Europe did fall into recession later than the U.S., and thus may recover later. Its export-driven factories are showing welcome signs of life. And very slow population growth means slower overall growth.  But the short-term outlook for Europe is distressingly bleak.

Debt-burdened Greece is not the problem. It’s a symptom. Wages and prices in Greece, Ireland, Italy, Portugal and Spain are too high to compete. The old solution was to devalue the currency, but sharing the euro makes that impossible. So wages and prices need to fall, as they are in Ireland.

If the ECB is to avoid Continental deflation, then falling prices in southern Europe must be matched with faster rising prices in stronger European countries to bring the euro-zone average close to the ECB target. But Germany won’t stand for that much inflation. So the risk is that monetary policy makers in Europe will be too tight fisted. And worries about government debt loads, and fixation on deficit targets set in a treaty that never contemplated a calamity like the one we just survived, block any substantial new fiscal stimulus to bolster demand.

Much of Europe, Germany especially, is proud of its exporting prowess, but every country can’t count on exports to employ the millions left jobless by the recession. Some country has to be a consumer. And it can’t be the U.S., which helped cause the crisis by borrowing and spending too much.

China is beginning to do its part: Consumer spending there last year grew faster than the overall economy for the first time in years. But Germans and some other European consumers aren’t spending readily. Perhaps aging Europeans fear government deficit-cutting will erode their pensions. Whatever the cause, European consumer caution—and governments’ inability or unwillingness to reverse it—is a brake on the global economy.

And then there are the banks. Japan’s escaped the worst of the financial crisis. U.S. banks are regaining their strength, if not yet their eagerness to lend. China’s banks are a ticking time bomb. And Europe’s—well, it’s hard to say, and that’s the problem. Investors and analysts keep whispering that European banks have yet to come clean and are sitting on undisclosed losses. Its biggest banks have smaller capital cushions than their U.S. counterparts. European bank lending to business is still shrinking.

Conclusions from BIS working paper ( Bank for International Settlements ). The future of Public Debt: Prospects and Implications

“Our examination of the future of public debt leads us to several important conclusions.

First, fiscal problems confronting industrial economies are bigger than suggested by official debt figures that show the implications of the financial crisis and recession for fiscal balances. As frightening as it is to consider public debt increasing to more than 100% of GDP, an even greater danger arises from a rapidly ageing population. The related unfunded liabilities are large and growing, and should be a central part of today’s long-term fiscal planning.  It is essential that governments not be lulled into complacency by the ease with which they have financed their deficits thus far. In the aftermath of the financial crisis, the path of future output is likely to be permanently below where we thought it would be just several years ago. As a result, government revenues will be lower and expenditures higher, making consolidation even more difficult. But, unless action is taken to place fiscal policy on a sustainable footing, these costs could easily rise sharply and suddenly.

Second, large public debts have significant financial and real consequences. The recent sharp rise in risk premia on long-term bonds issued by several industrial countries suggests that markets no longer consider sovereign debt low-risk. The limited evidence we have suggests default risk premia move up with debt levels and down with the revenue share of GDP as well as the availability of private saving. Countries with a relatively weak fiscal system and a high degree of dependence on foreign investors to finance their deficits generally face larger spreads on their debts. This market differentiation is a positive feature of the financial system, but it could force governments with weak fiscal systems to return to fiscal rectitude sooner than they might like or hope.

Third, we note the risk that persistently high levels of public debt will drive down capital accumulation, productivity growth and long-term potential growth. Although we do not provide direct evidence of this, a recent study suggests that there may be non-linear effects of public debt on growth, with adverse output effects tending to rise as the debt/GDP ratio approaches the 100% limit (Reinhart and Rogoff (2009b)).

Fourth, looming long-term fiscal imbalances pose significant risk to the prospects for future monetary stability”.

BIS Working Papers No 300

The yield on 10-year Greek government bonds jumped to a new 11-year high on Wednesday, while the cost of insuring Greek debt against default now exceeds the cost of insuring Icelandic debt, after the country’s government said it would revise up its 2009 deficit forecast.

The government said the deficit would be revised to around 12.9% of gross domestic product from an initial estimate of 12.7%, news reports said.The change, which had been expected, follows a steeper-than-expected 2% contraction in 2009 gross domestic product. The initial estimate was based on a 2009 GDP fall of 1.2%, Bloomberg said.

The yield on the 10-year Greek government bond jumped to hit 7.15%, the highest level in 11 years, from around 6.99% Tuesday. The yield premium demanded by investors to hold 10-year Greek government bonds over German bunds jumped to more than four percentage points.

The trouble is that China today exhibits many of the characteristics of great speculative manias. Let´s enumerate them from Charles P. Kindleberger´s view :

1) Compelling growth story

2) Faith in the competence of the authorities

3) A general increase in investment

4) Surge in corruption

5) Easy money

6) Fixed currency regimes

7) Rampant credit growth

Moral hazard

9) Financial structure become precarious

10) Rapidly rising property prices

Are we ready for the outcome ???

Greek Drama

Europe’s European Central Bank President Trichet spoke out against offering low- interest loans for Greece…The Greek crisis is getting serious. What started as a problem with the fiscal credibility of one euro-zone state has exposed political fault lines running through the currency bloc. Constructive ambiguity, whereby markets were placated with the belief that unspecified help could be provided to Greece, has given way to confusion. With politicians becoming increasingly entrenched on either side of the Greece-Germany divide, the risks are rising that Greece becomes a big problem for the global financial system.

Trichet’s demand for stringent terms and German Chancellor Merkel´s push for sanctions against nations that breach deficit limits heightened the chance that Greece will leave a March 25-26 summit empty-handed. That could force Greece to turn to the IMF.

And from John Maulding´s Outside  the box  :

“Hans-Werner Sinn’s remarks are apparently listened to as closely as are the Federal Reserve Chairman’s remarks in the US. He said:

• The Greek drama will have a ‘frightful’ (’schreklich’) ending no matter which course of action is taken. The objective is to avoid having a Greek default trigger another banking crisis across the EU.
• The EU member states are too financially fragile to take on any flaky Greek debt. The actual Greek deficit is running at 16% of GDP, not 12% as previously reported. Greece is in a deepening retraction, not a recovery, as previously claimed. [Germany's social security, welfare, unemployment, and health care entitlement programs are all running cash-negative or soon will be, but that is another subject entirely. Angela Merkel has a committee established to work on tax reform, meaning tax rate reductions - Steve].
• There are three bad alternatives. He recommends #3 (effectively, default):
  1. A Franco-German bailout. Dr. Sinn believes this is impractical and the worst of the three alternatives because the amounts required for an effective bailout are so large that it would trigger a jump in yields on French and German sovereign debt which would result in a Euro-wide financial crisis. In addition, Angela Merkel said ‘no,’ and so did Guido Westerwelle (her coalition partner and foreign minister).
  2. IMF loans. Dr. Sinn believes that this would accelerate the Greek economic contraction with a dramatic deflation of wages and prices, which could lead to civil war, revolution and a political destabilization of the area.
  3. Exit the Euro zone, revive the Drachma, re-denominate the sovereign bonds in Drachma, let the Drachma collapse, and rebuild after the collapse, largely on tourist remittances Assuming a small amount of domestic (internal) default, this would be the least-painful to the Greek populace, but German banks and investors would lose approximately $38 Bn in bond investments +/- what can be recovered after the Greek economy recovers. Eventually, Greece would be allowed to re-join the EU.
• Formation of an EU monetary fund is out of the question, he believes, because it requires treaty modifications that might take many years to pass.
• As an aside, he said that if German tax rates are not lowered, that Germany will slide back into recession.”

Difficult decisions ahead for Europe…

Today, we would like to recommend THE EMPATHIC CIVILIZATION by Jeremy Rifkin. We think that he is right in calling : The Third Industrial Revolution. And we quote :

“The great turning points occur when new, more complex energy regimes converge with communications revolutions, fundamentally altering human consciousness in the process. This happened in the late 18th century, when coal and steam power ushered in the industrial age. Print technology was vastly improved and became the medium to organise myriad new activities. It also changed the wiring of the human brain, leading to a great shift from theological to ideological consciousness. Enlightenment philosophers – with some exceptions – peered into the psyche and saw a rational creature obsessed with autonomy and driven by the desire to acquire property and wealth.”

“Today, we are on the verge of another seismic shift. Distributed information and communication technologies are converging with distributed renewable energies, creating the infrastructure for a third industrial revolution. Over the next 40 years, millions of buildings will be overhauled to collect the surrounding renewable energies. These energies will be stored in the form of hydrogen and any surplus electricity will be shared over continental inter-grids managed by internet technologies. People will generate their own energy, just as they now create their own information and, as with information, share it with millions of others.”

“This communications revolution will, like its predecessor, change the way we think. We are in the early stages of a transformation from ideological consciousness to biosphere consciousness. Scientists and the public are realising that all life is deeply interdependent. The very way we live leaves a carbon footprint, affecting every other human, our fellow creatures and the earth we cohabit.”

As William Strauss and Neil Howe say in The Fourth Turning  : ” the fourth turnings have provided the great pivot points for  Anglo-American legacy”.

We believe that we are in the middle of this turning point and hope as Rifkin explains that we will find prosperity through the Third Industrial Revolution but it won´t be easy !!!

It seems that Mr. Market just cares about GDP numbers but as David Rosenberg says : “If it is about GDP, then all we can say is that even with the latest statistical bounce that has largely reflected State capitalism and inventory adjustment, this measure of economic activity is still, amazingly, 1.7% lower today than it was at the pre-recession peak — despite the mountain of government stimulus.  What is “normal” is that by now — eight quarters after a recession begins and the stimulus follows — real GDP has actually not just surpassed the pre-recession peak but has not so by nearly 5%.”

Source: Clusterstock – Chart of the Day, March 11, 2010.

As we can see in the chart above there are some indicators that do not believe the strenght of the GDP…

Maybe other economic measures like :

• More than five million homes are behind on their mortgage.

• There are over six million Americans who have been unemployed for at least six months, a record 40% of the ranks of the joblessness.

• The private capital stock is growing at is slowest rate in nearly two decades.

• Roughly 30% of manufacturing capacity is sitting idle.

• Nearly 19 million residential housing units or about 15% of the stock is vacant. • One in six Americans are either unemployed or underemployed.

• Commercial real estate values are down 30% over the past year.

• The average American worker has seen his/her level of wealth plunge $100,000 over the last two years even with the recovery in equity markets this past year.

• Bank credit is contracting at an unprecedented 15% annual rate so far this year as lenders sit on a record $1.3 trillion of cash.

• Unit labour costs are down an unprecedented 4.7% over the past year and what has replenished household coffers has been the federal government as transfer payments from Uncle Sam now make up a record 18% of personal income.

can bring some more light to where we are…

Treasury Bonds

Since 1990 Treasury bond yields have steadily moved downward in line with a more benign inflationary environment (Chart 6). Those yearly declines in yields continued last year with an average interest rate of 4.07% versus 4.28% in 2008.

To remain fully invested in long Treasuries in this high volatility environment requires a simple discipline based on the academic literature which demonstrates that over time bond yields move in the same direction as inflation (Fisher equation).

Van R. Hoisington and Lacy H. Hunt have a very interesting opinion about it :

“Presently, we view the inflationary environment as benign because: 1) the U.S. economic system is overleveraged and academic research confirms that this circumstance leads to deflation; 2) monetary policy is, and will continue to be, ineffectual as efforts to spur growth are thwarted by declining asset prices, loan destruction, and adverse regulatory influences; 3) the federal government’s spending spree will necessarily cause taxes and borrowings to rise, further stunting any economic growth. These factors ensure that inflation will be quiescent. Interest rates easily can and do rise for short periods, but remaining elevated in a disinflationary environment is contrary to the historical experience. We are owners and buyers of long U.S. Treasury debt.”

Treasurie´s Holders

The United States government borrowed more money than ever before in 2009, but its largest lender — China — sharply reduced the amount it was willing to lend.

The United States Treasury estimated that last year China raised its holdings of Treasuries by just $62 billion. That was less than 5 percent of the money the Treasury had to raise.

That raised its holdings to $790 billion, leaving it the largest foreign holder of Treasury securities — Japan is second at $757 billion and Britain a distant third at $278 billion. But China’s holdings at the end of November were lower than they were at the end of July.

Meanwhile, Japanese Institutions are becoming the new buyers, seeing 10 Year Tresury Bond at 3% yield in June !!!

Who is right ? We think that Japanese know a lot better what happens when a Financial credit buble burst…

Europe’s leaders are struggling to avert the biggest financial disaster in the euro’s 11-year history…

Whether the EU has time is an open question. Credit Suisse says Greece must raise €30bn (£26bn) in debt by mid-year, mostly in April and May. Greek banks have been shut out of Europe’s inter-dealer markets, forcing them to raise money at killer rates. They are suffering an erosion of deposits as rich Greeks shift money abroad. This could come to a head long before April.

French banks have $76bn of exposure to Greece, the Swiss $64bn, and the Germans $43bn says Bloomberg. But this understates cross-border links. There are large loans between vulnerable states. The exposure of Portuguese banks to Spain and Ireland equals 19pc of Portugal’s GDP. Interlocking claims within the eurozone zone are complex. Contagion can spread fast.

The rescue of Greece marks a new wave of the global financial crisis. The first was about the solvency of banks; this one is about the solvency of sovereign countries.

As Ambrose Evans Pritchard said  ” There was an element of bluff in Thursday’s accord, as if the EU leaders hope to muddle through with “constructive ambiguity”, fingers crossed that their vague political pledge will never be tested. Bluff is a valid tool of statemanship, but in this case their bluff could be called very soon.”

We would like to come again to This Time is Different by Rogoff and Reinhart and how the authors enumerate the possible factors bringing Deflation :

” First, financial imbalances occur when aggregate domestic debt is excessive relative to income, regardless of whether the government or private sector is accumulating the debt. Once debt becomes excessive, countries do not grow their way out of the problem; they must go through the time consuming and often painful processes of debt repayment and increased saving.”

“ Second, whether the domestic debt is externally or internally owed is not as critical as the excessiveness of the debt.”

“ Third, government actions, even involving sizeable sums of money, are far less helpful than they appear. Infusions of cash can make a government look like it is providing greater growth to its economy than it really is.”

Fourth, Reinhart and Rogoff cover countries in debt crisis with a host of different conditions, such as growth and age of population, political regimes, technology status, education, and other idiosyncratic features. Nevertheless, economic damage as a result of extreme over-leverage has remarkably similar results, whether the barometer of performance is economic output, the labor markets, or asset prices.

Fifth, further increasing leverage to solve the problem only leads to greater systemic risk and general economic underperformance.

The real question for financial participants is whether all these influences result in inflation or deflation, and the authors’ research details both outcomes.

According to Reinhart and Rogoff the norm is that major economic contractions lead to deflation. Importantly, they call our present economic circumstances the “second great contraction.”

Thus, not only has the historical “qualitative” research on the subject of deflation chronicled the deflationary impulses emanating from overindebtedness (Fisher’s 1933 “Debt-Deflation Theory of Great Depressions”), but also modern “quantitative” methods have now essentially confirmed this conclusion. Over-indebtedness and major contractions lead to deflation.