Brexit and the Globalization Bubble

The stock market has returned to pre-Brexit levels.  So the crisis is over and everything is fine.  After all, if you're not losing money, what's the problem?  Let's think about what craft beer to try next.

Actually, Brexit is still very much affecting the financial markets.  The British pound is moribund.  The Euro isn't looking pretty.  And the Yen is strong, much to the unhappiness of the Japanese, who want a weak currency that gives them an advantage in exporting.  The bond market continues to show a flood of financial refugees into U.S. Treasury securities.  The crisis isn't over.

The volatility in stocks was more about short term speculation over the outcome of the Brexit vote, than about Brexit itself.  Shortly before the vote, much of the fast money crowd had placed large bets on the UK voting to remain.  When the vote went the other way, the speculators had to unwind their now stinky positions muy pronto.  But this volatility didn't reflect the impact of Brexit itself.  Brexit will take years, and its impact is largely unknowable at this time since we don't yet know the terms of the UK's decampment.

The EU is talking tough about the terms of divorce.  That's perhaps an understandable emotional reaction.  After all, the EU is afraid that the insurgents in other member nations will engineer more exits.  Taking a tough line, it apparently thinks, discourages further desertions. 

But the EU is missing the point.  What impelled a majority of British voters to choose exfiltration was that globalization and the benefits of the EU were oversold.  Britons were promised a glowing future if they cozied up to continental Europeans, who they haven't really trusted since before the Hundred Years War.  EU membership may have boosted British GDP, but there was a problem with most of the boost going to a small number of people who were doing pretty well to begin with.  And there was a perception that the EU's open borders policy allowed immigration that took jobs away from native-born Britons.  All this occurred under a legal regime in which many Britons felt they had no voice.  They apparently felt that, contrary to the principles of democracy, they, although voters, were being ruled instead of ruling. 

By playing tough with the terms of Britain's exit, the EU fails to address the real, legitimate grievances leading to Britain's vote.  The truth is that globalization is an oversold political bubble and the bubble is bursting.  Those with grievances aren't confined to the UK; they can be found throughout the other 27 member nations.  A punitive approach to the terms of Brexit could leave both the UK and the EU poorer, while the forces of insurgency would continue unabated.

The distribution of wealth isn't merely something for social scientists to study.  It really matters--politically and economically.  The elites who have led the way toward globalization must find ways to improve the lives and fortunes of all, or face much bigger problems than Brexit. 

This is true in America as well as across the pond.  Donald Trump hopes to emulate the Leave campaign.  Hillary Clinton has gotten a certain amount of mileage  from running as not-Donald-Trump.  But she is one of the elites who has pushed globalization.  She now purports to have changed her mind, but only after severe pressure exerted by Bernie Sanders.  It's not hard to wonder if she's really changed her stripes.  The widespread perception of her untrustworthiness will hinder her ability to convince the blue collar voters in swing states that she's really on their side.  She doesn't inspire or excite hardly anyone.  If she doesn't acknowledge the overselling of globalization in a clear and convincing way, and offer real relief for the distressed, Trump may yet strut to the tune of Hail to the Chief.

Put Britain at the Front of the Queue

The British electorate has voted to exit the EU.  Whether we agree or disagree with their reasons, or see the wisdom of exiting, the democratic process has spoken.   We in America, the land where modern democracy began, should respect the decision of Britain's voters.  Now is not the time for America, or Americans, to take partisan positions.  Europe is splintering, and potentially weakening.  Continental Europe will probably react badly, and set harsh terms for Britain's exit.  With Continental Europe beset by popular insurgencies, more instability is likely and other nations may leave the EU.    Bad actors, ranging from Russia to Iran to Islamic radicals, will attempt to take advantage of Europe's divisiveness.  America is the one nation in the world that can play the role of honest broker and bridge the gaps that will now emerge.

Britain will need to negotiate a new trade pact with the United States.  President Obama imprudently threatened that, if Britain voted to exit the EU, America would put Britain at the end of the queue for the negotiation of such a pact.  That ill-advised threat should now be disregarded.  Britain is America's staunchest ally in Europe, and America benefits greatly from a stable and prosperous Britain.  British troops have fought side-by-side with American troops in numerous conflicts since World War I, and America and Britain have one of the best intelligence sharing arrangements in the world. Britain is now headed for independence, and America can only lose by being punitive. Put Britain at the front of the queue.

America should also work with the EU to reduce, as much as possible, the friction likely to result from Britain's exit.  A wounded and angry EU can be detrimental to the world's economy and international security.  America may be the only nation that can calm things down.

Brexit gives America the opportunity to expand its international role, this time without having to send  troops overseas.  For those who think America is in decline, think again.  As much as ever, America is needed in Europe, and should now step forward and play the role of superpower.

The Fed's International Data Dichotomy

The Federal Reserve Board is meeting to decide whether or not to raise interest rates.  The costs and benefits of its decision, whichever way it goes, will fall to a large degree along international borders.

Most of the data favoring a rate hike are domestic.  The U.S. economy is growing, moderately but steadily (especially after data revisions).  Unemployment has fallen to the level generally regarded as full employment.  Jobs growth continues, not at a blistering pace but indicative of continued expansion.  Inflation is very low, but if you strip out energy and food prices (which are volatile), the rest of the price structure is pretty close to the Fed's 2% target.

Most of the data arguing against a rate hike is from overseas.  Chinese stocks have been volatile and China's growth is slowing.  Europe's and Japan's economies are  barely growing.  Emerging nations and commodities producing nations are on the ropes, with many facing shrinking economies.  The Greek debt crisis has temporarily simmered down, but the most recent "resolution" was just another kick of the can down the road.  So we can be confident that a Greek default will loom anon, and we'll have to revisit familiar angst.  A rate increase will strengthen the dollar, which will possibly exacerbate these international problems.

Much of foreign anxiety stems from the fact that the dollar is the international medium of exchange.  The entire world uses the dollar in numerous trade and cross-border transactions.  The Fed's monetary policy unavoidably affects people in distant lands.  A rate hike may help the domestic economy by easing asset distortions and increasing certainty (and desperately desired income for savers).  It is likely to have a negative impact overseas.  No wonder the IMF and other voices reflecting foreign perspectives argue against a rate hike.

What will the Fed do?  Most likely, not even the Fed knows before its meeting.  We've been told that its decision is data dependent.  What we don't know is how it weighs and balances the data.  What data receive greater consideration?  What data are downplayed?  What thought is given to the effect of the Fed's decision on foreign relations? Central banking is distinct from diplomacy, but the Fed can't ignore foreign concerns.  A rate hike will produce smiles and frowns, mostly on different sides of the border.  After World War II, America became the pre-eminent economic power in the world, and it cannot now avoid the consequences of its dominance.

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.

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.

Did Someone Blow Up the Swiss Currency Peg?

Much to the surprise of numerous market players, the Swiss National Bank yesterday (Jan. 15, 2015) dropped its commitment to peg the Swiss franc at 1.20 to the Euro.  The Swiss franc suddenly rose some 20% in value, a price shift that clobbered anyone betting the peg would hold.  Losses have been sudden and very sharp.  A major foreign exchange broker, FXCM, has received an emergency $300 million bailout loan from Leucadia National.  Another forex broker, Alpari UK, has entered insolvency proceedings.  A new Zealand broker, Excel Markets, has been knocked out of business.

The Swiss National Bank's reasons for abandoning the peg aren't very clear.  But the abrupt demise of the peg is reminiscent of the UK's withdrawal of the British pound from the European Exchange Rate Mechanism in 1992, after a large hedge fund shorted over 10 billion pounds on September 16, 1992.  The Bank of England was trying to fight market forces that dictated a lower valuation for the pound, and in the end couldn't win that fight. 

A news story reports that in December 2014, there was a very large capital inflow into the Swiss franc, with some 34 billion francs being bought up.  See http://www.cnbc.com/id/102343957.  This is about 10 times the monthly average.  One can wonder whether this flood of capital was the result of a calculated move by one or a few big market players.  While there has for some months been a flight to safety resulting from the EU's economic slowdown (and the likely de facto devaluation in the near future of the Euro via ECB quantitative easing), Vladimir Putin's banditry in Ukraine, and the never-ending turmoil in the Middle East, December's inflow is so abruptly large than one cannot exclude the possibility that it was a move made by a few powerful players.  And if it was, they would have profited handsomely from the Swiss franc's recent price rise.

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 Failure of European Economic Integration

Economic integration--intertwining the economies of nations--was supposed to promote economic efficiency, prosperity and ultimately peace.  The idea was that if nations need each other to keep their economies humming, they wouldn't start a shooting war.  Continental Europeans, having suffered tens of millions of deaths in two world wars, were particularly impassioned with this idea.  Who can blame them?  Arms races and wars hadn't solved their problems.  The League of Nations didn't solved their problems.  Why not give mutual dependence on each other for cheese, wine, sardines, sausage, and pasta a chance?

At first the idea seemed to work.  The EU prospered in its early years.  We now know those salad days resulted to a large degree from inexpensive borrowing by poorer EU nations, who snarfed up too much easy money and now struggle to avoid the death of a thousand budget cuts.  But optimism held sway in the early days of the EU, and economic kumbaya was extended to the nations of the former Soviet Union, including the big brown bear itself.

Economic integration provides leverage.  The proponents of the EU thought that the leverage would be used to restrain aggression. But leverage by itself is morally neutral, and can be used for good or evil.  Give leverage to a son of a ditch (sp), and he'll use it for evil.  This is what we see in Ukraine today, where Vlad the Invader has seized Crimea, and is sponsoring a "rebellion" in eastern Ukraine against the Kiev government, a war that is increasingly being conducted by Russian soldiers and Russian operatives.  As Russian personnel take over the fighting, the war is morphing into a clash between nations.  This is exactly what economic integration was supposed to prevent. 

Europe's response to Vlad's invasions has hardly gone beyond a tepid wrist slap, and talk of stronger sanctions is matched by behind the scenes maneuvering to prevent any economic consequences from the sanctions.  The horror of the shoot down of Malaysia Airlines Flight MH 17 was quickly followed by France reaffirming its intention to deliver a Mistral class helicopter carrier to Russia, a substantial warship that Russia apparently could not itself build.  Economic integration, it would appear, trumps moral rectitude.

Putin is using economic integration as a weapon, and in his insidious hands, it's devilishly effective.  Europe is dependent on Russia for gas and oil, and can't easily substitute other suppliers for Russia.  Putin has apparently increased his support for the rebels in Ukraine since the Flight MH 17 atrocity. He has much to gain by doubling down.  His increased aggressiveness forces the U.S. and Europe to struggle to respond, and this struggle heightens the divisions between the New World and the Old. He renders NATO a hollow shell, something the Poles have publicly admitted.  Putin doesn't have to conquer Ukraine, or even eastern Ukraine.  All he has to do is keep stirring the pot, and in so doing highlights Europe's dependence on Russia and America's weakness.

Economic integration doesn't turn a monster into a nice kitty.  When done with a dastard (sp), he remains dastardly, and will look for opportunities to slip the knife between the ribs of his trading partners.  The Europeans have, through economic integration, delivered themselves unto evil, and they are now paying the price.

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.

The Lucky, Lucky Fed

Soldiers want their generals to be lucky.  As capable and knowledgeable as generals may be, they still need luck to win.  And citizens want their central banks to be lucky, because central bankers often fail even if they are capable and knowledgeable.

The Federal Reserve has been very, very lucky.  Unrest in Ukraine, territorial disputes in East Asia, the usual morass in the Middle East, and now nationalist parties winning European elections, have all combined to push U.S. Treasury yields down even as the Fed steadily withdraws its quantitative easing.  Financial markets mavens who confidently predicted that this would be the year of rising interest rates and falling stock prices have had to substitute excuses and explanations for predictions. 

Some still persist in forecasting rising rates and falling stocks.  Perhaps they will be proven correct.  But if you're betting your money on these predictions, remember that you're, at least in part, betting on the Fed's luck running out.  A bet on bad luck is still a bet on luck.  If you wouldn't play the lottery or patronize a casino, why bet on (or against) the central bank's luck?  The smart thing to do is stay diversified, and be patient.  (See http://blogger.uncleleosden.com/2014/05/why-you-should-invest-like-smart-money.html.)  The tortoise tends to be a better investor than the hare.

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.

The Great Anxiety

The Great Recession has morphed into the Great Anxiety.  Economic growth is tepid, enough so that it inspires little confidence.  Unemployment, still high, is falling, but so slowly that consumers' animal spirits remain tame.  Individual investors, confronted by three year highs in the stock market, celebrate by fleeing.  The members of Congress devote their energies to calling each other finks, rat finks, double rat finks, and triple rat finks, while the nation veers toward a fiscal vortex.  Both candidates for the Presidency, although individually quite intelligent and accomplished, swap lies about how the other is lying and inspire little more than resigned sighs from their supporters.  The Federal Reserve is operating the only show in town, and its program consists of printing money, printing money while riding a bicycle sitting backwards, printing money while juggling eight balls and printing money while doing double somersaults on a trapeze.  But the Fed can't do much to resolve the problems in Europe, which is now sliding into recession even as the sovereign debt crisis gets kicked farther down the road.

If the Federal Reserve Board is correct in believing that public confidence is crucial to economic growth, then we are a long way from healthy, sustainable growth.  By all current indications, whichever candidate for President wins won't inspire much confidence.  Congress appears likely to remain divided between a Republican House and a Democratic Senate.  Gridlock isn't that big a problem when the economy is strong.  But it is deadly when the economy is moribund.  For better or for worse, a somnolent economy needs a decisive government, and we probably won't have one. Can kicking isn't a sound federal economic policy.  Both Japan, and more recently, the European Union, have vigorously kicked the can numerous times.  The problem, though, is that business people and consumers all know that the can is still there, and can bite them in the butt big time.  So they don't make big commitments; they don't go exuberant.  Can kicking virtually guarantees stagnation.  Yet can kicking has been the order of the day in Washington.

In a time when lukewarm coffee is all that you can hope for, invest cautiously.  It's not a bad idea to hold some risk assets.  But limit your exposure, and avoid the riskiest.  Hold a good dollop of stable assets, and don't stretch for yield.  One important way to give your net worth a boost is to save more.  Remember that the thriftiest squirrels have the best chance of surviving winter--and the coming winter could be cold indeed.

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.

Target2: The EU's Little Surprise

Well, it seems that if the financially weaker members of the Euro zone were to go belly up, their Target2 liabilities alone might be enough to soak up the entire EU bailout bazooka. Isn't that something?

What are Target2 liabilities, you ask? The Euro zone operates a settlement and clearance system called Target2. Settlement and clearance systems have existed for centuries, serving to provide centralized places where checks and other funds transfers between banks can be netted out and paid. For example, most major European banks have claims on each other for payment of checks, wire transfers and numerous other types of funds transfers. These transactions can be done directly with each bank (highly inefficient), or presented to a centralized clearinghouse, which adds up all claims of and on each bank, nets them, and asks the bank at the end of each business day to make a single payment to (or receive a single payment from) the clearinghouse. The Federal Reserve System operates a humungous settlement and clearance system for American and foreign banks dealing in dollar denominated transactions. Without settlement and clearance systems, modern finance couldn't exist.

The prototypical settlement and clearance system doesn't extend overnight credit. Its job is to make sure there are no unpaid liabilities on the part of member banks and expects each member to completely pay all its obligations at the end of the business day.

But the EU's Target2 system evidently is different. It seems to have a little spigot for overnight credit. And, indeed a fount for some EU member nations. Greece reportedly has a 100 billion EU indebtedness at Target2 (see http://www.cnbc.com/id/48094098). The total unpaid Target2 liabilities of Greece, Spain, Italy and other troubled Euro zone member nations could be in the range of 700 billion plus Euros, equal to or greater than the 700 billion Euro bailout bazooka. And we haven't counted the formal sovereign debt of these nations, which totals in the trillions of Euros. Target2 requires collateral for intraday credit. But its collateral requirements, if any, for overnight credit are unclear. There may be none.

This is a funny way to run a settlement and clearance operation, with credit available on a continuing, overnight basis. It contravenes the basic purpose of settlement and clearance, which is to balance the books. By allowing member nations to participate on an unbalanced basis, Target2 seems to have bought itself a mission creep problem that it can't solve without blowing up the European Monetary Union. After all, how does Target2 collect from Greece or another nation with an unpaid overnight balance? If it boots that nation out of Target2, it effectively boots that nation out of the Euro zone. That, in turn, precipitates all the dire consequences that Europe's leaders profess to want to avoid.

If a Euro zone member nation--let's randomly pick Greece--is unable or refuses to pay its Target2 liabilities, the losses evidently would be allocated among the central banks in the Euro zone. Most likely, the central banks of the larger nations like Germany and France would bear more liability than, say, Finland's central bank. Hence, the incentive for the EU powerhouses to keep trying to muddle through the crisis even though Greece is trying mightily not to repay its debts and Germany is striving mightily not to pay Greece's debts, either.

How Target2 became a secret sugar daddy for the spendthrift Euro zone members remains unclear. Whatever the explanation, the sudden surfacing of these liabilities only darkens the clouds gathering over the European financial world. Target2 evidently has been quietly carrying these liabilities without forcing repayment. That doesn't promote confidence in its financial solidity. Wary member banks might be inclined to take defensive measures, and those, if extreme enough, could resemble a credit crunch. We just had a credit crunch in 2008 and it made for a lousy party. There's no easy way to reduce these Target2 liabilities since the debtor nations ain't got the moola to pay down the outstanding overnight balances. Which means they'll be barking up any nearby tree for yet another bailout.

But the EU's bailout bazooka appears overwhelmed once Target2 is added into the mix of indebtedness it's supposed to cover. High ranking EU officials will surely issue a comforting sounding press release or two to paper over the Target2 problem. But talk therapy, a favorite EU maneuver, hasn't done squat to resolve the crisis and it won't help much here, either.

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.