November 25, 2014 6:17 pm

Radical cures for unusual economic ills

Martin Wolf

The crisis left a grim legacy, and the answers are likely to be unorthodox

Ingram Pinn illustration
The principal high-income economies – the US, the eurozone, Japan and the UK – have been suffering from “chronic demand deficiency syndrome”. More precisely, their private sectors have failed to spend enough to bring output close to its potential without the inducements of ultra-aggressive monetary policies, large fiscal deficits, or both. Demand deficiency syndrome has afflicted Japan since the early 1990s and the other economies since 2008 at the latest. What is to be done about it? To answer, you have to understand the ailment.
Crises are cardiac arrests of the financial system. They have potentially devastating effects on the economy. The role of the economic doctor is to keep the patient alive: preventing the financial system from collapse and sustaining demand. The time to worry about a patient’s lifestyle is not during a heart attack. The need is to keep them alive.
Like heart attacks, financial crises have long-lasting effects. One reason is the damage to the financial sector itself. Another is a loss of confidence in the future. Yet another is that it makes the debt accumulated in the run-up to the crisis no longer bearable. What happens then is a “balance-sheet recession” – a period when the indebted focus on paying down debt. Post-crisis policy has to offset or facilitate such private-sector deleveraging. Supportive monetary and fiscal policies can help do both. Without such policies enormous slumps are likely, as happened in crisis-hit eurozonee-member countries.
A complement to deleveraging is debt restructuring. Many economists have recommended such restructuring as an essential part of the solution. In the household sector at least, the US has done a far better job of this than the eurozone. But organising debt restructuring is extremely difficult so long as borrowers refuse to admit defeat. This is true of the private sector and even more so of the public sector. This is one reason why debt overhangs last so long.
Martin Wolf charts

Yet there are even more disturbing possibilities than debt overhangs. In my book, The Shifts and the Shocks, I suggest that a number of shifts in the world economy created chronically weak demand in the absence of credit booms. Among these were excess savings in emerging economies and shifts in income distribution, ageing and a secular decline in the propensity to invest in high-income countries.

Behind these shifts lay, among other things, globalisation, technological innovation and the growing role of the financial sector. It is not enough to clean up after the debt boom has collapsed. Policy makers also have to eliminate the dependence of demand on unsustainable credit.

Without that, even a radical clean-up will not deliver buoyant demand. True, if a country is small, it may be able to import the missing demand via the external account. But when huge parts of the world economy are afflicted, alternative solutions are needed. There are three broad alternatives: live with chronic demand weakness; run aggressive demand policies indefinitely (as Japan has done); or fix underlying structural demand weaknesses.

Martin Wolf charts

Hyper-aggressive monetary policy helps by delivering real interest rates that are well below zero. An alternative is fiscal deficits. But that risks putting debt on a permanently rising path.

Still more unorthodox is outright monetary financing of fiscal deficits, as Adair Turner, former chairman of the UK’s Financial Services Authority, has recommended. This means nationalising the creation of money now delegated to often-irresponsible private banks. This is a more direct (and probably more effective) way of using a central bank’s power to create money in order to expand demand than employing it indirectly, via manipulation of asset prices. Such direct monetisation of deficits seems particularly sensible in Japan.
The alternative is to address the sources of structurally weak demand. One policy would be to redistribute incomes from savers to spenders. Another would be to promote spending. This is why Japan’s consumption tax increase was so misconceived. Japan should tax savings instead. This violates the prejudice that thrift is valuable. But in a world suffering from demand deficiency syndrome, it is not. Unproductive savings should be discouraged.

Martin Wolf charts
Beyond both the post-crisis malaise and persistently weak demand lies the possibility of structurally weak supply. The solution is encouragement to work, invest and innovate. But policies designed to promote supply must not simultaneously weaken demand. This is one of the difficulties with the boilerplate recommendation of labour market reform, which entails lowering wages for a large proportion of the labour force and making it easier for employers to hire and fire. This is likely to lower consumption at least in the medium term – precisely Germany’s experience in the first decade of the 2000s. Reforms should promote demand. That is why the eurozone must settle on a balanced package, not excessive reliance on structural reforms.
The crisis left a grim legacy. The eurozone has done a worse job of dealing with this than, say, the US. But the origins of the crisis are to be found in longer-term structural weaknesses. Policy has to address these failings, too, if exit from the crisis is not to be the beginning of a journey into the next one. The answers are likely to be unorthodox. But so, too, is today’s economic condition. Rare ailments need unusual treatments. So look for them.

Copyright The Financial Times Limited 2014.


The Meaning of the Ferguson Riots
NOV. 25, 2014

      Dellwood, Mo., on Tuesday. Credit Justin Sullivan/Getty Images       

First, he refused to step aside in favor of a special prosecutor who could have been appointed by Gov. Jay Nixon of Missouri. He further undermined public confidence by taking a highly unorthodox approach to the grand jury proceeding. Instead of conducting an investigation and then presenting the case and a recommendation of charges to the grand jury, his office shifted its job to the grand jury. It made no recommendation on whether to indict the officer, Darren Wilson, but left it to the jurors to wade through masses of evidence to determine whether there was probable cause to file charges against Officer Wilson for Mr. Brown’s killing.
Under ordinary circumstances, grand jury hearings can be concluded within days. The proceeding in this case lasted an astonishing three months. And since grand jury proceedings are held in secret, the drawn-out process fanned suspicions that Mr. McCulloch was deliberately carrying on a trial out of public view, for the express purpose of exonerating Officer Wilson.

If all this weren’t bad enough, Mr. McCulloch took a reckless approach to announcing the grand jury’s finding. After delaying the announcement all day, he finally made it late in the evening, when darkness had placed law enforcement agencies at a serious disadvantage as they tried to control the angry crowds that had been drawn into the streets by news that the verdict was coming. Mr. McCulloch’s announcement sounded more like a defense of Officer Wilson than a neutral summary of the facts that had led the grand jury to its conclusion.
For the black community of Ferguson, the killing of Michael Brown was the last straw in a long train of abuses that they have suffered daily at the hands of the local police. News accounts have strongly suggested, for example, that the police in St. Louis County’s many municipalities systematically target poor and minority citizens for street and traffic stops — partly to generate fines — which has the effect of both bankrupting and criminalizing whole communities.

In this context, the police are justifiably seen as an alien, occupying force that is synonymous with state-sponsored abuse.
We get a flavor of this in Officer Wilson’s grand jury testimony, when he describes Michael Brown, as he was being shot, as a soulless behemoth who was “almost bulking up to run through the shots, like it was making him mad that I’m shooting at him.”
President Barack Obama was on the mark last night when he said, “We need to recognize that this is not just an issue for Ferguson, this is an issue for America.” The rioting that scarred the streets of St. Louis County — and the outrage that continues to reverberate across the country — underlines this inescapable point. It shows once again that distrust of law enforcement presents a grave danger to the civic fabric of the United States.


Dear Reader,

Most of you will recall our recent warning to prepare for the Crash of 2014. In that communication, I alerted you to the extreme danger facing global markets and the technical indicators pointing toward an imminent and significant market correction.

Our recommendations were to:

  • trim your portfolio to only its strongest stocks, the issues with the most emphatic fundamental reasons for owning them;
  • hold the resulting cash in US dollars;
  • keep your gold;
  • but buy "gold insurance," in the form of puts on GLD, to counter potential weakness in precious metals and related stocks; and
  • buy long-term Treasuries as a speculation that interest rates would move still lower.

As of today, the Crash of 2014 I warned of hasn't happened. Yet.

Everyone at Casey Research knows that we don't have a crystal ball. We do have solid analytical skills and a realistic view of the world on our side, but we can't predict the exact timing of a market crash. We can only assess the risk of one occurring. We continue to rate the risk as high, given the now worldwide folly of limitless QE, currency debasement, spiraling government debt and investor leverage, and the metastasizing tangle of financial derivatives. It is not going to end well for conventionally thinking buy-and-hold stock market investors.

Adding a sense of urgency to long-held concerns about such fundamentals was the number of critical technical indicators that turned bearish this fall.

All of a sudden last month, market players seemed to wake up to the geopolitical and economic worries they'd been ignoring. They got spooked.
Sentiment turned extremely bearish, but it wasn't just a matter of volatile investor emotions, and it wasn't just the long-scheduled wind-up of the Fed's Quantitative Easing. The market seemed to be waking up to the plain facts and recognizing them as frightening.

Then the Federal Reserved started backpedaling on its plan to end QE immediately. That was no great surprise, but the announcement from the Bank of Japan that quickly followed was a surprise to almost everyone: a commitment to purchase all the bonds that Japan's high-deficit government wanted to issue, i.e., QE from here to over the rainbow. The largest Japanese pension fund promptly announced that it would diversify into equities - and not just Japanese stocks, but US stocks as well. That was all it took for Wall Street bulls to come raging back. Mario Draghi topped it all by signaling that the European Central Bank would jump on the QE infinity bandwagon. Now, a few weeks later, markets are making new highs.

So while 2014 isn't over yet, it appears I was early with the warning of a crash. Of course I was. An early warning is the only kind likely to do any good.

It's not fun - and for some subscribers it's been painful - to watch the stocks they sold keep rising. But the alternative to getting out early is to stay fully invested and hope you'll get out at the last moment, just as the crash is starting. Many investors are telling themselves they're going to do just that - so many, in fact, that the eventual result will resemble one of those horrible stories of soccer fans getting crushed as thousands stampede and jam the stadium exits. If you judge that trouble is coming, leave the stadium early, even though that means missing part of the match.

Leaving early entails a cost in foregone profits, but all in all, for most readers the cost has been modest. Our call for asset deflation, including commodities and energy, has been correct; we've avoided losses in that area. Staying in US dollars rather than any of the competing paper currencies has also saved us some losses. By holding on to our strongest stocks, we've profited from the market's overall rise. And we still expect long-term Treasuries to do well next year.

I want you to know that all of us at Casey Research drink our own Kool-Aid and invest according to the recommendations we publish. We believe that the last round of unprecedented central bank actions has - at most - only postponed the inevitable for a little while longer and has done so at the cost of making the inevitable even messier.

We are confident that we and our subscribers are positioning themselves well by owning the best companies in recession-proof sectors, and lots of cash and gold. That way, we won't risk getting crushed in the exits, and while we wait for the crash, we'll have a free hand to exploit the speculative opportunities that Casey Research works diligently to identify.

The best of those opportunities may soon come to us from the resource sector. We likely are close to a final market capitulation for junior resource stocks, which could coincide with tax-loss season in the Canadian markets and the need for junior stock funds to raise cash to pay for year-end redemptions by their investors.

But don't let those opportunities draw you back toward a portfolio that is fully invested, with little or no cash. The unprecedented market backdrop of QE everywhere and QE all the time is pushing the world economy toward more and more leverage and hence exposing the markets to more and more danger.

Fear's brief October appearance on Wall Street wasn't a false alarm. All the most serious market crashes have been preceded by such early tremors.

Remember that the October 2008 crash triggered by the Lehman bankruptcy was preceded by: (i) Bear Stearns' $2 billion loss reported in June 2007; (ii) the Northern Rock collapse three months later; (iii) the distress sale of Bear Stearns to JP Morgan in March 2008; and (iv) the bankruptcy of IndyMac in July 2008. The markets, encouraged by Federal Reserve assurances, shrugged off every one of those warning signs. Then the market cracked.

So while today the urgency of the matter seems to have subsided, it would be a grave mistake not to prepare for a crisis that will make 2008 look like a walk in the park. We'll be ready.

On behalf of Casey Research, I wish all our American subscribers a happy Thanksgiving, and to all of our subscribers, I extend my best wishes for the coming holiday season.
Olivier Garret
Chief Executive Officer

Europe’s German Ball and Chain
Daniel Gros
NOV 24, 2014

 Euro Coins
BRUSSELS – A storm-tossed ship near dangerous cliffs needs a strong anchor to avoid finishing on the rocks. In 2012, when a financial storm engulfed the eurozone, it was Germany that kept the European ship off the shoals of financial disaster. But now Europe’s anchor has become a brake, hindering forward movement.
Of course, German Chancellor Angela Merkel acted in 2012 only when she could tell her domestic constituency that there was no alternative. But in the end, Merkel agreed to a permanent bailout fund for the eurozone. She also backed the formation of a banking union, which remains incomplete but still represents a key step toward a financial system supervised by the European Central Bank.
Thanks to these measures, and ECB President Mario Draghi’s vow, which Germany tacitly approved, to do “whatever it takes” to save the euro, the financial storm abated.
But now the eurozone seems incapable of escaping near-deflation, with little economic growth and prices barely moving upwards.
That was not supposed to happen. When the crisis struck, the economies of the eurozone periphery were buffeted by the twin shocks of spiking risk premiums and a collapsing housing market. At the same time, the German economy benefited from the return of capital fleeing the periphery. Real (inflation-adjusted) interest rates in Germany became substantially negative, triggering a housing boom. It was assumed that this would generate strong domestic demand in Germany, helping the periphery to export more.
Instead, the German economy has barely grown; indeed, weaker world trade threatens to put it in recession. The current-account surplus, which was supposed to decline sharply, has actually increased, as savings have remained higher – and investment lower – than expected.
Another problem, at least from the point of view of the rest of the eurozone, is that inflation in Germany remains too low. With German prices rising at less than 1% annually, the eurozone periphery needs falling prices in order to regain the competitiveness lost during the pre-2008 boom years.
This lack of dynamism at the core of the eurozone has now become its key problem. With no growth in Germany, the rest of the eurozone might not be able to reduce debt via external surpluses. And there might be no solution short of a magic button to increase German domestic demand.
Obviously, the German government is in charge of the country’s public finances. But fiscal policy has been roughly neutral in recent years, and thus cannot be blamed for the German economy’s lack of dynamism. This year, the public-sector budget might move from a small deficit to what German officials call a “black zero” – a very small surplus. But this tightening by a fraction of a percentage point of GDP implies no adverse effect on growth.
The root cause of Germany’s sluggish economic performance in recent years is the continuing unwillingness of its households and enterprises to consume and invest. And it is difficult to see what the government can do about this.
Indeed, investment has fallen despite financing conditions for enterprises that have never been easier, both in terms of ultra-low interest rates and banks’ willingness to lend. Yet Germany’s corporate sector remains reluctant to borrow and invest in the country, because it sees little reason to expect long-term economic growth, given that the population is set to decline and productivity gains remain anemic.
With investment unlikely to become a motor for the German economy, consumption holds the key to stronger demand growth in Germany. Its weakness is somewhat surprising: real incomes are up, and the coalition government that came to power last year has introduced a series of generous welfare measures, including a large increase in the minimum wage, a reduction of the retirement age, and a special top-up pension for women with children.
But even these measures, which foreign observers have largely overlooked, have failed to boost consumer demand. So what more could the German government do to wean the Germans off their abstemious habits?
Public investment is the one area where the government could act. But the growth fillip from public-sector infrastructure spending can only be modest. Increasing infrastructure spending by a quarter, which would represent a huge administrative effort, would lift GDP growth by just 0.4 percentage points.
The main danger now is political. A weak German economy makes the necessary structural adjustments in the eurozone periphery much more difficult. That, in turn, fuels the perception that responsibility lies with the German government, which is seen as unwilling to take the steps needed to strengthen domestic demand – even as it prohibits the periphery governments from spending more themselves. As unemployment remains stubbornly high and incomes stagnate in much of the eurozone, the temptation to blame “the Germans” is becoming ever stronger.
The German government, no surprise, does not even acknowledge that there is a problem. With unemployment remaining near record lows, the lack of demand growth is simply dismissed, and the absence of inflation is taken as a sign of success.
This is a mistake. Europe’s German anchor has become stuck, and the rising tide of anxiety among Germany’s partners should not leave its government indifferent.

11/25/2014 05:49 PM

Relations at Rock Bottom

Cracks Form in Berlin Over Russia Stance


Russian President Vladimir Putin as he departs from G-20 summit in Brisbane, Australia on Nov. 16

Russian President Vladimir Putin as he departs from G-20 summit in Brisbane, Australia on Nov. 16

A political solution is more distant than ever in the Russia conflict, with the German government and EU having exhausted their diplomatic options. A rift may now be growing between Chancellor Merkel and her foreign minister over Berlin's tough stance against Moscow.

Philip Breedlove needs a pen. He is surrounded by journalists and is looking around desperately. Finally, his advisor hands him one and it disappears almost entirely between the American four-star general's broad fingers. Then he begins sketching out in quick strokes the outlines of Ukraine on the back side of a white menu -- almost certainly not for the first time.

He then draws in eastern Ukraine that is under the control of pro-Russian separatists.

Breedlove is head of the United States European Command and NATO Supreme Allied Commander Europe. Last Monday in Berlin, he said what he would later explain in greater detail in an interview with the Frankfurter Allgemeine Zeitung newspaper -- namely that the forces supported by Russia want to create a more integrated and clearly defined area out of the small parts of the country already under their control. Currently missing from the equation is the Donetsk airport and land access to the Crimean Peninsula through the Ukrainian port city of Mariupol. Both are still in the hands of the Ukrainian government.

When asked what the European and NATO response will be, or even if one had yet been devised, the general said, just wait.

From Partner to Adversary

Almost exactly a year after the European Union's failed Eastern Partnership Summit in Vilnius, the situation on the ground in Europe has altered radically. Russia, a former partner, has now became an adversary. Borders have shifted. Soldiers have been given marching orders and innocent people have died. Much has happened in Europe that people thought would never happen again. Particularly not on a Continent that had seen so many millions of lives lost in the past century. Europe was supposed to have learned its lesson.

German Chancellor Angela Merkel now speaks openly about, "outdated thinking in terms of spheres of influence which tramples international law" and says it "must not be allowed to prevail." It's a thought she may have harbored many times, but when she said it in Sydney last week, it marked the first time she had uttered such sentiments to a global audience. It was a clear challenge and turning point after a year of diplomatic efforts that, while not useless, now appear to have been exhausted. From Russia's annexation of Crimea to the threat of secession in eastern Ukraine, there's little hope left that events can still be reversed. "Everyone seems to be at wits' end," say federal government sources in Berlin.

Europe has reached rock-bottom in the crisis with Russia -- and rock bottom is a dangerous place to be.

Divering Interests in Europe

Within the European Union, the interests of the 28 member states are diverging in what are becoming increasingly clear ways. Taking a tough stance against Russia is generally less important to southern Europeans than it is to eastern Europeans. In the past, the German government had sought to serve as a bridge between the two camps. But in Berlin itself these days, significant differences in the assessment of the situation are starting to emerge within the coalition government pairing Merkel's conservative Christian Democrats and the center-left Social Democrats (SPD). It's one that pits Christian Democrat leaders like Merkel and Horst Seehofer, who heads the CDU's Bavarian sister party, the Christian Social Union (CSU), against Foreign Minister Frank-Walter Steinmeier of the SPD and Social Democratic Party boss Sigmar Gabriel, who is the economics minister.

"The greatest danger is that we allow division to be sown between us," the chancellor said last Monday in Sydney. And it's certainly true to say that this threat is greater at present than at any other time since the crisis began. Is that what the Russian president has been waiting for?

Last week, German Foreign Minister Steinmeier traveled to Moscow to visit with his Russian counterpart Sergey Lavrov. With Steinmeier standing at his side, the Russian foreign minister praised close relations between Germany and Russia. "It's good my dear Frank-Walter that, despite the numerous rumors of recent days, you hold on to our personal contact." Steinmeier reciprocated by not publically criticizing contentious issues like Russian weapons deliveries to Ukrainian separatists. Afterwards, Vladimir Putin received him, a rare honor. It was a prime example of just how the Russian strategy works.

United Assessments, Divided Approaches

The German foreign minister is professional enough not to be surprised by the Russian kindness. Even as the chancellor sharply attacked Putin during her appearance in Sydney, saying the West shouldn't be "too conflict averse," Steinmeier struck a far softer tone on the same day in Brussels.

Without mentioning Merkel by name, Steinmeier urged for a bit more restraint in public statements, saying the West had to be careful to make sure "that in our use of language in public, we do not eliminate our chances of contributing to the easing of tensions and to the mitigation of conflict."

When he said that, the foreign minister knew that there was a chance he might get a meeting with Putin. As such, one could interpret his statements as an attempt to avoid jeopardizing his possible appointment with the Russian president at the Kremlin.

Still, the statements marked the first time any fissures had become visible in the joint position vis-a-vis Moscow held by Steinmeier and Chancellor Merkel. They are united in their assessment of Russia's actions, but their views differ on the best way to face the Russians in the coming weeks. That, though, has long since become the all-important question.

Merkel considers it to be crucial to make clear to Putin publicly how his conduct is viewed in the West and just what is at stake. She believes that the Russian president will only respond to clear statements -- if he bothers to respond at all.

Her approach is based on the concern that pro-Russian separatists may seek to divide eastern Ukraine for the long run and that the West will have to resign itself to that development. If that happens, then Russia will now have succeeded with its strategy for the third time since the end of the Soviet Union.

Both Abkhazia and South Ossetia, breakaway republics that are part of Georgian territory, are under Russian control, as is the Transnistria region of Moldavia. The consequence being that neither country is able to join NATO because the military alliance stipulates that any member state must have previously resolved all border disputes with its neighbors prior to accession.

'Highly Dangerous'

Steinmeier wants to avoid provoking the Russians. He fears that would force Moscow into an even more defensive posture and would further complicate cooperation with Russia in other areas like the nuclear negotiations with Iran. Just how deep these differences between the chancellor and foreign minister go may emerge at a meeting of senior leaders of the parties in Merkel's coalition government on Tuesday night.

"I want clarity from Sigmar Gabriel," says CSU boss Seehofer. "Does the SPD support the efforts of our chancellor or not?" He warns that the West needs to close ranks on the issue, the German government all the more so. He adds that, even within his own party, there is already too much friendly sentiment towards Russia that has to be kept in check. "They're asking, why are we permitting the SPD to have this Russia-friendly approach but not our own people in the CSU?" He also wants to call on Foreign Minister Steinmeier to not abandon the chancellor's hardline policy. "I know Mr. Steinmeier to be a level-headed diplomat, and we also need dialogue with Russia," Seehofer says. "But things will get highly dangerous if Mr. Steinmeier pursues his own diplomacy apart from the chancellor."

Last Wednesday, the chancellor discussed the issue with her foreign minister on the sidelines of a cabinet meeting. She convinced him to delay a meeting planned this week of the Petersburg Dialogue, a high-level meeting of representatives from Germany and Russia that serves as a prestigious forum between the two countries. Steinmeier went along with it, also agreeing to suspend the dialogue's traditional close working ties to the German-Russian Forum, which is led by Matthias Platzeck, a prominent Social Democrat. Platzeck, the former SPD national party leader, suggested in an interview last week that Russia's annexation of the Crimea Peninsula should be settled "retroactively according to international law," thus giving the move formal recognition. "The smarter ones" also have to give in now and then, Platzeck added. It's a statement that deeply irritated officials in Merkel's Chancellery. But it has been difficult for Steinmeier to distance himself from his friend.

Merkel, meanwhile, has taken sides with a group of critics of Moscow who want to extensively change the Petersburg Dialogue, which is intended to promote cooperation between civil society. The group includes Andreas Schockenhoff, the deputy head of the parliamentary group of Merkel's conservatives, Marieluise Beck, a member of parliament with the Green Party, and representatives of several non-governmental organizations. In a white paper, the group has called for a stronger role for foundations and other societal groups in the Petersburger Dialogue. They're also calling for a new chairperson.

The man currently heading the dialogue's German steering committee is Lothar de Maizière, the last prime minister of East Germany. Officials inside the Chancellery consider him to be too uncritical when it comes to Russia. Platzeck, who had hopes of becoming his successor, dashed them with his recent comments. "Anyone who wants to legalize the violation of international law and military aggression lacks critical distance to the Russian partners," says Shockenhoff.

Concern in EU Capitals

Officials are also worried in other European Union capitals about the differences between the Chancellery and the Foreign Ministry. It is clear to everyone, the ambassador of one major EU partner says, "that only Berlin can negotiate on equal footing with the Russians." Meanwhile, officials in the Baltic states and Poland worry that Steinmeier could abandon Berlin's clear position on the Ukraine issue.

Comments made at a meeting of EU foreign ministers last Monday helped to fuel those worries. Federica Mogherini, the EU's high representative for foreign affairs and security policy, proposed adding additional Russian citizen's to the EU's red sanctions list. But Steinmeier surprised the other ministers by pushing for a formulation that only addressed the separatists in eastern Ukraine. Participants said he argued that "new channels" to Moscow had opened up at the G-20 summit in Brisbane, Australia, and they shouldn't be slammed shut again.

It wasn't just the Lithuanian foreign minister rubbing his eyes and strongly disagreeing. The foreign ministers from Poland and Estonia opposed the effort to protect the Russians as well.

They said they had an entirely different perception of the talks in Brisbane and instead viewed them as a further hardening of attitudes. Critics of Moscow who took part in the talks argued that Russia hadn't undertaken any positive steps that would have justified the EU gesture.

That Frank-Walter Steinmeier prevailed in the end did little to assuage their concerns.

By Nikolaus Blome, Peter Müller, Christian Neef, Ralf Neukirch and Christoph Schult

German bond yields to trump Japan as ECB battles deflation

"Be very bullish. The huge elephant in the room is ready to roar again," RBS advises clients

By Ambrose Evans-Pritchard

7:14PM GMT 24 Nov 2014

Famous sight of the city of Berlin the Brandenburg Gate with colourful illumination during the Festival of Lights

'Net [Bunds] supply in Germany is zero since they are in budget surplus this year and next, and they have written a balanced-budget amendment into their constitution' Photo: Alamy
German bond yields are to fall below Japanese levels and plumb depths never seen before in history as Europe becomes the epicentre of global deflationary forces, according to new forecast from the Royal Bank of Scotland. 
“We are seeing `Japanification’ setting in across Europe,” said Andrew Roberts, the bank’s credit strategist. “We expect 10-year Bund yields to cross the 10-year Japanese government bond and we are amply positioned for such an outcome.”
Mr Roberts said it is a “weighty win-win” situation for investors. If the European Central Bank launches full-blown quantitative easing, it will almost certainly have to buy large amounts of German Bunds, and these are becoming scarce.
“Net supply in Germany is zero since they are in budget surplus this year and next, and they have written a balanced-budget amendment into their constitution. There are simply fewer and fewer Bunds to buy, and everybody wants them,” he said.
It is assumed that if the ECB buys sovereign bonds, it will have to buy them evenly in accordance with its capital “key”. This implies that 28pc would have to be German debt.

Yet if the ECB fails to deliver on hints that it will expand its balance sheet by €1 trillion, the damage would be so enormous that Europe would be sucked into a depressionary vortex, according to the bank. Bund yields would fall for different reasons, as debt markets began to reflect a Japanese-style deflation trap.

The bank’s credit team is betting that the ECB will act more quickly and on a greater scale than widely assumed, launching purchases of corporate bonds as soon as early December and full sovereign QE in February once the European Court has ruled on a previous debt rescue plan (OMT).

“We think Germany will be dragged to the table, kicking and screaming all the time,” said Mr Roberts.

Japanese yields are just 0.45pc, which is steeply negative in real terms now that ‘Abenomics’ is driving up Japan's inflation rate. This is a deliberate strategy to whittle away a public debt that has reached 245pc of GDP.

German yields are 0.78pc. RBS expects the two bonds to cross as Japanese yields rise while German yields fall. This would be a radical change in the structure of the global financial system.
Mr Roberts said ECB chief Mario Draghi is a “super-dove” who has to disguise his views but is in reality leading the North's hawkish bloc by the nose. “He has to tread a bit more delicately given sensitivities in a couple of Teutonic countries. This year, for all the talk of QE being a step too far, they have actually already been easing aggressively. They are not sitting on their hands,” he said.
The bank expects €500bn of asset purchases in the first round. This comes on top of easing by Japan and China, and will feed a euphoric rise in asset prices across the board. “Be very bullish The huge elephant in the room is ready to roar again, and we want to be onside,” it said, with the hallmark use of mixed metaphors that characterize City argot.
“It is a good time to be an equity, and credit, and periphery and bond bull, All ‘risk on’ wins.”

Stock Manipulation 101: Using Stock Buybacks to Mask Deep Business Problems

Stock buybacks are always a good thing… right? That’s what the mass media has trained investors to believe, but there are times when stock buybacks are a horrible strategy.

Let’s take a look at Herbalife, which has had very visible news items as billionaires like Carl Icahn, George Soros, Daniel Loeb, and Bill Ackman publicly debate the future of the company.

Herbalife shares have lost more than half their value in 2014 because of a Federal Trade Commission investigation and a big drop in profits. 50% is a huge haircut, but I believe Herbalife is poised for even more pain.

Rapidly Disappearing Profits
Herbalife recently reported its third-quarter results and they were just awful. Herbalife earned $0.13 per share in Q3, but that was a whopping 92% decline from the $1.32 it earned last year.

That’s awful, but Herbalife says business will be even worse going forward. The Wall Street crowd expected Herbalife to grow revenues by 7% in 2015, but the company said that its revenues will fall by -1% to -2% instead.

Part of that lower guidance is from the impact of the strong US dollar. Guidance for Q4 includes an unfavorable impact of $0.31 from currency conversions. If you remember, I previously wrote that the strong dollar was going to kill the 2015 profits of companies that do lots of business overseas.

I have to admit, I am skeptical of all the multilevel marketing businesses, but Herbalife is reinforcing that preconceived notion.

FTC and FBI Investigation

The Federal Trade Commission is investigating Herbalife for what could ultimately result in charges that Herbalife is operating an illegal pyramid scheme.

In March, the FTC sent Herbalife a civil investigative demand (CID), which is a subpoena on steroids because all the evidence produced by a CID can be used by other agencies in other investigations, such as the FBI, which is also investigating Herbalife.

The FTC outcome is unknown. Heck, Herbalife could eventually be declared innocent and pure… but I wouldn’t bet on it.

Board Members Gone Bad!

When your company is in the middle of FTC and FBI investigations, the last thing you want is for your company officers to get in trouble with the law. A current Herbalife board member, Pedro Cardoso, has been charged with illegal money laundering by Brazilian prosecutors. Time will tell if the charges are true… but it looks very bad.

That’s not the only problem with the Herbalife board of directors. Longtime Herbalife Board Member Leroy Barnes announced that he is leaving. Board members leave for legitimate reasons all the time, but Barnes is the fourth Herbalife board member to leave in 2014. Talk about rats jumping the ship!

The Smoke and Mirrors of Stock Buybacks

The above issues are all serious and enough to stay away from Herbalife, but the biggest red flag I see is the abusive financial engineering that Herbalife is using to prop up its stock.

Example: In Q2, Herbalife spent over $500 million to buy back its own stock for the purpose of propping up its earnings-per-share ratio. Fewer shares translates into higher earnings per share.

The root of the problem is that Herbalife is using up all its cash AND borrowing money like mad to finance the stock buyback.

In the last year, Herbalife’s debt has exploded by over $1 billion. Herbalife is using every penny of operating cash flow and taking on new debt just to buy back its stock.

Moreover, since Herbalife’s stock has plunged by 50% this year, Herbalife wasted hundreds of millions of dollar of shareholder money by buying stock at much higher prices.

And now that revenue, profits, and free cash flow generated by operations are shrinking, Herbalife is on a collision course with insolvency.

Carl Icahn, who is certainly a much better investor than I will ever be, is a big Herbalife fan and even went as far as to call the shares undervalued. “I would tell you I do believe Herbalife is quite undervalued and it is still a good business model.”

Ahhhh… Carl… sorry, but I think you couldn’t be more wrong.

George Soros, by the way, appears to agree with me because he reduced his Herbalife holdings by 60% after the company reported those disastrous third-quarter results a few weeks ago.

I’m not suggesting that you rush out and buy put options on Herbalife tomorrow morning. As always, timing is everything, but I have very little doubt that Herbalife’s stock will be significantly lower a year from now.

Moreover, the real point isn’t whether Herbalife is headed higher or lower, but that good, old-fashioned fundamental research can help you make money in any type of market environment.

Even during bear markets.

Tony Sagami
Tony Sagami
Mauldin Economics