All for one and none for all

Reciprocity is vital for harmonious relations between countries, yet it rarely happens. One glaring recent example of a lack of reciprocity is India’s retrospective imposition of capital gains tax on foreign companies overturning 50 years of practise and several supreme court judgements. Contrast this xenophobia and capriciousness with the UK’s willingness to allow Indian companies to buy significant parts of the UK’s industrial sector without penalties.

This sort of behaviour happens all the time in the area of trade and is part of the rough and tumble of global commerce. More serious, is a lack of reciprocity in legally binding supranational entities. The inability to achieve remedies through unilateral actions becomes a cancer to harmonious relationships.

When the history of the eurozone comes to be written in a few years time, one of the key roots of its failure will be the lack of reciprocity between Germany and the periphery. I cannot see how this won’t lead to a huge political rupture at some juncture.

At the beginning of the eurozone, Germany entered with an overvalued exchange rate. As we all know, Germany undertook a significant restructuring of its industrial base, improving labour competitiveness in the first 6–7 years of the euro’s life. This restructuring was not achieved in isolation. It was helped considerably by two interlinked factors.

Firstly, for many countries, especially the periphery, interest rates fell to levels not seen for at least a generation. Not surprisingly, this set off an economic boom which produced high levels of capital expenditure, property investment and surging trade deficits. The weakness of German domestic demand was offset for German corporates by the strength of demand in most of the rest of the eurozone.

The second interlinked factor was that inflation in the periphery was significantly higher than in Germany, enabling Germany to regain labour price competitiveness simply by allowing competitor wages rages to rise more quickly than its own. Unfortunately for the periphery, productivity did not rise rapidly enough to compensated for wage inflation, so competitiveness, both in a European and a global context was eroded. If countries had retained their own currencies, then exchange rates would have moved to accommodate these changes in relative prices, as they have for the UK, which shared many of the same features as the eurozone periphery.

Not only was the lack of currency flexibility an issue, but the “one size fits all” interest rate policy of the ECB turned out to be a “one size fits none” policy. Rates were too low for the booming periphery. While they might have been somewhat high for Germany, differential inflation and strong export demand eased the burden.

So we can characterise the history of the first 7–8 years of the eurozone as one where the imbalance of starting exchange rates were worked out by excessive demand growth and high inflation in the periphery helping Germany in its adjustment of lowering its relative wage costs. This process had largely run its course by 2007/8. Indeed, the global financial crisis revealed that Germany had become very competitive in both a European and global context.

Marching forward to 2010/12, we now see that the role of Germany should be reversed. For the periphery to regain competitiveness, it needs Germany to have strong domestic demand, a property boom, higher inflation and to run a trade deficit with the rest of the eurozone. This would reciprocate the boom conditions that prevailed in the periphery that allowed Germany to restructure relatively painlessly. Instead we see a growing reluctance to accept the flip side of the benefits that Germany has enjoyed in the euro system.

It seems that Germany was very happy to allow the “profligacy” of the periphery to benefit the German economy as it was going through its transition, but now that the boot is on the other foot, it will not allow stronger domestic demand, higher inflation or higher imports to help the periphery trade its way out of its problems. “All for one but none for all” when it comes to  Germany’s turn to reciprocate.

In fact, it gets even worse. Instead of leaving things as they are, German policy is now gearing up to prevent any boom in Germany from developing. We already have the debt brake in the constitution, but now other measures are being enacted specifically to dampen any rise in property prices and growth in consumer credit. With a friend like this, who needs enemies?

In one sense, I don’t blame the Germans for looking at the shambles that the credit boom produced in Spain an Ireland and wanting to prevent a recurrence in Germany. However, Germany accepted the benefits, now it should take some responsibility. Unfortunately, the domestic narrative in Germany appears to be one of German virtuosity and periphery profligacy. The unwillingness to acknowledge the role played by the boom in the periphery in helping Germany in the early difficult years of the eurozone is a significant block to a rational policy mix to enable the eurozone to survive.

Not only are German politicians in denial over economic history, they are also in denial over basic economic reality. Unsurprisingly, Germans want the debts run up by the periphery to be repaid. What they don’t seem to grasp is that the only way that this can be achieved is through Germany running a trade deficit with those countries. It’s not an economic theory, it’s a simple accounting fact.

In the end, the Achilles heel of the eurozone and the broader European project is the denial that sovereign states, when push comes to shove, will act in their own interests. Altruism is in short supply in international relations.

The eurozone is not dead yet, but the fundamental inconsistencies and paradoxes have yet to be solved. Germany’s actions suggest they are insoluble. For the eurozone to work, Germany needs to act in an altruistic manner which appears impossible given the domestic political background. LTRO has bought time for the politicians to come up with a solution, but it has also produced a deadline and a mechanism for the breakup of the euro.

The deadline will come in two years time when markets start to factor in a refinancing of the LTRO largesse. The mechanism for breakup is that the LTRO is producing the re-domestication of sovereign debt. Spanish and Italian banks are loading up on domestic sovereign debt, playing the carry trade. As current debt matures and is refinanced through the domestic banking system, there will be a natural unscrambling of assets within the eurozone. The asset side of bank balance sheets will become increasingly domestic. If this process continues, then the eventual splitting of the eurozone will be much easier.

Like Mark Twain’s death, the demise of the eurozone has been prematurely reported on a number of occasions. Because commentators have cried “wolf” on many occasions doesn’t mean that one day the wolf will not appear.

Animal spirits

Source: Zero Hedge

There are definitely signs that animal spirits are returning. Earlier in the week, the VIX made a five-year low. When you think about the levels of fear in markets back in October, it’s a remarkable recovery. A lot of people, myself included, underestimated the impact of  the ECB’s LTRO. By backstopping the funding requirements of the Eurozone’s banks for a couple of years, the ECB has removed the immediate threat of more Dexia type liquidity/solvency crises for a while. It’s open to question as to how long this palliative will last, especially as Germany is getting more vociferous in its opposition to further tranches of central banks funding.

Source: Zero Hedge

This has all been a pleasant surprise to investors, but an excessively low VIX is also a warning. The chart above illustrates that it can be a precursor to a sharp rise in volatility and a fall in the equity market. Equally, however, there can be extended periods of quiescent volatility. It seems to me that economic indicators may supply support to markets for a while longer. In the US recovery does seem to be gaining some traction and the resumption of borrowing by the economy overall is a sign of returning confidence. I think it’s also likely that eurozone indicators could surprise on the upside, now that the immediate crisis has been dampened down.

Source: Global Economic Trend Analysis

Bond yields in the US have started to rise. If banks really are cashing out on their profits from Operation Twist, then the money will flow back into the real economy, unless the Fed decide to start unwinding its balance sheet. I would be really surprised if the Fed started selling assets back into the market to extinguish bank reserves, so it seems likely that any rise in bond yields, as long as it is modest, will bring a stimulus to economic activity and should be welcomed.

The gazillion dollar question for the Fed is whether the money multiplier comes back into play. If banks start to multiply aggressively reserves held at the Fed, it will be presented with a huge policy dilemma. However, I think it unlikely that this will happen. The recent stress tests show that a number of banks are somewhat borderline, despite only four failing. The announcement that JPM is raising its dividend and buying back stock, suggests that banks are not about to apply aggressively capital or reserves to lending.

One little aside is that Mr Dimon must have mightily upset the Fed with his arrogant pre-empting of the results of the stress test. To me it seems like a pretty foolish move to antagonise your regulator needlessly. Dimon has put JPM in a potentially perilous position if it ever needs favours from the Fed. One reason why Bear Stearns was allowed to go under was long memories from its intransigence on the LTCM rescue. Remember hubris, Mr Dimon.

US deleveraging over?

This chart from Zero Hedge caught me completely by surprise. According to the Federal Reserve Flow of Funds report, the US economy is beginning to borrow again across all sectors. Wow, that’s big news and if it follows through, changes the game. The US can become an engine of world growth again and it should help ease the eurozone crisis.

However, I’m suspicious that this trend can last for any length of time. Firstly, it suggests that the US current account will start deteriorating again. This makes any growth phase self-limiting, although deregulation of the capital account in China could change that somewhat gloomy prognostication.

The second issue is that the US has to grasp the fiscal consolidation nettle. Obviously, if the private sector is borrowing again, fiscal consolidation is easier without destroying growth. However, aggressive consolidation might tip the private sector back into a more balance sheet strengthening mode, so there’s a delicate balancing act to achieve.

The third observation is that if the private sector is borrowing again, then monetary policy will need to change. The Fed will not need to indulge in QE3, indeed it will have to wind down its balance sheet. Also, if the money multiplier kicks in, the Fed will have to be aggressive in withdrawing monetary support if it wishes to avoid an inflationary pulse. This might become a huge dilemma for the Fed as it may have to reverse its recent pledge of keeping interest rates low to late 2014.

Potentially this is very concerning for bond investors as interest rates may have to rise, potentially wrong footing investors who are playing the yield curve. If the inflationary psyche changes from one of benign inflation or deflation to one of rising inflation, there will be carnage in bond markets, given the current low level of yields.

Rising bond yields would be negative for equities, but even more so would be a rising liquidity requirement from the non-financial economy implied by rising borrowing. All asset markets, but especially risk asset markets, have benefited from abundant central bank liquidity creation which has been soaked up by asset markets, driving prices higher. The lack of demand from the non-financial economy has meant that one way or another this liquidity has found its way to asset markets.

If the non-financial sector begins to borrow again, then asset markets could find themselves squeezed by the liquidity demand from the non-financial sector on the one hand and the removal of central bank (i.e. the Federal Reserve) accommodation on the other. Given that bonds are richly valued and that equities are at or near the top of the profit margin cycle, any market sell off could be very painful indeed.

I’m not sure that even gold could sit out the next downturn. As a zero income asset, if funding becomes tighter, then, presumably marginal holders will get shaken out. Who knows what leveraged structures there are in the gold market with derivatives and ETFs. The one thing you can be sure of is that long bull markets produce complacency and over leverage.

In the short-term,especially the run up to the US presidential elections, markets may be benign as growth pleasantly surprises on the upside in the US. Perhaps there will also be a calmer period in the eurozone as banks and governments get drunk on the LTRO. My feeling is that as we get to autumn time, the prospect of fiscal retrenchment in the US, together with inflationary and monetary strains, and a possible further round of problems in the eurozone, investors will get a cold shower.

All this assumes that there is no blow up in Iran or a re-run of the Greek farce in Portugal. Hey-ho, every silver lining seems to have a cloud.

National income and savings explained

I can’t imagine that any eurocrats or  German politicians read this blog, but just in case, I want to explain some really simple economics regarding national income, savings, investment and the trade balance.

In a closed economy, national income (GDP) is defined as:

Y=C+I+G

where Y=GDP, C=consumption, I=investment and G=government spending.

If we rearrange this formula to give us investment:

I=Y-C-G

In a closed economy, any money left over from consumption is deemed savings (S), hence,

S=Y-C-G

From these two equations, we can see that investment and savings must equal each other, i.e.

I=S

However, this model leaves out the trade account. In an open economy, we must add the trade balance or net exports (NX).

Y=C+I+G+NX

Rearranging this formula, Y-C-G=I+NX. We also know that S=Y-C-G. From this we can deduce that S=I+NX.

Again rearranging this formula we get  S-I=NX (or X-M, where X is exports and M is imports). Even more simplistically, net national savings equals the trade balance.

If we define the repayment of debt as the excess of savings over investment, then by definition the economy must run a trade surplus to pay down debt. If a creditor economy wants its loans to be repayed, then it has to run a trade deficit.

Will someone please explain this to Ms Merkel, Mr Schäuble and the buffoons in Brussels?

The eurozone is at war with double-entry bookkeeping

Sometimes you come across a brilliant description of a situation in the press. Martin Wolf sums up the eurocrats perfectly in today’s FT by writing that “The eurozone is at war with double-entry bookkeeping”. How many times must it be said: “for every surplus, there must be a deficit and for every creditor, there must be a debtor”? As I have said before, it’s not an economic theory, it’s an economic fact. I’m backing the double entry bookkeeping system to beat the eurocrats.

At the next ECOFIN meeting, someone needs to have the temerity to ask Ms Merkel how the periphery can reduce its government indebtedness without Germany running a trade deficit. Perhaps the Spanish will, having found the courage to face down the EU on its budget deficit. Someone has to.

Exactly

Barry Ritholtz on the great Credit Default Swap swindle.

The 2012 Chocolate Fireguard Award?

The financial industry has a long an inglorious history of selling products that are about as useful as a chocolate fireguard. The financial and economic system was brought to its knees by Collateralised Debt Obligations where triple A promises turned out to be worth little more than those attached to Zimbabwean government bonds. We’ve also seen the scam of Payment Protection Insurance which was not only sold to people who couldn’t claim payments but even if they did qualify, the conditions were so onerous and arcane, that many couldn’t receive benefits. At least in the last case, massive fines and compensation has been levied on the banks that sold the product.

Are Credit Default Swaps going to win the Chocolate Fireguard Award of 2012? The decision by the ISDA that the Greek “voluntary” restructuring is not a credit event beggars belief. Firstly, private sector debt holders have been unilaterally (probably illegally) subordinated by the ECB. To rub salt into the wound, they’ve had collective action clauses retroactively imposed on them.

I see the lawyers have been crawling all over the wording of Greek CDS contracts to see if the writers can wriggle out of their obligations. The ISDA determinations committee is riddled with conflicts of interest. It’s ironic that Bill Gross has criticised the decision but PIMCO are on the committee that agreed that a credit event hasn’t been triggered. These guys have no shame. Common sense says that bond holders have been forced to take a substantial write-down on the value of their bonds through the actions of the Greek government and the EU. Surely their insurance cover should be triggered on the orignal principal, not the value of the exchanged bond.

I have a nasty feeling that the CDS market is being manipulated and gerrymandered by the all-powerful investment banks. While they can well afford the payouts on Greek debt, they must be scared witless about the potential payouts on Italian and Spanish debt. Why not set a precedent through the Greek restructuring that reduces if not eliminates their liabilities? It’s a scandal that the precedents for payouts can be set by a committee of mainly banks that would benefit enormously from establishing a precedent from the Greek “restructuring”. Yet again we see the financial industry selling customers a product that claims to be one thing and when it comes to crystallising value, turns out to worth substantially less or virtually worthless.

Potentially, this is going to have huge implications. Faith in the Credit Default Swap market will be severely damaged, possibly irreparably. Clients are going to be much more reticent about buying CDS. In the short-term writers of CDS will benefit as the value of protection falls. Could this be part of the strategy of the large banks? Will they buy back and cancel the protection that they’ve written? It could be the biggest bear closing trade of all time.

Secondly, hedging is going to be a lot more difficult, so punters are going to be a lot more cautious about buying less than pristine debt. In the below A grade debt markets this is going to mean higher yields and less demand. You also have to wonder whether investors will want to buy certain classes of sovereign debt, given that the rules of the game can be retrospectively changed.

Thirdly, there has to be some significant valuation issues. Hitherto, CDS hedges have been “perfect”, i.e. models have assumed that CDS contracts will fully offset defaults. If this is no longer the case and a risk discount of non or partial payment has to be built-in, then there’s going to have to be some significant write-downs in the value of CDS holdings. My bet is that this will be a negative for most investment funds, insurers and small banks. Large banks may be a net beneficiary.

If I were a holder of a Greek CDS, I’d be spitting blood now. I suspect there will be some kind of partial payout in the end, but trust in the CDS market and the sanctity of contracts may have been fatally wounded. As I pointed out yesterday, financial markets and economies cannot operate efficiently without trust. Perhaps my Chocolate Fireguard of the Decade award should go to the all-powerful investment banks who have utterly corrupted the financial system.

Where are we now?

It’s been just over two weeks from my last post. At lunch, I was asked why I hadn’t posted much recently. Quite frankly, it’s difficult to add much to what I have already written. The fundamentals of the eurozone are little changed. As I mentioned last time, the LTRO has injected a huge amount of liquidity and taken away the near term liquidity risk in Eurozone banks. The chances of another Dexia type incident in the short-term are remote. The longer term solvency issues remain in place and the Eurozone banks are wading deeper into the sovereign bond risk mire. The ECB might say that banks need to wean themselves off central bank funding but the LTRO does the exact opposite. In 18 months time the market will start to get twitchy again. However, the bankers are handing over the problem to the politicians. The problem is now so large, to allow defaults will cause a catastrophic implosion.

Unlike ZeroHedge, I’m not whingeing. Governments and central banks do whatever they do. It may not be fair or necessarily the correct policy, but they are the house in the capital markets casino. Asset markets are enjoying being goosed by the liquidity rush. The real economy is not going to use it, so asset prices rise. Lie back and enjoy it while it lasts. How long will it last? It could go on for some while.

Something that increasingly concerns me is the way that trust is being abused. The latest example is the ISDA’s declaration today that the Greece restructuring is not a credit event. How can this be? The ECB (possibly illegally) ensures that the Greek debt it holds has seniority. Collective action clauses are inserted retroactively. Private sector bond holders will have to take substantial write downs on the values of the bonds they hold. HOW CAN THIS NOT BE A CREDIT EVENT? The only answer can be the committee of the ISDA who decide. It is rammed full of conflicted parties, mainly large banks who have written CDS contracts. Unless they change their decision, the conclusion has to be that CDS contracts are worthless.

Quite frankly, this is only the latest example of how trust is being destroyed in financial markets:

• The disappearance of client funds at MF Global despite the requirement to segregate them, coupled with the conflict of interest that JPM had in the affair.
• The US mortgage settlement, which looks like a stitch up by the banks at the expense of the US taxpayer, mortgage bond holders and mortgagees.
• The transfer of a huge derivative portfolio by Bank of America into a corporate entity insured by the FDIC.
• The back door funding of Eurozone governments through he LTRO.
• High frequency traders placing their computers next to exchanges to get in first on orders and their tactic of order stuffing.
• ETF Funds stuffed full of derivatives not underlying securities, claiming to be index trackers.
• Bank managements awarding themselves huge bonuses at the expense of shareholders and the tax paying public.

Those are just a handful of examples. I could go on but you get the picture. The word credit is derived from the Latin word to believe or trust. Capital markets, indeed economies need participants to trust each other, otherwise transaction costs rise, liquidity falls and markets become less efficient. I’m old enough to remember the old Stock Exchange motto “my word is my bond”. Those days are long gone. Who can be trusted these days? Where are we now? I actually think markets and investors are completely lost. It’s not just the policies, it’s the ethics.