John Maynard Keynes (pictured above) was a rare economist whose books sold well even among the common public. The only exception to this was his magnum opus, The General Theory of Employment, Interest and Money, which was published towards the end of 1936.
In this book Keynes discussed the paradox of thrift or saving. What Keynes said was that when it comes to thrift or saving, the economics of the individual differed from the economics of the system as a whole. An individual saving more by cutting down on expenditure made tremendous sense. But when a society as a whole starts to save more then there is a problem. This is primarily because what is expenditure for one person is income for someone else. Hence when expenditures start to go down, incomes start to go down, which leads to a further reduction in expenditure and so the cycle continues. In this way the aggregate demand of a society as a whole falls which slows down economic growth.
This Keynes felt went a long way in explaining the real cause behind The Great Depression which started sometime in 1929. After the stock market crash in late October 1929, people’s perception of the future changed and this led them to cutting down on their expenditure, which slowed down different economies all over the world.
As per Keynes, the way out of this situation was for someone to spend more. The best way out was the government spending more money, and becoming the “spender of the last resort”. Also it did not matter if the government ended up running a fiscal deficit doing so. Fiscal deficit is the difference between what the government earns and what it spends.
What Keynes said in the General Theory was largely ignored initially. Gradually what Keynes had suggested started playing out on its own in different parts of the world.
Adolf Hitler had put 100,000 construction workers for the construction of Autobahn, a nationally coordinated motorway system in Germany, which was supposed to have no speed limits. Hitler first came to power in 1934. By 1936, the Germany economy was chugging along nicely having recovered from the devastating slump and unemployment. Italy and Japan had also worked along similar lines.
Very soon Britain would end up doing what Keynes had been recommending. The rise of Hitler led to a situation where Britain had to build massive defence capabilities in a very short period of time. The Prime Minister Neville Chamberlain was in no position to raise taxes to finance the defence expenditure. What he did was instead borrow money from the public and by the time the Second World War started in 1939, the British fiscal deficit was already projected to be around £1billion or around 25% of the national income. The deficit spending which started to happen even before the Second World War started led to the British economy booming.
This evidence left very little doubt in the minds of politicians, budding economists and people around the world that the economy worked like Keynes said it did. Keynesianism became the economic philosophy of the world.
Lest we come to the conclusion that Keynes was an advocate of government’s running fiscal deficits all the time, it needs to be clarified that his stated position was far from that. What Keynes believed in was that on an average the government budget should be balanced. This meant that during years of prosperity the governments should run budget surpluses. But when the environment was recessionary and things were not looking good, governments should spend more than what they earn and even run a fiscal deficit.
The politicians over the decades just took one part of Keynes’ argument and ran with it. The belief in running deficits in bad times became permanently etched in their minds. In the meanwhile they forgot that Keynes had also wanted them to run surpluses during good times. So they ran deficits even in good times. The expenditure of the government was always more than its income.
Thus, governments all over the world have run fiscal deficits over the years. This has been largely financed by borrowing money. With all this borrowing governments, at least in the developed world, have ended up with huge debts to repay. What has added to the trouble is the financial crisis which started in late 2008. In the aftermath of the crisis, governments have gone back to Keynes and increased their expenditure considerably in the hope of reviving their moribund economies.
In fact the increase in expenditure has been so huge that its not been possible to meet all of it through borrowing money. So several governments have got their respective central banks to buy the bonds they issue in order to finance their fiscal deficit. Central banks buy these bonds by simply printing money.
All this money printing has led to the Federal Reserve of United States expanding its balance sheet by 220% since early 2008. The Bank of England has done even better at 350%. The European Central Bank(ECB) has expanded its balance sheet by around 98%. The ECB is the central bank of the seventeen countries which use the euro as their currency. Countries using the euro as their currency are in total referred to as the euro zone.
The ECB and the euro zone have been rather subdued in their money printing operations. In fact, when one of the member countries Cyprus was given a bailout of € 10 billion (or around $13billion), a couple of days back, it was asked to partly finance the deal by seizing deposits of over €100,000 in its second largest bank, the Laiki Bank. This move is expected to generate €4.2 billion. The remaining money is expected to come from privatisation and tax increases, over a period of time.
It would have been simpler to just print and handover the money to Cyprus, rather than seizing deposits and creating insecurities in the minds of depositors all over the Euro Zone.
Spain, another member of the Euro Zone, seems to be working along similar lines. Loans given to real estate developers and construction companies by Spanish banks amount to nearly $700 billion, or nearly 50 percent of the Spain’s current GDP of nearly $1.4 trillion. With homes lying unsold developers are in no position to repay. And hence Spanish banks are in big trouble.
The government is not bailing out the Spanish banks totally by handing them freshly printed money or by pumping in borrowed money, as has been the case globally, over the last few years. It has asked the shareholders and bondholders of the five nationalised banks in the country, to share the cost of restructuring.
The modus operandi being resorted to in Cyprus and Spain can be termed as an extreme form of financial repression. Russell Napier, a consultant with CLSA, defines this term as “There is a thing called financial repression which is effectively forcing people to lend money to the…government.” In case of Cyprus and Spain the government has simply decided to seize the money from the depositors/shareholders/bondholders in order to fund itself. If the government had not done so, it would have had to borrow more money and increase its already burgeoning level of debt.
In effect the citizens of these countries are bailing out the governments. In case of Cyprus this may not be totally true, given that it is widely held that a significant portion of deposit holders with more than €100,000 in the Cyprian bank accounts are held by Russians laundering their black money.
But the broader point is that governments in the Euro Zone are coming around to the idea of financial repression where citizens of these countries will effectively bailout their troubled governments and banks.
Financing expenditure by money printing which has been the trend in other parts of the world hasn’t caught on as much in continental Europe. There are historical reasons for the same which go back to Germany and the way it was in the aftermath of the First World War.
The government was printing huge amounts of money to meet its expenditure. And this in turn led to very high inflation or hyperinflation as it is called, as this new money chased the same amount of goods and services. A kilo of butter cost ended up costing 250 billion marks and a kilo of bacon 180 billion marks. Interest rates as high as 22% per day were deemed to be legally fair.
Inflation in Germany at its peak touched a 1000 million %. This led to people losing faith in the politicians of the day, which in turn led to the rise of Adolf Hitler, the Second World War and the division of Germany.
Due to this historical reason, Germany has never come around to the idea of printing money to finance expenditure. And this to some extent has kept the total Euro Zone in control(given that Germany is the biggest economy in the zone) when it comes to printing money at the same rate as other governments in the world are. It has also led to the current policy of financial repression where the savings of the citizens of the country are forcefully being used to finance its government and rescue its banks.
The question is will the United States get around to the idea of financial repression and force its citizens to finance the government by either forcing them to buy bonds issued by the government or by simply seizing their savings, as is happening in Europe.
Currently the United States seems happy printing money to meet its expenditure. The trouble with printing too much money is that one day it does lead to inflation as more and more money chases the same number of goods, leading to higher prices. But that inflation is still to be seen.
As Nicholas NassimTaleb puts it in Anti Fragile “central banks can print money; they print print and print with no effect (and claim the “safety” of such a measure), then, “unexpectedly,” the printing causes a jump in inflation.”
It is when this inflation appears that the United States is likely to resort to financial repression and force its citizens to fund the government. As Russell Napier of CLSA told this writer in an interview “I am sure that if the Federal Reserve sees inflation climbing to anywhere near 10% it would go to the government and say that we cannot continue to print money to buy these treasuries and we need to force financial institutions and people to buy these treasuries.” Treasuries are the bonds that the American government sells to finance its fiscal deficit.
“May you live in interesting times,” goes the old Chinese curse. These surely are interesting times.
The article originally appeared on www.firstpost.com on March 27,2013
(Vivek Kaul is a writer. He tweets @kaul_vivek)
So why is the world worried about the Cyprus? A country of less than a million people, which accounts for just 0.2% of the euro zone economy. Euro Zone is a term used in reference to the seventeen countries that have adopted the euro as their currency.
The answer lies in the fact that what is happening in Cyprus might just play itself out in other parts of continental Europe, sooner rather than later. Allow me to explain.
Cyprus has been given a bailout amounting to € 10 billion (or around $13billion) by the International Monetary Fund and the European Union. As The New York Times reports “The money is supposed to help the country cope with the severe recession by financing government programs and refinancing debt held by private investors.”
Hence, a part of the bailout money will be used to repay government debt that is maturing. Governments all over the world typically spend more than they earn. The difference is made up for by borrowing. The Cyprian government has been no different on this account. An estimate made by Satyajit Das, a derivatives expert and the author of Extreme Money, in a note titled The Cyprus File suggests that the country might require around €7-8billion “for general government operations including debt servicing”.
But there is a twist in this tale. In return for the bailout IMF and the European Union want Cyprus to make its share of sacrifice as well. The Popular Bank of Cyprus (better known as the Laiki Bank), the second largest bank in the country, will shut down operations. Deposits of up to € 100,000 will be protected. These deposits will be shifted to the Bank of Cyprus, the largest bank in the country.
Deposits greater than € 100,000 will be frozen, seized by the government and used to partly pay for the deal. This move is expected to generate €4.2 billion. The remaining money is expected to come from privatisation and tax increases.
As The Huffington Post writes “The country of about 800,000 people has a banking sector eight times larger than its gross domestic product, with nearly a third of the roughly 68 billion euros in the country’s banks believed to be held by Russians.” Hence, it is widely believed that most deposits of greater than € 100,000 in Cyprian banks are held by Russians. And the move to seize these deposits thus cannot impact the local population.
This move is line with the German belief that any bailout money shouldn’t be rescuing the Russians, who are not a part of the European Union. “Germany wants to prevent any bailout fund flowing to Russian depositors, such as oligarchs or organised criminals who have used Cypriot banks to launder money. Carsten Schneider, a SPD politician, spoke gleefully about burning “Russian black money,”” writes Das.
It need not be said that this move will have a big impact on the Cyprian economy given that the country has evolved into an offshore banking centre over the years. The move to seize deposits will keep foreign money way from Cyprus and thus impact incomes as well as jobs.
The New York Times DealBook writes “Exotix, the brokerage firm, is predicting a 10 percent slump in gross domestic product this year followed by 8 percent next year and a total 23 percent decline before nadir is reached. Using Okun’s Law, which translates every one percentage point fall in G.D.P. (gross domestic product) to half a percentage point increase in unemployment, such a depression would push the unemployment rate up 11.5 percentage points, taking it to about 26 percent.”
But then that is not something that the world at large is worried about. The world at large is worried about the fact “what if”what has happened in Cyprus starts to happen in other parts of Europe?
The modus operandi being resorted to in Cyprus can be termed as an extreme form of financial repression. Russell Napier, a consultant with CLSA, defines this term as “There is a thing called financial repression which is effectively forcing people to lend money to the…government.” In case of Cyprus the government has simply decided to seize the money from the depositors in order to fund itself, albeit under outside pressure.
The question is will this become a model for other parts of the European Union where banks and governments are in trouble. Take the case of Spain, a country which forms 12% of the total GDP of the European Union. Loans given to real estate developers and construction companies by Spanish banks amount to nearly $700 billion, or nearly 50 percent of the Spain’s current GDP of nearly $1.4 trillion. With homes lying unsold developers are in no position to repay. Spain built nearly 30 percent of all the homes in the EU since 2000. The country has as many unsold homes as the United States of America which is many times bigger than Spain.
And Spain’s biggest three banks have assets worth $2.7trillion, which is two times Spain’s GDP. Estimates suggest that troubled Spanish banks are supposed to require anywhere between €75 billion and €100 billion to continue operating. This is many times the size of the crisis in Cyprus which is currently being dealt with.
The fear is “what if” a Cyprus like plan is implemented in Spain, or other countries in Europe, like Greece, Portugal, Ireland or Italy, for that matter, where both governments as well as banks are in trouble. “For Spain, Italy and other troubled euro zone countries, Cyprus is an unnerving example. Individuals and businesses in those countries will probably split up their savings into smaller accounts or move some of their money to another country. If a lot of depositors withdraw cash from the weakest banks in those countries, Europe could have another crisis on its hands,” The New York Times points out.
Given this there can be several repercussions in the future. “The Cyprus package highlights the increasing reluctance of countries like Germany, Finland and the Netherlands to support weaker Euro-Zone members,” writes Das. The German public has never been in great favour of bailing out the weaker countries. But their politicians have been going against this till now simply because they did not want to be seen responsible for the failure of the euro as a currency. Hence, they have cleared bailout packages for countries like Ireland, Greece etc in the past. Nevertheless that may not continue to happen given that Parliamentary elections are due in September later this year. So deposit holders in other countries which are likely to get bailout packages in the future maybe asked to share a part of the burden or even fully finance themselves.
This becomes clear with the statement made by Jeroen Dijsselbloem, the Dutch finance minister who heads the Eurogroup of euro-zone finance ministers “when failing banks need rescuing, euro-zone officials would turn to the bank’s shareholders, bondholders and uninsured depositors to contribute to their recapitalization.”
“He also said that Cyprus was a template for handling the region’s other debt-strapped countries,” reports Reuters. In the Euro Zone deposits above €100,000 are uninsured.
Given this likely possibility, even a hint of financial trouble will lead to people withdrawing their deposits. As Steve Forbes writes in The Forbes “After this, all it will take is just a hint of a financial crisis to send Spaniards, Italians, the French and others scurrying to ATMs and banks to pull out their cash.” Even the most well capitalised bank cannot hold onto a sustained bank run beyond a point.
It could also mean that people would look at parking their money outside the banking system.
“Even in the absence of a disaster individuals and companies will be looking to park at least a portion of their money outside the banking system,” writes Forbes. Does that imply more money flowing into gold, or simply more money under the pillow? That time will tell.
Also this could lead to more rescues and further bailouts in the days to come. As Das writes “If depositors withdraw funds in significant size and capital flight accelerates, then the European Central Bank, national central banks and governments will have intervene, funding affected banks and potentially restricting withdrawals, electronic funds transfers and imposing cross-border capital controls.” And this can’t be a good sign for the world economy.
The question being asked in Cyprus as The Forbes magazine puts it is “if something goes wrong again, what’s stopping the government from dipping back into their deposits?” To deal with this government has closed the banks until Thursday morning, in order to stop people from withdrawing money. Also the two largest banks in the country, the Bank of Cyprus and the Laiki Bank have imposed a daily withdrawal limit of €100 (or $130).
It will be interesting to see how the situation plays out once the banks open. Will depositors make a run for their deposits? Or will they continue to keep their money in banks? That might very well decide how the rest of the Europe behaves in the days to come.
Watch this space.
This article originally appeared on www.firstpost.com on March 26, 2013.
(Vivek Kaul is a writer. He tweets @kaul_vivek)
In the past few pieces I have written about the huge amount of money being printed by central banks and governments all across the developed world.
The Federal Reserve of United States, the American central bank, has expanded its balance sheet by 220% since early 2008. The Bank of England has done even better at 350%. The European Central Bank came to the party a little late and has expanded its balance sheet by around 98%. The Bank of Japan has been rather subdued in its money printing efforts and has expanded its balance sheet only by 30% over the last four years. But is now joining the money printing party and is looking to print as many yen as required to get an inflation of 2% going.
The idea as I have mentioned in a couple of earlier pieces is to create some consumer price inflation to get consumption going again. As a greater amount of money chases the same amount of goods and services, the hope is to create some inflation. When people see prices going up or expect prices to go up, they generally tend to start purchasing things. This helps businesses as well as the overall economy. So by trying to create some inflation or at least create some inflationary expectations, the idea is to get consumption going again.
But this trick practiced by central banks hasn’t worked. Inflation has continued to elude the developed world.
Central bank governors and governments when they decide to print money are essentially following the Chicago university economist Milton Friedman. Friedman had even jocularly suggested that a recessionary situation could be fought by printing and dropping money out of a helicopter, if the need be, to create inflation.
The idea behind this assumption is that just by dropping money out of a helicopter there will be in an increase in money supply and the inflation will be created. So in that sense it did not really matter who is standing under the helicopter when the money is dropped. But French economist Richard Cantillon who lived during the early eighteenth century showed that money wasn’t really neutral and it mattered where it was injected into the economy. In the modern sense of the term, it matters who is standing under the helicopter when printed money is dropped from it.
Before we get back to Cantillon, let me deviate a little.
Christopher Columbus wanted to discover the sea route to India. He went on his first journey to find India on the evening of August 3, 1492. Before that he had managed to negotiate a contract with King Ferdinand and Queen Isabella of Spain, which entitled him to 10% of all the profit
But he ended up somewhere else instead of India. An island he named San Salvador, which the locals called Guanahani. The question though is why did he want to go to India? It seems he had read the published accounts of Marco Polo and was very impressed by the wealth that lay in store in India.
Columbus made three more journeys in search of a sea route to India, but never found it. In the end, it didn’t really matter, because the Spaniards found what they were looking for: gold and silver, in ample amounts. Though not in India, as was the original plan, but in what came to be known as the “New World” immediately and South America a little later. Within half a century of Columbus’ first expedition, the Spaniards had found most of the treasure that was to be found in the New World.
With all this silver/gold coming into Spain from the New World there was a sudden increase in money supply and that led to inflation in Spain. Richard Cantillon studied this phenomenon and made some interesting observations.
What he said was that when money supply increased in the form of gold and silver it would first benefit the people associated with the process of money creation, the mining industry in general and the owners of the mines, the adventurers who went looking for gold and silver, the smelters, the refiners and the workers at the gold and silver mines, in particular.
These individuals would end up with a greater amount of gold and silver i.e. money, before anyone else. This money they would spent and thus drive up the prices of meat, wine, wool, wheat etc. This new money would be chasing the same amount of goods and thus drive up prices.
This rise in prices would impact people not associated with the mining industry as well, even though there incomes hadn’t risen like the incomes of people associated with the mining industry had. As Dylan Grice an analyst formerly with Societe Generale told me a few months back “The problems arise for other groups. Anyone not involved in the production of money or of the goods the newly produced money purchased, but who nevertheless consumed them – a journalist or a nurse, for example – would find that the prices of those goods had risen while their incomes hadn’t.”
This is referred to as the Cantillon effect. “Cantillon, writing before the days of Adam Smith, was the first to articulate it. I find it very puzzling that this insight has been ignored by the economics profession. Economists generally assume that money is neutral. And Milton Friedman’s allegory about the helicopter drop of money raising the general price level completely ignores the question of who is standing under the helicopter,” said Grice.
The money printing that has happened in recent years has unable to meet its goal of trying to create consumer price inflation. But it has benefited those who are closest to the money creation like it had in Spain. In the present context, this basically means the financial sector and anyone who has access to cheap credit (i.e. loans).
Institutional investors in the developed world have been able to raise money at close to zero percent interest rates and invest that money in financial assets all over the world, and thus driven up their prices. As Ruchir Sharma writes in Breakout Nations – In Pursuit of the Next Economic Miracles:
What is apparent that central banks can print all the money they want, they can’t dictate where it goes. This time around, much of that money has flown into speculative oil futures, luxury real estate in major financial capitals, and other non productive investments…The hype has created a new industry that turns commodities into financial products that can be traded like stocks. Oil, wheat, and platinum used to be sold primarily as raw materials, and now they are sold largely as speculative investments. Copper is piling up in bonded warehouses not because the owners plan to use it to make wire, but because speculators are sitting on it…figuring that they can sell it one day for a huge profit.
Other than this all the money printing has also led to stock markets across the world reaching levels they were at before the financial crisis started. Investment banks and hedge funds have borrowed money at very low interest rates and invested it all over the world.
This has led to an increase in price of oil as well, something that impacts India majorly. Currently one basket of Indian crude costs around $108 per barrel. The Indian government hasn’t passed on this increase in oil prices to the Indian consumer and sells products like diesel, petrol, kerosene as well cooking gas at a loss.
The losses thus faced by the oil marketing companies on selling diesel, kerosene and cooking gas are compensated for by the government.
This means increased expenditure for the Indian government and thus a higher fiscal deficit. Fiscal deficit is the difference between what the government earns and what the government spends.The other impact because all this money printing has been an increase in price of gold. Investors all over the world have been buying gold as more and more money is being printed. The Indian investors are no exception to this rule. India produces very little gold of its own. Hence, most of the gold being bought in India needs to be imported. When these imports are made India needs to pay in dollars, because gold is bought and sold in dollars internationally.
In order to pay in dollars, India needs to sell rupees and buy dollars. This means that there is an increase in the supply of rupees in the market, and the rupee loses value against the American dollar.
A little over a year back one American dollar was worth Rs 49. It touched around Rs 57 by the middle of 2012. Currently one dollar is worth around Rs 53.5.
When the rupee loses value against the dollar it means that India has to pay more in rupees for the imports it makes. India’s number one import is oil. Hence, with the rupee losing value against the dollar over the course of the last one year, India has been paying more for the oil being imported in rupee terms.
This has in turn has led to increasing government expenditure and therefore a higher fiscal deficit. A higher fiscal deficit means that the government has had to borrow more and that in turn has meant higher interest rates as well. This explains to a large extent why the government has in recent times tried to control the import of gold by increasing the duty on it and thus control the value of the rupee against the dollar.
What this entire story tells us is that the likes of P Chidambaram and D Subbarao have far lesser control over the Indian economy and the fiscal deficit of the government, there attempts to prove otherwise notwithstanding. So as long as the Western world continues to print money prices of oil and gold will continue to remain high. Hence, that Indians will continue to buy gold and the oil bill will continue to remain high.
The article originally appeared on www.firstpost.com on February 12, 2013
(Vivek Kaul is a writer and he can be reached at [email protected])
Central banks around the world seem to have only one solution for every problem that the various economies have been facing: print more money. And a large portion of this money has been used to prop up banks and financial institutions that would have otherwise fallen and shut shop by now. “It is unfortunate that nobody is allowed to default these days, because all these bailouts are only adding to the inflation menace and the ongoing money creation is confiscating the purchasing power of the public,” says Puru Saxena, the founder and CEO of Puru Saxena Wealth Management. Based out of Hong Kong, Saxena is also the editor and publisher of Money Matters, a monthly economic newsletter. In this interview he speaks to Vivek Kaul.
In a recent column of yours you said “the world’s stock and commodity markets are defying all logic and advancing in the face of adverse economic conditions”. Why has that been the case?
All asset prices are determined by the risk free rate of return and by suppressing interest rates near historical lows, central banks in the developed world have engineered this rally in risky assets. When it comes to investing, monetary policy trumps economic fundamentals and cheap credit triggers a rally in stocks and commodities. This is why, despite sluggish economic growth in the US, Wall Street has been rallying for over 3 years. Conversely, despite good economic growth in India, due to monetary tightening, Indian equities have underperformed over the past year!
Do you expect this trend to continue?
As long as the Federal Reserve keeps interest rates at historical lows, the uptrend on Wall Street is likely to continue. Of course, the bull market will be subject to periodic corrections, but the primary trend should remain up. In our view, the next bear market on Wall Street will arrive after several months of monetary tightening by the Federal Reserve and we are at least 3 years away from this scenario. After all, Mr. Bernanke has pledged to keep short term rates unchanged until at least December 2014, so there is clear visibility for another 2 and a half years.
In Europe, the attention seems to have shifted to Spain. I was reading somewhere that the assets of the three biggest banks of Spain are at $2.7trillion or around twice the size of the Spanish economy. And the banking sector in Spain seems to be in a pretty bad shape. How do you see that playing out?
Spain is in real trouble, but the politicians will probably not let it default. So, either the European Central Bank will bail out Spain or it will continue to provide cheap loans under its LTRO(long term financing operations) scheme. It is unfortunate that nobody is allowed to default these days, because all these bailouts are only adding to the inflation menace and the ongoing money creation is confiscating the purchasing power of the public. Already, the Federal Reserve and the ECB have provided trillions of dollars of loans to hundreds of banks and this trend should continue for the foreseeable future.
What are the other dangers that you see the European markets throwing up in the days to come?
Many European nations are essentially insolvent and they cannot repay their loans in today’s money. So, unless they are allowed to default, the central banks will probably continue to bail out all the distressed bondholders and banks. The truth is that the central banks do not want anybody to default because the losses will be catastrophic for the financial institutions; so they are shoving even more debt down the throats of these heavily indebted nations! It is easy for us to see that more debt cannot solve a debt crisis but this is the strategy the central banks have come up with and we all have to live with the consequences.
The European Central Bank seems to be going the Federal Reserve way. The Federal Reserve in 2008-2009 seemed to have been rescuing banks and companies, the ECB is rescuing countries? Aren’t some of these countries like Italy and Spain are too big to bail-out?
So far, nothing has been ‘too big to bail out’! Already, the ECB has extended over $1.4 trillion of loans under its LTRO scheme to several hundred banks and if need be, it will probably create more currency units to bail out its banking cronies. If the situation becomes desperate, then, we may even get fiscal integration within the Euro zone but we don’t think that the establishment will let the Euro fail.
In all this talk about Europe, attention seems to have shifted away from the problems in the United States, which is where it all started. How good or bad is the scene there?
Although the economy is struggling in the US; things are much worse in Europe. Fortunately, the US is in the enviable position of being able to print its own currency at will and this is a luxury which the distressed European nations do not have. Under a crisis scenario, the US can always create even more dollars out of thin air and repay its creditors, but this is something Greece, Italy and Spain cannot do! Moreover, despite having a federal debt to GDP ratio of over 100%, the US still controls the world’s reserve currency and this is a big advantage.
One talk in the market seems to be that the Federal Reserve Chairman Ben Bernanke will initiate QE III given that Presidential elections are scheduled this year. Several Federal Reserve Chairmen have in the past have run easy money policies to help the incumbent US President who is running for the election again..
In our view, Mr. Bernanke will only initiate QE3 after a big dip in the CPI. Currently, the CPI is hovering around 2.7% and it is conceivable that QE3 will be announced when the CPI dips to around 1-1.5%. With the CPI close to 2.7%, we believe that Mr. Bernanke will find it difficult to unleash more stimulus.
You have maintained for a while that world’s developed nations are all bankrupt. In fact in a column last year you wrote “Let’s face it; many of the world’s ‘developed’ nations are insolvent and the writing is on the wall. Either these indebted states will default or they will try and inflate their currencies into oblivion.” How do you see this scenario playing out?
Given the developments of the past 3-4 years, it is clear that the policymakers do not want to see defaults. So, they have chosen the monetary inflation route and this is destroying the purchasing power of currencies all over the world. As a result of massive money creation, currencies are being debased and prices are rising all over the world. In fact, inflation is surging in most nations and people are struggling to make ends meet. In the US alone, the Federal Reserve has created trillions of dollars to bail out the banks and the ECB has also created and loaned out over US$1 trillion to hundreds of banks over the past six months! Never before in history have we witnessed such monetary inflation in so many nations and nobody really knows the consequences of this strategy.
“When the interest payments on US debt become painfully high, Mr. Bernanke will be called upon to unleash the hyperinflation genie.” This is something you wrote last year. When do you see this happening?
As long as foreigners are willing to invest in US Treasuries and demand for US government debt is high, hyperinflation will not occur. However, if one day, bondholders stop financing the US deficit and they stop buying US Treasuries, then Mr. Bernanke will have no other option but to use the printing press to purchase US Treasuries. Already, the Federal Reserve is a very large player in this market but if other investors flee this market, then out of desperation, we may experience hyperinflation in the US. Fortunately, there are no signs of that happening anytime soon as demand for US Treasuries is still strong.
Many pundits in the last few years have forecast the crash of the dollar. The biggest among them being Pimco’s Bill Gross. But that hasn’t happened. Every time there is a slight hint of some new trouble, money rushes into the dollar. How do you explain this?
In the global beauty contest, the US Dollar is being perceived as the least ugly candidate! This is why the US Dollar has not collapsed against major world currencies, although it has depreciated gradually over the past decade. If you review the world today, Europe is a mess and Japan is still struggling. So, apart from the US Dollar, we don’t really have very many choices! In the developing world, no nation wants a strong currency and countries such as China, India and Brazil are all engaged in competitive currency devaluations. Under this scenario, the US Dollar cannot really crash against other currencies because either they are equally bad or they are being held down on purpose.
What is your prognosis on gold?
Gold is in a multi-month consolidation phase and currently, it is trading under the 200-day moving average. So, in our clients’ portfolios, we do not have any exposure to gold at present. In our view, QE3 will be required to trigger the next big rally in gold and until then, prices are likely to drift lower. Furthermore, after 11 years of gains, investors should be mindful of the fact that gold is no longer cheap and the bull market is now in its mature phase. Thus, owners of gold should be very cautious and consider booking their profits on the first sign of trouble.
What about India? Which are the sectors and stocks you are positive about?
It appears as though India’s monetary cycle has peaked for now and further rate cuts should assist the Indian stock market. Usually, there is time lag between monetary easing and its effects on the economy, so in our view, the Indian stock market may not take off for another few months. Nonetheless, we remain optimistic about Indian stocks and continue to like those companies which earn high rates of return on shareholders’ equity.
(The article originally appeared in the Daily News and Analysis on May 21,2012. http://www.dnaindia.com/mumbai/interview_in-the-global-beauty-contest-the-dollar-is-the-least-ugly-candidate_1691544)
(Vivek Kaul is a writer and can be reached at [email protected] )
I’ve long said that capitalism without bankruptcy is like Christianity without hell. – Frank Borman
If you have been following the business newspapers lately, you would have probably come to the conclusion by now that a break-up of the euro will lead to a huge catastrophe in Europe as well as the rest of the world.
Yes, there will be problems. But the world will be a much better place if the countries like Portugal, Ireland, Italy, Greece and Spain opt out of the euro. To know why read on.
How it all started
The European Coal and Steel Community was an economic organisation formed by six European nations in 1958. This gradually evolved into the European Union (EU) which was established by the Maastricht Treaty in 1993. The EU introduced the euro on 1 January 1999. On this day, 11 member countries of the EU started using euro as their currency. Before the euro came into being the German currency deutschemark used to be the premier currency of Europe. The euro inherited the strength of the deutschemark. The world looked at the euro as the new deutschemark.
The move to euro benefitted countries such as Portugal, Italy , Ireland , Greece and Spain (together now known as the PIIGS). Before these countries started to use euro as a currency, they had to borrow money at interest rates much higher than the rates at which a country like Germany borrowed. When these countries started to use the Euro they could borrow money at interest rates close to that of Germany, which was economically the best managed country in the EU.
Easy money and the borrowing binge
With interest rates being low, the PIIGS countries as well as their citizens went on a borrowing binge. Greece took the lead among these countries. The Greek politicians launched a large social spending programme which subsidised most of the key public services. In fact a few years back, the finance minister of Greece claimed that he could save more money shutting down the Railways and driving people around in taxies. In 2009, Greece railways revenues were at around $250 million and the losses of around $1.36billion. All this extravagance has was financed through borrowing.
Greece was not the only country indulging in this extravagance, other PIIGS nations had also joined in. Also other than the low interest rates, the inflation in the PIIGS countries was higher than the rate of interest being charged on loans.
As John Mauldin and Jonathan Tepper write in Endgame – The End of the Debt Supercycle and How it Changes Everything “In plain English, that means that if the borrowing rate is 3 percent while inflation is 4 percent you’re effectively borrowing for 1 percent less than inflation. You’re being paid to borrow. And borrow they did. And the European peripheral countries (PIIGS) racked up enormous amount of debt in euros.”
This was because loans were being made by German, French and British banks who were able to raise deposits at much lower interest rates in their respective countries and offer it at a slightly higher rate in the PIIGS countries.
The citizens of Spain borrowed big time to speculate in real estate. All this building was financed through the bank lending. Loans to developers and construction companies amounted to nearly $700billion or nearly 50% of the Spain’s current GDP of nearly $1.4trillion. Currently Spain has as many homes unsold as the United States (US), though the US is six times bigger than Spain. With homes lying unsold developers are in no position to repay. And Spain’s biggest three banks have assets worth $2.7trillion or that is double Spain’s GDP, are in trouble.
The accumulated debt in Spain is largely in the private sector. On the other hand the Italian government debt stands at $2.6trillion, the fourth largest in the world. The debt works out to around 125% of the Italian gross domestic product (GDP). As a recent report titled A Primer on Euro Breakup brought out by Variant Perception points out “Greece and Italy have a high government debt level. Spain and Ireland have very large private sector debt levels. Portugal has a very high public and private debt level.” Debt as we all know needs to be repaid, and that’s where all the problems are. But before we come to that we need to understand the German role in the entire crisis.
The German connection
Germany became the largest exporter in the world on the strength of the euro. Before euro became a common currency across Europe, German exports stood at around €487billion in 1995. In 1999, the first year of euro being used as a currency the exports were at €469billion euros. Next year they increased to €548billion euros. And now they stand at more than a trillion euros. Germany is the biggest exporter in the world even bigger than China.
With euro as a common currency took away the cost of dealing with multiple currencies and thus helped Germany expand its exports to its European neighbours big time. Also with a common currency at play exchange rate fluctuations which play an important part in the export game no longer mattered and what really mattered was the cost of production.
Germany was more productive than the other members of the European Union given it an edge when it came to exports. As Mauldin and Tepper point out “since the beginning of the Euro in 1999, Germany has become some 30 per cent more productive than Greece. Very roughly, that means it costs 30 per cent more to produce the same amount of goods in Greece than in Germany. That is why Greece imports $64 billion and exports only $21 billion.”
German banks also had a role to play in helping increasing German exports. They were more than happy to lend to citizens, governments and firms in PIIGS countries. So the way it worked was that German banks lent to other countries in Europe at low interest rates, and they in turn bought German goods and services which are extremely competitively priced as well as of good quality. Hence German exports went up.
The PIIGS countries owe a lot of money to German banks. Greece needs to repay $45billion. Spain owes around $238billion to Germany. Italy, Ireland and Portugal owe $190billion, $184 billion and $47billion respectively.
Inability to repay
When the going is good and everything is looking good there is a tendency to borrow more than one has the ability to repay, in the hope that things will continue to remain good in the days to come. But good times do not last forever and when that happens the borrower is in no position to repay the loan taken on.
Greece tops this list. It has been rescued several times and the private foreign creditors have already taken a haircut on their debt i.e. they have agreed to the Greek government not returning the full amount of the loan. Between Spain and Italy around €1.5trillion of money needs to be repaid over the next three years. The countries are in no position to repay the debt. It has to be financed by taking on more debt. It remains to be seen whether investors remain ready to continue lending to these countries.
In the past countries which have come under such heavy debt have done one of the following things: a) default on the debt b) inflate the debt c) devalue the currency.
Scores of countries in the past have defaulted on their debt when they have been unable to repay it. A very famous example is that of Russia in 1998. It defaulted both on its national as well as international debt. Oil prices had crashed to $11 per barrel. Oil revenue was the premier source of income for the Russian government and once that fell, there was no way it could continue to repay its debts.
If the country’s debt is in its own currency, all the government needs to do is to print more of it in order to repay it. This has happened time and again over the years all over the world. Every leading developing and developed country has resorted to this at some point of time. The third option is to devalue the currency and export one’s way out of trouble.
Exit the euro
The PIIGS countries cannot print euros and repay their debt. Since they are in a common currency area there is no way that they can devalue the euro. A straight default is ruled out because German and French banks will face huge losses, and Germany being driving force behind the euro, wouldn’t allow that to happen.
So what option do the PIIGS then have? One option that they have is to exit the euro, redominate the foreign debt in their own currency, devalue their currency and hope to export their way out of trouble.
A lot has been written about how you can only enter the euro and not exit it. The situation as is oft repeated is like a line from an old Eagles number Hotel California “You can checkout any time you like / But you can never leave.” A case has also been made as to how it would be disaster for any country leaving the euro.
Let’s try and understand why the situation will not be as bad as it is made out to be. A report titled A Primer on Euro Breakup, about which I briefly talked about a little earlier explains this situation very well.
The first thing to do as per the report is to exit the euro by surprise over a weekend when the markets are closed. Many countries have stopped using one currency and started using another currency in the past. A good example was the division of India and Pakistan. As the report points out “ One example of a currency breakup that went smoothly despite major civil unrest is the separation of India and Pakistan in August 1947. Before the partition of India, the two countries agreed that the Reserve Bank of India (the RBI) would act as the central bank of Pakistan until September 1948….Indian notes overprinted with the inscription “Government of Pakistan” were legal tender. At the end of the transition period, the Government of Pakistan exchanged the non-overprinted Indian notes circulating in Pakistan at par and returned them to India in order to de-monetize them. The overprinted notes would become the liabilities of Pakistan.”
Any country looking to exit Euro could work in a similar way. It will need to have provisions in place to overprint euros and deem them to be their own currency. Then it will have quickly issue new currency and exchange the overprinted notes for the new currency. Capital controls will also have to be put in place for sometime so that the currency does not leave the country.
Despite the fact that there are no exit provisions from the euro, after the creation of the European Central Bank, the individual central banks of countries were not disbanded. And they are still around. “All the euro countries still have fully functioning national central banks, which should greatly facilitate the distribution of bank notes, monetary policy, management of currency reserves, exchange-rate policy, foreign currency exchange, and payment. The mechanics for each central bank remain firmly in place,” the report points out.
By applying the legal principle of lex monetae – that a country determines its own currency, the PIIGS countries can re-dominate their debt which they had issued under their local laws into the new currency. As the report points out “Countries may use the principle of lex monetae without problems if the debt contracts were contracted in its territory or under its law. But private and public bonds issued in foreign countries would be ruled on by foreign courts, who would most likely decide that repayment must be in euros.”
The good thing is that in case of Greece, Spain and Portugal, nearly 90% of the bonds issued are governed by local law. While redomination of currencies in their own currencies will legally not be a default, it will be categorized as a default by ratings agencies and international bodies.
Another problem that has brought out is the possibility of bank runs if countries leave the euro. Well bank runs are already happening even when countries are on the euro. (The entire report can be accessed here: http://www.johnmauldin.com/images/uploads/pdf/mwo022712.pdf).
The PIIGS coutnries can devalue their new currencies make themselves export competitive and hope to export their way out of trouble. This is precisely what the countries of South East Asia after the financial crisis of the late 1990s. As the report points out “history shows that following defaults and devaluations, countries experienced two to four quarters of economic contraction, but then real GDP grew at a high, sustained pace for years. The best way to promote growth in the periphery, then, is to exit the euro, default and devalue.”
The German export machinery
A breakup of the euro will create problems for the highly competitive export sector that Germany has built up. The PIIGS countries would start competiting with it when it came to exports. Given this they will not let the euro break so easily. As the bestselling author Michael Lewis said in an interview sometime back “German leadership does not want to be labeled as the people who destroyed the euro.”
But as Lewis also said “If you put Germany together with Greece in a single currency, it’s a little like watching an Olympic sprinter and a fat old man running a three-legged race. The Greeks will never be as productive as the Germans, and the Germans will never be as unproductive as the Greeks.” So it’s best for PIIGS countries to exit the euro.
In the end let me quote my favourite economist John Kenneth Galbraith as a disclaimer: “The only function of economic forecasting is to make astrology look respectable.”
(The article originally appeared at www.firstpost.com on May 19,2012. http://www.firstpost.com/world/if-piigs-have-to-fly-they-will-need-to-exit-the-euro-314589.html)
(Vivek Kaul is a writer and can be reached at [email protected])