Thursday, 27 October 2011

European banking crisis news

Tyler Durden references Peter Tchir in an analysis of the latest European deal re Greece. Essentially, the debt restructuring will be defined in a way that does not trigger claims under Credit Default Swaps (failure-to-pay insurance).

Karl Denninger points out that if CDS contracts don't pay as and when expected, that uncertainty will be built into the price in future.

Marc Faber says that the fudging will continue until sovereign nations bust themselves. The delay will simply make things worse in the end.

Charles Hugh Smith agrees, and compares the "rescue" to a lifebuoy made of plutonium - lethally heavy and poisonous.

Austerity is not the solution, says David Malone, recalling an Irish TV programme host who embarrassed Minister of State Brian Hayes by comparing Ireland's 14% unemployment rate with Iceland's 7% rate. But crisis is coming anyway: the blogger says he has seen a document from ECFIN (the European Directorate for Economic Affairs), which forecasts that the Irish Treasury will run out of cash in March 2012 and so desperately needs the next instalment of the IMF/EU bailout.

In a separate post, Malone says a top Irish banker has told him that this Europe-wide general banking bailout is the last, and next time round selected banks will be saved and others allowed to go bust. I suppose the financial industry will place its bets accordingly, so watch for high volatility in bank shares in due course.

A propos, Reggie Middleton declares Bank of America (BAC) doomed. He also discusses moves by BAC derivatives traders to transfer contracts to a subsidiary that has a lot of depositors' cash, so if/when there is a major loss it will become a liability for the Federal Deposit Insurance Corporation. The FDIC won't have enough to cover and so Congress will be forced to commit more taxpayers' money, so the public will be on the hook again.

Matt Taibbi brilliantly and passionately maintains that it is this kind of outrageous cheating and cronyism, not inequality per se, that has caused people to occupy Wall Street and other places around the world.

Back to austerity, and profligacy as its supposed cause. Marshall Auerback and Rob Parenteau say it's not Greece's overspending that have caused their problem, but the failure to collect taxes, especially from the top 20%, the legacy of a deal between the rich and the military junta that ran the country not so very long ago. That sort of cosy arrangement between society's winners might ring a bell with Americans.

However, if we go down the deflationary route, it may not be quite so bad as feared, according to Ralph Musgrave, who says that a major component of consumer costs in a country is the cost of labour in that same country. So if wages are cut, prices will come down. And, he continues, international wage differentials aren't everything: is it not, perhaps, better to work shorter hours in Greece, than long hours in Germany?

That's not quite how I think things will go. As governments around the world are locked into asymmetric trading arrangements, the exporters have a strong incentive to keep their currencies pegged to those of the debtor countries, and meanwhile the debtors keep multiplying their stock of money in order to finance their health and welfare systems. Apparently there is not much relative currency movement, then.

But that is like skydivers linking hands as they fall. What cannot be increased at the same rate as the monetary base, is commodities,which is why Alasdair Macleod says "Commodity prices are reflecting the increased quantities of paper money and credit." He argues, as so many do now, for sound money. However, it's how you get there that matters. At the speed we're going, it will not be a blessing that the ground breaks our fall.

In the long run, as Faber and others have said so many times, fiat currencies tend to zero value. The path has many twists and I fear there may be a sharp banking dislocation before then, so as well as considering what physical things to put what cash we have into (and worrying about the degree to which their price is too high because of others' speculation), I also have to consider the merits of continuing to hold cash - and perhaps, a sensible supply of it outside the banking system.

The 1933 Congressional Finance Committee hearings, chaired by Senator Reed Smoot, heard testimony from Marriner S. Eccles, soon to become Chairman of the Federal Reserve. Eccles showed that the stock of money had declined, not merely because people had begun to hoard it but also (and even more so) because of a decline in the velocity of its circulation in the economy.

We are experiencing another such decline in velocity,which deficit the authorities are trying to supply by injections of extra liquidity. This is not working, partly because (Australian economist Steve Keen maintains, with the help of his computer model) giving it to the banks is far (by two-thirds) less effective than giving it directly to debtors.

Another reason for the failure is the very different circumstances in which we now find ourselves. In the 1930s, rafts of US banks had been allowed to go bust, yet there was plenty that needed doing and plenty of people and resources to do it. And there wasn't a huge overseas workforce that was set up to undercut any bid by local labour.

As far back as 1993, Sir James Goldsmith perceived that GATT put the West into the jaws of a trap, as he explained in a book with that title. He argued the case in a TV interview against a complacent Laura d'Andrea Tyson; much good it did him, or us, though she's still going strong, it seems. Goldsmith advocated a sort of regionalised protectionism, to allow the West to survive while the developing world caught up by trading with its peers.

Instead, the world market has been opened up rapidly, and (maybe this is why it was allowed to happen) made some almost inconceivably wealthy while withering so many others. By the way, this process is not necessarily good for the developing economies, either. And it may be the worse for the latter when the system unravels.

We're hearing much at present about Occupy Wall Street - and St Paul's in London, and more. As I've suggested in the previous post, it may be that people are beginning to understand (however fuzzily) that the emerging economies have been used as an instrument in the process of transferring wealth, not so much from West to East, as from below to above within the developed world. It's not the embassies they're picketing.

Economics is becoming politics. If there is not an honest debate soon, we are contemplating a class war begun from above, a struggle that mad, hate-filled Communists used to welcome because of the magically wonderful millenial age that would follow it - a theory to which I in no way subscribe.

If the world is to remain open, then wage rates will have to tend towards some global mean, and that will only be possible if vast quantities of debt are purged from the system. You cannot have sharply reduced wages while attempting to sustain high liabilities fixed in nominal terms. Unless inflation does the job for us; creditors will resist that vigorously, so it has to be debt forgiveness (or default, it doesn't matter). In a world where personal indebtedness hugely outweighs government debt, official austerity measures will, in my view, be either ineffective or (because of effects on consumer demand, welfare costs and tax revenues) actually counterproductive.

Since this consumer slump appears to coming our way faster than the emerging economies can develop regional demand to replace it, I think the East is in for at least as hard a landing as the West.

However, they have come so far in such a short time that they may be able to cope psychologically with the material setback. And with all the tools, factories and industrial knowhow we sold them, the sources of essential raw materials they have secured in e.g. Africa, and the skills base they have developed, I think the East will be the first to pick themselves up and that is when the balance of world economic power will be seen to have shifted suddenly and decisively.

Goodness knows what our 1% will do then, or the 99%.

INVESTMENT DISCLOSURE: None. Still in cash (and index-linked National Savings Certificates), and missing all those day-trading opportunities.

DISCLAIMER: Nothing here should be taken as personal advice, financial or otherwise. No liability is accepted for third-party content.

The West is eating itself

The Economic Collapse blog comments today on widening inequality in the USA (

I think it's time to review who's really benefiting from globalisation. As I have said on that site:

Of course there's going to be widening inequality if the working class is undercut by foreign labour. This would happen even if the 1% didn't get richer.

But the dirty secret, I suspect, is not the economic destruction of the US (and UK, and just watch Europe) by outsiders, but the way that most of the international wealth transfer from globalisation has ended up where the money started.

James Kynge's book "China Shakes The World" says that only 15% of the end price goes to the Chinese manufacturers, the rest is captured by the middlemen - the importers, dealerships and supermarket owners.

America is cannibalising itself and throwing the bones abroad.

INVESTMENT DISCLOSURE: None. Still in cash (and index-linked National Savings Certificates), and missing all those day-trading opportunities.

DISCLAIMER: Nothing here should be taken as personal advice, financial or otherwise. No liability is accepted for third-party content.

Saturday, 8 October 2011

Money velocity, not quantity, caused the boom'n'bust

Reading "Extreme Money", the acclaimed new book by Satyajit Das, has highlighted for me the importance of money velocity.

As Das so clearly demonstrates (pp. 78-80), the banks altered their mortgage lending model in recent years. Instead of lending money and then holding that mortgage to maturity, they would sell it on for a sum that included the discounted value of future interest payments. This returned bank capital and depositors' money more quickly, which made it available for a new loan. Turning the money over faster massively increased the ratio of net profit to bank capital, so that the yield on banking activities outstripped other, one might say more productive, forms of enterprise. It became almost the only game in town, so that the economy has been skewed towards sterile financial hocus-pocus, instead of providing and exchanging useful goods and services.

The system created a boom, which could only be sustained as long as borrowers could absorb the increased quantity of loaned money. Asset prices boomed as fools sold on to bigger fools, and poorer-quality borrowers were suckered into joining. But we seem to have reached the limit of this pyramid scheme, and having run out of expansion room, the velocity of money is dropping and attention then turns to quantity instead.

The question now being asked - again, since we are in the throes of QE3 - is whether pumping extra cash into banks will balance the equation. If Wikipedia (see "money velocity" link above) quotes him accurately, I think the answer was given more than sixty years ago, by Paul Anthony Samuelson:

In terms of the quantity theory of money, we may say that the velocity of circulation of money does not remain constant. “You can lead a horse to water, but you can’t make him drink.” You can force money on the system in exchange for government bonds, its close money substitute; but you can’t make the money circulate against new goods and new jobs.

Banks have been given contradictory instructions: lend more, and build up your reserves. No wonder they take government support cash and buy safe, interest-earning government bonds with it. Effectively, the government is funding the gradual repair of bank balance sheets; it would be quicker and more honest if Uncle Sam and John Bull simply gave them enough cash to do the job.

But even that might not get the banks lending again. Would you, in their position?

Let's assume for a moment, sophisticated investor, that you have decided to stop day-trading because there's an increasing probability in this shark market that the bigger fool may turn out to be you. What longer-term investment might act as a safe haven for your gains?

  • Western manufacturing industry, with its high costs of labor and regulation?
  • Eastern manufacturing industry, so dependent on the once-profligate but now financially distressed Western consumer?
  • Industrial commodities, which have soared in the busy economic boom but also because of leveraged speculation?
  • Western real estate? Yes, the price-to-income ratio is dropping - but we haven't yet seen the drop in incomes that will continue the downward trend in nominal terms - especially as the borrower finds more of his limited income going on food and energy bills.
  • Emerging markets real estate? One for the specialists, such as Marc Faber.
  • Bank shares and sovereign debt? Junk bonds? Isn't that what got us into this mess?
  • Agriculture? Maybe.
  • Gold? Maybe - but what a rise it's seen in the last few years.
  • Cash? Inflation isn't hitting everything - big-ticket items have gotten cheaper in real terms for decades. Here in the UK my first new compact car cost me £6,000 in 1989 and I could get another for that price now, with higher specifications. If you can pay your living expenses from income, maybe cash isn't such a crazy option.

For the way our governments (US/UK) are seeking to shore up the system doesn't look destined to work. The increased quantity of money, now used so cautiously and unproductively by the banks, is not going to offset the drop in velocity.

Later, if that money stays around and is not withdrawn quickly enough, then when we revive economic activity there will be a rush of general price inflation; but not, I think, for some years yet. Such inflation as we're seeing now has different causes and effects from the type we saw before, and has more to do with physical supply and demand rather than monetary expansion.

So some experts are predicting "troubles ahead", "unprecedented velocity collapse", a "double dip recession", or even a breakdown that will make us envy simpler, more sustainable societies.

I don't go with that last, but then again, I don't expect my house to burst into flame and yet I still have smoke detectors and fire insurance; so I do think it's good to build up easily-accessible emergency reserves against the possibility of temporary disruption.

There is no royal road to predicting economic developments. All the charts in the world are no use when the powers that be decide something different really has to be done. The system is not a machine but a poker game, and a crooked one at that. So I expect the course of events to be determined by a negotiation between the interests of the powerful, which in our democracies also (to some small extent) includes us, the ordinary people.

For now, I'm still holding cash and government inflation-linked bonds, but if the consequences of deflation are too painful for the populace, then the rules may well alter. Maybe, in time, we will indeed get hyperinflation, even though these days the currency is managed in a very different way from that of Germany in 1923. Dr Faber noted recently that gold and bonds rose together, a counterintuitive phenomenon he analysed as arising from fear of systemic collapse. This fear may also explain why India and China (among others) are boosting their holdings of physical gold, which is supporting the price even as other commodities deflate.

But that time of game-changing crisis is not, I think, with us yet.

INVESTMENT DISCLOSURE: None. Still in cash (and index-linked National Savings Certificates), and missing all those day-trading opportunities.

DISCLAIMER: Nothing here should be taken as personal advice, financial or otherwise. No liability is accepted for third-party content, whether incorporated in or linked to this blog.