(A lot of flashbacks to recent American history today and thus a lot of very interesting hypertexts for those curious minds among us)
I have made myself discreet in recent weeks. out of concern for polluting classic macroeconomic analyses with political matters, as the on again/off again Greek debt negotiations, which skew any near term analysis of economic developments.
We have been comparing the nadir of Greek debt last week with the climax of American banking shares in March 2009, and were waiting impatiently for Europe to put its money where its mouth was, much like American authorities put their foot down as "experts" were insisting that the nationalisation of Citi, Band of America and other banks was inevitable.
A few flashbacks:
2009-02-18: Greenspan Supports U.S. Bank Nationalization
2009-02-21 : Nationalize' the Banks. Roubini.
However, the key did not turn out to be the nationalisation of the American banking system, which reminds us of those who were still clamoring for the restructuring of Greek debt just a few days ago (Minimize the Losses, NY Times 25 April), despite repeated denials by the European Commission and the ECB.
What enabled all asset classes to abruptly turn around in the second week of March 2009 was the expectation (Bernanke Pledges Forceful Action, 7 March), followed by the establishment by the Fed of a giant quantitative easing 18 March: Fed Plans to Inject Another $1 Trillion to Aid the Economy.
We heartily applauded this massive intervention by the Fed in our 19-03-09 Thaler's Corner (Shock and Awe: Achieving Rapid Dominance), with our reference to tactic used in 300 AD by Roman legionnaires and conceptualised by Harlan Ullman and James Wade in 1996.
So why rehash the Fed's QE of March 2009 today? Because we expect the German parliament to approve the new Greek debt bail-out by this Friday at which point we can also look forward to a huge rebound in Greek government bonds to yields more in line with the country's foreign financing needs in the years to come.
The fact that 2-year bonds continue to offer, as I write these lines, yields of over 6% (in fact, 10.66%, after trading at 12.90% at market opening!), proves that, beyond the issue of transaction liquidity, doubts persist about the viability of this new plan, even in the near term.
I don't think the doubt is so much about whether or not this weekend's plan will be implemented but on the viability of an ultra-recessive and ultra-deflationary budget programme that few investors believe will stand the test of events in that Mediterranean country.
Given its eurozone membership, Greece has no other choice but to engage in what is called domestic devaluation, meaning the establishment of a massive cost deflation of government worker salaries and pensions and, by contagion, salaries and production prices in the private sector.
That Germany has succeeded in imposing unimaginable budget cuts on Greece, as Ms Merckel declared yesterday is certainly a victory economic virtue and economic balances within the eurzone, but what Germany and its trading partners really need to understand is that this type of adjustment will also have consequences for their own balances.
If all European countries were to engage in massive budget cuts at the same time, while the Great Financial Crisis continues to make itself fel, as seen by the still negative growth in European bank loans or M3 money supply, we could end up in a huge deflationist trap, against which we have been warning since the Death of Securitisation.
The only hope for the eurozone to avoid Japanese-style lost decades, a spiral from which it would be all the more difficult to escape, given the lack of eurozone-wide economic coordination and the ECB's Austrian school posture, is for Germany's emerging country posture to take form.
As European demand will contract overall, European exports (mainly from Germany) will need to find new foreign markets.
Just as our German partners were able to benefit in 1981 from the ill-timed economic spending by the new administration in France, they hope today that the growth of the BRIC nations will keep Europe from sliding into deflation/depression.
You are well aware of my skepticism about the quality of Chinese economic growth today, which not only does not stand the test of Post-Keynesian analysis vis-à-vis the Minsky Path (credit explosion) but neither of Austrian school monetarism, because if there is one place where Ludwig Von Mises's Malinvestment thesis (Overinvestment and Malinvestment) applies, China's it!
And China's dogged determination to continue directing in a regulatory manner its economy, like with Sunday's announcement of a new hike in banks' required reserve ratios (from 0.5%, to 17% for the biggest), while refusing to change key interest rates or end the manipulation of the currency's parity, is not going to calm markets either.
All in all, our pessimistic scenario for mainland China is coming to fruit, which leaves Europe as the only hope to avoid falling into Sovereign Debt Deflation, implying that the ECB finally assume its responsibility in the conduct of eurozone economic policy, by launching a real quantitative easing, as opposed to its piece-meal approach, like the purchases of covered bonds, which are nearly over anyway.
Its announcement this morning that it would scrap Greek debt collateral rules is not a real quantitative easing measures but just one more band-aid solution.
The move simply aims to prevent the Greek banking system from going under (and by extension, that of Europe), which would find itself in an untenable position if it were unable to obtain refinancing with the ECB for its Greek government bonds.
Our main scenario remains therefore that the ECB, like for the entirety of the monetary decisions it has made in the past several years, must follow the footstep of its faster reacting peers (FED, BoE, SNB, BoJ) and launch a giant government bond buyback programme on the secondary market,, like when Portuguese debt will really come under attack.
To reach an amount equivalent to what the Fed bought, the ECB, would have to announce a €1.1 trillion buyback of government bonds, including some covered bonds, if it prefers to continue favouring German banks, based on the euro/dollar parity and the respective GDPs of the eurozone and the United States.
As for those who are worried how well the euro will resist in such a QE scenario, keep in mind that the euro was trading for $1.34 at 18 March 2009, when the Fed shifted gears: today, it is at $1.32.
Just a little quote which may indicate that, although the idea may still revolt the members of the Frankfurt council, this may be viewed an an arm of last resort by the ECB. Check out Mr Trichet's comment about the matter:
“As you know, we have decided in the past to purchase covered bonds”.
“At this stage, we have absolutely no decision on the purchase of government bonds”.
“At this stage, we have absolutely no decision on the purchase of government bonds”.
No decision, but a little less theological rigidity.
To end this text on a more optimistic note, let me give you a concrete example of what I call hope for civilisation, which argues for pulling out of this first severe crisis in the construction of a monetary European union with our heads up.
Few people realise that Greece is one of those countries for which military spending accounts for a large chunk of its total budget.
Although it may appear crazy to someone from outer space visiting planet earth, the large military budget stems from the country's fear of Turkey, a fellow NATO ally and candidate for admission to the European Union.
Greece is ranked number three, behind the United States (4.3%) and the United Kingdom (2.5%), both of which are engaged in foreign military interventions, and way ahead of France(1.8%), which spends a lot for its nuclear capabilities, and all other eurozone countries!
According to NATO, this percentage rose to 2.80% in 2008 to over €7bn, i.e. above that of the UK!
Greece and Turkey are among the best clients of arms exporting countries (with Saudi Arabia, the UAE and India), including the United States, as well as France and Germany.
So what are the immediate consequences of Greece's financial problems?
A huge more towards closer ties with Turkey, as illustrated by bilateral visits and commitments to freeze or reduce their respective military budgets! Greece, Turkey eye stronger ties, lower defense spending.
Thaler's Corner Asset allocation biases
All this remains far removed from asset allocation biases. All that remains are the advised Eurostoxx puts, because the Bund, Bobl and Schatz prices depend much more on political considerations than macroeconomic ones.
As for stock markets, as you can see, the salvation of Eurostoxx firms now depends on decoupling, and as far as that goes…
Disclosure: Long 20 years OAT and 30 years BTP Zero Coupons, EDF Corp 5 Years 4.5%, Grece 2 Y and 10 Y bonds