Tuesday, September 13, 2011

Panic exhaustion?

It should be obvious by now that financial markets have been in a panic for the past two months over the increasing likelihood of a Greek default, and all the death and destruction that could follow in its wake. In my posts I've tried to quantify the panic by looking at a variety of market-based indicators of the panic: the zero rate of interest on T-bills, the record-low level of Treasury yields in general, the very high level of implied equity volatility, the very high level of the ratio of implied volatility to the 10-yr Treasury yield, the very high level of Eurozone swap spreads, the generally low level of market PE ratios (as contrasted to the record-high level of corporate profits), the pronounced underperformance of Eurozone equities relative to US equities, and the huge declines suffered by Eurozone bank stocks. For an even greater variety of charts and figures, I suggest this post from Pater Tanebrarum, in which—among other things—he makes it absolutely clear that European bank stocks are collapsing. (HT: Tom Burger)

The charts that follow are a closeup look at some of the more important panic indicators from the US market. It is too early to draw a firm conclusion, but it looks to me like the panic is slowly fading. A skeptic would say this is just the last gasp of the bulls, but it's hard to square that with the fact that the news out of Europe has only gotten worse, as the first chart below (Greece 2-yr bond yields) shows. Perhaps the market is just getting exhausted from so much panic?

After a swift plunge in early August, US equities have been inching slowly higher.

The implied volatility of equity options, a good proxy for raw panic and fear, shot up to an impressively high level in early August, but since then it has been trending slightly lower.

The 10-yr Treasury yield also plunged in early August, but since then shows tentative signs of having bottomed.

The ratio of the Vix to the 10-yr shot up in early August and has been quite elevated ever since, but it has failed to make a new high.

Or here's another thought: maybe the panic has been overdone?

Most observers agree that the biggest problem these days is too much debt. Debt burdens are smothering economies, and a default by one government could spread like wildfire to others and quickly bring down the entire European banking system. Banks are undercapitalized and over leveraged, with too much exposure to a PIIGS default. If the banks fail then the wheels of commerce grind to a halt. 

But as I argued awhile back, the real damage that too much borrowing causes has already happened. Greece has been borrowing money for years and squandering it on inflated pensions, a bloated bureaucracy, corruption, etc. Greece has taken resources from the productive parts of the world and basically flushed them down the toilet. The money is gone, and its economy failed to grow enough to support the repayment of its debt obligations. The losses have occurred in fact, but it takes awhile for them to be recognized and written off. What we have seen in the past two months is the agonized attempts of market participants to avoid taking some of those losses. It's like a game of financial musical chairs: suddenly everyone realizes that there is one less chair (Greece's inability to repay its loans), and all scramble to avoid being the one left holding the bag.

Once again: it's not the burden of debt repayments that smothers economic growth, it's using debt for unproductive purposes that smothers an economy. That's why US economic growth has slowed even as government spending and debt have exploded; we've been wasting money left and right, and that reduces our capacity to grow because the money otherwise would have been used for more productive purposes.

So instead of fearing the eventual Greek default, we should realize that the damage has already been done and we have been living with the consequences for years. The losses have been incurred, and the market is well on the way to apportioning the losses by slashing the price of Greek bonds and decimating the market cap of the banks that hold Greek debt. These price declines don't mean more bad news for the economy, since they are merely the price tag for the mistakes of the past. 

The good news that will come out of all this is that Greece won't be able to continue to waste the world's resources nearly as much as it has in the past. Like it or not, in one way or another, the Greek economy is going to have to get by on less and lots of people are going to have to tighten their belts. Before Greece joined the eurozone, this would have been solved by a devaluation. (Devaluations are the process by which a government steals wealth by force from its citizens.) If Greece only does one thing right, it should remain in the eurozone and thereby avoid a devaluation, but then of course it would have to make the adjustments obvious (and politically painful) by cutting spending and raising taxes.

What about the likelihood of bank failures when Greece and perhaps another PIIGS country defaults? Well, banks can be recapitalized, or they can be nationalized, or new banks can sprout up out of the ashes of dead banks. It happens all the time. The failure of a bank is simply the last chapter in a book about money being flushed down the toilet. It's not the end of the world.

UPDATE: The excellent economist Alan Meltzer has an op-ed in today's WSJ in which he argues that Greece and the other welfare states (i.e., those who can't figure out how to control their spending) could effectively devalue without leaving the euro. How's that? The fiscally conservative countries could effectively leave the euro and start a new, stronger currency union:

Although the European Central Bank treaty does not permit devaluation, there is a way for Greece, Italy, Portugal and perhaps others (known by the acronym PIGS) to devalue while remaining part of the euro. The northern countries can start a new currency union limited to those who adopt common, binding or enforceable fiscal arrangements like those that German Chancellor Angela Merkel and France's President Nicolas Sarkozy discussed last month. The new currency could float against the euro, allowing the euro to devalue. Once devaluation restored competitive prices in the heavily indebted countries, they could be admitted to the new currency arrangement if, and only if, they made an enforceable commitment to the tighter fiscal arrangement. If all countries rejoined, the old system would restart with a more appropriate, binding fiscal policy rule.


Benjamin Cole said...

What a strange passage in our economic history. We have our factories, our farmlands, our infrastructure, and skilled workforces. There is gobs of capital on the sideline.

But we are letting something invisible, even imaginary hold us back. Debt.

Imagine a visitor from Mars.

"Why are not you working?" he asks.

"Oh, we are over-indebted, and uncertain about the future," we answer.

"Are you not then doing precisely the wrong thing, by slowing down output?" asks the Martian.

"Yes, we know we are making matters worse, but we can't help ourselves," we answer.

Bill said...


I read that Greece has defaulted (at least partly) some 51 times in its history. True? If true, why all the fuss this time?

Benjamin Cole said...

Call me an eternal optimist, but I think the worst is over. The market has priced in three of out every two forthcoming bad events.

The Fed is get more aggressive I think, good news for all.

Cabodog said...

I'd agree. The market should have priced in Greek default already and likely, added in a bunch of fear for good measure.

As an investor, this stuff is surely becoming very, very exhausting.

burmanhands said...

Are there any wise old heads in Europe. Germans make good cars and lousy politicians it seems. France, - well no comment. So many young executives I have met in Europe are too young to have lived through the last recession - just book experience, and paper qualifications.
Too cute by half.I don't know about the USA.

Benjamin Cole said...

PPI came out today dead as a doornail. The Chicken Inflation Littles would have us fight inflation in the worst recession since the depression.

As Milton Friedman would tell you, fighting a depression with tight money is not a good idea.

McKibbinUSA said...

We should all consider what the real implications would be if bonds were wiped out globally -- my guess is that consumers would still buy goods and services, shipping and transportation would continue, mining operations would continue, energy would still be consumed, and agriculture would still continue -- the only real losers in a total bond collapse would be world governments, public employees, and borrowers -- I'm willing to live with those outcomes just fine -- the coming bond collapses around the world are really not that meaningful to those who have dividend and rent-paying equities, certified skills, and paid for homes -- in many ways, a bond wipeout might be the best thing that could happen...

Jean-Pierre Deslandes said...


This explanation makes perfect sense to me. Of course Greece is an extreme case, but I believe the same logic applies to all welfare states.

It is a real pleasure to read you everyday and learn more about economic matters.



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Jason Schwarz

TradingStrategyLetter - Weekly Summary said...

Looking like a mighty fine call so far!

Jim said...

What a joke. Let's see if the Kumbaya, hand holding of the ECB will work. Sounds like an oversized union to me... unfortunately, they ran out of money.

WWII did less damage than these socialists.