"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."

In May 2010, I wrote: Anterograde Amnesia or Retrograde Amnesia? Or both?:

"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:

Fed officials not attached to dual mandate - Reuters

"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:

John Taylor Advocates Narrowing Fed Mandate - WSJ

“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:

Does the Fed's dual mandate spell doom for the dollar? - Macro Man

"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:

Charles Plosser and the 50% Contraction in the Fed's Balance Sheet (Hussman)

"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:

From Theory to Praxis - Sean Corrigan, Diapason Securities

"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:

If the economy is weak, why are stocks up?

"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

 

Creative destruction and the Minsky moment

“Panics do not destroy capital – they merely reveal the extent to which it has previously been destroyed by its betrayal in hopelessly unproductive works” - John Mills, “Credit Cycles and the Origins of Commercial Panics”, 1867

In this post I will review the consequences of this week price action.

I will also point out the current Minsky moment and theory as well as reviewing the Austrian Business Cycle Theory which if applied could have prevented much of the current mess we are in.
I will also underline again the incredibly accurate analysis and forecast made by Joseph Schumpeter in his book Capitalism, Socialism and Democracy.

From Wikipedia:

"A Minsky moment is the point in a credit cycle or business cycle when investors have cash flow problems due to spiraling debt they have incurred in order to finance speculative investments. At this point, a major selloff begins due to the fact that no counterparty can be found to bid at the high asking prices previously quoted, leading to a sudden and precipitous collapse in market clearing asset prices and a sharp drop in market liquidity."

http://en.wikipedia.org/wiki/Minsky_moment

The Minsky Theory:

"Hyman Minsky has proposed a post-Keynesian explanation that is most applicable to a closed economy. He theorized that financial fragility is a typical feature of any capitalist economy. High fragility leads to a higher risk of a financial crisis. To facilitate his analysis, Minsky defines three approaches to financing firms may choose, according to their tolerance of risk. They are hedge finance, speculative finance, and Ponzi finance. Ponzi finance leads to the most fragility.

-for hedge finance, income flows are expected to meet financial obligations in every period, including both the principal and the interest on loans.

-for speculative finance, a firm must roll over debt because income flows are expected to only cover interest costs. None of the principal is paid off.

-for Ponzi finance, expected income flows will not even cover interest cost, so the firm must borrow more or sell off assets simply to service its debt. The hope is that either the market value of assets or income will rise enough to pay off interest and principal.

Financial fragility levels move together with the business cycle. After a recession, firms have lost much financing and choose only hedge, the safest. As the economy grows and expected profits rise, firms tend to believe that they can allow themselves to take on speculative financing. In this case, they know that profits will not cover all the interest all the time. Firms, however, believe that profits will rise and the loans will eventually be repaid without much trouble. More loans lead to more investment, and the economy grows further. Then lenders also start believing that they will get back all the money they lend. Therefore, they are ready to lend to firms without full guarantees of success. Lenders know that such firms will have problems repaying. Still, they believe these firms will refinance from elsewhere as their expected profits rise. This is Ponzi financing. In this way, the economy has taken on much risky credit. Now it is only a question of time before some big firm actually defaults. Lenders understand the actual risks in the economy and stop giving credit so easily. Refinancing becomes impossible for many, and more firms default. If no new money comes into the economy to allow the refinancing process, a real economic crisis begins. During the recession, firms start to hedge again, and the cycle is closed."

http://en.wikipedia.org/wiki/Financial_crisis#Minsky.27s_theory


We have reached this moment this week. CDS prices are rising fast and furiously (Itraxx Main 5 year is now around 140 Bps an Itraxx Crossover 5 year is at 605 bps). I have witnessed similar price action in the credit market in August 2007 following the demise of the two highly leveraged Bear Stearns funds that collapse which triggered the subprime debacle. Some so called experts where at the time telling everyone that subprime was a small problem that could be contained. Same is happening today, some experts are telling us Greece is a small problem that can be contained. We are all witnessing the contagion in the market hence the Minsky moment we are in!

http://www.businessweek.com/news/2010-05-07/bank-risk-soars-to-record-default-swaps-overtake-lehman-crisis.html

TED spread is widening and this is clearly a sign of liquidity strain in the system as well as the widening in the OIS-Libor spread.

As per the Wall Street Journal on Friday, Short term lending is rising which is a sign of rising liquidity concern and counterparty risk aversion in the financial markets. This explains why there is 40 bps difference between the Itraxx Main 5 year CDS and the Itraxx Senior Financial Index 5 year CDS.

In normal markets Itraxx Financials index trades below Itraxx Main Europe as per below graph:



"The three-month dollar-lending rates among banks, the London interbank offered rate, or Libor, rose Friday, to 0.42813% from Thursday's 0.37359%, the highest since August, as risk-wary banks became more reluctant to lend to each other. Dollar Libor, which peaked in July 2009, has been mostly stable since the fall of 2009, but started to pick up again this past March.

Short-term funding markets already had shown signs of liquidity strains Thursday amid worries about counterparty risk with European banks."





Source Bloomberg

Fear gauges in the government bond market was higher Friday. The TED spread, measures the gap between the "risk free" rate three-month Treasury bills and the London interbank offer rate on three-month dollars, reached 30 bps, setting up a new high for the year so far...

Another indicator I mentioned previously as an indicator of risk spiking up is the VIX (on the 10th of April I argued that market were too complacent and the VIX was too low and VIX was at a very good entry point):


Source Bloomberg

The higher the VIX, the higher the fear and panic in the market.

We have witnessed all of the above towards the previous catastrophic Lehman collapse.

Now to the explaination of the Minsky moment, the Austrian Business Cycle Theory explains partly and the economic reasons behind our current financial crisis since 2007.

http://en.wikipedia.org/wiki/Austrian_business_cycle_theory

As per Wikipedia:

"The Austrian business cycle theory ("ABCT") is an explanation of the primary causes of business cycles held by the heterodox Austrian School of economics. The theory views business cycles (or, as some Austrians prefer, "credit cycles") as the inevitable consequence of excessive growth in bank credit, exacerbated by inherently damaging and ineffective central bank policies, which cause interest rates to remain too low for too long, resulting in excessive credit creation, speculative economic bubbles and lowered savings.

Austrians believe that a sustained period of low interest rates and excessive credit creation results in a volatile and unstable imbalance between saving and investment. According to the theory, the business cycle unfolds in the following way: Low interest rates tend to stimulate borrowing from the banking system. This expansion of credit causes an expansion of the supply of money, through the money creation process in a fractional reserve banking system. This in turn leads to an unsustainable credit-sourced boom during which the artificially stimulated borrowing seeks out diminishing investment opportunities. This credit-sourced boom results in widespread malinvestments, causing capital resources to be misallocated into areas that would not attract investment if the money supply remained stable. A correction or "credit crunch" – commonly called a "recession" or "bust" – occurs when exponential credit creation cannot be sustained. Then the money supply suddenly and sharply contracts when markets finally "clear", causing resources to be reallocated back towards more efficient uses.

Given these perceived damaging and disruptive effects caused by volatile and unsustainable growth in credit-sourced money, many Austrians (such as Murray Rothbard) advocate either heavy regulation of the banking system (strictly enforcing a policy full reserves on the banks) or, more often, free banking. The main proponents of the Austrian business cycle theory historically were Ludwig von Mises and Friedrich Hayek. Hayek won a Nobel Prize in economics in 1974 (shared with Gunnar Myrdal) in part for his work on this theory."


Alan Greenspan maintained interest rates too low for too long: 2000 to 2006 the creation of the bubble which led to the bust.

The Austrian Business Cycle Theory explains what happened very clearly:

"The boom then, is actually a period of wasteful malinvestment, a "false boom" where the particular kinds of investments undertaken during the period of fiat money expansion are revealed to lead nowhere but to insolvency and unsustainability. It is the time when errors are made, when speculative borrowing has driven up prices for assets and capital to unsustainable levels, due to low interest rates "artificially" increasing the money supply and triggering an unsustainable injection of fiat money "funds" available for investment into the system, thereby tampering with the complex pricing mechanism of the free market. "Real" savings would have required higher interest rates to encourage depositors to save their money in term deposits to invest in longer term projects under a stable money supply. The artificial stimulus caused by bank-created credit causes a generalized speculative investment bubble, not justified by the long-term structure of the market.

The "crisis" (or "credit crunch") arrives when the consumers come to reestablish their desired allocation of saving and consumption at prevailing interest rates. The "recession" or "depression" is actually the process by which the economy adjusts to the wastes and errors of the monetary boom, and reestablishes efficient service of sustainable consumer desires."

"The monetary boom ends when bank credit expansion finally stops - when no further investments can be found which provide adequate returns for speculative borrowers at prevailing interest rates. Evidently, the longer the "false" monetary boom goes on, the bigger and more speculative the borrowing, the more wasteful the errors committed and the longer and more severe will be the necessary bankruptcies, foreclosures and depression readjustment. There is also a notion of capital consumption contributing negatively to the readjustment period, which has been discussed in works such as Human Action."

Main critics of the Austrian Business Cycle theory such as Paul Krugman and Gordon Tullock argue the following:

"Mainstream economists argue that the theory requires bankers and investors to exhibit a kind of irrationality – that they be regularly fooled into making unprofitable investments by temporarily low interest rates."

Fabulous Fab Abacus CDO anyone?
Well guess what, bankers and investors exactly did that when they bought transactions similar to the Abacus CDO, and yes they were indeed fooled into making "unprofitable investments" enticed by the AAA provided by the complacent rating agencies which were being paid to issue the ratings by the very banks, issuing these structured credit transactions to these "sophisticated investors". This what some of the CDOs were all about (not all of them though as it depends what securities you include in the structure...).

The European govermnents are trying to postpone the day of reckoning for Greece and the markets are clearly showing they are not buying it.

The best for Europe would be a major debt restructuring for Greece, reducing the interest rate they have to pay, extending the maturity of the debt and the bondholders taking a haircut on their holdings.

The level of debt for Greece is clearly unsustainable and no matter how much money European countries will throw at it, it will not resolve the structural issues at the core which are widespread corruption in the Greek system, complete lack of fiscal discipline and fraud in the entire country.

To entice Greeks to accept the austerity measures, bond holders taking a haircut on their holdings would alleviate the pain and entice the Greek population to accept more willingly the austerity measures. The issues are that without being able to devaluate their currency, Europe is just trying to postpone the day of reckoning for Greece.

Creative Destruction and Schumpeter's contribution:

http://en.wikipedia.org/wiki/Joseph_Schumpeter

Schumpeter view on the demise of capitalism and "creative destruction":

"Schumpeter's theory is that the success of capitalism will lead to a form of corporatism and a fostering of values hostile to capitalism, especially among intellectuals. The intellectual and social climate needed to allow entrepreneurship to thrive will not exist in advanced capitalism; it will be replaced by socialism in some form. There will not be a revolution, but merely a trend in parliaments to elect social democratic parties of one stripe or another. He argued that capitalism's collapse from within will come about as democratic majorities vote for the creation of a welfare state and place restrictions upon entrepreneurship that will burden and destroy the capitalist structure. Schumpeter emphasizes throughout this book that he is analyzing trends, not engaging in political advocacy. In his vision, the intellectual class will play an important role in capitalism's demise. The term "intellectuals" denotes a class of persons in a position to develop critiques of societal matters for which they are not directly responsible and able to stand up for the interests of strata to which they themselves do not belong. One of the great advantages of capitalism, he argues, is that as compared with pre-capitalist periods, when education was a privilege of the few, more and more people acquire (higher) education. The availability of fulfilling work is however limited and this, coupled with the experience of unemployment, produces discontent. The intellectual class is then able to organise protest and develop critical ideas."

Schumpeter view on democracy:

"In the same book, Schumpeter expounded a theory of democracy which sought to challenge what he called the "classical doctrine". He disputed the idea that democracy was a process by which the electorate identified the common good, and politicians carried this out for them. He argued this was unrealistic, and that people's ignorance and superficiality meant that in fact they were largely manipulated by politicians, who set the agenda. This made a 'rule by the people' concept both unlikely and undesirable. Instead he advocated a minimalist model, much influenced by Max Weber, whereby democracy is the mechanism for competition between leaders, much like a market structure. Although periodic votes by the general public legitimize governments and keep them accountable, the policy program is very much seen as their own and not that of the people, and the participatory role for individuals is usually severely limited."


It is very important to review Schumpeter's view of democracy but also understanding the incredible fragility of democracy due to human nature and the role our policiticans have played, in today's major financial crisis.

The below quote is supposedly attributed to Alexander Fraser Tytler (1770), Cycle of Democracy but unverified. It makes never the less a very interesting point.

"A democracy cannot exist as a permanent form of government. It can only exist until the voters discover that they can vote themselves largesse from the public treasury. From that moment on, the majority always votes for the candidates promising the most benefits the public treasury with the result that a democracy always collapses over lousy fiscal policy, always followed by a dictatorship. The average of the world’s great civilizations before they decline has been 200 years. These nations have progressed in this sequence: From bondage to spiritual faith; from faith to great courage; from courage to liberty; from liberty to abundance; from abundance to selfishness; from selfishness to Complacency; from complacency to apathy; from apathy to dependency; from dependency back again to bondage."

Blue pill or Red Pill?

Morpheus: This is your last chance. After this, there is no turning back. You take the blue pill - the story ends, you wake up in your bed and believe whatever you want to believe. You take the red pill - you stay in Wonderland and I show you how deep the rabbit-hole goes.

The Matrix movie - 1999

There we are year end coming fast and everyone is expecting the recovery in 2010, following the surge in the many green shots seen in the economy.

Too many people have taken the blue pill.

The facts unfortunately doesn't support the idea of a strong recovery.

In my last post Greece Sovereign CDS was trading around 230 bps for 5year. Another downgrade from S&P came along and there we are with Credit-default swaps linked to Greek debt rising another 30 basis points to 260, according to CMA DataVision, the highest since March.

Everyone is expecting Greece to do the right thing, cutting on spending and reducing their abyssmal budget deficit before it is too late. Will a Greek socialist government be as aggressive as the Irish in tackling their issues?
The answer is definitely no.

Standard Bank has definitely turned negative on both Ireland and Greece:

http://www.bloomberg.com/apps/news?pid=20601087&sid=a3SIOdqSGOtE&pos=5

As per my previous post, there is a probability that Greece could at some point exit the Euro.

Prime Minister George Papandreou announced he was taxing greek bankers at the rate of90% of their bonus and a the same time he announced that civil servants making less than 2,000 euros a month would get pay rises above inflation.

How does the Prime Minister of Greece expect to fund the salary of his public servants? By issuing bonds that no one will want?

http://www.ft.com/cms/s/0/b0d436c0-ea90-11de-a9f5-00144feab49a.html

Get ready for another bumpy ride in 2010...

Also in the news, one of Austria's largest bank (ranked 6th) had to be rescued by the Austrian Government:

http://www.ft.com/cms/s/0/ebfa6b22-e890-11de-9c1f-00144feab49a.html

Hypo Group Alpe Adria hit the wall. Another one bites the dust.

"Under the terms of the deal, Austria will take over 100 per cent of HGAA and the shareholders surrender their stakes and inject about €1bn ($1.5bn) in capital."

"Meanwhile, Austrian banks could face another €10bn in writedowns over the next two years, Austria’s central bank warned on Monday. Austrian banks have about €200bn of exposure to central and eastern Europe and have written down €15bn since the start of the crisis."

Problems have not been resolved by the governements and the deleveraging is still an ongoing process globally.

Defaults are still rising and unemployment levels are still going up.

(Bloomberg) -- Homeowners with mortgages of more than $1 million are defaulting at almost twice the U.S. rate and some are turning to so-called short sales to unload properties as stock-market losses and pay cuts squeeze wealthy borrowers.

http://www.bloomberg.com/apps/news?pid=20603037&sid=aQED_96QBBkk


It started with subprime mortgages going sour, then the ALT-As and ARMS, now the prime and jumbo loans are getting hit hard as well.

What we can expect is that the FED will maintain the interest rates low for a long period. We cannot expect them to raise rates in 2010. By maintaining them artificially low, they are trying to ensure banks can offset somehow the tidal wave of defaults and provisions they are facing, ensuring they make some very good profits on the spread banks are borrowing at and lending at.

The recession will really be over when small businesses which are the motor of an economy will start to hire as they did last time we had a valid recovery.

Here is the Red Pill for all of you who want to see how deep is the rabbit-hole we are:

From David Goldman's excellent blog (the link is indicated in this blog as well)

"Structurally, a very large percentage of job losses during recessions reflect creative destruction: big companies who lay off workers in recessions downsize permanently. The jobs are not replaced at the same companies; the old jobs go away forever, and new jobs are created at the grass roots of the economy.

That’s why we have to look to small business for continued job growth, and why the prospects are grimmer than the market seems to believe."

http://blog.atimes.net/?p=1274

No matter how much liquidity the US administration injects, no matter how Obama would like bank to increase lending (for some who have the capacity to do so...), the recovery is not around the corner but at least a couple of years down the line.

This is the awful truth.

The governments are preventing creative destruction to take place by trying to prop up some dying parts of their economies: GM, some banks, etc.
I mean by creative destruction the emergence of a new economy based on new technology or new industries.

As Joseph Schumpeter mentioned creative destruction hurts a lot in the short term and this goes again governments and short term views for short term political gains.

Volcker, arguably the best president the FED ever had, killed stagflation in the US in the late 70s. Soon we will be entering a new phase of Stagflation and you can expect inflation to start creeping up at some point and commodities prices to reach new highs.

As per a Wikipedia article around Creative Destruction:
"Layoffs of workers with obsolete working skills can be one price of new innovations valued by consumers. Though a continually innovating economy generates new opportunities for workers to participate in more creative and productive enterprises (provided they can acquire the necessary skills), creative destruction can cause severe hardship in the short term, and in the long term for those who cannot acquire the skills and work experience."

Joseph Schumpeter was a visionnary, and probably on of the first takers of the "red pill".

For those of view who would like to extend on Schumpeter's economic views which are very accurate, I recommend reading his book: Capitalism, Socialism and Democracy.

Here is a link to Wikipedia's review on this major book.
http://en.wikipedia.org/wiki/Capitalism,_Socialism_and_Democracy

So which countries to look for to invest? Follow where innovation is taking place at a fast pace, where education levels are strong and where there are plenty of skilled workers: Asia. India and China will continue to grow strong in 2010, they have the skills and the ressources to navigate these treacherous waters much better than most developped countries.
Canada as well will do well thanks to their natural ressources and their solid financial sector which was not damaged by the financial crisis.

I will conclude this post by a quote from Joseph Schumpeter:

"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.