Angela Merkel’s Moment of Truth
Joschka Fischer
BERLIN – In the last two weeks, the two crises confronting Europe – in Ukraine and Greece – both escalated. In each case, Germany and its chancellor, Angela Merkel, were at the heart of efforts to achieve a diplomatic resolution. This is a new role for Germany, and the country is not yet accustomed to it.
The latest attempt to halt the war in eastern Ukraine by diplomatic means had an even shorter shelf life than the first attempt last September. The new accord – concluded, like the previous one, in Minsk – de facto recognized that Ukraine has been split by military means. But just where the dividing line is remains unclear, because Russian President Vladimir Putin may yet attempt to capture the strategic Black Sea port of Mariupol, thereby enabling the Kremlin to create a land bridge between Russia and the Crimea peninsula. Moreover, capturing Mariupol would keep open the option of conquering southern Ukraine, including Odessa, and extending Russian control all the way to Transnistria, Russia's illegal enclave in Moldova.
Through the continued use of military force, Putin has achieved the main aim of Russia's policy: control over eastern Ukraine and ongoing destabilization of the country as a whole.
Indeed, Minsk II is merely a reflection of facts on the ground.
The question remains, however, whether it would have been smarter to let the one power that Putin takes seriously – the United States – conduct the negotiations. Given Putin's low regard for Europe, this will most likely become unavoidable, sooner or later.
Still, despite the risks involved, it is important that Germany and France, in coordination with the European Union and the US, undertook this diplomatic effort. Though the Minsk II initiative exposed Europe's meager political clout, it also confirmed the indispensability of Franco-German cooperation, as well as Germany's changed role within the EU.
Merkel herself reflects this changed role. Her ten years in power were largely characterized by a new German Biedermeier era. The sun was shining on Germany and its economy, and Merkel regarded it as her highest duty to maintain citizens' sense of wellbeing by not disturbing them with politics. But Germany's new significance in Europe has put a brutal end to Merkel's neo-Biedermeier era. She no longer defines her policies in terms of “small steps"; now she takes strategic threats seriously and confronts them head-on.
This is also true of the Greek crisis, in which Merkel – despite her public image in southern Europe – was not aligned with the hawks in her party and administration. Indeed, Merkel seems to be well aware of the unmanageable risks of a Greek exit from the euro – although it remains to be seen whether she can muster the determination to revise the failed austerity policy imposed on Greece.
Without such a revision aimed at boosting growth, Europe will remain alarmingly weak both internally and externally. Given Russia's attack on Ukraine, this is a dismal prospect, because internal weakness and external threats are directly linked.
Greece has also shown that the euro crisis is less a financial crisis than a sovereignty crisis. With the recent election of the anti-austerity Syriza party, Greek voters stood up against external control over their country by the “troika" (the European Commission, the European Central Bank, and the International Monetary Fund), Germany, or anyone else. Yet if Greece is to be saved from bankruptcy, it will have only foreign taxpayers' money to thank for it. And it will be nearly impossible to convince European taxpayers and governments to provide further billions of euros without verifiable guarantees and the necessary reforms.
The Greek conflict shows that Europe's monetary union is not working because one country's democratically legitimized sovereignty has run up against other countries' democratically legitimized sovereignty. Nation-states and a monetary union do not sit well together. But it is not hard to understand that, should “Grexit" occur, the only geopolitical winner would be Russia, whereas in Europe, everyone stands to lose.
Though the geopolitical risks have, so far, barely figured in the German debate, they greatly outweigh any domestic policy risks of finally coming clean with the German public. Greece, Germans should be told, will remain a eurozone member, and preserving the euro will require further steps toward integration, up to and including transfers and debt mutualization, provided that the appropriate institutions for this are established.
Such a step will require courage, but the alternatives – continuation of the eurozone crisis or a return to a system of nation-states – are far less attractive. (Germany has a new national-conservative party whose leaders' declared aim is to pursue a pre-1914 foreign policy.) In view of the dramatic global changes and the direct military threat to Europe posed by Putin's Russia, these alternatives are no alternative at all, and the Greek “problem" looks insignificant.
Merkel and French President François Hollande should seize the initiative once again and finally put the eurozone on a sound footing. Germany will have to loosen its beloved purse strings, and France will have to surrender some of its precious political sovereignty. The alternative is to stand by idly and watch Europe's nationalists become stronger, while the European integration project, despite six decades of success, staggers ever closer to the abyss.
How ‘patient’ is Yellen?
Gavyn Davies
When Federal Reserve chairwoman Janet Yellen gives evidence to the Senate Banking Committee on Tuesday, she has an opportunity to speak above the heads of the financial markets to Congress and the American people. There is pressure in the Senate to bring the Fed under Congressional “audit”, something that almost everyone in the central bank abhors. So Ms Yellen’s main message is likely to be about how well the Fed has done in recent years, focusing on the generally good out-turns for unemployment and inflation.
The markets, however, will probably ignore most of this important stuff. Instead, they will focus attention on something which is intrinsically unimportant for the economy as a whole — the likely date of lift-off for short-term interest rates.
The Fed’s Open Market Committee is often impatient about the markets’ obsession with this date, arguing that this is irrelevant compared to the Fed’s wider message on the intended path for interest rates over the next couple of years. But investors know that a lot of money can be lost by getting the lift-off date wrong. And, if the FOMC is so unconcerned about this minor detail, why do they focus so much attention on it in their regular meetings?
The Fed’s main message is that the lift-off date will be determined by data, with a raft of releases on inflation and the labour market likely to be weighed in the overall balance. But they have muddied this simple message by giving an unnecessary further piece of guidance that depends on the calendar, not on the data. Here it is, as it first appeared in December 2014:
As progress in achieving maximum employment and 2 per cent inflation continues, at some point it will become appropriate to begin reducing policy accommodation. But based on its current outlook, the Committee judges that it can be patient in doing so. In particular, the Committee considers it unlikely to begin the normalisation process for at least the next couple of meetings. This assessment, of course, is completely data dependent.
That was Ms Yellen’s opening statement in her press conference, fully scripted in advance. The key piece of code is the word “patient”. This gives the firm guidance that there will be at least two clear meetings without a rate rise, unless the data develop in some totally unforeseen manner. Note that this code is different from the 2004 use of the word “patience”, which referred to only one clear meeting, as proven when rates were actually raised in June 2004 (see Tim Duy).
The “patient” attitude was reaffirmed in the January FOMC meeting, which means that lift-off is very unlikely in the March or April meetings. That presents no problem, but if “patient” is left in the statement in March, that would rule out a rate rise in April or June, which is too long for the hawks to stomach. Therefore they want to remove “patient” next month (see James Bullard).
The doves, however, made it clear in the January FOMC minutes that they are worried about removing “patient” in March, because the “two meetings” rule would then be used to price in a rate rise in June, with almost complete certainty. The doves are not ready to go that far at present. Here are the January minutes:
Many participants regarded dropping the “patient” language in the statement, whenever that might occur, as risking a shift in market expectations for the beginning of policy firming toward an unduly narrow range of dates. As a result, some expressed the concern that financial markets might overreact, resulting in undesirably tight financial conditions. Participants discussed some possible communications by which they might further underscore the data dependency of their decision regarding when to tighten the stance of monetary policy.
This begins to sketch out a viable solution to the problem. The FOMC could drop the word “patient” in March, but spell out much more clearly that this does not set any fixed timetable for the first rate rise. So they would remove the “patient” language, but also remove the “two meetings” interpretation at the same time.
In doing this, they might point to the fact that Ms Yellen has always said “at least” two meetings. The markets have never paid any attention whatsoever to the phrase “at least”, but the Fed could forcibly remind them that the words have always had an important meaning. Ms Yellen would not be forced to eat her words, always an important advantage for a central banker.
Exactly what language the FOMC might use to ram this home is unclear, but the Fed’s wordsmiths are nothing if not inventive (as well as verbose on occasions). The upshot would be that the Fed would be opening an option to announce lift-off in June at the earliest, while also retaining the option to delay until a later meeting, if the data work out that way. That, I think, is the message they want to convey at present.
How would the markets react to this? By opening the possibility of a June lift-off, there would probably be a sell-off at the front end of the money market curve, but there would be some uncertainty, so the sell-off may not be huge. After the announcement, the front end would become very sensitive to future data releases. That is what the Fed wants, instead of an “unduly narrow range of dates” for lift-off.
It is not clear whether Ms Yellen will do any of this on Tuesday. She might well prefer to wait until her March press conference.
Does any of this make any sense? Tim Duy again: “If you think this is a dumb way to manage monetary policy, you are correct.”
Europe’s Chimerical Capital-Markets Union
Howard Davies
LONDON – The eurozone's survival is in doubt again, as Greece demands debt forgiveness and an end to austerity – or else. But, though Europe's currency union is at risk, and its banking union remains at an early stage of development, the endlessly creative European Commission is embarking on another adventure: a so-called “capital-markets union."
That “so-called" is appropriate, because the project, despite being only vaguely defined at this point, is most certainly not intended to create a single European capital market. Indeed, European Union leaders know better than to announce such an ambition, which would require a new treaty – no one is prepared to open up that can of worms. After all, European voters are in no mood to transfer more powers to Brussels.
The capital-markets union actually began as a slogan, coined by one of EU Commission President Jean-Claude Juncker's acolytes. Now, the new financial markets commissioner, the United Kingdom's Lord Jonathan Hill, has been assigned the unenviable task of putting flesh on bare bones. The Commission's “Green Paper" consultation round on the subject produced more questions than answers.
Think tanks, lobby groups, and national regulators have wasted no time in trying to influence Hill's efforts, and to head off any initiatives that might damage their interests. The Bank of England has argued that there should be no replication of the banking union grant of new powers to the European Central Bank at the expense of national central banks. The capital-markets union, the BOE argues, “does not require institutional change," so no super-regulator should be created.
The Commission has accepted that conclusion for now, though one of Hill's aides has suggested that, “at some point…supervisory issues will pop up." In fact, establishing a European version of the US Securities and Exchange Commission is a longstanding aim of the Brussels Eurocracy – one that may be achieved one day, but not just yet.
But before delving into institutional issues – a favorite topic of EU veterans – one should consider what problem the capital-markets union is supposed to solve. And here, there is considerable agreement.
Most regulators and market participants agree that Europe's financial markets are dysfunctional. With banking assets amounting to roughly 300% of EU-wide GDP, compared to some 70% in the United States, large pools of savings are being left unused.
Moreover, European companies receive an excessive 80% of their finance from banks and less than 20% from capital markets (the proportions are roughly reversed in the US). The need to redress that imbalance has become increasingly evident since the recent financial crisis, as banks' efforts to rebuild their capital bases (and meet stricter regulatory requirements) has led to credit rationing.
Loosening that constraint on output growth would improve the European economy's resilience, encourage risk-taking, and promote dynamism.
The overall aim of the capital-markets union is thus relatively straightforward. But achieving it is not – in no small part because Europe's heavy reliance on bank finance stems from structural and cultural factors. And the remedies that the Commission has suggested so far – for example, encouraging crowdfunding and standardizing the terms of securitization – appear unlikely to promote rapid growth in non-bank finance.
Promoting a pan-European private placement market might help, as would aligning standards for covered bonds. But both strategies would face serious legal obstacles.
Indeed, though Hill's modest initial agenda certainly would do no harm (and should be pursued as quickly as possible), any substantial measures beyond it would confront major roadblocks. For example, harmonizing insolvency regimes across the continent and reducing tax incentives that favor debt over equity, while entirely logical, strike at the heart of member states' remaining sovereignty, and thus will be extremely difficult to push forward. Some of the other ideas that Hill has floated, such as relaxing the capital standards for long-term investments, run counter to the EU solvency standards for insurers and pension funds that will be implemented next year.
Some old nags have also been dragged out of the stables for another run around the course.
“Streamlined" prospectuses and exemptions from some accounting standards for small companies have been tried before in individual countries – and have failed. Looser standards for issuers weaken protection for investors, and there is evidence that lax regulation of new issues may reduce investor demand for them, raising the cost of finance.
Unless the political mood changes radically in Europe – an unlikely development – it would be unrealistic to expect the capital-markets union to be anywhere near as transformational as the banking union has been. It will be, at best, a small disturbance, in which few national sacred cows are slaughtered.
What began as a slogan may turn out to be helpful. But a capital-markets union is highly unlikely to end Europe's love affair with its banks. The biggest impact on market structure will continue to come from ever-rising capital requirements, which will make bank credit more expensive and encourage borrowers to look elsewhere.
ECB Faces Struggle in Sourcing Enough Bonds for QE
Scant supply of top-rated government bonds poses challenge for asset-purchase program, say analysts
Updated Feb. 25, 2015 10:06 a.m. ET
The European Central Bank’s headquarters in Frankfurt. The ECB plans to buy €60 billion of debt securities each month until September 2016, but some analysts and investors say it may struggle to find them. Photo: European Pressphoto Agency
The European Central Bank has pledged to buy hundreds of billions of euros of government bonds to help revive the eurozone economy. Now it will have to find them.
Analysts and investors are skeptical on its chances, though, given that many investors will be unwilling or unable to sell top-rated government bonds, particularly those belonging to Germany.
“It will be challenging for the ECB to source enough government bonds to meet its QE targets,” said Anthony O’Brien, co-head of European rates strategy at Morgan Stanley.
From next month, the ECB’s program of quantitative easing, or QE, involves buying €60 billion $68 billion) of debt securities each month until September 2016. Since late last year, the central bank has been buying around €13 billion of other assets a month, and analysts expect the difference—around €47 billion—to consist of government bonds.
Which government bonds the ECB buys depends on each country’s share of the European Union’s population and gross domestic product.
The problem is top-rated bonds are already in short supply—especially Germany’s, which make up the largest individual chunk of the program. German government debt, or bunds, will account for just over a quarter of the purchases, or around €12 billion each month.
But the German treasury says it expects to issue this year €147 billion of eligible bonds—those with maturities of two to 30 years—while €132 billion of bonds will mature, meaning net new bund issuance of just €15 billion for the whole year. Overall, the ECB’s plans mean it has to buy €215 billion of German government bonds between this March and September 2016—26 times more than the amount the German government bond market is predicted to grow over the same period, Morgan Stanley says.
This contrasts with the Federal Reserve’s multitrillion-dollar QE program, which was done against a backdrop of plentiful bond supply from the U.S. Treasury.
Peter Praet, the ECB’s chief economist, said the bank should be able to find enough investors willing to sell government bonds.
“We hear that pension funds and insurers don’t want to sell…But banks will probably rise to the bait,” Mr. Praet told Belgian weekly Trends in an interview released Wednesday.
“Institutions outside the eurozone also have large holdings of government bonds. They can sell too.”
The ECB could find that buying in-demand bunds from investors on the secondary market won’t be easy either. Investors have already sent yields on bunds tumbling. The yield on 10-year German government bonds is now 0.34%, compared with 1.69% a year ago. Yields fall as prices rise.
ECB President Mario Draghi has said the ECB would consider buying negative-yielding debt.
“There is already a huge shortage of German bonds in the market,” said Philipp de Cassan, head of euro core rates trading at Nomura. “We’re already seeing the symptoms of an ECB buying program.”
Central banks and financial institutions own by far the majority—around 90%—of the €1.1 trillion German government debt market. Banks and insurance companies favor these bonds because they help them meet regulatory capital requirements, while central banks also tend to hold bunds and other top-rated government bonds when building their foreign-exchange reserves.
“[European] passive investors and banks are unlikely to sell bunds in large size due to investment mandates and regulatory reasons,” said Cagdas Aksu, rates strategist at Barclays .
Anke Richter, head of European credit research at Conning, a U.S.-based asset manager with around $90 billion in assets, notes that some client portfolios will have guidelines dictating that government bonds must account for a certain proportion of their investments.
“The logical assumption is that everybody is going to sell and move into something else, but not everybody can do that,” she said.
Other investors may be reluctant to sell top-rated government bonds because there is a lack of appealing alternatives. Around a quarter of euro-area government debt now has negative yields, according to J.P. Morgan , meaning investors effectively pay to hold these assets.
Swapping bonds with positive coupons for investments with negative yields “doesn’t look like a very sensible move” for many investors, said Frances Hudson, global thematic strategist at Standard Life Investments, which handles £195 billion ($301 billion) in assets.
Mr. O’Brien said the ECB could loosen a self-imposed restriction not to own more than 25% of any single bond, aimed at ensuring the central bank doesn’t hold a stake large enough to block a debt restructuring. It could also consider increasing purchases of bonds belonging to government agencies, such as German development bank KfW, instead of government debt.
Analysts note that the ECB will find it easier to buy other government bonds such as those belonging to Spain and Italy, which should make up 17% and 13% of the program, respectively.
Meanwhile, some investors say the ECB will find willing sellers at the right price.
“There is definitely a scarcity of safe assets, but a price will be found,” said Luke Bartholomew, an investment manager at Aberdeen Asset Management , which oversees £323 billion in funds.
Further demand for 10-year German government bonds will push yields even lower, Mr. Bartholomew said, which is exactly what the ECB wants to achieve to get more cash flowing around the system.
“I see no reason why Germany’s 10-year bond yield can’t be negative by the end of the year,” he said.
NEW YORK – One day, historians will have their hands full debating the causes of the chaos now overtaking much of the Middle East. To what extent, they will ask, was it the inevitable result of deep flaws common to many of the region's societies and political systems, and to what extent did it stem from what outside countries chose to do (or not to do)?
But it is we who must deal with the reality and consequences of the region's current disorder. However we got to where we are in the Middle East, we are where we are, and where we are is a very bad place to be.
The stakes – human, economic, and strategic – are enormous. Hundreds of thousands have lost their lives; millions have been rendered homeless. Oil prices are low, but they will not remain so if Saudi Arabia experiences terrorist strikes or instability. The threat to the region is large and growing, and it menaces people everywhere, as extremist fighters return home and still others who never left are inspired to do terrible things. Indeed, though the Middle East is facing an abundance of challenges to its stability, none is as large, dangerous, and immediate as the Islamic State.
Those who object to calling the Islamic State a state have a point. In many ways, IS is a hybrid: part movement, part network, and part organization. Nor is it defined by geography. But it does control territory, boasts some 20,000 fighters, and, fueled by religious ideology, has an agenda.
Ultimately, of course, deciding whether to call what has emerged “ISIS" or “ISIL" or the “Islamic State" matters much less than deciding how to take it on. Any strategy must be realistic. Eliminating IS is not achievable in the foreseeable future; but weakening it is.
A strategy must also be comprehensive. First, the flow of money to the Islamic State must be reduced. Lower oil prices help, and there are only so many banks to rob. But extortion continues, as does financial support from individuals. Such flows should be shut down both by governments and financial institutions.
Curtailing the flow of recruits is even more essential. Countries can do more to make it difficult for individuals to leave for Iraq or Syria; a Europe-wide watch list, for example, would help. But nothing would have a greater impact than Turkey deciding that it will no longer allow itself to be a conduit, and that it will enforce United Nations Security Council Resolution 2178, which calls for stronger international cooperation against terrorism.
Another component of any strategy must be to counter IS's appeal and propaganda. This means publicizing the misery it has caused to those living under its rule. It also means persuading Muslim religious leaders and scholars to make the case that IS's behavior is illegitimate from the standpoint of Islam.
Of course, any strategy must challenge IS directly in Iraq and Syria. In Iraq, there is some evidence that its momentum has been halted; but the growing role of Iran and the Shia militias it backs all but guarantees that many Iraqi Sunnis will come to sympathize with or even support the Islamic State, whatever their misgivings. This is why outsiders should place greater emphasis on providing military and political support to Kurdish forces and Sunni tribes.
Syria is a far more difficult case, given its civil war and the competition among outsiders for influence. Attacks from the air on IS forces are necessary but insufficient. Because IS is a territorially based entity, there must be a ground dimension if the effort is to progress; after all, only ground forces can take and hold territory.
The best approach would be to create a multinational force consisting of soldiers from neighboring countries, particularly Jordan. The United States and other NATO countries could offer assistance, but the fight must be waged largely by other Sunnis. What is occurring in the region is a clash within a civilization; to enable IS to portray it as a conflict between civilizations – and itself as the true defender of Islam – would be a grave strategic mistake.
Moderate Syrian opposition forces and local Kurds could be part of such a multinational Sunni force, but they are not in a position to substitute for it. If such an expeditionary force cannot be formed, air attacks can be stepped up, thereby at least slowing IS and buying time to develop alternative strategies. Under such a scenario, IS would remain less a problem to be solved and more a situation to be managed.
Diplomacy cannot play a large role at this point. No solution can be imposed, given disagreements among the outside countries with a stake in Syria and the strength of both IS and the Syrian government. What diplomacy may be able to do is reduce, if not end, the fighting between the Syrian government and its own people, as the UN is attempting to do in Aleppo.
The biggest danger in 2015 may well be a widening of the regional crisis to Saudi Arabia and Jordan. Intelligence and military support for both countries will be essential, as will enhanced efforts to help Jordan shoulder its massive refugee burden. In this time of unprecedented turmoil in the Middle East, one of the region's basic rules still applies: No matter how bad the situation, it can always become worse.
viernes, febrero 27, 2015
DEBT BE NOT PROUD / JOHN MAULDIN´S WEEKLY NEWSLETTER
| Etiquetas: Europe Economic and Political, Government Debt Markets, Greece, The Euro
Debt Be Not Proud
Some things never change. Here is Eugen von Böhm-Bawerk, one of the founding intellectuals of the Austrian school of economics, writing in January 1914, lambasting politicians for their complicity in the corruption of monetary policy:
We have seen innumerable variations of the vexing game of trying to generate political contentment through material concessions. If formerly the Parliaments were the guardians of thrift, they are today far more like its sworn enemies. Nowadays the political and nationalist parties ... are in the habit of cultivating a greed of all kinds of benefits for their co-nationals or constituencies that they regard as a veritable duty, and should the political situation be correspondingly favorable, that is to say correspondingly unfavorable for the Government, then political pressure will produce what is wanted. Often enough, though, because of the carefully calculated rivalry and jealousy between parties, what has been granted to one has also to be conceded to others — from a single costly concession springs a whole bundle of costly concessions.
That last sentence is a key to understanding the crisis that is unfolding in Europe.
Normally, you would look at a country like Greece – with 175% debt-to-GDP, mired in a depression marked by -25% growth of GDP (you can’t call what they’re going through a mere recession), with 25% unemployment (50% among youth), bank deposits fleeing the country, and a political system in (to use a polite term) a state of confusion – and realize it must be given debt relief.
But the rest of Europe calculates that if they make concessions to Greece they will have to make them to everybody else, and that prospect is truly untenable. So they have told the poor Greeks to suck it up and continue to toil under a mountain of debt that is beyond Sisyphean, without any potential significant relief from a central bank.
This will mean that Greece remains in almost permanent depression, with continued massive unemployment. While I can see a path for Greece to recover, it would require a series of significant political and market reforms that would be socially and economically wrenching, almost none of which would be acceptable to any other country in Europe.
Sidebar: Japan would still be mired in a depressionary deflation if its central bank were not able to monetize the country’s debt. As Eurozone members the Greeks have no such option .
However, the rest of Europe is not without its own rationale. To grant Greece the debt relief it needs without imposing market reforms would mean that eventually the same relief would be required for every peripheral nation, ultimately including France.
Anyone who thinks that Europe can survive economically without significant market reforms has no understanding of how markets work. Relief without reforms would be as economically devastating to the entirety of Europe as it would be to Greece alone.
Ultimately, for the euro to survive as a currency, there must be a total mutualization of Eurozone debt, a concept that is not politically sellable to a majority of Europeans. (The European Union can survive quite handily as a free trade zone without the euro and would likely function much better than it does now.)
Kicking the debt relief can down the road is going to require a great deal of dexterity. The Greeks haven’t helped their cause with their abysmal record of avoiding taxes and their rampant, all-too-easily-observed government corruption, including significant public overemployment.
In this week’s letter we will take a close look at the problem that is at the core of Europe’s ongoing struggle: too much debt. But to simply say that such and such a percentage of debt to GDP is too much doesn’t begin to help you understand why debt is such a problem. Why can Japan have 250% debt-to-GDP and seemingly thrive, while other countries with only 70 or 80% debt-to-GDP run into a wall?
Debt is at the center of every major macroeconomic issue facing the world today, not just in Europe and Japan but also in the US, China, and the emerging markets. Debt (which must include future entitlement promises) is a conundrum not just for governments; it is also significantly impacting corporations and individuals. By closely examining the nature and uses of debt, I think we can come to understand what we will have to do in order to overcome our current macroeconomic problems.
Debt is future consumption brought forward, as von Böhm-Bawerk taught us. It is hard for me to overemphasize how important that proposition is. If you borrow money to purchase something today, that money will have to be paid back over time and will not be available for other purchases. Debt moves future consumption into the present. Sometimes this is a good thing, and sometimes it is merely stealing from the future.
This is a central concept in proper economic thinking but one that is all too often ignored. Let’s tease out a few ideas from this concept. Please note that this letter is trying to simply introduce the (large) topic of debt. It’s a letter, not a book. In this section we’ll deal with some of the basics, for new readers.
First off, debt is a necessary part of any society that has advanced beyond barter or cash and carry. Debt, along with various forms of insurance, has made global finance and trade possible. Debt fuels growth and allows for idle savings accrued by one person to be turned into useful productive activities by another. But too much debt, especially of the wrong kind, can also be a drag upon economic activity and, if it increases too much, can morph into a powerful force of destruction.
Debt can be used in many productive ways. The first and foremost is to use debt to purchase the means of its own repayment. You can borrow in order to buy tools that give you the ability to earn higher income than you can make without them. You can buy on credit a business (or start one) that will produce enough income over time to pay off the debt. You get the idea.
Governments can use debt to build roads, schools, and other infrastructure that are needed to help grow the society and enhance the economy, thereby increasing the ability of the government to pay down that debt.
Properly used, debt can be your friend, a powerful tool for growing the economy and improving the lives of everyone around you.
Debt can be created in several ways. You can loan money to your brother-in-law directly from your savings. A corporation can borrow money (sell bonds) to individuals and funds, backed by its assets. No new money needs to be created, as the debt is created from savings. Such lending almost always involves the risk of loss of some or all of the loan amount. Typically, the higher the risk, the more interest or return on the loan is required.
Banks, on the other hand, can create new money through the alchemy of fractional reserve banking. A bank assumes that not all of its customers will need the immediate use of all of the money they have deposited in their accounts. The bank can loan out the deposits in excess of the fraction they are required to hold for depositors who do want their cash. This lets them make a spread over what they pay depositors and what they charge for loans. The loans they make are redeposited in their bank or another one and can be used to create more loans. One dollar of base money from a central bank (sometimes called high-powered money) can over time transform itself into $8-10 of actual cash.
A government can create debt either directly or indirectly, by borrowing money from its citizens (through the sale of bonds) or by directing its central bank to “print” or create money. The money that a central bank creates is typically referred to as the monetary base.
Debt can be a substitute for time. If I want a new car today, I can borrow the money and pay for the car (which is a depreciating asset) over time. Or I can borrow money to purchase a home and use the money I was previously paying in rent to offset some or all of the cost of the mortgage, thereby slowly building up equity in that home (assuming the value of my home goes up).
Oh Debt, Where Is Thy Sting?
Let’s start with a simple analogy and then get more complex. When someone borrows money, they agree to make principal and interest payments over time. For instance, $25,000 borrowed at 5% interest over three years to pay for a car would require a monthly payment of $749.27. Not a problem for someone making $100,000 a year ($50 an hour) but a serious, almost impossible commitment for someone making $10 an hour. After taxes, the car payment would gobble up almost 50% of that person’s income.
All but the most disciplined of us have encountered the unpleasant reality of running up too much credit card debt, typically when we were young. For those outside the US, credit card interest rates can often run 18% or more, and the penalties for late payment can increase the net amount substantially and cause the interest rate to be jacked up even higher. The unpleasant reality of paying far more in interest each month than you are paying on the principal can be quite the eye-opener.
Sometimes debt can be overwhelming. In many countries, individuals can file for bankruptcy and get relief from their debt (as well as losing any remaining assets). In the middle of the last decade, the US bankruptcy laws were changed to make it more difficult to declare bankruptcy. As the chart below shows, bankruptcies fell precipitously but are now back to where they were just a few years before the law passed. Clearly the financial crisis contributed to the new steep rise in bankruptcies. (The 2005 spike in bankruptcy filings was from people rushing to file bankruptcy ahead of the new law’s taking effect.) The vast majority of bankruptcies are now filed by consumers, not by businesses. In 1980, businesses accounted for 13 percent of bankruptcies, but today, they are just 3 percent.
Personal bankruptcies can happen for all sorts of reasons, but in the US they are caused primarily by overwhelming medical expenses, accounting for around 60% of bankruptcies (depending on the year). Other causes are (in order of prevalence) job loss, out-of-control spending, divorce, and unexpected disasters.
Bankruptcy is designed to keep people from being literal slaves to debt. We have come a long way in our civilization from the days of debtor’s prisons. Texas actually wrote into its constitution that a debtor could not lose his horse, tools, or homestead, the principle being that a person needed to be able to move on from bankruptcy and make a living. That sort of basic protection has since evolved nationally into a rather complex but reasonable system for letting people move on from untenable financial situations.
I say that we’ve come a long way from debtor’s prisons. There is a qualifier to that statement. In the US, student loans cannot be discharged in bankruptcy. They are with you until you finally pay them off. In Spain, you cannot get out of a mortgage debt through bankruptcy. Even though the bank can take your home from you, you are still obligated to pay the debt forever. There are exceptions to bankruptcy protection everywhere.
Debt Is Future Consumption Denied
Why go on and on about personal bankruptcy when we are talking about government debt? Because the same principles apply, with a few caveats.
Governments have outright defaulted on their debt nearly 300 times in the past few hundred years. Spain is the all-time winner, with six defaults in the last 140 years and 12 if you go back to 1550. Italy and Argentina have made a sport of defaulting this last century, if you count monetization as a form of default, which it is. While I can find no statistics, inflation and loose monetary policies have almost surely destroyed far more buying power than outright defaults have.
There are times when a government simply cannot pay its bills and must either default outright or change the terms on its debt, just as individuals do.
If an individual or corporation or country has a significant amount of debt and their income drops by 25-30%, it may become impossible to pay that debt and also cover the necessities of life. Greece, as a current example, has not really added to the outstanding total of its debt over the past three years since its last debt default; but the growth of the country (and therefore of its tax revenues) has collapsed by about 25%. Even if tax collection can be improved, the interest rates Greece is forced to pay today may make the repayment of the country’s debt untenable.
Debt is future consumption brought forward into the present, but a corollary is that debt is also future consumption denied. If you will have to pay both principal and interest on debt in the future, then you are setting aside and spending money on debt service that is no longer available for current consumption. And, yes, that debt service goes to bondholders, but their return of capital does not necessarily express itself in consumption or further lending.
Further, when economies are debt-constrained, capital looking to be invested in fixed-income assets finds fewer creditworthy opportunities available and begins to take lower interest payments in a search for yield. The current low-interest environment is not just a product of the Federal Reserve and other central banks; it also stems from a lack of demand from creditworthy borrowers.
Dr. Lacy Hunt of Hoisington Asset Management has been documenting the drag on growth that overindebtedness creates. He recently wrote (emphasis mine):
Poor domestic business conditions in the U.S. are echoed in Europe and Japan. The issue for Europe is whether the economy triple dips into recession or manages to merely stagnate. For Japan, the question is the degree of the erosion in economic activity. This is for an economy where nominal GDP has been unchanged for almost 22 years. U.S. growth is outpacing that of Europe and Japan primarily because those economies carry much higher debt-to-GDP ratios. Based on the latest available data, aggregate debt in the U.S. stands at 334%, compared with 460% in the 17 economies in the euro-currency zone and 655% in Japan. Economic research has suggested that the more advanced the debt level, the worse the economic performance, and this theory is in fact validated by the real-world data.
There are a host of reasons for debt-related economic drag, but the primary cause is that the debt was of the nonproductive kind. The debt was incurred primarily to fund current consumption, whether to pay benefits or for defense spending or what have you.
Deflation Is the Enemy of Debt
Deflation is the general condition where prices go down. This can be caused by increased productivity or decreased demand. We all like it when the cost of our latest technological goodies and indeed everything else we buy goes down. We are generally not happy when the economy falters and prices fall because of slack demand. One of the primary debates among economists is whether economic slowdowns are caused by insufficient demand or insufficient income and productivity.
There have been periods in many countries when there has been economic growth in the midst of general price deflation, but we more typically think of deflation as occurring in periods of economic retreat. Recessions – and certainly depressions ­– are almost by definition deflationary.
In a growing, increasingly productive world, the trend for prices should be down, that is to say, deflationary. But that assertion assumes one necessary condition: a stable monetary base. Proponents of a gold-backed currency point out that gold offers a stable monetary base, while fiat currencies are subject to expansion or contraction by central banks and governments. It is often said that all fiat currencies will eventually explode or implode in value, but that is not necessarily true. A carefully constrained central bank and government will maintain the value of a country’s money. Think Switzerland (the primary example, but there are others). The value of the Swiss franc in relationship to currencies around the world has continued to rise even as the Swiss economy has grown, and their standard of living is among the highest in the world. (Of course, as the Swiss have learned, an overly strong currency can be problematic, too, in this era of intensifying curre ncy wars.)
But while a generally deflationary environment reduces the prices of things we buy, it does not reduce the cost of servicing debt – quite the opposite. Deflation is the enemy of debt. The obvious example, currently, is Greece, as noted above. The deflationary depression the Greeks are in has increased the value of their debt in relation to their income, even though the nominal value of the debt has hardly risen. And because they have not had the benefit of an increase in buying power (stuck, as they are with the euro as a currency and having no control over Eurozone monetary policy), deflation has ravaged their economy.
To put it in personal terms, if your real income drops 25%, then whatever debt service you’re carrying will be a correspondingly larger portion of your income.
In a world where incurring government debt is allowed only when and if that debt is deemed productive, deflation would not be a problem, as incomes would rise with increased productivity. But debt that is nonproductive will grow in absolute cost to an economy in periods of deflation.
One can argue with John Maynard Keynes, and I do so rather aggressively at times, but he did have some valuable insights. If an economy is in recession, the government can lean against the drag on demand by increasing spending. That of course means increasing debt, and Keynes argued that government should borrow and spend in times of recession. Governments everywhere have taken that dictum to heart.
What they have ignored is his second point: a government should pay back that debt during the good times that follow. That discipline allows it to borrow and spend again in when recession recurs. The very concept of a balanced budget is now considered anathema in much of what passes for academic economic circles. It is perjoratively labeled as “austerity.” As if balanced budgets were the cause of economic pain and suffering…
Following the historic budget compromise between Clinton and Gingrich, the United States began to run actual surpluses in the late 1990s, and indeed we were talking about what would happen if we eliminated government debt altogether, so rapidly were we paying it down. The surpluses were accumulated during a rather remarkable economic time. Then the Republican Congress, aided and abetted by George W. and Karl Rove, came along and squandered that surplus. Dick Cheney famously said that deficits don’t matter, in defense of the Bush administration’s policies of cutting taxes and increasing spending in order to curry favor with voters. (Refer again to the quote from von Böhm-Bawerk at the beginning of this letter.)
Absent those large increases in debt and deficits, the Obama deficits, while violating the rule of only accumulating debt for productive purposes (to mention only one violation of principle), would have been manageable in the grand scheme of things. But we are now rapidly approaching a time when debt will once again become an important issue in the US, as it was in the ’90s. Too much debt will become an ever larger drag on the US economy, just as it already is in Japan and Europe.
This rising debt in the US and around the world is one of the primary reasons that central bankers fear deflation. A little inflation plus a little GDP growth helps reduce the overall burden of debt in an economy. While central bankers everywhere seem to think that 2% inflation should be a target, many of them would accept a somewhat higher number. I personally take issue with the 2% figure, because that’s an inflation target that will reduce the purchasing power of any saved dollar by 50% in 36 years. A 2% inflation target is essentially a tax on savings and investment, no matter how you look at it. In a low-interest-rate world, 2% inflation means conservatively invested savings are losing buying power every year. But a little inflation does make debt more manageable, and central bankers seem to be more concerned with making sure that debt can be serviced than that savings can earn an adequate return. Current central bank policy is tantamount to financial repre ssion of savers and retirees.
Neo-Keynesians would argue that debt and deficits are not a problem, in that the central bank can ultimately monetize the debt if necessary. And they point to Japan, whose central bank is doing just that. They look at our own national balance sheet and GDP numbers and ask, so what’s the problem?
But debt is future consumption denied. If you monetize your debt beyond the real growth rate of the economy, then you are reducing the value of your currency and thus reducing your potential future consumption. The fact that this reduction doesn’t happen all at once and may not happen in the immediate future does not remove the reality. In the fullness of time, quantitative easing will result in the reduced buying power of the US dollar.
Yet the US monetary base has expanded significantly, and there has been no real increase in inflation, and the dollar is actually getting stronger. “So what’s the problem?” Mr. Krugman asks. Inflation is brought about by not just an expansion of the monetary base but also by a stable, concurrent rise in the velocity of money. It’s complicated, I admit. I have devoted more than a few letters to the concept of the velocity of money. The current period of low inflation has been caused by a rather dramatic fall, over the last eight to ten years, in the velocity of money. As I predicted almost five years ago, the Federal Reserve was able to print far more money than anyone could imagine without the threat of inflation rearing its head.
The problem is that the velocity of money is a very slow-moving statistic. It is what we call mean-reverting, in that the velocity of money can’t rise to the heavens unless you have a Weimar Germany-type situation, and it can’t fall to zero. It oscillates over long periods (think decades) around an average or mean. Right now the velocity of money is falling, which allows the US Fed to have a very loose monetary policy without having to worry about inflation. When the velocity of money begins to rise, the Fed will have to lean against what could quickly turn into soaring inflation with a tighter monetary policy than it otherwise would have, because of its recent, extreme episodes of quantitative easing. Think Paul Volcker in the early ’80s, turning the screws on 18% inflation. That was not exactly a fun time.
Of course, economists think that we can avoid any big mistakes. But sadly, there is no such thing as a free monetary lunch. Today’s quantitative easing (in a period of reduced velocity of money) will mean tomorrow’s much tighter monetary policy – or much higher inflation. Or both.
The Black Hole of Debt
Debt, when used properly, can overcome obstacles to productivity and bring on a warm day of sunshine, fostering life and growth everywhere. But if debt increases too much, just like a massive dying star it can collapse upon itself, explode like a supernova, and become a black hole instead, sucking in all the life around it.
Without a massive increase in debt, present-day China would have been impossible. Clearly that debt has improved the life of its citizens. But in recent years China has used debt to maintain a strange new form of growth and is increasingly using debt to build and consume, heading toward an ever less productive outcome. As in many other places in the world, each new dollar of debt is producing less in terms of GDP growth.
There has been a massive explosion of global debt since the beginning of the Great Recession in 2007. Normally, after a banking and financial crisis, one would expect a period of deleveraging and a reduction of debt. This time is truly different. Next week we will look at the actual growth of debt around the world and what it has accomplished.
They will be followed by Stephanie Pomboy, whom I have wanted to have at the conference for years. She is one of the truly elite macroeconomic analysts, known primarily in the institutional and hedge fund world, and over the last few years her insights have been a regular feature in Barron’s. My friend Ian Bremmer, the brilliant geopolitical analyst and founder of Eurasia Group, who is consistently one of the conference favorites (and whose latest book we will try to have for you if it is off the press in time), will join, us followed by David Zervos of Jefferies, former Fed economist and fearless prognosticator, who has an enviable track record since he joined Jefferies five years ago. He is currently quite bullish on Europe.
On the final day we will have Michael Pettis flying in from China to give us his views on how Asia rebalances and China manages its transition. Michael has been one of the most consistently on-target analysts on China and is wired into the thought leaders in the country. And what fun would the conference be without Kyle Bass of Hayman Advisors offering us his latest ideas? I am excited to announce that William White, the brilliant former chief economist of the Bank for International Settlements has also agreed to attend. We are finalizing agreements with another three or four equally well-known speakers, which will include a few surprises, as well as rounding out the panels. I will share those names with you as we nail them down.
Since the first year of the Strategic Investment Conference, my one rule has been to create a conference that I want to attend. Unlike many conferences, we have no sponsors who pay to speak. Normal conferences have a few headliners to attract a crowd and then a lot of fill-ins. Everyone at my conference is an A-list speaker I want to hear, who would headline anywhere else. And because all the speakers know the quality of the lineup, they bring their A games.
Attendees routinely tell me that this is the best conference anywhere every year. And most of the speakers hang around to hear what is being said, which means you get to meet them at breaks and dinners. Plus, this year I am arranging for quite a number of writers and analysts to show up just to be there to talk with you. And I must say that the best part of the conference is mingling with fellow attendees. You will make new friends and be able to share ideas with other investors just like yourself. I really hope you can make it.
The three major democratic advanced economies—the eurozone, Japan and the U.S.—continue to experience significant economic challenges. The eurozone is weak and vulnerable; Japan has been in recession again; and while recent data have been better, the American recovery is still slow by historical standards, with stagnant median real wages and a labor market that is weaker than the official unemployment rate indicates.
The particulars of these economic challenges differ, but in each region one thing is constant: endless focus by the media, analysts and investors on the yellow-brick road that leads to central banks. Will the European Central Bank’s quantitative-easing program have major impact?
How will the Bank of Japa n proceed? When will the Federal Reserve raise interest rates?
Monetary policy is important, but it is not omnipotent. The relentless focus on monetary policy creates serious moral hazard by taking attention away from elected officials’ failure to act on the fiscal, public-investment and structural issues that are the key to short- and long-term economic success. Commensurately, focusing on central banks reduces public pressure on elected officials to act. And monetary-policy decisions themselves require a rigorous balancing of benefits and risks.
ECB President Mario Draghi ’s famous promise to do “whatever it takes” to preserve the eurozone was a masterly move to buy time. But monetary policy cannot solve the currency union’s problems. In the eurozone, as in Japan, sovereign-bond yields have been very low for an extended time, especially when eurozone yields are viewed on a risk-adjusted basis. Even lower interest rates would probably have little impact on investment and consumer decision-making. ECB policy has generated a decline in the value of the euro that could go further, but the impact on the economy is likely to be limited and certainly not sufficient to revive the eurozone.
Given the limited transmission mechanism, QE in the eurozone is unlikely to raise inflation expectations significantly—though inaction could have reinforced deflation concerns and disrupted markets that already had reflected the prospect of policy action.
In the U.S., the risks from QE3—the most recent phase of quantitative easing—persist even though that round of bond buying is over. QE3 created comfort that the Fed could and would keep bond yields low. That, in turn, may have led political leaders to feel less pressure to act—political moral hazard—and exacerbated investors’ reaching for yield through riskier assets, contributing to excesses in the U.S. and globally.
The U.S. stock market has been roughly at an all-time high. Leveraged buyouts are being done with minimal or no covenants. Italian, Spanish and French yields on sovereign 10-year debt are lower than U.S. Treasurys. If these are excesses, the markets are at some point likely to destabilize, perhaps severely. Market fluctuations associated with the Swiss National Bank ’s ending of its cap on the franc against the euro could provide a glimpse of the destabilizing effects that central-bank currency actions can have, though in the Swiss case it was an appreciating currency after a long effort to maintain a capped exchange rate.
Moreover, the vast and unprecedented increase in the Federal Reserve’s balance sheet heightens the risk of a policy error—either too little or too much restraint—as the Fed manages the process of tightening. Some argue that risk can be minimized if the Fed tightens not through selling assets but by increasing interest rates on excess reserves or using instruments like reverse repos. But there is no magic solution here. The response of markets, banks and businesses to the use of such alternative tools is untested and unknowable. And the risk of economic slowdown or inflation may be about the same, though with different dynamics.
The greater these risks are, the more imperative it is that elected officials do what is needed for a successful economy. In the U.S., that agenda should include a sound and well-constructed fiscal regime, robust public investment, and structural change in areas like immigration, education, trade liberalization and much else. The fiscal regime should consist of upfront job-creating infrastructure spending, enacted simultaneously with somewhat deferred structural fiscal-discipline measures on the spending and revenue sides. And sequestration should be canceled.
In the eurozone, leaders of key troubled countries—including Italy, Spain, France and, most immediately, Greece—need to undertake structural reforms, further strengthen banking systems, and strike a fiscal balance between sufficient discipline to win market and business confidence and adequate fiscal room for growth. As to Japan, the fundamental requisite is structural reform.
In all three major advanced economies there should be a clear-eyed view of the moral hazard created by disproportionate focus on central banks. Monetary policy should be treated with a pragmatic analysis of all its attendant risks and rewards. Instead of looking for a wizard at the end of a yellow-brick road, we should demand that elected officials take the difficult fiscal, public-investment and structural actions that could do so much good now and that are imperative for the longer term.