14/10/2014: Budget 2015: Economic Forecasts a Bit Optimistic

Here's my take on economic side of the Budget 2015 projections:

Gross current expenditure for 2015 will be just over €50 billion. This figure represents an increase of €429 million over the 2014 Revised Estimates. Note: in H1 2014, Government spent EUR35.567 billion which is EUR1.255 billion more than in the same period 2013. As unemployment fell, social benefits rose from EUR13.823 billion to EUR14.016 billion. General Government Deficit has fallen only EUR307 million y/y in H1 2014. These numbers are not consistent with strong economy or strong fiscal performance. Meanwhile, the state took out of the economy EUR1.893 billion more in taxes and social contributions in H1 2014 compared to H1 2013. Where did this increase of funding go?

Government deficit target for 2015 is 2.7% of GDP under ESA 2010 classification. Which means that going back to Troika programmes-comparable measure (ESA 1995 classification), the target deficit is closer to 3.2% of GDP. This is ahead of 3% target and shows how much debt we owe not to smart management of resources, but to accounting rules changes.

Here's a set of economic puzzles courtesy of the Department of Finance:

Real growth is slowing down from 2014 levels, but employment generation is rising. A puzzle. Especially as domestic demand is expected to grow at same rate in 2015 and growth rate is expected to fall in years after.

As compared against other organisations forecasts:

Added puzzle: IMF projections for Irish economy real GDP growth are: 2015 3.045% - full 0.85 percentage points lower than DofF, 2016: 2.538% which is full 0.87 percentage points below DofF, in 2017 : 2.649% or 0.75 percentage points below DofF… and so on.

And another kicker in the teeth… the promise of fiscal rectitude and 'no going back to boom-and-bust cycles':

All of the above is rather academic, since the Department of Finance refuses to forecast Gross Voted Current expenditure of the Exchequer beyond 2015, setting all of it at EUR50.075 billion for each year 2015-2018. Which means the estimated effects on deficit and on borrowing are based on assuming zero growth in spending and continued growth in tax revenues. Happy times roll, even though Haddington Road agreement is about to expire.

Still, as you can see, debt/GDP ratio is expected to fall, courtesy of higher GDP, including the new classification effects that came into force this year. But debt itself is not expected to fall. Instead, from EUR 203.2 billion, Government debt is expected to rise to EUR 215 billion in 2017 and basically stay there in 2018.

So on the balance: a bit too much optimism, especially past 2015. Not enough risk cushion. May the numbers turn out this well in reality...

14/10/2014: One Chart to Keep in Mind when Watching Budget 2015

When you are listening to the Budget 2015, remember this chart:

Corporate activity has been booming (per National Accounts), Households' tax burden has been booming too...

14/10/2014: Expect the Expected: pre-Budget 2015

Pre-Budget Budget... what to expect based on leaks so far:

Big Items:

1) Corporate Tax Regime changes: we can expect some phasing out to be announced for the notorious Double-Irish Tax Scheme.

This is one of the most criticized parts of the Irish tax code. Double Irish a complex corporate structure whereby a multinational can channel revenues to an Irish subsidiary, which then pays royalties on Intellectual Property to another company resident in Ireland, but tax resident in a tax haven, e.g. Bermuda.

To close the loophole, we can expect the Government will announce that all companies registered in Ireland will be automatically deemed tax resident in Ireland. Such a change will make Irish tax law fully aligned with the US and UK systems.

Since MNCs employ around 160,000 in this country, or roughly 8.6 percent of our workforce, the impact can potentially be significant. Which means Minister Noonan will have to be careful in closing the loophole. It is expected he will off-set the impact by expanding the R&D and Intellectual Property taxation benefits.

It is worth remembering that in October 2012, Michael Noonan solemnly declared that changing the Double Irish 'situation' was not within his remit. Direct quote: "Mu understanding of the "double Irish" is that while it exists, it cannot be remediated by changes in Irish tax law".

2) Households: Budgets 2009-2014 have lifted tax (direct and indirect) take by EUR11.7 billion. Meanwhile, on spending side, all years of austerity have basically meant that our Government spending (excluding banks measures) stayed relatively flat on pre-crisis levels.

There has been re-allocation of some spending from services to paying interest on our massive debt, which or course means there were cuts to some specific services. But we had no significant improvements in public sector efficiencies and we had no significant changes in how the State does business:

• Semi-state companies continue to inflate their books by charging higher and higher prices, blessed by captive regulators;
• State employment, pay and promotion policies remain detached from productivity;
• State pensions remain unfunded, private pensions becoming de-funded;
• State health system continues to crumble, while private subsidy to this system is being eroded;
• Management in public services remains excessively bloated and inefficient, compared to front-office staff which is getting worked harder.

All of which means that 'austerity' years have shifted the burden of state even more directly onto ordinary income earners.

Now, with the economy expected to grow by 4.7 percent in 2014 and deficit expected to fall thanks to the national accounts reclassifications and booming MNCs tax arbitrage, Minister Noonan has some room for minor giveaways.

We can expect that he will cut income tax burden, possibly by lowering the top 52 percent tax rate or raising the income threshold for that rate. Another possible target is much despised USC which currently hits workers on earnings from €10,036.

Keep in mind, whilst the Government will claim credit for any tax reductions and austerity easing, these were made possible, primarily, by the EU-mandated changes in our National Accounts. On the other hand, keep also in mind that the Troika-demanded water charging is introduced as double-taxation measure on foot of Government-own design.

To appease trade unions and other 'Social Partners' pivotal to the Labor Party electoral base, he could also announce the hiring of more teachers and increase some benefits. One point he will probably address is the kick backs to taxpayers and vocal interest groups in terms of reduced cost of water provision. Rumour has it, he will:

• Create additional EUR100 credit for the elderly for water services; and
• Announce tax relief on water charges.

Net outcomes: We are some 18 months away from elections and the Government desperately needs to test waters to see what response from electorate they can get if they start 'McCreeviasing' their Budgets. Over months to come, the Government will be closely watching changes in opinion polls as a function of Budget 2015 'easing' of the austerity. Which is all about one thing: instead of 'stimulating the economy', the Government is attempting to gauge the extent of the Budget easing stimulus on electorate.

Still, keep in mind: Budget 2015 is likely to cut spending and raise revenues by some EUR800-900 million. So small giveaways will mask still substantial austerity. Which means that Budget 2015 is going to be about reallocating once again the burden on budgetary adjustments. Pensioners (already massive winners during deflationary period in the economy and low on debt burden courtesy of the previous property boom) are going to gain. Special interest groups are going to gain. General economy, ordinary working households are going to lose.

'McCreevization' by one half, then...

Little pesky details: Budget 2015 is, in part, going to be based on some non-trivial economic assumptions. In best practice terms, these should be conservative, rather than optimistic. But in Irish reality, the champagne of big 7.7% headline GDP print in Q2 2014 is starting to hit some heads in the Department of Finance. Government's forecast for 2015 Budget is for 3.6% GDP and 3.3% GNP growth. Seems conservative compared to H1 2014 figures, but is it conservative enough? Underlying these, there is a forecast for exports growth of 5% y/y in 2015. Again, might be a tad optimistic. And we also have forecast for accelerated jobs creation over 2015 +2.2% growth) compared to 2014 (+1.8% growth), despite the fact that the Government is forecasting slower economic growth in 2015 (3.6% GDP and 3.3% GNP) than in 2014 (4.7% GDP and 3.1% GNP).  Interestingly, in SPU 2014 (April 2014), the Government estimated employment growth to be 2.2% in 2014 and 2.0% in 2015. This is now revised down to 1.8% for 2014 and up to 2.2% in 2015. Labour force growth was penciled in at 0.5% in 2014 and 0.8% in 2015, but by Budget 2015 it was revised down to -0.1% in 2014 and up to 0.9% for 2015.

Past optimism is being reloaded forward? Or did someone miss their cup of milk before going to bed?

13/10/2014: Germany: Too Old to Read Paul Krugman or Rescue Europe

You want to know WHY Germany ain't 'saving Europe' in a fashion favoured by Paul Krugman? Read this:

Key point, of course, is demographics. Germany already experiencing shrinking working age population pool. And this process is only going to accelerate.

Here are 2009 projections for worker/retired ratios in economies:

Source: http://www.ncpa.org/pdfs/st319.pdf

This shows Germany as second worst-off economy to Italy. And here (from the above source) estimates of pensions and health liabilities:

In 2012, Germany already had second lowest income replacement ratio for new entrants into workforce, meaning its capacity to fund future cost increases without hitting directly the retirees is now pretty much exhausted:

Source: http://www.oecd-ilibrary.org/finance-and-investment/oecd-pensions-at-a-glance_19991363

And here's a table of projections for public spending on pensions, showing Germany accelerating spending as share of GDP earlier than other comparable economies:

All of which means that Germany is not in a position to ramp up leveraged fiscal expenditure or investment. It has no fuel to move itself, let alone the Euro area. So stop calling on Germany 'to do the right thing'. It is too old to read Paul Krugman.

11/10/2014: WLASze: Weekend Links on Arts, Sciences & zero economics

One of my by-now rather irregular WLASze posts: Weekend links of Arts, Sciences and zero economics. Enjoy!

In the week of Nobel prizes, it is worth taking a look at some awards.

Chemistry: a well-deserved award for empirical work on improving our ability to observe sub-cellular activities http://www.nytimes.com/2014/10/09/science/nobel-prize-chemistry.html?partner=rss&emc=rss&smid=tw-nytimes&_r=0 And a lovely story of a scientist leaving a big mark on his field and then leaving the field…

Meanwhile, in Physics, the Prize went for an invention that is rather more about engineering than science: the LED (and a sub-component of that, to boot): http://www.nytimes.com/2014/10/08/science/isamu-akasaki-hiroshi-amano-and-shuji-nakamura-awarded-the-nobel-prize-in-physics.html?rref=science&module=Ribbon&version=context&region=Header&action=click&contentCollection=Science&pgtype=article In my view, nothing earth-shattering as far as knowledge goes, but big item as far as practical applications are concerned.

Physiology (or popularisingly: Medicine): an exciting choice covering the discovery of the structure of the brain responsible for spatial positioning: http://www.nytimes.com/2014/10/07/science/nobel-prize-medicine.html?rref=science&module=Ribbon&version=origin&region=Header&action=click&contentCollection=Science&pgtype=article

And a priceless account by 2011 Nobel Physics Prize winner of his attempt at smuggling the Nobel medal to fargo, North Dakota… http://blogs.scientificamerican.com/observations/2014/10/10/nobel-prize-airport-security/

Stories are the stuff Literature is made of. And Modiano - this year's winner - is no stranger to them. http://www.theguardian.com/books/2014/oct/09/patrick-modiano-wins-nobel-prize-for-literature. Another take on same: http://moreintelligentlife.com/blog/simon-willis/my-first-patrick-modiano.
Let my literary professionals friends take this one over…

While you were on the pages of Scientific American, did you spot this gem? "Is Kindness Physically Attractive": http://blogs.scientificamerican.com/beautiful-minds/2014/10/09/is-kindness-physically-attractive/ . Clearly, there's no end to social 'sciences' experimentation… at which point it is probably worth shouting: "Stop! Leave at least something undiscovered, will you?" To break my own chain of thinking - here's a link I blogged on before, covering the Mathematics of Beauty: http://www.boston.com/ae/theater_arts/articles/2009/02/22/beauty/?page=full

But no, never, reply social 'scientists', deploying a total buzz-killer: the Social Machines to Tackle Twitter http://socialmachines.media.mit.edu/ At least, for now, the machines are chasing us… for now… Half-ironically, earlier today I tweeted:

which relates to the MIT Media Lab's latest Lab nicely and, of course, confirms the self-referential nature of social 'science'. At one point we will get fed up with all this trawling of the  www and start thinking once again.

Meanwhile, for those who still marvel at art and science and thought, a nice essay on one of my favourite artists of all times, Anselm Keifer: http://www.prospectmagazine.co.uk/arts-and-books/anselm-kiefer-inside-a-black-hole

Here are some of the links to his works:
http://www.saatchigallery.com/aipe/anselm_kiefer.htm

https://theartstack.com/artists/anselm-keifer
http://www.tate.org.uk/art/artists/anselm-kiefer-1406
Maybe it's German psyche exposed. Or human one. Or both... just kidding...

And to marvel at something entirely different, a wonderful essay on the Killogram: http://moreintelligentlife.com/content/ideas/tom-whipple/weight-almost-over via The Economist's Intelligent Life supplement.

9/11/2014: New WP on Tsallis Entropy application to FTSE & AIM

Just got a new Working Paper over the line (submission ready over the weekend): "Tsallis Entropy: Do the Market Size and Liquidity Matter?" (October 2014). Available at SSRN: http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2507977

9/10/2014: Where Did Ireland's Young Ones Go?..

ECB Monthly Bulletin for October: https://www.ecb.europa.eu/pub/pdf/other/art1_mb201410_pp49-68.en.pdf has a nifty chart, mapping proportion of younger people who are not in employment, education or training:

So guess what... Ireland has 3rd highest inactive population of younger people as proportion of total population - in other words, those who are neither unemployed, nor in education or training. And Ireland had the 3rd highest inactive population of the younger people back in 2007 too.

What on earth are these young people doing?! Working in the black economy?

9/10/2014: IMF Lagarde: We Are Out of Ideas, You Are Out of Convictions

In several recent posts, I have highlighted the fact that the IMF - that stalwart of global 'structural' reforms - has now effectively exhausted its toolkit of ideas as to how we can get global growth back on track. And the governments around the advanced economies world are now equally out of conviction to deploy the IMF's old toolkit.

This is evident across the board: from the Fund latest World Economic Outlook update which keeps endlessly banging on about the need for

• Accommodative monetary policies and, simultaneously, de-risking of the financial economy (the two tasks that actually contradict each other, as IMF own GFSR report admits);
• Structural markets reforms (which in the IMFspeak means preciously little more than more reforms of the labour markets, or in distilled terms: more 'activation' efforts to bring the unemployed to still inexistent jobs and push welfare recipients off the dole into still inexistent jobs);
• Credit supply restoration in the economy amidst continued banks deleveraging (which basically means that the banks need to get rid of old - presumably bad risk - loans while increasing their stock of new - presumably better risk - loans);
• Creation of better, more robust risk management frameworks in banking while increasing banking sector concentration (the outcome of the deleveraging process) and increasing risks concentrations by creating more centralised controls and supervision (e.g. the European Banking Union); and so on.

All of the above 'reforms' are clearly self-contradictory in so far as achieving one side of the objective implies undermining the other side.

And with today's release, we have a veritable Map to the Middle-Earth from the Fund's own Christine Lagarde. In today's "The Managing Director's Global Policy Agenda" Ms. Lagarde is navel gazing over 14 pages of text, charts and slides under the sub-heading of "Aiming Higher, Trying Harder". You get the sense of frustration of the Fund stuff with the intransigent Governments unwilling to deploy all of the medicines prescribed to them by the Fund, but you also get a feeling for the out-of-touch banality of the IMF's approach to the crisis.

Take the preamble. "Bold and resolutely executed policies are needed to prevent growth from settling into a “new mediocre,” with unacceptably low job creation and inclusion. Measures should emphasize":

• "Lifting growth. Decisive structural reforms are needed to bolster confidence and lift today’s actual and tomorrow’s potential growth and break the pattern of persistent underperformance and insufficient job-creation. Accommodative monetary policies should continue to support demand and provide breathing space as these reforms are implemented. But it is essential that they are accompanied by macro-critical reforms that remove deep-seated distortions in labor and product markets; improve credit flows to productive sectors; strengthen growth-friendly fiscal frameworks; and eliminate infrastructure gaps." You get a sense that this has been said before, argued many times over and offers nothing new. In effect, the IMF is saying: spend more, cut spending more, re-spend more; and fund it all by printing presses, while making sure the rag-tag of the real economy (SMEs and households) don't get their hands on the printed cash.
• "Building resilience. Easy money continues to increase market and liquidity risks, especially in the shadow banking sector, potentially compromising financial stability. Appropriate regulation and vigilant financial sector supervision, including developing and deploying macro-prudential tools, can help limit excessive financial risk-taking. Preparations for less benign financial conditions also need to be stepped-up. As monetary policy normalization approaches in some major economies, stronger policy frameworks, institutions, and economic fundamentals can mitigate potentially adverse spillovers." But, dear IMF, who creates this 'easy money'? And for who the money is 'easy'? The answer is in the first point above: printing presses do create 'easy money' and Governments and larger banks get 'easy money'. So de facto, IMF advice 1 and 2, taken together mean that creating growth + building resilience to risk = growing the share of Government and big banks in the economy. That should really keep troubles at bay, especially since the current crisis is caused by… yep, you've guessed it, rising role of Governments and big banks in the economy. Apparently, what can't kill you makes you stronger.
• And then there is IMF advice that IMF should learn to follow itself: "Achieving coherence. International cooperation is needed to amplify the benefits from these bold policies and to avoid exacerbating existing distortions, particularly regarding financial stability and global imbalances. Dialogue and policy cooperation can help smoothly rebalance global demand; minimize adverse spillovers and spillbacks from asynchronous monetary unwinding; ensure consistent financial regulation; and maintain an adequate global financial safety net. Fresh momentum must be injected into the global trade dialogue." Where did we hear that? Ah, yes, right - we've heard in Greece (when the IMF quietly stood by as the EU rained chaos onto Greek and Cypriot financial systems and Exchequers by refusing to get Public Sector Participation - or restructuring - going); and we heard it in Ireland (where the IMF stood idly by as the Irish Governments and European partners loaded some EUR70 billion-plus worth of banks debts onto the real economy and then destroyed entire sectors of the economy in the name of Nama-lution); and in Italy (where IMF is still refusing to acknowledge the need for sovereign debt restructuring).

Do not forget that the IMF team has run out of Athens this week in a hissy - the most heavily 'repaired' economy in the world seems to be going off-the-rails again.

Here is the road map for advanced economies as traced by the IMF:

As we have it: in Euro Area the achievements were: 1) 'good progress' on monetary easing (the printing press) but more to be done; 2) 'some progress' on consolidating the banking system eggs in one regulatory basket (and more to be done); 3) basically no fiscal reforms; and 4) no reforms on taxation, no improvement in competition across both labour and product markets (not to mention decline in competition in financial economy).

Are we still talking, Ms Lagarde? Oh yes…

Let's take a look at the first pillar of IMF 'wisdom': the printing press. Here's Fund own assessments of the outcomes: "Despite massive and welcome monetary support in major advanced economies and slowing fiscal consolidation, the recovery remains uneven and sluggish. Growth, and hence policy advice, are increasingly divergent across countries. Inflation is still below target in many advanced economies and is a growing concern in the euro area, while unemployment has stayed high. … The envisaged acceleration in economic activity has again failed to materialize."

So just as with Krugmanomics, the IMFology calls for more printing, cause previous rounds weren't enough: "Growth prospects in advanced economies are expected to remain uneven across regions. The strongest growth rebound is expected in the United States, while growth in Japan will remain modest. The crisis legacy brakes (including high private and public debt) are expected to only gradually ease in the euro area, while inflation expectations continue to drift down and deflationary risks are rising. Growth elsewhere, including other Asian advanced economies, Canada, and the United Kingdom, is projected to be solid."

And with all of those 'structural reforms' - do we have an uplift in at least potential (if not actual) output? Nope: "Growth potential may be lower than earlier assumed… Increasing evidence suggests that potential growth started to decline in advanced economies even before the onset of the crisis—which may be affecting the current pace of recovery. The recent slowdown in EMEs also has a large structural component, raising questions about the sustainability of growth rates achieved prior to the crisis and during the 2010–11 rebound."

So here are two road maps side by side: one for Spring 2014 and another for Fall 2014… and, save for gentle re-phrasing of the same, the two are largely identical when it comes to the advanced economies.

So spend more on infrastructure as opposed to reduce debt overhang... and that will be funded by what? Pears and apples?

Out of new ideas. QED.

9/10/2014: Revisiting that Scariest Chart for the US...

With all the 'good news' on US unemployment out, time to update my Scariest Chart relating to the subject.

Take a look at average duration of unemployment through September 2104:

And now take a look the Scariest Chart plotting duration of unemployment within every historical episode of unemployment duration exceeding pre-recession average:

In other words, positive momentum is retained and average duration of unemployment in the current crisis is falling relative to pre-crisis average, but:
1) Average duration of unemployment remains well above its pre-crisis average during the current episode;
2) Average duration of unemployment over and above pre-crisis average in the current period is well higher than in any other crisis period;
3) The duration of the jobs crisis in the US, measured by the length of period over which average duration of unemployment is above its pre-crisis period is now just 2 months shy of overtaking the third longest crisis in history (although we should really exclude that episode as it covers short-lived sharp 2001 recession during which the duration went up and stayed permanently above pre-crisis period).

So things are significantly better, but they are still epically bad...

9/10/2014: A couple of new black eyes for our Corporate Tax regime

Oh dear... as if Apple news were not pretty bleak for Ireland Inc, Wall Street Journal is now covering Google's tax practices with Ireland featuring prominently: http://online.wsj.com/articles/googles-tax-setup-faces-french-challenge-1412790355 and related explanatory note on how Google tax schemes work: http://blogs.wsj.com/digits/2014/10/08/how-googles-french-tax-structure-works/.

With a handy graph:

And an ugly question: Presumably (per Irish Government and its 'analysts'), Google is in Ireland for the quality of our workforce and R&D capabilities. Which begs asking: is that quality Irish workforce and R&D in Bahama-ed 'Ireland' or in Irish Ireland?

But never mind, bad news keep rolling in. It now looks like the savings of EUR350m per annum on the IMF 'repayment' deal are going to come with some hefty price tags... http://www.independent.ie/business/irish/germans-want-irish-tax-reform-in-return-for-deal-on-imf-loans-30650496.html

Did someone say 'reputational capital' is illusory? How about reputational damage costs?..

8/10/2014: IMF GFSR: That Battleship Potemkin Moment...

In the previous post (http://trueeconomics.blogspot.ie/2014/10/8102014-imf-gfsr-oh-dear-its-headless.html) I covered some of the IMF's discoveries concerning the risks present in financial markets.

Irony aside, the Fund does provide a handy map to these risks. Here it is:

The closer things are to the centre of the spiderweb, the lower are the associated risks. Which is preciously funny, if you are into morbid sense of humour.

You see, here's the same map from October 2013:

First thing first: let's take a look at Risks:

• Emerging Markets risks have scaled up in 12 months through April 2014 and then stayed where they were through October 2014. 
• Credit Risks have gone down - undoubtedly the result of just one thing: write down and insolvencies waves that swept across primarily the US and UK and to a lesser extent (due to slower response) through the EU banking systems.
• Market and Liquidity Risks - the wonder sparks of the Central Banks' attention - have grown, and by much. Now, recall that the entire first stage of the crisis was about providing liquidity. ECB is still forcing more and more liquidity into the system… and the risks are rising, not subsiding.
• Macroeconomic Risks - the gold dust of the Governments and Central Bankers - is not budging. Not a notch decline in these risks for all the efforts over the last 18 months.

Now look at the underlying Conditions:

• Monetary and Financial conditions have eased through April 2014 and then got stuck in the same spot.
• Risk Appetite conditions have improved a little in 6 months through October 2013, then grounded to a halt through April 2014 and deteriorated since back to where they were in April 2013. 18 months of going nowhere policies.

This really does make you wonder - all the heroic efforts of the Central Bankers, Treasuries, Governments and international agencies, all the push for more cash, more 'reforms', more 'deleveraging'... and what? Swimming harder to stand still?..

Mommy, the pram is still rolling moment from Battleship Potemkin anyone?..

8/10/2014: IMF GFSR: Oh dear, financial markets are headless chickens...

Financial markets are headless chickens rampaging across the risks landscape, says IMF. This being hardly surprising, the IMF goes on to astonish us all by admitting that the beheadings were the job of the Central Bankers and international policy advisers... aka, the IMF...


IMF's Global Financial Stability Report published today offers some very uneasy reading on the topic of the global financial system risks, both in terms of the evolution of these risks over time and the sources of the risks.

Per IMF: "Easy money continues to increase global financial stability risks. Accommodative policies aimed at supporting the recovery and promoting economic risk taking have facilitated greater financial risk taking."

In other words, instead of reducing the overall level of risks accumulated in the financial system, monetary and regulatory policies deployed since the onset of the Global Financial Crisis (GFC) have resulted in an increase in these risks. Why? Because the entire response since the start of the GFC was focused on priming the debt pump. This manifested itself in record low rates charged by Central Banks on funding they supply into the banking system; in massive waves of liquidity injected by the Central Banks into the sovereign and private debt markets; in incessant pressure to accumulate credit placed on the economies from the policymakers irrespective of the debt levels already present; in wilful reduction of the debt repayment capacity of the households via increased taxation by the insolvent states and so on. All of this has meant that while economic fundamentals (the Great Recession and debt overhang) should have led to a reduction in credit supplied into the global financial system, the opposite took place.

Asset bases of the banks grew, on the aggregate, Central Banks balance sheets swell and asset markets boomed. As IMF notes: "This has resulted in asset price appreciation, spread compression, and record low volatility, in many areas reaching levels that indicate divergence from fundamentals." In other words: as companies managed no significant gains in their productive capacity, their capital valuation exploded. Solely because the hurdle rate on investment (the cost of investment) collapsed. Never mind there is no new demand for companies' output. When money is cheap, it pays to borrow. So asset prices appreciated. Meanwhile, the risk spreads between various quality borrowers have become much tighter. During the crisis, we saw massive widening of risk premia that lower quality (higher risk) borrowers (sovereign, corporate and household) had to pay to secure credit. Now, with money being given away at negative real prices, no one gives a damn is one borrower is less likely to repay than the other: risks are misplaced once again. You don't have to look any further for the evidence of this than the Euro area sovereign yields. When Italy borrows in the markets at negative rates, you know the jig is up. Surprisingly, all of this: irrationally easy credit and outright bubbly assets valuations, coincided with a decline in markets volatility. In other words, markets are now acting as if their participants are 100% (or close) certain the trend is only up for asset prices. And worse, this applies to all asset classes: from housing to bonds to VCs to Private Equity.

IMF notes that "What is unusual about these developments is their synchronicity: they have occurred simultaneously across broad asset classes and across countries in a way that is unprecedented." The word *unprecedented* should ring the alarm bells. We are deep into the monetary policy corner (zero rates, massive liquidity pumping programmes) and fiscal policy corner (debt levels carried by the sovereigns are now breaking all-time records). Should the *unprecedented* start unwinding, what stands between here and a full blow disaster?

Nothing. Worse than nothing.

Most certainly not the fabled 'reformed' banking systems with all the layers of new supervisors and rules mounted on top of their crumbling strategies is no solution, despite all the European chatter about Banking Union and joint supervision and macro prudential risks oversights and so on… All of this is pure blabber. For as the IMF states: "Capital markets have become more significant providers of credit since the crisis, shifting the locus of risks to the shadow banking system. The share of credit instruments held in mutual fund portfolios has been growing, doubling since 2007, and now amounts to 27 percent of global high-yield debt." So risks have: (1) risen, and (2) migrated into the less manageable, more poorly monitored and understood sub-system.

"At the same time, the fund management industry has become more concentrated. The top 10 global asset management firms now account for more than $19 trillion in assets under management." So risks have: (3) concentrated behind fewer black boxes of management strategies.

With (1)-(3) above you have: "The combination of asset concentration, extended portfolio positions and valuations, flight-prone investors, and vulnerable liquidity structures have increased the sensitivity of key credit markets, increasing market and liquidity risks."

That's IMF-speak for 'sh*t about to hit the fan'. In more academic terms, Nassim Taleb - in 2011 article in Foreign Affairs said: "Complex systems that have artificially suppressed volatility tend to become extremely fragile, while at the same time exhibiting no visible risks. Such environments eventually experience massive blowups, catching everyone off-guard and undoing years of stability or, in some cases, ending up far worse than they were in their initial volatile state. Indeed, the longer it takes for the blowup to occur, the worse the resulting harm in both economic and political systems."


In 2008-2011 GFC, global economy had a buffer: the Emerging Markets. These fared better than advanced economies precisely because regionalisation has enabled them to offset the risk transmission channels that globalisation has created. But what about now? This time around, the buffer is no longer there. Quoting IMF: "Emerging markets are more vulnerable to shocks from advanced economies, as they now absorb a much larger share of the outward portfolio investment from
advanced economies. A consequence of these stronger links is the increased synchronization of asset price movements and volatilities." Translation: if sh*t does hit the fan, there won't be an umbrella big enough to cover everyone… nay, anyone…


But IMF does another useful thing in its GFSR report. It evaluates the impact of the credit risks present. "To illustrate these potential risks to credit markets, this report examines the impact of a rapid market adjustment that causes term premiums in bond markets to revert to historic norms (increasing by 100
basis points) and credit risk premiums to normalize (a repricing of credit risks by 100 basis points)." Now, note - they are not suggesting any risk-run on the markets, nor change in sentiment of any variety. They are just measuring what will happen if *historical norms* were to prevail (for comparison, however, that norm in the euro area implies credit risks and term premia repricing by more like 200 basis points).

"Such a shock could reduce the market value of global bond portfolios by more than 8 percent, or in excess of $3.8 trillion. If losses on this scale were to materialize over a short time horizon, the ensuing portfolio adjustments and market turmoil could trigger significant disruption in global markets." You don't say… sure they will. Remember that the ECB is hoping to deliver roughly USD1 trillion addition to its balance sheet through extraordinary measures, such as TLTROs and ABS purchases. And the shock is almost 4 times that of the ECB extraordinary efforts. What happens, then, with the euro area banks that are so stuffed with Government bonds and corporate debt they are making even thick-necked ECB squirm? Oh, right, they will need to either absorb these losses (which can be of the size of the GFC-induced write downs) or pretend that their bonds holdings are not subject to risks, just as the entire world will see them as being subject to huge risks. Take your pick - either we have an insolvent banking system or we have a dishonest banking system… or may be both… or may be we already have instead of *will have*…


The IMF is always keen on suggesting what needs to be done. But, alas, the Fund has now been devoid of any new ideas on all policy fronts for some time. Ditto on the topic of global financial stability. IMF says: "Managing risks from an ongoing overhaul in bank business models to better support economic risk taking. The policy challenge is to remove impediments to economic risk taking and strengthen the transmission of credit to the real economy." Wait, what? Superficial risk taking stimulation that the IMF said above is the cause of the imbalances is now also the solution to the built up imbalances? Yep, you've heard it right: hair of the dog to the power of 10. "Cure the hangover from 10 pints by downing 10 bottles of vodka…", says Doc. IMF.

But more on the banks in the next post…