The Stock Market, QE3 and Voodoo Finance

As we look across the economic landscape there is an abundance of reason to anticipate a global economic slowdown. It is already well in the works as reflected in anticipatory data. It would not be a garden-variety recession emanating from some lull in spending but rather the grinding process of over-indebtedness and uncertainty due to tax and health care issues.

At the same time, over-indebtedness also creates a withering of financial valuations, which sets off another chain reaction called systemic financial meltdown.  This reduces the value of assets held by individuals and institutions such as banks, which in turn further dissolves financial wealth when assets are dumped in order to pay off fleeing depositors.

As a result, financial intermediation withers so that the process of matching of savers, if there are any, with investments is impeded. This in turn negates future growth. For example, systemic financial forces causing a recession visited the U.S.  in the late 1980s. At that time large commercial banks were overburdened with Latin American loan defaults and simultaneously savings and loan associations (remember them?) were decimated when inflation depreciated their book of long-term mortgages.  This limited systemic financial event resulted in a prolonged 1990 recession.

Hence whether the over-indebtedness first strikes spending or financial intermediation, it is difficult to discern as they interact and both income flows and financial valuations suffer, whichever occurs first.

Today, the developed world’s over-indebtedness reactions of the combined recessionary forces and bank runs are emanating from Europe’s southern tier. Unemployment numbers in Greece and Spain rival those of the Great Depression.

But the question on the table is the ability of Northern Europe and the U.S. (and, for that matter, the rest of the world) to escape at least temporarily the ill effects of the above degenerative process.

To gauge that, the market looks to the ability of monetary and fiscal policy to come to the rescue, and if the rescue is attempted will it work? Given the succession of bailout funds established but without the means to fund them, it is not a realistic option. To the extent country debt has been carried by other contributing countries, it is extremely limited and if, indeed, the Spanish bank bailout takes place, it exhausts all bailout funds from the Eurozone’s willing contributing countries.

Nonetheless, the contributing countries keep promising more and more, with the latest being a bank deposit insurance fund — and the market somehow believes it.

If fiscal resources from other contributing countries are extraordinary limited, what is the extent of monetary funding to aid both a recession and systemic financial meltdown? Well, there is some defense to the systemic financial event as long as the Fed and the ECB and other central banks are willing to keep expanding their balance sheets. There is no theoretical or legal limit to how much can be purchased to keep financial asset valuations afloat in order to prevent imminent financial meltdown, but to go overboard they are willing to give up all discipline of monetary control, and with it, holders of the currency go elsewhere.

Given the vulnerabilities present, how then can one explain stock price buoyancy? Since the beginning of the year the S&P 500 index is up approximately 6% and FTSE 100 index is up 2 percent despite the onset of recession and bank runs.

If there is any logic to it, it seems to be resting on less than a firm foundation. While equity investors rely on current known information such as earnings, they also project forward the value of the claims they are purchasing, hence making financial pricing a mixture of facts and a learned history to project forward.

What you often hear these days is a general awareness of the economic and debt problems but a faith that the bigger the problem, the bigger the government response will be. That is to say, any investor citing “in my 25 years’ experience” is a candidate to be projecting a future based on the Great Moderation Period of Greenspan Puts and currency solidarity in Europe.

Financial prices are inherently an extrapolation of a history, but it’s certainly not the Great Moderation, though that was the dominant influence in the thinking of the 25-year U.S. veteran stock market investor.

But then there is a newer history called the Bernanke Put, best characterized as a succession of QEs or other outside-the-box monetary stimulus, the latest of which is operation twist.

It’s now a common attitude that if the situation becomes bad enough there will be a response equal to the task needed to keep financial values afloat. Now being cited is the above chart showing how equity markets respond to QEs. It seems that the Fed has well trained stock market investors in Voodoo financial logic. The worse the economic problem, the better it is for stocks despite declines in earnings.

As a side note, QE faith stock valuations are throwing noise into the long term relationship of stock prices to earnings and as an early indicator of a recession. This is one of many structural changes that are occuring which implies that one must be careful of which history is chosen to extrapolate.

Before one relies on Voodoo finance and a faith-based QE3, one should note that additional Fed stimulus is almost certain in the face of a systemic financial institution collapse but is less certain and will be less dramatic due to a softening economy. Systemic financial defense was the raison d’etre for the Fed and remains its number one policy objective, but some token form of monetary aid has now become necessary to prevent a collapse of the Voodoo expectations the Fed has created. If that occurs, expectations have become self-fulfilling.

 

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The Financial Multipliers of Globalism and Ross Perot’s Giant Sucking Sound

Fed Chairman Bernanke testified last week that “the situation in Europe poses significant risks to the U.S. financial system and economy”. This indicates the extent to which financial globalism has become a controlling factor in U.S. economic and financial prospects and policy.

While globalism wasn’t supposed to have that level of influence, there was a memorable warning in the great North Atlantic Free Trade Agreement (NAFTA) debate of 1992. As it was conceived of at the time, globalism meant trade rather than finance, and became a presidential campaign issue. It was at that time that Ross Perot famously associated globalism with a “giant sucking sound” of jobs being lost to low-wage countries.

Today, the issue is financial globalism, not trade,  and per Bernanke’s above statement, all efforts are being made to contain or “ring-fence” Euro sovereign and bank meltdown from also taking down the rest of the world’s financial asset valuations and the solvency of the institutions holding those assets.

This is not easy when Euro banks are highly leveraged, perhaps 30 times and funded by short-term financial claims such as deposits or Repo loans that can and do run without notice. This forces the sale of the banks’ troublesome assets, not just for liquidity to retire deposit but also to downsize the book of assets by the above leverage multiple for each dollar of declining net worth.

That all fits the description of a financial crisis (as previously explained in Dominos) but what makes it even more of a government crisis is when the bank’s questionable assets are government debt. The forced selling with few buyers and declining prices only makes it more transparent that the government is near insolvent and can’t backstop the bank’s insolvency as well.

This unstable equilibrium is destabilized one step further when other arm-twisted governments are coerced into providing bailout aid, because the costs of the spreading financial meltdown to them exceed their bailout costs. So the implication of financial globalism is indeed the giant sucking sound of sapping resources across the globe into a financial black hole which used to be called Greece, Ireland and Portugal but is now also called Spain.

This is done with a large multiple of the original bank asset write-downs as all banks are run, and in turn forces business firms to be cash-hoarding machines instead of expanding producers. The combined corporate stock market meltdown and bank asset sale meltdowns create financial multipliers of lost market value perhaps 10 to 20 times the bank’s actual defaulting assets. Such was the experience of 2008.

If the central banks are called in and they are indeed poised to spring into action, it would require a substantially larger asset purchasing infusion than the insolvency losses in the first place. This is because the multiplier of financial shrinkage due to a dollar loss of bank capital is far greater than the melt-up multiplier of a dollar of central bank liquidity. Banks are short of capital and don’t in turn expand with a money supply multiplier of textbook lore when central banks expand, which explains why central bank QEs are in the trillions when the bank losses causing the interventions are in the billions.

So here we are with governments and central banks poised to react with the old game plan of QEs to inject purchasing power into asset markets, but what we need is a new game plan with a reduced vulnerability to global financial interconnections unless fiscal sanity re-emerges. Hence, ring fencing or financial containment means the end of financial globalism as was developed over the last decade.

As the world moves away from financial globalism, expect one of the first and obvious disconnects to be Greece divorcing itself from the Euro currency — or, more rationally, for Germany to come to grips with the idea that they set themselves up to be the easy mark in the Euro game of wealth redistribution.

In response to prospective Euro breakup, both borrowers and lenders are re-aligning themselves to be borrowing and lending in the same country as cross border finance means one might end up holding assets in a declining country currency and owing in an appreciating currency. So private parties are de facto withdrawing from financial globalism even before governments constraints set in.

If and when Greece exits the Euro, financial markets will likely fade for a few hours until it collectively realizes it is better for Greece, Europe and global financial markets, and the flight to the U.S. Treasury and German Bund will recede.

Financial globalism has become a transmission mechanism to spread financial losses across the globe.  Hence, the pendulum of financial globalism is now swinging the other direction. Ironically, it will reinforce the reserve currency status of the U. S. dollar despite the U.S. fiscal problems.

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Warren Buffet and the New Calculus of Gold

There has long been a disconnect between gold and institutional investors. The instincts of these managers of large sums are typically tied to the generation of cash flows to feed the monster — that is, the institution’s cash flow needs. Alternative emphasis is given to growth, especially if obligations are long duration and not fixed. This is usually true for pension funds, endowments, some insurance companies or individuals investing for retirement.

For these investors, the preferred investment habitat tends to be a blend of income-generating fixed income and equity type investments that are thought to contain the potential for growth. Because gold, as an investment class, provides neither steady income nor systematic growth, it succeeds in only providing emotional discomfort for these investors.

Warren Buffet’s recent article in Fortune is a reflection of this sentiment. First on the list of asset categories to consider are bonds or, more generally, fixed income. His analysis is instructive.

From his point of view, over the relevant time frame of the 47 years he has been at the helm of Berkshire Hathaway, continuous rolling short term Treasuries bills would have averaged 5.7% annually. But if an investor paid income taxes at a rate averaging 25%, the return is reduced by 1.4 points. Buffet then goes on to point out that the return is then further reduced in real terms by the invisible inflation “tax” which would have devoured the remaining 4.3%. Hence rolling short-term Treasuries would have yielded nothing in real terms.

If one held long maturity Treasuries over this period — which included 30 years of general Treasury bond price appreciation — the investment outcome is questionable if you take into account the declining purchasing power of goods in U.S. dollar terms.  It is even worse when compared to a market basket of goods from around the world.

In Buffett’s terms, fixed-dollar investments have fallen a staggering 86% in real dollar value since 1965 during his tenure at Berkshire Hathaway. He points out that today it takes no less than $7 to buy what $1 did when he arrived in Omaha.

He concludes with the recommendation that fixed dollar income investments should come with warning labels advising you that they’re bad for your financial health.

What if contractual steady income doesn’t perform well? Asset categories outside the normal preferred habitat need to be examined. That’s where gold comes in, especially considering that for the first time in our monetary history the central bank has adopted positive inflation as a policy goal. Nonetheless, the institutional sale is a hard one, not just because it’s not been a member of the preferred habitat, but according to Buffet it has other fatal defects.

After conceding in a backhanded way that gold has performed well, with reference to its near $10 trillion in market capitalization, he argues that it doesn’t qualify to be in his preferred investment habitat because it doesn’t produce a growing revenue stream — and if it doesn’t grow, it doesn’t compound.

Rather, he states that his preference would be to employ his capital with growth commodities such as farmland or businesses that will continue to grow its bread-and-butter capacity that can be sold in real terms. That is to say, he rejects gold because it doesn’t produce gold sprouts. Gold is just inert, lying in neatly stacked bars in a subterranean vault. It has but limited use in electronics, jewelry, dentistry and few other applications.

Buffett then goes on to compare the rising price of the sprout-less gold to a Ponzi scheme, which depends upon finding a bigger fool to pay yet a higher price for the same subterranean inert matter. This is apparently proving easier to do by the day as the developed world continues to run outsized fiscal deficits and then compels its central banks to purchase its paper.

Instead, Buffett prefers investments such as Coca-Cola or See’s Candy, which have the ability to sell more candy in the future at the prevailing price level as a means to produce real growth.

That’s where I depart from the Sage of Omaha. While not arguing with the ability of See’s Candy to deliver and the American sweet tooth to be unaffected by the growing concerns for obesity, I believe he fails to see the new product that gold represents and its growing sales potential.

This is “the new calculus of gold.”

In a wealth-accumulating economy there is always demand for an ultimate store of value for wealth preservation. In finance terms, there is always a demand for some asset for which an investor takes no default risk, nor inflation risk, and can be obtained and sold on liquid markets.

For decades, U.S. Treasury debt took over from gold as the market’s preferred store of value. Treasury bonds mythically had no default risk and little inflation risk when central banks were not under pressure to be concerned about unemployment, lending to insolvent banks, or propping up the value of government debt. Moreover, U.S. dollar-denominated Treasuries served not only as the store of value but also sprouted interest payments.

But all that has changed, perhaps not forever but likely for the next four decades, as developed world democratic governments will be under pressure from their constituents to make good on the social contracts of social security and comprehensive health care to the bulging baby boomer population. And, if need be, they will recapture the central banks (by legislative changes if necessary) if they fail to support U.S. Treasury prices.

Given the debt and monetary growth ramifications of these pressures, investors will seek an alternative embodiment of a store of value other than fixed dollar denominated assets, especially sovereigns. With all other developed countries in similar straits and emerging market countries exposed to inflation generation from developed country central banks, their currencies and sovereigns also fail to qualify. Hence, gold has reemerged to play the role of the store of value, despite its sprout-less property. Sprouts are the icing on the cake but not the cake itself — and many gold admirers remember Mark Twain’s old saw: ‘I am more concerned with the return of my money than the return on my money.’

The New Calculus of Gold has much more to its story than merely the market-designated good for inflation and default protection, with or without sprouts.

We are at a historic point in time when both consumer and government debt have grown dramatically relative to income, which is our underlying economic problem (See Roadblocks to Recovery: An Interview with Dr. Lacy Hunt). In the great debt run-up of the last few decades, lenders or bond investors underwrote debt or loans based on either the borrower’s cash flow to service the debt or based on the borrower’s collateral, or both.

But debt has a maturity, and when the maturity is reached, borrowers seek to go back to the well and roll the debt over. From the easy lending days of the turn of the 21st century, the value of what has traditionally been accepted by the lender as good collateral has declined in market value as well as market esteem. That includes residential houses and commercial real estate for mortgages, mortgages for mortgage-backed securities, and mortgage-backed securities for CDOs.  Even government securities and guarantees have been questioned especially from abroad when collateral value is set by the credit rating of the collateral. By that measure even U.S. Treasuries and government guarantees fail the test of good collateral given rating downgrades.

Hence, the great corollary of over indebtedness is the relative scarcity of good collateral to support the debt load outstanding. This imbalance of debt to collateral is impacting the ability of banks to make loans to their customers, for central banks to make loans to commercial banks, and for shadow banks to be funded by the overnight Repo market. Hence the growth of gold as a collateral asset to debt heavy markets is inevitably in the cards and is de facto occurring. Gold is stepping up to the plate as “good” collateral in a world of bad collateral.

As described in the accompanying news story (J.P. Morgan to Accept Gold as Collateral), gold is now being accepted (or more likely demanded) as collateral for bank loans, which increases the demand for gold. Furthermore the scarcity of collateral has spread to Europe, where debt is now being priced according to the value of its collateral, and clearing houses are accepting gold as collateral and for exchange settlement. Furthermore in this environment of collateral scarcity, clearing houses that service the shadow banking repo loan closures are closing loans despite the arrival of the collateral (prosaically called settlement fails) but it doesn’t stop the loan from being closed without any collateral, either good or bad and is now causing a regulatory backlash to tighten up actual collateral.

In addition to the demand for gold as collateral to back private debt, there are growing instances of commercial banks and central banks stocking up on gold as assets to meet the perception of depositors that banks or currencies are financially healthy. In this regard there is a shifting of foreign exchange reserves of world central banks away from foreign currency (dollars) into gold as shown in the Figure.

Most importantly, China, in its not so secret desire for the Yuan to be a world reserve currency, is accumulating domestically produced gold as it bans exportation, and at the same time it is shifting its foreign exchange reserves from currency into gold. If the Yuan has a chance to have reserve currency status it likely would require gold backing. A gold-backed Yuan would make a big dent in the U.S. market for the dollar and Treasuries as the world’s store of value asset. A gold-backed Yuan would be the equivalent of gold certificates in a warehouse and denominated in a currency that would be on the upswing and very desirable as compared to developed country sovereigns or currency. It might even be more appealing than gold certificates stored in a Swiss warehouse, denominated in a currency that is not allowed by its central bank to appreciate.

We have entered an environment with elevated debt to collateral and elevated currency to goods, and gold is again demanded by market forces to enhance the value of debt paper and otherwise fiat currency.

What we are witnessing is a sea change in which market forces are driving a de facto return to the gold standard. All that is missing for this to be a de jure gold standard is some regulatory and legal recognition and one has been proposed. The Basel Committee for Bank Supervision, the maker of global capital requirements is studying making gold a bank capital Tier 1 asset.

This implies banks would be regulatory blessed to operate with less equity capital than is normally required of banks if they held more gold as an asset. Basically,  regulators would allow banks to be more leveraged, meaning the banks would not suffer as much equity dilution to recapitalize after sovereign and mortgage write downs. Not only would gold then be backstopping debt and currency but also be backstopping bank equity capital.  So the realm of gold is expanding to fill the void of other “money good” assets and elevating its demand.

The world has gravitated from one gold-backed paper currency to another before, and it likely is happening again. It would depend on whether investors in liquid, default-free, inflation-free paper prefer gold-backed Chinese Yuan to Swiss warehouse receipts or deposits from large international banks with large gold positions that operate with lots of leverage. This is a market choice that will determine the gold linked paper store of value, but the point is that all the paper contenders derive value from the gold backing, and thereby expands the demand for the shiny metal. This is the new calculus of gold. This state of affairs is likely to remain until developed world governments no longer reach for the unreachable and pressure their central banks to finance it.

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Financial Repression: The Unintended Consequences of Saving the Sovereign

What’s new has often been lived before, but sometimes it’s not pretty. Presumably that’s what Clarence Darrow meant when he said, “History repeats itself, and that’s one of the things that’s wrong with history.”

It is becoming increasingly clear that developed-world countries will attempt to go down a path followed before by governments facing similar debt loads… and it’s not pretty. In this case it’s not a wartime debt rollover, but a combination of lofty promises made to provide a social net to a burgeoning population demographic. And this follows years of fiscal sloppiness both here and abroad derived from an attitude best expressed in the infamous and thoughtless words of Dick Cheney, “Debt doesn’t matter.”  Well, Dick, it does.

With the U.S. and many other sovereign’s debt levels reaching or exceeding the 100% ratio to GDP, governments are in a mad scramble to line up financial resources to keep the debt thing afloat.

Europe (Greece in particular) continues to be the poster child for the illusion that a government can keep itself going by leaning on its citizens and others to create bailout funds, or by changing the accounting, regulatory or legal rules, or by engaging in other funny–money schemes. Europe has just concluded the 16th summit of its leaders in less than two years to solve the Euro debt problem once and for all — and all they do is create more debt (the ESM permanent fund) to solve an over-indebtedness problem.

Some of these efforts have brought a temporary reprieve from financial meltdown, but they do not provide a meaningful adjustment process to regain prosperity or debt sustainability. Basically, the horse is out of the barn. There is now so much debt and so many additional scheduled debt commitments that austerity on the rest of the budget will not contain the debt problem.

It would almost be an amusing soap opera if we, the spectators in the audience of this high-theatre drama unfolding in the daily financial tabloids in both Europe and the U.S., could sit back and enjoy the comedy, but unfortunately the bottom line is the actors in the comedy will soon be passing the hat around the audience — at first for voluntary contributions and later for mandatory contributions to the cause.

Moreover, we the audience will ultimately need to ante up less in direct contributions (whatever form of taxes you care to name), but more so in the loss of our income base and market value of wealth. All of this begins with the redirection of scarce capital to finance governments at terms favorable to the debtor government. When that is not enough, next comes the systemic raiding of banks and private resources to finance government debt.

Given the lack of will by the government actors in this soap opera to stop the entitlement game made by previous irresponsible governments, it appears that we will soon be learning the ultimate cost of attempting to keep the entitlement promise. The promise will not be delivered, but we will go down trying.

The cost of trying is not calculated in terms of the present value of the unfunded entitlement liabilities or in the cost of escalating government debt service that we can directly measure. Rather, the cost will be in the more difficult to calculate income, output and wealth losses as a result of a country’s undersupplied and misdirected capital resources. In the environment of attempting to keep the faith in entitlements, income flows and job growth occur at a diminished rate. The economic engine is stuck in low gear when a higher priority is given to financing the sovereign rather than the private sector.

All of this goes by the name of financial repression, a term that has resurfaced in the economic-financial policy lexicon in the last months and is becoming chic in the financial policy press. It’s a term that I am familiar with in that my Ph.D. Chairman, Professor Edward S. Shaw, along with Professor Ron McKinnon of Stanford University, invented it as an explanation of why the Less Developed Countries were less developed for about five decades. Now we get to view it in living color as the nightly news shows us how it is being applied to and affecting the developed economies of the world.

The idea of financial repression presented to me as a graduate student didn’t resonate then, but it does now as I view it and its side effects. It sometimes takes a while for ideas to sink in, and because history is repeating, I get to watch it live the second time — or the third, or however many times it’s been around. What needs to be understood is that financial repression is the unintended consequence of government efforts to suck private capital resources at favorable terms into the financing of government debt. It could just as well be called economic repression because that is what results.

While the general objective for a debt-stressed government is to induce or coerce the buying of its debt, it also needs the buying to take place at a cost the government can afford — not just zero, but even below zero. This occurs when the real interest rate (the nominal rate paid less the inflation rate) is held in negative territory. The cost becomes negative in real terms when a positive inflation rate depreciates the bond’s real value to a greater extent than interest is paid to the holder of the debt.

To pull this off requires a cooperative central bank to create the negative real rates. It’s been quite amazing how the “independent” central banks — made independent to provide checks and balances to prevent reckless government spending sprees — have been co-opted to play an essential role in financial repression. They do so by providing a negative real interest rate for governments by both targeting simultaneously both near-zero nominal rates of interest on government debt and a positive inflation rate.

Given this perspective it should be little surprise that the Fed has recently extended its near-zero nominal interest rate forecast (target) through 2014 and talk of another round of QE is alive both here and in Europe on top of all the others that have occurred in the last three years. While this cheapens government finance at the expense of the holders of the government debt, it also provides disincentives to save and accumulate capital for private uses, hence our near-zero saving rate.

A government’s central bank is its first line of defense in maintaining its ability to pay entitlements. The second line of defense consists of the banks and financial institutions that are coerced to hold greater proportions of government debt in the name of rising liquidity and capital requirements — but with almost zero nominal rates earned on this sizable asset class, they pay virtually nothing for deposits. Hence the banking system and financial institutions in general are also offering negative interest rates on deposits and are in a state of shrinkage, allocating smaller and smaller proportions of their portfolios to the private sector.

We the people will be the third line of defense as the government crams its debt down the throat of the unsuspecting and the unwilling. This generally takes the form of voluntary programs for debt purchases, as the WWII-era poster above suggests. Later this will be accomplished through a mandatory program, with mandatory purchases in the form of swapping “risky” private assets in an IRA for “secure government debt” to finance a private retirement.  This has just occurred in Hungry and Poland, and that discussion has been launched in the U.S. and is contained in the Annual Report of the White House Task Force on the Middle Class (p. 27).

But what do depressing government bond yields do to non-government financial prices? As discussed in my previous post Liquidity and Asset Bubbles: How Long Will the Dam Hold, the lowest interest rates in U.S. history promote a carry trade that finances the purchase of higher quality debt and higher quality dividend-paying equities that investors hope will survive a sovereign meltdown. By extending the time period of its zero interest rate policy out to three years, the Fed reduces the funding risk of the carry trade and ramps it up further.

There is substantial financial buying power to be spread out: the Fed and the ECB’s liquidity transfusions of operation twist, on top of swap financed lending to euro banks, on top of LTRO, on top of another LTRO in the works, and ad hoc ECB direct sovereign purchases, and now with just plain old out-and-out QE3 rumored to be on its way. Furthermore, QEs are also in operation with the BofE and the BofJ and other central banks concerned that capital flight to their currency will undercut their terms of trade. Hence, there is global impetus for central bank buying and money issuance in large numbers as depicted in the accompanying figure.

The equity price run up the last few months is fun while it lasts, but ultimately and fundamentally, if the government interest rate anchor for the financial markets is reduced to a rate that does not reflect its risk, and if further price distortions are introduced into the pricing of equity so that P/Es become transparently unsupportable by fundamentals (if anyone remembers what that is anymore), then expect to see investors seek to place their capital elsewhere.

If the government then attempts to head that off with capital outflow restrictions and more mandatory funneling of capital to the government’s cause, then we are into a full-fledged financial and economic repression. Europe is certainly much closer to that than the U.S., but if there is a buyers strike of government debt here (China has removed itself from accumulating Treasuries), it will eventually repress the economy here as well. We will be no different than the LDCs that self-inflicted decades of pain, as explained by professors Shaw and McKinnon, and history will indeed have repeated.

 

 

The Anatomy of a Financial Meltdown

The Euro debt situation continues to deteriorate and the U.S. is not far behind. All the distress that is now focused on government debt comes from excessive private indebtedness as developed world countries seek to support the private sector. This has shifted the debt burden to the government sector, and now the government is the problem, not the solution. This is the outcome of a debt-bloated economy. For more background on this topic, I recommend that you watch the splendid discussion I had with Dr. Lacy Hunt a week ago — the video, “The Morass of Debt,” is linked and posted below. It covers the extreme difficulty of resurrecting an economy that has a debt overload. Regarding the Greek debt containment status, consider the following;

The grand containment scheme — as noted in the previous two posts, “Why These People Are Smiling” and “As Greece Goes So Goes Europe: How the Unthinkable Happens” — continues to deteriorate. Cover-ups tend to unravel when there is a hole so large and getting larger relative to the resources available to fill it; this happens even faster when the cover-up involves so many moving parts and requires so many volunteers to take the hit, particularly when there are strong private incentives not to volunteer. A partial list of the unraveling of the past week is as follows:

The banks that were to rollover Greek debt at ridiculously low yields, considering their risks, have largely already dumped their bonds to get out of the charity business.

The rating agencies have shown some backbone (or creditability survival instincts) by downgrading Portugal and Ireland to junk, expanding the necessary cover-up.

Depositors are fleeing Greek banks (and probably others, as short-term funding rates in Europe rise), creating a liquidity crisis in which banks are loath to lend to other banks for fear of a default. A liquidity crisis morphs into a solvency crisis if banks are forced to dump bad assets at the already depreciated market terms and dump otherwise good assets at deep discounts to fund the deposit withdraw. Each asset sale is noted by the bank accountants as a reduction of income and capital.

Greece and other Euro banks are under a depositor flight that used to be called a bank run. The ECB is called in to lend to these banks, but the rules require investment-grade collateral for these loans. Since the banks do not have unpledged investment-grade collateral available, the ECB has indicated that it would accept virtually any opinion of quality (besides those of the three major rating agencies, which are now being realistic) to qualify as lawful collateral. The standards are depreciating, and the ECB will be left holding the bag of bad assets, adding to the loss of confidence in holding wealth denominated in the Euro.

To make matters even worse, a new bank stress test is supposedly being released that will make some ludicrous assumption of the value of government bonds. It is an intended cover-up of the situation and will add to Knightian Uncertainty —increased uncertainty from not having the facts to evaluate the risk causes depositors to flee and markets to sell off banks’ stock, making it impossible for banks to raise replacement capital of any form, except for the charity of the central bank.

In order to prevent financial insurance claims, the rules of the game are being altered. A “limited” Greek debt default is being created for the “volunteer” banks that are being forced to roll over Greece’s debt at below-market yields. The” limited” designation is to provide the basis for the argument that all other Greek debt outstanding is good, hence protecting against a financial insurance payout. We’ll see if that holds up in court as those who took out insurance want it to be paid — but that will be much later.

And now, Italy has come into focus as the second “I” in “PIIGS.” The market is turning against their bonds.Lastly the IMF, now under the former French finance minister (as of a week ago), is hardening its terms to provide budgetary help to Greece. It sea former classmate of mine, as the outgoing IMF acting managing director, pushed through a higher hurdle for Greece’s lending before the arrival of the Madame from France. Furthermore, the IMF is sticking to it as the developing countries are in the process of reining it in to prevent it from being an exclusive developed world slush fund.

There is more trouble for Greece and the PIIGS: Not only do they have debt that can’t be sold in the market and political inability to contain deficits, but the veterans of sovereign defaults from Argentina looked at the situation and claim the Greek situation is DOA (my interpretation). They point out that even if all Greek debt were somehow to disappear via default without any compensation to the debt holders whatsoever, Greece still runs a fiscal deficit.

Furthermore, in a very insightful piece, John Gilbert of GR-NEAM questions the sustainability of Greece and Portugal’s economies apart from the burden of past, present and future debt. It seems these countries have an extreme dependence on foreign energy that causes their trade deficit to balloon when oil approaches its current $100-a-barrel price tag. That is, apart from debt, these economies are toast because they can’t export enough to pay for imported energy.

Lastly, the distressed Greek assets are not finding eager buyers who are ready, willing and able to pay what Greece had hoped for.

All of the above components are the makings of a financial crisis on par with the Lehman weekend. The banks’ condition no doubt will be favorably spun with the new stress test, and the market will still run the banks. Even the Federal Reserve is making noises about the possible need for a new QE this week (what a retreat from last week), pinning the problem on slow U.S. economic growth. But the Fed’s real intention, it seems to me, is to be poised to be lender of last resort to back up the ECB as depositors flee banks here and abroad, as they did in 2008 in amounts greater than $1 trillion.

This is the outcome of a leveraged financial system that has taken a large position in an asset category (government bonds) that has subsequently been deemed to be risky: It all cascades down. The financial institution assets depreciate, and the liability side of bank balance sheets is compressed when depositors run and the banks’ capital account is written down.  The market forces them to face the reality that neither the banks nor their governments wanted to face. Financial gravity ultimately wins despite the best and deceitful government efforts.

One aside: When Mexico was faced with a similar situation in 1982, banks were failing and depositors were fleeing. The response was to beef up the containment package by requiring government permission to exchange local currency for foreign currency, and on top of that, all banks were nationalized so the government could determine who was withdrawing pesos in a capital flight. Unless you stay one step ahead of regulation, you risk becoming a “volunteer” to help out the banks. I think most have had enough of that.

Now the important and relevant question is where the private wealth will flee. It is the question of the systemic flight to quality asset. The usual response, as it overwhelmingly was in 2008, was the U.S. dollar and the U. S. Treasury — but that depends on the perceived riskiness of the U. S. situation, which is not likely to be resolved before the Euro situation comes to a head. So it appears the answer will be that wealth will not flee to the usual places even if a U.S. debt ceiling deal is done on time.

This is a vital issue and I am working on an analysis of it, as all investors need a safe haven asset if they wish to preserve their wealth. Euro bank deposits are obviously not it, and U.S. investors might be shocked to understand that the usual “risk off” asset of money market funds is also not the safe haven it once was.