Friday, May 7, 2010

Keynesian Waterloo

Keynesian Waterloo
By Chan Akya

When the Dow Jones Industrial Average records its biggest intra-day decline - 998 points - in its history on the same day that the world apparently reverts to a single reserve currency, ie the US dollar, which gained significantly against the euro even as the ''barbaric relic'', viz gold, records an increase in price, you know that it's not just another media-induced market swoon but rather something much more dramatic.

The apparent culprit in the day's big market declines has been identified as a combination of the Greek malaise that prompted a flight to safety (see
South Park - the markets Asia Times Online, May 6, 2010), significant currency market volatility, the European Central Bank refusing to comment on plans to directly purchase European government debt (quantitative easing), opinion polls showing a hung parliament in the United Kingdom and lastly a mysterious trading error on the New York Stock Exchange (NYSE) that caused a trade on index component Procter & Gamble at US$18 below the "actual" price ($38 vs $56) even as other reports suggested mistakes on the NASDAQ as well.

Weave it whichever way, the closing 3.2% decline in the Dow Jones with a backlog of sell orders on the close of the NYSE just a day ahead of an important economic data release (US non-farm payrolls for April) points as much to market reactions to a growing economic headwind as it does to the sheer volume of excess leverage still prevalent.

The effects of excess leverage can be seen in the usual area, namely the lack of confidence between banks in Europe; this week has seen a return of the same conditions that came about in mid-2007 when banks simply refused to lend to each other. That has in turn prompted a sell-off in the share prices of banks reliant on wholesale funding, as well as those with significant asset-liability duration mismatches (or in other words, ALL of them).

The leverage exists at the banks across the United States and Europe, as the level of assets relative to capital has remained high. An important difference though is that while US banks in general raised a fair amount of equity in the past 24 months, their European counterparts did no such thing and have instead resorted to accounting subterfuge over the period.

Meanwhile, governments indulged in a frenzy of Keynesian spending over the same period leading to an abnormal condition of rising sovereign debt that compounded the existing burdens of private and corporate debt; even as the growth multiplier of such spending proved illusory. The cure-all of economic malaise depends however on the ability of governments to pass along their debt to willing external buyers, and herein lies the problem with the whole gamble; namely that buyers now fear an explosion of credit risk that more than overwhelms their capital bases and are thus more keen to pull their
funds while they still can.

First look at Europe, the battleground, and quite possibly the Waterloo, for the Keynesians. Profligate government spending has been on the cards for more than three years now across the continent, where in addition to bailing out banks indiscriminately, governments have also engaged in an orgy of public spending that was designed to boost public confidence but instead appears to have had the opposite effect on the populace.

The instrument with which a lot of this misspending was hidden was through the common currency; an unwieldy combination of a common currency unit that did not have the backing of a political union. I have never been a fan of the euro, or indeed of Europe with the euro.

Well over two years ago, on March 10 2008, I wrote in an article titled "Euro-trash", wherein the notion of the euro as a major reserve currency was dismissed. My principal objection was the simple inefficacy of the ECB to handle the operations of various banks domiciled in Europe:
It is no secret across the banking world since the time that the first rumors of a UK bank being in trouble surfaced that the ECB has been quite generous in providing cheap liquidity access for banks. Over the course of the last one-third of 2007, the facilities were expanded to include all kinds of dud collateral.

When the US Fed last week made an announcement that it would expand its Term Auction Facility (TAF), the idea was greeted with sardonic smiles across the boardrooms of European banks. After all, the Fed had only made operational in March what the ECB had been doing since last summer.

How it operates is quite simple. Banks gather all the collateral on their books that cannot be sold into the wider market and provide it to the ECB against which, following some minor valuation adjustments, the central bank provides immediate liquidity. This has proven quite useful in the current climate of poor liquidity in various market instruments.

Thus, we have found out that European banks have continued to issue billions of euros-worth of
residential mortgage backed securities (RMBS) that are never sold to any investor. After securing the rating, the securities, which are simply paper representing actual mortgages in the books of various banks, are pledged as collateral to the ECB and liquidity lines are drawn.

In turn, this borrowing from the ECB is used to support the uneconomic overseas operations of European banks, ie their investments in US subprime collateral, poorly constructed collateralized debt obligations (CDOs) and the like. By not being forced to sell such assets, European banks continue to pretend that they have taken fewer losses than their US counterparts when the truth is the exact opposite. (See
Euro-trash, Asia Times Online, March 11, 2008)
Perhaps I should have added "dodgy European government debt" in the list of assets that are purchased by the European banks using the liquidity provided by the ECB. The article concluded with an apparently sweeping statement that has however been borne out now:
If the euro were to be acceptable to global central banks as the new reserve currency, it should bring with it a promise of superior performance against what is being replaced. The US dollar certainly offered all that and more when it pushed the pound sterling away in the years following World War II and certainly by the mid-60s.

In contrast, while the euro has been moving higher against the US dollar, much of this can be explained by the behavior of its own banks. The financial system of Europe is broken even more than that of the United States while its political system chases its own tail. Neither of this can help the case of the euro. If anything, the opposite is true - anyone buying the euro is doing so merely to avoid the recent problems of the US economy. When the problems of Europe come to the fore, the mad rush to the exit will leave the region and its currency unmasked as the frauds that they are.
Perhaps I was too subtle but a lot of investors DID end up piling into the euro in the months after the article was published. What exactly did everyone get wrong about the euro?

Reading various bits of prose written on the subject, it appears to me that a lot of comment has wasted away the primary question of the euro's construct, namely: WHY? As in, why did the strong, mature economies of Germany and France opt for a currency union with a bunch of free-spending Southern European countries such as Italy and Greece?

Simply put, the idea was to change the demographics and therefore the economic impetus of the European economic area. In other words, much as the US subprime crisis was about extending credit to the under-privileged in society to enable them to play "house" for real, eurozone bond markets became all about profligate Italians, Spanish and Greeks
borrowing money from the savers in Germany and France without paying an excessive premium. In turn, this borrowing binge allowed the Germans and French to sell the southern Europeans a bunch of expensive cars, cheese and wine.

In construct therefore, the European experiment ended up being merely a microcosm of the wider imbalances seen globally; and in particular the circular movement of funds, deficits and trade between the over-borrowing, over-consuming Americans and the over-producing, over-saving peoples of Asia.

So what now?

I expect a number of steps in the next few days to calm down the markets:
a. Possible announcement of government bond purchases by the ECB;
b. Imposition of trading curbs on major stock exchanges;
c. Acceptance of dud collateral by central banks (so, no change there).

Much as all these tactics may help markets calm down, the bigger question has now escaped into the public domain. That of course is who will eventually pay for the massive borrowings being taken over by the governments and paid for in a socialist fashion by citizens of other countries? It is clear that the euro experiment will end in riots if the Germans are continually forced to bail out every failing debtor nation in Europe in addition to bailing out its own banks. Then there is the significant increase in political risks across the continent as a restless populace rebels against austerity measures.

The obvious cure is to dump Keynes and his asinine ideology into the dustbin of history, and allow the inevitable to become imminent instead. That would be:
1. Push Greece to default, and effect sweeping "haircuts" or
debt reductions that will be borne by creditors; in return for warrants on the country's future growth;
2. Remove repo facilities for dud collateral;
3. Force banks to accelerate the acceptance of new accounting and capital standards whilst separating the "guaranteed" portions of banking from the riskier businesses;
4. Recapitalize banks that face capital shortfalls as a result of these changes but extract significant penalties including the dismissal of senior management.

All that said, I do not actually believe that politicians of any hue and much less in Europe will demonstrate the courage required to accept the stark message being given by the markets. A smart Keynesian (if one exists) will view Thursday's market moves as the Waterloo for bankrupt policies and quietly go into exile, along the lines of Napoleon, the losing leader in the battle. Less smart examples such as Paul Krugman will view it as a temporary setback on the lines of the earlier battle of Trafalgar and attempt a return to favor in coming months; to even more disastrous consequences.

Disclaimer: none of the preceding is meant to suggest that my longer-term bearishness with the state of the global economy has been addressed. On the contrary, Thursday's market moves simply suggest that the end-game towards more libertarian solutions has been accelerated.

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