Debt Deflation: Is It a Possibility?

There is still too much debt around.  The fact that there is too much debt around is a result of fifty years of credit inflation and financial innovation that resulted from it. 

The concern now as financial deleveraging takes place is whether or not we will go into a spiral of debt deflation.

The headlines currently are coming out of Europe.  Austerity plans are forthcoming everywhere.  Sovereign debt is the crowning issue…but there is growing concerns over corporate debt. 

And, with the cutback in government spending, the cutback in business spending, and the cutback in personal spending people are getting gloomier and gloomier about a new, European recession.  The clouds seem to be on the horizon.

But, a spillover of a European recession would be another American recession.  The United States depends upon the exports that it sells to Europe.  If Europe goes into a recession then the probability of the United States going into another recession increases. 

The problem is that America still has lots of problems on its own.  Just note some of the issues that have recently been floating around.

For one, corporate bankruptcies still are taking place on a regular basis.  Just recently we have Solyndra going bankrupt which brought attention to the solar industry area as a source of more financial difficulties.  Then we had Syms and its Filene’s Basement go into bankruptcy.  And, then who could forget MF Global.  And, there are many more still on the edge of considering such action…one of them possibly being Kodak.

And, what about the financially tenuous position of state and local governments?  Just Wednesday, Jefferson County, Alabama filed for the largest municipal bankruptcy in United States history.  And, Harrisburg, Pennsylvania was just taken over by the state of Pennsylvania because of its financial problems.  Now we learn that Flint, Michigan is on the verge of insolvency where the state government will takeover there.  And, what about Detroit, Michigan?  Again, the state is about to take over this financially distressed city.  And, there are many more still cities and states still on the edge of financial ruin with underfunded pension funds and so on.

Then we hear that mortgage problem is still not over and that banks are facing further write-downs of the mortgages on their books.   The latest case is that of HSBC which has garnered all sorts of attention over the past few days.   HSBC is still paying for its move into subprime loans earlier.  But, it is also facing a relatively new thing…a customer taking a mortgage payment “holiday.”  Given the political climate financial institutions are finding that people feel that they have very little to lose if they just stop payments on their mortgages.  Banks are finding it very difficult to foreclose on delinquent properties these days and that people fear little retribution if they just quit on any kind of payment to the bank. 

“Customers realized that if they stop paying, there’s very little we (HSBC) oar other banks can do.  This is an emerging trend.” (http://dealbook.nytimes.com/2011/11/09/hsbc-warns-of-economic-challanges-even-as-profit-rises-66/?scp=3&sq=julia%20werdigier&st=Search)

The commercial real estate market is not in very good shape either.  Although commercial real estate is picking up in some areas of the country, a look at the commercial banking data indicates that loans on commercial real estate is the item that is declining the fastest on the balance sheets of commercial banks…especially those that are smaller than the largest 25 in the country. 

Of course, these problems come through when we consider the condition of the banking system.  The commercial banking industry is still not very healthy yet and the prospect of it getting much better through 2012 is not that great.  Many small- and medium-sized banks are still really suffering. (http://seekingalpha.com/article/303929-business-lending-is-increasing-especially-at-the-largest-u-s-banks)

The Federal Reserve can’t really afford to tighten up at all because of the weakness that still exists within much of the banking system.  (See my post, “Post QE2 Federal Reserve Watch: Part 3” of November 7: http://maseportfolio.blogspot.com/. ) And, the FDIC still continues to close two banks per week and this does not include any banks that have been acquired and absorbed into other banks within the system.

The general desire within the economies of both Europe and the United States is to continue to shed debt…to de-leverage.  But, if this de-leveraging takes place at the same time that the economies of Europe and the United States go into another recession, the situation can become a cumulative one.  That is, de-leveraging can contribute to slower economic growth or even declining growth, which leads to more de-leveraging, which leads to even slower economic growth and so on.

This is a debt deflation.

We are not there yet, but, it seems as if we are edging closer to the precipice. 

The problem seems to be that this situation cannot be undone by fiscal stimulus.  If people want to de-leverage they will de-leverage.  Adding more debt to the situation, even government debt created through more government spending, does not help the situation as the “fundamentalist” Keynesian would like to think.  More debt implies more taxes in the future, which just adds that much more of a burden to the person trying to de-leverage.  And, maybe, this just adds incentives to the equation leading the individual to take a debt payment “holiday”.

But, more debt write-downs can cause more debt write-downs.  And, this is the problem of a debt deflation.  It can become cumulative.  And, this is something the Keynesian models cannot pick up.

And, writing down debt for some people just means that someone else has to “eat” the loss elsewhere…and then someone else has to take a loss…and so on and so forth.  The consequences of debt do not just go away. 

The dilemma: if fiscal spending is not an option and monetary policy is basically “spent”, what is there left to do?  Not much?  Is the problem of creating a situation where there is too much debt outstanding that you just have to wait until people work off the excess debt?

This is a conclusion that most people don’t like.

European Banks Getting Around Capital Rules

Bloomberg posted an article yesterday titled “Financial Alchemy Foils Capital Rules in Europe.” (http://www.bloomberg.com/news/2011-11-09/financial-alchemy-undercuts-capital-regime-as-european-banks-redefine-risk.html) Commercial banks are up to their old tricks again.

“Banks in Europe are undercutting regulators’ demands that they boost capital by declaring assets they hold less risky today than they were yesterday.”

The issue has to do with “risk-weightings”, “the probability of default lenders assign to loans, mortgages and derivatives.”  The technical label: risk-weighted asset optimization.”

The issue has to do with how banks define how risky an asset is. 

Whoops, the whole problem depends on what the definition of is, is!

Regulators have a very tough job…and they always have had a very tough job.  Rules and regulations are put in place.  And, financial institutions have the time and the incentive to find ways to get around them.  So, financial institutions take the time and spend the resources to get around the rules and regulations.

This is just Economics 101: if there is an incentive for someone to do something to “get around” the rules…someone will find a way to “get around” the rules. 

I had direct experience of this when I was working in the Federal Reserve System around the time that a wonderful financial innovation came into existence…the Eurodollar deposit. 

The Eurodollar deposit was one of the inventions that allowed commercial banks to become “liability managers” rather than just “asset managers”.  These financial innovations allowed commercial banks, especially the larger ones, to get around the geographic restrictions faced by American banks at the time, and become fully competitive with their less restricted global competition. 

The word inside the Fed at this time was that the Fed was six months behind the banks.  That is, the Federal Reserve would institute some rules or regulations to constrain the use of these Eurodollar deposits and the commercial banks would then find ways to get around them.  However, it would take the Fed about six months to find out what the commercial banks were doing and institute some new rules or regulations to close the escape hatch.  And, the “cat and mouse” game would be played once more.

In that “primitive” time, I gained an appreciation of the inventiveness of the private sector and the frustration faced by the regulators.  The only time the rules and regulations really were strictly adhered to was in the case that the incentives for circumventing the rules and regulations were small enough so that the banks would not put out the time or resources to innovate.

Today, the sophistication and complexity of the banking system is such that regulators are at an even greater disadvantage than they were back in the “good old days.”  And, the primary reason that the bankers are some much further ahead is information technology. 

Over the last decade, I have constantly put forward the idea that finance is nothing more than information.  The whole basis for the field of financial engineering is that finance is information…and information can be cut up and re-arranged just about any way a person might find it useful to cut it up and re-arrange it.  In other words, “slicing and dicing” in a natural characteristic of information technology…that is, of financial practice.

Thus, I have been arguing for more than two years that any efforts to put new rules and regulations on financial institutions to prevent the financial crisis of 2008-2009 from occurring again are just an exercise in futility.  The Dodd-Frank financial reform act was “Dead On Arrival”…especially since most of the rules and regulations contained in the act were not even written at the time.

In fact, I would call the efforts of the legislatures and regulators in the eurozone and in the United States to control the financial industry more closely as the “regulatory employment effort of 2011”…or whatever.  In order to have any chance to know what is going on in the banking system the eurozone and the United States has had to hire hundreds if not thousands of new employees to write the rules and regulations, to interpret the rules and regulations, to enforce the rules and regulations, and to re-write the rules and regulations as it is observed that the rules and regulations are not working as expected.

And, financial institutions will still be out ahead of the politicians and the regulators.

The financial industry is going to be what it is going to be.  One thing that needs to be avoided, in my mind, is the environment of credit inflation that has existed for the last fifty years.  The environment of credit inflation just exacerbates the speed at which financial innovation takes place putting even more pressure on the government and the regulators to “keep up” and stay on top of events. 

And, what can be done?  I have been a constant advocate for increased openness and transparency in financial reporting.  Stop this hiding of assets.  Stop the switching of assets from one class to another.  Mark-to-market assets.  And so on and so on. 

Furthermore, incorporate market information into the early warning system of financial institutions. I have written about this many times before.  One such market-based early warning idea proposed by Oliver Hart of Harvard University and Luigi Zingales of the University of Chicago is based on Credit Default Swaps.  (See http://seekingalpha.com/article/207293-banks-disclosure-and-reform.) 

In my view, finance has gotten so complex and sophisticated that government regulation of the financial industry, as it is done today, is something of a lost cause.  The fact that politicians pass bills and acts to regulate the financial industry and can’t even initially write up the specific provisions of the rules and regulations and then when they do get written up it takes 3,000 pages to define the rule or regulation, is evidence of the futility of the exercise. 

Greater disclosure and market-based early warning systems seem to me to be the only real chance we have to monitor these financial institutions and then have some influence over the course of events. 

Until the politicians change their tune, however, we are going to continue to work in a financial world that is opaque and “out-ot-control.”   

Post QE2 Federal Resserve Watch: Part 3

I didn’t post a “Post QE2 Federal Reserve Watch” last month because I was on vacation.  You have to go back to September 12 to get Part 2 of the “Post QE2” watch. (http://seekingalpha.com/article/292986-post-qe2-federal-reserve-watch-not-much-banking-system-activity)

Early in September, the excess reserves in the banking system totaled around $1,570 billion.  At the beginning of November, excess reserves were about $1,515 billion. 

A $55 billion drop in excess reserves might seem huge, especially when total excess reserves averaged around $2.0 billion, but in these days decreases or increases of this size don’t really seem to amount to a lot.

Federal Reserve policy for the past two years has basically been to throw all the “spaghetti” it can against the wall and see what sticks.  So far, very little of the “spaghetti” has stuck as total bank loans have not increased that much over the past year although business lending has picked up some at the larger banks (http://seekingalpha.com/article/303929-business-lending-is-increasing-especially-at-the-largest-u-s-banks)

On the money stock side, however, growth has picked up substantially over the past six months or so.  The M1 money stock growth (year-over-year) has risen from just over 10 percent six months ago to more than 20 percent in recent weeks.  

The growth rate of the non-M1 component of the M2 money stock measure also accelerated during this time period, more than doubling from around a 3 percent growth rate in early April to well more than 7 percent in late October. 

The reason for this acceleration seems to be a pick up in the movement from low interest bearing short-term assets like retail money funds and institutional money funds to bank deposits and a pick up in the demand for currency in circulation.  Movements of funds into currency holdings continue to rise at a rapid rate.

The movement of funds from other short-term, interest bearing accounts can be explained by the extraordinarily low interest rates being maintained by the Fed and because of the financial stress being felt by so many families and businesses who want to keep their funds in highly liquid form.  A number of large corporations are also holding onto large cash balances for purposes of acquisitions or their own stock repurchases. 

None of these actions contribute to bank loan growth or economic expansion.  All of these reasons are anticipatory of the need to have liquid assets “near-at-hand” in order to transact.  These are not signs of a real healthy economy.

As far as the banking sector is concerned, the increase in demand and time deposits has resulted in a need within banks to hold more required reserves.  Hence, over the past six months the required reserves of commercial banks have risen $4.5 billion to $96.4 billion from $91.9 billion in early September. 

   

Over the past six months, the required reserves at commercial banks have risen by just under $19 billion. 

This increase in required reserves seems to be the biggest operating factor that the Federal Reserve has had to deal with over the past six months.  Thus, although excess reserves at commercial banks have dropped over the past three months, they have risen over the past six months. 

The item on the Federal Reserve’s statement of “Factors Affecting Reserve Balances of Depository Institutions” (Fed release H.4.1) that is most closely associated with excess reserves in the banking system is called “Reserve balances with Federal Reserve Banks.”  This figure has risen by about $46 billion from May 4, 2011 to November 2, 2011.  The increase came about through a rise of $102 billion in “Total factors supplying reserve funds” and a $56 billion increase in “Total factors, other than reserve balances, absorbing reserve balances.”  The $46 billion is the difference between these latter two amounts. 

The $102 billion increase in factors supplying reserve funds came primarily from Federal Reserve purchases of U. S. Treasury securities, which exceeded the run-off from the Fed’s portfolio of Federal Agency securities, Mortgage-backed securities and the decline in other operating factors that supply reserves to the banking system.

There are two interesting factors that absorbed bank reserves during this time period.  The first interesting factor is the rise in “Currency in Circulation”, which increased by roughly $33 billion from May 4 to November 3.  This movement is a drain on bank reserves and hence causes reserves at commercial banks to decline.   This increase is interesting because currency in circulation usually increases during the summer months due to vacations but decreases in the fall.  Over the past three months, from August 3 to November 3, currency in circulation actually increased by more than $15 billion.  This just adds strength to the argument made above for the increase in currency outstanding.

The other interesting factor is that the Fed’s reverse repurchase agreements to foreign official and international accounts increased by almost $68 billion over the past six months, by $56 billion over just the last three.  This increase also reduces bank reserves. 

Here the Federal Reserve is selling securities under an agreement to repurchase the securities at some stated future time period. These are international transactions and the Fed uses U. S. Treasury securities, federal agency debt, and mortgage-backed securities as collateral in the transactions.  The timing of these transactions are interesting because of the events that have taken place in Europe of the last six months. 

My summary of these movements remains much the same as in previous months.  The Federal Reserve has done just about all it can at the present time to preserve the banking system and allow the FDIC to close as many banks as it has to without major disruption. 

The Fed has thrown just about everything it can into the financial system.  Given the economic weakness in the housing market, the desire of families and businesses to continue to reduce the financial leverage on their balance sheets, and the high level of underemployment in the economy, the demand for loans from commercial banks is very weak, so total bank loans are remaining relatively constant.  A further indication of weakness is the continued movement of wealth into currency holdings and bank deposits, a movement that has resulted in the rapid growth of the money stock measures.  Throwing more “spaghetti” against the wall at this time would not change the behavior of these people or businesses to any degree. 

The Fed may just have to wait until the deleveraging is completed before it sees people starting to borrow again or to hire new workers.  That is, unless the situation in Europe explodes and further ‘search and rescue” missions are needed to preserve western civilization.         

Government Incentives Do Matter--Part II: US Home Ownership

Just saw another example of the role that government incentives play within an economy. 

On Friday, I took off on the interesting essay by Financial Times columnist Gillian Tett about the impacts that the regulatory declaration that European sovereign debt was “risk free” had on the European sovereign debt crisis. (http://seekingalpha.com/article/305431-government-incentives-do-matter-the-european-case)

The conclusion presented by Ms. Tett was that declaring the debt of a government as “risk free” results in too much government debt being issued because it is so cheap to issue it.  Continuing to maintain the “risk free” tag after it becomes obvious that the debt is no longer “risk free” just exacerbates the situation.  Too much sovereign debt gets issued and a financial crisis can result.

Within that post I pointed to another situation in which government incentives produce a result that inconsistent with the original goal of the economy.  I argued that the credit inflation policies followed by many western governments over the past fifty years to keep people employed and provide a buoyant economy so that the income/wealth distribution of the country can stay more balanced or at least not deteriorate has had the exact opposite effect of making the income/wealth distribution more skewed toward the wealthy end of the spectrum.

Today in the Financial Times there is a major article on the United States housing market. (http://www.ft.com/intl/cms/s/0/a05d2a58-0565-11e1-a429-00144feabdc0.html#axzz1d1bsytCm)

Included within this article is more evidence of how government incentives, created with the best intentions, have produced results that are inconsistent with the original goals and objectives of the government’s policy. 

The specific programs at issue in this article are those US government programs intended to bring home ownership to more and more Americans.  These governmental efforts were an integral part of the credit inflation program of the United States government over the past fifty years, in both Republican and Democratic administrations.

The housing programs of the American government appeared to be very successful for a long period of time and with the underlying credit inflation policies in place, it seemed as if this success would continue on unabated.  Not only could people own their own home, home ownership seemed to be the “piggy bank” that accounted most of the wealth increases being experienced by the middle class. 

This was income/wealth re-distribution at its best because it was achieved without any overt or explicit governmental policies aimed a achieving such a re-distribution!

The numbers: in 1960, approximately 62.0 percent of Americans owned their own home; in 2004 69.4 of all Americans owed their own homes.  And, it looked like this number would continue to rise for the foreseeable future. 

The government programs worked!

Unfortunately, the current number is slightly more than 66.0 percent. 

And, analysts at Morgan Stanley argue that the true number is around 60.0 percent because many delinquent borrowers who say they are “merely renting” homes will soon be forced to give these homes up.  Hence, the number of actual homeowners in the country is substantially over-estimated. 

Behind this argument is the fact that about 20.0 percent of homeowners are either unable or unwilling to make their mortgage payments. This is consistent with those analysts who predict that one in five borrowers will default in the near future.  This problem only places more pressure on the prices of homes to continue to fall. 

The actual rate of home ownership in the United States could drop below 61.0 percent in the next three- to five-years.  This estimate is attributed to Karen Weaver at Seer Capital Management.  The shrinking of the American middle class will only add to this decline.

Thus, the picture of the United States as “a nation of renters.”

Who would have thought?

The structure of the United States housing industry, as we know it at the start of the twenty-first century, was built on the foundation of the continuation of credit inflation as the basis of the government’s fiscal policy.  This credit inflation and the ease with which someone could become a home builder helped to account, not only for the number of builders that existed within the industry, but also the size of many construction companies that were able to achieve substantial scale in home-building.

This structure is changing and will continue to change in the near future. 

But, all the firms and businesses that supported this structure will also have to change.  Business, especially if America becomes that “nation of renters”, will have to change and this will include real estate agents, mortgage brokers, security bundlers, and so forth. 

This is not a philosophical question, it is a reality for hundreds, even thousands, of people who have worked in the real estate area.  What is going to happen in this area and how will this impact investment opportunity in the “housing” space?

But, perhaps even more important is the question about how will this situation impact the federal government and the federal programs and the incentives that they create?  Fannie Mae and Freddie Mac are insolvent and costing the American taxpayer billions of dollars.  Who is going to finance mortgages in the future?  Security bundling and packaging is under scrutiny and is going to change.  And, who is going to buy these mortgage securities in the future?  The Federal Reserve? The rating agencies have been under attack and there is a movement for government to oversee or control them.  And, how about the subsidy of construction... and the construction of low-income units…that the government has played such a large role it?

The governmental incentives related to home ownership are changing as it the behavior of the American public with respect to whether or not people want own their own home.  As individuals continue to de-leverage, home ownership does not seems to be such a desirable allocation of their income/wealth. 

Government incentives obviously are important.  But, as with most incentives, one has to separate the impacts of the incentives in the short-run from the consequences of the incentives in the longer-run.    

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.      

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!

Europe is Still Struggling

The debt deal cut in Europe last week apparently did not get out in front of the markets through its own actions.  Interest rates and interest rate spreads over the German 10-year bond rate remained at or near Euro-era highs. 

There were a lot of questions still floating around financial markets last Friday.  (See my post on Blogspot of October 28, 2011: http://maseportfolio.blogspot.com/.) But just where is the weak spot in last week’s deal…the write down of Greek debt?  The recapitalization of the banks?  Or, the European bailout fund?  Or, all of the above?

The point still remains that financial markets are not satisfied.

The yield on Italian 10-year bonds closed at 6.11 percent yesterday, a new euro era high and this was 411 basis points above the comparable German bond.  The yield on Portuguese bonds on Friday was almost 1200 basis points above the German bond, also a new euro era high.  And, yields on Greek bonds, Spanish bonds and other stay at lofty spreads above the German bond.

It is one thing when credit inflation pervades the financial system.  Credit inflation provides incentives to create debt, to speculate, to absorb more risk. 

When credit inflation is checked, as it is at the present time (although not through the explicit desire of a large number of governments) the fiscally and economically strong dominate.  That is why Germany is currently in such a strong position in Europe.

Credit inflation like we have experienced over the past fifty years encourages financial leverage, excessive risk taking, and cutting corners.  The incentives that exist at such times allow governments and businesses and banks to issue debt and leverage up…and the credit inflation buys them out. 

Speculation thrives in a time of credit inflation.  I read an article like that of Andrew Ross Sorkin in the New York Times this morning (http://dealbook.nytimes.com/2011/10/31/its-lonely-without-the-goldman-net/?ref=business),  an article that discusses the trading and “big bets” placed by such names as John Corzine, John Thain, Robert Rubin, and J. Chris Flowers.  These individuals benefitted by taking on more and more risk during the time of credit inflation and financing this risk taking with lots of leverage, and especially short term debt.

The morning papers are filled with the news of the latest bets placed by John Corzine at MF Global.  Unfortunately, the environment was not one that was conducive to the recently placed bets of Corzine.

Furthermore, a period of credit inflation is a time when people cut corners on the truth, push hiddenness a little more, and engage in schemes that are on the edge of being legal if they are legal.  Greece hid its financial condition for a long time before it had to “fess up.”  Italy has not been fully forthcoming concerning its financial affairs.  Citigroup hid mountains of questionable assets “off-balance sheet”.  And, of course, look at all the instances of insider trading and Ponzi-schemes that have surfaced over the past few years.

As Chuck Prince, former CEO of Citigroup so famously stated: As long as the music is playing, you have to keep dancing.

When the music stops…

Or, as Warren Buffet has said, you have to wait until the tide goes out before you find who is swimming without a bathing suit!

Well, the music has stopped…the tide has gone out…

And, we are observing those who where not wearing bathing suits and the scene is not very pretty.

The financial markets are saying that the officials of Europe have not gotten out ahead of the situation…they are still behind.  And, since the tide has gone out, there is no credit inflation to buy them out of their situation.  As a consequence, some time or another, they are going to have to finally address the insolvencies that exist. 

And, it will be the strong that control the situation. 

Germany will be one of the strong…maybe gaining a position in the twenty-first century that they could not achieve in two world wars in the twentieth century. 

Will America be one of the strong?  People are raising questions about the ability of the United States to lead in the twenty-first century.  See John Taylor’s op-ed piece in the Wall Street Journal this morning: http://professional.wsj.com/article/SB10001424052970204394804577009651207190754.html?mod=ITP_opinion_0&mg=reno-secaucus-wsj.

It does not appear that Europe has made it yet.  Consequently, there will still be financial market turmoil, social unrest, and political dislocation.  The European continent had its fun over the past fifty years financed by lots of debt.  Now, it must pay the debt collector…or default.