Wednesday, December 28, 2011

PIIGS update



These charts illustrate the macro state of financial affairs in the Eurozone. As the top chart shows, 2-yr Eurozone swap spreads are still very high, almost as high as they were at the peak of the 2008 financial crisis, when the world confronted the perceived threat of a global financial market meltdown, several years of deflation, and a global depression. The bottom chart, on the other hand, shows that the risk of sovereign defaults has declined significantly in the past month or so, particularly in the case of Italy and Spain, the two largest PIIGS debtors. (The likelihood of a Greek default, of course, is extremely high, and it would surprise no one if the country actually did default.)

So the Eurozone banking system is still hanging by a thread, to judge from the level of swap spreads, but the outlook for the Eurozone's larger debtors has improved measurably—an apparent contradiction. One plausible explanation for this is that the ECB's massive balance sheet expansion in the past week or two (see chart below, which is measured in trillions of dollars) has artificially depressed Italian and Spanish yields, but has not done anything to address the fundamental problem of the Eurozone, which is that too many governments have borrowed and spent more than they should have, and on unproductive activities. Thus, Spanish and Italian debt prices have improved, thanks to ECB purchases, but the whole Eurozone financial structure, as reflected in very elevated swap spreads, rests on very shaky bedrock.


It makes sense that the ECB can't fix the Eurozone's problems simply by buying the bad debt of struggling PIIGS countries. The ECB can, however, buy time for the system to fix itself, and there are signs that the PIIGS countries are beginning to take needed action to reduce their spending. But in the meantime, what about the consequences of massive central bank balance sheet expansion? Doesn't that just compound the problem by introducing the risk of hyperinflation?

Not necessarily. As with the Fed's balance sheet expansion, the vast majority of the bank reserves that have been "created" in the process of accumulating Treasury, MBS, and sovereign debt are still sitting idle on the central banks' balance sheet in the form of excess reserves. In essence, all that has happened is that the central banks have exchanged bank reserves for bonds—the rough equivalent of transforming risky bonds into risk-free bills. The market has been happy to unload trillions of dollars of bonds for bank reserves, and this means that a huge share of the burden of default risk of PIIGS debt has been shifted to the ECB. It has also satisfied the huge demand for safe-haven assets.

But if the ECB's new assets end up defaulting or being written down significantly, this will erode the ECB's balance sheet and impair its ability to defend the value of the Euro. How would that work? Presumably, at some point the world will become less fearful of an economic and/or financial market collapse, and the demand for money will decline. A declining demand for money is equivalent to an increased desire to borrow money, and the existence of trillions of bank reserves gives banks a virtually unlimited ability to create new spendable money. Money supply expansion could become brisk and eventually undermine the value of the Euro; the ECB would ordinarily avoid that by withdrawing reserves from the banking system, and that would be achieved by selling off its accumulated balance sheets assets. Of course, if those assets have dwindled due to defaults, then the ECB couldn't fully reverse its reserve injections, and the Eurozone could end up with a huge surplus of money.


For the time being, there is no sign of any unusual expansion in the Eurozone money supply (the chart above uses the latest data available, as of 10/30/11). M2 in both the Eurozone and in the U.S. has been growing at slightly more than a 6% annualized rate for a long time.


So although the situation is far from ideal, it is neither catastrophic nor beyond hope.

28 comments:

Unknown said...

After looking at today's data, withhold tax receipts have *definitely* picked up the past ~week compared to last year, after languishing the previous month or so. This data set is definitely now looking consistent with initial claims, so a better-than-expected jobs report would not surprise me at this point.

If you want to follow this data, I'd recommend subscribing to this website:
Daily Jobs Update

Hale Stewart also usually posts a weekly summary on his blog:
Bonddad blog weekly summary

Dr William J McKibbin said...

The good news is that the PIIGS are experiencing deflation and economic depression, and so the small amount of money provided by the ECB ($0.6 trillion) is no doubt intended to shore up deflation and restore near zero inflation -- the ECB knows that the expanding global economic depression will open opportunities for stategic monetary expansion along the way, which will go unnoticed in our deflationary economic times -- the world is experiencing deflation and economic depression (according to real property values), and the central banks will throw just enough money into the system to keep deflation at bay and maintain near zero inflation rates -- it's all good for those with cash to invest in high quality dividend and rent-earning equities -- accredited investors are in a buy window -- deals are everywhere -- everyone else is screwed...

Benjamin said...

The ECB should be inflating, not deflating. ECB nations need to balance their budgets, but the ECB should be trying to help nations deleverage through monetary stimulus.

We may see a Japan in Europe--stagnant population growth, no GDP growth, deflation, etc. All the while prim ECB central bankers will pompously pettifog about inflation. Eventually, so many bonds are sold at 1 percent interest rates that a new bond holding class emerges, deadset against any stimulus of any kind.

William said...

Benjamin said: "Eventually, so many bonds are sold at 1 percent interest rates that a new bond holding class emerges, deadset against any stimulus of any kind."

That is an original thought! Do you suppose that is the case now in Japan?

burmanhands said...

Scott, after following your blog for about a year I would like to thank you for the work and wisdom you put into your updates. This is the wonder of the internet that a few good souls can give something of huge value to all of us.I look forward to more of the same. All the best to you and your family in the new year.

John said...

The top graph lumps a lot of countries together, some of which
are much more fiscally responsible than others. It excludes Norway, Sweden, UK and Denmark - all countries that are doing pretty well.

The media here, I think, tend to lump European countries together for purposes of argument. Such "lumping" can be misleading and lead to inaccurate assessments.

I like the second graph better. I'd be curious to see the swap spreads for the UK and Scandanavian countries compared to the US.

What countries make up the Eurozone?

"The eurozone currently consists of Austria, Belgium, Cyprus, Estonia, Finland, France, Germany, Greece, Ireland, Italy, Luxembourg, Malta, the Netherlands, Portugal, Slovakia, Slovenia, and Spain."

http://en.wikipedia.org/wiki/Eurozone

qwe said...

Scott,
Why gold is falling so sharply, is this due to a Citi eco suprise index rise which may delay QE3 in US?

Scott Grannis said...

I'm working on a post about gold, but the short answer is that at $1900 earlier this year, gold had priced in just about everything that could go wrong. As it turns out, not everything is headed for disaster, so gold had to give up some portion of its gains.

Benjamin said...

William-

I wish I knew more "inside baseball" on Japan's monetary policymaking.

The yen has been strong for 20 years, generally rising, while Japan's industrial output fell by 20 percent, property fell by 80 percent, and equities are down 80 percent.

Yet some in the USA call for tight money and a strong dollar!!!!

I assume the Bank of Japan has the usual banker's peevish fetish for currency and gold. These guys think about gold the way I think about sex.

They also do not make a living out in the business world, but are safely ensconced inside their banks.

I often wonder if bondholders make up a powerful interest group in Japan. In the USA, bondholders often preach about the virtues of saving and the sacrosanct nature of bondholders, as if people risking equity in business and real estate are somehow not as worthy.

In fact, the globe has plenty of capital, and rewarding savers is not the problem. We need to reward stock owners and property owners, who have not had a payday in more than 10 years.

Donny Baseball said...

Italy remains the trouble spot and looking at their yield curve, they seem to be doing better on the short end than on the long end. The 1 and 2 year yields are down nicely and even the 5 year has moderated, if a bit less so. But they are struggling with the 10 year which is back up to 7%. This tells me that all the actions to date have taken some pressure off the near term funding outlook but that, long term, investors still think that 1) structural reform in Italy is not believable, 2) there isn't enough capital to fund the Italian model and thus 3) Italy is cooked. By contrast Spain and France seem to be doing better across the yield curve. Take from that what you will, but I think we are no longer dealing with a "Euro" crisis, we are dealing with only a Greco-Italian crisis, and the Greco part is mostly resolved.

On the pessimistic side of the ledger, I heard some scary outlooks from a highfalutin analyst yesterday that the ultimate haircuts across the zone need to be in the 70% range and that they have to rationalize the banking system down to a more US-like size as a % of GDP. so it's going to be an ugly wipeout.

Dr William J McKibbin said...

@Donny, Europe will blowup once everyone realizes that the degree of "restructuring" required in the PIIGS is infeasible politically -- nevertheless, cuts in public spending are imminent, be they by public policy or simply national defaults -- either way, depression is imminent in Southern Europe -- the US is also facing a blowup given that banks made a "seasonal" decision to hold off on new foreclosures until after the new year -- in 2012, the US will be confronted with the largest increase in new foreclosures since 2008 -- likewise, the budget blowup in California has been on tacit hold until after the holidays -- nevertheless, California revenues are trailing budget requirments by a significant margin -- moreover, Gov Brown appears to be determined to conduct "business as usual" in order to amplify the California budget crisis into a voter mandate for tax increases -- whatever happens, its bad news for California where eventually, major cuts in government employment and/or major increases in taxes will reduce California to economic depression on a scale not seen on the West Coast since the Great Depression -- the combination of sharp increases in mortgage foreclosures and budget remedies in California means catastrophe in California on a scale similar to what is about to unfold along the southern flank of Europe -- deflation is already evident across America in home values, real wages, and the employment to population ratio -- accredited investors are in a buy window of opportunity at this point -- however, the 99% crowd in America is in for horrific times -- in fact, the worst of times...

Benjamin said...

Krugman, wh is not always wrong, suggest the ECB will practice monetary expansionism, by printing up money and giving it to the banks that own Euro debts.

Maybe.

Squire said...

Dr. William, deflation may have set in on home values but two things:

One is that on the San Francisco Peninsula I cannot find a decent value or positive cash flow rental house or small apartment house without a massive down payment.

Second is that in Nevada I can buy houses for a song and a dance but I cannot find renters who can pay the rent so my existing property sits vacant.

Maybe there is something inbetween I need to be looking at.

Dr William J McKibbin said...

@Squire, yes, rent-paying real estate generally requires a cash purchase deal, which is what you are apparently finding in San Francisco -- properties that are vacant are to be avoided, such as what you are finding in Nevada -- accredited investors with cash are in a "buy" window of opportunity -- cash is king during depressions -- all the good real estate that is earning rent generally requires cash to close -- good luck!

Dr William J McKibbin said...

PS: I know a physician who just purchased an apartment complex for half of its original market value -- however, this person was able to write a seven-digit check from his savings account -- again, this is what depressions look like -- the same conditions and opportunities prevailed across America during the 1930's -- rent and dividend-earning equites are in high demand these day, but cash is required to close the deal -- cash is in short supply along Main Street USA, which is in economic depression...

L.A. said...

Regarding the looming crisis in California (or any other state for that matter), what's to keep us from printing money to eliminate the debt? California doesn't seem remotely interested in changing its ways.

Junkyard_hawg1985 said...

"Regarding the looming crisis in California (or any other state for that matter), what's to keep us from printing money to eliminate the debt? California doesn't seem remotely interested in changing its ways."

1) Experience from the Hyperinflation that occurred when the Weimar republic tried it.

2) Experience from the hyperinflation when the Continental Congress tried it in the U.S.

3) Experience from the hyperinflation when Zimbabwe tried it.

4-20) Experience from hyperinflation when country X tried it.

L.A. said...

@ Junkyard
I don't disagree. But we print money for federal debts and to provide stimulus, so it wouldn't seem to be a big stretch to do the same for the states. If we are relying on past experiences and trust of elected officials that's a scary state of affairs. Printing money for state debts is merely an extension of existing policies it seems.

Benjamin said...

Hyper-inflation is probably a poor solution, alongside another demented cousin, deflation.

Moderate inflation and robust growth is what the doctor ordered.

Squire said...

LA, you must live in California too where we believe that people in other states should subsidize our $140k Highway Patrol Salaries, $136k nurses salaries who now start at $90k out of nursing school, firemen retiring in the early 50’s with over $100k a year, and prison guards making $200k a year with overtime.

We here do not believe there really is a budget problem and no action has been taken to reduce the public sector excess. I mean, we elected the guy who created public unions to be governor. We rejected the candidate who is now CEO of Hewlett Packard because she said the teachers union should take the lead and go to 401k's like everyone else in the private sector.

Squire said...

Someone buying rental property must be prepared for the long haul. When in California I live in a small apartment complex in a really nice yuppie area. The landlord has not been able to rent two of 16 apartments for months and I consider the asking rent to be at market.

An upside to buying with cash, which is a risk management technique, is that if the real estate market improves, one can borrow against the equity and buy another income property with it.

Rental property instead of cash seems like a good proposition if you are prepared for the long haul and don't expect deflation to wipe you out first.

Dr. William is right, there ARE two Americas. Those with good jobs and passive income and those who don't.

Benjamin said...

Mark Perry has good post today on inflation---there isn't any.

Can anyone tell me why the Fed and Ben Bernanke-san are targeting zero inflation during the worst economic recession since the Great Depression?

WC Varones--think about Japan. They have had mild deflation for the last 20 years, and the yen has been very strong. Their industrial output has fallen 20 percent in that time frame, while their stock and equity markets have fallen by 80 percent. (BTW, USA industrial production doubled in that time frame, and we had moderate inflation, until recently when we have had bouts with deflation).

To seek robust economic growth is to embrace mild inflation---this is not hyperinflation, the bane of the Chicken Inflation Littles.

Ben Bernanke-san needs to be far more aggressive in stimulating the economy. The feeble, dithering policy he is following is much more what I would expect from the Bank of Japan.

Dr William J McKibbin said...

@Benjamin, the US Fed (and ECB) are apparently prepared to ride with the four horseman of the apocalypse (i.e., disease, famine, pestilence, & war) in order to avert monetary expansion -- the time for monetary expansion will eventually arrive, but much of the US and Europe will first have to take a detour through economic depression to get there -- I expect the US and Europe will remain in economic depression for the next decade or so -- hence, a long-term view of investing is required today -- patience and diligence are the best guidance for today's economy, which is likely to ruin or destroy the lives of many in America -- remember that 75% of Americans never missed a paycheck during the Great Depression -- the key is to stay employed and not lose hope in the future -- those lacking world-class skills should take advantage of the times to acquire those skills (e.g., doctoral training in medicine, science, & engineering) -- those who are not bilinqual should consider acquiring a second language -- America is headed into an economic storm that will devastate much of country -- the only people (so far) who have enjoyed a pass from the devastation are government employees and the defense establishment -- restructuring the US economy will take at least a decade -- now is the time to be smart, careful, and focused on what matters most to each of us -- good luck!

Benjamin said...

Dr. William-

Good luck to you too. I hope we avoid a depression, and we can easily do so.

Bill said...

Don't know if anyone here reads Ken fisher at Marketminder but he predicted the market would be flat, based on historical data showing that bull markets are usually flat in their 3rd year because profits don't impress as much. Pretty awesome prediction>

Benjamin said...

Bill-

Maybe so, but corporate profits have been shooting through the roof. We hit record profits barely out of the recession.

American corporations seem to be fairly well-run, and able to make money in all markets.

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Dr William J McKibbin said...

According to the Wall Street Journal, Spain is enduring a current 22.8% unemployment rate, while Germany's unemployment dropped to roughly 6.8% -- herein lies the challenge for Europe -- the economic clash between Northern and Southern Europe has the makings of civil war and/or revolutions -- oh, but that's got nothing to do with monetary policy according to central bankers -- right -- what's the difference who's fault it is, and who could have fixed the problem if Europe blows up into continental warfare -- the austerity hawks are polemicists that are creating a world that cannot work...