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Bank lending in China slowed to Yuan562.2bn, as compared with Yuan587bn in October. In addition, M2 rose by just +12.7%, the slowest since May 2001 (source Bloomberg). There is no doubt that the Chinese authorities will ease further, though I remain sceptical as to whether it will be enough, given the structure and serious imbalances of the economy;

Inflation in India (the wholesale price index) declined to +9.11% in November as compared with +9.73% in October, though slightly higher than the consensus of +9.02%. However, lower inflation (which is expected to continue) will enable the RBI to ease monetary policy in the New Year (the last of the major S/S E Asian countries to do so).
Analysts expect the RBI to be on hold this week (16th December), following recent statements by the RBI. Bond yields continue to decline and the Rupee (down 16% against the US$ YTD) weakens further – a trend I expect to continue;

Putin may dump Medvedev in an attempt to bolster his Presidential aspirations – he remains the favourite to regain the post. Russian’s have been critical of the proposed job swap. The move may help Putin a bit, but his position, in particular in dealings internally and with foreign countries will be weaker. Currently Russia needs a US$100bpd oil price. With the expected increase in spending ahead of the Presidential elections, that will increase to maintain a balanced budget. Expect a weaker Ruble, uncertain equity markets and continued capital flight It is widely believed that Russian Oligarch Mr Prokhorov’s bid for the Russian Presidency has been sanctioned by Putin, who wants to allege competition for the role – children’s games basically;

Continued problems in Hungary are affecting Austrian and Italian banks
- basically Hungarian homeowners borrowed in Swiss Francs, rather than HUF’s to get lower interest rates, forgetting the currency mismatch – Oops. Other CEE homeowners did the same eg in Poland. CEE will remain a HUGE risk for Euro Zone banks and the EU. Watch this one;

There is continued speculation that the SNB will raise the effective Euro/CHF peg. Swiss investor confidence results were negative and, in addition, exporters are really feeling the pressure. However, these rumours have been around for some time now, I accept;

The German investor confidence index (the ZEW) came in at -53.8 in December, slightly higher than November’s 55.2, though well below the average of around 25. The construction, component was particularly strong, though private domestic consumption is holding up well. The ZEW economist suggested that Germany GDP may contract in the 1st Q next year, but recover thereafter, with GDP of +0.9% forecast for 2012. Exports are expected to decline modestly. Basically a better than expected report, particularly given recent events, though I remain sceptical;

The Bundesbank has agreed to providing funds to the IMF, as long as other countries (France, the UK, US and China) do so as well. Whilst these funds cannot be earmarked for Euro Zone countries, they certainly will be heading that way;

Mrs Merkel has stated that the size of the ESM would be capped at E500bn, with no leverage. Her comments came ahead of a key speech to the German Parliament in respect of the bail out funds, so not unexpected. However, the funds available to the EFSF/ESM is simply not enough. The proposed E200bn to be provided to the IMF by EU countries,to be on lent to Euro Zone countries, is fraught with difficulties – basically where will the money come from;

One key issue – German officials are now stating that (both) the size of the EFSF/ESM will not be increased and that Euro Bonds are not on the cards “AT THIS STAGE”. At this stage is the key message. Merkel has to bring her people around – that’s the issue. How long will it take – too long. As a result, another Euro Zone crisis is very likely, which will force Euro Zone politicians to ultimately move towards enabling the ECB to buy bonds aggressively and, in addition, employ QE. I remain convinced as there is no other alternative;

The German cabinet has reactivated its bank rescue fund (created post
Lehman’s) and, indeed, has agreed to increase its size to E480bn, from 360bn previously. The EBA has mandated that German banks must raise E13.1bn by June next year – still, far, far too little;

The WSJ quotes the European Council’s President Mr Rumpoy who expressed concern that last week’s political deal amongst the Euro Zone countries may be difficult to implement into a “watertight legal pact”. In addition, as the deal involves bilateral agreements, which was the fall back position, given the UK’s veto to a new treaty, the role that the European Commission can play must be suspect;

Italy sold E3bn (the maximum) of 5 year bonds today at a rate of 6.47%, as opposed to 6.29% on 14th November – however, the highest rate since 1997. Bid to cover was 1.42, as opposed to 1.47 previously.
Markets remain concerned as to PIIGS debt, though the auction results were close to expectations, possibly marginally worse;

Emails suggest that James Murdoch may have been “economical with the truth”. The content of the emails sent to Mr Murdoch reveal that there was widespread phone hacking at the News of the World. Mr Murdoch denies having read the emails !!!!!. Whatever, News International’s position will be under pressure, both in the UK and the US;

UK unemployment rose to a 17 year high. With a weakening economy, the situation will deteriorate further. Average earnings in the 3 months to October declined to 2.0%, from 2.3% in the previous 3 months, which will enable the BoE to increase its QE programme (a further £100bn -
£125bn) in Feb/March;

US retail sales rose by only +0.2% in November, lower than the +0.6% forecast. However, October’s data was revised upwards to +0.6%, from
+0.5% previously reported. Car and truck sales rose by +0.5% to an
annual rate of 13.6mn, the best since August 2009. Sales of electronics increased by +2.1% and on line retailers were up +1.5%.
Lower petrol prices reduce petrol station sales by -0.1%, though clearly will help in terms of disposable income;

The FED reported that the US economy “has been expanding moderately”, though expressed concern about slowing global growth, which “continue to pose significant downside risks”. Bernanke added that unemployment would decline “only gradually”. He did not announce any new measures, which was taken negatively by markets, though the message contained in his statement suggests that the FED has a bias to easing further, in some way. Still believe that further QE is likely.
The market reacted negatively – traders expected further moves towards easing – totally unrealistic at this stage;

The race for the Republican nomination to contest for the Presidency is in shambles. Allegedly Ron Paul is ahead in Iowa, Gingrich is gaining support, whilst Romney’s support is weakening. The only winner out of this is clearly Obama;

CME’s Mr Duffy’s testimony to the Senate Committee implies that MF Global were effectively “cooking the books”. He also challenged Mr Corzine’s testimony. This is going to get really messy. It remains staggering that the senior management of MF Global continue to allege that they do not know where client money went;

Summary

Markets reversed early gains on a much weaker Euro yesterday and disappointment that the FED did not announce further easing measures yesterday – they remain weak today. Personally, I believe the FED said more than enough, though am not surprised by the Euro’s weakness.

Germany continues to block measures re the Euro Zone, though the rhetoric is changing – officials are using the line “at this stage”.
This slowly, slowly process towards (the inevitable) QE/ECB bond buying will cost Germany far, far more ultimately. Another crisis looks more and more certain.

Next year, the composition of the ECB changes, with the appointment of the Frenchman Mr Coeure. These representatives will be pushing for more aggressive bond buying/QE by the ECB. To put the issue in context, the FED has bought US$2tr of bonds, the ECB only approx US$325bn and the BoE (once the current programme has been completed US$420bn, with a further increase of US$150bn – US$185bn+ certain).
Furthermore the ECB continues to sterilise proceeds. Complete and utter madness.

The Euro is trading below E1.30. Further weakness is very likely. Cant see any reason to buy the markets at present – indeed, short Euro against the US$, and short the indicies seem to be the right move.

Sorting Out the Euro Mess
John Mauldin
December 12, 2011

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I had the pleasure of spending the morning and part of the afternoon today with Louis Gave and Anatole Kaletsky at a seminar here in Dallas; and we shared a long lunch, where Europe and China were the topics of conversation. So, with their permission, here is their latest “Five Corners,” in which Charles Gave and Anatole Kaletsky discuss last week’s summit, and then engage in an internal debate about whether Italy really has a significant trade deficit with Germany. As I expect from GaveKal, it’s not your typical analysis. And since I have to run to dinner – and glean more insights from their team (there will be homework when I get back!), this introduction to Outside the Box is short, and we can jump right into today’s piece. Have a great week.

Your feasting on information analyst,

John Mauldin, Editor
Outside the Box

JohnMauldin@2000wave.com

Why Pennies are economically inefficient and should be abolished.

http://blog.cgpgrey.com/death-to-pennies/

If you would like to help me make more videos please join the discussion on:

Google+: http://goo.gl/vmMwz or Facebook: http://goo.gl/LRvDR

Or suggest ideas and vote on other peoples’ ideas on my channel: http://www.youtube.com/user/CGPGrey

Terribly amusing . . .

The UK is as isolated as someone left on the dock in Southampton as the Titanic sailed away.

-Terry Smith of Tullett Prebon

via FT’s Alphaville

The euro zone has only a matter of weeks to take steps that will ensure the common currency’s survival, former U.K. Prime Minister Tony Blair says in an exclusive interview with the Journal’s Managing Editor, Robert Thomson.

12/1/2011 5:36:22 PM

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The Financial Times – The terrible consequences of a eurozone collapse

What happens if the euro collapses?

A euro area breakup, even a partial one involving the exit of one or more fiscally and competitively weak countries, would be chaotic. A full or comprehensive break-up, with the euro area splintering into a Greater Deutschmark zone and about 10 national currencies would create pandemonium. It would not be a planned, orderly, gradual unwinding of existing political, economic and legal commitments. Exit, partial or full, would likely be precipitated by disorderly sovereign defaults in the fiscally and competitively weak member states, whose currencies would weaken dramatically and whose banks would fail.

If Spain and Italy were to exit, there would be a collapse of systemically important financial institutions throughout the European Union and North America and years of global depression.

Comment:

Looking at the chart of the euro above, we can’t help but notice a complete lack of trend one way or another.  Given all the stress in Europe, it is amazing that the currency is relatively unchanged on the year.  After all, the Intrade.com markets are pricing in a 63% chance that at least one country drops the euro by the end of 2014.  So why hasn’t the currency dropped appreciably in anticipation of such an occurrence?

The problem with this line of reasoning is that nobody knows what a “new euro” might look like.  Will countries such as Greece be kicked out of the euro, leaving a currency that more closely resembles the old Deutsche Mark?  This would likely result in a rally.  Or, will Germany and their more fiscally sound counterparts exit the euro, leaving the PIIGS to fend for themselves?  Barring a historic precedent for such a dismemberment, nobody is entirely sure what the euro might look like in such an event.  Until leadership in the EU resolves these issues, we would not be shocked to see the euro continue to trend sideways as it has most of this year.  Will the summit currently underway provide any of these answers?  Tune in tomorrow to find out.

Source: Arbor Research

Euro-Zone More Break than Make?
Satyajit Das
December 9, 2011

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European summits – over twenty at last count – have produced little. The planned summit on 8/9 December 2011 may well be the last chance for Euro leaders and Euro-crats to avoid a financial disaster. Given that European leaders cannot overcome their common sense deficit, which is proving as intractable as budget and trade deficits, this may not end well.

The last comprehensive and final plan – the fourth in the last 18 months – failed to mollify investors and markets. The crisis is now engulfing Italy, Spain and now re-infecting Ireland and Portugal. Stronger countries like France (at risk of losing its AAA credit rating) and Germany are increasingly vulnerable.

Standard & Poor’s is reviewing the ratings of a number of 15 Euro-zone countries with negative implications. This action was “prompted by … belief that systemic stresses in the Euro-zone have risen in recent weeks to the extent that they now put downward pressure on the credit standing of the Euro-zone as a whole.” The rating agency highlighted tightening credit conditions across the Euro-zone, higher funding costs for many Euro-zone sovereigns, high levels of government and household indebtedness, the rising risk of an European recession and a lack of agreement among European policy makers on tackling problems.

Critical Points…

The curious pas de deux between European banks and sovereigns has reached a critical stage. Needing to raise money and keep interest costs down, governments are pressuring banks to buy their bonds and use them as collateral to raise fund from central banks and the European Central Bank (“ECB”). At the same time, European banks exposed to the risk of large losses on holdings of sovereign bond, which would render them potentially insolvent need governments to support the banking system.

Time is running short. European Sovereigns and banks need to find Euro 1.9 trillion to re-finance maturing debt in 2012. Italy alone requires Euro 113 billion in the first quarter and around Euro 300 billion over the full year. European banks need Euro 500 billion in the first half of 2012 and Euro 275 billion in the second half. This means they need to raise Euro 230 billion per quarter in 2012 compared to Euro 132 billion per quarter in 2011. Since June 2011, European banks have been only able to raise Euro 17 billion compared to Euro 120 billion for the same period in 2010.

There has to be acknowledgment that austerity – draconian budget cuts and tax increases – to bring budget deficits and public debt under control cannot deal with the problem – the deflation of the debt-fuelled bubble. There also has to be acknowledgment that Europe doesn’t have a “liquidity” problem which can be alleviated by substituting fleeing private sector lenders with official lenders such as the European Union (“EU”), ECB or the International Monetary Fund (“IMF”).

The European Financial Stability Fund (“EFSF”), the European bailout fund, is now largely irrelevant, It lacks the resources to quarantine Spain and Italy as well as, increasingly, Belgium, France and Germany from contagion. Schemes to increase the capacity of the EFSF – borrowing to leverage the fund or partial guarantees or seeking Chinese funding – are simply far fetched or incomprehensible. The EFSF’s attempt to raise money to meet existing commitments has run into problems, meeting lack lustre support and a sharp increase in costs.

In the event that the AAA guarantors are downgraded, the EFSF structure, as originally envisaged, becomes unworkable. Rating agencies have signalled that the EFSF’s AAA rating is under threat. The risk that the cost of funding for the bailout fund is greater than the rate that it can charge is now increasingly evident.

European countries have a “solvency” problem – they have debt that they can never seriously expect to pay back. Stronger nations cannot save the peripheral nations without ultimately destroying their own credit and ability to raise funds.

Commonly touted solutions, such as fiscal union (greater integration of finances where Germany and the stronger economies subsidise the weaker economies) or debt monetisation (the ECB prints money) are unworkable.

Germany and France are unwilling or unable to increase the size of their commitments. Restricted by the German Constitutional Court’s decision, for the moment, Germany cannot or will not go above Euro 211 billion in guarantees for the bailout funds already committed –about 7% of its GDP. Fiscal integration would have a higher cost than Germany is willing to pay or can sustain without affecting the country’s creditworthiness.

France is at the limit of its financial capacity and at risk of losing its AAA credit rating. Fragile coalition governments in Netherlands and Finland are increasingly reluctant to increase their commitments to the bailout process. These constraints make full fiscal union difficult.

Stronger European countries have seen a sharp increase in the cost of their financing. Netherlands 10 year debt is trading around 0.40% above Germany, down from a November high of 0.68% but well above the 0.10% where it traded historically. Austria’s 10 year rate relative to Germany fluctuated between 0.80% to 1.90% in November, up from an average of 0.23% over the last 10 years. Finland’s 10-year spread to German bonds reached 0.79% in November, well above the low of 0.07% in January 2011 and an average of 0.35% over the last year. Finland’s 10 year bonds are trading at around 1.00% over that of neighbouring Sweden, down from a high of 1.37% but well above an average difference of 0.04% since the introduction of the Euro in 1999.

The higher rates and increased volatility of rates has made it increasingly difficult for these countries to finance, despite relatively sound public finances. For Finland, where 75% of its debt is sold to foreign investors, this is increasingly problematic.

The ECB is not allowed and also unwilling to print money. Germany’s Bundesbank opposes debt monetisation. The accepted view is that, in the final analysis, Germany will embrace fiscal integration or allow the printing of money. This assumes that a cost-benefit analysis indicates that this would be less costly than a disorderly break-up of the Euro-Zone. This ignores a deep-seated German mistrust of modern finance as well as a strong belief in a hard currency and stable money. Based on their history, Germans believe that this is essential to economic and social stability. It would be unsurprising to see Germany refuse the type of monetary accommodation and open-ended commitment necessary to resolve the crisis by either fiscal union or debt monetisation.

Printing money may buy some time. But it does not deal with the level of debt, the problems related to bank holdings of sovereign bonds (a small fall in value may affect the solvency of many institutions), allowing countries to regain access to investors on a sustainable basis or economic competitiveness.

If fiscal union and debt monetisation are unavailable, a “controlled” debt restructuring of some nations may be the only option available.

Contagion…

What happens in Europe will not stay in Europe. The shock will be rapidly transmitted through trade, investment and the financial system to the rest of the world. Problems in international money markets will not be welcome for America businesses and the Federal government, which relies on foreign investors for financing. It may truncate the nascent American recovery.

Not only are their financial health and savings affected by what happens in Europe, if the International Monetary Fund (“IMF”) gets involved American will be bearing around 16% of the bill for any European bailout.

The US and Europe account for around 40% of world GDP and 25% of trade. They also make up around 60% of direct investment flows and 60% of financial assets. Europe and the US is each other’s most important market for goods and services.

In 2010, the EU purchased just over $400 billion worth of US goods and services, around 20% of total exports. US exports to Asia are frequently components of or driven by exports to Europe.

The expected economic slowdown in Europe will affect US exports, one part of the American economy that is doing well growing are around 11%, the fastest rate for more than a decade. The slowdown in emerging markets that trade with Europe will have secondary effects on America’s economic activity.

A September 2011 report prepared by the Congressional Research Services estimated that American banks exposure to Greece, Ireland, Italy, Portugal, and Spain — some of the most heavily indebted euro zone economies — amounted to $641 billion. US banks direct exposure to European sovereigns is around $100 billion. The net exposure is probably lower due to hedges.

Indirect exposure via dealings with banks exposed to Europe is larger. American banks have exposure to German and French banks are greater than $1.2 trillion, about 10% of total commercial banking assets in the United States. US banks also have substantial open derivatives contracts with European banks, face value of around $750 billion although the current value of the positions is much lower.

In case of defaults or debt restructuring of one or more European nations or distress of a major European bank, US banks would suffer both direct and indirect losses, such as failed hedges. MF Global’s losses and bankruptcy are a stark reminder of the risks.

US retirement investments in European securities are at risk. Indirect exposure to losses on European securities is even greater. Around $800 billion of China’s currency reserves are invested in Europe. Losses would reduce this savings pool which would affect China’s ability to purchase US Treasuries.

The problems of European banks, previously active in financing local businesses, will compound the problem. These banks are required to increase capital to cover losses, including those on their sovereign bond investment. As they can’t or do not want to issue equity at deeply discounted prices and the limited investor appetite for such issues, the banks may sell assets or reduce lending to raise the required capital. Estimates suggest that these banks could have to sell (up to) $2.5-3.0 trillion in assets, resulting in a sharp contraction in availability of credit.

While they are not a significant component of lending to American businesses, in 2007, European banks accounted for 30% of loans in Asia-Pacific. This has fallen by around half to 15-16% and is likely to shrink further as a result of the problems of these banks. Troubled French banks account for about 11% of maturing loans in Asia Pacific in 2012. It is unlikely that these banks will maintain their level of commitment. Asia-Pacific banks have taken up the slack but are not sizeable enough to fill the gap completely. The absence of credit will affect Asian businesses, which will then flow through to the US through reduced exports.

Recent action by central banks to lower the cost of US dollar funding via liquidity swaps for non-American banks was designed to alleviate some of these pressures. While they have had some effect, the funding position of European banks remains fragile.

The US will be affected through the appreciation of the dollar against the Euro. The Euro has declined in value by already 5% in a few weeks and further falls are possible. This will reduce the competitiveness of America exports, particularly relative to European businesses. Continued decline in the Euro will have a substantial adverse impact on US exports.

Historically, growth in the two economies is highly correlated. A slowdown in Europe is generally reflected in lower growth in the US reflecting the economic linkages. US growth may slow in response to Europe’s problems.

Stock markets are also correlated. American companies, especially with major European operations, have already signalled lower earnings as economic activity slows. Firm affected includes bellwether businesses like GE and McDonald’s. Automobile companies, with sales of nearly 25-30% in Europe, food and tobacco companies are exposed.

Continued problems are likely damage weak consumer and business confidence affecting the recovery.

American investors and financial institutions have reduced exposure to European debt and investments. The US Federal Reserve has provided dollars via European Central banks to help calm markets and avoid a dollar liquidity crunch. But beyond these measures, Americans are largely spectators to the events in Europe.

Nien or Non…

Early signs are not good. In lead up to the summit, the French President has pronounced that no European country will be allowed to default. Germany placed its faith in more austerity without increasing her financial commitment, proposing a revised treaty between Euro-Zone members to reinforce a commitment to fiscal discipline. Automatic, court-enforced sanctions on countries that exceed 3% of GDP on budget deficits and 60% of GDP on debt are laughable. The bulk of Euro-Zone countries do not and can not meet these limits now or in the forseeable future. As for the proposed fine, they would have to borrow the money to pay them.

Plans to leverage the EFSF are to be tabled, although no one honestly knows whether any investor will support it with cash. The Chinese have said “nein, danke” and “non, merci”.

The ECB predictably reduced slash Euro interest rates and lengthened the term of emergency funding of banks to 3 years with easier collateral rules (they will now accept lottery tickets as security). European central banks will provide money (Euro 200 billion) to the IMF to provide money to beleaguered nations. Details are eagerly awaited but IMF funding would rank above ordinary creditors and impede the receipt’s access to commerical funding complicating the problem.

No restructuring of the Euro is contemplated as the French, Germans and the EU appear hopelessly devoted to the common currency.

There was no attempt to tackle the real issues with the seriousness and sheer financial strength required. But perhaps the reality is that the solution is now beyond Europe’a ability and there is simple not enough money – Euro 2.5 to 3.0 trillion would be required.

Instead, European leaders seem content to discuss long term lifestyle changes with the near death patient in ER.

~~~

Satyajit Das is the author of Extreme Money: Masters of the Universe and the Cult of Risk (2011) and Traders, Guns and Money: Knowns and unknowns in the dazzling world of derivatives – Revised Edition (2010)

© 2011 Satyajit Das All Rights reserved.

The Euro Debate Gets Philosophical
John Mauldin
December 5, 2011

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Europe is rapidly approaching the denouement, the Endgame, of its currency experiment. The outcome is not clear, at least to your humble analyst, as the debates rage and there are huge pluses and minuses the 17 nations must decide upon. But the proverbial road down which the can is tumbling and clattering, kicked along haphazardly, is coming to its end, and soon a rather sharp turn, either to the left or to the right, will be required. Let us hope they choose wisely.

Today’s Outside the Box is a rather philosophical debate between my friends at GaveKal, which they have graciously shared with us. It is important to note that Charles Gave, Louis-Vincent Gave and Francois-Xavier Chauchat are French. Louis served in the French army, studied at Duke, and has lived in Hong Kong for over a decade. Charles (his father) is the quintessential French patriot and patrician right from central casting, whose voice has the authority of God. Anatole Kaletsky is supremely British and one of the most influential economic thinkers in Europe. He is Editor-at-Large and Principal Economic Commentator of The Times, for which he writes a thrice-fortnightly column on economics, politics, and financial markets. These are Europeans vigorously debating the European future as only good friends can.

What we have is an email exchange among them on the future of the euro and the inherent philosophical tensions that are faced by European leaders. I have read it three times and will read it several times more. (Do not feel bad if you need Google to keep up with some of the references. When Anatole refers to Sedan, for instance, he is not talking about cars but a major battle the French lost to the Germans in 1870. Interesting Wikipedia page for you history buffs.)

Let me give you a taste, from so many great lines. Here’s Louis (who I will see Monday in Dallas – more below):

“Above, Charles focuses on the philosophical hurdles to any mass intervention. And while I subscribe to Charles’ reading of the German institutional framework, my concerns are far less intellectual and far more practical. Basically, we have to remember that the average sovereign debt buyer is not a hazardous investor. The guy who buys a government bond is looking for a very specific outcome: he gives the government 100 only so he can get back 102.5 a year later. That’s all the typical sovereign debt investor is looking for. Nothing more, nothing less.

“But now, the problem for all EMU debt is that the range of possible outcomes is growing daily: possible restructurings, possible changes in currencies, possible assumption of other people’s debt, possible mass monetization by the central bank etc. Given this wider range of possible outcomes, and the consequent surge of uncertainty, the natural buyer of EMU debt disappears. Again, the typical sovereign investor is not in the game of handicapping possible outcomes; he is in the game of getting capital back!

“… Even if the Bundesbank did agree to monetization (which is hardly a foregone conclusion), the window for this to work may now have closed.”

I will be with Louis and Anatole this coming Monday morning in Dallas at a seminar for money managers and accredited investors. If you would like to attend, drop me a note and I will get you an invitation.

And you can find out more about GaveKal consulting services and funds at www.gavekal.com.

What fascinating times. What an interesting period in which to live. And don’t we all want to get through this and have more certainty, in place of the roller-coaster ride we are now on? I will be glad to get back to long-term investing, but in the meantime we should appreciate the fascinating spectacles. It will make for interesting stories to tell our grandkids. Have a great week, and in the midst of spectacle enjoy the holiday season.

Your amazed to finally see it all happening analyst,

John Mauldin, Editor
Outside the Box

JohnMauldin@2000wave.com

Throwing Good Money After Bad
Peter Treadway
December 5, 2011

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“The surest way to destroy a nation is to debauch its currency.

The Capitalists will sell us the rope with which we will hang them.”

-Vladimir Ilyich Lenin

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Massive purchases of Club Med country (Italy, Spain, Portugal, Greece) debts, funded by the European Central Bank (ECB), a collective Eurobond, the European Financial Stability Facility (EFSF) or the International Monetary Fund (IMF)—any of these –will be a colossal misallocation of resources and a classic example of throwing good money after bad. In 1999 when the euro was launched, all participants – governments, investors, banks, bank regulators—bought into a fundamental error. That error was that solely by adopting the euro somehow weaker credit countries like Portugal, Greece, Ireland, Spain and Italy were now to be treated like the AAA rated Germany. And, like a college student who has just been granted unlimited access to his parents’ credit card, these weaker credit countries and their private sectors borrowed with wild abandon. The banks of the EU, encouraged by their governments and misguided regulation, feasted on the debts of these countries. And Germany’s export engine significantly benefited from these countries as markets.

Unfortunately the world has now “discovered” that the weaker credit countries really are weaker credits and the past twelve years of borrowing was a mistake. For me it’s very simple. If credit has been misallocated, you stop the misallocation process and when necessary write off the past mistake. You don’t throw more good money after bad.

Let’s start with the ECB. One hears deafening demands that the ECB begin printing money and buy the Club Med bonds. The world stock markets would no doubt rally. Just pick up any copy of the widely respected Financial Times and I’m sure you’ll find one of their columnists advocating just that. The German Chancellor Angela Merkel, who has been resisting this, is portrayed as the stubborn bad guy. For me, the ECB printing money to enable Italy to roll over its massive debt is the equivalent of destroying the euro in order to save it. The Germans of all people have a history of no less than six currencies in the twentieth century plus the memory of the early 1920s hyperinflation. I hope the Chancellor can stick to her guns. But I’m not sure she can.

Funding the Club Med countries by a Eurobond would also be a mistake as would funding by the bewilderingly complicated financial contortion called the EFSF. Cut through the turgid language of any hypothetical future prospectus for a eurobond or the EFSF and this essentially amounts to Europe putting its hand into Germany’s back pocket. Without a German “cosign “on the eurobonds or the EFSF borrowings, they are in the junk category. How can a gaggle of weak credit/ bankrupt countries raise money through Eurobonds or the EFSF to bail out themselves?

Now we come to the IMF. The IMF was set up as part of the Bretton Woods system to offset imbalances that arose in a regime of fixed exchange rates. Unfortunately the fixed rate Bretton Woods system was ended in 1971. But for the IMF no problem. To corrupt General of the Army Douglas MacArthur’s famous quote, old international agencies never die and they certainly don’t fade away. Post 1973 the IMF reinvented itself and went on to bail out one country after the other including Mexico in 1994, Indonesia, Thailand and Korea in 1997, Russia in 1998 and Argentina in 2001. The IMF has been widely criticized for its bailouts. In Asia, conditions were imposed that for example with Indonesia upset the domestic political order. Billions of dollars were stolen or wasted along the way. The Russian bailout was a particularly egregious example. Worst of all market participants learned that the IMF was always going to be there if they screwed up. The IMF has played a major role in global bubble creation and the installation of moral hazard in the world’s financial sector.

If the IMF gets involved with bailing out Europe, essentially this means that the rest of the world is going to do the bailing. Right now, the IMF doesn’t have the cash to take on a full European bailout. According to Bloomberg, Euro-area governments have to repay more than 1.1 trillion euros ($1.5 trillion) of long- and short-term debt in 2012, with about 519 billion euros of Italian, French and German debt maturing in the first half alone. European banks have about $665 billion of debt coming due in the first six months, with a further $370 billion by the end of the year. Europe is facing a huge problem: How to fund the upcoming Italian and Spanish debt and keep its insolvent banks from collapsing.

Christine Lagarde, the head of the IMF, has said she expects the non-European rest of the world to bolster the IMF’s currently “inadequate” resources. (There are those who would argue that the IMF’s resources are too “adequate.”) That isn’t going to go down well with the American public which views its own fiscally-out-of-control government as unable to afford such a task. The Tea Party will be out in force if there is any hint of American backdoor participation via the IMF. To get around Congress and help bail out Mexico in 1994, US President Clinton pulled some $20 billion out of a US Treasury “shoebox” called the Exchange Stabilization Fund. He got away with that then but this time it won’t be so easy. And I wonder about China. Spending a great deal of time in Hong Kong as I do, all I hear there is “China is still poor and Europe is rich but lazy. Why should we give money to these lazybones?”

Default Is the Best Option

I believe Europe needs to find a way to allow its member states to default if necessary. Despite what seems to be the conventional wisdom, I hold the heretical view that increased fiscal union is not necessary for the euro to survive. Angela Merkel is pushing for tight fiscal controls to be imposed on the Club Med states. I would argue that the market can do the disciplining. Europe isn’t ready for the kind of fiscal union Merkel seems to want.

The problem is the Europeans don’t trust markets. As I have argued repeatedly, nine American states defaulted in the 1840s. The defeated states defaulted after the American civil war in 1865. The US survived. Moreover, according to a new Peterson Institute paper by Reinhart and Rogoff, the province of Alberta defaulted on its debt in the 1930s. The last time I checked Canada was still there! Of course, the European banking systems will require massive recapitalization, especially since they are stuffed to the gills with Club Med debt. This recapitalization should take place with management changes and losses to bondholders as well as shareholders. Nobody including me has the stomach to let an entire banking system go down.

Having said all that, I seriously doubt the European leaders will do what I am suggesting. Instead, they will push for the ECB to print money, the IMF to join the bailout and the Club Meds to promise to fiscally sin no more. I would give them no better than a fifty percent chance of pulling this off. It is my belief any fiscal austerity will consist of largely growth destructive tax increases coupled with half-hearted efforts at cutting back government expenditures. Regardless of what they do, a major recession in Europe seems all but inevitable in 2012. The euro will survive at least until this “solution” is seen to be a failure.

I will conclude this section with a quote from a recent editorial in the Wall Street Journal, which summarizes my own views and is an example of reason in a cacophony of ill-thought out global advice. Not all the financial media is advocating the easy way out.

“Europe’s original sin in this crisis was not letting Greece default, remaining in the euro but shrinking its debt load as it reformed its economy. The example would have sent a useful message of discipline to countries and creditors alike. The fear at the time was that a default would spread the contagion of higher bond rates, but those rates have soared despite the bailouts of Greece and Portugal.”

The Recent Central Bank Moves Were Necessary

The Federal Reserve, the Bank of Canada, the Bank of England, the Bank of Japan, the European Central Bank and the Swiss National Bankfive other major central banks last week announced that they would take measures to provide cheap dollar financing for the ECB. The stock markets soared upward signaling their approval.

This was not designed to be a bailout of the Club Med countries. Rather it was to keep the European banking system functioning. I think in this case the Fed did the right thing. For those who care to look, the original purpose in the founding of the Fed was to offset seasonal funding shortages in the New York money markets and to be available in the case of a financial panic. The “Progressives” of the day didn’t want America depending on the wisdom and goodwill of evil profit making private bankers. It will be recalled that J.P. Morgan single handedly rescued the United States in the Panic of 1907. For that the he was vilified by the Progressives who were upset he might have made a profit on the whole thing. No good deed goes unpunished. Of course in 1914 the supporters of the new Fed couldn’t imagine that their creation would be providing liquidity for European banks.

What has been happening is a massive run on European banks. For example the vulnerability of American money market funds to European bank problems was exposed about two months ago in a Wall Street Journal article. Since then the American money funds have been pulling their deposits out of European banks, of course denying all the while that they had any vulnerability.

This action was not some kind of back door bailout of Europe. Rather it is keeping Europe’s fundamentally insolvent banking system functioning until a genuine bailout and recapitalization can be arranged. The European banking system was approaching the point where it could not fund and was about to implode.

A Note on Global Markets

No question that, as we have seen recently, gold can go down as well as up. Given that the advanced nations appear to all be headed for insolvency and that currency destruction is a time honored method of sovereign default, I continue to believe that holding some gold is a prudent investment strategy.

Having said that, investors have to face the facts. The global stock and bond markets are being manipulated by the central banks of the world. Quantitative easing is another word for market manipulation. Warren Buffet pretty much summed up how he was being manipulated. Interest rates are zero, he’s got oodles of cash, IBM is a great company, he had to buy something. So long as there is no serious bad news, the market will “default” to an upward direction. Unfortunately, lately there has been a lot of bad news.

On the side of the bulls the US seems to be avoiding a recession. The coming European downturn is presumably already largely priced into share prices. If the Europeans can cobble together a deal that refinances the Club Med countries over the next year, no matter how bad this deal the markets will likely react positively. If no agreement is reached and the euro falls apart, the world enters a monetary abyss that could be very ugly. And so unnecessary.

China remains a big question mark for global investors who long to find a place to hide. Right now, everything seems to be following the soft landing scenario in China. The economy is slowing in response to prior tightenings (plus exports to Europe will certainly be weak) and the Peoples Bank of China (PBOC) has started to ease. But as we should have learned by now, Chinese statistics are not reliable and China is a country where information does not flow freely. Is a hard landing lurking below the official numbers? I don’t know the answer to this question and I’m not sure anyone else does either.

But I remain skeptical about China near term. The state owned Chinese banking system is not a real banking system in the Western sense and in some ways resembles a collection of Fannie Maes and Freddie Macs. Managements report ultimately to their political masters (in this case the Communist Party) and not shareholders, money is directed to capital wasting state owned firms and profligate local entities, repayment is always problematic and periodic state sponsored bank recapitalizations – sometimes fake, sometimes real — have been necessary. China follows a state – not a market– directed industrial policy where Solyndras abound and there is an overinvestment in real estate and some types of infrastructure. Environmental quality is a disaster.

Offsetting all this has been the fact that hundreds of millions of Chinese have moved from the countryside to work in factories thus upping China’s total factor productivity. And it should never be forgotten that Chinese people are on a global basis relatively intelligent, hardworking and well educated. And driven to get rich albeit no matter how. Economists find it hard to model the quality of a population in comparing countries and generally shy away from this since it is politically incorrect to do so. But in my opinion its people are China’s major asset and so far have offset what is a terrible economic system. It is no fluke that Chinese dominated Hong Kong and Singapore – with Chinese energy and the inheritance of British law and a sense of honesty and transparency – have become economic miracles. My advice to any investor looking at China as a refuge from the bankrupt West is to stick to firms which have zero state ownership and zero connection to the real estate or state owned banking sectors. And remember. A Chinese hard landing will pull down all Chinese stocks.

Dr. Peter T Treadway is principal of Historical Analytics LLC. Historical Analytics is a consulting/investment management firm dedicated to global portfolio management. Its investment approach is based on Dr. Treadway’s combined top-down and bottom-up Wall Street experience as economist, strategist and securities analyst.

Dr. Treadway also serves as Chief Economist, CTRISKS Rating, LTD, Hong Kong.

USD-EUR currency exchange rate and the Ellsberg paradox.
David R. Kotok
December 4, 2011

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“Suppose you have an urn containing 30 red balls and 60 other balls that are either black or yellow. You don’t know how many black or how many yellow balls there are, but that the total number of black balls plus the total number of yellow equals 60. The balls are well mixed so that each individual ball is as likely to be drawn as any other. You are now given a choice between two gambles.” For the rest see: http://en.wikipedia.org/wiki/Ellsberg_paradox. For historical reference see: Ellsberg, Daniel, “Risk, Ambiguity, and the Savage Axioms,” The Quarterly Journal of Economics (Nov., 1961).

A variation of the Ellsberg paradox now drives the euro-dollar currency exchange rate. Here is the outline and the options with regard to certainty, the likely outcomes that may be forecast, and also Knightian uncertainty (the unknown unknowns). For information about Frank Knight’s theory see: Knight, F.H. (1921) Risk, Uncertainty, and Profit. Boston, MA: Hart, Schaffner & Marx; Houghton Mifflin Company. Thank you to Wikipedia.

What is certain? If you take 1350 US dollars today, you may exchange them for 1000 euros. Actually you need a million in a round-lot trade to get close to the exact market exchange rate, but the pricing of the USD-EUR is pretty transparent in the spot market.

Nearly certain is the USD-EUR price tomorrow, which is most likely going to be very close to the price today. Less certain but still estimable is the price next week. And as time goes by, the estimation has a wider margin for error. That said, we can still forecast the USD-EUR with some degree of probability. We can estimate the outcome, bearing in mind the Ellsberg paradox with regard to drawing a red ball from the urn. Under Ellsberg the odds that you will draw a red ball in the initial draw from the urn are 1 out of 3. Once you draw a ball, the odds change for the next draw, since only 89 balls are left.

In the USD-EUR currency exchange-rate estimate for today, the assumption is that the euro survives until tomorrow. As time horizon extends, that assumption becomes increasingly problematic. We cannot obtain a probability distribution on the eventual outcome of the Eurozone crisis. We can list the various outcomes, which range from Eurozone is preserved and strengthened to full dismemberment.

Many pundits project that the euro will dismember. Others say that Greece will be out and that this or that other country may also be out. They suggest that a smaller Eurozone can survive. They offer one- and two-year timeframes. They believe that a core Eurozone will continue. All these scenarios are speculation.

Part of the estimation of the USD-EUR exchange rate includes the probabilities of euro dismemberment or partial dismemberment. Erwan Mahé noted as much in the research piece we quoted a few days ago. See for reference the piece is entitled “Measuring Europe’s Contagion.”

The Ellsberg problem of estimation with Knightian uncertainty in play comes about when you need to find a break-up value for the euro. I get many emails forecasting a decline in the value of the euro. I’m not so sure. Others forecast all types of doom if and when Greece defaults. I’m not so sure. Let’s look at this issue.

Under the euro dismemberment scenario, Greece defaults and reverts to a new drachma. The devaluation is fierce. The country then experiences high, dislocating inflation and low capital formation. The banking system has been undermined. Government instability is coupled with destruction of remaining wealth and capital. Greece suffers for a generation. They brought it on themselves, and they pay the ultimate economic price of policy failure.

Italy is the next suspect. My friend and co-author of our book on Europe, Vincenzo Sciarretta, wrote me about the growing burden upon Italy. “Taxes in Italy will be 125 billion euro higher than before the crisis (on an economy of some 1600 bn). Starting next year and the following one, public spending before interest rises from some 39% in 2000 to 46% of GDP in 2010. Then there’s another large part of the economy which is formally private, but the management is chosen in Rome, ENI, ENEL, Finmeccanica and the like. All politicians of all parties have shared the idea that higher taxes are ‘necessary’. The idea of cutting spending has not emerged yet. When Italy was known as the ‘Italian Miracle back in the ’50s and ’60s, the tax burden was about 25% and the country was a locomotive.”

Greece is a small part of the Eurozone, so small that it will barely be missed. Italy is 18%, exceeded only by France (20%) and Germany (27%). Spain is fourth at 12%.

Now let’s think about what a post-euro dismemberment looks like. The new German deutschmark soars. I have seen estimates of a 20%, 30%, or even 50% gain in strength. The Swiss franc would no longer be linked, and soar as well. Netherlands, Finland, Austria, and others would be much more valuable in the FX market, while the peripheral south would go the other way. Greece would certainly set the low point. And the new Italian lira is an unknown unknown.

We could try to estimate what the exchange rates would be. We could use debt-to-GDP and/or income levels and/or labor productivity measures. GDP per Capita, External debt to GDP, inflation, government fiscal performance, ratios of fiscal performance—all these have statistical problems when used to forecast things like Eurozone credit spreads. My thanks to Kasper Bartholdy and Saad Skiddiqui, Credit Suisse, December 1.

Conclusion: we could use a whole variety of methods to guess. But the effort to be precise is a futile one. This is uncertainty as Frank Knight envisioned it. This is the application of the yellow-black ball decision in the Ellsberg paradox: we do not know the probability of drawing either yellow or black as an outcome when making a single draw from the urn.

But we do know that the USD-EUR currency exchange rate now carries some amount of Ellsberg paradox risk premium in its pricing. We do not know how much. We disagree with those who argue there is no premium. When we look at the monetary dynamics that ultimately influence the foreign exchange rates, we see the USD-EUR rate fairly consistent during this crisis. The yen has strengthened against both. Over longer time periods, currency exchange rate changes are partially explained by comparisons with central bank actions. So far this is not fully applicable to the USD-EUR. To compare, consider that the proportional change of the Federal Reserve’s balance sheet (It tripled) is much larger than that of the European Central Bank (It doubled). See the charts at the bottom of the homepage on www.cumber.com to compare them.

Ellsberg’s paradox is at work. It is not transparent but it does exist. That is why we are underweighting Europe today and waiting for this to play out. We are investment advisers. We are willing to take risk when we can make educated guesses at the probabilities attached to the various outcomes.

In the Ellsberg paradox we know there is an initial one in three chance to draw a red ball. We know it is two out of three to draw a non-red ball. If the market misprices that risk, we know what to do. But in the unknown unknown Knightian realm, it is more dangerous to play. That is why we are underweight Europe. That is why we are avoiding the periphery.

We will leave for a quick trip to Europe on Thursday night. The trip follows our Thursday morning (8:30) panel at the ETF conference hosted by IndexUniverse at the New York Stock Exchange. In Paris, five private meetings on the status of events will include Europe-based money managers, consultants on Europe and central bankers. It is a fast trip but absolutely necessary. Avec nos amis, we hope to find a good French meal (et le bon vin) along the way.

One postscript is in order. Several Eurozone countries are now using the Emergency Lending Assistance (ELA) programs. This is very hard to track since the reporting is by each national central bank and has a time lag. ELA is an obligation of the National Central Bank and, hence, the country behind it. It is not a liability of the ECB. This a monetary variation of the Ellsberg paradox. The latest estimate I’ve seen is 130 bn euro; Greece alone is 40 bn. This form of credit is expanded nation-by-nation without timely transparency. In some cases, the recipient may be an insolvent domestic commercial bank. In this model, we have no Ellsberg paradox red balls; there are 17 separate national yellow and black balls. Hence, forecasts of monetary policy outcomes are in the Knightian realm. For details see: http://www.nber.org/~wbuiter/sonofela.pdf.

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David R. Kotok, Chairman and Chief Investment Officer