June 8, 2012 8:04 pm
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Berlin is ignoring the lessons of the 1930s
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Is it one minute to midnight in Europe?



We fear that the German government’s policy of doingtoo little too laterisks a repeat of precisely the crisis of the mid-20th century that European integration was designed to avoid.



We find it extraordinary that it should be Germany, of all countries, that is failing to learn from history. Fixated on the non-threat of inflation, today’s Germans appear to attach more importance to 1923 (the year of hyperinflation) than to 1933 (the year democracy died). They would do well to remember how a European banking crisis two years before 1933 contributed directly to the breakdown of democracy not just in their own country but right across the European continent.



We have warned for more than three years that continental Europe needs to clean up its banks’ woeful balance sheets. Next to nothing has been done. In the meantime, a silent run on the banks of the eurozone periphery has been under way for two years now: cross-border, interbank and wholesale funding has rolled off and been substituted with European Central Bank financing; and “smart money” – large uninsured deposits of wealthy individuals – has quietly departed Greek and otherClub Medbanks.



But now the public is finally losing faith and the silent run may spread to smaller insured deposits. Indeed, if Greece were to leave the eurozone, a deposit freeze would occur and euro deposits would be converted into new drachmas: so a euro in a Greek bank really is not equivalent to a euro in a German bank. Greeks have withdrawn more than €700m from their banks in the past month.



More worryingly, there was also a surge in withdrawals from some Spanish banks last month. The government’s bungled bailout of Bankia has only heightened public anxiety. On a recent visit to Barcelona, one of us was repeatedly asked if it was safe to leave money in a Spanish bank. This kind of process is potentially explosive. What today is a leisurelybank jog” could easily become a sprint for the exits. In the event of a Greek exit, rational people would ask: who is next?



The way out of this crisis seems clear. First, there needs to be a programme of direct recapitalisation – via preferred non-voting shares – of eurozone banks, in the periphery and the core, by the European Financial Stability Facility and its successor, the European Stability Mechanism.



The current approach of recapitalising the banks by the sovereigns borrowing from domestic bond markets – and/or the EFSF – has been a disaster in Ireland and Greece: it has led to a surge of public debt and made the sovereign even more insolvent while making banks more risky as an increasing amount of the debt is in their hands.



Second, to avoid a run on eurozone banks – a certainty in the case of a Greek exit and likely in any case – an EU-wide system of deposit insurance needs to be created.


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To reduce moral hazard (and the equity and credit risk taken by eurozone taxpayers), several additional measures should also be implemented.



The deposit insurance scheme has to be funded by appropriate bank levies: this could be a financial transaction tax or, better, a charge on all bank liabilities.



There needs to be a bank resolution scheme in which unsecured creditors of banks – both junior and senior – would take a hit before taxpayer money is used.



Measures to limit the size of banks to avoid the too-big-to-fail problem need to be taken.



We also favour an EU-wide system of supervision and regulation.


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It is true that European-wide deposit insurance will not work if there is a continued risk of a country leaving the eurozone. Guaranteeing deposits in euros would be expensive as the departing country would need to convert all euro claims into a national currency, which would swiftly depreciate against the euro. On the other hand, a deposit insurance scheme that holds only if a country doesn’t leave will be incapable of stopping a bank run. So, more needs to be done to reduce the probability of eurozone exits.



Structural reforms that boost productivity growth should be accelerated. And economic growth needs to be jump-started. The policies to achieve this include further monetary easing by the ECB, a weaker euro, some fiscal stimulus in the core, more bottleneck-reducing and supply-stimulating infrastructure spending in the periphery (preferably with some kind of “golden rule” for public investment), and wage increases above productivity in the core to boost income and consumption.




Finally, given the unsustainably high public debts and borrowing costs of certain member states, we see no alternative to some kind of debt mutualisation.



There are currently a number of different proposals for eurozone bonds. Among them, the German Council of Economic Advisers’ proposal for a European redemption fund is to be preferrednot because it is optimal but because it is the only one that can assuage German concerns about taking on too much credit risk.



The ERF is a temporary programme that does not lead to permanent eurozone bonds. It is supported by appropriate collateral and seniority for the fund and has strong conditionality. The main risk is that any proposal acceptable to Germany would imply such a loss of sovereignty over fiscal policy that it would be unacceptable to the periphery, particularly Italy and Spain. Giving up some sovereignty is inevitable. However, there is a difference between federalism and “neo-colonialism” – as a senior figure put it to us at a meeting of the Nicolas Berggruen Institute in Rome.



Until recently, the German position has been relentlessly negative on all such proposals. We understand German concerns about moral hazard. Putting German taxpayers’ money on the line will be hard to justify if meaningful reforms do not materialise on the periphery. But such reforms are bound to take time. Structural reform of the German labour market was hardly an overnight success. By contrast, the European banking crisis is a real hazard that could escalate in days.



Germans must understand that bank recapitalisation, European deposit insurance and debt mutualisation are not optional; they are essential to avoid an irreversible disintegration of Europe’s monetary union. If they are still not convinced, they must understand that the costs of a eurozone break-up would be astronomically high – for themselves as much as anyone.



After all, Germany’s prosperity is in large measure a consequence of monetary union. The euro has given German exporters a far more competitive exchange rate than the old Deutschmark would have. And the rest of the eurozone remains the destination for 42 per cent of German exports. Plunging half of that market into a new Depression can hardly be good for Germany.



Ultimately, as Angela Merkel, the German chancellor, herself acknowledged last week, monetary union always implied further integration into a fiscal and political union. But before Europe gets anywhere near taking this historical step, it must first of all show it has learnt the lessons of the past. The EU was created to avoid repeating the disasters of the 1930s. It is time Europe’s leaders – and especially Germany’sunderstood how perilously close they are to doing just that.


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Copyright The Financial Times Limited 2012.



"Gold Monetization And The Big Reset"

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Macroeconomic Problems

1) The global banking system is functionally insolvent and will fail without exogenous policy action*
  • There is one, interconnected global banking system linked by global financial markets and coordination among currency boards and central banks

  • In the current banking system model, debts due tomorrow are serviced by newly-incurred debts today (which create deposits)

  • Stagnant or declining nominal global asset prices since 2008 have stressed bank balance sheets
    • Loan book marks remain at substantial premiums to:
      • The present value of their cash flows in real terms

      • Liquidation prices at current or higher interest rates

  • Central bank easing and asset purchases to date have only tempered the rate of asset price declines

  • Current adversity among European banks directly impacts global commerce and finance


*Bank balance sheets can deleverage either via nominal write-downs of assets, (leading to outright failure/insolvency as tangible equity is extinguished), or through nominal increases in system reserves via base money inflation (provided by central banks as they expand their own balance sheets)

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2) Governments and private parties are heavily-indebted and this indebtedness is growing exponentially

  • In the aggregate, the public and private sectors have “borrowed money into existence” for decades, as fractionally-reserved banks have created unreserved deposits and extended unreserved credit

  • In the net, private sector borrowing has stagnated and is prone to contraction

  • In response, public sector borrowings have been increased measurably to fill this gap

  • Public sector debts and deficits are increasing

  • The global economy is rapidly approaching the point where neither the public sector nor the private sector can service debts to the degree required to maintain asset prices, which, in turn, removes incentives to borrow further

  • The temporary benefit of growing debt obligations supporting ever-increasing nominal assets prices is now prone to reversal

  • Should global bank balance sheets thus contract, so would the global pool of bank deposits

  • Contracting bank deposits implies contracting money supplies and attendant deflationary pressures


3) The global economy is threatened because, in real terms, it continues to misallocate capital

  • The global relative price spectrum does not reflect true value and therefore is contributing to the general economic and financial malaise
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      Wealth and income concentration stemming from the asymmetric rise of asset prices tends to be self-reinforcing, and thus suffocates purchasing power for most economic participants (“the 99%”)


  • The more one pays for productive assets, the less one can pay for labor or other productive inputs

  • The extension of unreserved bank credit has fed the feedback loop of nominal asset price inflation (i.e. bubbles and subsequent busts)
    • Wages and basic input pricing has thus lagged, in relative terms, the robust upward trend of asset pricing

  • Over-priced assets have led to capital over-investment in many industries/projects
    • Unsupportable by labor inputs or unaffordable at current wage levels

  • Most developed economies have morphed into financial economies, which over time have become fragilely dependent on net imports to sustain living standards

  • The current propensity of both public and private sectors to channel ever more income towards debt service is threatening the debt-for-debt feedback loop that has maintained the appearance of stability since 2008 


European sovereign issues

  • global real estate setbacks

  • declining public participation in equity and other leveraged asset markets


The Expedient Solution: Policy-Administered Asset Monetization



1) Re-monetize gold as the asset against which newly-created central bank liabilities (base money) are created

  • Gold purchases would serve to promote deleveraging in two manners:
    • 1) via base money (bank reserve) creation and,

    • 2) by providing the currency proceeds to fiscal agents to retire existing debts

  • The threat of waning confidence in the currency unit in response to expanding central bank balance sheets would be arrested by a gold price peg in the aftermath of the base money expansion

  • Any future operations to expand the base money stock would require additional purchases of gold at, most likely, higher and higher nominal prices or exchange rates

  • A gold peg would thus act both as a deleveraging agent today and a fiscal/monetary policy discipline looking forward
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The Consequences (Pros & Cons)



1) The global banking system would be deleveraged via base money (bank reserve) inflation


  • Asset monetization is the least painful and most politically expedient option to reverse current conditions in which global bank deposit liabilities are many multiples of reserves (a classic precondition for bank runs)

  • Continued central bank purchases of sovereign debts would merely continue to roll and perpetuate the debts, albeit at attractively low interest rates (starkly negative in real terms)


2) Nominal asset (and bank asset collateral) pricing would be supported and perhaps even inflated

  • As nominal bank reserves grow, the illusion of returning strength to bank balance sheets would be perpetuated

  • The propensity for privileged speculators to place their “risk-onbets would likely increase


3) Public and private sector debts from the prior extension of unreserved bank credit would, at the margin, be paid down with the base money creation stemming from central bank asset purchases


  • Public debts in particular could be paid down in the event fiscal agents were to sell official gold holdings to their respective central bank (central bank purchases of gold then would be, in the net, debt-extinguishing and thus, deleveraging)


4) Wages and consumables pricing would rise in asset-price terms, which would arrest and begin to reverse the political consequences of several decades of wealth and income redistribution to the top 1%

  • An easy political posture to take for those who choose to promote it


5) Asset prices would decline relative to current and future expectations of consumption expenses which, in turn, would lead to lower living standards than currently anticipated by those asset holders


  • A necessary evil; however, the loss of future purchasing power as assets are sold to fund future consumption is alreadybaked in the cake

  • This loss of perceived value can either be crystallized and recognized today so the real economy can begin to rebalance and establish a foundation for growth, or, in the alternative, be suspended -- a slow and time-consumingdeath by a thousand cuts malaise (e.g. Japan’s lost decade[s])

6) Rising relative and nominal wages would support debt-servicing capacity going forward


  • Would promote debt pay-downs at par, which better ensures banking system solvency

  • Would raise wages relative to debt, a powerful political palliative


7) Banks, being agnostic to measures of consumer-type price inflation, would most likely see the nominal pricing of their current pool of assets rise, which would eventually restore their solvency because the nominal valuations of their liabilities are generally fixed


  • The value of the currency unit is a common denominator to both sides of bank’s balance sheet

  • Real losses/gains on one side of the balance sheet are simultaneously and proportionately offset with real losses/gains on the other side

  • However, this would not hold for nominal losses (insolvency would result if a bank were to go into a negative equity position should the variable nominal valuation of its assets decline as the nominal valuation of its liabilities remains constant)

8) Deleveraged government balance sheets would have less impact on private asset values and marketplace pricing


  • The political dimension could review and renew optimal levels of participation and capital market intervention

9) No overall meaningful impact on the general price level (but, as implied above, there would likely be a migration of value, in real terms, from leveraged assets to unleveraged goods, services and assets)

  • Stable to higher nominal asset prices would require even higher nominal wage and consumable pricing looking forward

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Conclusion


Asset monetization (and in, particular, gold monetization) would solve many more problems than it would create. The negatives would merely recognize the balance sheet damage already done and beginning to be manifest (first, in the private sector and now, increasingly in the public sector).




Mechanically, policy-administered asset monetization would be quite simple. Using the US as an example, the Fed would purchase Treasury’s gold at a large and specified premium to its current spot valuation. The higher the price, the more base money would be created and the more public debt would be extinguished. An eight-to-tenfold increase in the gold price via this mechanism would fully-reserve all existing US dollar-denominated bank deposits (a full deleveraging of the banking system). An appropriate multiple of today’s spot price could fully-extinguish the public debt if desired.



In terms of the relative price spectrum, a speculative 50% increase in the US median home price would be most-welcomed to the US banking system (and certainly to mortgage holders). Clearly, such an operation would be a subsidy to leveraged asset holders and banks. Would this be another form of perpetuating moral hazard? Superficially, it would be easy to conclude so; however, we think this conclusion would be incomplete. Such a “subsidy” is already embedded and institutionalized in the system. The key distinction would be that the system will have been reset to promote fairness and efficiency going forward. Given today’s circumstances, that should be a universal, non-partisan goal.


Rolling unfunded debts and debating in the political sphere over the merits and risks of unfunded growth or policy-administered national austerity programs is a futile endeavor. The math suggests strongly neither can work. We are convinced policy-administered asset monetization would stop the global financial system from seizing, restore sorely needed economic balance, and reset commercial incentives so that real growth can once again gain traction.



Lee Quaintance & Paul Brodsky
QB Asset Management Company, LLC
pbrodsky@qbamco.com

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Credit Bubble Bulletin
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Pavlovian
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by Doug Noland
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June 08, 2012


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Global systemic stress has been gaining critical momentum, and markets this week were heartened that global policymakers were in the process of mustering meaningful responses. Scores of headlines offered encouragement that European officials were working diligently on a plan to help Spain resolve its banking crisis. While reports were conflicting - and often contradictory - there was a general sense that circumstances had forced the Germans into a softer approach. And as global markets rallied, the fallback view again held sway that when global policymakers recognize the seriousness of a situation they will surely act accordingly – and, as such, “risk on” is alive if not well. Pavlovian.




Confidence in politicians may be rather shallow, yet there remains deep faith in the capacity of central bankers to rise to the occasion and bolster global risk markets. First came comments from ECB president Mario Draghi: “We monitor all developments closely and we stand ready to act.” Fed vice chair Janet Yellen made it clear the Fed was poised to do more: “There are a number of significant downside risks to the economic outlook, and hence it may well be appropriate to insure against adverse shocks that could push the economy into territory where self-reinforcing downward spiral of economic weakness would be difficult to arrest. I am convinced that scope remains for [the Federal Reserve] to provide further policy accommodation either through its forward guidance or through additional balance-sheet actions."




Yet on the policy response front, the biggest surprise this week arrived courtesy of Beijing.The People’s Bank of China reduced lending and deposit rates by 25 bps, the first cut in official rates since 2008. China’s central bank also took measures to loosen lending standards, allowing banks additional flexibility to both discount loans and attract deposits. There were also reports that Chinese bank regulators had delayed the implementation of more onerous bank capital requirements. From Bloomberg: “New draft rules from the China Banking Regulatory Commission aim to setreasonableschedules for banks to meet capital targets in a way that helpsmaintain appropriate credit growth’.” This week Beijing confirmed the bullish consensus view that China’s policymakers will ensure strong economic growth. Meanwhile, data continue to support the thesis that China’s economic and Credit engines are really sputtering.




In Europe, there were reports of special weekend meetings– and perhaps even Spain requesting emergency financial assistance. There are important French parliamentary elections Sunday. And, of course, there is the final countdown to Greece’s June 17th national election, which may be disrupted by a municipal workers strike. Markets confront a minefield of issues, although attention for now seems fixated on renewed policymaker largesse.




In studying past monetary fiascos, I've often been struck by the predictable nature of Credit inflations. Credit booms would be followed by busts – and the arduous downside of the Credit cycle would invariably provoke aggressive policy responses. Historically, governments would resort to printing larger amounts of currency (or simply incorporate more zeros), in increasingly desperate attempts to support post-Bubble faltering economic output, rising unemployment and sinking prices levels (goods and asset prices). 



Often it would come down to a critical dynamic: Policymakers would eventually recognize (admit) that their money printing operations were having deleterious effects. A consensus view would even develop that inflationary policies had to be wound down – if not scuttled altogether. Throughout history, there have been many derivations of the typical pronouncement, “Be on notice, this will be the last time this government resorts to the printing press.” And rarely would it ever work out that way. Indeed, not only would monetary inflations continue, the scope of the money printing would too often escalate to the point of being completely out of control. Once unleashed, monetary inflations take on a life of their own – and turn unwieldy on many levels. And this complex dynamic explains why monetary history is littered with worthless currencies.



Years of “activistcentral banking have conditioned markets to envisage eager-to-please policymakers with flasks in hands at the fountain of everlasting market vigor. Meanwhile, policymakers at this point (four years into crisis management mode) more clearly appreciate both the limits of their monetary tools and the costs associated with ultra-loose monetary conditions and sure-fire market interventions. Markets were nonetheless this week content to cling firmly to the view that markets and policymakers remain on the same page.



Curiously, ECB president Draghi and Fed chairman Bernanke this week seemed to be reading from similar scripts. While both, of course, assured market participants of their respective central banks’ commitment to providing market backstops in times of crisis, each also seemed determined to try to signal to the markets that monetary policy has done about all it can do. Both seemed to recognize that ultra-loose monetary policy has played an integral role in political foot-dragging when it comes to implementing fiscal reform/responsibility. Both were measured in their comments, as if reluctant to incite market animal spirits (i.e. destabilizing speculation).



There is also a view that Drs. Draghi and Bernanke are keen to save some of their central banks’ depleted arsenals in the event of destabilizing fallout post the Greek election. And there is certainly the possibility that the Spanish debt crisis rapidly spirals out of control. When I read a Reuter’s report with sources claiming that Spain would request bailout aid Saturday, I immediately assumed that capital flight must be turning unmanageable. But then a Financial Times article (Peter Spiegel) quoted “a senior European official”: “It is essential that the other euro-area member states are pre-emptively and effectively ringfenced and protected from any possible Greek fallout, before the elections.” This explanation for why Spain would do an about face on EU financial assistance - even before the completion of IMF and private audits of its banking system - seems as reasonable as problematic capital flight.




Spain and the EU face a serious dilemma. Several analysts have gone so far as to state that the euro will be made or lost in Spain. And while the markets seemed to welcome leaks of an imminent Spanish bailout, it might be one of those be careful what you wish formoments. Spain – it’s sovereign, banks, regional governments, corporations and economy – today suffers a market crisis of confidence. Estimates place (guess) the banking system’s capital shortfall in the wide range of between 40bn to 250bn euros. A full-scale Spain IMF/EU bailout program could tally in the hundreds of billions. The chatter is of somebailout lightstrategy that would tide Spain overat least through the Greek election and its immediate aftermath. Do too little and the plan lacks credibility; promise too much and the markets will question where the money is to come from.



The Telegraph’s Ambrose Evans-Pritchard (“Spain too big for EU rescue fund as China recoils”) reminded readers of potential problems associated with the EU’sfirewallfacilities. The EFSF, for example, is backed by euro zone member/creditors. But once a country taps emergency funds it can longer back EFSF borrowings. So the firewall shrinks or the additional liabilities accrue to the other member states. There is also the issue of prospective market appetite for EFSF/ESM debt. Mr. Evans-Pritchard’s article noted that China’s sovereign wealth fund is backing away from European debt. Quoting the chairman of China Investment Corporation: “The risk is too big, and the return too low.”





I have written previously that Europe’sfirewall” was created with the hope/intention that it would never be deployed – a big bazooka that sits there with everyone just kind of assuming it’s loaded and operational. Well, it’s likely to be called upon in a big way and in a hurry. And when the headline crosses that Spain has requested aid, it might very well be seen as good news (“resolves uncertainty”) in the marketplace. I don’t expect it to be long, however, before serious questions arise as to the credibility of the bailout structure. Is the bazooka legit? . Will global investors be willing to buy hundreds of billions of euros of EFSF/ESM debt in an environment where the marketplace surely will have serious questions as to the sustainability of the euro currency regime? Can bailout bond and the euro credibility persevere through the failure of a “core euro zone country?




There were reports that Greek government revenues during May were down 20 to 25% y-o-y. No matter the outcome of the Greek election – or even whether Greece stays or exits the euro – there is little to suggest that this deeply troubled little economy will anytime soon end its status as a quite formidable financialblackhole”. This post-Bubble dynamic makes one really fear for Spain – and the euro. I’ve believed that a preferred strategy – and perhaps the only hope for salvaging the euro - would have been to push the Greeks out of the euro to ensure that the full weight of policymaker attention and European resources could be deployed to “ring-fence” the euro zone’s vulnerable core.” Over the coming days and weeks we’ll instead be faced with the spectacle of a failed periphery (Greece) and a failing core (Spain) perhaps working in concert to pull the fabric of the euro apart at the seams.


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The view that this week provided only the opening policy response salvo is anything but unjustified. If things proceed in Europe (and globally) as I fear, we can expect the ECB to cut rates and implement additional liquidity measures, as the Fed moves forward with additional quantitative easing. The Chinese, Indians, Brazilians and others will stimulate in hope of sustaining faltering booms. And I expect all of these measures to have little, if any, constructive impact on deepening global Credit and economic crises. At the same time, the impact on financial markets is less clear. Even NYC taxi drivers are confident that policy measures are sure to bolster the markets. To what extent will the sophisticated operators now use generous market accommodation to head for the exits? It’s traditionally been referred to as “distribution.” Think Facebook IPO.