Wednesday, July 25, 2012
Like it or not, we are living through history. In Japan, 10 year bond yields (known as JGBs) have collapsed to 0.72% from 1% as recently as April. Why is this level significant? Because if you own an asset returning 0.72%, or 72 basis points, you will double your money in exactly 100 years! You want some? What is baffling is how bond prices in the land of the rising sun have continued their relentless 20-year rise in the face of a doubling of supply. The marginal buyer at the moment appears to be the foreign speculator/ investor. Hence, foreign ownership of JGBs has now reached ¥76 trn, 8.5% of the total, up from 5% in 2010. Every recent bout of weak economic data coming out of Japan has pushed yields lower, as one would expect. However, the Bank of Japan's February pronouncement of inflation targeting was blisfully shrugged off by the bond market. Bond prices have moved higher since. Why, as JGBs prices rise (yields fall) demand for them keeps rising, hence pushing prices ever higher? Are JGBs a Giffen good? Named after Scottish economist Sir R. Giffen, this phenomenon was explained by Alfred Marshall in the third edition of his Principles of Economics (1895). Marshall observed that demand for bread in the face of rising prices among Victorian era Britons was also rising. In isolated instances, demand for inferior goods actually rise as the price of the said goods increase. JGBs must be 'inferior goods'...
Sunday, July 15, 2012
In this week-end Wall Street Jounal's Week-end Interview, George Shultz: Memo to Romney — Expand the Pie, the former Secretary of State is interviewed by Robert Pollock, the Journal's editorial features editor. According to Mr. Pollack, "George Shultz, ... says America's current problems are large, and its power in the world is diminished. But the policies for revival are obvious with the right leadership."
I am not sure that the "right leadership" is about the emerge but, at least, George Shultz has a vision of what needs to be done to move America's economy in the right direction. At one point in the interview, when prompted, he recommands reading John Taylor's latest book, First Principles: Five Keys to Restoring America's Properity. I downloaded the book from Amazon to see what the economist had to say. His five principles are the following:
- Predictable policy framework
- Rule of law
- Strong incentives
- Reliance on markets clearly
- Limited role for government
These appear to be taken right out of the Republican agenda. However, even if admittedly, Shultz and Taylor are both Repulicans, these principles actually flow out of the constitution of the United States and the thinking of the Founding Fathers.
At one point in the book, Taylor writes: "Indeed, Adam Smith railed against the power of mercantilist government officials in England who unfaily transferred wealth to themselves or their small group of friends, actions that perversely prevented the creation of wealth by the multitude of people through the free exchange of goods within and between countries."
That is because our problems today are similar to those we were having back then. As Tylor writes, "We see these same moral sentiments today in populist complaints about crony capitalism where government, in the name of picking winners and losers, is actually picking friends and enemies." I take that as a relative endorsments of the Occupy Wall Street movement.
Here is the piece:
George Shultz has one of the most preposterously impressive résumés in recent American history. World War II Marine (1942-45); distinguished academic economist; business executive; secretary of labor (1969-70); director of the Office of Management and Budget (1970-72); secretary of the Treasury (1972-74); chairman of Ronald Reagan's economic transition team; and the secretary of state (1982-89) who wound down the Cold War.
He's also been an active adviser to GOP leaders including George W. Bush in the years since. And, as I just learned, he's not a bad singer either.
When I called out of the blue on Wednesday morning, the 91-year-old éminence grise was in his office at Stanford University's Hoover Institution and willing to meet for an interview that afternoon.
The executive summary? On the economy: "We have some big problems in this country." He's very concerned about debt, and about monetary, tax and regulatory policy. On foreign policy: "We're weaker, much weaker" abroad than we were two decades ago.
But despite it all, Mr. Shultz is confident that if we get the policies right again, America can regain its footing: "When Ronald Reagan took office, inflation was in the teens, the prime rate was in the 20s, and the economy was going nowhere. We still had the remnants of wage and price controls, particularly in oil and gas. And Jimmy Carter said we were in 'malaise.' It was a bad time. I'm convinced the economy can be turned around because I watched Ronald Reagan do it."
"It took long-term thinking," Mr. Shultz emphasizes. "I'll give you an example. [Reagan] knew and we all advised him you can't have a decent economy with the kind of inflation we've got. . . . The political people would come in and say 'You've got to be careful, Mr. President. There's gonna be a recession [if the Federal Reserve tightens the money supply]. You're gonna lose seats in the midterm election.'
"And he basically said, 'If not us who? If not now when?' And he held a political umbrella over [Fed Chairman] Paul Volcker, and Paul did what needed to be done. And by late '82 early '83, inflation was under control, the tax changes that he made were kicking in, and the economy took off. But it took a politician with an ability to take a short-term hit in order to get the long-run results that we needed."
Is inflation a primary threat today? Not an immediate one, says Mr. Shultz, "but it's a building problem because of all this liquidity that's being stored up. . . . They [the Fed] think their contribution to doing something about [our economic troubles] is very easy money. Well, by this time money is very easy. It doesn't have to get any easier. . . . It takes other things to get the economy going—not more money."
Mr. Shultz dwells at length on the national debt, and on the Fed's role in enabling it: "It's startling that in the last year, three-quarters of the debt that's been issued has been bought by the Fed and the balance has been bought by other countries, so U.S. citizens and institutions are not on net buying U.S. debt. . . . The Fed doesn't have an unlimited capacity because when it buys the debt what it's doing is monetizing the debt. Sooner or later that has got to get out into the economy. Can't be held forever. And when it does in that kind of volume—as Milton Friedman taught us, inflation is a monetary phenomenon—it's gonna be hard to control."
As Mr. Shultz sees it, there is plenty of empirical evidence about which policies promote growth and which don't.
"I think the things that need to be done are sort of in the air, and you almost feel as if everybody knows what they are," he says. "It's quite apparent that we need to have another round of the 1986 tax act. That is, clean out the preferences and lower the rates. . . . It's also not a mystery that our corporate tax rate is way too high and there are preferences there that could be cleaned out."
For Mr. Shultz, the tax issue is not just about rates—though he believes lower rates often produce more revenue than higher ones, and "it's the revenues you're looking for"—but about predictability.
He asks me what sports I like. "Let's talk about football. . . . You want to know the rules and have an impartial referee, but you also want to make sure somebody isn't going to come along and change the rules in the middle of the game. . . . Now it's as though we have all these people who have money on the sidelines and we say 'Come on and play the game,' and they say 'Well what are the rules?' and we say 'We'll tell you later.' And what about the referee? Well, we're still struggling for who that's gonna be. . . . That's not an environment designed to get people to play."
Mr. Shultz cites the handling of the auto bankruptcies as an important deviation from rules-based economic policy. The question was "are we gonna have a political bankruptcy or a rule-of-law bankruptcy? Political bankruptcy was chosen. So the result is that the unions got paid off and the regular creditors didn't."
He also cites Washington's "habit of passing bills that are thousands of pages long and you know most legislators haven't even read what they're voting for."
That would be ObamaCare, of course. "I fear that the approach to controlling costs in the health-care business is moving more and more to a wage-and-price-control approach. And one thing you know from experience is when you control the price of something, you end up getting less of it. So if you control the price of health-care providers, you will have fewer of them and that's gonna wind up as a crisis. The most vivid expression of that . . . was Jimmy Carter's gas lines."
Experience. Examples. Evidence. Shultz themes.
As we turn to foreign policy, the national debt again looms large: "Now remember something. Alexander Hamilton, our first secretary of the Treasury, and a very good one, redeemed all of the Revolutionary War debt at par value, and he said the 'full faith and credit' of the United States must be inviolate, among other reasons because it will be necessary in a crisis to be able to borrow. And we saw ourselves through the Civil War because we were able to borrow. We saw ourselves able to defeat the Nazis and the Japanese because we were able to borrow. We've got ourselves now to the point where if we suddenly had to finance another very big event of some kind, it would be hard to do it. We are exhausting our borrowing capacity."
Mr. Shultz is not an alarmist about the rising power of China. He believes Chinese leaders understand their interest in having good relations with the United States. He is withering in his critique of those who would blame cheap Chinese labor or a cheap Chinese currency for U.S. economic problems:
"We are consuming more than we produce and we've done that a while and we're complaining about the fact that we have an imbalance of trade with China. But if you consume more than you produce, you have to import. It's just arithmetic. And if you spend more than you earn, you have to borrow. It's just arithmetic."
Mr. Shultz is more concerned about the Middle East, an area where he concedes even the Reagan administration struggled, "just like everybody." So what would he do about the threat of an Iranian bomb? Is he concerned we haven't seized the current opportunity to weaken Iran's ally in Damascus?
"[Syrian President Bashar al-Assad] and the Iranians have been a strategic adversary. Gadhafi was sort of a tactical adversary. . . . I think I would have said to the Turks, 'I see you are providing safe havens on your border and probably you could use some help. We're there with you.'"
He also thinks we can have a deterrent effect without major military strikes. He recalls an episode from the 1980s when the U.S. Navy became aware of Iranian efforts to mine the Persian Gulf: "We boarded the ship. Took off some mines for evidence. Took off the sailors, sank the ship. Took the sailors to Dubai, I believe, and said to the Iranians 'Come and get your sailors and cut it out.'"
What about Mitt Romney? Is he running on the right themes? Will he have a mandate if he wins?
"He made one speech that I thought was outstanding, addressing a long-term problem. And that was the speech about K-12 education, and he pointed out the degree to which the United States is falling back. . . . We know that economic growth in the long run is correlated to education achievement."
Could he recommend one book for Mr. Romney to read this summer? "This book that John Taylor"—the Stanford economist and Mr. Shultz's colleague at Hoover—"has just published, 'First Principles: Five Keys to Restoring America's Prosperity.' You don't have to spend weeks reading it."
Mr. Shultz also mentions the memo his economic transition team wrote for President-elect Ronald Reagan in 1980, recently excerpted in The Wall Street Journal ("Advice for a New President," May 26): "If you just took that and put that into effect again, then we'd be in business."
I try hard to pull Mr. Shultz back toward despair. Aren't we an older, more poorly educated society than the one that climbed out of similar debt after World War II?
"Well, we gotta get after these things! Somehow people are locking into the idea of chronological age. There's another way of calculating age. That is what is the probability of your dying within the year. If you use that way of calculating, people who are 75 today on that basis are 65 as of some earlier time. . . . We need to gear our retirement system in such a way that people keep working longer."
He suggests ending Social Security taxes for people who have paid in for 40 years. The way to meet our demographic challenge is to keep people in the labor force longer, Mr. Shultz says, and not fall for European notions that there is some fixed amount of work to be divided up. "The trick is to keep expanding the pie."
We end on some wistful and optimistic notes. "There's no lack of creativity in the United States." Silicon Valley, he says, "is a giant Stanford spinoff." He waxes lyrical for a moment about Steve Jobs. "My wife tells a story," he says about a party with Jobs's wife. "[My wife] says well 'Where's Steve?'" "Steve is thinking. He's decided to take six months off and think" is the response. "He was a creative genius," adds Mr. Shultz with admiration.
Shultz conservatism is not dour, budget-balancing conservatism. Nor was Reagan's. It is a belief in the human spirit.
And, of course, in economic policies based on evidence. As the interview closes, I am treated to a song—not a note out of place—that was sung by the secretary on Milton Friedman's 90th birthday:
"A fact without a theory is like a ship without a sail. Is like a boat without a rudder. Is like a kite without a tail. A fact without a theory is as sad as sad can be. But if there's one thing worse in this universe, it's a theory . . . without a fact."
Tuesday, July 3, 2012
A few facts about financial markets, happy summer!
1602: the Dutch East India Company becomes the first to issue stocks and bonds on the Amsterdam Stock Exchange
1792: the NYSE is created and the Bank of New York becomes the first listed company
1810: Russia is the first “emerging market” country to establish a stock market
1879: US stocks record their best year ever, up 57% (annual total return)
1.45%: the 10-year bond yield in the US on June 1st 2012/ the lowest in 220 year
1.53%: Dutch government bond yield as of June 2012/ the lowest in 500 years
1958: the last time US AAA corporate bond yields were this low
63x: emerging markets equities are up 63 times since the late 1960s and the unravelling of the gold peg and Bretton Woods
43%: the drop in US real home prices since the 2006 peak, making the current bear market the worst since 1921
8%: Japan’s share of global equity market capitalization, down from 44% in 1988
$3,642,000: what $1 invested in US large cap stocks in 1824 would be worth today with dividend reinvested
44%: the share of US Treasuries owned by foreigners, up from 1% in 1945
2 decades: Japan’s two decade equity bear market is the longest of the major equity markets
Tuesday, June 19, 2012
The influential Hurun Research Institute (www.hurun.net) reconfirmed in its latest report published in early June an increasingly undeniable fact: the Chinese luxury travel market continues to flourish. The Institute derived its conclusions based on interviews with 150 Chinese millionaires between April and May of this year as well as questionnaire circulated in Shanghai and Beijing. The respondents were dominantly male with an average age of 37.
The number of Chinese out-bound tourists reached 77 million in 2011, an increase of 12% year on year. The main reason for the explosion in luxury overseas travel is the rapid increase in the number of millionaires in the country. There are 7,500 Individuals with total assets of RMB 1 billion (USD 150 million) or more and 600 individuals with USD 1 billion. The total number of millionaires (over USD 1 million in assets or more) is now 2.7 million.
Of these 2.7 mn millionaires, 30% are business owners, 20% professional investors, 20% real estate investors and 30% are high level senior executives. Among the super rich (assets of USD 16 mn or more), 75% are business owners, 10% professional investors and 15% real estate investors. More findings about the leisure habits of this elite circle:
- Travel has been singled out as the most common leisure activity, with more than 60 per cent choosing it as their preferred way to spend free time. Reading and tea tasting have been named as other favourite pursuits.
- Golf is a preferred sport, followed by swimming and yoga (popular with female millionaires).
- Travel takes up the largest slice of leisure consumption, followed by children’s education and daily luxuries.
- The US, France and Japan topped the list of popular international destinations for the rich in 2011 while Sanya remains the most preferred domestic destination. Of the group interviewed, 50 per cent travelled in business class, less than 20 per cent opted for first class, with Air China being the most preferred domestic airline and Singapore Airlines the most preferred international carrier. The preferred hotel brand among this crowd is Shangri-La, followed by Hilton and The Ritz-Carlton.
Chinese travelers account for 20% of total global expenditure on tax free shopping. Russians are second at 16%. The average Chinese spends US$1,016 per transaction on tax-free items, US$606 for the average traveller. France is the number one destination for tax free shoppers globally.
Saturday, June 16, 2012
In 1984 George Orwell described a dystopia the mid 20th century world seemed to be slouching toward, where “It was terribly dangerous to let your thoughts wander when you were in any public place or within range of a telescreen. The smallest thing could give you away [because]…Big brother is watching you”, which captured the essence of the means by which the totalitarian state used surveillance –and the fear of surveillance – to control human beings. The disintegration of the Soviet Union and the spread of democracy at the end of century seemed to reverse that trend, but the sudden rise of the internet raises new questions, even within free societies.
The issue revolves around the right to privacy in the new public commons; whether a Big Brother will have the ability to acquire personal information and invade the boundaries of human dignity without our consent, even if it does not –immediately – threaten our political rights. In light of this, Microsoft’s decision to set “privacy” as the default option on its browser is not only the morally correct decision, it should become the law for all browsers.
It is simply amazing how carelessly and thoughtlessly we have cast aside our private and personal boundaries, a demarcation that generation have struggled –and still struggle in much of the world – to establish autonomy over, in our craze over the internet. We may yet come to regret it.
Saturday, June 9, 2012
I guess that you all saw the movie "Who Killed th Electric Car". In Solving the Electric Car Puzzle, Ron Adner, a professor of strategy at Dartmouth's Tuck School of Business and the author of The Wide Lens: A New Strategy for Innovation, argues that "For the e-car to be more than a plaything for the rich, it has to succeed in the mass market." In other words, the problem is not with the car itself, nor with the technology but with the depreciation of the value of the battery and the power-grid which does not allow for a ramp up of electric cars.
Here is the piece which was published in The Wall Street Journal last week:
The Chevy Volt was crowned European Car of the Year for 2012 on March 5. But the celebration was muted by GM's decision—three days earlier—to halt the Volt production line due to a lack of consumer demand. Nissan's Leaf, which won the accolade in 2011, has also fared poorly in the market. Great cars, terrible sales—here is your e-car paradox.
The electric car has become a political litmus test. With billions of federal dollars spent to motivate further billions in private investment, the financial stakes are high, as are the environmental and energy-security implications. But in the tug of war between the caricatures of lefty liberal greens and righty conservative petroheads, love-it or hate-it are the only two options. Where does this leave the supportive, but objective, centrist?
Answer: dismayed with current efforts and desperate for broader solutions. For the electric car to be anything more than a plaything for rich environmentalists—and have any impact on energy security or the environment—it has to succeed in the mass market.
Unfortunately, manufacturers are approaching the electric car as another new product when what they really need is a new business model. The problem is not the cars themselves (which are technology marvels), or even the availability of charging infrastructure (which is improving thanks to government largess). Unless two neglected factors—battery depreciation and power-grid management—are addressed, costly efforts at improving e-cars and charge spots will fail in the mass market.
First, while much attention has been paid to the appeal of electric cars to new buyers, an equally important question will be their appeal to used-car buyers. Here the major determinant is battery technology. Electric car batteries are extremely expensive—they can account for one-third of the cost of the vehicle—and offer limited driving range. A steady stream of expected advances means they will improve every year. This is good news, but only for those who haven't yet purchased an electric vehicle.
With electric cars, the most expensive part of the car is also the one that depreciates fastest. The usable life span of batteries (their ability to hold a charge degrades with use) and the pace of technology improvement (lower cost and greater range of newer batteries) reduce the relative value of used batteries and depress the resale proposition for used electric cars.
While some car buyers may give little thought to resale value, or plan on refurbishing their cars for many years, for mainstream buyers resale value is crucial: Lousy resale value means goodbye to the mainstream market. (Note to Tesla owners: You are not the mass market.)
Second, while intense public attention and investment have been focused on rolling out plug-in charge spots, these efforts have been decoupled from investment in the smart-grid technology needed to assure that power generation and distribution can actually support mass charging. As long as only a handful of drivers plug in each morning, the current grid will hold. But if 5% of cars in Los Angeles County were to plug in simultaneously, they could place a 750-megawatt load on California's already strained grid, equivalent to the generating capacity of two midsize power plants. Unless the power infrastructure challenge is addressed in advance, the very success of the electric car will drive its failure.
Solving the e-car puzzle won't happen unless private firms and governments consider the bigger picture when strategizing their investments. An intriguing example is the approach of Better Place LLC in Israel and Denmark, which applies the familiar cellphone model to its electric cars, selling multiyear contracts based on miles of driving (analogous to minutes) to finance their infrastructure investments and battery depreciation.
The Better Place approach is but one alternative. One thing is clear: The success of electric cars hinges on the successful alignment of the entire electric-car ecosystem. Uncoordinated investment in the individual pieces is a recipe for failure.
Thursday, June 7, 2012
Tomorrow, more than 500 posts later, will mark the third anniversary of The Sceptical Market Observer. A big thank you to those who contributed to the blog over the last three three years.
Although I could not have predicted eveything that happened since the Summer of 2009 - and certainly a lot did happen - our basic forecast was right on. Our first entry was titled Are we out of the woods yet? Don't count on it! and was published on the premise that the Great Recession was far from over.
The piece was published on Monday June 8th 2009, the day I got tired of hearing so many improvised economists talk about "green shoots" - remember these? - and the pending recovery.
Well ... three years later, we are still not out of the woods; far from it! In fact, we are deeply lost in the thickest forest where green shoots don't even have a chance to grow. Big trees are still dominating the horizon and the rules of the game are still heavily favoring them. And no one has had the political courage to address the issue yet. The public is not helping either: It seems like it is hoping that things will return to normal on their own. It will probably take a bigger crisis to convince them to elect somone with the balls and the mandate to level the playing field and give green shoots a chance.
That bigger crisis might just be on-hand as there is a new threat that has just appeared on the horizon since 2011: Europe. Most of us knew that demography and actuarial deficits were going to plague Europe's economies sooner or later. However, sooner occurred relatively quicker than anybody anticipated and thought possible. And, to make things worse, it all happened before our own financial crisis was over; and it is still happening and gathering steam. Read my latest blog entry, How Europe Will Disintegrate, to learn what could very likely happen over there in the very near future. Based on the reading of an article published by Simon Johnson and Peter Boone, I am suddenly feeling very uneasy about what is going on in Europe right now.
To be fair, some of Europe's problems surfaced because of the financial crisis that rocked the U.S. economy but, in all honesty, America's financial crisis is not the cause of Europe's woes. These woes are self-made. They will also make it much harder for our economy to get its grove back. Which is just another way of saying that the path to recovery might be even longer than I originally thought three years ago. Worse, I now think that it could plunge us into a much deeper crisis than I would have thought possible back then.
It certainly seems very plausible to me that Europe's bureaucrats, stubbornly defending the concept of the European Union, are ignoring the political realities of their member countries - which make a successful bailout plan impossible to implement - and are thus holding Europeans hostage to their post WWII dream of a unified Europe. These bureaucrats control undemocratic institutions, like the ECB, which have enough power to artificially sustain defaulting countries, like Greece and Portugal, beyond the point of no return. The problem is that it will then be too late; especially if fear starts to spread to other larger countries like Spain and Italy.
I am leaving tomorrow for Europe for a week. This Johnson-Boone story about backdoor loans of the ECB to the banking systems of troubled European countries has to be pursued for all its worth.
I hope to have new insights to share with you when I come back. However, I do not expect that it will be good news.
Wednesday, June 6, 2012
In The End of the Euro: A Survivor's Guide, Simon Johnson and Peter Boone do not talk about how to guide Europe out of the crisis but rather how can investors save themselves when the inevitable is going to happen.
Simon Johnson, a former IMF chief-economist is the co-author, with James Kwak, of the recently published book White House Burning: The Founding Fathers, Our National Debt, and Why It Matters To You. Peter Boone, a long time collaborator of Simon, is chair of Effective Intervention, a UK-based charity, an associate at the Centre for Economic Performance at London's LSE and a principal in Salute Capital Management Limited.
The crisis in Europe is not over because Europeans, especially Germans, can't decide whether to pursue a truly European agenda or to each go their separate ways. Had they been able to make up their mind right away, Europeans would have either bailed-out the Greeks and guaranteed the debt of all European countries under the same umbrella or they would have quit the European Union and let the Greeks (and others) fail.
But you can't have a middle of the road solution. It's seems that, now that it has been revealed that the Greeks have gone rogue, Germans wish that they had never been naive enough (once again) to be part of the EU and agree to a common currency. In fact, most Germans did not want to have a common currency ten years ago. What convinced them to accept the Euro was that Germany was never going to be on the hook for the debts of other nations. And many believed this lie!
As Michael Lewis explained in his book, Boomrang, Germans are too disciplined to believe that others can be "Greeks". They bought loads of crappy mortgage securities before the financial crisis for the same reason: they could not believe that some bankers could dishonestly unload their crap on them. After bailing our East Germans in the nineties and, a only few years later, being left holding "perfumed" securities sold to them by U.S. banks, Germans now have enough. But they still can't agree on what to do and will be left, once gain, holding the bag of bad debt.
They know that they are the butt of the joke once again; and they have yet to finish paying for the reunification of Germany and for their more recent losses stemming from the U.S. mortgage crisis. This time, it's Greeks, Portuguese, Irish and Spanish that are leaving droppings on the door steps of Germany. If it works, Italians and others are sure to follow.
Had the Germans really believed in the European utopia, they would have bailed-out the Greeks and converted all sovereign debt into Euro-denominated/Europe guaranteed bonds at the start of the crisis. With harsh conditions imposed on potential borrowers, they could have contained a local crisis from developing into a continental one. The other options was to pull out of the Union and admit that the European dream did not work out as expected; because it was not properly concieved form the beginning. Nobody should have let the Greeks borrow their way to death. As one of my friends puts it: You can't be serving drinks to an already drunk alcoholic without asking for trouble before the evening is over!
But admitting that you are wrong is hard. Thus, the muddling through solution - which is not a solution - is still being pursued. It is only hopes and pipe dreams. Meanwhile, the situation is developing into a full blown crisis that risks bringing us all down.
The channels through which this is going to happen are exposed in the Johnson-Boone article below. It is a must read. Like many things pushed through the European parliament, it is through a very undemocratic and bureaucratic system that the crisis is now developing. The back door nature of the interventions of the European Central Bank is sure to backfire when Germans and others start realising what is really happening to them: They are on the hook even without knowing it. And they are swallowing the whole thing under anesthesia as we speak. For now, it is painless paper going through the bureaucratic channels of a system that most fail to grasp. But the awakening is sure to make them gag. That's when the real shit is going to hit the fans!
Here is the recently published piece (it is also available in French):
In every economic crisis there comes a moment of clarity. In Europe soon, millions of people will wake up to realize that the euro-as-we-know-it is gone. Economic chaos awaits them.
To understand why, first strip away your illusions. Europe's crisis to date is a series of supposedly "decisive" turning points that each turned out to be just another step down a steep hill. Greece's upcoming election on June 17 is another such moment. While the so-called "pro-bailout" forces may prevail in terms of parliamentary seats, some form of new currency will soon flood the streets of Athens. It is already nearly impossible to save Greek membership in the euro area: depositors flee banks, taxpayers delay tax payments, and companies postpone paying their suppliers -- either because they can't pay or because they expect soon to be able to pay in cheap drachma.
The troika of the European Commission (EC), European Central Bank (ECB), and International Monetary Fund (IMF) has proved unable to restore the prospect of recovery in Greece, and any new lending program would run into the same difficulties. In apparent frustration, the head of the IMF, Christine Lagarde, remarked last week, "As far as Athens is concerned, I also think about all those people who are trying to escape tax all the time."
Ms. Lagarde's empathy is wearing thin and this is unfortunate -- particularly as the Greek failure mostly demonstrates how wrong a single currency is for Europe. The Greek backlash reflects the enormous pain and difficulty that comes with trying to arrange "internal devaluations" (a euphemism for big wage and spending cuts) in order to restore competitiveness and repay an excessive debt level.
Faced with five years of recession, more than 20 percent unemployment, further cuts to come, and a stream of failed promises from politicians inside and outside the country, a political backlash seems only natural. With IMF leaders, EC officials, and financial journalists floating the idea of a "Greek exit" from the euro, who can now invest in or sign long-term contracts in Greece? Greece's economy can only get worse.
Some European politicians are now telling us that an orderly exit for Greece is feasible under current conditions, and Greece will be the only nation that leaves. They are wrong. Greece's exit is simply another step in a chain of events that leads towards a chaotic dissolution of the euro zone.
During the next stage of the crisis, Europe's electorate will be rudely awakened to the large financial risks which have been foisted upon them in failed attempts to keep the single currency alive. When Greece quits the euro, its government will default on approximately 121 billion euros of debt to official creditors, and about 27 billion euros owed to the IMF.
More importantly and less known to German taxpayers, Greece will also default on 155 billion euros directly owed to the euro system (comprised of the ECB and the 17 national central banks in the euro zone). This includes 110 billion euros provided automatically to Greece through the Target2 payments system -- which handles settlements between central banks for countries using the euro. As depositors and lenders flee Greek banks, someone needs to finance that capital flight, otherwise Greek banks would fail. This role is taken on by other euro area central banks, which have quietly lent large funds, with the balances reported in the Target2 account. The vast bulk of this lending is, in practice, done by the Bundesbank since capital flight mostly goes to Germany, although all members of the euro system share the losses if there are defaults.
The ECB has always vehemently denied that it has taken an excessive amount of risk despite its increasingly relaxed lending policies. But between Target2 and direct bond purchases alone, the euro system claims on troubled periphery countries are now approximately 1.1 trillion euros (this is our estimate based on available official data). This amounts to over 200 percent of the (broadly defined) capital of the euro system. No responsible bank would claim these sums are minor risks to its capital or to taxpayers. These claims also amount to 43 percent of German Gross Domestic Product, which is now around 2.57 trillion euros. With Greece proving that all this financing is deeply risky, the euro system will appear far more fragile and dangerous to taxpayers and investors.
Jacek Rostowski, the Polish Finance Minister, recently warned that the calamity of a Greek default is likely to result in a flight from banks and sovereign debt across the periphery, and that -- to avoid a greater calamity -- all remaining member nations need to be provided with unlimited funding for at least 18 months. Mr. Rostowski expresses concern, however, that the ECB is not prepared to provide such a firewall, and no other entity has the capacity, legitimacy, or will to do so.
We agree: Once it dawns on people that the ECB already has a large amount of credit risk on its books, it seems very unlikely that the ECB would start providing limitless funds to all other governments that face pressure from the bond market. The Greek trajectory of austerity-backlash-default is likely to be repeated elsewhere -- so why would the Germans want the ECB to double- or quadruple-down by suddenly ratcheting up loans to everyone else?
The most likely scenario is that the ECB will reluctantly and haltingly provide funds to other nations -- an on-again, off-again pattern of support -- and that simply won't be enough to stabilize the situation. Having seen the destruction of a Greek exit, and knowing that both the ECB and German taxpayers will not tolerate unlimited additional losses, investors and depositors will respond by fleeing banks in other peripheral countries and holding off on investment and spending.
Capital flight could last for months, leaving banks in the periphery short of liquidity and forcing them to contract credit -- pushing their economies into deeper recessions and their voters towards anger. Even as the ECB refuses to provide large amounts of visible funding, the automatic mechanics of Europe's payment system will mean the capital flight from Spain and Italy to German banks is transformed into larger and larger de facto loans by the Bundesbank to Banca d'Italia and Banco de Espana -- essentially to the Italian and Spanish states. German taxpayers will begin to see through this scheme and become afraid of further losses.
The end of the euro system looks like this. The periphery suffers ever deeper recessions -- failing to meet targets set by the troika -- and their public debt burdens will become more obviously unaffordable. The euro falls significantly against other currencies, but not in a manner that makes Europe more attractive as a place for investment.
Instead, there will be recognition that the ECB has lost control of monetary policy, is being forced to create credits to finance capital flight and prop up troubled sovereigns -- and that those credits may not get repaid in full. The world will no longer think of the euro as a safe currency; rather investors will shun bonds from the whole region, and even Germany may have trouble issuing debt at reasonable interest rates. Finally, German taxpayers will be suffering unacceptable inflation and an apparently uncontrollable looming bill to bail out their euro partners.
The simplest solution will be for Germany itself to leave the euro, forcing other nations to scramble and follow suit. Germany's guilt over past conflicts and a fear of losing the benefits from 60 years of European integration will no doubt postpone the inevitable. But here's the problem with postponing the inevitable -- when the dam finally breaks, the consequences will be that much more devastating since the debts will be larger and the antagonism will be more intense.
A disorderly break-up of the euro area will be far more damaging to global financial markets than the crisis of 2008. In fall 2008 the decision was whether or how governments should provide a back-stop to big banks and the creditors to those banks. Now some European governments face insolvency themselves. The European economy accounts for almost 1/3 of world GDP. Total euro sovereign debt outstanding comprises about $11 trillion, of which at least $4 trillion must be regarded as a near term risk for restructuring.
Europe's rich capital markets and banking system, including the market for 185 trillion dollars in outstanding euro-denominated derivative contracts, will be in turmoil and there will be large scale capital flight out of Europe into the United States and Asia. Who can be confident that our global megabanks are truly ready to withstand the likely losses? It is almost certain that large numbers of pensioners and households will find their savings are wiped out directly or inflation erodes what they saved all their lives. The potential for political turmoil and human hardship is staggering.
For the last three years Europe's politicians have promised to "do whatever it takes" to save the euro. It is now clear that this promise is beyond their capacity to keep -- because it requires steps that are unacceptable to their electorates. No one knows for sure how long they can delay the complete collapse of the euro, perhaps months or even several more years, but we are moving steadily to an ugly end.
Whenever nations fail in a crisis, the blame game starts. Some in Europe and the IMF's leadership are already covering their tracks, implying that corruption and those "Greeks not paying taxes" caused it all to fail. This is wrong: the euro system is generating miserable unemployment and deep recessions in Ireland, Italy, Greece, Portugal and Spain also. Despite Troika-sponsored adjustment programs, conditions continue to worsen in the periphery. We cannot blame corrupt Greek politicians for all that.
It is time for European and IMF officials, with support from the U.S. and others, to work on how to dismantle the euro area. While no dissolution will be truly orderly, there are means to reduce the chaos. Many technical, legal, and financial market issues could be worked out in advance. We need plans to deal with: the introduction of new currencies, multiple sovereign defaults, recapitalization of banks and insurance groups, and divvying up the assets and liabilities of the euro system. Some nations will soon need foreign reserves to backstop their new currencies. Most importantly, Europe needs to salvage its great achievements, including free trade and labor mobility across the continent, while extricating itself from this colossal error of a single currency.
Unfortunately for all of us, our politicians refuse to go there -- they hate to admit their mistakes and past incompetence, and in any case, the job of coordinating those seventeen discordant nations in the wind down of this currency regime is, perhaps, beyond reach.
Forget about a rescue in the form of the G20, the G8, the G7, a new European Union Treasury, the issue of Eurobonds, a large scale debt mutualization scheme, or any other bedtime story. We are each on our own.
Wednesday, May 30, 2012
A Tale of Two Memos to Two President-Elects is a recent entry posted by John Taylor on his blog, Economics One. In the piece, the economist contrasts two approaches to solving the present crisis: That of Republicans who advised President Reagan in the early eighties as he took over the White House and that of Larry Summers who was advising President Obama as he himself took over the White House following his 2008 election. Both presidents came into power when the economy was in a deep crisis and both seem to have followed the prescriptions of their advisers. Were they right?
We know that we eventually came out of the deep recession - a double dip recession actually - of the early eighties but we are still waiting to find out whether we are going to emerge from the Great Recession of 2008. The Question is thus whether the advice given to Ronald Reagan by his advisers in the early eighties would have been a better remedy for the current crisis than what Dr.Summers prescribed to his own patient, Barack Obama.
On the one hand, the current economic situation certainly looks more like that of the the one we had following the Great Depression of the thirties than the situation which prevailed in the early eighties. We are stuck with high unemployment but very low inflation. Morevoer, firms are investing very little. Hence they are creating very few jobs which in turn explains why we are not seeing inflation pick up in spite of very aggressive monetary policies on the part of the Fed. By contrast, the early eighties were all about fighting inflation and anchoring inflation expectations. In this context, short-term policy remedies, like the ones proposed by Larry Summers to Barack Obama, may seem appropiate.
On the other hand, more than three years after the measures were adopted, nothing much has happened. After spending money freely on the hope of jump starting the economy, the jury is still out as to whether this was a good idea and whether we should continue. The problem today thus appears to many to be more related to a lack of competitiveness on the part of U.S. economy than to a lack of stimulus. Moreover, credit constraints, rather than unfavorable "animal spirit", seem to be responsible for the lack of investment on the part of SMEs which, usually, invest and create jobs domestically in a disproportionate fashion. Finally, like in the seventies, the system appears to be strongly defending entrenched interests. This time, however, it is the interests of the ruling financial elite rather than that of unions which are holding us back. In this context, it would certain appear more appropriate to intervene with longer-term policies aimed at improving productivity, encouraging investments and providing the right incentives by resetting the rules of the games and crushing the power of entrenched interests.
The real problem, however, is the current political situation. While Republicans seem to have the right set of solutions in their arsenal, they appear less inclined to use them to fix the problems today than they were in the eighties. The New Deal had eventually badly biased the system in favour of unions and regulations that led to a crisis in the late seventies and early eighties. Ronald Reagan was able to bring us back on the path to prosperity by applying the receipe proposed by his advisers which mostly consisted in giving the right incentives to paricipate in the economy. Today, we are forced to acknowloedge that the ruling financial elite who has captured the system and who wants to preserve its privileges is protected by Republicans. It's like findout that my brother had been stealing my money. We are thus in a deadlock with Republicans.
Democrats, for their part, are nostalgic of the past and want the state to take over. Bad idea; especially now that the financial elite controls the government. Neither strategy will work. It's not that the short-term measures proposed by Larry Summers were necessarily bad. They helped save the system from a complete collapse after all. But they needed to be accompanied by credible longer term measures to break the monopoly of bankers on the state and to reset incentives; just like Ronald Reagan had done in the eighties by breaking the monopoly of the unions and regulations on our economic life.
We need today again to reform the system to encourage everyone to participate in the economy. We want students to acquire the skills needed in tomorrow's economy. We want workers to work at high-paying jobs. And we want entrepreneurs to invest and take risks. But who wants to play when the game is fixed? With incompetent Democrats and irresponsible Republicans, we are a long way from being able to solve our problems.
And the longer we wait, the more costly it will be to fix the system. Unfortunately, today the amount of austerity that would be required to fix the system - and there is no doubt in my mind that, like in the eighties, it is needed - is already being rejected by a population who no longer trust its leaders. The amount of needed austerity is also only going to grow with time. We are thus headed towards a social and political crisis of unprecedent proportion. When? I don't know. The sooner, the better because the alternative is worse.
It's too bad that President Obama missed his opportunity to save the day in 2009!
Here is John Taylor's recent blog entry:
Today the Wall Street Journal dedicated more than three-fourths of a page to publishing large excerpts from a 1980 memo to president-elect Ronald Reagan from George Shultz and other economists who had advised Reagan in the presidential campaign. In my view, that memo represents a watershed in the history of economics with great relevance today, and that is why I focused on it in my new book First Principles, where I explain why the economy prospers when policy adheres to the basic principles of economic freedom, but falters when policy deviates from those principles, as it is doing now. That original fifteen page 1980 memo was an important reason why policy veered back to the principles of economic freedom the 1980s and the 1990s. Here is how I describe the memo in First Principles:
Less than two weeks [after the 1980 election], on November 16, 1980, many of the economists who had worked together in the campaign wrote an extraordinary memo to Reagan entitled ‘Economic Strategy for the Reagan Administration.’ It began with a call for action: “Sharp change in present economic policy is an absolute necessity. The problems . . . an almost endless litany of economic ills, large and small, are severe. But they are not intractable. Having been produced by government policy, they can be redressed by a change in policy.”
The memo then outlined a set of reforms for tax policy, regulatory policy, the budget, and monetary policy. There were no temporary tax rebates, short-term public works projects, or other so-called stimulus packages. Rather there were sentences like “The need for a long-term point of view is essential to allow for the time, the coherence and the predictability so necessary for success.”
I believe it is instructive to compare this 1980 memo to President-elect Reagan with a similarly-timed fifty-seven page 2008 memo to President-elect Obama. The 2008 memo from Larry Summers was recently posted by Ryan Lizza on the New Yorker web page generating much political and economic debate. Both were written in times of great economic difficulties, but the contrast between the overall approaches to economic policy is striking. Most important, unlike the 1980 memo to Reagan, the 2008 memo focused mainly on short-term interventions and so-called stimulus packages. The recent debate in the press has been over whether the short-term stimulus package should have been larger. In contrast the 1980 memo did not even mention such short term stimulus packages, but rather focused on more permanent long-term strategies and policy predictability.
Thursday, May 24, 2012
The Market Is Starting To Recognize Reality is a recent market commentary by Comstock Partners Inc. The piece recognises that, once again, not unlike the situation last summer, optimistic forecast made at the beginning of the year are gradually fading and slowly giving ways to pessimism. I think that this pessimism is warranted.
Europe could take a turn for the worse with an increasing number of pundits calling for Greece to quit the Euro zone, emerging economies are slowing down and the U.S. consumer still seems reluctant to clean it's balance sheet once and for all. The latter, while helping to avoid a recession, is dragging the U.S. economy into an endless slowdown.
I guess that in the opinion of many, it is better to be "dragging along" than having to suffer from a profound recession. The policies of low interest rates and aggressive fiscal stimulus are supporting this spending behavior on the part of U.S. consumers but are also responsible for the U.S. economy dragging its feet for more than three years. Potentially, as amunitions are being drawn down and the world economies are slowing down, the slowdown could extent beyond 2012.
Are there some reasons to remain optimistic? Some will answer this question positiviely. For instance, yesterday (May 23rd), news of better than forecast new-home sales came out. However, by looking more closely at the data, one is forced to conclude that this piece of good news is most likely insignificant. The media were excited by the announcement but the markets knew better and were not impressed!
One has to remember that when it is claimed that new-home sales grow by 3.3% to 343,000 homes in the month of April, the 343,000 is given on an annual basis. This means that in reality only about 28,600 new homes were built last month. An increase of 3.3% of 28,600 new homes translates into an increase of less than 950 new homes ... in the entire country!
Using rough back-of-the-envelop calculations, the construction of 343,000 homes in the U.S. on an annual basis also only represents approximately an increase of 0.5% in the entire stock of American homes. If household formation is growing at a rate of above 1% per year for the foreseeable future, we would need an increase of 100% on a sustained basis (i.e. for several years) to keep pace with demand in a healthy economy.
Obviously, the glut of vacant existing homes is responsible for this snail's pace of new home construction. The inventory of empty and foreclosed homes has to be liquidated before construction gets its groove back. There are signs that this will happen ... in a few years!
But, for now, there is no escaping the fact that a single-month 3% increase in the pace of new homes building is like a drop into an empty bucket and thus cannot be considered as valid evidence of an emerging recovery.
In other words, a single rainy day did not put an end to the dust bowl! The recovery will have to wait ...
Here is the commentary:
As we have long expected, the economy is tracing out a trajectory typical of the weak recoveries that follow balance-sheet induced recessions and credit crises caused by highly excessive debt. This is significantly different from the garden-variety recessions after World War II that were primarily caused by Fed tightening of monetary policy in response to rising inflation and full resource utilization. In those instances, once the Fed achieved its desired response it eased monetary policy once again, and the economy resumed its normal growth path.
In a balance sheet recession, as is happening now, the dire effects of debt deleveraging overwhelm the efforts of the government to stimulate the economy. Periods of credit crises are almost always followed by many years of below average growth, high unemployment, anemic expansions and frequent recessions. Recent examples include Japan's two-decade period of sluggish growth and the current tepid recovery in the U.S. In our view, working our way out of the mountain of debt, both private and public, that was incurred during the boom will take many years and will keep a solid lid on overall gains in the stock market.
The current economic recovery remains in sharp contrast to any other expansion of the post-war period, and is now showing definitive signs of petering out once more. The recently reported first quarter GDP is a mere 1.3% above the amount reached at the peak of the last cycle in the fourth quarter of 2007. In eight previous post-war expansions, GDP had increased by an average of 13.3% in the 17th quarter following a peak, with the lowest being 10.5%.
Now, even this tepid recovery is slowing down once more. In the last two months the overwhelming weight of the evidence supports this view, as the following indicators have either come in below expectations or suffered an actual downturn: core durable goods orders, the Chicago Fed National Activities Index, new home sales, existing home sales, payroll employment, the NFIB Small Business Index, construction spending, the ISM Non-Manufacturing Index, the Kansas City Fed Index, the Philadelphia Fed Survey, industrial production, the Empire State Manufacturing Index, the NAHB Housing Index, the ADP payrolls, auto sales, real disposable income and the GDP.
At best, we think the economy will be disappointing in the period ahead. Consumers, who account for about 70% of GDP, are hamstrung by debt. In addition they have kept up their spending only by running their savings rate back down to 3.8% of disposable income, only the fifth month below 4% since 2007. Other limiting factors are low wage growth, high unemployment, the large numbers of workers who have dropped out of the labor force, declining home prices, higher tax payments and a flattening out of transfer payments. Therefore it no wonder that consumer confidence still remains at recessionary levels.
Still ahead is the so-called "fiscal cliff", another conflict as we approach the debt ceiling again, a contentious election, and the continued inability of a dysfunctional congress to get anything done. All in all this is not a political outlook that is likely to give investors any confidence in the period ahead.
Adding to the headwinds is the worrying state of the global economy. Europe is plunging into recession with the fragile consensus unraveling with the fall of the Dutch government, the election of a left-of-center government in France and the indecisive results pending the new election in Greece. For more than two years the goal of European leaders has been to prevent the Greek crisis from spreading to other southern-tier nations. After innumerable meetings, agreements and bailouts, that attempt has seemingly failed with the increased vulnerability of the Spanish financial system. Most of Europe has now plunged into recession, an event with global implications, as Europe is the largest source of Chinese exports.
China is dealing with a speculative housing boom and a major political scandal prior to a change in leadership to a new generation. Even the suspect official economic statistics have been indicating a slowdown in the economy, while other evidence indicates that the situation may be worse than the official numbers show. China's economy is heavily based on exports and is extremely vulnerable to slowdowns or recessions in other major economies. India is experiencing a similar deceleration of growth. In the last few years China and India have accounted for the lion's share of global growth, and any slowdown has major implications for the overall global economy.
We believe that the numerous headwinds to economic growth are creating substantial downside risks to the economy and corporate earnings that, until recently, were not being appropiately discounted by an increasingly euphoric stock market. We believe that the correction is only the beginning of a major downturn. At current levels the downside risks are still far greater than the potential upside rewards.