May 2011: MONTHLY MARKET COMMENTARY - (Subscription Service I - 21 Pages)
For nearly 30 years we have had two Global Strategies working in a symbiotic manner that created a virtuous economic growth spiral. Unfortunately, the economic underpinnings were flawed and as a consequence, the virtuous cycle has ended. It is in the process of reversing and becoming a potential vicious downward economic spiral. These two strategies have worked in harmony because they fed off each other, each reinforcing the other. However, today the realities of excess debt have brought the virtuous spiral to an end. One strategy is the "Asian Mercantile Strategy". The other is the" US Dollar Reserve Currency Strategy".. MORE>>
May 2011: GLOBAL MACRO TIPPING POINTS - (Subscription Service II - 60 Pages)
There has been a significant change in the Global Macro tipping Points since the last quarter. Event Risk associated with social unrest and Geo-Political actions in North Africa and the Middle East have taken center stage. The Natural Disaster in Japan is also a major Global Macro event becuase of its impact on the Yen Carry Trade and the global supply chain. These and more are creating shocks to an already unstable, high risk situation. MORE>>
May 2011: MARKET ANALYTICS & TECHNICAL ANALYSIS - (Subscription Service III - 83 Pages)
The market action since March 2009 is a bear market counter rally that is presently nearing a final end in a classic ending diagonal pattern. The Bear Market which started in 2000 will resume in full force by late spring of 2011. We presently have the early beginnings of a 'rolling top'. We are seeing broad based weakening analytics and cascading warning signals. This behavior is typically seen near major tops. This is all part of a final topping formation and a long term right shoulder technical construction pattern. MORE>>
CURRENCY WARS: Debt Saturation & Money Illusion
Most of the clearly evident financial problems that surround us today stem from one cause - Debt Saturation. Most, intuitively, sense this to be a correct assessment but few can either prove it or articulate it to the less sophisticated. Let me arm you to be the "Nostradamus" amongst your friends and colleagues in explaining the problem and what the future therefore foretells. However, let me make it very clear, this will not make you popular. Smart maybe, but highly likely to make you unwanted at the social gatherings of the genteel. MORE>>
CURRENCY WARS: BERNANKE'S QEx BOX!
Chairman Bernanke has placed himself in a box. It is not a box of his choosing, but rather the result of his misguided economic beliefs, use of flawed statistical data, geo-political events occurring during his watch, poor decisions and a penchant for political pandering. Some of these may be requirements for academia success but not for leading global financial markets during turbulent times. It is time for Professor Bernanke to return to the collegial setting of Princeton University while the world still has time to correct the path he has mistakenly set us on. MORE>>
CURRENCY WARS: RIP Shadow Banking System, Long Live QEx!
We have unwittingly become trapped in the snarled net of years of bad Public Policy. Like corporations that look no further than this quarter's results, our politicos never stop campaigning to start the tough task of ruling responsibly. A winning election simply represents 'rewards' and 'spoils' to all before quickly resuming the next campaign. Image has become reality! As a result the never ending political pandering has led to false expectations, undeliverable entitlements and false optimism in the electorate that rejects the immediate and obvious realities. The result of a degenerated political leadership process is we are on the brink of a massive and sudden reduction in the US standard of living. MORE>>
CURRENCY WARS: Flash Points in the "Age of Rage"
The conflict in North Africa was a predictable outcome of the US Monetary Policy of Quantitative Easing. It is not plausible that the US Federal Reserve, as the manager of the world's Reserve Currency, did not fully recognize the global ramifications of such monetary inflationary actions well in advance. Quantitative Easing like the Intercontinental Ballistic Missiles (ICBM) of the cold war era has had the same devastating pre-emptive impact on Libya.There can also be little doubt that the bi-monthly meetings of the Bank of International Settlements (BIS) board of directors, which specifically meet to discuss coordinated monetary policy outcomes, did not consider this eventuality. The board of directors of this global power center includes all G7 Central Banks chiefs, with the conspicuous absence of a single member of the Arab League not receiving US military financial aid. MORE>>
TIPPING POINTS - Mapping the Critical 2011 Themes
The conclusions of our "2011 Thesis - Beggar-thy-Neighbor" was that the world is on a glide path towards a global Fiat Currency Failure and the emergence of a New World Order. We are unclear whether it is planned or happenstance, but what our regularly conducted abstraction mapping process clearly indicates is that it is presently a high probability outcome. The paper (which will be made available to non subscribers March 11th, 2011- sign-up) uses the Process of Abstraction to avoid the media noise, abstract the facts, synthesis key macro drivers and then arrive at the highest probability outcomes. In the recent article "2011 Tipping Points" we laid out the 37 major Tipping Points we are presently tracking. These Tipping Points are show on the left hand side of the two charts below, which are the basis upon which our ongoing analysis process is conducted. These highly simplified representations of the process gives the reader a graphical perspective on what leads us to our conclusions. MORE>>
PRESERVE and PROTECT - 2011 Tipping Points
Throughout my 2010 article series "Extend & Pretend" and "Sultans of Swap" I stressed that we were rapidly moving from the Financial Crisis of 2008, through the Economic Fallout of 2009 - 2010, towards a Political Crisis in 2011 - 2012. We are now clearly beginning to see the early emergence of the final part of this continuum. From North Africa to Wisconsin all are fundamentally based on the single insidious underlying problem - excessive global debt and credit levels. MORE>>
05/18/2011 3:59 AM
Postings begin at 5:30am EST
and updated throughout the day
European Debt Talks Turn Murkier - Analysts say the IMF, and Mr. Strauss-Kahn, have played a stabilizing role in the sometimes tense disagreements among European leaders. "The fund is seen to be more of a neutral arbiter than the other bodies that are part of this discussion," said Sony Kapoor, managing director of Re-Define, a Brussels-based economic think tank. Mr. Strauss-Kahn, as a European politician of the first rank, commanded unusual influence in the Continent's power corridors. He "carries a very unique mix that makes him very relevant to the European crisis," said Uri Dadush, an economist at the Carnegie Endowment for International Peace in Washington.
The Euro Is Dead -
Europe is living in denial. Even after the economic crisis exposed the eurozone's troubled future, its leaders are struggling to sustain the status quo. At this point, several European countries will likely be forced to abandon the euro within the next year or two.The only way out of this conundrum is for countries with insurmountable debt burdens to default on their euro-denominated debts and exit the eurozone so that they can finance their continuing fiscal deficits by printing their own currency. Here's a hint for Europe's politicians: If the math says one thing and the law says something different, it will be the law that ends up changing
The Greek debt crisis: The ECB’s three big mistakes - Mistake number 1: The decision in 2000 to admit Greece in the Eurozone. Mistake number 2: Allowing the interest rate spreads on sovereign bonds issued by Greece (and other periphery countries) to fall almost to zero during the period 2002-2007. The third mistake was the failure to send Greece to the IMF early in the crisis.
Greece: Last Exit To Nowhere? -
"Some economists, myself included, look at Europe's woes and have the feeling that we've seen this movie before, a decade ago on another continent - specifically, in Argentina" -
"Think of it this way: the Greek government cannot announce a policy of leaving the euro - and I'm sure it has no intention of doing that. But at this point it's all too easy to imagine a default on debt, triggering a crisis of confidence, which forces the government to impose a banking holiday - and at that point the logic of hanging on to the common currency come hell or high water becomes a lot less compelling."
France Furious About Dominique Strauss-Kahn Perp Walk - In France, it is illegal to show pictures of people accused of crimes before they have been convicted, because the French believe that this tramples upon the presumption of innocence.
So not surprisingly, there was widespread outrage at the perp walk of Dominique Strauss-Kahn, which, in the great American tradition, was a humiliation ritual and media circus.
Foreign Banks Bet on China - During 2010, banks that report their holdings to the Bank for International Settlements plowed an exchange-rate-adjusted $77 billion into China, increasing their exposure by 86% from the end of 2009 and bringing the country's share of global cross-border lending - while still small at 1.1 % - to its highest level on records going back to 1977.
Chinese internet IPOs lose their sheen - Some investors now fear a repeat of the late-1990s tech bubble, arguing that valuations are unrealistic given the uncertainties about these companies' long-term profitability...
Americans shed mortgage debt at record pace - Low interest rates, defaults and refinancings have shaved more than $100 billion off the nation's annual mortgage bill - an amount comparable to all unemployment benefits for one year or this year's Social Security payroll tax cut.
Hanging Around, Hoping to Get Lucky - Grantham presently estimates fair value at "about 920 on the S&P 500," and warns "the environment has simply become too risky to justify prudent investors hanging around, hoping to get lucky." Now, since it is easy to show that the long-term peak-to-peak trend of S&P 500 earnings and other fundamentals has advanced at an annual growth rate of roughly 6% annually nearly as far back in history as you care to look, a 920 fair value today, coupled with a roughly 2% dividend yield and a current S&P 500 of 1340, works out to an implied total return over the coming decade of [(1.06)(920/1340)^(1/10) + .02 - 1 =] 4% annually
Paul: IMF Implicated After Chief Arrested on Attempted Rape Charge - "These are the kind of people that are running the IMF and we want to turn the world finances and the control of the money supply to them," Paul said. "That should awaken everybody to the fact that they ought to look into the IMF and find out why we shouldn't be sacrificing more sovereignty to an organization like that and an individual like he was."
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DISCLOSURE Gordon T Long is not a registered advisor and does not give investment advice. His comments are an expression of opinion only and should not be construed in any manner whatsoever as recommendations to buy or sell a stock, option, future, bond, commodity or any other financial instrument at any time. While he believes his statements to be true, they always depend on the reliability of his own credible sources. Of course, he recommends that you consult with a qualified investment advisor, one licensed by appropriate regulatory agencies in your legal jurisdiction, before making any investment decisions, and barring that, we encourage you confirm the facts on your own before making important investment commitments.
"The moment of critical mass, the threshold, the boiling point"
The tipping point is the critical point in an evolving situation that leads to a new and irreversible development. The term is said to have originated in the field of epidemiology when an infectious disease reaches a point beyond any local ability to control it from spreading more widely. A tipping point is often considered to be a turning point. The term is now used in many fields. Journalists apply it to social phenomena, demographic data, and almost any change that is likely to lead to additional consequences. Marketers see it as a threshold that, once reached, will result in additional sales. In some usage, a tipping point is simply an addition or increment that in itself might not seem extraordinary but that unexpectedly is just the amount of additional change that will lead to a big effect. In the butterfly effect of chaos theory , for example, the small flap of the butterfly's wings that in time leads to unexpected and unpredictable results could be considered a tipping point. However, more often, the effects of reaching a tipping point are more immediately evident. A tipping point may simply occur because a critical mass has been reached.
The Tipping Point: How Little Things Can Make a Big Difference is a book by Malcolm Gladwell, first published by Little Brown in 2000. Gladwell defines a tipping point as "the moment of critical mass, the threshold, the boiling point." The book seeks to explain and describe the "mysterious" sociological changes that mark everyday life. As Gladwell states, "Ideas and products and messages and behaviors spread like viruses do."
The three rules of epidemics
Gladwell describes the "three rules of epidemics" (or the three "agents of change") in the tipping points of epidemics.
"The Law of the Few", or, as Gladwell states, "The success of any kind of social epidemic is heavily dependent on the involvement of people with a particular and rare set of social gifts."According to Gladwell, economists call this the "80/20 Principle, which is the idea that in any situation roughly 80 percent of the 'work' will be done by 20 percent of the participants."(see Pareto Principle) These people are described in the following ways:
Connectors are the people who "link us up with the world ... people with a special gift for bringing the world together." They are "a handful of people with a truly extraordinary knack [... for] making friends and acquaintances". He characterizes these individuals as having social networks of over one hundred people. To illustrate, Gladwell cites the following examples: the midnight ride of Paul Revere, Milgram's experiments in the small world problem, the "Six Degrees of Kevin Bacon" trivia game, Dallas businessman Roger Horchow, and ChicagoanLois Weisberg, a person who understands the concept of the weak tie. Gladwell attributes the social success of Connectors to "their ability to span many different worlds [... as] a function of something intrinsic to their personality, some combination of curiosity, self-confidence, sociability, and energy."
Mavens are "information specialists", or "people we rely upon to connect us with new information." They accumulate knowledge, especially about the marketplace, and know how to share it with others. Gladwell cites Mark Alpert as a prototypical Maven who is "almost pathologically helpful", further adding, "he can't help himself". In this vein, Alpert himself concedes, "A Maven is someone who wants to solve other people's problems, generally by solving his own". According to Gladwell, Mavens start "word-of-mouth epidemics" due to their knowledge, social skills, and ability to communicate. As Gladwell states, "Mavens are really information brokers, sharing and trading what they know".
Salesmen are "persuaders", charismatic people with powerful negotiation skills. They tend to have an indefinable trait that goes beyond what they say, which makes others want to agree with them. Gladwell's examples include California businessman Tom Gau and news anchorPeter Jennings, and he cites several studies about the persuasive implications of non-verbal cues, including a headphone nod study (conducted by Gary Wells of the University of Alberta and Richard Petty of the University of Missouri) and William Condon's cultural microrhythms study.
The Stickiness Factor, the specific content of a message that renders its impact memorable. Popular children's television programs such as Sesame Street and Blue's Clues pioneered the properties of the stickiness factor, thus enhancing the effective retention of the educational content in tandem with its entertainment value.
The Power of Context: Human behavior is sensitive to and strongly influenced by its environment. As Gladwell says, "Epidemics are sensitive to the conditions and circumstances of the times and places in which they occur." For example, "zero tolerance" efforts to combat minor crimes such as fare-beating and vandalism on the New York subway led to a decline in more violent crimes city-wide. Gladwell describes the bystander effect, and explains how Dunbar's number plays into the tipping point, using Rebecca Wells' novel Divine Secrets of the Ya-Ya Sisterhood, evangelistJohn Wesley, and the high-tech firm W. L. Gore and Associates. Gladwell also discusses what he dubs the rule of 150, which states that the optimal number of individuals in a society that someone can have real social relationships with is 150.
PROCESS OF ABSTRACTION
SOVEREIGN DEBT & CREDIT CRISIS
Inverted chart of 30-year Treasury yields courtesy of Doug Short and Chris Kimble. As you can see, yields are at a "support" area that's held for 17 years.
If it breaks down (i.e., yields break out) watch out!
The state budget crisis will continue next year, and it could be worse than ever. That's part of what's freaking out muni investors, who last week dumped them like they haven't in ages.
States face a $112.3 billion gap for next year, according to the Center on Budget and Policy Priorities. If the shortfall grows during the year -- as it does in most years -- FY2012 will approach the record $191 billion gap of 2010. Remember, with each successive shortfall state budgets have become more bare.
Things could be especially bad if House Republicans push through a plan to cut off non-security discretionary funding for states, opening an additional $32 billion gap.
MUNI BOND OUTFLOWS
RESIDENTIAL REAL ESTATE - PHASE II
COMMERCIAL REAL ESTATE
2011 will see the largest magnitude of US bank commercial real estate mortgage maturities on record.
2012 should be a top tick record setter for bank CRE maturities looking both backward and forward over the half decade ahead at least.
Will this be an issue for an industry that has been supporting reported earnings growth in part by reduced loan loss reserves over the recent past? In 2010, approximately $250 billion in commercial real estate mortgage maturities occurred. In the next three years we have four times that much paper coming due.
Will CRE woes, (published or unpublished) further restrain private sector credit creation ahead via the commercial banking conduit?
Wiil the regulators force the large banks to show any increase in loan impairment. Again, given the incredible political clout of the financial sector, I doubt it.
We have experienced one of the most robust corporate profit recoveries on record over the last half century. We know reported financial sector earnings are questionable at best, but the regulators will do absolutely nothing to change that.
So once again we find ourselves in a period of Fed sponsored asset appreciation. The thought, of course, being that if stock prices levitate so will consumer confidence. Which, according to Mr. Bernanke will lead to increased spending and a virtuous circle of economic growth. Oh really? The final chart below tells us consumer confidence is not driven by higher stock prices, but by job growth.
9 - CHRONIC UNEMPLOYMENT
There are 3 major inflationary drivers underway.
1- Negative Real Interest Rates Worldwide - with policy makers' reluctant to let their currencies appreciate to market levels. If no-one can devalue against competing currencies then they must devalue against something else. That something is goods, services and assets.
2- Structural Shift by China- to a) Hike Real Wages, b) Slowly appreciate the Currency and c) Increase Interest Rates.
3- Ongoing Corporate Restructuring and Consolidation - placing pricing power increasingly back in the hands of companies as opposed to the consumer.
FOOD PRICE PRESSURES
RICE: Abdolreza Abbassian, at the FAO in Rome, says the price of rice, one of the two most critical staples for global food security, remains below the peaks of 2007-08, providing breathing space for 3bn people in poor countries. Rice prices hit $1,050 a tonne in May 2008, but now trade at about $550 a tonne.
WHEAT: The cost of wheat, the other staple critical for global food security, is rising, but has not yet surpassed the highs of 2007-08. US wheat prices peaked at about $450 a tonne in early 2008. They are now trading just under $300 a tonne.
The surge in the FAO food index is principally on the back of rising costs for corn, sugar, vegetable oil and meat, which are less important than rice and wheat for food-insecure countries such as Ethiopia, Bangladesh and Haiti. At the same time, local prices in poor countries have been subdued by good harvests in Africa and Asia.
- In India, January food prices reflected a year-on-year increase of 18%t.
- Buyers must now pay 80%t more in global markets for wheat, a key commodity in the world's food supply, than they did last summer. The poor are especially hard-hit. "We will be dealing with the issue of food inflation for quite a while," analysts with Frankfurt investment firm Lupus Alpha predict.
- Within a year, the price of sugar on the world market has gone up by 25%.
US STOCK MARKET VALUATIONS
WORLD ECONOMIC FORUM
Potential credit demand to meet forecast economic growth to 2020
The study forecast the global stock of loans outstanding from 2010 to 2020, assuming a consensus projection of global
economic growth at 6.3% (nominal) per annum. Three scenarios of credit growth for 2009-2020 were modelled:
• Global leverage decrease. Global credit stock would grow at 5.5% per annum, reaching US$ 196 trillion in 2020. To
meet consensus economic growth under this scenario, equity would need to grow almost twice as fast as GDP.
• Global leverage increase. Global credit stock would grow at 6.6% per annum, reaching US$ 220 trillion in 2020.
Likely deleveraging in currently overheated segments militates against this scenario.
• Flat global leverage. Global credit stock would grow at 6.3% per annum to 2020, tracking GDP growth and reaching
US$ 213 trillion in 2020 – almost double the total in 2009. This scenario, which assumes that modest
deleveraging in developed markets will be offset by credit growth in developing markets, provides the primary credit
growth forecast used in this report.
Will credit growth be sufficient to meet demand?
Rapid growth of both capital markets and bank lending will be required to meet the increased demand for credit – and it is
not assured that either has the required capacity. There are four main challenges.
Low levels of financial development in countries with rapid credit demand growth. Future coldspots may result from the
fact that the highest expected credit demand growth is among countries with relatively low levels of financial access. In
many of these countries, a high proportion of the population is unbanked, and capital markets are relatively undeveloped.
Challenges in meeting new demand for bank lending. By 2020, some US$ 28 trillion of new bank lending will be
required in Asia, excluding Japan (a 265% increase from 2009 lending volumes) – nearly US$ 19 trillion of it in China
alone. The 27 EU countries will require US$ 13 trillion in new bank lending over this period, and the US close to US$
10 trillion. Increased bank lending will grow banks’ balance sheets, and regulators are likely to impose additional capital
requirements on both new and existing assets, creating an additional global capital requirement of around US$ 9 trillion
(Exhibit vi). While large parts of this additional requirement can be satisfied by retained earnings, a significant capital gap in
the system will remain, particularly in Europe.
The need to revitalize securitization markets. Without a revitalization of securitization markets in key markets, it is doubtful
that forecast credit growth is realizable. There is potential for securitization to recover: market participants surveyed by
McKinsey in 2009 expected the securitization market to return to around 50% of its pre-crisis volume within three years.
But to rebuild investor confidence, there will need to be increased price transparency, better data on collateral pools, and
better quality ratings.
The importance of cross-border financing. Asian savers will continue to fund Western consumers and governments:
China and Japan will have large net funding surpluses in 2020 (of US$ 8.5 trillion and US$ 5.7 trillion respectively), while
the US and other Western countries will have significant funding gaps. The implication is that financial systems must
remain global for economies to obtain the required refinancing; “financial protectionism” would lock up liquidity and stifle
US$ RESERVE CURRENCY
SocGen crafts strategy for China hard-landing
Société Générale fears China has lost control over its red-hot economy and risks lurching from boom to bust over the next year, with major ramifications for the rest of the world.
Société Générale said China's overheating may reach 'peak frenzy' in mid-2011
- The French bank has told clients to hedge against the danger of a blow-off spike in Chinese growth over coming months that will push commodity prices much higher, followed by a sudden reversal as China slams on the brakes. In a report entitled The Dragon which played with Fire, the bank's global team said China had carried out its own version of "quantitative easing", cranking up credit by 20 trillion (£1.9 trillion) or 50pc of GDP over the past two years.
- It has waited too long to drain excess stimulus. "Policy makers are already behind the curve. According to our Taylor Rule analysis, the tightening needed is about 250 basis points," said the report, by Alain Bokobza, Glenn Maguire and Wei Yao.
- The Politiburo may be tempted to put off hard decisions until the leadership transition in 2012 is safe. "The skew of risks is very much for an extended period of overheating, and therefore uncontained inflation," it said. Under the bank's "risk scenario" - a 30pc probability - inflation will hit 10pc by the summer. "This would cause tremendous pain and fuel widespread social discontent," and risks a "pernicious wage-price spiral".
- The bank said overheating may reach "peak frenzy" in mid-2011. Markets will then start to anticipate a hard-landing, which would see non-perfoming loans rise to 20pc (as in early 1990s) and a fall in bank shares of 50pc to 75pc over the following 12 months. "We think growth could slow to 5pc by early 2012, which would be a drama for China. It would be the first hard-landing since 1994 and would destabilise the global economy. It is not our central scenario, but if it happens: commodities won't like it; Asian equities won't like it; and emerging markets won't like it," said Mr Bokobza, head of global asset allocation. However, it may bring down bond yields and lead to better growth in Europe and the US, a mirror image of the recent outperformance by the BRICs (Brazil, Russia, India and China).
- Diana Choyleva from Lombard Street Research said the drop in headline inflation from 5.1pc to 4.6pc in December is meaningless because the regime has resorted to price controls on energy, water, food and other essentials. The regulators pick off those goods rising fastest. The index itself is rejigged, without disclosure. She said inflation is running at 7.6pc on a six-month annualised basis, and the sheer force of money creation will push it higher. "Until China engineers a more substantial tightening, core inflation is set to accelerate.
- The longer growth stays above trend, the worse the necessary downswing. China's violent cycle could be highly destabilising for the world." Charles Dumas, Lombard's global strategist, said the Chinese and emerging market boom may end the same way as the bubble in the 1990s. "The basic strategy of the go-go funds is wrong: they risk losing half their money like last time."
- Société Générale said runaway inflation in China will push gold higher yet, but "take profits before year end".
- The picture is more nuanced for food and industrial commodities. China accounts for 35pc of global use of base metals, 21pc of grains, and 10pc of crude oil. Prices will keep climbing under a soft-landing, a 70pc probability. A hard-landing will set off a "substantial reversal". Copper is "particularly exposed", and might slump from $9,600 a tonne to its average production cost near $4,000. Chinese real estate and energy equities will prosper under a soft-landing,
- The bank likes regional exposure through the Tokyo bourse, which is undervalued but poised to recover as Japan comes out of its deflation trap. If you fear a hard landing, avoid the whole gamut of Chinese equities. It will be clear enough by June which of these two outcomes is baked in the pie.
PIMCO'S NEW NORMAL: According to PIMCO, the coiners of the term, the new normal is also explained as an environment wherein “the snapshot for ‘consensus expectations’ has shifted: from traditional bell-shaped curves – with a high likelihood mean and thin tails (indicating most economists have similar expectations) – to a much flatter distribution of outcomes with fatter tails (where opinion is divided and expectations vary considerably).” That is to say, the distribution of forecasts has become more uniform (as per Exhibit 1).
Federal Reserve Chairman Ben Bernanke gave his predictions on a House Republican plan to cut $60 billion dollars from the FY 2011 budget, saying it would eliminate 200, 000 jobs and only slightly lower economic growth.
He instead endorsed a Congressional federal deficit reduction plan that would take effect over a five to 10 year period, saying that markets look more towards Congressional action than the actual state of the economy. His remarks came during a House Financial Services Committee hearing in which he delivered his agency's semi-annual monetary report.
Despite Bernanke’s observations, several Republican lawmakers expressed doubt based on past efforts by the Fed and Congress to prompt economic growth through large stimulus packages.
Yesterday, the Fed Chair told the Senate Banking Committee that the U.S. economy will continue to grow this year despite rising oil prices, a high employment rate and weak housing market.
The 1978 Humphrey-Hawkins Act requires the Federal Reserve Board of Governors to deliver a report to Congress twice a year on its past economic policy decisions and discuss recent financial and economic developments.
It is a year since Greece was bailed out by EU and IMF and there are many who label it a failure. This column says that while there is plenty of blame to go around, there were three big mistakes made by the European Central Bank. Number one: Letting Greece join the euro in the first place
By now just about everybody agrees that the European bailout of Greece has failed (see for example Darvas et al. 2011). The debt will have to be restructured. As has been evident for well over a year, it is not possible to think of a plausible combination of Greek budget balance, sovereign risk premium, and economic growth rates that imply anything other than an explosive path for the future ratio of debt to GDP.
There is plenty of blame to go around. But three big mistakes can be attributed to the European leadership. This includes the ECB – surprisingly, in that it has otherwise been the most competent and successful of Europe-wide institutions.
Mistake number 1: The decision in 2000 to admit Greece in the Eurozone.
Greece was an outlier, geographically and economically. It did not come close to meeting the Maastricht Criteria, particularly the 3% ceiling on the budget deficit as a share of GDP. No doubt most Greeks would agree with the judgment that they would be much better off today if they were outside the euro, free to devalue and restore their lost competitiveness.
Mistake number 2: Allowing the interest rate spreads on sovereign bonds issued by Greece (and other periphery countries) to fall almost to zero during the period 2002-2007.
Despite budget deficits and debt levels that far exceeded the limits of the Stability and Growth Pact, Greece was able to borrow almost as easily as Germany. Part of the blame belongs to international investors who grossly underestimated risk on all sorts of assets during this period (Frankel 2007). And part of the blame belongs to the rating agencies who, as usual, have been lagging indicators of European debt troubles, rather than leading indicators. But in this case, both groups might justify their attitudes by pointing out that the ECB accepted Greek debt as collateral, on a par with German debt.
The third mistake was the failure to send Greece to the IMF early in the crisis.
By January 2010 the need should have been clear. Rather than going into shock, leaders in Frankfurt and Brussels could have welcomed the Greek crisis as a useful opportunity to establish a precedent for the long-term life of the euro (see Frankel 2010).
The idea that such a problem would eventually arise somewhere in the Eurozone cannot have come as a surprise. After all, why had the architects written the Maastricht fiscal criteria and the No Bailout Clause (1991) and the Stability and Growth Pact (1997)? Sceptical German taxpayers believed that, before the project was done, they would be asked to bail out some profligate Mediterranean country. European elites adopted the fiscal rules precisely to combat these fears.
When the rules failed and the crisis came, the leaders should have thanked their lucky stars that the first test case had arisen in a country that met two characteristics admirably.
First, the Greek government had broken the rules so egregiously and so frequently that Europe’s leaders could, with a clear conscience, judge a firm stand to be merited.
The only alternative was to risk establishing the precedent that all governments are ultimately to be bailed out all the time, with all the moral hazard headaches that precedent implies.
Second, the Greek economy was small enough to make it feasible for Europe to come up with the funds necessary to insulate others, who were vulnerable to contagion but not as blameworthy, for example Ireland.
European leaders also should have thanked their stars that the IMF exists. Instead of acting as if such a crisis had never been seen before, they should have realised that imposing policy conditionality in rescue loan packages is precisely the IMF’s job. International politics is less likely to prevent the IMF from enforcing painful fiscal retrenchment and other difficult conditions than it is among regional neighbours or other political allies. Europe is no different in this respect than Latin America or Asia. Even the need to include in the package substantial funds from regional powers on top of IMF money, subject to the same IMF conditionality, should have been recognised as familiar from big emerging-market crises such as those of the 1990s.
But the reaction of leaders in both Frankfurt and Brussels was that going to the IMF was unthinkable, that this was a problem to be settled within Europe. They chose to play for time instead, to treat insolvency as illiquidity (see Darvas et al. 2011). Against all evidence – and despite a decade of Stability and Growth Pact violations – they still wish to believe that they can impose fiscal discipline on member states. Despite two decades in which citizens of Germany and other European countries have expressed clearly that they do not share their leaders’ enthusiasm for Economic and Monetary Union (O’Rourke 2011), the latter apparently still wish to believe that further progress to political and fiscal union is possible. The Economic and Monetary Union has long since become an ostrich, burying its head in the sand.
It turned out that the German taxpayers were right all along. How, in light of that democratic deficit, can anyone think that Europe is ready for a transfer union?
Solutions looking forward
The three mistakes now lie in the past. How can Europe’s fiscal regime be reformed to avoid future repeats? The reforms in train are not credible. (“We are going to make the fiscal rules more explicit and make sure to monitor them more tightly next time” – see for example Thygesen 2011). But it is not too late to apply the lesson of mistake number two – the ECB policy of accepting the assets of all member states as collateral.
The Eurozone should adopt a rule that whenever a country violates the fiscal criterion of the Pact (say, a budget deficit in excess of 3% of GDP, structurally adjusted), the ECB must stop accepting that government’s debt as collateral.
This system would achieve the elusive objective of true automaticity. If a country exceeded the threshold for justifiable reasons, such as natural disaster or war, the private markets could perceive that and impose little or no default-risk premium. No judgment of the merits by bureaucrats or politicians would be required. More likely, for periphery countries, the result of such a re-classification would be the re-emergence of sovereign spreads of moderate magnitudes, in between the extremes of the 2002-2007 lows and the 2009-2011 highs. The interest rate premium would send a message far more credibly, forcefully, and promptly than any warning that any Brussels bureaucracy will ever turn out.
This is how it works among the US states and municipalities (Bayoumi et al. 1995). Despite the absence of their own currencies, the recurrence of dysfunctional local politics and excessive deficits, and even a history of state defaults in the 19th century, federal bailouts are not delivered and not expected. Without some such device, the new European Stability Mechanism is in danger of becoming a mechanism for instability.
Greece's bid for more financial aid for next year and 2013 could hinge on accelerated sales of state assets, according to people familiar with the matter.
Greek government officials are to resume talks with the European Union and the International Monetary Fund in Brussels later Monday to discuss what might become another aid package for the country.
The meeting comes amid concerns that Greece's austerity and reform program has stalled and that Athens will need more help to fill a funding gap over the next two years.
But Greece will be expected to play its part. "Any new money would require a faster pace of reforms and privatization," said Platon Monokroussos, head of financial markets research for EFG Eurobank Ergasias SA, one of the banks advising the government on asset sales.
Athens is expected to identify a funding gap of up to €60 billion ($85.43 billion) over the next two years.
EU officials so far have declined to comment on Greece's funding situation or to commit to any future aid until after a June audit of Greek budgets.
But more ministers Monday were raising the possibility of more aid under certain conditions. "Greece first itself has to perform much more actions: more reforms, more austerity packages, the privatization program should be definitely rolled out by Greece," Dutch Finance Minister Jan Kees de Jager.
Eurobank's Mr. Monokroussos, who is familiar with Greece's budget woes, said the range could be €50 billion to €60 billion, depending on whether the government hits its growth and budget targets.
In May last year, Greece narrowly avoided default with the help of an €110 billion bailout from the EU and IMF in exchange for a multi-year program to fix its public finances and reform its over-regulated economy.
Those plans will be in stark relief at this week's meeting of European finance ministers, although the weekend arrest of IMF chief Dominique Strauss-Kahn—who had been instrumental in arranging Greece's bailout a year ago—has cast a shadow on the proceedings.
An IMF official familiar with the Greek talks said Mr. Strauss-Kahn's arrest prevented his key meeting on Sunday with German Chancellor Angela Merkel, whose backing would be needed for any new program to be considered.
A spokesman for EU Commissioner for Economic and Monetary Affairs Olli Rehn said Monday that Mr. Strauss-Kahn's absence will have no impact on any needed decisions.
A lawyer for the IMF chief, who is facing charges of sexual assault in New York, said his client would plead not guilty.
Mr. Rehn's spokesman also said the EU, the IMF and the European Central Bank are making "important efforts" to ease the conditions of the Greek loan—including changes to maturities and interest rates.
German Finance Minister Wolfgang Schäuble said this weekend that Greece might receive an extension to the repayment of the EU-IMF loans already received, but only if private creditors also agree to wait longer for repayment of their Greek debt holdings.
Germany also is stipulating tougher austerity steps in Athens. Greek officials are getting the message that any new deal would mean the slow pace of selling government property and other assets would need to pick up.
The government is unhappy with suggestions that the privatization process be put under external management. "We are resisting this along with proposals that some assets should be 100% privatized," the official said.
While the government has targeted €50 billion in sales of state assets by 2015—mainly by exploiting state property holdings—the process has been impeded by labor protests, a raft of legal issues and opposition inside Prime Minister George Papandreou's own government.
The government says that by the end of this year, it hopes to raise between €2 billion and €4 billion from its first privatizations.
These would include the listing of a first portfolio of real-estate holdings.
The government also plans to reduce its 20% stake in former telephone monopoly Hellenic Telecommunications SA this year, and sell a 17% stake in incumbent power company Public Power Corp. SA next year.
Other privatizations or stake sales involve gambling monopoly OPAP SA, natural gas monopoly DEPA SA and companies ranging from state-owned casinos to local waterworks companies.
But there have been divisions within the Greek cabinet, including a public spat between Finance Minister George Papaconstantinou and Energy Minister Tina Birbili over whether the state would continue to control 51% of Public Power Corp., which has a virtual monopoly on electric power generation and distribution.
Where the finance minister wants to privatize the big utility, Ms. Birbili wants to retain state control as an asset of national importance, and to keep power bills down.
Also resisting the move is PPC's powerful labor union, Genop, which has warned it will stage rolling 48-hour strikes if the government proceeds with further privatizing the monopoly.
Europe is living in denial. Even after the economic crisis exposed the eurozone's troubled future, its leaders are struggling to sustain the status quo.
At this point, several European countries will likely be forced to abandon the euro within the next year or two.
European leaders tell us that this is impossible. There is no legal mechanism, they say, for exiting the euro. But the collapse of the euro is simple arithmetic: Once a country's debt-to-GDP ratio gets high enough, it becomes impossible for it to generate enough future taxes to repay its existing debt and interest costs.
This week, Portugal became the latest country to threaten the integrity of the eurozone when it saw the yield on its Treasury bills soar, based on investors' fears that it would be unable to pay its debt.
The only way out of this conundrum is for countries with insurmountable debt burdens to default on their euro-denominated debts and exit the eurozone so that they can finance their continuing fiscal deficits by printing their own currency.
Here's a hint for Europe's politicians: If the math says one thing and the law says something different, it will be the law that ends up changing.
The countries currently teetering on the precipice include "peripheral" countries -- such as Greece, Ireland, and Portugal -- as well as large countries, such as Spain, Italy, and France.
It is extremely unlikely that all of these countries will still be members of the eurozone by the time revelers gather to ring in New Year's 2013.
The most likely scenario is that the next two years will witness the departure of more than one peripheral country and at least one of the large countries.
Greece is at the top of that list.
The country will soon have a sovereign debt-to GDP ratio of more than 150 percent and an economy that contracted approximately 4 percent in the past year.
It has long suffered from:
the worst corruption
largest shadow economy in Europe,
some of the lowest labor participation rates,
most generous pension systems,
highest consumption rates among its European peers.
It is true that the Greeks have made heroic efforts in the past six months to cut spending and raise taxes, but it won't be enough to reverse the explosive costs of covering its debts. And yet, the story goes, Greece will somehow repay what it owes.
Following closely on Greece's heels is Ireland.
During the so-called "Irish miracle," the country experienced a housing boom that saw twice the appreciation as did the United States. When this bubble popped, Ireland's banking system suffered a massive loss.
The government's bank bailouts have added more than 20 percent of GDP to its budget deficit in the past year and will add a similar additional amount to its deficits in the near future.
The Irish case also shows the perils of EU intervention. Ireland was forced by its self-serving European partners to guarantee massive bank debts -- in order to forestall debilitating losses to German, Belgian, Danish, and British banks, among others -- as a condition for receiving emergency EU assistance.
This Irish policy mistake has raised its debt to stratospheric levels, which the government will be hard-pressed to bring down.
Thus, in effect, some of the largest EU countries proved their willingness to throw Ireland under the bus to postpone dealing with their own financial institutions' problems.
Now Spain is being pushed by those same European partners into making the same deadly mistake as Ireland.
Spain's housing boom was similar to that of Ireland and was similarly financed by large external borrowings.
The good news in Spain, however, is that most of the country's largest financial institutions appear to be solvent.
If Spain shuts down its insolvent savings banks and allows closed banks to default on their external bond debts held by other EU countries' banks, Spanish sovereign solvency can be preserved.
A number of other European countries face similarly daunting fiscal challenges. Italy, for example, is running a debt-to-GDP ratio in excess of 125 percent.
Although serious and immediate fiscal spending cuts could give Italy a reasonable chance of repaying its debts, the country seems so politically broken that it is unlikely to make the deep spending cuts that would permit it to stay in the euro.
Its meager cuts this past year are an indication of how difficult it is for Italy's political system to confront its challenges.
The same failure of political will bedevils France, Belgium, and Portugal.
The French proved that they are willing to riot over a two-year extension of the retirement age.
They will need to reconcile themselves to far more drastic measures if they hope to get their dismal fiscal situation under control.
This partial collapse of the euro is inevitable, and Europe's leaders should focus on the next step:
Their challenge now is to lay the groundwork for a sustainable currency union in the future, once exiting countries reform themselves enough to rejoin.
To do so, however, they will need to take stock of the institutional deficiencies undermining the current union, so that the new eurozone is more crash-proof than the last one.
Europe must do far more to cut the growth of government spending -- the only credible path to preventing ballooning deficits.
But it needs to go even a step beyond that: Europe must agree on measures that prevent countries from behaving irresponsibly to take advantage of their membership in the eurozone.
One of the reasons that Italy and Greece spent so much is that their interest rates on debt fell dramatically when they joined the eurozone, making deficit finance more attractive.
There is no substitute for the creation of a fiscal union, which would centralize enforcement power that could credibly control spending.
A currency union cannot survive without a corresponding fiscal union. But fiscal reform is not enough without measures to strengthen the competitiveness of southern Europe.
Southern European countries, notably Spain, Italy, Portugal, and Greece, are finding it increasingly difficult to compete in global trade --
the result of restrictive union contracts and
They have accordingly suffered from high current account deficits and high unemployment.
If left unchecked, these dynamics will produce a political powder keg of widening interregional economic-welfare differences that would threaten the long-term cohesion of the union.
The only way around this problem is to make southern Europe more business-friendly.
That means making it easier for businesses to fire workers and cut wages.
It also means less generous welfare programs and
credible efforts to reduce corruption and
lower entry barriers to foreign competition.
A reconstructed eurozone should make the implementation of these reforms part of the requirement for membership.
The European financial sector is also in dire need of reform. New regulations should be put in place that make banking collapse less likely, most importantly through the creation of credible means of measuring bank risks and requiring capital and liquidity commensurate with those risks.
Europe should also put in place policies that transparently and predictably allocate authority across different national regulators in the event of a bank's collapse.
Without a credible plan for resolving a large global bank crisis, politicians will tend to prefer bailouts as a means of avoiding unpredictable financial chaos.
Policymakers must learn that the "too-big-to-fail" problem is both dangerous and avoidable, and that choosing not to bail out banks is a viable option.
Politicians today are frightened of transparency in the recognition of bank losses and are often unwilling to close insolvent banks out of a fear of "systemic risk."
However, it is only by credibly recognizing banking-system losses that governments can put an end to uncertainties in the financial market.
The eurozone's problems are not going away. Whether these problems will eventually be seen as bumps on the road to a credible currency union or as symptoms of the irreconcilable conflicts within Europe depends on how the eurozone countries react.
The good news is that Europe possesses the techniques of statecraft and financial engineering to build the institutional foundations of a long-lived, stable union.
The lingering question, however, is whether it possesses the political will to do so.