...from Dr. John - Greece is toast

"The yield on 1-year Greek government debt ended last week at 110%, down slightly from a mid-week peak of 130%. Even with the pullback, the Greek yield structure continues to imply default with certainty. All the markets are really quibbling about here is the recovery rate - what percentage of face value investors can expect to obtain post-default. That figure was still hovering near 50% as of Friday, but was a bit higher than we saw a few days earlier.

Despite a Greek 1-year yield that is already over 100%, it is still possible to kick the can down the road for another few months with another bailout, but the costs of that would now be extraordinarily high because of the low expected recovery rate. Much better to provide the funds to a post-default Greece, or to use them to recapitalize the banking system after losses that now appear inevitable.

Doureios Ippos: Greek 1-year yields 

Equo ne credite, Teucri! Quidquid id est, timeo Danaos et dona ferentes*

As a refresher on how all of this works, the following chart appeared years ago in the Economist, a chronicle of the frantic bail-outs in the months preceding the default of Argentine debt (which amounted to about $81 billion. Needless to say, the numbers involved in a potential Greek default are much larger, but the pattern we are seeing in Greece is identical to the signature of other historical sovereign defaults (see Uruguay, Russia and other countries as well ) - a sustained rise in yields, coupled with official statements about the "impossibility" of default, multiple bailout efforts that quickly fail, culminating in a vertical spike in yields (toward the inverse of the expected recovery rate, minus 1).

The case of Argentina is instructive because it was in a situation much like that of Greece. Argentina's currency was both pegged and officially convertible into the U.S. dollar, and most of Argentina's debt was denominated in U.S. dollars, creating a situation where its debt burden was in the form of a currency that it effectively could not print. The subsequent default was accompanied first by an abrupt devaluation of the peso to a new peg, and eventually to complete abandonment of the pegged exchange rate.

From the history of sovereign defaults, we can already create something of a roadmap of the financial crisis that appears about to unfold, and the associated choices involved.

Suppose first that Greece agrees to implement new austerity measures and receives another tranche of bailout funding. We already know that applying severe budget austerity in an economy that is in depression (as Greece essentially is) does not materially close the budget deficit, but instead produces further economic weakness and revenue shortfalls. The past year has been a clear example of that. By the end of the year, even with new bailout funding, Greece will have a debt-to-GDP ratio approaching 180%. This is an impossible debt burden to service, and would be even if interest rates in Greece were only a few percent. New bailout funding here means that we'll observe more rioting in Greece as new austerity measures are implemented, the Greek economy will largely shut down, and within a few months, we'll be facing the default issue again but at an even higher debt-to-GDP level and even lower anticipated recovery rates.

Thus, a bailout today does not avert default, but at best defers it to a later date, and squanders funds that could otherwise be used to stabilize the European banking system once that inevitable default occurs.

Of course, there is the implausible option for stronger countries such as France and Germany to literally pay off half of the government debt of Greece, taking those debt burdens upon themselves. But this clearly would not be tolerable politically, and would invite similar expectations from other teetering Euro-zone countries such as Portugal, undoubtedly also encouraging them to completely abandon any remaining fiscal discipline.

So Greece will default, either now or within several months. In response, three actions will be critical: preventing contagion, preserving the euro, and stabilizing the banking system."

http://www.hussman.net/wmc/wmc110919.htm

European Sovereign Debt - Can't We All Just 'Net' Along?

It is seemingly clearer and clearer that with the current structure and membership, the Euro does not work. The market seems to be driving the change in the direction of membership changes (via restructurings and temporary devaluations - e.g. GRE CDS and WI Drachma) while the euro-zone-'management' seem prone to structural changes (i.e. EFSF umbrella, Euro-bonds, and fiscal union). While the cost of either approach is likely extremely high, some research from early Summer by ESCP Europesuggests a non-trivial approach that reduces aggregate debt for the European sovereign complex by almost 64% is possible. The solution:- bi- & tri-lateral netting, and free-trading.

Clearly, there will be winners and losers in this 'free exchange', and the game-theoretical bargaining process of 17 self-indulgent, self-interested career politicians is unlikely to resolve in an optimal direction. However, if nothing else, it is evident just how Gordian-knot-like any resolution is likely to be.

Europe's Web of Debt (as it stood in May 2011)

After three rounds of 'bargaining' including bilateral netting, trilateral netting, and then free-trading (in order to manage different maturities), the complexity reduces dramatically - leaving it very evident where the debt really lies.

The main results were as follows:

The EU countries in the study can reduce their total debt by 64% through cross cancellation of interlinked debt;

Six countries – Ireland, Italy, Spain, Britain, France and Germany – can write off more than 50% of their outstanding debt;

Three countries - Ireland, Italy, and Germany – can reduce their obligations such that they owe more than €1bn to only 2 other countries.

Additionally:

Around 50% of Portugal’s debt is owed to Spain;

Ireland and Italy can write off all of their debt to other PIIGS countries, and Ireland can reduce its debt from almost 130% of GDP to under 20% of GDP;

Greece can reduce their debt by 20%, with 60% owed to France and 30% to Germany;

Britain has the highest absolute amount of debt before and after the write off (owed mostly to Spain and Germany) but can reduce their debt to GDP ratio by 34 percentage points;

France can virtually eliminate its debt (by 99.76%) – reducing it to just 0.06% of GDP;

The authors summarize their findings thus:

This exercise does not solve the problem of the EU debt crisis, and raises more questions that it answers in terms of data reliability. However the revelation about how interlinked debt might net out (possibly even to zero) is a policy option. And indeed if this exercise leaves some countries with a large remainder it points to where the real problems are. Either way, it sheds light on the issue and uncovers information.

The fact that so much debt is interlinked presents a real opportunity to solve the problem. The web of interlinked debt is too thick to be dusted away by classroom games, however policymakers should attempt to replicate this study, and they may find that instead of spinning further webs they might get out a duster to clean things up.

The bottom line for us that while breaking up the Euro will be extremely expensive and potentially dramatically destabilizing from more than a simple market-perspective (as monetary-union disruptions have historically tended to end in civil hostility), this study provides a simple way to see how a fiscally-joined and central Treasury-based system 'could' come out stronger. However, the path to that 'potential' strength will be littered with the bodies of financial and non-financial equity holders, senior- & sub-debtholders, CDS traders, and FX jockeys thanks to risk-free rate re-adjustments, subordination, ringfencings, forced recapitalizations, and implicit austerity.

http://www.zerohedge.com/news/european-sovereign-debt-cant-we-all-just-net-along

Jim Rickards on Currency Wars

China states price for Italian rescue

By Ambrose Evans-Pritchard, in Dalian, China

9:22AM BST 14 Sep 2011

China has called for major strategic concessions from Europe before agreeing to rescue the eurozone, chilling hopes for immediate purchases of Italian bonds.

Mr Wen said he had spoken to José Manuel Barroso, the president of the European Commission, laying the conditions for Chinese intervention. Photo: Reuters

Premier Wen Jiabao said his country and will play its part to "prevent the further spread of the sovereign debt crisis," but warned that China will not sign a blank cheque for states that have failed to carry out full reform.

"Countries must first put their own houses in order," he told the World Economic Forum in Dalian.

Mr Wen said he had spoken to José Manuel Barroso, the president of the European Commission, laying the conditions for Chinese intervention.

"I made clear to him that we are confident Europe will overcome its difficulties and make a full recovery. We have on many occasions expressed our readiness to extend a helping hand, and that we are willing to invest more in European countries."

"At the same time, we need bold steps to give redirection to China's strategic objective. We believe they should recognise China’s full market economy status," he said, referring to World Trade Organisation rules.

"To show one’s sincerity on this issue ... is the way a friend treats another friend," he said.

Li Daokui, a member of the monetary policy committee of China's central bank, warned that nobody should delude themselves about China's willingness to play the role of white knight.

"I don't think any country can be saved by China in today's world. Countries can only save themselves by pushing through reforms," he told a panel at the forum, echoing langugage from German Chancellor Angela Merkel.

Professor Li said China must stop investing its hard-earned wealth in western debt and switch its incremental holdings into "physical assets", including the equities of major western companies.

"China is the most impatient investor in the world. Imagine if our $3.2 trillion in foreign reserves had been controlled by George Soros: financial markets would be in much greater chaos," he said.

China has accumulated roughly 800bn euros of eurozone bonds over the last decade, mostly from the AAA core such as Germany, France, and the Netherlands. This has been a crucial factor explaining the strength of the euro.

It has intervened a number of times in peripheral markets since the crisis began, allegedly accumulating €50bn (£43.48bn)of Spanish debt.

However, the relentless climb in Spanish and Italian yields over the summer indicates clear limits to Chinese buying. China's central bank has already suffered a large paper loss on Portuguese debt bought with much fanfare before that country needed a rescue.

Italy's finance minister Giulio Tremonti said it is hard to persuade Asian investors to buy Italian debt when the European Central Bank hesitates to do so.

China's sovereign wealth fund -- China Investment Corporation -- has been in talks with Italy but is more interested in buying key industrial and strategic assets.

Lou Jiwei, CIC's chief, came under harsh attack in China for losses on US investments after the Lehman crisis. He is unlikely to risk his career a second time by taking a gamble on Italian or Spanish debt.

Market status under the WTO has become the Holy Grail for China, both because it makes the country less vulnerable to 'anti-dumping' sanctions from the EU and because it marks the country's final coming of age in the global economy.

Beijing is bitter that the EU recognises the market status of Russia despite open violations of WTO rules by the Kremlin, claiming that the "double standard" is a disguised form of protectionism.

Under its WTO accesssion accord in 2001, China remains a "non-market economy" for 15 years unless other members agree to fast-track the process. There could still be problems even after 2016 if major powers take a tough line.

http://www.telegraph.co.uk/finance/china-business/8761805/China-states-price-for-Italian-rescue.html

To Save Euro, Turn Banks Into Mutual Funds: Laurence Kotlikoff

By Laurence Kotlikoff Sep 13, 2011 7:00 PM CT 


Eleven years ago, economic historian Niall Ferguson and I marked the euro’s birth with a Foreign Affairs article titled “The Degeneration of EMU.” We argued that absent centralized fiscal policy, euro-zone countries would fight over how much money the European Central Bank should print to help pay their bills. We gave the euro a decade.

Tragically, we may end up close to the mark. The euro could collapse this fall unless the ECB commits to printing every last euro needed to keep Greece, Portugal, Ireland, Italy, Spain and Lord knows who else (think Belgium andFrance) afloat. That’s a tall order.

The five most financially strapped euro-area governments collectively owe more than 3 trillion euros ($4.1 trillion), much of it short-term debt. They must roll over these obligations as they come due and issue new bonds to cover their still huge annual budget deficits. If the private sector doesn’t buy their paper, the ECB must. The International Monetary Fund and the European Financial Stability Facility can help, but their lending capacities are limited.

Why not force Greece and other troubled governments to enact deeper spending cuts and larger tax increases? Lots of luck. They don’t fancy more rioting, and their economies are shrinking. In the short run, they have no choice but to borrow or default.

No Appetite

Unfortunately, the private sector has no appetite for Greek, Portuguese, and Irish bonds and is losing interest in Spanish and Italian debt. Greece’s 10-year private borrowing rate is more than 20 percent. Portugal’s is 11 percent. Ireland’s is 8 percent. These rates are simply unaffordable, leaving all three governments as wards of the ECB.

Thanks to recent ECB intervention, Spain and Italy can borrow at 5 percent and 6 percent, respectively. But Spain and Italy must refinance 660 billion euros through the end of 2012. Private lenders might balk.

Germany and other solvent nations won’t raise new taxes to bail out their euro-area neighbors. And they won’t let the ECB print trillions of euros to continue financing Europe’s current malfeasants. They know there are more supplicants, both sovereign states and private banks, waiting in the wings. As important, they have a deep-seated fear of inflation going back almost a century.

Calling Quits

Even if the Germans don’t call it quits, struggling governments might. Greece’s latest bailout -- the 109 billion euros “agreed to” in July -- contains conditions that Greece, its private creditors and all euro-area members need to accept. Getting all three to say yes will be tough.

The subtext of this fiscal crisis is the horrendous financial meltdown that sovereign defaults could trigger. The government bonds are held, in large part, by European banks. Many of them would be insolvent today were they marking the bonds to market. But, as the International Accounting Standards Board just confirmed, these lenders are booking this junk at much higher prices than the market will pay.

Formal defaults would force financial institutions to tell the truth and declare their own insolvencies. This could trigger a massive bank run. Euro-zone members guarantee deposits, but they don’t have reserves remotely sufficient to cover a full- scale run. Nor can they print money to back account balances.

Cans of Soup

The ECB might step in and “protect” deposits. But if people kept withdrawing money, this, too, would require printing trillions of euros, which the public would cart off from banks they don’t trust. Then, with their money in unsafe keeping, consumers would try to buy something real: cars, cans of soup, you name it. They would turn the euro into a hot potato, producing hyperinflation. Consequently, those who didn’t run on the banks would retain secure claims to worthless pieces of colored paper.

Sovereign defaults are only the proximate cause of this euro-killing nightmare. The real culprit is bank leverage. If the lenders had no debt, sovereign defaults would reduce the value of their equity, but wouldn’t shut them down, thereby destroying the financial-intermediation system.

Non-leveraged banks are, effectively, mutual funds. If appropriately regulated, mutual funds don’t make promises they can’t keep and never go bankrupt. Yet they can readily handle all manner of financial intermediation as 10,000 of them in the U.S. make abundantly clear.

Default

Countries get into trouble, just like households and firms. Similarly, nations should be permitted to default without threatening the global economy. Forcing the banks to operate with 100 percent equity by transforming them into mutual funds - - as I have advocated in my Purple Financial Plan -- is the answer to Europe’s growing sovereign-debt crisis.

In a nutshell, the ECB tells the banks: “No more borrowing to buy risky assets, including sovereign debt, and forcing taxpayers to take the hit when things go south. You’re now limited to marketing mutual funds, including ones that hold nothing but cash and will constitute our new payment system.”

Banks would convert checking accounts to cash mutual funds, which they would back to the buck with reserves. They would gradually sell their remaining assets to pay off debts, while the mutual funds built up assets with money attracted from new shareholders. In cases where the banks’ assets didn’t cover their debts, governments or the ECB would pitch in money to make up the difference. But once the mutual-fund banks were up and running, there would be no need for further bailouts. And the euro would be safe if and when Greece and other governments defaulted.

(Laurence Kotlikoff, a professor of economics at Boston University, is a Bloomberg View columnist. The opinions expressed are his own.)

http://www.bloomberg.com/news/2011-09-14/to-save-euro-turn-to-mutual-fund-banks-commentary-by-laurence-kotlikoff.html

Is the US Monetary System on the Verge of Collapse?

By David Galland of Casey Research

Tune into CNBC or click onto any of the dozens of mainstream financial news sites, and you’ll find an endless array of opinions on the latest wiggle in equity, bond and commodities markets. As often as not, you'll find those opinions nestled side by side with authoritative analysis on the outlook for the economy, complete with the author’s carefully studied judgment on the best way forward.

Lost in all the noise, however, is any recognition that the US monetary system – and by extension, that of much of the developed world – may very well be on the verge of collapse. Falling back on metaphor, while the world’s many financial experts and economists sit around arguing about the direction of the ship of state, most are missing the point that the ship has already hit an iceberg and is taking on water fast.

Yet if you were to raise your hand to ask 99% of the financial intelligentsia whether we might be on the verge of a failure of the dollar-based world monetary system, the response would be thinly veiled derision. Because, as we all know, such a thing is unimaginable!

Think again.

Monetary Madness

Honestly describing the current monetary system of the United States in just a few words, you could do far worse than stating that it is“money from nothing, cash ex nihilo.”

That’s because for the last 40 years – since Nixon canceled the dollar’s gold convertibility in 1971 – the global monetary system has been based on nothing more tangible than politicians' promises not to print too much.

Unconstrained, the politicians used the gift of being able to create money out of nothing to launch a parade of politically popular programs, each employing fresh brigades of bureaucrats, with no regard to affordability.

Such programs invariably surged during political campaigns and on downward slopes in the business cycle when politicians hearing the cries of the constituency to “do something” tossed any concern about balancing budgets out the window of expediency. After all, the power to print up the funds for debt service whenever needed makes moot any concern over deficit spending.

Former VP Cheney, who fashions himself a fiscal conservative, let the mask drop when, in 2002, he stated that “Reagan proved deficits don’t matter.”

Those words were echoed just a few weeks ago, when both former Fed Chairman Alan Greenspan and Obama economic advisor Larry Summers, in separate interviews, said almost the same, paraphrased as, “There is no chance of the US defaulting on its bonds, not when our government can borrow dollars and print new dollars to meet any future obligations.”

Of course, Greenspan and Summers were referring to an overt default – of just not paying – and not to a covert default engineered by inflation. Unfortunately, like virtually all of the power elite, both miss the point that the mountain of debt that has been heaped up since 1971 is fast reaching the point of collapsing like a too-big tailings pile and taking the monetary system down with it.

Importantly, the debt shown in this chart whistles past the government's unfunded liabilities, in particular for the Social Security and Medicare systems. Adding those would more than triple the US government’s acknowledged obligations – to over $60 trillion.

Given the role the US dollar plays as the world’s de facto reserve currency – with all major commodities priced in dollars, and dollars forming the bulk of reserves held by foreign central banks –the dismal shape of the US monetary system spells trouble for the global monetary system.

Making matters worse, following the lead of the United States, governments around the world long ago adopted similar fiat monetary systems. You can see the deficit contagion in this next chart. It is worth noting that the dire condition of the United States now leaves it in the same muddy wallow as Europe’s desperate PIIGS.

In a recent article in The Telegraph, Ambrose Evans-Pritchard referenced a paper out of the BIS that paints the picture using appropriately stark terms.

Stephen Cecchetti and his team at the Bank for International Settlements have written the definitive paper rebutting the pied pipers of ever-escalating credit.

“The debt problems facing advanced economies are even worse than we thought.”

The basic facts are that combined debt in the rich club has risen from 165pc of GDP thirty years ago to 310pc today, led by Japan at 456pc and Portugal at 363pc.

“Debt is rising to points that are above anything we have seen, except during major wars. Public debt ratios are currently on an explosive path in a number of countries. These countries will need to implement drastic policy changes. Stabilization might not be enough.”

Viewing the situation from another perspective, we turn to the work of Carmen Reinhart and Ken Rogoff, who studied the factors contributing to 29 past sovereign defaults. They found that default or debt restructuring occurred, on average, when external debt reached 73% of gross national product (GNP) and 239% of exports. Using the Reinhart/Rogoff findings, Casey Research Chief Economist Bud Conrad prepared the following chart showing that the US government is already far along on the path to bankruptcy.

It’s hard to argue against the contention that the situation is, to be polite, precarious. Given that the obligations of the US government, as well as most of the world’s other large economies, are now impossible to repay and that their reserves are just IOUs backed by nothing, the stage is set for a highly disruptive but entirely necessary do-over of the fiat monetary system.

“Preposterous!” say the lords of finance and masters of all.

Is it?

Of course, these very same mavens completely missed the looming housing crash and the depth and duration of the subsequent crisis – a crisis that is still far from over. In other words, listen to them at your peril, because in our view it’s essential in calibrating your financial affairs to understand that, if history is any guide, we are now well down the road to a collapse in the monetary system.

In fact, over its relatively short history, the US monetary system has come unglued time and time again thanks to politically expedient attempts to interfere with the workings of a free market in order to reward constituents or kick the can on the economic problems of the day down the road.

Thus it is our contention that while the mainstream media focus on the daily gyrations of equity markets or the futile political charade that is Washington, they overlook powerful tectonic rumblings indicating the world’s prevailing monetary system is about to fracture.

A Brief Timeline of US Monetary System Failures

Here’s a brief history of past disruptions here in the United States. Importantly, with the US dollar now the de facto reserve currency of the world, this time around it’s global.

1861 –When the Civil War begins, the dollar is convertible into gold and silver.

1862 –Congress passes the Legal Tender Act and authorizes the issuance of non-redeemable "Greenback" currency. Convertibility into gold and silver is suspended for all US currency.

1863 –National Banking Act authorizes the chartering of banks by the federal government.

1865 – A 10% tax is levied on the issuance of bank notes by state-chartered banks, effectively ending that practice.

1879 –The US Treasury resumes redeeming dollars for gold and silver.

1900 – Passage of the Gold Standard Act, adopting the gold standard by the United States and demonetizing silver.

Specifically, the act provided for "...the dollar consisting of twenty-five and eight-tenths grains (1.67 g) of gold nine-tenths fine, as established by section thirty-five hundred and eleven of the Revised Statutes of the United States, shall be the standard unit of value, and all forms of money issued or coined by the United States shall be maintained at a parity of value with this standard..."

But 33 years later, to gain the power to inflate the currency and collect the profit from doing so…

1933 – By executive order, Franklin Roosevelt prohibits the private ownership of gold. Congress passes the Gold Reserve Act, which enacts Roosevelt's executive order, abrogates all gold clauses in all contracts public or private, past or future (which cancels the convertibility of Federal Reserve notes into gold), though it confirms the convertibility of US Treasury notes held by foreigners into gold. Eleven years later, the US government takes its show on the road…

1944 – Bretton Woods system adopted with signature countries agreeing to tie the exchange rates of their currencies to the US dollar, which itself is linked to a fixed price of gold. Foreign trading partners retained the right to swap dollars for gold, imposing a de facto restraint on printing more dollars. For all intents and purposes, the US dollar becomes the world’s reserve currency. But 27 years later…

1971 – Nixon abruptly closes the “gold window,” unilaterally reneging on the Treasury's promise to allow foreign governments to redeem dollars for gold. Bretton Woods collapses. With no remaining tie to a tangible, the dollar is reduced to a paper token. The transition to a global fiat monetary system is complete.

Until 40 years go by and the inevitable consequences of giving politicians free rein over money creation become untenable…

Present day – Sovereign debt crisis. Desperate, debt-laden governments around the globe – the bulk of their reserves composed of fiat US dollars and euros at risk of going up in smoke – turn to the only thing they know, printing more money and issuing yet more debt. The global monetary system cracks and heads toward failure with no workable alternative on the horizon.

Governments, corporations and investors alike are caught unprepared in the downward spiral of failing fiat currencies and are wiped out by a combination of frantic currency debasements, higher taxation, exchange controls and worse. Social unrest spreads, with the public paradoxically demanding that governments do more, not less.

That’s because all the world’s major currencies are at risk, simultaneously, as the issuers engage in a dangerous race to the bottom. As the monetary system moves inexorably toward terminal debasement and collapse, the results will be catastrophic for the unprepared.

Importantly, while the list of historical attempts to re-jigger the US monetary system have, to this point, more or less succeeded in kicking the can a bit further down the road, the sheer scale of today’s government obligations has driven us into a box canyon, with no way out. As the government’s debt and spending obligations are mathematically impossible to resolve, it is now a certainty that a lot of people are going to wake up one morning to the reality that they are a lot poorer than they thought.

Fortunately for those now paying attention, the collapse of a monetary system doesn't happen in a flash. It is a progression, like the spiral of water down a drain. Thus, while no one can predict exactly when the downward spiral will accelerate out of control, there is still time to prepare.

Dark though the lens may be, this is the lens through which we here at Casey Research view all our investments. Simply, being right or wrong about your investment decisions in the years just ahead will be insignificant if the currencies underpinning those investments shrivel to just a fraction of their current values.

Angela Merkel's Euro Contagion Band

...we hope you will enjoy the show.

..from William Banzai

http://williambanzai7.blogspot.com/