In answering a reader's question about the relationship between quantitative easing (QE) and food price inflation (hat tip: Crito) I mentioned that QE may not, in fact, increase money supply.  This is because it is not known how much of the liquidity injected by the Fed is additive to the system, or if it is just filling the vacuum left by debt defaults.

Here are some data on total credit expansion from the Fed's latest Z1 report (click to enlarge).

  Zero Total Credit Expansion in 2009-10

Credit expansion in the private sector collapsed after 2008 with the financial sector leading the way  down by contracting over 15% in two years.   The federal government took over as its borrowing zoomed 76% after 2007.  Net-net, however, total credit outstanding has been flat in 2009 and 2010, at least until the end of the third quarter (latest data available).

It seems to me, therefore, that QE1 and QE2 have merely substituted for  some of the "money" that has been destroyed via debt defaults and should not in theory create overall inflationary pressures.  But markets are mostly psychological manifestations and not theoretical structures;  if punters believe new money is pouring out of the printing presses, then they bet accordingly and commodities - to name but one - rise in price.  That's what I call Quantum Finance or, Perception Creates Reality.

Looking at things from a longer-term perspective it is obvious that total debt (i.e. money) and prices should move together: if there is more money chasing goods and services prices will inevitably rise.  Commodity prices have tripled in the last ten years (see chart below - click to enlarge).

 Reuters-CRB Commodity Price Index

The US dollar is the world's primary reserve currency used to price and trade everything from crude oil and gold to wheat and pork bellies, so it makes sense to look at how much of that "stuff" is around.  Total debt in the U.S. has more than doubled in the last 10 years.

Swift Action Required

This story appeared in the NY Times a couple of days ago, reporting on the possibility of  buy-backs for deeply discounted Greek Government Bonds (GGBs) in the secondary market by the European financial stability fund (EFSF).  The particular story - there are many more like it in the financial press - was brought to my attention by Okie (hat tip), a longtime reader who wondered if I had something to do with it. 

Well, no and yes.  No, I didn't write the story nor did I campaign actively from the "inside" for implementation of the buy-backs.  But, yes, I believe I was the first one to come up with the idea;  it was published in this blog on November 23 under the title How To Restructure PIGS Debt - A Modest Proposal.  Please read it if you feel like it.

Another reader wondered if I had a priori knowledge of these developments, i.e. if I possessed inside information.  Absolutely not - but I do have extensive knowledge and practical experience involving sovereign debt markets and derivatives, allowing me to recognize opportunity when it arises.  Couple that with a solid dose of common sense and, voila, A Modest Proposal.

No one, however, commented on the  (perhaps not so obvious) reference to Jonathan Swift contained in the original post's title.  A Modest Proposal was published anonymously in 1729 by the renowned Anglo-Irish satirist and in it he proposed that impoverished Irish farmers should fatten up their children and sell them as meat to the well-off gentlemen and ladies of the land.  His essay went to great detail, including statistics, economic benefit calculations, quotations from (fictional) presumed authorities - even recipes!

My post was not meant to be satirical in the least, of course.  However, the chance to allude to rich Europeans eating their own poor children as a solution, instead of firmly helping them overcome their difficulties, was too good to pass up.  And make no mistake, there were and still are many addle-brained idiots (I use the word in its classical meaning) in Europe who see the debt issue from a  destructive self-centered perspective. 

Nevertheless, the market is starting to smell that a more comprehensive solution is in the works.  Though still at lofty levels compared to a year ago, prices for credit default swaps on GGBs have come down considerably in the past week (see chart below, click to enlarge).

5-Year CDS On Greek Government Debt

My prediction for the European debt crisis is that it will involve a long process of adjustment and real economic convergence amongst the partner nations.  Unlike the 1990's, when countries who wished to enter the eurozone focused on meeting numerical targets laid down by the Maastricht Treaty, Europe today has no alternative  but to become more cohesive, more integrated, more co-equal, to use a fashionable term, itself alluding to the pigs of another famous essay.

It won't be easy, it won't be smooth, it won't be pretty.  But it will happen and it will succeed.

Sophomoric Opus

Sophomore: A person who is at the same time wise and foolish, perhaps because he lacks experience.  From the Greek sophos (wise) and moros (foolish).  

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When it comes to markets, I am a confirmed contrarian.  That is, I constantly look for signs of excess and act accordingly.   What signs?  It could be anything, really, but I usually focus on human behavior and psychology, e.g. doom, gloom, exuberance and frivolity.  What matters is the contrast between reality and unsustainable expectations - positive or negative.  Like  radioactivity, the best type of contrarian evidence is cumulative, i.e. it appears in additive layers, from many sources and in many varieties.

Here's one such bit: The Imminent Crisis: Greek Debt and the Collapse of the European Monetary Union is a short book (140 pages) by Grant Wonders.  Who is he? A Harvard sophomore studying economics and archaeology.    It is published by GW Publishing, the initials obviously from Mr. Wonders name.

Here's another:Bust: Greece, the Euro and the Sovereign Debt Crisis.  On the face of it, this work must be a bit more serious since it weighs in at 288 pages and is written by Matthew Lynn, an occasional Bloomberg columnist.  At least he's not a sophomore.  But, writing as Matt Lynn, he also turns out a serial military action thrillers with titles such as Death Force, Shadow Force, Fire Force, etc.  The blurbs claim that "You can taste the dust and smell the blood" .  You get the type..

And yet another, this one in song form.

So, there you have it. And Greek long bonds are trading at around 55 cents on the euro.

I can taste the fear, smell the money and wouldn't short Greek securities, stocks or bonds, not even on a Sunday.

Hell No, They Won't Go

Just like the premature announcement of Mark Twain's passing into the hereafter, breathless predictions of the Euro's death are greatly exaggerated.  In sharp contrast to this swirling maelstrom of half-truths, targeted innuendos and outright bull**, this well-reasoned and comprehensive analysis of the situation by Paul Krugman stands out and is well worth reading.

I do disagree with a few of Mr. Krugman's points, however.

1. Like nearly every non-European, he perceives the euro mostly in technical/monetarist terms, instead of historical/socio-economic ones.  It's like saying the U.S. Declaration of Independence was put together by a bunch of frustrated colonists solely for the purpose of avoiding King George's high taxes. He's definitely not alone in grossly underestimating the will of Europeans to integrate their separate nations into a cohesive peaceful Europe, but as a Nobel laureate maybe he should know better.
2. He mentions American economist Irving Fisher from almost 80 years ago, who claimed that economic crises deepen when incomes fall but debt remains unchanged.  That was and remains true in theory, but in the case of the eurozone today's secondary bond markets can be adapted as debt reduction mechanisms.  For example, with Greek government bonds trading at 50 or 60 cents on the euro, a pan-European entity  (e.g. the ECB) can quickly step in, scoop them up and refinance the purchased amounts at cost.  This is now being seriously considered by European leaders (but you heard it here first, eh?).
3. He draws a parallel with Argentina's default and the peso's 1-to-1 peg to the U.S. dollar.  Crucially, however,  the euro is not a peg but a national and international reserve currency.  No matter how "hard" and "irrevocable", Argentina's peg involved pesos, a national currency that was  vulnerable to psychological pressure and loss of confidence. Furthermore, unlike the eurozone, Argentina's economy was not at all integrated with that of the U.S.  For example, trade between Argentina and U.S. in 2007 (exports plus imports) amounted to a mere 9.6% of Argentina's total foreign trade.  Compare this to Greece, where 56% of its total foreign trade is with other EU nations.

My take on the "European Crisis" is that it amounts to more than a storm in a teacup, but much less than a perfect storm capable of sinking the euro or the EU itself.  It is United Europe's first real test, a challenge from which it will come through stronger and more confident.

Despite the currently deafening cacophony of opportunistic sycophants, Europeans will soon start doing a bit of their own yelling: "Hell No, We Won't Go" (..quietly to the dustbin of history).
 

CDS: Hedge Or Hog?

Are credit default swaps (CDS) legitimate hedging tools or just another way to bet the ponies?

I was there at the beginning, so I know that CDSs were originally designed to hedge or reduce credit exposure.  It was a highly specialized, custom-made and low-volume business stuck in quiet corners of trading floors, away from the glamorous hot spots of foreign exchange, money markets, derivatives and bond trading.  With trade documentation going back and forth, individual trades frequently took days to complete.

It was slow going for several years - and then everything changed. From a very modest $630 billion notional outstanding in the first half of 2001, CDSs exploded a hundredfold to $62 trillion at the end of 2007 (see chart below).

Data: ISDA

CDS Amounts Exploded 100-Fold Within Six Years

This mad rush into CDS was not caused by some pent-up craving to hedge credit risk  - quite the reverse, in fact.  Instead of seeking to reduce credit risk on existing bond portfolios, the new players who came into the market after 2004-05  used CDS as riskier and more volatile alternatives to straight bonds, viewing them as juicy income streams.  That's when CDSs ceased to be "hedges" and became "hogs".

This became very obvious with the issuance of synthetic and hybrid CDOs, types of second-order derivative products made up of a mixture of various CDSs, that acted like bonds on "speed".  In just three years between 2005-2007 a total of $160 billion of  purely synthetic CDOs (e.g. CPDOs) were issued globally, while cash flow and hybrid CDO issuance reached nearly another $1 trillion.  (All Data: SIFMA). 

Pointedly, a stunning 90% of all CDO issuance in this period was done for arbitrage purposes, i.e. to profit from the spread between the expected yield of the underlying CDO assets (e.g. CDSs) and the financing costs of the CDO tranches themselves.  This incredible percentage, more than anything else, reveals the true purpose of derivative finance: leveraged speculation.  It reveals that hedging - the usual excuse paraded out when credit derivatives come under criticism - was very far from the minds of those who dealt in them, since only 10% of the issues were "balance sheet" deals done to legitimately remove assets or their risk from originators' books.

It must be pointed out that CDS were not the only derivatives that went ballistic in that time.  Total derivatives outstanding reached a face value of $700 trillion in 2008 (see chart below).

Anyway, it takes two to do the CDS tango so there's an obvious question begging to be asked: Okay, greedy speculators and/or foolish pension fund managers knowingly or unknowingly sold credit insurance before the crisis on the cheap (see chart below) and by the boatload .....  But who bought?

 Chart: BIS

Who were so prescient and so smart as to keep buying the trillions of CDS that fools were literally giving away before the crisis hit?  Well, they didn't save AIG from collapsing into its CDS crater for the benefit of mom and pop policy-holders, did they?

The trouble with the property and casualty insurance business (and CDS are essentially P&C insurance products, no matter what bank traders say) is that it is very, very cyclical.  Competition increases and premiums  charged collapse when claims are low, but then a major disaster occurs and everyone scrambles to raise rates.  Sound familiar?

Right now, 9 out of the top 12 entities in CDS by notional amount outstanding are sovereign nations like Italy, Brazil, Spain and - of course - Greece (see chart below, click to enlarge).  Yes, it does make some sense as things stand right now with the CDS market, because nations are the largest debt issuers.  But how much sense does it make to allow  punters to go on betting on sovereign defaults, when it is the taxpayers who bail out the punters?  This is exactly like "Heads I win, tails you lose".

Data: DTCC

When you think about it, it's a paranoid/schizophrenic situation: paranoid CDS players have one personality that bets furiously against the credit of nations, driving up borrowing costs and forcing taxpayers to foot the increased bill.  Their other personality fervently believes that nations and taxpayers are the ultimate guarantors of the survival and smooth functioning of the financial system.  Can they have it both ways?  Well, sure - but only for as long as the sovereign CDS bubble lasts.  Because like any other bubble this too shall burst, and spectacularly so.  

Let me put it another way: how long can a dog keep biting the hand that feeds it?

Mythbusters

I'm a facts- and data- driven person, as one could easily surmise from my background.  So, when someone throws out comments like "lazy Greeks" I go looking for the numbers.  

Surprise, surprise... (click to enlarge chart).

Data: OECD

Greeks Are The Hardest Workers In The World

According to the OECD Greeks work 2,119 hours per year - that's 25% more than Slovaks (the commenter referred above said he is from the Slovak Republic) and a whopping 52% more than Germans.

Looks like the populist myth of Greeks lazing and dancing by the seaside, drinking ouzo and munching on souvlaki is solidly busted.

Quotes For A Future Decade

• The best way to predict the future is to create it.  Peter Drucker

• I do not want to foresee the future. I am concerned with taking care of the present. God has given me no control over the moment following.  Mahatma Gandhi

• Do not dwell in the past, do not dream of the future, concentrate the mind on the present moment.  Buddha

• The future ain't what it used to be.  Yogi Berra

•  Every saint has a past and every sinner has a future.  Oscar Wilde

•  Real generosity toward the future lies in giving all to the present. Albert Camus

• Never let the future disturb you. You will meet it, if you have to, with the same weapons of reason which today arm you against the present.   Marcus Aurelius
  
  
•  The future enters into us, in order to transform itself in us, long before it happens. Rainer Maria Rilke

•  There is no prophet of the future for mortal men.  Sophocles

•  Cease to inquire what the future has in store, and take as a gift whatever the day brings forth. Horace 

•  God doesn't play dice.  Albert Einstein 

• ,,, but he sure as hell loads them.  Hellasious   

  

Happy New Year!!

Greece Got Run Over By a Reindeer

What gives with Greece?  If we look at only one, narrow, set of the statistics, i.e. government debt and official GDP figures, and compare them with other nations, then by all means Greece is essentially bankrupt - just as so many fear-mongering "analysts" claim.

But... Disraeli's saying "lies, damned lies and statistics" is always a good piece of advice.  Even if he actually never said it himself.

So what should we look at?  Two facts:

1. Greece has one of the lowest total debt to GDP ratios amongst OECD nations.  Yes, that's right, lowest;  because even though government debt is very high at 127% of GDP (end of 2009 and going higher, probably to 140% by the end of 2012) private debt (i.e. corporate plus household) comes to only 108% of GDP, making for a total debt to GDP ratio of only 235%.  That's lower than Switzerland (313%), Canada (259%) or, gasp!, ever-so-self-righteous Germany itself (285%).
2. Greece has a very large, but very real, "shadow" economy due to widespread tax-evasion and corruption.  The IMF estimates it at 27% of GDP, by far the highest of any OECD nation (average is estimated at 11%).  This means that officially reported Greek debt/GDP ratios are grossly overstated.

Below is a table I constructed based on data from McKinsey for total debt (2009) and the IMF for the shadow economy.  The adjusted figures include the shadow economy in the total debt to GDP ratio.

 See anything grossly out of line?  

 One has to wonder how "the market" operates sometimes, eh?  Looks like Greece got run over by a reindeer this Christmas.  On purpose..?

It's The Politics, Stupid!

Everyone's taking potshots at the eurozone these days and  given the number and  clumsiness of European "leaders" running around in the open it's like a turkey shoot down at the country fair.  Even those who couldn't hit a barn at 100 ft. can go home feeling like sharpshooters.

 

Nevertheless, analysts from outside Europe's "hard core" have it all wrong.  They presume the eurozone to be all about finance and monetary policy and, having made this fundamental mistake, conclude that the euro is untenable, no more than a rickety structure about  to crash as weak-link peripheral countries like Greece and Ireland (or even - perhaps - Spain ) buckle under the strain of their large debts.

However, the establishment of the European Union over fifty years ago and the adoption of a common currency are not guided by money and economics, but a common vision for peace and prosperity after centuries and centuries of constant, bloody war.  Since 1300 AD (at least) there has never been a period of 50 consecutive years of peace in Europe - except now (excluding the "police action" in former Yugoslavia).  That alone says a lot.

There is no way that Europeans and their leaders are going to let the euro and the EU collapse;  there is simply way too much at stake.   Does anyone seriously think the Germans - to name only one nation - want the EU to fall apart?  The Europeans who arguably suffered the most as they lost not one, but two world wars? C'mon..

To paraphrase Bill Clinton, it's the politics, stupid!

So,  here's my wish for Christmas 2010 : Peace On Earth.

Have a wonderful holiday, all.

The Stupidest Cut Of All

Unlike the French, the British are most definitely not a nation of active protesters and rioters.  So when they take to the streets, smash shop windows, throw chunks of steel-reinforced concrete, set fires and attack Prince Charles's Rolls Royce (a smashing counterpoint to austerity, old boy) you know something is terribly wrong.

All this is caused by the conservative government's decision to cut university funding by an astonishing 80%, passing the bill on to students and resulting in doubling and tripling of tuition fees.  Since most students can't afford such a massive hike, they will end up with - what else - taking up loans of up to $63,000 for three years of study (the normal course in a UK college).

I won't elaborate much on why slashing education spending is the stupidest cut of all because I consider it to be self-evident to anyone who can fog the mirror and count past ten without the aid of his fingers.

But I will say this:  we have all of us in the West rolled up our manufacturing and unceremoniously packed it off to China (why else do you think China's energy use soared 100% in a mere five years?).  Instead, we were supposed to become post-modern vibrant economies based on technology, design, know-how, smarts;  in a word: education.

Well, Mr. Prime Minister Cameron, to quote from one of your famous countrymen, Goodbye To All That. Robert Graves was educated in Oxford just like you were, so I'm sure you understand my allusion to the needless slaughter of an entire generation of young men during WWI,  and the figurative parallel with today. 

The question is, will your children?