John Mauldin's Outside the Box : Mauldin

Memo to Central Banks: You’re debasing more than our currency

John Mauldin — Sat, 27 Oct 2012 20:29:00 GMT

I can only pass on Societe Generale’s work to you once in a while, but the piece for today’s Outside the Box is important enough that its author, Dylan Grice, worked hard to convince his bosses to let me share it with you. Dylan is one of my favorite investments analysts, as well as just an all-around nice guy.

In a change from his usual fun-loving demeanor, Dylan issues a serious warning here.

I am more worried than I have ever been about the clouds gathering today (which may be the most wonderful contrary indicator you could hope for...). I hope they pass without breaking, but I fear the defining feature of coming decades will be a Great Disorder of the sort which has defined past epochs and scarred whole generations….

So I keep wondering to myself, do our money-printing central banks and their cheerleaders understand the full consequences of the monetary debasement they continue to engineer?

He runs through some of the Great Debasements of the past, starting with third-century Rome, running through Europe’s medieval inflations and the French Revolution, to the monetary horror story of Weimar Germany in the 1920s.

His key point is that inflations and hyperinflations don’t just hurt money, they hurt people and the societies they live in. Inflating money is less trustworthy money, and so people doing business trust each other less. Plus, those who are farthest from the source of artificially created money suffer the most (the “Cantillon effect”).

And now the social debasement is clear for all to see. The 99% blame the 1%, the 1% blame the 47%, the private sector blames the public sector, the public sector returns the sentiment … the young blame the old, everyone blame the rich … yet few question the ideas behind government or central banks ...

I’d feel a whole lot better if central banks stopped playing games with money….

All I see is more of the same – more money debasement, more unintended consequences and more social disorder. Since I worry that it will be Great Disorder, I remain very bullish on safe havens.

In just 10 days we will see how the US elections turn out. Depending on what happens after, the US will either remain as one of those safe havens (and perhaps become even more of one) or those of us who reside here will need to start thinking more globally. I know a lot of thoughtful people who are already contemplating (if not acting on) plans to make sure their life savings maintain their buying power through the coming decade. I remain optimistic that we will set ourselves on a course that ends in a safe harbor, although the sailing will be quite volatile. What Dylan describes are the unintended consequences of people who think they understand macroeconomics and who are well-intentioned but whose policies can be most disruptive.

Sunday night I head for South America. I always enjoy traveling there, and I am interested to see what I can learn, both about how Brazil, Uruguay, and Argentina are doing and what they are thinking when they look north. I really do find that I learn much more than I impart on these trips.

Election night will find me in a bar drinking non-alcoholic beer in Cafayete in the far north of Argentina, where the California polls won’t close till almost midnight. It might be a long night. Maybe I can set up a twitter account from there. Might be fun. There will be lots of friends on hand to share the times and commentary. I will be back in Texas that Sunday to write my letter, and I’ll be thinking about how the results will impact all of us everywhere.

Have a great weekend. And I am off to cast my absentee ballot! You make sure to vote too!

Your wishing I was in Illinois so I could vote several times analyst,

John Mauldin, Editor
Outside the Box

Popular Delusions

Memo to Central Banks: You’re debasing more than our currency

By Dylan Grice, Societe Generale

At its most fundamental level, economic activity is no more than an exchange between strangers. It depends, therefore, on a degree of trust between strangers. Since money is the agent of exchange, it is the agent of trust. Debasing money therefore debases trust. History is replete with Great Disorders in which social cohesion has been undermined by currency debasements. The multi-decade credit inflation can now be seen to have had similarly corrosive effects. Yet central banks continue down the same route. The writing is on the wall. Further debasement of money will cause further debasement of society. I fear a Great Disorder.

“Next to language, money is the most important medium through which modern societies communicate” writes Bernd Widdig in his masterful analysis of Germany’s inflation crisis “Culture and Inflation in Weimar Germany.” His may be an abstract observation, but it has the commendable merit of being true … all economic activity requires the cooperation of strangers and therefore, a degree of trust between cooperating strangers. Since money is the agent of such mutual trust, debasing money implies debasing the trust upon which social cohesion rests.

So I keep wondering to myself, do our money-printing central banks and their cheerleaders understand the full consequences of the monetary debasement they continue to engineer? Inflation of the CPI might be a consequence both seen and measurable. A broad inflation of asset prices might be a consequence seen, though not measurable. But what about the consequences that are unseen but unmeasurable – and are all the more destructive for it? I feel queasy about the enthusiasm with which our wise economists play games with something about which we have such a poor understanding.

If you take a look around you, any artefact you see will only be there thanks to the cooperative behaviour of lots of people you don’t know. You will probably never know them, nor they you. The screen you watch on your terminal, the content you read, the orders which make the prices flicker … the coffee you drink, the cup you hold, the bin you throw it in afterwards … all your clothes, all your accessories, all the buildings you’ve been in, all the cars … you get the idea. Without exception everything you own, everything you want to own, everything you need, and everything you think you need embodies the different skills and talents of a mind-boggling number of complete strangers. In a very real sense we constantly trust in strangers to a degree, as strangers trust us. Such cooperative activity is to everyone’s great benefit and I find it is a marvellous thing to behold.

The value strangers put on each other’s contributions manifests itself in prices, and prices require money. So it is through money that we express the extent of our appreciation for the many different talents embedded in each thing we consume, and through money that our skills are in turn valued by others. Money, in other words, is the agent of this anonymous exchange, and therefore money is also the agent of the hidden trust on which it depends. Thus, as Bernd Widdig reflects in his book (which I urge you all to read), money …

“… is more than simply a tool for economic exchange; its different qualities shape the way modern people think, how they make sense of their reality, how they communicate, and ultimately how they find their place and identity in a modern environment.”

Debasing money might be expected to have effects beyond the merely financial domain. Of course, there are many ways to debase money. Coin can be clipped, paper money can be printed, credit can be created on the basis of demand deposits which aren’t there ... the effects are ultimately the same though: the implied trust that money communicates through society is eroded.

To see how, consider the example of money printing by authorities. We know that such an exercise raises revenues since the authorities now have a very real increase in purchasing power. But we also know that revenue cannot be raised by one party without another party paying. So who pays?

If the authorities raise taxes explicitly and openly, voters know exactly why they have less spending power. They also know how much less spending power they have. But if the authorities instead raise money by simply printing it, they raise the revenue by stealth. No one knows upon whom the burden falls. People notice only that they can’t afford the things they used to be able to afford, or they can’t afford the things which everyone else can afford. They know that something is wrong, but they just don’t know what, why, or who is to blame. So inevitably they look for someone to blame.

The dynamic is similar to that found in the well-worn plot line in which a group of strangers are initially brought together in happier circumstances, such as a cruise, a long train journey or a weekend away. In the beginning, spirits are high. The strangers exchange jokes and get to know one another as the journey begins. Then some crime is committed. They know it must be one of them, but they don’t know who. A great suspicion ensues. All trust between them is broken down and the infighting begins....

So it is with monetary debasement, as Keynes understood deeply (so deeply, in fact, that it’s ironic so many of today’s crude Keynesians support QE so enthusiastically). In 1921 he said:

“By a continuing process of inflation, Governments can confiscate, secretly and unobserved, an important part of the wealth of their citizens. By this method they not only confiscate, but they confiscate arbitrarily; and, while the process impoverishes many, it actually enriches some …. Those to whom the system brings windfalls …. become “profiteers” who are the object of the hatred … the process of wealth-getting degenerates into a gamble and a lottery .. Lenin was certainly right. There is no subtler, no surer means of overturning the existing basis of society than to debauch the currency. The process engages all the hidden forces of economic law on the side of destruction, and does it in a manner which not one man in a million is able to diagnose.”

History is replete with Great Disorders in which currency debasement has coincided with social infighting and scapegoating. I have written in the past about the Roman inflation of the Third Century AD. The following chart shows the rapid turnover of emperors during what is known as the Third Century Crisis. As trade declined, crops failed and the military suffered what must have seemed like constant defeat, it wasn’t difficult for a successful or even popular general to convince the rest of the empire that he’d make a better fist of governing.

But this political turnover was accompanied by what may be history’s first recorded instance of systematic currency debasement. With the empire no longer expanding and barbarians being forced westwards by the migrations of the Steppe peoples, Rome’s borders were under threat. But the money required to fund defence wasn’t there. Successive emperors therefore reached the same conclusions that kings, princes, tyrants and democratically elected governments would later reach down the ages when faced with a perceived “shortage of money”: they created more by debasing the existing stock. In the second half of the third century, the silver content of a denarius had shrunk to zero. Copper coins disappeared altogether.

This debasement of currency also coincided with a debasement of society. Factions grew more suspicious of one another. Communities fragmented. And one part of the community bore the brunt of the fears: Christians. While Rome had always welcomed new religions and Gods, incorporating new foreign deities as their empire grew, Christians were altogether different. They rejected Rome’s gods. They refused to pray to them. They said that only their God was deserving of worship. The rest of the Romans concluded that this obstinacy must be a source of great anger for their own ancient Roman gods, and supposed that those gods must now be exacting their own great punishment in return.

So the Romans turned on their Christians with a great violence which lasted throughout the period of the currency debasement but peaked with Diocletian’s edict of 303 AD. The edict decreed, among other things, that Christian meeting places be destroyed, Christians holding office be stripped of that office, Christian freedmen be made slaves once more and all scriptures be destroyed. Diocletian’s earlier edict, of 301 AD, sought to regulate prices and set out punishments for ‘profiteers’ whose prices deviated from those set out in the edict.

A similar dynamic seems evident during Europe’s medieval inflations, only now, the confused and vain effort to make sense of the enveloping turmoil saw the blame focus on suspected witches. The following chart shows the UK price index over the period with the incidence of witchcraft trials. Note the peak in trials coinciding with the peak of the price revolution.

Were the same dynamics at work during the French Revolution of 1789? The narrative of Madame Guillotine and her bloody role is well known. However, the execution of royalty by the Paris Commune didn’t begin until 1792, and the Reign of Terror in which Robespierre’s Orwellian sounding “Committee of Public Safety” slaughtered 17,000 nobles and counter-revolutionaries didn’t start until well into 1793. In the words of guillotined revolutionary Georges Danton, this is when the French revolution “ate itself”. But the coincidence of these events to the monetary debasement is striking.

The political violence was justified in part by blaming nobles and counter-revolutionaries for galloping inflation in food prices. It saw ‘speculators’ banned from trading gold, and prices for firewood, coal and grain became subject to strict controls. According to Andrew Dickson White, author of “Fiat Money Inflation in France”, (echoing Keynes’ remark that “wealth-getting degenerates into a gamble and a lottery”) “economic calculation gave way to feverish speculation across the country.”

However, the most tragic of all the inflations in my opinion, and certainly the starkest example of a society turning on itself was the German hyperinflation. Its causes are well known. Morally and financially bankrupt by the First World War, the reparation demands of the Allies (which Keynes argued vociferously against) followed by the French occupation of the Ruhr served to humiliate a once-mighty nation, already on its knees.

And it really was on its knees. Germany simply had no way to pay. The revolution following the flight of the Kaiser was incomplete. Concern was widespread that Germany would follow the path blazed by Moscow’s Bolsheviks only a year earlier. A de facto civil war was being fought on the streets of major cities between extremist mobs of the left and right. Six million veterans newly demobilized, demoralized, dazed and without work were unable to support their families ... the great political need was to pay off the “internal debts” of pensions, life insurance and welfare support in any way possible. The risk of printing whatever was required was well understood. Bernhard Dernberg, vice chancellor in 1919, found himself overwhelmed with promises to pay for the war disabled, food subsidies, unemployment insurance, etc., but everyone knew where the money was coming from:

“A decision of the National Assembly is made. On its basis, Reich Treasury bills are printed and on the basis of the Reich Treasury bills, notes are printed. That is our money. The result is that we have a pure assignat economy.”

But print they did. Prices would rise by a factor of one trillion. At the end of the war, Germany owed 154bn Reichmarks to its creditors. By November 1923, that sum measured in 1914 purchasing power was worth only 15 pfennigs.

It is difficult to comprehend the psychological trauma inflicted by this episode. Inflation inverted the efficacy of correct behaviour. It turned the ethics of thrift, frugality and notions such as working hard today to bring benefit tomorrow completely on their heads. Why work today when your rewards would mean nothing tomorrow? What use thrift and saving? Why not just borrow in depreciating currency? Those who had worked and saved all their lives, done everything correctly and invested what they had been told was safe, were mercilessly punished for their trust in established principles, and their inability to see the danger coming. Those with no such faith who had seen the danger coming had benefited handsomely.

Everything, in other words, was dependent on one’s ability to speculate, recalling what Dickson White observed of the French Revolution and Keynes reflections more generally. Erich Remarque is best known for his anti-war novel “All Quiet on the Western Front” but perhaps his best work was the “The Black Obelisk” set in the early Weimar period, and a penetrating meditation on the upside-down world of inflation. The protagonist Georg poignantly captures this speculative imperative when he sits down and lets out a long sigh:

“Thank God that it’s Sunday tomorrow … there are no rates of exchange for the dollar. Inflation stops for one day of the week. That was surely not God’s intention when he created Sunday.”

Perhaps the most eloquent chronicler of the Weimar hyperinflation was Elias Canetti, whose mother moved him from the security of Zurich to Frankfurt in 1921 to take advantage of cheaper living. Canetti never forgave her, and his life’s work shows what a lasting impression the move from heaven to hell made:

“A man who has been accustomed to rely on (the monetary value of the mark) cannot help feeling its degradation as his own. He has identified himself with it for too long, and his confidence in it has been like his confidence in himself … Whatever he is or was, like the million he always wanted, he becomes nothing”

More tragic still was what German society became during the inflation. Like other Axis countries on the wrong side of the War and now in the grip of hyperinflation, Germany turned viciously on its Jews. It blamed them for the surrounding evil as Romans had blamed Christians, medieval Europeans had suspected witches, and French revolutionaries had blamed the nobility during previous inflations. In his classic “Crowds and Power”, Canetti attributed the horror of National Socialism directly to a “morbid re-enaction impulse”.

“No one ever forgets a sudden depreciation of himself, for it is too painful … The natural tendency afterwards is to find something which is worth even less than oneself, which one can despise as one was despised oneself. It is not enough to take over an old contempt and to maintain it at the same level. What is wanted is a dynamic process of humiliation Something must be treated in such a way that it becomes worth less and less, as the unit of money did during the inflation. And this process must be continued until its object is reduced to a state of utter worthlessness. … In its treatment of the Jews, National Socialism repeated the process of inflation with great precision. First they were attacked as wicked and dangerous., as enemies; then, there not being enough in Germany itself, those in the conquered territories were gathered in; and finally they were treated literally as vermin, to be destroyed with impunity by the million.

All this is very disturbing stuff, but testament to a relationship between currency devaluation and social devaluation. Mine is not a complete or in any way rigorous analysis, I know. I emphasize that it’s not in any way meant as some sort of crude mapping on to today’s environment. My point is to show that money operates in many social domains beyond the financial, and that tying currency devaluation to social devaluation might have some merit.

Consider some recent and less extreme currency inflations. The 1970s bear market in equities saw relatively mild inflation which was also characterized by relatively mild but nevertheless real factionalization of society. An ideological left vs right battle played out between labour and capital, unions and non-unions and perhaps most bizarrely, between rock and disco. As already stated, money implies a trust in the future. It implies that today’s money can be used in the future. So in the era of punk, did the Sex Pistols provide the most concise commentary of the malaise?

Which brings us to today. Despite the CPI inflation of the 1970s receding, our central banks have continued to play games with money. We’ve since lived through what might be the largest credit inflation in financial history, a credit hyperinflation. Where has it left us? Median US household incomes have been stagnant for the best part of twenty years (chart below)

Yet inequality has surged. While a record number of Americans are on food stamps, the top 1% of income earners are taking a larger share of total income than since the peak of the 1920s credit inflation. Moreover, the growth in that share has coincided almost exactly with the more recent credit inflation.

These phenomena are inflation’s hallmarks. In the Keynes quote above, he alludes to the “artificial and iniquitous redistribution of wealth” inflation imposes on society without being specific. What actually happens is that artificially created money redistributes wealth towards those closest to it, to the detriment of those furthest away.

Richard Cantillon (writing decades before Adam Smith) was the first to observe this effect (hence “Cantillon effect”). He showed how those closest to the money source benefited unfairly at the expense of others, by thinking through the effects in Spain and Portugal of the influx of gold from the new world as follows:

“If the increase of actual money comes from mines of gold or silver … the owner of these mines, the adventurers, the smelters, refiners, and all the other workers will increase their expenditures in proportion to their gains. . . . All this increase of expenditures in meat, wine, wool, etc. diminishes of necessity the share of the other inhabitants of the state who do not participate at first in the wealth of the mines in question. The altercations of the market, or the demand for meat, wine, wool, etc. being more intense than usual, will not fail to raise their prices … Those then who will suffer from this dearness … will be first of all the landowners, during the term of their leases, then their domestic servants and all the workmen or fixed wage-earners ... All these must diminish their expenditure in proportion to the new consumption …

(Quoted in Mark Thornton, “Cantillon on the Cause of the Business Cycle” Quarterly Journal of Austrian Economics Vol 9, No 3 [Fall 2006])

In other words, the beneficiaries of newly created money spend that money and bid up the price of goods with their higher demand. Those who suffer are those who have to pay newly higher prices but did not benefit from the newly created money.

The credit inflation analog to the Cantillon effect has played out perfectly in recent decades. Central banks provided cheap money to banks, the cheap money artificially inflated asset prices, artificially inflated asset prices made anyone connected to those assets rich as we became a nation of speculators, those riches were achieved at everyone else’s expense, and ‘everyone else’ has now realized what has happened and is understandable enraged … as Keynes explained, “Those to whom the system brings windfalls …. are the object of the hatred.

And now the social debasement is clear for all to see. The 99% blame the 1%, the 1% blame the 47%, the private sector blames the public sector, the public sector returns the sentiment … the young blame the old, everyone blame the rich … yet few question the ideas behind government or central banks ...

I’d feel a whole lot better if central banks stopped playing games with money. But I can’t see that happening anytime soon. The ECB has thrown the towel in, following the SNB last year in committing effectively to print unlimited amounts of money for the greater good. The BoE and the Fed have long since made a virtue of what was once considered a necessity, with what was once the unconventional conventional. As James Bullard told everyone a few weeks before the last Fed meeting, lest there be any doubt:

"Markets have this idea that, there's QE1 and QE2, so QE3 must be the same as those previous ones. It's not that clear to me that this is the way this is going … it would just be to do balance sheet policy as the exact analogue of interest rate policy."

In other words, the central banks’ balance sheets are the new policy tool. As interest rates embarked on a multi-year decline from the 1980s on, central bank balance sheets are set to embark on a multi-year climb ...

So as Nobel Prize winning experts in economics punch the air because inflation expectations have been rising since the policy was announced, “It’s the whole point of the exercise” (Duh!) the BoE admits that QE has mainly benefited the rich, but vows to continue anyway.

All I see is more of the same - more money debasement, more unintended consequences and more social disorder. Since I worry that it will be Great Disorder, I remain very bullish on safe havens. The next few issues of Popular Delusions will outline some thoughts on what exactly that means.

The Euro Debate Gets Philosophical

John Mauldin — Tue, 06 Dec 2011 05:21:00 GMT

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

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

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

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

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

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

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

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

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

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

Your amazed to finally see it all happening analyst,

John Mauldin, Editor
Outside the Box

The Euro Debate Gets Philosophical

GaveKal
Nov. 29, 2011

Anatole: Clausewitz, the Prussian military theorist, said in his reflections on the Napoleonic period that “war is the continuation of policy by other means”. If so, then it would seem that Germany is again at war with Europe; at least in the sense that German policy is trying to achieve in Europe the characteristic objectives of war: the redrawing of international boundaries and the subjugation of foreign people.

Likening German policy to warfare is a controversial argument, to put it mildly, so let me begin by briefly reviewing how events in Europe have unfolded in the past few months. Angela Merkel has consistently claimed that Germany would “do whatever it takes” to save the Euro. But what has she actually done? She consistently refused to take any of the actions that could actually work to save the Euro and has prevented European institutions from taking such actions, even when the German veto had no legal or moral justification.

As the Euro crisis has intensified and spread from clearly bankrupt countries such as Greece to Spain, Italy and now France, it has been universally acknowledged, at least outside Germany, that three actions are absolutely essential to resolve the Euro crisis and put the European economy back on its feet.

1. The first step would be to restore financial stability through massive purchases of government bonds by the European Central Bank. To succeed, these would have to be on a scale at least comparable to the “quantitative easing” undertaken in the past two years by the US Federal Reserve, the Bank of England, the Bank of Japan and the Swiss National Bank.

2. The second step would be to restore long-term solvency to all the nations of Europe by issuing new bonds, jointly guaranteed by the entire Euro-zone, which would replace part of the government debts run up in nations such as Greece and Portugal which are clearly insolvent.

3. The third step would be to improve and coordinate economic policies in all Euro-nations to restore economic growth, ensure that the restructured debts can be serviced and that another crisis does not occur.

By blocking the first two of these actions—large-scale ECB intervention and the issue of joint European bonds—Germany has guaranteed the failure of the third step, the restoration of economic growth and national credit. Why then has Merkel so blatantly contradicted her own stated policy of “doing whatever it takes” to save the Euro?

The initial judgment was that Merkel did not understand economics, or was too beholden to longstanding monetary traditions, or was simply incompetent. But while the crisis has intensified, Merkel has become ever more stubborn in her refusal to do what was obviously needed to save the Euro, as David Cameron discovered last week. So a different interpretation of her inconsistencies must now be considered. Is it possible that Germany, far from trying to save the Euro, actually wants to break it up? A clear historical precedent is the sabotage of the European exchange-rate mechanism (ERM) in 1992. And the institution that now seems to be working to destroy the Euro is the same one that organised the ERM breakup—the Bundesbank.

The Bundesbank, as an institution, has always opposed European monetary unification, except insofar as it meant the imposition of German economic philosophy on other countries. This attitude of monetary imperialism was summarised by a remark in nt Times obituary published for Richard Medley (the legendary hedge-fund consultant who was at the centre of the ERM breakup as George Soros’s political consultant). Helmut Schlesinger, the Bundesbank president in 1992, was asked why he disliked the precursor of the Euro, which was called the Ecu. He replied, “I have nothing against the Ecu apart from its name—I think it should be called the Deutschemark”.

Back in 1992, the Bundesbank encouraged Soros and other speculators to sell Sterling and the Italian Lira in order to break up the ERM. But the Bundesbank also discretely hinted that the French Franc should be supported because France was in a different category as a German ally from Italy, Britain and Spain. As Soros later said in an interview, also quoted in last week’s obituary for Medley: “I felt safe betting with the Bundesbank. The Bundesbank clearly wanted the Pound and Lira devalued, but it was prepared to defend the French Franc. I did better than some others by sticking to the Bundesbank’s side.”

Today, the role of the Bundesbank in destabilising the European financial system is much more open than it was 19 years ago. Axel Weber, the former Bundesbank president, and Juergen Stark, the former vice-president, both voted against ECB support for Greece back in May 2010 and then publicly denounced these measures to the German media, in an almost unprecedented breach of central banking protocol. Last summer, when the ECB decided to extend its half-hearted support to Spain and Italy, Weber and Stark both resigned in protest—and launched openly political attacks on their own government’s European policies. A few weeks later a story emerged in The Financial Times reporting that Siemens had become nervous about the French banking system and withdrawn its cash balances from Societe Generale to deposit them “for safety” at the ECB. It is hard to imagine who could have leaked this story other than the Bundesbank?

Today, the Bundesbank is in the forefront of a campaign to persuade the German public and the German government that ECB bond purchases and quantitative easing are illegal under European law. In truth, the EU treaties specifically allow the ECB to buy bonds, as long as it does not do this directly from governments. And EU laws say nothing at all about the effects of quantitative easing—which is not surprising since QE is a complex issue of economic theory that could not possibly be subject to determination by the courts. What the Bundesbank believes, however, is that European law should have made bond purchases and expansionary monetary policy illegal—and if other European countries refused to write these laws into EU treaties they will just have to be imposed by Germany through financial main force.

In short, the Bundesbank policy on the Euro crisis is to present the other countries of Europe with a stark ultimatum: either they accept German economic directives, German monetary theories, German financial practices and even governments imposed by Germany, as part of a draconian new regime for national insolvency and administration. Or they must face financial chaos and expulsion from the Eurozone, under a new exclusion procedure now demanded for nations that refuse to submit to German rules. In short, Germany is trying to achieve through monetary diplomacy what were previously the objectives of warfare: redrawing the boundaries of Europe and imposing German ideas on those nations that remain within. That, surely, is a continuation of war by other means.

Charles: Dear Anatole, my first answer to the above is that there is nothing new here. I have argued incessantly in every single one of our debates since Axel Weber’s resignation that the Bundesbank was now in an open war with the concept of the Euro. I have also pointed out that, in my career, I have seldom made money when betting against the Bundesbank.

Now there are of course many reasons behind the hostility of the Bundesbank to the Euro. The first is obvious enough: the Euro was thrust on an unwilling Bundesbank by Mitterrand and Delors as a compromise to France accepting German re-unification. So the Euro’s very birth was an unhappy one to start with.

Beyond that, the hostility rests, I believe, on important philosophical differences. Indeed, Max Weber suggested two sets of ethical virtues that a proper political education should teach: the ethic of conviction (Gesinnungsethik) and the ethic of responsibility (Verantwortungsethik). According to the ethic of responsibility, an action is given meaning only as a cause of an effect; i.e., what matters is the consequences. According to the ethic of conviction, on the other hand, a free agent should be able to choose autonomously not only the means, but also the end; “this concept of personality finds its „essence‟ in the constancy of its inner relation to certain ultimate „values‟ and „meanings‟ of life”. Weber recognized a gulf between his “Two Ethics,” one which is concerned with consequences and one which is duty– and rules-bound. His problem arises from the recognition that the kind of rationality applied in choosing a means cannot be used in choosing an end. Increasingly, the current debate on the Euro is nothing but a conflict between these two forms of ethics.

In one camp, are those who, like François and yourself, say that nothing is more important than preventing a collapse of the Euro. In the other camp, the Germans say that nothing is more important than upholding the international treaties, and maintaining the supremacy of the law over the pressure of short-term solutions.

Now because of its unfortunate history, this debate can get emotional very quickly in Germany. Indeed, more than any other people, the Germans have suffered from adopting the second view, with huge negative consequences for Europe and the world. As a nation, it is thus my impression that Germany has come to the conclusion that, at the end of the day, one should never tamper with the law, whatever short-term benefits such tampering might bring.

If we apply this distinction to what money is, those who believe that money is a tool which belongs to the political sphere and can be manipulated to meet political goals, justify their destruction of money by an ethic of responsibility (fighting unemployment, creating economic growth, etc). For what it is worth, let’s call them “Keynesians”. On the ethic of conviction, we have the Bundesbank and the German population (but not so much the German political system) who say that money is a common good which does not belong to the state, and that the economy has to adapt to this reality, and not the other way around. Let us call them the “Austrians”. As our readers know, Anatole, you are intellectually very much in the first camp, while I plant my flag in the second. With that in mind, the current debate on the Euro can be framed as such:

· On the one hand, there are those who believe that the end justifies the means. If saving the Euro requires the destruction of the notion of money as a common good, so be it. The fact that the Euro is slowly destroying Europe (as was entirely predictable—and predicted in our pages), thus leads our “Keynesians” to recommend measures and actions which have been specifically forbidden in the treaties, the German constitution, or the bylaws of the ECB.

· On the other hand, there are those who remember that Hitler said that treaties and constitutions were nothing but pieces of paper. For such Germans, it is simply inconceivable that the law could be made subservient to a political or economic goal. They believe that destroying the law is far more dangerous than destroying the Euro, and they say to the others that the solution is simple: they signed the Treaties, they now have to respect them.

I respect the German vision. The treaties creating the ECB and the Euro were built around the German notion of money and everybody knew it. So when Merkel says that the others have to become Germans, she is perfectly entitled to do so, since it was exactly what the treaties said (and why the British, Swedes and Swiss rightly refused to join). In my view, on this point, the Germans are right. Frankly, one does not sign a treaty with Germans in the hope that the Germans will be flexible. They never were, and given their own history, are now less so than ever.

I also have a lot of sympathy for the German view of questioning why we should sacrifice every rule, and treaty, to uphold a currency that is clearly not working for a number of countries? Must the survival of the Euro in Southern Europe really only occupy every waking hour, of every European policymaker (and investor)? Must it really take precedence over every other institutional framework? In short, is the Euro really the end-all, be-all of European civilization; the altar on which everything else can be sacrificed? Is this really as good as we get? Or are European policymakers only trying to save the Euro (and sacrificing the youth of a number of countries) to avoid having to admit that they made a colossal mistake?

Louis-Vincent: In all our previous debates, and in The Divergence in European Spreads—Why Now?, I argued that there were four possible resolutions to the European crisis:

1. The first was for troubled countries to leave and redenominate their debt in their local currencies, thereby avoiding a default but imposing massive foreign exchange losses on foreign bondholders.

2. The second was for Germany to leave—though this seemed highly unlikely as this would in essence bankrupt every German bank, insurance company and pension fund (whose liabilities would be redenominated in DM and whose assets would remain in Euros).

3. The third was for the weaker links to default and restructure their debt.

4. The fourth was for the ECB to become far more aggressive in its purchases of troubled-country bonds and swell its balance sheet.

Now up to just a few months ago, the Europtimists kept arguing that all these events were just not going to happen. Instead, the more likely scenario was one of deep structural reforms combined with some fiscal transfers and a little bit of help from the ECB. Such a combination, I was told in many meetings and even in some of our internal debates, would help to keep the Euro-show on the road.

Fast forward to today, and every Europtimist (see the latest The Economist) is now arguing that solution 4 has to be the answer. Obviously, this is also what Anatole is arguing for by equating the German resistance to such an outcome to an “act of war.” So already we have witnessed quite a paradigm shift. But is it now too late for this? In other words, have Europe’s debt crisis and deflationary-bust moved beyond the powers of an ECB’s magic wand? Not that I don’t believe in Santa Claus, or in the ability of central banks to cure every ill, but it seems to me that, should the ECB decide (a day late and a Euro short?) to now intervene in size to prevent the European bond markets from deteriorating further, it would face some very significant hurdles.

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

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

This is very problematic because once uncertainty creeps in, bonds will tend to gradually drift towards what I have come to call the bonds “no-man’s-land”. Basically, once sovereign bonds reach 90c to par, they tend to have a much higher volatility and much greater uncertainty. As a result, they are no longer attractive to the typical bond manager or asset allocator looking to buy bonds to diversify equity risk (think how Italian bond yields are now correlated to European equities. If you want to be bullish Italian bonds, you may now just as well spend a fifth of the money and buy European banks for the same portfolio impact…). And once a bond enters into no-man’s-land, it has to fall a lot before attracting the attention of distressed debt and vulture investors (usually yields of 15%+). So the first obvious problem is that more and more European debt markets are entering this “no man’s land” bereft of “normal” investors.

Of course, this invites the conclusion that the ECB should thus do everything in its power to bring the bonds out of this no-man’s land. But what are those magical powers the market keeps referring to? After all, the various European institutions (ECB, EFSF…) and the IMF have mopped up almost a third of the Greek debt and yet it is now trading at 25c on the Euro! Perhaps this goes back to the way a typical sovereign debt holder thinks? Indeed, let us imagine that, tomorrow, the ECB follows every editorialists’ advice and comes in to mop up a third of Spanish and Italian debt in a bid to get yields fixed at, say 5%. Will our Spanish and Italian bondholders a) jump at the chance to get out of their positions with a smaller loss than forecast? Or b) sit tight and allow themselves to be transformed into junior bond holders?

Indeed, the Greek precedent (where basically the ECB insisted on being made whole while the private sector shared in the losses of lending money to the spendthrift Greek government) means that the default assumption of sovereign debt holders should be that a mass intervention of the ECB into their markets will relegate them to the “junior ranks.” And needless to say, most institutions who invest in sovereign bonds are not looking to be junior bond holders. They are looking for absolute safety. So in a perverse way, massive purchases by the ECB may actually highlight that the asset one owns is anything but safe; implying that for an ECB intervention to work, the amounts would likely have to be staggering. This is why I tend to believe that even if the Bundesbank did agree to monetization (which as Charles highlights is hardly a foregone conclusion), the window for this to work may now have closed. Instead we should brace ourselves for either defaults, or countries leaving and re-denominating debt in local currencies.

Anatole: Charles, your Weberian response to my article on Germany's war against Europe is thought-provoking. But it leaves out two crucial points:

Firstly, It is not at all clear that asking the ECB to buy bonds in the secondary market conflicts with any law. This is Merkel's interpretation of the EU treaty. But all that the treaty actually says (Article 123) is that the ECB will not finance governments by providing “overdraft facilities” and buying their debt directly in the primary market. The legislative history of this article is interesting. The Germans wanted a tougher prohibition about monetary financing written into the Maasrticht Treaty, but the other countries refused. The compromise was Article 123. Merkel is now trying to interpret this article as if it enshrined the laws that theywanted. It is therefore the Germans who are trying to twist the law in their favor, not the French, Italians, etc.

Secondly, laws need to be changed with the passage of time. That is what government, and especially democracy, is for. Therefore a dogma of upholding the law as it is, regardless of circumstances, and refusing to change it is not justifiable even for Weber's “ethic of conviction”. Your response to this objection would presumably be that some laws are so important that they should never be changed even by a democratic decision—for example, laws on human rights, racial equality and religious freedom, constitution arrangements and other fundamental laws (which is actually what Germany calls its constitution). I fully agree with this, although even constitutions always contain an amendment process—at least if they are properly drafted, which of course the treaty on European Union never was! Still, it is clear that your ethical argument (and Merkel's) only applies to tampering with fundamental laws, not the much larger number of everyday regulations that are needed for society to function, e.g.: driving speed limits, postal charges...

The question, therefore, is whether monetary laws should be treated as ethically fundamental in the same way as laws on free speech, political association, religious freedom, property rights, capital punishment, etc. I personally do not think so. To me economics is a pragmatic activity with no clear answers. The “right” of a central bank to operate independently of government is not, in my view, an ethical question, comparable to capital punishment or even the right of the citizens to adequate healthcare. This is, I think, the fundamental point on which you and I disagree.

Which leads to my third objection: even if we accept that the “right” of central bank independence is a fundamental right comparable to other constitutional requirements, Merkel is not upholding this right. In fact she is doing the opposite. She is issuing political instructions to the ECB on what it cannot do. If the Germans genuinely believed in the rule of law and in central bank independence, they would not try to prevent the ECB from doing whatever it thought was necessary and desirable. If the ECB board, as properly constituted under the EU Treaties, voted to buy the entire Italian, Spanish and French secondary bond market and to engage in QE to the tune of €10trn, then Germans would have to calmly accept this as a lawful consequence of the treaties their government had freely signed. In fact, therefore, Merkel is not exemplifying the respect for law and ethics of conviction as you describe. She is reinterpreting laws and tampering with treaties in whatever ways happen to suit her.

Charles: Anatole, since we are treading on philosophical grounds, could I say that we must both have studied casuistry in our youth for this is increasingly looking like a debate between a Jesuit and a rabbi.

On your first point, if a French commercial bank subscribes to a French bond and sells it in the following second to the ECB, what do you call this? Moreover, doesn’t the treaty specifically forbid joint responsibility of the debt and the mutualisation of said debt? What the ECB is doing in buying in the secondary markets in amounts higher than those needed for its open market operations is not compatible with these parts of the treaty (even if it is compatible with article 123), since Germany could be on the hook if a country failed (through the participation of the Bundesbank in the ECB). So it seems to me that Merkel is perfectly entitled to her legal views: the ECB’s recent actions are de jure and de facto against both the letter (no mutualisation of the debt) and the spirit (no financing of budget deficits by the central bank) of the treaty.

On your second point, I most definitely do believe that money is far too important to be left under the control of politicians (especially French ones!) and let me explain why. The purpose of economics is to understand why things have a value and why those values change over time. To do so requires a measurement in “money”. But no economist has ever been able to explain why money has any value since it has a marginal cost of production of zero. For me, money is a kind of social contract which binds a “demos” (Plato called it a “convention”) where citizens accept to use it in their transactions or for their savings. But this convention is a very fragile thing.

Renan used to say that a nation is defined by the willingness of its citizens to live together, and this willingness was what created a “demos.” There is no European demos, so there is no possibility of a European currency. To make it simple: to each demos its currency. There is no European Nation, there is a European Civilization, which is not at all the same thing (see Was the Demise of the Soviet Union a Negative Event?). Money thus does not belong to the government, but is a common good of the demos.

If I have learnt something after the debacle of the so-called “financial revolution of the last twenty years” it is that one should never put the monetary policy under the control of the politicians, and that money should never be “privatized,” or put under the control of the market, since it has a marginal cost of production of zero. The privatization of money which started under Clinton, and was continued under Bush and Greenspan, led to the current disaster. In my view, money is a common, (and more importantly—perhaps as I am getting older) trans-generational good that no generation should be able to manipulate for its benefit. The only role of the government should thus be to regulate the credit system without which an economy cannot work. The attempt to regulate this credit system internationally rather than at the national level is the root cause of the current problems, the governments having failed miserably in their regulatory role. Since they have failed, like any bad trader, they are now busy doubling and tripling down. This never works.

On your third point, I have read a thousand times that if the board of the ECB decides on monetization of the debt, the Germans should just accept that decision. Except of course that the board is bound by the bylaws or the treaties which specifically forbid such a decision. What Merkel is saying is thus very simple: if the board gives in to the French or the Italians because they have the majority, then this decision will not be legally binding for Germany. In other words, she is telling the board members to respect the treaties, which guarantee the ECB independence against French or Italian politicians looking for an easy exit, as they always do, or else…

This seems to me perfectly fair and leads me back to my original point, which our latest exchange of emails amply proves: you believe that the end justifies the means (ethic of responsibility). I (like the Germans) do not (ethic of conviction). To conclude on a historical note, I believe that Chamberlain practiced the ethic of responsibility and Churchill the ethic of conviction. And reviewing Chamberlain’s actions, Churchill said “they accepted dishonor to avoid war. They will have the war and will have lost their honor”. Looking at your proposed remedies, your solution is to destroy money to avoid ruin. We will have the ruin; it is too late and will lose our “money” anyway. Destroying money does not create wealth any more than deregulating it.

Anatole: As you have raised the issue of casuistry I must return the compliment and say that your casuistic education must have been even better than mine.

You are right that the ECB has been funding EU governments via the banking system, but the Germans never objected to this—and still do not—for the simple reason that this form of government funding is considered acceptable in Bundesbank theology. Why this is so has never been clear to me, but it must originate in some theorem of Austrian economics which I never studied. Last year, I had the chance to put this question to Axel Weber himself and he confirmed in the clearest terms that ECB lending to banks which then on-lend to governments is a perfectly acceptable way to conduct monetary policy.

Incidentally, some of the people I met in Frankfurt last week were as baffled as I was by the Buba doctrine that financing the Greek government directly is unacceptable, whereas funding insolvent Greek banks so that they can finance their government is perfectly OK. In any case, this issue of financing governments was thoroughly debated and negotiated in the Maasrticht Treaty talks. The result, as I said in my earlier email, was that the other countries refused to go as far as the Germans wanted in forbidding monetary financing under Article 123. Moreover, the German demand for a prohibition on mutualisaing debt, which you mention, was also rejected by the other countries at Maastricht. I know the Germans are always quoting the so-called "no bailout clause", but like the monetary financing clause this part of the treaty does not say what the Germans now claim. The no bailout clause (Article 125 of the new Lisbon Treaty) says this: "A Member State shall not be liable for or assume the commitments of central governments...or public undertakings of another Member State, without prejudice to mutual financial guarantees for the joint execution of a specific project."

This leaves plenty of scope for EU member governments to agree on mutual guarantees for institutions such as the EFSF and ESM to execute a specific project like the rescue of the Euro. Again, this is a case where the Germans, having failed to achieve their objectives in the original treaty negotiations, signed up anyway and are now trying to reinterpret the laws retrospectively to get what they want. Far from showing respect for Laws and Treaties, this is uncomfortably reminiscent of the German attitude to the Treaty of Versailles.

Now you may be right that money is a public good which should not be subject to political manipulation, but the precise mechanisms for issuing and managing money have always been subject to change—and rightly so, in my view. We both agree that returning to the gold or silver standard would not be a good idea even though money was “always” managed like that until the 1930s. Of course, others have different ideas about the gold standard and these are quite legitimate. And there are a multitude of different views about whether it is best to control money by using interest rates or inflation targets or monetary targets and which ones - eg monetary base, M1 or M3 or the exchange rate.

These different views about monetary management are not about moral or philosophical issues. They are empirical judgments about what works best in the real world. Thus the German idea that monetary financing of government deficits will always and everywhere generate inflation and destroy confidence in the public good money (which you seem to share) is not a moral principle. It is a particular view about how the economy works which can only be judged by whether it turns out empirically to be right or wrong.

As it happens, an important experiment is now being conducted in monetary financing all over the world. If the US, Britain, Japan and Switzerland, all of which are now engaged in monetary financing, suffer serious inflation and a loss of confidence in the value of money, then the Germans (and you) will be proved right. Thus far, however, most of the evidence points in the other direction. (By the way I am not claiming in the last sentence that monetary financing has been successful in managing the US, British, Japanese and Swiss economies—that is another issue—but merely that it has not undermined the public's desire to hold money, as the Germans and you seem to believe).

Finally, I have already responded to your point about what the laws actually say above. So let me comment on your claims about unprincipled pragmatism.

It seems to me that “The End justifies the Means” is actually a good description of your approach to this whole single currency disaster. For you, ‘the End’ is the breakup of the Euro and you are willing to endorse all kinds of dishonest and economically destructive behavior from Germany to achieve this end. I believe, on the contrary, that Merkel should be judged on the effects on the world of what she is doing as well as on her party’s motivations, which are politically self-serving and short-sighted. Like you, I would prefer to see the Euro break up, but I am not going to pretend that Merkel and Axel Weber are morally right, simply because their behavior happens to be advancing my side of the argument.

So in conclusion, I would return to a point that I have made before; namely that if Germany continues to want to play by its rules, rather than the rules of the community, then France should invite Germany to leave the Euro.

François: Anatole, even if your scenario of Germany leaving the Euro made economic sense for France (on which I am not convinced), I am sure that you have already noticed that French politicians are not that interested in economics. Instead, plans that are economically consistent but that threaten the French political influence in large parts of Europe remain a non-starter for our dear énarques. And you will never convince the French that they might eventually regain this influence thanks to the indirect, magical effects of a devalued currency. They won't believe in it (I don’t either, by the way), and even if they did believe in it, they would never have the guts to bet on it anyway. Maintaining the status quo remains the default option for any French politician.

In Capitalism 4.0, you wrote how many UK economists and politicians had been surprised by the good performance of the economy in the years after the Pound left the ERM. You explained that many in the UK initially feared that this "loss of monetary anchor" would lead Britain to nowhere. On the contrary, it provoked renewed internal confidence. Could this benefit happen to France and Italy? Implicitly, this is your bet, and I find it very interesting. But as you know the UK Pound did not stay in the ERM for long, while France and Italy have anchored their monetary destiny upon Germany for more than 30 years. It is in this respect very telling that Italy did not stay long outside the ERM after it was forced to leave in 1992 (it joined back in 1996). Similarly, France did not leave the ERM in 1983. For sure, these successive political choices might be seen as meaningful of countries that lack self-confidence, and these different episodes might well have represented lost opportunities to pursue more sensible economic policies. But for both historical and economic reasons, France and Italy have felt that they needed to keep up with Germany in order to participate to the elaboration of a soft-power of global dimension, which is what the European project is about. Whatever opinion we may have about how this project is being conducted, it is a very respectable project. And after so many years and so much capital invested in it, its possible dismantling would leave much deeper scars and provoke a much larger chaos than when the UK Pound left the ERM.

Anatole: François, you have hit the nail on the head. I agree with you completely that the French enarques would not want to break with Germany even if it could be demonstrated with 99% probability that such a policy would make France stronger and more prosperous. Such is the power of what I believe you call the “pensée unique”. But the problem is not a political one but is now an economic one. In other words, French politicians may decide to ignore economics but the rules of economics are not ignoring France and France may well not be able to cling to Germany much longer. This is especially true if the Germans now realise that France has become completely subservient and that, therefore, Germany no longer needs to compromise in any significant way to accommodate French demands. In short, France is currently living through yet another “Sedan”!

Louis: Speaking of Sedan, once it becomes apparent that the enarques are turning France into a German colony isn't it possible that the public will rebel? In other words, could we not see another “Paris Communes”? At the very least, we will likely see Marine Le Pen make new gains for the National Front in May, and likely make it to the second round. And who is to say that, as the French economic situation deteriorates further, she doesn’t face off against another fringe candidate, perhaps from the far left? Let us not forget that the combined far left (communists, various Trotskyites parties…) have typically polled a combined 15-25% in French elections. Fortunately, they were always scattered amongst many parties (in a scene reminiscent of “The Life of Brian” with the “Judean People’s Front,” the “Popular Front of Judea,” etc…). But now that they are gathered under the Melenchon roof...

Francois: Since 1983, French voters have indeed voted more and more against the traditional parties (2007 was an exception to this rule). It is however not that easy to assess why. Many countries with independent economic policies are seeing the rise of the extreme right or left, while in a suffering Euro country like Spain, the traditional parties continue to attract 95% of the votes. I would thus not be able to demonstrate that the rise of political tensions and dissatisfaction in France or Italy has been due to the anchoring of economic policy on Germany, contrary to what the you suggest.

Moreover, in France, the return of the German constraint upon economic policy is for now leading the country more towards introspection (the realization of the huge costs of our so-called social model) rather than towards resentment against Germany. In fact it is even possible that, contrary to what you suggest, the centrist parties attract more, rather than less, votes in the next elections as more and more people realize that the country needs to be more seriously managed. We will see.

Finally, what exactly are the real benefits of a rebuttal of the German constraints? I suspect that Anatole is too much influenced by the success of the devaluation of the Pound in 1992. But in Italy, which left the ERM at the same time, the following years were far less fun, as the chart below illustrates:

Indeed, the UK could enjoy the benefit of the 1992 devaluation because its economy had been re-vitalized by the reforms of the Thatcher era (meanwhile, today, after more than a decade of creeping Blair-Brown health and nanny-statism, it is a very different story!). Anyway, I do not think that anyone in France would suggest that if Germany left the Euro, or if France simply refused the German constraint, the French economic situation would improve. Our problems are of our own making and are not so much related to having the wrong currency, as to having a welfare, and regulatory, state on steroids.

A Special John Mauldin Outside the Box: Taking Control of Your World

John Mauldin — Thu, 01 Dec 2011 22:25:00 GMT

Today I offer something a little different from normal economic fare. As I keep saying, I think it is important that as business people and entrepreneurs we look for ways to increase our business while others are pulling back. While innovation can mean new technologies (and their costs!), in my experience it is often even better to figure out a new way to offer your products and services to the market, leveraging (in a good way!) your existing work.

Today, simply because you are one of my 1 million closest friends, I have arranged for you to receive absolutely free and with no strings attached some of the best (if not THE best) marketing and innovation materials I have ever read, from a long-time friend of mine who has sold this information for tens of thousands of dollars (and more!). It is my way of saying thanks for allowing me to come into your life each week. (The link is near the end of the letter.)

And for those who just want economic ideas from me, delete this now and move on. Seriously. No problem at all. I get it. This is not everyone's cup of tea. I offer you this material because it has made a real difference in my business life and the lives of so many others. Though I should point out that it's because of how I handle my business that I can write my weekly letter to you for free. Every week for 11 years. So before you put me in a "box" of your construction, you might want me to take a look and see what I see. And remember, when I say free, I mean free. If that is not a good price for you, then…

Now, with that out of the way, if you can't directly benefit from what I am going to share with you, I bet you know someone who can (young people starting out?)! Read on…

John Mauldin, Editor
Outside the Box

A Different "Take" on Improving Business Performance

I want to introduce a little personal note into the difficult times we are facing as business people, entrepreneurs, and investors. While my economic forecasts are decidedly not positive for the next 4-6 years, I really do not advocate digging a hole and crawling into it and pulling a cover over yourself.

Wrong, wrong, wrong! As business people we need to focus on how to improve our own situations. It is the collective acts of multiple millions of businesses, new, small and large, that will ultimately pull us out of this malaise. To let the dysfunctional actions of government prevent you from taking charge of your own world is precisely the wrong thing to do.

I believe you have far more control over the performance of your business than you might realize.

Years ago (in another bad economy) I remember reading an interesting perspective on business growth. The economist writing it acknowledged that it was tough times for any business. It was easy for entrepreneurs to think that this was not a time to grow, but rather a time to "bunker in" and focus on how to quickly cut operating costs.

But he went on to point out that that was reaction, not action. In looking at history (he pointed out) and the patterns and cycles of the economy, you see a bigger picture: one that tells us difficult times are the perfect time for explosive growth: when the giant trees fall in a forest, it's the new shoots that fill the gaps.

Did you know that the Great Depression created the largest number of new business millionaires in America? One key strategy these "positive deviants" (who defied reactive wisdom) used was developing innovative, breakthrough market strategies and business tactics that maximized their success. This let them gain the upper hand on larger, established brands that were focused on cutting costs or services. In short, they took positive strategic action while others simply reacted.

More recently, I was struck by these paragraphs sent to me by Daniel Stelter of the Boston Consulting Group:

"What Businesses Need to Do Now

"Nearly a year ago, we interviewed executives at companies that had dealt successfully with the downturn of 2009. They shared their approaches to managing through the recession – and, more important, to permanently improving their competitive position. All these winners in the crisis had set similar priorities.

"Innovation. Without exception, the manager we interviewed emphasized how innovation would play a decisive role in enabling them to exploit the opportunities arising over the next few years, particularly with less savvy competitors cutting back. As one of them observed, ‘The crisis is a catalyst for change in the technological environment. Things that we only gave half a thought to in the past are suddenly being addressed very quickly.' Many innovations are geared to optimizing processes and reducing non-personnel costs. Fundamental issues are also being broached: ‘Without innovating,' said one manager ‘it won't be possible to prosper over the next few years.' One characteristic shared by all the companies surveyed is that none reduced spending on research and development. On the contrary, some even increased it sharply because, as another executive emphasized, ‘The capital market is looking longer term – at least for now.' The winners are making the most of the opportunities arising from modified investor perspectives."

I am a big believer in innovation. We try and use the latest technology we can to enhance service, increase productivity, and cut costs. But innovation is not just about using some fancy piece of new tech or software. I think the most important innovations are in marketing. The right marketing innovation can make all the difference in the world between mere survival and prosperity. I have learned that lesson time and time again and have seen it done hundreds of times. And there is almost no limit to the possibilities of marketing innovation that you can access. Many actually reduce your costs, especially in cost per sale (while you sell more people more things, more often). And that funnels right into your bottom line.

I'm equally reminded of two staggering quotes from legendary business guru Peter Drucker. I'll paraphrase both, for brevity.

Peter said: Marketing and innovation are the only two factors that generate business. Everything else is an expense. He also said innovation refers to anything (technology or otherwise) that brings greater advantage, access, impact, interest, connection, trust, and buying motivation to the customer.

In a past life, some 30 years ago, I was considered something of a marketing wunderkind. I traveled around giving seminars, speaking at industry conferences, writing papers, and pioneering a few cutting-edge techniques in the direct marketing world. Then along came the financial world, in 1981 (for me personally, that is, as I got involved in the financial publishing industry). I began my economic studies in earnest and ended up today where I always wanted to be up until I left college in 1972 – as a writer. Who knew? I certainly did not see the path, but simply "took the fork in the road" when I came to it.

Along the way I met one person who I consider to be maybe the best marketing mind in the world.

I spent a lot of time with Jay Abraham, absorbing the perceptive, always useful information he dispensed in his own rapid-fire, almost maniacal, but truly brilliant way. Some of the best ideas I ever used I learned from Jay (the same was true of dozens of other companies I dealt with that Jay was also advising). We became good friends and are to this day. I am privileged that I can call Jay up and talk and don't have to pay the $50,000 a day he sometimes gets (if you're asking "What could a person know, do, or see in a given business situation that's worth $50,000 a day, the answer is "A lot!").

Jay has been laser-focused on how to maximize explosive business success for over 25 years. He's helped companies of all types and sizes find what I call "the difference that IS the difference" and add enormous profit and value to their brands, products, and companies in any and all economic climates. He has developed a vast breadth and depth of understanding on how true exponential business growth and profit increases happen – oftentimes doubling and even redoubling companies' current profit levels through the shifts in marketing, strategy, or their business model that Jay innovates.

Jay has had numberless accolades from serious partners and publications. Forbescalled him "the real thing." Investor's Business Daily said, "He knows how to get maximum results from minimum effort." The list of clients he has worked with (and engineered breakthroughs for) is huge, a "Who's Who."

Jay started out (about when I met him) only doing business with companies that would pay him a piece of the profits from new ideas he generated for them. He's almost unreal when it comes to finding hidden assets, overlooked profits, untapped opportunities, and underperforming activities a company isn't mining.

Over time he drifted into doing expensive seminars (we're talking up to $40,000 per attendee) and reports (priced up to $10,000 each) and sold tens of millions (lots of tens of millions) of proprietary "information" pieces. I have sent Tiffani to his seminars, and she always comes back charged up! But not merely motivated with optimism. Rather, she'd return armed with highly actionable, specific strategies and techniques we could apply right away.

And of course, eventually all of Jay's information got ripped off and repackaged by others. And the cost of the information dropped, even as the actual information remained the best out there. Jay correctly decided he did not wish to do battle with a bunch of internet information knock-off artists. He preferred competing on the front lines of capitalism, by personally helping real-world businesses grow and prosper.

So, Jay is coming full circle, back to private, performance-based advisory work and looking for a small handful of suitable, high-quality companies that he can work with on a contingency basis. He simply wants a piece of the money he makes them. He'll focus on improving their strategy, marketing, selling approach, business model, and competitive position).

He asked me if I could help him find a few such companies, betting that they are in my list of 1 million closest friends.

As I thought about it, I told him, "Yes, but there's a catch: I want you to make ALL of the best material you have done over the last 30 years available – for free – to ALL of my readers. Because 99.99% of my readers aren't the companies you can help, but any business can use your ideas if they spend the time and effort to read and study. And, you'll generate a huge sea of goodwill and referrals if you give freely to my friends."

Jay "got it" instantly, nd enthusiastically offered to give each of my business owner/CEO subscribers highly desirable resources – completely gratis – with his and my compliments and best wishes. He agrees that benefiting from all he'll freely share is the best possible way to get some of you excited about working with him, and build goodwill with all of you. (You can jump right in at http://www.abraham.com/gifts)

If you are a business owner or manager, you can take these ideas and apply them directly, meaningfully, and profitably to your particular situation; and my bet is you will improve your offering or unique selling proposition. Many of you will thank me and find this helps your situation more than my macroeconomic forecasts. At the very least, your mindset and methods of doing business will go through one of the most stimulating "reality checks" you ever experienced.

Below is a short list of what you will get. It doesn't begin to do justice to these resources. You access the full list by clicking the link above or below, along with information on how you can set up a personal interview to see whether you and Jay want to work together.

And let me just note that I have known Jay for more than 30 years. He does what he says, and delivers.

It's Like an Early Christmas for Business Owners and CEOs:

You'll receive (when you click on this link):

* Both of Jay's top-rated business books, containing 336 examples, 21 ways to outperform the competition, and 9 ways to turn stagnant performance into accelerated growth.

* Two full-length, two-hour-long, famous interviews of Jay. One by Anthony (Tony) Robbins, the other by Fran Tarkenton. Both will come in audio and text format.

* Two separate assessment test/questionnaires. One is an 87-question self assessment, the other is a 200-question giant Jay uses when evaluating profit-partner deals with companies.

* Two hours of watching Jay in action, performing 35 rapid business interventions/makeovers, which will show you how to think differently.

* The Strategy of Preeminence– A three-part collection (transcript, audio, reference notes) that teaches you now to hurtle your company from commodity status to preeminence in all you do –culture-changing, relationship-changing, impact-changing.

* 35 separate, short, 2-4 minute videos, each designed to instantly teach a different "Point of Power" or "Ex Factor" (for exponential growth) or strategic distinction.

* The transcript of a two-hour interview Jay conducted with Stephen M.R. Covey, teaching how to build greater trust between you and your marketplace.

* "Nine Drivers of Geometric Growth," which identifies the nine biggest upside leverage forces within any business/company that you can most effectively implement.

* Jay interviews Fran Tarkenton on how he's built over $250 million worth of entrepreneurial businesses.

* League of Extraordinary Minds – Jay and colleagues interview 57 of the business world's foremost icons on ways to make your business perform better right now!

* "The Abraham Mind Shift Challenge" – A 53-page dossier that teaches paradigm-shifting nonlinear thinking and a multitude of higher and better ways to think about your business possibilities, options, and opportunities – with 45 case studies.

* "How To Win Friends and Influence the Right People" (the right way) using social media. This provocative, four-segment compendium explains how to authentically connect, impact, and engage strategically in social media for your business.

You can get started changing your business life by clicking here.

Also, because each one of these resources is truly valuable – and there is a lot he is offering you– Jay and I don't want you to get overwhelmed. So he has carefully described each resource and recommended a program of orderly progress to follow to maximize your grasp of all he has to share. Also, when you opt in you'll get automatic access to Jay's periodic eclectic business perspectives and insights.

OK, the price is right. I truly believe you will learn a great deal and earn a great deal for your business. Now, go out and innovate and help get this economy moving! The link again is http://www.abraham.com/gifts.

One final thought. And it's important. In times like this, you must take forceful, innovative action to capitalize on economic opportunities in order to achieve real business growth. Jay Abraham is an excellent person to help you make this happen – whether you merely use his ideas, strategies, advice, and expert guidance on your own,– or collaborate with him directly and personally.

Your hoping to help analyst,

John Mauldin

P.S. Steve Jobs and Steve Wozniak started Apple in 1976. America was then at a low point, following the 1973-74 recession, the Arab oil embargo, the Watergate scandal, and the fall of Saigon. Other US companies that were started in bad times include General Electric, IBM, Hewlett-Packard, and Microsoft.

Question: Do tough times beget a disproportionate number of great companies? If so, why? Something to ponder.

So, you've got nothing to lose. There are no costs or hidden sign-up fees. No BS. Just solid, transformative information.

Warning: If your idea of marketing is to placidly cast something out there and hope people find you, then you will not like this work. This is not for business wimps. Will every idea make your business better? Obviously not, but what would 3-4 transformative ideas be worth? Yes, to get them you might have to do some reading and head scratching. I can't read your mind and tell you the five pages in Jay's work that will really light up your situation. And maybe getting outside your comfort zone will spur you to new vistas. So click and get started!And then write and tell me how you did!

Perspectives on the Crisis in Europe

John Mauldin — Tue, 01 Nov 2011 03:59:00 GMT

This week's Outside the Box will be unusual. Rather than one essay, I give you a number of short ones, and links that are representative of the confusion that is Europe, along with a little history. As I noted this weekend, last week's Eurozone announcement was short of details, and very little of the real work had been done. Merkel has to get her own country on board, keep the other nations that are in trouble from demanding haircuts, and keep the markets from trashing Italian and Spanish debt. Berlusconi has to figure out how to get the Italian budget balanced while staying out of jail and "balancing" his social calendar. Maybe he can dollar-cost average with a 70-year-old date? (Sorry, that was snarky, but it is so easy.)

Europe's problems will visit shores all over the world. China will not come to the rescue, at least not cheaply. It is becoming increasingly unclear where they will get the money without ECB participation, but that is VERY euro bearish.

I don't want to seem like I am piling on Euroland, but they are the crisis du jour. And it's just a matter of time until it's the US. Sigh.

And lest I forget again, let me say a special thanks to Joan McCullough for pointing me last week to Mike Masters, who was very helpful in understanding the intricacies ofcredit default swaps and their implications.

Another busy week and lots of airplanes. It will be my first time ever on Aer Lingus, as I fly to Ireland. This weekend will be fun, and even though I will do a few speeches, it will b a very different crowd than I normally speak to. No PowerPoints, just explanations of how the world works to average people – while professional stand-up comedians try and keep me honest! We shall see how that works.

Your keeping it simple analyst,

John Mauldin, Editor
Outside the Box

Perspectives on the Crisis in Europe

From David Zervos (of Jeffries and Company), writing this morning:

Seeing Greek bond investors take a 50 percent haircut, the 10yr BTP/Bund spread back to the August wides above 400 and the 10yr OAT/Bund spread north of 100 at the same time spoos have rallied 20 percent and CDX HY has fallen nearly 300bps over the past month is about as good as it gets for our "Fed Reflation vs European Detonation" view of the world. We are heading into the final few laps of the 2011 race with US equity indices up 2 to 5 percent for the year, European peripheral yield spreads at or very close to multi-decade wides, and European banks – many of which are down close to 50 percent on the year – about to be forced to raise heaps of capital. Those banks that cannot raise in the private sector, like the Greek and Cypriot ones which were lobotomized during the haircut process last week, will be forced into the EFSF vortex of pain. In there, ROEs will drop like a stone as executives are forced to delever and dilute. The only future allowable investments for these institutions will be in government-sponsored companies like the European version of Solyndra. When governments take over your capital allocation process it's "game over" – this is all part of the longer term "European Detonation" trade.

Importantly, there is NOTHING in the EU plan from last week that should make anyone comfortable about investing in European sovereign credit – or European banks. The barber shop is now open – who is the next customer? And of course this is no ordinary barber shop, in fact it's run by Sweeney Todd. The price that Greece is paying in austerity adjustment is heavy. The Portuguese, Irish and even the Italians and French are watching Athens closely. The Greek press and the Greek polls suggest that this debt relief is not being celebrated – rather it's a time for more and more violent protests (see the Salonika parade cancelation – http://www.keeptalkinggreece.com/2011/10/28/unprecedented-thessaloniki-parade-cancelled-due-to-protests/ and the other protests –http://www.keeptalkinggreece.com/2011/10/28/national-day-parades-turn-into-protests-with-eggs-yogurts-and-black-flags-pcts-videos/ post bailout).

If your bankers were to cut your mortgage and credit card debt by 50 percent, you certainly would celebrate. But if the haircut came with a forced sale of your prized possessions, a 50 percent cut in your wages, a 50 percent cut in your pension, a repossession of your car and a loss of nearly all of your state benefits such as education and health care, then maybe you too would be throwing molotov cocktails on the streets. Welcome to Syntagma Square. Oh yes and all of this austerity is happening while inflation is running well north of 3 percent.

This is NOT going to end well in Greece. And it's NOT going to end well for Europe. This barber shop is nothing more than the little shop of horrors and the Euro is the monster named "Audrey 2". But enough with the Broadway show metaphors. The point is simple, steer clear of a complicated and caustic Europe, and stick with our homeboys in the USA. Their reflationary policies are much easier to trade.

As promised last week I wanted to spend a little time on Greek history because I think it is crucial to understanding how the next phase of the crisis will unfold. This history sets the stage for how the political tides will turn in Greece during the coming "EMU exit" phase of the crisis. The 28th of October – the day last week when the final details of the EU haircut/bailout meeting were released – was ironically a very important Greek holiday. It is the day in 1940 when Benito Mussolini presented the Greek prime minister/dictator Ioannis Metaxas with an ultimatum – allow Axis forces to occupy strategic parts of Greece or face war. Metaxas answer was a simple "oxi". Oxi – pronounced oh-hee in Greek – means NO. This was the beginning of WWII in Greece. The Italians however never really fought hard against the Greeks – they were not particularly interested in battle. More than likely they all sat around having coffee together in the town squares. It was the German forces that ultimately came through Greece a year later and ravaged the country. And after the end of WWII, there was no reprieve for Greece – it became the center of the cold war battle. From 1946 to 1949, a British and ultimately US-backed fight against communism displaced over 15 percent of the population and generated more casualties than the German occupation. The Truman doctrine in 1947 was the beginning of US involvement in Greek government that would span 3 decades. For those that think the US will not take notice of a geopolitical crisis in Greece please reread Truman's speech to a joint session of Congress in 1947 – http://ourdocuments.gov/doc.php?flash=true&doc=81&page=transcript. Importantly, Communism was outlawed in Greece in 1947 and communist fighters against the Axis in WWII were declared enemies of the state. The battle between the left and right in Greece divided the country for decades and tore the country to shreds. During the 50s 12 percent of the population left Greece (including my father who walked off a Greek naval ship in New London CT in 1958). Many of the communist fighters and their children retreated into eastern bloc countries.

Greece entered NATO in 1952, and the right wing was largely in control with strong American financial backing. The move to the right culminated in a military coup in 1967 that lasted until 1974. During that period, many of the remaining left wing sympathizers were imprisoned and/or deported. The fall of the dictatorship in 1974 opened up Greece's entry into the EU. It applied for EEC membership in 1975 and entered in 1981. Also in 1975 Andreas Papandreau formed PASOK, the modern day socialist party in Greece. Further, the communist party was legalized and a new constitution that guaranteed individual rights and free elections was put in place. Importantly, it was not until 1975 that Greece even had a democracy post WWII. In 1981, PASOK took control of the government and allowed communist fighters from WWII to return from the eastern bloc to reestablish their estates. These fighters and many others that fought through the struggle with fascism were awarded generous state pensions. It was Andreas Papandreou in the 1980s who took Greece down the path of excess political patronage, excess debt and unsustainable budgets. It was a massive wealth redistribution process that not only came from within Greece, but more importantly from within the European Economic Community (the EEC).

Papandreou threatened leaving NATO and the EEC to secure constant funding from the West. In fact, in 1985, he blocked the admission of Spain and Portugal into the EEC until he was given nearly 30 billion in EEC funds. Jaques Delors finally caved! There is a constant and overriding theme in post WWII Greek politics: the world has used Greece as a pawn, and hence the world owes us. The Germans, the British and the Americans kept Greece from democracy and freedom until the late 70s. It suited their wartime aspirations. And while we in the US were going through the Reagan revolution in the 80s, the Greeks were still trying to right the many perceived wrongs from the WWII and Cold War battles. Much of Greece's debt troubles can be traced back to reparations for the tragedies associated with those two wars. There are strong senses of entitlement, retribution and redistribution that have taken Greece down this path of excess debt for the last 30 years. The political culture of redistribution that came with freedom in the 1980s, morphed into a culture of unsustainable state entitlement.

With this political backdrop, the endgame for Greece is extremely complex. Austerity will not last in Greece, and the threat of exit will ultimately be used by the citizens of Greece to attempt to secure a continuation of the welfare state. The stakes are high, and Angela Merkel is no Jaques Delors. The next chapter for Greece will be exit, and the losses to Western creditors will be seen rightly or wrongly – in Greece – as just part of the payback. Good luck trading!

___________________

From Dennis Gartman:

Firstly, for example, the 50% "haircut" is apparently only going to apply to the Greek sovereign debts that the private institutions own; that which the "public" of government institutions own shall be left with the 21% "haircut" previous agreed upon. We are now being told that the €150 billion held by the "Troika" and the ECB will not be included in the "haircut." As we understand the numbers, Greece had approximately €350 billion in outstanding debts, so already the haircut is far less than had been initially thought. The market was convinced as of late last week that Greece's outstanding debts had been… or would eventually be… cut to €175 billion and at that level perhaps Greece could be made fiscally stable over time. Now, however, we see that Greece's outstanding debts had been cut to €275 billion… far less than the market had thought. At that level, Greece will never be returned to solvency.

__________________________

Two links viaBill King Reports:

China warns it cannot 'cure' eurozone's debt crisis

China has stressed it will not be a "saviour" to Europe as President Hu Jintao embarks on an official visit to the continent that will take in this Thursday's crucial G20 summit in Cannes.

The official Xinhua news agency, used to communicate Communist Party policy, said…"China can neither take up the role as a saviour to the Europeans, nor provide a 'cure' for the European malaise," it stated. "Obviously, it is up to European countries themselves to tackle their financial problems."

– http://www.telegraph.co.uk/finance/financialcrisis/8858816/China-warns-it-cannot-cure-eurozones-debt-crisis.html

Merkel: Must prevent others from seeking hair cuts

[It's too late, baby, now, it's too late.]

Chancellor Angela Merkel said on Friday it was important to prevent others from seeking debt reductions after European Union leaders struck a deal with private banks to accept a nominal 50 percent cut on their Greek government debt holdings.

– http://www.reuters.com/article/2011/10/28/us-eurozone-germany-merkel-idUSTRE79R3NL20111028

_______________

And from Reuters:

Italy at heart of crisis as borrowing costs climb

Italy's Prime Minister Silvio Berlusconi talks to the media as he leaves a euro zone leaders' summit in Brussels October 27, 2011.

By James Mackenzie and Valentina Za

(Reuters) – Italy's borrowing costs jumped to record levels Friday, underlining its vulnerability at the heart of the euro zone debt crisis and skepticism about whether the struggling government of Prime Minister Silvio Berlusconi can deliver vital reforms.

The 6.06 percent yield paid at an auction of 10-year bonds was the highest since the launch of the euro, and not far from the level reached before the European Central Bank intervened in August to cap Rome's borrowing costs by buying Italian debt.

Italy, the euro zone's third largest economy, is again at the center of the debt crisis, as fears grow that its borrowing costs could hit levels that overwhelm the capacity of the bloc to provide support amid chronic political instability in Rome.

In a speech in Rome, Berlusconi insisted that Italy would meet its target of balancing the budget by 2013.

Tainted by scandal and repeatedly at odds with his coalition allies, Berlusconi has promised European partners a package of measures to spur Italy's stagnant economy and cut its towering public debt, but has failed to convince markets made skeptical by his repeated failure to deliver reforms.

European leaders welcomed a letter of intent on reforms that he delivered to their summit last Wednesday, but emphasized that the measures must now be implemented.

"The interest rates that they are paying are punitive," said Monument Securities strategist Marc Oswald. "Italy ... is still the 'bete noire' of the whole euro zone problem."

"They are still going to carry on having to pay higher yields unless they come up with reform plans and implement them. But anyone who expresses an optimistic opinion about that is probably looking through rose-tinted glasses," he added.

EXASPERATION

France and Germany have expressed open exasperation at a succession of unfulfilled reform promises by Berlusconi, and fear the crisis in Italy could spark a wider emergency that would threaten the very existence of the single currency.

Even if a weakened government manages to pass the promised reforms, most will not come into force until mid-2012. Markets are unlikely to remain patient for so long.

In his speech Berlusconi took aim at the euro, calling it a "strange" currency.

"There is an attack on the euro which as a currency has convinced no-one, because it belongs to more than one country but does not have a bank of reference and guarantee," he said, referring to reluctance by Germany and other countries to allow the European Central Bank to be used as a lender of last resort.

He later issued a statement saying his words had been interpreted in a "malicious and distorted" way.

"The euro is our currency, our flag. It is precisely to defend the euro from speculative attacks that Italy is making great sacrifices," the statement said.

Berlusconi, who is facing two court cases for accusations of fraud and one for allegedly having sex with an underage prostitute, complained that he faced 37 judicial hearings between now and mid-January. He says leftist magistrates are persecuting him in an attempt to undermine democracy.

Speaking after Wednesday's summit, French President Nicolas Sarkozy addressed fears that the crisis could spread to Italy.

"If we had allowed Greece to fall, and the speculation shifted on to attack Italy, the markets would then have said we will allow Italy to fall too, and that would be the end of the euro," he said in a television interview.

As Italy sinks deeper into the debt crisis, tensions in the government have grown sharply, prompting widespread speculation in the press and even Berlusconi's party that the government will fall, leading to an election in 2012, a year early.

"COALITION IS SOLID"

Berlusconi, whose ratings have been torpedoed by a mix of scandal and economic and political problems, rejected speculation that he might be forced into an early election.

He said his alliance remained solid with the pro-devolution Northern League party, whose leader Umberto Bossi has expressed open skepticism about the survival of the coalition.

"There is an absolute need for political stability and Bossi thinks exactly the same way I do. The pact we have with the League has never been up for discussion," Berlusconi said.

"No credible political alternative exists."

This week the League rejected plans to raise the pension age to 67, leading to tense late-night talks before a compromise was reached in time to take to the summit in Brussels.

The proposals, including an increase in the pension age, rules making it easier to lay off staff and provisions to place civil servants in special redundancy schemes, have raised fierce opposition from unions and skepticism about whether they will ever be implemented.

In Italy's increasingly murky politics, there has been speculation that the package is part of a deal between Berlusconi and Bossi to take the government to the end of the year before triggering an election in the spring.

Friday, Berlusconi dismissed such suggestions and said an election campaign in the middle of the crisis would be "very seriously damaging to Italy."

(Additional reporting by Marius Zaharia in London and Brian Love in Paris; Editing by Barry Moody and Alistair Lyon)

Things That Make You Go Hmmm…

John Mauldin — Tue, 25 Oct 2011 04:30:00 GMT

Do we need a law that makes it illegal to push a moose out of a moving aircraft? In baseball, what are the odds of a perfect game? How difficult will it be to solve the problems of the Eurozone? These and other issues are meditated upon by Grant Williams in his Things That Make You Go Hmmm… letter, which is this week’s Outside the Box. Maybe it was the baseball set-up (as my Rangers battle the Cardinals in the World Series) or that I keep getting asked about Europe here in New Orleans at the 2011 Oppenheimer Wealth Management Roundtable, but Grant really pulled me through his weekly missive when I got started, and I believe you will enjoy it as well. Long and short, Grant lays out the problems that we face in a very realistic assessment. I will also point out that he makes me look like a euro-optimist.

I am working on recovering from this past weekend, as this was the first time in 12 years I missed a letter due to simply not feeling well. But I guess that means I should be grateful I am not sick all that often. I hated to not write. The spirit was willing but the flesh was weak. It seems like I was “gifted” by my granddaughter with a nasty bug, which decided to show itself while I was in South Africa. Aaah, the joys of being a grandfather. Another round of catching nasty stuff from your progeny.

Your ready for some rest and baseball on TV analyst,

John Mauldin, Editor
Outside the Box

Things That Make You Go Hmmm…

“Everyone needs the ECB to step up to the plate. The ECB has no excuse not to act. In trying to keep its monetary virginity intact, the bank threatens to destroy the Euro Zone. If that happens, nobody will be able to profit from its virginity.”
- PAUL DE GRAUWE

“Simple Math:

The total overall cap [of the ESM] is 500 billion Euros

160 billion Euros has been spent

340 billion Euros remains

340 billion Euros + zero Euros = 940 billion Euros“

- Mike Shedlock, on the latest European ‘Masterplan’ to merge the EFSF + ESM

“The trouble with quotes on the internet is that it’s difficult to determine whether or not they are genuine”
- Abraham Lincoln

Lee Richmond, meet everybody. Everybody? Meet Lee Richmond.

It’s difficult to put an exact number on the number of games of professional baseball that have been played since 1900 - most estimates seem to be clustered around the high 300,000s though. For the purposes of this exercise, I am going to take the number provided in no-nonsense fashion by Wiki answers: 390,536.

In amongst those 390,536 games were home runs, walks, steals, strikeouts and singles, doubles and triples too numerous to keep track of; or rather, just too numerous for anyone but the most die-hard of stat geeks to even contemplate tallying.

(at this point, I should apologise to any non-baseball fans amongst you for whom the terms used above have induced a frantic bout of head-scratching and a desire to skip ahead – stick with me for a while longer and the fog will clear – I promise).

Part of the innate beauty of baseball to me is the fact that (certainly in the modern era), game by game, season by season every aspect of it is measured, quantified and evaluated and the myriad ways the numbers can be dissected enables you to drill down into any part of it and gain a real understanding, through those numbers, of exactly what is going on. You can't fudge the numbers. The Oakland Athletics' Billy Beane showed the power of this approach, which was documented so brilliantly in Michael Lewis' 'Moneyball'

But let's get back to Lee Richmond.

In 1880 Richmond became the first of only 20 men in baseball history to pitch a perfect game when he pitched the Worcester Ruby Legs to a 1-0 victory over the Cleveland Blues at the Worcester Agricultural Fairgrounds on June 12.

Think about that for a second.

Over 130 years. 390,536 games. 2 teams in each contest. That's 781,072 opportunities for a perfect game to be pitched or, to put it another way, the odds on a perfect game being pitched are 39,053:1 - and rising. In fact, more people have orbited the moon than have pitched a MLB perfect game and NOBODY has done it more than once.

(At this point I will again attempt to keep the non-baseball aficionados with us by the use of this short explanation of a 'perfect game':

A perfect game is defined by Major League Baseball as a game in which a pitcher (or combination of pitchers) pitches a victory that lasts a minimum of nine innings and in which no opposing player reaches base. Thus, the pitcher (or pitchers) cannot allow any hits, walks, hit batsmen, or any opposing player to reach base safely for any other reason - in short, "27 up, 27 down")

Interestingly enough, although it is technically possible for multiple pitchers to combine for a perfect game, to date, every major league perfect game has been thrown by a single pitcher.

That record needs to change. And fast.

Right now, the team comprising the ECB, EU and the various parliaments that make up that fractured and faltering alliance are sending pitcher after pitcher to the mound (sometimes in groups of two or three) trying to combine for the perfect game that they NEED in order to escape the debt trap they have backed themselves into.

Being in a situation where you lose unless you can pull something off against odds of multiple-thousands to one and pitch a 'perfect game' is a ridiculous spot in which to find yourself, but as this month has rolled by, it has become ever-more apparent that that is precisely where the Brussels Eurocrats now find themselves. It appears as though, as the pressure has ratcheted up this week, we are now in the ninth inning.

Personally, my own belief (as regular readers are by now well aware) is that the very best the Eurocrats can hope for is to extend the game by an inning or two, but their arms are tired, their bullpen is empty and, at some point, we are going to see an absolute avalanche of runs scored against them as the whole thing finally topples under its own weight.

This past week has been nothing short of farcical as the tension has built towards a crescendo that seemed at first to be willfully engendered in order to generate just enough sense of impending crisis to enable a resolution to be forced through in a similar fashion to that which preceded Henry Paulson and Ben Bernanke's now-infamous closed-doors fright-fest (hyphenation alert!) that led to the passing of the TARP in late 2008.

Obviously any and all capitulation towards outright bailouts (or 'QEU') must at least be seen to be against the will of the Germans and that proviso goes a long way towards explaining the raft of headlines that have flooded the Reuters and Bloomberg screens of investors all around the world this week. We have seen misdirection, scaremongering, u-turns and abject incompetence as well as the kinds of 'leaks' that are, frankly, laughable - the prime example being the 'leaked' draft copy of the Euro Summit statement which was printed, in its entirety, in the Daily Telegraph on Thursday - coincidentally at the precise moment when things were starting to come unglued as it became clear that this Sunday's Summit would NOT produce the magic bullet required.

The statement itself is priceless. It begins with a bit of back-slapping for the passing of the EFSF (after no less than six months of wrangling and an eleventh-hour drama in Slovakia):

The strategy we have put into place encompasses determined efforts to ensure fiscal consolidation as well as growth, support to countries in difficulty, and a strengthening of euro area governance. At our 21 July meeting we took a set of major decisions. The ratification by all 17 Member States of the euro area of the measures related to the EFSF significantly strengthen our capacity to react to the crisis.

The agreement on a strong legislative package within the EU structures on better economic governance represents another major achievement. The euro continues to rest on solid fundamentals

It then moves on to more familiar ground; an agreement to display their strong determination to fix things. Nothing concrete, of course, but they sure as hell are determined:

The crisis is, however, far from over, as shown by the volatility of sovereign and corporate debt markets. Further action is needed to restore confidence. That is why today we agree on additional measures reflecting our strong determination to do whatever is required to overcome the present difficulties.

The rest of the text, should you want to read it, is here, but allow me to summarise it through a few select phrases that will save you the trouble of doing so:

“blah, blah, blah… All Member States are determined, blah, blah, blah… We want to reiterate our determination, blah, blah, blah… We reaffirm clearly our unequivocal commitment that, blah, blah, blah… All other euro area Member States solemnly reaffirm their inflexible determination, blah, blah, blah… The euro area Heads of State or Government fully support this determination, blah, blah, blah… All tools available will be used in an effective way to ensure financial stability in the euro area, blah, blah, blah… We fully support the ECB, blah, blah, blah… “

See. I told you they were determined.

But, buried deep in the draft are (amazingly enough) some specific measures that will surely help solve the crisis:

• There will be regular Euro Summit meetings bringing together the Heads of State or government (HoSG) of the euro area and the President of the Commission. These meetings will take place at least twice a year

• The President of the Euro Summit will be designated by the HoSG of the euro area at the same time the European Council elects its President

• The President of the Euro summit will keep the non euro area Member States closely informed of the preparation and outcome of the Summits

• As is presently the case, the Eurogroup will ensure ever closer coordination of the economic policies and promoting financial stability.

• The President of the Euro Summit will be consulted on the Eurogroup work plan and may invite the President of the Eurogroup to convene a meeting of the Eurogroup, notably to prepare Euro Summits or to follow up on its orientations

• Work at the preparatory level will continue to be carried out by the Eurogroup Working Group(EWG)

• The EWG will be chaired by a full-time Brussels-based President. He/she should preferably also chair the Economic and Financial Committee

…and my personal favourite:

• Clear rules and mechanisms will be set up to improve communication and ensure more consistent messages.

It’s at this point that the non-Europeans amongst you are possibly finally beginning to get the joke that anybody caught in the tractor beam of ineptitude that is ‘Europe’ (and by‘Europe’ I mean the bureaucratic construct rather than the land mass) has understood for years.

THIS IS HOW EUROPEAN BUREAUCRACY WORKS, PEOPLE!!!!

Millions of Euros spent on days of‘talks’ to come up with solutions that fail to address any REAL problems.

Don’t believe me?

Article 47 of the Common Fisheries Policy will ensure that every fish caught by an angler is notified to Brussels so that it can be counted against that countries quota. If you go out for a days fishing and catch a couple of cod or mackerel you will now be required to notify the authorities or face a heavy fine.

There are EU regulations on the greenness of the person on the pedestrian crossing lights.

There are 3 separate EU directives on the loudness of lawnmowers.

Regulation (EC) 2257/94 - a great read, by the way - stated that bananas must be ‘free from malformation or abnormal curvature of the fingers’. It also contained stipulations about ‘the grade, i.e. the measurement, in millimetres, of the thickness of a transverse section of the fruit between the lateral faces and the middle, perpendicularly to the longitudinal axis’ ...

And then there are cucumbers:

Under regulation (EEC) No 1677/88 cucumbers are only allowed a bend of 10mm for every 10cm of length.

Do you think any of those were drawn up in 10 minutes on a single piece of paper?

No. (Actually, in fairness to Europe, they don’t have a monopoly on silly legislation: there IS a law in Alaska that makes it illegal to push a moose out of a moving aircraft.)

The Brussels bureaucracy has always been something of a laughing stock amongst the people of Europe - since long before the final creation of the EU, in fact. Way back in 1955, with a European union freshly on the drawing board ten years after the end of WWII, Russell Bretherton, an English Civil Servant was dispatched to Brussels to inform European ministers what Britain thought of plans for an ambitious new European treaty. Upon arrival, he had these words of wisdom for those assembled:

“Gentlemen, you’re trying to negotiate something you will never be able to negotiate. If negotiated, it will not be ratified. And if ratified, it will not work”

Three years later, the Treaty of Rome was signed, establishing the European Economic Community and from that day to this, the degree of meddling, interference and sheer bureaucracy has increased year after year until we find ourselves here.

Europe is broken and the people charged with trying to fix it are clearly not up to the job. There are way too many vested interests, too many national peccadillos and way too many good, old-fashioned egos in play for it to come down to anything but a last-ditch solution when they are forced into it - and that solution WILL be the printing of money in some shape or form which will help to magically inflate the debt away. The other alternatives are either just too painful (default/ forgiveness) or plain unworkable (growth).

A look at a selection of newsflashes that hit screens this week shows just how ridiculous things have become as everybody involved in trying to sort out the mess that is Europe attempts to get themselves in front of a microphone in order to let the world know just how important they are. Some of these appearances, it would seem, are stage-managed for maximum effect on markets - others are simply self-important politicians who just can’t bring themselves to utter the words “no comment”:

*GERMAN COALITION SOURCES: MERKEL SAYS LEVERAGING EFSF VIA ECB IS RULED OUT

*MERKEL TOLD LAWMAKERS MOVING FORWARD MILLIMETER BY MILLIMETER

*ECB TRICHET: CAN’T USE MONPOL TO CORRECT FAILURES OF GOVERNMENTS

*ECB NEVER ACTS AS A SUBSTITUTE FOR GOVERNMENTS: NEWSPAPER INTERVIEW

*FINANCIAL STABILITY IS THE RESPONSIBILITY OF GOVERNMENTS

*EMU HAS PRICE STABILITY TODAY; INFLATION EXPECTATIONS FIRMLY ANCHORED

*TRICHET REJECTS ASSERTION THAT ECB HAS OVERSTEPPED ITS LIMITS

*TRICHET: EURO WILL EXIST IN 10 YEARS

*SEIBERT SAYS `DREAMS’ OF SWIFT EURO SOLUTION WON’T MATERIALIZE

*GERMAN COALITION SOURCES: MERKEL SAYS LEVERAGING EFSF VIA ECB IS RULED OUT

*DJN-DJ REPORT EFSF FIREPOWER TO REACH EUR2T ‘TOTALLY WRONG’-SOURCE

*MERKEL SAYS NEXT EU SUMMIT IS `NOT THE END POINT’ FOR CRISIS

*DJ GERMAN GOVERNMENT DOESN’T EXCLUDE DELAYING OCT. 23 SUMMIT

*MERKEL CANCELS FRIDAY SUMMIT ON LACK OF EFSF DETAILS

*MERKEL CANCELS EFSF SPEECH ON DEADLOCK ON LEVERAGING: LAWMAKERS

*FRANCE, GERMANY SEE NEED FOR GLOBAL, AMBITIOUS CRISIS RESPONSE

And the piece de resistance:

*MERKEL SAYS EUROZONE TALKS STUCK. FLIES TO FRANCE: REUTERS

*SARKOZY SAYS EUROZONE TALKS STUCK, FLIES TO GERMANY: REUTERS

Amidst this barrage of headlines, Nicolas Sarkozy was quoted in two articles which outlined his own fears for Europe:

“Allowing the destruction of the euro is to take the risk of the destruction of Europe. Those who destroy Europe and the euro will bear responsibility for resurgence of conflict and division on our continent.”

And...

“If there isn’t a solution by Sunday, everything is going to collapse”

There’s something eerily familiar about that last sentence. Let’s see what Google Translate makes of the original French version, shall we?:

“If money isn’t loosened up, this sucker could go down”

Those words were uttered by another President on September 26, 2008 - a few days before TARP was passed into law.

No matter how long this charade continues, it seems impossible to see how it doesn’t end in a EuroTARP. The ECB have a brand new, never-been-used printing press just sitting there in a locked room waiting to be called into action. The only problem is; the Germans have the key to the door. How long they continue to try to do the ‘right’ thing before capitulating is pretty much the only unknown quantity right now.

Having backed themselves into a hopeless corner early last week with promises of a ‘solution’ come the end of this weekend’s summit, the Eurocrats have now postponed the decision until next Wednesday. On hearing this, the markets were eerily calm, as the UK Guardian noted:

(UK Guardian): Investors’ thinking seems to be that the adoption of a new deadline - “Wednesday, at the latest,” according to last night’s communiqué - could be construed as good news, or at least neutral from the point of view of share prices and bond prices. This theory says that more time to reach agreement makes a watertight plan more likely to happen.

Really? The notion sounds like a triumph of hope over experience. Okay, last night’s statement still promised “a global, ambitious response to the crisis currently facing the Eurozone” but it seems just as likely that more time will simply entrench disagreements between Germany and France. As the clock ticks, the definition of “ambitious” could simply be watered down..

But is this sense of calm justified? Well, in a word, no.

Overnight, the latest leaks out of the ongoing Crisis Summit paint an ugly picture about what happens next and, if the leaks are anything to go by, we are in for anything BUT a period of calm:

(UK Daily Telegraph): Europe’s leaders are threatening to trigger a formal default on Greek debt and risk a “credit event” if banks refuse to accept losses of up to €140bn (£120bn) on their holdings.

Hardline eurozone members, backed by the International Monetary Fund (IMF), delivered the ultimatum this weekend after an official report found that in a worst-case scenario Greece could need a second bail-out of€450bn – twice the current package and more than the entire €440bn in the eurozone’s rescue fund.

Vittorio Grilli, a senior EU official, travelled to Rome yesterday to present the “take it or leave it” deal to the Institute of International Finance, which is leading the negotiations for the banks. “The only voluntary element for the banks now is to take a 50pc haircut or face a credit event, a default,” said an EU diplomat.

Apparently, even a once-taboo idea of a centralized Treasury is also now on the table:

(UK Daily Telegraph): European Union chiefs are drawing up plans for a single “Treasury” to oversee tax and spending across the 17 eurozone nations.

The proposal, put forward by Herman Van Rompuy, the European Council president, would be the clearest sign yet of a new “United States of Europe” — with Britain left on the sidelines.

The plan comes as European governments desperately trying to save the euro from collapse last night faced a new bombshell, with sources at the International Monetary Fund saying it would not pay for a second Greek bail-out..

Or how about an EFSF SPV that will attract money from our old friends the Sovereign Wealth Funds (surely, by now, even THEY are starting to understand the folly of investing in these things?):

(UK Guardian): Finance ministers from the 17 eurozone countries are discussing the option of creating a “special purpose vehicle” for the European Financial Stability Facility (EFSF) in order to boost its current€440bn (£383bn) lending capacity.

The idea, according to sources, would be to attract further money from official and private investors, with the sovereign wealth funds of countries such as China, Singapore or Qatar a prime target. Some of these already invest in European banks such as Barclays and UBS.

So here we are.

It’s Sunday morning in Asia as I finish writing this week’s missive and the messages coming out of Europe are as mixed as ever, despite the clear need for a ‘solution’ (which has been perhaps the only consistent communique for about two years now). Sadly for the Eurocrats, the time when they have to stop telling us how important a ‘solution’ IS and actually devise one that WORKS is now at hand.

Any more prevaricating and the markets will give them their solution whether they like it or not.

The chances are that we will see another photo-op featuring the region’s finance ministers this week as they unveil their latest ‘plan’ that will fix everything. There will be a communique issued which lays out exactly how determined they are to solve everything and quantifies all the important steps they have so far taken as well as the improvements they are seeing in the finances of the PIIGS. There may be some criticism of the banks for forcing them to this point, and there will most likely be certain promises made about how they aim to extract retribution for their forced largesse, but they will take one more swing at a solution - one that stops short of the massive steps they need to take to shore things up once and for all.

Then the markets will have their say.

Ultimately, the only realistic way to fix Europe’s problems is to shovel money into the gaping hole that is the region’s finances. Which means that the REAL question that has to be answered is fairly simple:

Where is that money going to come from?

Growth? Nope.

Inflation? Not quickly enough.

Forgiveness or default? Not if you don’t want M. Sarkozy’s prediction coming true.

The ECB’s printing press? Only if you can change German minds.

Until German minds are harder to change than the immutable laws of mathematics, I suspect we have our answer.

Only one Perfect Game has been thrown in a World Series game - when it REALLY counted. The year was 1956, the pitcher that day was Don Larsen and, as the 27th opposing batter was finally struck out, Larsen leapt into the arms of a man whose words of wisdom have graced the cover of Things That Make You Go Hmmm..... on several occasions: Yogi Berra.

The latest European Crisis Summit? Well, as Yogi would probably have said, it’s déja-vu all over again.

∞∞∞∞∞∞∞

So what do we have for you this week? Well, naturally, there’s a whole lotta Europe including warnings of a French downgrade from top economists, warnings of a ‘downgrade blitz’ across the EMU from S&P and a warning for Mario Draghi as he prepares to take the crown from Jean-Claude Trichet’s greying head in a little over a week.

Morgan Stanley explain Europe’s‘Triangle of Terror’, we hear how the EU is mulling over a $1.3 trillion fund and little Belarus is doing its bit to show that austerity is the way forward by heading to eBay.

Amidst Boston’s own ‘Occupation’ we find some of the most delicious irony of the year, the next wave of mortgage-backed lawsuits is set to traumatize Wall Street yet again, Peter Tchir imagines the EFSF as a hedge fund and we investigate the mysterious China International Fund and its activities in Africa.

Gillian Tett examines the possibility that there is a ‘shadowy plot’ behind gold, we look at common equity to total asset ratios that are downright scary, examine Libya’s population pyramid and examine the implications for other Arab nations and see how the cost of oil extraction and the yields on Italian government debt are both heading in the same direction.

Finally, we put the price of gold in Weimar Republic Marks in stark perspective and hear from Rick Santelli, Doug Casey and Paul Brodsky who all have something important to say and do a damn fine job of saying it.

That’s all for me for another week.

Play Ball!

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.

Is the US Monetary System on the Verge of Collapse?

John Mauldin — Tue, 13 Sep 2011 06:04:00 GMT

This week we take in a piece that is somewhat outside my own box. There are a number of people who feel strongly that the US (and world governments in general) cannot pull out of the downward spiral they are in, that monetary policy is fixed on printing ever more money, and that the problems of fiat currencies are now coming to the fore.

I was interviewed last week by David Galland and Doug Casey of Casey Research. Those of you familiar with them know they (and especially Doug) have a strong libertarian bent and a distrust of government. Not all that unusual, of course, except that they work at finding ways to invest based on their philosophy. That has meant a lot of gold and natural resources, plus new tech, which has worked at rather well overall.

In the interview, I was the “optimist.” By that I mean I was the guy who thinks the US government will do what is necessary to bring down the deficit beginning in 2013. David pointedly asked, “So you mean your ‘optimism’ is based on your faith that the US political leaders will do the right thing?” And the blunt answer is, “Yes, because not doing it would be a disaster, and I think, based on conversations with some of them, that they actually get that.”

Which is the case I outlined in my book, Endgame.But if I am wrong and we do not deal with the deficit in a controlled manner, then all bets are off. Sadly, the guys at Casey would be right. So, today’s Outside the Box is an op-ed from David Galland.

If you like it you can click on the link at the end and, for the exorbitant price of your email address, you can see the entire webinar (and my part in it), or sign up now at http://www.americandebtcrisis.com?ppref=JMD420ED0911A.

I think this week we’re going to be focused on Europe. I am getting ready for my trip there at the end of next week, so I am reading more about the situation there to prepare myself. But right now let’s focus on the US.

Your wondering where the time goes analyst,

John Mauldin, Editor
Outside the Box

Is the US Monetary System on the Verge of Collapse?

By David Galland of Casey Research

Tune into CNBC or click onto any of the dozens of mainstream financial news sites, and you’ll find an endless array of opinions on the latest wiggle in equity, bond and commodities markets. As often as not, you'll find those opinions nestled side by side with authoritative analysis on the outlook for the economy, complete with the author’s carefully studied judgment on the best way forward.

Lost in all the noise, however, is any recognition that the US monetary system – and by extension, that of much of the developed world – may very well be on the verge of collapse. Falling back on metaphor, while the world’s many financial experts and economists sit around arguing about the direction of the ship of state, most are missing the point that the ship has already hit an iceberg and is taking on water fast.

Yet if you were to raise your hand to ask 99% of the financial intelligentsia whether we might be on the verge of a failure of the dollar-based world monetary system, the response would be thinly veiled derision. Because, as we all know, such a thing is unimaginable!

Think again.

Monetary Madness

Honestly describing the current monetary system of the United States in just a few words, you could do far worse than stating that it is“money from nothing, cash ex nihilo.”

That’s because for the last 40 years – since Nixon canceled the dollar’s gold convertibility in 1971 – the global monetary system has been based on nothing more tangible than politicians' promises not to print too much.

Unconstrained, the politicians used the gift of being able to create money out of nothing to launch a parade of politically popular programs, each employing fresh brigades of bureaucrats, with no regard to affordability.

Such programs invariably surged during political campaigns and on downward slopes in the business cycle when politicians hearing the cries of the constituency to “do something” tossed any concern about balancing budgets out the window of expediency. After all, the power to print up the funds for debt service whenever needed makes moot any concern over deficit spending.

Former VP Cheney, who fashions himself a fiscal conservative, let the mask drop when, in 2002, he stated that “Reagan proved deficits don’t matter.”

Those words were echoed just a few weeks ago, when both former Fed Chairman Alan Greenspan and Obama economic advisor Larry Summers, in separate interviews, said almost the same, paraphrased as, “There is no chance of the US defaulting on its bonds, not when our government can borrow dollars and print new dollars to meet any future obligations.”

Of course, Greenspan and Summers were referring to an overt default – of just not paying – and not to a covert default engineered by inflation. Unfortunately, like virtually all of the power elite, both miss the point that the mountain of debt that has been heaped up since 1971 is fast reaching the point of collapsing like a too-big tailings pile and taking the monetary system down with it.

Importantly, the debt shown in this chart whistles past the government's unfunded liabilities, in particular for the Social Security and Medicare systems. Adding those would more than triple the US government’s acknowledged obligations – to over $60 trillion.

Given the role the US dollar plays as the world’s de facto reserve currency – with all major commodities priced in dollars, and dollars forming the bulk of reserves held by foreign central banks –the dismal shape of the US monetary system spells trouble for the global monetary system.

Making matters worse, following the lead of the United States, governments around the world long ago adopted similar fiat monetary systems. You can see the deficit contagion in this next chart. It is worth noting that the dire condition of the United States now leaves it in the same muddy wallow as Europe’s desperate PIIGS.

In a recent article in The Telegraph, Ambrose Evans-Pritchard referenced a paper out of the BIS that paints the picture using appropriately stark terms.

Stephen Cecchetti and his team at the Bank for International Settlements have written the definitive paper rebutting the pied pipers of ever-escalating credit.

“The debt problems facing advanced economies are even worse than we thought.”

The basic facts are that combined debt in the rich club has risen from 165pc of GDP thirty years ago to 310pc today, led by Japan at 456pc and Portugal at 363pc.

“Debt is rising to points that are above anything we have seen, except during major wars. Public debt ratios are currently on an explosive path in a number of countries. These countries will need to implement drastic policy changes. Stabilization might not be enough.”

Viewing the situation from another perspective, we turn to the work of Carmen Reinhart and Ken Rogoff, who studied the factors contributing to 29 past sovereign defaults. They found that default or debt restructuring occurred, on average, when external debt reached 73% of gross national product (GNP) and 239% of exports. Using the Reinhart/Rogoff findings, Casey Research Chief Economist Bud Conrad prepared the following chart showing that the US government is already far along on the path to bankruptcy.

It’s hard to argue against the contention that the situation is, to be polite, precarious. Given that the obligations of the US government, as well as most of the world’s other large economies, are now impossible to repay and that their reserves are just IOUs backed by nothing, the stage is set for a highly disruptive but entirely necessary do-over of the fiat monetary system.

“Preposterous!” say the lords of finance and masters of all.

Is it?

Of course, these very same mavens completely missed the looming housing crash and the depth and duration of the subsequent crisis – a crisis that is still far from over. In other words, listen to them at your peril, because in our view it’s essential in calibrating your financial affairs to understand that, if history is any guide, we are now well down the road to a collapse in the monetary system.

In fact, over its relatively short history, the US monetary system has come unglued time and time again thanks to politically expedient attempts to interfere with the workings of a free market in order to reward constituents or kick the can on the economic problems of the day down the road.

Thus it is our contention that while the mainstream media focus on the daily gyrations of equity markets or the futile political charade that is Washington, they overlook powerful tectonic rumblings indicating the world’s prevailing monetary system is about to fracture.

A Brief Timeline of US Monetary System Failures

Here’s a brief history of past disruptions here in the United States. Importantly, with the US dollar now the de facto reserve currency of the world, this time around it’s global.

1861 –When the Civil War begins, the dollar is convertible into gold and silver.

1862 –Congress passes the Legal Tender Act and authorizes the issuance of non-redeemable "Greenback" currency. Convertibility into gold and silver is suspended for all US currency.

1863 –National Banking Act authorizes the chartering of banks by the federal government.

1865 – A 10% tax is levied on the issuance of bank notes by state-chartered banks, effectively ending that practice.

1879 –The US Treasury resumes redeeming dollars for gold and silver.

1900 – Passage of the Gold Standard Act, adopting the gold standard by the United States and demonetizing silver.

Specifically, the act provided for "...the dollar consisting of twenty-five and eight-tenths grains (1.67 g) of gold nine-tenths fine, as established by section thirty-five hundred and eleven of the Revised Statutes of the United States, shall be the standard unit of value, and all forms of money issued or coined by the United States shall be maintained at a parity of value with this standard..."

But 33 years later, to gain the power to inflate the currency and collect the profit from doing so…

1933 – By executive order, Franklin Roosevelt prohibits the private ownership of gold. Congress passes the Gold Reserve Act, which enacts Roosevelt's executive order, abrogates all gold clauses in all contracts public or private, past or future (which cancels the convertibility of Federal Reserve notes into gold), though it confirms the convertibility of US Treasury notes held by foreigners into gold. Eleven years later, the US government takes its show on the road…

1944 – Bretton Woods system adopted with signature countries agreeing to tie the exchange rates of their currencies to the US dollar, which itself is linked to a fixed price of gold. Foreign trading partners retained the right to swap dollars for gold, imposing a de facto restraint on printing more dollars. For all intents and purposes, the US dollar becomes the world’s reserve currency. But 27 years later…

1971 – Nixon abruptly closes the “gold window,” unilaterally reneging on the Treasury's promise to allow foreign governments to redeem dollars for gold. Bretton Woods collapses. With no remaining tie to a tangible, the dollar is reduced to a paper token. The transition to a global fiat monetary system is complete.

Until 40 years go by and the inevitable consequences of giving politicians free rein over money creation become untenable…

Present day – Sovereign debt crisis. Desperate, debt-laden governments around the globe – the bulk of their reserves composed of fiat US dollars and euros at risk of going up in smoke – turn to the only thing they know, printing more money and issuing yet more debt. The global monetary system cracks and heads toward failure with no workable alternative on the horizon.

Governments, corporations and investors alike are caught unprepared in the downward spiral of failing fiat currencies and are wiped out by a combination of frantic currency debasements, higher taxation, exchange controls and worse. Social unrest spreads, with the public paradoxically demanding that governments do more, not less.

That’s because all the world’s major currencies are at risk, simultaneously, as the issuers engage in a dangerous race to the bottom. As the monetary system moves inexorably toward terminal debasement and collapse, the results will be catastrophic for the unprepared.

Importantly, while the list of historical attempts to re-jigger the US monetary system have, to this point, more or less succeeded in kicking the can a bit further down the road, the sheer scale of today’s government obligations has driven us into a box canyon, with no way out. As the government’s debt and spending obligations are mathematically impossible to resolve, it is now a certainty that a lot of people are going to wake up one morning to the reality that they are a lot poorer than they thought.

Fortunately for those now paying attention, the collapse of a monetary system doesn't happen in a flash. It is a progression, like the spiral of water down a drain. Thus, while no one can predict exactly when the downward spiral will accelerate out of control, there is still time to prepare.

Dark though the lens may be, this is the lens through which we here at Casey Research view all our investments. Simply, being right or wrong about your investment decisions in the years just ahead will be insignificant if the currencies underpinning those investments shrivel to just a fraction of their current values.

The dismal state of the US economy and out-of-control government spending affects every American’s life and wealth. In the free online video event, The American Debt Crisis– How Big? How Bad? How to Protect Yourself, held on September 14, 2011, a Casey Research team of Doug Casey, Bud Conrad, Olivier Garret, Terry Coxon and David Galland will be joined by guests John Mauldin, Mike Maloney and Lew Rockwell to discuss the potential for a breakdown in the monetary system, and specific ways to protect and build your assets. Register for this free event today at www.americandebtcrisis.com?ppref=JMD420ED0911A

Things That Make You Go Hmmm…

John Mauldin — Tue, 06 Sep 2011 17:15:00 GMT

I love Grant Williams and his writing in his letter Things That Make You Go Hmmm... And this week's Outside the Box is the first section from his recent post, where he starts with a brief history of Gadhafi and ends up giving us a tutorial on oil pricing. This may be "inside baseball" (too much detail) for some of you; but these details are important, as the very ground of oil pricing is shifting away from the traditional sources. What will the mainstream media do? Wonder when they will shift, which will result in a LOT higher costs for most of the world. Besides, this is a fun read, and Grant is a great writer.

And quickly, this note From Dennis Gartman: "Finally... and we shall cover this at some greater length tomorrow... S&P has said over the weekend through one of its senior spokespeople in Europe that if a EUR-bond is underwritten it shall have the rating of the lowest rated constituent country involved and thus will have coupon far, far above that of Germany, or France or Belgium et al. A EUR-bond would thus have the credit rating of Greece!"

I may have to write about Europe again this week, as there is just so much going on. The key to watch is the German Constitutional Court decision, due Wednesday. If they rule against the euro, all h#$% will break loose. And they could, although I expect a more moderate outcome, as they realize the entire future of the euro project is riding on their ruling. Do they want to get blamed for imploding the euro?

This week's OTB comes at the end of Labor Day, when all my kids and various friends (some 30-odd) have shown up for food and grilling. I think I am a fair to middling writer and analyst, but I am a brilliant cook (none of this humble analyst stuff in the kitchen!), as all who get to sample my culinary offerings agree. Definitely not low-calorie offerings. Cooking is an all-morning and day affair. Partner Steve Blumenthal of CMG came down Monday morning for some needed businesses meetings, and it may be the first time we met in the kitchen while his partner was cooking. I had to attend to the serious stuff! Butternut squash/carrot soup must cook for 6-8 hours. Mushrooms, veggies, meat, grilling seasoning. They all take time and great attention to detail.

And Steve and Billy Peters (of Baton Rouge) took me to the LSU-Oregon game this Saturday evening in Cowboys Stadium with 87,000 fans, most of whom were from LSU. I have never seen such a rabid (the correct word) crowd. It may be something like English football crowds. I attend professional events all the time, but nothing prepared me for the volume of noise.

Have a great week. The house is starting to smell awesome, and my kitchen calls.

Your my ears are stilling ringing analyst,

John Mauldin, Editor
Outside the Box

Things That Make You Go Hmmm...

"Formula for success: rise early, work hard, strike oil"

– J. PAUL GETTY

"China gets their oil from Libya. Why isn't China involved? They're going out spending billions of dollars a day on trying to take over the world economically. And we're spending billions and billions and billions of dollars on policing the world. Why isn't China involved with Libya?...we don't get oil from Libya, China does."

– Donald Trump

Pythagorean theorem: 24 words
Lord's prayer: 66 words
Archimedes' Principle: 67 words
Ten Commandments: 179 words
Gettysburg address: 286 words
US Declaration of Independence: 1,300 words
US Constitution with all 27 Amendments: 7,818 words
EU regulations on the sale of cabbage: 26,911 words

– Europe's Problems Summed Up

(Thanks Cyril)

On September 1st, 1969, a 27 year-old army captain and son of a Bedouin farmer who had been born in a tent in the Libyan desert in 1942 staged a bloodless coup when King Idris I travelled to a Turkish Spa to receive treatment on an injured leg.

The army captain, one Muammar al-Qaddafi, had graduated from the University of Libya a mere six years earlier and the Libyan military academy in 1965, but somehow he forced himself to the forefront of a group of Arab nationalist insurgents and, once the monarchy had been abolished and Idris banished to first Greece and finally Egypt, he took his place at the head of the newly-formed Libyan government.

And there he would stay – for almost exactly forty two years.

The History Channel takes up the story:

Blending Islamic orthodoxy, revolutionary socialism, and Arab nationalism, Qaddafi established a fervently anti-Western dictatorship in Libya. In 1970, he removed U.S. and British military bases and expelled Italian and Jewish Libyans. In 1973, he took control of foreign-owned oil fields. He reinstated traditional Islamic laws, such as prohibition of alcoholic beverages and gambling, but liberated women and launched social programs that improved the standard of living in Libya. As part of his stated ambition to unite the Arab world, he sought closer relations with his Arab neighbors, especially Egypt. However, when Egypt and then other Arab nations began a peace process with Israel, Libya became increasingly isolated.

It all sounds rather idyllic, doesn't it? Liberating women, improving the standard of living and attempting to unite the Arab world. Let's see Wikipedia's take on the aftermath of Gaddafi's arrival at the helm of the world's 17th-largest oil producer:

After seizing power, Gaddafi proceeded to eliminate any opposition and severely restricted lives of ordinary Libyans. Gaddafi's ideology was termed the Third International Theory and it was described in the Green Book. Gaddafi and his relatives took over much of the economy. Gaddafi started several wars, had a role in others, and spent on acquiring both chemical and nuclear weapons. More covertly, he directed the country's revenues to sponsor terror and other political activities around the world. The United Nations called Libya under Gaddafi a pariah state.

Gaddafi was unpredictable, radical and a force to be reckoned with by the West and his combative stance towards Western oil companies was rewarded with the kind of concessions that would alter the balance of power between OPEC and its biggest customers:

(Wikipedia): In The Age of Oil, historians considered Gaddafi's success in 1970 to be the "decisive spark that set off an unprecedented chain reaction" in oil-producing nations. Libya continued a winning streak against the oil companies throughout the 1970s energy crisis; Later that year, the Shah of Iran raised his demands to match those of Gaddafi. OPEC nations began a game of "leap frogging" to win further concessions from the oil companies after following Gaddafi's lead.

Gaddafi and the Shah of Iran both argued for quadrupling the cost of oil in 1975.

SOURCE: BP

'The oil price' is something of an interesting animal.

Since 1970, the oil price, which had nominally traded in the tightest of ranges since the late 1800s, has experienced enormous volatility with twin inflation-adjusted spikes almost 30 years apart finally being breached earlier this year when Brent hit a high of $126.65 on April 8th of this year.

Back in 2008, when 'the oil price' was hitting record high after record high – peaking at $145.29 in July of that fateful year – 'the oil price' being referred to was West Texas Intermediate (WTI), the light, sweet crude delivered into the facility at Cushing, Oklahoma which holds, at various times, between 5 and 10% of US crude inventory. That same 'oil price' now trades almost 40% lower at $88. Except...

The rumblings began in earnest in 2007 with the release of a Lehman Brothers report which argued that WTI was no longer the benchmark for 'the oil price' due to the fact that it was highly localized and, with the tendency for inventory spikes in what is, with all due respect to any Cushing-based readers, well..... before I get myself into any trouble, I will let an aerial map of Cushing, OK (below) do all the heavy lifting for me.

SOURCE: GOOGLE MAPS

Any questions? Good. Let's press on.

In October of 2009, WTI was dealt another hammer blow by Saudi Arabia:

(FT): Saudi Arabia yesterday decided to drop the widely used West Texas Intermediate oil contract as the benchmark for pricing its oil, dealing a serious blow to the New York Mercantile Exchange.

The decision by the world's biggest oil exporter could encourage other producers to abandon the benchmark and threatens the dominance of the world's most heavily traded oil futures contract...The move reveals the growing discontent of Riyadh and its US refinery customers with WTI after the price of the benchmark became separated from the global oil market this year.

The surge in oil inventories in Cushing, Oklahoma, where WTI is delivered into America's pipeline system, depressed the value of the WTI against other global benchmarks, throwing the global oil market into disarray.

Argus Sour Crude, 2010 – Present

SOURCE: BLOOMBERG

Saudi Arabia moved to a new index developed by Argus in London; the Argus Sour Crude Index. This was assembled to track the price in the physical market of a basket of US Gulf Coast crudes, including Mars, Poseidon and Southern Green Canyon:

(FT): ...Argus said the change in policy reflected the "increased importance of the US Gulf coast sour crude market, in which both production and trading activity was rising sharply".

Paul Horsnell, head of commodities research at Barclays Capital in London, said Saudi Arabia's decision was likely to reflect a "wider discontent" from its customers in the US about WTI performance.

Edward Morse, chief economist at LCM Commodities in New York, said: "It is a recognition by large players that WTI sometimes does not reflect the true value of crude oil in the waterborne market."

Saudi Arabia has priced its oil using WTI since 1994.

And so it was that 'the oil price' gradually became less about the little town in Oklahoma with a population of 9,596 and more about the real world price: and that meant Brent.

Brent Crude, 2006 – Present

Brent Crude vs. WTI, 2007 – 2011 (% change)

SOURCE: BLOOMBERG

It is notable that when people talk about oil having hit its 'highs' of $140 back in 2008 and now trading almost 40% lower they are referring to the price of WTI, which has tumbled back into the $80s, but both Argus Sour Crude (left, top) and the more ubiquitous Brent Crude (left, middle) contracts are still trading within shouting distance of their lifetime highs. The bottom chart shows how Brent and WTI have disconnected from an almost perfect correlation EXACTLY at the time QE2 was announced back in August of 2010 - not that Quantitative Easing is in ANY way responsible for an increase in the price of commodities of course. I want to make that QUITE clear....

Naturally, it is useful when one is in the business of managing an economy and attempting to control inflation while simultaneously printing as much money as one can get away with, to be able to point to a falling oil price as evidence that the dreaded spectre of inflation is not an immediate concern and the weakness in WTI has afforded the US government and their Central Bank sidekicks the luxury of being able to do that, but the stubbornly high price of Brent is becoming something of an irritant.

Back in June when the IEA announced they were releasing 60 million barrels of oil from OECD inventories due to the high price of crude, it was suggested that the main reason for such an action was the loss of oil production that accompanied the beginning of the popular uprising against Colonel Gaddafi and a look at a chart of world oil production (below) shows just how severe a drop-off in price the unrest in Libya caused. What is even more interesting, however, is the chart that follows, which shows Saudi oil production levels at the time of the virtual shutdown of Libyan oilfields with the March data for both countries' output circled. Clearly, Saudi Arabia was either unwilling or unable to plug the Libyan output gap:

SOURCE: GREGOR/EIA

SOURCE: THE OIL DRUM

At the time, Reuters reported on the Saudi response to the supply disruption and it appeared as though they were opening up the spigots:

Saudi Arabia has increased its oil production to more than 9 million barrels per day (bpd) to compensate for disruption to Libyan output, an industry source familiar with the kingdom's production told Reuters on Friday.

"We have started producing over 9 million barrels per day (bpd). We have a lot of production capacity," the source said, but said he could not say when the change had taken place.

But clearly, from the graph (above, right), the 'change' had taken place gradually over the preceding six months - the Saudi response to Libyan production dropping off the proverbial cliff could hardly be labelled 'shock and awe'.

The Oil Drum leaned distinctly in the direction of 'unwilling' as the reason for the less-than-dramatic response:

Back in 2006, when [Saudi] production started to gradually decline from 9.5mbd even as global oil prices were in the worst spike since the 1970s, I was an advocate of the view that the decline was largely involuntary: they'd never produced more than 9.5mbd, they'd underinvested for decades, and some of their big fields were getting very tired (particular northern Ghawar and Abqaiq) and they were starting a big rash of new projects and ramping up their rig counts at the same time.

I see current events differently. The reduction in late 2008 was clearly voluntary to support prices in the face of the great recession. There's no new projects announced, and the rig count hasn't taken off. So my take is that the failure to increase production to compensate for Libya is deliberate. We can only speculate, but my guess is that, having watched how the west has helped to ease Mubarak and Ben-Ali out of power and is intervening in Libya to the same end, the Saudi regime is in no mood to care about our desire for more oil. Instead, they are very much in the mood to build as large a war chest as possible with which to appease their own population, strengthen their defense measures, etc.

So, instead of Saudi production increasing to compensate for Libya, total world production decreased, and oil prices went up sharply to enforce the necessary conservation on the world's oil consumers.

The debate about Peak Oil has been raging since the fateful day in 1956 when M. King Hubbert presented to the American Petroleum Institute his theory that oil production would follow a bell curve and, at an unspecified stage in the future, enter a terminal decline, but that debate is too multi-faceted for these pages so we will simply use a couple of charts (which would coincidentally appear to support Dr. Hubbert's thesis) in order to flesh out the remainder of our discussion for today.

First up, a list of the world's biggest oilfields:

SOURCE: AAPG/OGI/EIA

The list of the 18 largest 'supergiant' oilfields (left) highlights one of the biggest challenges facing the oil industry to date in that the average age of these fields is exactly 60 years old. Moreover, the most recent discovery was made 35 years ago when the Cantarell Complex (highlighted) was found by a fisherman named Rudesindo Cantarell 80 km off the coast of Mexico in the Bay of Campeche.

Cantarell complained that oil seepage was ruining his fishing nets and the good folks at PEMEX (Mexico's national oil company) kindly investigated the problem for him - only to find the motherlode.

In 2004, however, PEMEX suddenly announced that production from Cantarell was forecast to steeply decline from 2006 - at a rate of 14% per year.

By 2008, the annual rate of decline had reached 36% and by 2009 it hit 38%.

In graphical form, the fall from grace of the Cantarell supergiant is even more amazing:

SOURCE: FEDERAL GOVT OF MEXICO

Clearly, in oil we have a commodity the world cannot live without which is the subject of great debate as to whether its future supply is sustainable. The largest concentration of this commodity resides underneath the most combustible region on the planet, the guardians of that oil are very secretive about their production rates and have a vested interest in maximising profits from the sale of their only asset, the evidence that is in the public domain (such as that surrounding Cantarell along with Great Britain's experience with North Sea Oil) would seem to suggest that once the decline stage is reached it will be rapid and.... what was the other thing?

Oh yes, the institution in charge of producing the colourful pieces of paper which can be swapped for that commodity are committed to producing as many of them as they can get away with before anybody notices.

As stock markets plummeted in August, one thing that was noticeable was the resilience of both 'the oil price' (in the shape of Brent Crude, of course) and that of copper - two bellwether indicators of any slowdown in growth that can be relied upon to flash signals when a recession is nigh.

To be sure, the data reported in August was dreadful. In the US we saw a slew of appalling regional manufacturing reports, (the Philly Fed and Empire numbers could genuinely be described as 'shockers'), shattered consumer confidence numbers and rising inflation all topped off with a big fat goose egg in the NFP report last Friday, while in Europe, as the periphery continued to confirm just how week their economies continue to be, the real shocks came from the region's perennial powerhouse economy, Germany.

German private investment and consumption were down, government spending rose, GDP was below forecast and the PPI number was alarmingly elevated on both a month-on-month and year-on-year basis and the ZEW survey (Germany's barometer for economic growth expectations) had its biggest fall since July 2006. On balance, it looks for all the world as though the two largest and most powerful regions on Earth are about to head into synchronised recessions - the only possibility that this turns out NOT to be the case would seem to be that they are both already IN recessions.

So why doesn't 'the oil price' reflect this likelihood? Simple:

1. China has a LOT of paper money and is happy to swap it for hard assets that it knows will ultimately be far more beneficial in the long run as Western governments continue to debase their currencies.

2. Western governments continue to debase their currencies.

But it isn't just 'the oil price' that has shown remarkable resilience into the teeth of what looks like another severe recession. Throughout August, sitting out here in Asia, it was plain to see that there was a firm hand bidding for copper in the Shanghai market and, realistically, nobody in the region was in any doubt as to exactly who that firm hand belonged to. Consequently, copper - that great barometer of both economic activity and inflationary pressure - held up surprisingly well given the poor economic backdrop and the 'risk off' episodes that littered the first half of the month.

Shanghai Copper

Brent Crude

SOURCE: BLOOMBERG

The signs are clear: Inflation is not only the preferred option to soothe the pain of a world drowning in debt, but (semantics about which 'oil price' to use aside) pretty much the only bullet left in the guns of central bankers and, until somebody stamps a 'sell-by date' on such things as copper, oil or our old friends gold and silver, the Chinese will continue to swap their paper for hard assets and, realistically, the price is of secondary importance to them.

Ben Bernanke's 'disappointing' speech at Jackson Hole was received poorly by markets that have become used to a generous helping of stimulus from the Fed Head whenever things looked bleak but subsequently, with a non-farm payrolls report that showed the US economy produced precisely zero jobs last month, further wobbles in stock markets that are focusing ever-more intently on the debacle that is Europe and the remarkably pro-stimulus words of two Fed officials, it has become even clearer that, come the Fed's extended two-day meeting in late September, QE3 (or whatever it ends up euphemistically being labelled) is pretty much a done deal.

Add to that the increasing likelihood that the ECB begin to monetize their own problems via Eurobonds and rate cuts (ECB mandates and approval by the citizens of Europe be damned at this point in the game) and the odds on seeing a meaningful retreat in 'the oil price' - even in the face of a global recession - are becoming thinner by the day.

The surprising relative strength in 'the oil price' is signaling that the familiar paradigm of slowing growth being accompanied by a falling oil price to help equilibrium be reached at which point growth can begin again is just another casualty of central bank interference in markets via unprecedented monetary printing experiments. The inevitable inflation that results from massive money-printing operations is a concern to many, and, while it is seemingly not apparent in Western government numbers, it is out there. Believe me. It is out there in the price of oil, and copper it can be seen in the price of gold and silver and it is in the price of such vital things as Thai Hom Mali rice which has risen 26% this year and looks set to rise a further 25% NEXT MONTH ALONE according to the Bangkok Post. If you want to see what problems inflation can cause, keep an eye on the price of rice here in Asia. The fact that the US CPI appears benign, means very little. The less obvious signs are far more important.

Of course, the other thing to consider is the new man at the head of the Libyan government when it is finally established. We don't know who he is. We don't know how he thinks. But surely, the new leader of the world's 17th-largest oil producer HAS to offer more stability to both the world in general and 'the oil price' in particular than Muammar al-Qaddafi.

Surely?

Some Problems With Banks

John Mauldin — Mon, 29 Aug 2011 21:20:00 GMT

This week your Outside the Box offers two views, one from the US and one from Europe, both dealing with banks and financing. First, back in July, my friend Chris Whalen at Institutional Risk Analytics wrote an important comment about how the situation in the housing market is blocking efforts by the Fed to stabilize the US economy. IRA is a rating agency that follows every US bank and consults for a number of large commercial and governmental institutions on bank performance and risk.

(You can see the IRA reports of all the failed banks since 2008 on their website. The folks at IRA have a retail website (www.irabankratings.com) that allows you to follow your bank’s performance for just $50 per year or subscribe to see all US banks for $1,000 per year. Many large corporations, investment advisors, insurers, and banks use the retail IRA bank ratings for counterparty risk management and other bank credit tasks. It is a great value for people who want to sleep soundly at night with reliable knowledge about their banks.)

One of the things that Chris has been writing about for the past several years is how the policies followed by the top four banks – Citigroup, JPMorgan Chase, Wells Fargo, and Bank of America – plus Fannie Mae and Freddie Mac, are preventing millions of American homeowners from refinancing their homes. While banks and corporate issuers of debt have benefited greatly from the Fed’s low-rate policies, consumers have been locked out. At long last, we now see President Obama and other politicians talking about the need to refinance American homeowners. Chris and his colleagues in the mortgage market, like Alan Boyce, are largely responsible for educating policy makers on this issue. Hopefully they are not too late to make a difference.

The second and shorter part of today’s OTB is two articles from Ambrose Evans-Pritchard of the Telegraph, on the current crisis in Europe. You need a scorecard to keep up with the latest developments, and he certainly provides one. Things could get very volatile, if he is even close to correct.

Have a great week, and my sympathies to all my friends who have “issues,” as in no power, etc., in the Northeast. Makes 100+ degrees seem like nothing.

Your waiting for cooler weather in Texas analyst,

John Mauldin, Editor
Outside the Box

The Institutional Risk Analyst

Are the Housing GSEs and TBTF Banks Blocking the Economic Recovery?

Yesterday our colleague Chuck Gabriel at Capital Alpha Partners in Washington put out a research note indicating that the Obama Administration has decided to support a two-year extension in the conforming loan limit for Fannie and Freddie.

As we have noted in past comments, the limit on loans that can be guaranteed by the GSEs is set to fall back to pre-crisis levels at the end of September. Loan markets around the US have already begun to seize up in anticipation of the change.

But while this eleventh hour fix is good news of sorts, it does not change the fact that the Obama Administration and most of the federal regulatory community have badly botched the government's response to the mortgage crisis. Part of the issue is a lack of understanding of the problem, but mostly it is the big banks and GSE continuing to exercise their cartel pricing power to deny American home owners their legal right to refinance.

Let's review the history so we can all get on the same page. In 2002, when the Fed dropped interest rates dramatically after the banking industry and markets went into a stall, the mortgage markets saw a wave of home refinancings. This is precisely what the Federal Open Market Committee wanted to see happen; liquefy households and boost consumer demand.

In response, the GSEs started to accelerate their purchases of private label securities ("PLS"), buying the "AAA" pieces of PLS to help to maintain the yield on their retained portfolios. Remember that a decade ago, we were still pretending that the GSEs were private corporations and their officers were busy enhancing earnings to build their bonus pool.

Paul Krugman, Bob Kutner and Frank Portnoy, among others, are right when they say that Wall Street's greed drove the mortgage debacle. But they forget that Fannie Mae and Freddie Mac were considered part of Wall Street until the collapse of Lehman Brothers and Bear Stearns in 2008. You cannot separate the private and public sector contributions to the crisis; it was a true partnership, but one that starts with the government intervention in the housing sector with the New Deal.

While the GSEs were buying all of that "AAA" rated PLS paper from the Wall Street dealers for the retained portfolio, the inferior tranches went to fuel the CDO machine, paper that was eventually bought by EU investors. While liberal commentators still argue that Wall Street and not their beloved New Deal agencies caused the crisis, the fact is that those CDO deals built on "A" through "BB" tranches would never have been done without the GSEs providing a ready market for the "AAA" rated tranches.

The surge in prepayments in 2002 drove the banks and GSEs to loosen their criteria in order to generate new, high spread at time of origination or SATO loans to replace the RMBS in portfolio that were seeing very high prepayment speeds. This decrease in credit quality at banks and by the GSEs had the same motivations, namely greed. But, again, it is impossible to separate the role of the government and the private banks in creating this mess. The two constituencies were locked in a loving embrace that went on for years and with the full connivance of both political parties in Washington.

In 2008, when the Fed again dropped interest rates to liquefy households and boost consumer demand, the GSEs responded by raising the barrier to home refinancing by changing the loan level pricing adjustment or LLPA. This move defeated the Fed's LSAP program to purchase mortgage securities and thereby drive a significant increase in home refinancing. Rich people got refinancings, but the vast majority of Americans now had the legal right to refinance in 2008 and 2009 were locked out by the banks and the GSEs, who did not want to see the high coupon, high SATO loans produced between 2002 and 2007 prepay. Again the reason, greed, both by banks and the GSEs.

Remember that the biggest holders of these RMBS are the GSEs themselves and the Fed, followed by banks and private investors. But because of the actions of the GSEs to prevent Americans from exercising their legal right to refinance, the holders of the high coupon securities have been overpaid for years.

Hundreds and hundreds of billions of dollars worth of Fannie and Freddie securities should have prepaid years ago, but instead the GSEs and other holders of these securities have been receiving above-market yields on their investments. This is not only unfair to American home owners, but it also means that the US economy is not going to recover until the government forces the GSEs to change their LLPAs and aggressively start to refinance these high SATO loans.

Senator Barbara Boxer (D-CA) has introduced a proposal to force the GSEs to refinance the loans in their portfolios as well as in pass through securities. The Obama Administration has finally put forward a proposal to force trustees of private RMBS to allow principal reductions on mortgages to help keep up to 1 million people in their homes. Both of these initiatives are important and necessary for the US economy to recover. But both proposals also represent a deliberate government-mandated default on these debt instruments. So much for the arguments about raising the federal debt ceiling that rely on the need to avoid default.

In the event, this new wave of refinancings will mean a massive prepayment to the GSEs and to private investors, who have been free riding at the expense of home owners and the American economy. A broad program of refinancing will make the losses at Fannie and Freddie soar and will reduce the cash flow going to banks and other investors in GSE paper. It is likely that several large financial institutions will be forced into a Dodd-Frank restructuring when the government rips away half of their net interest margin as a result of prepayments on vintage RMBS.

These two proposals will be very bad for the support of bond owners of PLS for future participation in the mortgage market, but senior bond holders will likely do much better. The Boxer and Obama proposals are probably good for loan servicers too as they are first in line to get repaid servicing advances when the loan is sold. This is a "servicer safe harbor" issue, but the larger economics are always better for all investors on a short sale or modification than a long drawn out foreclosure process.

But shed no tears for holders of private RMBS. The excess spread that these investors have been receiving because of the GSE efforts to block home mortgage refinancings for the past three years more than compensates for the lower yields they will receive when the proceeds of prepayments are reinvested at today's market rates. Strange as it may seem, we support the Boxer proposal. Indeed, we suspect that Senator Boxer may have been reading the work of our friend Alan Boyce, head of the Absalon Project.

For the past three years and more, Boyce and other member of our Berlin-Los Angeles axis of understanding have been trying to educate members of Congress and other inhabitants of Washington as to the reality of the GSE-bank mortgage market cartel. In particular, Boyce has focused on how the GSEs and the largest banks are actively seeking to prevent Americans from refinancing their mortgages -- and at the same time thwarting the Fed's efforts to stabilize the economy through QE.

Click here to see the latest version of Alan's presentation. Note particularly Page 13, which shows that high income home owners who could qualify for the tighter LLPAs put in place by the GSE's in 2008 were twice as likely to refinance as lower income borrowers. The bottom and lower middle income households with high SATO loans are precisely the mortgages that the GSEs and banks own in their portfolios.

"Now that it's the one year anniversary of Dodd-Frank, there has been lots of discussion on what should be done in the future," Boyce notes, "but no discussion of what is happening on a daily basis."

Bottom line: If the Obama Administration wants to see the US economy recover, then we must start the real process of restructuring that Washington & Wall Street have been avoiding since 2007. President Barack Obama may not be able to turn things around before the 2012 election, but he will be remembered more kindly in the history books if he has the courage to do the right thing. As always, we are available to help in this process as and when somebody in the White House or Treasury wants to pick up the telephone.

And from the Telegraph:

Euro bail-out in doubt as "hysteria" sweeps Germany

German Chancellor Angela Merkel no longer has enough coalition votes in the Bundestag to secure backing for Europe's revamped rescue machinery, threatening a constitutional crisis in Germany and a fresh eruption of the euro debt saga

Seething discontent in Germany over Europe's debt crisis has spread to all the key institutions. Photo: AP

By Ambrose Evans-Pritchard

28 Aug 2011

Mrs Merkel has cancelled a high-profile trip to Russia on September 7, the crucial day when the package goes to the Bundestag and the country's constitutional court rules on the legality of the EU's bail-out machinery.

If the court rules that the €440bn rescue fund (EFSF) breaches Treaty law or undermines German fiscal sovereignty, it risks setting off an instant brushfire across monetary union.

The seething discontent in Germany over Europe's debt crisis has spread to all the key institutions of the state. "Hysteria is sweeping Germany " said Klaus Regling, the EFSF's director.

German media reported that the latest tally of votes in the Bundestag shows that 23 members from Mrs Merkel's own coalition plan to vote against the package, including twelve of the 44 members of Bavaria's Social Christians (CSU). This may force the Chancellor to rely on opposition votes, risking a government collapse.

Christian Wulff, Germany's president, stunned the country last week by accusing the European Central Bank of going "far beyond its mandate" with mass purchases of Spanish and Italian debt, and warning that the Europe's headlong rush towards fiscal union strikes at the "very core" of democracy. "Decisions have to be made in parliament in a liberal democracy. That is where legitimacy lies," he said.

A day earlier the Bundesbank had fired its own volley, condemning the ECB's bond purchases and warning the EU is drifting towards debt union without "democratic legitimacy" or treaty backing.
Joahannes Singhammer, leader of the CSU's Bundestag group, accused the ECB of acting "dangerously" by jumping the gun before parliaments had voted. The ECB is implicitly acting on behalf of the rescue fund until it is ratified.
A CSU document to be released on Monday flatly rebuts the latest accord between Chancellor Merkel and French president Nicholas Sarkozy, saying plans for an "economic government for Eurozone states" are unacceptable. It demands treaty changes to let EMU states go bankrupt, and to eject them from the euro altogether for serial abuses.
"An unlimited transfer union and pooling of debts for any length of time would imply a shared financial government and decisively change the character of a European confederation of states," said the draft, obtained by Der Spiegel.
Mrs Merkel faces mutiny even within her own Christian Democrat (CDU) family. Wolfgang Bossbach, the spokesman for internal affairs, said he would oppose the package. "I can't vote against my own conviction," he said.
The Bundestag is expected to decide late next month on the package, which empowers the EFSF to buy bonds pre-emptively and recapitalize banks. While the bill is likely to pass, the furious debate leaves no doubt that Germany will resist moves to boost the EFSF's firepower yet further. Most City banks say the fund needs €2 trillion to stop the crisis engulfing Spain and Italy.
Mrs Merkel's aides say she is facing "war on every front". The next month will decide her future, Germany's destiny, and the fate of monetary union.
++++++++++++++++++++++

European banks set cash test by IMF chief

European banks face ordeal by fire this week after the International Monetary Fund called for “urgent” action to shore up their defenses, if necessary with state money and under legal compulsion.

Recovery is in danger if we don’t shore up defenses, says Christine Lagarde. Photo: AP

By Ambrose Evans-Pritchard

9:27PM BST 28 Aug 2011

Christine Lagarde, the IMF’s new chief, set off tremors at the Jackson Hole summit over the weekend with warnings that the global financial system is on very thin ice and vulnerable to the slightest shock.

“We are in a dangerous new phase. The stakes are clear: we risk seeing the fragile recovery derailed, so we must act now,” she said.

“Banks need urgent recapitalisation. If it is not addressed we could easily see the further spread of economic weakness to core countries, even a debilitating liquidity crisis. The most efficient solution would be mandatory substantial recapitalisation,” she said.

Europe’s lenders are already reeling from a share price collapse since the debt crisis spread to Italy and Spain, threatening to overwhelm Europe’s bail-out fund and leave banks exposed to sovereign defaults.

Shares of Intesa SanPaulo, Credit Agricole and Commerzbank are all below the extremes seen during the panic in March 2009.

Europe’s inter-bank market is effectively frozen and EMU banks have lost access to America’s $7 trillion (£4.3 trillion) money markets. Lenders have parked €126bn (£112bn) at the European Central Bank for safety rather than risk exposure to peers.

The IMF exhorted Europe’s banks over the last two years to beef up their capital base while the rally lasted. Many failed to do so and will now face harsher terms. Some may fall under state control, wiping out shareholders.

The eurozone economy ground to a halt in the second quarter, tightening the noose on EMU’s weaker states and their banks. Julian Callow from Barclays Capital said Europe is already in “industrial recession” and risks tipping into outright economic slump.

“The recent slide is eerily reminiscent of the pattern during the third quarter of 2008,” he said.

Mrs Lagarde issued a thinly-veiled attack on the ECB’s rate rises and Europe’s fiscal austerity drive. “Monetary policy should remain highly accommodative, as the risk of recession outweighs the risk of inflation. Fiscal policy must navigate between the twin perils of losing credibility and undercutting recovery,” she said.

Tim Congdon from International Monetary Research said it is folly to force Europe’s banks to raise money too quickly or crystallize losses abruptly. This will cause a monetary implosion and a repeat of the 2008 disaster.

He said the ECB’s restrictive policies over the last 18 months and the lack of EMU fiscal union have doomed the euro. to certain break-up.

“It cannot be saved. Banks will suffer large losses,” he said.

Dynamic Economic Decision Making

John Mauldin — Tue, 23 Aug 2011 02:23:00 GMT

This week’s Outside the Box is from my good friend John Silvia, the Chief Economist at Wells Fargo and fishing buddy in Maine. He has written a powerhouse book called Dynamic Economic Decision Making: Strategies for Financial Risk, Capital Markets, and Monetary Policy.

Combining three intellectual disciplines – economics, business, and decision making– that have traditionally been taught separately, Dynamic Economic Decision Making forges a new path that redefines how we view business choices. And that is the main point of the book. So many business leaders and investors make decisions based on static factors, historical patterns, or straight-line assumptions that it is no wonder that all too many bad decisions are made. And worse, we train our MBAs to approach decision making with outmoded tools that have proved themselves worthless in the real world.

Jim McTague of Barron’swrote:

“For the price of a book you receive the equivalent of a three-credit course from a top MBA program. Silvia, one of the nation's most astute economists, has written a comprehensive, accessible masterpiece on applied economics. The author is an able teacher: Anyone, novice or expert, will profit from this well-written book.”

I agree. Even though John sent me this book for review, I will download it to my iPad for $40! (note to my editor at Wiley, who published this book: Why can Silvia get $39 for Kindle and I get $12?) I get a lot of reading done as I travel, and this is one I want to get through.

I asked John to write a short piece to give us a flavor of his main points, and I don’t think you’ll be disappointed. You can get the book on Amazon at http://www.amazon.com/Dynamic-Economic-Decision-Making-Strategies (37% off).

Have a great week, and learn to enjoy volatility. And please get the fact that Silvia (and I) keep noting: We are not going back to the old days. We are in a brand new world and we need to deal with it.

Your actually looking forward to the future analyst,

John Mauldin, Editor
Outside the Box

Dynamic Economic Decision Making

The Great Recession of 2008-10 demonstrated the power that macroeconomic and financial forces have to alter the risks and rewards that frame choices for both private and public sector decision makers. Moreover, these forces completely overwhelmed the complex, micro mathematical strategies that were the rage of many investors. Yet many approaches to decision-making in finance and economics are more like cookbooks—they tell you how to prepare a specific meal, step-by-step, but not the fine art of being the gracious host that leads the guests through a wonderful evening. Too much focus is exclusively on the fine techniques of micro management, while ignoring the reality of the broader set of macro scenarios faced by actual decision-makers involving the many changes in economic growth, finance, and globalization that are ongoing. Is it any wonder that failure and surprise accompany the economic shocks of the day? Our finest financial engineers fail in the face of real world change.

Dealing With Cyclical & Structural Change

“You can’t argue with a hundred years of success.”

--William I. Walsh(The Rise and Decline of the Great Atlantic & Pacific Tea Company, Lyle Stuart, New Jersey, 1986)

Actually you can when the environment changes around you—not knowing that the economic world is changing and the world is always changing. In the early 1950s, A&P, which was then the leading grocery chain in America, ranked only behind General Motors in annual sales. Americans tastes changed. They wanted choices, not the limited availability associated with the Great Depression and World War II periods of thrift. A&P stores did not provide the level of variety, nor cleanliness, expected by the new, growing middle class suburban households that began to emerge after the war. America’s tastes had changed and the offering of A&P did not. (See Jim Collins, Good to Great, Harper Business, 2001, pp. 65-69.)

Three forces interact to drive economic success. First, economic activity provides the overall flow of information and sets the character of surprises and our decision-framework. Yet, in practice, decision makers conduct stress tests, risk assessments and simulations that do not deal with the cyclical nature of economic behavior. This would appear for two reasons.

Second, most business and public policy decision-makers are not trained to deal with or think in terms of the business cycle. Forecasting for most consists of straight-line projections from a spread sheet.

Third, dealing with the business cycle demands a set of assumptions and the interaction of those assumptions that can require scenario building. The results of these scenarios on the outlook for growth, inflation and interest rates, for example, can be more complex than decision-makers have the time or willingness to engage.

Many decision-makers feel more comfortable on focusing on the business, where they feel comfortable, and not of forecasting. Even more misleading, over time the model of the economy does not fundamentally change and, thus retaining its original framework. In addition, many simulations are defined in terms of allowing one factor, for example economic growth, to fluctuate. This is done to simplify the analysis but with the knowledge that other key variables are likely to change at the same time.

There is a tradeoff here between simplicity and reality. Often, the comfort of simplicity leads to a misrepresentation of the outlook. Better to deal with the complexity and get a sense of the issues than fall back on simplicity and misrepresent the future outlook. These simulations and ignore the reality that other drivers, such as inflation, interest rates, profits and exchange rates, also move along with changes in growth. Over the last fifty years, the economy does has not ever returned to its prior “normal” but a new framework has always emerged with each business cycle, always different than previous frameworks, sometimes in significant ways. The original equilibrium was never restored. Creating economic models as if it did will not make it so.

Decision-traps limit the leader’s ability to deal with cyclical but especially longer-term changes. Decision-makers tend to anchor their expectations about the future in the past and to think in terms of their historical investments in their career and in their firm. Their career is their memory of events and decisions tend to be framed in terms of our experience. Decisions about the future of the firm tend to reflect the firm’s existing structure. Seldom do firms break out of character and set a new course. This causes them not to examine the marginal costs and benefits of moving to a new future. In addition, public policy makers are slow to recognize the changing character of competitiveness in industries (autos, textiles, and consumer electronics) and thereby subsidize such industries for far too long. This is not only a U.S. tendency but very much the general case as evidenced by the United Kingdom in the post-World War II period until Prime Minister Margaret Thatcher took office in 1980 and introduced a market-driven approach regarding subsidization of industries.

Finally, decisions on the future of the institution reflect the influence of past decisions (path dependent) and which sets the parameters for success regarding future decisions. In some cases, decisions today cut off options tomorrow while other decisions today open up options for the future. A student who decides to go to one college cuts off the opportunity to go to another college. An athlete decides to play baseball and give up playing soccer. A business firm decides to pursue project A and set aside project B. Once we decide on one path, generally we cut off other options and decisions today will reflect our decisions in the past. Business decisions also have this tendency for path dependence as will be shown in several cases in this chapter.

Four Biases in Decision-making

(For a great read on decision-making biases see Michael Roberto, Know What You Don’t Know: How Great Leaders Prevent Problems before They Happen.)

Two aspects of successful decision-making in a changing economic world are evident so far. First, a strategy is needed that recognizes the reality of fluctuations in economic growth as well as in the four other economic drivers. Second, this strategy should prevent economic shocks or change from causing business failures. If they use the three techniques to identify change, decision makers now have observations that suggest the future direction of economic change. But what mental barriers prevent decision makers from accepting such change?

Normalization of Deviance

Our first decision-making challenge is the normalization of deviance. In this situation we normalize, learn to live with, small deviations in the normal run of affairs. We learn to live with a dripping faucet, a toilet that runs a bit longer, a door that sticks. Diane Vaughan, sociology professor at Columbia, made a study of the Challenger space shuttle disaster of 1986. (The Challenger Launch Decision: Risky Technology, Culture and Deviance at NASA.Chicago: University of Chicago Press, 1996.) Vaughan’s study focused on the gradual development of a set of beliefs that small deviations from the norm in the behavior of the O-rings under cold temperatures were acceptable since no major problems had occurred. Since most flights had occurred with temperatures in a normal range the overwhelming evidence was that there was no problem. The small amount of erosion that did occur in some flights was considered an anomaly. Over time, these anomalies became the accepted course, much like the sticky door, and so they were taken for granted as the normal course of action. Deviations from the normal became accepted as part of the acceptable risks of any flight. At the time of the flight in 1986 the temperatures at launch were much colder than normal and disaster soon followed.

In business, normalization of deviance was apparent in the credit standards involved in subprime lending yet borrowers continued to pay, or enough of them paid, so that the entire enterprise was profitable, at least in the short run. The rise in housing prices over the last twenty years provided the underlying rational of the housing mortgage market. Credit standards were continually eased, often for political purposes, by government-supported enterprises such as Fannie Mae and Freddie Mac. At the same time, capital gains taxes were lowered on housing taxes on income in general were rising and interest rate deductions were eliminated for consumer credit and auto loans. Thus, to meet their desire for consumption, households increasingly took equity from their homes through home equity loans, which reduced the capital cushion of ownership. Easier credit standards, meanwhile, meant that the purchaser of the home had “less skin in the game,” that is the buyer of the home has less invested in the home and therefore less interest in paying off the mortgage if events turned bad (which they did as house prices fell) and therefore the real credit risk in lending was rising. This ultimately proved to be the undoing of the market. Lower credit standards meant more buyers could qualify. Rising demand for housing initially drove up prices. Eventually, supply caught up. Housing prices slowed and the carrying costs of the mortgage could not be justified. Many buyers, walked away now.

In recent years, the normalization of deviance was evident in the housing market bust of 2008-2009 and the deterioration of credit standards that came to be accepted. Mortgage standards eased by 2005 and 2006 such that 60 day plus delinquencies were rising earlier in the life of adjustable rate mortgages (ARMs) suggesting that the risk profile of the borrowers had risen and likely this rise was faster than investors in these loans had expected. The rapid rise of delinquencies in 2006 suggested that indeed the housing problem was much greater than many had expected. In short the mortgage market framework changed and many failed to notice. The fact that home prices were rising justified the increasing deviance of lending standards—until home prices no longer could rise and started to fall dramatically. In fact, in the history of markets, it often takes a substantial change in prices to reveal the underlying deviance of traded prices from their fundamentals. Success was defined in terms of rising home ownership even though the underlying credit quality of the borrower and the appraisal/market value of the house were increasingly suspect. The markets normalized the deviance in credit standards as long as home ownership rates went up.

Change as a process not an event

A second barrier to effective decision-making is the failure to recognize change as a process and not an event. Decision-makers want to identify one event as the “cause” of a significant change. Yet, the lessons of the pre-World War I period is that an entire sequence of decisions lead to the outbreak of the conflagration and not a single cause such as the shooting of Archduke Ferdinand. (Barbara Tuchman, The Guns of August, Ballantine Book, 1962.) Since 1956, three firms have dropped out of the Dow Jones index, Bethlehem Steel, General Motors and Woolworth. Yet there is not a single event in each of these company histories that caused the companies’ relative decline. Instead, changes in the overall economy led to an increasing disconnect between the economy and the framework of decision-making in each company. (Jim Collins,Good to Great, provides an interesting view on Bethlehem Steel. James O'Toole, in Leading Change, provides a view on the decline of General Motors.) Catastrophic failures such as Johns Manville (Asbestos litigation led to bankruptcy filing in 1982.) and Enron (irregular accounting concerns led to bankruptcy in 2001) can be attributed to singular failures over a short period of time.

For business firms the trend growth in the globalization of trade signifies the process of rising competition that characterizes the economic framework today. Recent years have also produced a trend of lower inflation and lower interest rates. Lower inflation, on average, suggests a reduction in pricing power with products and services increasingly being perceived by customers as commodities—perfect substitutes in a perfectly competitive market place. The challenge for businesses is to create the impression, if not the reality, of product differentiation—imperfect substitutes in a monopolistically competitive environment. For example, in financial services, are the services offered significantly different to justify a pricing for service model or are all the benefits of a financial service firm generated at the back-end by reducing back office recordkeeping costs?

The Illusory Correlation

A third decision-making stumbling block is the illusory correlation. This idea, which is particularly popular when many decision-makers are scrambling for simplistic explanations in a very complex environment, is the leap from observing one economic trend and then using that trend as an explanation of another trend without any intervening theory. Certainly odd events happen and there is a tendency to ascribe cause-effect to situations where no real link exists. This illusion is particularly prevalent among financial commentators.

It is also true among decision makers at firms or in state governments who ascribe changes to individual decisions. In fact national or global trends are the real culprits. U.S. presidents and corporate head are credited or blamed for every advance or decline on their watch while trends occur totally outside their control.

In the early years of the post World War II period, some analysts asserted that the economic success of the Soviet Union validated their economic model. In fact, the correlation of economic growth and with the Soviet model was purely coincidence. The Soviet Union was living off the resource transfers from other nations and countries that it had conquered with little regard to the long run consequences. It had the incentives within its economic framework that would insure continued success over the long run. In economic studies, the appearance of success in the short-run may hide underlying problems and those countries, states and companies may be living off past success with little provision for the future. Flash-in-the pan success in the short-run, may give the appearance of a new economic model but often that success is illusory unless supported by long-run oriented policies.

In economic or business comparisons, Americans are hampered by their anchoring bias dating back to the early post-World War II period. Japan and Germany had been destroyed by war. China, India, and Russia were not trading partners. Brazil and Mexico were run by military juntas. The U.S. had a largely closed economy and little global competition. Yet current public policy makers continue to speak in terms of America’s leadership in many industries—textiles, furniture and consumer electronics—that have become global. In fact, the post-World War II period was an exception in economic leadership with one country—America—holding such a dominant position. The reality is that change is constant and memories of the past are a prescription to failure in most cases.

Sunk Costs

Finally, decision makers’ability to react to cyclical and structural change is hampered by their attachment to sunk costs, which are the costs already put into a project that are past and irreversible and are not altered by the decision to continue ahead or to stop the project. Richard Brealey (Professor at the London Business School) and Stewart Myers (professor at MIT) point out the decision in 1971 whether to continue with Lockheed’s development of the TriStar airplane after $1 billion had already been spent. Lockheed had already spent one billion dollars and was not recoverable whether Lockheed went ahead or not with the project. (Richard A. Brealey and Stewart C. Myers, Principles of Corporate Finance, third edition, McGraw-Hill, 1988, p. 95.) In 1981 Lockheed announced it would stop production of its money-losing L-1011 jetliner. Eventually Lockheed dropped out entirely from commercial airline production. (John Greenwald, Jerry Hannifin/Washington, Joseph J. Kane/Burbank, Catch a Falling TriStar, Time magazine, December 21, 1981.) Overly committed to certain activities, decision makers stick with investments that are quickly losing their value. They are unable to let go of the past and move on to new opportunities. As a result, these investments lose value. Cyclical and secular change, by its nature, means that old investments become sunk costs, and barriers to innovation.

In fact, in many cases decision makers escalate their commitment believing that just a bit more investment will allow them to achieve their goal. (For a real-world example of the sunk cost effect with tragic consequences see Krakauer, J. Into Thin Air: A Personal Account of the Mount Everest Disaster. New York: Anchor Books, 1997.) In public policy, this can be seen in the commitment to retain the scale of many industries through protectionism and subsidies beyond any economic justification. While many U.S. firms in the textile, furniture, steel, auto and consumer electronics industries are globally competitive, government subsidizes these industries on a scale that allows weak companies to persist. They then can sell products at low prices and thereby hamper the ability of competitive firms to earn a profit and reinvest so as to remain globally competitive. Policy focuses on preserving jobs with little regard to workers and their skills. As a result, there are too many workers in old technology fields when these workers must to move into fields where they have a competitive future.

Example abound for both private and public policy decision-makers today. Credit standards are an obvious example of the normalization of deviance whereby credit standards that were questionable in the past now serve as good credit today. As for the illusory correlation, every investor can recite numerous examples of one-time wonders in forecasting the future of stock prices. Sunk costs are exemplified in both the public and private sectors by those continuously failing projects that continue to somehow get financing without ever becoming successful.

As for the current cycle/structural evolution of the economy, each of these decision biases is well represented. For successful investors, the challenge is to recognize our own biases and to better adapt to the constant evolution of the economy. Change in the economy is a process, not an event, and the bias to recognize the old blinds us to what is new.

You Need This Dirty Word, Euro Bonds

John Mauldin — Tue, 16 Aug 2011 01:40:00 GMT

This week's Outside the Box is in the tradition of showing the other side of the argument. Normally, anything George Soros says or does politically has my blood pressure up about 20 points. Yet, I posted another piece of his today in Over My Shoulder – and then ran across this longer piece from Der Spiegel. Note this is from a dedicated Europhile wanting to save the euro. He succintly outlines what must be done if it is to be saved, and does it as well as anyone. (I know that among my readers there are both likers and haters of Soros, but as an observer of markets he is to be respected. And this is an article in which his acumen is in evidence.

I refer you to last week's regular letter (one of my more important ones: http://www.johnmauldin.com/frontlinethoughts/the-beginning-of-the-endgame) and also to the Outside the Box piece I passed on from Michael Lewis, in which he points out that to survive, the rest of Europe must learn to behave more like Germans. This is the great objection of the euro-skeptics, since the rest of Europe does not want to be like Germans. But Soros is right to some extent when he says, "There is simply no alternative. If the euro were to break up, it would cause a banking crisis that would be totally outside the control of the financial authorities. So it would push not only Germany, not only Europe, but also the whole world into conditions very reminiscent of the Great Depression in the 1930s, which was also caused by a banking crisis that was out of control."

We find ourselves in a binary world. Either Europe goes to a fiscal union with the various countries losing control of their budgets, or the Eurozone breaks up. As I recently wrote, we must not underestimate the commitment of the European elites to do whatever it takes to hold their project together. Neither must we underestimate the ability of voters to change their leaders. This is a very volatile situation with far more implications than our subprime problem.

I continue to say that a euro crisis will lead to a recession (or worse) in the US. Attention must be paid. Soros lays out the Euro-elite agenda. I suggest you read.

Your euro-skeptic analyst,

John Mauldin, Editor
Outside the Box

Der Spiegel Interview with George Soros

'You Need This Dirty Word, Euro Bonds'

In a SPIEGEL interview, billionaire investor George Soros criticizes Germany's lack of leadership in the euro zone, arguing that Berlin must dictate to Europe the solution to the currency crisis. He also argues in favor of the creation of euro bonds as a way out of the turbulence.

SPIEGEL: Mr. Soros, we currently see a global banking crisis, a currency crisis and a sovereign debt crisis. Has the financial dilemma become too big to handle? How can politicians on both sides of the Atlantic be expected to solve such a multitude of crises?

Soros: The politicians have not really tried to fix any crisis; they have so far tried only to buy time. But sometimes time actually works against you if you refuse to face the relevant issues and explain to the public what is at stake.

SPIEGEL: Are you talking about the Germans? Many experts think Chancellor Angela Merkel has been particularly hesitant to address the euro crisis.

Soros: Yes. The future of the euro depends on Germany. This is the point I really want to drive home. Germany is in the driver's seat because it is the largest country in Europe with the best credit rating and a chronic surplus. In a crisis, the creditor always calls the shots. Sure, this is not a position Germany or Chancellor Merkel ever desired and they are understandably reluctant to embrace it. But the fact is that Germans are now in the position of dictating to Europe what the solution to the euro crisis is.

SPIEGEL: Why should Berlin embrace that idea?

Soros: There is simply no alternative. If the euro were to break up, it would cause a banking crisis that would be totally outside the control of the financial authorities. So it would push not only Germany, not only Europe, but also the whole world into conditions very reminiscent of the Great Depression in the 1930s, which was also caused by a banking crisis that was out of control.

SPIEGEL: What, then, needs to be done to fight this crisis?

Soros: I think there is only one choice. It is not a question of whether Europe needs a common currency. The euro exists, and if it were to break apart, all hell would break loose. Germany has to make it work. To make it work, you have got to allow the members of the euro zone to be able to refinance the bulk of their debt on reasonable terms. So you need this dirty word: "euro bonds". But when you study what it involves to have euro bonds, you really have a problem because each European country remains in control of its own fiscal policy, and you have to rely on the country to meet its financial obligations.

SPIEGEL: Germans hate the euro bonds idea. They fear that under this scenario they will ultimately need to bail out everyone, even large nations like Italy.

Soros: That is why you need to establish fiscal rules that will ensure the solvency of every member. This should make the euro bond acceptable to German voters. Europe needs a fiscal authority that has not only financial but also political legitimacy. The difficulty is agreeing on the rules. Unfortunately, Germans have some funny ideas. They want the rest of Europe to follow their example. But what works for Germany can't work for the rest of Europe: No country can run a chronic surplus without others running deficits. Germany must propose rules that other countries can also follow. These rules must allow for a gradual reduction in indebtedness. They must also allow countries with high unemployment, like Spain, to continue running cyclical budget deficits until they recover.

SPIEGEL: More and more economists, especially in Germany, would like to see Greece leave the European Union. Do you consider that to be a viable option?

Soros: I think that the Greek problem has been sufficiently mishandled by the European authorities that this may well be the best solution. Europe, the euro and the financial system could survive Greece leaving. It could survive Portugal leaving. And the remainder would be stronger and more easily managed. But the financial authorities have to arrange for an orderly exit in order for the European banking system to survive it. That will cost money because the European banking system including the European Central Bank has to be indemnified for its losses. Depositors in Greek banks also need to be protected. Otherwise, depositors in Irish or Italian banks will not feel safe.

SPIEGEL: Is the current crisis even worse than the one in 2008?

Soros: This crisis is still the continuation of the same crisis. In 2008, the financial system collapsed and it had to be put on artificial life support. The authorities managed to save the system. But the imbalances that caused the crisis have not been removed.

SPIEGEL: What do you mean?

Soros: The method the authorities rightly chose three years ago was to substitute the credit of the state for the credit in the financial system that collapsed. After the failure of Lehman Brothers, the European financial ministers issued a declaration that no other systemically important financial institutions would be allowed to fail. That was the artificial life support; it was exactly the right decision. But then Chancellor Merkel stated that such support would only be granted by each EU member state individually, and not by the European Union.

SPIEGEL: That undermined the concept of a strong European response to the crisis. Has that been the biggest mistake so far?

Soros: That Merkel statement was the origin of the euro crisis. It shattered the vision that the EU will protect the euro in a joint effort.

SPIEGEL: Where will the current crisis stop? Even France now seems to be threatened by a financial meltdown.

Soros: Of course it is spreading. Markets fear uncertainty. Germany has to realize that it has no alternative but to defend the euro. The longer it takes, the higher the price Germany will have to pay.

SPIEGEL: You have been very critical of how the crisis has been handled by governments. Many European citizens, however, blame speculators like you for their attempts to bring down the euro. Huge hedge funds like yours have waged massive bets against the European currency over the past year. And in recent days, several European countries have even imposed temporary bans on short selling, bets on falling share prices.

Soros: You are confusing markets and speculators. At the moment, the biggest speculators are the central banks because they are the most important buyers and sellers of currencies. Hedge funds have definitely been supplanted by central banks. Markets expect the authorities to produce a financial system that actually holds together. If there is any hole in that system, speculators will rush through that hole.

SPIEGEL: That sounds very noble. But in reality, speculation makes any crisis worse. Look at the credit default swaps (CDS) market where speculators can bet on a further decline of currencies and economies. How can that be helpful?

Soros: Of course, speculation will always make a crisis worse. If there is a weak point, it will expose it. And you are right, the CDS market is a very dangerous instrument and I think it should not be allowed. I am one of the very few people who argue that the CDS is a dangerous instrument because it is so lop-sided in favor of a negative outcome.

'You Can Count on China To Back the Euro'

SPIEGEL: Do you think the European Central Bank is part of the solution or part of the problem when it comes to the dealing with the euro crisis?

Soros: It is part of the solution, but which part? Any central bank should only be in charge of liquidity. Solvency is a matter for the treasury. But because there is no European treasury, the ECB was pushed into that arena. To keep the financial system alive they overstepped their limits, as the former German Bundesbank president Axel Weber pointed out, by discounting the government bonds of a country that was clearly bankrupt.

SPIEGEL: You are referring to the purchase of Greek bonds. Now the European Central Bank even started buying Spanish and Italian bonds. It is not even clear, however, if it is legally allowed to do so.

Soros: Yes, but there is a well-established conviction that the central banks always do what is necessary to keep the system going and then afterwards you then take care of the legal aspects. In a crisis, you simply do not have time to think about such concerns for too long.

SPIEGEL: The United States is drowning in even more debt than Europeans. Its economic recovery has been painful. Are we going to see a double-dip recession in the US?

Soros: The indebtedness of the US is not all that high, but if a double-dip recession was in doubt a few weeks ago, it is less in doubt now, because financial markets have a very safe way of predicting the future. They cause it. And the markets have decided that America is going to see a recession, particularly after the recent downgrade of the US by the rating agency Standard & Poor's.

SPIEGEL: President Barack Obama has been fiercely criticized for his handling of the economy. You were one of his biggest supporters in 2008. Are you happy with his economic policy?

Soros: No, of course not. But the reality is that we have had 25 years of excesses building up in America -- a combustible mix of too much credit and too much leverage. You need a long time to reverse that.

SPIEGEL: Obama tried to stimulate growth with a gigantic stimulus program which increased the national debt further. Was that a mistake?

Soros: Obama embraced the ideas of John Maynard Keynes. Basically, the analysis of Keynes is still very relevant -- with one big difference between now and the 1930s. In the 1930s, governments had practically no debt and could therefore run deficits. Nowadays, all governments are heavily indebted, and that is a big change.

SPIEGEL: If Keynes were still alive, would he adjust his theory?

Soros: Definitely. He would say governments can still benefit from running fiscal deficits, but the new debt has to be invested in a way that will pay for itself. So the money spent would have to increase productivity.

SPIEGEL: The $800 billion stimulus program launched by Obama did not live up to that?

Soros: Obama's stimulus program was not big enough and it was not directed at improving infrastructure nor human capital. So it was not productive enough.

SPIEGEL: And any further stimulus is now basically a non-starter, because the conservative majority in Congress is hell-bent on preventing it.

Soros: That is what is pushing the world towards another recession, into a double dip.

SPIEGEL: The Republicans are doing that?

Soros: Yes, but Obama is also at fault. He yielded the agenda to the Republicans. He is talking their language. The president would have to show leadership to counter the Republican wave, and so far he has not done so.

SPIEGEL: Do you think the US deserved the recent downgrade by Standard & Poor's?

Soros: Probably not. This decision was the attempt by the rating agencies to reinvent themselves as anticipating rather than responding to changes that have occurred. So they are really basing that downgrade on the expectation that the political process will not provide the solution. Judging such political developments is a very new role for the rating agencies, though.

SPIEGEL: As an investor, do you listen to the rating agencies?

Soros: Well, I do not, but many other investors do.

SPIEGEL: The credit rating agencies are accused of exacerbating the crisis. Do you think the role of the rating agencies in the financial system needs to be scaled back?

Soros: I do not have an answer to that.

SPIEGEL: There are no alternatives.

Soros: Frankly. It is an unsolved problem in my mind

SPIEGEL: As an investor, would you still bet on the euro?

Soros: I certainly would not short the euro because China has an interest in having an alternative to the dollar. You can count on China to back the efforts of the European authorities to maintain the euro.

SPIEGEL: Is that the reason why the euro is still so strong compared to the dollar?

Soros: Yes. There is a mysterious buyer that keeps propping up the euro.

SPIEGEL: And it is not you.

Soros: It is not me (laughs).

SPIEGEL: In the end, will China be the only winner in this crisis?

Soros: China, of course, has been the great winner of globalization, and if globalization collapses, the Chinese will also be among the losers. So they have a strong interest in preserving the current global system. However, in some ways, they have been just as reluctant to accept it as the Germans. Germans have been hesitant to accept responsibility for Europe, and the Chinese have been hesitant to accept responsibility for the world. But they are both being pushed into it.

SPIEGEL: Mr. Soros, we thank you for this interview.

Interview conducted by Gregor Peter Schmitz and Thomas Schulz

Germany's Choice: Part 2

John Mauldin — Thu, 28 Jul 2011 04:13:00 GMT

For today's special-edition OTB, let's turn our fiscal eye across the pond to all that's going haywire in Europe. But not the continent's banking crisis, per se. Today's piece takes a broad look at who's really running the show. I'll give you a hint: they've done it before, and it wasn't too long ago. The folks at STRATFOR (a global intelligence publication) have spent the better part of two years saying that Germany will run Europe. The newly redesigned EFSF (European Financial Security Facility) can be considered concrete evidence of such.

From Berlin's point of view, the Eurozone is its sphere of influence, and its preservation is in Germany's national security interest. It's a new Europe, where Germany is not just the checkbook anymore, but holds some reins.

I'm sure you'll find this piece as thought-provoking as I did. Investors are always talking about geopolitical risk (but you and I talked about it first here); and if you're looking for geopolitical analysis and forecasting, I highly recommend you check out STRATFOR. OTB readers can get a hefty discount on a STRATFOR subscription, plus a free copy of (warning: more self-promotion) my book Endgame.

Your now craving schnitzel analyst,

John Mauldin, Editor
Outside the Box

Germany's Choice: Part 2

July 26, 2011

Three Competing Theories

John Mauldin — Tue, 19 Jul 2011 02:28:00 GMT

Long-time readers are familiar with the wisdom of Lacy Hunt. He is a regular feature of Outside the Box. He writes a quarterly piece for Hoisington Asset Management in Austin, and this is one of his better ones. Read it twice.

“While the massive budget deficits and the buildup of federal debt, if not addressed, may someday result in a substantial increase in interest rates, that day is not at hand. The U.S. economy is too fragile to sustain higher interest rates except for interim, transitory periods that have been recurring in recent years. As it stands, deflation is our largest concern …”

As I write, Europe is starting to unravel. This is going to be much worse than 2008, at least as far as Europe is concerned, and odds are high that it will be very bad for the US. And the markets are still acting as if the problems in Europe can be resolved. The recent bank stress tests were a joke, as they assumed no Greek or Irish defaults. This simply can’t be. There is a banking crisis of massive proportions in our future.

As Lacy notes, we are testing the economic theories of three (I think von Mises should be added) dead white guys. The dominant theories are being shown to be wrong. The sooner we acknowledge that the better. But don’t hold your breath waiting for the major economic schools to come to grips with their failure.

This is a real problem, and there is just no way to avoid it. I wish I had more positive things to say.

Your trying to figure this out analyst,

John Mauldin, Editor
Outside the Box

Three Competing Theories

By Lacy Hunt, Hoisington Asset Management

The three competing theories for economic contractions are: 1) the Keynesian, 2) the Friedmanite, and 3) the Fisherian. The Keynesian view is that normal economic contractions are caused by an insufficiency of aggregate demand (or total spending). This problem is to be solved by deficit spending. The Friedmanite view, one shared by our current Federal Reserve Chairman, is that protracted economic slumps are also caused by an insufficiency of aggregate demand, but are preventable or ameliorated by increasing the money stock. Both economic theories are consistent with the widely-held view that the economy experiences three to seven years of growth, followed by one to two years of decline. The slumps are worrisome, but not too daunting since two years lapse fairly quickly and then the economy is off to the races again. This normal business cycle framework has been the standard since World War II until now.

The Fisherian theory is that an excessive buildup of debt relative to GDP is the key factor in causing major contractions, as opposed to the typical business cycle slumps (Chart 1). Only a time consuming and difficult process of deleveraging corrects this economic circumstance. Symptoms of the excessive indebtedness are: weakness in aggregate demand; slow money growth; falling velocity; sustained underperformance of the labor markets; low levels of confidence; and possibly even a decline in the birth rate and household formation. In other words, the normal business cycle models of the Keynesian and Friedmanite theories are overwhelmed in such extreme, overindebted situations.

Economists are aware of Fisher’s views, but until the onset of the present economic circumstances they have been largely ignored, even though Friedman called Irving Fisher “America’s greatest economist.” Part of that oversight results from the fact that Fisher’s position was not spelled out in one complete work. The bulk of his ideas are reflected in an article and book written in 1933, but he made important revisions in a series of letters later written to FDR, which currently reside in the Presidential Library at Hyde Park. In 1933, Fisher held out some hope that fiscal policy might be helpful in dealing with excessive debt, but within several years he had completely rejected the Keynesian view. By 1940, Fisher had firmly stated to FDR in several letters that government spending of borrowed funds was counterproductive to stimulating economic growth. Significantly, by 2011, Fisher’s seven decade-old ideas have been supported by thorough, comprehensive and robust econometric and empirical analysis. It is now evident that the actions of monetary and fiscal authorities since 2008 have made economic conditions worse, just as Fisher suggested. In other words, we are painfully re-learning a lesson that a truly great economist gave us a road map to avoid.

High Dollar Policy Failures

If governmental financial transactions, advocated by following Keynesian and Friedmanite policies, were the keys to prosperity, the U.S. should be in an unparalleled boom. For instance, on the monetary side, since 2007 excess reserves of depository institutions have increased from $1.8 billion to more than $1.5 trillion, an amazing gain of more than 83,000%. The fiscal response is equally unparalleled. Combining 2009, 2010, and 2011 the U.S. budget deficit will total 28.3% of GDP, the highest three year total since World War II, and up from 6.3% of GDP in the three years ending 2008 (Chart 2). Importantly, the massive advance in the deficit was primarily due to a surge in outlays that was more than double the fall in revenues. In the current three years, spending was an astounding $2.2 trillion more than in the three years ending 2008. The fiscal and monetary actions combined have had no meaningful impact on improving the standard of living of the average American family (Chart 3).

Why Has Fiscal Policy Failed?

Four considerations, all drawn from contemporary economic analysis, explain the underlying cause of the fiscal policy failures and clearly show that continuing to repeat such programs will generate even more unsatisfactory results.

First, the government expenditure multiplier is zero, and quite possibly slightly negative. Depending on the initial conditions, deficit spending can increase economic activity, but only for a mere three to five quarters. Within twelve quarters these early gains are fully reversed. Thus, if the economy starts with $15 trillion in GDP and deficit spending is increased, then it will end with $15 trillion of GDP within three years. Reflecting the deficit spending, the government sector takes over a larger share of economic activity, reducing the private sector share while saddling the same-sized economy with a higher level of indebtedness. However, the resources to cover the interest expense associated with the rise in debt must be generated from a diminished private sector.

The problem is not the size or the timing of the actions, but the inherent flaws in the approach. Indeed, rigorous, independently produced statistical studies by Robert Barro of Harvard University in the United States and Roberto Perotti of Universita Bocconi in Italy were uncannily accurate in suggesting the path of failure that these programs would take. From 1955 to 2006, Dr. Barro estimates the expenditure multiplier at -0.1 (p. 206 Macroeconomics: A Modern Approach, Southwestern 2009). Perotti, a MIT Ph.D., found a low but positive multiplier in the U.S., U.K., Japan, Germany, Australia and Canada. Worsening the problem, most of those who took college economic courses assume that propositions learned decades ago are still valid. Unfortunately, new tests and the availability of more and longer streams of macroeconomic statistics have rendered many of the well-schooled propositions of the past five decades invalid.Second, temporary tax cuts enlarge budget deficits but they do not change behavior, providing no meaningful boost to economic activity. Transitory tax cuts have been enacted under Presidents Ford, Carter, Bush (41), Bush (43), and Obama. No meaningful difference in the outcome was observable, regardless of whether transitory tax cuts were in the form of rebate checks, earned income tax credits, or short-term changes in tax rates like the one year reduction in FICA taxes or the two year extension of the 2001/2003 tax cuts, both of which are currently in effect. Long run studies of consumer spending habits (the consumption function in academic circles), as well as detailed examinations of these separate episodes indicate that such efforts are a waste of borrowed funds. This is because while consumers will respond strongly to permanent or sustained increases in income, the response to transitory gains is insignificant. The cut in FICA taxes appears to have been a futile effort since there was no acceleration in economic growth, and the unfunded liabilities in the Social Security system are now even greater. Cutting payroll taxes for a year, as former Treasury Secretary Larry Summers advocates, would be no more successful, while further adding to the unfunded Social Security liability.

Third, when private sector tax rates are changed permanently behavior is altered, and according to the best evidence available, the response of the private sector is quite large. For permanent tax changes, the tax multiplier is between minus 2 and minus 3. If higher taxes are used to redress the deficit because of the seemingly rational need to have“shared sacrifice,” growth will be impaired even further. Thus, attempting to reduce the budget deficit by hiking marginal tax rates will be counterproductive since economic activity will deteriorate and revenues will be lost.

Fourth, existing programs suggest that more of the federal budget will go for basic income maintenance and interest expense; therefore the government expenditure multiplier may become more negative. Positive multiplier expenditures such as military hardware, space exploration and infrastructure programs will all become a smaller part of future budgets. Even the multiplier of such meritorious programs may be much less than anticipated since the expended funds for such programs have to come from somewhere, and it is never possible to identify precisely what private sector program will be sacrificed so that more funds would be available for federal spending. Clearly, some programs like the first-time home buyers program and cash for clunkers had highly negative side effects. Both programs only further exacerbated the problems in the auto and housing markets.

Permanent Fiscal Solutions Versus Quick Fixes

While the fiscal steps have been debilitating, new programs could improve business considerably over time. A federal tax code with rates of 15%, 20%, and 25% for both the household and corporate sectors, but without deductions, would serve several worthwhile purposes. Such measures would be revenue neutral, but at the same time they would lower the marginal tax rates permanently which, over time, would provide a considerable boost for economic growth. Moreover, the private sector would save $400-$500 billion of tax preparation expenses that could then be channeled to other uses. Admittedly, the path to such changes would entail a long and difficult political debate.

In the 2011 IMF working paper, “An Analysis of U.S. Fiscal and Generational Imbalances,” authored by Nicoletta Batini, Giovanni Callegari, and Julia Guerreiro, the options to correct the problem are identified thoroughly. These authors enumerate the ways to close the gaps under different scenarios in what they call “Menu of Pain.” Rather than lacking the knowledge to improve the economic situation, there may not be the political will to deal with the problems because of their enormity and the huge numbers of Americans who would be required to share in the sacrifices. If this assessment is correct, the U.S. government will not act until a major emergency arises.

The Debt Bomb

The two major U.S. government debt to GDP statistics commonly referred to in budget discussions are shown in Chart 4. The first is the ratio of U.S. debt held by the public to GDP, which excludes federal debt held in various government entities such as Social Security and the Federal Reserve banks. The second is the ratio of gross U.S. debt to GDP. Historically, the debt held by the public ratio was the more useful, but now the gross debt ratio is more relevant. By 2015, according to the CBO, debt held by the public will jump to more than 75% of GDP, while gross debt will exceed 104% of GDP. The CBO figures may be too optimistic. The IMF estimates that gross debt will amount to 110% of GDP by 2015, and others have even higher numbers. The gross debt ratio, however, does not capture the magnitude of the approaching problem.

According to a recent report in USA Today, the unfunded liabilities in the Social Security and Medicare programs now total $59.1 trillion. This amounts to almost four times current GDP. Modern accrual accounting requires corporations to record expenses at the time the liability is incurred, even when payment will be made later. But this is not the case for the federal government. By modern private sector accounting standards, gross federal debt is already 500% of GDP.

Federal Debt – the End Game

Economic research on U.S. Treasury credit worthiness is of significant interest to Hoisington Management because it is possible that if nothing is politically accomplished in reducing our long-term debt liabilities, a large risk premium could be established in Treasury securities. It is not possible to predict whether this will occur in five years, twenty years, or longer. However, John H. Cochrane of the University of Chicago, and currently President of the American Finance Association, spells out the end game if the deficits and debt are not contained. Dr. Cochrane observes that real, or inflation adjusted Federal government debt, plus the liabilities of the Federal Reserve (which are just another form of federal debt) must be equal to the present value of future government surpluses (Table 1). In plain language, you owe a certain amount of money so your income in the future should equal that figure on a present value basis. Federal Reserve liabilities are also known as high powered money (the sum of deposits at the Federal Reserve banks plus currency in circulation). This proposition is critical because it means that when the Fed buys government securities it has merely substituted one type of federal debt for another. In quantitative easing (QE), the Fed purchases Treasury securities with an average maturity of about four years and replaces it with federal obligations with zero maturity. Federal Reserve deposits and currency are due on demand, and as economists say, they are zero maturity money. Thus, QE shortens the maturity of the federal debt but, as Dr. Cochrane points out, the operation has merely substituted one type for another. The sum of the two different types of liabilities must equal the present value of future governmental surpluses since both the Treasury and Fed are components of the federal government.

Calculating the present value of the stream of future surpluses requires federal outlays and expenditures and the discount rate at which the dollar value of that stream is expressed in today’s real dollars. The formula where all future liabilities must equal future surpluses must always hold. At the point that investors lose confidence in the dollar stream of future surpluses, the interest rate, or discount rate on that stream, will soar in order to keep the present value equation in balance. The surge in the discount rate is likely to result in a severe crisis like those that occurred in the past and that currently exist in Europe. In such a crisis the U.S. will be forced to make extremely difficult decisions in a very short period of time, possibly without much input from the political will of American citizens. Dr. Cochrane does not believe this point is at hand, and observes that Japan has avoided this day of reckoning for two decades. The U.S. may also be able to avoid this, but not if the deficits and debt problem are not corrected. Our interpretation of Dr. Cochrane’s analysis is that, although the U.S. has time, not to urgently redress these imbalances is irresponsible and begs for an eventual crisis.

Monetary Policy’s Numerous Misadventures

Fed policy has aggravated, rather than ameliorated our basic problems because it has encouraged an unwise and debilitating buildup of debt, while also pursuing short term policies that have increased inflation, weakened economic growth, and decreased the standard of living. No objective evidence exists that QE has improved economic conditions. Even before the Japanese earthquake and weather related problems arose this spring, real economic growth was worse than prior to QE2. Some measures of nominal activity improved, but these gains were more than eroded by the higher commodity inflation. Clearly, the median standard of living has deteriorated.

When the Fed diverts attention with QE, it is possible to lose sight of the important deficit spending, tax and regulatory barriers that are restraining the economy’s ability to grow. Raising expectations that Fed actions can make things better is a disservice since these hopes are bound to be dashed. There is ample evidence that such a treadmill serves to make consumers even more cynical and depressed. To quote Dr. Cochrane, “Mostly, it is dangerous for the Fed to claim immense power, and for us to trust that power when it is basically helpless. If Bernanke had admitted to Congress, ‘There’s nothing the Fed can do. You’d better clean this mess up fast,’ he might have a much more salutary effect.” Instead, Bernanke wrote newspaper editorials, gave speeches, and appeared on national television taking credit for improved economic conditions. In all instances these claims about the Fed’s power were greatly exaggerated.

Summary and Outlook

In the broadest sense, monetary and fiscal policies have failed because government financial transactions are not the key to prosperity. Instead, the economic well-being of a country is determined by the creativity, inventiveness and hard work of its households and individuals.

A meaningful risk exists that the economy could turn down prior to the general election in 2012, even though this would be highly unusual for presidential election years. The econometric studies that indicate the government expenditure multiplier is zero are evidenced by the prevailing, dismal business conditions. In essence, the massive federal budget deficits have not produced economic gain, but have left the country with a massively inflated level of debt and the prospect of higher interest expense for decades to come. This will be the case even if interest rates remain extremely low for the foreseeable future. The flow of state and local tax revenues will be unreliable in an environment of weak labor markets that will produce little opportunity for full time employment. Thus, state and local governments will continue to constrain the pace of economic expansion. Unemployment will remain unacceptably high and further increases should not be ruled out. The weak labor markets could in turn force home prices lower, another problematic development in current circumstances. Inflationary forces should turn tranquil, thereby contributing to an elongated period of low bond yields. The Fed may resort to another round of quantitative easing, or some other untested gimmick with a new name. Such undertakings will be no more successful than previous efforts that increased over-indebtedness or raised transitory inflation, which in turn weakened the economy by directly, or indirectly, intensifying financial pressures on households of modest and moderate means.

While the massive budget deficits and the buildup of federal debt, if not addressed, may someday result in a substantial increase in interest rates, that day is not at hand. The U.S. economy is too fragile to sustain higher interest rates except for interim, transitory periods that have been recurring in recent years. As it stands, deflation is our largest concern, therefore we remain fully committed to the long end of the Treasury bond market.

China Security Memo: Looking into 'Reverse Mergers' on Wall Street

John Mauldin — Thu, 14 Jul 2011 17:51:00 GMT

The saying goes that you can learn something new every day. If you're paying attention that is - and more importantly if you know where to look. Today I was getting my morning fill of geopolitical intel from my friends over at STRATFOR (on everything from personal security to country economic profiles) and stumbled onto their weekly China Security Memo, this particular edition on Looking into Reverse Mergers on Wall Street. Is this another head-scratcher in the less-than-conventional foreign policy coming from China or a regulatory end-around by some enterprising Chinese companies? Take a few minutes to read this report, which also goes through everything that happened in China this week that matters.

This article discusses the SEC's ongoing investigation of the "reverse mergers" where questionable Chinese auditing allowed companies to list on U.S. stock exchanges despite their fraudulent accounts. The report is a superb example of the detail and insight STRATFOR gives its customers. If you're into the idea of learning something new on a daily basis (the desire grows with age, I believe...) you'll enjoy learning about the current state of Chinese regulations (or lack thereof) for companies that list on US stock markets, State-Owned Enterprises (SOEs) that compete with American businesses, recent bank robberies, tensions with the Catholic church, and bottled water contaminated with E.coli. In other words, you'll definitely meet your novel knowledge quota for the day, all while getting the deepest insight on the security situation in China.

And if you're interested in getting more than just an occasional note and article from me every now and then, I've procured a nice discount of 63% on a STRATFOR subscription. It's one of the smartest sources I read every morning - a great investment, in my humble opinion.

John Mauldin, Editor
Outside the Box

China Security Memo: Looking into 'Reverse Mergers' on Wall Street

July 13, 2011

What is a Trade Secret Now?

Members of the U.S. Securities and Exchange Commission and the U.S. Public Company Accounting Oversight Board (PCAOB) went to Beijing for meetings July 11-12 with the Chinese Ministry of Finance and the China Securities Regulatory Commission. The meetings were prompted by a series of accounting scandals that involved Chinese companies being listed on U.S. stock exchanges through “reverse mergers.” This is a process in which companies enter an American exchange not by an initial public offering but by acquiring a shell company that is already publicly traded on the exchange.

The United States allows foreign companies to gain access to its markets if approved by foreign auditors, and the PCAOB is responsible for accrediting the foreign auditors. But if the auditors fail to perform due diligence they can allow fraudulent accounting to affect American markets — hence the need for the PCAOB to conduct investigations abroad.

For years the Chinese government has rejected American appeals to investigate 110 Chinese auditing companies on the basis of preserving its sovereignty over China’s business practices. The latest scandals have resulted in the U.S. suspension of 24 Chinese-listed companies that had already been reviewed by the approved auditing companies. This has had a significant impact on the markets, so there is renewed market pressure for U.S. authorities to gain access to Chinese books. STRATFOR sources say the most recent round of negotiations was preliminary and that it will be a long time before the two countries agree on a solution, such as raising standards for accreditation or allowing joint U.S.-China inspections on Chinese soil.

Chinese auditors have reportedly denied giving American investigators access to their books, claiming that to do so would be to violate China’s state-secrets law. STRATFOR sources believe this reference to the state-secrets law is a smokescreen for firms that do not want to provide transparency or cooperate with American authorities. Therefore, entirely aside from the stock scandals and financial regulatory negotiations, this incident has again brought up the issue of China’s state-secrets laws.

The question comes down to whether auditors in China can legally be allowed to give information to U.S. regulators or whether such information can be designated as state secrets. The current state-secrets law, which was updated in 2010, theoretically gives the Chinese government less flexibility in prosecuting such cases, but it does not make it impossible. The reality is that taking action under the new law — trying to prosecute a case — is the only way to assess how the new law will be interpreted.

One criterion for information to qualify as a state secret would have to be whether it is related in any way to state-owned enterprises (SOEs). The rules set in April 2010 by China’s State-Owned Assets Supervision and Administration Commission (SASAC), which manages SOEs, and the state secrets law that went into effect in October 2010 provided some clarity on this issue. Any commercial information from “central enterprises,” which are identified as 120 companies overseen by the SASAC, could be considered a state secret. None of the Chinese companies that have been publically identified so far in the recent accounting scandals is an SOE, so information on these companies is not clearly defined as state secrets. But if any of the companies being audited has major business dealings with SOEs, or if SOEs are stakeholders in these companies, such information could be so defined.

Another criterion would be whether the information is related to any “strategic sectors” defined by Beijing or whether it would be in the interest of national security. This is the part of the law that gives Beijing flexibility, and any information relevant to the U.S. investigation could be considered a state secret. An example of this would be the prosecution of Xue Feng, who collected public information on oil reserves, which relate to an industry classified as a strategic sector. This also ignores the whole concept of commercial secrets, which could more clearly be applied to the companies in question. While not as serious as a state secrets prosecution, commercial secrets are also protected under Chinese law, a charge Stern Hu also faced, but was not convicted of, in the 2009 Rio Tinto scandal.

The redefinition of SASAC rules and the new state-secrets law came after Hu’s case, in which he was originally accused but not prosecuted for violating the previous law. The new law broadened the potential classification for information related to state-owned companies but not private ones. If what Chinese authorities consider important auditing information is exposed during the U.S. investigation, they may use the same tactics they used in the Hu case. Chinese authorities have created a culture of fear around the issue, making it difficult to move forward with proper due diligence for fear of prosecution.

The problem faced by Chinese companies, and more broadly the Chinese government, is this: To be listed on U.S. stock exchanges, Chinese companies have to make their financial information public. The companies and their Chinese auditors may be trying to hide behind the threat of state-secrets prosecution in order to hide their own problems. The Ministry of Finance may also be bringing up the importance of “national economic information,” as Reuters reported July 6, to deter Chinese companies and auditors from revealing too much.

In the end, Beijing may decide that the release of information by the Chinese companies being investigated could reveal state secrets and threaten national security. However it chooses to handle the situation will be telling. If the Chinese government prosecutes auditors for handing over their books, the message will be clear: China’s state-secrets law is incompatible with American expectations regarding foreign access to U.S. equity markets. If no auditors hand over their books, it will reinforce the assumption that they are using their fears to hide fraudulent accounting.

(click here to view interactive map)

July 6

The Nanjing Public Security Bureau announced it was looking for two suspects in a local robbery in Jiangsu province. The two suspects followed a woman after she withdrew 500,000 yuan (about $77,000) from a China Merchants Bank branch in Gulou district and stole her bag. They dropped the bag as they were being chased by the woman and bystanders.
A man was arrested in Taixing, Jiangsu province, after falsely claiming there was an explosive device on a subway car in Shanghai. The man was arguing with a real estate broker when he shouted, “There is a bomb on the train,” indicated the broker was carrying it and escaped in the rush of passengers getting off the train. He was tracked down and arrested that day.
An accountant and her husband were sentenced to death and life imprisonment, respectively, for embezzling 70 million yuan (about $10.8 million) of public funds from Jiangxi Guixi Electric Co. in Yingtan, Jiangxi province.
Three gunmen in Cangshan, Shandong province, attacked 200 villagers staging a protest over a demolition dispute. The police issued a warrant for the gunmen’s arrest.
A spokesman for the Higher People’s Court of Yunnan province in Kunming city announced that a convicted murderer and rapist could be retried after a public outcry over his sentencing. He was originally sentenced to death, but after an appeal he received a two-year reprieve.

July 7

The Beijing Public Security Bureau announced it had detained a man for sending phishing messages through the microblogging service Sina Weibo that automatically made any receiver of the messages a follower of his microblog when they clicked on a link and forwarded the messages to other users.
Hong-Kong based media outlet Mingpao reported that thousands of people protested water shortages July 5 in Chongqing during a heat wave in the area. Three protestors said they had drinking water only from 2 a.m. to 6 a.m. each day.
The Beijing Transport Commission said that all 1,331 escalators and elevators used in the city’s subway system had been checked for faults. The announcement followed an accident when an escalator reversed direction and the resulting crush of people killed a 13-year-old boy.

July 8

China’s Ministry of Land and Resources announced that 73 officials from city- and county-level posts were recently punished for illegal use of agricultural land for development purposes. The officials received warnings and demotions.
Beijing authorities halted the sale of 31 brands of filtered water after it failed safety tests. The water, commonly used in water coolers, was found to have high levels of bacteria, including E. coli.
Su Jinsheng, the former chief engineer of the Ministry of Industry and Information Technology, was fired from his job and expelled from the Communist Party for corruption, the Ministry announced.
A former Hunan Provincial People’s Congress deputy was sentenced to 20 years in prison in Xiangtan, Hunan province, for involvement in organized crime. The man, also the general manager of real estate development company Hunan Zhongyi Group, was convicted of organizing rape, assault, racketeering, illegal imprisonment and gun smuggling.

July 10

AsiaNews reported that three Catholic bishops in China loyal to the Vatican were recently detained in the cities of Jiangmen, Meizhou and Zhanjiang, all in Guangdong province. Another bishop from Guangzhou, in Guangdong province, is missing. The four bishops may have refused to participate in the ordination of Haung Binzhang, which they were scheduled to attend July 14 in Shantou. Tensions have been high between the Catholic Church and the Chinese government following the ordination of a Chinese bishop in November 2010 without the permission of the Vatican, which excommunicated him in May 2011.

July 11

Journalist Qi Chonghuai was convicted of extortion and blackmail and sentenced to eight years in prison after completing a four-year sentence in Tengzhou, Shandong province, on the same charges. Qi reported various instances of corruption, unemployment, labor violations and illegal demolitions. Authorities say he took hush money not to report certain illegal acts, but his wife claims that he was forced to accept the money. She attempted to commit suicide by jumping off of a bridge after the second sentence was announced.

July 12

Zhang Chunjiang, the former deputy manager of China Mobile, went on trial in Cangzhou, Hebei province. Zhang has been under investigation for bribery since before January 2010, when he was removed from his post.
A court in Zengcheng, Guangdong province, sentenced six people to prison terms for their involvement in protests over three days in June. The longest sentence, three and a half years, was given to Li Zhonghuang for leading a group that threw rocks at police and set their vehicles on fire. Others were sentenced to prison terms ranging from nine months to two years for engaging in violence during the protests.
Radio Free Asia reported that Urumqi police intercepted 13 to 15 Uighurs who were bringing leaflets to the city from Aksu July 1 calling for the independence of Xinjiang. The leaflets have reportedly already been circulating in Aksu, where police are said to be at a higher level of alert.

Economic & Copper Advisory Services: Economic Report – June 2011

John Mauldin — Tue, 21 Jun 2011 06:02:00 GMT

This week’s Outside the Box is from one of the more interesting thinkers and observers of the markets I know, Simon Hunt. When we get together in London, conversations are lively, as we don’t always see eye to eye; but we can always discuss, in a very civil manner, the affairs of the world. This particular piece is wide-ranging and thought-provoking. Simon is always ready to apply actual times to his predictions, and he has held steady on them for years.

It is late here in Geneva and I have to get up early for a speech. A big thanks to Hervig von Hove of Notz Stucki for hosting one of the more stimulating dinners with 16 people I have enjoyed in a long time, at his home out in the country, on a perfect night. I will probably make the discussion there the topic of this week’s letter. Charles Gave was in rare form. The Swiss gnomes were so very fascinating, and we had such an international table. These are the nights I wish my 1 million closest friends (a few of whom were there) could listen in on. More to come on Friday!

Your living for these moments analyst,

John Mauldin, Editor
Outside the Box

Economic & Copper Advisory Services: Economic Report – June 2011

Simon Hunt

The global economy is facing a difficult period. The US Federal Reserve’s QE2 program ends at the end of the month. Europe’s debt issues continue to roll on as no party wants to pull the plug on Greece. The Middle East is in turmoil and high oil prices, together with food, are a tax on global consumers. Japan’s reconstruction has yet to get into full gear; and there are new concerns about the durability of China’s economy. Any significant slowdown there will send ripples of fear around the world.

The Federal Reserve is likely to sit pat for some months to see how the US economy will be able to perform without the steroids provided by them. Foreign central banks have largely been absent from Treasury auctions. In quarter 1 this year, foreign central banks bought just 16% of the issuances while the Federal Reserve acquired almost 200%, according to Russell Napier. In other words, the Fed’s activities have masked the exodus of foreign central banks including China from these auctions.

If foreign central banks continue to abstain from purchasing US Treasuries, the private sector will have to fund the fiscal deficit, implying quarterly remittances to the US Treasury of some $370bn. The private sector will be able to fund these auctions but at a price. They will demand a higher return on treasury paper and the funding will mean that the free-flow of funds into equity and commodities will come to an end. Many institutions are taking risk off the table.

On our associate’s, WaveTrack International technical work, 10-year US Treasuries should be yielding around 4% later this summer and 6% a year or so later. The repercussions of such a change in the yield structure will have global consequences, not least on stock and commodity markets.

Debt has woven a dangerous spider’s web in Europe. The basic truth is that Greece can never repay its debt; the ECB, the IMF and Euro governments are merely buying time by granting new loans, hoping that the problem goes away. Future stability, however, does not depend on what these institutions and governments do, but on how the electorates will react. In their view, austerity can be accepted only on a one or two year view, not as an ongoing way of life.

This is especially true of Greece whose national pride will find the sale of assets to foreigners wholly unacceptable. The same is true in other debt-laden Euro countries. All, apart from Italy, have seen their economies contract significantly over the past two years with little hope of any imminent improvement. The next major move could emanate from Ireland; the Irish government wants to renegotiate its ECB and other loans.

In fact, nearly all the conventional forward looking indicators (PMIs, OECD leading indicators etc.) are suggesting that global growth is slowing and rolling over. The US ISM data for May was universally awful with every component from New Orders to Imports down significantly. This is a view shared by industry mills we talk to and visit regularly.

The USA does not only have a cyclical problem, but a structural one also. The fundamental issue is that sooner rather than later government will be forced to introduce measures that will allow the country to live within its means. It will take a deep crisis before such policies can be put together and passed by the country’s politicians. For instance, a run on the US dollar sometime next year or early in 2013 might do the trick.

Unemployment amongst teenagers has become a serious structural and social problem for the USA in an economy that is becoming dominated by skilled workers. The number of unemployed teenagers (16-19) now totals almost one in four. However, the number of African-American, not seasonally adjusted U-3 unemployment, including both sexes, in the same age group has risen to a stunning 41%, almost every other teenager.

Once Washington puts its act together, (it will have to or else the crisis will get so deep that US markets will become dysfunctional), America will find a large number of companies which had vacated the shores of the USA for China and other parts of Asia returning to their homeland.

There are two main reasons for this change, what we call reverse globalisation. First, manufacturers want their supply chains located close to the market, not on the other side of the world. And second just as important is the cost differential trend which is narrowing together with the increasing logistical costs. It is not only the wage profile looking 10 years forward, but the other costs, such as land, electricity, taxes together with the indirect supply chain cost increases. There is also the reluctance of the system in China to allow foreign companies to gain access to government contracts.

Within a decade, the USA could supplant China as the manufacturing hub of the world. To repeat, big changes will be needed in Washington for this historic development to occur. The changes will not just be on the fiscal side, but the need to offer businesses the right incentives to produce in the USA rather than abroad, the permitting procedures to allow the development of the country’s resources, including oil (the USA could become self-contained), making government less intrusive in households and businesses and so on.

In short, it is putting back in place the principals that made America the great country it once was. Crises produce opportunities and this one is as big as they have been since the USA entered WW11. What is noteworthy is that should America grab its opportunity, it will become self-contained in energy and of course food. What other major power has those valuable twin assets?

China and the rest of Asia are no exception to this slowing economic trend. In the former, government’s focus on CPI inflation and the housing market together with its concerns on the degree of speculative or hot money circulating within the economy will almost ensure that the tight monetary policy will continue for some months yet. In these circumstances, further hikes in interest rates and Reserve Requirements are likely to be seen before the end of the year.

Chart 1: Shanghai Composite Index

Such a scenario fits the political cycle. Some of the country’s excesses can be cleaned out by end 2011, much to the delight of the incoming leadership, whilst monetary policy remains tight. The chief economist of the State Information Centre, who is well regarded in Beijing, said at a recent conference in Shanghai that “China has a serious inflation”. He concluded his speech by saying that China had to endure some short term pain for the longer term benefit of the economy. Early in 2012, monetary policy will start to be loosened and should continue to do so throughout that year. The economy should recover so allowing the outgoing leadership to depart on a high note. Post 2012, we guess that the incoming leadership will want to put the economy on a firmer long-term footing, meaning more tightening. This may well coincide with the real estate sector seeing major falls in prices and, externally, the global economy starting to suffer from the breakout of its second global credit crisis. Oil prices in the $150-200 will be a disaster for China as one senior government economist said to us. China may well go through two odd years of real recession in 2013-14 years, in our view. The impact of an effective recession in China on the rest of the world will be serious and widespread.

Chart 2: The Demographics of the Middle East

Some of the underlying causes for MENA countries’ youth to rebel against their autocratic governments are common with China. The youth in these countries don’t care about democracy or who governs: they want freedom of expression, for governments to uphold their rights and the right to work. It is why Beijing has become so sensitive to the Jasmine movement and ongoing developments in MENA. Workers’ protests appear to be on the rise. The ability to communicate via computers and mobile phones (Facebook etc.) increasingly makes government powerless to control the flow of information.

As the Financial Times wrote on 20th July, “the perception that local protests might be gaining a broader national coherence is deeply threatening to China’s Communist Party....That is the conclusion of the government itself. A report by the State Council Development Research Centre blamed protests on the marginalisation of about 150M migrant workers...

Graph 1: Global Food Prices

Global food prices have risen by 37% in the past year according to the FAO. It was higher food prices plus the high level of unemployment in MENA countries that sparked so much rioting in the region. China’s government is highly sensitive to rising food prices. They may well rise further over the coming months due to the hog cycle so ensuring that pork prices increase further followed by corn and in due course even wheat. But, China’s agricultural base is deteriorating. Top soil is collapsing to dangerous levels; its fertility is being destroyed by acidification; water is being consumed way beyond sustainable levels; and aquifers are being exhausted. These are structural issues, not short term cyclical ones.

The demographics of the rural areas of China imply that the pool of active workers in the age group 15-30 is fast diminishing. It means that productivity will decline to a rate closer to the Asian Tigers ex. China or down to the 2% a year level from its historic 5% rate. The above remarks also imply that China will be importing more foodstuffs over the coming decade. Unlike the USA, China is becoming increasingly dependent on imports of food and energy.

The above is a more likely scenario to evolve than the benign outlook postulated by so many. The world is not back to the 1990s sustainable growth, but its fragility is being patched up by unsustainable fiscal and monetary excesses. In fact, as Charles Gave wrote recently in GaveKal Five Corners, these policies have had the opposite effect than those intended (the unintended consequences of policy actions!), “Capitalism cannot work without a proper cost of capital. Capitalism needs the process of creative destruction, and if real rates are negative or abnormally low, the destruction part of the process cannot happen, zombie companies are kept on perpetual life support and growth flags.”

This is exactly what is happening nearly everywhere. Politicians won’t bite the bullet (perhaps with the exception of the UK) without a crisis. That crisis is coming, certainly by early 2013 if not sooner, to be followed by years of recession and deflation, a period when the down years will outnumber the up ones. It will be accompanied by a serious deflation of assets, both equities and commodities, perhaps excepting food. This period of austerity is likely to last until around 2018; a generation of debt should by then have been worked off so laying the foundations for a long period of sustainable growth.

Chart 3: Historical Sovereign Default/Restructuring Events

The truth is that the lessons of history have been conveniently forgotten or ignored, as illustrated by Carmen Reinhardt and Kenneth Rogoff in their epic work “Growth in a Time of Debt”. Those lessons are simple: credit crises are followed by years of sub-par growth and sovereign defaults.