Year Two of the big cleanup

 About this time last year I wrote that 2010 would be a year of normalisation. In particular that risk premiums should adjust to a new normal. I have for quite some years had the perception that risk had become way to cheap as the US Federal Reserve for more than two decades had chosen to add liquidity every time some problem showed up. Every time the result was to push down interest rates.

Well, I was only partly wrong in my predictions. Apparently, returning to a normal situation in the credit markets will take several years and could not be done in just one year. The Peripheral Euro zone members are far from being saved yet. The overall banking sector in Europe could suffer badly and end up zombie-like in the years to come.

The European debt crisis is far from over. The financial press has with great success obfuscated the fact that there are two problems. The sovereign crisis in Southern Europe is well covered. Much less so the European banking crisis and the two are intertwined, as the European banks hold loads of debt issued by the Southern Europe. Letting one of the southern countries default would immediately hit e.g. German banks badly.

I have great respect for the German design to strengthen the Eurozone institutions, saving the banking sector AND to make sure that Moral Hazard cannot be an element in business risk taking going forward. The problem is that unless radical action is taken, it cannot all happen at the same time. Without the will to actually solve the problems, Europe will simply postpone, play for time, while the bill keeps climbing.

The only radical action would be to nationalise the banks, fire the management, let bondholders take a haircut, keep the banks on the balance sheet while they reorganise and eventually sell them off in the stock market. The bad debt could be sold off in the market too with a partial government guarantee.

This Swedish solution appears more and more appealing by the day. Except of course that the banking lobby is now so strong that politicians cannot any more ignore it.

But elsewhere things are looking equally bad. The US has a well-known Federal budget problem. And a much less publicised problem with states and cities that also have deep financial problems. According to recent data releases, US states may together have a $1tn deficit that has to be financed somehow. Those working to find out how bad the situation is, are complaining that the transparency in the accounts is worse than anything seen in the banking sector (sic!).

So we entered 2010 with a vague feeling that risks had to be re-priced. At the end of the year it is dawning that the debt problem is larger than assumed and that more radical action is needed, but the political will is sorely needed. The markets will continue to re-evaluate the price of risk.

The problem for the rest of us is that the subsequent need to curb runaway budget deficits will act as a brake on the economic growth going forwards. Add that the pension problem is now growing quickly in Europe, creating a further long term problem.

So do not expect 2011 to be any calmer than 2010. Two years ago I believed that it would take five to seven years to work our way out of the debt crisis. 2010 proved that the way out is not an easy one. And it seems likely that we have another 3 to 5 years ahead of us before the situation will approach normal.

Moral Hazard receives another boost

I have a great deal of sympathy for the German Chancellor Merkel’s stated project of “maintaining the primacy of policy over the markets”. This wish has led Germany to underwrite the giant European attempt at salvaging the Euro zone from collapsing under the speculation against government debt issued by Greece, Ireland, Portugal, Spain, and soon Belgium.

I am, however, afraid that the chosen method is making things worse. By effectively guaranteeing government debt from various EU member countries, Germany effectively tells the speculators that there is no problem in holding the debt of those countries. It is possible to operate in the bond markets without having to factor in the risk that the issuer will go bankrupt. Merkel is not alone in underwriting certain kinds of market behaviour.

Since the creation of the US Federal Reserve it has been the practice that if economic trouble was brewing in the US markets, FED would simply open the monetary spigots and the crisis would go away somehow. Currently, it is known as the “Bernanke Put”, a free insurance against capital losses. When the bank sector was effectively insolvent, it was bailed out by the US government with few conditions attached. The people who through monumental greed and incompetence had created the crisis, are mostly still holding on to their handsomely paid jobs. And they pay each other silly bonuses.

Having learnt the lesson that if they behave stupidly, they will receive generous help to get themselves out of trouble, they are now back to their old ways. By underwriting fully the debt of European sovereign borrowers, Merkel and her political allies are exactly supporting the behaviour they want to stop. If there is no real risk of loss, gambling against the troubled countries become a pastime, where you just have to adapt your strategies to the short term trends. Real caution is not called for.

For every rescue package put together, moral hazard becomes more and more engrained in the working of the financial markets. More and more money can participate in the speculative runs, making such runs more and more difficult to handle.

Ms Merkel has the common sense of believing that lending money should be a risky business. If a lender does not check the quality of the borrower, there is a risk of losing money. But when she had the guts to say it out loud, she was met by a storm of protest from the financial markets and their political backers: Never should there be any risk of losing moneys lent to a sovereign. The prices of Irish debt plummeted and Ms Merkel was rapidly forced to issue a calming message that it was only something she meant from 2013, when the current rescue system is to be replaced by something more permanent.

It still baffles me that the Swedish bank rescue action from 1991-92 has inspired so few of today’s politicians. Sweden’s banking problems were in every way as serious as the problems seen now (with the exception of the global systemic risk if we do not get out of the trouble).

In brief, the Swedish package saw management and shareholders of failing banks wiped out, banks were nationalised (i.e. integrated in the government balances) for a while, essential services were continued, banks were restructured, recapitalised, and sold. Bad loans were floated in the market with a temporary guarantee. The operation was quick and efficient – not the least because the government obtained full insight into the loan books. The whole action was run in a perfectly capitalist way: If you screw up, you lose your shirt. Such straight forward action was never taken in this crisis.

Now politicians are afraid of taking on the ever-larger banks, whose lobbying activities are based on huge resources. Politicians allow banks to obfuscate and hide the real magnitude of the problems. It all ends up being more expensive to the taxpayers than necessary. And when somebody – even with Ms Merkels position of strength – has the nerve to tell a few obvious truths, they are forced to beat a hasty retreat by a howl of protest from the banking sector.

I am afraid we are in for a very, very long time of trouble. So far it is becoming increasing clear that because of the attempts to “maintain the primacy of policy” the markets are being given a golden opportunity to speculate against the governments. Obviously, the influence of the bank sector lobbyists continues to grow. The markets strengthen their primacy over politics with every timid step aiming at reducing their influence.

The Irish bail-out teaches us a lesson about EU

The bail-out package for Ireland is the story of a pre-announced disaster. First the Irish allowed their economy to become a hedge fund, allowing the banks to grow their balances to levels disproportionate with the size of the economy – just like Iceland. Just like Iceland, the Celtic Tiger dreamt of having invented a new economic model of debt-fuelled hyper growth. They had not.

At the same time, they decided to attract foreign direct investments by lowering tax rates to levels that have been a thorn in the side of larger EU countries. As the crisis struck, they made a colossal mistake by guaranteeing all deposits in the Irish banks. As the scale of the losses in the banks began to become clear, it dawned upon most observers able to do simple sums that honouring that guarantee would lead to budget cuts so severe that social unrest could be the consequence.

The reaction from the corporate and financial sector was predictable. Yields on Irish government debt soared and companies withdrew billions form the Irish banks. As the cost of refinancing government debt increased, it became clear that the real cost of servicing the debt would surpass the growth rate of the Irish economy, catching the Republic in a debt trap.

The situation was compounded by German Chancellor Merkel’s untimely – but essentially correct – remark that when things go badly, it is not only the borrowers that should be punished. The lenders should also take a haircut if they had not assessed the quality of the borrower properly, which should be the responsibility of any lender. That remark gave a further push to the borrowing costs, and may seen in retrospect have been the event that finally pushed the Irish over the edge. They would have gone there anyway, but it might have taken longer time.

Now that the Irish have formally asked the EU and the IMF for a “contingent loan”, i.e. an overdraft facility, we are told that granting the facility was in order to protect the Euro zone.  Maybe it would be a good idea to remember that German and French banks hold large swathes of Irish debt, and would obviously have been badly hit in case of an Irish default. They are now saved from that ignominy.

All of this is just another episode in the ongoing saga of greed, incompetence, and cynicism that is the story of the European debt crisis. At every twist in the road, Moral Hazard becomes more engrained and acceptable as a business concept.

If there is any lesson to be learned from the Greek and the Irish bailout, it is that EU is slowly waking up to the fact that the common currency was launched for political reasons essentially without the support of rules and institutions required to secure the survival of the Euro zone.

In the weeks before the bailout it became clear that some of the wrangling had more to do with the future of the EU than with Ireland. Germany (again) suggested that the EU should be given far more power to control and influence the budgets of the individual member countries. This would mean a transfer of sovereignty to the EU commission and France would have none of that.

The differing positions could well be understood on the basis of economic logic. Germany has no problems transferring economic decision power to the commission, knowing full well, that the German economic strength will continue to give the Federal Republic a strong say in Europe’s fiscal affairs.

France, on the other hand, has for ages used German economic strength to project her own global aspirations. Obviously, the new assertiveness of Germany is a threat to that position, and France will for that reason resist any transfer of economic decision power to the Commission.

For now, France won the battle. Germany backed down and accepted that the procedure for dealing with bail-outs will continue to be led by politicians instead of bureaucrats. But make no mistake. The Germans are getting sharper and more precise than we are used to. In the words of German finance minister Schäuble, pretending that things can continue like they have worked in the past decade, implies a lot of wishful thinking. When Ireland has faded from the headlines, the issue of making the Eurozone work will be the most important for the future of the EU.

Chinese food price

The recent weeks have given us all a clear impression that the US is losing global influence on all fronts, and in particular on the economic scene. There is nothing strange about it. An economic textbook from my days at university put it clearly: A country running a steady current account deficit will sooner or later lose room for manoeuvring.

By running a persistent deficit, the US is now inextricably linked to its largest creditor, China. For a long time, China would be influenced by whatever the US decided. But now, China’s economic decisions will gradually have an influence on the US. Already now, China’s decisions concerning her currency reserve have the potential to influence the USD and US interest rates.  By implication, it affects the rest of us.

I have written about China’s problems that derive from the peg to the dollar. So far, China has profited enormously from that peg in terms of export. The flip side of the coin is a huge inflow of liquidity that China’s immature financial system cannot really cope with.

This inflow has given rise to a strong inflation in certain types of assets in China – mainly in property – but has so far not given rise to general consumer price inflation. China’s monetary authorities have tried to limit the financing of building projects, and using selective capital controls. It has cooled the economy somewhat but has not of course not resolved the real problem, namely the growth in the money stock resulting from the export surplus.

China’s Consumer Price Inflation is estimated to be in the region of 4% and ought not to be a course for real worry. But the food subcomponent is rising at a rate of 10% per year, and that is a course for concern. So much so that China is about to introduce selective price controls. A technique that has been tried on many occasions in the West. But it has never worked anywhere. It merely postpones inflation, it does not remove it.

The main reason that the Chinese government is targeting food inflation is straightforward. Despite the economic boom in the south and the east of the country, there are still large parts of the population in the North and the West that are eking out a living not much higher than the bare subsistence minimum. Authorities in Beijing rightly fears that if the inflation in food prices continue, it could lead to social unrest. Fears of social unrest remain one of the most powerful drivers of the Chinese leadership and has been so for several decades. Back in the 1970’s it was one of the drivers of the economic reform policy introduced by Deng Hsiao-Ping. After the Tien An Minh massacre it became clear that the crackdown on protesters had been severe as the authorities feared it could spread.

My guess is that the announced selective price controls and initiatives against food price speculation will have a temporary effect, but as long as the current account surplus remains capital inflows will continue unabated.

Only a change in the exchange rate policy will mean a real difference, and it will come at some point in time.

When China decides to take steps toward floating the Yuan, it will have a dramatic impact on the financing of the US current account deficit, and that will affect us all. While not many of us bide out time studying Chinese food prices, it is more important to us than you would think. 

US Elections – bad for Obama, positive for risk assets

The US mid-term elections ended largely as opinion polls had predicted. Republicans took the House of Representatives, Democrats kept the Senate. Given the influence of the anarchistic right-wing movement, the “Tea Party”, there is little reason to believe that the Republicans will co-operate with President Obama and the Democrats to solve the deep economic problems besetting the US. Instead, two years of further obstruction is likely.

Just like the Republican party (correctly) gambled on the economy not having recovered by 2010, the next Republican gamble appears to be that by simply doing nothing, the economy will have recovered somewhat by 2012. The election strategy will probably then be to claim having “saved” the US economy.

As a stark reminder of the seriousness of the economic situation, IMF and ILO yesterday released a study telling that since 2007, USA has suffered 25 percent of the job losses recorded globally.

For the financial markets, the consequences are likely to be the following:

No major economic initiatives will be forthcoming from President or Congress. 48 out of 50 US states are in deep economic trouble. No economic stimulus will be forthcoming from neither federal, state, nor local governments. Instead, budget cuts are likely to happen by default as spending programs expire and are not replaced.

This leaves Federal Reserve as the only institution holding the rope. Monetary easing is the only viable economic instrument available for a foreseeable future. Hence, the QE2 should be in the bag, and my guess is that it will come in two tranches of 500bn USD each.

As we have stated earlier, it will continue the ongoing inflation in risk assets, mainly stocks, commodities, gold, silver and tradable energy. The only question is how far it will run. No end in sight so far.

USD will remain under downward pressure until the US consumer demand begins to pick up in a substantial way.

Bond yields will remain under downward pressure from a combination of continued deflationary pressures and purchasing programmes from the US Fed/Treasury.

So-called inflationary expectations – which are in reality just a relative price between small-volume inflation bonds (TIPS) and big volume T-bonds - will point upwards but will have no real economic effect.

US corporations will continue to be hugely profitable in spite of unsatisfactory top lines. There will be a river of ink telling that it translates directly into higher stock prices. Wrong argument, but right conclusion. Instead we are looking for an increase in bank lending to private equity firms, looking for financing for leveraged take-overs. It has not started yet.

US policy makers stand pat and will have to play a waiting game. They are waiting for US consumers to finish the repair of their badly stretched balance sheets. As known from previous episodes of this kind throughout history, it takes years. The US consumer is 2-2.5 years into this cycle. There may be another 4 years to go.

Growth will be slower than trend growth in the time to come, and it is unlikely that the US Output Gap will have closed by 2012. Consumer Price Inflation remains unlikely.

Fortunately, things are looking better almost everywhere else.

A new currency war?

To students of the Great Depression, the current discussion about a currency war should come as no surprise. In the ‘30s, the world had a fixed exchange rate system, based on a US-centered gold standard. It made it obvious for all that a series of competitive devaluations were taking place as countries turned their attention to exports as a way of boosting domestic growth.


This time around it is a bit different. We do not have a global fixed exchange rate. We have dollar, we have the euro, and the yen. Until the outbreak of the crisis, we also had two currency blocs, the Euro and the US dollar bloc. By the latter I refer to the fact that a number of South American and in particular Asian exporters unilaterally kept their currencies largely stable against the dollar.

We are now in a situation where competitive devaluations are off the table, since there is no fixed exchange rate system. This has opened the floodgates for something far more insidious, quiet and discrete manipulation of the currencies. And there is a sneaking feeling that the US of A is actually the main culprit. The US allegedly want to weaken the dollar in order to redress the huge hole in the trade balance. Doing this is so not kosher.

It is very easy to come to that conclusion when looking at the weakening of the USD since in the past months. Several currencies have appreciated significantly against the USD. I talk about the euro, the ASEAN currencies, the yen. And even the Chinese yuan also increased a bit. For all practical purposes the implicit dollar bloc has gone and the USA appear to be exporting its economic trouble to everybody else.

It always makes good headlines to accuse somebody else of currency manipulation. US lawmakers are specialists in that discipline as they pound the Chinese in order to obtain a significant appreciation of the CHY.

I am sure that everybody in the US economic policy circles welcomes a weaker USD. It was the same in Euroland in the first half of the year. But I am equally sure that the current dollar depreciation is the result of what I described in my previous post. Namely the current situation of the USA being caught in a liquidity trap.

There is a near universal expectation that the Federal Reserve will resume its asset purchasing programme within weeks. Such a program increases reserves in the banking system, but so far it does not lead to an increase in the money stock. Banks do not lend money and consumers and businesses do not borrow. Banks have a tendency to increase deposits at the central banks in that situation. It could however also happen that they help finance investments in securities. In other words, the main consequence is to inflate the value of financial assets.

To the extent that investments are not made exclusively in dollar-denominated assets, this liquidity flow will tend to weaken the dollar and to drive up assets in the “host” countries. In other words, the side effect of the US monetary policy is to drive the dollar down and financial assets upwards, also outside the USA.

Obviously, there is nobody complaining about the asset inflation, since it is supposed to lead to consumers feeling better and increasing demand. Eventually, that is.

But the falling dollar is obviously provoking a lot of politicians in other countries, from China to Brazil. A lot of noise is now audible and it is fully understandable. The weakening dollar makes US exports more competitive. The country that triggered the financial crisis through a disastrous combination of private and public sector deficits, a debt explosion and a terminally weak regulatory regime are now trying to export their way out of the crisis. At least according to the critics. I am sure that US policy makers would prefer to be in a situation where they could indeed push a string – using the monetary policy to get the economy growing faster.

Eventually the US economy will pull out of the liquidity trap, but nobody knows the timing of this. In the meantime the trends in the financial markets will continue, no matter how contradictory they are.

And in the meantime, we can all marvel at the best manipulators in town, the Chinese. Following months of increasing pressure from the Western World, the crawling peg regime from the pre-crisis years was reinstated. Not that CNY has moved a lot against the USD. But the change came virtually at the same moment as the USD began to weaken against the EUR and the JPY. So the net effect has been a weakening of the CNY in trade-weighted terms. Not bad for presumed novices in the noble art of waging a currency war.

Helicopter Ben getting ready for take-off? He ought to

Back in the ‘80s, then-US Fed Governor Paul Volcker used some serious weapons to quell inflationary expectations in the US. Interest rates were hiked to a point where the economy went into recession, excess capacity was established and a veritable press blitz focused on the need to stop inflation. At the same time, like-minded governments in the Western world gave the same message and such a thing as inflation indexing was killed in most countries. And it worked. Over a couple of years, inflation and inflationary expectations were falling rapidly and they have remained on a falling trend ever since.

Now that deflation – or at least disinflation – is a very real possibility, the game is to create some inflationary expectations, hoping it will feed through the economy. The reason is the same as fighting excessive inflation, namely that inflation as well as deflation leads to sub-optimal economic decisions.

The question is how to boost inflationary expectations, and it is not quite as easy as one would expect. Monetarists have told us that inflation is essentially a monetary phenomenon – “too much money chasing too few goods”. But that is clearly not the case now. With excess capacity nearing 10 per cent of GDP in several large countries, including the US, and monetary policy not leading to credit growth, inflationary pressures are totally absent. No matter how much money Federal Reserve and other central banks have pushed into the banking sector, most of it has remained with the banks, deposited at the central bank. It has not led to an increase in credit, and the main effect has been to salvage the banking sector and to recapitalise it by stealth.

Economic textbooks prescribe increased public spending that directly creates demand. With governments across the Western world moving to reduce public sector deficits, this solution is not exactly on the agenda. So rumours abound that now the central banks, led by Fed, are about to introduce another round of asset purchases, also known as “Quantitative Easing”. Which is again supposed to increase the money stock.

It probably won’t work this time either. The rumours have created some minor moves in the financial markets, though. The break-even inflation rate between T-bonds and US Inflation-indexed bonds, known as TIPS, has increased to 2.20 per cent. It means that if US inflation over the coming 10 years is 2.2 per cent, an investor will receive the same real return on a TIPS as on a normal government bond. 2.2 per cent is obviously higher than Fed’s assumed inflation target of 2 percent. Thus the situation receives quite some attention in the financial press.

But bond dealers do not create inflation expectations out there in the real economy. Such technicalities have nothing to do with how the average consumer perceives of the world. He/she begins to expect inflation once everyday goods and services begin to increase. We need the price of homes, groceries, haircuts, child care and so on to increase before inflation becomes tangible. At this moment in time it appears that only food prices are going up.

So I am very sceptical that Fed’s attempts at creating inflationary expectations through intervention in the financial markets will work. Fed Chief Ben Bernanke (unfairly) earned the nickname “Helicopter Ben” when in 2002 he quoted the monetary economist Milton Friedman’s recipe on how to stop deflation: Drop money from a helicopter. In the same speech Bernanke went on to describe the monetary policy as it is being implemented right now.

The problem is only that as long as Fed buys T-bonds off the private sector, including the banks, essentially it turns some private sector savings into cash. If the cash is not spent, it will not increase demand. Friedman saw clearly that the cash money had to be aimed at people who would spend it.

Maybe Ben should begin to look for his pilot helmet and get himself ready for that helicopter drop.

A sweet sport ... followed by?

Renowned Fed hawks believe it is necessary to expand and extend the Quantitative Easing programs in the US. Bank of Japan is doing it already. Bank of England is being strongly recommended by business leaders to do the same. And in continental Europe it is all quiet. I must admit that some of what I hear makes me rather apprehensive. Apparently there are strong worries that the current slow growth phase will last long enough to spur deflation. And deflation is the thing we do not want. At all!


In the past months we have seen some broad trends: Stronger stock markets, strong bond markets, weaker dollar, weaker yen, Stronger EUR, stronger EM currencies and EM stock markets. Market risk indicators are coming down. Credit spreads are falling.

Plainly, some of it does not make sense. I am afraid that we are setting ourselves up for a new round of market turmoil, maybe even at the level of what we experienced in May.

Since the outset of the crisis, the central banks have worked to reflate, and the asset prices have indeed recovered much of the lost ground. The loss of paper wealth should not be a major obstacle to growth. But now we have arrived at another critical junction. It is marked by a slew of new growth forecasts for 2011 from various institutions – they all represent downward revisions of growth forecasts.

The Great Recession was triggered by a huge increase in debt, mainly by households in the Western world. Households are now involved in a gigantic cleaning up of their own balance sheets. Meanwhile, the sharp recession undermined government revenue, leading to huge government deficits. Governments are now cutting back on expenditure and increasing tax revenue to fill the coffers.

Some had hoped for business investment to step in as a driver. But in terms of volume, investments do not match neither consumption nor public spending. And we have already seen an inventory rebuilding. New business investment is being delayed as final demand appears sluggish.

It means that attention turns to the original purpose of monetary policy, namely to stimulate the economy. But we are in a “liquidity trap” where pouring more money into the economy has very little effect on economic activity, since banks to not increase lending. As Keynes would have put it, we are trying to push on a string.

Several central banks have taken the step of introducing Quantitative Easing. Instead of massaging the money market they buy securities (various bonds) directly in the market, pushing money into the pockets of banks and other corporations. But the question is whether that has any effect on the economy. If we look at traditional measures, there are no significant signs that it is actually moving the economy forward. So what happens is quite simply that the reflation of the financial assets takes another step forward.

It all looks like a replay of the events following Internet bubble. This time it is not different. It is more of the same, just on a grander scale. Stocks move up, bond yields fall, commodities prices increase. We are in a liquidity driven sweet spot. It all goes well until it becomes clear that the underlying reality does not correspond to the current market perceptions.

Given that the stock markets have not yet taken to heart that growth will be slow because of the ongoing attempts to repair public and household balance sheets, this is where things may go wrong, maybe sometime in 2011. Until then, the markets look set to have quite a good time.

Fed as a dis-inflation fighter

Under normal circumstances I consider close reading of the Fed statements about as useful as Bible exegesis. Important for the believers, but an utter waste of time for everybody else. The early August statement was, however, right up my alley as Fed clearly gave the hyperinflationists a cold shower:  the ballooning of Fed’s balance sheet is not leading to any kind of inflationary pressures as long as the excess capacity in the US (you could substitute that by “OECD” if you like) is at the highest in decades.

This time, Fed is back at the same issue. But in a way that the FOMC is now risking to paint itself into a corner.

Firstly, Fed does not expect dis-inflation. Instead they expect inflation to hit a bottom at roughly zero: “The Committee anticipates a gradual return to higher levels of resource utilization in a context of price stability, although the pace of economic recovery is likely to be modest in the near term”. We are talking price stability, not falling prices.

But the inflation is clearly too low: “Measures of underlying inflation are currently at levels somewhat below those the Committee judges most consistent, over the longer run, with its mandate to promote maximum employment and price stability”.

And what will Fed do about it? Nothing, at least for now: “The Committee (...) is prepared to provide additional accommodation if needed to support the economic recovery and to return inflation, over time, to levels consistent with its mandate”

Let us recapitulate. Inflation is falling towards zero because growth is below par. As the output gap is not closing at a fast clip, deflationary forces remain strong. Over time, this gap will close, so inflation will come back to desired levels. And in the meantime, we will be ready to add liquidity to the economy in order to stave off disinflation.

But honestly, since households are still restrained by “tight credit” and businesses are investing but at a slower pace than last year, what is it exactly that the “additional accommodation” that may materialise should actually do.

We are still in a classical “liquidity trap”, the QE has saved the banking sector but has not materially contributed to the economic growth. And now Fed has promised us more in case dis-inflation continues.

I am afraid it is not enough. Deflationary pressures remain strong, and monetary policy will not contribute to closing the output gap, as long as we are in a liquidity trap. More demand is needed. Which Fed of course cannot control.

This is good news for bond holders. Not so for equity investors, but they seem to be blissfully insouciant of the underlying situation.

Price trends appear never to be able to make it to the headlines. Until it is too late, that is.

There is one investment conclusion possible: go short inflation protection.

Don't ask, don't tell

During the Great Depression, the world had a fixed exchange rate system, tied to the gold standard.  But then a number of smaller countries began to devalue their currencies. The purpose was obviously to obtain export advantages, since domestic demand was flatlined.

Given that domestic demand is still disappointing in many countries, we see that quite a number of (smaller) countries have provoked a depreciation of their currencies by flooding their markets with liquidity. Obviously, without a global fixed exchange rate system there is no longer talk about a round of competitive devaluations. It would be more correct to talk about competitive depreciations.

But whatever the label, the end result is that there are some countries that end up being the big losers in this game, since obviously we cannot all obtain an increase in export competitiveness at the same time.

While some smaller countries – Sweden is a good example – have had an enormous success with letting their currencies weaken dramatically in late 2008, it becomes more complicated when talk is about the major currencies, dollar, euro, and yen.

These economies are closed enough that management of the exchange rate is not a primary concern. Federal Reserve has often stated that they have no exchange rate policy for the dollar. ECB just wants a “strong and stable” EUR. USA and Europe have maintained a studied silence, even if the ECB (and the rest of the EU policy-making elite) feels that the EUR is way too strong against the USD.

Predictably, there were no objections from the ECB when the financial markets decided to sell EUR as a result of Greek trouble. With no inflationary pressures in the Euro-zone, a weaker EUR would exactly give the European economy a shot in the arm. And indeed, the Eurozone exporters have done very well as a consequence.

The story is slightly different when it comes to Japan. The country has been mired in a recession/deflation situation for nearly 2 decades. A direct consequence of a rapidly aging population and a stunning inability to make the right policy choices. JPY nevertheless started to strengthen in 2007, and has continued as everybody else introduced quantitative easing in order to revive economic growth. Since late 2007, JPY has gained some 40 per cent against a trade-weighted average of other currencies. Read that again, 40%! Not exactly doctor’s orders for an export driven country in order to pull out of a recession.

Recently, the Japanese government has begun to make all the right noises, rumours of a substantial (quantitative) easing of the monetary policy have been floating around and last week the BoJ finally decided to step in and intervene directly in the forex market.

Absurdly enough, this decision drew ire from many market participants. The Chairman of the Eurozone council sharply berated Japan for the unilateral intervention. Politicians of all colours were suitably “appalled”. Most of the FX market was in shock that Japan would do it alone. Personally, I have a hard time understanding the hoopla. Intervention to stop a currency from strengthening further after it has already gained significantly somehow appears to make good sense. Except of course if your competitors had more or less secretly hoped to profit from the rise of your currency.

And China drew its own conclusions. A spokesperson stated that China would never commit the same mistake as Japan, to let herself be pressured into an appreciation of the currency.

What can we learn from all this? That manoeuvering your currency in order to gain an export advantage is still very bad style. Unless you do it discretely. The Japanese did not. 

Banks to become less profitable

So, there they are, the new Basel rules for solvency. Effectively, the required capital base to run a bank will have to double over the next 8 years. Despite what industry representatives will tell you, it is good news for the rest of us. Let me explain.

In the past 20 years or so, the banks' importance in the economy has grown disproportionately, and the weight of the bank's stock in the stock market indices has followed.

Most of the explanation is that banks essentially have been very imaginative in influencing what could be counted as "capital base". As a result, the bank sector has been able to inflate their balances, and thereby increasing the return on the equity. As a consequence, banks have been highly profitable in the past.

The way banks operate has also had a tendency to allow them to increase loans when the economy was doing well. Conversely, they were quick to cut back lending activities once the economy was doing badly. By having this "procyclical" element, the banks have played a role in augmenting the volatility of the economy as a whole.

The crisis that began in the banking sector was to a large extent caused by the banks effectively increasing their leverage in the pursuit of a higher profitability. They did so by pushing the possibility of using their own investment products (mortgage loans, CDO) as part of their capital reserves. When that is a possibility, of course the banks could leverage their real capital harder and earn more money.

Obviously, when the sub-prime crisis started, many banks saw that a part of their reserves simply evaporatedand the banks became insolvent overnight. Since they did not have detailed knowledge of how bad the situation was at the neighbour's, they stopped lending to each other. The rest is history.

I wrote more than a year ago that one element in the Big Cleanout would be stricter capital rules. That is exactly what we are getting now. Unless the banking industry manages to lobby significant changes to be introduced between now and 2018 when the rules are fully implemented, it will mean that the profitability of the banking sector will trend downwards over the coming years. Probably it will also mean that the finance sector will end up weighing less in the stock market indices.

In my book, it is all good news. Of course we all need an effective solid banking sector. Increasing the capital reserve will only contribute to that. Tightening the rules for what can be counted as capital will also be positive. Reducing the banks' possibilities of using the capital reserves to play the financial markets will not be a negative influence on their lending activities.

Banking industry representatives have already been out there telling that the new rules will "delay the recovery". Excuse me! For new rules that are implemented in 2018?? In the past year, at a time of record profits and government guarantees, the banks have not resumed lending but have preferred to place their liquidity reserves with the central banks and play the bond market yield curve as best they could.

The risk willingness of the sector has shrunk dramatically in the recent past, and leads to yet another bout of behaviour that holds the rest of the economy hostage. This time it delays the recovery.

The banking sector as a whole had demonstrated its greed-driven incompetence beyond any reasonable doubt in the past two years. So when regulators now tighten up the rules, it is in order to protect the rest of us from a yet another repeat performance. That implies reducing that bank balances and increasing the capital reserve requirements. Time for the banking sector to go back to work.

Judging deflation risk

Are you afraid of deflation? Probably not, and for two reasons. One is that we have not had any experience with deflation for more than 70 years. The other is that because of this time distance, we have no real experience in estimating the conditions under which deflation will prevail.

For many years, the dominant way of thinking was that inflation is purely a monetary phenomenon. If the central bank for some reason "prints too many bank notes", we will end up with "too much money chasing too little goods" and that will force up prices.

However, this simplistic theory ignores another fact, that when increased demand can be met quickly by increasing output, no inflationary pressures will emerge. Only when production cannot keep up with demand, the foundation for inflation is laid. Several institutions, eg. OECD, regularly publish an estimation for how much extra capacity the economy has available. It is commonly referred to as the "Output Gap". For many years, this gap has comfortably been around 2 percent.

In 2008, the Western world saw the fastest contraction of output ever seen. My perception is that Cisco-style production and inventory management combined with a carpet bombing of media coverage of the bank crisis created an extraordinary fear in business managers. As a result, orders were cancelled, inventories were slashed, investment plans were binned, all at a pace never seen before. It is probably fair to assume that managers still have a tendency to act quickly in case of bad news.

As a result, the Western world today has the largest output gap on record. Probably, the economies could increase output by 5-7% before reaching capacity. Add that despite the downturn, the technological progress continues, adding quite a bit every year through new technologies and work routines.

And here we come to the real problem. Despite the economic recovery seen over the past 12 months, the growth speed has not been enough to significant reduce the output gap. It means that despite economic growth, the deflationary pressures remain. On top of that, the intense price competition from Asia continues as strong as ever.

Add now that economic growth is slowing. In the US and the UK, it is a structural phenomenon, as households continue to repair and reduce their balance sheets, killing the much-hoped-for recovery in private sector demand and will continue to do so for the next 4-5 years. Elsewhere, the slowdown appears to be a combination of premature austerity programs and a regular "mid-cycle" slowing of growth.

I do not (yet) subscribe to the double dip view. But the fact that the economic growth is anaemic is enough for the Output Gap to remain wide open. In other words, there is nothing out there that can counter the deflationary forces of having a huge output gap for an extensive period of time. If it continues we will enter a period of negative inflation sometime in 2011

Oddly enough, only the bond markets have reacted rationally to the situation. And they have only reacted to the ever-falling inflation, not to the expectation of a lower future inflation. The stock market has not yet eyed the risk. Caveat emptor.

Yuan back to normal

In a statement crafted with traditional Chinese care, it was announced the China's monetary authorities would allow for more flexibility in the movements of the Yuan. This Newspeak caused something of a stir in the markets, which immediately began to brace themselves for a major appreciation of the Chinese currency. Markets are likely to be disappointed in this respect.

There had been rather quiet around the Yuan for a while. USA's China-bashers had for some reason backed down and that created the situation we described in an earlier post: China needs to revalue the Yuan for purely internal purposes, but cannot be seen to bow to pressure from the most populist US lawmakers.

China has an urgent need to control the capital inflows that result from running a huge current account surplus, but has not equipped herself with a modern money market and the necessary instruments. Instead, Chinese monetary policy is run on the basis of quantitative methods reminiscent of the period of central economic planning.

Needless to say, when there is a huge appetite for credit in one segment of the economy (property and construction sectors), and the government tries to cut off this sector's access to otherwise abundant liquidity, you set yourself up for major distortions that provide huge incentives for corruption.

In 2008, the Chinese government was the first to introduce a major package to cushion the impact of the international banking crisis: This package has now been proven efficient, and the Chinese leadership can rightly be proud of the timely action. However, the package did not shift as much growth over to domestic demand as hoped, and recently the Chinese trade surplus has begun to grow again.

Thus the monetary inflows have begun to increase again at a time where the Chinese economic policy authorities have clearly signalled that they want to see slower growth.

Before the outbreak of the international crisis, the Yuan had been allowed to appreciate in a clear but controlled manner against the USD. In July 2008 this policy was reversed and the currency was again locked to the USD. As a defensive initiative it was a brilliant move. Nobody knew if the Dollar would go up or down as a result of the goings-on in the banking sector. Roughly half of the world's economy is running a de facto peg to the USD.

By locking the Yuan to the dollar, China chose to protect their relative position towards the major export markets. Obviously not against Europe, but the Euro proved to be the stronger currency. This solution helped Chinese exports but created some other problems.

Now the exports are back on track, and the Chinese authorities appear poised to resume a policy of a slow and controlled revaluation of the Yuan. The probability of a sudden, major appreciation of the Yuan is close to zero.

The winners will be China's direct competitors as well as companies exporting to China. This has been clear for a while. This week-end's announcement is not revolutionary. It is just a reassurance that China's monetary policy has reverted back to the crawling peg policy from 2005-2008.

Stressful stress testing

EU leaders yesterday agreed to publish the results of stress tests, performed by European banks. Spain was forcing the hand of her fellow Euro-zone members by declaring that the results of stress tests performed by Spanish banks would be published irrespective of the EU decisions. The stated goal of conducting stress test and of publishing the results is to increase transparency. Hopefully this will calm down the markets, which are now increasingly doubtful about Spain's public debt.

A stress test is a series of calculations, aimed at simulating losses incurred by a bank under a series of specific assumptions about the economic developments. The purpose is to show whether the bank has sufficient capital to survive if accident strikes. US banks were subject to a stress test in 2009 and some banks were revealed as being undercapitalised. The US government subsequently provided help to those banks under the TARP program.

The direct reason for the EU move is the increasing rumours concerning the health of the Spanish banking sector. Spain is currently undergoing its own savings bank crisis, with most of the 45 regional savings banks having ventured into lending activities that are now killing them. 16 of the savings banks are on the brink of collapse and one, CajaSur was taken over by the central bank.

Markets now fear that a) the commercial banks are in similar dire straits and b) that healthy banks will be forced to take over the unhealthy ones, given that the government finances will not allow a bail-out.

The Spanish government and central bank (who had impeccable credentials before the creation of the Euro) have attacked the issue head-on. They have pushed Spanish banks to bring losses forward instead of hiding them, as it is now allowed under European accounting rules.

This step towards transparency has already brought two consequences: Spanish banks have underperformed their European counterparts, and they are already rumoured to come out on top once the stress tests are performed and presented. Seen on this background, the Spanish government had little to lose by releasing the stress tests.

Not surprisingly, virtually every European banker has taken to the microphone in the past 18 hours. 'Stress tests are a not a bad idea, but please do not publish the results' seems to is the message they convey.
This looks like a living proof how little bankers have learned from the crisis over the past couple of years. They still believe that their businesses are best protected behind a shroud of secrecy, when it is increasingly clear that transparency is the way to create reassurance.

Of course some European banks are badly capitalised. European governments have tried to make bank rescue packages on the cheap and that will show. But the correct way of handling this is not by pretending that the problems do not exist.

Armies of financial analysts are convinced that Spanish banks are carrying tonnes on hidden bad loans on the books. This is a clear sign that the secrecy thinking is deeply entrenched in Europe. It can only be bad for business.

In a past life I worked in an investment firm where we almost never had European financials in the portfolio – for the simple reason that they were not sufficiently transparent. While stress testing for sure has its shortcomings, there are only reasons to cheer the EU for the decision to force the banks' hands. Obfuscation is no solid basis for business.

Rating agencies under heavy pressure

As an element in the ongoing political battle for financial reform in the US, the newspapers report a victory for the rating agencies. Well, sort of.

First, for those who have not yet heard of rating agencies, an ultra-short primer. A rating agency is a commercial company that produces ratings of various debt instruments, paid for by the issuer. The ratings are supposed to be based on a thorough analysis of the issuers' ability to repay the debt. There are three US based rating agencies that have government authorisation, Moody's, Standard and Poor's, and Fitch. Across the world, pension funds and insurance companies have used the ratings to "control risk" in their portfolios.

Many of financial institutions have a provision that if one of the rating agencies has issued a rating below investment grade, the institution simply cannot hold the security in their portfolios. US government agencies are required to use the ratings. Further, the ratings agencies have been protected under a peculiar interpretation of the Constitution, whereby their ratings were considered an expression of "free speech", meaning that it was impossible to sue them for any kind of malpractice. Their ratings are – despite the supposedly thorough analysis – just an opinion.

In the aftermath of the dotcom bubble, the reputation of the agencies took a bad hit, as the ratings of companies such as Enron dropped from the coveted AAA to "junk" in a matter of weeks before the company went bankruptcy (and months after the stock price had fallen by more than 90%). Surely the ratings agencies should have seen it coming, if they really had checked the books.

In the wake of the Sub-Prime Crisis it became abundantly clear that the rating agencies had "adapted" to the wishes of the issuers and had bestowed their highest ratings on packages of dodgy debt based on a paper-thin assurance from badly capitalised insurers. Who had by the way also been rated by the very same rating agencies.

And most recently, the rating agencies began to meddle with the EU as they have lowered the rating of Greek debt to "junk" status, despite a massive underwriting by the EU. Yes, the rating agencies defend themselves, but the underwriting will end in three years. Apparently their experience with both Sub-Prime issues and Enron or WorldCom have taught them a lesson about being ahead of the curve. But many institutional investors decided not to sell their holdings of Greek government debt, breaking with the diktat from the agencies.

Now their previously unassailable status is under heavy attack. The EU is actively trying to promote European rating agencies. The planned US reform of the financial sector will most likely lead to a change in the constitutional protection (so they can be sued for telling fibs), US government agencies will not any longer be required to use the services of the rating agencies. There will have to be far more openness and transparency about their ratings and analysis.

Amid all this bad news for the rating agencies, it is made out to be a victory that the US Congress has dropped an idea of assigning rating assignments on a random basis. Some victory.

For the rest of us who take an interest in risk management, what is going on is highly interesting. In a recent blog post I laid out how some of the thinking members of the financial community have arrived at the conclusion that mathematical models of risk are useless when they are most needed.

Now all of those who had used ratings as an excuse for independent thinking are receiving yet another blow. If you cannot consider the ratings as the results of proper diligence, how should you then manage a portfolio of debt instruments? I am afraid that I again come back to my conviction that there is no alternative to independent thinking.

In the real world, businessmen know that there is no such thing as a free lunch. Risk exists, even if you would really, really like it to go away (or to be sold off in tasty little morsels). Faced with this categorical imperative, too many risk managers have for too long relied on mathematical models and ratings. The mathematical models are built on assumptions alien to the real world. Ratings are issued by commercial companies who have shown clearly that ratings are a product which can be moulded to the clients' needs. For sure it is not quite as independent and well-founded as rating agencies would like us to believe.

Risk managers of the world, unite. You have everything to lose if you don't start thinking.

New risk regime – or “Houston, we have a problem”

We have long been adamant that risk models based on Value at Risk (VaR) or other backward-looking statistical models are close to useless. The reason is that the underlying correlations between financial variables are inherently unstable, and that this instability is most pronounced in periods of strong market movements.

In a remarkable piece, Jim Caron, Morgan Stanley's Head of International Bond Strategy admits to have found out that something is wrong. In a recent piece, he admits to having been wrong on interest rates and bond yields. It may well be so, but the more interesting is his observation of recent market movements.

"April and May were difficult months for us and others, judging by fund data on market performance. We did not properly discount the risks associated with peripheral Europe. As a result, we had a larger risk exposure than we should have. We measure the return potential for our positions on a per-unit-of-risk basis, similar to a Sharpe Ratio. That unit of risk turned out to be much higher than we anticipated. This will force us, and many others, to right-size our risks."

In other words: the models used to discount risk have understated the risk. Caron is optimistic that it is possible to "right-size". It counts in his favour that he actually tries to find a way out of the problem. He suggests the following

Liquidation of risk exposure: Portfolio positions turned out to be much more correlated than we had initially anticipated. Traders seek to reduce correlation by liquidating many positions, leaving behind perhaps only a few core positions. We saw these liquidations in May and early June

Sit, wait and re-assess: Traders will now have to evaluate the new risk relationships. Since there is great uncertainty, traders might start by making small and short-term tactical bets to get a feel for the risks. Again, only a few core positions may still be left on.

Right-size risk: As the new market environment becomes somewhat better understood – albeit still marked by great uncertainty and higher realized volatility – traders could now start to make an assessment on the proper risk they should have relative to the increased level of expected volatility of returns. For example, if the market is twice as volatile today as it was before, then one should run positions with half the size of risk.

For better or for worse – the introduction of a new tail risk: Given the losses taken and positions liquidated in the past few months, the new tail risk is for risky assets to reverse sharply higher and for yields to rise. This could cause traders to chase performance, so as not to be left behind relative to their peers. Similarly, if markets turn against them, then they will be quick to exit. This introduces two-way risk: traders may start to react equally to both good and bad news. Previously, the tail risk traders were mostly focused on a worsening of risky assets. Now they have to be concerned about both tails, for better or for worse, which will add to market volatility.

It all sounds very reasonable. But it sidesteps one important issue: the complete collapse of predictive models when multiple sigma events like the May Flash Crash and the accelerating sovereign collapse of the past several months occur.

Carons observation that "Portfolio positions turned out to be much more correlated than we had initially anticipated" hammers the point home - markets are not inherently stable. But the situation is more serious than Caron thinks: There are no models that can model the behaviour of the financial markets when disaster strikes. The solution is to introduce much simpler and much more pragmatic ways of dealing with risk, once it appears. Risk cannot be dealt with by a machine, however clever. This has been known for ages outside of the financial markets. The financial markets need to reconnect with the real world.

EU Commission is (again) told to back off

The week started off in a way that looked constructive. Facing a major run on the Euro and the debt of the Club Med members, EU responded constructively. A prototype of a European Monetary Fund was launched and the ECB assumed wider responsibilities than seen before in running day-to-day monetary policy. So far, so good.

To anybody with a bit of insight it has been clear that the Eurozone was a project where everybody wanted the benefits of a common currency without being willing to sacrifice political sovereignty. Everybody wanted to maintain the fiscal policy as a purely national matter.

The "Stability Pact" was a feeble attempt at establishing some rules that would at least impose some limits on the most profligate members. The Pact envisioned a system of economic sanctions on those member states that did not adhere to some simple rules regarding government debt and budget deficits.

As it is now obvious, nobody took those rules seriously, and the sanctions were never applied. Greece's lack of budgetary discipline threw the EU into one of the deepest crises ever.

Some of the ideas flying around after last week-end's panic summit were in fact quite sensible. One idea presented yesterday was to equip the European Commission with some powers to approve budgets before they were implemented. In order to avoid the nasty idea that the EU Commission would try to exert influence on national budgets, the approval was suggested to take the form of a "peer review". This would imply that representatives of other EU countries – but not the Commission - would review a country's budget.

The idea was then to let the "review committee" suggest changes and ultimately even sanctions that could take the form of withdrawal of EU subsidies.

This seems reasonable, particularly given that German Chancellor Merkel and French President Sarkozy in the days leading up to the summit jointly vented the idea of giving EU more authority in budget matters.

But now the crisis is over (?) and we are back to reality. And the reality is that France has no intention to hand over budget authority to Brussels. A French government spokesperson briefly stated that the authority over budgets lie with the national governments and not with the Commission. The Swedish prime minister expressed that the peer review was only necessary for country with "bad finances". One can only guess about the reaction in London, but it is unlikely to be positive.

So it goes. The reality is that Europe is not yet ready for the political demands of having a monetary union. Everybody wants a free ride on Germany's tailcoats. One can only guess how many more crises are necessary to either break up the Euro Zone under the weight of huge differences in government finances and productivity or to remove the political resistance to the necessary integration.

Nationalism was invented in Europe in the aftermath of the 1848 Paris Commune as sovereigns tried to protect themselves from revolutionary ideas spreading. Among the many results were national hymns, the sudden creation of national languages, national education system, a professionalisation of the administrative systems.

And it may still lead to the collapse of the most ambitious attempt at creating a European Union.

Small but important steps in fixing the monetary union

Most of us harbour bad habits and it often takes a life-threatening event to make us change our ways. It seems to work that way in many other contexts as well. EU or the Euro Zone was badly under pressure last week as the financial markets began to doubt the viability of the Euro project.

In some of my earlier posts, I have expressed my doubts about the long term prospects for the Zone, given the huge structural differences between the countries and the lack of integration. The EU summit in Brussels this weekend addressed none of that, but took clear steps in overcoming some of the most glaring deficiencies.

Right from the start it has been a problem that the Euro was launched without the creation of strong institutions to support it. In order for a currency union to work, one would expect a strong central bank, and a central budget instance with the possibility of financing deficits in the markets if needed.

Instead we got a central bank with a very limited charter (inflation fighting), and no central fiscal authority. Plus an increasingly unwieldy decision process as a steadily increasing number of members have resisted handing over authority to the EU institutions.

The Greek crisis forced some changes to all that. We now have the first steps towards establishing the Commission as a fiscal authority (managing the huge stand-by facility for countries in need of credit while dealing with fiscal problems), ECB announced that they suspend the rating limits for Repos, and will begin to make open market purchases in bonds issued by institutions and companies in Europe. ECB will also become more active in offering overdraft rights to commercial banks, something that the US Federal Reserve and Bank of England did already in 2008.

While market participants may complain that the underlying budget issues have not been resolved, the steps agreed by the EU member states have all the potential to become a game changer. EU just made a significant move in the direction of strengthening the monetary union. It may not dispel all doubts about the debt of the Club Med members immediately. However, I believe that the markets will eventually realise that this is meant very seriously.

So compared with the situation a week ago, we have now seen that the EU has moved to strengthen the community institutions, to give the ECB a good deal more muscle, and to show that fiscal solidarity is available to member states who take determined action to address their fiscal deficits. The only question that lingers is: why did it take so long until something happened?

That is an issue for the history books, but it has to do with Europe being made up of sovereign states which have a very hard time accepting to play together as it is needed in order to have a monetary union.

For now, we should see the panic sentiment seep out of the market. The market panic was based on ignorance about the fiscal and financial effects of the Greek loan package. With the new stand-by package, such worries should be addressed. ECB's new liquidity facility for the banks should remove the fears between European banks. Markets should recover. The long term problems inside the EU will, however, persist and will rear their heads again. But that is for tomorrow's markets, not today's.

Another Greek lesson

The misadventures of the Hellenic Republic continue to roil the financial markets. Despite a considerable stand-by loan package from IMF and the EU, the markets continue to react as if there is an imminent danger of a Greek debt default. Stock markets fall, yield spreads continue to increase, crude oil has plummeted, other commodities are falling, and the Euro is heading south. Junior parliament members are taken as witnesses that the European governments will renege on premises, and all the Euro-sceptic analysts in the entire English-speaking world have come out of the wormholes. There is apparently only one possible reaction: SELL!

I have repeatedly stated my conviction that the initiatives taken by the IMF and the Euro Zone in concert will be sufficient to solve the current situation at least for the next 3-4 years, and it follows that my take on the market reaction is that it is blown out of proportion.

Greece is the black sheep of the Euro Zone, no doubt. 13-14 per cent budget deficit, fudged budget numbers, lax accounting standards, collusion with Goldman Sachs to "hide" debt. The list of misdemeanours is long and impressive. Worst of all, however, is the culture of tax evasion. In a country of more than 11m inhabitants, less than 5000 persons filed a tax return stating taxable revenue in excess of €100,000 in 2008. Apparently large swathes of the population do not pay income taxes at all, and predictably, it tends to be the better off who enjoy this privilege.

No wonder that it will take a while to fix.

But even when the package is in place and the financial markets have caught their breath, there are certainly issues to address. One was raised by Germany's Merkel and France's Sarkozy in concert. Their point is the simple, that in order to make the Euro work better, there has to be a much better budget discipline among the member countries. Their solution would be to strengthen the central oversight – i.e. to create some kind of Euro Zone budget watchdog.

Sounds fair enough, but the question would be what kind of powers would be invested in the new central budget authority. Already, there is a draconian system of fines put in place. But as the Greek adventure has shown, the sanctions are dropped once the going gets tough. So let me guess.

Merkel and Sarkozy want to create a central budget authority that can, could, would kick out countries with an insufficient budget discipline. Such as Greece in three years' time if a comprehensive tax reform is not in place.

Productivity is another issue. Germany built its economic success in the Post-war period on having a stronger productivity growth than all other countries. It gave Germany a huge economic advantage and room to keep inflation down by constantly revaluing the D-Mark against the trade partners.

When Germany purchased the neighbouring DDR at an inflated price it took some 15 years until the German productivity miracle was back. In the meantime Euro had replaced D-Mark and countries with higher inflation and much, much lower productivity growth had managed to gatecrash. And this is the fundamental problem of the Euro, if there ever was one. Combining national states, different languages and cultures, and low labour mobility with pronounced productivity differences and a common currency is not exactly the recipe for success, EU had expected.

Germany, which has been bankrolling EU for decades, is understandably worried about the contingent claims that may be forthcoming. Referring to Germany's success, officials have been busy promoting German budgetary virtues everywhere. But the issue really is not the budget. It is only a beginning. The issue is what it takes to maintain a currency union across huge differences. It may well be that all the political will and all the stand-by loan facilities may not be enough.

Headlines and other lines

The Greek story continues to take the headlines and is being used as the explanation for the continued weakening of the Euro. I see no reason to buy the story. When you have finished listening to the news programs and reading the newspapers, all telling that the Euro is doomed, try and think objectively, you might end up reaching a different conclusion.
For starters, it is useful to watch such a thing as the USD trade-weighted index. Since December 2009, this index has increased by 13 percent. So when somebody says that the Euro has weakened by 15 per cent against dollar, 13 per cent of that change comes from a strengthening of the dollar.
Of course, part of that has to do with the fact that the Euro-zone is one of the USA's largest trade partners. But it nevertheless indicates that the talk about "the" European sovereign debt crisis as being the reason for an imploding Euro completely misses the point.
At the outset of the global economic crisis, virtually every major currency weakened against the Euro. Probably many reasons could be given for that, nevertheless the result has been that European exports have suffered and increasingly it looks as if the European economic could enter into a "double-dip". Even if it was not announce that way, the situation looks like a replay of the competitive devaluations of the '30s.
USA, UK, Japan, and Sweden have all pushed some of their economic problems over to the Euro Zone. When the Euro weakens, the member countries of the Euro Zone recover some of their lost competitiveness. Probably this is the reason that no comments at all in order to support the EUR have been forthcoming from ECB or any other quarters in order to reverse the trend. European politicians appear quite happy to see a stronger dollar.
Meanwhile, the US economy appears to have turned the corner and has repeatedly seen growth data well ahead of the expectations. The US trade deficit has shrunk visibly (even if it again trends towards a widening). US corporations are making money and more than widely expected. So buying dollars rather than Euro is not a hard case to sell.
It has also become popular to refer to the PIGS countries when talking about the southern European EU members. Apart from the obviously derogative content of the abbreviation, it also belies the fact that the 4 countries have very different situations and very different problems.
Greece has a huge debt and chaotic public finances. Portugal has a huge debt, but relatively well run public finances, Spain's debt is by comparison low, and the main problem is the soaring unemployment. Italy has a high debt, but did not see a disastrous deterioration of the budget deficit in 2008 and 2009.
Summing all of this up, it means that we should not fear a weaker Euro, as it will only create better possibilities for European exports, and we should not be led to believe that the southern European EU members have uniform problems that require uniform reactions. In particular, their current problems do not threaten the Euro.
If we should begin to look for European fault lines, we could begin to talk about the fact that the productivity differences between the various EU countries have widened markedly in the past decade, with Germany having made the most convincing progress. But this kind of talk does not easily translate into market talk, and is largely ignored.

A couple of Greek lessons

Greece has taken all the headlines in the past week. Greek government bond yields have soared and so have the price on CDS's, also known as default protection. S&P downgraded Greek government bond yields to junk status. The air has been thick with rumours of an imminent default. The Greek government yield curve took the shape seen in countries just before a default: Short yields much, much higher than the yield on longer-dated issues.

All of this happened against a backdrop of an agreed standby facility offered by IMF and the European Union.

So we have now seen most of the financial markets and one of the 3 (American) rating agencies basically telling IMF and the European Union: we do not believe in your rescue plan. True, a number of European politicians have been trying to make some political mint on denouncing the Greek people/politicians profligate ways. True, the German government has not been forthcoming in terms of the soothing messages the market wanted to hear. True, the Greek government has met determined resistance to any cutbacks. All of this has of course created a fertile ground for rumours and half truths. Both are important elements in a good market run on something, be it a weak company, a currency, or the debt of a country.

There are many aspects of the Greece story. One is the potential viability of the current Eurozone. That is a subject for the longer term. In the short term, there are two lessons that market will probably have to learn. One is: don't mess with us! If the EU governments, led by Germany say that they will put a hand under Greece's debt, it means that they will actually do so. ECB and the German/French governments will with great gusto enjoy if speculators lose their shirt here.

It is my guess that Germany's Chancellor Angela Merkel will have some special consideration for S&Ps downgrading of Greece. As early as 2008, when the insidious role of the ratings agencies in creating the the Sub-Prime debacle, Ms Merkel pointed out that the ratings agencies were for-profit institutions and that the European Union ought to create an independent rating institution. S&P's description of the IMF/EU support package for Greece was described as "revocable". This choice of words is a direct challenge to the EU's resolve and is bound to reinforce the impression that S&P's downgrade was politically inspired. We will see.

The other lesson is that the financial markets may finally be waking up to the uncomfortable reality that default risk is a fact of the day. For the past decade, risk has almost been considered equal to the short term interest rates: when rates are comfortably low, we do not have to worry too much about risk, so let us add some. For the technically minded: When market volatility (or one of its derivatives, such as Value-At-Risk) is low, risk is low. I believe that the way the stock markets shook off the speculative selling of Greek bonds is a valuable signal. A general widening of the credit spreads would be another indication that a reasonable pricing of risk is on its way back.

A Chinese revaluation?

American lawmakers, supported by some Europeans are clamouring for a strengthening of the Yuan or the introduction of a tariff on Chinese imports, aimed at protecting the domestic industry. China retorts out that there is no reason to listen to American claims, as the US trade deficit is structural and has not been helped by the steady decline in the value of the USD over the past decades.

The fact of the matter is that China pegged the Yuan to the USD for years until 2005. The Chinese authorities let the Yuan appreciate some 21% between 2005 and 2008, but when the crisis struck, the Yuan was again locked to the USD, and has been there ever since. My best guess is that we are about to see a slow appreciation of the CNY sometime in 2010.

Through its exchange rate policy since early 2008, China has profited from the weaker dollar, in the sense that exports have remained competitive to the USA and have gained strongly towards Europe and Japan. Together with a very quick response in terms of fiscal stimulus, China has been pulling out of the current downturn earlier than other large countries. It has also helped that the Chinese banks are government owned, removing any need for dealing seriously with bad debts.

If we for a moment ignore the political noises, there are two elements that strongly point to a coming strengthening of the Yuan. For years China has claimed that the domestic financial system was unfit for living in a world of floating exchange rates. While this may have been a valid objection 10 years ago, it is certainly not the case anymore. Hong Kong has for years been a major hub in Asian FX trading, and the transfer of knowledge from there has been significant.

The problem now seems to be the opposite. The peg to the USD is becoming a problem. Perusing official Chinese newspapers quickly reveal concerns over the domestic monetary situation. The combination of a huge export surplus and a fixed exchange rate towards the major trading partner is creating a healthy capital inflow. Without a bond market designed to soak up the extra liquidity, foreign currency (read: dollars) wind up in the currency reserve, while domestic liquidity increases quickly. This forces the government to introduce quantitative measures in order to restrict lending towards certain economic activities, such as construction. This has now reached a level, where domestic monetary policy is rapidly losing effectiveness, and despite trying to put a spin on it, it is obvious that the situation is getting untenable.

Letting go of the dollar peg would lead to a rapid increase in the Yuan, to less competitive exports, cheaper imports, and would immediately stop the inflow of capital. Given that Chinese exporters were already suffering at the beginning of 2008, it is unlikely that China would accept a sudden – and very possibly, disruptive – appreciation of the CNY.

But given the economic situation of the Chinese economy, the increasing exasperation of US congress members, and the difficult domestic monetary situation, all odds are that China will resume the "crawling peg". We are just waiting for a situation where it will not look as if the People's Bank of China is giving in to American pressure.

Bailing out Greece – to help the Euro?

So Greece will really be bailed out by the EU? So it seems, even if there will be a good deal of smoke and mirrors making the support package look better than it really is. It will mainly be a series of measures, allowing Greece to finance her existing debt at better conditions than currently offered by the market, while maintaining the pressure on the Greek government to improve public finances. Personally, I do not believe that Greece will receive any support except for some loan guarantees.

But the whole Greece episode points importantly to two aspects of the current Euro cooperation. One is the cultural differences between north and south. The other is the political importance of the Euro, often overlooked by the financial markets.

When digging into the Greek public finances, it quickly becomes clear that profligate spending indeed is a problem. But that haphazard tax collection is a far bigger problem. Greece may make one ambitious budget after the other, but realistically, government finances will not improve visibly on this side of 2015 unless tax collection is improved. As opposed to Northern Europe, where taxes are collected with ruthless efficiency (and often with scant regard for the most basic principles of the rule of law), Greek tax collection is random. Just making sure that the government actually received the taxes due would make much of the current crisis go away.

Probably Greek tax collection will improve somewhat, but it will still remain a far cry from the standards of Germany, Sweden, or Denmark. Without a reliable tax collection mechanism, any Greek budget forecasts are pure fantasy. This is a cultural problem far more than just a question of overspending. Even a convergence to the European average will take quite some time.

The Euro is the posterboy of the European Union ambitions. So when the usual choir of anti-Euro campaigners from the City of London and their allies in the mostly Conservative press began to discount the demise of the Euro, they again overlooked the sheer determination to keep it afloat.

The Euro was not created in order to solve largely hypothetical problems in the Intra-European trade flows. It was created as a part of the European ambition to create an economic unit strong enough to challenge the US when it comes to domination of the world markets, including the financial markets.

The charter of the European Central Bank may well be too narrow for stepping in and taking the lead in a critical situation. And the reliance of the majority of EU countries on Germany to shoulder the economic costs may well be exaggerated. But in the end, all stops will be pulled to make sure that the Euro survives. This political will to make the Euro work will put everything else aside.

Including the fact that the Euro currently is overvalued by quite a bit. We are likely to see something of a relief rally in the EUR. Europe would need the opposite in order not to end up having a much slower recovery than other regions. Engineering a weaker Euro is probably out of the reach of the ECB. So we could do with another glorious little budget crisis inside the Euro Zone.

Carry trades

Most people would think that a carry trade consists in borrowing in a currency with low interest rates (typically Swiss Franc) and investing in a currency with higher interest rates (let us say Icelandic Krona, just for illustration), the idea is to pick up the interest rate differential which is supposed to be the reward for the currency risk involved in the transaction.

As of late, the meaning of carry trade has changed a bit. It now appears that the interest rates are not important any more, which is quite evident, given that interest rates are close to zero everywhere. So carry trades now means borrowing in a currency which is expected to weaken against other currencies.

Since Dollar weakened against pretty much all other currencies from March to December 2009 (losing some 13 per cent against the Euro), the market began to talk about the "Dollar carry trade". News media have now begun to report that some investors are beginning to "worry" about the dollar carry trade, meaning that the dollar will continue to appreciate. At the same time, Wall Street Journal Friday printed an article stating that leading NY hedge fund managers have decided to gang up and try a "career trade" against Euro.

Europe should be so lucky! It would be just what we needed. Europe would truly profit from a weaker currency and the quicker the better. So if some hedge fund managers can help us, so much the better.

The English language financial press is prone to present any news about a weaker Euro as a sign of the Union's imminent demise. In this case, Greece's perennial budget problems are the reason.

Conversely, a stronger euro is rarely – if ever – presented as a sign of the strength of the European project. Usually you have to read the French, German, Belgian and possibly even the Italian financial press to get that view on things.

If we try to ignore all this political talk, the situation is that from the beginning of the European downturn, the Euro has been the currency that strengthened the most against pretty much everything: Dollar, Sterling, Yen, Swiss Franc, Swedish Krona. There has been little talk about this fact and even less talk about the fact that Europe's economic recovery would be significantly hampered by the surging Euro. But it is now visible in the European growth data.

In my mind there is no doubt that the Euro needs to weaken and by quite a bit in order to escape the worst effect of the "beggar-thy-neighbour" policy openly implemented by our friends and allies. The only question is by how much and how quickly.

Using my own indicator, the Euro can fall far. This indicator simply says that if Europeans are willing to travel to NYC to go shopping and come home laden with shopping bags, dollar is too weak. If the good burghers of my native Copenhagen are willing to sit on a bus for two hours to go shopping in Swedish Malmö on the other side of the Sound, then the Euro (and by extension the DKK) is way too strong.

Some are talking about parity between Euro and Dollar. Why not? In 2002 a Euro would buy only 85 cents. After the most recent 10% weakening, it still buys $1.35, still a whopping 60 per cent increase. Nothing in the relative productivity growth justifies that increase.

Would it not create inflation? Probably not as long as the potential output gap is as big as it is now. More expensive import goods, then? Yes, but that is the whole point of a weakening currency, that the domestic products gain in competitiveness.

And the speed of adjustment? Everybody loves to see things develop smoothly and in a straight line, not too quickly. The truth is of course that if the Euro were to weaken quickly, it would cause some disruption, once things stabilise everything settles back to normal.

So please, do not fear for the "dollar carry trade" when it can be turned into a "euro carry trade" instead. NYC hedge fund managers, please do not waste your time on too many "idea dinners". Do something, go ad sell some Euros short.

It would even make it easier for Greece to handle her economic situation.

Curious enough

A month ago, I wrote that I thought we were in for a round of general re-rating of risk. It proved more right than I had expected it to be in the short run. But it happened in a quite different way than I expected it. Under normal circumstances, the bond markets would be where the clearest indications would show up and then the stock market would latch on at a later stage. That is what happened from early 2007 and onwards to August 2008. But this is not a replay of August 2008.

I find it quite obvious that fears of the looming debt crisis are playing havoc with the markets. It is equally obvious that there most market players have no idea what is really at stake and when and how it will strike. So all we have to relate to is a general feeling of uneasiness.

This time around we have seen a rather muted reaction in the bond markets and a strong reaction in the stock markets. It could be explained as follows: after the stock market collapse and a good run in 2009, probably the reactions from the risk management departments have become a good deal quicker. Faced with a mounting uncertainty about sovereign debt, probably quite a number of risk managers have strongly recommended to reduce portfolio risk, i.e. to cut exposure to the stock markets. This appears to be done broadly and not with reference to any specific countries. Probably a wise move given that once this kind of broad-based panics occur, it does not matter a lot what kind of stocks you happen to have in the portfolio.

Adjusting the bond market risk appears to be done using CDS's and not much else. The bond market appears to have the most muted response, being steeped in the tradition of evaluating individual default risks. We have simply seen a dramatic widening in spreads reflecting the apparently increased default risk in Greece.

This could be interpreted in a way, not particularly gentle on the stock markets. They reacted quickly to a rumour, to an unconfirmed story, and to facts that are not yet known.

The recent euro trend is more interesting. Since March last year Euro had gained against most other currencies, and as a result European exports have suffered. Now the markets – and the perennially Euro-critic camp in London - use the Mediterranean debt crisis as an excuse to sell Euro. We are now supposed to believe that the Euro is coming apart in the seams, as it has weakened some 10 per cent against dollar.

Most of the English language press chose to ignore the dramatic increase in Euro, but focused on the dollar's weakening instead. It was not a good story that Europe's economic recovery would be hampered by a stronger Euro.

Contrary to what one would believe reading the reports about Euro's terminal decline, its weakening is welcomed in most European quarters. A weaker Euro will support an economic recovery in the growth and reverse the beggar-thy-neighbour policy quietly supported by Washington and London. Instead of fearing a weaker Euro, we should celebrate it.

Waking up to a new reality

This is beginning to look like something we have seen before. Stock markets are falling in a straight line. Yield spreads – the difference between government bonds and corporate/mortgage bonds – are widening. Sovereign spreads – the difference in yield between bonds issued by virtuous states (read: Germany) and reckless states (read: Greece, Spain, Portugal, Dubai) are moving the same way.

VIX, the index for S&P volatility, had fallen in a straight line since the panic in October 2008. With the recent setback, VIX has moved up visibly, indicating nervousness in the stock market. After months of overperforming, emerging markets are now leading the stock markets downwards.

Adding all of this together paint a picture of a market where risk aversion is increasing. Investors want to be better paid to take on risk.

We last saw this in early 2007 (and we all know how it continued), when there were good, solid reasons for the financial markets getting jittery.

This time around the situation is quite different. The economies are recovering, corporate earnings are heading north and beating expectations easily. Interest rates are low and liquidity is more than abundant. The stock markets are not by any measures expensive. Ben Bernanke has even been confirmed for his second term in office and the weather is beautiful in Davos.

So we cannot really use the economic background as an explanation. Instead I believe that the best explanation is found in the theme I addressed last week, general versus specific risk aversion.

Since 2007 risk pricing has moved in two long trends: First pricing of risk went through the roof and then, as the central banks opened the liquidity spigots, risk pricing fell dramatically. By some measures it even fell to prices lower than seen any time since 2005.

In other words, since 2007, the fears of a systemic meltdown and the attempts to stave it off have been the major drivers of risk aversion. Now that the economy is improving and the central banks are signalling that they will eventually adjust the monetary policy to a more normal situation.

The financial markets are coming off their life support and that will have a lot of practical implications. The tide will not lift all boats as it was the case through 2009 and we will be on our way back to a situation where we have to estimate the risk related to each individual investment.

The current trouble in Greece is a good example. The yield spread on Greek sovereign debt has risen in line with the market's appreciation of the risk. But as the story broke, the first reaction was to price all the other southern European countries as if they had the same problems. They may also have problems, but those problems are not the same as those of the neighbours.

This analogy is probably also true for the stock markets where even badly managed companies have gained strongly in value during the relief rally. This is unlikely to continue going forward. We will all have to go back to work and get used to the fact that risk is not only a macro factor.

Why should this mean that the markets go in reverse? For the simple reason that it represents a change in the dynamics compared to what we have seen in the past two years or so. And the markets have shown beyond any reasonable doubt that they are very bad at handling changing dynamics.