October, it became obvious that what needed to be done in Europe to avoid a financial crisis which will become a global financial crisis will not only not be done -- it is being ignored and economic history denied in immoveable Orwellian terms.  The EU Summit was a colossal failure and, despite media reports to the contrary, nine countries, other than the UK which opposes the Treaty changes, must consult their parliaments and Ireland may need to seek public approval.  Since the euro has never survived a public vote, it will be interesting to see to what extent the EU will go to suppress any public vote in Ireland or elsewhere as it did in Greece prior to staging its coup d'etat and deposing the democratically elected government of Greece.

To hear more of my analysis, including my concern that the euro has become an enemy of democracy, of the European economic crisis, listen to my most recent radio interview here.

It became my duty to serve my consulting and advisory clients to get them to position themselves appropriately consistent with their business model and to rebalance individual portfolios defensively.   Anyone who has not taken by advice or implemented my advice: Good Luck.  Desired results require decisive and informed action.

Consequently, I have not been blogging despite have several large articles researched which I have not had the time to write.  I would like to write everyday.  However, I do not like to write just to write but when I have something substantive to say.  What little advertising is on this blog site is obvious and minimal.  The links --- all links --- within my blogs are substantive sources and often offer different views.  No links within my blogs are advertising, which I find a repugnant practice.  Blogging is not about making money; it is about ideas and communication and discussion.  Other bloggers, not all, have found my practice of link referencing sources, much as academic papers would be referenced, and providing extended reading material through those links as impediments to cross publication.  On the other hand, individual opinions without substantiation seldom rise to Proustian levels. It also means I do not close my mind to different viewpoints and attempt to remain true to the data and the developing macroeconomic environment.  I have never been a joiner of cliques and have been schooled in critical thinking in which no one's opinions, including my own, are sacrosanct.  If this offends others, so be it.


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Is the Euro Steeped in Self-Deception and Suicidal Delusion?

After only one day, the Euro Deal of the recent EU Summit began to wilt under the bright heat of the flood lights of rational scrutiny.  On Day 2, we saw a repetition of how the German Constitution is a fundamental stumbling block to a politically united eurozone fiscal union with additional pleadings which could force Bundestag approval of EFSF bond purchases (not the bond purchase program but the actual individual purchases themselves).

We also saw on Day 2 the Erste Group bank of Austria suddenly writedown its CDS portfolio by 1.49 billion euro creating a a 750 million euro shortfall just two weeks after projecting a profit and reducing its 2010 profit 12%.  It reduced its CDS portfolio to 300 million euro yesterday from 5.2 billion euro as of the end of September.  It also announced it was cancelling its repayment of 1.2 billion euro in State aid, while proclaiming it had no intention of requesting new State aid as it would cover the loss with a 35% (only) return of executive bonuses and the use of retained earnings over the next three quarters.  It should be noted that the Erste Group had substantial exposure to Eastern Europe as do Greek bank Subsidiaries in Eastern Europe.

Worse, not only is Sarkozy seeking China's investment in EFSF bonds or the SPV to be created (Van Rompuy is on record from earlier in the year favoring consideration of Chinese investment), but Klaus Regling, the executive director of the EFSF, was not only already talking with the Chinese but even suggesting that EFSF debt could be issued in Yuan.  It is economically incompetent for a sovereign nation with its own fiat currency to issue debt denominated in a foreign currency.  For a monetary union with no fiscal transfer mechanism to issue debt in a foreign currency (Yuan), when its member nations are under credit attack for debt already denominated in a foreign currency (euro), is beyond incompetent; it is economically suicidal.

The surplus countries of the eurozone have the money to invest in the deficit countries; there is no need for foreign investment in eurozone debt which will cause the euro to be sold and dollars purchased by the eurozone countries which will strengthen the euro and make eurozone exports more expensive.  The surplus eurozone countries, in order to economically correct trade imbalances within the eurozone, should be using the current account surplus funds to invest in the infrastructure and manufacturing of the deficit countries. The Euro Deal of this past week has not increased the equity stake of member nations; it only has the member nations providing insurance guarantees. 

The one size fits all approach of the eurozone just does not work.  The deficit countries cannot export and privatize their way into surplus under austerity.  The current account surpluses needed to drive down the existing high private sector leverage and public sector deficit in the deficit countries is too massive (even in Ireland) to be obtained from export growth and the privatization of public assets.

Yet, the mantra of convergence, competitiveness and austerity remain as the key mistakes enshrined as European Monetary Union holy grails carry forwarded from the EMU 1991 currency crisis.  Convergence never happened.  Kantoos Economics, a German economics blog, has had two recent posts which exemplify the group think mindset of the European Monetary Union. One was on competitiveness in which a post by Kash Monsori is used in an attempt to show how misunderstood the European concept of "competitiveness" is and that imposed austerity in the deficit countries is not a self fulfilling economic disaster. The second post on Kantoos Economics is on the "necessary" rigidity of currency unions and internal devaluation as the only method of adjustment for trade imbalances with a currency union.  If Kantoos Economics wants to take on a non-European on competitiveness, then Kantoos would be well advised to take on Rebecca Wilder who has shown the "competitiveness" concept as promulgated in the eurozone is a chimera in which all countries must be like Germany in which the concept has become to mean the efficiency of the economy as a whole involving "...strong macro-prudential policy, infrastructure, efficiency and income gains, savings, etc."  In fact, the concept of competitiveness more generally describes and reflects data from a variety of factors such as education, infrastructures, institutions, technological development, health, macroeconomic environment, market efficiency, labor efficiency, and innovation to name a few.  It is always best when theory adapts to the reality of data rather than morph data to fit a phantasmagorical theory.

When one looks at worker statistics, the Greek worker works longer hours for less money than workers in other EU countries.  However, most Greek workers are involved in agriculture and the worker productivity has a smaller euro value.  For productivity to improve, there needs to be technological improvement within Greece.  In fact if you look at the northern and southern eurozone countries, there is no evidence of profligacy and laziness.  What you will see is, the creation of the euro lead t a massive flow of capital from the northern countries to the southern countries, because it was profitable for the northern countries.  Marshall Auerback and Rob Parenteau have provided a concise and strong economic criticism of the Greek myth of profligacy and the ultimate self-destructive nature of austerity not only on the deficit countries but also on the surplus eurozone countries.  They paint a convincing picture of the need for a more coordinated mutually beneficial growth option involving direct investment by the surplus countries in the infrastructure, technological development, and manufacturing of the deficit countries.

The Australian economist, Bill Mitchell, who has been a long time critic of the euro, sees the Euro Deal as one which solves nothing, continues all of the same problems, intensifies the anti-democratic policies of the eurozone, and increases the pressure on the surplus countries to suffer the same fate as the deficit countries.

What does this leave us with?  Desperation, human suffering, failed nations, a breeding ground for authoritarian regimes, economic collapse?  Or does it leave us with an existential epiphany of NO HOPE and the recognition of a common humanity and purpose that digs down and comes up with the political will to get things done for the best interests of the many and a respect for individual freedom which promotes unbiased, empirical analysis of economic data, the needs of aggregate demand, and recognizes the economic growth power of full employment?

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Euro Deal Euphoria or Wake?

The announcement of a euro deal emerging from the EU Summit on the "debt" crisis yesterday pleased the markets, but it has solved nothing  and appears to have a 100% chance of failure.  In fact the deal only further exposes the the fundamental construction weaknesses and limits of the euro which has doomed it to failure.

How far can you kick a can down the road with a dead cat inside?  Apparently, only one day.  Italian bond yields exceeded 6% at auction today.

Auerback, Wolf, and De Grauwe, among others, have called for the ECB to step up and be a lender of last resort consistent with the role of a central bank.  Unfortunately, the ECB by Treaty construction and ECB rules and establishment is not a real central bank and does not have the independent authority to buy bonds, issue currency (the NCBs issue currency under a rigid ratio per nation with the ECB limited to 8% for clearing purposes), or provide liquidity without difficult collaterization guidelines being met.  The ECB in setting interest rates has shown an inclination to be overly concerned with headline, rather than core, inflation which has caused rates to raised at least one time to far and maintained unchanged rather than lowering rates which has primarily served Germany and France at the expense of the deficit countries.  The ECB can only buy bonds on the secondary market and only of prescribed credit quality.  In its attempts to buy bonds on a limited basis to assist in relieving credit pressure and yields, it has faced significant political opposition from surplus countries which has caused it to act as a Fiscal Enforcer and threaten and/or hold back needed liquidity to NCBs in Ireland, Greece, Portugal, and Italy to force national politicians to enact budget cuts and austerity measures despite no public support in those countries.  The role of a real central bank is monetary policy with the ability to provide liquidity, buy bonds, set interest rates, and promote monetary stability as well as act as a clearinghouse.  To get the ECB to act as a real central bank would require Treaty changes and a complete change in the rules and functions of the ECB.  There is not enough time.

Trichet has even recommended a Finance Ministry for the eurozone, but what good would a Finance Ministry have if there is no fiscal transfer mechanism, eurozone taxing authority, and relinquishment of national sovereignty by member countries?  The EU and the eurozone has suffered for too long the determination of sovereign policy in member countries by an elite which is defiant of democratic approval.

Munchau has repeatedly expressed doubts on the leveraging proposed for the EFSF and the SPV which will apparently be created.  Has everyone forgot how disastrous the big banks SPVs were going into the recent Great Financial Crisis?

Sarkozy is promoting the involvement of China when this would only worsen the economic problems as I and Tim Duy have written citing Michael Pettis.

The 50% "voluntary" haircut is not enough and it is unlikely there will be 100% private participation and 1.4 trillion euro EFSF funding is not enough, particularly if European bank's liquidity and recapitalization is eventually challenged.  Additionally, it is popular to overlook the very negative direct effect these haricuts would have on Greek banks if Greece stays in the eurozone.

Many commentators have questioned the jury-rigged euro deal's attempt to structure 50% haricuts as not a defined default triggering CDS.  In fact, in just one day, Fitch has said the 50% haircuts do constitute a default and will affect Greece's credit ratings send the euro down.

The eurozone crisis band aid approach of temporary patches is not sustainable and is just setting the stage for recession and the eternal re-emergence of the very same problems.

Is the eurozone a monetary union with a stable currency benefiting all of its members or is it a tontine in which the last remaining country becomes the Imperial power and the other countries its colonies?  Meanwhile, Greece, Ireland, Portugal, Italy, and Spain are being repeatedly raped and France has been moved to the credit rating coming attraction.


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BRICS to the Rescue? Kiss Eurozone Growth Goodbye

In September, when Michael Pettis' private newsletter discussed how destructive a BRICS rescue of the eurozone or any eurozone country by buying bonds would be, his observations and conclusions were too obvious to justify further comment.  Here is a shorter public version of the newsletter.

Bottomline, if China and Brazil were to buy sovereign bonds in the eurozone or EFSF eurobonds (if any are ever approved), it would would mean the eventual shift of financial flows to the BRICS from the eurozone stifling eurozone economic growth, because, as Pettis said, "foreign investment simply replaces domestic savings, undermines the manufacturing sector, and raises unemployment or debt."  As the BRICS bought European bonds, the Europeans would be forced to buy United States bonds, US dollars would be sold to buy euro and the euro would strengthen while trade balances would shift to the BRICS, particularly China.  This is the consequence of foreign investment.  To make matters worse, as Pettis points out, the foreign investment is not needed as Europe is awash  in capital in the surplus countries.

Yet, as the trade surplus nations of the eurozone continue to avoid the trade imbalances within the eurozone, this possible scenario is being floated as the EU Summit  draws out with France and Germany unable to agree and the UK demanding all EU countries participate.  This will only seriously aggravate the eurozone problem as, according to Pettis, "the increase in foreign investment would simply be matched either by an equivalent reduction in domestic savings or an equivalent increase in domestic debt to counteract the rise in unemployment. Rather than ease the burden, in other words, foreign investment simply replaces domestic savings, undermines the manufacturing sector, and raises unemployment or debt."

If the BRICS want to help Europe then they need to invest in infrastructure and manufacturing in the eurozone and, particularly, in the peripheral countries.

If BRICS buy eurozone peripheral sovereign nation bonds through the EFSF or individually, the eurozone can kiss economic growth goodbye and the currency problems of the euro multiply with decreased savings, increased debt, increased unemployment, and loss of trade surplus to non-eurozone countries.

As we indicated in our last post, the eurozone needs to decide if it will be a fiscal European Union or if it needs to break up. 


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Has Germany Castrated the Euro?

The German Bundestag now has the legal authority to require the German government to submit all EU proposals which will have budgetary effect to the Bundestag for approval prior to negotiation committing Germany to any agreement.  This virtually prevents the German executive from negotiating any substantive EFSF or other economic support for the eurozone as a whole, or particular member countries, through the EU, ECB, or EFSF.

Despite early French-German discord, there was some renewed hope that a 3 trillion euro package could be put together for the EFSF only to have the German Finance minister quickly and very publicly state that no miracle cure will emerge from tomorrow's EU Summit on the eurozone's sovereign debt crisis and further stating that the process for resolution will take much longer into next year, which has again placed focus and pressures on bank credit and liquidity rather than the more centrally important issue of sovereign risk in a monetary union without any fiscal transfer mechanism.

The EU Summit tomorrow will not only be a disappointment, but it could well be the ultimate stone thrown on the victim of European union.  The 3 trillion euro package has been reduced to 2 trillion and now they are again talking of 1.3 trillion with no additional public sector haircuts beyond 50%, when it is obvious is needs to be much larger if not 80% or more, at the insistence of the ECB, although that would only amount to a 22% writedown of Greek debt and far too little money to provide bank recapitalization and sovereign credit support.  European banks alone face a potential 7 trillion loan contraction.  A conservative economic stabilization fund would need at least 10 trillion if bond buying to support sovereign credit is included to provide some (this is an off the cuff figure and would only be a temporary solution as the political problems will lengthen the process) time to politically provide either the necessary treaty changes with democratic approval for fiscal union or a planned orderly default and withdrawal of Greece from the eurozone.

Already France is being threatened with a ratings downgrade by Moody's and the S&P is warning of an EMU downgrade blitz.  European officials and economists have lost focus on the big picture in attempts to defend cherished political and economic policies which defy real economic data.  While Munchau has maintained the optimal fix would be a democratic fiscal union with the alternative an unacceptable public recapitalization of European banks, this, in my opinion, would only further the depth of sovereign risk and potentially endanger democratic rule.  Munchau has asserted that the choice will be between fiscal union or break up.  Martin Wolf has essentially agreed in the need for fiscal union as first aid will not remedy the eurozone internal balance of payments crisis which is at the heart of the euro currency crisis, as Michael Pettis has clearly described as an economic imperial and colonial relationship.

The European Commission's assessment report has been leaked which shows the total unsustainability of current program and proposals and further discloses the ECB does not agree with the private sector involvement scenarios.  The full leaked version can be found here.   As Rob Parenteau and Marshall Auerback have asserted in private email communications (of which I was a copied recipient), this document substantially documents not only the unsustainability of current programs but refutes current austerity economic polices as indefensible.  In another private email to them from Martin Wolf, he has indicated that Greece's present problem is one of economic flows, which is correct for the current situation in which Greece's debts are denominated in a foreign currency (euro) and default would gain Greece little.

However, any planned, orderly default by Greece would require an immediate take it or leave it redenomination of all Greek debt, public and private, into the new Greek currency.  This would establish an economic stock in which the economic flows are secondary as a fiat currency sovereign nation which taxes cannot become insolvent. The market would decide the haircuts and devaluation.  Most economic speculation has assumed any Greek default would be within the euro which would be suicidal sacrifice on the alter of European union on the part of the Greece, whose citizens do not appear to want to slink into the darkness of slavery quietly.

The EU Summit tomorrow will not only be a disappointment, it may well be a defining moment of existential despair.  In that despair, what choices will the different people of Europe make?

UPDATE:

Here is a post by Rob Parenteau entitled "Leaked Greek bailout document: Expansionary fiscal consolidation has failed" which can be found at Credit Writedowns here.


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Michael Pettis on the Euro, Swiss Franc. RMB trading, and Chinese Debt

In a very long private newsletter received on September 13th, Michael Pettis began with "Slow growth is embedding itself solidly into the US economy and the bond mayhem in Europe continues. The external environment for China is getting worse. This will almost certainly make China’s adjustment – when Beijing finally gets serious about it – all the more difficult. With still weak domestic consumption growth, and little chance of this changing any time soon, weaker foreign demand for Chinese exports will cause greater reliance than ever on investment growth to generate GDP growth.

"Europe’s travails in particular can’t be good for exports. What’s worse, it’s now pretty much official that the euro will fail soon enough."  Pettis saw Merkel's assertion that the euro will not fail as an official government denial confirming that it could fail as in the political maxim, "The first rule of politics is never believe anything until it is officially denied."  Pettis then proceeds to discuss in depth Otto Henkel's proposal ( "A Sceptic's Solution - A Breakaway Currency") for a two currency euro.  Although Pettis thinks there is little likelihood of the creation of two euro currencies dividing the deficit and surplus eurozone countries, he likes the idea, because all the deficit countries will not adjust fast enough as long as they maintain the euro and their economies will continue to contract and debt grow until their electorate rebels.  If those countries will then leave the euro and default and the surplus countries will eat the losses, why shouldn't the surplus countries force the deficit countries to leave the euro now?  Pettis answers his own question.

If a deficit euro country leaves the eurozone and adopts its own fiat currency, Pettis believes it would be caught in a downward currency spiral such as Mexico in 1982 and 1994 and Korea in 1997 suffered, because a substantial portion of Mexican and Korean debt was denominated in foreign currency.  A deficit euro country leaving the eurozone would have its debt denominated in euro.  This would be a foreign currency.


My comment in response to Pettis on the above scenarios is the High euro and Low euro bifurcation would merely create to stage productions of the very same play; one with a short and the other a longer audience length of the play.  Both would suffer the same, inevitable fate of the exporting country economically subjugating the importing countries with no fiscal transfer mechanism to resolve the current account imbalances creating an inevitable currency crisis as the deficit countries are challenged by the bond market one by one since they cannot guarantee payment under such a system.  Any eurozone country which withdraws from the euro must default on all euro debt and immediately redenominate all public and private debt at a fixed conversion to the new fiat currency on a take it or leave it basis and then let the new fiat currency trade freely with the market deciding the devaluation, which must occur.  The euro is a foreign currency to all eurozone countries and it would be irresponsible to leave debt in euro when exiting to a fiat currency; yet, almost all scenarios of such exits assume the debt would remain in euro.  That would be a fatal economic error.


As Pettis well knows, as he continues, to leave debt in a foreign currency means the devaluation may well not be in line with estimates of overvaluation.  It could cause a devaluation of 50% or more, when the overestimate might be only 15-20%.  The external debt would rise as its fiat currency devalues, because it would remain denominated in an appreciating foreign currency.  The credibility question of bond payment would rear its ugly head again and financial distress cost would rise just as they are now.  As domestic borrowers try to hedge the currency risk, investors would flee the new fiat currency in a self-defeating currency crisis involving foreign currency debt.  Default would be unavoidable.


For Pettis, this is not an argument for a deficit country to stay in the eurozone, because, if the deficit country "stays in the euro, we will still arrive at default, but much more slowly, and mainly at first through a grinding away of wages and economic growth over many, many years and a gradual building up of debt as Germany refinances Spanish debt at interest rates that exceed GDP growth rates. The default will occur anyway, but only after years of high unemployment."  He leaves unstated the likelihood of growing social unrest and intra eurozone national distrust of the surplus eurozone countries.


This is why he likes Henkel's two euro currency idea, but with the surplus country (such as Germany) leaving the euro as Marshall Auerback has repeatedly suggested.  The new fiat German currency would immediately appreciate while the euro depreciates, but their banks would still have loans in euro which would cause them significant losses.  Pettis thinks the losses would be less and more orderly than a deficit country leaving the euro.  Either way the surplus country leaving the euro would take a big hit and it is a waste of time trying to avoid it and it is better to face it and deal with it and "as any good Minskyite would tell you, that means we have to pay special attention to the balance sheet dynamics."  Pettis also believes this would set up a two entity Europe of Germany and its associated countries and France and its associated countries.

With respect to the Swiss franc, Pettis believes the Swiss National Bank has decided to become very serious about currency wars.  Switzerland is enduring a large inflow of foreign currency and appreciation of the franc with significant negative impact on Swiss exports.  "The world is seriously deficient in demand compared to capacity and every country is going to try (has already tried) to capture as large a share of that demand as it can. This means every country is going to try aggressively to export capital or limit capital imports."

"But of course it doesn’t work that way. If capital-exporting countries want to increase capital exports in order to acquire a bigger share of global demand, and capital-importing countries want to limit or reverse capital imports, something has to give way. This is basically what we mean by trade and currency wars."

Switzerland has chosen to slow or eliminate foreign capital inflow by capping the rise of the franc.  Pettis believes it cannot work and there will be massive speculative inflows in the Swiss franc on the expectation the inflows will cause the Swiss National Bank to revalue.  In a few months the SNB will have to take even more forceful measures.  When countries continue to desperately export capital to each other while continually crying foul at attempts to import capital, currency wars will roll on as he explain in his recent Foreign Policy article. 

This also means we should not get too excited about news London may become an offshore trading center for the Chinese RNB currency.  Every time the suggestion is made that the renminbi will become more international, excitement sweeps the world, although nothing ever really happens.  One only has to look at the developing currency wars and understand everyone wants to export capital and no one wants to import it so why would China want its currency to evolve into a reserve currency by trading internationally.

There has also been speculation that a country like Nigeria would want to diversify reserves and hold renminbi, but Pettis thinks this is only a speculative idea based on the renminbi price being heavily subsidized by the PBoC and, therefore, only likely to appreciate.  China is unlikely to allow any but the financially small countries to attempt this and does not want to see it at all, since "The PBoC is required to buy up all the dollars offered in exchange for RMB in order to keep the value of the currency where it is, and any increased foreign demand for RMB bonds automatically means that the PBoC must take the other side of the trade. Its reserves will have to increase by exactly the amount of dollars that Nigeria (or any other foreigner) uses to buy the RMB. And the faster China’s reserves rise, the greater than domestic monetary mayhem and the greater the losses the PBoC will ultimately take on the negative carry and the revaluation of the RMB."  The short version of his discussion of this in his mid-May newsletter was "...that once you exclude intercompany transactions, nearly all the trade activities denominated in RMB consist of Chinese imports, and almost none of it consists of Chinese exports. Why is this important? Because Chinese imports denominated in RMB result in long RMB positions in Hong Kong, whereas exports result in short RMB positions."  Once the speculative demand dries up, there is little real demand for RNB transactions and the off shore RNB market would be very small.

Speculative demand will begin to dry up when the perceptions on the total amount of debt on the Chinese national balance sheet begin to improve.  However, debt levels continue to rise and rise very rapidly.  Most analysts have downplayed the resulting credit impact of China's spectacular growth.  Such an analysis implies China has an infinite debt capacity, which Pettis finds impossible.  What concerns Pettis now is that as analysts have caught on to this, the "horror" stories have begun to multiply out of control about "...cash flow squeezes among SOEs and the smaller banks, about unrecorded guarantees and lending by SOEs, about highly pro-cyclical lending by banks, about a huge variety of dubious transactions in the informal banking sector, with non-transparent links to the banking sector, and so on and so on. Everyone nowadays seems to have horror stories.  For this reason, Pettis advises we remain skeptical.  We should not scare ourselves into overreacting.  Pettis does not see China reaching its "... debt capacity until one of three things has happened:

1. Depositors flee the banking system because of uncertainty about repayment prospects. I think this is unlikely to happen unless inflation rises sharply and, because of the highly adverse cash flow impact of high nominal rates, the PBoC is unable to raise deposit rates sufficiently.

2. Household transfers are too high. Debt servicing costs should be met out of the increased economic activity generated by the debt. If they aren’t, the balance one way or another must result in a transfer of wealth from one sector of the economy – usually the household sector. As these transfers rise, the ability of that sector to generate growth becomes smaller and smaller. At some point the transfers are too large to be managed, and investment growth must stop. Of course if the government begins to privatize assets and uses the proceeds to clean up the banks and repay loans, this problem need not happen.

3. The private sector becomes so worried about the possibility of financial instability and rising of financial distress costs that they disinvest faster than the government can invest."
   Another way to extend debt capacity limits, according to Pettis, would be similar to Brazil in the mid 1970's when it was "saved" by massive petro-dollar recycling and a subsequent lending boom switching domestic debt to external debt, which allowed Brazil to keep investing and growing until the 1982 crisis and a lost decade.  In principle, China could do this, but it is unlikely to become a net foreign borrower as it would also have to reverse its huge current account surplus into a current account deficit.  He thinks there would institutional impediments preventing this from happening.
   
   
   Everyone knows by now that Chinese inflation is down to 6.2% in August, but he finds these numbers to be so much within expectation that he has nothing to add.  Inflation appears to have peaked, but the numbers require another month or two of observation and Pettis believes the PBoC also believes this.  There is also growing concern among economically literate policymakers about rising debt and weak consumption, because these are basically the same problem.  He expects to see comments back and forth on inflation, but a number of policymakers are reluctant to support more expansionary credit growth as a credit contraction is politically very unlikely.
   Pettis remains concerned that the Chinese consumption imbalance remains a fundamental problem despite Yukon Huang writing in the Wall Street Journal that consumption is in fact far higher than official government figures and takes issue with Huang's interpretation of the studies cited, because one study actually shows 2/3rds of hidden income accruing to the top 10% wealthiest and almost all to the top 50% and, since the wealthy a much smaller share of income than the poor, it would suggest the consumption imbalance is actually much larger.  Pettis also finds the reported size of the imbalance by Huang to be astonishing.  Just because the NBS data is awfully wrong, this would not increase China's invulnerability from crisis.  In the end, all the possible arguments against the dismissal of the fundamental consumption imbalance problem need not be made, because the balance of payments tell us it is extraordinarily low.  "... China doesn’t have either a current account deficit or a balance of zero. It has instead one of the highest current account surpluses ever recorded. This can only happen if the savings rate exceeds by a huge margin the investment rate – which, remember, was itself by 2008 the highest we had ever seen, and which has soared even further in the past few years
   
   
   "By definition, then, China’s savings rate must be extraordinarily high to allow it both a huge investment rate and a huge current account surplus. Since savings is simply the difference between total production and total consumption, China must also have an extraordinarily low level of consumption in order for the balance of payments to balance. I would argue that it almost certainly does."

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Edward Hugh Links: On the Eurozone Crisis

Despite the misplaced hope of the stock markets this past week, the eurozone is headed towards a decision point the leaders of the eurozone do not want to face.  I heavily research the eurozone macroeconomic issues as well as China, because they have global implications.  The eurozone could quite easily unravel with a Greek default within the euro or the need to bailout Spain or Italy.  A currency crisis would ensue and European banks and, quite probably, banks globally could have significant liquidity problems as the interbank market freezes up with the possibility, if nations are not prepared to fund liquidity through their central banks and governments, of some banks failing.

Edward Hugh is an intellectually eclectic British born macroeconomic economist who lives in Barcelona.  Whether one agrees with his conclusions or not, he always has something important worthy of consideration to say.

Here are some observations on eurozone and China PMI showing slower growth.

Ireland is being advertised by the eurozone as a success story to sooth the egos of the newly indentured (to European banks) Irish people.  What is going to happen to Ireland, which is a trade surplus exporting country dependent on exports for its economic recovery, as the global economy continues to slow down?

High Noon is approaching for Greece

Italy has low growth, an aging population, and is the third largest economy in the eurozone.  Can they make the penalty kick?

I have repeatedly stated privately that the breakup of the eurozone into a High euro and a Low euro will only create two stage productions of the same play with different lengths of production and the same tragic ending.  Here is Hugh's take on the subject.

Here he discusses recession risks in Germany.

Here he reviews the recession warning on the eurozone periphery.

Here he covers the flashing red lights for eurozone growth.

Hugh correctly identifies Italy, not Spain, as the elephant in the room.

How can Greece devalue?

Eastern European growth is very dependent on Germany.

Why Spain's economy is more different than you think.

The eurozone crisis is imploding.  If it will not accept a democratic fiscal transfer mechanism the euro is doomed and the international bond markets have recognized this for some time.  The euro is not a fiat currency which can be devalued and as such is a foreign currency, economically, for each and every eurozone country, which means their national debt is denominated in a foreign currency (the euro).  Consequently, no eurozone nation can guarantee its debt.

Being informed on the issues involved requires reading many different viewpoints.  There is a debt crisis, because this is a currency crisis and it could lead to a bank liquidity crisis and potentially to a global depression.

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