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An Autodidactic Lesson

Blog entry posted by anciendaze, Oct 7, 2011.

This is a departure from my recent biological posts and a temporary return to topical economic issues. Two things have prompted this: 1) news of further problems with European debt; 2) a recent announcement by the Securities and Exchange Commission (SEC).

The news of a downgrade in Spanish and Italian credit ratings, the second this week for Italy, is hardly surprising. It is part of a slow unraveling of the Eurozone monetary system which has been in progress since 2008. While I have had great hopes the European Union would offer an alternative to cultural homogeneity and a unique experiment in pluralism which the world badly needs to learn, I have come to the conclusion the present system is unworkable. This is not altogether damning. The American experiment with Articles of Confederation was not the end of the line for our constitutional democracy. Our constitution could not have been written until (almost) everyone was convinced the preceding confederation had failed. Financial integration was the driving force behind American federalism.

The present Eurozone system plan of unified monetary policy with separate fiscal policy resembles an automobile designed with one gas tank and a steering wheel for each wheel on the ground. This has the advantage of removing any distinction between drivers and passengers, and a slight disadvantage for attempts at going in any particular direction. One must also expect disputes over filling the tank.

It worked surprisingly well while conditions were good, during the build up of a bubble, (though we now know the gas gauge was measuring air as well as petrol.) The catch comes when conditions are indisputably bad.

At present arguments over whether or not Greece will default are largely academic exercises. If my understanding is correct, (and this is a tricky business,) the current restructuring of sovereign debt owed by Greece amounts to paying off about 50 cents on the Euro borrowed. Half the money is effectively gone beyond recovery.

The impact of this, and the danger of further default, has pushed shares in the Benelux/French bank Dexia down fast enough to cause exchanges to suspend trading temporarily. Dexia, for those unfamiliar, took a big hit in the 2008 contraction, requiring a massive bailout (compared to the size of the economies) by the governments of Belgium and France. Sovereign debt owed by Belgium is already in danger of causing a downgrade by rating agencies. This puts that country in a dilemma: if it goes further into debt, to save a major part of its financial industry, it could lose its top rating -- forcing it to pay more to service debt already outstanding.

Spain and Italy are already in such a situation. With economic projections virtually flat, the question of where additional revenue (to pay for servicing that debt) will come from is tricky.

Piled on top of this burden, we find central banks facing increased risk, and raising reserve requirements for other banks. This means those banks must keep more capital on hand to prevent a run on a bank from destroying liquidity -- a bank failure. This money must simply sit there to offset that risk. It is being sucked out of economic activity outside the banks.

The Bank of England just conducted another round of "quantitative easing". This means buying assets from other banks to free up more liquid capital. Unfortunately, this is a weak measure, when other actions, like lowering interest rates, are not practical. Interest on loans between banks is down to almost nothing. The problem for industry is that risk aversion is causing banks to simply avoid lending to anyone who actually needs a loan, due to risk of default. Nobody knows how to tell good risks from bad ones, except by checking on the size of bank accounts. No collateral seems especially solid.

All these things amount to a standard prescription for economic contraction. Europe needs a massive infusion of funds, but -- barring divine intervention or extraterrestrial contact -- there is no obvious source.

Now, back to the U.S. SEC. This agency has decided that 10 credit rating agencies singularly failed in their primary responsibility during the 2008 crisis. As books explaining in considerable detail how they did so have now passed into mass-market paperback editions, this bulletin must be considered a lagging indicator. To have averted the 2008 collapse, those rating organizations would have had to act in 2007, which means any correction to their operation by the SEC should have taken place earlier. The lag is about 5 years. This is not exactly proactive.

We badly need some clues which will make financial management less risky than a market in celebrity marriage futures. Without better indicators, any models based on the behavior of rational investors must favor survivalist supplies.
anciendaze

About the Author

As the name suggests, I am old and dazed. The avatar illustrates my rule of thumb: "Hang on! This ride isn't over."
  1. anciendaze
    It's hard to tell the difference between irony and being serious, or even seriously delusional.

    I just opened a letter from my bank, and misread it as saying they were changing accounting on a trust they manage to "first-in never-out". I am still carrying forward a loss from the financial acumen they exhibited during 2008.
  2. markmc20001
    I knew somebody would catch my some guy on television comment! :D
  3. anciendaze
    On Greek sovereign debt: since it won independence from the Ottoman Empire in 1829, Greek sovereign debt has been in default or restructuring about half the time. It has a pattern of serial default typical of young national economies. The anomaly of a first-world nation with a high standard of living being a serial defaulter gets lost in debate. Governments there have had a practice of using weak currency to solve their problems. When the opportunity to spend hard currency arose, they were enthusiastic participants in the Eurozone. Borrowing to pay political debts and meet current social expenses was a time-honored practice.

    What Greece needs today is major investment, austerity alone will not get them out of the hole. This simply will not take place unless investors have some hope of getting money back. This hope depends on structural changes in Greek fiscal policy and an end to the practice of buying votes with borrowed money. The alternative is that Greece will leave the Eurozone. It may also slide toward third-world status.

    I would hope for a better source than "some guy on television", but the truth is that there is never enough money to pay off all the debt in the world. Virtually every asset you can name is only of value if economic activity continues. The liquidation value of a business may be assumed to be far below its value as a going concern.

    That said, at some point we will have to face reality -- many loans were bad bets, they will have to be written down.
  4. markmc20001
    What a mess eah?

    More power in fewer hands is all we need right now in my opinion. I want to see the Euro fall apart.

    Russia has publically stated it is going to stay out of the euro. Good for Russia. Good for freedom.

    Can you imagine if the whole world was ruled by the European Elites? That's essentially what we would get by allowing that Euro consolidation to spread and turn into a common state in my opinion.

    Just look at Greece, they can't devalue their currency and are loosing tourism because of the high exchange rate that suits France, Germany, and the other main players. Their interest rate is 37% for a two year note. How in the heck can that be any good? The IMF is giving them really impossible terms, and they are locked in because of this Euro contract being used to force austerity and other agendas.

    Another problem is there is too much debt. Some guy on TV said that there is not enough money to pay off all the debt in entire world.

    I also heard that the federal reserve was going to support the Euro with more bond buying. That essentially puts the USA over a debt barrell even more. I don't support any more bailouts for the banks. Time to write down debt and deal with the consequences. This privatizing the gains and socializing the losses is balony. The taxpayers should not have to bail out the looters.

    Get the federal reserve out of the way and the world would be a much better place.

    Survival supplies? Not there yet. I'm long "Get the Money out" campaign.

    http://www.getmoneyout.com/