#globalfinancialcrisis

Japan’s moral hazard plan would be harakiri

I’ve said it before and I’ll say it again. Central banks are in such dire straits. ECB President Draghi admitted that he is merely doing what every other central bank is doing. Group think. Perhaps more telling is  Alan Greenspan has started to put himself into the public again saying we are in trouble. You know we are in really big trouble because he’s always ‘behind the curve’. My bigger concern is how the Central Banks cannot play moral hazard like the private sector has. If central banks decide to magically make debt disappear through a debt jubilee the financial devastation would be 100x worse than 1929.

The Japanese have been toying with a plan to wipe out the US$10 trillion of public debt by converting the JGBs they’ll buy with printed money into zero coupon perpetual bonds.The value of a zero coupon perpetual is mathematically zero. So in a heart beat the Japanese government debt gets written down to zero. The Bank of Japan has a $10 trillion asset which is now worth nothing. 200% of GDP gone in an instant. Mauldin also made this assertion that monetising all debt at once by all countries would be unthinkable but the only way you could do it.

Let’s entertain the premise if Japan did this. What would happen? Global markets run on confidence. Nothing more. Nothing less. Without confidence markets will fret. People forget that the Japanese government STILL needs to fund Y40-50 trillion every year to plug the hole in the deficit. Tax take is less than Y56 trillion. Expenditures, thanks to an ageing society are rising above Y100tn. That gap won’t close easily. Sure the BoJ could print that gap every year but honestly, how could Japan’s yen be worth anything if they printed $400-500bn per annum? That’s right Japan would press start on the printing presses and produce the GDP of Thailand or Austria or Sweden or Belgium or Taiwan. Does this pass any sniff test?

Japan imports 60% of its food. It imports most of its energy sources like coal or LNG. It imports iron ore and coking coal to make steel. They must pay these foreigners in their currency. What supplier would want to accept a currency where the central bank just prints it. No country would accept yen pricing. Yes, hyper inflation would be the result. 

The debt service costs of the Japanese banks would become extreme. The low interest fixed mortgages which drives bank income are funded by predominantly depositors. However to avoid the Japanese banks witnessing capital flight they would need to raise deposit rates to dizzying levels and even then as Mrs Watanabe realises the Japanese yen is becoming like the Zimbabwean dollar she’ll convert into another currency exacerbating the downward pressure. Japanese banks would quickly become insolvent. Then corporations would start collapsing causing widespread unemployment.

The Global Financial Crisis (GFC) of 2008 taught us about moral hazard. People just walked away from their interest only mortgages and left the taxpayer to clean up the mess. Moral hazard is not good under any circumstances but if central banks and governments start playing moral hazard by ‘walking away from debt’ then effectively you permanently ruin trust and financial markets are destroyed. Think about. If people think that the end game will always result in a bail out then moral hazard becomes the default. It is permanent helicopter money. There is absolutely zero incentive to act prudently. Everyone should have a $50mn home, a Rolls-Royce and not have to work for it. Simple economics means that this solution is completely untenable. In a sense paper money would be worthless, we would have full unemployment and society would cease to function.

Now before we start reeling off the resumes of the incredibly intelligent people who can mathematically prove theories like this, note that was exactly the same type of argument hurled at me back in 2001 when I heavily criticised Greenspan predicting he would lead the world off a cliff in 5 years. I was right and they were wrong. Central banks have no idea. Their policies are group think. They don’t live in markets. They don’t breath markets 24-7. The only thing Greenspan was right on was to say “The gut feel of the 55-year old trader is more important than the mathematical elegance of the 25-year old genius.” Ask any of your experienced financial sector friends and get them to give you their gut feeling in private (publically they’e always bullish) and their answer to an almost 100% degree will be funereal.

If Japan makes the move to make $10 trillion dollars disappear (i.e. the GDP of China, home to 1.2 billion people) it will be the biggest mass suicide the world has ever seen in financial markets. You can take that to the BANK.

1/3rd of China’s GDP is now spent on debt servicing

debtgdp china

John Mauldin has an interesting piece out that pretty much is inline with my thoughts on how the global economy is heading for the tank. This GFC will be worse than the first although different in its form.

We are drowning in more debt than we were at the time of GFC. It is chronically bad. Mauldin mentioned.

“So, China has problems. Their debt has just ballooned. Depending on whom you want to listen to, 40% to 80% of the last $6 trillion the Chinese borrowed went to pay interest on the debt they already had. In less polite circles we would call that a Ponzi scheme….Now, they do have a lot of money. Yes. Can they print more? Yes. Do they want to have a New Silk Road? Do they want to be the world’s reserve currency? Do they want to be the most powerful country in the world? Of course they do…The Chinese see themselves rebuilding their own ancient empire. You don’t do that on the back of a weak currency – but then we come to the problem of a strong Chinese currency. Oh, by the way, their debt service is up to 30% of GDP, but that’s a detail that is mostly overlooked.”

Emerging markets is a massive elephant in the room and we will see their currencies get sold off heavily.

“Emerging markets are the fourth weak link. How do they dig out? They borrowed $10 trillion in dollars that they have to pay back from income earned in their local currencies. Dollar valuation can create serious problems for their debt. And it happens at the worst possible time, during a crisis or global recession when the US dollar is the cleanest dirty shirt in the closet. The value of the dollar will rise at precisely the time when the profits and tax revenues of the emerging-market corporations and countries will fall.”

The US is heading toward $30 trillion of debt and you can bet the Fed has to move to negative rates too.

The folly of negative rates is simple. The retiring population are now finding it harder to get stable income products without going further up the risk chain both in term and product. Obviously the longer the term of the bond, the worse it will be for duration. People talk of debt monetisation and writing it all off but the confidence of the financial system cannot stay alive if those that hold the debt get wiped out. It may still happen but anyone thinking it would be a good thing invite moral hazard of the worst kind.

I completely agree that savers are being buried. Any inflation has been in asset markets and this comment backs up what  I have been saying about the person on the street is still being crushed. 47% of Americans, according to the Fed, can’t raise $400 in emergency cash without selling something. I believe Brexit was also a function of the sharp rise in poverty.  The rise of Trump is also a function of the anti-establishment movement.

“I am afraid that the one thing we can count on is that whatever policy the Fed chooses will be the wrong policy. They believe they can set the price of money and thereby balance demand and supply. Can anybody name me one instance where fixed prices worked in the real world, creating a paradise where supply and demand were balanced? They have manipulated [I keep making this claim] the system and set the wrong price of money. They have created a world where savers are penalized, companies are paid to buy their competition rather than compete, and only the participants on Wall Street are rewarded with appreciation of their assets. My Austrian and monetarist economics school friends, who predicted inflation from all the QE that we saw, have actually seen inflation it has just been in asset prices that benefited Wall Street and not Main Street…And it’s not just a US problem. It’s Europe and Japan and anywhere in the world where interest rates and savers have been repressed.”

Several EU banks headed for insolvency?

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Looks as though several European banks are headed for the dustbin. In the prelude to GFC1 we had words like NINJA loans (no income, no job or assets) which entered financial lexicon. Now the latest word for equity markets is TINA (there is no alternative).

ZeroHedge wrote on the folding of a Belgian bank

Belgium-based Optima Bank has been shut down by both the National Bank of Belgium (which also acts as the Belgian regulating body) as well as the ECB. According to the national supervisor, the bank would have been unable to meet its commitments to its clients and was forced to cease all banking activities after some potentially fraudulent transaction were unveiled.

It’s surprising to see the main media have tried to keep this silent as even the website of the National Bank of Belgium didn’t bother to issue the press release in English (whereas all other press releases on the home page can be read in English). There’s no statement from the ECB either, nor has this news been translated on the English version of website of the state-owned national television station.

The situation is so bad the regulator has already immediately tasked the special fund organizing the Deposit Guarantee Scheme to start paying out the clients of the bank, even though Optima Bank hasn’t filed a bankruptcy procedure just yet. The urgency of the need to pay the clients does indicate the situation is extremely bad and even though it’s a very small one (it had closed the savings accounts division last year), there are two more important things you need to keep in mind.