Why did Gold and Silver Plunge? No, It's Not CME Margin Hikes; What will the Fed do Next?

Many people have asked me to comment on the plunge in gold and silver. First let's take a look at the wrong answer: Case Closed: CME Hikes Gold, Silver, Copper Margins
And there you have it: CME just hiked gold margins by 21%, silver by 16% and copper by 18%. Mystery solved.
Sorry Tyler, wrong answer.

Four Reasons for Metals Plunge

  1. Fed did far less than expected
  2. Mutual fund redemptions
  3. Margin calls at hedge funds
  4. China growth story fading

1. Fed Did Far Less than Expected

The Fed did not do what everyone thought, which is to say something far more than "Operation Twist".

As noted in advance, I explained why the Fed wouldn't do more than Operation Twist, in Six Things the Fed May Announce Tomorrow (But Likely Won't); Would Any of Them Matter? Gaming the Reaction.

In short, the Fed did not print, or even threaten to print. Moreover the Fed committed to a strategy not through the end of this year, but all the way through June of 2012. Perhaps the Fed does more in the interim, perhaps not.

For those expecting drama, the Fed's non-action was decidedly bearish for commodities in general, even gold.

2. Mutual Fund Redemptions

Mutual fund cash levels are at or near record lows. In general, mutual funds were not prepared for the market selloff and sell orders came in. Rather than sell garbage like Bank of America at $6, mutual funds unloaded stuff like gold, taking profits.

3. Margin Calls at Hedge Funds

Hedge funds unloaded gold and silver for the same reasons as mutual funds, but also because they mistimed the play and what Bernanke would do. Leverage works both ways.

4. China Growth Story Fading

Commodities in general have been clobbered along with currencies of commodity producing countries because the global economy is slowing rapidly.

As in 2008 there will be no decoupling. China is not a growth engine in any real sense of the word. Instead, China desperately needs demand from the US and Europe. Moreover, China is overheating and has a huge property bubble to boot, at precisely the wrong time. Commodities were set to plunge on the China story alone.

Metals Volatility

In the wake of increased volatility related to the above, the CME hiked margins. That likely added to the volatility but was not a fundamental "cause" of the plunge in precious metals.

What will the Fed do Next?

"Bay of Pigs" asks ...

Mish, Any thoughts on what the FED will do next? I doubt they sit there and do nothing.

Thanks Bay. That was a good question. This is why:

1. It is a single question, not five questions
2. It is a question on topic
3. It is a question I have not explained 10 times already
4. It is macro-based, not stock specific
5. It seeks an honest opinion rather than asking for something that may take hours of research


Problems for Bernanke

Market expectations were clearly for the Fed to do more. Goldman Sachs was shocked at the market reaction, I was not. See Goldman Surprised by Reaction to "Operation Twist" for details.

The problem for Bernanke is every action he may take now has serious negative ramifications. Fort example, take Operation Twist: The flattening of the yield curve may (I doubt it) help mortgages by lowering mortgage rates. However, the flattening of the yield curve will without a doubt hurt banks struggling to make profits on spreads.

The flattening of the yield curve also hurts those on fixed income as well as pension plans with 8.5% or so yield assumptions. The irony is pension plans might have gotten big returns had they been in treasuries, but they weren't because treasury yields were "too low".

Instead, pension plans all plowed into foreign bonds, commodities, currencies, and global equities to make their 8.5% assumptions.

So what is Bernanke to do?

See Bernanke, a Complete Dunce, "Puzzled by Weak Consumer Spending" for more on how the self-proclaimed student of the great depression is clueless about the current depression.

Bottom line: The Fed is more or less out of bullets. Moreover, Bernanke admitted he does not know why his policies are not working even though it is perfectly obvious.

When backed in a corner, Bernanke may conceivably try nearly anything. However, Bernanke is just not that desperate yet. Right now, European banks are at far greater risk than US banks so Bernanke may easily bide his time.

Silver Daily Chart

Silver, once again, is acting more like a leveraged commodities plaything than a currency.



I traded all my silver for gold on April 27, as noted in Taking Silver Profits - Swapping Silver for Gold.

Gold is still higher than my swap point.

At the time, I commented "I believe the price of silver is highly likely to revisit the low $20's at some point. Thus, I see no point in chasing silver higher here. Moreover, except for pure speculation, I see little reason to even hold silver in this spike."

I really do not know if silver hits the low 20's or not, but I was not tempted by that previous decline to near $32. Had I bought it there, I made a mental sell at $40. Silver got all the way to $44 and to be honest I was wondering if it would take out my swap point.

Silver breached $30 today.

As I have commented many times, silver is a far riskier play than gold. I believe this volatility proves my point.

CME margin hikes are not a cause of 40% collapse in silver from the top.

No Hiding Places

On September 19th I wrote No Hiding Spots Except Despised US Dollar: Equities Red, Metals Red, Energy Red, Grains Red
No Hiding Spots Except Despised US Dollar

If you have not done so already done so, please consider the possibility there will be no hiding spots except for US dollars and short-term US treasuries (yielding nothing) in a renewed strong downturn.

I expect gold to hold up in a major decline, but I could easily be wrong. One encouraging sign is the $HUI gold miner index is down less than a percent even though gold is down by 2% and the S&P and Dow are down by almost 2% as well.
Short-term, I have been wrong about gold holding up. Then again, I really do not concern myself with short-term action. Moreover, gold is higher than it was the day I swapped it. The equity markets in general sure are not.

Bernanke Will React

It's a safe bet Bernanke will react, we just do not know when. Things may (or may not) get ugly for miners (especially silver) in the meantime.

Those with cash, should be rooting for a selloff in gold and miners. In the meantime, hold a core position in gold. Take profits on big spikes and buy big dips.

At some point that advice will stop working, I just do not think this is the time.

Mike "Mish" Shedlock
http://globaleconomicanalysis.blogspot.com
Click Here To Scroll Thru My Recent Post List

Eurozone Breakup Logistics (Never Believe Anything Until It's Officially Denied)

In his latest Email update, Michael Pettis at China Financial Markets discusses the in more detail the likelihood of a Eurozone breakup.

Until the label "End Pettis", what follows is from Pettis and anything in blockquotes (indented) is a reference that Pettis quotes.

Logistics of Denial by Michael Pettis

Slow growth is embedding itself solidly into the US economy and the bond mayhem in Europe continues. The external environment for China is getting worse. This will almost certainly make China’s adjustment – when Beijing finally gets serious about it – all the more difficult.

With still weak domestic consumption growth, and little chance of this changing any time soon, weaker foreign demand for Chinese exports will cause greater reliance than ever on investment growth to generate GDP growth.

Europe’s travails in particular can’t be good for exports. What’s worse, it’s now pretty much official that the euro will fail soon enough. We have this on no less an authority than Angela Merkel. Here is what Thursday’s Financial Times says: Merkel Promises Euro Will Not Fail
Angela Merkel, German chancellor, declared on Wednesday that “the euro will not fail” after the country’s powerful constitutional court rejected a series of challenges to the multibillion-euro rescue packages agreed last year for Greece and other debt-strapped members of the eurozone.

In a passionate restatement of Germany’s determination to defend the common currency, the chancellor welcomed the court’s judgment as “absolutely confirming” her government’s policy of “solidarity with individual responsibility”.
First Rule of Politics

No, I didn’t misread the article. I just have a very different understanding of the logistics of a denial. Last year, for example, I wrote on my blog about ferocious denials by both Spain and Portugal that they would need any official help in funding themselves. But according to one of my favorite British television comedies, Yes, Minister, an official denial means something very different from what is intended.

“The first rule of politics,” Sir Humphrey, the wily civil servant in the show, insists is: “never believe anything until it is officially denied.”

I don’t want to sound too glib or too jokey, but I wonder if there has ever been a forced devaluation that wasn’t preceded by ringing assertions from presidents and central bank governors that under no circumstance would the currency ever devalue.

What is all the more interesting is that I recently discovered that the quote “never believe anything until it is officially denied” doesn’t originate with the writers of the British TV comedy. Apparently it can be traced to at least as far back as Otto von Bismarck, who was born not too far from where Angela Merkel grew up. Never believe anything until it is officially denied, the Iron Chancellor warned us.

An Interesting Proposal

So if Germany’s Iron Lady is now denying that the euro will fail, can its failure be far off? It depends I guess on what we mean by failure. If any important reversal in the structure and membership of the euro is a failure, then it will almost certainly fail, but I suppose there are many ways the euro project can be transformed without quite calling it a failure.

At the end of last month Hans-Olaf Henkel, for example, the former head of the Federation of German Industries, had an interesting OpEd in the Financial Times. In Sceptic's Solution he says:
Having been an early supporter of the euro, I now consider my engagement to be the biggest professional mistake I ever made. It would be misleading to proclaim there is an easy way out. But it is irresponsible to maintain there is no alternative. There is.

The end result of plan “A” – “defend the euro at all cost” – will be detrimental to all. Rescue deals have led the eurozone on the slippery path to the irresponsibility of a transfer union. If everybody is responsible for everybody’s debts, no one is. Competition between politicians in the eurozone will focus on who gets most at the expense of the others. The result is clear: more debts, higher inflation and a lower standard of living. The eurozone’s competitiveness is bound to fall behind other regions of the world.

As a plan “B” George Soros suggests that a Greek default “need not be disorderly”, or result in its departure from the eurozone. But a Greek default or departure from the eurozone implies risks too high to take. First in Athens, then Lisbon, Madrid and perhaps Rome, people would storm the banks as soon as word got out. A “haircut” would not improve Greece’s competitiveness either. Soon, the Greeks will have to go to the barber again. Anyway, we now talk also about Portugal, Spain, Italy and, I am afraid, soon France.

That is why we need a plan “C”: Austria, Finland, Germany and the Netherlands to leave the eurozone and create a new currency leaving the euro where it is. If planned and executed carefully, it could do the trick: a lower valued euro would improve the competitiveness of the remaining countries and stimulate their growth. In contrast, exports out of the “northern” countries would be affected but they would have lower inflation. Some non-euro countries would probably join this monetary union. Depending on performance, a flexible membership between the two unions should be possible.
I think Henkel is right, although I think the likelihood of Europe’s adopting his Plan C is pretty small. Still, it is interesting to consider why he might be right.

Damned Either Way

The problem is that if Spain leaves the euro and returns to the peseta, it will be caught in a downward currency spiral like the ones suffered by Mexico in 1982 and 1994 and Korea in 1997. In both cases the currency plunged by far more than the amount of its theoretical overvaluation. This happened because a substantial portion of Mexican and Korean debt was denominated in foreign currency. Of course once Spain revives the peseta, it will be in a similar position – with a lot of its debt denominated in euros, which will become a foreign currency.

What does external debt have to do with the extent of the devaluation? Quite a lot, it turns out. Mexico and Korea (and a host of others examples) remind us that when a country is forced to devalue, the amount of the devaluation is not necessarily in line with estimates of the amount of overvaluation.

I would argue that Spain probably suffers from 15-20% overvaluation, but once Spain returns to the peseta the peseta will not devalue by that amount. It will devalue by at least 50%, and probably a lot more. Why? Because of the self-reinforcing relationship between the currency and external debt.

It always works the same way when a country with a lot of external debt devalues its currency. As the peseta devalues, Spain’s external debt will rise in tandem since it is denominated in the appreciating currency. Since Spain is already believed to be overly indebted, as the debt rises relative to domestic assets, Spanish credibility will decline quickly and financial distress costs will rise.

But of course as credibility declines and defaults rise, the peseta will drop even more as investors flee the currency and as domestic borrowers with euro-denominated debt try to hedge the currency risk. This will go on in a self-reinforcing way until the currency has been crushed. In the end, for Spain to leave the euro would probably cause its external debt to more than double – perhaps even triple – as the peseta falls. Of course it will be forced into default within days or weeks.

This, by the way, is not an argument for Spain to stay in the euro. If Spain stays in the euro we will still arrive at default, but much more slowly, and mainly at first through a grinding away of wages and economic growth over many, many years and a gradual building up of debt as Germany refinances Spanish debt at interest rates that exceed GDP growth rates. The default will occur anyway, but only after years of high unemployment.

This is why I think Henkel’s proposal makes sense. Rather than have Spain leave the euro, Germany can leave the euro. The new German currency would automatically appreciate and the euro would depreciate, but without the terrible debt dynamics, the adjustment in the currency value would be much closer to the theoretically correct adjustment. The relative adjustment would probably be in the 20% range rather than in the 50% range.

Of course German banks would still have a problem. Their deposits would be in the form of the new German currency, and a lot of their loans – all those to Spain, for example – would be in the depreciating euro, and so they would take large losses. But at least the losses will be less – and more importantly the process will be more orderly – than if Spain simply leaves the euro and defaults.

One way or the other Germany is going to take a pretty big hit. It is a complete waste of time trying to figure out how to avoid it. It would be far more constructive to resolve the problem as quickly as possible in as orderly a manner as possible, and as any good Minskyite would tell you, that means we have to pay special attention to the balance sheet dynamics. That’s why I think Henkel’s proposal is an interesting one.

Of course the really interesting thing about Henkel’s proposal (at least to me) is to figure out what decision France would make if something like this happened. If France remained within the euro (i.e. “peripheral” Europe in Henkel’s scenario), the possibility of a United States of Europe would be forever dashed, but it would almost certainly be replaced with a two-entity Europe – the United States of Germany and the United States of France, or perhaps, for those who like 19th Century monetary history, the new Zollverein and the new Latin Union.

End Pettis - Start Mish

There is much more in Pettis' email including a discussion of trade, the irrelevance of China's trade agreements conducted in the Yuan (a point I emphatically agree with) and competitive currency devaluations by Switzerland.

The post will be up on his blog shortly.

I raised the possibility that Germany would leave the Eurozone some time ago, and I am sure others have as well.

However, it was interesting to see detailed reasons from a former EuroBull (Hans-Olaf Henkel not Pettis), as to why option C makes sense.

Is it Plan B or Plan C?

Ironically, the longer everyone sticks with plan “A: defend the euro at all cost” remain, the more likely Plan C is, because plan A cannot possibly last.

Eventually someone will leave.

Pettis Speculates on what France would do in a breakup. I think the answer is easy enough, or rather we will know the answer soon enough.

French President Nicholas Sarkozy May Be Ousted in Preliminary Voting

In French elections, the top two candidates face a runoff in the national elections. France 24 reports New poll shows far right could squeeze out Sarkozy
Marine Le Pen, leader of the anti-immigration National Front (FN), is projected to win enough votes to knock out President Nicolas Sarkozy from the second round of next year’s all important 2012 presidential election, the French daily Le Parisien's revealed on Thursday.
Marine Le Pen Says "Let the Euro Die"

The results for Le Pen are very interesting because of her stance on the Euro. Via Google Translate, please consider M. Le Pen says "let the euro die".
We must "let the euro die a natural death," means of reassuring the markets and revive the economy, said the president of the Front National Le Pen Marine, interviewed this morning on France Info.

Asked about the remedies it proposes to end the economic crisis, she said that we must "first stop bailouts repeat: there was Greece, now there will be Cyprus, Italy, the Spain ... " "There are masses of savings to do," she said, particularly expenses related to immigration. "The cost of the AME (State medical assistance for undocumented) explodes, there are 20 billion euros of social fraud against which nothing is done," she added, saying that "of 60 Vitale million cards, 10 million are false, that qualify for benefits unjustified ".

The market clearly says "Time's Up", yet politicians cannot agree on one major thing, and to top it off, voters are fed-up with austerity measures, bailouts, and politicians.
Clearly Le Pen is an anti-Euro, anti-immigration candidate and that is just the kind of message that can easily catch fire in this environment.

Elections in Germany or France may seal the direction, unless we see exodus by countries before the election.

Plan B and Plan C?

Do not rule out Plan B and Plan C. By that, I mean Greece leaves, and everyone else initially stays on until an election in Germany or France seals the deal for plan C.

Thus, I am more optimistic for Plan C than is Pettis. However, there will be more pain involved than necessary because Merkel and Sarkozy will stay with plan A until they are booted out of office.

Both will likely be gone soon enough (along with Italy Prime minister Silvio Berlusconi and Greece Prime Minister George Papandreou). Spain's Prime minister Jose Luis Rodriguez Zapatero has already indicated he will not seek reelection.

Look for a new set of leaders in Italy, Greece, and Spain, and probably France and Germany. Also look for those leaders to win on platforms far different than the "bail out the bondholders at all costs" platform of Merkel and Sarkozy.

Mike "Mish" Shedlock
http://globaleconomicanalysis.blogspot.com
Click Here To Scroll Thru My Recent Post List

Bernanke's Waterloo; Midst of Deflationary Collapse or Brink of Inflationary Disaster? 12 Specific Recommendations

The September Contrary Investor It's A Long Hard Road is an exceptional marriage of debt-deflation concepts, long-wave K-Cycles, credit cycles, and Austrian economic thinking. Here is a lengthy snip of several key points with permission.
If there has been one consistent theme since day one at CI, it has been our perhaps near myopic focus and focal point highlight of importance that is the macro credit cycle. Does this play into long wave and perhaps Kondratieff cycle or Austrian economics type of thinking? Call it what you will, but elements of all of these schools of thought very much overlap. Right to the point, we believe THE key thematic construct to keep in mind as a macro cycle decision making overlay and character point dead ahead is the now more than apparent collision of the generational long wave credit cycle with the current short term business cycle of the moment. Without trying to reach for melodrama, this is the first time a multi-decade long wave credit cycle has collided with the short-term business cycle since the late 1920’s/early 1930’s. Most decision makers and Street seers of the moment have absolutely no experience with this type of a generational collision. Moreover, our illustrious academician Fed Chairman has never even considered long wave or credit cycle based Austrian economics thinking in his and the broader Fed’s policy making – absolutely key and crucial mistake. Although it’s just our perception, this will be Bernanke’s legacy Waterloo. It also tells us directly that his only policy tool ahead will be more money printing.

We suggest to you that macro credit cycle issues did not end in 2009. Certainly Europe is a poster child example of this thinking, but it absolutely also applies to what lies ahead for the domestic US economy. We’ve only had a reprieve from long cycle reconciliation over the last few years due to historically unprecedented Government and Federal Reserve balance sheet levering, which itself is unsustainable longer term. Has the election cycle played havoc with needed deleveraging reconciliation and simple identification of the underlying causes of current circumstances? Without question. Although it’s clearly a personal comment, we’ve been disgusted with the short-term focus and actions of politicians at the expense of longer cycle strategic domestic economic thinking and needed financial reconciliation. These actions simply guarantee the deleveraging process will play out over a longer period than may otherwise have been the case. A very important construct with direct implications for the tone and rhythm of the domestic economy over time.

The top clip of the following chart is probably the one graphic we’ve published the most times over our short existence. Total US credit market debt relative to GDP. As is more than clear, the process of total credit cycle reconciliation has barely begun.



The bottom clip of the chart is one you’ve seen a number of times from us and we believe quite important to what lies ahead. To the point, real final sales to domestic purchasers is GDP stripped of the influence of inventories and exports. What we’re left with is as good look at domestic only GDP and as you can see, the year over year change in terms of growth in the current cycle is the weakest of any initial economic recovery cycle over the time in which official numbers have been kept. Message being? We are seeing very weak aggregate demand, exactly as one would expect in a generational credit cycle reconciliation process.


We also need to remember that THE primary goal of the Fed and politicians has been to thwart the generational credit cycle deleveraging process to the best of their abilities while it is occurring, all in the interests of being reelected. So as you look at the bottom clip of the chart above, remember that this is the growth in domestic economic activity in the current cycle that has occurred while the Government has borrowed $5 trillion and used the proceeds for increased transfer payments, cash for clunkers, help for those with mortgage problems, deals for appliances, etc. And yet still we’ve experienced incredibly subdued domestic economic activity. Just what would this have looked like in the absence of historic Government balance sheet leveraging?

Monetary Policy Useless in Deleveraging Cycles

Although it appears obvious conceptually, we're not so sure the markets yet fully appreciate the fact that in true generational deleveraging cycles, monetary policy is powerless to influence credit expansion. Again, our near myopic focus on credit is driven by the fact that credit is the cornerstone of modern economic development and balance, and certainly not just in the US. The character, availability and price of credit regulate the ongoing tone of aggregate demand, so monitoring credit is simply crucial. If credit cannot expand, then neither can aggregate demand. A simple yet key truism, especially in our current circumstances. As you can see below, we've seen literally unprecedented monetary expansion so far in the current cycle, yet private sector credit creation (as is exemplified by the bank loans and leases outstanding) remains wildly subdued at best. The whole pushing on a string thesis? Exactly.



The bottom clip of the chart above has been adjusted for the $450 billion of off balance sheet bank loans that were mandated to arrive back on bank balance sheets as per FASB dictates in April of last year. As is clear, bank loans and leases out since early 2009 have declined significantly. The bulls have trumpeted the growth over the last three months. You can decide for yourself whether this minor uptick is deserving of trumpeting, if you will. To ourselves the message appears absolutely crystal clear. In generational deleveraging cycles, Fed monetary policy is simply a non-event. Rather monetary extravagence finds its way into inflation hedge assets and can be used simply to speculate. Remember, as per Fed monetary largesse, the banks are sitting on $1.5 trillion of excess reserves as we speak. Excess reserves can be used as collateral for derivative and futures trading. You already know trading profits have been a crucial piece of bank earnings since 2009. As of now, monetary policy has been completely ineffective in the current cycle in creating credit - the lifeblood of economic activity and growth - except in one instance. And that instance lies below. Of course we are referring to Government debt.



In typical recessionary periods past, the Fed has been able to lower interest rates and stimulate demand for credit. Demand for credit ultimately stimulates broad economic activity via an increase in aggregate demand. But in deleveraging cycles as opposed to typical business cycles, interest rates can fall to zero and still not positively influence demand for credit. This is exactly what has occurred in the current cycle. You may remember from our discussions over the years we asked one question again and again, "is this a business cycle or a credit cycle?" The only borrower of substance in the current cycle has been the Federal Government, yet we are currently reaching the limits of Government balance sheet expansion tolerance, as clearly witnessed by the debt ceiling melodrama. This has only served to weaken the US as a credit. Again, the inability to generate demand for credit by almost any means (and in our present circumstance historic means) is simply a classic fingerprint of a generational deleveraging cycle.

Bernanke No Student of History

Never in modern history have we faced the type of domestic labor market circumstances we face today. As we've tried to describe, monetary policy is powerless to change this. If Mr. Bernanke was the true student of history he would fully realize exactly the circumstances we've described. It's not that we don't have precedent. The US in the 1930's and Japan over the last two decades are the model. Looking at the Depression years and claiming the issue was that the Fed was not loose enough misses the key fingerprint character points of a generational deleveraging cycle completely. Again, the refusal of Bernanke and friends to even acknowledge Austrian or Kondratieff economic constructs has been and will continue to be their policy making downfall. Who knows, maybe all of this will find its way into the economics textbooks of tomorrow. Let's hope so anyway for future generations. But as the old market saying goes, people don't repeat the mistakes of their parents, they repeat the mistakes of their grandparents.

Government and Fed policy has been aimed at fostering credit creation up to this point. Fed money printing and Government borrowing has been undertaken in an attempt to stimulate credit creation and likewise spark broad reacceleration in consumption. Certainly Government and Fed actions have also been an offset to the contraction in private sector (think financial sector) credit so far in the current cycle. As of now, unprecedented Fed actions have acted to both devalue the dollar and suppress interest rates. But in a generational deleveraging cycle, the Fed is ultimately impotent in terms of being able to successfully spark private sector credit creation that would lead to expansion in aggregate demand and macro GDP growth.

But what has occurred as a result of Fed and Government "solutions" again is a classic macro deleveraging cycle response - a devalued currency and negative real interest rates has driven investors into inflation hedge assets such as gold, oil, ag assets, etc. at the margin. As opposed to having achieved the stated goal of fostering employment growth, credit creation and raising aggregate demand, etc., Fed QE has essentially succeeded in raising the cost of living in a cycle characterized by generational labor market and direct wage pressure among the middle and lower class wealth demographic. From a broad perspective, has Fed and Government policy actually done more harm than good? It simply depends where one sits amidst the wealth demographic pyramid of life. Policy has been fabulous for Wall Street and the banks, but not so fabulous for the average household. The average household has faced vanishing interest income and negative real wage growth amidst an environment of a meaningfully rising cost of every day living (food and energy prices).

Policy has been counterproductive because policy makers continue to focus on short term outcomes as opposed to longer term structural remedies. Remember, people repeat the mistakes of their grandparents, not their parents. Mr. Bernanke is apparently an "expert" on the actions of "grandparents", yet he is very much repeating their same mistakes by his implicit refusal to even consider Austrian/Kondratieff like economic ideas. You already know, THE key character point of successful investors over time is flexibility in outlook and behavior. It's just a shame we can't clone that character point inside the Fed and Administration at present. But of course that would be counterproductive to the interests of Wall Street and the big banks.
Credit Cycle Understanding is Key to Returns

There is much more in the Contrary Investor article. I excepted the ideas pertaining to credit.

It is very refreshing to see someone else writing about debt deflation and how powerless the Fed is to stop it. Instead, we see article after article by people touting high inflation, even hyperinflation.

Hyperinflation is complete silliness at this point. Were it to come, it would be an act of Congress that would create it, not an act of the Fed, and the Fed would probably have to play along. I doubt the Fed would. For all its many faults, the Fed does not want to destroy banks. Hyperinflation would do just that.

The Republican dominated House wants little or nothing to do with more stimulus. Certainly US government debt is going to mount, but it is going to mount in Japan, the Eurozone, and the UK as well.

Moreover, Eurozone structural issues matter now, while US government debt will matter more in the years to come.

Midst of Deflationary Collapse or Brink of Inflationary Disaster?

Although the Keynesian and Monetarist economists have missed the boat on what is happening and why, Austrian minded folks who fail to understand the importance of credit and how little the Fed can do to revive it have blown the call as well.

It pains me to see articles like On the Brink of Inflationary Disaster by Austrian economist Robert Murphy.

We are clearly in the midst of a deflationary collapse as noted in Yes Virginia, U.S. Back in Deflation; Inflation Scare Ends; Hyperinflationists Wrong Twice Over

Focus on Money Supply Alone is Fatally Flawed

Deflation is about credit, it is also about attitudes that govern the demand for credit.

As I have stated many times over the years, and as stated above in the Contrary Investor, there is nothing the Fed can do to force businesses to expand or banks to lend.

That point explains why Austrian economists who focus on money supply alone have failed and will continue to fail.

Until consumer demand returns, businesses would be foolish to expand. Unfortunately, the Fed's misguided easing policies have stimulated commodity speculation thereby increasing manufacturing costs, while simultaneously clobbering those on fixed income and reducing final consumer demand.

I wrote about the plight of those on fixed income in Hello Ben Bernanke, Meet "Stephanie" back in January. Please give it a read if you have not yet done so.

The Deflationary Hurricane of Deteriorating Social Mood

One of the best posts recently on social mood and deflation is by Minyanville professor Peter Atwater.

Please consider The Deflationary Hurricane of Deteriorating Social Mood
This morning, in the aftermath of Fed Chairman Ben Bernanke’s speech on Friday, the editorial page of the Wall Street Journal noted, “Mr. Bernanke also lectured that ‘U.S. fiscal policy must be placed on a sustainable path,’ though not by cutting spending in the short-term. So the Fed chief joins the Keynesian queue of spending St. Augustines – Lord, make us fiscally chaste, but not yet.”

Everything we need to do for long-term economic, if not societal success and stability comes with very severe short-term consequences. And so the response of most policymakers (and not just those responsible for fiscal policy but also regulatory policemen like Mr. Bernanke himself) has been to advocate for short-term expansionary programs and rules, while postponing the real teeth of necessary change until some later date in the future. Basel III, for example, has a phased-in capital-strengthening requirement for the banking system that does not finish until 2019 – again, "chaste, but not yet."

I am sure that what is behind the thinking of policymakers is the notion that if we can just get through this tough “transitory” period, the economy will turn up; and at that point, whether it is fiscal or regulatory policy, our ability to handle constraints will be much, much easier to bear.

After 11 years of declining social mood, the notion that further monetary stimulus has limited use is hardly a surprise. As I have cautioned so many times, when it comes to the consumer it is not the depth of a recession that matters, but rather its length. And while for policymakers and financiers this may feel like a three-year-old recession (and for some even just a three-week-old recession!), for the American consumer this is a decade-old recession that has deteriorated well into a depression. The average American is now financially and emotionally exhausted. And given the news reports out of Washington over the past month, they are also now afraid that they are at risk of losing some or all of their government safety net, too. Like the children of fighting, divorcing parents, they are now fearful of what an increasingly uncertain future holds.

While further fiscal stimulus – particularly job-related initiatives – may slow the pace of deterioration, I am increasingly afraid that further fiscal and monetary policy actions are now impotent agents against our current social mood. Where in 2000, the future was so bright that we’d need shades, in 2011, the future for many Americans is so dark that they can’t see their way forward.

The consequence will be price deflation -- and not just further price deflation across those debt-dependent purchases like homes and automobiles, but across all categories of consumer goods. And for the first time since the 1930s, American businesses will see that lower prices are not always met with greater demand.
Price Deflation on the Way?

My definition of deflation is "a decrease of money supply and credit with credit marked-to-market". Judging by symptoms of deflation and Fed's efforts at fighting it, the US is back in deflation now by my measure. In my model, falling prices are not a requirement for deflation.

The important point is not definition, but rather the expected conditions. Yet, the conditions I expect and indeed the conditions in the US right now (in aggregate) match deflationary scenarios, not inflationary ones.

Murphy calls for an "inflationary disaster" while Atwater calls for "price deflation across all categories of consumer goods".

I do not know if we see across the board price deflation Atwater calls for given peak oil constraints and an inept US energy policy that also affects food prices.

However, I do expect to see falling education costs and falling medical costs as well as falling prices in a broad array of consumer goods and services, especially if Republicans can get a few sensible deficit measures passed.

Whether that scenario happens or not, the idea "brink of inflationary disaster" is complete silliness unless and until the Fed can revive credit, yet the Fed is powerless to do so.

So, unless Congress goes really haywire, attitudes will change and deleveraging will play out before the US experiences serious inflation. Unfortunately, Fed and Congressional policies have only served to lengthen the deleveraging timeline.

Those looking for hyperinflation or even strong inflation have missed the boat again, and again, and again, and will continue to do so, interrupted by periodic inflation scares until debt-deflation plays out.

Understanding the Deflationary Cycle

To understand what is happening, why businesses are not hiring, why housing is stagnant, and where the economy is headed, one needs a model that takes into consideration five key factors ...

  1. Mark-to-Market Measures of Bank Credit and Capitalization Ratios
  2. Credit Cycle Theory
  3. Attitudes of Banks, Businesses, and Consumers
  4. Futility and Limits of Keynesian Stimulus
  5. Futility of Monetary Stimulus

1 -Mark-to-Market Measures of Bank Credit and Capitalization Ratios

Banks cannot and will not lend unless they are not capital impaired and unless they have credit-worthy customers. Atwater noted Basel III was delayed until 2019. I noted on many occasions banks are still hiding investments off the balance sheets in SIVs and mark-to-market rules have been suspended several times.

As happened in Europe, delay tactics can only work for so long before the market questions if loans on the balance sheets of banks will ever be repaid. That time is now, not 2019. Thus banks are too capital impaired to take excessive risks, even if they wanted to. Moreover, too few credit-worthy businesses want to expand in the first place.

2 - Credit Cycle Theory

In accordance with long-wave, Kondratieff Cycle (K-Cycle) theory credit expansion and contraction cycles play out over decades. At least 75% of the time, continuously (not on and off), the economy grows in an inflationary manner. When deflation hits, few expect it because all many have known for their entire lives is inflation.

As long as consumers have ability and willingness to add debt an leverage, the Fed seems to have power to revive the economy via various stimulus efforts. Once a consumer deleveraging cycle starts, the Fed's power ends.

3 - Attitudes of Banks, Businesses, and Consumers

The willingness and ability of banks to lend and consumers to borrow and increase leverage is shot. Banks don't want to lend (or are to capital impaired to lend), and boomers are heading into retirement overleveraged in housing, without enough savings.

Consumers first thought tech stocks would be their retirement, then housing. Both dreams have been shattered. Consumers are now determined to pay down debt (saving), even if by outright default or walking away. Default and walking-away impacts banks willingness and ability to lend.

Think of attitudes like a pendulum. Attitudes can only go so far before they reverse. Housing reversed in 2007 as did the Nasdaq in 2000. Both reversed when the pool of greater fools ran out.

The Nasdaq is still nowhere close to old highs. These cycles last longer than most think. I expect housing will be weak for a decade once it bottoms, and it has not yet bottomed.

Finally, it's not just boomer attitudes that affect credit. Kids see their parents and grandparents arguing over debt, worried about bills, worried about jobs and vow not to repeat their mistakes. This point ties in with K-Cycle theory above.

4 - Futility and Limits of Keynesian Stimulus

Keynesian economists always want more, then more, then still more stimulus until the economy heals. Japan with debt-to-GDP ratio over 200% has proven such policies cannot ever work.

Keynesian economists always refuse to discuss the endgame, how the debt can be paid back, and what happens when stimulus stops.

The US has virtually nothing to show for all the make-shift, ready-to-go projects that temporarily put people back to work in 2009 and 2010. Not only did we repave roads that did not need paving, those hired still have debt-overhang and are still underwater on their houses.

All that happened was a delay in the day-of-reckoning. More Keynesian stimulus will only further delay the day-of-reckoning while adding to the national debt and interest on the national debt.

Priming-the-pump Keynesian theory will fail every time in a debt-deleveraging cycle. Indeed, it never works, it only appears to work until debt leverage is maxed out.

5 - Futility of Monetary Stimulus

As discussed above, monetary stimulus negatively affects the real economy for the temporary benefit of the financial economy and Wall Street. The tradeoff was not worth it except through the perverted-eyes of Wall Street.

Telling action in bank stocks says the limits of helping Wall Street may have even run out.

Many point to excess reserves as a sign of future inflation. I point to excess reserves as a sign of failed Fed policy. Commentary from Austrian economists shows they fail to understand how credit even works.

The idea those excess reserves are going to pour into the economy in a 10-1 leveraged fashion is simply wrong. Banks do not lend when they have excess reserves. Banks lend when they have credit-worthy borrowers, provided they are not capital impaired.

It is time Austrian economists finally wake up to this simple economic truth.

Academic Theory vs. Reality

Economists of all sorts stick to failed models.
  • The Monetarist currency cranks want more monetary stimulus even though it is counterproductive
  • The Keynesian clowns simply will not admit end-game constraints
  • The Austrians for the most part either ignore credit or incorporate failed models of credit expansion into their theories.

Each camp points the finger at the others as to why the others are wrong. Ironically, none of the camps seems to understand the combined mechanics of debt-deflation, deleveraging, and attitudes.

That said, I side with the Austrians about what to do (essentially let things play out, while implementing much needed structural reforms).

Twelve Specific Recommendations

  1. Banks and bondholders should take a hit. Banks are not going to lend anyway so bailing them out at the expense of taxpayers is both morally and economically stupid. End the bailouts, all of them, and prosecute fraud, the higher up the better.
  2. Implement serious bank reform now, not 9 years from now. Banks should be banks, not hedge funds. This proposal will necessitate breaking up banks. So be it.
  3. Scrap Davis-Bacon and all prevailing wage laws. Such laws drive up costs and have wreaked havoc on many cities and municipalities, now bankrupt or on the verge of bankruptcy.
  4. Pass national right-to-work laws. Once again, we need to reduce costs on businesses and local governments to spur more hiring and reduce costs.
  5. End collective bargaining rights of all public unions. The goal of unions is to provide the least service for the most money. The goal of government should be to provide the most services for the least money.
  6. Scrap ethanol policy and end all tariffs.
  7. Legalize hemp and tax it. Prison costs will go down, tax revenue will grow, and biofuel and fiber research will expand as hemp produces very soft fibers.
  8. Corporate income tax rates should be lower in the US than abroad. Current policy encourages capital flight and jobs flight via lower tax rates on profits overseas than in the united states. This penalizes businesses that work only in the US, especially small businesses that do not have an army of lawyers and lobbyists.
  9. Stop the wars and set a plan to bring home all US troops from Iraq, Afghanistan, and 140 or so other countries.The US can no longer afford to be the world's policeman.
  10. Implement Paul Ryan's Medicare voucher proposal. It is the only way so far that anyone has proposed that puts much needed consumer "skin-in-the-game" that will reduce medical costs.
  11. Legalize drug imports from Canada
  12. End the Fed and fractional reserve lending. Both have led to boom-bust cycles of ever-increasing amplitude.
Those are the kinds of things we need to do, not throw more money at problems. The latter does nothing but drive up national debt and interest on the national debt for short-term gratification.

Notice how counterproductive Fed policy is and how counterproductive Obama's policies are.

The Fed wants positive inflation but businesses have not been able to pass the costs on. Instead, companies outsource to China. Those on fixed income get hammered.

Fool's Mission

Obama wants to create jobs via stimulus measures. It's a fool's mission.

Prevailing wages drive up the costs, few are hired, and the cost-per-job (created or saved) is staggering. Money never goes very far because the US overpays every step of the way.

Stimulus plans that do not fix the structural problems are as productive as pissing in the wind. Then when the stimulus dies, which it is guaranteed to do, a mountain of debt remains.

Instead, my 12-point recommendation list will fix numerous structural problems, create lasting jobs, and reduce the deficit. What more can you ask?

Mike "Mish" Shedlock
http://globaleconomicanalysis.blogspot.com
Click Here To Scroll Thru My Recent Post List

Economic Crossroads of Immense Consequences: Will Governments and Central Bankers Bail Out Bondholders and Banks (again), or the Public at Large?

As noted previously, it is crystal clear to everyone but bankers and brain-dead analysts that banks need to be recapitalized, in Europe and the US as well.

The crucial question is "how?".

In 2008, US taxpayers bailed out AIG (Goldman Sachs really), Fannie Mae, Citigroup, Bank of America and scores more financial corporations of all sizes, too numerous to mention.

Why?

Ben Bernanke, Hank Paulson, Tim Geithner, Larry Summers, and a parade of bankers and ex-Goldman employees all said this had to be done to spur lending. It was a lie. The bailouts were nothing but a gigantic transfer-of-wealth scheme from the poor to the wealthy.

Banks are not lending because they are still capital impaired, even after the massive bailouts and Fed reflation efforts. Worse yet, corporations do not want to expand because the underlying problem of consumer debt has not gone away.

Similar Setup in Europe

A similar setup is underway in Europe, except it's sovereign debt not mortgages in the spotlight. As in the US, the ECB will not agree to let bondholders take a substantial hit, even though it is perfectly obvious Greece will default.

Greek 1-Year Yield Hits 82%



If 82% interest rates do not scream default, nothing does.

Yet Trichet and the Central Banks do nothing but insist on more austerity measures for Greece.

Yes, Greece has structural problems and they need to be fixed, but where is the written rule "Investing is Winning"?

Investing and Speculation have Risks

Investing and speculation have risks. Those who take risks should take responsibility, not taxpayers.

I salute Iceland and its taxpayers for telling the ECB, the IMF, and the rest of Europe to go to hell. The Icelandic economy is now in repair.

Eurozone Torture

In sharp contrast, Greece, Spain, Ireland, and Italy have nothing but torture to look forward to for the rest of the decade if taxpayers have to foot the bill for stupid loans made by banks.

The rationalization "we need to bail out the banks so they can make loans" has been disproved in spades. Of course anyone with any common sense knew it was a lie in the first place.

Will Bondholders Be Bailed Out Again?

Whether bondholders get bailed out again is the critical question. John Hussman picks up the discussion in An Imminent Downturn: Whom Will Our Leaders Defend?
The global economy is at a crossroad that demands a decision - whom will our leaders defend? One choice is to defend bondholders - existing owners of mismanaged banks, unserviceable peripheral European debt, and lenders who misallocated capital by reaching for yield and fees by making mortgage loans to anyone with a pulse. Defending bondholders will require forced austerity in government spending of already depressed economies, continued monetary distortions, and the use of public funds to recapitalize poor stewards of capital. It will do nothing for job creation, foreclosure reduction, or economic recovery.

The alternative is to defend the public by focusing on the reduction of unserviceable debt burdens by restructuring mortgages and peripheral sovereign debt, recognizing that most financial institutions have more than enough shareholder capital and debt to their own bondholders to absorb losses without hurting customers or counterparties - but also recognizing that properly restructuring debt will wipe out many existing holders of mismanaged financials and will require a transfer of ownership and recapitalization by better stewards.

In game theory, there is a concept known as "Nash equilibrium" (following the work of John Nash). The key feature is that the strategy of each player is optimal, given the strategy chosen by the other players. For example, "I drive on the right / you drive on the right" is a Nash equilibrium, and so is "I drive on the left / you drive on the left." Other choices are fatal.

Presently, the global economy is in a low-level Nash equilibrium where consumers are reluctant to spend because corporations are reluctant to hire; while corporations are reluctant to hire because consumers are reluctant to spend. Unfortunately, simply offering consumers some tax relief, or trying to create hiring incentives in a vacuum, will not change this equilibrium because it does not address the underlying problem. Consumers are reluctant to spend because they continue to be overburdened by debt, with a significant proportion of mortgages underwater, fiscal policy that leans toward austerity, and monetary policy that distorts financial markets in a way that encourages further misallocation of capital while at the same time starving savers of any interest earnings at all.

We cannot simply shift to a high-level equilibrium (consumers spend because employers hire, employers hire because consumers spend) until the balance sheet problem is addressed. This requires debt restructuring and mortgage restructuring (see Recession Warning and the Proper Policy Response ). While there are certainly strategies (such as property appreciation rights) that can coordinate restructuring without public subsidies, large-scale restructuring will not be painless, and may result in market turbulence and self-serving cries from the financial sector about "global financial meltdown." But keep in mind that the global equity markets can lose $4-8 trillion of market value during a normal bear market. To believe that bondholders simply cannot be allowed to sustain losses is an absurdity. Debt restructuring is the best remaining option to treat a spreading cancer. Other choices are fatal.

Greek debt races toward default

On Friday, the yield on one-year Greek debt soared to 67% [Mish note: On Monday it hit 82% as shown above]. Europe is demanding greater and greater austerity as a condition for additional bailouts, but austerity has already resulted in a depression for the people of Greece, and a loss of tax revenues that has paradoxically but very predictably resulted in even larger budget deficits.

To see the one-year yield leaping suddenly to 67% is an indication that we should brace for a very serious turn of events almost immediately.

One problem appears to be that European banks are eagerly volunteering for a 21% haircut on the debt (which is trading far less than that on the open market), but only in exchange for shifting the debt covenants from Greek law to more binding international law. This would be a bad deal for Greece, because it would essentially impose further severe austerity on the Greek people in return for a debt reduction that would still leave the debt/GDP ratio well above 100% and growing. Greece should reject this, because a larger default is inevitable, and it would serve the country best to maintain as much control over the size of the default as possible. Ultimately, my impression is that it would serve Greece best to exit the Euro, but it appears too late for this to be graceful.

What is particularly unfortunate is that all of this is unfolding in a very predictable way, but the constant attempts to ignore reality and defer the inevitable restructuring is imposing enormous costs on the public. As Ken Rogoff and Carmen Reinhart wrote two years ago in their book This Time It's Different, "As of this writing, it remains to be seen whether the global surge in financial sector turbulence of the late 2000s will lead to a similar outcome in the sovereign debt cycle. The precedent [a close historical overlap between banking crises and external debt crises in data from 1900-2008] however, appears discouraging on that score. A sharp rise in sovereign defaults in the current global financial environment would hardly be surprising."
Stimulus

By the way, unlike Hussman, I think the best stimulus measures would come from structural changes such as scrapping prevailing wage laws, slashing military spending, and ending collective bargaining of public unions, combined with a serious overhaul of Medicare.

If we are going to revamp infrastructure, it should be done sensibly and at the lowest cost possible to taxpayers. That means scrapping Davis-Bacon for sure.

Should Greece Exit the Euro?

Hussman writes "Ultimately, my impression is that it would serve Greece best to exit the Euro, but it appears too late for this to be graceful."

One might wonder what the consequences of that action might be.

In Euro break-up – the consequences UBS addresses that very issue. It's a 21 page PDF that interestingly begins with the statement "The Euro should not exist".

That's a true statement but the reason as UBS explains "the Euro as it is currently constituted – with its current structure and current membership – should not exist. This Euro creates more economic costs than benefits for at least some of its members – a fact that has become painfully obvious to some of its participants in recent years."

Simply put, currency unions without fiscal ties have never worked and the Eurozone as it exists today will not work either.

The report goes through an analysis of the costs if a strong nation pulls out (say Germany) and a weak nation pulls out (say Greece).

In the case of Germany leaving, the report states "If a strong economy like Germany leaves the Euro there arenon-currency trade consequences. The exit from the European Union raises potential trade barriers and border disruption. Further, the exit causes a growth shock to the rump Euro, which undermines the export potential."

This is the same conclusion of Michael Pettis as noted in Long-Term Outlook for China, Europe, and the World; 12 Global Predictions. Here are predictions 10-11.
10. Spain, other PIIGS Leave Euro

Spain will leave the euro and will be forced to restructure its debt within three or four years. So will Greece, Portugal, Ireland and possibly even Italy and Belgium.

The only strategies by which Spain can regain competitiveness are either to deflate and force down wages, which will hurt workers and small businesses, or to leave the euro and devalue. Given the large share of vote workers have, the former strategy will not last long. But of course once Spain leaves the euro and devalues, its external debt will soar. Debt restructuring and forgiveness is almost inevitable.

11. Germany Will Not Voluntarily Share Costs

Unless Germany moves quickly to reverse its current account surplus – which is very unlikely – the European crisis will force a sharp balance-of-trade adjustment onto Germany, which will cause its economy to slow sharply and even to contract. By 2015-16 German economic performance will be much worse than that of France and the UK.

For one or two years the deficit countries will try to bear the full brunt of the adjustment while Germany scolds and cajoles from the side. Eventually they will be unable politically to accept the necessary high unemployment and they will intervene in trade – almost certainly by abandoning the euro and devaluing. In that case they automatically push the brunt of the adjustment onto the surplus countries, i.e. Germany, and German unemployment will rise. I don’t know how soon this will happen, but remember that in global demand contractions it is the surplus countries who always suffer the most. I don’t see why this time will be any different.
Do monetary unions break up without civil wars?

UBS tackles an interesting question "Do monetary unions break up without civil wars?"
It takes enormous stress for a government to get to the point where it considers abandoning the lex monetae of a country. The disruption that would follow such a move is also going to be extreme. The costs are high – whether it is a strong or a weak country leaving – in purely monetary terms. When the unemployment

consequences are factored in, it is virtually impossible to consider a break-up scenario without some serious social consequences.

Past instances of monetary union break-ups have tended to produce one of two results. Either there was a more authoritarian government response to contain or repress the social disorder (a scenario that tended to require a change from democratic to authoritarian or military government), or alternatively, the social disorder worked with existing fault lines in society to divide the country, spilling over into civil war. These are not inevitable conclusions, but indicate that monetary union break-up is not something that can be treated as a casual issue of exchange rate policy
The likelihood of civil war seems remote.

However, I agree with the UBS statement "it is virtually impossible to consider a break-up scenario without some serious social consequences"

Investing in a break-up scenario

Inquiring minds may be wondering how to play this from an investment standpoint. UBS concludes ...
Our base case for the Euro is that the monetary union will hold together, with some kind of fiscal confederation (providing automatic stabilisers to economies, not transfers to governments).

But what if the disaster scenario happens? How can investors invest if they believe in a break-up, however low the probability? The simple answer is that they cannot. Investing for a break-up scenario has not guaranteed winners within the Euro area. The growth consequences are awful in any break-up scenario. The risk of civil disorder questions the rule of law, and as such basic issues such as property rights. Even those countries that avoid internal strife and divisions will likely have to use administrative controls to avoid extreme positions in their markets.

The only way to hedge against a Euro break-up scenario is to own no Euro assets at all.
Zero Hedge offers more comments in UBS Quantifies Costs Of Euro Break Up, Warns Of Collapse Of Banking System And Civil War

Warnings Everywhere

In case you missed it, please consider Trichet Warns Heads of States; Italian President Warns "Markets Lost Confidence in Italy"; IMF Warns again on Bank Capitalization; Mish Warns Trichet

Breakup or Not, Avoid Euro Assets

UBS does not think a breakup will happen. I think a breakup is quite likely, as does Michael Pettis. Timing is uncertain.

Regardless, avoidance of Euro assets seems wise for multiple reasons.

  • The ECB and Eurozone governments seem hell-bent on protecting bondholders and imposing severe austerity measures. Those will impede growth in Europe.
  • Trichet will be gone in October and will be replaced by Italian central bank head, Mario Draghi. Draghi will act to protect Italy and that may not be good for the rest of Europe.
  • Draghi is an ex-vice chairman and managing director of Goldman Sachs International. I presume we can guess whether he will act to protect banks and bondholders or promote growth.
  • Recapitalization of European banks is coming and it is likely to be painful, perhaps more painful than needed actions in the US.

Mike "Mish" Shedlock
http://globaleconomicanalysis.blogspot.com
Click Here To Scroll Thru My Recent Post List

Italy Backs Down on Austerity Measures; Bank of Italy Warns Tax Hikes Needed; German Central Bank Complains EU Treaty "Completely Gutted"

In the wake of fresh sex and bribe scandals of Italian Prime Minister Silvio Berlusconi as well as Italy's backing down on austerity measures, interest rates are once again creeping back up on Italy.



10-Year Italian Government Bond Yields







Italy Drops Plan to Tax Higher Earners From Austerity Bill



Bloomberg reports Italy Drops Plan to Tax Higher Earners From Austerity Bill

Prime Minister Silvio Berlusconi’s government has dropped a planned bonus tax on Italians earning more than 90,000 euros ($131,000) a year from a package of austerity measures that aims to balance the budget in 2013.



The levy will be replaced with other measures that aim to target tax evaders, Berlusconi’s office said in an e-mailed statement. The decision came after Berlusconi and Finance Minister Giulio Tremonti met with Northern League leader Umberto Bossi, a coalition ally that opposed some of the key aspects of the austerity plan passed by Berlusconi’s Cabinet on Aug. 12.



As a result of today’s agreement, the plan will also be modified to reduce the cuts in transfers to regional and local governments. The note did not give details of how the government would compensate for the lost deficit reduction from today’s changes.
Revenue Replaced in Unknown Way



Allegedly the revenue will be replaced in an unannounced, unknown way. Does anyone believe that?



Bank of Italy Warns Tax Hikes Needed



The Washington Post reports Bank of Italy warns government’s new austerity measures must raise taxes, cut spending

The Bank of Italy warned Tuesday that the government’s revamped austerity plan must not cut back on its original €45.5 billion ($65.9 billion) proposal to raise taxes and cut spending — and said even with the plan Italy risked economic stagnation.



Premier Silvio Berlusconi and his allies late Monday issued a revision of the proposed austerity measures after widespread public anger, deciding to scrap special tax on high earners and spare small town governments. The new measures tinker with retirement age and call for a reduction in the number of lawmakers.



The Bank of Italy’s deputy chief Ignazio Visco told parliament committees Tuesday that he hoped the market’s response to the revision “isn’t too penalizing.” He said the overall austerity measures “cannot be reduced” and will be monitored to ensure they’re being followed.



He warned that regardless of the measures, Italy still risked “a phase” of economic stagnation. Growth might be less than one percent this year and even less in 2012, making aims for a balanced budget more difficult, he warned.
Phase of Recession Not Stagnation



I remain in awe of cental bank ability to tell bald-faced lies. The idea that Italy will grow in 2011 and 2012 in the face of a global recession with additional austerity measures is nonsensical.



German Central Bank Complains EU Treaty "Completely Gutted"



The Telegraph reports EU law "gutted" by bail-outs, growls Bundesbank



Jens Weidmann, the bank's president, said monetary union risks losing its democratic legitimacy as EU leaders take a "large step" towards a debt union without legal authority, and sever the crucial link between budget policy and elected parliaments.



He said mass bond purchases by the European Central Bank had "strained the existing framework of the currency union and blurred the boundaries between monetary policy and fiscal policy. Decisions on further risk-taking should be made by governments and parliaments, as only they have democratic legitimacy."



Mr Weidmanm said that if Europe is unwilling to accept a genuine fiscal union backed by a European tax system, it must strengthen the existing 'no bail-out' clause in the EU Treaties "instead of letting it be completely gutted."



The escalating protest from the Bundesbank leaves the ECB in an invidious situation as it tries to shore up Italy and Spain, holding yields on their 10-year bonds at 5pc by intervening on the secondary market.



Julian Callow said Italy must redeem a record €62bn (£55bn) of debt by the end of September yet the government of Silvio Berlusconi is blacksliding on its austerity package and cavilling over details.



"This is a very large sum of money. The situation is extremely serious, and this is no time to be rearranging deck chairs," Mr Callow said, suggesting that ECB chief Jean-Claude Trichet may have to go to Rome to read the riot act.



Mr Callow said the eurozone is already in an industrial recession and needs stimulus to head off a possible credit crunch and stabilise the debt crisis. He said the ECB should cut interest rates to cushion the effect of fiscal tightening in a string of EMU states and halt accelerating capital flight from the eurozone.



Holger Schmieding from Berenberg Bank said there is a "significant risk" of recession across Europe and the UK but insisted it would be a mistake for the authorites to relax on either the fiscal or monetary front. "They must tough it out," he said.



Europe's sharp downturn will make it even harder for Italy and Spain to meet budget targets and grow their way out of debt traps. It may doom Greece's rescue programme.



Barclays Capital said the Greek economy is in the grip of debt-deflation and is likely to contract a further 5.7pc this year. The deficit remains stuck at 8pc of GDP. The parliament's own watchdog said debt dynamics are "out of control".

Riot Act



Julian Callow, Managing Director and Chief European Economist for Barclays Capital suggests

"Trichet to go to Rome to read the riot act."



There will be a riot act alright, and it will come when the people of Greece, Spain, Italy, and Ireland have had enough of austerity measures aimed at bailing out foreign banks.



Mike "Mish" Shedlock

http://globaleconomicanalysis.blogspot.com

Click Here To Scroll Thru My Recent Post List

Zero Jobs Growth, Unemployment Rate Flat at 9.1%; Charts, Graphs, Details

Jobs Report at a Glance



Here is an overview of today's numbers.



  • US Payrolls +0
  • US Unemployment Rate Flat at 9.1%
  • Participation Rate +.1 to 64.0%

  • Actual number of Employed (by Household Survey) rose by 331,000
  • Unemployment rose by 36,000

  • Those not in the labor force dropped by 165,000
  • Civilian population rose by 200,000, Labor Force rose by 366,000

  • Average Weekly Workweek Fell .1 hours to 34.2 hours

  • Average Private Hourly Earnings Fell 3 Cents
  • Government employment decreased by 17,000 - Not Enough



Recall that the unemployment rate varies in accordance with the Household Survey not the reported headline jobs number, and not in accordance with the weekly claims data.



For a change, the labor force actually rose today. This is a welcome sign. However, were it not for people dropping out of the labor force for the past two years, the unemployment rate would be well over 11%.



August 2011 Jobs Report



Please consider the Bureau of Labor Statistics (BLS) August 2011 Employment Report.



Nonfarm payroll employment was unchanged (0) in August, and the unemployment rate held at 9.1 percent, the U.S. Bureau of Labor Statistics reported today. Employment in most major industries changed little over the month. Health care continued to add jobs, and a decline in information employment reflected a strike. Government employment continued to trend down, despite the return of workers from a partial government shutdown in Minnesota.



Unemployment Rate - Seasonally Adjusted







Nonfarm Employment - Payroll Survey - Annual Look - Seasonally Adjusted







Notice that employment is lower than it was 10 years ago.



Nonfarm Employment - Payroll Survey - Monthly Look - Seasonally Adjusted







click on chart for sharper image



Between January 2008 and February 2010, the U.S. economy lost 8.8 million jobs.



Ignoring the effects of the census, in the last 11 months of a recovery 2+ years old, the economy averaged about 117,000 jobs a month. That is very poor as recoveries go.



In the last 4 months the economy has averaged 40,000 jobs a month, a downright pathetic number.



Statistically, 127,000 jobs a month is enough to keep the unemployment rate flat.



Nonfarm Employment - Payroll Survey Details - Seasonally Adjusted







Average Weekly Hours







Index of Aggregate Weekly Hours







Average Hourly Earnings vs. CPI







"Success" of QE2



Over the past 12 months, average hourly earnings have increased by 1.9 percent. The Consumer Price Index for All Urban Consumers (CPI-U) was up 3.6 percent over the year ending in July.



Not only are wages rising slower than the CPI, there is also a concern as to how those wage gains are distributed.



BLS Birth-Death Model Black Box



The BLS Birth/Death Model is an estimation by the BLS as to how many jobs the economy created that were not picked up in the payroll survey.



The BLS has moved to quarterly rather than annual adjustments to smooth out the numbers.



For more details please see Introduction of Quarterly Birth/Death Model Updates in the Establishment Survey



In recent years Birth/Death methodology has been so screwed up and there have been so many revisions that it has been painful to watch.



The Birth-Death numbers are not seasonally adjusted while the reported headline number is. In the black box the BLS combines the two coming out with a total.



The Birth Death number influences the overall totals, but the math is not as simple as it appears. Moreover, the effect is nowhere near as big as it might logically appear at first glance.



Do not add or subtract the Birth-Death numbers from the reported headline totals. It does not work that way.



Birth/Death assumptions are supposedly made according to estimates of where the BLS thinks we are in the economic cycle. Theory is one thing. Practice is clearly another as noted by numerous recent revisions.



Birth Death Model Adjustments For 2011







BLS Back in Outer-Space



Do NOT subtract the Birth-Death number from the reported headline number. That is statistically invalid. However, in my estimation the BLS is back in outer-space.



It is clear the economy is slowing and the BLS model has not picked it up. The model is horrendously wrong at economic turns.



-18,000 may look reasonable but bear in mind that January and July are revision months where the BLS adjusts for prior errors. I believe the BLS has missed another economic turn, and the BLS is terribly wrong following turns.



Household Data







click on chart for sharper image



In the last year, the civilian population rose by 1,772,000. Yet the labor force dropped by 523,000. Those not in the labor force rose by 2,295,000.



Were it not for people dropping out of the labor force, the unemployment rate would be well over 11%.



Table A-8 Part Time Status







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There has been no improvement in part-time employment in a full year. 8.8+ million workers want a full time job and cannot find one.



Table A-15



Table A-15 is where one can find a better approximation of what the unemployment rate really is.







click on chart for sharper image



Distorted Statistics



Given the total distortions of reality with respect to not counting people who allegedly dropped out of the work force, it is hard to discuss the numbers.



The official unemployment rate is 9.1%. However, if you start counting all the people that want a job but gave up, all the people with part-time jobs that want a full-time job, all the people who dropped off the unemployment rolls because their unemployment benefits ran out, etc., you get a closer picture of what the unemployment rate is. That number is in the last row labeled U-6.



While the "official" unemployment rate is an unacceptable 9.1%, U-6 is much higher at 16.2%.



Things are much worse than the reported numbers would have you believe. Moreover, the unemployment rate is barely better than it was a year ago. It would actually be worse than a year ago were it not for people dropping out of the labor force.



Mike "Mish" Shedlock

http://globaleconomicanalysis.blogspot.com

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