For Mr. Trichet, the New Rules are "Insufficient"

The European sovereign debt unpleasantness continues.

Muddle, muddle, muddle…

The European finance ministers want automatic sanctions against EU countries that violate the debt levels assigned to the countries…

That is, unless a country has enough allies to be able to avoid the sanctions if they break the rules.

Jean-Claude Trichet, president of the European Central Bank, states that the new rules put into place on Tuesday are “insufficient.”

The next step in the application of these rules involves the approval of the European Parliament. The feeling is that this body, given the position taken by Mr. Trichet, will push for tougher rules.

We’ll see.

Meanwhile, back at the ranch, Moody’s Investors Service downgraded Portugal’s long-term government bond rating.

And, the finance minister of Greece, George Papaconstantinou, indicated that Greece might need additional aid beyond what was in its initial bailout which came in 2010.

Interest rate spreads on European government debt over German government debt rose again yesterday after spreads had fallen on Monday after reports from the weekend meeting of the finance ministers was released.

Financial markets just don’t seem to be convinced that the problems that exist within the eurozone are being faced. Government officials seem to want to return to a previous world and will try any band aid they can construct in order to get things “back to the past”.

At least two governments within the European Union are going to have to write down the value of their debt. Maybe there might be two more that will have to do the same thing.

Then, these nations are going to have to severely limit their future budget deficits.

After this, some of the peripheral nations are going to have to bring their economies into the 21st century. This is going to be the hardest part of this exercise.

The point here is that just getting government budgets back into greater balance is not going to do resolve all the issues of the European Union. One of the fault lines that Raghu Rajan writes about in his award winning book “Fault Lines: How Hidden Fractures Still Threaten the World Economy,” is the one that exists between those eurozone countries that are growing rapidly and those whose growth is lagging behind because they are still trapped in the 20th century.

So, in addition to just the fiscal issue, there are structural issues that some nations are going to have to deal with, and, given the protests and riots we have already experienced, it is obvious that such changes are going to be painful. But, the future of the European Union, as it now stands, depends upon this effort.

How can the European Union hold together when these social, as well as economic, issues that are so divisive must be dealt with? If the budget constraints are held to, the governments that face the greatest amount of change are not going to have the “deep pockets” needed to resolve the social unrest that might result. How can the needed change take place without a lot of economic “safety nets” in place, especially in Europe?

In my view, Europe has a long way to go and the sovereign debt problem is just a bump along the road. But, since the “people” issues connected with making these peripheral countries competitive in the 21st century are so important, the debt of these troubled countries should be written down so that the governments of these countries can get their fiscal houses in order.
Then, these governments can deal with the “safety net” issues that they will be facing.

Trichet is correct, what has been done is “insufficient”, but there is much more to the situation than that.

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!

G-19 Plus One

“Another phenomenon on display (at the G-20 conference over the weekend) was China’s willingness to continue fighting on its own in the G-20 if necessary.” (See “G-20 skeptics wait for shift in behavior”: http://www.ft.com/cms/s/0/1b5a9a62-3d23-11e0-bbff-00144feabdc0.html#axzz1EcmIs0vg.)


“In the face of determined and often solo opposition from China, the finance ministers did not mention foreign exchange reserves in the list of indicators (to be used in determining economic imbalances in the global economy).”


Actually, the makeup of the G-20 seems to look more like a quadrilateral. At the corners: China; and the United States; and Germany; and the rest.


China seems to be holding its own against the others: Eswar Prasad, former head of the IMF’s China division stated that “With the rest of the G-20 arrayed against it, China still managed to hold its own.” China, more and more, is feeling its rising strength in international policy discussions.


Then there is the United States. Over the weekend we heard comments from Ben Bernanke, Chairman of the Board of Governors of the Federal Reserve System, and Tim Geithner, United States Secretary of the Treasury.


The common thread in the remarks of Mr. Bernanke and Mr. Geithner: the problems connected with the international imbalances are the fault of China…or, everyone else. The United States is not responsible for any of the imbalances that have occurred.


But, people don’t really seem to be listening to “Ben and Tim” any more, a sign of the respect the United States now gets in the world.


Germany, well, Angela Merkel, the German leader, has problems at home. She is perceived as not tough enough and the feeling is that she has sold out to the rest of Europe. Thus, she is trying to re-establish herself and deal from the strength of the German economic position without sounding conciliatory.


And, the rest of the crop? Well, Nicholas Sarkozy has not taken the G-20 leadership anywhere and although he wanted to use it as a vehicle to regain his popularity in France…or anyplace else it seems. His agenda for the year seems to lie in tatters.


The others…there is no mention of them…well, with the exception of words from Brazil from

time-to-time.


There is no real leadership anywhere, and, there is no real current crisis that needs attending.


So, everyone can basically stake out their own claims and gripe about the others.


However, this does not satisfy anybody.


Everyone knows that there are all kinds of financial and economic problems in the world. But, no one seems to be in a position to really drive home the point that something needs to be done about them.


China and the emerging nations in the world are on their own track, economic growth seems to be robust with the prestige of this group on the upswing. Momentum seems to be on their side.


The United States, the eurozone, the UK…the developed world…seems to be experiencing some

kind of a recovery…but…nothing seems to be easy.


And, a worldwide inflation that seems to be picking up steam.


As a result…the shadow of (financial) crisis seems to looming over everything in the western world.


The eurozone has not resolved its problems, either in terms of the sovereign debt issue or the healthiness of its banking systems. Many investors are just hanging around waiting for the next round of the crisis to rear its ugly head. There still is the feeling that some nations are still going to have to write down their debt. The questions there revolve around when this might occur and just how many nations will be involved.


And, with the menace of inflation growing in Europe and the UK, mediocre economic growth is keeping the European Central Bank and the Bank of England on the sidelines with respect to raising short term interest rates. Also, raising short term interest rates might disturb the financial markets.


The United States government has the cloud of a shutdown hanging over its head. And, even if a shutdown is avoided and some reduction in the budget deficit takes place, the country is still looking at a cumulative increase in the amount of government debt outstanding in excess of $15 trillion over the next ten years. But, the United States still has the reserve currency of the world, and, as long as the United States continues to hold onto this privilege, serious concern over the debt of the government will remain muted. All seems to be posture, there is really no sense of urgency.


Concern still exists in the rest of the world concerning all the reserves the Federal Reserve has pumped into the banking system. The total of commercial bank reserve balances with Federal Reserve banks, a proxy for the excess reserves in the banking system, exceeds $1.2 trillion, a rise of more than $200 billion over the past six weeks. And, the Fed continues to keep its target short term interest rate below 25 basis points and still is not expected to allow this rate to creep up for several months more at the least.


Interest rates in the rest of the world (like in China and Brazil) continue to rise and continue to draw liquid funds from the United States and Europe.


This scenario continues to promise volatility in financial markets. If the global problems are not resolved and the financial imbalances continue to exist, the world will remain unsettled and funds will flow here and there as dramatic movements take place…in financial markets…in commercial banks…in commodities…in whatever markets seem to be the most unstable for the moment.


Is it going to take another major crisis to get action? We had a major financial crisis just a year ago or so and the response to it was pathetic and remains so. Do we really need another one to get people to move?


Here is where China…and Brazil…and a couple of other countries are setting in the driver’s seat. And, the west doesn’t seem to see the situation as a game of chicken. China…and Brazil…and others are not going to blink as long as the United States and Europe continue to drive their midget car against the huge SUV being driven against them. Right now, China does not believe it has to budge from its position. The United States and Europe argue that China is being “unfair”. And, Chinese confidence seems to grow every day. The recent G-20 meeting just reinforces this picture.

More Stress Tests Coming for the Banks of Europe

We have been given Quantitative Easing 2 (QE2) by the Federal Reserve System in the United States and now we are facing Stress Tests II (ST2) to be imposed on banking institutions in the European Union. (http://professional.wsj.com/article/SB10001424052748703994904575646903413631856.html?mod=ITP_moneyandinvesting_0&mg=reno-wsj)

Will we eventually be facing Financial Reform Act II (FR2) that will incorporate the next round of regulatory reforms of the financial system of the United States?

I put this new round of stress tests for banks in the same place I put QE2 and the initial Financial Reform Act of 2010 and Basel III (B3)…in the dust bin. For my comments on QE2 see http://seekingalpha.com/article/234814-the-fed-s-850-billion-bet-negative-long-term-implications; for my comments on the Financial Reform Act see http://seekingalpha.com/article/206341-the-sound-and-fury-of-banking-reform; and for my comments on B3 see http://seekingalpha.com/article/225116-basel-iii-chuckle.

Regulators and reformers (R&R) just never seem to get it right!

One reason is that they are always fighting the last war. The current popular belief amongst the R&R is that the initial stress tests in Europe did not include tests on liquidity and this element of the banking structure needs to be examined to get a real view of how much “stress” the banks can take. The R&R intend to correct this omission in the next round of stress tests.

Just two points on this. First, liquidity is a market condition and not something that exists on balance sheets. One cannot look at a balance sheet and determine how liquid markets will be. Duh!

Second, if a bank cannot raise funds in financial markets because they have bad assets, this is a solvency problem and not a liquidity problem. In addition they cannot retain funds from market savvy customers

Hugo Dixon wrote in the New York Times yesterday that the Irish banks, Allied Irish Banks and the Bank of Ireland, were “excessively dependent on wholesale money from other banks and big investors.” These monies are very interest rate sensitive and very sensitive to credit risk. Even though these banks passed the earlier stress tests, when the smell of problems arose, the wholesale money “started to flee.”

However, the problem faced by these banks was not a liquidity problem. The problem arose because the wholesale depositors were concerned over the health of the banks and this is a solvency problem.

The situation here is that the R&R can only work with historical data and, consequently, are always behind the times. Their analysis is always static. The movement of the “wholesale money” is current market information and provides a forward looking assessment of the condition of a bank or banks .

What would be desirable would be current information that was “forward looking” and more accessible to the investing public. What would be desirable would be some kind of “forward looking” market information that reflected the viewpoint of market participants that were “betting” their own money.

In a recent post I included a chart that presented market information and was very current. (See http://seekingalpha.com/article/239296-market-behavior-at-odds-with-european-bailouts-liquidity-vs-solvency.) This chart shows information on Credit Default Swap (CDS) spreads on European banks as well as on Spanish banks. One can see that the price of these CDSs began rising in late 2009 in anticipation of the sovereign debt crisis of 2010 and began rising even more dramatically before the current crisis that Europe is now facing. It seems as if some market indicator like these CDS’s could be used as an early warning signal that trouble was brewing in the financial sector of an economy or in specific banks.

Note, that the information provided by the Credit Default Swaps could be used as an early warning signal that something was wrong and this “signal” could then set off further analysis of the institution, or institutions, involved that would be conducted by the regulatory agencies.

Just such a suggestion has been made by Oliver Hart is the Andrew E. Furer Professor of Economics at Harvard University. Luigi Zingales is the Robert C. McCormack Professor of Entrepreneurship and Finance at the University of Chicago, Booth School of Business. Two references to their work are “Curbing Risk on Wall Street,” http://www.nationalaffairs.com/publications/detail/curbing-risk-on-wall-street, and “To Regulate the Finance, Try the Market,” http://experts.foreignpolicy.com/blog/5478.

To quote from the latter article: “In our mechanism, when the CDS price rises above a critical value (indicating that the institution has reached an unacceptable threshold of weakness), the regulator would force the LFI (large financial institution) to issue equity until the CDS price and risk of failure came back down. If the LFI fails to do this within a predetermined period of time, the regulator will take over.”

In the former article the authors argue that “The financial crisis of 2008 resulted from a series of misguided policies, failures of regulation, and missed signals. Unfortunately, much of the conversation about regulatory reform since has revolved around ideas that would only extend and exacerbate all three.”

The problem with implementing a plan like this is it that it causes the R&R to feel like they are losing some of their control…their power. Furthermore, many people within the R&R have little confidence in financial markets…it does not fit within their worldview. This is why I ended up a recent post with this comment: “many politicians and certain economists don’t like the market system. Market performance often contradicts the world views held by these politicians and economists. And, that makes them angry”

In conclusion, I have very little confidence in a new round of stress tests and believe that ST2 will lead to ST3…and then ST4…and eventually ST(n) where n is any number you want to give it. To me the sign that an approach is not appropriate and will not be successful over time is that people continue to use the same system and attempt to make the system tougher and tougher. Their system never works because their worldview needs to be changed.

How Long will the United States Dollar be a Safe Haven?

“The U. S. dollar is recapturing its role as the primary safe-haven currency, eclipsing the yen and the Swiss franc, as tensions in Korea and Europe escalate.

That re-emergence as the ultimate sanctuary for those fleeing risk will likely result in continued strength against major rivals in the next few weeks, analysts expect.

‘Recent events just reinforce the underlying message that during times of turmoil, almost no matter what the source, the U. S. dollar is seen as a safe harbor for investors,’ said Doug Porter, an economist at BMO Capital Markets in Toronto.” (http://professional.wsj.com/article/SB10001424052748704008704575639022158300444.html?mod=ITP_moneyandinvesting_1&mg=reno-wsj)

The question is “how long will the U. S. dollar remain a safe haven?

Twice in the past three years, the United States dollar has served as a “safe haven” for the world. Once, following the financial collapse in the fall of 2008, the value of the United States dollar against the currencies of major currencies rose from a trough in March 2008 of 70.3 to a peak of 84.0 in March 2009.

The next trough came in November 2009 at 72.2, but the sovereign debt crisis in the Euro-Zone in early 2010 caused the value of the dollar to rise again as a “safe haven”, peaking at 79.0 in June of that year.

After June the dollar, once again, continued to decline, falling to 71.0 in the first full week of November 2010. As mentioned above, the value of the United States dollar is now climbing.

Most analysts, including myself, believe that the long term trend in the value of the dollar is down. The United States government is basically un-disciplined with little or no self-control. This is not a slam against the Democratic Party because I believe that the Republicans have acted in a similar way. Fiscal deficits have led to mountains of federal debt, and the example set by the federal government has been emulated by the public at large over the past fifty years building up more-and-more debt over time. The Federal Reserve has supported this credit inflation and has even underwritten a large portion of it…and promises to underwrite a whole lot more.

The consequence of this lack of discipline and self-control has been reflected in the decline in the value of the dollar over the past forty years, since President Nixon floated the dollar. The chart below just shows us what has happened over the past ten years where the primary culprit has been the Republican Party.

From the peak value reached in February 2002 the dollar reached a trough in March 2008, 37.3 percent below the earlier peak. The dollar became a “safe haven” in the fall of 2008 and moved from its March trough to a short-term peak in March 2009, rising by 19.4 percent. Once this move was over, the value of the dollar dropped once again, this time by 15.5 percent.

The point is, the long-term pressure on the value of the United States dollar is to decline. This can be observed very clearly in the accompanying chart.

Since the value of the dollar was floated and the current data series began, January 1973, the dollar has declined by about 34.4 percent. So, the general trend of the value of the dollar since it was set free has been downward. Over the longer haul, nothing has really changed much in the way of American economic policy.

The bottom line to all of this is that nothing has changed in the past fifty years as far as the fundamental philosophy behind the economic policy of the federal government. The long run prospect for the value of the dollar is down!

There will be upswings, flights to the “safe haven”, but the basic trend will be downwards.
But note, the 2008 recovery in value of the dollar went on for about one year before the decline set in again. Therecovery in value associated with the euro-zone sovereign debt crisis lasted only seven months before the movement down began once more. The short-term peak reached in 2010 was 6.0 below the previous peak in 2009.

How long will this move into the dollar “safe haven” last and how high will the value of the dollar reach?

My guess is that the value of the dollar will move upwards for several months. The peak will be somewhere in the neighborhood of the March 2009 peak and the June 2010 peak. But, the decline will begin once again.

And, the longer run? As the periphial countries in the euro-zone get their acts together and become stronger over time, attention will look for other countries that need to be chastized. After Greece, Ireland, Portugal, Spain, Italy, and possibly France…will the focus of the financial markets turn to the Unitred States…and not as a “safe haven”?

The European Situation and the Financial Markets

Are the financial markets the WikiLeaks of economics?

Politicians and economists and business people ignore what financial markets are saying at their peril.

The financial markets have not responded well to the “rescue” package for Ireland put together by the European Union. The news out of London: “The euro continued to slide Tuesday, falling to a 10-week low under $1.30 as Italian, Spanish, Portuguese and Irish bond-yield spreads all continued to widen relative to Germany.” (http://professional.wsj.com/article/SB10001424052748704679204575646211228101600.html?mod=WSJ_Currencies_LEFTTopNews&mg=reno-wsj)

“The euro had started the European day with a rally, helped by regular month-end flows in its favor. However, things turned sour again as it became apparent that the risks of contagion remained as strong as ever and that Italy is now being affected by the lack of investor confidence in the euro zone.

Like the debtor countries on the periphery, Italy watched the yield on its bonds rise relative to those of Germany as investors demanded greater returns for holding Italian debt.”

The Financial Times writes: “it is still hard to see how Ireland can repay all the debt it has now taken on. So it is unsurprising that the market sensed a fatal combination: governments lacked the means either to nix moral hazard or end the crisis by writing an enormous check.” (http://www.ft.com/cms/s/3/8540ea0a-fb9f-11df-b79a-00144feab49a.html#axzz16locxnQW)

The European banks still remain a problem. Not only do the banks have serious solvency issues facing them, the eurozone’s banking system is a much bigger proportion of the economy than the proportion found in other countries, especially the United States.

The financial markets are flashing a warning signal that the cost of insuring a bank default has risen severely in Europe and in Spain. Plus, given how large the banks are relative to the size of the economy, questions have arisen about the ability of these countries to continue to provide bailouts. The situation in the banking sector of Greece looks positively “great” relative to Ireland, France, Spain, and Portugal.

Yet people continue to ignore what the financial markets seem to be telling them. It is very easy to claim that the markets don’t really understand a situation or that the blame for a situation rests elsewhere. See, for example, the op-ed piece in the Financial Times, “Spain is threatened by a crisis made in Germany”: (http://www.ft.com/cms/s/0/bb515190-fbf2-11df-b7e9-00144feab49a.html#axzz16lsMDit2). Every time the author makes an argument that Spain stood up for Germany in earlier times, he only talks about individuals, not what was happening in the market place. He now makes the argument that Germany, out of short sightedness, is hurting Spain. There is nothing about markets or what markets are doing. It’s all personal, not business!

Spain has problems and the problems are of their own doing. Now they need to get their books in order. (See my post “Is the Euro Bad News for Spain,” http://seekingalpha.com/article/239065-is-the-euro-bad-news-for-spain.)

In the vast majority of cases I am familiar with, the people who ignore the information being generated by the financial markets end up losing. One needs to have an overwhelmingly strong case that the market is wrong before one places a bet. In fact, betting against the market is like setting up one-way bets for traders. (See my post “Interventionists are setting up one-way bets for traders”: http://seekingalpha.com/article/237076-interventionists-are-setting-up-one-way-bets-for-traders.)

Furthermore, when talking about the banks, we still find a lot of people not really understanding the difference between a liquidity problem and a solvency problem. A liquidity problem is a short-run problem pertaining to “asymmetric information.” Something happens, a bankruptcy in the case of the Penn Central situation, and the “buy-side” of the market begins to question the situation of other high-grade customers that have issued commercial paper. In cases like this a central bank provides liquidity to the market so that the buyers will return as prices begin to stabilize. But, this is a short-run event.

A solvency problem is much longer-term and the state of the organizations, banks in this case, is known in the marketplace. And, that is a problem as far as raising funds is concerned. Firms in this situation cannot raise funds because no one wants to lend to them due to their extremely weak financial condition. But, this is not a liquidity crisis, it is a solvency crisis. People would lend to the organization if they were not financially challenged.

Yet, this is what we read in the New York Times with respect to the European financial crisis: “Ireland’s banking problems are only the latest example of how seemingly solvent institutions can be brought to the brink because they cannot in the short term raise the cash needed to finance themselves. Only four months ago, Allied Irish Banks and Bank of Ireland were given a clean bill of health in the European Union’s official stress tests. One weakness of these tests was that they stressed solvency, not liquidity, although that may be remedied next year.

The two biggest Irish banks did not have a large enough base of stable retail deposits. The loan-to-deposit ratios at Allied Irish and Bank of Ireland stand at just above 160 percent, which made them excessively dependent on wholesale money from other banks and big investors. When that dried up, they had to turn to the European Central Bank. When deposits from corporate customers also started to flee, emergency action was required.” (http://www.nytimes.com/2010/11/30/business/global/30views.html?ref=todayspaper&pagewanted=print)

Maybe, just maybe, the stress tests were not strong enough, as many have claimed. Certainly “the markets” did not think that the banks were healthy. This is even admitted in the article: the banks were “excessively dependent on wholesale money” and “when that dried up” real problems ensued.

Come on…wholesale money is very sensitive to the financial condition of the banks. The banks may have passed the stress tests but they failed the market test. Who is kidding who? You believe the stress tests? I’ve got a bridge to sell you!

This is why many politicians and certain economists don’t like the market system. Market performance often contradicts the world views held by these politicians and economists. And, that makes them angry!

The Euro is "Bad News" for Spain!

Paul Krugman says it all this morning in the New York Times: “If Spain still had its own currency, like the United States—or like Britain, which shares some of the same characteristics—it could have let that currency fall, making its industry competitive again. But with Spain on the euro, that option isn’t available.” (http://www.nytimes.com/2010/11/29/opinion/29krugman.html?_r=1&hp)

It’s that Trilemma thing again!

The Trilemma problem in international financial theory is that a nation can only achieve two out of the following three objectives: it can participate in the international flow of capital; it can have a fixed exchange rate; or it can conduct an economic policy that is independent of every other nation.

Spain, and other nations in the Euro-zone, is constrained by the first two of these objectives. Being a part of the Euro-currency-system, Spain has, in effect, a fixed exchange rate with all other nations in the Euro-zone. Spain also benefits from participating in the international flow of capital.

Given that these two conditions exist within the Euro-zone, Spain, and all other nations within the Euro-zone, cannot conduct its economic policy independently of every other nation within this currency area.

If Spain could conduct its economic policy independently of every other nation within the Euro-zone it could inflate its debt and currency all it wanted to and just suffer the injustice of seeing the value of its currency decline in the international financial markets. But, this would be “good” according to Krugman because the falling value of its currency would make its industry competitive again.

The problem in Europe, according to this fundamentalist Keynesian preaching, is Germany. Germany is the most disciplined country within the Euro-zone and hence is causing all sorts of problems for Greece, Ireland, Portugal, Spain, and possibly Italy and France. And, when times get tough, discipline wins.

This situation highlights the difficulty in attempting to build a currency area. A currency area has a single currency. So, by definition, a “fixed” exchange rate exists within the area. Unrestricted capital flows are very desirable within a currency area because everyone benefits when capital can flow to its most productive uses.

That leaves one prong of the Trilemma hanging…independent economic programs.

This has always been the “hidden bump” along the road to the formation of a currency area. Governments within the currency area need to conduct economic policies that are consistent with one another. But, governments don’t like to give up this independence.

And, if you have a nation like the Germans who believe in self-control and fiscal discipline, it becomes hard for nations who chaff at self-control and believe in credit inflation to continue upon their path forever.

Keynes realized this problem in attempting to construct his economic model in the 1920s and create the post-World War II international monetary system. Keynes knew that his proposals for debt inflation depended upon nations having the ability to conduct their economic policies independently of one another. And, he was, during this time period, very adamant about having a system of fixed exchange rates. Thus, Keynes advocated controls on the international flow of capital.

Unfortunately for Keynes’ view of the post-World War II environment, international capital flows increased, particularly in the 1960s and have accelerated ever since.

What then has to give? Fixed exchange rates or the ability of a nation to conduct its economic policy independently of other nations?

The United States, in August 1971, chose to do away with fixed exchange rates. The Euro-zone came into existence in 1993 and on January 1, 1999 opted for a one-currency system by introducing the euro to the world. The Euro-zone created a single central bank for the area, the European Central Bank which began business in 1998, but allowed national governments to still conduct their budgetary policies independently of one another.

Thus, countries in the Euro-zone could maintain self-control and discipline, if they so desired, or, they could creates mounds of debt and live way beyond their means, if that was what they wished to do. Governments did not want this choice taken away from them.

Times went well for the Euro-zone and most seemed happy with the existing arrangements. Then, the bond markets got antsy. And, we had the first “debt crisis” in the Euro-zone earlier this year. Band-Aids were felt to be appropriate.

Now, we are in the second “debt crisis” and the bill is coming due. Wouldn’t it be nice, as Krugman suggests, to keep on inflating and just let the value of the currency declining? Remember in the economic model Krugman uses there is no debt and no penalty for piling up more and more debt. No harm, no foul!

Therefore, Krugman believes, Spain should be as fortunate as the United States: “The good news about America is that we aren’t in that kind of trap: we still have our own currency, with all the flexibility that implies.”

America can create debt and inflate its currency all it wants to and no one else can do anything about it!

Yet, there is a conspiracy afoot. Now, Krugman has joined Oliver Stone! The “bad guys” are trying to stifle government spending and constrain the Federal Reserve System. These “bad guys” are trying to “voluntarily put (America) in the Spanish prison.”

Does Krugman advocate the demise of the euro? Krugman doesn’t really see this happening because of the disruption it would create. Therefore, Spain must remain in a prison of its own creation.

Germany has contemplated this move. But, Germany really doesn’t want the Euro-zone to fall apart. (See “Crises Shake German Trust in Euro-Zone”: http://www.nytimes.com/2010/11/27/world/europe/27germany.html?scp=10&sq=michael%20slackman&st=cse.)

Maybe the continuing efforts to provide rescues to member nations may lead to a more unified Euro-zone that realizes and accepts greater coordination of national economic policies. The road to such a solution, however, has many, many bumps and potholes along the way. Countries that have established overly-generous social policies may not be able to reconcile their demands with that of the more controlled nations, like Germany, that support greater fiscal and monetary discipline.

The conclusion to this story is far from over.

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!

The European Union: It's a Question of Leadership

The dust is clearing around the recent negotiations in Europe concerning the “bailout” bill and what we are seeing, at least to me, is unnerving.

“France has won!” (“Paris seen as trumping Berlin at EU table” at http://www.ft.com/cms/s/0/4fbef0b4-5d5e-11df-8373-00144feab49a.html)

“The French government yesterday vowed to ‘reinvent the European model.” (“Sarkozy triumphs in his bid to rewrite the rules” at http://www.ft.com/cms/s/0/f2666c76-5d5d-11df-8373-00144feab49a.html)

The press has predominantly been following German Chancellor Angela Merkel over the past month or so as she struggled to achieve a “German” twist to the negotiations concerning the fate of Greece and the bailout package that was needed to keep the EU together.

Many in Germany did not like what her leadership has achieved as people voted against her party last Sunday making it ever so much more difficult for her to lead her nation.

Sarkozy, the president of France, kept a very low profile…for him.

And, who seems to have come out on top? France!

France’s intent? To build a new structure with greater budgetary policy co-ordination and more effective fiscal rules. In essence, to follow the French model, allowing the spenders to spend and the savers to pay for what the spenders are spending on.

The start is a vast loan facility to distribute cash quickly to “a stricken member” without prior approval from other national governments…especially Berlin! (However, the current effort is to last only three years, but once begun…)

Also, Sarkozy is said to be very happy with the decision of the European Central Bank to start buying euro-zone government debt. This is a massive step toward “Quantitative Easing” something the ECB had been constantly resisting.

The ECB has been “Bernankied”!

This shift in policy direction is seen by Sarkozy as “irreversible” and puts France in the driver’s seat.

In my mind, this “victory” just exacerbates the “race to the bottom” (See “How the euro-zone set off a race to the bottom” at http://www.ft.com/cms/s/0/5d666d5a-5c69-11df-93f6-00144feab49a.html.)

The feeling in Germany? The newspaper Bild Zeitung puts is very simply: "The 'safety parachute' for the euro is the ultimate crime for Europe. We Germans have made sacrifices for a stable euro for the last 10 years, with wage restraint and sacrificing pension rises. We have paid the price while others have been partying at our expense . . . Europe's path to a transfer union is simply a road to its ruin."

And, what direction are you betting the euro will go?

This whole muddle returns to the question of leadership and in Europe.

Unfortunately, I don’t see anyone there that I would call a real leader.

In terms of the leadership at central banks, the head of a central bank can only go so far in achieving a monetary policy independent of the party that rules a nation.

NOTE: Check out what recently happened to the head of the central bank in Argentina!

Ben Bernanke and the Federal Reserve System have never acted independently of the presidential administration in Washington, D. C. whether it was the Bush 43 administration or the Obama administration.

The only show of independence that Bernanke and the Fed has made is to keep the Congress from conducting an audit of them.

Alan Greenspan was the lackey of whoever was in the White House.

This is why the financial markets expect that sooner or later massive governmental deficits will be monetized. Central banks cannot forever “hold out” against a government that wants to continue to live way beyond its means.

And, because of this Jean-Claude Trichet should not be judged too harshly. The “profligates” are in charge and a central banker can only fight back so hard. At least if they want to keep their high profile position.

So, we go back to the victory that France has achieved. If people were uncertain over the future of the European Union and the future of the euro, in my mind a lot of that uncertainty has been removed.

The major uncertainties now relate to when the periodic financial upheavals are going to take place, how severe they will be, and how long it will take for a European leadership to arise that will have had enough of the “race to the bottom”?

Weak leadership always caves in to the popular short run viewpoint!

More on Europe's 'Trilemma'

The name of John Maynard Keynes became prominent once again with financial collapse beginning in 2008 and the “Great Recession” that followed. I would like to introduce his thinking once again to maybe put the idea of the “Trilemma” into a historical perspective.

Yesterday, I wrote of the idea of the “Trilemma” and how it applied to the current situation in Europe (see “Europe’s ‘Trilemma’, http://seekingalpha.com/article/204066-europe-s-trilemma). Today I would like to hold up an earlier example that I believe highlights the difficulties faced by the European Union in attempting to resolve the problems it now faces. The earlier example is that of the United States going off the gold standard in August 1971.

The basic economic framework the world worked within in the 1950s and 1960s was created at the Bretton Woods conference in July 1944. Essentially, the Bretton Woods system was a fully negotiated monetary order aimed at governing monetary relations between member nations. The conference included 730 delegates from all “allied” nations which numbered 44 at the time. Out of this conference grew the International Monetary Fund (IMF) and the body that became the World Bank. These latter organizations became operational in 1945.

Primary among the obligations flowing out of the Bretton Woods system was the obligation for each country to adopt an economic policy that would maintain a fixed exchange rate (within a range of plus or minus one percent) in terms of gold. The IMF would be used to bridge temporary imbalances in a country’s balance of payments.

Historically John Maynard Keynes came to dominate the discussions at Bretton Woods and the resulting agreement that was signed by the participants reflected many of his ideas, some of which he had been promoting for twenty years or so. For more on the role Keynes played in international financial discussions during the 1919 to 1945 period see the book by Donald Markwell titled “John Maynard Keynes and International Relations” (http://seekingalpha.com/article/167893-john-maynard-keynes-and-international-relations-economic-paths-to-war-and-peace-by-donald-markwell).

Keynes was very forceful in promoting two policies he felt were crucial for the peace of the post-World War II period: the first was fixed exchange rates; and the second was independence for nations to follow their own economic policies. What he did not want was international capital mobility. That is, capital flowing freely between countries.

The driving force behind these policies was the worker unrest that dominated Western Europe in the post-World War I period which, of course, included the Great Depression. Of great concern was the possibility that Western civilization, the culture that Keynes was prominent in, was under siege. The problem was the Russian Revolution and the fear of potential Bolshevik revolution throughout Europe in the 1920s and 1930s.

It was crucial to Keynes that governments kept workers “fully employed” and not allow their (nominal) wages to decline. To do this, governments had to adopt economic policies that promoted “full employment” and that were necessarily independent of other nations so that they could respond to their internal labor markets.

The way to achieve the autonomy of the economic policy of governments was to fix the exchange rate of the currency.

But, there was a third part of the plan. The international movement of capital needed to be discouraged. Of course, at the time, gold was still an important aspect in the international movement of capital. Coming out of the experiences of the 1920s and 1930s there was grave concern that capital should remain inert, at best. A very lucid exposition of the existence of this attitude can be found in Liaquat Ahamed’s award winning book, “The Lords of Finance: The Bankers Who Broke the World” (http://seekingalpha.com/article/121616-financial-collapse-a-lesson-from-the-20s).

So, in line with the conclusions of the “Trilemma” argument, the post-World War II world implemented just two of the three policy goals. The Bretton Woods agreement created a world in which there were fixed exchange rates and autonomous national economic policies, but discouraged free international capital mobility.

The result: relative stability in the system during the 1950s when governments were generally conservative in terms of their monetary and fiscal affairs. However, in the 1960s, nations began to implement “Keynesian” type fiscal policies (note the “Keynesian” tax cut enacted by the Kennedy/Johnson administration) connected with a monetary policy stance that encouraged inflation (note the inflation/employment trade off in the popular economic model labeled the Phillips Curve). By 1968 or so, we Americans at least, were all “Keynesians” according to President Richard Nixon.

What occurred in the 1960s was the re-ignition of inflation and inflationary expectations as the Johnson administration pursued a fiscal policy that included both “guns and butter.” As inflation and inflationary expectations grew, financial innovation advanced as commercial banks became more international in scope and began raising funds throughout the world through the management of their liabilities. Note, for one, the development of the Eurodollar deposit.

International capital market mobility became a reality!

As a consequence, the Bretton Woods system could not hold. According to the “Trilemma” diagnosis, the world was trying to live with all three of the policy goals connected to the “Trilemma” and one of them had to go.

President Nixon believed that full employment was very important to him in terms of his re-election bid and so the autonomy of his administration’s economic policy could not be aborted. Furthermore, globalization was in its infancy and business and finance were pushing as hard as possible to keep international capital markets expanding. Hence, the fixed exchange rate had to go!

On August 15, 1971 President Nixon announced to the United States (and to the world) that America was going off the gold standard and the value of the dollar would be floated. The world was now different than it was before.

The basic reason I wanted to bring this episode to your attention was to provide some historical backing to the dilemma now facing the European Union. The “Trilemma” problem is relevant to what they are trying to achieve. Ignoring or assuming that Europe can overcome the conclusion reached in the “Trilemma” analysis is foolhardy. Therefore, we shall all be waiting to see how the European Union can resolve their dilemma. Enacting a bailout package is only a stopgap to dealing with the real issues the leaders of the EU face. The problem concerns the absence of real leadership in Europe!

The Dilemma for Europe

One of the most important conclusions reached in modern open-economy macroeconomics is captured in what is called “The Trilemma.” The principle presented in this analysis is that governments cannot achieve all possible policy goals simultaneously.

More specifically, a government cannot, simultaneously achieve a fixed exchange rate, international capital mobility and economic policy autonomy. Only two can realistically be achieved at any one time.

Governments within the euro-zone have been attempting to achieve all of these goals at the same time. And, that is why they are experiencing the current difficulties. The euro represents the fixed exchange rate between euro-zone countries. Although an attempt has been made to bring economic policies within certain boundaries either through stated requirements to join the community or ongoing standards of behavior once a country joins the euro-zone, strict adherence to these rules have not really been observed. Consequently, nations within the community have been able to act with relative autonomy in regards to the economic policy they have followed.

Finally, membership in the euro-zone has provided all nations with greater access to international capital and this, as much as anything seems to have been one of the major attractions to countries on the periphery of Europe to join the body. Becoming a member of the euro-zone has allowed less credit-worthy countries to gain access to capital and at lower interest rates than would have been possible had they remained independent. In this, the creation of the euro has been a great success.

However, that very success is undermining the community. Ken Rogoff, the co-author of “This Time Is Different,” agues in the May 6 edition of the Financial Times, that “Europe Finds that the Old Rules Still Apply,” (See http://www.ft.com/cms/s/0/be41b758-58a7-11df-a0c9-00144feab49a.html.) It seems as if people, and governments, living well beyond their means ultimately have to “pay the piper.”

Martin Wolf in his ft.com/wolfexchange of May 4 raises the question, “Must All Capital Inflows Always End In Crisis?” (http://blogs.ft.com/martin-wolf-exchange/). One conclusion is that if a country has a large capital inflow and it cannot allow for a change in the value of its currency in the foreign exchange market then it must adjust its internal economic policy. If it is not willing or cannot do so in a sufficient magnitude then a financial crisis must take place.

And, this brings us right back to the Trilemma dilemma. A country cannot have a fixed exchange rate, run an autonomous economic policy, and enjoy the fruits of international capital flows. So, the question boils down to the problem of how is this going to be resolved?

The International Monetary Fund has now moved to approve a three-year, €30 loan to help the Greek government. Also, French President Nicolas Sarkozy and German Chancellor Angela Merkel Sunday said they are in complete agreement with measures to be unveiled later on Sunday by the Ecofin, the group of the European Union's 27 finance ministers.

NOTE: Exit polls predict Merkel defeat in federal state election (see http://www.ft.com/cms/s/0/7a717746-5b60-11df-85a3-00144feab49a.html) making it more difficult for Ms. Merkel to effectively govern in Germany.

So, the euro-zone seems to be moving toward some combined help for Greece and possibly others within the European community. But, there seems to be an absence of real leadership. And, that is a problem, for people really don’t like a leadership void. How this void is going to work itself out is anyone’s guess right now.
The problem is, as I see it, that in situations like this one the drift goes one of two ways. Either the community moves toward the country that is most fiscally sound, in this case Germany, or the community moves toward those that are the weaker links: Greece, Portugal, Italy, and Spain.

If left alone, I would bet that the countries that are more in control of their finances would come out on top! Why? Well, because the less disciplined ultimately have to get their act together in order in order to be able to compete with those countries that are in better shape than they are.

One can easily use a sports analogy in this case and that is why sports can be so popular because it can be used to explain life. Usually, the most talented and most disciplined player or teams come out as the winner or champion. Other individuals and teams know that they must practice and train and discipline themselves if they are going to have a chance to compete. Those that don’t have the attitude to commit themselves to this regimen are not kept around.

But, we have another model to work with. In this model, those that are weakest and least disciplined draw on others so that they can keep playing the game. Here, the weakest links become a drag on the performance of others and define the nature of the relationship.

Why are Greece…and Portugal…and Spain…and Italy…having such a difficult time? Their economies are as undisciplined as are their finances. They still, according to Rogoff in the article mentioned above, are emerging nations, if not worse. Their entry into the European Union provided them with an opportunity to move beyond the “emerging” classification more rapidly than the amount of time usually needed to achieve this maturity. The problem is that these countries have “wasted” the opportunity. They have used their access to capital to “buy off” voters with social programs and benefits and have devoted very little attention toward developing a more competitive economy.

Bailing these countries out only exacerbates the situation. Can these countries really deliver the fiscal discipline needed to move into the modern world? The rioting in Greece does not give us much hope for such an outcome.

One further problem seems to be that European banks have purchased too much of the debt of these countries. And, in this respect, the difficulty is not just the Greek debt, but the debt of these other countries that people are now raising questions about. Of course, this is the problem when something turns out worse than thought. Thus, questions arise about others with similar difficulties.

Coming to the support of the Greek government may be a signal of the extreme concern that exists over the safety of the European banks.

Few officials want to talk about a debt restructuring. The problem again seems to be the feeling that if the Greek debt is restructured then this will have to be followed by a restructuring of the debt of other European nations. Then the problem just becomes that much more severe.

Yet, the economics of the situation give little hope that the Greek government, and possibly other governments, will be able to resolve their situations through massive changes in their governmental budgets. That is why many analysts are betting that, sooner or later, a write down of the debt will have to occur. The picture is something like that enacted by Argentina who wrote down their debt by 50%.

I would argue that this is the only real way to begin the move beyond the solvency crisis.

As far as the fate of the euro and the euro-zone? According to the “Trilemma” analysis, the only way the euro and the euro-zone can survive without recurring “political” difficulties is to coordinate the economic policies of the member nations. That is a lot to hope for at the present time…or, maybe at any time.

Euro Solvency?

The financial markets hate uncertainty. It is the unknown that creates uncertainty and unexpected new information often creates uncertainty because investors must not only absorb the new information but must also translate what they have learned into action!

This is what I tried to emphasize in my post of April 28, 2010, “Greece: The ‘Surprise’ That Breaks The Camel’s Back” (http://seekingalpha.com/article/201382-greece-the-surprise-that-breaks-the-camel-s-back). Recently we were given knowledge that the budget deficit of the Greek government was much worse than we had been told, and, as a result of this news, the rating on Greek bonds was lowered. Immediately, investors began to sell off these bonds.

The financial market unrest continued. Then the European Union and the International Monetary Fund came up with its bailout package of €110 billion “to save the euro by providing Greece with enough cash to meet its financial obligations over the next twelve months or so.” (http://seekingalpha.com/article/202754-greece-and-insolvency-finding-a-way-out)

The problem is, as I pointed out in this last post, that the response was aimed at preventing a liquidity crisis and not a solvency crisis. These two types of financial crises are different and a failure to understand the difference and react in the appropriate way can just exacerbate a problem and not solve it.

The Federal Reserve under Ben Bernanke has been guilty of this very thing and, as a consequence, has contributed to the lingering solvency problem in the “less than mammoth” banks in the United States banking system today. (I have discussed this in many other posts.)

A liquidity crisis is a short run phenomenon related to the disclosure that the price of a certain financial asset should be different from what it had recently been trading at. The buy side of the market disappears and the price of the financial asset drops, sometimes precipitously. In the classical case, the central bank comes into the market and makes sure that there is sufficient liquidity in the market so that the price of the asset in question stabilizes and trading can resume.

The prices of other similar assets may be caught up in this uncertainty but the response of the central bank is enough to stabilize the market.

A solvency crisis is different. In a solvency crisis the value of the assets must be written down, but the concern is over the ability of the institutions that own the assets to cover the value write down with the equity capital they possess. Of course, the value of the assets may go up at some time in the future but in general these institutions must “work off” these assets over time in a way that does not exhaust their capital base.

Otherwise, if the effected institutions have to write off these “underwater” assets immediately they may have to be closed.

A solvency crisis takes a much longer time to get over than does a liquidity crisis. That is why so many small- to medium-sized banks are still having so much difficulty even with massive amounts of liquidity available in the banking system.

The problem with the current situation in the European Union is that the situation is not one of liquidity, but one of solvency. There is a very real concern in the market for sovereign debt about whether or not certain nations within the EU can maintain their solvency given the debt load their governments have assumed and given the very weak nature of their economies.

There is a question about the ability of certain governments to be able to pay-off their debts. And, if these debts cannot be re-paid, what will happen to the solvency of the banks and other institutions that now hold this sovereign debt. Special concern exists about commercial banks in Germany and France. Some think that the real reason for the Greek bailout is to keep several major banks in Germany and France from failing. (See the second post mentioned above.)

Just providing Greece the ability to be able to roll over its debt in the next twelve months or so is an attempt to make Greek debt “liquid”. The hopes are that this will buy time for the Greek government to “right its ship” so that it will be able to meet its financial obligations and then go bravely forward. The financial markets have responded by saying that the Greek situation is not a problem of market liquidity but a problem of government solvency: the government, as it appears now, cannot pay its bills.

The concern over solvency has spread. If Greece lied to its debtors, maybe other countries have been doing so as well. Maybe these other countries are not as well off as was thought. Hence, a need to check other “undisciplined” countries out.

The credit ratings of Spain and Portugal were lowered (with Portugal facing additional review concerning its credit rating). Isn’t this evidence enough. But, of course, other countries are on the radar screen: countries that have been particularly profligate like Great Britain where the Labour Government outspent the rate of inflation since 1997 by 41%! But also Italy and Ireland.

What we seem to be seeing in the world is a realignment away from countries that have over-stayed their welcome in the credit markets. We see this especially in the currency markets. The value of the euro has plunged against the dollar and other major currencies. Today, May 6 it hit a 52-week low around 1.26. In other areas of the currency market the move seems to be away from the currencies of countries having “debt problems” to those that appear to be more secure.

The same thing has occurred in bond markets. The rush to United States Treasury bonds has been phenomenal over the past week. The two-year Treasury was yielding about 1.07% April 23 while the ten-year Treasury was yielding around 3.82%. These two yields have dropped to 0.79% and 3.39%, respectively, a major move!

When uncertainty increases, market volatility also increases. If we look at one index of market volatility, the CBOE’s VIX index, we see it peaking over 40 today, up from around 20 or so over the past week and in the 15-20 range before that. The market appears to be spooked and this means one might expect the volatility of the financial markets to remain high in the near future.

The major problem going forward is leadership: who can lead the eurozone and Great Britain out of this mess? The concern is captured in Landon Thomas’ article in the New York Times, “Bold Stroke May Be Beyond Europe’s Means,” (http://dealbook.blogs.nytimes.com/2010/05/06/bold-stroke-may-be-beyond-europes-means/?scp=5&sq=landon%20thomas%20jr.&st=cse). In the case of the eurozone, there is no leader. And, this has been a problem the detractors of this union have pointed to since before the euro was put into place. There is an economic union but no political union. It is like herding cats and given the cracks that are occurring in the structure, many are wondering if this economic union can last for more than two or three years more.

In Great Britain, there is going to be a “hung” Parliament. But, who really wants to rule in jolly ole England. Some are saying that if the new government (‘hung’ or not) really does what it needs to do with respect to the fiscal condition of the nation, these politicians will not be able to be re-elected for the next ten- to fifteen years because they will be so unpopular. Shades of Greece?

The bottom line: governments have lived beyond their means. Certain ‘brands of economics’ have argued that this is possible because people don’t really take into account future tax liabilities or future inflation. They are very ‘current minded.’ It just seems possible that this philosophy has run its course!

Why Should We Trust the Financial System?

Every day, it seems as if people are given more reasons to distrust financial institutions and the leaders of those financial institutions.

Lloyd Blankfein has become a joke!

Banks are not to be believed!

And, governments and members of governments have even lower ratings!

Finance is supposed to operate on trust and financial markets are said to function because people have confidence in them.

Well, if this is the case anywhere at the present time it must be in a parallel universe.

And, the stories continue. “It’s an open secret on Wall Street that many big banks routinely—and legally—fudge their quarterly books.”

“Window dressing is so pervasive on Wall Street…”

“The big question is the extent to which other banks (other than Lehman Brothers and Bear Stearns) used, and still use, creative financing, and whether they, like Lehman, broke any rules.”

These quotes are from the New York Times article “Crisis Panel to Probe Window-Dressing at Banks”: http://www.nytimes.com/2010/05/05/business/05repo.html?ref=business.

It is not just the big banks. It is on the public record that the Greek government lied to the world about its fiscal position. What other governments might be falsifying their records?

State and local governments in the United States are not forthcoming about their financial commitments and liabilities such as those connected with the funding of pensions and other contracts. And, many of these entities are facing the bankruptcy court these days.

Ponzi schemes come in many different flavors.

But, those that work in financial markets claim, at least in theory, that the markets are efficient, that the prices that exist in financial markets reflect all relevant information. They assume that participants in financial transactions are “sophisticated” meaning that the participants are canny professionals who have all the information they need.

That is why the executives at Goldman Sachs can, in good conscience, argue that their customers are “sophisticated” and are “big boys, fully capable of looking after themselves.” (See “Goldman and the ‘Sophisticated Investor” in the Wall Street Journal this morning, http://online.wsj.com/article/SB20001424052748703866704575224511672855990.html#mod=todays_us_opinion.)

What! The financial wizards claim that investors have all the information they need, yet they hide information from the public on a regular basis!

And, why does Lloyd Blankfein look silly testifying before Congress or on the Charlie Rose program?

Government officials hide information from the public on a regular basis!

And, then these same officials cry foul when financial markets sell off once the information on their lies becomes known.

Hello, Bernie Madoff…

We now know that Lehman Brothers and Bear Sterns used “shadow financial vehicles” and produced results that mislead investors and regulators. This seems to be the case most of the time in terms of companies that fail.

I know from the bank turnarounds that I was involved in, one of the first requirements of the new management was to open up the books and let the world know what actually was going on in the “troubled” institution. When this was done, the basic response I got from the investment community was one of “incredulity” and “disbelief.” The investment community could not believe that I was willing to make the books as open to them as I did. But, once they got used to this “openness” they began to trust me and what was being done at the troubled institution.

Secrecy, to me, is the worst thing the leadership of an organization can pursue. But, then, people tend to run to secrecy when things go wrong because they either were not capable of running the organization or because they made bad decisions.

As a consequence, my experience has made me a firm believer that openness and transparency, in all financial institutions…and governments…are a requirement for sound finance. Openness and transparency are a requirement for the building of trust in organizations and the system so that investors will have confidence in markets.

Openness and transparency should be one of the building blocks for any new financial reform and re-regulation that takes place.

Yet, the Obama Administration and the Congress seem to be focused on the past; they are fighting the last war. And, this means that any reform package they get will be out-of-date and irrelevant when it is passed. As the New York Times article reports “JP Morgan Chase and Goldman Sachs are examining how to use shadow vehicles to help them borrow money in the future.” The article points to such major players as BSN Capital Partners in London as one firm that has created such vehicles for banks in the past. Even the best seem to need secrecy!

International financial markets still don’t know all they need to know about the Greek situation…and the Spanish situation, and the Portuguese situation, and the Irish situation, and the Italian situation, and the English situation, and so on and so on. International financial markets still don’t know all they need to know about who holds the debt of these countries and how much of an impact would take place if the debt where to be substantially written down.

So we see that another financial crisis has taken place because the expectations of investors were surprised. (See my post http://seekingalpha.com/article/201382-greece-the-surprise-that-breaks-the-camel-s-back.) Maybe we are asking the wrong question, that question being “Why have investors lost confidence in these euro-zone securities?” May the question should be “Why did investors have confidence in them in the first place?”