US Debt

Courtesy of the Atlantic

Reagonomics in 2016 ?

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2014 : Let´s be careful


Courtesy of Armstrong Economics

Protests in Greece Show The Strain in Europe


Merkel is being really demonized in Athens for the German fear of hyperinflation imposing deflation as the solution. Politicians must wake up before they tear Western Society apart. There is no way out with austerity. You cannot cut everything to pay the debt. Social unrest will tear everything apart and 2014 is not looking very good. We ABSOLUTELY must revise the world monetary system and eliminate the debt. Unless we do this restructuring, there will be nothing that resembles modern society within months of the default that will destroy all pension funds even those fully funded.

We will be reviewing the Cycle of War/Revolution/Civil Unrest at the upcoming conferences in Bangkok and Berlin. Suffice it to say. World War I and II, Vietnam, and the Fall of Communism all began on this cycle, They next target remains 2014. The politicians are ignorant of history and the consequences of their actions. It appears we are all going to pay the price.

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( source Zerohedge )


Difficult for US to take a side…

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Rajoy´s illusion

(Reuters) – “ Spain continues to study the price it will have to pay for seeking help from the European Central Bank’s bond-buying program but improved market conditions may make aid unnecessary, Prime Minister Mariano Rajoy said on Wednesday.

“I don’t know if Spain needs to ask for it,” Rajoy told parliament in a debate session, referring to an international rescue for Spain.

Yields on Spanish bonds have fallen dramatically, to five-month lows, since the ECB agreed last week to launch a new bond-buying program to reduce struggling euro zone countries’ borrowing costs provided they first request assistance from the euro zone’s rescue fund and abide by strict conditions.”

ECB will NOT buy Spanish bonds until Spain asks especifically for a Bailout.

Please Mr. Rajoy, stop daydreaming.

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What recovery ?



Courtesy of John P.Hussman
Late-Stage, High-Risk

John P. Hussman, Ph.D.
All rights reserved and actively enforced.

Reprint Policy

For investors who don’t rely much on historical research, evidence, or memory, the exuberance of the market here is undoubtedly enticing, while a strongly defensive position might seem unbearably at odds with prevailing conditions. For investors who do rely on historical research, evidence, and memory, prevailing conditions offer little choice but to maintain a strongly defensive position. Moreover, the evidence is so strong and familiar from a historical perspective that a defensive position should be fairly comfortable despite the near-term enthusiasm of investors.

There are few times in history when the S&P 500 has been within 1% or less of its upper Bollinger band (two standard deviations above the 20-period moving average) on daily, weekly and monthly resolutions; coupled with a Shiller P/E in excess of 18 – the present multiple is actually 22.3; coupled with advisory bullishness above 47% and bearishness below 27% – the actual figures are 51% and 24.5% respectively; with the S&P 500 at a 4-year high and more than 8% above its 52-week moving average; and coupled, for good measure, with decelerating market internals, so that the advance-decline line at least deteriorated relative to its 13-week moving average compared with 6-months prior, or actually broke that average during the preceding month. This set of conditions is observationally equivalent to a variety of other extreme syndromes of overvalued, overbought, overbullish conditions that we’ve reported over time. Once that syndrome becomes extreme – as it has here – and you get any sort of meaningful “divergence” (rising interest rates, deteriorating internals, etc), the result is a virtual Who’s Who of awful times to invest.

Consider the chronicle of these instances in recent decades: August and December 1972, shortly before a bull market peak that would see the S&P 500 lose half of its value over the next two years; August 1987, just before the market lost a third of its value over the next 20 weeks; April and July 1998, which would see the market lose 20% within a few months; a minor instance in July 1999 which would see the market lose just over 10% over the next 12 weeks, and following a recovery, another instance in March 2000 that would be followed by a collapse of more than 50% into 2002; April and July 2007, which would be followed by a collapse of more than 50% in the S&P 500, and today.

The prior instances were sometimes followed by immediate market losses, and were sometimes characterized by extended top formations – which produce a sort of complacency as investors say “see, the market may be elevated and investors may be over-bullish, but the market is so resilient that it’s ignoring all that, so there’s no reason to worry.” Ultimately, however, the subsequent plunges wiped out far more return than investors achieved by remaining invested once conditions became so extreme. We are in familiar territory, but that territory generally marks the mouth of a vortex.

Based on ensemble methods that capture a century of evidence – from Depression-era data, through the New Deal, World War, the Great Society, the electronics boom, the energy crisis, stagflation, the great moderation, the dot-com bubble, the tech crash, the housing bubble, the credit crisis, and even the more recent period of massive central bank interventions – our estimates of prospective market return/risk have been negative since April 2010 and have remained negative even as new data has arrived. Since early March, those estimates have plunged into the most negative 0.5% of historical instances.

It’s worth noting that the S&P 500 posted a negative total return between April 2010 and November of last year. Of course, the market has also enjoyed a risk-on mode since then. Through Friday, the S&P 500 has achieved a total return of nearly 25% since our return/risk estimates turned negative in early 2010. Defensiveness has clearly been taxing in that respect. But this doesn’t remove the question of whether the market’s recent gains are durable, much less whether they will be extended. Corporate insiders certainly don’t seem to think so – their sales have tripled since July, to a rate of six shares sold for each share purchased.

Far from being some novel “new era” environment, present conditions – rich valuations, overbought trends, lopsided bullishness, heavy insider sales, and lagging market internals – are part of a historical syndrome that is very familiar in the sense that we’ve repeatedly seen it prior to the worst market declines on record. But as the chronicle above should make clear, this doesn’t make our short-term experience any easier, because these conditions can emerge, go dormant for a few months while the market retreats modestly, and then reappear as the market registers a marginal new high. The ultimate outcome has historically been spectacularly bad, but it still takes patience and discipline to stay on the sidelines during late-stage, high-risk advances. Of course, the present instance may turn out differently than every prior instance has – it’s just that we have no basis to expect that outcome.

Economic Notes

The most interesting feature of last week’s “decision” by the European Central Bank was the continued eagerness of investors to hear what they want to hear, rather than what is actually said. With little doubt, what investors think they heard was that the ECB has finally decided to launch a new program by which it will begin purchasing Italian and Spanish debt in unlimited – unlimited – amounts, putting an emphatic end to European debt strains, and decisively ensuring the future unity of the Euro.

Here is what the European Central Bank actually said:

“A necessary condition for Outright Monetary Transactions is strict and effective conditionality attached to an appropriate European Financial Stability Facility/European Stability Mechanism (EFSF/ESM) programme. Such programmes can take the form of a full EFSF/ESM macroeconomic adjustment programme or a precautionary programme (Enhanced Conditions Credit Line), provided that they include the possibility of EFSF/ESM primary market purchases. The involvement of the IMF shall also be sought for the design of the country-specific conditionality and the monitoring of such a programme.”

If you wondered why Angela Merkel and the whole of Germany was not immediately up in arms, it is because prior to transactions by the ECB, the receiving country would have to submit to an adjustment program, ideally involving the IMF. This is nothing like what Spain has been asking for, which is for the ECB to make unconditional purchases. To benefit from the proposed OMT program, these countries have to subordinate their fiscal policy to outside conditionality.

What if they don’t?

“The Governing Council will consider Outright Monetary Transactions to the extent that they are warranted from a monetary policy perspective as long as programme conditionality is fully respected, and terminate them once their objectives are achieved or when there is non-compliance with the macroeconomic adjustment or precautionary programme.”

But assuming these countries accept the adjustment programs, at least they can be assured that the ECB will buy their debt in unlimited amounts, can’t they?

“No ex ante quantitative limits are set on the size of Outright Monetary Transactions.”

Read carefully – the ECB did not promise “unlimited” financing. Rather, it refused to specify an amount in advance (ex-ante), because it doesn’t want the markets to look at some inadequately small and fixed number and begin to speculate against the ECB as soon as that particular number is approached. By refusing to set a specific amount in advance, Draghi said in his press conference that he wanted the policy to be perceived as fully effective. But perception substitutes for reality only for so long. If Merkel, Monti and Rajoy were stranded on a mountaintop and Merkel was the only one with a bag of muesli, she might offer some to the other two without specifying an amount in advance, but there’s no doubt she’d be slapping it out of their hands if things got out of control.

Finally, “The liquidity created through Outright Monetary Transactions will be fully sterilised.”

This last provision is likely to both calm Germans and inflame them. Sterilization means that for every euro of Spanish or Italian bonds the ECB buys (creating new euros in the process), it will drain euros by selling some other security – most likely bonds of Germany, Holland, Finland, or other stronger European nations. This will help to calm Germans because it indicates that the overall supply of euros will not expand. It will also inflame them, however, because the existing stock of euros will now have been created to provide fiscal support to Spain, Italy and other troubled countries, while Germany, Holland, Finland and stronger countries will not have benefited at all from the money creation.

It will be interesting how this plays on September 12, when the German Constitutional Court is set to decide on the legality of the European bailout funds, the EFSF and the ESM (technically, the Court will rule on an injunction against even passing it into law, but will not formally rule on constitutionality until possibly next year). My expectation is that they will rule that these mechanisms are in fact allowable and consistent with the German Constitution. Where it gets interesting is whether they will rule that it is allowable to leverage these mechanisms or operate with a banking license (which would make Germany’s existing contribution “capital” that could be wiped out, leaving Germany on the hook for much, much larger amounts – which essentially cedes fiscal authority from the German people to the ESM). I suspect that there is a fair chance that the Court will add language in their ruling to reject that possibility, which may force the idea of a “big bazooka” back to square one. We’ll see.

Here in the U.S., Friday’s August employment report was surprisingly weak relative to Wall Street’s expectations, though hundreds of thousands of workers abandoned the labor force, which allowed the unemployment rate to decline. Relative to our own expectations, the figure was elevated, as I expect that the August employment figure will ultimately be revised to a negative reading. This would be consistent with revisions that we’ve seen around prior recession starting points.

For example, if you look at the originally reported data for May through August 1990, you’ll see 480,000 total jobs created (see the October 1990 vintage in Archival Federal Reserve Economic Data). But if you look at the revised data as it stands today, you’ll see a loss of 81,000 jobs for the same period. Look at January through April 2001, at the start of that recession. The vintage data shows a total gain of 105,000 jobs during those months, while the revised data now shows aloss of 262,000 jobs. Fast forward to February through May 2008, and though you’ll actually see an originally-reported job loss during that period of 248,000 jobs, the revised figures are still dismal in comparison, now reported at a loss of 577,000 jobs for the same period. As other good economic analysts have recognized, economic time series tend to be revised after-the-fact, with upward revisions in periods just before the recession begins, and downward revisions in periods just after the recession begins. I continue to believe that the U.S. joined an unfolding global recession, most probably in June of this year.

Ahead to QE3. A week ago, The Wall Street Journal ran a piece by Jon Hilsenrath titled Will Fed Act Again? Sizing Up Potential Costs. The article reviewed concerns about additional quantitative easing, noting that inflation has remained muted and the dollar has remained firm. Both of those outcomes were presented as evidence counter to Fed Governor Charles Plosser’s concern that “Without appropriate steps to withdraw or restrict the massive amount of liquidity that we have made available… the inflation rate is likely to rise to levels that most would consider unacceptable.”

There is strong evidence to suggest that this is little but false comfort. While we don’t expect material inflationary pressures until the back-half of this decade, the Federal Reserve has increasingly placed itself into a position that will be nearly impossible to disgorge without enormous disruption. Specifically, the U.S. economy could not achieve a non-inflationary increase in Treasury bill yields to even 2% without requiring a nearly 50% reduction in the Federal Reserve’s balance sheet.

This point is easily demonstrated in data from 1947 to the present. The relationship between short-term interest rates and the amount of monetary base per dollar of nominal GDP is very robust, and is widely recognized as the “liquidity preference” curve. We are already way out on the flat part of this curve. Note that Treasury bill yields have never been at even 2% except when there was less than 10 cents of base money per dollar of nominal GDP. There are only 3 ways to get there from the current 18 cents – dramatically cut the balance sheet, keep interest rates near zero for the nextdecade (assuming nominal GDP growth of 5% annually), or accept much higher rates of inflation than most would consider acceptable.

Moreover, with a portfolio duration that we now estimate at about 8 years, historically low yields on Treasury securities, and a Fed balance sheet currently leveraged about 53-to-1 against the Fed’s own capital, an increase in long-term yields of anything more than 20 basis points a year would produce capital losses sufficient to wipe out interest income, making the Fed effectively insolvent, and turning monetary policy into fiscal policy.

On the subject of Fed leverage, it is one thing to purchase long-dated bonds when yields are high. It is another to purchase them when yields are at record lows and very small yield changes are capable of wiping out all interest income and leaving the Fed in a loss position when it is already levered 53-to-1 (2.9 trillion of assets on 54.6 billion of capital, according to the Fed’s consolidated balance sheet). At a 10-year Treasury yield of just 1.6% and a portfolio duration of about 8 years (meaning that a 100 basis point move causes a change of about 8% in the value of the securities held by the Fed), it takes an interest rate increase of only about 20 basis points (1.6/8) to wipe out a year of interest on the portfolio held by the Fed and push it into capital losses. It would then take another 24 basis points to wipe out all of the capital on the Fed’s balance sheet. Of course, they don’t mark the balance sheet to market. So the public might not be aware of those losses, but that would only mean that we would have an insolvent Fed printing money on an extra-Constitutional basis to fund its own balance sheet losses instead of public spending.

Based on a report from UBS (h/t ZeroHedge), the Federal Reserve now holds all but $650 billion of outstanding 10-30 year Treasury securities, with UBS warning “a large, fixed size QE program could cause liquidity to tank”, with a similar outcome in the event that the Fed pursues mortgage-backed securities instead. A couple of years ago, Bernanke asserted in a 60 minutes interview that “We could raise interest rates in 15 minutes if we have to. So there is really no problem in raising interest rates, tightening monetary policy, slowing the economy, reducing inflation, at the appropriate time.” Really? Tell that to Paul Volcker, who had to deal with enormous inflation at unemployment rates even higher and a monetary base dramatically smaller than we observe at present.

The Fed now holds virtually no Treasury debt of maturity of less than 3 years, as Operation Twist and other efforts have been designed to force investors to choke on short-dated paper yielding next to nothing, in hopes of forcing them into riskier securities. The chart below shows the distribution of Fed holdings (dark bars) versus private sector holdings of Treasury debt, at various maturities. Of course, in equilibrium, someone still has to hold the short-dated Treasury securities, in addition to about $2.7 trillion in zero-interest cash and bank reserves, until those securities, currency, and reserves are retired. To believe that an unwinding of the Fed’s present balance sheet would not be disruptive is full-metal make-believe.

Good economic policy acts to relieve some binding constraint on the economy. How does the Fed argue that base money is a binding constraint? At present, there are trillions of dollars held as idle reserves on bank balance sheets. While a “portfolio balance” perspective may well suggest that additional zero-interest reserves will force more investors into risky assets at the margin (which has been most effective after significant market declines over the prior 6-month period), so what? There is no historical evidence that changes in stock market value have a significant effect on GDP. Indeed, a 1% change in stock market value is associated with a change of only 0.03-0.05% in GDP, largely because individuals consume off of their expectation of “permanent income”, not off of transitory changes in volatile securities.

In regard to why inflation has remained low, a useful way to see the relationship between the monetary base, interest rates, GDP and inflation is the “exchange equation”: MV = PQ, where M is base money, V is velocity, P is prices, and Q is real output. As is evident from the liquidity preference chart, base velocity (PQ/M) is tightly related to short-term interest rates. In fact, as long as short-term interest rates fall in response to increases in the monetary base, those increases have virtually no effect on real output, but instead translate almost directly into declines in velocity. Again, some data from 1947 to the present:

If the decline in velocity exactly offsets the increase in base money, inflation is not going to explode overnight. But this happy outcome is brought to you by the passive response of short-term interest rates and the willingness of the public to accumulate zero-interest assets, which is in turn the result of strong and legitimate concerns about credit risk, default risk, and economic weakness. But remove any of those factors, or allow any other exogenous upward pressure on short-term interest rates, and the result will be upward pressure on velocity. Barring enormous rates of real GDP growth, the only way to counter that, as the first chart suggests, will be through either massive (and potentially disruptive) contraction of the Federal Reserve’s balance sheet, or acceptance of undesirable rates of inflation.

As hedge funds often discover, and JP Morgan recently learned, it is very easy to get into a position that later turns out to be nearly impossible to exit smoothly. A significant reduction in the Fed’s balance sheet is unlikely to be achieved at long-term interest rates nearly where they are now, which implies capital losses on the Fed account, which implies that in contemplating a further round of quantitative easing, the Federal Reserve is effectively contemplating a fiscal policy action.

Unfortunately, they’re likely to do it anyway.

From an investment perspective, it’s important to consider the potential effect of additional quantitative easing. As I noted several weeks ago (see What if the Fed Throws a QE3 and Nobody Comes?), the effect of prior rounds of quantitative easing both in the U.S. and abroad has generally been limited to little more than a recovery of the loss that the stock market sustained over the prior 6-month period. Presently, the S&P 500 is at a 4-year high, valuations are rich on the basis of normalized earnings, and advisory sentiment exceeds 50% bulls – over twice the number of bearish advisors according to Investors Intelligence. In recent years, each round of QE emerged closely on the heels of a significant market loss that produced a spike in risk premiums. In that environment, expanding the stock of zero-interest rate assets had the effect of bringing those risk premiums back down to those observed over the prior 6-months or so, and more recent interventions have shown diminishing returns. At present, risk-premiums are already depressed and there is no 6-month loss to recover.

In short, even the evidence of the past several years does not support the automatic assumption that stock prices will advance in the event of another round of QE at present levels. With little doubt, the market is likely to enjoy some immediate cheer from that sort of move, particularly if the Fed refrains from providing a specific ex-ante limit on its purchases – allowing investors to rejoice in the perception that the Fed had launched “unlimited” QE. Still, that cheer may be short-lived. If we examine the way that QE actually operates, and how and why risk premiums have responded to prior rounds, it is entirely unclear that a further round will have much effect beyond an initial spike of enthusiasm. That is, unless one adopts a superstitious faith that stocks will rise in response to QE, since QE makes stocks rise, because QE equals stocks rising, with no further analysis needed.

The foregoing comments represent the general investment analysis and economic views of the Advisor, and are provided solely for the purpose of information, instruction and discourse. Only comments in the Fund Notes section relate specifically to the Hussman Funds and the investment positions of the Funds.

Fund Notes

As of Friday, our estimates of prospective return/risk in the stock market remain in the most negative 0.5% of historical instances. Notably, the S&P 500 is within 1% of its upper Bollinger band (two standard deviations above its 20-period moving average) on daily, weekly and monthly resolutions. According to Investors Intelligence, bullish advisors outnumber bearish advisors by more than two-to-one (51% vs. 24.5% respectively), and corporate insiders are selling stock at a pace of six shares sold for every share purchased.

On the valuation front, profit margins remain elevated and the ratio of corporate profits to GDP is nearly 70% above its historical norm, and as a result, price/earnings multiples that are based on near-term earnings estimates are elevated, but do not seem extreme. But stocks are not a claim on one year of earnings – they are a claim on a very long-term stream of cash flows that will actually be delivered to investors over time. On the basis of normalized earnings, we estimate a 10-year prospective total return for the S&P 500 of less than 4.5% nominal. The Shiller P/E is presently 22.3, which is in the richest 5% of all historical data prior to the late-1990’s bubble. While this multiple may not seem extreme relative to the data of the past 13 years or so, it should be remembered that stocks have lagged Treasury bill yields during this period, and the market has experienced two separate plunges in excess of 50% each, precisely because valuations have been so rich.

The market conditions we observe at present are very familiar from the standpoint of historical data, matching those that have appeared prior to the most violent market declines on record (e.g. 1973-74, 1987, 2000-2002, 2007-2009). That is no assurance that market losses will be swift, as some of those instances included extended tops characterized by some amount of “churn” and exhaustion before failing. Indeed, even the historical record of these instances is not an assurance that stocks will decline at all in the present case. It’s just that we have no other basis to form expectations about prospective return and risk except to understand how valuations, market action, sentiment and other factors have converged to drive market returns over history.

In any event, we are creatures of discipline, and I strongly believe that our discipline is well-suited to achieve our investment objectives over the complete bull-bear market cycle, despite what will inevitably include shorter-term frustrations. Meanwhile, long-time readers of these weekly comments may be somewhat relieved that going forward, I’ll simply refer to our 2012 Annual Report to elaborate on why the recent cycle has been an outlier, compared with the full-cycle performance that we achieved prior to 2009, and that I expect in future cycles.

There will be periods where a few of our large holdings get hit (as we saw on Friday) despite the fact that our stock selection has strongly outperformed the S&P 500 over time. There will be periods where we are defensive in an advancing market because we face familiar sets of market conditions that have been devastating for investors, as we do now. But what matters to our strategy, and what produces strong risk-adjusted returns over the complete market cycle, is the habit of accepting greater risk in conditions where risk has generally been well-rewarded, and avoiding risk in conditions where risk has generally been punished. We are now in a very familiar environment that has regularly punished risk-taking severely, if not immediately.

Strategic Growth remains fully hedged, with just over 1% of assets invested in additional option time premium to raise the strike prices of the put option side of our hedge, looking out to the end of the year. Strategic International remains fully hedged. Strategic Dividend Value remains hedged at 50% of the value of its stock holdings – its most defensive position. In Strategic Total Return, we used recent bond market strength to cut our portfolio duration to 1.4 years (meaning that a 100 basis point change in interest rates would be expected to affect the portfolio by about 1.4% on the basis of bond price changes), and we cut our exposure in precious metals shares to about 6% of assets, as the prospect for open monetary spigots is likely to be far more limited than investors seem to expect, and global economic activity is slowing rapidly, now including China and other presumed economic bulwarks. Our return/risk estimates remain positive in that sector, but have become much more muted in response to the recent price advance and other factors. The Fund continues to hold small allocations in utility shares and foreign currencies.

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EU´s dilema


It is still possible   economically and politically to find a way out of the euro zone crisis if policy makers separately address two  problems:  dealing with the  legacy  costs of  the  initially flawed design of  the euro  zone,  and fixing the  design  itself. The  former  requires  significant  burden sharing  and an  economic  strategy  that  focuses on  stabilising  the  countries  that  are  suffering from  recession  and  capital  flight.  In  contrast,  fixing  the  design  requires  a  financial  (banking) union with strong euro+area institutions and a minimal fiscal backstop.

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Europe can rescue Europe

Courtesy of George Soros

Proposal for a European Fiscal Authority (EFA), a Debt Reduction Fund and European Treasury Bills


In retrospect it is now clear that the member states entered the monetary union that was incomplete in its construction.  The main source of trouble is that the member states surrendered their right to print money to the ECB without fully realizing what that entails- and neither did the European authorities. When the euro was introduced the regulators allowed banks to buy unlimited amounts of government bonds without setting aside any equity capital; and the central bank discounted all government bonds on equal terms. Commercial banks found it advantageous to accumulate the bonds of the weaker countries to earn a few extra basis points. That is what caused interest rates to converge.  The large fall in the cost of credit helped fuel housing and consumption booms, which went unchecked.  At the same time, Germany, struggling with the burdens of reunification, undertook structural reforms and became more competitive.  This led to a wide divergence in economic performance.

Then came the crash of 2008 which created conditions far removed from those prescribed by the Maastricht Treaty. Governments had to bail out their banks and some of them found themselves in the position of a third world country that had become heavily indebted in a currency that they did not control. Due to the divergence in economic performance Europe became divided into creditors and debtors countries.

When financial markets discovered that supposedly riskless government bonds may actually be forced into default they raised risk premiums dramatically. This rendered commercial banks whose balance sheets were loaded with those bonds potentially insolvent. That gave rise to an adverse feedback loop between the solvency of the banks problems of the banks and the risk premium on sovereign debt.

The Eurozone is now replicating how the global financial system dealt such crises in 1982 and again in 1997. Then the international authorities inflicted hardship on the periphery in order to protect the center; now Germany is unintentionally playing the same role. The details differ but the idea is the same: the creditors are shifting all the burden of adjustment onto the debtors and the “center” avoids its own responsibility for the imbalances. Interestingly, the terms “center” and “periphery” have crept into usage almost unnoticed. Yet in the euro crisis the responsibility of “the center” is even greater than it was in 1982 or 1997: they were the architects of a flawed currency system and failed to correct its defects. In the 1980’s Latin America suffered a lost decade; a similar fate now awaits Europe.

At the onset of the crisis a breakup of the euro was inconceivable: the assets and liabilities denominated in a common currency were so intermingled that a breakup would have led to an uncontrollable meltdown. But as the crisis progressed the financial system has been progressively reordered along national lines. This trend has gathered momentum in recent months. The LTRO enabled Spanish and Italian banks to buy the bonds of their own countries and earn a large spread. Simultaneously banks are giving preference to shedding assets outside their national borders and risk managers are trying to match assets and liabilities within national borders rather than within the eurozone as a whole.

If this continued for a few years a break-up of the euro would become possible without a meltdown but even then the creditor countries would be left with large claims against the debtor countries which would be difficult, if not impossible, to collect. In addition to all the rescue packages and ECB interventions the central banks have large claims against the central banks of the debtor countries within the Target2 clearing system. The Bundesbank had claims of €644 billion on April 30th and the amount is rapidly growing due to capital flight.

The creditor countries led by Germany are always willing to do what is necessary to avoid a cataclysm. But that is not enough to resolve the crisis so it continues growing. Tensions in financial markets have risen to new highs. Most telling is that Britain, which retained control of its currency, enjoys the lowest yields on government bonds in its history while the risk premium on Spanish sovereign debt is at a new high despite Spain’s deficit and debt to GDP ratio being lower than those of the UK. The real economy of the Eurozone as a whole is declining while Germany is still booming. This means that the divergence between debtors and creditors is getting wider. The political and social dynamics are also working toward disintegration.  Public opinion as expressed in recent election results is increasingly opposed to austerity and this trend is likely to grow until the policy is reversed.

What is needed is a set of bold initiatives that are convincing enough to persuade both the public and the financial markets that the authorities have both the will and the resources to make the euro work. These initiatives have to conform with the existing Treaties yet they have to be bold enough to bring conditions back closer to those that were prescribed by Treaties. The Treaties could then be revised in a calmer atmosphere so that the current excesses will not recur.

It is difficult but not impossible to construct a set of initiatives that will meet these tough requirements. They would have to simultaneously tackle the banking and the sovereign debt problems without neglecting to reduce divergences in competitiveness. There are various ways to provide it but they all need the active support of Germany as the largest creditor country.

At the Rome meeting on Thursday June 22 the four heads of state agreed on steps towards a banking union and a modest stimulus package to complement the fiscal compact but Chancellor Merkel resisted all proposals to provide relief to Spain and Italy from the excessive risk premiums prevailing in the market. This threatens to turn the June summit into another fiasco which may well prove fatal because it will not provide a strong enough firewall to protect the rest of the eurozone against the possibility of a Greek exit. Even if a fatal accident can be avoided the divisions between creditor and debtor countries will be reinforced and the “periphery” countries will have no chance of regaining competitiveness because the playing field is tilted against them. This may serve Germany’s narrow self-interest but it will create a Europe that is very different from the open society that fired people’s imagination. That is not what Chancellor Merkel or the overwhelming majority of Germans stand for.

Chancellor Merkel argues that it is against the rules to use the ECB to solve the fiscal problems of member countries and she’s right. President Draghi of the ECB has said much the same. There is a missing element in the current plans and this proposal is designed to provide it.

The Proposal

The June summit has to produce a Political Declaration which outlines not only the long-term vision of a political union but also practical steps towards a fiscal and a banking union. Since plans for a banking union are well advanced this proposal is confined to:

•        A European Fiscal Authority (EFA) which will serve as the embryo of the fiscal union and also provide fiscal backing for an embryonic banking union.

•        A Debt Reduction Fund (DRF) which will provide immediate relief to the periphery countries on refinancing their sovereign debt by issuing European Treasury Bills.

These measures will require an Intergovernmental Agreement. With unanimity at the summit the process could be accelerated and, on the basis of the Political Declaration, some steps could already be taken in the meantime. This would bring immediate relief to the financial markets and reverse the political dynamics from conflict to cooperation.

This is how it would work.

European Fiscal Authority (EFA): To be established by inter-governmental treaty a.s.a.p.

Membership: Finance Ministers of Eurozone countries

Organization: Embryonic European Treasury

Voting: According to shareholdings in ECB                                                                       


•        80% when guarantees are involved that disproportionately affect creditor countries

•        50% plus when members are affected proportionately


1.      Implement Debt Reduction Fund – a modified form of the European Debt Redemption Pact that has been proposed by the German Council of Economic Advisors.

2.      Provide fiscal backing for banking union.

3.      Assume solvency risk on government bonds held by ECB.

4.      Provide financing for a growth policy to complement the fiscal compact.

5.      After a suitable transitional period allow for annual settlement of Target2 balances.

Financial resources

1.    Control of ESM, EFSF

2.    One tenth of 1% additional VAT contribution from member states- approved by 80% majority.  This will demonstrate the political will necessary to carry out the mission.

3.   Additional financial resources: to be mobilized as needed.

The Debt Reduction Fund

The EFA will conclude agreements with individual countries that will oblige them to abide by the fiscal compact and introduce specific structural reforms like labor market liberalization and pension reforms. In return the EFA would reduce that country’s stock of debt to 60% of GDP or such higher figure as the agreement specifies by acquiring bonds in 1) primary market 2) secondary market and 3) from the ECB and other official bodies.

The EFA will finance its purchases by issuing European Treasury Bills and pass on the benefit of cheap financing to the country concerned. The bills will be assigned zero risk rating by the authorities and will be treated as the highest quality collateral for repo operations at the ECB.  The banking system has an urgent need for risk-free liquid assets. Banks are currently holding more than €700 billion of surplus liquidity at the ECB earning only one quarter of 1% interest.  This assures a large and ready market for the bills.

Should a participating country subsequently fail to live up to its commitments the EFA may impose a fine or other form of penalty which would be proportionate to the violation so that it would not turn into a nuclear option that cannot be exercised. This would provide strong protection against moral hazard. For instance, it would make it practically impossible for a successor government in Italy to break any commitments undertaken by the Monti government.  Having practically half the Italian debt financed by European treasury bills will have an effect similar to a reduction in the average maturity of its debt.  That would make a successor government all the more responsive to any punishment imposed by the EFA.

Only after the demand for European treasury bills has been exhausted will the EFA consider issuing longer-term bonds.   After a transitional period long enough to insure that the Eurozone resumes growth, the participating countries concerned will enter into a debt reduction program which will be tailored not to jeopardize their growth. That will be the prelude to the establishment of a full fiscal union with the appropriate political arrangements which, in turn, will allow the replacement of the remaining 60% of sovereign debt by Eurobonds.

A Euro Area Banking Union

By taking control of the ESM and the EFSF, the EFA would be able to provide the necessary fiscal backing for a banking union. The EFA as a political authority acting in partnership with the ECB can do what the ECB as a monetary authority cannot do on its own.

A banking union has to have three components

1. A European source of funding for recapitalizing the banks

This could be provided by the ESM acting under the control of the EFA.  While the ESM has substantial resources that could be used for this purpose, allowing it to borrow from the ECB would substantially reinforce it.  It would require a banking license for the ESM, best provided by a modification of the Intergovernmental Agreement.  This is highly desirable but not critical for the plan to work.

2. Eurozone-wide supervision and regulation of banks – this is best provided by the ECB acting together with the European Banking Authority.

3. A Eurozone-wide deposit insurance scheme. This is the thorniest immediate problem. German depositors are reluctant to pay for the extra risk posed by Spanish banks in the current economic climate and German taxpayers are unwilling to make up the difference. But the EFA assuming the solvency risk on government bonds held by the ECB provides a makeshift solution. Specifically, the EFA could take over the Greek bonds held by the ECB coming due on August 20th and thereby avoid a Greek default. The ECB could then continue to provide unlimited liquidity to the Greek banks which have recently been recapitalized. This would not eliminate capital flight but it would remove the most immediate threat confronting the euro-area – a run on the banks of other periphery countries.  A more lasting solution will have to await the formation of a full-fledged banking union. The EFA taking over the solvency risk on the bonds held by the ECB would establish the principle that the EFA is responsible for solvency risks and the ECB for providing liquidity.

Growth Policy

By laying the groundwork for a banking union and substantially reducing the financing costs of sovereign debt, the June summit will offer an escape route from the deflationary debt trap in which the European Union is currently caught. Nevertheless, it would be highly desirable to develop a growth policy to accompany the fiscal compact.  This could form part of the Political Declaration but time is too short to go into details.  The Political Declaration could point out that the EFA is providing the institutional framework for developing a growth policy.

Annual Settlement for Target Balances

Similarly, the Political Declaration could contain a paragraph announcing that after an appropriate transitional period Target2 balances would be annually settled.  This would be a reward to Germany and other creditor countries for their willingness to provide the guarantees implied by the issuance of European treasury bills.

Creditor countries should remember that they have made practically no transfer payments; they have only made loans which will result in losses if they are not repaid.   The proposals outlined here to are comprehensive enough to reduce the likelihood that any losses will be incurred.  The more complete the guarantees the less likely they are to be invoked.


Immediately – at June summit issue a Political Declaration and set in motion and Intergovernmental Agreement establishing the EFA with the appropriate powers to carry out its mission.

Very short term – in anticipation of Intergovernmental Agreement

•        ECB starts accumulating Italian and Spanish bonds.

•        ESM takes over ECB’s holdings of Greek bonds insuring the ECB against default risk.

•        No implementation of austerity measures as long a country has negative GDP growth rate.

•        Finance Ministers start negotiating structural reforms that will qualify “periphery” countries to benefit from debt reduction scheme.

Short term – hopefully before year-end

•        Ratify and implement new Intergovernmental Agreement.

•        Develop growth policy.

Medium term – next 3 to 5 years

•        Creation of fiscal, banking, and political union.

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from Sober Look by Walter Kurtz

The recent sharp decline in Brent crude should have a positive knock-on effect on the US consumer. That’s because it is likely to give a small boost to disposable income by bringing down retail gasoline price (gasoline and US crack spreads are tightly correlated with Brent.)

CS: – The latest declines in Brent futures should provide light relief to stretched US consumers. If sustained gasoline prices could fall to around $3.10 a gallon, 20% lower than their late March peak and a level last seen in January 2011.

Brent futures and retail gasoline

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Berlusconi : More Italy less €

(Reuters) – Italy should consider leaving the euro unless Germany agrees to the European Central Bank acting as a guarantor for sovereign debt and printing money to reflate the economy, former Prime Minister Silvio Berlusconi said on Wednesday.

“Leaving the euro is not a blasphemy,” he wrote on his Facebook page.

If Germany does not agree to a new role for the ECB then it should consider leaving the euro itself, Berlusconi said. “I have spoken to some German experts who would be in favor,” said Berlusconi, leader of one of two main parties backing pro-European Prime Minister Mario Monti.

Earlier, at a book presentation, Berlusconi was more explicit about the prospect of a return to the lira.

“What would happen if Italy, Spain or Greece went back to their old currencies? I don’t know, maybe there would be a loss of wealth but I don’t understand why,” he was quoted as saying by Italian news agencies.

The 75-year-old media magnate, whose People of Freedom party (PDL) lost heavily in local elections last month and has been shedding supporters steadily over the last year, is increasingly targeting the euro in a bid to regain popularity.

On June 1, he made very similar comments on the ECB and Germany and said Italy’s central bank should begin printing euros or printing lira to help Italy out of recession, only to say the following day that his remarks were a “joke”.

With less than a year before the next general election, Italy faces the prospect of at least two large parties running on an anti-euro ticket.

The Five Star Movement led by comedian Beppe Grillo, who urges an exit from the euro, has overtaken the PDL according to recent polls to become Italy’s second largest party, with more than 20 percent of voter support.

The pro-devolution Northern League also often expresses skepticism or hostility about the single currency.

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