When it couldn’t get worse, the best is yet to come

Pubblicato il 29 Maggio 2012 da Veronica Baker

When it couldn’t get worse, the best is yet to come

“Just when you thought it couldn’t get worse, surprise – the best is yet to come”.

In this moment, all commentators are pessimistic and expect an immediate total collapse of the economy.

But on my opinion there will be an improvement on the short term about the situation of Eurozone, even in Italy.
No, I’m not suddendly gone mad : first of all , in any downtrend, there are always rebounces.

But in particular it is now very likely that the ECB will shortly decide to support the entire banking system .

The mechanism is simple :  ECB will guarantee bank liquidity via lending to any member bank with qualifying collateral.

And consequently the list collateral will be kept sufficiently inclusive and haircuts sufficiently low to ensure liquidity.

The  national government debt (on the list of qualifying collateral  will allow the banking system to support national goverment funding needs. EuroZone deficit spending in this moment  is still sufficient to support flat to modest growth , even if in peripheral countries of the Mediterranean the recession will continue, at a time when the politics are unlikely to push for additional material proactive austerity measures.

For understanding the reason why I am in this moment rather optimistic (at least on the short term ) you can read the last Ray Dalio’s interview with Barron’s .

Don’t remember : Dalio is a powerful member of the WEF…he knows the truth behind the curtains.

Barron’s: You’ve called the current phase of the U.S. deleveraging experience “beautiful.” Explain that, please.

Dalio: Deleveragings occur in a mechanical way that is important to understand.
There are three ways to deleverage. We hear a lot about austerity.

In other words, pull in your belt, spend less, and reduce debt. But austerity causes less spending and, because when you spend less, somebody earns less, it causes the contraction to feed on itself. Austerity causes more problems.

It is deflationary and it is negative for growth. Restructuring the debt means creditors get paid less or get paid over a longer time frame or at a lower interest rate; somehow a contract is broken in a way that reduces debt. But debt restructurings also are deflationary and negative for growth. One man’s debts are another man’s assets, and when debts are written down to relieve the debtor of the burden, it has a negative effect on wealth.

That causes credit to decline. Printing money typically happens when interest rates are close to zero, because you can’t lower interest rates any more. Central banks create money, essentially, and buy the assets that put money in the system for a quantitative easing or debt monetization.

Unlike the first two options, this is an inflationary action and stimulative to the economy.

Barron’s : How is any of this “beautiful?”

Dalio : A beautiful deleveraging balances the three options. In other words, there is a certain amount of austerity, there is a certain amount of debt restructuring, and there is a certain amount of printing of money.

When done in the right mix, it isn’t dramatic. It doesn’t produce too much deflation or too much depression.
There is slow growth, but it is positive slow growth. At the same time, ratios of debt-to-incomes go down.
That’s a beautiful deleveraging. We’re in a phase now in the U.S. which is very much like the 1933-37 period, in which there is positive growth around a slow-growth trend.

The Federal Reserve will do another quantitative easing if the economy turns down again, for the purpose of alleviating debt and putting money into the hands of people. We will also need fiscal stimulation by the government, which of course, is very classic.

Governments have to spend more when sales and tax revenue go down and as unemployment and other social benefits kick in and there is a redistribution of wealth. That’s why there is going to be more taxation on the wealthy and more social tension. A deleveraging is not an easy time.
But when you are approaching balance again, that’s a good thing.

B : What makes all the difference between the ugly and the beautiful?

D: The key is to keep nominal interest rates below the nominal growth rate in the economy, without printing so much money that they cause an inflationary spiral. The way to do that is to be printing money at the same time there is austerity and debt restructurings going on.

B:How do you expect Europe to fare?

D:Europe is probably the most interesting case of a deleveraging in recorded history. Normally, a country will find out what’s best for itself.
In other words, a central bank will make monetary decisions for the country and a treasury will set fiscal policy for the country.
They might make mistakes along the way, but they can be adjusted, and eventually there is a policy for the country.

There is a very big problem in Europe because there isn’t a good agreement about who should bear what kind of risks, and there isn’t a decision-making process to produce that kind of an agreement.

We were very close to a debt collapse in Europe, and then the European Central Bank began the LTROs [long-term refinancing operations]. The ECB said it would lend euro-zone banks as much money as they wanted at a 1% interest rate for three years.
The banks then could buy government bonds with significantly higher yields, which would also produce a lot more demand for those assets and ease the pressure in countries like Spain and Italy. Essentially, the ECB and the individual banks took on a whole lot of credit exposure.

The banks have something like 20 trillion euros ($25.38 trillion) worth of assets and less than one trillion euros of capital.
They are very leveraged. Also, the countries themselves have debt problems and they need to roll over existing debts and borrow more.
The banks are now overleveraged and can’t expand their balance sheets. And the governments don’t have enough buyers of their debt.
Demand has fallen not just because of bad expectations, although everybody should have bad expectations, but because the buyers themselves have less money to spend on that debt.

So the ECB action created a temporary surge in buying of those bonds and it relieved the crisis for the moment, but that’s still not good enough.

They can keep doing that, but each central bank in each country wants to know what happens if the debtors can’t pay, who is going to bear what part of the burden?

B:Have the French and Greek elections changed the outlook?

D:They are the latest steps in a long drama that is not in and of itself much more important than most of the other steps.
It’s normal that the pendulum swings to produce these sorts of changes, and it is to be expected that tensions will increase and agreements will be harder to come by. This will add to the risks over the next year.

B:So what is the solution to this? How will the European debt crisis be resolved?

D:What is happening in Europe now is essentially the same, almost totally analogous, to what happened in the U.S. in 1789. It is an interesting comparison.

When it couldn’t get worse, the best is yet to come


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