Afraid of Another Financial Crisis? Watch the Banks

Financial crises like we had in 2008 before the Great Recession, and earlier in the 1930's before the Great Depression, are the triggers for big, long lasting economic downturns that require painfully long times from which to recover.  They differ from ordinary economic recessions (i.e., two quarters of negative economic growth), which generally don't last more than a couple of years and are usually followed by good levels of growth.  Financial crises are caused by liquidity shortages in the financial system.  When major banks and other financial institutions cannot obtain ready access to loans, especially short term loans, the financial system can teeter, and in worst case scenarios, collapse. 

Recent news articles report that European banks are under stress because of the decline in oil prices (http://www.cnbc.com/2016/02/08/european-banks-face-major-cash-crunch.html), and because of low interest rates and legal costs, as well as oil prices (http://money.cnn.com/2016/02/05/investing/bank-stocks-worse-than-oil/index.html?iid=EL).  Things got so shaky today that Deutsche Bank, Germany's largest, felt compelled to put out a statement reassuring shareholders about its financial condition.  http://www.reuters.com/article/us-deutsche-bank-stocks-idUSKCN0VI1WI.  If Europe's major banks begin to encounter liquidity shortfalls, we could have a problem.  If not addressed properly, it could be a big problem.

Europe's big banks are in general not as well capitalized as America's big banks, so it's not surprising that the Europeans might encounter turbulence sooner.  But if Europe's big banks teeter, America's big banks will, because of the interconnections between all major banks worldwide, at least feel pretty nauseated.  Of course, in such a scenario, the European Central Bank and U.S. Federal Reserve will mount up and ride to the rescue.  But not even the Brobdingnagian bailouts of 2008 prevented the Great Recession.

If the financial system stays sound, the slowdown in China and the other BRICS may cause a recession, but probably not a catastrophe.  But if the financial system dives into the septic tank, as it did in 2008, then we can expect a stinky mess.  So watch the banks.

The Challenge For China

The Chinese stock market fell some 12% this first week of 2016.  The downturn triggered corresponding drops in other stock markets around the world, including a loss of over 6% for the week in the U.S.  The financial press is probably secretly delighted, since such volatility captures the attention of a lot of people and brings a surge of traffic onto their websites.  But most people are unhappy.

The Chinese stock market fell for a simple reason--it's overvalued.  It's been overvalued for a while, at least since early 2015.  As we in America know, overvalued stocks fall sooner or later.  It happened in 2000 and 2008.  It's happening now in China, and elsewhere. 

Chinese financial regulators complicated matters by halting trading after a circuit breaker was triggered by a 7% fall two days in a row.  Circuit breakers can be useful in ameliorating short term panics.  But significant overvaluation, as one sees in China, is a long term problem, and circuit breakers may actually increase selling pressure by sharply limiting the time available for trading.  When trading hours are circumscribed, sellers want to move quickly to sell, but buyers want time to evaluate whether or not prices are leveling out.  The result is that there are many more sellers than buyers in a limited amount of time and prices plummet.  Chinese regulators had to suspend the circuit breakers, which was followed by a modest rise in Chinese stocks at the end of the week.

But the regulatory miscues aren't the long term story.  Stocks in China were pumped up by a number of government policies that directly or indirectly encouraged investment in equities.  The bubble peaked and burst this past summer, and the Chinese government has since been trying to prop up the market with restrictions on selling and government-induced purchasing.  These measures to balance supply and demand don't address the basic underlying problem--Chinese stocks aren't worth their nominal market prices--and consequently can't really calm things down. 

At this point, losses inhere in Chinese stocks.  These losses have not been fully recognized in market prices.  With the Chinese economy slowing and capital flowing out of China, there isn't much realistic prospect of the losses reversing.  They will have to be realized sooner or later.  The Chinese government probably understands this, but will endeavor to smooth out the process of realization of the losses to reduce the pain perceived by investors.  The U.S. Federal Reserve and European Central Bank used similar smoothing strategies to deal with the fallout from the Great Recession and the European sovereign debt crisis.  Smoothing carries a major risk of kicking the can down the road, with losses emerging like new heads of the Hydra if underlying economic growth hasn't been revived.  The challenge for China will be to accelerate its economic growth.  But the prospects for a near-term rebound of the Chinese economy are poor.  Low-cost manufacturing is gradually shifting out of China, where wages are rising, and hasn't yet been fully replaced by anything else.  China's economy seems to be meandering.  We can expect more market volatility.

The Market Dropped 3%, So What's For Dinner?

On Monday, Oct. 19, 1987, the U.S. stock market nose-dived, with the Dow Jones Industrial Average falling 22.61% in a single day.  That was volatility.

Recently, the market has been bouncing around, losing as much as a few percent a day, and edging into correction territory (a loss of over 10% from the latest high).  This turbulence isn't surprising, given the six year age of the longstanding bull market.  Indeed, in the summer of 2011, the market dropped around 17% on account of various investor jitters.  Then, it recovered.  Markets regularly have downturns, even bull markets.

So what does the future hold?  Nothing that anyone can reliably foretell.  The direction of the financial markets today is determined first and foremost by central bank policies.  The key players are the U.S. Federal Reserve, the European Central Bank and the Bank of China.  Predicting central bank policies is difficult in the best of times.  These days, with the data unusually uncertain, central bank policy is harder to predict than one's luck at the  roulette wheel.  This is especially so since politics appears to infiltrate central bank policy, making prediction even harder.  But one thing you can expect is they'll be cautious about doing anything that isn't accommodative.  If the Fed raises rates in 2015, it will probably do so once, and be done with rate raising for quite a long while.

The Chinese stock markets have a bubbly aura, making further volatility in Shanghai and Shenzen likely.  But China's economy is not heavily dependent on rising Chinese stock prices--and neither are Europe's economy or North America's.  Many individual savers in China are getting hosed, but the Chinese economy doesn't rely on domestic consumption. If Chinese investors lose their savings, Chinese manufacturers will still keep exporting to the rest of the world.  So the acid reflux in the Chinese stock markets may, ultimately, have only so much impact and not more.

Keep an eye on the market, but don't miss any meals over it.  If you're nervous, stay the course and don't invest more right now.  On the other hand, if you're feeling lucky, think about adding a bit to your stock holdings as the averages move down.  You know what they say about not letting a good crisis go to waste.

Is there a black swan lurking?  Maybe.  Since China has been the major source of world economic growth in recent years, any major upheaval in China could be the black swan.  What could happen there?  Well, President Xi Jinping has been aggressively consolidating power.  He may be the most powerful leader China has had since Mao Zedong.  But the market turmoil in China, and the recent slowdown in its economic growth, may be causing some to question his leadership.  The secretive nature of China's Communist Party makes it impossible to know for sure how strong Xi's grip on power may be.  While there are no overt signs of change, if Xi is forced out of power and there is a struggle for control in China, then all bets are off and you might want to do some hard thinking about how much risk you care to hold in your portfolio.

Is Greece No Longer a Risk?

In the last few days, the upstart government of Greece formed by Syriza Party leader Alexis Tsipras has completely reversed itself and signed up for a bailout from the EU that requires far more austerity than Greek voters rejected in a referendum just a week ago.  By all appearances, the EU rammed the ultra austere package down the throat of the Greek left-wing party, flattening Syriza's contentions like a tractor trailer rolling over a marshmallow.  We've had months of hand-wringing and teeth-gnashing over the dangers of a Grexit, and financial markets have shuddered every time Greece appeared to be heading out of the EU.  The EU's peremptory demands at the last minute might seem to have been a high-risk roll of the dice that somehow went in the EU's favor.  Or the EU knew that Greece had no leverage and made the Greeks take everything the EU wanted.

Considering how cautious the EU has been in the past, giving Greece two earlier bailouts totaling some $250 billion, it isn't probable the EU was bluffing in this round of talks.  That would likely mean it believes it has built a shield wall around its banking system that could withstand the consequences of a Grexit.  Stated otherwise, Grexit may no longer be thought to be a major risk to the European financial system. 

Even though the EU and Greece announced a "deal" today for a bailout, it's not at all a firm agreement, but rather a process for pursuing the possibility of more European assistance to Greece.  First, Greece has to adopt a number of austerity measures dictated by the EU.  Next, the parliaments of individual EU member nations have to approve further bailout talks.  Then, Greece will get interim financing that will keep it barely afloat while it and the EU yak for more months, maybe many more, to try to reach the final terms of a third bailout. 

There are many contingencies in this process, and it's quite possible the process won't lead to another bailout.  In that case, Grexit will follow.  But will it matter?  The EU seems to believe that Grexit wouldn't be a disaster, or it wouldn't have taken such a seemingly high risk negotiating position.  If it's right, then Greece will be mired for a long time in austerity and hard times one way or another.  And if the EU is wrong, then watch out, because a European financial crisis could lead to many, many bad consequences for a lot of people.

Ode To Greece's No Vote

Greek voters said "no" to the EU's latest bailout proposal, defiantly rebuffing another round of austerity. Democracy spoke, but the fat lady has yet to sing.  With a nod to Gilbert and Sullivan, this is how the song might go:

Here's a how-de-do.
If I vote for you,
When the time comes to make payments,
You will tell them we have ailments,
Default will ensue.
Here's a how-de-do,
Here's a how-de-do.

Here's a pretty mess.
In a month or less,
Greece will add some extra drama
By reviving the old drachma.
Banks will be distressted.
Here's a pretty mess,
Here's a pretty mess.

Greece's state of things
Is to life it barely clings.
Paying its debts with devotion
Doesn't seem to suit its notion.
More depression it brings.
Here's a state of things,
Here's a state of things.

No one knows what will be the result of this crisis.  Just remember that, no matter what, a good gyros makes for a fine meal.

Greece, the EU and the Power of Fiat Currency

Greece is evidently going to hit the financial skids next week.  The EU appears to have stopped bargaining (as have the Greeks, who now want to put the issue of austerity in exchange for another EU bailout to their voters).  Without bargaining, there won't be a deal.

How did things end up this way?  One perspective is that, by entering the Euro Zone, Greece gave up a lot of power and put itself under the control of the EU.  When a country issues its own currency (i.e., fiat currency), it has considerable control over its currency's value in relation to other currencies.  If the country slides downhill economically speaking, it can devalue its currency and export its way out of trouble.  The Japanese have done this for decades, and the Chinese and other developing nations are endeavoring to emulate the Japanese. 

But what if the country, instead of issuing its own currency, uses another medium of exchange?  Historically, gold and silver, and sometimes copper, served such a role.  But a country that uses an independent medium of exchange can't devalue its way out of a recession.  It has to find another way; and sometimes it can't.  That's why the industrialized West moved off the gold standard in the 20th Century.  It prevented them from using central bank policies to recover from economic downturns.

Fiat currencies have a very bad image among many in the political right.  Gold standard conservatives fear that governments will inflate the wealth of citizens away for reasons of political expediency.  They rightly point to the morass of post-World War I Germany, when the Weimar Republic did that, resulting in widespread malaise and paving the way for fascism. 

But gold standard adherents forget a basic principle of economics:  goods become widespread in the market because people demand them.  Fiat currency is simply another good, and people demand a lot of it.  It serves as a medium of exchange, and no major economy can exist without a copious supply of the medium of exchange.  Gold was extremely scarce in Colonial America, and deer skins (i.e., buck skins, from whence came the term "buck"), tobacco and other goods served as an alternative to gold.  Various commercial promises to pay, such as drafts, promissory notes, banker's notes, and the like, also came to be used in lieu of gold.  Fiat currency was government's way of simplifying the problem of lack of gold and silver that could be used as media of exchange.

Fiat currency also conferred power. When the American Revolution began, the Continental Congress issued paper money in order to finance the rebellion.   This paper was subject to inflation, and considerable controversy eventually surrounded its use.  Nevertheless, the Continental Congress' ability to issue fiat currency helped to sustain the Revolution.

The U.S. government in the 19th Century outlawed the issuance of bank notes and other private currency and substituted the greenback in their stead.  Although the U.S. government clung to the gold standard, it devalued the dollar against gold once the Great Depression began, and took the dollar off the gold standard during the economic difficulties of the early 1970's.  In other words, gold wasn't really the standard.  The dollar was worth what the government said it was worth, not what the market price of gold happened to be.

The power of fiat currency became vividly clear during the Great Depression and World War II.  The U.S. government began to borrow in large amounts (i.e., engage in deficit spending) in order to alleviate the Depression.  Then, it borrowed enormous amounts to finance the war and defeat fascism.  After World War II, the U.S. government flooded the free world with dollars, so that there would be a currency to replace the British pound as the world's reserve currency.  The U.S. government derives enormous power from the fact that the dollar is the world's reserve currency.  People in other countries have to pay attention to America, because America's currency keeps the world's economy going.  Even in the Communist bloc, the dollar mattered.  As Communist economies flagged, the dollar became the underground, but de facto real, currency in many Communist nations.  Communism's legitimacy was in part undermined by the strength of America's fiat currency.

Greece is in a real fix, because its citizens don't want austerity, but they want to remain part of the EU.  Reality is that they are damned if they do and damned if they don't.  Staying in the EU will require agreement to the EU's demands for more austerity, which will probably worsen Greece's depression.  Leaving the EU will also likely mean that the Greek depression will worsen.  Who's at fault for this mess is a complicated question, but the answer, in short, is like Agatha Christy's novel, Murder on the Orient Express.  Everyone involved in and with the EU is responsible.  And there's no easy way out of the mess, for anyone.

But a larger point is that fiat currencies aren't good or evil.  They are a tool, one that can be used productively or counter-productively.  We need to watch what the Fed is doing--closely.  But let us recognize that much of America's strength comes from its fiat currency. 

The Low Euro: Greece's Salvation?

Greece is within a few weeks of running out of money to pay its debts.  Default looms, and it could cause financial disruption in Europe and around the world.  Yet the Greek government and the Euro bloc are at loggerheads in an Alphonse-and-Gaston routine where true compromise is as commonplace as hen's teeth.  Sounds like Congress.  Meanwhile, the rest of us wait for Godot. 

Luck, however, is part of life, and both Greece and the EU are very lucky.  In its current state of economic extremis (and Greece is suffering the equivalent of the U.S. Great Depression of the 1930s),  Greece would want to depreciate its currency.  If it could do so, depreciation would make its export businesses more competitive and bring in tourism.  But Greece, being part of the Euro bloc, has no control over its currency.  The European Central Bank calls the shots for the Euro. 

Serendipity would have it that the ECB decided recently to engage in quantitative easing (i.e., the buying of Euro-denominated bonds in the open market) as a way to stimulate the EU's stagnant economy.  Quantitative easing is one way of printing money, and the Euro has fallen by about 25% as a consequence.  A 25% price move is an elephantine move in the currency markets, and changes all kinds of economic relationships.  European exports just got gussied up in a big way, and European tourism is now a bargain compared to a year ago. 

Greece doesn't export a lot outside of Europe, but it is one heck of a tourist destination.  If given some time, Greece's tourist business will probably pick up.  Some of Greece's exports might be shifted to non-Euro bloc nations.  Greece might have a shot at recovery.

Much of the problem is that neither the EU nor the Greek government trust each other.  Definitive resolution is impossible without trust.  The result has been a steady kicking of the can down the road every time Greece and the EU have to negotiate.  This time, however, if they kick the can down the road (which is one possible outcome of the current impasse), the consequence may be positive.  If Greece has a couple of years to turn itself around using the low Euro, it may have a shot at recovering enough to satisfy the EU's debt collectors.  But will the EU and Greece muddle through one more set of negotiations?  If everyone were rational, they might pull it off.  But then again, if everyone were rational, they wouldn't be in the mess they are now in.

The Next Market Bubble

Bulls and bears alike wonder when the next market bubble will emerge and pop.  In recent years, major stock market downturns have come from bursting bubbles.  Recessions, threats of war, terrorist attacks and other disturbances have caused market ripples.  But the big gut wrenchers--the nosedives that wrecked your retirement--have come from the popping of asset bubbles.  The gross over-valuation of tech stocks in 2000, the ridiculous real estate lending of 2005-07, those are the events that clobbered equities.  What does the future portend?

Today, the mess in the Middle East grips our attention.  Medieval atrocities by the Islamic State, a mosh pit with weapons in Gaza, mind-numbing slaughter in Syria and sectarian strife in Iraq appall and fascinate.  But none of them will significantly drive down stock valuations.  They just don't have the economic impact.  The Ebola epidemic is now raging out of control in West Africa.  But America's economic exposure to West Africa is miniscule.  And the disease isn't likely to present a major threat to the industrialized world.

Is there an impending market bubble that could burst and dynamite the world's financial system?  The answer is maybe, in Europe.   The European economy is slowing.  Growth is seen only on alternating Sundays.  The EU stays afloat on a cushion of sovereign and bank debt--a lot of it.  With Europe's slowing economy, it will be tough to pay down this debt and expedient to refinance by issuing even greater amounts of debt.  Risks to larger members like Italy and France are rising.  The EU is a financial and currency union without a unitary government.  Thus, it is tailor made to borrow in bulk without governmental controls to interfere.  We in America know from the 2007-08 mortgage crisis what happens when you bulk up on debt that can't be easily repaid.  The vast amount of European debt presents potential systemic risk, just like the vast amount of American mortgage debt outstanding in 2007.

Exacerbating Europe's problems is the war between Ukraine and Russia.  As Russia's direct involvement in combat is becoming increasingly clear, the war is likely to have ever greater impact on Europe.  Sanctions by the West will probably be heightened, and Russia's retaliation will likely hit Europe harder than America.  Europe's financial system could begin to totter as the EU is pushed into recession and capital flees the Old World.  (Indeed, part of the buoyancy of U.S. stocks can be attributed to the arrival of capital now fleeing Europe.)  A run on the Euro could be the straw that breaks the bubble's back.

The European Central Bank, as always, does a fan dance about how accommodative it will be.  While it's become much more interventionist in the past couple of years, it remains constrained by its anti-inflation charter and the stolid, ever-frowning Germans. Maybe the ECB will save the day.  Or maybe not.

Europe's economy, as a whole, is larger than America's.  A tummy ache there could affect the rest of the world.  if you're worried about where the next bursting asset bubble could come from, keep your eye on Europe.

The EU Bubble

Today's kerfluffle in the stock markets over the debt default of an entity affiliated with Portugal's largest bank reminds us that if there is a financial bubble anywhere, it's in EU sovereign and bank debt.  EU sovereign debt and the debt of EU banks have become almost synonymous.  That's because they are linked by a problematic circularity.  EU banks have invested heavily in EU sovereign debt.  EU nations, in turn, have pretty much become the guarantors of the debts of their banks.  Thus, the banks borrow to invest in sovereign debt, and the sovereigns in turn guarantee the banks' debt that funds the sovereigns.  It's rather clever, as long as nothing goes wrong.

However, one could note that EU banks and sovereign nations appear to be burdened with each others' liabilities, and that the guarantees of EU nations accordingly have limited efficacy.  Given that the EU and its banks, in toto, can be reasonably described as overleveraged, this circularity can become a circular firing squad if there is a run on a major EU bank or an EU sovereign member nation.  This is particularly so since no EU nation can issue its own currency and pay its or its banks' debts with printed money.

Of course, the European Central Bank has in recent years made a show of pointing to shining armor it could don and white horses it could mount to ride to the rescue if there is another European financial crisis.  And it has adopted accommodative, money printing-like maneuvers when the going got tough (like letting EU banks use sovereign debt as collateral for borrowings at the ECB without any discounting of their face value).  If the dustup across the pond is limited to Portugal, the ECB should be able to find one way or another to keep the cookie from crumbling.  But if other EU nations, particularly larger ones like France, begin to waver, the EU financial bubble could burst in a nasty way.  The economic consequences could be bad.  Given the growing extremism in Europe, the political consequences could be worse.

There are some asset classes in the U.S. that may be getting bubbly.  Many Internet stocks are suspect. Housing except for the $1 million and up price range seems to be struggling.  In addition, small cap stocks haven't been doing well recently and may turn out to be a bubble bursting.  But it's unlikely that the frothiness of these asset classes could re-trigger the Great Recession.   On the other hand, if the EU sovereign nations can't keep their banking systems on an even keel, then all bets are off. 

Going Negative in Europe

"Going negative" is a political term of art, usually meaning that one candidate campaigns primarily by throwing mud at the other candidate(s).  In our jaded times, going negative has come to predominate.  Trash talking, if nothing else, captures attention.

These days, Europe is going negative for political reasons, although not in the usual sense.  The European Central Bank announced recently that it was cutting the interest rate it pays on deposits from banks to -0.1%.  In other words, banks that deposit funds with the ECB will pay a 0.1% fee for the privilege of having the ECB hold their money.  The ECB claims to be concerned with a low nominal interest rate of 0.5%, and supposedly cut rates below zero to spur bank lending.  Whether more lending will be done is unclear, as banks in the EU have been awfully finicky about extending credit in recent years (except to sovereign nations that sometimes aren't creditworthy).  Banks could cover the costs of the ECB's negative move by lowering interest rates paid on deposits (i.e., on longer term deposits that still have a positive rate) and increasing lending rates for existing borrowers. There's no necessary reason for them to make new loans.

The 0.5% inflation rate that supposedly led the ECB to go negative isn't strikingly different from the low inflation that already prevailed in Europe. One can't help wondering how much the EU was motivated by politics, as opposed to monetary policy.  The EU's badly conceived structure--a monetary union without true fiscal controls--encouraged overly enthusiastic borrowing by sovereign members, particularly those that were economically weaker.  The resulting debt crisis was met with the EU's BYOB (bring your own bailout) policy that meant austerity for those least able to cope, and economic recession (or, in some EU member nations, depression).  It's hardly surprising that political extremism flourished.
 
Nationalistic parties in Europe have recently made striking gains in EU parliamentary elections (yes, in the election of delegates to the EU Parliament, a quarter of whom now would favor the dissolution of the EU).  It must scare the mudcakes out of the ECB's bureaucrats that a quarter of the EU's governing body would be pleased to defenestrate the ECB.

Moreover, nationalistic impulses in Russia led to its seizure of Crimea from Ukraine.  Even though Russia formally transferred Crimea in political marriage to Ukraine in the 1950s, Vladimir Putin (Vlad the Invader, one might call him) seems to believe that Russia nevertheless holds a droit du seigneur to take Crimea for itself. In addition, Russian nationalism (plus surreptitious Russian military intervention) has fueled unrest in eastern Ukraine, leading to civil warfare.  It now looks like Ukraine may go the way of Syria.  Neither side is strong enough to win, and both sides are supported by outside interests that cannot afford to lose.  Russia can protect its interests by keeping the insurgency going at a low boil, just enough that Ukraine is afraid to cozy up too closely to NATO.  America has to do something to help Ukraine, but can't offer enough military assistance to decisively defeat the insurgents.  (Given the pathetic performance of the Ukrainian military, the only way the insurgents can be defeated is if we send in the Marines, and that ain't happening).  So, the nastiness of irregular warfare and flight of civilians from war zones, so familiar to observers of the Syrian civil war, is now being replayed in Ukraine.

Policy makers at the ECB undoubtedly noticed the rising manifestations of nationalism around them, and surely understand that the fiscal austerity imposed by the doyennes of the EU isn't doing a bang up job of fostering economic growth.  That leaves the central bank as the only actor in this drama who can administer the antidote to extremism:  the promotion of economic prosperity.  So, the ECB surely is going negative for political reasons.  And that's a problem.  Central banks were created to foster financial stability, not political stability.  But, with political processes in Europe (as well as in America) moribund on their best days, the ECB is trying to bail out a life raft with a tea cup.  And it's not hard to figure out its chances of success.

What's Wrong With The Cyprus Bailout

The draft proposal on the table to bail out Cyprus consists primarily of closing one bank--Popular Bank of Cyprus, also called Laiki Bank--transferring deposits of 100,000 Euros or less to another large bank called Bank of Cyprus, and freezing deposits exceeding 100,000 Euros.  The frozen assets, which evidently amount to somewhat over 30 billion Euros, will be used to fund Cyprus' share of the cost of the bailout (5.8 billion Euros).  How much frozen account holders will ultimately receive is unclear, since the funds for paying them out would have to come from bad assets of Laiki Bank--defaulted loans and the like.  The hit they will sustain apparently could be large.

At first glance, this revised bailout appears not unlike bank liquidations as seen in the U.S.  Account holders with insured deposits (i.e., at or below the $250,000 threshhold) are fully protected, and those holding excess balances are at risk, taking losses if the assets of the bank don't fully cover the nominal value of their accounts.  But the Cyprus bailout is different.

The process by which Cyprus and the EU got to where they are today was one of political fits, false starts, near collapses and last minute expediency.  The first proposed bailout included a levy on all deposits, a proposal which the Cypriot legislature roundly rejected.  After scrambling futilely for assistance from Russia, the Cypriot government bowed to the stern diktat of the European Union that depositors be tapped.  But both the EU and the Cypriot government wanted to protect insured deposits (those of 100,000 Euros or less), so the burden had to fall on deposits in excess of the insured amount.  And because Laiki Bank is suspected to be the bank of choice for a supposed den of money launderers, tax evaders and other scoundrels, the blade fell on its large depositors.  Large depositors at other banks were spared the guillotine.

 What's missing is the due process of law.  There isn't even a flimsy facade of legal due process.  This isn't an ordinary liquidation of a troubled bank.  Cyprus got into financial trouble, asked for a bailout, was told by the EU that a Cypriot contribution would be a prerequisite, and only then did Cyprus figure out who would pay the piper.  The ultimate resolution is politically driven, not the result of the application of established legal procedures. 

If the large depositors of Laiki Bank are iniquitous Russian oligarchs as some EU officials have hinted, one can't feel terribly sympathetic about their plight.  Legality doesn't seem to have played much of a role in the way many wealthy Russians acquired their riches.  But, ordinarily, modern nations seize property only in accordance with the rule of law.  If a bank depositor isn't proven to be liable, for one lawful reason or another, then he or she shouldn't be deprived of property. 

It wasn't Robin Hood, or even Jesse James, who absconded with the assets of large depositors of Laiki Bank.  It was the sovereign governments of the European Union.  When governments depart from the rule of law, capital will start exiting stage right.  Large depositors in any EU nation that's financially shaky will likely behoove themselves to move their capital to safer places.  The shaky countries may get shakier.  The EU tries to present the Cyprus situation as a unique, one-time problem.  But how many well-to-do depositors want to leave their money at risk, in case that's not true? 

The EU will enjoy a near-term rebound from the Cyprus bailout.  But longer term, it encounter trouble attracting the capital it badly needs to rebound from recession and fuel future growth.  And it may well find that dealings with one of its major energy suppliers--Russia-- will take sharper tone.  When the due process of law isn't applied, some people start thinking that might makes right.  And that would be unfortunate for Europe, given the history of the last century.

The Central Banks' Failure to Eliminate Risk

Now, it's Cyprus--tiny Cyprus, with 0.2% of the EU's GDP--that's shaking up the financial world.  The Asian stock markets are falling on Monday, March 18, 2013, and stock futures indicate that the European and U.S. stock markets are also headed downward.  Runs have already started at Cyprus' banks, and a bank holiday was declared for Monday, in order to stop the outflow of rats from the ship. 

The proximate cause of the panic is a proposed EU bailout for Cyprus that includes taking from depositors at its banks 6.7% of deposits under 100,000 Euros, and 9.9% of deposits exceeding 100,000 Euros.  Surprisingly, this tax (which is to help pay for the bailout) would hit small depositors that were supposed to be fully insured up to 100,000 Euros.  The bailout violates a sacrosanct principle of bank regulation--that deposit insurance cannot be impaired.  Deposit insurance is the key to depositor confidence, and the foundation of commercial banking.  America's banking system recovered from the Great Depression (which saw thousands--yes, thousands--of bank failures) only when deposit insurance was instituted.  If you scare depositors, an entire banking system can go belly up in less time than it takes to scramble a couple of eggs.

The powers that be which fashioned the Cyprus bailout--the EU, the European Central Bank and the IMF--imposed the depositor tax because of the somewhat shady doings of Cypriot banks.  They extended the scope of their businesses way beyond their home island, accumulating assets amounting to twice the size of Cyprus' GDP.  Reportedly, around half of their deposits are from Russians, and suspicions of money laundering, tax evasion, and other alleged shenanigans lurk.  The stolid burghers of northern Europe have been wrinkling their noses over the unsavory aromas rising from Cyprus' banks, and they evidently view a tax on depositors as fair compensation for the trouble the EU is now being put to.

Whether or not the deposit tax is fair is, from a commercial standpoint, pretty much irrelevant.  The financial markets thrive on confidence.  The EU's financial crisis eased last summer when the head of the European Central Bank said, in substance if not words, that he would authorize the printing of money to prop up failing EU member nations.  The bond vigilantes backed down.  But the Cyprus bailout's tax on deposits is the opposite of money printing, and implies that losses are possible for holders of deposits in banks at other weak EU nations.  There's nothing that shakes confidence like the prospect of losses, especially if one was supposed to be insured against them. 

The financial markets have been coasting on a mellow buzz from toking up on central bank monetary accommodation.  Ultra low interest rates and quantitative easing have taken the edge off volatility, and the markets seem to know no fear.  But there is no way to eliminate financial risk.  You can only transfer it somewhere.  The Cypriots apparently wanted to transfer the risks and costs of their bankruptcy as far north as they could.  But the folks up north didn't seem to cotton to that notion.  So the risks and costs blew back, and as we now see, blowback can be nasty. 

Who knows how this will all end.  No doubt high ranking officials on both sides of the Atlantic are engaged, even as we write, in frantic discussions to figure out how to prevent the spread of financial contagion.  The baseline problem is that the EU as a whole hasn't decided how to allocate the costs of resolving its financial crisis.  This is probably a harder problem than the resolution of the U.S. government's current dysfunction, since, in Europe, people from disparate countries and cultures must somehow find common ground.  Since these are the same people who fought two horrendous World Wars against each other in the 20th Century, it remains unclear if they will succeed.

In the meantime, remember that central bank monetary policy can provide a methadone high, at best.  It won't last forever, and the aftermath may be a real downer.  It's fine to feel good about the financial markets right now.  But keep in mind that the central banks cannot eliminate financial risk, and if you relax your vigilance, risk could bite your left ankle in a flash.

Pan Europeanism's Gambit

It would appear that a group of key European leaders combating the EU financial crisis have coalesced around the banner of Pan Europeanism.  Mario Draghi, head of the European Central Bank, has positioned the ECB to start financing struggling EU governments.  This is a paradigm shift from past ECB policies, and moves the ECB toward the money printing mode of the Federal Reserve and the Bank of England.  Recently, Angela Merkel, Germany's Chancellor, has spoken of cutting Greece a break on its austerity obligations under the terms of the EU's bailout for that nation. Such magnanimity is at rather sharp odds with her tough stated positions not many months ago.  The recent election in France of Socialist Francois Hollande shifted the EU's political center of gravity toward more accommodative measures--Hollande's notion of austerity is to raise taxes on the wealthy and give them a taste of austerity. 

The award of the Nobel Peace Prize to the European Union may be the latest move in the gambit to persuade skeptical northern European taxpayers of the need to keep the EU together.  The point is that failure to stay together will raise the specter of another continental war.  Although actual war seems highly unlikely in today's non- and often anti-militaristic Europe, the subliminal message is clear. 

The Nobel award is like a mutual admiration society of Pan Europeanists high fiving each other. The political in-crowd on the continent has to be very pleased with itself at the moment.  But the baseline problem for saving the EU remains whether or not northern European taxpayers are prepared to foot the bill for keeping the whole shebang together.  If not, the $1.5 million or so that comes with a Nobel Prize won't matter.  An interesting question is who will the EU select as its representative to receive the award.  Here's betting it's Angela Merkel, who needs political cover.

What's Behind the ECB's Unlimited Bond Buying Program?

It's kind of hard not to smell a rat in Mario Draghi's proposal for the European Central Bank to make "unlimited" purchases of sovereign bonds of troubled EU member nations. According to the proposal, the ECB will buy an EU member's bonds if the member requests assistance and submits to fiscal oversight by the EU. The latter, however, has been the problem with Greece. It doesn't want to submit to the EU's fiscal oversight. And when it did agree to terms demanded by the EU, it failed to comply with them. In return, Greece has been given break after break after break. It effectively defaulted months ago, but the EU papered the default over with a loan workout that forced creditors to sustain losses (which they may have recouped via credit default swaps, so the losses actually fell on the writers of the CDSs or their unfortunate direct, secondary or tertiary counterparties who held the ultimate risk of loss). Stated otherwise, the EU has supported Greece without Greece having to do the full austerity dance it was supposed to do.

The two countries that Draghi's proposal was aimed to help, Spain and Italy, insist that they will not submit to fiscal oversight by the EU (for domestic political reasons). If they really mean it, that means they won't get bond buying assistance from the ECB. Possibly, their hardline insistence that they won't ask for help (and thereby submit to central oversight) is a bluff, meant to get Draghi to drop the fiscal oversight condition. They could simply let market forces push their bond yields higher. That would shove the EU closer to the brink. Draghi might then drop the fiscal oversight condition when the markets threaten to go haywire. Of course, the bluff isn't really aimed at Draghi, who seems amenable enough to U.S. Fed-style money printing, but at the Germans and other northern Europeans of the frugal persuasion. The Greeks have proven themselves adept at brinksmanship with Germany and its economic allies. Spain and Italy have little incentive to be any more austere.

Germany may be wealthy enough to bail out Greece. But it can't bail out both Spain and Italy, which have much larger economies. So a move by Draghi to drop the fiscal oversight condition could lead to German withdrawal from the EU. That could be catastrophic. But writing blank checks to Greece, Spain and Italy could be catastrophic for Germany, and one can't expect Germany to knowingly sign up for a catastrophe. Mario Draghi may be playing a most dangerous game, and he'd better play it well or the abyss will beckon.

How the Financial Markets Enable the EU Sovereign Debt Crisis

Imagine Barack Obama or Mitt Romney saying, "If re-elected/elected President, I'm going to do everything I can to restore prosperity and full employment, and, believe me, it will be enough." The stock market's reaction would be neutral to negative, and a lot of people, perhaps most, would laugh and suggest the candidate try out as a joke writer for the Tonight Show.

Last week, the head of the European Central Bank, Mario Draghi, vowed to do everything he could to prevent the collapse of the Euro zone and added that "it will be enough." He offered no details on what he had in mind. The stock market rallied and Euro zone interest rates dipped. The next day, the leaders of Germany and France, Angela Merkel and Francois Hollande, rose from the chorus and shouted "Amen" (while also skimping on details). The stock market rose again, with the Dow Jones Industrial Average closing over 13,000, a threshold it hadn't crossed since May. In the last two trading days of the past week, the Dow rose almost 400 points (or 3.15%)--all because a few EU leaders swore on a stack of sovereign bonds that, by golly, they were going to something or other really good.

This follows a pattern that has persisted throughout the EU sovereign debt crisis. Storm clouds gather, interest rates rise, and stocks fall. European leaders, alarmed by the market action, issue rosy press releases, promising rose gardens while avoiding any detailed explanation of how salvation will be attained. Stocks rise while interest rates fall. Everyone is happy.

But, then, reality inserts itself. The baseline problem with the EU debt crisis is that the sovereign liabilities in questions are simply too great for the debtor nations to repay. The question is where the losses will fall--on creditors, citizens of debtor nations, taxpayers of wealthy EU nations, issuers of credit default swaps or other interested parties? The intractable tussling over this essential and, for some, existential, question forces examination of ugly details revealing that there are no easy answers. Bottom line: someone needs to give up a shipload of real wealth to pay off the debts. There are no volunteers. Stocks again fall and interest rates again rise.

But the EU's leadership has learned that the financial markets respond to talk therapy, and talk is cheap. If they talk interest rates down, even if only temporarily, they can stall on making the hard choices needed for true resolution. Politicians have never met a hard choice they wanted to make. So they yak their way to a brief respite, and fiddle until the markets waver again. Meanwhile, overall debt levels among EU nations keep rising while Europe slides into recession. There's something wrong with this picture. But, as long as the financial markets display an appetite for b.s., the EU's leaders will keep serving it up.

Over There at the EU Crisis

Paralysis now grips Europe. The EU has no solution for its sovereign debt-banking-economic crisis. Greece is in a political netherworld, with a second election to be held this month to determine, perhaps, if the electorate can choose a government.

But Greece is a side show. Spain now occupies center stage, with a banking crisis that the country itself cannot solve. Although Spain's sovereign debt is, proportionately speaking, no greater than Germany's, enormous losses from a collapsed real estate market have overwhelmed Spain's banks. The government, directly and indirectly, is in the process of taking over its banking system. But it cannot handle the shipload of liabilities it is assuming. So it has turned to the EU.

The EU, in its familiar, inimitable fashion, wallows in dysfunction as it squirms around to find someone to pick up the tab. The European Central Bank, by holding interest rates steady today, has signaled its firm intention not to take responsibility for the messes made by politicians. Most of Europe's politicians have raised their eyebrows in the direction of Germany. But the Germans fear, not irrationally, that they are being asked to pick up the tab not only for the table, but for the entire restaurant. Any bailout of Spain's banks would surely entail greater EU (read, German) control over Spain's banks. That may or may not be acceptable to the Spanish, since German control over Spain's credit spigots means German control over Spain's economy.

Not surprisingly, hints and even calls for American action have grown. It's not at all crazy for Europe to look westward. In 1917 and 1941, the United States called its men to arms in order to end world wars emanating from Europe's endemic political dysfunction. Over 400,000 Americans made the supreme sacrifice in Europe during these two wars and American taxpayers coughed up many, many billions of dollars to stop Europeans from killing each other. In 1947, America adopted the Marshall Plan, an extraordinary act of generosity that propped up a Europe devastated by war and prevented much of the continent from falling under Soviet control. Surely, it's quite rational for Europe to expect America to step up again and reach for the tab. We've fostered the greatest case of moral hazard in human history, and now have to live with the consequences.

But America has its own problems. The vituperative animosity between Republicans and Democrats, well-exemplified by the bitterness of Wisconsin's recall election, prevents the President and Congress from taking effective action before this fall's presidential election. Action thereafter, even if possible, may be too late.

That leaves the Federal Reserve. Market players twitch their ears around, hoping for any sound of Chairman Bernanke warming up his helicopter. We know from the 2008 financial crisis that Bernanke's default setting is to act. That setting isn't going to change in the foreseeable future. Whether or not the Fed can do anything effective is a different question. More QE might temporarily support the stock markets--and, naturally, that's Wall Street's underlying motive in encouraging an activist Fed. Never mind the spectacle of America's capitalists par excellence looking for more government intervention. But there's little reason to think that QE III will save Europe. The sources of the badness in Europe's bad debt won't be cured by Fed purchases of dollar denominated debt.

Is there any way the Fed could have an impact in Europe? The answer is maybe, but it would involve replacing the Euro with the U.S. dollar. Since the Fed can (and perhaps will) printed unlimited quantities of dollars, it could buy up Euro-denominated debt if the sellers would accept dollars. Because the EU crisis involves the heart of the European financial system (banks, central banks and sovereign debt), the result would be to make the dollar Europe's continental currency. Not necessarily for all daily spending at the supermarket and the gas station, but at least for all significant central banking, interbank and monetary policy transactions. With the dollar the only financial asset in the world that is readily available to provide a measure of stability to Europe, conversion from the Euro to the dollar may be the one card the Fed might effectively play.

Europeans wouldn't readily cotton to such a notion, because it would recreate the 1950s and 1960s, when the dollar played such a role and the United States exercised extra-sovereign power over Western Europe. But it might be the way the Fed, being the only central bank in the world with the inclination and capacity to act, could prop up Europe.

In essence, the EU faces a choice between dissolution, German dominance, or in this perhaps far fetched scenario, American dominance. Given the history of the past century, in which America was the most generous and benevolent of super powers, what do we think Europeans might prefer? Germany's stubborn insistence on its world view during the current crisis has, however unfairly, brought back in many European minds images of jackbooted stormtroopers and civilian killings by screaming Stuka dive bombers. But American intervention, if it occurs, would stir memories of raw, inexperienced GIs by dint of sheer determination and courage pushing their way through murderous German fire onto the heights overlooking Omaha Beach, and continuing from there to liberate a continent. A European return to the dollar may be the only real choice left. Time will tell.

The Bank Run Deposit Insurance Doesn't Protect Against

A slow motion run on banks in Greece, Spain and other distressed Euro bloc nations has been taking place ever since the sovereign debt crisis blew up two years ago. Recent news reports indicate it has accelerated, particularly in Greece. The top 1% and others in distressed nations have been moving money to banking havens such as Switzerland and Luxembourg, and stable nations like Germany and the UK.

Depositors have two reasons to flee banks in troubled countries. One, those holding deposits exceeding the 100,000 Euro limit on deposit insurance in the Euro bloc have much to lose if their local bank collapses. Two, depositors in any nation that potentially may depart the Euro bloc confront the risk of compelled conversion of their deposits into a new, depreciated currency. Greece presents a vivid example of the latter problem. Conversion back to the drachma could sharply reduce the value of Greek bank deposits. There is no deposit insurance that protects against losses sustained when one's home nation drops out of the Euro zone and adopts a depreciated national currency. Some Greeks have been withdrawing Euros from ATMs (presumably to pad their mattresses). Others have been moving Euros electronically to safe haven nations.

The capital mobility created by the adoption of the Euro facilitates such bank runs. Since the Euro bloc, by definition, eliminates the problems of currency conversion, moving funds from one Euro bloc nation to another is easier than in the bad old days of national currencies. The upside of increased capital mobility is that money was supposed to go where it could earn the highest return, which was thought to promote economic efficiency and greater overall prosperity. The downside is that capital can more readily flee ugly situations, even if it's needed to help finance a nation's way out of ugliness.

The European Central Bank might be able to stop the burgeoning bank runs. The core mission of central banks is to promote depositor confidence. The ECB seems to have been lending many billions of Euros to Greek and Spanish banks. But it won't print money, and that limits its options if the run quickens. The Euro bloc, a 21st Century financial innovation, may have laid the foundation for an old-fashioned 19th Century financial panic. Time will tell.

Fools Among the Holders of Greek Debt

A couple of months ago, most holders of Greek government debt reluctantly agreed to a deal to take a loss (called a "haircut" by the financial cognoscenti) of about 75% of the nominal (i.e., face) value of the debt as part of the second bailout package offered to Greece by the EU. Another aspect of that deal was the Greek government would institute austerity measures in order to reduce its future need for debt. The coalition government then governing Greece, a pushmi-pullyu shotgun marriage of two opposing parties, solemnly agreed to the austerity measures.

Just a couple of days ago, Greek voters gave the coalition government something like a machine gun divorce, placing bootprints on the behinds of the coalition parties and effectively putting a Communist politician in the position of calling the shots. It's been decades since Communists in any democratic nation have had a scintilla of political power. But there's never a dull moment with the ongoing economic and financial crisis.

Needless to say, the Communist leader, Alexi Tsipras, isn't of a mind to embrace austerity. He does say he wants Greece to remain in the Euro zone. And why not? Since the beginning of the EU sovereign debt crisis, Greek governments have made promises about fiscal probity and austerity, gotten promises of bailouts, not quite fully lived up to their promises to throttle back spending, and gotten bailed out anyway because the wealthy EU nations always blinked first. The Greek Communists might as well play the same game, and take credit for any blinks they can induce.

Meanwhile, back at the ranch, those holders of Greek debt who agreed to the 75% haircut must be wondering how foolish they now look to the people on whose behalf they manage money. It's well understood that there is political risk associated with speculating in sovereign debt. Politicians will, when push comes to shove, favor their constituents over money managers in the top 1%. Nevertheless, professional financiers dabbling in sovereign debt are supposed to be able to assess political risk astutely. Just two months after the second bailout deal, they've lost the benefit of their bargain because of a political risk that was staring them in the face when they agreed to the haircut.

Private investors will be reluctant to play in the EU sovereign debt sandbox in the future. It's not a winning strategy to take a big haircut and then find out two months later that you have to deal with a newly risen Communist politician.

With the evaporation of private investment interest in the sovereign debt of weaker EU nations, the European Union will have a problem. A fairly large one, in fact. Its member nations can't function without debt. But, with natural investors unwilling to lend their savings, EU sovereign debt (at least for the weaker member nations) would have to be financed by the European Central Bank. The ECB would protest that this violates the letter and spirit of its charter. But what choice will it have? The EU doesn't have a mechanism for defenestrating a member nation, however badly it behaves. And its undercapitalized banking system is up to its ears in the sovereign debt of weak EU nations and can't afford to keep booking losses.

But if the ECB starts to monetize the debt of weaker EU nations (which it already is doing in shadow form with its three-year loans to large member banks), the debt of the wealthier EU nations will become less attractive to private investors. A big money print by the ECB will inflate the Euro in Germany just as it inflates it in Greece, and no creditor wants to hold debt denominated in a potentially inflationary currency. If private investors step back from German sovereign debt, the EU game will be up.

In the end, the wealthier nations will probably leave the EU, and possibly create a smaller currency union with each other. Or they may just go it alone. Either path will garner the interest of private holders of capital. And that would be the way to restore true financial stability.

A Farewell to European Union

The stock market's penchant for taking the short term view has never been so evident as tonight, with Japanese stocks down over 2% and U.S. stock futures down around 1% following anti-austerity elections in France and Greece. These election results are hardly a surprise; they've been predicted for weeks. Yet, the market is acting like it is shocked--shocked--that electorates would put their personal well-being ahead of the bond market's interests.

The market, as it so often does, allowed itself to be lulled into complacency by the EU's bailouts, which were just kicks of the can down the road with maximum PR effort. Press release politics, it was, and the market took the press releases at face value.

But the problem with the EU sovereign debt crisis is that debt must ultimately be repaid. It can be repaid by debtor remittances to bond holders. Or it can be repaid by forcing bondholders to take partial losses, with debtors kicking in a few pennies for the sake of principle (or principal, if you will). And most typically for the EU, it can be repaid by rolling the debt over, with the help of bailouts from wealthier nations. The last was the EU's first choice, although Teutonic imposition of austerity policies was the EU's way of trying to make debtor nations share some of the burden.

Austerity by itself is likely to produce only economic deceleration. It reduces spending and therefore economic stimulus. The workable form of austerity--austerity along with currency devaluation--can work. It was a formula for recovery by various Asian nations following the 1997 financial crisis there, albeit with substantial short term pain. But Greece's and France's citizens aren't willing to bear the pain of austerity, and the ECB and Germany aren't willing to devalue the Euro. So the EU's brand of austerity isn't destined for success.

The absence of true political union within the EU made it too easy for member nations to ask, not what they could do for the EU, but what the EU could do for them. Europe's political leaders bear much responsibility, presenting the EU as an great opportunity, while downplaying the risks. If the EU were selling securities in the U.S., the SEC would have serious questions about the completeness of its disclosures.

A true currency union can't realistically be a goal by itself. It must be accompanied by true political union. Witness America's Civil War, which not only unified the United States. It also made the U.S. dollar America's sole currency, when federal legislation in 1863 taxing state issued currencies--and federal victory over the Confederacy two years later--effectively eliminated all competing legal tender.

But Europe is too diverse for true political union. Unity requires a willingness to share burdens, to pay an economic price so that political unity can be maintained. Europeans don't have enough in common to contemplate such generosity with any degree of equanimity. So the EU as it now exists cannot survive. Some nations will exit. Those sufficiently similar in outlook and economic strength may stay together in a smaller currency union. But the recent collapse of the Dutch government, due to the growing strength of the right in the Netherlands, raises doubts about the potential for even a smaller currency union.

In one sense, the Euro was part of Europe's effort to prevent another world war. Both world wars of the 20th Century imposed almost unimaginable costs on Europeans. Postwar leaders sought economic union in order to diminish national differences that had fostered the hostilities. But Europeans remain tribal, something that economic interests and market forces have not overcome. And European tribalism will take its toll on the financial markets.

America: a Nation of Cash Hoarders

The stock market has just finished its best quarter since 1998, with the S&P 500 up almost 12%. But retail investors keep exiting the market, stashing money in bonds or sidelining it in bank accounts and money market funds. Why are investors so skittish when returns seem so good? Because they've learned the hard way.

First, stock market gains are no longer seen as solid. That was the lesson of the 2000 tech market crash and the 2007-08 financial crisis. The lesson was reinforced by the May 2010 flash crash, and by the motion sickness caused by volatility from the European sovereign debt crisis. For Baby Boomers in particular, who are reaching retirement age, easing back on stocks and into more stable investments is eminently sensible. (For more on this point, see http://blogger.uncleleosden.com/2012/02/maybe-retail-investor-is-retiring.html). After all, it's pretty hard to retire on ethereal gains.

Second, financial assets derive much, if not most, of their value today from government policies and political maneuvering. Indeed, the world's second most important currency--the Euro--was created and is sustained by government policy and bailouts. Take the EU's governments out of the picture and there would be no Euro. Nothing is as unpredictable or unreliable as politics. And few investors want to bet their remaining retirement savings on the flightiness of politics.

Third, investors need only look at the smart money to see that cash is the preferred asset. Large corporations are hoarding cash like it was spring water in the Sahara. This cash hoarding reflects the breakdown of the banking system, which corporations in the U.S. and Europe know can't be relied upon. If big names in the corporate world are stuffing their mattresses with greenbacks, how many retail investors think they're so much smarter than major corporations that they should do something different? Okay, so Apple just declared a dividend. But that looks more like Apple is trying to prevent its cash hoard from getting larger rather than sending a lot of its current holdings of cash to shareholders.

Fourth, look at the banking system itself. Major banks borrow heavily from the Fed or the European Central Bank, only to turn it around and redeposit the borrowed funds with their central bank. Why? Because they're hoarding cash as well. They don't want to do something dangerous like invest in risk assets because they might lose money. Are investors to believe that risk assets are for them when the world's largest banks won't touch the cr . . . stuff.

Fifth, the Fed's longstanding suppression of positive interest rates net of inflation can only be viewed as an official statement that the economy is still deep in the septic tank and going nowhere fast. Its promise to stamp out positive interest rates until at least 2014 is tantamount to predicting that things won't get better any time soon. Who would want to invest in risk assets with the government so gloomy? When interest rates are effectively zero or less, you know you can't recover your losses from interest income. So it may be best not to take losses even if you get no gains. The Fed's blatant effort to arm twist investors into risk assets only pushes many of them away from taking any risk at all.

As regards economic recovery, we're basically in a stand off. Corporations aren't investing or hiring until consumer spending rebounds. But consumers won't spend because they're afraid of losing their jobs or have lost their jobs, and, for many, are underwater on their mortgages. The Federal Reserve's war on positive interest rates prevents savers from getting hardly a thimbleful of interest income. So retirees and others having savings dial back their consumption in order to preserve capital. The housing market remains a disaster area, with vast amounts of foreclosed properties and defaulted mortgages continuing to lurk. The losses in real estate (realized and unrealized) are so great that it will be years before this market recovers (for this writer's not inaccurate prediction made four and a half years ago, see http://blogger.uncleleosden.com/2007/09/when-will-housing-prices-recover.html).

The biggest and most successful corporations hoard cash. The banks at the center of the financial system hoard cash. Cash feels good. (See http://blogger.uncleleosden.com/2011/11/old-timers-and-their-rolls-of-cash.html.) Why wouldn't investors get on the bandwagon and hoard cash?