Disaster Myopia, Normal Accidents, and the Euro Policy Elite

2012 has taken on a decidedly optimistic tone after an  inauspicious start.  Some people seem to think that things in the Eurozone are largely settled and done with and that we can begin moving on with our lives.   I am not one of those people.


As we stand today there are two possible outcomes for the EU. In the first scenario, a critical mass of member states enacts a sweeping range of thoughtful and clever reforms that allow them to transform themselves into sustainable economic systems, capable of  creating livelihoods for the majority of the population without placing untenable costs on society.  This will require convincing or forcing a large number of entrenched insiders - politicians, pensioners, workers in closed trades, criminals, subsidized farmers, and so on- to relinquish some or all of the benefits they have come to enjoy over many years to outsiders.  By outsiders, I mean largely mean people under 30.  And they must do so while not incurring adjustment costs so high as to break the fragile banking system and, by extension, the EU.  This doesn't mean simply firing people and exposing uncompetitive enterprises, public or private, to economic realities, it means having a significant number of people consent to their lives being drastically changed so that others might have the opportunity to live productive, dignified lives.


It is that, or the EU continues to slowly deteriorate until it won't, at which point policy makers will find the decisions being made for them.  It didn't always have to be this way.  But this is what the EU's assembled political apparatus has left us with.  In zen bhuddism, this is called 'small mind'.  In markets, we call this disaster myopia, or perhaps simply collective incompetence.

Prospects for Structural Reform in Italy: Evasori, 'ndrine, and the Culture of Non-Compliance

Perhaps its better not to look

In the wake of Silvio Berlusconi’s departure from Italian politics and the ascendancy of Mario Monti’s technocratic government, many commentators have suggested that Italy’s fate now hinges on the achievement of structural reform that will allow it to win its race against rising debt service costs, slow growth, and a rapidly graying populace.  With this in mind, I’d like to review some of the more disconcerting structural features of the Italian economy that should illustrate the magnitude of the problems facing Italian policymakers, many of which have been a part of the Italian economic landscape for decades.   Achieving reform will be a challenging task, demanding policy that is effective on a micro-economic level and capable of altering a deeply ingrained culture of non-compliance.

Hungarian Hot Pot

This could hurt a bit

“Men!” announced the baneful god of Pannon memory 

"I give to you a joyous land; yours to fight for, if necessary” 

So great, brave nations fought determinedly for her 

Until the Magyar finally emerged as the bloody victor 

Oh, but discord remained in the souls of the nations: the land 

Can never know happiness, under this curse’s hand"

19th century Hungarian romantic poet Mihály Vörösmarty, expounding on the ill fortune that has so frequently cursed his native land.  


Hungary has been getting a lot of press lately as its looming debt and balance of payments crisis continues to intensify, with Fitch lately joining S&P and Moody’s in downgrading the former Republic of Hungary (now just Hungary) to junk.  I've taken an interest in Hungary in the past few months as it offers an interesting play on European deleveraging while its increasingly erratic and isolationist administration has provided some of the most exciting political theater to date in the Euro crisis.

With the situation beginning to spiral out of control after a disastrous bond auction and an ever-weakening domestic currency, Hungary will likely need outside assistance similar to what it received in 2008 in order to arrest its slow but steady downward trajectory.  In light of the potentially dire economic consequences, the analyst community seems to regard an IMF/EU deal as a foregone conclusion, having taken at face value the government’s recent comments on its willingness to negotiate in good faith. 

Why Dragonomics is Wrong

A colleague recently forwarded me an amusing puff piece from a few months ago on the prospects for China drawn up by Arthur Kroeber at GK Dragonomics, in which he argues that there is nothing to fear from a slowdown as all of the elements of the Chinese growth story remain intact.  While I'm not without my own vested interest here I'd like to address his analysis and in doing so further illuminate my own perspective.  His argument is inconsistent and contradictory, frequently lapsing into broad generalizations extrapolated from top-down aggregates, and evades the fundamental problem at the core of the Chinese economic machine.  In this respect its fairly representative of most of the bull-case arguments floating around as of late, so I figured I'd take a crack at it. 

My issues center around a critical distinction, the importance of which I think is pretty hard to overstate- while China is undoubtedly in need of hard infrastructure in some areas, the real problems that will continue to hinder Chinese development are in the country’s ‘soft’ infrastructure – its political and legal system in general and its capital allocation infrastructure specifically.  This is attributable to the limited liberalization of interest rates, the dominance of finance by state-controlled banks, and the attendant politicization and corruption of capital allocation.  This is a government that has its hands on everything.  Even with efficient capital allocation rapid growth, such as that enjoyed by China in the past decade, is often accompanied by accumulated imbalances and when you wed the captive below-market financing offered through financial repression to China's banking system the results are unlikely to be positive.  Indeed, the past three decades of Chinese banking suggest that when the bill inevitably comes due, the costs will be enormous.

Repo & Euro Financials' Intermediation of Shadow Banking

Despite a less-worse Italian auction this morning, the Euro took a rather ominous swan dive this morning on the wholly unsurprising announcement that the ECB’s balance sheet has swelled to an all-time high of €2.73 trn.    With the market otherwise fairly dull (aside from the odd story about JPMoMo sticking it to some infants and widows with a BBG headline comparing the House of Dimon to the Wehrmacht) I figure I’d take the time to succinctly re-cap my views on Europe, which I briefly touched on in my post last week.

I’m not negative on LTRO per se.  I just think that the necessity of LTRO speaks volumes about the dire funding situation of Euro banks and to the inability of the EU as a federal body to summon the political will to act comprehensively and decisively.  As we lose count of the number of EU interventions lets not forget that this is a slow-rolling, snowballing crisis that has been mounting for more than a year, during the course of which the EU has lost its credibility as a crisis manager.  In LTRO we have yet another stop-gap, backdoor solution that barely responds to the immediate problems while leaving little possibility of further rapid expansion should the situation fail to improve on its own.  A significant improvement in the policy environment notwithstanding, I don’t feel that this is a particularly likely outcome. 

LTRO may look impressive at first glance.  However, with €291.6bn maturing from the ECB’s 7 day main repo operation (MRO) and €169bn of MRO financing rolled on 12/21 against a further €140.6bn of older LTRO maturing (with only €29.7bn rolled), the actual new credit extended is significantly less.  Net this refinancing against a slight increase in fixed-term deposits (€3.5bn) and €45.7 bn moved from October’s 12 mo. LTRO, the new 3-year LTRO adds only €206.5bn in new repo financing extended to financials.  It’s worth noting that this covers only about 60% of the approximately €350bn of sub/unsecured/and otherwise currently un-rollable debt maturing in the coming year.