Guest Blogger: Warren Mosler With Economic Speech for President Obama

Warren Mosler is an economist, former hedge fund manager, and institutional investment advisor with his own broker/dealer and investment management firms.  This article was first posted on his blog The Center of the Universe.  I have my own concerns and thoughts on what President Obama should do to create jobs and economic growth with less systemically dangerous financial activity which I intend to write this weekend.  Different opinions and analysis are always useful in developing one's own analytical conclusions.

                                        PRESIDENT OBAMA --- USE THIS SPEECH

This is the speech I would make if I were President Obama:

My fellow Americans, 

let me get right to the point.

I have three bold new proposals to get back all the jobs we lost, and then some.

In fact, we need at least 20 million new jobs to restore our lost prosperity and put America back on top.

First let me state that the reason private sector jobs are lost is always the same.

Jobs are lost when business sales go down.  

Economists give that fancy words- they call it a lack of aggregate demand.

But it's very simple.  

A restaurant doesn't lay anyone off when it's full of paying customers, 

no matter how much the owner might hate the government, 

the paper work, and the health regulations.

  

A department store doesn't lay off workers when it's full of paying customers,

And an engineering firm doesn't lay anyone off when it has a backlog of orders.

Restaurants and other businesses lay people off when their customers stop buying, for any reason. 

So the reason we lost 8 million jobs almost all at once back in 2008 wasn't because all of a sudden 

all those people decided they'd rather collect unemployment than work.

The reason all those jobs were lost was because sales collapsed.  

Car sales, for example, collapsed from a rate of almost 17 million cars a year to just over 9 million cars a year.

That's a serious collapse that cost millions of jobs.

Let me repeat, and it's very simple, when sales go down, jobs are lost, 

and when sales go up, jobs go up, as business hires to service all their new customers.

So my three proposals are specifically designed to get sales up to make sure business has a good paying job for anyone 

willing and able to work.

That's good for businesses and all the people who work for them.

And these proposals are bipartisan.  

They are supported by Americans ranging from Tea Party supporters to the Progressive left, and everyone in between.

So listen up!

My first proposal if for a full payroll tax suspension.

That means no FICA taxes will be taken from both employees and employers.

These taxes are punishing, regressive taxes that no progressive short ever support.

And, of course, the Tea Party is against any tax.  

So I expect full bipartisan support on this proposal.

Suspending these taxes adds hundreds of dollars a month to the incomes of people working for a living.

This is big money, not just a few pennies as in previous measures.

These are the people doing the real work.  

Allowing them to take home more of their pay supports their good efforts.

Right now take home pay is barely enough to pay for food, rent, and gasoline, with not much left over.

When government stops taking FICA taxes out of their pockets, 

they'll be able to get back to more normal levels of spending.

And many will be able to better make their mortgage payments and their car payments,

which, by the way, is what the banks really want- people who can make their payments.

That's the bottom up way to fix the banks, and not the top down bailouts we've done in the past.

And the payroll tax holiday is also for business, 

which reduces costs for business, 

which, through competition,

helps keep prices down for all of us, which means our dollars buy more than otherwise.

So a full payroll tax holiday means more take home pay for people working for a living,

and lower costs for business to help keep prices and inflation down,

so sales can go up and we can finally create those 20 million private sector jobs we desperately need.

My second proposal is for a one time $150 billion Federal revenue distribution to the 50 state governments 

with no strings attached.  

This will help the states to fill the financial hole created by the recession, 

and stay afloat while the sales and jobs recovery spurred by the payroll tax holiday

restores their lost revenues.

Again, I expect bipartisan support.  

The progressives will support this as it helps the states sustain essential services, 

and the Tea Party believes money is better spent at the state level than the federal level.  

My third proposal does not involve a lot of money, 

but it's critical for the kind of recovery that fits our common vision of America   

My third proposal is for a federally funded $8/hr transition job 

for anyone willing and able to work, 

to help the transition from unemployment to private sector employment.

The problem is employers don't like to hire the unemployed, 

and especially the long term unemployed.

While at the same time, 

with the payroll tax holiday and the revenue distribution to the states,

business is going to need to hire all the people it can get.

The federally funded transition job allows the unemployed to get a transition job,

and show that they are willing and able to go to work every day,

which makes them good candidates for graduation to private sector employment.

Again, I expect this proposal to also get solid bipartisan support.

Progressives have always known the value of full employment, 

while the Tea Party believes people should be able to work for a living, rather than collect unemployment.

Let me add here that nothing in these proposals expands the role or scope of the federal government.

The payroll tax holiday is a cut of a regressive, punishing tax, 

that takes the government's hand out of the pockets of both workers and business.

The revenue distribution to the states has no strings attached.  

The federal government does nothing more than write a check.

And the transition job is designed to move the unemployed, who are in fact already in the public sector,

to private sector jobs.

There is no question that these three proposals will bring drive the increase in sales we need to 

usher in a new era of prosperity and full employment.

The remaining concern is the federal budget deficit.  

Fortunately, with the bad news of the downgrade of US Treasury securities by Standard and Poors to AA+ from AAA,

a very important lesson was learned.

Interest rates actually came down.  And substantially.

And with that the financial and economic heavy weights from the 4 corners of the globe 

made a very important point.

The markets are telling us something we should have known all along.

The US is not Greece for a very important reason that has been overlooked.

That reason is, the US federal government is the issuer of its own currency, the US dollar.

While Greece is not the issuer of the euro.

In fact, Greece, and all the other euro nations, have put themselves in the position of the US states.

Like the US states, Greece and other euro nations are not the issuer of the currency that they spend.

So they can run out of money and go broke, and are dependent on being able to tax and borrow to be able to spend.

But the issuer of its own currency, like the US, Japan, and the UK, 

can always pay their bills.

There is no such thing as the US running out of dollars.

The US is not dependent on taxes or borrowing to be able to make all of its dollar payments.

The US federal government can not go broke like Greece.

That was the important lesson of the S and P downgrade, 

and everyone has seen it up close and personal and they all now agree.

And now they all know why, with the deficit at record high levels, interest rates remain at record low levels.

Does that mean we should spend without limit and not tax at all?

Absolutely not!

Too much spending and not enough taxing will surely drive up prices and inflation.

But it does mean that right now, 

with unemployment sky high and an economy on the verge of another recession,

we can immediately enact my 3 proposals to bring us back to 

a strong economy with good jobs for people who want them. 

And some day, if somehow there are too many jobs and it's causing an inflation problem,

we can then take the measures needed to cool things down.

But meanwhile, as they say, to get out of hole we need to stop digging,

and instead implement my 3 proposals.

So in conclusion, let me repeat these three, simple, direct, bipartisan proposals

for a speedy recovery: 

A full payroll tax holiday for employees and employers

A one time revenue distribution to the states

And an $8/hr transition job for anyone willing and able to work to facilitate 

the transition from unemployment to private sector employment as the economy recovers.

Thank you.

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Uncertainty and European Bank Risks

The stress of the global financial crisis continue to haunt European banks as the economy continues to slow and bond vigilantes target sovereign debt of countries (such as the countries of the eurozone) who do not have their own fiat money.  The emergency lending facilities of the ECB have become more important for many European banks. On last Monday, banks deposited 128.7 billion euro with the ECB and borrowed 555 million euro overnight from the ECB Marginal Lending Facility, which was up from 90 million the prior day.  As Greek default becomes more inevitable and other eurozone countries struggle with sovereign debt financing, the interbank lending market has shown increasing stress as the skepticism about bank liquidity throughout Europe grows.  On Tuesday, European banks borrowed 2.82 billion euro overnight from the ECB, despite the stigma attached to the Marginal Lending Facility.

As the result of increasingly perceived risk by investors, European banks will pay more for the $100 billion of cash they need to raise by the end of the year.  Banks are hoarding cash, depositing it with the ECB, rather than lend it to other banks as political leaders squabble and preach deficit reduction which will only slow the economy faster.  Credit Agricol, with significant Greek exposure, posted profits which beat forecasts and felt compelled to complain about unjustified market irrationality and volatility.  A Bundesbank board member stressed in public comments that recent dollar money market tensions were far from the 2008 crisis levels and European banks are not facing a funding crisis as the result of U.S. money market funds becoming more selective to whom they lend.  The Bundesbank board member emphasized the liquidity available through repos and the ECB's readiness to mitigate problems with the swap agreement with the Fed. On Thursday, the Greek central bank (Bank of Greece) announced it had activated an Emergency Liquidity Assistance program to insure liquidity funding and all small, medium, and large Greek banks, except the National Bank of Greece, have indicated they will participate.  A Fitch survey of U.S. money funds showed a 9% decreased exposure to Europe last month and significant caution with respect to Italy and Spain.  Bankers have estimated that Italy lost $40 billion worth of money market funding in July.  While these figures are miniscule compared to the 8000 billion euro funding of the 91 eurozone banks, it does show the true state and reliance of eurozone banks on short term funding with some 58% of that funding needing to rolled over in two years and 47% in less than one year, but the official line is that there is nothing really wrong with the eurozone banks.

Today, Christine Lagarde of the International Monetary Fund, in a speech at Jackson Hole, said that European banks may need urgent forced capital injections to stem the eurozone's sovereign and financial crisis as they must be strong enough, in her words, to withstand the risks of sovereigns and weak growth.  She indicated that while private funding should be the priority, public funding, perhaps through the EFSF, should be ready.  She emphasized the IMF's change from immediate fiscal tightening to fiscal programs which allow spending to continue now while economies stay weak and reduce deficits over the long term.  This speech occurred at the same time as the second and third largest Greek banks announced an all share merger to be followed with a 500 million euro capital injection.

This IMF changed emphasis which acknowledges the need for public spending to feed growth during periods of declining aggregate demand is a refreshing change from the 1997 austerity mistake the IMF imposed on Japan which stifled growth.  Eurozone banks will remain key indicators in a global economy which is slowing down and economic contraction which eurozone austerity has accelerated.

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European Bank Liquidity

Starting last week we started seeing questions surfacing regarding the liquidity needs of European banks as a result of the volatile swings in the stock markets (if bank stock equity goes down they face the need to raise more capital) and potential opening market attacks on French banks (which I find hard to believe resulted from misinterpretation of a fictional series in a French newspaper). On August 10th, ECB overnight lending facility use jumped $5.75 billion dollars (4.058 billion euro), although it could have been from timing issues as banks awaited the arrival of ECB six month funds.  It was noted last week that the LIBOR-OIS (bank credit risk) spread with EURUSD basis swaps was widening but differently than it did in 2008.  The LIBOR-OIS was due to a rise in the LIBOR which would indicate the gap is being driven by liquidity measures, but the EURUSD basis swap was increasing on the short end implying near term caution rather than systemic risk.  Short term wholesale funding problems are magnified when access to long term funding in senior unsecured debt markets become more independently difficult for banks.  Nomura  noted the net stable funding ratio shows CASA, SocGen, Bankia, UniCredit, Commerzbank, and Intesa with the lowest ratios, but no European banks have reserve problems and, as of last week, no European bank had gone to the ECB for USD liquidity.  In relation to the short term liquidity functions last week, it also appeared that the peripheral eurozone countries were having a collateral crunch as well as a credit crunch.

Yves Smith at naked capitalism noted this week that mid-tier banks are finding it harder to get funding in interbank markets, that five year CDS of eurobanks are trading wider than they did in 2008m U.S> money market funds have cut back on exposure to European banks, eurobanks are have a harder time borrowing euro from the ECB to swap for US dollars, and the eurozone is not prepared for any large scale recapitalization of banks program.

On Wednesday of this week, one European bank borrowed $500 million, which was an unusually large amount for one bank, from the ECB in US dollar liquidity for the first time since February.  This would indicate it was probably a larger European bank under temporary stress.

Today, the Wall Street Journal wrote that the New York FED is meeting with the U.S. offices of large European banks to gauge their vulnerability to to escalating financial conditions and potential funding difficulties as U.S. branches of foreign banks became net borrowers of dollars from their overseas affiliates for the first time in a decade.  The New York FED President, Dudley, was quick to publicly state this was just a standard FED review.

On this Wednesday, excess liquidity in money markets actually rose 167 billion euro as Euribor lending rates went down.

This has led to a renewed discussion, involving nerves, noise and funding fears, of what level of funding stress European banks may or may not be facing.  While there are indications of stress in the wider markets, the spread on the three month Euribor rate and the overnight  index swap OIS rates has widen but nowhere near the post-Lehman 2008 peak.  What is interesting is the spike is from a drop in the OIS rate not the Euribor, which implies banks think the swap rates will drop and liquidity improve.  This would indicate the situation is not one of extreme stress, but an evolving situation which requires watching.

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Links 8/16/2011: Eyes on Growth

These are links from last week through 8/13/2011.  A little hindsight never hurt objective analysis.

Hussman's market commentary beginning of last week.

Grantham last week on global economy, seven lean years, and investing in a corrupt world.

Kudlow Comedy Capers.

Facing reality

Investor flows and 2008 Oil prices.

Index funds and commodity prices.

Equity prices and growth scares.

Down stock market not S&P downgrade but lack of growth.

S&P decision irrelevant.  Bill Mitchell

David Levey on S&P downgrade as unwarranted.  Rajiv Sethi

Defining economic interests.

Limitations of ECB are its failures.

Market reaction and default. Paul Krugman

Eurobonds or bust.

Slithering to the wrong kind of union.

Stagnant and paralyzed.

Tax Expenditures are big government and should be cut (what the rich do not want to hear).

Target2 & ECB liquidity management.

An experiment in austerity. Bruce Bartlett

An alternative to austerity.  L. Randall Wray

Bank of England's substantial risks.

Deficits and defense spending.

The many ways to count Chinese debt.

Eurocrisis reaches the core.

We don't have a long term debt problem.  James Galbraith

It is a weak economy not a AAA credit rating downgrade.

Illinois budget does not address pension payment backlog.  Moody's

Still waiting for expansionary contraction in UK.

The crisis is unemployment not debt.

Income inequality is bad for rich people.  Yves Smith

The FED dissenters.

Failed monetary policy created this crisis.  Joseph Stiglitz video interview

The return of the Bear.  Steve Keen

Debunking demand and supply analysis.  Steve Keen

Fractious national leaders cannot lend stability to Europe.

Irish NAMA bad debt assets.

Freedom is not built on free market corruption.

Europe's rational idiocy.  Yanis Varoufakis

Why ECB must issue eurobonds for its own survival.  Yanis Varoufakis (I have long advocated need for eurobonds but I do not believe the ECB would be the proper issuer)

Chaos is dawning on dysfunctional governments.  Andy Xie

German taxpayers willingly subsidize bankers.  Michael Hudson

Germany must defend the euro.

Tea Party not factually correct; a conservative criticism. Simon Johnson

Shorting ban on euro banks and macroeconomic threats.


Will the Swiss franc be pegged to the euro?

Swiss franc exposes foreign currency denominated debt exposure of Hungarian banks.

Unofficial U.S. problem bank list at 988.


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Were UK Riots Symptoms of Larger Global Unrest With Austerity and Inequality?

The UK recent riots have been characterized as nihilist acts of thugs, looters, and common thieves, yet, they lasted four days and spread to other neighborhoods in London and other cities and the participants crossed racial lines.  Much like the UK riots in 1981, there was a general dislike and distrust of authority and the police.  The authorities and mainstream media played the riots as criminal anarchy resulting from poor parenting and a history of government coddling which should be suppressed and order restored in order to proceed with government austerity programs supported by the financial services sector which is seeing a concentration of power in their protected status from failure without regard to systemic risk.

Austerity deepens and intensifies social-economic inequality, which brings into question government austerity programs which slow and destroy growth.  As is being seen in Greece, Spain, and Italy, as well as Israel, where protests and demonstrations are becoming common, as well as past UK demonstrations over social and education cuts; just as protests in Egypt, Tunisia, Yemen, Bahrain, Libya, and Syria sought social justice, democracy, and opportunity, when the concentration of power increasingly disenfranchises citizens and/or fiscal consolidation intensifies the likely reaction against corruption and self-serving elitism, historically, is social unrest.  Global economic uncertainty in one form or another is a breeding ground for social unrest.  When it gets so bad it seems as if you have nothing more to lose and you hate the life from which you have no opportunity to improve, civil disorder gets the attention of those in authority and privilege and it then becomes a question of whether they will eventually listen or if they will keep cutting of the heads of the people to restore order.

Living standards and social-economic inequality have been bad in the UK and austerity has magnified the problem.  These UK rioters are being brought before Magistrate's Court for a few minutes of summary hearing before a judge.  Some are as young as 11 and many are over 35 years of age; some young adults are voluntarily surrendering when they realize they looted and not just protested as everyone who thinks is asking why rather than condemning.  During the riots and currently, there are those in the media, politics, and UK government who are attempting to minimalize and paint the rioters not just as thieves and thugs but leaches on the public dole.  This serve no good public purpose in a democracy.  The global financial crisis, protection of financial interests, continuing high unemployment,  social service, health care, and education cuts limiting survivability, much less quality of life, and access to opportunity and the level playing field of a free society not only breed social unrest seeking justice and equality of opportunity, it also breeds right wing extremism.

Edward Harrison of CreditWritedowns has elegantly summarized the the right wing threat and growing crisis in Europe succinctly in the failure of the EU and the eurozone to confront the obvious defects of the euro and act democratically in unity for a common purpose and common safety to provide eurobonds and insure liquidity in a monetary union in which necessary fiscal transfers and fiscal union are perceived as "taxes" and "costs" rather than the normal resolution of current account trade imbalances within the monetary union.

My graduate and post graduate work has concentrated on social economic changes, not just the turning or tipping points, but the periods immediately prior and after.  We are in a period in which the actions of our politicians in all the countries of the world and the citizens of those countries are going to determine in society continues to evolve democratically or if it prefers the neo-feudalism of a corporatist state in which the government and the private financial sector have the same interests.  The economist Nouriel Roubini in a recent interview not only assessed the probability of recession at 50%, but also observed that we are at a stage where it is possible that capitalism could destroy itself.

What do you choose?  Freedom or security?  Access to opportunity or special privilege? 
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Are French Banks Under Self-Fulfilling Market Attacks?

 On Monday August 8th, the cost of CDS and bond yields of  both France and Germany went up, when one would have expected them to go down with the ECB buying Italian and Spanish bonds.  The euro also declined in value to the Scandinavian currencies, which would indicate the Scandinavian currencies were perceived as safer.  Together, France and Germany constitute 1/3 of the equity of the ECB and are the two largest economies in the eurozone.  France's AAA credit rating became the target of market rumors that it could be downgraded as the result of the United States downgrade and the realization the ECB bond buying would be a temporary stop gap on Spanish and Italian yields with the EFSF needing significant expansion if it was to have the economic resources to handle intervention into Spain and/or Italy.  France has gained the perception of being in the market eurozone crisis crosshairs with the illusion that Germany would be the remaining safe haven, despite its bond yields and CDS also going up.  Standard and Poor's was quick to state publicly that France is more serious in addressing its public debt than the United States and is implementing higher taxes and spending austerity, which is not very encouraging because France is suffering from slowing growth just as Spain, Italy, and Germany are to different degrees. 

The realization that bond buying by the ECB will only be temporary and the EFSF will need more money and the creation of eurobonds, as we have advocated, may actually be unavoidable has caused overnight lending to tighten and eurozone banks to be perceived as more risky sending bank shares down lead by the French banks SocGen and CreditAgricole.  Rumors of a French bank having problems pervaded the market, while the more likely reality was a recognition of broader macroeconomic issues of growth and deteriorating eurozone stability with the euro effectively being shorted and the decline in bank equity values only magnifying the potential need of eurozone banks to raise capital.  At least one Asian bank cut the credit lines of French banks.  The willingness of banks to lend to each other continued to diminish with more pressure on short term lending raising questions of pressure on the long end of lending and the increasing likelihood the ECB would have to do much more to maintain liquidity besides by sovereign debt.

Commerzbank, which is 25% owned by the German government, announced it's profits would decline 93% on Greek debt writedowns and its shares still went up 4.5% on Wednesday, but the illusion that German banking is strong and Commerzbank (and any other German bank or landesbank that discloses risks or funding needs) is a special case continues to be promulgated.  The continuing uncertainty of the eurozone's continued failures in the deepening implementation of austerity and refusal to create a democratic fiscal union with eurobonds is showing itself in the declining equity value of European banks and the need of those banks to raise more capital in what is forming up as a potential global crisis. 

Despite statements to the contrary, after the market in the United States closed Thursday, Spain, Italy, Belgium, and France banned short selling.

The euro was defectively constructed with fiscal union and the means to fiscally adjust eurozone internal trade imbalances legally prohibited creating a monetary union with no fiscal union transfer process as a sovereign nation with fiat money has and monetary union in which all of its sovereign nation members were effectively reduced to nations using and financing sovereign debt in a foreign currency (the euro).  They are reaping the harvest of that crop.

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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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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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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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Does the ECB Use Liquidity as a Weapon?

 Interest rates and money markets are moving up in the eurozone.  Yet, the ECB has continued to contract its balance sheet which has sporadically forced the EONIA above the ECB refi rate, which would indicate the ECB is contracting liquidity at the very time its member countries need liquidity.  Given the current problems with Greece, this is like, as David Beckworth has written, throwing gasoline on the fire.

I have previously questioned whether the ECB has used liquidity to force Portugal into a bailout and definitely used its purse strings to push Ireland into a bailout which nationalized Irish bank debt protecting core eurozone banks as senior bond holders. 

As Michal Darda elaborates in Beckworth's post, contracting the ECB balance sheet, contracting liquidity, and raising interest rates may be the right monetary policy for Germany and France, but it is the worst thing that the ECB could do for Greece, Portugal, Ireland, Spain, and Italy.  It is one thing to have banks in Ireland who threw risk management out the window and decades of political and private corruption in Greece and it is another to defend austerity to the destruction of the peripheral member countries by driving Portugal to bailout, Greece to the brink of default, and place cross hairs on Spain and Italy.  Just as inappropriate deficit reduction and tightened monetary policy in the United States in 1936-37 led to a depression within a depression, the ECB is following a confidence debasing path in the monetary base of its currency, which may very well result in an international loss of confidence in the euro and the need of the ECB to refinance itself.  But it is intent on making those outraged Greek "peasants" accept austerity and protect the core eurozone financial system --- at least for awhile.

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On the Supremacy of The Irrational: Pushing Greece to the Brink of Implosion

While Europeans saw the decision of the eurozone Finance Ministers to back away from a funding plan for Greece and demand an affirmative Greek vote and a further austerity program as a smart political move, other parts of the world saw it as yet another internecine failure to comprehend what is going on in Greece and the conditions of the Greek people.  Europeans refuse to consider that it is the euro which has driven Greece to its present state and believe Greece would enjoy no confidence from the international market if it defaulted whether within the euro or by adopting its own fiat currency.  Nor do they understand that a default within the euro would be a disorderly default, while a planned (is there enough time?) default with a fiat currency could be orderly.  The question of confidence is in how long the euro will continue destroying its current account balance deficit members with its refusal to adopt proper fiscal transfer mechanisms consistent with an economically efficient monetary union.

The essential and fundamental differences between a fiat currency and the euro have confused many commentators and economists, because they do not recognize the euro's failure to provide a fiscal transfer process creates a denial of national fiscal policy and how continued political demands for more and more austerity is destructive of aggregate demand creating a perceived lack of political will which engenders a growing lack of international confidence in the ability of the euro to serve the people of the eurozone.

While John Dizard dismisses Greek protests as just "striking civil servants" who will have no impact on Greek politics and incorrectly assumes that periodic monthly large withdrawals from Greek banks are runs on the banks and a banking crisis when there are no lines of clamoring depositors demanding their money.  He assumes a default is coming and that it will be within the euro and it will cause Greek banks to fail, because they own Greek debt, as do many individuals, pension funds, and foreign banks.  Wealthy Greeks, beginning for a period in 2010, have and are periodically moving money out of Greece, as well as other assets such as yachts, to avoid taxes and ordinary Greeks have started this year to withdraw deposits in order to maintain living conditions, i.e., they are devouring their savings, as we have written in this recent post.  This is consistent with a currency crisis, which is a lack of confidence, rather than a banking crisis.  The Greek protestors are a diverse group of union members. unemployed, pensioners, and small business people, who despair over the loss of sovereignty, threats to democracy and human freedom from eurozone proponents who demand political unity at any cost which cannot fix the euro, and living conditions which are spiraling down.  They have had enough of austerity and politicians who cannot serve the best interests of the people.

In order to protect the euro, Greece, Ireland, and now Portugal have been forced into austerity and bailout designed to defend core European banks.  Ireland was conned into accepting indentured servitude for its citizens.  Portugal has been duped into accepting austerity which the ECB demanded and which the Portugese may find unpalatable more quickly than desired.  Greece has been pushed and pushed to the brink of enslavement as the eurozone demands absolute fiscal control of Greece as core Europe continues to hide the capitalization needs of its large and smaller banks.  At what point will a people not fight back?

If Greece were to default, why would they not do so in an orderly process which includes withdrawal from the euro and redenomination of its debt in its own fiat currency, devalued in relation to the euro, which would protect its banks and citizens?  It would not be easy, but, if it were thoroughly planned, the substantive economic damage would be primarily contained to eurozone banks and foreign holders of private debt which would still be income producing.  This is not a scenario which I relish, nor one I have advocated, but the eurozone seems committed to implosion as long as it defends the euro as a currency without a fiscal transfer process and demands austerity and human misery of its less economically powerful members even if it means the destruction of sovereign rights to protect its citizenry and democracy.  I would much rather see eurobonds, a fiscal transfer mechanism, and coordinated investment from the European Investment Bank, as Rob Parenteau and Jan Kregel have written and/or tranche transfers, as Yanis Varoufakis has proposed, although I wonder if tranche transfers by themselves might just delay the end game.  Unfortunately, we do not live in reasonable times.  The Irrational rules.  Are we doomed to relive the currency crisis of 1931 Germany which was caused by a lack of political will and deficit reduction economic policies, which created an international lack of confidence in Germany's ability, despite a trade surplus, to pay international debts in a currency fixed to the gold standard?


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Greek Bank Withdrawals Continue

In the first six months of 2010, we saw large withdrawals from Greek banks by what appeared to be wealthy Greek citizens who were taking their money out of Greece and perhaps the euro.  Domestic non-financial Greek corporations began a relatively steady withdrawal of time deposits in July 2009.  Non-euro residents began their withdrawals in June 2008 accelerating in December 2008.  Other euro residents to a lesser degree began a weaker pattern of withdrawals in December 2008.  A spreadsheet can be accessed at the Bank of Greece here (choose "breakdown by sector" in part A; then "deposit flows" in spreadsheet).

For the year ending March 2011, Emporiki, which is a subsidiary of the French bank Credit Agricole, saw its deposits decline 17.8% and Geniki, a subsidiary of the Fench bank Societe Generale, saw its deposits decline 12%.

One of the distinctions between a currency crisis and a banking crisis is that a currency crisis is a lack of confidence that prompts foreign depositors and investors to withdraw money but domestic depositors do not massively withdraw.  A banking crisis occurs when domestic demand depositors withdraw their money en masse.  The latter has not occurred.

However, since November 2010, Greek household deposits have declined 12,108 million euro through April 2011.  While some of this may be further withdrawals by wealthy Greeks, it appears that this series of withdrawals are probably by ordinary citizens for whom it is not efficient to take their money out of Greece.  It would appear that ordinary Greek citizens are finding it necessary to use their savings to maintain an acceptable standard of living.  With Greek unemployment in March at 16.2% and youth unemployment at 42.5% for Q1 unemployment of 15.9% or an increase of 35.1% from Q1 2010, it is not hard to understand the need of Greek households to reduce savings to live. With austerity imposing higher taxes, higher fees, lower wages, rising prices, and less work, Greece is venturing into the territory of desperation and riots with its government ready to fall as it seeks to pass another, deeper austerity program mandated by the EU, IMF, and ECB.

While you can read about Greek demonstrations when they turn into riots, there has been little to no mention of Greek domestic bank withdrawals in the Greek mainstream or government media.  The reports of domestic withdrawals have been in News247 on May 26th and sources citing News247.  In fact, there appears to be an official campaign to suppress economic opinions, debate, and information by the government which can only aggravate the tensions in a democracy and promote divisive argument.  Given recent proposals within the eurozone to strip deficit countries of fiscal decision making and place it with a central eurozone authority, to what extent is the eurozone becoming a threat to democracy and human freedom?

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Michael Pettis on Rebalancing Through Wage Increases in China

In Michael Pettis' most recent private newsletter, from which I am only allowed to make excerpts, which arrived by email yesterday, he brings up in the beginning the question of what is going on in copper in China and comes to the same conclusions I did in my April 29 article, "China: Copper In, Copper Out".  He observes, "What is happening here in China is not that credit growth is too slow, but rather that infrastructure and real estate investment is so high that it has overwhelmed the available sources of credit ... Borrowers are resorting to some fairly convoluted and expensive ways of obtaining short-term credit largely because they cannot obtain financing from the local banks ... That doesn't mean there isn't liquidity in China.  There is tons of it, but much of the credit is being disintermediated because of constraints on bank lending ... So Chin's problem isn't that liquidity is tight --- how could it be with so much credit expansion and hot money inflow?  The problem is that much of the real investment growth seems to be funded outside the normal lending channels ... The weird distortions in the banking system, where credit isn't rationed by price but by quantity and hierarchy, has turned China, at least temporarily, into a revolving door for copper imports and exports."

In response to Jeremy Grantham's newsletter, on which I commented as part of my article, "Where Is the Global Economy Going?", he provides a revised set of tables comparing Chin's contribution to world GDP as opposed to its consumption of food and non-food commodities:

	Share of global GDP
China’s GDP	9.4%
China’s GDP (PPP basis)	13.6%

Non-food commodities	Share of global demand
Cement	53.2%
Iron Ore	47.7%
Coal	46.9%
Steel	45.4%
Lead	44.6%
Zinc	41.3%
Aluminum	40.6%
Copper	38.9%
Nickel	36.3%
Oil	10.3%

Food commodities	Share of global demand
Pigs	46.4%
Eggs	37.2%
Rice	28.1%
Soybeans	24.6%
Wheat	16.6%
Chickens	15.6%
Cattle	9.5%

He observes that these tables show "... the disproportion between China's share of global GDP and China's commodity consumption"  and "The tables give a very good sense of what might happen to global demand for various commodities as China rebalances."  If Chinese demand declines 10%, world global demand will decline nearly 5%.  However, he is stressing non-food commodities, because "... food consumption will continue rising as Chinese households move up the income scale."

He then asks is China currently rebalancing?  Rebalancing would have to consist of three segments: rising wages, appreciating currency, and interest rate hikes.  "... rebalancing means eliminating and reversing the wealth transfers from the household sector to the state and corporate sector.  The most important of these transfers has been the undervalued exchange rate, the lagging wage growth, and artificially low interest rates."  In the last year this has begun to reverse with the currency appreciating, interest rate hikes, and wages surging.  To the question of have we "... seen an improvement in the underlying economy caused by a rising consumption share", his answer is no.  He cites the most recent (April 2011) World Bank quarterly report on China from which he quotes a summary citing resilience in moving towards macroeconomic normalization with fiscal and monetary contribution, with which Pettis does not agree.  He does, however, think the rest of the quote about the slow down in consumption growth in 2011 is key.  The World Bank said, "Consumption growth slowed in early 2011. But overall domestic demand held up well, supported by still strong investment growth. Real estate investment has so far remained robust to measures to contain housing prices—a policy focus. Reducing inflation is the other policy priority, after inflation rose to 5.4%, largely on higher food prices."  For Pettis, "Growth has been propped up by what I think are very unhealthy increases in investment, and you can always increase growth in the short term by increasing investment, but its sustainability is really questionable."  It should be understood that "increasing investment" is referring to state owned enterprise (SOE) investment as opposed to private small companies.  This imbalance is creating an unsustainable situation which is causing a slow down in consumption growth that one would not expect (as shown by this World Bank graph) if rebalancing growth was taking place with GDP growth.

If China is doing all of the right things --- raising wages, the exchange rate, and interest rates, Pettis asks, why isn't the economy rebalancing?  For Pettis, the key is the difference between real and nominal changes, because the nominal changes are not what matters.  Since last June the currency has appreciated approximately 5% since last June.  "On an annualized basis that's around 6% in currency appreciation since June.  But changes in a currency's real value reflect more than just changes in its nominal value.  They also depend crucially on inflation growth differentials and productivity growth differentials."  If Chinese inflation is higher than US inflation, then "... the RMB is appreciating in real terms even if its nominal exchange value hasn't changed.  Conversely, if US inflation is higher than Chinese inflation, then the RMB is depreciating in real terms."  Pettis then engages in an analysis of inflation in China and dismisses the argument that the higher inflation in China means is being appreciated by 8-9% annually by a combination of nominal appreciation and inflation and the 25% undervaluation of the renminbi could be eliminated in three years, because it would "... only be true if there were no differences in the productivity growth rates between the two countries."  But the Chinese worker productivity is growing faster than the American worker productivity and Chinese CPI inflation has not been in the tradable good sector but almost all in the food sector.  Pettis believes there has been relatively low inflation in the price inputs to both the US and Chinese tradable goods sector making the relevant price differential relatively small.  "In other words we can probably ignore the impact of inflation on the real changes in the currency." Pettis obviously disagrees with those who believe China's relatively high CPI means China's appreciation is not as low as it seems and is two or three percentage points higher. 

With respect to productivity growth differentials, Chinese worker productivity has been growing annually at two to three percent faster than US worker productivity and maybe even more depending on how one measures it.  This would mean the renminbi should nominally appreciate 2-3% just to keep from depreciating in real terms.  "Real appreciation, in other words, is less than nominal appreciation because of China's more rapid productivity growth."  He concludes there may have been some real appreciation against the US dollar but not very much.  Given the dollar is the world reserve currency and the renminbi is pegged to the dollar and the sharp depreciation of the dollar against the euro and other major currencies, the renminbi has also probably depreciated depending on the period at which you look.  "So what does this mean?  Just this: the claim that one of the key components of rebalancing --- an appreciating currency --- has been occurring may be vastly overstated or even simply wrong.  There has been little or no real appreciation of the RMB and there may actually have been some depreciation."

Just because interest rates have gone up since October does not mean rebalancing either.  While lending rates have gone up 100 basis points, depending on maturity rate, inflation has gone up 200-300 basis points, depending on the construction of the inflation index and focus on components.  "Real interest rates, in other words, have actually declined steeply.  Borrowers can obtain financing at lower real costs than ever, and depositors are suffering a significant and growing real loss on the money they leave in the banks.  This just increases the transfer of wealth from net depositors, who are households for the main part, to net borrowers, who are the state and corporate sector."  In fact, the imbalances from interest rates have been exacerbated.

With respect to wage growth, wages have been growing very quickly in the last year, but, given inflation, real wages have been growing less quickly than nominal wages.  Pettis believes that real wages have probably risen faster than productivity, which means that household wages have comprised a growing share of GDP.  Pettis' concern is the reason for the rising wages may be "... that demand for workers is driven primarily by unsustainable and unhealthy increases in the past two years in real estate and infrastructure development ..."  However unhealthy the reason, if it continues,  the problem of lagging wage growth to productivity growth may be eliminated and reversed.

Pettis summarizes that the undervalued exchange rate has not changed much and has not contributed to rebalancing, excessively low interest rates have gotten worse and significantly exacerbated the imbalances, and wage growth has gotten better and has contributed to rebalancing.  He sees no real way to compare the impact of these variables to judge the net effect.  He believes all one can do is look at household consumption, its relationship to GDP growth, and infer the net impact.  If, as the World bank suggests, household consumption is slowing, it might infer the imbalances are getting worse or it might mean there is a lag in the positive impact of rising wages and we will just have to wait until the end of 2011 to make an assessment.

Pettis has more surety in knowing, if wages are rising and interest rates are declining, there would be more real wealth transfers within the economy from corporates to households in the form of wages and from households to corporates in the form of lower interest rates.  This "... means that labor-intensive industries are bearing more than the full cost of whatever adjustment may be happening and capital-intensive industries are bearing a negative cost."  he then anecdotally relates he is hearing from his students, many of whom are the children of the owners of SME (small and medium enterprises), which tend to be labor intensive, that they are raising wages as fast as they can and still losing workers to the SOE's, which are capital intensive.  For SME's, wages are a significant portion of the business expenses, particularly if the cost of borrowing is declining.  It is Pettis' position the small businesses have driven real and sustainable growth in China, while SOE's and government investment have promoted growth by pumping wasteful levels of unsustainable investment.  For me, this brings up the question of why the SMEs and SOE's are competing for the same workers given the unemployment problem in China and the use of infrastructure projects to put people to work.  I am just surmising, but it would appear the SOE's may be raising wages faster than the SME's, leaving the SME's the job of training new employees.  If that is so, then government infrastructure projects are not hiring the unemployed and training them as much as such projects would warrant.  All of which goes back to Pettis' problem with the SOE's privileged existence.

For Pettis, the hope is not for smaller companies to grow faster to facilitate the reduction of investment growth, but the necessity to engineer the reduction of investment growth.  "The more important the capital-intensive sector is to the economy, and the more addicted these companies become to cheap capital that can be flung into wasteful projects, the harder it will be to rebalance the economy."  It will only make rebalancing transfers more difficult.

It is clear to Pettis that China is not rebalancing.  Beijing's growth model implies to Pettis that rebalancing cannot happen in theory except with a sharp contraction of investment growth.  It is not happening.  Pettis thinks, if there is another year or two of stagnant consumption as a share of GDP, maybe policymakers will wake up.  Until then do not expect the SME sector to prosper.  You can expect more of the same.

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