Friday, March 27, 2015

Greek Tragedy Nearing its Final Act

Despite occasionally falling out of the news for certain periods of time, the Greek debt problem has never gone away. In fact, the problem has grown continually worse.

Greece remains in a full blown depression. The economy suffered through a six-year recession (meaning output continually contracted), from which it only emerged last year. The unemployment rate is a staggering 26 percent, while youth unemployment stands at a whopping 60 percent.

That always leads to societal unrest, and rising crime. Leaving so many young men idle for so long is a recipe for disaster.

The European Commission, the International Monetary Fund (IMF) and the European Central Bank (the so-called Troika) have been granting loans to Greece for the past few years to keep it afloat.

Further increasing Greece's debt as a means of solving its debilitating debt problem is no solution at all. It is madness. It's akin to a son asking his parents for $100 to repay them the $100 he owes them.

Greece hid the magnitude of its debt problem prior to its entry into the European Union.

The 28 Member states of the European Union agreed to the Stability and Growth Pact in 1997, which limits government deficits to 3% of GDP and debt to 60% of GDP.

Greece was well above those limits at the time, which should have precluded it from inclusion. But no one outside the Greek government knew this back then. In fact, the Greek government didn't admit the falsifications of its predecessors until February 2010, years after the fact and well into its national crisis.

It is now known that by 1996, the Greek debt-to-GDP ratio stood at 95 percent. By the end of 2009, Greek government debt had reached 130 percent of gross domestic product, or more than twice the agreed upon limit. And by 2013, the debt-to-GDP ratio had soared to 175 percent.

About three quarters of Greek debt is owed to the EU and the IMF. In other words, Greece's creditors have given it just enough rope to hang itself.

Greece recorded an enormous government budget deficit equal to 12.7 percent of the country's gross domestic product in 2013.

While the country is expected to post a small budget surplus this year, that is before its debt payments are taken into account. Debt service won't allow Greece to get out of its cavernous hole. It is a country on its knees.

With such a weak economy, Greece cannot be expected to ever grow its way out of debt. During a recession, tax revenue shrinks along with economic output. Even in the absence of further annual deficits (which were still mounting), Greece hasn't possessed the means to service its existing debt for years.

Yet, it was continually adding to it, with the help of the Troika.

The IMF predicted the Greek economy would grow as the result of its 2010 aid package. Instead, the economy has shrunk by 25%. Wages are down by the same amount.

Meanwhile, Greece has a notorious tax evasion problem, which only makes its fiscal and debt problems worse. Greeks are fearless and defiant about not paying their taxes, yet the government lacks the resources, or infrastructure, or authority to do anything about it. The Greek government appears to be neutered.

Tax revenues so far this year are more than 1 billion euros below target; that's a lot of money for an economy that totaled just $179 billion last year.

The reality is that Greece has no means to ever repay its debts, and the Troika surely knows this. But the hope of central bankers everywhere is to create unlimited debts that can never be repaid, with interest payments continuing in perpetuity.

What we have right now is a game of chicken between the Troika and the new Greek government, which was elected on a mandate to rebel against the crippling austerity and debt payments imposed by its creditors. So, who will blink first?

Greece represents just 1.4% of the EU economy, so it really amounts to a bit player. If Greece were to leave the EU, economically it wouldn't be missed.

The trouble for the EU is the legal unwinding of a Greek exit. There is no mechanism in place for this because no one imagined such a scenario when the EU was created.

The other problem is that a Greek exit would set a precedent that could allow a much bigger economy, such as Spain or Italy, to make a similar exit. Such a scenario would be crippling, and it would set off a cascading series of government defaults and bank failures.

At present, there is no concern about either Italy or Spain exiting, as they are both enjoying cheap and easy access the debt markets, as seen below.

10-Year Government Bond Yields

United States 2.05%
Italy 1.26%
Spain 1.24%

It is patently absurd that yields in Italy and Spain are substantially lower than those in the US. There is no good reason for that. In a normal world, those yields would more than twice as high as the US. At some point, reality will set in and the bond market will realize that Italy and Spain are nearly as bad as Greece, with unsustainable debts and weak economies.

That's why the possibility of a Greek exit is so worrisome to EU leaders. It would set a very dangerous precedent.

This is the leverage the Greek government wields over the Troika.

At best, Greece's leadership failed its people through years of mismanagement and continual debt spending. At worst, they were a bunch of lying, duplicitous crooks and frauds.

The new government is trying to come to grips with the sins of the past, and it seems to have remembered an age old principle: The first step to get out of a hole is to stop digging.

A recent report says that Greece may run out of money as soon as April 9. Without another round of loans, the Greek government's coffers will soon run dry.

It's not simply a matter of it being unable to service its debt payments; Greece won't be able to pay government workers or retirees. Furthermore, Greek banks are running out of money. Fearful depositors are withdrawing their money en masse.

In other words, if Greece runs out of money, there will be societal chaos.

This is the leverage the Troika wields over Greece.

Under the current terms, there is no way for Greece to get out of its debt crisis. Yet, its creditors cannot stomach the notion of a debt write down.

The day of reckoning is near. Everyone involved has tried to avoid some uncomfortable realities, but those realities are now becoming unavoidable. The can has been kicked down the road for far too long, and they have finally run out of road.

So, who prevails and who buckles?

Well, it can be easily argued that Greece needs the EU more than the EU needs Greece. The Greek economy is so small that it is hardly important to the larger union. And the Greek crisis will reach entirely new levels of social catastrophe without further loans.

On the other hand, if Greece stops repaying its loans, its financial position would be greatly improved. That money could then be redirected into the Greek economy. Greece would have to go back to its former currency, the drachma, and it would lose access to the international debt markets for a few years. But keeping that money at home might be enough to at least help it get back on the road to solvency.

That said, not servicing its debts won't correct Greece's tax evasion and corruption problems. That requires a strong government committed to genuine reform.

The new Greek government is in a desperate situation, with its back is against the wall. That makes its response unpredictable. Since it is a new government with new leaders, elected on a platform of resistance — even defiance — there is no precedent to predict how they will act or what they will do next.

This Greek tragedy is at last entering its final act. Like all good dramas, it is both riveting and unpredictable.

Wednesday, March 18, 2015

Deflation, Not Inflation, Is the Fed's Big Threat

It was little surprise to me that the Federal Reserve announced today that it will not raise interest rates in June. In fact, the Fed gave no definitive timeline for a rate hike, but many market watchers presume the first bump will come in September.

The Fed wants more time to watch how things pan out.

There's good reason for the central bank's hesitation. According to the latest “nowcast” from the Atlanta Fed, first-quarter gross domestic product could come in at just 0.3%.

Given the continued weakness in the economy, tepid wage growth, plunging oil prices and the tendency toward deflation, a rate hike seems imprudent to me. In fact, in normal circumstances, a rate cut would be more likely.

But these aren't normal times we're living in.

One of the core problems confronting central banks around the world is a lack of consumer demand, which is leading to weak economic growth, low inflation and even deflation.

When inflation in the US was very high in the late '70s and early '80s, Fed Chairman Paul Volker raised rates repeatedly and vigorously to crush it, and the strategy worked.

In a time of low inflation, or even deflation, the opposite tactic (cutting rates) is typically employed. However, the US has been living with near-zero interest rates for over six years. There is little room left to maneuver without going into negative territory.

While low interest rates generally stimulate the economy, they have not really stimulated demand in recent years. Cautious consumers are wary of spending and have not been compelled to borrow at previous levels. After all, excessive borrowing is what ultimately blew up our economy in 2008.

People haven't forgotten that yet.

Perhaps they expect a crisis event, such as another war or market crash. One way or the other, people aren't spending strongly enough to reinvigorate our consumption-based economy.

Inflation over the past 12 months turned negative (0.1%) for the first time since 2009. With the menace of deflation becoming all too real, how will the Federal Reserve respond?

There is a fairly recent precedent for cutting rates to fight the specter of deflation.

The Federal Reserve cut its key interest-rate (the Federal Funds Rate) to 1% in 2003, which at the time was its lowest since 1958.

But as the Wall St. Journal noted at the time, "Below 0.25%, the market for Treasury bills, eurodollars and other short-term IOUs would function less smoothly."

Therein lies the problem: The Federal Funds Rate has been at 0.25% since December 2008.

A quartet-point reduction, which is the minimum level the Fed will typically raise or lower rates, would result in zero — no interest at all. That could kill the bond market, but it might just might stimulate the precious metals markets.

After all, why keep money in the bank if it earns nothing?

But what about rates of less than zero, as is the case at some European banks at present? Central banks cannot easily push their policy rates into negative territory.

Gold may not earn interest, but zero interest it still higher than negative interest.

Deflation is worrisome because falling prices make it hard for the government and companies to repay debts. It leads to falling wages and layoffs, and can be the prelude to a bad recession. Once it takes hold, deflation is very difficult to defeat, as the Japanese can attest.

Former Fed Chairman Alan Greenspan said in 2003 that the serious consequences of deflation required a wide "firebreak" against it and that the Fed would "lean over backwards" to prevent it.

Inflation is generally perceived as rising prices, while deflation is the opposite. However, while inflation is really a decline in the purchasing power of the dollar, deflation is ultimately an increase in the purchasing power of the dollar. That makes the current environment all the more troubling.

The dollar is at its highest level since 2003. In fact, the dollar is now reaching parity with the euro, after being less valuable for many years.

So, what's the Fed to do about this?

An interest rate hike would just make the dollar even stronger against other currencies. That would hurt the US export market even more than it's already hurting. It would also make American-made goods less competitive at home against cheaper imports.

An interest rate hike would also add to deflationary forces. In simple terms, a stronger dollar increases the risk of deflation.

A strong dollar makes imports cheaper, most critically oil. Cheaper oil lowers the cost of all transported goods, which means essentially everything.

Cheap oil is already a prime deflationary force. Crude plunged below $43 a barrel on Monday, the lowest price since 2009.

Deflation is the biggest fear of both governments and central bankers. But the primary means to fight it — a cut in interest rates— may not be that effective since we're just a quarter-point away from zero.

The possibility of negative interest rates should concern everyone. There is, however, current precedent; it's happening right now in Europe.

It costs money to leave deposits at some European banks. In essence, a depositor's principle is guaranteed to lose value.

That's something most Americans can't even imagine.

But neither could most Europeans, until recently.

Wednesday, March 11, 2015

Federal Reserve Has No Good Options in Rate/Currency War

There are many opposing forces at play in the global economy today. We are living in truly historic, and unprecedented, times.

Central banks around the world have been steadily cutting interest rates — some into negative territory, a stunning development — as they fight to stimulate their beleaguered economies.

This is seen as an antidote to weak consumer demand. Low interest rates are meant to discourage saving and instead encourage spending.

Low rates also typically devalue a nation's currency, which keeps exports competitive.

Government bond yields in the eurozone have plummeted to record lows since the European Central Bank started purchasing government debt and other bonds this week. It's all part of a €60-billion-a-month quantitative-easing program aimed to stimulate the eurozone’s sluggish economy.

But yields in some european countries were already negative before the QE program began, and the market didn't seem to fully price in the arrival of QE. That means yields could be driven even lower — in some cases further into the negative.

Falling yields elsewhere in the world have drawn many investors into US Treaurys, which have a better return. However, this demand is only pushing Treasury yields lower. Call it an unintended consequence.

The flight from the euro and other currencies has pushed the dollar to 12-year highs.

The ICE dollar index, which measures the greenback’s strength against a basket of six rivals currencies, rose 0.66% to 99.26 on Wednesday. The index was on track to hit the 100-mark for the first time since April 2003.

The dollar has already gained nearly 13% versus the euro this year, and the two currencies are now nearing parity. That will hurt US companies that sell to Europe, one of our largest export customers.

Europe is a half-trillion dollar market for US exporters. A stronger dollar makes US goods more expensive overseas.

Meanwhile, the Federal Reserve seems poised to raise interest rates this summer, which would only exacerbate the currency divergence.

Big American firms that generate a large portion of their sales overseas will likely to see the impact of the stronger dollar when they report their first quarter results. Many companies are already warning that the stronger greenback will hurt their sales and profits this year. Foreign revenues will wind up looking weaker when converted back into US dollars.

With foreign interest rates so historically low, investors will keep buying the dollar. Simply put, the dollar looks like a better, safer, store of value right now, compared to other currencies.

The other side of the coin is that a stronger dollar also makes imports cheaper, including oil and other commodities. While that sounds good for the US economy, there are other consequences.

The US is the world's No. 3 oil producer, so plunging prices are hurting a major domestic industry.

At roughly $50 per barrel, the price of oil is leading to layoffs in the energy sector, particularly in states like Texas and North Dakota, whose economies have boomed in recent years due to fracking. The real estate markets in these states are now imperiled.

So, what will the Federal Reserve do next?

Inflation is barely existant. In fact, deflation is a bigger concern at the moment.

Consumer prices fell 0.7%,in January, the third straight monthly decline, while inflation over the past 12 months turned negative (0.1%) for the first time since 2009.

While that was largely driven by the huge drop in oil prices, surely it has given pause to Fed policy makers. Interest rates are typically raised to thwart inflation. Clearly, that's not an issue at present.

Additionally, raising interest rates would only: 1. Strengthen the dollar; 2. Funnel more foreign money into the US; 3. Hurt US exports; 4. Drive crude prices even lower; and 5. Maintain, or even inflate, the stock market bubble with that flood of foreign money.

The Fed's zero interest rate policy (ZIRP) has fueled increased risk-taking by borrowers and yield-hungry investors. The result has been a massive mispricing of financial assets, such as housing and stocks.

Yet, even with near-zero interest rates, demand for credit remains weak. Consumers aren't spending as robustly as they were prior to the Great Recession, and consumer spending drives roughly 70% of our economy. Higher rates will ultimately hurt housing and autos, etc.

On the other hand, low rates are hurting savers and discouraging saving.

You can see why the decision to tighten (raise rates) has to be such a tough one for the Fed at present.

Deflation is the biggest nightmare of governments and central banks because it makes it harder for countries to pay off debts. The US is currently grappling with an $18 trillion national debt. That's why the Fed may feel compelled to act.

But there are so many wheels simultaneously in motion throughout the global economy. Any Fed action will have resulting reactions, not all of which will be intended or desired.

It's easy to argue that there are no good choices. Fed policy makers are damned if they do, and damned if they don't.

This is shaping up to be another stunning year for the global economy. Watching it all unfold will be equally fascinating and unpredictable.