Last week Portugal sold 1 billion euro of 12 month bonds for a yield of 5.902% which was up from 4.331% only three weeks previously. Former Portuguese President Mario Soares in a speech claimed that Germany and France are trying to own the European Union, the financial crisis was global and imported into Portugal, and Germany has benefited the most from the eurozone and will not be content until Germany it the Master. Soares went so far as to say Germany has led us into two world wars and asked if it is leading Europe to another.
During the week the five year bond rose to 9.91%, which would indicate bailout level, while Portuguese politics remained polarized over any attempt to ask for EU/IMF aid. Moody's cut Portugal's sovereign debt by a notch and the largest Portuguese banks told the central bank of Portugal that they would stop buying government bonds and urged the government to take a short-term interim loan until the June 5th election. With the bank's ultimatum, many market commentators concluded it was already too late and the EU said there would be no interim loan without first agreeing to a international bailout with strict conditions.
By Wednesday the government sought financing assistance from the European Union. Wednesday's short term debt auctions indicated Portugal had met its debt ceilings and many observers were still mystified at the refusal of the Portuguese banks to buy sovereign debt as it was not in their interest to not do so. Portugal's banks did rally, as a result, in the stock market. The rich countries of the Europe immediately pushed Portugal to make even deeper fiscal cuts and privatization during its national election if it hoped to receive any aid.
Subsequently, the Portuguese banks publicly said that the ECB had instructed them to cut their exposure to Portuguese sovereign debt if they wanted continued financing liquidity from the ECB. Trichet immediately denied the ECB had "forced" the Portuguese banks or government to do anything. Trichet also publicly stated that the ECB, in fact, had encouraged the Portuguese. This would not be unlike the pressure the ECB exerted on Ireland.
The ECB has chosen repeatedly to abandon the national needs of eurozone members and forsake a stronger union, while asserting austerity which is dooming each eurozone country one at a time to more debt, no growth, and no power.
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Monday, April 11, 2011
Tuesday, April 5, 2011
European Economic Commentary Week Ended 4/3/2011
As other investment advisors have told me, institutional investors are blasé about the global financial threat inherent in the eurozone currently, because they either believe the eurozone will just keep muddling along or it is doomed to collapse and the ECB and EU will provide sufficient backstop; these high level investors just do not want to think about the threat to the global financial system. Interestingly, the same holds true for the high probability of a housing double dip in the United States and a financial system which has become more concentrated and systemically dangerous, more politically powerful, and has successfully resisted significant regulatory change. At the same time China is on the brink of slowing and slowing rapidly until it suddenly jumps back on economic growth with excessive investment. In the past, I have characterized the Chinese adjustment problem as similar to a driver in an automobile with two accelerators and two brakes. These are all serious potential threats to the global financial system.
Last week we wrote about "Reorganizing Irish Banks" in which the ECB has refused to provide necessary medium term bridge financing, in which the EU is not willing to discuss lower interest rates for loans to Ireland, and the Irish people are becoming increasingly dissatisfied with how other European banks and countries are being beneficially fire-walled at the expense of the Irish people. That article took a lot of the European commentary for the week, but much has been left. I realize my former weekly "Economic and Market Commentary" were very popular, but they took an average of eight hours or more to organize and write and after two weeks I was only half finished with the week ending 12/25/2010.
While the QNA report showed annual declines in Ireland's GDP and GNP were <1%> and <2.1%>, the year to year quarter comparison showed a real GNP gain of 2.7% and a GDP decline of <.6%>. The nominal effects on the budget deficit were not encouraging for a country which does not have a fiat currency.
During 2010, the average price for a house in Ireland dropped 10.8%.
In the UK anti-austerity demonstrations were allowed by authorities to get out of hand, despite knowing the plans of fringe groups to be disruptive and destructive in other wise peaceful demonstrations. The UK Chancellor defended the austerity cuts as necessary to create growth and jobs. As we have written numerous times, there is significant economic theory from different economic theoretical schools which shows the opposite will happen, except for a small elite class. Meanwhile, UK productivity is disappearing, although I doubt it is the result of rising business regulation and more the result of less demand creating less investment.
In France right wing nationalists have softened their speech to appeal to larger segment of the French population and are gaining support. The True Finns, a nationalist party, is expected to get 18-30% in the elections in Finland. The nationalist party in the Netherlands, as the third largest party, remains a policy influential coalition partner in the government. In Germany, the nationalist concerns with immigration, debt and budgets, and EU fiscal transfers have caused divisions which have allowed the left Greens and SPD to benefit in Baden-Wurttemberg state election.
Greek unemployment was up to 14.8% in December and austerity is making the social problems more toxic. Increased demonstrations and strikes are occurring and increased fees and taxes are being ignored by the people.
It has been popular to blame the current eurozone problems on unit labor cost in the different countries and the degree of debt to GDP. While the period after the adoption of the euro did show a significant increase in unit labor costs, except for Germany, debt was not a problem until the global financial crisis. Since nominal depreciations are precluded in the eurozone and fiscal transfers are not sufficiently available in the monetary union which has failed to provide fiscal union, the common currency is central to the problem. Looking at unit labor costs in relation to other competitiveness indicators would appear to show that it is a misguided analysis and that internal devaluations will not work as the real lack of competitiveness comes in the export basket of each nation --- and I would add in what they import. Unfortunately, movements towards fiscal centralization have been to enforce fiscal stringency and not to reduce the problems of a common currency. Consequently, continued austerity, as the Australian economist Bill Mitchell has inveighed, will mean a slow, sluggish recovery in Europe.
While Spain has been actively building a firewall against contagion, its efforts to bolster the capital strength of its banks is being constantly questioned. The merger of four Spanish cajas (savings banks) failed when they asked for 2.78 billion euro from the Fund of Orderly Bank Restructuring after the Bank of Spain had estimated their need at half that amount (1.45 billion euro). Later in the week, another savings bank, CAM, was not able to complete a merge and the Bank of Spain began hunting for a buyer. This has been seen by many as a prelude to what will come. While the Bank of Spain has estimated savings banks capitalization needs at 15 billion euro, others are estimating 23.6-29.2 billion euro. I have maintained for some time the Spain is the keystone and will be the next target after Portugal whether it deserves to be or not. Meanwhile the Bank of Spain is estimating unemployment will rise to 20.7%. This unemployment is wide spread across age and education. While the EU dithers and looks to punish rather than preemptively help, Norway's (not in the eurozone) sovereign wealth fund is looking to invest in Spanish companies.
The new Basel III bank rules, which German banks are fighting, may mean that European banks have to raise 2.3 billion euro in capitalization at the same time insurers, at the same time as the largest buyers of bonds, are be forced to limit bond purchases under the EU Solvency II rules.
Portuguese debt yields soared. The resignation of Portugal's government means it will be very difficult to negotiate a bailout, which is not politically popular in Portugal, during an election. S & P downgraded Portugal's five largest banks for what was essentially seen as not financial reasons but the political situation. The Portuguese opposition party has endorsed a plan of budget cuts without tax increases as a conservative attempt to gain votes despite heavy public opinion against austerity. The Portuguese government maintains it can meet its bond redemptions in 2011, although there are those who say it will not have the liquidity to meet May redemptions. The government also announced it had a budget deficit of 8.6% rather than the target 7.3% in 2010. When Portugal did sell 1.6 billion euro of short term bonds due June 2012, it was at 5.793% versus 4.331% on one year bonds sold on March 16th, just two weeks earlier.
A German finance minister has joined several other European countries in suggesting covered bonds be included in Level 1 assets as there are not enough sovereign bonds to fulfill the asset level needs for banks.
As we wrote last week, the European Council's emergency funding creation the ESM is being recognized as a threat to the perceived credit worthiness and credit ratings of peripheral countries, because it would require default and/or restructuring of debt for assistance. Portugal and Greece were both downgraded by S & P on concerns the ESM would force them to restructure debt and S & P called the ESM a negative game changer. Even the Italians have shown skepticism and referred to the ESM reforms as the Germanization of the euro. The French, despite France's faithful companion role with Germany, have expressed the observation that the ESM is imperfect and requires immediate revision. While the ESM has been hailed as the Grand Bargain, it has failed to create an exit from crisis at an acceptable political cost, it has complicated the fiscal costs of the financial crisis, and it has failed to create a mechanism which will deal with and prevent fiscal crisis in a system which does not allow orderly fiscal transfers. Munchau has also pointed out the ESM "Grand Bargain" will be phased in and not fully funded until 2018 to appease German voters, everyone is guaranteeing everyone, the EFSF has no capital making default a risk to guarantors and is the emergency mechanism until 2013, and the fiscal adjustments of a guaranteed payment will not be politically acceptable to national governments. Institutional ownership of Greek and Portuguese bonds has melted away to the point where not even short, via demand to borrow bonds, positions are dead. The S & P lowered Ireland's credit rating to BBB+ from A- citing the possibility of restructuring under the ESM. The IMF is, according to Der Spiegel, rumored to be urging the Greek government to restructure its debt now with lower interest rates, extended maturities, or actual haircuts on the debt.
The ECB has informed Ireland that if it wants a medium term funding facility, it will need to guarantee the debt. Prior to the release of the Irish bank stress tests, the Bank of Ireland made a plea to the government to avoid nationalization. The ECB does not fear default by Ireland or other peripheral countries, because the central banks of all eurozone countries are borrowers from the ECB, which means the risk is piling on other central banks and money flows from one national central bank indirectly through the eurosystem. This means, for example, that Germany has actually provided more funding than estimated. The European banking system is highly interconnected with, for instance, German banks exposed to 22% of Greek external debt, 21% of Spain's external debt, 20% of Ireland's, and 14% of Italy's. While the ECB sees hidden burden sharing, the Irish do not see burden sharing. The eurozone is flying without a safety net and with a higher possibility of a potential significant drop in aggregate demand than is discounted. The ECB and the eurozone cannot afford a sovereign default and, yet, the newly designed emergency fund would require default and restructuring before assistance is given a country. How is the ESM "Grand Bargain" not the the Grand Shaft for the peripheral countries?
Despite having been rebuffed by the ECB on lower interest rates on its bailout, Ireland still intends to argue for lower interest rates at future EU meetings and with the visiting IMF team. As I have argued in past articles and as was discussed in the above paragraph, if the ECB ultimately fails to provide the medium term funding facility, is the ECB willing to take the blame for the ECB and other European national central banks being left with what would remain of the Irish banks and the losses of the Irish bank senior bond holders, who are banks in Germany, France and the UK among others. Politically, the new Irish government sees no possibility in turning back on their election promises to the people. Some informed commentators in Ireland believe the recent bank stress tests did not disclose anything which was unexpected and the more serious problem are domestic and international market commentators who do not understand Ireland's financial condition and have ulterior publicity motives in claiming default is inevitable. What begs the question is, how will the Irish government answer to its people if the ECB and European Council run the country for the greater benefit of mainland Europe?
The possibility the ECB will raise the interest rate in response to German inflation is ignoring the very negative economic impact such a move will have on the peripheral countries. It will be like throwing oil on the fire. While some might argue that inflation will cause greater cohesion in unit labor costs as Germany adjusts internally, it is still acknowledged that ample discord will result within the eurozone over inflation and the ECB response. Jurgen Stark has confused the states within the fiscal union of the United States with the nations of the eurozone and jumps from the Fed does not create policy for individual states (because they are part of a fiscal union with fiscal transfers) to the ECB cannot tailor monetary policy for individual eurozone (which has no fiscal union) countries. They are not comparable except in contrast. As far as Stark and others are concerned, including the ECB, the peripheral countries can suck it up and suffer. The German view prevailed at the European Council and provided limited liabilities in an emergency funding ESM mechanism, which will not take effect until 2013 but is now negatively affecting the peripheral countries credit worthiness and ratings. The German viewpoint is actually accelerating the problem of domino credit attack and crisis on one eurozone country after another. Bill Mitchell has elaborated in lengthy detail on how the eurozone is pursuing the wrong goals.
This completes this European/eurozone economic commentary for the week ended 4/2/2011. It took over six hours and I have not touched any market commentary for that week or any general economic commentary, or United States, China, Japan, or the Middle East of which I have plenty left.
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Last week we wrote about "Reorganizing Irish Banks" in which the ECB has refused to provide necessary medium term bridge financing, in which the EU is not willing to discuss lower interest rates for loans to Ireland, and the Irish people are becoming increasingly dissatisfied with how other European banks and countries are being beneficially fire-walled at the expense of the Irish people. That article took a lot of the European commentary for the week, but much has been left. I realize my former weekly "Economic and Market Commentary" were very popular, but they took an average of eight hours or more to organize and write and after two weeks I was only half finished with the week ending 12/25/2010.
While the QNA report showed annual declines in Ireland's GDP and GNP were <1%> and <2.1%>, the year to year quarter comparison showed a real GNP gain of 2.7% and a GDP decline of <.6%>. The nominal effects on the budget deficit were not encouraging for a country which does not have a fiat currency.
During 2010, the average price for a house in Ireland dropped 10.8%.
In the UK anti-austerity demonstrations were allowed by authorities to get out of hand, despite knowing the plans of fringe groups to be disruptive and destructive in other wise peaceful demonstrations. The UK Chancellor defended the austerity cuts as necessary to create growth and jobs. As we have written numerous times, there is significant economic theory from different economic theoretical schools which shows the opposite will happen, except for a small elite class. Meanwhile, UK productivity is disappearing, although I doubt it is the result of rising business regulation and more the result of less demand creating less investment.
In France right wing nationalists have softened their speech to appeal to larger segment of the French population and are gaining support. The True Finns, a nationalist party, is expected to get 18-30% in the elections in Finland. The nationalist party in the Netherlands, as the third largest party, remains a policy influential coalition partner in the government. In Germany, the nationalist concerns with immigration, debt and budgets, and EU fiscal transfers have caused divisions which have allowed the left Greens and SPD to benefit in Baden-Wurttemberg state election.
Greek unemployment was up to 14.8% in December and austerity is making the social problems more toxic. Increased demonstrations and strikes are occurring and increased fees and taxes are being ignored by the people.
It has been popular to blame the current eurozone problems on unit labor cost in the different countries and the degree of debt to GDP. While the period after the adoption of the euro did show a significant increase in unit labor costs, except for Germany, debt was not a problem until the global financial crisis. Since nominal depreciations are precluded in the eurozone and fiscal transfers are not sufficiently available in the monetary union which has failed to provide fiscal union, the common currency is central to the problem. Looking at unit labor costs in relation to other competitiveness indicators would appear to show that it is a misguided analysis and that internal devaluations will not work as the real lack of competitiveness comes in the export basket of each nation --- and I would add in what they import. Unfortunately, movements towards fiscal centralization have been to enforce fiscal stringency and not to reduce the problems of a common currency. Consequently, continued austerity, as the Australian economist Bill Mitchell has inveighed, will mean a slow, sluggish recovery in Europe.
While Spain has been actively building a firewall against contagion, its efforts to bolster the capital strength of its banks is being constantly questioned. The merger of four Spanish cajas (savings banks) failed when they asked for 2.78 billion euro from the Fund of Orderly Bank Restructuring after the Bank of Spain had estimated their need at half that amount (1.45 billion euro). Later in the week, another savings bank, CAM, was not able to complete a merge and the Bank of Spain began hunting for a buyer. This has been seen by many as a prelude to what will come. While the Bank of Spain has estimated savings banks capitalization needs at 15 billion euro, others are estimating 23.6-29.2 billion euro. I have maintained for some time the Spain is the keystone and will be the next target after Portugal whether it deserves to be or not. Meanwhile the Bank of Spain is estimating unemployment will rise to 20.7%. This unemployment is wide spread across age and education. While the EU dithers and looks to punish rather than preemptively help, Norway's (not in the eurozone) sovereign wealth fund is looking to invest in Spanish companies.
The new Basel III bank rules, which German banks are fighting, may mean that European banks have to raise 2.3 billion euro in capitalization at the same time insurers, at the same time as the largest buyers of bonds, are be forced to limit bond purchases under the EU Solvency II rules.
Portuguese debt yields soared. The resignation of Portugal's government means it will be very difficult to negotiate a bailout, which is not politically popular in Portugal, during an election. S & P downgraded Portugal's five largest banks for what was essentially seen as not financial reasons but the political situation. The Portuguese opposition party has endorsed a plan of budget cuts without tax increases as a conservative attempt to gain votes despite heavy public opinion against austerity. The Portuguese government maintains it can meet its bond redemptions in 2011, although there are those who say it will not have the liquidity to meet May redemptions. The government also announced it had a budget deficit of 8.6% rather than the target 7.3% in 2010. When Portugal did sell 1.6 billion euro of short term bonds due June 2012, it was at 5.793% versus 4.331% on one year bonds sold on March 16th, just two weeks earlier.
A German finance minister has joined several other European countries in suggesting covered bonds be included in Level 1 assets as there are not enough sovereign bonds to fulfill the asset level needs for banks.
As we wrote last week, the European Council's emergency funding creation the ESM is being recognized as a threat to the perceived credit worthiness and credit ratings of peripheral countries, because it would require default and/or restructuring of debt for assistance. Portugal and Greece were both downgraded by S & P on concerns the ESM would force them to restructure debt and S & P called the ESM a negative game changer. Even the Italians have shown skepticism and referred to the ESM reforms as the Germanization of the euro. The French, despite France's faithful companion role with Germany, have expressed the observation that the ESM is imperfect and requires immediate revision. While the ESM has been hailed as the Grand Bargain, it has failed to create an exit from crisis at an acceptable political cost, it has complicated the fiscal costs of the financial crisis, and it has failed to create a mechanism which will deal with and prevent fiscal crisis in a system which does not allow orderly fiscal transfers. Munchau has also pointed out the ESM "Grand Bargain" will be phased in and not fully funded until 2018 to appease German voters, everyone is guaranteeing everyone, the EFSF has no capital making default a risk to guarantors and is the emergency mechanism until 2013, and the fiscal adjustments of a guaranteed payment will not be politically acceptable to national governments. Institutional ownership of Greek and Portuguese bonds has melted away to the point where not even short, via demand to borrow bonds, positions are dead. The S & P lowered Ireland's credit rating to BBB+ from A- citing the possibility of restructuring under the ESM. The IMF is, according to Der Spiegel, rumored to be urging the Greek government to restructure its debt now with lower interest rates, extended maturities, or actual haircuts on the debt.
The ECB has informed Ireland that if it wants a medium term funding facility, it will need to guarantee the debt. Prior to the release of the Irish bank stress tests, the Bank of Ireland made a plea to the government to avoid nationalization. The ECB does not fear default by Ireland or other peripheral countries, because the central banks of all eurozone countries are borrowers from the ECB, which means the risk is piling on other central banks and money flows from one national central bank indirectly through the eurosystem. This means, for example, that Germany has actually provided more funding than estimated. The European banking system is highly interconnected with, for instance, German banks exposed to 22% of Greek external debt, 21% of Spain's external debt, 20% of Ireland's, and 14% of Italy's. While the ECB sees hidden burden sharing, the Irish do not see burden sharing. The eurozone is flying without a safety net and with a higher possibility of a potential significant drop in aggregate demand than is discounted. The ECB and the eurozone cannot afford a sovereign default and, yet, the newly designed emergency fund would require default and restructuring before assistance is given a country. How is the ESM "Grand Bargain" not the the Grand Shaft for the peripheral countries?
Despite having been rebuffed by the ECB on lower interest rates on its bailout, Ireland still intends to argue for lower interest rates at future EU meetings and with the visiting IMF team. As I have argued in past articles and as was discussed in the above paragraph, if the ECB ultimately fails to provide the medium term funding facility, is the ECB willing to take the blame for the ECB and other European national central banks being left with what would remain of the Irish banks and the losses of the Irish bank senior bond holders, who are banks in Germany, France and the UK among others. Politically, the new Irish government sees no possibility in turning back on their election promises to the people. Some informed commentators in Ireland believe the recent bank stress tests did not disclose anything which was unexpected and the more serious problem are domestic and international market commentators who do not understand Ireland's financial condition and have ulterior publicity motives in claiming default is inevitable. What begs the question is, how will the Irish government answer to its people if the ECB and European Council run the country for the greater benefit of mainland Europe?
The possibility the ECB will raise the interest rate in response to German inflation is ignoring the very negative economic impact such a move will have on the peripheral countries. It will be like throwing oil on the fire. While some might argue that inflation will cause greater cohesion in unit labor costs as Germany adjusts internally, it is still acknowledged that ample discord will result within the eurozone over inflation and the ECB response. Jurgen Stark has confused the states within the fiscal union of the United States with the nations of the eurozone and jumps from the Fed does not create policy for individual states (because they are part of a fiscal union with fiscal transfers) to the ECB cannot tailor monetary policy for individual eurozone (which has no fiscal union) countries. They are not comparable except in contrast. As far as Stark and others are concerned, including the ECB, the peripheral countries can suck it up and suffer. The German view prevailed at the European Council and provided limited liabilities in an emergency funding ESM mechanism, which will not take effect until 2013 but is now negatively affecting the peripheral countries credit worthiness and ratings. The German viewpoint is actually accelerating the problem of domino credit attack and crisis on one eurozone country after another. Bill Mitchell has elaborated in lengthy detail on how the eurozone is pursuing the wrong goals.
This completes this European/eurozone economic commentary for the week ended 4/2/2011. It took over six hours and I have not touched any market commentary for that week or any general economic commentary, or United States, China, Japan, or the Middle East of which I have plenty left.
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Sunday, April 3, 2011
Michael Pettis on Financial Reform in China
In Michael Pettis' most recent private newsletter released today, he noted that the People's Bank of China in just three months had changed its global economic outlook from one in which the global economic recovery would continue through 2011 in which stabilizing the price level was a main priority as well as controlling liquidity inflows and bringing credit growth to normal levels to a global economic outlook in which the fundamental basis of the global economic recovery is not very solid and, while price stabilization is still an important task, they are now only referring to "manageable liquidity efficiently". To Pettis this implies policymakers are more concerned about slowing growth than domestic overheating. He would not be surprised to see less tightening
Pettis observes that "Every case of rapid, investment-driven growth in the past century ... has at some point reached a stage in which debt levels rose to unsustainable levels ...". He believes that in the early stages of the growth model much of the economic investment is viable and necessary but at some point, as the result of subsidies, distorted incentive (in which investment benefits accrue to those making the investments while losses are shared by society), and cheap financing lead to wasted investment and debt rising faster than asset values.
I have argued in the past in "It's All About Leverage" that the excessive growth or decline of private debt can be an indicator of economic bubbles or contraction and the need for appropriate fiscal action.
For Pettis, China is at the very least headed towards misallocated resources and excessive debt levels. The key problem, according to Pettis, is the way in which the financial system allocates capital. It can happen in any financial system, but he sees two basically different conceptions of financial systems. In one, banks act as agents of the government or an economic elite, accumulating savings and deploying them in projects selected by the economic elite. This rapid credit expansion is inherently risky and results in extracting the risk from banks and imbedding it in the state in order to guarantee financial stability. Losses and risks are socialized. This can generate tremendous growth in '... countries that are economically and technologically undeveloped and in which it is relatively easy to identify projects that generate economic value." However, it will not easy to properly identify projects in more advanced countries with a well developed infrastructure, high wealth level, and worker productivity. In the long run, this financial banking model begins to over invest, because it continues to use the same allocation process, which is supported by increasingly powerful segments of society which benefit most directly and have no desire to support change.
The other banking financial system is one in which there is reduced misallocation, because the banks decide themselves what activities they fund and their shareholders and depositors share both the rewards and the risks. This type of system, while prone to instability, is more efficient at allocating capital as the result of proper risk management. In my opinion, many U.S. and other international banks have obviously not practiced proper risk management and in the recent financial crisis they greatly benefited from getting to keep their profits and have their losses absorbed by society while they grew even larger and more powerful.
For Pettis, "The current Chinese financial system ... is clearly one in which the purpose of the financial system is to act as the state's fiscal agent and in which the banking stability is guaranteed by the state" and it i clearly one in which capital misallocation is a problem. Consequently, there has been little financial reform in China, because it needs to mover from the first model to closer to the latter. Much obvious investment has been identified and funded in China during the last thirty years and the last ten years has seen socialized credit risk, very low interest rates, and short term goal oriented state lending to generate employment and growth increasing the probability of dangerous misallocation of capital. "The growth in bank assets, in other words, would be less than the growth in bank liabilities if both were correctly valued as a function of discounted expected cash flows." He is firmly convinced if government credibly removed guarantees on bank loans and removed interest rate controls, investors and depositors would assume non-performing loans would wipe out the bank's capital base and sell their stocks and withdraw their deposits. While this is unlikely to happen in China, it just means the losses are hidden and transferred to the state and from the state to households. This makes the bank as state fiscal agent inefficient. What China needs now is "... to have banks in China that can correctly identify economically useful projects in which to invest and limit their credit growth to those projects." It is Pettis' contention "... that reform in the Chinese context means moving away from the fiscal-agent model and towards one with stronger internal incentives for monitoring capital allocation, then most Chinese economists would probably agree that in the past two years reform has gone backward. There is however also a view among many academics --- one that I share --- that there has been very little meaningful reform at all, at least in the past decade."
According to Michael Pettis, financial reform in China means four things: 1) "Interest rates must be liberalized so that the true cost of capital is reflected in evaluating the worth of a project", 2) "Corporate governance must be reformed, and this means in part a significant reduction in the number of projects whose risks are socialized", 3) "The regulatory framework must be stabilized and government intervention should become much more predictable, at least on economic grounds", and 4) "Information quality must be sharply improved --- macroeconomic information as well as financial statements".
While there has been improvement in the quality of macroeconomic and financial sector data, there is still a long way to go in the quality of financial statements. I have consistently advised investors to be wary of the financial statements of Chinese companies and avoid direct ownership of Chinese stocks, deferring to well managed and diversified mutual funds in a well diversified portfolio only.
With respect to the other three areas of reform, Pettis sees not just very little change, but backward movement over the last three years. While banks compete for deposits they cannot compete on price. Bond and money market rates are not set by the market, but by the banks who are the largest purchasers of these instruments with the PBoC determining the prices in bond and money markets via its setting of deposit and lending rates. There would be a very heavy cost if corporate governance reform proceeded to quickly. Pettis is not only skeptical of talk about tremendous financial reform in the past decade and continued improvement, he believes there has been no real movement and no real reform. It needs to happen.
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Pettis observes that "Every case of rapid, investment-driven growth in the past century ... has at some point reached a stage in which debt levels rose to unsustainable levels ...". He believes that in the early stages of the growth model much of the economic investment is viable and necessary but at some point, as the result of subsidies, distorted incentive (in which investment benefits accrue to those making the investments while losses are shared by society), and cheap financing lead to wasted investment and debt rising faster than asset values.
I have argued in the past in "It's All About Leverage" that the excessive growth or decline of private debt can be an indicator of economic bubbles or contraction and the need for appropriate fiscal action.
For Pettis, China is at the very least headed towards misallocated resources and excessive debt levels. The key problem, according to Pettis, is the way in which the financial system allocates capital. It can happen in any financial system, but he sees two basically different conceptions of financial systems. In one, banks act as agents of the government or an economic elite, accumulating savings and deploying them in projects selected by the economic elite. This rapid credit expansion is inherently risky and results in extracting the risk from banks and imbedding it in the state in order to guarantee financial stability. Losses and risks are socialized. This can generate tremendous growth in '... countries that are economically and technologically undeveloped and in which it is relatively easy to identify projects that generate economic value." However, it will not easy to properly identify projects in more advanced countries with a well developed infrastructure, high wealth level, and worker productivity. In the long run, this financial banking model begins to over invest, because it continues to use the same allocation process, which is supported by increasingly powerful segments of society which benefit most directly and have no desire to support change.
The other banking financial system is one in which there is reduced misallocation, because the banks decide themselves what activities they fund and their shareholders and depositors share both the rewards and the risks. This type of system, while prone to instability, is more efficient at allocating capital as the result of proper risk management. In my opinion, many U.S. and other international banks have obviously not practiced proper risk management and in the recent financial crisis they greatly benefited from getting to keep their profits and have their losses absorbed by society while they grew even larger and more powerful.
For Pettis, "The current Chinese financial system ... is clearly one in which the purpose of the financial system is to act as the state's fiscal agent and in which the banking stability is guaranteed by the state" and it i clearly one in which capital misallocation is a problem. Consequently, there has been little financial reform in China, because it needs to mover from the first model to closer to the latter. Much obvious investment has been identified and funded in China during the last thirty years and the last ten years has seen socialized credit risk, very low interest rates, and short term goal oriented state lending to generate employment and growth increasing the probability of dangerous misallocation of capital. "The growth in bank assets, in other words, would be less than the growth in bank liabilities if both were correctly valued as a function of discounted expected cash flows." He is firmly convinced if government credibly removed guarantees on bank loans and removed interest rate controls, investors and depositors would assume non-performing loans would wipe out the bank's capital base and sell their stocks and withdraw their deposits. While this is unlikely to happen in China, it just means the losses are hidden and transferred to the state and from the state to households. This makes the bank as state fiscal agent inefficient. What China needs now is "... to have banks in China that can correctly identify economically useful projects in which to invest and limit their credit growth to those projects." It is Pettis' contention "... that reform in the Chinese context means moving away from the fiscal-agent model and towards one with stronger internal incentives for monitoring capital allocation, then most Chinese economists would probably agree that in the past two years reform has gone backward. There is however also a view among many academics --- one that I share --- that there has been very little meaningful reform at all, at least in the past decade."
According to Michael Pettis, financial reform in China means four things: 1) "Interest rates must be liberalized so that the true cost of capital is reflected in evaluating the worth of a project", 2) "Corporate governance must be reformed, and this means in part a significant reduction in the number of projects whose risks are socialized", 3) "The regulatory framework must be stabilized and government intervention should become much more predictable, at least on economic grounds", and 4) "Information quality must be sharply improved --- macroeconomic information as well as financial statements".
While there has been improvement in the quality of macroeconomic and financial sector data, there is still a long way to go in the quality of financial statements. I have consistently advised investors to be wary of the financial statements of Chinese companies and avoid direct ownership of Chinese stocks, deferring to well managed and diversified mutual funds in a well diversified portfolio only.
With respect to the other three areas of reform, Pettis sees not just very little change, but backward movement over the last three years. While banks compete for deposits they cannot compete on price. Bond and money market rates are not set by the market, but by the banks who are the largest purchasers of these instruments with the PBoC determining the prices in bond and money markets via its setting of deposit and lending rates. There would be a very heavy cost if corporate governance reform proceeded to quickly. Pettis is not only skeptical of talk about tremendous financial reform in the past decade and continued improvement, he believes there has been no real movement and no real reform. It needs to happen.
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Friday, April 1, 2011
Reorganizing Irish Banks
Going into the week when the Irish bank stress tests would be made public on March 31st, the Irish government tried to build a consensus for EU burden sharing with a proposal that the deleveraging of Irish banks be slower than previously agreed, that the EU provide medium term lending to make that possible, that holders of senior bank bonds share investment losses, and empower the EFSF to be a provider of last resort in the bank recapitalization. The Irish threat of haircuts was blunted by rumors that the ECB was preparing a new liquidity facility for troubled eurozone banks and that the plan would initially be tailor made for Ireland, but analysts quickly began speculating that the new liquidity facility would allow guaranteed collateral of a lower quality than previously accepted by the ECB.
Ireland and Europe braced themselves for the results as the belief grew that the banks would need more liquidity than previously estimated. The 24 billion euro identified recapitalization need in the stress test report was actually less than estimates of 26-30 billion euro, but it came with a warning to the Irish government from Governor Honohan of the Central Bank of Ireland that a unilateral imposition of losses on the senior bond holders without the agreement of the EU state would not be a net gain for Ireland. At the same time the Irish Department of Finance issued a bank reorganization plan which paralleled the stress test and the finance minister editorialized on the need to radically reorganize Irish banks to be smaller and more sustainable. The ECB did issue a ratings agencies preemptive strike by announcing a suspension of "... the application of minimum credit rating threshold in the collateral eligibility requirements for the purposes of the Eurosystem’s credit operations in the case of marketable debt instruments issued or guaranteed by the Irish government. The suspension applies to all outstanding and new marketable debt instruments..." until further notice.
However, the ECB's governing council were in disagreement and refused to provide the necessary the medium term funding facility which had been so publicly leaked earlier in the week on "legal concerns" it would violate European treaties. Actually, some governors argued that Ireland should be left to itself while other (like Weber) favored bond holders being bailed-in. Bottom line, it was a warning to Ireland -- if you want monetary assistance, forget about your sovereign rights and threats to make senior bond holders share in the losses of their investment. Ireland capitulated to the ECB and yielded to demands to protect senior bond holders which are German, French, and UK banks among others. While some have argued that the EU has invested large sums already to prop the Irish banking system up, it remains that the Irish banking system is being used as a firewall to protect European banks at the indentured expense of the people of Ireland. Whether Ireland will have market access given the conditionality of the proposed ESM for 2013 and if burden sharing by the senior bond holders will not happen anyway appears questionable to many in Ireland. Is it reasonable for the people of Ireland to just live with it if the European nations persist in this self-defeating policy? At some point in time, if the European nations keep on this monetary union without fiscal union course of credit destruction, a eurozone nation will just say no to the suffering and assert its sovereignty.
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Ireland and Europe braced themselves for the results as the belief grew that the banks would need more liquidity than previously estimated. The 24 billion euro identified recapitalization need in the stress test report was actually less than estimates of 26-30 billion euro, but it came with a warning to the Irish government from Governor Honohan of the Central Bank of Ireland that a unilateral imposition of losses on the senior bond holders without the agreement of the EU state would not be a net gain for Ireland. At the same time the Irish Department of Finance issued a bank reorganization plan which paralleled the stress test and the finance minister editorialized on the need to radically reorganize Irish banks to be smaller and more sustainable. The ECB did issue a ratings agencies preemptive strike by announcing a suspension of "... the application of minimum credit rating threshold in the collateral eligibility requirements for the purposes of the Eurosystem’s credit operations in the case of marketable debt instruments issued or guaranteed by the Irish government. The suspension applies to all outstanding and new marketable debt instruments..." until further notice.
However, the ECB's governing council were in disagreement and refused to provide the necessary the medium term funding facility which had been so publicly leaked earlier in the week on "legal concerns" it would violate European treaties. Actually, some governors argued that Ireland should be left to itself while other (like Weber) favored bond holders being bailed-in. Bottom line, it was a warning to Ireland -- if you want monetary assistance, forget about your sovereign rights and threats to make senior bond holders share in the losses of their investment. Ireland capitulated to the ECB and yielded to demands to protect senior bond holders which are German, French, and UK banks among others. While some have argued that the EU has invested large sums already to prop the Irish banking system up, it remains that the Irish banking system is being used as a firewall to protect European banks at the indentured expense of the people of Ireland. Whether Ireland will have market access given the conditionality of the proposed ESM for 2013 and if burden sharing by the senior bond holders will not happen anyway appears questionable to many in Ireland. Is it reasonable for the people of Ireland to just live with it if the European nations persist in this self-defeating policy? At some point in time, if the European nations keep on this monetary union without fiscal union course of credit destruction, a eurozone nation will just say no to the suffering and assert its sovereignty.
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Saturday, March 26, 2011
Did the EU Council Just Kick the Can?
As the week ended and the EU Council meeting of March 24/25 concluded, it was as if the week had never begun and all of the prior and continuing debate on a competitiveness pact and extending the EFSF and establishing a permanent ESM, the bitter Irish question of their higher interest rate, the Irish consideration of default of guaranteed debt which is not national debt exposing senior bond holders of Irish banks, the German and French canard of Ireland's corporate tax being too low when it actually generates more tax on corporate income than other eurozone countries with lower corporate taxes, and the week's events in Portugal, with rising interest rates on its debt and CDS and short term debt maturing in May and June, rejecting austerity and the international market's adamant speculation it must kneel to EU/IMF bailout, having its government resign had been some funky dream with phantom giants.
It was as if, while peering into the magic mirror, the reflection of another severe financial crisis which could cost European banks 250 billion euro vanished. Never mind that the proposed ESM funding mechanism was a convoluted everyone guaranteeing everyone by using an inverted capital structure in which, if there was actual need, it would cause a reflexive price action in the bonds. Here comes an important EU Council meeting with laborious and contentious preparation at a time when the Irish hold a default trump card, Portugal was rejecting an austerity budget forcing the resignation of its government bringing the specter of another EU bailout front and center under intense flood lights, Spain's banks capital funding is being questioned (will the German banks ever be properly tested?), Greek revenue is declining on higher taxes and fees, the rigorousness of bank stress tests remain negotiable, rising interest rates in Ireland, Greece, and Portugal as the eurozone continues to take no timely and effective action until it is too late, spreading anti-austerity demonstrations and protests in Greece, Portugal, and the UK as well as other eurozone countries, the Finns saying they will vote on no issues until after their April elections, nationalist political movements in France, Finland, and the Netherlands, and the never ending bitter internecine German national political tragic-comedy. Knock, knock, is any body listening, watching, or paying attention? Are there no clear fiscal solutions which are not two speed divisive and destructive?
Yet, the proposed ESM was viewed to be divisive. After a third round of stress tests, Ireland may have to pump 27.5 billion euro into Irish banks which would exhaust 80% of the 35 billion euro bond fund set up last year by the EU. With Ireland standing to lose over 35 of revenue if the corporate tax was harmonized, many in Ireland thought that it would be best to have no deal, and not play the trump yet, rather than a bad deal if Germany threw its weight around and France continued to tag along. Germany actually seems to be unable to understand finacial risk figures with German banks having 21.4 billion euro exposure to Irish banks and 64.7 billion euro in loans to Irish businesses. All of the ESM restructuring talk predictably sent the bonds of Ireland, Greece, and Portugal spinning. However, much of the restructuring being discussed is just a deepening of the pit with those servicing the bonds having to accept lower wages while the bondholders do not share in the union and keep wages high. Ireland is contracting not growing. Ireland is very dependent on exports and is still recovering from 2009, although its 2010 current account balance deficit is only about one fourth of the 2009 deficit. Portugal has a deteriorating cash position despite believing it has enough to get through debt maturities in May if not June, however, the political situation was untenable to the degree that the ruling party pushed a no confidence vote scenario. While many believe there is no eurozone crisis as long as Spain remains sustainable, the value of its banks assets are constantly being questioned with mortgages on the books being, perhaps, overvalued by as much as 45% laying the ground work to pressure rates up despite Spain trading very much like Italy in the bond market.
The pessimism surrounding the EU Council meeting was pervasive and on the the 24th Wolfgang Munchau voiced his three scenarios, including break up if Germany continues to insist on limited liability. Danske Bank in its three scenarios was even darker with default, Germany withdrawing, and eurozone total breakup with possibilities of revolution in parts of Europe. The EU itself had only a four item agenda: current crisis resolution, future crisis resolution, the pact for the euro, and the Commission’s proposal for reform and extension of the stability pact. To which was added Libya. What Europe got was a less substantial ESM with more funding commitment starting in 2013 which gave Merkel political cover in Germany and with an extended funding period over five years beginning in 2013 just after elections in Germany. The conclusions of the meeting were limited, soft, contradictory, and avoided action on any problem facing the eurozone. This was seen as a great victory in Germany. Of course, the day after the meeting the worry over debt and commitments and liabilities as well as the absolute need to punish surfaced, without any consideration of the effects of haircuts on bonds would have to German banks.
In the rest of Europe the reality was quick to set in with the realization that Greek and Irish bonds have already been discounted making any buy back program inadequate. The ESM cannot have a triple-A status and an effective lending capacity of 500 billion euro. The ECB began working on an emergency plan to provide 60 billion euro in medium term liquidity to Irish banks. A "major" European default still remains the biggest threat to the global financial market. All of the fanfare in Germany, France, and Italy are premature in the face of Portuguese instability. The EFSF would in effect be collateralizing or wrapping bonds of restructured bonds which would be guaranteed by the eurozone as a whole. As of Monday the 27th, Portuguese bonds will not be eligible for delivery in any of the RepoClear single A €GC basket, although LCH.Clearnet will continue delivery of Portuguese government bonds.
Portugal is going to have to come up with some bridge financing from the core eurozone or other international or private sources to insure it can get through June debt redemptions. Ireland is waiting to see if they will get help with their banks and, if Portugal is forced into bailout, what interest rate they get. Greece is fighting mounting demonstrations and tax protests. Anger is spreading against the inequity of austerity is condemning countries forced into austerity, lower wages, and personal family financial sacrifice by the eurozone rules to a future of no growth or very slow and low growth, if they are lucky, while the benefactors (the eurozone countries that export to them) continue to profit from their current account surpluses generated by the faulty construction of the monetary union and refusal to allow the formation of an effective fiscal union.
The EU Council has kicked the can down the road to June. Will they kick it even further down the road in June until, as is their usual practice, it is too late to act decisively in a timely and effective proactive manner? The bond vigilantes have been betting NO and winning; there will, consequently, always a next victim until they run out of eurozone countries. At what tipping point will this credit crisis be recognized as a currency crisis and the global financial market catches contagion?
Print Page
It was as if, while peering into the magic mirror, the reflection of another severe financial crisis which could cost European banks 250 billion euro vanished. Never mind that the proposed ESM funding mechanism was a convoluted everyone guaranteeing everyone by using an inverted capital structure in which, if there was actual need, it would cause a reflexive price action in the bonds. Here comes an important EU Council meeting with laborious and contentious preparation at a time when the Irish hold a default trump card, Portugal was rejecting an austerity budget forcing the resignation of its government bringing the specter of another EU bailout front and center under intense flood lights, Spain's banks capital funding is being questioned (will the German banks ever be properly tested?), Greek revenue is declining on higher taxes and fees, the rigorousness of bank stress tests remain negotiable, rising interest rates in Ireland, Greece, and Portugal as the eurozone continues to take no timely and effective action until it is too late, spreading anti-austerity demonstrations and protests in Greece, Portugal, and the UK as well as other eurozone countries, the Finns saying they will vote on no issues until after their April elections, nationalist political movements in France, Finland, and the Netherlands, and the never ending bitter internecine German national political tragic-comedy. Knock, knock, is any body listening, watching, or paying attention? Are there no clear fiscal solutions which are not two speed divisive and destructive?
Yet, the proposed ESM was viewed to be divisive. After a third round of stress tests, Ireland may have to pump 27.5 billion euro into Irish banks which would exhaust 80% of the 35 billion euro bond fund set up last year by the EU. With Ireland standing to lose over 35 of revenue if the corporate tax was harmonized, many in Ireland thought that it would be best to have no deal, and not play the trump yet, rather than a bad deal if Germany threw its weight around and France continued to tag along. Germany actually seems to be unable to understand finacial risk figures with German banks having 21.4 billion euro exposure to Irish banks and 64.7 billion euro in loans to Irish businesses. All of the ESM restructuring talk predictably sent the bonds of Ireland, Greece, and Portugal spinning. However, much of the restructuring being discussed is just a deepening of the pit with those servicing the bonds having to accept lower wages while the bondholders do not share in the union and keep wages high. Ireland is contracting not growing. Ireland is very dependent on exports and is still recovering from 2009, although its 2010 current account balance deficit is only about one fourth of the 2009 deficit. Portugal has a deteriorating cash position despite believing it has enough to get through debt maturities in May if not June, however, the political situation was untenable to the degree that the ruling party pushed a no confidence vote scenario. While many believe there is no eurozone crisis as long as Spain remains sustainable, the value of its banks assets are constantly being questioned with mortgages on the books being, perhaps, overvalued by as much as 45% laying the ground work to pressure rates up despite Spain trading very much like Italy in the bond market.
The pessimism surrounding the EU Council meeting was pervasive and on the the 24th Wolfgang Munchau voiced his three scenarios, including break up if Germany continues to insist on limited liability. Danske Bank in its three scenarios was even darker with default, Germany withdrawing, and eurozone total breakup with possibilities of revolution in parts of Europe. The EU itself had only a four item agenda: current crisis resolution, future crisis resolution, the pact for the euro, and the Commission’s proposal for reform and extension of the stability pact. To which was added Libya. What Europe got was a less substantial ESM with more funding commitment starting in 2013 which gave Merkel political cover in Germany and with an extended funding period over five years beginning in 2013 just after elections in Germany. The conclusions of the meeting were limited, soft, contradictory, and avoided action on any problem facing the eurozone. This was seen as a great victory in Germany. Of course, the day after the meeting the worry over debt and commitments and liabilities as well as the absolute need to punish surfaced, without any consideration of the effects of haircuts on bonds would have to German banks.
In the rest of Europe the reality was quick to set in with the realization that Greek and Irish bonds have already been discounted making any buy back program inadequate. The ESM cannot have a triple-A status and an effective lending capacity of 500 billion euro. The ECB began working on an emergency plan to provide 60 billion euro in medium term liquidity to Irish banks. A "major" European default still remains the biggest threat to the global financial market. All of the fanfare in Germany, France, and Italy are premature in the face of Portuguese instability. The EFSF would in effect be collateralizing or wrapping bonds of restructured bonds which would be guaranteed by the eurozone as a whole. As of Monday the 27th, Portuguese bonds will not be eligible for delivery in any of the RepoClear single A €GC basket, although LCH.Clearnet will continue delivery of Portuguese government bonds.
Portugal is going to have to come up with some bridge financing from the core eurozone or other international or private sources to insure it can get through June debt redemptions. Ireland is waiting to see if they will get help with their banks and, if Portugal is forced into bailout, what interest rate they get. Greece is fighting mounting demonstrations and tax protests. Anger is spreading against the inequity of austerity is condemning countries forced into austerity, lower wages, and personal family financial sacrifice by the eurozone rules to a future of no growth or very slow and low growth, if they are lucky, while the benefactors (the eurozone countries that export to them) continue to profit from their current account surpluses generated by the faulty construction of the monetary union and refusal to allow the formation of an effective fiscal union.
The EU Council has kicked the can down the road to June. Will they kick it even further down the road in June until, as is their usual practice, it is too late to act decisively in a timely and effective proactive manner? The bond vigilantes have been betting NO and winning; there will, consequently, always a next victim until they run out of eurozone countries. At what tipping point will this credit crisis be recognized as a currency crisis and the global financial market catches contagion?
Print Page
Friday, March 25, 2011
Dear Martin Wolf
Disagreement on economic issues is common and can be heated when the differences debated are significantly divergent. More often then not many exchanges of differing opinion actually involves economists who hold similar views but take exception to the use of a word or phrase. Both types of exchanges should be mutually educational in that open minded people find such exchanges stimulating of critical thinking. No one is right 100% of the time. This does not make it less difficult or challenging.
One such exchange over the use of words and phrases and the concepts they convey or imply broke out last week between Martin Wolf and Bill Mitchell. Bill Mitchell is an Australian economist and proponent of Modern Monetary Theory and sectoral balances ( a macroeconomic balance sheet in which the economy at any given time must sum up to zero for all three sectors). Martin Wolf is current day icon as a well established economic commentator and columnist who has expressed an appreciation of sectoral balances in his writings.
When on March 15th, 2011, Martin Wolf wrote a relatively innocuous article, "Japan can meet the Earthquake Test" on Japan's ability to finance recovery from its recent devastating earthquake and tsunami. The following day Bill Mitchell posted on his blog, "So near but so far ... from comprehension", a very strong series of objections to the use of "solvency" and "afford additional spending" and questions his understanding and/or use of sectoral balances, despite correct conclusions. Such an exchange is likely to become personal, despite the importance of the concept of sectoral balances and the difficulty of many people, without regard to how many monetary theories they learned, to keep the three sectors in perspective and balanced while engaging the important economic concepts of aggregate demand and output. The necessary use of the words/phrases deficit, government spending, private savings and private consumption/investment bring the curtains down in many minds and are cause for differing opinions on use and meaning among economists.
As I read both articles several times, it appeared to me that Martin Wolf was having problems with the use of sectoral balances and aggregate demand and output, which many of us coming from different monetary theory backgrounds have, and which causes to have to pause and think all three sectors through together, from time to time as we try to wrap our minds around sectoral balances without becoming confused from what we were taught. In such a situation, an exchange as above is many times not productive, because it becomes personal rather than intellectual.
Interestingly, (is anything coincidental?), on the 17th of March, Bill Mitchell wrote a very elegant piece on the 19th century Confederate States of America, "Printing money does not cause inflation", which was a very academic and yet readable piece that, low and behold, directly addressed the issues of aggregate demand and output in relation to sectoral balances in very emotionally neutral, intellectually clear exposition. Martin Wolf was never mentioned. I have no idea if this was meant as a communication to Martin Wolf or if was just how the issues coalesced in Bill Mitchell's mind and produced this independent piece.
All I can conclude is I hope Martin Wolf read it, because he would have appreciated it.
Print Page
One such exchange over the use of words and phrases and the concepts they convey or imply broke out last week between Martin Wolf and Bill Mitchell. Bill Mitchell is an Australian economist and proponent of Modern Monetary Theory and sectoral balances ( a macroeconomic balance sheet in which the economy at any given time must sum up to zero for all three sectors). Martin Wolf is current day icon as a well established economic commentator and columnist who has expressed an appreciation of sectoral balances in his writings.
When on March 15th, 2011, Martin Wolf wrote a relatively innocuous article, "Japan can meet the Earthquake Test" on Japan's ability to finance recovery from its recent devastating earthquake and tsunami. The following day Bill Mitchell posted on his blog, "So near but so far ... from comprehension", a very strong series of objections to the use of "solvency" and "afford additional spending" and questions his understanding and/or use of sectoral balances, despite correct conclusions. Such an exchange is likely to become personal, despite the importance of the concept of sectoral balances and the difficulty of many people, without regard to how many monetary theories they learned, to keep the three sectors in perspective and balanced while engaging the important economic concepts of aggregate demand and output. The necessary use of the words/phrases deficit, government spending, private savings and private consumption/investment bring the curtains down in many minds and are cause for differing opinions on use and meaning among economists.
As I read both articles several times, it appeared to me that Martin Wolf was having problems with the use of sectoral balances and aggregate demand and output, which many of us coming from different monetary theory backgrounds have, and which causes to have to pause and think all three sectors through together, from time to time as we try to wrap our minds around sectoral balances without becoming confused from what we were taught. In such a situation, an exchange as above is many times not productive, because it becomes personal rather than intellectual.
Interestingly, (is anything coincidental?), on the 17th of March, Bill Mitchell wrote a very elegant piece on the 19th century Confederate States of America, "Printing money does not cause inflation", which was a very academic and yet readable piece that, low and behold, directly addressed the issues of aggregate demand and output in relation to sectoral balances in very emotionally neutral, intellectually clear exposition. Martin Wolf was never mentioned. I have no idea if this was meant as a communication to Martin Wolf or if was just how the issues coalesced in Bill Mitchell's mind and produced this independent piece.
All I can conclude is I hope Martin Wolf read it, because he would have appreciated it.
Print Page
Portugal Refuses to Be Held Hostage
Portugal has consistently iterated that it has no desire for any EU and/or IMF bailout. Portugal has consistently railed against the international market pressures betting on bailout which have forced up bond and CDS prices and has fought back with private placements and short term borrowing to avoid locking in high interest rates for long periods. Portugal refuses to be held for ransom by an international market which is playing the historical incompetence (original Spanish text here) of the eurozone countries, the ECB, and the EU, which has consistently waited until it is too late to respond to the fiscal union needs of the eurozone members resulting from the structural deficiencies of the euro and its eurozone exchange rates.
While Portugal has committed to austerity to please the eurozone rules, its sincere attempts have meet with increasing political opposition, public protests, and little eurozone help. If Portugal had its own fiat currency, would the international bond market be as concerned about its ability to grow? What the international bond market recognizes is the dependence of eurozone members upon the willingness of other eurozone members to act together for mutual self-interest within a monetary union which has no functional fiscal union mechanisms of fiscal support. The willingness to support each other has been perverted (original Spanish text here) by a fear of debt, by a fear of sharing debt, by a fear that union means not just taking but giving, and this fear is so great that the body stench of fear is overpowering in its pervasiveness, in its intellectual panic and dreading, and in its crowding out of rational, critical analysis and consistent, collective resolution.
While the ECB has stepped in to buy Portuguese bonds to marginally keep interest rates down, they did not do so in a manner which did not influence the market rate as a market maker would have done and the market has broken down consistently in Greece, Ireland, and now Portugal. The ECB is a central bank with no sovereign funding base relying on contribution assessments which must be ratified. The good faith credit of a sovereign nation with a fiat currency depends on its perceived ability to tax and collect revenue, promote output, and create fiscal policy. The eurozone has created the euro as if it were based on a gold standard, which it is not, while failing to provide for fiscal transfers, fiscal account balance adjustments, the fiscal means to promote growth, and a unified debt issuance facility, preferring to leave each member to issue euro denominated debt which is at least, if not more, as dangerous as if it were a sovereign nation with a fiat currency issuing foreign denominated debt.
While the German and the Austrians were trying to convince each other the EFSF was big enough for improved conditions and the Germans were trying to find ways to evade the upcoming European bank stress tests, Portuguese bonds were setting off alarms and moving up towards crisis levels in February despite, almost as if independently driven, Portugal's strong efforts to find alternatives to debt auctions, such as syndication. When that happens then sovereign related corporate debt also begins to hike and become broken. Still, Portugal continued to raise money but at higher rates and with lower credit ratings. ECB liquidity operations were helpful but not significant given Portugal's banks may not have been able to issue debt to foreign investors for at least a year. With falling tax collections and revenue in Greece, Ireland challenging why its bailout interest rate is higher, a cold reception to EU finance ministers permanent EU bailout fund, and the market saying Portugal will have to ask for a bailout, Portugal remained adamant it would not ask for a bailout, despite an austerity driven contracting economy, as bond interest rates rose for all three.
It was as if no matter what Portugal did financially or economically or politically, the Gods of Debt were orchestrating its fate without regard to human effort or purpose. A new, more severe austerity budget was being proposed against strong popular and political opposition by the Portuguese government of Prime Minister Jose Socrates and the market could smell the spoils of political defeat. The austerity budget was overwhelming defeated with only the Prime Minister's party members voting for it. This left Portugal with the need to raise 20 billion euro this year, a Prime Minister resigning, and the EU Council meeting convening. Portugal's deficit may be revised up to 8% for 2010 and analysts woke up to the effect of the rising Irish bond rates, which exploded in September, had on other eurozone countries like Portugal, at the same time Germany is throwing the whole permanent bailout fund proposal back on the table for renewed debate.
Still, Portugal remained defiant it would never ask or accept a bailout having seen what happened to Greece and Ireland, but the market just shrugged it off as what they all say before it happens. All of the warnings have been essentially ignored by the eurozone and the ECB until Portugal is on the brink and facing elections with no credible government to ratify any bailout, even if one is forced upon them. The failure of the eurozone to proactively support member nations and promote growth with fiscal policy leaves Portugal's bonds heading towards 8% and no real government and a EU council which has continually kicked the can down the road. The Pact of the Euro basically proposed a mechanism for future crises, has been solidly criticized as too punishment oriented and not enough resolution oriented, and exposes the currency as unstable. With early estimates of a Portuguese bailout at 70 billion euro ($99 billion), creditor countries are scrambling for cover. Any actual bailout may cost 80 billion euro with another 37 billion euro in maturing private Portuguese bank debt up in the air, as if the Portuguese central bank and government could come up with it without the help of the ECB. The whole agenda of the European Council has been thrown in disarray with the likelihood that nothing of substance will be accomplished: no permanent bailout fund, no action on Irish interest rates, no competitiveness pact, no current or future crisis resolution, and no reform and extension of the stability pact. The Finns are not prepared to support anything with elections in April. The Germans have intensified their internal political squabbling and are demanding that their ESM capital injections be delayed until after the German 2013 elections as well as an insistence in providing financial assistance only when it is too late to prevent bailout and just prior to financial collapse.
What remains beyond the grasp of the eurozone countries with the predominant preoccupation with debt and transfers to debtor nations is the root problem is one of low growth (original Spanish text here) and an inability to recognize that growth requires not austerity and government debt reduction but economic stimulation through fiscal policy with government spending efficiently concentrated on the creation of output and jobs. With the turmoil of German politics, the rise of nationalist parties in France, Finland, and the Netherlands, and popular anti-austerity protests growing in Greece, Ireland, Portugal, and the UK, the eurozone is converging fast towards a showdown between those creditors who preach the sins of debt while raking the money in and those who realize their only hope is growth. Spain is a trillion dollar economy, the fourth largest in the eurozone, and has a smaller debt to GDP ratio than Germany. If Portugal is made hostage to a bailout and forced to continue to pay ransom to the bond vigilantes, then the pressure will turn to Spain. Without growth Spain cannot survive. The consequences to European banks are horrendous, particularly for German and French banks. One-third of the assets of Spain's banks are composed of private and government sector exposure to Portugal (original Spanish text here). German banks have three times more activity in Portuguese banks than Spanish banks do. French banks have twice the exposure to Portuguese public debt compared to Spanish banks. One could go on with individual countries banking exposure to Greece and Ireland which can be found in the Bank of International Settlements data.
The root problems are not new, but the major players are flying blind in their sleep, trembling in fear of growth for all.
On very directly related subjects, we have recently written:
German Economists & Eurozone Insolvency
The Eurozone's Murder-Suicide Pact
Ireland's Indentured Servitude
and more past:
Ireland Betrayed
Germany's Irish Hair Shirt
On the Road Out of Ireland
Ireland's Bad Bank
Denial and the Pan-European Debt Crisis
The Unfolding Pan-European Debt Crisis
Greece, Spain, and the Euro Trojan Horse
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While Portugal has committed to austerity to please the eurozone rules, its sincere attempts have meet with increasing political opposition, public protests, and little eurozone help. If Portugal had its own fiat currency, would the international bond market be as concerned about its ability to grow? What the international bond market recognizes is the dependence of eurozone members upon the willingness of other eurozone members to act together for mutual self-interest within a monetary union which has no functional fiscal union mechanisms of fiscal support. The willingness to support each other has been perverted (original Spanish text here) by a fear of debt, by a fear of sharing debt, by a fear that union means not just taking but giving, and this fear is so great that the body stench of fear is overpowering in its pervasiveness, in its intellectual panic and dreading, and in its crowding out of rational, critical analysis and consistent, collective resolution.
While the ECB has stepped in to buy Portuguese bonds to marginally keep interest rates down, they did not do so in a manner which did not influence the market rate as a market maker would have done and the market has broken down consistently in Greece, Ireland, and now Portugal. The ECB is a central bank with no sovereign funding base relying on contribution assessments which must be ratified. The good faith credit of a sovereign nation with a fiat currency depends on its perceived ability to tax and collect revenue, promote output, and create fiscal policy. The eurozone has created the euro as if it were based on a gold standard, which it is not, while failing to provide for fiscal transfers, fiscal account balance adjustments, the fiscal means to promote growth, and a unified debt issuance facility, preferring to leave each member to issue euro denominated debt which is at least, if not more, as dangerous as if it were a sovereign nation with a fiat currency issuing foreign denominated debt.
While the German and the Austrians were trying to convince each other the EFSF was big enough for improved conditions and the Germans were trying to find ways to evade the upcoming European bank stress tests, Portuguese bonds were setting off alarms and moving up towards crisis levels in February despite, almost as if independently driven, Portugal's strong efforts to find alternatives to debt auctions, such as syndication. When that happens then sovereign related corporate debt also begins to hike and become broken. Still, Portugal continued to raise money but at higher rates and with lower credit ratings. ECB liquidity operations were helpful but not significant given Portugal's banks may not have been able to issue debt to foreign investors for at least a year. With falling tax collections and revenue in Greece, Ireland challenging why its bailout interest rate is higher, a cold reception to EU finance ministers permanent EU bailout fund, and the market saying Portugal will have to ask for a bailout, Portugal remained adamant it would not ask for a bailout, despite an austerity driven contracting economy, as bond interest rates rose for all three.
It was as if no matter what Portugal did financially or economically or politically, the Gods of Debt were orchestrating its fate without regard to human effort or purpose. A new, more severe austerity budget was being proposed against strong popular and political opposition by the Portuguese government of Prime Minister Jose Socrates and the market could smell the spoils of political defeat. The austerity budget was overwhelming defeated with only the Prime Minister's party members voting for it. This left Portugal with the need to raise 20 billion euro this year, a Prime Minister resigning, and the EU Council meeting convening. Portugal's deficit may be revised up to 8% for 2010 and analysts woke up to the effect of the rising Irish bond rates, which exploded in September, had on other eurozone countries like Portugal, at the same time Germany is throwing the whole permanent bailout fund proposal back on the table for renewed debate.
Still, Portugal remained defiant it would never ask or accept a bailout having seen what happened to Greece and Ireland, but the market just shrugged it off as what they all say before it happens. All of the warnings have been essentially ignored by the eurozone and the ECB until Portugal is on the brink and facing elections with no credible government to ratify any bailout, even if one is forced upon them. The failure of the eurozone to proactively support member nations and promote growth with fiscal policy leaves Portugal's bonds heading towards 8% and no real government and a EU council which has continually kicked the can down the road. The Pact of the Euro basically proposed a mechanism for future crises, has been solidly criticized as too punishment oriented and not enough resolution oriented, and exposes the currency as unstable. With early estimates of a Portuguese bailout at 70 billion euro ($99 billion), creditor countries are scrambling for cover. Any actual bailout may cost 80 billion euro with another 37 billion euro in maturing private Portuguese bank debt up in the air, as if the Portuguese central bank and government could come up with it without the help of the ECB. The whole agenda of the European Council has been thrown in disarray with the likelihood that nothing of substance will be accomplished: no permanent bailout fund, no action on Irish interest rates, no competitiveness pact, no current or future crisis resolution, and no reform and extension of the stability pact. The Finns are not prepared to support anything with elections in April. The Germans have intensified their internal political squabbling and are demanding that their ESM capital injections be delayed until after the German 2013 elections as well as an insistence in providing financial assistance only when it is too late to prevent bailout and just prior to financial collapse.
What remains beyond the grasp of the eurozone countries with the predominant preoccupation with debt and transfers to debtor nations is the root problem is one of low growth (original Spanish text here) and an inability to recognize that growth requires not austerity and government debt reduction but economic stimulation through fiscal policy with government spending efficiently concentrated on the creation of output and jobs. With the turmoil of German politics, the rise of nationalist parties in France, Finland, and the Netherlands, and popular anti-austerity protests growing in Greece, Ireland, Portugal, and the UK, the eurozone is converging fast towards a showdown between those creditors who preach the sins of debt while raking the money in and those who realize their only hope is growth. Spain is a trillion dollar economy, the fourth largest in the eurozone, and has a smaller debt to GDP ratio than Germany. If Portugal is made hostage to a bailout and forced to continue to pay ransom to the bond vigilantes, then the pressure will turn to Spain. Without growth Spain cannot survive. The consequences to European banks are horrendous, particularly for German and French banks. One-third of the assets of Spain's banks are composed of private and government sector exposure to Portugal (original Spanish text here). German banks have three times more activity in Portuguese banks than Spanish banks do. French banks have twice the exposure to Portuguese public debt compared to Spanish banks. One could go on with individual countries banking exposure to Greece and Ireland which can be found in the Bank of International Settlements data.
The root problems are not new, but the major players are flying blind in their sleep, trembling in fear of growth for all.
On very directly related subjects, we have recently written:
German Economists & Eurozone Insolvency
The Eurozone's Murder-Suicide Pact
Ireland's Indentured Servitude
and more past:
Ireland Betrayed
Germany's Irish Hair Shirt
On the Road Out of Ireland
Ireland's Bad Bank
Denial and the Pan-European Debt Crisis
The Unfolding Pan-European Debt Crisis
Greece, Spain, and the Euro Trojan Horse
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