Euro Drops Below $1.30

This morning the value of the Euro dropped below $1.30.  The United States should thank the European Union for the diversion it has created.  With all the turmoil taking place in Europe, little attention is being paid to the monetary and fiscal policies of the United States and the impact these policies are having on the value of the United States dollar against other major currencies. 

As can be seen in the following chart the value of the United States dollar against other major currencies in the world continues its secular decline.  In terms of monetary policy and fiscal policy, international financial markets continue to give a negative rating to the United States and continue to see further future declines in the value of the dollar.

I continue to believe that, given the current policy leanings of the United States government, that the value of the United States dollar will continue to decline in the future.  Since the early 1960s the United States government, both Republican and Democrat, has generally followed a policy of credit inflation that resulted in the United States going off the gold standard and then resulted in the secular decline in the value of the dollar since President Nixon floated the dollar’s price in August 1971.  The two exceptions to this secular decline occurred when Paul Volcker was the Chairman of the Board of Governors of the Federal Reserve System in the early 1980s and when Robert Rubin was the Secretary of the Treasury in the Clinton administration in the latter part of the 1990s.

To me, there the Obama administration has continued the policy of credit inflation carried on by his predecessors and perhaps even improved upon it. 

The only times that the value of the dollar has rebounded over the past several years has been when there has been a “flight to quality” in US Treasury securities.  Other than this the value of the dollar has continued to decline except relative to the Euro.

Again, it seems to me that the United States should thank the European officials for all their follies because they have taken attention away from the political mess in the United States and the continued weakness in the value of the United States dollar in the world.   

The European Model: Broken Beyond Repair?

I am really tired of the German bashing!

The model for the Euro was unsustainable.  But, the lessons learned from the effort should not be taken lightly.

The major lesson from the experiment with the Euro is that a currency area cannot be set up without a central political body that is strong enough to enforce the rules of the currency area.  One can have separate states within the area, but, as in the United States, there must be a political union with enough authority to dominate the individual components of the area.

A second lesson from the experiment is that the economic model based upon “social engineering” is not sustainable.  The German economic model of low inflation, high labor productivity, and fewer government handouts has worked better than the model that includes substantial credit inflation, an inefficient private sector, and bloated government payrolls. 

And, as usual, the “losers” in the game cry foul against the successful. 

“The press review from around Europe does not make pleasant reading for the German foreign ministry these days.  ‘Look at this stuff, it’s just unacceptable,’ laments one diplomat—pointing to a front-page article from Il Giornale, an Italian newspaper owned by Silvio Berlusconi.  The piece links the euro crisis to Auschwitz, warns of German arrogance and says that Germany has turned the single currency into a weapon.  The Greek papers are not much better.  Any taboos about reference to the Nazi occupation of Greece have been dropped long ago.

Across southern Europe, the ‘ugly German’ is back—accused of driving other nations into penury, deposing governments and generally barking orders at all and sundry.

There is also a much more polite form of German-bashing going on at the official level.’ (http://www.ft.com/intl/cms/s/0/9d38ffee-5639-11e1-8dfa-00144feabdc0.html#axzz1mGnbTALH)

Economics, at one time, was defined as the study of the allocation of scarce resources.  That is, there are limits to what a country can attain given the amounts of human capital and physical capital that are available to it. 

Over the past fifty years, many countries came to believe that they had overcome these limitations and through credit inflation and social engineering they could achieve something beyond the boundaries set by the amounts of human capital and physical capital that existed.

Some of these programs included government created credit inflation that kept workers locked in jobs that were becoming legacy positions and that also promoted a home ownership scam that seemingly created middle-class piggy-banks; government hiring practices that resulted in excessive overstaffing of bureaucratic agencies (about one-third of the Greek workforce is in the public sector); and pension benefits that allowed for very comfortable early retirements. 

The economies of these countries just did not have the resources to sustain these programs. 

If everyone is following these policies then everyone is basically in the same boat.

However, a problem occurs if one or more other countries do not follow the same policies. 

The eurozone is having a problem because Germany, for one, has not taken the path most travelled.  And, over time, their more disciplined approach came out on top.

Germany now has the wealth, the resources, that others don’t.  Consequently, those that don’t have the wealth and are now struggling believe that Germany should compensate them for Germany’s success. 

The article quoted above states that the weaker countries in Europe are asking three things from the Germans: first, to commit more money to a European “bailout” fund that would be “so large that it would frighten the markets from speculating against southern European bonds”; second, to commit to Eurobonds to make the debts of individual countries the debts of the eurozone itself; and to stimulate the German economy so that Germans would buy more goods from southern Europe.

These requests, in my mind, are totally off-the-wall!

The Germans should not give in on these issues and they should maintain their position of strength.  And, the German-bashing should stop!

The eurozone is not going to get stronger by making every one of its members weaker!

This is because the eurozone is not the only game going on in the world.

Other areas in the world are maintaining their discipline and can only benefit, competitively, from a weaker eurozone.  Need I mention China?  And, Brazil?

And, these other areas of the world are growing in relative economic strength as Europe fights its own little family fights.  The pressures coming from this competition are not going to go away and Europe, as a whole, may have already postponed dealing with its problems for so long that it may still be years away from a resolution in which it becomes as competitive as it needs to be in the world of the 21^st century.

I still fail to see anyone in Europe that I would call a leader.  Consequently, I find it hard to defend the continued existence of the Euro, as we now know it.  At this point in time, I see several countries leaving the Euro over the next couple of years.  I see a much-diminished role for the eurozone in the world, both economically and financially.  I also see economic social engineering receding as a government policy in the western world even though Paul Krugman and Joseph Stiglitz will still be around.  The era of economic social engineering is past its prime, even though this fact is not fully recognized yet.

The United States should be grateful to the eurozone for the way it has conducted itself, otherwise we would be talking more about the fifty-year weakness in the value of the US dollar.       

Where Does Sovereign Credibility Come From? The European Sitaution

As usual, when Bob Barro of Harvard writes something it usually contains some provocative ideas.  In the Monday morning Wall Street Journal, Barro writes about how Europe might get out of the Euro. (http://professional.wsj.com/article/SB10001424052970203462304577134722056867022.html?mod=ITP_opinion_0&mg=reno-secaucus-wsj)

What interested me most in Barro’s piece was the emphasis he placed on the credibility of the organizations that issue a currency. 

In essence, as I read the article, Barro argues that the credibility of the Euro comes from those within the eurozone that are fiscally sound and carry those that are not fiscally sound, the “free riders”, along with them. 

This credibility is maintained for as long as the “free riders” conduct their irresponsibility within limits.   In fact, this is what the original charter of the eurozone called for…limits to how irresponsible the “free riders” could be.

But, the limits must be enforced.

“Greece…has been increasingly out of control fiscally since the 1970s.  But instead of expulsion, the EU reaction has been to provide a sufficient bailout to deter the country from leaving.” 

The bailouts have become serial, as bailouts have also been given to Portugal, Ireland, Italy, and Spain. 

Thus, the only way credibility can be maintained is for Germany to continue to be fiscally strong while the union continues to provide bailout packages that will carry the “free riders” along for as long as possible.

Meanwhile, the internal effort of the members of the eurozone has been to create a stronger “fiscal” bond within the zone itself…ultimately moving to a “centralized political entity” that will oversee the fiscal and currency policy of the whole eurozone. 

Europe, to achieve such a “centralized political entity”, would have to overcome many, many issues that have existed on the continent for a long time.  For one, the internal rivalries that have existed for centuries would have to be overcome.  Already the resentment against Germany has grown as Germany has become a more demanding partner within the union.  Even statements like “Germany is achieving through economics what it could not achieve militarily at an earlier date” demonstrate some of the underlying emotions that exist on the continent.  Then you have the cultures, languages, and other hurdles to overcome to achieve the needed unity.

Even so, Barro continues, in the shorter run, the credibility of the nations is vitally important because of the sovereign debt that has already been issued by the governments of Europe and that rest on the balance sheets of the banks within the eurozone.  This is the reason there is rush to achieve the near term austerity in the budgets of Italy, Spain,…and France…among others. 

Greek debt is now yielding more than 34 percent on its ten-year bonds.   Portuguese bonds are yielding more than 13 percent.  The debt of Italy is yielding more than 7 percent.  And Spanish bonds are above 5.5 percent.  These rates are unsustainable!

French debt is yielding around 3.5 percent and the rating agencies are soon expected to remove their AAA rating.

The status of this debt is important because, “the issue that has prompted ever-growing official intervention in recent months has been actual and potential losses of value of government bonds of Greece, Italy and so on.  Governments and financial markets worry that these depreciations would lead to bank failures and financial crises in France, Germany, and elsewhere.”

Credibility is lacking because “it is unclear whether Italy and other weak members will be able and willing to meet their long-term euro obligations.” 

Not only is the banking system threatened by this lack of confidence, the uncertainty that exists surrounding the future structure and performance of this area does not contribute to the achievement of stronger economic growth.  If anything, this uncertainty works to reduce growth.

Only as independent nations with their own currencies would these countries be able to meet their own obligations and achieve the credibility a nation needs to function within the global economy.  “This credibility underlay the pre-1999 system in which the bonds of Italy and other eurozone countries were denominated in their own currencies.  The old system was imperfect, but it’s become clear that it was better than the current setup.”

The issue is one of credibility. 

Right now, Germany seems to possess credibility.  But this credibility is based on its maintaining the position of fiscal responsibility it has already achieved.  And, this is just what the Germans seem to be doing. (“Germany Resists Europe’s Plea to Spend More,” http://www.nytimes.com/2012/01/09/business/global/germany-resists-europes-pleas-to-spend-more.html?_r=1&ref=business)  

As long as the current economic structure exists for the eurozone, the credibility of the eurozone will depend upon it’s ability to provide sufficient “band aides” to piggy-back on the credibility of Germany.   My guess is that it will become harder and harder for financial markets to buy-into this piggy-back arrangement. 

Credibility requires the provision of actions that backup promises.  Barro is suggesting that the only way that the fiscally irresponsible will become credible is for them to be “out-on-their-own” again where they will have to be totally responsible for their own actions.  Unless this happens, there is too much historical baggage carried by the eurozone that will not be overcome.      

Initial Verdict on European Summit: the Can Got Kicked Further Down the Road

“European leaders’ blueprint for a closer fiscal union to save their single currency left the onus on central bankers to address investor concerns that Italy and Spain would succumb to the two-year-old financial crisis.” (http://www.bloomberg.com/news/2011-12-09/euro-states-to-shift-267-billion-to-imf-as-focus-shifts-to-deficit-deal.html)

In other words, the so-called leaders of the European Union did not lead! 

In place of action, they asked the European Central Bank to cover for them.

 

“Nineteen months since euro leaders forged their first plan to contain the debt turmoil, the fifth comprehensive effort added 200 billion euros ($267 billion) to the war chest and tightened rules to curb future debts. They sped the start of a 500 billion-euro rescue fund to next year and diluted a demand that bondholders shoulder losses in rescues.”

The biggest winner: Nicholas Sarkozy.  The “second best” award went to Angela Merkel. 

In other words, we still have not resolved the European sovereign debt crisis. 

And, what else was occurred?

The major loser award was given to Britain’ David Cameron.  Cameron refused to agree to a full change in the treaty for all 27 members of the European Union if there were no special safeguards for the financial services of the United Kingdom…more specifically, protection for the financial industry in London.  In taking such a stance, Cameron basically isolated himself from the proceedings of the summit.

The response of Financial Times editorial writer Wolfgang Münchau: “So we have two crises now. A still-unresolved eurozone crises and a crisis of the European Union.” (http://blogs.ft.com/the-a-list/2011/12/09/the-only-way-to-save-the-eurozone-is-to-destroy-the-eu/#axzz1g2glnIN4)

To Münchau, “The eurozone may, or may not, break up. The EU almost certainly will. The decision by the eurozone countries to go outside the legal framework of the EU and to set up the core of a fiscal union in a multilateral treaty will eventually produce this split.”

In other words, the inability of the officials of Europe to resolve the sovereign debt crisis is leading to additional difficulties that must be dealt with going forward.

The problem with not dealing with problems is that the problems tend to multiply and grow.

And, what about the threat made by Standard & Poor’s?  Will Standard & Poor’s downgrade the debts of the eurozone countries? 

The initial feeling is one of uncertainty.  It may be that Standard & Poor’s will not move right away…but, the European sovereign debt crisis is not over and the downgrade will probably come in the very near future. 

But, this raises another question…what about the European banks who hold so much of the sovereign debt of these nations?

Yesterday, the European Banking Authority declared that European banks needed to add 115 billion in euros to their capital base by next June.  New stress tests have indicated that the banking system, especially Germany’s, has a much bigger shortfall of capital than earlier thought.  Without the capital the EBA is concerned that the banks will be able to handle the continued financial stress in European capital markets. 

European officials, once again, fail to get their arms around the situation.

Perhaps one should not be surprised at this.

However, one question still lingers in my mind.  So much was made of the role that Angela Merkel was playing in the effort to get a more comprehensive solution to the European problems that concerns were raised about the possibility of German dominance of the European Union.  I even saw articles that made the following assertion: “What Germany could not achieve by military might may be obtained through financial strength.” 

If this is true then it appears that Europe is still fighting the old battles.  As long as Europe continues to operate on the basis of prejudices established years ago it will not move itself into the 21^st century.  If this is true, the European financial crisis still has a long way to go.

Super Mario and the European Central Bank

Tuesday, a new player moves into the top rung of European officials dealing with the European financial crisis. 

Mario Draghi is not “new” to the European scene, but on Tuesday he takes over as the president of the European Central Bank replacing Jean-Claude Trichet, and so is “new” in this important position.

A new head of a central bank is generally “known” but, not having ever been in the position before, he (when are we going to get a woman head of a central bank?) is untested and it is uncertain how he will really act under pressure. 

There is an interesting article in the Sunday New York Times about Mr. Draghi titled “Can Super Mario Save the Day for Europe?” that gives us some background on this “new” leader: (http://www.nytimes.com/2011/10/30/business/mario-draghi-into-the-eye-of-europes-financial-storm.html?_r=1&ref=business)

In this article Mr. Draghi is cited as vowing “that there would be no surprises on his watch.”

Vintage Draghi seems to provide a “performance so subtle and politic that it seem(s) to please everyone.  Which, it turns out, is the Draghi way: people often seem to see what they want to see in him.” 

Yet, Mr. Draghi seems to produce.  Although having sterling academic credentials, he in not some academic that gained his laurels by writing about historical events.  He has actually been in “real” administrative positions that have required tough decisions to be made and leadership to be shown.  In these positions he has shown well. 

He has been in the private sector and, although this is the place where people seem to question some of what he has done, he performed well in his role as a vice chairman of Goldman Sachs in Europe.  

He seems to be a person that let’s his actions define his positions and does not get all “hung up” about how best to communicate with investors and markets as does the current Federal Reserve System. 

I particularly like the description of Mr. Draghi given by Francesco Giavazzi, who worked for Mr. Draghi at the Italian treasury.  Mr. Giavazzi, a classmate of his at M. I. T., states that Draghi learned a very important lesson in his efforts to bring Italy’s fiscal problems under control so that Italy could join the new common monetary zone that was being created for Europe.  At that time Italy was dealing with “high levels of debt” and “runaway deficits” which led to Italy being expelled from the European Exchange Rate Mechanism, the European currency system that preceded the formation of the eurozone. 

The efforts of Mr. Draghi and his team brought things under control so that Italy avoided bankruptcy and could become a founding member of the new currency union.

Mr. Giavazzi states that the lesson that Mr. Draghi learned through this experience “is that rather than waiting for help, you need to regain the confidence of the markets through your own actions, and that if you do not do the right thing, no outside help is enough—you will have a solvency problem.” 

Encouraging.

Furthermore, people that have worked with Mr. Draghi claim that even though he is an economist he “put aside models and theories for what actually works.”  Mr. Draghi seems to be a pragmatist. 

So, Mr. Draghi appears to be an experienced, pragmatic leader who is confident enough in his abilities that he can let his actions speak for themselves.

Sounds too good to be true!

Best wishes, Mr. Draghi, we all wish you the greatest success!        

European Bankers Balk at Big Write Downs

In my experience there are three ways for bankers with “bad” assets to move on.  First, the bank can “work out” the bad assets, but this takes time and in some cases a lot of luck.  The “lot of luck” component of this solution often refers to a recovery of the economy, local or national, that lifts up all asset values and brings the value of the “bad” assets more in line with the accounting values that exist on a banks’ balance sheet.

The second way is to get someone else to take over the “bad” assets.  Can the bankers find a “sucker” to acquire the “bad assets” at a price near book value and relieve the bank of the need to write down the value of the asset?  There are “suckers” out there, but the “suckers” then have the problem of having an overvalued asset on their balance sheet.  Of course, in some cases, the “sucker” turns out to be the government…or, should we say the “sucker” turns out to be the taxpayer. 

Third, the bank can write down the assets to a realistic value and get on with business. 

The first way is what bankers generally try to do.  Bankers are notorious for their optimism concerning the value of the assets on their balance sheets.  “We just need a little more time and everything will be fine.”  “The borrower just had some bad luck, but is getting things back in order.”  “The economy is improving and we just have to hold on until things get better.”  Of course, in the case of bonds on the balance sheet: “We plan to hold on to them until maturity.” 

In many cases, the old line applies: “People told to smile because things could be worse, so I smiled and sure enough things got worse.”

When the hole gets deeper the problem becomes more severe. 

I have successfully completed three bank turnarounds in my professional career and my general impression is that bankers tend to “look the other way” and postpone dealing with their problems, particularly when the problems pile up.  In many cases, the time runs out and the bank either has to be sold or taken over or has to be closed.

In terms of the second avenue, “suckers” are all around.  However, in the case of one bank “selling” a “bad asset” to another investor, the bank escapes the problem of dealing with an overvalued asset, but the “system” does not get rid of the overvalued asset.  It still has to be dealt with.  In the case of the government (Fannie Mae or Freddie Mac) buying the asset, or, as in the case of the FDIC closing a bank, or, in the case where the government “bails out” a company or an industry and sets up a company with the “bad assets, the government must absorb the difference between the accounting value of the asset and the market value of the asset.  The losses incurred in this way must be paid by the taxpayer over time. 

Admitting one made a mistake and writing down the value of assets is the only way for a bank to really get on with business.  This is a hard thing to do, but to recognize the problem early on and deal with the problem as soon as possible is the only way to allow the bank to get back to the business as usual.  If bankers take the first or second route mentioned above, they lose focus and their performance suffers. 

This is why I am such an advocate of banks marking their assets to market on a regular basis.  It forces them to address their problems as early as possible and after facing their problems head on, they can then turn their focus back to what they should be doing, making loans and building their customer base. 

Even in the case of the bankers buying long-term securities with short-term funds: bankers are doing this to increase the interest rate spread they earn.  They are intentionally taking on interest rate risk in order to improve their performance.  To me it is disingenuous for these bankers to act surprised and perplexed when interest rates rise and the market value of their long-term securities drop relative to their accounting value.

The problems bankers face related to overvalued assets can never really go away until the bankers fully embrace the situation and write down the value of their assets to realistic values.  The asset values must be written down to a level that, at least, eliminates the uncertainty about whether or not the bankers are fully recognizing the problem.

This is one of the freedoms of coming into a troubled situation to “turnaround” a bank.  The “turnaround” specialist can assume a “worst case” scenario and write down assets sufficiently to eliminate the uncertainty surrounding the value of the assets.  If the “turnaround” specialist does not do this, he or she is only creating further problems for themselves sometime down the road.  It is the only way to move on!

European banks still appear to be somewhere in the middle of these three paths to the future.  See, for example, the piece “Bankers Balk at EU push for Bigger Greek Losses” in Bloomberg this morning. (http://www.bloomberg.com/news/2011-10-16/bankers-balk-at-eu-push-for-bigger-greek-losses-higher-capital.html)

The problems faced by the European banks are huge.  The problems faced by European governments are huge.  The lack of fiscal discipline on the part of European governments for the past fifty years or so has caught up with both the governments and the banks that supported this deficiency.  Now, the governments and the banks find that they cannot continue to ignore the problem and hope for things to get better.  Furthermore, the governments and the banks cannot just push the problems off on the taxpayers.

Still they continue to hold out!

The only way the Europeans can resolve their current difficulties is to “bite the bullet” and accept the fact that several of the governments in Europe are insolvent and that the value of the sovereign debt issued by these governments must be written down to values that will eliminate the uncertainty pertaining to whether or not the governments are really accepting the severity of the problem. 

A difficulty inherent in this solution, however, is that the European Union may have to become more politically unified.  Letting the EU dissolve at this time is almost unthinkable and would end up, I believe, in an unconscionable banking catastrophe for the continent.  This may be the “unforeseen consequence” of the formation of the EU…that the crisis resulting from the way the union was initially set up may result in the nations of the EU forming a more unified political structure.  Imagine…

But, the financial problems will not go away as long as those running the governments of Europe continue to face up to the real issues and then deal with them.  The real issues relate to the fiscal irresponsibility of several of the European nations and the consequent insolvency that has resulted.  This insolvency is threatening the insolvency of the European banking system.

Unless this reality is accepted and acted upon, the crisis will just continue to play itself out. 

United States At Blame for Eurozone Problems?

Recommended read this morning, the op-ed piece by Kenneth Rogoff, “The Global Fallout of a Eurozone Collapse,” in the Financial Times. (http://www.ft.com/intl/cms/s/0/e66a3d7c-9073-11e0-9227-00144feab49a.html#axzz1OaJbLwdu)

“It is ironic that the euro…is suffering from having an overly strong exchange rate, particularly against the dollar, and at precisely the moment when a huge depreciation would be most helpful.”

“I think it would be more accurate to say that markets are more worried... about the US’s lack of a plan A than Europe’s lack of plan B.”

“Unfortunately…the euro is looking very much like a system that amplifies shocks rather than absorbs them.  The UK, which of course did not adopt the euro, has benefited from a sharp sustained depreciation of the pound.  The peripheral countries of Europe are meanwhile stuck with woefully weak competitive positions and no easy adjustment mechanism.  European leaders’ plans to achieve effective devaluation through major wage adjustment seem far-fetched.  The only clean rescue for Europe would be if growth far outstripped expectations.  Unfortunately, post-financial crisis growth is likely to continue to be hampered by huge debt burdens.”

The worst of all worlds for this crisis…stagflation.

And, the United States continues to pound away creating more and more credit inflation for itself and the world…both in terms of monetary and fiscal policies.  (See my post about the Fed’s feeding of world inflation: http://seekingalpha.com/article/273506-cash-assets-at-foreign-related-financial-institutions-in-the-u-s-approach-1t.) 

“The markets are more worried about the US’s lack of a plan A…”

To me the world is seeing the current leadership in Washington, D. C. as little different than any group of leaders in Washington, D. C. over the past fifty years.   For the past fifty years the government debt produced by the United States government has risen at a compound rate of growth of more than 8 percent per year.  Economic growth has averaged a little more than 3 per cent every year for this same 50-year period.  

This is “credit inflation.”

And, the value of the dollar?

In 1961, at the start of this binge, the value of the dollar was pegged to gold.  In August 1971, President Nixon floated the dollar.  With the open capital markets that arose in the 1960s, a country could not independently follow a policy of credit inflation and keep the value of its currency fixed. 

Since the dollar was floated, the general trend in the value of the dollar has been downward with three exceptions.  The first was in the Volcker years of the early 1980s; the second was when Rubin was Secretary of the Treasury in the late 1990s; and the third was in the world rush to quality during the financial crisis of 2008-2009. 

The leaders of the United States have not had a plan to halt the decline in the value of the dollar for the past fifty years.  And, the Obama Administration is no different from any of the other administrations that preceded it since 1961. 

United States government officials have stated their support for a “strong” dollar throughout this time and yet have done little or nothing to stem the decline.

Again, “watch the hips and not the lips!”

And, the longer-term trend in the value of the United States dollar is still downward.

However, in an interdependent world, actions have repercussions elsewhere.  And that is what Rogoff is calling our attention to.  The policy actions of the United States government impact others.  And, the blanket government policy of credit inflation followed by Republican and Democratic Presidents over the last 50 years has come to dominate the world. 

Not only is it exacerbating the sovereign debt problems of Europe, it is spreading inflation throughout the world as the US dollars pumped into the US banking system by the Federal Reserve flow almost seamlessly into commodity markets throughout the world. (Again, see my post from yesterday.)

The irresponsible creation of debt and more debt does come to a limit.  And, as one approaches the limit, the number of options available to the issuer of the debt shrink in number as the desirability of those options also lessen. (“Debt Ultimately Leaves You With No Good Options,” http://seekingalpha.com/article/271651-debt-ultimately-leaves-you-with-no-good-options.)

The United States is experiencing this difficulty as we speak.  There are “things” the government would like to get into but can’t because there is no fiscal room for anything more, and there are “things” the government must get out of but don’t want to because they are in political favor. 

In a world of excessive debt, there are no good choices…period!

Rogoff goes on to talk about whether or not the world will succeed in forming a co-reserve currency system.  This would happen as the benefits of the co-reserve currency system were observed which would result in a trend towards the consolidation of currencies throughout the world. 

The current period of stress, Rogoff argues, is a period of learning.  “Having a smaller number of currencies is a phenomenon that makes a lot of sense economically, economizing on transactions’ costs and leveraging economies of scale.  The real question is whether common currency is sustainable politically.  My guess is that if the current slow patch in global growth does not quickly subside, we will not have to wait long for an answer.”

The Dollar: America versus the World

I look at the following chart and ask whether or not there is some constant factor that stands behind the decline in the value of the dollar over the past fifty years.

Well, you say the chart only covers roughly forty years, why are you talking about fifty years?

You are right that the chart covers only the last forty years or so, but the consistency that runs from the early 1960s to the present began around fifty years ago.

The constant that runs throughout this time period is credit inflation. The foundation for this credit inflation was a “new” philosophy of the government’s program of fiscal policy, one that aimed at achieving high levels of employment. And, this new philosophy was essentially adopted by both the Republicans and Democrats in the United States government.

The consequences of this policy:

• The gross federal debt of the United States increased at a compound growth rate of about 8.0% per year for the last fifty years;

• Up until 2008, the Federal Reserve increased the monetary base at a compound rate of 6.2%;

• Total credit market debt in the United States increased at a compound rate of almost 10.0%.

• A dollar which could purchase $1.00 worth of goods and services in 1960 could only purchase $0.15 in 2011.

The credit inflation was started in the 1960s. It became such a problem that the United States floated its currency on August 15, 1971, and, with two exceptions, declined by about 35% against major currencies from early 1973 through March 2011. The two exceptions were the Volcker-led monetary tightening beginning in 1980 and the Rubin-led efforts to balance the federal budget around 1995.

One could argue that the credibility of the United States government for maintaining a stance of fiscal discipline, with these two exceptions, has been very, very low. And, that is the problem the United States finds itself in at the present: the behavior of the government, especially represented by Chairman Bernanke at the Federal Reserve, is seen as “just more of the same” economic policy that has been followed over the last fifty years. Consequently, the value of the dollar continues to decline.

In terms of the euro, Jean-Claude Trichet, the president of the European Central Bank, seems strong relative to Mr. Bernanke, and the value of the dollar continues to decline against the Euro. (http://seekingalpha.com/article/261863-the-euro-trichet-vs-bernanke)

It has been argued that Mr. Trichet and Mr. Bernanke have been working together during the recent financial crisis. That may be true, but coming out on this side of the crisis it looks to me like Mr. Trichet was the “craftier” of the two. Check out the chart below.

Beginning in September 2008 Mr. Bernanke began to inflate the Fed’s balance sheet. The total assets of the Fed jumped from about $0.9 trillion to $2.2 trillion. Mr. Trichet saw the total assets of the ECB increase, but the increase was far short of what the Federal Reserve did. (http://www.ft.com/cms/s/3/98ad43ec-5fac-11e0-a718-00144feab49a.html#axzz1IeD3XCmo)

Now the ECB may not have had as much to work with as the Fed, but in any case it looks as if Mr. Trichet got Mr. Bernanke to do most of the work for him through the crisis. (Check out the Fed’s recent release of borrower’s during the crisis and all the various comments that reflected on this release. There is some feeling that maybe Mr. Bernanke did not always act in the most disciplined way during this time period: http://seekingalpha.com/article/106186-the-bailout-plan-did-bernanke-panic.)

As a consequence, the current position of the ECB is much more conducive for Trichet to begin raising the Eurozone policy interest rate and, if needed, begin to focus more on the fact that inflation in the Eurozone is starting to become of concern once again.

The United States still faces the reality that, in terms of monetary and fiscal policy, there are no leaders who possess any credibility when it comes to budgetary discipline. This is the underlying constant of the past fifty years (with the two exceptions mentioned) and this is the basis for a continuing downward trend in the value of the United States dollar against other major currencies.

Paul Volcker has argued that the value of a nation’s currency is the most important price in its economy for policy purposes. It seems as if very few people agree with him. So, it seems as if the future will be more of what we got over the past fifty years. This is not what is needed for an economically strong America.

The Euro: Trichet versus Bernanke

How important is reputation in monetary circles?

I believe that the general movement in the value of the Euro relative to the United States dollar over the past seven months or so gives a picture of how the reputation of a central banker, when compared with his peers, can be reflected in financial markets.

The particular comparison here is between Jean-Claude Trichet, president of the European Central Bank (ECB), and Ben Bernanke, chairman of the Board of Governors of the Federal Reserve System. The winner has been Trichet; the loser Bernanke.

In general, the “bad” news has been coming out of Europe, the fiscal problems in Ireland, Greece, Portugal, Spain, and, if we want to get even more picky, Italy and France. The fiscal crisis really began to heat up at the beginning of 2010. The “crisis” caused another “flight to quality” in foreign exchange markets, that is a movement into the United States dollar and this is shown in the accompanying chart. The U.S./Euro Foreign Exchange Rate dropped early in 2010 and bottomed out in June as the European Union seemed to be getting its act in order.

Notice that the value of the Euro really begins to rise again in early September. This marks the time just after Chairman Bernanke announced to the world that the Federal Reserve was going to enter into another round of Quantitative Easing, now fondly referred to as QE2. (http://seekingalpha.com/article/222704-bernanke-in-the-hole)

The rise in the value of the Euro against the dollar was almost 12 percent throughout the fall.

Still the Europeans dawdled and the dollar strengthened again as money left Europe for “quality” assets.

Trichet took care of this after the March rate-setting meeting of the ECB. At that time he sent out strong signals that the ECB should raise its target interest rate at the April meeting.

So, after a decline of something less than 8 percent following the peak value reached in early December, the Euro has climbed another 9 percent or so, even in the face of continued concerns about the health of the banks in these countries and the revelations about the fiscal condition of some of the governments trying to get their budgets back in order. These concerns were accompanied by several downgrades of some sovereign European debt.

“As traders continued to bet the European Central Bank would pull the trigger on the first of several interest-rate increases on Thursday, the euro hit five-month highs against the dollar,” (http://professional.wsj.com/article/SB10001424052748703806304576242362812362214.html?mod=ITP_moneyandinvesting_3&mg=reno-wsj).

Thursday is the meeting of the ECB. The bets are obviously on the ECB raising its target interest rate.

Trichet has a credibility that Bernanke does not have. Trichet is standing up for some kind of monetary constraint. Bernanke keeps throwing spaghetti against the wall.

Trichet has moved ahead of events. Bernanke has always missed the turn of events and lagged sadly behind resulting in the need to over-react to situations.

But, this reflects the whole position in the United States. There is no one around that seems to have any credibility for establishing any financial or monetary discipline in the United States government. Why should anyone want to bet on the United States government establishing some kind of responsible budgeting when projections are for the government debt to increase by as much as $15 trillion over the next ten years? And, why should anyone want to bet on the Federal Reserve system controlling inflation during this time period when the leader of the central bank has injected $1.5 trillion dollars of excess reserves in the banking system and is always “late to the dance”?

The market is taking Trichet at his word. The market is also trusting his determination.

The United States? Maybe Paul Ryan, chairman of the budget committee of the United States House of Representatives, can build up some reputation in financial markets that someone in America is going to draw a “line in the sand.” Right now the financial markets are not betting on his success.

So for now, Trichet…and the Euro…seem to win.

Is This Europe's Month of Reckoning?

Interest rate spreads on European sovereign debt jumped to new levels yesterday. On 10-year bonds, Greek debt rose to 942 basis points over German bonds of the same maturity. Portugal rose to 436 basis points over the German yields and Spain jumped back up to over 200 basis points.

Is something on the horizon?

A lot it seems. See my earlier post, “Meanwhile Back In Europe” (http://seekingalpha.com/article/256255-meanwhile-back-in-europe-a-view-of-the-ecb-inflation-and-other-matters).

The new round of stress tests began on European banks last weekend. And,ever since they started the tests the bank regulators have had to defend themselves, to defend that the tests WERE NOT too soft!

Not a very good beginning to the upcoming events, is it?

How much confidence are we going to have in the results if the regulators are not even “out of the gate” and their methodology is being questioned? It’s just like the United States government saying it believes in a “strong dollar”.

Then again, how good can the tests be if the banks are changing how they do business right in front of the efforts of the regulators to re-regulate them? All sorts of things are going on, in Europe (http://www.ft.com/cms/s/0/da2622e4-4a8a-11e0-82ab-00144feab49a.html#axzz1GCsIX7ra and http://professional.wsj.com/article/SB10001424052748704629104576190732643514492.html?mod=ITP_moneyandinvesting_0&mg=reno-wsj) as well as in the United States, and the regulators still seem to be creating an environment to avoid another 2008 crisis.

Oh, well, what else do regulators have to do to keep themselves busy?

And, the politicians still are on the lookout for “speculators”, those dastardly villains that create havoc for nations that don’t seem to have sufficient discipline to manage their fiscal affairs prudently. There are still a substantial number of member states in the European Union that want to ban the use of “uncovered” credit default swaps on sovereign debt. (See http://www.ft.com/cms/s/0/15e871a0-4aaf-11e0-82ab-00144feab49a.html#axzz1GCsIX7ra.)
This will stop the speculators!

Most of the distressed European nations that have experienced problems in the bond markets continue to deny responsibility for creating these sovereign debt problems. And, with unrest continuing or even increasing in these countries, governments face substantial internal pressure to place the blame for their problems “out there”, out where the shady “speculators” gather.

These “shady” speculators have taken the place of those “shadowy” international banks that inhabited the 1980s and caused sovereign nations, like France and Mitterrand for example, such incredible trouble.

Readers of my posts know what I feel about people who claim that their problems are “out there”!

One example of such unrest is that which is taking place in Greece. Adding to this is the fact that the unemployment rate in Greece recently hit a historic high.

In the face of all that is going on Portugal was able to issue new two-year debt on Wednesday, albeit at very expensive rates. Wednesday’s offering was for €1, which means that Portugal has raised almost €7 this year; approximately 35% of the year’s total funding need.

But, even this successful offering does not seem to ease the general concern in international financial markets that the overall political solutions to the problems being faced in the Eurozone are going to be resolved. In addition to the increased spreads in the bond markets, the Euro has fallen off in the last couple of days as the traders have worried that the leaders of the European Union will “pass” on reaching strong enough solutions to stem the lingering crisis.

There are still a lot of “unresolved” issues in the world and the existence of these issues points up the difficulties that people, states, and nations have created for themselves.

In my estimation it has taken Europe (and the United States) fifty years to get into the position it now finds itself. Europe (and the United States) has dug a big hole for itself. In many cases, people, states, and nations have not stopped digging the hole deeper!

In some cases, efforts have been made to stop the digging…and in one, possibly two, cases there have even been efforts to start filling the hole up.

No one seems to be really stepping up to really address the bigger problems…the leaders are nowhere in sight.

The international financial markets are indicating a lack of confidence in what is going on. The “stress” tests are too soft. Nations are still looking backwards to develop regulations. And, the leaders of the European Union are not going to come up with anything effective in their deliberations that begin again this Friday.

Kenneth Rogoff, who co-authored the book “This Time is Different," has recently stated that Greece and Ireland will need to restructure their debts. He also suggested that Spain and Portugal may be forced to do the same thing.

A debt restructure may be the only way to really make something happen. Historically, this is often the only way to get things changed when there is a total void of leadership!