Former ECB Chief Economist Says ECB Is In Panic, As Czech President Warns The End Of Democracy Is Imminent

If anyone thought the bad blood between Germany and the rest of the insolvent proletariat, aka the part of the Eurozone which is out of money (most of it), and which has been now confirmed will be supporting Obama (one wonders what the quid for that particular quo is, although we are certain we will find out as soon as December), complete collapse of the Greek neo-vassal state of the globalist agenda notwithstanding, had gone away, here comes former ECB chief economist Juergen Stark to dispel such illusions. In an interview with Austrian Die Presse, the former banker said what everyone without a PhD understands quite well: “The break came in 2010. Until then everything went well…”Then the ECB began to take on a new role, to fall into panic…. Together with other central banks, the ECB is flooding the market, posing the question not only about how the ECB will get its money back, but also how the excess liquidity created can be absorbed globally. “It can’t be solved by pressing a button. If the global economy stabilises, the potential for inflation has grown enormously… It gave in to outside pressure … pressure from outside Europe” Why, whichever bank headquartered at 200 West, NY, NY might he be referring to?

From Telegraph:

He added that “panic” about the eurozone breaking up was “nonsense” but that the only way to end the crisis was for member states to bring down their debts and implement structural reforms to boost economic growth.


“Governments have recognised that returning to budgetary discipline is indispensable. Markets focus much more on whether states will be able to service their debts in five years’ time,” he said.


Mr Stark quit in late 2011, following in the footsteps of former Bundesbank head Axel Weber, who stepped down earlier in the year from Germany’s central bank because of unease about the ECB’s policies.


Mr Weber’s successor Jens Weidmann was the only member of the ECB’s policy-setting governing council to vote against the bank’s new programme earlier this month.


“Weidmann’s arguments … should not be made light of,” Mr Stark told Die Presse. “The way in which his position has been publicly commented upon by the ECB leadership has crossed the line of fairness.”

And speaking of continuing takeover of the world by a few not so good banks, a loud warning that the advent of globalist influences (i.e., bankers) is taking over Europe and that the “destruction of Europe’s democracy is in its final phase” comes not from some European (or American… or Zimbabwean) fringe blog, but from the 71 year old president of the Czech Republic, someone who certainly knows about the difference between communism and democracy, Vaclav Klaus. In an interview with The Sunday Telegraph, “Václav Klaus warns that “two-faced” politicians, including the Conservatives, have opened the door to an EU superstate by giving up on democracy, in a flight from accountability and responsibility to their voters. “We need to think about how to restore our statehood and our sovereignty. That is impossible in a federation. The EU should move in an opposite direction,” he said.”

Alas, what also is impossible in a Federation is for a banker-controlled entity to provide money out of thin air, i.e., public debt, which dilutes the “common currency” in the process preserving the illusion that credit-fueled growth (the only kinds the world has seen since the advent of the Federal Reserve) can continue for ever, when in reality all that is happening is the ongoing dilution of sovereignty alongside the destruction of individual currencies. This is precisely what the status quo, i.e., the abovementioned company headquartered at 200 West, wants.

And what the status quo wants it always gets, absent a revolution.

Back to Klaus:

Speaking in Hradcany Castle, a complex of majestic buildings that soars above Prague, and is a symbol of Czech national identity, Mr Klaus described Mr Barroso’s call for a federation, quickly followed by the German-led intervention, as an important turning point.


“This is the first time he has acknowledged the real ambitions of today’s protagonists of a further deepening of European integration. Until today, people, like Mr Barroso, held these ambitions in secret from the European public,” he said. “I’m afraid that Barroso has the feeling that the time is right to announce such an absolutely wrong development.


“They think they are finalising the concept of Europe, but in my understanding they are destroying it.”


President Klaus, 71, is one of Europe’s most experienced conservative politicians; he has served as his country’s prime minister twice after winning national elections and will complete his second term as Czech President next year.


Frequently referred to as the “Margaret Thatcher of Central Europe”, Mr Klaus was born in Nazi-occupied Prague, played a key role in the 1989 Velvet Revolution that overthrew Communism and became founder of the Czech Civic Democratic Party, which has remained in government for most of the Czech Republic’s independence.


He reluctantly recommended Czech Republic membership of the EU in 2004 and five years later was the last European head of state to sign the Lisbon Treaty, delaying signature, under intense international pressure, until all legal and constitutional appeals had been exhausted against it in his country. “We were entering the EU, not a federation in which we would become a meaningless province,” he said.



“When it comes to the political elites at the top of the countries, it is true, I am isolated,” he said. “Especially after our Communist experience, we know, very strongly and possibly more than people in Western Europe, that the process of democracy is more important than the outcome.


“It is an irony of history, I would never have assumed in 1989, that I would be doing this now: that it would be my role to preach the value of democracy.”

Even more ironic than the return of corporation-controlled statism under the guise of socialism, will be the return of fascism, whose neo-variants are already exhibiting themselves in countries like Greece.

But more on that in a few months, when other European countries get sick and tired of the banker oligarchy and realize that there is really no party that represents the people in a world in which democracy is merely a mirage.

And so, once again, the most horrific aspects of humankind history will repeat themselves, only this time with far more potent and destructive weapons to enforce one’s ideological superiority, or in this case to preserve an global equity tranche where the legacy wealth is preserved, and which in any normal parallel universe would have long since been wiped out. Just as soon as the “Democratic” emperor is exposed as having no clothes by more than just those who still are not afraid to tell the truth.

Guest Post: Draghi's Coup D'Etat And Why OMT Is Illegal

Submitted by Blankfiend of Fibs And Waves blog,

According to Mario Draghi, OMT, or Outright Monetary Transactions, is a program of conditional bond buying targeted at specific countries to restore the perception of the euro’s irreversibility and stability, and repair a broken monetary policy transmission mechanism.  Once launched, OMT has no ex ante limits, it is within the ECB’s price stability mandate, and it can be halted or interrupted based on achievement of its objectives or non-compliance with conditions imposed upon the targeted national government.

I would posit that OMT is much more than what the party line states.  Here are some alternative interpretations for your consideration.  I challenge you to refute the logic of any of them.

OMT is a Eurobond equivalent, targeted toward specific countries.  Given that ECB holdings are joint and several backed by all of the National Central banks (NCB’s) that make up the European System of Central Banks (ESCB), any losses on these bond purchases would be distributed among the NCB’s according to their capital key.  OMT would be a peculiar type of Eurobond, with some parallels to the discard red vs. blue Eurobond schema.  Instead of being differentiated by levels of debt-to-GDP (greater or less than 60%), these bonds would be differentiated by country of issue.  For example, if Spain enters this program, its bonds would now have the backing of the ECB, while Italy’s would not.  Now, the red vs. blue idea was discarded precisely because it would have established a market preference for the blue bonds (joint and severally backed Eurobonds) versus the red bonds, which would have only had the backing of the issuing sovereign.  Is it so difficult to imagine that the market would quickly develop a preference for the bonds of countries on OMT life support, to the detriment of those NOT on it?

OMT is a banking license for the ESM.  Once the ESM buys the debt of a target country on the primary market, the ECB will follow with potentially unlimited purchases on the secondary market.  This obviously allows the resources of the ESM to be greatly extended without a formal banking license or leverage scheme.  At the same time, it completely bypasses any safeguards countries may think they have in place to limit their bailout related losses.  This is, of course, due to the joint and several liabilities of the NCB’s that comprise the ESCB.  Ironically, an official banking license for the ESM has been declared clearly in violation of Article 123(1) of the TFEU by no less than the ECB itself.  The OMT is an obvious scheme to bypass that “technical inconvenience.”

OMT is a sham.  While I have no doubt that our beloved Italian central banker will be more than willing to purchase the bonds of program countries, I do not believe for one minute that he would have the resolve to either permanently halt or reverse those purchases if a large target country backslides on its commitments.  I am sure that the markets – and the beneficiary national governments – recognize this as an empty threat as well.  If Draghi carried through on his threat in any meaningful way, he would be abandoning the goals of monetary transmission and euro irreversibility he claims to be striving for.  This is particularly true for big countries like Spain and Italy, sort of like mutually assured destruction.  Once countries like this are on the OMT methadone program, there will be no discharging them for abuse.

OMT is fiscal policy by Central Bank fiat.  Eurobonds, ESM banking licenses, and ESM leverage schemes have all been previously rejected by various European political leaders, most notably Angela Merkel and the Finns, but also Nicholas Sarkozy.  OMT is a clever way to skirt all of those objections and concerns in order to restore confidence in sovereign European debt markets.  At the same time, it is a backdoor method of committing national fiscal authorities to backstopping potential extra-national losses far in excess of what those fiscal authorities were ever willing to commit their taxpayers.  OMT is a full-scale abandonment of the concept that a supra-national central bank should not be able to undertake measures which could subsequently force the hand of national fiscal authorities.  OMT embarks us upon the treacherous path of fiscal policy by unelected, unaccountable central bank bureaucrats.

OMT is a Credit Facility.  Let’s see….  We have an unlimited program specifically designed to support the sovereign debt of targeted countries.  We have implausible revocability, dubious terms for enforceability, open-endedness regarding both time and quantity of support provided, and, supposedly, no recourse by the lender.  Furthermore, the provider of this credit is specifically willing to buy even if no one else will.  Admittedly, the credit provider will not buy on the primary market.  However, when you examine the TFEU, there are two distinct restrictions in this regard.  The commonly cited one obviously forbids the ECB from primary market sovereign debt purchases.  But the one that Draghi wants us to ignore forbids ECB credit facilities in favor of national governments.  “In favor of” is clearly broader in scope than the primary market restriction.

OMT is ILLEGAL.  Here I am beating a dead horse, as I have made this argument several times before.  But, one more time for effect:


IceCap Asset Management: Three Days That Shook The World, And The Law Of Diminishing Returns

From Keith Dicker of Ice Cap Asset Management

Three Days That Shook The World

The Law Of Diminishing Returns

While there are plenty of complex laws to keep lawyers happily billing forever, there is one law that is very simple and is never mentioned by those responsible for the good health of our global economy – the law of diminishing returns.

This un-billable law becomes a nightmare for anyone trying to produce more of anything. It occurs when despite putting increasingly more effort into an activity, the desired outcome becomes less and less rewarding.

Case in point, one just has to consider America’s growth of borrowed money and the resulting growth in GDP over the last 50 years.

Chart 1 shows that in the 1950s, America had to borrow just $1.36 to grow their economy by 1 extra dollar. That’s not so bad until you  consider that over the next 50 years America had to borrow more and more to produce less and less GDP. In fact, during the 2000s America had to borrow $5.76 to grow its economy by an extra buck – that’s progress.

Now, we’re sure that over the years all of this borrowed money was put to great use. After all, the future never comes so why worry about it. Unfortunately, the future is today and the “credit cliff” is quite steep (see chart 2). The debt reaper is knocking on the door and he wants his money back. There’s just one minor problem – no one has the money to repay him.

No problem, the central banks & governments have plenty of money tools available to beat back any financial challenges presented by the debt reaper.

To make you feel more uncomfortable, let’s review the tricks in their money bag:

Money tool # 1 = deficit spending. For years, the G7 countries have believed that spending more than you make, will create jobs and prosperity. To measure the success of this strategy, we invite you to hang out in Spain, Greece or Italy.

Money tool # 2 = cut interest rates to 0%. All the really smart people in the World know that lower interest rates encourage people and companies to borrow more money and spend this money. To measure the success of this strategy, we invite you to hang out at the US Federal Reserve and help them count the $1.5 trillion in excess money held by the big banks.

Money tool # 3 = when all else fails print money. Everyone knows by now the reason the Great Depression was great was because no one had the idea to print money to kick start the economy. To measure the success of this strategy, we definitely do not invite you to visit Japan. The Japanese have been printing money for over 10 years and that hasn’t shaken their economy from its funk one bit.

As we enter the always dangerous months of September and October, central bankers and governments just can’t get their heads around the fact that their cherished money tools are not shaking the World. Never one to quit, someone somewhere muttered “we must do something” – and something they did.

Day 1 – September 6, 2012

Up to this point, the European Central Bank (ECB) has provided over EUR 1 trillion in bailouts to banks and countries with two separate Long Term Refinancing Operation (LTRO) schemes. It was thought that these two initial financial bazookas would be enough to restore confidence, but it wasn’t.

Investors became bored with Greece and its 25th final bailout and now all the attention was turning to Spain. The rapid decline in Spain’s real estate market was causing an even rapider decline in the health of Spanish banks. In fear of losing their life savings, people and companies were yanking billions of deposits out of the country.

This bank run was serious stuff. So serious that investors began refusing to lend not only to the banks but to the Spanish government itself. And if Spain wasn’t bad enough, Italy has the potential to be even worse. Yes, the dreaded contagion had started again and this time the hats had seemingly run out of rabbits.

And then it happened. The ECB announced that they would provide unlimited amounts of Euros to any European country that required a bailout. But – because this is Europe, there was a small catch. Any country who wanted the money had to first formally apply.

While this may sound a lot like “pretty please” it isn’t. Unsurprisingly, Germans are growing tired of using their money to bailout it’s southern European friends. Reluctantly, the Germans agreed to this latest save Europe scheme but only if the bailout contained conditions. Now, you can’t really blame Germany for this requirement. After all, it was only a year earlier when Italy pulled the old switcheroo and reneged on its promise to raise their retirement age after receiving bailout money from Germany. Lesson learned.

On hearing that the ECB would provide unlimited amounts of money

over an unspecified time, markets naturally soared on the news. Hey – it’s free money! How could you not like this?

While you would assume this conditionality clause would be deemed fair everywhere else in the World – not so in Europe. Naturally, the Spanish and Italians have a beef – they were under the impression that money is always free, never wrapped tightly with any kind of strings.
Now the World patiently awaits for the Spanish to formally request a bailout, yet the Spanish have an entirely different plan and that plan involves anything to keep Brussels and the IMF away from Madrid.

The Spanish government’s fear (which will soon become reality) is that as soon as these non-Spanish accountants and bureaucrats discover how bad the finances really are, someone might actually lose their job, government car and government expense account.

The irony of course, is that the mere announcement of the ECB’s unlimited money for an unlimited time scheme has had the effect of pushing Spain (and Italy’s) cost of borrowing down. No money or conditions have changed hands, yet markets are reacting as if it already has.

This brings us to a stalemate – as long as Spain’s cost of financing remains low, it will not formally request a bailout. However, we ask you not to fret and frown. As soon as Spanish interest rates shoot up again and thousands of protesters march in Madrid and Barcelona, Mr. Rajoy and his government will be forced to raise the white flag.

What isn’t known just yet, is what happens once the rest of the World discovers how bad Spain’s finances really are. And of course, bailouts aside – none of these money tricks will have any impact on economic growth or job creation.

Nevertheless, everyone in Europe slept well that night – at least for another six days anyway.

Day 2 – September 12, 2012

It was all fine and dandy for the ECB to announce six days earlier that they would provide unlimited money to anyone who formally requests a bailout from Brussels. The ECB however, forgot to mention just one itty bitty tiny detail called Germany.

After three years, the German public have started to become increasingly uncomfortable with giving their money away to Greece, Ireland and Portugal. As one would expect, eventually politicians hear their common man and actually exercise their duty of representation by government.
In effect, the German “no more bailout” snowball has started to roll and its first encounter is the question of whether Germany can legally participate in the European bailout fund – the ESM. While the Law of Diminishing Returns racks up zero billable hours for lawyers, German
lawyers had a field day with the legality behind the ESM issue. The decision would be decided by the German high court and a ruling against the legality of the ESM bailout fund would effectively end the whole Euro experiment once and for all.

When the announcement hit the news wires, the result was unsurprisingly “for” the ESM bailout fund (whew!) yet the decision also came with a twist, similar to the twisted twist delivered by the ECB a few days earlier.

While the German high court stated that the ESM was not against the German constitution, it did set a cap on the maximum amount Germany would contribute to the fund – EUR 190 billion.

This cap can be increased, but only if agreed to by a vote in the German parliament. And considering the taste for additional bailouts is not exactly being embraced by the voting population, this is a significant caveat.

The significance behind this “capped” amount cannot be overstated, and it is only a matter of time before the French catch on to the fact that they’ve just been hoodwinked by the Germans.

With Germany now capping their ESM bailout liabilities at EUR 190 billion, the question must now be asked “who picks up the slack?”
Unfortunately for the French, they have no idea what just happened.

While the good bankers in La Défense are cheering the latest run up in stock prices, the rest of the French population are about to be baguetted in the side of the head.

Considering that France just decreased the retirement age, increased minimum wages while slapping a 75% tax on anyone earning greater than EUR 1 million, the likelihood of it eliminating its fiscal deficit and then reducing its debt are slim and none. Yet, with Germany now drawing a line in the bailout sand, France’s commitments have suddenly increased significantly.

The ESM bailout fund is structured so that if a country requests a bailout it no longer has to accept its share of liabilities. Considering this entire charade is being orchestrated to bailout Spain and then Italy – it directly results in France having to pick-up the tab not being absorbed by Germany.

The numbers are staggering to say the least. Frances’s ESM liability increases from EUR 143 billion to EUR 226 billion. From another perspective, France’s ESM commitment will soon equal over 44% of the government’s tax revenues for the year.

While today, everyone in France is talking about Germany we’re quite confident that at some point soon, everyone in France will be talking about France.

Day 3 – September 13, 2012

With the Europeans clearly taking the lead in shaking the World, you knew it was only a matter of time before the Americans would take note. And why not – America continues to have the World’s largest economy, the World’s largest debt burden and the World’s largest money printing machine.

Since telegraphing its newest money printing intentions from Jackson Hole a few weeks earlier, the only surprise available from Ben Bernanke and the US Federal Reserve was how much money they would print. Guesstimates ranged from $250 billion up to $700 billion. No matter what happened, bankers everywhere had Bollinger Champaign sitting on ice.

Never one to disappoint, Mr. Bernanke’s announcement to print $40 billion a month until eternity was too much for even the talking heads to comprehend. America has now committed to printing money forever – or at least until the job market improves.

This new approach by the Federal Reserve is interesting on several levels. First, previous goals of printing money was to bolster the housing market. It was believed that fixing the housing market would boost the economy out of its slump and save the day. Well, today millions of homes remain worth less than their mortgage and millions more sit in the shadows waiting to be sold. The only bolstering that happened was of the big banks’ bank accounts.

But that’s ok. The Federal Reserve had another trick up its sleeve. Instead of targeting the housing market, it would instead target “wealth creation.”

“Wealth creation” is another academic, economic, and prehistoric belief that if everyone was wealthier, they would spend more money. And as we have all been told, spending your money is a guaranteed way to prosper. Unfortunately for the Federal Reserve, the old wealth creation thingy hasn’t quite worked out either.

And with two strikes in the count, there was nothing left for Ben Bernanke and the US Federal Reserve to do except close their eyes and swing for the fences. And swing they did and they will keep on swinging until something, anything, happens.

Well, one thing is for sure – something will happen.

As for what, we have little confidence it will involve a rebound in the economy or a rebound in new jobs – you need “real” not “manufactured” prosperity for this to happen.

What will happen, will be a continued widening in the rift between financial markets and the economy.

There is little doubt this new edition of money printing American style will bolster financial markets, the fact remains that the real economy in the US, Europe and Japan will not begin to recover until the central banks and the governments simply allow bad debt to be written off. At this rate, don’t hold your breath as the bad debt scenario will not be allowed to happen anytime soon.

Continue reading below:


On The Rise Of ETFs As A Driver Of Bond Returns

The seemingly inexorable rise of corporate bond ETFs (most specifically HYG and JNK is the high-yield market, and LQD in investment grade) have been discussed at length here as both a ‘new’ factor in the underlying bond market’s technicals (flow) as well as their correlated impact on equity and volatility markets. Goldman Sachs’ credit team delve deep into the impact of these relatively new (and rapidly growing) structures with their greater transparency but considerably higher sensitivities and conclude that not only are they here to stay but the consequences of ETF-inclusion (dramatic outperformance bias relative to non-ETF bonds) are deepening the liquidity divide (and relative-value) of what is already a somewhat sparsely-traded market. Our concern is that, as the divide grows (and liquidity is concentrated in ETF bonds), given the crowding tendency we have witnessed, (even with call constraints at extremes thanks to low interest rates), this is yet another crowded ‘hot potato’ trade hanging like a sword of Damocles over our markets (courtesy of Bernanke’s repression).


Via Goldman Sachs: The “ETF Bid” – A Robust Driver of Bond Returns.


The dramatic growth of credit mutual funds over the past five years has been something of a paradigm shift for the US corporate bond market. According to data from Lipper, IG and HY mutual funds manage roughly $1.3tr and $279bn, respectively, up from $525bn and $126bn at the end of 2007. Even when scaled by the overall size of the US corporate bond market, these figures suggest a bigger ownership share of credit mutual funds. Perhaps more impressive is the growth of corporate bond ETFs, whose size for IG and HY has increased to $105bn and $31bn, respectively, from just $12bn and $288mn at the end 2007.

Despite all-time low yields, the appetite for corporate bonds remains firm, with net inflows to IG and HY mutual funds still running at a robust pace.


Inflows to the HY market have been steady all year with the exception of a brief episode of outflows from mid-May to mid-June, while IG inflows have remained firm, having been positive for all but two weeks this year.


As we often point out, the strength of the inflows is by and large a reflection of sluggish growth, which has maintained a friendly outlook for inflation as well as a challenging outlook for growth expectations, trends we expect to persist.

In the past we have extensively analyzed the price impact of mutual fund flows, showing that fund flows provided a significant boost to bond returns in the early months that followed the crisis and gradually normalized afterwards. In this Credit Line, we focus on the ETF market and use bond-level data to quantify the impact of ETFs on the cross-section of IG bonds returns.

Despite their recent growth, ETFs remain a relatively small subset of the mutual fund complex, but they are of particular interest to us, for two reasons. First, unlike mutual funds, ETFs generally try to track an existing bond index and are thus more transparent in terms of their composition. Second, unlike institutional investors, ETF managers need to be fully invested, and thus need to put money to work “urgently” when inflows increase. Intuitively this should make returns on ETF bond constituents more sensitive to flows.


The ETF factor: Is it really there?

Our primary goal is to determine whether, all else equal, the bid for ETFs has boosted the return on their bond constituents, both in absolute terms and relative to the broad market.

More specifically and using the bond constituents of the iBoxx USD domestic index and its sub-index the LQD IG index, which is tracked by one the largest IG ETFs, we investigate the following questions:

  1. Controlling for maturities, ratings, sectors and liquidity, how do the bond constituents of the LQD ETF perform relative to those bonds that are not part of the ETF? Put differently, how do two otherwise identical portfolios of bonds, one with ETF constituents and the other with non-ETF constituents, compare in terms of performance.
  2. To what extent is this relative performance related to ETF flows?

To address the above questions, we use a factor approach and construct hypothetical portfolios, one with only ETF bonds and the other with non-ETF bonds, that have otherwise identical compositions. These portfolios are constructed using the constituents of the iBoxx USD domestic index of which the LQD ETF is a sub-index.

One immediate challenge that such an exercise raises is that our ‘ETF’ factor might be hard to disentangle from a ‘liquidity’ factor. In the extreme case where the ETF only include on-the- run bonds, the ETF factor might just be an arte fact for the on-the-run/off-the-run premium. Partly to address this issue, we include an “on-the-run” dummy variable in our regressions.

Our definition of on-the-run bonds uses the following rule. We group our universe of bonds into three buckets in terms of their original maturity: 1- to 7-year, 7-to 15-year and 30-year and longer. Within each of these buckets and for each issuer, we rank the bonds according to their age. The most recently issued bonds are considered on-the-run while the remaining ones are treated as off-the-run.


Exhibits 5 and 6 plot the cumulative total return and spread change since January 2009 for these two otherwise identical portfolios of ETF and non-ETF bonds. The plot shows that after controlling for maturity, rating, sector and the on-the-run/off-the-run premium, ETF bonds outperformed their non-ETF counterparts from the second half of 2009 to the first quarter of 2011. They subsequently underperformed in the second half of 2011 as the European crisis intensified only to resume their outperformance during the LTRO rally and then more recently following Draghi’s speech in July.


Compared to January 2009 and as shown by Exhibit 6, a monthly rebalanced portfolio of ETF bonds trades 268 bps tighter while an identical portfolio of non-ETF bonds trades 200 bps tighter. This suggests that the bid for ETFs has acted as a tailwind for its bond constituents since the economy turned the corner in the second half of 2009.

Exhibit 7 addresses our second question—the relationship between the relative performance of ETF bonds to ETF flows—showing a simple scatter plot of the monthly return on a long ETF vs. non-ETF bonds against the flow 4-week moving average into IG ETFs.


Our estimates indicate that the correlation is decent with every additional $1 bn worth of weekly average inflows to IG ETFs translating into 60 bp of additional monthly return on a strategy that is long/short two otherwise identical portfolios of ETF and non-ETF bonds.

In sum, the above evidence suggests that fund flows to ETFs are likely to remain an
important driver of credit spreads for the foreseeable future.

"What's Next?": Simon Johnson Explains The Doomsday Cycle

Via Simon Johnson and Peter Boone – Originally posted at VoxEU, (Via CentrePiece magazine)

There is a common problem underlying the economic troubles of Europe, Japan, and the US: the symbiotic relationship between politicians who heed narrow interests and the growth of a financial sector that has become increasingly opaque (Igan and Mishra 2011). Bailouts have encouraged reckless behaviour in the financial sector, which builds up further risks – and will lead to another round of shocks, collapses, and bailouts.

This is what we have called the ‘doomsday cycle’ (Boone and Johnson 2010). The cycle turned in 2007-8 and was most dramatically manifest in the weeks and months that followed the fall of Lehman Brothers, the collapse of Iceland’s banks and the botched ‘rescue’ of the big three Irish financial institutions.


The consequences have included sovereign debt restructuring by Greece, as well as continuing problems – and lending programmes by the IMF and the EU – for Greece, Ireland, and Portugal. Italy, Spain and other parts of the Eurozone remain under intense pressure.

Yet in some circles, there is a sense that the countries of the Eurozone have put the worst of their problems behind them. Following a string of summits, it is argued, Europe is now more decisively on the path to a unified financial system backed by what will become the substance of a fiscal union.

The doomsday cycle is indeed turning – and problems are undoubtedly heading towards Japan and the US: the current level of complacency among policymakers in those countries is alarming. But the next turn of the global cycle looks likely to hit Europe again and probably harder than before.
The continental European financial system is in big trouble: budgets are unsustainable and growth is nowhere on the horizon. The costs of bailouts are rising – and the coming scale of the problem is likely to undermine political support for the Eurozone itself.

The structure of the doomsday cycle

In the 1980s and 1990s, deep economic crises occurred primarily in middle- and low-income countries that were too small to have direct global effects. The crises we should fear today are in relatively rich countries that are big enough to reduce growth around the world.

The problem is that the modern financial infrastructure makes it possible to borrow a great deal relative to the size of an economy – and far more than is sustainable relative to growth prospects. The expectation of bailouts has become built into the system, in terms of government and central bank support. But this expectation is also faulty because, at times, the claims on the system are more than can ultimately be paid.

  • For politicians, this is a great opportunity.

It enables them to buy favour and win re-election. The problems will become apparent, they calculate, on someone else’s watch. So repeated bailouts have become the expectation not the exception.

  • For bankers and financiers of all kinds, this is easy money and great fortune – literally.

The complexity and scale of modern finance make it easy to hide what is going on. The regulated financial sector has little interest in speaking truth to authority; that would just undercut their business. Banks that are ‘too big to fail’ benefit from giant, hidden and very dangerous government subsidies. Yet despite repeated failures, many top officials pretend that ‘the market’ or ‘smart regulators’ can take care of this problem.

  • For the broader public, none of this is clear – until it is too late.

The issues are abstract and lack the personal drama that grabs headlines. The policy community does not understand the issues or becomes complicit in the schemes of politicians and big banks. The true costs of bailouts are disguised and not broadly understood. Millions of jobs are lost, lives ruined, fiscal balance sheets damaged – and for what, exactly?

Over the past four centuries, financial development has strongly supported economic development. The market-based creation of new institutions and products encouraged savings by a broad cross-section of society, allowing capital to flow into more productive uses. But in recent decades, parts of our financial development have gone badly off-track – becoming much more a ‘rent-seeking’ mechanism that draws support from politicians because it facilitates irresponsible public policy.

  • The question is: Who will be hurt next by this structure?

There are three prominent candidates: Japan, the US, and the Eurozone.

Japan’s long march to collapse

Figure 1 shows the path of Japan’s ratio of debt to GDP over the last 30 years, including IMF forecasts to 2016.

Figure 1

This is a worrying picture:

  • Japan has a rapidly ageing population.

The average Japanese woman today has 1.39 children, far fewer than is needed to replace the elderly. This means that the total population is set to decline by 26% by 2050. Having peaked in the mid-1990s, the country’s working age population will decline by a staggering 40% between 1995 and 2050. Naturally, many of the ageing Japanese have been saving for their retirement for decades. They deposit those funds in banks, buy government bonds, hold cash savings or buy Japanese equities.

  • Japan’s growth is slowing.

With an ageing population and slower growth, the broad outlines of responsible policy are straightforward. Japan should become a big investor in countries with younger populations, providing the capital investment needed to generate growth. Those countries can then return the savings to the Japanese as they retire. Singapore’s government does just that via one of the world’s largest investment funds.

Instead, for the last two decades, Japan’s government has been running large deficits, borrowing and then spending the savings of the young. When the elderly finally demand their savings back in the form of pensions, the government will need to reduce its budget deficit of 8% of GDP and start running a sizeable budget surplus. Unless there is a sudden burst of romance and fertility, there will be far fewer Japanese taxpayers in the future to pay this debt.

The government has not been willing to raise taxes in a timely manner to match its spending. The latest agreement is for a modest (5%) increase in the retail sales tax, which would only be fully implemented in 2015. Why would it do so in the future when the burden on the remaining workers will need to be ever larger?

Japan is saved from immediate pressure by the fact that about 95% of its government debt is held by domestic residents. As long as these investors are satisfied with very low – or perhaps negative – real rates, this situation can continue.

But sooner or later, Japan’s dreadful fiscal mathematics will catch up with the government. There is no sign yet of a broad loss of confidence, but major shifts in market sentiment are not typically signalled in advance.

America’s reckless private finance

In the US, the symptoms are different. Figure 2 illustrates the US version of the doomsday cycle: the rise of total credit as a fraction of national income. Major players in the financial system have become too big to be allowed to fail – and consequently receive large subsidies.

Figure 2

The latest crisis has led to the largest monetary and fiscal bailouts on record. The Congressional Budget Office estimates that the final fiscal impact of the crisis of 2007-8 will end up increasing debt relative to GDP by about 50 percentage points. This is the second largest debt shock in US history; measured in this way, only the Second World War cost more. (For more detail, see Johnson and Kwak 2012.)

The alliance that leads to unsustainable finance here is simple: the US financial system earns large ‘rents’ (excess returns to labour and capital) from the implicit subsidies offered by taxpayers. These rents finance a massive system of lobbyists and campaign donations that ensures ‘pro-bailout’ politicians win elections regularly.

Each time the US has a crisis, politicians and technocrats admit their errors and buttress regulators to ensure that ‘it never happens again’. Yet still it happens, again and again. We are now on our third round of the so-called Basel international rules for banks, with the architects of each new reform admonishing the previous architects for their mistakes. There’s no doubt that the US will someday soon be correcting Basel 3 and moving on to Basel 4, 5, 6 and more.

The problem that the country faces is that with each crisis, the financial risks are getting larger. If continued in this manner, bailing out the system will eventually be unaffordable. When the US finally runs out of enough savers to buy the bonds needed to bail out the system, it will suffer the ultimate collapse. (For more detail, see Schularick and Taylor 2012.)

Roughly half of all US federal debt is currently held by non-residents. So US fiscal policy remains viable only as long as the dollar is seen as the ultimate safe haven for investors. But what is the competition? Japan is not appealing today as a haven and it is unlikely to become more appealing in the near term. A great deal of the prospects for the US budget and growth therefore rest on what happens in the Eurozone.

The Eurozone: Flawed dreams

There is no sign that the Eurozone will emerge from crisis any time soon.

The incentive structure of the Eurozone ensured that each country’s financial sector clamoured to join it. The key feature that made it so attractive was the liquidity window at the ECB.

For smaller countries, the ECB is a modern day Rumpelstiltskin. Rather than spinning straw into gold, the ECB converts unattractive government and bank-issued securities into highly liquid ‘collateral’ that can be readily swapped for cash from the ECB. This feature instantly made sovereign and bank bonds very attractive debt instruments. Knowing that the borrowers had essentially unlimited access to liquidity from the ECB, investors became willing lenders at low interest rates to all banks in the Eurozone.

Given such attractive features, it is easy to understand why 17 countries mastered the political debate to join the Eurozone. It is also easy to understand how the system got abused and why it will be so difficult ever to make it ‘safe’. If the Japanese can’t control their public finances and if the US can’t control its too-big-to-fail banks, the added complexity of merging 17 regulators and 17 national governments into a system where someone else can be made responsible for bailing out the intransigents seems a financial and regulatory nightmare.

Such a system is sure to be crisis-prone. The Federal Reserve and the US federal government’s attempt to provide bailouts when there is trouble in the US. But in Europe, the bailouts are only partial. No country has a ‘lender of last resort’ like the Federal Reserve or the Bank of Japan – so markets are now learning that large risk premia are needed to reflect default risk in troubled countries.

Flexible exchange rates would undoubtedly make it easier to manage these crises. Devaluations instantly reduce wages and raise countries’ competitiveness. If Greece had managed a large devaluation, it could probably have avoided much of the unemployment and social turmoil we see today. Instead, each troubled country in Europe now suffers when having to force down wages and prices during adjustment.

This system poses great dangers to global financial stability. The Eurozone faces myriad problems, including insufficient bank capital, high levels of private and public debt, and the chronic inability of some member countries to grow.

It is now common to hear policymakers blackmailing populations: unless the Eurozone survives, tragedy will result. And it is true that tragedy will result; we only need to look at the rise of complex derivatives and the dangers they pose were the Eurozone to dismantle. (For a broader discussion of Europe’s problems, see Boone and Johnson 2011 and 2012.)

Figure 3 illustrates the growth of euro-denominated interest rate derivatives, the notional value of which now totals more than 10 times the GDP of the Eurozone. Regulators commonly use net figures when they consider ultimate risk for banks and this makes sense under the usual circumstances of bankruptcy. But when a currency area breaks up, the practice of netting off contracts needs to change dramatically and banks will be facing far more risks than regulators and risk officers currently report.

Figure 3

For example, if a German bank has a contract with a French bank and an opposite identical contract with a German pension fund, it can net those two contracts and report the ultimate risk as zero. (Of course there is counterparty risk, but under standard agreements, derivatives are cleared instantly at liquidation so the counterparty risks can be netted).

But if investors start to believe that there will be new currencies in each country, then the two contracts in this example are no longer offsetting so they must not be netted. It is reasonable to think that after any demise of the euro, the contracts between two German counterparties will be converted into deutsche marks, while contracts with international partners will be disputed or maintained in a euro proxy.

As a result, risk officers at banks should understand that if the Eurozone breaks up, all banks in Europe face enormous and unaccountable currency risk. Each of their ‘euro’ assets and liabilities needs to be examined to understand into which currency it would be converted. (For more discussion on redenomination issues, see Nordvig and Firoozye 2012.)

The threat of future crises

The tragedy of the Eurozone appears unavoidable, but it reflects far greater risks that will spread to Japan, the US, and other advanced economies.

Through our financial systems, we have created enormous, complex financial structures that can inflict tragic consequences with failure and yet are inherently difficult to regulate and control. We are at the behest of our politicians and financial sectors to prevent them from creating dangers. Yet around the world, our political and financial systems have aligned to build these dangers rather than suppress them.

The continuing crisis in the Eurozone merely buys time for Japan and the US. Investors are seeking refuge in these two countries only because the dangers are most imminent in the Eurozone. Will these countries take this time to fix their underlying fiscal and financial problems? That seems unlikely.

The lesson from all these troubles is clear: the relatively recent rise of the institutions of complex financial markets, around the world, has permitted the growth of large, unsustainable finance. We rely on our political systems to check these dangers, but instead the politicians naturally develop symbiotic relationships that encourage irresponsible growth.

The nature of ‘irresponsible growth’ is different in each country and region – but it is similarly unsustainable and it is still growing. There are more crises to come and they are likely to be worse than the last one.

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