Posted on October 19th, 2012

European defaults on Sovereign Debt may trigger Double – Digit Global Inflation

The European crisis used to be called the European sovereign debt crisis. Later on, it was referred to as the European banking crisis. Finally, it winds up being just the European crisis. Is there a difference? Not really. Experience in Japan, the US, Ireland, Spain and numerous other countries reveals what ought to have been clear: no developed economy can afford to have one of its large banks go under and when the risk is severe,  the local government (including the central bank) is forced to take over the ailing bank and/or back its liabilities. And vice versa, when the government cannot find buyers for its debt, the local banks will buy it, because if the government reneges on its debt, so will the local banks who normally own much of the existing government debt. Of course if the government and the banks go bankrupt, so will the whole economy.
These facts are best demonstrated by the evolving story of Spain. At present, nobody would buy Spanish government debt except for domestic banks or an occasional large speculator who thinks he is buying these bonds cheap and will eventually be able to sell them (directly or indirectly) to the ECB. After all didn’t the president of the ECB, Mario Draghi, say he will do everything necessary to support the EMU? And didn’t the EU summit decide that the ECB will buy any amount of Spanish government debt necessary to support their prices. And wasn’t the only precondition that Spain will ask for aid (and by the way also sign a memorandum transferring the power to run fiscal policy to Germany)?
Meantime, only a slight delay. German finance minister, Schauble, said he does not believe the Bundestag will approve this aid to Spain so soon after € 100 billion was allocated to support the Spanish banks. But there could be another slight problem. If the Germans are worried about a `measly`  € 100 billion, what will they say when they find out that the ECB has to finance all the maturing Spanish and Italian debt plus their budget deficits, over 3 years, a total of € 3 trillion or more? Yes, the IMF, Japan and even China may possibly come to the rescue – provided they miscalculate the amount involved. But they all, including Germany, the Dutch and other smaller economics cannot shoulder this task.
Shortly, when all of this becomes clear, what else will follow? The Spaniards may revolt when they see the punishment the Germans have in store for them, but assume for the moment that they are so demoralized already that they will not go to the streets. And assume also that that applies to the Italians and the Greeks (and the Cypriots) too. To be optimistic, assume also that Catalonia does not secede so fast from Spain. And in the same  optimistic vein, assume that not all holders of Spanish and Italian debt with up to 3 years to maturity will line up to sell it to the ECB. And that Chancellor Merkel survives all of this for a while. So the ECB will only be called upon to buy several hundreds of billions in the next few months, and so it does. The money paid for Italian and Spanish debt will of course flood Europe, including Italian and Spanish banks and French and German banks that own Italian and Spanish debt. And the ECB may be called upon to bail out the latter group of banks too if they own obligations other than short- term soverign debt.

This flood of newly created money will come on top of € 1 trillion in “liquidity” the ECB already injected several months ago and a few hundred billions injected into or now expected by the Spanish banks and in the support programs for Greece, Portugal, Ireland and Cyprus. But given the size of the needed aid for Spain and Italy, it is likely that all of this will not suffice and the Eurozone will eventually have to be taken apart.
Meantime, the Fed has engaged in money (reserve) creation on an enormous scale as well. Its balance sheet has increased 200% in the last 4 years. And since the banks were not able to use all of the reserves they accumulated, their excess reserves grew to $1.5 trillion. China actually increased its money supply much faster.
Eventually Germany will have to  decide that the burden of keeping the euro intact is too heavy whether before or after funneling a few more hundred billions of euros into the weak Eurozone economies .  When it comes, the decision may be made by the Bundestag, by Merkel, by the courts or by the general public. (This decision reportedly has already been made by the Bundesbank). As it stands now, Spain will soon after that default on its obligations, followed in short order by Italy and probably by France. Investors the world over will re-learn that government obligations are not “risk free”, and neither are bank obligations. But there is no reason to believe that this lesson will be confined to Europe. Investors (savers) in Japan may finally conclude that their government obligations are too large to be safe, and investors in US federal debt securities may soon reach the conclusion that these obligations are increasing too fast for comfort. Finally, China which holds all these obligations in huge quantities may be hurt too.
Obviously, there is a big difference between the Eurozone members who can’t each just print more Euros on their own and the US, for example,  that has been doing just that (in US. dollars, of course) big time in recent years. Therefore the process in the US will be different. As people lose confidence in government obligations they will naturally also lose trust in those little government pieces of paper (or plastic, or book entry) called money.  After all they are only different from bonds in that they say “In God We Trust” and other interesting imprints. As investors lose confidence in government paper and rush for real assets such as real estate or gold or even stocks that represent some real income stream, inflation will start rising.
The inflation foreseen here is not the type of “cost push” or “demand pull” that the US experienced in the 1970’s. Rather, it is more akin to the hyperinflation experienced by Germany in the early twenties in that it is caused by loss of confidence in government obligations. It is unlikely to reach anywhere near the levels seen then, but could reach levels not even imagined by most analysts, let alone being reflected in the markets.
In some respects the risk of inflation now is even harder to fight than it was in Germany. First, its nature is global. So much so that it is not even possible to tell where it will develop earlier. Second, some governments and central banks are actually trying to boost inflation intentionally for various reasons. These include Germany, Japan and the US. Finally the speed at which it could develop and ratchet around the globe may make it intractable.
All of this does not have to happen but it will take a lot of ingenuity and flexibility on the part of several major decision makers to avoid it. Some, like Merkel, Draghi, Bernanke and others would have to reverse policies. And the chances of that are slim at best.
The writer is Chief Economist and strategist of 4L Macro Opportunities SP


Posted on June 5th, 2012


Those of us who nearly 14 years ago foresaw that the euro would eventually have to be taken apart have had to endure several years of cynical comments. Even now, however, we cannot breathe a sigh of relief, because the economic well-being of the world depends on it being done immediately and in an organized manner. And the chances of that are slim.
The inherent flaw in the construction of the euro is now plainly visible to most observers: it is not possible to construct a uniform monetary policy for all members each with a separate and diverse fiscal policy. A uniform fiscal policy is not only those items Germany was pushing for in the “fiscal compact” but also a re-distribution of wealth from the strong economies of the north (Germany and may be France and Holland) to the periphery states, a measure that of course cannot be agreed politically.  What is surprising is how long it lasted while all the time the relevant data were so blatantly obvious.
The problem is evident even with the simplest and least controversial data. It is enough to take a look at wage increases since Greece joined the euro in 2001. Clearly, Greece and Spain were bound to get into trouble due to loss of competitiveness. Also, while short-term interest rates were uniform across the eurozone, real — inflation adjusted — rates were much lower in Greece, Ireland, Spain and Portugal than in Germany. In fact, for some of these countries, they were probably negative for much of this period, helping create the bubbles in housing in Spain and Ireland, and more generally, “bubble economies” in Europe’s periphery.
The conclusions from Chart 1 are generally valid except for Italy and for the comparison with the U.S.  During the period shown, all countries discussed had an increase in productivity, except for Italy. Therefore the Italian economy could not afford even the relatively slow increase in wages it experienced. In contrast, the U.S. had a strong increase in productivity and therefore remained competitive with most of the eurozone other than Germany.
Chart 1

The data are therefore rather clear: the so-called “sovereign debt crisis” and “banking crisis” only name the symptoms of the structural deficiency in the euro. Of course, the cracks appeared first when and where the structure was most vulnerable. First to fail were those eurozone members that were weakest, most indebted, least competitive and so on. It is conceivable that at the early stages of the crisis it was still possible to delay its progression if the U.S., China, Japan, Germany and the IMF were to have banded together to build a “firewall” massive enough to recapitalize the European banking system, the ECB, the EFSF the ESM and any other institution the Europeans designed to stabilize the “European monetary project” i.e. the euro. Had that been done, there would have been some meaning to the “fiscal union” the Europeans plan to discuss at their June 28 -29 summit meeting. The time gained could also allow the German policy, begun in 2011 and continued in the more recent union agreements of accelerating labor wage increases, to work. This policy makes Germany less competitive and therefore the rest of Europe gets a relative gain. Finally, the “new” idea of the new European leaders (and of the UK) that Europe cannot make do with only austerity and that it needs some growth enhancement, could have been implemented.
But, that was then. Now, time is up. The euro experiment is over. The patient is barely breathing and cannot hold his breath for long. People with money in Europe are not thinking about where to invest for growth but where to shift their deposits. Money is flowing fastest out of Spanish banks into Germany that itself will be insolvent once the euro falls apart. Some funds are also flowing to Swiss banks (will they survive when the eurozone collapses?)  and to the most highly indebted economic power: Japan. Consumers are afraid to spend. As a result, the European economies are shrinking fast, as the latest PMI indices show. And in the age of information, US consumer and investor confidence is shaken too, with China not far behind. Finally, in reaction, the global stock markets are plunging too, guaranteeing that the confidence will ebb some more.

In their enlightening paper, Simon Johnson and Peter Boone describe the mayhem in the European markets and conclude that the euro is doomed and will have to be taken apart in a few months or even years. In his piece, Jim O’Neill at Goldman wrote several weeks ago that since the Europeans cannot agree on fiscal unification that will solve the euro’s problem, or on dismantling the euro, they will just keep kicking the can down the road.
That, however, is not how markets work. To see how they do behave, just look at one relevant example: when the true magnitude of the Greek fiscal problem surfaced, it took four months until the eurozone had to come to help and the amount necessary to temporarily  calm the market was relatively small (30 billion euro loan). Recently, when private investors wrote off more than 100 billion euro of Greek debt and made Greece eligible for additional help of similar magnitude from the eurozone it didn’t take the market more than a few minutes to reprice the new debt to reflect highly likely default levels. In other words, the markets are forgiving at first but their reaction time grows shorter and more violent as the problem persists. The Europeans are now trying to kick the can up the hill.


The EU Recession

Posted on August 29th, 2011

Will the EU and China pull the US down into recession?

A couple of weeks ago the Chancellor of the Exchequer gave a great speech in Parliament (see link: The essence of it was: we cut government spending and the deficit and therefore retained our Triple A credit rating. Left unsaid was the comparison to those that did not cut the deficit and did not retain their Triple A rating.

It took some nerve for the Chancellor to say what he did at a time when there were already riots in the streets of London and other cities, even before the cutbacks became effective. More to the point here, the UK economy is barely growing and tightening fiscal policy can easily tip it into recession (see chart 1).
A recession in the UK is of course of limited significance for the global economy. Unfortunately, however, the UK was only following decisions taken by the EMU for its members. And some governments were forced by the sovereign debt market to take more painful cuts in spending (Italy is the latest, soon to be followed by Spain and France).
As a result of this tightening of fiscal policy, economic growth in the EMU came to a screeching halt (see charts 2-5). Against this background, the leaders of the largest economies in the EMU, Merkel and Sarkozy, had an emergency meeting last week. Their decisions included even more aggressive tightening of fiscal policy in the future and a tax on financial transactions (don’t worry about the latter decision – politicians periodically fall in love with the idea of taxing something they hate because it brings home the bad news. Eventually, they always retreat before causing the damage). What was glaringly absent from their decisions was any measure to boost the economy, even if only by monetary policy means.
This is not the first time Europeans have ignored the need for them to do something when their economy is falling into recession. In 2001, the US economy fell into recession but bounced back after 6 months. The recovery however wasn’t solid enough and Europe remained in a recession so that the Fed had to keep taking Interest Rates lower for the next couple of years. Eventually, rising house prices solidified the recovery in the US and the US in turn through its balance of trade deficit helped Europe out of the recession. This of course was a dangerous gambit in which the housing market in the US had to pull the world economy out of recession. I warned about those risks already in 2003 and the end result is well known. Unfortunately, the world cannot expect the US to pull it out of recession this time. On the contrary, Europe and China with a large and growing trade surplus – which of course means trade deficit for the rest of the world —can easily pull the US down (see charts 6-8). The only hope of avoiding this rests on the dollar continuing to go down sufficiently so the US balance of trade does not worsen significantly. This is also contingent on China continuing to let the yuan appreciate at a faster pace.


A World at Risk

Posted on August 3rd, 2011

♦ The pace of global economic growth started to slow down at the beginning of the year and is now close to zero.

♦ The main cause of this slowdown in growth is an almost universal tightening of economic policy. In the developing world, interest rates were raised to stop inflation. In the developed world, government spending was cut in order to reduce the debt. Thus, irrespective of its motives, tightening of monetary or fiscal policy has caused a slowdown around the world.


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