Back From The Desert

It has been so long since the last post that I might as well have been perambulating in the desert!  Which, in a way, I have.

But, no matter, dear readers and friends, here goes.

I have been trying to think how the current situation will play out.  Brief description of what's happening today:

1. The US is stuck in Quantitative Easing (call me printing) to the tune of hundreds of billions yearly.
2. Europe is mired in deflationary misery and recession, with Germany calling all the shots and everyone else hating them.
3. China is the world's second largest economy, with serious contention for hegemony. 

There is an enormous imbalance in the global economy, and it needs to be corrected.

How will this be accomplished?  The key is China. After nearly two decades of massive growth, the country is no longer a bowl of rice a day economy. Far, far from it.  It is fast becoming wealthy, particularly in the major cities, and needs to protect and improve living standards for its burgeoning middle class. Up to now it has done so through being cheapest-to-produce in export goods, gutting the West's manufacturing base.  

 In my opinion, everyone understands that this game is over.  The current model of borrow-import-spend can't survive any longer and is in dire need of immediate replacement.  Something like a new Bretton Woods agreement is necessary to correct the imbalances, and recirculate China's vast reserves back into the global productive economy, and not as passive portfolio investments.

Chinese FX Reserves - $ Million

Here's a possible solution:

• China will gradually shift from being export-driven, to investing its reserves in productive assets abroad.  It will generate jobs within its western customer base AND recirculate its reserves into the real economy, instead of letting it sit in Treasurys and Bunds.  The current "bubble" in low interest rates for AAA borrowers and the (previous) bubble in gold prices also stems from that condition.

 10-Year US Treasury Yield

Gold

•  A significant revaluation of the yuan is probable in this scenario.

 Chinese Yuan per $US

•  Europe will introduce its own version of QE, probably laced with heavy doses of Germanic rectitude and fiscal righteousness.  But it will ease.

Everyone benefits under this scenario: The west is lifted from recession, the US can ease off its own QE pedal, and China can invest its reserves more safely than risking bond defaults and haircuts.

I believe we are already observing early signs of such a move:

1.  The US is hinting heavily of ending QE.
2. China is clamping down on domestic credit expansion, and is looking to invest in infrastructure abroad.
3. Europe realizes that deflationary politics are now fast becoming counterproductive, since they risk popular backlash.  Italy, in particular, could blow up without warning.
4. Japan is now on the QE wagon.

Key date: the German elections in September.

Bite The Bullet

Moody's just lowered the rating outlook for Germany, the Netherlands and Luxembourg to negative (currently AAA) because of the ongoing debt turmoil in Europe's South.  In other words, Mrs. Merkel, if you force a starvation diet onto your trading partners it won't be long at all before they stop buying BMWs and Miele washing machines.  Fiscal rectitude can go way too far, when imposed at the long end of a dogma stick.

It's time to bite the bullet and face facts: the EU is not a federal union a la USA.  Instead, it is a theoretical construct created by political and idealistic visionaries who had enough of perpetual bloodshed in Europe.  As such, it is irreplaceable and should never be allowed to fail because a bunch of short-sighted hacks cannot create a workable common monetary and fiscal policy.

Bottom line, once again: Spain and Italy, accounting for 22% of the EU's GDP, are now falling apart. It is plainly insane to think that the euro will survive Grexit, if it happens.  And it is certain that the EU itself will not long survive the demise of the euro.

...Time to bite the bullet...

Just A Quote

"Democracy destroys itself because it abuses its right to freedom and equality. Because it teaches its citizens to consider audacity as a right, lawlessness as a freedom, abrasive speech as equality, and anarchy as progress."

Isocrates, an Athenian orator ( 436–338 BC)

I dedicate this quote to all EU leaders:  Wake up ladies and gentlemen, they smoked you out THOUSANDS of years ago.  You can't keep on abusing "democracy", hidden behind the smokescreen of popular opinion...

The "Real Economy" Makes The News

Well, darn it!, I feel vindicated at long last... I've been harping on the need to focus on the Real Economy (tm) for so long in this blog, I was beginning to feel like a "nut".  

Lo and behold, Reuters just ran an article on the theme: Crisis forces "dismal science to get real".  Out go "rational expectations", "supply and demand", econometric formulas, etc. and in come... Argentinian ants, of all things (read the article).

 As Real As It Gets, Apparently..

Here's another "shock" from the Reuters report: testosterone levels in human "players" are more important than risk-return analysis (duh.. anyone who's been around a dealing room/trading floor could have told 'em, several dozen years ago, even).

Mmm... better lay off the bug spray.  It may prove dangerous to your (financial) health.

One Picture Is Worth A Thousand Marks (or Merkels)

Given what is going on in the eurozone at the moment, it is worth it to point out that the biggest beneficiary of the euro is Germany itself - and by very, very far. 

Data:Statistiches Bundesamt

The German Economic "Miracle":  It's All About The Euro...

And where do Germany's surpluses come from?

Data:Statistiches Bundesamt

A full 41% of Germany's surplus comes from France, Italy, Spain and (gasp!) Greece, where Germany is still exporting like gangbusters despite the poor country being in its fifth year of recession.  In fact, Germany's trade surplus per person with Greece is 3.6 times bigger than that with the U.S. (290 euro per Greek versus 81 euro per American).
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.... and something totally unrelated, but still in the subject of "one picture worth a thousand..."

Photo Credit

Shanghai 1990

Shanghai 2010

Debt Distribution

We know that debt is not equally distributed across our society.  That is to say, lots and lots of people OWE debt but very few, proportionally, OWN it as an asset.  For example, everyone owes equally his/her portion of public debt through the issuance of Treasurys and other public-sector bonds (e.g. muni bonds), but a very small number of people ultimately hold most of those bonds in their portfolios, directly or indirectly.

Here are three charts which point to this imbalance, from the Fed's Survey of Consumer Finances.

In the first chart, we see that debt OWED is pretty well distributed among all income groups.

The picture changes dramatically in the next chart, which shows the distribution of financial assets, used here as a more general proxy for debt OWNED.

But even if look only at the distribution of bonds held directly by families, the picture does not change.

Poor, middle class and rich people all owe debt, pretty much alike.  However, it is by far the rich that are owed this debt - and the gulf between them has widened enormously in the last quarter century. In 1989, 90% of the people owned bonds worth around $100,000, while the top 10% owned $300,000.   In 2007 (latest data available) this picture has changed dramatically: 90% still own bonds worth around $150,000 but the top 10% holdings have soared to $900,000.

This enormous imbalance has serious social consequences, now plainly evident in Europe where people are being asked to slash their (formerly inflated) living standards in order to sustain a rickety debt structure.  It can't be done and it should not be done - at least not in this way.

Of Men And Their Donkeys

OK, Greek voters did what they could, never mind what they should.  In last Sunday's elections they favored one of the pro-eurozone, pro-bailout parties, admittedly with a slim (if comfortable at nearly 3%) margin over its left-wing competitor who called for tearing up the bailout agreement.

Greece is in an unprecedented fifth year of deep economic contraction with unemployment  over 22%.  If pushed too far by some of its dogmatic EU partners, Greece will simply fall apart and become a virulent failed state in the heart (yes, the heart) of Europe.  Certainly, reforms in the Real Greek Economy (tm :) are desperately and urgently needed, since the country had previously swallowed hook line and sinker the imported Pump - Borrow - Spend model for generating so-called "growth".

 It wasn't really its fault, if one of course overlooks cronyism, paternalism, corruption and cheating endemic in Greek politics since the early part of the 19th century (some would go as far back as Pericles).

There is no use, no profit, nay nay no gain at all in flogging a horribly overloaded donkey.  All we will get is a dead donkey and an upset cart, instead.

Stop Treating Greeks Like So Many Donkeys

What's to be done?  Here are some suggestions...

1) Stop beating the crap out of them.  Yes, that means mostly you Herr Schauble - God Above Mein Herr, STFU!!

2) Provide some immediate relief from the most onerous clauses of the Bailout Agreement by (generously) extending the time needed to reach a primary budget surplus AND reducing the size of the surplus envisioned.  Give them, say, five extra years and 1-2 percentage points less on the surplus needed.  In any case, I bet they will do better than that, if at the same time...

3) Promote sizable investments in the sectors where the Real Greek Economy has obvious comparative advantages: renewable energy (oodles of sunshine, wind, geothermal AND huge tracts of unused real estate up in the mountains of arid islands), shipping (e.g. at least three big shipyards sit empty), tourism (an old saw, but true nevertheless), second/retirement housing, organic/quality farming, software design (It's true, check it out. Highly educated and skilled professionals go for a song in Athens).

In sum, focus on REAL not just monetary/budgetary issues.  Go to it and lay of that damn whip, because what goes around comes around (and that also means you Mr. Fico, Prime Minister of Slovakia).

P.S.  An anonymous comment grabbed my interest. 

"...Investment? With your personal money, dear generous banker? Of course investment makes sense.
But no decent investment can start until REAL asset prices have come down in a significant way."

Here's a chart as an answer...

Greek share prices down 90% in five years

I think 90% is pretty significant, won't you say?  Here's another bit: at current prices, total market cap for the Athens Stock Exchange stands at a ludicrous 10% of GDP.

It's All About The Real Economy, (Stupid!)

The Eurozone Crisis... what is it about?

a) Debt

b) Deficits

c) Currency rates

d) None of the above

The correct answer is.. (d) none of the above.  Because it's all about the Real Economy (tm), that's why...

Competitiveness is arguably the most "real" indicator for the Real Economy, one that we can use to gauge a nation's economic health.  Here's a chart I constructed based on the latest data from the World Economic Forum's The Europe 2020 Competitiveness Report: Building a More Competitive Europe.

I have used the data to calculate and present competitiveness as percentages of the Eurozone average (blue bars), of Germany (red bar) and Finland's maximum score (yellow bar). Click on the chart to enlarge it for easier viewing..

 Competitiveness In The Eurozone

To make a long story short... how can Spain and Germany (see previous post) share the same currency - and just about nothing else - when Spain is only 85% as competitive as Germany?  It stands to reason that, given no other measures, Germany's economic prowess will  quickly "swamp" Spain's less competitive economy.  Not to mention Greece (at a horrible 75% of Germany's competitiveness), Italy (at 81%) and  Portugal (at 87%).  Even France (94%) is at risk, given enough time.

Germany's solution is to insist on quickly making the competitiveness "deficit" countries more competitive via a wrenching process of internal devaluation and outright deflation. 

Well, it's not working - at least thus far. After two years of pain, the cost of huge unemployment and loss of earned income is simply too high for societies to bear.  At best, the "operation" will eventually succeed, but the patients will be dead!

Europe's laggards unquestionably need the economic reforms contained in Germany's "medicine"; but Eurozone as a whole requires a common fiscal policy (e.g. outright transfer payments between nations) if it is to survive.

Never Underestimate...

From an article in today's NY Times...

“The market is massively short Europe,” said a hedge fund trader based in London not authorized to speak publicly. “There is just a feeling that it’s too late for steps like deposit guarantee schemes to help Greece or Spain.”

In the last couple of years I have learned - the hard way - to never overestimate the ability of European politicians and EU mandarins to agree on a rational way to deal with the Debt Crisis.  The stubborn dogmatism of Germans and the flip-flops of the EU Commissioners alone can fill a book (and they will, when the postmortem is eventually performed).

Yet, things are clearly coming to a showdown: Spain is now on the ropes, a country that simply cannot be allowed to fail catastrophically as it will drag down the entire world with it.  No, I am not exaggerating - Spain is the world's 12th largest economy at $1.5 trillion (by comparison, France is at number five with $2.8 trillion).  

Spain's benchmark 10 year government bonds are at 6.53%..

 ...when Germany's 10 year Bunds are at 1.17%..!!

It is beyond obvious that these two countries can't possibly share the same monetary policy, they can't possibly use the same currency - unless...  they can also cobble together a common fiscal policy, i.e. agree on common tax, pension, labor, etc. laws.

It's showtime, folks... if the Eurozone countries can't agree on fast and concrete steps to deal with the debt/monetary crisis the entire EU will fall apart.  Notice I say EU, not just Eurozone, and I firmly believe this.

There is a glimmer of hope that European leaders will finally grow up and lead - as opposed to just preach dogma ex-cathedra and/or wring their hands. Again... the European Union was founded to establish peace in a continent ravaged by continuous wars for centuries.  The euro - enfin - is all about peace, not specie.

If (big if) there is real movement towards rational solutions (again, not dogmatic ones), the market is going to react violently upwards - and that's the reason for the NY Times article excerpt... that "massively short Europe" bit is darn intriguing...

The 60% Solution

There's an intriguing idea making the rounds in the Eurozone: issue Eurobonds backed by all the nations participating in the currency union, but only up to the amount stipulated by the Maastricht Treaty cut-off, i.e. 60% of GDP.

In rough numbers, this amounts to a range of 3.8 - 4.8 trillion euro, depending on what is included in the definition of government debt (e.g. bonds, loans, guarantees, etc.).  Obviously, this will not be new debt;  it will merely replace existing debt with new securities backed by the group of nations, as opposed to each nation individually.  According to this proposal, a prerequisite will be that each country will implement constitutional reforms for its economy and fiscal policy.

I like this idea.  It is a major step towards fiscal integration (for the n-th time: there can be no currency union without fiscal union) and a credible solution to the EU's debt crisis - a crisis that seriously threatens to split the entire EU apart.  Assuming, of course, that it is implemented rationally and does not end up being just another way to ramp up debt.

Something is finally shifting in the EU: the freaky Greek politics and - more importantly - the election of Francois Hollande in France, plus the dismal showing of Frau Merkel in local German elections is maybe, just maybe, forcing hardcore European deflationists to yield a bit on their dogmatic stance.

In any case, I hope so...