Signs that are becoming part of life in Tokyo

Italy's regions are microcosm of the European Union

Merkel/Sarkozy lost in an Escher like maze with no exit

The onslaught of headlines in this morning's media (July 21st) exclaiming that we have reached the day of reckoning for the Euro project etc. etc. suggests a rather apt metaphor which sums up the bind that EZ leaders find themselves in.

According to reports on talks that took place for most of the preceding day Angela Merkel and Nicholas Sarkozy would appear to be completely and frustratingly lost in an Escher like maze, where even trying to get back to the entry point (rediscovering EMU structural flaws at its inception) is not only historically impossible but also topographically impossible

This only goes to highlight the hubris and financial engineering mistakes made by those who conceived the idea of a single currency club and were then very lax about handing out membership cards.

To extend the metaphor even further it is as if they are literally imprisoned in a construct similar to those M C Escher drawings where, quite simply you cannot get there from here.

Larger Private Sector not good for GDP growth

Chart: Penile Length Leads to Little Economic Growth

The following article is provided without comment.

DINO GRANDONI JUL 18, 2011
The opening question to most undergraduate macroeconomics courses usually is, "Why are some countries rich and others poor?" The lecturer will then probably dive into all of the usual suspects behind economic growth--natural resources, technological innovation, savings rate--without mention of perhaps the most primal of measurements: penis size.

That's right, penis size. In a study published today, the University of Helsinki's Tatu Westling points out a surprising strong correlation between a country's GDP growth rate and average penile length. As the chart above shows, countries that averaged smaller penis sizes grew at a faster rate than their larger counterparts between 1960 and 1985. Every centimeter increase in penis size accounted for a 5 to 7 percent reduction in economic growth. The study also showed that overall GDP was at its highest in countries with average-sized penises with GDP falling at the extremes of penis length.

As Westling explains in his paper, previous studies "concentrate on economic, social and political factors, these and many related treatments largely abstain from biological and/or sexual considerations. The aim of this paper is to fi ll this scholarly gap with the male organ." Interesting choice of words (the study is full of them, as you'll see below), but why should this particular, um, unit have any explanatory power? Penis size and economic growth might be related through some intermediary variable like gender equality, political stability, or population growth, Westling writes, but he seems to prefer an admittedly more Freudian explanation that goes like this: Penile length and income are both factors that contribute to an individual's level of self-esteem, and if a person has more of the former, he'll need less of the latter. Or, to put it in layman's terms, some fast-growing countries may be compensating for something. Not a particularly poor argument until you realize, as Westling acknowledges, that half the world's population don't have penises.

As Westling told the GlobalPost, he was only half-serious about the study until he saw such a strong statistical correlation. "But seriousness," he says, "does not imply that I believe in causality at this point." That seriousness doesn't always quite come through given the way some things are worded in the study. Here are some choice quotes; sometimes it's not entirely clear if the double entendres are intentional.

Taken at face value the findings suggest that the `male organ hypothesis' put forward here is quite penetrating an argument. Yet for the best of author's knowledge, male organ has not been touched in the growth literature before.

...the `small male organ' countries would gain more utility by expanding their economy than the `large male organ' countries. Actually the latter populations would simply exploit their nature-given, non-disposable groin-area endowments.
And finally...
It clearly seems that the `private sector' deserves more credit for economic development than is typically acknowledged.
Zing!

At critical times markets need disambiguation

Much of the time, during non-critical phases, capital markets will embrace the ambiguities being promulgated (spun) by central bankers, policy makers, and analysts, and this provides the basic disagreements about price and value amongst traders and investors which promotes liquidity. There is no urgent demand for transparency or unequivocal clarification of systemic information. Risk appetites and complacency levels are relatively high.

But from time to time, when a disruptive event occurs or when markets have moved into a critical phase -as they are now with regard to the Eurozone crisis specifically, and to some extent with the US debt ceiling "crisis" (or melodrama) - market participants will immediately press for disambiguation on as many fronts as possible. Risk aversion moves to center stage, non-equivocation is demanded, and the fractiousness which enables liquidity, is replaced by a coherent viewpoint which results in markets becoming lopsided with a subsequent (and sudden) drop in liquidity.

The longer the demand for disambiguation goes accompanied by a failure by policy makers to be decisive and provide unambiguous answers, the greater the risk of systemic accidents and a complete collapse in liquidity. When markets reach such critical stages - and we could be getting quite close to one in the mid summer of 2011 - the more likely it will be that there are no private bids only private sellers that ultimately will be seeking out public sector bids (i.e. bailouts).

Defaulting: Keep it simple

If your income is less than your expenses and you can’t borrow money, you are insolvent and should be required (not allowed!) to default.

The PBOC has a larger wallet than the BOJ

With the highest debt/GDP ratio in the developed world (at well in excess of 200%) and with yields on its 10 year bonds at just a fraction over one percent there is a real enigma about the macro financial picture in Japan. In recent weeks, despite the protestations of the BOJ, including a round of intervention in the FX market, the yen has continued to strengthen against most major currencies. On July 15th, USD/JPY closed below the pivotal 80 level and during the course of the preceding week had reached back down to within less than 300 pips of the historic lows seen right after the tragic events of March 11th.

Here are just two observations on key factors that keep pushing the yen higher. Both of them reflect the activity of the People's Bank of China (PBOC)

The PBOC have at least two motives for wanting to see a strong yen:

1. China is extremely keen to diversify its holdings of FX reserves so that it is less reliant on the USD (esp if more QE is on the horizon) and the yen is a currency for which there is a deep and liquid market.

2. The higher the yen is against the US dollar and other currencies the more competitively priced will be Chinese goods, priced in RMB which is fixed against the dollar, for exporting to major consumer markets.

Despite what the BOJ may say the PBOC have a larger wallet.

Will Germany take the Mister Creosote option?

In a nutshell the hard problem which has to be resolved in the Eurozone crisis can be reduced to this simple question: "Will Germany backstop the entire obligations of the EFSF, or whatever mechanism is put in its place to "assist" those EZ states that are insolvent, or not?

The head of the Bundesbank Jens Weidman was quoted recently as follows

"Nothing would destroy the motivation for solid budgetary policies faster than joint liability for (EZ) state debts" [emphasis added]

There is a huge difference between a backstop up to a limit - which for Germany at present under the current EFSF framework is approximately 27% or, to use the inimitable words from Mr Creosote, when faced with a menu of many options, choose to backstop "the lot". It comes down to the difference between a joint guarantee or a several guarantee. While Germany insists on the latter - which is the position of the German central bank chief and Angela Merkel, the legal framework of the EFSF would not provide suitably enduring underpinnings for the issuance of Eurobonds with a bulletproof AAA rating.

As others have argued there may well be contamination already within the capital structure or tranches of the CDO which is the framework of the EFSF. For Germany to agree to a joint guarantee of all of the obligations of the facility - which in effect would mean that in a worst case scenario it could end up on the hook for the lot would impair Germany's credit rating - and according to one very insightful analyst that process may currently be under way.

The existential risk for the German government - and the electorate - can be simply expressed in the analogy of a group of mountain climbers who are all inextricably linked together; if the most vulnerable was to fall it has the potential for "the lot" to fall into the abyss.

Expressed even more grotesquely it is worth remembering what happened to Mister Creosote when he elected to go for the lot.

World is drowning in supposedly risk free debt -but is AAA risk free?

The chart above was shown in a very good article from FT Alphaville from July 15th written by Tracy Alloway. To cut to the chase the main point of the piece is to expose the complacent manner in which so much debt is being piled up with AAA ratings which, at least according to canonical notions in finance, is supposedly risk-free. Whether or not one can have confidence that all of this annual issuance is without risk is left for the reader to judge.

Here is an explanation of what the chart shows from Felix Salmon.

At the left-hand side of the chart we see that global issuance of triple-A bonds was more or less nonexistent back in the early '90s. All those Treasury bonds, all those agency securities from Fannie (FNMA.OB) and Freddie (FMCC.OB), all that Japanese debt — add it all up, and it still comes to essentially zero by the standards of what seems normal today. Check out the left-hand y-axis: it goes up in $1 trillion increments. And we’re not talking stock, here, we’re talking flows: this chart is issuance per year.

(It’s pretty easy to see, looking at this chart, how a company like Pimco can find itself with over $1 trillion in assets under management: that’s now just a small fraction of the bonds issued each year.)

Now zoom back, and look at the chart as a whole: it’s going up and to the right, which says two things. Firstly, the amount of debt in the world is soaring. That’s a bad thing, because debt is much more systemically dangerous than equity. And secondly, the amount of triple-A debt in the world is soaring as well. Which is a worse thing, because triple-A debt is much more systemically dangerous than most other debt.
Then look at the green line. Triple-A debt wasn’t a huge part of the bond market back in the early 90s, but for the past decade it has invariably accounted for somewhere between 50% and 60% of total global fixed income issuance. That’s possibly the most horrifying bit of all: it simply defies credulity for anybody to be asked to believe that more than half the bonds issued in any given year are essentially free of any credit risk.
Finally, look at the way that the maroon bars — structured products, basically — have given way to a scarily large purple bar at the far right of the chart. That’s sovereign debt, and it tells you all you need to know about where the next crisis is likely to come from.

In a nutshell, triple-A debt is dangerous; there’s far too much of it; its growth seems out of control; and the triple-A problem has now become a sovereign-debt problem, in a world where sovereign-debt crises are the most damaging crises of all.
All that said, there are two things worth bearing in mind which make the chart slightly less horrific. The first is that for reasons I don’t understand, the chart ends in 2009, a crisis year when sovereigns pulled out all the stops in their attempt to prevent a global Depression. We’re more than halfway into 2011 at this point, there’s no good reason why the chart couldn’t include 2010 as well. And that might show 2009 as being a bit of an aberration. Does anybody have the numbers for total triple-A bond issuance in 2010, and how much of that was sovereign?

S&P puts USA on credit watch with 50% chance of downgrade

Here is the relevant text from the decision by S&P to place US debt on credit watch with negative outlook from July 14, 2011

United States of America ‘AAA/A-1+’ Ratings

Placed On CreditWatch Negative On Rising

Risk Of Policy Stalemate

Overview

Standard & Poor’s has placed its ‘AAA’ long-term and ‘A-1+’ short-term sovereign credit ratings on the United States of America on CreditWatch with negative implications.

Standard & Poor’s uses CreditWatch to indicate a substantial likelihood of it taking a rating action within the next 90 days, or in response to events presenting significant uncertainty to the creditworthiness of an issuer. Today’s CreditWatch placement signals our view that, owing to the dynamics of the political debate on the debt ceiling, there is at least a one-in-two likelihood that we could lower the long-term rating on the U.S. within the next 90 days. We have also placed our short-term rating on the U.S. on CreditWatch negative, reflecting our view that the current situation presents such significant uncertainty to the U.S. creditworthiness.

Since we revised the outlook on our ‘AAA’ long-term rating to negative from stable on April 18, 2011, the political debate about the U.S.’ fiscal stance and the related issue of the U.S. government debt ceiling has, in our view, only become more entangled. Despite months of negotiations, the two sides remain at odds on fundamental fiscal policy issues. Consequently, we believe there is an increasing risk of a substantial policy stalemate enduring beyond any near-term agreement to raise the debt ceiling.

As a consequence, we now believe that we could lower our ratings on the U.S. within three months.

We may lower the long-term rating on the U.S. by one or more notches into the ‘AA’ category in the next three months, if we conclude that Congress and the Administration have not achieved a credible solution to the rising U.S. government debt burden and are not likely to achieve one in the foreseeable future.

We still believe that the risk of a payment default on U.S. government debt obligations as a result of not raising the debt ceiling is small, though increasing. However, any default on scheduled debt service payments on the U.S.’ market debt, however brief, could lead us to revise the long-term and short-term ratings on the U.S. to ‘SD.’ Under our rating definitions, ‘SD,’ or selective default, refers to a situation where an issuer, the federal government in this case, has defaulted on some of its debt obligations, while remaining current on its other debt obligations.

We may also lower the long-term rating and affirm the short-term rating if we conclude that future adjustments to the debt ceiling are likely to be the subject of political maneuvering to the extent that questions persist about Congress’ and the Administration’s willingness and ability to timely honor the U.S.’ scheduled debt obligations.

Convergence/Divergence of Greek and German bonds

So what’s the takeaway? Basically investors front-ran the inclusion of Greece into the eurozone. The trade worked. A lot of people made a lot of money as the spreads came in to Germany as expected. And on the face of it, some of the statistics such as Greek inflation numbers seemed to back up the story that the Greek economic/technocratic establishment was starting to behave in a way that would be more favorable to bond investors. (Although, as we know now, it would have been a good idea to view those stats with some skepticism.)

But in giving a quick glance to the coverage of the great convergence, it’s tough to find any indication that anybody really understood what what “convergence” really was and how it explained bond yields that low. In short, it was a trade that worked, until recently, when it stopped working.

Source

Key US Employment Metrics

EFSF not funded sufficiently to deal with rescue of Italy

As Reuters has reported the EFSF does not have sufficient guarantees in place to rescue Italy should that be required.

(Reuters) - The existing European rescue fund now in place is not large enough to protect Italy as it was never designed to do that, an unnamed European Central Bank source was quoted telling Die Welt newspaper on Sunday.

"The existing rescue fund in Europe is not sufficient to provide a credible defensive wall for Italy," the central bank source was quoted telling the newspaper in an advance text of an article to appear on Monday.

"It was never designed for that," the source added.

The newspaper said that the rescue fund might have to be doubled to up to 1.5 trillion euros. But it was not clear if it was the central bank source calling for the increase.

There was a sharp sell-off in Italian assets on Friday, which has increased fears that Italy, with the highest sovereign debt ratio relative to its economy in the euro zone after Greece, could be next to suffer in the crisis.

Why Italy really matters for the Eurozone

As the graphic reveals the CDS market for Italian debt is particularly vulnerable and as useful background the following is excerpted from an article in the FT for July 10th.

On Friday, yields on Italian government debt – the largest bond market in Europe – hit their highest levels since October 2002. Italy is now borrowing at its biggest premium over German bunds, the benchmark for the region.

The move followed the surfacing last week of tensions between Silvio Berlusconi, prime minister, and Giulio Tremonti, Italy’s finance minister, over the country’s proposed austerity programme.

Good Graphic on System Risk from Greek default