Inconclusively Iberian

Tony Barber paints a melancholic picture of Spain's waltz towards aid although the results of a relatively successful auction may beg to differ. Spain's 859 million euro 10 year auction drew an average yield of 5.66% - almost a 100 basis points less than last month. The 3.9 billion offering on 3 year notes drew 3.845%.

That's the Draghi effect for you. The ECB's OMT pledge bought Spain an almost unimaginable amount of relative time to resist a bail-out. The problem is that Spain sits on the junk-bond cusp for Moody's and while safe from an S&P downgrade, is also on the investment-grade cusp at Fitch. A slash here or a slash there could sharply precipitate bond-yields and throw Rajoy's government into an immediate quandary. 

Come on, let's face it. No on really believes that Rajoy can defy fate for much longer when the heavy burden of under-capitalized banks, unfavourable debt dynamics, no growth and almost mass unemployment weighs heavy on his crown. Skip the talk of banks and bonds and you arrive at the more serious matter of regional friction, political disarray and social discontent. 

A large factor is the national pride and perception of sovereignty yet Rajoy has all but admitted to resisting aid unless borrowing costs increase again. 

If I was the ECB, it would make sense that the OMT pledge succeeded in one short-term respect. It bought Spain enough time to figure out what kind of aid they could use without seemingly compromising all and sundry. It doesn't have to be a strict, comprehensive package, maybe a flexible credit line. The important aspect is the relative ebb of the current waters. Should the tides rise again, stiffer consequences will naturally accompany stiffer conditions.

As the IBT reports,

"Critical to Spain's ability to use the time bought by the Draghi Effect to avoid a bailout will be its plans for the funding and budget needs of its 17 semi-autonomous regions, which collectively contribute to nearly a fifth of Spain's overall debts and more than a third of its annual deficit.

Spain's federal government has set up a domestic rescue fund of around €18bn to help the regions refinance maturing debt, but a good portion of that funding comes from Spain's troubled banking sector, whose debts are among the highest - at 340 percent of GDP - in the whole of the Eurozone."

And there's the matter of regional impasse with Catalan requesting a few billion in assistance as well as more fiscal self-authority which poses a heads-on conundrum to an equitable distribution of any potential aid. 

Spain's socialists, in power when the bubbles began to burst, are naturally vehemently opposed to any sort of a rescue, which they say would "affect the Spain brand" and force citizens to make further incomprehensible sacrifices thus placing additional pressure on the Rajoy government that quite frankly, they could do without. 

On September 28th, a stress-testing for Spain's banks will be complete and their capital deficiencies and requirements will be further brought to light. This fleeting warmth is uncomfortable at present but if the majority of factors start trending in unfavourable directions, they may well give rise to a scalding heatwave from which escape without serious repercussion may be too difficult.

(40.2, 53.9, 61.2 and 68.5 are Spain's General Govt Debt as a % of GDP for '08-'11. g is the year on year growth rate for real GDP while r is the interest rate on a 10 year Spanish bond discounted by the average inflation rate.)

Mitt Gaffeney

A faux pas.

A blunder.

A mistake.

An unintentional act or remark causing embarrassment to its originator

You know, when politicians dare to speak the truth - a moment when they slip up, when they let the guard down perhaps taken in by the comfort of their surroundings. Of course, the great thing about gaffes is that it's the easiest thing in the world to misconstrue them. Take a candy from a kid, take a gaffe and put a spin on it. 

Obama's guns-and-religion clinging remark was preceded by a commentary on the sad economic affairs caused by previous administrations. In reality, he was sympathizing with them. 

You didn't build that? Nope. Not the business, stupid! The roads and bridges that help your business. 

And to be fair to Romney, he didn't mean that he doesn't have to worry about that "47%". Just for the purposes of votes, of course he'll care about them after he's elected.

Yes, Mitt Romney's made lots of gaffes. Commenting on the London Games from his high vantage point of rescuer-in-chief of Salt Lake City, accusing his country's administration of apologizing on a day when a US Foreign Ambassador was killed.

This one's going to turn the election. Josh Barro thinks so too. 

You see, it's not fair to say that 47% of the American populace don't pay taxes and then imply that they're entitled, depend on government for everything etc.

Firstly, they DO PAY TAXES. The high number is the product of a depressed economy and a horrible financial crisis with mass unemployment. Before the crisis struck, this number was about 40%. 

Secondly, and this relates to the first point, THEY DO PAY TAXES, just not federal income tax. Not because they're tax evaders or tax avoiders (ahem!), but because they're simply under the bracket. What THEY DO PAY, is the payroll tax (which means they're employed) among others.

The people who don't pay the payroll tax too are, for the majority the elderly, especially those with disabilities. Students fall in this bracket too, but most go on to start contributing. 

CBO data in fact, estimates that low-income households (the poorest fifth), paid about 4% of income in 2007, a significant proportion when the average income was $18,400. The next fifth paid about 10.6% (avg income: $20k-$34k)

Best of all, when all federal, state and local taxes are taken into account, the poorest fifth pays about 16%! Here's the data for your own eyes (courtesy Center on Budget and Policy Priorities and Krugman).

It's not that this release flipped the election around. There's still no guarantee of an Obama victory. But I would like to believe that what this does, is guarantee Obama the popular vote victory (meaningless). 

And if it doesn't? 

That would say a lot about the American 'majority'.

The Lucky Sperm Club

Straight from the mouth of a Job Creator comes Gina Rinehart's diatribe bemoaning the difficulties her business has to face. David Lazarus in the LA Times has this piece where Rinehart, who struggled from the depths of poverty to hit the capitalist jackpot (the same way I was born the King of England only to be dethroned), railed against the high minimum wage laws. 

She could have made her case if she talked about the economics of it all. All said and done, she's lamenting an increased lack of competitiveness. It's obvious the pie isn't big enough and she wants a bigger slice. But one of the problems is in the jargon used. To quote, she feels that 

"There is no monopoly on becoming a millionaire. If you're jealous of those with more money don't just sit there and complain, do something to make more money yourself. Spend less time drinking, smoking and socializing and more time working."

Yup. This coming from a mining tycoon.

The usual rebuttal from Australian parliament members, while swift, may not have been harsh enough. Gillard obviously reiterated support for a "decent" minimum wage and how it wasn't the "Australian Way" to toss people $2. Perhaps she should have come out more strongly against the tone Rinehart used. For heavens sake, "Butt out the fag, put down your beer and start bloody working!" isn't exactly a polite way of saying something!

Contrast this with Buffett who found himself in a political uproar the right caused over the "Buffett Rule" where he wondered how it could be 'fair' for his secretary to be paying a higher tax rate than him. Someone who could have never done what he did in any other country, perhaps at any other time yet who's still aware that 

"the market economy creates some lopsided payoffs to participants … who may lack the right endowment of vocal chords, anatomical structure, physical strength, mental powers or inherited wealth to hit the capitalist jackpot themselves''

And yeah, according to him, Rinehart would be a star member of the "lucky sperm club" -  someone who chose her ancestors wisely.

The bottom line is that this is disgusting. There's nothing wrong in wanting to collectively lift people higher but the way to do it is by offering a hand, not a swift kick. 

Logical Traps

With Bernanke's $40 billion a month promise...and the famous Woodford paper on which much has been written about, I was left wondering when i glanced at an article by Blackrock's Peter Fisher which is based on the threat of a liquidity trap, you know, the one that Keynes conceptualized. Fisher's point can be found in the first line itself.

The. Federal. Reserve. Should. Stop. Trying. To. Engineer. Lower. Long-Term. Interest. Rates

The reasoning is straightforward, i.e: that the lower long-term rates go, the more lending would be discouraged. That basically, there "would be no reward for those willing to give up current consumption or liquidity" - cash becomes attractive and rates this low would not positively impact credit creation but rather, have a perverse effect on lending and investment.

But the US economy IS in a liquidity trap. Conventionally, a liquidity trap would occur when increased money supply would fail to lower interest rates. On the ground, people would hoard cash based on expectations of deflation, depressed demand, war etc. Mathematically, it refers to a state in which the nominal interest rate is close or equal to zero effectively "zero-binding" conventional monetary policy. As it goes, a deflationary environment can arise thus creating a vicious cycle of output stagnation and further deflationary expectations. Furthermore, in a leveraged sector, the real value of debt rises leading to more balance sheet pain. 

Using a Taylor Rule, like most before me I'll use the Mankiw version with an indicator at -8.5, i could run the numbers using BLS data and here's my chart with the Mankiw rule and the actual fed funds rate:

2009 is where the disparity starts. It's also interesting to note that sometime back in January, the economist ran an article in Free Exchange which claimed that the Mankiw rate would be positive in no time but that this steep is unlikely to continue. Here's a graph of the same data only from 2009 onwards (the effective fed funds rate is the right scale):

The problem is that Krugman re-estimates the coefficients (it's still a linear combination of 
the unemployment/inflation differential), but his data is fresher and the results makes these look significantly overestimated. Hmmm. Four more years of zero-bound flirtation if you extrapolate using conservative CBO projections. 

It's easy to hear the chorus singing the "unintended consequences" of the easing. By driving down long-term rates and easing mortgage pressure among others, the Fed, all said and done is making clever use of its balance sheet. In Bernanke's defense, it's hard to predict investment behavior in the absence of any easing. The zero bound constrains options because quite simply, when banks lend money to one another in the fed funds market, lenders simply don't pay for the "lending privilege". Hence, the fed is definitely not going to raise rates anytime soon. Mathematically, you would need (ballpark estimates) a percentage point drop in the unemployment rate coupled with near 1% inflation and even with a 2% inflation rate, there would ened to be a drop to 8% in the unemployment rate. Not happening. Zero-rate environment where conventional monetary policy will have minimal stimulatory effect. 

Also, from an IS-LM view, expansionary fiscal policy would shift the conventional IS to the right thus putting upward pressure on interest rates - the 'crowding out' effect. But in a liquidity trap, the LM curve is flat and only curves towards the end of the output gap (full employment cuts through the LM curve but the economy isn't there). So a shift in IS has its effect on output but no push on interest rates. 

The relationship between long-term yields and short-term interest rates brings out critics in full force. Fisher argues that lower yields forces investors to notice the smaller opportunity cost of holding cash. Simply put, if the Fed continues to hoard securities, investors might be forced to replace such assets with comparable risk leading to a further lowering of rates, easier lending conditions etc. What Fisher says is that portfolio shifts are far more ambiguous, i.e: it could spark a chase for yield and a path of increased  (and perhaps abrupt) expected reversal in trend. 

By the way, this is what the long-term US government bond yield and the Fed Funds rate differential looks like historically. I vaguely attempted to shade in recessionary periods but they're not perfectly accurate:

A more exact approximation would be helpful but at a glance, it seems better to focus on the pre-recession periods which seem to be associated with a kind of convergence or a downward trend. A convergence would imply either a drop in long-term treasuries or a rise in the fed funds rate (tighter monetary policy). What's interesting is that from 2009 onwards the significant movement in the differential can be broadly attributed to what's happening with the long term treasuries, the effects of easing. 

It seems, from an aesthetic perspective, that most times there's a convergence to zero, a grey area follows but in a depressed economy with near-zero rates, the differential is simply the long-term treasury yield assuming no increases in the fed funds rate for the next couple of years at least. 

EU stuff

Martin Wolf's piece in today's FT is coherent, predictable and above all - true. While he is quick to dole out credit to Draghi for taking such a step against the "sole, albeit significant" opposition of Weidmann, he is equally quick to point out that not only could this be too late a step but that still, it is too little. It is here that he makes the distinction of the monetary responsibility of the ECB and the political responsibility of keeping the eurozone intact.

The ECB's rationale may very well be to affect the transmission mechanism of policy through "Outright Monetary Transactions (OMTs)" and ensure that the heavy penalty of a "fear-of-break-up" premium is reduced. As obvious, this might turn out to be as far a conditional program as there can be which leads us to an eventual double-edged sword of an outcome post-program - Either the ECB stops buying sending markets into panic, or the ECB continues, which could lead to paralysis and disagreement in the union. Aggressive monetary policy is a no-go and German discontent is gathering intractable momentum. In layman's terms, the bottom line is:

ECB conditional bond buying with German opposition leads to eurozone forever.
This statement is false.

Here are a few charts on the EU mostly courtesy Eurostat over the past decade. Data is yearly.

1) This is the outstanding Money Supply (EUR trillions) tracked with the ECB main refinancing rate (currently at 0.75%). I've included M1, M2 and M3. For the euro area, the ECB's 
M1 is basically all currency in circulation and overnight deposits. 
M2 is M1 + Deposits upto 2 years maturity and those redeemable at a notice period of upto 3 months. 
M3 is M2 + repos, MMFs and debt securities upto 2 years.

2) Here's World Bank data to compare (as a % of GDP), Capital formation and Household & General Govt. Consumption:

3) This, for the EU, is the unemployment rate with the trend in wage index (2005=100):

4) Here's what happened to the CPI-based Real Effective Exchange Rate and the % of GDP levels for trade. Note the significant appreciation for the first four years:

5) Finally, this is the common deficit level [RHS] (i've used absolute numbers so positive is basically negative) and the Maastricht debt levels for the euro area:

The problem is that EU faults are best observed either individual or grouped (core-peripheral etc.) countries. Even so, there are still some almost glaring trends in principal variables. More on this later.

Win for Weidmann

The passage of time changes people. The advent of even foreseen circumstances can affect behaviour. NOTHING however, works better than fear. 

Here's Mario Draghi at his first press conference taking over from JCT in November:

“What makes you think that the ECB becoming the lender of last resort for governments is what is needed to keep the euro area together?” he said then. “No, I do not think that this is really within the remit of the ECB.”

Eight months later in July he unequivocally pledged to do whatever it took to save the Euro. 

Has Spain been saved? Is Italy sitting pretty? Is the worst over? No, no and NO. Forget the plunging yields and soaring shares for a moment and think of consequences. Possible, Impossible, Unlikely, Unintended, doesn't matter.

1)  Unlimited fire power is a good thing. It means you never run out of ammo. You could keep shooting all night long without worry. Of course, there's no guarantee that you'd hit the target and there's just no free lunch anywhere in the world, least of all in the ECB. There's going to be a heavy-duty bailout attached to every inch of the ECB's bond-buyin' assistance. Strict austerity and unpopular reform is going to be the carrot at the end of every stick and in fragile political climates, popular vote most often will determine the attractiveness of such packages. 

2) There are no specifics as to what extent the program would be implemented; no numerical cap on borrowing costs for Spain or Italy at which point the ECB decides it has done enough. Furthermore, even if the fire power is unlimited, there's a maturity cap that stands at one to three years which doesn't necessarily mean that long-term markets will suddenly have a change of heart based solely on lessening risk. A lack of access to the long-term market could signal the entrance of the EU's bailout funds which most certainly is nowhere close to covering what is required.

3) When has a loss ever been a win? Here's the most important part of the whole exercise. The President of the Bundesbank was the lone dissenting voice! Think about that for a minute. 

4) The ECB justification may be the "convertibility risk" but the difference in peripheral borrowing costs compared to Germany cannot be wholly attributed to a fear-of-break up attitude in investors. There's a lot of underlying macroeconomic fundamentals at play here.

5) Weidmann is now a hero back home. A loser in the ECB decision, his underlying view that bond purchases by a central bank are eerily parallel to debt monetization is the consensus in German academia. When the time comes to look at cutting the refinancing rate or perhaps raising them at the first sign of recovery, Draghi will run into Weidmann again, this time perhaps with a lot less leverage.

6) The instant euphoria of investors cannot be looked at as a barometer of dampening risk sentiment. A promise to stave off a break up is not the same as actually doing so and furthermore, a big play in-game does not guarantee a win when the clock runs out. Each second that passes will have an incremental effect on the old fear returning. Every moment of hesitation by Spain to be sold on the deal, every minor disagreement over the program to be implemented will stoke panic and raise fundamental fears of blatant moral hazard in the EU. 

7) Ironically, as Louis Bacon of Moore Capital states, there's been a market rally because a central bank violated its golden rule, using it's balance sheet to finance a deficit. Envision a scenario on the other side of the double-edged sword where targets are missed and forecasts are deemed unachievable. Do further rules and cuts kick in and send the country in question into a deep recession? Does the ECB stay quiet and continue buying bonds, risk losing the complete backing of Germany and destroying its own credibility? 

The Eurozone is an intricate maze of difficulty, its foundation long a quagmire. In the absence of unity, it will break apart but in the absence of decisiveness it will not survive either. Markets may react rationally or not but irrespective of the merits and advantages of the ECB program, what is most important is that a certain consensus seems to be taking a more opaque form, gathering shape and stature with every passing day. The German consensus, political and public, will ultimately decide the fate of the EU, just like it always has. 

Made in the USA, financed by China

“China manipulates its currency giving it an unfair trade advantage. So why doesn’t the president do something about it?” Portman asked. “I’ll tell you one reason – President Obama could not run up his record trillion dollar deficits if the Chinese did not buy our bonds to finance them…This will end under Mitt Romney.”

One would like to think that a high-school student with basic macro-knowledge or even someone who just reads the newspaper would laugh at the absurdity of such a statement. But here's what's intriguing: there are a whole host of respected economists supporting the GOP agenda this election - Mankiw, Taylor, Hubbard, Feldstein, Lazear

As DeLong angrily states, what on earth [in more polite language] do they think they are doing? Why won't a single one of them have the temerity to say, "Portman's statement was flavorful and hyped rhetoric and not based on fact by any stretch of imagination?"

Krugman is a lot more methodical, preferring to focus on what's behind the financing and concluding kindly that Portman is simply misinformed.

Here's why they should do it. First, recall the current account-capital flows relationship and then look at the consequence of financing the deficit. 

This, according to MGI research sourced from the Federal Reserve flow of funds, is the private sector deleveraging post 2008:

And here's the current account deficit, as a percentage of nominal GDP (adjusted seasonally) which peaked in 2006:

Corporations stop investing + consumers stop spending and start paying of debt = massive private sector surplus. 

The US could still run up record deficits even if China did not "buy bonds to finance them". It just wouldn't be an exciting story to hear if you narrated it that way.