Greece, Spain, and the Euro Trojan Horse

We have written and commented on Greece and Spain as well as Iceland, Italy, Ireland, and Portugal.  This week saw a rash of sovereign debt credit default swap speculation driving the costs of CDS for Greece, Spain, and Portugal higher as well as other countries, including the United States.  The speculation is another example of the need for derivatives regulation and a transparent trading and recording market.  The fear of sovereign debt default by a European Union Euro currency nation is a wasted exercise, unless you are profiting from the same type of unregulated speculation which helped bring Bear Stearns and Lehman down and drove Merrill Lynch and Morgan Stanley into larger, more systemically dangerous relationships.

The problems in Greece and Spain are vastly different, but both are derived from the Euro.  Greece and Spain both suffer from a competitiveness gap in that their Euro exchange rate is overvalued while surplus exporting countries, like Germany, have an undervalued exchange rate.  Greece has tourism, shipping, agriculture, and banking, with an aggressive exposure to emerging Eastern Europe, as economic engines combined with an aging demographic population and falling birth rate.  The immediately prior Greek government also soured relations with the EU by supplying economic information which was not correct leaving the current Greek government with testy EU demands.  Given the lack of industrial economic growth and exports, Greece has less immediate but longer term problems.

Spain has more immediate problems.  The Euro caused negative interest rates in Spain from 2002 to 2006, which caused massive economic overheating during which Spain became the largest issuer of covered bonds in Europe driven by the mortgage market. These Cedulas are secured by mortgage loans on domestic properties issued by any Spanish bank or savings institution.  In some instances, they are participation securitizations in which the holder is entitled to only a percentage participation.  Under Spanish law, unlike the Phandbriefe in Germany, Spain undertook the largest departure from the German bond model and it is less demonstrable that investors could lay hands on the assets in the event of issuing institution insolvency.  When the current global financial crisis caused lending to cease in Spain in August of 2008, it was as if the whole financial system had seized up.  The question has become to what extent the government may have to act if the individual issuing institutions do not have the ability to make these covered bonds good in the future.  This would be a serious European problem, because, in over 200 years no Phandbriefe has ever defaulted. The financial seizure in the financial sector and the bursting of the mortgage asset bubble has created significant unemployment. Nationally, unemployment is in excess of 19% and youth unemployment (16+) is 44.5%.  The unemployment situation places a much more immediate pressure on the Spanish problem.

If Spain or Greece had their own currency, they would have more ability to apply fiscal and monetary policies to stimulate their economies and create employment. The speculative attack on their ability to issue bonds at reasonable yields is an unwarranted attack on their sovereignty, because the actual target of the attack is the Euro and is fueled by EU rules which require member nations to have only 3% debt to GDP without respect to the Euro competitiveness gap or internal national economic conditions.  Both countries should be increasing public spending to target economic growth and job creation, but they are being forced by the EU to reduce their budget deficits.  These enforced budget austerity programs are both reducing public sector wages.  This will fuel deflation.  Prior to the global financial crisis, Spain had a surplus.  The 2010 deficit estimate is 9.8% of GDP. 7.5% in 2011, 5.3% in 2012 with an austerity program which will cut $70.1 billion.  Despite the high unemployment, the people of Spain have not yet realized the fate to which the EU is consigning them.

In Greece, it is another story.  General strikes are already planned for February 10 and 24.  It is estimated that the EU enforced austerity program will accelerate the decline in Greek GDP from <1.7%>; to <7%>;.  Greek unemployment, presently 8.3%, will increase by another 300,000 as a direct result.  Does the EU really want to promote social disturbances in Greece and have them spread to Spain and then to Portugal, with its politically divided government?  Greece is raising its fuel tax.  Lower public spending, higher taxes, lower wages, and increasing unemployment are not the economic drivers the EU should be forcing on these countries.  Greece needs more budgetary control given the historical level of corruption which means spending should be efficiently targeted to spur economic growth and jobs.  Despite those deficit hawks who would drive countries into depression, public debt is not the same as private debt and it is private debt fueled by unregulated derivatives speculation which has caused this global financial crisis.  To turn our focus away from needed financial regulatory reform to an an unwarranted sovereign debt default fear which has been promoted by derivatives speculators is intolerable.  Are we to allow the derivatives speculators to become the new terrorist overlords?

There has been much gratuitous talk of bailing out Greece and how the EU will not bail out any member nation.  In fact, the legal authority exists for the EU to bail out a member nation, but it is not necessary.  All that is required is that the EU provide loans which will target economic growth and jobs and revise its monetary policies to more appropriately take into consideration the competitiveness gap of the Euro exchange and the actual internal economic conditions of each member country.  To force a debt to GDP rule down a countries throat when it needs to increase public spending is asking for economic turmoil.  To the extent, that some countries budget deficits have been inefficiently expanded by corruption or incompetence is an issue which needs to be addressed by targeted, efficient public spending.  The problem with the EU providing loans is the surplus EU countries, like Germany , who benefit from the Euro competitiveness gap, are not going to want to share in the risk.

Yet, there are European rumors that large French and German banks have significant exposure to Greek debt. Greek banks have used Greek debt as collateral on loans from (repos)  the ECB, but the ECB, at the end of 2010, will no longer accept collateral with less than an A credit rating, which Greek bonds no longer have.  Currently, there is every expectation that market pressures will continue and, perhaps, grow.  All of this makes it all the more important for the EU and ECB to quickly formulate a loan plan for targeted spending in Greece and Spain, as well as any other Euro competitiveness gap country with similar problems, such as Portugal and Italy.

Much has been made of the IMF providing money to Greece as the preferred process and the IMF has indicated it would be willing to work with Greece, but Greece has not approached the IMF.  In as much as these problems in Greece and Spain have been at least partially caused by the Euro, I do not see the EU wanting the IMF to help Greece.  Additionally, the EU and the ECB need to face up to the need of the Euro to be responsive to the economic conditions of the member nations and the need to address the Euro competitiveness gap.  The EU has studied the possibility of issuing EU bonds since at least 2000 and this current situation is just the reason the EU and ECB should quickly develop an EU bond program and begin issuing EU bonds.

If EU member nations using the Euro are not able to apply fiscal and monetary policy, because they no longer have a national currency, then the EU and the ECB need to develop the monetary policy tools to allow their member nations to apply appropriate fiscal policies to best serve their citizens.

The possibility of default is speculative hoopla and deficit hawk destructiveness.  While deficits need to be controlled,  targeted public spending grows an economy and the withdrawal of public spending constricts an economy.  At the present time, Greece and Spain need targeted spending and financial regulatory reform.  Default is not a plausible option given the domino effect.

Note:  I am aware that the EU currency is spelled euro and not capitalized, but I have chosen to capitalize it to emphasize that it is a currency of 16 nations and, as such, it faces the problems a global currency would have to resolve.


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Krugman and Canada

In my last post, I said Canada was one of the developed countries that weathered the current global financial crisis better than the United States, because Canada had a more effective financial regulatory system.  Yesterday, Paul Krugman, in an op-ed column entitled "Good and Boring", said Canada is a country which did it right and is an important role model of stability from which we need to learn.

Canada has an independent Financial Consumer Agency and Canada sharply restricted sub-rime lending.  Krugman characterizes the Canadian banking system as boring, because they kept banking safe by strictly limiting banks' leverage while the United States, since Reagan, has lived dangerously on the path of deregulation.  Canada limited the process of securitization.  In the United States the process of securitization was unfettered and became a cash cow for banks to make ever increasing risky bets with other people's money rather than a means to reduce risk by spreading it.

Krugman takes issue with Paul Volcker's assertion that the "... crisis lay in the scale and scope of our financial institutions --- in the existence of banks 'too big to fail' ", because there are only five banking groups in Canada and they are all "too big to fail".  Krugman is not correct in his assessment of Volcker.  Volcker has consistently said derivatives were not only misused but possibly unnecessary financial innovations.  He has called for regulatory reform and breaking up banks which inappropriately combine commercial retail banking with investment/trading banking.  In that Volcker has used the phrase "too big to fail", he is as sloppy as most commentators and media.  As Joseph Stiglitz has repeatedly said and which I have explained for months, the issue is not size or just banks but whether any financial institution of any size without respect to whether it is a big bank, small bank, insurance company, mortgage company, hedge fund, equity investment group, or some other shadow banking firm is systemically dangerous.

In as much as the so-called currently proposed "Volcker" Rule uses the phrase "too big to fail" while keeping the financial system, in actuality, just as it is, Mr. Krugman would be correct in his criticism.  "Too big to fail" is a bogus , if not purposefully misleading, concept which deflects the public from the need to regulate systemically dangerous financial institutions of any size.  In 1998, a single hedge fund, Long-Term Capital Management, came very, very close to causing a systemic failure.  And the United States made no attempt to correct that crisis with financial regulatory reform.

Krugman also is not correct in his assertion that Canada proves that keeping low interest rates over a long period of time does not aggravate and lengthen the recession (I also believe it keeps unemployment high).  In fact, Canada has had a more active intervention with the use of their overnight rate and it has been at a higher rate, 25 basis points as opposed the US federal funds rate of zero to 25 basis points, for a shorter period of time.  Krugman does not believe the Fed lowered interest rates too low too fast.  I do not agree.

Here is a comparison of the Federal Funds Rate and the Canadian Overnight Rate:

6/30/05                                   3.25                                                  2.50
7/9/05                                                                                              2.75
8/9/05                                     3.50
9/20/05                                   3.75                                               
10/18/05                                                                                          3.00
11/1/05                                   4.00                                               
12.6/05                                                                                            3.25
12/13/05                                 4.25                                 
1/24/06                                                                                            3.50
1/31/06                                   4.50
3/28/06                                   4.75                
4/25/06                                                                                             4.00
5/10/06                                   5.00
5/24/06                                                                                              4.25
6/29/06                                   5.25
7/3/06                                                                                                3.75
7/10/07                                                                                              4.50
9/18/07                                   4.75
10/31/07                                 4.50
12/4/07                                                                                               4.25
12/11/07                                 4,25
1/22/08                                   3.50                                                     4.00
1/30/08                                   3.00
3/4/08                                                                                                  3.50
3/18/08                                   2.25
4/22/08                                                                                                3.00
4/30/08                                   2.00
10/8/08                                   1.50                                                      2.50
10/21/08                                                                                              2.25
10/29/08                                 1.00
12/9/08                                                                                                1.50
12/16/08                                  0 - .25
1/20/09                                                                                                1.00
3/3/09                                                                                                    .50
4/21/09                                                                                                  .25

The Fed has made its quantitative easing nest and will have a much more difficult series of exit strategies to execute if they are to sustain even a slow recovery which is why the recession will be long and drawn out and unemployment will remain high.  How difficult will it be to exercise monetary policy to control inflation and output gaps in a slow recovery with high unemployment?

The United States must learn from Canada as well as Australia and France.  The United States needs an independent Consumer Financial Protection Agency, transparent derivatives markets, regulation of securitizations, a modern version of Glass-Steagall separating commercial retail banking from investment/trading banking, and financial regulations which limit, if not prevent, the existence of systemically dangerous financial institutions of whatever size and regardless of whether they operate in transparent daylight or the shadows.


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Leftovers - Radio Show 1/30/2010

During the show we briefly commented that the Fed is considering a new benchmark rate as the current Fed funds rate policy has not been adequate in providing the Fed with control and flexibility.  When the Fed lowered the interest rate as fast and as low as they did, they left themselves with no room to maneuver and control and they had to respond with quantitative easing.  One possible move would be to raise the deposit rate and have the Fed funds rate trade with a spread to that.  The deposit rate could set a floor under the Fed funds rate and give the Fed direct control over a policy rate rather than just targeting a market rate.  Theoretically, this could give the Fed more control to draw excess reserves from banks and control lending as the Fed begins its exit strategies.  There are, however, those who have reservations that the Fed has not been encouraging lending and that quantitative easing as practiced by the US and the UK  may not be able to control inflation effectively and may have the outcome of encouraging the development of a global currency and central planning.

It should be noted that of the developed countries which have weathered the financial crisis relatively well, Canada has a system of more effective financial regulation, Australia has a higher core inflation target rate and a higher interest rate policy, and France did not engage in significant deficit spending to deal with the current financial crisis.  All of these allowed those countries more control over leverage.


We talked about Greece and its recent well received bond issuance and subsequent on-going attack by speculators who are driving up the cost of Greek credit default swaps and increasing the spread between Greek bonds and German bonds.  Greece has a newly elected government which is trying to cut its deficit budget.  It has a significant deficit to GDP, the past government was not supplying accurate economic information to the EU, bonds outstanding are over 200 billion US dollars, a poor private savings rate, and its economy needs stimulus and job creation.  The Eu has said it does not bailout EU countries but the statements have been contradictory even with respect to EU legal authority to provide a bailout.

Part of the problem is that Portugal has similar problems, including a poor private savings rate, and Spain has a significant deficit and is in the process of cutting public sector wages during high unemployment in Spain.  These countries could well be in line after Greece, particularly Spain.  These countries combined with Italy and Ireland have begun to be referred to as the PIIGS.  One of the problems is the EU rule that member countries deficit to GDP be no more than 3%.  During a global financial crisis, this prevents a country like Spain from the fiscal policy spending it needs to spur economic growth and job creation.  It is almost as if the EU is trying to act as if the Euro is a gold standard currency rather than the fiat money it is.  If the EU wants to control spending in member countries, it needs to be prepared to provide targeted lending from wealthier EU countries to assist in spurring economic growth and job creation in countries which are trying to control spending deficits.


Interestingly enough, the EU member states and the ECB combined are the single largest holder of gold reserves in the world.


We also commented on the need for the UK an Dutch to compromise with Iceland over payments under Icesave to the UK and Dutch governments for payments those countries made to their citizens who sought greedy interest rates in Iceland banks and lost their money.  While not required under international law, Ieland has agreed to make a payment of $5.5 billion, but the legislation was vetoed and must now face a national referendum which will likely fail.  The Nordic countries which have backed the IMF loan to Iceland are demanding Iceland make the payments to continue to receive $2.5 billion in loans.  The Icesave payments would be approximately 2% of Iceland's GDP and carry a high 5.55% interest rate, neither of which Iceland can afford.  Iceland has sought mediation and the UK and Dutch should agree to mediation.  A reasonable, compromise interest rate consistent with the lower treasury rates in the UK and the Netherlands would be more appropriate.

Iceland should not be forced by intransigent forces in the UK to default in self protection.  The global consequences of any national default of any developed European nation would ripple through highly leveraged nations.

Last week I mentioned that the recent NBER dating committee statement implied a double dip possibility.   Now, Edward Harrison of Credit Writedowns, on the basis of an email exchange he had, is offering a re-interpretation of the NBER statement to suggest depression based on similarities between now and 1929-33 role of the gold standard in inducing debt deflation..  Harrison is arguing that more financial assets must be manufactured or the dynamics of debt deflation will kick in.  He sees only two exit strategies: either manufacture more US denominated financial assets or maintain existing money stock despite the credit claims.  Neither of these are desirable as stand alone policies in my opinion.  Targeted spending  to create jobs and stimulate economic growth through small businesses could diminish and possibly negate a deflationary spiral.  My post below, "It's All About Leverage", addresses this issue.

Mark Thoma of Economist's View had a post referencing the research paper at an IMF conference on the influence of lobbyists in defeating financial regulations, which I have previously discussed.  Thoma also provides a link to an article which discusses the failure to provide financial regulatory reform as the result of this current global financial crisis.  The exceptional influence of lobbyists to neuter and defeat financial regulation and the absolute need to provide significant financial regulatory reform is an issue which I find at the core of our current political inability to act in the public interest.  I have commented on this many times and it appears it will be a long continuing subject.  My post, "Corporate Socialism vs Regulatory Reform", is just the obvious possible conclusions of our present political process.  It is important that the public heat on politicians be amped up and maintained if the dollars of the financial industry lobbyists are to become dead weight in the desert of a long period of slow growth and high unemployment.

President Obama has announced a partial three year budget freeze on discretionary spending beginning with fiscal year 2011 in what appears to be a political bone for the deficit hawks.  This political ploy could have disastrous economic consequences with high unemployment sticking for years.  Even those who have concerns about deficits understand the difference between uncontrolled spending  and targeted spending.  This brings up the question of has President Obama's economic advisors (i.e., Larry Summers) forgotten the mistake of 1937 when Roosevelt tried to negate conservative criticism of government spending  and a perception of growing inflation cut government spending significantly and the recession flared back up with a vengeance.  Krugman and other economists as well as i have long maintained the stimulus was too small (only 5% of what was given the banks and AIG in the bailout) and that a second stimulus which more efficiently targets job creation now and small businesses is necessary to avoid the possibility of a double dip.

At the same time Tyler Durden of zero hedge has put forward a detailed argument that it will be more and more difficult to find indiscriminate treasury buyers and sees a $700 billion US funding hole.  His post is very detailed and you should read it completely.  Again, this goes straight to the issue of how leverage should be used in the current financial crisis in this country.  Inefficient deficit spending is destructive while targeted spending which stimulates economic growth and creates jobs now is constructive.

Spain will cut $70.2 billion in public sector wages and take other steps to reduce its budget deficit which is presently at 11.4% of GDP.

Ireland is facing mounting mortgage defaults.

Fed Governor Kohn said banks face interest rate risks if the Fed raises interest rates.

The 16 member EU inflation rate rose less than 1% in Q4.

UK GDP Q4 rose one-tenth of one percent.

Ford posted 2009 profits of $2.7 billion, which was its first full year profit since 2005.

Verizon had a $653 million Q4 loss with EPS falling 11.5% to 54 cents per share and revenue up 10% but below views.  Verizon will layoff approximately 13,000 enployees or 6% of workforce.

Dow Chemical Q4 profit was 44 cents per share beating estimates by 3 cents with sales up 12%.  It raised its 2010 EPS estimate to $2.15 - 2.45.

Whitacre assumed permanent CEO job at GM rather than find an outside successor.  While this may have short term positive results, it will not create the long term changes needed at this company.

Treasury auctions:

2yr Treasury, $44 billion, yield .88%, bid-to-cover 3.15, foreign interest 43.11%.

5yr Treasury, $42 billion, yield 2.37%, bid-to-cover 2.81, foreign interest 52.97%.

7yr Treasury, $32 billion, yield 3.127%, bid-to-cover 2.856, foreign interest 51.06% but foreign interest is usually about 56%.






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It's All About Leverage

Last week, both Rajiv Sethi and then Mark Thoma, who republished Sethi's post with an additional interview and links, had posts on John Geanakoples and his general equilibrium model of asset pricing.  In this model leverage along with collateral and default play a key roles.  This is a concept he has been developing since a paper first published in 1997.  The catalyst for these posts is a paper entitled "The Leverage Cycle" which is to be published early this year in the NBER Macroeconomics Annual, which means it will be available for purchase only to non-members.  However, he has published a version dated January 2010 as a discussion paper at the Cowles Foundation.  Of the series of papers preceding this, there is one on leverage cycles which contains a considerable amount of the mathematical logic involved in the model.

The attention arises, because this leverage model provides a theoretical model for understanding how we arrived at the current financial crisis, how we can recognize asset bubbles, and implies the use of leverage once an economy is in a financial crisis.  In good times, in the absence of intervention, asset prices and leverage are too high and, in bad times, asset prices and leverage are too low.  His conclusion that the Fed should actively "manage system wide leverage, curtailing leverage in normal or ebullient times, and propping up leverage in anxious times", to me, offers an opportunity to formulate a Leverage Rule, despite not being responsive to only inflation and output gap.

The Leverage Cycle model includes distribution of wealth across individuals (level of inequality), heterogeneous agents, , incomplete markets, asymmetric  information, and endogenous leverage cycles..  The looser the collateral requirements, the higher asset prices will be.  With leverage as endogenous rather than fixed, as in prior equilibrium models, then the extent of leverage should be determined jointly with the interest rate for loans in the market, which means one must recognize that loan contracts can differ along both dimensions of leverage and interest rates.  As Sethi surmises, this means "Conceptually, we must replace the notion of of contracts as ordered pairs of promises and collateral."

Bernanke has been very adamant that the Fed cannot recognize asset bubbles prior to bursting, although he has recently, although reluctantly, indicated that it would be appropriate if the Fed could recognize asset bubbles, while still equivocating that he does not see how it could be done practically.  The Leverage Cycle shows that in crisis leverage becomes too low.  In the current crisis we continue to see deleveraging in housing and credit default swaps.  I have been very adamant that the unregulated growth of derivatives privately trade rather than public traded on a transparent market multiplied the leverage in the economy, not just housing but also in any other area of credit.

When I read The Leverage Cycle and its use of endogenous leverage, Steve Keen and his modeling of endogenous money supply and how similar the two models are immediately leapt into my mind.  There are those who have claimed that Steve Keen predicted the current financial crisis.  Keen's recent post on why Bernanke should not be reappointed Fed chairman (which he was yesterday and I have been ambivalent on his reappointment for a variety of reasons too long for here) is a good example of Keen and Geanakoples have both used Irving Fisher, as he corrected himself post 1929 Crash.  Keen argues that Bernanker, despite being a scholar of the Great Depression does not understand the Great Depression, because Bernanke, by his published work and his public actions, has apparently never considered Fisher's argument that over-indebtedness and low inflation in the 1920's created a chain reaction which caused the Great Depression.  Fisher also delineated a dynamic process in which falling asset and commodity prices create pressure on nominal debtors, forcing distress sales, which in turn lead to further price declines and financial difficulties.  In other words, a financial crisis is a debt driven disequilibrium in which current equilibrium models of inflation and output gaps do not work and The Great Moderation, with its false belief in the end of economic volatility with greater economic predictability which encouraged increased debt levels and insufficient acknowledgment of risk, has been revealed as The Great Enabler.  Keen shows that an analysis of debt, aggregate demand, and nominal GDP could be used by the Fed to identify potential problems and the possibility that one or more asset bubbles exist.  Consequently, Bernanke's actions once the crisis erupted did reduce the immediate impact, but Keen is adamant that Bernanke and the Fed could have seen it coming if Bernanke and other economists had not ignored the debt-driven cause of The Great Depression.

To me, John Geanakoples and Steve Keen are working towards the same concept from divergent perspectives but common ground.  To me, it also brings into question how liquidity has been used and distributed during the crisis and its impact on the distribution of wealth and aggravation of income equality.  It also reinforces my long held belief that the fiscal stimulus was too little, too slow in spending, and not efficiently targeted towards correcting unemployment quickly.  By not utilizing fiscal policy to significantly improve unemployment by the end of Q2 2010, which I have maintained was necessary for almost year or more, the government and the Fed have insured this recession will linger for an intolerable period with preferential liquidity practices (bailouts) and the inefficient increase in national debt.




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Corporate Socialism vs Regulatory Reform

The failure of Congress to pass any meaningful financial regulatory reform, establish transparent derivatives markets, or even attempt to establish usury laws with respect to credit cards as well as the power of banking and financial industry lobbyist to gut, neuter, and transform proposed regulations into money cascades has illuminated that we no longer live in a free capitalist society in which there is access to opportunity and an even playing field on which talent and ability prevail as opposed to activity/results rewards of the closed, exclusive social structure of criminal enterprises.

Joseph Stiglitz has again re-emphasized that today's corporate world tramples shareholders as if they were serf's who have no need to own property or money and in which the managers (employees of the shareholders as owners of the corporation) get to keep excessive profits personally and, when the managers incur losses as the result of excessive risk taking, they dump the losses on the shareholders and society.  In doing so, the managers have privatized the gains and socialized the losses.  They have been allowed through deregulation and lax regulation to develop financial products that create risk rather than manage risks.

IN his new book, Freefall, Stiglitz specifically addresses this direct assault on capitalism by the reckless greed of financial product peddlers which has significantly aggravated income inequality and the diminishment of the middle class without which a republican democracy cannot survive much less flourish.  When the risk taking fails, society is left paying the tab while the corporate managers keep the profits.  In this recession the inadequate stimulus, which spent too little too slowly without properly targeting unemployment, amounted to only 5% of the money the banks and other financial companies got.  The trust has been broken.  Those who caused the problem should bear the brunt of paying for the problem, but we allow them, instead, to continue business as usual and tell the common man to suck it up.  Enough is enough.  "We have altered not only our institutions --- encouraging ever increasing concentration in finance --- but the very rules of capitalism.  We have created an ersatz capitalism with unclear rules -- but with a predictable outcome: future crisis, undue risk taking at the public expense, no matter what the promise of a new regulatory regime, and greater inefficiency."

Stiglitz, in the above excerpt from his book, also emphasized how the current financial crisis has exposed the division within our society: "This crisis has exposed fissures in our society, between Wall Street and Main Street, between America's rich and the rest of our society.  While the top has been doing very well over the last three decades, incomes of most Americans have stagnated or fallen."  But the United States has chosen to go in a completely different direction by lessening competition and strengthening the grip of a corrupt financial oligarchy as it seeks to achieve objectives of a world market.

Even within the sheltered world of the Risky Rich, an awareness is showing its rebellious head within the very bastions of finance.  Albert Edwards, a chief strategist for Societe Generale, has written "Theft!  Were the US and UK central banks complicit in robbing the middle classes?"  He asserts that the central banks were actively complicit in an aggressive re-distribution policy benefiting the very rich by the creation of housing bubbles through increased leverage with derivatives and a mollifying increased leverage availability for the consumer, which in actuality extracted equity from the middle class.  He lays the problems not at the feet of the banks but with the monetary and regulatory authorities.  Edwards goes into detail on central bank policies in facilitating the process and how it has also aggravated income inequality which has contributed to an under-consumption problem, because the rich have a relatively low marginal propensity to consume.  Citing the work of Emmanuel Saez, the peaks of income skewness "... tell us there is something fundamentally unsustainable about excessively uneven income distribution."  He concludes the ordinary working people would not have gone along with these redistributive policies if they had not trusted the central banks.

Dan Geldon, a fellow at the Roosevelt Institute, has written "How Supposed Free-Market Theorists Destroyed Free-Market Theory" in which he cites the deregulatory push within American society since World War II and how the analysis of the current crisis, with its information asymmetry, moral hazard, and agency costs, reveals glaring holes in free-market theory as it has been distorted by the supposed heirs of Hayek and Friedman.  Geldon particularly concentrates on the proliferation and growth of fine print, complex products with hidden costs and dangers. Complexity was touted as innovation while government interference was pilloried.  Yet, consumer contracts became so complex not even lawyers could interpret or understand them.  This has amounted to a corporate assault on contract law which is the bedrock of capitalism.  These complex contracts not only harmed consumers but municipalities, who were lured into buying derivatives, and institutional investors.

Geldon continues his argument to deride the current success of financial lobbyists in preserving the implicit government guarantee created by the bailout which allows large banks to access capital more cheaply than smaller banks and to leverage power.  These market distortions have allowed the financial industry to reduce real competition with massive consolidation and excessive leverage in dictating terms and conditions within the economy under the well-worn guise of freedom to contract and freedom to choose while actually doing just the opposite with complex contracts purposefully designed to deceive and plunder.   In doing so, they have betrayed Hayek and Friedman, while asserting "industry interests" over "free-market interests", and turned free-market theory and capitalism upside down into nothing less than corporate socialism.

We need meaningful financial reform, transparent markets, and corporations who are responsible to and answerable to their shareholders.  The bailouts have exposed precisely what is wrong with corporate management, regulators who look the other way, central banks complicit ignorance of asset bubbles, governments which support the rich rather than exercise fiscal policy which benefits society as a whole, and the insidious corruption of lobbyists and Congress which excludes the people as worthless rabble without influence.



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Leftovers - Radio Show 1/23/2010

In yet another example of the facade over substance of the proposed "Volcker" Rule announced by President Obama, Austan Goolsbee, an economist on the Council of Economic Advisors, said the bank reform will not do a "full" Glass-Steagall.  It is aimed at limiting banks from investing their own capital in hedge funds, private equity funds, and engaging in proprietary trading.  Already there is rampant speculation as to how to define "proprietary trading" when everyone knew what it was two days ago.  We have previously disclosed other "limiting details" from the background briefing to the media, but here is more from the actual briefing which further confirms the Administration is not moving against the banks as is but against some nebulous, undefined future.  This not reform.

It is apparent that all the market indexes are at a low resistance line, which means Monday will be very interesting, and that investors looking for safety are going to be very challenged.  Yields on money markets, Cds, and short term Treasuries are too low and long term Treasuries and bonds may have interest rate risk going forward.  John Hussman has written in his weekly commentary that he expects inflation to be a problem in the latter part of the next decade.  I think it will be a problem when the Fed tries to exit quantitative easing and then again when it attempts to sell the MBS it has bought.  The Fed has already shown an ineptitude in recognizing the strangulation of the recovery by its failure to address unemployment, preferring instead to encourage banks to not lend while unemployment keeps inflation down during this continuing deleveraging process.  Hussman also questions China's ability to sustain economic growth.  He thinks there will be a second wave of credit losses.  His commentary then proceeds to provide an explanation of inflation, the misconceptons of inflation, and how it arises.

The European Union said it is going to investigate high frequency trading, which already constitutes 42% of the U.S. market, as well as dark pools.

The FDIC's Bair urged banks to recognize losses related commercial real estate loans on their books.  Fitch has indicated that loan delinquencies on commercial real estate securities will not peak until 2012, although they have already risen 5 times what they were one year ago.  At the end of 2009 the rate was 4.71% and is expected to peak at 12%.  In 2009, commercial real estate surpassed residential real estate as the worst performing property class.  There is $3.5 trillion in CRE debt outstanding with little equity buffer.

Australia may carefully withdraw stimulus measures as private demands recovers, but signaled there would be no overnight withdrawal which would hurt confidance, small business, and job creation.  Here is a Central Bank which is concerned about unemployment.  It is also a central bank who core target inflation rate is 3% and which did not lower its interest rate as fast or as far as the Fed and has raised it at least twice since to protect its currency from the weak U. S. dollar.  Because its interest rate policies were not unduly low prior to the financial crisis, it had a more shallow housing bubble.

ECB Giverning Council member, Nowotny, does not see EU falling back into recession, no double dip.  He said they may have to copy the Fed's plans to squeeze excess cash out of the banking system.  This is contrary to the current ECB policy of charging banks for depositing excess reserves with the ECB rather than lending it.  Nowotny heads the Austrian Cental bank and he warned that the EU will not bailout Greece or any other country.

The head of the International Monetary Fund warned countries may suffer a double dip if they begin exit strategies too soon without adequate recovery in private demand and employment.

New York Fed President Dudley said persistently tight credit and high unemployment are putting a damper on the economic recovery and circumstances are far from where the Fed wants them to be.  He also defended the Fed's extraordinary response to the financial crisis, including the controversial bailouts of financial institutions.

The World Bank said there is a modest recovery under way but it could quickly lose steam as central banks and governments begin to pull extra liquidity.  It indicated this may place an economic burden on developing countries in managing debt and sustaining economic growth.

Paul Krugman has written that the Obama Administration has not been able to move health care, a more targeted stimulus, and any meaningful financial regulatory reform because the Obama Administration has been guided by poor policy and political misjudgments. He compares the Obama Administration with that of Reagan.  While Krugman thinks there is little Obama can do about job creation right now, I think he must fiscally target job creation which creates jobs now not two years down the road in green energy jobs which will soon be outsourced to cheaper foreign work places.

What keeps the AIG bailout controversial is that it is at the center of what was wrong with the bank bailouts.  The New York Fed told AIG to stand down on any discussions about unwinding its CDO portfolio at less than full value.  Emails have been released which detail the New York Fed helping AIG build a case to keep the CDO payments secret.  It is obvious Geithner will testify next week that he had no knowledge.  Yves Smith of naked capitalist has detailed that the efforts to keep the Maiden Lane III details secret are an attempt to keep public information confidential.  She indicates it appears that the Fed does not want to disclose it has the AIG assets on its books at full value rather than whatever their real illiquid value may be.  In a later post she provided a more detailed analysis of the CDOs.  Then she followed up with another post on how the details are actually publicly available.  This is the best succinct and practical analysis I have read of the AIG CDO bailout controversy.

Meanwhile AIG is asking its employees who receive retention bonuses to take a 15% cut and get their bonuses earlier than the March payment in order for the savings to be used to pay the federal government the $165 million dollars that the employees did not repay as promised in 2009.  To make it even worse, 40% of the absolutely essential people who are receiving these retention bonuses are no longer AIG employees,

This week saw more monetary policy tightening from China as China asked some banks to curb lending and turned their attention to controlling inflation while its Q4 GDP grew at 10.7% and 8.7% for 2009.  This will continue to be a direct pressure on the recovery, the stock market, and international mutual funds.

The EU remained strident in its calls for Greece to get tough on budget cuts.  This concentration on a country's debt level to GDP rather than on the country's use of properly targeted spending to stimulate the country's economy is baffling as it is reminiscent of economic policy under a gold standard rather than the current fiat currency and modern monetary theory.  It is directly harming not only Greece, which badly needs to redraw its budget and become more efficient in its spending and appears to be making a very serious attempt to do so, but it is also preventing Spain from doing what it needs to stimulate its economy.  At some point in time the EU is going to have to come to grips with the destructive nature of this monetary policy trumping individual country's need for fiscal stimulus as tension also continues to build in Portugal, Italy, and Ireland.  If Greece or these other countries are forced to fiscally tighten, a deep recession will result in these countries.  Despite EU repeated statements it will not bailout any country, many economic commentators do not believe the EU could accept the consequences of a member country's default.

The continued UK and Dutch insistence Iceland to repay UK and Dutch payments to investors within their countries who deposited money at high rates in Iceland banks which were then taken over by the Iceland government is nothing short of international extortion.  It threatens the continued IMF loan to Iceland which the country badly needs.  Although the IMF says it is not dependent on Iceland's actions in submitting the UK and Dutch payment plan to national referendum, the Nordic "common view" of the Nordic countries which are actually making the IMF loan payments to Iceland is that Iceland adhere to a depositor guarantee requirement which is actually not required under EU law.  If the UK, Dutch, and the Nordic countries want Iceland to default, do they want to be named as the culprits who accelerated this global recession?

UK retail sales in December were up 3/10ths of a percent (expected 1.1%) and up 2.1% vs year ago.
German manufacturers orders were up 2.8% in November; capital goods orders were up 6.2% (prior report has a 6.7% drop).  This will likely boost Q4 GDP.
Eurozone industrial new orders were up 1.6% in November, which was 3 times expectations.




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This Recession is Not Over

The Big Picture commented on a recent National Bureau  of Economic Research statement by their Business Cycle Dating Committee in which they said, " In both recessions and expansions, brief reversals in economic activity may occur --- a recession may include a short period of expansion followed by further decline; an expansion may include a short period of contraction followed by further growth."  The Big Picture than looked at the St. Louis Fed tracking the recession indicators page and found the indicators clearly in conflict with each other.

Credit Writedowns cited the above article and then carried it further by going through a series of NBER member comments and statistical indicators throughout last year which were used to argue the recession is over.  Ed Harrison also continues his criticism of economic multipliers.  Despite when the recession may have technically ended or whether it is a real or fake recovery, Credit Writedowns still continues to point to a depression with a small "d" and a coming double dip.

Many commentators and economists have been warning about the possibility of a double dip just as we have for many months.  At the very least, given the over valuation of the stock market, we have yet to see a healthy 10% correction from this March 2009 rally which would shake out some of the over valuation.  A double dip is a 30%-50% correction. 

As we have reported on the Radio Show, there has been speculation the Fed or U.S. Treasury may be buying S&P futures each month and selling them each month which would inject a large multiple amount into stock market equity.  This began with a Trim Tabs report that could not account for all the sources of money invested in the stock market beginning with the March rally.  If the Fed or Treasury were buying equities or futures contracts to boost the market, this is not illegal.  At the same time, it has also been noted that there has been an informal 1989 agreement the Fed, banks, and stock exchanges to buy stock if there appears to be a problem.  We have commented that the March 2009 rally has moved forward without apparent reason on large volume increases towards the end of the trading day which do not appear normal.  We have also commented that this rally has been used by the banks to raise capital through debt and stock issuance.

It is now being speculated that the Fed is timing MBS purchases with options expiration week each month.  This actually appears to be a reasonable market timing method and not a manipulation.  Its primary impact will be when The Fed begins to sell MBS and how that will affect the market.

Of more concern, one Treasury trader has observed that there is a very well organized buying surge of U.S.Treasury denominations, driving the price up,  2 weeks to 1 week prior to the Fed making an announcement it would be buying that denomination at the inflated price.  The question is this front running and, if it is, who is doing it?  Is it a Fed tool to increase the price of Treasury denominations or is someone trading on illegal information?

As we have been reporting, there are a variety of unusual and repetitious market activities beginning with the March 2009 rally that have market analysts scratching their heads and trying to find rational explanations.  It makes this "bullet proof" rally all the more weak in a rational market context.


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Banking Reform & Geithner

As we wrote yesterday, the new proposal to limit the scope and size of systemically dangerous banks appears to be very limited and vague.  We used the specific information of the background briefing after the announcement which indicated the size of banks would be limited "as is".  This is in line with the soft bank tax previously announced of 15 basis points on banks with $50 billion only to discover, despite the cries of anguish from bankers, that the bank tax is deductible on their corporate tax returns.

Much of the concern from the scope and limit proposals yesterday is circling around proprietary trading and how will proprietary trading be defined.  If everyone knew what comprised proprietary trading before yesterday, why is the definition so obscure today?  It is not just a matter of asking all the attorneys to leave the room, the smoky confusion is also emanating from the aft decks of the retreating banking fleet.  The banking analyst Meredith Whitney has questioned the meaning of scope and size with emphasis on proprietary trading.  In actuality, proprietary trading in easily defined by its operational  impact and purpose.

The absolute vagueness of yesterday's proposals have engendered a response that it is a political play and not designed to be a substantial reality.  Given the need for financial reform and the failure of Congress and the President to push any effective financial reform with real teeth to fruition, this new emphasis needs to be very real or the public will seek change elsewhere.

Of more concern is comments by Treasury Secretary Geithner would appear to further confirm that either the Administration is not serious or he is not on board with limiting the scope and size of banks, because he has voiced concern that the proposals, which he supposedly helped draft with Larry Summers and Paul Volcker, would sacrifice good economic policy.  Did anyone see Larry Summers at President Obama's announcement yesterday?  Of even more concern is Geithner's PBS interview in which he answered "No, this does not propose that" to a question is this meant the break up of big banks.

Any attempt at financial regulatory reform must include a definition of "systemically dangerous".  The term "Too Big To Fail" is bogus and misleading as we have discussed many times and as Joseph Stiglitz has enumerated on more than one occasion.  Systemically dangerous should not just be banks but any financial institution whether it is a hedge fund, insurance company, or some other company engaged in shadow banking.

This Administration has put forward too many proposals without specific details, which has allowed the lobbyists to mangle, neuter, and fulgaratively defenestrate originally content empty legislation.  It is time to be purposeful and definitive.

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To Systemically Dangerous Banks: No More Hostages

In my last post I talked about FDR's 1936 speech in which he threw down the gauntlet and challenged the bankers with a clear, defining word picture: "We had to struggle with the old enemies of peace--business and financial monopoly, speculation, reckless banking, class antagonism, sectionalism, war profiteering.

"They had begun to consider the Government of the United States as a mere appendage to their own affairs. We know now that Government by organized money is just as dangerous as Government by organized mob."

In our last post we talked about the need for President Obama to step up to his vision of change and stop avoiding the consequences of real financial regulatory reform.  We have repeatedly, through the Radio Show and this blog, conveyed the calls by economists, such as Joseph Stiglitz and Paul Volcker, for the regulation of systemically dangerous financial institutions (banks, hedge funds, insurance companies, as well as any other member of the shadow banking system), the need for a modern Glass-Steagall bill (Senators Cantwell and McCain have introduced a bill) to remove business activities which are in obvious conflict of interest, the need to transparently monitor and record the transactions of derivatives trading, the need to create a Consumer Financial Protection Agency, and the need to require fiduciary responsibility since sales people cannot exercise fiduciary duty (which is conflict free).  

We have documented how financial reform has been gutted by banking lobbyists, the CFPA neutered if not aborted, and otherwise filled with so many holes and exemptions as to constitute a coup d'etat by the financial industry.  Derivatives are still not traded on an open market and the only consideration is what derivatives, if any, should be defined as requiring transparent market trading in which the trades are recorded and we have an idea of the extent of synthetic exposure exists globally (it still appears to be over $600 trillion but no one really knows for sure).

Paul Volcker was isolated by Larry Summers and Tim Geithner and he defied them and went on a European speaking tour which got wide coverage outside of the United States but was often portrayed within the United States by main stream media as a pathetic "who is listening?".  Today, Paul Volcker stood with President Obama and President Obama said, after the official statement, "Never again will the American taxpayer be held hostage by a bank that is too big to fail."

His proposal would limit scope by preventing a bank from engaging in trading and investment for their own profit and limit size to an unspecified market share of liabilities and deposits.  Just as we disclosed in our last post that his bank tax of 15 basis points was tax deductible to the corporations, the background briefing today after the official statement, indicated the bank size would be limited "as is".

There needs to be a very specific definition of "systemically dangerous", because it is not all about size.  While the big banks are obvious, the shadow banking community which directly participated in the weaving of this financial crisis are dangerous by their very hidden anonymity and business in the unregulated shadows of global finance.

President Obama has tried to placate and please the financial industry on the advice of others and now the American people are speaking out that they have had enough and they want the systemically dangerous regulated, they want target government programs creating jobs now, and they want the politicians who find lobbyists more important than constituents to have the opportunity to find a new career path which is less parasitic.

Given the failure of other current financial reforms, we need well defined specifics and the public leadership to push those specifics in defiance of organized financial money mobs.  

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Leftovers - Radio Show 1/16/2010

The Baseline Scenario had a post in which Kevin Drum is asking why President Obama has not, with respect to financial regulatory reform, let us know what side he is on.  James Kwak notes there is no powerful lobbyist support for financial regulatory reform, unless you count Elizabeth Warren who is the Chairperson of the TARP Congressional Oversight panel.  Drum cites FDR's 1936 gauntlet to the bankers and Kwak says it is not too late for Obama to pick up the mantle.

President Obama has three problems in seeking financial regulatory reform and a sustainable economic recovery in which there is job creation: Tim Geithner, Larry Summer, and the people who recommended them.  The economist, Randall Wray, is calling for Geithner to be replaced and a new economic team installed which recognizes: 1) banks are not facing a liquidity crisis, but are insolvent, 2) saving financial systems does not save the economy, 3) all bailouts and guarantees to financial institutions need to be unwound, and 4) a need to understand government finance.

Bill Black, who is a professor of economics and law at the same University as Wray and who has regulatory experience with the unwinding of the Savings and Loan bubble of the 90's, has an article delineating the history of the Federal Reserve's opposition to regulation despite Bernanke's recent statements.  He particularly concentrates on the Greenspan and Bernanke periods, including Bernanke's appointing an economist, Patrick Parkinson,  with no regulatory experience and who has publicly stated derivatives do not need regulation as the Fed's top regulator.

Prior to President Obama announcing a 15 basis points tax on banks liabilities if they have assets of $50 billion or more and accepted TARP money, The Baseline Scenario put forward the argument for a supertax on bank bonuses.  It is expected to raise $90 billion dollars over 10 years, but TARP losses are approximately $117 billion.  While banks call it unconstitutional, others say it does not go far enough.  Some Congressmen have proposed a 50% tax on bank bonuses.  The UK and France already have a tax on bank bonuses but they assessed it wrong by making the banks pay the tax rather than the bankers.

What has not been disclosed in the vast majority of stories about the proposed bank tax is that the tax is deductible on corporate tax returns, consequently reducing the economic impact to the banks by approximately 35%.

Bernanke has been arguing that the housing bubble was not caused by low interest rates but a lack of regulation.  To that end Bernanke has engaged in a direct argument with John Taylor over the effectiveness of the Taylor Rule, which is designed to indicate the appropriate Fed target interest rate. Tyler Cowan has written on the Taylor-Bernanke argument and the failure of the Fed to critique its monetary policy. Taylor has an op-ed piece which is direct reply to Bernanke in which he criticizes the Fed's inflation forecasts and failure to develop a vigilant program for detecting bubbles.  Taylor also has his own blog.

Richard Alford, who is a former NY Fed economist, wrote an article, "Why Bernanke's Defense of Super Low Interest Rates Does Not Hold Up", argues Bernanke's definition of deflation does not hold with Bernanke's favorite  favorite inflation indicator, the PCE.  Alford believes that between 1996 and 2006, there was a fundamental mismatch between the causes of disinflation, unemployment, and the policy steps taken in response with undesirable domestic side effects.  He holds that the Fed should have listened to the many voices after 2002 warning about trade imbalances and decline in private savings.

Tom Duy in his Fed Watch says "It's Not About Interest Rates Yet" and the Fed will hold interest rates at low, rock bottom levels.  Consumers have failed to resume spending,, retail activity remains well below the trend expected in 2007, and there has been no offsetting improvements in trade balances.  The underlying rate of growth is doubtful, industrial production is improving, the reversal of unemployment is elusive, households are hobbled, and the trade imbalance is not turning around.  There is little likelihood interest rates will be raised and the possibility of future asset purchases may be resumed is not unlikely.  I have been saying for some time that, historically, the Fed does not raise interest rates until 12-18 months after the end of a recession.

Hussman still remains concerned about the over valuation of the stock market and the weak recovery.  Consequently, he still expects an abrupt market decline within the next few months.

John Prestbo has written that it appears the stock market inflation adjusted return for 12/31/1999 to 12/31/2009 was actually negative.

John Mauldin still believes in the V-shaped recovery and cites a variety of minor improvements, but still sees 2010 as a year of uncertainty and believes that a tax cut is necessary.  However, I would disagree, because tax cuts have seen growth in unemployment, while tax increases have seen growth in employment.  Government spending spurs employment more than private spending.  I think we need to target creating jobs now with government programs and creating more credit availability for small businesses if we are to see job creation in the foreseeable future.

Nouriel Roubini is saying that the second half of 2010 may bring downside surprises with the possibility of a double dip recession.  The stimulus has not spurred top line revenue growth fast enough and thinks US GDP will be anemic at 2%-3%, which is not enough to drive GDP growth or job creation.

The CFTC has announced proposals to limit big energy traders, but they would apply to only the ten biggest position holders.

ECB Governing Council member, Nowotny, warned that US banks need to curb risk taking.

US banks are lifting executive salaries as they but bonuses just as many have predicted.  They want their cake whatever frosting it has on it.

China's $1.2 trillion 2009 exports edged out Germany's $1.17 trillion to become the world's top exporter.

Central banks in South Korea, Indonesia, India, and Singapore bought US dollars to curb the gains in their currencies.  There was also speculation China would let its yuan rise.

Bullard, St. Louis Fed President, said global growth, particularly in Asia, is driving the US recovery.  I have been saying and publishing in my blog and in nationally published articles that China has a spending bubble, real estate bubble, and increasing use of leverage.  As China tightens its monetary policy, how will that braking effect the global recovery.  I think the stock market showed us an advertisement for what might happen on 1/12.

UK trade deficit decreased November from $11.4 to 11.0 billion; the Canadian trade deficit was $331 million in November, but it was the 4th monthly deficit in five months.

The German economy was down 5% in 2009 as exports fell 14.7% in Q4 and is estimated to grow 1.2%-1.5% in 2010.

China renewed vows to curb real estate speculation amid concerns over a possible asset bubble and said it will keep an eye on excessive lending.

California's credit rating was reduced another level by S&P, which said the state will run out of cash in April.

Foxwoods Casino (owned by The Pequots tribe) is in financial difficulty.  Since the casino is owned by a sovereign tribe, only they can own the casino.  Where does this leave lenders who have no legal right to foreclose?  Why did the lenders provide credit without addressing this issue in the loan contract?

Heineken is to acquire FEMSA in a $7.7 billion deal.

Treasury auctions:
10 yr TIPS, $10 billion, yield 1.43%, bid-to-cover 2.69, foreign 40.7%.
3yr Treasury, $40 billion, yield 1.49%, bid-to-cover 2.98, foreign 38.0%.
10yr Treasury, $21 billion, yield 3.754% (lower than expected), bid-to-cover 3.01 (strong), foreign 29.02% (Primary Dealers took over 50%).
30yr Treasury, $13 billion, yield 4.640%, bid-to-cover 2.69, foreign 40.7%.


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