Meanwhile, Back At the Ranch
It
is simply hard to tear your eyes away from the slow-motion train wreck that is
Europe. Historians will be writing about this moment in time for centuries, and
with an ever-present media we see it unfold before our eyes. And yes, we need
to tear our gaze away from Europe and look around at what is happening in the
rest of the world. There is about to be an eerily near-simultaneous ending to
the quantitative easing by the four major central banks while global growth is
slowing down. And so, while the future of Europe is up for grabs, the true
danger to global markets and growth may be elsewhere. But, let’s do start with
the seemingly obligatory tour of Europe.
David
Zervos is the managing director and chief market strategist of
Jefferies and Company. He is an astute observer of Europe and brings a very
interesting perspective to the trade, with his Greek heritage. I got an email
this morning from him that I wish I had written. It is hard for many of us in
the US to understand just how deeply flawed the structure of the European
Monetary Union is (as opposed to the actual political union which, for all its
flaws, seems to work quite well). David came up with a very fun analogy that makes
the problem readily apparent. What if California behaved like Greece and the
rest of the US was asked to pay for its debts and other obligations? What would
ensue? So, rather than paraphrase what is already a very solid if short essay,
let’s turn to David:
By David Zervos
“The euro monetary system is
flawed. It is a system that was cobbled together for political purposes; and
sadly it was set up in such a way that each member state retained significant
sovereign powers – most importantly the ability to exit the system and
default on debts in times of stress. There is virtually NO federal power in the
Union, as witnessed by the complete breakdown of the Maastrict and Lisbon
treaties. In fact, what we are seeing today is that the structure of the
monetary system is so poorly designed, it actually creates perverse fiscal
linkages across member states that incentivize strategic default and exit. Our
new leader of the Greek revolt, Mr CHEpras, has figured this one out. And in turn
he is holding Angie hostage as we head into June 17th!
[JFM note: CHEpras is David’s
tongue-in-cheek name for the 37-year-old leader of the Syriza Party, Alexis
Tsipras, whose rhetoric does indeed resemble Che Guevara’s from time to time.]
“To better understand these
flaws in the Eurosystem, let's assume the European monetary system was in place
in the US. And then imagine that a US ‘member state’ were to head towards a
bankruptcy or a restructuring of its debts – for example, California.
“So let's suppose California
promised its citizens huge pensions, free health care, all-you can-eat baklava
at beachside state parks, subsidized education, retirement at age 45, all-you-can-drink
ouzo in town squares, and paid 2-week vacations during retirement. And let’s assume
the authorities never come after anyone who doesn’t pay property, sales, or
income taxes.
“Now it's probably safe to
further assume that the suckers who bought California state and municipal debt
in the past (because it had a zero risk weight) would quickly figure out that
the state’s finances were unsustainable. In turn, these investors would dump
the debt and crash the system.
“So what would happen next in
our US member-state financial crisis? Well, the governor of California would
head to the US Congress to ask for money – a bailout. Although there is a
‘no-bailout’ clause in the US Constitution, it would be overrun by political
forces, as California would be deemed systemically important. The bailout would
be granted and future reforms would be exchanged for current cash. The other
states would not want to pay unless California reformed its profligate
policies. But the prospect of no free baklava and ouzo would then send Californians
into the streets, and rioting and looting would ensue.
“Next, the reforms agreed by the
Governor fail to pass the state legislature. And as the bailout money slows to
a trickle, the fed-up Californians elect a militant left-wing radical, Alexis
(aka Alec) Baldwin, to lead them out of the mess!
“When Alexis takes office, US
officials in DC get very worried. They cut off all California banks from
funding at the Fed. But luckily, the "Central Bank of California" has
an Emergency Liquidity Assistance Program. This gives the member-state central
bank access to uncollaterized lending from the Fed – and the dollars and
the ouzo keep flowing. But the Central Bank of California starts to run a huge
deficit with the other US regional central banks in the Fed's Target2 system.
As the crisis deepens, retail depositors begin to question the credit quality
of California banks; and everyone starts to worry that the Fed might turn off
the ELA for the Central Bank of California.
“Californians worry that their banks
will not be able to access dollars, so they start to pull their funds and send
them to internet banks based in ‘safe’ shale-gas towns up in North Dakota.
Because, in this imaginary world, there is no FDIC insurance and resolution
authority (just as in Europe), the California banks can only go to the Central
Bank of California for dollars, and it obligingly continues to lend dollars to
an insolvent banking system to pay out depositors. In order to reassure
depositors, California announces a deposit-guarantee program; but with the
state's credit rating at CCC, the guarantee does nothing to stem the deposit
outflow.
“In this nightmare monetary scenario,
with the other regional central banks, ELA, and Target2 unable to stop the
bleeding – and no FDIC – the prospect of a California default
FORCES a nationwide bank default. The banks automatically fall when the state plunges
into financial turmoil, because of the built-in financial structure. A bank run
is the only way to get to equilibrium in this system.
“There is sadly no separation of
member-state financials and bank financials in our imaginary European-like
financial system. So what's the end game? Well, after Californians take all their
US dollars out of California banks, Alexis realizes that if the Central Bank of
California defaults, along with the state itself and the rest of its banks, the
long-suffering citizens can still preserve their dollar wealth and the state can
start all over again by issuing new dollars with Mr. Baldwin's picture on them
(or maybe Che's picture). This California competitive devaluation/default would
leave a multi-trillion-dollar hole in the Fed’s balance sheet, and the remaining,
more-responsible US states would have to pick up the tab. So Alexis goes back
to Washington and threatens to exit unless the dollars and ouzo and baklava
keep coming.
“And that’s where we stand with the
current fracas in Europe!
“Can anyone in the US imagine
ever designing a system so fundamentally flawed? It’s insane! Without some form
of FDIC insurance and national banking resolution authority, the European Monetary
System will surely tear itself to shreds. In fact, as Target2 imbalances rise,
it is clear that Germany is already being placed on the hook for Greek and
other peripheral deposits. The system has de facto insurance, and no one in the
south is even paying a fee for it. Crazy!
“In the last couple days I have
spent a bit of time trying to find any legal construct which would allow the
ELA to be turned off for a member country. I can't. That doesn't mean it won't
be done (as the Irish were threatened with this 18 months ago), but we are
entering the twilight zone of the ECB legal department. Who knows what happens
next?
“The reality is that European Monetary
System was broken from the start. It just took a crisis to expose the flaws.
Because the member nations failed to federalize early on, they created a
structure that allows strategic default and exit to tear apart the entire
financial system. If the Greek people get their euros out of the system, then
there is very little pain of exit. With the banks and government insolvent,
repudiating the debt and reintroducing the drachma is a winning strategy! The
fact that this is even possible is amazing. The Greeks have nothing to lose if
they can keep their deposits in euros and exit!
“Let's thank our lucky stars
that US leaders were smart enough to federalize the banking system, thereby not
allowing any individual state to threaten the integrity of our entire financial
system. There is good reason for the separation of the banking system and the
member states. And Europe will NEVER be a successful union until it converts to
a state-independent, federalized bank structure. The good news is that our
radical Greek friend Mr CHEpras will probably force a federalised structure
very quickly. The bad news (for him) is that he will likely not be part of it!
I suspect this Greek bank run will be just the ticket to precipiate a
federalized, socialized, stabilized Europe. Then maybe we can get back to the
recovery and growth path everyone in the US is so desperately seeking.
“Good luck trading.”
The
debate among very knowledgeable individuals and institutions as to the future
of Europe is intense. There are those who argue that the cost of breaking up
the eurozone, even allowing Greece to leave, is so high that it will not be permitted
to happen. Estimates abound of a cost of €1 trillion to European banks,
governments, and businesses, just for the exit of Greece. And that does not
include the cost of contagion as the markets wonder who is next. Keeping
Spanish and Italian interest-rate costs at levels that can be sustained will
cost even more trillions, as not just government debt but the entire banking
system is at stake. Not to mention the pension and insurance funds. If the cost
of Greece leaving is €1 trillion, then who can guess the cost of Spain or
Italy?
A
total Greek default wipes out more than twice the ECB balance sheet. That means
the remaining countries will have to put twice as much into the ECB as their present
commitment, just to get the ECB back to where it
technically stands today (because theassumption is still that Greek
debt is good, and so the ECB is still lending money to the Greek Central Bank).
Then
there are those who argue there is
no way
Greece can stay in the eurozone. The political costs are just too high, not
only to the Greek people but to the rest of Europe. How long can Greece demand
that Europe cover its government deficits, when its own citizens are not diligent
in paying taxes? Listen to Alexis Tsipras, the leader of Syriza, at a campaign
rally:
“There's one real choice in
these elections: the bailout or your dignity…
“We want all the peoples of
Europe to hear us, and we want their leaders to hear us when we say that no [country]
chooses to become servile, to lose their dignity or commit suicide... We are
the political party that with the help of the people will fulfill our campaign
promises and cancel this bankrupt bailout deal.”
The Syriza Party appears to be
ahead in the polls as I write, but that has shifted several times this week.
Not only do European leaders not know what will happen, apparently even the
Greeks cannot make up their minds, if we are to believe the polls. They want to
stay in the eurozone but don’t want to have to endure the cuts in spending that
simply moving toward a balanced budget will requirs. This is a classic case of
wanting to have your cake and eat it too.
I
simply don’t know what the eurozone will do in the next year, or even the next
month. If Syriza wins the elections and forms the government, how can Europe
back down and give them what Tsipras is demanding? And if the Greeks continue
to pull their money from Greek banks (and it is now billions a week), then it
will not be very long before they have their euros everywhere but in Greece,
and they will in fact have little reason to stay in the eurozone, as Zervos
points out.
This
latter fact will not be lost on Spanish and Italian voters.
If there is not that great a cost to Greece for leaving; and especially if
Greece, after a period of severe recession/depression, starts to rebound; then
voters all over Europe will be paying close attention. Some will ask why they should
not default as well, and others will wonder why they are paying taxes to
support other countries that might leave.
Even
if European leaders have no real idea what will actually happen, there are some
things that are more likely than others. I think the whole idea of eurobonds is
dead on arrival. Who would be responsible for paying that bond structure, which
would soon be in the trillions of euros? Some European authority? The EU itself,
which would then need to levy taxes and set national budgets? I can’t really
see any country giving up control of its budget to Brussels, let alone give the
EU the power to raise taxes. And if the eurozone has a problem raising a
relatively paltry €400 billion for the ESM, etc., from the various governments,
how can it expect to get the authority to raise trillions? Does anyone really
think the German Bundestag will agree to their share of that?
That
then leaves the options of either designating the ESM or some other entity as a
bank that can borrow relatively unlimited amounts from the ECB, or having the
ECB monetize the debts of various governments in trouble and saddling them with
a program of budgetary reforms (which are clearly not popular if you are the
one being reformed!).
I
still think it is likely that Greece will leave the eurozone. It makes sense if
you are Greece; and even though it will cost the other eurozone members huge
sums of money, I think they are getting “Greek fatigue.” But let’s stay tuned,
as they say.
Germany
was able to sell €4.56 billion ($5.8 billion) of two-year
bonds at a 0% coupon interest rate on
Wednesday. That was not a typo. Why would people give Germany money to
use for two years at no cost?
I
can think of several reasons, but the one I think is most likely – and
the one that will not be admitted in polite circles – is that it is
basically a very low-cost call option on the possibility of Germany leaving the
eurozone. If Germany left, they would likely denominate their bonds in Deutsche
marks, which would rise in value over those of the countries that remained in
the euro.
But this also points up the fact
that Germany is falling into recession, hard on the heels of the rest of Europe,
which is mostly already there – some countries severely so. Leading
economic indicators as well as purchasing-manager indexes are down all across
Europe. But the saddest statistic is that of youth unemployment. Below is a
chart from Reuters (courtesy of Frank Holmes at US Global). Only Germany is
seeing its youth unemployment rate fall below 10%.
This letter is translated into
Chinese, Spanish, and Italian; so I have to write with an international
audience in mind, and also remember that I am of a certain age. Some concepts
may not translate well, either to other languages or across generations. So let
me set up the theme for younger readers and those not familiar with early 20
th-century
American culture. In the dawn of film, cowboy movies were all the rage. These
were typically low-budget, and most were shot on the same set and ranch in
southern California. The same saloons, jails, large rocks, and dirt roads kept
showing up in movie after movie; but no one much noticed, back then. The magic
of movies was still fresh.
You would watch your hero (you
knew he was the good guy, because he wore a white hat) chase bank robbers and cattle
rustlers and duke it out with gunslingers; and there was usually at least one
pretty girl involved. In the era of silent movies, there would literally be a
title graphic that said, “Meanwhile, Back at the Ranch” when there was a segue
between the action involving the hero and the bad guys and the doings of the
people back home on the ranch.
So then, “meanwhile, back at the
global economy,” let’s look at a few graphs and some data to see what is
happening in the rest of the world.
First
of all, China is really beginning to slow down from its torrid pace of growth. Thr
growth of their manufacturing output has fallen for seven straight months, and it
is now contracting. Media reports everywhere are talking about actual
statistics or anecdotal stories from Chinese merchants and businesses.
Construction is under real pressure, as are real estate prices. Just as in the
US or Europe, when construction starts to slow it affects all sorts of smaller
businesses that supply products to people building or remodeling their homes.
A
few data points. Deposit growth in China is slowing rapidly, and money supply
suggests a decelerating economy. The ratio of M1 to M2 growth suggests an even
weaker economy than the contracting purchasing manager’s index. The M1-M2 ratio
is now back to where it was in the last financial crisis.
Let’s look at two charts from
Credit Suisse. I have long been concerned about the very high percentage of GDP
growth in China that is attributable to direct investment, bank loans, and
infrastructure spending. While all of those are good things, the levels in
China are without precedent anywhere in the world that I am familiar with, and
have been there a long time.
What happens when you have to
slow down investment and try to become a more consumer-driven economy? The
transition is generally not smooth. And what happens when you try and do that
when your largest customer (Europe) is in recession? And when the bank lending
from Europe that finances the spending of many of the developing nations you
sell to begins to dramatically shrink?
Reports
from around the world show South African and Australian mines with lower sales,
growth in Taiwan slowing and Great Britain in recession. The MSCI World Index,
which tracks equity markets around the globe, is down more than 9% since
mid-March.
The
US economy is also starting to slow. Job growth is getting weaker. Food stamps
are at an all-time high. The effects from stimulus spending have just about
gone away, and there are large numbers of people falling off extended
unemployment benefits. Lakshman Achuthan, of the Economic Cycle Research
Institute (ECRI), has recently reaffirmed his belief that a return to economic
contraction is likely in 2012, noting that the coincident data used to
officially define economic-cycle boundaries continue to signal slowing growth.
Achuthan is a very sober fellow, and you have to pay attention when he makes
these calls. ECRI does not make them lightly.
Let’s also look at a couple charts
from my friend Rich Yamarone, the chief economist at Bloomberg. (We will be
together at a symposium at the University of Texas in Austin, on June 7, along
with David Rosenberg.) Rich has also been stating that he believes the US
economy is headed for recession, for a different set of reasons.
At our dinner meeting last week
(as indeed he has been for months) he was talking about the fall in real
disposable personal income. It is hard to get growth when incomes are not
rising .
And
he too is worried about the fact that government stimulus (transfer payments,
unemployment benefits, welfare, food stamps, etc.) has had a major effect on
consumer spending, but as people fall off extended unemployment benefits (and
they are, by the hundreds of thousands each month) personal income could
actually drop.
The
recent round of global quantitative easing is beginning to ebb. Europe, Great
Britain, and the US are all wrapping up their stimulus and have not announced plans
for any more. China is more or less on hold until the leadership changes in
October (or that is what most observers I read seem to think).
The recent QE had provided a
clear boost to commodity prices and stocks, and the anticipation of withdrawal
seems to be having a depressive effect on market prices. This was the third
round of global QE, and each round has resulted in less real benefit than the
previous one. There is reason to believe that another round would continue that
trend. While it is probable that the ECB will soon take action, as Europe is
clearly in recession, there seems to be no such consensus as yet in the US. And
with an election coming in November, if the Fed is going to do anything, they
have just two meetings left (on June19-20 and August 1) before September, at
which point the economy would have to be in very serious trouble for them to do
anything before the election – which then takes us out to the December
meeting.
Since the recent most QE will still
be in effect at the time of the June meeting, that would leave August 1 for an
announcement. We will only have two unemployment reports between now and that
meeting. They will therefore be of more than usual importance. We will be
watching.
