``The problem is that the fundamentals of these economies are not right. People in those countries cannot maintain a decent standard of living because they are not producing enough in the private economy to keep the public-sector unions afloat. Unfortunately, these unions are so powerful that they can extort pay and work agreements that plunder the taxpayers, and now that the bailouts have arrived, look for the unions to be even more militant and violent. These countries don’t need more inflation, contra Keynesians. They need to stop feeding the monster of public-employee unions and permit business to operate without being smothered by rules and regulations. But after being bailed out, these governments will go back to doing things as they always have, and the malinvestment will continue.” William L. Anderson, Will the New Bailout Save Europe?
The ultimate question at present is whether the Greece crisis would escalate into a full-blown international sovereign debt crisis, in spite of the recent monster $1 trillion bailout[1] announced by an EU-IMF syndicate last Sunday or if the market stresses emanating from the Greece episode would lead to a cascading impact on the real economy. And for that matter the sequential question should be, what would be the attendant policy response if the markets continue to react negatively?
Bailouts Are Politically Motivated And Ballooning
It’s a silly notion to limit ourselves to only the economic aspects, when throughout the decade the policy response, when confronted with a crisis, has been mostly politically designed which eventually had political results, particularly boom bust cycles. And this is why political reactions[2] by global leaders have been like clockwork, which has seemingly validated us anew.
For instance, the nearly 10% plunge[3] in the US the other Friday, which was mostly pinned on computer error, has prompted authorities to conduct an investigation. Here is a very telling commentary, as quoted by the Financial Post[4], from a US lawmaker,
"We cannot allow a technological error to spook the markets and cause panic," Rep. Paul Kanjorski said late on Thursday. "This is unacceptable."
This only implies that US markets have been very much incorporated into the policy setting modules of US authorities, where falling stockmarkets for valid reasons or not, e.g. due to technological glitches, is like a taboo.
And there is little nuance when compared to the EU’s bailout of the Euro, where EU Commissioner Olli Rehn announced, ``We shall defend the euro whatever it takes”[5]
These are more than enough proofs that the guiding principle for global authorities is to shore up their markets as means to convey “confidence”. As we have been saying, the intuitive response by global governments has been to unceasingly throw money at the problem. And confidence in the market is likely to translate to financing for politicians running for elections, aside from a favourable image to the public.
And one would note that the cost of bailouts have been growing,
This from Bloomberg[6],
``The cost of saving the world from financial meltdown has been bloated by ‘hyperinflation’ since Long Term Capital Management LP’s rescue in 1998… rising price of bailouts since the $3.5 billion pledged to hedge fund LTCM after it was crushed by Russia’s default, and the almost $1 trillion committed to halt the European Union’s sovereign debt crisis this week. It cost just $29 billion to sooth markets in March 2008 when Bear Stearns Cos. was taken over, and $700 billion for the Federal Reserve to save the banking system with the Troubled Asset Relief Program in October that year. ‘We haven’t had any kind of normal inflation in the last decade, but we’ve had hyperinflation in writedowns and the magnitude of bailouts,’ said Jim Reid, head of fundamental strategy at Deutsche Bank… ‘You have to do more to get a similar effect every time.’”
As we earlier wrote[7], To paraphrase Senator Everett Dirksen ``A trillion here and a trillion there, and pretty soon you're talking real money; (gold as money)"
There seems to be no apparent end to the spate of bailouts.
QE In 4 Largest Economies And A Different Kind Of Carry Trade
Will global governments wake up to face reality recognizing the attendant risks by adapting policies that require stringent sacrifices to clear their respective markets of excesses or malinvestments? Or will they continue to flush the economic system by the massive use of their printing press as a short term fix or a nostrum?
For us, until they are faced with a crisis that forces their hands, the path dependency for authorities is for the latter.
Yet a genuine manifestation of an international sovereign crisis would be a surge in interest rates among nations afflicted by growing risks of debt default.
However this seems unlikely to occur yet, as governments would still be able to manipulate the bond markets for political expediency, particularly to finance existing deficit as incidences of inflation appear muted.
And part of such policies to suppress interest rates would be to buy government bonds from the financial markets or the banking system. And this apparently has been part of the measures that was packaged with the bailout of the Euro.
In essence, we have 4 of the world’s largest economies that have now engaged in “quantitative easing” (even if the ECB denies these, for the reasons that she would “sterilize” her purchases or offset bond purchases from banks/financial institutions with sale of EU bonds).
And these 4 economies constitute nearly 85% of the $83 trillion global bond markets as of 2009[8].
In short, world markets and the global economy would likely suffer from an unprecedented meltdown in a horrific scale, which would make 2008 a walk in the park, if any of the developed nation’s sovereign crisis transform into a full contagion.
However, I don’t believe that we have reached that point yet.
Figure 2: US Treasuries Index, EM Index, Yield Curve, US Dollar
The highly volatility in the markets have led a misimpression of a repeat scenario of carry trade circa 2008.
As we have pointed on last February, there is little evidence that a carry trade from the US dollar has been building among the global banking system[9].
Instead what the Euro crisis has been showing us is that the carry trade has been within the Eurozone system as seen by the interlocking[10] activities or the vastly intertwined network among private and national banks, EU member governments and the ECB. In short, it isn’t a foreign currency arbitrage, but a carry trade of government debts distributed among EU banks.
As we earlier quoted[11] Philipp Bagus[12],
(bold emphasis mine)
``The banks buy the Greek bonds because they know that the ECB will accept these bonds as collateral for new loans. As the interest rate paid to the ECB is lower than the interest received from Greece, there is a demand for these Greek bonds. Without the acceptance of Greek bonds by the ECB as collateral for its loans, Greece would have to pay much higher interest rates than it does now. Greece is, therefore, already being bailed out.
``The other countries of the eurozone pay the bill. New euros are, effectively, created by the ECB accepting Greek government bonds as collateral. Greek debts are monetized, and the Greek government spends the money it receives from the bonds to secure support among its population.”
And the existing regulations which mandate the banking system to hold government debt as a risk-free reserve has equally contributed to the current mess by introducing the moral hazard problem effectively channelled into subsidies to the subprime EU member states as Greece.
So the pressure seen in the Euro markets of late isn’t due to the unwinding of US dollar carry trades but a perceived rise in the default risks and possibly the consequent impact to the real economy from a perceived slowdown due to compliance to fiscal adjustments, or of the question of the European Union ability to survive the crisis without getting dismembered.
As shown above, US interest rates markets and the US dollar have been chief beneficiaries from the troubled Euro. The Morgan Stanley US Government Morgan Stanley Fund (USGAX), a fund where 80% of its assets are invested in Treasury bills, notes and bonds, has surged. Moreover, the US dollar Index where the Euro has the largest share of the basket, has continually spiked.
This, in essence, looks more of a rotation away from EU assets into US assets than a looming full blown international sovereign crisis.
In addition, we are seeing parts of that rotation away from the EU into Emerging Market Bonds as shown by rise in the Salomon Bros. Emerging Market Debt Funds (XESDX).
Likewise, the spread between the 3 month Bills and 30-year Bonds remains steep in spite of a relatively higher 3 month rates since the start of the year.
In a full scale sovereign crisis we are likely to see a faster surge of short term bills rather than bonds. And this will likely be triggered by a spike in inflation which sets about a self feeding mechanism that would force up rates. At this point, governments will have to choose to bring down interest rest rates by printing more money or by totally renouncing inflationism.
This Isn’t Lehman Of 2008; China’s Role And Slumping Commodities
Well obviously this isn’t 2008, where the disruptions in the interbank funding markets forced a seizure or a rapid system-wide contagion in the banking system.
Yes, we are seeing some volatility but this has been nowhere near the post Lehman episode as shown in the credit markets or in the interest spreads (see figure 3).
Figure 3 Danske Bank: Credit Markets Isn’t Manifesting Signs Anywhere Near 2008
The yields in US cash indices for different corporate bonds (left window) have largely been unscathed in spite of the current selling pressures.
And the 3 month Libor-OIS spread considered as a measure of the health of the banking system (in the US and Europe), hasn’t been suffering from the same degree of stress during the zenith of the Lehman days (right window).
And that’s also why EU officials have been quick to institute “buying of government bonds” or “quantitative easing” in response to signs of growing stress in Europe’s banking system.
By making sure of the ample liquidity of markets, these actions which work to suppress interest rates are meant to allow markets and the banking system continually finance EU’s bailout. In other words, the bailout is not only meant to politically uphold the Euro as the region’s currency, but to also keep intact the carry trade, unless overhauled by reforms-which appears to be nowhere in sight.
Morgan Stanley’s Joachim Fels sees the same view,
(bold highlights mine)
``More generally, with the establishment of a potentially large stabilisation fund, fiscal policy in the euro area is being effectively socialised. No country will be allowed to fail, and it seems that no country will be too big to bail. Ultimately, this creates an incentive for governments to run a looser policy than otherwise. If markets then refuse to fund a profligate government, it could turn to the fund, borrow at below-market interest rates and domestically blame the required fiscal tightening on the ‘diktat' from the euro area partners and the IMF. So, our bottom line on the implications of the European fiscal emergency plan is that, while it addresses the near-term liquidity problems, it does little to solve the underlying problem of fiscal sustainability and may even make things worse on this front over the medium term.”
Moreover, I’d like to add that while some have argued that the EU’s actions will not violate the principle of Maastricht treaty, which disallows for direct bailouts, the Special Purpose Vehicle (SPV) created to extend loans to troubled nations, for me, signifies as EU’s act to go around their self-imposed rule, or regulatory arbitrage, but this time by the EU government.
If governments would work to circumvent their rules in order to accommodate political expediency and likewise save particular interest groups in the context of the meme of saving the economy or the Union, then how else would this politically privileged group react when they knowingly feel protected? They are likely to engage in more reckless behaviour.
This reminds us of Hyman Minsky[13] who warned that bubbles emanate from government intervention, ``It should be noted that this stabilizing effect of big government has destabilizing implications in that once borrowers and lenders recognize that the downside instability of profits has decreased there will be an increase in the willingness and ability of business and bankers to debt-finance. If the cash flows to validate debt are virtually guaranteed by the profit implications of big government then debt-financing of positions in capital assets is encouraged. An inflationary consequence follows from the way the downside variability of aggregate profits is constrained by deficits.”
So its more than just inflating, it’s also a burgeoning moral hazards problem.
In addition, considering that the US is directly and indirectly involved, through the Federal Reserve via the currency swap lines and the IMF respectively, this can’t be seen as “beggar thy neighbour” approach considering that the US Federal Reserve sees the spillover risks from a banking contagion as possibly harmful to the sensitive state of her counterparts. In other words, the Fed isn’t causing a higher a US dollar for trade purposes but to ring fence the US banking system from a Euro based contagion.
Instead, such policy is more of a “beggar thy economy” genre where resources are being marshalled to save the banking system in the US and in Europe, at the expense of the real economy.
It’s not clear that the recent spate of falling oil or commodity prices are materially connected to the events in Greece or Europe, as they seem more correlated to the developments in China (figure 8).
Figure 4: China and commodities
As you can see the sharp drop in China’s Shanghai index (SSEC), which has been under constant assault from her government in an attempt to quash formative bubbles, has nearly been concurrent with the drop in oil (WTIC) and general commodities (CRB). Albeit the SSEC’s recent steep decline has also coincided with the fall of global markets from the Greece crisis the other week.
However, one bizarre development which seems moving in contrast to the current tide has been the Baltic Dry Index (BDI). The BDI appears headed towards the opposite direction almost as markets have been falling.
And with reports that consumer price inflation has been accelerating, it is quite likely that the Chinese yuan, could be expected to appreciate soon. And possibly, the rising BDI could possibly mean two things: one, a rising renmimbi means cheaper imports, which could reflect on the possibility of China’s positioning, and second, the falling prices could also be another factor for increased demand.
Unlikely Slump For Global Markets
So what does this tell us of the global markets?
First I am doubtful if this is the “inflection point” as expected by the permabears.
I see this more of a reprieve than a reversal. As said earlier, for as long as consumer price inflation rates are low, governments can continue to flood the economic system with newly printed money that may artificially contain interest rates levels.
Since money isn’t neutral, the impact from bailouts will have uneven effects to countries or specific sectors in particular economies. Even those expecting a deflation in Greece seem gravely mistaken[14].
Second, aside from the liquidity enhancement programs, policy rates by developed economy central banks are likely to stay at present levels for a longer period of time.
We even think that EM economies are likely to maintain rates at current levels, given the current conditions. In addition, rate increases enhances the risks of attracting more foreign capital in search of higher yields. Policymakers in EM nations will be in a fix.
Three, given the still steep yield curve, I have been expecting a pick-up in credit activities even in nations afflicted by over indebtedness. So far there have little signs of these (see figure 5)
Figure 5: St. Louis Federal Reserve: Consumer Loans at All Commercial Banks
Our basic premise has been that incentives provided for by the government to punish savers and reward debtors by suppressing rates will eventually force people to spend or speculate at the risk of blowing another bubble.
Besides, debt has been culturally ingrained in Western societies. It is an addiction problem[15] that will be hard to resist considering that the government itself is the main advocate of the use of addictive credit.
Fourth, economies of emerging markets have been performing strongly and are likely to maintain this momentum given the ultra loose liquidity backdrop.
Fifth, any slowdown or economic problems in any countries is likely to produce more bailouts from governments.
The trend has been set, therefore the chain of events are likely to follow. For instance, US participation in the bailout of Greece is likely to set a moral hazard precedent for financially troubled domestic states.
As Ganesh Rathnam argues[16], (bold highlights mine)
``The Federal Reserve's and IMF's participation in the eurozone bailout will not be lost on union members and politicians of heavily indebted US states such as California and Illinois. When the day of reckoning arrives for the US states who are unable to close their budget gaps and whose pension plans have huge funding gaps, they will be up in arms for their bailout as well. How could the US government politically defend its bailing out Greece via the IMF and the Federal Reserve and refusing the same for its own citizens? The idea that California would be allowed to default on its obligations when Greece wasn't is unthinkable. Therefore, the bailout of the PIIGS sets the stage for similar bailouts of bankrupt US states and cities.”
So governments worldwide will continuously pour freshly minted or digital money into the system. And yes this is going to be an ongoing battle between the markets and government armed with the printing presses.
Finally, Nassim Taleb in a recent interview[17] said, “No government wants solution to apply on themselves”.
And this only means that there will be even more government spending, bigger deficits and debts, higher inflation and missed fiscal targets or slippages from proposed austerity programs.
In the Eurozone, the EU circumvented existing rules to accommodate a bailout. These are signs that rules can flouted for political goals.
For the interim, this will all help. But at a heavy price in the future.
[1] see $1 Trillion Monster Bailout For The Euro!
[2] Stock Market Investing: Will Reading Political Tea Leaves Be A Better Gauge?
[3] See A Black Monday 1987 Redux?
[4] Financial Post, Obama says authorities probe cause of stock swoon
[5] see $1 Trillion Monster Bailout For The Euro!
[6] InvestorVillage/Bloomberg, Cost of Bailouts Keep on Rising
[7] See Are Record Gold Prices Signalling A Crack-Up Boom?
[8] The Asset Allocation Advisor, World Stock and Bond Markets and Portfolio Diversity; distribution share as follows US 37.9%, Euro 28.7%, Japan 13%, UK 4.9%
[9] See Does This Look Like A US Dollar Carry Bubble?
[10] See Was The Greece Bailout, A Bailout of The Euro System?
[11] See Why The Greece Episode Means More Inflationism
[12] Bagus, Philipp, The Bailout of Greece and the End of the Euro Mises.org
[13] Minsky, Hyman "Inflation, Recession and Economic Policy", 1982 (page 67) quoted earlier here More On Goldman Sachs: Moral Hazard And Regulatory Capture
[14] See Is Greece Suffering From Deflation?
[15] See Influences Of The Yield Curve On The Equity And Commodity Markets
[16] Rantham, Ganesh A Greek Tragedy in the Making
[17] See Nassim Taleb: Waking Up One Day To Perceptional Hyperinflation
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