George Soros Speech

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>   
>   (email exchange)
>   
>   On Mon, Jun 21, 2010 at 6:31 AM, wrote:
>   
>   Soros’s recipe, FYI
>   much about bubbles,
>   also about how bad can be deficit reductions at this time
>   

I usually don’t read or comment on Soros, but comments below this one time only for you.

:)

George Soros Speech

Institute of International Finance, Vienna, Austria
June 10, 2010

In the week following the bankruptcy of Lehman Brothers on September 15, 2008 – global financial markets actually broke down and by the end of the week they had to be put on artificial life support. The life support consisted of substituting sovereign credit for the credit of financial institutions which ceased to be acceptable to counter parties.

As Mervyn King of the Bank of England brilliantly explained, the authorities had to do in the short-term the exact opposite of what was needed in the long-term: they had to pump in a lot of credit to make up for the credit that disappeared and thereby reinforce the excess credit and leverage that had caused the crisis in the first place. Only in the longer term, when the crisis had subsided, could they drain the credit and reestablish macro-economic balance.

Not bad, but he doesn’t seem to understand there is no ‘macro balance’ per se in that regard. He should recognize that what he means by ‘macro balance’ should be the desired level of aggregate demand, which is altered by the public sector’s fiscal balance. So in the longer term, the public sector should tighten fiscal policy (what he calls ‘drain the credit’) only if aggregate demand is deemed to be ‘too high’ and not to pay for anything per se.

This required a delicate two phase maneuver just as when a car is skidding, first you have to turn the car into the direction of the skid and only when you have regained control can you correct course.

It’s more like when you come to an up hill stretch you need to press harder on the gas to maintain a steady speed and if you get going too fast on a down hill section you need to apply the brakes to maintain a steady speed. And for me, the ‘right’ speed is ‘full employment’ with desired price stability.

The first phase of the maneuver has been successfully accomplished – a collapse has been averted.

But full employment has not been restored. I agree this is not the time to hit the fiscal brakes. In fact, I’d cut VAT until output and employment is restored, and offer a govt funded minimum wage transition job to anyone willing and able to work.

In retrospect, the temporary breakdown of the financial system seems like a bad dream. There are people in the financial institutions that survived who would like nothing better than to forget it and carry on with business as usual. This was evident in their massive lobbying effort to protect their interests in the Financial Reform Act that just came out of Congress. But the collapse of the financial system as we know it is real and the crisis is far from over.

Indeed, we have just entered Act II of the drama, when financial markets started losing confidence in the credibility of sovereign debt. Greece and the euro have taken center stage but the effects are liable to be felt worldwide. Doubts about sovereign credit are forcing reductions in budget deficits at a time when the banks and the economy may not be strong enough to permit the pursuit of fiscal rectitude. We find ourselves in a situation eerily reminiscent of the 1930’s. Keynes has taught us that budget deficits are essential for counter cyclical policies yet many governments have to reduce them under pressure from financial markets. This is liable to push the global economy into a double dip.

Yes, and this is an issue specific to govts that are not the issuers of their currency- the US States, the euro zone members, and govts with fixed exchange rates.

It is important to realize that the crisis in which we find ourselves is not just a market failure but also a regulatory failure and even more importantly a failure of the prevailing dogma about financial markets. I have in mind the Efficient Market Hypothesis and Rational Expectation Theory. These economic theories guided, or more exactly misguided, both the regulators and the financial engineers who designed the derivatives and other synthetic financial instruments and quantitative risk management systems which have played such an important part in the collapse. To gain a proper understanding of the current situation and how we got to where we are, we need to go back to basics and reexamine the foundation of economic theory.

I agree, see my proposals here.

I have developed an alternative theory about financial markets which asserts that financial markets do not necessarily tend towards equilibrium; they can just as easily produce asset bubbles. Nor are markets capable of correcting their own excesses. Keeping asset bubbles within bounds have to be an objective of public policy. I propounded this theory in my first book, The Alchemy of Finance, in 1987. It was generally dismissed at the time but the current financial crisis has proven, not necessarily its validity, but certainly its superiority to the prevailing dogma.

First we can always act to sustain aggregate demand and employment at desired levels across any asset price cycle with fiscal policy. No one would have cared much about the financial crisis if we’d kept employment and output high in the real sectors. Note that because output and employment remained high (for whatever reason) through the crash of 1987, the crash of 1998, and the Enron event, they were of less concern than the most recent crisis where unemployment jumped to over 10%.

Let me briefly recapitulate my theory for those who are not familiar with it. It can be summed up in two propositions. First, financial markets, far from accurately reflecting all the available knowledge, always provide a distorted view of reality. This is the principle of fallibility. The degree of distortion may vary from time to time. Sometimes it’s quite insignificant, at other times it is quite pronounced. When there is a significant divergence between market prices and the underlying reality I speak of far from equilibrium conditions. That is where we are now.

I’d say ‘equilibrium’ conditions are necessarily transitory at best under current institutional arrangements, including how policy is determined in Washington and around the world, and continually changing fundamentals of supply and demand.

Second, financial markets do not play a purely passive role; they can also affect the so called fundamentals they are supposed to reflect. These two functions that financial markets perform work in opposite directions. In the passive or cognitive function the fundamentals are supposed to determine market prices. In the active or manipulative function market prices find ways of influencing the fundamentals. When both functions operate at the same time they interfere with each other. The supposedly independent variable of one function is the dependent variable of the other so that neither function has a truly independent variable. As a result neither market prices nor the underlying reality is fully determined. Both suffer from an element of uncertainty that cannot be quantified.

Goes without saying.

I call the interaction between the two functions reflexivity. Frank Knight recognized and explicated this element of unquantifiable uncertainty in a book published in 1921 but the Efficient Market Hypothesis and Rational Expectation Theory have deliberately ignored it. That is what made them so misleading.

Reflexivity sets up a feedback loop between market valuations and the so-called fundamentals which are being valued. The feedback can be either positive or negative. Negative feedback brings market prices and the underlying reality closer together. In other words, negative feedback is self-correcting. It can go on forever and if the underlying reality remains unchanged it may eventually lead to an equilibrium in which market prices accurately reflect the fundamentals. By contrast, a positive feedback is self-reinforcing. It cannot go on forever because eventually market prices would become so far removed from reality that market participants would have to recognize them as unrealistic. When that tipping point is reached, the process becomes self-reinforcing in the opposite direction. That is how financial markets produce boom-bust phenomena or bubbles. Bubbles are not the only manifestations of reflexivity but they are the most spectacular.

Ok, also seems obvious? Now he need to add that the currency itself is a public monopoly, as the introduction of taxation, a coercive force, introduces ‘imperfect competition’ with ‘supply’ of that needed to pay taxes under govt. control. This puts govt in the position of ‘price setter’ when it spends (and/or demands collateral when it lends). And a prime ‘pass through’ channel he needs to add is indexation of public sector wages and benefits.

In my interpretation equilibrium, which is the central case in economic theory, turns out to be a limiting case where negative feedback is carried to its ultimate limit. Positive feedback has been largely assumed away by the prevailing dogma and it deserves a lot more attention.

Even his positive feedback will ‘run its course’ (not to say there aren’t consequences) for the most part if it wasn’t for the fact that the currency itself is a case of monopoly and the govt. paying more for the same thing, for example, is redefining the currency downward.

I have developed a rudimentary theory of bubbles along these lines. Every bubble has two components: an underlying trend that prevails in reality and a misconception relating to that trend. When a positive feedback develops between the trend and the misconception a boom-bust process is set in motion. The process is liable to be tested by negative feedback along the way and if it is strong enough to survive these tests, both the trend and the misconception will be reinforced.

Makes sense.

Eventually, market expectations become so far removed from reality that people are forced to recognize that a misconception is involved.

I’d say it’s more like the price gets high enough for the funding to run dry at that price for any reason? Unless funding is coming from/supported by govt (and/or it’s designated agents, etc), the issuer of the currency, that funding will always be limited.

A twilight period ensues during which doubts grow and more and more people lose faith but the prevailing trend is sustained by inertia.

‘Inertia’? It’s available spending power that’s needed to sustain prices of anything. The price of housing sales won’t go up without someone paying the higher price.

As Chuck Prince former head of Citigroup said, “As long as the music is playing you’ve got to get up and dance. We are still dancing.”

This describes the pro cyclical nature of the non govt sectors, which are necessarily pro cyclical. Only the currency issuer can be counter cyclical. Seems to me Minsky has the fuller explanation of all this.

Eventually a tipping point is reached when the trend is reversed; it then becomes self-reinforcing in the opposite direction.

The spending power- or the desire to use it- fades.

Typically bubbles have an asymmetric shape. The boom is long and slow to start. It accelerates gradually until it flattens out again during the twilight period. The bust is short and steep because it involves the forced liquidation of unsound positions. Disillusionment turns into panic, reaching its climax in a financial crisis.

The simplest case of a purely financial bubble can be found in real estate. The trend that precipitates it is the availability of credit; the misconception that continues to recur in various forms is that the value of the collateral is independent of the availability of credit. As a matter of fact, the relationship is reflexive. When credit becomes cheaper activity picks up and real estate values rise. There are fewer defaults, credit performance improves, and lending standards are relaxed. So at the height of the boom, the amount of credit outstanding is at its peak and a reversal precipitates false liquidation, depressing real estate values.

It all needs to be sustained by incomes. the Fed’s financial burdens ratios indicate when incomes are being stretched to their limits. The last cycle went beyond actual incomes as mortgage originators were sending borrowers to accountants who falsified income statements, and some lenders were willing to lend beyond income capabilities. But that didn’t last long and the bust followed by months.

The bubble that led to the current financial crisis is much more complicated. The collapse of the sub-prime bubble in 2007 set off a chain reaction, much as an ordinary bomb sets off a nuclear explosion. I call it a super-bubble. It has developed over a longer period of time and it is composed of a number of simpler bubbles. What makes the super-bubble so interesting is the role that the smaller bubbles have played in its development.

Fraud was a major, exaggerating element in the latest go round, conspicuously absent from this analysis.

The prevailing trend in the super-bubble was the ever increasing use of credit and leverage. The prevailing misconception was the believe that financial markets are self-correcting and should be left to their own devices. President Reagan called it the “magic of the marketplace” and I call it market fundamentalism. It became the dominant creed in the 1980s. Since market fundamentalism was based on false premises its adoption led to a series of financial crises.

Again, a financial crisis doesn’t need to ‘spread’ to the real economy. Fiscal policy can sustain full employment regardless of the state of the financial sector. Losses in the financial sector need not affect the real economy any more than losses in Las Vegas casinos.

Each time, the authorities intervened, merged away, or otherwise took care of the failing financial institutions, and applied monetary and fiscal stimuli to protect the economy. These measures reinforced the prevailing trend of ever increasing credit and leverage and as long as they worked they also reinforced the prevailing misconception that markets can be safely left to their own devices. The intervention of the authorities is generally recognized as creating amoral hazard; more accurately it served as a successful test of a false belief, thereby inflating the super-bubble even further.

‘Monetary policy’ did nothing and probably works in reverse, as I’ve discussed elsewhere. Fiscal policy does not have to introduce moral hazard issues. It can be used to sustain incomes from the bottom up at desired levels, and not for top down bailouts of failed businesses. Sustaining incomes will not keep an overbought market from crashing, but it will sustain sales and employment in the real economy, with business competing successfully for consumer dollars surviving, and those that don’t failing. That’s all that’s fundamentally needed for prosperity, along with a govt that understands its role in supporting the public infrastructure.

It should be emphasized that my theories of bubbles cannot predict whether a test will be successful or not. This holds for ordinary bubbles as well as the super-bubble. For instance I thought the emerging market crisis of 1997-1998 would constitute the tipping point for the super-bubble, but I was wrong. The authorities managed to save the system and the super-bubble continued growing. That made the bust that eventually came in 2007-2008 all the more devastating.

No mention that the govt surpluses of the late 90’s drained net dollar financial assets from the non govt sectors, with growth coming from unsustainable growth in private sector credit fueling impossible dot com business plans, that far exceeded income growth. When it all came apart after y2k the immediate fiscal adjustment that could have sustained the real economy wasn’t even a consideration.

What are the implications of my theory for the regulation of the financial system?

First and foremost, since markets are bubble-prone, the financial authorities have to accept responsibility for preventing bubbles from growing too big. Alan Greenspan and other regulators have expressly refused to accept that responsibility. If markets can’t recognize bubbles, Greenspan argued, neither can regulators–and he was right. Nevertheless, the financial authorities have to accept the assignment, knowing full well that they will not be able to meet it without making mistakes. They will, however, have the benefit of receiving feedback from the markets, which will tell them whether they have done too much or too little. They can then correct their mistakes.

Second, in order to control asset bubbles it is not enough to control the money supply; you must also control the availability of credit.

Since the causation is ‘loans create deposits’ ‘controlling credit’ is the only way to alter total bank deposits.

This cannot be done by using only monetary tools;

Agreed, interest rates are not all that useful, and probably work in the opposite direction most believe.

you must also use credit controls. The best-known tools are margin requirements

Changing margin requirements can have immediate effects. But if the boom is coming for the likes of pension fund allocations to ‘passive commodity strategies’ driving up commodities prices, which has been a major, driving force for many years now, margin increases won’t stop the trend.

and minimum capital requirements.

I assume that means bank capital. If so, that alters the price of credit but not the quantity, as it alters spreads needed to provide market demanded risk adjusted returns for bank capital.

Currently they are fixed irrespective of the market’s mood, because markets are not supposed to have moods. Yet they do, and the financial authorities need to vary margin and minimum capital requirements in order to control asset bubbles.

Yes, man is naturally a gambler. you can’t stop him. and attempts at control have always been problematic at best.

One thing overlooked is the use of long term contracts vs relying on spot markets. Historically govts have used long term contracts, but for business to do so requires long term contracts on the sales side, which competitive markets don’t allow.

You can’t safely enter into a 20 year contract for plastic for cell phone manufacturing if you don’t know that the price and quantity of cell phones is locked in for 20 years as well, for example. And locking in building materials for housing for 20 years to stabilize prices means less flexibility to alter building methods, etc. But all this goes beyond this critique apart from indicating there’s a lot more to be considered.

Regulators may also have to invent new tools or revive others that have fallen into disuse. For instance, in my early days in finance, many years ago, central banks used to instruct commercial banks to limit their lending to a particular sector of the economy, such as real estate or consumer loans, because they felt that the sector was overheating. Market fundamentalists consider that kind of intervention unacceptable but they are wrong. When our central banks used to do it we had no financial crises to speak of.

True. What the govt creates it can regulate and/or take away. Public infrastructure is to serve further public purpose.

But both dynamic change and static patterns have value and trade offs.

The Chinese authorities do it today, and they have much better control over their banking system. The deposits that Chinese commercial banks have to maintain at the People’s Bank of China were increased seventeen times during the boom, and when the authorities reversed course the banks obeyed them with alacrity.

Yes, and always with something gained and something lost when lending is politicized.

Third, since markets are potentially unstable, there are systemic risks in addition to the risks affecting individual market participants. Participants may ignore these systemic risks in the belief that they can always dispose of their positions, but regulators cannot ignore them because if too many participants are on the same side, positions cannot be liquidated without causing a discontinuity or a collapse. They have to monitor the positions of participants in order to detect potential imbalances. That means that the positions of all major market participants, including hedge funds and sovereign wealth funds, need to be monitored. The drafters of the Basel Accords made a mistake when they gave securities held by banks substantially lower risk ratings than regular loans: they ignored the systemic risks attached to concentrated positions in securities. This was an important factor aggravating the crisis. It has to be corrected by raising the risk ratings of securities held by banks. That will probably discourage loans, which is not such a bad thing.

My proposals, here, limit much of that activity at the source, rather than trying to regulate it, leaving a lot less to be regulated making regulation that much more likely to succeed.

Fourth, derivatives and synthetic financial instruments perform many useful functions but they also carry hidden dangers. For instance, the securitization of mortgages was supposed to reduce risk thru geographical diversification. In fact it introduced a new risk by separating the interest of the agents from the interest of the owners. Regulators need to fully understand how these instruments work before they allow them to be used and they ought to impose restrictions guard against those hidden dangers. For instance, agents packaging mortgages into securities ought to be obliged to retain sufficient ownership to guard against the agency problem.

One of my proposals is that banks not be allowed to participate in any secondary markets, for example

Credit default swaps (CDS) are particularly dangerous they allow people to buy insurance on the survival of a company or a country while handing them a license to kill. CDS ought to be available to buyers only to the extent that they have a legitimate insurable interest. Generally speaking, derivatives ought to be registered with a regulatory agency just as regular securities have to be registered with the SEC or its equivalent. Derivatives traded on exchanges would be registered as a class; those traded over-the-counter would have to be registered individually. This would provide a powerful inducement to use exchange traded derivatives whenever possible.

There is no public purpose served by allowing banks to participate in CDS markets and therefore no reason to allow banks to own any CDS.

Finally, we must recognize that financial markets evolve in a one-directional, nonreversible manner. The financial authorities, in carrying out their duty of preventing the system from collapsing, have extended an implicit guarantee to all institutions that are “too big to fail.” Now they cannot credibly withdraw that guarantee. Therefore, they must impose regulations that will ensure that the guarantee will not be invoked. Too-big-to-fail banks must use less leverage and accept various restrictions on how they invest the depositors’ money. Deposits should not be used to finance proprietary trading. But regulators have to go even further. They must regulate the compensation packages of proprietary traders to ensure that risks and rewards are properly aligned. This may push proprietary traders out of banks into hedge funds where they properly belong. Just as oil tankers are compartmentalized in order to keep them stable, there ought to be firewalls between different markets. It is probably impractical to separate investment banking from commercial banking as the Glass-Steagall Act of 1933 did. But there have to be internal compartments keeping proprietary trading in various markets separate from each other. Some banks that have come to occupy quasi-monopolistic positions may have to be broken up.

Banks should be limited to public purpose as per my proposals, here.

While I have a high degree of conviction on these five points, there are many questions to which my theory does not provide an unequivocal answer. For instance, is a high degree of liquidity always desirable? To what extent should securities be marked to market? Many answers that followed automatically from the Efficient Market Hypothesis need to be reexamined.

Also in my proposals, here.

It is clear that the reforms currently under consideration do not fully satisfy the five points I have made but I want to emphasize that these five points apply only in the long run. As Mervyn King explained the authorities had to do in the short run the exact opposite of what was required in the long run. And as I said earlier the financial crisis is far from over. We have just ended Act Two. The euro has taken center stage and Germany has become the lead actor. The European authorities face a daunting task: they must help the countries that have fallen far behind the Maastricht criteria to regain their equilibrium while they must also correct the deficinies of the Maastricht Treaty which have allowed the imbalances to develop. The euro is in what I call a far-from-equilibrium situation. But I prefer to discuss this subject in Germany, which is the lead actor, and I plan to do so at the Humboldt University in Berlin on June 23rd. I hope you will forgive me if I avoid the subject until then.

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Professor Bill Mitchell on inflation

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Zimbabwe for hyperventilators 101

A very good read. Today’s hyper inflation fears due to ‘money printing’ are pure fear mongering.

My comment to Bill in support of his article:

Russia in 1998 is an example of how much the flat earth economists are wrong in what determines the value of a currency

Russia had a fixed fx rate of 6.45 rubles to the US dollar going into the August crisis.

At the end, rates on gko’s went to over 200% until there was no interest rate where holders of rubles did not want to cash them in at the CB for dollars. Dollar reserves were depleted, and no more dollars could be borrowed to support the currency.

Instead of simply floating the ruble and suspending conversion the CB simply shut down the payments system and the employees all walked out the door.

It was several months before the payments system was restarted.

There was no confidence, no faith, and no expectations of anything good happening.

The ruble went from 6.45 to about 28 or so in what has turned out to be a one time adjustment.

There was no hyper inflation, and not even much inflation as per Bill above, just a one time adjustment.

Pretty much the same for Mexico when it’s fixed fx regime blew up in the mid 90′s. The peso went from about 3.5 to 10 in a one time adjustment.

These are two examples of stress far in excess of whatever the US, Uk, and Japan could possibly face, yet with no actual inflationary consequences, as defined.

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China Yuan Pledge Suggests Peg to Dollar May Go

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Reads to me like they don’t like the yuan strength vs the euro which means it could weaken vs the dollar if they buy euro instead of dollars as suggested below:

China Yuan Pledge Suggests Peg to Dollar May Go

June 19 (Bloomberg) — China’s central bank said it will allow a more flexible yuan after the nation cemented its economic recovery, indicating the currency’s 23-month- old peg to the dollar may be scrapped.

The yuan’s 0.5 percent daily trading band will remain unaltered, the central bank said in a statement on its website today.

“The central bank’s statement means China’s exit from the dollar peg,” saidZhao Qingming, an analyst at China Construction Bank in Beijing. “If the euro continues to remain weak, it could also mean that the yuan may depreciate against the dollar.”

Allowing the yuan to strengthen may curb inflation by reducing the cost of imported goods and limit the need for central bank dollar buying, which has left the nation with $2.4 trillion in currency reserves. A stronger Chinese currency may also help avert a trade war after U.S. lawmakers urged President Barack Obama to use the threat of trade sanctions to force a policy change.

“The global economy is gradually recovering,” the central bank said today. “The recovery and upturn of the Chinese economy has become more solid with the enhanced economic stability. It is desirable to proceed further with reform of the renminbi exchange rate regime and increase the renminbi exchange rate flexibility.”

The central bank was using another word for the yuan. The currency has been trading at about 6.83 per dollar since July 2008.

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Greenspan in WSJ: U.S. Debt and the Greece Analogy

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History will not be kind to the former Fed Chairman with regard to his understanding of monetary operations.

He understands solvency is not an issues which does seem to put him ahead of most. But he lacks a critical understanding of interest rate determination, particularly with regard to how the entire term structure of risk free rates is set by Fed policy (or lack of it), with US Treasury securities functioning to alter those risk free rates, and not funding expenditures per se:

“The U.S. government can create dollars at will to meet any obligation,
and it will doubtless continue to do so. U.S. Treasurys are thus free of
credit risk. But they are not free of interest rate risk. If Treasury
net debt issuance were to double overnight, for example, newly issued
Treasury securities would continue free of credit risk, but the Treasury
would have to pay much higher interest rates to market its newly issued
securities.”

U.S. Debt and the Greece Analogy

By Alan Greenspan

June 18 (WSJ) —Don’t be fooled by today’s low interest rates. The
government could very quickly discover the limits of its borrowing capacity.

An urgency to rein in budget deficits seems to be gaining some traction
among American lawmakers. If so, it is none too soon. Perceptions of a
large U.S. borrowing capacity are misleading.

Despite the surge in federal debt to the public during the past 18
months-to $8.6 trillion from $5.5 trillion-inflation and long-term
interest rates, the typical symptoms of fiscal excess, have remained
remarkably subdued. This is regrettable, because it is fostering a sense
of complacency that can have dire consequences.

The roots of the apparent debt market calm are clear enough. The
financial crisis, triggered by the unexpected default of Lehman Brothers
in September 2008, created a collapse in global demand that engendered a
high degree of deflationary slack in our economy. The very large
contraction of private financing demand freed private saving to finance
the explosion of federal debt. Although our financial institutions have
recovered perceptibly and returned to a degree of solvency, banks,
pending a significant increase in capital, remain reluctant to lend.

Beneath the calm, there are market signals that do not bode well for the
future. For generations there had been a large buffer between the
borrowing capacity of the U.S. government and the level of its debt to
the public. But in the aftermath of the Lehman Brothers collapse, that
gap began to narrow rapidly. Federal debt to the public rose to 59% of
GDP by mid-June 2010 from 38% in September 2008. How much borrowing
leeway at current interest rates remains for U.S. Treasury financing is
highly uncertain.

The U.S. government can create dollars at will to meet any obligation,
and it will doubtless continue to do so. U.S. Treasurys are thus free of
credit risk. But they are not free of interest rate risk. If Treasury
net debt issuance were to double overnight, for example, newly issued
Treasury securities would continue free of credit risk, but the Treasury
would have to pay much higher interest rates to market its newly issued
securities.

In the wake of recent massive budget deficits, the difference between
the 10-year swap rate and 10-year Treasury note yield (the swap spread)
declined to an unprecedented negative 13 basis points this March from a
positive 77 basis points in September 2008. This indicated that
investors were requiring the U.S. Treasury to pay an interest rate
higher than rates that prevailed on comparable maturity private swaps.

(A private swap rate is the fixed interest rate required of a private
bank or corporation to be exchanged for a series of cash flow payments,
based on floating interest rates, for a particular length of time. A
dollar swap spread is the swap rate less the interest rate on U.S.
Treasury debt of the same maturity.)

At the height of budget surplus euphoria in 2000, the Office of
Management and Budget, the Congressional Budget Office and the Federal
Reserve foresaw an elimination of marketable federal debt securities
outstanding. The 10-year swap spread in August 2000 reached a record 130
basis points. As the projected surplus disappeared and deficits mounted,
the 10-year swap spread progressively declined, turning negative this
March, and continued to deteriorate until the unexpected euro-zone
crisis granted a reprieve to the U.S.

The 10-year swap spread quickly regained positive territory and by June
14 stood at a plus 12 basis points. The sharp decline in the euro-dollar
exchange rate since March reflects a large, but temporary, swing in the
intermediate demand for U.S. Treasury securities at the expense of euro
issues.

The 10-year swap spread understandably has emerged as a sensitive proxy
of Treasury borrowing capacity: a so-called canary in the coal mine.

I grant that low long-term interest rates could continue for months, or
even well into next year. But just as easily, long-term rate increases
can emerge with unexpected suddenness. Between early October 1979 and
late February 1980, for example, the yield on the 10-year note rose
almost four percentage points.

In the 1950s, as I remember them, U.S. federal budget deficits were no
more politically acceptable than households spending beyond their means.
Regrettably, that now quaint notion gave way over the decades, such that
today it is the rare politician who doesn’t run on seemingly costless
spending increases or tax cuts with borrowed money. A low tax burden is
essential to maintain America’s global competitiveness. But tax cuts
need to be funded by permanent outlay reductions.

The current federal debt explosion is being driven by an inability to
stem new spending initiatives. Having appropriated hundreds of billions
of dollars on new programs in the last year and a half, it is very
difficult for Congress to deny an additional one or two billion dollars
for programs that significant constituencies perceive as urgent. The
federal government is currently saddled with commitments for the next
three decades that it will be unable to meet in real terms. This is not
new. For at least a quarter century analysts have been aware of the
pending surge in baby boomer retirees.

We cannot grow out of these fiscal pressures. The modest-sized
post-baby-boom labor force, if history is any guide, will not be able to
consistently increase output per hour by more than 3% annually. The
product of a slowly growing labor force and limited productivity growth
will not provide the real resources necessary to meet existing
commitments. (We must avoid persistent borrowing from abroad. We cannot
count on foreigners to finance our current account deficit
indefinitely.)

Only politically toxic cuts or rationing of medical care, a marked rise
in the eligible age for health and retirement benefits, or significant
inflation, can close the deficit. I rule out large tax increases that
would sap economic growth (and the tax base) and accordingly achieve
little added revenues.

With huge deficits currently having no evident effect on either
inflation or long-term interest rates, the budget constraints of the
past are missing. It is little comfort that the dollar is still the
least worst of the major fiat currencies. But the inexorable rise in the
price of gold indicates a large number of investors are seeking a safe
haven beyond fiat currencies.

The United States, and most of the rest of the developed world, is in
need of a tectonic shift in fiscal policy. Incremental change will not
be adequate. In the past decade the U.S. has been unable to cut any
federal spending programs of significance.

I believe the fears of budget contraction inducing a renewed decline of
economic activity are misplaced. The current spending momentum is so
pressing that it is highly unlikely that any politically feasible fiscal
constraint will unleash new deflationary forces. I do not believe that
our lawmakers or others are aware of the degree of impairment of our
fiscal brakes. If we contained the amount of issuance of Treasury
securities, pressures on private capital markets would be eased.

Fortunately, the very severity of the pending crisis and growing
analogies to Greece set the stage for a serious response. That response
needs to recognize that the range of error of long-term U.S. budget
forecasts (especially of Medicare) is, in historic perspective,
exceptionally wide. Our economy cannot afford a major mistake in
underestimating the corrosive momentum of this fiscal crisis. Our policy
focus must therefore err significantly on the side of restraint.

Mr. Greenspan, former chairman of the Federal Reserve, is president of
Greenspan Associates LLC and author of “The Age of Turbulence:
Adventures in a New World” (Penguin, 2007).

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Estonia adopts the euro

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We still contend that the world’s economic analysts do not understand the problem with the EMU mechanism, namely that there is no central fiscal authority that is allowed to credit accounts in an unlimited fashion. If you have doubts, please read the article below.

I mentioned when Estonia announced entry three weeks ago that if any sovereign really understood that they were giving up true ability to simply supply all the credits necessary in local currency, versus now having to tax or borrow before you spend (like municipalities), Estonia would not enter.

And please read the underlined portion of the article below. They still position the Euro mechanism weakness as “no policy fits all” or “there is no authority to distribute EU wide tax revenues collected”, or “there is no political union”. It all misses the point.

The U.S., Canada, Japan, Australia and UK do not borrow money. They drain excess reserves by issuing government securities so we can earn interest. Remember, when Japan allowed 30trn of excess reserves by not issuing government securities, the bill auctions were 200 times oversubscribed, even though the bills yielded only 2 or 3bps.

The mechanism is not fixed, the governments have limited resources for obligations, unless they allow the ECB or some other fiscal authority to have unlimited ability to credit accounts.

Thanks, Cliff

Agreed.

They also seem to equate a strong euro with economic prosperity.

What Crisis? The Euro Zone Adds Estonia

June 18 (NYT) —Guess what? The funniest thing happened in Europe on Thursday. A new country joined (yes, joined) the euro zone. And the mood here was upbeat.

With a debt crisis that appears to be spreading from Greece to Spain, membership for the country, Estonia, might seem more curse than blessing. There had been speculation that countries might abandon the single currency. And some doubt Estonia is even ready for the move.

“Maintaining low inflation rates in Estonia will be very challenging,” the European Central Bank warned last month.

Still, the euro remains among the strongest currencies in the world, and membership opens the door to a club with global influence. For small and unsure countries on the fringes of the European Union, it doesn’t get much better — no matter the mounting downsides for countries already on the inside.

“Joining the euro is a status issue for countries seeking to cement their position at Europe’s top table,” said Simon Tilford, the chief economist for the Center for European Reform, a research organization based in London. “But you also could call it sheer bloody-mindedness of Estonia to join now with the outlook for the currency so uncertain.”

Meeting in Brussels, Europe’s 27 governments hailed the “sound economic and financial policies” that had been achieved by Estonia in recent years. They said Estonia would shift from the kroon to the euro on Jan. 1, 2011.

For the leaders of the bloc, expanding the euro zone to 17 nations is tantamount to a show of confidence at an inauspicious time for the battered euro, which has lost about 13 percent of its value against the dollar since the beginning of the year.

“The door to euro membership is not closed because we are going through a sovereign debt crisis,” said Amadeu Altafaj, a spokesman for Olli Rehn, Europe’s commissioner for economic and monetary affairs. “Estonia’s admission is a sign to other countries that our aim is to continue enlarging economic and monetary union through the euro.”

With economic output of about $17 billion, the Estonian economy is tiny. Yet the country’s central bank governor, Andres Lipstok, will now be able to take a seat on the European Central Bank’s powerful council that sets interest rates.

Membership is also an important signpost that a country is on the way to achieving Western European standards of living, an important goal for a former Soviet republic like Estonia that has long been among the Baltic states eager to develop.

Perhaps most important, membership is recognition of the hard work and sacrifice it took to keep Estonia’s bid on track.

Estonia, along with Sweden, were the two countries with the smallest shortfalls between revenue and spending among all members of the 27-member European Union. Moreover, public debt in Estonia at 7.2 percent of gross domestic product is tiny compared with that of most other countries in the bloc.

“It’s a great day for Estonia,” Andrus Ansip, the Estonian prime minister, told Latvian state radio in an interview here.

“We prefer to be inside, to join the club, to be among decision makers.”

Estonia becomes the third ex-Communist state to make the switch to the euro, after Slovenia and Slovakia, but it is the first former Soviet republic to do so, sending a signal to other countries in Central and Eastern Europe that they, too, can aspire to membership.

That said, the euro zone is not expected to expand further for some time to come as other candidates like the Czech Republic, Hungary, Latvia, Lithuania, Bulgaria, Romania and Poland still fall short of the entry criteria partly because of their large budget deficits.

And the accession of Estonia will do little to erase the chief criticism of the euro project: that Europe’s nations are too economically disparate to maintain supranational institutions like a single currency in the long term.

Price stability is one of the main criteria for admission to the euro club. But in the past, political leaders have brushed off concerns from the European Central Bank about candidate nations in their eagerness to expand the euro zone.

Greece won admission even after the central bank reported in 2000 that the country’s debt equaled 104 percent of gross domestic product, far above the limit of 60 percent set out in the Maastricht Treaty. The bank said that Greek inflation met targets only because of declines in oil prices and other exceptional factors.

According to economists, the preparation to join the euro zone created some disadvantages for Estonia compared with neighboring countries, which have enjoyed a relative degree of flexibility by hanging on longer to their legacy currencies for now.

Now that Estonia is joining the euro zone, the most immediate advantages are likely to include greater interest from foreign investors and lower borrowing costs for both the public and private sectors.

But those could be short-term advantages. Estonia and its export-driven economy could be quickly overshadowed by financial difficulties, particularly if the euro zone remains unstable and if neighboring countries like Poland and its Baltic neighbors insist on hanging on to their currencies.

“Investors will only be willing to lend to Estonia on favorable terms if Estonia can continue to compete,” said Mr.

Tilford, the London economist. “That is where the biggest risks for Estonia now lie.”

And there is another downside, Mr. Ansip, the Estonian prime minister, said in the radio interview.

“Our banknotes are more beautiful than euro banknotes,” he said.

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BP response- this is a no bailout zone

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I agree the guilty need to be identified and punished, but that doesn’t stop with those responsible at BP, their suppliers and contractors, or the regulators who failed us. It runs much deeper, extending to our failed political process.

The financial crisis is analogous. The criminals need to be tracked down and prosecuted, as Bill Black did in after the savings and loan crisis. But the financial architecture/institutional structure that set it all up is at least equally at fault, as is the political process that created that institutional structure, as per my response to Roger.

I do think costs and losses should be paid for by BP, even if that means insolvency proceedings and 100% losses to shareholders and creditors.

I consider this a no bailout zone.

And any drop in aggregate demand/increase in unemployment should be ‘offset’ with whatever size tax cut and/or revenue sharing is necessary to sustain full employment.

And adding to Rogers idea again, my proposal for an $8/hr job for anyone willing and able to work should include those jobs for anyone wanting to join in the clean up efforts. (Not to say that clean up efforts should be limited to those workers.)

Punish BP or . . . ?

By Rodger Malcolm Mitchell

Those rotten scoundrels have ruined our oceans and our shores. They should pay not only for the cleanup, not only for the jobs lost because of the pollution, not only for the damage, but they even should pay for jobs lost because of President Obama’s decision to stop deep-water drilling. BP should pay, pay, pay until they bleed, then pay some more. These people must be held accountable.

Phew! Now I feel better.

But, wait. What is BP? It’s a legal description, nothing more than words on a piece of paper. It has no physical existence. You can’t punish BP any more than you can punish a law or a page of sheet music. BP, as a legal entity, neither caused, nor can cure, the oil spill. That disaster was caused by people, and it is people, not a piece of paper, who must be held accountable.

So the question becomes, which people should be punished? BP has a huge number of employees, the vast majority of whom had nothing to do with the oil spill. It has a huge number of innocent shareholders, a huge number of innocent suppliers, a huge number of innocent oil users. In some ways, you and I are part of BP, because as users of oil and oil-related products (i.e. all products) we are affected by what its employees do.

Which of those people should be “held accountable”? What if holding all of BP “accountable” means thousands of innocent people will be fired, or innocent suppliers will be put out of business, or all of us will have to pay more for our oil and gas, or all of us who hold BP stock, either directly or as part of a fund, will lose? What if punishing BP has an adverse effect on the whole economy. Is that wise?

Somewhere between vengeance and economic reality lies the answer. Punishing BP, as a company, punishes all of us who already are suffering from the gusher. And though widespread vengeance may feel good, there is a “cut-nose-spite-face” aspect to be considered. So, what can be done to help prevent a repeat?

First, let’s identify the people specifically responsible. Certain BP employees. Certain employees of BP suppliers. The guys who mixed and poured the rotten cement that didn’t hold.

And, with all the focus on BP, let’s not forget those government employees who failed equally. I’m talking about the people who, after having been bribed with nice gifts, so readily approved all of BP’s actions.

Yes, we should fine, fire, even jail all the responsible individuals. That would help prevent future problems. Of course, that doesn’t pay for all the efforts to cure the situation nor for all the losses. Who should pay the billions for that?

If you really care about the economy, and are not just flailing out in retribution, you would agree the economically wise approach would be for the federal government to pay. That way, the guilty would be punished, the innocent spared and the economy stimulated.

Government pays = people benefit. BP pays = people pay.

So what’s your choice: Vengeance or money in your pocket?

warren mosler says:
June 15, 2010 at 7:15 am

Well stated!

And we do know we all are responsible.

Our government regulators failed us much the same way they failed us in the financial crisis.

We have failed to create the alternative transportation (including user friendly public transportation, alternative fuels, incentives to reduce our travel needs, etc.) that could cut our use of crude oil by 50% or more, removing the need and incentives for what we know is dangerous offshore drilling.

We should know that the strategy of rushing to use up our domestic oil as soon as we discover it, rather than saving it for later when the rest of the world has used up theirs, is not in the best long term interest of our children and grand children.

We have elected representatives at all levels based on most everything but the wisdom of proposed agendas, often due to incentives we allow to remain in place regarding campaign finance, the power of special interests, and the incentives in place for our two party system to deliver candidates on criteria unrelated to their capabilities to provide the leadership on these critical issues.

Don’t get me started!

Thanks!

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EU

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The same forces are at work that have limited net exports via a stronger euro over the last 10 years.


Europe Industrial Output Rises More Than Forecast

ECB’s Nowotny Says Euro Volatility Is ’Completely Unproblematic’

German Tax Income Rises as Euro Aids Exports, Handelsblatt Says

Goodhart Says He Doesn’t See Inflation Danger in Eurozone

French and Germans Most Exposed in Euro Debt Crisis

EU Says No Financial Aid Plan Being Prepared for Spain

EU President Says Euro Hid ‘Underlying Problems,’ FT Reports

Nowotny Says ECB to Buy Government Bonds Until Market Calms

ECB’s Orphanides Doesn’t View High Inflation as Concern, DJ Says

Spain Considers Raising Top Rate of Income Tax, Gaceta Says
Greece’s Economic Figures Under Inspection by IMF, EU

Europe Industrial Output Rises More Than Forecast

By Simone Meier

June 14 (Bloomberg) — European industrial production increased more than economists forecast in April, led by demand
for intermediate goods such as steel and car engines.

Output in the economy of the 16 nations using the euro rose 0.8 percent from March, the European Union’s statistics office in Luxembourg said today. Economists had projected a gain of 0.5 percent, the median of 33 estimates in a Bloomberg survey showed. From a year earlier, April production jumped 9.5 percent, the biggest gain since the data started in 1991.

Reviving exports are helping to fuel the euro-area economy’s expansion as consumers curb spending. Continental AG, Europe’s second-largest car-parts maker, on June 10 raised its full-year sales forecast. Still, European manufacturing growth slowed in May and European Central Bank President Jean-Claude Trichet said last week that the euro region may expand at an “uneven pace” this year.

“The recovery in the export-sensitive industrial sector has been little affected so far by the region’s fiscal woes,” said Martin van Vliet, an economist at ING Group in Amsterdam. “Euro-zone industry should continue to benefit from the recovery in global demand, helped by the recent weakening of the euro.”

The 16-nation currency has fallen 15 percent against the dollar this year on concern governments’ measures to tackle swollen budget deficits may hamper economic growth in the region. The euro was little changed after the output data, trading at $1.2238 at 10:26 a.m. in London, up 1 percent.

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Subversion???!!!

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Do we have enemies that are using our misunderstanding of our monetary system to undermine our actual national defense?

Could they be playing on our deficit phobia that’s taken hold to subdue us?

Or is it all just innocent fraud?

While there is certainly spending on waste and fraud in the military that should be addressed, weakening our actual defense capabilities we would otherwise elect to support is an entirely different matter.

What was a serious problem has just taken on a new dimension.

The deficit terrorists are now a force that’s subverting our real defense needs.

On Mon, Jun 14, 2010 at 5:37 AM, Project on Defense Alternatives wrote:

Dear Warren Mosler: I am pleased to announce publication of “Debt, Deficits, and Defense: A Way Forward” by the Sustainable Defense Task Force (members listed below). The report, which is now publically accessible, identifies options for $100 billion annual savings in the US defense budget for consideration by the recently appointed deficit reduction commission.


You can access the report on the home page of the Project on Defense Alternatives here: http://www.comw.org/pda


You will also find there a video of the briefing the Task Force held on 11 June in the US Capitol with over 100 congressional staffers, NGO leaders, and journalists in attendance.

The report concludes that, in order to find significant savings and put defense on a sustainable path, we must change how we produce military power and the ways in which we put it to use. It sees recent official reform efforts as a first step, but concludes that “they fall far short of what is possible and what is needed to put defense spending and defense strategy back in check.” The report offers suggestions for strengthening current reforms and argues that, in addition, we must rethink our military commitments and our defense strategy.


You can follow discussion of the report and other debates on US Defense Policy on the PDA Defense Strategy Review page, here http://www.comw.org/wordpress/dsr/


Thanks, Carl Conetta and Charles Knight – best contact: pda@comw.org

Sustainable Defense Task Force

– Carl Conetta, Project on Defense Alternatives
– Benjamin H Friedman, Cato Institute
– William D Hartung, New America Foundation
– Christopher Hellman, National Priorities Project
– Heather Hurlburt, National Security Network
– Charles Knight, Project on Defense Alternatives
– Lawrence J Korb, Center for American Progress
– Paul Kawika Martin, Peace Action
– Laicie Olson, Center for Arms Control and Non-Proliferation
– Miriam Pemberton, Institute for Policy Studies
– Laura Peterson, Taxpayers for Common Sense
– Prasannan Parthasarathi, Boston College
– Christopher Preble, Cato Institute
– Winslow Wheeler, Center for Defense Information

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Individuals Dumping Euro Funds Amid Fiscal Crisis

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This is the portfolio shifting aspect.

It’s like if the corn crop dies and consumption remains the same, which would drive up the price.

But someone with a huge warehouse full of corn decides to sell it.

The price can go down until that warehouse selling winds down, and then the crop failure aspect takes over.

TOKYO (Nikkei)–Japanese retail investors fled euro-denominated assets in May as Europe’s fiscal troubles dragged on.

The balance of publicly offered euro-denominated investment trusts plunged to 3.92 trillion yen in May, down 14.3% on the month, according to data released Friday by the Investment Trusts Association, Japan. With the decline, euro funds became the third-most favorable type of foreign-currency investment trust — being passed for the first time ever by Australian dollar funds, whose balance slid 9.9% to 4.9 trillion yen.

U.S. dollar funds remained the most popular, with 9.76 trillion yen in assets.

Assets in foreign currencies as a whole fell 8.2% to 27.52 trillion yen.

The balance of all publicly offered investment trusts came to 60.5 trillion yen, down 7.5%.

The steep decrease in the value of euro-denominated assets prompted investors to keep taking their money out of such funds. Investment trusts that mainly target European stocks and those invested in bonds denominated in European currencies marked their 33rd and 20th straight months of fund outflows in May, according to the Nomura Research Institute.

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