Thursday, October 11, 2012 – The Bigger Debate

by Sinclair Noe
DOW – 18 = 13,326
SPX +0.28 = 1432
NAS – 2 = 3049
10 YR YLD – .02 = 1.67%
OIL + 1.22 = 92.47
GOLD + 4.60 = 1768.00
SILV +.06 = 34.10
PLAT + 4.00 = 1682.00
A fairly remarkable thing happened today. I doubt you’ll hear much of it on the nightly news because after all, there is a big debate this evening, but the news out of Tokyo this morning centered around and even bigger debate.
The International Monetary Fund and the World Bank are holding their annual meeting in Japan and the Managing Director of the IMF, Christine Lagarde announced that the harsh austerity measures that European monetary officials have been pushing could produce the opposite effect on struggling nations like Greece and Spain and Portugal and Ireland. In other words, austerity has not worked and it probably isn’t the solution to Europe’s problems after all.
For those of you that have been alert and attentive, you know that Euro-crisis has served as the testing ground for major economic theory. The IMF announcement today marks a dramatic turning point moving forward, or at least it marks a dramatic sounding announcement and a surprising admission of policy failure. Still to be determined is how the Euro-crisis plays out from here. Large parts of the Euro-zone are now in economic depression that threaten not just the weak nations but even the strongest.
We are familiar with the situation in Greece; unemployment is running at 25%; the Greek government remains in upheaval; the old government gave up; World Bank technocrats took control for a while; elections could not produce a coalition; political parties went to wild extremes; another election produced a splintered coalition but it wasn’t enough to alter the economic downward spiral. Big chunks of government owned assets went on the auction block. Greeks took to the streets in protest.
Portugal has been the poster child of fealty to the Troika of the IMF, the World Bank, and the ECB. Portugal accepted any and all austerity measures with hardly a whimper; government spending was cut, taxes were raised and still the Portuguese economy contracted and debt to GDP grew. Finally the Troika demanded cuts to pensions and the Portuguese people responded with a determined “no, you’ve gone too far.”
Spain is also facing economic depression. Unemployment is running at 25% and there is no hope it will improve over the next couple of years. Falling tax revenue and rising costs of unemployment benefits are confounding the government’s efforts to hit a 2012 deficit reduction target of 6.3 percent of gross domestic target agreed with the European Union. The problem is that GDP is a moving target and it has been consistently moving lower. Yesterday, Standard and Poors issued a 2-notch downgrade to Spain’s sovereign credit rating to BBB-minus, in line with Moody’s rating. Both firms have Spain just on the cusp of junk status. If Spain is cut to junk status, it could cause Spanish bond yields to spike; there might even be a carry over effect to Italian debt.
There have already been huge bailouts for Spanish banks and they appear no healthier for it; meanwhile, there have been severe public sector wage cuts, and lower spending on education and healthcare; tensions between the central and regional governments have been rising, making policy outcomes even more challenging. The Spaniards took to the streets; the protests were overwhelming; more than 1.5 million marched on Madrid a couple of weeks ago.
Perhaps because of the enormous display of people power, Spain has resisted submitting a request for a bailout from the Troika, which would include submitting to the Troika’s austerity demands. The IMF’s chief economist warned Madrid was courting fate by trying to muddle through without a bailout and without the tough terms it would bring, but the Spaniards keep showing up in the streets and there was no way to accept the bailout.
More than 300-billion-euro has left Spain, a capital flight that is roughly 27% of GDP. The banks can’t turn to the ECB because the banks are short on usable collateral. The likely outcome is a credit crunch that economists estimate would trim 4% off Spain’s GDP. And if Greece, Portugal, and Spain fall any farther, they would surely drag Italy with them. The economic contraction is already being felt in the strongest northern countries.
There was a deal for more bank bailouts but Spain insisted the money go directly to the banks rather than have it channeled through the government and become official government debt, The northern countries figure the banks are a risky bet and Germany, Austria, Finland, and Holland reneged on the bailout deal two weeks ago.
So, once again, the EU is on the edge of a full scale meltdown, and maybe Christine Lagarde had no choice but to change philosophy and change course; maybe she is buying time; it remains to be seen if she can shift the trajectory at this late stage in the game. Lagarde said Greece should be given an extra two years to meet its budget targets
Lagarde says that governments should no longer pursue specific debt reduction targets but focus on implementing reforms. If borrowing rises as a direct result of growth-sapping measures, the IMF now thinks it should be tolerated rather than addressed with even more tax rises or spending cuts. Lagarde said: “It’s sometimes better to have a bit more time” with regard to spending cuts and tax increase.
The IMF warned that governments around the world had systematically underestimated the damage done to growth by austerity. And they produced charts which show that activity over the past few years has disappointed more in economies with more aggressive fiscal consolidation plans. Still, this was not a complete rethink of austerity economics. Rather, it is just acknowledgment of the painfully obvious reality that countries are missing their targets, economies are contracting, it is useless to require further cuts, people power is actually powerful, and a shift in ideology might buy some time.
According to the IMF’s World Economic Outlook report:”Risks for a serious global slowdown are alarmingly high.” The IMF expects the global economy to expand 3.3% this year and 3.6% in 2013, the slowest rate of growth since the 2009 recession. Lagarde applauded efforts to stimulate growth taken by central banks, including the Bank of England and the Fed, but warned that they were just buying time for fiscal reforms, and the monetary stimulus, “in and of themselves will not be sufficient.”
Action should be focused on four key areas; completing stalled financial sector reforms, establishing “credible medium term strategies” to deal with government debts, supporting job-rich growth “as unemployment levels are terrifying and unacceptable”, and facing up to “the fundamental issues of global imbalances”.
Unsurprisingly, she said the most urgent action is needed in Europe, saying the eurozone remained “the epicentre” of the global crisis.

However, she added that “fiscal risks are becoming more threatening” in the US, where the scheduled withdrawal of tax cuts in January threatens to squeeze the world’s largest economy and further erode global growth.
Yes, the Euro-crisis has served as the testing grounds for the big debate about austerity versus stimulus, and we are feeling the effects here in the US, where we’ve been testing this austerity stuff for a couple of years. It may surprise you to learn that during the past three years, the growth in government spending has been the slowest in 60 years just a 1.4% increase in government spending between 2010 and 2013.
Yes, government spending is still increasing but it is increasing at the slowest pace since Ike was in office. Under Reagan’s first term, government spending grew at an 8.7% annualized pace; up 5.4% under Bush, the senior; up 3.2% in Clinton’s first term; up 7.3% under Bush the junior; but up 1.4% in the past three years.
What gives? Well, you may remember that Congress passed the Statutory Pay-As-You-Go Act which mandates that new government spending be offset with spending cuts or new revenue; this was the American effort at austerity and from what we learned today from the IMF, that contractionary policy has likely been the blame for at least some contraction in the US economy. Oh, I know, the US economy is still the expanding, even if it is just sluggish growth it looks fairly strong compared to Europe; but how much better off would we be if we had just avoided the austerity hysteria and invested in America? But nooo! Congress insisted on cuts, and so they passed the Statutory Pay-As-You-Go Act of February 2010, passed by a highly partisan Democratic Congress and signed into law by a Democratic President without a single Republican vote. I can’t wait for that topic to come up in tonight’s debate.
And finally, tomorrow we’ll see the earnings reports of several big banks, including JPMorgan Chase. This will be especially interesting to see how they portray the $6 billion “London Whale” trading loss. Expect them to paint a picture of rogue traders leading to an unfortunate mistake. What Jamie Dimon calls a mistake, others would call criminal action, as the bank failed to honor internal controls mandated under the Sarbanes-Oxley Act, instead allowing traders to provide the valuations for its financial disclosures to shareholders. The law stipulates that the top executives, including Jamie Dimon, are responsible for any fraudulent valuations delivered to shareholders. Period. Sarbanes-Oxley makes this incredibly simple.If JPMorgan Chase “submitted inaccurate financial statements to regulators,” then top management is criminally responsible under Sarbanes-Oxley. Anything less simply ignores the clear duty under the law.
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