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December 15, 2011

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Fed Watch: Europe Still Heading For Collapse

Posted: 15 Dec 2011 12:33 AM PST

Tim Duy:

Europe Still Heading For Collapse, by Tim Duy: The half-life of the effectiveness of European summits is growing increasingly shorter. While I have been a long-term Europessimist, market participants are more willing to trade on whatever appears to be positive news, thus markets jump whenever it appears the Europeans are taking action. But eventually the game will wear thin as market participants increasingly realize European "solutions" are never more than half-measures intended to kick the can down the road another few months.

And the last summit was no exception. The reality is quickly sinking in that, relative to the dimensions of the challenge, very little was really accomplished two weeks ago. And very little will be accomplished until European leaders come to the realization that they continue to treat the symptoms of the disease, not the cause of the disease. They need to find a mechanism to address Europe's internal imbalances that does not rely exclusively on deflation as a cure. Alan Blinder provided the background in the Wall Street Journal:

All financial eyes are fixed on the euro. Europe's common currency actually has two gigantic problems. The debt and banking crisis hogs all the attention because of its immediacy, plus the high drama of all those summit meetings. But the other, slower-acting problem—lopsided competitiveness within the euro zone—is far more intractable.

Blinder sees three paths out of the resultant mess:

There are three ways for the other countries to close the gap with Germany—and remember, the gap is large. First, Germany can volunteer for higher inflation than its euro partners by, for example, implementing a large fiscal stimulus or ending its wage restraint. How do you say "ain't gonna happen" in German?

Second, the other countries can engineer German-like productivity miracles through structural reforms while Germany, relatively speaking, stands still. Good luck with that. And even if it somehow happens, the timing is all wrong. Reforms take years to bear fruit while financial markets count time in seconds.

Third, the other countries can experience deflation, meaning a prolonged decline in both wages and prices, which is incredibly difficult and painful—and generally happens only in protracted recessions. Sadly, this may be the most likely way out.

The reality of Blinder's view - that option two will not work and option three is excessively painful - is revealed by the most recent IMF update on Greece. From the report:

Meanwhile, since the fourth review, the economic situation in Greece has taken a turn for the worse, with the economy increasingly adjusting through recession and related wage-price channels, rather than through structural reform-driven increases in productivity.

Really, this is a surprise to IMF economists? Yet apparently, the IMF still believes that structural change is an immediate cure:

We recognize the need to reach a critical mass of reforms and reform synergies to jump-start growth.

I like this - the IMF does not believe in "confidence" fairies; they believe in "synergy" fairies. I keep kicking myself for missing the "synergy" fairy lecture in graduate school. Apparently all the IMF economists made it to that lecture.

Of course, it is not their fault. The IMF attempts to shift some of the blame onto the Greeks:

Structural reforms have not yet delivered expected results, in part due to a disconnect between legislation and implementation.

While likely true, this is something of a red herring. The long-term nature of reforms was no match for the pace of financial market developments, while the willingness of the population to accept externally-driven reforms is understandably lacking given the desire of the external agents to support ongoing recession. Without more direct transfers and debt relief, the IMF, ECB, and EU continue to use more stick than carrort.

Arguably, European policymakers might see the fundamental problem, but also recognize a real solution in years away. Via the Financial Times:

Member states of the eurozone have set themselves on an "irreversible course towards a fiscal union" to underpin their common currency, even if it may take years to reach that goal, Angela Merkel, the German chancellor, told her parliament on Wednesday.

Europe doesn't have years. The vice of austerity packages will eventually crush to hard, and the cost of staying within the Euro will exceed the costs of exit.

Meanwhile, the ECB is at best having mixed results. On one hand, recent actions appear to have stabilized government debt markets in Spain, Belgium, and France. On the other, Italian yields have retraced much of their collapse. Probably more importantly, however, stabilization of the banking crisis remains elusive. From the Financial Times:

But, despite the central bank facilities, the cost of obtaining dollar funding in the private market continues to soar, pointing to a dollar funding squeeze as Europe's banks head into their all-important year-end reporting period.

The three-month euro-US dollar basis swap dropped to as low as -150 basis points on Wednesday, meaning banks would have to pay an extra 1.5 per cent premium to swap their euros into dollars for a three-month period. The premium has not been persistently below the -140bps region since late 2008, during the depths of the financial crisis.

Not good, not good at all. Also, the hopes that the ECB will provide an unlimited backstop for soveriegn debt now look to be premature at best. Via the Wall Street Journal:

With many in Europe still hoping against hope that the European Central Bank will step in more aggressively to buy bonds and bring down borrowing costs for struggling governments, Jens Weidmann, the president of Germany's Bundesbank and member of the ECB governing council, indicated his opposition to that hadn't softened.

The idea that the ECB should turn on the printing presses to help finance some debt-ridden euro-zone states should be put to rest for good, Mr. Weidmann said. Central bank "independence is lost when monetary policy is tied to the wagon of fiscal policy and then loses control over prices," he said.

Some argue the ECB is just jawboning to drive a hard bargain when it comes to fiscal and structural reforms. I am not so sure - these guys sound pretty serious to me.

And perhaps you thought the Fed would ride to the rescue. Think again. From Bloomberg:

Federal Reserve Chairman Ben S. Bernanke told Republican senators the Fed plans no additional aid to European banks amid the region's sovereign debt crisis, according to two lawmakers who attended the meeting.

Senator Bob Corker, a Republican from Tennessee, said Bernanke made it "very clear" in closed-door comments today the central bank doesn't intend to rescue European financial institutions. Lindsey Graham, a South Carolina Republican, said Bernanke told lawmakers that "he doesn't have the intention or the authority" to bail out countries or banks. Both senators spoke to reporters after leaving the one-hour session at the Capitol in Washington.

Simply put, the Fed is politically limited in what it can do for Europe. I don't see the hopes that the Fed could step in for the ECB being realized. Moreover, US lawmakers will resist efforts to contribute more to the IMF to help Europe, especially if this is the general attitude:

Senator Charles Grassley, speaking after leaving the meeting with Bernanke, said excessive U.S. financial support may enable Europe to avoid enacting necessary measures in fiscal austerity.

"If there's too much of an effort on the part of the United States to help Europe, it's going to impede their fiscal changes that must be made," Grassley, a Republican from Iowa, said to reporters.

The belief in fiscal austerity runs deep. We need to teach those Europeans a lesson even if it means shooting ourselves in the foot. Now, in all honesty, you really can't expect US taxpayers to offer much support to Europe when German taxpayers themselves are resistant. Because I think that fundamentally Blinder is right on the appropriate cure to save the Euro. Germany needs to issue a massive amount of debt to support demand in Europe, even at the cost of higher relative inflation. And, better yet, to support debt writedowns in the periphery. The response from Germany: Nein.

Bottom Line: I still don't see where this ends well. Play the news cycle if you are so inclined, but keep one eye on the key issue. Is Europe working to resolve their fundamental internal imbalances with anything other than deflation? As long as the answer continues to be "no," be afraid. Be very afraid.

Fed Watch: Global Growth Struggles, Fed Stands Still

Posted: 15 Dec 2011 12:24 AM PST

One more from Tim Duy:

Global Growth Struggles, Fed Stands Still, by Tim Duy: The news from Japan tonight:

Japanese business mood turned pessimistic in the three months to December, the central bank's tankan survey showed, a sign the stubbornly strong yen, Europe's debt crisis and slowing global growth were taking their toll on the export-reliant economy.

Earlier this week:

India's industrial production slid 5.1 percent in October, helping drive the rupee to a fresh record low against the dollar — more signs of the reversal of fortunes in Asia's third-largest economy.

The decline in output from a year earlier was driven by mining and manufacturing, as well as waning consumer demand and lackluster investment, according to government figures released Monday.

Another one, via Bloomberg:

Brazil's real fell to a two-week low after data showed Latin America's largest economy shrank for a third month in October...

..Brazil's seasonally adjusted economic activity, a proxy for gross domestic product, fell 0.32 percent in October from the previous month, capping its longest contraction since the bankruptcy of Lehman Brothers Holdings Inc. in 2008, according to central bank data. The real fell along with other currencies of commodity-exporting countries such as the Australian dollar and South African rand after the Federal Reserve dashed some investors' expectations yesterday for monetary easing.

And a depressing global outlook via the Financial Times:

Cargill has become the Dr Gloom of the commodities trading sector.

The Minnesota-based company was the first big trading house to warn about the economic slowdown; its latest quarterly results reflected a sharp drop year-on-year; and now it is firing 2,000 people due to the "continued weak global economy".

This is no small matter: Cargill is at the centre of global trade, shipping commodities from wheat to beef, and the wide reach of its business network helps it anticipate changes in the economic cycle. Other top commodities trading houses – particularly Glencore and Noble Group – are, however, painting a much rosier outlook, offering a much more positive view both about the global economy and their businesses.

It is too early to say whether Cargill's bearishness is justified. But it is worth noting that Cargill is a privately-owned company – still controlled by the MacMillan and Cargill families, descendants of the founders who set up the group in 1865 – so it does not feel obliged to put as brave a face on in a bad economic environment as its publicly-listed rivals...

..Back in September, Paul Conway, Cargill deputy chief executive, said that the company felt that global economic growth was "weak and weakening". He said: "We are going through a long, slow, anaemic, tough recovery". The statement over the weekend indicates that Cargill's view has not changed at all, further pointing to a global economic slowdown. Mr Conway indicated back in September that the problem was that the economic slowdown was not only affecting the US and Europe, but was then already spreading to several Brics countries – Brazil, India and China.

In contrast to much of the globe, and despite Cargill's assertions, the United States is seen as weathering the storm, at least so far. From the FOMC statement:

Information received since the Federal Open Market Committee met in November suggests that the economy has been expanding moderately, notwithstanding some apparent slowing in global growth.

The expectation is that the Fed's next move will be to alter its communication strategy at the January meeting. Whether or not they gear up for another round of QE, this time via mortgage assets, remains dependent on the economy. Since I tend to be cautious that the US can forever resist the global drag now firmly in place, I expect additional easing. That said, I also believe the Fed will delay until the strains become more obvious, which may not be until deep into the first or second quarters of next year. In other words, hopes that the Federal Reserve would jump in with QE3 to save financial markets from the European disastor were simply premature. They should get ahead of this curve, in my opinion, but they won't.

For those that believe the Fed has the tools to stop another crisis in its tracks, FT Alphaville has some sobering news. Covering a report by Lewis Alexander, formerly of the US Treasury and Federal Reserve, currenty Nomura Chief US economist, they spot a particularly disconcerting element of Frank-Dodd:

DFA expressly prohibits the Federal Reserve from using 13(3) to support individual institutions. The legislative record on this provision indicates that Congress' intent was to rule out the sorts of interventions that the Federal Reserve implemented to support the sale of Bear Stearns to JP Morgan and the backstop that was provided to AIG...

...In particular, the Federal Reserve could not have supported the Bear Stearns transaction, the backstop for AIG would not have been possible, the guarantees provided by the TLGP program would have required Congressional approval, and the ring fences provided for assets owned by Citi and the Bank of America would not have been possible.

It is not inconceivable that another US institution gets pulled in the European economic vortex. It would be unfortunate if, should that institution be in fact too big or connected to fail, the Fed could not be a backstop to hold the system together. While I think many of us were initially shocked by some of the Fed's actions, particularly salvaging AIG, in retrospect we realize it would have been a bad time to start playing moral hazrd games. Note also the process of winding down a too big to fail firm is untested. I have to admit that an orderly wind down during a crisis is something of a contradiction. Immovable object meet irresistable force.

Read the whole piece, and part I as well. They are worth the time, although they leave me feeling despite the lessons of the past few years, we are less prepare than we think we are.

Bottom Line: The global economy is hitting turbulence, just as the US data turns more sanguine. Can this decoupling be sustained as Europe sinks deeper into recession? I would like to think so, but remain very cautious that the US can escape without some significant cuts and bruises. So far, the Fed remains in a holding position. I expect them to stay there until more significant signs of economic distress emerge.

Links for 2011-12-15

Posted: 15 Dec 2011 12:06 AM PST

High Unemployment Is *Not* Primarily the Result of "Generous" Unemployment Insurance Benefits

Posted: 14 Dec 2011 11:16 AM PST

Brad DeLong takes on the claim that our unemployment problem is due to "generous" unemployment insurance benefits.

Percentage Growth in Annual Wages and Salaries

Posted: 14 Dec 2011 12:38 AM PST

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