http://pragcap.com Wed, 08 Dec 2010 06:35:36 +0000 en hourly 1 http://wordpress.org/?v=3.0.2 http://pragcap.com/goldmans-favorite-asia-trades-for-2011 http://pragcap.com/goldmans-favorite-asia-trades-for-2011#comments Wed, 08 Dec 2010 06:35:36 +0000 TPC http://pragcap.com/?p=29095 If you’re a raging bull on equities you’d be a fool not to consider some exposure to the higher growth region of Asia.? And as a raging bull on equities in 2011 Goldman Sachs has laid out their favorite trades for Asia in the coming year:
1. Our three favorite markets for 2011 are the lowest vol markets globally. KOSPI 200, TWSE, and MSCI Singapore are three of the lowest implied vol markets in the world. On each of these three markets, owning 6-mo 110% upside calls costs less than 2% and is a reasonably easy way to put on long exposure with limited risk. While we have often suggested long AEJ vs. short DM trades, our more positive DM view makes us prefer the simplicity of simply using calls for exposure. Currently 6-mo 110% calls cost 1.75%, 1.71%, and 1.25% on KOSPI2, TWSE, and MSCI Singapore, respectively. Risk is loss of premium.
2. HSCEI vs. SPX 1-year variance is our favorite China inflation hedge, but NKY vs. SPX 1-year variance also carries very well. We believe the three ingredients to a strong derivative trade are (1) A good fundamental story; (2) An attractive entry point; and (3) Historical profitability. The HSCEI vs. SPX 1-year variance trade satisfies all three criteria, as we discussed Thursday in our piece China inflation hedge with positive carry: HSCEI vs. SPX variance. The Nikkei 225 vs. S&P 500 1-year variance pair satisfies two of the three factors, given historical profitability and an attractive entry point, though we have less of a fundamental case relative to the HSCEI vs. SPX pair. Sellers of variance swap risk unlimited loss at expiry;
buyer of variance swaps risk losing var strike^2 / (2 * var strike) at expiry.3. HSCEI and oil correlations have begun to decline with oil prices moving lower and HSCEI moving higher. Two of our macro views for 2011 are high commodity prices and muted returns for emerging markets. On this note, it is interesting to see HSCEI and WTI have begun to de-correlate. Given our view that inflation is a problem for China, the correlation could remain low. Owning puts on HSCEI contingent on oil prices higher plays into this trend. Current 3-mo ATM puts on HSCEI contingent on WTI up 10% cost 1.2%, a 80% discount to ATM vanilla puts. Risk is loss of premium.
4. NKY calls are an inexpensive way to play our global strategists’ top trade to go long Japan. Following this year’s underperformance, we expect NKY to display beta to the improving global industrial cycle. Nikkei calls remain half a standard deviation below their one-year average, and have recently been a profitable way to gain market exposure while keeping risk limited in the case of Japan equities disappointing. For exposure through the Japan fiscal year, NKY Apr-11 105% calls cost just 2.6%. For exposure to our Japan over China view, selling 3-mo 105-115% call spreads on HSCEI fully funds 3-mo NKY 105% calls (Ex 4). Risk is loss of premium.
5. NIFTY puts remain inexpensive and are a preferred hedge. We continue to see NIFTY puts as attractive hedges. The market is expensive in our view, earnings have been revised down for six months in a row, there has been a lot of foreign inflow, and probes by the CBI create additional uncertainty. Feb-10 95% puts cost 1.7%, which we find inexpensive in light of the risks we highlighted in our 2011 Outlook. Risk is loss of premium.
6. Forwards create opportunities. The TWSE vs. NIFTY forward differential provides a “head-start” via divergent strikes for a call vs. call pair trade. Our analysis shows that forwards have very little correlation with future returns. As such, the 10-point differential between the TWSE and NIFTY forwards is an attractive starting point for buyers of TWSE calls and sellers of NIFTY calls. Currently, selling 1-year 115% calls on NIFTY fully funds 1-year 105% calls on TWSE; attractive entry levels in our view for a trade we fundamentally like. Risk is unlimited if NIFTY rises more than 15% and TWSE does not rise more than 5%.
7. Geopolitical risk in Korea? Limited, according to the options market. We believe implied vols remained surprisingly low on KOSPI. Current 3-mo 25-delta put implied vol is just 22 and one of the lowest among major markets globally. While we continue to like Korea fundamentally, short-dated put or put spread hedges appear to be pricing in limited risk following the North Korea tensions, given little rise since the most recent North Korea incident towards the end of November.
Source: Goldman Sachs
]]> http://pragcap.com/goldmans-favorite-asia-trades-for-2011/feed 2 http://pragcap.com/ireland-iceland-and-letting-banks-fail http://pragcap.com/ireland-iceland-and-letting-banks-fail#comments Wed, 08 Dec 2010 06:22:46 +0000 TPC http://pragcap.com/?p=29155 As the crisis in Europe continues to unfold another crisis is slowly coming to an end.? The economy in Iceland has finally started to grow again.? What’s interesting about the two crises is the dramatic difference in the ways they were able to attack their problems.? While both have implemented austerity measures there have been vast differences.? In particular, Ireland, embroiled in the flawed single currency Euro has been unable to devalue their currency while at the same time being forced to succumb to the pressures of foreign bankers.? In Iceland, they have benefited enormously from being able to devalue the Krona.? Finance Minister Steingrimur Sigfusson recently said:“(devaluing the Krona) significantly increased our export business and got us ahead of our competitors which, without a doubt, helped us through this difficulty and continues to drag us along and eventually out.”
In addition, Iceland did not force the public to accept the losses of private bankers.? In a recent Bloomberg interview ólafur Ragnar Grímsson, President of Iceland explained why this was important:
“The difference is that in Iceland we allowed the banks to fail… These were private banks and we didn’t pump money into them in order to keep them going; the state did not shoulder the responsibility of the failed private banks….How far can we ask ordinary people — farmers and fishermen and teachers and doctors and nurses — to shoulder the responsibility of failed private banks….That question, which has been at the core of the Icesave issue, will now be the burning issue in many European countries.”
Tryggvi Herbertsson, an econ professor at the University of Reykjavik described why the two approaches are having dramatically different results:
“That alone (forcing bondholders to take losses) has made for a very different result within the two countries.? Ireland is now over-leveraged (with debt) and their banking system continually weak. The difference in Iceland is that our banking system is clean and once the debt has been written off, we have a healthy banking system but in Ireland the system is broken.
This is the proper process. If you go through a bubble economy and you need to correct it, the answer is not to convert private debt into public debt. Rather it is to restructure the debt to the level of the assets.”
The parallels between Japan/Sweden and the Ireland/Iceland sage are striking.? In the early 90′s Sweden and Japan suffered substantial financial crises following asset bubbles.? In Sweden the banking system was nationalized whereas in Japan they allowed the banks to earn their way out of the crisis.? The results were dramatically different as Sweden recovered quickly and Japan muddled along for years. In Iceland the banks were punished and I believe they have laid the foundation for sustainable long-term growth.
In Ireland they are only just now beginning to confront a crisis that has only grown worse by the day and the newly implemented austerity measures are truly savage.? With no ability to devalue their currency and a necessity to appease foreign bankers it’s difficult to understand how Ireland’s economic woes will end any time soon.? Judging by the unemployed in the two countries it’s safe to say that the results speak for themselves as Iceland begins to put Main Street back to work and Ireland continues to layoff workers:
In January 2009 I called for the USA to go Swedish on the banking system by forming a RTC type unit to force the bondholders to take losses, avoid moral hazard and maintain some semblance of capitalism and an environment where losers lose.? Here we are almost two years later with unemployment at its highs and an economy that can’t seem to get off the ground without more government aid.? Even worse, we have not allowed the excesses in the economy to fully clear.? While the economy is certainly improving in recent months the math still doesn’t add up.? What has changed since before the crisis started?? The problems that caused this crisis in the USA have not been dealt with and you could even make the argument that the losers have been emboldened by the Bernanke Put and a government that thinks capitalism can run smoothly without any losers.? We’ll see how this unfolds in the coming decade.? So far, the results are not good and if Iceland and Sweden are any precedent it’s clear that we made a huge mistake in choosing to save the banks in 2009.
]]> http://pragcap.com/ireland-iceland-and-letting-banks-fail/feed 8 http://pragcap.com/jobs-and-taxes http://pragcap.com/jobs-and-taxes#comments Wed, 08 Dec 2010 02:49:13 +0000 Annaly Capital http://pragcap.com/?p=29149 By Annaly Capital ManagementFor months, Ben Bernanke has been more or less pleading with fiscal policymakers to catch up to him. In his August 27 Jackson Hole speech, he said, “[A] return to strong and stable economic growth will require appropriate and effective responses from economic policymakers across a wide spectrum, as well as from leaders in the private sector. Central bankers alone cannot solve the world’s economic problems.” In his November 4 op-ed in the Washington Post, he said, “The Federal Reserve cannot solve all the economy’s problems on its own. That will take time and the combined efforts of many parties, including the central bank, Congress, the administration, regulators and the private sector.” In his speech in Frankfurt on November 19, he said, “The Federal Reserve is nonpartisan and does not make recommendations regarding specific tax and spending programs. However, in general terms, a fiscal program that combines near-term measures to enhance growth with strong, confidence-inducing steps to reduce longer-term structural deficits would be an important complement to the policies of the Federal Reserve.” And in his “60 Minutes” interview on December 5, he said it again: “We need to pay close attention to the fact that we are recovering now. We don’t want to take actions this year that will affect this year’s spending and this year’s taxes in a way that will hurt the recovery. That’s important.”
With yesterday’s announced agreement on tax cuts and the extension of unemployment benefits, Congress and the Administration are making the first tentative steps in that direction. It is unclear at this point what the impact might be to tax receipts, the deficit and the debt load, but estimates run as high as $800 billion for the package of maintaining the Bush-era tax regime, extending unemployment benefits, offering workers a 2% payroll tax holiday, a one-year increase to a 100% accelerated depreciation benefit for corporations and lowering the estate tax. One thing that is clear, however, as President Obama said repeatedly in his statement, is that the desired effect is to boost jobs (emphasis added):
· “Allowing taxes to go up on all Americans would have raised taxes by $3,000 for a typical American family. And that could cost our economy well over a million jobs.”
· “This agreement would also mean a 2 percent employee payroll tax cut for workers next year — a tax cut that economists across the political spectrum agree is one of the most powerful things we can do to create jobs and boost economic growth.”
· “We will provide incentives for businesses to invest and create jobs by allowing them to completely write off their investments next year.”
· “As for now, I believe this bipartisan plan is the right thing to do.? It’s the right thing to do for jobs.”
· “It’s not perfect, but this compromise… will spur our private sector to create millions of new jobs, and add momentum that our economy badly needs.”
· “And my singular focus over the next year is going to be on how do we continue the momentum of the recovery, how do we make sure that we grow this economy and we create more jobs.”
The transmission of tax cuts to job creation may or may not work. As the graphs below show, there is no visible correlation between tax policy and the unemployment rate and job creation.
We understand that these graphs are simplistic to a fault, but we want to make the point that in fiscal and monetary policy it is all about transmission mechanisms. The idea behind tax strategy is not exactly to create or protect jobs, but to increase aggregate demand, i.e., GDP growth, which is what would cause employers to start hiring again. In the case of this tax compromise, the only aspects of it that seem likely to increase aggregate demand are the reduction in the employee side of the payroll tax and the accelerated depreciation benefit. The biggest slug of it, maintaining the current income tax rates, doesn’t increase aggregate demand at all, it merely avoids decreasing it. Stay tuned.
]]> http://pragcap.com/jobs-and-taxes/feed 1 http://pragcap.com/consumer-credit-expands-in-october http://pragcap.com/consumer-credit-expands-in-october#comments Tue, 07 Dec 2010 20:32:38 +0000 TPC http://pragcap.com/?p=29139 Consumer credit increased $3.4B in October to the best levels since July 2008.? The 1.75% year over year expansion is the second consecutive month of gains.? Revolving credit declined 8.4% for the 26th straight month while non-revolving credit increased 6.8%.? This was driven primarily by new auto loans and student loans.? Has the U.S. consumer stopped de-leveraging?
]]> http://pragcap.com/dont-fight-the-fed/feed 7 http://pragcap.com/do-global-imbalances-lead-to-financial-crises http://pragcap.com/do-global-imbalances-lead-to-financial-crises#comments Tue, 07 Dec 2010 18:31:52 +0000 TPC http://pragcap.com/?p=29131 This new paper from the NBER asks a most pertinent question: do global imbalances lead to financial crises?? They conclude:Since the first cut in the Fed funds rate on September 18, 2007 …
- The S&P 500 has gone from 1,520 to 1,223.
- The unemployment rate has gone from 4.7% to 9.8%.
- Industry capacity utilization rates have gone from 81.5% to below 75%.
- The 10-year note yield has gone from 4.5% to below 3%.
- Housing starts have gone from 1.183 million units to 0.519 million.
- Median real estate values have gone from $210,500 to $170,500.
- Core inflation has gone from 2.1% to 0.6%.
Well done!
“The final prediction part of this paper addressed the question whether widening external imbalances are a signal for policymakers that financial instability risks are building. Our overall result is that,from a policy maker’s perspective, credit growth – not the current account – generates the best predictive signals of impeding financial instability. However,the relation between credit growth and current accounts has grown much tighter in recent decades.In a globalized economy with free capital mobility credit cycles and capital flows have the potential to reinforce each other more strongly then before.The historical data clearly suggest that high rates of credit growth coupled with widening imbalances pose stability risks that policy makers should not ignore.”
If someone could forward this on to the Chinese government the global economy would really appreciate it.
The full paper is attached:
]]> http://pragcap.com/do-global-imbalances-lead-to-financial-crises/feed 2 http://pragcap.com/the-inflation-vs-deflation-debate http://pragcap.com/the-inflation-vs-deflation-debate#comments Tue, 07 Dec 2010 16:23:22 +0000 TPC http://pragcap.com/?p=29125 Peter Schiff, the long-time hyperinflationist, takes on Gary Shilling, the long-time deflationist. I don’t think either quite understands how the monetary system works, but Shilling is much closer to getting it right. In particular, he notes that the Fed does not create money – they only create reserves. This proves that Shilling maintains a key fundamental understanding that Schiff does not. Schiff has been calling for a spike in rates and a collapsing dollar for years on end. He thinks the USA is going bankrupt and that default is right around the corner. Could he have been more wrong? The debate follows:]]> http://pragcap.com/the-inflation-vs-deflation-debate/feed 32 http://pragcap.com/the-three-stages-of-delusion http://pragcap.com/the-three-stages-of-delusion#comments Tue, 07 Dec 2010 07:49:18 +0000 TPC http://pragcap.com/?p=29113 Flashback to Crises Past: Three Stages of Delusion Popular Delusions (via John Mauldin)By Dylan Grice
The recent sequence of reassurances from various eurozone policymakers suggests we are in the early, not latter, stages of the euro crisis. Only an Anglo-Saxon style QE will prevent dissolution of the euro. Such a radically un-German solution will only be taken with a full acceptance of how serious the euro’s problems are. But denial persists.
The dawning of reality hurts. Prodded and bullied along a tortuous emotional path by events unforeseen and beyond our control, we descend through three phases: the first is denial that there is a problem; the second is denial that there is a big problem; the third is denial that the problem was anything to do with us.
US policymakers’ three steps during the housing crash fit the template well. Asked in 2005 about the danger posed to the economy by the housing bubble, Bernanke responded: “I guess I don’t buy your premise. It’s a pretty unlikely possibility. We’ve never had a decline in house prices on a nationwide basis.” Here was the denial that there was a problem. But as sub-prime issues arose, Ben Bernanke reassured the world that they would be “contained.” And when Bear Stearns collapsed, Hank Paulson promised “The worst is likely to be behind us.” Here was denial that there was a big problem.
Soon the financial system was on the brink of collapse. There could no longer be any credible denial of the problem, so the locus of delusions shifted: there was a problem, but it was someone else’s fault. Thus a ban on naked short selling of financials was implemented in Sept/Oct 2008, as though the crisis was somehow short-sellers’ fault. (It certainly wasn’t the Fed’s fault, according to the Fed. Ben Bernanke argued this year “Economists … have found that only a small portion of the increase in house prices … can be attributed to the stance of US monetary policy.”)
What’s interesting is that the journey Bernanke and Co. took fits the journeys of policymakers presiding over crises past very closely, as I’ll show inside. What’s worrying is that taken in this context, eurozone policymakers’ denials/reassurances sound eerily familiar. And if these past crises are any guide, the euro crisis is still in its early stages.
A descent through the three stages of delusion characterises most crises. Dick Fuld went from saying “as long as I live, Lehman will never be sold” in December 2007, to “We have access to Fed funds; we can’t fail now” during the summer of 2008, to agreeing with a colleague that half of any capital injection then being negotiated with the Korean Development Bank be used to buy back Lehman stock, to “hurt Einhorn bad.”
Identical stages can be traced during the Asian Crisis of 1997. For those who don’t recall, the Asian Tigers were ‘miracle’economies whose dizzying growth rates proved the superiority of export liberalisation, high investment and free markets. Their miracle image was burnished by the ‘good crisis’ they enjoyed in 1994, when their fixed exchange rate systems (they were pegged to the dollar) successfully withstood the contagion caused by the collapse of the Mexican peso.
Bear in mind that the world had bought into the Asian Tiger story hook, line, and sinker. The World Bank wrote a now infamous series of reports called “The East Asian Miracle” from 1993, lauding the strength of the region’s institutions and preaching its commitment to an export-driven growth model to anyone who’d listen. And while there was a feeling that some tigers (e.g. Thailand and the Philippines) were riskier than others (Indonesia), the idea that Taiwan or South Korea would be caught up in anything was viewed as utterly preposterous. Early in 1997, Jeffrey Sachs said:
“Since the economic structure of Korea is fundamentally different from that of Mexico, there is no possibility of recurrence of the situation that happened to Mexico.”
But early in 1997, problems emerged. The first sign of trouble came in Korea in January when a large chaebol called Hanbo Steel collapsed under $6bn of debts. Then in February, Thai property company Somprasong Land missed a payment on foreign debt in February. These turned out to be the first cockroaches. The following chart shows the sequence of events which would soon follow. First the small economies fell – then the big ones.
Yet denial that there was any problem characterized early observations. Immediately following the Thai government’s $3.9bn aid to Thai banks to cover dud property loans, Michel Camdessus – then head of the IMF – said, “I don’t see any reason for this crisis to develop further.” And on 30th June that year, Chavalit Yongchaiyudh, then Thai Prime Minister, made a televised address to the nation saying “We will never devalue the baht.”
Yet the baht was floated on 2 July. It was soon followed by the Philippine peso.
But the initial denial that there was a problem simply became denial that there was a big problem. Indonesia wasn’t Thailand, after all. According to an article in the 8th Oct 1997 New York Times:
“Indonesia’s financial condition is far better than Thailand’s was this summer … while Thailand depleted its foreign-currency reserves in a last-ditch effort to prop up its currency, the baht, Indonesia still holds foreign reserves of about $27 billion.”
And as the Indonesian crisis began to intensify and the US made financial help available as a precaution, an Administration official said: “We don’t expect that Indonesia will need to draw on our direct help, but what we need to address here is an atmosphere of contagion.”
As it turned out, Indonesia wasn’t Thailand. It was worse. It would prove to be the worst affected of the Asian tigers with a near 80% exchange rate collapse bankrupting the corporate sector which had borrowed heavily in dollars. GDP collapsed by 14%, triggering unrest and street violence which ultimately forced out President Suharto.
Yet denial that there was a big problem persisted. James Wolfensohn, then president of the World Bank, reassured that the Indonesian bailout marked the end of the crisis: “The worst is over” he proclaimed confidently.
Korea wasn’t Indonesia. Michel Camdessus, said on Nov 6th: “I don’t believe that the situation in South Korea is as alarming as the one in Indonesia a couple of weeks ago.” Yet South Korea turned out to be just as vulnerable, and certainly more costly. On December 1st1997, the government said it had agreed to a $55bn bail-out (which then, was the largest bailout in the history of the world. In today’s money it’s a mere $75bn, less than the bill for Ireland). The storm moved on. Before petering out it would engulf Latin America, then Russia, and then the once mighty hedge fund LTCM. But for now, Asia had been destroyed. The miracle was myth. The depth of the problems was now undeniable.
Yet the denial persisted, only now it emphasised the fault of others to demonstrate that the crisis was in no way related to anything policymakers had done. It was all caused by speculators, international bankers and the foreign media. Most infamous was Malaysia’s then Prime Minister Mahathir Mohamed blaming George Soros, who he bizarrely implied was part of some kind of wider plot. “Today we have seen how easily foreigners deliberately bring down our economy by undermining our currency and stock exchange …” and “Soros is part of a worldwide Jewish conspiracy.”
There’s nothing unusual about the emotional need to find a scapegoat when things go wrong. As always, Shakespeare wrote about it four centuries ago. From King Lear:
“This is the excellent foppery of the world, that, when we are sick in fortune – often the surfeit of our own behaviour – we make guilty of our disasters the sun, the moon, and the stars: as if we were villains by necessity; fools by heavenly compulsion; knaves, thieves, and treachers by spherical predominance; drunkards, liars, and adulterers, by an enforced obedience of planetary influence; and all that we are evil in, by a divine thrusting on: an admirable evasion of whoremaster man, to lay his goatish disposition to the charge of a star!”
And if we’re looking for signposts on the way to a crisis’ closing chapters, it turns out that the “excellent foppery” of blaming everyone else is a good indication. Thus, as the Greek crisis unfolded in December 2009, George Papandreou went from denial of the problem, insisting it to be “out of the question” that Greece would resort to the IMF, to denial that it was the Greeks’ fault, lamenting in March 2010 that “we ourselves were in the last few months the victims of speculators.”
As the Irish crisis reached its conclusion, Finance Minister Brian Lenihan blamed the “unintended consequences” of various German and French comments for its spiralling borrowing costs.
Today Spain is the battlefield. A few weeks ago, the Spanish were in denial that there was a problem. Zapatero said “I believe that the debt crisis affecting Spain, and the eurozone in general, has passed.” Now they are in denial that there is a big problem. Last week, Spanish Finance Minister Elena Salgado said there was “absolutely no risk” the country would need an international bailout and stressed the differences between Spain and Ireland, much as the Indonesians stressed the difference between themselves and the Thais thirteen years ago:
“Our financial sector has always had the Bank of Spain’s supervision and regulation, which is what has probably been missing in Ireland … We have a solid financial sector and we should remember that it’s the financial sector that’s provoking the difficult situation in Ireland.”
When they start blaming everyone else for their problems, we’ll know their crisis is nearly over Until then, their plight likely has some way to go.
But of course, the real issue isn’t Ireland, or Portugal or even Spain. The real crisis is the euro, and the strains continued membership is placing on the relationships between euro members and the attitude of electorates in the member states towards the single currency.
Yet policymakers are as in as much denial that there is a big problem (i.e. with the euro rather than any individual country) as Ben Bernanke and Hank Paulson were that there was a housing bust, as Dick Fuld was that Lehman was toast, or as the IMF was that Thailand, let alone Asia, had profound economic weaknesses. Last week the Finnish Central Bank head and ECB Governor Erkki Liikanen said “The euro will survive. It is not questioned.” Klaus Regling, heading up the EFSF, said “No country will give up the euro of its own will: for weaker countries that would be economic suicide, likewise for the stronger countries. And politically Europe would only have half the value without the euro.”
Such logic has been used before. Barry Eichengreen wrote in 2007 that euro membership was effectively irreversible because withdrawal would be too traumatic. But what if the cost of staying in the euro becomes so high that exit is preferable? Surely this is the risk in Germany’s current strategy.
Peripheral eurozone countries need to default. Traditionally this is done with currency debasement (which the Fed and the BoE have already begun) or by imposing a haircut on lenders. Germany refuses to sanction the former, while flagging up the latter triggered the latest bout of contagion. Instead, they are imposing depressions on countries which lose the bond market’s confidence.
How many years of austerity before the voters of Greece/Ireland/Spain/wherever blame Germany, France, or the euro for everything that is wrong with their economy? Will this become the blame game signalling the final chapter of the euro’s crisis?
I certainly hope not. Last week, Axel Weber said: “The European Financial Stability Fund should be sufficient to dissuade markets from speculating against the solvency of Eurozone member countries, and if not, more money will be provided.”
If and only if that money comes from the ECB’s printing presses – in the style of the BoE and the Fed – will Mr. Weber be correct. A large risk rally will ensue. If not, we still have a long, long way to go. On 27 May this year, following the original set-up of the EFSF, I wrote:
“The EU’s ‘shock and awe’ $1trillion rescue was certainly a big number and reflected European governments going all in. But going all in is risky if you don’t have a strong hand, and the EU’s seems weak. Two-thirds of the rescue money comes from the EU itself, which means that the distressed eurozone borrowers are to be saved by more borrowing by … er … the distressed eurozone borrowers.”
This remains the case. The EFSF is flawed. It invites speculative attack. Simply expanding it in its current form so that the ‘solvent core’ commits to raise yet more funds for the ‘insolvent periphery’ fails to address the risk that as more dominos fall the bailers shrink relative to the bailees (Italy and Spain combined – who’s spreads have been blowing out this week – are combined bigger than Germany). At what point does the insolvent periphery include so many countries that markets lose confidence in the solvency of the shrinking core to bail them out. Leaving aside for now the unpleasant reality that the solvent core might not actually be so solvent, perhaps the spread between ‘insolvent’ Greece and solvent France should be narrower? I wish I knew. In the absence of ECB printing, I suspect we’re going to find out.
The London Brief
Omar Sayed
The Cypriot banking system holds assets that are seven times Cyprus’ GDP.?? While the system is almost one hundred percent deposit funded, over one third of these deposits are foreign, mostly from Greeks trying to hide or protect savings by moving them out of Greek banks.? Cyprus banks hold €5 billion of Greek government bonds.? If the bonds received a 30% haircut, the banks Tier I capital would be gone.? Most of the Cyprus bank loan books are to Greeks and non-performing loans are edging sharply upward as a result of the austerity programs.
Cyprus’ GDP is only $25 billion, a drop in the fiat money printing ocean.? But it’s indicative of a major problem governments don’t have the tools to solve: volatile and sudden capital flows.?? Greeks worry about their banking system and rapidly transfer deposits to Cyprus creating a banking system that is larger than the state’s ability to support in a crisis.? Then as a shock hits the banking system, the capital flows violently flow somewhere else creating a new banking crisis.
European Crisis
An unidentified banker in the Financial Times said, “The ECB needs to use the bazooka option to lift sentiment in a lasting way.? That is the only way to stop this crisis from spreading.? We had a good day today, but yields are only coming down because the ECB is buying.? It has got to continue doing so and in size.”? Considering many of the banks are the ones selling sovereign bonds to the ECB for profit, I can understand the banker’s sentiment.? But is ECB bond purchases a real solution?
CDS trading in Irish debt saw opening prints compress with the five year CDS trading at 275/295 and the ten year at 215/235.?? Within minutes they were back trading 575/595 and 515/535 respectively.?? A few hours later, they were flat to Friday’s close and Portugal was widening.? It wasn’t until later in the week when the ECB stepped in with €100 million per clip in Irish and Portuguese bond purchases that spreads narrowed.
The market realizes the European sovereign crisis is still not solved.? There is wide sentiment that the EU may disintegrate and the euro is a short.
Yet European disintegration is practically unfeasible.? For instance, if Ireland were to pull out of the euro, they would have to force conversion on depositors so that bank assets could match liabilities.? Ireland would have to reintroduce capital controls to prevent people from sending their money overseas.? They might even have to restrict foreign travel or check briefcases at the airports.? There would be caps on bank withdrawals.
It would be a nightmare for Germany too.? Germany’s exporters would instantly lose competitiveness and customers.? Germany is the EU’s largest creditor and it would see its investments outside Germany sharply decline in value.? Monetary policy would be in disarray.? German banks and pension funds would be in trouble.
So in order to preserve this unholy union, what options does the EU have??? I see four: (1) the Marshall Plan II; (2) the Treaty of Versailles II; (3) the printing press option and (4) the Icelandic option.? Each has its challenges and problems.
The first option is the most politically sensitive, but potentially the most effective.? Currently the EU’s program can support Portugal, Greece and Ireland, but is too small for Spain and Italy.? Under this option, the EU boosts the size of the rescue fund or turns it into an asset buying program where they buy sovereign bonds.? The EU can also float its own euro-bonds for the periphery or make guarantees that periphery debt is EU debt.? They can cut interest on loans to help states better balance budgets.? The EU could also lighten up on austerity and take a more active role in fiscal programs and auditing.? Then focus on fixing the periphery’s lack of export competitiveness.? The EU is sitting on billions of unspent redevelopment funds that could be channelled into projects.? For instance, Greece has certain off-shore power projects that could provide energy for the whole EU but also jobs for Greeks.? Port redevelopment is a major growth initiative from goods coming from the Middle East and Africa.? The rigidities in the Greek system that make it more expensive to move goods around internally than externally could be reformed under a crisis pretext.?? Companies like Siemens could be incentivized to build a factory in Portugal or Ireland.? The idea is that rather than make periphery nations deflate, you help them grow and pay their way out of debt.
Political sentiment in Germany in favour of this option is changing because the country is having a good crisis.? GDP grew by 3.5% this year and is expected to grow 2% in 2011.? Retail sales jumped 2.3% in October suggesting rising domestic demand.? Half of Germans now support the Greek bail-out according to an Economist poll versus 20 per cent in April.
For EU integrationists, this could be a dream come true, a way to homogenize fiscal accounts and assume greater EU sovereignty over individual states.
The challenges though are execution, the willingness of states to allow the EU to assume fiscal responsibilities, the willingness of northern Europeans to make rival nations more competitive and implementing projects that would take many years before seeing results.
Currently, the EU is adopting the Treaty of Versailles II option.? This option entails an internal devaluation or lowering wages to regain export competitiveness.? However, this doesn’t work because you are not making capital cheaper.?? Debt to GDP gets larger until a frustrated Irish or Greek public elect politicians to take actions to break their slavery through default.
The third option is to get the ECB to keep buying sovereign bonds while the EU works on a way to help Ireland, Greece and Portugal balance their budget so they don’t need to issue more bonds.? The ECB can keep monetizing the debt and hope the problem gradually goes away.? The problem is that Spain and potentially Italy are deflating; therefore the problem will not go away.? Also the euro would decline leading to the potential for significant inflation.?? My commodity basket is pushing its highs.? At some point debt monetization becomes suicidal.
Finally, there is the Icelandic option.? This involves restructuring the debt and making bond-holders share losses.? Already there are discussions taking place about a managed default where deposits and payment systems would be transported into a “good bank”.? Bank loan books would be excised and the bank would be infused with new capital through “bail-in” procedures, where bond-holders receive equity.?? A mechanism would be necessary to manage cross-border banks.? Such a program would trigger an instant sell-off in other nations such as Spain, Italy and Belgium and potentially force debt restructurings there too (the contagion effect).? Also the losses from such restructurings could end up creating a Lehman like effect through the shadow banking system, which still exists and is difficult to measure.? This strikes me as the second best solution if a Marshall Plan option is unfeasible.
The Marshall Plan II is quite possible given the IMF’s (ie – America) willingness to give more money to help Europe.? But I am doubtful that this is the path that is chosen.? Many northern Europeans have adopted the same approach as the French and British did after World War I and want to make the periphery suffer in a bout of self righteousness.? I can understand the sentiment and it can be done to a limited extent, but they will force the people to rebel against austerity.? At that point, the whole experiment unravels.? If the EU wants its venture to succeed, they have to think growth and restructuring, not austerity.
(Courtesy of John Mauldin)
]]> http://pragcap.com/the-three-stages-of-delusion/feed 5 http://pragcap.com/further-thoughts-on-the-tax-cuts-2 http://pragcap.com/further-thoughts-on-the-tax-cuts-2#comments Tue, 07 Dec 2010 07:28:40 +0000 TPC http://pragcap.com/?p=29115 The Obama tax cut plan appears less meaty than the $900B in deficit addition that is advertised.? It essentially keeps plans in place rather than adding substantively to the recovery.? All in all, the plan seems to rhyme with the Obama presidency – providing big hopes and coming up well short.? Talk about speaking loudly and carrying a small stick…..The plan breaks down approximately as follows:- The payroll tax cut is the only part of the plan that the President appears to have negotiated ardently for.? This portion of the cut is a reduction in social security taxes to 4.2% from 6.2% in 2011.? This would generate an additional 2% for employed workers.? Total deficit addition: $120B.
- The Making Work Pay tax, part of the original stimulus plan, will not be extended.? This will reduce the deficit by $60B a year.
- Unemployment benefits will be extended for 13 months maintaining $56B in the deficit.
- The Bush tax cuts will be extended for two years with a provision protecting estates under $5MM from the estate tax.? The tax rate on qualifying estates will be 35%.? This is projected to add less than $10B to the deficit.
- The Earned Income Tax Credit, the Child Tax Credit and the American Opportunity Tax Credit, all parts of the stimulus plan will be extended.?? This will maintain $40B in the current deficit.
- The President’s business expensing plan is passed.? This breaks down as follows and adds up to $200B to the deficit in the next two years:
1) Accelerate $150 billion in tax cuts to 2 million businesses: 100 percent expensing will accelerate $150 billion in tax cuts to 2 million businesses – providing $200 billion in relief over the next two years when combined with small business expensing and bonus depreciation provisions the President signed into law last month.
2) Lower the average cost of capital for business investment by more than 75 percent: Through temporary 100 percent expensing, Treasury estimates that businesses’ average cost of capital on new investments will fall from 7.18 percent to 1.68 percent – providing an incentive to pursue a broader range of investments through the end of 2011
3) Produce about $50 billion in new investment: Studies of similar tax cuts in the past have found they encouraged businesses to increase targeted investments. Based on the results of one such study, Treasury estimates 100 percent expensing could support $50 billion in new investment, while other outside estimates have projected an even larger impact.
So, in essence, what the plan amounts to is somewhere in the ballpark of $270B in NEW stimulus over two years while mostly maintaining plans that were already in place.? At 0.9% of total GDP per year it’s safe to call this plan small at best.? It’s not going to provide a huge jolt to the economy and much of it could expire after the first year.
All in all, it looks like more political negotiating and jockeying for position in 2012 rather than doing what is in the truly best interests of the American people. This plan has something to infuriate everyone.? It’s too small to satisfy the Keynesians and too big to satisfy the libertarians. It is likely to infuriate the defaultistas, inflationistas and stock market permabears. It will also cause a great deal of fear mongering over the future of social security and how the country will pay for this additional short-fall.
The primary upside here is that we’re not succumbing to the fiscal austerity drumbeat that is dragging countries like Ireland into depression and that’s a good sign.? We’re moving further away from our 1937 moment. Unfortunately, the plan still doesn’t do much for Main Street, but that’s par for the course given the government’s response of the last few years.? So, the mediocre recovery should continue with the hope that some exogenous risk doesn’t cause a hiccup.
]]> http://pragcap.com/further-thoughts-on-the-tax-cuts-2/feed 36 http://pragcap.com/cbo-stimulus-driven-recovery http://pragcap.com/cbo-stimulus-driven-recovery#comments Tue, 07 Dec 2010 00:16:28 +0000 TPC http://pragcap.com/?p=28743 The latest from the non-partisan CBO shows that the stimulus continued to positively impact the economy in 2010:“In ?an updated report on the American Recovery and Reinvestment Act of 2009, the CBO said that the legislation will increase the budget deficit by $814 billion from 2009-2019, compared with an original estimate of $787 billion. “By CBO’s estimate, close to half of that impact occurred in fiscal year 2010, and about 70% of ARRA’s budgetary impact was realized by the close of that fiscal year,” the report said.
The CBO estimates that the expenditures had a big impact on the economy, though the benefits have likely peaked. For the third quarter it says the stimulus added between 1.4 and 4.1 percentage points to growth and reduced the unemployment rate by between 0.8 and two percentage points. The benefits from the stimulus are expected to wane for the rest of this year and through 2011 and 2012.
CBO slightly lowered some of its estimates of the impact of the stimulus from ?a previous report prepared in August. That was mostly due to the timing of expenditures and no amount changed by more than 0.1.”
Some excellent charts from the Center on Budget and Policy Reform puts this all in perspective:
]]> http://pragcap.com/cbo-stimulus-driven-recovery/feed 8http://pragcap.com Wed, 08 Dec 2010 06:35:36 +0000 en hourly 1 http://wordpress.org/?v=3.0.2 http://pragcap.com/goldmans-favorite-asia-trades-for-2011 http://pragcap.com/goldmans-favorite-asia-trades-for-2011#comments Wed, 08 Dec 2010 06:35:36 +0000 TPC http://pragcap.com/?p=29095 If you’re a raging bull on equities you’d be a fool not to consider some exposure to the higher growth region of Asia.? And as a raging bull on equities in 2011 Goldman Sachs has laid out their favorite trades for Asia in the coming year:
1. Our three favorite markets for 2011 are the lowest vol markets globally. KOSPI 200, TWSE, and MSCI Singapore are three of the lowest implied vol markets in the world. On each of these three markets, owning 6-mo 110% upside calls costs less than 2% and is a reasonably easy way to put on long exposure with limited risk. While we have often suggested long AEJ vs. short DM trades, our more positive DM view makes us prefer the simplicity of simply using calls for exposure. Currently 6-mo 110% calls cost 1.75%, 1.71%, and 1.25% on KOSPI2, TWSE, and MSCI Singapore, respectively. Risk is loss of premium.
2. HSCEI vs. SPX 1-year variance is our favorite China inflation hedge, but NKY vs. SPX 1-year variance also carries very well. We believe the three ingredients to a strong derivative trade are (1) A good fundamental story; (2) An attractive entry point; and (3) Historical profitability. The HSCEI vs. SPX 1-year variance trade satisfies all three criteria, as we discussed Thursday in our piece China inflation hedge with positive carry: HSCEI vs. SPX variance. The Nikkei 225 vs. S&P 500 1-year variance pair satisfies two of the three factors, given historical profitability and an attractive entry point, though we have less of a fundamental case relative to the HSCEI vs. SPX pair. Sellers of variance swap risk unlimited loss at expiry;
buyer of variance swaps risk losing var strike^2 / (2 * var strike) at expiry.3. HSCEI and oil correlations have begun to decline with oil prices moving lower and HSCEI moving higher. Two of our macro views for 2011 are high commodity prices and muted returns for emerging markets. On this note, it is interesting to see HSCEI and WTI have begun to de-correlate. Given our view that inflation is a problem for China, the correlation could remain low. Owning puts on HSCEI contingent on oil prices higher plays into this trend. Current 3-mo ATM puts on HSCEI contingent on WTI up 10% cost 1.2%, a 80% discount to ATM vanilla puts. Risk is loss of premium.
4. NKY calls are an inexpensive way to play our global strategists’ top trade to go long Japan. Following this year’s underperformance, we expect NKY to display beta to the improving global industrial cycle. Nikkei calls remain half a standard deviation below their one-year average, and have recently been a profitable way to gain market exposure while keeping risk limited in the case of Japan equities disappointing. For exposure through the Japan fiscal year, NKY Apr-11 105% calls cost just 2.6%. For exposure to our Japan over China view, selling 3-mo 105-115% call spreads on HSCEI fully funds 3-mo NKY 105% calls (Ex 4). Risk is loss of premium.
5. NIFTY puts remain inexpensive and are a preferred hedge. We continue to see NIFTY puts as attractive hedges. The market is expensive in our view, earnings have been revised down for six months in a row, there has been a lot of foreign inflow, and probes by the CBI create additional uncertainty. Feb-10 95% puts cost 1.7%, which we find inexpensive in light of the risks we highlighted in our 2011 Outlook. Risk is loss of premium.
6. Forwards create opportunities. The TWSE vs. NIFTY forward differential provides a “head-start” via divergent strikes for a call vs. call pair trade. Our analysis shows that forwards have very little correlation with future returns. As such, the 10-point differential between the TWSE and NIFTY forwards is an attractive starting point for buyers of TWSE calls and sellers of NIFTY calls. Currently, selling 1-year 115% calls on NIFTY fully funds 1-year 105% calls on TWSE; attractive entry levels in our view for a trade we fundamentally like. Risk is unlimited if NIFTY rises more than 15% and TWSE does not rise more than 5%.
7. Geopolitical risk in Korea? Limited, according to the options market. We believe implied vols remained surprisingly low on KOSPI. Current 3-mo 25-delta put implied vol is just 22 and one of the lowest among major markets globally. While we continue to like Korea fundamentally, short-dated put or put spread hedges appear to be pricing in limited risk following the North Korea tensions, given little rise since the most recent North Korea incident towards the end of November.
Source: Goldman Sachs
]]> http://pragcap.com/goldmans-favorite-asia-trades-for-2011/feed 2 http://pragcap.com/ireland-iceland-and-letting-banks-fail http://pragcap.com/ireland-iceland-and-letting-banks-fail#comments Wed, 08 Dec 2010 06:22:46 +0000 TPC http://pragcap.com/?p=29155 As the crisis in Europe continues to unfold another crisis is slowly coming to an end.? The economy in Iceland has finally started to grow again.? What’s interesting about the two crises is the dramatic difference in the ways they were able to attack their problems.? While both have implemented austerity measures there have been vast differences.? In particular, Ireland, embroiled in the flawed single currency Euro has been unable to devalue their currency while at the same time being forced to succumb to the pressures of foreign bankers.? In Iceland, they have benefited enormously from being able to devalue the Krona.? Finance Minister Steingrimur Sigfusson recently said:“(devaluing the Krona) significantly increased our export business and got us ahead of our competitors which, without a doubt, helped us through this difficulty and continues to drag us along and eventually out.”
In addition, Iceland did not force the public to accept the losses of private bankers.? In a recent Bloomberg interview ólafur Ragnar Grímsson, President of Iceland explained why this was important:
“The difference is that in Iceland we allowed the banks to fail… These were private banks and we didn’t pump money into them in order to keep them going; the state did not shoulder the responsibility of the failed private banks….How far can we ask ordinary people — farmers and fishermen and teachers and doctors and nurses — to shoulder the responsibility of failed private banks….That question, which has been at the core of the Icesave issue, will now be the burning issue in many European countries.”
Tryggvi Herbertsson, an econ professor at the University of Reykjavik described why the two approaches are having dramatically different results:
“That alone (forcing bondholders to take losses) has made for a very different result within the two countries.? Ireland is now over-leveraged (with debt) and their banking system continually weak. The difference in Iceland is that our banking system is clean and once the debt has been written off, we have a healthy banking system but in Ireland the system is broken.
This is the proper process. If you go through a bubble economy and you need to correct it, the answer is not to convert private debt into public debt. Rather it is to restructure the debt to the level of the assets.”
The parallels between Japan/Sweden and the Ireland/Iceland sage are striking.? In the early 90′s Sweden and Japan suffered substantial financial crises following asset bubbles.? In Sweden the banking system was nationalized whereas in Japan they allowed the banks to earn their way out of the crisis.? The results were dramatically different as Sweden recovered quickly and Japan muddled along for years. In Iceland the banks were punished and I believe they have laid the foundation for sustainable long-term growth.
In Ireland they are only just now beginning to confront a crisis that has only grown worse by the day and the newly implemented austerity measures are truly savage.? With no ability to devalue their currency and a necessity to appease foreign bankers it’s difficult to understand how Ireland’s economic woes will end any time soon.? Judging by the unemployed in the two countries it’s safe to say that the results speak for themselves as Iceland begins to put Main Street back to work and Ireland continues to layoff workers:
In January 2009 I called for the USA to go Swedish on the banking system by forming a RTC type unit to force the bondholders to take losses, avoid moral hazard and maintain some semblance of capitalism and an environment where losers lose.? Here we are almost two years later with unemployment at its highs and an economy that can’t seem to get off the ground without more government aid.? Even worse, we have not allowed the excesses in the economy to fully clear.? While the economy is certainly improving in recent months the math still doesn’t add up.? What has changed since before the crisis started?? The problems that caused this crisis in the USA have not been dealt with and you could even make the argument that the losers have been emboldened by the Bernanke Put and a government that thinks capitalism can run smoothly without any losers.? We’ll see how this unfolds in the coming decade.? So far, the results are not good and if Iceland and Sweden are any precedent it’s clear that we made a huge mistake in choosing to save the banks in 2009.
]]> http://pragcap.com/ireland-iceland-and-letting-banks-fail/feed 8 http://pragcap.com/jobs-and-taxes http://pragcap.com/jobs-and-taxes#comments Wed, 08 Dec 2010 02:49:13 +0000 Annaly Capital http://pragcap.com/?p=29149 By Annaly Capital ManagementFor months, Ben Bernanke has been more or less pleading with fiscal policymakers to catch up to him. In his August 27 Jackson Hole speech, he said, “[A] return to strong and stable economic growth will require appropriate and effective responses from economic policymakers across a wide spectrum, as well as from leaders in the private sector. Central bankers alone cannot solve the world’s economic problems.” In his November 4 op-ed in the Washington Post, he said, “The Federal Reserve cannot solve all the economy’s problems on its own. That will take time and the combined efforts of many parties, including the central bank, Congress, the administration, regulators and the private sector.” In his speech in Frankfurt on November 19, he said, “The Federal Reserve is nonpartisan and does not make recommendations regarding specific tax and spending programs. However, in general terms, a fiscal program that combines near-term measures to enhance growth with strong, confidence-inducing steps to reduce longer-term structural deficits would be an important complement to the policies of the Federal Reserve.” And in his “60 Minutes” interview on December 5, he said it again: “We need to pay close attention to the fact that we are recovering now. We don’t want to take actions this year that will affect this year’s spending and this year’s taxes in a way that will hurt the recovery. That’s important.”
With yesterday’s announced agreement on tax cuts and the extension of unemployment benefits, Congress and the Administration are making the first tentative steps in that direction. It is unclear at this point what the impact might be to tax receipts, the deficit and the debt load, but estimates run as high as $800 billion for the package of maintaining the Bush-era tax regime, extending unemployment benefits, offering workers a 2% payroll tax holiday, a one-year increase to a 100% accelerated depreciation benefit for corporations and lowering the estate tax. One thing that is clear, however, as President Obama said repeatedly in his statement, is that the desired effect is to boost jobs (emphasis added):
· “Allowing taxes to go up on all Americans would have raised taxes by $3,000 for a typical American family. And that could cost our economy well over a million jobs.”
· “This agreement would also mean a 2 percent employee payroll tax cut for workers next year — a tax cut that economists across the political spectrum agree is one of the most powerful things we can do to create jobs and boost economic growth.”
· “We will provide incentives for businesses to invest and create jobs by allowing them to completely write off their investments next year.”
· “As for now, I believe this bipartisan plan is the right thing to do.? It’s the right thing to do for jobs.”
· “It’s not perfect, but this compromise… will spur our private sector to create millions of new jobs, and add momentum that our economy badly needs.”
· “And my singular focus over the next year is going to be on how do we continue the momentum of the recovery, how do we make sure that we grow this economy and we create more jobs.”
The transmission of tax cuts to job creation may or may not work. As the graphs below show, there is no visible correlation between tax policy and the unemployment rate and job creation.
We understand that these graphs are simplistic to a fault, but we want to make the point that in fiscal and monetary policy it is all about transmission mechanisms. The idea behind tax strategy is not exactly to create or protect jobs, but to increase aggregate demand, i.e., GDP growth, which is what would cause employers to start hiring again. In the case of this tax compromise, the only aspects of it that seem likely to increase aggregate demand are the reduction in the employee side of the payroll tax and the accelerated depreciation benefit. The biggest slug of it, maintaining the current income tax rates, doesn’t increase aggregate demand at all, it merely avoids decreasing it. Stay tuned.
]]> http://pragcap.com/jobs-and-taxes/feed 1 http://pragcap.com/consumer-credit-expands-in-october http://pragcap.com/consumer-credit-expands-in-october#comments Tue, 07 Dec 2010 20:32:38 +0000 TPC http://pragcap.com/?p=29139 Consumer credit increased $3.4B in October to the best levels since July 2008.? The 1.75% year over year expansion is the second consecutive month of gains.? Revolving credit declined 8.4% for the 26th straight month while non-revolving credit increased 6.8%.? This was driven primarily by new auto loans and student loans.? Has the U.S. consumer stopped de-leveraging?
]]> http://pragcap.com/dont-fight-the-fed/feed 7 http://pragcap.com/do-global-imbalances-lead-to-financial-crises http://pragcap.com/do-global-imbalances-lead-to-financial-crises#comments Tue, 07 Dec 2010 18:31:52 +0000 TPC http://pragcap.com/?p=29131 This new paper from the NBER asks a most pertinent question: do global imbalances lead to financial crises?? They conclude:Since the first cut in the Fed funds rate on September 18, 2007 …
- The S&P 500 has gone from 1,520 to 1,223.
- The unemployment rate has gone from 4.7% to 9.8%.
- Industry capacity utilization rates have gone from 81.5% to below 75%.
- The 10-year note yield has gone from 4.5% to below 3%.
- Housing starts have gone from 1.183 million units to 0.519 million.
- Median real estate values have gone from $210,500 to $170,500.
- Core inflation has gone from 2.1% to 0.6%.
Well done!
“The final prediction part of this paper addressed the question whether widening external imbalances are a signal for policymakers that financial instability risks are building. Our overall result is that,from a policy maker’s perspective, credit growth – not the current account – generates the best predictive signals of impeding financial instability. However,the relation between credit growth and current accounts has grown much tighter in recent decades.In a globalized economy with free capital mobility credit cycles and capital flows have the potential to reinforce each other more strongly then before.The historical data clearly suggest that high rates of credit growth coupled with widening imbalances pose stability risks that policy makers should not ignore.”
If someone could forward this on to the Chinese government the global economy would really appreciate it.
The full paper is attached:
]]> http://pragcap.com/do-global-imbalances-lead-to-financial-crises/feed 2 http://pragcap.com/the-inflation-vs-deflation-debate http://pragcap.com/the-inflation-vs-deflation-debate#comments Tue, 07 Dec 2010 16:23:22 +0000 TPC http://pragcap.com/?p=29125 Peter Schiff, the long-time hyperinflationist, takes on Gary Shilling, the long-time deflationist. I don’t think either quite understands how the monetary system works, but Shilling is much closer to getting it right. In particular, he notes that the Fed does not create money – they only create reserves. This proves that Shilling maintains a key fundamental understanding that Schiff does not. Schiff has been calling for a spike in rates and a collapsing dollar for years on end. He thinks the USA is going bankrupt and that default is right around the corner. Could he have been more wrong? The debate follows:]]> http://pragcap.com/the-inflation-vs-deflation-debate/feed 32 http://pragcap.com/the-three-stages-of-delusion http://pragcap.com/the-three-stages-of-delusion#comments Tue, 07 Dec 2010 07:49:18 +0000 TPC http://pragcap.com/?p=29113 Flashback to Crises Past: Three Stages of Delusion Popular Delusions (via John Mauldin)By Dylan Grice
The recent sequence of reassurances from various eurozone policymakers suggests we are in the early, not latter, stages of the euro crisis. Only an Anglo-Saxon style QE will prevent dissolution of the euro. Such a radically un-German solution will only be taken with a full acceptance of how serious the euro’s problems are. But denial persists.
The dawning of reality hurts. Prodded and bullied along a tortuous emotional path by events unforeseen and beyond our control, we descend through three phases: the first is denial that there is a problem; the second is denial that there is a big problem; the third is denial that the problem was anything to do with us.
US policymakers’ three steps during the housing crash fit the template well. Asked in 2005 about the danger posed to the economy by the housing bubble, Bernanke responded: “I guess I don’t buy your premise. It’s a pretty unlikely possibility. We’ve never had a decline in house prices on a nationwide basis.” Here was the denial that there was a problem. But as sub-prime issues arose, Ben Bernanke reassured the world that they would be “contained.” And when Bear Stearns collapsed, Hank Paulson promised “The worst is likely to be behind us.” Here was denial that there was a big problem.
Soon the financial system was on the brink of collapse. There could no longer be any credible denial of the problem, so the locus of delusions shifted: there was a problem, but it was someone else’s fault. Thus a ban on naked short selling of financials was implemented in Sept/Oct 2008, as though the crisis was somehow short-sellers’ fault. (It certainly wasn’t the Fed’s fault, according to the Fed. Ben Bernanke argued this year “Economists … have found that only a small portion of the increase in house prices … can be attributed to the stance of US monetary policy.”)
What’s interesting is that the journey Bernanke and Co. took fits the journeys of policymakers presiding over crises past very closely, as I’ll show inside. What’s worrying is that taken in this context, eurozone policymakers’ denials/reassurances sound eerily familiar. And if these past crises are any guide, the euro crisis is still in its early stages.
A descent through the three stages of delusion characterises most crises. Dick Fuld went from saying “as long as I live, Lehman will never be sold” in December 2007, to “We have access to Fed funds; we can’t fail now” during the summer of 2008, to agreeing with a colleague that half of any capital injection then being negotiated with the Korean Development Bank be used to buy back Lehman stock, to “hurt Einhorn bad.”
Identical stages can be traced during the Asian Crisis of 1997. For those who don’t recall, the Asian Tigers were ‘miracle’economies whose dizzying growth rates proved the superiority of export liberalisation, high investment and free markets. Their miracle image was burnished by the ‘good crisis’ they enjoyed in 1994, when their fixed exchange rate systems (they were pegged to the dollar) successfully withstood the contagion caused by the collapse of the Mexican peso.
Bear in mind that the world had bought into the Asian Tiger story hook, line, and sinker. The World Bank wrote a now infamous series of reports called “The East Asian Miracle” from 1993, lauding the strength of the region’s institutions and preaching its commitment to an export-driven growth model to anyone who’d listen. And while there was a feeling that some tigers (e.g. Thailand and the Philippines) were riskier than others (Indonesia), the idea that Taiwan or South Korea would be caught up in anything was viewed as utterly preposterous. Early in 1997, Jeffrey Sachs said:
“Since the economic structure of Korea is fundamentally different from that of Mexico, there is no possibility of recurrence of the situation that happened to Mexico.”
But early in 1997, problems emerged. The first sign of trouble came in Korea in January when a large chaebol called Hanbo Steel collapsed under $6bn of debts. Then in February, Thai property company Somprasong Land missed a payment on foreign debt in February. These turned out to be the first cockroaches. The following chart shows the sequence of events which would soon follow. First the small economies fell – then the big ones.
Yet denial that there was any problem characterized early observations. Immediately following the Thai government’s $3.9bn aid to Thai banks to cover dud property loans, Michel Camdessus – then head of the IMF – said, “I don’t see any reason for this crisis to develop further.” And on 30th June that year, Chavalit Yongchaiyudh, then Thai Prime Minister, made a televised address to the nation saying “We will never devalue the baht.”
Yet the baht was floated on 2 July. It was soon followed by the Philippine peso.
But the initial denial that there was a problem simply became denial that there was a big problem. Indonesia wasn’t Thailand, after all. According to an article in the 8th Oct 1997 New York Times:
“Indonesia’s financial condition is far better than Thailand’s was this summer … while Thailand depleted its foreign-currency reserves in a last-ditch effort to prop up its currency, the baht, Indonesia still holds foreign reserves of about $27 billion.”
And as the Indonesian crisis began to intensify and the US made financial help available as a precaution, an Administration official said: “We don’t expect that Indonesia will need to draw on our direct help, but what we need to address here is an atmosphere of contagion.”
As it turned out, Indonesia wasn’t Thailand. It was worse. It would prove to be the worst affected of the Asian tigers with a near 80% exchange rate collapse bankrupting the corporate sector which had borrowed heavily in dollars. GDP collapsed by 14%, triggering unrest and street violence which ultimately forced out President Suharto.
Yet denial that there was a big problem persisted. James Wolfensohn, then president of the World Bank, reassured that the Indonesian bailout marked the end of the crisis: “The worst is over” he proclaimed confidently.
Korea wasn’t Indonesia. Michel Camdessus, said on Nov 6th: “I don’t believe that the situation in South Korea is as alarming as the one in Indonesia a couple of weeks ago.” Yet South Korea turned out to be just as vulnerable, and certainly more costly. On December 1st1997, the government said it had agreed to a $55bn bail-out (which then, was the largest bailout in the history of the world. In today’s money it’s a mere $75bn, less than the bill for Ireland). The storm moved on. Before petering out it would engulf Latin America, then Russia, and then the once mighty hedge fund LTCM. But for now, Asia had been destroyed. The miracle was myth. The depth of the problems was now undeniable.
Yet the denial persisted, only now it emphasised the fault of others to demonstrate that the crisis was in no way related to anything policymakers had done. It was all caused by speculators, international bankers and the foreign media. Most infamous was Malaysia’s then Prime Minister Mahathir Mohamed blaming George Soros, who he bizarrely implied was part of some kind of wider plot. “Today we have seen how easily foreigners deliberately bring down our economy by undermining our currency and stock exchange …” and “Soros is part of a worldwide Jewish conspiracy.”
There’s nothing unusual about the emotional need to find a scapegoat when things go wrong. As always, Shakespeare wrote about it four centuries ago. From King Lear:
“This is the excellent foppery of the world, that, when we are sick in fortune – often the surfeit of our own behaviour – we make guilty of our disasters the sun, the moon, and the stars: as if we were villains by necessity; fools by heavenly compulsion; knaves, thieves, and treachers by spherical predominance; drunkards, liars, and adulterers, by an enforced obedience of planetary influence; and all that we are evil in, by a divine thrusting on: an admirable evasion of whoremaster man, to lay his goatish disposition to the charge of a star!”
And if we’re looking for signposts on the way to a crisis’ closing chapters, it turns out that the “excellent foppery” of blaming everyone else is a good indication. Thus, as the Greek crisis unfolded in December 2009, George Papandreou went from denial of the problem, insisting it to be “out of the question” that Greece would resort to the IMF, to denial that it was the Greeks’ fault, lamenting in March 2010 that “we ourselves were in the last few months the victims of speculators.”
As the Irish crisis reached its conclusion, Finance Minister Brian Lenihan blamed the “unintended consequences” of various German and French comments for its spiralling borrowing costs.
Today Spain is the battlefield. A few weeks ago, the Spanish were in denial that there was a problem. Zapatero said “I believe that the debt crisis affecting Spain, and the eurozone in general, has passed.” Now they are in denial that there is a big problem. Last week, Spanish Finance Minister Elena Salgado said there was “absolutely no risk” the country would need an international bailout and stressed the differences between Spain and Ireland, much as the Indonesians stressed the difference between themselves and the Thais thirteen years ago:
“Our financial sector has always had the Bank of Spain’s supervision and regulation, which is what has probably been missing in Ireland … We have a solid financial sector and we should remember that it’s the financial sector that’s provoking the difficult situation in Ireland.”
When they start blaming everyone else for their problems, we’ll know their crisis is nearly over Until then, their plight likely has some way to go.
But of course, the real issue isn’t Ireland, or Portugal or even Spain. The real crisis is the euro, and the strains continued membership is placing on the relationships between euro members and the attitude of electorates in the member states towards the single currency.
Yet policymakers are as in as much denial that there is a big problem (i.e. with the euro rather than any individual country) as Ben Bernanke and Hank Paulson were that there was a housing bust, as Dick Fuld was that Lehman was toast, or as the IMF was that Thailand, let alone Asia, had profound economic weaknesses. Last week the Finnish Central Bank head and ECB Governor Erkki Liikanen said “The euro will survive. It is not questioned.” Klaus Regling, heading up the EFSF, said “No country will give up the euro of its own will: for weaker countries that would be economic suicide, likewise for the stronger countries. And politically Europe would only have half the value without the euro.”
Such logic has been used before. Barry Eichengreen wrote in 2007 that euro membership was effectively irreversible because withdrawal would be too traumatic. But what if the cost of staying in the euro becomes so high that exit is preferable? Surely this is the risk in Germany’s current strategy.
Peripheral eurozone countries need to default. Traditionally this is done with currency debasement (which the Fed and the BoE have already begun) or by imposing a haircut on lenders. Germany refuses to sanction the former, while flagging up the latter triggered the latest bout of contagion. Instead, they are imposing depressions on countries which lose the bond market’s confidence.
How many years of austerity before the voters of Greece/Ireland/Spain/wherever blame Germany, France, or the euro for everything that is wrong with their economy? Will this become the blame game signalling the final chapter of the euro’s crisis?
I certainly hope not. Last week, Axel Weber said: “The European Financial Stability Fund should be sufficient to dissuade markets from speculating against the solvency of Eurozone member countries, and if not, more money will be provided.”
If and only if that money comes from the ECB’s printing presses – in the style of the BoE and the Fed – will Mr. Weber be correct. A large risk rally will ensue. If not, we still have a long, long way to go. On 27 May this year, following the original set-up of the EFSF, I wrote:
“The EU’s ‘shock and awe’ $1trillion rescue was certainly a big number and reflected European governments going all in. But going all in is risky if you don’t have a strong hand, and the EU’s seems weak. Two-thirds of the rescue money comes from the EU itself, which means that the distressed eurozone borrowers are to be saved by more borrowing by … er … the distressed eurozone borrowers.”
This remains the case. The EFSF is flawed. It invites speculative attack. Simply expanding it in its current form so that the ‘solvent core’ commits to raise yet more funds for the ‘insolvent periphery’ fails to address the risk that as more dominos fall the bailers shrink relative to the bailees (Italy and Spain combined – who’s spreads have been blowing out this week – are combined bigger than Germany). At what point does the insolvent periphery include so many countries that markets lose confidence in the solvency of the shrinking core to bail them out. Leaving aside for now the unpleasant reality that the solvent core might not actually be so solvent, perhaps the spread between ‘insolvent’ Greece and solvent France should be narrower? I wish I knew. In the absence of ECB printing, I suspect we’re going to find out.
The London Brief
Omar Sayed
The Cypriot banking system holds assets that are seven times Cyprus’ GDP.?? While the system is almost one hundred percent deposit funded, over one third of these deposits are foreign, mostly from Greeks trying to hide or protect savings by moving them out of Greek banks.? Cyprus banks hold €5 billion of Greek government bonds.? If the bonds received a 30% haircut, the banks Tier I capital would be gone.? Most of the Cyprus bank loan books are to Greeks and non-performing loans are edging sharply upward as a result of the austerity programs.
Cyprus’ GDP is only $25 billion, a drop in the fiat money printing ocean.? But it’s indicative of a major problem governments don’t have the tools to solve: volatile and sudden capital flows.?? Greeks worry about their banking system and rapidly transfer deposits to Cyprus creating a banking system that is larger than the state’s ability to support in a crisis.? Then as a shock hits the banking system, the capital flows violently flow somewhere else creating a new banking crisis.
European Crisis
An unidentified banker in the Financial Times said, “The ECB needs to use the bazooka option to lift sentiment in a lasting way.? That is the only way to stop this crisis from spreading.? We had a good day today, but yields are only coming down because the ECB is buying.? It has got to continue doing so and in size.”? Considering many of the banks are the ones selling sovereign bonds to the ECB for profit, I can understand the banker’s sentiment.? But is ECB bond purchases a real solution?
CDS trading in Irish debt saw opening prints compress with the five year CDS trading at 275/295 and the ten year at 215/235.?? Within minutes they were back trading 575/595 and 515/535 respectively.?? A few hours later, they were flat to Friday’s close and Portugal was widening.? It wasn’t until later in the week when the ECB stepped in with €100 million per clip in Irish and Portuguese bond purchases that spreads narrowed.
The market realizes the European sovereign crisis is still not solved.? There is wide sentiment that the EU may disintegrate and the euro is a short.
Yet European disintegration is practically unfeasible.? For instance, if Ireland were to pull out of the euro, they would have to force conversion on depositors so that bank assets could match liabilities.? Ireland would have to reintroduce capital controls to prevent people from sending their money overseas.? They might even have to restrict foreign travel or check briefcases at the airports.? There would be caps on bank withdrawals.
It would be a nightmare for Germany too.? Germany’s exporters would instantly lose competitiveness and customers.? Germany is the EU’s largest creditor and it would see its investments outside Germany sharply decline in value.? Monetary policy would be in disarray.? German banks and pension funds would be in trouble.
So in order to preserve this unholy union, what options does the EU have??? I see four: (1) the Marshall Plan II; (2) the Treaty of Versailles II; (3) the printing press option and (4) the Icelandic option.? Each has its challenges and problems.
The first option is the most politically sensitive, but potentially the most effective.? Currently the EU’s program can support Portugal, Greece and Ireland, but is too small for Spain and Italy.? Under this option, the EU boosts the size of the rescue fund or turns it into an asset buying program where they buy sovereign bonds.? The EU can also float its own euro-bonds for the periphery or make guarantees that periphery debt is EU debt.? They can cut interest on loans to help states better balance budgets.? The EU could also lighten up on austerity and take a more active role in fiscal programs and auditing.? Then focus on fixing the periphery’s lack of export competitiveness.? The EU is sitting on billions of unspent redevelopment funds that could be channelled into projects.? For instance, Greece has certain off-shore power projects that could provide energy for the whole EU but also jobs for Greeks.? Port redevelopment is a major growth initiative from goods coming from the Middle East and Africa.? The rigidities in the Greek system that make it more expensive to move goods around internally than externally could be reformed under a crisis pretext.?? Companies like Siemens could be incentivized to build a factory in Portugal or Ireland.? The idea is that rather than make periphery nations deflate, you help them grow and pay their way out of debt.
Political sentiment in Germany in favour of this option is changing because the country is having a good crisis.? GDP grew by 3.5% this year and is expected to grow 2% in 2011.? Retail sales jumped 2.3% in October suggesting rising domestic demand.? Half of Germans now support the Greek bail-out according to an Economist poll versus 20 per cent in April.
For EU integrationists, this could be a dream come true, a way to homogenize fiscal accounts and assume greater EU sovereignty over individual states.
The challenges though are execution, the willingness of states to allow the EU to assume fiscal responsibilities, the willingness of northern Europeans to make rival nations more competitive and implementing projects that would take many years before seeing results.
Currently, the EU is adopting the Treaty of Versailles II option.? This option entails an internal devaluation or lowering wages to regain export competitiveness.? However, this doesn’t work because you are not making capital cheaper.?? Debt to GDP gets larger until a frustrated Irish or Greek public elect politicians to take actions to break their slavery through default.
The third option is to get the ECB to keep buying sovereign bonds while the EU works on a way to help Ireland, Greece and Portugal balance their budget so they don’t need to issue more bonds.? The ECB can keep monetizing the debt and hope the problem gradually goes away.? The problem is that Spain and potentially Italy are deflating; therefore the problem will not go away.? Also the euro would decline leading to the potential for significant inflation.?? My commodity basket is pushing its highs.? At some point debt monetization becomes suicidal.
Finally, there is the Icelandic option.? This involves restructuring the debt and making bond-holders share losses.? Already there are discussions taking place about a managed default where deposits and payment systems would be transported into a “good bank”.? Bank loan books would be excised and the bank would be infused with new capital through “bail-in” procedures, where bond-holders receive equity.?? A mechanism would be necessary to manage cross-border banks.? Such a program would trigger an instant sell-off in other nations such as Spain, Italy and Belgium and potentially force debt restructurings there too (the contagion effect).? Also the losses from such restructurings could end up creating a Lehman like effect through the shadow banking system, which still exists and is difficult to measure.? This strikes me as the second best solution if a Marshall Plan option is unfeasible.
The Marshall Plan II is quite possible given the IMF’s (ie – America) willingness to give more money to help Europe.? But I am doubtful that this is the path that is chosen.? Many northern Europeans have adopted the same approach as the French and British did after World War I and want to make the periphery suffer in a bout of self righteousness.? I can understand the sentiment and it can be done to a limited extent, but they will force the people to rebel against austerity.? At that point, the whole experiment unravels.? If the EU wants its venture to succeed, they have to think growth and restructuring, not austerity.
(Courtesy of John Mauldin)
]]> http://pragcap.com/the-three-stages-of-delusion/feed 5 http://pragcap.com/further-thoughts-on-the-tax-cuts-2 http://pragcap.com/further-thoughts-on-the-tax-cuts-2#comments Tue, 07 Dec 2010 07:28:40 +0000 TPC http://pragcap.com/?p=29115 The Obama tax cut plan appears less meaty than the $900B in deficit addition that is advertised.? It essentially keeps plans in place rather than adding substantively to the recovery.? All in all, the plan seems to rhyme with the Obama presidency – providing big hopes and coming up well short.? Talk about speaking loudly and carrying a small stick…..The plan breaks down approximately as follows:- The payroll tax cut is the only part of the plan that the President appears to have negotiated ardently for.? This portion of the cut is a reduction in social security taxes to 4.2% from 6.2% in 2011.? This would generate an additional 2% for employed workers.? Total deficit addition: $120B.
- The Making Work Pay tax, part of the original stimulus plan, will not be extended.? This will reduce the deficit by $60B a year.
- Unemployment benefits will be extended for 13 months maintaining $56B in the deficit.
- The Bush tax cuts will be extended for two years with a provision protecting estates under $5MM from the estate tax.? The tax rate on qualifying estates will be 35%.? This is projected to add less than $10B to the deficit.
- The Earned Income Tax Credit, the Child Tax Credit and the American Opportunity Tax Credit, all parts of the stimulus plan will be extended.?? This will maintain $40B in the current deficit.
- The President’s business expensing plan is passed.? This breaks down as follows and adds up to $200B to the deficit in the next two years:
1) Accelerate $150 billion in tax cuts to 2 million businesses: 100 percent expensing will accelerate $150 billion in tax cuts to 2 million businesses – providing $200 billion in relief over the next two years when combined with small business expensing and bonus depreciation provisions the President signed into law last month.
2) Lower the average cost of capital for business investment by more than 75 percent: Through temporary 100 percent expensing, Treasury estimates that businesses’ average cost of capital on new investments will fall from 7.18 percent to 1.68 percent – providing an incentive to pursue a broader range of investments through the end of 2011
3) Produce about $50 billion in new investment: Studies of similar tax cuts in the past have found they encouraged businesses to increase targeted investments. Based on the results of one such study, Treasury estimates 100 percent expensing could support $50 billion in new investment, while other outside estimates have projected an even larger impact.
So, in essence, what the plan amounts to is somewhere in the ballpark of $270B in NEW stimulus over two years while mostly maintaining plans that were already in place.? At 0.9% of total GDP per year it’s safe to call this plan small at best.? It’s not going to provide a huge jolt to the economy and much of it could expire after the first year.
All in all, it looks like more political negotiating and jockeying for position in 2012 rather than doing what is in the truly best interests of the American people. This plan has something to infuriate everyone.? It’s too small to satisfy the Keynesians and too big to satisfy the libertarians. It is likely to infuriate the defaultistas, inflationistas and stock market permabears. It will also cause a great deal of fear mongering over the future of social security and how the country will pay for this additional short-fall.
The primary upside here is that we’re not succumbing to the fiscal austerity drumbeat that is dragging countries like Ireland into depression and that’s a good sign.? We’re moving further away from our 1937 moment. Unfortunately, the plan still doesn’t do much for Main Street, but that’s par for the course given the government’s response of the last few years.? So, the mediocre recovery should continue with the hope that some exogenous risk doesn’t cause a hiccup.
]]> http://pragcap.com/further-thoughts-on-the-tax-cuts-2/feed 36 http://pragcap.com/cbo-stimulus-driven-recovery http://pragcap.com/cbo-stimulus-driven-recovery#comments Tue, 07 Dec 2010 00:16:28 +0000 TPC http://pragcap.com/?p=28743 The latest from the non-partisan CBO shows that the stimulus continued to positively impact the economy in 2010:“In ?an updated report on the American Recovery and Reinvestment Act of 2009, the CBO said that the legislation will increase the budget deficit by $814 billion from 2009-2019, compared with an original estimate of $787 billion. “By CBO’s estimate, close to half of that impact occurred in fiscal year 2010, and about 70% of ARRA’s budgetary impact was realized by the close of that fiscal year,” the report said.
The CBO estimates that the expenditures had a big impact on the economy, though the benefits have likely peaked. For the third quarter it says the stimulus added between 1.4 and 4.1 percentage points to growth and reduced the unemployment rate by between 0.8 and two percentage points. The benefits from the stimulus are expected to wane for the rest of this year and through 2011 and 2012.
CBO slightly lowered some of its estimates of the impact of the stimulus from ?a previous report prepared in August. That was mostly due to the timing of expenditures and no amount changed by more than 0.1.”
Some excellent charts from the Center on Budget and Policy Reform puts this all in perspective:
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