August 2012 Gnostam Economic Commetary

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Making  sense  of  what  ECB  and  Fed  are  attempting  to  do.  INFLATION  vs  DEFLATION  

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After over 30 months of crisis in the Euro zone, have had stirrings of a tentative willingness, on behalf of the ECB to purchase Spanish and Italian government debt, but only after more conditions have been met by Spain and Italy. It is not clear whether it will be the EFSF that will be the vehicle for the purchases, or whether it will be the ECB. In fact there is some real question whether the “announcement” of the ECB will ever occur given the many legal and constitutional issues that Germany has as the funding nation for this effort. On Friday August 3rd, 2012 the spreads on the Italian 10 year bonds over the equivalent Bunds were in a range of 4.62% to 5.07%, while the spread Spanish bonds were 5.91% to 5.42%. Clearly this reflects the risk of convertibility into both Lira and the Peseta. This risk of conversion is covered for the main by the ECB’s payment system guarantee in the Euro-zone and in effect guarantees that the Central Banks of the stronger economies, [Bundesbank], effectively guarantee that they are potentially able to offer unlimited credit to central banks of the weaker economies, [Greece, Spain, Italy]. The mechanism

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by which they do this is the ECB, Target 2 payment system. Mr. Draghi has been very equivocal about intervening directly in the bond markets of Spain and Italy, to help reduce the spiraling borrowing costs faced by these two fundamental members of the Euro-zone, but by actually raising questions over the inviolability of the conversion mechanism of the Euro, he has actually undermined credibility in the payments system upon which the common European currency stands and thus his proposed interventions in the sovereign bond markets of Italy and Spain, appear half hearted, and an acknowledgement that the Bundesbank and the German parliament do not want to extend a blanket guarantee to all of the European periphery, [looking increasingly like every country in the Euro zone save Holland , Finland and Germany] government debt. Jens Wiedemann, current Bundesbank

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Making  sense  of  what  ECB  and  Fed  are  attempting  to  do.  INFLATION  vs  DEFLATION  

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President and Angela Merkel’s former economic adviser, has already dissented from the Draghi proposal of providing refinancing assistance by the ECB to the short end of the Spanish and Italian yield curve. His view of what a central bank should do is colored by the ingrained fear of hyper-inflation of Wiemar Germany of the 1920’s, but also by the pure monetarist faith that it is not the job of a central banker to provide assistance for “nominal” GDP growth, [by increasing money supply] as in the end this all an illusion and the extra tax revenues that may be collected from increased nominal income actually will be negated by a corresponding increase in government inflation adjusted costs. It is now clear that the “step by step” approach to solving the Euro-zone debt crisis advocated by the Bundesbank and the German parliament will result essentially in serious deflation and an eventual convertibility of the Lira, Peseta, and Drakma, at “conversion bands” which will result in severe capital losses for those in the “strong” Euro zone area, which will exacerbate an already undercapitalized bank sector in the EU. I am

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unsure whether the convertibility risk will improve the recovery rate of Italy, Spain and Greece. In the table on page 1, the different types of debt that are involved in the Euro zone are expressed as Government debt, Corporate debt, and Household debt. Each Euro zone country exceeds the 180% figure of total debt to GDP, with Ireland the worst. But this table also highlights how each debt problem is unique to the country concerned, and how policy responses have to be targeted to the individual realities of each country. Italy and Greece have the highest government debt, but Ireland Portugal and Spain and the UK all have very substantial corporate debt issues. Italy has the lowest household debt. So in conclusion what this says is that the super austerity for all, advocated by Germany does not work. In fact it is highly counter productive, and until the Germans become able to analyze the debt problem in its component parts there can be no effective recovery for the

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Making  sense  of  what  ECB  and  Fed  are  attempting  to  do.  INFLATION  vs  DEFLATION  

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indebted part of Europe through austerity. As a result we hear advocates of nominal growth in incomes, [inflation will erode the value of fixed income debt, and allow governments to destroy bond holder values], as opposed to “pure” austerity winning the day, even in Germany, especially the left opposition to Ms. Merkel. Given the devolution trend in Europe, with so many regional parties advocating more not less self rule, it is very difficult in my view to reconcile the super central State that would enforce taxes and expenditures at the center. In addition it is my contention that the increased debt burden that the Euro Zone faces is best dealt with by local measures, as democratically it is local area politics that seem most able to implement the wholesale public and private sector restructuring that is necessary to exit the deflationary spiral. .According to the Bank for International Settlements [BIS], the combined private and public debt of 18 OECD countries nearly quadrupled between 1980 and 2010, and is estimated to grow, reaching between 250%

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(for Italy) and about 600% (for Japan) of GDP by 2040. A June 2012 BIS study warns that budgets of most advanced economies, excluding interest payments, "would need 20 consecutive years of surpluses exceeding 2 per cent of gross domestic product - starting now - just to bring the debt-to-GDP ratio back to its pre-crisis level". The same authors found in a previous study that increased financial burden imposed by aging populations and lower growth makes it unlikely that indebted economies can grow out of their debt problem if only one of the following three conditions is met: ▪ government debt is more than 80 to 100

percent of GDP; ▪ non-financial corporate debt is more than

90 percent; ▪ private household debt is more than 85

percent of GDP. The Boston Consulting Group (BCG) adds that if the overall debt load continues to grow faster than the economy, then large-scale debt restructuring becomes inevitable. To prevent a vicious upward debt spiral from

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Making  sense  of  what  ECB  and  Fed  are  attempting  to  do.  INFLATION  vs  DEFLATION  

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gaining momentum the authors urge policy makers to "act quickly and decisively" and aim for an overall debt level well below 180% for the private and government sector. This number is based on the assumption that governments, nonfinancial corporations, and private households can each sustain a debt load of 60% of GDP, at an interest rate of 5% and a nominal economic growth rate of 3% per year. Lower interest rates and/or higher growth would help reduce the debt burden further. To reach sustainable levels the Eurozone must reduce its overall debt level by €6.1 trillion. According to BCG this could be financed by a one-time wealth tax of between 11 and 30 percent for most countries, apart from the crisis countries (particularly Ireland) where a write-off would have to be substantially higher. The

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authors admit that such programs would be "drastic", "unpopular" and "require broad political coordination and leadership" but they maintain that the longer politicians and central bankers wait, the more necessary such a step will be. Instead of a one-time write-off, German economist Harald Spehl has called for a 30 year debt-reduction plan, similar to the one Germany used after World War II to share the burden of reconstruction and development. Similar calls have been made by political parties in Germany including the Greens and The Left. The current account deficits of the EU countries have also co-incided with their rising debt, as the fundamental problems of the PIIGS economies is that of underlying

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Making  sense  of  what  ECB  and  Fed  are  attempting  to  do.  INFLATION  vs  DEFLATION  

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loss of competitiveness, see table overleaf. As we have discussed previously, Italy's unit labor costs rose 32% relative to Germany's since 2001. WHAT DOES ANY OF THIS MEAN TO ME IN THE UNITED STATES? We keep on hearing that Europe’s financial problems are among the chief dangers facing the world’s weak economic recovery, significantly slowing global trade and causing investors to shy away from risky investments.

On Wednesday, the IMF warned that the crisis is reaching a point where a mild recession could give way to a more destabilizing round of deflation. Just as prices that rise too quickly can hurt a nation’s economy, falling prices can create a corrosive spiral leaving consumers hesitant to spend because they hope prices will fall in the future. Meanwhile, companies and households can be pushed into bankruptcy as real estate and other asset prices fall, and banks can be saddled with potentially ruinous

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levels of bad loans. Still this is still about the EU zone.

In the US we have the following issues:

In the US have historically low debt service to income, as is shown in the Fed Chart on page 2, which shows that we are at a low relative to 1984, for both debt service and financial obligations;

But, if we have deflation income will shrink and the US faces huge uncertainty next year over what it’s effective tax rate will be given the expiry of the “Bush” temporary tax cuts, and the threat of expenditure sequestration by a do nothing Congress.

Given nobody knows what their effective tax rate is going to be next year so they cannot plan, that uncertainty requires higher liquidity ratios in business and rising savings rates in the personal sector. This damps spending growth and spending is what gross domestic product is all about.

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Making  sense  of  what  ECB  and  Fed  are  attempting  to  do.  INFLATION  vs  DEFLATION  

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Astonishingly, had spending by the private sector continued at the pre 2006-7 crisis rate, the economy should have expanded by over 8% per annum from the fours of $1 trillion plus deficits. Which shows that notwithstanding the Fed’s easy policy, the expansion of the monetary base by the Fed has coincided with cash hoarding by corporations and consumers. The wealth collapse and the change in consumer spending in the US will mean years of sub-par growth, extremely low long term interest rates and very power deflationary tendencies regardless of who is in the White House for the next four years. The likelihood of the Fed engaging in QE 3 and extending twist is very high in my view.

• Philip Corsano August 6th 2012

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Making  sense  of  what  ECB  and  Fed  are  attempting  to  do.  INFLATION  vs  DEFLATION  

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