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Five years on, the Great Recession is turning into a life sentence

Five years into the Long Slump it almost seems as if we are back to square one.

By Ambrose Evans-Pritchard, International business editor

5:30PM BST 12 Aug 2012

Five years into the Long Slump it almost seems as if we back to square one.
 
Some date the crisis to August 9 2007, the day it became clear that Europe’s banks were up to their necks in US housing debt. The ECB flooded markets with €95bn of liquidity. It seemed a lot of money then. The term “trillion” was still banned by the Telegraph style book in those innocent days. We have since learned to swing with the modern dance music from central banks. Photo: Reuters



China is sufficiently alarmed by the flint hardness of its "soft-landing" to talk up trillions of fresh stimulus. The European Central Bank is preparing to printwhatever it takesto save Spain and Italy. Markets are pricing in an 80pc chance of yet more printing by the US Federal Reserve in September or soon after.



There is no doubt that the three superpowers acting in concert can launch a mini-cycle of growth early next year - assuming they deliver on their rhetoric - but the twin headwinds of debt-leveraging and excess manufacturing plant across the globe cannot easily be conjured away.



The world remains in barely contained slump. Industrial output is still below earlier peaks in Germany (-2), US (-3), Canada (-8) France (-9), Sweden (-10), Britain (-11), Belgium (-12), Japan (-15), Hungary (-15) Italy (-17), Spain (-22), Greece (-27), according to St Louis Fed data. By that gauge this is proving more intractable than the Great Depression.



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Some date the crisis to August 9 2007, the day it became clear that Europe’s banks were up to their necks in US housing debt. The ECB flooded markets with €95bn of liquidity. It seemed a lot of money then. The termtrillion” was still banned by the Telegraph style book in those innocent days. We have since learned to swing with the modern dance music from central banks.



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For me, the defining moment was twelve days later when yields on 3-month US Treasury bills crashed from 3.76pc to 2.55pc in just two hours. At first we thought it was a mistake, a screen glitch. Nothing like this had happened before, not during the crashes of 1929 or 1987, or after the Twin Towers attack on 9/11.



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Investors were pulling money out of America’s $2.5 trillion money market industry in panic. This was the long-feared heart attack in the credit system, even if the economic malaise behind it did not become clear for another year.




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The original trigger for the Great Recession has since faded into insignificance. America’s house price bubble -- modest by European or Chinese standards -- has by now entirely deflated. Warren Buffett is betting on a rebound. Fannie and Freddie are making money again.




Five years on it is clear that subprime was merely the first bubble to pop, a symptom not a cause. Europe had its own parallel follies. Britons were extracting almost 5pc of GDP each year in home equity by the end. Spain built 800,000 homes in 2007 for a market of 250,000. Iceland ran amok, so did Latvia and Hungary. The credit debacle was global. If there was an epicentre, it was Europe’s €35 trillion banking nexus.




Monetarists blame the ECB and the Fed for keeping money too tight in early to mid 2008, pushing a fragile credit system over the edge. They blamepro-cyclicalregulators for aborting recovery ever since by forcing banks to raise asset ratios too fast. They are right on both counts.



Yet the `Austrian School is surely right as well to argue that a rise in debt ratios across the rich world from 167pc of GDP to 314pc in just thirty years was bound to end badly. There comes a point when extra debt draws down prosperity from the future. The future arrived in 2008.




A study by Stephen Cecchetti at the Bank for International Settlements concludes that debt turnsbad” at roughly 85pc of GDP for public debt, 85pc for household debt, and 90pc corporate debt. If all three break the limit together, the system loses its shock absorbers.




Debt is a two-edged sword. Used wisely and in moderation, it clearly improves welfare. Used imprudently and in excess, the result can be disaster,” he said.




Creditors and debtors may in theory offset each other, but what actually happens in a crunch is that borrowers cut back feverishly. Creditors do not offset the effect. The whole system spins downwards. It is debt’s fatalasymmetry”, long overlooked by New Keynesian orthodoxy.




It is how people behave, and how countries behave. Creditor Germany did not offset the squeeze in Club Med. Creditor China did not offset the squeeze in the US. The world contracted.



But why did the credit bubble happen in the first place? You could argue that it is merely the flip-side of too much saving. The world savings rate has crept up to a modern-era high of 24pc of GDP. That is the most important single piece of information you need to know to understand the great economic drama we are living through.



There is nowhere for this money to go. The funds flood into investment -- now a world record 49pc of GDP in China -- or into asset bubbles.



So my candidate for chief cause is Asia’s `Savings Glut, and indeed whole the structure of East-West trade under globalisation.



The emerging powers built up $10 trillion of foreign reserves -- ie bonds -- in a decade. They flooded the global bond market. That is why spreads on 10-year Greek debt fell to a wafer-thin 26 basis points over Bunds in the bubble.



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They also flooded Western markets with cheap goods, driving down goods inflation. Western central banks -- in thrall to inflation-targeting -- cut short-term interest rates ever lower. They set the price of credit too low, forcing pension funds and insurers to hunt frantically for yield to match their books. The central banks compounded the effect.




Western multinationals played their part in this saga. They drove up the profit share of GDP to historic highs, playing off wage rates in the US and Europe against cheaper labour in China, Latin America, or Eastern Europe. That too concentrated wealth among those who tend to buy shares, land, and Impressionist paintings, rather than goods. The GINI coefficient of income inequality went through the roof, as it did in the late 1920s. It is a formula for asset bubbles.




The credit bubble disguised the exorbitant imbalances in trade, capital flows, and incomes. The game could continue only as long as the West in general -- and the Anglosphere and Club Med in particular -- were willing to run ruinous current account deficits, borrowing themselves into dire trouble.




As soon as the debtors hit the brakes and slashed spending, the underlying reality was exposed. There is too much saving and too little consumption in the world to keep growth, and people in jobs. It is the 1930s disease. On this the Keynesians are right.



None of this would have been any different if banks had been saints. The forces at work are tidal in power.





So this is where we are in the summer of 2012. The imbalances are slowly correcting. Wage inflation has eroded Asia’s competitiveness. China’s current account surplus has dropped from 10pc of GDP in 2007 to around 2.5pc this year.



Yet Europe refused to adjust. Germany is still running a surplus of 5.2pc, down from 7.4pc in 2007. The North has refused to offset the demand squeeze in Club Med.



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Indeed, Germany legislated its own internal squeeze through a balanced budget law and imposed this curse on the rest of Euroland. The effect is to trap Euroland in chronic slump, at least until the victims rebel and take matters into their own hands.



As for our debt mountain, we have barely begun the great purge. Michala Marcussen from Societe Generale says the healthy level is around 200pc of GDP for advanced economies. If so, we have 100 points to cut.
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This cannot be achieved by austerity alone because economic contraction would tip us all into a Grecian vortex. Such a cure is self-defeating.



Much of the debt will have to be written off. Whether this done by inflation (1945-1952) or default (1930-1934) will be the great political battle of this decade. Pick your side. Pick your history.




Currency's Days Seen Numbered
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Investors Prepare for Euro Collapse
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By Martin Hesse
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08/13/2012 05:17 PM
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Banks, companies and investors are preparing themselves for a collapse of the euro. Cross-border bank lending is falling, asset managers are shunning Europe and money is flowing into German real estate and bonds. The euro remains stable against the dollar because America has debt problems too. But unlike the euro, the dollar's structure isn't in doubt.





Otmar Issing looks a bit tired. The former chief economist at the European Central Bank (ECB) is sitting on a barstool in a room adjoining the Frankfurt Stock Exchange. He resembles a father whose troubled teenager has fallen in with the wrong crowd. Issing is just about to explain again all the things that have gone wrong with the euro, and why the current, as yet unsuccessful efforts to save the European common currency are cause for grave concern.




He begins with an anecdote. "Dear Otmar, congratulations on an impossible job." That's what the late Nobel Prize-winning American economist Milton Friedman wrote to him when Issing became a member of the ECB Executive Board. Right from the start, Friedman didn't believe that the new currency would survive. Issing at the time saw the euro as an "experiment" that was nevertheless worth fighting for.



Fourteen years later, Issing is still fighting long after he's gone into retirement. But just next door on the stock exchange floor, and in other financial centers around the world, apparently a great many people believe that Friedman's prophecy will soon be fulfilled.



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Banks, investors and companies are bracing themselves for the possibility that the euro will break up -- and are thus increasing the likelihood that precisely this will happen.



There is increasing anxiety, particularly because politicians have not managed to solve the problems. Despite all their efforts, the situation in Greece appears hopeless. Spain is in trouble and, to make matters worse, Germany's Constitutional Court will decide in September whether the European Stability Mechanism (ESM) is even compatible with the German constitution.



There's a growing sense of resentment in both lending and borrowing countries -- and in the nations that could soon join their ranks. German politicians such as Bavarian Finance Minister Markus Söder of the conservative Christian Social Union (CSU) are openly calling for Greece to be thrown out of the euro zone. Meanwhile the the leader of Germany's opposition center-left Social Democrats (SPD), Sigmar Gabriel, is urging the euro countries to share liability for the debts.



On the financial markets, the political wrangling over the right way to resolve the crisis has accomplished primarily one thing: it has fueled fears of a collapse of the euro.




Cross-Border Bank Lending Down




Banks are particularly worried. "Banks and companies are starting to finance their operations locally," says Thomas Mayer who until recently was the chief economist at Deutsche Bank, which, along with other financial institutions, has been reducing its risks in crisis-ridden countries for months now. The flow of money across borders has dried up because the banks are afraid of suffering losses.



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According to the ECB, cross-border lending among euro-zone banks is steadily declining, especially since the summer of 2011. In June, these interbank transactions reached their lowest level since the outbreak of the financial crisis in 2007.




In addition to scaling back their loans to companies and financial institutions in other European countries, banks are even severing connections to their own subsidiaries abroad. Germany's Commerzbank and Deutsche Bank apparently prefer to see their branches in Spain and Italy tap into ECB funds, rather than finance them themselves. At the same time, these banks are parking excess capital reserves at the central bank. They are preparing themselves for the eventuality that southern European countries will reintroduce their national currencies and drastically devalue them.


 


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"Even the watchdogs don't like to see banks take cross-border risks, although in an absurd way this runs contrary to the concept of the monetary union," says Mayer.




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Since the height of the financial crisis in 2008, the EU Commission has been pressuring European banks to reduce their business, primarily abroad, in a bid to strengthen their capital base. Furthermore, the watchdogs have introduced strict limitations on the flow of money within financial institutions. Regulators require that banks in each country independently finance themselves.



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For instance, Germany's Federal Financial Supervisory Authority (BaFin) insists that HypoVereinsbank keeps its money in Germany. When the parent bank, Unicredit in Milan, asks for an excessive amount of money to be transferred from the German subsidiary to Italy, BaFin intervenes.




Breaking Points

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Unicredit is an ideal example of how banks are turning back the clocks in Europe: The bank, which always prided itself as a truly pan-European institution, now grants many liberties to its regional subsidiaries, while benefiting less from the actual advantages of a European bank. High-ranking bank managers admit that, if push came to shove, this would make it possible to quickly sell off individual parts of the financial group.




In effect, the bankers are sketching predetermined breaking points on the European map. "Since private capital is no longer flowing, the central bankers are stepping into the breach," explains Mayer.



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The economist goes on to explain that the risk of a breakup has been transferred to taxpayers. "Over the long term, the monetary union can't be maintained without private investors," he argues, "because it would only be artificially kept alive."




The fear of a collapse is not limited to banks. Early last week, Shell startled the markets.




"There's been a shift in our willingness to take credit risk in Europe," said CFO Simon Henry.




He said that the oil giant, which has cash reserves of over $17 billion (€13.8 billion), would rather invest this money in US government bonds or deposit it on US bank accounts than risk it in Europe.



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"Many companies are now taking the route that US money market funds already took a year ago: They are no longer so willing to park their reserves in European banks," says Uwe Burkert, head of credit analysis at the Landesbank Baden-Württemberg, a publicly-owned regional bank based in the southern German state of Baden-Württemberg.




And the anonymous mass of investors, ranging from German small investors to insurance companies and American hedge funds, is looking for ways to protect themselves from the collapse of the currency -- or even to benefit from it. This is reflected in the flows of capital between southern and northern Europe, rapidly rising real estate prices in Germany and zero interest rates for German sovereign bonds.
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'Euro Experiment is Increasingly Viewed as a Failure'




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One person who has long expected the euro to break up is Philipp Vorndran, 50, chief strategist at Flossbach von Storch, a company that deals in asset management. Vorndran's signature mustache may be somewhat out of step with the times, but his views aren't. "On the financial markets, the euro experiment is increasingly viewed as a failure," says the investment strategist, who once studied under euro architect Issing and now shares his skepticism. For the past three years, Vorndran has been preparing his clients for major changes in the composition of the monetary union.




They are now primarily investing their money in tangible assets such as real estate. The stock market rally of the past weeks can also be explained by this flight of capital into real assets. After a long decline in the number of private investors, the German Equities Institute (DAI) has registered a significant rise in the number of shareholders in Germany.




Particularly large amounts of money have recently flowed into German sovereign bonds, although with short maturity periods they now generate no interest whatsoever. "The low interest rates for German government bonds reflect the fear that the euro will break apart," says interest-rate expert Burkert. Investors are searching for a safe haven. "At the same time, they are speculating that these bonds would gain value if the euro were actually to break apart."




The most radical option to protect oneself against a collapse of the euro is to completely withdraw from the monetary zone. The current trend doesn't yet amount to a large-scale capital flight from the euro zone. In May, (the ECB does not publish more current figures) more direct investments and securities investments actually flowed into Europe than out again. Nonetheless, this fell far short of balancing out the capital outflows during the troubled winter quarters, which amounted to over €140 billion.




The exchange rate of the euro only partially reflects the concerns that investors harbor about the currency. So far, the losses have remained within limits. But the explanation for this doesn't provide much consolation: The main alternative, the US dollar, appears relatively unappealing for major investors from Asia and other regions. "Everyone is looking for the lesser of two evils," says a Frankfurt investment banker, as he laconically sums up the situation. Yet there's growing skepticism about the euro, not least because, in contrast to America and Asia, Europe is headed for a recession.




Mayer, the former economist at Deutsche Bank, says that he expects the exchange rates to soon fall below 1.20 dollars.




"We notice that it's becoming increasingly difficult to sell Asians and Americans on investments in Europe," says asset manager Vorndran, although the US, Japan and the UK have massive debt problems and "are all lying in the same hospital ward," as he puts it. "But it's still better to invest in a weak currency than in one whose structure is jeopardized."
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Hedge Fund Gurus Give Euro Thumbs Down





Indeed, investors are increasingly speculating directly against the euro. The amount of open financial betting against the common currency -- known as short positioning -- has rapidly risen over the past 12 months. When ECB President Mario Draghi said three weeks ago that there was no point in wagering against the euro, anti-euro warriors grew a bit more anxious.





One of these warriors is John Paulson. The hedge fund manager once made billions by betting on a collapse of the American real estate market. Not surprisingly, the financial world sat up and took notice when Paulson, who is now widely despised in America as a crisis profiteer, announced in the spring that he would bet on a collapse of the euro.





Paulson is not the only one. Investor legend George Soros, who no longer personally manages his Quantum Funds, said in an interview in April that -- if he were still active -- he would bet against the euro if Europe's politicians failed to adopt a new course. The investor war against the common currency is particularly delicate because it's additionally fueled by major investors from the euro zone.




German insurers and managers of large family fortunes have reportedly invested with Paulson and other hedge funds. "They're sawing at the limb that they're sitting on," says an insider.





So far, the wager by the hedge funds has not paid off, and Paulson recently suffered major losses.



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But the deciding match still has to be played.





Translated from the German by Paul Cohen


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August 11, 2012
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Breaking a Buck, Maybe, but Not Taxpayers’ Backs
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By GRETCHEN MORGENSON






MARK Aug. 29 on your calendar. It’s the day all of us could end up on the hook for a big future bailout.



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The Securities and Exchange Commission is expected to vote that day on a proposal that would limit taxpayers’ exposure to the $2.6 trillion world of money market mutual funds. The plan would reduce the odds of having to rescue teetering funds when the next financial crisis comes — and it will.



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Money market funds are a huge cog in the nation’s financial machinery. Many people think that these funds are as safe as federally insured bank deposits. In most cases, they aren’t. But then, in the dark days of 2008, a run on one fund, Reserve Primary, reverberated in the industry.



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Investors fled, and the Treasury stepped in. It earmarked $50 billion to protect money market funds and to prevent them from “breaking the buck,” or having their shares fall below the sacrosanct $1 net asset value. Of course, if the government rides to the rescue once, the thinking goes, it will surely do so again.



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But the S.E.C. has a plan to make money market funds safer, at least for taxpayers. It has proposed that funds set aside enough capital to withstand future runs.



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It has also suggested that funds’ share prices reflect investment reality. Right now, prices are reported daily as $1, regardless of gyrations in funds’ investments.


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A spokesman for Mary Schapiro, chairwoman of the S.E.C., said she is “committed to enhancing structural safeguards of money market funds so that investors are better protected and future taxpayer bailouts can be avoided.”



      
Not surprisingly, the fund industry sees it differently. Capital requirements would be costly and drive investors away, fund backers say. Letting share prices fluctuate would also cause investors to flee, seeking more stable instruments.



      
Testifying before Congress in June, Paul Schott Stevens, the head of the Investment Company Institute, the fund industry’s lobbying group, said regulators were making a mistake — that they were viewing money market funds through the lens of 2008. He also noted that while the banking sector encountered multiple and large failures during the turmoil, only one money fund failed to return a $1 share price to investors.



But five years after the financial crisis erupted, it’s hard to see why investors and regulators wouldn’t consider how any part of the financial system held up to the extreme stress of that period. And it is worth asking whether other money market funds might have broken the buck if the government hadn’t stepped in.


 
 

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DOCUMENTS recently produced by the Treasury in response to a Freedom of Information Act request support this view. The materials indicate that when the insurance program began, market values of more than a dozen money market funds’ portfolios had fallen below $1 a share. The information request was made by Linus Wilson, an assistant finance professor at the B. I. Moody III College of Business Administration at the University of Louisiana, Lafayette.



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Under the terms of the program, money funds paid to participate based on the market values of their portfolios as reported to the government. Those whose market-based net asset values were at least 99.75 cents were asked to pay one basis point, or hundredth of a percentage point, per dollar of insurance every three months, while funds with values of between 99.5 cents and 99.75 cents had to pay 1.5 basis points per dollar. The increased insurance cost reflected the increased risk that a guarantee might have to be paid to holders of these funds.




If a fund broke the buck and was liquidated, shareholders were supposed to receive $1 a share within 30 days. No fund did, and the program registered no losses over its one-year term. The Treasury received $1.2 billion in premiums from participants.



Last August, Mr. Wilson asked Treasury for a list of program participants and an accounting of the insurance premiums they paid. He received a tally of more than 300 funds last week and, by comparing the premiums they paid to the assets they reported, he determined how many funds had less than $1 in assets for every share outstanding. The funds with 99.5-cent net asset values were those that could have come closest to breaking the buck, he said.



Among the funds reporting values of around 99.5 cents, the five largest had assets totaling $31.5 billion insured under the program, Mr. Wilson calculated. The largest fund in the category was the DWS Money Market Trust, at the time a $12.6 billion fund overseen by Deutsche Bank; it was followed by a Russell Investments money market fund and T. Rowe Price Prime Reserve, both then at $6.4 billion.



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Brian Lewbart, a spokesman for T. Rowe Price, said its fund maintained a $1 share value and never had to tap the program. Along with other money fund providers, we participated in the program to provide an additional layer of reassurance for our money fund shareholders during a difficult period for credit markets,” he said.


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A spokeswoman for Russell said, “The global financial crisis of 2008 was extraordinary for the industry and we took all steps with an eye toward the interest of our shareholders.” A Deutsche Bank spokesman declined to comment.





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The government’s offer to rescue funds in 2008 opens the door to future bailouts, Mr. Wilson said. “That prospect may lead to careless behavior by sponsors and investors seeking yield,” he added. As a result, he supports the S.E.C.’s idea of requiring that funds maintain a capital cushion.



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FURTHERMORE, even though the government incurred no losses in the temporary program, the premiums it extracted from participants were inadequate for the risks involved, Mr. Wilson said. 



     
“To break even on the money market guarantee program, the U.S. Treasury needed to charge between 13 and 34 basis points per annum,” he said. “The 4- to 6-basis-point fee was far too low.”


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Yet again, in the heat of the financial crisis, the government granted generous guarantees to private industry far too cheaply. This will always be the tendency when regulators have to put out a financial wildfire. That’s why it is so crucial that the industrywhether a bank or a money-market fundbe required to set aside enough cash before the next crisis hits