S&P's Rating Folly, Part 2: Grading Political Will

 In April, we thoroughly covered how a threatened S&P downgrade of US debt would be economically meaningless to a sovereign nation with debt issued in its own currency.  The April S&P warning fueled the political divisiveness of public debate placing the S&P directly in the political game as a player influencing political debate.  Credit ratings agencies are federally licensed and regulated businesses as NRSRO's (Nationally Recognized Statistical Rating Organizations) and they are not lobbyists, although they escaped financial reform after the Global Financial Crisis which they helped precipitate with misleading credit ratings for companies that failed and investments which were actually toxic.

On Friday, S&P downgraded United States debt from AAA to AA+ despite a $2 trillion S&P error in their analysis.  Economically, this is meaningless.  You only have to look at the low yields on Japanese bonds after losing their triple A credit rating almost ten years ago.  Is the S&P engaged in a political agenda contrary to its regulated purpose?

It appears from the S&P report that the primary concern was the lack of political will by elected representatives and officials to come to a reasonable agreement prior to a repetitive political drama over extension of the debt ceiling.  The job of the S&P, as a NRSRO, is to provide an independent statistical analysis of financial credit worthiness which can be relied upon by investors and they have not demonstrated any compelling analysis in the report.

Felix Salmon has noted that default is an act of political will not an econometric decision and that "...it’s fair to pin the lion’s share of the blame on the existence of the debt ceiling."  The political debate over the debt ceiling was vicious and destructive and exactly why Section 4 of the 14th Amendment to the U.S. Constitution was passed after the Civil War.  The debt ceiling law is not only destructively counter productive, it is legally superfluous.  Conservative economic commentator, Megan McArdle, went so far in noting the lack of political will in the debt debate and the obvious necessity to increase the debt ceiling that she said, "...I'm afraid I think that the lion's share of the blame goes to the GOP, which escalated to this completely unnecessary showdown, and then gave up any hope of a grand bargain because it would have required some revenue increases."  Given that President Obama believes, and has voted in the past to not raise the debt ceiling as a Senator, in deficit reduction and aided and abetted the deficit hawk elements, although he recognized the need for revenue increases, he appears to be getting off light in the lack of political will department, which is unfortunate since he has demonstrated little political will since assuming office.

Did the S&P downgrade United States debt on the lack of political will in the political process in the United States?  On page four of the report which is linked above, the S&P states "We have changed our assumption on this because the majority of Republicans in Congress continue to resist any measure that would raise revenues, a position we believe Congress reinforced by passing the Act."  They are saying the Republicans in Congress lack the political will to to do what is reasonably necessary to govern in a fiscally responsible manner consistent with the economic needs extant.  The mainstream media has ignored this sentence in the report, because it exposes the political charade of the debt ceiling debate as economically incompetent wasted demagogic rhetoric on the debt rather than one of governance.

The S&P, however, used these same tactics, in combination with Moody's, in the 1990's in Canada to assist financial interests in slashing unemployment insurance and health care just as they used their power in 2000 to squash mortgage lending reform.  As the economist Rajiv Sethi argues, perhaps, it is time that the credit ratings agencies, which were so instrumental in profiting from credit ratings which were so unreliable they directly contributed to the Global Financial Crisis, be stripped of their legally protected status and monopoly power and made to compete on merit of work with full legal fiduciary liability to the investing public in a democratic society.  It is coming to a decision point about whether we are a corporatist market state or a republican democracy.

Jesse's Cafe Americain observed that Friday's market showed visible signs of movement of knowledge of a hidden agenda with respect to the expected S&P announcement, as Felix Salmon and Megan McArdle also mentioned, and concludes that the class war will only intensify now as governance is being cast aside.

Futures at this point in time are mixed with the DOW positive and the Nasdaq and S&P 500 negative.  The German Dax futures are negative.  The Middle East stock markets on Sunday were down with the Israeli stock market down 6.99% (TA-25), supposedly as a reaction to the US downgrade.  Any down movement on Monday solely attributed to this downgrade would be foolish herd behavior and soon recognized as such.  However, the eurozone meeting of Central bankers is this Sunday night and the professional market will be watching what the ECB does on Monday.  Here are the economic reports, including retail, household debt, and FOMC meeting (which is expected to result in the FED saying they are watching and waiting), which will come out this week and could potentially impact the market.


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Links 8/6/2011: Eyes on Growth

US employment saw a modest monthly increase which should only take a little over 74 years to get unemployment down to 5%.  Basically, the July report showed a decline in the working population which is translating itself into a decline in unemployment.

The employment report
Part time workers and duration of unemployment
Employment to population ratio has fallen to 1953 levels
as jobless benefits end, recession looms
still mystified over unemployment (Menzie Chinn)

study: unions decline increases wage inequality

Jobs report means FED will announce next week they will think about it for awhile (Tim Duy)

Inflation, what US inflation?(Paul Krugman)

Study: tax flight by businesses is a myth

James Galbraith on why economist's will not discuss fraud in financial sector

another explanation of why debt-to-GDP ratio is mathematically incorrect

Unofficial US problem bank list down to 988 banks
The Bank of America deathwatch
Bank of America has no clue what its mortgage losses will be

RBS losses on Greek writedowns
How different European banks treat Greek bonds
Dexia losses most in history

Balanced budget amendment in US would defeat economic purpose of government (Simon Johnson)
Austerity defeats the purpose of government which is to serve the people (Bill Mitchell)

Top ten misconceptions of eurozone crisis (take this with a critical grain of salt -- some people do not have the courage to default correctly if they prefer to be indentured servants for generations)

The contagion of bad ideas (austerity & protecting financial companies rather than citizens) since the Global Financial Crisis is destructive of economic fundamentals (Joseph Stiglitz)

Is the eurozone lost in the depth of structural reforms and the growth destruction of austerity (apply critical analysis to this piece)   (Daniel Gros)

Will wage cuts with debt reduction decrease prices and make Greece more competitive in time to survive?  Oh! the pain, the pain!

the liquidity problems of the eurozone without a central bank acting as lender of last resort = inevitable failure (Edward Harrison)

The argument for eurobonds issued by ECB, which has no authority to issue bonds (Yanis Varoufakis): why is the EIB not being considered as Rob Parenteau has suggested? Is it because the EIB is an investment bank run by investment bankers who do not understand a societal role?

Germany is in denial that it is a member of a monetary union

Meanwhile, Ireland tries to manipulate the price of distressed property owned by NAMA


The FED and the ECB  are both behind the learning curve of debt deflation (Tim Duy)

Italian and Spanish growth slow as austerity pinches
sluggish growth threatens recovery

Why Italy? Why Spain? The EFSF will fail as long as the toxic debt-to-GDP ratio lives in its heart (Yanis Varoufakis)

Portugal's austerity fails to reduce bond yields (does the market understand it is hard to make interest payments if growth is impaired by austerity?)

Europe's plan will not cut Greek debt

Austerity and public safety in Athens

Spain cancels August 18th bond auction

Greece cannot recover on innovation because research, education, and innovation require spending



The Parade of the EU and ECB in the celebration of a Failure of Political Will as demonstrated this past week:

Trichet's purchase of Portuguese and Irish bonds fails to help Italy and Spain
ECB's shock-and-awe wimps into whimper
temporarily throws Italy and Spain to the wolves
the international markets react impatiently
Barroso constructively suggests reconsideration of EFSF and receives anger in return
Italy must cut services to people as condition for ECB to help
Italy will accelerate austerity and balance budget in 2013 (want to bet on the plunge in growth into recession?) to get ECB help
ECB agrees to buy Italian and Spanish bonds next Monday


Economically knowledgeable people internationally have been urging  to buy Spanish and Italian bonds to constrain the market and provide support to their ability to make their debt payments in the future since they have no ability to exercise the normal sovereign nation's escape valves through fiat currency depreciation, because they use a foreign currency (euro) of a monetary union with no fiscal transfer mechanism to correct current account imbalances resulting from trade lack of competitiveness within in a currency union.

But these very same economically knowledgeable people also know this is only a very necessary stop gap and very temporary if the eurozone will not start acting as if all of its citizens are members of a single union:

We have seen this before (Cullen Roche).
It is incredibly difficult to stabilize finances in a debt-deflation spiral (Tim Duy) if they cannot print their own currencies.

S&P downgrades United States to from AAA to AA+ despite $2 trillion S&P error is their analysis.  Economically, this is meaningless.  You only have to look at the low yields on Japanese bonds after losing their triple A credit rating almost ten years ago.  Is the S&P engaged in a political agenda contrary to its regulatory constraints?


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Unemployment - July 2011: Less workers = Less Unemployment

The July 2011 employment  report came in at a net increase of 117,000 jobs after a decrease of 37,000 government jobs from an increase of 154,000 private sector jobs.  Consensus had been for an increase of 75,000.  The ADP private employer survey had shown an increase of 114,000 earlier in the week.  Given the market correction this week, it was a welcome positive however weak it is.  The unemployment rate decline one tenth of a percent to 9.1%.  The total unemployed including discouraged workers declined one tenth to 16.1%.  If one used the 1980's calculation (the Shadow Statistics chart in the link changes monthly) for total unemployed including discouraged, it would have been approximately 22.7% rather than 16.1%.

The employment population ratio fell to 58.1% which is the lowest since August 1983 (also that low in November 1973 and March 1953) as can be seen in the third chart here at dshort.com.  The participation rate of national available workforce declined from 64.1% to 63.9%, which is also the lowest since the early 1980's as shown in the first chart here from calculatedrisk.com or in the Calculated Risk employment charts gallery here.

The unemployment rate is down not because there has been an increase in jobs, but because the population who could work has declined and the number of available workers participating from the population has declined.  Less workers equals less unemployed being reported.  6.2 million Americans have been unemployed for more than 6 months and as the 99 week unemployment benefits keep expiring more and more unemployed are no longer even counted and they drop into statistical oblivion.  8.4 million Americans are involuntary part time workers, because they cannot get full time work.  The official 16.1% total unemployed including discouraged equates to 24,800,240 Americans unemployed; the old 1980's calculation equates to 34,750,953 Americans unemployed.

If one were to reduce the official unemployment rate of 9.1% (13,931,000 Americans) to an economic concept of full employment at 5% (7,654,395 Americans) at 117,000 jobs increase per month, it would take 74 years and 9 months, because it takes 110,000 (between 100,000 to 150,000 but 110,000 should be very close) new jobs per month just to keep up with the population increase.  If 250,000 jobs were added each month, it would take 3 years and 9 months.  If there was economic growth consistent with strengthening recovery, job growth should be at least 350,000 per month and it would take 2 years and 2 months to reach 5% unemployment.  A truly strong recovery would be over 400,000 to 450,000 jobs per month and at 450,000, it would take 1 year and 6 months.


But as unemployment starts to abate, more and more discouraged workers and workers, who have exhausted all extended benefits, no longer counted will start looking again for work and theoretically re-enter the available worker population.  To the official total unemployed including discouraged workers to only 5% unemployed (economic full employment) at 250,000/month it would take11 years and 1 month; at 350,000 it would take 6 years and 5 months; at 450,000 it would take 4 years and 6 months to get to 5% unemployment.

Using the old 1980's calculation for total unemployed including discouraged workers, at 250,000 it would take 16 years and 11 months; at 350,000 it would take 9 years and 9 months; at 450,000 it would take 7 years to reach 5% unemployment.

If you are over 50 years old and unemployed, it becomes even more difficult to obtain new work of any kind much less work consistent with experience and ability.  Since 2008, each year has gotten worse for those over 50.  By December 2010, unemployed workers 55-64 years old who had been unemployed for more than a year composed 40% of the total unemployed for that age group and for the 65 years and older group unemployed approximately 43% of that group had been unemployed for more than a year.  And there are those help wanted ads which have started to appear that will consider only those currently employed.  During the Depression ads, which are illegal now, included ages discriminating against older workers; now, discriminatory employers just do not interview older workers.

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Links 8/4/2011: Eyes on Growth

Recession risk in Germany (Edward Hugh)

Is France being sucked in?

Is deflation back?

Washington debt battle as diversion 

US economy on brink, no safety net

Societe Generale Bank income and Greek debt

Swiss franc depreciation

Hungarian local governments want delay in repaying Swiss franc debt
Swiss franc & Japanese yen

Japan selling yen

currency intervention & FED possible easing resumption


Bank of England holds rate on weak growth

Czech central bank holds interest rate with inflation up on higher sales taxes not demand

European banks liquidity funding stress


South Africa bails out Swaziland

Turkish currency to tumble

Turkey cuts interest rate to support growth

Turkish lira tumbles

Denmark trying to side step EU bank resolution laws

Spain 7% ten year bonds will be trigger

will Eurozone become transfer union?

In Ireland 1-in-4 have only part time job

ECB needs to support Spain and Italy now, what is taking them so long?

will buy bonds?

needs to intervene

eurozone banks hoarding cash


ECB pause rate increases and buy bonds?

only ECB can halt eurozone contagion


ECB buys Portuguese and Irish bonds in secondary market but not Spanish or Italian --- excuse me!

ECB extends liquidity measures to six months and -- gasp! -- expresses continuing concern about headline inflation (woops)

ECB action crucial in European liquidity crisis (Edward Harrison)


ECB/Trichet only hope for eurozone (but he is no Austin Powers)

 Spanish & Italian bonds worsen as Trichet fiddles

Spain sells 3 year bonds for high price

Markets unimpressed with ECB failure to act decisively

ECB's Trichet has no comment on not buying Spanish and Italian bonds -- will this power vacuum be filled?



Is Berlusconi worn out from partying? -- no debt concern

Europe's dominos

Italy bound to default?

Spain's high risk election (Edward Hugh) -- I am already on record as saying Zapatero made a huge mistake in calling for elections

US long term unemployment will depress wages (Menzie Chinn)

US incomes down 15.2% since 2007 through 2009

BNY Mellon bank to charge cash depositors

US economy on the edge (Tim Duy)

Soldering on in Ireland or we can climb any mountain

US bond yields down, Italian bond yields up: Context not good either way -- Somebody needs to do something (Paul Krugman)



If this market has you running scared, you were not properly diversified for your investment growth, preservation of assets, and cash needs investing time horizons.

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Eyes On Growth: Update Links 8/3/2011

 The US ADP Private Employment Survey came in at up 114,000 jobs which was over expectations of 100,000.

The ISM Non-Manufacturing (service sector) PMI was down in July to 52.7 from 53.3.  It was expected to be up.

On Italy running out of money

Is Italian bond sell-off self-fulfilling?

eurozone crisis widening


eurozone domino effect

Widening eurozone crisis demands bigger rescue fund

Death by 1000 cuts or EU bond

Italian growth & banks


Italian, Spanish ten year bond yields at record high on growth concerns

European money markets freezing

Irish leaving Ireland to find jobs

European crisis is not over (this is a somewhat hopeful apologia that only debt reduction will save Greece; it will only make it worse)

Greek default not realistic (argues that it would take two years to print and coin new currency and it would have to be done in absolute secrecy)

Germany's road to 1930's currency crisis (it was not hyperinflation --- that was in early twenties)

1930's redux

Swiss defend franc with interest rate cut (at least they are not repeating their mistake of last year and buying euro to intervene and lower franc; it cost them significant losses)

Australian retail sector in recession

China non-manufacturing PMI up to 59.6

Assessing the debt ceiling damage on growth and unemployment

The debt ceiling debate that did not happen (the middle class is getting stiffed while the wealthy skate)

The Rube Goldberg doomsday machine (from Nouriel Roubini's Econometer blog)

Debt debate distracted us from recession threat

Small business owners using pawn shops for business liquidity

Lack of jobs and weak tax receipts trump deficit hysteria

Recession probability increases (national Bureau of Economic Research, which ex post facto determine beginning and end of recessions, members give personal opinions)

Keep you eyes active and your minds open; keep your critical analysis skills sharp.



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Keep Your Eyes on Growth: United States and Global Growth are Declining Not Slowing

United States  Q2 2011 GDP was a disastrous 1.3% and Q1 was revised down to 4 tenths of a percent as well as other prior quarters revised down as this chart from Econbrowser show:





The predicted stronger second half of 2011 seems decimated, leaving the FED sidelined, also as it looks, after the new data, more like 6 tenths of a percent and  7 tenths of a percent for Q3 and Q4 with the output gap widening even further as the graph from Tim Duy in the last link above shows.



Anyone who has invested and/or was consumed by the conviction of coming inflation can drop the illusions, because inflation is not happening in an economy in which growth is stalled and banking down.  The recession was deeper than thought and sheds some light on high lingering unemployment.

This week the Global Manufacturing PMI for July was down from 52.3 to 50.6, which is the lowest since July 2009.  The U.S. ISM Manufacturing PMI for July was down 50.9 from 55.3 for a two year low.  China HSBC Manufacturing PMI was down to 49.3 (any PMI below 50 is a contraction) from 50.1, while official China PMI was down to 50.7 for a 29 month low.  UK PMI was down to 49.1 for the lowest since June 2009.  Russia was down to 49.8, which was the first sub-50 since December 2009; Taiwan was down to 46.1, which is the largest decline since January 2009.  Eurozone PMI was down to 50.4 from 52.0 for the slowest pace in 22 months.  Australian PMI was down 9.5 points to 43.4.  This is a global decline in growth which is shaping up like a train wreck.

German June retail sales, which were reported this week, surprised with a 6.3% increase when only a 1.6% increase had been expected, but it was still down 1% from a year ago.  This is probably an outlier resulting from disruptions in the calendar shopping days with June having two less and May having three more this year.  While German car makers are optimistic for the rest of the year, electronics and DIY sales are down.  Eyes will be watching the July retail sales reported at the end of August.

53% of European companies which have reported earnings since July 11 have missed earnings which is the most in approximately five years.  Lenders in Brazil, Russia, India, and China are under increasing credit pressure from their growing economies raising questions about the level of possible non-performing loans.  If you look at our July, June, and May articles you will see several on the eurozone and China, such as this one on the consequences of trade imbalances and the debt dilemma.

All of this economic information quashed any short lived delusional euphoria over deficit reduction in the United States.  A sovereign nation which issues its own currency can only default by political choice, i.e., as an act of political will, as it can always pay its debts in its own currency.  As of Tuesday, August 2nd, we have had eight down days in the DOW for the first time since October 2008.  And we still have the ADP Private Employment Survey (consensus 100,000 up), the ISM service sector index (up a little), and the July employment report (consensus up 75,000).  If the July employment report is less than expected, as were the ISM Manufacturing, consumer spending, and GDP reports this week, it will cap a very negative week of declining growth which will be aggravated by the proposed austerity deficit reduction passed this week, which will cut growth by .3% and increase unemployment by .15% - .2% in 2012 and continue to cut growth in each year through 2021 with 2013 growth potentially cut 1.6% as the chart from, Macoadvisers in the immediately preceding link shows (multiply the columns by 2 for the economic multiplier effect, i.e., negative .15% = negative .3% for FY 2012 and FY 2013 = negative .8%):


This further contraction on top of growth moving towards stagnation in the United States and globally will only further push us futilely towards recession if not depression.  Take a look at the top ten biggest tax breaks which could be cut in deficit reduction and you will find the predominant burden is on the middle class not the wealthy who are being protected from tax increases. Despite public belief, taxes are at historical lows (they were as high as 90% in 1960 until John Kennedy lowered them) and tax revenues in 2009 (24%) are almost the same percentage of GDP as in 1965 (24.7%) as the OECD chart in the immediately preceding link shows:


In fact, Americans pay almost the lowest taxes of  the developed countries in the world with Chile and Mexico only having lower taxes.

As growth stagnates, the deep problems of unemployment officially at 9.2% in June and total unemployment, included discouraged workers, at 16.2% (approximately 22.6% if one used the old 1980's calculation) will only worsen.  The July GDP numbers, global PMI numbers, and the debt limit deficit reduction are final nails in the mystery of the lingering, long term high unemployment.  The charts at Calculated Risk (take a look at all of them here), such as this graph, show how significantly different unemployment as a result of this recession as opposed to other recessions and how exceptionally bad unemployment is.


When you consider all of the above and you add Cyprus, whose traded ten year bond yields are going higher from 8.9% to over 10% more recently, facing an invitation to a eurozone bailout and, if bond yields keep rising, Italy and Spain potentially running out of money in September and February respectively, you have converging global and United States contractions which will feed off each other and austerely intensify the pain.


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The Seven Percent Solution

I was somewhat astonished recently to see coverage of Goldman Sachs analysis that Italy could be in trouble if its ten year bond yield reaches 7%.  After all, the ECB has consistently brought out the sniper rifle and uncapped the scope when eurozone country's 10 year bond yield reaches 7% and puts the finger on the trigger when it exceeds 7.5% as it did with Greece, Ireland, and Portugal.  That is the point the ECB decides it is not going to continue providing liquidity and risk raising the eurozone average ten year interest rate.  It is also a level at which public debt in a fixed monetary union, in which trade imbalances cannot be economically resolved between countries and devaluation is only possible through internal adjustments which can only be achieved by austerity and deflation, verge towards unsustainability.  Deflation does not promote growth since growth creates inflation.  Consequently, the 7% level and the 7.5% trigger is the point of uncompetitive divergence at which imperial Europe dictates to colonial Europe that the Irish will become indentured servants to protect European banks, the Portuguese will be groomed to become serfs (after all the Portuguese social programs to bring the Portuguese people from dictatorship to the modern developed world cost money), and the Greek people will be pushed into slavery.

Understand the trading yields of the ten year bonds are not the concern except as they indicate what the issuing yield of any new ten year bonds might be.  Since Italy's economic growth is slowing, as Rebecca Wilder has thoroughly explained and Edward Hugh has documented, and Greece, Ireland, Spain, Italy, and France all have declining growth.  In fact, all of Europe is slowing in growth including German production amid global slowdown.  If these countries have a need to grow, whether inhibited by austerity or not, then they have a need to issue debt in the international market.  These countries also have high private debt which is a larger negative than public debt to GDP (at least less important in a fiat currency country).  If the newly issued debt is likely to be 7.0% - 7.5% or higher, depending on the size of the national economy and debt, the ECB will have its finger on the trigger.  The question of Spain, Italy, and France being to big, i.e., too costly to Germany and the banks of Europe, is a question which has been repeatedly kicked down the road just as recently as last Thursday and Friday and has already been viewed as a restricted default.

Are there any exceptions to the 7% solution?  Portugal tried to evade the ECB sniper by arranging private placements of public debt issuance but got too close to needing a true international auction.  The Cyprus ten year bond is trading in a volatile range, having exceeded 7.5% on June 23rd when Commerzbank recommended they no longer be bought, from 8.2% on June 29 to 8.9% on July 20 just before the newest kick the can down the road plan for Greece, which has temporarily lowered traded bond yields for all eurozone countries.  Why has Cyprus not had the trigger pulled?  It has not issued new debt in the international market since the ten year bond in February 2010 which was issued at 4.625% and is now trading at 8.9% as of July 20.  Cyprus has considered, and is considering issuing new debt in November at international auction, but has so far, as recently as this June, successfully placed the debt locally.  As long as it can stay away from the international market in issuing and placing debt, it will evade the ECB sniper.  With banks in Cyprus heavily exposed to Greek debt (Marfin alone has as much exposure as Dexia), new austerity budget which will decrease growth, and the need to rebuild the recently explosion damaged utility plant, the ability to place new debt locally and/or by private arrangement may become increasingly difficult.


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European Bank Exposure to PIIGS

The EBA published its stress test results of 90 Eurozone banks of which eight were found to have less than the 5% target capital ratio, but actually 20 banks were below that level.  Twelve banks were not listed as failed, because they are raising money.  One German landesbank, Helaba, withdrew from the stress test when its silent participation capital was questioned.

Olaf Storbeck has documented the two different definitions of exposure used in the EBS report which make the different numbers not add up.  More importantly, sovereign default exposure was not included in the study.

Here is an important spreadsheet, which was laboriously compiled by Olaf Storbeck, showing each of the 90 banks exposure to each of the PIIGS.  Spain and Italy have large exposure, but they also had some of the strongest banks.  If you want to get a look at some of the potential exposure of European banks, Storbeck's spreadsheet is invaluable.

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Irish Bank Withdrawals

In looking at bank withdrawals in the eurozone, it is necessary to distinguish between a banking crisis, in which there are bank runs, and a currency crisis, in which foreign investors and depositors withdraw money and domestic households and non-financial corporations draw down monies as the result of unemployment and a poor business loan market.

In Ireland, there was a real estate bubble and banking failures.  The ECB threatened the Irish government into guaranteeing senior bond holders, who were core European banks who had financed the real estate bubble, at the expense of the Irish people.  Did Irish households and non-financial corporations run with their money?

In looking at the May 2010 to May 2011 yearly figures and the different deposit peaks to May 2011 for Irish households, Irish non-financial corporations, other euro area depositors, and rest of the world depositors, we see vastly different transaction patterns.

The peak deposit of the rest of the world was September 2007 at 91,068,000,000 euro which declined to 43,139,000,000 euro as of May 2011; a decline of 47,829,000,000 euro or 52.52%.  The last twelve month decline was 21,666,000,000 euro or 33.43%.  The peak deposits of the other euro area depositors in Ireland peaked in June 2007 at 43,388,000,000 euro which declined to 28,984,000,000 euro as of May 2011; a decline of 14,404,000,000 euro or 33.20%.  The last twelve month decline was 6,191,000,000 euro or 17.60%.  You can see the outstanding balances and monthly transactions here in two tabs of Table A.12.2.

The peak deposits for non-financial Irish corporations was in September 2007 at 45,679,000,000 euro and the peak for households was August 2009 at 99,407,000,000 euro, because households increased deposits from 81,822,000 euro in September 2007.  From the September 2007 peak to May 2011, Irish non-financial corporations declined to 31,655,000,000 euro as of May 2011; a decline of 14,024,000, 000 euro or 30.70%.  The last twelve month decline was 5,325,000,000 euro or 14.40%.  From the August 2009 household depositor peak to May 2011, household deposits declined to 92,133,000,000 euro; a decline of 7,274,000,000 euro or 7.32%.  The last twelve month decline was 5,758,000,000 or 5.88%.  You can see the outstanding balances and monthly transactions in the two tabs of Table A.1 or Table A.11.1 in the link above.

Irish corporations are struggling for money to continue business operations in which consumers are not spending.  There is no pattern of household withdrawals until approximately February 2010 and it is not month to month consistent or accelerating; it does appear to be consistent with growing eurozone and Ireland political crisis, unemployment at 14.1%, which is the highest since 1994, declining property values decreasing home equity, where some prices are down 53%, and increased austerity.

Even with the failure of banks and ECB imposed defense of core European banks which indentured Irish citizens, Irish households and non-financial corporations are showing no runs on Irish banks.  The large withdrawals by rest of world depositors and other euro area depositors are consistent with foreign withdrawal of deposits and investments during a currency crisis, which increases liquidity problems.

I have been watching deposits throughout the eurozone countries, not just the periphery, and I intend to write a larger post in the future as withdrawals are not just occurring in the periphery.

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Michael Pettis on the Trade Imbalances and Debt Dilemma

In Michael Pettis' private newsletter which arrived on 7 July 2011, he begins by observing that creditor nations are worried that obligors will take steps to undermine or erode the value of their obligations just as complaints in Germany voice concern that German banks could lose money if eurozone peripheral countries default and this whole argument strikes him as surreal, because the creditors have totally mixed up the causality of the process.  Any erosion in the value of liabilities owed them is the almost certain consequences of their own continuing domestic policies.  "It is largely the policies of the creditor countries, in other words, that will determine whether or not the value of those obligations must erode in real terms."  The accumulation of U.S. bonds by China and German bank peripheral eurozone loan portfolios "... were simply the automatic consequences of policies in the surplus countries that may very well have been opposed to the best interests of the deficit countries."  Net capital exports are the obverse of current account surpluses (trade surpluses) and one requires the other.  "If China buys huge amounts of dollars, the US must run a deficit."  Likewise with Germany whose recent economic strength has largely rested on its export success.  "But for Germany to run a large current account surplus --- the consequence I would argue of domestic policies aimed at suppressing consumption and subsidizing production --- Spain and the other peripheral countries of Europe had to run large current account deficits.  If they didn't, the euro would have undoubtedly surged, and with it Germany's exp[ort performance would have collapsed.  Very low interest rates in the euro area (set largely by Germany) ensured that the peripheral countries would, indeed, run large trade deficits."  The funding by German banks of peripheral borrowing was a necessary part of the deal and, if the deficit countries have acted foolishly, they could not have done so without Germany's support of their foolishness.  Consequently, for Germany to insist the deficit countries have a moral obligation to prevent loan portfolio losses is like saying they have a moral obligation to accept higher unemployment in order for Germany to reduce its unemployment.  "Whether or not these countries default or devalue should be wholly a function of their national interest, and not a function of external obligation."

There is another reason why it makes no sense to demand deficit countries to act to protect the value of portfolios accumulated by surplus countries and it has to do with the sustainability of policies aimed at generating trade surpluses, because the maintenance of the value of those obligations is largely the consequence of the trade policies in the surplus countries.  To explain this, Pettis uses Germany as an example of all trade surplus countries and Spain as an example of all trade deficit countries and it should be remembered going forward that the use of "Germany" and "Spain" are allegorical for the purposes of argument although true for each specifically.  Germany and Spain have put into place policies that ensure Germany runs a current account surplus and Spain runs a current account deficit.  "As long as Germany runs current account surpluses for many years and Spain the corresponding deficits, it is by definition true there must have been net capital flows from Germany to Spain as Germany bought Spanish assets (which includes debt obligations) to balance the current account balances.  The capital and current accounts for any country, and for the world as a whole, must balance to zero."

In the old specie currency days this would have meant gold and silver flowed from Spain to Germany with less gold and silver in Spain being deflationary and more gold and silver in Germany being inflationary until the real exchange rate between the two countries adjusted sufficiently to reverse the trade imbalances as the result of changes in domestic prices.  During the imperial period of the late 19th Century, this adjustment mechanism was subverted by a process described by John Hobson in his theory of under-consumption in which "... the imperial centers systematically under-consumed and exported huge amounts of their savings to the colonial periphery, which of course allowed them to run large and profitable trade surpluses against the periphery."  The export of money from the imperial countries to the colonial peripheral countries was the primary method of colonial exploitation.  The imperial countries "managed" the colonial economies and their tax systems ensuring repayment of all imperial debts.  Consequently, large current account imbalances could persist as long as the colony had assets to trade.  Pettis discussed this in May using this paper by Kenneth Austin.

Things are different in today's world where there is no adjustment mechanism that permits or prevents persistent current account imbalances. Consequently, if Germany runs persistent trade imbalances with Spain, there can be only three possible outcomes.  The first would require a scenario in which Germany is a very small country like Sri Lanka or runs a very small trade surplus than Spain's borrowing capacity would be unlimited as long as its growth in debt is more or less in line with Spain's GDP growth.  If Germany is a large country or runs large surpluses, this is not a possible outcome.  The second is once Spain's debt levels become a worry, Germany and Spain can reverse the policies which led to the large trade imbalances, i.e., Germany would begin to run a current account deficit and Spain a current account surplus.  "In this way German capital flows to Spain can be reversed as Spain pays down those claims with its own current account surplus.  Neither side loses."  The third possibility is Spain takes steps to erode the value of those claims in real terms by devaluing its currency, by inflating away the value of its external debt, by defaulting on its debt and repaying only a fraction of original value, by expropriating German assets, or by a combination of these actions all of which are not available to any country which is a member of the eurozone monetary union.

In Pettis' opinion, the claims must be eroded, because Spain's debt must grow at an unsustainable pace with respect to GDP growth and it must eventually default not having unlimited borrowing capacity.  This is a variation of the Triffin Dilemma.  The important point is "Once you have excluded infinite borrowing capacity there are arithmetically no other options."  Germany must either reverse its current account balances with Spain or accept erosion in Spanish assets as a consequence of the current account imbalances between the two countries.  To Pettis it is obvious the Germanys of the world, like Japan, are doing everything possible to resist reversing the current account balances.  In that case the Spains of the world are left with no choice but to erode the value of assets held by creditor countries by devaluation, inflation, or default.  Pettis uses the Marshall Plan, which was an economic stimulus not an austerity plan, as an example of a mechanism to facilitate the flow of US current account surpluses to Europe.  "The alternative to the Marshall Plan was either the collapse in the US export market, a European default, or a less friendly European expropriation of US assets."   Pettis suspects that Germany is hoping and arguing that Spain can reverse its current account deficit without the need of Germany to reverse its current account surplus, but this will not work.  China makes the same illogical demand when it insists the US raise its savings rate while China avoids making necessary domestic adjustments, including its currency.  It does not solve the problem and pushes the imbalances off into the future or unto another country with the same consequences.

This is why Pettis finds the moaning and groaning over the erosion of the value of claims accumulated by surplus countries as surreal:  "There is only one possible way to avoid the erosion of value, and that requires that the surplus countries work with the deficit countries to reverse the trade imbalances."

Pettis continues with his "obsession" (his word) with the debt story in China.  For six years he has been saying it is unsustainable while other analysts ignored the balance sheet problems,  Now other analysts are worried about debt in China, but Pettis is unconvinced they recognize the problem is systemic, because the other analysts focus on different sectors of the Chinese economy and look for government plans to address these specific sectors.  "Specific debt problems, in other words, are simply the consequences of the underlying imbalances and there is nothing the government can do except shift rising debt from one part of the balance sheet to another.  Debt overall will continue to rise inexorably until there is a radical reform of the growth model ..."

Even the least aggressive parts of the Chinese press is no longer ignoring the problem as this article in the People's Daily reports that a potential 3.5 trillion yuan ($541 billion) of local government loans were not discussed and are not covered in a National Audit Office report.  Local government debt, according to the article, stands at 10.7 trillion yuan of which 8.5 trillion yuan was funded by bank loans.  For Pettis the issue is not the lack of a master plan to solve the problems of local government debt, "The issue is that debt, whether at the local government level, the central government level, or the corporate and SOE level, is going to continue to rise quickly."  He then cites this South China Morning Post article (topics.scmp) as closer to understanding the underlying balance sheet problem by discussing that 70% of local government funded projects were not producing enough cash flow to repay debts and listed prominent examples.  The article also says there is a disagreement between the national Audit Office report and the PBoC which puts the local government debt figure at 14.4 trillion yuan not 10.7.  Different agencies are producing different numbers using different research methods and the article says "The resulting asset writedowns would wreak havoc on bank balance sheets and means they may have to be bailed out by the government."  Pettis concludes "The problem, in other words, is borrowing for overinvestment in projects that are not economically viable.  Irving Fischer said in his "Debt deflation Theory of the Great Depressions" that "over-investment and over-speculation are often important, but they would have far less serious results were they not conducted with borrowed money."  Over indebtedness lends importance to over investment and over speculation is the key point for Pettis as "The resolution of overinvestment with borrowed money pushes the cost off into the future, and so makes it less likely that governments, worried about rising unemployment today, minimize the eventual cost.  Debt exacerbates the underlying problem as well as the cost of the adjustment because it tends to force pro-cyclical behavior, both on the way up, when it exacerbates overinvestment, and on the way down, when debt repayments constrains growth even further."  By this, I interpret Pettis to be concerned about the misallocation of spending which aggravates a country's balance sheet, which is composed of the private sector, the public sector, and the external sector, problems rather than balance them at zero as a proper direct employment stimulus would, i.e., the money has been diverted to capital projects and not aggregate demand.

Pettis then cites this Caixin article on SOEs (state owned enterprises) becoming private equity funds.  Pettis finds it hard to accept a booming private equity industry in China is being funded by SOE's.  He does not agree that SOEs are investing as the result of their rising profitability and finacial strength, because we have no very good view of the true structure of their balance sheets.  STudies have shown that SOEs are not profitable in meaningful sense as they rely upon monopoly pricing, direct subsidies, and artificially low financing costs which reduces there only way to make money as a massive direct and indirect transfer from the household sector.  Pettis would not be surprised, if next year, after the government has clamped down on local government debt, all sorts of problems will be found in the financial operations of the SOEs.  Pettis believes the SOEs are actually wealth destroyers, although technically profitable.  It still makes no sense for them to be involved in private equity except their access to artificially cheap capital and the real cost of capital is so low that SOEs borrow and invest in anything that moves to make money on capital rather than production.  "Capital (for those who can get it) is virtually free and there is absolutely no need for borrowers to worry about whether or not they are investing it productively."  It is easier to invest in any hot money sector.

The whole growth money needs to be radically reformed and the cost of capital raised.  Pettis believes there is a worried group at the PBoC and State Council who know this, but the last interest rate raises were a response to knowing inflation figures will be higher in June than May.  This shows a lack of discipline, because the higher inflation rate means real interest rates are still declining.  Even at the higher interest rates, no one with access to credit is going to turn credit down.

Pettis then finishes by citing this article from Caixin on a recent speech by the economist Wu Jinglian, which said "China's 'market forces have regressed' as government agencies have started to play a more obstructive role in resource allocation ... Governments at various levels also have a huge hold over major economic resources such as land and capital ...China lacks a legal foundation that is indispensable for a modern market economy ... Government officials intervene in the market at their will through administrative means ...China's market forces gained vigor when the pricing of goods was liberalized in the early 1990s and million of township enterprise privcatized ...Entering the 2000s, however, the reform of state-owned enterprises suffered a setback, and the SOEs have inhabited an increasingly assertive role in the market at the expense of private businesses ... Wu noted the current growth model is unsustainable and has been built on investment that exploits resources ... Another consequence of strengthened government control over the distribution of resources and active intervention in economic activity is more corruption and a larger wealth gap ..."

Pettis then refers to Mahatma Gandhi complaining that speed is irrelevant if you are going in the wrong direction and finishes with the observation that Temasek Holdings (Singapore state investment fund) is reported to be selling its shares in Chinese bank stocks.

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