By Claus Vistesen, on May 18th, 2010
Edward does a nice job to sum up the flurry of the past week which saw the ongoing problems in Greece elevated to a full fledged systemic crisis in the Eurozone economy which, if it ultimately blows, will have ramifications far beyond the borders of the European continent. Being a firm believer in the notion of markets as conversation it is funny to see that although Lehman Brothers is dead and buried, people are talking an awful lot about it.
Consequently, the official figure for a Greek bailout has now risen to EUR120-130bn and with S&P downgrading Spain earlier this month it suggests that the ultimate cost of this mess may exceed the already dizzying number note above many times over. As the Economist neatly puts it this week;
THERE comes a moment in many debt crises when events spiral out of control. As panic sets in, bond yields lurch sickeningly upwards and fear spreads to shares and currencies. In September 2008 the failure of once-stellar Lehman Brothers almost brought down the world’s banking system. A decade earlier, Russia’s chaotic default on its sovereign debt rocked the credit markets, felling Long Term Capital Management, a hugely profitable American hedge fund. When the unthinkable suddenly becomes the inevitable, without pausing in the realm of the improbable, then you have contagion.
As the Economist goes on to argue events are indeed spiraling out of control, a statement with which I concur in full. One question then which, at the moment, may not seem particularly important is how we managed to get ourselves into this mess.
In my most recent working paper entitled Quantifying and Correcting Eurozone Imbalances – Fighting the Debt Snowball I try to provide an intial answer to this question. Well actually, I don’t set out to address this question specifically. But, I do think that if you want to understand why the Eurozone has ended up where it is today and why it is essentially threatened as an economic entity you need to take a long hard look at the issue of intra-Eurozone imbalances and why correcting them from within the Eurozone is almost impossible without some form of disruptive sovereign default in key member economies.
As an introduction, here is the abstract:
This paper quantifies and discusses the concept of Eurozone current account imbalances. Using panel data estimations, the analysis shows how the external positions of the Eurozone economies can be modelled as a function of divergences in unit labour costs. Specifically, the results indicate that the formation of EMU has exacerbated the extent to which even relatively small divergences in unit labour costs may materialize in large current account imbalances. These results are framed in the context of the idea of a debt snowball effect and why the idea of an internal devaluation as a tool to correct external imbalances is inconsistent with the current setup of the Eurozone.
So, do I bring anything new to the table in terms of the overall discourse on the Eurozone’s economic problems? Not really. The story I tell is pretty well known but I still see the main contribution of the paper as the attempt to give a concrete quantitative perspective on the effect of divergent inflation rates (in my case unit labour costs) in an economic setting where countries are grouped together with seperate control over fiscal policy and no sovereign monetary policy and exchange rate.
Crucially, I argue that the forces which have lead to the build-up of imbalances are joined at the hip with the same forces which make it almost impossible to correct from within the Eurozone. Specifically the idea of a debt snowball effect is a good way to show why it will be almost impossible for some economies to correct their external imbalances without an explosive evolution in government debt and since they need to correct external competitiveness issues in order to achieve economic growth, the whole thing turns into a vice and essentially a catch 22.
Please note that this is a first draft only and still subject to several re-reads and editing (especially the tables) before I send it off for hopeful approval somewhere. However, for now your comments are welcome both on the paper itself as well as the topic.
By Winton Bates, on May 18th, 2010
‘The instrument of labour, when it takes the form of a machine, immediately becomes a competitor of the workman himself. … That portion of the working-class, thus by machinery rendered superfluous, i.e., no longer immediately necessary for the self-expansion of capital, either goes to the wall in the unequal contest of the old handicrafts and manufactures with machinery, or else floods all the more easily accessible branches of industry, swamps the labour-market, and sinks the price of labour-power below its value’ Karl Marx, Capital, 1887 ( first English edition).
Since Marx wrote that, real wages have increased by massive amounts in industrialized countries. Authors of some books I have read recently suggest, however, that Marx’s predictions could end up being right in the end. Gregg Easterbrook warns that we should not take too much comfort from the fact that Marx’s predictions of gloom have not yet come true (‘Sonic Boom’, p 153; discussed here) and Jacques Attali suggests that tomorrows West will resemble today’s Africa (‘A brief history of the future’, discussed here).
In attempting to think our way around this question an obvious place to start is with the effects of technological progress on the demand for labour. This approach makes sense if labour can be assumed to be more or less homogeneous, that aggregate capital stock can be measured appropriately, that most income from capital tends to accrue to people with high incomes and that technological change is the only factor influencing income distribution. I’m actually not sure that any of those assumptions stand up to scrutiny, but let us keep the discussion as simple as possible to begin with.
As Marx observed, new technology often involves capital-intensive processes displacing labour-intensive processes, e.g. the use of power looms to replace hand looms in the textile industry at the beginning of the industrial revolution and, more recently, increased use of robot technology in car manufacture replacing labour-intensive assembly lines. This kind of technological change tends to increase the ratio of capital to labour. However, introduction of new technology often occurs through the introduction of superior capital equipment that replaces existing capital (or more efficient sources of energy, financing innovations, business practices etc) without necessarily increasing the ratio of capital to labour. Most importantly, new technology makes possible an increase in national product, or real national income, and with increased demand for factors of production, including labour.
The net effect of those factors on future demand for labour will depend partly on whether, on balance, the new technology is a closer substitute for labour than for existing capital equipment (and other factors of production). Further development of electronics and robotics, in particular, can be expected to displace a lot more manual and mental labour, but my guess is that before too long new technology will largely involve superior robots replacing inferior robots, leaving demand for human labour relatively unaffected. There are some parts of the economy where new technology is unlikely to have much effect at all on the ratio of capital to labour, e.g. symphony orchestras. (That example has, unfortunately, been cited before by someone else, but I can’t remember who.)
Another important influence on the future demand for labour will be whether average incomes are likely to result in a changing pattern of consumer spending toward more on labour-intensive or more capital-intensive goods and services. My guess is that ‘real’ experience (of foreign travel etc.) will trump ‘virtual’ experience and that people will prefer to interact with other humans rather than robots to obtain services such as restaurant meals.
So, I think there are limits to the extent that technological progress will result in substitution of capital for labour. When we take into account the fact that labour is not homogeneous, that investment in human capital and investment in physical capital can be substitutes or complements, and that people embody new technology in the skills they acquire it is not even obvious that it is particularly helpful to think in terms of aggregate categories such as labour and capital. It is probably more meaningful to consider demand for particular categories of labour e.g. unskilled labour. Perhaps it is reasonable to predict that demand for unskilled labour will continue to shrink, but even that is problematic if we define ‘unskilled’ in terms of lack of formal qualifications and overlook the possibility that inter-personal skills – often acquired without formal training – will become increasingly important.
The idea that there is a class of people who obtain their income from selling their labour (workers) and another class of people who obtain their income from ownership of capital (the idle rich) seems likely to become increasingly irrelevant. As working people invest for their retirement they will be increasingly buying shares in the robots that will earn the income they previously earned for themselves.
Technological progress is not the only factor influencing income distribution. Factors affecting the supply of labour, e.g. immigration, could have effects on wage rates in some countries that are as important as the effect of technological progress. Then there are the effects of globalization both in providing international competition for labour-intensive industries and, increasingly, new sources of innovation and competition for technology-intensive sectors of industrialized countries.
Finally, the taxing and spending policies of governments modify the effects of technological progress on income redistribution. If Marx turns out to have been right about technological progress, it seems likely that governments in democratic countries will come under increasing pressure to intervene further in income distribution to ensure that all groups have an opportunity to benefit from the fruits of technological progress.
However, my personal view is that history will probably continue to judge Marx to have been largely wrong about the effects of technological progress on income distribution.
By B.P.T., on May 18th, 2010
At 7:45 AM EDT, the weekly ICSC-Goldman Store Sales report will be released, giving an update on the health of the consumer through this analysis of retail sales.
At 8:30 AM EDT, the Housing Starts report for April will be released. The consensus is that construction on 650,000 new homes were started last month due to a major increase in the number of housing permit applications submitted in March.
Also at 8:30 AM EDT, the Producer Price Index for April will be released. The consensus is that the index increased 0.1% over last month, and 0.1% when food and energy are excluded, after cold weather caused a higher than expected index value in March.
At 8:55 AM EDT, the weekly Redbook report will be released, giving us more information about consumer spending.
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By Claus Vistesen, on May 17th, 2010
If an ECB in QE mode, €60 billion in cash, €440 billion from a pooled EMU effort and €220 billion from the IMF only lasts a week, then I’d humbly submit that we have a problem.
(Screenshot from Bloomberg, click for better viewing)
It is difficult to say whether it was former Fed chairman Volkcer’s comment on Euro breakup which set alight the initial fire, but what is certain is that it does not seem that markets have calmed down. And they shouldn’t be. The package may be impressive, but the growth prospects of the Eurozone has now been moved down more than a couple of nudges and still there is looming and large risk that debt restructuring will come eventually (I believe so for example).
As ever, I should point out that in my world slumping stocks do not constitute a problem as such, but volatility is rising and with it, risks of a veritable rout against which it is difficult to see where policy makers will find the tools prevent a sea of red turning into severe bloodletting.
By Eldon Mast, on May 17th, 2010
Retail sales in the U.S. climbed more than forecast in April, indicating the economic recovery is gaining momentum int the second quarter of 2010.
Sales increased 0.4 percent in April. Last week’s Commerce Department report also upped the measure for March to a 2.1 percent gain — larger than previously estimated. Production rose 0.8 percent, the most in three months, the Federal Reserve said.
Another report showed consumer sentiment improved in May following four straight months of payroll gains, suggesting Americans will keep shopping to help sustain the expansion of the world’s largest economy.
“We’re seeing a broadening of the recovery,” said Brian Bethune, chief U.S. financial economist at IHS Global Insight in Lexington, Massachusetts, who correctly forecast the gain in industrial production. “Consumers are still engaged. There is some pent-up demand out there.”
By B.P.T., on May 17th, 2010
At 8:30 AM EDT, the Empire State manufacturing index for May will be released. The consensus is that the index value will be 30, which would be a decline of almost 2 points from April, but still indicates an improving economy.
At 9:00 AM EDT, the Treasury International Capital report for March will be released, showing the flow of capital in and out of the United States economy.
At 1:00 PM EDT, the Housing Market Index for May will be announced. This index is created from a survey of homebuilders, so it shows the confidence that the sector has in the overall economy and their business.
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By Bron Suchecki, on May 14th, 2010
Below is an exchange of comments to an article about gold I found amusing:
a fed serf: “The gold trade is way, way too CROWDED, Weisenthaw said it yesterday. On CNBC believe it or not, they were saying it is a great time to get into equities and the market is cheap.”
imkeithhernandez: “only an idiot looks to “trade” gold… those w/true intelligence look to hold it; and it’s crowded in the same way that lifeboats were crowded when the titanic sunk”
Also, the article says “JP Morgan’s John Bridges believes the latest breakout for gold was a huge positive sign for the metal. Euro weakness fears, coupled with dollar weakness fears, could lead to an enormous amount of demand.”
What is JP Morgan doing pumping gold, I thought they had a massive naked short position?
By Claus Vistesen, on May 14th, 2010
As we are about move into the fourth day of the week where EU policy makers together with the IMF and the ECB launched an unprecendented series of aid tools to combat the mounting risk of a collapse in Greece and elsewhere in the European periphery I am finally ready to move in with some comments. First of all, there has been no shortage of comments, opinions and market calls on the back of the bailout package and while risky assets have indeed rallied, it is if the underlying reality of the situation looms ever more prescient underneath the surface than what one would have expected from such a collosal dose of stimulating policy.
And for good measure, let us re-cap the list of stimulating efforts taken by Europe and the IMF based on, no less than, Macro Man’s last post as a financial blogger;
* €60 billion in cash from the European Commission, funded by bond sales
* €440 billion in loan guarantees, via pooled support of member governments
* Up to €220 billion from the IMF
* Outright bond purchases from the ECB, to be sterilized (this has evidently already started)
* 3m and 6m full-allotment LTROs
* Reactivation of FX swap lines
This is an impressive laundry list if there ever was one and among the points is the very, very interesting u-turn at the ECB which will now, albeit sterilised, be buyers of real assets. This last change of policy and the effectual skydive by part of the Trichet and his accomplished out of the ivory tower may be what eventually clinches it for Europe. Together with the most recent news this week that Portugal and Spain now seem to be getting the message in the form of introducing some very own austerity measures of their own (which as the song goes are of course complete voluntary and preemptive [1]) this might just be the combination of policy moves that Europe needs to see this through without a nasty default of a further intensification of the crisis.
But then again, it might not. I am sceptical here although I concede that if it is backed up by serious and real measures to rein in deficits I might just be turned into a believer here. However, there are some things that still bugs me.
Firstly, it should not escape us here that what our dear policy makers effectively are doing is to fight fire with fire. More debt will thus be substituted with even more debt and it is not clear just what the end game is supposed to be. However, one thing which is now crystal clear to me is that if there is any way that the EU and the Eurozone are to make out of this in one piece it will mean a much tighter coordination of fiscal policy. This will require a monumental rethink of the EU setup and while I believe that the joint effort of EU policy makers could indeed be pooled to make this happen the chance of it actually materialising is slim. In this sense it will be interesting to see what exactly it will mean for the fiscal coordination (if any) that Eurozone economies are now jointly asking the market for funds to pool in that loan guarantee entity.
Secondly, the introduction of implementation of all these so-called austerity measures are not linear and we can’t feed them into linear models and expect these models to come up with usable results. In this sense, and abstracting a minute from the general risk of doing too little too late, the road ahead is very difficult. On the good side it now appears that Spain and Portugal have awoken to the fact that they too need to turn on the screw and that what ultimately distinguishes them from Greece is merely market timing. This is universally good news, but it this is only the statement of intent. In fact, before we close the book on 2010 this is all we are going to see since the 2010 budgets (already passed) are thoroughly in the red. The biggest problem here is simply that for all the good intentions in various EU commission and IMF proposals the actual process of implementation on the ground may proove near impossible. And here I am not talking about some innate laziness or non-voluntarism by part of the Greek, Portuguese and Spanish people; I am simply talking about the near impossibility of letting the entire burden fall on internal price and competitiveness adjustment from within an fixed currency union, but this of course has been the main issue all along. As I noted in another context, any state can only take so much of having to fight its own citizens with water and teargas week in and out even if they are trying to do good.
The considerations above have slowly, but surely convinced me that while I support the efforts by EU policy makers (both in spirit and in terms of the technical measures) I have increasingly converged on the idea that some form of debt restructuring in Greece (and possibly elsewhere in EMU) has to be included in what we could call the main scenario going forward. In coming to this conclusion of course, I am met with formidable resistance.
Take for example the IMF’s communiqué on the situation in Greece and why a debt restructuring would be a very bad idea (see also Emmanuel’s take).
Restructuring debt would not help Greece’s capacity to grow. The type of fiscal and structural reforms being put in place under the Government’s program are designed to do that – to bring down costs, to make the labor market more flexible and to improve the business and investment climate.
The web of economic and political inter-linkages—including that Greek bonds are held by a wide variety of private investors and public entities—severely complicates alternatives to the program the government has put in place. Any perceived positive near term effects of a debt restructuring need to be weighed against contagion effects.
Most of the adjustment in Greece is needed to eliminate its large primary deficit (the deficit net of interest payments). This is the main issue for Greece, not the level of the debt.
My main problem here is simply I think the IMF misses the main point by a mile. It is thus exactly the combination of too high interest rates and negative nominal growth rates (deflation) which make the situation in Greece unmanageable and also why I believe it was a mistake not to include some form of hair cut on Greek sovereigns (up front) as part of the Sunday’s shock and awe move. Now, I don’t dispute the point that the fiscal and structural reforms wouldn’t help, but the numbers just don’t add up. Greece is currently running a fiscal deficit to the tune of 12-15% and even if we assume that this will come down during the envisioned horizon Greece will still be caught in a debt trap once we are done. For a lack of a better comparison, Greece will come to resemble the Baltics and trust me, this is not a comparison you would like to be branded with. In this way, it is in fact the level of debt that will eventually force a debt restructuring in Greece and it will do so exactly because the terms with which Greece is about to embark on her structural adjustment are unsustainable from within a monetary union.
This brings us to the newfound QE profile by the ECB which could, in theory, make a lot of the problems of Greece (and Spain and Portugal) go away. However, we are alo moving into uncharted territory here. Consequently, echoes from Japan are coming closer and it is not altogether clear how the ECB would deal with the fact that it would have to permanently [2] massage the yields of Greek sovereign bonds in order keep the boat afloat. I emphasise permanent here since there is a real risk that the ECB has now decisively had its Japan moment and should the ECB commit to unwavering support for the Eurozone periphery it would not be a misnomer to dub the Eurozone Japan 2.0.
Among the long list of comments and analysis that has so far been ditched up to provide a view on the situation, I think that the one by John Hussmann comes very close to an adequate picture of the situation where you will forgive me, I hope, the following lenghty quote;
Looking at the current state of the world economy, the underlying reality remains little changed: there is more debt outstanding than is capable of being properly serviced. It’s certainly possible to issue government debt in order to bail out one borrower or another (and prevent their bondholders from taking a loss). However, this means that for every dollar of bad debt that should have been wiped off the books, the world economy is left with two – the initial dollar of debt that has been bailed out and must continue to be serviced, and an additional dollar of government debt that was issued to execute the bailout.
Notice also that the capital that is used to provide the bailout goes from the hands of savers into the hands of bondholders who made bad investments. We are not only allocating global savings to governments. We are further allocating global savings precisely to those who were the worst stewards of the world’s capital. From a productivity standpoint, this is a nightmare. New investment capital, properly allocated, is almost invariably more productive than existing investment, and is undoubtedly more productive than past bad investment. By effectively re-capitalizing bad stewards of capital, at the expense of good investments that could otherwise occur, the policy of bailouts does violence to long-term prospects for growth. Looking out to a future population that will increasingly rely on the productivity of a smaller set of younger workers (and foreign labor) in order to provide for an aging demographic, this is not a luxury that our nation or the world can afford.
“Failure” and “restructuring” mean only that bondholders don’t get 100 cents on the dollar. We can continue to bail out the poor stewards of capital who voluntarily made bad, unproductive investments, and waste our future productivity in order to make those lenders whole, or we can turn the debate toward deciding the best strategies for restructuring existing debt.
I agree with all of the above and it echoes my general sentiment which is not that Europe is about to sink into a hole, but that a real hard look at the face value of the obligations in Greece and elsewhere is needed. Naturally, and as a counter argument to this point is the increasingly worrying barrage of numbers purporting to show the exposure of European and US banks to Greek sovereign bonds and indeed the bonds of the Southern Europe. No matter where you look, the numbers aren’t small and it does not take a lot of imagination to see how this could very easily turn into a Lehman 2.0 moment for banks and thus the real economy. The only problem this time would be that we would be, for the most part, all out of firepower. It is important for me to point out that it is not because I discount this event too easily that I am calling for a preliminary look into debt restructuring. It is simply because I believe that with the current road map, the end game is given in advance. This won’t of course make the exposure any less grave, but did we really think that a haircut on the debt could be avoided here?! Especially, if we are talking about banks playing the funky chicken on the short end of the Greek yield curve (is there any other?!)by sucking up liquidity in Frankfurt only to park it a couple of thousand kilometers further south, then it really escapes me if people had seriously imagined that this would not unravel at some point.
We all know that it will be a regime change when the first OECD economy pushes the restructuring button, but it was bound to happen at some point. I’d thus recommend that we stopped kicking the can down the road and in stead picked it up and threw it away; only in doing so will be able to say that we are indeed still standing.
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[1] – This is pooh-pooh of course, but as long as they believe it themselves I am happy to indulge them.
[2] – Let us say for 10 years to begin with.
By B.P.T., on May 14th, 2010
At 8:30 AM EDT, the Retail Sales report for April will be released. The consensus is that retail sales increased 0.2% from March.
At 9:15 AM EDT, the Industrial Production report for April will be released. The consensus is that there will be a gain 0f 0.6% in production and a gain of 0.5% in industrial capacity utilization.
At 9:55 AM EDT, Consumer Sentiment for the first half of May will be announced. The consensus is that the index will be at 73.8, which would be an increase of 1.6 points from the second half of April.
At 10:00 AM EDT, the Business Inventories report for March will be released. The consensus is that inventories increased 0.4% from February, which would be the third month of increases in a row as businesses rebuild inventory to handle increasing demand.
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By Trace Mayer, on May 13th, 2010
On 6 May 2010 the DOW dropped a massive 600 points in a mere seven minutes and at one point was down 998.50 points which is the largest nominal drop ever. One of the reasons for this increased volatility is the knowledge of all major market participants that their assets are neither safe nor liquid yet the greed to engage in speculation. As the true state of the worldwide financial markets and their fake liquidity increasingly permeates the zeitgeist more and more individuals will simply withdraw their capital and store it is the monetary metals. 
Those who have followed RunToGold for a while have been adequately warned. For example, on 9 October 2009 I was interviewed on BNN and suggested that gold would reach $1,300 in Q2 2010 as the credit crisis intensifies. Now gold is within striking distance. On 7 February 2010 I warned of the approaching Laboon of sovereign debt default and Euro evaporation. Now it is happening. On 27 July 2009 I warned of the coming market crash. While the market is crashing when priced in gold it has still remained fairly orderly and but for The President’s Working Group On Financial Markets it would be a lot more chaotic.
VOLATILITY
When the financial markets experience unusual palpitations then those closely involved often flee for safety and liquidity. With high frequency trading powered by computer algorithms the result is a gigantic electronic herd moving at the speed of light. The result is an explosion in the VIX or CBOE Market Volatility Index.
… value and price are completely discrete.
The higher the VIX the more difficult it is for the entrepreneur, the individual that creates real wealth by providing the goods and services the economy desires, because making mental calculations of value becomes more difficult and therefore decisions to allocate capital become based on more arbitrary premises. In this current economy, value and price are completely discrete.
The end result is that holders of capital, instead of taking risk and buying an ice cream machine or building a new factory, buy gold, silver and platinum while waiting for calmer days. When the devaluation of intrinsically worthless fiat currencies happens it will likely be extremely quick.
THE GREAT CREDIT CONTRACTION
 I really wish this liquidity pyramid could accurately convey all I want but it gets the main point across. During a credit contraction capital, both real and fictitious, burrows down the pyramid into safer and more liquid assets. The illusory capital evaporates.
… the riots in Greece are the prelude not the encore …
What happened on Thursday? Capital burrowed into FRN$ Treasuries and gold. Gold is now perched atop a near record all-time high around $1,210 per ounce.
As reported by Bloomberg, the EU’s $645B fund to fend off the ‘wolfpack’ will be like a decrepit brontosaurus trying to fend off 100+ hungry velociraptors. Europe is too old, too beauracratic, too slow and fighting economic law to be able to mount a sufficient defense. The little baby velociraptors, hatched with the merger of bank, currency and state through ignoring Article 1 Section 10 Clause 1 of the United States Constitution and the establishment of the unconstitutional Federal Reserve, have now grown up and they have unlimited avarice to feed.
But I think the real value is to be found in buying platinum which, during the past week, got cheaper when priced in gold. A likely scenario will be a summer consolidation or pullback in gold, silver and platinum and then starting in August the trek towards $1,650 gold with the bulk of the upleg happening in November.
There will come a time to buy the S&P 500 and real estate with one’s monetary metals but that time is still a few years away. In the meantime, the name of the game is to retain the capital and purchasing power already accumulated. Keep in mind, the riots in Greece are the prelude not the encore and will be coming to a city nearby before The Great Credit Contraction is over.
CONCLUSION
The entire worldwide financial and economic system are built on an illusion. Neither I nor other prepared individuals really care if the stock market crashes 700 points in ten minutes. What is going on is fairly simple economic law which I discuss in The Great Credit Contraction. While the time to buy the precious metals at a good value was earlier there is still incredible reasons to at least have some material portion of one’s net worth allocated to them.
After all, whether the fire of inflation or even hyperinflation or the ice of deflation that freezes the global economy in its tracks a holder of capital will be protected when ensconced within a golden forcefield. And the monetary metals can do wonders for reducing blood pressure when watching Iceland, Greece, New York or LA on television.
DISCLOSURES: Long physical gold, silver and platinum with no interest in DOW, S&P 500, the problematic SLV ETF, gold ETF or the platinum ETFs.
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