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Michael Pettis Asks "When Do We Call It A Solvency Crisis?"
This post is extracted from Michael Pettis' newsletter sent out a few weeks ago, at a time when the mood in Europe was much better than now and when there was even a sense that the crisis was in the process of being resolved. We mention this to remind readers of how quickly sentiment can change.
Authored by Michael Pettis, originally posted at China Financial Markets,
I got back last week from a two-day trip to London, where I spoke at an interesting event organized by the Carnegie Endowment. The attendees were for the most part senior bankers and investors, and I got the impression that several, though maybe not all, shared with me a certain amount of surprise that European bond markets were up this year. We were even a little shocked that the buoyant markets were being interpreted as suggesting that the worst of the European crisis was behind us. The euro, the market seems to be telling us, has been saved, and peripheral Europe is widely seen as being out of the woods.
I cannot name any of the attendees at the Carnegie event because it was off the record, but one of them who seemed most strongly to share my skepticism is a very senior and experienced banker whose name is likely to be recognized by anyone in the industry. After I finished explaining why I thought the euro crisis was far from over, and that I still expected that absent a serious effort from Germany to boost domestic spending – an effort likely to leave the country with rapidly rising debt – at least one or more countries would eventually be forced off the currency, he told the group that he hadn’t made as gloomy a presentation only because he considered it impolitic to sound as pessimistic as I did.
Neither of us, in other words, (and few in the meeting) felt that the recent market enthusiasm was justified. Never mind that the Spanish economy, to return to the country I know best, contracted again in the fourth quarter of last year, that it is expected to contract again this year, that unemployment is still rising, and that the ruling party is involved in yet another scandal that has driven its popularity down to 20%. Never mind that young Spaniards are emigrating (20,000 a month net), that the real estate market continues to drop, that businesses are still disinvesting and popular anger is extraordinarily high. The ECB, it seems, is willing to pump as much liquidity into the markets as it needs, so rising debt levels, greater political fragmentation, and a worsening economy somehow don’t really matter. This crisis continues to be just a liquidity crisis as far as policymakers are concerned – and not caused by problems in the “real” economy – and the solution of course to a liquidity crisis is more liquidity.
But is peripheral Europe really suffering primarily from a liquidity crisis? It would help me feel a lot better if I could find even one case in history of a sovereign solvency crisis in which the authorities didn’t assure us for years that we were facing not a solvency crisis, but merely a short-term problem with liquidity. A sovereign solvency crisis always begins with many years of assurances from policymakers in both the creditor and the debtor nations that the problem can be resolved with time, confidence, and a just few more debt rollovers.
To take one possibly illuminating example, I started my trading career during the Latin American debt crisis, which officially began in August 1982. I joined the market in 1987, when bankers and policymakers were still assuring everyone that the problem Latin America was facing was a liquidity problem. As long as we could keep rolling loans over, they earnestly explained, the problem would eventually resolve itself at little to no relative cost (well, Latin America was struggling with unemployment, capital flight, hyperinflation and political turmoil, but I guess that doesn’t really count).
It wasn’t until 1990 that the first formal debt forgiveness took place – known as the Mexican Brady Bond restructuring – and before the end of the decade nearly every country except Chile and Colombia had their own Brady bonds. Even those two countries, and all the others, had managed to obtain for themselves a significant amount of informal debt forgiveness through debt-equity swaps and debt repurchases at huge discounts from face value (some legal and some not quite legal).
Why did it take so long for bankers and policymakers to recognize the truth – that this was not just a liquidity problem? Actually it didn’t. Most bankers knew by 1985-86 that the region was actually suffering from a generalized solvency problem, and among the big banks JP Morgan had been taking substantial provisions all along. No one could formally acknowledge the possibility of insolvency, however, because to have done so would have required that all of banks take much greater provisions than they already had. This would have created a problem. Of the top ten banks in America, only JP Morgan would not have been technically insolvent had the banks been forced to mark their LDC loan portfolios to market.
In May 1987 Citibank, after many years of replenishing its capital, was able to announce suddenly and to the great surprise of the entire market that it had decided to take a huge amount of provisions against dodgy sovereign loans. By 1989-90 the rest of the big American banks were also able to accept the write-offs without becoming technically insolvent. That is when everybody formally “discovered” that in fact the LDC debt crisis was a lot more than just a liquidity crisis.
This is the key point. The American bankers weren’t stupid. They just could not formally acknowledge reality until they had built up sufficient capital through many years of high earnings – thanks in no small part to the help provided by the Fed in the form of distorted yield curves – to recognize the losses without becoming insolvent.
And this matters to Europe. There is simply no way European banks, especially in Germany, can acknowledge the possibility of sovereign insolvency until they, too, have built up enough capital to absorb the losses. They have, unfortunately, been painfully slow to do so, even with yield-curve help from the ECB, and so I suspect that this is going to remain a “liquidity” problem for many more years. While it does, the debt-burdened countries of peripheral Europe are going to suffer a decade of weak growth, high unemployment, and contentious politics, all the while the debt growing faster than the economy.
The new gold bloc
Or the peripheral countries can regain competitiveness quickly by leaving the euro, in which case after a year or so of confusion growth would return almost immediately, especially in countries like Spain that have managed to put into place a number of very important labor market reforms. The historical precedent is clear. Crisis-stricken countries that have forced through robust reforms to address their comparative lack of competitiveness will continue to struggle under the burden of high debt and an overvalued currency, but once they directly address both, growth usually returns quite quickly.
And there have been real reforms in Spain for all the grumbling. Several euro-optimists have pointed out that unit labor costs in Spain have dropped substantially relative to Germany, by as much as 6 or 7 percentage points. So this whole reform process is working, they claim, and if we can just wait it out another year or two Spain will be fully competitive again.
I am not so sure. Although I agree that there have been real economic reforms, I am a lot less sanguine about the ability of these reforms to stave off the crisis. First, the reforms have come at a huge social cost, and it isn’t obvious that people can suffer much longer as they already have. After all we know how to force down unit labor costs. It is really quite easy. High unemployment usually does the trick.
The problem is that Spain, after four years of punishingly high unemployment, has only clawed back in labor competitiveness about one-third of what it needs to claw back in total, and Madrid has already picked most of the low hanging fruit. As brutally difficult as this has been, this was the easy part. For Spain to claw back other 10-15 percentage points in unit labor costs, and it may need more, may well be beyond the capacity of the population to endure.
Second, labor is only one factor in international competitiveness. Capital is the other, and everyone is in a hurry to forget this. It is hard to calculate the appropriate trade-off, but while relative labor costs in Spain have certainly declined, the relative cost of capital has just as certainly risen, and probably by a lot more (to the extent that businesses can even get capital). On Monday the Financial Times had this article:
Businesses in the core of the eurozone are cashing in on easy monetary policy to borrow at record low rates, while those based in the periphery are still struggling to find market funding, according to new data. Barclays analysis of European Central Bank data suggests that companies based in the “core” of the bloc have been the main beneficiaries of the central bank’s promise last June to do “whatever it takes” to save the eurozone.
Companies based in France, Germany, Belgium and Holland were able to borrow a net €37bn of ultra-cheap debt from the markets in the second half of last year, following the announcement. But companies based in Italy, Spain, Portugal and Greece added only about €12bn of market borrowing, with only the biggest companies such as Telecom Italia and Telefonica able to access the capital markets.
At the same time these peripheral eurozone countries faced a €65bn reduction in net bank lending, as the region’s crisis-hit banks reduced lending in a bid to strengthen balance sheets.
At best we can say of the combination of lower labor costs and higher capital costs that there has been a transfer of resources from the capital-intensive parts of the economy to the labor-intensive parts. Aside from the fact that this probably doesn’t bode well for future productivity growth, it suggests that for all the pain of reform Spanish businesses still cannot compete.
Some people might argue – and do – that the sharp contraction in Spain’s current account deficit, from 5% of GDP in 2008 to around 1% today, shows that Spain has indeed become more competitive, but this of course isn’t at all obvious. Much of the “improvement” seems to have occurred because of a drop in imports, which suggests greater export competitiveness hasn’t played much of a role here – which it shouldn’t have done if I am right about the impact of higher costs of capital in eroding the benefits of lower labor costs.
Unemployment levels well above 15-20% (and I assume official unemployment of 26% is probably overstated by the failure to account for the “black” economy) are an incredibly effective way of forcing a trade deficit to contract, because when people can’t buy anything, they also can’t buy tradable goods. As they stop purchasing those tradable goods however these goods would necessarily have been diverted to exports, even without any improvement in the country’s overall competitiveness.
This might imply that whatever increase in exports we have seen may be no more than the export of goods that Spaniards used to buy but no longer can. This kind of export performance is not a consequence of improved competitiveness. It is simply a consequence of rising unemployment.
What’s more, if Spain is ever going to repay its very rapidly rising debt, it needs a lot more than a lower trade deficit. It needs a very high trade surplus to fund net capital outflows (unless we are expecting an unlikely surge in net private capital inflows). Actually to be technically correct I should say that in order to repay its debt Spain needs a very high current account surplus, and given Spain’s huge interest burden, this actually means it needs a whopping trade surplus since the trade surplus has to exceed the interest outflows before it can be used to pay down debt. If unemployment is the best tool to get us there, I am not sure the Spanish population can bear the burden needed to get us the necessary high trade surplus.
So in spite of the good news in the Spanish bond markets, I still don’t think we can pop the champagne corks. Except for the debt refinancing costs, the underlying fundamentals have not gotten better in the last six months. At best they are unchanged, and probably they are worse.
How long must Spain hold on to prove how serious it is about staying the course? A lot longer, I think. After all it wasn’t until around 1931-32 that France began suffering from its membership in the gold bloc, but they doggedly held on until 1936 when they finally threw in the towel and devalued. The Spaniards are proving tougher than the French were, possibly because among the older generation (although not so much the younger) there is a tremendous residual worry (and shame) that Spain might not truly be European, and this is creating much of the loyalty to Europe, of which the euro is the great symbol.
But the Spanish still have a lot of pain to absorb. By the way if we were to see an intensification of the debate in France about the euro, I suspect that this will give a green light to Spanish public intellectuals, for whom France is the North Star, to discuss the prospect themselves. Until then, in Spain you are not really supposed to talk about abandoning the euro if you want to be taken seriously. It is a little like England in the 1920s, when for much of the policymaking elite abandoning the country’s free trade principles and leaving gold were unmentionable – until many years of unemployment suddenly made both policies very “mentionable” in the first years of the 1930s.
In my opinion the happy bond markets are, as they have so often been under similar circumstances in history, a little premature. I think the phrase “there is light at the end of the tunnel” was popularized by Herbert Hoover around 1931, when the US stock markets staged a strong rally, convincing him and others that the crisis was over. Of course it wasn’t, and the buoyant markets gave back everything and more over the next three years.
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when there's no more cake...
As a typical, concerned American...
Blah blah blah.
What are the Kardashians up to today??
Which one? The one who likes to get pissed on or the one with a glandular disorder? I can't believe America turned those people into a 100 million dollar empire.
In my opinion the happy bond markets are, as they have so often been under similar circumstances in history, a little premature. I think the phrase “there is light at the end of the tunnel” was popularized by Herbert Hoover around 1931, when the US stock markets staged a strong rally, convincing him and others that the crisis was over.
This article misses the * bigger * historical picture, debt crisis goes back hundreds (probably thousands) of years. EVERY debt based system has failed, from Egypt to Rome to (soon) the USA.
When people finally admit the western economic system is completely idiotic, human beings are basically stupid apes, no individual alone should ever be entrusted with very much power and driving down labour & capital costs will solve exactly nothing we can all finally move on.
Or just repeat the same thing on a larger and larger scale, as is the current mantra.
People need to consume less, countries need to produce less and most debt needs to be relegated to what it was the whole time - fantasy.
/rant
Doesn't Zerohedge need to provide some commentary along with clippings from other people's articles, to avoid getting shutdown?
AP vs Meltwater:
https://www.eff.org/deeplinks/2013/03/ap-v-meltwater-disappointing-rulin...
good link. however the present article is weeks old and offered as contrast to current events. perhaps the author offers permission as it is obsolete newsletter but useful advertising?
" bankers are not stupid. They just could not formally acknowledge reality until they had built up sufficient capital"
Actually, yes they are. Retarded gradeschool kids could have seen this coming..............but to be fair; retarded gradeschool kids arent distracted by near as much coccaine and hookers.............
From the article:
"Of the top ten banks in America, only JP Morgan would not have been technically insolvent had the banks been forced to mark their LDC loan portfolios to market.
In May 1987 Citibank, after many years of replenishing its capital, was able to announce suddenly and to the great surprise of the entire market that it had decided to take a huge amount of provisions against dodgy sovereign loans. By 1989-90 the rest of the big American banks were also able to accept the write-offs without becoming technically insolvent. That is when everybody formally “discovered” that in fact the LDC debt crisis was a lot more than just a liquidity crisis.
The American bankers weren’t stupid."
What ????????????????
So a bank lends more than its capital base as an unsecured loan to a sovereign country and that country cannot repay ?
ONLY A BANKER CANNOT RECOGNIZE STUPIDITY WHEN IT IS STARING HIM IN THE FACE.
I can't wait until the day comes when they disappear.......
And I sure hope the Kardashians are paying their "fair share" in taxes.
But sadly, I can 100% believe that America turned those clowns into what they are. It's ridiculous that every time I go to Yahoo's home page, about every other day there's some idiotic "headline" about them. Those broads are even on TV in Europe. Cultural imperialism at its pathetic worst (and I thought Mickey Mouse was bad).
So Michael is saying our elected officials are liars...?
Oh, wait....
They will lie until the ceiling falls down around them. They are not going to admit their mistakes.
http://ericsprott.blogspot.ca/
Tomorrow
Fall 2008.
In 2014, catalonia will vote for independence.
In 2015, Scotland will vote for independence.
Europe will survive. But there will be hundreds of states where now it are only 27 countries.
Even Belgium could break up in 2015, italy.
Smaller communities are more controllable and make it easier to control finances.
DIVIDE AND CONTROL BITCHEZ!!!!
Exactly right SD. And, each US State sized country should be broken down into smaller States. That is the ability that technology has given humans. No need for banksters either. My bet is on tech and ever faster communications to bring about social change. The ones that want to control are the enemies of all people and many other species too.
Europe will survive as a continent, but not a union. The union will be incontinent. It is pissing itself now and diapers are running out. People are going to remember that Nazi's simply can't be trusted. Nor can nations whose leaders immediately welcomed the invaders without a fight.
Don't get confused. Some Scotish people want Scotland to leave the UK whereas the majority of people in the UK wants to leave the EU. Catalonians want to leave the Kingdom of Spain but stay (or re-enter) in the EU.
So... extrapolating from that logic... We can expect TX, the South, SoCal, Cascadia, etc. to be independent when? Piece of cake, right? Especially with all the local pride and weapons -- compared to those soft, socialist Europeans?
Iowastan?
Solve debt with more debt - it's a twilight zone world we live in. Maybe Tyler can talk to Bezos or Musk about creating a ZH planet.
I had a argument this week about the europea controlled economy.
Believe me... it's hard to explain to a moron that europe can only solve a problem by creating 2 new problems in the future...
and whatever isn't happening right now doesn't bother anybody... untill it happens... than they didn't see it comming...
A wise person once said, "it's not about liquidity, it's about access to credit." Oh, wait.. That was The Barnank. Never mind.
.
A famous person once said:
"I put the hamburger on the assembly line."
. McDonalds.
I would hazard a guess that the one thing they will never say is that there is a solvency crisis. When they do that, the bank runs go to 80% instead of just 30, 40, 50, 60 over the course of days or weeks and the equal and opposite reaction finds critical mass to begin a chain reaction that ends in fission.
It's kind of hard for them bankers to be building a capital store against that sort of admission of a solvency issue when they're paying out capital a fast as possible in the form of compensation, or buying back shares with capital as fast as possible to make the per share numbers look better to drive the stock price up on their equity compensation...
In short- bankers are a bunch of lying thieving parasitic leaches trying to suck all they can while they can, and they are making no arrangement to be able to absorb an admission of a solvency crises on their balance sheets.
the verbal games and interventions have worn me out. wish we could just fast forward to the modern equivalent of a archduke-assassination and get this crap over with. why drag it out?
money changers... olderst profession... always same long noses...
Why do you think the DHS is buying billions in ammunition? Why do you think the media is selling you on drone security? Because we are insolvent.
2002 – 2012 paper trail – Bank of International Settlements [BIS]
http://ideas.repec.org/s/bis/bisbps.html
Great read, Mr. Pettis
thankyou
M Pettis understands economics in a very different way.
Don't expect to understand him easily.
SPIEGEL: There are currently considerations in Berlin to make both creditors and depositors of Cyprus's banks participate in the costs of the bailout.
Rehn: The European Commission is opposed to a debt haircut. Nor do we aspire to include depositors. I am certain that we will find a solution that will take into account the concerns of all the euro-zone countries.
http://www.spiegel.de/international/europe/interview-with-european-currency-commissioner-olli-rehn-on-euro-crisis-a-886736.html
This guy writes like Joan Maudlin. Rhetorical blah.
Pettis is another dodgy old econo-twit rendered obsolete by last Friday's 'New Normal' (of outright theft).
That's unworkable now that central banks have flattened out the yield curve ... or rather, the market has flattened it out. There is declining real demand for credit. Who would lend or borrow for more than a year? How will any loans be repaid?
Pettis refuses to believe/fails to understand that 'other' exchange mechanisms have straitened the precious banking system ... from the outside. Wanna know the real price of money? Go to a gas station and find out! Interest rates are irrelevant, lending is also irrelevant to any purpose other than a rationale for monetary conquest.
South Europe is not Iceland which is an energy exporter. Ditto Mexico, Argentina, Brazil and Colombia during the 'Brady bond' period. Chile had a military government that was borrowing to steal. Pettis avoids any discussion of energy. Wasteful consumption has bankrupted Europe to the point where the banking system has to cannibalize itself to stay alive.
What does Pettis believe happened last weekend? A meteor shower? All the old rules are done in, they are so for a reason. Europe isn't just insolvent it's bankrupt. All of Europe's assets are falling worthless. The only collateral for these loans are bank deposits and some used cars. Now ... the deposits are set to run out the door! Some reform that!
The historical precedent is completely irrelevant. We are in an new operating paradigm that has never existed before: a secular decline in the amount of available, affordable primary energy supplies. There is no precedent for this. There are no energy-wasting 'reforms' that will allow more waste to take place from tomorrow onward.
Pettis is a lost sheep: the energy constraints now are nothing more than a loss of supply growth. Comes soon enough is a set of constraints where supply diminishes with each passing day. There is only one reform possible: to use less.
The reason for the energy problem in the first place is all the growth the system has 'enjoyed' for the past 200 years. Pettis cannot bring himself to understand that the capital is now gone, that the only source is the money derivative found in people's bank accounts. Pettis does not grasp that bank deposits are not fuel and stealing them is not the same as discivering another Saudi Arabia.
With his blabber about 'competitiveness' Pettis comes across as a complete idiot. What reforms are needed: stringent conservation and placement of capital off limits to the capitalists ...
The other reform is to hang said 'capital wasters' by the neck until dead.
He's an academic economist - one of those, if laid end to end with a hundred others, would not reach a conclusion.
"Would I be offbase if I pointed out that all this Debt growth is INHERENT into a banking system that uses fiat currency plus FRB?
It's like pundits arguing about good and bad skiers on Avalanche Mountain.
Can't speak for others, but as someone trained in the real, natural sciences, I always find it useful to start with basic principles. You can't deal with celestial mechanics with flat-earth theories. Not very well, that is. Unless you have the raw power to enforce compliance by 'heretics'.
Same applies to fiscal policy issues, when dealing with a fatally flawed monetary system.
/But don't let me stop anyone from a good... 'discussion'. /s
moronic essay.
Michael Pettis is the best original thinker writing as an economist today with a broad understanding of history.
He has no connection with the mainstream (unless you consider his Beijing professorship mainstream) and his stuff is fresh and thought provoking.
Sometimes it's hard to follow him despite his use of simple English. Perhaps writing in and about China he has to be a little circumspect!