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, an excerpt of Philippe Bagus’ book The Tragedy of The Euro

Current Macro Thesis

Inflation is one way out of this debt crisis. However, the situation in Europe is complicated by the EMU.
  • There is a sizeable (and growing) political constituency in Germany/Finland/Holland and other CREDITOR countries against the bailouts
  • The German Constitutional courts have placed severe constraints on the government’s ability to negotiate bailouts without the German parliament’s approval
  • Euro treaty rules have strict prohibitions against direct monetization of government debt by the ECB & creating permanent bailout mechanisms
  • All current support provided by the ECB to Italy/Spain/Greece is done on a Euro-neutral basis … they have to repo-out assets to repo-in other assets

My current macro thesis is:
  • The debt-deflation scenario envisioned by Prechter and others is the 800lb Gorilla on the macro-stage. No question in my mind that without intervention we WILL see all assets (incl. Gold) fall, and a flight to cash
  • The powers that be will use whatever they can to prevent a deflationary depression by “dampening” the asset price deflation by (1) providing liquidity, (2) quantitative easing (3) monetization of impaired debt assets
  • If they succeed, this will cause inflation in “the things we need” – food, energy, basic commodities, etc as all the liquidity finds its way into the speculative world, while slow deflation in “the things we want” like houses, stocks
  • The economy will cycle between periods of growth (unsustainable, liquidity fuelled) and deflation (caused by inflationary shocks) causing massive volatility in global markets
  • The “stimulus” process is a tightrope walk between runaway inflation & deflationary depression – either outcome is possible if policy mistakes are made
  • In western economies, a decade of stagflation is the most likely outcome – no wage increases, increasing food and energy inflation, persistent deficits & high taxes