The eurozone leadership is finally coming around to accepting that a major continent-wide bank recapitalization program is necessary.  Germany wants each country to take care of its own banks.  This approach could buy time, but it won’t work for long.  National bank backstops are untenable in a common currency area, as each sovereign has its own credit risk profile.  Depositors will simply flee toward the better backstops.  This can already be seen in the correlation between bank deposits in Germany and the PIGS (Portugal, Ireland, Greece, and Spain).  Before the financial crisis, those deposits were tightly correlated, as shown in the graphic above, but over the past two years the correlation has flipped – deposits are fleeing the PIGS and flying into Germany.  A stable eurozone banking system will require a unified regulatory, resolution, and rescue regime. Read more »

Chinese Premier Wen Jiabao recently hinted teasingly that China might buy more risky-country European debt; a “helping hand,” he called it.  Yet even if China follows through, it is unlikely to increase its intended purchases of European debt but rather just change the composition.  China’s euro purchases have increased dramatically over the past two years (we estimate these to be ¾ of reserves purchased in excess of the change in China’s U.S. asset holdings).  Most of this can be presumed to have been invested in German bunds, Europe’s closest thing to U.S. Treasurys.  Chinese euro purchases over the coming twelve months equivalent to those of the previous twelve months could cover the entire 2012 net financing needs of Portugal, Ireland, Italy, Greece, and Spain (PIIGS), as the figure above shows.  Every euro China invests in new PIIGS debt, however, can be expected to come at the expense of bunds.  Such a diversion would push up German interest rates—precisely what Germany wants to avoid by resisting eurobond issuance—without giving Germany any greater say over eurozone fiscal policies.  Chancellor Merkel therefore gains little, if anything, in making political concessions to secure Wen’s “helping hand.”

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In its most recent update to the Budget and Economic Outlook, the Congressional Budget Office projects robust GDP growth of 4.4% in 2014 and 5.0% in 2015.  This projected spurt is unexplained, but appears to have been reverse-engineered from the belief that the United States should return to the trend growth it seemed to be following prior to the financial crisis—as can be seen in the figure upper-left above.  There is precedent for this: after the double-dip recession of the early 1980s, strong growth in 1983 and 1984 quickly closed the gap between actual and so-called potential levels of output—as can be seen above, upper-right.  But the CBO would be wrong to assume that economic history is destined to repeat itself.  In the early 1980s, industrial capacity continued to expand throughout the recession, while the labor force remained at the same level.  The recent downturn, however, has seen declines in both industrial capacity and the labor force of 2% and 5%, respectively—as seen in the bottom figures.  There is little justification for believing that potential economic activity has continued to grow while critical inputs to economic activity—labor and capital—have shrunk.  If potential output has shrunk along with them, then the U.S. faces considerably greater fiscal challenges than the CBO’s analysis implies. Read more »

Weak economic data, a Washington debt standoff, a downgrade of U.S. federal debt, and rising European default fears helped send the S&P 500 stock index down 16% between July 22and August 6.  As the figure above shows, equity prices of late imply the worst earnings growth rate expectations in 25 years—such expectations even turned negative last week.  This dour outlook stems partly from renewed risk-aversion, which ironically redirected cash into downgraded U.S. debt, but it also reflects a sharp rise in concerns about where new profits will come from.  Operating margins and profits are near all-time highs, but revenues are still below their 2008 peak and real consumer spending has grown by only 2% over the past year.  Corporations currently have strong balance sheets and the lowest net debt-to-revenue ratio on record, but this is largely the result of cost-cutting which may have run its course.  In short, either stocks are very cheap or growth prospects very dim.

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The rapidly approaching August 2^nd deadline, as proclaimed by the U.S. Treasury, for raising Congress’s self-imposed debt ceiling is producing a flurry of deficit-reduction plans – or, more accurately, plans for having plans.  Whereas a U.S. default triggered by a failure to raise the debt ceiling is the worst possible way to address the country’s unsustainable deficits, as it would cause borrowing rates to soar and pummel growth prospects, raising the debt ceiling without a credible deficit-cutting agreement still poses real risks of imminent, damaging market turmoil.  This is because of the regrettable but real power of the credit ratings agencies, whose downgrade pronouncements trigger automatic selling and purchase-restriction directives hardwired into public and private investment fund guidelines.  S&P has announced that it needs to see a $4 trillion deficit reduction commitment over 10 years—consistent with stabilizing U.S. debt as a percentage of GDP—in order to sustain the United States’ AAA rating.  Speaker Boehner’s plan aims at only $3 trillion in cuts; Senator Reid’s plan at $2.7 trillion.  Rep. Ryan’s plan is, from a practical perspective, meaningless, as its big spending cuts don’t materialize until well after 10 years.  President Obama’s budget also falls well short of the mark, relying on wildly optimistic near-term growth forecasts to juice the GDP denominator (see the Geo-Graphic here).  As the spending graph above-left shows, both Ryan and Obama set the country off on a path of much higher spending than the average over the past 50 years.  In short, debt ceilings and ratings agencies may be stupid inventions, but they will drive us into a major economic crisis if Congress doesn’t take serious action now.

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