John Mauldin's Outside the Box : Spain

Things That Make You Go Hmmm…

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

John Mauldin, Editor
Outside the Box

Things That Make You Go Hmmm...

GRANT WILLIAMS
15 JULY 2012

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

– H. Khunrath, Amphitheatrum

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

– Jean Dubuis

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

– JP Getty

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

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

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

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

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

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

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

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

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

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

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

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

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

But I digress.

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

1. Plugging 2. Pushing

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

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

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

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

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

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

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

1. Greecification

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

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

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

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

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

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

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

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

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

2. Backtrackification

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

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

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

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

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

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

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

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

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

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

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

3. Transmission

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

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

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

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

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

4. Restatigence

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

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

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

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

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

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

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

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

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

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

5. Bullyfication

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

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

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

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

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

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

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

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

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

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

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

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

6. Renegotiation

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

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

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

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

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

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

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

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

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

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

7. Realization

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

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

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

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

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

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

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

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

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

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

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

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

That's 'professional competence'.

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

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

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

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

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

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

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

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

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

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

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

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

Over the next five years things get even more interesting.

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

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

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

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

Oh Boy.

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

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

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

Not great, Jamie, not great.

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

– David Stockton, FOMC Minutes Sep 2005

The Tragic Decline of Gibraltar’s Spanish Neighbor

John Mauldin — Tue, 10 Jul 2012 16:14:00 GMT

I was on the ground in Spain a few weeks back, and then I ran into this piece in Spiegel Online about a small, struggling town on the Spanish border with (British) Gibraltar. This essay resonates in some of the same ways as the Michael Lewis piece on Greece. This is just one town, and Spain has many regions, some more prosperous than others; but in a country where there is 23% unemployment and 50% among youth, there is plenty of suffering everywhere. The general story is one of deep problems, especially with regard to inefficient labor laws.

The author asks a big question: "Can the demise of a single city serve as an example that reflects the crisis in the entire country, isolated like a bacterium under the microscope? A crisis that is so severe that it threatens the continued existence of the euro, if not the European Union as a whole?" The answer: probably not, but the plight of La Línea illustrates the problems and the difficult choices faced by the periphery.

Meanwhile, at the other end of the European economic teeter-totter (but just as peripheral, in its own way), we find the City, London's version of Wall St.; and while the residents of La Línea seem to be rather adept at smuggling, they can't hold a candle to the traders of Barclays (and, it would appear, other eminent financial institutions) when it comes to criminality. (There is never just one cockroach.) We have seen some egregious antics by the too-big-to-fail boys the past several years, but Liborgate really takes the cake and eats it too.

It will be hard to contain the outrage when hundreds of trillions of dollars of financial instruments are priced on this figure. A few basis points means tens of millions to the average guys. Heads should roll. And don't think for a minute that the damage – and the blame – are going to be confined to that side of the pond, either. In a deeply probing commentary yesterday on the Libor fiasco, David Kotok takes the Federal Reserve to task over the abandonment of its formal surveillance and oversight role with respect to its primary dealers (which include Barclays Capital, Inc.).

And so the global economic teeter-tottering grows more extreme and destabilizing. What will it take to restore the dynamic balance we need for continued growth? It's a big old system we're all part of, and it's not going to fly right as long as we're more interested in gaming it than growing it.

It was interesting to be at the table tonight with David Zervos of Jefferies, who invited a few local fund managers and your humble analyst to meet with a former voting member of the ECB and Greek citizen (a US-trained economist, too). I want to think more about what I learned, but I imagine my thinking will spill over into future letters. Dear God, we have dug a deep hole for ourselves. I hope at some point we can stop digging.

And finally, as an antidote to the rather somber take on Spain in today's OTB, take a few minutes and watch and listen to this flash mob in Barcelona. How can you be pessimistic for very long about a country that can do this?

http://www.youtube.com/watch_popup?v=GBaHPND2QJg&feature=youtu.be

Your wanting to stand on solid ground again analyst,

John Mauldin, Editor
Outside the Box

The Tragic Decline of Gibraltar's Spanish Neighbor

Between a Rock and a Hard Place

By Walter Mayr in La Línea, Spain
Spiegel Online, 6/27/2012

Many places in Spain are suffering as a result of the euro crisis, but few have been hit as hard as La Línea, a Spanish town which neighbors the prosperous British overseas territory of Gibraltar. With the city on the verge of bankruptcy, many residents have turned to smuggling to earn money.

The residents of La Línea de la Concepción are leaving, like rats deserting a sinking ship.

They've been crossing the border by the thousands since early morning, first the cleaning women, nannies and construction workers, and then the smugglers. They all want to get out of Spain, if only for a few hours. There is work across the border, in the British overseas territory of Gibraltar, and work spells hope for a better life.

By around 11 a.m. on what promises to be a hot early summer's day, the traffic jam on the Spanish side already stretches from the border, across the coastal road and back to the town hall, where Mayor Gemma Araujo is holding down the fort in her office on the second floor, which has a view of the caravan of commuters. Araujo is 33, a Socialist and the first woman in her position. It's not exactly the most rewarding job in Spain. A "crisis tsunami" has reached La Línea, says Araujo, and the situation is more serious than ever before. "Our city isn't bankrupt, but it's close."

The city hasn't been able to pay its employees eight of their last nine monthly salaries. On this morning, the mayor found a sign posted opposite her office door with an unmistakable demand: "Pay or resign." Her house was pelted with eggs and besieged by protesters, and the mob set fire to her secretary's car.

Lawless City

La Línea already made headlines under Araujo's Socialist predecessors in the 1980s and 1990s, when it was dubbed a "ciudad sin ley," or lawless city. At the time, drug dealers, smugglers and other criminals made their living in the Andalusian border town. Conservatives came into power in 1995, including members of the populist Grupo Independiente Liberal (GIL), but mostly politicians with the center-right People's Party. Calm returned to the city for a period of time.

But the unsettled accounts from those days, says Araujo, slowly became a problem. The number of people employed in the city administration had been doubled during conservative rule. Dozens of police officers, 24 attorneys and eight psychologists, as well as expensive consultants and loyal friends, were all given jobs. According to certain records, some city employees were making up to €90,000 ($112,000) a year in second jobs. Within 15 years, the city had increased its debt by more than a hundredfold.

A city was looted in broad daylight, and now no one is willing to accept responsibility.

Shortly before she came into office in the early summer of 2011, "truckloads of documents were burned," says the mayor. "We photographed it." Araujo lists the debts that were accumulated at the time, almost with relish, given that her party was in the opposition at the time. There was "€120 million in debts to private companies, €45 million in unpaid court fines and €39 million in debts to the social security system for unpaid employee contributions." The latter debt, says Araujo, is the reason why the national government is now refusing to pay the city an annual €15 million tax refund and the city administration in La Línea is no longer able to pay salaries. La Línea, a city of 65,000 people, now has a per-capita debt of close to €3,000 – the highest in Spain, after Madrid.

Unemployment in La Línea is around 40 percent. By comparison, the official unemployment figure in Germany is 6.7 percent, while the average rate for all of Europe, which includes so-called problem children like Romania and Bulgaria, is currently 10.3 percent. Spain, however, is reporting 24.4 percent unemployment nationwide, with the autonomous community of Andalusia leading the pack. The worst province within Andalusia is Cadiz, which includes La Línea.

The Hangover after the Party

Can the demise of a single city serve as a example that reflects the crisis in the entire country, isolated like a bacterium under the microscope? A crisis that is so severe that it threatens the continued existence of the euro, if not the European Union as a whole?

In Spain, unlike Greece or Italy, the debt-to-GDP ratio is relatively low. Private debt, however, is substantial, which explains the current troubles of Spanish banks. The conservative Prime Minister Mariano Rajoy, in office since December, is now being urgently advised to take advantage of a European bailout under preferred conditions, so that he can spend more money on what is truly important: fighting unemployment and getting the economy back on track.

But what if the true roots of Spain's plight are not even on the global financial experts' radar? What if it is not just the high borrowing costs in the capital markets that make a rapid improvement difficult, but also structural and historical reasons? A walk through La Línea reveals the faces of a country that still seems to be reeling from a period of excessive intoxication.

The multimillionaire developer from La Línea who hung himself, leaving behind half-built developments in top locations, is emblematic of the Spanish crisis. The buildings are silent reminders of a time when cheap credit fueled the illusion that everyone in Spain could own property. "But it isn't just that we bought houses and apartment on credit," says author Elisabeth Iborra, with a touch of bitter derision. "People also had to have the right furniture."

The picture of the crisis also includes the deep-seated rivalry between the "two Spains," the political camps of the left and the right. Their largely irreconcilable attitudes to each another makes it difficult to achieve the kinds of compromises that are needed to combat a crisis. If the left is in power in the city (La Línea) and the region (Andalusia), but not in the province (Cadiz) and not in Madrid, politics comes to resemble a funnel that is clogged twice, with nothing coming out of the bottom at all anymore.

Like the Wild West without Gold

Finally, the picture of the crisis includes the prosperity gap. In Spain, the north carries a cross for the south. In the case of La Línea, the reasons for this include the following: 85 percent of unemployed young people either have no professional training or none worth mentioning; more than one in three unemployed people has no high-school diploma; and the largest employer, the city administration, isn't paying its salaries. The fact that many people "prefer to make €200 a day smuggling cigarettes than €400 a month as an unskilled worker in a supermarket," as a Guardia Civil officer at the border puts it, doesn't make things easier.

But Mayor Araujo, sticking to her party line, doesn't pin the blame on individuals. In March, during a ceremony in the provincial capital C‡diz, she approached King Juan Carlos and gave him a letter. In it, she wrote about the "social drama" in La Línea and the "real tragedies" faced by the families of city employees with no income, and appealed for help.

The monarch passed on the letter to his underlings and went elephant hunting in Botswana, where he famously fractured his hip. In La Línea, they haven't heard anything from him since, and everything there has stayed the same.

Some parts of the city look like a Wild West town after the gold prospectors left. When five police cars, sirens screaming, show up in broad daylight for a raid in the La Atunara harbor district, a favorite haunt of tobacco smugglers and drug dealers, locals line the street and silently greet the police in a hostile phalanx. And when paramedics at the courthouse pull a half-dead homeless woman from the confiscated Audi she calls home, it isn't because passersby have alerted the emergency services. It's because charity workers who were distributing roast chickens to the needy in the deserted downtown area late at night managed to call an ambulance in the nick of time.

'The Ass of Europe'

La Línea is livelier in the morning. Or at least it is in front of the bar where the matuteras are preparing to cross the border. The matuteras are female smugglers who bring in cheap cigarettes from the British overseas territory a few hundred meters away. Overweight women are especially prevalent among the smugglers, because being overweight makes it easier to hide a few more packs of cigarettes in various parts of the body without being noticed.

The women set out across the border. The more experienced ones wear their ID cards on a chain around their necks, so that they don't have to search for it every time they cross the border. One carton of cigarettes per person and crossing is allowed. Those who do not get checked and registered put on different clothes on the Spanish side and set out for Gibraltar again.

This helps to explain why there is such a long line in front of the "Parody" kiosk, an unassuming shack under a barbed-wire fence on the British side of the border. A total of €25.90 is paid for a carton of Marlboros, and then the smugglers go back across the border again, passing the Spanish customs agents, who are not exactly highly motivated. The border crossers make a profit of €4 per carton. The operators of the kiosks on the Spanish side, who will sell the cigarettes later, collect another €6. The actual retail price is another €9 higher. But the retail price is no longer important in La Línea, where five of the several regular tobacco shops have gone out of business.

What else is there to do but smuggle? La Línea has no factories, no sights for tourists and no luxury hotels on sandy beaches. "We are the ass of Europe," says one local.

But the shadow economy is still an attraction. Entire Andalusian extended families make weekend excursions to La Línea, says a lieutenant with the Guardia Civil. "They come from Seville or Jerez in the morning, fill up their tanks with cheap gasoline in Gibraltar and eat their meals from Tupperware containers they've brought along. Then they walk across the border in groups of five and bring back cigarettes, until they've made €300 in profits. That's enough to live on for another week at home."

'We Have Been on the Wrong Track'

Local residents are familiar with other sources of food. For example, they pay visits to the courtyard of the San Pío X church as often as they can. There, Padre Rafael Pinto runs the Caritas charity's food aid program for La Línea. On this morning, there is a delivery van in the courtyard loaded with white beans and UHT milk. The program also keeps fruit and rice, toys, shoes and clothing in a storage room.

Caritas already provides regular assistance to 500 families in La Línea, and the numbers are still growing. They also include city employees. In some cases, Caritas even pays for rent and electricity bills. Generally speaking, every setback and every challenge is also an opportunity, says Padre Rafael. "Perhaps this crisis will help us realize that we have been on the wrong track in the last few years, and that it's time to turn around. In Spain, it was all about having things, and not about being. Christian values gave way to consumerism."

Affected citizens and volunteers in La Línea say that things are going rapidly downhill. First people lose their jobs, or they keep their jobs but lose their pay, as in the case of the city employees. Then their cars are seized, their mobile phones disconnected and their electricity shut off. For most people, mortgage payments are their downfall. If families hadn't stepped in to help, more people would have lost their homes long ago.

At the Hogar Betania hostel, which is also run by Caritas, all 14 beds are constantly taken. People who are down on their luck are taken in there, treated and fed. They're expected to be back on their feet after one year. "The crisis has greatly accelerated social decline," says Begoña Arana, the director of the facility. "In 2011, we already had 575 homeless men and 105 women in La Línea. Nevertheless, we'll have to close this hostel at the end of June, unless there is a miracle. The new Socialist government of Andalusia isn't sending us any money anymore."

'They Don't Lift a Finger after Two in the Afternoon'

Diagonally across the street, at the local branch of the Spanish Labor Ministry, men and women are standing in line to obtain documents certifying that they are destitute and therefore entitled to receive aid. White-collar workers are also among those standing in line. A clerk who came to La Línea from central Spain years ago can hardly conceal her consternation over conditions in the south. "We are living in a country in which civil servants can't be laid off, and yet they no longer have to be paid, either."

This is true to a certain extent. Most civil servants, or "funcionarios," are still employed, but because their core working period is only a few hours a day, they are not very popular among ordinary people. For example, the people from the La Línea social security office who are cheerfully lunching and drinking at the "Hermanos Tomilleros" seafood restaurant at 3 p.m. get nothing but an angry snort from the waiter, who says: "They don't lift a finger after two in the afternoon. That's Spain."

Something else that is typical of Spain is the fact that it was only with difficulty that the traditional magnificent processions could be conducted during Easter week this year. Of the 111 police officers in La Línea, first 32 and then, by the beginning of the Easter week, 52 were on sick leave – almost half of the entire police force.

From his air-conditioned office, José Luis Landero Mateos keeps an eye on those in La Línea who are in significantly worse shape than the civil servants. Surveillance cameras send live images from the overfilled waiting rooms at the job centers on Saragossa Street directly to his computer screen.

Landero Mateos is the director of the agency. If he isn't having a late breakfast or out of the office for important meetings, he is willing to talk about the situation in his city, provided the questions have previously been submitted to him in writing. "We had 10,820 unemployed people last month," the director says gloomily. "That's an historic record. Many here are so desperate that they are thankful to have someone listening to them."

A Good Neighbor

Was it cynics who decided to put two metallic sculptures of Don Quixote and Sancho Panza, the literary figures who famously fought windmills in Cervantes' novel, in the lobby of the La Línea town hall? Mayor Araujo, at any rate, is forced to walk past the two sad-looking figures every day.

On this day, her driver takes her across the border to Gibraltar in the last remaining official car. A visit to Gibraltar, says Araujo, "is a visit to a good neighbor." It's also a brief excursion into a different world, although she doesn't say this. It's a world with 6 percent growth rates and one of the world's highest rates of value creation per capita.

Winston Churchill Avenue cuts straight across the runway at Gibraltar Airport, where flights from London and Manchester land, and then into downtown Gibraltar, passing dozens of facades displaying flags with portraits of Queen Elizabeth II. More than 10,000 Spaniards, less than half of them with regular working papers, take this route on weekdays – one way in the morning and the other way in the evening. It's the street they traverse to make a living.

One of them, an officer with the Guardia Civil, has a second job as a gardener for a doctor in Gibraltar. Others work as domestic servants, at the base of the massive Rock of Gibraltar, for those who have established luxury residences in the area surrounding the Queensway Quay Marina: the multi-millionaires in the online gaming industry.

Before they pay their occasional visits to their company headquarters in Gibraltar, flying in from London or Tel Aviv, the floors are waxed and the refrigerators stocked in the apartments and villas – by servants who have come across the border from La Línea to make sure everything is in order. The workers are paid hourly wages of about !8, but they have no income when the owners of the luxury residences are away.

Helping Stray Animals

Not even in New York, between Central Park and the Bronx, are the rich and the poor closer together than they are in Gibraltar. Ruth Parasol, currently the richest woman in Gibraltar, worked her way up through the telephone sex and Internet pornography industry to become the founder of Party Gaming Plc. Together with her husband, Parasol now controls a fortune estimated at 700 million pounds (€875 million).

Parasol devotes a small amount of her money to the ailing euro zone or, to be more precise, to the neighboring city of La Línea. Her charity, Bonita, is currently paying for the construction of a new playground across the border, in Reina Sofia Park, where some of the homeless sleep at night. The charity also provides funding for the care of stray animals in La Línea.

Gibraltar's Chief Minister Fabian Picardo sits in his office under the Union Jack. "Even if everything is falling apart around us," he says, the Gibraltar model, "an open labor market, and the peaceful coexistence of peoples and religions," will survive. He does have serious concerns, however, about the well-being of neighboring Spain.

"If Spain were ejected from the EU, which I hope won't happen," says the chief minister, "the consequences would be dramatic – not just for us here in Gibraltar, but for Europe as a whole."

Translated from the German by Christopher Sultan

Necessary But Not Sufficient

John Mauldin — Tue, 12 Jun 2012 06:06:00 GMT

We woke up this weekend to a €100 billion "rescue" of Spanish banks, and the initial reaction of the market was relief. But did we not just see this movie, but with Greek subtitles rather than Spanish? Was this another of those "necessary but not sufficient" plot lines that Europe is so good at? Kick the can down the road and hope for a happy ending?

Pardon my skepticism, but I see numerous problems. In the first place, €100 billion will not be enough. While the current estimates are closer to €40 billion (if you ask the Spaniards), JP Morgan estimates it will be more like €350 billion. Others estimate more or less, but €100 billion is decidedly optimistic. Even the Spanish authorities are acknowledging that there is another 35% downside for the housing market, which is the main source of the losses. It appears that has NOT been included in the guesstimates.

Secondly, this saddles Spain with yet more debt, which will force the rest of already-sold Spanish debt into a subordinated position (more on that from Louis Gave, below). It does not address the problem that Spain is running an almost 10% of GDP deficit and will need to access the markets for very large sums in the near future. For all intents and purposes, they have been shut out of the bond market, which is why they needed a "rescue."

Third, it does not address one of the fundamental problems, which is the subject of this week's Outside the Box from Charles Gave: it does not help solve the trade imbalance between Germany and the periphery nations.

Germany has two very bad choices. It can finance the multiple trillions of euros of debt of Spain and Italy (and France), converting it into eurozone debt, while giving up its own fiscal sovereignty and allowing a eurozone-wide fiscal union and taxing authority; or the Germans can spend trillions of euros allowing the eurozone to break up, either by exiting themselves or allowing the southern countries to exit.

The market is not going to finance Spain, Italy, et al. in the short term (i.e., this year). That means the ECB will have to print money or some European entity will need to have a basically unlimited blank check at the ECB, if those countries are not allowed to default on their debt. Someone, or some group of someones, is going to have to write a rather large check. The question is whether it costs more to stay or to go. Germany leaving the euro would not be good for German exports, which are 40% of their economy.

Finally, it is not clear exactly how this bailout (let's call a spade a spade) is going to come about. There will have to be, I assume, agreement from the eurozone countries if the EFSF or ESM funds are to be used. Further, if you make this deal for Spain, then Greece, Portugal, and ESPECIALLY Ireland are going to demand a reset. I am sure there is a coherent plan here somewhere, but I can't find it as of Monday night. What I did find is this quote in the Financial Times (jumping to the end of the story):

" 'Many Irish people looking at the deal this morning will be asking themselves why is there one set of conditions for us and another for Spain,' said Mr Doherty. Ireland's economic crisis closely resembles the situation in Spain, where a property crash has morphed into a banking crisis, leading to calls that Dublin should renegotiate its existing EU-IMF bail out deal. Aware that it is unlikely to persuade the troika to reopen its own bailout program, however, Dublin moved quickly on Sunday to deny that Spain's program would be less onerous than its own.

"The Spanish program could also produce political problems outside current bailout countries, particularly over the issue of which of the eurozone's two bailout funds is used for the rescue.

"Dutch and Finnish officials have warned they do not want the new bailout funded through the existing rescue system, the €440bn European Financial Stability Facility, because its lending is treated like any other private lender, meaning it has no seniority in the repayment queue." (emphasis mine)

The Spanish prime minister played the Germans very well. He got what appears to be a much better deal than the Irish. But then, he was playing hardball. This note from Joe Weisenthal at Business Insider:

"According to El Mundo, Spanish PM Mariano Rajoy sent a stunning text message to FinMin Guindos prior to the bailout negotiations. He said, according to El Muno editor Pablo Rodriguez:"Resist, we are the 4th power of the EZ. Spain is not Uganda." Translation: We're a major power, not some random IMF-case banana Republic.

"The followup message (according to Googletranslate) "If you want to force the redemption of Spain will prepare 500,000 billion euros and another 700,000 for Italy, which will have to be rescued after us."

"Bottom line: hold out for something good. We are powerful, and if they don't give in, the whole thing will go down. It will cost Europe 500 billion if Spain goes bust, and then another 700 billion if Italy goes bust. No wonder Der Spiegel, which represents the German point of view, has an article blasting Spanish blackmail."

And before we get to Charles's piece, let's look at this quick analysis by his son Louis Gave, the CEO of GaveKal, writing from Hong Kong (www.gavekal.com):

"As we go through the few scant details of the bank bailout offered to Spain, we cannot help but shake an uneasy feeling of deja-vu all over again:

Banks confronting a deposit flight – check.
Sovereign shut out from debt market – check.
Loans provided to help sovereign deal with the situation – check.
Potentially pushing current sovereign debt investors into a subordinated position – check.

"It is on this last point that the Spanish 'bailout' could prove to do more harm than good. Indeed, as we highlighted with Greece, when policymakers transform government debt into subordinated debt, they may as well shut down that market for good. This for a very simple reason: most investors who buy government debt do so on the premise that the paper is the most 'risk-free'. These are not equity investors, carefully weighing the risk-reward of a current asset.

"Investors into sovereign debt are all about minimizing risk. The reason one buys government bonds is first and foremost for capital preservation and portfolio diversification. Subordinated debt does not meet those requirements. Thus, Europe's policymakers, from one day to the next, could potentially not only increase the Spanish debt load by 9% of GPD but simultaneously make Spanish debt considerably more risky, and thus more unattractive. Beyond an immediate knee-jerk reaction, it seems unlikely that the Spanish contraction in spreads will be meaningful or lasting."

What Europe did over the weekend was put a band-aid on a very deep gash. To actually fix the problem, Europe must remove bank liability from the various nations and make them joint and several. But that is going to be something that Germany and other nations will fiercely resist. When the dust settles, the markets will realize, I think, that this latest move did not solve the real problems. It was just a way to stop the immediate pain. There is more to come, and it will require a lot more money and the loss of a great deal of national sovereignty if the eurozone is to hold together. It took the US decades, if not a century, to get to that place. Europe has a few years under its belt at most, and the crisis is right on top of them.

I am in New York tonight, just back from dinner with some of "the guys." (Jonathan Carmel of his eponymous hedge fund, Dan Greenhaus of BTIG, Barry Ritholtz of the Big Picture, and Rich Yamarone of Bloomberg). The topics were all over the board. I am not certain we solved any big problems ourselves; but the Chinese food at Shun Lee was sure good, and the conversation was sparkling.

It is time to hit the send button. Note: There will be no new postings on the Over My Shoulder website for the next 24 hours, as we do a major web-hosting switchover.

And now, let's turn it over to the always-incisive Charles Gave.

Your sorry to rain on Spain analyst,

John Mauldin, Editor
Outside the Box

Federalism, Debt Traps and Competition

By Charles Gave

At times I have this feeling that I am living on a different planet than most economic commentators. Everyone is waiting to see if Germany will bite the bullet and mutualize the EMU's debt—thus saving the euro. Not only will this not work, but it would make the situation even more unmanageable, by papering over what are essentially debt-trap situations for a number European countries. The only escape for these struggling countries is through a growth-boosting improvement in competitiveness, which cannot be done under a monetary union.

Let us take the example of Italy:

Italy's economic growth has stagnated since entering the euro, yet its debt load has grown apace. Now heading into its fourth recession in 10 years, the country will see tax receipts collapse as automatic stabilizers kick in, and as a result its budget deficit will magnify. This will push the cost of capital up even higher, which in turn will depress growth further—the classic vicious cycle of a debt trap. We are seeing this quagmire not just in Italy but in many of the troubled EMU economies, including Spain.

Why is Italy in a debt trap? The answer is deceptively simple: Italy is not competitive. From 1982 to the euro's start in 2000, German and Italian industrial production expanded at the same growth rate. However, as the chart overleaf underlines, rebasing the German industrial production index to 2000, we see it has moved from 100 to 111 while Italy's IP index shrunk from 100 to 76. Italy is clearly having a harder time competing against Germany since they joined a common monetary union.

The explanation of this phenomenon can partly be explained by the next chart. In the past, the Italians could devalue now and then to increase productivity vis-a-vis the Germans. Without this option, Italy's real labor productivity has sorely lagged Germany's—i.e., the Germans are getting more bang for every "euro" buck.

With lower productivity and a higher cost of capital, one would have to be brain dead to put a factory in Italy, especially if one knows that the tax rate in Italy is going to go up to try to close the budget deficits (as if a tax increase ever led to a reduction in the deficit!). Needless to say, the financial markets have perfectly anticipated this state of affairs and expect the unavoidable re-emergence of the lira.

Please have a look at this graph:

Based on current 10-year sovereign prices, the chart tells us what the market is willing to pay for 10-year zero bonds of Germany and Italy. The difference between the two lines (see next chart) is about 32%—which means a 32% devaluation is already priced into the market.

The marvelous thing is that the expected devaluation and or write-off of the debt also can be seen as pricing in differences in labor costs.

Enter federalism

Let us explore now the possibility that Germany and other EMU hold- outs agrees to accept joint responsibility for all EMU debt. Then one would expect the German and Italian rates to converge again towards an average of roughly 4%, which has been more or less constant for the best part of the last 14 years, and with a very small standard deviation:

This would imply a massive bull market in Italian bonds and a massive bear market in German bonds. Since the German banks are already not very robust, they need a quasi collapse in the German bond market like a hole in the head.

However the decline in Italian yields to 4% would solve none of the Italian problems. Most crucially, it would not solve the key issue of lack of competitiveness against EMU powerhouses like Germany. Italy will not be able to grow itself out of its current bind under the yoke of currency which is overvalued for a country like Italy. Which means the structural growth rate will never catch up with the cost of capital — Italy might still have to write-off some of its debt.

And keep in mind—Italy is a country that will have its cost of capital lowered by debt mutualisation. A country like France will be much worse off as its cost of capital rises by at least like 150 bp at a time when she is also heading into a recession—drastically lowering the odds that France can escape a debt trap.

With German yields rising, one could probably say goodbye to the bull market in real estate in Germany and with three of its main clients going under one should start worrying about Germany too.

I am flabbergasted. Why would anybody believe that a federalization of the debt is a solution to the Euro crisis is beyond my understanding? Such a move would make the economic and financial situation far worse than it is today for almost every player, Italy , France, Germany Spain, Portugal.

Unfortunately, since it is at the same time idiotic and counterproductive, I fully expect the European elites to try to and go for it. If so, I would recommend selling across the board in Europe—currencies, bonds, equities—and become very cautious on the rest of the world.

My only hope is that the markets and the Greeks will stop this new suicidal move. Let's wait for the Greek elections and hope for the bad guys to win.

The Pain in Spain

John Mauldin — Tue, 24 Apr 2012 02:45:00 GMT

It really does seem to be All Spain All the Time, but there is a reason. Unlike Greece, Spain makes a difference to the eurozone. It may be both too big to allow to fail and too big to save. Last week I came across a very informative 50-page PowerPoint on the situation in Spain from Carmel Asset Management. It is too big to send, but I asked Jonathan Carmel to draft a smaller document with some of the key points. I find it compelling. You can access the entire PowerPoint on my website. If you are not registered with me, you will need to enter your email address and, if you would, your zip code or country. There is a lot if information and data in the report. It will certainly make you think.

I want to emphasize that I do not think Spain is hopeless. Rather, it has a narrow set of limited options that will require a great deal of austerity and economic pain on the part of Spain and significant help from the rest of Europe, combined with the forbearance and patience of the bond market or massive buying of Spanish bonds by the ECB for an extended period of time. I think it will need to be the latter, as the bond market is on the brink of breaking down on Spanish debt, failing a realistic path to economic balance and growth. The way ahead is most difficult and treacherous. It appears to me that at the end of the day only ECB participation can buy Spain the time it needs. If they give Spain the time, it can get through. But the pain will then be spread to the valuation of the euro and thus the entire eurozone.

Is a new fiscal compact a possibility? One with nations giving up control of their budgets and a euro-wide bond issue by which all the nations guarantee the others' debt? Or is there some middle option? Anything is possible and everything will be discussed, as the cost of a eurozone breakup would be massive.

This week's Outside the Box shows some of the reasons why the task is so daunting. Not to mention Italy. And the election results in France suggest a new government may be coming in May, whose leader has promised to renegotiate the recent eurozone agreement, although the details of what that really means are quite murky. And of course France is only a few years from its own crisis, if its deficit is not brought under control. Hollande has said no more austerity yet has not proposed a plan that promotes real growth.

We will soon plunge into yet more last-minute crisis meetings and summits, in which will be hatched yet more "plans." The German Bundesbank will complain about ECB largesse, but they don't control the ECB, as they once thought they did. They are toothless. But any pan-European plan that requires more German pledges (taxes and debt) must get through their legislature. And the Bundestag is most definitely NOT toothless. Can Merkel tame them once again? It will be difficult if the ECB ignores the Bundesbank warnings. You can only push so much.

A very narrow and treacherous path indeed. And it wends all through Europe, not just Spain.

I write this on my iPad from the train to Philadelphia, as I have managed to fry my computer. Somehow, the coffee spilled on the keyboard this morning did not seem to do it any good. Oh well. I get a backup laptop tomorrow. No data lost, just time and money. Sigh.

Your feeling like a rookie traveler analyst,

John Mauldin, Editor
Outside the Box

The Pain in Spain

Carmel Asset Management

Spain grew a remarkable 8% per year in nominal GDP in the first nine years after the introduction of the euro in 1999. During this time, Spain focused its economy on housing and selling "the Mediterranean lifestyle." Millions flocked to its sun-drenched shores, buying houses along the way. As the demand for houses increased, construction became the industry. Housing prices exploded, tripling in just over a decade. Who wouldn't want to get in on the action? Indeed, people invested almost all their assets in real estate. Hundreds of thousands of homes were built; for two decades, one home was built for every additional person in the population.

Now the bubble is bursting. Home prices have started to fall but have much further to go. Housing construction employed one of every seven people. Most of those people will lose their jobs, and there are no new jobs available. Historically, countries facing this situation have devalued their currency, but the euro has made this impossible. Therefore an "internal" devaluation is needed, where prices of wages and goods fall in nominal terms. While this is possible, it is painful and slow.

Spain's national debt is 50% greater than the headlines report

Spain's debt-to-GDP actually looks pretty reasonable compared to that of other countries. In fact, the United States is in worse shape than Spain on this measure alone. A more comprehensive account of Spain's debt, however, suggests that the country's debt-to-GDP is substantially higher, just at the 90% debt-to-GDP level that Rinehart and Rogoff have identified as diminishing GDP growth.

Between 2000 and 2006, Spain's decentralized autonomous regions grew spending, mostly on healthcare and education. None of this debt is counted in the country statistics. Yet health care has proven to be one of the hardest expenditures to cut any where in the world, especially with aging populations. When coupled with the fact that Spain is unlikely to be able to grow GDP, what seems to be a low debt-to-GDP ratio is actually much higher.

Spain's housing prices will fall by an additional 35%

Housing was an enormous driver of the Spanish economy, powering incomes from both the construction and real estate industries, as well as the wealth of homeowners from price appreciation. There is no doubt that there was a housing bubble in Spain. What is remarkable is the size of it in both building activity and prices. Here is a chart of houses and population over the last two decades. While the levels are different, the units are the same: a home for every new person added to the population.

In the United States, the picture is very different. We have been adding about 2.5 people to our population for each home we build. Just the sheer number of homes built in Spain is staggering. Some of this will be foreigners buying second homes, and certainly, this happens more in Spain than in the U.S. But the construction activity was furious.

Developers need an incentive to build a house; that incentive is price, usually appreciating. This spurred the market in the U.S., but it did even more so in Spain.

Remarkably, despite the fall from the top, housing prices in Spain are still above the peak in the U.S. Nor are they in line with Spanish wages, as you can see below.

This is before considering the internal devaluation that must occur. Wages must fall in Spain, and this will put even more pressure on housing prices.

One question is why prices have not yet fallen further. There are several reasons. First, mortgages in Spain are all recourse to the borrower. There is no possibility of "jingle mail," where an underwater borrower returns the keys to the bank. In Spain, the bank can come after other assets or earnings. So it is preferable to keep paying and hold onto your home in the hope that prices will come back rather than to declare personal bankruptcy. Second, the banks are desperate to keep loans as current and maintaining interest payments so that they can avoid further reductions to their already depleted capital. We believe that they are making such modifications as taking an amortizing loan and converting it to a bullet loan. This would reduce the monthly payments, but it increases the risk to the bank, as the borrower is not repaying the loan bit by bit.

The number of houses being built and their rapidly increasing prices had the effect of generating lots of income and jobs. At one point, one in every seven workers was in construction.

This does not count the people that were involved with the marketing, selling, or financing of all of this real estate. The economy depended on housing and construction; now these jobs are gone and they will not return soon. The question remains, what will take their place in the Spanish economy?

The rapid increase in prices had other dangerous effects as well. Housing provided the best returns on investment of any major asset class from 1990 to 2011. So Spaniards put a frighteningly high percentage (79%) of their wealth into housing.

As people age, they will need to sell their real estate to finance their retirement. This would work if there were people to buy the houses. According to the National Statistics Institute of Spain, those nearing retirement (ages 55-70) will swell by 1.4 million between 2011 and 2021 –these are the home sellers. But the people that are likely to buy (ages 25-40) will decrease by 3.3 million. Given lots of sellers and few buyers, the effect will be twofold. Housing prices will likely continue to fall in the intermediate future, and there will be additional pressure on the government to help retirees more, since their assets will be worth far less than they had planned.

Spain has "zombie" banks, which make massive loans to developers and homeowners

The banks that lent to homebuyers and to the developers of housing projects have not fully recognized the decline in the value of their assets. While Spain has a few notable, truly international banks (Santander and BBVA) with strong assets and franchises, most of the problems are concentrated among the domestic savings banks, known collectively as cajas. Spain has tried to reconcile the problems with its banking assets, but it has consistently raised the amount of money that is needed to restore solvency to the banking system in a piecemeal fashion. The latest estimate is that an additional €50 billion was needed. We believe that the number is more likely a multiple of that, perhaps on the order of €200 billion, given the expected fall in housing price and the highest unemployment in the developed world.

Spanish banks still have an inordinate balance sheet exposure to commercial real estate. Too many of these loans are still to real estate developments that are substantially worthless or to assets whose earning power has been diminished by the failing economy.

Spain's economy has not become stable and will continue to deteriorate

Spain's economy is neither competitive nor balanced. Something is needed to replace the jobs in construction and real estate that will not be coming back. Labor costs, however, are simply too high to attract business successfully. Spain's unit labor costs (in yellow in graph below) needs to fall ~15% to match the European average or a full ~30% to match Germany.

Falling wages will hurt Spain in multiple connected ways. Housing prices will be pressured as homeowners find that they can no longer afford to maintain their mortgages or their homes. Consumption is about 60% of the Spanish economy, so falling wages will reduce GDP until real job growth returns. The government will be pressured by this initially falling tax base, which will hamper its efforts to reduce the deficit. Finally, deflation in wages will lower GDP and make the debt-to-GDP ratio that much worse.

The introduction of the euro caused massive imbalances, and Spain was a net loser. Here is a chart of the cumulative current account balances of the eurozone countries since the inception of the euro.

Spain imports far more than it exports, and it has been able to finance this only by leveraging the country to the hilt. The net international investment position (NIIP) of a country is the sum of all its external financial assets and liabilities. Countries with a strong positive NIIP have major claims on other nations' assets, either in the form of debt or equity, while those that are negative have many more foreign claims on them. Spain's NIIP has been a disaster over the last decade.

An NIIP can go sharply negative for "good" reasons. In the nineteenth century, America had a large negative NIIP, as mostly British capital financed the massive increase of productive capacity in the form of railroads, factories, roads, bridges, and other infrastructure. But too much of the decrease in the NIIP of Spain has gone into housing. Housing is not productive per se; it is consumption for the end user – even if it produces income for an owner.

Between 2001 and 2011, the NIIP of Spain decreased by €856 billion. We could find no figures that quantified the value that went into housing. But a back-of-the-envelope measure is this: roughly 5 million homes were built, the average size of Spanish homes is roughly 100 m² and cost per m² is in a wide range, from €400 to €1,200.Therefore Spain spent €200 to €600 billion on housing over the decade. Too much of the Spain's borrowing went into an asset that is unproductive.

The EU will not have the firepower or political will to bail out Spain

Spain will need some help from its neighbors. While there has been much talk of the increase in the size of the "firewalls" that Europe has constructed, we remain unconvinced that they have really grown substantially. For example, Germany pledged a maximum of €211 billion to the EFSF, which has been approved by the Bundestag and the Constitutional Court. Neither body has approved a change to this limit. The total size of the ESM and EFSF is not clear at this point, nor is the size of the IMF commitment. Should Spain be denied access to the capital markets like Portugal, Ireland, and Greece and come to rely on help from the public sector, the available resources would be severely strained. Should both Spain and Italy rely on financing, there simply isn't enough money.

Recently, the IMF has announced that it is close to raising $400 billion as a rescue fund. This will help meet the financial needs of the recipient country. But it will also subordinate all the other creditors of that country. The effect might be that creditors become reluctant to lend to a country for fear that they will just suffer subordination once the IMF starts to lend. If the market believes that the IMF loan is big enough to get the country through to stability, then it will continue to lend. If the market does not believe this, the IMF can precipitate the very run it was supposed to prevent.

This does not mean that the measures that the Europeans and the rest of the world have put together are for naught. At some point, there is enough financing to give Spain the time to go through the long and slow process of lowering wages and prices and rebalancing the economy. We are not predicting a sudden collapse, nor do we believe that a major restructuring in Spain is either imminent or even probable in the short or intermediate term. But the market will continue to test the resolve of the Spanish government and its people to find a way to restore balance to the economy.

In summary, Spain desperately needs to find other industries to replace the real estate sector. This will not be easy or quick – realignment of an economy takes time and patience, neither of which the bond market is known for. Spain's issues are not impossible to solve -- there might be time enough to fix what is broken -- but the path is a narrow one, and the problems involve interlocking variables (housing, wages, employment, and growth). There will be more moments of panic and relief before the final story is told.

Working Out of Debt

John Mauldin — Tue, 24 Jan 2012 04:45:00 GMT

This week we look at a report called “Working Out of Debt,” about debt and deleveraging, from the McKinsey Global Institute. This is a well-done summary of their longer paper, which has been updated, called “Debt and deleveraging: Uneven progress on the path to growth.” I discussed the original paper both in my regular letter and in Endgame. It is one of the best, most definitive pieces on the topic I have read. For those trying to understand how the deleveraging process will affect their particular world, I think it is a must-read. I have been spending more and more time thinking about the whole process of deleveraging, and am coming to think deleveraging is the critical and fundamental factor shaping the economic environment and impacting every decision countries and businesses are faced with. This paper was done by Karen Croxson, Susan Lund, and Charles Roxburgh; and they are to be especially commended for their insight and work.

This summary and the full report look at the relevant lessons from history about how governments can support economic recovery amid deleveraging, and at the signposts business leaders can look for to see where economies are in that process.

Overall, they tell us, the deleveraging process has only just begun: “During the past two and a half years, the ratio of debt to GDP, driven by rising government debt, has actually grown in the aggregate in the world’s ten largest developed economies. Private-sector debt has fallen, however, which is in line with historical experience: overextended households and corporations typically lead the deleveraging process; governments begin to reduce their debts later, once they have supported the economy into recovery.”

You can sign up at their website and see the full report at https://www.mckinseyquarterly.com/Working_out_of_debt_2914. I would strongly recommend you do so, not only for this report but because their website is chock full of well-done articles on a wide variety of topics, and they update it frequently with more material. It is all top-notch. It is worth visiting just to see what they have done in areas that may be of more specific interest to you, or because like me you are an information junkie and want to keep up on a wider world than just macro-economics.

Have a great week. Mine will be busy but interesting, which is always good. And this Friday I start a series on the choices that we face in the US, so there will be lots to ponder amidst the noise.

Your wondering how the Giants got into the Super Bowl analyst,

John Mauldin, Editor
Outside the Box

Working out of debt

McKinsey Global Institute

January 2012

Karen Croxson, Susan Lund, and Charles Roxburgh

An update of our research on the efforts of developed countries to work out from under a massive overhang of debt shows how uneven progress has been. US households have made the greatest gains so far.

The problem

The deleveraging process that began in 2008 is proving to be long and painful, with many countries struggling to reduce debt during a sluggish economic recovery.

Why it matters

National economic prospects depend on how deleveraging plays out. Historical experience suggests that excessive debt is a drag on growth and that GDP rebounds in the later years of deleveraging.

What to do about it

Companies active in countries that are experiencing deleveraging should closely monitor progress toward targets that historically have coincided with economic improvment. These include banking-system stabilization, structural reforms, growing exports and private investments, and housing-market stabilization.

The deleveraging process that began in 2008 is proving to be long and painful. Historical experience, particularly post–World War II debt reduction episodes, which the McKinsey Global Institute reviewed in a report two years ago, suggested this would be the case. And the eurozone’s debt crisis is just the latest demonstration of how toxic the consequences can be when countries have too much debt and too little growth. (The full report, Debt and deleveraging: The global credit bubble and its economic consequences (January 2010), is available online at mckinsey.com/mgi.)

We recently took another look forward and back—at the relevant lessons from history about how governments can support economic recovery amid deleveraging and at the signposts business leaders can watch to see where economies are in that process. We reviewed the experience of the United States, the United Kingdom, and Spain in depth, but the signals should be relevant for any country that’s deleveraging.

Overall, the deleveraging process has only just begun. During the past two and a half years, the ratio of debt to GDP, driven by rising government debt, has actually grown in the aggregate in the world’s ten largest developed economies. Private-sector debt has fallen, however, which is in line with historical experience: overextended households and corporations typically lead the deleveraging process; governments begin to reduce their debts later, once they have supported the economy into recovery.

Different countries, different paths

In the United States, the United Kingdom, and Spain, all of which experienced significant credit bubbles before the financial crisis of 2008, households have been reducing their debt at different speeds. The most significant reduction occurred among US households. Let’s review each country in turn.

The United States: Light at the end of the tunnel

Household debt outstanding has fallen by $584 billion (4 percent) from the end of 2008 through the second quarter of 2011 in the United States. Defaults account for about 70 and 80 percent of the decrease in mortgage debt and consumer credit, respectively. A majority of the defaults reflect financial distress: overextended homeowners who lost jobs during the recession or faced medical emergencies found that they could not afford to keep up with debt payments. It is estimated that up to 35 percent of the defaults resulted from strategic decisions by households to walk away from their homes, since they owed far more than their properties were worth. This option is more available in the United States than in other countries, because in 11 of the 50 states—including hard-hit Arizona and California—mortgages are nonrecourse loans, so lenders cannot pursue the other assets or income of borrowers who default. Even in recourse states, US banks historically have rarely pursued borrowers.

Historical precedent suggests that US households could be up to halfway through the deleveraging process, with one to two years of further debt reduction ahead. We base this estimate partly on the long-term trend line for the ratio of household debt to disposable income. Americans have constantly increased their debt levels over the past 60 years, reflecting the development of mortgage markets, consumer credit, student loans, and other forms of credit. But after 2000, the ratio of household debt to income soared, exceeding the trend line by about 30 percentage points at the peak (Exhibit 1). As of the second quarter of 2011, this ratio had fallen by 11 percent from the peak; at the current rate of deleveraging, it would return to trend by mid-2013. Faster grow th of disposable income would, of course, speed this process.

Exhibit 1

Although the debt ratio of US households remains high, they may be halfway through the deleveraging process.

US household debt as % of gross disposable income, quarterly, seasonally adjusted

We came to a similar conclusion when we compared the experiences of US households with those of households in Sweden and Finland in the 1990s. During that decade, these Nordic countries endured similar banking crises, recessions, and deleveraging. In both, the ratio of household debt to income declined by roughly 30 percent from its peak. As Exhibit 2 indicates, the United States is closely tracking the Swedish experience, and the picture looks even better considering that clearing the backlog of mortgages already in the foreclosure pipeline could reduce US household debt ratios by an additional six percentage points.

As for the debt service ratio of US households, it’s now down to 11.5 percent—well below the peak of 14.0 percent, in the third quarter of 2007, and lower than it was even at the start of the bubble, in 2000. Given current low interest rates, this metric may overstate the sustainability of current US household debt levels, but it provides another indication that they are moving in the right direction.

Exhibit 2

In the United States, household deleveraging may have only a few more years to go, while in Spain and the United Kingdom it has just begun.

Household debt,% of gross annual disposable income¹

1 Total household debt outstanding and annual disposable income for Spain, United Kingdom, and United States as of Q4 in given year.

2 For Sweden, 1998; Spain, 2007; United Kingdom and United States, 2008. Source: Statistics Sweden, Haver Analytics; McKinsey Global Institute analysis

Nonetheless, after US consumers finish deleveraging, they probably won’t be as powerful an engine of global growth as they were before the crisis. That’s because home equity loans and cash-out refinancing, which from 2003 to 2007 let US consumers extract $2.2 trillion of equity from their homes—an amount more than twice the size of the US fiscal-stimulus package—will not be available. The refinancing era is over: housing prices have declined, the equity in residential real estate has fallen severely, and lending standards are tighter. Excluding the impact of home equity extraction, real consumption growth in the pre-crisis years would have been around 2 percent per annum—similar to the annualized rate in the third quarter of 2011.

The United Kingdom: Debt has only just begun to fall

Three years after the start of the financial crisis, UK households have deleveraged only slightly, with the ratio of debt to disposable income falling from 156 percent in the fourth quarter of 2008 to 146 percent in second quarter of 2011. This ratio remains significantly higher than that of US households at the bubble’s peak. Moreover, the outstanding stock of household debt has fallen by less than 1 percent. Residential mortgages have continued to grow in the United Kingdom, albeit at a much slower pace than they did before 2008, and this has offset some of the £25 billion decline in consumer credit.

Still, many UK residential mortgages may be in trouble. The Bank of England estimates that up to 12 percent of them may be in some kind of forbearance process, and an additional 2 percent are delinquent—similar to the 14 percent of US mortgages that are in arrears, have been restructured, or are now in the foreclosure pipeline (Exhibit 3). This process of quiet forbearance in the United Kingdom, combined with record-low interest rates, may be masking significant dangers ahead. Some 23 percent of UK households report that they are already “somewhat” or “heavily” burdened in paying off unsecured debt.2 Indeed, the debt payments of UK households are one-third higher than those of their US counterparts—and 10 percent higher than they were in 2000, before the bubble. This statistic is particularly problematic because at least two-thirds of UK mortgages have variable interest rates, which expose borrowers to the potential for soaring debt payments should interest rates rise.

Given the minimal amount of deleveraging among UK households, they do not appear to be following Sweden or Finland on the path of significant, rapid deleveraging. Extrapolating the recent pace of UK household deleveraging, we find that the ratio of household debt to disposable income would not return to its long-term trend until 2020. Alternatively, it’s possible that developments in UK home prices, interest rates, and GDP growth will cause households to reduce debt slowly over the next several years, to levels that are more sustainable but still higher than historic trends. Overall, the United Kingdom needs to steer a difficult course that reduces household debt steadily, but at a pace that doesn’t stifle growth in consumption, which remains the critical driver of UK GDP.

Spain: The long unwinding road

Since the credit crisis first broke, Spain’s ratio of household debt to disposable income has fallen by 4 percent and the outstanding stock of household debt by just 1 percent. As in the United Kingdom, home mortgages and other forms of credit have continued to grow while consumer credit has fallen sharply.

Spain’s mortgage default rate climbed following the crisis but remains relatively low, at approximately 2.5 percent, thanks to low interest rates. The number of mortgages in forbearance has also risen since the crisis broke, however. And more trouble may lie ahead. Almost half of the households in the lowest-income quintile face debt payments representing more than 40 percent of their income, compared with slightly less than 20 percent for low-income US households. Meanwhile, the unemployment rate in Spain is now 21.5 percent, up from 9 percent in 2006. For now, households continue to make payments to avoid the country’s conservative recourse laws, which allow lenders to go after borrowers’ assets and income for a long period.

In Spain, unlike most other developed economies, the corporate sector’s debt levels have risen sharply over the past decade. A significant drop in interest rates after the country joined the eurozone, in 1999, unleashed a run-up in real-estate spending and an enormous expansion in corporate debt. Today, Spanish corporations hold twice as much debt relative to national output as do US companies, and six times as much as German companies. Debt reduction in the corporate sector may weigh on growth in the years to come.

Exhibit 3

If forbearance is factored in, up to 14 percent of UK mortgages could be in difficulty—identical to the percentage of US mortgages in difficulty today.

% of residential mortgages in difficulty, 2011

1 UK delinquency data as of Q2 2011, represents mortgage loans >1.5% in arrears. UK forebearance data based on worst-case estimates from Bank of England Financial Stability Report, June 2011.

2 US delinquency and foreclosure data as of Q1 2011; delinquency represents mortgage loans >30 days delinquent.

Source: Mortgage Bankers Association, United States; Bank of England; McKinsey Global Institute analysis

Signposts for recovery

Paring debt and laying a foundation for sustainable long-term growth should take place simultaneously, difficult as that may seem. For economies facing this dual challenge today, a review of history offers key lessons. Three historical episodes of deleveraging are particularly relevant: those of Finland and Sweden in the 1990s and of South Korea after the 1997 financial crisis. All these countries followed a similar path: bank deregulation (or lax regulation) led to a credit boom, which in turn fueled real-estate and other asset bubbles. When they collapsed, these economies fell into deep recession, and debt levels fell.

In all three countries, growth was essential for completing a fiveto seven-year-long deleveraging process. Although the private sector may start to reduce debt even as GDP contracts, significant public-sector deleveraging, absent a sovereign default, typically occurs only when GDP growth rebounds, in the later years of deleveraging (Exhibit 4). That’s true because the primary factor causing public deficits to rise after a banking crisis is declining tax revenue, followed by an increase in automatic stabilizer payments, such as unemployment benefits. (See Fiscal Monitor: Navigating the Fiscal Challenges Ahead, International Monetary Fund, May 2010.)

Exhibit 4

Significant public-sector deleveraging typically occurs after GDP growth rebounds.

Average of relevant historical deleveraging episodes (Sweden and Finland in 1990s)

Source: Haver Analytics; International Monetary Fund (IMF); McKinsey Global Institute analysis

A rebound of economic growth in most deleveraging episodes allows countries to grow out of their debts, as the rate of GDP growth exceeds the rate of credit growth.

No two deleveraging economies are the same, of course. As relatively small economies deleveraging in times of strong global economic expansion, Finland, South Korea, and Sweden could rely on exports to make a substantial contribution to growth. Today’s deleveraging economies are larger and face more difficult circumstances. Still, historical experience suggests five questions that business and government leaders should consider as they evaluate where today’s deleveraging economies are heading and what policy priorities to emphasize.

1. Is the banking system stable?

In Finland and Sweden, banks were recapitalized and some were nationalized. In South Korea, some banks were merged and some were shuttered, and foreign investors for the first time got the right to become majority investors in financial institutions. The decisive resolution of bad loans was critical to kick-start lending in the economicrebound phase of deleveraging.

The financial sectors in today’s deleveraging economies began to deleverage significantly in 2009, and US banks have accomplished the most in that effort. Even so, banks will generally need to raise significant amounts of additional capital in the years ahead to comply with Basel III and national regulations. In most European countries, business demand for credit has fallen amid slow growth. The supply of credit, to date, has not been severely constrained. A continuation of the eurozone crisis, however, poses a risk of a significant credit contraction in 2012 if banks are forced to reduce lending in the face of funding constraints. Such a forced deleveraging would significantly damage the region’s ability to escape recession.

2. Are structural reforms in place?

In the 1990s, each of the crisis countries embarked on a program of structural reform. For Finland and Sweden, accession to the European Union led to greater economies of scale and higher direct investment. Deregulation in specific industry sectors—for example, retailing—also played an important role. (See Kalle Bengtsson, Claes Ekström, and Diana Farrell, “Sweden’s growth paradox,” mckinseyquarterly.com, June 2006; and Sweden’s Economic Performance: Recent Developments, Current Priorities (May 2006), available online at mckinsey.com/mgi.) South Korea followed a remarkably similar course as it restructured its large corporate conglomerates, or chaebol, and opened its economy wider to foreign investment. These reforms unleashed growth by increasing competition within the economy and pushing companies to raise their productivity.

Today’s troubled economies need reforms tailored to the circumstances of each country. The United States, for instance, ought to streamline and accelerate regulatory approvals for business investment, particularly by foreign companies. The United Kingdom should revise its planning and zoning rules to enable the expansion of successful high-growth cities and to accelerate home building. Spain should drastically simplify business regulations to ease the formation of new companies, help improve productivity by promoting the creation of larger ones, and reform labor laws. (A Growth Agenda for Spain, McKinsey & Company and FEDEA, 2010.) Such structural changes are particularly important for Spain because the fiscal constraints now buffeting the European Union mean that the country cannot continue to boost its public debt to stimulate the economy. Moreover, as part of the eurozone, Spain does not have the option of currency depreciation to stimulate export growth.

3. Have exports surged?

In Sweden and Finland, exports grew by 10 and 9.4 percent a year, respectively, between 1994 and 1998, when growth rebounded in the later years of deleveraging. This boom was aided by strong exportoriented companies and the significant currency devaluations that occurred during the crisis (34 percent in Sweden from 1991 to 1993). South Korea’s 50 percent devaluation of the won, in 1997, helped the nation boost its share of exports in electronics and automobiles.

Even if exports alone cannot spur a broad recovery, they will be important contributors to economic growth in today’s deleveraging economies. In this fragile environment, policy makers must resist protectionism. Bilateral trade agreements, such as those recently passed by the United States, can help. Salvaging what we can from the Doha round of trade talks will be important. Service exports, including the “hidden” ones that foreign students and tourists generate, can be a key component of export growth in the United Kingdom and the United States.

4. Is private investment rising?

Another important factor that boosted growth in Finland, South Korea, and Sweden was the rapid expansion of investment. In Sweden, it rose by 9.7 percent annually during the economic rebound that began in 1994. Accession to the European Union was part of the impetus. Something similar happened in South Korea after 1998 as barriers to foreign direct investment fell. These soaring inflows helped offset slower private-consumption growth as households deleveraged.

Given the current very low interest rates in the United Kingdom and the United States, there is no better time to embark upon investments. Those for infrastructure represent an important enabler, and today there are ample opportunities to renew the aging energy and transportation networks in those countries. With public funding limited, the private sector can play an important role in providing equity capital, if pricing and regulatory structures enable companies to earn a fair return.

5. Has the housing market stabilized?

During the three historical episodes discussed here, the housing market stabilized and began to expand again as the economy rebounded. In the Nordic countries, equity markets also rebounded strongly at the start of the recovery. This development provided additional support for a sustainable rate of consumption growth by further increasing the “wealth effect” on household balance sheets.

In the United States, new housing starts remain at roughly one-third of their long-term average levels, and home prices have continued to decline in many parts of the country through 2011. Without price stabilization and an uptick in housing starts, a stronger recovery of GDP will be difficult, since residential real-estate construction alone contributed 4 to 5 percent of GDP in the United States before the housing bubble. (In 2010, residential real-estate investment accounted for just 2.3 percent of GDP, compared with 4.4 percent in 2000, before the housing-bubble years. Personal consumption on furniture and other household durables added about 2 percent to growth in 2000.) Housing also spurs consumer demand for durable goods such as appliances and furnishings and therefore boosts the sale and manufacture of these products.

At a time when the economic recovery is sputtering, the eurozone crisis threatens to accelerate, and trust in business and the financial sector is at a low point, it may be tempting for senior executives to hunker down and wait out macroeconomic conditions that seem beyond anyone’s control. That approach would be a mistake. Business leaders who understand the signposts, and support government leaders trying to establish the preconditions for growth, can make a difference to their own and the global economy.

The authors wish to thank Toos Daruvala and James Manyika for their thoughtful input, as well as Albert Bollard and Dennis Bron for their contributions to the research supporting this article.

Karen Croxson, a fellow of the McKinsey Global Institute (MGI), is based in McKinsey’s London office;
Susan Lund is director of research at MGI and a principal in the Washington, DC, office;
Charles Roxburgh is a director of MGI and a director in the London office.

___________________________

Deleveraging: Where are we now?

The financial crisis highlighted the danger of too much debt, a message that has only been reinforced by Europe’s recent sovereign-debt challenges. And new McKinsey Global Institute research shows that the unwinding of debt—or deleveraging—has barely begun. Since 2008, debt ratios have grown rapidly in France, Japan, and Spain and have edged downward only in Australia, South Korea, and the United States. Overall, the ratio of debt to GDP has grown in the world’s ten largest economies.

1 Defined as all credit-market borrowing, including loans and fixed-income securities. Some data have been revised since our Jan 2010 report.

2 Defined as an increase of 25 percentage points or higher. Source: Haver Analytics; national central banks; McKinsey Global Institute analysis

MACRO-EUROPE: The Titanic is SINKING

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

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

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

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

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

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

John Mauldin, Editor
Outside the Box

WELDON'S MONEY MONITOR

Tuesday April 27, 2010

MACRO-EUROPE: The Titanic is SINKING ...

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

Greek Finance Minister George Papaconstantinou ...

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

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

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

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

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

And from German Chancellor Angela Merkel ...

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

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

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

It is ALWAYS a LOSING proposition.

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

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

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

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

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

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

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

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

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

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

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

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

Also ...

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

And ...

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

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

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

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

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

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

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

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

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

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

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

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

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

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

The ship ... is going DOWN.

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

We have been anticipating this event for months.

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

... and bullish on Gold priced in EUR.

Gregory T. Weldon ---

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The European Union Trap

John Mauldin — Tue, 09 Mar 2010 16:01:00 GMT

Let's start with the conclusion to today's Outside the Box:

"The underlying principle flows from the financial balance approach: the domestic private sector and the government sector cannot both deleverage at the same time unless a trade surplus can be achieved and sustained. Yet the whole world cannot run a trade surplus. More specific to the current predicament, we remain hard pressed to identify which nations or regions of the remainder of the world are prepared to become consistently larger net importers of Europe's tradable products. Countries currently running large trade surpluses view these as hard won and well deserved gains. They are unlikely to give up global market shares without a fight, especially since they are running export led growth strategies. Then again, it is also said that necessity is the mother of all invention (and desperation, its father?), so perhaps current account deficit nations will find the product innovations or the labor productivity gains that can lead to growing the market for their tradable products. In the meantime, for the sake of the citizens in the peripheral eurozone nations now facing fiscal retrenchment, pray there is life on Mars that exclusively consumes olives, red wine, and Guinness beer." - Rob Parenteau, CFA

Let me state upfront that this is not the easiest to grasp Outside the Box that I have sent you. But if you can get what Rob is saying, you will understand why the problems facing the world, and especially Europe, are so difficult. Everyone cannot export their way out of this crisis. Someone has to actually run a current account (trade) deficit.

My suggestion is that you read this once through, and then read it again. If you see where Rob is going, it makes it easier to understand the second time. Warning: Rob Parenteau is an Austrian economist. In many circles, what he is saying is controversial, if not at least counter-intuitive. But it makes us think, which is the purpose of Outside the Box. If I get a response that is robust and thoughtful, I will run it in the future. The problem that Rob articulates is the center of the problems we face. There are no good or easy choices, as I have been writing for a log time.

Rob Parenteau, CFA, is the sole proprietor of MacroStrategy Edge and editor of The Richebacher Letter. He also serves as a research assistant to the Levy Institute of Economics. For those interested, you can subscribe to The Richebacher Letter at https://reports.agorafinancial.com/RCH497ControlPromo/LRCHL300/landing.html (yes, more hyper marketing copy, but that is the link if you want his letter.)

John Mauldin, Editor
Outside the Box

Will the Earnest Quest for Fiscal Sustainability Destabilize Private Debt?

By Rob Parenteau

The question of fiscal sustainability looms large at the moment - not just in the peripheral nations of the eurozone, but also in the UK, the US, and Japan. More restrictive fiscal paths are being proposed in order to avoid rapidly rising government debt to GDP ratios, and the financing challenges they may entail, including the possibility of default for nations without sovereign currencies.

However, most of the analysis and negotiation regarding the appropriate fiscal trajectory from here is occurring in something of a vacuum. The financial balance approach reveals that this way of proceeding may introduce new instabilities. Intended changes to the financial balance of one sector can only be accomplished if the remaining sectors also adjust in a complementary fashion. Pursuing fiscal sustainability along currently proposed lines is likely to increase the odds of destabilizing the private sectors in the eurozone and elsewhere - unless an offsetting increase in current account balances can be accomplished in tandem.

To make the interconnectedness of sector financial balances clearer, proposed fiscal trajectories need to be considered in the context of what we call the financial balances map. Only then can tradeoffs between fiscal sustainability efforts and the issue of financial stability for the economy as a whole be made visible. Absent consideration of the interrelated nature of sector financial balances, unnecessarily damaging choices may soon be made to the detriment of citizens and firms in many nations.

Navigating the Financial Balances Map

For the economy as a whole, in any accounting period, total income from producing final goods and services must equal total expenditures on final products. There are, after all, two sides to every transaction: a spender of money and a receiver of money income. Similarly, total saving out of income flows must equal total investment in tangible capital during any accounting period.

For individual sectors of the economy, these equalities need not hold. The financial balance of any one sector can be in surplus, in balance, or in deficit. The only requirement is, regardless of how many sectors we choose to divide the whole economy into, the sum of the sectoral financial balances must equal zero.

For example, if we divide the economy into three sectors - the domestic private (households and firms), government, and foreign sectors, the following identity must hold true:

Domestic Private Sector Financial Balance + Fiscal Balance + Foreign Financial Balance = 0

Note that it is impossible for all three sectors to net save - that is, to run a financial surplus - at the same time. All three sectors could run a financial balance, but they cannot all accomplish a financial surplus and accumulate financial assets at the same time - some sector has to be issuing liabilities.

Since foreigners earn a surplus by selling more exports to their trading partners than they buy in imports, the last term can be replaced by the inverse of the trade or current account balance. This reveals the cunning core of the Asian neo-mercantilist strategy. If a current account surplus can be sustained, then both the private sector and the government can maintain a financial surplus as well. Domestic debt burdens, be they public or private, need not build up over time on household, business, or government balance sheets.

Domestic Private Sector Financial Balance + Fiscal Balance - Current Account Balance = 0

Again, keep in mind this is an accounting identity, not a theory. If it is wrong, then five centuries of double entry book keeping must also be wrong. To make these relationships between sectors even clearer, we can visually represent this accounting identity in the following financial balances map as displayed below.

On the vertical axis we track the fiscal balance, and on the horizontal axis we track the current account balance. If we rearrange the financial balance identity as follows, we can also introduce the domestic private sector financial balance to the map:

Domestic Private Sector Financial Balance = Current Account Balance - Fiscal Balance

That means at every point on this map where the current account balance is equal to the fiscal balance, we know the domestic private sector financial balance must equal zero. In other words, the income of households and businesses just matches their expenditures (or alternatively, if you prefer, the saving out of income flows by the domestic private sector just matches the investment expenditures of the sector). The dotted line that passes through the origin at a 45 degree angle marks off the range of possible combinations where the domestic private sector is neither net issuing financial liabilities to other sectors, nor is it net accumulating financial assets from other sectors.

Once we mark this range of combinations where the domestic private sector is in financial balance, we also have determined two distinct zones in the financial balance map. To the left of the dotted line, the current account balance is less than the fiscal balance: the domestic private sector is deficit spending. To the right of the dotted line, the current account balance is greater than the fiscal balance, and the domestic private sector is running a financial surplus or net saving position.

This follows from the recognition that a current account surplus presents a net inflow to the domestic private sector (as export income for the domestic private sector exceeds their import spending), while a fiscal surplus presents a net outflow for the domestic private sector (as tax payments by the private sector exceed the government spending they receive).

Accordingly, the further we move up and to the left of the origin (toward the northwest corner of the map), the larger the deficit spending of households and firms as a share of GDP, and the faster the domestic private sector is reducing the stock of net financial assets it holds. This usually entails an increasing its private debt to income ratio, or a falling net worth to income ratio (absent an asset bubble, which would raise the valuation of assets held). Moving to the southeast corner from the origin takes us into larger domestic private surpluses, where households and firms can increase their holdings of net financial assets.

The financial balance map forces us to recognize that changes in one sector's financial balance cannot be viewed in isolation, as is the current fashion. If a nation wishes to run a persistent fiscal surplus and thereby pay down government debt, it needs to run an even larger trade surplus, or else the domestic private sector will be left stuck in a persistent deficit spending mode.

When sustained over time, this negative cash flow position for the domestic private sector will eventually increase the financial fragility of the economy, if not insure the proliferation of household and business bankruptcies. Mimicking the military planner logic of "we must bomb the village in order to save the village", the blind pursuit of fiscal sustainability may simply induce more financial instability in the private sector. Fiscal sustainability may ultimately prove destabilizing to the economy.

Leading the PIIGS to an (as yet) Unrecognized Slaughter

The rules of the eurozone are designed to reduce the room for policy maneuver of any one member country, and thereby force private markets to act as the primary adjustment mechanism. Each country is subject to a single monetary policy set by the European Central Bank (ECB). One policy rate must fit the needs of all the member nations in the eurozone. Each country has relinquished its own currency in favor of the euro. One exchange rate must fit the needs of all member nations in the eurozone. The fiscal balance of member countries is also, under the provisions of the Stability and Growth Path, supposed to be limited to a deficit of 3% of GDP. The principle here is one of stabilizing or reducing government debt to GDP ratios. Assuming economies in the eurozone have the potential to grow at 3% of GDP in real terms, and inflation is held to 2%, nominal GDP growth of 5% will be likely over the medium term. Starting from a 60% government debt to GDP ratio nominal terms, which is also the proposed public debt limit, a fiscal deficit of 3% of nominal GDP, when combined with a 5% nominal GDP growth tendency, will stabilize the government debt ratio at this limit (.03/.05 = .6, and the average debt ratio will migrate toward the marginal over time).

In other words, to join the European Monetary Union, nations have substantially diluted their policy autonomy. Markets mechanisms must achieve more of the necessary adjustments - policy measures are circumscribed. Policy responses are constrained by design, while experience suggests relative price adjustments in the marketplace have a difficult time at best of automatically inducing private investment levels consistent with desired private saving at anything approach the level of full employment income. This is a recipe for subpar growth outcomes, if not stagnation, and it presents quite a challenge if growth paths are knocked down by a global financial crisis, for instance.

Now let's layer on top of this structure three complicating developments of late. First, current account balances in a number of the peripheral nations have fallen, in part due to the prior strength in the euro. Second, fiscal shenanigans along with a very sharp global recession have led to very large fiscal deficits in a number of peripheral nations. Third, following the Dubai World debt restructuring, global investors have become increasingly alarmed about the sustainability of fiscal trajectories, and there is mounting pressure on governments to commit to tangible plans to reduce fiscal deficits over the next three years, with Ireland and Greece facing the first wave of demands for fiscal retrenchment.

We can apply the financial balances approach to make the current predicament plain. If, for example, Spain is expected to reduce it's fiscal deficit from roughly 10% of GDP to 3% of GDP in three years time, then the foreign and private domestic sectors must be together willing and able to reduce their financial balances by 7% of GDP. Spain is estimated to be running a 4.5% of GDP current account deficit this year. If Spain cannot improve its current account balance (in part because it relinquished its control over its nominal exchange rate the day it joined EMU), the arithmetic of sector financial balances is clear. Spain's households and businesses would, accordingly, need to reduce their current net saving position by 7% of GDP over the next three years. Since they are currently estimated to be net saving 5.5% of GDP, Spain's domestic private sector would move to a 1.5% of GDP deficit, and thereby enter a path of increasing leverage.

Spain already is running one of the higher private debt to GDP ratios in the region. In addition, Spain had one of the more dramatic housing busts in the region, which Spanish banks are still trying to dig themselves out from (mostly, it is alleged, by issuing new loans to keep the prior bad loans serviced, in what appears to be a Ponzi scheme fashion). It is highly unlikely Spanish businesses and households will wish to raise their indebtedness in an environment of 20% plus unemployment rates, combined with the prospect of rising tax rates and reduced government expenditures as fiscal retrenchment is pursued. More likely, they will try to preserve their recent net saving or financial surplus position.

Alternatively, if we assume Spain's private sector will attempt to preserve its estimated 5.5% of GDP financial balance, or perhaps even attempt to run a larger net saving or surplus position so it can reduce its private debt faster, Spain's trade balance will need to improve by more than 7% of GDP over the next three years. Barring a major surge in tradable goods demand in the rest of the world (especially demand for Spanish tradable goods by chronic current account surplus nations in the eurozone like Germany), or a rogue wave of rapid product innovation from Spanish entrepreneurs, there is an additional way for Spain to accomplish such a significant reversal in its current account balance.

Prices and wages in Spain's tradable goods sector will need to fall precipitously, and labor productivity will have to surge dramatically, in order to create a large enough real depreciation for Spain that its tradable products gain market share (at, we should mention, the expense of the rest of the eurozone members). Arguably, the slack resulting from the fiscal retrenchment is just what the doctor might order to raise the odds of accomplishing such a large wage and price deflation in Spain. But how, we must wonder, will Spain's private debt continue to be serviced during the transition as Spanish household wages and business revenues are falling under higher taxes or lower government spending?

Spain Ensnared in the EMU Trap

As evident from the financial balances map, there are a whole range of possible combinations of current account and domestic private sector financial balances which could be consistent with the 7% of GDP reduction in Spain's fiscal deficit. But the simple yet still widely unrecognized reality is as follows: both the public sector and the domestic private sector cannot deleverage at the same time unless Spain produces a nearly unimaginable trade surplus - unimaginable especially since Spain will not be the only country in Europe trying to pull this transition off.

As an admittedly rough exercise, we can assume each of the peripheral nations will be constrained to achieving a fiscal deficit that does not exceed 3% of GDP in three years time. In addition, we will assume each nation finds some way to improve its current account imbalances by 2% of GDP over the same interval. What, then, are the upper limits implied for domestic private sector financial balances as a share of GDP for each nation?

Greece and Portugal appear most at risk of facing deeper private sector deficit spending under the above scenario, while Spain comes very close to joining them. But that obscures another point which is worth emphasizing. With the exception of Italy, this scenario implies declines in private sector balances as a share of GDP ranging from 3% in Portugal to nearly 9% in Ireland.

Private sectors agents only tend to voluntarily target lower financial balances in the midst of asset bubbles, when, for example home prices boom and gross personal saving rates fall. Alternatively, during profit booms, firms issue debt and reinvest well in excess of their retained earnings in order take advantage of an unusually large gap between the cost of capital and the expected return on capital. We have no compelling reasons to believe either of these conditions is immediately on the horizon. If peripheral eurozone private sectors try to maintain something close to their current financial surpluses, current account balances will not to improve more dramatically, or nominal income growth will slow, if not fall into deflation.

The above conclusion regarding the need for a substantial trade balance swing in nations pursuing fiscal retrenchment flows straight from the financial balance approach, and yet it is obviously being widely ignored, because the issue of fiscal retrenchment is being discussed as if it had no influence on the other sector financial balances. This is unmitigated nonsense. It is even more retrograde than primitive tales of "twin deficits" (fiscal deficits are nearly guaranteed to produce offsetting current account deficits) or Ricardian Equivalence stories (fiscal deficits are nearly guaranteed to produce offsetting domestic private sector surpluses) mainstream economists have been force feeding us for the past three decades. Both of these stories reveal an incomplete understanding of the financial balance framework - or at best, one requiring highly restrictive (and therefore highly unrealistic) assumptions.

The EMU Triangle

This observation is especially relevant in the eurozone, as the combination of the policy constraints that were designed into the EMU, plus the weak trade positions many peripheral nations have managed to achieve, have literally backed these countries into a corner. To illustrate the nature of their conundrum, consider the following application of the financial balances map.

First, a constraint on fiscal deficits to 3% of GDP can be represented as a line running parallel to and below the horizontal axis. Under Stability and Growth Pact rules, we must define all combinations of sector financial balance in the region below this line as inadmissible. Second, since current account deficits as a share of GDP in the peripheral nations are running anywhere from near 2% in Ireland to over 10% in Portugal, and changes in nominal exchange rates are ruled out by virtue of the currency union, we can provisionally assume a return to current account surpluses in these nations is at best a bit of a stretch. This eliminates the financial balance combinations available in the right hand half of the map.

If peripheral eurozone nations wish to avoid a return to private sector deficit spending - and realistically, for most of the peripheral countries, the question is whether private sectors can be induced to take on more debt anytime soon, and whether banks and other creditors will be willing to lend more to the private sector following a rash of burst housing bubbles, as well as a severe recession that is not quite over - then there is a very small triangle that captures the range of feasible solutions for these nations on the financial balance map.

It is the height of folly to expect peripheral eurozone nations to sail their way into the EMU triangle under even the most masterful of policy efforts or price signals. More likely, since reducing trade deficits is likely to prove very challenging (Asia is still reliant on export led growth, while US consumer spending growth is still tentative, and, as mentioned earlier, most of the eurozone trade takes place within the eurozone itself), the peripheral nations in the eurozone will find themselves floating somewhere out to the northwest of the EMU triangle. The sharper their fiscal retrenchments, the faster their private sectors will tend to run up their debt to income ratios.

Alternatively, if households and businesses in the peripheral nations stubbornly defend their current net saving positions, the attempt at fiscal retrenchment will be thwarted by a deflationary drop in nominal GDP. Demands to redouble the tax hikes and public expenditure cuts to achieve a 3% of GDP fiscal deficit target will then arise. Private debt distress will also escalate as tax hikes and government expenditure cuts the net flow of income to the private sector. Call it the paradox of public thrift.

As it turns out, pursuing fiscal sustainability as it is currently defined will in all likelihood just lead many nations to further destabilization of private sector debt. European economic growth will prove extremely difficult to achieve if the current fiscal "sustainability" plans are carried out over the next three years. Realistically, policy makers are courting a situation in the region that will beget higher private debt defaults in the quest to reduce the risk of public debt defaults through fiscal retrenchment. European banks, which remain some of the most leveraged banks, will experience higher loan losses, and rating downgrades for banks will substitute for (or more likely accompany) rating downgrades for government debt. A fairly myopic version of fiscal sustainability will be bought at the price of a larger financial instability involving private debt as well.

Summary and Conclusions

These types of tradeoffs are opaque now because the fiscal balance is being treated in isolation. Implicit choices have to be forced out into the open and coolly considered by both investors and policy makers. It is not out of the question that fiscal rectitude at this juncture could place the private sectors of a number of nations on a debt deflation path - the very outcome policy makers were frantically attempting to prevent but a year ago.

There may be ways to thread the needle - Domingo Cavallo's [Argentina] recent proposal to pursue a "fiscal devaluation" by switching the tax burden in Greece away from labor related costs like social security taxes to a higher VAT could be one way to effectively increase competitiveness without enforcing wage deflation (http://www.voxeu.org/index.php?q=node/4666). The cost of exported goods is thereby lowered (as in a currency devaluation) without the need for domestic wage cuts and nominal income deflation, and this introduces the possibility of an improved trade balance with an unchanged fiscal balance.

Cavallo's claims to the contrary, however, it was not the IMF that tripped him up in pursuing this fiscal devaluation angle. Cavallo was, like Greece, under pressure to reduce Argentina's fiscal deficit. Fiscal expenditure cuts and tax hikes begat lower domestic income flows, which led to subsequent tax shortfalls, missed fiscal balance targets, and another round of fiscal retrenchment, in a vicious spiral fashion (another illustration of the paradox of public thrift).

Regardless, more innovative and effective solutions than the fiscal devaluation approach, need to be considered. Financial stability, not just fiscal sustainability, must be taken into account. But such solutions will not even be brought to light unless policy makers and investors begin to think coherently about how sector financial balances interact.

Or to put it more bluntly, if eurozone countries try to return to 3% fiscal deficits by 2012, as many of them are now pledging, unless the euro devalues enough or some other measure produces a large current account swing, then either a) the domestic private sectors of many nations will have to adopt a deficit spending trajectory, or b) nominal private income will deflate, and Irving Fisher's paradox will apply (as in the very attempt to pay down debt leads to more indebtedness), thwarting the ability of policy makers to achieve fiscal targets. In the case of Spain, (or adjacent to the eurozone, the UK) with large private debt/income ratios, this is an especially critical issue. In addition, given the eurozone tended to run a minor current account surplus (until recently) as a whole, falling nominal incomes in the peripheral nations, or improved current account balances in the periphery, will tend to come at the expense of growth in the eurozone's current account surplus nations. This introduces a possible contagion vector for Germany in particular, one that lies beyond the exposure of German banks to peripheral nation public debt or private debt. It is not obvious Germany's policy makers have fully considered these possible feedback effects which could lead to larger. Ironically, Germany's own fiscal balance could decline if these effects prove large enough on German income growth.

The underlying principle flows from the financial balance approach: the domestic private sector and the government sector cannot both deleverage at the same time unless a trade surplus can be achieved and sustained. Yet the whole world cannot run a trade surplus. More specific to the current predicament, we remain hard pressed to identify which nations or regions of the remainder of the world are prepared to become consistently larger net importers of Europe's tradable products. Countries currently running large trade surpluses view these as hard won and well deserved gains. They are unlikely to give up global market shares without a fight, especially since they are running export led growth strategies. Then again, it is also said that necessity is the mother of all invention (and desperation, its father?), so perhaps current account deficit nations will find the product innovations or the labor productivity gains that can lead to growing the market for their tradable products. In the meantime, for the sake of the citizens in the peripheral eurozone nations now facing fiscal retrenchment, pray there is life on Mars that exclusively consumes olives, red wine, and Guinness beer.

Rob Parenteau, CFA
MacroStrategy Edge
February 22, 2010
macrostratedge@yahoo.com

If PIIGS Could Fly

John Mauldin — Tue, 02 Feb 2010 15:45:00 GMT

I wrote about Greece in last week's letter. Then I ran across this column in the Financial Times by my friend Mohammed El-Erian, chief executive of Pimco, and someone who qualifies to be introduced as one of the smartest men on the planet. It is short and to the point. (www.pimco.com)

Then, somehow my London partner, Niels Jensen of Absolute Return Partners found the time to write a letter while we were running around Europe. As we had a lot of conversations with some very key players, and a lot of debate, the letter reflects a lot of what we learned, as well as further documents the serious straits that European nations face in the coming years due to their debt and deficits. It is not just a US or Japanese problem. I have worked closely with Niels for years and have found him to be one of the more savvy observers of the markets I know. You can see more of his work at www.arpllp.com and contact them at info@arpllp.com.

And finally, many of you are probably familiar with TED Talks. If you are not, you should be. They basically get very smart, creative people to come in and do short talks Tiffani just sent me one of their latest videos. 13 minutes. It blew me away. The world of Minority Report is here, 40 years ahead of schedule. All I could do was just say "Wow!" Its young men like this that should make us all optimists that somehow we will figure out how to get through all this. http://www.ted.com/talks/view/id/685

John Mauldin, Editor
Outside the Box

Greece part of unfolding sovereign debt story

By Mohamed El-Erian

Global investors worldwide are starting to pay more attention to what is unfolding in Greece. Yet most still think of Greece as an isolated case, just as they did for Dubai a few months ago.

With time, they will see Greece as part of a much larger investment theme that is a direct outcome of the global financial crisis: the 2008-09 ballooning of sovereign balance sheets in advanced economies is consequential and is becoming an important influence on valuations in many markets around the world.

As realisation spreads of this key sovereign investment theme, it is important to be clear about what Greece is, and what it is not.

At the simplest level, think of Greece as Europe's big game of chicken, with the operational question for markets being two-fold: who will blink first, the Greek authorities, donors or both; and will they blink in time to avoid truly disorderly debt and market dynamics that also entail significant contagion risk.

Let us start with Greece where, under any realistic scenario, a meaningful internal adjustment is needed.

There is no solution to the country's debt issues without a deep and sustained policy effort. Yet, given the initial conditions (including the size and maturity profile of its debt) and the existing policy framework (anchored on adherence to a fixed exchange rate via the euro), such adjustment is difficult and not sufficient.

If unaccompanied by extraordinary external assistance, it would entail such contractionary fiscal measures as to raise legitimate socio-political problems.

External assistance is needed to support the meaningful implementation of internal policies. And it has to be consequential in scale and durability, as well as timely and well-targeted.

Understandably, such assistance faces headwinds on account of donors' moral hazard concerns (vis-à-vis Greece and beyond); of donors' understanding that a Greek bail-out would not be a one-shot deal; and of donors' own domestic budgetary considerations.

Because of this, I suspect that at least three of the following four conditions are needed to force the hand of European donors, and that is assuming that Greece provides them at least with the fig leaf of commitment to meaningful internal policy actions.

First, evidence that Greek markets are being severely impacted by funding concerns. With the recent surge in borrowing costs and the disruptions in the normal functioning of government and corporate markets, this condition is clearly already met.
Second, evidence that other peripherals in Europe – such as Ireland, Italy, Portugal and Spain – are also being impacted. This is happening, as signalled by the gradual widening in market risk spreads.
Third, evidence that other providers of capital are sharing the burden of financing Greece. Tuesday's €8bn bond issuance to private creditors is consistent with this.
Fourth, evidence that the Greek financial disruptions are starting to undermine core European countries. Evidence here is limited to the weakening of the euro, which, as yet, cannot be viewed as disruptive (indeed, some view it as helpful for Europe).

Notwithstanding this last condition, we are much closer today to the point where donors' hands will be forced. Yet investors should remain wary, as this would offer, at best, only a short-term tactical opportunity. Greater clarity as to what Greece can deliver in internal adjustment should remain the primary driver for long-term investment opportunities.

Investors should also remember that "market technicals" remain tricky and now constitute a meaningful marginal price setter. The shift in the investment characterisation of Greece, from being primarily an interest rate exposure to a credit exposure, has happened in such a way as to allow for little orderly repositioning. Many investors are trapped and the phenomenon has been accentuated by the recent evaporation of market liquidity.

Where does all this leave us?

Over the next few days, we are likely to get some combination of Greek and European donor announcements aimed at calming markets, reducing volatility, and reducing contagion risk. But the impact on markets is unlikely to be sustained as both sides face multi-round, protracted challenges which contain all the elements of complex game dynamics.

No matter how you view it, markets in Greece will remain volatile and more global investors will be paying attention. In the process, this will accelerate the more general recognition that sovereign balance sheets in many advanced economies are now in play when it comes to broad portfolio positioning considerations.

And now to Niels Jensen's piece.

If PIIGS Could Fly

By Niels Jensen

The Absolute Return Letter - February 2010

"A democracy is always temporary in nature; it simply cannot exist as a permanent form of government. A democracy will continue to exist up until the time that voters discover that they can vote themselves generous gifts from the public treasury. From that moment on, the majority always votes for the candidates who promise the most benefits from the public treasury, with the result that every democracy will finally collapse due to loose fiscal policy..."

Alexander Fraser Tytler, Scottish lawyer and writer, 1770

Travelling with John Mauldin

It was always naïve to believe that a crisis so deep and profound was going to go away with a whimper; however, an increase of more than 50% in global equity prices can be very seductive, and nine months of virtually uninterrupted gains have led many to believe that the problems of 2008-09 are now largely behind us.

Well, not quite everybody. Friend and business partner John Mauldin remains a sceptic. I have had the pleasure of travelling across Europe with John over the past week or so and, as the week progressed, my mood swung decisively towards a state where Prozac would probably be the most appropriate remedy.

Now, John and I do not agree on absolutely everything. For example, I believe – and have believed for a while – that he is too bearish on equities. But, before we go there, allow me to share with you the essence of John's views which can be summed up quite nicely by two charts, courtesy of BCA Research.

In John's opinion – and I do not disagree – we are still only in the second or third innings of the de-leveraging process (chart 1). Years of excessive debt accumulation cannot be reversed in 18 months, and it will take at least another 5-6 years to play out, possibly longer.

The other part of John's argument – and again it is hard to disagree – is that it remains an open question how much de-leveraging has in fact taken place. As you can see from chart 2, US sovereign debt has risen as fast as private debt has declined (and the picture is similar in many other countries), providing support for the argument that all we have achieved so far is to move liabilities from private to public balance sheets, effectively burdening tomorrow's taxpayer.

The basket case named Greece

In the last few days, developments in Greece have totally overshadowed other events. As I write these lines, the 10-year Greek government bond trades a shade under 7%, now yielding a whopping 370 basis points more than the corresponding Bunds. At the same time, and not at all surprisingly, Greek credit default swaps – measuring the cost of insurance against a Greek sovereign default – have exploded (chart 3).

When I was in Zurich with John last week, I bumped into the famous Swiss investor, Felix Zulauf, who pointed out to me that Greece has in fact been in default in 105 of the last 200 years, so never say never. Having said that, Greece cannot be allowed to default, as the implications would be catastrophic. Bond investors would immediately pick apart the next country in line, and it is almost certainly going to be one of the other PIIGS – Portugal, Italy, Ireland or Spain. Bailing out Greece is just about manageable, but having to save all of them would overwhelm the EU. Swift action must therefore be taken, moral hazard or not.

Back in early January, the research team at Danske Bank in Copenhagen produced a most interesting research paper[1], revealing how desperate the fiscal outlook is for many EU members. Table 1 illustrates the path of debt-to-GDP between now and 2020, assuming no change to current policy.

Now, we all know what cannot happen, will not happen. There is a reason the EU, via its stability pact, set the debt-to-GDP ceiling at 60% for its euro zone members. Obviously, with the low interest rates we currently enjoy, one could argue that a higher debt-to-GDP ratio could be sustained, and that is essentially correct as long as interest rates remain low; however, you leave yourself seriously exposed, should rates rise which they almost certainly will as sovereign debt increasingly becomes junk. .

Danske Bank then went one step further in its analysis. In order to illustrate the magnitude of the problem, they calculated how aggressive the fiscal tightening would have to be in order for the euro zone member states to comply with the stability pact by 2020. Table 2 below indicates how much the deficit must be reduced every year for the next five years in order to bring debt-to-GDP to 60% by 2020. Greece, being in the most precarious position, would need to shave 4% off its budget every year. We all know that is not going to happen because that would spell depression.

In the short term, Greece needs to find over €50 billion before the end of the year to refinance debt which is about to mature. The question is not so much whether it will fail in its endeavour but what price it will have to pay. An already fragile Greek fiscal situation could be further undermined, if Greece is forced to pay 7% going forward which it can hardly afford.

Is Spain next?

Towards the end of last week it became apparent that there might be some appetite for rescuing Greece, although few details are currently available. However, I am not convinced that there is a strong consensus in favour of a rescue package. Most of the positive vibes have come from Spain, whereas Germany and France have been decidedly less forthcoming. It is perhaps not surprising that it is the Spanish who seem most eager to bail Greece out, considering that they could very well be the next victim of the bond market's invisible hand.

In the last few days, Spain has gone out of its way to demonstrate its commitment to greater fiscal discipline in general and to the stability pact in particular. The government has just proposed for the retirement age to be increased from 65 to 67 (to be introduced gradually from 2013), and a fiscal programme designed to reduce the annual deficit to 3% of GDP by 2013 has been presented. The problem for Spain is that words are cheap. Few commentators believe that 3% is a realistic target given the depth of Spain's problems at the moment. Don't hold your breath.

The outlook is very grim

The outlook goes from murky to unbelievably grim, if one includes off-balance sheet items such as social security, pension and health liabilities, which have been promised to us over the years by well meaning but financially inept governments (see chart 4). As Societe Generale's Dylan Grice puts it:

"I don't see how our governments can pay these liabilities. EU and US net liabilities add up to around $135 trillion alone. That is four times the capitalization of Datastream's World equity index of about $36 trillion, and forty times the cost of the 2008 financial crisis."[2].

I also note that Greece, not included in the chart, stands at 875% debt-to-GDP when including off-balance sheet items!

The bond market will ultimately determine when enough is enough. As President Clinton's campaign strategist James Carville once put it:

"I used to think if there was reincarnation, I wanted to come back as the President or the Pope or a .400 baseball hitter. But now I want to come back as the bond market. You can intimidate everyone."

It can play out in a couple of different ways. Either bond investors will go on strike until they feel that they are being sufficiently rewarded for the higher risk associated with sovereign debt following the credit crunch or governments will implement budget curtailments designed to bring the debt escalation under control again, but that will be detrimental to economic growth. My bet is that the latter outcome will ultimately prevail but not until the bond market forces the hand of our governments.

The end game for Japan?

The first country to really feel the pinch could very well be Japan; in the bigger context, Greece is just the appetizer. Japan's debt-to-GDP ratio has grown from 65% in the early 1990s when their crisis began in earnest to over 200% now. Fortunately for Japan, the high savings rate has allowed shifting governments to finance the deficit internally with about 93% of all JGBs held domestically[3]. This is the key reason why Japan gets away with paying only 1.3% on their 10-year bonds when other large OECD countries must pay 3-4% to attract investors.

Now, predicting the demise of Japan has cost many a career over the years. Despite the ever rising debt, and contrary to many expert opinions, the yen has been rock solid and bond yields have remained comparatively low. I often hear the argument from the bulls that the Japanese situation is sustainable because they, unlike us, are a nation of savers. Wrong. They were a nation of savers.

Looking at chart 5, it is evident that the demographic tsunami has finally hit Japan. The savings rate is in a structural decline and the Ministry of Finance in Tokyo may soon be forced to go to international capital markets to fund their deficits. I very much doubt that non-Japanese investors will be as forgiving as the Japanese, and that could force bond yields in Japan in line with US and German yields. Herein lies the challenge. Japan already spends 35% of its pre-bond issuance revenues on servicing its debt. If the Japanese were forced to fund themselves at 3.5% instead of 1.3%, the game would soon be up.

Why stock markets go up

Despite the grim outlook, the world's stock markets have produced brilliant returns over the past nine months. This has provoked some of the best and brightest in our industry (most recently Mohamed El-Erian, CEO of Pimco[4]) to declare that there is a dis-connect between the economic reality and the picture painted by Wall Street.

I am not convinced. Firstly, global equities reached extremely depressed levels back in February 2009, and the recovery, however muted it may ultimately turn out to be, has stopped the bleeding in most large companies, giving investors an excuse to accumulate stocks again (smaller companies is a different story altogether, but that is a story for another day). What matters to the likes of Coca Cola, Rolls Royce and Volkswagen is not so much how the domestic economy performs, because the leading lights of industry today are becoming increasingly detached from the domestic economy. Ever more important to those companies is the global stage, and the global outlook is considerably more upbeat than, say, the US, UK or German growth prospects.

Secondly, equities usually do very well in the very late stages of recession and early stages of recovery. I refer to our July 2006 Absolute Return Letter for an in-depth analysis of this, which you can find here.

Thirdly, valuations are not prohibitively high. Many bears refer to the stock market (whether European or US) as being very expensive at current levels, but that is plainly untrue. Based on 2010 projected earnings, most OECD markets are either in line with or 10-20% below historical averages (see table 3). Only in emerging markets can you reasonably argue that current P/E levels are not cheap relative to the long term average.

In 2009 there have been massive flows of capital towards emerging markets – and towards Asia in particular – and valuations have been driven up as a result. It is hard to argue that those markets are yet in bubble territory, if one uses the valuations in table 3 as a benchmark; however, by pegging their currencies to the US dollar, Asian countries have effectively adopted a monetary policy which is entirely unsuitable for economies growing as fast as they do. That is how bubbles have been created in the past and why Asian equity markets should be monitored closely for signs of overheating in the months to come.

Conclusion

Summing it all up, the fate of global equity markets is very much in the hands of bond investors. Under normal circumstances, this is the best time to be in equities. But these times are not normal, so do not expect that the outstanding performance of 2009 will be repeated in 2010. If international bond markets calm down again – and that may happen, at least temporarily – equities can probably post further (but modest) gains in 2010; however, the end game is approaching. If bond investors do not revolt in 2010, they probably will in 2011, so playing the economic recovery through equities is a dangerous game.

As far as the bond market is concerned, as often pointed out by Martin Barnes at BCA Research, if you want to know where the next crisis will be, then look at where the leverage is being created today. And nowhere is there more leverage being created at the moment than on sovereign balance sheets. What is happening is an experiment never undertaken before. As John Mauldin puts it, we are operating on the patient without anaesthesia.

The big challenge will be to get the timing right. These situations can run for longer than most people imagine. Japan's crisis has been widely predicted for almost a decade now, and the ship appears to be as steady as ever. As I suggested earlier, the key to predicting the timing of Japan's demise – because there will be one – may very well be embedded in the savings rate, which could quite possibly turn negative in the next few years.

The Dubai crisis taught us that markets are in a forgiving mode at the moment and, before long, Greece could very well find some respite from its current problems. But then again, ultimately, governments will find – just like millions of households have found over the years – that you cannot spend more then you earn in perpetuity. The enormous debt levels being created at the moment will haunt us for many years to come and we may have to wait a long time to see the PIIGS fly again.

Footnotes:

[1] 'Debt on a dangerous path', 4^th January, 2010, by Danske Bank. You can find the entire report here.

[2] 'Popular Delusions', Societe Generale, 12^th November, 2009

[3] Source: http://econompicdata.blogspot.com/2009/12/real-lost-decade-japanese-gdp-edition.html

[4] Source: http://www.investmentpostcards.com/2010/01/16/el-erian-markets-not-facing-reality-of-slow-economy/

Spain: The Hole In Europe's Balance Sheet

John Mauldin — Mon, 31 Aug 2009 20:24:00 GMT

Today's offering for this week's Outside the Box starts off with a quote from Titus Maccius Plautus: "I am a rich man as long as I don't pay my creditors." Even 2200 years ago, it seems that problems of credit were an issue.

I talked last Friday about the US being faced with a number of bad choices. But it is not just the US. Today we look at a piece from my friends at Variant Perception based on London. They are a relatively new institutional research house. I have been reading their material for some time and have begun to look very much forward to it. They do some very good in-depth analysis. I asked then to shorten a piece they did on Spain and Spanish banks for this week's Outside the Box. Spain will soon be faced with a number of very uncomfortable choices, but for now they appear in denial.

For those interested, I also provide a link to another report they did on the United Kingdom, tax collections (way down!) and the link to UK gilts (or bonds). It seems they also have a problem with issuing too much debt. http://www.variantperception.com/sites/default/files/uploads/Taxing_Problems_and_a_Gilt-y_Solution.pdf

I have highlighted problems in Japan and with the European banking system. The problem from the credit crisis are world wide. To think they are not interconnected would be naiveté in the extreme. What happens in Japan and Spain and the US will affect your part of the world, some more than others. Today, let's look at Spain, which has as many unsold hoes but at one-sixth of the population, and these homes are on the books of banks at full price. I will let you read about the rest of the future train wreck that is Spain from Variant Reception (www.variantperception.com which has some other interesting sample commentary as well).

Choices indeed.

John Mauldin, Editor
Outside the Box

Spain: The Hole In Europe's Balance Sheet

Dives sum, si non reddo eis quibus debeo.
I am a rich man as long as I don't pay my creditors.

Titus Maccius Plautus (c. 254-184 BCE), "Curculio"

Themes

Spain = Japan 2.0? - We argue that 1) the real estate crash in Spain is worse than is widely believed, 2) Spanish banks are hiding their losses, and 3) investors are smoking crack if they believe that Spanish banks are among the strongest in Europe, (see Forbes latest Spanish Banks In Top Form). If all these are true, Spain will soon have zombie banks like Japan.
Banks are hiding losses - We believe that Spanish banks are not marking their real estate loans to market and are extending credit to zombie construction companies. They do this by 1) Getting a boost from accounting changes, 2) Not marking loans to market, 3) Continued lending to zombie companies, 4) Extending 40 year and 100% loan-to-value loans, and other bubble-like lending practices. We look at each of these in turn.
Spain is in deflation - In a deflationary environment, servicing debt becomes even harder. Even when rates go to zero the real burden of debt goes up. That is why deflation is such a terrible thing. Eastern Europe, Spain and Ireland are now all experiencing the beginning of deflation. We believe that we will see much more deflation to come, which will have broad ramifications across the European banking sector.
Who's holding the bag? - The periphery countries are net debtors, and the rest of Europe is the net creditor. When a debtor can't pay, the creditor suffers. Germany, France and others will need to cope with recapitalizing the periphery and Spain.

Strategies

We recommend shorting or being underweight Spanish government bonds vs German bonds and short equities, particularly banks, builders and anything related to the consumer.

Spain = Japan 2.0?

We hate to bang on about Spain like an old Salvation Army drum, but we believe that Spain is a disaster waiting to happen. Misunderstanding the severity of the crisis will prove costly to investors as it will have profound implications to the European banking system.

Spain is set for a long, painful deflation that will manifest itself via a very high unemployment level for an industrialized economy, a real estate collapse and general banking insolvencies.

Spain had the mother of all housing bubbles. To put things in perspective, Spain now has as many unsold homes as the US, even though the US is about six times bigger. Spain is roughly 10% of the EU GDP, yet it accounted for 30% of all new homes built since 2000 in the EU. Most of the new homes were financed with capital from abroad, so Spain's housing crisis is closely tied in with a financing crisis.

The impact on the banking sector will be severe. Consider this: the value of outstanding loans to Spanish developers has gone from just €33.5 billion in 2000 to €318 billion in 2008, a rise of 850% in 8 years. If you add in construction sector debts, the overall value of outstanding loans to developers and construction companies rises to €470 billion. That's almost 50% of Spanish GDP. Most of these loans will go bad.

Spanish banks, in our view, are now facing a very bleak outlook. Spain's unemployment rate reached over 17%; there are now four million unemployed Spaniards and over one million families with not a single person employed in the family.

We argue and will document anecdotally in this report that:

The real estate crash in Spain is worse than is widely believed, much as the subprime problem was much worse than people believed
Spanish banks are hiding their losses and rolling over debt to zombie companies, much as Japan did in the last decade
Investors are deluding themselves if they believe that Spanish banks are among the strongest in the world. (This is a new theme. See Forbes's latest "Spanish Banks In Top Form" for an example of the new fawning articles on Spanish banks.)

If we are right, Spain will soon have zombie banks like Japan and it will face a prolonged period of deflation. However, Spain will be much worse. As Edward Hugh, the doyen of clear-headed analysts of Spain, points out, "Japan in 1992 could leverage its own savings, it had a current account surplus of 3% of GDP. Spain has massive external debt - in 2007 the current account deficit was 10% of GDP - and little in the way of major export industries."

Putting Together A Mosaic

At Variant Perception, we try to stay away from writing too many words. Anything that cannot be explained with a few charts is most likely not worth explaining. In the case of Spanish banking's subterfuge and hiding of bad loans, we have had to assemble a mosaic of news pieces, interviews with banking insiders and others to piece together what is in fact happening. This reminds us very much of the early days of subprime where all the banking results looked good, until they didn't. We believe it will be the same with Spanish real estate.

The Situation In Spanish Housing Is Much Worse Than People Think

The standard line that most analysts buy about Spanish banks is the following:

Dynamic provisioning - In 2000, Spain's central bank introduced a system of "dynamic provisioning" that forced banks to build up reserves against future losses. Spanish banks reserved three to four times as much as most of their international competitors. In a sense, the Bank of Spain was building countercyclical buffers to prepare for an eventual credit crisis.
Prudent lending - The large private Spanish banks claim that their risk management led them to concentrate mortgage lending on primary residences in the cities at reasonable loan-to-value ratios, leaving lending to developers and buyers of second homes to the Cajas.

However, despite dynamic provisioning, in the recent rally, Spanish banks have been rushing left, right and centre to shore up their capital. They have mainly done so by tapping their clueless retail customers for investment in preferred shares. It is a good start, but we believe they still have not done enough.

The magnitude of the Spanish problem is staggering, and will overwhelm all the benefits of dynamic provisioning. Conservatively, Spain has over 1,000,000 unsold homes. Unfortunately, many of the homes are on the coast, and without a return of overleveraged British tourists, they are likely to remain unsold. Spain's homes are all in the wrong places.

Spain's building stocks bubble looks very much like the US bubble and other classic bubbles. It went up 10x and then went down 90%. The math is very simple.

Given this woeful state of affairs, you might assume Spanish house prices had suffered like US house prices. This is not the case.

As the following chart shows, according to official statistics, Spanish house prices are down little more than 10% from their peaks.

Why have Spanish banks not experienced the same fate as American, Irish and UK banks? We've often wondered how it is that our thesis for Spanish real estate and industrial collapse has not created more victims.

We believe that Spanish banks are hiding their problems. We explore how they are doing this through:

Getting a boost from accounting changes
Not marking loans to market
Continued lending to zombie companies
Making 40 year and 100% loan-to-value loans

Let's look at them in turn.

1) Getting a boost from accounting changes

The Bank of Spain is thought of as a very conservative, prudent institution. That is true, but it is now changing its tune. It must now be very concerned for the fate of some Spanish banks and some analysts estimate it will help them avoid posting losses this year.

In July the Bank of Spain changed its provisioning rules on risky mortgages. Previously, banks have made provision for the full value of loans above 80% of a loan to value ratio after two years of payment arrears. Following the new directives from the Bank of Spain, banks now only need to reserve for the difference between the value of the loan and 70% of the property's market value. For many Spanish banks, this has allowed them not to lose money this year.

Source: http://www.ft.com/cms/s/0/adcd2d5c-725d-11de-ba94-00144feabdc0,dwp_uuid=4034778a-37aa-11dd-aabb-0000779fd2ac.html

Source: http://www.economist.com/businessfinance/displaystory.cfm?story_id=14133692&CFID=75849280&CFTOKEN=62919779

2) Not marking loans to market

We also believe that Spanish banks are not marking their books to market. According to an article from the 19th of April in Expansión, the Spanish equivalent of the Financial Times, entitled 'Spanish banks control half of all real estate appraisals.' , Spanish banks control 25% of appraisals directly and another 25% indirectly through their shareholdings.

In the words of Expansión:

The valuation of the guarantees of the mortgage book of the cajas and banks and of its real estate gains importance. The thirteen companies tied to financial entities represented 47% of all real estate appraisals in 2007.

The valuation of these real estate assets has taken on new importance for banks in the context of the current economic recession. The valuation of the mortgage guarantees and of the real estate assets they are taking on through the courts and debt for equity swaps is key to calibrate the solvency of the financial system. This situation has placed the focus once again on the links between banks and the real estate appraisers that goes beyond in many cases a mere commercial relationship.

Source: http://www.expansion.com/2009/04/19/inversion/1240172606.html

Official housing statistics are not corroborated by anecdotal evidence, web searches and the real estate sales by the banks themselves. According to a study by El Mundo, housing prices in many areas of the coasts have already dropped 30-50%.

Source: http://www.elmundo.es/elmundo/2009/08/07/suvivienda/1249655305.html

Spain also confronts to problems of banks essentially taking on defaulted assets onto their books at the stated value of the mortgage. The following comes from a highly regarded foreign surveyor in Spain, describing what happened to a client who had run into problems:

On the banking side, he stated that one development had already been taken back by the bank. However, the bank had 'bought' the development from the developer for the price of the mortgage. Thus they had converted a non-performing mortgage into a property asset. However, the bank is now the owner of a development it cannot sell and is unlikely to for a number of years and has a debt of its own in the purchase price 'paid'. The banks are not experienced developers/property marketers and thus are building up problems for themselves, which must come to light at sometime, depending upon accounting practices. Alternatively, there is the potential that they are then bundling these discounted properties on to friends or holding property companies with notional loans and interest being rolled up until the property is sold.

Source: http://www.surveyspain.com/articles/asp-stats-comments.htm

3) Rolling over loans to zombie construction companies

In the last few weeks we've seen many Spanish property companies announce that they had refinanced their debt, which will postpone bankruptcy for a time. The latest to announce debt refinancing has been Realia, and before that Aisa, Afirma, Reyal Urbis, and Renta Corporacion. After the debacle of having to seize Colonial and Martinsa-Fadesa in 2008, Spanish banking stocks tanked and few Spanish bank executives want to see a repeat.

This lending to zombie developers will merely postpone the day of reckoning.

Banks have realized that instigating a bankruptcy process when builders can't roll their loans or sell houses isn't good for builders or for them. They now try to give as much rope to the builders as possible so that they don't have to report large defaults. In the words of a banking insider:

As soon as a small business becomes delinquent, even if it is a longstanding client, it is "everyman for himself" and everyone runs away as if he has the plague. But in the case of the big builders, the bank is fed up with taking on more assets and gives them a line of credit so that they can at least pay interests on their existing debts and give them room for two years to see if things fix themselves and if they can pay the loan back.

Source: http://www.cotizalia.com/cache/2009/08/02/noticias_96_pymes_solventes_credito_inmobiliarias.html

The willingness of banks to play ball with developers shouldn't come as a surprise. As they say in banking, "If you owe me a million, it is your problem. If you owe me a billion, it is my problem."

4) Offering 100% Loan to Value loans, 40 year mortgages and other bubble-like practices.

Spanish banks are now the largest real estate holders in Spain. They have come to own properties through many different avenues. In order to hide from the effects of the real estate crash, Spanish banks have been buying properties before the loans on them go bad and trying to dispose of them through their own real estate companies. They have also come to own dozens of thousands of homes through debt for equity swaps. Estimates put the value of property repossessed or swapped for debt by Spanish banks at about €16 billion.

Spanish banks have websites set up to move their stock. Among selling points are: pricing discounts of 25-50%, financial terms of Euribor plus 0% over 40 years, and guarantees to re-purchase the property in the future.

Source: http://www.elmundo.es/elmundo/2009/05/19/suvivienda/1242718086.html

The lending to Spanish developers has been institutionalized in agreements between the banks and the main developer's body, the Asociación de Promotores Constructores de España (APCE). Spanish banks will provide 40 year, 100% loan to value mortgages for any home that is discounted by 20% by a developer. The buyer has no need for a down payment. Santander signed such a deal with the APCE in order to reduce the stock of housing outstanding. This is another way to provide credit indirectly to zombie developers.

Source: http://www.elmundo.es/elmundo/2009/07/29/suvivienda/1248879035.html

What Is The Endgame For Spain?

As we pointed out in the last monthly commentary, Spain's problem is tied in with the problem of the entire European periphery. The boom years following the adoption of the euro provided 1) easy money via negative real interest rates, and 2) overvaluation of prices as measured by real effective exchange rates.

Spain, and the rest of the European periphery, can solve their problems either through massive productivity gains, which is highly unlikely, or through a reduction in wages and prices in the order of 20-30%, which is what will happen slowly and painfully. You could call such a reduction of wages and prices an "internal devaluation".

Such an internal devaluation will imply large losses to domestic banks and to external creditors. In the case of Eastern European countries, the damage will be bad, but not very large. In the case of Spain, writing off mortgage debt will be massive. We estimate that Spanish real estate losses will be over €250 billion when all is said and done. Clearly Spanish and foreign banks are unwilling to admit to the size of the problem and write off the debt. That is why the losses are being hidden.

Running large trade deficits is a form of dis-saving. Spain's large growth in consumption has had to be financed by the rest of Europe. Spain's trade deficit was among the highest in the world in absolute and relative terms at around 10% of GDP in late 2007.

Indeed, Spain's current account deficit at one stage was the largest in the world besides the United States in absolute terms. The Spanish economy acted like a giant consumer sucking up savings from the rest of Europe.

The high degree of consumption in Spain has mostly come from external borrowing and has not been financed out of existing savings.

How bad is that relative to other countries? Spain's external debt is extremely high in relative and absolute terms. It is among the highest in the world, the fifth largest:

Real Interest Rates: Deflation Is A Bitch

Eastern Europe, Spain and Ireland are now all experiencing the beginning of deflation. We believe that we will see much more deflation to come, which will have broad ramifications across the European banking sector. The periphery countries are net debtors, and the rest of Europe is the net creditor. When a debtor can't pay, the creditor suffers. Germany, France and others will need to cope with recapitalizing the periphery and Spain. In the words of Plautus, "I am a rich man as long as I don't pay my creditors." A deflationary spiral means that most of the debt will need to be written off, and the creditors will have to absorb the losses.

In a deflationary environment, servicing debt becomes even harder. Even when rates go to zero, prices and wages can go down faster and the real burden of debt can still go up. That is why deflation is such a terrible thing.

Spain now has negative CPI and PPI

Inflation in Spain has been negative for the last three months in a row. Spain has not experienced a similar decline in inflation like this in over 47 years. However, the Bank of Spain and the government are behaving like ostriches with their heads in the sand.

The problem with deflation is that even low interest rates are extremely high. Despite massive cuts by the ECB, real interest rates in Spain are still elevated due to negative CPI and PPI.

Spain is not the only country facing deflation. It is a problem for the entire European periphery. Ireland, for example, has the highest rate of deflation in the world. Prices in Ireland are falling at an annual rate of 5.9%, well ahead of the drops in other countries - only Thailand, at 4.4%, comes even close.

We believe that Ireland's experience is what Spain will see more of in the months ahead as the economy slowly adjusts to new realities. Almost all of Ireland's banks have been taken over by the government, and Ireland is struggling to decide how best to dispose of its bad assets. We believe Spain will be much more like Ireland than any of its European neighbours.

Oddly, even though inflation is negative, and unemployment is high, unions are still winning pay rises. Most wage agreements in Spain are reached through collective bargaining on an industry level. So far, wage increases are happening above the ECB's 2% target inflation rate. (It should come as no surprise that businesses try to get around wage bargaining. Last year almost five million jobs were temporary in Spain.)

Given how far out of line wages are with unit labor costs and the reality of deflation in Spain, we see Spain's unemployment level heading towards 25%. With a 25% unemployment rate and a debt deflationary dynamic, how exactly do the banks think they'll be paid back? Who will earn the money to pay the mortgage payments, and how will housing be affordable when wages have been deflated? Assuming the worst has passed in Spain does not pass the common sense test.

We believe Spanish politicians and international investors have grossly misjudged Spain, but events will force them to change their mind. In retrospect Spain will be viewed much like subprime where all the banking results looked good, until they didn't. This is typical of bubbles, and Spain will be no different.