Greece Crisis: Does Fiscal Austerity Mean a Deflationary Policy?

The same principle leads to the conclusion, that the encouragement of mere consumption is no benefit to commerce; for the difficulty lies in supplying the means, not in stimulating the desire of consumption; and we have seen that production alone, furnishes those means. Thus, it is the aim of good government to stimulate production, of bad government to encourage consumption.-Say, Jean-Baptiste

For some it is held the current actions by Eurozone government represent as “deflationary policies”.

Such notion has been premised from the economic ideology which sees the economy as driven by aggregate demand.

Demand side economics see spending as the ultimate driver of any economy. Where private spending has been reckoned as insufficient or inadequate, government has been prescribed to takeover the spending process or through “socialization of investment”; otherwise the lack of spending, which supposedly impairs the aggregate demand, would result to people hoarding money, an outcome which this camp morbidly dread most: deflation.

This is why this camp argues for the “euthanasia of the rentier” which is to keep interest rates at perpetually low levels (if only they can abolish interest rates!).

Also, because spending is seen as the only driver of the economy, it doesn’t matter if spending is financed by unsustainable debt loads or by money printing “parting with liquidity”[1]. For them, spending is spending period.

This is an example of what I would call as analysis blinded by the Nirvana fallacy or “the logical error of comparing actual things with unrealistic, idealized alternatives. It can also refer to the tendency to assume that there is a perfect solution to a particular problem[2]” where mathematical models based on aggregate assumptions have substituted for real life activities. Statistical aggregates assume that people think and act homogeneously.

This also serves as another example where this mainstream economic pedagogy leads to a lack of common sense and self-discipline[3] because this camp basically advocates that people should borrow and spend to prosperity even when reality says that this would be impossible (see Jean Baptiste Say quote above).

How true has deflation been the problem of the PIIGS or the crisis affected nations of peripheral Europe?

At present, NONE of the PIIGS has shown DEFLATION as an economic condition as exhibited by the charts from tradingeconomics.com.

Instead, PIIGS have shown symptoms of mild stagflation (high unemployment and high inflation).

Of the five, only Ireland encountered consumer price deflation for over a year in 2009-2010.

Others like Spain and Portugal experienced very limited bouts of deflation in 2009.

Thus, little of what the demand side economics have feared has ever been true since the 2008 Lehman crisis began to unravel.

Theoretically, fiscal austerity means transferring of non-productive resources to productive resources.

Yet because of the dependency/entitlement culture which had been inbred from too much of “socialized investment”, as in the case of Greece, Greeks have taken to the streets[4]

As Takis Michas, staff writer for the Greek national daily, Eleftherotypia in a Cato Forum accounting for the seeds of the crisis[5]

The largest part of public expenditure was directed, not to public works or infrastructure, but to the wages of public service workers and civil servants.

The grounds for the rent-seeking struggles of the future were thus firmly laid.

As resources are freed for productive use, deflation then should be seen as positive because the productive private sector should be able to use these freed resources to produce goods and services, which would fuel a genuine recovery. With more output than than the growth of supply of money this is known “growth deflation” similar to the dynamics of falling prices of mobile phones, appliances and computers.

And that’s why a major part of Greece’s crisis ‘austerity plan’ resolution has been to undertake mass privatization[6].

However theoretical isn’t actual.

The unfolding Greece crisis isn’t being resolved entirely to free resources for productive means, instead the bailouts have been intended to use these resources to protect the banking system from a collapse[7]. Resources are merely being transferred from government welfare programs to the politically privileged banking sector.

Thus, the Greece bailout has been and will continue to be financed by European Central Bank’s inflationism.

Since the end of 2009, just as the Greece Debt Crisis surfaced[8], ECB’s M3 annual growth rate continues to climb, as shown by the chart from Bloomberg[9] (upper window). Such rate of increase in the money supply has shadowed the growth rate of the Euro’s inflation (chart from trading economics.com[10]).

For as long as the ECB and EU governments will continue to finance these serial bailouts by inflationism, then we should see more inflation and not deflation.

At the end of day, false economics leads to misdiagnosis and wrong predictions/conclusions.

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[1] what-when-how.com SOCIALIZATION OF INVESTMENT

[2] Wikipedia.org Nirvana Fallacy

[3] See Financial Success is a Function of Common Sense and Self Discipline June 23, 2011

[4] See The Anatomy of False Economics as Revealed by the Greece Crisis, June 28,2011

[5] Michas Takis , Policy Forum: A Greek Tragedy, Cato Policy Report Cato.org, July/August 2011

[6] ca.reuters.com Greek sovereignty to be massively limited: Juncker, July 3, 2011

[7] See Greece Crisis: The Lehman Moment Hobgoblin, June 19, 2011

[8] News.bbc.co.uk Greece timeline June 16, 2011

[9] Bloomberg.com ECB M3 Annual Growth Rate SA (ECMAM3YY:IND)

[10] Tradingeconomics.com Euro Area Inflation Rate

Ron Paul: Expect 50% Inflation

US Presidential candidate Ron Paul expects the US government to default via inflation

The unionleader.com writes, (hat tip lew rockwell political theatre)

Texas congressman Ron Paul on Friday predicted that inflation will hit 50 percent in the next couple of years, thanks to the massive debt the country has accumulated.

Paul, who spoke to admirers and Republican activists at a Manchester house party, said the inflation will act like default.

Social Security checks will still be cut and interest payments will still be made, but the inflated dollars will allow the government to repay borrowed dollars with devalued money, Paul said.

“They cannot pay the debt,” he said. “I don't think that means you shouldn't try and work things out, but with the size of this debt it never gets paid.”

The national debt is about $14.3 trillion.

Currently about 2/5 of the US CPI index accounts for housing which only means that for inflation to reach 50% that commodity prices will have to go vertical. There would be a flight to real assets. The inflation would have to be so devastating that even housing prices which currently has reverted to a declining price trend, would rise.

Thus Ron Paul sees that the US Federal Reserve will likely take, or experiment, on the path of hyperinflation rather than an outright default.

I would surmise that this is more of a warning than of a prediction.

Yet, this is one tail risk that the mainstream has continued to ignore which is why Ron Paul raises this concern. The obstinacy to maintain current path of government spending profligacy risks this outcome.

The next global financial crisis will likely signify what I call the Mises Moment—the critical moment where the set of choices of policymakers determines whether the entire paper money system collapses or major economies suffers from debt deflation.

Remember in 2008 the banking system nearly collapsed. Major economy governments assumed many of the banking system’s bad assets by flooding the world with money in the hope that these concerted rescue efforts can wish away the accrued malinvstements.

Today, both the banking system and governments have been disproportionately leveraged, and which continues to rely on further inflation (via serial bailouts) to maintain price levels that keeps the banking system afloat. The unfolding events in Europe, particularly the PIIGS, seem as appetizers to the next government-banking system crisis. The difference would be the intensity.

What is unsustainable can’t last.

Have a nice day.

Serial Bailouts For Greece (and for PIIGS)

From the Bloomberg

European Union officials will focus on preparing a new aid package for Greece that includes a “voluntary” role for investors after the EU and International Monetary Fund approved the fifth installment of Greece’s 110 billion-euro ($161 billion) bailout.

“I expect the euro group to agree to additional financing to be provided to Greece under strict conditionality,” Luxembourg Prime Minister Jean-Claude Juncker said after meeting with Greek Prime Minister George Papandreou in Luxembourg yesterday. “This conditionality will include private-sector involvement on a voluntary basis.”

Papandreou agreed to 78 billion euros in additional austerity measures and asset sales through 2015 to secure the 12 billion euro bailout payment and meet conditions for receiving an additional rescue package. He agreed to make “significant” cuts in public-sector employment and establish an agency to manage accelerated asset sales, according to a statement released in Athens yesterday. The plan is fueling popular opposition and protests across Greece...

Under the original rescue, Greece was due to sell 27 billion euros of bonds next year. EU leaders and Papandreou have acknowledged that a return to markets won’t be possible with Greece’s 10-year debt yielding 16 percent, more than twice the level at the time of the bailout. The EU is looking to close that funding gap through new loans and bondholders’ willingness to roll over Greek debt, EU officials have said.

Europe’s financial leaders needed to hammer out a revised Greek package to persuade the IMF to pay its share of the 12 billion-euro tranche originally due in June. The IMF had indicated that it would withhold its 3.3 billion-euro piece unless the EU comes up with a plan to close Greece’s funding gap for 2012. The EU-IMF statement said the full payment would be made in early July. [all bold highlights mine]

These developments seem on the way to validate my views.

Mainstream has been ignoring the political role of the EU’s existence, the role of central bankers, the intertwined complex political relationships between the banking sector, the central banks and the national governments and the inherent ability of central banks to conduct bailouts by inflating the system.

If the US had QE [Quantitative Easing] 1.0, 2.0 and most likely a 3.0...until the QE nth, despite poker bluffing statements like this [Morningstar.com]

"The trade-offs are getting--are getting less attractive at this point. Inflation has gotten higher," Bernanke said. He cited the rising inflation expectations seen then and offered "it's not clear that we can get substantial improvements in payrolls without some additional inflation risk." He went on, "If we're going to have success in creating a long-run sustainable recovery with lots of job growth, we've got to keep inflation under control."

...or that the earlier consensus view that QE 3.0 is unlikely,

central bank watchers believe there is simply no appetite within the central bank to undertake such an effort, which some in markets are already referring to as QE3.

...QE 3.0 will be coming for the above reasons as earlier discussed.

The path dependence from previous actions of regulators and political leaders and the dominant ideological underpinnings which influence their actions combined with the framework of current network of political institutions are highly suggestive of the direction of such course of actions.

Importantly, the implicit priority to support the politically privileged industries as the banking system—which functions as the main intermediary that channels private sector funds to governments. Alternatively, this means policies has been designed to sustain the status quo for politicians and their allies.

Further, it would be misplaced to put alot of emphasis on political protestations by the public as measure to predict future policies.

Political leaders have learned the lessons of Egypt and Tunisia and have been applying organized violence as seen in Libya, in Yemen or in Syria.

It won’t be different for the political leaders of the developed world. As indications of their prospective actions against popular political pressure, even several protestors on US Memorial Day have suffered from police brutality from just “dancing”

In addition, sentiment can shift swiftly.

Recent soft patches in economic data, which I think has been part of the signaling channel maneuver, which has likewise began to affect markets, appear to be reversing previous sentiments which says that the Fed has “no appetite” for QE 3.0.

Again from Morningstar

Having received the strongest indication yet of a slowing economic recovery, traders of U.S. interest rate futures on Friday backed off on the notion that the Federal Reserve will start raising its short-term federal-funds rate during the first half of next year.

Finally, for those who say they are ‘massively’ short the Euro...

...it’s gonna be alot of pain for them.

So like the US, the above only reveals that the Eurozone crisis will mean that Greece and the PIIGS will experience bailouts after bailouts after bailouts. Thus, an implied currency war in the process until the unsustainable system of fiat money collapses or people awaken to the risk thereof and apply political discipline.

For now, the policy of bailouts and inflationism will continue to be the central feature of today’s global policy making process where currency values will be determined by the degree of relative inflationism applied.

Updated Ranking of Global Credit Default Risks

Consistent with my earlier post, FT’s James Mackintosh: US Credit Risk Greater Than Indonesia, Bespoke Invest has updated tables of the 5-year Credit Default Swaps (CDS) reflecting on default risks of 60 countries.

On a year-to-date basis, Greece has the highest default risk while the US has seen a hefty nearly 20% increase.

Major ASEAN nations have also seen an uptick in default risks with Thailand registering as the worst performer.

Meanwhile major European economies posted most of the improvements over the same period.

But it’s a different view when seen from the ranking in terms of CDS prices.

The biggest improvements seen among European nations have been as consequence to the previous actions, where the nations affected by the PIIGS crisis have led to a contagion as seen with the prior price surges.

And almost along the lines of Newton’s second law of motion, where for every action there is an equal and opposite reaction, the previous steep increases has prompted for equally substantial declines.

What this seems to suggest is that the Greece crisis appears to be isolated for now.

And Europe's performance can be measured relative to the major ASEAN economies. While CDS prices of the ASEAN contemporaries did suffer some deterioration, in the context of prices, ASEAN CDS remains below the levels compared to the prices of nations affected by the PIIGS crisis.

So the above only reveals of the degree of price volatility or the rapid changes in the market’s perception of credit risks.

As Bespoke notes,

The countries that investors believe are least at risk of default are currently Norway, Sweden, Finland, and Denmark. The US used to be the least at risk of default, but CDS prices here have ticked up 20% so far in 2011. US default risk is still low relative to the rest of the world, but any tick higher is something we don't want to see.

Credit rankings can shift swiftly and meaningfully. All these depend on the policies adapted.

So far, the practice to inflate debt has subdued default risk concerns on some the major economies as the US. However, the law of the late economist Herb Stein should apply “If something cannot go on forever, it will stop”.

Scenarios of A Greece Default

Andrew Lilico writing in the UK’s Telegraph draws up a litany of possible scenarios of a Greece default.

He writes,

It is when, not if. Financial markets merely aren’t sure whether it’ll be tomorrow, a month’s time, a year’s time, or two years’ time (it won’t be longer than that). Given that the ECB has played the “final card” it employed to force a bailout upon the Irish – threatening to bankrupt the country’s banking sector – presumably we will now see either another Greek bailout or default within days.

What happens when Greece defaults. Here are a few things:

- Every bank in Greece will instantly go insolvent.

- The Greek government will nationalise every bank in Greece.

- The Greek government will forbid withdrawals from Greek banks.

- To prevent Greek depositors from rioting on the streets, Argentina-2002-style (when the Argentinian president had to flee by helicopter from the roof of the presidential palace to evade a mob of such depositors), the Greek government will declare a curfew, perhaps even general martial law.

- Greece will redenominate all its debts into “New Drachmas” or whatever it calls the new currency (this is a classic ploy of countries defaulting)

Read the rest here

I share Austrian economics Professor Dr. Antony Mueller’s opinion, that these exactly serve as main reasons why Greece would likely avoid a default.

It’s more than just economics as the Greek or PIIGS crisis would mostly account for politics.

As the Economist wrote last April (bold emphasis mine)

THE announcement on April 6th that Portugal will become the third euro-area country to receive a bail-out was not well received in Germany. As the largest euro-area country, it is contributing 20% or €52 billion ($75 billion) to the bail-out funds of the three profligate countries, mostly via the euro area's European Financial Stability Facility. This is dwarfed however, by Germany's banks' exposure to the three countries, which totals €230 billion. Only around 12% of this is sovereign or public debt, but a sovereign default could easily lead to a slew of domestic bank and corporate defaults too, to which the country is far more exposed. America is also footing a cool €14 billion via the IMF's contribution to the bail-out. But it too seems to have got good value for money—its banks have a total of €144 billion in exposure to the three countries.

And as earlier said, today’s monetary architecture makes for an intricate web of entwined cartel and patron-client relationships among central banks, governments and the banking system.

Unless we see a systemic crisis unravel, any resolution will likely be molded around these political relationships. Expect more inflationism to be used.

Credit Default Risk: From PIIGS To The 4 US States

Four US states, particularly California, Illinois, New Jersey, and New York, has been in a race with the European "PIIGS" in terms of credit risks or default risk as measured by CDS (Credit Default Risk).

As Bespoke Invest notes,

``All four states are closer to the top of the list than the bottom in terms of default risk. As noted earlier, Illinois has the highest default risk at 368.6 bps. The state sits between Dubai and Bulgaria. California ranks second out of the four at 352.9 bps, while New York and New Jersey are both right around the 290 bp level. Illinois and California are both at higher risk than Portugal, while all four are in a worse situation than Spain. In terms of year-to-date change, Illinois default risk is up 117%, New York and New Jersey are both up about 87%, and California is up 35%."

The difference is that the European PIIGS constitute about 18% of EU's GDP while the US contemporary is about 29% of the US GDP. Incidentally, the 4 states are among the biggest (in terms of share of GDP): California (ranked 1st), New York (3rd), Illinois (5th) and New Jersey (8th).

Yet financial markets seem to be singing contrasting tunes which seem inconsistent: jump in the Euro, firming CDS of 4 US states while new lows in 10 year US treasury yields. If there is a shift in concerns towards the 4 US states then treasuries yields are suppose to go higher.

I'd like to add that the gap between the PIIGS and the US-4 relative to the ASEAN-4 led by Indonesia and the Philippines seems to have widened. This partly explains the signs of 'decoupling'.

Italy's Government Owned Cars And The Debt Crisis

This is one manifestation or symptom of why the PIIGS (Portugal, Italy, Ireland, and Greece) are in a crisis.

From the Economist, (bold highlights mine)

``RECKLESS, flashy and chaotic sums up the general view of Italian governments as well as the popular image of the country's drivers. It is hardly surprising that the two are so similar according to Renato Brunetta, Italy's minister for public administration. He reckons that the country runs a fleet of 629,000 official cars, ten times the number in similar European countries and 50,000 more than just a couple of years ago. The official fleet includes top-of-the-range Maseratis to ferry senior officials around Rome. Italy's domestic carmakers, which are starting to recover after a tough time, will be hoping that this particular government-efficiency drive goes no further."



Markets have been revealing the cracks from the unsustainable lavish spending by governments of mostly developed nations. Yet, as shown by the recent spate of bailouts, governments will fight to retain these privileges.

As an old saw goes, What are we in power for?

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

Successful Bond Raising Dispels The Greek Debt Crisis Myth

Greece successfully raised funding on the debt markets on an oversubscribed basis.

This from the Timesonline,

``Concerns over a possible debt crisis in Greece eased yesterday after huge demand for the Greek Government’s first bond issue of this year.

``Greece had planned to sell €5 billion (£4.4 billion) of new five-year bonds to investors, but, after about €25 billion of demand emerged, it decided to issue €8 billion.

``The auction had been seen as a key test of investors’ appetite for Greek government debt and was heralded as a triumph by the authorities in Athens. “There was a lot of interest,” Spyros Papanikolaou, head of Greece’s public debt management agency, said. “This proves the trust [that] investors have in Greece’s economy. Greece [has] proved [that] it can raise the funds it needs for 2010 without a problem.”

The Greece Athex Composite rallied 2.8% as shown below from Bloomberg, in spite of the sustained pressures on the European and Asian markets.

While the uncertainty over Greece's debt problems haven't been entirely resolved, the successful bond issuance serves to validate our thesis that the PIIGS problem isn't the likely cause of the current stock market pressures, as discussed in When Politics Ruled The Market: A Week Of Market Jitters.

For the mainstream, it's more about the available bias or seeking of any available event that could be imputable to market action.

Poker Bluffing Booby Traps: PIMCO And The PIIGS

``…the state consists not only of politicians, but also those who make use of the politicians for their own ends; that would include those we call pressure groups, lobbyists and all who wrangle special privileges out of the politicians. All the injustices that plague "advanced" societies, are traceable to the workings of the state organizations that attach themselves to these societies.”-Frank Chodorov, Gentle Nock at Our Door

The mainstream is loaded with booby traps.

Without critical thinking it would be easy for anyone to get entranced or fall victim to the metaphorical enchanting ‘songs of the Sirens’, as in one of Odysseus’ tests in his voyage home to Ithaca.

PIMCO’s Bill Gross: Do What I Say, Not What I Do

Basically a major objection to an upside market is that policy reversals from central banks are likely to lead to a withdrawal of liquidity, thereby adversely affecting market outcomes.

Here are some examples:

Pimco’s Bill Gross: ``if exit strategies proceed as planned, all U.S. and U.K. asset markets may suffer from the absence of the near $2 trillion of government checks written in 2009. It seems no coincidence that stocks, high yield bonds, and other risk assets have thrived since early March, just as this “juice” was being squeezed into financial markets. If so, then most “carry” trades in credit, duration, and currency space may be at risk in the first half of 2010 as the markets readjust to the absence of their “sugar daddy.”

From John Maudlin: ``The Fed is going to stop the music in March. There will be a scramble for the chairs. This is a huge experiment with no precedent.”

The World Economic Forum chimes in, ``The risks of a sovereign-debt crisis, asset-price-bubble collapse and a hard landing for the Chinese economy will be high on the agenda of global leaders convening in Davos, Switzerland, for the World Economic Forum this month…

``The report found a collapse in asset prices to be the most severe and likely risk, amid concerns that the weak dollar and low global interest rates could fuel a liquidity-driven, rather than debt-driven, bubble.”

Note: Either the journalist here misquotes the authority interviewed or the authority doesn’t understand that liquidity is driven by debt.

In contrast, Morgan Stanley analyst Manoj Pradhan argues that liquidity won’t get affected by the reversal of policies, (bold highlights mine, italics his)

``Barring a major policy error, the exit from ultra-low interest rates should not mean a removal of accommodative monetary policies. The GCB [Global Central Bank] is unlikely to move rates back to neutral in 2010 - and there appear to be no dissenters on this ‘vote'. As the experience of front riders in the monetary peloton has shown, sharp interest rate hikes when major central banks are still in expansionary territory creates headwinds via currency appreciation and reduced policy traction in asset markets. Very few of the smaller economies will be able to hike aggressively, given these headwinds and weak export sectors in 2010, while monetary policy in the larger economies will be constrained by the BBB recovery. Thus, the ‘AAA' liquidity cycle (ample, abundant, augmenting) is likely to remain largely intact in 2010. The slow exit to a relatively less expansionary stance and the arrival of a sustainable recovery will be a key combination that will support growth and asset prices, in the G10 and even more so in emerging markets.

David Kotok of Cumberland Advisors has what I think the better perspective,

``In our opinion, we think the Fed is now trapped.

``By becoming the buyer of last resort, the Fed has now impacted the markets in such a way that the very idea that it may withdraw has caused mortgage interest rates to rise. Markets aren't dumb, and they realize that rates will rise, for two reasons. First, if the supply of funds to Freddie and Fannie stops with the Fed's purchases, then home-mortgage interest rates will have to rise. Moreover, they will rise even further if the Fed starts selling its existing securities into the market. What this also means is that the interest-rate risk associated with any future increases in interest rates will be shifted from the private sector to the Fed and ultimately the taxpayer – and this risk will grow as the Fed begins to unwind its current low-interest-rate policy.” (bold emphasis mine)

In other words, like us, Mr. Kotok believes that markets have essentially been propped up by the Fed and “exiting” the market could prompt for unwarranted uncertainty and result to increased volatility. Hence, Mr. Kotok prescribes a more transparent and credible strategy to alleviate the ‘exit risks’, as well as, raising reserve deposits to mitigate any incidental upsurge of the risks of inflation.

It’s true that markets aren’t dumb, but they haven’t been negatively reacting to the alleged ‘exit risks’ either, which is due on March. Maybe it’s because the Fed still covertly supports the stock market [as argued in Politics Ruled The Market In 2009].And importantly, markets aren't representative of their actual state, instead they represent distorted markets from massive interventions.

Moreover, it would also be quite naïve to think that Fed Chair Ben Bernanke or the US Federal Reserve backed by its huge platoon of economists and the sundry of employed experts, aside from their extensive network of allies in Wall Street or in the academia, are nitwits.

What we are suggesting is that these concerns are apparently NOT out of bounds for the Fed officials or authorities including Mr. Bernanke.

They know it.

On the contrary, asset prices seem to exhibit the top concern in the scale of priorities for authorities. And this has been flagrantly echoed by the official from the World Economic Forum, `` a collapse in asset prices to be the most severe and likely risk”.

They see it.

In short, global officials appear to prioritize the asset market dimensions as we have been arguing for the longest time.

They’d most probably act on it.

Hence, the other way to read the insights from Wall Street mainstays as Bill Gross is that they’re engaged in a psy-war, or particularly reverse psychology.

Being a political entrepreneur, who have constantly benefited from policy maneuvers by their central bank, one can’t ignore that the current missive by Mr. Gross signifies as tacit appeal to Ben Bernanke for maintaining or even expanding current policies.

Mr. Gross seems to be an avid adherent of the recent Nobel Prize winner and Keynesian high priest Paul Krugman, who proposed last December that the Federal Reserve should buy $2 trillion MORE of assets to jumpstart credit!

In other words, many of the talking heads seem to operate like masquerading propagandists, whose overall agenda have been cosmetically dressed up or disguised as ‘analysis’.

In putting money where his mouth is, Mr. Gross’ PIMCO has actively been expanding its global equity exposure by incorporating emerging market specialists (‘pirated’ from the top notch Franklin Templeton firm) to its team.

According to citywire.co.uk, ``The group is also going on the offensive in the equity space, last month hiring leading global equity fund managers Anne Gudefin, Charles Lahr and Neel Kashkari from franklin Templeton to improve its level of expertise in the area.”

Moreover, PIMCO pared its holdings of US and UK debt and appears to have switched into Southeast Asia’s sovereign debts!

So if Bill Gross sees an ominous reckoning for 2010, ``If so, then most “carry” trades in credit, duration, and currency space may be at risk in the first half of 2010 as the markets readjust to the absence of their “sugar daddy”, then why has he been aggressively expanding on his global equity-bond markets to even add Southeast Asian debts on his portfolio mix?

Apparently actions don’t match with rhetoric.

This category of bluffing appears to reinforce our thesis discussed last week. [see Poker Bluff: The Exit Strategy Theme For 2010].

The PIIGS Bogeyman

Another objection recently brought up has been the possible risks of contagion from Europe’s crisis affected PIIGS-most notably Greece, (as Ireland has reportedly been coping positively with present austerity policies).

I would place such “concern” in the same category of the Dubai Debt Crisis, as it would seem more of a political than of an economic/financial problem [see Why Dubai’s Debt Crisis Isn’t Likely THE Next Lehman].

Yet again this would seem to uphold my contention that today’s trend will be more on political bluffing aimed at perpetuating inflationary policies.

This fabulous excerpt from Danske Bank’s Fixed Income Research team (all bold highlights mine),

``Moody’s sent out a report on the European Sovereign outlook on Wednesday, in which they argue that countries such as Portugal and Greece could be facing a “slow death” as higher debt costs will cause the economies to “bleed” economic potential. Hence, a large part of the future public revenues would have to be spent paying off the debt rather than on welfare etc. Moody’s thinks that the risk of a “sudden death” is negligible, but warned that the countries have to act and do NOT have an open window indefinitely in order to restore public finances. Moody’s highlighted Greece, saying that it would have significantly less time than Portugal. Hence, if the forthcoming fiscal austerity plan from Greece is not considered to be sufficient, then Moody’s is very likely to downgrade Greece, and this will bring Greece closer to ECB’s temporary threshold of BBB-, as the other rating agencies will also act. Portugal tried to distance itself from Greece…

``Furthermore, the current rating threshold is only temporary and is valid until the end of 2010, and we do not think that Greece will have been able to stabilise its finances such that its rating will be at or above A-. The risk of Greece not being able to use its government bonds as eligible collateral was highlighted at yesterday’s ECB meeting. Here, Trichet said that ECB “would not change its collateral rule for the sake of any particular country”, although on the question as to whether Greece or any other country could leave the Euro area, Trichet replied that "I do not comment on absurd hypotheses".

What’s the article been saying?

For Greece, it means ‘Heads I win, Tails you lose’, a bailout is in order. Just look at Trichet’s statement, the dice is loaded for a Greece rescue.

Why?

Because the European Central Bank (ECB) is likely to suffer more from the ripples of a withdrawal (unlikely expulsion) which appear likely to risk materially undermining the political and monetary significance of the European Union.

More proof?

The ECB has recently issued a report on the prospects of a withdrawal or expulsion from ECB based on the LEGAL aspects,

Here is the Wall Street Journal Blog (all bold emphasis mine), ``Written by the ECB’s legal counsel, it notes that “recent developments have, perhaps, increased the risk of secession (however modestly), as well as the urgency of addressing it as a possible scenario.”

``It concludes that unilaterally withdrawing from the European Union “would not, as a matter of public international law, be inconceivable, although there can be serious principled objections to it; and that withdrawal from EMU without a parallel withdrawal from the EU would be legally impossible.”

``As for expulsion, “the conclusion is that while this may be possible in practical terms — even if only indirectly, in the absence of an explicit Treaty mechanism — expulsion from either the EU or EMU would be so challenging, conceptually, legally and practically, that its likelihood is close to zero.”

“Absurd hypotheses, legally impossible and close to zero” reverberates as strong political phrases which seem to reinforce our view that the obvious course of political action will be a bailout of Greece.

Yet even assuming the worst scenario that if Greece were to withdraw, considering its present financial and economic state, the most likely actions that she would undertake would be similar to the others-inflate by devaluing its resurrected currency, the drachma.

So it would be just a matter of WHO does the inflating, the ECB or Greece.

Of course the ECB bailout would come with the attendant ‘disciplining chastisement’ policies which mostly likely would signify melodious political leadership face saving soundbytes.

Besides, PIIGS sovereign debts account for only 38% of the Euro denominated Government Debt securities as of November 2009 as per the ECB. The biggest exposure would be Italy (20.16%) and Spain (12%) the balance spread between Ireland (1.506%), Portugal (1.91%) and Greece (2.43%).

Finally, if one were to argue that the hubbub over Greece should translate to a contagion, we should be seeing rising default risks in the credit standings of broader Europe (see figure 5)

Figure 5 Danske Bank: Smooth Credit Ratings Still Intact, Peak In Default Risks

Apparently this has not been the case, as seen in the iTraxx Europe CDS (left window) which consists of 125 investment grade companies, the iTraxx Crossover CDS (middle window) which comprises of 50 sub-investment grade credits and the default rates of Europe and the US (right windows) which appears to have peaked as measured by Moody’s and Danske Bank.

Like in last week’s article, I wouldn’t be calling on their bluff. Neither should you.