How could the Euro be so strong?

That’s the usual question posed by people who read articles about the grim political economic situation in the Eurozone.

Since the Greece debt crisis has began unraveling in 2009 (see timeline here), the Euro had initially been affected (see red arrows) but eventually as the price chart shows, the Euro has been discounting the issue.

This isn’t to say the crisis isn’t real, but rather the crisis is a relative issue. One cannot tunnel on Europe without looking at the conditions of the US or of the other economies.

I superimposed gold’s price trend to illustrate the strong correlation between the Euro and gold. My bullishness in the Euro had been validated (see here and here).

Now going back to the question

Here is my terse reply:

The Euro has been strong because the problems of the US dwarfs the crisis in Europe.

Proof?

From Danske Bank

The Euro has been validating the theory of the great Ludwig von Mises [Causes of Economic Crisis, Stabilization of the Monetary Unit—From the Viewpoint of Theory] who wrote, [emphasis added]

These observers do not understand that the valuation of a monetary unit depends not on the wealth of a country, but rather on the relationship between the quantity of, and demand for, money. Thus, even the richest country can have a bad currency and the poorest country a good one.

The above chart puts the entire global debt crisis predicament into perspective by showing how central banks has responded with ‘bailouts’ of their respective financial system

From the supply side, massively printing of money to resolve the debt issue represents the diminishing marginal value of additional money into the economic system.

Here the ECB has printed a lot less of money compared to the US Federal Reserve, perhaps owing to the trauma experienced from the hyperinflation of the Weimar Republic in 1921-23.

From the demand side, the quality and price value of securities absorbed and held in the balance sheets of the US Federal Reserve from the banking system during the crisis should be viewed as a continuing concern.

It’s a misplaced idea or belief that the seeming tranquil conditions today in the US be interpreted as the policy of inflation having successfully settled the legacies of the economic and financial crash in 2008.

The Fed has printed trillions yet home price indices appear to be in a double dip recession.

From yesterday’s S&P press release [bold highlight mine]

This month’s report is marked by the confirmation of a double-dip in home prices across much of the nation. The National Index, the 20-City Composite and 12 MSAs all hit new lows with data reported through March 2011. The National Index fell 4.2% over the first quarter alone, and is down 5.1% compared to its year-ago level. Home prices continue on their downward spiral with no relief in sight.” says David M. Blitzer, Chairman of the Index Committee at S&P Indices. “Since December 2010, we have found an increasing number of markets posting new lows. In March 2011, 12 cities - Atlanta, Charlotte, Chicago, Cleveland, Detroit, Las Vegas, Miami, Minneapolis, New York, Phoenix, Portland (OR) and Tampa - fell to their lowest levels as measured by the current housing cycle. Washington D.C. was the only MSA displaying positive trends with an annual growth rate of +4.3% and a 1.1% increase from its February level.

Chart from CLSA Greed and Fear

A double dip in home prices suggests that the value of the Fed’s assets have been deteriorating considering huge amounts of exposure on mortgage and agency papers.

So neither does this represent as a plus for the US dollar.

Add to that the unresolved fiscal issues.

So how will the US government act on the above? Quantitative Easing 3.0, 4.0, 5.0...nth? Will these make the case for a stronger US dollar relative to the Euro?

To argue so means that money printing won’t have negative effects on the US economy. This would be like believing in a philosopher’s stone—the alchemy of turning lead into stone.

Of course it’s also nonsense to believe in the argument that fiscal restraint or “austerity” as the sole or main basis for bearishness on the Euro, except when you see the world as being driven by “spending” alone. Yet this view appears gradually being disproven.

Putting one’s house in order should be seen as a virtue and not a vice.

Also the above discussion hasn’t been new, I have dealt with this before here

True, political events (the clash between the ECB and national officials) can undermine the Euro, but again the big picture, based on the above, says the balance of risks has been tilted against the US dollar.

And it isn’t in the political interests of both contending political entities to see a worsening of schism that would only undermine their statures and importantly their tenures.

As fund manager Axel Merk writes, (bold emphasis mine)

We have long argued that it is not in Greece's interest to default at this stage because Greece needs to get its primary deficit under control before restricting its debt. As further reforms are implemented, the risk/reward ratio for Greece will change to potentially favor a default to reduce its debt burden. Delaying any default benefits Greece because any default now would impose an immediate adjustment of the primary deficit as it may be impossible to get new loans at palatable terms.

However, if ECB deserts Greece, the risk/reward assessment for Greece is changing. If the ECB gets too tough on Greece, dynamics in Greece may drive political dynamics to favor a default or even a re-introduction of the drachma.

Mind you that this would not be in Greece's interest: a default now won't fix Greece's underlying structural issues. Leaving the eurozone might cause an implosion of Greece's financial system. But from Greece's point of view, if they feel deserted by the ECB, political dynamics may favor the worst of the bad choices at hand.

And that’s why a second round of bailout seems to be at work as of this writing. So both the US and the Euro will be inflating again and that the question would be which currency inflates more.

Popular analyst John Mauldin predicts “The euro appears to me to be a massive short.” I hope he puts his money on his forecast, and wish him a lot of good luck.

I’d be taking the opposite fence though, until I see signs of the Eurozone inflating more than the US or an imminent political instigated collapse of Euro.

However, instead of buying the Euro, the best position in my view, would be to buy gold.

Gold would not share the same risk of the Euro although both of them have paralleled each other’s moves.

Gold’s nemesis would be a fiscally disciplined limited government, sound money and free markets, forces which we won’t be seeing anytime soon yet.

The Euro Bailout And Market Pressures

``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

Is Greece Suffering From Deflation?

New York Times' Floyd Norris writes,

``Making Greece’s exporters competitive will be a very difficult task while the country remains in the euro zone. If it does, the likelihood is that there will be a prolonged period of deflation, with wages being reduced in an effort to cut costs." (bold highlights mine)

The mainstream impression is that because Greece is stuck with the rigidities of having a monetary system anchored on the Euro, where devaluation isn't an option, the attendant adjustments to the current debt problems intuitively leads to deflation.

But how true is this perception?

Greece has indeed been suffering from recession throughout most of 2009 until the present as shown in the above annual and quarterly charts from tradingeconomics.com.

Yet the inflation index registers a hefty jump (annual basis)!

In addition, during the depth of the global crisis, Greece's inflation index shows that consumer prices had NOT fallen below zero or to the negative levels! So even if we stick by the mainstream's definition of deflation- of falling consumer prices and not shrinking money supply- deflation has been non-existent in Greece!

And the index has even yet to account for the recent massive bailout.

Bottom line: the mainstream perception, premised on the dominant economic ideology, of how the world operates seems far far far away from reality.

Before I forget, let me add that Greece seems to be suffering from 'stagflation' or a period of slow economic growth, high unemployment and rising prices, a scenario which mainstream has blatantly overlooked in the past (1970s) and seemingly appears to be the same source of vulnerability today.

$1 Trillion Monster Bailout For The Euro!

I'm back!

And am vindicated anew!

Coming back from my self imposed exile away from the miasma of domestic politics, I picked this up from media on my way home; this from the Associated Press,

"We shall defend the euro whatever it takes," EU Commissioner Olli Rehn said after an 11 hour-meeting of EU finance ministers that capped a hectic week of chaotic sparring between panicked governments and aggressive markets." (bold emphasis mine)

It's been long argued on this space that policymakers have the innate proclivity to act towards inflationism. That's because of the following factors: inherent addiction to the printing press (or government spending), policy "triumphalism" (recent gains from interim policies), prevailing economic ideology and short term or "career" oriented policy based decisions.

And the political reaction to last week's meltdown was as clinically precise as we had anticipated.

Whether it is the US, China or the EU, the policy approach have all been similar-throw money at the problem- regardless of the long term consequences of their actions.

And it will be no different even for the newly elected authorities in the Philippines.

More from the AP,

(bold emphasis mine)

"The European Union spearheaded a $1 trillion plan Monday to contain Europe's spreading debt crisis and keep it from tearing the euro currency apart and derailing the global economic recovery.

"Central banks around the world joined the coordinated effort to prop up the euro and repel speculative attacks against Europe's weakest countries. The European Central Bank used what analysts called its "nuclear option" — buying public and private debt to shore up liquidity in "dysfunctional" markets and lower borrowing costs.The U.S. Federal Reserve separately reopened a currency "swap" program to ship billions of dollars overseas, pumping more short-term cash into the financial system...

"Under the three-year plan, the European Commission — the EU's governing body — will make euro60 billion ($75 billion) available while countries from the 16-nation eurozone would promise backing for euro440 billion ($570 billion). The IMF would contribute an additional sum of at least half of the EU's total contribution, or euro250 billion."

So the massive bailout is essentially another redistribution from the real economy to the banking system, and to bank related creditors, as well as governments -the Euro version!

But this time with much of the world participating in the monster bailout via the IMF.

Rest assured that inflationary pressures are not limited to one country or region, but a concerted global action. So while the Fed inflates to protect her domestic banking system, the ECB, EU and the IMF along with everyone else are doing the same. We expect any further problems, say in China, to be met by the same response.

It's good to be back and proven right!

Was The Greece Bailout, A Bailout of The Euro System?

Here are two great charts depicting why European policymakers opted for bailout route for Greece.

Albeit the perspective from these charts strictly focuses on the financial system and not the political facets.

To aptly quote the analyst interviewed by the New York Times, "This is not a bailout of Greece...This is a bailout of the euro system.”
Europe's banking system has been deeply interconnected....

Again the New York Times, ``For all the handwringing, the reality is that the Germans, the French and the rest of Europe have little choice. In the decade since the introduction of the euro, the economies on the continent have become increasingly interwoven. With cross-border banking and borrowing, many countries on the periphery of Europe owe vast sums to one another, as well as to richer neighbors like Germany and France." (bold emphasis added)

where the amount of exposure has been substantial.

To quote the Economist, ``Estimates by The Economist put the total euro-area exposure of foreign banks to Greek sovereign debt at €76 billion, with over 71% held by France and Germany. Estimates for Portugal, which may also be vulnerable to a default, are €32 billion. Little wonder that investors are taking flight."

The argument that Europe have little choice rests on the fundamental premise of the operating platform of the Euro system.

As Gavekal's Charles Gave argues, ``Indeed, the balance sheets of European banks and insurance companies are heavily distorted by past investments made in the debt of technically bankrupt governments. For the past 15 years, banks and insurance companies all over Europe have been lured into believing that the Greek risk was equivalent to the German risk, or the Spanish risk similar to that of the Dutch, etc. As a result, the capital of too many financial institutions was invested in very dubious paper.

``Moreover, in the countries which have "enjoyed" a massive real estate bubble (Spain, Ireland...) because of the distortions in the cost of money introduced by the Euro, the banks are now loaded with real estate loans of very questionable value. To add insult to injury, regulatory powers all over Europe have literally forced banks and insurance companies into buying the bonds issued by European governments ("risk free" they were told, and zero reserve requirements!) while forcing them to sell good quality equity positions established over decades. So whether one looks at balance sheets, reserves, loan books or future sources of income, it is hard to avoid the conclusion that European financials are in a pickle. This is a true and very unfortunate consequence of the Euro." (all bold highlights mine)

In gist, the problem is with de facto monetary system, which I don't think is limited to the Euro but to the concurrent paper money standard.

When regulators compel or require the financial system to buy government debts as part of the 'risk free' reserves, this essentially signifies as subsidies to government expenditures which consequently induces more spending, regardless of the necessity.

Said differently, government debt is considered "risk free", because it is backed the barrel of the gun via taxation. However, taxation can only finance part of these expenditures because they depend on the performance of the entities that operate on the real economy.

So in order to continually fund burgeoning government expenditures, central banks encourage deficit financing by inflating the system. And inflating the system engenders a feedback mechanism that leads to an unsustainable Ponzi financing system combined with intractable government spending. The charts above simply illustrates this dynamic.

And as the Greek crisis has shown, reality eventually dawns on the fictitious world where spending equals prosperity and where 'risk free' isn't what it had seemed.

And this is further proof that the cartelized system from which the central banking operates on exist to serve political goals. Fiat paper money system is highly political.

Mr. Gave, a prominent Euro bear, argues here that the disintegration of the Euro will be bullish for markets and the global economy as the political "Roman Empire" wisdom from which lays as the foundation to the EU's concept of "centralized super-government" will pave way for freer markets.

But I don't believe that the political elite in the Eurozone will easily succumb to free market forces knowing that free markets would emasculate their privileges. Perhaps, not until economic reality totally overwhelms the fantasyworld.

I see this as happening farther down the road.

So yes, the bailout translates to a rescue of the Euro system.

Update: Addendum: Greece's bailout will need to have the commitments of the financiers ratified by their respective governments (parliaments).

Selling In May, The Greek "Contagion" Panic In Perspective

We will try to put into perspective last night's panic which was supposedly triggered by concerns over a Greek contagion.

The chart below from Bespoke shows of the Credit Default Swap (CDS) prices or the cost of insuring debt, as of last night.

Bespoke decries the exaggeration in the news, "While CDS prices are higher today for countries like Greece, Portugal, Spain, and Italy, they were just as high late last week prior to declining quite a bit yesterday on news of the Greek bailout. Basically default risk today is right back where it was late last week and not "blowing out" to higher levels."


It's true that the PIIGS led by Greece has seen a rebound in CDS prices to indicate renewed concerns over sovereign issues in spite of the bailout, but they remain below their previous highs and have NOT reached the level of Argentina and Venezuela levels for now.

Again from Bespoke, ``Greece 5-year CDS is at 737 basis points today. Prior to the bailout it was above 800 bps. Venezuela and Argentina still have higher default risk than Greece. Portugal CDS is at 355.4 bps today, up from 275 bps yesterday, but still below the 380 bps it was at last week. Spain is probably the most worrisome country on the list at 208 bps, since it has a much bigger economy than any of the other countries at similar default risk levels. And Italy has jumped up to 164 bps today, which is more than double the next closest G-7 country."

The interesting part is, despite the so-called contagion spurred selloffs, CDS prices in the US and the UK have barely budged! In short, the selling frenzy could be media "exaggerations" and market sentiment feeding into each other more than a real "contagion" related dynamic.


We see parallel developments in the US treasury market. US 10 year yields have fallen (alternatively bond prices rallied) as stock markets retrenched. This implies more of "fear" than sovereign related concerns as both the CDS and treasury markets suggests.

Yet despite the spike in the VIX "fear" index, the US S&P seems more resilient relative to the similar episode last February-meaning that while the VIX have climbed about three quarters of the VIX high in Feb, the decline in the S&P have been relatively less.

Importantly while both the Euro benchmark (STOX50E) and the S&P fell nearly by the same degree last February, today, the S&P appears to outperform the Eurozone by falling less.

So even if the month of May could be partially validating the maxim, sell in May and go away, it isn't clear that this is the start of THE major inflection point. It looks more like a reprieve following the string of gains with Greece as serving as a rallying point for the current market action- of course, until proven otherwise.

Who Pays For Greece's Bailout?

Great chart from the Wall Street Journal...
One, Europe including crisis affected Spain (!).

Next, the world through the IMF (186 members) via the respective quota system "Most resources for IMF loans are provided by member countries, primarily through their payment of quotas".


Importantly, the US- since she constitutes the largest share in the IMF's membership quota system [chart courtesy of Stratfor].

After all, since the US functions as the operator of the de facto monetary standard, this only implies that she can simply inflate even under her current "tight" fiscal conditions [yeah-what are we in power for?]

In addition, this also goes to show that the US has indirect means to conduct foreign policy. And that the current bailout only implies that the US has also vital political interests to protect in the Eurozone. And this became evident when President Obama called on German Chancellor Angela Merkel during the peak of the crisis.

As we've been saying all along inflationism is the standard policy approach of global policymakers or authorities to concurrent political-economic problems.

Inflationism And The Bailout Of Greece

``The most difficult subjects can be explained to the most slow-witted man if he has not formed any idea of them already; but the simplest thing cannot be made clear to the most intelligent man if he is firmly persuaded that he knows already, without a shadow of doubt, what is laid before him.”- Leo Tolstoy

Speaking of economic reality, the unsustainable state of welfare system in Greece and the PIIGS in the Eurozone today seems like a good example of government wastrel, that needs to be rebalanced or ‘revert to the mean’.

But this outcome while necessary may not likely be a preferred path for policymakers.

Mainstream’s Penchant For Currency Devaluation

Figure 4: Danske Bank[1]: The Euro Crisis

Yet the problems of the PIIGs (see figure 4) is not mostly because of the recent bursting of the US housing bubble but from previous government profligacy which arose from the incentives brought about by the prevailing monetary platform...the fractional reserve system operated by central banking.

Economists Peter Boone and former chief of the IMF, Simon Johnson formerly chief of the IMF writes[2], (bold highlights mine)

``The underlying problem is the rule for printing money: in the eurozone, any government can finance itself by issuing bonds directly (or indirectly) to commercial banks, and then having those banks “repo” them (i.e., borrow using these bonds as collateral) at the ECB in return for fresh euros. The commercial banks make a profit because the ECB charges them very little for those loans, while the governments get the money – and can thus finance larger budget deficits. The problem is that eventually that government has to pay back its debt or, more modestly, at least stabilize its public debt levels.

``This same structure directly distorts the incentives of commercial banks: they have a backstop at the ECB, which is the “lender of last resort”; and the ECB and European Union (EU) put a great deal of pressure on each nation to bail out commercial banks in trouble. When a country joins the eurozone, its banks win access to a large amount of cheap financing, along with the expectation they will be bailed out when they make mistakes. This, in turn, enables the banks to greatly expand their balance sheets, ploughing into domestic real estate, overseas expansion, or crazy junk products issued by Goldman Sachs. Just think of Ireland and Spain, where the banks took on massive loans that are now sinking the country.” (all bold highlights mine)

While Messrs. Boone and Johnson prescribe a whopping $1 trillion backstop for Portugal, Italy and Greece, they also call for the end of the current “repo window” to be substituted by “eurozone bonds”.

And like most of the Euro doomsayers, the common denominator to blame for the Greece or the PIIGS crisis has been the rigid monetary system from the Union or that these crisis-affected-countries can’t devalue its way out of the mess.

However, contra such generalizations, devaluing a currency would have some merit if the debts had been priced in local currency. But if they are priced in foreign currency then devaluation raises the cost of real debts. Hence, devaluations will not resolve the problems that require massive adjustments or reversion to the mean in economic sphere.

Central Banking Means Inflationism, ECB Included

For the mainstream economists, as always, money printing appears to be the only feasible solution to the mess surrounding the government’s spendthrift ways for so-and-so noble reasons.

Whether it is the ECB or the Fed, the political incentives for the central banks remain the same, to re-quote Murray N. Rothbard[3] anew,

``The Central Bank has always had two major roles: (1) to help finance the government's deficit; and (2) to cartelize the private commercial banks in the country, so as to help remove the two great market limits on their expansion of credit, on their propensity to counterfeit: a possible loss of confidence leading to bank runs; and the loss of reserves should any one bank expand its own credit. For cartels on the market, even if they are to each firm's advantage, are very difficult to sustain unless government enforces the cartel. In the area of fractional-reserve banking, the Central Bank can assist cartelization by removing or alleviating these two basic free-market limits on banks' inflationary expansion credit.”

In other words, governments are not likely to radically alter the framework of the banking system because of the following reasons:

One, it defeats the purpose of having a central bank, i.e. finance government deficit, cartelize private banks and circumvent market’s restriction to expand credit,

As for the government banks financing of government debt, Germany’s government banks had been recently reported to have sizeable holdings of Greek debt. According to the New York Times[4], (bold highlights mine)

``Germany’s financial institutions hold some €28 billion, or $37 billion, in Greek bonds, Barclays Capital estimates, extrapolating from International Monetary Fund data.

``A quick survey of Germany’s largest banks Wednesday indicates that probably half of that debt — rated “junk” by Standard & Poor’s since Tuesday — sits on the balance sheets of institutions that are owned or controlled by the government. The percentage could be much higher, but outsiders have no way of knowing for sure because bank regulators and many of the banks refuse to disclose precise numbers.”

So this only serves as proof of how central banks and the banking cartel system work hand in hand.

Second, the most conspicuous path dependency for the authorities of the ECB and the US Fed (or even with Bank of Japan) would be to inflate the system (as we previously discussed[5]), given the du jour mainstream ideology triumphalism of present policies and the addiction to the printing press,

Third, except for some tweaks (via financial reforms) in the banking regulation, the path towards banking regulation is to maintain the status quo but with more control over the cartelized system (one just needs to ask why has governments steadfastly refrained from the nationalizing the system?) and

Importantly, as long as the private sector continues to use government’s “legal tender” as the preferred medium of exchange then some semblance of political control over the economy is assured.

In essence, central banks are means to a political end. This only extrapolates that politics and central banking have been tightly enmeshed. And to argue that politics only emerged recently is unalloyed hogwash.

So it would be quite naive to suggest that for instance, Germany can simply walk away given the current problems, as this view ignores the main function of central banks.

Understanding The Euro’s Political Foundation, The Bailout Of Greece

One major reason why the Eurozone forged a union through a common currency had been to avoid from having to get immersed into repeated military conflicts, given its vulnerable geographic location.

As Marko Papic and Peter Zeihan of Stratfor[6] writes, (bold emphasis mine)

``Germany’s exposure and vulnerability thus make it an extremely active power. It is always under the gun, and so its policies reflect a certain desperate hyperactivity. In times of peace, Germany is competing with everyone economically, while in times of war it is fighting everyone. Its only hope for survival lies in brutal efficiencies, which it achieves in industry and warfare.”

``Pre-1945, Germany’s national goals were simple: Use diplomacy and economic heft to prevent multifront wars, and when those wars seem unavoidable, initiate them at a time and place of Berlin’s choosing.”

So I guess Frederic Bastiat’s “when goods don’t cross borders, then armies will” serves as the foundation behind Euro’s emergence.

From a moral point of view (which I subscribe to), the EU should have kicked Greece’s wazoo for fudging or falsifying her data, just to be included in the elite membership. But that would be overly simplistic reasoning.

Again we cite Messrs. Papic and Zeihan[7], (all bold highlights mine)

``The problem with that logic is that this crisis also is about the future of Europe and Germany’s place in it. Germany knows that the geopolitical writing is on the wall: As powerful as it is, as an individual country (or even partnered with France), Germany does not approach the power of the United States or China and even that of Brazil or Russia further down the line. Berlin feels its relevance on the world stage slipping, something encapsulated by U.S. President Barack Obama’s recent refusal to meet for the traditional EU-U.S. summit. And it feels its economic weight burdened by the incoherence of the eurozone’s political unity and deepening demographic problems.

``The only way for Germany to matter is if Europe as a whole matters. If Germany does the economically prudent (and emotionally satisfying) thing and lets Greece fail, it could force some of the rest of the eurozone to shape up and maybe even make the eurozone better off economically in the long run. But this would come at a cost: It would scuttle the euro as a global currency and the European Union as a global player.”

And this appears to undergird why Germany assiduously took all the time and efforts to convince Greece on reforms, than to speedily embrace a bailout. By successfully convincing Greece to adapt fiscal austerity, Germany would be able to reduce the leash effect from the moral hazard that would influence the actions of the other “crisis affected countries” from taking on the same path.

Yet Greece has adamantly resisted reforms until last week’s panic in the CDS and bond markets (see Figure 5), which apparently posed as the proverbial straw that broke the camels’ back.

Figure 5: Danske Bank[8]: Greece Debt Meltdown - What's Next?

And this has forced the arms of both the Eurozone and Greece to come up with a package.

And as of this writing, Greece appears to have finally acceded to a €100 billion (US $133 billion) bailout[9], which appears to validate our view once again!

No Trend Goes In A Straight Line

Does the panic in the European bond markets imply the end to the inflation driven financial markets?

Hardly.

The incentives driving the authorities of central banks have been to use more inflation in the face of any crisis (throw them money at them[10]), and the Greek episode simply amplified and validated this path dependency.

Considering that much of the world has been more on the recovery phase in the current economic cycle (or at the next phase of a budding bubble cycle), we aren’t inclined to believe that a market meltdown from a contagion is likely to prosper.

Also, it doesn’t mean that because global equity markets stumbled this week translates to the end of the current cycle.

For the perma-bears that would be wishful thinking.

In the US, the Dow Jones Industrials has been up for 8 consecutive weeks prior to this correction along with the Nasdaq, while the S&P 500 had been up for 6 straight weeks prior to 2 successive weekly declines (see figure 6).

In short, markets don’t move in a straight line!

Figure 6: stockcharts.com: Greece Contagion?

Yet there is hardly any trace that the correction has been related to the contagion of the Greek crisis.

Funny how, perma bears scamper for any piece of evidence to justify a bearish outlook- a cart before the horse logic. Two weeks ago it was Goldman, now they’re back to Greece after failing last February.

If the recent correction is about a Greece sovereign spillover, then why has US treasury 10 year yields fallen or why has US treasuries bonds rallied?

We seem to be seeing some rotation away from the Euro area and into US Treasuries. The US dollar appears to likewise validate this perspective.

Most of Asia, except for China, has been less as pressured. The Philippine Phisix was up this week, while the Philippine Peso was slightly lower. Asia’s mixed performance implies that the rotation was very much a Euro-US dynamic.

The VIX or the fear index isn’t likely much of a forward looking indicator either. The current spike in the VIX index hasn’t even surpassed the February high, yet the S&P after this week’s correction is still very much higher than the when the VIX previously spiked.

Moreover we are seeing a rally in Gold and Oil.

While US treasuries haven’t chimed with these commodities to indicate general inflation, this only continues to affirm our outlook that we are currently treading in the sweet spot of the inflation cycle.

So there are hardly any vital signs to exhibit that markets are about to inflect. What we are likely seeing is just a natural pause from a persistent run-up.

China’s Next Wall Of Inflationism

Finally, today’s Keynesian world only means more money printing to fund the government sponsored shindig as insurance against any crisis.

China’s market is in an apparent doldrums following the repeated assaults by her government to stem a localized bubble. The latest government directive was reportedly the “most draconian measures in history[11]” as noted by an analyst, as China’s government ordered a total freeze in loans on acquisitions of third properties.

So aside from the government actions, China’s languid markets may also reflect on the present weakening of her domestic credit cycle.

Nevertheless China appears to be preparing for any eventuality. A Chinese daily have recently floated that the next tsunami of government spending worth 4 trillion yuan ($586 billion) for nine industries will be announced in August[12].

Apparently for policymakers there is no alternative route but to engage in rampant inflationism.

In my view, it is not worthy to fight this trend.

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[1] Danske Bank, The Euro Crisis, Can Politicians Catch Up With The Avalanche?

[2] Boone, Peter and Johnson, Simon; To Save The Eurozone: $1 trillion, European Central Bank Reform, And A New Head for the IMF

[3] Rothbard, Murray N. The Case Against The Fed p. 58

[4] New York Times, Germany Has Big Investment in Greece Even Before Bailout

[5] See Why The Greece Episode Means More Inflationism

[6] Papic, Marko and Zeihan, Peter; Germany's Choice stratfor.com

[7] Ibid

[8] Danske Bank Greece Debt Meltdown - What's Next?

[9] Bloomberg, Greece Accepts Terms of EU-Led Bailout, ‘Savage’ Budget Cuts

[10] See Mainstream’s Three “Wise” Monkey Solution To Social Problems

[11] Bloomberg.com, China’s Property Demand May Remain ‘Strong,’ HSBC’s Yorke Says

[12] Bloomberg.com, China May Announce 4 Trillion Yuan Stimulus, China Business Says