Depression in Europe?

There seems to be growing optimism in the United States that the economic recovery is picking up steam.  This is all fine and good, but I still believe that the major potential bump in the road for the United States is the economic and financial situation in Europe. (See my post of January 4, http://seekingalpha.com/article/317268-issue-number-1-for-2012-recession-in-europe.)

Now we have the new austerity program passed by the Greek parliament and the unrest in the streets of Greece protesting the austerity program.

But, the new austerity program, at this point, does not end the concern over whether or not this new plan will be sufficient to end the Greek insolvency.

Greece is insolvent.

With the government’s new austerity program, however, Greece will get a new financial bailout.  The question now becomes: will this new bailout program buy Greece enough time to get its ship in shape so that it can work its way out of its insolvency?

Some think not.  For example, Wolfgang Münchau writes in the Financial Times, “My central expectation is that the program will happen.  A period of calm will set in, but after a few months it will become clear the cuts in Greek wages and pensions have worsened the depression…. Before long, another round of haircuts will be beckoning.” (This from the article “Why Greece and Portugal ought to go bankrupt,” http://www.ft.com/intl/cms/s/0/57485f60-540a-11e1-8d12-00144feabdc0.html#axzz1mGnbTALH.) 

There is another problem on the horizon, however, and that is the fact that a new Greek government will be be elected in April.  The expected winner at this time is Antonis Samaras.  The question is, what will this new government do after it assumes power?

Münchau argues: “I cannot see how this (the bailout) is going to work politically.  For a new prime minister who contemplates a full term of four years, the temptation to pull the plug and blame the mess on his predecessors must be big. He will then have four years to rebuild the country from the rubble of a eurozone exit.  It would be politically much riskier for him to stick to a program that he himself says does not work, and which will keep his country in a depression for the length of his mandate—possibly beyond.” 

And this is exactly the dilemma a “turnaround” leader faces…do I struggle along with the things that were left me…or, do I clean house and start with as clean a slate as possible.

I have successfully completed three corporate turnarounds and to me there is no choice.  The nice thing about being brought in to turnaround an organization is that you have a certain time period to blame everything on the previous management and clean house.  If you don’t do the house cleaning right up front, however, you lose most of your leverage to change things.  The decision is not difficult: you start with as clean a slate as possible.  In the case of Greece, then, declare bankruptcy

Greece is insolvent.  “To rebuild itself, Greece needs a functioning economic infrastructure, a modern labor market, and a less tribal political system.”  It also needs less corruption throughout its culture. 

This is not the only set of problems that Greece…and Europe…faces.  New data on the economies of Europe coming out this week are expected to be rather dismal.  The forecasts for the fourth quarter GDP of the eurozone run from a 0.4 percent to a 0.6 percent contraction.  These figures include the fact that even Germany seems to be in a decline.  Industrial production figures for December are also to be released this week and some analysts see a decline in this measure of more than one percent. (http://www.ft.com/intl/cms/s/0/f9558702-53e1-11e1-bacb-00144feabdc0.html#axzz1mGnbTALH) 

There is some feeling that the first quarter of 2012 may find growth in positive numbers, but not by much.  Germany and others may experience some kind of recovery then, but the southern peripheral countries are not expected to start growing again for some time.  And, with unemployment in excess of twenty percent in some of these countries and continued government austerity, 2012 prospects remain quite gloomy. 

The next question, though, is where the pressure will be applied next.  Münchau contends that Portugal is also bankrupt and should follow Greece in declaring bankruptcy.  Will the international investors now turn their attention to Portugal?  I wouldn’t be surprised. 

Countries…businesses…individuals…do not resolve their financial difficulties until they resolve them.  Continued bailouts only tend to postpone a final solution.  They very seldom correct the insolvency that is causing the problem. 

Federal Reserve Report: No Need for QE3

I keep reading that some people want to have the Federal Reserve begin a new round of quantitative easing…QE3.

I see nothing in the financial figures that calls for more quantitative easing.

For one, there seems to be no pressure on interest rates.  Looking over the last 13-week period the yield on the 10-year US Treasury (constant maturity) has remained relatively constant.  The weekly average for the week of November 4, 2011 was 2.07 percent: for the week of January 27, 2012 the weekly average was 2.01.  And, the market yield on 10-year Treasuries has been below 2.00 percent all of this week.

The European sovereign debt situation has certainly contributed to this weakness in yields.  Hence, there does not seem to be any demand pressure on interest rates at this time.

Economic growth continues to be modest and consequently is not adding any demand pressure on rates.

The commercial banking system is quiet and even though bank closures average around 2 per week adjustments are being made smoothly and with little or no disruption to the industry. 

Excess reserves in the banking system have fluctuated around $1.5 trillion over the past three months indicating little or no pressure on the financial system on the loan demand front.  This, too, is consistent with the modest economic growth.

Overt Federal Reserve actions have been absent over the past 13-week period indicating that the Fed is allowing operating factors to work themselves out without undue disturbance to the monetary system. 

The big change on the Fed’s balance sheet has to do with the European debt crisis.  Central bank liquidity swaps have risen by a little more than $100 billion since November 2, 2011 as the Fed moved to assist central banks in Europe.  It appears as if part of this increase went to take pressure off the market for Reverse Repurchase agreements with foreign official and international accounts.  The account recording this activity fell by about $41.0 billion over the same time period.

This has resulted in a net increase of about $53 billion in Reserve Balances at Federal Reserve banks but this has had little or no immediate impact on the United States banking system.

Actually, Reserve Balances at Federal Reserve banks declined by $7.0 billion over the past four-week period.  The increase in central bank liquidity swaps was just about totally matched by the decline in reverse repos with foreign official and international accounts as other factors removed reserves.

In terms of Federal Reserve open market operations, the securities account at the Fed actually declined in both the latest 4-week and 13-week periods.  Securities bought outright dropped by a little more than $11.0 billion since November 2 and by a little more than $5.0 billion since January 4. 

Over the past 13 weeks, about $20.0 billion in federal agency issues and mortgage-backed securities ran off in the portfolio.  The Fed only replaced this runoff by a little more than $8.0 billion.  In the latest 4-week period, the runoff in securities was across the board.

The conclusion I draw from the latest Federal Reserve statistics is that the Fed has had a relatively peaceful 13 weeks.  Money continues to flow into the United States Treasury markets seeking a “safe haven” from what is going on in Europe.  This, along with the mediocre economic growth in the country, has taken pressure off the Fed to buy more securities in order to keep interest rates low.  The fact that the securities portfolio at the Fed has declined over the past 13 weeks indicates that the Federal Reserve is letting market forces keep interest rates low and, for a change, is staying out of the market. 

If these conditions continue, I see no justification for any talk about another round of quantitative easing.

The money stock numbers are continuing to maintain excessive growth rates.  The year-over-year rate of growth of the M1 measure of the money stock for the week ending January 24, 2012 is 18.7 percent; the M2 measure of the money stock is growing at 9.7 percent.

Over the past three years I have been arguing that the reason that these money stock growth rates are so high, given the fact that commercial banks did not seem to be lending and that the reserves being pumped into the system by the Fed were going into excess reserves, is that the dire economic conditions have caused individuals and businesses to move their funds from interest bearing assets to transaction assets like currency and demand deposits.  The very low interest rates on the interest bearing assets also contributed to this movement.

Now, however, it seems as this re-arrangement of liquid asset holdings has slowed down.  This is something I think we want to keep our eyes on, for it could be that households and businesses have done all they can do to “be liquid” in bad times.  Thus, we will either see a slow-down in money growth measures (the rates have dropped since the first of November from a 20.0 percent year-over-year rate of growth for M1 and a 10.0 percent rate for M2) or we will see spending starting to increase as these transactions accounts are being used to actually buy things.  It will be interesting to see what happens here.

If people and businesses do speed up their expenditures, this fact would be another reason why another round of quantitative easing would not be necessary.  The Fed would have done enough.   

European Defaults: Portugal is Next After Greece

It ain’t over until it’s over…

The yield on the 10-year Portuguese government bond closed above 14.80 percent yesterday, a new record for the euro-era. 

“The markets are pricing in a Portuguese default with 10-year bonds trading at about 50 percent of par, a deeply distressed level in the eyes of many investors.” (http://www.ft.com/intl/cms/s/0/49916f7a-468a-11e1-89a8-00144feabdc0.html#axzz1kTbnc8Yy)

“Friday the 13^th may be an unlucky omen for Portugal.  On that day, almost two weeks ago, Standard & Poor’s became the last rating agency to downgrade Lisbon to junk, marking the moment for many investors when default looked inevitable for Portugal as well as Greece.” 

For more on this see my post on blogspot “Credit Downgrades and Europe” for January 16, 2012. (http://maseportfolio.blogspot.com/).

The downward spiral in defaults will continue as long as Europe fails to honestly face its problems. (See my post on blogspot for January 25, 2012 titled “How Long Will Europe Continue to Lie to Itself”: http://maseportfolio.blogspot.com/.)  

In the past, analysts, including myself, tried to explain what officials in Europe were doing by casually remarking that their actions amounted to “kicking the can down the road.”  Basically, the actions of the European officials were an effort to postpone dealing with the real issues, hoping that by delaying what was needed to be done the situation would eventually correct itself.

Now, it seems that the days of “kicking the can down the road” are reaching a climax. 

European officials hope to reach a deal on the Greek debt situation by the end of this month.  The current write down seems to be somewhere around 50 percent of face value, but there still remain issues to be decided like whether or not the European Central Bank will have to write down the Greek debt it has on its books. 

Bond markets have responded to this reality by dumping Portuguese debt.  Note that the yield on the ten-year government bond was about 10.40 percent (compared with 14.80 percent yesterday) around the middle of November, a time when it still seemed that maybe the European Union might be able to pull things together and avoid a Greek default. 

As the officials of Europe finally seriously travelled down the path to restructure Greed debt, the price of Portuguese debt started to weaken.  The price declines accelerated, as the possibility of a Greek write-down became more of a reality.  Today, the yield on the 10-year bond was around 15.00 percent.

I know that governmental officials hate to give in on these write-downs because they hate to concede to the “bond markets” and “speculators”. 

It is hard for governmental officials to admit that maybe the “bond markets” and the “speculators” might be right. 

It is a very difficult lesson for governmental officials to accept the fact that they cannot continue to cater to their constituencies with jobs and other benefits ad infinitum.  Over the longer-run, either taxes have to be raised or money has to be printed because the bond markets will not continue to underwrite debt that will be repaid, both principal and interest, by the issuance of more debt.

The economist Hy Minsky referred to this kind of debt financing as a “Ponzi” scheme.

 “Ponzi” schemes come to an end and the end cannot just be blamed on the “bond markets’ and the “speculators”.  In fact, the governments just line the pockets of the “bond markets” and the “speculators” by extending their uncontrolled spending until the collapse of the market becomes a “sure thing.” 

So the charade continues and Portugal seems to be next. 

Who will follow Portugal?  Spain…or Italy…who knows?

Yet, this is not the only concern that many of these officials are facing.  The austerity programs enacted by governments throughout Europe are not setting well with the people.  There is “discontent” and “upheaval” arising in many countries.

“The only consistent messages seem to be that leaders around the world are failing to deliver on their citizens’ expectations and that Facebook, Twitter, and other social media tools allow crowds to coalesce at will to let them know it.  That is not a comforting picture for the 40 heads of state  or leaders of governments who are attending the World Economic Forum (in Davos, Switzerland)…”  (http://www.nytimes.com/2012/01/26/world/europe/across-the-world-leaders-brace-for-discontent-and-upheaval.html?_r=1&scp=1&sq=across%20the%20world,%20leaders%20brace%20for%20discontent%20and%20upheaval&st=cse)

The situation is quite uncomfortable.  But this is what happens when you fail to deal with a problem…when you continually try to “kick the can down the road.”  The situation does not go away and the delay in dealing with the situation often turns out messier than if the situation had been dealt with earlier. 

The only way for the officials to resolve a condition like this is to get in front of it.  I don’t see anyone around in a position to do this.  The only real possibility is Merkel but the resentment that already exists against Germany makes it that much more difficult for her to achieve what is needed. 

If no leader arises then the defaults will continue…and the austerity will grow…as will the “discontent” and the “upheaval.” 

“Europe risks being handicapped if it doesn’t deal decisively with this challenge to democracy.”  Thought provoking way to end the New York Times article.    

Credit Downgrades and Europe

The problem is the free flow of capital throughout most of the world. 

When capital flows freely you cannot escape the consequences of your actions.

What is called the “trilemma” problem of international economics makes this very clear.  The “trilemma” problem states that a country can only choose two of the following three options.  The three options are to be a part of world capital markets where capital flows freely; have a fixed exchange rate; or, be free to run an independent economic policy.

If there is a free flow of capital internationally, then the choice is reduced to just one of the two remaining options.  But, there are consequences to either choice.

First, if a country choses to run its economic policy independently of all other nations, then it must let it currency float in the foreign exchange markets.  Generally, a nation that wants to run an independent economic policy has particular domestic economic goals it wants to achieve and so wants to be able to choose an independent economic policy that supports these goals.

The goals most often chosen in the latter part of the twentieth century have been full employment and social welfare programs like government jobs, early retirement, substantial amounts of vacation, and high pension levels.  The means of achieving these goals has often been a policy of public sector credit inflation. 

If a country chooses the path of credit inflation then the price of its currency in foreign exchange markets must be allowed to float.  And, if credit inflation becomes extreme, the value of the currency in the foreign exchange markets will decline.  And, this will bring on other problems. 

This is one reason John Maynard Keynes wanted restrictions on the international flow of capital in the 1920s and 1930s. (http://seekingalpha.com/article/167893-john-maynard-keynes-and-international-relations-economic-paths-to-war-and-peace-by-donald-markwell)   A limited flow of capital internationally was a reality when Keynes helped to craft the Bretton Woods agreement that created the rules for the post-World War II international monetary system.  This agreement also included fixed exchange rates between the currencies of the participant nations. 

The purpose of this system was to allow member countries to follow their own economic policies aimed at achieving high levels of employment in their own country.  Therefore, a policy of credit inflation could be followed in each country without disrupting changes in foreign currency rates.

The Bretton Woods system fell apart as international capital markets opened up in the 1950s and 1960s and the credit inflation created in the United States in the 1960s resulted in a situation where the United States could not maintain its fixed exchange rate.  On August 15, 1971, President Nixon choose to float the value of the U. S. dollar.

A second choice, given the unrestricted flow of capital internationally, is to choose a fixed exchange rate.  But, if a nation chooses a fixed exchange rate then it must give up its sovereignty with respect to running an economic policy that is independent of other nations. 

This is what the European nations did when they choose to form a monetary union based on a single currency, the euro: in essence, they choose to have a fixed exchange rate between member nations.  But, the nations forming the union did not want to give up their sovereignty with regards to the formation of their government budgets. 

Oh, they allowed for budget deficits to be run, but they were to be limited in scope.  This, they felt, gave the included nations some flexibility in creating their budgets, but, they were not supposed to exceed the set limits.  The problem was that these limits were unenforceable. 

Which brings us to the current time.  Budget limits have been grossly exceeded and the nations forming the European currency union and these eurozone nations are unable…or unwilling…to give up the sovereignty of running their own economic policy or abiding by the rules of the union.

The “trilemma” analysis states very clearly that in circumstances like this the monetary union must be broken up and the countries must form a central budgetary unit or must once again establish their own currency units whose price will be floated against the other currencies of the former eurozone countries. 

The ultimate cost of running independent economic policies and trying to run a single currency monetary union will be the destruction of the sovereign political bodies as we know them in Europe or the euro, as we know it now, will have to become history.

Current events now relate to the break down of solvency talks, which had been taking place between the Greek government and private investors in Greek debt.  An “unrealistic” proposal has been rejected by the debt holders.     

Furthermore, the credit downgrades of France and other nations, which took place over the past week, were expected, yet no one really exhibited any sense of urgency.   Now that the downgrades have taken place a downward spiral seems to be starting.

“Both events are important because they show us the mechanism behind this year’s likely unfolding of events.  The eurozone has fallen into a spiral of downgrades, falling economic output, rising debt and further downgrades.  A recession has started.  Greece is now likely to default on most of its debts and may even have to leave the eurozone.  When that happens, the spotlight will fall immediately on Portugal, and the next contagious round of downgrades will begin.” (http://www.ft.com/intl/cms/s/0/987fd2fe-3ddc-11e1-91ba-00144feabdc0.html#axzz1jd5VycTs)

The European Financial Stability Facility has also been downgraded and this means that its effective lending capacity has been reduced.  The ability to “bailout” distressed countries has declined.  And, the European Central Bank cannot resolve the longer-term issues.  There is very little still available to the European officials to “kick the can down the road” any more.

I just do not see the European countries at this time getting over their resistance to form “a strong central fiscal authority with power to tax and allocate resources across the eurozone.”  Hence, I don’t have much confidence for the continued existence of a common currency for Europe, except maybe, on a much more limited scale.  Right now, I don’t see alternatives to the downward spiral mentioned above.

The bottom line is that the conditions of the “trilemma” problem seem to hold.  Given that capital is flowing freely throughout the world nations cannot just totally ignore the consequences of their choice of economic policy.  And, if the consequences of that economic policy are not realized immediately, the evidence shows that they will be realized sooner or later.  This is a lesson in macroeconomic decision-making that all countries need to take into account when determining what economic policy they should be following.  Are you listening America?     

No. 1 Issue of 2012: Recession in Europe

I believe that the number one economic issue for 2012 will be a recession in Europe.  I don’t see how this will be avoidable. 

The sovereign debt crisis in Europe has not ended and a lot of the debt is turning over this year and must be financed in the face of greater scrutiny by the rating agencies. 

The solvency problems in the European banking system has not been resolved and with more severe capital requirements and a rising level of troubled loans on their balance sheets, commercial banks are not going to be in the mood to increase lending levels.

And the governmental austerity programs of Greece, Italy, and Spain are just beginning to hurt.  The pain will only rise over the next year or two.

Furthermore, the lack of leadership on the European continent (and elsewhere) is astounding!  How do you resolve a difficult situation when there are no leaders around to realistically deal with the problems embedded within the situation?

A European recession has a high probability of occurring, but the depth of the recession is still to be determined.  On the surface, one might think that the recession would be relatively shallow, but there are other factors one must filter into the picture that adds to the uncertainty of how deep the recession might be.

Given this picture as the most likely leading scenario for 2012, I believe that we must further focus our sights on two other factors. 

The first of these is how the recession might spread to other nations.  Contagion is obviously the biggest concern here.  If a recession hits an area as large as the eurozone, even if it is a modest one, the effects of that recession will spread to others.  The exports of non-European nations will drop.  And there will be financial markets consequences. 

It is highly unlikely that a European recession will be contained just to the continent.  And, since many of Europe’s trading partners are already facing economic expansion that is modest, at best, the repercussions could spread to a relatively large part of the world.

 The second factor is even more disturbing.  If we have a European recession in 2012, given the austerity programs that are being embedded in the economic policies of eurozone states, the likelihood that social unrest in these nations will accelerate both in the current year and beyond. 

We have already seen outbursts of social unease in 2011 and with the increasing information on greater income inequalities, higher levels of unemployment, lower pensions, and so forth, that will be in the news, social unrest can only increase. 

But, these protests will have the examples of the Arab spring to build upon.  As was seen in 2011, the use of modern information technology can only strengthen the capability of protesters to organize and to disrupt.  What happened in 2011 has not been lost on the discontented of the developed world.

And, what happens if a European recession spreads to other areas of the world.  The seeds of protest have already been planted in many areas, including the United States.  Just mention the word “occupy” and you will get your response.

Which leads me to one final point.  I believe that modern society is now going through a period of substantial transition, and, like most periods of substantial transition there will be a lot of suffering as the “new world” emerges and there will be a substantial period of uncertainty as we grapple with the issues and move into this “new world.”

Of course, this will be one of the major problems we have to face…the problem of identifying what needs major changes and what needs only minor adjustments.

With certainty, however, I will argue that the evolving information technology is going to play a huge role in whatever results.  People are going to be dealing with more and more information and they will have this information is “real time.”  There will be much greater connectivity between people.  Due to this there is going to have to be greater openness and transparency in life and this is going to force major changes on the way we do things and the speed at which people react.  Governments are going to have to respond to this.  Corporations are going to have to respond to this.  And, whole societies and their social structures are going to have to respond to this. 

Changes in the availability of information have resulted in major upheavals in the world from the use of mobile type in printing which occurred around 1450 CE and resulted in societal changes like the Renaissance and the Reformation…and the Enlightenment…to the creation of the typewriter, the telephone, the telegraph, the radio, and television.

In a very real sense, I believe that a worldview is passing.  A recession in Europe during 2012 would accelerate changes that are already in motion.  If I am correct, this conclusion does not present a real comfortable picture for the next five to ten years but in terms of the human suffering that will result and in terms of the needs involved in adapting to the changes.    

U. S. Businesses Shop Europe

“As Europe struggles with its debt crisis, American businesses and financial firms are swooping in amid the distress, making loans and snapping up assets owned by banks there—from the mortgage on a luxury hotel in Miami Beach to the tallest office building in Dublin.” (http://www.nytimes.com/2011/12/26/business/us-firms-see-europe-woes-as-opportunities.html?_r=1&scp=2&sq=nelson%20schwartz&st=cse)

Where in our current understanding of macroeconomics does it indicate that a sovereign debt crisis might end up with foreign interests owning large chunks of a country’s physical assets?  How much of Ireland will United States interests buy?  How much of Spain will Middle Eastern countries end up owning?  And, how much of Italy will China possess?

Macroeconomics just cannot pick up the complexity of real economies.  Too much of the reality of an economy takes place at the micro-level and cannot be comfortably incorporated into the simple structures of the aggregate models of the economy. 

Macro-models just cannot include all of the incentives that are created within the total economy that lead to results that can even produce contradictory outcomes to what the macro-economists had been predicting. 

One of the most egregious results of the past fifty years is the prediction of the macro-economist that inflation can help the working classes and the middle classes.  Yet fifty years of credit inflation in the United States produced exactly the opposite effect in that the income/wealth distribution in the U. S. became highly skewed toward the wealthier in the society.

For one, the economists used aggregate models to show that there was a favorable tradeoff between employment and inflation.  The policy implication: if a little more inflation can be created then more people will be hired and unemployment will decline.

These models did not pick up micro-behavior that indicated that the “less wealthy” could not protect themselves from credit inflation whereas the “more wealthy” could not only protect themselves from credit inflation but could actually benefit from it.

Furthermore, these models did not include the fact that the credit inflation would provide incentives for manufacturing companies to move more into financial services while shifting their focus away from their historically productive enterprises.  Who would have thought in the 1960s that General Electric and General Motors would, by the end of the century, be earning more profit from their financial wings than from their manufacturing capacities?

Another macroeconomic idea that I have repeatedly used in discussing international financial arrangements has been that of the “trilemma”.  The “trilemma” analysis concludes that a country can only achieve two of the following three policy objectives: a free international flow of capital; a fixed exchange rate; and the ability to follow an independent economic policy.

Since 1971 when the United States went off the gold standard, many countries floated the value of their currencies in foreign exchange markets.  This had to occur, the argument went, because in the 1960s, capital began to flow freely throughout the world. 

Therefore, if governments wanted to gain the favor of those that worked in manufacturing and the labor unions by conducting a policy of credit inflation to keep unemployment low and, in many countries, housed in their own home, they had to be able to conduct an independent economic policy.  Within this effort, popular pension programs were also expanded to encourage people to retire earlier and governments became a large supplier of jobs to the economy.   

Thus, the value of the currency could be allowed to decline as governments created massive amounts of debt often financed by foreign interests.  Governments were able to keep the pedal to the floor during this period by generating a relatively steady flow of credit to their economies.

And, what was the micro-impact that the “trilemma” models did not pick up?  It was the declines that occurred in labor productivity that made many nations uncompetitive in world product markets. 

Here we see Greece…and Spain…and Ireland…and Portugal…and Italy…and, others...

And, corporate interests in the United States…and elsewhere…have lots of cash available…either on their balance sheets…or through financial markets that have been generously supplied by the Federal Reserve.

“At Kohlberg Kravis (Roberts), Nathaniel M. Zilkha, co-head of the special situations group, is expanding his London team to eight, from two, and hoping to take advantage of opportunities in Europe.  The firm is even considering potential investments in the country where the crisis began, Greece, despite headlines warning of a default by Athens or the possibility that Greece may withdraw from the eurozone…

Besides Greece, Kohlberg Kravis bankers have also been looking for deals in Spain and Portugal, where private companies are having a similarly hard time winning new credit or extending existing loans.”

As we see over and over again, the excessively loose monetary policy of the Federal Reserve is not helping the “working people”, those 20- to 25-percent of the labor market that are under-employed.  The Fed’s largesse is going to those that can use the money to “do the deal”.  Now, it seems that the flow of funds is going into the acquisition of assets formerly owned by Europeans.  Earlier, we saw Fed injections creating bubbles in commodity prices and in the stocks of emerging markets.   Even earlier than that, we saw Fed injections creating bubbles in the U. S. housing market and in U. S. stocks. 

The macroeconomic models are becoming less and less useful because the world works at a more micro-economic level.  It is at this micro-economic level that we can really observe the complexity of human behavior and also see how markets can self-organize and emerge to take on a life of their own.  Until governments become more sophisticated in their analysis of economic problems, they will continue to create opportunities that the wealthy and the better connected can take advantage of.  And, a Fed guarantee that short-term interest rates will remain at levels that are close to zero only exacerbates the situation.      

How to Solve the European Sovereign Debt Crisis

“It’s a question of courage or actually facing the issues, not being in denial, accepting the truth, accepting the reality and then dealing with it.” 

That is what is needed to resolve the European sovereign debt crisis.  So says Christine Lagarde, the managing director of the International Monetary Fund. (http://www.bloomberg.com/news/2011-12-15/imf-s-lagarde-says-escalating-european-crisis-requires-more-cooperation.html)

Need one say more?

But, she stated, the world economic outlook “is quite gloomy” with a pervasive downside risk.

So, the international community must work together. 

Working together means that, starting at the core…the European countries…economic and fiscal union must be achieved.  This would be attained through fiscal solidarity and risk-sharing around the globe. 

Unfortunately, one has to ask…is this “actually facing the issues…accepting the truth…accepting reality...” or is it just another way to postpone what needs to be done for a while longer?

My blog yesterday discussed the underlying economic dilemma faced by the European nations.  Over the past ten years or so, unit labor costs in Germany have increased 20 percent to 30 percent less than in other eurozone countries. (http://seekingalpha.com/article/313888-the-problem-is-germany)  That is, German labor has consistently become more productive than non-German labor.

And, the non-German countries, in an attempt to keep their labor as fully employed as possible given the divergence in labor productivity, engaged in programs of fiscal stimulus which created a credit inflation that was unsustainable.  Hence, the sovereign debt crisis.

Since the eurozone is subject to a single monetary authority and a common currency, fiscal budget tightening, at this time, can only bring on the “pain and suffering” of a recessionary restructuring.

The problem is that countries within the European Union have been allowed to get “out-of-line” with one another, economically.  And, in a union of countries like this, nations cannot “paper-over” the differences in labor productivity by the creation of lots and lots of debt.  In fact, such behavior only can exacerbate the problem.

The countries in the European Union are facing a need for a massive restructuring of their economies, their labor markets, and their industrial structure.  Yet, “fiscal solidarity and risk-sharing” will not do this job. 

As I mention in my blog post yesterday and Alan Blinder states in his op-ed piece in the Wall Street Journal (http://professional.wsj.com/article/SB10001424052970203430404577094313707190708.html?mod=ITP_opinion_0&mg=reno-secaucus-wsj) we have reached the stage where the only possible solution may be a substantial change in how people do things.

According to Blinder, the only path left may be debt deflation. The countries, other than Germany, “can experience deflation, meaning a prolonged decline in both wages and prices, which is incredibly difficult and painful—which generally happens only in protracted recessions.”

A possible response to this, however, is social unrest.  We have already seen protests in Greece, and Spain and Italy and France…  But, protests have become a worldwide phenomenon.  We have protests in Russia.  These movements are also seen as a kin to the events of the Arab spring.  Furthermore, there are the “Occupy” efforts…in the United States…and in other parts of the world that cannot be totally divorced from these other events.  Modern information technology is being felt everywhere.

It is difficult to see how the protests and unrest in the non-German countries of the eurozone are going to resolve the situation.  Just as with the idea of “fiscal solidarity and risk-sharing”, a movement that does not address the fundamental misallocations that exist within these societies will not come up with viable alternative solutions.   

The issue is that many countries are “out-of-line” economically.  German labor productivity exceeds that of other European nations.  The industrial structure of Germany is more competitive than the non-German eurozone countries in the global marketplace.

I am not in favor of returning to a world of mercantilism, as I mentioned in yesterday’s blog.  But, as many emerging nations have recently managed their economies so as to improve their relative position in the world, those developed countries that have focused just on buying off labor unrest over the past fifty years, may have to alter their approach to how their economies are managed.  “Soft” solutions will only enlarge the gap they face with more competitive nations.   

Remember, one conclusion about the internal management of a nation’s economy within the framework of world trade is that a country can only choose two of the following three alternatives available to them: the nation can have a fixed exchange rate; it can have a free flow of capital internationally; or it can conduct an economic policy independent of all other countries.  This problem is referred to as the “trilemma.”

Well, the countries within the eurozone have a fixed exchange rate and they have a free flow of capital internationally.  Therefore, they cannot conduct their economic policies independently of the rest of the world.

The only thing left for these countries to do is to create an environment in which the productivity of their labor and capital become more competitive within world markets.  If not, the most productive capital and labor will move on to other nations. 

This solution has little to do with “fiscal solidarity and risk-sharing.”

The labor and capital utilization within the countries that are not doing so well…must be restructured.

As managing director Christine Lagarde stated, “It’s a question of courage or actually facing the issues, not being in denial, accepting the truth, accepting the reality and then dealing with it.”

I’m not sure she is there yet…but neither are a lot of other people.  

European Sovereign Debt Must Be Restructured

A debt crisis for an organization occurs when either its debt repayment cannot be covered by the cash flow being generated by the organization or the outstanding debt of the organization cannot be reduced sufficiently to reduce the debt repayment needs. 

In the case of a governmental organization, the cash flow needed to cover the debt repayment requirements comes from economic growth that is large enough to generate governmental revenues that cover the government’s cash outflow.

Or, the cash needed to reduce the amount of government debt outstanding comes from a cash surplus generated by the government’s prudent fiscal budgets.

If neither of these conditions is met, then the government is insolvent and the debt outstanding must be restructured.

What is so hard to understand?

The growth rate of many countries in the eurozone is exceedingly low or non-existent. 

The new budgets being generated in these countries do not reduce deficits sufficiently to reduce their ratio of government debt to Gross Domestic Product.

The current efforts of the effected governments produce a cumulative result that just exacerbates the situation.  If the deficits cannot be reduced sufficiently, the debt repayment crises continues which puts greater pressure on governments to reduce budget deficits, and so on, and so on.  The experience of the eurozone over the past few years just confirms this dilemma.   

This reality pervades the bond markets. 

But, this reality is still being evaded by eurozone officials. 

A movement to enact a “fiscal union” to go with Europe’s “currency union” cannot correct the current situation without a debt restructuring because it ignores the reality of what the current situation has inherited.

A “fiscal union” can only be achieved if, at the same time, a debt restructuring takes place in those nations that are fiscally insolvent.  That is, the resolution of the current problems can only be achieved when the fact of insolvency is dealt with AND some form of a “fiscal union” with sufficient power is put in place. 

The past must be dealt with and some hope must be established for the future.     

A debt restructuring will be costly because of the impact this restructuring will have on European banks…and other banks and financial institutions throughout the world.  Any new “fiscal union” combined with a debt restructuring must include some plans to “backstop” banks.  This “backstopping” may spillover into other countries, like the United States and the United Kingdom.

And, all of this will have further negative repercussions on economic growth…in Europe, in the Untied States, and elsewhere. 

As Milton Friedman warned, “There is no such thing as a free lunch.”  Well, it appears as if the “free lunch” we have been trying to live off of is just about over.