Throwing Good 'Money' After Bad

By: Doug Noland | Fri, May 27, 2011
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For the week, the S&P500 slipped 0.2% (up 5.8% y-t-d), and the Dow dipped 0.6% (up 7.5%). The broader market outperformed. The S&P 400 Mid-Caps added 0.3% (up 9.1%), and the small cap Russell 2000 rallied 0.9% (up 6.7%). The Morgan Stanley Cyclicals were unchanged (up 3.4%), while the Transports slipped 0.7% (up 5.9%). The Morgan Stanley Consumer index declined 1.2% (up 4.3%), and the Utilities dropped 1.7% (up 5.8%). The Banks were little changed (down 4.8%), while the Broker/Dealers added 0.1% (down 5.7%). The Nasdaq100 declined 0.7% (up 5.3%), and the Morgan Stanley High Tech index fell 0.7% (up 2.5%). The Semiconductors added 0.1% (up 5.2%). The InteractiveWeek Internet index declined 0.9% (up 3.1%). The Biotechs fell 1.0% (up 12.7%). With bullion jumping $51, the HUI gold index rallied 3.9% (down 4.0%).

One-month Treasury bill rates ended the week at 3 bps and three-month bills closed at 4 bps. Two-year government yields declined 3 bps to 0.48%. Five-year T-note yields ended the week down 7 bps to 1.72%. Ten-year yields dropped 7 bps to 3.08%. Long bond yields fell 6 bps to 4.24%. Benchmark Fannie MBS yields declined 6 bps to 3.93%. The spread between 10-year Treasury yields and benchmark MBS yields widened one to 85 bps. Agency 10-yr debt spreads declined 2 to negative 4 bps. The implied yield on December 2011 eurodollar futures was unchanged at 0.40%. The 10-year dollar swap spread was little changed at 9.75 bps. The 30-year swap spread declined one to negative 25 bps. Corporate bond spreads were somewhat wider. An index of investment grade bond risk added a basis point to 91 bps. An index of junk bond risk rose 7 bps to 452 bps.

Investment-grade issuers included Hewlett-Packard $5.0bn, Caterpillar $4.5bn, Barrick $4.0bn, Cameron International $750 million, AON $500 million, RPM International $450 million, Tupperware $400 million, Reinsurance Group of America $400 million, GE Capital $350 million, Duquesne Light $350 million, GATX $250 million, Markel $250 million, Oklahoma G&E $250 million, and Gamco $100 million.

Junk bond funds inflows declined to $98 million (from Lipper). Junk issuers included Oil States International $600 million, Level 3 $600 million, Regency Energy $500 million, GM Finance $500 million, Exopack $235 million, and WCA Waste $175 million.

Convert issuers included Akorn $100 million.

International dollar bond issuers included OGX Petroleo $2.56bn, Vendanta Resources $1.65bn, Rentenbank $1.5bn, Sweden $1.5bn, Petroleos Mexicanos $1.25bn, Boligkreditt $1.25bn, Bancolombia $1.0bn, Credit Suisse $1.0bn, Russian Agricultural Bank $800 million, CGG Veritas $650 million, TAM $500 million, Lonking Holdings $350 million, Gala Group $350 million, International Auto Components $300 million, and Forbes Energy $280 million.

U.K. 10-year gilt yields declined 5 bps this week to 3.29% (down 22bps y-t-d), and German bund yields fell 7 bps to a 4-month low 2.98% (up 2bps). Ten-year Portuguese yields jumped 20 bps to 9.35% (up 277bps). Irish yields surged 54 bps to 10.85% (up 180bps), while Greek 10-year bond yields declined 15 bps to 16.22% (up 376bps). Two-year Greek yields dropped 14 bps this week to 24.58%. Spain's 10-year yields fell 16 bps to 5.31% (down 13bps). The German DAX equities index declined 1.4% (up 3.6% y-t-d). Japanese 10-year "JGB" yields were unchanged at 1.12% (unchanged). Japan's Nikkei declined 0.9% (down 6.9%). Emerging markets were mixed. For the week, Brazil's Bovespa equities index rallied 2.7% (down 7.2%), and Mexico's Bolsa gained 1.5% (down 7.1%). South Korea's Kospi index slipped 0.5% (up 2.4%). India's equities index dipped 0.3% (down 10.9%). China's Shanghai Exchange sank 5.2% (down 3.5%). Brazil's benchmark dollar bond yields added about a basis point to 4.24%, and Mexico's benchmark bond yields rose 4 bps to 4.07%.

Freddie Mac 30-year fixed mortgage rates slipped a basis point to 4.60% (down 18bps y-o-y). Fifteen-year fixed rates declined 2 bps to 3.78 (down 43bps y-o-y). One-year ARMs were dropped 4 bps to 3.11% (down 84bps y-o-y). Bankrate's survey of jumbo mortgage borrowing costs had 30-yr fixed jumbo rates down 3 bps to 5.09% (down 55bps y-o-y).

Federal Reserve Credit jumped $11.2bn to a record $2.751 TN (29-wk gain of $470bn). Fed Credit was up $343bn y-t-d and $427bn from a year ago, or 18.4%. Elsewhere, Fed Foreign Holdings of Treasury, Agency Debt this past week (ended 5/25) dipped $0.4bn to $3.442 TN. "Custody holdings" were up $92bn y-t-d and $376bn from a year ago, or 12.3%.

Global central bank "international reserve assets" (excluding gold) - as tallied by Bloomberg - were up $1.476 TN y-o-y, or 17.7%, to a record $9.829 TN. Over two years, reserves were $3.116 TN higher, or 47% growth.

M2 (narrow) "money" supply rose $10.4bn to $8.995 TN. "Narrow money" has expanded at a 4.7% pace y-t-d and 4.7% over the past year. For the week, Currency increased $1.7bn. Demand and Checkable Deposits jumped $5.6bn, and Savings Deposits rose $3.1bn. Small Denominated Deposits declined $3.1bn. Retail Money Funds gained $3.0bn.

Total Money Fund assets expanded $9.6bn last week to $2.748 TN. Money Fund assets were down $62bn y-t-d, with a decline of $101bn over the past year, or 3.6%.

Total Commercial Paper outstanding jumped another $14.8bn to $1.198 Trillion, the high since December 2009. CP was up $229bn y-t-d, or 48.5% annualized, with a one-year rise of $125bn.

Global Credit Market Watch:

May 24 - Bloomberg (Mark Deen): "European Central Bank Governing Council member Christian Noyer ruled out a restructuring of Greece's debt, calling it a 'horror story' that would leave the nation shut out of financing for years. 'There's no solution possible' for Greece other than to follow its austerity program, Noyer told reporters... 'Restructuring is not a solution, it's a horror story,' and if the country fails to meet the terms of its bailout, Greek government debt will be 'ineligible as collateral' at the ECB."

May 27- Bloomberg (Boris Groendahl): "Euro-area policy makers trying to avert a financial calamity may turn to a blueprint that arrested contagion in eastern Europe after Lehman Brothers Holdings Inc. collapsed. A plan, modeled on the Vienna Initiative of 2009, would involve leaning on creditors to roll over expiring bonds, buying time for Greece until its austerity program shows results or until a law takes effect in 2013 permitting sovereign-debt writedowns... 'It's burden sharing without restructuring,' said Mark Wall, Deutsche Bank AG's... chief euro-area economist. 'You're not changing the terms of outstanding bonds, you're not lengthening their maturities, you're not imposing haircuts on them. The bonds will mature but new bonds will be issued. What you're asking the creditors to do is to participate in those new issues,' he said. Such a proposal may bridge differences among European leaders over allowing a Greek debt restructuring..."

May 23 - Bloomberg (Abigail Moses and John Glover): "Government borrowing costs may rise if Greece restructures its debt without triggering credit-default swaps because investors will lose faith in their ability to protect against losses, according JPMorgan... Greece has significant latitude to restructure its liabilities without triggering the contracts but doing so would 'spill over' into cash bonds and risk infecting other peripheral markets, said... strategist Pavan Wadhwa... Investors are concerned that Greece may seek to avoid triggering the contracts to avoid reputational damage and punish speculators as it looks for ways to reduce its interest payments. 'CDS, which is generally speaking used as a hedge against cash bonds, will likely no longer be viewed as a viable hedge,' Wadhwa said. 'Counterparties who are holding CDS protection will likely be forced to unwind those trades and physically sell cash bonds in order to hedge their risks.'"

May 24 - Bloomberg (Paul Dobson): "Investors are demanding more yield to hold bonds from the European Union's two bailout funds rather than benchmark German notes, suggesting forthcoming sales won't sell as well as their debut auctions did. Five-year European Financial Stabilization Mechanism securities sold in January yield 30 bps more than similar-maturity German debt, the most since March 24, and up from 22 bps on Feb. 9."

May 24 - Bloomberg (Boris Korby): "Brazilian companies from Banco do Brasil SA to Marfrig Alimentos SA are boosting the size of international bond sales to a record to finance growing investment plans in Latin America's biggest economy. The average size of dollar debt offerings soared 85% in the past two years to $577 million, the highest level since Bloomberg began compiling the data in 1999. In the U.S., the average size of corporate debt sales declined 19%... to $585 million. Brazilian borrowers are boosting offerings to pay for investments in everything from oil drilling to increasing consumer lending... Companies are also taking advantage of growing investor demand for emerging-market assets that is pushing down borrowing costs."

May 25 - Bloomberg (Sapna Maheshwari): "Borrowers... are selling floating-rate notes at the fastest pace in four years as the Federal Reserve plots its exit from record monetary stimulus. Offerings... helped push such issuance to $102.7 billion this year... That compares with $42.2 billion a year earlier..."

May 24 - Bloomberg (Lisa Abramowicz): "Speculative-grade companies are accelerating bond sales to finance acquisitions and leveraged buyouts as U.S. private-equity takeovers surge 76%. About $4.7 billion of last week's high-yield, high-risk bond offerings were to pay for purchases and LBOs, the greatest amount since October, according to JPMorgan...

May 23 - Bloomberg (Sarah Mulholland): "Collateralized debt obligations linked to commercial real estate may emerge as soon as next month for the first time since 2007 as property values rebound. Moody's... has had more than a dozen requests from Wall Street banks this quarter to rate new CDOs comprised of loans and securities tied to commercial mortgages, more than double the number in the first three months, said Deryk Meherik, an analyst."

Global Bubble Watch:

May 26 - Bloomberg (Tony Czuczka and Helene Fouquet): "Angela Merkel and Nicolas Sarkozy walked side by side on an Atlantic beach boardwalk in October to show their resolve in combating Europe's debt crisis. Seven months later, the common bond is fraying. As the German and French leaders return to the coastal resort of Deauville today for a Group of Eight summit, Europe's two biggest nations are squabbling over approaches to Greek debt, nuclear power and the war in Libya. Their failure to maintain a united front may deepen the 18-month-old financial crisis by weakening an alliance that both have said is crucial to persuading investors the euro region can avoid its first default."

May 25 - Financial Times (Daniel Schäfer): "Private equity groups have cashed in a record amount of money by selling companies in the past two months as they aim to hand cash back to investors to attract them into their next funds. The value of companies sold by buy-out groups worldwide reached a high of $85bn in April and May, data by Preqin... shows. This exceeds the record deal volume of the last quarter of 2010, when private equity groups sold out of 325 companies worth a total of $81.3bn."

Currency Watch:

The U.S. dollar index declined 0.9% to 74.76 (down 5.4% y-t-d). For the week on the upside, the Swiss franc increased 3.35, the New Zealand dollar 2.9%, the Norwegian krone 2.3%, the Brazilian real 1.8%, the Swedish krona 1.4%, the Danish krone 1.2%, the euro 1.1%, the Japanese yen 1.1%, the Australian dollar 0.4%, the Mexican peso 0.4%, and the Singapore dollar 0.2%. On the downside, the Taiwanese dollar 0.2%, the South African rand 0.2%, and the Canadian dollar 0.2%.

Commodities and Food Watch:

May 27- Bloomberg (Heather Walsh): "Colombia, the second-largest producer of mild arabica coffee bought by companies such as Starbucks Corp. and Nestle SA, said consumers will have to get used to higher prices because of rising demand and reduced supply. Production next year will fall short of consumption, keeping the cost of arabica coffee in a range of $2 to $3 a pound for the next 12 months..."

The CRB index rose 1.4% (up 4.0% y-t-d). The Goldman Sachs Commodities Index gained 1.5% (up 10.6%). Spot Gold jumped 3.4% to $1,563 (up 10%). Silver surged 7.9% to $37.86 (up 22%). July Crude increased 49 cents to $100.59 (up 10%). July Gasoline jumped 5.3% (up 26%), and July Natural Gas rose 5.3% (up 2.6%). July Copper was up 1.6% (down 6%). July Wheat rose 1.6% (up 3.2%), while July Corn was little changed (up 20%).

China Bubble Watch:

May 25 - Bloomberg: "China ordered the operator of the world's biggest dam to begin disgorging about 5 billion cubic meters of water today to replenish the Yangtze River and counter the Hubei region's lowest rainfall in half a century. The Three Gorges Dam will discharge enough water to fill 2 million Olympic-sized swimming pools by June 10... Lower water levels on the 6,264-kilometer (3,915-mile) river may increase China's oil demand by 300,000 barrels a day to make up for lost hydropower generation, Barclays Capital said last week. China's longest river sustains 65.7% of the nation's paddy fields... Poyang Lake, China's biggest, has shrunk to less than a fifth of its usual area... State-run China Daily said there was 40% less water in almost 1,600 reservoirs in Hubei province than a year ago."

May 23 - Bloomberg: "China's ban on unauthorized golf courses failed to stem a record 14% increase in such facilities last year as developers circumvented rules aimed at halting the erosion of the nation's farmland. The world's fastest-growing major economy added 60 18-hole courses last year, taking the total to 490, according to... Forward Management Group, a golf tour organizer in China. Only 10 of the nation's golf facilities are licensed..."

Japan Watch:

May 25 - Bloomberg (Mayumi Otsuma): "The Bank of Japan indicated its willingness to expand lending programs to support reconstruction efforts after the nation's record March 11 earthquake crippled factory production and pushed the economy into a recession."

May 26 - Bloomberg (Shigeru Sato): "Japan's atomic energy specialists are discussing a plan to make the Fukushima Dai-Ichi nuclear plant a storage site for radioactive waste from the crippled station run by Tokyo Electric Power Co. The Atomic Energy Society of Japan is studying the proposal, which would cost tens of billions of dollars, Muneo Morokuzu, a professor of energy and environmental public policy at the University of Tokyo, said..."

India Watch:

May 26 - Bloomberg (Rakteem Katakey): "India may increase diesel, kerosene and cooking oil prices to support state-run refiners facing revenue losses of 2 trillion rupees ($44bn) this fiscal year, an oil ministry official said..."

Asia Bubble Watch:

May 26 - Bloomberg (Chris Spillane): "Asian buyers accounted for the majority of new home purchases in central London for the first time as they took advantage of the pound's weakness and avoided rising prices at home, Knight Frank LLP said. The share of deals increased to 59% in the six months through April from 48% a year earlier..."

Latin America Watch:

May 25 - Bloomberg (Adriana Brasileiro): "Brazil's three largest banks are forecasting that lending will rise more than the central bank is targeting this year, a sign the government is failing to curb credit growth... Itau Unibanco Holding SA, Banco Bradesco SA and Banco do Brasil SA estimate their lending will expand 15% to 20% as mortgages surge and businesses borrow to invest in new factories and stores. The central bank targets credit growth of 13% this year after 21% expansion last year..."

May 26 - Bloomberg (Alexander Ragir): "Brazil's unemployment rate fell in April to the lowest for the month since at least 2002, boosting pressure on policy makers who are trying to cool demand fueled by full-employment conditions. Joblessness in April fell to 6.4% from 6.5% in March..."

Unbalanced Global Economy Watch:

May 26 - Bloomberg (Luzi Ann Javier): "Global food output may be hurt as climate change brings more extreme weather over the next decade, with China likely set for harsher droughts and North America getting heavier rain, said the World Meteorological Organization. 'Extreme events will become more intense in the future, especially the heat waves and extreme precipitations,' Omar Baddour, a division chief at the United Nations' agency, said... 'That, combined with less rainfall in some regions like the Mediterranean region and China, will affect crop production and agriculture.'"

May 24 - Bloomberg (Gonzalo Vina): "Britain posted its largest budget shortfall for any April since at least 1993 as tax income fell and spending climbed, keeping up pressure on Chancellor of the Exchequer George Osborne to stick to his deficit-cutting plans. Net borrowing was 10 billion pounds ($16bn)... Revenue fell 0.8%... and spending rose 5%."

May 27- Bloomberg (Jeff Black): "Money-supply growth, which the European Central Bank uses as a gauge of future inflation, weakened in April as the region grappled with a debt crisis. M3 money supply rose 2% from a year earlier, after increasing 2.3% in the previous month... Loans to the private sector rose 2.6% from a year earlier."

May 26 - Bloomberg (Johan Carlstrom): "Swedish household credit growth slowed for a seventh consecutive month, with the rate easing to the lowest in nine years... Household borrowing slowed to an annual 7.2% in April from 7.3% in March... That compares with a peak of 13.2% growth in March 2006."

U.S. Bubble Economy Watch:

May 27- Bloomberg (Anna-Louise Jackson and Anthony Feld): "Staffing agencies are charging companies more for temporary workers, a possible harbinger of a bump up in salaries for permanent employees later this year. The bill rate at... On Assignment Inc., which places temporary staff primarily in the information technology and health-care fields, climbed 6.3% in the quarter ended March 31 from the same time last year, the largest 12-month gain since 2008. The increase in the amount the company charged was 'surprising,' said Tobey Sommer... analyst at SunTrust Robinson Humphrey..."

Real Estate Watch:

May 26 - Bloomberg (Dan Levy): "U.S. homes in the process of foreclosure sold at an average 27% discount in the first quarter and purchases of distressed properties fell to less than half the peak set two years ago, according to RealtyTrac Inc."

Central Bank Watch:

May 23 - Bloomberg (Caroline Salas and Scott Lanman): "The cue for the Federal Reserve to start withdrawing its record monetary stimulus may be a measure of its own credibility: inflation expectations. Expectations for annual consumer-price gains have jumped by 43% to 2.10 percentage points since the central bank began its second round of asset purchases in November, as measured by the breakeven rate for five-year Treasury Inflation Protected Securities. The measure is close to levels before the recession -- when the central bank's benchmark interest rate was 5.25%, compared with about zero today."

May 23 - Bloomberg (Simon Kennedy): "Bank of England Chief Economist Spencer Dale said that monetary policy makers should boost interest rates to control inflation, even if Britain's economic recovery isn't yet guaranteed. 'I'm not at all confident that the recovery has taken hold and will definitely power away,' Dale said... 'However, I'm even more worried about what's going on in terms of inflation.' Inflation accelerated to 4.5% in April, the fastest since 2008..."

Muni Watch:

May 24 - Bloomberg (Simone Baribeau): "U.S. state tax revenue grew 12% in April, adding to higher-than-expected first-quarter collections that may trim $20 billion from forecast budget deficits, Goldman Sachs Group Inc. estimated... 'Revenues for the fiscal year coming to a close should be nearly 8% higher over the previous fiscal year' compared with budgeted gains of 4% to 5%...' Stronger-than-expected revenue in California and New Jersey lowered their estimated deficits by $6.6 billion and $900 million, respectively, Goldman said."

May 26 - Bond Buyer (Yvette Shields): "The political standoff in Minnesota over taxes between Democratic Gov. Mark Dayton and Republican lawmakers showed no sign of easing this week after the governor vetoed the two-year budget approved by the GOP-controlled Legislature and officials... started planning for a possible shutdown... Dayton wants a combination of cuts, and a tax increase that would raise $1.8 billion, to wipe out a $5 billion deficit in the fiscal 2012-13 budget."


Throwing Good "Money" After Bad

With market focus returning to Credit issues, I'll attempt to somewhat refine and reiterate my macro thesis. Unique from a historical perspective, the world has been operating for some time now without mechanisms to limit either the quantity or quality of Credit creation. There is no gold standard, no Bretton Woods currency management regime, or even an ad hoc functioning dollar reserve system. I believe it was about a decade ago I began referring to "Global Wildcat Finance."

Myriad complex forces nurtured such an extraordinary backdrop. The "technology revolution" and "globalization" were, of course, big factors. Financial innovation played a major role, as did increasingly "activist" policymaking. The Greenspan era radically changed the way much of the world viewed the role of monetary policy. Within Credit systems, "dynamic" marketable debt and Wall Street structured instruments increasingly replaced the "staid" bank loan as the driver of system Credit creation. Meanwhile, the centerpiece of American monetary management shifted to market intervention and the assurance of ample marketplace liquidity. Global financial systems and policymakers jumped aboard this powerful trend.

The world remains gripped in a multi-decade Credit Bubble. There have, of course, been assorted "hiccups" all along the way: The U.S., Japan, Mexico, Thailand, Indonesia, South Korea, Malaysia, Russia, Argentina, Brazil and Iceland come quickly to mind. Tightly interrelated U.S. and global Credit systems almost succumbed back in 2008. At the end of the day, however, the most aggressive - and synchronized - reflationary policymaking imaginable rejuvenated global Credit Bubble Dynamics and spurred yet another round of financial excess. This has in no way alleviated structural Credit system fragilities and vulnerabilities.

Not all Credit is created equal. Over the years, I've differentiated between "productive" and "non-productive" Credit. Japan has been mired in a prolonged post-Bubble stagnation period. Japanese Credit excesses were quite extreme - including momentous asset Bubbles. Fortunately, however, the Japanese Credit boom included the financing of substantial investment in high-quality manufacturing capacity. This has provided an important foundation for their economy and Credit system as it has struggled though years of wrenching financial crisis and recession.

As an exporting and savings rich economy, Japan has enjoyed the great benefits associated with a stable currency throughout its protracted post-Bubble duress. Japanese domestic savings have financed federal deficits, as opposed to the reliance on foreign investors or "hot money" inflows. The Japanese experience has been dismal but manageable. The economy has been able to persevere through years of minimal private sector Credit growth and limited foreign investment. It's been a historic boom and bust, although things could have definitely been much worse.

Other Asian economies - and regional Credit systems - were able to bounce back relatively quickly from devastating crises - on the back of robust production-based economies and strong trade positions. A core of "productive" Credit has underpinned financial systems and economies throughout the region. I would argue that the capacity to produce real economic wealth matters a great deal - in terms of sustainable economic recoveries, stable currencies, and robust Credit systems. The nature of Bubble Economy economic distortions matters greatly in how a system is able to respond to Credit crisis. Will the emphasis be on ramping up production, trade and savings to work one's way through a crisis? Or, instead, will it be more a case of depending largely on additional Credit creation/inflation?

Let's turn to the Greek debt situation. Greece is mired in crisis a year after an enormous bailout package. The Greek economy is performing quite poorly in spite of ongoing huge federal deficit spending. Prospects for deficit reduction are grim, which is making everyone nervous. There is today insignificant capacity to boost production - thus limiting the capacity for real wealth creation to stabilize economic and financial systems. Greece required a big handout last year; they need another this year; and they'll be seeking ongoing assistance for years to come. Greece enjoyed a huge Credit-induced boom - and regrettably little of the debt was "productive." Not surprisingly, the Greek economy and Credit system are proving the opposite of robust.

Especially over the past decade, "developed" and "developing" Credit booms took divergent paths. I have railed over the risks associated with U.S. Credit excess fueling asset Bubbles and financing consumption and intractable Current Account Deficits. Over the years, others followed our path, perpetuating uncontrolled and dangerous expansions of "non-productive" Credit. While China and much of the "developing" world invested heavily in manufacturing capacity and export industries, too often the European periphery luxuriated in asset inflation, consumption and Bubble Economy Dynamics.

In analysis directed chiefly at U.S. dynamics, I've noted in the past how Credit Bubbles inflate myriad price levels (assets prices, system incomes, expenditures, govt. receipts/spending, corporate profits, imports, etc.) and, over time, alter the underlying economic structure. Financial systems and Bubble Economies in time become increasingly dependent upon increasing amounts of Credit expansion to sustain inflated price structures and to ensure sufficient system-wide spending levels. And if the bias is to de-industrialize and move toward a services and consumption-based economy, loose finance and inflating asset prices definitely grease the wheels of economic restructuring. At the end of the day, the resulting economic structure will have developed a gluttonous appetite for ongoing Credit creation. Eventually, Credit bust will entail staggering amounts of ongoing Credit assistance.

Greece is in trouble - and the entire European periphery is in trouble. Protracted private-sector Credit booms significantly elevated price levels and distorted economic structures. The events of 2008 incited a crisis of confidence in the underlying Credit, which instigated a cycle of massive government debt issuance. The public sector debt splurge, while having only a temporarily stabilizing impact, then hastened a problematic crisis of confidence in government debt, first in Greece, then Ireland and Portugal - and increasingly pointing toward Spain and Italy.

I have drawn parallels between Greece and U.S. subprime - as the initial cracks in respective Bubbles. I expect the global sovereign debt crisis to unfold over months and, likely, years. Studying the unfolding European debt crisis is imperative both from the standpoint of crisis contagion as well as to garner early insight into how an American debt crisis might unfold.

Thus far, we've received important confirmation of the thesis that there is no easy resolution to sovereign Credit busts. They will surely prove incredibly expensive and be resolved over many difficult years. The conventional view that a recapitalization of the banking system will go a long way towards sustainable recovery is proving overly optimistic - and much too simplistic. Indeed, inadequate bank capital is not the greatest source of system fragility. Instead, the key issue is the amount of ongoing additional system Credit required both to stabilize inflated price levels and to ensure sufficient expenditures to hold economic collapse at bay. I would argue that this amount is dictated by the scope (and duration) of previous boom-time Credit excesses and economic maladjustment.

Instead of the initial $150bn or so bailout resolving the Greek crisis, as had been expected, there's growing recognition that it's no more than an initial down-payment. A "drop in the bucket" and "seeming black hole" are perhaps too pessimistic. Importantly, expectations that early resolution to the Greek crisis would thwart contagion effects throughout the periphery have proven miscalculated. Many European policymakers must now wish that Greece had been cut loose a year ago. But just saying "no" becomes only more difficult - more political, the consequences more uncertain, and possible outcomes increasingly dangerous. Unfortunately, it is the nature of the way these things unfold that the stakes seem to only rise year-to-year. Somehow, next thing you know, it's the classic dilemma of open-ended financing for insolvent borrowers - the dreadful "throwing good money after bad."

The scope of the Greek debt problem is proving much greater than was appreciated not long ago (recall that Greece enjoyed 2-yr yields of about 2% in early 2009 vs. today's 24%). The problem in Portugal is much larger, and ditto for Ireland. I expect, over time, the marketplace to come to appreciate similar dynamics for Spain, Italy and others, including the U.S. Ominously, stabilization here at home has required zero rates, massive Fed monetization, and double-digit-to-GDP federal deficits for going on three years now.

Think of it this way: prolonged booms in private-sector Credit inflated both asset prices and nurtured maladjusted Bubble economies throughout the "developed" world. This unprecedented expansion of household and corporate debt fueled a bonanza of tax and other receipts for the government sector (which, in Bubble economy fashion, was extrapolated and spent lavishly). When the Bubble burst in 2008, federal finances - in Washington, Athens, Madrid and elsewhere - seemed, fortuitously enough, in good shape. This Bubble distortion emboldened policymakers - and emboldened policy emboldened the markets. And we jumped head first right back into Bubble Dynamics.

Going unappreciated was the extent to which previous Bubble excess had inflated receipts and distorted the true fiscal situation of most governments - along with the extent to which Bubble Economies had become Credit gluttons. Unbeknownst to policymakers at the time - and remaining unappreciated, especially here at home - is how aggressive (fiscal and monetary) stimulus packages set a course for severely impairing the creditworthiness of the underlying sovereign debt. What was thought to be a couple of years of elevated spending to resolve post-Bubble issues has evolved into ongoing public-sector borrowing and spending that does little more than hold the next crisis at bay.

The unprecedented expansion of sovereign debt throughout the "developed" world is all that sustains the entire private and public debt pyramid. I see overwhelming support for the Bubble thesis, with (Minsky) "Ponzi Finance" footprints all over Credit systems, the markets and real economies. Fortunately for the Eurozone, Germany and other "core" economies have powerful manufacturing and export sectors that tend to underpin system stability. Unfortunately, the "core" is now seemingly trapped in costly ongoing subsidies to the European "periphery." Here at home, the "core" is the problem. There is no credible plan to get runaway federal deficits under control - and the markets are for now just fine with it.

 


 

Doug Noland

Author: Doug Noland

Doug Noland
The Credit Bubble Bulletin
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