What If Europe "Marked-to-Market"?

“The now inevitable restructuring of eurozone debt…”

So writes Jim Millstein, Chairman of Millstein & Co. and former chief restructuring officer of the US Treasury Department. (http://www.ft.com/intl/cms/s/0/461464fa-0617-11e1-a079-00144feabdc0.html#axzz1dmPTNMw5)

Have people really come to accept this fact?

The full sentence: reads “The now inevitable restructuring of eurozone debt will result in bank capital deficiencies that the IMF estimates could exceed €300 billion.”

Now, what if we added a European recession on top of this, a recession that would slow down government receipts and increase unemployment payments and so forth?

Just out this morning: “A rebound in German and French growth propelled a modest expansion of the eurozone economy in the third quarter of this year – but failed to dispel fears of a looming recession across the 17-country region.

Eurozone gross domestic product expanded 0.2 per cent compared with the previous three months – the same pace of expansion as in the second quarter, according to Eurostat, the European Union’s statistical office. But with the escalating debt crisis already feeding into falling factory production, growth may already have gone into reverse, economists warned.” (http://www.ft.com/intl/cms/s/0/d1b0e2c6-0f5f-11e1-88cc-00144feabdc0.html#axzz1dmPTNMw5)

Are we coming to the end game?

Angela Merkel, the German chancellor, is now calling for a political union of Europe as the only way to “underpin” the euro and help the members of Europe emerge from their “toughest hour since the second world war.”

Doom and gloom seem to be all around us.  Just in the past two days we have articles like “New Austerity Incites a Bitterness the Postwar Generation Did Without,” (http://www.nytimes.com/2011/11/14/world/europe/austerity-in-europe-brings-bitterness-unknown-in-postwar-era.html?_r=1&scp=2&sq=alan%20cowell&st=cse) and David Brook’s “Let’s All Feel Superior,” (http://www.nytimes.com/2011/11/15/opinion/brooks-lets-all-feel-superior.html?hp0).  Also, this morning there is a review of Niall Ferguson’s new book “Civilization” whose subject matter is “the end of western civilization as we know it”  (http://www.nytimes.com/2011/11/15/books/niall-fergusons-empire-traces-wests-decline-review.html?ref=books).

Do these pieces of information point to the existence of a debt deflation cycle that is at the opposite end of the spectrum from the credit inflation cycle that we have been going through for the past fifty years? (http://seekingalpha.com/article/307261-debt-deflation-is-it-a-possibility)

The solutions Mr. Millstein proposes for the writing down of European sovereign debt are focused on the banking system and the estimated bank capital deficiencies.  But, part of the solution involves more debt: “a federal financial body, such as the European Investment Bank, must provide a capital backstop…”  In other words, more debt!

But, “To give it the firepower it needs for the size of the problem, the EIB must be empowered to raise debt supported by a stream of new tax revenues dedicated to retire the debt incurred.”  And, “the EIB’s capital backstop should be funded through a new federal tax on bank salaries and profits above defined levels.”

This does not seem like a solution to me.  The solution to the problem of too much debt around is not more debt and more taxes.  Yet that seems to be the best that many people can come up with.  However, this seems to me to be more of the same “thinking” that got us into this situation.

This brings me back to the opening quote: “The now inevitable restructuring of eurozone debt…”

The European problem is not a new one; it has been growing for several years now.  Government officials have just not been willing to accept the reality of the situation and economists have helped them to hide their heads in the sand by arguing that Europe’s problem has been one of “liquidity” and not one of “solvency.” 

If the problem is one of “liquidity” then a bank…or, anybody else…does not have to mark down an asset because the bank will, they say, hold the asset until it matures.  If the bank accepted the fact that the asset was experiencing difficulties then it would have to “mark” the value of the asset down.  But, this admits that something might be wrong…and people don’t like to admit that a mistake might have been made.

And, as Steven Covey has stated, “if the problem is ‘out there’, that is the problem!”  Even a month ago, European officials were still claiming that their problem was one of “liquidity” brought on by speculators and other “greedy bastards.”  And, if the problem was someone else’s fault, real solutions could be postponed.  And that is what these officials did.

“Solvency” problems, however, do not just go away.  First, “solvency” problems have to be recognized…people have to “own” them before anything can be done about them. 

I am still not convinced that we have arrived at that point.  Yes, we have an editorial piece in the Financial Times that declares that “the inevitable restructuring of eurozone debt” must take place.  However, eurozone governments, I don’t believe, generally accept this conclusion. 

Until eurozone officials do accept the fact that “all” eurozone debt must be restructured, the problem will still be that these officials do not accept the fact that their debt must be restructured.  And, this is no solution.    

Merkozy Posts A Win!

Greek prime minister George Papandreou cancelled the referendum.  Angela Merkel and Nicolas Sarkozy called Papandreou back to the “shed” Wednesday for a tongue-lashing…and worse…to set him straight on the marching orders he had been given. 

And, the Greek prime minister backed down.

It seems as if Merkel and Sarkozy believe that there are only two choices in the current debate.  The first is that the European Union stay together and maintain the single currency zone.

The alternative is that the EU split up with some countries maintaining the single currency zone.

To Merkel and Sarkozy there really is no choice…the EU stays together and supports the euro.

If the EU stays together and supports the euro…then the bailouts will continue. 

It seems to me that there are two most likely outcomes to following this path.  Of course, there are more but they are all derivatives of these two in my mind.

First, financial markets will continue to reject the solution and there will be further “summits” down the road with more bailouts and more distress.  The ultimate result of following this path will be when the EU finally decides that the fiscal policies of all countries in the union will have to be coordinated and there will be fiscal and political union as well as monetary union.

Some have seen this conclusion as the missing component of the efforts to achieve the monetary union right from the start.  Others, like myself, have seen this possibility as the ultimate end to the financial crisis as we now know it.  And, a political union may have been the goal of some EU “leaders” throughout the turmoil. 

If there is going to be a real “coming together” of the nations in the EU, the “strong” will be the drivers (Germany and France and who else?) but in order to achieve the final union the solvency of the laggards (Greece, Italy, Spain, Portugal and who else?) will have to be resolved.  That is, there will have to be some kind of central “Treasury” that will aggregate all debts and pay off those nations still in the union that are insolvent.

One can look at the American after its Revolutionary War where Alexander Hamilton opted for a strong central “Treasury” and the assumption of all of the debts of the states that were then a part of the United States.

The problem with this solution?

The problem lies with the people of the nations within the EU.  Some of these people’s may not want to come under the regime of the “strong” nations that will be the driving force in a strong, centralized fiscal EU. 

There have been riots and protests in Greece…and in Spain…and in Portugal…and in Italy…indicating resistance to the fiscal austerity being imposed on them by especially Germany and France.

And, the resistance is even getting more personal.  For example, a Greek newspaper has a cartoon with a German general manipulating two puppets…the two puppet being the Greek prime minister and another Greek official.  The underlying theme: “The Germans didn’t succeed in occupying Greece through arms because the Greek people resisted.  They try now to occupy Greece through the economy.”

Pretty heavy stuff. 

The Merkel/Sarkozy path to fiscal/political union may be a desirable goal but the question that still needs to be asked is whether or not this goal is consistent with what the people in these countries want.  European officials have often been accused of being an “elite” that wishes to impose its will upon the people of Europe.  Whether or not the “elites” can pull off this union without too great of a popular upheaval is a question that no one can answer at this moment.

The other alternative is that the financial markets may not allow the “leaders” of Europe to get too much farther  along this path. 

Just today, 10-year Greek bonds were trading to yield almost 34 percent, almost 3,200 basis points above the yield on 10-Year German bonds.  The bonds of the Italian government have been trading at the largest spreads above the German bonds in the euro era.  And the same with the bonds of Portugal. 

If these governments have to pay these kinds of yields on their debt there is no way that they will be able to get their fiscal budgets under control.  If these governments cannot issue bonds or can only issue them to the European Central Bank then the fundamental reality of their insolvency will become more and more of a problem. 

Add to this a European recession, where tax revenues take a further nose-dive, and you only exacerbate the problem.

I should add that “Super Mario” Draghi, the new head of the ECB oversaw a reduction in the central bank’s main policy interest rate in his third day in the new job.  The reason for this reduction is to combat weaknesses being experienced in European economies.

Over-shadowing all of this is the fear of the European officials of financial “contagion”.  The spectre of Lehman Brothers hovers over Europe. The fear is that if these “officials” let Greece go “insolvent” in a “disorderly default” kicking off the use of Credit Default Swaps, that there will be a “spill over” effect moving from the sovereign debt of Italy…and of Spain…and of Portugal.  Then, the concern spreads to the commercial banks in Europe…remember the stress tests conducted on these banks did not include a write down of the sovereign debt on their balance sheets.

The problem Europe is facing is a solvency problem.  This is what European officials have been trying to deny for the last four years.  And, many are still in denial!

Solvency problems do not just go away!  Denying they exist only causes the problems to 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?

The Debt Crisis: It Ain't Over Until It's Over!

The people in charge, both in the United States and Europe, still believe that the problem we are facing is a liquidity problem.  They, therefore, continue to come up with plans that “kick the can down the road a little further” but fail to come up with any solutions that will allow us to move on into the future.

For three years now, I have been arguing that the problem is not a liquidity problem but a solvency problem. 

There is too much debt outstanding in the world!  People, businesses, and governments cannot carry this debt much further, their debt load is unsustainable. 

This is a solvency problem.

Liquidity problems are short-lived problems.  They have to do with the ability of an asset holder to sell assets into the market place at prices that are near to the value of the assets on the balance sheet of the asset holder. 

Liquidity problems arise because the two sides of a market have different information sets.  The sellers of assets have a different set of information than do the buyers.  Because of this, the buyers generally take a little vacation until they have more information about the asset prices and regain sufficient confidence in the amount of information they have to begin trading again.  At this time the liquidity problem goes away.

Central banks (and other government agencies) may intervene in the market providing a floor to asset prices until such time as the buyers start buying again.  This is the “classic” function of the central banks to provide liquidity to the banking system.

Solvency problems are different.  When solvency problems occur, the holders of assets know that the value of their assets are below that recorded on their balance sheets.  They are reluctant to sell the assets or recognize the value of the assets because any write down of the value of the assets would have to be taken against net worth and this might threaten the solvency of the economic unit that holds the underwater asset.

A solvency problem is a “sell” side problem whereas a liquidity problem is a “buy” side problem.

Economic growth or price inflation may help asset prices regain their balance sheet value.  However, in the absence of either of these forces, market prices may remain below the book value of the asset and this threatens the existence of the household, business, or government.

There is too much debt outstanding in the world!  Whoops, I said that before?

Much of the debt is underwater.  Economic growth or inflation are not coming along fast enough or strong enough to “buy out” this underwater situation.  Hence, the threat of insolvency exists for many people, businesses, or governments. 

Sooner or later asset values are going to have to be written down!

Continuing to postpone the day when they are going to be recognized just creates more and more uncertainty.

The fact that the people running the governments in America and Europe can’t come to grips with this just creates even more uncertainty.   

This uncertainty is the biggest factor in the marketplace right now.  With so much uncertainty in the world, market participants jump this way and that way in response to almost any new bit of information being released. 

And, my guess is that this volatility will continue until people recognize the nature of the problem they are facing.  Until the people running things accept the fact that the crisis they are facing is a solvency crisis and do something about it, this uncertainty and volatility will just increase. 

As Yogi Berra said, “It ain’t over ‘til it’s over.”

Until people realize it is a solvency problem and propose solutions to “get it over with”, the situation will continue. 

Now we know what it is like to live in a world without leaders!    

European Choices Continue to Narrow

On May 24, my post stated that debt ultimately leaves you with no good options. (http://seekingalpha.com/article/271651-debt-ultimately-leaves-you-with-no-good-options)

Martin Wolf in the Financial Times reduces the choices now available to the European Union to two: “The eurozone confronts a choice between two intolerable options: either default and partial dissolution or open-ended official support.  The existence of this choice proves that an enduring union will at the very least need deeper financial integration and greater fiscal support than was originally envisaged.” (See “Intolerable choices for the eurozone,” http://www.ft.com/intl/cms/s/0/1a61825a-8bb7-11e0-a725-00144feab49a.html#axzz1O1hWLIwZ.)

The “original” design of the union, Wolf contends, is for all purposes, dead.  That could only be achieved by removing some of the countries now in the union.

To achieve the second of the two choices he mentions above is going to require a contortionist.  First, Wolf argues, European banks cannot remain national.  Whoa!  Second, he argues that the current system of European System of Central Banks (ESCB) must be eclipsed by a “sufficiently large public fund” that manage “cross-border” financial crisis.  Double Whoa!  And, third, the finance of the “weak countries” must be taken out of the market for years, “even a decade.”  Whoa! Whoa! Whoa!  What would result would be something Wolf calls a “support union.”

This certainly is “deeper financial integration and greater fiscal support than was originally envisaged” by the creators of the European Union. 

The question is, “could this ‘support union’ ever be achieved short of all countries in the eurozone coming under a common government. 

But, even so, I do not see that this “solution” reflects any change in the underlying economic philosophy of the current leaders of Europe concerning the propagation of the credit inflation that the leaders of Europe have perpetrated for the last fifty years or so.  With no basic change in philosophy, I cannot see how this second choice achieves anything except the postponement of the “day of reckoning” in which the range of options available to the European Union drops to one. 

Does this mean that the European Union will eventually be providing investors with a “sure-fire”, riskless investment similar to the one given George Soros by the British government in 1992?

It seems to me to be a real possibility.

John Plender, who also writes for the Financial Times, argues that the European Union can “Muddle along for now; but a Greek default is inevitable.” (http://www.ft.com/intl/cms/s/0/21922f88-8ba4-11e0-a725-00144feab49a.html#axzz1O1hWLIwZ)

Plender writes that the burden of the policies imposed upon the Greek government by the IMF will only produce “great demands on the population” which is already enduring a deep recession.  Greek workers will have to ‘endure wage deflation” so as to restore the competitiveness of the Greek economy and the privatization program being discussed will put the transfer of Greek assets in the hands of an external agent. 

However, the other option, debt restructuring, is not currently acceptable to Plender, either.

He sees it as the only real choice for the time being: “If a package is agreed in June, which seems probable, the challenge will be to bring Greece to a primary budget surplus...” and “at that point, it would be sensible for Greece to bow out of the monetary union and take advantage of currency devaluation.” 

He goes on, “For that to work, though, European banks would need in the interim to have bolstered their capital.  And the execution risks are phenomenal.  This is policymaking on a wing and a prayer.”

The leaders of the United States need to absorb this lesson.  No matter that the United States is richer and deeper in resources than Europe.  No matter that the United States is bigger.  No matter that the United States has the reserve currency of the world.  The debt burden catches up with you.  As, as the debt burden is catching up with you…your options become fewer in number and they become less and less desirable.

The United States is not exempt from this outcome…unless it changes course before all the options go away. 

In all financial crises, the initial response of the central bank and the government must be to provide sufficient liquidity to keep the banks open and to avoid cumulative downturns in companies and the economy.  Bailouts and quantitative easing may be appropriate…for the short run.

But, there is a difference I have written about many times, between a “liquidity” crisis and a “solvency” crisis.  A liquidity crisis is a short-run phenomenon, which gets an economy over the short-run shock of a financial event. 

The longer-run problem is the solvency problem.  And, solvency is tied up with debt…debt loads that must be worked off.  And, working off debt loads takes time…lots of time.  And, working off debt loads cannot really be achieved by flooding the financial markets with more credit and more liquidity.  This is a “postponing” strategy.

To solve the “debt” problem and to prevent it occurring again in the future, leaders must change their basic economic philosophy about the creation of debt.  Credit inflation always leads to debt problems, and further credit inflation aimed at solving debt problems only leads to diminishing options and eventual collapse.  Insolvency cannot be solved by more debt. 

It should be obvious that more debt is not the solution to a problem if the options one has decline in number and the desirability of the options also declines.  To continue to pile on more and more debt is like the person in the hole, digging the hole deeper and deeper in an effort to get out of the hole. 

Europe is finding this out.  It, apparently, must be the case that the United States will have to learn this lesson as well.

If anything is going to give the emerging countries of the world the chance to close the gap on the developed countries it is a continuance of the credit inflation policies of Europe and America.  The ironic thing is that the shoe used to be on the other foot…the developed countries had control over their credit inflation whereas the emerging nations were reliant on excessive amounts of credit inflation.  This relative performance was given as an important reason why the developing countries could not hope to catch up with the developed world. 

China is catching up with the west faster than most analysts believed it would.  So with India…and Brazil….  If the European Union…and the United States…continue to push the edge of debt creation and continue to shrink their options, the tipping point  to this emerging world might occur sooner than most of us imagine.     

Making the Same Mistakes All Over Again

Policy makers continue to base their economic and monetary policies on the contention that the problems “out there” are liquidity problems…not solvency problems.  This focus is highlighted in three articles in the morning newspapers. 

The most direct treatment of this is that of Desmond Lachman of the American Enterprise Institute, “The IMF is making the same mistake all over again”: http://www.ft.com/intl/cms/s/0/b2f38dd2-8195-11e0-8a54-00144feabdc0.html#axzz1Mnj4kmN5.

Mr. Lachman makes the argument that the policies followed by Dominique Strauss-Kahn and the IMF with respect to the sovereign debt crisis in Europe is that they have treated “the crisis as a matter of liquidity rather than solvency…” The consequence of this approach is that this philosophy has “led the IMF to eschew any notion of debt restructuring or exiting from the euro, as a solution to the periphery’s public sector and external imbalance problems.”

In another article, Scott Minerd, chief investment office at Guggenheim Partners, argues that “There will Be More Monetary Elixir After the End of QE2”: http://www.ft.com/intl/cms/s/0/96ec2b02-8146-11e0-9360-00144feabdc0.html#axzz1Mnj4kmN5. 

The motivation for QE3? “The same motivation for QE1 and QE2: namely, stimulating growth to help employment recover…Looking ahead, the expiration of tax cuts in 2011 and a government deficit reduction program will present real headwinds to growth.  Layer on top of that the fact that 2012-13 would probably be the end of the expansionary portion of the business cycle, and what is left is a recipe for a serious economic slowdown or possibly even another recession.”

And, finally, there is Alan Blinder’s opinion piece “The Debt Ceiling Fiasco,” http://professional.wsj.com/article/SB10001424052748703421204576329374000372118.html?mod=ITP_opinion_0&mg=reno-wsj.  To stay within the debt ceiling, Mr. Blinder argues, the government must immediately drop it expenditures by 40%. “Suppose the federal government actually does reduce its expenditures by 40% overnight…That’s an enormous fiscal contraction for any economy to withstand, never mind one in a sluggish recovery with 9% unemployment.” 

“Second, markets now assign essentially zero probability to the U. S. losing its fiscal mind.”  That is, the credit risk built into U. S. government securities is zero and the inflationary expectations that are now built into long-term interest rates are also roughly zero. 

And, what has allowed the United States to get into this position?  Well, “The full faith and credit of the United States has been as good as gold—no one has better credit.”  The federal government has been allowed to increase its debt at an annual compound rate of growth of about 8%, year-after-year for the last fifty years.  “Should the view take hold that threats to default are now a permissible weapon of political combat in the world’s greatest democracy, U. S. government debt will lose its exalted status as the safest asset money can buy—with unpleasant consequences for the dollar and interest rates.” 

That is, the United States government will lose its unlimited privilege to flood the world with debt and liquidity at little or no consequence to itself.

  

All three of these articles are concerned with the view that the basic problems of the economy have to do with liquidity…and not solvency.

I have argued for several years now in this blog that this has been a major problem in the analysis of the economy and the current financial difficulties we are now going through.   Right from the start of the current unpleasantness, the problem has been diagnosed as a liquidity problem and not a solvency problem.  The TARP program was designed to give liquidity to certain “troubled” assets on the balance sheets of various financial institutions.  QE1 was designed to provide liquidity to banking and financial markets.  So was QE2.  So were the bailout programs, both in the United States and Europe. 

But, liquidity problems have historically been considered to be “short-term” problems.  They have to do with whether or not an asset can be sold into the current market in real time without having to take a discount from market on the price at which it is sold.  In the past, a liquidity crisis should be over, given the appropriate monetary policy, in a matter of weeks, six- to eight-weeks at most. 

Liquidity problems did not and do not exist for three or four years!

Yet, this is what our policymakers are claiming.  They are claiming we are still in the midst of a liquidity crisis and so we must tailor our monetary and fiscal policies to deal with the lack of liquidity in financial markets.

The reason for this approach?  The models that these policymakers and their advisors are using only include debt in a cursory fashion.  The structure of conventional macroeconomic models over the past fifty years has not included debt in any meaningful way and so the existence of large amounts of debt has not really been relevant for analysis.  And, consequentially, the solvency issue does not surface.  

The focus then is placed on the “liquidity” issue, the desire of economic units to want to hold onto cash assets.  If banks and other economic units desire to hold onto cash rather than lend the funds to others or to spend the funds themselves then the economic will falter and economic growth will be tepid at best leading to high rates of unemployment.  This is a “liquidity trap.”

The solution to this problem is to flood the banking and financial markets with so much liquidity that people just can’t hold on to any more liquidity and so either begin to lend the funds or begin to go out and spend the funds themselves.  This seems to be the current thrust of economic policy, at the Federal Reserve…and throughout the world. 

But, what if a large number of economic units are insolvent.  In such cases, even with large amounts of liquidity on their balance sheets, they will not lend, or will not borrow any more, or will not go out and spend this excess liquidity because of their balance sheet problems.  What about homeowners who find that they cannot pay their loans or find that the value of their home is less than what they have borrowed?   What about banks who hold large amounts of delinquent residential mortgages or commercial real estate loans on their balance sheets?  What about businesses that owe way too much debt and have little or no current cash flows to cover the debt?  What about State and Local governments that have obligations far in excess of their current revenues?  And, what about sovereign nations who face similar problems?

If the problems are ones of solvency, liquidity is going to do very little for those who have a negative net worth other than postpone the day of reckoning. 

This is the problem of debt.  America (and Europe) has done a very good job over the past fifty years of inflating people, organizations, and governments, out of their increasing debt burdens.  The inflation of housing prices was a wonderful “piggy bank” for the middle class during this time period.  Maybe, the United States government went a little overboard in trying to push down this “piggy bank” to more and more people who even with the inflation could not support the debt.  The credit inflation did wonders for building up the salaries and pension funds of state and local governments.  Unfortunately, history shows over and over again that there are limits to the amount of debt people can carry.  But this is a solvency problem not a liquidity problem.

Finally, a country whose “faith and credit “ is as “good as gold” can abuse that privilege.  This, too, is a solvency problem and not a credit problem.  And, as we are finding out…once again…solvency problems cannot be postponed forever.      

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!

Bailouts or Defaults?

This question is the defining question in finance and economics today.

Yet, the predominant approach used in macroeconomic policymaking does not include debt and the possibility of defaults in its model. So, the policy answer is obvious. The policy makers must “bailout” individuals, banks and businesses, and governments.

Well, forget individuals, let them default!

But, we need to save banks and businesses…and governments. Provide them with cash grants. Provide them with excessive amounts of liquidity. Defaults of banks and businesses and governments are not a part of our theoretical picture of the world.

Look through the book “”Ben Bernanke’s Fed” written by Ethan Harris, a former research officer at the Federal Reserve Bank of New York and published by Harvard Business in 2008. Chapter 2 is called “How the World Works: a Brief Course in Macroeconomics.” Here we get a picture of the basic model the Federal Reserve uses in its analysis of the state of the world.

“Getting into the head of the Fed requires a basic primer on how the economy and monetary policy works, Harris writes, “Nonetheless, a relatively simple framework underlies much of the discussion at central banks today.”

The foundation of the Fed’s analysis, according to Harris is something called “the Phillips Curve” which supposedly captures the tradeoff between inflation and unemployment. This, of course, incorporates the two government policy objectives written into law in 1978 and affectionately referred to as the Humphrey-Hawkins Full Employment Act.

Harris continues that “Bernanke is a proponent of the ‘financial accelerator model,’” which brings the credit market into the picture. “The idea that strong financial and credit conditions and a strong economy can reinforce each other to create economic booms (and that weak conditions can interact to create busts). During booms, both firms and households have stronger incomes and their assets are worth more, encouraging relaxed lending rules. Easy lending makes the economy even stronger and that, in turn encourages even easier lending standards.”

In other words, Bernanke, and people within the Fed, believe that pumping credit into the economy produces “stronger incomes” and “assets are worth more.” Thus there is a wealth effect. But, as long as inflation is “in check” there will be no problems on the “real” side of the economy and unemployment will be reduced. BINGO!

However, within this view of the world, there are no problems with debt loads, foreclosures, and bankruptcies. Piece of cake…just throw more spaghetti against the wall! (See “Bernanke’s Next Round of Spaghetti Tossing”: http://seekingalpha.com/article/233773-bernanke-s-next-round-of-spaghetti-tossing.)

Remember, Keynes won and Irving Fisher lost the battle for the hearts and minds of the economics profession. To resolve economic downturns just create more and more debt. Forget about the fact that debt has to be paid off. Just toss more liquidity into the markets.

Defaults are not considered in the model because the assumption is that the problem is one of liquidity, not solvency. (See http://seekingalpha.com/article/235712-it-s-a-solvency-problem-not-a-liquidity-problem.)

Therefore, individuals, banks and businesses, and governments can issue all the debt they want and the Federal Reserve, the European Central Bank, the United States government, or the European Union can step in and solve any discomforting situations that arise through bailouts and loose monetary policy.

However, debt does matter! And, defaults should not just fall on individuals and families. Foreclosures and bankruptcies are very common into the world today.

Yet, governments continue to try and sweep solvency issues “under-the-rug” when it comes to banks and businesses…and to governments.

The only time we really hear about problems of this sort within these institutions is the weekly list of bank closings overseen by the FDIC. But, this information tends to end up on the fifth or sixth page of the business section of the newspaper and rarely, if ever, gets into the radio or television news. Maybe this news, week-after-week, is too boring. However, the FDIC is closing three to four banks a week and they have been doing this for more than a year. Still there are nearly 900 banks on the FDICs list of problem banks, and this does not include a thousand or more banks that are sliding into this problem bank list but have not reached the “statistical” test of being on the list.

This has to be the case within the sector of non-financial businesses. How many small- to medium-sized firms are still on the brink of insolvency? My guess is…a lot. It seems like every week there are more and more empty spaces in the strip malls and other business buildings.

And, then there are the state and local governments. The municipal bond market is in a mess!

In the banking week ending November 19, 2010, the Federal Reserve reports that the average yield on State and Local bonds was 4.72 percent. In the same week 30-year U. S. Treasury bonds yielded 4.30 percent. And, State and Local bonds are not taxed.

WHEN HAVE YOU SEEN AN INTEREST RATE RELATIONSHIP LIKE THIS BEFORE?

Now we get into sovereign debt. Let me just start listing the problems: Greece, Ireland, Portugal, Spain, Italy, France…

Need I say more?

And, what about the United States? On September 30, 2009, the Gross Federal debt outstanding was almost $12 trillion; the Federal debt held by the public was about $8 trillion on that date. And, what if the Gross Federal debt more than doubles over the next ten years as I have been predicting? How acceptable will the debt of the United States government be in the world?

DEBT MATTERS!

Why isn’t debt included in the models the policy makers use? We can’t continue to operate under the assumption that debt doesn’t matter and that all we need to do, policy wise, is throw more spaghetti against the wall.

People, other than individuals, families, small businesses, and small banks, must come to realize that there is a penalty for taking on too much debt. That penalty is default followed by bringing one’s books under control. People must learn that the solution to issuing debt is not issuing more debt!

It's A Solvency Problem, Not A Liquidity Problem!

Discussion is swirling around the Fed’s new quantitative easing program, QE2.

The wisest comment I have heard up to this point about the QE2 exercise is the quote attributed to the economist Allan Meltzer at a recent celebration on Jekyll Island, Georgia commemorating the clandestine meetings that resulted in the creation of the Federal Reserve System 100 years ago.

Mr. Meltzer is quoted as saying, “There isn’t a liquidity problem.” (http://www.nytimes.com/2010/11/08/business/economy/08fed.html?ref=business)

But, one of the problems of this whole exercise is that almost the whole effort to reverse the financial meltdown and the economic slowdown has been attributed to the fact that many of our governmental leaders, Mr. Geithner and Mr. Bernanke, have seen the crisis as a “liquidity” problem. That is, to the problem that financial institutions can’t sell their assets.

And, these leaders continue to assess the situation as a “liquidity” problem. Some of us, however, see the continuing problem as a “solvency” issue. There is a world of difference between the two.

The original response of the government to the financial crisis was to create a program, the Troubled Asset Relief Program (TARP), which would allow the Treasury “to purchase illiquid, difficult-to-value assets from banks and other financial institutions.” This was enacted by Congress on October 3, 2008.

On October 14, 2008, Secretary of the Treasury Paulson and President Bush announced the first revisions to the program. Without going into the revisions more deeply, the Treasury announced their intention to buy senior preferred stock and warrants in the nine largest American banks. For there on, the effort “to purchase illiquid, difficult-to-value assets” all but completely disappeared.

Yet, the leadership in Washington, D. C. continued to speak as if the whole financial crisis was just a “liquidity crisis”.

I have addressed this issue many times before in my writings. But, let me use the words of Richard Bookstaber in his book “Demon of Our Own Design”: “A liquidity crisis is generally related to financial institutions and not to nonfinancial institutions. This is because financial institutions have assets on their balance sheets that have ‘liquidity’. The very ability to liquidate is at the root of the liquidity crisis.”

In a liquidity crisis there is the problem of “asymmetric information”. This problem occurs where one party to a potential transaction has all or most of the information about the value of an asset and other parties do not have the same information.

A liquidity event is most often set off with a shock to the market. In the case of Long Term Capital Management, an arbitrage situation was interrupted by a default by Russia on outstanding bonds. In the case of the Penn Central Crisis, the Penn Central railroad company declared bankruptcy when it had been thought to be a going concern. The buy-side of the market goes away because investors have little or no information.

Exacerbating this situation, Bookstaber states, is the fact that, very often, market participants can identify the seller that MUST sell its assets and this means that the buy side can be even more selective as to when buyers want to enter the market or not. In the recent problem experienced by the French bank, Society General, the market knew who was having problems and that they had to sell a substantial amount of assets to unwind certain transactions on their books.

In many cases associated with a liquidity crisis, without the intervention of the central bank, there is no reason for buyers to re-enter the market until more information becomes available to them. The bottom line to this analysis is that a “liquidity crisis” is a short term affair that requires immediate central bank action. Funds must be made available to the financial markets so that market participants can feel and believe that a “bottom” is reached in terms of the decline in asset values. This is where the Federal Reserves’ “Lender of Last Resort” function comes into play.

The “solvency crisis” is not usually such an immediate problem. Solvency issues can play a part in the liquidity crisis (note the longer term outcomes relating to Long Term Capital Management, Bear Stearns, and Lehman Brothers) but the real solvency crisis relates to a longer period of time and has to do with cleaning up balance sheets and raising new capital. It is not just an issue of “liquidating” an asset in the market place. The value of assets can deteriorate either due to changes in market valuations or due to the financial condition of borrowers. It is a question as to the ability of someone to fully repay another.

A solvency crisis is longer term than a liquidity crisis because the financial institutions need to proceed in an orderly way to work out the situation they face with respect to the value of the assets on their balance sheets. But, this “working out” process may take six months or a year to resolve. The working out of assets requires a substantial amount of time and attention from the managements of financial institutions. Thus, to get back to business as usual requires that a management get the problems behind them so that they can concentrate on what they really should be doing…running a business, not “working out” loans.

If a recession is not to broad or deep then some kind of governmental stimulus can “buy the banks” out of their solvency problems by means of inflation. If the problems have existed for some period of time and are also connected with too much risk taking and excessive amounts of financial leverage, the problems may not be so easily overcome. And, in these latter cases, fiscal and monetary stimulus may not be able to accomplish much in helping financial institutions “get back to business.” Inflation doesn’t help a lot.

How, then, should we interpret the current “crisis”? Well, do you believe that our main problem is still “liquidity” or is our main problem “solvency”?

For those that read this blog regularly, they know that I believe that the “liquidity crisis” occurred a long time ago, in the fall of 2008. I believe that we have been dealing with a “solvency” crisis since then. And, I believe that we are still going through this “solvency” crisis.

If you look at my post of November 8, 2010 you can see that I believe that the “solvency” crisis still has a ways to run. (http://seekingalpha.com/article/235487-the-banking-system-seems-to-be-dividing-large-vs-small-commercial-banks) If you believe as I do that we are still in the midst of a solvency crisis then you also should believe that further additional fiscal or monetary stimulus will have little or no effect on the banking system or the economy. Financial institutions are still “working out” their bad assets and they will not really want to return to “business-as-usual” until they can devote their full attention to making loans.

It is a hard thing to do to run a financial institution. I have been involved in the running of three of them. In order to be successful you need to give your complete attention to running the business and not to “working out loans” which is very demanding and very time consuming. A “liquidity crisis” does not draw this kind of long-time attention.