Spain , Banks and Real Estate - Again....

After two quick posts in succession, this will be a very quick post. Just before my long pause in posting, in June I posted on the subject that Spain would be in a worse state than was being claimed. This is what I said:

My own belief is that the prospects of such a bailout are remote, and that the scale of the problems in Spain have not yet been fully acknowledged. In particular, there are concerns about the true scale of losses for Spain's banks. As the Economist reports, construction and real estate loans grew from 10% of GDP in 1992 to 43% in 2009. The same report highlights the degree and severity of the real estate bust in Spain, and the various (self-defeating) methods the Spanish banks are using to hide or delay the losses.

It perhaps comes as no surprise that there are rumours of delays of an audit of the Spanish banks, although the government denies any delays and is still promising to publish results at the end of July. Even when published, it is not clear how real estate assets might be valued in the context of the broadening problems and downwards spiral of the Spanish economy; the spiral will continue to impact upon real estate prices, and any assessment will only reflect, at best, a guess at the non-performing and underwater loans going forward. In other words, the losses in the Spanish banks are likely to be far greater than is currently accepted, and the Spanish economy likely has a long way to fall yet. When so much of an economy is dedicated to real estate, and real estate goes bust, the damage is going to be huge. As such, even if a large rescue fund were put together, however improbable that prospect remains, the scale of the rescue needed may be larger than is currently imagined.

Well, this is what has appeared in the news:

A bank-by-bank test of financial stability due on Friday is expected to conclude that Spain's lenders are dangerously over-burdened with toxic debts and need to be recapitalised, restructured or shut down. 

The stress test is expected to show a dramatic deterioration since the previous tests were carried out at the beginning of the summer which suggested a €60bn cash injection would be the worst-case scenario. 

Nomura Global Economics said in a note: "Our initial reaction to the publication of those estimates has been negative. The announced figures are well below the market expectations, which start at around €100bn, and, in our view, not only fall short of bolstering market confidence but may actually increase the risk of Spain losing market access."

Last week, the Bank of Spain said bad debts at Spanish lenders had risen to record levels, with almost one in 10 loans in arrears. It is the highest bad-loan ratio since central bank records began in 1962.

In June, Mariano Rajoy, the Spanish prime minister, negotiated a deal that secured lending from Brussels of up to €100bn to recapitalise the banks. Experts now think that it will not be enough. Amid soaring borrowing costs and a stricken economy, Spain has come under intense pressure to ask Brussels for a full sovereign bail-out.

My own view is that the latest calculation of the losses is still probably way off the mark of the real scale of the losses. This uptick is just that. I am very confident that, in few months time, the figures for toxic debt are going to be raised even higher, and the size of the potential bailout will grow again. I suspect that those doing the audits will be fully aware of this, and that any figures given are there to try to make the scale of the bailout that would be needed less dramatic, by implementing it in small increments. However, we shall see.

Eurocalamity

I have been reading many views from an endless number of commentators on the potential roll on effects of a Euro break-up; a new language has sprung up around the Euro crisis, such as the now widely used Grexit, and even less pleasant sounding Spexit (which does not seem to have caught on). What to make of all these scenarios that are being trotted out?

My answer makes this a relatively (and unusually) short post; the answer is that nobody really has any idea at all, and if they say they do, then they are genuinely geniuses, have an outstanding set of tarot cards, or they are just plain guessing. The reason why I argue this is very straightforward. As I argued in my last post, we are entering a special set of circumstances. In particular, the drivers of the world economy long ago ceased to be about market fundamentals, and is instead dominated by state action; whether fiscal or monetary policy. This is largely the result of what I termed as extreme policy making setting up a dynamic in which the extreme policy enacted in economy x, sends ripples out into the markets, leading to a further extreme policy response from country y, which in turn washes back onto economy x, which reacts with further extreme policy.....and so it continues with all of the major economies now acting with increasingly extreme policy to a point where markets are now 'nationalised'.

There are therefore some very basic reasons why it is not possible to predict the roll on effects of a Grexit, or any other exit, from the Eurozone. The only certainty is that, as and when these events take place, the economic policymakers will not stand back, but will again intervene in an even more dramatic fashion, in an attempt to 'save' the world economy. Here I am assuming that the coming Euro-calamity will actually take place in the coming month/s. Quite suprisingly, I am in rare agreement with Paul Krugman that there is currently no plausible avenue out of the current path to crisis in Europe. However, I put a small caveat that there just might be a new action from policymakers, and not just those in Europe, and these might still hold back the tide a little longer.

Like many commentators, I am tempted to hazard a guess at possible outcomes, but keep on trying to grab hold of any scenario which is driven by clear principles, theory or the market. However, as I argued in my last post, any theory or generalisation from past events has been torn up along with the economic textbooks.

Instead of finding any clear scenario, I simply finding myself contemplating what will be done as a large ditch attempt to turn back the tide, and how this will set up even more unpredictable outcomes. One obvious answer will be that the printing presses will roll, and not just in Europe. We might even see concerted and coordinated central bank responses, including the Euro area, Japan, China, the US and the UK. In all events, the central banks will continue to at least try to stand behind the banks, perhaps producing something like an LTRO on steroids.

Perhaps the most interesing question will be the timing of action. At what point will policymakers act; before Grexit, during Grexit, or once the consequences of Grexit are apparent. Also, although Grexit is often seen as the forthcoming trigger for crisis, it may be that the trigger will emerge in one of the larger Euro economies, with Spain, Italy, Portugal, Ireland, and even France, all looking fragile. There is a real risk of events overtaking the current 'magic' date of the Greek elections.

Regardless of the 'trigger', if my guess is right, and that there will be a coordinated response, there will likely be a positive spike upwards, as relief grips the market. Commodities and stocks will likely briefly soar in so-called safe haven markets. As with previous state interventions, eventually the markets will fall back down, or even crash. Alternatively, if policy is uncoordinated, then there is likely to be a series of small market rallies, which will extinguish themselves as quickly as they started. This might encourage yet further extreme policy responses. Running to gold is another possibility, as gold in some respects is entirely irrational and that very irrationality is also gold's strength. It just feels safe when all else feels unsafe*.

Nevertheless, this is all speculation, and the only certainty in the policy response is that there absolutely will be a policy response, and it will almost certainly be extreme. As such, the ripples of the actions of each of the policymakers will ripple out and interact in the global economy, and will likely further swamp any market signals that might remain. It is for this reason that I emphasise that my commentary is nothing more than speculation; I am guessing.

As such, we are now in the uncomfortable position that, come what may, the world economy now no longer sits in the hands of markets, firms, banks and individual actions of economic actors. Instead, we now wait upon the action of states to determine the next steps in this economic crisis. The track record of states at managing the crisis is not encouraging. They have tugged and heaved on both fiscal and monetary policy levers, and still the situation in the world economy swings back towards negative outcomes. With each swing back to negative from each policy response, the stakes are being raised ever further. Again, in my last post, I discussed how the LTRO has compounded the problems in Spain, albeit giving both the Spanish banks and state a very, very brief reprieve.

My final guess is to suggest that, at the very least, the economic ride of the coming months will be a turbulent one. In this, I think I am in agreement with everyone. For the rest, and my own comments, treat is all with a big pinch of salt.

* I do not believe that gold is some kind of 'special' form of 'money', but its history as money is what I believe gives it the feeling of safety. 

Note: For my next post, I will try to get away from the Euro crisis and instead take a more analytical look at China or the US going forwards. The European crisis is not the only issue of interest. However, for all my good intention, I keep being distracted by Europe and, for obvious reasons, may be pulled back to Europe. If I do return to the European situation, rather than a very general post such as this one, I will try to focus on some of the detail of the situation (country/market/institution etc.).

The UK Economy, the Euro and the Least Ugly Contest

I have, for a while, been focused on the Euro crisis, and I will not be the first to note that, as the UK's largest trading partner, the Euro crisis is set to have an impact upon the UK. It is therefore unsurprising that David Cameron (and also notably Barack Obama) has argued for Germany taking more direct action to support the Euro, in particular as it is Germany that is in the front of the line to pay the bill. Jeremy Warner of the Telegraph speaks for many when he says:

The stand-off got a whole lot worse this week. France and Germany are now in open conflict over the way forward, if indeed there is one. For the UK, already bleeding badly from the after-effects of the financial crisis, the situation could scarcely look more threatening.

 The fiscal consolidation chosen by the Coalition was always likely to have a negative impact on output, at least in the short term. To make it work, the Government needed the following wind of decent growth elsewhere in the world economy. Instead, it’s facing a hurricane. We look set to be broken by the storm.

There are no end of commentators expressing their thanks that the UK is not in the Euro, so I will not add to these. However, in response to the Euro, of particular interest is that Bank of England is yet again likely to go down the road of further quantitative easing (printing money). This from Reuters:

Evidence that both may be needed was sharply underlined by data showing that Britons have been shopping much less and factories getting far fewer orders.

In minutes of its May meeting, the Bank of England reported that while 8 of 9 policymakers voted to end a 325 billion pound round of asset buying to keep interest rates low, they had not closed the door on more.

Separately, Deputy Prime Minister Nick Clegg said it was an "absolute priority" to get credit into the economy and pledged to "massively" amplify what the government was doing in its 20 billion pound credit-easing scheme.

Both echoed a prescription delivered on Tuesday by International Monetary Fund head Christine Lagarde, who urged the central bank to buy more assets - possibly including company bonds and mortgages - and called on the government to find money to boost infrastructure spending.

Longstanding followers of the Bank of England's policy of printing money will undoubtedly recall that the policy was put in place with the justification that it was a unique circumstance that drove the policy. As has now been reported ad infinitum, the Bank of England long ago lost all credibility with regards to their original excuse of using money printing to prevent deflation. It now seems that, whatever might produce headwinds for the UK economy, the printing presses will start rolling. What has become an exceptional policy is now becoming routine policy.

We can see the same phenomenon in the US, Europe and Japan. There are two possible interpretations for the 'routinisation' of printing money; the first is that policy makers actually believe that it works, and the second is that they are now completely bereft of any idea of how to fix the ongoing economic problems.I go with the a mix of these two interpretations. For the former, I am guessing the Bank of England aim is a defensive attempt to pull down the value of sterling, out of fear of the impacts of a strengthening of sterling against the Euro. However, as an offset to this the resultant low interest rate will only encourage further borrowing, with potentially negative impacts upon the current account balance (see later, and chart below for the current account balance from ONS).

I have previously discussed flows of capital as a least ugly contest. Investing is no longer a case of looking for attractive investments, but trying to find the least unattractive.There is a catch, though; whilst investors may look for the least ugly, sometimes it pays for countries to be a little ugly. This pulls down the exchange rate, and this in turn helps to maintain a competitive exchange rate (regular readers may recall my example of Switzerland some time ago). Printing money might help with this, but the problem is that it is becoming a universal solution to trouble; right now, nobody wants their currency to appreciate and competitive devaluations are a real possibility. As it is, the UK economy is looking rather ugly without any further money printing:

The U.K. economy shrank more than initially estimated in the first quarter after construction was revised to show a deeper slump, which may bolster the case for the Bank of England to restart bond purchases.

Gross domestic product fell 0.3 percent, compared with a 0.2 percent decline estimated last month, the Office for National Statistics said today in London. Construction output fell 4.8 percent, the most in three years and more than the 3 percent initially estimated, while services and production were unrevised. Net trade and inventories subtracted from GDP.

I say 'rather ugly', as it must be remembered that this decline is still taking place in an environment of massive fiscal stimulus, with UK  government borrowing and spending supporting the economy at the cost of an anticipated deficit of £120 billion for the year 2012/13. There is no austerity anywhere in sight, and yet the UK economy is showing declining GDP. What is, in fact, taking place, is a slowdown in the rate of borrowing, as can be seen below (from the Guardian).

 

It is notable that this excludes financial interventions, which is the government's 'preferred' measure. More worrying is the cumulative total of debt being accrued, with the UK debt clock providing a graphic representation of the growth in debt.The Daily Mail provides a good summary of the current situation of debt in the UK, and it extends beyond concerns about government debt (I do not usually cite the Mail, but they are using some good sources):

There's also the not-so-small issue of Britain's household consumer debt problem which, in relative terms, is the second worst in the developed world.

They have a point. I checked the latest statistics from the Bank of England, and it sees a slow month on month climb in consumer debt. This helps to explain small increases in consumer spending even whilst real income is in decline. Again, from the Mail:

But there's also a misconception about consumer debt. There's much talk of businesses and households 'deleveraging' - paying off debts.

But in reality, Britons are not paying off what they owe. There were hopeful signs of this happening when mortgage rates fell sharply in 2008 and 2009 - some borrowers used the opportunity to pay extra off their mortgages. But consumers soon returned to form and began borrowing again to spend.

Even the falls there have been are due to banks writing off debts, according to the campaign group Save Our Savers (SOS). It points out that total consumer debt stood at £1,461billion in November 2008 and £1,452 billion in November 2011. But banks wrote off £26.7billion of consumer debt. So excluding the bank write-offs debt actually rose by £18.4billion.

Credit card debt continues to 'run rampant', says SOS, rising from £53.3billion to £56.5 billion over that time even thought an 'extraordinary' £13billion has been written off. Total credit card debt when write-offs have been stripped out has exploded by £16.1billion.

So the clear picture is that debts are not only still rising, by bad consumer debts are also just shifting across to become financial sector company debt which, if recent history is anything to go by, could one day become state debt.

And the projection, is that UK debt is set for another explosion. According to the Office of Budget Responsibility, personal debt will grow by nearly 50 per cent from £1.5trillion today to £2.12trillion by 2015.

More interesting than any individual sector is the overall picture of debt, and the graphic below paints the picture by including government, retail, financial and business debt.

These figures should be a cause for worry in all circumstances, but become even more worrying when seeing the UK balance of trade and current account. This from the ONS:

• The UK’s current account deficit was £15.2 billion in the third quarter of 2011, the highest on record.
• The trade deficit widened to £9.9 billion in the third quarter of 2011, up from £7.2 billion the previous quarter.
• The income surplus was £0.3 billion, the smallest surplus since the fourth quarter of 2000.
• The financial account recorded net inward investment of £22.0 billion during the third quarter of 2011.
• The international investment position recorded UK net liabilities of £245.5 billion at the end of the third quarter 2011

This is a chart of the trade balance from the ONS:

 

 A quote from the explanatory note on the chart is given below:

The trade in goods deficit increased to £27.6 billion in the third quarter of 2011, the highest on record. Exports increased by £0.1 billion to £74.2 billion and imports rose by £2.7 billion to £101.8 billion. Both exports and imports are the highest on record.

In crude terms, UK borrowing and spending is a good way to help other countries export goods and services to the UK, and in particular goods. Sure, it increases activity in the economy, as distribution of the goods and services creates activity. However, this cannot be sustained forever. Whilst this has been the case for many years, there must come a point at which borrowing can go no further, and the earlier chart from the Mail highlights that the UK is now reaching a point where the unsustainable nature of the borrowing is becoming very apparent.

I return now to the question of the Euro crisis. As the situation stands, the situation in the UK has been continuing to deteriorate, despite talk of austerity and living within our means. Borrowing and spending is ongoing, and the UK is still consuming more than it can produce. Nothing has really changed since the onset of the financial crisis, excepting that the total volume of debt has increased, and is increasing. No real reform of the UK has yet taken place and the current account figures tell the real story.

Notwithstanding the lack of substantive action so far, the government appears to be genuinely seeking to reduce the rate of debt accumulation and, if it succeeds, as I have argued many times, this absolutely will see a fall in GDP. I have never accepted the absurd idea of expansionary austerity. However, as the earlier chart of total UK debt shows, austerity is a necessity as debt levels become unsustainable. Again, regular readers will know that I do not accept GDP as representing a useful measure of the economy, as GDP figures include activity from borrowed money. However, many take GDP seriously, and as GDP declines, the UK economy will start to look a little more ugly. In short, even without the Euro crisis, the UK was set to become uglier.

To add to these concerns, we have the accelerating Euro crisis and, on top of this, if the Bank of England prints more money, this will add a little more to the ugly factor, albeit partially offsetting this by possibly (temporarily) shoring up GDP figures. The question that this raises is how the UK will look overall in the least ugly competition. I would argue that, so far, the UK government has managed to convince the world that it is not so ugly and have done so with with the promise of future action. That action is now commencing, and doing so just as a shock is about to hit the UK economy in the form of the Euro crisis. The UK economy, as I have outlined, is in no state for this kind of shock, and the fallout of the Euro crisis will combine with the impact on GDP of genuine moves towards austerity. It is not a pretty picture. The UK may become very ugly.

The only possible offset is how ugly other economies will look as the Euro crisis accelerates, and this might allow for some kind of reprieve. In other words, the confidence in the UK economy will be measured by its relative ugliness to other economies. How ugly those economies will be will only become apparent as the Euro crisis accelerates. Perhaps the UK may yet survive a little longer in the least ugly contest, if only because some of the other contestants are going to become so very, very, ugly. Only time will tell, and whichever way this runs, the UK is heading for some very tough times.

Note 1: I assume here that the Euro crisis will not be resolved. I would never say that a resolution is impossible, but it becomes less and less probable as each day passes.

Note 2: I was hoping to respond to comments, but this took me far longer than anticipated. As such, please accept my apologies.

Is Extend and Pretend Coming to an End?

I can't remember where I first saw the phrase 'extend and pretend' (so apologies to the originator for not citing them), but it is a good expression to the reaction to the economic crisis. Another good one is 'kicking the can down the road'. Both expressions concern the endless (and often hidden) bank bailouts, the fiscal stimuli and the monetary policy that has been the reaction to the economic crisis. What they have been attempting to bury with their policy levers is debt. Or rather, debt that is not going to be repaid. Consumer debt accumulated in the build up to the crisis, sovereign debt built up in the aftermath (and to some degree in some states before the crisis). Tied in with the rise in debt, was the rise in asset prices, as floods of borrowed money created booms.

In Europe, to add another metaphor to the many, the wheels look like they may be about to fall off the Euro bus. Yet another metaphor is contagion, but (as I mentioned before) a better metaphor is that the financial doctors have become better at diagnosis. It is not a contagious disease that is hitting Europe, but the cancer of debt fuelled consumption. We had a bust back in the days of Lehman's and, instead of taking the pain at the time, the reaction was to extend and pretend. Whatever happened, intoned our policy gurus, we must not repeat the Great Depression. And, with the magic of their policy levers, that is what they claim to have done. Avoided another Great Depression. The European Central Bank has thrown everything but the kitchen sink at the Euro crisis. The IMF and the EU, and even the Federal Reserve, have bailed out, and the bailees have to varying degrees tried to reduce their consumption.

If only we had not imposed 'austerity' is the cry of many. But who was going to continue to fund the borrow and spend policies? In Europe, the only taker stepping up was the ECB, who lent money to insolvent banks so that they could buy the debt of their insolvent governments. You may note here that there is something very wrong with the concept of austerity; it still includes huge amounts of borrowing by governments. No country is stopping their borrowing, they are just trying to decrease their rate of borrowing. That borrowing is going to support ongoing unaffordable consumption. In the meantime, the background is one of accumulation of mountains of debt.

Alongside the attempt to reduce the rate of borrowing, there has been shrinkage in many economies. As the economy shrinks, so does the ability to service the existing debt. It is not, as the growing legions of anti-austerity commentators claim, that austerity is causing the crisis. Their answer is to return to growth in the rate of debt accumulation in order to hide, for a little longer at least, the underlying fundamental problem. Many countries are consuming more than they produce, and have no real prospects of being able to pay back the money they have borrowed to over-consume, or to continue to live at the level they have become used to. They are, to quote my first ever post, poorer than they think. They mistook debt for wealth, and must now learn to live based on their own productive output.

The only real step that can solve the European crisis is to just stop borrowing. Alongside this, there needs to be a recognition that many countries have, in the most basic terms, an unaffordable lifestyle. It is very simple. They must accept that they are poorer than they think. In order to return to stability, that relative poverty must be accepted. In crude terms, over the economy as a whole, the borrowed and consumed money is the equivalent of adding to the salary of every individual within that economy. As the borrowed money flows through the economy, it is adding unaffordable goods and services for consumption. The borrowed money indirectly subsidises consumption, and in some cases does so directly.

The solution is simple, and always has been. Stop borrowing money. The Greeks complain of Germany forcing them into austerity by diktat. However, Germany is not forcing any country into anything. It is saying that, if you wish to continue to borrow, you must do something to ensure that you can repay the money. If Greece wishes to restore its sovereignty, the answer is to stop borrowing. It really is that simple.

However, in Greece, and in so many countries, there is a reluctance to accept this. The standard of living that they have enjoyed on borrowed money is seen as a right. Civil servants protest, unions protest, and anti-austerity leaders demand the lifestyle that the country cannot afford. They all demand the status quo of pre-crisis borrow and consume, but just do not accept that the lenders are no longer there. They are all demanding the impossible, and their populations believe that the impossible is possible. We can see how seductive the calls for greater borrowing and spending are. If you are a civil servant thrown out of work, and you have a mortgage and family to support, it just seems unfair.

However, when faced with pay cuts, the same civil servants will protest, even though their collective salaries are unaffordable. The same with the workers throughout the economy. They simply are not, collectively, productive enough to support their lifestyle. The answer is unpalatable. It is cuts in wages and benefits to the point where the economy as a whole returns to competitiveness. How these are spread over the economy is an issue of politics, but the reality is that this is the only answer. The reality is that, for all but the most productive economies, the price of labour must fall. There is a glut of labour in the world, and this is resultant from the emergence of the emerging economies. Unless labour is exceptionally productive, there is no other way out.

If we take the example of Germany and Spain, German workers and Spanish workers are in direct and indirect competition with one another. German workers are, in aggregate, more productive than their Spanish counterparts, but this is not reflected in the costs of workers. If it were, then Spain would be able to balance their trade with Germany. There are no trade barriers, and we have to just conclude that, in aggregate, Spain's companies cannot compete with those of Germany. I am not just talking about wages here, but the overall structure and cost of the economy as a whole. This is why I included benefits in my earlier point. The many benefits provided by governments are an indirect cost of labour. The cost of labour in the economy is a critical factor in competitiveness. It is the productivity of the collective output of the economy in relation to competing economies.

These underlying differences in the real productivity and competitiveness of economies were both obscured by debt accumulation. They can continue to be obscured by debt accumulation, but this simply prolongs the moment when reality must finally emerge. At this stage, we cannot know whether the ECB, EU or IMF might just pull some new lever to extend and pretend a little longer. However, it is starting to look like extend and pretend has reached the limits. It is starting to look like there is no road left to kick the can down. The cuts in wages and benefits looks to be the next step. This process looks likely to be disorderly, and that is the real pity. It could have been gradual, controlled, and less painful. The way it will take place, the degree of pain, can be laid directly at the door of extend and pretend. 

Greece, Spain and Germany, and the World

This is the latests on Greek GDP:

ATHENS—The Greek economy shrank further at the beginning of the year, official data showed Tuesday, confirming that the country remains deeply mired in recession even before new austerity plans are due to be implemented in the months ahead.

Greece's gross domestic product contracted by an annual rate of 6.2% in the first quarter of 2012 compared with a year earlier, the country's statistics office said Tuesday. This follows a year-on-year decline in economic output of 7.5% in the previous quarter.
The relatively slower pace of decline reflected, in part, a boost to business and consumer confidence following Greece's recent debt restructuring and promises of new aid from its European partners and the International Monetary Fund.

Still, even if the figures do show some mild improvement and were better than economists' estimates for a first quarter contraction of between 6.7% to 7.9%, many forecasters say the economy shows no signs of recovery with some estimating a decline of 7% or more this year.

The equation was very simple. As long as growth in the rate of borrowing continued unabated, the Greek economy could appear to be in growth mode, activity in the economy continued to grow, and government had the revenue from taxing the growth in activity in the economy to pay for previous borrowing. The apparently virtuous cycle had to stop sometime, as there comes a point at which the debt mounts to such a degree that repayment starts to look increasingly impossible. Then comes the downward spiral as the borrowing slows and activity slows, and then reduces, with commensurate reductions in government revenue, and the inability to meet the terms of previous borrowing. It is not a lesson for Greece, but for all who think that borrow and spend is the way to economic prosperity. Apparently, the Greeks themselves know that the game has now come to an end. This is the news on the Greek banking system:

ATHENS—Greek depositors withdrew EUR700 million from local banks on Monday, the country's president said, and warned that the situation facing Greece's lenders was very difficult.

In a transcript of remarks by President Karolos Papoulias to Greek political leaders that was released Tuesday, Papoulias said that withdrawals plus buy orders received by Greek banks for German bunds totalled some EUR800 million.

Citing a conversation he had with Greek Central Bank Governor George Provopoulos earlier in the day, Papoulias said: "Withdrawals and outflows until 4:00 p.m., when I called him, exceeded EUR600 million, they reached EUR700 million. That doesn't include all those orders that the banks received to convert to German government bonds and other such things. Taking those into account it sums up to about EUR800 million."

Again citing Provopoulos, the president added: "that the strength of banks is very weak right now."

This is not new, but the scale may be. And who can blame those people running for the exit. They compound an already dire situation, but each individual who is looking for a safe haven has good reasons to do so. Of course, the 'safe havens' are actually not so safe, they are just less unsafe. It has not taken much imagination to see the roll-on consequences from the deteriorating situation in Greece, for countries like Spain and Portugal, and for all of the 'at-risk' countries. When (and it now looks like 'when', not if) the Greek economy finally collapses under its own mismanagement, the massive losses to the holders of anything attached to Greek debt will send shudders of fear around the world. The problem is that there are more 'at-risk' countries than currently acknowledged, and this means that the consequences will ripple out into the wider European economy. 

The problem is this; rather than accept that the economic crisis was about something truly fundamental, governments and policy were directed towards saving a system that was unsustainable. The European economy is a micro version of the macro of the world economy. You have the big export creditor countries lending to the import and borrowing countries. To be simplistic, think Germany to Greece, China to the U.S. There are, of course, major differences, with the EU tied together by a dysfunctional currency union. The real difference here is that the union makes the problem more apparent more quickly. The fates of the lender and borrower become tied together, as the failure of the borrower country directly impacts upon the lender. The more money that is lent to the borrower, the greater the potential damage to the lender.

The problem is this; someone, somewhere is providing their savings to lend to the borrowers. This is not the abstraction that is so often reported. Economies are abstractions rooted in the actions of individuals and companies. I will grossly simplify here. When a bank lends the savings of a German worker to a Greek worker, and the Greek worker loses his/her job, that means that the German worker has just lost some money. But its much worse than this. When the German bank lends the savings of a German worker to a Greek worker, some Greek workers then use the borrowed money to buy German goods. This sends a signal to the German company to invest more money in production to meet the demand from Greece, and to hire more workers. These very same newly hired German workers are the ones who then provide further savings that will then be lent to the Greek workers.

The problem is this; it all appears as a virtuous circle, right up to the point where it is not. To illustrate this, think of Greece and Germany not in terms of financial flows, but in terms of goods. To illustrate, think in terms of Germany as producing BMW's and Greece producing Ford Fiestas. The value of these two cars are different, but imagine that each is making the same number and exporting the same number cars to each other, on a one for one basis. The Germans do so on the basis that, in the future, their workers will be able to call on Greece to provide more Ford Fiestas than they provide BMWs. When German workers, for example retire, they have a call on a Ford Fiesta which Greece is obliged to produce, in return for a Greek worker being allowed to drive in a BMW now. As long as this situation is one where there is the belief that Greece will provide future Fords, the Germans continue to provide BMWs for now, even expanding their capacity to meet the new demand from Greece.

This is all very well, right up to the point at which the entire capacity of Greece's Ford Focus manufacturing capability is unable to produce enough Ford Focus cars to meet their growing obligations. The German worker is alarmed to hear that, when push comes to shove, Greece is not going to provide the Ford Focus that they promised him in retirement. Even worse, the problem is that, as it becomes apparent that Greece is not going to return the promised Ford cars, workers stop lending money to Greek workers to buy BMWs. The demand for BMWs drops, and some BMW workers start to lose their jobs.

This is a highly simplistic illustration. It omits the aggregated way in which this process has developed, with governments and banks and other countries/economies sitting in the middle of the process. However, it is an illustration of what sits beneath the abstractions we are continually reading about. When an economist suggests that the solution is to lend ever more money to Greece, they mean that they will take the savings of German workers, or income from taxation, and will forward it to Greece so they can continue to buy their BMWs, and this will continue to support German employment of BMW workers. This does not alter the fact that Greece is only returning a Ford Focus for every BMW, and Greece continues to grow its future obligation in provision of the Fords.

I read today about an estimated cost of a Greek Euro exit to Germany, which is around Euros 90 billion. This is a recognition of the imbalance (to continue the illustration) between the consumption of BMWs and Greece's Ford Focus production capacity. For years, Greece has been exchanging a Ford Focus for a BMW, and has promised to provide more Fords than it could ever produce. The capacity in Greece will never grow enough to provide the Fords that it owes. The loss is simple to see. When our German worker goes to the bank at some point in the future, and asks for his 'Ford Focus', he will be told that it does not exist or, if he is fortunate, that he must accept a Ford Fiesta. A German bank received a promise from a Greek bank that the Ford Focus would be there for our German worker, and in turn the German bank promised the German worker the Ford Focus. Along the way, a Greek worker enjoyed driving his BMW.

The loss to the German worker is real, and nothing is ever going to change this. It is the reality of the problem. The losses are real. They cannot be wished away. Extending further credit just extends the losses even further. Lending more of the German worker's savings can only put the problem into the future, and make the problem worse. As for imposition of austerity on Greece, this is an attempt to free more capacity in the Greek economy towards 'Ford Production' for export, and a reduction in the import of BMWs (sorry to stretch the illustration this far, but I hope you get the point). However, even with austerity, the backlog of owed Fords is now so high, that no realistic increase in capacity will ever be enough to clear the backlog.

Lending more money to countries to continue to import goods is just a problem extension, not a solution. It grows the problem. The real solution is to accept the real losses now. It is painful, but miracles do not happen. Greece, Spain, Portugal and all of the rest of the 'at risk' countries are not, as far as I can see, going to have a productivity/competitiveness miracle that will increase their capacity to allow debt repayment. The extend and pretend policies that have been the business of governments have just made the situation worse, and the costs to the creditors are still growing. Whilst my account given here is simplistic, it is exactly how a trade imbalance really works. It is not some magical entity, but rooted in the exchange of value of goods x for value of goods y, with a deficit in the exchange amounting to z. The z is then supported by lending. The lending is expected to be repaid. If the country taking the deficit cannot repay z, the loss must be realised by somebody.

How is this so difficult, and how do so many suggest that this can fixed by continuing to lend to those who cannot repay, and will never be able to repay? The only question is the size of the losses, when they will be realised, and by who? These are the questions that are being evaded. The evasion of these questions is why we keep growing the problem. It is not just a problem of Europe, but a wider problem in the world.

The Greek Crisis

I don't know about the readers of this blog, but I am now at a stage of simply being overwhelmed by the ongoing and endless rescues of the Euro. Every day the news pours out on the latest initiative, the latest plan, the latest crisis meeting/summit, the latest bad news......In light of this, it was a pleasure to read the latest take on the story from Spiegel Online, which cuts through much of the fluff on Greece. The headline and sub-head offer a great summary:

European Politicians in Denial as Greece Unravels


Europe's politicians are losing touch with reality. Greece is broke, and yet Brussels wants to send the country billions in new loans, to which there is growing opposition within the coalition government in Berlin. Rescue efforts are hopelessly bogged down by bickering over who will ultimately step up.

This was the part that I really liked:

The Greek economy is not productive enough to generate growth. Aside from olive oil, textiles and a few chemicals, there are hardly any Greek products suitable for export. On the contrary, Greece is dependent on food imports to feed its population.

"Greece has been living beyond its means for years," an unpublished study by the German Institute for Economic Research (DIW) concludes. "The consumption of goods has exceeded economic output by far."

Especially devastating is the assessment that the DIW experts make about the condition of an industry that is generally seen as a potential engine for growth: tourism. According to the DIW study, the Greek tourism industry concentrates on the summer months, with almost nothing happening throughout the rest of the year. There is almost no tourism in the cities, which translates into low overall capacity utilization and high costs for hotel operators. By contrast, capacity utilization in the hotel sector is much more uniform in other Mediterranean countries.

I have long argued that this is one of the fundamental problems that sits beneath the economic crisis. It is the fantasy that a country can just continue to endlessly consume more than it produces. Whilst Greece may be an extreme case, it is very apparent that Greece is not alone. I am going to quote at length from the first post of this blog, which is from an essay I wrote in 2007:

I am going to start by looking at the world from the point of view of many modern economists. Whilst none of the economists would accept that what I am about to portray is their belief, when you look hard, you will find that this must be their basic belief. If not, then they have no justification for their pronouncements of success for the UK economy.

Imagine a family living in the UK, not an atypical family, not a typical family, but an ordinary middle class family. We will call them the Wilsons. The father has a job in management for a chain of retailers, and earns £30,000 per year. The mother has a good job in a local hotel where she is the marketing manager and earns £30,000 per year. They therefore have an income of £60,000 a year. They have two children at the local school.

The Wilsons have purchased a home, which cost them £300,000, which is five times their combined income, using a 95% mortgage. The house has increased in value by £30,000 a year, in each of the three years since they purchased it. They are very pleased to see their house growing in value, as it is like having another earner in the house, except this earner pays virtually no tax on the income, making it an even better earner than themselves.

The Wilsons have a relatively large mortgage, but interest rates are low. Despite this, they struggle to balance the quality of life that they enjoy against their income. As such, they make use of credit cards to occasionally purchase items. Each year, for three years, they have added £6000 to the family debts through overspending on the ‘little luxuries’ in life, such as holidays, and new goods for the house. At the end of the second year in the house, Mr. Wilson decided that he would fulfil his dream of owning a Mercedes, and re-mortgaged the house to realise £20,000 of the increase in value of this asset. He used this as the down payment on the car, and took a loan for £20,000 to pay for the remainder.

Overall, the Wilsons non-mortgage debt stands at £18,000 for the credit cards, and £15,000 remains of the loan for the car. They are starting to find the payments on these debts are stretching them, and they seem to be using the credit cards a bit more often than before.

Next door to the Wilsons live the Jones family. The Jones family know and respect their next door neighbours. They can see how successful they are. They are always doing something to the house, making improvements, and they seem to be living the good life. Only recently the Wilsons bought a new Mercedes and Mr. Jones feels a little jealous, as he would love a Mercedes too.

The Jones family, have less income than the Wilsons, but every year they save a few thousand pounds. They have no debt except for their mortgage, and only spend what they earn. They purchased their house at the same time as the Wilsons, and are steadily paying their mortgage. Their belts are tight, but they get by, and look forward to better days ahead.

Which of these two families is the more wealthy family?

The answer largely depends on whether you are an economist who has been a cheerleader for the boom of the last ten years, or whether you are a person grounded in the real world. The Wilsons have been the motor of growth in the Anglo-Saxon economies. Apparently we have gone through a period of sustained growth and, in moments of hubris (Gordon Brown in the UK being a wonderful example), we promote the ‘success’ of the Western economies to the rest of the world. The trouble arises when we ask a simple question; ‘Where is this growth?’

The Greeks are the Wilsons. Yes, they have lived a good life. But the bills have simply grown to the point where they do not have enough income to repay them. This aspect of economics has never been complicated. If you are continually borrowing to pay for consumption, you will indeed have a high standard of living - for a while. Unless your income growth is outstripping the rate of debt accumulation, it is only a question of time before the credit becomes too much to service. It is not a case of 'if', but 'when'.

It is very curious how much effort and time goes into denying this simple formulation. The answer to the problems of too much debt is apparently to just borrow more....We see it endlessly from economists, politicians and commentators. Austerity is self-defeating. The answer is to borrow more. 'Yes', when borrowing more, the economy will appear to grow. Just like the Wilsons, there will be an illusion of wealth for a little longer. However, like the Wilsons, it can not change their actual real income; it cannot change the ability to create real wealth.

The Spiegel article gets to exactly this point with Greece. Greece simply does not have the ability to continue to have the high standard of living that it has previously enjoyed. That standard of living was supported by unsustainable debt accumulation. They just do not create enough wealth to either continue to live as they have done, or pay back the debts accumulated in giving them an illusion of wealth.

I just do not understand how it is that this simple and evident reality can be ignored by so many. In the case of Greece, it is plain to see. And just as it is plain to see in the case of Greece, it is also plain to see in the cases of other economies. They may not be as dramatic as Greece, but the same principle applies.It really is very simple.

Austerity in the UK

I know I bang on about Krugman, but his pronouncements become ever more silly, and I would like to relate his latest silliness to the post above. This is his commentary on austerity in the UK:

Britain, in particular, was supposed to be a showcase for “expansionary austerity,” the notion that instead of increasing government spending to fight recessions, you should slash spending instead — and that this would lead to faster economic growth. “Those who argue that dealing with our deficit and promoting growth are somehow alternatives are wrong,” declared David Cameron, Britain’s prime minister. “You cannot put off the first in order to promote the second.”

[and later]

And we may get tipped in the wrong direction by Continental Europe, where austerity policies are having the same effect as in Britain, with many signs pointing to recession this year. 

The infuriating thing about this tragedy is that it was completely unnecessary. Half a century ago, any economist — or for that matter any undergraduate who had read Paul Samuelson’s textbook “Economics” — could have told you that austerity in the face of depression was a very bad idea. But policy makers, pundits and, I’m sorry to say, many economists decided, largely for political reasons, to forget what they used to know. And millions of workers are paying the price for their willful amnesia.

There is one very fundamental problem with his use of the exemplar of the UK for the evils of austerity; there is no 'austerity' in the UK, just talk of it. It is a point made very well in a post in the Money Illusion:

But I am seeing article after article claiming that the coming recession is due to fiscal tightening.  I was curious to see just how tight British fiscal policy actually is, so I checked the “Economic and Financial indicators” section at the back of a recent issue of The Economist. They list indicators for 44 countries, including virtually all of the important economies in the world.  Here are the three biggest budget deficits of 2011:
1.  Egypt  10% of GDP
2.  Greece:  9.5% of GDP
3.  Britain:   8.8% of GDP
Egypt was thrown into turmoil by a revolution in early 2011.  Greece is, well, we all know about Greece.  And then there’s Great Britain, third biggest deficit in the world.

There is absolutely nothing that can be described as 'austere' about the rate of borrowing in the UK. Quite the opposite - it is shockingly profligate. In reality, the UK is doing exactly what Krugman has long argued for, and has now been doing it for a long time. The UK is borrowing and spending with abandon. The really shocking thing about the UK economy is that, despite following this reckless path, it is still seeing shrinkage of the economy.

What Krugman means is that the UK government should increase the rate of debt accumulation to even higher levels. It is his solution to all ills. Just borrow more, or print more money. He cannot even see that the UK is already doing exactly what he recommends, that it has been doing so for a long time, and that it has not worked. Quite the opposite. For all the debt accumulation, the UK economy is still shrinking.

As regular readers know, I do not argue the case of expansionary austerity. I can at least agree with Krugman on this point. Real austerity will be a hard and painful path. If the UK were to balance the government budget tomorrow, the UK economy will nosedive. However, as I argue above, in the end, there is no real choice but to see the economy nosedive at some point. It is not 'if', it is 'when'. Again, as argued above, Krugman's solution will keep the illusion going for a while, assuming that bond markets play ball, but it will only prolong an illusion.

In the post above, I talked of the way that modern economists might see the two families. At the time of writing I was not familiar with Krugman. However, he is exactly the kind of economist who would propose that the Wilsons are the wealthier of the two families. He seems to really believe this......it is shocking. It is why his pronouncements are so very, very wrong.

The EU Downgrades

This will be quite a short post. It has been impossible to miss the news from last Friday about the downgrades of several EU countries by Standard and Poor's (S&P):

Ratings agency Standard & Poor's downgraded the government debt of France, Austria, Italy and Spain on Friday. But it kept Germany's at the coveted AAA level.

The downgrades deal a blow to the eurozone's ability to fight off a worsening debt crisis. All told, S&P cut its ratings on nine eurozone countries.

The rating agency ended France and Austria's triple-A status. It also lowered Italy's and Spain's by two notches and did the same for Portugal and Cyprus. S&P also cut ratings on Malta, Slovakia and Slovenia.

"In our view, the policy initiatives taken by European policymakers in recent weeks may be insufficient to fully address ongoing systemic stresses in the eurozone," S&P said in a statement.
France's downgrade to AA+ lowers it to the level of U.S. long-term debt, which S&P downgraded last summer.

S&P had warned 15 European nations in December that they were at risk for a downgrade.

The way that the press have reacted is as if this is some kind of shock, even though the potential for a downgrade has been been trailed, as is mentioned in the quote above. S&P's statement about why they made the downgrade can be found here. It has also had an impact on the rather dubious Euro bailout fund, with this from the WSJ:

Standard & Poor's Ratings Services on Friday said it had stripped triple-A ratings from France and Austria and downgraded seven others, including Spain, Italy and Portugal. It retained the triple-A rating on Europe's No. 1 economy, Germany.

The downgrade to France, the bloc's second-largest economy, will make it harder—and potentially more expensive—for the euro zone's bailout fund to help troubled states, because the fund's own triple-A rating depends on those of its constituents. The downgrades also speak to how deeply the concerns over countries on the euro zone's periphery have penetrated its core. Worst-case fears weren't borne out: France avoided the two-notch downgrade S&P had warned of last month.

So, is this really news? In some senses 'yes', and in some senses 'no'. The most interesting thing about the ratings agencies is that they are supposed to look into the future and make assessment of asset risk, but they nearly always seem to play 'catch up' with the reality on the ground. Even the most casual browse of the financial news would have told anyone that the problems of the Euro were spreading from the so-called periphery into the so-called core. The S&P downgrade is, as always seems to be the case, just playing catch-up.

However, it is news in the sense that it has real impacts. The first impact is on the bailout mechanism, as mentioned in the WSJ article. However, another impact is upon European banks. I expected to find a raft of headlines to this effect, but a search of Google News did not turn up what I expected (perhaps my keywords were not right, and I missed the articles). In particular, those banks that hold the sovereign debt of the downgraded countries will see further erosion of their already (in many cases) strained balance sheets. The only example I found discussing this point was curiously in reference to Japanese banks:

France’s loss of its AAA rating probably won’t have any immediate effect in Japan as domestic banks’ holdings of French bonds aren’t large, Azumi said in Tokyo yesterday, according to Kyodo News.

It is now an open secret that the ECB has been bailing out European banks in the hope that they will in turn use the money to purchase European sovereign debt. This from Wolfgang Münchau in the FT:

And no, the European Central Bank’s huge liquidity boost is not going to fix the problem either. I do not want to underestimate the importance of that decision. The ECB prevented a credit crunch and deserves credit for that. The return of unlimited long-term money might even have a marginal impact on banks’ willingness to take part in government debt auctions. If we are lucky it might get us through the intense debt rollover period this spring. But a liquidity shower cannot address the underlying problem of a lack of macroeconomic adjustment.

Regular readers will know that I do not agree that the bailout was a 'good thing', but I quote this as it as it makes the point about the indirect purpose of the bailouts. I have mentioned before that there are large chunks of debt coming due in the next couple of months, and funding these chunks of debt may be a severe problem. I used this chart from the Economist before, as it paints the picture well:



When bank balance sheets are already under strain, the question is what they might do with all of the money that the ECB is pouring into their balance sheets. The new Basel accords are demanding higher levels of capital, and the ratings of assets will impact upon their compliance. The question is this; with their balance sheets already strained, when the periphery debt looks ever more dangerous, and the core debt is now being recognised as high risk, why on earth would any bank actually purchase high risk European sovereign debt?

The problem is this, that in the topsy-turvy world of banking regulation the ratings agencies really matter. They are, of course, completely hopeless in their assessment of risk, but they nevertheless have major impacts. However, it does occur to me that there is the possibility that the bailout of the banks by the ECB might come with strings attached, in backroom deals, that as a quid pro quo, the banks agree to continue to purchase dubious Euro sovereign debt. I can only speculate on this but, if such an agreement has taken place, it is a great way to increase the contagion. It really is kicking the can down the road.

Furthermore, as many (including myself) argued, the establishment of the Euro bailout fund would spread the problems into the Euro core, as countries such as France were already in a position of having too high levels of debt. A long time ago, I discussed the problem of who would be left to do the bailing out when every country was racking up too much debt. The context of the discussion was the US, if I remember correctly, but the same applies here. It has long been the case that any bailout is being funded by countries borrowing more money to enact the bailout. They are not using a net credit position to bailout, they are just borrowing more on the basis of having a better credit position than the bailee. However, when they are in a position of having too much debt themselves, they start to tip their own creditworthiness into the danger zone. Again, using your own fragile creditworthiness to support the less creditworthy is another case of kicking the can down the road.


The problem with such can-kicking is that it ratchets up the final consequences of the crisis. I have argued against the idea of contagion before, as the problem was not one that might be compared with a contagious disease, but more like a cancer that is destroying from within each country. However, the actions of trying to avert a major crisis are genuinely creating contagion. It was in the early points of the crisis that I suggested that contagion was the wrong metaphor for the problem, but it now seems appropriate. I am genuinely puzzled at what is going on. It just seems that policy-makers must actually see that they are in a hole, but they continue to keep digging it deeper.


It is not as if I am alone in questioning the endless successions of bailouts. Again, it does not take long to find voices expressing concern. What on earth do those who are enacting the policies think the end of the game might look like? Do they really believe that, for example, that one year from now that the Euro crisis will have ended, that sovereign debt problems will have disappeared, and that Europe will be on the road to economic recovery? They must, surely, have some kind of belief that this will be the case, and this must be why they continue to try to 'solve' the crisis? However, if they were to stop digging their hole for just a moment, the absurdity of this idea becomes apparent.

The crisis is getting ever larger, not diminishing. The fact that the ratings agencies are downgrading is just a belated indication of the reality of the situation, and just highlights exactly how bad things have become. When such clueless organisations have finally accepted the depth of the crisis, then it must be very, very bad indeed.


Note: A longer post than intended...

Update: 

Just after I completed the post, I found this in the Telegraph:

Use of the European Central Bank's three-year funding programme is expected to exceed €500bn in February when lenders are offered their second chance to access its new long-term refinancing operation (LTRO), according to Credit Suisse.

Last month, banks borrowed a total of €489bn using the LTRO, which has effectively seen the ECB take on the role of providing a large part of the funding required by several eurozone banks.

Analysts at Credit Suisse point out the ECB's willingness to provide an increasing proportion of the short and longer-term funding required by eurozone banks has led to a widening gap in the size of its balance sheet versus those of the Bank of England and the US Federal Reserve.

The ECB's balance sheet has risen in size to close to 30pc of eurozone GDP from just over 20pc before it launched the LTRO. By comparison, the Bank and Fed's balance sheets are both worth just under 20pc of domestic GDP.

And later:

The ECB's decision to increase its exposure to banks has effectively seen it provide the "bazooka" markets had been urging it to use to help stem the debt crisis.

Spanish banks that borrowed money using the LTRO are thought to have used most of it to buy Spanish government debt, leading to a lowering in yields.

Interesting, is it not? It still does not discuss the problem of the downgrades for the bank balance sheets, but it is there in the subtext. I still suspect my Google News search was looking for the wrong key words, so if anyone has seen an article on the effect of the downgrades on bank balance sheets, a link would be welcome.