spotfxtrader

This is an excellent piece posted at : http://charleshughsmith.blogspot.com/2011/11/whats-lost-with-demise-of-euro-only.html?

Buy his book here

Tuesday, November 22, 2011
What’s Lost With the Demise of the Euro? Only What Was Unsustainable

Scaremongering aside, the demise of the euro does not end European integration. It only means that which is unsustainable has been relinquished and a return to stability is finally possible.

So the euro is doomed. Toast. History. This will lead to:

1. the end of civilization

2. the end of European integration

3. the start of new Dark Ages

4. the return to a sustainable reality

The correct answer is 4. The euro was an unsustainable, self-destructing extension of the integration that has long simplified trade, travel and work throughout the EU (European Union).

At the risk of over-saturating you with more euro-related material, here are the basics we need to keep in mind as the third act plays out.

A common currency seemed like a good way to simplify trade and lower transaction costs. As I noted yesterday in Some Heretical Thoughts on the U.S. Dollar, such “folk” convictions rest on “sole-source causation”: in this case, that a single currency would only offer more benefits of integration because it lowered complexity and transaction costs.

The euro supporters forgot or ignored the primary purpose of national currencies:to account for differences in transparency, productivity, trust, money creation and risk between nations’ economies and their Central Banks/States.

If you remove this means of accounting for these fundamental differences, then you have removed a feedback loop from a dynamic system, and thus removed an absolutely essential flow of information and transparency.

What you’re left with is a system of lies, officially sanctioned opacity, misinformation, disinformation, cooked books, artifice and propaganda, i.e. exactly what Europe has become. With the euro, there was no way for the system to account for thr vast differences in debt loads, credit risks, transparency, productivity and a dozen other fundamentals that are expressed in foreign exchange rates.

By all accounts, Greece and Italy have painfully dysfunctional national finances and political Elites resistant to admitting the dysfunction is unsustainable. Once those nations revert to national currencies, then their currencies will reflect the market’s assessment of their economy and their national/Central Bank policies.

The same will hold true for all the other EU member states: the market will shift through the various metrics and feedback loops and reach an equilibrium around the value of each nation’s currency.

Profligate, over-indebted nations with dysfunctional Elites and systems plagued by political corruption and gridlock will see their currencies devalued and the interest rates they must pay to borrow money raise to the point that borrowing will no longer be an option to escape the consequences of profligacy, and the devalued currency will preclude buying imports from strong-currency nations.

These feedback loops are essential to providing the citizenry and their economy with the transparency and information they need to adapt to reality. The euro has erased all that vital information, leaving only interest rates as the sole expression of differences between economies.

Interest rates are simply not a rich enough source of information and market feedback to express the differences between national economies; the global markets need the information and feedback loop provided by currencies.

As I attempted to describe yesterday, currencies are not explicable with “sole-source causality” or “folk” understandings; they are distillations of numerous information feeds and feedback loops that only a transparent market can generate.

I have little doubt the euro is being held aloft by cloaked Central Bank intervention; the Elites are desperately attempting to cloak the system’s intrinsic dysfunction and stop the market from repricing the euro based on the inevitable return to national currencies.

Rather than fear this return to transparent feedback, we should welcome it and hurry it along. Systems which cut off feedback and choke transparency with artifice and lies are doomed to implode. If Europe ditches the failed “folk” experiment called the euro, then the process of recognizing and pricing dysfunction can begin, and the stability that only transparency and feedback can provide will soon return to the EU.

This may sound counter-intuitive, but it’s the only way forward to a sustainable, stable reality. The immense hubris of Europe’s dysfunctional Elites precludes their recognition that reality eventually trumps artifice and intervention. Their feeble, addled cries cannot turn back the tide, even if their bloated self-importance is infinite.

After the most awful piece that was published in Bloomberg last week [not linked] I was very glad to come across this clip and strongly recommend you listen to it. It’s about 27 minutes long.

Martin Armstrong Interview

Read all his stuff at http://www.martinarmstrong.org/economic_projections.htm

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.

There’s an anecdote in a book called “What They Teach You At Harvard Business School” by Philip Broughton about a speech given to the students concerning the little things that make a good leader.

He emphasised the difference between the victims at a company, those who blamed others and felt sorry for themselves, and those who tried to make things right. Identifying the victims, or ‘spectacle makers’, was vital, or else they would contaminate everything you did. To illustrate the polluting effect of a whiner, he said: ‘If I had my favourite bowl of ice cream over here and a bowl of shit over here, if I took one speck of shit and put it in the ice cream, would you eat the ice cream?’

In an interview given by Soros to Der Spiegel he argues that unless Germany agrees to fiscal union with the other eurozone members the Euro will break up and there will be a banking collapse. However, what he is advocating is stirring all the PIIGS shit into the ice cream.

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

Predictions are hard to make, especially about the future, but following the latest piece from AEP in the telegraph, where he states :

“The Chinese central bank’s reserve manager SAFE is clearly buying euros on a large scale to hold down the yuan and safeguard export advantage in Europe, but it appears to be purchasing short-term debt of a one-year maturity or less and other liquid assets.”

also..

“The three-month euribor/OIS spread, the fear gauge of credit markets, reached the highest level in two years today, jumping 7 basis points to 40 in wild trading.

“Europe’s money markets are undoubtedly starting to freeze up,” said Marc Ostwald from Monument Securities.

“It’s not as dramatic as pre-Lehman but it is alarming and shows the pervasive degree of fear in the markets. People are again refusing to lend except on a secured basis.”

If those with demand for Euros can’t borrow any, short term rates will go up, even if the market is non functioning. This will put upward pressure on the currency…. Given that we’re sitting in the middle of the range formed since the low in May, and given the violence of the rejection of each new low seen during the last couple of days’ trading, a break to the upside of this range is now not inconceivable. The “negative” outlook for the eurozone probably means that the market is short, which to me warns of the possibility of a significant move higher.

1.51 is back in the frame.

Negated by a break back below 1.40.

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.

Contagion.

From Simon Black

The world is now divided into essentially three categories:
(1) those nations that can effectively sidestep catastrophic meltdown;
(2) those nations that cannot avoid meltdown, but can afford to kick the can down the road
(3) those nations that must face their grim, unavoidable meltdown reality now

The United States, for better or worse, is in category 2. Politicians can keep pretending that the wheels on the bus go ’round and ’round because, at present, there are too many other countries in category 3… namely, much of Europe.

Greece is on the brink of official insolvency… yet in an exceedingly bizarre interview with German news magazine Der Spiegel published today, Jean-Claude Junker insists that (a) Greece is not broke, (b) if Greece doesn’t make its debt payments, this is not the same as ‘default,’ and (c) it’s OK for politicians to lie because people don’t understand capital markets.

(*Note, suspension of disbelief IS required to read this interview; Junker caps it off with a metaphoric riddle, “If the donkey were a cat it could climb a tree. But it is not a cat,” which has about as much insight as “Confucius say: Man who go to bed with itchy butt wake up with smelly finger….”)

As the Prime Minister of Luxembourg and president of the Euro Group, Junker is a very important figure in European finance… and in the interview, he makes it quite clear where his priorities lie: with the bankers.

As Junker states, “If Greece were to declare a national bankruptcy tomorrow, the country would have no access to the international financial market for years to come, and its most important creditors, the banks in Germany and Europe, would have an enormous problem…”

Well, certainly no one should expect Europe’s banks to suffer their own losses after making idiotic loans to corrupt governments. It’s much easier to stick the people with the bill by establishing a trillion dollar bailout fund with taxpayer money.

Problem is, people in Europe are starting to wake up and get it.

The anti-euro “True Finn” party in Finland recently surged in the polls to become the country’s third-largest political party and a major obstacle for any European bailout. This weekend, Spain’s ruling Socialist party was hammered with losses as voters voiced their utter disgust with the current government’s handling of the economy.

In Germany, this year’s state election results are showing that voters are sick and tired of shouldering the financial burden for the rest of Europe. Chancellor Angela Merkel’s ruling party is losing miserably, though in a pathetically desperate move, some local governments are changing suffrage limits and allowing 16-year olds to vote.

This is the strongest indicator yet of how bad the situation in Europe has become: German banks are so over-exposed to the PIIGS sovereign debt that, in the face of political revolt all across Europe, German politicians have resorted to recruiting the Justin Bieber crowd to maintain the status quo.

Simply put, if Greece fails, the banks will collapse, and European financial markets will tank. Politicians will stop at nothing to prevent this from happening… including sticking every man, woman, and child with the bailout bill, as well as pulling socialist-minded teenagers into the voting booths to ensure they stay in power.

Eventually, though, these efforts will prove fruitless. Greece has two months of cash left… and a default by any other name is still a default. The ‘have’ nations in Europe don’t want to foot the bailout bill any more than the ‘have not’ nations in Europe want to accept deep austerity measures.

This is going to cause a lot of turmoil in Europe in the short-term… and as the US government has successfully kicked its can down the road through late summer thanks to the Treasury Department plundering public pension money, investors are free to get their worry on in Europe.

I would suspect gold and silver in euro terms to do quite well as the market looks around, once and for all and realizes that there are truly no good major currency alternatives. This could be the start of a chain reaction.