Friday, August 12, 2011

It's Europe, stupid

The recent collapse in stock prices and Treasury yields in the U.S. was not related to any direct evidence that the U.S. economy was headed for a double-dip recession. It was mainly driven by fears of a European sovereign debt crisis that could potentially lead to a massive bank failure and a collapse of the Eurozone economy. With Europe already weak, a financial crash would likely bring the economy to its knees, and that in turn would be a serious drag on the U.S. economy. The chart above, which compares the S&P 500 index to its Eurozone counterpart, illustrates the dynamics. The recent Stoxx decline correlates highly (0.85) to the decline in the S&P 500, but the Stoxx index has fallen almost 20% more than the S&P 500 in the past six months. If investors are running scared here, they are in full-blown panic mode in Europe.

As the above chart shows, a Greek default/restructuring on its $500 billion of debt is a foregone conclusion; the only issue now is how serious the haircut will be. The likelihood of a Portuguese ($225 billion of debt) or Irish ($160 billion of debt) default/restructuring is less, but still a haircut of some magnitude is expected. The chances of an Italian default are not much higher than that of a BAA-rated company, but the size of Italian debt outstanding ($2.3 trillion) is what makes the market shudder. Pick even relatively small haircuts on the total debt of these four countries (just over $3 trillion) plus maybe Spain ($920 billion), and you quickly come up with losses that could wipe out the capital (about $600 billion) of Europe's 20 largest banks, which collectively own over $4 trillion of PIIGS debt. The numbers are scary indeed.

This chart of swap spreads offers some consolation. Eurozone swap spreads are quite high, signaling serious systemic risk and investor's attempts to avoid bank counterpart risk, but they are not catastrophically high like they were in late 2008. Plus, U.S. swap spreads remain at low, normal levels, which is a good indication that U.S. banks are almost entirely insulated from the consequences of a Eurozone sovereign debt default.

I refer back to a post I made a month ago, in which I argue that "most of the bad effects of too much debt have already happened." The money borrowed by Greece, Italy, et. al., has already been squandered on non-productive activities. Governments have misused scarce resources, and that is why their economies are relatively weak. Defaults don't necessarily lead to weaker economies, since debt is a zero-sum game: a restructuring of Greek debt means a loss for the holder of the debt, but a gain for the Greek government, since it is relieved of some of its debt burden. The Greek economy won't shrink just because it defaults; it is still full of people, offices, factories, and machinery that will go on producing. The worst thing about the threat of a default is that everyone wants to avoid taking the loss, and fear and panic can produce an economic slowdown—this is the phase Europe is in right now. The one good thing that will surely come from this is that governments will be forced to reform their spending habits. The era of Big Government is slowly drawing to a close.

Meanwhile, the 6% growth of real retail sales over the past year disproves any suggestion that the U.S. economy might be entering a double-dip recession.


Benjamin Cole said...

Sometimes, Inflation Is Not Evil
Published: August 11, 2011

Sometimes, you have to unlearn your lessons.

Ken Rogoff, the Harvard economist, suggested central bankers consider “the option of trying to achieve some modest deleveraging through moderate inflation of, say, 4 to 6 percent for several years.”

Thirty years ago, it became clear that defeating inflation was crucial, even if the means needed to accomplish that would cause a deep recession. By the time the European Central Bank was created in the 1990s, it seemed so obvious that inflation must be fought that the bank was given only one mandate — to fight inflation. The other mandate given to its United States counterpart, the Federal Reserve — to promote employment — was pointedly not included.

It is time for a new lesson to be learned. Sometimes we need inflation, and now is such a time.

Had the central bankers of the world understood that inflation in asset prices could be just as bad as, if not worse than, inflation in the prices of consumer goods, this would not be necessary. But they did not. So they did nothing to resist soaring home prices, just as they had seen no reason to worry about the Internet stock bubble."

Happily, we are seeing more and more right-wing economists (and yes these labels are just about falling apart) call for inflation and growth.

We have now Greg Mankiw, Maryin Feldstein, this guy Rogoff, and the Milton Friedmanites of Scott Sumner, David Beckworth, and David Glasner.

I think these guys are right. But for so long, the battle has been against inflation. Every federal institution fights the last war, be its against poverty, formidable military enemies, or inflation.

Always, semi-religious virtuous goals are touted, as in uplifting humanity, fighting against totalitarianism or holding the line against debasing the currency.

But times change. Poor people have air-conditioning and are fat. We have no military enemies and inflation is dead.

Scott Grannis said...

The way I see it, the Fed has been fighting deflation for most of the past 10 years. That's because they were fighting inflation too hard in the previous 5 years (1996-2000). Inflation is coming back slowly but surely, led by a huge decline in the dollar and a huge increase in gold, both classical warning signals of impending inflation.

I lived in Argentina when economy ministers argued for deleveraging through inflation, and it always proved disastrous. That is a fool's game, and the Argentines have been so foolish as to try it about a dozen times, to no effect.

One last word: you don't wait for inflation to show up to know it's a problem. By the time inflation hits the CPI it's already well entrenched.

Bill said...


Just catching up on your posts this week and want to thank you for putting things in perspective. Do you think your post a few weeks ago regarding the surge in M2 was the warning sign of things to come? Does this suggest that we're in for a bumpy ride for the foreseeable future?

Scott Grannis said...

Bill: it sure does look like the surge in M2 was due to the rising panic in Europe. And I note that this week it surged yet again. Something like a run on the European banks as everyone tries to avoid the pain of default. I imagine this means the problem is not over (obviously) so we have some rough sledding ahead. But I think we will make it ok.

Benjamin Cole said...

I see no problem with inflation in the five percent range--and indeed in the USA we prospered for 20 years with mild inflation 1980-2000.

The problem after that period of moderate inflation was not runaway inflation, but deflation (2008-10).

When July CPI figs come out, compare them against July 2008. It is a shocker.

mmanagedaccounts said...

Scott, I'm sorry but I don't get it. If the total amounts of outstanding debt among the PIIGS is just past $3 Trillion, how do the top 20 European banks own over $4 Trillion of their debt?

Huntington Hartford said...

The way they calculate CPI isn't intellectually honest. It's a political process. Its usefulness is questionable.

Benjamin Cole said...

Huntington Hartford:

Maybe so, but Don Boudreaux, chairman of the Econ Department at George Mason (if you get any more right-wing that that, you start wearing high boots and jodhpurs) says the CPI overstates inflation. Actually, several other studies have come to the same conclusion.

Many say the CPI overstates inflation by about one percent. If true, we have been deflating since July 2008.

Right now there is deflation in real estate and manufactured goods. Unit labor costs, until recently were also deflating, but stabilized in last reading.

My take on commodities is that we cannot have sustained inflation there--people start switching, conserving. There is a ceiling on commodities inflation, and we have run up against it twice with oil.

For the next year I anticipate deflation. We are doing a Japan.

acrossthecurve said...

Am I crazy to think of deflation as tax break for the poor? relief for the poor would be welcome surprise of a deflationary to low inflation environment. Im not talking about job creation but affordibilty of lifes needs and demands. we dont want to have a riot on our hands and this might be one way to ensure that; price stability. The fomc has done all they can, its up to our political and business leaders to revive the economy on a smaller federal budget.


Do you see any solution to our woes in the US other than inflating our way out?


I hope you are right about the end of big govt. It would revilatize my very low confidence it govts ability to govern properly.

CPI igonres too much to be relevant.