June 12, 2012
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This essay is excerpted from a recent version of The Credit Strategist (formerly the HCM Market Letter). To obtain the complete issue, you must subscribe directly to this publication; Please go here. The Credit Strategist is on Twitter - @credstrategist
“[D]eflation caused by the debt reacts on the debt. Each dollar of debt still unpaid becomes a bigger dollar, and if the over-indebtedness with which we started was great enough, the liquidation of debts cannot keep up with the fall of prices which it causes. In that case, the liquidation defeats itself. While it diminishes the number of dollars owed, it may not do so as fast as it increases the value of each dollar owed. Then, the very effort of individuals to lessen their burden of debts increases it, because of the mass effect of the stampede to liquidate in swelling each dollar owed. Then we have the great paradox which, I submit, is the chief secret of most, if not all, great depressions: The more the debtors pay, the more they owe. The more the economic boat tips, the more it tends to tip. It is not tending to right itself, but is capsizing.”
Irving Fisher 1
Not to put too fine a point on it, but anybody who believes that the $360 billion portfolio being managed by J.P. Morgan’s Chief Investment Office was not an example of proprietary trading is either on the bank’s payroll or is completely unqualified to render an opinion on the subject (that is a much longer version of what we wanted to say).
It is said that “In the kingdom of the blind, the one-eyed man is king.” Today, there are no more one-eyed men – there are only kingdoms of the blind.
The world remains in the midst of the massive margin call that began in 2007. Readers of this publication should not be surprised by what is occurring since we have written about it consistently for years in this newsletter, in El Mundo, and in The Death of Capital (John Wiley: 2010 – still available at Amazon.com and still worth reading!). Economies worldwide are merely entering the next stage of the deleveraging that triggered the 2008 financial crisis, whose underlying causes were never properly addressed through effective monetary, fiscal or regulatory policy reforms.2 Recent events offer a rare illustration of the combined effects of the failure of these three policy areas to coordinate a meaningful policy response. Rising budget deficits, record low interest rates, J.P. Morgan’s proprietary trading blunder3 and the botched Facebook IPO process speak to abject policy failures in virtually every aspect of finance. It’s not even a question of not having learned our lessons; our collective policy intelligence actually appears to have diminished.
While the immediate focus is properly on Europe, whose southern economies are literally crumbling before our eyes, the malady is global. Brazil announced weak first quarter growth of 0.8%. India and China are slowing sharply. India reported its slowest GDP growth in 9 years (+5.3% year-over-year in 1Q12), while China’s May manufacturing PMI dropped more sharply than expected to 50.4 from 53.3 in April. Moreover, China has no plans to step forward with a sufficiently sizeable stimulus plan to bail the world out of its misery. China’s official economic numbers are obviously doctored in any case and are inconsistent with more reliable (and downbeat) data such as electricity usage and cement production. The U.S. 10-year Treasury bond yield hit a record low of 1.457% on June 1, but yields in the rest of the world are even lower: Swiss 10-year rates are at 0.50%, Japan’s at 0.80% (Kyle Bass was, as we noted at the time, far too early in shorting JGBs despite his masterful press management), Germany’s down to 1.13% (its 2-year rates went negative) and Denmark’s below 1%. Markets are sending a strong deflationary signal. That is what a flight to safety in the bond market is all about.
Europe would have a much greater chance of solving its problems if its leaders spent 1/100th as much time doing the right thing as doing the wrong things. Instead, they continue to waste time and effort trying to prevent Greece from leaving the EU when that is so clearly both the necessary and correct course of action. It would be another matter were someone to propose a credible scenario under which Greece could remain in the EU as anything other than a ward of the union. But no such scenario is possible. Greece’s economy cannot be competitive tethered to the Euro. The appropriate cost of capital for Greek businesses is hundreds of basis points higher than the cost of capital for businesses in other European countries, even weak ones like Spain or Italy. How in the world can a Greek business hope to compete with such an albatross tied around its neck?
The Greeks vote on June 17 on what has become a referendum on continued EU membership. In the meantime, Greeks are moving their assets out of Greek banks and into safer institutions in Northern Europe. The alternative is to risk being told one morning that the Euros sitting in their Greek bank accounts have been exchanged into sharply devalued drachmas (likely worth 70 percent less than the Euros out of which they were spawned). This capital flight, which is eminently reasonable on an individual basis, is merely accelerating the inevitable Greek collapse.4 For all we know, by June 17th the Greeks may have already voted with their pocketbooks and rendered their decision. Make no mistake – a Greek exit will be incredibly disruptive to financial markets. But that is where we are. Are the markets prepared for such an outcome? We doubt it.
Greek bank run
1. Irving Fisher, The Debt-Deflation Theory of Great Depressions, Econometrica, October 1933, p. 344.
2. With respect to regulatory reform, not only are many of the proposed reforms ineffective or misguided, but very few are even being implemented. According to the law firm David Polk & Wardwell, as of May 1 the Securities and Exchange Commission had yet to draft 2/3 of the required regulations under the Dodd-Frank Wall Street Reform and Consumer Protection Act.
3. Not to put too fine a point on it, but anybody who believes that the $360 billion portfolio being managed by J.P. Morgan’s Chief Investment Office was not an example of proprietary trading is either on the bank’s payroll or is completely unqualified to render an opinion on the subject (that is a much longer version of what we wanted to say).
4. A Greek exit will give rise to all sorts of unintended or unanticipated consequences, none of them positive. Some of those consequences are already coming to light as those doing business with Greek companies begin taking steps to protect themselves. For example, the Financial Times reported on May 31 that two trade credit insurers, Euler Hermes and Coface, took the unusual (but wise) decision to stop extending covering for companies exporting to Greece (“Two trade credit insurers halt cover for exporters to Greece,” p. 16). This move reflects the fact that Greek importers will still be obligated to pay their bills in Euros but could conceivably be left holding devalued drachmas and be rendered incapable of paying their bills.
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