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When Deflation Comes

The economies of Europe, China, Brazil, and India are all rapidly shrinking, though it will take a while for the data to show it. The markets keep hoping for the governments to save the day, though there is no indication that any of them will do anything sustantive or helpful. Europe's governments have already postponed so long that the real economy has entered a vicious cycle of doom. China's government provided massive stimulus in 2009, but it was for even more investment in a nation that already had too much unproductive investment and too little consumption. 

Consumption and investment in at least half the world is falling, which will lead to a prolonged and dramatic plunge in most commodity prices. Labor prices may be sticky, but the price of most goods will fall. It may even infect the US, where the dollar will become much more valuable compared to other currencies. The downside to your dollar being worth more is that it means everything else is worth less. The lack of global investment opportunities and the fear of loss will drive ever more savings into cash, particularly when holding US currency becomes not only the safest, but also the highest return investment globally available. 

The deflation won't be a dramatic bust, but a slow and steady withering. We are looking at a global Japan, but worse than Japan. What is frightening is that 23 years later, Japan still has no solution. Their deflation hasn't been that bad, but there has been de minimus economic growth. And their government continues to borrow more money every year on a stagnant tax base. Is this what awaits the rest of the world?

The private sector is too afraid to consume and/or invest outside of the US. Most governments either won't or can't borrow money to invest on infrastructure, education, and technology - much less to spend on social benefits. Central banks create money, but they only provide it to banks, who then sit on the cash because they see no safe lending opportunities and need to preserve their capital for expected higher future credit losses.

Central banks must do what the public and private sector will not or cannot - they must make people spend. The last gasp of Monetarists is the call for central banks to create inflation by talking it up and raising  inflationary targets. But the fear of possible inflation is overwhelmed by the fear of certain default and deflation in a depression. All that raising inflationary targets through verbage will do is convince everyone that central banks are both impotent and absurd. Central banks like to calm markets, but now they need to scare them. This is a tough role for central bankers, who are known for being boring rather than scary. They will need radical action.  

Central banks must find a way to flood households with money, where it will be immediately spent since a) households have pent-up demand in a depression, and b) if enough money really is distributed then households will want to spend it before inflation lessens the value. If consumption is elevated for long then it will draw out private investment to collect the household spending and start a virtuous cycle of consumption and investment (then you can worry about inflation).

The trick is that most central banks can't just send households checks, instead they must buy assets. Large banks can sell bonds and other liquid securities to central banks, but what asset can most households sell? Their mortgaged house, their children, and their souls? There's the rub that will require creative policy and rule interpretation. We need central banks to buy mortgage and credit card debt, and then agree to either not collect on the debt and/or force the debt to be restructured so that the household's interest rate is set to the risk free rate (approximately zero in a deflationary environment). Central banks must take credit risk, and perhaps willingly take credit losses. And why not? They can make their own money, they aren't really a bank. They can afford to do what no one else can.

Central banks can go too far in printing money. Zimbabwe and Weimar Germany show why central banks should be independent, so that they don't go crazy making money for government operating expenses. That is what central banks fear today. I suspect it will take prolonged depression and deflation for  private creditors and central banks to realize that there are worse things than your returns being eaten away by inflation, such as debtors defaulting because their income falls even as their debt burdens remain, or central banks that are at best ignored and at worst abolished.

Hopefully we will appreciate the difference between currency (paper) and wealth (serving each other) before things get too bad. Otherwise we won't have much of either.

Europe Watching - Edition XXII

We wait for Europe's next announcement. Maybe they can pull this off a few more times. After all, Germany still wants to be repaid for a decade of exports on credit. Greece, Spain, et al still want a stable currency. All sides want the Euro to continue.

Too bad the Euro is doomed, all because.... well, the Euro is a bad idea. As I and others have said before, there's no way for money flows to balance across nations. Now they are in a doom loop. Money is leaving peripheral nation banks and heading for Germany. Investment and consumption is contracting in perhipheral Europe, thereby assuring they can't increase production to pay back their debt or sell more exports. In the future we will look back at a horrific graph of plummeting money supply in peripheral Europe.

The only hope is for both sides to realize that you can't squeeze blood from a turnip. Particularly in Spain, I think people are starting to realize that the common currency is hopeless. And Germans are starting to realize that not only will they not get paid back, but that every bailout increases the public's losses. If there is hope within the Euro, it would require debt forgivenss (at least interest forgiveness) and for Germany to buy goods and services from the periphery. This isn't about morality, it is about math. Maybe France can convince Germany.

Not gonna happen. So I guess Germans can wait for their banks to default and their exports to plummet (including all those luxury cars to China). Their money will flee to the US, just like it is now fleeing from Spain to Germany. Germany's final export to Spain will be Schadenfreude.

Maybe Europe can pull off a few bank bailouts, some QE, maybe a common bond or new emergency fund. But we are reaching the point where creditors (including the IMF and ECB) realize that this is good money after bad. They must already know it, but they haven't figured a way out (real or diplomatic).

All that's kind of a given, here's what I'm watching:

• Many have come to expect general asset appreciation after every bailout and QE event and try to time it. At first they expected inflation, now they are merely Pavlov's dog. Sometime this year the ECB will ring its bell, but asset prices will continue to fall. Who will be long and wrong?
• Which creditor will be the first to flinch, the ECB, Germany, or someone else?
• Will gold increase with the demise of the Euro, or will the US dollar become the new gold?
• Which US financial institution(s) will have European exposure? Or even just the uncertainty of exposure? This could include common place investments (interest rate swaps, money market).
• What will Putin do when the price of oil and consumption of gas falls, cutting off his money?
• What will China do as their biggest export market continues to shrink, while at the same time their real estate bubble falls hard?
• What will the BRICs do as their commodity exports, currency, and domestic credit collapse?
• Will the markets' perceived power of central banks plummet? And will that in turn cause central banks to lose even more of their soft expectations power?
• Is this the end of austerity and monetarism?

As for the last question, I fear the pendelum will swing too far at some point. Austerity and monetary policy both have their place, though they are the wrong medicine for this disease. Someday we will see asset bubbles, inflation, and money printing for political shenanigains (and no, that isn't what's been happening lately). "The boom, not the slump is the right time for austerity at the Treasury."

Why Should We Forgive Mortgage Principal?

If liberals, Democrats, the President, the FHA Secretary, and others really want to forgive principal then they can do so on many of the 707,863 FHA mortgages that are seriously delinquent. FHA now has more seriously delinquent mortgages than Fannie Mae (654,912), yet FHA is producing only a third as many modifications per month (5,553 for FHA vs 15,557 for Fannie). 

Jawboning continues on forgiveness of mortgage principal. Conservatives are against it and liberals are for it. Unfortunately I think many opinions are driven more by the desire to punish borrowers (make them stand up to their promise on a mortgage they were lucky to get to begin with) or to punish banks (their crooked underwriting and outrageous profits are to blame) than based on any theory of recovery.

The best reason for forgiveness of principal is to reduce the supply of distressed house sales, which will improve house prices, home equity, and growth to the general economy. And it will end a lot of personal suffering. The best reason for not forgiving principal is that it sets a dangerous precedent, so that whenever the economy is weak borrowers will want forgiveness again. And it seems unfair to everyone who didn't get debt forgiven.

As I have repeatedly stated for years, I think it is far preferable to modify and refinance borrowers into 1-month, 1-2% adjustable rate mortgages with low lifetime interest rate caps (5%), than to forgive principal. It is quid pro quo; lower rate in return for accepting limited interest rate risk. For current borrowrers, the 40% lower payment could be used to pay down principal faster.  That there is no interest in this, or really in any plausible workout plan, tells me that most principal forgiveness discussions are just political grandstanding. People in DC rarely resort to action (as opposed to rhetoric) unless you can provide large numbers of votes or campaign contributions.

In truth, many of the delinquent mortgages are so far gone, after missing literally years of payments, that I doubt that anything will bring them back. But for those who do want principal forgiveness, put it to the test on FHA loans.

Who Got Bailed Out?

Greek sovereign debt was restructured in March, and private bond investors suffered €100 billion in writeoffs. But before, during, and after the restructuring much of Greece's debt has been refinanced, purchased, or indirectly funded by pan-government agencies. Here are the big exposures: 

• ECB: €126 b,
• Euro interbank lending (TARGET2): €107 b,
• Euro Emergency Stability Fund: €73 b, 
• IMF: €22 b

After a couple of years of theater and over €300 billion of support, most private owners of Greek government debt have had time to sell their bonds to the ECB and friends. Banks with loand or bonds to Greek businesses have had time to build up reserves and/or create a supposed hedge for the risk. So most of the private risk of a Greek government default has been transferred to quasi-government institutions. I don't mind that, but when we say there was a Greek bailout, let's figure out who really gets bailed out.

Banks should be the safer for the bailouts (in time we may discover that some still gambled it away). But it looks like the ECB, Bundesbank, and others could take some big losses. That won't go over well with European voters - none of who got to vote on the officials of the quasi government entities.

If private lenders lost €100 billion, and the quasi-government entities end up losing another €100+, does that mean that Greece came out ahead? Greece's nominal GDP peaked in Q3, 2008. The cumulative GDP since then is €82 billion below what their GDP would have been if they had stayed at that high point 3.5 years ago. The shortfall will blow past €100 billion within the year.

No one is better off. This isn't a zero sum game. But people, including politicians and economists who should know better still tend to think that way. Greece can't just save money and thereby pay back its debtors. Remember that the whole problem is that Greece doesn't have Euros. They've run trade deficits, investment deficits, and government deficits for years (if there's another kind of deficit possible, they are probably running it too).

In order for Greece to pay back their accumulated debts they have to sell goods and services. Government cutbacks would only help that if the government had been crowding out private investment, but that isn't the case. Until the crisis, Greek businesses could borrow at much lower rates than they had seen before thanks to the easy credit that all Euro members got with the new currency.

Thanks to austerity, Greece is now even less capable than before to repay its debts - though repayments was dubious to begin with. Now it looks like Spain won't be able to repay either, but they weren't a basket case to begin with.

Austerity made sense if one was trying to solve the problem with microeconomics, finance, self-rightousness, or various political agendas. It never made any sense in macroeconomics. Unfortunately most business people and politicians know far more about finance than macroeconomics. 

The Euro is only money. They can always make more (and they will). But the cycle of fear has lead to falling consumption, bank runs, and a cessation of business lending and investment. If people don't have financial transactions then the money doesn't matter. The focus has to be on increasing wealth (goods and services), not currency.

Sovereign Debt Subordinate to Bank Debt

I see that Spain has finally gotten around to bailing out its 3rd largest bank, Bankia. This raises several questions:

1. Does the name 'Bankia' prove that executives were bankrupt of creativity, if not general intelligence? 
2. The CEO of Spain's largest bank, Santander said two weeks ago, "Mortgages get paid in good times and in bad... Anyone raising this problem as one of the issues for the Spanish financial system is saying something stupid." Will we see a dumber quote by a bank CEO this year?
3. Bankia was created by merging a bunch of regional savings banks (cajas) together. Which reminds me of the Southwest Plan and Southwest Savings from the US in the late 80's and early 90's. It didn't end well either. Does someone think that there is an economy of scale in failure?

The economy of scale for failure is Too Big to Fail. That leads to outrage, but something far more outrageous is quietly being accepted...

Several years ago the Irish government guaranteed not only the deposits of all their banks, but also all the bonds issued by banks. In so doing, a government that had run close to balanced budgets in preceeding years took on a liability several times the nation's GDP.

The bailout of Greece by the IMF, ECB, and others channeled money to Greek banks so that not only would they be able to pay back depositors, but that they would also continue to pay bank bond holders - while allowing the bonds of the national government to default.

In spite of these efforts, the banks are eventually failing. Ireland is slowly taking down their banks. Most of the Greek banks will be soon be nationalized as their losses mount and they are unable to raise private fund to become solvent. 

Iceland was the exception in allowing its banks to go bust and default on bonds and uninsured foreign deposits. So what will Spain do? It will certainly bail out its depositors, but will it also bail out the investors who bought bank bonds? Probably.

Stop. Think about the extraordinary precedent that is being set in the developed world. Government debt is being subordinated to bank debt (it is also being subordinated to IMF and ECB debt). Greece was a basket case without the banks. But Ireland and Spain governments did not even have large deficits or high social benefit spending (even by German standards). The big liabilities of the governments were assuming bank losses and paying higher unemployment benefits (not to mention collecting less tax revenue in a depression).

What does it say about Western democracies when a nation bails out its banks' bond holders at the risk of its sovereign debt solvency?