Tuesday, 13 December 2011

Europe's debacle stems from the euro itself

Ambrose Pritchard Evans writes in the Telegraph: http://blogs.telegraph.co.uk/finance/ambroseevans-pritchard/100013758/europes-blithering-idiots-and-their-flim-flam-treaty/

Competitiveness mismatch
  • The Eurozone was never an optimal currency area, and is highly unlikely to become one
  • Historically, the dense river network in northwestern Europe afforded the region much lower transportation costs
  • This competitive advantage allowed the accumulation of capital and construction of roads, railways and industry
  • The industrial environment fostered cultural habits of efficiency, innovation and hard work
  • No amount of regulations, treaties, currency unions or monitoring can change this historical development
  • The only trick Southern nations had up their sleeve (currency depreciation) ended with the adoption of the Euro.
  • The result is the trade surplus in the North and huge debts in the South


The Output Gap is a Depression risk
  • Without a debt-liquidation the cost of servicing the debt (private or public) has created an Output Gap reflected in the Unemployment and Excess Capacity figures
  • An oil shock, global slowdown, or simply austerity can widen this Gap into a Depression.
  • The best case scenario under the present course will only result in a prolonged Japan-style slump
  • The worst case will be a deflationary Eurozone depression which can bring down the entire EU and periphery
  • A common market was a great idea. Currency union is a proven disaster. Austerity without debt-liquidation (PSI) will only make things worse.

How can the Eurozone turn this around?
  • The bad debts resulting from the banking bubble must be liquidated & stifling regulations in the Eurozone loosened. This is unappetizing but it is ABSOLUTELY the only way to restart growth.
  • Reinstatement of national currencies will fix the currency misalignment issue depreciation. This will also allow indebted countries to inflate their debts away without a default.
  • A Eurozone split (along North-South lines) can allow indebted countries to inflate and regain competitiveness (France would belong in Club Med, not in the North)

Sunday, 6 November 2011

Extreme Bank Runs in REPO Markets

Here is a primer on how repo markets relate to the conventional banking system.


In our financial system, a bank loan creates a bank deposit from "thin air". This deposit sits on the bank's books as a liability. The books are "balanced" by the loan agreement, which is an asset. 

A cashier's cheque drawn on the new bank deposit can buy your groceries in a way that the IOU from the borrower to the bank can not. You could say that the bank deposit has higher "moneyness" than the borrower's promise to repay. 

New money is created this manner as the borrowers promise to pay is "financialized". 

Physical cash has the highest "moneyness" (even more than the bank deposit). It is simply decreed to be money by the government's legal-tender laws.


A broader concept related to "moneyness" is "marketability". If legal tender laws did not exist,  the most marketable commodity would become money. People find it convenient to quote prices in terms of a marketable commodity. Financial transactions (including borrowing and lending) gravitate to using the most marketable commodity as money. 

Anything that is marketable can be used as money - metals, tobacco, salt, cowrie shells, beaver pelts etc have all been used. Historically, gold and silver were eventually adopted as money by the free market. If a shortage of the monetary commodity occurs (e.g. gold), people simply start using the next most convenient commodity as money (e.g. silver). 

Legal-tender laws ensure the marketability of cash - by requiring that taxes and other legal obligations be paid using paper money. However, the government can make any commodity money by "fiat" (decree).


Traditionally, financial regulations & prudential banking limited the amount of credit lent into the economy by a banking system - by tying it to the amount of CAPITAL in the retail banks. 

However, investment banks found a way to get around these limits to "financialization" using securitization. The securitization machinery at investment banks bought loans from retail banks and converted them to securities that were sold to investors. Retail bank capital was thus freed up to re-use lending channel to REPEAT this cycle and increase the credit in the system. The system was thus leveraged to many times the amount that would normally have been permitted by regulations. 

This arrangement may sound innocuous at first but it HYPER-LEVERAGES the investment banks' balance sheets. Every time investment banks securitize a batch of loans into investable tranches, they retained the riskiest portion of these loans on their own balance sheet. A small loss on these loan books had the potent to totally wipe them out. 

To mitigate this risk investment banks purchased CDS insurance on the safer tranches from reinsurers like AIG. However AIG itself underestimated the risk in these loans and was not capitalised sufficiently to write this insurance. 

This entire arrangement created a powder-keg ready to explode. The explosion happened in 2008 taking down Bear Sterns and Lehman brothers. AIG, Morgan Stanley, JP Morgan and Goldman Sachs would have disappeared too had the US taxpayer not massively recapitalized AIG, and twisted its arms to ensure that AIG paid the investment banks every last dollar of insurance due to them.


What is not well understand is that the purchase of a lot of these securitized assets was in fact funded indirectly by the retail banks themselves!! There is a MASSIVE lending market for REPOS between dealers and banks, wherein dealers pledge any asset that is valuable for loans from a bank. 

The newly created credit is lent out by the Prime Brokerage divisions of the investment banks to their customers, who buy risky assets. Depending on the potential volatility and liquidity of the pledged asset, the customers may be lent (say) 90%, or 80% or 70% of the value of the security, thus potentially leveraging their position enormously.


During periods of growth, increased confidence and competition amongst banks would cause creeping over-extension of loans to increasingly marginal borrowers. At some point marginal loans start to go bad. As this becomes known, the fear of bank runs starts to spread and the solvency of affected banks comes into question. 

If a bank's assets lost value (i.e. loans go bad) the books would become unbalanced and bank deposits could lose their "moneyness". Depositors became fearful and would try to to convert their deposits into cash, or transfer them into other banks. 

A distressed bank would attempt to restore confidence in the deposits by trying to raise cash through a combination of the following actions:

(a) Borrow money in the unsecured inter-bank market
(b) Pledge "marketable" assets in the REPO market
(c) Call in loans and pull credit lines, where possible
(d) Liquidate assets that can be sold, even if at a loss 
(e) Raise money in the capital markets through a share, rights or bond issue

The resulting curtailment of lending caused a "credit crunch" and liquidation of assets. This disrupted trade and manufacturing, giving rise to the business cycle

Central banks were created to try and "smooth out" the business cycle. They act as a lender-of-last-resort for distressed banks to provide them loans during a credit crunch. Central banks operate using REPO transactions. Banks pledge high-quality (i.e. "marketable") assets in exchange of central bank loans. Only the highest quality assets are usually accepted as "eligible collateral" for central-bank repos, otherwise the central bank may end up stuck with these if the bank becomes insolvent due to loan losses  

Central banks stipulate that banks maintain a minimum capital buffer to cover any loan losses. Accounting rules also mandate that any expected losses must be marked down in the books, curtailing further "risk-taking" (i.e. lending). Unfortunately, over the past couple of decades capital requirements and accounting standards have been watered down in the name of "supporting growth". In practice this means that marginal borrows continue to be funded and their claims on real resources (such as groceries) are not liquidated. 


Now let's examine what happens when loans go bad in the hyper-leveraged REPO  markets. The immediate effect was the 2008 collapse of the investment banks. Central banks and the taxpayers stepped into the breach and shored up these entities through massive lender-of-last-resort loans, recapitalization, and by simply purchasing distressed securities off their books for well above market values.

However, the fundamental problem remains. We are in a world where the financial system contain too many promises to pay, and not enough means to pay them. Bad loans are losing the moneyness all over the world, grinding down the capital on bank balance sheets everywhere. The world economy can not grow while it is weighed down by the the burden of servicing all the accumulated debt during the boom times. 

The repo markets are where the real action is. Banks will not lend against these deteriorating assets - whether they are mortgage loans, European debt, chinese grey market debt, etc. 

Left to itself, the world economy will experience a long deflation to clear out the excesses. However, the policy response of countries like the US and UK is INFLATION of the money supply. The obstruction to this policy are CREDITORS like Germany and China, who do not want to see the value of their loans inflated away. The battle of will between these opposing forces will continue and the outcome is a function of POLITICS. 

Sunday, 30 October 2011

Markets up 20% in a month - what just happened?

Those surprised by the financial markets' incredibly positive response to the EFSF expansion to $1.4 TN may find Doug Noland's piece about Money and the European Credit Crisis quite helpful in understanding what just happened.

Writing about the historical "preciousness" of money, Doug explains how our financial system creates money. Using an array of financial innovations it "monetizes" any sound financial claim by lending bank deposits against it. This creates an artificial demand for these credits and ensures that sound financial claims are highly liquid and thus, as good as "Money."

2008: Questioning "Moneyness"

The credit bubble leading up to 2008 crisis was fuelled by “monetization” of sub-prime mortgage credits through the securitization machinery. The soundness of the resulting derivatives was underpinned by (questionable) credit ratings. Using cheap CDS insurance from AIG, banks could provide liquidity in the secondary market. 

When the securities were revealed to be unsound, they became highly illiquid and lost their “moneyness”. This threatened to bring down AIG and the banks that depended on the unsound insurance provided by an undercapitalised insurer based on fantasy ratings.

The markets enjoyed an incredible windfall since 2009 as Treasury and Federal Reserve backing has restored "moneyness" to Trillions of suspect financial claims. Massive federal debt issuance and Federal Reserve monetization have reflated asset markets and sustained the maladjusted U.S. economic structure.

A Closer Look at Sovereigns

The end of the credit binge caused a painful slowdown in liquidity-fuelled global growth, exposing fundamentally unsound sovereign credits. Governments such as Dubai - dependent on tax revenues from the bubble economy - were bailout out by rich cousins. Those hopelessly in debt, such as Iceland, simply collapsed. Those that weren't permitted to collapse, such as Ireland, were drip-fed financing and their people condemned to debt slavery.

The 2008 crisis has brought forward the Global Government Finance Bubble by several years.

Essentially, the European crisis is about the escalating risk that the entire region's debt could lose its "moneyness." Ever since the introduction of the euro, the European financial system has had an insatiable appetite for Euro-government credits. Under the Euro system European Banks were incentivised to lie to themselves. Euro governments were believed to be fundamentally sound despite unsustainable deficits, and despite explicit EMU treaty prohibitions against bailouts. Core European governments and the ECB would, the banks told themselves, back all government and banking system obligations. 

Many expected that German politicians to calculate that it will cost less to backstop the region's debt than to risk a collapse of European monetary integration. The Germans, however, appreciate like few other societies the critical role that stable money and Credit play in all things economic and social. So far, they have refused the type of open-ended commitments necessary for the marketplace to again trust the Credit issued by the profligate European borrowers, and have insisted that the incredibly bloated banking system eat the losses on Greek debt.

The Franco-Italian Connection 

Increasingly, the consequences of a loss of "moneyness" at the periphery have weighed heavily upon the European banking system. Greece, Portugal and Ireland are just a side-show. Faltering confidence in Italian debt is the real issue. An Italian default will devastate French banks. At the same time, any meaningful French participation in PIIGS bailouts would see France lose its AAA rating. 

The above French conundrum risked impairing the "moneyness" of French Credit,
which is at the core of the European debt structure. This is why the Germans have permitted EFSF leverage up to $1.4 trillion.

The grand plan is to allow IMF/BRIC/Japan/Sovereign Wealth investors to backstop the "moneyness" of European debt, thus providing the bazooka that will ensure market confidence in European Credit generally. For now, the markets are assured that the near-term implosion risk is off the table, which set the stage for a huge short squeeze and destabilizing unwind of hedges across virtually all markets. There may be grand plans and grand designs for a credible "ring-fence," but the critical issue of how to ensure ongoing Italian debt "moneyness" continues to prove elusive.

Haircuts and Inflation

Clearly, the world has too much debt to pay off honestly. Most of it will either be defaulted on, or inflated away. There will be repeated crises of confidence as the soundness of credit after credit is called into question and ultimately "demonetized". 

Inflation, where possible, will steal from savers. It will have to be executed carefully, as any rapid loss of value can lead to capital fright, resulting in a loss of confidence in the inflated currency. Witness the masters of propaganda at the Bank of England employ deflationist scare tactics to cloak the effects of their QE-fuelled inflation, which runs rampant in the UK.

As the crisis inexorably grinds from the periphery to the core of the global financial system, the dominos will fall one by one. US treasury bears will have to be very patient. There is plenty of drama to sit through before the final act - demonetization of US credit - is played out. Meanwhile the dollar devaluation will continue in a volatile downtrend.

Tuesday, 25 October 2011

The Euro: A Tragedy of the Commons

Imagine that each EMU country possessed a Euro printing press. Each country would accrue benefits (higher income) by printing money, whereas the costs (a lower purchasing power) would be borne by all Euro countries. The country that prints the fastest makes gains at the expense of others. In this (hypothetical) situation we are faced with a "pure" Tragedy of the Commons where there is no limit to the exploitation of the Euro resource. The currency ends in a hyperinflation and a crackup boom, in other words, the destruction of the common resource.
Although hypothetical, the example of several printing presses helps us understand the risk to the Euro. Reality is different - deficit countries run deficits and issue bonds, which is not the same as printing Euros. Banks earned a yield spread by purchasing these bonds and posting them as collateral for cheaper loans from the ECB. The loans were effectively new money from the ECB, which was used to repeat this process.
Similar to the mortgage securitization process by US investment banks, this created a “demand” for Euro government, which politicians were only too happy to supply. The incentive for politicians was redistribution. Early adopters bought electoral favors at low prices. Spending the newly borrowed money increased prices and monetary incomes across the EMU. This forced greater borrowing to finance the same lifestyle. The higher the deficits became and the more governments were forced to borrow.
There were several risks to this arrangement continuing forever.
1. Low yields - Banks needed sovereign bond yields to be higher than the ECB lending rate interest rate for this to be profitable.
2. Default risk - default was considered impossible. It was widely confused with a country leaving the Eurozone. As the euro was seen as an irreversible political project the market assumed there were implied bailout guarantees, even though these are explicitly prohibited by the EMU treaties.
3. Collateral quality - Before the 2008 crisis, the minimum rating required by the ECB was A–. This was reduced to BBB– during 2008 for one year, and then another. Finally, the ECB, in contrast to its stated principles of not applying special rules to a single country, announced it would accept Greek debt even if rated junk.
4. Liquidity risk - Government bonds are of a longer duration than ECB bank loans (1 week to 3 months, now increased to 1 year). The risk was that the ECB might refuse to roll over loans collateralized with downgraded country debt, causing liquidity problems for the borrowing bank.
5. Haircuts -The ECB distinguishes five different categories of collateral, demanding applying different haircuts. Haircuts for government bonds are the smallest, thereby subsidizing their use as collateral vis-à-vis other debt instruments. This supports government borrowing. Downgrades mean that haircuts applied by the ECB on the collateral may not allow for full refinancing.
6. Tightening - The ECB might not accommodate all demands for new loans. If a restrictive monetary policy was applied, the risk was that not every bank offering government bonds as collateral would receive a loan.
However, for political reasons, the ECB did accommodate such demands, especially if some governments were in trouble. Indeed, the ECB started offering unlimited liquidity to markets during the financial crisis. Any demand for a loan was satisfied — provided sufficient collateral was offered. Loans up to 1 year were offered. Collateral quality control was waived.
EMU leaders externalized the costs of government spending in two dimensions: geographically and temporarily. Geographically, some of the costs are borne in the form of higher prices by the whole Eurozone. Temporarily, the problems resulting from higher deficits are possibly borne by other politicians and only in the remote future.

These tragic incentives stem from the unique institutional setup in the EMU: one central bank. These incentives were not unknown when the EMU was planned. The Treaty of Maastricht (Treatise of the Economic Community), in fact, adopted a no-bailout principle (Article 104b) that states that there will be no bailout in case of fiscal crisis of member states. Along with the no-bailout clause came the independence of the ECB. This was to ensure that the central bank would not be used for a bailout.
Political interests and the will to go on with the euro project have proven stronger than the paper on which the no-bailout clause was been written. Moreover, the independence of the ECB does not guarantee that it will not assist a bailout. In fact and as we have seen, the ECB is supporting all governments continuously by accepting their government bonds in its lending operation. It does not matter that it is forbidden for the ECB to buy bonds from governments directly. With the mechanism of accepting bonds as collateral it can finance governments equally well.
There was another attempt to curb the perverse incentives of incurring in excessive deficits. Politicians introduced "managed commons" regulations to reduce the external effects of the tragedy of the commons. The stability and growth pact (SGP) was adopted in 1997 to limit the tragedy in response to German pressure. The pact permits certain "quotas," similar to fishing quotas, for the exploitation of the common central bank. The quota sets limits to the exploitation in that deficits are not allowed to exceed 3 percent of the GDP and total government debt not 60 percent of the GDP.
If these limits had been enforced, the incentive would have been to always be at the maximum of the 3 percent deficit financed indirectly by the ECB. Countries with a 3 percent deficit would partially externalize their costs on countries with lower deficits. However, the regulation of the commons has failed. The SGP is just an agreement of independent states - without credible enforcement.
Inflation and deficit quotas of independent states are difficult to enforce. Automatic sanctions, as initially proposed by the German government, were not included in the SGP. Even though countries violated the limits, warnings were issued, but penalties were never enforced. Politically influential countries such as France and Germany, which could have defended the SGP, violated its provisions by having more than 3 percent deficits from 2003 onward. With a larger number of votes, they and other countries could prevent the imposition of penalties. Consequently, the SGP was a total failure. It could not close the Pandora's Box of a tragedy of the commons which will now follow. Expect more bailouts.
Adapted from http://mises.org/daily/5331, an excerpt of Philippe Bagus’ book The Tragedy of The Euro