September 11, 2012
Spain’s economy is not waiting for Germany’s Constitutional Court of anybody else to keep dropping off a cliff. One-by-one, Spain’s regions are approaching the central government for bailouts. These are not small bailouts either, but multi-billion bailouts. Moreover, the heads of these regional governments are demanding assistance while claiming they will not accept any conditions on any support they receive. At the same time, the Spanish banking system grows more infirm by the day. In July, gross ECB lending to Spanish banks rose to a record €402 billion from €365 billion in June. This accounted for a full 33% of ECB lending to Eurozone banks (see Figure 1 above) and illustrates that Spanish banks have nowhere else to go to fill their funding needs (would you put your money in a Spanish bank? Or lend money to one?). This latter point was confirmed by the latest data on capital outflows from the banks. Private deposits fell another €8 billion in July and have fallen by €158 billion over the last 12 months to €1.58 trillion, the lowest level since June 2008 (see Figure 2 below). Why would capital want to remain in Spanish banks when a restructuring is imminent? This is the same question that was asked of Greek banks before that country’s faux-restructuring, and the answer is the same – there is no good reason for any sane person or business to keep money in a bank inside a nation that is likely to default on its obligations.
Money Flows Out of Spain
Speaking of Greece, that country is back once again asking for more time to meet its prior promises to Germany and the rest of EU to cut its expenditures to the bone in exchange for prior support commitments. It is now asking its police and other previously untouchable civil servants for steep pension cutbacks, which has triggered the expected protests and strike threats. Greece is being bled dry by austerity demands from Germany and the result is going to be disastrous. One would think that Greek leaders would figure out what is abundantly clear to its people by now, that the so-called benefits of membership in the EU are not remotely worth the years of impoverishment that remaining in this club are going to cost. For the sake of the Greeks and the sake of the Germans who are going to have to pick up the tab, it is long past time to let Greece leave the EU in peace. Greece is asking for a two-year extension to meet austerity demands, but honestly it could ask for two hundred years and it wouldn’t make a difference. Enough is enough.
The United States
Politics and regulation
Some people may think that Clint Eastwood embarrassed himself at the Republican National Convention, but those same people should remember that Mr. Eastwood has been awarded the Legion d’donneur in France. And France, after all, was the adopted home of the great Irish playwright Samuel Beckett, author of one of the most profound works of literature of the 20th century, Waiting for Godot. Mr. Beckett surely would have appreciated the image of Mr. Eastwood addressing Barack Obama as an empty chair. After all, in Happy Days, Mr. Beckett buried his characters up to their neck in dirt, while in Play he had them standing in urns. He was never lacking for a sense of the absurd. Then we come to Mr. Obama, a man who, if truth be told, was little more than a specter when elected, a politician long on wind but completely bereft of any tangible accomplishments. Almost four years into office, his signature accomplishments are a stimulus plan that didn’t stimulate, a healthcare bill that was sold as a faux-civil rights law and fails to do what it intended , and a financial reform bill that reforms leaves the financial system more fragile than it was before. The Senate has not passed a budget in three years during his administration (for which the Republicans share the blame), although that has not stopped the government from running up another near $6 trillion in deficits. But that is not the worst of it. Some of Mr. Obama’s most strident supporters, such as Paul Krugman and Robert Reich, complain that the stimulus bill wasn’t big enough and that the government didn’t spend enough!2 They claim that had we only spent another $1 trillion on shovel ready jobs that even the President has joked weren’t as shovel-ready as he thought, things would be much better! Both Samuel Beckett and Paul Krugman were awarded Nobel Prizes, but only one of these men had any insight into the human condition – and it surely wasn’t the economist.
During the convention, Mitt Romney asked people if they were better off today than they were four years ago. Figure 3 suggests that many people are not better off. While there is blame enough to go around, there is only one incumbent President. It would be very surprising for any incumbent to retain office in the face of plunging hourly earnings or endless months of 8%+ unemployment. Mr. Obama can look to the fact that unemployment has come down sharply in some key battleground states as Ohio, Michigan and Wisconsin, but whether that will be enough remains to be seen. Mr. Obama was dealt a bad hand, but nobody put a gun to his head and forced him to run for president, and more importantly nobody compelled him to focus on a deeply flawed healthcare bill that lacked public support at the expense of putting more people back to work. If Mr. Obama becomes a one-term president, he may try to blame George W. Bush, or John Boehner, or Mitch McConnell, but the truth is he should only blame himself.
Obama’s Worst Nightmare
The outlook for Wall Street has deteriorated significantly during Mr. Obama’s administration. That does not mean that the financial system is more stable than it was prior to the financial crisis – I would argue the opposite. But Wall Street’s profitability has been severely diminished by the Volcker Rule and virtual elimination of proprietary trading. To the extent some institutions thought they could out-clever the rule, the London Whale put an end to that hope. Large banks, led by J.P. Morgan’s Jamie Dimon, spent a great deal of money and political capital fighting off the restrictions contained in Dodd-Frank, but thus far they have had far more limited success than I would have expected. The London Whale pretty much snuffed out any hope that the Volcker Rule will go gently into that good night. Where the banks did succeed, unfortunately, is in neutering many of the necessary restrictions on derivatives trading. Dodd-Frank, which in addition to insultingly bearing the name of the politician who single-handedly did more than virtually anyone else in Washington to enable the GSE’s to cripple the economy, fails where it matters most – in reducing systemic risk.
The global financial system is even more fragile today than it was before the crisis. This fragility is not only a result of there being fewer too-big-to-fail institutions (Tim Geithner still doesn’t get it, and will likely never get it), nor of the massive government borrowing used to prevent a total systemic collapse, but of an abject failure to regulate derivatives in any meaningful or intelligent manner. Today, the 25 largest institutional derivatives traders collectively have approximately $230 trillion of gross derivatives positions on their books. Their net derivatives positions are probably about 10% of that, or somewhere around $25 trillion.3 As Jim Rickards reminds us, in a systemic crisis, it is the gross rather than the net figure that matters since many counterparties will be unable to fulfill their contractual obligations. Accordingly, the derivatives market is not merely out of control; it is uncontrollable. The folly that requiring derivatives to be traded on an exchange demonstrates just how unqualified those charged with regulating these instruments are for the job. All the creation of an exchange will do is bring into existence another entity that will have to be bailed out in a crisis. The CEOs of the institutions that trade these derivatives don’t understand them, the regulators don’t understand the, legislators don’t understand them and many of the people who trade them don’t understand them. Allowing them to trade in volumes that dwarf the footings of the global financial system is so reckless that one has to wonder if even the self-interested [fill in the blank] who lobbied against their regulation don’t have a death wish. As you will see, this is not merely a theoretical discussion for me. It has led me to seriously alter my investment recommendations at the end of this newsletter. Ignoring this issue is going to come back to haunt every one of us, mark my words.
2. Mr. Krugman is not alone; he has been joined by Michael Grunwald, who has a new book describing the stimulus as too small. And of course we know that Christina Romer and Larry Summers thought more was needed (as much as $1 trillion more in Romer’s case according to Noam Scheiber in his book The Escape Artists) but realized that a larger plan was thankfully politically impossible. The argument is that economic growth and job growth would be even smaller without the stimulus, and would have been more robust with a larger stimulus; the counter-argument is that the stimulus was poorly designed, wasteful, and was one more attempt to cure a debt problem with more debt. I am firmly in the latter camp. The economy was suffering from overcapacity heading into the crisis; the last thing it needed was more debt-financed capacity.
3. I didn’t even have to do press a button to make those numbers red – they just turned red by themselves!
Would you like to send this article to a friend?Remember, if you have a question or comment, send it to .