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

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

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

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

 

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

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

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

And, what else was occurred?

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

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

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

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

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

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

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

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

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

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

Perhaps one should not be surprised at this.

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

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

Government Incentives Do Matter--The European Case

Gillian Tett’s essay in the Financial Times this morning gives us another example of how government policies can create incentives that have very serious consequences on an economic system, consequences that are very often detrimental to the health and welfare of the economic system.  Tett’s excellent piece “Subprime moment looms for ‘risk free’ sovereign debt,” (http://www.ft.com/intl/cms/s/0/88151ed6-0639-11e1-a079-00144feabdc0.html#axzz1cfzAfdXG) examines the consequences of European bank regulators assuming that all sovereign debt in Europe were “risk free”.

“When regulators drew up the Basel I capital adequacy framework in the 1980s, they gave western sovereign bonds a ‘zero’ risk weighting, in terms of how capital is calculated.  This was subsequently modified in Basel II, to give banks some theoretical discretion to raise reserves against sovereign risk.  In practice, this zero-risk weighting policy has prevailed.

In some senses it has been actually reinforced in the past five years because regulators have demanded that banks raise their holdings of liquid, safe assets, following the subprime turmoil.  Those ‘safe’ assets have been—you guessed it—mostly government bonds.”

Furthermore, one can add that in both applications of stress tests to judge the vulnerability of European banks to a financial crisis, no allowance was made for the writing down of sovereign debt in financial simulations.  Obviously, European banks came out looking pretty good.

And, in the “deal” constructed last week by officials of the eurozone, only ‘private’ holders of Greek debt were required to write down the debt by 50 percent, ‘public’ holders of the Greek debt, the ECB and other governmental organizations, did not have to write down the debt at all.  The ‘private’ holders represented only about 60 percent of the total amount of the Greek debt outstanding.

Of course, assuming that the sovereign debt of many of the eurozone countries was “risk free” allowed the governments to issue much more debt than they might have otherwise at the cheapest rates possible. 

In the essay, Ms. Tett also makes reference to the fact that assuming that sovereign debt is ‘risk free’ is one of the most basic assumptions of modern finance.

The result?

“If regulatory systems had not encouraged banks and investors to be so complacent about sovereign risk in the past, markets might have done a better job of signaling that structural tensions were rising in the eurozone—and today’s crunch would not be creating such a convulsive shock.”

Ms. Tett compares this “mis-pricing” exercise to the earlier experience of the subprime market.  In the latter case, subprime securities were repackaged into bonds that the rating agencies gave Triple A ratings to.  Again, this pricing facilitated the purchase of these securities and allowed many financial institutions to acquire the securities, comfortable that they were holding assets of the highest quality.  But, one cannot ignore the pressure put on mortgage originators, lenders, rating agencies and such, by governmental officials pushing hard to provide home ownership to more and more people.   And, this situation, too, resulted in “a convulsive shock.”

My point is that in both cases, the financial institutions and their executives have been blamed or are being blamed for the mess and are assessed the title of “greedy bastards”!

As many people know from reading my blog posts over the past three years, I feel the same way about the credit inflation created by governments in the eurozone and in the United States.  I have argued over and over that the credit inflation that has existed over the last fifty years has provided incentives for banks, businesses, and individuals to leverage up their balance sheets to excessive levels.   This credit inflation has also promoted excessive risk taking and the financing of long-term assets with short-term liabilities.  And, this credit inflation has created perhaps the most desirable environment possible for financial innovation. 

Yet the consequence of people responding to these incentives has resulted in the worst financial and economic collapse since the Great Depression of the 1930s. 

In addition, these incentives have also produced the most skewed income/wealth distribution in the history of the United States since the 1920s.  The wealthy, top executives, and people with access to information and markets can protect themselves from inflation or even take advantage of inflation.  The less wealthy, etc., cannot even hold their own against inflation.

Again, those that responded to the incentives created by this extended period of credit inflation and benefitted from them are labeled “greedy bastards.”

And, nothing is said about the politicians, another set of “greedy bastards” that originally created the incentives because they wanted to get re-elected!

Ms. Tett is correct in wondering what might happen if people change their assumptions about the sovereign debt, assuming now that all sovereign debt is not “risk free”.

She argues that “more realistic assessments” of the debt “would probably fore banks to hold more capital, and raise borrowing costs.”

More realistic assessments might “force the central banks to change how they conduct money markets operations, and impose tougher haircuts not just for obviously impaired debt, but bonds carrying potential risk, too.”

Or, “The other 800 lb—or $500 trillion—gorilla in the room is the derivatives market.  Until now, sovereign entities have generally ot posted collateral for derivatives, partly because of that risk free tag.  But, Manmohan Singh, an economist at the IMF, believes that this anomaly has helped to create a severe under-collateralization problem, worth $1.5 trillion--$2.0 trillion for the 10 largest banks alone.  If ‘true’ counterparty risk were ever recognized in derivatives, in other words, the implications could be brutal.” 

One of the reasons why European public officials are denying that the problem they face are ones of solvency is because someone might discover that a good deal of the blame for the insolvency is due to what they have done in the past.   One of the nice things for politicians about economics is that the consequences of economic policies usually take a long time to work themselves out.  Because of this people find it difficult to connect the policy with the consequences of the policy or may even fail to identify any sort of a connection. 

This is where work like that provided by Ms. Tett is so enlightening and helpful.      

Europeans Facing More of a "Haircut" Than Preciously Thought

News is leaking out that the “haircuts” on European Sovereign debt are going to be greater than imagined just several weeks ago!  “EU looks at 60% haircuts for Greek debt.” (http://www.ft.com/intl/cms/s/0/66bdcbc0-fc11-11e0-b1d8-00144feab49a.html#axzz1bRwsVH3F)

Three months ago European officials agreed to a 21 percent haircut.  Then, in the last several weeks, the figure moved to around 50 percent.

And, still officials are dawdling.

European banks are troubled, and we hear about how the “French Banks Fought Oversight.“  Seems as if French banks and French regulators consistently ignored the reality of the situation within the banks claiming that no problems ever existed. 

Of course, bankers are notorious for claiming that problems do not exist on their balance sheets!  But, this is not new. (See my http://seekingalpha.com/article/300076-european-bankers-balk-at-big-write-downs.)  The bankers’ denial of any problems on their balance sheets is maintained right up to the time hey begin to argue that “It was not our fault!”

The problem I have with all this is that attention is being deflected from the real issues while blame is being diverted from the real culprit.

The real culprit, to me, is the post-World War II attitude in America, the UK, and Western Europe that the creation of debt, especially by governments, could keep unemployment at low levels and this would end the possibility of social unrest caused by masses of unemployed persons.  The result was that the latter half of the twentieth century became the “poster child” for the benefits of what can be called credit inflation. 

Creating debt, especially government debt, was not just a policy of the left, but it was also the policy of the right.  The creation of debt would resolve almost all social issues since it kept people at work.  This would also help politicians get re-elected.

In the 1960s we added to the goal of keeping people working the goal of seeing to it that every family owned their own home.  This was especially the case in the United States.  I was working for a cabinet secretary in the early 1970s in a “conservative” administration, and one of the major goals of this administration was the development of mortgage-backed securities.

The reason for the development of this instrument was certainly not an economic one.  The reason for the development of the mortgage-backed security was to get politicians re-elected.  The argument was that if more Americans owned their own home, the more willing they would be to re-elect those Senators, Representatives, and Presidents that supported this goal. 

The government’s development of the mortgage-backed security, of course, brought several new things to the financial markets, like ‘slicing and dicing’ cash flows, that paved the way for the financial innovation that was to take place later in the century.

Of course, the major driver behind all of this was the continual efforts of the national governments to create credit through deficit spending to hire large numbers of people themselves, to almost continuously stimulate the economy to keep unemployment low, and to continue to find ways to put more and more people into their own homes. 

This is the essence of credit inflation!  And, the central banks, fundamentally, helped the national governments to write the checks.

The undisciplined creation of debt, however, does not end well.  This is the story that Carmen Reinhart and Kenneth Rogoff tell in their book “This Time is Different.”  And, for the United States, the UK, and Western Europe, this time was not different and financial crisis arose.

The point I am getting at is that the resolution of a financial crisis is not a unique action.  However, many of those in authority are crying out “This time is different”!

One of the boldest “criers” is Fed Chairman Ben Bernanke.  I have written my opinion of him in an earlier post. (http://seekingalpha.com/article/300076-european-bankers-balk-at-big-write-downs)  But, Mr. Bernanke is not the only authority at the central bank that is searching for a new or better way to conduct monetary policy. (http://professional.wsj.com/article/SB10001424052970203752604576643510352250474.html?mod=ITP_pageone_0&mg=reno-secaucus-wsj)

Gillian Tett also writes in the Financial Times that “Central Bankers must update outdated analytical toolkit.” (http://www.ft.com/intl/cms/s/0/877b7bfa-fb21-11e0-bebe-00144feab49a.html#axzz1bRwsVH3F)  

Let me just say in answer to this situation we are in: This time is not different!

The problem is too much debt!  The cause of the problem was 50 years of credit inflation in the United States, the UK, and Western Europe.  This debt must be worked off and it takes time to work off excessive amounts of debt.  Again, I recommend you check the Reinhart and Rogoff book.  I have also just written a post on this: http://seekingalpha.com/article/300450-the-u-s-economy-will-continue-to-grow.

And, the lessons from this experience are not new.  Don’t issue too much debt!  Don’t just focus on short-run goals…like fiscally stimulated low unemployment, like everyone owning their own home, like governments hiring all their own supporters…and so on and so forth.

The problem is not financial innovation or greed or speculators.  These things will never go away. 

The problem has been that the credit inflation created in the last 50 years has created huge incentives to develop financial innovation, to exercise greed, and to benefit from speculation.  And, in the frenzy, things got out-of-control.

That is where we are today.  The haircuts that are now necessary are large and if something is not done about them soon, the haircuts will get even larger!  What if the write-down on Greek bonds were 90 percent?  What if the write-down on the bonds of Italy were 50 percent?  Portugal…60 percent? Spain…?  And, France…?

Over the last fifty years or so, people in the United States, the UK, and Western Europe have been living pretty well.  They can live well again.  But, we need to get away from Keynesian policies that promise something for nothing and return to some fundamentals that have played well over the years.

This time is not different!  Discipline and integrity are winners and have always been winners.  But, in a state of chaos, returning to discipline and integrity is difficult and painful.  The historical lesson, however, is that if people do not return to a condition of discipline and integrity the pain and suffering does not end…and in many cases it will only get worse!   

The Solution to the European Problem?

“The bare minimum the eurozone needs to cope with its crisis is an effective mechanism for writing down the debts of evidently insolvent private and sovereign borrowers, such as Greece; funds large enough to manage the illiquid bonds markets of potentially solvent governments; and ways to make the financial system credibly solvent immediately.”

‘

This is the prognosis of Mr. Martin Wolf, the economics editor of the Financial Times, in today’s edition of the paper. (http://www.ft.com/intl/cms/s/0/3ba2f7c4-ee76-11e0-a2ed-00144feab49a.html#axzz1ZuI4wzxo)

“Yet, alas, the eurozone requires more still: it needs a credible path of adjustment, at whose end we see weaker economies restored to health.”

The word is getting out…the European banks are going to have to take bigger write downs of their holdings of sovereign debt than ever imagined. 

Can the eurozone governments cover the hole in the balance sheets of these banks?

The United States stock market seems to think that they can.  This is the reason given for the rapid recovery of stock prices in the market yesterday. 

But, let’s look more closely at what Mr. Wolf is saying.  In the first condition, he writes about how the amount of the write down will be determined along with how the write down will be administered.  This is a daunting task in, and of, itself. 

Note further, however, that he is including ‘private’ debt along with the debt of sovereign borrowers.  The need to write down the ‘private’ debt is something new, something that has not gotten a lot of attention in the press in all the noise relating to the sovereign debt issue.  

The second point Mr. Wolf makes is about contagion.  How is any write down of the debt of the peripheral nations going to be kept to just the peripheral nations bonds, themselves?  The concern is that once write downs take place in bonds of the fiscally weaker nations that some spread is bound to occur to the nations that are in a stronger position, fiscally.

Then, Mr. Wolf addresses the issue of credibility.  Given all the “messing around” for the better part of almost three years, how can financial markets come to believe that solvency has been restored to the impacted nations?  If anything has increased over the past three years or so, it is the lack of trust in the eurozone governments when it comes to how the politicians carry out their responsibilities.  There is little or no trust in the people heading up most of the governments in Europe.  Can this “trust” be regained…and in time?

The add-on to this analysis is that the eurozone countries also need an immediate return to a robust economic recovery.

The happy conclusion to the analysis: “If such a path is not found, the eurozone, as it is now, will fracture. The question is not if, but when. The challenge is simply as big as that.”

Two comments on this analysis: first, I am glad to see that some people are finally seeing the problem as one of solvency and not one of liquidity.  It has taken a long time for the analysis to get to this point.  Now, it is time for the policy makers to accept this fact.

Second, Mr. Wolf pretty well lays out the dislocation that is going to have to take place in order to restructure and restore the eurozone to some sense of order and balance. 

“How, then, did the eurozone fall into its plight? The easy credit conditions and low interest rates of the first decade (of the European Union) delivered property bubbles and explosions of private borrowing in Ireland and Spain, incontinent public borrowing in Greece, declines in external competitiveness in Greece, Italy and Spain and huge external deficits in Greece, Portugal and Spain.”

The European condition is the result of credit inflation!  Quite an admission for a dyed-in-the-wool Keynesian!

The point is, however, that a long period of excesses must be matched by a painful and uncomfortable period of restructuring. 

In conclusion, however, one cannot ignore the social situation in Europe.  The “social contract” of the post-World War II era appears, to many, to be broken, and there is protesting and rioting in the streets.  Strong economic growth and low levels of unemployment, something that seems more and more unlikely to happen in the near future, of course, can resolve this situation.  Writing a new “social contract”, as history shows us, is not an easy thing to do.

Are there any lessons here for others?

Where Are The Leaders In Europe?

The story unfolding in Europe in a nutshell:

“Undercapitalized banks are supporting over-indebted governments by holding their IOUs; over-indebted governments are supporting troubled banks; and there is insufficient equity in the European banking system to absorb the losses implicit in the solvency gap.  The outcome is that the European Central Bank ends up providing liquidity on an open-ended basis to the peripheral countries to keep their banking systems afloat at the cost of an ever weaker balance sheet.  The one surprise in all this is that more of the retail deposit base of southern Europe has not disappeared in capital flight.”

From John Plender, “Time for Eurozone Policymakers to Grasp the Nettle”: http://www.ft.com/intl/cms/s/0/207fb2a4-ac9d-11e0-a2f3-00144feabdc0.html#axzz1SZnxOYcr.

Almost everyone in Europe seems to have his or her head in a hole in the ground ignoring reality.

Anytime we hear anything from them it is always about who is to blame for the current crisis…the international banking community…greedy speculators…rating agencies…or the cheating being done in world class men’s soccer. 

Real leadership seems to be totally absent from the scene.

Few make such a blatant claim as the New York Times did this morning: “Greece is effectively insolvent.” (http://www.nytimes.com/2011/07/20/world/europe/20europe.html?_r=1&ref=todayspaper)

There, I wrote it!

Greece is effectively insolvent!

It is not the international banking community that is causing the problem.  It is not “greedy speculators” or the rating agencies causing the problem.

The problem exists because of what the Greek government has done.  (For another take on this see Thomas Freidman’s column in the New York Times this morning:  http://www.nytimes.com/2011/07/20/opinion/20friedman.html?ref=opinion.)

Countries…people and businesses…cannot live way beyond their means forever. 

Greece did this to itself, and now the debt is coming due.

Does the Greek debt need to be written done?  You betcha’!

Will the write down be around 50 percent of face value?  That is what the market seems to think.

Can the banks holding Greek sovereign debt weather such a hair cut?  Certainly the “cowardly” stress tests just administered by the eurozone officials give us no such information about this possibility. 

However, sufficient information has been made public about the balance sheets of eurozone banks to indicate that many banks (many more than the nine identified by the stress tests) might have a “hard go” if this amount of a write down did take place.

But, we are in “hard go” country…thanks to the leadership in this area of the world.

Leadership that postpones dealing with problems is not leadership at all. 

“If one says that the problem is ‘out there’…that is the problem!” One of my favorite quotes from Stephen Covey.

I have worked with many failed institutions and in every case when one reviews the records, previous management never assumed that the fault was their own…it was always someone else’s fault. (Are you listening Mr. Murdoch?) 

As a consequence, steps were never taken to correct the problems faced by the organization and, therefore, the problems just got bigger and bigger and bigger.

The same has been true with Greece.

But, the contagion issue arises.  Is this the “Lehman Brothers” moment for Europe?  Will Portugal, Italy, and Spain follow in the footsteps of Greece?

These countries are not immune from the criticism leveled at Greece…and the statement of Plender above.  They have exposed themselves to the fate of the debtor and the debt collector is at the door.  Interest rates now paid by these nations on their debt are exorbitant and unsustainable. 

The losses must be absorbed…they cannot continue to be postponed in the hope that further credit inflation can buy them out of their dilemma.

Read my lips: the debt levels are unsustainable and must be dealt with now!

I like the quote at the end of the New York Times article quoted above: “The market is far more intelligent and resilient than a lot of politicians realize,” said Lee C. Bucheit, a lawyer who has handled sovereign defaults. “Investors realize that sometimes you make money and sometimes you don’t.  But they can’t abide prolonged uncertainty.”

I would close with a slightly modified statement: “Investors can’t abide a prolonged absence of leadership.”

Are you listening America? 

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.

Are There Any Leaders in Europe?

On March 10, I asked the question, “Is this Europe’s month of reckoning?” (http://seekingalpha.com/article/257590-is-this-europe-s-month-of-reckoning).

Well, the answer is no! The result of the meetings held this past weekend at the emergency summit in Brussels: “Not if we can postpone it for a while!”

In essence, however, we got the worst of two possible worlds...a combination of the two.

The leaders came together and seemed to say, “On the one hand we will provide some bailout protection for the nations struggling to right their fiscal distress, but on the other hand in our plan we will not get penalized for the funds we advance because our repayment will stand first in line over any prior claims.”

No real bailout, no real restructuring…which, in the longer run will mean that we will get a restructuring...we just don’t know when this restructuring will take place.

Current holders of Europe’s sovereign debt can now respond to Europe's leaders, “Don’t do us any favors.”

My patience is gone.

Let’s have the European sovereign debt restructuring now and get this thing over with!

The European Union does not seem to be workable in its present form. No one can lead.

I still believe that there should be a Euro, a common currency for Europe, but there needs to be
some other serious governing body behind it.

The current structure is awful!

Get on with it!

Bring on the debt restructuring!

Let’s move on to something else that we might have a chance of resolving!

Will the Financial Industry Dance Alone?

Last Wednesday, February 23, I argued that “The Music’s Begun Again..” (http://seekingalpha.com/article/254474-the-music-s-begun-again-time-to-start-dancing), and I fully believe that to be the case.

The economy has been growing. Since its low point in the second quarter of 2009, real Gross Domestic Product (GDP) has risen by 4.4%. The compound rate of growth has been approximately 0.7% per quarter which works out to an annual rate of roughly 2.9% per year. So the economic recovery continues.

However, capacity utilization of the manufacturing industries remains low, at 76.1% in its latest reading, substantially below the previous peak of around 82%. Even this peak was the lowest peak since the 1960s when the series was originally constructed.

My calculation for under-employment still hovers above 20%, again a high for the period following the 1960s

And, this, of course, raises the fear of a period of economic “stagflation” for the United States. Although the economy is recovery, one certainly could not apply the term “robust” to describe it.

From the credit side…more and more evidence comes in every day that the credit inflation that began in the 1960s continues. Although the world is going through a massive re-structuring, our leaders in the government continue to cry…more of the same…more of the same.

As with the last fifty years, credit inflation begins with the Federal government. The national debt is set to more than double over the next ten years and none of our leaders seem to be really seriously concerned about it.

For the debt to double over the next ten years, government debt would need to increase at a compound rate of about 7.2% per year during this time period. This is not too different from the compound rate at which the gross federal debt increased annually over the fifty years which began in January 1961.

During this period of time, the United States saw the biggest buildup in private financial leverage in the history of the country and also saw the biggest spurt of financial innovation ever to take place in the world.

Aided by advancements in information technology, the world of finance seemed to take on a life
of its own, separate from what was going on in the real economy. Employment in finance rose to approach 50% of all employment in the country as the number of financial institutions and the number of financial instruments traded ballooned.

We were getting a glimpse of the future.

Thanks to our leaders in Washington, D. C., and elsewhere, the “music” is playing again and, as we read daily, people have begun to dance once again in earnest. We read that auto sales are up because the auto companies have gotten auto finance to step up to the dance floor.

But, sovereigns are also leading the charge. Check out a lead in the Financial Times, “Sovereigns Turn to Pre-crisis Financial Wizardry” (http://www.ft.com/cms/s/0/53b445a0-4045-11e0-9140-00144feabdc0.html#axzz1FMM69iWr). It seems as if Portugal, and others, are getting back to “structured finance technology” with the use of Credit Default Swaps (CDSs) and Collateralized Debt Obligations (CDOs) to help themselves climb their way out of the current crisis in the sovereign debt market.

What else?

Did I hear someone say that issues of mortgage-backed commercial real estate securities are back? They are, and in a fairly big way. (See http://dealbook.nytimes.com/2011/02/28/commercial-real-estate-breathes-life-into-a-moribund-market/?ref=business.) Morgan Stanley and Bank of America have recently completed a $1.55 billion deal while others have sold roughly $5 billion in mortgage-backed securities so far this year. And, more is on the way.

The quote I like…from Brian Lancaster, as securitization specialist at the Royal Bank of Scotland…”Things have going from vicious to virtuous.”

It seems that car loans and collateralized loan obligations “are showing signs of life.”

And, the trading platforms built on the latest technology are beginning to fight for “territory.” GFI, a London interdealer broker, launched a swaps trading platform in advance of what is being done in the United States. (See http://www.ft.com/cms/s/0/e107d684-4369-11e0-8f0d-00144feabdc0.html#axzz1FMM69iWr.) Whereas firms in the United States are having to wait on the Commodities Futures Trading Commission for the new rules and regulations forthcoming from the Dodd-Frank legislations, others are getting a head start on them.

Technology booms ahead…while the regulators scramble to catch up to 2008. The Financial Crisis Inquiry commission just released information that the Office of the Comptroller of the Currency questioned several aspects of how Citigroup valued certain troubled securities way back in February 2008: seems as if “weaknesses were noted.” The question concerns whether or not Citigroup should have reported this information in its public documents. (See http://www.ft.com/cms/s/0/3b673370-4399-11e0-b117-00144feabdc0.html#axzz1FMM69iWr.)

My point is that we are still re-hashing what went on or what went wrong two or more years ago. The world has moved on since then. Information technology has moved on since then.

Note the headline in the New York Times: “For South Korea, Internet at Blazing Speeds is Still Not Fast Enough.” (http://www.nytimes.com/2011/02/22/technology/22iht-broadband22.html?scp=1&sq=for%20south%20korea,%20internet%20at%20blazing%20speeds%20is%20still%20not%20fast%20enough&st=cse) South Korea is seeking to have every home in the country connected with speeds of one gigabit per second. And, this is for homes.

One should also read about the changes that are coming to banking for individuals and families in places like India and Africa! This, while American banking is constrained by archaic restrictions that is causing it to lag behind much of the rest of the world in terms of customer delivery.

And, if all this is happening for the consumer, what is taking place in the biggest, most sophisticated financial institutions? Anyone for some science fiction? And, we are just worried about “flash trading”?

Regulation always lags behind the private sector. In the credit inflation of the last fifty years, the gap widened considerably. But, in re-fighting the last war will Congress and the regulators drive more business “off shore”?

The music has begun to play again. Credit inflation is underway. Further financial innovation is right on its heals. The economic recovery is underway…but, I fear, finance is going to go its own way again.

No Peace on European Sovereign Debt

When I read the news coming out of the Eurozone these days I get a very strong sense of déjà vu, all over again.

This feeling comes from hearing over and over again, leaders, whether of nations or of corporations, complaining that “the markets just don’t understand us!”

My response in cases like this is that the markets understand you…too well!

We have been going on and on about the fiscal crisis in Europe for at least a year now. And, things still are unsettled. (See my post “Four Uncomfortable situations to watch in early 2011”, http://seekingalpha.com/article/244531-four-uncomfortable-situations-to-watch-in-early-2011.)

And, the resulting financial crisis is not because there is not enough liquidity circulating around in world markets. The European Central Bank and the Federal Reserve System have seen to that. (See my post “Is QE2 a Bubble Machine?”, http://seekingalpha.com/article/245255-is-qe2-a-bubble-machine.)

As evidence of this I point to the fact that Brazil has launched a fresh attempt to limit the appreciation of its currency, “Brazil in Push to Curb Rising Currency”, http://www.ft.com/cms/s/0/7becb4e4-19c6-11e0-b921-00144feab49a.html#axzz1AMDfgcKJ.
And, it is not that Europe is not getting a sympathetic response from other countries. China, especially, has moved to provide funds to purchase sovereign debt. However, China is not that excited about further bailouts.

Still, Greece is continually fighting off concerns about how it is handling its fiscal affairs. (See http://professional.wsj.com/article/SB10001424052748704415104576065250841058220.html?mod=ITP_pageone_2&mg=reno-wsj.)

And, “Portuguese yields near euro-era high” (http://www.ft.com/cms/s/0/d2b3d95e-19c3-11e0-b921-00144feab49a.html#axzz1AMDfgcKJ). “If Portugal’s borrowing costs keep rising, then the government will reach a point where it will have to seek financial assistance from the international community.”

The major rating companies continue to put out downgrades of government debt and voice their concerns that further downgrades will be necessary. Investors also continue to translate this viewpoint into market prices: “The costs of insuring against a default by Western European sovereign borrowers in the credit default swap market surged, briefly touching a record on Thursday, according to data provider Markit. Swaps prices for Spain, Belgium, and Ireland closed at records, according to Market. The gap between yields on most European sovereign bonds and relatively safe German debt also widened.” (http://professional.wsj.com/article/SB10001424052748703730704576066243894186226.html?mod=ITP_moneyandinvesting_0&mg=reno-wsj)

The fact that this situation still exists after a year of massive efforts by the nations in the European Union and the International Monetary Fund and that lots and lots of money has been spent to resolve the underlying problems indicates to me that somebody is on the wrong page.

Furthermore, given that the situation has not gone away during this twelve month period indicates that the problems have not just been created by the “greedy bastards” known as speculators that have turned against a weakened opponent. If anything the leaders of the European Union have created “one-way bets” that have drawn speculators to feast on their difficulties. (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.)

My final comment on the behavior of the leaders of the European Union with respect to their sovereign debt crisis goes back to one of my favorite Stephen Covey quotes: “If you think the problem is out there, that is the problem!” It is very easy to pick out people in the investment community as a scapegoat for the problems you experience, especially if you can brand them as “greedy bastards.” Yet, pointing fingers at others and calling others names seldom, if ever, solve problems.

The leaders of the European Union need to face reality. Somewhere, sometime, the value of the debt that is being questioned is going to have to be written down. These leaders are going to have to accept the reality that they did a bad job in managing the responsibilities that they were given.

The process that these leaders are going through now is taking up too much time, is costing too much money, and is drawing the focus of these leaders away from things they really should be dealing with.

My experience is that when things like this are drawn out for such a long time and do not seem to be resolving themselves, it is time to “bite-the-bullet”, admit your mistakes, and move on.

This is a difficult thing to do but it is time to start attacking other problems that need to be dealt with.