Thursday, May 13, 2010

Yes Virginia, there is no free lunch

IMF report predicts long, painful road ahead for Greece's recovery
The risk that the joint IMF-European Union rescue plan will come unwound is "undeniably high," said the IMF staff report, which detailed how variations in the fund's assumptions about growth, inflation, interest rates, restructuring and other variables could leave Greece's debt load climbing despite the efforts to bring it down.

The level of concern that Greece's problems might spill over to other countries became clear last weekend when European finance ministers and the IMF approved a separate, near-trillion-dollar effort to support other indebted European nations if they run into trouble.

After years of growth fueled by low-interest borrowing available after Greece adopted the euro, the country must now go through years of "internal devaluation" -- falling wages, rising unemployment rates and stunted growth. As a member of the 16-nation European Monetary Union, the country does not have its own currency. But using local economic conditions, the IMF staff estimated that the country's "effective exchange rate" was overvalued by as much as 30 percent -- an excess that will have to be squeezed out of the economy in a "long and painful process."

The program's success "requires a decisive break from past behavior," the report said, and "hinges on deep and comprehensive structural reforms. . . . Without such reforms, Greece would not restore competitiveness, growth, and real incomes will remain stagnant and unemployment high, and the debt burden would eventually prove unsustainable."

Greek debt bailout makes no sense in any language
Equity and credit investors can't both be right -- and they're not. This European package of paper and promises is likely to end up on the scrap heap of history faster than you can say, ''auf wiedersehen, adieu, arrivederci, bye-bye," because it has little credibility with those who count the most -- potential buyers of the new mountain of debt.

Once equity investors figure this out, it will be lights out for Europe. Start the clock for a new Dark Ages: the whole Continent will be a massive short.

The key reason, says Jeddeloh, is that investors recognize what European politicians couldn't muster the courage to say: If launched, the loan package would force structural reforms that would require higher taxes, lower government spending, more unemployment, a recession in the EU and a depression in Greece.

A trillion dollars cannot be snapped out of thin air.

"Region of Reverse Command:" Consequences of the Industrialised Country Debt Explosion
A pilot usually gets a plane to gain altitude by pulling back on the controls to raise the plane’s nose, which directs more engine thrust upward and causes the plane to climb. But as student pilots quickly learn, there is a limit. While raising the plane’s nose causes the plane to climb, it also induces a type of drag that causes the plane to slow down. As a plane slows down, it becomes progressively more difficult to maintain the lift needed to get the plane into a climb. Eventually, the induced drag is so large that it overwhelms the impact of raising the nose, so that pulling back on the controls does the opposite of what it normally does, causing the plane to descend instead of climb. Pilots know this as the “region of reverse command”.

Economic policy has a region of reverse command, too.

Emerging economies have experienced many painful moments with this region of reverse command. When financial crises spread across the emerging world in the 1990s and early 2000s, many emerging governments had to respond to deep recessions by doing exactly the opposite of the Keynesian response: cutting government spending, in order to establish fiscal credibility in the midst of crisis.

But this concept is new for the global economy as a whole, specifically for the industrial world.

If 2008 showed how quickly financial crisis could push the global economy toward the abyss, 2009 illustrated the potency of a whatever-it-takes government policy in pulling it back from the brink. A year ago, it was almost conventional wisdom that the bulk of the US financial system was insolvent and needed to be nationalised, threatening to create a new wave of uncertainty at a moment when the US economy was shedding jobs at the fastest rate since the Great Depression.

But this didn’t happen. The combination of a massive increase in government spending and zero interest rates alongside over $1 trillion in asset purchases by the Federal Reserve provided direct support to economic activity and – at least as importantly – gave financial markets a perceived government-underwritten green light to add risk. And add risk they did, generating historic increases in equity, corporate bond, and other asset markets that helped repair damaged balance sheets in the financial and household sectors.

The extraordinary effectiveness of government policy in 2009 has given way to a new focus on the limits of government policy in 2010. At the core of the discussion is the extraordinary build-up of government debt in the industrial world. The increases in public debt in the United States and other key industrial countries are without precedent outside of wartime.

Investors are only beginning to enumerate and understand the full consequences of the debt explosion in industrial countries.

The financial crisis has ushered in a period where investors discuss not just interest rate risk at the core of the industrial world, but also credit risk.

The problem now confronting the industrialised world is that the increase in debt levels is a secular, not cyclical phenomenon; and it is also increasingly structural in nature. It is not a matter of belt-tightening during the recovery phase to bring debt levels down to pre-crisis levels and pave the way for fiscal policy to come to the rescue during the next downturn. Rather the belt-tightening is needed to prevent the medium-term debt path from becoming explosive. The reaction function of core governments as they confront future economic disruptions will be constrained in ways they have not experienced in recent history.

Debt: America versus Greece
Paul Farrell points out the ugly truth about profligacy, American style:

1. Federal government debt … $14.3 trillion
2. Treasury and Fed cheap-money policies … $23.7 trillion
3. Social Security’s rising debt … $40 trillion
4. Medicare’s unfunded debt … $60 trillion
5. Annual health-care costs … $2.5 trillion
6. Secretive global derivatives trading … $604 trillion
7. Population growth of 50% vs. Peak Oil demands … $30 trillion
8. U.S. dollar losing as reserve currency … $20 trillion
9. Global real estate losses … $15 trillion
10. Foreign trade and ownership … $5 trillion
11. State and local budget and pension shortfalls … $3.5 trillion
12. Corporate pensions plus 401(k) plans … $3.2 trillion
13. Consumer card debt … $2.5 trillion
14. Lobbyists annual costs … $1.4 trillion

Paul McCaulley's prescription:
After the Crisis: Planning a New Financial Structure
Learning from the Bank of Dad



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