The Fed preparing a cruise on the QEII

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

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...

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

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

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?

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

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