Saturday 23 April 2011

"Arx tarpeia Capitoli proxima" or the recent US Downgrade threat and the Fed dual mandate issue

"Arx tarpeia Capitoli proxima"

The price of continued US lax fiscal policies has seriously risen with S&P putting the US economy under negative watch.
The Fed has now kept the benchmark at zero to 0.25 percent since December 2008 while proceeding to two rounds of Quantitative Easing.
Whereas in Europe, the ECB has started tightening. It is the first time ever the ECB has acted before the FED preemptively in relation to inflation concerns.

This is an important point, as it clearly shows the divide in policies between the US and Europe.

While Trichet and the ECB seems to be sitting in a more classical camp, Bernanke and the Fed, seems to believe in a Keynesian approach in resolving the difficulties faced by the US economy.

It is important to remind at that point the clear differences in mandates between the ECB and the FED. While the ECB's core mandate is of price stability, the FED has a dual mandate, price stability and maximum employment. Hence the current difficulties faced by the Fed. Targeting both unemployment levels and inflation levels is a near impossible task for the Fed currently. It has to promote both “maximum employment” and “stable prices. The Fed’s mandate was extended to "maximum employment" in 1978 as a way of forcing the central bank to "print money". This extension of the mandate made sure the Fed would always be under continuous pressure from the politicians. But, Paul Volcker initially in the early 80s did not play it that way. He clearly understood the risk in not taming the inflation beast. He knew he could not fight on two fronts and initially targeted inflation versus maximum employment. His policy of taming inflation with a rapid surge in interest rates led to a very severe recession but put back the US economy on track. The recession was short but indeed very painful which led Mr Volcker to be hated by both Republican politicians as well as Democrat politician.

One of the main reason of QE2, can be sourced to this ill-fated dual mandate.
The Fed tried to increase jobs by lowering interest rates, weakening the dollar in the process, boosting exports but exporting inflation on a global scale, as well as lifting stock prices, playing on the wealth effect game. I criticised the wealth effect policy in February 2011 (Ben Bernanke - The illusionist and the year of the rabbit - The illusion of wealth).

It is important at this stage to link this post to a previous one I have written: "The Hurt Locker". In this previous post I published in September last year, I discussed the fundamental flaws in Washington’s stimulus policies, linked to the flawed dual mandate imposed on the Fed.
Also, I quoted Jacques Rueff and his analysis of the failings of Keynesian stimulus policies:

"Keynes came up with a subterfuge. The central bank should cause price inflation during a slump, he proposed. Rising prices for 'things' meant that salaries - in real terms - would go down. That was the greasy scam behind Keynes' General Theory of Employment, Interest and Money: inflation robbed the working class of their wages without them realizing it. The poor schmucks even thank the politicians for picking their pockets: "salary cuts without tears," Rueff called them."

What we are seeing right now is a Fed creating price inflation during the current slump ensuring the "poor schmucks" real terms wages are going down.

This is what happened during the big Stagflation period of the 70s:
"Between 1974 and 1984, real wages fell as much as 30%."

In Homage to Jacques Rueff, Bill Bonner added the following:

"But Rueff’s insight comes with a warning. The faith-based, dollar-dependent monetary system is like a loaded pistol in front of a depressed man. It is too easy for the US to end its financial troubles, Rueff pointed out, just by printing more dollars. Eventually, this “exorbitant privilege” will be “suicidal” for Western economies, he predicted."

Bill Bonner concluded:
"Paul Volcker put the pistol in the drawer. Ben Bernanke has found it. And Jacques Rueff must look on in amusement to see what happens next."

"Anterograde amnesia refers to the inability to remember recent events in the aftermath of a trauma, but recollection of events in the distant past in unaltered." This seems to be the position of the classical ECB while the Fed seems to be suffering from Retrograde Amnesia. "Retrograde amnesia is the inability to remember events preceding a trauma, but recall of events afterwards is possible."

It is very important to understand the game played by politicians in relation to creation of the additional mandate of the Fed, namely maximum employment and its fallacy.
Joseph Schumpeter, one the greatest economist we ever had, clearly understood's the role politicians played; He presented in the quote below as "The Intellectual in reality our politicians. I initially referred to Schumpeter in December 2009 in the following post: "Blue pill or Red Pill?"

"Capitalism’s Greatest Enemy: The Intellectual
"The proper role of a healthily functioning economy is to destroy jobs and put labor to better use elsewhere. Despite this simple truth, layoffs and firings will still always sting, as if the invisible hand of free enterprise has slapped workers in the face. Unsettling by nature, capitalism’s churn gives rise to a labor movement designed to protect workers from job loss. That movement is fed emotionally by displaced workers and others who blame the capitalist system for their troubles, but it is led psychologically by a whole other type of person—the intellectual. Intellectuals—with little to do owing to the success of the capitalist economic system but with an intense desire to be seen as caretakers of society’s general well-being—anoint themselves as leaders of the labor movement. They object to capitalism on moralistic grounds and seek its destruction and replacement by another system—socialism—which places them center stage."
"You could replace "intellectuals" in the quote in today's economy by politicians and you would not be far from what is currently happening in many countries today" I argued back in 2009.

Creative Destruction as defined by Schumpeter, is at the core of Capitalism. Politicians for the sake of getting elected or re-elected cannot accept this core feature of capitalism. One could argue that Schumpeter's view of the evolution of Capitalism towards Socialism, is in fact quite accurate in the description of the process.
But I digress, let's go back to the Fed's dual mandate issue and the current situation.

The Fed is trapped in its dual mandate enforced by US politicians. QE2 will make it extremely much tougher for the Fed to eventually reduce its gigantic balance sheet, therefore risking higher inflation.
While the ECB's mandate make it more easier to react to inflationary pressures, regardless of unemployment levels:

"In a clean discussion of what the appropriate role for a central bank is, I can see some merit in looking at a narrower objective," Chicago Federal Reserve Bank President Charles Evans.

"It's interesting," he said in November. "The ECB (European Central Bank) has a price stability mandate ... The only thing a central bank can do in the long run is control the long run rate of inflation, so from that point of view it makes sense to have single mandate"
according to St. Louis Fed President James Bullard.

"With no explicit plan for when or how this quantitative easing will be withdrawn, the Federal Reserve could do more for the American economy by focusing singularly on maintaining the value of the dollar and protecting the purchasing power of Americans,"
Mike Pence, No. 3 Republican in the House.

It looks like Mike Pence care about the "poor schmucks" Jacques Rueff mentioned, who are seeing their real terms wages are going down with the US dollar...

Former U.S. Treasury Department undersecretary John Taylor indicated as well is wish for an end to the dual mandate of the Fed in January 2011:

It would be better for economic growth and job creation if the Fed focused on the goal of “long run price stability within a clear framework of economic stability,’”
Taylor told the House Financial Services Committee.

An excellent post from November 2007 on the blog published by Macro Man can be find below, relating to the subject of the dual mandate:

"Simply put, the Federal Reserve, as a matter of policy, is less interested in protecting the international purchasing power of its currency than other central banks are. Such a policy focus is really quite remarkable for the central bank of THE hegemonic reserve currency, and no doubt explains why the FX reserve managers are, broadly speaking, trying to reduce (or at the very least not increase) their dollar holdings as a percentage of their reserve baskets.

It is also a damned good reason why the dollar pegs of current account surplus countries, particularly those with high inflation, are wildly inappropriate. The Fed's implicit promise to sacrifice the international purchasing power of the dollar (and by extension under current policies, the renminbi, riyal, dirham, etc.) to support domestic employment as a matter of course is wrong, wrong, wrong for China, Saudi Arabia, the UAE, etc."
Recently Dr Hussman, wrote an excellent article related to the trap the Fed has put itself in with QE2:
"A week ago, Charles Plosser, the head of Philadelpha Federal Reserve Bank, argued that the Fed should increase short-term interest rates to 2.5% "starting in the not-too-distant-future," preferably during the coming year. Given the robust historical relationship between short-term yields and the amount base money per dollar of nominal GDP, we can make a fairly tight estimate of how much the Fed would have to contract the monetary base in order to achieve a 2.5% yield without provoking inflationary pressures. While the monetary base will be over $2.5 trillion by the end of this month, a 2.5% interest rate would require a contraction of about $1.3 trillion in the Fed's balance sheet, to a smaller monetary base of just under $1.2 trillion.
In his comments, Plosser discussed a plan to sell about $125 billion in Fed holdings for every 0.25% increase in the Fed Funds rate. That overall estimate is just about right (ten increments of 0.25 each, with an overall contraction approaching $1.3 trillion in the Fed's balance sheet). So Plosser's estimates correctly imply that a 2.5% non-inflationary interest rate target would require the Fed's balance sheet to contract by more than 50%.
The problem, however, is that the required shift in the monetary base is not linear. It's heavily front-loaded. Based on the historical liquidity preference relationship (which explains about 96% of the variation in historical data), and assuming nominal GDP of $15 trillion, the following are levels of the monetary base consistent with a non-inflationary increase in short-term interest rates up to 2.5%. The non-inflationary provision is important. You can't just allow interest rates to rise without contracting the monetary base. Otherwise, as noted earlier, non-interest bearing money would quickly become a hot potato and inflation would predictably follow.
The upshot is that Plosser's estimate of about $125 billion in asset sales for every 0.25% increase in yields is an accurate overall average, but the profile of required asset sales is enormously front-loaded. The first hike will be, by far, the most difficult. In order to achieve a non-inflationary increase in yields even to 0.25%, the Fed will have to reverse the entire amount of asset purchases it has engaged in under QE2. Indeed, the last time we observed Treasury bill yields at 0.25%, the monetary base was well under $2 trillion.
In my view, this is a major problem for the Fed, but is the inevitable result of pushing monetary policy to what I've called its "unstable limits." High levels of monetary base, per dollar of nominal GDP, require extremely low interest rates in order to avoid inflation. Conversely, raising interest rates anywhere above zero requires a massive contraction in the monetary base in order to avoid inflation. Ben Bernanke has left the Fed with no graceful way to exit the situation."
Dr Hussman also added in this must read article:

"The first 25 basis points will require an enormous contraction of the Fed's balance sheet. Risky assets have already been pushed to price levels that now provide very weak prospective returns."
In relation to today's market environment, the outcome is likely to be a very significant risk of unstability and sharp volatility increase. Given the potential for the economy to come to a stalling point in the upcoming quarters due to external inflation pressures (oil prices high prices) already creating serious headwinds on corporate profit margins as well as consumption, it is extremely important to be well aware of the consequences of unbalances which has been generated by a reckless Fed in launching QE2.

Another surge in Gold was clearly expected, I agreed with Martin Sibileau's view when he posted in his blog A View from the Trenches, on April 4th, 2011: "Gold, the Fed, Ron Paul and Napoléon Bonaparte"

"The Fed is not stimulating anything. The Fed is only massively monetizing the US fiscal deficit. Therefore, a lower unemployment rate is actually worse, because a lower unemployment rate implies higher wages, sooner rather than later. And if wages rise, people will have more purchasing power to afford the increasingly higher commodity prices. The higher wages will validate the higher prices of food and oil. In the process, the supply of money, ceteris paribus, will decrease. If the US fiscal deficit continues unabated (our key assumption here), the Fed will be forced to engage again in quantitative easing. For this reason, we think that the unemployment rate announced on Friday was actually bullish of gold."
The release of information related to the access to the discount window of the Fed, thanks to Bloomberg's tenacity in their lawsuit also underlines a very important point between the current relationship between the Fed and the ECB. Martin Sibileau in his post,goes further in the analysis of the access to the Discount Window of the Fed: loans to overseas banks including cross-currency swaps, and their implication in magnifying global leverage worldwide.

"These loans and cross currency swaps are the “leverage of the leverage”, so to speak. With them, other central banks give up their sovereignty and the Fed effectively becomes the world’s lender of last resort. For instance, when the Fed loans US dollars to a German bank, as it did, the European Central Bank can no longer act as lender of last resort, should the German bank default on its obligations with the Fed. But, would this in reality occur? Of course not! If the German bank was not able to repay its US dollar denominated loans, the Fed would simply roll over the liquidity line. This is a very troubling scenario because the Fed in fact expands the supply of US dollars worldwide (global leverage), without any counterbalancing reduction of credit in the US currency zone.

In our view, these “global” discount window operations are the necessary (but not sufficient) step towards the collapse of fiat money. If we are ever going to see the end of fiat money, it will be thanks to global loans from the Fed. Without them, other central banks will always retain their sovereignty and become alternatives to the US dollar. But with them, once the loans are out and a wave of defaults is triggered, the Fed becomes the easy prey for the collective gold longs."
Like Martin Sibileau, I sit in the same camp, outcome will be stagflation.  We both believe in strong stagflationary forces being at play in the current environment.

What will happen when Asian countries as well as Oil rich countries, gorged with USD reserves and facing the rising threat of inflation, will decide it is not wise anymore to invest these reserves in US Treasuries, but to invest in gold, tangible assets and more yielding assets?
As I wrote previously you cannot expect China to bow to American pressure and start revaluating the Yuan versus the dollar. China has learnt the lessons from Japan: Revaluation of Japanese Yen, a historical lesson to draw: analysis - This is an article on the seventh page of People's Daily, September 23, by Pro. Jiang Ruiping, Chairman of the Department of International Economics, Foreign Affairs College, Beijing.

Chinese government officials have stepped up the rhetoric game with the USD stating they might have to diversify their USD 3 trillion of currency reserves away from U.S. dollars. Who would blame them, given the sinking value of the USD, therefore the sinking value of their chips in the game of marbles?

The dollar is 5% away from its all-time low, touched in March 2008, as tracked by the dollar index, which dates back to 1971.

The recent action led by S&P relating to its concern on the US economy, is a stark message sent to the US politicians, they need to put the US house in order and begin to show some long term fiscal discipline.

On the subject:

"Only under the rules of what Jacques Rueff scathingly termed the 'childish game of marbles' by which the winners (the Chinese) return their spoils (the excess dollars) back to the American losers at the end of each round - by buying US Treasury and Agency bonds, in the main - and as a result of what the great Frenchman also dubbed the 'monetary sin of the West' - the fact that the dollar hegemony allows the US to go on mindlessly inflating and blaming others for its own lack of financial virtue - can the Chinese be held culpable for what is at work here."
Sean Corrigan also adds in his article:

"Emphatically, the only 'risks associated with deflation' are those which come from clinging too long in the naive faith that the value of one's money will be preserved by a central bank which can still talk about such an eventuality while the malign effects of its inflationary policies are everywhere increasingly undeniable."

"In a West already displaying symptoms of the extirpation of the middle class, in favour of the governing military-political elite and at the cost of buying off its feckless urban proletariat with a higher dole and more spectacular circuses, the more the state expands in this way, the more success it will enjoy in the only one of its wars on abstract nouns which it wages unremittingly and a outrance - its War on Capital."
The Dollar Standard which succeeded Bretton Woods in 1971, following its collapse, has allowed the deficit countries like US, to consume more than they produce. Whereas surplus countries, such as China, Singapore and others, have been able under the new system to produce more than they consume, therefore accumulating vast USD reserves accordingly.
Between January 2004 and the beginning of 2008, worldwide international reserve assets more than doubled. Asian countries have boosted their reserves by acquiring export dollars. These dollars then moved back to the US, where they funded most of the excesses: subprime mortgages, leveraged buy-out, structured credit markets and so on.

QE2's wealth effect, it can be argued, cannot be branded as a success. The surge of US stock prices has been a mere reflection of the decline of the US dollar, hence the rise in Gold in the process.

The excellent David Goldman clearly illustrates the point:

"The last two weekly unemployment claims prints above 400,000 show how weak the labor market is. I’ve been saying for two years (pardon the broken record) that an entrepreneurial economy can’t do that well as long as there are no entrepreneurs in the picture. If that’s the case, why are stocks doing so well?

Part of the answer is that stock prices reflect the declining dollar: overseas profits increase when translated back into dollars, and American cash flows look cheaper to foreign investors."
Trade Weighted Dollar vs. S&P 500, April 20, 2008 to April 20, 2011

In relation to the current situation, the recent warning shot fired towards the USA by S&P, is an important inflection point as we moved towards what I have previously called relating to Chess, "The Endgame - Fin de partie":
An endgame is when there are only a few pieces left. We are close to the point.

"Artistic endgames (studies) – contrived positions which contain a theoretical endgame hidden by problematic complications".
This is the situation the Fed is currently in.

"You have a choice between the natural stability of gold and the honesty and intelligence of the members of government. And with all due respect for those gentlemen, I advise you, as long as the capitalist system lasts, vote for gold."
George Bernard Shaw

Sunday 17 April 2011

The Good, the Bad and the Ugly - Update on some Macro situations

First of all, apologies for not having posted more frequently. I have been quite busy recently on other matters.

In the current market environment, differences between countries are more marked than ever.

While in the Euro area clear divergences are showing, between the German power house and the weak peripheral countries, Greek, Ireland and Portugal sinking further, some countries are clearly doing better than some others.

Not everything is all Doom and Gloom.

It is become more paramount to carefully study in details the full macro pictures in this difficult investment environment, plagued by low yields, rising inflation and high unemployment. Are we moving towards stagflation? Not yet, but signals are getting stronger.

In this post we will review the Good, the Bad and the Ugly, highlighting the differences and reviewing the current market context and significances.

The Good:

We will start by Sweden:

"The Gross Domestic Product (GDP) in Sweden expanded 7.3 percent in the fourth quarter of 2010 over the same quarter, previous year. Unlike the commonly used quarterly GDP growth rate the annual GDP growth rate takes into account a full year of economic activity, thus avoiding the need to make any type of seasonal adjustment. From 1994 until 2010, Sweden's average annual GDP Growth was 2.68 percent reaching an historical high of 6.90 percent in September of 2010 and a record low of -6.70 percent in March of 2009."
Source - Trading Economics.

Furthermore, Sweden predicts a budget surplus and plans to tax cuts are economy beats Europe according to Bloomberg article from Johan Carlstrom.

"The largest Nordic economy will expand 4.6 percent this year, compared with the 4.8 percent predicted last month, the government said in its spring fiscal policy bill released today in Stockholm. The government raised its forecast for growth in 2012 and 2013 and predicted a widening surplus over the next four years as unemployment falls."

"The Swedish economy grew 5.5 percent in 2010, the most since 1970, as exports recovered from the global financial crisis."

Sweden is doing the right thing:
"Reinfeldt’s four-party government alliance had already revealed it will invest more money in the country’s railway infrastructure and that it wants to ease benefit rules for long- term sick leave. It’s also considering next year cutting income taxes for foreign nationals with “expert knowledge,” dividend taxes for some small businesses and allowing bigger write-offs for investments in research and development."

Applying recipes for expansion:
"The government has cut income taxes by 70 billion kronor ($11.1 billion), or about 2.1 percent of the economy, since coming to power in 2006. It has also reduced corporate and payroll taxes and abolished a levy on wealth."

The results, a booming economy and a fall in unemployment:

A History of Balanced budgets:

Leading to a rising GDP per Capita:

Finance Minister Anders Borg wants Sweden to introduce tougher rules on capital buffers than other countries.
The government is closely monitoring housing to avoid a bubble and already has introduced measures to contain rising household debt such as introducing a loan-to value cap of 85% for mortgage borrowing.

Sweden definitely sits in "The Good" camp, macro wise.


I posted before on Canada as a leading example:

Canada, a great example of successful structural reforms and efficient banking regulation

Here is an update on the macro picture for Canada.

GDP Growth for Canada, January 2007 until January 2011:

Canada's budget was either balanced or in surplus, ensuring a reduction of Canada's debt to GDP and enabling them to face the financial turmoil in a much better shape than many other countries.

According to the IMF, Canada’s economy will grow by 2.8 per cent this year, up from an earlier forecast of 2.3 per cent.
The Canadian economy grew 3.1 per cent in 2010.

For the OECD, the forecast is that Canada’s GDP will grow by 5.2 per cent in the first quarter, and 3.8 per cent in the second. In comparison, the OECD has the U.S. economy growing at 3.1 per cent in the first quarter and 3.4 in the second.

"Canada’s economy will grow faster than any other country in the G7 in the first two quarters of 2011."

That’s full-steam ahead. 5.2 per cent would rank as the second-best quarter of the past 10 years,” said BMO deputy chief economist Doug Porter of the OECD’s Canadian outlook.

Unemployment is falling thanks to solid growth prospects:

Canada is clearly part of "The Good" section of our current macro review.

Another strong member of the group, Germany, the clear power house of Europe.

GDP growth is way above its European peers:

Consequences, unemployment is falling faster than in other EU countries:

What is very interesting is that, 10 years ago, France and Germany were at the same economic levels, both were the leading European power economic houses. Now France is clearly lagging behind. In a future post I endeavour to go into more details about this evolution which we witnessed in the last 10 years and the consequences for France in the not so distant future. Unless some major structural reforms are implemented, like they were in Germany, France will not move in the right direction.

The German discipline:

"The Good, the Bad and the Ugly" in the Eurozone per GDP Growth in 2010:

"The Good, the Bad and the Ugly" in the Eurozone per Government Budget Country Ranking in 2010:

"The Good, the Bad and the Ugly" in Scandinavia per Government Budget Country Ranking in 2010:

"The Good, the Bad and the Ugly" in Latin America per Government Budget Country Ranking in 2010:

"The Good, the Bad and the Ugly" in Major Economies per Government Budget Country Ranking in 2010:

Governmnent Yields 10 Year Notes - Source Trading Economics:

The Bad:

United Kingdom struggling to surge from the ashes of the financial crisis:

Inflation lower this month to 4% thanks to price war between major UK retailers:

I posted extensively on the effect QE in the UK would have on inflation on this blog. Previously, I commented that the Bank of England is facing a difficult situation, with the rise of inflation and its mandate of keeping it around 2%. At some point the Bank of England will have to raise rates, but, given the fact two thirds of UK mortgages are depending on short term rates and UK households are already massively leveraged (debt to income at a record level in the G7 countries club), the risk of a double-dip is massive and Mervyn King is fully aware of the difficulties that lie ahead. Mervyn King is trying to delay as much as possible the inevitable rise in interest rates and the March inflation figure at 4% clearly gave him some small room to breath.

UK budget deeply stretched:

UK unemployment levels not falling fast enough at the moment:

UK unemployment rate for the three months to February 2011 was 7.8 per cent of the economically active population, down 0.1 on the quarter. The total number of unemployed people fell by 17,000 over the quarter to reach 2.48 millions.

France is yet again, delivering below par performance which is clearly not helping its already strained budget.

A slow GDP growth below potential for France:

A sticky unemployment level due lack of structural reforms and flexibility in the labor market:

A decaying trade balance, January 2000 - April 2011:

As a comparison, France's closest and biggest trading partner, Germany has seen its trade balance soar, leading to a faster and more solid GDP growth.

Could France lose its coveted AAA rating? One thing for sure, the decoupling of the French and German economy has increased dramatically in the last ten years. I will post more on the subject in a future post.

Another member of "The Bad" group in the Eurozone is Italy.

"The Gross Domestic Product (GDP) in Italy expanded 1.5 percent in the fourth quarter of 2010 over the same quarter, previous year. Unlike the commonly used quarterly GDP growth rate the annual GDP growth rate takes into account a full year of economic activity, thus avoiding the need to make any type of seasonal adjustment. From 1982 until 2010, Italy's average annual GDP Growth was 1.45 percent reaching an historical high of 4.70 percent in December of 1988 and a record low of -6.50 percent in March of 2009. This page includes: Italy GDP Annual Growth Rate chart, historical data and news."

Italy GDP growth from January 2000 to April 2011:

While benefiting from a GDP boost following the introduction of the Euro after 1999, since then, Italy's GDP growth has been overall muted.

As The Economist posted in early April, Italy can be seen as the Achilles heel of Europe.

"ITALY’S public debt is the sleeping dog of the euro zone’s crisis. So far the markets have mostly let it lie. Although in 2010 it rose by three points, to 119% of GDP, Silvio Berlusconi’s finance minister, Giulio Tremonti, held the budget deficit to an impressive 4.6%, well below his target of 5%."

The article goes on:

"In fact the euro crisis has again laid bare the structural weaknesses in Italy’s economy. When euro-zone GDP falls, Italy’s falls by more; when it rises, Italy’s rises by less (see chart). The country has too few big firms. It is not generating jobs for the young: more than a fifth of the country’s 15- to 29-year-olds neither work nor study. Too few women have jobs (in the euro zone only Malta has a lower female-participation rate). The south remains a huge drag: in broad terms, GDP in the north may grow by as much as 3% a year, but in the south it shrinks by 2%, pulling the average down. Youth unemployment in parts of the south is 40%. And, as the Bank of Italy’s governor, Mario Draghi, has noted, Italian entrepreneurs have to cope with an unusually high level of organised crime. Police operations show that the ’Ndrangheta from Calabria has burrowed deep into the economic fabric of the north."

For the excellent The Economist interactive guide on the Eurozone spreading infection please use the below link:

Europe's economies - Spreading infection

Unemployment for Italy is still too high: January 2000 - April 2011.

But Italy's public finances were held tight thanks to its finance minister.
Italy Budget Deficit from January 2000 until April 2011:
Much tighter than France for instance.

The issue for Italy is that to meet the European rules on public debt, Italy will need annual economic growth of about 2 percent and a balanced budget. I do not see it happening in the near future.

ECB’s Draghi Says Italy Needs GDP Growth Near 2% for Debt Rule - Bloomberg

"The European Union last month reached an agreement on tougher economic oversight rules for member countries, including fines for governments that don’t cut overall debt fast enough. The accord came after Italy, with debt of 118.9 percent of gross domestic product last year, pushed for a broader definition of government borrowing that may offer a better chance of avoiding future sanctions for violators of the debt rules.

While countries with debt over 60 percent of GDP will be required to make annual cuts equal to 1/20th of the excess, progress will be judged against a range of “relevant factors,” the ministers agreed. Italy has pushed for private debt levels, which are low in Italy compared with the EU average, to be included in the gauge."

Analysis: Marchionne offers reform model to stagnant Italy - Reuters

"There is no doubt Italy is in dire need of reform."

According to this article from Reuters by Gavin Jones and Lisa Jucca

"Its economic growth consistently lags its euro zone partners and, according to International Monetary Fund data, it was the world's fourth most sluggish economy between 2000 and 2010, ahead of Zimbabwe, Eritrea and Haiti. Real disposable income has been stagnant since 1990 and the average hourly wage, adjusted for the cost of living, is 30-40 percent below that of its three main European peers, Germany, France and Britain. It is the only euro zone country where per capita output is lower now than it was in 2000.

Of course there are many reasons for this state of affairs, but analysts agree that one factor is the rigid and centralised system of industrial relations and an inability to increase productivity in line with its competitors."

But it is not too late for reforms. Germany remain's Italy’s largest trading partner. Germany is purchasing 12.7 per cent of Italian exports.

What is currently plaguing Italy's economy remain its ongoing North-South divide. Italy is a two zones economy and it is hindering its growth dramatically:

It is not too late for France either.

Both Italy and France, need to become probably more like Germany. In order to do so, they have to go through much needed structural reforms: Productivity and competitiveness were key to Germany's recent success.

The Ugly - Peripheral Europe:

Ireland has been the subject of quite a few posts on this blog.

Ireland debt status is now closer to junk following another round of downgrades from the rating agencies:
Moody's downgraded Ireland to Baa3 status with a negative outlook.

The Irish economy contracted for the third year running in 2010. GDP growth of 0.9% and 2.2% is forecast for 2011 and 2012.

As I posted previously, the Irish financial sector sunk the country.
Allied Irish Banks latest financial results is a good indication on how the country's public finances were deeply put into the red. AIB used to be Ireland's largest lender. AIB revealed additional losses recently: 10 billion Euros in 2010 from 2.3 billion Euros in losses a year earlier.

Now AIB, which is almost totally owned by the Irish government.

So far AIB has received 7.2 billion Euros in government aid to date and we know now it needs an additional 13.3 billion Euros in capital, following the latest Irish banks Stress Tests. On its own, AIB's capital injections so far represents an incredible 12.5% of GDP. And this is just for AIB, I am not including, Anglo Irish or Bank of Ireland.

There is only one explaination for the high losses in the Irish financial sector: High concentration of risk in property lending. Anglo Irish's loan book was on 10 promoters only as indicated previously.

Since Ireland embarked on its fiscal austerity programme two years ago, the Irish economy has contracted by at least 11%, and, 16% in three years in total. Consumer spending is down 14 percent since 2008.

"Commercial property prices have plunged 60 percent since peaking in 2007, while rents have fallen an average 50 percent, according to real-estate agent CB Richard Ellis Group Inc. (CBG)"

Source Bloomberg: Irish Retailers Fight Investors Over Rents After Economy Sinks

For the IMF, Irish growth will be "Ugly" in 2011, a miserable 0.5% according to there latest forecast.

In comparison:

"Growth for the Euro Area is estimated to be 1.6%. In advanced economies worldwide, growth is estimated at 2.5%, with developing world growth put at 6.5%."

The employment in Ireland is as well, a truly "ugly" picture:

Ireland Unemployment: January 2000 - April 2011

The blame for financial crisis is not all our own
We need to draw attention to punitive stance on financing of bank resolution, writes Colm McCarthy

"Holders of Irish bank bonds should take losses instead of the Irish Government footing the bill for their bailout," European Central Bank governing council member Axel Weber said.

Mr Weber added:
"To save a country's banking system, it is not necessary to write a blank cheque for the total balance sheet of the banking system."

"'In Ireland, the question is whether the banking sector has to be saved as a whole,' he added. 'Would it not be a better route to isolate deposits, to minimise losses to Irish taxpayers and to find a complete solution . . . with private sector participation instead of buying them out.'"

"Mr Weber echoes the consistent editorial position of the Financial Times, the Wall Street Journal and the Economist magazine among others."

This is the difficult dilemna, Ireland is facing, haircuts or more austerity for its taxpayers.

As for Portugal, last time it received an IMF package in 1983, the result was higher productivity and exports. Is it going to be different this time?
The key element for Portugal, as well as Spain to some extent, lies in a major structural reform of its labor market. Portugal needs to become more competitive again. Competitiveness is a key factor of success as highlighted by the German economic situation.

Portugal benefited as Italy in a short boost to its GDP growth after 1999, but since then, its GDP growth has not been stellar to say the least:

Portugal GDP Growth: January 2000 - April 2011

"The Gross Domestic Product (GDP) in Portugal expanded 1.20 percent in the fourth quarter of 2010 over the same quarter, previous year. Unlike the commonly used quarterly GDP growth rate the annual GDP growth rate takes into account a full year of economic activity, thus avoiding the need to make any type of seasonal adjustment. From 1989 until 2010, Portugal's average annual GDP Growth was 2.16 percent reaching an historical high of 6.50 percent in March of 1995 and a record low of -3.70 percent in March of 2009."
Source Trading Economics.

Austerity is biting even more Portugal's employment levels:
Portugal Unemployment Rate Jan 2000 - April 2011

As a reminder, CDS for financials are deeply correlated to Sovereign CDS levels as of the 7th of April 2011.

In regards to Greece, the writing is on the wall and a restructuring seems to be the most likely outcome:

Greek Government bonds run on the 14th of April 2011:
Price Yield

GGB 4.6 05/20/13 78.4410 17.8539
GGB 5 1/2 08/20/14 68.2760 19.1830
GGB 6.1 08/20/15 67.1960 17.3838
GGB 3.6 07/20/16 58.9710 15.5923
GGB 4.3 07/20/17 59.1350 14.7267
GGB 4.6 07/20/18 59.2450 13.8444
GGB 6 07/19/19 61.2950 14.257
GGB 6 1/4 06/19/20 64.1660 13.1971
GGB 5.3 03/20/26 58.6110 11.0967
GGB 4.6 09/20/40 53.6850 9.2031

Greece Sovereign CDS 5 year spreads reached a record on the 14th of April 2011 to 1164 bps, implying a Cumulated Probability of Default of 60% according to CMA.
CDS 5 year levels for Peripheral countries as of the 14th of April 2011:

A real recovery in productivity is the only way for a sound economic recovery.

An interesting article as a follow up on European Banks financial woes:

Euro vs. Invasion of the Zombie Banks

By Tyler Cowen in the New-York Times

Are we seeing the application of Gresham's law in current market turmoils and hot money pouring into Emerging Markets? I will discuss on this subject in a future post.

Gresham's law as per wikipedia:
"Gresham's law is an economic principle "which states that when government compulsorily overvalues one money and undervalues another, the undervalued money will leave the country or disappear into hoards, while the overvalued money will flood into circulation."

"It is commonly stated as: "Bad money drives out good", but is more accurately stated: "Bad money drives out good if their exchange rate is set by law."

Robert Mundell believes that Gresham's Law could be more accurately rendered, taking care of the reverse, if it were expressed as, "Bad money drives out good if they exchange for the same price."

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