The euro area debt crisis remains in focus

The sovereign debt crisis in Euro-land remained a major market focus last week. Immediately following the announcement of the almost $ 1 trillion big bail-out fund agreed on by the IMF and the EU, markets breathed a sight of relief and a large retracement rally of the preceding mini crash in risk assets ensued.  By mid-week, doubts began to resurface, and the markets retreated once again.


A major factor in the swift reassessment of the situation was probably the fact that the euro resumed to sink almost immediately after a brief short-covering bounce. The bounce began on the Friday prior to the bail-out announcement and started to fizzle again by mid-Monday. From Tuesday onward, the euro's slide resumed in full force.



The S&P 500 Index vs. the dollar-euro rate. The stock market's rebound was limited by the 50-day moving average as the euro continued to slide – click on chart for higher resolution.


As mentioned last week, bearish sentiment on the euro has reached an extreme. This is best illustrated by the commitments of traders data of the euro contract, where large speculators have now amassed a record net short position of over 113,000 contracts, and open interest has surged to a record high as well:




The speculative net short position in euro futures reaches a new record high – click on chart for higher resolution.



The DSI (daily sentiment index) of retail futures traders published by Jake Bernstein at one point last week reached an unheard of 2%. This combination of factors normally leads to at least some sort of short covering rally soon, but often in emotionally charged markets with strong momentum, the final moves with the trend can be quite large, even though the market as in this case appears very 'oversold'. Nevertheless, traders who are currently short the euro should be prepared for an eventual counter-trend move of some significance.


Ironically, what was cited in the press as the main problem to worry about was not whether the bailout package would in fact be implemented as advertised – but rather, that the strict implementation would require austerity measures by the over-indebted euro-area governments that could 'slow down economic growth in the euro area'.


To quote from an article in ABC news:


“Investors initially cheered Monday's announcement of the $1 trillion debt bailout package from the European Union and International Monetary Fund as it halted a speculative run against Greek bonds that had threatened to engulf other countries. But now, with the worst case scenario averted, investors are wondering how deep spending cuts aimed at cutting deficits in Spain, Portugal and Greece — as well as big economies like the U.K. — will slow the global economy. "It was taken as good news at first, but investors are starting to focus on the impact the austerity measures will have on the macroeconomic picture in Europe," said Lee Kok Joo, head of research at Phillip Securities in Singapore.



Certainly, after an orgy of government spending and monetary pumping such as the one we have witnessed in reaction to the 2008 crash (in Europe's case, not a single euro-area member has been able to keep its deficit within the Maastricht limits, and the money measure TMS grew by an astonishing 16%, one percentage point more than the comparable statistic in the US), any attempt to slow spending and money printing will tend to immediately unmask the 'recovery' as the mirage it was and is.

After all, government spending is counted as a positive factor in the computation of such  flawed measures of economic activity as 'GDP', in spite of the fact that government spending actually represents a burden on the economy. It appears to be a case of  'rightly worried, but for the wrong reasons'. An interesting chart was recently posted at It shows the performance of the stock markets in the Baltic region since the early 2009 crisis low. If you are not familiar with what happened in the Baltics, in brief, the governments of the region basically went bankrupt and had to  dramatically curtail their spending as a prerequisite for receiving IMF loans. Interestingly, the stock markets of the region have since then outperformed the stock markets of the  deficit spending countries by a mile.



The Baltic OMX stock index of countries with frugal governments that reduced spending outperforms the stock index of the biggest spender by 46%. Who would have thought? – click on chart for higher resolution.





Economic stimulus spending harms the economy


It is important to remember at this point that deficit spending by the government and money printing by the central bank in order to avert an economic recession in fact have the effect of structurally weakening the economy even more. Let me briefly recap why this is so. The government possesses no economic resources of its own – it produces nothing (in those cases where the government owns commercial enterprises it does of course produce something, but as a rule this is done at a loss, so these activities are uneconomic as well – as an example, consider the post office). 

In order to intervene in the economy in an effort to prop it up, it has to first take already existing wealth and resources from someone else, and then decide on how to redeploy them. This can be done by either borrowing or taxation (whereby more borrowing now inevitably leads to more taxation later), but the end result is the same: it is in fact not the government that 'finances' this spending – it is the private sector. The idea behind stimulus spending is that the economy has become stricken by 'subdued animal spirits' on the part of consumers and producers, a fault that the government must rectify by force.

Since immediate tax hikes to finance this increase in spending would reveal the futility of the exercise right away, the governments as a rule rely on increasing their borrowings and letting the printing press of the central bank do some overtime. The assertion by modern day central banks that they would, on account of their vaunted 'independence', never  resort to monetizing the government's increased spending is easily refuted by looking at money supply data – and we refer here specifically to the Austrian money supply measures, of which you can see regular updates at this link. (A brief side note: Michael Pollaro, who gathers these data, has written an excellent and concise article on why the Austrian money supply measure TMS is superior to the 'M's' published by the Fed. Read 'Money supply – the Austrian take'.

The problem with broad measures such as M2 is that they contain non-money components that in reality represent credit transactions). This then leads to a 'false boom', as economic activities are undertaken that would not be deemed economic in the absence of such deficit spending and money printing. Note here that this de facto means that they are not economic, period.

Every dollar or euro the government directs to spending that is to its liking, goes missing somewhere else. There is the seen effect on the surface, and the unseen effect – the countless economic projects that could not be undertaken because the government decided to spend funds on whatever pet projects it deemed worthy.


Japan's bridges to nowhere

When e.g. Japan's government decided to build countless 'bridges to nowhere', it certainly kept a number of construction companies that were surplus to requirements in business. However, as the term 'bridges to nowhere' already implies, these government investments turned out to be gigantic boondoggles.

There was an article in the NYT about this a while back that should truly frighten everyone. Not so much because it describes the utter futility of government intervention in Japan over the past two decades – that is a given – but because it shows that  no-one has come to the correct conclusions about this failure. The political class in the US and Europe and the plague of courtier economists that provide it with advice, seem convinced that all you need is a 'better plan'.


HAMADA, Japan — The Hamada Marine Bridge soars majestically over this small fishing harbor, so much larger than the squid boats anchored below that it seems out of place. And it is not just the bridge. Two decades of generous public works spending have showered this city of 61,000 mostly graying residents with a highway, a two-lane bypass, a university, a prison, a children’s art museum, the Sun Village Hamada sports center, a bright red welcome center, a ski resort and an aquarium featuring three ring-blowing Beluga whales.

Nor is this remote port in western Japan unusual. Japan’s rural areas have been paved over and filled in with roads, dams and other big infrastructure projects, the legacy of trillions of dollars spent to lift the economy from a severe downturn caused by the bursting of a real estate bubble in the late 1980s. During those nearly two decades, Japan accumulated the largest public debt in the developed world — totaling 180 percent of its $5.5 trillion economy — while failing to generate a convincing recovery.



Emphasis mine.


Failing to generate a convincing recovery – well, duh. Of course this flies into the face of everything we hear regularly about the alleged benefits of government-directed deficit spending during downturns from officials and the above mentioned courtier economists. When confronted with Japan's failure, their stock replies are: A) 'they didn't spend enough!' or B) 'if they hadn't spent so much, it would have been worse!'. It never occurs to them that things may actually be so bad because of this spending.

As a Japanese economist notes further down in the article:


“It is not enough just to hire workers to dig holes and then fill them in again,” said Toshihiro Ihori, an economics professor at the University of Tokyo. “One lesson from Japan is that public works get the best results when they create something useful for the future.”


Oops. Didn't Keynes advise that getting workers to dig holes and fill them in again was the very thing to do? All of a sudden it turns out that this is not true after all? And it took hundreds of trillions of yen in deficit spending to finally, after 20 years, come to this conclusion? Naturally, Mr. Ihori doesn't go as far as to say that there is no way to get good results from 'public works'. That would evidently be an impolitic thing to say. However, how is the government to know which projects it should invest in?

There is after all no profit motive to guide it. This is precisely the problem that eventually brought down the Soviet Union. The economic planning agency GOSPLAN was simply unable to know how to best direct the resources at its disposal, what to produce and how much of it to produce – it had no price mechanism, and no profit incentive to guide it. In short, it tried to do the impossible.

To see why it is impossible for a committee of central planners to succeed at this, you only have to think about why a free market economy is so successful at dealing with the same problem. In the market economy, knowledge about the various production processes that create our wealth is widely dispersed. Every producer has specialized knowledge about the markets he or she serves, and by means of numerous inputs from prices to the level of interest rates decides on what to produce, how much of it to produce, and which production processes will likely be profitable.

A myriad of such individual highly specialized plans guided by the profit motive work together like the cells of an organism to create the results desired by consumers. The amount of knowledge that is needed for a complex economy to work is simply too large and multi-layered to allow for successful central planning, however 'well-intentioned' it may be.

Now, here comes the scary part. The NYT is not exactly known for its free market leanings, and it liberally quotes all the critics of Japan's approach – all of whom sniping from the left, so to speak. One of the snipers is current treasury secretary Geithner – a life-long bureaucrat (as he himself admits, he never had a real job'), who nonetheless fancies himself an expert on the economy.


“Now, as the Obama administration embarks on a similar path, proposing to spend more than $820 billion to stimulate the sagging American economy, many economists are taking a fresh look at Japan’s troubled experience. While Japan is not exactly comparable to the United States — especially as a late developer with a history of heavy state investment in infrastructure — economists say it can still offer important lessons about the pitfalls, and chances for success, of a stimulus package in an advanced economy.  In a nutshell, Japan’s experience suggests that infrastructure spending, while a blunt instrument, can help revive a developed economy, say many economists and one very important American official: Treasury Secretary Timothy F. Geithner, who was a young financial attaché in Japan during the collapse and subsequent doldrums. One lesson Mr. Geithner has said he took away from that experience is that spending must come in quick, massive doses, and be continued until recovery takes firm root. Moreover, it matters what gets built: Japan spent too much on increasingly wasteful roads and bridges, and not enough in areas like education and social services, which studies show deliver more bang for the buck than infrastructure spending.”


Well here we go – 'massive doses of spending' are allegedly needed, and 'must be continued until recovery takes firm root' – apparently two decades are just not enough. The problem is then identified as  'if spending on 'A' didn't work, it means you should have rather spent on 'B'. Studies show so, allgedly. Which studies, it doesn't say. Rest assured though, Mr. Geithner is on top of this. He apparently wants to outdo the Japanese, massively. The NYT then delivers the following ironic paragraphs:


“Economists tend to divide into two camps on the question of Japan’s infrastructure spending: those, many of them Americans like Mr. Geithner, who think it did not go far enough; and those, many of them Japanese, who think it was a colossal waste. Among ordinary Japanese, the spending is widely disparaged for having turned the nation into a public-works-based welfare state and making regional economies dependent on Tokyo for jobs. Much of the blame has fallen on the Liberal Democratic Party, which has long used government spending to grease rural vote-buying machines that help keep the party in power.“


It seems those predominantly Japanese economists as well as the Japanese people have actually groked it by now. 'Colossal waste' is definitely an apt description of the situation, and the fact that Japan has been turned into a society of people dependent on Tokyo's welfare largesse reveals why the political class is so strongly in favor of deficit spending – it inter alia helps create a captive bloc of voters. This is promptly followed by the litany of excuses I listed above – 'it would have been so much worse if they hadn't spent so much' as well as the old standby, 'they didn't spend enough!'


“But some Western economists who have studied Japan’s experience say the stimulus accomplished more than it is now given credit for. At a minimum, they argue, it saved the economy from an outright, 1930s-style collapse.  Moreover, they say, any direct comparison of Japan and the United States is inevitably misleading, because Japan has spent so much more over the years on infrastructure. Having neglected its roads, bridges, water treatment plants and more over the years, the United States is bound to generate a greater payback for such spending than would Japan. Beyond that, proponents of Keynesian-style stimulus spending in the United States say that Japan’s approach failed to accomplish more not because of waste but because it was never tried wholeheartedly.”


I actually get a queasy stomach when reading such abject nonsense. 'Not wholeheartedly'? Japan's cumulative government deficit is slated to jump to over 200% of the nation's GDP this year. It doesn't get any more 'wholehearted'. The Greeks and Italians look like veritable misers by comparison. Japan has not yet been forced to own up to the failure of its grandiose Keynesian experiment, because the government was able to draw on the massive savings of its citizens to finance its deficit and the enormous boondoggles it has produced. There are very few foreign investors in JGB's, and so Japan has been spared the ignominy of being unable to roll over its debt (the largest investors in Japan's government debt are beholden to the government, such as the giant Postal Bank). However, given a massive decline in Japan's savings rate over the past two decades, the day of reckoning is clearly drawing closer.



Japan's once formidable household savings rate has collapsed. It will become increasingly difficult to finance the burgeoning government deficit. After 20 years during which economic resources were wasted with both hands, Japan is lurching toward the end game. The choice will be between austerity and money-printing – click on chart for higher resolution.



The howling of the Keynesians

In the wake of the euro-area crisis, Keynesians are predictably beginning to howl about the prospect of austerity. As an example, see Marshall Auerback's assertion that 'The US is not Greece'.  The entire argument rests essentially on the presence or absence of a printing press. Since Greece is unable to 'print itself back to prosperity' (the method that has worked so excellently in Zimbabwe and Weimar era Germany) on account of not issuing its own currency anymore, it now finds that there are constraints to its spending.

Constraints on government spending are to Keynesians like a red flag to a bull.  Memo to Auerback: whether you default via inflation or default directly doesn't make much of a difference to bondholders. They lose in both cases – default is default. A default via inflation however has countless additional negative effects that go well beyond a brief period of pain for bondholders. Not surprisingly, Auerback works for Warren Mosler, who in turn is a fount of downright bizarre ideas about government deficits and inflation (see: 'Mosler: just print more money').

As it turns out, the two of them are working overtime to 'save Greece' by promoting what is essentially a huge Ponzi scheme – not that it is much different from the Ponzi scheme the fiat money system already represents,  Mosler and Auerback merely want to introduce yet another layer of obfuscation to the Three Card Monte (largely modeled on the UK's historical tally stick system, which ultimately is the model for the fiat money system itself). I mention this primarily for its curiosity and entertainment value.

Their scheme is so absurd that it hardly deserves further comment (not that that has kept people from actually discussing it in all seriousness). Now, there can be no doubt that that if the world's governments were all to stop their deficit spending, bailouts and money printing, numerous malinvestments would be unmasked and head for their long overdue liquidation. There would without a doubt be a deep recession. However, the choices facing us are quite different from how the Keynesians prefer to frame them.

Remember, when supporters of the free market pointed out that the reaction of governments to the bust following the technology bubble, while helping to avert near term pain, would eventually lead to an even bigger bust, the Keynesians scoffed that their mentor had pointed out that 'in the long run, we're all dead', and that counter-cyclical policies were most definitely called for. 

Paul McCulley frequently urged the authorities to engage in deficit spending and money printing as a panacea for the tech bust, even opining that the then blossoming housing bubble was in principle a good thing. In 2001/2002, McCulley was intensely worried about 'deflation' in the face of money TMS growing by 20% (!) within one year (see his article archive at PIMCO (link broke on August 5th 2010) for proof). The result of all this was the crash of 2008 –  and contrary to what the Keynesians believe that was not some 'natural catastrophe', but merely the unmasking of a false boom – the very inflationary boom they advocated in the first place (it was unmasked by the Fed raising administered rates beyond the threshold the bubble activities could stomach).

This, and Japan's dire legacy of failure, should be empirical proof enough (one would think) that the problem of malinvested capital and unsound debt can not be solved by piling on even more unsound debt. Essentially the Keynesian position is that we should somehow be able to have a 'never-ending boom', as long as interest rates are kept artificially low and there is someone spending his head off.

However, the central problem facing actors in the economy is not that there is 'not enough money' or 'not enough spending', but the scarcity of capital and real funding.  It is production that creates wealth, not consumption. This is such a simple, obvious verity that one really wonders why it has to be repeated over and over again. The false choice the Keynesians present is: 'If the government doesn't spend gobs of money, we will have a severe depression. Therefore, even if you are correct that the spending will be wasteful, we can not afford austerity'. 

What they don't say – and this is what the 2000 tech bust, the artificial boom following in its wake and the 2008 slump show – is that you actually can not avoid the depression. The choice is only between having a comparatively mild bust right away, or an even worse bust later.  The bust as such can not be avoided at all.

As I have previously mentioned, the main reason why nowadays no-one talks anymore about the very painful 1920-1921 recession is that it was over so quickly that it is simply not thought worth studying by our various 'Great Depression experts', such as Ben Bernanke (see 'The forgotten depression of 1920' for details). They do us all a big disservice by ignoring it. It was the last time a US government decided not to interfere with the downturn and actually cut its spending instead of increasing it.

President Warren Harding refused to listen to his interventionist secretary of commerce, one Herbert Hoover,  who urged the opposite course, and was essentially using the same arguments so popular with most mainstream economists and governments today. Unfortunately for the US and the world, Hoover was presented with the chance to implement his ideas nine years later – in turn ignoring the advice of his non-interventionist secretary of the treasury, Andrew Mellon.


The global political backlash

By announcing the big bail-out, and having money supply inflation on 'standby' in the form of the ECB buying up the bonds of the profligate governments in trouble, the EU has essentially thrown its rule-book out of the window. This bodes ill for the euro's future, but we have to consider that the entire rescue operation was politically very difficult to arrange.

Allegedly, Sarkozy threatened Merkel with France leaving the euro-zone if she didn't accede to that plan, and as Mish remarks, it is entirely credible that Sarkozy had a temper tantrum, for the simple reason that he has them all the time.  Mrs. Merkel was probably more worried about the exposure of euro-area banks, including German banks,  to the growing problem than about Sarkozy's antics. In view of how unpopular the rescue is with the citizens of the countries that will end up footing the bill, we can be reasonably assured that there will be an attempt to enforce the austerity measures. The first indications of this can be found in Zapatero's unexpected willingness to tackle Spain's expenses on civil servants (link broke on August 5th 2010), and Greece's likely doomed attempt to crack down on the only part of its economy that probably remains in working order, namely the tax-free 'shadow economy'.

The biggest worry should of course not be that austerity will lead to a 'debt-deflation spiral' in the economies concerned, although there will no doubt be significant short term pain should the austerity measures be adhered to. The worry should be that the governments concerned will find it impossible to stay the course in the face of the pain this will produce, and that the final solution will be the abandonment of all pretense, with the the ECB beginning to print money outright.

The fact that the ECB has relented with regards to the direct buying of government debt already represents a significant loss of credibility – the press in former 'hard currency' countries like Germany and Austria is full of accusations that the euro is being sacrificed on the altar of political convenience. 

There is little faith that the promise of 'sterilization' is worth much. It is however precisely this backlash that creates at least a small glimmer of hope that the ECB will refrain from taking the final destructive step of going for outright 'quantitative easing', i.e. money printing. I have already recounted the difficulties it will face, but we will have to wait and see what actually develops.

The same public backlash against deficit spending and the Fed's monetary pumping operations has been simmering for quite a while in the United States as well. There is a good chance that the current incumbents will face a withering defeat in the mid-term elections. This could produce a a cohabitation situation, similar to the one Clinton faced when the Republicans led by Gingrich took the reins of Congress. Such cohabitations tend to be positive for the economy, as little legislative work is getting done during them – which means that a lot of harm is avoided by dint of political inaction.

No wonder the Obama administration was in such a hurry to implement the president's 'legacy' programs, such as the convoluted health care bill and the currently debated financial regulation bill (which is an especially dangerous bill due to the fact that the people involved in drafting it are utterly clueless – but that is a topic for another time). 

The states are in a roughly analogous situation as the European PIIGS insofar as many of them have to balance their budgets by law – in short, they can not continue to spend willy-nilly. California and Illinois, to name two especially glaring examples, seem to be closing in on bankruptcy. The mobility of the US labor force which faces no cultural or language barriers, limits their ability to hike taxes, so spending cuts will result – even though the public employee unions are politically very powerful and demand tax hikes rather than spending cuts.

The problem for the unions is that you can't get blood from stones. Once the producers of wealth flee a state, it doesn't matter anymore how beholden the politicians are to these unions – there will simply be no more loot to grab. The Federal government faces no such constraints, and ironically, the fact that it can in extremis rely on the Fed's printing press is probably a factor in keeping the confidence of foreign lenders intact for now.

Nevertheless, the political cost of the government's tax and print and spend policies may eventually prove too high.  To wit, when it became evident in 1937-1938 that the policy of inflation and deficit spending the Roosevelt administration had engaged in had completely failed to halt the Great Depression (in fact, the New Deal made the depression considerably worse, as is nowadays thankfully ever more widely acknowledged), FDR's administration was politically finished. It was only saved from electoral defeat by the outbreak of WW2.



The explosion of the federal deficit. As a percentage of GDP, it is now at the highest level since the WW2. To illustrate how far we've come – the federal deficit in the month of February 2010 alone amounted to approximately the entire deficit of the Nixon administration (in nominal, not real dollars) – click on chart for higher resolution.



As Marc Faber reminds us in this interview, governments can always resort to war if they want to continue spending and wish to distract the population from economic troubles at home. This argument may sound extreme to many people, but it is solidly grounded in historical experience. History is littered with examples of governments detracting their citizens from internal problems by going to war (I leave it to readers to verify that fact for themselves. I can think of several examples off the cuff).


Should an economic bust be feared?

Lastly, I want to once again dispel the notion that a bust is something that should be feared. The mistakes made during the boom can only be rectified by a bust – that is unfortunately the reality. Malinvested capital must either be liquidated or redirected where this is possible (since most capital is not homogeneous, only some of the malinvested capital can be used for other purposes).

Where capital consumption has occurred due to neglect of capital maintenance during the boom, such maintenance must be performed. Naturally these activities require far fewer laborers than the many false economic activities of the boom have required (as an example, in 2005, at the height of the housing bubble, some 8,000 new real estate agents were registered every single month in California alone. It is a good bet many of them are not in this job anymore). It follows from this that a bust is not an enjoyable experience, but it is important to realize that it performs an important economic function – it is the sine qua non for a sustainable recovery.

The government's exertions aimed at 'softening the blow' or artificially restarting another boom can only  result in even more pain at a later stage. If you're asking yourself why it so often seemed to 'work' in the past, the reason is that artificial stimulation can motivate new bubble activities as long as the pool of real funding is still growing.  All economic activities require funding – this is to say, they do not require just 'money' – but real savings, i.e. saved production.

Monetary and fiscal pumping merely serves to divert scarce resources into uneconomic activities, creating an illusion of prosperity (with the veil of illusion ripped from the housing boom, many readers will surely recognize the truth of this statement, even if they are not familiar with the requisite economic theory). So while it often seemed to 'work' in the past, it really undermined the generation of true wealth – until one day this process of undermining the economy's structure went one step too far, resulting in a truly enormous bust  (I think 2008 and what has followed since certainly qualifies for this designation). A bust may be unpopular, and often politically deadly – but it is a necessary part of the economy's healing process. Avoiding it serves no good purpose.


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