October 4, 2011 8:07 pm

How to keep the euro on the road


The eurozone was launched on a wing and a prayer. The wing has fallen off and the deities are not listening to prayers. Everyone focuses on averting a crash. But it is as vital to ask how to fly securely.

How, then, did the eurozone fall into its plight? A part of the answer is that it lacked mechanisms for handling crises, that its members have diverged hugely and that it was blighted by its early successes.

The easy credit conditions and low interest rates of the first decade delivered property bubbles and explosions of private borrowing in Ireland and Spain, incontinent public borrowing in Greece, declines in external competitiveness in Greece, Italy and Spain and huge external deficits in Greece, Portugal and Spain. When financial markets panicked, borrowers suffered “a sudden stop”, which caused cascading crises of illiquidity and insolvency for sovereigns and banks. The eurozone has been running to catch up. But the crisis runs faster. Almost half of the sovereign debt shows heightened credit risk.

The eurozone had no mechanisms for cross-border financing of borrowers who had lost access to funds. In theory, adjustment should have occurred via the classical mechanisms: a spiral of sovereign defaults, banking collapses, slumps, unemployment, falling wages, fiscal retrenchment and all round misery. Nobody forewarned the public that such brutality lay in wait. Politicians did not understand this either. When the time came, they all flinched.

So what has to be done? The answer comes in two pairs: the first is “stocks and flows”; the second isfinancing and adjustment”. Stocks refers to cleaning up the legacy of the past. Flows refer to the need to return to sustainable economic growth. Financing and adjustment refer to the how and the when of efforts to clean up stocks and restore sustainability to flows.

Several eurozone members have emerged from the crisis with huge overhangs of private and sovereign debt. If these stocks cannot be rolled over, a mixture of financing and restructuring remains. Either the official sector provides finance or it ensures a restructuring of debt in terms of face value, maturity or interest rates. In the case of Greece, the decision has been made to finance the debt overhang, via the official sector, indefinitely. No voluntary private financing exists. The private sector debt restructuring now being organised offers next to no relief to Greece, but substantial relief to erstwhile private lenders. In the case of Greece certainly (and Portugal and Ireland possibly), substantial reduction in the burden of debt service are essential.

This stock problem runs through banking, too, where the overhang of bad loans impairs both solvency and liquidity. Again, the solution is financinginjections of capital and support from the central bank – and restructuring write-downs of assets and some liabilities. So long as the overhangs of bad debt remain, private finance will not return.
Dealing with the stocks is relatively simple. A far bigger challenge is to achieve sustainable flows of income and expenditure, at high levels of economic activity. That means far more than the fiscal austerity with which Europeans are obsessed. To paraphrase the Roman historian Tacitus, “they make a depression and call it stability.” If activity is to be restored, the structural external deficits must fall to levels readily financed through private markets. Greece and Portugal have huge external deficits today, despite deep recessions, a cogent indicator of a severe lack of competitiveness. This is also a bit of a worry for Spain and Italy, but the challenge is smaller. Ireland is in external surplus, which is encouraging for its future.

Adjustments of this kind take time: big changes in relative prices and investment in new activities must both occur. In a bleak paper for London-based Lombard Street Research, Christopher Smallwood argues that Greece and Portugal – and perhaps even Italy and Spain – will find restoring competitiveness via falling wages and mass layoffs extremely painful.* Moreover, this would raise the debt burden further. The effort may even cause a political breakdown. To limit the trauma, the eurozone will probably offer some financing. But that could also slow the pace of the needed adjustment.

What makes adjustment still more difficult is that it involves two sides. If external deficits are to fall, so must surpluses elsewhere. That has obvious implications for Germany and other core countries. But the latter do not recognise the need to adjust. They believe one hand can clap. The two-handed nature of adjustment may not matter so much for small debtor countries. It matters far more for bigger ones.

If the needed adjustment proves impossible within the straightjacket of the eurozone, two alternatives exist: exit, with the risks I noted two weeks ago, or permanent financing via a fiscal union, so putting failing economies on life support. Doing the latter may be possible for one or two small economies.

But it would be impossible, economically or politically, for larger ones. This is why today’s high spreads on Italian and Spanish debt are so dangerous for the future of the eurozone.

It is the flows, stupid. Merely lowering debt burdens does not solve that problem. The fear must be that deeply uncompetitive economies will not be financed, but cannot adjust. If so, they may just wither away. This is why some people already argue that the way out may have to include exits. In broken marriages, argues Nouriel Roubini of the Stern School in New York, “it is better to have rulesdivorce laws – that make separation orderly and less costly to both sides.”

The bare minimum the eurozone needs to cope with its crisis is an effective mechanism for writing down the debts of evidently insolvent private and sovereign borrowers, such as Greece; funds large enough to manage the illiquid bond markets of potentially solvent governments; and ways to make the financial system credibly solvent immediately. The sums required will surely be several times larger than the €440bn of the existing European Financial Stability Fund, as I noted last week.

Yet, alas, the eurozone requires more still: it needs a credible path of adjustment, at whose end we see weaker economies restored to health. If such a path is not found, the eurozone, as it is now, will fracture. The question is not if, but when. The challenge is simply as big as that.
.* “The eurozone must shrink”, www.lombardstreetresearch.com.
Copyright The Financial Times Limited 2011.

Up and Down Wall Street


The Bear Market is Made in the U.S.A.


Greece's situation is hopeless, but not serious. U.S. stocks reflect the weakness of the U.S. economy.

"Sell in May and go away" is the hoary cliché that proved prescient this year for stock traders. The Standard & Poor's 500 peaked around May Day, along with President Obama's popularity with the termination of Osama bin Laden, and it's been downhill for both since.

The S&P 500 closed within a percentage point of the conventional definition of a bear market Monday, down 19.4% from the April 29 high. Other measures are off much more, such as the Russell 2000 index of small-capitalization stocks, which is down nearly 30%.

The putative reason for the declines has been the political wrangling on both sides of the Atlantic, fought mainly over fiscal matters, that would qualify as farce if it weren't so deadly serious and indeed tragic. America saw the loss of top triple-A credit rating following the unfunny spectacle of the debt-ceiling bluster talk during the summer while Europe remains enveloped with the never-ending efforts to stave off a default by Greece and a debacle of the Continent's banks.

But the proverbial observers from outer space, agnostic in their expectations or presumptions about economies and markers, would likely have come to a simpler explanation for the gyrations in financial markets. The decline in U.S. stock prices (and in bond yields) has roughly paralleled the slowing in the American economy, as measured by the gauges from an outfit that has reliably called turns in the business cycle.

The Economic Cycle Research Institute Friday declared that a U.S. recession was all but unavoidable, as reported in the Current Yield column of this week's print edition of Barron's. ECRI's call is based on a compilation of measures from the firm founded by the late Geoffrey Moore, who was called the father of leading indicators.

ECRI's Weekly Leading Indicator plateaued last April and began to show serious signs of deceleration in May, coincident with the peak in the stock market, which itself is supposed to be a leading indicator. Of course, stocks supposedly have forecast something like nine of the past five recessions, according to the quip by the late economist, Paul Samuelson.

This time, however, stocks' slide has been corroborated by the sharp drop in industrial commodities, notably copper, and the action in the bond markets. The plunge in Treasury yields, with the benchmark 10-year yield cut by more than half, from 3.74% in February to 1.77% Monday, anticipated the continued torpor in the economy. That contrasted with the conventional wisdom earlier in the year that a smart rebound would be under way by now. Moreover, credit spreads -- the extra yield on speculative-grade bonds to compensate for their greater risk -- also have widened to levels associated with a significant downturn in the economy.

Even though the near-bear market in U.S. stocks is entirely consistent with the deterioration of growth prospects in the American economy, the connection is denied. The S&P 500 no longer moves in lock-step with U.S. gross domestic product, which is the result of nearly half of those companies' revenues coming from overseas. But the bigger decline in the Russell 2000 small-cap stocks, whose business comes primarily from within U.S. shores, would seem to reflect more accurately the state of the domestic economy.

The explanation offered daily is the European situation is what's taking a toll on Wall Street. The inability to come up with a solution to Greece's debt problem (after the first two bailouts) weighs on risk assets, especially financials. The mantra is repeated continuously until it is accepted uncritically.

The situation in Greece is hopeless, but not serious, as David Goldman has brilliantly observed. The former head of credit research at Bank of America contends this is not a rerun of the Lehman Brothers collapse in 2008. Nobody knew then what lurked on the balance sheets of major banks in terms of mortgage derivatives, least of all their chief executives, who were particularly clueless.

That's not the case this time. "This is NOT a crisis," Goldman asserts, "but a negotiation, in which the main issue is who will own Europe's productive assets when all is over," he writes on his Inner Workings blog at Asia Times (www.atimes.com.)

That other Goldman -- Goldman Sachs -- Monday wrote that the effects of Europe's credit woes will shave more than one percentage point from U.S. growth in 2012. Weaker export growth, tighter financial conditions and reduced availability of credit will constrain the U.S. economy next year. Europe will slip into recession as global growth slows, Goldman economists predict.

The fault for the stumble in the U.S. economy lies closer to home than Europe. Massive monetary and fiscal stimulus staved off a second Great Depression after the 2008 credit collapse. The Federal Reserve no longer is expanding its balance sheet, just reshuffling its assets. Deficit-cutting is the order of the day for the federal budget while austerity has arrived for many states and localities. The puzzle is why anybody would be surprised the economy could slip back into recession.

Withdrawal of the palliatives that eased the pain of the credit bust has to hurt. Easier to blame Greece instead.
Copyright 2011 Dow Jones & Company, Inc. All Rights Reserved



Watching The Fed Drop The Ball

by: Tim Duy

October 4, 2011

(Note: I am feeling bearish today, especially looking back to lost opportunities to get ahead of the current environment.)

By mid-summer it was evident the recovery was in jeopardy, that the slowdown in economic activity could not be entirely explained by temporary factors, that unemployment would remain unacceptably high, and that the slow motion train wreck that is the European experiment would be resolved only in the aftermath of financial chaos.

The Fed had the opportunity to get ahead of the curve. They chose not to. To be sure, they offered some half-hearted support to the existing policy stance. But this amounts to bring a knife to a gunfight.

At this point, we are faced with mounting recession forecasts. The Economic Cycle Research Institute publicly announced their recession call last week, confidently expecting to extend their 3-0 forecasting record. Nouriel Roubini already offered up his recession call. Today, Goldman Sachs placed 40% odds on recession in 2012.

And in the Goldman Sachs call lays the obstacle to an aggressive monetary response, as opposed to the simple rearranging of the deck chairs currently underway. There may be widespread belief that the seeds of the recession are planted and beginning to sprout, but the near-term data certainly will not confirm a recession is underway. From the Wall Street Journal:

So far, as many economists point out, the worst readings on the economy come from sentiment measures rather than hard numbers on economic activity.

The pessimism among consumers and businesses alike may be reactions to political uncertainty and the volatility in the stock market, while the nuts-and-bolts data on the U.S. economy look better.

In the latest round of data, August construction spending surprisingly rose 1.4% when a 0.4% drop was expected. September factory activity beat forecasts as well. The Institute for Supply Management said the sector’s expansion strengthened for the first time since June.

The data point to real gross domestic product growing at an annual rate above 2% in the third quarter, more than double the pace of the first half.

The economy was not in recession in the third quarter, which means the backward looking data flow through this month will not be particularly dire. We are really looking for whatever acceleration we see in third quarter GDP growth to ebb in the fourth quarter, a bad omen for the fiscal drag we will experience as the payroll tax credit expires. On top of that, you have to believe in unicorns and fairies if you think the European crisis is going to go anywhere other than from bad to worse in the next three months. The lesson of the past two years is the Europeans will arrive late and bring a club to the gunfight. Indeed, while today’s late rally was credited to the latest round of optimism on Europe, via Bloomberg:

Equities rebounded after the S&P 500 fell below 1,090.89, the closing level required to give the index a 20 percent slump from the three-year high reached on April 29. Stocks rose after the Financial Times quoted Olli Rehn, European commissioner for economic affairs, as saying there is an “increasingly shared view” that the region needs a coordinated approach to halt the sovereign debt crisis. After U.S. markets closed, Belgian Prime Minister Yves Leterme said a “bad bank” to hold Dexia SA (DXBGF.PK)’s troubled assets will be set up.

The reality is likely less optimistic:

People are looking for optimism anywhere they can get it,” said Christopher Bury, co-head of fixed-income rates at Jefferies & Co., one of the 22 primary dealers that trade with the Federal Reserve. “You have these random stories and the market reacts, but how many times have we been down this road where these are just words?”

One additional note on the global environmentsigns are emerging that the long running Chinese property boom is running into trouble. From Deustche Bank and via Business Insider:

In recent weeks, the number of phone calls received by an author of this report from China-based property agents has increased several fold, indicating a significant rise in the urgency for developers to raise cash from selling properties. A property consultant told us that he recently received requests to help raise RMB10bn for cash-strapped small and medium-sized property developers – this amount is a huge multiple of what he is used to dealing with. In the offshore market, where many Chinese developers seek foreign currency funding due to lack of access to domestic funds (the domestic stock, bond and trust loan markets are closed to them due to policy tightening, and banks are also very stringent), their USD bond yields have surged to 20-25% in past weeks from around 10% before August. This means that even the offshore markets are now largely closed to Chinese developers

The Chinese government will act to cushion the downside for their property sector, but what will be the consequences of even a short-term slowdown for a global economy already on the downside?

Put aside the non-recessionary real economy data and instead turn to the financial markets for hints. There the signals are decidedly more pessimistic. Equities are heading into bear market territory, interest rates are collapsing, spreads between Treasuries and corporate debt are widening, commodity prices are in virtual free-fall, and the TED spread, while still well short of the highs reached during the financial crisis, have more than doubled from 15bp in the spring to 38bp now.

There is no way to read the ongoing financial turmoil as anything other than increasing fear that a recession is underway. Perhaps it is all simply a growth scare, and that in a few months we will wonder what all the fuss was about. But ECRI believes it is already too late for that story:

A new recession isn’t simply a statistical event. It’s a vicious cycle that, once started, must run its course. Under certain circumstances, a drop in sales, for instance, lowers production, which results in declining employment and income, which in turn weakens sales further, all the while spreading like wildfire from industry to industry, region to region, and indicator to indicator. That’s what a recession is all about.

About the only good news is that, as pointed out by Goldman Sachs, perhaps the downside will remain limited:

The downside risk is of course that these financial spillovers--or conceivably some other shock, perhaps greater fiscal tightening in 2012 than we now anticipate--prove sufficient to push the US economy into recession; both a quantitative model and our subjective assessment put recession risk in the neighborhood of 40% at this point. For now, we still think the base case is that the US economy avoids this outcome. The cyclical sectors of the economy are already quite depressed--in particular, homebuilding is barely above the depreciation rate of housing--so downside looks more limited.

Cold comfort, according to ECRI:

I’ts important to understand that recession doesn’t mean a bad economywe’ve had that for years now. It means an economy that keeps worsening, because it’s locked into a vicious cycle. It means that the jobless rate, already above 9%, will go much higher, and the federal budget deficit, already above a trillion dollars, will soar.

Here’s what ECRI’s recession call really says: if you think this is a bad economy, you haven’t seen anything yet. And that has profound implications for both Main Street and Wall Street.

With the US, we know that fiscal policy is off the table as gridlock rules the day in Washington. What more, it looks like the Federal Reserve resistance to additional action is at least partly based on a conviction this is no longer a problem for monetary policy – it is up to fiscal policy now. To be sure, financial markets today were at least initially buoyed by Federal Reserve Chairman Ben Bernanke’s comment:

The Committee will continue to closely monitor economic developments and is prepared to take further action as appropriate to promote a stronger economic recovery in a context of price stability.

But, after financial market participants sober up, they should recognize that this is nothing new. The Fed will offer more support. A hint from Bernanke as quoted by the Wall Street Journal:

Republicans also pressed the Fed chairman on the risk that the central bank could be stirring inflation with its efforts to pump money into the financial system to bring down interest rates. Mr. Bernanke dismissed such worries. He said a spurt in consumer prices earlier this year was already receding and that unemployment was a bigger threat.

"Right now, frankly, we're much further away from full employment than we are from price stability," he said. With that comment was a hint: The Fed might not be hurrying to do more to help the economy right now, but it is still leaning in that direction.

The only question is when and how much. Already, though, it is arguably too late. Recession or just slow growth, the policy delay will weigh heavily on the unemployed. Moreover, the Fed chair gives us little reason to believe he has much to offer:

Monetary policy can be a powerful tool, but it is not a panacea for the problems currently faced by the U.S. economy. Fostering healthy growth and job creation is a shared responsibility of all economic policymakers, in close cooperation with the private sector. Fiscal policy is of critical importance, as I have noted today, but a wide range of other policies--pertaining to labor markets, housing, trade, taxation, and regulation, for example--also have important roles to play. For our part, we at the Federal Reserve will continue to work to help create an environment that provides the greatest possible economic opportunity for all Americans.

How different is this view from that of Dallas Federal Reserve President Richard Fisher in defending his last dissent?

One other factor gave me pause and that was, and remains, the moral hazard of being too accommodative. For years, I have been arguing that monetary policy cannot solve the problem of substandard economic performance unless it is complemented by fiscal policy and regulatory reform that encourages the private sector to put to work the affordable and abundant liquidity we are able to create as the nation’s monetary authority. These actions are not within the Fed’s purview; they are the business of Congress and the president.

fail to see the wisdom in neglecting policy options simply because Congress is falling down on the job.

It seems that Bernanke is more center-right of Fed policymakers than center-left. Which suggests that he will need to be dragged kicking and screaming into another round of asset purchases. And, unfortunately, we will first need to see more citizens added to the ranks of the unemployed for that to happen.

Perhaps events will evolve in such away that the current round of pessimism will prove unfounded. But even if we avoid recession, the slow growth and constant threat of recession serve as a reminder that policymakers have fallen far short of doing what is needed to lift the economy from the zero bound. And, worse yet, neither monetary nor fiscal authorities appear particularly worried about achieving such a goal.

Italy downgrade deepens contagion fears over euro debt crisis

Ratings agency Moody's slashes Italy debt rating by three points, increasing pressure on European governments trying to contain financial crisis

Dominic Rushe guardian.co.uk,

Tuesday 4 October 2011 22.51 BST 

Italy's sovereign debt rating has been cut for the second time in as many weeks, with ratings agency Moody's citing "sustained and non-cyclical erosion of confidence" as it slashed its forecast for the country.

In a report released after US stock markets closed on Tuesday, Moody's downgraded Italy's government bond ratings from Aa2 to A2 with a "negative outlook", suggesting further cuts could be to come. The move threatens to increase Italy's cost of borrowing, and will add yet more pressure to European finance ministers now wrestling with a financial crisis that has spread across the continent.

Italy's prime minister, Silvio Berlusconi, criticised Moody's rival Standard & Poor's when it cut Italy's credit rating last month, saying the ratings agency's action was "dictated more by newspaper stories than by reality".

In its report, Moody's said the decision had been driven by three main factors: the debt crisis, which was causing a "sustained and non-cyclical erosion of confidence" in Europe and increasing "long-term funding risks" for Italy; the increased downside risks to economic growth due to macroeconomic structural weaknesses; and a weakening global outlook.

"The implementation risks and time needed to achieve the government's fiscal consolidation targets to reverse the adverse trend observed in the public debt, due to economic and political uncertainties," Moody's said.

Berlusconi again tried to play down its significance, saying "Moody's choice was expected".

"The Italian government is working with the maximum commitment to achieve its budget objectives," Berlusconi said.

The move came at the end of a day when markets were awash with fears that €3.4bn (£2.9bn) of exposure to Greek debt would bring down Franco-Belgian bank Dexia and tensions rose across the banking sector, putting pressure on the European Central Bank to be more generous in loans to banks to prevent a rerun of the 2007 credit crunch.

The gloom that has lingered over the banking industry since August deepened further when Deutsche Bank, Germany's biggest, warned it would miss its profits target and the cost of insuring major US banks against default reached levels last hit in October 2008.

Anders Borg, the Swedish finance minister, has been urging colleagues to prop up banks, possibly with public funds, even before the downgrade of Italy and despite fierce resistance from the French, who insist Europe is not at risk.

Senior officials led by Olli Rehn, EU economic and monetary affairs commissioner, backed this stance, which is endorsed by Christine Lagarde, managing director of the International Monetary Fund. She has said up to €300bn in capital may be required.

Comments by Rehn, reported after European markets had closed, that there was now a "shared view" of the need for co-ordinated action in banks helped to lift Wall Street off its lows to end the day higher.

Italy last month approved a €54bn package of austerity measures aimed at eliminating the country's budget woes and that it hoped would stave off a Moody's downgrade. The pledge to cut government spending and raise taxes met with cautious approval from Brussels, the European Central Bank and the International Monetary Fund but has not appeased Moody's.

"Even if policy actions were to succeed in the short term in returning some degree of normality to euro area sovereign debt markets, the underlying fragility and loss of confidence is deep and likely to be sustained," Moody's said in its report.

"The Italian economy continues to face significant challenges due to structural economic weaknesses. These problems — mainly low productivity and important labour and product market rigidities — have been an impediment to the achievement of higher potential growth rates over the past decade and continue to hinder the economy's recovery from the severe recession it experienced in 2009," said Moody's.

"These structural impediments to economic growth cannot be removed quickly. The government's reform plans have only just started to address some of these structural challenges, and they need to be implemented efficiently.

Moreover, moderate medium-term growth prospects for the Italian economy have been further revised downwards due to potential adverse effects of a weakening European and global growth outlook."

The downgrade may put more pressure on Italy's banks at a time when they need to shore up confidence in the eurozone's banks is increasingly recognised by politicians. Senior figures are pressing for stress tests for Europe's banks to be brought forward from next year after Dexia passed the July tests with flying colours. Several officials in Luxembourg referred to Dexia as "the canary in the coalmine".

Borg, also a non-zone minister, was blunter. "Government support is the best kind of backstop," he said.

Rehn appeared to be endorsing their view, saying: "We need to get more firepower against contagion effects and support recapitalisation of the banks."

The head of the European regulator, the European Banking Authority, Andrea Enria, joined the chorus of calls to solve the eurozone crisis. "It's a major issue that could go from Dexia to other banks, so it's important this is fixed and the sooner it's done the better," said Enria, who oversaw the July stress tests on banks.

Italy's latest downgrade follows cuts for eurozone partners Spain, Ireland, Greece, Portugal and Cyprus.