A year ago we posted Why Is This Recession Dragging On? . There we noted that the key domestic problem is the high debt levels of private households, due primarily to the housing/mortgage boom and bust. In 2008 to mid-2009 there was a vicious contraction in economic activity, and unemployment rose from a comfortable 4.9% in April, 2008 to 10.1% in October, 2009. For most of 2010 it was around 9.5%, dropping to around 9% for 2011. This is for the official “U3” unemployment rate, which is the yellow-green line on the chart below (click to enlarge). If we count folks who have just given up looking for work, and those involuntarily under-employed, the “U6” rate is about 17%. Particularly worrisome is the large number who have been out of work for over 18 months – these folks tend to become unemployable, since companies prefer to hire people without that stigma.
This stubbornly high plateau of employment has not been seen since the 1930s. Corporations are actually doing pretty well – they adjusted to the economic slowdown by massive layoffs and getting more work out of the remaining employees. Earnings have held up fine and companies are flush with cash. They would start hiring again if they were confident of increased sales, but they don’t have that confidence. U.S. households are slowly reducing their debt levels, but it will likely take into 2013 before these levels are low enough that folks can start raising their spending in a sustainable manner.
In 2009-2010 the Fed undertook a number of measures to stabilize the tottering banking system. These measures included various types of loans to banks, and buying away their “troubled assets.” However, the $600 million 2010-2011 round quantitive easing (QE2) by the Fed has been largely ineffective. Typically, quantitative easing (purchase of government bonds by central bank) does not place money in the hands of the consumer. Rather, it places the money in the reserves of the major banks. Businesses and consumers can only get their hands on that money by borrowing it from the banks. But more borrowing is not what consumers want or need to do at this point. The main effect of QE has been to push up stock prices (which is arguably a good thing for consumer confidence), and commodity prices (which is clearly a bad thing – consumers now have to pay more for fuel and food). Thus, it seems that we will not have an economic breakthrough any time soon.
U.S. government debt has shot up since the start of the Great Recession. People fret over that, but most of the worry is misplaced. If the economy is going to get back on its feet, consumers MUST reduce their level of indebtedness (e.g. pay down credit cards, pay down or default on mortgages, etc.). As Cullen Roche explains , if the private sector is to reduce its level of debt by say a trillion dollars, then (all else staying equal) the government MUST take on an extra trillion dollars in debt by deficit spending. This is simply an accounting identity, not a statement of what policies are right or wrong.
Furthermore, it is impossible for the U.S. to default on its debt or to not be able to pay it, because this debt is denominated in U.S. dollars, which the government can create at the stroke of a key. Fears that the U.S. government might run out of money if China ceases to buy our bonds are likewise groundless, as discussed in the Roche article above. Current law requires that the Treasury issue bonds to cover the spending deficit, but that law could be changed so that Treasury simply created (“printed”) the money for deficit spending without issuance of debt. That was how Lincoln financed the Civil War without getting scalped by the bankers, by the fiat issuance of $450 million in “greenbacks”. Even under present law, the Treasure could mint a few trillion-dollar coins to settle its account with the Fed, and the federal debt would start to go away. Such outright monetization of course could lead to massive inflation if the money supply outran production of real goods and services, but it is important to realize that the U.S. has the option, at least in theory, of creating fiat dollars to pay off its debts.
For countries on the European continent that are using the euro, it is a different story. When Greece had its own currency, it could print more to pay off debts (in drachmas), and the drachma could devalue relative to other currencies in order to keep relative labor costs in Greece competitive with other nations. Now that Greece is on the euro, with wages and debts denominated in euros, those options are not open to it. Greek labor costs (in euros) are uncompetitively high, so they import much more than they export, running up high debt in euros. There is no realistic prospect that Greece could ever fully repay its debt.
Therefore a deal has been struck, whereby some of Greece’s debt has been reduced by a 50% “haircut,” and a Eurozone-wide bailout fund (“EFSF”) agreed to. Unfortunately, Greece will probably not be able to service even this reduced debt; the conditions of the bailout involve forced austerity measures, which can only further crimp the Greek GDP and government revenues. Also, there are pervasive structural reasons for Greek uncompetitiveness, that aren’t fixed simply by slashing government spending.
The EFSF is to be funded about half with direct contributions by eurozone countries, and half by selling its bonds on the open market. Ominously, the market does not want to buy the EFSF bonds; in its latest auction, the EFSF had to buy its own bonds (huh??) to complete the offering. Thus, instead of the all-purpose fix it was touted to be, the EFSF looks to be dead on arrival.
Italy has not been as profligate as Greece. Under normal circumstances, their debt would not be a big concern. Although as a eurozone country Italy cannot print money to pay its debts, as long as interest rates remain below say 5.5%, Italy should be able to service its debt. However, nervous investors are now demanding higher interest rates on Italian government bonds to cover the risk of an Italian default. Ironically, this fear of default may push Italy towards actual default, since its low economic growth rate will not allow it to service a high-interest debt like the recent 7% levels. With over 2 trillion dollars in sovereign debt, Italy is too big for the rest of Europe to bail out. Even a partial default or haircut would ruin the Italian domestic banking system, and other European banks (which hold much Italian debt) as well. As Zerohedge puts it, “when the bottom finally [falls] out from the market, the implosion of the Italian banking system, and thus economy, will be instantaneous. And when Italy goes, so goes its $2 trillion+ in sovereign debt, and at that point we will see just how effectively hedged and offloaded the rest of the world is, as contagion shifts from Italy and slowly but surely engulfs the entire world.”
This meltdown scenario could likely be avoided if the European Central Bank (ECB) committed to keep buying Italian bonds at moderate interest rates. However, Germany is blocking the ECB from such a massive and long-term commitment. The Germans are playing a waiting game , letting the pressure build on the peripheral countries like Greece and Italy to force them to adopt austerity measures to balance their budgets. Loathing of monetization is etched into the German psyche, as a result of the Weimar hyperinflation Germany experienced in the early 1920’s. Also, many Germans genuinely believe that they are doing the southern countries a favor by forcing them on the path of honesty and efficiency in their finances.
Germany may agree to unleash the ECB to stabilize Italian and other bonds, but only if other eurozone member countries agree to grant sweeping new, intrusive powers to a central budget watchdog. Thus, we will witness a giant game of “chicken” play out over the next weeks and months. (For non-U.S. readers, “chicken” is a game where two automobile drivers drive directly at each other, and the first driver who turns aside loses; of course, if neither driver turns aside, they both lose). If the Germans get their way on guarantees of austerity and other efficiencies, and then permit the ECB buy trillions upon trillions of dollars of sovereign debt, the crisis may be averted.
However, the rest of Europe is starting to resent the Germans pushing them around on this issue. The Eurocrats have engineered the ouster of the elected leaders in Greece and Italy, replacing them with unelected puppets. This is an opportunity to drive Europe towards deeper unification, whether or not the citizens want it. Resistance may build in the peripheral countries against handing over even more of their sovereignty and undergoing further painful austerity, seemingly for the benefit of French and German bankers. The Germans seem to think that there is no rush to fix things, but the credit markets may sieze up (a la 2008) faster than the politicians anticipate.
An alternative to ECB easing/harsh austerity path would be for the peripheral PIIGS (Portugal, Italy, Ireland, Greece, and Spain) to leave the euro and go back to having their own currencies that they could print and devalue like in the good old days. This may be a viable ultimate solution, but the transition would likely have devastating short and medium term effects. The Greek economy could simply collapse, if other nations were disinclined to exchange real goods like oil, pharmaceuticals, and spare parts for hastily-printed drachmas. Presumably the Eurocrats are counting on this fear factor to motivate the PIIGS to stay in the euro game.
As shown below, even without formal approval , ECB has in fact made large purchases of Italian (and Spanish and Portuguese) bonds, but these purchases have only partially stemmed the rise in yields. Even French and German bond yields are starting to creep up, indicating loss of investor confidence in some of the “core” eurozone countries. This pain-in-the-bond may motivate even the Germans to look the other way whilst the ECB continues to purchase just enough Italian bonds to prevent near-term catastrophe, but high enough (6-7%) to maintain pressure on Italy for financial reform. The ECB does have authorization to lend trillions directly to European banks, which may help prop them up for a while. Also, the International Monetary Fund, with help from the U.S. Fed, may reach in to try to stabilize things.
There is a nontrivial probability, then, of a catastrophic blow-up of European bonds and banks in the next few months. How may this affect the big US banks? Their direct holdings of peripheral euro bonds is not very high. The scarier problem is the many trillions of Credit Default Swaps (CDS) that have been written by major US banks. Focusing on just Bank of America (BoA), they have written over 50 trillion dollars in CDS and other risky derivatives. That is over three times the size of the entire US GDP! According to Bloomberg, last month BoA adroitly moved to transfer $53 trillion of that explosive stuff from its holding company, to its retail arm, which happens to contain the FDIC-insured money of depositors like you and me.
The FDIC protested this gross transfer of risk to depositors and taxpayers, but the Fed supported BoA’s move. If that puzzles you, note that the Fed is not a government agency. Although it is suppose to operate primarily in the public interest, that is not its only agenda: the twelve regional Federal Reserve banks that are the core of the Federal Reserve system are owned by the private “member banks”. Thus, the Reserve Banks are independent, privately owned and locally controlled corporations. The private member banks elect 6 out of the 9 members of the Fed’s Board of Directors, and are paid 6% dividends on their shareholding in their local Reserve Bank. You can now connect the dots…
If the euro situation blows up fast, BoA will quite possibly go bankrupt due to inability to deliver on all those derivatives. The same is true for Citibank and Morgan Chase. The wily Goldman Sachs usually manages to profit from these crises, though squid-hunter Reggie Middleton claims this time is different. In its favor, Goldman Sachs alums or advisors have taken over many of the key financial posts in Europe, most recently Deutchebank. This supplements the high-profile Goldman presence in the U.S. government.
The banks claim that they have hedged their trillions down to billions by contrary bets, but if it all hits the fan, their counterparties will likely be unable to deliver, so (per Zerohedge) the real exposure will be the gross ($ trillions), not the net ($ billions). In the event that any of these banks goes belly-up, even though our deposits are nominally insured by the FDIC, it would likely be weeks or months before we could get our money extricated from the mess.
It gets more complicated because the big banks like BoA and Morgan have upwards of $1 trillion apiece in deposits. A full-on failure at one of these banks could break the FDIC, which has only limited funds (supplied by an assessment on bank deposits) and limited borrowing rights at the Fed. The FDIC is widely thought to have the backing of the “full faith and credit of the United States government,” but in fact there is no clear statute committing the government to a rescue of the FDIC. It is likely that Congress would in the end bail out the FDIC, but this would not happen overnight.
We cannot say how probable is this sort of “Black Swan” event, but the same folks who correctly predicted the 2008 mortgage meltdown are warning that a similar meltdown from the eurozone debt is quite possible. What to do? Even if the odds of a banking crisis are low (5%? 10%?) it seems prudent to protect yourself if you can do so without undue burden. A simple step would be to move most of your funds from these large banks to a smaller regional bank or credit union. Another suggestion is to keep enough cash on hand to get you through a number of weeks in case the ATM stops working. Hopefully these measures will prove as unnecessary as was the stockpiling for Y2K, but better safe than sorry.
Banking apocalypse aside, are there indicators here to help in investment decisions? the stresses in Europe will likely continue to make the US dollar and US bonds look attractive. Hedge funds should be able to pick up assets on the cheap from distressed European banks. Depending on how they are calculated, stock price/earnings look about average at the moment. U.S. GDP has kept slogging forward, but momentum is slowing, and seems vulnerable to shocks from Europe and potential slowdown in China, which is struggling with the popping of its own real estate bubble.
As always, a regular program of investing a fixed sum per month gives the benefit of buying more shares when the market is cheaper (“dollar cost averaging). It would seem prudent to keep a cash kitty in hand to take advantage of a market crash; the trick then is to buy when no one else is, which is emotionally challenging. Stocks or funds/ETFs of stocks sporting high dividends may provide both welcome cash flow, and some protection against market swings. Gold seems to be on a long-term uptrend, though it may weaken near-term as the dollar strengthens due to Euro furor. If you hold a lot of paper gold such as GLD, you can garner some income from it by selling covered calls on a portion of your portfolio.
[Post-script 01Dec2011: The interbank swap lines announced this week drove stock markets higher in a heartbeat, but as pointed out in ThePragmaticCapitalist, this does little to solve the fundamental problems with euro debt. However, it could go a long way towards mitigating collatoral damage to fundamentally solvent banks should the euro finances blow up and to help business keep going in the meantime. Now we wait for the Next Big Meeting, on Dec 9]
On a related topic: In this 6-minute interview with Kyle Bass he makes a case that an even bigger sovereign debt crisis is brewing in Japan. Its government debt per GDP is far higher than in the U.S. or most of Europe. Japan can currently service that debt at low interest rates with the help of a robust trade surplus, but as the Japanese population declines, that will no longer be possible. Bloomberg also noted the danger in Japan : “While Japan has enjoyed borrowing costs at global lows for its debt, the International Monetary Fund said in a report released on its website yesterday there’s a risk of a “sudden spike” in yields that could make the debt level unsustainable”…“Once confidence in sustainability erodes, authorities could face an adverse feedback loop between rising yields, falling market confidence”and “a more vulnerable financial system”. In theory, the Japanese central bank can keep buying bond or the Japanese government could simply print the yen in which its debt is denominated, so, like the U.S., Japan cannot default outright. Nevertheless, rising rates in the land of the rising sun are probably a good bet.
******* RETROSPECTIVE , 16 MONTHS LATER *****
March 23, 2013: I feel most of my posts have stood the test of time, but for this one I should note that the euro crisis has managed to muddle along more benignly than I thought it would. Germany has allowed the ECB to purchase peripheral (e.g. Spainish, Italian) bonds in sufficient amounts to keep interest levels under control. I understand that U.S. banks have taken some measures to reduce the risks of their derivatives, though if things really blew up there could still be big problems. The Fed has established that they will create as much thin-air money as needed to save the big banks from their mistakes. Japanese interest rates continue to bump along the bottom, and Kyle Bass has lost money big time on his shorting of Japanese bonds.