What is Causing the Worldwide Government Debt Crisis?

Mohamed El-Erian, the Chief Executive Officer of PIMCO, writes this morning that “It is now commonly accepted that Greece’s predicament is due to two inter-related problems: the economy is unable to grow, and the debt burden is enormous. (http://blogs.ft.com/the-a-list/2011/06/17/only-a-totally-new-greek-approach-can-save-europe-now/)

Yet, El-Erian states, neither of these issues are being addressed in the discussions going on concerning the resolution of the debt crisis in Greece.

The reasons for this are complicated although they very often boil down to the priority to handle short-run problems immediately and postpone the long-run problems to another day.  Of course, the famous quote of John Maynard Keynes comes to mind: “In the long-run we are all dead!”

A good listing of the complicated entanglement of the politics of the Eurozone is present in the Wall Street Journal article “Europe’s Greek Stress Test” by John Cochrane and Anil Kashyap. (http://professional.wsj.com/article/SB10001424052702304186404576389542793496526.html?mod=ITP_opinion_0&mg=reno-wsj) The authors list four key facts:

“First, the Greek government has borrowed more than it can plausibly afford to pay and certainly more than it will choose to pay. It now owes more than one and a half years' economic output.”

“Second, European banks are holding the bag.”

“Third, the European Central Bank (ECB) is now involved as well.

“Fourth, in the end this is all about Ireland, Portugal, Spain and Italy.”

In other words, by ignoring the basic underlying causes of the problem, the sickness has spread and now envelopes nor only Europe…but the world.

In other words, the old economic paradigm is dead, and the political leaders of the western world have only made things worse by trying to keep the old paradigm alive. 

As a consequence, the options available to these leaders are shrinking and those options that are left are becoming less and less desirable.

And, even if the bailouts continue and postpone the resolution of the crisis until another day, the two basic issues mentioned by El-Erian are not being addressed.  These are the issues pertaining to the reasons for slow economic growth and the reduction of the massive debt levels that are outstanding. 

The solution…increase economic growth and lower debt levels.

The problem…over the past fifty years or so the political leaders of most western nations worked with an economic paradigm that resulted in an increase in debt levels to increase economic growth.  That is, credit inflation, whether in the economy as a whole, or in a particular sector like housing, would buy politicians additional votes by keeping economic growth high and unemployment low. 

“The solution” reverses almost 100 years of the economic and political thought of western intellectuals.  It also contradicts the perception of many voters in western countries. 

Keeping a lid on debt exposure is an old-fashioned idea and one that collides with the modern day concept of what governments should do and of the excesses of the consumer society. 

An emphasis on education and training also is an old-fashioned idea although it was the basis of economic productivity and inventions in the nineteenth and early twentieth centuries in the United States.  And, this particular emphasis is one that collides with the modern-day approach to “certification” and the building up of “self-esteem” where everyone passes or everyone gets A’s.

The current sovereign debt crisis is not going to go away with “doing more of the same.”   Yet, changing the economic paradigm is going to be difficult.  We see this on the streets of Greece…and Spain…and Vancouver…oops, sorry…

The focus is on Greece right now and rightfully so.  But, the lessons need to be learned by others…but this will not make it any easier.  Long-run solutions are never “easy”.

There was an interesting article in the Saturday Wall Street Journal titled, “What Kind of Game is China Playing?” (http://professional.wsj.com/article/SB10001424052702304259304576374013537436924.html?mod=ITP_review_0&mg=reno-wsj) The answer is that American leaders need to learn how to play the game of “Go”, an ancient Chinese board game.  The game of “Go”, “emphasizes long-term planning over quick tactical advantage, and games can take hours. In Chinese, its name, wei qi (roughly pronounced "way-chee"), means the "encirclement game."

The economic paradigm of the past fifty years emphasizes “tactical advantage”, the short-run.  Why this approach became so popular was that the political leaders of the western world saw it as the means of gaining their goals…getting elected and then getting re-elected.

What El-Erian and others are arguing for is more emphasis by these political leaders on the “strategic” and not the “tactical.”  The “strategic” aims to achieve “sustainable” results.  The “tactical” way of dealing with a problem always contains the caveat that the other problems will be dealt with when they become the major issue.

Well, the other problems have now become the major issue.

And, this is the lesson for the countries included within the definition of the western world. 

Politicians are going to have to learn how to think “strategically.”  The question is, “Can politicians be allowed to think strategically in a democracy in which winning the next election is the most important thing on their agenda?”

Greece, in my mind, is going to have to restructure its debt in one way or another.  So is Ireland…and so is Portugal…and so in Spain…and so on and so on.  How many more countries will find themselves facing a restructuring of their debt is, of course, unknown. 

It is painful when you find out you have been working with a model that is not correct.  Creating more spending and more debt is not the solution to every problem.  Yet, we have lived by this model for a long time.  And, now the bill seems to be coming due.

To me, this is what is causing the worldwide government debt crisis. 

Bring on the Debt Restructuring in Europe

Did you hear the latest one…94% of college professors in the United States believe that they are better teachers than the average college professor! Furthermore, the vast majority of college professors also believe that they are better researchers than the average college professor!

I just thought of this when a quote in the Financial Times this morning. The columnist Gideon Rachman writes of the European leaders: “European leaders do not know whether to be more frightened of the bond markets or of their own voters.” (http://www.ft.com/cms/s/0/38e83edc-4e70-11e0-98eb-00144feab49a.html#axzz1GaG5raM7)

In the first case, the European nations do not seem to be able to create any workable plan to bail out the sovereign nations whose debt is under attack by those nasty “speculators” in the bond markets. In the second case, more and more elected officials, like German chancellor Angela Merkel, French president Nicolas Sarkozy, and others, are under pressure from the voters in their countries to adopt “much harder-line policies on everything from immigration to European spending.”

There is a real possibility that Europe could move much more to the right, politically, than has been the case for a long time. Two countries provide vivid examples of this possibility: the Netherlands and England.

The reason I included the little bit of humor in the first paragraph above is that I needed an example of the fact that not everyone can be above average (except in Lake Wobegon). To be honest, there are a lot of horrible college teachers. And, there are a lot of horrible (peer reviewed) research papers written by college professors.

And, not every country (or business or individual) in the world can “pump up” its economy through fiscal deficits and create more and more and more debt.

Someone has to buy the debt and countries and businesses and individuals will not always be available to run fiscal surpluses so as to acquire this debt for their portfolios.

I know this sounds like heresy, but there ultimately comes a day of reckoning for those that issue excessive amounts of debt. I know that the meaning of the term “excessive” is in the eye of the beholder, but, how the financial markets decide what is “excessive” can be cumulative.

That is why we talk of a “debt deflation” and a “credit inflation.” In periods of “credit inflation” the taking on of risk accelerates during the buildup and leverage increases. In a “debt deflation” people cumulatively reduce their exposure to risk and they also de-leverage at such times.

We cannot “average” the amount of debt across nations and say that all these nations just have an average amount of debt outstanding: if we average the amount of sovereign debt in Greece and in Ireland with the sovereign debt of Germany and the Netherlands we cannot say that these countries combined will then have the “average” amount of debt outstanding.

Rachman provides the example of the current Franco-German relationship: “A senior EU official in Brussels says that this is not the old Franco-German relationship that was built on a basis of equality: ‘Germany needs France to disguise how strong it is. And France needs Germany to disguise how weak it is.’”

But, the people of Germany do not seem to be buying this and Ms. Merkel is in trouble. Because of this she has been taking stronger and stronger positions in the negotiations within the European Union. And, Sarkozy seems to be trailing the far right candidate in the buildup for next year’s presidential election and has, therefore, been more of a supporter of Ms. Merkel.

Within such an environment it seems almost impossible that a unified political settlement could be reached that would ultimately satisfy the bond markets in terms of a bail out financing package for EU countries. This would take a political union that I just don’t see happening in the present state of the world.

Some of the weak, like Ireland and Greece, do not appear to be willing to submit to the strong, Germany, in the ways the strong believes the weak must act. Thus, the bond markets will not be satisfied.

But, there seems to be a section of the voting public that are saying that they should not be paying for the undisciplined way others have acted in the past. This body of voters appears to be gaining ground as the coherence of their message grows and the confidence in their ability to succeed expands.

As I said yesterday, there seems to be only one path out of this dilemma: the sovereign debt of the fiscally troubled nations must be restructured. (See http://seekingalpha.com/article/258172-are-there-any-leaders-in-europe.)

Bring it on!

Meanwhile Back in Europe

Europe has been relatively quiet recently, except for occasional bursts of news coming from or about German Chancellor Angela Merkel. The euro has been relatively strong: it has risen a little over 7% against the U. S. Dollar since the beginning of the year. Relative interest rate spreads on sovereign debt in the eurozone have remained relatively steady.

However, there still remains a lot of work to do in Europe and with all the disagreements among the leaders as well as everything else happening in the world the bailouts and other financial relationships are just not getting done. Let’s just say one shouldn’t get too comfortable in this quiet.

Something concrete for the near term: the European banks are starting their second round of stress tests this weekend. This second round is supposed to be “sufficiently stringent” this time.
We’ll see! They sure weren’t very “stringent” the first time around.

The question is whether or not confidence in the European banking and financial system can be returned so that other matters can be dealt with.

Beyond that, meetings will continue among the leaders of the European nations. Whether or not they can craft a bailout plan is still up in the air. In addition, the process for how the nations are to conduct their fiscal affairs also needs to be decided upon. Problems will still linger until they achieve some more coordination in budget-setting…hard for sovereign nations to give up.

But, speaking of sovereign nations, the problem of sovereign debt still overhangs the financial
markets.

Kenneth Rogoff, who co-authored the book “This Time is Different”, stated in Berlin yesterday that Greece and Ireland will need to restructure their debts. (See http://www.bloomberg.com/news/2011-03-02/rogoff-says-debt-restructuring-inevitable-in-greece-ireland.html.)

Rogoff also added that Spain and Portugal may be forced to do the same thing.

Bondholders, he argued, may have to take losses as large as 40 percent of their holdings of this sovereign debt.

“If Spain were to have a restructuring of central government debt, I don’t think it would end there” said Rogoff, “Spain is just too big.” Other countries facing a restructuring might then include Belgium and more.

But, this is not all!

Europe is facing more inflation. For one, the United Nations announced that world food prices rose to a record level in February and may exceed this level over the next few months. Furthermore, the turmoil in the Middle East is not easing price pressures as the pressure on oil prices increases.

The new element in this latter situation is that Asian countries like China and India now have the wherewithal to hedge against the unrest in the Middle East by shoring up their oil reserves. Even as these oil importing countries add to world demand as their economies grow they also have the financial resources to stockpile reserves in a way that presents a new dynamic to global markets.

And, the money is there for this process to continue worldwide: “What can best be described as ‘the unintended consequences of quantitative easing’ (on the part of the Federal Reserve in the United States) have played a major role. With many emerging nations addicted to their dollar currency pegs, easy US monetary policy finds its way into every nook and cranny of the global economy.” This written by Stephen King, group chief economist at HSBC in “Central Banks Risk Wrecking Recovery” (http://www.ft.com/cms/s/0/cab418ce-44c3-11e0-a8c6-00144feab49a.html#axzz1FMM69iWr).

These “unintended consequences” will continue to plague commodity markets worldwide. Nations and investors have the dollars or the access to dollars to keep these prices rising and this access will not go away soon.

So what about an increase in interest rates?

Well, for the twenty-second month the European Central Bank (ECB) held its main interest rate steady at 1%. Jean-Claude Trichet, ECB president, stated that inflation was a worry and although the rate was held at the current level for the time being, it certainly could rise in April.

Inflation in the eurozone was 2.4% in February, above the target limit of the ECB which is 2.0%.

Rising interest rates can only put more pressure on the governments in Europe, just as rising inflation rates can increase calls from Germany for greater government discipline in fiscal affairs.

“Back in Europe” things are still unsettled. As to the undercurrents going on above look out for the following:

First, the bank stress tests will show little or nothing and will give financial markets very little additional confidence in the European banking system;

Second, no agreements will be reached within the European Union until some of the nations within the EU restructure their debt and the pain of the fiscal situation will then become very obvious;

Third, this restructuring of debt and the continued increase in inflation will put Merkel and Germany in an even stronger position to get a more conservative process of fiscal oversight included in any package that the EU agrees upon;

Fourth, the ECB will hold off an increase in its main interest rate for as long as it can so that a rise in the rate will not serve as a cause of the debt restructuring and will allow the leaders in the EU to craft a new relationship in as orderly fashion as possible.

Inflation will continue to rise in Europe and in the rest of the world and this will put central banks under greater and greater pressure to begin to combat the inflation. Politically, this is still going to be very hard because of the mediocre economic recovery now taking place and the political unrest being caused by governmental restructurings. But, that is another story.

The World Debt Crisis Lingers

The Federal Reserve, the European Central Bank, the Bank of England, and others, are all desperate to keep interest rates from rising. The debt overhang in the developed world is humongous and any substantial rise in interest rates would just exacerbate the financial crisis that hangs over Europe and America.

We observe the debt crisis all around us. Gretchen Morgenson writes in the Sunday New York Times about the need of commercial banks to write off billions of dollars of mortgage loans sold to Fannie Mae and Freddie Mac. The article is “$2.6 Billion to Cover Bad Loans: It’s a Start,” (http://www.nytimes.com/2011/01/09/business/09gret.html?_r=1&ref=fairgame). She writes, “Analysts in JPMorgan Chase’s own research unit published a report last fall stating that possible mortgage repurchase liabilities for the overall banking industry ranged from a best case of $20 bill to a worst case of $90 billion.”

The Financial Times reports that “US Regional Banks Set for Consolidation,” (http://www.ft.com/cms/s/0/2388dd24-1c27-11e0-9b56-00144feab49a.html#axzz1AjUYZy6X). The gist of this article is that commercial banks have about $1,500 billion in commercial real estate loans coming due over the next four years. People have been watching these loans for about 18 months now, but they have been kept “evergreen” as bank lenders have continually renewed these loans to keep them on the books till “something good happens.” The article list 15 regional banks that have loan portfolios consisting of, at least 38% of their loans in commercial real estate loans. Seven of these banks have more than 50% of their loans in commercial real estate. The smallest of these banks is $4.2 billion in asset size.

Many corporations in the United States and Europe still have massive debt loads that continue to increase. Several times a week there is more news about corporations facing bankruptcy. Yesterday, Sbarro announced that it was hiring bankruptcy lawyers (http://professional.wsj.com/article/SB10001424052748704458204576074214100579944.html?mod=ITP_marketplace_0&mg=reno-wsj). Last week, the Philadelphia company Tastykake indicated that it was looking for someone to buy it because of the debt problems it was having.

Another article in the New York Times on Sunday reported on “The Crisis That Isn’t Going Away,” (http://www.nytimes.com/2011/01/08/business/global/08euro.html?scp=1&sq=the%20crisis%20that%20isn't%20going%20away&st=cse). This article was about a report produced by Willem Buiter, Chief Economist at Citigroup, who claims that debt restructuring in Greece, Ireland, and Spain is inevitable: “All bank and sovereign debt is now at risk…” European debt levels, he argues, are unsustainable.

This argument is re-enforced by the information contained in another article in the Financial Times, “Europe’s Woes Put Debt Restructuring Back on the Agenda,” (http://www.ft.com/cms/s/0/c25cc3e6-1cec-11e0-8c86-00144feab49a.html#axzz1AjUYZy6X).

Not only is the sovereign debt of Portugal currently under attack but Belgian bonds came under attack yesterday.

The debt estimates for 2013 are downright scary: Greece is expected to have its debt at 144% of GDP in 2013; Italy at 120%; Belgium at 106%; Ireland at 105%; Portugal at 92%; France at 90%; the UK at 86%; and Spain at 79%.

And, what about European banks? Check out the article “Fears Mount Over European Debt, Banks,” (http://www.ft.com/cms/s/0/c25cc3e6-1cec-11e0-8c86-00144feab49a.html#axzz1AjUYZy6X). European banks are expected to go through a new “stress” test this year, one that will be much tougher than the “joke” that was administered last year. There is great concern about how these European banks will fare in the new test.

And what about government debt in America? New governors are taking a tough stance on the budgets for the upcoming year. Jerry Brown is seeking $12.5 billion in spending cuts for the upcoming California budget. And, Andrew Cuomo in New York is asking for salary cuts of 10% and is seeking even more cuts elsewhere. The governor of Illinois is (seriously) hoping that the lame-duck legislature will pass a substantial tax increase on corporations before they leave. Still many states are in dire straits, hoping to avoid bankruptcy. And, there are dozens of municipal governments on the edge of declaring bankruptcy.

Oh, and what about the federal government: Have you seen the projections for interest expense going forward given the deficits that are expected in the future?

Now, what if long term interest rates were to rise by another 100 basis points? 150% basis points?

Just how much longer can the central bankers of the world keep long term interest rates below where the market believe they should be?

Research indicates that central bank actions can keep long term interest rates lower than market conditions warrant for a short period of time. However, to maintain the rates at below market levels, central banks must inject increasing amounts of money.

QE2 was announced as a policy decision to get the economy growing faster so that the unemployment rate would be brought down.

Yet, now we see what a farce the Fed has been playing on us. Chairman Bernanke, himself, just told Congress that the unemployment rate was not going to improve much at all, even if the economy picks up speed, and that it would take five to six years for the unemployment rate to even show much of a decline.

So, one can conclude from this that QE2 is not really aimed at getting the unemployment rate down.

I have argued for a long time that the reason the Fed was providing the financial markets with so much liquidity was because of all the insolvent banks “out there”. The Fed was helping to keep banks “open” so that the FDIC could close all the banks that needed closing in an orderly fashion.

I believe that investors are coming to realize that the Fed is not trying to keep rates down in order to spur on the economy. To me, this realization contributed to the fact that the yield on 10-year Treasury securities rose by about 100 basis points after the Fed laid out its plans for QE2. The financial markets just rebounded to levels that more closely approximated where the market should be if the Fed were not “messing” with it.

Bottom line: the debt problem is still real. There is a lot of debt “out there” and the value of this debt is not really the economic value of the debt. The central banks of the world are just trying to keep long term interest rates low in order to push off the day when the debt will have to be written down to a more realistic value. The problem is that more and more attention is being paid to the fact that this debt needs to be written down. And, until this write-down takes place, we cannot really recover, economically.

Known Unknowns: Debt Refinancings in 2011

When does a financial institution write down an asset?

To those in the banking industry the answer has always been, “Not until I am not responsible for that portfolio anymore.”

My experience with lenders is that when making a loan they tend to be pessimistic and, in addition, require collateral. Unless, of course, they are securitizing the asset created and selling it off.

However, when overseeing a loan portfolio, lenders tend to be very optimistic. “Well, the borrower is just experiencing a slight setback, but things will get better.” “The economy is going to improve soon and then the loan will be alright.” “Yes, the borrower made a mistake, but he has learned from the mistake and is getting his act in order.”

Lenders (bankers) are reluctant to write down anything if they don’t have to. And, this applies to all aspects of their asset portfolios.

But, a big cloud is hanging over the financial industry going into 2011 in the United States, and also in Europe. The big cloud relates to number of bank assets that will need to be refinanced during the year. These numbers are staggering.

My guess is that this is one of the major reasons why commercial banks are not lending now. (See “Little or No Life in the Banking Sector,” http://seekingalpha.com/article/241507-little-or-no-life-in-the-banking-sector.) Banks do not want to write off any more assets now and are reluctant to add any more funds than they have to in order to build up their loan loss reserves. They add to these reserves as little as possible, as little as the regulators will let them get away with, so that they can build up their equity capital positions. If they then let the loans that are maturing run off without replacing them, their capital positions improve. The debt/equity ratio can fall as debt can be reduced while capital is being increased.

Making new loans does not fit into this strategy because the new loans will have to be financed and that will tend to raise the debt/equity ratio. So commercial banks are not lending now.

So what is this cloud and why is it so scary?

There are two specific areas that are being highlighted these days that stand out as potential problems for the banks: the first is the commercial real estate sector; and the second is governments, local, state, and nation.

In all cases a lot of loans or securities are going to mature in 2011 and the bet is that a large number of these assets that are found on bank balance sheets will either not be sufficiently credit worthy to be able to refinance or will not be able to handle the interest rates they will have to pay on the new debt to be issued..

In November 2010, commercial real estate loans made up almost 40 percent of the loan portfolios of the banks not among the largest 25 commercial banks in the United States and over 25 percent of their total assets. If these “smaller” banks had to write down 10 percent of their commercial real estate loans that would amount to about 3 percent of their assets: a substantial blow to their capital positions.

The problem is not so great in the largest 25 banks in the country as commercial real estate loans make up only 14 percent of their loan portfolios and about 8 percent of total assets.
This situation is the one pointed to by Elizabeth Warren in congressional testimony when she stated that 3,000 commercial banks, primarily the smaller ones, faced substantial problems ahead in this part of their loan portfolio.

The other problem mentioned has to do with government securities. More and more concern is being expressed about the condition of the finances of state and city governments in the United States. Layoffs are taking place all over the place, with many of the layoffs threatening health and safety. Yet, there is still substantial concern that the unfunded commitments of these state and city governments embedded in their pension funds have not really fully been addressed.
They may have to be addressed in 2011.

And so we get articles like “Bankrupt City, USA” (http://www.ft.com/cms/s/3/07eabcdc-06c8-11e0-86d6-00144feabdc0.html#axzz185wrM18g) which carry statements like this, “A Congressional Budget Office report reaches a conclusion to terrify investors in America’s $2.8 trillion municipal bond market. Municipal bankruptcy, permitted in 26 states, should be considered by city leaders to restructure labor contracts and debts.”

And the yields on municipal securities are the highest they have been in over a year. (http://online.wsj.com/article/SB10001424052748704681804576018022360684088.html?mod=ITP_moneyandinvesting_0) The situation related to state-issued securities is not too different.

The smaller banks, as defined above, have around 25 percent of their securities portfolio in state and local political issues. This makes up about 5 percent of the total assets of these banks. Again, a write down in this area could cause substantial damage to bank capital positions.
But, this problem relating to government debt is not constrained to United States banks. “Eurozone countries will have to refinance more debt next year than at any time since the launch of the euro amid investors’ warnings that the debt crisis in the region will intensify in the new year….Eurozone nations will have to refinance or repay €560 billion ($740 billion) in 2011, €45 billion more than 2010 and the highest amount since the launch of the single currency in January 1999.” (http://www.ft.com/cms/s/0/f9d781f6-0619-11e0-976b-00144feabdc0.html#axzz1860QqksJ) Much of this debt is held by banks.

What would you do if you were running a bank and were facing the possibility that a substantial portion of your portfolio would have to refinance in 2011? Oh, by-the-way, you also have foreclosures and business bankruptcies running at a relatively high rate as well.

You probably would stop lending, try to shrink you balance sheet as much as you could without damaging profitability and build up as much capital as you could before the time of refinancing arrived.

The question that we don’t have an answer for at the moment relates to whether or not the bankers, themselves, have a good handle on which assets will present the biggest refinancing problems and just how much will have to be written off due to these refinancings. Are they still just “hoping for the best.”

In addition, a rising interest rate environment would be one of the worst scenarios possible given all the refinancings that are going to have to take place.

Happy New Year!

One-Way Bets for Traders

Government interventions are taking place all over the world from the Federal Reserve’s quantitative easing program to the efforts to prevent debt write-downs in Europe to South Korea’s currency intervention.

Will governments ever learn?

Wise advice: “Today’s eager interventionists should take note. Far more than they realize, they are setting up one-way bets for traders.”

The reason: sooner or later, markets “revert to the mean”: markets ultimately adjust to their underlying economic value.

“Hedge funds know that South Korea’s won is being artificially held down by the government and is therefore more likely to rise than to depreciate, so they are hosing Seoul with capital and compounding the problem of hot inflows that Korea is desperate to alleviate.”

Both of these quotes come from “Currency Warriors Should Consider India” by Sebastian Mallaby in the Financial Times. (See http://www.ft.com/cms/s/0/0f26703c-f105-11df-bb17-00144feab49a.html#axzz15Rw49cE9)

In other words, international investors, like hedge funds, are pouncing on the opportunities governments set up for them.

The won situation is just the reverse side of the classic George Soros “bet” against the British Pound in 1992. The British government tried to keep the value of the pound above an agreed lower limit in agreement with the policies of the European Exchange Rate Mechanism. “Black Wednesday” refers to the events of September 16, 1992 when the value of the pound was allowed to drop toward its underlying economic value. Soros, who had been selling the pound short is reported to have made over one billion dollars on this effort of the government to intervene in the market. The government set up a “one-way bet” for traders.

But, this is happening all over. Karim Abdel-Motaal and Bart Turtelboom, portfolio managers at GLG Partners, write this morning: “…emerging markets are being flooded with freshly minted dollars. No matter how much sand is thrown in the wheel in the form of intervention, transaction taxes or capital controls, these capital inflows will get through.” (See http://www.ft.com/cms/s/0/81dd24ea-f0c9-11df-8cc5-00144feab49a.html#axzz15S17R06s)

Preparations to take advantage of these “one-way bets” are not limited to one part of the world. “Asia’s financial firms are on the prowl—for deals as well as for new investors. Even as they continue to strengthen their capital base through stock offerings, Asian banks, insurers and other financial firms are converting the floods of capital in the region into firepower for acquisitions.” (See http://professional.wsj.com/article/SB10001424052748703670004575616162768312620.html?mod=ITP_moneyandinvesting_2&mg=reno-wsj)

Financial capital is being built up around the world to take advantage of the incentives that exist within the current environment. And, governments are creating some of the most attractive incentives going!

With these huge amounts of capital available, governments can only maintain their interventions for a limited amount of time. Eventually, the markets win!

In trying to overcome the market, the “one-way bets” are created that make certain traders enormously wealthy, as in the case of George Soros. That is, these governments are underwriting Wall Street and not Main Street, just what they say they don’t want to do!

This seems to be what is happening to the debt markets in Europe. Earlier this year the European Union pulled together to avoid a collapse of the debt markets and save the Euro. It has become apparent that these efforts just provided a temporary escape from the underlying economic realities alive in Europe.

Europe, once again, seems to be approaching the edge of the abyss. Now, participants in the financial markets are calling for a debt re-structuring in many nations and not just a financial “safety net” to help support existing debt levels. Investors seem to be insisting that Ireland, Portugal, Spain, Greece, Italy, and even, possibly France, write down their debt and begin anew.

The earlier efforts did not produce the result desired. The earlier efforts did not achieve the path to the real underlying economic realities that exist.

Speaking of debt, let’s shift to the debt situation in the United States. I was taught that the Federal Reserve could only really control short-term interest rates because they had short-term maturities. The Fed could impact longer-term interest rates but only for a limited amount of time because these investments provided cash flows for a longer period of time than the Fed could dominate the markets. Thus, longer-term interest rates could be held below real economic values for the short-run, but the “bets” of the financial markets would come to dominate over time and the longer-term interest rates would either rise back to the levels market conditions warranted or could even rise above levels the market was once happy with because inflationary expectations would overcome and offset the efforts of the central bank to hold down long-term interest rates.

In other words, in attempting to artificially keep long-term interest rates low, the Fed will be creating a “one-way bet” that market participants can take advantage of and make lots and lots of money.

This is a “reversion to the mean” argument and is the basis for “Value Investing.” Over the longer run, markets adjust to economic realities. The risk associated with this conclusion is connected to the length of time it takes for the market adjustment to take place. This is the problem that Long Term Capital Management ran into. The “reversion to the mean” did not occur soon enough.

Eventually, the long-run is achieved and many investors make a lot of money!

Large amounts of cash have been accumulated to take advantage of these “one-way bets.” If it is observed that governments have set up “one-way bets” and will set up even more “one-way bets” in the future, capital will rush to take advantage of the free gift of the governments. The more the government’s attempt to maintain this intervention, the more money there is to make.

The underlying question concerns how much the government is willing to pay to maintain its intervention. In the Soros case described above, it has been revealed that the British government expended £3.3 billion in its attempt to keep the value of the pound above the lower limits. These are 1992 values and not 2010 values.

Who knows how much governments in Europe and the United States have spent in order to try and maintain their interventionists policies. The basic guess is in the trillions.

And how much have investors made taking advantage of these interventions? The Fed has kept its Federal Funds target close to zero for two years. This policy has put trillions of dollars into the hands of the already wealthy. So much for a more equal distribution of wealth in the world!

Governments never seem to learn.

Europe and the Solvency Issue

More and more people are becoming aware of the fact that the problem in Europe is one of solvency and not liquidity! Yesterday, the European Central Bank warned “that euro-zone banks face a €195 billion in write-downs this year and next due to an economic outlook that remained ’clouded by uncertainty.’” (See http://online.wsj.com/article/SB20001424052748703406604575278620471963334.html#mod=todays_us_money_and_investing.) This is equivalent to slightly more than $239 billion.

Not only that but it is estimated that these banks will need to refinance roughly €800 by the end of 2010. (See http://www.nytimes.com/2010/06/01/business/global/01ecb.html?ref=business.) This is equivalent to about $984 billion or roughly $1.0 trillion.

More and more people are beginning to realize that countries within the European Union are going to have to restructure loans and this will mean that many euro-zone banks are going to have to write down many of the assets they have on their balance sheets. Hence, we face the problem of the solvency of the banking system.

Why has it taken so long for these people to realize that the problem is a solvency problem?

The reason, I believe, is that the mainstream economic models we have been working with over the past 50 years have focused upon “liquidity” issues. Debt has played very little role in these models.

Yes, I know that some ‘fringe’ economists like Hyman Minsky wrote about these issues, but try and find any kind of a discussion of debt and solvency in major macroeconomic textbooks.

Many post-World War II discussions of money and the demand for money are “framed” within the terminology developed by John Maynard Keynes in the 1930s, around the term liquidity preference, “The term introduced by Keynes to denote the demand for money.” (This is from the Glossary of the macroeconomic textbook by the Keynesian economist Olivier Blanchard.)

Moving from liquidity preference we get the concept of “liquidity trap” from the Keynesian dogma: “The case where nominal interest rates are equal to zero and monetary policy cannot, therefore, decrease them further.” (This, too, comes from Blanchard.) That is, people want to hold money and don’t want to loan money to invest in plant or equipment or inventories and so forth.

Obviously, this latter possibility resonates with Keynesian fundamentalists in terms of the situation that has existed over the past year or so.

The problem with this is that the idea of liquidity preference and the liquidity trap apply to the future. People don’t want to invest privately and just want to hold money because the expectations of future investment performance are so low and so risky that money is the safer way to hold their wealth. This is why, in the Keynesian paradigm, government deficit spending works because people will buy the government debt and the government can then “invest” and put people back to work whereas the private sector cannot.

But, what if the problem is that people and businesses (including banks) are so in debt that they cannot spend and that the cash they are holding is to provide them with funds to exist on in the future? That is, what if people and businesses are bankrupt or are facing bankruptcy because of the debt they have accumulated and are hoarding their wealth in very liquid assets so that they can buy what they need out of what remains of their wealth?

Maybe economic cycles are connected with credit inflations or debt deflations, cumulative buildups of debt followed by the need to unwind the excessive use of leverage built up in the earlier period. This cyclical behavior contains the problem of solvency, not liquidity. (Keynes, interested in the short run, focused on liquidity. Irving Fisher, the prominent American economist from the 1920s, focused on the longer run and wrote about debt deflations.)

It seems that economic policymakers in Europe (and in the United States) have been interpreting the problems of the last two years or so as a liquidity problem. Hence the responses of the leaders of the European Union have been couched in terms of solving their economic and fiscal issues by making sure that there is sufficient liquidity in financial markets for them to continue to function. Yet, the problems have not gone away because the issues of restructuring the debt and asset write-downs have either been ignored or pushed under the covers so that they don’t have to be discussed.

This has been true in the United States as well. The United States Treasury Department responded with the TARP program that was, at least initially, aimed at providing liquidity for ill-liquid assets on the books of banks and other institutions. (See my post of November 16, 2008,”The Bailout Plan: Did Bernanke Panic?” http://seekingalpha.com/article/106186-the-bailout-plan-did-bernanke-panic.) Furthermore, much of the effort of the Federal Reserve in 2008 and 2009 was aimed at providing liquidity to the banking system and the financial markets and not to problems of solvency.

In fact, I have been arguing over the last six months or so that the real reason why the Federal Reserve is keeping its target Federal Funds rate so low is that there are real asset problems in many of the small- to medium sized commercial banks. The Fed is keeping the rates low so as to help the banking system escape the “solvency” problem of the smaller banks from getting worse while the FDIC works through the liquidation process. Note, again, that the FDIC is closing more than 3.5 banks per week through May 28, 2010 and has 775 banks (There are about one out of every eight commercial banks on the problem list!) on its watch list, a number that is still increasing every quarter.

“The challenges for banks in the 16-nation euro-zone include exposure to a weakening commercial real estate market, hundreds of billions of euros in bad debts, economic problems in East European countries, and a potential collision between the banks’ own substantial refinancing needs and government demand for additional loans.” This quote is taken from the New York Times article referenced above.

The source of this concern? The European Central Bank!

The problem with a solvency crisis is that ultimately assets must be written down to more realistic values. In the cumulative process that occurs in the euphoric credit inflation that precedes a debt problem, asset values attain unrealistic levels. That is why people and businesses (including banks) continue to leverage up their balance sheets.

Valuations eventually must be put on a more realistic basis. This is where the European Union is at the present time. The unanswered question is, how far must valuations be reduced to achieve this realistic basis. And, of course, the bigger concern is whether or not these reductions can be achieved without inducing a cumulative debt deflation. No one really has the answer to either of these questions before the fact.

However, the excesses of the past must be paid for!