The trick to flying is to fall ... and miss. Douglas Adams, Hitchhiker's
Guide to the Galaxy
Douglas Adams should have been around now, but tragically died a few years ago
aged in his late forties (rather than at '42'). If he had been around, perhaps
he would have given some wise counsel to world leaders who all seem out at sea
in attempting to handle a crisis that wasn't necessarily of their making but
almost seems certain to be their undoing.
The weekend saw political parties in the United States failing to agree on a
program to adjust let alone cut sharply the country's yawning budget deficit.
Alongside, the seventh regime change since the beginning of 2010 in Europe
after this week's booting
out of Spain's prime minister Jose Luis Rodriguez Zapatero marks yet another
chapter of voters throwing not just the baby out with the bathwater, but in
this case also the midwife and the entire bedroom. (See
The men without qualities, Asia Times Online, October 29, 2011).
Cue the markets pushing Spanish and Italian yields to record levels this week,
and even "reassuring" statements from rating agencies about US creditworthiness
being shrugged off. The talk in Europe is now when, not if, Italy and Greece
leave the euro; speculation has even mounted about the tenability of the French
Meanwhile banks on both sides of the Atlantic are being pummeled into
submission with eye-watering declines in share price which the banks are
attempting to correct by shedding thousands of employees. The count this year
so far is that over 200,000 banking jobs will be lost in the major financial
centers of the West - in effect reversing the entire marginal hiring by the
industry since 2008. Alongside business sentiment continues to fall, and as
companies postpone indefinitely their plans to invest, the job market isn't
going to bounce back anytime soon.
Then there is the economic data. European data is no surprise except to those
who have been sleeping for a while, but the ugly numbers from US gross domestic
product on Tuesday showed declining inventories - exactly the kind of
multiplier effect on the negative end of the spectrum that predicts further and
sharper economic pain.
Politicians in the US and Europe need to be aware of two basic tenets of
a. If you are going to bluff, do it big and do it early;
b. If you are going to panic, do it early and do it big.
The unsaid supplemental rule here is: don't do both. This is the reason for the
opening quote from Douglas Adams.
Suspension of disbelief is an art form but apparently also broadly applicable
to various aspects of modern life ranging from market sentiment to voter angst.
There is very little certainty about any initiative, which basically calls for
strong confidence in one's ability to achieve something and more importantly in
one's ability to convince the other side of one's confidence in respect to the
same. For the markets, the common thread is really one of credibility, not of
Think about this broadly - if the European Union had stepped out and initiated
a broad program to buy every unsubscribed bond from Greece, Italy, Spain et al
in the beginning of 2010, would any of the problems really have gotten out of
hand since then? Instead, they embarked on a series of "limited" interventions,
which have been fruitless precisely because everyone knows they are limited.
It's a bit like walking into battle carrying a single revolver - everyone knows
you only have six bullets, and once they dodge those you are the one in serious
trouble. If on the other hand the other side has no clue about your weapons and
ammunition, the battle is most likely won without firing a single shot.
In the end, this is the primary reason for the Keynesian policies of the past
three years to have failed utterly. They were simply insufficient, vastly
under-estimating the true economic damage wrought by the 2007-8 financial
crisis (I really shouldn't be dating this financial crisis, given that it very
much continues to this day). This was then a case of bluffing late and bluffing
small time. I am of course happy with this failure because, as I argued before,
the demographic necessity of the West was to embrace poverty either broadly
through inflation or narrowly through significant write-offs in savings and
So much about the Keynesian failures, but how did the Austrian School followers
do in their neck of the woods? Not too well I am afraid. Austrian principles
such as credit tightening in a crisis, allowing banks and companies to go bust
without hesitation were observed in the exception (Lehman Brothers) rather than
the rule (countless US and European banks).
Even in the case of sovereign debt, the demands for austerity (Greece) were
trivial and the penalties for noncompliance, laughable ("You veel resign Mr
Papanderou, ja?"). This isn't the way that free markets work.
If you really wanted to stem the moral hazard tide, the best way would have
been to rescue depositors but let the banks go into administration. That would
have ended up costing Ireland a fraction of what the country has spent on its
banks since the beginning of 2008, primarily to mollify German bankers who had
made incredibly stupid lending decisions (see
(F)Ire and Ice", Asia Times Online, November 20, 2010) in the first
Even in the US, research has shown that in situations where private
institutions purchased mortgages at deep discounts from the banks (or more
likely from the Federal Deposit Insurance Corporation, which rescued the
banks), the turnaround has been palpable. Mortgages have been quickly modified,
some useless tenants kicked out while a majority see their payments adjusted to
more affordable levels along which they also have upside participation. In
contrast, the government-rescued banks still carry billions of zombie mortgages
and have simply failed to address them adequately if at all.
This isn't a surprise as the banks invested government bailouts not into their
decrepit operations but rather in punting across their fixed-income books,
essentially loading up on a whole bunch of underpriced assets. Some of these
assets rose in price, but some others have since fallen back over the course of
"Those damn Europeans sold from summer," exclaimed an American banker by way of
explanation of his horrific trading losses in the second half of this year.
"Yes, but what were you doing with a 30x leverage position on your books in the
first place?" I countered, to no avail. "What else could I do - everyone else
was hiring in 2009 and management asked me why I wasn't" he replied. That is
moral hazard in practice for you. A game of passing the parcel where everyone
knows that the parcel contains an explosive device that may be set off by
movement, time or just randomly.
The way forward
How do I expect this all to be resolved? This presupposes that I do expect this
situation to be resolved in the first place, which I really can't see at this
stage. Among all the worst body of options out there, it is my belief that the
following combination is likely to produce the most acceptable solution from
1. An unpopular Obama administration attempts to reverse the mollycoddling of
US banks going toward the elections. This means a crackdown on banking system
leverage, proprietary trading and a long look at jailing a bunch of bankers.
This would also involve taking a couple of US banks (you know who you are) to
the proverbial cleaners, in essence allowing a controlled bankruptcy of those
2. Meanwhile the Europeans simply go ahead and commit big time to Keynesian
solutions, essentially overruling the German opposition. The European Central
Bank indulges in significant and unlimited quantitative easing, while European
governments turn their back on austerity.
In this combination, the following market impacts come through:
a. A significant decline in the value of the euro against the US dollar,
perhaps approaching parity or worse;
b. A sharp decline in global stock prices followed by a sharp rally next year;
c. Rampant inflation in the Western world that helps to push up commodity
prices after the initial decline;
d. Recovery in European sovereign bonds for the short-term.
In every possible way of looking at all this though, I cannot help but admit to
a strong whiff of wishful thinking in all this. Oh well, it is Thanksgiving
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