Notes From Underground: The Magician of Frankfurt Will Be Called to Answer

We’ve been discussing the problems in the Italian debt market at NOTES FROM UNDERGROUND for many years but with the Five Star/Lega coalition coming into government many of the issues that were once theoretical are now an increasing possibility. The Five Star group is openly proposing a debt restructuring for Italy in the hopes of spurring growth and improving the Italian unemployment situation. Economic growth in Italy has lagged the developed world economies and none more so then its neighbor, Germany.

The Italians feel they have borne the brunt of Germany’s fiscal austerity desires while the German export machine has benefited from the weak euro at the expense of many of its EU partners. While Italy, Greece, Spain and Portugal were forced into a policy program of INTERNAL DEVALUATION (programs designed to improve current account deficits by enduring high levels of unemployment), the Germans were advantaged through a currency too weak for their robust export machine.

Adding to the weak currency was Draghi’s negative interest rate program and massive QE,resulting in low borrowing costs for the debt-plagued economies but a weaker currency to benefit the Germans. The issue has been and will be how will the ECB deal with its huge balance sheet of sovereign debt. As Italian yields have risen by 40 basis points in five days the question becomes: How large will the LOSSES BE ON THE ECB’s BOOKS?

The flip answer will be: THE ECB HAS A PRINTING PRESS,or that the ECB will hold all that debt until it matures at PAR so no losses will be incurred. But then it means that ECB QE will live on far longer than many investors wish to believe. Draghi will argue that he had no choice (THE ULTIMATE COUNTERFACTUAL), but as the EU growth story improved Draghi should have raised rates from the NEGATIVE 40 BASIS POINTS. Draghi took Bernanke’s idea of a portfolio balance channel and raised its power by going to a NIRP program. The results from Draghi’s appropriation of fiscal and monetary authority will be a theme that will be discussed as Italy threatens the entire financial edifice. The Italians feel strongly that they will control outcomes as the leverage of owing TRILLIONS is enough to shake confidence in the global financial system.

In Tuesday’s Financial Times there was an article about a group of 154 German economists publishing an op-ed in the Frankfurter Allgeimne Zeitung (FAZ) citing opposition to the proposed Macron plan for a unified banking system in the EU and some type of harmonized fiscal policy. The economists set out to make the case against the French plan in three key points:

  1. “The eurozone needs an orderly insolvency procedure for states and an orderly withdrawal procedure.”;
  2. There is an urgent need for individual nations to continue down the path of reforms for their economies rather accepting the yoke of a “union of liabilities”;
  3. “A common deposit insurance scheme would ‘socialize the costs’ of mistakes  that banks and governments have made in the past.”
The bottom line is that the “prominent” economists state the case against making the Germans the transfer agents for the welfare of the fiscally profligate. The road to imposing the Macron Plan is fraught with political landmines. Italy is just the beginning.

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16 Responses to “Notes From Underground: The Magician of Frankfurt Will Be Called to Answer”

  1. Stefan Jovanovich Says:

    The Euro is likely to have more sellers than buyers. Its highly-leveraged states, like those in the U.S. (Illinois, to name one egregious example), are going to default, even if the workouts and non-payment and forced maturity extensions end up being called something else. Trading Capital will want to look to Trumpland, even as it apologizes by saying that the dollar longs are only justified by Fed’s having the good sense to raise rates, not by any confidence in the Americans’ system of political economy. So, Germany will have its exports continue to be protected by a currency price discount. What’s not to like if you are Berlin? You can have your cake and blame other people for the calories.

  2. Asherz Says:

    The German economists rational path to handling the problems of the weak sister in the EU would have made a lot of sense nine years ago when the numbers were manageable. The borrower now owns the bank (the old joke). Once you let that genie out of the bottle, watch the other weak sisters take the same route.
    The other unintended consequences will follow.
    Draghi’s “whatever it takes” are past the point of no return. A long term QE and a probable Eurobond is in the wings. A bad theory gave a short term answer that required a long term solution. Too late now.
    And globalization will affect all.

    • yraharris Says:

      Asherz—absolutely.So Draghi did the bidding of the G30 and the davos crowd by bailing out the creditors and leaving the german tax payers on the hook–just the beginning of the great unwind–interesting piece by John Authers today in the FT—smart money.Will write about it tomorrow

  3. Joseph Says:

    He was excoriated for saying this but the chickens have come home to roost in Euroland…Only time will tell if it is already too late, but things will get worse before they get better…..

  4. Arthur Says:

    STAN DRUCKENMILLER (TRANSCRIPT): “If I were trying to create a deflationary bust, I would do exact exactly what the world’s central bankers have been doing the last six years. I shudder to think that the malinvestment that occurred over this period. Corporate debt has soared, but most of it has been used for financial engineering. Bankruptcies have been minimal in the most disruptive economy since the Industrial Revolution. Who knows how many corporate zombies are out there because free money is keeping them alive? Individuals have plowed ever-increasing amounts of money into assets at ever-increasing prices, and it is not only the private sector that is getting the wrong message, but Congress as well. I have no doubt we would have not gotten such a big increase in fiscal deficits if policy had been normalized already.” – May 3, 2018

    • David Richards (@djwrichards) Says:

      Yeah, I saw that too. As I recall, he is very bearish equities. Not to be taken lightly when it’s Mr Druckenmiller. Yet, some prominent technicians are newly bullish. Thing is, money has to go somewhere. Where? Institutions are not paid to sit in cash. And no pension fund can stay solvent on bond coupons today.

  5. David Richards (@djwrichards) Says:

    What if Germany leaves the Eurozone? Save itself the bill and burden of subsidizing Europe, but lose some of the “domestic” Eurozone market. What’s the cost-benefit analysis? In the long run. As per the PWC study, the entire EU will comprise only 9% of global GDP after 2030. Even today, Germany’s top export market is already China, not the rest of the Eurozone. The Germans will always still sell things to Europe, whither the Eurozone, just like Germany did beforehand, albeit in lesser quantity. Why drown with the sinking ship?

  6. Mike Temple Says:

    So, if Euro weakens and talk of parity emerges, how long before Trump starts tweeting that Powell needs to ensure #MAGA and orders Fed to soften interest rates to reverse the strong USD?

    • Stefan Jovanovich Says:

      Or, the President chooses the alternative of establishing “reciprocal” tariffs that allow the seemingly impossible combination of a “strong” exchange rate and rising domestic earnings for the “ordinary people” i.e. the recipe that allowed the Republicans to own the White House from Buchanan’s departure to Wilson’s arrival ( Cleveland was a reform Democrat whose policies were indistinguishable from the Republicans he beat and lost two). The tariff leaves domestic and foreign deposits in U.S. banks being allowed to keep the rewards of “high” interest rates while preserving “high” wage rates and leaves the central bank free to get out of the business of being the Treasury’s buyer of last resort. What’s not to like?

      • Stefan Jovanovich Says:

        Idiot mistake – My snarky comment was about the Fed being the buyer of FIRST resort, not LAST.

      • yraharris Says:

        Stefan–snarky yes and thanks for correcting because i was struggling with it.

      • Stefan Jovanovich Says:

        I greatly appreciate Yra’s willingness to tolerate my episodic disquisition about the economic similarities between the present and the period when Ohio Republicans owned the White House (another point about the exception – Grover Cleveland – he is best seen as the one Democrat outlier in the Lake Erie combine that ran the country). My speculation is that the United States is going through a period when, then as now, it is the world’s largest economy in nominal GDP, the world’s largest sovereign borrower, and – after a period of effectively open borders – its politics have turned decisively against immigration. At the same time, (thank you, Ulysses Grant) the country has chosen to welcome unrestricted capital inflows even as it increases tariffs and does not “pay off” (sic) the enormous national debt; and – miracle of miracles – both the Federal Treasury and national bank note issuing financial institutions actually keep straight books for the liabilities and reserves.
        I confess that I am talking my book: I want all this to come true. But, it is my book in large part because the political parallel is real: Trump and this generation of Midwestern national union free labor politicians now own the Republican Party and the electoral majority in the same way Grant and his successor Union Army veteran Presidents did.

      • yraharris Says:

        Stefan–as I am in the middle of professor Irwins Clashes in Finance I find your posts quite provocative and stmulating of thought

  7. Mike Temple Says:

    Not sure what point John Authers is trying to make about inflation/deflation/gold in his piece. If he is trying to say that gold is forecasting deflation ahead, it isn’t much of one. Gold is still roughly $1300 and stocks most everywhere see sunny skies ahead.

    And if he believes deflation is just around the bend, then QE to Infinity is the likely policy response with even the Fed reversing course after market turmoil hits.

    His “conclusion” leaves me with more questions than answers. 2011 saw deflationary ghosts from an existential Euro crisis swirling.
    Yet, gold rallied from $1500 to its manic high of $1900 by September as capital ran scared. Any such repeat of 2011 with Italy forcing the issue would far more problematic for markets and might trigger market chaos that puts us back to QE Infinity.

    In a world of such inhuman currency volatility, I daresay Gold might become extremely valued for the constancy of it North Pole orientation in a world of spinning compasses.

    In short, Authers seems not to be forecasting any dramatic moves up or down for gold, just that it is forecasting that higher real US yields is sapping the lust for gold. Ok, fine. But US overall indebtedness has grown over 50% from $30 trillion to $47 trillion since Lehman 2008 (statistic courtesy of David Rosenberg).

    Forget about waiting for the US yield curve to invert to signal slowdown or possible recession. The sheer weighty rise in short rates of a cool 200ish bps in the past 24 months is going to have a very big impact on corporate/municipal/consumer balance sheets long before the curve ever inverts.

    In a world of suddenly tectonic market rumblings such as Italy, Turkey, Argentina to go along with unsettling geopolitical fault lines such as NKorea/potential US China trade war/US Iran nuclear discord and finally, everybody’s favorite, actual kinetic war possibility between Israel and Iran as Syria becomes the battlefield, it is easy to say that every market climbs a wall of worry.

    Well, in that case, S&P must be ready to explode to 3200….Or maybe just not.

    Looking forward to your commentary on Authers

  8. kevinwaspi Says:

    The alchemy in today’s world makes Merlin envious:
    “In a move that doubtless prompted relief across Europe, Italy’s populist about-to-be government made clear that it is not now looking for the European Central Bank to write down 250 billion euros ($295 billion) of Italian sovereign debt…. But the populists do, reportedly, want all of the sovereign bonds held by the central bank as part of the ECB’s bond-buying program to be magicked away in official assessments of Italy’s public debt.
    This second proposal will sound less alarming to most observers. Alas, it suggests that the people who would like to run the next Italian government do not know the difference between a stock and a flow.”
    Ah yes, the old “we owe it to ourselves” proposition!

  9. Chicken Says:

    Bullard claims the yield curve has a “nice slope” but I’m having difficulty following his logic.

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