Givanomics

Too-Big-To-Rescue

2011-11-23T14:54:00.000-05:00

Dear readers,

As indicated in the previous newsletter we are preparing an academic paper on a potential alternative for central banks being a liquidity provider in times of crises and acting as the lender-of-last-resort. As you all know this is closely related to the moral hazard and too-big-to-fail issues.

Recent events have once again shown we are unfolding an endgame where socializing losses cannot continue at the current pace. Instead of a too-big-to-fail risk we are now entering into a dangerous zone of too-big-to-rescue.

In this weeks’ newsletter will show why we have reached this turning point with illustrated data on accumulated outstanding guarantees governments are taking onto their balance sheet. As an example we would take the EUR-zone country Belgium, which has recently come into the spotlight of financial markets due to the forced bailout of one of its banks. The author would like to stress that this is not an isolated case and that a similar exercise is trivial for other EUR-zone member states.

In case of the Kingdom of Belgium the current total public debt as a percentage of GDP is around 98%. Like many other governments this percentage rose quickly at the end of 2008 during the first Great Credit Crisis, in an attempt to save its banking industry.

As a reminder we sum up the amounts that were in large responsible for this rise of debt:

• 29 September 2008: Fortis Bank NV/SA a EUR 4.7 billion cash injection by the Federal Government of Belgium in exchange of 50%+1 shares in common equity of which 75% of shares were transferred to BNP Paribas. In exchange the Belgian Government became a 11.6% shareholder of the French bank. (bear in mind that at the moment of conversion the BNP Paribas share price was still well above EUR 60 per share compared to a share price of EUR 26.85 today)

• 30 September 2008: Dexia Bank NV/SA a EUR 1 billion cash injection of the Belgian Government next to another EUR 1 billion investment by the 3 regional governments of the country.

• 8 October 2011: Dexia Bank NV/SA is bailed out by France and Belgium, of which the Belgian government will pay EUR 4 billion for the Belgian franchise.

• 20 October 2008: Ethias received a EUR 1.5 billion cash injection by the 3 regional governments of the country.

• 27 October 2008: KBC Bank NV receives a EUR 3.5 billion direct investment by the Federal Government, where the proceeds are used to strengthen its Tier 1 capital by EUR 2.5 billion plus a solvency margin on its insurance business by EUR 1 billion. This operation is completed on the 19th of December 2009 by issuing non-transferable, non-voting core capital securities to the Belgian government at EUR 29.5 per share (current share price is EUR 9.5 per share). Then, the Flemish Government supported on aggregate another capital injection of EUR 3.5 billion between January 2009 and May 2009 based upon similar terms and conditions as the Belgian Government.

• On a side note, car manufacturers Ford Genk and Volvo Ghent received subsidies and tax relieves of respective EUR 9.3 million and EUR 300 million.

Unfortunately the rescuing of the banking industry did not stop with direct capital injections. Additional government guarantees had to be put in place for outstanding liabilities. The latter is becoming a hazardous situation for public finances in general.

As Belgium is concerned the following guarantees have been underwritten by the government:

KBC Bank: EUR 20 billion of which EUR 5.5 billion of super senior CDO risk and EUR 14.4 billion of counterparty risk on the mono-liner MBIA which wrote credit protection on the banks structured credit portfolio. 90% of default risk is guaranteed by the Belgian government with a 1st loss of EUR 3.2 billion.

Dexia Bank: during the first bailout in 2008 an aggregate of EUR 150 billion of guarantees were granted to the bank by France, Luxemburg and Belgium. These were up to EUR 90 billion re-written during the nationalization of the bank in October 2011, where the Belgian government takes up to 60.5% or EUR 54 billion of guarantees with a maturity of up to 10 years. Next to this guarantee the government inherits, as it is from now on the owner of Dexia Belgium, an un-collateralized credit line of EUR 20 billion to Dexia France. Apart from this credit facility it also inherited a sovereign bond portfolio of EUR 20 of which EUR 8.5 billion has exposure on Greece, Portugal, Italy, Spain and Ireland.

FSA (Financial Securities Assurance Inc.) a US daughter of Dexia NV/SA: USD 16 billion is jointly guaranteed by the French and Belgian government if losses exceed USD 4.5 billion.

Fortis NV/SA: EUR 150 million is guaranteed by the government for interbank transactions. Then a larger guarantee of EUR 5.365 billion is granted for a SPV that is set up to isolate toxic assets of Fortis.

Gemeentelijke Holding ( a cooperative structure of Belgian local authorities: among the regional and federal governments a guarantee of EUR 1.5 billion had to be granted to cover a loan of the Holding to finance a participation for a capital increase in Dexia Bank.

Arco (a Belgian cooperation linked to the Christian Workers’ Union). Via the deposit guarantee system a guarantee has been granted for up to EUR 1.5 billion to cover losses on Dexia shares.

NMBS Holding (Belgian Rail Road) A Belgian government guarantee to cover 80% of a sale and lease back operation with AIG. Guarantee in EUR equals EUR 260 mio.

Then we do not take into account pension liabilities that have been taken over by the Belgian government, such as the Belgacom Pension fund for a minimum liability of EUR 5.8 billion, pension fund of the Port Authorities of Antwerp etc. The fee the government received in exchange of taking over the liabilities was deposited into a so called Silver fund which invested in EUR sovereign bonds such as Germany, France but also Italy, Greece etc…..

The above list already accounts for over EUR 140 billion of guarantees. The entire amount is not at risk. However, taken into account that a lot of these guarantees are related to sovereign and toxic paper that is facing haircuts of 50% and even more (Greece will eventually be faced with haircuts of up to 80-90% and the same can be argued for toxic assets in the portfolio of Fortis, KBC and Dexia), it is not unrealistic to assume that the outstanding public debt as a percentage of GDP can rapidly rise to levels far above 120%.

These are levels well above those like Portugal, and close to those of Italy, both countries that are already spit out by the bond market. Considering these levels, the government is hardly capable of executing its moral hazard role it has been playing over the last couple of years. This means that if one of their last standing banks, that is KBC, would need to ask for additional government support, the Belgian government would get stuck between a rock and a hard plate.

If it would be forced into a situation where it has to rescue the bank, the public debt would shoot well above the levels of Italy as it would have to take on additional guarantees such as an impaired Irish loan portfolio of EUR 18 billion, which the bank is carrying.

If on the other hand the government argues the bank is too-big-to-rescue, it would trigger a run on the Belgian banking system as we have seen in Iceland back in 2008, and as a result the Belgian government would see its liabilities sky rocket as well due to the deposit guarantee system that it is responsible for.

In both cases an eminent bankruptcy is around the corner and the country would need to ask for direct support from the ECB, which is more and more hesitant to step in, as we have seen in its recent market operations.

As we mentioned earlier on, the above described scenario can be applied on other countries such as Ireland, Portugal, Italy and even France. Between now and 2014 the EUR zone would need a sovereign refinancing together with a banking recapitalisation of close to EUR 4 trillion.

These are numbers that sends chills through your spine and show that Europe or more in general the world is in a structural state of balance sheet depression. Inspired by the work of Reinhart & Rogoff, the BIS recently published a report on "The Real Effects of Debt". (1)Its conclusion is that the deleveraging process will continue most of this decade. Taking the above mentioned numbers into account, we certainly are not going to challenge this.

Nevertheless this brings us to the one million dollar question which has kept us awake over the last 3 years: will it either be deflation or inflation that the world economy will be facing?

The answer is not straight forward. Most probably the outcome will be similar to what the EUR-zone has been coping with over the last decade. Certain regions will be struggling with deflationary price pressures. Other regions will see (considerable) upward price pressures.

As for Europe is concerned we share the view of analyst Simon Hunt.(2) Germany and the ECB will have to decide whether they want to safe the EUR project or allow it to explode with a big bang. Either they agree upon the ECB, probably in cooperation with the EFSF, to open up the printing machine where even Ben Bernanke would start feeling uncomfortable with. However, the chance that this decision will be vetoed by either the old Bundesbank lobby or the German’s Constitutional Court is immense high. Nevertheless, this would further destabilize the system and trigger acceleration in asset inflation.

If they decide not to walk down that road, they will be forced to throw in the towel and accept the fact that the EUR project has failed in its current form. This conclusion will cause even more chaos as this would push the European economy into a deep recession, not to use the word of depression, as all member states will have to introduce their own currencies again. This will put in motion a severe deleveraging process that would deflate all asset prices.

As both scenarios could come straight out of a horror movie it is up to our European and global leaders to start thinking out of the box and start working on a new monetary order as we are in the final stages of the End Game.

[1] Cecchetti, Mohanty, Zampolli "The Real Effects of Debt", Bank of International Settlements, September 2011
[2] John Maulding, Outside the Box, 21st November 2011

A call for structural changes

2011-11-13T14:36:00.000-05:00

Remember the Green Shoots back in 2009. It became such an hype that it got rewarded by becoming an official term on Wikipedia. Back then we were highly sceptical and with great disbelieve we saw the market taking off after that memorable G20 summit at the beginning of April which set the streets of London literally on fire.

This encouraged us to participate in the academic debate on causes of the crisis and the challenges we would face in the foreseeable future. All our findings were bundled in a book “The Future of Finance: a New Model For Banking and Investment.”

In brief we warned that nothing was done about the real issues, such as the systemic risk in the financial industry via its exposure on derivatives, the destabilising forces of central banks and governments, and last but not least the colossal debt built up both at the private and public side. All this would trigger a currency crisis which in the end would result in a global sovereign crisis. Hence, investment portfolios should have been protected against this by avoiding certain currency zones and sovereign creditors (cfr. The Rings of Fire) and searching for hard underlying assets.[1]

However, like so many out-of-the-box thinking economists, we were spit out by the system as being too cynical, doom-and-gloom and in the end we ended up shouting in the desert.

The last few months have been particularly interesting. From our desert we have seen the clouds packing together again and noticed a perfect storm is in the making: a sovereign crisis going hand in hand with a banking and currency crisis.

The interesting part is not because we warned for all this back in 2009, but due to the same indecisive approach and ostrich behaviour by our political leaders who still don’t seem to realize that the can they have been kicking down the road is about to hit a brick wall.

In this respect it would be worthwhile to update some of the data we referred to back in 2009-2010 and point at the mounting challenges we are facing.

One of the eye catching data back then was the total global outstanding derivative exposure. After reaching a peak of approximately $ 683 trillion mid 2008 the Great Credit Crisis caused a significant reduction in volume due to the deleveraging that was triggered through the market, however since 2010 volumes picked up again. At the end of June 2010 the exposure was around $ 583 trillion to rise further to $601 trillion by the end of December 2010 (see also most recent data of Bank of International Settlements (BIS))(cfr. Table 3.).

To give the reader an idea of the systemic risk, within the US banking system only 96% of the US outstanding derivative exposure is in the hands of only 5 US banks: JP Morgan, Citi, Bank of America, Goldman Sachs and HSBC Bank USA National Association.

Table 1: Derivative exposure by US commercial banks

Source: Office of the Currency Controller, 2011

The argument that these data are gross numbers, not taking into account the bilateral netting effect among banks and as a result are not representative to outline the risk, does not stand. The issue here is that bilateral netting assumes that in an orderly credit event the issuing bank will honour all its outstanding contracts. Back in 2008 with AIG the market was already confronted with this problem and trillions of dollars threatened to become worthless within a few hours, as those who had bought protection from AIG were at risk to be left empty handed, as Goldman was the only player that was hedged by buying protection on AIG itself.

Until today nothing has done about this issue either. On the contrary it hangs over the market as a very dark cloud. This risk is eminent as European, and among them especially French, banks are in the eye of the storm of the recent European sovereign crisis.

This brings us to our second issue: a perverse and vicious mechanism between a European banking sector which is in principle bankrupt and Euro sovereigns that face the same problem. Deteriorating mark-to-markets of Euro sovereign bonds is pushing banks deeper into insolvency.

Two of our favourite analysts, John Mauldin and Michael Lewitt, point at a too-big-to-rescue issue where European banks hold as much as $55 trillion of assets. This is four times larger than the U.S. banking sector as European banks surprisingly are more leveraged. Until now nothing has been learned from the past on how to fund this enormous position. Back then we made suggestions on proper ALM management that banks should take into account. The major principle in all this is becoming less dependent on wholesale or interbank funding. This has been further worked out more in detail by my co-author, Prof. Dr. Moorad Choudhry, in his recent book “The Principles of Banking” . [2]

Unfortunately European banks are still funding themselves for a large part via the interbank market, which is less stable than deposit money. From this $ 55 trillion almost $30 trillion has to be raised by European banks in the interbank market. Bear in mind this is roughly 10 times more than U.S. banks. As we have seen over the last several weeks, this market dried up completely for European banks, which forces them to pay back this wholesale funding by internal generated cash flows.

Michael Lewitt argues further that this wholesale funding has on average a three year maturity. This means that European banks need to generate approximately $830 billion each month to fund maturing wholesale money. It goes without saying this is not a situation that can take too long which is also indicated by the markets. The CDS market for European banks for example is back at or above the peak levels seen during the 2008 financial crisis. [3]

We could very quickly come into a situation where many other banks face a similar future as Dexia, i.e. nationalization. The problem however here is that governments’ balance sheets are stretched as well. This brings us to our last item of data to be updated, that is total outstanding debt of nations. Remember back then we referred to the famous Rings of Fire of Bill Gross of Pimco.

A similar exercise has recently been done by BIS and they came up with the following numbers:

Table 2: Total debt as a % of GDP

Source: BIS

Compared to the exercise Pimco did back in January 2010 there is a striking difference that much more countries are clustering together in a dangerous debt zone of + 330% of GDP. The only similar conclusion compared to back then is that Japan is still like a bug looking for a windscreen.

Levels like these are unsustainable not only because, as Reinhart and Rogoff concluded, for each 90% of debt in terms of GDP one full percentage of GDP growth is lost. Then we are challenged with the ageing of society which is going to put further pressure on both pension fund managers, who will not be able to realize the over ambitious returns their models are counting on, and public finances of our economies.

To solve this more drastic and structural changes will be necessary. It goes beyond doubt this will take political courage and leadership to say that we all have to make sacrifices and most probably have to take a step back from our current living standards.

My co-author, Prof. Dr. M. Choudhry, and I are preparing an academic paper which will focus on these structural changes we need to push through in the very near future and we will keep you updated on this via our Givanomics newsletters.

To give you a brief indication into which direction we are looking for, we argue that it will be as drastic as the events like Breton Woods (1944), the end of it in 1971 and the Plaza Accords (1985).

It will question our current capitalistic free market model where banks and central banks are the corner stones of the model. In the financial system as we know it we aim for stability. Central banks play a pivotal role in all this to guarantee this stability. In a stable environment liquidity is not an issue and central banks are not on the radar screen. Only in times of shocks one is challenged. The problem however is, there are different kinds of shocks. The question is when or where do we draw the line to step in and guarantee stability again. This is once again the moral hazard issue.

There are shocks of technical nature (such as the potential Y2K event 11 years ago) or geo-political nature (events such as 9/11) or international nature (retreatment of international capital flows such as the Asian and Russian crisis) and corporate nature (such as LTCM, Bear Stearn and Lehman).

We think there is a broad consensus that in principle in case of a corporate shock, we should not use tax payers’ money, as we should not throw good money after reckless behaviour. Unfortunately we let it come way too far as this is an impossible task nowadays due to the interconnectivity of our financial system. We do believe though a great opportunity was missed back in 1998 with LTCM not to do anything about it.

The Fed should not have come to the rescue and should have given an example that a liquidity shock, due to a corporate event, would be something a central bank should step in for. Or, after the rescue of the banks from LTCM one should have done something about the systemic risk in the market, which only grew exponentially since then. Table 3 gives a very good indication on this subject in respect to the rise of derivatives over the last 13 years. The question will be though where to draw the line? Do we only exclude a corporate shock, or even at an international level, such as the examples of Russia, Asia and now Greece etc….?

Table 3: Rise of Derivatives

Source: BIS

Then we also come to our paradox, as in our aiming for financial stability we created central banks. Remember that back in 1907 the US went through a similar deep recession and after the collapse of the Knickerbocker Trust Company, liquidity dried up and there was a run on the banks. It was the late J.P. Morgan himself who put his own private money and that of other fellow competitor bankers on the table to guarantee liquidity and avoid a further collapse of the system. This because of the simple reason, there were no central banks. It was due to this event that two years afterwards the Federal Reserve was founded.

However due to the creation of this type of institution, in order to safeguard financial stability, one put in place public financial safety nets, which are an incentive to moral hazard behaviour, which on its turn is just the very reason why financial instability is created. This is quite of a paradox.

Maybe we should go back to a system as in 1907, where banks had to put a pool of money together themselves to rescue each other. By doing this, you automatically take away the public floor or safety net from underneath the market. From the moment that banks have skin in the game, they probably will be more cautious towards each other when it comes down to wholesale funding and leverage, which were/are one of the major reasons why a liquidity crunch takes place when we are talking about a shock of corporate nature. In case something would go wrong and a bank has to turn to this facility pool, there would be a penalty involved where the bank is absorbed by the others.

This will not be the only challenge. As back in 1944 when Breton Woods was negotiated, we urgently need a new monetary order which would issue new rules on how we deal with global financial and commercial relations and the currency risk that is closely related to this. A question we will ask ourselves is whether abandoning the fiat currency system, which was introduced at the Plaza Accord in 1985, would reduce the leverage in the system.

These are according to us the topics that should come on top of the agenda of G20 summits. Unfortunately these discussions are being avoided and it is far more popular to pin point on a round of bankers bashing or focussing on marginal discussions like abandoning short selling. The longer this discussion is postponed the deeper the crisis will become. We can only hope one does not make the same mistake as President Hoover and his generation did back in the 1930s, which made the crisis even worse. We all know by now what price we had to pay for that.

[1] See also Bill Gross, The Rings of Fire.

[2] Prof. Dr. Moorad Choudhry “The Principles of Banking: Capital, Asset-Liability and Liquidity Management”, Wiley Finance, 2011

[3] Michael Lewitt, “It’s all Greek to me”, Newsletter, November 2011

Update on the Future of Finance

2011-10-02T08:54:00.002-04:00

In the last several months we have experienced increased nervousness around the Mediterranean Eurozone countries and their sovereign debt, with Greece in the spotlight and now Spain and Italy creating further political divergence among euro members. All this comes to a climax now with the US itself under attack by one of the rating agencies. These are of course the same agencies that were heavily criticised before for being too loose in their credit assessments during the build-up to the previous credit crisis.

We have absolutely no pleasure in reiterating that we warned about all of this in our book “The Future of Finance: a New Model for Banking and Investment”, which was written back in 2009. At that time, among many other issues, we pointed out the risk of increased volatility and sovereign debt crises of the magnitude observed during the Great Credit Crisis of 2007-2009. Furthermore we warned that this sovereign debt crisis would go hand in hand with a currency crisis, where hard underlying assets would function as safe heavens.

We are now in the middle of what can be described as the third and final phase of this Great Debt Cycle. The first one can be identified as the period where the seeds of the crisis of 2007-2009 were sown. This was characterised by a complex mixture of financial deregulation, globalization, increased financial innovation, a shadow banking system, political and monetary intervention, currency manipulations and moral hazard issues. By the end of this cycle, back in September 2008, governments all over the world had to step in to save the financial system from a total implosion, by transferring the debt liabilities from the private to the public sector. Remember banks, as well as corporates such as GM, were bailed out at the time.

The end result was that public deficits and debts as a percentage of GDP rose exponentially. The euphoria experienced on the stock markets back then from March 2009 onwards, was misplaced as the outstanding debt did not disappear. This can be identified as the second stage in the Great Debt Cycle, where central banks started expanding their balance sheets rapidly. Some of these monetary institutions were more reluctant than others, for example the Federal Reserve versus the ECB. However, now that the sovereign crisis is coming to a climax, the latter also has been forced to give up its final political independence and has stated buying up debt that cannot be absorbed anymore by governments.

This is the start of the third and final cycle where continuous balance sheet expansion will result to a point where it will no longer be accepted by the financial markets. These financial markets are blamed by indecisive politicians as the cause of the turmoil. Unfortunately they only act as a thermometer that displays that the patient has a high fever and is very ill. At this stage politicians lean back comfortably in their chairs as central banks once again will come to the rescue and reinforce the moral hazard principle. However this “kicking-the-can-down-the-road” game will come to an end in due course, as there is a limit to how much a central bank can stretch its balance sheet. Note that the ECB’s and Fed’s balance sheets are already leveraged approximately 1:25 (EUR 81 bio of capital versus EUR 2.3 trillion outstanding assets) and 1:50 ($51 bio capital versus $ 2.6 trillion outstanding assets) respectively. We point out once again that this does not make the debt issue go away. Sooner or later one has to start paying all this debt back. However in the meantime the central banks are running the risk of becoming insolvent themselves. Bear in mind that for example a decrease of only 4% of the value of the ECB’s assets is enough to erase its capital completely.

More then ever politicians need to face reality and bring their household finances in order. This will become even more urgent as the ageing of society is now just around the corner and will put further pressure on welfare payments and public finances. Just passing on the problem to the lender-of-last resort is not an option anymore, as this will end up in global demonetization and collective pauperization. Neither is throwing away the thermometer. The longer we put off the solution, the more painful the end implosion will be.

Gino Landuyt, Brussels, August 2011

The Fed preparing a cruise on the QEII

2010-09-28T08:38:00.000-04:00

Dear Readers,

Last week’s FOMC statement brought nervousness back into the market as the Fed hinted it might start with quantitative easing (QE) again. It is a fact that the three major central banks in the world, FED – BoE – ECB, are struggling in their fight against deflation and do everything they can to inject some inflation into the system.

As Alan Greenspan will go in history as the man who put a safety net under financial markets with his famous “Greenspan Put”, Ben Bernanke is working hard to become the Knight that fights Deflation. It would certainly be a great title for a cartoon and the best way to illustrate his future legacy in one picture would be as follows:

The very reason why the monetary authorities are still struggling with deflation is obvious. The deleveraging process which was put in motion from the beginning of the Great Credit crisis has not come to an end yet. The public has been put on a wrong footing with comments such as ‘green shoots’, given a false sense of illusion that the crisis could simply be put behind us via massive stimulus packages.

Before the summer of 2007, the global economy was performing on testosterone. In this case it was a shadow banking system that was flooding the market with cheap credit. This parallel circuit exploded via its leverage and has brought global demand back to new levels.

The first round of QE was trying to smooth out the shock that was caused to the system due to the Lehman collapse. This bankruptcy was only a cathartic event in a process that was built up more than a year before when the first subprime lenders started to go bust. As the US economy was fueled by an accommodative credit card industry and a leveraged housing market that functioned as ATM machines for US households, other parts of the global economy, for example Germany and Japan, were driven by a (cheap) credit fueled trade.
Governments and central banks stepped in to prevent the world falling off a cliff. To a certain extent the authorities have succeeded in kickstarting the global economy. At least inventories have been rebuilt, but now we are muddling through a New Normal as Mohammed El-Erian from Pimco described more than a year ago.

What did we learn from the first round of QE, and more importantly is a trip on the QEII worthwhile? Will a couple of trillion of extra USD into the system bring back the good old times? We doubt it.

Banks are still struggling with capital and Basel III. Although it turned out to be a compromise, it will keep banks under pressure to focus on more rigid capital ratios for the time being. In this respect extra liquidity is not the right answer to capital issues.

Will a couple of trillion of extra USD loosen up the lending standards among banks? Most probably not, since this was also one of the reasons that brought us into this mess in the first place.

Will a couple of trillion of extra USD bring back all the customers that went bankrupt? The answer is once again no, as they disappeared due to the over capacity that was created by the shadow banking system earlier on.

Figure 1 below also points out that in general banks simply put this money back with the central bank (in this case the Fed).

Figure 1: Fed total reserves, not adjusted for changes in reserve requirements

Source: St. Louis Federal Reserve and John Mauldin

One can argue though if this money is not used by banks to lend among each other, how would or could this trigger inflation? This is a valid point. At this stage central banks are not successfully injecting inflation into the system via QE. As a consequence why inject another trillion dollars into the market?

The danger is though from the moment that there are signs the economy is recovering at a faster pace, this money will be (very) quickly used by banks and flow rapidly into the market. We have written on a number of occasions that central banks, and the Fed to start with, have a very poor track record in anticipating trend reversals.

Figure 2 US 2y Average GDP versus Fed Fund Rates

Source: Bloomberg data

As Figure 2 illustrates especially the Fed has a tendency of overshooting its rate policy. During the 1970s and from 2001 onwards the Fed had a policy where it kept Fed fund rates systematically below average growth.

We know by now what the result of that was in the 1980s. Volcker and with him many other central bankers had to fight a period of increased inflation.

Such a Keynesian policy run the risk of intensifying great imbalances in an economy. Due to a mispricing of the cost of money, misallocations of capital take place which lead to boom and bust cycles as we have seen during the credit crisis of 1974 and more recently the Great Credit Crisis.

This is based upon the findings of the economist Ludwig von Mises who in turn further developed the theory of Knut Wicksell in the 19th century. He argued that a disequilibrium between general demand and supply on monetary prices are not temporal but cumulative. In simple terms, any deviation from an equilibrium sets off a dynamic process that continually leads the system away from the equilibrium. If for any reason, the general demand is set and maintained above the general supply, no matter how small that gap is, the consequence will be that prices will start rising and keep on rising.(1)

Both Wicksell and von Mises suggest that a central bank should occasionally keep its rate above the growth rate of the economy to smooth out the excesses or overcapacity in the economy. In this respect a recession should be self correcting. Or “recessions are nothing more but a natural consequence of a free economy created by the divergence between the natural rate and the market rate “ (2)

This is exactly what is worrying us with the Fed planning to go on a QEII cruise. Taking back one trillion USD from the first QE operation will already be a challenge as we are in uncharted territory. Imagine what could happen if this amount becomes USD 2-3 trillion.

Therefore in a deflation versus inflation debate we remain convinced that an extended period of above average levels of inflation sooner rather than later will come to bear. Governments like the US-UK and certain EUR-zone members will not oppose against this as it would enable them to inflate away their outstanding debts.

At least the gold market is showing similar signs of worriedness. Bear in mind though, gold is usually not an ideal hedge against inflation. The underlying volatility is too high to keep it as a single asset against inflation in a portfolio. In this respect it would be sensible to look for alternative hard assets to protect ones capital against the erosion of inflation.

1. Wicksell “Interest and Prices”, p. 101, 1936 Augustus M Kelley Pubs
2. Charles Gave and Louis-Vincent Gave, “Ricardian Growth, Schumpeterian Growth and the Cost of Capital.” Sept 15 2010, Hong Kong

Post Tenebras Lux

2010-06-28T11:55:00.001-04:00

Dear readers,

We have been out of circulation for the last three months due to several reasons. First of all we experienced ourselves that the deleveraging in the banking industry is still in full force, causing an abrupt re-orientation in our career path. However this mini sabbatical gave us the chance to work on other projects such as finishing our second book on the new banking paradigm in co-authorship with Moorad Choudhry which will be available at the end of this year.

Alongside this project we did some extensive reading. As the Latin saying goes: “Otium sine litteris mors est et hominis vivi sepulture” or free time without literature is the death and funeral of a living man. In the months ahead Givanomics will share these findings with you. For example we will write more in detail about a major academic work “This time is different: Eight centuries of financial folly” by Reinhart and Rogoff which is very topical with the ongoing sovereign debt crisis.

Then we spent some time travelling and empirically experiencing on the ground the forces of the Great Credit Crisis in some countries and developments in emerging markets. In this respect we noticed that the gold rush has still some way to go. We also noticed that China is aggressively expanding into Latin America to get access to hard assets. In a country like Peru, Chinese companies have invested more than $ 1.4 billion. The majority of its investments are located in the mining industry. According to Chinese officials Peru is the major destination of China’s investment rage which is only the beginning as ultimately $ 4.5 billion of new investments are planned.

We think this development should be placed in a broader context related to the worrisome share of US Treasuries in China’s financial reserves. Together with Japan, they hold in total +/- 45% of US Treasuries. China is the biggest owner of U.S. government debt and totaled $ 900 billion in April 2010. Already during the G20 summit in London back in April 2009 we saw growing reluctance from the BRIC countries to keep on investing and being overexposed to US depth and the USD in general.

Although the major focus has been on the South of Europe recently, foreign demand for American financial assets also fell to a six-month low earlier this year.

China has been a net seller of US Treasuries from July 2009 through April this year which is the longest stretch since the end of 2007. (Note that also Japan cut its holdings in January by $300 million to USD765.4 billion.) In return China has been shifting its reserves into hard assets. This enables them to get less dependent on USD denominated paper and in the meantime not causing an abrupt shock in the currency market as commodities are quoted in USD as well. Based upon what we have seen in Latin America and the amounts in play this is not going to come to a halt any time soon.

As far as the state of the global economy is concerned the situation remains very poor. At both sides of the Atlantic tax increases and/or cuts in public spending will hamper future growth prospects. Especially the latter together with robust demand from emerging market economies kept economies in the West artificially afloat. But the chances of dropping back into a recession are rising by the day now.

Leading indicators in the US are already pointing into this direction, certainly when one has a closer look at the Weekly Leading Economic Indicators of the Economic Cycle Research Institute's (ECRI). With a statistical adjustment (taking a 13-week annualized rate of change which reflects short term momentum) we notice a sharp fall, i.e. -23% which is in line with the US recessions in 1974, 1980, 2000 and 2008.

What certainly won’t help is that both in the US, UK and several EUR-member countries tax increases will be implemented in the months ahead of us. The impact on growth will be negative. Based upon earlier work from Christina Romer, who is also Chair of the Council of Economic Advisers in the Obama administration, a tax cut/raise of 1% of GDP has a 3% impact on GDP growth. Or if you raise taxes by 1% it will slow down growth by 3%. We do have to note that this study was done on the US economy. The multiplier effect is probably less for the EUR-zone economy because it has different dynamics, but the impact overall will remain negative.

Unless we would see another Lehman-like event, the recession will probably not be as deep as the previous one but we do believe the economies in the developed world will keep on struggling and muddle through for the time being. Certainly, with a (commercial) real estate market that continues to struggle and banks that remain reluctant to lend.

On a happy note, Givanomics is back, so at least there is light after darkness (Post tenebras lux) but as far as the state of the economy is concerned, we remain highly skeptical.

The Witch Hunt Continues and Fidel Castro liked it...

2010-03-10T10:53:00.001-05:00

Dear readers,

From both sides of the Atlantic more worrisome signals were sent out to the market that the populism, which struck the market after the Lehman fallout, is continuing.

The turmoil around Greece and its public finances have brought hedge funds and rogue traders back into the spotlight. They are blamed to have caused the crisis and creating unnecessary unrest both on the markets but also in the streets of Athens.

Politicians are jumping on the same bandwagon that was put in motion late 2008 when bank stocks came under fire as the hedge fund industry questioned the healthiness of the entire financial industry. Back then government officials tried to mule the crisis by putting a ban on “short-selling” of financials in the stock market.

A similar reflex is in the making right now as the PIIGS, and Greece more in particular, are under attack from market players in the Credit Default Swap (CDS) market. Market participants simply view the health of the public finances as problematic as that of the banking industry back in 2008, and respond to the situation via buying protection on sovereign names

However our “world leaders” find this as unacceptable as a woman being a priest in the Vatican.

A first response came from the US where the US government ordered the hedge fund community to keep track of every trading record on EUR positions either in the currency market or in the CDS market as it will be subject of an investigation to see whether there was a “speculative” attack on the said sovereigns or on the currency.
Of course Germany and France couldn’t stay behind and are pushing for hard line measures against these so-called sinners / speculators. Angela Merkel and Nicolas Sarkozy have urged the Chairman of the EU-Commission José Manuel Barroso to take an initiative.
One of the suggestions is to ban trading in CDS’s, at least on sovereigns. A similar idea was already launched by the Minister of Finance in Belgium, Didier Reynders, who has a surprisingly high reputation among the G-20 Ministers of Finance (as per FT ranking published late last year).
In the meantime Greek Prime Minister George Papandreou is even going on a mission to convince President Obama to help Europe against these “unprincipled speculators” .To further quote the Prime Minister: “Europe and America must say ‘enough is enough’ to those speculators who only place value on immediate returns, with utter disregard for the consequences on the larger economic system.” It even gets better when Mr. Papandreou is arguing further that due to driving up the CDS spread Greece now has to borrow at rates almost twice as high as any other EU country. He continuous by saying: “So when we borrow 5 billion euros ($6.8 billion) for five years, we must pay about 725 million Eur more in interest than Germany does.”
An obscene idea is crystallizing among governments around the world that hedge funds and the use of CDS’s are to blame for the public finances and banning them would solve the problems. A better sophism couldn’t be created.
Apart from the core of the discussion where we will come to in a moment, data provided by the U.S. Depository Trust & Clearing Corporation downplay the allegations towards hedge funds. According to its findings there is no sign of new open positions being build up and neither is there an indication of “massive speculative action,” this according to a BaFin official statement on Bloomberg.

However, the core of the matter is that politicians do not have the courage and ambition to push through structural reforms that are urgently necessary to cope with the imbalances that are still in place and which triggered the Great Credit Crisis 2007-2009 initially. We already indicated that in our previous column on the ageing of society.

The public finances are in such an impaired state that investors, who properly do their home work, can only come to one conclusion that the current risk premiums that certain sovereigns are offering for their bonds are simply too low.

Therefore hedge funds and other global macro investors are making the market more efficient by pointing at the problem and taking on positions against these anomalies. In stead of blindly focussing on the astronomic profits they sometimes make, one should look at the initial goal they are focussing on, that is getting rid of inefficiencies which otherwise would keep on existing for an extended period of time.

At this moment especially, global macro players, who continuously screen macro-economic inefficiencies, are at play against sovereign entities, but they are doing exactly the same as the likes of private equity players or other hedge funds that have an active investment strategy in the corporate industry.

Of course some melancholic socialists will consider these hedge funds as the antichrist brought to earth by crony capitalism. But bear in mind that long before hedge funds existed, our economies were featured by (government owned) monopolies and cartels which could hide their inefficiencies and overcharge the consumer for this.

Not only state companies are being put under pressure by these financial wizards, also privately owned companies do not escape from it, but then unions heavily protest against these devil incarnators. If we look at Germany for example, their corporate industry was chased up by private equity investors to make them more efficient, and modernized its entire industry over the last two decades.

Indirectly they put pressure on the German government to become more flexible, more productive and a competitive player in the globalized world. In the meantime the contrast becomes only more painfully noticeable with countries such as Italy, Spain, Portugal and Greece to name a few, that did not find it necessary to respond to the needs that globalization brought with it.

The same is taking place at this very moment in the sovereign bond market. Market players, as we refuse to call them speculators who only flip a coin and see what the outcome is, are poking the finger in a tedious wound. They have done their homework thoroughly before they decided to put their capital at work against the likes of Greece and potentially other countries.

In this way they are forcing the local governments to start finally doing something against the state of the public finances. Obviously politicians do not like this, as they have to take extremely painful measures they have postponed for too many years. Therefore it is easier for them to shoot the messenger.
To the extent it would be possible to ban CDS trading, it would have devastating effects to the global economy. To use an analogy, despite the daily number of accidents nobody has ever raised the idea of banning cars. Instead governments continuously work on traffic rules and regulation on how to make cars and driving safer. This is how derivatives should be approached as well.
If not we run the risk of turning the back the clock 15-20 years which will come at the expense of liquidity. This would also mean we would step back into the dark ages where inefficient government interventions are ruling our world again, where entrepreneurial initiatives are considered to be “not done”. It is certainly a society where Fidel Castro would prosper, but those who have not been there we invite to emigrate (temporarily) and compare the difference in living standards.

Ageing societies and public finances

2010-02-19T03:47:00.003-05:00

Dear readers,

This is the debt I pay
Just for one riotous day,
Years of regret and grief,
Sorrow without relief.
Pay it I will to the end --
Until the grave, my friend,
Gives me a true release --
Gives me the clasp of peace.
Slight was the thing I bought,
Small was the debt I thought,
Poor was the loan at best --
Oh God! What about the interest!

P.L. Dunbar

No, we are not struck by lightening and convert our Givanomics bi-weekly newsletter into a Death Poet Society club. We just continue our journey along the mounting debts governments are stacking up across the world and building further on the topic Bill Gross raised at the beginning of this month with his “Rings of Fire”.

In the past we have pointed at the series of causes of the Great Credit Crisis 2007-2009. There were several seeds planted over the course of time, and by the summer of 2007 they created a lethal jungle.

One of these was globalisation with its emerging economies that via currency manipulation were flooding the financial markets with USD liquidity, which even puzzled Alan Greenspan at the time with its “interest rate conundrum” and “savings glut”. The reason behind that originated from previous crises. Emerging market economies learned their lessons from the Asian and Latin American Crises which had devastating effects on their respective economies. As a consequence, instead of reinvesting the monies into their own economies, they repatriated the USD’s back to the US who went on to use it as ATM money to fund their housing market (bubble).

There was also a demographic phenomenon influencing financial markets. To a certain extent we can argue that the baby boomer generation had a huge share in the equity bull market of the late 1990s and the internet bubble.

A study of Barclays and the IMF confirms this trend.(1) During the late 1990s the share of baby boomers that started to re-direct their savings into equities reached an all time peak. This inflated the stock market rapidly and one can even argue that the internet hype was irrelevant to the bubble build up. Even without the presence of the IT revolution a bubble would have formed taking into account the demographic forces in play.

As far as the US is concerned, one should take into account two major data points. First of all the share of the group of 35-55 year olds grew to 30% of the total population by the beginning of the new millennium. This group had the highest saving ratios, while putting that money at work into the stock market. Simultaneously, a second group of retirees was slowing down rapidly as well during the same period. (The newly retired)

As two tectonic plates collide, these two groups created a severe shift in capital market flows. The 35-55 group that was accumulating stocks grew rapidly while the retiree group that was selling stock diminished rapidly. A similar phenomenon we had seen in Japan during the 1980s which caused a gigantic stock and real estate bubble.

In summary a cocktail of demographic shifts and globalisation, which contributed to a low inflation environment, contributed to the equity bubble which forced the Federal Reserve to intervene with monetary stimuli which in turn contributed to last decade’s housing bubble.

So far a brief summary of the last 20 years. This brings us back to the future where these two tectonic plates are still in full motion and are going to influence the aftermath of the Great Credit Crisis 2007-2009 substantially.

On the one hand we have the group of 35-55 year olds (the baby boomers) that is going to shrink more rapidly due to the ageing of society. This will have a negative impact on saving ratios which in turn will have a negative effect on asset valuation. On a side note we would like to warn that this phenomenon will not be limited to the Western world. Countries such as China will be confronted with a similar situation 5-8 years from now as well. (see our Givanomics on China and its demographics in December 2008)

Then there are the emerging markets that keep on growing and raise their share in global GDP continuously, aided by currency manipulation. The latter is less relevant at this point in the discussion, although over the long term this is going to create huge tensions on the FX market, which we see as taking the spotlight in future asset allocation.

For now we want to focus on the impact that demographics will have on markets and more specifically the consequences it will have on public finances. The debate is back on the agenda as government deficits are back on the rise, going ballistic since the Great Credit Crisis and a reason of major concern.

In Belgium for example, both the central bank and an ex-minister (an authority in the field of pension issues) issued a severe warning. The analyses they made are nothing new. The remedies to sail the ship through a heavy storm are less convincing.

First we sum up some numbers again, based upon a recent study of the IMF on the effects of ageing societies and also confirmed by the OECD and the Barclays study.
(2) The data is quite upsetting taking into account the current situation.

In the next 20 years the most developed countries among the G20 will see their government debts rise by at least 50%. From 2030 onwards this will even accelerate and government debt ratios of 275% of GDP will be seen by 2050 in the West.

Exhibit 1 G20 economies forecasted government debt evolution

Source: IMF, March 2009

The chart above is only showing an average picture for the G20 on aggregate. Obviously some countries will be hit harder than others. Data from the IMF indicates that Japan and South Korea have a demographic time bomb ticking under their public finances. For example Japan year to date has already a government debt of almost 200 % of GDP. By 2030 an expected additional 190% of GDP may be added to this mountain of debt.

In case of the US this is 40% of GDP that can be added to its current government debt level by 2030.

The major problem at this moment is that due to the Great Credit Crisis, certain governments’ savings for this demographic earthquake have been used to save the economy from falling into a depression. As a consequence all the reserves that have been put aside are not there anymore and create extra pressures. In the first place we think of the core EUR-zone countries that applied fiscal discipline over the last 10 years to fulfil the Maastricht Treaty.

Then there are other countries where the situation is even worse, such as the UK and the US who did not show fiscal discipline over the last decade and have no reserves at all. In these countries one could argue that they have stronger privatised pension schedules compared to continental Europe.

There are two reasons to suggest this is no panacea either. First of all the US and UK household saving rates are inferior to the levels of mainland Europe. Over the last 1.5 decades in both countries it dropped to 2% and 4% respectively, as households got buried deeper and deeper into (mortgage) debts. Therefore the savings rate had to go up substantially in these countries eventually, but it is a paradox in an ageing society environment. Supported by empirical evidence we know that an ageing society tends to save less.

The pension reserves that have been built up also have been affected heavily due to the stock market correction which wiped out gains of an entire decade. Estimated losses in the U.S. and the U.K.during 2008 are, respectively, 22 percent and 31 percent of GDP. (IMF data)

Not that UK pensions suffer a unique disease. Across the pension industry, overambitious payout schemes were promised to the retirees. A standard practise is to commit to 6% compounding returns until the retiring age. These returns were probably plausible in the 1980s and 1990s, however the low yield environment over the last decade has changed the investment climate drastically.

The law of compounding interests can go very quickly against a fund manager who has to make 6% year after year. In this case an annual loss of 30% makes it almost impossible to meet its promises in 20-30 years time, unless much higher risks are taken.

The US is not only facing such a problem in its private pension schemes. The mismatches between its long dated pension liabilities and its reserves are jeopardizing its wrecked public finances further.

The local states, such as New Jersey and California to name only a few, have promised considerable pension and retirement benefits to their employees without putting aside enough money to pay for them. According to a report by the Pew Centre (a US think tank )on the States’ condition, the 50 states on aggregate have accumulated more than $3.3 trillion in long-term liabilities (between now and 2030) in pensions, health care and other retirement benefits that are promised to their current workforce and retirees, but they only have made $ 1 trillion of reserves against this.

Since US states are legally obliged to have a balanced budget at the end of each fiscal year, there are only two outcomes. Either they eventually default under these liabilities with retirees being left in the cold, or the government has to bail them out, adding a multi-trillion hole in the US deficit.

The outcome of all this can be twofold.

Under a first scenario, where governments do not have the courage to take painful but structural measures, the outcome will be one of higher inflation and maybe in some cases hyperinflation. As the private sector will see its saving rate decrease (the OECD anticipates a drop between 3.5-6% of GDP on savings) and the public sector will run deficit after deficit, it will become increasingly difficult to meet domestic commitments.

In this environment risk premiums on government bonds will skyrocket. Back in 2005, a long time before the Great Credit Crisis broke out and public finances were not affected by the crisis yet, Standard & Poor’s simulated the rating evolution of the UK, US, France and Germany. Back then all countries were expected to lose their AAA rating rapidly between 2015-2025 all the way down to BBB- by 2035 at the latest. In the meantime, conditions only deteriorated. (3)

Therefore it is not an understatement to say that risk premiums on government fixed income paper are expected to rise significantly over time.

As far as growth prospects is concerned this would also be a scenario which would perfectly fit into the New Normal described by Pimco’s CIO, Mohamed El-Erian, where a prolonged period of below average growth is waiting for us.

Reinhart and Rogoff, who are very topical with their “This time its different” book, have also recently published a paper where they investigate the impact of government debt on economic growth. They come to a similar conclusion as Mohamed El-Erian, but based on an empirical analysis of the relationship between economic growth and government’s total debt (taking into account also private debt).

They come to the conclusion that real GDP, adjusted after inflation, falls by one percent from the moment your debt GDP ratio rises above 90% of GDP. When external debt (taking into account private and corporate debt) rises above 60% of GDP this will deduct another 2% of GDP growth, and in case of higher levels growth is even cut in half. (4)

In a second scenario, where governments would have the ambition to take painful measures, the outlook will not be more prosperous, but at least there will be a relief from the gigantic debt burden that is weighing on each of our shoulders.

In a scenario like this the government is going to cut drastically on the supply side. There is an economic law that argues that whatever the public sector spends needs to be saved by the private sector and vice versa. In this case the government will bear that responsibility. The governmental labour force would have to be reduced significantly in order to bring down a heavy public payroll and public pension liabilities.

Those civil servants that are allowed to keep their jobs will be faced with pay cuts.

Furthermore the massive pension liabilities and promises the governments have made will also have to be brought down one way or another. This can take place in a very refined manner by increasing the legal retiring age above 70 years, or by simply reducing the promised pay outs. Certainly in continental Europe private pension schemes will have to be promoted much more than in the past.

This scenario will have an opposite effect and trigger further deflationary pressures as the private sector will increase its saving rates further, this time at the expense of consumption. As a consequence, growth will be below average as well, which fits once again into the New Normal.

The question remains though whether governments are prepared to take these type of decisions as this will cause substantial social unrest.

Either way, more and more we are convinced that the Great Credit Crisis from 2007-2009 was also the beginning of the end of an era…

(1) Barclays Capital: “Equity Gilt Study 2010”, Jan 2010

(2) IMF, “The State of Public Finances: Outlook and Medium Term Policies After the
2008 Crisis” March 2009

(3) Standard & Poor’s, “In The Long Run, We Are All Debt: Aging Societies And
Sovereign Ratings”, June 2005

(4) C. Reinhart and K. Rogoff “Growth in a time of debt”, Harvard University,
December 2009

The Circle of Lucifer

2010-02-02T10:56:00.004-05:00

Dear readers,

We have written on several occasions about the credit bubble that triggered a considerable deleveraging wave in the private sector. However the world has not become a safer place. The debt build up among banks and consumers, in the period before the break out of the Great Credit Crisis 2007-2009, has transferred to the public sector.

Like in physics there is the law of communicating barrels. As one barrel full of water can be emptied with a tube whilst filling another barrel, so is the private sector trying to lower its outstanding debt level while increasing the leverage of the public sector.
Exhibit 1 shows that the total outstanding debt, taking every sector into account (corporates, financials, non-financials, households and governments), is still very worrisome in the developed markets despite a serious deleveraging process in the financial sector.

Exhibit 1 Total Debt as a % of GDP in 2008

Source: McKinsey January 2010

As we have seen during the latest deleveraging cycle, government debts are mounting. This is also described by H. Minsky. The problem is that certain countries before the break out of the crisis already showed bad public finance practices, which makes the current situation even more serious.

Japan, that has been fighting against deflation for more than a decade, the US and some southern EUR-zone countries are threatened by a sovereign debt crisis. (Exhibit 2)

Exhibit 2 Public debt as a % of GDP in 2009

Source: IMF and * OECD

Bill Gross (Pimco) used a striking analogy for these countries, calling them “the ring of fire” and placed the respective countries in an illustrative matrix. (Exhibit3)

Exhibit 3 The Ring of Fire

Source: PIMCO, January 2010

This is not an unusual phenomenon. Rogoff and Reinhart analysed financial crises and the spill out effects since the inception of banking. In their paper they come to the conclusion that the aftermath of banking crises goes hand in hand with a sharp rise of domestic debt (between 50-100%), which consequently triggers a high inflation environment and ultimately ends in a series of defaults on outstanding sovereign debt and usually a currency crisis.

At this very moment Greece is already becoming a victim of this phenomenon. The spill over effects towards the rest of Southern European countries, the PIGS, is more than science fiction. Therefore all these countries are in the “Circle of Lucifer” as we would call it.

In the CDS market we have already seen a clear divergence since the beginning of last year, and lately the EUR has been under pressure due to the Greek turmoil. However a country that we miss in this Lucifer’s club is Belgium.

We do believe there is a very strong case to be made that the market is underestimating a similar risk for Belgium. At this moment the 5 year CDS spread of Belgium is only trading slightly above 60 bps. Compared with the PIGS countries this is negligible, as all of them are trading well above 100 bp and even higher.

Taking into account the macro economical and political situation of Belgium there is a strong case to be made to buy protection of Belgium sovereign risk. There are a few reasons to underwrite this argument:

• Weak Industry

The Belgian industry has been losing competitiveness over its direct trading partners over the last 8-10 years. The labour cost compared to their main trading partners Germany-Netherlands-France and UK is more than 10% higher which gives them a major competitive handicap.

Furthermore the Belgian industry has disappeared over time in the hands of foreign multinationals. The energy industry for example came into the hands of French conglomerate Suez, and makes Belgium among EU members one of the most energy dependent countries in Europe. As an important side note, Suez is paying 0% taxes on the Belgium synergies due to a tax loop. Due to this, the Belgian Treasury is missing hundreds of million of EUR’s in taxes.

This is an amount that would be very welcome, considering the state of Belgian public finances. Belgian government debt showed a similar trend like other sovereigns around the world, and is expected to rise above 100% of GDP again this year. In this respect Belgian government debt is catching up rapidly with the PIGS debt.

• Wrecked Banking Industry

In Western Europe, the Belgian banking industry was hit almost as hard as Ireland and Iceland. Fortis, Dexia and KBC were brought on the verge of bankruptcy and either had to be sold to foreign competitors (Fortis) or came under curatele from the Belgian government (Dexia) or received very expensive government loans (KBC).

Because of this, the three banks that played a major role for the local mid cap industry that is the driving economic engine of Belgium, remain very restrictive in their credit policy. As a consequence the economy is suffering considerably. In January alone an additional 20,000 jobs went lost, bringing the unemployment rate back above 8.2%, which is an average national level. The differences between North and South are even more flawed. In the South there are regions with over 17% of unemployment.

• Political instability

For over 2.5 years the country has been pulled into its deepest institutional crisis since its inception in 1831. The contradictions between the rich North and the poor South have become so obstructive that it is almost impossible to put a government in place which can run an effective economic policy. The cry for more autonomy is high in the North, Flanders, which destabilizes the country and feeds extremism.

Structural decisions that urgently must be taken in order to tackle the aging of the population and issues around public finances are postponed as there is no will at either side of the language frontier to take an initiative.

• Deteriorating legal environment

Over the last 4-5 years Belgian dropped on the official UN Corruption ladder a couple of notches and is now at the same level of Italy. The Justice Department is hopelessly underinvested and understaffed. It is no exception that law suits settle after more than 10 years. There are even several examples where certain legal disputes even expire their legal dead line which creates a legal vacuum for business.

Jail sentences of less than 3 years are not executed anymore because of a painful over population of prisons, for which Belgium has been condemned already on several occasions by the Court of Human Rights, which feeds a further feeling of anarchy.

Taking all these arguments into account, there is a good reason to expect that Belgians credit spread will start sliding off into the direction of the PIGS and soon becomes a member of the Circle of Lucifer.

Greece... The next Atlantis?

2010-01-22T12:02:00.001-05:00

The turmoil around Greece started two weeks ago when ECB board member Juergen Stark said that Greece should not expect the EU to bail it out if its public deficit becomes unbearable. Since then even ECB President Jean Claude Trichet echoed similar comments on the public finances of Greece.

At the moment Greece is looking for a way out, either autonomously, or through help via the IMF. So far plans worked out by the Greece government to reduce the fiscal deficit from -12% back below the Maastricht level of - 3% by 2013, are received negatively.

This scepticism has to do with the fact that Eurostat, the statistical data centre of the European Commission (EC), found out that Greece has been manipulating the budget data towards the EC between 2005 and 2009. In this respect chances of reducing the budget deficit on its own strength are less credible.

This makes the exit via IMF advisors more likely. IMF officials arrived in Athens last week and are looking at the situation. Previous emerging market crises teach us that such kind of visits often precede a full IMF assistance programme. In the current environment, we think the announcement of such a programme would force Greek spreads significantly lower, even if the amounts being offered by the IMF are relatively small.
For the ECB and EC the IMF solution would be a clean one as well. It would be a strong signal towards other member states such as Spain, Portugal, Italy and Belgium to get their finances back under control. If not they would risk the loss of sovereign control over their finances towards the IMF. A non-intervention by the ECB and/or EC would avoid a moral hazard as we know it in the banking system.
If the ECB and/or EC would act as lender of last resort, it would be a signal towards countries such as Spain etc. to loosen their fiscal discipline as they would be bailed out somewhere in the future anyway.
We believe that the chances of a EUR break up are very small. For both the strong EUR-zone members as for the vulnerable ones such as Greece this would be a lose-lose situation. For the stronger members it would raise the risk of contagion towards other member states, and this would put significant pressure on the EUR.

In such a scenario a drop of the EUR of 20-30%, which is a similar drop if one compares this with other FX EM crises, would not be unrealistic. This is the type of volatility that EUR members want to avoid by any means. It would give them temporarily an export advantage over the US, but the credit spreads for the EUR members to issue sovereign credit would widen substantially as well.

Exiting the EUR for a country like Greece would be even more disastrous. The country would undergo an extreme devaluation of its new Greek Drachme. This would then give short term benefits from an export perspective. This is a technique Italy applied on various occasions during the 1980s. However Greece has less revenue coming from export activities compared to Italy. It would though have a small revival impact on export and growth, which would temporarily diminish the debt issues and raise employment, all this via tax revenues.

However, they would very quickly be faced with a spiralling of wage inflation and domestic prices as well. This is the phenomenon that we have seen in countries like Argentina at the beginning of this decade.

All this makes an IMF solution more probable. As a consequence credit spreads would come in slightly, but we will keep on seeing a substantial divergence of spreads between Greece and the core countries of the EUR-zone.

Bernanke playing Pontius Pillatus

2010-01-11T09:11:00.003-05:00

Dear readers,

Fed Chairman Ben Bernanke made surprising comments during a speech at the annual meeting of the American Economic Association. He argued that the link between the aggressive monetary policy after the burst of the dotcom bubble and the 9/11 events on the one hand, and the rise of real estate prices on the other was weak to non existent.

In other words he is denying that the zero-rate policy from his predecessor, Alan Greenspan, was not the driving force behind the build up of the US real estate asset bubble. To support his thesis, he argues that there were a number of countries that had tighter monetary restrictions but still faced an even greater housing bubble compared to the US.

He continued by saying that the use of Adjustable Rate Mortgages (ARM’s) and the lack of regulation prohibiting the sale of these products that was more to blame for blowing up a housing bubble.

There are three major arguments to counter Mr. Ben Bernanke’s thesis:

• Taylor Rule
• Euro zone project
• Financial innovation versus regulation

A. The Taylor Rule

Lat year we already wrote about the Taylor rule. In the early 1970s professor John Taylor developed a model that could determine the appropriate level for (nominal) interest rates based upon the difference between real GDP and potential GDP, often called the GDP GAP.

Apart from the issues that we raised regarding the application of the Taylor rule in the current economic environment, the rule is up to a certain level a reliable tool for central banks to analyse their monetary policy.

Although a proactive/forward looking central bank will concentrate on a variety of macro economic leading indicators instead of examining the realized or expected inflation gap. Nevertheless as a back testing tool the Taylor rule gives reliable results on appropriateness of monetary policies.

Applying this over the period 2002-2005, the Taylor rule shows that the Fed’s monetary policy was too aggressive. Figure 1 shows where Fed fund rates should have been corresponding with 0,1,2,3 or 4% of inflation. Over the period Jan 2002 – Jan 2005 the average US inflation rate was 2.18%. As the chart indicates, Fed fund rates were well below the level what the Taylor rule teaches us (calculations are based upon analysis from the Fed of St. Louis).

Figure 1 Federal Fund Rates based on Taylor’s rule

Source: Federal Reserve of St. Louis

The chart also confirms the fundamental problem that central banks are coping with, i.e. the mismatch in timing of monetary policy versus economic growth. If one compares the change in federal fund rates with the average growth rate in GDP terms during the previous two years one gets a clear view of the overshooting of monetary policy of the Fed (Figure 2).

Figure 2: US 2 Year Nominal GDP Growth versus Fed Fund Rates 1960 – 2008 (1)

Source: Bloomberg Data
Figure 2 also illustrates that the Fed, but this can be generalised to any other central bank, is only catching up periods of economic recovery, but due to its slow response it is paving the way of a next crisis. In other words interventions by central banks can are akin to a pendulum swinging from one extreme to another.

The major reason forl this is because central banks focus not enough on asset price developments. Not only the Fed failed stumbled over this over the years. Another good example is the Bank of Japan that failed to acknowledge the build up of an asset bubble in its economy as well during the late eighties. This triggered the Lost Decade of Japan with deflation continually hampering a sustained economic recovery.

This is a first argument against Chairman Ben Bernanke’s effort in downplaying the role of the Federal Reserve in the US housing crisis.

B. Euro zone project

Then, there is the argument from the Fed Chairman that there were also countries that had tighter monetary restrictions but still faced an even greater housing bubble compared to the US.

It is true that in Spain and/or Ireland, two countries that suffered greatly in the housing crash, interest rates were higher than in the US. However one should not forget that these countries are part of a monetary (EUR) zone where interest rates are set for the whole region. Especially countries like Spain and Ireland were struggling right from the start with an overheating economy, as interest rates set by the ECB were far too low for their domestic economies.

This was inherent in the EUR project where the ECB had to apply a “one size fits all” monetary policy. Nevertheless it is highly unlikely that an independent central bank of Ireland would have kept interest rates that low. Bear in mind that during 2000 Irish inflation ran up to almost 7%. A lose monetary policy (for Ireland) set by the ECB led to cheap Irish credit and consequentially to a real estate bubble. A similar phenomenon was observed in Spain.

This weakens Mr. Bernanke’s thesis further.

C. Financial innovation versus regulation

Last but not least ARM’s and other inventive mortgage products are blamed for the housing bubble. It would be more correct to argue that these products contributed in part to the inflation of house prices, nevertheless the source of the problem remained too much money chasing too few goods.

Hyman Minsky already described the phenomenon of increased financial innovation and deregulation at the end of a business cycle. ARM’s and other products were simply a sign of the times. Even without these products the housing bubble would have been continuously fed via more conventional mortgage products. If money is available for free and on top of that there is the dogmatic conviction amongst house buyers that prices will only ever go up, the end result is a drop in lending standards and asset price inflation.

It is naïve to believe that regulators could have prevented the negative fall out of excess cheap credit by restricting exotic financial instruments. It is like using garden tools in the kitchen. Furthermore regulatory bodies can not regulate as fast as financial institutions innovate. Also, one should not forget that financial institutions are more pushed towards financial innovation (in creating cheap money) when rates are high. That was not the case when banks started to introduce these ARM’s. Rates were very close to zero at the time they were introduced.

In this respect the arguments Mr. Bernanke is raising in playing down the role of the Fed in the build up of this crisis are weak. Certainly there were perhaps 10.12 different key factors, all interacting together over a period of time, that created the crash. For example the role of the US government should not be forgotten. Indirectly via its government sponsored enterprises (GSE’s), Fannie Mae and Freddie Mac, it supported the mortgage-backed securities market and encouraged risk taking.

Nevertheless central banks carry a huge responsibility and as long as they will not start paying attention to asset price developments they risk staying behind the curve and fueling the flames of the next crisis.

(1) Also see Brian S Wesburry “ A US Addiction to Easy Money “, Oct 1994 Journal of Commerce and Gerald O’ Driscoll Jr. ”Asset Bubbles and their Consequences”, May 2008, Cato Institute

2010 outlook

2009-12-04T04:57:00.002-05:00

Dear readers,

We are in the last straight line of what has been a challenging 2009 for every one of us and not only those who have a job in finance. It was an emotional roller coaster where the world crawled through the symbolic eye of the needle in avoiding a depression we only saw back in the 1930s. After that we saw equity markets euphorically rebound from their lows in mid March under the umbrella of massive government worldwide.

Green shoots were added to our vocabulary but we can not shrug off the impression there is a divergence going on between the health of the economy and the state of the stock market. The world is clearly looking for a new equilibrium, and it is obvious it will be at a (much) lower level than we have known earlier this decade.

We admit we underestimated the rebound of the stock market, but we should have known if we had considered the trillions of dollars of liquidity that were poured into the market by governments to keep the financial system afloat. So far our mea culpa of 2009.

Nevertheless we persist in seeing very dark clouds above us. While the stock market is taking a massive advance on economic recovery, the bond market is telling us a completely different story. Yields on short term fixed income paper have been pushed down to almost zero (US T-Bills maturing April 2010 are yielding hardly 7 bps) which forces investors to chase more risky assets or, as Bill Gross of Pimco argued recently “The process of reflation involves lowering short-term rates to such a painful level that investors are forced or enticed to term out their short-term cash into higher-risk bonds or stocks.”

However this almost negative yield level is also indicating that some investors prefer to pay the government to hold their cash in stead of putting their money at work.

It remains the one million dollar question when the Fed and other central banks are going to take back all this liquidity. Maybe from mid 2010 onwards, but it can be (much) later as well. One thing we know already, this will be a painful process for investors. We live at this moment in a very confused environment. On the one hand it is the best of times for investors as central banks offer a “free lunch” to the market, but on the other hand we face the worst of times as the economic fundamentals are still impaired.

One of the major economic challenges will be what will happen in the commercial real estate market. There are some similarities with the residential – subprime market which triggered the Great Credit Crisis of 2007. Back then prices of subprime mortgage bonds, reflected in the ABX Index, were already falling systematically since July 2006. Things deteriorated dramatically over that year and early 2007, HSBC and New Century, two of the major US lenders in that market, gave a first hint they had to make considerable provisions on their mortgage portfolio. It was only at the beginning of August, when two money market funds of BNP Paribas got into trouble, that the distress of the real estate market caught the eye of the public.

Of course, since the beginning of the crisis commercial real estate has been hit hard as well, however there are signs that things are deteriorating. Even the Federal Reserve admits this in its recent Beige Book report.

In the US, year to date there were already 5,772 foreclosures, defaults or bankruptcies representing an amount of $ 123 billion (data: Real Capital Analytics). The major reason is because commercial real estate was highly leveraged, and as a lot of these loans need to be re-financed, the industry is suffering as banks stand on the brakes to continue lending.

To underwrite the statement of Carolyn Maloney, Chairwoman of the Congressional Joint Economic Committee, saying that the commercial real estate market is a ticking time bomb: in the US alone, over $ 2.7 trillion of commercial real estate debt will have to be rolled over in the next 5 years with a peak in 2012 (these numbers do not take into account the additional $ 700 billion – $1.1 trillion of speculative leveraged finance debt). For 2010 between $ 530 and $ 700 billion is due for refinancing (data: Foresight Analytics LLC). According to the FDIC this can bring a total of 700 banks at risk of failure. A disproportionately high number of small and medium-sized banks have sizeable exposure to commercial real estate loans, and delinquency rates at around 7 percent will add further pressure on banks balance sheets that must mark these loans to market.

Financial institutions around the globe are very aware of this next tsunami wave and this is one of the major reasons why banks are so reluctant to lend. The facilities being put in place by central banks are primarily used to restore banks’s balance sheets so as to be robust enough to take the next commercial real estate hit. Lending is only of secondary concern.

Another worrying sign of the commercial real estate situation was the Fed intervention to throw out five commercial market bonds that were pledged as collateral for taxpayer loans to purchase debt earlier in November.

In an effort to clean up bank balance sheets and encourage new lending, the Fed opened its Term Asset-Backed Securities Loan Facility (TALF) to so-called legacy commercial-mortgage bonds. TALF attracts buyers by pumping up returns with low-cost Fed loans. Bonds deemed too risky are rejected. But the latter will limit future appetite for the programme.

All this will continue to weigh as a sword of Damocles on the market in 2010. Will it trigger a huge correction? Maybe, but not necessarily. This is in the hands of the central banks. Only as from the moment they indicate rates will rise again, markets will get nervous.

An interesting report published by the Investment Company Institute, the national association of US investment companies overlooking over $ 11 trillion of assets under management, is showing that cash which was parked on the sideline since the Lehman collapse back in September last year is steadily flowing back to the equity market. Nevertheless the amount that is parked on deposit accounts and money market funds is still well above historical levels.

This teaches us that the stock market remains well supported as any major correction will be used to put money at work. Not because the economic outlook is prosperous, but fund managers are judged by benchmark performances and many of them have missed the rally which took off mid March.

Furthermore the data of the ICI shows especially institutional investors have missed out on the rally, confirming our previous reports that this was a retail driven rally.

This means there is a reasonable possibility that the rally will continue into early 2010, as institutional investors can not afford to remain sidelined.

In the meantime, most probably, we will get further mixed economic data, confirming what John Mauldin still calls a muddle through economy as banks, corporates and consumers continue their deleveraging process.

Around April, when Q1 results come in, it will be a first moment of truth to see whether the preliminary recovery that we have experienced so far is only built upon stockpile adjustments or whether the US consumer shows more resilience. Although considering the fact that Average Joe still needs to bring down its debt ratios and increase it savings it is unlikely that it will come from that side. Therefore any further growth prospects should come from China that continues its path of economic development, on further governmental support.

This brings us to another potential dark cloud, the US government debt. During 2009 the US Treasury had to finance approximately $ 1.8 trillion of debt as a consequence of several bailout packages. For the fiscal year 2010 the White House projects a deficit of roughly $ 1.26 trillion. This is under the assumption that no further bailouts or stimulus packages are needed during next year. Also bear in mind there is another $ 1 trillion to be digested by the bond market for fiscal year 2011 ceteris paribus. (These numbers do not even take into account the additional burden on the US budget due to the new healthcare plans which were approved in Congress earlier this month).This is certainly an environment where the US Treasury can not afford any failed auctions on its bond issuances. Together with a USD which remains under pressure it will be interesting to see how US sovereign debt credit spreads will behave.

There will be no problems at all as long as sovereign wealth funds and other foreign banks continue to buy up US government debt. However from the moment the bond market starts sputtering spreads will widen again. Consider this as a potential black swan event hanging over the market for the next few years with a probability that the market priced at a too low a level the actual risk. This will certainly be a trade where event driven and/or global macro hedge fund managers will continue to look at.

It’s a small step from the US government debt to the USD. Due to the monetary outlook from the Fed, the USD is now used as a borrowing currency in the carry trade, similar to what happened to the JPY over the last 15 years.

We are still waiting for data from the Bank of International Settlements (BIS) to get an idea what the size is of this USD carry trade. Mr. Roubinni earlier this week argued it is 10 times the size of the JPY carry trade. To put this into perspective, according to data from the BIS the total amount of the JPY carry trade was around $ 1.05 trillion!!!

A change in the outlook of US monetary policy will trigger immense volatility in the currency market. In case this happens the borrowed currency starts rising rapidly as every investor involved in the trade has to start buying this currency in order to pay back the loan.

There are several examples of that over the last several years. One to remember was the unwind of the JPY carry trade in September 1999 when the hedge fund LTCM collapsed. In less than a month USDJPY dropped from 122 to almost 100.

Therefore we remain very cautious on recent USD weakness. This can be reverted in a split second, and we consider this one of the major risks of 2010. Even when the current USD carry trade is only twice the amount of the JPY position in 2007, there is a massive systemic risk hanging above the market which can easily push EURUSD towards 1.20 again in a number of weeks. The longer term outlook on the USD however remains very concerning due to the US deficit.

Last but not least the financial state of banks. On both sides of the Atlantic some banks still are in deep trouble but can mask their situation at this moment by a combination of creative accounting and the benefits of a steep yield curve. The head of the IMF, Dominique Stauss-Kahn, expressed similar concerns, arguing that there is a reasonable possibility that 50% of bank losses have not been reported yet, and are hidden in the balance sheets especially among European banks. Only last week the market got shaken up by woes in the Middle East where Dubai World was unable to roll over its debt. Especially major European banks have exposure of up to USD 20 billion to the Emirates state. This is certainly not helpful to the already fragile balance sheets of the financial industry.

If this is a fact 1 of 2 developments could be seen in 2010. Either we might see another wave of nationalisations or, depending on the risk aversion of the markets, banks will have to raise more capital individually. The latter is more likely if we do not return into a Minsky moment like we have seen when AIG and Lehman collapsed during the same week.

To round up cryptically, 2010 will remain a very difficult year, where the cheap funding from central banks act as the Lorelei, one of the Rhine Maidens of the famous Nibelungen song, who rises from the waters trying to lure the ships onto the cliffs with her seductive singing. Despite these temptations it would be wise to keep your ships close to the coast in these stormy weathers.

Animal Spirits: lessons to be learned out of the crisis.

2009-11-05T05:14:00.004-05:00

Dear readers

Back in June we already wrote about the importance of psychology on issues such as inflation (The Unemployment – Inflation Theme). When inflation is discussed it is only a small step towards asset inflation and asset bubbles more specifically. One of the fuel components of the Great Credit Crisis was obviously the housing bubble. Before that people had only just shrugged off another crisis, that is the dotcom bubble.

Unfortunately in this debate on too many occasions one forgets to mention the responsibility of central banks and certainly that of former US Federal Reserve Chairman, Alan Greenspan who fuelled both bubbles with aggressive monetary policy like the way he handled the LTCM Crisis, Y2K and 9/11 events.

According to the Chairman it was not up to central banks to detect the build up of asset bubbles. The only thing a central bank should do in case of an asset bubble burst was to provide enough liquidity to the banking system in order that it would not collapse. Later on this was named the Greenspan doctrine and is closely related to issues such as lender-of-last-resort and moral hazard.

It is not our intention in this newsletter to overload Mr. Greenspan with all the sins of Israel, but do think that central banks should spend more time in studying asset price developments and should search for bubbles which could potentially wreck a (global) economy.

By trying to fix this problem we will have to look at how central banks and (investment) banks have been operating over the last 3-4 decades. Certainly since the Greenspan era there was this blind believe in the “Invisible Hand” and the Efficient Market Theory. There was this dogmatic conviction that the market was always right and would solve any problem. Putting this into doubt brings us on a collision course with one of the greatest economic thinkers of the 20th century Milton Friedman and his Chicago School.

We do not want to throw the free market principle over board. We are still strongly convinced that this has been the best socio-economic model in creating wealth. We all know by now what the credentials were of a state planned economy. So we will not touch this part of the discussion.

More importantly is to go to the core of the assumptions which are being made by the Efficient Market Theory and monetarists such as Milton Friedman. All of these theories start from the hypothesis that all market participants act rationally. Even Mr. Friedman knew that everybody has its individual preferences, but the concept of Homo Economicus, was so tempting as abstraction and strategic simplification, is the only way we can impose some intellectual order on the complexity of economic life.

This reasoning was the corner stone to theories such as the idea Mr. Friedman always taught us that employees and employers remain rational when negotiating on wages or deciding on investments and taking inflation into account this in an undiluted way.

But if this is true, bubbles could not exist. The Efficient Market Theory is also claiming that all information is priced into the market at any time and today’s price is the best indicator for the price of tomorrow. Furthermore the market always finds a balance between buyers and sellers at the right price. This equilibrium can only be disturbed due to a shock in the supply and demand chain, like for example the oil shock we have known in the 1970s. The thought of a previous price increase would lead to another is simply impossible to these classical economists.

However, how can one explain that from one day to another prices collapse? We all have seen the charts of stocks or real estate that fell of a cliff. Conventional economists have no explanation to this either. Even one of its greatest supporters, Alan Greenspan himself, admitted in 2008 he was spooked by this thought.

Behavioral economists may have the answer to this. They have done extensive research around the concept of “the illusion of money”. During a bubble build up it became obvious that investors are selectively ignoring obvious data and their behavior distorts price developments which inflates the price of the underlying asset. Dr. Robert Shiller, one of the great researchers on behavioral finance, applied this to the housing market and described it as follows: “Since people are likely to remember the price they paid for their house from many years ago but remember few other prices from then, they have the mistaken impression that home prices have gone up more than other prices, giving a mistakenly exaggerated impression of the investment potential of houses.” (1)

First of all this comes close to experiences that most of us must have had in the past when trading or investing, in for example stocks. We can call it the state of denial where an investment is going against you, and one refuses to cut your losses. The self fulfilling prophecy in believing that a position will come back to its initial level and hopefully goes back above it. Information is selectively read and analysed and other data pointing to a justification of the correction is ignored.

This to us is already a first sign of the presence of irrational participants in financial markets.

Another lesson that we should have learned already long before the outbreak of the Great Credit Crisis is that markets are more driven by mutual trust than pure rational decision taking. One can detect this easily in the functioning of emerging markets where spreads are much wider compared to developed markets. The spread is the reflexion of available liquidity which can simply be brought back to trust as well. It is because not a lot of people are confident putting their savings at work in let’s say a country like Kazakhstan (just to name one) that it is difficult to find an equilibrium between a buyer and a seller.

This is only an emotional perception, which can easily trigger anxiety and can quickly turn into outright panic. This is what ultimately causes a collapse of prices, what we have seen on many occasions in the past. How many of us didn’t own stocks during the dotcom bubble which decimated overnight? All of us are driven by this illusion of money. It is the failure of this money illusion to account for inflation that will lead to emotion driven investment decisions with painful outcomes at the end of the process.

This is also what happened in the real estate market. Lenders had huge trust in economic data that over the past 70-80 years real estate prices never dropped on average on a national scale. They did not take into account that for example a rise in interest rates would have devastating effects on the repayment capacities of a large number of borrowers. This would lead to foreclosures and would negatively affect the value of houses. Unfortunately when the Federal Reserve started rising rates rapidly from 2003 onwards real estate prices did come under pressure.

Finally it does not take a neurologist or Sigmund Freud to know that there is a huge difference between starting from scratch and making EUR 2 million or having EUR 10 million and losing EUR 8 million but ending up with the same EUR 2 million. For our Homo Economicus, who behaves rationally, it would not make any difference. Unfortunately socio economic pressures around us indicate it makes a massive difference!

Neuroscientists have identified the source of this problem and it is located in the cortex of the brain. People who experienced a car accident with severe head injuries or even patients suffering from autism apparently do not have problems with a balancing exercise of gains versus losses. In both cases a malfunctioning of the ventromedial prefrontal cortex (VMPFC) is to blame. This does not mean that we should put the whole investment world on drugs which would switch out our VMPFC functioning in order to avoid bubbles in the future.

A more useful tool would be the model developed by a group of researchers at MIT which is known by the name “the Adaptive Market Hypothesis” (AMH). The framework they worked out is based upon the evolutionary theory and tries to predict increased volatility among investors. Basically it comes down to measuring the correlation between price changes that took place on a certain trading day and the influence of this on the price change the day after. (2)

This goes against the Efficient Market Theory that argues that price changes are randomly generated in time. However during the build up of a bubble they will identify high correlation, indicating that investors are showing herding behaviour and vice versa. The approach does not throw away the Efficient Market Theory as they recognize that markets can be in an efficient or rational mode but at times it can turn inefficient or irrational. After a bubble has burst the market can return into a more rational condition where investors’ view on the direction of the market is not influenced by each other. But during a bubble build up investors decisions will be highly correlated. We recognize this from street talk such as the TINA-hype (there-is-no-alternative) during the dotcom area and the subprime cycle.

If this AMH model proves to be reliable, it could be used as a tool by central banks to determine their monetary policy. This does not imply that a central bank should immediately start hiking rates when it detects a bubble but as a regulator it can start adjusting certain anomalies in the industry via legislation or rhetoric.

The AMH has also another advantage. It would help explaining why certain trading strategies are successful in certain specific markets. This would increase the performance of funds.

Now we are dealing with the aftermath of the Great Credit Crisis a debate should be started to revise the Efficient Market Theory and the unlimited trust in strength of “the invisible hand” of financial markets. Not only behavioural scientists have the answer to do this. Academics should also go back to their libraries and read the likes of Hyman Minsky. He already warned during the 1990s that financial markets are by definition unstable.

Unfortunately also in the academic world there was herding behaviour. Those who dared to argue that for example Eugene Fama’s theory was build on lose sand got marginalised and treated as a paria. How long took it before the likes of Paul Krugman and Nouriel Roubini were taken seriously? Also among the brightest minds of the world Animal Spirits are king.

(1)Robert Shiller “The Subprime solution: How Today’s Global Financial Crisis Happened and What to Do about It” Princeton University Press, 2009

(2) See also Gary Stix “The Science of Bubbles & Busts”, Scientific American, 2009

And the Fed kept on printing...

2009-10-20T09:38:00.003-04:00

Dear readers,

Recent USD weakness has brought more nervousness in the market. Apart from the EUR and AUD the currency is losing rapidly its value against gold. How is this compatible with our deflationary view? Last week we got further confirmation the deleveraging process is still far from over. US consumer credit contracted more than expected (- $12 billion), and it isn’t showing any sign what so ever of slowing down. Headlines like Barclays wanting to spin off a £ 4 billion structured credit portfolio should be considered as part of the deleveraging process the global economy is going through as well. This should keep consumer prices contained.

Then the Federal Reserve is doing its outmost best to inject some inflation into the system. This is certainly the case for some asset classes such as equities and commodities. Last weeks rhetoric from Fed members Tarullo and Fisher, who is famous for being a hawk, already indicated the Fed will stay on hold for “an extended period” of time. Also the Fed’s 5year-5year forward breakeven inflation rate has been dropping consistently since its spike back at the beginning of August. So no signs of inflation there either. But still gold is touching new historic highs against the USD.

The explanation behind all this might very well be a distrust from foreign investors in how the US Government will succeed in managing this Mount Everest of debt they are building up. There are reasons to believe central banks are already distancing themselves from the USD.

Recent US Treasury auctions showed however good appetite for USD debt paper. The bid-cover ratio has been well above 2%. And foreign central banks subscribed well above $ 250 bln. But the question is whether this is reflecting what is really going on behind the scenes. The Treasury International Capital Flows (TIC) data shows that foreign demand for USD paper is falling off a cliff.

Figure 1: Foreign Assets in the US: Net, Capital Inflow

Source: US Department of Commerce – Bureau of Economic Analysis

This has a direct impact on the value of the USD, as foreigners are net sellers of US assets. The US spending spree financed by foreigners during this decade is also very well illustrated in Figure 1. From 2001 onwards until the breakout of the Great Credit Crisis in 2007 foreigners bought massively US assets. It was part of the build up of a current account and trade balance deficit. The US was the consumer of last resort and the oil-exporting and Asian economies re-invested these revenues back into the US. This US asset buying stopped abruptly from the moment the US consumer couldn’t use his house as an ATM machine.

It does not take a rocket scientist to figure out what would happen to the USD if this structural foreign buying flow dries up. And it is certainly an issue for a country like the US which mounting debt depends on 50% of foreigners.

According to the TIC report, foreign central banks only bought roughly $ 75.7 bln (from Jan 09 till Aug 09). At first one can argue this is highly contradictive against data from the US Treasury auction, which is over $ 250 billion. Fortunately there is no paradox here.

First of all what you need to know is that the Federal Reserve acts as a custodian bank for foreign central banks that buy US Treasuries or Agency paper. In other words the Fed holds these bonds “in custody” for these foreign banks. The TIC data is only showing the amount of capital that is entering or leaving the US, but what happens on these custodian accounts at the Fed is not told.

A first look at these custodian accounts doesn’t raise any suspicion either. The amounts on these accounts have been growing over the years. But when we have a closer look one notices something odd. Central banks have not only been buying US Treasuries, but also US Agency bonds. This is paper issued by for example Freddie Mac and does not have the same guarantee like US Treasuries. Over the years foreign central banks were buyers of US Agencies. At the beginning of October 2008 a peak was reached at around $ 970.4 bio. Over the last 10-12 months this amount has dropped by $ 207.6 billion. US Treasuries on the other hand have risen by more than $ 600 billion.

Remember the TIC data, which is pointing at $ 75.7 of new money entering the US (from foreign central banks). So how does this explain the success of the US Treasury auctions?

Chris Martenson noticed the following phenomenon already back in June.

Foreign central banks are fully supporting the new issuances, but indirectly via their huge amounts of US Agency debt that they swap with the Federal Reserve. This avoids a situation where the Federal Reserve has to start buying its own paper. Imagine which kind of panic this would cause in the bond market.

So basically out of the sale of their US Agency paper, foreign central banks keep on supporting the Fed in buying new US Treasury bonds. But in some way or another, it is ultimately the Fed that is buying its own paper.

However, as we learn from the TIC data, compared to the total of USD 600 billion that has been issued, only USD 75.7 of new money is coming from foreign central banks. In the meantime $ 552.6 billion of private money has been repatriated back abroad. This shows that there is a negative flow leaving the US and explains why the USD is has come under so much pressure recently.

US (Un)-Employment

2009-10-01T10:51:00.002-04:00

Dear readers,

In last weeks’ Givanomics we explained the New Normal. In summary the New Normal stands for much lower economic growth, higher public debts and unemployment rates compared to the levels we were used to before the Great Credit Crisis 2007-2009.

This week we will have a closer look at some data of the US labour market in specific. The data we use is obtained by the Bureau of Labour Statistics, the Federal Reserve and research company Millennium Wave Investments run by John Mauldin.

Last month US unemployment hit 9.7%, getting close at the levels of the 1980-1983 economic recession. In real numbers, based upon a total labour force of 154,577,000 people available for the labour market, almost 15 million are out of a job right now. Over the last two years the US economy lost around 8 million of jobs.

This number is actually even worse if one takes into account the number of people who lost their full time job and have to accept a lower level part-time job. When this group is taken into account the unemployment number would be around 16.8% (this is also known as U-6 unemployment). Then we are not taking into account those who still would like to work but are not available anymore to the job market. Bear in mind in order to be part of the US labour market one needs to be registered. Those who lost all hope because of disappointment fall out of this database. Despite the fact that this is percentagewise a very small group, it would bring the unemployment number closer to 20%.

Reverting to the old normal would mean that 8 million people would need to be put back at work. On top of that one needs to take into account that the US labour market needs on average between 125,000 and 150,000 new jobs every month to accomodate newcomers to the job market. This comes from migration, people who graduate and/or women who are still entering the labour force.

Like there is subordination in a debt structure there will be a hierarchy in the job market to put all these people back to work. This will work out as follows:

The first signs of recovery in the labour market will be seen in the numbers of hours worked on a weekly basis. The first thing an employer usually does when demand is dropping, is to slow down the production process. Job lay offs are the last drastic measure to rationalise the business. From the moment that economic activity is picking up again the average hours worked in a week will start rising again. This fell from 34 hours a week to a record low of 33 hours last June.

Before there will be a substantial recruitment wave in the unemployed labour force, employers will ask part-time workers to work a bit longer, driving up the weekly hours worked. So these will be the first who will turn back to full employment. Then, if we get back to pre-recession levels of 33.8 – 34 hours worked a week, companies will hire back out of the available labour pool of fully unemployed people. The newcomers on the job market however will be the group who will find it most difficult to find a decent job.

When we extrapolate this group for the next 5 years this means that the US job market will need to add 150,000 or 125,000 * 12 * 5 or 7.5 and 9 million jobs. This comes on top of the 8 million people that lost their jobs during the current crisis.

This is the challenge the US economy will face: creating between 15.5 and 17 million jobs over the next 5 years. If we use the lowest number this still would mean that the US job market should grow on a monthly basis by 258,000, and this every month for the next 5 years.

This is a performance that the US economy not even matched during the “Old Normal”. During the booming years this average was around 230,000. If this is averaged out over the last 10 years the average was only 50,000. This was of course with a recession incorporated, but during the prosperous times of the Clinton years the US economy created only 150,000 on average every month.

We can almost guarantee you this will not happen in the absence of a Shadow Banking system that was the driving engine of cheap credit and overconsumption. As far as unemployment is concerned this is the New Normal. The US economy will have to adjust to a new environment of much higher unemployment rates which will have, in turn, a severe impact on spending.

The New Normal

2009-09-25T04:25:00.002-04:00

We may have mentioned the New Normal already a couple of times in our previous newsletters. The term was first introduced by Mohammed El-Erian, co-CIO of Pimco, in May and has triggered a debate among economists on what this means for the long future.

Let us first explain what is meant with this New Normal. Before the Great Credit Crisis broke out in 2007 we were used to robust economic growth numbers north of 3% year on year and a labour market which was close to full employment. The private sector was flourishing and benefitted from a world that got more interconnected.

Since the Great Credit Crisis 2007-2009 all this has come to an end and we will have to adjust ourselves to a new equilibrium which is created by more regulation, higher taxes, less leverage, lower growth and higher unemployment.

There are a number of valid reasons why it will be hard to return to the Old Normal for the next 10 or even 20 years.

The cycle of cheap credit, which was the fuel of the economic growth engine, is definitely behind us. The Shadow banking system collapsed and quite rightly regulators are looking at ways to shut that door for good. Of course markets move in cycles, and there will be again a period in the future where banks will be able to loosen their credit standards. But this will take time. The first phase of deleveraging of the banking sector is behind us. This was an abrupt and disruptive one. Now the second phase has started and should be more orderly. Nevertheless after the residential property market, commercial real estate and credit card write downs will force banks to deleverage their balance sheets further. This means that in the years ahead the supply of credit will be limited and this will be reflected in economic growth numbers.

Then there was the global imbalance of Asian and oil exporting countries that were funding the American spending spree. Although nothing fundamentally has been done yet about this problem, recent rhetoric from the BRIC countries (Brazil-Russia-India-China) shows there is growing caution to invest in US paper which is printed to finance the public household deficits. The Old Normal was based upon a model where the rest of the world was producing cheap products to satisfy American Consumerism and in return received US fixed income paper for it. THE solution to this problem would be that emerging market economies start buying the products that they produce themselves but this is not going to happen immediately and therefore growth will be at a much lower pace.

After the Lehman collapse the private economy imploded and governments all over the world had to issue rescue packages to avoid the global economy coming to a complete stand still. Apart from the banking sector which needed to be rescued anyway for the sake of the deposits of the public, the manufacturing industry needed a helping hand too. The US car industry for example was almost nationalised. Other industries got all kind of life lines and stimulus packages as well and most of them are still in place. Withdrawing these incentives would trigger a new turmoil. As Bill Gross, CEO of Pimco would say, the invisible hand of Adam Smith has been replaced by the visible hand of the public sector.

The US housing market could be considered as the crucial cylinder of the economic growth engine. After the collapse of the dotcom bubble the American consumer used his house in stead of the stock market to keep on spending via several creative refinancing techniques. As a consequence homeownership rose to approximately 70% in the US, but we now know that a lot of people should never have qualified for a home in the first place. At least not if prudent lending practices would have been applied by banks. Under the New Normal homeownership will drop again to pre-housing bubble levels of around 65%. As a consequence, this will not be a driving force for economic growth and the economy will grow at a lower pace as mentioned previously.

The gigantic stimulus and rescue packages issued by governments across the world have derailed the public finances and the taxpayer will eventually pick up the tab. In Europe everybody remembers a similar episode during the early eighties where tried to deal with the aftershocks of the Oil Crises. Fortunately they had the Maastricht Stability Pact to bring their finances back under control. However the problem now is the threat of the aging population in the Western World which is further going to jeopardise the public household deficits of European, American and Japanese governments. This environment will also contribute to lower economic growth.

We concur therefore with Bill Gross’s conclusions that the outcome of this New Normal will be an environment where rates will remain low for a considerable period of time, the USD will face serious difficulties, above average growth will come from new economies in Asia. He even adds two more valid points to this New Normal to be taken into account:
“The extent and duration of quantitative easing, term financing and fiscal stimulation efforts are keys to future investment returns across a multitude of asset categories, both domestically and globally. Investors should continue to anticipate and, if necessary, shake hands with government policies, utilizing leverage and/or guarantees to their benefit.” (1)

(1)Bill Gross “On the course to a New Normal” Investment Outlook, Pimco, Sep 2009

True reasons of USD weakness and other misconceptions...

2009-09-17T11:30:00.004-04:00

Dear readers,

Major theme of this week is the USD under continued pressure driven by two factors : further hopes on recovery, and inflation expectations. In our opinion both are overestimated. The question is however whether these are the true reasons behind this current move?

As far as the recovery theme concerns investors are only listening to what they want to hear. Markets rallied since the beginning of the week on further so called upbeat comments from government officials, central bankers and crucial market players.

Treasury Secretary Timothy Geithner was the first one to come out with comments over the weekend regarding plans to wind down the stimulus packages for banks. This contributed to another boost for bank stocks.

Then central banks officials such as Chairman Ben Bernanke or former Chairman Paul Volcker with comments on the end of the recession. Both though added to this the prospect of low sluggish growth with a severe risk of a double dip. That part however was ignored by the market.

Last but not least Warren Buffet who fuelled the debate by saying some stocks are cheap. First of all he did not mention which stocks were a bargain, but the market generalised his comment and buys whatever is available. Furthermore Mr. Buffet’s comments on the state of the economy were not that upbeat. He literally said “the economy has hit a plateau at bottom”. This to us can be placed under similar comments like Mohammed El-Erian from PIMCO who previously mentioned the global economy will look for a New Normal which will be lower economic growth compared to pre Credit Crunch GDP numbers. An economy at plateau bottom is flat and does not give any signs of upward potential. It is like a plateau in the Alps. It is a temporary relief, but around the corner there are two choices. Either a steep uphill climb resumes or a steep descend is waiting. Nevertheless the market is in a buying mood and ignores for the time being the real warning signs.

We receive further equity flow indications that this rally since August is mainly driven by retail money and logarithmic trading platforms. Major institutional investors keep on being sidelined. We plan to dedicate a separate piece on equity flows caused by algorithmic trading platforms in the week ahead, which will give an interesting inside in what is driving these stock markets recently.

Re. inflation expectations, it’s not clear-cut either. The hype around gold going through $ 1,000 an ounce to us is not a signal of increased inflation risks. We backtested the correlation between gold and inflation over time and there is no clear correlation between them. We compared the price action of the spot price of Gold (in USD terms) versus US CPI over a period of 40 years on an annual basis and also over a period of 30 years on a quarterly basis. The first one gave a negative correlation of 0.1606, the second only +0.1252. This will make you think twice before buying a Gold ETF from a pushy broker that wants to sell this as a protection against inflation risks.

To us the only indicator which would signal a return of inflation will be a rise in the velocity of money V, a topic that we broadly discussed on several occasions in our previous newsletters (remember GDP = M*V). This is still dropping however and indicates that central banks will not take liquidity back in the short term. V rises in an environment where financial innovation flourishes. Securitization was the fuel that drove the M2 & M3 engine. But at this moment we are still in the middle of a deleveraging process and the securitization market is frozen.

M2 is topping off as well after a massive liquidity injection of the Federal Reserve at the end of 2008 (Figure 1). Luckily they did this as, given our equation, the economy would be in an even deeper recession right now. This also means that at this moment the Fed will have no other choice than keep on printing money. How much? To be honest they do not know either and if they would know they will certainly not communicate it to the market as the bond market would start throwing up spontaneously. (1)

Figure 1 M2

Source: Board of Governors of Federal Reserve

The question whether this potential further rise in M2 is going to threaten the USD is hard to answer. To cause a drop in the USD, credit growth by banks needs to rise. This is not the case right now as financial innovation is put on hold and a lot of this money is still sidelined on balance sheets and does not boost economic activity. In this case it can not create selling pressure in the foreign exchange market.

Also, rising inflation expectations from the massive debt build up from various US stimulus packages is another explanation for the current USD weakness. We have always warned that this debt build up would end up in tears sooner rather than later, and quite correctly this will have an impact on the value of the USD. However if we look at the 5 year forward USD inflation curve tracked by the Fed, there are no signs whatsoever either about growing concern on this part. As a matter of fact forward inflation expectations have been falling since the end of July. This is in line with the Federal Reserve’s concern on deflation at the moment. (Figure 2)

Figure 2 Fed’s 5y-5y forward break-even inflation rate

© Bloomberg L.P. Used with permission. Visit www.bloomberg.com

A more valid point for USD weakness would be an increase in risk appetite. Rising stock markets have been a sign of falling risk aversion for several months now. The Volatility Index on the Chicago Board Option Exchange (VIX) fell from above 50 during the turmoil of financial markets at the beginning of the year to 23.44 today. Together with this renewed risk appetite we see the carry trade returning again. However, in the past, this trade was usually set up via low yielding currencies such as the JPY and or CHF ; at this moment the USD is used as funding currency to invest in other high yielding places such as AUD or NZD.

This is only possible when the market does not expect any rate hikes soon from the Federal Reserve as this would damage their funding play. This is not the case with a Fed still concerned about deflation as mentioned above. As long as this is the case this creates automatically additional selling pressure in the FX market as USD loans are sold and swapped for other high yielding currencies.

Then again, current USD weakness could also partially be explained by a trade balance and current account deficit that is showing signs to start widening again. Although the shrinking of both deficits were a positive development in working away one of the major global imbalances, this will only be a temporarily development. The reduction of these deficits was more due to the fall in import prices because global trade came to a standstill after the Lehmann collapse.
The chances that this may have come to an end are rather high and creates more USD pressure.

(1) For more in depth macro analysis we refer to John Mauldin, “Elements of Deflation, Part 2” Sep 11 2009, Thoughts from the Frontline

Dancing on the Ceiling

2009-08-28T07:47:00.003-04:00

Dear readers,

This week we move away from our macro-economic analysis and focus on a worrisome development in the banking sector that was brought to our attention via a Bloomberg story posted this Friday.

Despite the enormous fiscal cost to the tax payer around the world, the past twelve months have been a treasure for global macro players like us who try to detect imbalances and exploit these opportunities or at least protect our investments against these excesses. We were privileged to sit on the first row to see the Great Credit Crisis unfold and it gave us a massive amount of inspiration to write about it. This even ended up in an invitation from Moorad Choudhry to contribute a chapter on the Origin of a Crisis for the 3rd edition of one of his many books he has published so far. More info on this you will find on http://www.palgrave.com/Products/title.aspx?PID=335493

This throws us immediately into our subject of this week. One can easily sum up more than 10 reasons that can be held responsible for causing this crisis. Each of them has a different weighting. For example despite what populists may argue the bonus culture is not top on the list but is rather a Tier 3 or 4 factor in all this. The combination of leverage and the fact that financial firms chose not to transfer credit risk could be appointed as one of the root causes of the financial crisis.

We are now in the midst of a process that governments and regulators are trying to fix the system and make the rules more robust to prevent this from happening again. Certainly one should hope that we would not return to the old sins that brought us into trouble in the first place. Unfortunately when we read the Bloomberg headline we were shocked that some market players return to their old bad habits. It is as if the party has just started again and everybody is singing Lionel Richie's song " We are dancing on the ceiling."

At this moment banks are gearing up their lending to buyers of high-yield corporate loans and mortgages and this at a pace which is even faster then before the outbreak of the Great Credit Crisis in July 2007. To quote Bob Franz, co-head of syndicated loans at CSFB “I am surprised by how quickly the market has become receptive to leverage again.”

According to data from the Fed one can see that among the 18 prime dealers who bid for US Treasuries there is a total of $ 27.6 billion of securities held as collateral for financings lasting more than one day as of August 12. This is up 75% since the beginning of May!!!

The increase proves money is being used for riskier home loans, corporate and asset-backed securities because it excludes Treasuries, agency debt and mortgage bonds guaranteed by
Fannie Mae, Freddie Mac and/ or Ginnie Mae.

Furthermore the increase over that 14-week stretch is the biggest since the period that ended April 2007, three months before two Bear Stearns Cos. hedge funds failed because of leveraged investments. Fortunately lenders are asking more collateral for the loans.

We have no issues with the technique of using a bit of leverage especially when a fair amount of collateral is behind it. Risk needs to be taken. This is crucial to our financial capitalistic system. It may sound harsh but a market economy needs to some degree bankruptcies as it is a healthy sign of risk taking. A financial system so stable that no bankruptcy would take place would be an indication that risk taking is (too) low and this will negatively affect entrepreneurship.

The only issue we have is that there is a justified political pressure on banks to start lending again, but this would be the last form one would expect to return. To the degree leverage coming back represents a normalization of the markets but the idea it should be part of any permanent residential or commercial mortgage securities portfolio strategy is not clever. It is like a heart patient who just recovered from a heart transplant and is immediately trying to run a marathon again.

The risk now is that this new credit leads to more losses at a time when consumer and corporate default rates are rising. Company defaults may increase to 12.2 percent worldwide in the fourth quarter, from 10.7 percent in July, according to rating agency Moody’s. Then there still is the ticking time bomb of commercial real estate.

The end game of this is very colourful described by Julian Mann, a $ 5 billion fund manager in California, “If you leverage up an asset at these already elevated prices, and the underlying fundamentals, like termites, start to chew through the performance of the security, at some point it becomes unsustainable.” We don’t have to remind you what happened from July 2007 onwards…

Stepping back from the experience of the current crisis, and looking forward, it is clear that the issue of financial stability should remain a central focus. The experience of the past few decades in both emerging markets and advanced economies shows the pervasiveness of financial crises. These crises, signals of financial instability and the failure of the proper working of the financial system, have important economic and financial consequences, and usually lead to severe economic contractions that may either be short-lived or persist over time. If the real effects persist, the long-run potential and actual growth rate of an economy may be significantly lowered, negatively affecting long term welfare. (1)

(1) Viral Acharya and Matthew Richardson “Restoring Financial Stability. How to Repair a Failed System.” NYU Stern, 2009

Deflationary spirals

2009-08-12T10:47:00.004-04:00

Dear readers,

We keep on digging in the deflation (D) versus inflation (I) theme as this will keep on dominating the debate for the foreseeable future. In our hunt for an I-D outcome in our last letter, we took a strong bias towards deflation. This week in our I-D series we share a few thoughts from Dr. De Grauwe, who was once on the short list to be nominated on the board of the ECB.

In our Tamiflate (July 2009) and Central Banker’s Paradox (Feb 2009) articles we already highlighted the task of a central bank and the Fed more in specific to inject extra inflation into the system in order to avoid a Dark Decade scenario like Japan. However we also explained at the time that expanding its balance sheet by asset purchases is not enough to influence the price level. Other parameters that might be out of reach of a central bank need also be influenced, i.e. the money multiplier must rise and/or the velocity of money must rise and/or the aggregate supply must show an upward sloping curve.

Remember this is captured in the simple equation GDP = M2 * V (see also Text book economics and keeping President Hoover in mind – April 2009) with M2 a measure for money supply and V representing the velocity of money.

We all know by know that none of these conditions are fulfilled. Personal income is still dropping, consumer spending is contracting due to the deleveraging process and the world will suffer for a very long time from overcapacity. Despite the fact that the new US jobs report last Friday accrued the camp of those who believe in a V-shaped recovery, we should warn for a false perception. The recovery we are seeing is first of all the result of government intervention and stock adjustments. And of that government intervention we can also argue that the only one that is having a significant impact is the one coming out of China. The US stimulus packages hardly make a difference. Once again this empirically proves the very low multiplicator effect of state aid to economic growth. In one of our earlier articles we also pointed out that for every USD spend by the government this would add maximum .3% to economic growth as far as the US is concerned. Furthermore the assumption that the US would lead the world back to growth would mean that the US consumer would return to his old habit of stretching his credit card like wet clay. We all know we are still in the midst of a deleveraging process, so this is not going to happen.

Bear also in mind, and this brings us immediately back to our topic of this week, deleveraging causes deflationary pressures.

Coming back to our equation we will show you why a central bank has limited impact on the money supply. Let’s argue that M2 = MB * m with MB the monetary base and m the money multiplier.

The money multiplier interacts with changes in time, Treasury deposit ratios and the currency. As a rule of thumb when Treasury deposit ratios or excess reserve ratios rise, the money multiplier drops. With the Fed now expanding its balance sheet like there is no tomorrow the excess reserves rise sharply, and as a consequence the money multiplier drops.

The excess reserves simply rose due to the fact that the Fed now pays interest on its deposits, so banks have been incentivized to shift transaction deposits from riskier alternatives to the safety and liquidity offered by the Fed. We still see that a lot of banks park their liquidity at their corresponding central banks. Historically transaction deposits at the banks have fluctuated around 3% to 7% of a bank's balance sheet. In the second quarter, excess reserves averaged $800 billion which is 4.4% of the $18 trillion of bank debt (including off balance sheet). This is the reason that this money does not get recycled into the system. If it is parked at the Fed, ECB, BoE or BoJ it will not be used for investments or new loans issuance.

This is why commercial trade and industrial production fell of a cliff. Now productivity has been rebounding recently and on Tuesday it surprised on the upside, but there is a logical explanation for this. Labour costs have dropped at such a rapid pace as well. This explains why companies have been beating earnings estimates. Before the recession of 2001 productivity typically fell in recessions because companies waited too long to respond to the
downturn. Now, however, the pace of layoffs and the drop in hiring has been so quick and severe that productivity is up 1.8% y/y and unit labor costs are down 0.6%. Labor is the biggest cost by far for most businesses so if demand stabilizes while costs are falling, earnings improve. And the pressure on inflation eases too.

Four deflationary spirals
At this moment there are four deflationary spirals at work, i.e. the Keynesian savings paradox, Fisher’s debt deflation, the cost cutting deflation, and the bank credit deflation. Each of these deflationary spirals can be dealt with when they occur in isolation. However it becomes a dangerous cocktail when they are mixed together.

Keynesian savings paradox.

When one individual desires to save more, and he is alone to do so, his decision to save more (consume less) will not affect aggregate output. He will succeed to save more, and once he has achieved his desired level of savings he stops trying to save more.

When the desire to save more is the result of a collective lack of confidence ( our favorite animal spirits theme from Shiller) the individual tries to build up savings when all the others do the same. As a result, output and income decline and the individual fails in his attempt to increase savings. He will try again, thereby intensifying the decline in output, and failing again to build-up savings. There is thus a coordination failure: if the individuals could be convinced that their attempts to build up savings will not work when they all try to do it at the same time, they would stop trying, thereby stopping the downward spiral.

Somebody must organize the collective action. An individual agent will not do this because the cost of collective action exceeds his private gain.

Fisher’s debt deflation:

When one individual tries to reduce his debt, and he is alone to do so, this attempt will generally succeed. The reason is that his sales of assets to reduce his debt will not be felt by the others, and therefore will not affect the solvency of others. The individual will succeed in reducing his debt.

When the desire to reduce debt is driven by a collective movement of distrust, the simultaneous action of individuals to reduce their debt is self-defeating (Fisher(1933)). They all sell assets at the same time, thereby reducing the value of these assets. This leads to a deterioration of the solvency of everybody else, thereby forcing everybody to increase their attempts at reducing their debt by selling assets.

Here also there is a coordination failure. If individuals could be convinced that their attempts to reduce their debt will not work when they all try to do this at the same time, they would stop trying and the deflationary cycle would also stop. An individual, however, will have no incentive to organize such a collective action.

Cost cutting deflation
When one individual firm reduces its costs by reducing wages and firing workers in order to improve its profits, and this firm is alone to do so, it will generally succeed in improving its profits. The reason is that the cost cutting by an individual firm does not affect the other firms. The latter will not react by reducing their wages and firing their workers.

When cost cutting is inspired by a collective movement of fear about future profitability the simultaneous cost cutting will not restore profitability. The reason is that the workers who earn lower wages and the unemployed workers who have less (or no) disposable income will reduce their consumption and thus the output of all firms. This reduces profits of all firms. They will then continue to cut costs leading to further reductions of output and profits.

There is again a coordination failure. If firms could be convinced that the collective cost cutting will not improve profits they would stop cutting their costs. But individual firms have no incentives to do this.

This is not contradictory to what we have stated above. There we made the assumption that labour costs would drop in case of a stabilizing demand. In case of a deflationary environment demand will not stabilize but drop further as well and ultimately will effect the profitability of firms.

Bank credit deflation:

When one individual bank wants to reduce the riskiness of its loan portfolio it will cut back on loans and accumulate liquid assets. When the bank is alone to do so (and provided it is not too big), it will succeed in reducing the riskiness of its loan portfolio. The reason is that the strategy of the bank will not be felt by the other banks, which will not react. Once the bank has succeeded in reducing the riskiness of its loan portfolio it will stop calling back loans.

When banks are gripped by pessimism and extreme risk aversion the simultaneous reduction of bank loans by all banks will not reduce the risk of the banks’ loan portfolio. There are two reasons for this. First, banks lend to each other. As a result when banks reduce their lending they reduce the funding of other banks. The latter will be induced to reduce their lending, and thus the funding of other banks. Second, when one bank cuts back its loans, firms get into trouble. Some of these firms buy goods and services from other firms. As a result, these other firms also get into trouble and fail to repay their debt to other banks. The latter will see that their loan portfolio has become riskier. They will in turn reduce credit thereby increasing the riskiness of the loan portfolio of other banks.

There is again a coordination failure. If banks could be convinced that the simultaneous loan cutting does not reduce the risk of their loan portfolio they would stop cutting back on their loans and the negative spiral would stop. They have no individual incentives, however, to engage in collective action.

This reduction by bank loans got once again confirmed last month. According to the Wall Street Journal 13 out of 15 US banks cut back on their loan book in the second quarter. And the trend is continuing. Total bank credit contracted $41 billion (a 20% plunge at an annual rate!) for the week ending July 15. This was the fourth weekly decline in bank credit, totaling $94 billion. During the July 15th week, residential loans contracted $23 billion and have been down now for five of the past six weeks. Credit card outstandings fell $1.5 billion during the week (also a 20% annualized slide). Commercial & industrial loans dropped $1.7 billion — down over $50 billion in just the past three months or a 13% annual rate, which is unprecedented. It is worth highlighting that credit is the tint that makes the mare run — there is zero chance that the green shoots will amount to anything with bank credit in contraction mode as of mid-July, ironically the same month that so many pundits are pegging as the end of the recession.

Now coming back to the deflationary spirals that we described above, they all have the same structure. The actions by economic agents create a negative externality that makes these actions self-defeating. This spiral is triggered by a collective movement of fear, distrust or risk aversion ( once again we refer to animal spirits of Akerlof and Shiller(2009)). Individuals (savers, firms, banks) are unable to internalize these externalities because collective action is costly. As a consequence there is a failure to coordinate individual actions to avoid a bad outcome.

Cyclical movements in optimism and pessimism (animal spirits) have always existed. The question is though why exactly now they lead to such a breakdown of coordination? Paul De Grauwe makes a thorough analysis on this that we share in full text with you:

“The four deflationary spirals we identified, although similar in structure, are different in one particular dimension. The savings paradox and the cost deflation can be called “flow deflations”. They arise because consumers and firms want to change a flow (savings and profits). The other two involve the adjustment of stocks (the debt levels and the levels of credit). We call them “stock deflations”. Problems arise when the flow and stock deflations interact with each other.

In “normal” recessions such as the ones we have experienced in the postwar period prior to the present crisis, only the flow deflations were in operation. There had not been a preceding period of excessive debt accumulation and unsustainable levels of bank loans. As a result, households, firms and banks were not trying to adjust their balance sheets. The pessimism of households and firms was related to expected shortfalls in income and profits, and led to increased savings and cost cutting. In such an environment in which the stock levels were perceived to be right, there were sufficient automatic equilibrating mechanisms that prevented these two flow deflations from leading to an unstoppable downward spiral. The most important equilibrating mechanism occurred through the banking system.

When banks function normally they have a stabilizing force on the business cycle. The reason is that in a recession the central bank typically reduces the interest rate making it easier for banks to lend. In normal circumstances, when banks are not in the process of cleaning up their balance sheets, they will be willing to transmit this interest rate decline into a reduction of the loan rate. As a result, banks will engage in automatic “distress lending” to firms and households. Households will be less tempted to increase their savings. In addition, private investment by firms will be stimulated, i.e. firms will be willing to dissave, thereby mitigating the deflationary potential provoked by the savings paradox.” (In De Grauwe(2009) I show this in the context of a simple IS-LM analysis).

The interest rate decline will also mitigate the cost cutting dynamics. This is so because it improves the profit outlook for firms, giving them lower incentives to go on cutting costs. Thus when the banking system functions normally, there are self-equilibrating mechanisms that prevent the flow deflations from degenerating into uncontrollable downward spirals.

The problem the world economy faces today is that flow and stock deflations interact and reinforce each other. The period prior to the crisis was one of excessive buildups of private debt and banks’ assets. The result of these excessive buildups of private debt and balance sheets is that the stock deflation processes described in the previous section operate with full force. As a result, the equilibrating mechanism that exists in normal recessions does not function. The lower interest rates engineered by central banks are not transmitted by the banking sector into lower loan rates for consumers and firms. In addition, we now are confronted by the interaction of the flow and stock deflations. This interaction amplifies these deflationary processes. This interaction, which is especially strong in the US, can be described as follows. Because of excessive debt accumulation of the past, households desire to reduce their debt levels. Thus they all attempt to save more. As argued earlier, these attempts are self-defeating. As a result, households fail to save more, and thus fail to reduce their debt. This leads them to increase their attempts to save more. The fact that the banks do not pass on the lower deposit rates into lower loan rates makes things worse. There are no incentives for firms to increase their investments (no dissaving). Nothing stops the deflationary spiral.

The interaction goes further. The deteriorating conditions in the “real economy” feed back on the banking system. Banks’ loan portfolios deteriorate further as a result of increasing default rates. Banks reduce their lending even further, etc. In De Grauwe(2009) it is shown that a banking sector that is in the grips of credit deflation and deleveraging can destabilize the economy and can push the economy into a true deflationary spiral.

The irrelevance of modern macroeconomics

Modern macroeconomics as embodied in Dynamic Stochastic General Equilibrium models (DSGE) is based on the paradigm of the utility maximizing individual agent who understands the full complexity of the world. Since all individuals understand the same “Truth”, modern macroeconomics has taken the view that it suffices to model one “representative individual” to fully represent reality. Thus as a consumer the agent continuously maximizes an intertemporal utility function and is capable of computing the implications of exogenous shocks on his optimal consumption plan, taking full account of what these shocks will do to the plans of the producers. Similarly, producers compute the implications of these shocks on their present and future production plans taking into account how consumers react to these shocks. Thus in such a model coordination failures cannot arise. The representative agent fully internalizes the external effects of all his actions. When shocks occur there can be only one equilibrium to which the system will converge, and agents perfectly understand this (Woodford(2009)).

Deflationary spirals as we have described them in the previous sections cannot occur in the world of the DSGE-models. The latter is a world of stable equilibria. It will not come as a surprise that DSGE-models have not produced useful insight allowing us to understand the nature of the present economic crisis. Yet vast amounts of intellectual energies are still being spent on the further refining of DSGE-models.

Collective action to stop the deflationary spirals
The common characteristic of the different deflationary spirals is a coordination failure. The market fails to coordinate private actions towards an attractive collective outcome. This market failure can in principle be solved by collective action. Such a collective action can only be organized by the government. Let us analyze what this collective action must be to deal with the different forms of deflation.

The key to economic recovery is the stabilization of the banking sector. As argued earlier, a banking sector that is in the grips of credit deflation and deleveraging can destabilize the economy and can push the economy into a true deflationary spiral.

There is no secret about how the bank credit deflation can be stopped. Here are the principles (see Hall and Woodward(2009) for a more detailed analysis). First, bad loans should be separated from good loans, putting the former in separate entities (“bad banks”) to be managed by specialized management teams whose responsibility it is to dispose of these assets. Losses on these bad assets are inevitable, and so is the inevitability that the taxpayer will be asked to foot the bill.

The good loans remain on the balance sheet of the “good bank”. The hope is that this good bank, freed as it is from the toxic assets, will feel liberated and will be willing to take more risk so that the credit flow can start again. One can doubt, however, that a privately run good bank will have sufficient incentives to start lending again. The reason is that extreme risk aversion and a desire to “save the skin” of the shareholders will restrain the managers of the good bank in extending loans. If that is what the managers of the good bank do, the bank credit deflation process described earlier will not stop. This leads to the issue of whether it is not desirable to (temporarily) nationalize the good bank. Such nationalization would take away the paralyzing fear that new bank loans put the bank’s capital (and its shareholders) at risk.

There is a second reason why the government may want to temporarily nationalize the good bank. The bad bank – good bank solution carries the risk of socializing the losses while privatizing the profits. Indeed, the losses of the bad bank will necessarily be borne by the taxpayers. If the good bank remains in private ownership the expected future profits will be handed out to the shareholders. But these profits will be realized only because the toxic assets have been separated and the losses on these assets have been borne by taxpayers. It is therefore more reasonable to make sure that these future profits are given back to the taxpayers.

The resolution of the bank crisis along the lines discussed in the previous paragraphs is a necessary condition for the recovery. It will also make the use of other macroeconomic policies easier and more effective. These other macroeconomic policies must be geared towards resolving the other deflationary processes. Let us discuss these consecutively.

The Keynesian savings paradox
The collective action failure implicit in the Keynesian savings paradox calls for the government to do the opposite of what private agents do, i.e. to dissave. Dissaving by the government is a necessary condition for making it possible for private consumers to succeed in their attempts to save more.

A well-functioning banking sector reduces the need for dissaving by the government. When the banking sector works well, the consumers’ attempts to save more leads to a lower interest rate and induces firms to invest more (they dissave). As a result, the required dissaving by the government is reduced correspondingly.

Fisher’s debt deflation
Government action is required to solve the coordination failure implicit in the debt deflation process. This can be done by taking over private debt and substituting it with government debt. In doing so, the government makes it possible for the private sector to reduce its debt level. The private sector will then stop attempting (unsuccessfully) to reduce its debt level. The debt deflation process can stop.

The issue that arises here is whether the substitution of private by government debt will not lead to unsustainable government debt levels. There are two aspects to this issue. Let us first look at the debt levels of the public and private sectors in the euro zone. These are shown in figure 1. The most remarkable feature of this figure is how low the government debt is relative to private debt. In addition, the government debt is the only one that has declined (as a percent of GDP) during the last 10 years. This contrasts with the debt of households and especially the debt of financial institutions that has increased significantly and that stood at 250% of GDP in 2008. This is three times higher than the debt of the government which stood at approximately 70%. We conclude that more than the public debt, the private sector’s debt has become unsustainable. The process of substitution of private debt by public debt can go on for quite some time before it reaches the levels of unsustainability of the private debt.

Figure 1

Source: European Commission

The second dimension to the sustainability issue of government debt arises from the question of what will happen in the absence of a government takeover of the private debt. The answer is that in that case the debt deflation process is not likely to stop soon. As a result, output and income are likely to go down further. This will negatively affect tax revenues and will increase future budget deficits, forcing governments to increase their debt. Refusing to stop the debt deflation dynamics by issuing government debt today will not prevent the government debt from increasing in the future. The same problem of sustainability of the government debt will reappear.

To conclude it is useful to formulate a methodological note. The effectiveness of fiscal policies has been very much analyzed by economists. It appears from the empirical evidence that fiscal policy is limited in its effect to boost the economy. This evidence, however, is typically obtained from equilibrium models estimated during “normal” business cycle movements (see e.g. Wieland(2009), Cogan, et al. (2009)). In the context of the flow and stock deflations that are disequilibrium phenomena and that at the core of the present economic downturn, fiscal policy becomes an instrument to stabilize an economy that otherwise can become unstable. This feature is absent from modern macroeconomic models that are intrinsically stable. The evidence obtained from these models may not be very relevant to gauge the effectiveness of fiscal policies in the present context.

References
Akerlof, G., and Shiller, R., (2009), Animal Spirits: How Human Psychology Drives the Economy and Why It Matters for Global Capitalism, Princeton University Press,
Cogan, J, Tobias, C, Taylor, J, and Wieland, V., (2009), “New Keynesian versus Old Keynesian Government Spending Multipliers”, CEPR Discussion Paper 7236, March 2009.
De Grauwe, P. (2009), Keynes’ Savings Paradox, Fisher’s Debt Deflation and the Banking Crisis, http://www.econ.kuleuven.be/ew/academic/intecon/Degrauwe/PDG-papers/Work_in_progress_Presentations/Flow-Stock%20Deflations.pdf
Fisher, I, (1933), The Debt-Deflation Theory of Great Depressions, Econometrica, 1, October, pp. 337-57.
Hall, R., and Woodward, S., (2009), The right way to create a good bank and a bad bank, www.voxeu.org/index.php
Minsky, H., (1986), Stabilizing an Unstable Economy, McGraw Hill, 395pp.
Wieland, V., (2009), The fiscal stimulus debate: “Bone-headed” and “Neanderthal”? http://www.voxeu.org/index.php?q=node/3373
Woodford, Michael (2009), “Convergence in Macroeconomics: Elements of the New Synthesis”, American Economic Journal: Macroeconomics, Vol. 1, No. 1, 267-279

Tamiflate: A strong medicine against deflation

2009-07-23T12:05:00.003-04:00

Inflation versus deflation will be an infinitive ongoing academic debate. On several occasions we have pointed at the Federal Reserve’s balance sheet which has been expanded to unseen levels and simultaneously a US government which is creating a budget deficit which will soon go through the 100 % per GDP level.

When you are a classic monetarist you can only come to the conclusion this is going to ignite a serious inflation bubble in a couple of years from now. If you look at the logic that is used by the Australian Economic school there are arguments to be made this is a recipe for deflation seen in Japan, as foreign investors to flee both the dollar and Treasuries, driving up real interest rates, pole axing any revival in risk asset prices, themselves backed by the fruits of bubble-driven mal-investment.

Both schools have valid arguments, and that is why it is so difficult to choose a side in the debate and as a consequence tailor a policy on the back of the current issues. Certainly if the risk of a deflationary environment is being discussed, and Chairman Bernanke even repeated only this week in front of a Congress hearing Committee that deflationary risks are still present, the glooming picture of the Lost Decade in Japan shows up. However two highly reputed economists, Ben Bernanke himself and Paul Krugman, have developed a draft of a policy framework to solve the problem.

Paul Krugman’s paper in 1998 starts from the IS-LM curve in looking for an answer what Japan should have done to break through its deflationary cycle. He argues that when a central bank has brought its short term interest rates to zero, it will not be enough to start using the tool of quantitative easing to solve the liquidity trap. The reason for that is that from the moment, and this is very topical at this stage, that the markets believe that all this liquidity will be taken back somewhere in the future (for example central banks that are talking about exit strategies) the extra money that is printed right now will simply be parked on accounts and will not be spend. In this case the deflationary cycle remains intact.

In order to ignite spending behaviour a central bank should give a signal to the public that it will keep on printing money in the future rather than taking this money back. By doing this it will shift deflationary expectations to inflationary expectations. Or: “The way to make monetary policy effective is for the central bank to credibly promise to be irresponsible – to make a persuasive case that it will permit inflation to occur, thereby producing the negative real interest rates the economy needs." (1)

The way to achieve this would be by putting upfront an inflation target which is higher than the real (negative) inflation number at that moment. To get out of this liquidity trap the central bank needs to radically change expectations to the notion that there is no exit strategy, at least until inflation is appreciably higher – not just inflation expectations, but inflation itself. Only then would the commitment to higher inflation be credible, with the central bank not just talking the reflationary talk, but walking the reflationary walk, turning deflationary swamp water into reflationary wine.

This was Krugman’s advice towards the Bank of Japan in the late 1990s. Unfortunately they were not followed up by the central bank until in 2001 they applied his policy advice to a certain extent. In stead of setting an explicit higher inflation target it committed itself to a policy where they would continue with QE until year-over-year core CPI moved above zero on a "stable" basis. This is a light version of what Krugman initially recommended and it would still take five more years before the deflationary cycle was broken.

Then there is Mr. Bernanke who did extensive academic research on the issue of deflationary pressures and reflected his findings in one of his most important speeches in November 2002 “Making sure it doesn’t happen here.”

His idea was that the BoJ should set itself a price level target (PLT) in stead of an inflation target (IT). The difference is that IT does not define the future path of the price level. This can result in a costly uncertainty for the economy. PLT reduces the future price level uncertainty. The question remains though whether this would come at the expense of increased macro economic instability.

The major problem with IT is that it does not require a credible commitment to long-run stability in the price level. In practical terms, shocks to the price level under IT are simply accommodated and as a consequence not reversed. And uncertainty around price stability is a major concern for consumers when they enter in mortgages for example.

PLT takes this uncertainty away as the central bank in question explicitly commits itself to a certain price level target number. (2)

Mr Bernanke argues: “to restore the price level (as measured by some standard index of prices, such as the consumer price index excluding fresh food) to the value it would have reached if, instead of the deflation of the past five years, a moderate inflation of, say, 1 percent per year had occurred. (I choose 1 percent to allow for the measurement bias issue noted above, and because a slightly positive average rate of inflation reduces the risk of future episodes of sustained deflation.) Note that the proposed price-level target is a moving target, equal in the year 2003 to a value approximately 5 percent above the actual price level in 1998 and rising 1 percent per year thereafter. Because deflation implies falling prices while the target price-level rises, the failure to end deflation in a given year has the effect of increasing what I have called the price-level gap. The price-level gap is the difference between the actual price level and the price level that would have obtained if deflation had been avoided and the price stability objective achieved in the first place.
A successful effort to eliminate the price-level gap would proceed, roughly, in two stages. During the first stage, the inflation rate would exceed the long-term desired inflation rate, as the price-level gap was eliminated and the effects of previous deflation undone. Call this the reflationary phase of policy. Second, once the price-level target was reached, or nearly so, the objective for policy would become a conventional inflation target or a price-level target that increases over time at the average desired rate of inflation." (3)

In this thesis Mr. Bernanke is counting on the communication skills from a/the central bank to create a clear difference between on the one hand a one-time re-flation to adjust a deflated price level back to levels in case there would not have been a deflationary cycle and on the other hand the central banks long term inflation target. Apart from the moral influence of a central bank to realise this perception change in the market he was also counting on a good interaction between the monetary and fiscal authorities to achieve this goal. Meaning one needs a government who is willing to apply a lose fiscal policy for a number of time together with a central bank who is willing to expand its balance sheet unlimited.

He continues: “My thesis here is that cooperation between the monetary and fiscal authorities in Japan could help solve the problems that each policymaker faces on its own. Consider for example a tax cut for households and businesses that is explicitly coupled with incremental BOJ purchases of government debt – so that the tax cut is in effect financed by money creation. Moreover, assume that the Bank of Japan has made a commitment, by announcing a price-level target, to reflate the economy, so that much or all of the increase in the money stock is viewed as permanent.
Under this plan, the BOJ's balance sheet is protected by the bond conversion program, and the government's concerns about its outstanding stock of debt are mitigated because increases in its debt are purchased by the BOJ rather than sold to the private sector. Moreover, consumers and businesses should be willing to spend rather than save the bulk of their tax cut: They have extra cash on hand, but – because the BOJ purchased government debt in the amount of the tax cut – no current or future debt service burden has been created to imply increased future taxes.
Essentially, monetary and fiscal policies together have increased the nominal wealth of the household sector, which will increase nominal spending and hence prices. The health of the banking sector is irrelevant to this means of transmitting the expansionary effect of monetary policy, addressing the concern of BOJ officials about 'broken' channels of monetary transmission. This approach also responds to the reservation of BOJ officials that the Bank "lacks the tools" to reach a price-level or inflation target.
Isn't it irresponsible to recommend a tax cut, given the poor state of Japanese public finances? To the contrary, from a fiscal perspective, the policy would almost certainly be stabilizing, in the sense of reducing the debt-to-GDP ratio. The BOJ's purchases would leave the nominal quantity of debt in the hands of the public unchanged, while nominal GDP would rise owing to increased nominal spending. Indeed, nothing would help reduce Japan's fiscal woes more than healthy growth in nominal GDP and hence in tax revenues.
Potential roles for monetary-fiscal cooperation are not limited to BOJ support of tax cuts. BOJ purchases of government debt could also support spending programs, to facilitate industrial restructuring, for example. The BOJ's purchases would mitigate the effect of the new spending on the burden of debt and future interest payments perceived by households, which should reduce the offset from decreased consumption. More generally, by replacing interest-bearing debt with money, BOJ purchases of government debt lower current deficits and interest burdens and thus the public's expectations of future tax obligations.
Of course, one can never get something for nothing; from a public finance perspective, increased monetization of government debt simply amounts to replacing other forms of taxes with an inflation tax. But, in the context of deflation-ridden Japan, generating a little bit of positive inflation (and the associated increase in nominal spending) would help achieve the goals of promoting economic recovery and putting idle resources back to work, which in turn would boost tax revenue and improve the government's fiscal position." (4)

As far as the US concerns to a certain extend this is already happening. The Federal Reserve expanded its balance sheet considerable and the US Treasury is creating a mountain of debt (USD 1.8 trillion by the end of the year). The deflationary pressures at this moment are not yet that deep as was the case in Japan, but we are only the midst of the deleveraging process. As a result the US will stay in some sort of a liquidity trap for a while and will be the only party responsible for credit demand.

The question remains what will happen if the US consumer does not resume spending. In this case it is clear that Chairman Bernanke will be willing to go and use this extreme powerful tool. It will be like walking over thin ice and there is a possibility that the next generations will be paying a very high price for this (to the extent that we all are not already paying this), but the Fed Chairman made it clear in his title of his speech: "Making Sure 'It' Doesn't Happen Here" (5)

(1)"Japan's Trap," http://web.mit.edu/krugman/www/japtrap.html
(2) See also Donals Coletti and Rene Lalonde “Inflation targeting, Price level targeting and fluctuations in Canada’s terms of trade”, Central Bank of Canada, Winter 2007-2008
(3)http://www.federalreserve.gov/boarddocs/speeches/2002/20021121/default.htm
(4) See also Ben Bernanke, Essay “Japanese Monetary Policy: A Case of Self-Induced Paralysis." Princeton University, December 1999.
(5) The article is also inspired on thoughts from Paul McCulley, MD at Pimco

The Capitol Hill Baby sitting experiment

2009-07-13T05:00:00.004-04:00

We have discussed the issues around deflation versus inflation already extensively in previous weekly reports. In this weekly we try to explain why recessions and the deflationary pressures that go hand in hand with them, take place. Then, we look at some data which can give some guidance whether deflation or inflation might win the debate in the foreseeable future.

Usually the best way to describe a certain system is to look at a model and see how it works on a micro level. One can compare it with model planes or cars being tested in a wind tunnel. In this case Nobel prize winner, Paul Krugman, explains the complex mechanics behind recessions and their deflationary pressures by referring to an example in history which is known as the Capitol Hill Baby-sitting Co-op.

This was a project, which started in the late 1950s, with the intention to give young families, who were living and working in Washington, a network of responsible, experienced adults to take on babysitting duties on a sit-for-sit basis. The experiment grew out to become a micro economy and would be highly representative in explaining how recessions take place and the pressure on prices it can have.

The project would work as follows:
Each member family is given a coupon – pieces of paper worth one half-hour of sitting time. That allowance is to be paid back within a year, in order to keep everyone sitting and everyone going out. A scheduling system is in place to organize sits each month, as well as a payment plan that includes time and a half for things like later hours.
In this system everything is based upon the belief that every couple goes out regularly and some others fit in to do baby-sitting. By doing so one part of the population could earn or save coupons which could be spent in turn when they decide to go out for an evening dinner.
However in the mid 1970s, the co-op experiment experienced something of a recession. There was a shortage of coupons, which led people to panic and hoard their shares. Because there was no regular circulation, the system was falling apart. When a rule requiring that couples go out at least once every six months ended up falling flat, the powers that be decided to create more coupons to alleviate the problem and encourage people to spend.
The shortage of coupons was created due to a lack of effective demand as households wanted to accumulate their cash (coupons). As is the case in a real economy the problem was located on the demand side and not on the supply side. Or in the words of the late Milton Friedman, too many people were chasing too few coupons.
In order to solve the problem the governing board of the co-op decided to put more coupons in circulation and the short term result was that couples were more willing to go out. This in turn created more opportunities to baby-sit, which in turn again stimulated young families to go out more regularly. In other words the vicious circle was broken by printing new coupons.
The latter is a text book recipe used by central banks to fight recessions; that is printing money.
In this respect one can wonder why for instance a nation like Japan could not get out of the deflationary spiral as the authorities used every tool available to break the vicious circle. They lowered short term rates to zero and kept them there for a considerable period of time. They did substantial amounts of quantitative easing. Last but not least there was public spending up to more than 170% of their GDP. None of the above was able to break the deflationary spiral.
Returning back to the micro economy of the baby-sitting co-op we can detect similarities. In order to get the system running again the governing board created the opportunity to borrow coupons and pay them back at a later stage with coupons earned from baby sitting. Of course to keep the system fair there was a penalty imposed where couples who borrowed coupons would have to pay an extra coupon back.
This gave the governing council a tool to boost demand, by changing the conditions of borrowing in times when demand was lagging. This is exactly what central banks are doing in general. However in the example of Japan interest rates were cut back to zero and nevertheless the economy did not kick back into gear.
The explanation for that: seasonal effects. Like in every economy, the baby-sitting co-op experiment experienced cyclical effects as well. Intuitively one can expect that couples were less motivated to go out during winter compared to the summer season. People would accumulate coupons for the summer when they would go out more frequently. When this seasonal phenomenon is not too strong the governing council could still make adjustments on the coupon borrowing in order that supply and demand returned to an equilibrium.
However it is perfectly possible when for example the winter would be very long and cold that even at no penalty to borrow coupons (zero interest rates) households would not be motivated to go out.
This is the situation where Japan has been in for the last 1.5 decades. Most probably due to demographic factors the Japanese population is not willing to spend anymore. An aging population is by definition more savings and less investing oriented. Furthermore an older society is more afraid for challenges of the future. This is why Japan’s economy will underperform significantly even with interest rates a zero.
This is what economists also call the liquidity trap.

The major reason Japan was/is stuck in a liquidity trap is due to the fact that the liquidity provided by the central bank was not passed on to the consumer or the industry. Banks used the extra liquidity to clean up their balance sheets. This is happening right now as well. One could argue, like Milton Friedman, that the solution to this problem would be that the central banks start lending directly to corporates and/or consumers. In theory this is possible, however central banks do not have the infrastructure to do this. Secondly this would not resolve the balance sheet problems of the banks either.
This is however the price one has to pay when a system built up excesses over many years and has to go through a deleveraging process. During this process the available credit is erased at a much faster pace than a central bank can print money. At this moment the amount of credit that is lost is approximately USD 14 tln versus USD 2 tln coming from the Fed and US government. This can be illustrated by looking at the gap between broad and narrow money (Figure 1). Broad money is reflected in M2. Narrow money is what the central bank is injecting into the system.

Figure 1 Broad versus narrow money

Source: John Mauldin OTB newsletter

Figure 1 describes the situation in the US however the picture is very similar in the Euro-zone and the UK.

As long as the gap remains very high it is unlikely that inflationary pressures will return. Even the argument that commodity prices sooner than later will automatically re-ignite inflationary pressures does not pass the test. This for the simple reason that commodity prices are inelastic. Elasticity is the degree to which a demand and supply curve reacts to a change in the underlying price of a product. In case a product is inelastic it means that it would be insensitive to price changes because the consumer has to buy it anyway even when the price would rise considerably.
Products such as oil and food are inelastic products. If prices would rise substantially people would look for alternatives to cut in their household budget. As a consequence demand for other products would fall and still create a deflationary environment.
Further taking into account that the industrial production apparatus is facing overcapacity (the aftermath of the excesses of cheap credit) and as a consequence a very weak labour market which keeps wages contained. This might be the ultimate reason why deflation is a much bigger threat than inflation right now, and for the next foreseeable future.

Average Joe is getting tired

2009-07-01T04:17:00.004-04:00

Dear readers,

This week we will have a look at some data which shows how painful the deleveraging process is for US consumers.

We have talked about the deleveraging process of Average Joe already a few times. Like the Rolling Stones song “Between a rock and a hard place” the US consumer is getting squeezed between his employer and his banker. And the situation is getting more than worrisome.

The global economy is simply looking for a new equilibrium now that the Shadow Banking system has disappeared. Cheap credit was the fuel for US consumption which in turn gave the opportunity to Asian export-led economies to build up huge reserves. Simultaneously in order to meet this high demand, expansion was necessary and production capacity was increased to historically high levels. However, US companies (as a matter of fact this is a global phenomenon but let’s focus on the US situation for now) are now faced with overcapacity and they simply do not need such a large workforce anymore. As a consequence they are still laying off people on a daily basis.

The unemployment rate has been rising since the beginning of 2008. From around 5 % in Jan 2008 this rate has been rising to 9.6% last month. And there is no sign this trend will be reverted any time soon. But instead of showing you an unemployment rate number which might be a bit abstract, let’s translate this into a number for people who are sitting at home.

The total number of US unemployed workers is now at 14.5 million. Figure 1 shows the staggering spike unemployment is taking. This is the first way to visualise the de-leveraging process. In the late 80s we experienced a similar process when the US economy was dealing with the Latin America Banking crisis and later on with the Saving and Loan crisis. Earlier on in that decade we also had the period when former Fed Chairman P. Volcker was fighting an epic battle against inflation.

Figure 1 Total US unemployed workers

Source: © Bloomberg L.P. Used with permission. Visit www.bloomberg.com

However, one immediately notices that the spike we are seeing right now is much more severe. This is simply because of the avalanche of cheap credit created by the Shadow Baking system has been unseen in history. By the end of 2008, total credit outstanding in the US was 3.7 times the US GDP. In real numbers this is between $ 50 – 52 trillion. Figure 2 shows you the breakdown between US households, financials, Government and GSE (Fannie Mae and Freddie Mac).

Figure 2 US Total Credit Debt as a % of GDP

Source: Morgan Stanley

As far as financial institutions are concerned they are in the midst of their deleveraging process. Over the last couple of months we have already seen the pain they have to accept on their balance sheets going through this process. The government is actually more or less taking over this debt mountain. So this is more the law of communicating barrels that we are seeing.

But how is Average Joe doing? We saw the savings rate in the US is rising again. At this moment it is back around 5-6%. But we are not there yet. A lot of people simply do not have the luxury to save. There is an interesting data index which gives a good indication how hard people are feeling the pain on their monthly payments. It is called the exhaustion rate Index and represents the rate at which people who started collecting unemployment benefits have used up their allotted payments before finding a job. This number is showing that the water is above their eye balls. It is at 49.17 % or to put a real number on it, of the 6.96 million people who were receiving benefits aid last month there are 3.42 million people who have used up their payments and desperately need to find a job, otherwise they will have to fall back on family aid to make ends meet up or even worse a bench in the park is waiting for them. Bear in mind the total amount of people who are in a similar condition is much higher. These numbers do not reflect those who have been kicked out of benefit aid programmes or those who are still combining 2-3 jobs a day trying to keep up with their mortgage payments but are on the verge of foreclosure.

The latter is also a painful situation as the government programmes in place to give debt relief is for those who have hit rock bottom and have digged a whole in the ground. To qualify for government aid you don’t only have to fall behind of your payments. You must be delinquent. If you’re trying to cut on your food budget, or selling you’re wedding dresses and jewelry just in order to keep track with your mortgage payments, you will simply not qualify! We are talking about several millions of people here on top of these numbers.

The latest developments on the mortgage market is not helping these people either as the US 30-year average mortgage rate has surged from an April low of 4.85% to a high of 5.74% before falling back slightly. Current levels of US mortgages are still around levels last seen in 2001.

Figure 3 US Exhaustion rate

Source: © Bloomberg L.P. Used with permission. Visit www.bloomberg.com

As long as this keeps on deteriorating one cannot expect any improvement in sustainable growth on the consumer side. Neither can Asian economies, which are highly export dependent, expect that there will come a recovery in international commercial trade. The demand which has to come from Average Joe, who has funded their enormous reserves over the years, is simply not there anymore. With less supply for credit (due to the disappearance of the Shadow Banking system), these economies shift towards a new consumption equilibrium, which exporters are not prepared for.

Do not get us wrong. We probably see some slight recovery in growth, but this is only inventory driven. The so called green shoots that some people might have seen were based on this global inventory rebuild. This is not an abnormal phenomenon. One needs to bear in mind that the global economy around October last year came to a total stand still and inventories were build down very slowly. Around March the store shelves around the world got finally empty (depending on which products you are looking at as in the car industry the parking lots are still full with cars assembled in August-September of last year) and this needed to be restored to some extent.

For a full sustainable recovery we first need the housing market to restore and this goes hand in hand with the labour market as there is a high correlation between delinquencies on loan payments and losing one’s job.

On behalf of the Federal Reserve...

2009-06-19T11:55:00.003-04:00

In this bi-weekly update we will have a closer look at the Quarterly Flow of Funds published by the Federal Reserve earlier this month. However as things are still following each other up rapidly we would like to start with the new reform plan President Obama has unfolded this week and which will trigger a clash between Capitol Hill and Wall Street.

Let us first outlay the most important parts of the Regulatory Reform Plan:

• The Federal Reserve Bank will become the ultimate systemic risk regulator
• Creation of a ‘Council of Regulators’
• Requirement of the originator and/or broker of a securitisation deal to participate over the lifetime of the structure
• Regulation of all OTC derivatives
• Increase Consumer Protection on financial advisory and investments
• New resolution mechanism that allows for the orderly resolution of any financial holding company whose failure might threaten the stability of the financial system, including large hedge funds and major insurers such as AIG.
• Lead the effort to improve regulation and supervision around the world

The first thing that strikes us is the increased power that is given to the Federal Reserve. In its mandate of ultimate systemic risk regulator the Fed will have day-to-day supervision of the largest bank holding companies. It will also have the power to supervise non-bank financial companies (read hedge funds) that reach a size and complexity comparable to these banks. The Fed is also likely to be given the final word on bank capital requirements, including a surcharge for the systemically important financial institutions. This is a lot of power given to a single institution which could come at a cost. One should not forget that the Federal Reserve until now has a lot of credibility and respect in the international financial market scene as a non politicised and independent institute. This reform plan will undermine this.

Secondly by getting access on a day-to-day basis to the management of banks and non financial institutions (read once again hedge funds) it is abandoning the free market principle which is the most important fundamental on which the US became a world leading nation.

We do agree that new rules have to be put in place to lower the systemic risk and force banks to pay attention to their mismatches on the ALM side. But directly interfering in the daily management is a step too far. Simple rules such as limiting the possibility of funding long dated assets (15-20-30 years) with 90 days CP would avoid a large part of the problems that we are in right now. A clearing house for the credit derivative market would make securitisation more transparent. A simple 70-30 ratio on mortgage financing versus equity participation of households buying a property could easily avoid that people leverage up on their housing and will limit the creation of a housing bubble.

The requirement of the originator to take a stake in the securitisation he is bringing to the market is a good initiative, however we want to point to the fact that a large number of banks already did this. Unfortunately there are a lot of examples of securitisation deals where the bank in question took a considerable stake but nevertheless the deal suffered considerable losses.

Consumer protection is also a noble initiative. However such regulatory initiatives have been taken already two years ago in Europe under the Mifid guideline and this has not made a significant difference. We would also like to warn against a pampering of the consumer. To a certain extent one should expect from every investor to do his own analysis properly. Why can a consumer do it when he decides to make a significant investment in for example a house, but does not have the same discipline when he decides to put the same money at work in a bond or stock or even a structure?

Part II on behalf of the Fed…

Last week Federal Reserve chairman Bernanke gave a less optimistic outlook on the economy. Although it is still ignored by the market as they are too occupied with their search for the famous “green shoots”. Prospects remain very worrisome even to a point that Mr. Bernanke came to admit that in certain places in the US things are even deteriorating.

Do not get us wrong. We would love to see things picking up. There is nothing more beautiful when the green shoots and the blossoms from spring are turning into tulips, roses and the caterpillar turns into a butterfly that can flirt from flower to flower.

The only problem in this debate is the lack of underlying fundamentals to justify the arguments. When we start a discussion with the romantics we do lack hard facts from their side. The only argument you hear is that confidence data are rapidly improving. Previously we referred to optimism growing on rising confidence data such as ZEW and consumer confidence surveys. We warned at the time to be very cautious with this kind of data as it is based upon a diffusion index and there is a statistical trap built into it. Remember our argument we made at the time that for example a rise from 25 to 35 is less significant as an increase from 45 to 49. The smaller gain is actually more significant, since it will only require a small further improvement, before actual economic growth is achieved. Apart from that, confidence is nothing more than a perception. The band on the Titanic was playing like there was no tomorrow too…

We on the other hand try to rely on quantitative data which leaves little room to argue with. In our ever lasting search for this type of data, the Fed is very helpful. Earlier this week we came across the Fed’s Flow of Funds Report which is a quarterly highly detailed statistical release on the shape of the US economy. Basically this was the data that made Mr. Bernanke admit last week that things aren’t that sunny as previously indicated.

For those who want to do some real number crunching themselves we share you the website where you can find the data. We had a closer look at it as well and picked out a number of bullet points that caught our eye immediately.

http://www.federalreserve.gov/releases/z1/Current/z1.pdf

To start with on page 7 we come across the borrowing activities split up per sector. We made a quick chart of it and see that basically the abrupt deleveraging process of the financial sector has been taken over by the government. One can argue that the deleveraging is completely offset by the fiscal stimulus pumped in by the US government.

Of course this phenomenon you can notice as well when one has a closer look at the expansion of the Fed’s (and other central banks) balance sheet. The government is replacing the private sector and on previous occasions we have pointed out that the multiplicator effect of governmental stimulus towards growth is very low. We reckon that per USD spend by the government only maximum 30 cents is added to growth.

Table US Borrowing by sector

Source: Federal Reserve Flow of funds

One page 11 we get a good indication about the condition of the credit market. The data clearly shows that the credit market is not improving at all. On the contrary there are even signs that after the Lehman collapse things were more or less contained. It is more specifically in Q1 of this year that circumstances deteriorated. This is the same quarter that government officials started to talk about green shoots.

For example if one has a look at the “open market paper” you will see that in Q4 the activity was to some extent stable, USD 81.5 bln. Only since Q1 of 2009 things are falling again of a cliff: minus USD 662.5 bln.

Also what direct lending concerns from banks things only started to deteriorate in the last quarter: minus USD 856.4 bln. Basically this means that banks are pulling out of the credit market at a pace never seen before.

Similar developments are seen from non bank lenders which contracted by USD 468 bln and mortgages and consumer credit.

This shows that demand is only driven by people who have cash on their accounts. The only borrower in this market is the government, this with an astonishing USD 1,442.8 billion in Q1 (line 3).

The ABS market, one of the markets that the US government identified as need to be supported, is not showing any signs of stabilization. Once again in the last quarter it fell further to a new record low of minus USD 623.4 bln. This is a crucial part in trying to stabilize the housing market.

When we scroll further in the document to page 36 we find out that Security Brokers and Dealers are still disinvesting massively. In Q4 of last year there was of course the exceptional effect of the Lehman debacle where USD 3,336 bln got unwound. However in Q1 of this year this still went on and $ 1.159.2 bln of investments got turned back into cash. The US Treasury, who is desperate to find any investor willing to put money in their bonds, saw the brokers selling off $ 424 bln.

A similar phenomenon comes from the households who are dumping their Fannie Maes and Freddie Macs like there is no tomorrow in the hunt for cash. USD 1,395.7 bln of GSE securities were sold in Q1 of this year.

We have talked about the issues in the Letter of Credit market on several occasions. International trade, due to the implosion of the trade credit market, is as good as dead. Similar as the households, as an entrepreneur or business leader you better have cash in the bank if you want to maintain your inventories as the trade credit door is closed. (cfr. page 51 lines 3 and 10 make this picture very clear)

Towards the end of the report the most astonishing number arises and shows how deep the wounds have been cut by the crisis: the loss of wealth among households. Over 2008 in total USD 10.88 trillion of wealth was lost. The trend continues during the Q1 of 2009 where another USD 1.33 trillion of wealth was destroyed. From the start of the Great Credit Crisis in 2007 in total approximately USD 13.9 trillion went lost in the US alone.

Losses of this dimension are going to take a very long time before people start spending back like in the good old days. All of this has a deep impact on the retail sector and restaurant industry. Quite anecdotally we observed it with our own eyes during one of our latest business trips to the US. In Greenwich and Westport, which are the Beverly Hills of the East Coast, you see supermarkets and high brand international chains closing their doors.

We agree with one of our favourite overseas analysts Mr. Weiss that all we have seen so far is rhetoric of perceptions creating the ultimate pitfall for investors by making them believe that the situation is improving and soon we will be seeing (robust) growth again. In the meantime however, as the report clearly shows, the Federal Reserve is stretching its balance sheet to such an extreme that it has transformed itself in the ultimate SIV that has to keep the US economy on the rails.

The question remains how long can they keep doing this? Can Mr. Bernanke take even MORE radical steps? Can he boldly go where no other modern-day central banker has ever gone before?

Not without shooting himself in the foot! It still won't be enough to avert a continuation of the debt crisis. Indeed, all it can accomplish is to kindle inflation fears, drive interest rates even higher, and actually sabotage any revival in the credit markets.

The nearly $14 trillion in financial losses suffered by US households has inevitable consequences. And massive, nonstop borrowings by the US Treasury in the month’s ahead ˜ driving interest rates still higher ˜ can only make them worse.

Our warning: If you fall for Wall Street's siren song that "the crisis is over," you could be in for a fatal surprise.

Don't believe them. Follow the numbers we have highlighted here. Then, reach your own, independent conclusions.

The unemployment - inflation theme

2009-06-02T05:27:00.003-04:00

Dear readers,

In this week’s report we would like to pay attention to the debate of unemployment versus inflation, this from an alternative angle by using behavioural economics. The findings will be applied to the current macro-economic situation in the US.

Among classic economists, such as Keynes and Samuelson, there was a strong belief in the positive relationship between low unemployment and permanent high growth, highlighted by the Philips curve (Figure 1) which shows high levels of inflation only to be reached when unemployment is exceptionally low.

Figure 1: Illustration of Philips Curve of US in 1960.

Source: Wikipedia

Friedman was one of the first to neutralise this thesis by introducing the concept of ‘money illusion’, which refers to the tendency of economic agents to think in nominal opposed to real terms. This is a typical pattern among monetarists as they make the assumption in their theories that all economic agents act rationally.

This assumption has been attacked over the last 5-7 years as behavioural scientists are gaining importance in the debate. Proof of this is the Nobel Prize reward to Kahneman in 2002, for having integrated insights from psychological research into economic science, especially concerning human judgment and decision-making under uncertainty. (1)

However, the money illusion does play an important role in the mechanics between unemployment and inflation. With the help of behavioural finance we will quickly notice that money illusion is the missing link in the natural rate theory.(2)

In the footprints of Kahneman, G. Akerlof and R. Shiller have done extensive research on this subject and give further guidance on this issue in “Animal Spirits”. Once again it is like a place where tectonic plates come into contact with each other. In this debate it’s the Chicago School under the guidance of the great and late Milton Friedman on the one hand versus the introduction of irrational behaviour to text book economics by the behavioural scientist.

Of course, mainstream economists do not like this approach as it becomes fairly impossible to model or quantify economic relationships when elements like uncertainty are being added to their models. They think in terms of probability which can be mathematically formulated. However, uncertainty, like intuitive behaviour, can not be expressed in a mathematical equation. Here psychology and social group behaviour will lead the way.

The inflation-unemployment debate follows a similar rationale. In the current economic climate jobs are at risk and employers are cutting back on labour as excess capacity outpaces demand. However before an employer (contrary to what many socialists believe) will decide to lay off people, he will look at other options such as reducing productivity which basically comes down to cutting back on the number of working hours and even salary cuts.(3)

Certainly in a deflationary environment wage cuts could be more defendable as disposable income rises as opposed to falling prices. Unfortunately there is something fundamentally rigid between this relationship as we all consider wage cut s as being highly unfair. Of course this is an intuitive approach but statistical date underlines this thought.

“Downward money rigidity can be easily detected from data on wage changes. All one needs to do is look at how often wage changes of different magnitude occur. Suppose we see that wage changes bunch at exactly zero, and there are many more wage changes just above zero, than just below zero. Then we can conclude that employers stop to think before they give their workers wage cuts.”

Further insights are given by Truman Bewley who did a similar qualitative approach.(research conducted in 1999 based upon 334 interviews)

He came to a similar conclusion that in the employers opinion workers would view wage cuts as unfair. They would reduce their commitment to their jobs. Furthermore when the economy revived, they would still be angry and thus more likely to quit.

Employees would only accept exceptional circumstances, such as eminent bankruptcy, as a last effort to save their jobs. Mainstream economists have finally accepted this thesis of wage rigidity but still consider the impact as marginal.

Akerlof did research on this to what extent wage rigidity plays a role. He and his colleague Dickens made simulations on the impact on unemployment of going from 2% to zero inflation. In the benchmark simulation, a permanent reduction of inflation from 2% -> 0% increases the unemployment permanently by 1.5%.(4)

A back-of-the-envelope calculation shows why these results occurred and so robustly. “If workers resist wage cuts, when inflation is lower, their wages will be higher. In the benchmark simulation they would be higher 0.75% if inflation would be 0% rather than 2%. The 0.75% on wages translates into an increase of unemployment by 1.5%.” (5)

How do we know? Akerlof continues that there is a rule of thumb that comes from the Philips curve itself. It takes a 2% increase in unemployment to reduce inflation by 1%. Therefore to neutralise the 0.75% cost increase of the companies, unemployment must rise by 1.5%. This argument is made precisely, with the underlying equations shown, in both Akerlof (1996-200) and Akerlof and Dickens (2007).

If we apply these findings on the current economic data of the US we come to the following findings.

US Inflation dropped by a staggering 6.3% (this reflects a drop from its high at 5.6% in July 2008 to a deflation level of 0.7% late in April 2009). Let us now compare this with the US unemployment rate at the respectively dates. July 2008 unemployment was at 5.8%. April 2009 unemployment stood at 8.9%. As unemployment is a lagging indicator, this would mean the US unemployment rate could still potentially rise to 18.4%. This is under the assumption that the Fed does not succeed in fighting deflation.

Of course a number like this needs to be double checked with reality as well. Our own reference in this case is Japan during the 1990s. The December 1991 inflation was 2.7% at the time. This continued to drop over the next three years to a negative number of -0.3% at the beginning of 1995 and stayed there for the next five to six years. Simultaneously unemployment rose from 2% to 6 % over that period.

This is a much lower factor compared to the study of Akerlof, which is 1.33. For further reference we also checked the Philips curve of Germany, which showed an even lower factor of approximately 1.15.

Important to note in the comparisons of wage inflation versus unemployment among several countries one needs to take into account the influence of unions. We can conclude that the factor in countries where the unions have significant power, such as Japan and Germany, the factor will be rather low. A trivial reasoning goes for countries with low union influence such as the US.

In this case let us assume that the factor of Akerlof is overoptimistic and that the relationship is slightly higher than Japan, for example 1.5. In this case we still come out at a potential unemployment rate for the US at 15.25%. Even a similar factor of 1.33 as in Japan would leave us a number of 14.18% for the US.

The major conclusion of this exercise is that unemployment in the US has much further to go in the coming years under the assumption that the Fed does not succeed in re-inflating the economy. This has two major consequences. First of all we need to take into account that the US will face a prolonged period of below par growth. The second and more eminent consequence will be on the state of the banking industry. Remember that the US Government based their stress-test of the solvency of the US banking industry on the assumption of an US unemployment rate of 8.8% which is already lower than the current rate.

Going forward the unemployment rate has further to rise and as a consequence US banks will face another capitalisation round.

This also means that in the current environment the inflation hype is a bit too early to jump on the band wagon. Of course there will be huge inflation concerns 2-3 years from now, but at this very moment we are still in a deflationary environment.

The current rise of US Treasuries and inflation has more to do with the concerns the market has on the aftermath of the astronomical debt build up that now needs to be issued. To put it into perspective, the US government needs to issue $ 1.8 trillion over the next 10 months. Last year this was “only” $ 400 bln. Take into account that also the UK government needs to come to the market with close to a trillion. The EU governments and Japan will have similar amounts and soon we get a situation where everybody is rushing for the same fire exit. It is this which causes great concern and nervousness.

But at the same time, as unemployment rises, salaries remain contained and have a considerable deflationary impact.

This is a great dilemma for central banks who see their QE initiatives not working as the long end of the curve is running away from them..

1. "Nobel Laureates 2002". Nobelprize.org. http://nobelprize.org/nobel_prizes/lists/2002.html. Retrieved on 2008-04-25.
2. The natural rate theory describes this mechanics as mentioned above by arguing that Actual unemployment cannot fall below the NAIRU, and the inflation rate is likely to rise quickly (accelerate) in times of strong labor demands during periods of growth. It is sometimes referred to as the "natural rate of unemployment" as well, although this term describes an estimated unemployment rate derived from the market's actual performance while the NAIRU is calculated from the Philips Curve.
3. See studies of wage stickiness in Australia, Japan, Germany, Switzerland, USA an UK by Kahn, Card and Hyslop (1997)
4.Similar results were obtained from econometric estimations and in hundreds of other simulations, in which parameters were chosen randomly over a reasonable range.
5. George A. Akerlof and Robert J. Shiller, “Animal Spirits: How Human Psychology Drives the Economy, and Why It Matters for Global Capitalism”, Princeton University Press, 2009

A story of a Russian tourist

2009-05-21T06:48:00.003-04:00

Dear readers,

Last week we received what looked as a funny entertaining story at first, but it made us think about the true reasons behind it. Surprisingly this has been one of the topics we have been writing about recently and could not be more topical.

The story goes as follows:

In a small town on the South Coast of France, with the holiday season supposed to be in full swing, but unfortunately it is raining so there is not too much business going on.

Everyone is heavily in debt. Luckily, a rich Russian tourist arrives in the foyer of the small local hotel. He asks for a room and puts a Euro100 note on the reception counter, takes a key and goes to inspect the room located up the stairs on the third floor.

The hotel owner takes the banknote in a hurry and rushes to his meat supplier to whom he owes €100.

The butcher takes the money and races to his wholesale supplier to pay his debt.

The wholesaler rushes to the farmer to pay €100 for pigs he purchased some time ago.

The farmer triumphantly gives the €100 note to a local prostitute who gave him her services on credit.

The prostitute goes quickly to the hotel, as she owed the hotel for her hourly room use to entertain clients.

At that moment, the rich Russian is coming down to reception and informs the hotel owner that the proposed room is unsatisfactory and takes his €100 back and departs..

There was no profit or income. But everyone no longer has any debt and the small town people look optimistically towards their future.

At the end of the e-mail they raise the question whether this could be the solution to the current crisis. Or is there a catch 22?

Unfortunately indeed there is. Over the last couple of months we have been writing about quantitative easing and the central banks who need to take over the Shadow Banking system as without them the money supply, M2, would collapse which in turn has a negative impact on economic growth.

Remember our equation: GDP = M2 * V

In the example above the Russian tourist plays surprisingly the role of central banker. It is obvious that growth in this cosy little village came to a standstill as their velocity of money turned to zero. The visit of our Russian tourist to the hotel could be seen as the central bank injecting extra money into the village’s micro economy, this to jumpstart the economy again.

The major problem in the town was that previously the inhabitants went on a spending spray and burried themselves in debt. The money injection from the Russian tourist triggered a deleveraging process, similar to what we are seeing right now among US consumers. People within the village also decided to pay off their debts first before they would start spending again.

This illustrates very well the limitations of central banks in generating growth in the current environment. As we previously noted, growth will only be achieved when V at least stays stable and certainly is not zero.

But there is even a bigger problem. At first sight, the story above looks like a happy ending. The hotel owner recuperates his EUR 100 note in time before the Russian tourist comes down from his inspection.

In the real world life is not that kind to us. Chances are high that the hotel owner spends the money again before the Russian tourist returns. In this case this would achieve the initial goal of the central bank, that is creating growth. This will create some new dynamism in the little village and as a result the butcher-farmer- etc will start to adjust their prices again.

However at a certain stage the central bank needs to withdraw the money it has injected in the system before as inflation starts to rise. And this is the moment when our Russian tourist comes down the stairs, and disappointed from the room he has seen, asking his money back.
The catch is that the central bank will come too late. Their track record in the past has been very poor in that matter. The mismatch in timing of monetary rate policy versus economic growth is something central banks always struggle with. If one compares the change in federal fund rates with the average growth rate in GDP terms during the previous two years one gets a clear view of the overshooting of monetary policy of the Fed.

Figure 1: 2 Year Nominal GDP Growth versus Fed Fund Rates 1960 – 2008

Source: Bloomberg data

As Figure 1 clearly shows this was not a one off incident. In 1974 the Fed cut rates aggressively from 10.5% to 5 % over a period of 2 years. In the second year though the economy was already taking off again and the Fed wanted to catch up their previous monetary easing which contributed to the banking crisis of the eighties. The central banks intervention can almost be compared with a pendulum which goes from one extreme to another. The major reason behind this mismatch in timing is the lack of focus by central banks in monitoring asset price developments in the price indices.
Going back to our story, the Russian tourist does not pay attention to what is happening with his EUR 100 note while he is inspecting the room upstairs either. By default he comes downstairs and assumes the money is still there.
Unfortunately in our example the money will be most probably gone. We have all read stories in the press on how Russians are keen on recuperating their money and what happens to the people involved when they can not pay them back. We certainly will not envy our beloved hotel owner as he will face some very rough times…

Smoke and Mirrors

2009-05-07T08:16:00.000-04:00

We keep on being puzzled by the recent stock hysteria. The last couple of weeks we have been shouting from the roof top that we have not seen the bottom (read our Smugglers Bottom article) and soon the market would resume its downturn. Apparently we are wrong as in the meantime the market steamed further ahead and since this week the S&P 500 is showing a positive return year to date.

But still we can not let go that same feeling we had late 1999 and early 2000 when the NASDAQ day after day was setting new records on the board. Also during that period we almost had to go into therapy as we didn’t participate in the rally and saw the people around us their monopoly wealth rising to multi millionaire levels. However we know by now that party ended up in tears as well. The question remains: “Will it be different this time?”

Without being negative or giving the impression we start looking like Waldorf and Stadler, the two grey, old and bitter men on the balcony top of the Muppet Show, we question a couple of things we have seen passing by lately and what is giving hope to a large number of people who think we are out of the woods.

As said earlier on the S&P 500 is back in positive territory since the beginning of the year. A remarkable rally of over 30% was needed from the lows since mid March to establish this. However we still have clear indications the big money managers are not taking part in this rally. There are more signs this is driven by hedge fund managers who are caught by surprise since the G20 at the beginning of last month and have short covered themselves as the bears are driven to the hills.

We have come reasonably unharmed out of the season earnings and some investors have interpreted this as a signal we have seen the worst. Banks quadrupled, obviously leading the pack as they were slaughtered the most of the last couple of months, on phenomenal profit reports. But are they as profitable as they say they are? First of all there is a big difference between operational profit and solvency. The stress-tests on US banks, the government (still) has to publish, will prove this.

Although we have to wait the concrete outcome of the results, it already seems that 10 out of
19 banks will not fulfil the test. In other words they are insolvent. BoA for instance would need $ 34 bln of extra capital to continue their business for the time being. There is also no guarantee they will have to come to the market again 6-9-12 months down the road to raise even more capital.

The IMF calculated in their Q1 report, US banks would still have to write down a joint amount of $ 2.7 trillion on their outstanding loans. Mr. Roubini is even expecting a total of $ 3.6 trillion.

Furthermore bear in mind that the stress tests have been made on a couple of macro economic assumptions which are to us at least very optimistic as well. Probably the government is getting carried away by Chairman Bernanke’s green shoots. One of the parameters the stress tests rely upon is unemployment. The government’s worst case scenario for Q1 unemployment was set at 7.9%. The real result is at 8.06% and is expected to go much higher this year than they expect. So here is already a clear prove the stress tests are based upon highly unstable fundamentals.

An interesting piece on this was written by John Mauldin earlier this week. Refreshingly he made the connection between mortgage failures and job losses. People often forget the correlation between these two parameters. Realty Trac, a company that lists the majority of the foreclosures in the US housing market, detected that job losses result in a foreclosure 10% to 15% of the time. In this case the job losses are a leading indicator. If job losses narrow from the monthly average of 670,000 in the first quarter to let’s say 325,000, almost 3 million more jobs will be lost before year end. Taken into account the above percentages this would result into another 300,000-450,000 foreclosures, and an unemployment rate of almost 11%.

This makes us believe that the re-capitalisation of banks is far from over. It also shows what kind of a vicious circle we potentially are in. The housing market needs to stabilise before banks are out of the wood. And for that the labour market needs to bottom out. On its turn it needs demand picking up again so companies can start hiring again. This summarizes the de-leveraging process we are still in.

When we have a closer look at the Q1 profits of banks we have two observations. First their profits should not be a surprise. The current environment of zero short term interest rates is extremely kind to banks. One should be hung on the highest tree if you would not succeed in making money. But are the profits really what they look like? Let us not forget that banks’ accounting rules have been changed in their advantage.

Take a look at Citygroup’s $ 1.5 – 1.6 bln profit for example. The only way they were able to show this result was by booking a profit of $ 2.7 bln on the decline of their own debt. Under the new accounting rules banks can book a one-time gain equivalent to the decline in their bonds, because in theory they can buy back their own debt cheaply and save $ 2.7 bln over time. This is only paper profit. In hard cash Citi’s real result would have been - $ 1.1 bln. They also reduced the loan loss reserves by $ 1.3 bln this during a time that consumer credit quality is worsening. If you would adjust this to reality (taking into account that Average Joe’s consumer credit is going south) the result of Citigroup would have been a los of around $ 2.4 bln.

Next to the banking sector we forget the troubling car industry. Fiat, who is also a troubled car maker, is trying to take over a virtually bankrupt Chrysler and the European arm of GM, aka Opel. Their ambition is to become one of the leading car manufacturers in the world. We are highly sceptical of these plans. The industry is already buried under excess capacity. Merging these two-three car makers together will cause even greater over supply as they are both fishing in the same pool. This can only end up in further massive lay-offs. Not to mention the end game for Fiat themselves. How are they going to fund this operation? This reminds us of the Fortis saga who wanted to join in the take-over of ABN-Amro. We all know how this ended. Right! In tears…

Furthermore most market participants are not taking into account the impact of a failure of Chrysler, and probably GM later on, on the pension funds that have been a stone mill around the neck of the US carmakers in general over the past decade.
Like there is the Federal Deposit Insurance Corporation (FDIC) to safeguard the deposits of at US banks (up to a USD 100,000 per deposit) there is also the Pension Benefit Guaranty Corporation (PBGC) which is a quasi-governmental agency that insures defined benefit pension plans. They will take over the plan in case a corporate would file for bankruptcy in order that the pension benefits of employees are saved. However there is a pitfall in this so-called safety net. When the PBGC takes over a pension plan the benefits they will have to pay out to the employees are capped to a certain amount, being $ 51,750 a year to be exact. This number is for the people older than 65. For those who are younger the cap is even put at a much lower amount. The first consequence of a Chapter 11 of Chrysler will automatically mean that tens of thousands of people will receive lower benefits than promised or are currently receiving. (Chrysler’s pension plan counts 250,000 participants)
The second catch is, the PBGC is underfunded too. Imagine what the impact is going to be on the funding position of the agency when a player like Chrysler and GM fall. Either the government will have to start an extra money printer to inject new money into it or less/no money available for other potential corporate bankruptcies. The first option is most probably the outcome.
The third pitfall, which is not an issue right now but will become an issue in 3-4 years from now, is the benefits paid out by the PBGC are not inflation adjusted. The pledges that are taken over by the agency become static and will not follow the rise of inflation which will be a disastrous consequence in 10-15 years from now.
In this respect it is not Chapter 11 itself that is an issue right now, but the indirect impact for more than a quarter of a million of workers at the Chrysler factory (and probably GM later on) who will see their live savings being sharply reduced. This will have consequences on future consumer behaviour.
These are only a couple of examples of problems which are making this recovery hype very early days. Mr. Bernanke may be right that in Q4 of this year the US economy might show some modest growth. The plunge in housing starts took out 0.9% of GDP over the last quarters. If the housing market would show signs of stabilisation the .9% hit to GDP would become 0%.
The production cuts which took out 1-2% out of GDP, as companies had to lower their inventories, might stabilise as well as inventories will dry up eventually. As a consequence the decline in GDP from these production cuts can come back to 0% too.
Add to that the tax refunds that people will start to spend temporarily and we might have indeed a slightly positive GDP number at the last quarter of the year.
But this growth is going to be very weak and fragile. At this moment it is based upon a public sector that is taking over the functioning of the private sector. The government is on the board of the banking, insurance and car industry and is controlling the housing market. This is an economy driven by BIG government as Minsky describes in his masterpiece “Stabilizing an unstable economy”. This is a phenomenon we have seen during the mid seventies as well. After the 74-75 US banking crisis we went through a prolonged period of very low growth too.
We are aware that during that period the sky was about to fall as well and it didn’t thanks to the huge government interventions. But don’t forget the leverage at that time was much lower as it is now.
In the meantime equity markets are having a blast. People who had no idea there was anything wrong with the world financial system two years ago, now say the problem has been fixed. Who fixed it? The people who had no idea what was wrong with it, of course. What did they fix it with? The same thing that caused the problem they didn't see - debt. Who makes sure it won't break again? The people who didn't notice the wheels coming off the last time.

I am off to another session at my shrink…

Text book economics and keeping President Hoover in mind.

2009-04-27T03:35:00.006-04:00

First of all our apologies for the delay of this article as it was supposed to be published last week but it got delayed due to unforeseen events. Apparently there are still fat tail curves all over the place. Nevertheless the subject we discuss remains very topical. This week we examine the efficiency of quantitative easing and the continuous danger of taking the wrong policy measures, with the mistakes made by President Hoover during the 1930s in the back of our mind. The decision of the Brown Administration taken last week could potentially be a similar mistake only making the ongoing crisis more difficult to fix.

Quite a lot has been written about it already and this debate will surely dominate the economic agenda in the years ahead. Lately we have been criticized over this exact issue as well as we have been talking about the risk of deflation for more than 10 months now. Until last week, especially in the UK, we were being questioned that despite our negative outlook pure deflation had not yet crystallised compared to three or four Eurozone countries and the US. A major explanation for this is that the UK could ease the deflationary pressures over the last six to eight months due to a devaluation of its currency.

However if we take a look at the pace of inflation dropping from nearly 5% a year ago to 0% in February this would fit well into the definition of the Australian School of Economics as deflation as well. Figure 1 illustrates the deflationary pressures in the UK very well. How much more do you need? In the meantime from the month of March onwards the UK has joined the other countries as well. The Retail Price Index (RPI) showed a contraction by -0.4%.

Bear in mind, deflation is a slow process comparable to the interest rate policy of a central bank. When for example the Fed would hike or cut interest rates, the effects of this move will only show up in the economy the earliest nine months down the line if not longer. The same argument goes for a deflationary process, and having a look at the chart this process still went pretty fast if you are asking us.

Figure 1 UK Retail Price Index

© Bloomberg L.P. Used with permission. Visit www.bloomberg.com

Going forward the debate will be whether the substantial quantitative easing and build up of public debt by governments all over the world will have inflationary consequences. Sooner or later that may well be the case. This is also the ultimate objective of central banks, to inject inflation into their respective economies by quantitative easing.

But if we have a look at what happened in history or go back to our elementary textbooks of economics we get indications that inflation will be more something for later on. The latter will be a topic we will discuss in one of our next newsletters as there is a lot to be said about the over/under shooting of central banks’ monetary policy.

Let us assume for a moment that inflation would start rising again during the ongoing recession or let’s even for a while join the camp of the optimists and assume we are in the early phase of an economic recovery. If so this would automatically hamper the economic expansion and push the economy back into recession. The reason for that is unemployment and manufacturing capacity utilisation. Both have been dropping to historic lows, which is a logic phenomenon in severe recessions. (Figure 2)

Figure 2: US Manufacturing Capacity Utilisation on a monthly basis

Source: Federal Reserve, March 2009

Let us further assume that inflation would start to rise from this point onwards. Given the high level of unemployment, wages would be lagging inflation substantially. As a consequence real household income would decline and further depress consumer spending. This is the ultimate feature of deflation.

Also basic economics support this intuitive thinking. The mechanics of excess labour and production can be explained by looking at the Aggregate Supply and Demand Curve. (Figure 3)

Figure 3 Aggregate Supply and Demand Curve in periods of over capacity

GDP in Trillions

Source: Van R. Hoisington and Lacy H. Hunt

Inflation will not commence until the Aggregate Demand (AD) Curve shifts outward sufficiently to reach the part of the Aggregate Supply (AS) curve that is upward sloping. The AS curve is perfectly elastic or horizontal when substantial excess capacity occurs. Excess capacity puts pressure on companies to lay off staff, cut wages and other costs. Since wage and benefit costs are approximately about 70% of the cost of production, the AS curve will shift outward, meaning that prices will be lower at every level of AD. Therefore, multiple outward shifts in the Aggregate Demand curve will be required before the economy encounters an upward sloping Aggregate Supply Curve and as a consequence creating higher price levels. And this can only take place when household incomes start to rise again. In our opinion such a process will take a lot of time. If we look at what happened to Japan, they had a similar problem which turned into ... The Lost Decade.

Then there is the mainstream argument that the monetary efforts by central banks in general and the Federal Reserve more in particular will raise the risk of inflation considerably. One cannot deny that for example the Fed is expanding its balance sheet to unseen levels in an attempt to push the money supply M2 back up to acceptable levels. Unfortunately until now these efforts did not have any effect on new lending efforts by banks or economic growth.

The problem with this is that M2 is influenced by a number of factors which lay outside the power of a central bank. For instance the public's preference for checking accounts versus their preference for holding currency or time and saving deposits and the bank's needs for excess reserves have an impact on M2. This is also known as the multiplier of money and a central bank has hardly any grip on these parameters.

Having a closer look at the data from the Fed, the total money reserve increased by approximately $ 736 bln. However the excess of reserves went up almost as much, which is $ 722 bln. This caused a significant drop of the money multiplier. (Figure 4)
As a consequence only $ 14 bln of the increase in money reserves was available for lending. This in turn explains in part the significant drop in bank lending over the last two quarters.

Figure 4 M2 Money Multiplicator and Excess Reserves

Source: Federal Reserve Bank

The point we are trying to make here is that sometimes it is naive to assume that considerable expansion of reserves by a central bank (in our example the Fed) is inflationary.

Economic activity can not move forward unless credit expansion follows reserves expansion. This is not happening. Too much and poorly financed debt has rendered monetary policy ineffective.

The Fed did succeed until now in moving up the absolute amount of M2. They had to as M2 was created by the official and shadow banking system over the past couple of years. The latter though is in the midst of a deleveraging process and as a result the Fed has to take over this role.

But only printing of money will not be enough to generate new economic growth. Economic growth represented by GDP can be formulated as follow:

GDP = M2 * V ( )

A central bank will only manage to generate extra growth by increasing the amount of money in case that V remains stable. However if we look at the behaviour of V in times of recessions we see a substantial drop in frequency. (Figure 5) The reason for that is that V is determined by the amount of leverage the banking sector is able to use. This in turn is influenced by financial innovation. We know by now that financial innovation is put back in to the refrigerator and will not come out of it for the next couple of years.

Figure 5 Velocity of Money 1900-2008

Source: Federal Reserve

If we assume that the Shadow Banking system will have more deleveraging ahead, we can conclude that V has further to drop. As a result this can only mean one thing, in order to support economic growth (and this is an explicit mandate for the Federal Reserve) the quantitative easing will not be limited towards the $ 300 bln that was announced last month. Similar like the TARP I, II (and perhaps III and IV) we will see QE I and QE II, III in the next quarters ahead.

All this because a central bank can not control the velocity of money. This also means that the balance sheet expansion, which stands at astronomical levels already, has further to go.

There is also a paradoxical thought in this. We all agree the lessons to be learned from the ongoing Great Credit Crisis are the lack of regulation or de-regulation that took place at the end of the latest boom cycle. Policy makers are eager to increase regulation again for the banking industry and preferably also hedge funds. This with the goal to tame the unnecessary or imprudent use of financial innovation.

However if history is right this entails a paradoxical twist to conventional wisdom. Regulation should be the tightest when leverage is increasing rapidly, but lax in the face of deleveraging.

A similar argument can be made about tax policies. During times of prosperity and flourishing economic growth it is more rational to increase taxes. In times of economic downturns or recessions it is more advisable to lower taxes in order to support disposable income.

Taxes in general always have an effect on price development. In our case when we talk about taxes we refer to income taxes. A sales tax or VAT has an upward price effect. A rising income tax however will have a decreasing effect on prices as consumer demand is cut.

Corporate taxes however are a different story but give the same end result. They allow interest rates to be deductable and as a consequence stimulate debt-financing. In the current environment of de-leveraging it would be more appropriate to promote corporate tax cuts to digest the excesses which have been built up over the last decade.

The problem in the current crisis is a massive / structural build up of public deficits among governments around the world. Politicians are usually tempted to increase taxes to get their household finances back under control. Unfortunately these are the wrong tools to get us out of the crisis. In one of our earlier newsletters we already referred to the crucial policy mistakes made during the Great Depression of the 1930s by President Hoover which made the crisis only worse.

What did we see from the UK Government this week when they presented their budget plans for the current and next fiscal year? They announced a revision of their tax system and increased the income tax from 40 % to 50 % and a 10% rise on national insurance for salaries above £ 100,000.

The consequences of this move will be catastrophic for the UK economy. Socialists will argue this will only affect the 5% rich of the population as only the happy few earn £100,000 + salaries. The problem with this initiative however is that this is a hidden agenda to punish the bankers for the turmoil we are in.

Unfortunately one of the side effects of increasing income taxes to astronomical levels, and the UK tax revision can certainly be categorized as one ( salaries above £ 100,000 will have a tax rate of 60%), is tax avoidance. This group that is targeted is highly mobile and will re-locate to other more tax friendly regions. The only result by imposing such tax will be playing in the cards of the likes of The Caymans, Switzerlands and Lichtensteins.

Despite the unpleasant humid climate, the United Arab Emirates, which are also suffering from a burst real estate bubble, are still very eager to build out Dubai as the fourth financial centre in the world as a hub between Europe and the Asian markets. Initiatives from the Brown Administration will only contribute to a further brain drain from the UK to that country.

This is certainly not the way forward to restore the banking / financial services industry, which in the UK represents 20%+ of GDP. Compared to the US, where that number is only 6 to 8 %, this is a number to be reckoned with.

A more sensible and solid way to stimulate consumer spending would be the introduction of a flat tax system. In this case all household incomes (with an exemption of households of e.g. four would not pay taxes until their annual income would rise above $ tbd) would be taxed by a single marginal tax rate of for example 19 %.

A first advantage would be that it simplifies the tax system. Instead of needing a tax advisor helping you through all the exceptions and filling in hundreds of forms, the tax form would be reduced to a simple post card size form, with on the left hand side the labour income and the right hand side business and or capital income.

Secondly it would avoid double taxation of savings. Registration rights, dividends etc. would be cancelled.

The biggest advantage would be the substantial impact on consumer behaviour and economic growth. Economists from the Heritage Foundation’s Centre for Data Analysis, Dale Jorgenson from Harvard, and think tank The Hoover Institute did research on the subject of growth contribution of a Flat Tax system.

Adopting e.g. a 17 % flat tax system would lead to significant improvement of economic activity in the first 10 years:

• 3.8 million new jobs would be created
• $ 550 billion extra GDP (current US GDP is approximately 13,000 billion)
• Increase in personal savings by 50 %
• Nations capital stock would rise by $ 1.3 trillion

All these factors are desperate elements every economy is looking for. A large part of the 5 million jobs that were lost during the current crisis would be recovered. GDP would rise by roughly 4 %. The savings ratio would be considerably boosted for a nation which is currently buried under debt. A small part of the capital destruction would be restored.

Critics argue this is an unfair system because it would further punish the middle class which is carrying the majority of the burden. The question is whether the critics have already wondered how unfair the current system is. Their calculations invariably take the adjusted gross incomes reported by taxpayers as if they were their true incomes. They fail to come to grips with the shocking fact that over half of all business income never shows up in anyone’s adjusted gross income.

Because the critics are unaware of the additional revenue available from effectively taxing business income at a rate of let’s say 17- 19 percent, they examine flat- rate plans that extract excessive revenue from working people and find that those plans put a heavy burden on middle income wage and salary earners. They do not consider the option of raising a suitable amount of revenue from business income; instead, they propose to continue the current practice of generating almost all revenue by taxing wages and salaries. By letting business income continue to go virtually untaxed, they perpetuate the unfairness of the current tax system.

Bottom line, apart from the potential loss of talent, in times of deflationary pressure it is ludicrous to hamper consumer spending and reduce disposable income by increasing taxes. The UK and possibly the US (as President Obama has similar thoughts on this in order to balance their budget deficits again) will pay a very expensive price for this down the road.

Debriefing the G20 summit: Ceci n'est pas une pipe!

2009-04-07T04:03:00.001-04:00

Now that we have the G20 behind us, it remains to be seen how long this market can drive on the optimism and momentum that has been generated by that summit. The question remains whether the optimism that was present among the G20 leaders was prescient at best, or premature at worst.

When we scroll through the numbers we notice that a lot of packages were already committed to long before the start of the summit and should have been priced into the market last month. So from the $ 1.1 trillion headline there was a lot of “old money” in it.

The $ 1.1 trillion which was sold by Gordon Brown during the press conference as “additional money to support and restore credit, growth and jobs” is misleading. Let’s vivisect this spectacular amount:

• $ 500 bln are additional contributions to the IMF,
• $ 100 bln to the Multilateral Development Bank (MDB)
• $ 250 bln of Special Drawing Rights which the IMF can create itself
• $ 250 bln for international trade finance

Of the $ 500 bln promised to the IMF only $ 250 bln will be transferred immediately and this has already been confirmed by Canada, the EU, Japan and Norway before the summit. Japan’s contributions to this were already communicated back in November. The remainder has been left open and will be decided upon in future G20 summits.

As Capital Economics is arguing, it remains very unclear to which extent the UK and US are going to contribute to this action plan. Since it is money transferred to the IMF, quota’s need to be respected. If these were to be followed, the US might have to contribute up to 17% or $ 85 bln, and the UK 5% or $ 25 bln. Japan’s $ 100 bln promise exceeds their quote of 6% by far, so the UK and or US could try to argue their contribution to be less then their fair share.

$ 100 bln to the MDB will be spread over three years and to be divided between:

• The African Development Bank
• The Asian Development Bank
• The European Bank for Reconstruction and Development
• The Inter-American Development Bank Group

Per EM (Emerging Market) country only a $ 2-3 bln will or could be used for additional aid. Considering the impaired situation of EM, this amount is like a drop in the bucket.

The $ 250 bln of SDR’s will be printed by the IMF and can be considered as quantitative easing but organised by the IMF on a more global scale. However it will be less effective as the QE applied by the Fed-BoE-SNB-BoJ, as this money is stored on the bank accounts of the members, each according to their quotas. Only a fraction will be injected directly to the EM countries (approximately $ 100 bln).

Last but not least there is the $ 250 bln committed to get international trading back going. This will be spread over the next two years. So once again this is not $ 250 bln that will be injected into the system immediately. More importantly the majority of this will have to come from the private sector. The only explicit pledge at the moment is $ 3-4 bln for an aid programme managed by the World Bank.

The only way to get international trade going again is to do something about the Letter of Credit markets. As long as banks are not going to issue LoC’s commercial trade will remain anaemic.

Adding up all these numbers gives a less spectacular amount than the $ 1.1 trillion. It does not even come close to $ 250 bln of new money which would supposedly be injected immediately into the system

There are though a number of positive signs such as the commitment to prevent protectionist measures and stricter regulation, but an important test will be to which extent they translate all these well intended commitments into national legislation. It will be interesting to see regarding the protectionism issue whether the Obama Administration is going to withdraw their “Buy America” Act. (aka ARRA).

As far as regulation is concerned, we are already noticing two-three days after the summit a deep split between continental Europe and the UK. Britain opposes any form of authority given to a centralised European Regulator transformed from a national level.

Also the Council of Systemic Risk creates a split between the member states. The ECB under supervision of President Trichet is all in favour to bring this under its umbrella. Unfortunately, the UK is vetoing this and considers this too a breach of the sovereignty principle.

As you can see the G20 was all about the package and verbal spinning to talk the stock markets up. Even FED Chairman Bernanke on Friday repeated his comments from March, that he is seeing greens seeds of recovery in the economy. Of course one can understand they are not going to create more panic to the public, but it is a big gamble.

Very soon we will need much better data to confirm this optimism in the markets. If not, risk aversion could return very quickly. Many global central banks only began with QE measures in full force during March and so far the jury is still out on their efficiency. Lending remains difficult and as the slow bleed in global labour markets continues, investment demand is now also falling rapidly, regardless of credit availability. The actual trough in growth may be approaching, but it is still sufficiently far away to halt fresh risk-seeking flows as economic performance fails to impress. The volatiliy index (VIX) came down gradually but is still trading at substantial above normal levels indicating further nervousness in the market.

It will be very interesting to see whether we already get through earning season, kicking off tonight after NY close with Alcoa but the outlook on banks is already weighing on sentiment. Certainly Mr. Mike Mayo from Calyon reiterated that the problems in the banking sector are from over.

“While certain mortgage problems are farther along, other areas are likely to accelerate, reflecting a rolling recession by asset class," He continues by saying "New government actions might not help as much as expected, especially given that loans have been marked down to only 98 cents on the dollar, on average." We are also worried by about $ 7 trillion outstanding bank loans in private plus commercial real estate and consumer lending that the public private partnership does not focus on and will not fix. Mr. Mayo expressed similar concerns regarding those loans.

An interesting paper on this subject was published last week by John Hussman. (See link attached.) It describes very well the current situation and recommendations to get the banking sector out of this vicious circle.

http://www.hussmanfunds.com/wmc/wmc090330.htm

So we remain highly sceptical on the current rally and G20 hype and would use Magritte’s famous painting to characterize the whole situation: “Ceci n’est pas une pipe.”

The Smugglers Bottom

2009-03-25T05:47:00.006-04:00

On the 6th of March we set a new low at 666 on the S&P 500 only to rally all the way up again to almost 800 just after the Fed meeting last Wednesday (18th March). The rally was triggered by news from Citigroup (later confirmed by other banks such as Bank of America) that their first two months were profitable again. This made people believe we have seen the worst and from now on we can start looking up again.

During the weekend of March 14th, Fed Chairman Bernanke was lured into an exceptional TV interview where he said on tape that he saw the first green seeds of recovery in the economy. The following Monday markets rallied euphorically further.

Later that week the FOMC surprised the market again with their aggressive decision on quantitative easing. The consensus in the market was they would still take a wait and see stance.The result of all this was that markets were torn apart between the believers of “we have seen the bottom” and those who are still sceptical about it. The Fed action immediately sparked extreme volatility in the equity, currency, commodities and bond markets. The Dow Jones went from -200 points before the announcement to +200 immediately thereafter to end the session at +90. The dollar was under pressure throughout the session, trading in a 1.3416-1.3530 range against the EUR and in an 95.27-96.62 range against the JPY. The USD had its biggest fall since the G7 intervention in 2000 against the EUR and not surprisingly US 10y Treasury yields plummeted 47 bps to yield 2.535 %, the biggest drop since 1962. Gold was testing a technical resistance at 880 to rally back to 935, a 6.25 % rise.

The big question is whether we have seen the bottom indeed. If so, why would the Fed take out the most aggressive tool in history to fight the deflation monster? If there were signs of recovery deflation would certainly not be an issue with all that liquidity that has been pumped into the market so far.

Chairman Bernanke was probably right in saying they narrowly avoided a scenario which unfolded during the Great Depression. Unemployment rose above the 20% globally. At the moment there are no signs it is going to be like that, but on the other hand we are not out of the woods yet.

As said on previous occasions the current crisis is the result of imbalances and excesses built up over a long sustained period, and it will take time before we have digested all this. Global economic growth was driven by a spending spree of the US consumer.

The dynamics are well known by now. The US consumer bought goods from Asia and energy from oil exporting countries. The value of those purchases were simply larger than the US consumers’ income. The difference was funded with home equity or mortgage refinancing. In turn, the rise in mortgage debt was repackaged by investment banks. And to end the cycle all this was sold of and distributed all over the world.

It was just a matter of time before this gigantic imbalance would create a major economic distortion and to return to a normal equilibrium will take much more time then 12 months.

The US consumer will have to start saving (credit is not available anymore to the same extent as it was before 2008) (current savings rate stands at 5%+, vs. negative in the recent past !) which will cause a long period of low economic growth. The spending spree of the US consumer is felt in all layers of society. A very striking article on Bloomberg earlier this week underlines this. Stores on Greenwich Avenue, the ‘Rodeo Drive’ of Connecticut, are closing one after another. As banks and hedge funds cut jobs and close down, the stores on this exclusive avenue shut their doors too. Even a less exclusive brand as Banana Republic closed their shop earlier this month.

Further the global deleveraging process of the banking industry is best case at around 65% with a couple of USD trillion still to go. Increased government regulation and protectionism are hampering further a strong recovery. And excess capacity remains a huge problem.

All this means we will see economic growth below average, with further pressure on employment and corporate results. These are certainly not the signs that the bottom has been reached already. Otherwise, why would we see defaults of corporates of one a week on average at the moment?

Then there is the question whether the euphoria triggered by the upbeat results from Citigroup and BoA is appropriate. The banks posted a much better than expected operating profit. But operating profit says nothing about the solvency state. To be quite honest in the current is extremely attractive for banks. If one does not make a profit now when will they?

An interesting paper came out last week from Dr. Martin Weiss who runs an economic think tank in Washington. He made a thorough analysis on the banking bailout programme that is going on and he gave further arguments to believe the worst is not over yet. (1)

The Federal Deposit Insurance Corporation (FDIC) whose task is to protect deposit holders up to $ 250,000 in case a bank would fail has made a list of 252 institutions that are at risk. The total assets of these banks represent $ 159 bln.

However there is reason to believe that the FDIC is underestimating the outstanding risk and the list will be far greater:

• E.g. one of the largest banks who failed last year, IndyMac Bank of Pasadena ($ 32 bln) was not on the list.
• A number of banks, with total assets much higher than $ 159 bln, and who already received TARP money are not on the list, but this does not mean they are not at risk anymore
• Statistical rating model, developed by banking regulators, made a list of banks at risk which is more accurate then the FDIC’s list

This statistical rating model, called CAMELS ratings, takes into account capital adequacy asset quality, earnings, liquidity and sensitivity to market risk. Based upon this model Weiss Research came up with 1,372 commercial and saving banks still at risk with a total asset portfolio of $ 1.79 tln. Furthermore there are 196 savings and loans associations with $ 528 bln also at risk. Compare this with the FDIC’s number of $ 159 bln and there is reason to believe this is not over yet…

Last year in December we already referred to the exponential growth of the derivatives market causing sever systemic risk. The market already got a serious warning when Lehman Brothers was allowed to go bankrupt what the fallout of all this could mean.

The systemic risk is not going away. On the contrary due to the failure of Lehman and bailout of Bear Stearns and Merrill Lynch the systemic risk is even rising. At this moment the total notional amount of outstanding OTC derivatives is at $ 175 TRILLION. 97 % of the total amount is controlled by 5 banks!!! 49.9 % or $ 87 TRILLION is in the hands of one single bank, JP MorganChase!!!

All these banks have a credit exposure that by far exceeds their risk based capital.

Bank of America : 177.6 % ( credit risk as percentage of risk based capital)
Citigroup : 259.5 %
JPMorgan Chase : 400.2 %
HSBC Bank USA : 664.2 %

The major problem with this situation is that the US Government might not even be capable to bailout one of these banks as their exposure exceeds by far the resources the US Government has.

And the risk is not marginal. Why would for instance JP Morgan have better risk management tools as Lehman or Bear Stearns?
But stock markets are rallying indeed. Although in the past we have seen a similar phenomenon. This is a bear market rally. Figure 1 shows that in Japan they had at least 4 very strong rallies within the bear market trend. The last one was even a rise of over 55 % only to see the market resume its downward spiral. A similar trend was experienced after the tech bubble and 9/11 turned the markets in turmoil. There we can detect at least three false recoveries of 20 % on average each time (Figure 2).

Figure 1: Nikkei Index 1990 - 1999

© Bloomberg L.P. Used with permission. Visit www.bloomberg.com

Figure 2: S&P 500 1999 - 2003

© Bloomberg L.P. Used with permission. Visit www.bloomberg.com

Figure 3: S&P 500 2007 - 2009

© Bloomberg L.P. Used with permission. Visit www.bloomberg.com

In the current bear market this is only the second rebound we are seeing. From November till the beginning of this year we already saw the markets rebound by roughly 25% only to revisit new lows.

Based upon the fundamentals we just outlined above we are very sceptical the rally we are seeing right now is sustainable. Comments like “We have seen the bottom” are misplaced and will cause more pain. That’s why we call this the Smugglers Bottom. A smuggler always has a fake bottom in his suitcase to hide something behind it. This market is the same. The only difference with the smuggler will be that it ain’t something valuable behind it.

Certainly now that central banks across the globe (with the ECB the only exception at the moment but soon they will follow) are starting to bring the long end of the curve also down, sitting on cash could be so depressing that Average Joe is pushed, in a desperate search for some yield, to the stock market. He is even tempted by portfolio managers who are driven by performance anxiety and linked to a benchmark and drive prices up at the moment as the end of Q1 is coming up. The same happened at the end of last year. Managers still wanted to show some performance before the end of the year and a suckers rally was set in for the end of the year.

Forcing money into risky assets is perhaps the most dangerous experiment ever done, and is so large in scale and so unprecedented that we have no idea how it will end. I expect it to end poorly and with hyper-inflation. The funneling of assets into risk is masking the deteriorating fundamentals and giving the appearance of a market that has bottomed. But this is sleigh of hand, an illusion, a chimera.
The Fed has declared a war on savers, a war on prudence and provided the ultimate Moral Hazard Card-and with our money no less (Bernanke put anyone ?). They are also setting up the ULTIMATE BULL TRAP-a trap so large that when it is sprung, perhaps as early as the end of the first quarter/beginning of second quarter, there will only be sellers left. (2)

Following the aggressive QE of the FED we also expect extreme volatility in the currency markets in the next 24 months.

The USD will experience some further weakness in the next couple of weeks due to the fallout of the unexpected aggressive quantitative easing program from the Fed. Although it is remarkable that investors are not leaving the USD head over heels. As we said on several occasions, once there are signs of stabilisation in the US economy it will bear the fruits of the actions undertaken. In that respect the EUR might be the victim longer term given the fact that European political and monetary leaders remain clueless how to tackle the crisis. On the other hand the risk of double digit inflation due to the massive printing of money can cause a Wicksellian disequilibrium.

Just to give a brief introduction into this mechanism, economist Knut Wicksell came to the view that the effects of a disequilibrium between general demand and supply on monetary prices are not temporal but cumulative. In simple terms, any deviation from an equilibrium sets off a dynamic process that continually leads the system away from the equilibrium. If for any reason, the general demand is set and maintained above the general supply, no matter how small that gap is, the consequence will be that prices will start rising and keep on rising.

Wicksell came to his conclusion based upon the findings of his experiences in physics. “The analogous picture of money prices should rather be some easily movable object, such as a cylinder, which rests on a horizontal plane in so called neutral equilibrium. The plane is somewhat rough and a certain force is required to set the price cylinder in motion and to keep in motion. As long as this force remains in operation the cylinder continues to move in the same direction. After a while it will start rolling: the motion is accelerated one up to a certain point, and it continues for a time even when the force has ceased to operate. Once the cylinder has come to rest, there is no tendency for it to be restored to its original position. It simply remains where it is so long as no opposite forces come into operation to push it back again.” (Wicksell 1936) (3)

This also partially explains the danger of intervention by central banks and the overshooting of their targets. From now on it will be key for the FED to start preparing the markets in explaining they have an exit strategy ready. If not the problems down the road can be very worrisome.

Therefore saying that we have seen the bottom is dangerous. We even dare to say it is almost beyond belief to hear this on prime time television from the most powerful man in the world.

(1) Martin D. Weiss “Dangerous Unintended Consequences: How Banking Bailouts, Buyouts and Nationalization can only prolong America’s second Great Depression and weaken any subsequent recovery.” March 19th 2009, Weiss Research Inc

(2) John Mauldin “Setting the Bull Trap”, Investors Insight, Jan 2009

(3) Wicksell “Interest and Prices”, p. 101, 1936 Augustus M Kelley Pubs

China and its Demographics Part II

2009-03-16T05:56:00.002-04:00

Last year in December we wrote an article about China and the demographic challenges they have to tackle in the future. A major growing issue they are facing is the potential social unrest caused by unemployed people in the cities where they are experimenting with capitalism. And this unrest is mounting. Over the last three months more then 20 million people lost their jobs due to the crisis and a drop in exports globally. A lot of those people are simply sent back to their villages inland where they were low paid farmers before they came to the big cities to look for fortune.

In our article we also referred to a possible way the Chinese government would deal with this problem, by expanding their military force to suppress the social unrests. (cfr “The Dark Theory” )

There were already indications over the last couple of years they were heavily investing in their army and last week some further confirmation hit the screens that this is the way they are moving forward and in turn will have an impact on domestic economic growth.

Chinese spokesman Li Zhaoxing confirmed that China would further boost its defence spending by raising salaries of the army and also expand spending in the further build up of their naval and space capabilities. China’s military spending will now total $ 70.3 bln on an annual basis.

Obviously, immediately thereafter came a response from the US Defence Department (David Sedney) by insisting they wanted clarification from China on the connection between its developing military capacity and strategic objectives.

It is, obviously, nothing compared to the budget that the US is spending on its military complex, $ 513 bln for 2009. However, the actual number of China is much higher (as all data produced by the Chinese government is). Based upon data from the International Institute for Strategic Studies (IISS), the official numbers don’t include overseas weapon purchases and research and development. As a consequence the IISS estimates the real number should be much closer to $ 120 bln.

Probably part of their ambition is to expand their influence in the region. What else would you do by ordering the building of a new aircraft carrier, the construction of a new space launch centre (meteorological and telecommunication service centre) for military purposes? However these investments have a much more crucial objective: a tool to keep social unrest under control.

Therefore we also argue that the recent improvement in economic data from China can be explained by an increase in their military spending. The Purchase Manager Index in February was up towards 49 coming back from 35 the month before. Also bank lending was on the rise again.

However we doubt whether this news is as good as the market perceived it. The rise of the PMI is completely due to a rise in government spending. Stocks of warehouses are still massively piling out, ships are still waiting in the ports to deliver their goods. Export numbers are still depressed.

Source: John Mauldin weekly newsletter / www.stratfor.com

Even their import numbers are falling of a cliff which is indicating that domestic demand is as weak as global demand. Therefore it makes sense for the Chinese government to ease the pain that is caused by the global recession to offset this by an expansion in government spending – read military spending. Through this, the Dark Theory becomes ever more concrete.

(1) D. Smick “The World is Curved, 2008 Marshall Cavendish

The Risk of $ repatriation

2009-03-03T05:23:00.005-05:00

This week might be for some of our readers a contreversial topic. We would welcome any feedback on this because we can imagine this is going to raise some eyebrows. At this very moment the theme of the day remains the risk aversion of investors supporting the $. Looking further down the road there still is this phenomenal and exponentially rising debt the US is carrying and which is funded by the rest of the world. This is a serious risk hanging over the markets and could lead to a collapse of the currency. There is a broad consensus to support this view.

However during the research we did over the last couple of months we came across a couple of influential writers who threw a different view on this. We did our number crunching and must admit there is a point to be made by saying that the risk of a total $ collapse might be not that high.

Earlier last week there were already some very encouraging comments from Chinese government officials arguing they keep on having faith in and commit themselves towards their further investments in US Treasuries. Usually there is a gap between rhetoric and facts however the recent auctions in US Treasuries confirm these statements and show that investors in general keep on buying US sovereign paper.

In order to finance the current account deficit foreign investors have been willing to buy a record number of US assets. A detailed overview for 2008 is not available yet but the overall number of foreign purchases of US portfolio assets is at $ 9.5 tln. Table 1 shows an overview of the different assets held by investors outside the US.

Table 1: Foreign Holdings of U.S. securities, by type of security

Source: United States Dpt. of the Treasury

If we compare this with the total value of US citizens holding foreign securities we come out at a number of roughly $ 5 trio. This is down from $ 7.21 tln at the end of 2007. Two important things do strike us when looking at these numbers. First of all the amount of US investments foreigners are holding is almost twice as high as the amount of foreign securities held by US citizens.

Secondly the drop of foreign assets held by US citizens versus the continuous rise of foreign purchases of US assets. The more than $ 2 tln drop of foreign assets held by US citizens explains the recent rally of the $ versus EUR and £ as American investors repatriated their money over the last year rapidly. Especially in times of crises this is a typical phenomenon. Chart 1 shows the net flows of US purchases of foreign securities, with a negative number indicating a net outflow of capital from the US vice versa a positive number showing a US sales of foreign securities (on a month-to-month basis).

Chart 1: Net in versus outflows for American Investors

Source: United States Dpt. of the Treasury

Since the late nineties we see more volatile spikes. 1998 was accompanied by the Asian crisis and the implosion of LTCM, followed by late 2000 the beginning of the dotcom bubble bursting and 9/11 causing some distress among investors as well. All these periods went hand in hand with a rally in the $ across the board.

As history shows, US investors have the tendency to shy away form foreign markets for several years, after being hit by a shock. This backs our view that for the time being the $ will remain very well supported.

The current crisis clearly underlines once again (as supported by other data) the seriousness of the situation.

The good news for the time being is that foreigners are still willing to buy US assets despite the credit crunch, Fed rates going to zero and a worrisome mounting level of US Government debt. The official comment from the Chinese Government is a clear example of this and very important towards other big institutional players who consider China the leading player at the table.

However, to what extent is the risk of a repatriation of foreign investors money realistic, and could the impact be significant? Assume that ten percent of the USD 9.5 tln held by foreigners would be repatriated during a year of extreme events and let’s assume the US current account deficit would stay around the same current levels of $ 600 bio.

The end game would be the US economy suffering a balance of payments deficit of appr. $ 1.55 tln. This in turn would require American investors to repatriate 30% of the current $ 5 tln held in foreign assets to prevent the $ from collapsing. Last year the brief fall of the $ versus the EUR from 1.25 towards 1.48, may have been a simple strategic adjustment from the central bank of China by $ 60-65 bio of bonds that were shifted in European sovereign bonds. We will come back to this later on whether this is a valid point.

The next question we need to ask is whether this risk is realistic? As Table 2 shows, foreigners hold over 55 % in US Treasuries. However compared to the total amount of outstanding long-term US Securities this is less than five percent. If we add this up to the US government agency securities we still come out at a number far below ten percent of the total US capital market.

So the argument whether the high dependency of the US Treasury debt from foreign institutional investors needs to be tempered. Given the flexibility of the US capital market there is enough room of reallocation of investments by different groups of investors among different asset classes. If foreigners decided to shift their holdings of treasuries other investors would be attracted by the reduction in prices of treasuries to make switches in the opposite direction. There might be some alteration in the relative prices of the different US assets, with a modest increase in the cost of financing the federal debt, but major disruptions would be highly unlikely. This is more from an interest rate perspective.

The impact on the FX rate of the $ towards other currencies will be less positive but should also not be overestimated. It is plausible that we could see a move of 20-30%, which is already huge, like we have seen in £ or like the EURUSD move from late August last year. However a sudden unwind by e.g. the Japanese ($ 578 bio) or Chinese authorities ($ 696 bio) of their total US Treasury reserves hand in hand with a total implosion of the $ is at this stage less probable. One should not forget that both countries, who hold the largest part of US government bonds, are very much in favour of avoiding market disruptions and (this is more unfortunate) favour to maintain undervalued exchange rates to bolster even further international competitiveness.

Then there is the liquidity argument of the Foreign Exchange markets. Based upon the data from the BIS the daily volumes of the FX market were $ 3.21 tln in April 2007 (this is a survey held every three years). The FX market is by far the most liquid market in the world.

Already intuitively you might see that it is not correct to draw conclusions on flow info that e.g. a $ 60 bio bond issue coming to maturity from the Bank of China would cause a movement from 1.25 to 1.48. There are a couple of reasons for that.

As far as we know there are no theoretical studies on the impact of volumes on the price action of a currency pair. Even empirical studies are very limited since there are not a lot of data available on foreign exchange traded volumes at high frequencies. As mentioned above the BIS offers surveys on this subject only every three years.

Literature on equities and futures though gives us an indication that volumes and spreads are positively correlated. So basically we can use the bid-offer spread as an indicator how a market can swallow certain flows. As a point of reference if you would be active on a corporate desk responsible for the execution of FX flows of companies and other institutional clients, a spot trader would quote you a bid offer spread of 50 – 70 points for an order of $1 bio. One can not extrapolate this linearly for an amount of $ 60 bio but we can say for sure that a $ 60 bio amount will not move the markets by 2,300 points. One has to take into account that in a $ 2.3 trio daily market by nature there will be similar interests at the other side which will absorb a substantial part of this.

Then there is the evidence that US investors repatriated appr. $ 2 tln during 2008 back to the US. This information by itself counters the argument that a $ 60 bio flow would move EURUSD from 1.25 to1.48. Let’s even assume this would be the case, and let us assume the repatriation would have started at the top of the market, i.e. 1.60. If that would have been the case a $ 2 tln flow should bring EURUSD much lower then 1.25 at the moment.

Furthermore, based upon the above information, if the Bank of China would decide to sell its total portfolio of US Treasuries for an amount of $ 695 bio, we believe the market would be mature enough to absorb this flow. This does not mean it would not have an impact, but it would certainly not create the total implosion of the $ as many claim. There could even be some follow through from other market participants who join the move. But let’s even assume this would cause a total outflow out of the US of $ 4 tln (which is substantial) it would probably only have a similar impact as the recent repatriation from US investors we have seen.

For a total implosion one would need a complete repatriation of foreign investors US Treasury holdings. The question would be however: where to? Europe with a similar rising debt and the PIGS countries on the brink of default? The UK with a similar imploding banking system? Japan with its deflationary vicious circle? Or China which does not want a stronger renminbi and far from a transparent and developed country?

Table 2: Table 3 Value of foreign-owned US long-term securities and share of total outstanding, by asset class

Source: United States Dpt. of the Treasury

(1) Fred Bergsten and Edwin Truman “Why Deficits Matter: The International Dimension.” Peterson Institute of International Economics, January 2007.

The Vicious Circle: West European Banks versus CEE

2009-02-23T08:55:00.006-05:00

In previous week reports we pointed out that Central and East Europe (CEE) were also facing deteriorating macroeconomic conditions. Some of them are based upon the current financial turmoil where the lack of lending activity of banks is damaging global commercial trade. CEE countries became an important part in the chain of globalisation and are now experiencing severe difficulties. Besides the pressure on commercial trade and production cut backs also lose lending standards towards retail clients in the mortgage market have created significant imbalances.

Over the last five years a lot of local banks have been lending mortgages in other currencies, mostly in CHF but also JPY. Especially home owners in Poland – Hungary – Czech Republic are exposed, with a total amount of $ 1.6 tln linked to the consumer market. Since our report on this on 23rd of January the CHF strengthened further against those currencies by 15 %!

All this is putting pressure on domestic demand and is creating a vicious circle.

CEE countries were able to grow via foreign funding which came directly from West European banks which have been expanding in the region over the last decade by acquiring local banks. These West European banks are now facing on their turn further downgrades as their subsidaries already got downgraded by the rating agencies due to a very weak economic outlook.

Furthermore as capital ratio’s for Western banks in general come more under pressure, their capital allocation towards their CEE subsidaries will be streamlined as well. Capital allocation is based upon expected risk-adjusted returns and as risks are more pointing to the downside in the CEE region, West European banks will be very conservative towards funding their subsidaries. A good example is Citigroup’s decision to put its CEE franchise for sale.

And as the CEE region is depending on external funding this will put more pressure on growth and so a vicious circle is created.

Important to mention is that there are differences among the CEE countries what dependence on external debt concerns. If we look at the relation between the CDS spread of each of the countries compared to their current account deficit we get a good idea of the vulnerability of each country.

Table 1: 5y CDS Spread versus current account deficit - 2007

Source: Data from IMF world economic outlook database, April 2008
Bloomberg
As table 1 shows the Baltic states, Croatia and Bulgaria are heavily dependent on external funding. Russia, Ukraine and Kazakhstan are also under pressure but have a better current account number due to their natural resources.

Interesting to know is which Western European countries are via their banks exposed to CEE and to what extend? Moody’s recently wrote an interesting report on this, and we updated the figures based upon the database of Bank of International Settlements (BIS). We then compared their CEE exposure with their own GDP numbers.

As chart 1 shows most banks are based in either Austria, Belgium, Germany, Italy, France and/or Sweden and have appox. 85% of the total exposure of West European Banks. Austria has the biggest exposure on CEE. But the most worrying part is that almost 72% of their GDP is exposed to CEE loans.

This explains why the CDS spread of Austria is catching rapidly up with the one of Greece. Greece has still the highest CDS spread among the Euro-zone members with 254 bp above Euribor. However since February we see a rapid widening of Austrian credit spreads, and currently trading at 245 bp above Euribor, leaving the other PIGS (Portugal-Italy-Greece-Spain) countries behind them.

Do also note that Belgium’s credit spread is catching up with the PIGS countries due to its recent turmoil of KBC and Fortis. KBC had to go already for the second time in less then five months to seek for help at their local government for capital injections. In there recent earning report they were still up beat or less pessimistic about growth expectations in their second home market, being CEE. However they clearly differ from the official growth forecasts from the IMF and other public institutions.

Chart 1 Claims of Western European Banks on CEE countries

Source: BIS Consolidated Banking System – June 2008
See also Appendix

Table 2: CEE outstanding debt as % of GDP

Source: Data from BIS Consolidated Banking System and Worldbank

We share the conclusions of Moody’s that in first instance CEE banks will be extremely exposed to increasingly worsening economic conditions and will come under negative rating pressure against a background of depreciating currencies and large foreign currency lending.

West European Banks, in their search for improving their capital ratio’s might further prefer to lower the exposure to the CEE region or even digest such as Citigroup is already doing. This deleveraging process is going to put further pressure on CEE economies because of their dependence towards foreign funding, but this will also put further pressure on the group of West European Banks with considerable CEE franchises, as the deleveraging will further decline the market value of their consolidated balance sheets.

As a consequence some banks will have to revert back to their respective governments for additional capital injections. It is not impossible that some of these banks might even be pushed to the edge of nationalisation.

This unfavourable scenario is certainly dangerous for Austria, since their exposure expressed in terms of their GDP is considerable. In this case it might be possible that Austria need to ask for help at the EU and/or the IMF.

Appendix 1 Claims of Western European Banks on CEE countries

Source: Data from BIS Consolidated Banking System – June 2008

(1) Moody’s Global banking, February 2009
(2) Note that Poland has 50 % of its total bank loans outstanding in foreign currency. Source : BIS

The Central Banker's Paradox

2009-02-12T14:22:00.000-05:00

This week we would like to have a closer look at the challenges the central banks are facing and the fundamental problem of a central bank in general. We look at their workings from an alternative angle and even go back to the industrial revolution to compare them with the mechanics of a steam engine. Furthermore in tackling the current crisis we wonder whether the Keynesian approach will bear fruits.

But we won’t be too strict on the current generation of government officials as some of them are showing leadership in trying to divert the crisis. As even the IMF is starting to acknowledge under Mr. Strauss-Kahn, the developed economies are on the brink of tumbling into a depression and there are not a lot of text books out there how we have to cope with the current situation. Apart from the Great Depression there is not a lot of literature available what we can do, so probably this era will go down in history as the Great Experiment.

Apart from bailing out the banks the only remedy they are using is a good old fashioned Keynesian tool and hope that with massive government expenditures one can kick start the economy. One of the questions we will raise is whether this is going to be effective?

But let us take a step back and dig into the literature that is available of the Great Depression. Probably the most important guidance available is Milton Friedman’s classic “A Monetary History of the United States, 1867 – 1960”

The greatest mistake made during the Great Depression was the Fed relaxing the money supply not enough and too late. As a matter of fact they even reversed their quantitative easing mid July 1932 which gave the final neck shot to the economy.

Fed Chairman B. Bernanke, realises this very well as he studied the Great Depression from close by during his academic career at Princeton University. As he learned from Friedman, it is key to increase the liquidity in the system and stabilize the velocity of money, which is the frequency with which a unit of money is spent during a specific period of time.

We don’t want to scare you away but this can be expressed as:

VT = nT/M

VT : Velocity of money
nT : nominal value of aggregate transactions
M : amount of money in the economy ( M1; M2; M3)

The Fed or any central bank in general is doing this by injecting cash directly into the system by purchasing US Treasuries. In this case there will come more money M into the system.

The Fed’s ability to create money by purchasing assets is only limited by its balance sheet. Its balance sheet liabilities consist of bank reserves held on deposit and deposits from the Treasury. Recently the Treasury sold a substantial amount of debt for the purpose of depositing the proceeds at the Fed. This allowed the Fed to double its balance sheet to about $2T. The Fed is using this extra leverage to buy assets or loan on collateral with risks much higher than treasuries. Even though Chairman Bernanke says the Fed is taking an appropriate haircut and the Fed can sit on assets until they mature, these toxic and semi-toxic assets will be far more difficult to sell when the Fed needs to unwind its liabilities.
But there is another problem. As you have noticed in the formula velocity is also a measure for the turnover of money supply. If banks are not lending the velocity of money will keep dropping. And even worse, as people start to realise that they have to save more and spend less, because this is what got us into trouble initially, it will not solve the problem either.
This is the paradox that central bankers are facing now with the risk of lifting the system one more time over the edge. As we saw in Japan, people adjusted their behaviour and took more then a decade before there were signs they started spending again. Neither government spending could trigger economic growth (see more later). We are only 1.5 years in this crisis and what central bankers are saying to us is start spending again and go back to your old behaviour.
And the last challenge they will face is once the economy starts recovering again, and let’s all hope we will see this sooner rather than later (although we doubt very much) the Fed and other central bankers will have to be extremely fast to remove the excess liquidity they provided at the beginning. Otherwise the velocity of money will explode, read inflation will be back with a vengeance.
This was the mistake Greenspan made at the beginning of this decade. After the dotcom bubble exploded and 9/11 pushed the economy into a recession there was a short scare of deflation as well. What we know now is that the Fed was much too late in starting to take part of that money back in 2004, with the ultimate consequences we are in right now.
The only difference with 2001-2004 is the Fed and other central banks in the world are providing liquidity at a multiple of the period then. The saying “We are walking on thin ice here” is an understatement. We even think the central bankers believe that they are Jesus…
Ben Bernanke knows the dangers and even publicly admitted they aren’t gifted with an invisible hand. In a speech given in honour of Friedman’s 90th birthday in 2002 he said: “I would like to say to Milton and Anna: Regarding the Great Depression, you’re right. We did it. We’re very sorry.”

The problem however is that central banks have a great hand in the boom and bust cycles and are accelerating economic events. Friedman is reported to have said, just before he died : “It is preferable to abolish the Fed entirely and just have the government stick to a monetary growth rule. Unfortunately there is no chance at all of it happening”(1)
There is an interesting reading on the role of central banks by George Cooper where he compares the central banks with the working of a steam engine during the industrial revolution.(2)

More specifically the way a central bank operates is similar to the workings of mechanical devices which were developed to stabilize the rotation of steam engines in the 1860’s. For example a sawmill powered by steam engines at the time faced the danger to run out of control once it got into contact with a chunk of wood that needed to be sawn. For that reason they placed governors on the machine which kept the steam engine going at a constant speed under conditions of variable load. Soon one discovered that rather than bringing the rotation speed of the machine to a constant level, there were disturbances in the machines speed which could create heavy vibrations and even shake the machine apart.

The mathematician J.C. Maxwell did some research on the mechanics of these governors and his conclusion on the cause of these disturbances can be closely compared with the short comings of central banks. The problem was that the governors would hit the breaks quite abruptly when they noticed the rotator was spinning to fast, causing the machine to slow down suddenly. Afterwards it would release the breaks abruptly and causing a sudden re-acceleration. As a result the machine showed very heavy vibrations.

Does this already look familiar with a central bank?

Further findings of Maxwell showed that one did not need more powerful governors but calibrate the device to a lighter touch. In doing so the engine linked to the sawmill would rotate within a tolerable range and converge the control process over several sawing cycles.

That’s what central banks also need to do. Since 2001 central banks have been swinging the pendulum of interest rates violently from one side to another with severe disturbances in the economy as a consequence.

In the meantime the governments around the globe are taking Keynesian measures to get the economy going again. However the added value of this tax money spend is highly inefficient. As Keynes argues higher government spending increases GDP and the consumers respond to the extra income they earn by spending more themselves. Unfortunately the contribution of a dollar spent to GDP turns out to be very low. An interesting paper was written on this subject by Valeri A. Ramey, from the University of California. Both quantitively as empirically she came to the conclusion that for every USD the government injected to the system, GDP expanded only by a third of a dollar.(3) It is very important whether the spending is on things which are necessary or valuable. If it is on repairing bridges that lead to nowhere or putting an asphalt layer on an existing road this multiplier will be even zero.

To put it ironically, if you hire your neighbour for $100 to dig a hole in your backyard and then fill it up, and he hires you to do the same in his yard, the government statisticians report that things are improving. The economy has created two jobs, and the G.D.P. rises by $200. But it is unlikely that, having wasted all that time digging and filling, either of you is better off.

No matter how you turn it, government spending will always be at the expense of the private economy. To fund your debt you either have to raise taxes which will push down the private economy or go to the capital markets to issue new debt and taking funds away which could be used by the private sector. If you look at Japan since the late 1980’s they ran huge budget deficits but still their economy did not take off.

The only result one achieves is a distortion of the free economy. Luckily there are still politicians who are aware of this and are still willing to fight for this. The battle between those who would like to throw the system overboard and go to a state intervened model like France has known for decades or those who want to safeguard the system which has brought the most prosperous 25 years since mankind but with some adjustments and cutting off the sharp edges of capitalism is gigantic.

Apparently this battle is even going on within President Obama’s own Administration and can explain to a certain extent why the TALF, or call it TARP II, is lacking details. Based upon findings of analyst James Barnes at Gavekal Dragonomics, and conversations with well-informed people in Washington there are two camps within the US government at the moment.

On one side there is Geithner and Summers, who want to focus on the financial issues of how to free banks from toxic loans. On the other side we have Rahm Emanuel, David Axelrod and most Congressional leaders, who think it is more important to announce punishments for senior bankers and, more importantly that any measures to support banks should be clearly punitive of bank shareholders.

However, you can not punish the banks and restructure the banks at the same time. You have to choose.

Geithner and Summers won the argument by pointing out that the Paulson approach was very punitive to shareholders and where did that get us?
But the internal bickering over pay curbs etc - plus the effort of pushing the stimulus bill through Congress - makes it difficult to finalize controversial issues like the amount of effective taxpayer support in pricing of toxic assets which could only in the end be decided at the very top, being President Obama.

This is, of course, all pretty depressing and makes one wonder whether the Obama administration will descend into Carter-style impotence.

(1)Interview in Reason magazine “Can we Bank on the Federal Reserve” November 2006
(2)George Cooper “The Origin of Financial Crises. Central banks, credit bubbles
and the efficient market fallacy.” 2008, Harriman House Ltd.
(3)Valerie A. Ramey “Identifying Government Spending Shocks : Its all in the Timing”
2006, University of California

CEE contamination: Austria seeking for help.

2009-01-28T05:20:00.000-05:00

Dear readers,

Building further on our report from last week where we pointed out the problems the CEE region is facing we would like to have a brief look at the contamination risk that is now spreading into the EU.

The whiff of worry has been wafting in the wind for a long time now on CEE and Russia, and yesterday the news stepped up a notch as the Austrian Chancellor said he wants to approach the EIB for assistance in protecting its banks exposures to CEE + Russia (CEE-R), and that Austria will call for a European Union initiative to support these banks with the possibilities offered by the European Investment Bank, the ECB and the cohesion fund.

This Austrian move looks ostensibly to be designed to bail out Erste and RZB which are massively exposed to the CEE region : 40 % of Erste and 51 % of RZB’s loan book is exposed to CEE-R. Next to the Big 2 Austrian banks we also have Bank Austria (part of Unicredito) which Bloomberg reckons to be EUR 230 bio exposed to CEE. At present the Austrians have offered a EUR 75 bio repo facility with its banks on very flexible terms (low hair cuts and low rated paper) and a 5 year guarantee on senior debt for up to only EUR 15 bio. Bear in mind that Austria’s GDP is only EUR 285 bio.

The latter is the core of the problem. Similar like Iceland their banks grew above their heads. In the hype of bank bail-outs Austria, with a debt / GDP ratio of around 50 % will need to look for external help because its banking sector’s liabilities are too large. That it is seeking a loan facility over funding its own way out of the problem is a clear indication that this is going to be an EU problem (and probably at a later stage a joint intervention alongside the IMF) and not just a domestic issue country-by-country.

As a consequence we will see the EU, via the EIB, being presented the bill for the repair of Europe and even CEE.

The one million dollar question will be how long they can be put up with this? Other questions to be raised are, what will Italy and Greece do, who have sizeable exposures to the CEE region. Will they be asking for a bail out as well?

Swiss clouds hanging over Central Europe.

2009-01-23T05:05:00.000-05:00

Dear readers,

This week we would like to address another imbalance that is shaking up the financial system, more specifically recent strength in the Swiss Franc (CHF).

Several board members of the Swiss National Bank (SNB) have recently expressed their concern on the strength of their Swiss Franc. Even against the EURO the Swiss currency has gained more then 7 % over the last couple of months. The move in September can easily be explained by the Lehman event, where the market went into total risk aversion. The Swiss Franc has been over time one of the ultimate safe heavens together with gold in times of crises.

But the picture against Central European (CE) is even more dramatic. The Polish Zloty (PLN)lost 50%. The Hungarian Forint lost over 36 %, and the Czech Crown fell by more then 32 %. This move is even more dramatic compared to the EURO, but this can easily be explained by emerging markets which were hit quite hard in the second half of the year due to the ongoing crisis and capital repatriation from these countries.

The rally of the CHF against those CE currencies is even more worrisome due to the fact that over the last 5 years local banks have been lending mortgages in other currencies, such as CHF, EUR and JPY. CHF denominated mortgages were the most favourable ones creating a huge potential foreign exchange risk for home owners in Poland – Hungary - Czech Republic to name a few.

On several occasions we have been referring in our weekly commentaries to the imbalances that have been built up in the global financial system. The very lose lending standards that were applied in Central Europe by local banks are one of those. The loans were sold massively to retail / real estate buyers with the teaser that all these countries would benefit from further European integration and as a result their local currency could only strengthen on the back of this. Of course the very low interest rate on the mortgage was the sale argument to close a foreign currency denominated mortgage.

Unfortunately these clients were not realizing they were putting on a similar carry trade like the rest of the investment world was building up year after year. As the chart indicates after the mild recession at the beginning of this decade all these countries started at a phenomenal growth pace. The currencies were strengthening and this gave first home buyers a false feeling of personal wealth creation.

Now that the tide has turned quite rapidly all these mortgage lenders see themselves squeezed between a fall in property prices and a dramatic rise in their outstanding debt they need to pay back. A numerical example will make this whole process more clear:

Suppose client Mikolaj Sikorsky steps to his bank for a mortgage on the house he wants to buy for the amount of PLN 325.000 (ca. EUR 75.000). The bank offers him the choice to either borrow PLN 325.000 at a rate of 9.50 % with a maturity of 20 years, or to borrow CHF 147.725 at a rate of ONLY 3.00 % for 5 years. In the loan agreement is written in small letters the outstanding amount will have to be paid back after 5 years and if during the tenor of the loan agreement the exchange rate of CHFPLN is breached above a level (e.g. 3.00) the loan needs to be early redeemed. As in every mortgage is the case the underlying house will be used as collateral.

Our client Mr. Sikorsky (not) surprisingly chooses for the CHF denominated mortgage and receives from Polanska Banka the amount of CHF 147.725. However to close the deal with the current owner of the house he needs to convert this CHF into PLN which is now trading at 2.20, since the seller does not want to have CHF. The transaction goes very smoothly, since Polanska Banka is quite happy to assist Mr. Sikorsky in all this. Even paying the monthly CHF interest rate goes without any problems, since he notices that in PLN the amount debited from his account is less and less every month.

However during his summer holiday at the Black Sea in August, he receives a call from the bank that his account is in overdraft, and that he needs to credit his account since there are not enough funds available to pay the monthly amount on his mortgage. Although the amount is negligible it was a bit awkward since he got used to pay the monthly amount to the bank at an ever lower PLN amount. Basically what happened was that the CHF in the mid of the credit crisis of last summer was starting to rise, and effecting our clients monthly payments.

By October things get worse, and Mr. Sikorsky notices he is now paying 25 % more every month since last May and he will have to change his expenditure pattern. Later that month he receives a call again from the bank, saying there might be a problem with the loan. The CHFPLN exchange rate has been rising aggressively (2.60) and although there is no reason to panic yet they would like to have a discussion with him whether he would have extra funds available in case for additional collateral, if not (and still highly unlikely) his house might have to be confiscated in case the CHFPLN would touch 3.00.

Even if all things stay the same for now, Mr. Sikorsky will have to take into account that in 3 years time the repayment of his mortgage at maturity is going to be more expensive. The problem is our client borrowed CHF 147.725 which he converted immediately into PLN in order to close his housing deal. At the current rate he will have to buy PLN 384.085 in order to give the CHF amount back to the bank. This is PLN 59.090 (or 18%) more then he initially paid for his house. In order to prevent to lose more money he starts to convert part of his savings already in CHF to prevent to make things worse.

The above described story is not fiction, and neither it’s something to laugh with. This happened and is happening to a lot of people in Central Europe. Basically what happened above is that our client was sold a forward currency contract on a margin call basis.

Just to give our dear readers an idea of the extend of the problem, only in Poland up to apx. PLN 88 bio – or EUR 20 bio – was lent to Polish mortgage borrowers in foreign currency denominated amounts. The total amount for the whole region – Central and Eastern Europe – is estimated at $ 1.6 TRILLION tied to the consumer and not the corporate market. (source: Morgan Stanley)

With access to capital now drying up worldwide, banks have stopped lending in foreign currencies and are calling in outstanding debts as they look to raise capital anywhere they can. This has left a lot of consumers unable to pay back their mortgages and increasing the concern of potential default of Central and Eastern European countries’ foreign currency related debt.

It is also due to this kind of exposure that the credit agencies red flagged Allied Irish bank, which was a heavy lender into Central and Eastern Europe. A total exposure of $ 1.5 trillion is at the expense of Euro-zone, Swiss and Swedish banks who were lending massively to these countries on this basis.

This explains the nervousness of the SNB as their currency is getting squeezed in the turmoil and they would use the intervention weapon to turn the tide. If this is going to help is another question, as history proves little success in these operations. Once a currency starts to slide there is little a central bank can do. Ask the BoE…

I wish you a very nice relaxing weekend.

Gino Landuyt

Those Letter of Credits...

2009-01-14T11:37:00.000-05:00

Dear readers,

First of all a Happy New Year. We had a bit of a delay to kick-start the year, but here we finally are with our first newsletter for the year. We would like to pick up the themes of our last letter in December and update our statements with some numbers and facts. For those who were still wondering that the light at the end of tunnel was near will quickly change their mind and realize it is the light of a train that is coming at high speed from the other side of that tunnel…

Just to freshen up the memory the four major topics we expected for 2009 were:

• Further de-leveraging of banks
• Increase of defaults and write downs of corporate debt
• Deteriorating conditions in Central and East Europe
• Second round of re-capitalizing banks

We are only 2 weeks in the new year and we see a couple of these themes crystallizing themselves already. The deteriorating conditions for Central and East Europe were already confirmed this week with the horrible industrial production numbers for the Czech Republic. They came out at their lowest point ever since inception in 1993 : - 17,4 % for the month of November against – 7.6 % the month before. Bear also in mind that the market consensus was – 8.9 %. This will also be a good indication to e.g. the Q4 GDP numbers in the US at the end of this month. People will be surprised how bad that number is going to be. Expectations are still at around – 6.5 %, but market consensus is clearly still underestimating the impact and or damage done after the Lehmann failure. We are clearly dealing with the nuclear fallout of that Financial China Syndrome.

Commercial trade came to a stand still after Lehmann’s event and I already pointed out in one of my weekly newsletter for the bank in October that the problems we were facing in the commercial paper market at the time were dramatic, but the sniper of the tightening credit conditions would be the Letter of Credit (LoC’s) which were frozen by banks.

To remind you about the importance of a LoC, in simple terms it is a document issued by a financial institution presented to another financial institution to obtain release of goods (commodities – household articles – food etc). If banks refuse to give you a LoC, you would simply have no economy.

Below is an article in the Financial Post of Canada that was written on the 10th of October.

“The credit crisis is spilling over into the grain industry as international buyers find themselves unable to come up with payment, forcing sellers to shoulder often substantial losses.
Before cargoes can be loaded at port, buyers typically must produce proof they are good for the money. But more deals are falling through as sellers decide they don't trust the financial institution named in the buyer's letter of credit, analysts said.
"'There are all kinds of stuff stacked up on docks right now that can't be shipped because people can't get letters of credit,' said Bill Gary, president of Commodity Information Systems in Oklahoma City. 'The problem is not demand, and it's not supply because we have plenty of supply. It's finding anyone who can come up with the credit to buy.'
"So far the problem is mostly being felt in U.S. and South American ports, but observers say it is only a matter of time before it hits Canada. 'We've got a nightmare in front of us and a lot of people are concerned it's going to get a lot worse,' said Anthony Temple, a grain marketing expert based in Vancouver.
"Access to credit is key to the survival of maritime trade and insiders now say the supply is being severely restricted. More than 90% of the world's trade by volume goes by ship. 'The credit crisis has made banks nervous and the last thing on their minds is making fresh loans,' Omar Nokta, an analyst at investment bank Dahlman
Rose, said in an interview with Reuters.
"While shipping has always been a cyclical industry whose fortunes rise and fall with the global economy, analysts said the current crisis over the drying up of credit is something they have never seen before."

A good indicator for the shipping industry is the Baltic Freight Index, which gives investors a good idea of supply and demand of shipped goods. That index decimated over the last couple of months. To come back to our example of the Czech Republic, the volume of industrial orders came in at – 30.2 %, which suggests that production figures in the months to come will get worse.

We can extrapolate those numbers for other countries or regions who are highly export driven as well. And if we are talking about export, we need to look at China too. Their exports suffered the deepest drop in a decade in December, -2.8 %. Keep in mind these are official numbers from the Chinese government. The real numbers will probably be even worse.

The news came as the World Economic Forum held its annual meeting in Davos this week and warned that a ‘hard landing’ is in the making, with annual growth dropping even below 6 %. If you look at the import number ( -21.3%) it clearly is a sign that also domestically China is falling of a cliff. If the Chinese economy is hit by slowing international trade volumes, its domestic economic activity is even slowing at a faster pace. Of the total of 130 million migrant workers already 10 million of them have been sent back to the country to start planting rice again.

The one million dollar question will be whether the danger of social unrest, where we warned for in our last newsletter in December, might break out sooner then expected.

China and its demographics

2008-12-23T11:36:00.000-05:00

Dear readers,

This newsletter will be the last one for the year. For an economist who tries to think outside the box, 2008 was a fantastic year. One could compare it with a meteorologist who would get the chance of a lifetime to observe a perfect storm. However the social drama’s caused by the crisis counterbalance the academic joys. 2009 unfortunately will most probably not be any different.

We do have the reputation to be the ‘Waldorf and Statlers’ of the finance industry, but one can not expect that the excesses and imbalances which have built up the last 25 years can be digested by a stock market correction of 30-40 % and a bailout plan of USD 1 trillion. This is the core philosophy of Givanomics. In this dangerous ocean of liquidity some tectonic plates need to be reshuffled and this is going to keep on causing giant waves in the near future. Volatility is going to be something we will have to deal with in the next coming years.

Before we have a closer look at another potential black swan, i.e. China and its demographics, let us for the record make some projections what to expect for 2009. One of the central themes will be further de-leveraging. It is naïve to think the market has de-leveraged sufficiently. Past experience of credit bubbles taught us that they would be followed by a credit contraction. Until now the major banks have only written down apx. EUR 800 bio of a potential EUR 5.5 trio still outstanding. So, we haven’t seen anything yet .

Leading indicators clearly show a contraction of economic growth around the world. As a consequence banks will be faced with write downs of bad corporate debt. Areas that will be hit first are most probably commercial real estate and shipping, two industries which built up huge over capacity. Then given the problems Ukraine, Russia and Hungary are facing, we see East and Central Europe deteriorating. Based upon discussions we have with our contacts with banks that have exposure in the region, we get clear indications that economic activity in e.g. Czech Republic is also coming to a stand still.

All this will in turn cause further funding needs for the banking industry, as further write downs will jeopardize their capital ratios further. Stress tests from Merrill Lynch show the European banking sector could potentially require between EUR 60 – 120 bio of additional new capital depending on how much the economic downside would be.

So far for our 2009 expectations…

In our newsletter on deflation we briefly mentioned the potential thread of Chinese social unrest which could have a major impact on the global economy.[1] For this week we would like to elaborate a bit more on these social issues China is facing.

One would have thought that Europe and Japan and to a lesser extent the US have some serious challenges ahead with the aging of their population. You ain’t seen nothing yet until you have a closer look at China. Their single child policy in the late seventies created a potential monster which is about to be unleashed.

The sociological nature of the Chinese society traditionally preferred male above female children. This combined with the implementation of a one-child policy has triggered a sex ratio imbalance which has caused far reaching damage towards the demographic structure of their society. An interesting paper on the subject was written in 2006, at the University of Michigan [2]

Initially the one-child policy matched its objectives. However after a while it overshot its goal, and it is believed that in the last 20-25 years the policy brought down the population growth by more than 300-350 mio people. This caused a sex ratio (males over females) of up to 1.30 in certain rural areas. Bear in mind that a normal ratio ranges between 1.03 – 1.07 in industrialized countries.

Together with the urbanization of China’s economy, which caused higher or better living standards, this has led to an increasingly aging population. In the beginning of the eighties people older than 65 were only 5 % of the total population. The percentage at this moment has risen to 9%, but will start to rise exponentially over the next 25 years to hit 22 % by 2035. The age group of 0-4 years old dropped from 94 million people to 68 million over the last decade. This together with a drop of the birth rate itself makes the bias of the population age profile moving to the age category of 40. To put this into perspective at the moment 52% of adults are over the age of 40. By 2015 this will rise towards 60 %. Another interesting number is the households who do not have a child younger then 20. This is 37% at the moment. Models forecast a rise to 51 % by 2015 and 71 % by 2025.[3]

All this will have a dramatic effect on the labor force. Models anticipate the labor force already to have peaked this year and will start to decline rapidly. Of course, part of this decline will be offset by an increase in productivity given the improved education and rise in investments, but it won’t be enough. The labor force is declining at a faster pace than increase in productivity and investments can keep up with. As a result this will slowdown GDP growth further, as an aging population reduces the labor force and on in turn lower the return on capital. Investments will fall due to lower returns, which completes the vicious circle: labor falls -> investment falls -> output falls -> living standard falls.

Their one-child policy also has some indirect socio-economic effects. Since it almost became a privilege to have a child, parents start to adore and spoil their children which turned into a mass psychological disorder. Among sociologist they are talking about the ‘Little Emperor Syndrome’. These children carry high expectations for the future and lose their Chinese cultural values. They grow up in a more Western oriented atmosphere and falling victim of the negative influences of the fast food culture. Studies expect by 2010 one in five children in China will be coping with obesity. This is rather dramatic given the fact that the Chinese culture was known for good health and gastronomy practices.[4]

Another socio-economic effect ofto the sex imbalance is that it becomes increasingly difficult for men to find a partner. This has triggered a huge kidnapping campaign and is increasing crime and violence.

Next to an aging population, Chinese officials face another demographic challenge. The rush from the rural areas to the coastal cities of China. This urbanisation already started in the early eighties, but it accelerated when the Chinese government started to experiment with capitalism in some of their provinces near the coast. People from the country heard about the success stories of people who left and became overnight a millionaire and decided to throw the dice and try their luck out in the city next door. This has triggered an exodus from the inland towards the coast. This rush is even expected to accelerate.

In the next 15 years Chinese cities expect to add 350 mio people who all will be looking for a better future. By 2030 the total amount of people living in cities is expected to hit the one billion mark.

All this is going to put a lot of pressure on resources such as water and energy, but the government will need substantial amounts of public funds to offer social services. Apart from that the economy will have to keep up growing by 8-10 % annually for the next 20 years in order to offer employment to those people.

There are already social unrests in many cities, because the difference between the expectations they have for a better future and the real outcome of it once they arrive in a highly polluted and super competitive city is extreme.[5] One can imagine what is going to happen when growth is falling back to 3-4% levels and millions of people keep rushing into those cities…

One can wonder what this has to do with the current crisis. In the short term probably not much. China has enough of financial reserves to manage these social unrests for now. However in the long run it might be, given the huge exodus that is still expected ( 350 mio people even outpaces the total population of the USA!!!) they would have to dig very deep in their reserves to keep this situation under control. As indicated in our previous newsletter it might very well be possible that at a certain stage the Chinese government might be forced to unwind their strategic investments to buy off social unrests. This would trigger huge changes in exchange rates and interest rates.

To give you an idea what the impact could be, just look at the recent move in EURUSD in the last 3 weeks. The EURO rallied sharply from 1.28 to all the way up to 1.46. One of the major drivers behind this move was the Peoples Bank of China who was diversifying at least a minor part of its reserves away from the USD. During that period they bought about USD 60 bio of EURUSD starting from the 1.25 area. A big chunk of that came from emerging market bonds denominated in USD which came to maturity and which were not rolled over. If a move of USD 60 yards can trigger this kind of volatility in the market, imagine what it would trigger when they would have to use only 20-25% of these reserves. For the record, the reserves of China’s central bank are estimated at USD 1.7 trillion at the moment.

The Chinese government is aware of these developments and is anticipating to that in a way you can only expect from totalitarian regimes. At this very moment they are modernizing and expanding their army. This is not for the purpose to conquer the world but to maintain domestic order. One can compare it with the military of Saudi Arabia. To support this thesis, in March 2007 the Chinese government announced they would increase their military spending by 18 % annually. This was the biggest increase in more than 10 years. This is also called the ‘Dark Theory’ which goes around in the highest Japanese intellectual circles nowadays.[6]

[1] http://givanomics.blogspot.com/2008/12/its-all-in-curve-or-scary-story-on.html
[2] C. Chan, M. D’Arcy, S. Hill and F. Ophaso : “Demographic Consequences of China’s One-Child Policy”, April 2006, University of Michigan
[3] Research numbers JP Morgan 2006
[4] Dr. Philip James, chairman of the International Obesity Task Force, quoted in “Study Foresees Soaring Rate of Childhood Obesity,” March 6, 2006. Xinhua News. http://news.xinhuanet.com/english/2006-03/06/content_4263297.htm.

[5] Thomas Lum, “Social unrest in China”, may8, 2006
[6] For more insight we refer to D. Smick “The World is Curved, 2008 Marshall Cavendish
www.theworldiscurved.com

It's all in the curve... or a scary story on Deflation

2008-12-18T04:50:00.000-05:00

Dear readers,

This is an article I wrote on the 5th of December as part of my research job I am doing at EAB, but I thought it still would be relevant to share. The FED decision earlier this week has made this article even more relevant, and the debate about demonetizing debt will resume.

As we are working ourselves through the credit crisis and the recession we will regularly look back to see what got us into this and try to learn from the past in order to avoid the same mistakes are made. This morning we were discussing Kaletsky’s column in the Times. Apart from which camp you are in, the doom and gloom supporters or the band that kept on playing on the Titanic, the measures that have been taken will take time before they start showing signs of economic improvement.

Kaletsky has a valid point that most of the Central Banks are ahead of the curve this time and flooding the market with liquidity and cutting rates like there is no tomorrow. At least on the monetary front people learned from the mistakes that were made in the past. Japan is in every central bankers text book nowadays how things should NOT been done.

To refresh your memory, let us go back in time and see what exactly happened there, and whether this might give us some insights whether history will repeat itself?

Japan in the eighties was the China of today. It was the economical miracle of the century, even more than the impressive turn around that Germany experienced after WW II. After the Plaza Accord[1] the JPY rallied dramatically against the USD. Especially in the late 80-ties they were using their JPY strength to buy up the world, with the most eye catching move the purchase of the Rockefeller Centre in NY. It was a sign of the times their economy was becoming a bubble. Everything rose on a day-by-day basis. Stocks (Nikkei went from 20.000 to just below 39.000 in 2 years) and real estate went through the roof.

Property became highly inflated due to reckless financing by Japanese banks, similar to what American banks did during the last decade, but with one exception: in Japan there wasn’t subprime involved and even less SIV’s and shadow banking (proving by the way, as I have always said, that one does not need fancy derivatives or synthetic instruments in order to lose money!).

The only similarity with the current crisis was that models assumed that real estate couldn’t drop, or certainly could not drop on a national level. Typical for every bubble the talk of the street was TINA (there is no alternative) or ‘this time it is different’. But it wasn’t. All bubbles pop, one more brutally than the other, but burst they do. What ultimately triggered the sell off in the Nikkei is difficult to say even now, as this is more an area for behavioural finance. Lemmings behaviour is part of the explanation as markets get ahead of themselves. However, usually one can also look at the build up of all this and there one ends up with human error. This is a people business after all, and some people are just better at their jobs than others…

What was the human error in Japan? The reckless behaviour of banks? No. This was only the consequence of a far more serious error. As was pointed out above, the JPY started to strengthen on the back of the Plaza Accord. The Bank of Japan (BoJ), under political pressure, tried to counter the negative impact of JPY strengthening on their export competitiveness by lowering interest rates even all the way to 2.5% at the beginning of 1987. Only 2 years later Japanese officials started to realize the mistake they made, and started to hike aggressively all the way up to 6%. They actually kept on hiking far beyond the burst of their bubble.

The latter is the big difference with today. At this moment especially the FED and BoE – the ECB is more lagging in all this – showed strong signs of leadership., however especially the FED has played its cards on the short term interest rate front, and similar as the BoJ in the late 90-ties, is facing the liquidity trap. Basically this means that a central bank is unable to continue to stimulate the economy with the traditional monetary tools, being the discount rate, as it is already close to zero. As a consequence an even more uglier ghost shows up : DEFLATION.[2]

Let us first explain why the FED doesn’t have a lot of room to manoeuvre anymore with the classical monetary tools, given the fact that FED fund rates are still at 1 %. The simple answer to that question is the money market industry. Especially in the US the business model of money market funds breaks down when rates drop below 0.5 %. The reason for that is because of their fee income.

Money Market Funds Fee structure

Fee bp Assets($bio) %

> 75 235 7%

50-74 613 19%

25-49 736 23%

< 25 1.619 51%

Total 3.203

Source : Bank of America

This is a fee they charge for managing the fund. As a consequence, at a certain point the assets of the fund will not generate enough return to pay the fees of the manager and simultaneously offer a return to the investor/client.

This means that the Fed has still one more bullet of 50 bp to go before the liquidity trap is turning around the corner for them.

However there are other tools that a central bank can use in case of deflation, and Bernanke already gave a hint back in November 2002 :
“To stimulate aggregate spending when short-term interest rates have reached zero, the Fed must expand the scale of its asset purchases or, possibly, expand the menu of assets that it buys. Alternatively, the Fed could find other ways of injecting money into the system--for example, by making low-interest-rate loans to banks or cooperating with the fiscal authorities. Each method of adding money to the economy has advantages and drawbacks, both technical and economic. One important concern in practice is that calibrating the economic effects of nonstandard means of injecting money may be difficult, given our relative lack of experience with such policies. Thus, as I have stressed already, prevention of deflation remains preferable to having to cure it. If we do fall into deflation, however, we can take comfort that the logic of the printing press example must assert itself, and sufficient injections of money will ultimately always reverse a deflation.
So what then might the Fed do if its target interest rate, the overnight federal funds rate, fell to zero? One relatively straightforward extension of current procedures would be to try to stimulate spending by lowering rates further out along the Treasury term structure--that is, rates on government bonds of longer maturities.”[3]
Whether we will be dragged into a deflationary spiral is not clear yet, because there will be other forces into play which can have an influence on this. China for instance will be an important factor in all this. When the Chinese bubble bursts, and trust us it will, it can either result into deflation or inflation. It all depends how the Chinese government would react. Deflation risks would come in case of the consequential economic slowdown. As a result China would have no other choice to dump the stocks of commodities that they have been building up recently and next to that the world markets would be flooded with Chinese finished goods at fire sales prices.

An inflation outcome is also possible in case the Chinese government would act under extreme internal social unrests and withdraw their massive reserves from the global system to use these sources to buy off social riots. This would raise interest rates because one would need to buy off the Chinese bond holdings and central banks would have to increase the money supply. We will pay more attention to the potential social problems of China in one of our following news letters to explain the above.

What we are trying to explain is given the current imbalances it is a very difficult call what the final outcome will be, however for 2009 we think that the chances of dealing with / proactively fighting deflation are quite high, as Bernanke prefers to prevent it instead of to cure it.

Why do we think deflationary forces might be an issue next year?

Recessions and bubbles have per definition a deflationary effect
Financial institutions will have to continue deleveraging
US consumer will be forced to save and cut expenses due to credit limitations
Commodity prices are falling ( China is already reducing their stocks)
Considerable slowdown in the velocity of money

This view is also reflected in the swap market. Since last week we saw a strange phenomenon. The swap spread between the 10 years and 30 years in USD (but also EUR’s) is starting to invert. In the US Treasury market we don’t see this yet. So basically the swap market is already anticipating that the FED somewhere in the future will be forced to start using unorthodox monetary tools to fight the deflation ghost.

Cfr. Bloomberg Chart Swaps USD 10 – 30

Cfr. Bloomberg Chart US Treasuries 10 – 30

I wish you a very good trading week.

---------------------------------------------

Gino Landuyt

[1] Plaza Accord was put in place to weaken the USD and address the trade imbalances that were build up with the USA
[2] For a more detailed discussion see D. Smick in “The world is curved” – Chapter 5 : “Japanese Housewives take the commanding heights.”
[3] Speech by Governor Ben Bernanke before the National Economists Club, Washington. “Deflation: Making sure ‘it’ doesn’t happen here.”

Globalization and the merits of securitization

2008-12-16T11:45:00.000-05:00

Dear readers,

Since the crisis broke out mid 2007 a witch hunt was organized to find the scapegoats who brought us into this. In a discussion like this you always end up with the banks and their financial weapons of mass destruction as Warren Buffet used to call them. It might be wise though to take a step back and leave the emotions aside in this debate. The last thing we want to do is throwing the child with the bath water away.

What most people often forget is that the current crisis goes far beyond the use of derivatives, securitization, CDO’s and Structured Investment Vehicles (SIV’s). The dynamics which created the global imbalances were US consumers who bought goods from Asia and energy from oil exporting countries. The best way to illustrate this trend is by referring to the evolution of the trade balance of the US.

Chart 1 : US Trade Balance : 1968 - 2008

Source : Bloomberg

However, the value of those goods was far much greater then their consumer income. As a result they had to fund this gap with home equity and/or mortgage refinancing. The rising of the US mortgage debt was on its turn repackaged by US investment banks and placed among Asian and oil exporting countries. The major mistake in this model was the assumption of the rating agencies (plus from investors as well) that the value of house assets would never decline, certainly not on a national level (cfr. Newsletter of 5 Dec.)

As with all bubbles is the case, one usually gets an acceleration at the end. This happened when investment banks started their Shadow Banking system, where they decided to set up SIV’s in which they could undertake activities which didn’t need the capital backing which would be required by the regulator if this was applied ‘on balance’ sheet. Under this activity the technique of securitization was (ab)used. For those who are not familiar with this technique, it is best described as bundling a number of individual loans into a reference pool. On its turn one divides this pool up into several tranches of risk. Each investor can pick out a tranche in relation to its risk appetite.

There are two important things to remember though:

this whole process of creating a global imbalance started long before the Shadow Banking System (cfr. Chart 1 : US Trade Balance)
the abuse of a valuable technique called securitization, was driven by pure greed

The question we need to ask: “Does securitization has its benefits and merits?” To answer this we need to look at the journey of globalization and the liberalization of markets over the last 25 years. It goes beyond a doubt that the G-10 countries experienced a remarkable period of rising wealth and falling unemployment during that time. But did globalization contribute to a decline of poverty on a more global scale?

This question was answered by Surjit Bhalla, who used to work for Goldman Sachs and the World Bank. He compared 2 periods, 1950-1980 where the World Bank and other international agencies pumped in billions of dollars of government money in developing countries and the era of globalization starting around the early 1980s. He concluded that poverty even rose during the period of considerable international aid and poverty only started to decline when free trade and liberalization was embraced across the global. This fell together with globalization, when communication, transportation and production costs were considerably reduced.[1]

Also Greenspan came to a similar more intuitive conclusion by arguing that the first who would suffer from a set back of globalization would quite ironically be those in the developing countries.[2] This to the great upset of the anti-globalist movement that is still lingering among left intellectualists.

It is not a coincidence that during the era of globalization we noticed an exponential rise of derivatives products. [3]

The financial innovation that we knew over the last 25 years was a major contributor to let globalization flourish across the globe. The growth in derivatives reduced barriers and opened up markets to investors who would never been able to enter these initially. Securitization played a major role in this financial innovation process. Due to its characteristics of tranching a pool of loans in different risk categories it enables venture capitalists to participate in funding major projects, and this to the most broadest sense of the word.

A very good example is the securitization programme that Deutsche Bank launched in the microcredit market. Microcredit are very small loans which are extended to the unemployed, and extremely poor who lack collateral or who don’t have a credit history. Microcredit is a financial innovation which originated in Bangladesh where it has successfully enabled extremely impoverished people to engage in self employment projects that allow them to generate an income and, in many cases, begin to build wealth and exit poverty.
By securitizing such a deal Deutsche Bank enabled private and ethical institutional investors to participate in the financing of this and make an effective contribution to the fight against poverty by distributing at least 120,000 very small loans to micro businesses in 15 developing and emerging market countries.

There are many other examples to show that securitization is a valuable tool and has its merits. Chief Investment Officer of Pimco, the largest bond manager in the world, Mohamed El- Erian, described it very well. Securitization broadens the potential group of buyers and sellers due to its characteristics of diversification and customization. As a result it increases liquidity and simultaneously reduces transaction costs. “The combination of greater liquidity, diversification, customization is illustrative of the more general process of integration of financial markets. Like other components of this process, it is subject to excesses, including overproduction and overconsumption, but this need not necessarily derail the phenomenon over the medium term. Indeed, it may even render it more sustainable over the long term.”[4]

Gino Landuyt

[1] Surjit Bhalla in Imagine There’s No Country : Poverty, Inequality and Growth in the Era of Globalization ( Peterson Institute, Oct 2002)
[2] Alan Greenspan in The Age of Turbulence: Adventures in a New World (Penguin Press, 2007)
[3] Bank for International Settlements (BIS) Triennial and regular OTC Derivatives Market Statistics, November 2007
[4] Mohamed El-Erian in “When Markets Collide. Investment Strategies for the Age of Global Economic Change.” (McGraw Hill 2008)