Notes From Underground: Ok, Notes From Underground, Where 2+2=5

For the almost three years that NOTES has been published, I tried to make it clear why the subtext of NFU was that 2+2=5. The idea of the math being so obviously incorrect was a direct reference from Dostoyevsky’s short story Notes From Underground in which the great Slav nationalist rails against the rationalists of the day. My use of the 2+2=5 reference is an attack on the rationalists of today, otherwise known as those dependent on sophisticated models to offer explanations for all the answers to questions in the realm of social science–economics of course being the main target. I bring this up as a reflection on the most recent stress tests of the Spanish Banks for if those literalists who think that the math in the Dostoyevsky story is wrong, then the math in the Spanish stress tests should cause one’s eyes to glaze over.

As one of the great feats of modern math, the capital shortfall in the Spanish banking system was revealed to be 59.3 billion euros. The consultancy, Oliver Wyman, compiled the data but I am highly skeptical of whatever stress levels were tested as the unemployment rate is already 25%. Adding to the high unemployment rate is the fact that GDP predictions for the last two years have been wildly optimistic. Spanish banks have seemingly also been under reporting non-performing loans as the data does not equate of the fallout experienced by Greece and Ireland whose economies also suffered massive credit sprees. So if faulty data was used in the measurements then the capital shortfall has to be a bad miss. It appears that a smaller number would be easier for the ECB and the German paymaster to digest for just a month ago the 100 billion number was being discussed for the Spanish banks’ immediate needs.

In Monday’s Financial Times, Wolfgang Munchau discussed the dispute between Spain and Germany about what was agreed to at the June 29 summit. Spanish Prime Minister Rajoy and Italian Prime Minister Monti believed that they achieved a banking union from Chancellor Merkel  and Finance Minister Schaeuble. However, it seems that the German leader believed the agreement was far different from what the Italians and Spaniards assumed. Frau Merkel seems to have changed her opinion as she has come under pressure from Bundesbank President Jens Weidmann. As Munchau states: “Jens Weidmann, president of the Bundesbank, last week said a banking union was a disguised transfer mechanism. On this point, he is right. A banking union would recapitalize Spanish banks at the expense of Northern European taxpayers.This is the whole point of having it.It would be dishonest to deny that. A banking union, properly constructed, thus constitutes a fiscal union.”

The fact that one of the most pro-EU journalists is raising this point reflects the intense criticism that the German Chancellor is facing over the creation of a backdoor transfer system. Again, raising the issue brought to the public debate by Otmar Issing: “NO TAXATION WITHOUT REPRESENTATION.” So it seems that the Spanish stress tests would contrived to bring about the least financial pain as possible. Lies, damn lies and statistics (Disraeli).

***Last night the RBA lowered the overnight lending rate from 3.5% to 3.25%. All economists that were polled expected no change. Last month I discussed that the flattening 2/10 curve in Australia was signaling that the Aussie economy was struggling and that the RBA needed to cut rates. It seems that 25 basis points is not enough as the 2/10 curve failed to move today and closed in NY at 57 points. Of greater interest is that the overnight rate/10-year note is inverted as the TEN YEAR AUSSIE NOTE is a yield of 2.98%. We like to read the RBA’s statement as Governor Stevens has a solid record of reporting on the International economy. The RBA decided to cut rates as it noted the softening in the world economy and “economic activity in Europe is contracting.” China and Asia are not as clear-cut and the U.S. is growing slowly. Further concern for the RBA was that “key commodity prices for Australia remain significantly lower than earlier in the year.”

Over the last decade, Australia’s economy has been the recipient of massive capital investment in its natural resource sector. New mines are bringing added supply into a slowing global economic environment and Australia has to compete with Brazil and others for raw material markets (iron ore, copper, natural gas, coal). Since the Brazilian real has depreciated over the last 12 months, the very strong Aussie dollar is making it difficult for the large Aussie mining conglomerates. Prior to the RBA announcement, the New Zealand commodity price index was released and it showed that powder milk and other dairy products had price increases, aiding the KIWI export sector. The bottom line was that the Aussie/Kiwi spread dropped substantially after the Aussie rate cut sending the cross to its lowest levels of in a year. This cross is a good barometer of potential Aussie weakness.

***Quick Hit: In a weekend piece in the FT by the highly regarded Gillian Tett, she titles the article, “Dad, you were right.” The FT’s United States editor is publicly apologizing to her father for claiming he was wrong about the EURO in an argument they had in 1996. It is not so much that they had a huge family row over the euro, but what Ms. Tett advises to be the biggest lesson that she learned and the wisdom she passes on to her readers: “…. journalist,financiers and politicians should all have posted up on their desks, is how wrong we can sometimes be, especially when we are excited by a CAUSE.” I have had many similar arguments over the last 20 years and while I always am ready to learn I always maintain that when the zealots are preaching it is important to remember that 2+2=5. It is the mainstay of why this BLOG leans on political economy as its theoretical basis.

As a side note: If Gillian Tett had read the Rudi Dornbusch piece in the 1996 Sept./Oct Foreign Affairs Journal, she may have tempered her blind enthusiasm. The Dornbusch article is entitled, “Euro Fantasies.” I would advise all of my readers to pull it up and read a wonderful piece from a greatly missed political economist.


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9 Responses to “Notes From Underground: Ok, Notes From Underground, Where 2+2=5”

  1. Jacob Steelman Says:

    The RBA traditionally makes rate changes on Melbourne Cup day which is an unofficial holiday in the afternoon. This event takes place the 1st Tuesday of November. So we are expecting another similar rate drop then. – Jacob Steelman, Fortun8-IVG Captial Partners

  2. chuck reeder Says:

    Nice article Yra.

  3. tom quayle Says:

    always an important read – good to watch a first rate mind in motion.
    Tom Q

  4. yra Says:

    Tom ,Chuck ,Jacob–thanks for the feedback.Now let’s continue to take the pulse of these markets and prepare for what looks to be a volatile quarter across the entire spectrum of assets

  5. Danny Says:

    If only the current slate of U.S. politicians would take the quick hit to heart, it would make the election season a bit more bearible. People are fallible. Deal with it. The political parties should stop trying to be spin doctors and admit when they just have it wrong or actually had a mishap. How about a campaign against disinginuine rhetoric? In fact, one may rightfully question how much longer the recession has been and will be prolonged as a direct result of political pride preventing a geniune discussion of facts and development of well thought out proposals to help solve some problems? They say nothing is free – so, I guess a prolonged recession is the price we pay in order to accept self rightous pride at the expense of humility and resolution.

  6. Dustin L. Says:

    Yra- I know this is a little off topic but, I am currently reading Nightmare On Wall Street by Martin Mayer and I could not help but notice the name Ira Harris, who just so happened to be from Chicago, keeps coming up. I was just wondering if there is any relationÉ

  7. Mario Says:

    Aussie world….The river is flowing into the US mistakes when DTI ratios on average households at 150%. An economy can not sustain those levels especially a commodity driven economy. The world is pointing fngers directly at these emerging markets that have become heavily dependent on their mothership countries….Love the take on the rationalist, makes total sense …

  8. yra Says:

    Dustin–no relationship what so ever.He is an investment from the time when that meant something positive as they actually accepted the idea of fiduciary responsibility.Every credible source I know speaks very highly of J.Ira Harris and his integrity

  9. Dustin L. Says:

    Yra-Okay, Martin Mayer seems to portray him in a very positive light as well. Fiduciary responsibility, what is that? I was born in 1989, I don’t think I have witnessed a banker engage in such action, haha!

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