spotfxtrader

Sovereign Man
Notes from the Field

Originally posted here

Date: February 28, 2012
Reporting From: London, England

[Editor’s note: Tim Price, a frequent Sovereign Man contributor and Director of Investment at PFP Wealth Management in London, is filling in for Simon today.]

In December last year, the poet Alice Oswald withdrew from the TS Eliot poetry prize on the grounds that the prize was being sponsored by an investment company (Aurum, a fund of hedge funds manager).

How you feel about this principled stance may depend on whether you are a UK taxpayer. If you are a UK taxpayer, you will probably feel relieved that your tax pounds are no longer being squandered on the Arts Council’s sponsorship of the prize in question “a tiny victory” but a victory nevertheless against the arrogant dissipations of the state.

Ms Oswald seems to believe that poetry prizes should be funded with everybody else’s money, rather than by a private patron grown-up enough to be responsible for its discretionary expenditure (private patronage being what you might call “traditional” in the arts).

As a graduate in English Language and Literature, this commentator has no animus against poets. But I am not sure we want them in charge of the economy. They are notorious for starving in garrets for a reason.

Ms Oswald’s “protest” is part of a wider intellectual malaise that lazily conflates government spending with the real economy and which conveniently ignores the fact that without a flourishing private sector, there would be no government and certainly no government spending to speak of.

It is part of that lazy thinking that inspires journalists to keep speaking of “the government” spending money on this or that, as if “the government” were somehow sitting on an infinitely large pile of “government money” that most of the time it was unreasonably withholding from worthy causes.

The reason our economy is knackered is because successive governments have indeed pandered to subjective worthy causes with money that those governments did not possess.

Tomorrow and tomorrow and tomorrow, taxpayers will be paying the bill. It is not government money because the government doesn’t have any. It has liabilities only. It is taxpayers’ money.

The finest achievement to date of the UK’s coalition government has been a triumph of PR’ as one might expect, given that PR appears to comprise the only work experience our current Prime Minister has ever had outside politics.

A myth has arisen, polished frequently by an ignorant media, that the British government has started to deal with the grotesque debt inherited from the previous government. But as Prosperity Capital’s chief economist Liam Halligan points out, government spending was actually higher for the fiscal year 2010/11 than under the last year of the last government.

The UK debt figures are also much worse than conventionally believed because 2011 debt including “interventions” stood at ~£2,270 billion as at September 2011, or 150% of UK GDP. To this we should add public sector pensions (~£1,100bn+), PFI (~£400bn+) and sundry other off-balance-sheet obligations of the state.

Liam Halligan’s bleak summary is that after five years of supposed austerity, UK government spending will be back to 2005 levels… but with twice as much debt.

Just as there has been no real austerity in the UK, yet’ there has been no real deleveraging in the global economy at an aggregate level. Paul Marson of Lombard Odier points out that global credit market debt stands at $220 trillion, having grown by 11% annually since 2002, versus 8% nominal GDP growth:

[Credit Market & Debt to GDP]

In debt markets we are seeing a catastrophic example of the law of diminishing returns. As Marson makes clear, it takes greater amounts of debt to have the same marginal impact on GDP. The marginal effectiveness of debt has collapsed during the period since the end of the Second World War.

For the USA, for example, 1 unit of debt generated 0.63 units of GDP between 1953 and 1984; that same 1 unit of debt generated 0.24 units of GDP between 1985 and 2000; since 2000, 1 unit of debt has generated just 0.08 units of GDP.

The problem is insuperable. More debt has been created in the past forty years than will ever realistically be paid back… which leads us to the existential financial problem of our time:

The modern, debt-based economy requires constant economic expansion if only to service all that debt. So what happens when the modern economy goes ex-growth and stops expanding?

Iceland already found out. Greece is in the process of discovering. But we will all get a chance to participate in this lesson.

Runaway fiscal and monetary stimulus throughout the western economies is in the process of destroying the concept of creditworthiness at the centre of the modern monetary system. Private investors, we suspect, have little or no conception of the extent to which the state is now the predominant player in the financial markets.

Central banks control the money supply and interest rates. Central banking and commercial banking interests have essentially become fused.

The ECB’s long-term refinancing operations are banking bailouts by the back door. Central banks are now also the swing players in government bond markets which directly influences the price for corporate credit. Central bank monetary stimulus also directly influences equity market direction and confidence.

Be careful, be very careful about the sort of government debt you hold. You may well end up being paid in whole- but in such depreciated terms that being “kept whole” will be meaningless in real terms.

In all other respects, our investment choices remain what they have always been: high quality, high yielding defensive equities; uncorrelated systematic trend-following funds; gold, silver, and gold and silver mining companies.

There will come a point, and it may admittedly be some time in coming, when a major government bond market goes bang. Perhaps Japan, some peripheral market in the euro zone, some core market in the euro zone, the UK, or even the US.

You will hear the echo throughout the world. We intend to be a very long way away when that time comes.

http://graphics.thomsonreuters.com/11/07/EZ_BNKEXP0711_SB.html

this from zerohedge .

written by Brian Rogers of Fator Securities

http://www.zerohedge.com/news/guest-post-welcome-currency-wars

Wither the Euro

Which brings us to Europe and the highly imperfect Euro. The only solution for Europe is a consolidation of fiscal authority at the national level, something like a United States of Europe. This will allow for the issuance of a Eurobond and allow the proverbial debt can to be kicked down the road a bit further. However, even this imperfect solution will never fly. There were times in the mid-2000s where the powers that be in Europe tried to pass a unifying constitution and they were soundly rejected. And this was when the economy was strong, jobs plentiful and the cost of integration viewed to be relatively light. In the current economic situation, however, integration seems unthinkable. All of the recent local and regional elections in Germany, Finland and elsewhere seem to verify this viewpoint as voters continue to elect politicians who will not support more bailouts or further losses of national sovereignty. Europeans are voting for less integration rather than more so this is a non-starter in my opinion. Which means more EUR weakness and eventually an unwind of the currency union. As investors exit the EUR, some will buy CHF and test the SNB. They lost billions earlier in the year on market interventions. They will lose billions more on this one until they eventually capitulate.

The currency union will fail not because the current political leadership wants it to, quite the opposite, it will fail because the people of Germany are Germans and don’t want to be equal members of a broader European concept called United Europe. Same thing for the Dutch, French, Belgians and others. This will ultimately kill the hope some hold out for the Eurobond concept. No fiscal union.

Print More Euros? Nein!

So the other option is massive printing, aka the preferred option of one Ben S. Bernanke. In my opinion, the ECB is really a proxy for the Bundesbank. The Germans, having a particular history with money printing to solve debt problems, will be loath to support much more printing and the polls in Germany so little support for this “solution.” Trichet will continue to print as the banking crisis worsens but at some point he will simply have to pull the plug and allow the chips to fall where they may. The Germans will not repeat the mistakes of the Weimar Republic, even if it means the breakup of the decade or so experiment called the Euro.

This means a banking crisis is coming. The major European are all under-reporting their exposure to the PIIGS because they are reporting net, not total exposure. They have hedged some of their PIIGS risk in the CDS market but in a modern-day banking crisis, the value of those hedges will approach zero as counterparty risk will surge once one of the main banks begins its death spiral. Redemptions will hit the hedge funds, forcing them to liquidate and further rendering the value of any protection they wrote worthless. A hedge only has value if your counterparty is financially able to deliver on the contract. With Greek paper implying at least a 40% haircut, the big banks in Europe are toast. And that’s only discussing Greece. If Italy comes under further pressure, forget it, game over. Italy is way Too Big To Bailout.

Could the US Fed end up purchasing European sovereign debt in an attempt to prevent a collapse of the Euro? Although it doesn’t seem too likely today, I wouldn’t bet against it completely. If buying more PIIGS debt helps keep the banks alive another day, then buy they will. Don’t be too surprised if it happens. As the Swiss and Brazilians just showed, all options are on the table.

This will affect the US banks as well, particularly the large derivative players. Counterparty risk will surge, funding will dry up and capital levels will be questioned in detail. And this particular leg of weakness doesn’t even consider the capital that may need to be raised from the FHFA lawsuits announced last week.

This will force the US government to enact the bank nationalizing powers of the Dodd-Frank Act to ring fence the good assets (assuming there are some) of the major US banks that come under fire. In turn, this will put significant pressure on the US government as the FDIC is forced to make good on billions of dollars of deposits. In addition to the billions being lost on the GSEs, the government will be forced to spend billions on the banking sector while teachers lose their jobs to austerity. This will further roil US politics as both major parties will want to bailout the banking sector but neither will want to move first! You think we had gridlock over the debt ceiling debate, you ain’t seen nothin’ yet!

He touches on the possibility of the Fed bailing out Europe..
I think the last throw of the dice will be concerted central bank intervention by all the major central banks, but this too will probably ‘fail’, since the whole system is gangrenous and what is needed is not that it be preserved but that the gangrene be excised.

Watch 1.3837.

If Chinabot doesn’t show up right beneath there then look for 1.3693

The business daily Handelsblatt writes:

“The problem (with the decision to peg the franc to the euro) is that its ultimate success is not, in the end, under the control of the Swiss National Bank. For a long time now, the franc’s exchange rate has had little to do with fundamental economic indicators and a lot to do with fear: the fear that the euro zone will not get its debt problems under control. Some investors have even been willing to accept negative interest for Swiss franc investments just so they could own francs.”

“But even the Swiss central bank would be powerless against a renewed wave of panic. Should doubt crop up once again as to Italy’s solvency — or even that of France — the franc exchange rate could no longer be controlled.”

“By pegging the franc to the euro, the Swiss central bank gave up independent control over monetary policy. Yet according to Swiss law, it can only do so for a limited amount of time. The markets know that too — and they likely have more patience in this game.”

Again from ZeroHedge
Submitted by Tyler Durden on 08/12/2011 08:43 -0400

One of the key catalysts for Wednesday’s market rout which originated in Europe came following news that Chinese banks had cut down on their credit lines to Europe, which highlighted the key threat to the European banking system: access to liquidity. The Chinese reaction is merely a symptom of a much deeper underlying ailment: the increasing lack of counterparty confidence across various funding markets, both traditional and shadow, which has continued to accelerate over the past week, a development summarized effectively by the latest report in the International Financing Review which uses some powerful words (of the type that European bureaucrats hate) to explain where Europe stands right now: “credit taps run dry for European lenders, setting scene for liquidity crisis.” For those strapped for time the take home message is that: “with bond markets shut and investors unwilling to buy asset-backed securities, the repo market – for some banks the sole remaining source of private funding – has become the most recent tap to run dry, with some investment banks pulling credit lines worth tens of billions of euros in recent weeks.” This is very disturbing as with liquidity windows shut, Europe’s bank have no recourse on how to roll the €4.8 trillion in wholesale and interbank funding which expires in the next two years. End result: the only recourse is the ECB, which unlike the Fed, is not suited to be a lender of last resort and has been morphing into that role over the past year kicking and screaming. And when that fails, there are the Fed’s liquidity swap lines. Too bad that the liabilities in the European banking system are orders of magnitude bigger than in the US, and should this liquidity crisis transform into its next and more virulent phase, even the Fed will find it does not have enough capital to prevent a worldwide short squeeze on the world’s carry trade funding currency (once known as the reserve currency).

First, IFR summarizes briefly how the last ditch liquidity conduit, repo, has now run out. The fact that even shadow banking system aggregates, or those entirely off the books, are being withheld, is very disturbing:

Bankers who once ran the now-defunct repo facilities for mid-sized European banks say the credit lines were withdrawn after risk managers became concerned about their own exposure to the enfolding sovereign debt crisis, leaving some clients now solely reliant on central banks for cash.

“Given what’s going on in the markets, there are big question marks surrounding some of these clients,” said one banker who has closed such lines. “The appetite from investment banks is fading. There is a great deal of concern about financing wrong-way collateral.”

“Many of the wholesale banks are starting to rethink these credit lines,” added the global markets chief of one European investment bank heavily present in the repo markets. “Things can turn pretty nasty if you get these things wrong.”

This is further distressing since the traditional venue of capital raising in Europe, covered bond issuance has ground to a halt, with not “a single publicly announced European covered bond deal since June.”

The culprit for the market freeze is quite simple to anyone who recalls the state of the markets in late 2008 and early 2009, when the Fed and the central bank cartel will had the option of backstopping the global financial system.

“Everyone has been cutting off their exposure,” said the head of another European investment bank. “It started with Greece, then Spain and now Italy. People don’t want to do business with these banks. Many of them have good underlying businesses but they are stuffed.”

At his point however, the global central bank intervention has not already occurred but is actively priced in at any given moment. There is no step function of additional liquidity that the central bankers can provide, which is why the status quo is scrambling so hard to avoid a quantum leap in the risk perception of European banks.

Another indication of the unwillingness to participate in the market is the complete elimination of crap collateral from tri-party repo lines:

The latest repo markets survey by the International Capital Market Association indeed shows a marked pick-up in the use of riskier assets in European tri-party repo deals. Though small as a proportion of the region’s entire €5.91trn repo market, the use of assets with a rating of below BBB– accounted for 5.1% of all transactions in December, up from 1.2% a year earlier.

That has now largely stopped, say bankers once heavily involved in such deals. Previously, they were able to hedge their exposures to such collateral – or repackage the collateral on behalf of clients to sell off in chunks to fund managers. But growing investor concern, and a rush towards safer assets, has meant that neither investment banks nor investors want to go near the stuff.

“We’ve attempted to do some trades with illiquid assets on behalf of peripheral banks, but we haven’t managed to syndicate deals,” said one senior banker that helped repackage some past deals. “Anything slightly peripheral-orientated is completely out of the question right now.”

What is, however, bad for banks, is perfectly good for the ECB, which will gladly hand over 100 cents on the dollar for the most worthless collateral it is stuffed with. There is one problem with this: Lehman did precisely this in the days and weeks before it filed. It did not help.

So with the ECB now happy to be Europe’s not-bad but thourughly toxic bank, how long until everyone realizes that the ECB is massively undercapitalized and its existence (yes, that includes its ability to print money), purely a factor of continued German good will.

Total use of the ECB’s main refinancing and long-term refinancing facilities – both part of the open market operations – are now close to €500bn, up from about €400bn in the spring.

According to Goldman Sachs, although such levels are well short of the almost €900bn used in 2009, the uptick is worrying. “This is a substantial figure, reflective of the strains in the banking system,” analysts wrote.

But banks’ use of the ECB open markets operations remains dependent upon them having ample quality assets on their books. Under the terms of the operations, the central bank will only provide liquidity against certain assets – generally those rated BBB– and above, with some exceptions.

If ECB eligible collateral runs out, banks will have little option but to sell off assets in a final fire sale, say bankers. That will depend on whether there are willing buyers for such assets, much of which were accumulated pre-2007 as retail, commercial and wholesale loans.

And as Germany has indicated, it is getting fed up with the ECB pledging what is effectively an ever increasing portion of its GDP either directly, by accepting worthless collateral, or indirectly, by funding an ever greater portion of the AAA-rating constrained EFSF. When does Germany find that the trade off between its sovereign risk and the fate of the EUR no longer makes practical sense.

So what is the conclusion:

“The financial wreckage at many of these banks is along the lines of World War Two,” added the global markets chief. “There is so much detritus. But a lot of them don’t want to sell at these current prices, they know there will be a capital hit if things are properly priced.”

Bottom line: 3 years after Lehman blew up we are in precisely the same position, only this time the culprits are European banks. This is to be expected as absolutely nothing has changed in that time period, and the end result, by implication, will be absolutely the same.

from zerohedge :

Submitted by Tyler Durden on 08/12/2011 – 07:28

BUNGA BUNGA: -25
SIESTA: -20
PORT: -90
YOGURT: unch
WAFFLES: -36
RIOTS: -11
GUINNESS: -45
F. FRIED: -21
ANSTALT: -10
GERM: -11.5

We are going to keep throwing good money after bad and work as hard as we can to transfer the debt that is on the banks to the ECB and European taxpayers as long as the voters will let us. This first tranche will be another €109 billion. That will last a few years, and Greece will only have to pay about 3.5% on that debt and the rollover debt, and people who expected to be repaid in that period will see payment extended to either 15 or 30 years.

hahahaha….

you mugs….

Call my chauffeur and get me back to my taxpayer funded penthouse…

This is a great article which I am reposting from John Mauldin’s Outside the Box E-Letter.

You should sign up here

Three Competing Theories

By Lacy Hunt, Hoisington Asset Management

The three competing theories for economic contractions are: 1) the Keynesian, 2) the Friedmanite, and 3) the Fisherian. The Keynesian view is that normal economic contractions are caused by an insufficiency of aggregate demand (or total spending). This problem is to be solved by deficit spending. The Friedmanite view, one shared by our current Federal Reserve Chairman, is that protracted economic slumps are also caused by an insufficiency of aggregate demand, but are preventable or ameliorated by increasing the money stock. Both economic theories are consistent with the widely-held view that the economy experiences three to seven years of growth, followed by one to two years of decline. The slumps are worrisome, but not too daunting since two years lapse fairly quickly and then the economy is off to the races again. This normal business cycle framework has been the standard since World War II until now.

The Fisherian theory is that an excessive buildup of debt relative to GDP is the key factor in causing major contractions, as opposed to the typical business cycle slumps (Chart 1). Only a time consuming and difficult process of deleveraging corrects this economic circumstance. Symptoms of the excessive indebtedness are: weakness in aggregate demand; slow money growth; falling velocity; sustained underperformance of the labor markets; low levels of confidence; and possibly even a decline in the birth rate and household formation. In other words, the normal business cycle models of the Keynesian and Friedmanite theories are overwhelmed in such extreme, overindebted situations.

Economists are aware of Fisher’s views, but until the onset of the present economic circumstances they have been largely ignored, even though Friedman called Irving Fisher “America’s greatest economist.” Part of that oversight results from the fact that Fisher’s position was not spelled out in one complete work. The bulk of his ideas are reflected in an article and book written in 1933, but he made important revisions in a series of letters later written to FDR, which currently reside in the Presidential Library at Hyde Park. In 1933, Fisher held out some hope that fiscal policy might be helpful in dealing with excessive debt, but within several years he had completely rejected the Keynesian view. By 1940, Fisher had firmly stated to FDR in several letters that government spending of borrowed funds was counterproductive to stimulating economic growth. Significantly, by 2011, Fisher’s seven decade-old ideas have been supported by thorough, comprehensive and robust econometric and empirical analysis. It is now evident that the actions of monetary and fiscal authorities since 2008 have made economic conditions worse, just as Fisher suggested. In other words, we are painfully re-learning a lesson that a truly great economist gave us a road map to avoid.

High Dollar Policy Failures

If governmental financial transactions, advocated by following Keynesian and Friedmanite policies, were the keys to prosperity, the U.S. should be in an unparalleled boom. For instance, on the monetary side, since 2007 excess reserves of depository institutions have increased from $1.8 billion to more than $1.5 trillion, an amazing gain of more than 83,000%. The fiscal response is equally unparalleled. Combining 2009, 2010, and 2011 the U.S. budget deficit will total 28.3% of GDP, the highest three year total since World War II, and up from 6.3% of GDP in the three years ending 2008 (Chart 2). Importantly, the massive advance in the deficit was primarily due to a surge in outlays that was more than double the fall in revenues. In the current three years, spending was an astounding $2.2 trillion more than in the three years ending 2008. The fiscal and monetary actions combined have had no meaningful impact on improving the standard of living of the average American family (Chart 3).

Why Has Fiscal Policy Failed?

Four considerations, all drawn from contemporary economic analysis, explain the underlying cause of the fiscal policy failures and clearly show that continuing to repeat such programs will generate even more unsatisfactory results.

First, the government expenditure multiplier is zero, and quite possibly slightly negative. Depending on the initial conditions, deficit spending can increase economic activity, but only for a mere three to five quarters. Within twelve quarters these early gains are fully reversed. Thus, if the economy starts with $15 trillion in GDP and deficit spending is increased, then it will end with $15 trillion of GDP within three years. Reflecting the deficit spending, the government sector takes over a larger share of economic activity, reducing the private sector share while saddling the same-sized economy with a higher level of indebtedness. However, the resources to cover the interest expense associated with the rise in debt must be generated from a diminished private sector.

The problem is not the size or the timing of the actions, but the inherent flaws in the approach. Indeed, rigorous, independently produced statistical studies by Robert Barro of Harvard University in the United States and Roberto Perotti of Universita Bocconi in Italy were uncannily accurate in suggesting the path of failure that these programs would take. From 1955 to 2006, Dr. Barro estimates the expenditure multiplier at -0.1 (p. 206 Macroeconomics: A Modern Approach, Southwestern 2009). Perotti, a MIT Ph.D., found a low but positive multiplier in the U.S., U.K., Japan, Germany, Australia and Canada. Worsening the problem, most of those who took college economic courses assume that propositions learned decades ago are still valid. Unfortunately, new tests and the availability of more and longer streams of macroeconomic statistics have rendered many of the well-schooled propositions of the past five decades invalid.Second, temporary tax cuts enlarge budget deficits but they do not change behavior, providing no meaningful boost to economic activity. Transitory tax cuts have been enacted under Presidents Ford, Carter, Bush (41), Bush (43), and Obama. No meaningful difference in the outcome was observable, regardless of whether transitory tax cuts were in the form of rebate checks, earned income tax credits, or short-term changes in tax rates like the one year reduction in FICA taxes or the two year extension of the 2001/2003 tax cuts, both of which are currently in effect. Long run studies of consumer spending habits (the consumption function in academic circles), as well as detailed examinations of these separate episodes indicate that such efforts are a waste of borrowed funds. This is because while consumers will respond strongly to permanent or sustained increases in income, the response to transitory gains is insignificant. The cut in FICA taxes appears to have been a futile effort since there was no acceleration in economic growth, and the unfunded liabilities in the Social Security system are now even greater. Cutting payroll taxes for a year, as former Treasury Secretary Larry Summers advocates, would be no more successful, while further adding to the unfunded Social Security liability.

Third, when private sector tax rates are changed permanently behavior is altered, and according to the best evidence available, the response of the private sector is quite large. For permanent tax changes, the tax multiplier is between minus 2 and minus 3. If higher taxes are used to redress the deficit because of the seemingly rational need to have“shared sacrifice,” growth will be impaired even further. Thus, attempting to reduce the budget deficit by hiking marginal tax rates will be counterproductive since economic activity will deteriorate and revenues will be lost.

Fourth, existing programs suggest that more of the federal budget will go for basic income maintenance and interest expense; therefore the government expenditure multiplier may become more negative. Positive multiplier expenditures such as military hardware, space exploration and infrastructure programs will all become a smaller part of future budgets. Even the multiplier of such meritorious programs may be much less than anticipated since the expended funds for such programs have to come from somewhere, and it is never possible to identify precisely what private sector program will be sacrificed so that more funds would be available for federal spending. Clearly, some programs like the first-time home buyers program and cash for clunkers had highly negative side effects. Both programs only further exacerbated the problems in the auto and housing markets.
Permanent Fiscal Solutions Versus Quick Fixes

While the fiscal steps have been debilitating, new programs could improve business considerably over time. A federal tax code with rates of 15%, 20%, and 25% for both the household and corporate sectors, but without deductions, would serve several worthwhile purposes. Such measures would be revenue neutral, but at the same time they would lower the marginal tax rates permanently which, over time, would provide a considerable boost for economic growth. Moreover, the private sector would save $400-$500 billion of tax preparation expenses that could then be channeled to other uses. Admittedly, the path to such changes would entail a long and difficult political debate.

In the 2011 IMF working paper, “An Analysis of U.S. Fiscal and Generational Imbalances,” authored by Nicoletta Batini, Giovanni Callegari, and Julia Guerreiro, the options to correct the problem are identified thoroughly. These authors enumerate the ways to close the gaps under different scenarios in what they call “Menu of Pain.” Rather than lacking the knowledge to improve the economic situation, there may not be the political will to deal with the problems because of their enormity and the huge numbers of Americans who would be required to share in the sacrifices. If this assessment is correct, the U.S. government will not act until a major emergency arises.

The Debt Bomb

The two major U.S. government debt to GDP statistics commonly referred to in budget discussions are shown in Chart 4. The first is the ratio of U.S. debt held by the public to GDP, which excludes federal debt held in various government entities such as Social Security and the Federal Reserve banks. The second is the ratio of gross U.S. debt to GDP. Historically, the debt held by the public ratio was the more useful, but now the gross debt ratio is more relevant. By 2015, according to the CBO, debt held by the public will jump to more than 75% of GDP, while gross debt will exceed 104% of GDP. The CBO figures may be too optimistic. The IMF estimates that gross debt will amount to 110% of GDP by 2015, and others have even higher numbers. The gross debt ratio, however, does not capture the magnitude of the approaching problem.

According to a recent report in USA Today, the unfunded liabilities in the Social Security and Medicare programs now total $59.1 trillion. This amounts to almost four times current GDP. Modern accrual accounting requires corporations to record expenses at the time the liability is incurred, even when payment will be made later. But this is not the case for the federal government. By modern private sector accounting standards, gross federal debt is already 500% of GDP.

Federal Debt – the End Game

Economic research on U.S. Treasury credit worthiness is of significant interest to Hoisington Management because it is possible that if nothing is politically accomplished in reducing our long-term debt liabilities, a large risk premium could be established in Treasury securities. It is not possible to predict whether this will occur in five years, twenty years, or longer. However, John H. Cochrane of the University of Chicago, and currently President of the American Finance Association, spells out the end game if the deficits and debt are not contained. Dr. Cochrane observes that real, or inflation adjusted Federal government debt, plus the liabilities of the Federal Reserve (which are just another form of federal debt) must be equal to the present value of future government surpluses (Table 1). In plain language, you owe a certain amount of money so your income in the future should equal that figure on a present value basis. Federal Reserve liabilities are also known as high powered money (the sum of deposits at the Federal Reserve banks plus currency in circulation). This proposition is critical because it means that when the Fed buys government securities it has merely substituted one type of federal debt for another. In quantitative easing (QE), the Fed purchases Treasury securities with an average maturity of about four years and replaces it with federal obligations with zero maturity. Federal Reserve deposits and currency are due on demand, and as economists say, they are zero maturity money. Thus, QE shortens the maturity of the federal debt but, as Dr. Cochrane points out, the operation has merely substituted one type for another. The sum of the two different types of liabilities must equal the present value of future governmental surpluses since both the Treasury and Fed are components of the federal government.

Calculating the present value of the stream of future surpluses requires federal outlays and expenditures and the discount rate at which the dollar value of that stream is expressed in today’s real dollars. The formula where all future liabilities must equal future surpluses must always hold. At the point that investors lose confidence in the dollar stream of future surpluses, the interest rate, or discount rate on that stream, will soar in order to keep the present value equation in balance. The surge in the discount rate is likely to result in a severe crisis like those that occurred in the past and that currently exist in Europe. In such a crisis the U.S. will be forced to make extremely difficult decisions in a very short period of time, possibly without much input from the political will of American citizens. Dr. Cochrane does not believe this point is at hand, and observes that Japan has avoided this day of reckoning for two decades. The U.S. may also be able to avoid this, but not if the deficits and debt problem are not corrected. Our interpretation of Dr. Cochrane’s analysis is that, although the U.S. has time, not to urgently redress these imbalances is irresponsible and begs for an eventual crisis.
Monetary Policy’s Numerous Misadventures

Fed policy has aggravated, rather than ameliorated our basic problems because it has encouraged an unwise and debilitating buildup of debt, while also pursuing short term policies that have increased inflation, weakened economic growth, and decreased the standard of living. No objective evidence exists that QE has improved economic conditions. Even before the Japanese earthquake and weather related problems arose this spring, real economic growth was worse than prior to QE2. Some measures of nominal activity improved, but these gains were more than eroded by the higher commodity inflation. Clearly, the median standard of living has deteriorated.

When the Fed diverts attention with QE, it is possible to lose sight of the important deficit spending, tax and regulatory barriers that are restraining the economy’s ability to grow. Raising expectations that Fed actions can make things better is a disservice since these hopes are bound to be dashed. There is ample evidence that such a treadmill serves to make consumers even more cynical and depressed. To quote Dr. Cochrane, “Mostly, it is dangerous for the Fed to claim immense power, and for us to trust that power when it is basically helpless. If Bernanke had admitted to Congress, ‘There’s nothing the Fed can do. You’d better clean this mess up fast,’ he might have a much more salutary effect.” Instead, Bernanke wrote newspaper editorials, gave speeches, and appeared on national television taking credit for improved economic conditions. In all instances these claims about the Fed’s power were greatly exaggerated.

Summary and Outlook

In the broadest sense, monetary and fiscal policies have failed because government financial transactions are not the key to prosperity. Instead, the economic well-being of a country is determined by the creativity, inventiveness and hard work of its households and individuals.

A meaningful risk exists that the economy could turn down prior to the general election in 2012, even though this would be highly unusual for presidential election years. The econometric studies that indicate the government expenditure multiplier is zero are evidenced by the prevailing, dismal business conditions. In essence, the massive federal budget deficits have not produced economic gain, but have left the country with a massively inflated level of debt and the prospect of higher interest expense for decades to come. This will be the case even if interest rates remain extremely low for the foreseeable future. The flow of state and local tax revenues will be unreliable in an environment of weak labor markets that will produce little opportunity for full time employment. Thus, state and local governments will continue to constrain the pace of economic expansion. Unemployment will remain unacceptably high and further increases should not be ruled out. The weak labor markets could in turn force home prices lower, another problematic development in current circumstances. Inflationary forces should turn tranquil, thereby contributing to an elongated period of low bond yields. The Fed may resort to another round of quantitative easing, or some other untested gimmick with a new name. Such undertakings will be no more successful than previous efforts that increased over-indebtedness or raised transitory inflation, which in turn weakened the economy by directly, or indirectly, intensifying financial pressures on households of modest and moderate means.

While the massive budget deficits and the buildup of federal debt, if not addressed, may someday result in a substantial increase in interest rates, that day is not at hand. The U.S. economy is too fragile to sustain higher interest rates except for interim, transitory periods that have been recurring in recent years. As it stands, deflation is our largest concern, therefore we remain fully committed to the long end of the Treasury bond market.

June 27, 2011 by guidoromero
As I speculated some two years ago, it seems to me that if anyone should leave the Euro it is Germany. The rationale is that weak members need the union more than the union needs them. Conversely, the union needs strong members more than strong members need it.

Even assuming Greece should leave the union, I don’t see how other weak members could stay on. If Greece goes, borrowing costs will sky rocket for all other weak members thereby hastening their demise. This in turn brings about two dilemmas. First, if all weak members start falling off the wagon then how many members other than Germany might be left? Second, even assuming Greece should go, this will bring about the marking to market of Greece’s debt held by the ECB… which I think should bring about the marking to market of all other sovereign debt held there… in other words this would be the “poof!” moment for the ECB thus the dissolution of the EU…

In my view, the path of least complication is if Germany quits the Euro and the EU

There is actually a faint hope that with the bayonets of the German taxpayers pointed at their arses, the dumbf*ck German politicians might make the right choice. All is now crystal clear; It’s a race to become toilet paper between the Euro and the US Dollar now.

Sorry, second thoughts… Can politicians admit mistakes ?

Oh shit…