Periphery Fragility List

Doug Nolan

Friday, February 27, 2015

There’s a natural ebb and flow to financial markets. It can be clear-cut Greed versus Fear – but often it’s more leaning Risk Embracement or Risk Aversion. Yet these days, little is typical or “natural” when it comes to market behavior. Speculative Dynamics rule: What evolved over time into an unstable, policy-induced Risk On, Risk Off (“RoRo”) dynamic has regressed to a destabilizing Bubble On, Bubble Off ("BoBo"). Desperate policymakers have sunk to blatant promotion of Bubble On. And a protracted liquidity-fueled market dynamic ensures that “money” continues to gravitate to those with a propensity to embrace risk. Pushing the risk envelope has paid handsomely. Use of leverage has been amply rewarded. Popular derivative strategies have performed splendidly.

I have argued that protracted global securities market Bubbles have become increasingly fragile. As such, fledgling signs of risk aversion should be monitored closely. One of these days… Yet latent fragilities are easily masked during periods of risk embracement, speculative leveraging and attendant strong flows. It is the nature of self-reinforcing Bubbles to gain momentum over time. For good reason, market players have been convinced that persistent global fragilities guarantee that policymakers will do “whatever it takes” to sustain abundant market liquidity and risk embracement. The Greek “resolution” further emboldens the view that global markets command politics. The current backdrop of open-ended central bank liquidity ensures that once markets gather a head of steam the sky is the limit.

The powerful Periphery vs. Core Dynamic was prevalent again this week. The S&P 500 and the Dow traded at all-time highs, along with the small-caps and mid-caps. Nasdaq indices are rapidly approaching March 2000 peaks. The Bubbling “Core” is not limited to U.S. securities markets. UK’s FTSE 100 index this week surpassed the previous 1999 record level. Japan’s Nikkei equities index jumped 2.5% to a 15-year high.

“Do whatever it takes” Draghi has by this point incited a full-fledged mania in eurozone securities. The German DAX surged 3.2% this week to an all-time high – increasing 2015 gains to 16.3%. France’s CAC 40 jumped 2.5% to the highest level since May 2008. Stocks in Spain and Italy advanced 2.8% and 2.3%, respectively. Portuguese stocks surged 4.4%, Ireland 3.6%, Netherlands 3.0%, Belgium 2.5% and Denmark 3.5%. Greek stocks recovered 2.8%. It’s become a free-for-all.

Importantly, Bubble On at the Core for now encompasses the debt markets. A couple Bloomberg headlines this week made the point: “Riskiest Debt Has Busiest Start of Year as Investors Demand Higher Yields.” “Dash for Trash Back as Bonds Show Animal Spirits.” Investment-grade CDS this week traded to the lowest level since early-December. Junk CDS dropped to the lows since September. February junk bond returns were the strongest since 2013 (2.3% according to Bloomberg).

And, again, it is not just an American phenomenon. Bloomberg: “Italian Spread Shows Risk Premium Vanishing in Euro Area’s Bonds.” From my perspective, risk perceptions vanished some time ago. This week saw further astonishing yield declines. Italian 10-year yields were down 25 bps, Spain 24 bps and Portugal an incredible 40 bps. At 1.33%, Italian 10-year sovereign yields are a notable manifestation of global securities prices radically divorced from fundamentals. And then there are Japanese yields at 0.32%, French at 0.60%, Spanish at 1.26% and Portuguese at 1.81%. Simply incredible.

The booming Core easily draws attention away from the fragile Periphery. This week saw the Turkish lira slammed for 2.2% to a record low versus the dollar – pushing y-t-d losses to 6.9%. Turkey is vulnerable. The economy remains in a Credit induced boom (Istanbul home prices up 25% y-o-y!). Trade deficits have swelled and inflation has taken hold – a dynamic bolstered by the weak lira. Meanwhile, the central bank is under intense political pressure to cut rates.

February 26 – Reuters (Asli Kandemir and Orhan Coskun): “President Tayyip Erdogan’s broadside against the central bank has raised concern about the future of its governor and of respected Deputy Prime Minister Ali Babacan, an anchor of investor confidence in Turkey for more than a decade. Erdogan on Wednesday slammed the bank's monetary policy as ‘unsuited to the realities of the Turkish economy’ after it failed to meet his repeated demands for sharper rate cuts than those it had made the previous day. He questioned whether the bank was under external influence… ‘If Babacan or Basci are forced out by the Erdogan loyalists I think the market reaction would be severe and brutal,’ said Timothy Ash, head of emerging markets for Standard Bank…, predicting agencies Fitch and Moody's would consider ditching Turkey's investment grade credit rating.”
Turkey’s 10-year lira yields jumped 50 bps this week to 8.23% (high since mid-December). 

Turkey has been near the top of my Periphery Fragility List. Similar to many EM economies, Turkey has luxuriated in six years of ultra-loose financial conditions. Debt has grown tremendously, too much of it dollar-denominated. Turkish bank borrowings have been instrumental in a 50% increase in external debt over the past four years.

Positioned up near the top of the Periphery Fragility List, this week provided added confirmation of mounting trouble for Brazil – the world’s seventh-largest economy. On a much greater scale than Turkey, Brazil’s six-year Credit boom has seen a dramatic increase in inflation, trade deficits and external debt. Brazilian corporations and financial institutions have added enormous amounts of dollar-denominated debt, borrowings that have become increasingly problematic with the real’s almost 20% decline against the dollar over the past year.

February 26 – Wall Street Journal (Will Connors and Paulo Trevisani): “A decision by a major credit-rating firm to downgrade to junk status the debt of Petróleo Brasileiro SA is stoking fears that Brazil’s sovereign rating could be next. Moody’s… late Tuesday slashed the debt of the company, known as Petrobras, two notches to Ba2, two steps below investment grade, on continued concern about the fallout from a corruption scandal and the state-run oil giant’s ability to pay down about $135 billion in debt. The downgrade was the third by Moody’s since October. Still, the size and timing of Tuesday’s cut surprised some analysts and sent the country’s leaders into a defensive crouch. Brazil’s largest company, Petrobras plays an outsize role in the nation’s economy, which is flirting with recession. Petrobras’s newfound junk status is ‘an unequivocal blow’ to the administration of President Dilma Rousseff , Eurasia Group analysts wrote… and ‘there is growing concern over a negative spillover effect in macroeconomic management and potentially in Brazil’s sovereign rating.’”
The Brazilian real’s big Friday bounce erased what would have been another week of losses.

Yet despite Friday’s better performance, key Brazilian CDS prices rose again this week. 

Petrobras CDS traded above 610 Wednesday, up from 460 bps to end 2014 and the year ago 285 bps. Petrobras CDS averaged 185 bps during the four-years 2010-2013, a period when the company doubled its liabilities.

The expanding Petrobras fraud investigation seems to be moving closer to ensnaring the major state-directed Brazilian banks (up at the top of The Fragility List). Banco do Brasil CDS closed the week up 21 bps to 379 bps, after beginning the year at about 300 bps (2014 avg. 249). BNDES (Brazil’s national development bank) CDS jumped 11 bps to 295 bps, after beginning the year at 230 bps (2014 avg. 181). After trading above 13% during Monday’s session, Brazilian sovereign (real) yields ended the week at 12.31%. Brazilian sovereign CDS traded Friday at the highest level (253bps) since April 2009.

Foremost on the Periphery Fragility List, I have posited that dollar-denominated emerging market (EM) debt is a global Credit boom weak link. And no boom has generated external dollar-denominated debt comparable to China’s. Chinese external debt more than doubled over the past four years to approach $1.0 TN. The scope of “hot money” flowing into China in recent years to play an appreciating currency and enticing yields is unknown but surely massive. And with the historic Chinese Bubble now faltering, there are myriad forces working against the renminbi. In a period of intense currency wars, the Chinese peg to king dollar has become a major issue for China’s exporters. There is also the specter of a reversal of speculative flows, spurred on by deteriorating economic prospects and weakened Credit dynamics. And throw in the likelihood that wealthy Chinese have one eye on the exit, fully intending to exit a crumbling Bubble.

February 27 – Financial Times (Patrick McGee and Michael Hunter): “China’s renminbi has touched a 28-month low against the US dollar, the latest slide reflecting central bank activity and investment flows. On Friday the renminbi fell 0.17%, the largest downward move for the tightly-controlled currency in a month… The PBoC ‘fixes’ the currency’s mid-rate each day, allowing investors to then trade the currency 2% higher or lower. The decline in the renminbi continues pressuring Chinese companies that borrowed in US dollars and expected to benefit over time by paying back such debts via an appreciating domestic currency. The rising dollar has upended that strategy and mainland companies are paying down dollar debt to avoid incurring a loss, in turn further boosting demand for the US currency. Dariusz Kowalczyk, senior strategist at Crédit Agricole, said anecdotal evidence suggests there continues to be ‘very strong demand for dollars in the mainland market’ over recent days and weeks, pushing the currency to the low end of its trading band.’”
February 25 – Wall Street Journal (Andrew Browne): “China’s superrich are nervously watching as the Chinese currency weakens against the dollar. Because of the extreme concentration of money at the apex of Chinese society, national stability rests to an extraordinary extent in the hands of just two million or so families. They are the top 1% of urban households, and already, their confidence in China’s future under President Xi Jinping is shaky. Many are fleeing with their cash--not all of it, but enough to bid up prices of luxury real estate from Mayfair to Manhattan to Mission Bay, a waterfront neighborhood of Auckland, New Zealand. Financial authorities are trying to ensure that the remainder doesn’t disappear across the borders. A potential trigger for a disorderly exodus of capital, one that could threaten the entire fragile financial system, would be a precipitous decline in the value of the Chinese currency… There’s little doubt that the growing anxieties of China’s superrich also weigh on currency decision-making. Mr. Xi has shaken up the status quo with the fiercest campaign against corruption in modern times. That’s creating political tensions at the heart of the Communist Party. The Gilded Age is over: We’re in a new era of austerity. All this uncertainty has unsettled the owners of China’s great fortunes who are now focused on protecting their capital.”
The Chinese Credit Bubble has been historic, dwarfing the fateful Japanese Bubble from the eighties. Arguably, China’ Bubble today even exceeds its mirror image U.S. Bubble. I have also referred to the Chinese renminbi link to the dollar as the King of All Currency Pegs. The bullish consensus scoffs at notions of Chinese fragility. With an international reserve position of $3.8 TN (and shrinking), the belief is that China has more than sufficient “money” to stimulate the economy, recapitalize the banking system and support the renminbi. Yet with anecdotes suggesting mounting outflows and heightened nervousness, a destabilizing dislocation in renminbi trading becomes a real possibility.

How long will the PBOC be willing to use its nation’s reserves to allow speculators, fraudsters and Chinese elite to cash out of China at top dollar? Chinese officials confront great challenges that will require difficult decisions. So far, bullish sentiment remains impervious to the major uncertainties enveloping China’s economy, financial system and policymaking. The perception that Chinese officials have everything well under control could soon be challenged.

Meanwhile, signs of Bubble excess have become increasingly conspicuous in the U.S. – Silicon Valley, Manhattan, upper-end real estate around the country, subprime auto loans, jumbo mortgages, record corporate debt issuance, etc. Record stock and bond prices – record prices for anything that provides a yield. Record hedge fund assets, in the face of ongoing performance issues. Record ETF assets. Resurgent derivative markets. A couple other Bloomberg headlines caught my attention this week: “VIX Poised for Record Drop as Stable Oil Ignites Stocks” and “That Awkward Moment When Stocks Rise While Profits Fall.”

Friday from the New York Fed’s William Dudley, as he rationalized his cautious view toward commencing rate normalization: “If the transmission of monetary policy to the real economy is more variable and uncertain, as I believe it is, then monetary policy cannot be put on autopilot guided only by a fixed policy rule.”

Market-based Credit and discretionary monetary policy mix dangerously. Over this long cycle, market-based finance (as opposed to traditional bank lending) has come to dominate system Credit – along with market and economic performance. Policymakers have responded to resulting serial booms and busts with ever more obtrusive activism – including interest rate, liquidity, communication and monetization policies. Policy measures have reached previously unimaginable extremes - pro-speculation, pro-leverage, pro-Credit cycle and pro-maladjustment. It’s not that “the transmission of monetary policy to the real economy is more variable and uncertain.” The critical issue is instead that market-based Credit is inherently highly unstable. That the Fed and global central bankers have responded to this instability with progressively more experimental intervention and manipulation only ensures a momentous calamity. A rules-based policy approach incorporating disincentives for leveraged speculation and financial excess would over time work to restrain speculative cycles and resulting Credit booms and busts.

Shovelin’ Schmitt Against the Tide

John Mauldin

Feb 27, 2015

There is an obsession in the marketplace over the date when the Fed will once again begin to raise rates. As if another 25 basis points is going to change the economics on tens of trillions of dollars of investments. But as we reflect on the issue more deeply, it becomes obvious that a minor bump in the fed funds rate will indeed change a great deal of economics all over the world.

No, it won’t do much to the cap rate on your latest real estate purchase, but it is likely to greatly affect the pricing of the currency and commodity markets. And those markets will affect corporate profits, which will affect the stock market. It’s all connected.

And what if the Fed has lost control? What if they are in a no-win situation where raising rates will cause reactions they don’t want, but not raising rates will result in equally unpleasant reactions?

A big part of the problem lies in what we analysts call divergent and convergent monetary policies. With Japan mounting an unprecedented quantitative easing attack on currencies everywhere and Europe getting ready to join in, with smaller nations all over the world lowering their interest rates, if the US were to raise rates, that move would strengthen the dollar even more. But that would mean even more deflation imported into the US.

Today we find that the headline CPI was -0.7% for January, coming on the heels of two previous months at -0.3%. The year-over-year rate slipped into negative numbers for the first time since October 2009, when we were still reeling from a deep recession. The Fed typically raises rates when it wants to lean into inflation, not when inflation is falling. Yes, I know that Yellen in her testimony and in recent Fed releases has said the Fed is confident that inflation will once again rise to 2%.

And that, even if you take out food and energy, inflation has still risen at 1.6% over the last 12 months.

I want to thank Joan McCullough for allowing me to use the essay she wrote yesterday morning, which is the single best description of the dilemma facing the Federal Reserve that I’ve read in some time. It’s not all that long, and it has Joanie’s irreverent humor sprinkled liberally throughout, so it’s not only a short read, it’s fun.

So our economy will be impacted negatively not by official interest rates; the multinationals also come to mind for the stock pickers. Because we already know that the entire interest-rate, fiscal position, underlying economic metrics relationship has been decommissioned. By the tidal wave of printed money. That has us comin’ and goin’ at the moment. With the present “beneficiary,” the US Dollar. We started it. We flooded it. We yanked it back. It’s their turn now.

The situation with the Fed and its impact on the global economy is starting to get really interesting. I am really looking forward to my conference, where I will have both those who believe the Fed can control things and others who are equally convinced that the world is about to change profoundly no matter what the Fed does. I intend to get them up on the stage together and throw them raw meat – like the piece you are going to read today – and see what ensues. It will be fun theater; but even more importantly, it will help us understand the realities of the world we live in.

We actually had a little bit of winter here in Texas this past week. Not a whole lot, but ice and snow, and enough to close the schools for a few days, so all the kids were happy. But we still had a good-sized gathering on Monday when I invited the boards of the various Ashford companies, which are all involved with hotel REITs in one way or another. Full disclosure: I have joined the board of Ashford Inc., partly because Monty Bennett is my very good friend and fun to work with, and partly because it exposes to me to a business that is very sensitive to the economy and thus gives me a little more insight into what’s really happening in the world. There has been a great deal to learn about Ashford’s business, and it’s been quite fun.

I am on one other public board (Galectin Therapeutics or GALT), and the two businesses could hardly be more different. And then I think what it would be like to be involved with any number of other interesting businesses I’m familiar with, and I realize again the enormous complexity of our capitalist system. I am invited to speak at various corporate gatherings and board meetings from time to time and try to learn a little bit about their industries when I have the opportunity. I remember speaking to a group that did what was basically property insurance, which I thought was mundane going in. Then in the course of interacting with them I realized that there were 1,000 intricate moving parts necessary to simply allow me to have property insurance. And the mind boggles at what it takes to bring some of the technology that’s on my desk to the marketplace, let alone to sell it substantially more cheaply every year.

Every bit of the far-flung capitalist enterprise has to be executed against the backdrop of the Federal Reserve’s manipulating the marketplace, screwing (that’s about as nice a term as one should use in referring to financial repression) savers and fixed-income investors, creating chaos in the pension fund world, and roiling the currency markets with their decisions. Seventeen people sitting around a table thinking they have enough understanding to set interest rates for a market of one million companies whose complexities are staggering. The mind reels.

The good news is that I will get to ponder some of this while reading a book by the pool in Orlando this weekend, where I’ll speak on behalf of my friends at Altegris Investments to the American Bankers Association, yet another extremely complex business. Have a great week and look for my letter over the weekend, where we will further explore the explosion of debt in the world over the last eight years.

Your getting off his soapbox analyst,

John Mauldin, Editor
Outside the Box

Shovelin’ Schmitt Against the Tide

By Joan McCullough

I used to be quite sure that raising rates was a sure-fire way of slowing an economy.

Given the worldwide printing orgy currently being staged by the central banks … with China reiterating a need for more participation overnight … I wonder now. If official rates amount to a tinker’s dam. 

You remember official rates, right? Often called “base rates” because it was upon this first step that the cost of money going forward was supposed to be priced. 

But the size of the largesse both extant and anticipated is such that the protocols as we knew them have been battered into nonexistence.

So given the investor response to the printing jamboree which has become frenzied to the extent that Germany is negative now out thru 7 years. And 10-year paper issued by the Portuguese government is trading this a.m. at least 10 bps cheaper than the yield on US paper. I wonder aloud if the entire relationship between interest rates, fiscal position and underlying economic metrics has not been permanently abolished. As the seemingly never-ending flow of printed money has out of necessity crowding outoverflowed into corporate issuance from investment grade right on down to toilet paper. Blurring all lines as the ability to assign value has likewise been washed away in the flood.

The visual is of a tidal wave; origin an unnecessary detail. Flowing around the global markets. Hot spots, of course, are the currently-targeted sovereign issues with overflow driven by gravity at this stage.

These thoughts occurred to me having reread Yellen’s testimony and reviewed the Q&As which followed both days.

Conclusion: Let there be no further pretense of the superiority of any US recovery; any pretense about the effectiveness of ZIRP and QE are likewise dispensed with.

The FED is about to be hoisted way high up. By its own petard.

They had one tool left for all intents and purposes. The tinkering with interest rates. 

So as the global currency war went full swing, they had the option of accepting the deflation being sent their way by the other sovereigns or deflecting it. 

To accept the deflation, they would tighten. To deflect it, they would ease. Standing pat? While under suspicion of a tightening bent or when backing away from same during Congressional testimony, standing pat does not exist. As innuendo alone acts on rates. In both directions. Which the buck follows obediently.

Until the FED loses control of the buck as well. This is where we are at the moment.

The FED was first to unleash a tsunami of free money on the world. The withdrawal of that flow via the demise of QE3 was felt to be sure. The deflation of China as evidenced by the rout in commodities which followed is proof. Of the beginning of the end.

In response to that withdrawal which was announced under the guise of an improving US economy, the global economies took a defensive tack. The majors conjured up their own printing operations which engendered bigger trade imbalances, which of course led to the current forex war, the hallmark of which is the quest to debase one’s currency and in so doing, gain a trade advantage.

Any control of the Dollar is about to be snatched back from the FED. By a sequence of events set in motion by the FED itself.

As the effect of the global tidal wave of free money. Which arose out of necessity when the FED tapered QE into silence. Heads now for these shores. 

Lifting the buck aloft. Accepting the deflation (which I prefer to call “negative inflation” at this juncture) without raising an official interest-rate finger. Because that m.o. has been rendered obsolete! Or if you prefer, just accept that any FED moves would be tantamount to shovelin’ schmitt against the tide [of printed money]. 

Please take a look at commodities if you need confirmation. Crude is leading the way lower. 

All this relegates the FOMC to a new role as observers. Because they will be powerless to do anything much but watch. As the fruits of their toxic labor come home to roost. 

QE1, 2 and 3 ran from late 2008 thru 2014. 

During that period, the buck was under pressure, bouncing around. And intermittently bottoming vs. the Euro around the 1.50 level. It wasn’t until mid-2014 that the Euro had its last hurrah at 1.40. And then the buck finally got solid legs and has been rallying steadily from May of last year. Pretty much 1.40 to 1.13.

To the printer, then, goes the weak currency. And as we saw with the ECB, this is clearly by design.

As mentioned already, let’s dispense with the pretense of a solid US recovery.

That’s hogwash, particularly the baloney about the tightening of the labor market. Housing’s punk state is self-evident and the slippage in consumer confidence, unnerving.

The FED is in a corner. They cannot raise rates. But because of the backlash comin’ at us now, the buck continues on a tear higher. They cannot control it. 

So our economy will be impacted negatively not by official interest rates; the multinationals also come to mind for the stock pickers. Because we already know that the entire interest-rate, fiscal position, underlying economic metrics relationship has been decommissioned. By the tidal wave of printed money. That has us comin’ and goin’ at the moment.

With the present “beneficiary” the US Dollar.

We started it. We flooded it. We yanked it back. It’s their turn now. 

Bend over, Rover. Any questions?


Greece eyes last central bank funds to avert IMF default

Syriza is not interested in emergency EMU funding if it means kowtowing to Troika demands

By Ambrose Evans-Pritchard

7:52PM GMT 02 Mar 2015

Pensioners try to brake through the police barrier to reach the entrance to the Greek governments' headquarters

Greek pensioners try to break through a police barrier during protests in 2010. It is far from clear whether the government can legitimately tap pension funds without breaching other fiduciary obligations Photo: EPA
Greece is preparing to tap its final pension reserves at the country’s central bank if needed to avert a devastating default to the International Monetary Fund and keep the government going over the next two weeks.

The Greeks must pay the IMF €1.5bn in a series of deadlines this month, starting with €300m as soon as Friday. No developed country has ever defaulted to the IMF in the history of the Bretton Woods financial system. Such a move would shatter confidence and reduce Greece to a financial pariah in motley company with Zimbabwe.
George Stathakis, the economy minister, said the government still has hidden reserves to keep operations going for a few more weeks, brushing aside warnings that the state could run out of cash within 10 days. “These stories are exaggerated. We have various buffers, including €3bn or €4bn at the Bank of Greece," he told The Telegraph.
It is understood that the central bank deposits are mostly part of Greece’s social security and pension system. Analysts say it is far from clear whether the government can legitimately tap this money without breaching other fiduciary obligations. “We think the funds are already down to €1.8bn. If they draw on this, how are they going to meet their pension bills next month?” said one banker.

A senior Greek official opened the door last week to a possible “delay” in repayments to the IMF, perhaps for a month or two, setting off alarm bells among investors and bank depositors. It was taken as an admission that the country is now desperate as capital flight runs at €800m a day.

Yanis Varoufakis, the finance minister, sought to silence such talk over the weekend, telling Associated Press that a default to the IMF was out of the question, even if a halt in payments to the EU institutions remains a serious threat. “We are not going to be the first country not to meet our obligations to the IMF. We shall squeeze blood out of stone if we need to do this on our own, and we shall do it," he said.

The IMF deadlines are not rock hard. The Fund usually allows some grace period. There is a procedure for arrears if a country genuinely wishes to pay. "The clock starts ticking. It is another matter if they start saying they won't pay for six months," said one expert.

Syriza officials are aware that the IMF will be their last safeguard if Greece is ultimately blown out of the euro, although it is far from clear what would happen in such circumstances. Greece has already exhausted its IMF borrowing quota in earlier EU-IMF Troika bailouts, and patience is wearing thin among the Asian and Latin American representatives on the IMF board.

Greece has reached its €15bn limit for issuance of short-term T-bills imposed by the European Central Bank. The ECB could in theory raise the ceiling on Wednesday but the mood in the governing council is unlikely to be friendly after the latest remarks by Mr Varoufakis.

He warned that the debts owed to the European Central Bank are in a “different league” from IMF loans, and continued to insist that Greece will demand relief from EMU creditors.

Payments of €6.7bn to the ECB are due in July and August. “We will fight it. If we had the money we would pay. They know we don't have it," he told Skai television.

Syriza has long argued that this debt is illegitimate, alleging that the ECB bought Greek bonds in 2010 in order to save the European banking system and prevent contagion at a time when the eurozone did not have a financial firewall, not to help Greece.

Mr Varoufakis said the result was to head off a Greek default to private creditors that would have led to a large haircut for foreign banks if events had been allowed to run their normal course, reducing Greece’s debt burden to manageable levels. Instead, the EU authorities took a series of steps to avert this cathartic moment, ultimately foisting €245bn of loan packages onto the Greek taxpayer and pushing public debt to 182pc of GDP.

Relations between Greece’s Syriza government and the rest of the eurozone remain extremely tense despite a fragile ceasefire agreed in Brussels to buy time and prevent a forced ejection of Greece from the euro, a development ruled as unthinkable by the leaders of Germany and France, and the European Commission.

Greek leader Alexis Tsipras lashed out at Spain and Portugal over the weekend, calling them “Axis powers” that are trying to suffocate Greece’s Left-wing revolution. The conservative leaders of the two countries appeared stunned by the vehemence of the attack, seeking to defuse the crisis by expressing warm support for the Greek people.

Jeroen Dijsselbloem, the Eurogroup’s chief, said Greece could secure some new funding as early as this month if it delivers promptly on reforms imposed by the now defunct Troika, but the comments were dismissed in Athens as a mere repetition of demands by creditor powers that have yet to face up to the anti-austerity revolt sweeping southern Europe. Syriza has already said it will cancel privatisation of the Port of Piraeus and the major utilities, and “drastically review” the sale of Greek airports.

Mr Varoufakis said Greece did not want any further money if it meant having to buckle to Troika terms. “We won’t take the next tranche if the price is having to continue with the 'Memorandum'.

That is not what the people voted for,” he said. It is a thinly-veiled warning that Greece will default on €300bn of combined liabilities to EMU entities and states if pushed too hard, regardless of what this implies for monetary union.

Whatever piece of paper they signed in Brussels 10 days ago, the two sides are still talking past each other.

02/27/2015 07:00 PM

Family Feud

The Tortured Relationship between Schäuble and Varoufakis

By Nikolaus Blome, Christian Reiermann and Alexander Smoltczyk

German Finance Minister Wolfgang Schäuble and his Greek counterpart Yanis Varoufakis do not always see eye to eye.

 German Finance Minister Wolfgang Schäuble and his Greek counterpart Yanis Varoufakis do not always see eye to eye.

Athens relented in the end. But prior to the compromise deal allowing for an extension of Greece's bailout program, Greek Finance Minister Varoufakis and his German counterpart Schäuble engaged in a bitter battle for supremacy.

The end began in the National Theater of Greece in Athens. It was the evening of Wednesday, Feb. 18, and the work on stage was "Happy Days," a two-character play by Samuel Beckett.

On stage, a not-particularly-young woman slowly sank into a pile of dirt, talking all the while.

Finally, she was stuck up to her neck, but continued talking and making plans even though she could move little more than her eyes and her mouth.

Greek Finance Minister Yanis Varoufakis was in the audience. "Splendid performance(s)," he tweeted two days after the show. The evening, he wrote, was "such a relief from you know what ..."

In hindsight, the scene seems like an omen -- like a screenplay for the days to come. Theater, after all, is a reflection of humanity's existence as a whole -- and sometimes it reflects the specific existence of a Greek finance minister.

At the same time as Varoufakis was enjoying his visit to the theater, his German counterpart Wolfgang Schäuble was attending a very different show, one in which the main character was Portuguese Finance Minister Maria Luís Albuquerque. She was a guest speaker at the Bertelsmann Stiftung and used her talk to review the significant progress her country has made since almost going broke four years ago. The country's finances are now under control and economic growth has returned.

"My dear friend," Schäuble addressed her pleasantly. The warmth in his voice made him sound like a teacher who had just barely managed to prevent a student from failing out of school. Why, he seemed to be thinking, can't all finance ministers in Europe be like Maria Luís Albuquerque?

A Two-Person Drama

Still, it was the Greek finance minister's Wednesday evening program that was more reflective of recent events. It has been a two-person drama, with the lead roles played by Varoufakis and Schäuble, a confrontation between two radically different characters. Only one could win in the end, but both would have to pay.

A telling episode in the clash between the two took place in Brussels last Friday. European finance ministers were gathered for a decisive meeting of the Euro Group, one that would decide whether emergency aid for Greece would be extended by four months. More than that, though, it would go a long way toward deciding if the country would remain in the euro zone.

Varoufakis arrived early in the morning, flying second class without advisors and bodyguards in an effort to save money. He was still confident. "This is not the most difficult day of my life," he said prior to the meeting. "But perhaps it will be the most difficult in Schäuble's life." He then put in his earphones and began reviewing his papers.

Schäuble is Varoufakis's nemesis. And it is difficult to imagine two people being more different.

The Greek finance minister is in excellent physical shape and nicely tanned. His German counterpart sits in a wheelchair, the result of a 1990 assassination attempt, and his shoulders are slumped, as if giving way under the weight of a long political career and the responsibility he has carried for decades -- in particular, responsibility for the euro, which he helped create.

Varoufakis is the newest finance minister in the Euro Group; Schäuble has served the longest.

Varoufakis is a professor of economics, a man always good for a clever turn of phrase and a beaming smile. Schäuble is better known for being caustic and irritable. He is a lawyer by training and prefers practice to theory; he is matter-of-fact and deeply skeptical of those who seek to grab the spotlight. And he doesn't hold university professors in high regard.

Since Schäuble has gotten to know his new colleague from Athens, his appreciation for economy professors has dropped even further. He is suspicious of those who believe in their own theories and who think that the world is predictable. For Wolfgang Schäuble, societal behavior cannot be easily explained, not even by social scientists. That is why, he believes, negotiated rules -- and adherence to those rules -- is the best policy.

For Yanis Varoufakis, the euro is a defective currency. For Schäuble, it is his legacy.

The German minister is unconcerned with formalities. He doesn't care if his Greek counterpart tucks in his shirt or not, nor would he be bothered if Varoufakis were to wrap it around his head like a turban. Former Swedish Finance Minister Anders Borg, after all, used to come to Euro Group meetings with his hair in a ponytail. But Borg possessed competence, authority and political gravitas, qualities that, from Schäuble's perspective, the new Greek finance minister has not yet demonstrated.

Schäuble was annoyed by Varoufakis' insistence during his initial visit to Berlin that he could save not just his country, but the entire euro zone, from the clutches of austerity and install a new financial architecture. And he found the Greek finance minister's presentation during his first Euro Group meeting, full of well-prepared and well-meaning proposals, to be confused and muddled.

Vigorous Disagreement

Indeed, by the time Schäuble arrived in Brussels for last Friday's meeting of euro-zone finance ministers, EU diplomats were finding it difficult to bring the two together in a single room. And tensions were high among others in the group as well. Jeroen Dijsselbloem, head of the Euro Group, had even planned to hold telephone conferences and individual meetings rather than bring everyone together.

His concern was the consequence of vigorous disagreement during the previous meeting -- a conflict which almost descended into blows. That, at least, is what the long-time Brussels correspondent Jean Quatremer reported, citing sources in the French delegation. Varoufakis, his report said, shouted "liar!" at Dijsselbloem over and over again until the meeting ended inconclusively.

Varoufakis denies that version of events. He says the disagreement had to do with different versions of the compromise paper. Varoufakis says he wasn't aware that, according to Brussels custom, only the version on Dijsselbloem's desk was official.

The result was that last Friday's Euro Group meeting was atomized, with small groups of two to four people meeting individually with Schäuble, with International Monetary Fund head Christine Lagarde, with European Central Bank head Mario Draghi and with Dijsselbloem.

Varoufakis quickly realized that he was alone, that the other 18 finance ministers were against him.

But he took it as validation for his approach. Late that night, he forwarded an article from Foreign Policy to his Twitter followers headlined "Greece Should Not Give In to Germany's Bullying." The piece speaks of the "dead hand of Merkelism" and argues that economic logic lies with the Greek finance minister.

The Greek finance minister's defiance makes some sense. Voters in Greece had just made it eminently clear that they wanted their leaders to shed austerity and to come up with a radical alternative to the Schäuble-doctrine of growth-through-austerity. Furthermore, the entire European left was rooting for Varoufakis.

But time was short. Last Thursday and Friday alone, €2 billion was withdrawn from Greek banks and they were running out of cash. Furthermore, the political opposition in Athens was spreading the rumor that a new currency would be introduced when banks opened for business on Monday.

Stoking Resentment?

The beginning of the Euro Group meeting was repeatedly delayed -- and a Greek diplomat on the sidelines was in a gloomy mood. "The Greeks don't have anything left to lose," he said.

"Even a Grexit isn't a horrifying scenario anymore." The man went on to speak of "Weimar conditions" of violence between Syriza followers and those of the right-wing extremist party Golden Dawn.

"Tsipras has given what he could. What more do the Germans want? I can see only one rational reason: They want a new government."

Yet Schäuble is as unconcerned with the political leanings of the new Athens government as he is with the clothes they wear. In the days leading up to last Friday's Euro Group meeting, he was primarily concerned with preventing Varoufakis from isolating Germany.

But he had also become wary of what he saw as Athens' efforts to stoke resentment, particularly following the unflattering caricatures of him printed in leftist Greek newspapers.

One, published in a newspaper affiliated with Varoufakis' Syriza party, showed Schäuble, one of the last architects of the euro remaining in office, wearing a Nazi military uniform. Another, in the leftist-intellectual weekly Bromos, depicted Schäuble in a chair with tank tracks instead of wheels and holding a flag on which the swastika had been replaced by a euro symbol. The minister is ordering the execution of 50 ("no, make it 100") Greek civilians for every financially burdened German taxpayer.

Schäuble believes the victim complex that many Greek politicians have adopted to be a mixture of misguided pride and prideful misguidedness. They believe that the crisis was triggered by Germany's trade surplus and then made worse by Germany's austerity demands. And they seem to believe that Greece's financial problems would disappear were Germany to simply pay World War II reparations.

Prior to the beginning of last Friday's meeting, Dijsselbloem had telephoned with European leaders to consolidate support behind his compromise proposal. German Chancellor Angela Merkel made it clear to Tsipras that there were no other alternatives. "It's either that, or it's over," she said. And Tsipras relayed his decision to his finance minister: He had decided to give in. Thereafter, Varoufakis was largely uninvolved in the talks, sources say.

When all 19 euro-zone ministers finally gathered to go through the text line by line, only Portugal and Spain had much to say, freeing Schäuble from the need to play the enforcer in the process. His "dear friend" Maria Luís Albuquerque took on the role herself, together with Spanish Finance Minister Luis de Guindos. Both of their countries implemented painful, but ultimately successful reform programs and the two finance ministers warned Schäuble that if concessions were granted to Greece, they could forget about being reelected. Voters, they said, would immediately replace their governments with political parties likewise interested in rolling back reforms.

The result was Schäuble's conclusion: "It won't be good for Europe if we are too generous with the Greeks."

A Default Leadership Role

Being from the Euro Group's strongest economy, Schäuble is essentially the body's informal leader.

But because he prefers modesty, he often comes across as being uncomfortable in the role. "I surely don't speak the best English in the group, but everyone is always asking: Wolfgang, what do you think?"

At last Friday's meeting, the joint statement was finally finalized. It stated that Greece would only receive the promised IMF and ECB loans if it sticks to its promises and also presents a quantifiable list of its reform projects. In exchange, the aid program will be extended by four months. Relief will also be provided for Greece's 2015 budget.

The previous Greek government had hoped that around €10 billion from the bank bailout fund would be reallocated, but there are no plans now to shift that money. Athens has also assured it will refrain from unilateral steps that could "negatively impact" the declared stability goals.

Alexis Tsipras won the election based on his pledge that the current agreement with the troika would be terminated and that there would no longer be any commitments made to the Euro Group. The short joint Euro Group statement includes four references to the "current arrangement" and seven to "commitment." The word "troika," however, has been replaced with "institutions."

Christine Lagarde of the International Monetary Fund praised the document as being "very deep and dense." One floor lower, Yanis Varoufakis could be found sitting in a stuffy room filled with journalists. He spoke of a "constructive ambiguity," especially in terms of the future primary surplus.

"The times have passed when Greece's policies are dictated to it," he said. "From today we are going to be co-authors of our destiny." "Like Odysseus, sometimes you have to tie yourself to a mast in order to avoid the sirens and get where you need to go," he added. In this case, the siren call referred to is that of leftist Keynesians and their fiscal excesses. But it was also a reference to a Greece that is now being tamed.

Indeed, that was the moment that Varoufakis demonstrated that he is more of an intellectual than a political drone. He appeared to enjoy trying to transform defeat into victory using only the sheer power of words.

Just a few steps away, Wolfgang Schäuble could be found sitting in the German delegation's room. Visibly tired, he took pains not to come across as triumphant, even mentioning that Varoufakis would have difficulty explaining the result of the negotiations to voters back home. But he also noted that the outcome is one the Greeks also could have gotten 10 days earlier. Sometimes the German finance minister can came across like an aging math teacher counting his days until retirement.

Once again, Schäuble was witness to a much admired political newcomer falling prey to reality. After three weeks spent being a pop star among finance ministers, Varoufakis' spell had been broken -- in Schäuble's mind, at least. What he can still do, though, became apparent this week: He continues to have room to make the kind of derogatory remarks about Schäuble's ideas that got published in an interview with French satire magazine Charlie Hebdo. Schäuble was quoted as being "stunned" about the Greek politician's comments.

Running Roughshod

Still, Schäuble has been in politics long enough to have understanding for Tsipras and Varoufakis, who must now sell their defeat as a triumph back home. It's simply part of politics. What's important to him is that the wrangling doesn't leave Germany isolated in the end.

Schäuble has a reputation for being a stubborn negotiator, uncompromising when it comes to austerity, and for sticking to his principles. He's been playing the role of grumpy old man for years now.

The truth, however, is more nuanced. Schäuble is disposed to seek conciliation and compromise, which he considers to be hallmarks of democracy. At the same time, Schäuble takes laws, treaties and agreements very seriously because he considers rule of law to be a fundamental trait of Western democracy and civilization. The casualness with which his newly elected Greek colleagues want to run roughshod over EU agreements is deeply abhorrent to Schäuble.
The German finance minister regards Europe as an educational project, one for which the past seven decades has been about civilizing the Europeans and educating them about peace and democracy.

Indeed, a Kantian imperative is visible in EU regulations and directives. The rules issued in Brussels force member states to act in such a way that the union will not break apart, provided the others do so as well.

It's an imperative that is also a factor in the fight over Greek debts and Greek blame. Athens' revolt is reminiscent of a teenager who doesn't want to accept the limits to personal freedom that living in a mutually dependent collective necessitates -- moreover, in a collective designed by his predecessors.

'One Must Imagine Sisyphus Happy'

Schäuble's office in the Finance Ministry looked just as tidy as always this week. But the minister himself was exhausted and didn't try to conceal it. His eyes were red and he repeatedly rubbed them and yawned.

Schäuble used to be fond of comparing politicians in general, and himself specifically, with Sisyphus, the character from Greek mythology who is damned to spend eternity trying to roll a stone up a hill, to no avail. "One must imagine Sisyphus happy," Schäuble would say, quoting Albert Camus.

When asked if he could imagine simply allowing Greece to stumble out of the euro zone, Schäuble shakes his head. "We are on the right path towards leaving the euro crisis behind us," he says. "We can't allow that to be ruined by a country that doesn't follow any rules."

It is a typical Schäuble sentence. Basically, he means that, if Greece lives up to its agreements, it can stay. If not, then the country will have to leave the club. And he doesn't have all that much sympathy for those now in power in Athens. "What the Greeks must now do is not exactly what they promised in the campaign," he says. "But that's not my problem."

Just before midnight on Tuesday, Yanis Varoufakis sent the required list of reforms to Brussels. It includes a national plan to take on corruption, measures against tobacco and gasoline smuggling, higher taxes for the rich and the closing of tax loopholes. It includes food vouchers for the poor and the introduction of a Citizen Smart Card for access to the health system. There are 64 items in total.

Does Schäuble believe that the Greek government will fulfill its promises? The German finance minister stares at the table in front of him. The corners of his mouth fall and he shrugs his shoulders.

Sisyphus is tired. And sad.

Heard on the Street

Fed Faces Foreign-Policy Dilemma on Rates

Factors Outside U.S. Complicate Central Bank’s Decision on Raising Rates

By Justin Lahart

March 1, 2015 3:43 p.m. ET

The Port of Los Angeles. Morgan Stanley estimates that Monday’s report on consumer prices from the Commerce Department will show that they fell 0.5% in January from a month earlier, putting them 0.1% higher year over year. Photo: Associated Press 

Prices in America face a stiff offshore breeze—complicating the Federal Reserve’s decisions on interest rates.

Even as the U.S. economy has picked up speed and unemployment has fallen, inflation has been remarkably cool. Morgan Stanley estimates that Monday’s report on consumer prices from the Commerce Department will show that they fell 0.5% in January from a month earlier, putting them 0.1% higher year over year. Much of that weakness was due to lower gasoline prices. But the bank estimates that core prices, which exclude food and energy, were flat in January, putting them just 1.2% above the year-earlier level.

Low oil prices likely are having some effect on core prices. Manufacturers’ fuel tabs are lower, for example, and the cost to ship goods has also fallen. The dollar, which on a trade-weighted basis last month was 10% higher against other currencies, year over year, also plays a role by driving down the cost of imports.

The effects of both oil and the dollar can be seen as transitory. If they merely stabilize, their effect on inflation will be neutralized. But it is also important to remember that what has happened with both of them result from weakness outside the U.S. The global economy isn’t growing rapidly enough relative to the supply that has been put in place in recent years to push prices higher. Hence, core inflation isn’t low just in the U.S., but all over the world.

Moreover, low prices abroad have a more pronounced effect on prices within the U.S. than they did in the past. That is because trade plays a much bigger role in the economy. Last year, the combined value of U.S. imports and exports was $5.2 trillion, an amount equal to 30% of gross domestic product. That compares with 25% in 2000 and 20% in 1990.
Indeed, the riddle of why core inflation didn’t fall as much when there was high unemployment after the recession may be partly explained by the fact that, with the dollar weak and China booming, import prices picked up.

Recent research from University of Chicago economists Martin Beraja, Erik Hurst and Juan Ospina shows that areas of the U.S. that saw the biggest increases in unemployment also saw prices for nontradable goods—items that include a lot of local costs—come under pressure while tradable goods prices held up better. If that happened at the local level, perhaps it also did at the national level too, with import costs buoying prices overall.

For the Fed, the cooling effect of low overseas inflation poses two problems: The first is that it is hard to measure confidently how much of what is going on with prices comes from overseas and how much is home brewed. The second is that just because prices might be higher if it wasn’t for influences from overseas, that might not make a compelling argument for taking a tighter stance on monetary policy.

Prices may have to show some sign that they are pushing through the overseas headwind, or those will have to subside, before the Fed starts raising rates.

martes, marzo 03, 2015




In a quagmire

Latin America’s erstwhile star is in its worst mess since the early 1990s

Feb 28th 2015

CAMPAIGNING for a second term as Brazil’s president in an election last October, Dilma Rousseff painted a rosy picture of the world’s seventh-biggest economy. Full employment, rising wages and social benefits were threatened only by the nefarious neoliberal plans of her opponents, she claimed. Just two months into her new term, Brazilians are realising that they were sold a false prospectus.

Brazil’s economy is in a mess, with far bigger problems than the government will admit or investors seem to register. The torpid stagnation into which it fell in 2013 is becoming a full-blown—and probably prolonged—recession, as high inflation squeezes wages and consumers’ debt payments rise. Investment, already down by 8% from a year ago, could fall much further.

A vast corruption scandal at Petrobras, the state-controlled oil giant, has ensnared several of the country’s biggest construction firms and paralysed capital spending in swathes of the economy, at least until the prosecutors and auditors have done their work. The real has fallen by 30% against the dollar since May 2013: a necessary shift, but one that adds to the burden of the $40 billion in foreign debt owed by Brazilian companies that falls due this year.

Escaping this quagmire would be hard even with strong political leadership. Ms Rousseff, however, is weak. She won the election by the narrowest of margins. Already, her political base is crumbling. According to Datafolha, a pollster, her approval rating fell from 42% in December to 23% this month. She has been hurt both by the deteriorating economy and by the Petrobras scandal, which involves allegations of kickbacks of at least $1 billion, funnelled to politicians in her Workers’ Party (PT) and its coalition partners. For much of the relevant period Ms Rousseff chaired Petrobras’s board. If Brazil is to salvage some benefits from her second term, then she needs to take the country in an entirely new direction.

Levy to the rescue?
Brazil’s problems are largely self-inflicted. In her first term Ms Rousseff espoused a tropical state-capitalism that involved fiscal laxity, opaque public accounts, competitiveness-sapping industrial policy and presidential meddling in monetary policy. Last year her re-election campaign saw a doubling of the fiscal deficit, to 6.75% of GDP.

To her credit, Ms Rousseff has at least recognised that Brazil needs more business-friendly policies if it is to retain its investment-grade credit rating and return to growth. This realisation is personified by her new finance minister, Joaquim Levy, a Chicago-trained economist and banker and one of the country’s rare economic liberals. However, Brazil’s past failure to deal promptly with macroeconomic distortions has left Mr Levy to grapple with a recessionary trap.

To stabilise gross public debt, he has promised a whopping fiscal squeeze of almost two percentage points of GDP this year. Part of this is coming from the removal of an electricity subsidy and the reimposition of fuel duty. Both measures have helped to push inflation to 7.4%.

He also plans to curb subsidised lending by public banks to favoured sectors and firms.

Ideally, Brazil would offset this fiscal squeeze with looser monetary policy. But because of the country’s hyperinflationary past, as well as more recent mistakes—the Central Bank bent to the president’s will, ignored its inflation target and foolishly slashed its benchmark rate in 2011-12—the room for manoeuvre today is limited. With inflation still above its target, the Central Bank cannot cut its benchmark rate from today’s level of 12.25% without risking further loss of credibility and sapping investor confidence. A fiscal squeeze and high interest rates spell pain for Brazilian firms and households and a slower return to growth.

What makes this adjustment perilous is the political fragility of Ms Rousseff herself. On paper she won a comfortable, though reduced, legislative majority in the October election. Yet the PT is already grumbling about Mr Levy’s fiscal policies—partly because the campaign did not lay the ground for them. Ms Rousseff suffered a crushing defeat on February 1st in an election for the politically powerful post of head of the lower house of Congress. Eduardo Cunha, who vanquished the PT’s man, will pursue his own agenda, not hers. Not for the first time, Brazil may be in for a period of semi-parliamentary government.

The country thus faces its biggest test since the early 1990s. The risks are clear. Recession and falling tax revenue may undermine Mr Levy’s adjustment. Any backsliding may in turn prompt a run on the real and a downgrade in Brazil’s credit rating, raising the cost of financing for government and companies alike. Were Brazil to see a repeat of the mass demonstrations of 2013 against corruption and poor public services, Ms Rousseff might be doomed.

From weakness, opportunity
Yet the president’s weakness is also an opportunity—and for Mr Levy in particular. He is now indispensable. He should build bridges to Mr Cunha, while making it clear that if Congress tries to extract a budgetary price for its support, that will lead to cuts elsewhere. The recovery of fiscal responsibility must be lasting for business confidence and investment to return. But the sooner the fiscal adjustment sticks, the sooner the Central Bank can start cutting interest rates.

More is needed for Brazil to return to rapid and sustained growth. It may be too much to expect Ms Rousseff to overhaul the archaic labour laws that have helped to throttle productivity, but she should at least try to simplify taxes and cut mindless red tape. There are tentative signs that the government will scale back industrial policy and encourage more international trade in what remains an over-protected economy.

Brazil is not the only member of the BRICS quintet of large emerging economies to be in trouble. Russia’s economy, in particular, has been battered by war, sanctions and dependence on oil. For all its problems, Brazil is not in as big a mess as Russia. It has a large and diversified private sector and robust democratic institutions. But its woes go deeper than many realise.

The time to put them right is now.

Brazil’s coming recession

The crash of a titan

Brazil’s fiscal and monetary levers are jammed. As a result, it risks getting stuck in an economic rut

Feb 28th 2015

IT IS easy for a visitor to Rio to feel that nothing is amiss in Brazil. The middle classes certainly know how to live: with Copacabana and Ipanema just minutes from the main business districts a game of volleyball or a surf starts the day. Hedge-fund offices look out over botanical gardens and up to verdant mountains. But stray from comfortable districts and the sheen fades quickly. Favelas plagued by poverty and violence cling to the foothills. So it is with Brazil’s economy: the harder you stare, the worse it looks. 
Brazil has seen sharp ups and downs in the past 25 years. In the early 1990s inflation rose above 2,000%; it was only banished when a new currency was introduced in 1994. By the turn of the century Brazil’s deficits had mired it in debt, forcing an IMF rescue in 2002. But then the woes vanished. Brazil became a titan of growth, expanding at 4% a year between 2002 and 2008 as exports of iron, oil and sugar boomed and domestic consumption gave an additional kick. Now Brazil is back in trouble. Growth has averaged just 1.3% over the past four years. A poll of 100 economists conducted by the Central Bank of Brazil suggests a 0.5% contraction this year followed by 1.5% growth in 2016.

Both elements of that prediction—the mild downturn and the quick rebound—look optimistic. The prospects for private consumption, which accounted for around 50% of GDP growth over the past ten years, are rotten. With inflation above 7%, shoppers’ purchasing power is being eroded. Hefty price rises will continue. Brazil is facing an acute water shortage; since three-quarters of its electricity comes from hydroelectric dams, this is sapping it of energy. To avoid blackouts the government plans to deter use by raising prices: rates will increase by up to 30% this year. With the real losing 10% of its value against the dollar in the past month alone, rising import prices will bring more inflation.

There is little hope of disposable income keeping pace. One reason is that Brazilian workers’ productivity does not justify further rises. In the past ten years wages in the private sector have grown faster than GDP; cosseted public-sector workers have done even better (see chart 1). Since Brazil’s minimum wage is indexed to GDP and inflation, a recession will freeze real pay for the millions who earn it.

Austerity will bite, too, as Brazil’s new finance minister, Joaquim Levy, tries to balance the books. Higher taxes on fuel are being phased in, a blow for a car-loving country. If Mr Levy reforms the generous state pension, the incomes of older Brazilians will stall.

Debt payments add to the woes. Total credit to the private sector has jumped from 25% of GDP to 55% in the past ten years. With total household debt at around 46% of disposable income, Brazilian households are much less indebted than those in Italy or Japan. Yet the price of this borrowing is sky-high. Four-fifths of it is punishingly costly consumer credit (the average rate on new lending is 27%, according to the Central Bank). Once hefty principal payments are added in, debt service takes up 21% of disposable income. With the economy slowing and the Central Bank reluctant to cut interest rates because of high inflation, consumers will feel the pinch, says Arthur Carvalho of Morgan Stanley. On February 25th a survey put consumer confidence at a ten-year low.

There are few compensating sources of demand. Investment, which rose in eight of the ten years to 2013, often substantially, will sink in 2015. Petrobras, the partially state-owned oil giant that is Brazil’s largest investor, is mired in a corruption scandal that has paralysed spending: the affair may cost up to 1% of GDP in forgone investment. On February 24th Moody’s, a credit-rating agency, cut its debt to junk status; if Petrobras fails to publish audited results soon it may be unable to borrow at all.

Exporting is no answer, despite the falling real. Five countries—China, America, Argentina, the Netherlands and Germany—buy 45% of Brazil’s exports. Ten years ago these economies’ average GDP growth, weighted by their heft in Brazilian trade, was 12%; this year 5% would be good.

Yet the biggest worry is not that Brazil has a bad year, but that its broken policy levers mean that it gets stuck in a rut. Brazil spent 311.4 billion reais (6% of GDP) on interest payments in 2014, a 25% increase on 2013. This means that even if Mr Levy’s fiscal drive works—he is aiming for a primary surplus of 1.2% of GDP—Brazil will be nowhere near the black. The state’s outgoings have proved hard to control, with benefits payments rising despite falling unemployment. In a recession it will be harder still.

Brazil’s parlous finances leave no room for debt-financed stimulus. At 66% of GDP its gross public debt is the highest of the BRIC countries. Its bonds yield 13%—more than Russia’s. Rates could rise further. Fitch, a credit-rating agency, puts Brazil one notch above junk, but it has more debt, bigger deficits and higher interest rates than most countries in that category. If growth evaporates, a downgrade would be a certainty, raising debt costs even more.

Such predicaments are not uncommon, but Brazil’s monetary problems are. The governor of the Central Bank, Alexandre Tombini, must choose between two nasty paths. The first is a hard-money approach: keeping interest rates high despite the weak economy. This would prop up the real and boost the bank’s inflation-bashing credentials. But it is not just households that are hurt by high rates; firms are, too. In aggregate the big Brazilian firms Fitch rates have had negative cashflow since 2010. They have plugged the gap by running down savings and issuing debt. Borrowing is up by 23% in five years. With the risk of default rising, a fifth of these firms face a downgrade, in many cases imminent.

In reality, a tough monetary stance would have to be softened by an extension of Brazil’s lavish financial subsidies. State-owned banks like BNDES, a development bank, and Caixa Econômica Federal, a retail one, made 35% of loans in 2009. Today their share is 55%. Since many Brazilian firms cannot pay private market rates (the average rate for new corporate loans is 16%) BNDES lends at a concessionary rate, currently 5.5%. That makes banking in Brazil a fiscal operation, says Mansueto Almeida, an expert on the public finances. The funding comes from the state, which borrows at a much higher rate than firms pay. The difference, a loss, is borne by taxpayers.

The alternative path for Mr Tombini to go down is to cut rates despite rising inflation—a daring move given Brazil’s history. The cause of price increases, after all, is not an overheating economy, but the real’s fall, rising taxes and the drought. The textbook response would be to “see through”—ie, ignore—this inflation.

But soft money would hurt, too. It would cause the real to fall further, and thus accelerate increases in the prices of imported goods. Foreign debts, which Brazilian firms and local governments have accumulated due to the lower interest rates on offer, would become harder to bear. Data collected by the Bank for International Settlements show dollar debts rising from $100 billion to $250 billion over the past five years. But the burden in local-currency terms has jumped much more, from around 210 billion reais to 655 billion reais (see chart 2). The state lends a hand here too, with the central bank offering swap contracts to insure firms against a falling real. The scheme cost the bank 38 billion reais in the second half of last year alone.

Faced with these poisonous options, a middle path is most likely. Interest rates will be too high for households and firms, so subsidised funding will grow. But they will be too low to protect the real, so swap costs will rise, too. Both subsidies put extra pressure on the government’s finances. By mixing monetary and fiscal policy in this way, Brazil is slowly rendering both ineffective. In an economy heading for recession, that is not a good place to be.

A Five-Step Plan for European Prosperity
Michael J. Boskin
FEB 25, 2015

  WASHINGTON, DC – Though the Greek crisis has been placed on pause, the economic situation in Europe remains bleak. Eurozone growth is up slightly from its near-recession levels of a few months ago, but projections by the International Monetary Fund for 2015 and 2016 barely exceed 1%. Unemployment remains above 11% – and twice that among the young (and doubled again in countries like Greece and Spain).
Greece's exit from the eurozone would likely be less disruptive now than it would have been a few years ago. The countries most at risk of contagion – Portugal, Spain, and Italy – are less vulnerable now in the eyes of the markets; the European Union has established a bailout fund; and the European Central Bank has launched a large bond-buying program.
The real challenge in Europe is continued stagnation and rising public-sector fiscal pressures in bloated welfare states with rapidly aging populations. Restoring growth, opportunity, prosperity, and financial stability will require bold solutions to five inter-related problems.
The first problem is fiscal. The math is simple. The tax rate necessary to fund social spending must equal the ratio of the number of people receiving benefits to the number of taxpayers (the dependency ratio), multiplied by the average benefit relative to the income being taxed (the replacement rate). It was this math that led Mario Draghi, the president of the European Central Bank, to declare that, “The European social model has already gone." Too many Europeans are collecting too many benefits, but so far governments have mostly ducked the issue, taking on massive debt in order to postpone the reckoning. Reform that targets social spending at true need is long overdue.
The second problem is economic: growth in Europe has fallen far short of that in the United States, decade after decade. Though economic theory predicts convergence in standards of living, Europe lags behind the US by 30% or more. High taxes and burdensome regulations stifle the labor market and potential new businesses. Overgenerous social-welfare payments create disincentives to work, hire, invest, and grow. Chronic sluggish growth is insufficient to create opportunities for the continent's masses of unemployed and underemployed young people.
The third problem is the banking crisis. In Europe, banks supply roughly 70% of the credit to European economies, compared to 30% in the US. But many European banks are over-leveraged zombies, kept alive by emergency public infusions of liquidity.
Fourth, there is the currency crisis. The euro's many benefits – cross-border pricing transparency, lower transaction costs, and inflation credibility – required surrendering independent monetary policies and flexible exchange rates. But, given limited interregional transfers and labor mobility, this means that the continent has far less ability to absorb disparate shocks through the operation of so-called automatic stabilizers. In the US, by contrast, people in high-unemployment Michigan move to, say, Texas, where jobs are plentiful, even as the federal tax and transfer system automatically shifts money in the opposite direction, cushioning the local downturn.
Finally, Europe faces a severe governance deficit. Citizens are becoming increasingly disenchanted with European elites and supra-national institutions such as the European Commission, which impose rules and regulations that conflict with their countries' economic interests and sovereignty. Voters are restless, as the Greek election result demonstrated. Nationalist sentiment is rising, and demagogic parties of the far right and left are gaining in every poll.
Addressing these problems will be difficult, but not impossible. The core challenge is fiscal; Europe cannot escape the need to scale back its sclerotic welfare states. By recognizing that, and implementing the following series of mutually reinforcing policies, the continent can move beyond its current torpor.
Gradual fiscal consolidation – reducing the projected future size of government spending, and hence future tax rates – will have to be at the center of the effort. This should be combined with the mutualization of some portion of the liabilities of highly indebted countries – defined as a debt-to-GDP ratio above, say, 60% or 70% – and modest write-downs in exchange for long-term zero-coupon bonds. The “Brady bonds" that the US used to help resolve the Latin American debt crisis in the 1990s could serve as a model.
Meanwhile, Europe's zombie banks will have to be rapidly resolved by acquisition or temporary takeover, cleanup, and asset sale, as was done by the Resolution Trust Corporation during the US savings and loan crisis in the 1980s. Structural reforms that increase labor-market flexibility and reduce red tape and related obstacles to new business formation must also be implemented.
Finally, the eurozone should adopt a two-track euro with a fluctuating exchange rate – an idea championed by the American economist Allan Meltzer. Systematic rules would have to be developed to determine when members of the eurozone are demoted to “euro B" or promoted to “euro A." Such a halfway house – call it “depreciation without departure" – would avoid some (but not all) of the problems of a country's complete withdrawal from the eurozone. It would create its own set of incentives, which, on balance, would pressure individual countries to avoid demotion, just as top-tier football (soccer) teams seek to avoid relegation to the minor leagues.
Together, these policies would reduce sovereign debt, lower interest rates, ameliorate tax pressures, enable countries to increase competitiveness with fewer sacrifices to living standards, and provide Europe with a road map to prosperity. Until now, the EU's leaders have followed the easiest, but least productive path, patching temporary, partial fixes on problems as they erupt. The possibility of a brighter economic future should be a prize large enough to evoke the same type of leadership through which Europe rose from the ashes of World War II.