How to Create a Depression

Martin Feldstein

2012-01-16




CAMBRIDGE – European political leaders may be about to agree to a fiscal plan which, if implemented, could push Europe into a major depression. To understand why, it is useful to compare how European countries responded to downturns in demand before and after they adopted the euro.


Consider how France, for example, would have responded in the 1990’s to a substantial decline in demand for its exports. If there had been no government response, production and employment would have fallen.


To prevent this, the Banque de France would have lowered interest rates. In addition, the fall in incomes would have automatically reduced tax revenue and increased various transfer payments. The government might have supplemented these “automatic stabilizers” with new spending or by lowering tax rates, further increasing the fiscal deficit.


In addition, the fall in export demand would have automatically caused the franc’s value to decline relative to other currencies, with lower interest rates producing a further decline. This combination of monetary, fiscal, and exchange-rate changes would have stimulated production and employment, preventing a significant rise in unemployment.


But when France adopted the euro, two of these channels of response were closed off. The franc could no longer decline relative to other eurozone currencies. The interest rate in France – and in all other eurozone countries – is now determined by the European Central Bank, based on demand conditions within the monetary union as a whole. So the only countercyclical policy available to France is fiscal: lower tax revenue and higher spending.


While that response implies a higher budget deficit, automatic fiscal stabilizers are particularly important now that the eurozone countries cannot use monetary policy to stabilize demand. Their lack of monetary tools, together with the absence of exchange-rate adjustment, might also justify some discretionary cyclical tax cuts and spending increases.


Unfortunately, several eurozone countries allowed fiscal deficits to grow in good times, rather than only when demand was weak. In other words, these countries’ national debt grew because of “structural” as well as “cyclicalbudget deficits.


Structural budget deficits were facilitated over the past decade by eurozone interest rates’ surprising lack of responsiveness to national differences in fiscal policy and debt levels. Because financial markets failed to recognize distinctions in risk among eurozone countries, interest rates on sovereign bonds did not reflect excessive borrowing. The single currency also meant that the exchange rate could not signal differences in fiscal profligacy.


Greece’s confession in 2010 that it had significantly understated its fiscal deficit was a wake-up call to the financial markets, causing interest rates on sovereign debt to rise substantially in several eurozone countries.


The European Union’s summit in Brussels in early December was intended to prevent such debt accumulation in the future. The heads of member states’ governments agreed in principle to limit future fiscal deficits by seeking constitutional changes in their countries that would ensure balanced budgets. Specifically, they agreed to cap annualstructuralbudget deficits at 0.5% of GDP, with penalties imposed on countries whose total fiscal deficits exceeded 3% of GDP – a limit that would include both structural and cyclical deficits, thus effectively limiting cyclical deficits to 3% of GDP.


Negotiators are now working out the details ahead of another meeting of EU government leaders at the end of January, which is supposed to produce specific language and rules for member states to adopt.


An important part of the deficit agreement in December is that member states may run cyclical deficits that exceed 0.5% of GDP – an important tool for offsetting declines in demand. And it is unclear whether the penalties for total deficits that exceed 3% of GDP would be painful enough for countries to sacrifice greater countercyclical fiscal stimulus.


The most frightening recent development is a formal complaint by the European Central Bank that the proposed rules are not tough enough. Jorg Asmussen, a key member of the ECB’s executive board, wrote to the negotiators that countries should be allowed to exceed the 0.5%-of-GDP limit for deficits only in times of “natural catastrophes and serious emergency situationsoutside the control of governments.


If this language were adopted, it would eliminate automatic cyclical fiscal adjustments, which could easily lead to a downward spiral of demand and a serious depression. If, for example, conditions in the rest of the world caused a decline in demand for French exports, output and employment in France would fall. That would reduce tax revenue and increase transfer payments, easily pushing the fiscal deficit over 0.5% of GDP.


If France must remove that cyclical deficit, it would have to raise taxes and cut spending. That would reduce demand even more, causing a further fall in revenue and a further increase in transfers – and thus a bigger fiscal deficit and calls for further fiscal tightening. It is not clear what would end this downward spiral of fiscal tightening and falling activity.


If implemented, this proposal could produce very high unemployment rates and no route to recovery – in short, a depression. In practice, the policy might be violated, just as the old Stability and Growth Pact was abandoned when France and Germany defied its rules and faced no penalties.


It would be much smarter to focus on the difference between cyclical and structural deficits, and to allow deficits that result from automatic stabilizers. The ECB should be the arbiter of that distinction, publishing estimates of cyclical and structural deficits. That analysis should also recognize the distinction between real (inflation-adjusted) deficits and the nominal deficit increase that would result if higher inflation caused sovereign borrowing costs to rise.


Italy, Spain, and France all have deficits that exceed 3% of GDP. But these are not structural deficits, and financial markets would be better informed and reassured if the ECB indicated the size of the real structural deficits and showed that they are now declining. For investors, that is the essential feature of fiscal solvency.


Martin Feldstein, Professor of Economics at Harvard, was Chairman of President Ronald Reagan's Council of Economic Advisers and is former President of the National Bureau for Economic Research.



It's 2007.2, and Our Next "Lehman Moment' Is Coming Fast

January 17, 2012

By Shah Gilani, Capital Waves Strategist, Money Morning



It seems that my Thursday edition of Wall Street Insights & Indictments was warmly received by the bullish crowd, many of whom reached out to me to thank me for my optimism.


I'm sorry to burst your bubbles, but I am not a raging bull (but thank you for asking).


In fact, I'm still bearish.


There's a big difference between being bullish and playing all stocks (and other asset classes) from the long (that means "buy") side, and judiciously buying select momentum stocks with fat dividend yields, which is what I was recommending on Thursday.


I was talking about taking the path of least resistance, which I identified as "upward," based on equity activity through year-end and so far in 2012. You've heard the old adage "the trend is your friend." Well, that's what I was talking about. The trend has been up.


I'm bearish because I'm afraid of a European meltdown and a "hard landing" in China.


But there's a huge danger in missing what could be the beginning of a real bull market.


So, it makes sense to start putting on solid positions and even speculating here and there. But I am not all in - not yet. However, the time is coming. But, that is also the problem.


I'm fearful that a crash is coming, and maybe soon. If we get one, and everything flushes out and we get a capitulation bottom amidst a global panic sell-off, then I'll be all in, all the way, for the long-term. I'm talking about loading the boat up with stocks and commodities and enjoying a generational ride that will last for maybe 10 years, or more.
.
What keeps me up at night now, however, is the echo of 2007. I call where we are now 2007.2. If we are facing 2007.2, then 2008.2 will follow with a vengeance.


I'm guessing the breakdown could come in the first or second quarter of this year (although it could also take as long as 18 months to develop, which would only make it 10-times as bad when it does come).


Think about what I'm about to lay out for you, and ask yourself, what if he's right?


In the spring of 2007, U.S. Treasury Secretary Henry Paulson, when addressing problems surfacing in the subprime mortgages arena said things "appear to be contained." Fed Chairman Ben Bernanke said: "We believe the effect of the troubles in the subprime sector on the broader housing market will likely be limited."


Comforting words, right?


Then, speaking to members of the Federal Reserve Bank of Chicago in May of 2007, Bernanke said, "Importantly, we see no serious broader spillover to banks or thrift institutions from the problems in the subprime market."


Comforting words, right?


Even before two Bear Stearns hedge funds imploded in June of 2007, the Fed Chairman was touting the virtues of derivatives and the widespread sale of mortgage-backed securities when he stated, "The key thing to remember is that these losses are not just held by American banks, as the bad loans were in Japan (referring to Japan's lost decade), but they are dispersed."


Comforting words, right?


Then, on August 9, 2007, after one Bear fund was shut down and the other fund temporary propped by an injection of some $3.2 billion from Bear itself, and the seemingly contained fallout from subprime and AAA mortgages hitting "dispersed" banks in Europe, the European Central Bank's (ECB) Website quietly announced that the ECB would provide as much funding as banks might wish to borrow at only 4%.


What was happening was that European banks weren't lending to each other. The commercial paper market was at a standstill, and there was no short-term funding facility open wide enough to finance their longer-term mortgage positions. And they couldn't sell their positions because after the Bear funds imploded, there were no buyers for mortgage bonds, even the super-senior AAA tranches many European banks and all the big American banks were holding.


Two hours later, 49 banks borrowed three-times what they were usually asking to borrow. And by the time trading closed in the United States on that same day, gold had spiked higher, as had safe-haven U.S. treasuries.


Of course, the equity markets were doing their own thing and were rising that summer, nearing new all-time highs (which they would reach in September 2007).


It took another year before we got our "Lehman moment." But, boy did it hurt.
.

Fast-Forward to Now....



We're being told by the Fed that our banks are in good shape. We're being told by bank CEOs that they are in good shape and their European exposure is limited.


We're being told that there won't be any significant hit to our economy from events in Europe. We're being told that there won't be any significant spillover because European debts are dispersed and banks have derivatives hedges.


These are all lies.


Exactly like what happened in 2007, banks in Europe aren't lending to each other. The commercial paper market over here is closed to them. That's why the ECB announced it would effectively execute unlimited three-year term repos at 1%. And, by the way, they are taking just about anything for collateral, really.


Did 49 banks step up like in 2007? No, in 2007.2 (meaning now) some 500 banks stepped up and took $620 billion (489 billion euros) the following day. And they've been adding to that.


What's happening to gold in 2007.2? After selling off as part of the initial risk-on grab for equities a couple of months ago, it's rising again, and fairly quickly.


What about safe-haven bonds? U.S. bonds have been rising rapidly in price as investors clamor for safety. The 10-year closed Friday at a 1.87% yield, only 20 basis points from its all-time low yield, which it saw in September as European woes were strangling global markets.



How panicked is a lot of smart money? Yields on German and U.S. short-duration bills are less than zero. That means investors have bid up the price of these short-term safe government instruments that the premium they are paying is greater than their yield. Put another way, people are paying to place their money in safe government securities.


Comforting, right?


No, it's not.


Talk about concentration build-up. First of all, most U.S. banks and most European banks are still sitting on tons of mortgage-backed securities that they can't unload. And the U.S. housing market isn't getting any better, nor is Spain's, Ireland's, or China's.


Sure, foreclosures are down lately. But that's because of foreclosure moratoriums resulting from lawsuits. There are estimated to be 10 million homes for sale and over 11 million homeowners holding onto upside-down mortgages. What's going to happen when banks get on with foreclosing and start dumping houses again? It's about to happen.


All that nonsense about dispersed risks - don't believe it. There is no dispersion that matters because all the big banks in the U.S. and Europe and plenty of others hold the same asset mixes, the same duration mortgage pools, and the same sovereign debts.


But in the place where things are smoldering and there's kindling everywhere, European banks are buying more of their sovereign's toxic debts to stave off a collapse of the prices of the debts already on their books. It amounts to a crazy leveraging up on the same bet that sovereign debts will pay off 100 cents on the dollar.


And where are they getting the money to buy more of this crap? From the ECB, which is printing it against the backstop of the same countries who need banks to buy their constantly rolled-over debts.


It's musical chairs, and sooner or later the music is going to stop. Greece looks like it will be the first one standing, or in this case, falling down. Portugal could be next, or Spain, or Italy.


Greece has more than $1.26 trillion (1 trillion euros) of public sector debt outstanding. Do you think that a real default isn't going to crush a lot of banks? Wake up. And if you think that Greece defaulting (or even forcing a 50% haircut on private investors, that would be banks, folks) wouldn't spill over into other countries and across the globe... wake up.


Talks in Greece over private investors taking a 50% haircut - meaning they will only get 50 cents on the dollar on the 100 cents they lent out previously and the other 50% they are giving up will be replaced with longer-term bonds yielding less interest - aren't going well. Most analysts and even central bankers believe the haircut needs to be closer to 75% than 50%. Comforting words to be spoken while negotiations are ongoing, right?


Ah, then there's that little downgrade thing that happened on Friday after European markets were closed. Just because the downgrade of the U.S. from AAA to AA+ didn't cause our borrowing costs to rise doesn't mean it isn't going to happen in Euroland.


It will happen. Downgrades will trigger new capital calls as margin requirements will increase to offset the lower quality of collateral, we're talking about the same collateral folks, the same sovereign bonds. It's an increasing pile, make that pyre, and it's going to self-ignite.


We have a big week ahead; we have Citigroup Inc. (NYSE: C), Goldman Sachs Group Inc. (NYSE: GS), and Bank of America (NYSE: BAC) reporting fourth-quarter numbers. We have housing starts (homebuilders are up 60% since their October lows) and new home sales. And Spain and Italy are auctioning off bonds on Thursday.


Our markets have risen nicely. And on Friday, after selling off hard on the S&P downgrade news, they rallied back impressively. I tell you, it's 2007.2.


Stocks are going one way, and credit markets are signaling trouble ahead.


Sovereign debt has replaced subprime as the powder keg. That makes the brewing storm infinitely more powerful than the subprime dust-up was. It's a question of how long before we get the Lehman moment.


We've survived, even thrived, on a series of "liquidity puts," which is what I call all central banks' stimulus and "free and easy" money thrown at banks to keep them afloat. In a politically charged 2012, that could change.


Keep this in mind. If we're facing 2007.2, then 2008.2 is coming right around the corner. It's just a matter of time.


That's why I say play the equity market diligently; we could scrape higher for a while, as we did in 2007. But, when the fat lady sings, it's going to be deafening.


And everyone knows the opera isn't over until the fat lady sings.




The eurozone’s three deadly sins

Stephen King

January 16, 2012




Friday’s actions from Standard and Poor’s were hardly the biggest surprise in the financial universe: the ratings agency warned in December that eurozone nations were in danger of being downgraded.


Germany is, in effect, the last man standing. Others have succumbed to a mixture of three deadly sins: optimism, inaction and omission.



Too many countries are too optimistic about recovery when all the evidence is now pointing towards a eurozone-wide recession. Contracting output will only exacerbate the revenue shortfalls which have already placed countries on unsustainable fiscal paths.



Inaction is, perhaps, inevitable for politicians faced with a difficult trade-off between political expediency and fiscal reality. France, for example, needs to deliver austerity to bring its primary deficit back under control – and also to persuade its eurozone colleagues that Paris is serious about fiscal discipline – yet Nicolas Sarkozy hopes also to win the presidential election this spring.


As for omission, the idea of a fiscal pact is all very well but it doesn’t deal with the shortfall of income which led to today’s crisis. Until the 2008 economic collapse, many countries in Europe had good fiscal records. They would surely have met many of the conditions associated with the proposed fiscal pact.



Fiscal conservatives in the eurozone have, up until now, argued that austerity will bring its own rewards: tighter fiscal policy will lead to lower deficits and lower deficits, in turn, will lead to lower interest rates and, hence, faster economic growth. Throw into the mix the gains to competitiveness of lower labour costs associated with austerity and it suddenly looks like austerity really can pay off.



Within the eurozone, however, the argument hasn’t worked. Greece has its own problems which, if Friday’s breakdown of restructuring talks are anything to go by, are set to get worse.


Even those who have been fiscally-conservative, however, have not been rewarded. Irish 10-year government bond yields are still up at 7.8 per cent, a ludicrously high level given the weakness of economic activity.



In the months ahead, the eurozone’s difficulties are likely to mount. As the contagion spreads, and as investors lose confidence in the ability of countries to deliver lasting fiscal austerity, countries which, to date, have benefited from immunity will also begin to suffer.



Next in the firing line may be Germany, not so much because its bond yields are about to spike higher but, instead, because its exporters are hugely exposed to trade with the rest of the eurozone and its financial institutions are groaning under the weight of the region’s financial disorder.



The narrative may then change. Until recently, the orthodox German take on the crisis was simply to argue that other countries should be more like Germany delivering fiscal conservatism, hard work and a current account surplus. But Germany may end up more like the others, unable to avoid a descent into recession.



That, in turn, could provide the eurozone with an unexpected lifeline. Faced with recession in both the periphery and the core, and with interest rates already close to zero, the European Central Bank may have to bite the bullet and begin a programme of quantitative easing, using newly-created money to buy government bonds. It won’t solve the crisis – that requires a leap of political imagination – but it would at least make the crisis easier to solve.



The writer is group chief economist at HSBC


Gold Trend Forecast for 1st Quarter of 2012

January 15th, 2012 at 11:11 pm



Over the past five months gold has fallen sharply and is no longer headline news which it once dominated back in 2011 when it was making new highs every day. The shiny metal has been under pressure because traders and investors started to pull some money off the table to lock in gains. Gold prices had surged so fast most advanced traders knew that final high volume surge was not sustainable. But the main reason gold topped out in my opinion was because the US Dollar index had put in a bottom and started to build a base. As we all know a rising dollar typically means lower stocks and commodity prices.


I have posted some charts below covering gold in detail using multiple time frames. The weekly which is long term, daily which is the intermediate trend and the 4 hour chart which shows gold momentum and intraday action. At the very bottom I talk about the US Dollar and what is happening with that.

Gold Weekly Long Term Trend Analysis


The weekly chart is not the most exciting time frame to follow as you will grow old watching it. That being said it is crucial for understanding the long term trend, price and volume analysis.


Below you can see that gold’s recent pullback has been a 3 wave correction, which is a normal pullback for any investment. But taking into account the rally from 2008 – 2011 I feel this pullback will have one more low put in before bottoming out. This would make for a 5 wave correction much like what happened in 2008.

Gold Trend Forecast



Daily Chart of Gold Showing the Intermediate Trend


The daily chart allows us to see gold intra-week price action and use the 150 moving average which is my preferred daily moving average. As you can see we are getting a similar pullback as 2008 with gold now trading under the 150 MA.


I would like to see gold make another lower low in the next 2-3 months. If that happens I feel it complete the correction and trigger a strong multi month or multiyear rally in gold.

Gold Price Forecast


4 Hour Intraday Chart of Gold

The 4 hour chart of gold allows us to see all the intraday price action which would normally not be seen with a daily chart. It also gives us enough data to build our analysis upon.


My preferred setup for gold which I feel if happens will trigger major buying in the yellow metal. If/when we get a rally in gold would also likely mean some more economic uncertainty has entered the market either from within the USA, Europe or China.

Gold Trading Newsletter Forecast


Weekly Dollar Index Long Term Analysis

The dollar has the potential to rally to the 87 – 88 level before putting in a major top. For this to happen we will need to see the Euro crumble (both currency and countries divide) in my opinion.


If you look at the weekly chart of gold and this chart of the dollar index you will notice that gold topped when the dollar bottomed. Over the past couple year’s gold and the dollar have had an inverse relationship to each other.


With all kinds of crap about to hit the fan overseas I think it’s very possible gold will rally with the dollar. Reason being there is way more people overseas who want to unload their euro’s and with all the negative talk and doubt with the US Dollar individuals will naturally want to buy more gold.

Dollar Index Trend



Weekend Trend Trading Conclusion:


In short, I expect a bumpy ride for both stocks and commodities in the first quarter of 2012. With any luck gold will pull back into my price zone shaking the majority of short term traders out just before it bottoms. And we will be positioning ourselves for a strong rally buying into their panic selling.


To just touch base on the general stock market quickly. I have a very bearish outlook for stocks. If the dollar continues to rise it is very likely the stock market will fall into a bear market. So I am VERY cautious with stock at this time.


Chris Vermeulen