John Mauldin's Outside the Box : Europe, Greece

Things That Make You Go Hmmm…

John Mauldin — Tue, 17 Jul 2012 18:22:00 GMT

In today's Outside the Box, the ever-philosophical Grant Williams introduces us to the ancient and profound art and science of alchemy – "the original 12-step program," as he calls it, the avid pursuit of übernerds from Hermes Trismegistus to Isaac Newton to (believe it or not) John Maynard Keynes, who referred to certain early works of econometrics as statistical alchemy (and some still are!). And we should not forget Carl Jung, who wrote the seminal workPsychology and Alchemy (for those who do not sleep or are looking for something to put you to sleep: http://en.wikipedia.org/wiki/Psychology_and_Alchemy).

Grant notes that, in contrast to the mechanically and spiritually laborious (not to mention ultimately futile) process of transmuting lead into gold, the steps to convert paper into money are only two: (1) Plugging and (2) Pushing. Nevertheless, he says, the fervid attempts by latter-day magi to concoct a successful outcome to our present economic crisis are proving no more successful than the Alchemical Work. Where alchemists got hung up, says Grant, was in the final, climactic step of the process, Projection.

Projection "was the moment when, despite all the work that went into getting to that last point in the program, hope and faith took over as the alchemist found himself having to rely on just a little bit of magic in order to get the outcome he so desperately wished for."

And Projection has much in common with Pushing. Whether it is Ben Bernanke pushing the outlandish assertion that "subprime is contained" or Spanish Prime Minister Mariano Rajoy hopefully projecting that Spain would "... stop being a problem and instead form part of the solution [to the debt crisis]," the economic alchemists have struggled. (I have a mental image of Ben Bernanke as the Sorcerer's Apprentice, with about the same results – forced to try and clean up the mess he made and ultimately being swept away in it!)

Grant wishes to speed the economic magicians in their arduous task by offering a new, slimmed-down transformational schema – it only has seven steps: Greecification, Backtrackification, Transmission, Restatigence, Bullyfication, Renegotiation, Realization. The outcome might not be any more satisfactory than it was for the conjurers of old, but at least they may learn something as they kick the Holy Economic Vessel down the road.

(See, I don't call this letter Outside the Box for nothing.)

Grant, by the way, is the best "new" wordsmith/storyteller I have seen in a dozen years. I am a huge fan. (If you want to be a Hmmm…’er too, you can subscribe for free at http://ethreemail.com/subscribe?g=bdc736be.) And I get to see him tomorrow in Singapore, where he works at Vulpes with master hedge fund manager Steven Diggle, who was with us in Tuscany for a few nights. (I am not supposed to mention how much he lost on Italian soccer, betting against Newt Gingrich, so I won't. But then, Newt has to fund his campaigns somehow. Might as well take it from a hedge fund guy who thinks he understands soccer.)

I have been in New York today (I'm writing this note from the Virgin Lounge at JFK) and did media hits all morning. Two hours of air time and never had to repeat myself. A great deal of fun. We started off at 7 a.m. with two segments with the super-serious and wicked-smart Tom Keene and crew at Bloomberg, then three segments with Matt Nesto at Yahoo Breakout (where I surprised him by agreeing with President Obama, kind of), and then finished off the trifecta with old fishing buddy and always-fun (where does he get all those obscure facts?) Mike McKee for an hour on Bloomberg Radio. You can listen on or watch at:

http://www.bloomberg.com/video/millennium-s-mauldin-on-yen-euro-fed-strategy-7B799RrsSSycENLmv66QHw.html

http://finance.yahoo.com/blogs/breakout/business-owners-responsible-own-success-154922729.html

http://www.bloomberg.com/video/mauldin-on-how-to-make-money-off-a-weak-yen-PqavukgvQO2spZ2aFyxqPA.html

(Bloomberg Radio has not posted yet, but I assume it will be there when you get this. Look for the Bloomberg Radio 10 a.m. show with Mike McKee.)

They will call the first leg of my 24 hours to Singapore in a minute, so time to sign off. The next letter will come from Singapore. Have a great week.

Your still seeing Mickey Mouse and Ben Bernanke in my head analyst,

John Mauldin, Editor
Outside the Box

Things That Make You Go Hmmm...

GRANT WILLIAMS
15 JULY 2012

"Finally, after the matter has passed from ashen-colored to white and yellow, you will see the Philosopher's Stone, our King and Dominator Supreme, issue forth from his glassy sepulcher to mount his bed or his throne in his glorified body . . . diaphanous as crystal; compact and most weighty, as easily fusible by fire as resin, as flowing as wax and more so than quicksilver . . . the color of saffron when powdered, but red as rubies when in an integral mass..."

– H. Khunrath, Amphitheatrum

"Alchemy is the art of manipulating life, and consciousness in matter, to help it evolve, or to solve problems of inner disharmonies"

– Jean Dubuis

"If you owe the bank $100 that's your problem. If you owe the bank $100 million, that's the bank's problem"

– JP Getty

Fans of J.K. Rowling's Harry Potter books will be vaguely familiar with the name Nicolas Flamel, though, unlike the book's eponymous hero, his wizardly sidekicks and characters such as Professor Dumbledore, Hagrid and, of course, He-WhoMust-Not-Be-Named, Flamel has one rather extraordinary (at least in the context of the stories) distinction: He actually existed.

Flamel's birth is steeped in confusion, but the later years of his life are well-documented due, in large part, to a book he wrote which was finally published in Paris in 1613, some 200odd years after his death. The book, Livre des Figures Hieroglypiques or Exposition of the Heiroglyphical Figures contained an introduction that documented Flamel's search for a legendary substance that contained the most magical of properties including the ability to cure any illness known to man, and to turn base metals into gold through the process of alchemy.

The substance – sought fervently by men throughout history, not just Messrs. Potter and Flamel – is known as lapis philosophorum; The Philosopher's Stone:

(Wikipedia): According to alchemical texts, the philosopher's stone came in two varieties, prepared by an almost identical method: white (for the purpose of making silver), and red (for the purpose of making gold), the white stone being a less matured version of the red stone. Some ancient and medieval alchemical texts leave clues to the supposed physical appearance of the philosopher's stone, specifically the red stone. It is often said to be orange (saffron colored) or red when ground to powder. Or in a solid form, an intermediate between red and purple, transparent and glass-like. The weight is spoken of as being heavier than gold, and it is said to be soluble in any liquid, yet incombustible in fire.

The physical properties of the Philosopher's Stone remain shrouded in mystery and some of the more esoteric descriptions of its appearance throughout the years tend to make it even more so:

(Wikipedia): Alchemical authors sometimes suggest that the stone's descriptors are metaphorical. It is called a stone, not because it is like a stone. The appearance is expressed geometrically in Michael Maier's Atalanta Fugiens. "Make of a man and woman a circle; then a quadrangle; out of the this a triangle; make again a circle, and you will have the Stone of the Wise. Thus is made the stone, which thou canst not discover, unless you, through diligence, learn to understand this geometrical teaching."

Right then. So let me get this straight: we turn a man and a woman into a circle, then a quadrangle, then into some kind of a triangle and finally back into a circle again? Thanks Mike. Your seat in the European Parliament awaits.

Leaving aside whatever the hell Michael Maier was trying to explain to us, the Philosopher's Stone was long believed to be the key to the mythical process of alchemy; the science of turning base metals into gold.

According to legend, the Philosopher's Stone is created through the alchemical method known as Magnum Opus (Great Work) and this process is widely-held to consist of a series of four very distinct stages which between them number twelve individual steps (the original 12-step program). These have become known as the Twelve Gates of George Ripley – a famed 15th century alchemist whose twenty-five volume work on the subject contained the Liber Duodecim Portarum, a tome that brought him considerable notoriety.

The means to transform base metal to precious metal that man has searched for since the beginning of recorded time was laid out in simple and concise terms in the progression through George Ripley's 'gates':

1. Calcination 2. Solution (or Dissolution) 3. Separation 4. Conjunction 5. Putrefaction 6. Congelation 7. Cibation 8. Sublimation 9. Fermentation 10. Exaltation 11. Multiplication 12. Projection

This convoluted process would drive many men to distraction – including amongst them, one Isaac Newton, 'physicist, mathematician, astronomer, philosopher, theologian and alchemist' who, as Britain's Master of the Mint managed alchemy of a slightly lower quality when he moved the Pound Sterling from the silver standard to the gold standard by adjusting the bimetallic relationship between the two.

Newton suffered a nervous breakdown during an extended period of alchemical work which had nevertheless resulted in his producing substantive written research. That written research was later purchased by none other than John Maynard Keynes who, after studying it, proclaimed Newton "...was not the first of the age of reason, he was the last of the magicians".

But I digress.

Twelve distinct steps seems an awful lot of work just to turn lead into gold. It's far easier these days to just turn paper into money which only takes a couple of steps:

1. Plugging 2. Pushing

Now, I am certain that there are those amongst you who, based on past performance, would, at this point, feel extremely confident in placing a sizeable wager that we are about to go wandering off down a path strewn with references to attempts by central banks to turn paper into gold through the process of alchemy but I am afraid I am going to surprise/disappoint you by taking a turning of a different kind altogether and will concentrate my efforts – believe it or not – on the last of Ripley's twelve steps; Projection.

Projection, in alchemic terms, was the coup de grace, the final step in a long process whereby a small amount of the Philosopher's Stone would be cast into a molten base metal – most commonly the 82nd element in the periodic table, Lead and, hey presto, that lowly element would be transmogrified into its near-neighbour just three steps higher in the table; #79; gold.

Projection was the moment when, despite all the work that went into getting to that last point in the program, hope and faith took over as the alchemist found himself having to rely on just a little bit of magic in order to get the outcome he so desperately wished for.

Throughout history, in all the annals of recorded time, every single alchemic projection ever attempted has turned out to be unsuccessful – a track record which gives alchemists only a marginally less-successful record than the Fed, the BoE, the Troika, the EC, the Eurogroup, the US Congressional Budget Office, the combined governments of the UK, Greece, Spain.... I could go on, but we've all got things to do so I won't.

Over the last five years, there have been so many 'projections' from the economic and political glitterati that have failed spectacularly as to be almost unbelievable. In fact, as I sat and thought about what to write this week, I struggled to think of a single major projection that hasn't come in on the bad side of good.

From Chairman Bernanke's confidently-delivered projection that "subprime is contained"in March 2007, to Mariano Rajoy's promise upon being elected last November that Spain would "...stop being a problem and instead form part of the solution [to the debt crisis]"the hits have just kept on coming, so today we are going to look at the modern version of alchemy whereby finances are turned to farce and examine a few of the most outrageously poor projections of recent times. If time allows, I will even make a couple of 'projections' of my own (thereby setting me up for ridicule at an as-yet-to-be-determined point in the future).

Ladies and gentlemen, in place of The Twelve Gates of George Ripley – and using Greece and Spain as examples – I give you The Seven Fates of Grant Williams, a series of steps that are certain to take place one after another, in sequence, once the primary stage has been initiated:

1. Greecification

This is the process whereby ordinary people are given estimates of important economic metrics by impressive-looking politicians who, when delivering said figures, sound confident and assured:

(CNN, September 21, 2011): The Greek government announced budget cuts Wednesday aimed at securing additional aid from its European partners as the debt-stricken nation struggles to dig itself out of a deep hole.

Elias Mossialos, a government spokesman, said in a statement that the cuts demonstrate Greece's commitment to meet its obligations and remain a member of the European Union.

The measures will enable Greece to achieve its budget targets for this year and next, "and allow the full implementation of the support of the Greek economy by 2014," said Mossialos.

(Bloomberg, November 17, 2011): Spanish Finance Minister Elena Salgado said the economy will grow about 0.8 percent this year, less than the government's target, and it's too early to know if the regions will meet their deficit goal this year.

The new forecast is below the 1.3 percent government target that Salgado had said since August would be hard to meet, and is in line with the estimate of 0.7 percent published by the European Commission last week.

Salgado said that while the central government will meet its budget-deficit target, it's not clear whether the regional governments will do so, casting doubt on the overall budgetdeficit goal of 6 percent of gross domestic product.

"I maintain 6 percent as the priority," Salgado said in an interview.

"Mariano Rajoy of the opposition People's Party, the favorite to win a majority in the vote, has pledged not to stray from the deficit goal of 4.4 percent of GDP next year "under any circumstances."

2. Backtrackification

This is the process whereby, shortly after the Greecification process has been completed and , often, the promise of a bailout secured, the forecasts made in the first stage are altered to reflect a new and 'completely unexpected' reality. The process can take anywhere from a matter of weeks to a matter of hours:

(CNN, October 2, 2011): The Greek cabinet announced late Sunday that it adopted a draft budget for 2012, but the debt-ridden nation will miss key deficit targets for this year and next.

According to this preliminary budget, Greece's budget deficit will be 18.69 billion euros, or 8.5% of gross domestic product, in 2011. Greece had originally agreed to a deficit of 17.1 billion euros, or 7.8% of GDP, with the International Monetary Fund, European Commission and the European Central Bank.

The Greek cabinet said in a statement that the main reason it would miss the deficit target is due to a deeper-than-expected recession.

The Greek economy is now expected to contract by 5.5% this year, according to the statement. That's worse than projections of a 3.8% decline in May.

(Fundweb, March 2, 2012): Spanish prime minister Mariano Rajoy has warned that the country will miss the deficit reduction target it agreed with the European Union (EU).

Rajoy says the government will seek to bring its deficit down from 8.5% of GDP in 2011 to 5.8% this year. The Spanish government previously agreed to a target of 4.4%.

The news comes after all but two of the EU's 27 members signed a fiscal treaty to prevent countries from running up the kind of large debts that pushed Greece, Portugal and Ireland into needing bailouts from the international community.

The Spanish prime minister said he has not discussed the deficit with fellow EU leaders at the first session of the European Council.

"We will present our proposals according to what we consider to be reasonable and sensible, but this is not closed here, nor negotiated here nor discussed here," he told reporters.

"Nobody has asked me about the public deficit in Spain."

3. Transmission

The third part of the process is the conveyance of blame onto either external parties or a set of conditions that were 'completely unforseeable' at the time Greecification commenced:

(BBC, October 3, 2011): The [Greek] government, which on Sunday adopted its 2012 draft austerity budget, blamed the shortfall on deepening recession.

(WSJ, October 3, 2011): The missed target was "mainly the result of the deeper-thananticipated recession of the Greek economy that affected tax revenue and social security contributions," the Greek government said in a statement...

(Huffington Post, February 23, 2012): Last Thursday, Spain's minister of economy admitted that the 2011 budget deficit had missed the 6% of GDP target by about 2 percentage points and doubted that Spain could comply with the EU-imposed deficit target for 2012. With its debt risk still at high levels, the strategy of the new Spanish government is to shift the blame to the regional governments, like Catalonia, and at the same time use the crisis to grab back the power that was devolved to the regions in the 1980s.

(UK Guardian, April 30, 2012): Rajoy had insisted that all of Spain's economic troubles were the fault of his predecessor, the Socialist José Luis Rodríguez Zapatero. So now what? You can't change horses in a storm, but you can change scapegoats, the politician's favourite pet. Another culprit had to be found, and there we have it: Spain's regions and their "reckless over-expending".

4. Restatigence

The fourth stage is the announcement of a new, improved estimate that will undoubtedly prove to be the very worst-case scenario now that all problems are in the past and a completely realistic set of estimates have been made. It is the basis upon which the continuation of the process is underpinned:

(Marketall, February 22, 2012): Greece revised its 2012 budget targets in a draft bill which was submitted to parliament. The new estimates include the full impact of the 53.5% haircut on Greek government bonds.

Budget deficit target is revised to 6.7% of GDP from 5.4% before. The government now looks for a 2012 primary deficit of 0.2% of GDP from a primary surplus of 1.1% of GDP previously. Budget revenues are seen at 56.16 billion euros compared to 59.19 billion euros before, on deeper than expected recession. Interest payments are expected to reach 13.05 billion euros, up 300 million euros from November's estimates.

(WSJ, May 18, 2012): Spain's Budget Ministry said late Friday it has revised its budget deficit estimates for last year to a wider 8.9% of gross domestic product, largely because of more red ink reported by four regional governments.

In a press release, the ministry said it is maintaining its budget deficit target of 5.3% of GDP for 2012.

Spain initially reported a budget deficit equal to 8.5% of GDP for last year, far in excess of the 6%-ofGDP target it had committed to with the European Union and international investors. Much of the overrun was the fault of the regions, which have moved to the center of the country's fiscal crisis.

Spain's regions control almost half of spending, including socially sensitive areas like healthcare and education, and have a long history of budget overruns. They are now grappling with plummeting tax revenue in a weak economy after the collapse of a taxrich housing boom and have encountered increasing difficulties to obtain financing from international capital markets, and more recently, even from local banks.

The revised budget deficit estimates released on Friday are mostly linked to higher debt reported by the regional governments of Madrid, Valencia, Andalusia and Castille-Leon.

The Budget Ministry said that the higher level of debt was uncovered by a program the central government launched this year to help the regions pay an estimated €35 billion in overdue bills to their suppliers. In exchange for credit lines to help them to pay the bills, the government required a full accounting of their outstanding debts. Many business leaders and economists had long suspected there were hidden debts at Spain's regions.

Under intense pressure from European authorities to slash spending, Spain has also pledged to cut its deficit to the 3%-of-GDP limit for euro zone countries in 2013.

5. Bullyfication

This stage occurs when, having added a sufficient amount of OPM (pronounced 'Opium' but standing for Other People's Money, this compound is critical if the chain reaction is to continue to its end point), the politicians involved use the leverage already built up in the first four stages to alter the dynamics of the process:

(UK Daily Telegraph, May 8, 2012): Stock markets around the world fell sharply as fears grew that Greece was moving towards a euro exit following Sunday's general election, where parties rejecting internationallyimposed austerity measures made major gains.

Alexis Tsipras, the head of Greece's radical Left-wing Syriza party, said that the result "nullified" bail-out deals with the European Union and International Monetary fund... Greece has received £190 billion in aid. In exchange, it is required to make deep cuts in public spending. Mr Tsipras called the loan agreement policy "barbaric".

(Bloomberg, May 30, 2012): Tsipras tells voters he has no desire to bring back the drachma. But neither does he believe that staying in the euro requires the massive cuts in government spending to which Greece's leaders have agreed as a condition of receiving international assistance over the last two years.

The case that Tsipras and his colleagues make is that it's those austerity measures – known in the country as "the memorandum" – that are the biggest threat to Greece's membership in the euro. By crippling the economy, Tsipras contends, austerity has brought Greece closer to insolvency and default, heightening the risk of a financial catastrophe throughout the European periphery, as panicked markets bring down country after country.

(AP, July 3, 2012): Greek government spokesman Simos Kedikoglou told reporters on Tuesday that Greece intended to present troubling data to EU debt inspectors meetings this week.

throughout the course of "We will present information that is astounding. It is alarming in terms of the recession and unemployment, and it shows beyond any doubt that the current policy does not bring results. It brings the opposite results," Kedikoglou said.

(Bloomberg, June 1, 2012): Economy Minister Luis de Guindos said late yesterday that the future of the euro is at stake, as data showed a net 66 billion euros ($81 billion) of capital left Spain in March. "I don't know if we're on the edge of the precipice, but we're in a very, very, very difficult situation," he said at a conference in Sitges, Spain.

(UK Daily Telegraph June 2, 2012): Mr Rajoy has become the latest European politician to call for countries to, in effect, abandon their sovereignty in a last-ditch attempt to save the beleaguered currency.

Mr Rajoy said a new central authority would go a long way to alleviating Spain's economic crisis as it would send a clear signal to investors that the single currency is an irreversible project.

He said: "The European Union needs to reinforce its architecture. This entails moving towards more integration, transferring more sovereignty, especially in the fiscal field.

"And this means a compromise to create a new European fiscal authority which would guide the fiscal policy in the eurozone, harmonize the fiscal policy of member states and enable a centralised control of [public] finances."

6. Renegotiation

Step six is when the power generated by the intensifying heat that is a by-product of the process switches sides, leading to a substantial shift in the molecular structure of the compound:

(Al Jazeera, June 23, 2011): Greece's new government has said it wanted to review several austerity measures that the debt-ridden country agreed as part of bailout packages.

The government on Saturday said it wanted to bargain for a two-year fiscal adjustment extension as it prepared for an EU-IMF audit next week.

A policy document released by the conservative-led coalition said efforts to "revise" Greece's bailout deal in talks with creditors starting on Monday include "the extension of the fiscal adjustment by at least two years," to 2016.

The aim would be to meet fiscal goals "without further cuts to salaries, pensions and public investment" and new taxes, it said, announcing a freeze on further civil-service layoffs, sales-tax cuts and longer unemployment benefits.

"The aim is to avoid layoffs of permanent staff, but to economise a serious amount through non-salary operational costs and less bureaucracy," the three-party coalition document said.

(Firedoglake July 10, 2012): Finance Ministers meeting in Europe agreed on a series of measures for Spain. First, they authorized a first installment of 30 billion euros for lending to Spanish banks, subject to approval from Eurozone governments. The money will be distributed by the end of the month, a faster schedule than previously considered. The real question is who is held responsible for the lending, the Eurozone bailout facility or the sovereign government. The assumption at the EU summit was the former, but talk that governments are actually ultimately responsible caused Spanish debt yields to soar, leading to this emergency action.

Second, the finance ministers agreed to slow down the austerity demands for the Spanish government. At the same time, Spain's targets for cutting its gaping budget deficit will be eased as the country sinks deeper into its second recession in three years, with an unemployment rate of almost 25 percent. But the ministers demanded that Spain squeeze its austerity budget even tighter to meet the new targets.

"I would expect that some additional measures will have to be taken rather soon," the European Commission's vice president, Olli Rehn, said at the news conference.

For its part, the European Commission had proposed that Madrid's deficit target this year be relaxed to 6.3 percent of gross domestic product, from 5.3 percent earlier. Madrid also would get an additional year – until 2014 – to bring the deficit below 3 percent of G.D.P., which is the target for all euro zone countries.

7. Realization

Now we reach the part where the truth finally dawns that the words spoken long ago by JP Getty are actually not just an amusing motif fit for the front of a t-shirt or a fridge magnet:

"If you owe the bank $100 that's your problem. If you owe the bank $100 million, that's the bank's problem."

The sum total of bailouts offered to Europe's prodigal offspring is mounting daily, but the Achilles Heel of the entire construct continues to be the Target2 payment system which has been so assiduously ignored by most observers yet followed so closely by my friends at Zerohedge for many months now.

This problem remains below the radar of most observers but, I suspect, will turn out to be the straw that breaks the camel's back.

(Zerohedge, 6 July, 2012): We have some good news for our German readers: in the month of June, your implicit cost of preserving the Eurozone (read the PIIGS) via TARGET2 funding of current account and various other public sector deficits and imbalances amounted to only €1 billion/day, down from €2 billion in June. We also have some bad news, which is that Europe's negative convexity ticking inflationary time bomb, which guarantees that with every month in which nothing is done to undo the Buba's onboarding of liquidity risk, the risk for an out of control implosion of German, and implicitly all European monetary institutions, rises exponentially, and just hit an all time high of €729 billion.

To everyone who naively believes that a deus ex can come out of stage left and somehow reverse this guaranteed loss to German taxpayers in the form of even more guaranteed inflation down the road, we suggest you short this chart:

(For good measure, the chart below shows the debits on the peripheral side of the balance sheet versus Germany's credits).

And so you can see that the steps are the same in every crisis. They really are. Poor projections are made and in every case, as is the wont of human nature, the most palatable estimate is always given because it is far easier to keep people as happy as possible in the present. After all, maybe they don't actually need to be disappointed in the future. Things may just work out, and if they don't, well it can always be played off as an 'unseen set of circumstances' that led to the poor projection and the painful adjustment necessary to meet reality.

Unfortunately, as the events in Greece and Spain are proving, one such situation can be masked and dealt with, but multiple situations occurring simultaneously – each bigger than the last – is guaranteed to bring the house of cards tumbling down.

Along time ago now, I promised you a look at some of the more feeble projections of the last several years so, leaving aside those of Greek and Spanish politicians, let's kick things off with the US Congressional Budget Office (CBO).

The CBO's projection record is second-to-none in terms of its ineptitude and the distance away from the mark that they regularly manage to achieve is nothing short of wondrous; particularly for a body which is described thus on its own website:

Since its founding in 1974, the Congressional Budget Office has produced independent, nonpartisan, timely analysis of economic and budgetary issues to support the Congressional budget process. The agency's long tradition of nonpartisanship is evident in each of the dozens of reports and hundreds of cost estimates its economists and policy analysts produce each year. CBO analyses do not make policy recommendations, and each report and cost estimate discloses our assumptions and methodologies. All CBO employees are appointed solely on the basis of professional competence, without regard to political affiliation.

That's 'professional competence'.

(WSJ, August 30, 2001): In 1993, the CBO predicted that the deficit would soar to $653 billion in 2003. This week, they said that same budget will be in surplus by $172 billion. Little of that $825 billion revision can be explained by legislation or luck. Nearly all of it reflects the magnitude of past forecasting blunders.

Errors are unavoidable, but perpetual bias is another matter. CBO errors always tilt in a specific direction. Aside from the first year of recessions, the CBO always exaggerates future budget deficits and underestimates surpluses.

Past forecasts often overstated deficits by huge amounts even for the current year -by $78 billion in 1992 and $102 billion in 1997. In early 1998, the CBO thought the next year's surplus would be $2 billion, but it turned out to be $125 billion. Looking further ahead, CBO errors have been staggering. Next year's budget, now estimated to be in surplus by $176 billion, had once been expected to show deficits of $579 billion (per the CBO's 1993 forecast), $349 billion (1995 forecast), and $188 billion (1997 forecast).

In January 2001, the CBO famously projected that cumulative surpluses in the United States would be $5.9 trillion through 2011. Instead, the United States ended up with cumulative deficits of $6.0 trillion during this period.

Yes, I know, "who could have seen the GFC coming in 2001?", right? Well take a look at the chart below to see just how off the mark the CBO has been since the very day it made the projection:

But it's not just the 2001 projection that is 'off'. As Casey Research's Bud Conrad pointed out late last year, some people just never learn:

Looking at the future of government deficits, the Congressional Budget Office (CBO) starts with a baseline projection of the expected government budget deficit based solely on laws already enacted. In other words, the baseline doesn't account for new laws, which invariably expand spending. Not surprisingly, as you can see in the chart [below] of previously published baseline forecasts, the CBO's deficit projections are always optimistic about the expected deficit.

Well at least we can take solace in their professional competence.

How about our old friends in the UK? Specifically Her Majesty's Treasury, who have some wonderful 5-year projections all of their own as we discussed in these pages a short while ago by picking the brains the marvellous Greg Weldon (http://www.weldononline.com):

(TTMYGH): ... UK government spending will increase, every year, including an expansion of +2.8% scheduled to be implemented this year.

The UK government is 'banking on' growth in Revenue that will exceed the rate of growth in Expenditures, including growth of +3.5% cooked-into-the-books for this year.

But, the margin for error is slim, with yearover-year Revenue forecast to grow by more than the growth in year-over-year Spending, by a mere £1.4 billion.

Over the next five years things get even more interesting.

In order to 'support' a sizable EXPANSION in SPENDING over the next five years (pegged at +12.7%), the UK Treasury is RELYING on an astronomical rise in Revenue over that same five year period, pegged at +33.4%.

Revenue is forecast to rise by +£184.2 billion over the next five years, or by nearly +£40 billion per year.

Ahem, excuse me ... perhaps the UK Treasury overlooked the FACT that Revenue in February, pegged at £38.631 billion was (-) 1.9% BELOW the year-ago February revenue of £39.381 billion.

A decline of nearly £1 billion is FAR from the projections calling for a near +£40 billion per year increase over the next five years.

Oh Boy.

Moving right along we reach more topical ground with JP Morgan's recent CIO loss which, on April 13 was famously described by CEO Jamie Dimon as "a tempest in a teacup". In the space of two weeks it ballooned to a $2bln loss that Dimon projected could possibly grow further to $3bln during the quarter.

(Bloomberg, July 13, 2012): Botched trades by a JPMorgan Chase & Co. unit that Jamie Dimon had pushed to boost profit were masked by weak internal controls and may ultimately saddle the bank with a $7.5 billion loss.

JPMorgan's chief investment office has lost $5.8 billion on the trades so far, and that figure may climb by $1.7 billion in a worst-case scenario, Dimon, the bank's chairman and chief executive officer, said yesterday.

Not great, Jamie, not great.

This most recent example is the perfect illustration of the point I have so laboriously been trying to make.

At the very moment the potential loss was announced as "possibly as high as $3bln", commentators began speculating as to the REAL magnitude of that loss. Projections as high as $9bln were mooted in the blogosphere and so, when the loss came in at a 'mere' $5.8bln (or, put another way, roughly double the worst-case estimate of a mere 8 weeks ago), it didn't look quite so bad and the stock rallied. Oh so quietly, the total loss projectionwas increased from $3bln to $7.5bln 'in a worst-case scenario'.

Worst-case, folks. More worst than the previous worst-case, admittedly, but definitely worst-case.

And so, with time and space running short, I could hardly take pot-shots at all and sundry for their poor projections without making a couple of my own so that my feet may also be held to the fire in the months to come and I shall begin with my friends in France and M. Hollande's recent projections about the amount of money his new tax increases will generate for the country's coffers.

Hollande's recent moves to raise income taxes, taxes on foreign-owned second homes, rental income and capital gains on property sales were instantly projected by the French Treasury to add a significant amount to their income:

(UK Daily Telegraph): The tax rises are part of a wider package of increases that are intended to raise €7.2 billion (£5.8 billion) to meet a budget deficit target of 4.5 per cent after the government of Nicolas Sarkozy left the French exchequer with an expenditure black hole.

An additional €2.3 billion (£1.8 billion) will be raised from a levy on those whose net wealth is €1.3 million (£1 million)...

The French finance ministry said the new rule would affect about 60,000 rental properties in France whose owners made an average profit of £12,000.

It said this would add €50 million (£40 million) to French revenue this year and €250 million in 2013.

My projection? This scheme will fail miserably and will end up reducing the overall amount of tax collected in France.

I base my own projection upon many similar efforts that have been tried over the years, but will pick on two specific examples; the ill-fated Crude Oil Windfall Profits Tax Act, signed into law by Jimmy Carter on April 2, 1980 and, most recently, in Britain where a new 50p top tax rate was 'projected' to increase tax revenues by more than £1 billion. The outcome?:

(UK Daily Telegraph): The Treasury received £10.35 billion in income tax payments from those paying by self-assessment last month, a drop of £509 million compared with January 2011... The self-assessment returns from January, when most income tax is paid by the better-off, have been eagerly awaited by the Treasury and government ministers as they provide the first evidence of the success, or failure, of the 50p rate... Although the official statistics do not disclose how much money was paid at the 50p rate of tax, the figures indicate that it is falling short of the money the levy was expected to raise.

But why were the projections so errant, I wonder? Well, it appears that human nature is far more reliable than government projections:

(UK Daily Telegraph): Senior sources said that the first official figures indicated that there had been "manoeuvring" by well-off Britons to avoid the new higher rate. The figures will add to pressure on the Coalition to drop the levy amid fears it is forcing entrepreneurs to relocate abroad... A Treasury source said the relatively poor revenues from selfassessment returns was partly down to highly-paid individuals arranging their affairs to avoid paying the 50p rate.

"It's true that SA revenues are a bit disappointing – it's still early, but it looks like there's been quite a lot of forestalling and other manoeuvring to avoid the top rate," said the source.

Worse still was the money spent on increased taxation projects in the UK that failed to deliver the projected returns:

(Huffington Post): A public spending watchdog has found two projects costing £98 million that were set up to boost tax collection rates failed to help rake in any extra cash.

The new systems at HM Revenue and Customs (HMRC) were expected to bring in £743m by the last financial year but had not delivered "any additional benefits"...

"Two projects Caseflow and Spectrum received £98m of programme funding and were originally forecast to achieve net yield increases of £743m by 2010/11.

"At the end of 2010/11, the two projects had not delivered any additional benefits."

Carter's attempts to increase revenues through taxation were even farther fromprojections as this one, simple graph demonstrates:

If Monsieur Hollande thinks things will be any different in France he is, as they say in that neck of the woods, "en désordre".

Projection number two is that, when QE3 finally arrives (and arrive it will), it will mark the top of the S&P500 for a VERY long time and its positive effects will be far shorter-lived than many – including the Fed – are projecting.

Far from an overwhelming rising tide that will float all boats, QE3 will be a dismal failure and the last bullet in the Federal Reserve's gun will turn out not to be the hollowpoint that many are projecting, but instead a simply a 'bang flag'.

In the course of the conversations I have whilst performing my day-job, I am constantly searching for anybody who is buying and holding stocks as an asset class because they offer tremendous long-term value, but I have yet to find them. Yes, there absolutely are some wonderful companies out there that offer tremendous long-term value. Corporate balance sheets have, by-and-large, never been healthier, companies are sitting on a heap of cash and, at ground level, businesses are doing extremely well. The problem comes with the fact that 99% of the people I speak to and 99% of the commentaries I read are either holding 'stocks' per se or recommending doing so for one reason and one reason only; they are terrified of missing out on the projected strong rally that will undoubtedly come once QE3 is unleashed by Ben Bernanke's Merry Band of Brothers.

That is a terrible, terrible reason to hold stocks and, when the correction comes, those good companies with strong, healthy balance sheets will be sold right alongside all the overpriced, overvalued stocks that take turns as the darlings of the analyst crowd (you know who you are, stocks). The only difference will be that the better companies' share prices will recover far faster once appetite for value and risk returns.

2008 is still too fresh in the collective minds of investors for there to be any other reaction to another major market swoon and, as the world nears the closest thing we have ever seen to a truly global recession, it's incredibly hard to see where the growth is coming from to justify buying stocks on 2% yields on multiples in the teens.

The 1982 bull market began with the S&P500 trading on 7x earnings and yielding 6.3% (green dotted line, below). It ended in the tech blow-off at 30x earnings and a 1% yield (red dotted line, below).

As we stand today, the S&P is yielding 2.5% and is trading at roughly 11x earning (blue dotted line, above). Expensive? Maybe not, but hardly the stuff dreams are made of.

So there we have it, folks; a wander through the process that both begins and ends inprojections of one kind or another. History will either look upon the two I have made kindly or with the type of scorn usually reserved for Central Bank governors or the CBO, but the one thing that gives me comfort in making them is that I have gone for the darkest end of the projection spectrum which will keep me nicely distant from those I desire NOT to emulate.

Be nice. After all, they're only projections.

I will leave you with a story, beautifully told by David Stockton that was culled from the transcript of an FOMC meeting in September 2005 and demonstrates the absurdity ofprojections (particularly in government-run institutions).

During World War II, [Nobel laureate, Ken] Arrow was assigned to a team of statisticians to produce long-range weather forecasts. After a time, Arrow and his team determined that their forecasts were not much better than pulling predictions out of a hat. They wrote their superiors, asking to be relieved of the duty. They received the following reply, and I quote "The Commanding General is well aware that the forecasts are no good. However, he needs them for planning purposes."

– David Stockton, FOMC Minutes Sep 2005

It’s All Greek To Me

John Mauldin — Tue, 08 Nov 2011 06:15:00 GMT

Long-time readers will be familiar with Michael Lewitt, one of my favorite thinkers and analysts. He has gone off on his own to write his letter, and I am encouraging him to write even more. I call Michael a thinker because he really does. He reads a lot of thought-provoking tomes and then thinks about them. And then writes, making his readers think. The world needs more Michael Lewitts.

Today, he roams the world, commenting as he goes, starting of course with Europe. I have permission to use the first half of this most recent letter as today’s Outside the Box, leaving off the investment recommendations that he shares with his subscribers. If you are interested you can subscribe at www.thecreditstrategist.com.

I am back from the Kilkenomics Economics Festival in Ireland, where there was a lot of attendee angst about their banks. They are not happy about taking on private debt with public money, and the mood in Ireland is to tell the ECB to take their debt and (insert your favorite personal expletive). Clearly, the rest of Europe wants the Irish to pay.

I told them to be patient. When the rest of European banks are upside down sometime next year and France, Spain, et al. have to pay, the mood among voters everywhere will be quite different. I said they could probably default on their bank debt at that point and no one would notice, amidst the massive debts that are going to implode on the Continent. My remarks excited a measure of schadenfreude-tinged laughter from the crowd.

Michael Lewitt agrees. Noting this interview with Oliver Sarkozy, the half-brother of France’s Nicholas Sarkozy, he says:

“Institutional funding has a three-year average life, so European banks need to generate more than $800 billion each month to fund maturing institutional borrowings. This is, in Mr. Sarkozy’s words, unsustainable. And the markets are saying so. The CDS market for European banks is back at or above the peak levels seen during the 2008 financial crisis. While Mr. Sarkozy does not come out and say it, TCS will – the likely future for European banks is Dexia SA, which was nationalized by France and Belgium when it ran aground a couple of weeks ago.”

I will write more about what I learned in Kilkenny later this week, but Europe is getting ever closer to imploding, one way or another. There is no end of problems for the markets to focus on. I can only hope that we in the US will observe the increasingly sad state of affairs in Europe and become sufficiently motivated to fix our own problems. If we do not, we will end up in an even worse condition, which will then be worse for the entire world. I remain somewhat optimistic that we will fix what ails us, as not doing so is just too horrible to contemplate.

On that bright note, have a great week. I am off to Atlanta tomorrow and then DC this Sunday, and then home for a few months (more or less).

Your seeing too much to worry about analyst,

John Mauldin, Editor
Outside the Box

It’s All Greek To Me

By Michael Lewitt

“This is a great trap of the twentieth century: on the one side is the logic of the market, where we like to imagine we all start out as individuals who don’t owe each other anything. On the other is the logic of the state, where we all begin with a debt we can never truly pay. We are constantly told that they are opposites, and that between them they contain the only real human possibilities. But it’s a false dichotomy. States created markets. Markets require states. Neither could continue without the other, at least, in anything like the forms we would recognize today.”

– David Graeber, Debt: The First 5,000 Years

For a couple of days last week, European authorities appeared to have settled on a massive monetization scheme that would have eliminated the imminent risk of a collapse of Europe’s banking system. We wrote “appeared to have settled” because less than a week after the plan was announced, Greek Prime Minister Papandreou unexpectedly called on Monday for a public referendum on the plan. The vote wouldn’t occur until January 2012, which would extend the period of uncertainty for two more months. The market reaction to this announcement was dutifully panicked, with European bourses plunging (the DAX and CAC indices were both down 5 percent) while German bond yields dropped 26 basis points to 1.76 percent as investors flocked to safety. Systemic risk was placed squarely back on the table and cut out the legs from the rally that boosted markets out of the upper end of their trading range at the end of last week.

The markets thought they could step back from the brink on the news that the European Financial Stability Facility (EFSF) would be leveraged by 400 percent and European banks had agreed to write-off 50 percent of their Greek debt. These measures had convinced the market that Armageddon would have to wait for another day. Now the markets are not so sure. Counting on byzantine Greek politics to deliver certainty is a dubious proposition to say the least. But the plot thickened even further as money managers around the world were pulling out their remaining strands of hair. On Tuesday, November 1, shortly after European markets closed, reports surfaced that the Greek referendum was off. As I wrote to one of my friends, every time I tried to put this issue to bed, more news came out of Greece that made it impossible to know exactly what to say. At this point, I am starting to feel like Sybil, the girl with 27 personalities (and now we’ve learned –like we didn’t already know – that she was a complete fabrication in the first place). Nonetheless I will do my best to wade ahead with the limited number of personalities I have left.

At best, the proposed bailout plan would have been/will only be a temporary solution to a long-term structural problem that requires an entirely different set of solutions than monetization and leverage. Our initial reaction to the plan was decidedly positive, however. We believed it would lead to a strong rally because it would remove systemic risk through the end of 2012 even though it did not provide a permanent solution. TCS wrote the following last month: “If the plan ultimately takes the form of leveraging the EFSF, the markets will likely rally and ignore the fact that such a program would at best place a Band-Aid on the underlying wound. Even a flawed plan will be perceived to be better than no plan at all. Unfortunately, such a plan would only create the illusion of stability while allowing the underlying imbalances and flawed policies to fester”(The Credit Strategist, October 1, 2011, “Confidence Games,” p. 1). The markets were desperate for a genuine solution but would have settled for stopgap measures. Now, unfortunately, they aren’t even being granted the latter.

In terms of the substance of the plan, it is obviously designed to cover Italy’s and Spain’s collective €1.5 trillion of borrowing needs over the next three years as well as those of Greece, Portugal and others. In that respect, however, it leaves little, if any, margin of error. After all, the EFSF is not an actual pool of money but merely a collection of IOUs that have to be fulfilled by 17 European states, at least two of which (Italy and Spain) are unlikely to keep them. As a result, one can expect further strains in the arrangement and market volatility resulting therefrom if the plan actually proceeds. If the plan does not proceed, investors will be begging for volatility as a welcome alternative to what they could be facing.

As one who has written that there is little chance of a long-term solution to these problems without a radical rethinking of global economic policy, the Europeans still have little choice once they peer over the cliff to realize other than to step back and buy some time before taking the inevitable leap. For, in the end, they have no other options than to jump. If they can squeeze a favorable vote out of Greece in January, they will then face the test of trying to implement meaningful pro-growth economic policies as their banks absorb their Greek losses. Skeptics are certainly correct to raise questions about the prospects for long-term solutions, but investors were not being reckless in acting as though systemic collapse was a worry for another day. They were wrong-footed by the announcement of a Greek referendum, which came as a surprise to us and to many others. But the removal of imminent systemic risk was a reasonable short-term buy signal for those with short-term investment horizons.

European economies are facing severe economic contractions in late 2011 and 2012 with little clarity on pathways toward growth. This is not news to the markets. Italian 10-year bond yields took little time to blow back through 6 percent and have now widened by 225 basis points this year. The European Central Bank might as well thrown money down a rat hole as purchased Italian bonds earlier this year. Yet, while Italy seems to be getting most of the attention of both the media and European political leaders pressuring its Prime Minister to implement budget cuts, Spain is starting to experience alarming degrees of economic pain.

In the third quarter, Spain’s unemployment rate reached the highest level in 15 years –an abominable 21.5 percent. The number of households without any income also reached a record level – 559,900, or 3.2 percent of all families. This is a result of the exhaustion of unemployment benefits for a growing number of Spaniards. In Spain, these benefits end or decline significantly after 24 months, compared with 3 to 5 years in some other European countries. While the Spanish government is looking for ways to stimulate job growth through government spending, the European Union is pressuring the country to reduce its budget deficit from more than 9 percent of GDP to 3 percent by 2013. The struggle between the government safety net and budget discipline will be increasingly painful across the union for the next few years.

Greece is mired in a depression that is getting worse by the day as it is forced to meet its northern neighbors’ austerity demands in order to receive aid that still won’t get it out of the bottomless economic pit it has dug for itself (the country needs to exit the EU, something that may be addressed in the referendum – if there is one). Banks taking 50 percent haircuts on Greek debt will now have to raise additional capital either in the public markets (highly unlikely) or via the EFSF, which will further dilute their already washed out stocks and divert them from the business of lending into recessionary economies (see below for more on European banks). The rating agencies are licking their chops in anticipation of dunning France’s AAA-rating, and Germany is only slightly further behind on their list for downgrade (for more on Germany’s credit rating, see below). The costs of fiscal union are proving to be somewhere between excessive and prohibitive.

One of the rabbits that the Europeans succeeded in pulling out of their hats is deeming the 50 percent write-off of Greek debt something other than a “credit event” that would trigger payment under the credit insurance contracts governing Greek debt. According to The Wall Street Journal, only a relatively small amount of money would have actually changed hands had a “credit event” been deemed to have occurred - $3.7 billion. But European leaders were able to convince holders of the debt to accept a “voluntary” write-down, which does not trigger a payment under the insurance contracts (known as credit default swap contracts, or CDS). The concern raised by market participants is that CDS will lose its utility as a hedge if parties are able to negotiate around it as they did in this case. A number of bankers were fretting in the media that this would result in higher borrowing costs for sovereigns by making it harder for buyers of sovereign debt to hedge their positions. To a limited extent that argument may have some merit, but for the most part CDS is used to speculate and not to hedge. If these self-interested bankers are really concerned about lowering sovereign borrowing costs, they should simply support a ban on naked sovereign CDS. That would leave investors with the ability to hedge, which would lead borrowers to lower their yield demands, and eliminate the pressure on rates placed by speculators who sell short sovereign credit without actually owning it. One of the reasons European leaders were so focused on not invoking a “credit event” in a Greek debt restructuring was to prevent speculators from profiting from Greece’s troubles.

European Banks

Figure 1

The Banks That Swallowed Europe

A key part of the European rescue plan is leveraging the EFSF so that banks will be able to take the write-downs of their Greek debt holdings and then access capital so they will not be rendered insolvent (although since the entire edifice is built on debt it is unclear how they will be able to pull that off: It would seem that some non-traditional financing structures are going to be required for European banks. Among the structures that should be considered are bonds with warrants and convertible securities. Lenders will be taking equity risk and should be compensated accordingly. They should also be granted appropriate covenants that limit the ability of managements to make the same kind of stupid decisions that got them into their current messes). Nonetheless, the dilemma facing Europe’s banks is truly formidable. Banks represent a much larger presence in European economies than they do in the United States, as Figure 1 illustrates above.

In an appearance on CNBC’s Squawk Box and in an important essay in the Financial Times, Oliver Sarkozy, the half-brother of France’s Nicholas Sarkozy, laid out the challenges facing the sector. (Oliver Sarkozy, “Europe’s dithering over banking risks 2008 again,” Financial Times, October 25, 2011, p. 9.) Mr. Sarkozy notes that Europe’s banking sector has $55 trillion of assets, four times larger than the U.S. sector. As a result, European banks are funded through institutional (what he calls wholesale markets, which he describes as much less stable and much more fickle than depositors. European banks rely on institutional markets for about $30 trillion of their funding, about 10 times more than U.S. banks. In the third quarter, this market was essentially closed to European banks, leaving them with only internally-generated sources of cash to repay institutional funding as it rolls off. Institutional funding has a three-year average life, so European banks need to generate more than $800 billion each month to fund maturing institutional borrowings. This is, in Mr. Sarkozy’s words, unsustainable. And the markets are saying so. The CDS market for European banks is back at or above the peak levels seen during the 2008 financial crisis. While Mr. Sarkozy does not come out and say it, TCS will – the likely future for European banks is Dexia SA, which was nationalized by France and Belgium when it ran aground a couple of weeks ago. Figure 2 below shows the horrible performance of European bank stocks over the past few years and since January 2011(readers will note that TCS has been recommending that investors short European banks all year).

Figure 2

The Heart of the Problem

Mr. Sarkozy suggests that European banks will require $2 trillion of recapitalization, twice the amount that is provided for in the plan announced by European leaders.TCS would like to ask what type of financial prestidigitation is going to be required to transmogrify EFSF borrowings into bank equity. Either way, the problem is enormous and is unlikely to be solved by what the Europeans have proposed thus far.

U.S. Economy

Fears of a double dip recession can placed on the back burner as the U.S. economy grew at a respectable 2.5 percent annual rate in the third quarter. After six months of below one percent growth, this was a welcome recovery. The main contributors to growth were personal spending, which increased by 2.4 percent (adding 1.7 percent to annualized GDP) and business fixed investment (which added 1.5 percent to annualized GDP). Inventories subtracted 1.1 percent from GDP growth and government spending was flat. If readers are puzzled by the contribution of personal spending in the face of 9.1 percent unemployment and a persistent housing crisis, we are too. The will-to-spend of the American consumer is something to behold, and apparently the addition of even a disappointing 100,000-125,000 jobs per month is sufficient to keep it afloat. But it should also be recognized that personal spending remains below the levels of previous recoveries (as does pretty much every other sign of economic health). Business spending is responding to decent demand in the emerging world, but there are indications that this is starting to slow. The point to be taken from these numbers is that the U.S. would do well to maintain growth in the 2.5-3.0 percent range going into 2012. This is a growth rate that is going to have to be proven; it is not something to bank on.

The Global Debt Albatross

In a late August interview on Bloomberg television with Tom Keane, I argued that one of the major factors suppressing economic growth in the U.S. is the enormous weight of debt throughout the economy. Debt service is a drag on economic growth today because much of this debt was not incurred with respect to productive activities. Instead, much of this debt is related to either housing (which is an unproductive asset) or financial speculation in the markets. Accordingly, economic actors are required to commit their capital to service debt that didn’t contribute to productive economic growth.

Figure 3

A Civilization Built on Debt

There is also increasing evidence that the sheer amount of debt has reached the point where it is retarding growth and that additional debt will place additional downward pressure on the economy. TCS came across confirmation of its argument in the always indispensable writings of our friend Christopher Wood. Mr. Wood wrote in the October 6, 2011 issue of GREED & fear that: “the evidence increasingly suggests that the Western world has now reached a point where further increases in total aggregate indebtedness are bad for growth even if it is assumed, optimistically, that the authorities are successful in triggering private-sector deleveraging.”

Mr. Wood cited a Bank of International Settlements (BIS) Working Paper written by Stephen Cecchetti, M.S. Mohanty and Fabrizio Zampolli entitled “ The real effects of debt.” This paper was presented at the August meeting of central bankers in Jackson Hole, Wyoming. The authors of this report analyzed data for 18 OECD countries for the 30-year period 1980-2010. Their findings are disturbing (though hardly surprising). First, the ratio of debt-to-GDP (total government, corporate and household debt but excluding financial sector debt) has risen from 167 percent to 314 percent during that period. Second, regression analysis showed that debt becomes sufficiently large to slow economic growth as follows: government debt – 85 percent; corporate debt – 90 percent; household debt – 85 percent. Needless to say, the United States has exceeded those levels today with no diminution of the debt burden in sight. U.S. government debt is at 97 percent and household debt is 95 percent. Only corporate debt, at 76 percent, is below the threshold. Figure 3 above shows these statistics for all of the countries studied. It is not a pretty picture.

One thing to focus on in Figure 3 above and in Figure 4 below is the fact that Germany, the country on which the economic fate of Europe largely rests, is itself heavily indebted. Germany carries a total non-financial debt-to-GDP ratio of 241 percent (government – 77 percent; corporate– 100 percent; household – 64 percent). One can see why it is far from certain that Germany will have the economic or political wherewithal to bail out its weak European neighbors even if it musters up the political will to do so.

Figure 4

Germany– Going, Going, Gone?

One of the other points made in the BIS paper – something TCS discussed in the Introduction to The Death of Capital – is the enormous impact that aging populations will have on countries throughout the world. Figure 5, which appears on the next page (it appears on page 24 of The Death of Capital), was developed by the International Monetary Fund to show that spending on the 2008 financial crisis, which was in the trillions of dollars, is dwarfed by the projected costs of caring for aging populations. On average, aging populations will cost the advanced G-20 countries 14 times more than the financial crisis.

The point made in both the BIS study and my book is that it is incumbent upon advanced economies to bring their debt under control. Otherwise, the world is at risk of not having the resources to deal with the problems that they are going to face in the future. These problems include natural disasters (like Japan’s tsunami); environmental degradation and climate change; nuclear proliferation; terrorism; military conflict; pandemics, and hunger and poverty. Each one of these poses a potential threat to human survival (and is precisely the type of Black Swan for which most investors are not prepared). To continue to run our economies like a bunch of drunken sailors is incredibly reckless in the face of these future challenges.

Figure 5

Debt May Kill Us Before Old Age Does

It should also be noted that China, the Great Hope of the global economy, is hardly a paragon of fiscal rectitude. China’s total non-financial debt-to-GDP ratio is 174 percent (government debt –44 percent; household debt – 19 percent; corporate debt – 111 percent. This does not include the massive amounts of debt hidden on the balance sheets of opaque Chinese banks. China is concealing its own debt problem and the opaque nature of the situation renders it a bit of a wild card in the global economic picture.

Zuccotti Park

The “ Occupy Wall Street” movement has received more than its fair share of media attention. There is no doubt that the protestors are emitting a primal scream against the system of “ capitalism for the poor, socialism for the rich” that characterized the steps that both led to the 2008 financial crisis and those that were taken to stem it. A growing percentage of the citizenry is coming to believe that a system that privatizes profits and socializes losses lacks legitimacy.

At the same time that protestors are railing against the current capitalist regime, and European leaders are doing everything in their power to perpetuate it, legal authorities in the United States are doing their part to insure that little will change. The recent insider trading prosecutions have properly attacked a flagrant and distasteful underside of the capital markets, although someday it will have to be explained how it is not insider trading when a well-known investor is permitted to accumulate a position in a company before publicly disclosing it and watching it soar in value. Leaving that aside, however, there is another legal assault that raises far more important systemic questions that the insider trading prosecutions. TCS is speaking of the lawsuits against the nation’s largest financial institutions for their sales of toxic mortgage securities. Last August, the Federal Housing Finance Agency sued 17 major Wall Street and European banks for selling more than $200 billion of these mortgage securities to Fannie Mae and Freddie Mac. At the same time, a number of state attorney generals are suing mortgage servicers for various abuses. Finally, there are a number of specific ongoing investigations (and a lawsuit or two) against specific underwriters for transactions similar to the Abacus abortion that brought so much shame on Goldman Sachs (and might one say that the Gods have exacted their revenge this year on John Paulson for his profiteering from that dirty business?). Where these legal proceedings will ultimately end up is anybody’s guess (although one can say with certainty that they will enrich the attorneys working on them).

TCS would like to raise a broader issue. The people camping out in Zuccotti Park are evidence of societal unease about the legitimacy of the current form of crony capitalism that has contributed to this country’s economic difficulties. Contributing to this unease has been the often-heard complaint that virtually nobody has gone to jail for causing the financial crisis. There is a very good reason for that, however. And that reason is not the one we heard from the U.S. Attorney with respect to its failure to bring charges against the incompetents who ran Washington Mutual, that the evidence did “ not meet the exacting standards for criminal charges.” Of course there was no evidence of criminality – the perpetrators of the conduct are on the same side of the table as the prosecutors! The reason that blatantly dangerous and unethical behavior cannot be prosecuted under our current system of laws is that there is no independent, third party, arm’s-length arbiter of behavior for the system. The system is worse than one in which the fox is guarding the henhouse. In our system, the fox is the architect that designed the henhouse!

Our justice suffers from a design flaw. It requires an independent investigative/prosecutorial arm that is part of the judicial rather than the executive or legislative branch of government. The only individuals that have truly stepped up and challenged the status quo that governs the political-financial ascendancy are federal judges such as Jed Rakoff. Judge Rakoff has given hell to the Securities and Exchange Commission over its bogus settlements with the large banks over settlements that are obvious political accommodations rather than true holdings to account. The judicial branch, which is certainly less beholden to large financial interests than the legislative branch (our bought-and-paid-for Congress) and the Executive Branch (our bought-and-paid-for President and Justice Department), is well positioned to serve as an independent arbiter of financial wrongdoing. It therefore offers the best opportunity to restore legitimacy to a system that has lost any right to judge its own conduct.

The Devolution of Wall Street

During the final segment of CNBC’s Strategy Session (which TCS will miss), David Faber made a very compelling comparison between two financiers – Michael Milken and John Paulson. Mr. Faber made the point that when he began his career as a Wall Street journalist (he started in the same year that I joined Drexel Burnham Lambert, Inc. –1987) the most highly compensated financier of the era was Michael Milken. Today John Paulson wears that crown. Mr. Milken famously earned $550 million in1987 (which pretty much sealed his legal fate regardless of the validity (or lack thereof) of the charges brought against him) while Mr. Paulson earned an astounding $5 billion in 2010 (and a couple of billion more in 2009 from his bet on subprime mortgages). Mr. Faber then went on to point out that Mr. Milken created the high yield bond market, which has expanded into a major economic force that financed many new businesses such as telecommunications (MCI), cable television (John Malone), and casinos (Steve Wynn and others). In contrast, Mr. Paulson has created nothing and instead profited from mere speculation. The difference between how these two men made their fortunes not only says a lot about how Wall Street has devolved over the last 25 years, but also how the U.S. economy has deteriorated during that period.

Navigating the Eurozone Crisis and Preparing for Greece’s Failure

John Mauldin — Thu, 06 Oct 2011 17:53:00 GMT

Folks, you hear a lot about the eurozone crisis, but what you don't run across very often is a coherent idea on how to move forward. My friends at STRATFOR, a private intelligence company, have done us all the courtesy of saying out loud what everyone else shies away from: Eject Greece from the eurozone.

It's not pretty. It belies the lovely concept of a unified and prosperous Europe. And the worst part: it comes with a big fat price tag, of the 2-trillion-euro variety. But it may be the only way to steer the train before it derails completely.

Today I have the privilege of sending you two pieces from STRATFOR. If you have a couple of minutes now, <<watch this video on preparing for Greece's (inevitable) failure>>. Then check out the written piece below, a deeper dive into the crisis as a whole. If you're interested in following all of STRATFOR's geopolitical analyses, as an OTB reader you can get a hefty discount off their subscription rate, plus a free copy of the NY Times bestseller by George Friedman (my buddy, and STRATFOR's founder).

Your hoping the Rangers take it all analyst,

John Mauldin, Editor
Outside the Box

Navigating the Eurozone Crisis and Preparing for Greece’s Failure

September 28, 2011

LOUISA GOULIAMAKI/AFP/Getty Images
A protester sets fire to euro banknote copies in Athens on Sept. 17

Summary

The eurozone's financial crisis has entered its 19th month. Germany, the most powerful country in Europe currently, faces constraints in its choices for changing the European system. STRATFOR sees only one option for Berlin to rescue the eurozone: Eject Greece from the economic bloc and manage the fallout with a bailout fund.

Analysis

The eurozone's financial crisis has entered its 19th month. There are more plans to modify the European system than there are eurozone members, but most of these plans ignore constraints faced by Germany, the one country in the eurozone in a position to resolve the crisis. STRATFOR sees only one way forward that would allow the eurozone to survive.

Germany's Constraints

While Germany is by far the most powerful country in Europe, the European Union is not a German creation. It is a portion of a 1950s French vision to enhance French power on both a European and a global scale. However, since the end of the Cold War, France has lost control of Europe to a reunited and reinvigorated Germany. Berlin is now working to rewire European structures piece by piece to its liking. Germany primarily uses its financial acumen and strength to assert control. In exchange for access to its wealth, Berlin requires other European states to reform their economies along German lines — reforms that, if fully implemented, would transform most of these countries into de facto German economic colonies.

This brings us to the eurozone crisis and the various plans to modify the bloc. Most of these plans ignore that Germany's reasons for participating in the eurozone are not purely economic, and those non-economic motivations greatly limit Berlin's options for changing the eurozone.

Germany in any age is best described as vulnerable. Its coastline is split by Denmark, its three navigable rivers are not naturally connected and the mouths of two of those rivers are not under German control. Germany's people cling to regional rather than national identities. Most important, the country faces sharp competition from both east and west. Germany has never been left alone: When it is weak its neighbors shatter Germany into dozens of pieces, often ruling some of those pieces directly. When it is strong, its neighbors form a coalition to break Germany's power.

The post-Cold War era is a golden age in German history. The country was allowed to reunify after the Cold War, and its neighbors have not yet felt threatened enough to attempt to break Berlin's power. In any other era, a coalition to contain Germany would already be forming. However, the European Union's institutions, particularly the euro, have allowed Germany to participate in Continental affairs in an arena in which they are eminently competitive. Germany wants to limit European competition to the field of economics, since on the field of battle it could not prevail against a coalition of its neighbors.

This fact eliminates most of the eurozone crisis solutions under discussion. Ejecting from the eurozone states that are traditional competitors with Germany could transform them into rivals. Thus, any reform option that could end with Germany in a different currency zone than Austria, the Netherlands, France, Spain or Italy is not viable if Berlin wants to prevent a core of competition from arising.

Germany also faces mathematical constraints. The creation of a transfer union, which has been roundly debated, would regularly shift economic resources from Germany to Greece, the eurozone's weakest member. The means of such allocations —direct transfers, rolling debt restructurings, managed defaults — are irrelevant. What matters is that such a plan would establish a precedent that could be repeated for Ireland and Portugal — and eventually Italy, Belgium, Spain and France. This puts anything resembling a transfer union out of the question. Covering all the states that would benefit from the transfers would likely cost around 1 trillion euros ($1.3 trillion) annually. Even if this were a political possibility in Germany (and it is not), it is well beyond Germany's economic capacity.

These limitations leave a narrow window of possibilities for Berlin. What follows is the approximate path STRATFOR sees Germany being forced to follow if the euro is to survive. This is not necessarily Berlin's explicit plan, but if the eurozone is to avoid mass defaults and dissolution, it appears to be the sole option.

Cutting Greece Loose

Greece's domestic capacity to generate capital is highly limited, and its rugged topography comes with extremely high capital costs. Even in the best of times Greece cannot function as a developed, modern economy without hefty and regular injections of subsidized capital from abroad. (This is primarily why Greece did not exist between the 4th century B.C. and the 19th century and helps explain why the European Commission recommended against starting accession talks with Greece in the 1970s.)

After modern Greece was established in the early 1800s, those injections came from the United Kingdom, which used the newly independent Greek state as a foil against faltering Ottoman Turkey. During the Cold War the United States was Greece's external sponsor, as Washington wanted to keep the Soviets out of the Mediterranean. More recently, Greece has used its EU membership to absorb development funds, and in the 2000s its eurozone membership allowed it to borrow huge volumes of capital at far less than market rates. Unsurprisingly, during most of this period Greece boasted the highest gross domestic product (GDP) growth rates in the eurozone.

Those days have ended. No one has a geopolitical need for alliance with Greece at present, and evolutions in the eurozone have put an end to cheap euro-denominated credit. Greece is therefore left with few capital-generation possibilities and a debt approaching 150 percent of GDP. When bank debt is factored in, that number climbs higher. This debt is well beyond the ability of the Greek state and its society to pay.

Luckily for the Germans, Greece is not one of the states that traditionally has threatened Germany, so it is not a state that Germany needs to keep close. It seems that if the eurozone is to be saved, Greece needs to be disposed of.

This cannot, however, be done cleanly. Greece has more than 350 billion euros in outstanding government debt, of which roughly 75 percent is held outside of Greece. It must be assumed that if Greece were cut off financially and ejected from the eurozone, Athens would quickly default on its debts, particularly the foreign-held portions. Because of the nature of the European banking system, this would cripple Europe.

European banks are not like U.S. banks. Whereas the United States' financial system is a single unified network, the European banking system is sequestered by nationality. And whereas the general dearth of direct, constant threats to the United States has resulted in a fairly hands-off approach to the banking sector, the crowded competition in Europe has often led states to use their banks as tools of policy. Each model has benefits and drawbacks, but in the current eurozone financial crisis the structure of the European system has three critical implications.

First, because banks are regularly used to achieve national and public — as opposed to economic and private — goals, banks are often encouraged or forced to invest in ways that they otherwise would not. For example, during the early months of the eurozone crisis, eurozone governments pressured their banks to purchase prodigious volumes of Greek government debt, thinking that such demand would be sufficient to stave off a crisis. In another example, in order to further unify Spanish society, Madrid forced Spanish banks to treat some 1 million recently naturalized citizens as having prime credit despite their utter lack of credit history. This directly contributed to Spain's current real estate and construction crisis. European banks have suffered more from credit binges, carry trading and toxic assets (emanating from home or the United States) than their counterparts in the United States.

Second, banks are far more important to growth and stability in Europe than they are in the United States. Banks — as opposed to stock markets in which foreigners participate — are seen as the trusted supporters of national systems. They are the lifeblood of the European economies, on average supplying more than 70 percent of funding needs for consumers and corporations (for the United States the figure is less than 40 percent).

Third and most importantly, the banks' crucial role and their politicization mean that in Europe a sovereign debt crisis immediately becomes a banking crisis and a banking crisis immediately becomes a sovereign debt crisis. Ireland is a case in point. Irish state debt was actually extremely low going into the 2008 financial crisis, but the banks' overindulgence left the Irish government with little choice but to launch a bank bailout — the cost of which in turn required Dublin to seek a eurozone rescue package.

And since European banks are linked by a web of cross-border stock and bond holdings and the interbank market, trouble in one country's banking sector quickly spreads across borders, in both banks and sovereigns.

The 280 billion euros in Greek sovereign debt held outside the country is mostly held within the banking sectors of Portugal, Ireland, Spain and Italy — all of whose state and private banking sectors already face considerable strain. A Greek default would quickly cascade into uncontainable bank failures across these states. (German and particularly French banks are heavily exposed to Spain and Italy.) Even this scenario is somewhat optimistic, since it assumes a Greek eurozone ejection would not damage the 500 billion euros in assets held by the Greek banking sector (which is the single largest holder of Greek government debt).

Making Europe Work Without Greece

Greece needs to be cordoned off so that its failure would not collapse the European financial and monetary structure. Sequestering all foreign-held Greek sovereign debt would cost about 280 billion euros, but there is more exposure than simply that to government bonds. Greece has been in the European Union since 1981. Its companies and banks are integrated into the European whole, and since joining the eurozone in 2001 that integration has been denominated wholly in euros. If Greece is ejected that will all unwind. Add to the sovereign debt stack the cost of protecting against that process and — conservatively — the cost of a Greek firebreak rises to 400 billion euros.

That number, however, only addresses the immediate crisis of Greek default and ejection. The long-term unwinding of Europe's economic and financial integration with Greece (there will be few Greek banks willing to lend to European entities, and fewer European entities willing to lend to Greece) would trigger a series of financial mini-crises. Additionally, the ejection of a eurozone member state— even one such as Greece, which lied about its statistics in order to qualify for eurozone membership — is sure to rattle European markets to the core. Technically, Greece cannot be ejected against its will. However, since the only thing keeping the Greek economy going right now and the only thing preventing an immediate government default is the ongoing supply of bailout money, this is merely a technical rather than absolute obstacle. If Greece's credit line is cut off and it does not willingly leave the eurozone, it will become both destitute and without control over its monetary system. If it does leave, at least it will still have monetary control.

In August, International Monetary Fund (IMF) chief Christine Lagarde recommended immediately injecting 200 billion euros into European banks so that they could better deal with the next phase of the European crisis. While officials across the EU immediately decried her advice, Lagarde is in a position to know; until July 5, her job was to oversee the French banking sector as France's finance minister. Lagarde's 200 billion euro figure assumes that the recapitalization occurs before any defaults and before any market panic. Under such circumstances prices tend to balloon; using the 2008 American financial crisis as a guide, the cost of recapitalization during an actual panic would probably be in the range of 800 billion euros.

It must also be assumed that the markets would not only be evaluating the banks. Governments would come under harsher scrutiny as well. Numerous eurozone states look less than healthy, but Italy rises to the top because of its high debt and the lack of political will to tackle it. Italy's outstanding government debt is approximately 1.9 trillion euros. The formula the Europeans have used until now to determine bailout volumes has assumed that it would be necessary to cover all expected bond issuances for three years. For Italy, that comes out to about 700 billion euros using official Italian government statistics (and closer to 900 billion using third-party estimates).

All told, STRATFOR estimates that a bailout fund that can manage the fallout from a Greek ejection would need to manage roughly 2 trillion euros.

Raising 2 Trillion Euros

The European Union already has a bailout mechanism, the European Financial Stability Facility (EFSF), so the Europeans are not starting from scratch. Additionally, the Europeans would not need 2 trillion euros on hand the day a Greece ejection occurred; even in the worst-case scenario, Italy would not crash within 24 hours (and even if it did, it would need 900 billion euros over three years, not all in one day). On the day Greece were theoretically ejected from the eurozone, Europe would probably need about 700 billion euros (400 billion to combat Greek contagion and another 300 billion for the banks). The IMF could provide at least some of that, though probably no more than 150 billion euros.

The rest would come from the private bond market. The EFSF is not a traditional bailout fund that holds masses of cash and actively restructures entities it assists. Instead it is a transfer facility: eurozone member states guarantee they will back a certain volume of debt issuance. The EFSF then uses those guarantees to raise money on the bond market, subsequently passing those funds along to bailout targets. To prepare for Greece's ejection, two changes must be made to the EFSF.

First, there are some legal issues to resolve. In its original 2010 incarnation, the EFSF could only carry out state bailouts and only after European institutions approved them. This resulted in lengthy debates about the merits of bailout candidates, public airings of disagreements among eurozone states and more market angst than was necessary. A July eurozone summit strengthened the EFSF, streamlining the approval process, lowering the interest rates of the bailout loans and, most importantly, allowing the EFSF to engage in bank bailouts. These improvements have all been agreed to, but they must be ratified to take effect, and ratification faces two obstacles.

Germany's governing coalition is not united on whether German resources — even if limited to state guarantees — should be made available to bail out other EU states. The final vote in the Bundestag is supposed to occur Sept. 29. While STRATFOR finds it highly unlikely that this vote will fail, the fact that a debate is even occurring is far more than a worrying footnote. After all, the German government wrote both the original EFSF agreement and its July addendum.

The other obstacle regards smaller, solvent, eurozone states that are concerned about states' ability to repay any bailout funds. Led by Finland and supported by the Netherlands, these states are demanding collateral for any guarantees.

STRATFOR believes both of these issues are solvable. Should the Free Democrats — the junior coalition partner in the German government — vote down the EFSF changes, they will do so at a prohibitive cost to themselves. At present the Free Democrats are so unpopular that they might not even make it into parliament in new elections. And while Germany would prefer that Finland prove more pliable, the collateral issue will at most require a slightly larger German financial commitment to the bailout program.

The second EFSF problem is its size. The current facility has only 440 billion euros at its disposal — a far cry from the 2 trillion euros required to handle a Greek ejection. This means that once everyone ratifies the July 22 agreement, the 17 eurozone states have to get together again and once more modify the EFSF to quintuple the size of its fundraising capacity. Anything less would end with— at a minimum — the largest banking crisis in European history and most likely the euro's dissolution. But even this is far from certain, as numerous events could go wrong before a Greek ejection:

Enough states — including even Germany — could balk at the potential cost of the EFSF's expansion. It is easy to see why. Increasing the EFSF's capacity to 2 trillion euros represents a potential 25 percent increase by GDP of each contributing state's total debt load, a number that will rise to 30 percent of GDP should Italy need a rescue (states receiving bailouts are removed from the funding list for the EFSF). That would push the national debts of Germany and France — the eurozone heavyweights — to nearly 110 percent of GDP, in relative size more than even the United States' current bloated volume. The complications of agreeing to this at the intra-governmental level, much less selling it to skeptical and bailout-weary parliaments and publics, cannot be overstated.

If Greek authorities realize that Greece will be ejected from the eurozone anyway, they could preemptively leave the eurozone, default, or both. That would trigger an immediate sovereign and banking meltdown, before a remediation system could be established.

An unexpected government failure could prematurely trigger a general European debt meltdown. There are two leading candidates. Italy, with a national debt of 120 percent of GDP, has the highest per capita national debt in the eurozone outside Greece, and since Prime Minister Silvio Berlusconi has consistently gutted his own ruling coalition of potential successors, his political legacy appears to be coming to an end. Prosecutors have become so emboldened that Berlusconi is now scheduling meetings with top EU officials to dodge them. Belgium is also high on the danger list. Belgium has lacked a government for 17 months, and its caretaker prime minister announced his intention to quit the post Sept. 13. It is hard to implement austerity measures — much less negotiate a bailout package — without a government.

The European banking system — already the most damaged in the developed world — could prove to be in far worse shape than is already believed. A careless word from a government official, a misplaced austerity cut or an investor scare could trigger a cascade of bank collapses.

Even if Europe is able to avoid these pitfalls, the eurozone's structural, financial and organizational problems remain. This plan merely patches up the current crisis for a couple of years.

The Stark Choice for Europe

John Mauldin — Mon, 06 Jun 2011 15:14:00 GMT

This will be one of the more controversial Outside the Box posts in a great long time. Indeed, I debated with myself at some length. It will make some readers mad, but I decided it is more important to make most readers think. And, as it happens, there are parts of this week’s essay that I rather aggressively disagree with. That being said, there is a great deal of truth here. This represents a serious body of thought that is being debated, and we need to hear all sides, rather than just the ones we like.

Michael Hudson is a research professor of economics at the University of Missouri, Kansas City and a research associate at the Levy Economics Institute of Bard College, which is a serious place, so this is no ill-informed screed. I generally like their stuff.

Hudson first lays the European crisis at the feet of banks and the institutions (ECB, IMF, and the EU) that are taking the Greek (and other) bank debt and putting it into public hands. He has a very real point. Then he points out that Greece is far better off just walking away, a la Iceland (at least read the last part of this post, on Iceland). And in polls he cites, 85% of the Greek people are against taking on the debt and paying the banks.

As I wrote last week, there is a revolution going on all over Europe, slowly building up as people realize that the “solution” being offered benefits banks and not German taxpayers or Greek creditors. Ireland will be watching. There is no easy way out. If there is a referendum on this new “troika” proposal, it is likely to lose. This is not over.

Hudson offers a a lot of facts with his analysis. This is a little longer than most Outside the Boxes, but I encourage you to take the time to read it. It will make you think, that at least I can promise.

(Thanks to Yves Smith for posting this at Naked Capitalist.) And if you like this, be aware that I read scores (if not hundreds) of pieces each week for Outside the Box (yes, even here in Tuscany). And now I'll bring you the 5-10 best of the best each week as part of my new subscription service, Over My Shoulder. If you like Outside the Box, then you're going to love Over My Shoulder. It's like having your own personal filter – with decades of analyst experience and access to exclusive resources. If your time is as valuable to you as your investments, click here to find out more about how I help you home in on the essentials.

Tuscany is renewing my soul. What a contrast. Such beauty to view while I think about the ugliness of Greek debt. My good friends and old business partners Gary and Debi Halbert just showed up to spend a few days, and we have a local sommelier coming in to do a wine and cheese tasting in a few minutes, so I am going to call it a day. Have a great week.

Your getting ready to sample some Tuscan wines analyst,

John Mauldin, Editor
Outside the Box

The Greek bailout provides an opportunity for privatization grab

When Greece exchanged its drachma for the euro in 2000, most voters were all for joining the Eurozone. The hope was that it would ensure stability, and that this would promote rising wages and living standards. Few saw that the stumbling point was tax policy. Greece was excluded from the eurozone the previous year as a result of failing to meet the 1992 Maastricht criteria for EU membership, limiting budget deficits to 3 percent of GDP, and government debt to 60 percent.

The euro also had other serious fiscal and monetary problems at the outset. There is little thought of wealthier EU economies helping bring less productive ones up to par, e.g. as the United States does with its depressed areas (as in the rescue of the auto industry in 2010) or when the federal government does declares a state of emergency for floods, tornados or other disruptions. As with the United States and indeed nearly all countries, EU “aid” is largely self-serving – a combination of export promotion and bailouts for debtor economies to pay banks in Europe’s main creditor nations: Germany, France and the Netherlands. The EU charter banned the European Central Bank (ECB) from financing government deficits, and prevents (indeed, “saves”) members from having to pay for the “fiscal irresponsibility” of countries running budget deficits. This “hard” tax policy was the price that lower-income countries had to sign onto when they joined the European Union.

Also unlike the United States (or almost any nation), Europe’s parliament was merely ceremonial. It had no power to set and administer EU-wide taxes. Politically, the continent remains a loose federation. Every member is expected to pay its own way. The central bank does not monetize deficits, and there is minimal federal sharing with member states. Public spending deficits – even for capital investment in infrastructure – must be financed by running into debt, at rising interest rates as countries running deficits become more risky.

This means that spending on transportation, power and other basic infrastructure that was publicly financed in North America and the leading European economies (providing services at subsidized rates) must be privatized. Prices for these services must be set high enough to cover interest and other financing charges, high salaries and bonuses, and be run for profit – indeed, for rent extraction as public regulatory authority is disabled.

This makes countries going this route less competitive. It also means they will run into debt to Germany, France and the Netherlands, causing the financial strains that now are leading to showdowns with democratically elected governments. At issue is whether Europe should succumb to centralized planning – on the right wing of the political spectrum, under the banner of “free markets” defined as economies free from public price regulation and oversight, free from consumer protection, and free from taxes on the rich.

The crisis for Greece – as for Iceland, Ireland and debt-plagued economies capped by the United States – is occurring as bank lobbyists demand that “taxpayers” pay for the bailouts of bad speculations and government debts stemming largely from tax cuts for the rich and for real estate, shifting the fiscal burden as well as the debt burden onto labor and industry. The financial sector’s growing power to achieve this tax favoritism is crippling economies, driving them further into reliance on yet more debt financing to remain solvent. Aid is conditional upon recipient countries reducing their wage levels (“internal devaluation”) and selling off public enterprises.

The tunnel vision that guides these policies is self-reinforcing. Europe, America and Japan draw their economic managers from the ranks of professionals sliding back and forth between the banks and finance ministries – what the Japanese call “descent from heaven” to the private sector where worldly rewards are greatest. It is not merely delayed payment for past service. Their government experience and contacts helps them influence the remaining public bureaucracy and lobby their equally opportunistic replacements to promote pro-financial fiscal and monetary policies – that is, to handcuff government and deter regulation and taxation of the financial sector and its real estate and monopoly clients, and to use the government’s taxing and money-creating power to provide bailouts when the inevitable financial collapse occurs as the economy shrinks below break-even levels into negative equity territory.

Regressive tax policies – shifting taxes off the rich and off property onto labor – cause budget deficits financed by public debt. When bondholders pull the plug, the resulting debt pressure forces governments to pay off debts by selling land and other public assets to private buyers (unless governments repudiate the debt or recover by restoring progressive taxation). Most such sales are done on credit. This benefits the banks by creating a loan market for the buyouts. Meanwhile, interest absorbs the earnings, depriving the government of tax revenue it formerly could have received as user fees. The tax gift to financiers is based on the bad policy of treating debt financing as a necessary cost of doing business, not as a policy choice – one that indeed is induced by the tax distortion of making interest payments tax-deductible.

Buyers borrow credit to appropriate “the commons” in the same way they bid for commercial real estate. The winner is whoever raises the largest buyout loan – by pledging the most revenue to pay the bank as interest. So the financial sector ends up with the revenue hitherto paid to governments as taxes or user fees. This is euphemized as a free market.

Promoting the financial sector at the economy’s expense

The resulting debt leveraging is not a solvable problem. It is a quandary from which economies can escape only by focusing on production and consumption rather than merely subsidizing the financial system to enable players to make money from money by inflating asset prices on free electronic keyboard credit. Austerity causes unemployment, which lowers wages and prevents labor from sharing in the surplus. It enables companies to force their employees to work overtime and harder in order to get or keep a job, but does not really raise productivity and living standards in the way envisioned a century ago. Increasing housing prices on credit – requiring larger debts for access to home ownership – is not real prosperity.

To contrast the “real” economy from the financial sector requires distinctions to be drawn between productive and unproductive credit and investment. One needs the concept of economic rent as an institutional and political return to privilege without a corresponding cost of production. Classical political economy was all about distinguishes earned from unearned income, cost-value from market price. But pro-financial lobbyists deny that any income or rentier wealth is unearned or parasitic. The national income and product accounts (NIPA) do not draw any such distinction. This blind spot is not accidental. It is the essence of post-classical economics. And it explains why Europe is so crippled.

The way in which the euro was created in 1999 reflects this shallow vision. The Maastricht fiscal and financial rules maximize the commercial loan market by preventing central banks from supplying governments (and hence, the economy) with credit to grow. Commercial banks are to be the sole source of financing budget deficits – defined to include infrastructure investment in transportation, communication, power and water. Privatization of these basic services blocks governments from supplying them at subsidized rates or freely. So roads are turned into toll roads, charging access fees that are readily monopolized. Economies are turned into sets of tollbooths, paying out their access charges as interest to creditors. These extractive rents make privatized economies high-cost. But to the financial sector that is “wealth creation.” It is enhanced by untaxing interest payments to banks and bondholders – aggravating fiscal deficits in the process, however.

The Greek budget crisis in perspective

A fiscal legacy of the colonels’ 1967-74 junta was tax evasion by the well to do. The “business-friendly” parties that followed were reluctant to tax the wealthy. A 2010 report stated that nearly a third of Greek income was undeclared, with “fewer than 15,000 Greeks declar[ing] incomes of over €100,000, despite tens of thousands living in opulent wealth on the outskirts of the capital. A new drive by the Socialists to track down swimming pool owners by deploying Google Earth was met with a virulent response as Greeks invested in fake grass, camouflage and asphalt to hide the tax liabilities from the spies in space.”

As a result of the military dictatorship depressing public spending below the European norm, infrastructure needed to be rebuilt – and this required budget deficits. The only way to avoid running them would have been to make the rich pay the taxes they were supposed to. But squeezing public spending to the level that wealthy Greeks were willing to pay in taxes did not seem politically feasible. (Almost no country since the 1980s has enacted Progressive Era tax policies.) The 3% Maastricht limit on budget deficits refused to count capital spending by government as capital formation, on the ideological assumption that all government spending is deadweight waste and only private investment is productive.

The path of least resistance was to engage in fiscal deception. Wall Street bankers helped the “conservative” (that is, fiscally regressive and financially profligate) parties conceal the extent of the public debt with the kind of junk accounting that financial engineers had pioneered for Enron. And as usual when financial deception in search of fees and profits is concerned, Goldman Sachs was in the middle. In February 2010, the German magazine Der Spiegel exposed how the firm had helped Greece conceal the rise in public debt, by mortgaging assets in a convoluted derivatives deal – legal but with the covert intent of circumventing the Maastricht limitation on deficits. “Eurostat’s reporting rules don’t comprehensively record transactions involving financial derivatives,” so Greece’s obligation appeared as a cross-currency swap rather than as a debt. The government used off-balance-sheet entities and derivatives similar to what Icelandic and Irish banks later would use to indulge in fictitious debt disappearance and an illusion of financial solvency.

The reality, of course, was a virtual debt. The government was obligated to pay Wall Street billions of euros out of future airport landing fees and the national lottery as “the so-called cross currency swaps … mature, and swell the country’s already bloated deficit.” Translated into straightforward terms, the deal left Greece’s public-sector budget deficit at 12 percent of GDP, four times the Maastricht limit.

Using derivatives to engineer Enron-style accounting enabled Greece to mask a debt as a market swap based on foreign currency options, to be unwound over ten to fifteen years. Goldman was paid some $300 million in fees and commissions for its aid orchestrating the 2001 scheme. “A similar deal in 2000 called Ariadne devoured the revenue that the government collected from its national lottery. Greece, however, classified those transactions as sales, not loans.” JPMorgan Chase and other banks helped orchestrate similar deals across Europe, providing “cash upfront in return for government payments in the future, with those liabilities then left off the books.”

The financial sector has an interest in understating the debt burden – first, by using “mark to model” junk accounting, and second, by pretending that the debt burden can be paid without disrupting economic life. Financial spokesmen from Tim Geithner in the United States to Dominique Strauss-Kahn at the IMF claimed that the post-2008 debt crisis is merely a short-term “liquidity problem” (lack of “confidence”), not insolvency reflecting an underlying inability to pay. Banks promise that everything will be all right when the economy “returns to normal” – if only the government will buy their junk mortgages and bad loans (“sound long-term investments”) for ready cash.

The intellectual deception at work

Financial lobbyists seek to distract voters and policy makers from realizing that “normalcy” cannot be restored without wiping out the debts that have made the economy abnormal. The larger the debt burden grows, the more economy-wide austerity is required to pay debts to banks and bondholders instead of investing in capital formation and real growth.

Austerity makes the problem worse, by intensifying debt deflation. To pretend that austerity helps economies rather than destroys them, bank lobbyists claim that shrinking markets will lower wage rates and “make the economy more competitive” by “squeezing out the fat.” But the actual “fat” is the debt overhead – the interest, amortization, financial fees and penalties built into the cost of doing business, the cost of living and the cost of government.

When difficulty arises in paying debts, the path of least resistance is to provide more credit – to enable debtors to pay. This keeps the system solvent by increasing the debt overhead – seemingly an oxymoron. As financial institutions see the point approaching where debts cannot be paid, they try to get “senior creditors” – the ECB and IMF – to lend governments enough money to pay, and ideally to shift risky debts onto the government (“taxpayers”). This gets them off the books of banks and other large financial institutions that otherwise would have to take losses on Greek government bonds, Irish bank obligations bonds, etc., just as these institutions lost on their holdings of junk mortgages. The banks use the resulting breathing room to try and dump their bond holdings and bad bets on the proverbial “greater fool.”

In the end the debts cannot be paid. For the economy’s high-financial managers the problem is how to postpone defaults for as long as possible – and then to bail out, leaving governments (“taxpayers”) holding the bag, taking over the obligations of insolvent debtors (such as A.I.G. in the United States). But to do this in the face of popular opposition, it is necessary to override democratic politics. So the divestment by erstwhile financial losers requires that economic policy be taken out of the hands of elected government bodies and transferred to those of financial planners. This is how financial oligarchy replaces democracy.

Paying higher interest for higher risk, while protecting banks from losses

The role of the ECB, IMF and other financial oversight agencies has been to make sure that bankers got paid. As the past decade of fiscal laxity and deceptive accounting came to light, bankers and speculators made fortunes jacking up the interest rate that Greece had to pay for its increasing risk of default. To make sure they did not lose, bankers shifted the risk onto the European “troika” empowered to demand payment from Greek taxpayers.

Banks that lent to the public sector (at above-market interest rates reflecting the risk), they were to be bailed out at public expense. (At the time of the spring 2010 bailout French banks held €31 billion of Greek bonds, compared to €23 billion by German banks. This helps explain why French President Nicolas Sarkozy sought to take major credit for the bailout, based on a May 7, 2010 discussions with EU Commission President José Manuel Barroso, ECB President Jean-Claude Trichet and Eurogroup President Jean-Claude Juncker.)

Demanding that Greece not impose a “haircut” on creditors, the ECB and related EU bureaucracy demanded a better deal for European bondholders than creditors received from the Brady bonds that resolved Latin American and Third World debts in the 1980s. In an interview with the Financial Times, ECB executive board member Lorenzo Bini Smaghi insisted:

First, the Brady bonds solution was a solution for American banks, which were basically allowed not to ‘mark to market’ the restructured bonds. There was regulatory forbearance, which was possible in the 1980 but would not be possible today.

Second, the Latin American crisis was a foreign debt crisis. The main problem in the Greek crisis is Greece, its banks and its own financial system. Latin America had borrowed in dollars and the lines of credit were mainly with foreigners. Here, a large part of the debt is with Greeks. If Greece defaulted, the Greek banking system would collapse. It would then need a huge recapitalization – but where would the money come from?

Third, after default the Latin American countries still had a central bank that could print money to pay for civil servants’ wages, pensions. They did this and created inflation. So they got out [of the crisis] through inflation, depreciation and so forth. In Greece you would not have a central bank that could finance the government, and it would have to partly shut down some of its operations, like the health system.

Mr. Bini Smaghi threatened that Europe would destroy the Greek economy if it tried to scale back its debts or even stretch out maturities to reflect the ability to pay. Greece’s choice was between or anarchy. Restructuring would not benefit “the Greek people. It would entail a major economic, social and even humanitarian disaster, within Europe. Orderly implies things go smoothly, but if you wipe out the banking system, how can it be smooth?” The ECB’s “position [is] based on principle … In the euro area debts have to be repaid and countries have to be solvent. That has to be the principle of a market-based economy.”

A creditor-oriented economy is not really a market-based, of course. The banks destroyed the market by their own central financial planning — using debt leverage to leave Greece with a bare choice: Either it would permit EU officials to come in and carve up its economy, selling its major tourist sites and monopolistic rent-extracting opportunities to foreign creditors in a gigantic national foreclosure movement, or it could bite the bullet and withdraw from the Eurozone. That was the deal Mr. Bini Smaghi offered: “if there are sufficient privatizations, and so forth – then the IMF can disburse and the Europeans will do their share. But the key lies in Athens, not elsewhere. The key element for the return of Greece to the market is to stop discussions about restructuring.”

One way or another, Greece would lose, he explained: “default or restructuring would not help solve the problems of the Greek economy, problems that can be solved only by adopting the kind of structural reforms and fiscal adjustment measures included in the programme. On the contrary it would push Greece into a major economic and social depression.” This leverage demanding to be paid or destroying the economy’s savings and monetary system is what central bankers call a “rescue,” or “restoring market forces.” Bankers claim that austerity will revive growth. But to accept as a realistic democratic alternative would be self-immolation.

Unless Greece signed onto this nonsense, neither the ECB nor the IMF would extend loans to save its banking system from insolvency. On May 31, 2011, Europe agreed to provide $86 billion in euros if Greece “puts off for the time being a restructuring, hard or soft, of Greece’s huge debt burden.” The pretense was a “hope that in another two years Greece will be in a better position to repay its debts in full.” Anticipation of the faux rescue led the euro to rebound against foreign currencies, and European stocks to jump by 2%. Yields on Greek 10-year bonds fell to “only” a 15.7 percent distress level, down one percentage point from the previous week’s high of 16.8 percent when a Greek official made the threatening announcement that “Restructuring is off the table. For now it is all about growth, growth, growth.”

How can austerity be about growth? This idea never has worked, but the pretense was on. The EU would provide enough money for the Greek government to save bondholders from having to suffer losses. The financial sector supports heavy taxpayer expense as long as the burden does not fall on itself or its main customers in the real estate sector or the infrastructure monopolies being privatized.

The loan-for-privatization tradeoff was called “aiding Greece” rather than bailing out German, French and other bondholders. But financial investors knew better. “Since the crisis began, 60 billion euros in deposits have been withdrawn from Greek banks, about a quarter of the country’s output.” These withdrawals, which were gaining momentum, were the precise size of the loan being offered!

Meanwhile, the shift of 60 billion euros off the balance sheets of banks onto the private sector threatened to raise the ratio of public debt to GDP over 150 percent. There was talk that another 100 billion euros would be needed to “socialize the losses” that otherwise would be suffered by German, French and other European bankers who had their eyes set on a windfall if heavily discounted Greek bonds were made risk-free by carving up Greece in much the same way that the Versailles Treaty did to Germany after World War I.

The Greek population certainly saw that the world was at financial war. Increasingly large crowds gathered each day to protest in Syntagma Square in front of the Parliament, much as Icelandic crowds had done earlier under similar threats by their Social Democrats to sell out the nation to European creditors. And just as Iceland’s Prime Minister Sigurdardottir held on arrogantly against public opinion, so did Greek Socialist Prime Minister George Papandreou. This prompted EU Fisheries Commissioner Maria Damanaki “to ‘speak openly’ about the dilemma facing her country,” warning: “The scenario of Greece’s exit from the euro is now on the table, as are ways to do this. Either we agree with our creditors on a programme of tough sacrifices and results … or we return to the drachma. Everything else is of secondary importance.” And former Dutch Finance Minister Willem Vermeend wrote in De Telegraaf that ‘Greece should leave the euro,’ given that it will never be able to pay back its debt.”

As in Iceland, the Greek austerity measures are to be put to a national referendum – with polls reporting that some 85 percent of Greeks reject the bank-bailout-cum-austerity plan. Its government is paying twice as much for credit as the Germans, despite seemingly having no foreign-exchange risk (using the euro). The upshot may be to help drive Greece out of the eurozone, not only by forcing default (the revenue is not there to pay) but by Newton’s Third Law of Political Motion: Every action creates an equal and opposite reaction. The ECB’s attempt to make Greek labor –(“taxpayers”) pay foreign bondholders is leading to pressure for outright repudiation and the domestic “I won’t pay” movement. Greece’s labor movement always has been strong, and the debt crisis is further radicalizing it.

The aim of commercial banks is to replace governments in creating money, making the economy entirely dependent on them, with public borrowing creating an enormous risk-free “market” for interest-bearing loans. It was to overcome this situation that the Bank of England was created in 1694 – to free the country from reliance on Italian and Dutch credit. Likewise the U.S. Federal Reserve, for all its limitations, was founded to enable the government to create its own money. But European banks have hog-tied their governments, replacing Parliamentary democracy with dictatorship by the ECB, which is blocked constitutionally from creating credit for governments – until German and French banks found it in their own interest for it to do so. As UMKC Professor Bill Black summarizes the situation:

A nation that gives up its sovereign currency by joining the euro gives up the three most effective means of responding to a recession. It cannot devalue its currency to make its exports more competitive. It cannot undertake an expansive monetary policy. It does not have any monetary policy and the EU periphery nations have no meaningful influence on the ECB’s monetary policies. It cannot mount an appropriately expansive fiscal policy because of the restrictions of the EU’s growth and stability pact. The pact is a double oxymoron – preventing effective counter-cyclical fiscal policies harms growth and stability throughout the Eurozone.

Financial politics are now dominated by the drive to replace debt defaults by running a fiscal surplus to pay bankers and bondholders. The financial system wants to be paid. But mathematically this is impossible, because the “magic of compound interest” outruns the economy’s ability to pay – unless central banks flood asset markets with new bubble credit, as U.S. policy has done since 2008. When debtors cannot pay, and when the banks in turn cannot pay their depositors and other counterparties, the financial system turns to the government to extract the revenue from “taxpayers” (not the financial sector itself). The policy bails out insolvent banks by plunging domestic economies into debt deflation, making taxpayers bear the cost of banks gone bad.

These financial claims are virtually a demand for tribute. And since 2010 they have been applied to the PIIGS countries. The problem is that revenue used to pay creditors is not available for spending within the economy. So investment and employment shrink, and defaults spread. Something must give, politically as well as economically as society is brought back to the “Copernican problem”: Will the “real” economy of production and consumption revolve around finance, or will financial demands for interest devour the economic surplus and begin to eat into the economy?

Technological determinists believe that technology drives. If this were so, rising productivity would have made everybody in Europe and the United States wealthy by now, rich enough to be out of debt. But there is a Chicago School inquisition insisting that today’s needless suffering is perfectly natural and even necessary to rescue economies by saving their banks and debt overhead – as if all this is the economic core, not wrapped around the core.

Meanwhile, economies are falling deeper into debt, despite rising productivity measures. The seeming riddle has been explained many times, but is so counter-intuitive that it elicits a wall of cognitive dissonance. The natural view is to think that the world shouldn’t be this way, letting credit creation load down economies with debt without financing the means to pay it off. But this imbalance is the key dynamic defining whether economies will grow or shrink.

John Kenneth Galbraith explained that banking and credit creation is so simple a principle that the mind rejects it – because it is something for nothing, the proverbial free lunch stemming from the principle of banks creating deposits by making loans. Just as nature abhors a vacuum, so most people abhor the idea that there is such a thing as a free lunch. But the financial free lunchers have taken over the political system.

They can hold onto their privilege and avert a debt write-down only as long as they can prevent widespread moral objection to the idea that the economy is all about saving creditor claims from being scaled back to the economy’s ability to pay – by claiming that the financial brake is actually the key to growth, not a free transfer payment.

The upcoming Greek referendum poses this question just as did Iceland’s earlier this spring. As Yves Smith recently commented regarding the ECB’s game of chicken as to whether Greece’s government would accept or reject its hard terms:

This is what debt slavery looks like on a national level. …

Greece looks to be on its way to be under the boot of bankers just as formerly free small Southern farmers were turned into “debtcroppers” after the US Civil War. Deflationary policies had left many with mortgage payments that were increasingly difficult to service. Many fell into “crop lien” peonage. Farmers were cash starved and pledged their crops to merchants who then acted in an abusive parental role, being given lists of goods needed to operate the farm and maintain the farmer’s family and doling out as they saw fit. The merchants not only applied interest to the loans, but further sold the goods to farmers at 30% or higher markups over cash prices. The system was operated, by design, so that the farmer’s crop would never pay him out of his debts (the merchant as the contracted buyer could pay whatever he felt like for the crop; the farmer could not market it to third parties). This debt servitude eventually led to rebellion in the form of the populist movement.

One would expect a similar political movement today. And as in the late 19th century, academic economics will be mobilized to reject it. Subsidized by the financial sector, today’s economic orthodoxy finds it natural to channel productivity gains to the finance, insurance and real estate (FIRE) sector and monopolies rather than to raise wages and living standards. Neoliberal lobbyists and their academic mascots dismiss sharing productivity gains with labor as being unproductive and not conducive to “wealth creation” financial style.

Making governments pay creditors when banks run aground

At issue is not only whether bank debts should be paid by taking them onto the public balance sheet at taxpayer expense, but whether they can reasonably be paid. If they cannot be, then trying to pay them will shrink economies further, making them even less viable. Many countries already have passed this financial limit. What is now in question is a political step – whether there is a limit to how much further creditor interests can push national populations into debt-dependency. Future generations may look back on our epoch as a great Social Experiment on how far the point may be deferred at which government – or parliaments – will draw a line against taking on public liability for debts beyond any reasonable capacity to pay without drastically slashing public spending on education, health care and other basic services?

Is a government – or economy – be said to be solvent as long as it has enough land and buildings, roads, railroads, phone systems and other infrastructure to sell off to pay interest on debts mounting exponentially? Or should we think of solvency as existing under existing proportions in our mixed public/private economies? If populations can be convinced of the latter definition – as those of the former Soviet Union were, and as the ECB, EU and IMF are now demanding – then the financial sector will proceed with buyouts and foreclosures until it possesses all the assets in the world, all the hitherto public assets, corporate assets and those of individuals and partnerships.

This is what today’s financial War of All against All is about. And it is what the Greeks gathering in Syntagma Square are demonstrating about. At issue is the relationship between the financial sector and the “real” economy. From the perspective of the “real” economy, the proper role of credit – that is, debt – is to fund productive capital investment and economic growth. After all, it is out of the economic surplus that interest is to be paid. This requires a tax system and financial regulatory system to maximize the growth. But that is precisely the fiscal policy that today’s financial sector is fighting against. It demands tax-deductibility for interest, encouraging debt financing rather than equity. It has disabled truth-in-lending laws and regulation keeping prices (the interest rate and fees) in line with costs of production. And it blocks governments from having central banks to freely finance their own operations and provide economies with money.

Banks and their financial lobbyists have not shown much interest in economy-wide wellbeing. It is easier and quicker to make money by being extractive and predatory. Fraud and crime pay, if you can disable the police and regulatory agencies. So that has become the financial agenda, eagerly endorsed by academic spokesmen and media ideologues who applaud bank managers and subprime mortgage brokers, corporate raiders and their bondholders, and the new breed of privatizers, using the one-dimensional measure of how much revenue can be squeezed out and capitalized into debt service. From this neoliberal perspective, an economy’s wealth is measured by the magnitude of debt obligations – mortgages, bonds and packaged bank loans – that capitalize income and even hoped-for capital gains at the going rate of interest.

Iceland belatedly decided that it was wrong to turn over its banking to a few domestic oligarchs without any real oversight or regulation over their self-dealing. From the vantage point of economic theory, was it not madness to imagine that Adam Smith’s quip about not relying on the benevolence of the butcher, brewer or baker for their products, but on their self-interest is applicable to bankers? Their “product” is not a tangible consumption good, but interest-bearing debt. These debts are a claim on output, revenue and wealth; they do not constitute real wealth.

This is what pro-financial neoliberals fail to understand. For them, debt creation is “wealth creation” (Alan Greenspan’s favorite euphemism) when credit – that is, debt – bids up prices for property, stocks and bonds and thus enhances financial balance sheets. The “equilibrium theory” that underlies academic orthodoxy treats asset prices (financialized wealth) as reflecting a capitalization of expected income. But in today’s Bubble Economy, asset prices reflect whatever bankers will lend. Rather than being based on rational calculation, their loans are based on what investment bankers are able to package and sell to frequently gullible financial institutions. This logic leads to attempts to pay pensions out of a “wealth creating” process that runs economies into debt.

It is not hard to statistically illustrate this. There amount of debt that an economy can pay is limited by the size of its surplus, defined as corporate profits and personal income for the private sector, and net fiscal revenue paid to the public sector. But neither today’s financial theory nor global practice recognizes a capacity-to-pay constraint. So debt service has been permitted to eat into capital formation and reduce living standards – and now, to demand privatization sell-offs.

As an alternative is to such financial demands, Iceland has provided a model for what Greece may do. Responding to British and Dutch demands that its government guarantee payment of the Icesave bailout, the Althing recently asserted the principle of sovereign debt:

The preconditions for the extension of government guarantee according to this Act are:

1. That … account shall be taken of the difficult and unprecedented circumstances with which Iceland is faced with and the necessity of deciding on measures which enable it to reconstruct its financial and economic system.

This implies among other things that the contracting parties will agree to a reasoned and objective request by Iceland for a review of the agreements in accordance with their provisions.

2. That Iceland’s position as a sovereign state precludes legal process against its assets which are necessary for it to discharge in an acceptable manner its functions as a sovereign state.

Instead of imposing the kind of austerity programs that devastated Third World countries from the 1970s to the 1990s and led them to avoid the IMF like a plague, the Althing is changing the rules of the financial system. It is subordinating Iceland’s reimbursement of Britain and Holland to the ability of Iceland’s economy to pay:

In evaluating the preconditions for a review of the agreements, account shall also be taken to the position of the national economy and government finances at any given time and the prospects in this respect, with special attention being given to foreign exchange issues, exchange rate developments and the balance on current account, economic growth and changes in gross domestic product as well as developments with respect to the size of the population and job market participation.

This is the Althing proposal to settle its Icesave bank claims that Britain and the Netherlands rejected so passionately as “unthinkable.” So Iceland said, “No, take us to court.” And that is where matters stand right now.

Greece is not in court. But there is talk of a “higher law,” much as was discussed in the United States before the Civil War regarding slavery. At issue today is the financial analogue, debt peonage.

Will it be enough to change the world’s financial environment? For the first time since the 1920s (as far as I know), Iceland made the capacity-to-pay principle the explicit legal basis for international debt service. The amount to be paid is to be limited to a specific proportion of the growth in its GDP (on the admittedly tenuous assumption that this can indeed be converted into export earnings). After Iceland recovers, the Treasury offered to guarantee payment for Britain for the period 2017-2023 up to 4% of the growth of GDP after 2008, plus another 2% for the Dutch. If there is no growth in GDP, there will be no debt service. This meant that if creditors took punitive actions whose effect is to strangle Iceland’s economy, they wouldn’t get paid.

No wonder the EU bureaucracy reacted with such anger. It was a would-be slave rebellion. Returning to the applicable of Newton’s Third Law of motion to politics and economics, it was natural enough for Iceland, as the most thoroughly neoliberalized disaster area, to be the first economy to push back. The past two years have seen its status plunge from having the West’s highest living standards (debt-financed, as matters turn out) to the most deeply debt-leveraged. In such circumstances it is natural for a population and its elected officials to experience a culture shock – in this case, an awareness of the destructive ideology of neoliberal “free market” euphemisms that led to privatization of the nation’s banks and the ensuing debt binge.

The Greeks gathering in Syntagma Square seem to need no culture shock to reject their Socialist government’s cave-in to European bankers. It looks like they may follow Iceland in leading the ideological pendulum back toward a classical awareness that in practice, this rhetoric turns out to be a junk economics favorable to banks and global creditors. Interest-bearing debt is the “product” that banks sell, after all. What seemed at first blush to be “wealth creation” was more accurately debt-creation, in which banks took no responsibility for the ability to pay. The resulting crash led the financial sector to suddenly believe that it did love centralized government control after all – to the extent of demanding public-sector bailouts that would reduce indebted economies to a generation of fiscal debt peonage and the resulting economic shrinkage.

As far as I am aware, this agreement is the first since the Young Plan for Germany’s reparations debt to subordinate international debt obligations to the capacity-to-pay principle. The Althing’s proposal spells this out in clear terms as an alternative to the neoliberal idea that economies must pay willy-nilly (as Keynes would say), sacrificing their future and driving their population to emigrate in a vain attempt to pay debts that, in the end, can’t be paid but merely leave debtor economies hopelessly dependent on their creditors. In the end, democratic nations are not willing to relinquish political planning authority to an emerging financial oligarchy.

No doubt the post-Soviet countries are watching, along with Latin American, African and other sovereign debtors whose growth has been stunted by predatory austerity programs imposed by IMF, World Bank and EU neoliberals in recent decades. We should all hope that the post-Bretton Woods era is over. But it won’t be until the Greek population follows that of Iceland in saying no – and Ireland finally wakes up.

Financial Times columnist Martin Wolf writes that the eurozone “has only two options: to go forwards towards a closer union or backwards towards at least partial dissolution. … either default and partial dissolution or open-ended official support.” But ECB intransigence leaves little alternative to breakup. Europe’s payments-surplus nations are waging financial war against the deficit countries. Without a common union based on mutual support within a mixed economy – one capable of checking financial aggression – the European Central Bank replaced the military high command. Its bold gamble is whether the Greeks will be as stupid as the Irish, not as smart as the Icelanders.

Macro E.U. — D.O.A.

John Mauldin — Wed, 25 May 2011 02:43:00 GMT

I am attending the Global Interdependence Center’s latest conference here in Philadelphia, writing you from the Admiral’s Club on my way to Boston. The chatter last night at dinner and between sessions was focused on the risks in Europe. I did an interview with Aaron Task on Yahoo’s Daily Ticker, where I noted that European leaders are starting to use the word containedwhen they talk about Greece. Shades of Bernanke and subprime. This too will not be contained.

And that brings us to this week’s Outside the Box. Greg Weldon has graciously allowed me to use his latest missive on Europe’s woes. A teaser:

“The EU, like the US, suffers from what we might call the 'Cyrenaic Syndrome', a dynamic linked to the ancient Greek philosophers Aristippus and Hegesias of Cyrene, who, in 3rd and 4th Centuries BC, hypothesized that the goal of life was the avoidance of pain and suffering. Addicts accomplish this thru substance abuse. The EU is trying to accomplish this thru pure denial, and an outright refusal to accept that austerity, like sobriety, is the ONLY way to actually deal with the problems it faces.”

Greg is my favorite slicer and dicer of data. And he (as a registered CTA) has real skin in the game, as he runs money; so his work is not just some guy drawing lines on charts. He has to draw real-world conclusions, for real-world trades. For those who have NOT had a free trial of Weldon’s three research publications, visit www.Weldononline.com and sign up for a free trial.

And for the record, the euro will not fall out of bed until I have exchanged my last dollar in the third week of June. But what’s a little exchange-rate issue when you are talking Tuscany? I can’t complain too much. Have a great week.

Your wondering if Bernanke will ever say the word contained again analyst,

John Mauldin, Editor
Outside the Box

Macro E.U. — D.O.A.

By Greg Weldon

Today's Money Monitor theme can be pitched two ways ...

... D.O.A. = Dead on Arrival ...

... or ... D.O.A. = Debt Offenders Anonymous

Either way, the title applies to our examination of the still-intensifying EU debt-deficit debacle. We are tempted to say that the Eurocurrency is currently being rushed to the hospital, and that it is likely to be pronounced 'D.O.A.', or dead-on-arrival ...

... but we think the more 'appropriate' analogy is to look at the EU as if it were a prime candidate to join a twelve-step self-help program called D.O.A., or 'debt-offenders-anonymous'.

The first step would be 'acceptance'.

However, the EU is not yet capable of this, as it remains 'in denial'.

As EU debt markets come under renewed pressure amid a broadening in the scope of downgrades to sovereign credit ratings, and ratings outlooks, we note commentary from the Union's Economic and Monetary Affairs Commissioner Olli Rehn ...

... "We have contained the crisis to the three countries now in the EU-IMF programs. It is not correct to speak of a crisis of the euro or monetary union."

DENIAL, case closed.

EU officialdom, via their denial, continues to be an 'enabler'.

Of course, a symptom almost always attached to an 'addict', is lying ... by the addict, AND by the co-dependent enabler.

Thus we find it MOST interesting to observe last week's startling admission from the head of the EU Finance Ministers, Luxembourg's Jean-Claude Juncker, who stated that he "LIED' to the press and the public, regarding a secret meeting of top EU officialdom, held to discuss the Greek situation ...

... "It was done in the interest of the people who use the euro as their common currency. The denial immediately prevented further speculation in the markets. Speculation about an exit by Greece from the euro-zone had to be avoided at all costs, in the interest of the euro-zone."

Denials and lies --- this has become the EU's arsenal.

The reality is ... the EU is unwilling to accept the fact that it has become addicted to debt and deficits, and that their fiscal life has become 'unmanageable’. The EU must first admit to themselves, and to the markets, the exact nature of their wrong-doing.

Without acceptance, the EU cannot reach the point where they can make a conscious decision to turn over their 'will' to a 'higher power', which in this case would be 'fiscal austerity', and a restructuring of debt that will allow the situation to become 'manageable'.

Without acceptance, the EU cannot even think about 'making amends'.

The EU (along with the US) is in desperate NEED of a 'spiritual awakening'.

The problem is one linked to our instinctive nature as human beings ...

... a thing called ... the desire to avoid pain, at any cost.

The EU, like the US, suffers from what we might call the 'Cyrenaic Syndrome', a dynamic linked to the ancient Greek philosophers Aristippus and Hegesias of Cyrene, who, in 3rd and 4th Centuries BC, hypothesized that the goal of life was the avoidance of pain and suffering. Addicts accomplish this thru substance abuse. The EU is trying to accomplish this thru pure denial, and an outright refusal to accept that austerity, like sobriety, is the ONLY way to actually deal with the problems it faces.

The EU is still ... FAR ... from 'hitting bottom'.

For SURE ... the debt-deficit crisis is NOT "contained", as Olli Rehn would have us believe. We have been pounding the table for years, screaming that the problems facing Greece, Ireland, and Portugal, will look like CHILD'S PLAY, when the situation in Belgium, Spain, and Italy, begins to take center stage. This is NOW HAPPENING, on the back of today's outlook downgrade placed on Belgium and Italy, in synch with intensified anxiety linked to Spain following weekend elections in which the ruling Socialist party got mauled.

At the heart of the issue in Spain, and Greece, is rising unemployment. Indeed data released last week in Greece revealed a jump to yet another new high in the Unemployment Rate, as seen in the chart. The Unemployment Rate jumped to 15.9% in February (data lagged by one-month), up from 15.1% in January, and up from 12.1% in Feb-2010. Worse yet, the Number of Unemployed has now spiked higher by +30.1% versus last February, and is up by a mind-numbing +99.9% versus February of 2008.

We also shine the spotlight on data released by the Greek National Statistics Service two weeks ago revealing that Industrial Production contracted by (-) 8.0% year-over-year during the month of March, plummeting deeper into negative territory versus the decline of (-) 4.8% yr-yr posted in February ...

... LED by a double-digit decline in the year-year rate of Manufacturing Output, which plunged by (-) 10.3% during March, sliding from a (-) 6.8% yr-yr contraction in February, and the (-) 4.5% yr-yr decline seen in January. Evidence the chart on display below, which speaks for itself.

Further, we note today's report on the Greek Budget, revealing that DESPITE austerity measures undertaken as part of the EU-IMF directed program, the Deficit WORSENED during the month of April. Indeed, the government reported a deficit of (-) EUR 7.246 billion in the four-month YTD 2011, an 'increase' of +13.7% versus the same period 2010.

Worse yet ... Revenue FELL, while Spending ROSE ... with Revenue falling by (-) 9.1% in the YTD-yr-yr, and Spending rising by +3.6%.

Problematic for SURE ... as a rise of +14.4% in Outlays linked directly to Interest Payments on the debt, which accounted for a MIND-BLOWING 52.7% of the TOTAL DEFICIT in the year-to-date, pegged at (-) 3.819 billion EUR.

Unfortunately, Greek bond yields continue to SOAR, reaching a new ALL-TIME HIGH TODAY, as evidenced in the chart below, wherein the 2-Year Bond yield now exceeds 25%.

Turning to Spain, we note that the ruling Socialist Party got crushed in regional elections, falling victim to promises made by the People's Party that they will move to restructure the electoral process, and squash planned cuts to social spending programs.

Perhaps more troubling is the fact that the United Left Party, formerly the Spanish Communist Party, saw a significant rise in support from a disenchanted populous, in line with massive protests among the youth in the country last week, who reject thoughts of ... austerity.

Subsequently, we continue to closely monitor the action in the Spanish Government Bond market, with focus on the line-drawn-in-the-sand at 5%, as evidenced in the chart on display below plotting the country's 5-Year Sovereign Bond yield. Clearly, from a technical perspective, a rise in this bond's yield thru the double-top marked at 4.93%-4.95% would constitute a major upside breakout, and would come in synch with the upside acceleration taking place in the long-term trend defining 200-Day EXP-MA.

Similarly, we observe the chart shown below in which we plot the 5-Year Sovereign Credit Default Swap Rate linked to Spain's government's credit worthiness. We focus on the upside push taking place today, and the violation of the highs reached last May, in line with the upside directional reversal by the long-term 200-Day EXP-MA.

We have repeatedly stated that Greece, Ireland, and Portugal represent the minnows in the debt-deficit pond, while Spain and Belgium might be considered big-fish.

But, when it comes to Italy, we have used the term WHALE to describe the country and the risk attached to their HUGE outstanding debt, pegged at more than $2 trillion (including interest payments). With that in mind, we shine the spotlight on today's downgrade to Italy's credit rating outlook, instituted by Standard and Poor's, with specific focus on commentary from the agency ...

... "In our view, Italy's current growth prospects are weak, and the political commitment for productivity-enhancing reforms appear to be faltering, and potential political gridlock could contribute to fiscal slippage. As a result, we believe Italy's prospects for reducing its general government debt have diminished. If one or a combination of these risks materializes, Italy's general government debt could stagnate at current high levels. In this case, we may lower the long- and short-term ratings on Italy."

Subsequently, Italian Government Bond yields rose sharply today, with the 2-Year Bond moving above 3%, and the 5-Year yield spiking upwards to more than 4% ... amid a widening in the spread over Germany's comparable 2-Year Schatz yield, and the German 5-Year BOBL yield. We note the 5-Year spread in the chart on display below, with focus on the fact that Italy's yields are threatening to breakout to the upside, while German yields actually fell today, amid a flight to safety among regional bond investors.

We are keen to watch the price action in the Italian 10-Year BTP futures contract, as noted in the chart below, with thoughts of being short amid the downside violation of the 100-Day EXP-MA, and the fresh sell signal being generated by the med-term Oscillator.

Against the negative backdrop of ratings news, macro-economic weakness, and overt denial by EU officialdom ...

... we examine the chart on display below plotting the Italian MIB Stock Index, which PLUNGED by (-) 3.32% in today's trading session, producing THE SINGLE LARGEST one-day LOSS of ANY industrialized nation, and trailing only Vietnam (down -3.48%) and Bangladesh (down -5.98%) as the day's largest losers in the world, stock market wise.

More importantly, we note the technical damage inflicted on the Italian stock index during today's trading session. We evidence the downside violation of the uptrend line that has defined the bull market run since the 1Q of 2009, in synch with the move below the March swing low, and the penetration of the long-term 200-Day EXP-MA (which has completed its downside directional reversal). A further decline below the May-25th 2010 low marked at 18,382 would constitute a full-blown breakdown.

The Spanish stock market got whacked as well, losing (-) 1.42% and taking out its March low. As noted in the chart below, the Spanish IBEX stock index is highly correlated to the German DAX, and tends to lead the German market. Indeed, both the Italian MIB and the Spanish IBEX are now threatening to lead the German market to the downside.

As such, we are becoming increasingly bearish on the DAX, in synch with the weakness exhibited by the Spanish and Italian equity markets. We shine the spotlight on the long-term weekly chart of the German DAX, shown below, with specific focus on the significant degree of bearish momentum divergence exhibited by the 52-Week Rate-of-Change indicator, and the long-term Oscillator, neither of which 'confirmed' the most recent newer new high in the underlying index itself.

Moreover, we note that both the long-term Stochastic indicator and the long-term Oscillator have generated renewed 'sell signals', via their dual downside rollovers. Subsequently, the door has been opened for a move to test the swing low set on March-16th at 6,412 (basis the nearby futures contract). A violation of this key technical support pivot would also cause a downside penetration of the long-term trend defining 52-Week EXP-MA, last marked at 6,792.

But there is a 'bigger picture' risk in play here, as ALL the addicts are at risk, the debt addicts, and the dollar-debasement/excess-liquidity addicts, as evidenced in the overlay chart on display below. We plot the path of the Spanish IBEX (blue), the German DAX (black), along with the US S+P 500 Index (purple), and the CRB Index of commodities prices (red).

In fact, Fed monetization driven 'Dollar Debasement' has been like 'smack' to the asset market ... without it ... withdrawal could be UGLY.

We note the high degree of correlation between dollar depreciation, as defined by the green bars plotted in the overlay chart shown below, representing the inverted price of the US Dollar Index (inverted to reflect a rise, when the value of the dollar declines) ...

... and ... the European stock markets, as represented by the German DAX (black line) and the Spanish IBEX (blue line).

With the Fed threatening to pull their debt monetization support for a continued debasement in the value of the USD ... the time for DENIAL is running short. We will be keeping an EKG attached to the Eurocurrency, seen in the daily chart below, to determine if it might be, DOA, or dead-on-arrival. We focus on today's technical breakdown, with a violation of the med-term trend defining 100-Day EXP-MA, completion of a head-and-shoulders topping pattern, and the bearish divergence in, and preliminary sell signal offered by, the med-term Oscillator.

Debt addicts are in denial, and monetary officialdom's enablers have shown a willingness to LIE, in order to provide protection from reality.

Dollar debasement addicts are also in denial, if they believe that there is NO pain to be felt in ALL asset markets, if the USD's multi-month trend towards depreciation is in the process of reversing, in line with a breakdown in the Eurocurrency.

If Europe is NOT willing to feel some pain, fiscally ...

... the markets will INFLICT PAIN, in the form of lower equity quotes, and higher bond yields.

Within the context of our Macro-Global Discretionary Managed Accounts Trading Program, we are bearish on European stock markets, and are becoming increasingly interested in the bearish side of the US equity market.

We are bearish on bond markets linked to fiscally challenged countries, against a bullish stance on the US and German bond markets.

We are bullish on the US Dollar Index ... and bearish on the EUR, along with the Canadian Dollar.

And, we are bearish on select commodity markets, with specific focus on the Industrial Metals sector (with focus on Copper, Nickel, Lead, Zinc, and Palladium) along with the Tropical-Soft sector (focusing on Sugar, Cocoa, Cotton, and Coffee).

Gregory T. Weldon

For those who have NOT had a free trial of Weldon’s three research publications, visit www.Weldononline.com and sign up for a free trial.

For information on Weldon’s Investment Programs, contact Eileen Cassidy at eileen@weldononline.com

GaveKal Five Corners

John Mauldin — Tue, 10 Aug 2010 18:32:00 GMT

This week we look at some mostly bullish analysis from my friends at GaveKal for the Outside the Box. Much of the letter is devoted to looking at why Europe may fare better than many think (which will make uber-European bull David Kotok happy to read!). But be very sure to read the last page as Steve Vannelli analyzes the latest speculation about the Fed and quantitative easing. All those calling for QE2 may not actually do what they think it will. His conclusion?

"Once again, if there is no growth in broad money, no increase in velocity and no increase in Fed credit (hybrid money), then the only source to finance growth in the real economy will remain the sale of risky assets. When confidence seems to be stuck in a low plateau and talk of reigning in fiscal deficits is growing louder, a policy of undermining the value of risky assets couldn't be more counterproductive to growth."

I find myself in New York this morning (I once again did Yahoo Tech Ticker) leaving for DC later. Then sadly will have to forego Turks and Caicos, but that does allow for me to go to Baton Rouge for a one day course on the affects of the gulf oil spill on the regional economy, helicopter flyovers, etc. I will report back in this week's letter what I learn.

Have a great week.

Your wishing he was still fishing in Maine analyst,

John Mauldin, Editor
Outside the Box

GaveKal Five Corners

By Francois-Xavier Chauchat, Pierre Gave, Steve Vannelli

The German Question

Looking at consensus growth forecasts for 2010-12, most believe that Germany’s current export boom will fail to translate into a convincing improvement for the domestic economy. Needless to say, this issue is of crucial importance for the sustainability of growth in Europe, and for its much-needed rebalancing. Simply put, Europe needs Germany to be more than an export power-house.

Fortunately, the inability of most to see beyond Germany’s exporting prowess (see, for example, every other Martin Wolf column) may just reflect the extrapolation of the previous economic upswing of 2003-2008. Indeed, the previous German export boom did not trigger an increase in domestic consumer spending (annual growth of private consumption averaged, over that period, a discouraging +0.25%). But looking forward, things may be different for the following reasons:

• To start with the obvious, domestic growth is not just about consumption; it is also about investment. Fixed capital formation grew very strongly in Germany from late 2005 to 2008, after a decade of sustained weakness, and contributed to no less than 40% of German GDP growth over that period. The same could easily happen from late 2010 to 2012. Interestingly, for the first time since early 2008, German banks are now reporting higher loan demand by companies for investment needs.

• From 2003 onwards, the sustained rise of the Euro and the overall inflexibility of the corporate environment made companies unable, and unwilling, to sacrifice their emerging profitability. Among other things, this resulted in nonexistent wage growth. But today, corporate Germany is competitive and profitable, the Euro has declined by -10% since last year, and unemployment has reached an 18-year low. As such, capping wage growth is no longer useful, nor is it feasible.

• The consolidation of government accounts from 2000 to 2007 hurt households considerably. Social contributions were hiked, social spending and pensions were cut, and the VAT was raised by a significant 3 percentage points in January 2007. For the years 2011-2014, the government plans a series of gradual spending cuts and tax increases on banks and utility companies. This time around, households should be spared. Meanwhile, the Ricardian effect of fiscal consolidation will likely be quite powerful as this could be the last push before Germany finally achieves the solid budgetary stability that it enjoyed before the country’s unification.

• Finally, evidence is increasing that former East Germany is emerging from a twenty year lethargy that cost some 3% of GDP each year in budget transfers from the West (see Green Shoots in the East German Desert). According to the latest IFO survey, companies of all kinds in the New Landers—from industrials to retailers—have the best assessment of the economic situation in the region’s History. Unemployment in DDR is also decreasing fast. Thus, for the first time since reunification, East Germany is no longer a headwind. For the above reasons, and even though the German economy will remain extremely dependent on global trade, the case for a gradual and sustained revival of investment and consumption in the biggest economy of Europe is probably more compelling than what most believe. After a decade of near-deflation comes normalization. And this normalization, coming on the heels of years of stagnation, could well look like a boom.

A US$2,000bn Rebalancing

As we have argued repeatedly in numerous reports, the Western World faces two distinct challenges:

• Over-extended banks that have over-collateralized real estate linked assets.

• Governments with massive unfunded liabilities (pensions, healthcare, etc…)

But needless to say, the picture is not uniform across the OECD and some nations are actually in fine shape (see The Nordic Hedge). Scandinavia or Switzerland, for example, will enjoy very favorable monetary conditions and rapidly recovering economic growth for the foreseeable future. In fact, these economies are already seeing their export boom morph into a strong pick-up in domestic demand, a recovery enhanced by rising consumer confidence and falling unemployment rates. According to the Swiss national bank and to the Swedish Riksbank, the domestic macro-situation justifies a continued normalization of monetary policy. However, with Euro, US$ and Sterling interest rates bound to remain close to zero for the foreseeable future, the SEK or CHF risk going to the roof if monetary policy is tightened significantly.

This constraint upon monetary policy in fiscally-sound countries (see The Riksbank Dilemma) implies that interest rates in these economies will very likely remain well below neutral over the next few years. The flipside is that the boom of domestic growth in Scandinavia and Switzerland thus has much further to go. For the Eurozone, this is significant as Scandinavia and Switzerland are even larger clients (12.7% of Euroland exports) than the US (11.6%) or China (5.8%). Interestingly, and importantly for the debate about Europe, the size of these economies almost exactly matches that of Portugal, Ireland, Greece and Spain (roughly US$2,000bn). So while the deflationary forces in these latter countries will remain a drag on European growth, the dynamism in Scandinavia and Switzerland could very well counter the downside pressures emanating from the PIGS.

The regional rebalancing of growth within continental Europe remains one of our central themes for the area (see Euroland’s Growth Prospects and Europe’s Outperformance and Strong Data). In the coming quarters, monitoring this rebalancing will be of crucial importance to assess the nature and the magnitude of risks attached to European financial assets. In our view, the ability of fiscally healthy countries in Europe to compensate for the very poor economic performance of the PIGS is one, usually underestimated, element of comfort.

Breaking the Curse?

A year ago, most opinion polls had the Social democrat party comfortably in the lead and it seemed a given that the Swedish Left would sweep this September’s elections. In other words, we were looking at another one-term reign by the Swedish Right (the last time a incumbent non-socialist party was re-elected in Sweden was in 1979). One could also argue that to find a true ‘rightwing’ party (i.e., non-centrist), Swedish voters have to look all the way backto 1932.

One of the reasons Sweden’s right-wing parties rarely get to handle the levers of power is their unfortunate habit of coming to power at the worst possible times. In 1976, for example, when Torbjorn Fälldin’s centrist-led government came to power, the nation promptly fell into recession and GDP dropped by –1.6% in 1977. Fälldin came back to power in 1979, just in time for the second oil shock and another recession. In 1991, Carl Bildt arrived to power just in time to see the SEK forced out of the ERM, the Swedish banking system implode and three years of contracting GDP. This time around, Reinfeltd’s government had to handle the worst global recession since the 1930s.

But maybe it will be different this time, as Europe’s sovereign debt crisis has
actually triggered a bounce in the polls for the sitting government. All of a sudden, unrestrained welfare spending and excessive government debt are no longer fashionable, whether in Europe or in Scandinavia!

Of course, the big issue of the election campaign has been jobs, or the lack thereof. The opposition, as one would expect, is focusing on this weakness of Reinfeldt’s term in office but it seems that, for reasons reviewed on the prior page, Sweden may be experiencing an important turn on this front:

The reality is that the economy, which has always been the Achilles' heel of any
Swedish right-wing government, is now booming and jobs are coming back. As such, it seems likely that Reinfeldt, and his supply-side agenda, will return to Rosenbad after the elections. The SEK should cheer this news.

Back to Work

Current economic comparisons between the US and Europe mostly hinge on assessments of fiscal policy, monetary policy, and the like. While these are no doubt important issues, there is also another very important dimension to the debate. Specifically, if we take a step back and think about the foundations of economic growth, the differences between Europe and the US are clear to see. An increase in output is simply labor productivity * labor utilization (hours worked * employment). So when comparing output between say the US and Germany, a simple truth is quickly revealed: the US works more than Germany does. In the chart below we compare the hours worked per employee in the business sectors of Germany and the US. This difference of some 20% is the biggest reason for the divergent per capita output of the two countries. Assuming a 52-week year, the average American works 32.4 hours per week, while his German counterpart works a far more leisurely 27.5 hours per week.

Of course, the rate of labor productivity varies, as does the level of employment (e.g., European countries tend to prefer to maximize employment and cut down on hours worked, e.g., 35-hour week in France, kurzabeit plan in Germany). However, when thinking about structural growth rates, the biggest difference is often a direct consequence of the utilization of labor. For Germany this is—in a round-about way—good news for growth going forward.

Indeed, the above chart shows that the German deterioration in labor utilization of the 1990s has given way to greater stability in the 2000s. Will the 2010s be the decade where Germans go back to work? If so, it could have powerfully positive consequences for growth, wealth, and the fiscal situation.

Over the last 20 years, German labor productivity and real GDP growth have averaged around 1%, which implies a long term stagnation in labor utilization (employment * hours worked). The US, by contrast, has been able to grow approximately at a rate of 1% in excess of its labor productivity, implying structural growth in labor utilization.

If, over the next decade, hours worked in Germany increase to match the current amount of hours worked in the US (granted, this is a very big if), they will increase by roughly 1.66% per year. All else equal, this would give Germany tremendous scope to increase its structural rate of growth from something of around 1.25% to something closer to 3%.

The Tug of Rope

The stock market appeared to pivot last week after Federal Reserve President Bullard opined that the Fed should consider further asset purchases if growth continues to falter. President Bullard advocated buying a large quantity of Treasury bonds to pre-empt what, in his opinion, are mounting deflationary forces. This is in-line with our own belief that, while the private sector is still deleveraging and bank loan books contracting, the Fed cannot stop—let alone reverse—asset purchases (as is the current policy direction, given that proceeds from MBS and agency debt holdings are not being reinvested).

However, while we think further asset purchases are warranted, we are of the belief that they should take the form of more private assets—e.g., securities backed by mortgage, auto or consumer credit; unfortunately, recent comments by the Fed would seem to convey no further scope for such ‘credit easing’ (see Lessons from Bernanke’s Testimony). And Bullard’s comments seemed to suggest that not only should the Fed stop ‘credit easing’, it should move straight on to outright ‘quantitative easing’ (which is what the purchase of further UST would likely be, depending on how they are financed). Thinking about the current dynamic in a Fisheresque MV=PQ framework:

1. Velocity is not increasing, a function of contracting commercial loan books.

2. Money is not increasing either because of the massive government deficits. While private sector gross savings—a product of personal savings and undistributed corporate profits—have surely improved over the last year, they have been overwhelmed by the soaring deficits in Washington. The result is that the net national savings rate is below zero. No money saved, no increase in money…sometimes, it’s just that simple.

With neither money nor velocity increasing, and assuming a steady preference for liquidity, how then do we finance a marginal dollar of nominal GDP growth—the P*Q part of the equation? The answer is simple and not all that constructive: the money has to come out of other risky assets. This, in many ways, explains why the stock market has been fairly tepid in so far this year despite very attractive valuations, why real estate prices cannot seem to find a bottom despite record affordability, and why the economy seemed to decelerate each month in the second quarter. Risky assets and economic growth are at odds with each other, playing a game of tug of rope.

The only variable of adjustment has been the Fed’s purchase of MBS, which stopped in April. With the program, the Fed was supplying credit directly to the household sector. This credit was not a component of V as it was created by the public sector. And, it was not a component of M because base money represents a claim on the Federal government itself (M is bank money, e.g., M2). So, this brings us to a new Fisher equation: (M * V)+FRB credit = P*Q.

Thus, unless or until commercial banks are in a position to increase their claims on the private sector, or the private non-bank sector decides to increase its claims on itself (the shadow banking system), the Fed needs to fill the void by increasing its claims on the private sector. In other words, the Fed needs to change course, and discussions revolving around a lower rate paid on excess reserves, on asset sales, on the purchase of UST… are nothing but counter-productive noise.

Once again, if there is no growth in broad money, no increase in velocity and no increase in Fed credit (hybrid money), then the only source to finance growth in the real economy will remain the sale of risky assets. When confidence seems to be stuck in a low plateau and talk of reigning in fiscal deficits is growing louder, a policy of undermining the value of risky assets couldn’t be more counterproductive to growth.

Europe: The State of the Banking System

John Mauldin — Thu, 08 Jul 2010 13:55:00 GMT

We're bombarded with information from the minute we wake up until the second we fall asleep. I was watching a news network last night for 45 minutes and the exact stories started coming back around. Nothing new to report, but the same topics on repeat, with the rare nominal development.

When I need something different (and relevant to me), I go to STRATFOR.com. They provide deep insight and explanation of events the networks can't begin to tackle. Today I'm including an extensive article on the banking situation in Europe. Enjoy, and sign up for their free email list to receive weekly reports and special offers.

John Mauldin
Editor, Outside the Box

Europe: The State of the Banking System

July 1, 2010 | 1245 GMT

PATRIK STOLLARZ/AFP/Getty Images
The European Central Bank in Frankfurt, Germany

Summary

In the last six months, the eurozone has faced its biggest economic challenge to date — one sparked by the Greek debt crisis which has migrated to the rest of the monetary union. But well before the sovereign debt crisis, Europe was facing a full-blown banking crisis that did not seem any closer to being resolved than when it began in late 2008. With investors and markets focused on European governments' debt problems, the banking issues have largely been ignored. However, the sovereign debt crisis and banking crisis have become intertwined and could feed off each other in the near future.

Analysis

July 1 is a milestone for eurozone banks, with 442 billion euros ($541 billion) worth of European Central Bank (ECB) loans coming due. The loans were part of the ECB's one-year liquidity offering made in 2009, which was intended to help stabilize the banking system.

However, one year after the ECB provision was initially offered, the eurozone's banks are still struggling, and now Europe's banks must collectively come up with the cash roughly equivalent to Poland's gross domestic product (GDP).

Fears regarding the potentially adverse consequences of removing ECB liquidity are gripping many European banks and, by extension, investors who were already panicked by the sovereign debt crisis in the Club Med countries (Greece, Portugal, Spain and Italy). These concerns are as much a testament to the severity of the eurozone's ongoing banking crisis as to the lack of resolve that has characterized Europe's handling of the underlying problems.

Origins of Europe's Banking Problems

Europe's banking problems precede the eurozone's ongoing sovereign debt crisis and even exposure to the U.S. subprime mortgage imbroglio. The European banking crisis has its origins in two fundamental factors: euro adoption in 1999 and the general global credit expansion that began in the early 2000s. The combination of the two created an environment that inflated credit bubbles across the Continent, which were then grafted onto the European banking sector's structural problems.

In terms of specific pre-2008 problems we can point to five major factors. Not all the factors affected European economies uniformly, but all contributed to the overall weakness of the Continent's banking sector.

1. Euro Adoption and Europe's Local Subprime Bubble

The adoption of the euro — in fact, the very process of preparing to adopt the euro that began in the early 1990s with the signing of the Maastricht Treaty — effectively created a credit bubble in the eurozone. As the adjacent graph indicates, the cost of borrowing in peripheral European countries (Spain, Portugal, Italy and Greece in particular) was greatly reduced due, in part, to the implied guarantee that once they joined the eurozone their debt would be as solid as Germany's government debt.

(click here to enlarge image)

In essence, euro adoption allowed countries like Spain access to credit at lower rates than their economies could ever justify based on their own fundamentals. This eventually created a number of housing bubbles across Europe, but particularly in Spain and Ireland (the two eurozone economies currently boasting the relatively highest levels of private-sector indebtedness). As an example, in 2006 there were more than 700,000 new homes built in Spain — more than the total new homes built in Germany, France and the United Kingdom combined, even though the United Kingdom was experiencing a housing bubble of its own at the time.

It could be argued that the Spanish case was particularly egregious because Madrid attempted to use access to cheap housing as a way to integrate its large pool of first-generation Latin American migrant workers into Spanish society. However, the very fact that Spain felt confident enough to attempt such wide-scale social engineering indicates just how far peripheral European countries felt they could stretch their use of cheap euro loans. Spain is today feeling the pain of a collapsed construction sector, with unemployment approaching 20 percent and with the Spanish cajas (regional savings banks) reeling from their holdings of 58.9 percent of the country's mortgage market. The real estate and construction sectors' outstanding debt is equal to roughly 45 percent of the country's GDP.

2. Europe's 'Carry Trade'

"Carry trade" usually refers to the practice in which loans are taken in a low interest rate country with a stable currency and "carried" for investment in the government debt of a high interest rate economy. The European practice, which extended the concept to consumer and mortgage loans, was championed by the Austrian banks that had experience with the method due to their proximity to the traditionally low interest rate economy of Switzerland.

In the carry trade, the loans extended to consumers and businesses are linked to the currency of the country where the low interest loan originates. Because of this, Swiss francs and euros served as the basis for most of such lending across Europe. Loans in these currencies were then extended as low interest rate mortgages and other consumer and corporate loans in higher interest rate economies in Central and Eastern Europe. Since loans were denominated in foreign currency, when their local currency depreciated against the Swiss franc or euro, the real financial burden of the loan increased.

This created conditions for a potential economic maelstrom at the onset of the financial crisis in 2008 when consumers in Central and Eastern Europe saw their monthly mortgage payments grow as investors pulled out from emerging markets in order to "flee to safety," leading these countries' domestic currencies to fall. The problem was particularly dire for Central and Eastern European countries with a great amount of exposure to such foreign currency lending (see adjacent table).

(click here to enlarge image)

3. Crisis in Central/Eastern Europe

The carry trade led Europe's banks to be overexposed to Central and Eastern European economies. As the European Union enlarged into the former Communist sphere in Central Europe, and as security and political uncertainties in the Balkans subsided in the early 2000s, European banks sought new markets where they could make use of their expanded access to credit provided by euro adoption. Banking institutions in mid-level financial powers such as Sweden, Austria, Italy and even Greece sought to capitalize on the carry trade by going into markets that their larger French, German, British and Swiss rivals largely shunned.

This, however, created problems for the banking systems that became overexposed to Central and Eastern Europe. The International Monetary Fund and the European Union ended up having to bail out several countries in the region, including Romania, Hungary, Latvia and Serbia. And before the eurozone ever contemplated a Greek or eurozone bailout, it was discussing a potential 150 billion-euro rescue fund for Central and Eastern Europe at the urging of the Austrian and Italian governments.

4. Exposure to 'Toxic Assets'

The exposure to various credit bubbles ultimately left Europe vulnerable to the financial crisis, which peaked with the collapse of Lehman Brothers in September 2008. But the outright exposure to various financial derivatives, including the U.S. subprime market, was by itself considerable.

While the Swedish, Italian, Austrian and Greek banking systems expanded into the new markets in Central and Eastern Europe, the established financial centers of France, Germany, Switzerland, the Netherlands and the United Kingdom dabbled in various derivatives markets. This was particularly the case for the German banking system, where the Landesbanken — banks with strong ties to regional governments — faced chronically low profit margins caused by a fragmented banking system of more than 2,000 banks and a tepid domestic retail banking market. The Landesbanken on their own face between 350 billion and 500 billion euros worth of toxic assets — a considerable figure for the 2.5 trillion-euro German economy — and could be responsible for nearly half of all outstanding toxic assets in Europe.

5. Demographic Decline

Another problem for Europe is that its long-term outlook for consumption, particularly in the housing sector, is dampened by the underlying demographic factors. Europe's birth rate is at 1.53, well below the population "replacement rate" of 2.1. Exacerbating the demographic imbalance is the increasing life expectancy across the region, which results in an older population. The average European age is already 40.9, and is expected to hit 44.5 by 2030.

An older population does not purchase starter homes or appliances to outfit those homes. And if older citizens do make such purchases, they are less likely to depend as much on bank lending as first-time homebuyers. That means not just less demand, but that any demand will depend less upon banks, which means less profitability for financial institutions. Generally speaking, an older population will also increase the burden on taxpayers in Europe to support social welfare systems, dampening consumption further.

In this environment, housing prices will continue to decline (barring another credit bubble, which would of course exacerbate problems). This will further restrict lending activities because banks will be wary of granting loans for assets that they know will become less valuable over time. At the very least, banks will demand much higher interest rates for these loans, but that too will further dampen the demand.

The Geopolitics of Europe's Banking System

Given these challenges, the European banking system was less than rock-solid even before the onset of the global recession in 2008. However, Europe's response as a Continent to the crisis so far has been muted, with essentially every country looking to fend for itself. Therefore, at the heart of Europe's banking problems lie geopolitics and "capital nationalism."

Europe's geography encourages both political stratification and unity in trade and communications. The numerous peninsulas, mountain chains and large islands all allow political entities to persist against stronger rivals and continental unification efforts, giving Europe the highest global ratio of independent nations to area. Meanwhile, the navigable rivers, inland seas (Black, Mediterranean and Baltic), Atlantic Ocean and the North European Plain facilitate the exchange of ideas, trade and technologies among the disparate political actors.

This has, over time, incubated a continent full of sovereign nations that intimately interact with one another but are impossible to unite politically. Furthermore, in terms of capital flows, European geography has engendered a stratification of capital centers. Each capital center essentially dominates a particular river valley where it can use its access to a key transportation route to accumulate capital. These capital centers are then mobilized by the proximate political powers for the purposes of supporting national geopolitical imperatives, so Viennese bankers fund the Austro-Hungarian Empire, for example, while Rhineland bankers fund the German Empire. With no political unity, the stratification of capital centers becomes more solidified over time.

(click here to enlarge image)

The European Union's common market rules stipulate the free movement of capital across the borders of its 27 member states. Theoretically, with barriers to capital movement removed, the disparate nature of Europe's capital centers should wane; French banks should be active in Germany, and German banks should be active in Spain. However, control of financial institutions is one of the most jealously guarded privileges of national sovereignty in Europe.

One reason for this "capital nationalism" is that Europe's corporations and businesses are far less dependent on the stock and bond market for funding than their U.S. counterparts, relying primarily on banks. This comes from close links between Europe's state champions in industry and finance (for example, the close historical links between German industrial heavyweights and Deutsche Bank). Such links, largely frowned upon in the United States for most of its history, were seen as necessary by Europe's nation-states in the late 19th and early 20th centuries because of the need to compete with industries in neighboring states. European states in fact encouraged — in some ways even mandated — banks and corporations to work together for political and social purposes of competing with other European states and providing employment. This also goes for Europe's medium-sized businesses — Germany's mid-sized businesses are a prime example — which often rely on regional banks they have political and personal relationships with.

Regional banks are an issue unto themselves. Many European economies have a special banking sector dedicated to regional banks owned or backed by regional governments, such as the German Landesbanken or the Spanish cajas which in many ways are used as captive firms to serve the needs of both the local governments (at best) and local politicians (at worst). Many Landesbanken actually have regional politicians sitting on their boards while the Spanish cajas have a mandate to reinvest around half of their annual profits in local social projects, tempting local politicians to control how and when funds are used.

Europe's banking architecture was therefore wholly unprepared to deal with the severe financial crisis that hit in September 2008. With each banking system tightly integrated into the political economy of each EU member state, an EU-wide "solution" to Europe's banking problems — let alone the structural issues, of which the banking problems are merely symptomatic — has largely evaded the Continent. While the European Union has made progress in enhancing EU-wide regulatory mechanisms by drawing up legislation to set up micro- and macro-prudential institutions (with the latest proposal still in the implementation stages), the fact remains that outside of the ECB's response of providing unlimited liquidity to the eurozone system, there has been no meaningful attempt to deal with the underlying structural issues on the political level.

EU member states have, therefore, had to deal with banking problems largely on a case-by-case (and often ad hoc) basis, as each government has taken extra care to specifically tailor its financial assistance packages to support the most and upset the fewest constituents. In contrast, the United States — which took an immediate hit in late 2008 — bought up massive amounts of the toxic assets from the banks, swiftly transferring the burden onto the state.

ECB to the 'Rescue'

Europe's banking system obviously has problems, but exacerbating the problems is the fact that Europe's banks know that they and their peers are in trouble. This is causing the interbank market to seize up and thus forcing Europe's banks to rely on the ECB for funding.

The interbank market refers to the wholesale money market that only the largest financial institutions are able to participate in. In this market, the participating banks are able to borrow from one another for short periods of time to ensure that they have enough cash to maintain normal operations. Normally, the interbank market essentially regulates itself. Banks with surplus liquidity want to put their idle cash to work, and banks with a liquidity deficit need to borrow in order to meet the reserve requirements at the end of the day, for example. Without an interbank market there is no banking "system" because each individual bank would be required to supply all of its own capital all the time.

In the current environment in Europe, many banks are simply unwilling to lend money to each other, as they do not trust their peers' creditworthiness, even at very high interest rates. When this happened in the United States in 2008, the Federal Reserve and Federal Deposit Insurance Corporation stepped in and bolstered the interbank market directly and indirectly by both providing loans to interested banks and guaranteeing the safety of the loans banks were willing to grant each other. Within a few months, the U.S. crisis mitigation efforts allowed confidence to return and this liquidity support was able to be withdrawn.

The ECB originally did something similar, providing an unlimited volume of loans to any bank that could offer qualifying collateral, while national governments offered their own guarantees on newly issued debt. But unlike in the United States, confidence never fully returned to the banking sector due to the reasons listed above, and these provisions were never canceled. In fact, this program was expanded to serve a second purpose: stabilizing European governments.

With economic growth in 2009 weak, many EU governments found it difficult to maintain government spending programs in the face of dropping tax receipts. They resorted to deficit spending, and the ECB (indirectly) provided the means to fund that spending. Banks could purchase government bonds, deposit them with the ECB as collateral and walk away with a fresh liquidity loan (which they could use, if they so chose, to buy yet more government debt).

The ECB's liquidity provisions were ostensibly a temporary measure that would eventually be withdrawn as soon as it was no longer necessary. So on July 1, 2009, the ECB offered the first of what was intended to be its three "final" batches of 12-month loans as part of a return to a more normal policy. On that day 1,121 banks took out a record total of 442 billion euros in liquidity loans (followed by another 75 billion euros taken out in September and 96 billion euros in December). The 442 billion euro operation has come due July 1. The day before, banks tapped the ECB's shorter-term liquidity facilities to gain access to 294.8 billion euros to help them bridge the gap.

Europe now faces three problems. First, global growth has not picked up sufficiently in the last year, so European banks have not had a chance to grow out of their problems. This would have been difficult to accomplish on such a short timeframe. Second, the lack of a unified European banking regulator — although the European Union is trying to set one up — means that there has not yet been any pan-European effort to fix the banking problems. And even the regulation that is being discussed at the EU-level is more about being able to foresee a future crisis than resolving the current one. So banks still need the emergency liquidity provisions now as they did a year ago (to some degree the ECB saw this coming and has issued additional "final" batches of long-term liquidity loans). In fact, banks remain so unwilling to lend to one another that they have deposited nearly the equivalent amount of credit obtained from ECB's liquidity facilities back into its deposit facility instead of lending it out to consumers or other banks.

(click here to enlarge image)

Third, there is now a new crisis brewing that not only is likely to dwarf the banking crisis, but could make solving the banking crisis impossible. The ECB's decision to facilitate the purchase of state bonds has greatly delayed European governments' efforts to tame their budget deficits. There is now nearly 3 trillion euros of outstanding state debt just in the Club Med economies — vast portions of which are held by European banks — illustrating that the two issues have become as mammoth as they are inseparable.

There is no easy way out of this imbroglio. Reducing government debts and budget deficits means less government spending, which means less growth because public spending accounts for a relatively large portion of overall output in most European countries. Simply put, the belt-tightening that Germany and the markets are forcing upon European governments likely will lead to lower growth in the short term (although in the long term, if austerity measures prove credible, it should reassure investors of the credibility of the eurozone's economies). And economic growth — and the business it generates for banks — is one of the few proven methods of emerging from a banking crisis. One cannot solve one problem without first solving the other, and each problem prevents the other from being approached, much less solved.

There is, however, a silver lining. Investor uncertainty about the European Union's ability to solve its debt and banking problems is making the euro ever weaker, which ironically will support European exporters in the coming quarters. This not only helps maintain employment (and with it social stability), but it also boosts government tax receipts and banking activity — precisely the sort of activity necessary to begin addressing the banking and debt crises. But while this might allow Europe to avoid a return to economic recession in 2010, it alone will not resolve the European banking system's underlying problems.

For Europe's banks, this means that not only will they have to write down remaining toxic assets (the old problem), but they now also have to account for dampened growth prospects as a result of budget cuts and lower asset values on their balance sheets due to sovereign bonds losing value.

Ironically, with public consumption down as a result of budget cuts, the only way to boost growth would be for private consumption to increase, which is going to be difficult with banks wary of lending.

The Way Forward?

So long as the ECB continues to provide funding to the banks — and STRATFOR does not foresee any meaningful change in the ECB's posture in the near term or even long term — Europe's banks should be able to avoid a liquidity crisis. However, there is a difference between being well-capitalized but sitting on the cash due to uncertainty and being well-capitalized and willing to lend. Europe's banks are clearly in the former state, with lending to both consumers and corporations still tepid.

In light of Europe's ongoing sovereign debt crisis and the attempts to alleviate that crisis by cutting down deficits and debt levels, European countries are going to need growth, pure and simple, to get out of the crisis. Without meaningful economic growth, European governments will find it increasingly difficult — if not impossible — to service or reduce their ever-larger debt burdens. But for growth to be engendered, the Europeans are going to need their banks, currently spooked into sitting on liquidity, to perform the vital function that banks normally do: finance the wider economy.

As long as Europe faces both austerity measures and reticent banks, it will have little chance of producing the GDP growth needed to reduce its budget deficits. If its export-driven growth becomes threatened by decreasing demand in China or the United States, it could also face a very real possibility of another recession which, combined with austerity measures, could precipitate considerable political, social and economic fallout.

Germany, Greece and Exiting the Eurozone

John Mauldin — Thu, 20 May 2010 16:29:11 GMT

The cause célèbre these days is the potential reconstitution of the eurozone: ie, Germany leaving it, or Greece getting kicked out. To look a little deeper, today I'm sending you STRATFOR's take on these two scenarios. STRATFOR explores the geography of the continent and the historical context of the EU to understand what a German exit or a Greek expulsion might mean for the rest of the region.

After you read the article, sign up here to receive more STRATFOR global intelligence reports like this one.

John Mauldin
Editor, Outside the Box

Germany, Greece and Exiting the Eurozone

By Marko Papic, Robert Reinfrank and Peter Zeihan

Rumors of the imminent collapse of the eurozone continue to swirl despite the Europeans' best efforts to hold the currency union together. Some accounts in the financial world have even suggested that Germany's frustration with the crisis could cause Berlin to quit the eurozone - as soon as this past weekend, according to some - while at the most recent gathering of European leaders French President Nicolas Sarkozy apparently threatened to bolt the bloc if Berlin did not help Greece. Meanwhile, many in Germany - including Chancellor Angela Merkel herself at one point - have called for the creation of a mechanism by which Greece - or the eurozone's other over-indebted, uncompetitive economies - could be kicked out of the eurozone in the future should they not mend their "irresponsible" spending habits.

Rumors, hints, threats, suggestions and information "from well-placed sources" all seem to point to the hot topic in Europe at the moment, namely, the reconstitution of the eurozone whether by a German exit or a Greek expulsion. We turn to this topic with the question of whether such an option even exists.

The Geography of the European Monetary Union

As we consider the future of the euro, it is important to remember that the economic underpinnings of paper money are not nearly as important as the political underpinnings. Paper currencies in use throughout the world today hold no value without the underlying political decision to make them the legal tender of commercial activity. This means a government must be willing and capable enough to enforce the currency as a legal form of debt settlement, and refusal to accept paper currency is, within limitations, punishable by law.

The trouble with the euro is that it attempts to overlay a monetary dynamic on a geography that does not necessarily lend itself to a single economic or political "space." The eurozone has a single central bank, the European Central Bank (ECB), and therefore has only one monetary policy, regardless of whether one is located in Northern or Southern Europe. Herein lies the fundamental geographic problem of the euro.

Europe is the second-smallest continent on the planet but has the second-largest number of states packed into its territory. This is not a coincidence. Europe's multitude of peninsulas, large islands and mountain chains create the geographic conditions that often allow even the weakest political authority to persist. Thus, the Montenegrins have held out against the Ottomans, just as the Irish have against the English.

Despite this patchwork of political authorities, the Continent's plentiful navigable rivers, large bays and serrated coastlines enable the easy movement of goods and ideas across Europe. This encourages the accumulation of capital due to the low costs of transport while simultaneously encouraging the rapid spread of technological advances, which has allowed the various European states to become astonishingly rich: Five of the top 10 world economies hail from the Continent despite their relatively small populations.

Europe's network of rivers and seas are not integrated via a single dominant river or sea network, however, meaning capital generation occurs in small, sequestered economic centers. To this day, and despite significant political and economic integration, there is no European New York. In Europe's case, the Danube has Vienna, the Po has Milan, the Baltic Sea has Stockholm, the Rhineland has both Amsterdam and Frankfurt and the Thames has London. This system of multiple capital centers is then overlaid on Europe's states, which jealously guard control over their capital and, by extension, their banking systems.

Despite a multitude of different centers of economic - and by extension, political - power, some states, due to geography, are unable to access any capital centers of their own. Much of the Club Med states are geographically disadvantaged. Aside from the Po Valley of northern Italy - and to an extent the Rhone - southern Europe lacks a single river useful for commerce. Consequently, Northern Europe is more urban, industrial and technocratic while Southern Europe tends to be more rural, agricultural and capital-poor.

Introducing the Euro

Given the barrage of economic volatility and challenges the eurozone has confronted in recent quarters and the challenges presented by housing such divergent geography and history under one monetary roof, it is easy to forget why the eurozone was originally formed.

The Cold War made the European Union possible. For centuries, Europe was home to feuding empires and states. After World War II, it became the home of devastated peoples whose security was the responsibility of the United States. Through the Bretton Woods agreement, the United States crafted an economic grouping that regenerated Western Europe's economic fortunes under a security rubric that Washington firmly controlled. Freed of security competition, the Europeans not only were free to pursue economic growth, they also enjoyed nearly unlimited access to the American market to fuel that growth. Economic integration within Europe to maximize these opportunities made perfect sense. The United States encouraged the economic and political integration because it gave a political underpinning to a security alliance it imposed on Europe, i.e., NATO. Thus, the European Economic Community - the predecessor to today's European Union - was born.

When the United States abandoned the gold standard in 1971 (for reasons largely unconnected to things European), Washington essentially abrogated the Bretton Woods currency pegs that went with it. One result was a European panic. Floating currencies raised the inevitability of currency competition among the European states, the exact sort of competition that contributed to the Great Depression 40 years earlier. Almost immediately, the need to limit that competition sharpened, first with currency coordination efforts still concentrating on the U.S. dollar and then from 1979 on with efforts focused on the deutschmark. The specter of a unified Germany in 1989 further invigorated economic integration. The euro was in large part an attempt to give Berlin the necessary incentives so that it would not depart the EU project.

But to get Berlin on board with the idea of sharing its currency with the rest of Europe, the eurozone was modeled after the Bundesbank and its deutschmark. To join the eurozone, a country must abide by rigorous "convergence criteria" designed to synchronize the economy of the acceding country with Germany's economy. The criteria include a budget deficit of less than 3 percent of gross domestic product (GDP); government debt levels of less than 60 percent of GDP; annual inflation no higher than 1.5 percentage points above the average of the lowest three members' annual inflation; and a two-year trial period during which the acceding country's national currency must float within a plus-or-minus 15 percent currency band against the euro.

As cracks have begun to show in both the political and economic support for the eurozone, however, it is clear that the convergence criteria failed to overcome divergent geography and history. Greece's violations of the Growth and Stability Pact are clearly the most egregious, but essentially all eurozone members - including France and Germany, which helped draft the rules - have contravened the rules from the very beginning.

Mechanics of a Euro Exit

The EU treaties as presently constituted contractually obligate every EU member state - except Denmark and the United Kingdom, which negotiated opt-outs - to become a eurozone member state at some point. Forcible expulsion or self-imposed exit is technically illegal, or at best would require the approval of all 27 member states (never mind the question about why a troubled eurozone member would approve its own expulsion). Even if it could be managed, surely there are current and soon-to-be eurozone members that would be wary of establishing such a precedent, especially when their fiscal situation could soon be similar to Athens' situation.

One creative option making the rounds would allow the European Union to technically expel members without breaking the treaties. It would involve setting up a new European Union without the offending state (say, Greece) and establishing within the new institutions a new eurozone as well. Such manipulations would not necessarily destroy the existing European Union; its major members would "simply" recreate the institutions without the member they do not much care for.

Though creative, the proposed solution it is still rife with problems. In such a reduced eurozone, Germany would hold undisputed power, something the rest of Europe might not exactly embrace. If France and the Benelux countries reconstituted the eurozone with Berlin, Germany's economy would go from constituting 26.8 percent of eurozone version 1.0's overall output to 45.6 percent of eurozone version 2.0's overall output. Even states that would be expressly excluded would be able to get in a devastating parting shot: The southern European economies could simply default on any debt held by entities within the countries of the new eurozone.

With these political issues and complications in mind, we turn to the two scenarios of eurozone reconstitution that have garnered the most attention in the media.

Scenario 1: Germany Reinstitutes the Deutschmark

The option of leaving the eurozone for Germany boils down to the potential liabilities that Berlin would be on the hook for if Portugal, Spain, Italy and Ireland followed Greece down the default path. As Germany prepares itself to vote on its 123 billion euro contribution to the 750 billion euro financial aid mechanism for the eurozone - which sits on top of the 23 billion euros it already approved for Athens alone - the question of whether "it is all worth it" must be on top of every German policymaker's mind.

This is especially the case as political opposition to the bailout mounts among German voters and Merkel's coalition partners and political allies. In the latest polls, 47 percent of Germans favor adopting the deutschmark. Furthermore, Merkel's governing coalition lost a crucial state-level election May 9 in a sign of mounting dissatisfaction with her Christian Democratic Union and its coalition ally, the Free Democratic Party. Even though the governing coalition managed to push through the Greek bailout, there are now serious doubts that Merkel will be able to do the same with the eurozone-wide mechanism May 21.

Germany would therefore not be leaving the eurozone to save its economy or extricate itself from its own debts, but rather to avoid the financial burden of supporting the Club Med economies and their ability to service their 3 trillion euro mountain of debt. At some point, Germany may decide to cut its losses - potentially as much as 500 billion euros, which is the approximate exposure of German banks to Club Med debt - and decide that further bailouts are just throwing money into a bottomless pit. Furthermore, while Germany could always simply rely on the ECB to break all of its rules and begin the policy of purchasing the debt of troubled eurozone governments with newly created money ("quantitative easing"), that in itself would also constitute a bailout. The rest of the eurozone, including Germany, would be paying for it through the weakening of the euro.

Were this moment to dawn on Germany it would have to mean that the situation had deteriorated significantly. As STRATFOR has recently argued, the eurozone provides Germany with considerable economic benefits. Its neighbors are unable to undercut German exports with currency depreciation, and German exports have in turn gained in terms of overall eurozone exports on both the global and eurozone markets. Since euro adoption, unit labor costs in Club Med have increased relative to Germany's by approximately 25 percent, further entrenching Germany's competitive edge.

Before Germany could again use the deutschmark, Germany would first have to reinstate its central bank (the Bundesbank), withdraw its reserves from the ECB, print its own currency and then re-denominate the country's assets and liabilities in deutschmarks. While it would not necessarily be a smooth or easy process, Germany could reintroduce its national currency with far more ease than other eurozone members could.

The deutschmark had a well-established reputation for being a store of value, as the renowned Bundesbank directed Germany's monetary policy. If Germany were to reintroduce its national currency, it is highly unlikely that Europeans would believe that Germany had forgotten how to run a central bank - Germany's institutional memory would return quickly, re-establishing the credibility of both the Bundesbank and, by extension, the deutschmark.

As Germany would be replacing a weaker and weakening currency with a stronger and more stable one, if market participants did not simply welcome the exchange, they would be substantially less resistant to the change than what could be expected in other eurozone countries. Germany would therefore not necessarily have to resort to militant crackdowns on capital flows to halt capital trying to escape conversion.

Germany would probably also be able to re-denominate all its debts in the deutschmark via bond swaps. Market participants would accept this exchange because they would probably have far more faith in a deutschmark backed by Germany than in a euro backed by the remaining eurozone member states.

Reinstituting the deutschmark would still be an imperfect process, however, and there would likely be some collateral damage, particularly to Germany's financial sector. German banks own much of the debt issued by Club Med, which would likely default on repayment in the event Germany parted with the euro. If it reached the point that Germany was going to break with the eurozone, those losses would likely pale in comparison to the costs - be they economic or political - of remaining within the eurozone and financially supporting its continued existence.

Scenario 2: Greece Leaves the Euro

If Athens were able to control its monetary policy, it would ostensibly be able to "solve" the two major problems currently plaguing the Greek economy.

First, Athens could ease its financing problems substantially. The Greek central bank could print money and purchase government debt, bypassing the credit markets. Second, reintroducing its currency would allow Athens to then devalue it, which would stimulate external demand for Greek exports and spur economic growth. This would obviate the need to undergo painful "internal devaluation" via austerity measures that the Greeks have been forced to impose as a condition for their bailout by the International Monetary Fund (IMF) and the EU.

If Athens were to reinstitute its national currency with the goal of being able to control monetary policy, however, the government would first have to get its national currency circulating (a necessary condition for devaluation).

The first practical problem is that no one is going to want this new currency, principally because it would be clear that the government would only be reintroducing it to devalue it. Unlike during the Eurozone accession process - where participation was motivated by the actual and perceived benefits of adopting a strong/stable currency and receiving lower interest rates, new funds and the ability to transact in many more places - "de-euroizing" offers no such incentives for market participants:

The drachma would not be a store of value, given that the objective in reintroducing it is to reduce its value.
The drachma would likely only be accepted within Greece, and even there it would not be accepted everywhere - a condition likely to persist for some time.
Reinstituting the drachma unilaterally would likely see Greece cast out of the eurozone, and therefore also the European Union as per rules explained above.

The government would essentially be asking investors and its own population to sign a social contract that the government clearly intends to abrogate in the future, if not immediately once it is able to. Therefore, the only way to get the currency circulating would be by force.

The goal would not be to convert every euro-denominated asset into drachmas but rather to get a sufficiently large chunk of the assets so that the government could jumpstart the drachma's circulation. To be done effectively, the government would want to minimize the amount of money that could escape conversion by either being withdrawn or transferred into asset classes easy to conceal from discovery and appropriation. This would require capital controls and shutting down banks and likely also physical force to prevent even more chaos on the streets of Athens than seen at present. Once the money was locked down, the government would then forcibly convert banks' holdings by literally replacing banks' holdings with a similar amount in the national currency. Greeks could then only withdraw their funds in newly issued drachmas that the government gave the banks to service those requests. At the same time, all government spending/payments would be made in the national currency, boosting circulation. The government also would have to show willingness to prosecute anyone using euros on the black market, lest the newly instituted drachma become completely worthless.

Since nobody save the government would want to do this, at the first hint that the government would be moving in this direction, the first thing the Greeks will want to do is withdraw all funds from any institution where their wealth would be at risk. Similarly, the first thing that investors would do - and remember that Greece is as capital-poor as Germany is capital-rich - is cut all exposure. This would require that the forcible conversion be coordinated and definitive, and most important, it would need to be as unexpected as possible.

Realistically, the only way to make this transition without completely unhinging the Greek economy and shredding Greece's social fabric would be to coordinate with organizations that could provide assistance and oversight. If the IMF, ECB or eurozone member states were to coordinate the transition period and perhaps provide some backing for the national currency's value during that transition period, the chances of a less-than-completely-disruptive transition would increase.

It is difficult to imagine circumstances under which such support would not dwarf the 110 billion euro bailout already on the table. For if Europe's populations are so resistant to the Greek bailout now, what would they think about their governments assuming even more risk by propping up a former eurozone country's entire financial system so that the country could escape its debt responsibilities to the rest of the eurozone?

The European Dilemma

Europe therefore finds itself being tied in a Gordian knot. On one hand, the Continent's geography presents a number of incongruities that cannot be overcome without a Herculean (and politically unpalatable) effort on the part of Southern Europe and (equally unpopular) accommodation on the part of Northern Europe. On the other hand, the cost of exit from the eurozone - particularly at a time of global financial calamity, when the move would be in danger of precipitating an even greater crisis - is daunting to say the least.

The resulting conundrum is one in which reconstitution of the eurozone may make sense at some point down the line. But the interlinked web of economic, political, legal and institutional relationships makes this nearly impossible. The cost of exit is prohibitively high, regardless of whether it makes sense.

The Death of Capital

John Mauldin — Mon, 10 May 2010 20:41:10 GMT

Was it only last week I was expressing outrage that US taxpayers would have to pick up the check for Greek profligacy in the form of IMF guarantees? This morning we wake to up the sound of $250 BILLION in IMF guarantees for a European rescue fund, most of which will go to countries that are eventually (in my opinion) going to default. That is $50 billion in US taxpayer guarantees. Not sure what that translates into for Britain or Canada or Australia.

I can swallow the Fed dollar swaps to the ECB. Don't really like it, but I can deal with it, as I don't think it will ultimately put US tax-payers at risk, as long as the swaps are in dollar terms. But the IMF bailout is just wrong.

Interestingly, the euro shot up on the announcement in what was now clearly short covering. As I write this, it is almost back down to where it started. That seems to me to be a vote of "I don't believe you." We will see. But if the ECB actually goes ahead and floods the market with liquidity, that will be very good for all types of risk assets.

Note that in last Friday's letter I quoted Trichet where he said we would not do what he agreed to do over the weekend. What a turn-about. So much for ECB independence. The European leadership must have realized the wheels were coming off and brought out the nuclear option in order to stave off a very serious crisis. In my opinion, this buys time but does not solve the problem.

The eurozone leaders assume that this is a liquidity problem. It is not. It is a solvency and balance sheet problem. You do not solve a debt problem with more debt. This only shoves the football a few yards (or maybe I should say meters) down the field. And it is going to cause a MASSIVE misallocation of capital once again which will create more imbalances that will have to be dealt with. Ugh.

Now, with that off my chest, let's turn to this week's Outside the Box, which is an essay by a name that is familiar to readers, Michael Lewitt. He has written a brilliant book, the Death of Capital, which should be on your short reading list. I asked him to give us a note for Outside the Box and he graciously complied. It is a thoughtful and fun read with wonderful lines you will want to read again peppered all the way through this all-too-short piece. The book is a ringing indictment of both the regulatory and money management worlds. Get it at Amazon.com.

Your how can I get even more outraged analyst,

John Mauldin, Editor
Outside the Box

The Death of Capital

Michael E. Lewitt

Two years ago, John Mauldin was kind enough to publish my initial proposals for reforming the financial system. Entitled "How to Fix It," the April 2008 issue of The HCM Market Letter raised a lot of eyebrows and upset many established interests on Wall Street with its outspoken call for financial reform. Among the changes I called for were the following:

Compensation reform to better align the interests of Wall Street executives with those of society at large.
Requiring private equity firms and hedge funds to be registered with regulators.
Taxing private equity partners' carried interests at ordinary tax rates instead of capital gains tax rates, and prohibiting private equity firms from going public.
Sharply reducing the leverage of financial institutions (including hedge funds).
Banning off-balance sheet vehicles such as Structured Investment Vehicles.
Reining in quantitative trading strategies.
Reinstituting the downtick rule with respect to short selling stocks.

At the time these proposals were considered controversial; in retrospect it is clear that they were not aggressive enough. While many of these suggestions have been adopted or are in the process of being adopted, much more needs to be done to stabilize the financial system.

Since the publication of that essay, I have written a new book that is being published by John Wiley & Sons this month. Entitled The Death of Capital: How Creative Policy Can Restore Stability, the book explores the origins of the 2008 financial crisis and expands the call for reform. In addition to the recommendations listed above, the book calls for additional regulatory changes including:

Derivatives reform, with a preference for an outright ban on naked credit default swaps or, recognizing that such a ban is politically unrealistic, calling for such contracts to be listed on exchanges and requiring substantial capital commitments by their participants.
A Tax on Speculation that would apply to the types of speculative activities that have so badly damaged the American economy, including naked credit default swaps, leveraged buyout, quantitative stock trading strategies and other stock and bond transactions.

The book also takes an unvarnished look at the private equity industry, which has been a prime abuser of capital as it has diverted an inordinate amount of capital into unproductive uses while producing (at best) mediocre returns and charging unjustifiably exorbitant fees.

The recent problems experienced by Goldman Sachs highlight just how far the financial system has lapsed from the days of gentlemanly capitalism. Change in itself is neither good nor bad – it is an inevitable feature of human life and it must be managed. Change on Wall Street has by and large been managed poorly by being left to the most self-interested forces. My April 2008 essay began with a quote from Adam Smith that should be etched into the brains of every Wall Street CEO and included in the oath of office of every new member of Congress. The quote is from Adam Smith, who is best known as the author of the bible of capitalism, The Wealth of Nations, but who wrote an equally important book two decades earlier entitled The Theory of Moral Sentiments. Smith wrote the following:

"This disposition to admire, and almost to worship, the rich and the powerful, and to despise, or, at least, to neglect, persons of poor and mean condition, though necessary both to establish and to maintain the distinction of ranks and the order of society, is, at the same time, the great and most universal cause of the corruption of our moral sentiments."

What Adam Smith pointed out more than two hundred years ago is equally true today – our society, fed by the media, worships wealth at the expense of other values that are far more important to a cohesive and healthy society. The entire mission of The Wealth of Nations was to try to recognize man for what he is – a social animal who is reliant on the good opinions of his neighbors – and to develop the optimal economic system to harness that human essence for the good of all mankind. Smith believed that system was a free market, and history has by and large proven him correct. But the United States has strayed from a free market model to a system that privatizes gains and socializes losses.

During the last two decades, the American economy has suffered from a series of legal, fiscal and monetary policies that have favored speculation over production. The result has been the financialization of the economy, which has been characterized in economic terms by an unhealthy growth in debt at all levels of the economy and in cultural terms by the monetization of all values. Entities such as Fannie Mae and Freddie Mac were perfect examples of how the free market had been corrupted before the 2008 financial crisis. The crisis itself demonstrated, however, that the logic of the system required all large institutions to suffer from a similar flaw. Yet these flaws were not inevitable, even at the height of the crisis; they were deliberate political choices. While stakeholders of some institutions, such as Lehman Brothers, were wiped out, those of other firms were not and some were even made whole. The most egregious example of this was the handling of American International Group (AIG), the insurance giant that morphed itself into a giant hedge fund while enriching the officials responsible for some of the most ill-informed judgments in financial history. There was no reason for the government to handle the AIG failure in a manner that made whole foreign counterparties and Goldman Sachs; alternatives including offering a blanket credit guarantee to the insurance company that would have calmed markets and obviated the necessity of the company paying out one hundred cents on the dollar for its reckless insurance bets on synthetic mortgage obligations. While the result – avoidance of the extinction-level-event that an AIG failure would have been for the financial system – was the correct one, the means by which it was achieved furthered the agenda of socializing losses and privatizing gains and bred deep distrust in the government and the system.

Much of the crisis could have been avoided had policymakers and investors operated under realistic assumptions about how markets and economies work. Several years ago, former Federal Reserve Chairman Alan Greenspan described the failure of interest rates to react in the manner he expected as a "conundrum." We now know that Mr. Greenspan was operating under a false set of assumptions about human nature, as well as a misguided understanding about how market participants behave. As noted in my book, had Mr. Greenspan been an acolyte of Hyman Minsky instead of Ayn Rand, he would have been less susceptible to such a fatal conceit. But beyond that, the real conundrum in modern markets is the continued reliance of investors and policymakers on two false mantras. The first is that markets are efficient; and the second is that investors are rational. Both assertions are so decidedly specious that one has to question both the sanity or the intelligence of those who cling to them. Yet these two bugaboos are supported by reams of academic research and much of the investment establishment! It is my contention that these delusions are why capital continues to be terminally mismanaged by the professional investment class. With few exceptions, professional investors in all asset classes have produced at best mediocre returns for their investors. There are exceptions, of course, but they are essentially of statistical insignificance. Private equity is one asset class that I pay particular attention to in my book, but the same criticism can be applied to virtually all asset managers. The reality is that most managers do a very poor job for their investors. This is not only because they cling to the false Gods of market efficiency and investor rationality; it is because they misunderstand the true nature of capital.

Capital is not a thing or a category; capital is a living, breathing phenomenon. Capital is an expression of the human relationships that generate economic value. Just as these relationships are dynamic, so is capital. The most important attribute of capital as it functions in the real world is that it is a relationship; as such it has the capacity to change form. This is often described as its liquidity function. Capital is also a human construct; it is not something found in nature or subject to scientific laws, despite the misguided attempts of today's rocket scientists to claim that it possesses such qualities. Most importantly, capital is unstable. If capital were better understood for what it is, it could be better managed and regulated.

Because capital is not properly understood, however, it is abused. And the consequences of that abuse are not theoretical – they are human. Our ill-begotten economic policies have exacted an incalculable toll on the citizens of this country and around the world. Millions of people have lost their jobs and their homes. The official jobless rate is still around 10%, and the real jobless rate is closer to 20% when discouraged and underutilized workers are included. Economic hardship and the stresses of unemployment have led to the break-up of families and higher rates of addiction and suicide. At the end of last year, one in eight Americans was receiving part of his or her nutrition from food stamps, including one in four children. Communities around the country are being destroyed by house foreclosures, and the American heartland has been decimated by the failure of the American automobile industry. And our country is facing even greater challenges ahead in terms of caring for its aging population, dealing with unsustainable fiscal deficits, reducing the growing cost of healthcare, not to mention the incalculable costs of dealing with the inevitable but unknowable Black Swans that are bound to occur, such as Gulf oil spills, terrorist attacks, or nuclear proliferation. Only a sound financial system will place us in a position to deal with these challenges. The Death of Capital is intended to contribute to the discussion of how we achieve such a system.

The Global Crisis of Legitimacy

John Mauldin — Thu, 06 May 2010 19:04:00 GMT

From my friend George Friedman, founder & CEO of STRATFOR, here's my newest favorite quote concerning economic recessions: "Like forest fires, they are painful when they occur, yet without them, the forest could not survive. They impose discipline, punishing the reckless, rewarding the cautious." The thin line of where risky becomes reckless is something I'd like to focus us on today. No matter the risk-level of your portfolio, if you are reading this you are probably smart enough to know that when you play with fire you may get burned. You have to know how to look for smoke, or signs of a potential catastrophe, so you know not to grab the doorknob with both hands.

I'm including George's discussion of the contributing facets of a recession, its inevitability and the idea of risk. As if the title won't intrigue you to begin with, take my advice and give "The Global Crisis of Legitimacy" a read. STRATFOR uses its signature analytic approach to decipher today's issues, applying historical context ranging from Adam Smith to the Lehman Brothers. Also, join their mailing list to receive two weekly intelligence pieces, and find that fire before your next investment opportunity comes along.

John Mauldin
Editor, Outside the Box

The Global Crisis of Legitimacy

May 4, 2010 | 0856 GMT

By George Friedman

Financial panics are an integral part of capitalism. So are economic recessions. The system generates them and it becomes stronger because of them. Like forest fires, they are painful when they occur, yet without them, the forest could not survive. They impose discipline, punishing the reckless, rewarding the cautious. They do so imperfectly, of course, as at times the reckless are rewarded and the cautious penalized. Political crises - as opposed to normal financial panics - emerge when the reckless appear to be the beneficiaries of the crisis they have caused, while the rest of society bears the burdens of their recklessness. At that point, the crisis ceases to be financial or economic. It becomes political.

The financial and economic systems are subsystems of the broader political system. More precisely, think of nations as consisting of three basic systems: political, economic and military. Each of these systems has elites that manage it. The three systems are constantly interacting - and in a healthy polity, balancing each other, compensating for failures in one as well as taking advantage of success. Every nation has a different configuration within and between these systems. The relative weight of each system differs, as does the importance of its elites. But each nation contains these systems, and no system exists without the other two.

Limited Liability Investing

Consider the capitalist economic system. The concept of the corporation provides its modern foundation. The corporation is built around the idea of limited liability for investors, the notion that if you buy part or all of a company, you yourself are not liable for its debts or the harm that it might do; your risk is limited to your investment. In other words, you may own all or part of a company, but you are not responsible for what it does beyond your investment. Whereas supply and demand exist in all times and places, the notion of limited liability investing is unique to modern capitalism and reshapes the dynamic of supply and demand.

It is also a political invention and not an economic one. The decision to create corporations that limit liability flows from political decisions implemented through the legal subsystem of politics. The corporation dominates even in China; though the rules of liability and the definition of control vary, the principle that the state and politics define the structure of corporate risk remains constant.

In a more natural organization of the marketplace, the owners are entirely responsible for the debts and liabilities of the entity they own. That, of course, would create excessive risk, suppressing economic activity. So the political system over time has reallocated risk away from the owners of companies to the companies' creditors and customers by allowing corporations to become bankrupt without pulling in the owners.

The precise distribution of risk within an economic system is a political matter expressed through the law; it differs from nation to nation and over time. But contrary to the idea that there is a tension between the political and economic systems, the modern economic system is unthinkable except for the eccentric but indispensible political-legal contrivance of the limited liability corporation. In the precise and complex allocation of risk and immunity, we find the origins of the modern market. Among other reasons, this is why classical economists never spoke of "economics" but always of "political economy."

The state both invents the principle of the corporation and defines the conditions in which the corporation is able to arise. The state defines the structure of risk and liabilities and assures that the laws are enforced. Emerging out of this complexity - and justifying it - is a moral regime. Protection from liability comes with a burden: Poor decisions will be penalized by losses, while wise decisions are rewarded by greater wealth. Because of this, society as a whole will benefit. The entire scheme is designed to increase, in Adam Smith's words, "The Wealth of Nations" by limiting liability, increasing the willingness to take risk and imposing penalties for poor judgment and rewards for wise judgment. But the measure of the system is not whether individuals benefit, but whether in benefiting they enhance the wealth of the nation.

The greatest systemic risk, therefore, is not an economic concept but a political one. Systemic risk emerges when it appears that the political and legal protections given to economic actors, and particularly to members of the economic elite, have been used to subvert the intent of the system. In other words, the crisis occurs when it appears that the economic elite used the law's allocation of risk to enrich themselves in ways that undermined the wealth of the nation. Put another way, the crisis occurs when it appears that the financial elite used the politico-legal structure to enrich themselves through systematically imprudent behavior while those engaged in prudent behavior were harmed, with the political elite apparently taking no action to protect the victims.

In the modern public corporation, shareholders - the corporation's owners - rarely control management. A board of directors technically oversees management on behalf of the shareholders. In the crisis of 2008, we saw behavior that devastated shareholder value while appearing to enrich the management - the corporation's employees. In this case, the protections given to shareholders of corporations were turned against them when they were forced to pay for the imprudence of their employees - the managers, whose interests did not align with those of the shareholders. The managers in many cases profited personally through their compensation system for actions inimical to shareholder interests. We now have a political, not an economic, crisis for two reasons. First, the crisis qualitatively has moved beyond the boundaries of a cyclical event. Second, the crisis is rooted in the political-legal definitions of the distribution of corporate risk and the legally defined relations between management and shareholder. In leaving the shareholder liable for actions by management, but without giving shareholders controls to limit managerial risk taking, the problem lies not with the market but with the political system that invented and presides over the limited liability corporation.

Financial panics that appear natural and harm the financial elite do not necessarily create political crises. Financial panics that appear to be the result of deliberate manipulation of the allocation of risk under the law, and from which the financial elite as a whole appears to have profited even while shareholders and the public were harmed, inevitably create political crises. In the case of 2008 and the events that followed, we have a paradox. The 2008 crisis was not unprecedented, nor was the federal bailout. We saw similar things in the municipal bond crisis of the 1970s, and the Third World Debt Crisis and Savings and Loan Crisis in the 1980s. Nor was the recession that followed anomalous. It came seven years after the previous one, and compared to the 1970s and early 1980s, when unemployment stood at more than 10 percent and inflation and mortgages were at more than 20 percent, the new one was painful but well within the bounds of expected behavior.

The crisis was rooted in the appearance that it was triggered by the behavior not of small town banks or third world countries, but of the global financial elite, who took advantage of the complexities of law to enrich themselves instead of the shareholders and clients to whom it was thought they had prior fiduciary responsibility.

This is a political crisis then, not an economic one. The political elite is responsible for the corporate elite in a unique fashion: The corporation was a political invention, so by definition, its behavior depends on the political system. But in a deeper sense, the crisis is one of both political and corporate elites, and the perception that by omission or commission they acted together - knowingly engineering the outcome. In a sense, it does not matter whether this is what happened. That it is widely believed that this is what happened alone is the origin of the crisis. This generates a political crisis that in turn is translated into an attack on the economic system.

The public, which is cynical about such things, expects elites to work to benefit themselves. But at the same time, there are limits to the behavior the public will tolerate. That limit might be defined, with Adam Smith in mind, as the point when the wealth of the nation itself is endangered, i.e., when the system is generating outcomes that harm the nation. In extreme form, these crises can delegitimize regimes. In the most extreme form - and we are nowhere near this point - the military elite typically steps in to take control of the system.

This is not something that is confined to the United States by any means, although part of this analysis is designed to explain why the Obama administration must go after Goldman Sachs, Lehman Brothers and others. The symbol of Goldman Sachs profiting from actions that devastate national wealth, or of the management of Lehman wiping out shareholder value while they themselves did well, creates a crisis of confidence in the political and financial systems. With the crisis of legitimacy still not settling down after nearly two years, the reaction of the political system is predictable. It will both anoint symbolic miscreants, and redefine the structure of risk and liability in financial corporations. The goal is not so much to achieve something as to create the impression that it is achieving something, in other words, to demonstrate that the political system is prepared to control the entities it created.

The Crisis in Europe

We see a similar crisis in Europe. The financial institutions in Europe were fully complicit in the global financial crisis. They bought and sold derivatives whose value they knew to be other than stated, the same as Americans. Though the European financial institutions have asserted they were the hapless victims of unscrupulous American firms, the Europeans were as sophisticated as their American counterparts. Their elites knew what they were doing.

Complicating the European position was the creation of the economic union and the euro by the economic and political elite. There has always been a great deal of ambiguity concerning the powers and authority of the European Union, but its intentions were always clear: to harmonize Europe and to create European-wide solutions to economic problems. This goal always created unease in Europe. There were those who were concerned that a united Europe would exist to benefit the elites, rather than the broader public. There were also those who believed it was designed to benefit the Franco-German core of Europe rather than Europe as a whole. Overall, this reflected minority sentiment, but it was a substantial minority.

The financial crisis came at Europe in three phases. The first was part of the American subprime crisis. The second wave was a uniquely European crisis. European banks had taken massive positions in the Eastern European banking systems. For example, the Czech system was almost entirely foreign (Austrian and Italian) owned. These banks began lending to Eastern European homebuyers, with mortgages denominated in euros, Swiss francs or yen rather than in the currencies of the countries involved (none yet included in the eurozone). Doing this allowed banks to reduce interest rates, as the risk of currency fluctuation was pushed over to the borrower. But when the zlotys and forints began to plunge, these monthly mortgage payments began to soar, as did defaults. The European core, led by Germany, refused a European bailout of the borrowers or lenders even though the lenders who created this crisis were based in eurozone countries. Instead, the International Monetary Fund (IMF) was called in to use funds that included American and Chinese, as well as European, money to solve the problem. This raised the political question in Eastern Europe as to what it meant to be part of the European Union.

The third wave is represented by crisis in sovereign debt in countries that are part of the eurozone but not in the core of Europe - Greece, of course, but also Portugal and possibly Spain. In the Greek case, the Germans in particular hesitated to intervene until it could draw the IMF - and non-European money and guarantees - into the mix. This obviously raised questions in the periphery about what membership in the eurozone meant, just as it created questions in Eastern Europe about what EU membership meant.

But a much deeper crisis of legitimacy arose. In Germany, elite sentiment accepted that some sort of intervention in Greece was inevitable. Public sentiment overwhelmingly opposed intervention, however. The political elite moved into tension with the financial elite under public pressure. In Greece, a similar crisis emerged between an elite that accepted that foreign discipline would have to be introduced and a public that saw this discipline as a betrayal of its interests and national sovereignty.

Europe thus has a double crisis. As in the United States, there is a crisis between the financial and political systems. This crisis is not as intense as in the United States because of a deeper tradition of integration between the two systems in Europe. But the tension between masses and elites is every bit as intense. The second part of the crisis is the crisis of the European Union and growing sense that the European Union is the problem and not the solution. As in the United States, there is a growing movement to distrust not only national arrangements but also multinational arrangements.

The United States and Europe are far from the only areas of the world facing crises of legitimacy. In China, for example, the growing suppression of all dissent derives from serious questions as to whom the financial expansion of the past 30 years benefits, and who will pay for the downturns. It is also interesting to note that Russia is suffering much less from this crisis, having lived through its own crisis before. The global crisis of legitimacy has many aspects worth considering at some point.

But for now, the important thing is to understand that both Europe and the United States are facing fundamental challenges to the legitimacy of, if not the regime, then at least the manner in which the regime has handled itself. The geopolitical significance of this crisis is obvious. If the Americans and Europeans both enter a period in which managing the internal balance becomes more pressing than managing the global balance, then other powers will have enhanced windows of opportunities to redefine their regional balances.

In the United States, we see a predictable process. With the unease over elites intensifying, the political elite is trying to stabilize the situation by attacking the financial elite. It is doing this to both demonstrate that the political elite is distinct from the financial elite and to impose the consequences on the financial elite that the impersonal system was unable to do. There is precedent for this, and it will likely achieve its desired end: greater control over the financial system by the state and an acceptable moral tale for the public.

The European process is much less clear. The lack of clarity comes from the fact that this is a test for the European Union. This is not simply a crisis within national elites, but within the multinational elite that created the European Union. If this leads to the de-legitimization of the EU, then we are really in uncharted territory.

But the most important point is that almost two years since a normal financial panic, the polity has still not managed to absorb the consequences of that event. The politically contrived corporation, and particularly the financial corporations, stands accused of undermining the wealth of nations. As Adam Smith understood, markets are not natural entities but the result of political decisions, as is the political system that creates the allocation of risk that allows markets to function. When that system appears to fail, the consequences go far beyond the particular financials of that event. They have political consequences and, in due course, geopolitical consequences.

Was the Demise of the USSR a Negative Event?

John Mauldin — Wed, 05 May 2010 20:32:01 GMT

Let's have a thought game. What if the Eurozone breaks up? My friend and very serious philosophical thinker Charles Gave (of GaveKal) thinks that would be a positive event. To quote his conclusion:

"But we return to the most simple of questions, namely: Was the end of the USSR a negative event? When Americans stopped wasting capital building empty condos in Florida or Arizona, was that bad news? If, like us, our reader answers "no" to the above questions, then the Greek crisis should be seen as a reason for hope, rather than despair."

Now, that is a truly Outside the Box proposition and one which I found very compelling. His partner, Anatole Kaletsky, elsewhere argues that the ECB will enlarge their mandate to try and save the day by printing enormous sums of money, ultimately making things worse.

The team at GaveKal gave me permission to share this with you, as I think it deserves a wide audience. Warning: the first part is philosophical in nature. You will need to think through it. This is not one for speed reading. But if you grasp what he is saying, I think it will give you a major insight into the plight that is now engulfing Europe. Note. Even though Marc Faber calls the GaveKal team "euro perma-bears" GaveKal is mostly quite bullish on everything else. They always seem to find the bright side of the street to walk on, or at least a few spots in the sun in which to sit.

Read this and learn why the break-up of Europe might be a bullish event. As I said, Outside the Box is for ideas that challenge the status quo, and this, if anything, does just that.

John Mauldin, Editor
Outside the Box

Was the Demise of the USSR a Negative Event?

Everything one reads on Europe these days varies from the seriously gloomy to the downright apocalyptic so let us immediately re-assure our reader: this is not yet another GaveKal paper explaining that the Euro is a doomed currency. GaveKal has done too many of those over the years to the point where our friend Marc Faber started to refer to us as the 'Euro perma-bears'. I even wrote a book, in French (Des Lions Menés Par Des Anes) in which I explained, as simply as I could, that the Euro would lead to the biggest misallocation of capital since the Soviet Union, leaving us with too many houses in Spain, too many factories in Germany, and too many civil servants in France, everybody specializing in what they were best at.

Amazingly, now that the markets finally seem to be putting an end to a political interference in the free market which, like the Soviet Union, or Fannie and Freddie Mac, could only lead to disaster, most commentators appear to believe that Europe is on the edge of a precipice. And two reasons are typically proposed to defend the notion of sending good money after bad: the first is that without a bailout of Southern Europe, the very existence of the Common Market and the dream of European Unity will collapse.

The second is that, without a bailout, the European financial system will enter into a tailspin which will make the Lehman crisis look like a dress-rehearsal. In our view, both of these assumptions are either tremendously self-serving (when wheeled out by politicians hoping to avoid the blame that should rightfully fall on their doorstep for putting together a monetary system that had no chance of working), or belie a lack of knowledge of European History, and a fundamental understanding of how financial markets work.

1– The Ideological Background Behind the European Idea

Every French school child will at some point have been told by his professors: 'very well, this works in practice. But more importantly, does it work in theory?' Probably for this reason, it is hard for me to believe that there can be any kind of political construction without some kind of hidden, or obvious, ideological backbone. Looking at Europe, I have long felt that two 'ideologies' have been competing since the 1950s to define what the future organization of Europe should look like:

The 'Roman Empire' Model:

the main goal is to have Centralized State, managed by an efficient techno-structure with a supremacy of the center over the periphery. Unification of the law through a common jurisprudence is necessary, as are regulatory powers leading to a de facto unification of all regulations. This vision is fundamentally Hegelian with the notion of 'History on the March" and while the process of integration is a work in progress, crisis should be seen as opportunities to re-enforce the center against the periphery either through new institutions being created to deal with the problem (e.g., the ECB, the creation of a European Ministry of Finance) or the granting of new powers given to existing centralized institutions (European Commission, European Parliament, etc.).

The end goal is obviously to arrive at a European State which will be "big enough" to have an impact not only on the rest of the world, but also on the underlying sovereign states which will have no choice but to become subservient over time. Aside from the Roman Empire, historical precedents for this include Charlemagne, Louis XIV, Napoleon, Hitler, Staline... The good news, of course, is that this time around, the integration is proceeding peacefully, rather than through military conquest. The main problem is that the institutions being built are less and less democratic and increasingly more technocratic and removed from public control (Commission, Court of Justice, ECB, soon a European EMF).

This leads to a general disenchantment from voters and a backlash from the countries with the longer democratic traditions (UK, Sweden...). The other problem in this model is that there are no obvious geographical limits to the growth of this vision of Europe since the main criteria of acceptance is a common belief in general humanist ideas loosely defined as 'European values'. So why not include Turkey, Georgia, Ukraine... and who knows, one day maybe even Russia or North Africa?). This leaves a lot of traditionalist voters feeling very uncomfortable.

The Catholic Model.

In The Rise of Christian Europe, Hugh Trevor Roper, explained the diversity of political systems was one of the key reasons why the Europe 'controlled' by Rome was successful while the Roman Empire of Constantinople failed. Under the catholic popes, Western Europe was catholic from one end to the next with free movements of people, traders, businesses, etc... But meanwhile, political structures were massively different systems, from independent cities in Flanders and Northern Italy, to Kingdoms, to Republics like Venice... So it could be argued that political diversity served Europe well; until, of course, the 19th and 20th century when Europe's nation-states (well, really France and Germany), in a mutual suicide pact, went for each other's throats in a bid to each become 'the new Rome, the new Imperial Power".

These fratricides led to the efforts towards European integration which, in their infancy, were heavily supported by the Catholic Church. Indeed, the real founding-fathers of Europe, Schuman (France), Adenauer (Germany), Alcide de Gasperi (Italy) were all Christian Democrats, and (German-speaking) Catholics. And their main bond was obvious enough: they shared a common, Christian, civilization. But beyond that, at inception, the European ideal's main legal principle was subsidiarity. Competing political systems were the norm, integration was the exception. Pieces of political sovereignty could be abandoned but never the principle of sovereignty itself (incidentally, we now have had a reminder of this view in the recent decision by the German high court to block any further abandonment of sovereignty by Germany).

Such a system automatically leads to the re-emergence of old political systems centered on provinces and ever closer proximity to the voters. Examples of such an evolution include Spain, Switzerland and Germany (with a lot of political powers such as taxation, education, police... being decentralized). Italy might be moving fast in this direction. Philosophically, this model has to stop at Europe's borders (no Turkey), since the common ground is Christianity. In this model Nation-States are weakened dramatically though instead of losing out to a super-state, they lose to provinces. Another fine example of this trend is the re-emergence of forgotten nations following the collapse of communism across Eastern Europe, either peacefully (Slovakia) or through bloodshed (Bosnia).

For this model to work, one needs adherence to the same legal rules (with final decisions belonging to the European court of justice, or to the Commission, used as some sort of arbitration court). Experiments are the rule and normalization to a common standard the exception. The main challenge is establishing processes to arrive at a common decision and the biggest is that some countries (think France, the inventor of the Nation-State) could decide to discard common rules and instead return to the old European ways of nationalism, protectionism, industrial policies, national champions, etc... Aside from that, the common institutions should be seen as places where arbitrages between different views take place, rather than places where decisions are taken. Another risk worth mentioning is the simple disappearance of nations which have no real reason to exist (Belgium?).

To summarize and put it in the language of today, at the risk of oversimplifying: In partisan political terms, Europe's Christian Democrats, typically led by Germany and Holland, were usually aligned with the "Christian" view of Europe, while Social-Democrats and Socialists, usually led by France, were more of the "Roman Empire" persuasion. And so, Europe went on and on, never really making a choice between the two models, which was quite wise. Europe was in fact a "Hayekian" construction, emerging from below in ways that nobody really understood, but which at the end delivered a satisfactory result. If Democracy can be defined as "government through discussions, compromises and debates", then Europe was indeed democratic, in its own inimitable and incomprehensible ways.

2– The Collapse of the Evil Empire Tips the Scale

However, this marvelous equilibrium was broken with the collapse of the Evil Empire and the German reunification. With a stronger Germany, a free (and very Christian) Poland, Hungary, Czechoslovakia... came the threat that the 'Christian' vision of Europe would overwhelm the 'Roman Empire' camp. The sense of urgency was profound: If a European State was not built rapidly, the newly freed Eastern European countries would, in the future, likely be very weary of abandoning large chunks of the sovereignty they had just recovered from the Soviets (without any help from the rest of Europe) to a European State (see Vaclav Klaus as an example).

For the proponents of the "Roman Empire", the European State had to be organized immediately, whatever the risks, and become inevitable. Otherwise, the proponents of 'Christian Europe' would win by default and History would likely never reverse its course. The collapse of the Soviet Union was the crisis which gave the opportunity, and drive, to the Roman Empire to push though an overly ambitious program. The scale had been tipped and the "Roman Empire" needed to tip it the other way; and the creation of the Euro, more than anything, came to symbolize the push by the Roman camp towards a centralized super-structure.

Of course, the reasoning was that a common currency would facilitate trade, tourism and exchanges amongst Europe's people and thus generate a large "Ricardian growth" spurt. But the common currency was also seen as a first step towards the creation of a European State. And the only reason "Christian Democrat" Germany, which for historical reasons should have been wary of such an endeavor, went along with the plan is that it was seen as a qui-pro-quo for German Reunification. The Germans thought: "we allow the French to build their European 'Roman Empire' and sacrifice the DM, and we get to re-unify with East Germany".

In this 'Roman empire' roadmap, The second step would be the writing of a constitution (by French ex-President Giscard) which would establish the super-structures of a functioning state. Unfortunately, this constitution was immediately voted down by the French themselves and then by the Dutch to boot (the Germans were never given a vote but would have most likely voted 'nein'). Having been shown the door by the citizens, the constitution came back through the windows, under a different name, which did not require a popular vote. Still, the new construct was not a "Constitution" per se, but merely a treaty. And this thus left the Euro as the only tool for the 'European State' to deploy its nascent power.

This is why today one reads everywhere that, should the Euro be consigned to the trash heap of History, then the whole European Union effort might disappear along with it. Of course, this is dead wrong. Rather than the death of Europe, a demise of the Euro would simply mean the collapse of the "Roman Empire" idea of Europe and the resurgence of the "Christian" idea of Europe.

After all, if some countries start to revert to their own currencies, why should this impact common market rules? A number of European countries are not members of the Euro (UK, Sweden, Denmark, Poland...) so who cares if Greece, or Spain, or Ireland join them? Instead, the bigger question investors, and commentators should ask themselves when confronting the current crisis is simple: for Europe to function, do we need more centralization, more government and more intervention? Or does Europe need more freedom to experiment? The answer to that question will dictate whether our reader is a proponent of the 'Roman Empire' idea of Europe, or the 'Christian' idea of Europe.

Needless to say, there are no prizes for guessing which camp I happen to fall into. However, let me dispel any possible lingering doubts by saying that, for me, the revival of the 'Christian idea' of Europe, and the possible, though still unconfirmed, demise of the 'Roman Empire' idea of Europe could actually be one of the most bullish developments since the collapse of the Soviet Union. So why does every one think it is bad news?

3– The End of Massive Capital Misallocation

As has now become painfully obvious, the low cost of financing which resulted from the Euro has allowed various governments to borrow at rates far too low for far too long. In other words, for the past decade, and because of political diktat, Europe has been grossly misallocating capital. That much is clear. So what could be the possible answer for Europe's policy-makers? Is it:

*Recognize the capital misallocation, restructure the debt, and reform a system which obviously, and painfully, does not work?

*Try to force a square hole into a round peg by imposing conditions on Greece, Portugal and Spain that would have made Bruning or Laval blush?

*Send good money after bad?

Somewhat unsurprisingly, Europe's policymakers first tried the second option and are now drifting towards the third. But this is where things are getting very exciting, and in my view, very long-term structurally bullish; the one conclusion we can draw from recent events is that the markets are simply not letting the European governments get away with the idea of sending good money after bad! Since the Greek rescue plan was announced, instead of tightening, and to the great surprise of all European policy-makers, spreads on Greece and all other risky European signatures have widened massively.

As our friend Alain Madelin (a former French Minister of Finance) recently said on French radio: 'politicians are saying that markets are acting irresponsibly but instead what is happening is that markets are starting to ensure that politicians act responsibly!' This reality means that Europe's politicians will either have to send even more good money after bad (and that too may fail), or throw in the towel and allow for the weak debt to be restructured.

Of course, it would be Panglossian of us to assume that a restructuring of the debt of Southern European nations, and the possible return to national currencies, would not trigger large hits across Europe's financial system. Indeed, the balance sheets of European banks and insurance companies are heavily distorted by past investments made in the debt of technically bankrupt governments. For the past 15 years, banks and insurance companies all over Europe have been lured into believing that the Greek risk was equivalent to the German risk, or the Spanish risk similar to that of the Dutch, etc. As a result, the capital of too many financial institutions was invested in very dubious paper.

Moreover, in the countries which have "enjoyed" a massive real estate bubble (Spain, Ireland...) because of the distortions in the cost of money introduced by the Euro, the banks are now loaded with real estate loans of very questionable value. To add insult to injury, regulatory powers all over Europe have literally forced banks and insurance companies into buying the bonds issued by European governments ("risk free" they were told, and zero reserve requirements!) while forcing them to sell good quality equity positions established over decades. So whether one looks at balance sheets, reserves, loan books or future sources of income, it is hard to avoid the conclusion that European financials are in a pickle. This is a true and very unfortunate consequence of the Euro.

But having said that, I believe that the banking crisis that a sovereign debt default in Southern Europe would most likely trigger need not unleash a wave of destruction similar to what followed Lehman's bankruptcy. Indeed, if we look back at the situation in 2008:

Financial leverage in the system was off the charts with every hedge fund, investment bank, retail investor, fund of funds... running on as much leverage as risk-blind commercial banks would provide.

Operational leverage was also at record highs with companies having built up stocks, double or triple-ordered commodities to cushion from further price increases, expanding rapidly on all continents, etc.

The situation could not be more different today. Following the Lehman shock, investors everywhere around the world have learned to focus disproportionately on risk rather than on returns. Companies have cut inventories, salaries, workers and are now as efficient as they have ever been (see Europe and The SAP Recession).

This profound difference between the 2008 and current underlying economic and financial conditions help explain why, while the bond markets are increasingly pricing in a debt default in Europe, an event which would undeniably trigger much gnashing of teeth amongst European financials, the larger European equity markets (Dax, FTSE, OMX, AEX...) seem to be taking the bad news in stride. The decent performance of European equity markets in the face of the EMU bond market meltdown indicates that, as things stand, the larger European companies do not need the banks.

The other possible explanation for the resilience of Europe's equity markets is that European stocks are looking beyond the near term hic-cups and problems linked to debt restructuring and towards a far more bullish 'Christian' Europe, which stops misallocating capital on a grand scale. After all, does any one seriously believe that, by maintaining the institutional arrangement which created the current problem, that Europe's policymakers would solve the balance sheet problems of the European financial institutions? Would creating an unprecedented depression in Greece, Portugal, Spain, Ireland and elsewhere across Europe, as the current plan seems to propose, really improve the ability of such nations to repay their debt?

Instead, isn't the reality that a nation such as Greece has now been found to be insolvent and that the longer we wait to acknowledge that fact, the worse the pain for both investors, and the Greek population, will be? To ease the suffering of this particular dog, should we cut the tail in one motion, or in small increments? The current reality is that the losses are already there, and now blatantly visible. The losses will thus have to be marked to market pretty soon and trying to sweep them under the carpet will not work now that the markets have understood that Europe's Roman Emperor has no clothes.

4– The Way Out

The question for Europe should not be how we can get the highly indebted and unproductive Southern nations to service their debt. Instead, the question should be how will Southern Europe achieve an improvement in its income statement? And the answers provided by both the economic textbooks and experience are obvious enough: the exchange rate has to fall to a level where the external sector starts contributing massively to growth and a level where asset prices become incredibly cheap for foreigners. Of course, right now, the weaker countries cannot devalue within the Euro.

Which leaves us with two possibilities:

*The Euro itself collapses and falls below its current purchasing parity of US$1.1/€. With Greece, and potentially others, having to restructure their debt and the European financial system having to take large hits, one would expect the ECB to maintain short rates at zero forever. But meanwhile, Northern Europe does not really need very low interest rates, nor does it need an undervalued exchange rate, but this will happen anyway. From there, we can imagine an export-led boom of historic proportions for Northern Europe. In turn, this should trigger tremendous capital flows which will no longer be recycled into Southern European debt. Instead, that money will more likely get re-invested in local real estate and local equity markets—for one of the consequences of the current crisis may well be that equities start being perceived as a better 'risk-free' asset than sovereign bonds! Or perhaps even in undervalued assets in Southern Europe (beach houses in Corfu).

*But if the above scenario is not bullish enough for you, try this one on for size: European governments decide that the Euro was a bad idea after all and that the time has come to return to national currencies. They restructure their debt— which at first triggers some volatility (a mild understatement) though, after that, the threat of defaults would disappear. From there, capital would start flowing in Europe according to the various nations' real comparative advantages, and not according to the monetary diktats of Frankfurt and Brussels-based technocrats. The currencies would settle at levels that would ensure the financing of external or domestic deficits... and Europe would then embark on the mother of all bull markets (think Asia post Asian Crisis).

5– Conclusion

As we write, the level of uncertainty about Europe's future remains at an all time high. The current lack of visibility, and the feeling that Europe's survival depends on the decisions of a few politicians, is leading most of the clients we talk to into a great level of despondency. But, although one has to acknowledge that the short term outlook will remain extremely challenging, there are very good reasons to start feeling cautiously more optimistic about the future. These reasons include:

The fact that the markets are simply no longer letting politicians send good money after bad. In essence, the markets are calling time on the disastrous experiment of the Euro and this should lead to a structurally more efficient allocation of capital across the Old Continent.

The fact that this crisis is coming at a time when EMU companies have never been so efficient, when leverage in the financial markets has never been so low, and the dependency on local banks has never been so insignificant. All this ensures very limited transmission mechanisms from 'weak hands' to 'strong hands'.

The fact that the "Roman Empire" idea may, with this crisis, have reached its nadir and will now never recover. Indeed, if Europe is now returning towards its marvelous historical roots of allowing diversities and differences to express themselves freely, then we should rejoice!

But we return to the most simple of questions, namely: Was the end of the USSR a negative event? When Americans stopped wasting capital building empty condos in Florida or Arizona, was that bad news? If, like us, our reader answers "no" to the above questions, then the Greek crisis should be seen as a reason for hope, rather than despair.

The Great Reflation

John Mauldin — Mon, 03 May 2010 18:49:00 GMT

Let me start this week's Outside the Box by venting a little anger. It now looks like almost 30% of the Greek financing will come from the IMF, rather than just a small portion. And since 40% of the IMF is funded by US taxpayers, and that debt will be JUNIOR to current bond holders (if the rumors are true) I can't tell you how outraged that makes me.

What that means is that US (and Canadian and British, etc.) tax payers will be giving money to Greece who will use a lot of it to roll over old bonds, letting European banks and funds reduce their exposure to Greece while tax-payers all over the world who fund the IMF assume that risk. And does anyone really think that Greece will pay that debt back? IMF debt should be senior and no bank should be allowed to roll over debt and reduce their exposure to Greek debt on the back of foreign tax-payers.

I don't think I signed on for that duty. Why should my tax money go to help European banks? This is just wrong on so many levels and there is nothing seemingly we can do. Oh, well. Thanks for listening.

This week we look at an essay by my friend Tony Boeckh, who from 1968 until 2002, was chairman and editor-in-chief of BCA Publications, publisher of The Bank Credit Analyst. He has written a very important book called The Great Reflation. Tony feels that one of the most important things for investor to understand is money flows, whether from debt or monetary easing. The ebb and flow of money can both create and burst bubbles and we are now in what he calls a Great Experiment where governments around the world are trying to again reflate the economy (and are succeeding). What bubbles will this create and how does it end? How should we then invest?

My good friend Marc Faber has this to say about The Great Reflation:

"The Great Reflation is by far the best economic and investment book that I have read in the last ten years. Tony is a seasoned historian, economist, and strategist with a unique ability to explain complex issues in simple, readable terms. These are illustrated with numerous charts on economic and financial trends that put current conditions in a historical context."

- Marc Faber, Editor, The Gloom, Boom & Doom Report

The book is in most bookstores and you can of course get it by going to www.amazon.com and you save 34% and it is available on Kindle. So, let's enjoy Tony's essay.

Your never did like the IMF anyway analyst,

John Mauldin, Editor
Outside the Box

The Great Reflation:

The Mother of all Financial Experiments

By Tony Boeckh

Chuck Prince, the former CEO of Citigroup, who presided over the bank's collapse, famously remarked in July 2007 that "as long as the music is playing, you've got to get up and dance. We're still dancing." Shortly after, the music stopped, the financial system broke, and Citigroup and other financial behemoths went under.

To rescue the economy and financial system from near-total meltdown, the government created an unprecedented package of bailouts, stimulus, free money and massive fiscal deficits. It succeeded, and a 1930s style debt deflation and depression were aborted. Liquidity, on a vast scale was unleashed into the financial system, demonstrating, once again, the power of such flows to drive up the prices of stocks, commodities and other risky assets.

In Tony Boeckh we focus on how the authorities pumped air back into the balloon, and got the music playing again. Investors and banks, including Citigroup, are back out on the dance floor. However, just because the system was saved, doesn't mean it has been fixed.

Why do we say that the system isn't fixed? The major theme running through The Great Reflation is that we have been living through a multi-decade period of money and credit inflation that started back in the 1960s when the post-World War II global monetary system (Bretton Woods) began to break down. The Great Reflation is about this inflation and the consequences of the Act II, which is now unfolding.

From the late-1960s until 1982 we had out-of-control price inflation; after that, a series of asset bubbles and mini-crashes, leading up to The Big One in 2008-2009. One of the implications outlined in The Great Reflation is that we continue to live in an age of money and credit inflation and a monetary system that is unanchored and has no brakes. Until that is fixed, monetary inflation and instability will be a way of life.

The great reflation can only be understood properly in this longer-term context. It is a continuation of what went before, but with two main differences. The first is the sheer magnitude of the reflation this time—by far the biggest in peacetime U.S. history. The second difference is that the governments of the U.S. and other countries have had to transform collapsing private debt into a burgeoning public debt supercycle with projected government debt:GDP ratios heading to the stratosphere. This effort to reflate—pump air back into the balloon—had to be on a scale at least as large as the bubble itself. It is an experiment never before attempted in the context of U.S. experience, and it will have consequences unlike anything seen before.

No one knows exactly where the great reflation is going, what is going to happen, and what the end point will be like. However, there are some things we do know. When new money is created on a grand scale, it must go somewhere and have some major consequences. One of these will be greatly increased volatility and instability in the economy and financial system compared with the roller-coaster ride of the past 15 years when the private credit bubble was forming.

The Roller-Coaster

It is critical for investors to understand that there has been a linked sequence of events since the 1960s that lead to the disaster of 2008-2009. In particular, over the past 15 years, we experienced first the tech bubble, followed by a crash, then the recession and deflation of 2000-2002. Next came the Federal Reserve's first effort at massive reflation to avoid a debt collapse. This led to new bubbles—in housing, exotic new financial products, commodity prices, energy, and world food markets. They were financed by an unprecedented credit bubble that was unsustainable. When the bubble burst, debt levels were much higher and more precarious than ever. In 2008-2009 asset prices were crushed, causing the collateral behind the debt to evaporate. That, in turn, is what triggered the mother of all reflation experiments.

This sequence of events has an ominous undertone. The great reflation effort has clearly given the economy a big boost, just as the preceding one did but it is very artificial, based on free money and unprecedented fiscal deficits and subsidies to spending.

Extrapolation of this out-of-control roller coaster suggests more bubbles in the short run. Hot markets have already begun forming in such things as commodities, gold, and world stock markets. There are many assets that could be recipients of the new money created. However, a warning for investors: We don't believe another inflation of asset prices will last as long as the previous one for several reasons. Private debt has been pushed to the limit; government debt will be pushed to the limit in a few more years; the U.S. dollar, as the world's main reserve currency, will not be able to withstand open-ended monetary and fiscal reflation; and finally, the world economy is too fragile to withstand another spike in energy and food prices which will certainly occur if monetary inflation continues.

The great reflation, if left unchecked, will run into a brick wall in the next few years, and another credit implosion and deep recession will occur. The result will be even bigger budget deficits and lower economic growth. Logic says that if the recent crisis was caused by excessive money and credit inflation, even more of the same should cause an even bigger crisis. The ultimate end point to this trend is worrisome, to say the least.

The Engine of Inflation

Inflation is the biggest enemy of investors in the long run. However, in the short term, inflation in its early stages is often a wonderful elixir, greasing the wheels of the economy and causing riskier assets like stocks, commodities and corporate bonds to levitate. Euphoria tends to build as people get richer. But, it is important to understand that inflation is an undue expansion of money and credit. It can have the effect of raising the prices of things we consume or the prices of assets that we own or want to buy. But those are the symptoms of inflation that, if extreme, tell us that a bust is coming. In the case of rising consumer prices, the central bank ultimately has to raise interest rates and curtail credit. Recession follows. Or, if asset prices rise on the back of credit expansion, debt servicing ultimately becomes unbearable and asset prices—the collateral—start to fall, but debt levels are fixed in the short term. When people can't service or repay debt, panics and crashes follow, and the risk of a debt deflation and depression rises dramatically.

Too much debt and falling asset prices caused the depression of the 1930s and almost another one in 2008-2009. One Important reason that debt rose to such extremes, both in 1929 and 2007 was that the monetary system had a built-in inflationary bias. In the 1920s, it was called the gold exchange standard, whereby countries held both gold and currencies in their reserves. In the post-1971 world, it was called the floating dollar standard or Bretton Woods II. Countries held mainly dollars in their reserves. As a result, the U.S. could inflate at will and foreign countries had to buy the excess dollars on the foreign exchange market if they wanted to prevent their currency from rising. In a world of low and falling price inflation, as was the case after 1982, almost all countries want a cheap currency.

This is an important consequence of our flawed monetary system. Countries that buy dollars to keep their currency depressed, experience money and credit inflation. Bubbles result. When those countries re-invest their dollars back into the U.S., the U.S. financial markets remain highly expansionary. Lenders keep lending and borrowers keep spending beyond their means. In a fixed exchange rate system in which countries do not hold dollar reserves, a U.S. international payments deficit results in a drain on domestic liquidity until the deficit is corrected. In the current system, the U.S. can inflate and run huge balance of payments deficits with no pain and no mechanism to stop it, other than a financial panic. It is like a fast car with no brakes. Sooner or later a crash occurs.

This fundamental flaw in the international monetary system remains. The combination of this with the unleashing of the great reflation has created a toxic brew. There is little wonder that people fear even greater monetary instability in the future than we have experienced.

When looking for scapegoats to point the finger of blame for the crash, it is natural that people have looked to the appalling performance of the regulators. That is valid, and it is also right to highlight the greed-driven excesses of lenders and the virtually criminal conflicts of interest of the ratings agencies. But these characteristics—greed, conflict of interest and criminal behavior—are always present when inordinate inflations and manias occur. It is the inflation that is the real villain.

The Long Wave and Deflation

The money and credit inflation following the breakdown of the Bretton Woods I system in 1971 originated, we believe, from the deflationary forces of the long wave decline that became quite evident after 1973. The private debt supercycle build-up and overspending in the 1982-2007 period caused a countertrend, but artificial, recovery in some long wave economic forces. Employment, earnings and wealth in industries that benefitted from the credit inflation, such as real estate, the financial industry in general, retail spending, technology (from the 1990s bubble) rose quite strongly, masking the continued downward pressure on capital intensive industries and particularly, but not exclusively, in the capital goods industry itself. Growing excess capacity resulted. Middle-class incomes on average continued to erode and the gulf between rich and poor widened dramatically as in the late 1920s.

With the end of the private credit bubble, the long wave decline has resumed its downward course. No one knows how long that will last until the natural, Schumpeterian forces of long-term renewal take over. This would include the implementation of new technologies and the development of new industries. Our guess is that it could take another five years or so.

Policy and Markets

In The Great Reflation, we look at the inflationary causes of the credit bubble and the ensuing crash of 2008-2009 and the consequences of the massive monetary and fiscal program that was needed to abort an incipient debt deflation like the 1930s. The world, and in particular the U.S., will remain very deflationary for a few more years as the post-crash stimulus will soon begin to dissipate. The recovery engineered by the authorities will face additional headwinds from the unwinding of the private debt supercycle, the resumption of the long wave economic decline and the coming massive fiscal restraint. The U.S. and almost all other governments, at both national and lower levels (states, provinces, municipalities, hospitals, etc.) rein in expenditures and raise taxes. That is the new imperative—no one wants to hit the wall like Greece. However, massive fiscal restraint also carries risks, just as the lack of restraint causes risks of a different sort. The big issue is whether there exists a middle ground that could eventually bring us to stability. That will only be revealed in the fullness of time.

Spending and borrowing excesses of governments and the public have a long and dangerous history, suggesting a deeper malaise is affecting the nation. Moreover, there are other serious signs of long-term decline, and policy and leadership will have to be particularly adroit in steering the U.S. through the difficult few years ahead. It has been documented that the latter stages of a long wave decline are parochial, nasty and politically unstable. People are fed up with the system, their loss of wealth, jobs, and income. Traditional politicians are blamed. People look for quick and easy solutions and are open to simplistic solutions provided by demagogues. It is difficult to sell the austerity, sound policies and pro-growth strategies needed to transition through the long wave trough before really big crises occur. Countries in denial face the prospect of repeating Greece's calamity.

The risk for the U.S. and other countries is that politicians will cater to populist pressures and impose spending and tax policies that are counterproductive. In the aftermath of the Great Reflation, this could mean more government programs (e.g. health care), failure to raise taxes, where appropriate, out of fear of losing office, and excessive monetary ease because the Treasury bond market cannot absorb government funding on its own.

However, we should avoid the temptation to get too pessimistic. It is important never to underestimate the ability of the U.S. to recover from adversity, rejuvenate itself and get its house in order. Its long-term track record is pretty good, and realistic hope should not be jettisoned too readily. The question remains however, as to whether the U.S. needs an economic Pearl Harbour before serious action is taken. Investors have seen empty promises many times before and hence should be sceptical until they see clear, positive evidence that such action is being taken. Until then, they should take the attitude "show me".

The Investment Challenge

The great problem for investors in today's environment is that there is no return on short-term, safe assets yet the higher risk levels on longer-term, higher return assets are too uncomfortable for most people. There are a number of conservative strategies that investors can employ, which are discussed at length in The Great Reflation and in our Boeckh Investment Letter (www.boeckhinvestmentletter.com), which, for lack of space, cannot be discussed here.

The centerpiece of our own strategy, and outlined in the book, is understanding liquidity flows. They are the single most important force driving investment markets both up and down. Contracting liquidity caused the crash in 2008-2009 and dramatically expanding liquidity since March 2009 has triggered one of the greatest bull markets in U.S. history. The next bear market will also be driven, at some point, by a contraction in liquidity flows. However, as long as the great reflation is doing its work, that day can be postponed. Chuck Prince, if he were to comment today, would probably point out that the music is playing again. People are back out on the dance floor. But, if the great reflation is as artificial as we believe, then this is still musical chairs. When the music stops, there won't be a chair for everyone, just like the last time.

MACRO-EUROPE: The Titanic is SINKING

John Mauldin — Wed, 28 Apr 2010 21:09:00 GMT

This is a special Outside the Box. I got this letter from my good friend Greg Weldon last night and got permission to pass it on to you. I think it illustrates the problems that the world is facing from the sovereign debt crisis that is building in Europe.

There are no good solutions here, only very difficult ones. In order to get financing, Greece must willingly put itself into a multi-year depression. And borrowing more money when it cannot afford to pay back what it has will not solve the problem. 61% of Greeks now favor leaving the euro. How has Greece responded? By banning short selling on its stock market for the next two months. That should make things better. Greeks are responding by rioting and going on strike. But you truly know when a country is dysfunctional when its AIR FORCE goes on strike. Yesterday Reuters reported that hundreds of Greek pilots called in sick in protest. The response from government? The Minister of Defense said he was "profoundly disappointed." Now that had to make the pilots feel bad.

Money is flying from Greek banks, which makes sense, as how can a bankrupt Greek government guarantee Greek bank deposits? I know that Greek bankers may have a different view, but Greek depositors are voting with their feet. And Greg shows us it is not just Greece. It is fast becoming Portugal. And Spain is not far behind in my opinion.

I can well imagine there are private meetings among Greek government officials, banks and other leaders as to what must now be done. Those meetings I am sure can be tense. These things matter, as European banks hold a lot of Greek debt, as well as Portuguese and Spanish debt. European banks have not come close to dealing with their problems and are seriously over-leveraged. There is the potential for yet another banking and credit crisis stemming from European banks. Will world banks see their trust for each other (and especially European banks with large amounts of Club Med bonds) devolve as it did on August of 2008? It is something we must think about. It is possible, in my opinion. I sincerely hope it does not happen, but we must think about it. (Note, this is not something that will happen for awhile, but we should be aware of the problem.)

I want to thank Greg for letting me send this on to you. His website is www.weldononline.com. This letter is typical of his work – thorough and detailed and full of charts. He is the best slicer and dicer of data that I know.

John Mauldin, Editor
Outside the Box

WELDON'S MONEY MONITOR

Tuesday April 27, 2010

MACRO-EUROPE: The Titanic is SINKING ...

We rewind to our February 15^th Money Monitor entitled "Three Card Monty", with its focus on the 'early stages' of the now full-blown Greek debt-deficit-debacle, and we replay the quotes we spotlighted at the time ...

Greek Finance Minister George Papaconstantinou ...

... "We are basically trying to change the course of the Titanic. People think we are in a terrible mess. And we are.

We note comments from Jean-Claude Juncker, speaking on behalf of European Finance Ministers following a meeting of top EU officialdom in Brussels this afternoon ...

... "Greece is responsible for the consolidation of its public finances. It is first a Greek problem, and an internal Greek problem."

From European Central Bank President Jean-Claude Trichet ...

... "Everyone needs to respect their commitments. We have a particular Greek problem, but the other countries have their programs and they must be implemented. It is important that all of the heads of state and governments do what is necessary to guarantee the stability of the euro zone."

And from German Chancellor Angela Merkel ...

... "Germans should not pay for the consciously flawed fiscal and budgetary policies of others."

We stated, in our conclusion to that Money Monitor ...

Thinking that the problems of Greece, let alone two dozen other European debt-deficit 'offenders', will be 'solved', without PAIN, quickly ... or that they will be easily and quietly 'papered-over' ... is like playing Three Card Monty with the hustlers of Eighth Avenue in Manhattan.

It is ALWAYS a LOSING proposition.

Now, over two months later ... the Titanic is SINKING ... amid today's credit rating downgrade announced by Standard and Poor's, as it relates to Greece's sovereign debt.

Moreover, in our March 3^rd Money Monitor, "It's All Over Now, NOT !!!", we stated the following ...

In short, it is NOT, at all ... "all over now", in Europe.

And, in our April 12^th Monitor, "Three Blind Mice" ... published in the wake of the announcement of the (alleged) solution via a loan to Greece, from EU member nations, and the IMF ... we said the following ...

What happens when Italy needs a bailout, or Portugal, or Spain ...

... bailouts-that-are-not-a-bailout that would be significantly LARGER than the 45 billion EUR offered to Greece ... what then ????

Again, as we have stated repeatedly since the 4Q of last year ... Europe's fiscal debt-deficit crisis is FAR from 'over'.

Again, as we have repeatedly stated ... it will not be over, until draconian fiscal austerity measures are implemented ACROSS the region.

It will not be over ... for years to come.

Fast forward to the present ... and the announcement by Standard and Poor's wherein the credit ratings agency cut Greece's sovereign debt rating to JUNK status ... and we shine the spotlight on commentary from today's S+P 'statement' ...

... "We believe that the government's policy options are narrowing because of Greece's weakening economic growth prospects, at a time when pressures for stronger fiscal adjustment measures are rising. Moreover, in our view, medium-term financing risks related to the government's high debt burden are growing, despite the government's already sizable fiscal consolidation plans."

... "Our updated assumptions about Greece's economic and fiscal prospects lead us to conclude that the sovereign credit rating is no longer compatible with an investment grade rating."

Also ...

... "The government's multi-year fiscal consolidation program is likely to be tightened further under the new EMU-IMF agreement. This is likely to further depress Greece's medium-term economic growth."

And ...

... "The government's resolve is likely to be tested repeatedly by trade unions and other powerful domestic constituencies that will be adversely affected by the government's policy."

Adding insult to injury, Standard and Poor's also put Greece's credit 'outlook' on 'negative watch', opening the door for FURTHER downgrades ...

... "The negative outlook reflects the possibility of a further downgrade if the Greek government's ability to implement its fiscal and structural reform program materially weakens, undermined by domestic political opposition at home, or by even weaker economic conditions than we currently assume."

Indeed, the ICEBERG is HUGE ... and the unsinkable ship is sinking !!!

Evidence the rising water levels in the engine room, as represented by the 'price' of default 'protection', evidenced in the chart below plotting Greece's 5-Year Credit Default Swap Rate ... which has SOARED today, easily reaching a NEW ALL-TIME HIGH ... by FAR !!!

In fact, in our March 22^nd Money Monitor entitled "Three Card Monty, Revisited", we offered a chart perspective on the 5-Year Greek CDS. We spotlighted the downside correction that took the CDS to the med-term trend defining 100-Day EXP-MA, in line with a text-book Fibonacci retracement (between the 38% and 50% retracement levels) ... suggesting that the downside correction provided a 'buying' opportunity.

We also 'warned' about the potential for higher interest rates to significantly impact the entire fiscal environment in Greece. Thus we note additional commentary from within the Standard and Poor's statement ...

... "Pressures for more aggressive and wide-ranging fiscal retrenchment are growing, in part because of recent increases in market interest rates."

After today's parabolic rise in the 5-Year Greek Bond yield, as noted below, the word 'increases' becomes a substantial understatement.

As if this was not enough turbulence, we also note that in line with the downgrade of the Greek government credit rating, Standard and Poor's also marked down the 'rating' on the nation's largest banks ... stating that ...

... "We find that Greece's fiscal challenges are increasing pressure on the banking and corporate sectors. In particular we see continuing fiscal risks from contingent liabilities in the banking sector, which, could, in our view, total at least 5%-6% of GDP in 2010-2011."

Standard and Poor's downgraded the 'long-term counterparty credit ratings on National Bank, Eurobank, Alpha Bank, and Piraeus Bank ... causing share prices to plummet. Evidence the pair of charts on display below in which we plot Piraeus Bank ...

... and, the National Bank of Greece, both of which are breaking down technically, following a rally that mapped out another 'text-book' Fibonacci retracement correction.

Hence we turn the spotlight on the Greek stock market as a whole, represented within the chart below in which we plot the Greek ASE stock index. Indeed, we note another Fibonacci retracement, to the 33% target, followed by this week's renewed technical breakdown.

The ship ... is going DOWN.

We have been bearish on the Eurocurrency since October-November of last year, and after suffering because we were 'early' to this thematic-trade, we have been rewarded for our patience and perseverance ... as evidenced in the longer-term daily chart on display below, revealing today's decline in the EUR to a new move LOW.

Further, we spotlight the bearish technical dynamic, as defined by the negative action in the moving averages, and the slide into bearish territory by the long-term 200-Day Rate-of-Change.

While the Titanic (also known as the Eurocurrency) SINKS ... the price of Gold denominated in the Euro is SOARING, reaching a NEW ALL-TIME HIGH today, in excess of EUR 875 per ounce ...

... as observed in the long-term weekly chart seen below.

We are now watching for a 'confirming' upside breakout in the spot (USD based) price of Gold. Noting the daily chart on display below we focus on the most recent re-acceleration to the upside in the med-term trend defining 100-Day EXP-MA.

An upside violation of the April 12^th high of $1169 would constitute a full-blown med-term upside breakout.

All 'passengers' are going down with the ship ... with a downgrade to Portugal's sovereign credit rating also announced today, as Standard and Poor's marked down Portugal's rating by two notches, from A+ to A-, while placing the country on a negative outlook watch, portending more downgrades in the future.

Subsequently, Portugal's 5-Year Credit Default Swap is SOARING, as noted in the chart below, spiking to a NEW ALL-TIME HIGH ... today.

Similarly, Portugal's 5-Year Government Bond yield SOARED to a NEW HIGH, jumping by + 60 basis points today alone, capping a monstrous +215 basis point rise in the month of April, easily violating the February high of 3.95% ... as evidenced in the chart below.

Like the Titanic ... the Portuguese stock market is also ... sinking ...

... as evidenced in the daily chart on display below, replete with technical breakdown, head-and-shoulders pattern, violation of the med-term trend defining 100-Day EXP-MA ... and ... the downside reversal by the moving average itself, directionally speaking.

And finally, we have been focused on the downside price action and severe underperformance exhibited by the Spanish stock market (specifically spotlighted as recently as last Friday's ETF Playbook) ...

... and thus we note the chart on display below as Spain begins to unravel too, with the 5-Year Credit Default Swap SOARING to a NEW ALL-TIME HIGH, slicing through the (previous) double-top formed as defined by the February 17^th, 2009 high at 170 basis points, and the February 8^th, 2010 high at 173 basis points, reaching towards 200 basis points.

And, we shine the spotlight on the chart below plotting Spain's 5-Year Bond yield, which is breaking out to the upside, today, and doing so 'from' historically low levels below 2.75%, violating the February 5^th high of 3.13%.

The Titanic is sinking, and ultimately, ALL passengers will go down with the ship, including Portugal, Spain, Greece, and several other Maastricht Treaty debt-deficit offenders.

We have been anticipating this event for months.

Thus, we remain bearish on the European currencies ....

... and bullish on Gold priced in EUR.

Gregory T. Weldon ---

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The Making of a Greek Tragedy

John Mauldin — Mon, 26 Apr 2010 22:09:00 GMT

Back and recovering from my Strategic Investment Conference this weekend (where I decided to give myself permission not to write my usual letter, but I promise I will be back at it this next Friday!) I have spent some time pondering what we learned. It was a fabulous conference. Lacy Hunt, Dr. Gary Shilling, David Rosenberg, Niall Ferguson, Paul McCulley, George Friedman, former Fed Senior Economist Jason Cummins (who is now Chief Economist for Brevan Howard, the largest European hedge fund, and who was quite impressive), Jon Sundt of Altegris, and your humble analyst were all in top form. I must admit with a little pride that I think this is the finest speaker lineup for ANY investment conference anywhere. We were given a lot to think about.

Let me give you a few key points as an intro to this week's Outside the Box. First, there is a bubble building and it is in sovereign debt. It threatens to be a worse bubble than subprime or the credit crisis. Second, at one panel where we were asked what is our main worry, Paul McCulley said "Europe," which triggered an intense discussion, both in the panel and later that night over dinner. I agreed, of course, as I have written that very thing.

Both Paul and Niall think the consequences of a euro breakup could be severe, not only for Europe but for the world. I agree. That is why I have focused so much space in my writing and in Outside the Box on the European and especially the Greek situation. Everyone is hopeful that a major breakup can be avoided, but the problems the Mediterranean countries face are serious. I got the sense that most everyone expects the euro to fall further over the coming years.

In my opinion, there is little hope that Greece can resolve its fiscal crisis in a way that is less than draconian. I see almost no way out without a default of some kind. There will be band-aids and other measures to postpone the day of reckoning, but not to avoid it. They have just gone too far down a road of bad decisions.

Today we look at two short essays on Greece, one from Stratfor (George Friedman was in rare form this weekend) and the other from my friends Eric Sprott and David Franklin of Sprott Asset Management. Sprott gives us some details on a brewing Greek banking crisis and then closes with some thoughts on sovereign debt. He throws this little bon mot at us:

" ... [the US Government Accounting Office] goes on to state, however, that using reasonable assumptions, 'roughly 93 cents of every dollar of federal revenue will be spent on the major entitlement programs and net interest costs by 2020.'"

That is an example of the economic truism that if something can't happen, then it won't. Long before we get to 2020, massive change will be forced upon the US. The question is, do we do it willingly or do we become Greece?

And before I turn you over to the capable hands of Stratfor and Sprott, I have to end with what I think was the best one-liner of the conference (and there were so many). Paul McCulley noted that the debt crisis (the shadow banking system, subprime mortgages, SIVs, etc.) was the equivalent of an under-age drinking party with the rating agencies handing out fake IDs.

Have a good week. (And a special thanks to Lee Stein and David Malcolm for being so generous with their homes and wine cellars, respectively.)

Your feeling like I was drinking information through a fire hose analyst,

John Mauldin, Editor
Outside the Box

The Making of a Greek Tragedy

From Stratfor

Greece has not had many good days in 2010, but Thursday was a particularly bad day. First, Europe's statistical office (Eurostat) revised up the Greek 2009 budget deficit, which placed Athens' accounting shenanigans in the spotlight again. The bottom line is that the situation is even worse than previously thought, and the budget deficit may very well be adjusted up as more Greek accounting malfeasance comes to light. Following the announcement, credit rating agency Moody' s dropped Greece's credit rating one notch, immediately prompting a rise in Greek government bond yields, thus increasing Athens' borrowing costs.

The yield on a Greek 10-year bond shot above nine percent, while a two-year bond rose above 11 percent, both record highs since Greece joined the eurozone. Particularly daunting is the fact that short-term debt financing is now more expensive than long-term funding. This situation is referred to as an "inverted yield curve," and it is generally considered a harbinger of financial doom. This means that investors are sensing that Athens is more likely to experience problems sooner rather than later.

Higher yields mean that Greece is facing increasingly larger interest payments on an increasingly larger stock of debt. This all but confirms that Athens' claim that its stock of public debt will peak at 120 percent of gross domestic product (GDP) is simply wishful thinking. Worse still, Greece is also facing continued economic recession, induced in part by Athens' austerity measures designed to reduce its budget deficit. Given this vicious dynamic, we cannot see how Greece's debt level will stabilize at anything below 150 percent of GDP range.

The point is that the financial writing is now on the proverbial wall; some form of default is simply unavoidable. Exactly how the Greek default will unfold is unclear, but the bottom line is that the question now is not "if" but "when." Under "normal" circumstances, when the IMF becomes involved with a country in a situation similar to Greece's, the standard procedure is to devalue the local currency. By lowering the relative prices within the economy, the devaluation increases the competitiveness of the country's export sector and helps to reorient the economy toward external demand. Devaluation is also politically expedient because regaining competitiveness does not require employers to slash employees' wages, as the devaluation adjusts the relative costs silently and discreetly.

However, Greece does not have the option of devaluation because it is locked into a monetary union. The eurozone's monetary policy is controlled by the Frankfurt-based European Central Bank. The fact that Greece is locked in the "euro straitjacket" raises two questions, the first being how the Greek debt crisis will play out.

Without the option of devaluation, the Greeks will have to implement and endure draconian austerity measures - in addition to the ones it has already enacted - similar to what Latvia and Argentina endured as part of their IMF programs. Argentina in 2000 and Latvia in 2008 also could not go the currency devaluation route because neither country controlled its monetary policy. In Argentina' s case, the austerity measures were so severe that they caused considerable social unrest - including a brief period of outright anarchy in late 2001, which saw the country go through five heads of government in about two weeks - ultimately culminating in the country's partial debt default in 2002. To this day, Argentina is still dealing with the fallout of that financial calamity.

Latvia is a case of more recent vintage. In late 2008, Latvia agreed to what the IMF itself has called one of the most severe austerity programs since the 1970s. To accomplish it, Latvia has done everything from slashing public sector wages by 25 to 40 percent, increasing taxes, reducing unemployment and maternity benefits and cutting the defense budget. The crisis has already cost the Latvian prime minister his job and stoked social unrest. Despite all of that, the budget deficit has not budged much, remaining around eight percent of the GDP mark. Spending has been cut to the bone, but Latvia is simply too small of an economy to emerge from recession on its own.

Since the broader European economic recovery remains moribund at best, less government spending has translated directly to less growth. Less growth means less tax income, and less tax income means that the country' s budget deficit remains stubbornly high. Latvia has essentially become a ward of the IMF, and will remain so until either the broader European economic recovery is more robust or the Baltic state is fast-tracked into the eurozone itself.

An EU-IMF bailout of Greece would ultimately give Athens the choice of becoming either an Argentina or a Latvia. A financial assistance program that does not involve substantial structural reform on Greece's part would lead to a default a la Argentina. A bailout that forces Greece to get serious about reforms would mean Greece becomes an IMF-ward like Latvia, with default still a serious possibility down the line. In either case, Greece will essentially lose control over its destiny.

The next question is what the rest of Europe will look like, and there is no shortage of impacts. Europe, and Germany in particular, must decide whether and to what extent it should "bail out" the Greeks. How that might happen is now the topic of the day in Europe. Driving the urgency is this simple fact: In the absence of substantial (and subsidized) financial assistance, Greece will inevitably default on its debts, thus generating write-downs for all those who hold Greek government debt (mostly European banks).

The Greek default therefore is no longer an isolated problem, but a problem that threatens to aggravate an already weakened European banking sector. One of the most misunderstood facts of the international financial world is that even at the peak of the U.S. subprime crisis, in the dark hours when American hedge funds seemed to be snapping like matchsticks, Europe's banks were in even worse shape. As the Americans stabilized, so did their banks. But Europe never cleaned house, and now a Greek tsunami is poised to wash over the whole mess. [emphasis mine - JM]

Weakness Begets Weakness: from Banks to Sovereigns to Banks

By: Eric Sprott & David Franklin
Sprott Asset Management

The Greek debt situation has been an interesting case study for students of the sovereign bond markets. If there's a lesson to be learned from Greece's experience thus far it's that sovereign bailouts are far more complicated than bank bailouts. They require more sophisticated negotiations and proposals and involve an extra layer of diplomacy that makes them especially difficult to accomplish. As we write this, the European Union has recently announced new lending terms to support the Greek government, with great efforts made to assure the markets that these new terms do not constitute a 'bailout'. The problem with the Greek situation is that an actual bailout would involve an almost impossible coordination among all the major powers within the EU. It would require the unanimous pre-approval of all the EU heads of state. It would involve the European Commission, the European Central Bank and the International Monetary Fund (IMF) all visiting Greece to perform financial assessments. And finally, it would involve at least seven EU countries affirming support through parliamentary votes - all of this before a single euro is spent.

A true bailout involves an almost impossible number of hurdles that essentially guarantee nothing will happen until all other avenues of rescue are exhausted. However, judging by the recent increase in yields on 10-year Greek bonds, Greece may soon need more than a loan package proposal to solve its fiscal problems.

One aspect of the Greek situation that has been obscured by all the recent political wrangling is the crisis' impact on the Greek banks. Although the banks were supposed to be rock solid after all the government-injected capital they received (not to mention zero-percent interest rates and generous lending terms from the European Central Bank), data shows that Greek bank deposits have fallen 8.4 billion euros, or 3.6 percent, in two months since December 2009. With no restraints on capital flows within the European Union, Greek savers are free to transfer their assets elsewhere. Given that bank deposit guarantees in Greece are the responsibility of the national government rather than the European Central Bank, we suspect Greek citizens are pulling money out of their banks because they question their government's ability to honour its domestic deposit guarantees. We envision Greek depositors asking themselves how a government that can't raise enough money to stay solvent can then turn around and guarantee their bank deposits? It's a fair question to ask.

The Greek bank stocks have been thoroughly punished throughout the crisis. Chart A plots an index consisting of the four largest Greek bank stocks and shows an average decline of 47% since November 2009. The deposit withdrawals from these banks have been so damaging to their respective balance sheets (remember bank leverage?) that the Greek banks have asked to borrow 17 billion euros left over from a 28 billion euro support program launched in 2008.3 You see the connection here? Greece experienced a financial crisis, followed by a sovereign crisis, followed by another financial crisis. There is no doubt that the Greek crisis has helped drive the gold spot price to its recent all time high in euros. Gold is a prudent asset to own in times of crisis, and it's possible that a portion of the Greek deposit withdrawals were reinvested into the precious metal. The fact remains, however, that if the Greek government cannot stem the outflows of deposits soon, the EU will have no other choice but to undertake a real sovereign bailout with all its bells, whistles and arduous protocols.

It's a vicious spiral from financial crisis to sovereign debt crisis to banking crisis, and there is no reason it can't spread to other European countries suffering from similar fiscal imbalances. With Spain and Portugal next in line with their own sovereign debt issues, we can expect depositors in these countries to make similar runs to the bank for their cash. "Guaranteed by Government" is truly beginning to lose its potency in this environment. The International Monetary Fund (IMF) seems to be preparing for such a scenario with its recent announcement of a tenfold increase in its emergency lending facility. The IMF's New Arrangements to Borrow (NAB) facility is designed to prevent the "impairment of the international monetary system or to deal with an exceptional situation that poses a threat to the stability of that system." The NAB facility has grown from US$50 billion to US$550 billion with the mere stroke of a pen. Does the IMF know something that the market doesn't? Is this a pre-emptive measure to repel an attack by bond vigilantes' on Europe's fiscally-weakened countries?

Sovereign Debt

In our examination of the Greek situation this past month, we kept coming across various sovereign credit ratings. In an effort to better understand the Greek situation, we decided to look at how the ratings agencies generate their actual rankings and built our own model to determine a country's credit risk.5 We used common metrics such as GDP per Capita, Government Budget Deficits, Gross Government and Contingent Liabilities, the inflation rate and incorporated a simple debt sustainability metric in order to generate our own sovereign ratings. What we discovered in the process was quite puzzling.

It should first be noted that the rating agencies are in the business of offering their 'opinions' about the creditworthiness of bonds that have been issued by various kinds of entities: corporations, governments, and (most recently) the packagers of mortgages and other debt obligations. These opinions come in the form of 'ratings' which are expressed in a letter grade. The best-known scale is that used by Standard & Poor's ("S&P") which uses AAA for the highest rated debt, and AA, A, BBB, BB, for debt of descending credit quality.

In our opinion, as they relate to sovereign debt, the ratings provided by the agencies are highly suspect. While these agencies claim to provide ratings that consider the business credit cycle, there appears to be very little forward-looking information actually factored into their credit models. In some cases, the agency ratings end up looking absurdly optimistic. This of course should come as no surprise - we all remember the subprime mortgages that were rated AAA that are now worth pennies on the dollar.

While there were some similarities in our rankings (for example, our model ascribed AAA ratings to the local currency debt of Australia, Canada, Finland, Sweden, New Zealand which matched the ratings given by S&P), we found some glaring inconsistencies in the rating results for less fiscally prudent countries that left us scratching our heads. A good example is South Africa. The agencies currently rate South Africa an A+ entity, while our model calculated a 'BBB-' rating for its debt using our estimates. 'BBB-' is the lowest 'investment grade' rating for local currency sovereign debt - one level above junk. We arrived at this rating without having factored in South Africa's resource endowment. A significant contributor to South African GDP is derived from mining, particularly gold mining. While South Africa has been the largest producer of gold until very recently, their below-ground reserves have not been revised since 2001 when the country held 36,000 tonnes of gold (or about 40% of the global total). Recent stats from the United States Geological Survey (USGS) estimate that South Africa now has only 6,000 tonnes worth of economic gold reserves remaining. Further review by Chris Hartnady, a former associate professor at the University of Cape Town, using similar techniques to those of M. King Hubbert (the Peak Oil theorist), suggests that South Africa could have only half of the gold reserves estimated by the USGS.7 If these new estimates are correct, South Africa could have 90% less gold than claimed - and it's not even factored into our BBB- rating! So what's South African debt really worth? An 'A+' from the ratings agencies seems far too generous based on our cursory review of the country's fundamentals.

The rating agencies' ranking of the United States is even more disconnected from reality. To believe that the US sets the benchmark for sovereign debt credit ratings is preposterous. While we have written ad nauseam about the excessive debt issuance by the United States, we found a recent update written by United States Government Accountability Office (GAO) to be particularly instructive. The update noted the US's budget deficit equivalent to 9.9% of GDP in 2009 - the largest 10 since 1945 - and stated that without significant policy changes the US government would soon face an "unsustainable growth in debt".

This was not news to us. It goes on to state, however, that using reasonable assumptions, "roughly 93 cents of every dollar of federal revenue will be spent on the major entitlement programs and net interest costs by 2020." This is news! In less than ten years, using reasonable assumptions, there will essentially be no money left to run the US government - 93% of all tax revenues the US government collects will go to pay social security, Medicare, Medicaid and the interest costs on their national debt. This implies no money left over for defense, homeland security, welfare, unemployment benefits, education or anything else we associate with the normal business of government. And the US government is rated AAA!?

The historian Niall Ferguson recently wrote that, "US government debt is a safe haven the way Pearl Harbor was a safe haven in 1941." It's hard not to agree given the foregoing statements by the GAO. The risk inherent to investors, of course, is what happens when the bond market begins to realize and react to this new level of risk. In a speech earlier this month, Jürgen Stark, who is a member of the board of the European Central Bank, stated, "We may already have entered into the next phase of the crisis: a sovereign debt crisis following on the financial and economic crisis."

The activities of the IMF would confirm this statement. The question we must now ask ourselves is whether "backed by government" actually means anything anymore. In the depths of the 2008 crisis it was the governments that stepped in to provide a guarantee on financial assets. It was the governments that backed our savings accounts, money market funds, day-to-day business banking accounts, as well as debt issued by US banks. But what happens when confidence in the government guarantee begins to erode? We've seen what happened to Greece. Leverage inherent in the banking system elevated a bank run, equivalent to a mere 3.6 percent of deposits, into another full blown banking crisis. In our view it's time for investors to acknowledge sovereign risk. The ratings agencies can opine all they want, but it seems clear to us that the only true AAA asset to protect your wealth is gold.

April 2010AGEMENT LP

Has Germany just killed the dream of a European superstate?

John Mauldin — Mon, 22 Mar 2010 19:26:00 GMT

While the US was focused on the health care drama over the weekend, over across the pond events are rapidly deteriorating in euro land. For this week's Outside the Box I offer two columns, one from the Financial Times and another from the London Telegraph. Both describe the problems that the eurozone faces. It is not pretty.

I was sent this note from a Steve Stough who translated this from a German TV news show' It is a nice set-up for the two short columns.

I was reading an interview with Germany's most-quoted economist and then, all of a sudden, his face pops up on a TV show (a panel discussion on Germany's version of Fox Business News) at the same time, so I paid close attention. Hans-Werner Sinn's remarks are apparently listened to as closely as are the Federal Reserve Chairman's remarks in the US. He said:

The Greek drama will have a 'frightful' ('schreklich') ending no matter which course of action is taken. The objective is to avoid having a Greek default trigger another banking crisis across the EU.
The EU member states are too financially fragile to take on any flaky Greek debt. The actual Greek deficit is running at 16% of GDP, not 12% as previously reported. Greece is in a deepening retraction, not a recovery, as previously claimed. [Germany's social security, welfare, unemployment, and health care entitlement programs are all running cash-negative or soon will be, but that is another subject entirely. Angela Merkel has a committee established to work on tax reform, meaning tax rate reductions - Steve].
There are three bad alternatives. He recommends #3 (effectively, default):
1. A Franco-German bailout. Dr. Sinn believes this is impractical and the worst of the three alternatives because the amounts required for an effective bailout are so large that it would trigger a jump in yields on French and German sovereign debt which would result in a Euro-wide financial crisis. In addition, Angela Merkel said 'no,' and so did Guido Westerwelle (her coalition partner and foreign minister).
2. IMF loans. Dr. Sinn believes that this would accelerate the Greek economic contraction with a dramatic deflation of wages and prices, which could lead to civil war, revolution and a political destabilization of the area.
3. Exit the Euro zone, revive the Drachma, re-denominate the sovereign bonds in Drachma, let the Drachma collapse, and rebuild after the collapse, largely on tourist remittances Assuming a small amount of domestic (internal) default, this would be the least-painful to the Greek populace, but German banks and investors would lose approximately $38 Bn in bond investments +/- what can be recovered after the Greek economy recovers. Eventually, Greece would be allowed to re-join the EU.
Formation of an EU monetary fund is out of the question, he believes, because it requires treaty modifications that might take many years to pass.
As an aside, he said that if German tax rates are not lowered, that Germany will slide back into recession.

Steve Stough

As a quick aside, I know I said two weeks ago that I would do an assessment of the affect of taxes on the US economy. I decided to hold off until we can see what the health care taxes rally look like, rather than guessing. I will get to it, as I am quite curious as to the total level of the tax increases.

Now, to this week's OTB.

John Mauldin, Editor
Outside the Box

Has Germany just killed the dream of a European superstate?

By Ambrose Evans-Pritchard from the Telegraph

German Chancellor Angela Merkel has little hope of selling a bail-out of Greece to German voters

German and Dutch leaders have concluded in the nick of time that they cannot defy the will of their sovereign parliaments by propping up a country that lied about its deficits, or risk court defeats by breaching the no-bail-out clause in Article 125 of the EU Treaties.

Chancellor Angela Merkel has halted at the Rubicon. So has Dutch premier Jan Peter Balkenende, as well he might in charge of a broken government facing elections in a country where far-right leader Geert Wilders is the second political force, and where the Tweede Kamer has categorically blocked loans for Greece.

The failure of EU leaders to cobble together a plausible bail-out - if that is what occurs at this week's Brussels summit - is a 'game-changer' in market parlance. Eurogroup chair Jean-Claude Juncker said last month that such an outcome would shatter the credibility of monetary union. It certainly shatters many assumptions.

There will be no inevitable move to fiscal federalism; no EU treasury or economic government; no debt union. It is Stalingrad for the federalist camp and the institutions of the permanent EU government.

I remember hearing Joschka Fischer, then German Vice-Chancellor, telling Euro-MPs a decade ago that EMU was "a quantum leap ... creating an inexorable federal logic". Such views were in vogue then.

Any euro crisis would force Europe to create the necessary machinery to make it work, acting as a catalyst for full-fledged union. Yet the moment of truth has come. There is no quantum leap. We have a Merkel pirouette.

Paris is watching nervously. As Le Monde put it last week, "behind the question of aid to Greece is a France-Germany match that pitches two conceptions of Europe against each other." The game is not going well for 'Les Bleus'. The whole point of the euro for the Quai D'Orsay was to lock Germany into economic fusion. Instead we have fission.

EU leaders may yet rustle up a rescue package that keeps the IMF at bay, but alliances are shifting fast. Even Italy has slipped into the pro-IMF camp, knowing that rescue costs can be shifted on to the US, Japan, Britain, Russia, China, and the Saudis, lessening the burden for Rome.

Besides, too much has been said over the last week that cannot be unsaid. Mrs Merkel's speech to the Bundestag was epochal, a defiant warning that henceforth Germany would pursue the German national interest in EU affairs, capped by her call for treaty changes to allow the expulsion of fiscal sinners from Euroland. Nothing seems so permanent about the euro any more.

Days later, Thilo Sarrazin from the Bundesbank blurted out that if Greece cannot pay its bills "it should do what every debtor has to do and file for insolvency. This would be a suitably frightening example for every other potentially unsound state," he said, pointedly excluding France from the list of sound countries.

Dr Sarrazin should be locked up in a Frankfurt Sanatorium. It was such flippancy that led to the Lehman disaster, requiring state rescues of half the world's financial system. A Greek default would alone be twice the size of the combined defaults by Argentina and Russia. Contagion across Club Med would instantly set off a second banking crisis.

Some suspect that ultra-hawks in Germany want to bring the EMU crisis to a head, deeming delay to be the greater danger. How else to interpret last week's speech by Jürgen Stark, Germany's man at the European Central Bank, calling for tightening to head off inflation.

This is alarming. Core inflation in Euroland was 0.9pc in February, the lowest since the data series began. It is certain to fall further as the doubling of oil prices fades from the base effect. M3 money has been contracting for a year. Business credit is shrinking at a 2.7pc rate.

So, it is not enough for the EU to impose a fiscal squeeze of 10pc of GDP on Greece, 8pc on Spain, and 6pc on Portugal, and 5pc on France over three years, we need a dose of 1930s monetary policy as well to make sure life is Hell for everybody.

Be that as it may, Greece's George Papandreou says his country is in the worst of both worlds, suffering IMF-style austerity without receiving IMF money - which comes cheap at around 3.25pc. So why allow his country to be used as a "guinea pig" - as he put it - by EU factions pursuing conflicting agendas?

The IMF option has its limits too. The maximum ever lent by the Fund is 12 times quota, or €15bn for Greece, not enough to nurse the country through to June. The standard IMF cure of devaluation is blocked by euro membership. So Greece will have to sweat it out with a public debt spiralling to 135pc of GDP next year, stuck in slump with no exit route.

The deeper truth that few care to face is that under the current EMU structure Berlin will have to do for Greece and Club Med what it has done for East Germany, pay vast subsidies for decades. Events of the last week have made it clear that no such money will ever be forthcoming.

Let me be clear. I do not blame Greece, Ireland, Italy, or Spain for what has happened. No central bank could have tried more heroically than the Banco d'España to counter the effects of negative real interest rates, but the macro-policy error of monetary union washed over its efforts.

Nor do I blame Germany, which generously agreed to give up the D-Mark to keep the political peace. It was the price that France demanded in exchange for tolerating reunification after the Berlin Wall came down.

I blame the EU elites that charged ahead with this project for the wrong reasons - some cynically, mostly out of Hegelian absolutism - ignoring the economic anthropology of Europe and the rules of basic common sense. They must answer for a depression.

Gaps in the eurozone 'football league'

By Wolfgang Münchau from the Financial Times

At last we are heading towards a resolution, albeit a bad one. After weeks of pledges of political and financial support, Angela Merkel appears ready to send Greece crawling to the International Monetary Fund.

Germany cites legal reasons for its position. In past rulings, its constitutional court has interpreted the stability clauses in European law in the strictest possible sense. These rulings have left a deep impression among government officials. It is hard to say whether this argument is for real or is just an excuse not to sanction a bail-out that would be politically unpopular. It is probably a combination of the two.

I have heard suggestions that a deal may still be possible at this week's European summit, but only if everybody were to agree to Germany's gruesome agenda to reform the stability pact. That would have to include stricter rules and the dreaded exit clause, under which a country could be forced to leave the eurozone against its will. I am not holding my breath.

But either outcome will mark the beginning of the end of Europe's economic and monetary union as we know it. This is the true historical significance of Ms Merkel's decision.

While Greece faces the most acute difficulties, it is not the only member in trouble. There are at least four - Greece, Spain, Portugal and Ireland - that are probably not in a position to maintain a monetary union with Germany under current policies indefinitely. There may be several more, where the problems are not yet quite so evident. In the presence of extreme current account imbalances and a lack of bail-out or fiscal redistribution mechanisms, a monetary union among such a diverse group of countries is probably not sustainable.

In a column several weeks ago I put forward three conditions necessary for the eurozone to survive in the long run: a crisis resolution mechanism, a procedure to deal with internal imbalances, and a common banking supervisor. Since then, things have been moving in the wrong direction on all three counts.

For a start, we have come from a situation in which the "no bail-out" clause of the Maastricht treaty, having been almost universally disbelieved for 10 years, is suddenly 100 per cent credible. The minute the IMF marches into Greece, all ambiguity will end.

The debate on imbalances is also regressing. It would be unreasonable to ask Germany to raise wages or cut exports, but there is a legitimate complaint about Germany's lack of domestic demand. Berlin should accept it needs to develop a strategy. But the opposite is happening. Rainer Brüderle, economics minister, said last week there was nothing the government could do about demand because consumption was a decision by private individuals. A senior Bundesbank official even compared the eurozone to a football league, in which Germany proudly held the number one slot. The long-term direction of fiscal policy is even more alarming, as the gap between Germany and the others will widen.

On banking supervision, the main reason for a common European system is macroeconomic. In a monetary union, imbalances would matter a lot less if the banking system were truly anchored at the level of the union, not the member state. As banks can obtain liquidity from the European Central Bank, even extreme and persistent current account deficits should not matter in good times. But they matter in times of crisis. For as long as bank failures remain a national liability, persistent imbalances could ultimately lead to a national insolvency. If the banking sector were genuinely European, imbalances would still be an important metric of relative competitiveness but we would need to worry a lot less, just as we do not worry about the current account deficit of a city relative to its state.

The lack of a bail-out system, of an agenda to reduce imbalances and of a common banking system are realities that investors should take into account when making long-term decisions, as should policy-makers when they make important choices for citizens. The reality is that the eurozone, as it works today, is not a monetary union but a souped-up fixed exchange rate system.

In the past, global investors have placed a lot of trust in European politicians. They believed Peer Steinbrück, the former German finance minister, in February 2009 when he ended a speculative attack on Ireland, Greece and others with a simple statement of support. They also believed, as I did myself, that political leaders would ultimately do the right thing to save the system, having first explored all the alternatives. As I follow the political debate in Berlin, I am no longer certain that is the case.

Ms Merkel is not a politician driven by a strong historical destiny, unlike Helmut Kohl, her predecessor but one as chancellor. However real the constitutional problems may be, I suspect Mr Kohl would never have hidden behind a technical or legal argument on such a crucial issue.

Europe's current generation of leaders lacks this accident-avoiding instinct. So when Ms Merkel and her colleagues in the European Council see the iceberg coming, they will tend to rush not to the helm but to the nearest constitutional judge.

I am not predicting a catastrophe. I am merely pointing out that the present policy choices are inconsistent with the survival of the eurozone in its current form.