Economics 28/06/2010: Watch out for VIX

Short-term VIX options and VIX itself are starting this week on the upside... is risk contagion spreading from sovereign bonds to corporate?
An interesting view here.

Let's put this on record - I think we are now in 50:50 chance of a new recession - Euro area, UK and US, plus Japan. Time horizon - 6 months.

Economics 28/06/2010: Knowledge economy blueprint worth the ink

A quick post on two articles relating to science, research and knowledge economy Ireland.

Sunday Business Post printed an excellent article by Professor Colm Kearney of TCD School of Business on the policies for developing a real knowledge economy. The link is here. As those of you who follow my writings would know, I have campaigned for a long time now for proper recognition of the non-hard science fields of social sciences, business research and humanities as contributors to the 'knowledge economy'. See links here, here, here, here, here, and probably most succinctly - here.

Professor Kearney's article is certainly worth a read for anyone interested in the economic future of this country.

Note: Professor Kearney, unbeknown to many in Ireland, advised Australian Government during the period when Australia established one of the most progressive economic and fiscal environments which has resulted in its economy being able to weather the latest global crisis remarkably well.

One just hopes Professor Kearney gets drafted into a policy-making framework in this country, with some real power to change things.

The second story, related to the subject was also published by Sunday Business Post (here). It relates to the issue of collapsing funding for research in Irish leading academic institution - TCD. In the article in early 2009 published by the Sunday Business Post (here) I warned that it is only a matter of time when thousands of Irish post-docs - funded by the EU, Irish Government and minor private sector grants - are going to face a chop. Jobless PhD - as labeled them - are the direct cost of our short-sighted policies for pursuing lab-coats based innovation and knowledge economics.

Economics 28/06/2010: G20 to euribor: beware of the central banks

Update: with a slight delay on this blog's timing - Reuters picks up the same thread here.


Another Monday, another set of pear shape stats.

First, we had a farcical conclusion to a farcical meeting of G20. If Pittsburgh summit was a hog wash of disagreements, Toronto summit had a consensus view delivered to us, mere mortals who will pay for G20 policies. This consensus was: G20 leaders called for

• austerity, but not too much (not enough to derail growth, but enough to correct for vast deficits - an impossible task, assuming that public deficit financing has much of stimulating effect in the first place);
• generating economic growth (with no specifics as to how this feat might be achieved);
  
• increased tax intake (to help correct for deficits); and
• no changes to be made to the global trade and savings imbalances.

In other words, G20 decided that it is time to have a 4 course meal without paying for one.

Then , on the heels of these utterly incredible (if not outright incompetent) pronouncements by G20, Bank for International Settlements (BIS) came in with a stern warning to the Governments worldwide to cut their budget deficits "decisively", while raising interest rates. Funny thing, BIS didn't really see any irony in cutting deficits, while raising the overall interest bill on public debt. Talking of Aesopian economics - let's pull the cart North and South, in a hope it might travel West.

In many ways, BIS got a point: “...delaying fiscal policy adjustment would only risk renewed financial volatility, market disruptions and funding stress” said BIS general manager Jaime Caruana. Extremely low real interest rates distort investment decisions. They postpone the recognition of losses by the banks, increase risk-taking in the search for (usually fixed) yield, perpetuating nearly economically reckless financing of sovereigns that cannot get their own finances in order, and encourage excessive levels of borrowing by the banks.

Continued water boarding of the western economies with cheap cash through Quantitative Easing operations by the CBs risks creation of zombie banks and companies with sole purpose in life to suck in liquidity from the markets. Alas, the problem is - shut these zombies down and you have no means for monetizing public debt in many countries, especially in the Eurozone. Boom! Like the main protagonists in Stephen King's movies, governments around the world now need zombies to rush into their disorganized homes before the whole plot of deficit financing blows up in their face.

BIS also warned that many economic experts and central banks are underestimating inflation risks. And this is just fine, assuming you are dealing with short term investment horizons. However, for a Central Bank to ignore the possibility of a restart of global inflation - fueled by the emerging markets growth and later also supported by accelerated inflationary pressures in the advanced economies following the re-flow of liquidity out of the bank vaults into the real economy once writedowns are recognized and banks balancesheets stabilise - is a very dangerous game. inflation, you see, is sticky.

And inflation might be coming. Look no further than the Fed (here) and the US Administration insistence on the need for continued debt-financed stimulus.

Or, look no further than the movements in the interbank lending markets:

So the long term Euribor is up, up and away despite all the Euro area leaders' talk about fiscal solidarity funds and tough austerity measures. Think: why? Either the interbank markets don't believe in Euro area's ability to get its own house in order (which they certainly don't) or they believe that future inflation will be higher (which of course they do)...

Hence, shorter maturities are in an even more pronounced push up:

While dynamically, the trends are deteriorating:
Now, think about the Irish banks (Spanish, Portuguese, Greek - etc) that are on life support of interbank markets and ECB. Can they sustain these credit prices?.. While facing continued writedowns?.. Don't tell I did warn you about these.

Economcis 27/06/2010: US retail sector - lessons for Ireland?

A very interesting perspective on the consumer side of the US economy in a recent post on Seeking Alpha (here):

"Let’s compare and contrast 2007 and 2010:

• We have lost 7.8 million jobs since then.
• The unemployment rate is 9.7% versus 4.5%.
• Total unemployed workers are now 15.7 million versus 6.5 million.
• Real personal income less government transfers is lower by 6.5%, or $624 billion.
• Real retail sales have rebounded just 4% from their lows and are still down 9% from the 2007 peak.
• Consumer credit for February showed another sharp retrenchment of -5.6B.
• Consumer bankruptcies for March were the highest level since 2005.
• There is a glaring $1.5 TRILLION hole in the consumer balance sheet.
• Home foreclosures surged 19% last month and are at their highest level since 2005.
• The consumer’s largest asset (housing) is down 33% since 2007."

And a chart:
The index closed down at 89.49 this Friday.

This has three implications for Ireland:

1. US problems on consumer side pale in comparison with those found here. We had much deeper contractions in housing asset prices, much greater exposure to housing in the overall composition of household assets portfolios, much more severe acceleration in unemployment, much deeper collapse in disposable after-tax incomes (courtesy of twin forces: Government tax policies and indirect tax hikes, plus wages compressions), lack of compensating increases in Government transfers, more restrictive personal bankruptcy laws, greater consumer leveraging, and steeper fall-off in credit availability;
2. As I wrote before (here), household investment is the core leading indicator of recoveries and recessions; and
3. Our cohort of official commentariate on matter economic has been very eager to drum up the stories about 'return of consumer spending' in recent weeks.

To remind you - here are our latest retail sales stats:
In my view, what we are seeing is a temporary uplift in sales of some items that are overdue replacement (due to amortization) after 3 years of collapsed sales. This, folks, is not a recovery. It is a dead-cat-bounce... When you hit concrete at 100mphs, the bounce can be substantial. But it hardly qualifies as a 'structural improvement'. Looks like some folks might be deluding themselves...

Economics 27/06/2010: G20 - real stats and real issues

As G20 leaders undertake another attempt at injecting some balance into global economic order - with last meeting in Pittsburgh focused on stimulus strategies, while the current one in Toronto focusing on austerity - it is worth taking a look at the stakes.

Bank of Canada estimates that disorderly (or uncoordinated) exit from global stimulus phase of the recession can lead to a loss of up to USD7 trillion worth of output, primarily concentrated in the advanced economies.

However, the story is more complex than the simple issue of whether G20 nations should opt for a fiscal solvency or for a continued monetary and fiscal priming of the pump. Here are the key stats on the leading global economic blocks, revealing the structural imbalances that suggest the real problem faced by the advanced economies is the debt-driven nature of their fiscal and private sector financing.
First chart above shows Current Accounts for the main blocks, including the G20. Two things are self-evident from the chart. Firstly, the crises had a crippling effect on the overall trade flows from the emerging economies to the advanced economies, though this came about mostly at the expense of countries outside Asia Pacific. Second, crisis notwithstanding, IMF forecasts (data is from IMF April 2010 update to WEO database) the trend remains for unsustainable trade deficits for the Advanced Economies. European (read: German) surpluses of the last two decades are going to be wiped out in the post-crisis scenario, but it is clear that the US, as well as other advanced economies, will have to face a much more severe adjustment toward more balanced current account policies in years to come.

These adjustments will have to involve government finances:
Chart above shows government deficits, highlighting the gargantuan size of the fiscal measures deployed by the US and European countries, as well as a massive stimuli used in some 'Tiger' economies and China, over the latest crisis. This puts into perspective the size of the austerity effort that has to be undertaken to bring fiscal policies back to their more sustainable path. You can also see the relative distribution of these adjustments - the gap between the red line and the blue line. This gap is accounted for, primarily, by the UK, Japan and US and is much smaller than the overall Euro area contribution to G7 deficits.

But there is more to the deficits picture than what is shown above. Expressed in terms of percentages of GDP, the figure above obscures the true extent of the problem. So let's look at it in absolute dollar terms:
Now you can clearly see the mountain of debt (deficit financing) deployed in the crisis. Someone, someday will have to pay for this. It will be you, me, our children and grandchildren. Can anyone imagine that things will get back to pre-crisis 'normal' any time soon with this level of deficit overhang on the side of Governments alone?

What is even more disturbing in the picture is the position of Advanced Economies in the period between the two recessions. It is absolutely clear that Advanced Economies have lived beyond their fiscal means, even at the times of plenty, running up massive deficits in the years of the boom.

This puts to the test our leaders (EU and US) claims that the banking system reckless lending was a problem. The banks were not shoving cash at the Clinton-Bush-Obama administrations, or at European Governments. Instead, just as the banks were hosing their domestic economies down with cheap cash, courtesy of low interest rates, Western governments were hosing down their friends and cronies with deficit financing. The two crises might have been inter-related, but both fiscal profligacy and banks reckless risk-taking are to be blamed for our current woes.

Irony has it, neither the banks, nor the political profligates have paid the price for this recklessness.
Hence, the dire state of the governments' structural balances. As chart above shows, in the entire period of 20 years there was not a single year in which advanced economies (G7 or G20 or the Euro zone) have managed to post a structural surplus. Living beyond ones means is the real modus operandi for the advanced economies' sovereigns. Expressed in pure dollar terms:

Now, on to the levels of economic activity:
As I remarked on a number of occasions before, the whole idea of the Advanced Economies decoupling from the world is really a problem for the Euro area first and foremost. want to see this a bit more clearly?
Look at G7 plotted above against the Euro area and ask yourself the following question. G7 includes Japan - a country that is shrinking in its overall importance in the global economy. This contributes significantly to the widening gap between the world income and G7 income. But the region in real trouble is the Euro zone. Again, this puts Euro area problems into perspective:

• Anemic growth
• Poor relative performance in terms of absolute levels of activity

In short - decay? or put more mildly - Japanese-styled obsolescence? Whatever you might call it, the likelihood of the Euro area being able to cover its debts and reduce its deficits is low. Much lower than that for the US and the rest of G7 (ex-Japan).

Some revealing stats on savings and investment:
Clearly, chart above shows the opening of the gap between the need for demographically-driven savings growth in the advanced economies, where ageing population is desperately trying to secure some sort of living for the future, and the lack of real savings achieved. It also shows the downward convergence trend in rapidly developing economies, where younger population is finally starting to demand better standard of living in exchange for years of breaking their backs in exports-focused factories.

Yet, as savings rose during the peak in advanced economies (pre-crisis), investment was much less robust and it even declined in rapidly developing economies:
Why? Because of two things: much of domestic savings in Advanced Economies, especially in Europe, was nothing more than the Government revenue uplift during the boom. In other words, instead of European citizens keeping their cash to finance future pensions, Governments were able to increase expenditure out of booming tax revenues and borrowing against the booming savings rates. Ditto in the USofA (although to a smaller extent). In the mean time, Asia Pacific Tigers started to finance increasingly larger proportion of fiscal imbalances in Advanced Economies, driving down their domestic investment pools and shifting their domestic savings into foreign assets. Which, of course, is an exact replica of the Japanese global investment shopping spree of the 1980s - and we know where that has led Japan in the end...

So the scary chart for the last:
The big question for G20 this time around will be not the stated in official press conferences and statements - but will remain unspoken, although evident to all involved: Given that over the last 20 years, advanced economies financed their purchases of exports from the rapidly developing countries by issuing debt monetized through savings of the developing countries, what can be done about the current twin threat of excessive debt burdens in advanced economies and the shrinking savings in emerging economies?

This is a far bigger question that the USD7 trillion one posited by the Bank of Canada. It is a question that will either see some drastic changes in the ways world economy develops into the next 20 years, or the permanent decline of the advanced economies into Japan-styled economic and geo-political obsolescence.

Economics 25/06/2010: eurozone leading indicators down

Eurocoin, CEPR-Bank of Italy leading economic indicator of economic activity in the Eurozone is down for the fourth month in a row, signaling continued pressure on economic growth:
As the result, I am revising my forecast for Eurozone growth for Q2 2010 to between 0.2% and 0% with the risk to the downside from that.

Negative weights coming from declining industrial production activity and composite PMIs, falling consumer sentiment in Germany, France, Italy and Spain, and equity markets declines. Robust growth in exports provides sole positive support.