The Euro Area Debt Crisis Escalates Further – No More Bank Bailouts In Europe?

Compared to how stock and commodity markets reacted to the first iteration of the euro area's sovereign debt crisis in May to August 2010 they are currently in a state of blissful serenity. However, if there were any hopes that the crisis would pause in the new year, then they were forcefully dispelled in Thursday's trading. The reason du jour came in the form of what the Telegraph calls 'sweeping  plans to govern reckless banks'.   As Ambrose Evans-Pritchard relates:

„The European Commission’s "Framework for Bank Recovery and Resolution" draws on Scandinavia’s hard-line approach during their banking crises in the early 1990s. The goal is to end the pattern of moral hazard and mispricing of risk that generated Europe’s debt woes.

"Banks will fail in the future and must be able to do so without bringing down the whole financial system," said Michel Barnier, the internal market commissioner Mr Barnier’s consultation paper will lead to a "legislative proposal for a harmonized EU regime" as soon as this summer, with an insolvency structure in place by 2012.

The final phase will be the creation of a European Resolution Authority by 2014, adding a fourth pillar to the EU’s new architecture of financial regulation. EU "authorities" typically have their own permanent staff and powers to override national bodies.

The document said regulators should be given "statutory power" to write down senior bank debt, by any amount necessary, or to convert debt into equity. "Such a power would only apply to new debt (or existing debt contracts renewed or rolled over) after entry into force of the power."


Worries over the exact shape of the bondholder haircuts caused credit default swaps on senior European bank debt to rise sharply earlier in the day, with the Markit iTraxx Senior Financials index rising 16 basis points to 196.

Spanish and Italian banks were hit hard, among them Banco Santander, with some lenders in the eurozone periphery at even higher levels than during Europe's so-called "Lehman moment" last May.

The jitters spread to sovereign debt as well. The CDS on Portugal rose 25 points to 525, Ireland rose 18 to 630, Belgium rose 17 to 240, and Spain rose 13 to 350.“


There is certainly nothing wrong with trying to avoid future bailouts of reckless banks. It remains to be seen what will happen should some of Europe's 'too big to fail' institutions get into trouble (we are thinking specifically of the German banks here, several of which are among the most highly leveraged in the world. Banks in PIIGS nations holding too much of the debt of their sovereigns are likewise somewhat dubious).

What one might be slightly surprised about is that it was even necessary to introduce a special 'resolution mechanism' for insolvent banks. Does that mean that hitherto, it was assumed banks could never face insolvency? Was there  no corporate bankruptcy mechanism in place that applied to banks?

Although Evans-Pritchard's article doesn't spell this out in great detail, it was apparently deemed necessary to imbue financial regulators with special dictatorial powers in order to avoid governments being 'railroaded' into bailouts by a sudden financial crisis, such as the one that happened in 2008.

While completely 'unexpected by experts' such as Fed chairman Bernanke and the great bulk of modern-day macro-economists, we happen to think that any observer with even a smattering of common sense should have been able to foresee the crisis. We first uttered critical comments on the leverage of the GSE's back in 1999 (to give credit where it is due, so did Doug Noland of the Prudent Bear Fund – he was in fact to our knowledge the first analyst to harshly criticize  the GSE's leverage as well as the budding credit insurance schemes that ultimately did in AIG and a number of the 'mono-lines'). Although it didn't matter for another 9 years, it was blindingly obvious already back then that these institutions were so leveraged that they would be unable to survive a credit crisis. However, most mainstream analysts and economists just didn't think a credit crisis was even possible.  After all, that's what we have a central bank for, right? It was apparently missed by all these leading lights that the Fed got into business before the Great Depression and that it couldn't avert the credit contraction back then either. Neither was the BoJ able to keep Japan's credit contraction from unfolding (once again, consider the laughable assertions made by Gregory Mankiw in the NYT at the time the crisis broke out in late 2007. The naivete and faith in central planning displayed in this editorial  by a man who is widely regarded as one of today's leading economists in the United States is a wonder to behold).

So governments everywhere were just as 'surprised' as their economic advisers and central bankers when the financial cart got stuck in the mud in 2008. Politicians faced with the possibility of a systemic collapse then went for what they considered the 'lesser evil' and bailed out the banks. The recently  famously intransigent Germans threw so much good money after bad in cases like 'Hypo Real' that one could not help but shake one's head in wonderment. However, all these 'we must save the banking system at all costs' contortions have saddled already strained tax payers with enormous additional burdens, while recessions and high unemployment struck in the countries with the biggest pre-crisis bubbles anyway. The result was a political backlash that now has led to the establishment of new rules (we note that bankers didn't skip a beat in terms of paying themselves bonuses – a practice that didn't make them any more popular, although they probably couldn't care less).


The Main Problem Remains Unaddressed

We believe however that the central problem of the modern-day banking system was once again skirted completely – it did not even come up for discussion. This is the monetary system itself.

The practice of fractional reserve banking with an unlimited liquidity backstop guarantee by a central bank is, to paraphrase J.H. de Soto, at the heart of the economy's manic-depressive behavior (interested readers may want to peruse our previous in-depth discussions of the topic which can be found here: Fractional Reserves Banking Parts 1, 2 and 3, Quantitative Easing, and Money and Credit).

Not only that, it is an unethical practice, as it is infringes upon property rights. Not only does it, according traditional legal principles that have been with us since antiquity, infringe on the property rights of depositors, it also infringes on the rights of everybody else in the economy. It does so by inducing the boom-bust cycle. The boom-bust business cycle engendered by loose monetary and credit policies and the associated creation of money from thin air invariably enriches a select few to the detriment of the great majority. It favors the reckless over the prudent, and it arrogates profits to the banking system the legitimacy of which is highly questionable  – especially in view of the subsequent socialization of losses. The boom-bust cycle entails impoverishment for society at large – this is to say, impoverishment relative to what would have happened  without the cycle (it is not necessarily the case that people are poorer after the boom ends than they were on its eve – it is merely clear that they would have been better off had there not been a boom-bust cycle at all).

As long as this central problem remains unaddressed, we can not hope to avert future financial crises. Piling on yet more regulations atop the mountain of regulations already in existence won't change this fact. A free banking system based on traditional legal principles would not even need half a page of regulations. The current system needs thousands of pages of regulations, wastes the time and energy of countless people who are charged with inventing and/or enforcing them, and still can not avoid financial crises.  It never will, regardless of how big this towering regulations-berg becomes. One is almost tempted to call this latest attempt a complete waste of time and effort, but we acknowledge that as long as the system works the way it does, it is better to have bankruptcy resolution rules for insolvent banks in hand than having nothing at all and bailing them out at every opportunity. Lastly, the central banks impose ultra-low interest rates whenever a bust strikes, which punishes savers  by depriving  them of a reasonable interest income. In short, the banks now can 'ride the yield curve' to make themselves whole on the backs of people depending on fixed income, many of which are pensioners, widows and orphans. It is essentially legalized robbery.

In passing we would like to draw your attention to recent remarks made by Kansas Fed president Thomas Hoenig (who famously dissented with the FOMC's decisions at every meeting in 2010) regarding a number of issues, including the Frank-Dodds monstrosity and the gold standard.


Asked about the new Dodd-Frank financial reform legislation, Hoenig reiterated that it had failed to address the problem of firms considered too big to fail, adding that the crisis had actually boosted concentration in the financial sector.

Hoenig also faced questions about a possible return to the gold standard, a fringe view advocated by some economists and politicians that would force countries to back their currencies with bullion reserves. He was surprisingly open to the idea.

"The gold standard is a very legitimate monetary system," Hoenig said. "We're not going to have fewer crises necessarily. You will have a longer period of price stability or price level stability, but I don't know that you'll have lower unemployment, I don't know that you'll have fewer bank failures."


(our emphasis)

Color us unsurprised by Hoenig's assessment of Frank-Dodds – it was what we would have expected him to say, since he has never shied away from airing his usually quite reasonable views candidly. Naturally we agree – in the US, the banking system has become even more concentrated and as it were, a 'bailout through the backdoor' via the GSE's continues to be underway. Treasury secretary Geithner is fond of telling the lie that the bank bailout 'didn't cost tax payers anything'. He can do that because the costs have been shifted away from prying eyes. They have partly moved onto the Fed's balance sheet, which has become the graveyard of numerous monetized toxic mortgage assets and partly onto the balance sheets of the already thrice-over bankrupt GSE's. The next crisis is certain to see even more socialization of bank losses – the argument that the now even more concentrated 'systemically important' banks are 'too big to fail' will most definitely be raised again. If anything, we would think that these behemoths need to be broken up into more manageable chunks if this is the case. They know they will be bailed out again after all, so they have every incentive to once again take inordinate risks in the drive to produce higher bonuses. Moral hazard clearly lives on in all its 'glory' in the wake of  Frank-Dodds.

As to the gold standard, we are happy to hear Hoenig is 'open to the idea'. He is however attacking a straw man when he notes that apart from improved price stability the economy would still be as prone to crises and bank failures as it is now. We imagine he said this in view of economic history (the 19th century was plagued by numerous boom-bust sequences), but he neglected to mention the crucial point that it was not the fault of the gold standard that these crises occurred. It was in every single instance the practice of fractional reserve banking – banks fraudulently issuing more receipts for gold ('bank notes') than they had specie on deposit – as well as early experiments in central banking that ultimately led to the crises and bank failures. At least the occasional healthy bank runs kept these escapades to a minimum that the free market coped with easily every time. No interventions were deemed necessary, and the economy recovered quickly on its own in all instances.


Useless Credit Rating Agencies

The WSJ had a few interesting remarks in the wake of Thursday's drubbing of European credits as well, some of which are well worth highlighting:


“Even before Thursday's flare-up, the credit-default-swap and bond markets already suggested high and rising investor worry about the credit-worthiness of not only financially strapped nations on the periphery of the euro zone, but some core nations, too.

The credit-default-swaps market suggests that Portugal, Ireland, Italy, Greece and Spain still are all rated too highly by the three leading global rating firms, Fitch Ratings, Moody's Investors Service and Standard & Poor's. Italy should be rated BB by this measure, and other countries in financial distress like Portugal, Spain, Greece and Ireland should be rated B, according to an analysis by Markit.

All of those implied ratings are in "junk-bond" territory, or below investment grade. Only Greece is rated below investment grade by any major ratings firms. Markit's analysis assigns implied ratings to a country based on how its credit-default-swaps price compares with those of other countries. Belgium has a similar swaps price as Italy and so gets a similar implied credit rating.

Credit-default-swaps prices also suggest European nations such as Belgium, France and the U.K. also might be at risk of a ratings downgrade of at least one notch. The latter two nations have AAA ratings by all three ratings companies.

Downgrades could raise government borrowing costs and add to market anxiety. A downgrade to junk status would force some investors to sell out because they can hold debt rated only as investment grade.

"Markets see the agencies are behind the curve," said Win Thin, a currency strategist at Brown Brothers Harriman.”


(our emphasis)

Imagine that! The credit rating agencies are behind the curve! Who would have thought that could ever happen? It isn't exactly the first time we're wondering what these rating agencies are actually good for. Don't they have anyone who can judge a country's financial condition by perusing the published fiscal and economic data, or failing that, is at least able to read a chart or two?

It appears the incestuous relationship between credit rating agencies and borrowers is just as cemented at the sovereign borrower level as it was – and likely still is – in the private sector. The essential flaw is of course that the rating cartel gets paid by debt issuers instead of investors to impart its judgment calls. This is mainly to help sell debt securities, which are seemingly often rated by a mixture of incompetence and wrongly aligned incentives.

Evidently, the markets are not so easily fooled anymore these days, but there is a more serious point to consider here: pension funds and other institutions that invest according to certain guidelines rely on these ratings when allocating funds to investments. Since many pension funds are basically faceless bureaucracies, their reliance on such ratings is inter alia a 'cover your behind' strategy for the people responsible for investment decisions involving the  'hunt for yield'. The sad reality is that nowadays many pension funds are woefully underfunded after living through one investment disaster after another. The ratings agencies are not doing pensioners, widows and orphans any favors either –  that much is certain.


European Welfare States on the Ropes

As we mentioned in our 'Market Observations' piece earlier this week, a heavy debt auction calendar in the euro area would put the markets to a renewed test and we specifically pointed to Belgium as the most recent applicant to join the 'PIIGS' stable  – lately also known as 'GIPSI', which represents the actual as well as the likely future sequence of bailouts, i.e. Greece (check), Ireland (check), Portugal, Spain and Italy. Well, we'll soon have to get a 'B' in there somewhere.

According to a WSJ summary of Thursday's activities:


Portugal. It sold short-term bills at a steep yield this week, an auction that most traders think isn’t sustainable. Next week it intends to sell 1.25 billion euros of three- and nine-year bonds. Currently, Portugal 10-year bonds are fetching yields just above 7%, more than 4 percentage points higher than similar German bonds. Yields at that level would make government financing wickedly expensive. That may be why a Reuters poll of economists found 44 of 51 queried believe that Portugal will need a bailout like Greece and Ireland before it.

Spain. While Spain’s funding costs are a bit more modest than Portugal’s, its banks are another question. Credit insurance costs for several banks are rising close to crisis-record levels. Dow Jones reports that rising concern of “haircuts” for senior bondholders is augmenting the nervousness.

Belgium. Usually not included in the melange of euro-zone misery, Brussels has no government for six months and counting. The most recent bid to try and bring the Walloons and Flemish together have not worked and Dow Jones says the caretaker government has busily been denying reports that its banks need more money. Its credit insurance costs have risen 19% today. The 10-year yield for Belgian debt has risen above 4%.


(our emphasis)

To the above we would add that yields above 7% mean that Portugal would currently save about 200 basis points by accepting an EFSF ('European Financial Stability Facility') bailout. They're a shoe-in, no matter how strongly they deny it.

As regards Spain, sovereign debt yields there are now about even with those it would have to pay on EU bailout funding – in short, it is once again creeping closer to becoming a serious candidate. Spain's banks  have the huge albatross of Spain's collapsed housing and mortgage credit bubble around their collective neck, while their accounting practices are such that they have been able to sweep the true extent of their problem loans under the rug (this is roughly analogous to the 'extend and pretend' strategies practiced by many US banks, but reportedly a good deal more brazen).

If Belgium's caretaker government is busily denying that its banks need more money, then it means that its banks most definitely need more money. Nothing is more certain to be true than stuff that a government strenuously, frequently and sotto voce denies to be so. This is on a par with the equally strenuous denials be Greek and Irish politicians that Greece and Ireland would need to be bailed out up until about one week before they acceded to their respective bailouts.

As an aside, another noteworthy recent development is that the Swiss National Bank (SNB) has stopped accepting the sovereign debt of Ireland as collateral in its repos. We can not fault the SNB for this show of good sense, but we do wonder what the ECB ultimately intends to do with the toxic trash piling up on its balance sheet. We realize of course that the ECB is also implementing an 'extend and pretend' policy in the forlorn hope that things will magically get better, but the fact remains that if it has to eventually eat big losses on its bond holdings it will end up having monetized defaulted debt. This will likely shoot any of its remaining credibility on 'controlling inflation' (a similar problem awaits the QE – prone Federal Reserve one of these days).

What prompted the slightly sensationalistic title of this post was a recent NYT article that highlights the desperate situation of young people in Southern Europe. Whether in Greece, Italy or Spain, all of these nations have a growing demographic problem (i.e. they are all 'graying' societies) coupled with such sclerotic, over-bureaucratized and over-regulated economies in which well-entrenched interest groups battle tooth and nail over a shrinking economic pie, that the complete financial collapse of these welfare states appears at best a question of time.

This situation is analogous to that of the communist command economies of the former Eastern Bloc/Warsaw Pact nations in the early 1980's. An essentially bankrupt system muddled through for another decade, more dead than alive, with halfhearted attempts at 'reforming' what was clearly an utter failure. We never quite agreed with the enthusiasm Michail Gorbachev was greeted with in the West, where he was treated like a veritable  pop-star during his disastrous reign over the Bolshevik corpse. In the Soviet Union people knew better of course and his popularity suffered a Bush/Obama-like collapse there. In the end, people had to queue for hours on end to buy bare necessities, only to often find the shelves completely bare.

European welfare statism will likely last even longer, since in this particular case the State can still feed on the accumulated wealth created by what are nowadays the sorry remnants of a free market.  Naturally, not all European states are in a similar stage of decay, but don't let that fool you – even the 'better ones' run a system that is doomed to fail in the long run.

We would note here that Ludwig von Mises famously proved in the early 1920's,  when he first discussed the calculation problem, that socialism can not possibly work. While the communist system took 70 years from its birth to its complete collapse, he was eventually vindicated. This did not keep people from asserting for decades that he must be wrong and that somehow, central planning could be made to work, if only 'implemented properly' or pursued by 'properly trained people'. Even today, whenever it is pointed out to any of the  few remaining Marxists that communism has quite obviously failed for all to see, they use this as their fallback position: 'it wasn't done properly'. Alas, the problem runs much deeper than a mere 'implementation' issue – it is indeed as Mises said all along – it can be proved beyond a shadow of doubt that the calculation problem makes a socialist economy regressive and that it can only exist until all the earlier accumulated capital has been consumed, after which it inevitably collapses. J.H. De Soto has extended this proof to include all the central planning institutions that plague our society, such as most prominently the central banks.

So what did Mises think of the 'third way' , the 'social-democratic' modern-day welfare state? He thought it would be unworkable as well. In 'The Anti-Capitalistic Mentality' Mises noted:


“Capitalism and socialism are two distinct patterns of social organization. Private control of the means of production and public control are contradictory notions and not merely contrary notions. There is no such thing as a mixed economy, a system that would stand midway between capitalism and socialism.”

and ibidem:

“To the grumbler who complains about the unfairness of the market system only one piece of advice can be given: If you want to acquire wealth, then try to satisfy the public by offering them something that is cheaper or which they like better. Try to supersede Pinka-pinka by mixing another beverage. Equality under the law gives you the power to challenge every millionaire. It is in a market not sabotaged by government-imposed restrictions exclusively your fault if you do not outstrip the chocolate king, the movie star and the boxing champion.”

In 'Planned Chaos' Mises wrote:

The planner is a potential dictator who wants to deprive all other people of the power to plan and act according to their own plans. He aims at one thing only: the exclusive absolute preeminence of his own plan.”

And in 'Planning for Freedom':

“If one rejects laissez faire on account of man's fallibility and moral weakness, one must for the same reason also reject every kind of government action.”


Note here that it matters not one whit in practice nowadays if declared 'social democrats' or declared 'conservatives' are elected to run the government – all of them are deeply committed to welfare/warfare statism, to  such an extent that fundamental issues such as the monetary system and the very idea of the State comprising an ever bigger part of economic activity are not  questioned in the slightest anymore.

Similarly, the unchecked growth of faceless bureaucracies and the 'administrative laws' that they both create in shocking abundance and execute in personal union are widely accepted as 'unalterable givens' of modern democracies. It is a gilded prison, and the 'free citizens' are faced daily with the fact that under the velvet glove the iron fist is just biding its time. Most people are of course blissfully unaware of this, distracted by television and ubiquitous electronic gadgetry, but their awareness level is bound to increase once suitable 'emergencies' happen with increased frequency. One of the 'long term emergencies' inherent to the welfare state is coming to the fore now in many Southern European nations. The above mentioned NYT article, “Europe’s Young Grow Agitated Over Future Prospects” illustrates how the often-cited negative effects of 'borrowing from future generations' have in fact come home to roost in Europe in the here and now (so much once again for 'We're all dead in the long run'. The long run has arrived):


“Politicians are slowly beginning to take notice. Italy’s president, Giorgio Napolitano, devoted his year-end message on Friday to “the pervasive malaise among young people,” weeks after protests against budget cuts to the university system brought the issue to the fore.

Giuliano Amato, an economist and former Italian prime minister, was even more blunt. “By now, only a few people refuse to understand that youth protests aren’t a protest against the university reform, but against a general situation in which the older generations have eaten the future of the younger ones,” he recently told Corriere della Sera, Italy’s largest newspaper.”


Even before the economic crisis hit, Southern Europe was not an easy place to forge a career. Low growth and a corrosive lack of meritocracy have long posed challenges to finding a job in Italy, Greece, Spain and Portugal. Today, with the added sting of austerity, more people are left fighting over fewer opportunities. It is a zero-sum game that inevitably pits younger workers struggling to enter the labor market against older ones already occupying precious slots.

As a result, a deep malaise has set in among young people. Some take to the streets in protest; others emigrate to Northern Europe or beyond in an epic brain drain of college graduates. But many more suffer in silence, living in their childhood bedrooms well into adulthood because they cannot afford to move out.

“They call us the lost generation,” said Coral Herrera Gómez, 33, who has a Ph.D. in humanities but still lives with her parents in Madrid because she cannot find steady work. “I’m not young,” she added over coffee recently, “but I’m not an adult with a job, either.”

There has been a national debate for years in Spain about “mileuristas,” a nickname for college graduates whose best job prospects may well pay just 1,000 euros a month, or $1,300.

Ms. Herrera is at the lower end of the spectrum. Fed up with earning 600 euros a month, or $791, under the table as a children’s drama teacher, Ms. Herrera said she had decided to move to Costa Rica this month to teach at a university.

As she spoke in a cafe in Madrid, a television on the wall featured a report on the birthday of a 106-year-old woman who said that eating blood sausage was the secret to her longevity.

The contrast could not have been stronger. Indeed, experts warn of a looming demographic disaster in Southern Europe, which has among the lowest birth rates in the Western world. With pensioners living longer and young people entering the work force later — and paying less in taxes because their salaries are so low — it is only a matter of time before state coffers run dry.

“What we have is a Ponzi scheme,” said Laurence J. Kotlikoff, an economist at Boston University and an expert in fiscal policy.”


“The problem goes far beyond youth unemployment, which is at 40 percent in Spain and 28 percent in Italy. It is also about underemployment. Today, young people in Southern Europe are effectively exploited by the very mechanisms created a decade ago to help make the labor market more flexible, like temporary contracts.

Because payroll taxes and firing costs are still so high, businesses across Southern Europe are loath to hire new workers on a full-time basis, so young people increasingly are offered unpaid or low-paying internships, traineeships or temporary contracts that do not offer the same benefits or protections.

“This is the best-educated generation in Spanish history, and they are entering a job market in which they are underutilized,” said Ignacio Fernández Toxo, the leader of the Comisiones Obreras, one of Spain’s two largest labor unions. “It is a tragedy for the country.”

Yet many young people in Southern Europe see labor union leaders like Mr. Fernández, and the left-wing parties with which they have been historically close, as part of the problem. They are seen as exacerbating a two-tier labor market by protecting a caste of tenured older workers rather than helping younger workers enter the market.

For Dr. Kotlikoff, the solution is simple: “We have to change the labor laws. Not gradually, but quickly.”

Yet in Greece, Italy, Portugal and Spain, any change in national contracts involves complex negotiations among governments, labor unions and businesses — a delicate dance in which each faction fights furiously for its interests.

Because older workers tend to be voters, labor reform remains a third rail to most politicians. Asked at a news conference last year about changing Italy’s de facto two-tier system, Italy’s center-right finance minister, Giulio Tremonti, said simply, “You can’t make violent changes to the system.”


There you have it – an unworkable Ponzi scheme is coming to its inevitable end – the 'third way' of the 'social market economy' is about to implode in these countries, and yet, their political leadership is completely paralyzed, unable to 'make violent changes to the system'. So the changes will eventually be forced on them, and very likely under even more unfavorable and violent circumstances.

If you ever thought in a guilty moment that perhaps you should go 'hunting for yield' in the bond markets of the 'PIIGS' (after all, they will all be bailed out, right? Someone or other from the EU promised…) , this article in the NYT should thoroughly disabuse you of the notion. The very end may not be here quite yet, but it has come well into hailing distance. All the 'extend and pretend' stratagems in the world will not keep the eventual disaster at bay. After the collapse of communism, we are now closing in on the collapse of welfare/warfare statism.

With that, we take our customary look at the relevant charts concerning the usual suspects:


1. CDS

On Thursday numerous CDS spreads in euro-land went to new crisis wides. Most notably, CDS spreads on Belgian debt soared along with yields. CDS spreads on the 'already bailed out' Greece and Ireland both were at new wides as well, ignominiously and ominously (prices in basis points, color-coded).



5 year CDS spreads on the debt of Portugal, Italy, Greece and Spain – all moving higher again, with Greece and Spain reaching new highs – click for higher resolution.



5 year CDS spreads on Ireland's sovereign debt, Bank of Ireland's senior debt, France and Japan. The 'Irish duo' is making new highs here as well. As we have noted several times before, all of these charts continue to look bullish – click for higher resolution.



5 year CDS spreads on Hungary, Romania, Austria and Belgium. Both Belgium's and Hungary's have reached new highs as well – click for higher resolution.



The Markit SovX index of CDS on 19 Western European sovereigns. Another new high in a methodical rally – click for higher resolution.



2.    Euro Basis Swaps 

In spite of CDS on the debt of many European banks rising strongly as well, euro basis swaps have recovered , a sign that the strongly negative levels reached in the final week of 2010 had in large part to do with seasonal year-end funding pressures.



One year euro basis swap – bouncing back to minus 38.125 bips – click for higher resolution.



5 year euro basis swap – likewise bouncing this week – click for higher resolution.



3.    Other Charts


The SPX, the gold-silver and gold-commodities ratios, and T.R.'s proprietary VIX – based  volatility indicator. Some early indications of possible trend changes, but nothing really firm yet. Just a heads-up, but one we wouldn't dismiss – click for higher resolution.



A one year daily chart of the euro – contrary to the relatively sanguine behavior of the euro up until recently, the most recent break-out of sovereign debt trouble has led to a pretty sharp fall in the euro's exchange value. This could easily be the beginning of a more pronounced downtrend and we recommend to closely watch for a possible lateral support break – click for higher resolution.



A one year daily chart of the dollar index (in which the euro has the biggest weighting) shows a mirror image of the action in the euro. Earlier this week we opined that perhaps a little more near term weakness was going to be in store, but obviously this was not to be – and now MACD is closing in on a new buy signal. Resistance awaits in the form of the 200 day ma. We would note that by failing to break lower, the chart has acquired a more bullish tint, but just as the euro still rests barely above short term support, this requires confirmation by breaking resistance – click for higher resolution.



Another chart from the 'the ones that went awry' collection. Instead of rallying further in the short term, gold has retreated again in the face of USD strength. Note though that it may yet defend support, as troubles in euro area sovereign debt have previously seen gold ignore a stronger dollar for a while. Alas, the MACD buy signal from last week has been invalidated again. In gold's favor counts that it has worked off an overbought condition by merely going sideways so far. However, Thursday's close represents the first below the 50 dma in some time – click for higher resolution.



In closing, if the foregoing has not convinced you that we're doomed,  take note that it is even raining dead birds and dead fish lately. :)

Conspiratorially and some religiously minded people are convinced it's a message from on high – and in a way, it is. Apparently the phenomenon is real, as it has been widely reported.



Crash-landed birds decorating a road in Louisiana – the end is nigh!



FOMC dissident and Kansas Fed president Thomas Hoenig: a central banker who thinks the gold standard is a legitimate monetary system – inflationists need not  worry too much though,  he won't have a vote at the FOMC this year and is set to retire this October. Perhaps this imminent retirement is what has at least in part informed his candor. Be that as it may, he is one of the very few monetary authority bureaucrats we  hold in high esteem, even though we don't always agree with him. He has integrity and is evidently deeply suspicious of the inflationary Keynesian doctrines that hold sway among most of his colleagues.


Charts by: Bloomberg,



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6 Responses to “The Coming Collapse of the Welfare State”

  • pandora:

    Thanks again for another comprehensive and informative article. Unfortunately it has left me feeling somewhat pessimistic. As you note, too many remain in self-imposed ignorance, preferring to immerse themselves in electronic gadgetry, frivolous activity and glued to the box. Shades of Huxley’s Brave New World and Postman’s Amusing Ourselves to Death.

    @mannfm11 ‘Demographics upside down’ Yes, but only in the developed nations! Emerging economies have the reverse situation, a surge of the young, with few economic prospects, often in politically and religiously volatile regions…that is another story.

    Buckle up – we are in for a bumpy ride.

  • jbr:


    Thanks for another of your very insightful commentaries.

    In your recent posts you’ve done a wonderful job describing the factors underlying the ongoing stand-off between deflationary and inflationary forces and the likelihood of additional debt driven deflationary impulses followed by interventionist driven reflationary impulses before a possible end-game currency crisis and hyperinflation.

    Although I agree with your analysis, I continue to struggle with the investment implications as one cannot predict the timing of these cycles – there are simply too many unpredictable factors and events behind it and a single timing error could be fatal. What are the odds of even the best getting all the turns right? Given all this, from a practical standpoint, how does one preserve purchasing power as the cycles play out?

    I’m wondering if the only way to deal with the uncertainties is to simply assume one cannot time the ongoing inflationary & deflationary impulses correctly and as a result the only rational option is to employ a deflation – inflation barbell, ie, position roughly half of one’s assets for deflation and half for inflation attempting to hedge the swings. The challenges with that approach are to choose offsetting hedges that actually work (survive) and balancing them. It’s not clear to me whether this approach would require periodic rebalancing – if so, timing errors doing that could be problematic. One example might be to put half of ones assets into precious metals and commodities (via some combination of bullion and equities) and the other half in US government bonds. Although my conservative side would want to create a bond ladder using 1 yr to 5 durations, I have to wonder if, for the barbell to actually work properly, whether it would in fact be necessary to use only long duration bonds or zeros instead. Of course, there is also the problem that even if the barbell functions properly and largely survives the cycles that a desperate and panicked government wouldn’t ultimately tax away the preserved capital from the few survivors since in this case the preserved capital would be claimed to be investment “gains”.

    I would highly appreciate if you could share your thoughts on the barbell approach and/or other strategies to preserve hard earned purchasing power throughout this difficult environment since ultimately that is the goal of your superb analysis.


    • I have in fact advocated such a ‘barbell’ strategy for many years. Funny enough, in most years over the past decade, BOTH legs of it produced positive returns. I see no reason as of yet to deviate from it, even though obviously the question of sovereign debt risk has come into sharp relief with the euro-land crisis. Nonetheless, the market will likely continue to treat US treasury bonds as a ‘safe haven’ in times of upheaval for the time being (this may change at some point in the future, but I don’t see it changing in the near term). If one wants to ‘keep it simple’, a one third bonds, one third gold and one third cash allocation will probably work best, with the intent of putting the cash portion to work when extraordinary opportunities present themselves. Also, one can hedge the gold and fixed income exposure as you propose, or ‘trade around it’ by reducing exposure when one of these markets becomes short term overbought and increasing it when it becomes oversold. This is not meant to be ‘investment advice’ , since everybody’s personal situation is unique in terms of risk tolerance, etc. – it is just meant as an illustrative example of how one can deal with the problem of timing the deflation and inflation scares in the short to medium term. Also, there are of course numerous ways of fine-tuning such a strategy, with regards to the maturity profile of the fixed income portion, possibly apportioning the gold investment between bullion and gold mining stocks , the size of the cash reserve position, the hedges one adopts, etc.
      As a final comment, no matter which strategy one pursues to preserve the purchasing power of one’s savings, the current interventionist macro environment clearly forces one to adopt a pro-active approach. The times of simple ‘buy and hold’ are unfortunately well behind us. The risk that policy makers will make additional severe mistakes is palpable.

      • jbr:

        Thank-you for taking your time to reply.
        One of the reasons I very much appreciate reading your blog is the clarity of thought you exhibit – something completely lacking in mainstream financial media.
        I agree with you about the need for a pro-active approach in this interventionist macro environment but I wish it wasn’t so. Unfortunately, I don’t have the skills, discipline, or time to personally manage my own funds and I suspect the number of managers who actually “get it” and also have the risk management skills as well as the needed operational infrastructure are quite few. To make matters worse, one would actually need several (or many) of them to mitigate individual manger risk if one had a large capital base. Prior to the bursting of the tech bubble, because of my concern about what was coming at that time, I allocated exclusively among numerous hedge fund managers (that very unconventional in 1999) and they did quite well during the post bubble bust period. I redeemed from those funds during late 2007 and early 2008 because I was concerned that even those relatively conservative hedged strategies might not survive the rapidly approaching “echo bust” (and many probably wouldn’t have had the interventionists not gone into over-drive). I don’t have much confidence most hedge fund managers will deal with the current scenario as it evolves this time around so I’m not keen to re-allocate to a conventional diversified hedge fund portfolio now. Also, the hedge fund partnership structure and associated liquidity limitations (lockup, gates, etc) may become even more problematic than they were during 2008 (although perhaps more hedge fund manager will allow separate managed accounts now that third party platforms make that approach more cost effective).
        Bottom line – do you know of one or more managers who are sufficiently enlightened to the current macro environment who are implementing strategies similar to that which you described and who posses necessary risk management disciplines and good operational infrastructure? My prior experience with third party alternative investment advisory / due diligence firms showed them to be severely lacking – do you know of any trustworthy firms providing that function (who don’t only cater to institutional investors)?
        Thanks for your input.

  • What was that old Laurel and Hardy saying? This is a fine mess you got me into Stan? Looks like Stan has been running things a long time.

    I am going to post this on my facebook account in hopes some uninformed take time to read it. Much appreciated.

    You speak of the young peoples trap that has hit the world. Demographics upside down. Debt too high. Demand will soon be too low. We have reached the ultimate paradox, well to do older generation who holds excessive debt that is being paid by the younger generation that is supposed to create the demand to support the value of assets. Bankers cashing checks in the hundreds of billions, all sucked out of the pockets of those in the rest of the economy. Thus the older generation is being forced to look for yield, clearly in my mind buying the next wave of defaulting assets. There is no income to sustain the lifestyle of the older generation for 20 years, so they have to quit spending, killing more demand and slowing the transfer of money downward. The compound debt equation works in reverse as well, as it will start consuming itself in a compound manner, making prices fall, repayment more and more difficult and further deflation likely. The CB’s aren’t helping matters allowing bankers to suck more money out of peoples pockets to balance an equation that has no solution. The more they draw out of the economy, the more insolvent the economy and the remaining bank assets become. Witness Japan. Those that think we should follow Japan should be immediately discredited. But, I had to laugh 10 to 12 years ago when the crooks in charge of the media at the time teased Japan about their solutions. I knew these same jackasses would be clamoring for the solutions, ZIRP, excessive spending, etc.

    The wealth of the American middle class has been sucked into the pockets of the banking wealthy. The function of government is to continue this procedure as long as it can go on, by socialistic means. Government debt is for the continued accumulation of money for the banking class, as only those that receive the flow can purchase the bonds. Thus the welfare system is an indirect program for the rich, to be worked for by the middle class.

    In order to survive, the middle class have been told they need to buy stocks. Problem is the market of the future and the debt problems of the future are going to fall harder on the stock market than the debt markets. In the meantime, the productive capital of the United States has been sent out of the country to build China and the American economy replaced by a bunch of financial bubbles in stocks, real estate and bonds. The bankers take a slice of all of this and acquire claims against the economy for their destruction.

    Banking is indispensable for the economy in its proper function. In the current situation, it must be made clear that what is in the bank isn’t the bankers money and it is under government guarantee to boot. He goes to the casino with our chips, giving us the bill if he loses and keeps the gains if he wins. Bankers took nearly 1% of the GDP in bonus, roughly a 1% fee on the money supply of the US. Bank margin, from my understanding was supposed to be a gross 2%, meaning the net was at best 1%. Knowing this, it is quit probable that the US banking system had no real earnings when the longer term shakes out. Add this to the fact that bank credit has no mathematical solution and that liabilities are owed to a different group of people than the assets. The longer this system runs, the wider the valley between the 2 camps, the solvent and the insolvent.

    Pater, it is quite possible the Europe situation is manageable for the next year or so, but the Japan debt problem is beginning to make waves. I note the default swaps there are 70 BP or so. Last I recall, the 10 year bond in Japan was in the 1.5% range, so 1/2 its yield is systematic risk. Japan is in a trap, in that its government debt is over 200% of GDP and its government income is about 10% of GDP. Spending around 19% from the rough figures in my head presents a problem, but the prime problem is that about 4% interest on the debt wipes out the entire tax revenues. When blood hits the water, the sharks will appear quickly and rates will go right past 3% to 8% or 10% rapidly. The trap will be sprung. A 50% haircut of about $12 trillion in debt will reverberate around the world, as will the moves to higher taxes and austerity necessary to fix that equation. It is then the US government will realize the double barrel they are looking down.

    • I agree, it has become an intractable situation. The biggest credit bubble in the history of mankind, occasioned by throwing the ‘gold anchor’ overboard in 1971 and embarking on the fateful experiment of instituting a pure fiat money system is drawing to its inevitable close.
      I would agree that euro-land can probably ‘muddle through’ for a while longer by applying band-aids in the form of further bailouts and bond market intervention by the ECB, but the crisis appears to have a habit of recurring until some sort of credible long term solution is found. This may well involve a break-up of the euro zone as it is presently constituted.
      As regards Japan, its fiscal situation is indeed the greatest potential systemic risk at the moment. Over the past two days, CDS on Japanese debt have incidentally continued to shoot higher. It seems likely that Japan’s deflationary era will at some point end with a bang and flip over into a highly inflationary regime. In spite of keeping rates at a very low level, the BoJ has not inflated much in recent years. Money supply growth in Japan has remained quite subdued. However, should the government find it is unable to continue to finance its debt domestically, it will very likely resort to the printing press. The only alternative would be a direct default, which I think is politically unpalatable given that 98% of outstanding JGBs are held by domestic investors. Naturally the transition from one regime to the next is unlikely to be peaceful. Major upheaval seems likely. Japan is now the quintessential ‘gray swan’. Everybody knows the situation is untenable, but what is not known is when the threshold separating the current tranquility from the future chaos will be crossed and how precisely this will play out. Alas, I fear we will find that out sooner rather than later.

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