Sunday, December 4, 2011

Economic Commentary: Eurozone crisis and Depression era politics - Ari

First I'll briefly discuss the Eurozone crisis and then delve into the possibility that the US will repeat depression era politics and fiscal policies.

The Eurozone crisis is truly in the endgame. Investors began shunning even German debt in the past two weeks and the EU leaders responded by swiftly negotiating for fiscal union. There is now a consensus that Europe must begin the formation of a fiscal union in the very near future (probably within 4 weeks) or face a self-fulfilling spiral into disintegration The big announcement three days ago of coordinated central bank intervention only prevented the collapse of several European banks this week. It basically provided unlimited overnight funding to avoid liquidity problems. It did not deal with the sovereign debt issue at all. A possible short-term bandaid that's being talked about is an $700 billion+ bailout for Italy that would include IMF funding. This would require a vote by Congress, and it looks like Republicans are unlikely to approve this. The real solution is to turn the eurozone monetary union into a fiscal union, but Germany wants to walk a fine line. They are advocating a fiscal union but say that the issuance of eurozone bonds is completely off the table. They're demanding almost unilateral control over the eurozone budgetary process, which is unacceptable to France. The ECB is currently standing firm against monetizing the debt of the profligate countries, but suggested they will be willing to step in aggressively if there is a credible plan for fiscal union in the future. I'm not an expert on European politics, but I'd guess that there's a 40% chance they'll form a meaningful fiscal union, a 35% chance the eurozone dissolves, and a 25% chance of something in between (e.g. a two-tiered euro or a couple countries leave). I've been short a small number of euros for the past two years and have scalped around the last couple weeks, but am retaining a small short position. We will likely get a major announcement within the next 10 days.

In the Great Depression, the economic consensus was for a policy of fiscal austerity. The wealthy banker Andrew Mellon advised president Herbert Hoover to, "liquidate labor, liquidate stocks, liquidate farmers, liquidate real estate… it will purge the rottenness out of the system. High costs of living and high living will come down. People will work harder, live a more moral life. Values will be adjusted, and enterprising people will pick up from less competent people." Today economists understand that in a recession, companies and consumers deleverage, so the government must increase spending or you can get a downward spiral. To take a simple example, consider bank assets. In 2008, many banks were leveraged 40 to 1 or even 150 to 1. That means that if asset prices fell by just 2%, these banks were insolvent. When asset prices fall 1%, banks start selling assets to raise capital; this selling sends prices down further forcing more selling, which sends prices down further and so on. In the classical view of the free market system, smart buyers will step in to buy up these underpriced assets. But what if there's more forced selling than money available to buy? If the majority of investors try to sell at the same time, prices will continue collapsing until some new source of buying power enters the system. Partly because of President Hoover's fiscal austerity measures, the Great Depression became deeper and lasted longer than necessary.

Ben Bernanke learned this lesson and in fact wrote several academic papers on how the central bank should have "dropped money from a helicopter" back in 1930 to prevent the depression. Bush, Obama, Paulson, and Geithner were also determined to avoid repeating history and they launched the most ambitious fiscal stimulus projects since the New Deal. However, the political sentiment today is that we have little to show for the spending and money printing, and the excessive deficit is the biggest problem.

I see two likely political paths that both lead to bearish outcomes. The first is that the market and unemployment continue to improve through election day and Obama is re-elected. By choice or because he simply can't get Congress to pass any spending bills, government spending shrinks. This will happen automatically unless Congress reverses the automatic spending cuts that were part of the debt ceiling legislation this summer. Obama will likely resist republican pressure for even greater spending cuts and will be painted as profligate. Within a couple months of the next term, I would expect markets to be turning downward in anticipation of next recession that these spending cuts will almost inevitably create. Obama gets blamed for the worsening economy, and 4 years later we get a "tea party" style candidate who takes austerity to an extreme and creates deflationary pressure for an additional 4+ years.

The second path is that the government is unable to "juice" the economic data into election day and Obama loses. The republican led government imposes austerity which creates a recession. The negative effects of the austerity are quickly visible and the next candidate reverses course with mild "New Deal" type policies. Either way, it seems like we're going to be getting some form of fiscal austerity in the next few years that will be very bearish for the markets. Historically, the stock market has rallied strongly in the 4th year of a president's first term; the president has the ability and incentive to "juice" the markets in all sorts of ways. I wouldn't be surprised by a repeat heading into the upcoming presidential election and will be looking to buy equity puts if the rally happens.

It's worth repeating a key theme in this commentary of the last two years: company revenues, profit margins, and balance sheets are healthy; but only because of the exceptional fiscal and monetary policies. Back in 2008, the Fed made $7.7 trillion in loans to banks (the exact number was just made public recently), from which the banks profited directly by at least $13 billion. Of course, they profited much more indirectly by being able to avoid costly liquidations and continue funding their core operations. Similarly, the fiscal stimulus has mostly wound up in the coffers of large corporations. As soon as the US deficit shrinks, we'll see profit margins fall immediately, and revenue growth will likely decline after a small lag.

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