Wednesday, August 31, 2016

Fast Approaching Crisis

News of the U.K. withdrawal (“Brexit”) from the European Union drove the Dow Industrial Average down 611 points, but that was just the tip of the iceberg. More unsettling news is on the way on economic, political and social fronts. Events will be startling, severe and global.

France's president Hollande is losing support among the public, according to polls. Meanwhile, Marine Le Pen, leader of the opposition National Front political party, is gaining in the polls, which show she would easily get more votes than Hollande if the election were held today. She has stated that if she wins the April election she will immediately call for a referendum on a “Frexit,” that is, whether France should withdraw from the European Union.

In the long period leading up to the vote on the Brexit, the “stay in” voters held a comfortable lead over the “leave” voters until nearly the very end. An important factor—perhaps the decisive one—in the Brexit vote was increased concern the country was losing its “Britishness” because of the influx of Syrian immigrants. The EU policy calls from free movement of people across the borders of the individual countries. No need for passports. France has taken in far more Syrians than the U.K., and Hollande has stated his country will accept 30,000 of them, which is not likely to help him politically. After the terrorist attack in Nice, France, in July  that killed 84 people, the polling gap between Le Pen and Hollande widened. Sixty-one percent of the French now have an unfavorable view of the EU.

Brexit has compounded the strains on Europe's banks and Italy's in particular. “Brexit could lead to a full-blown banking crisis in Italy,” says Lorenzo Codogno, former director general of the Italian Treasury. A Frexit would add momentum for an Italian exit from the EU. But even before the Brexit, Europe was facing a looming banking crisis in Italy, which has $400 billion in bad loans, nearly 18% of the nation's loans. That is nearly ten times the level in the U.S., where even in the worst of the 2008-09 crisis, the level was only about 5%. Italian banks have nearly half of all the bad loans in the entire 19-nation euro zone.

In the crisis of 2008, Italian banks were inclined to roll over loans of delinquent borrowers and hope an economic recovery would rescue the borrowers and the banks. It didn't happen. Impaired loans are now quadruple the 2008 level—and still rising. On July 29, 2016, the European Banking Authority disclosed the result of stress tests on 51 euro zone banks. Italy's Banca Monte dei Paschi di Siena—the oldest bank in the world (since 1472) and the nation's third largest—finished dead last. The EBA concluded that bank would be wiped out if the global economy and markets were strained. The EBA test did not factor in negative interest rates or the effect of Brexit. Also, it didn't include any Portuguese or Greek banks and left out some of the smaller unprofitable Italian banks. So the situation is really worse than the stress test showed.

Germany is the largest economy in the euro zone, followed by France and Italy. United Kingdom, which had been in the number two spot, is already gone. If France and Italy leave, the euro zone will have lost three of its four largest members. That will likely spell the end of the European Union. Dissatisfaction with the EU is already growing in various other member countries. Recent polls in Germany, Spain and the Netherlands show almost 50% of their populations have negative views of the EU. In Austria, polls show anti-EU candidate Norbert Hofer has an edge in October's presidential election. And Greece probably will not be able to remain in the euro zone for long, said Alan Greenspan in a recent CNBC interview—a conclusion that certainly doesn't surprise me or anyone who has read my latest book. Greece now has a debt of 320 billion euros ($362 billion), about 175 percent of gross domestic product, and no one wants to lend that country any more money, having been disappointed by three bailouts already.

While banking problems are most severe in Italy, other banks in Europe and elsewhere too, have their problems largely because of the stupid policy of negative interest rates. Banks are in business to make a profit by making loans at a higher rate than they pay depositors for use of their money. When loans are made cheap by increasing the supply of money (quantitative easing) or negative interest rates, bank profits plummet. In the second quarter 2016, profits at the British bank HSBC, Europe's biggest lender, dropped 45% from a year earlier. At Santander, Spain's largest bank, the drop was 50%. And at Deutschebank, Germany's largest bank, profits plummeted 98%.

Not surprisingly, the decline in banking profits has been reflected in the banks' stock prices. The shares of Italy's largest bank, UniCredit, have lost nearly 70% of their value. Shares of the Royal Bank of Scotland has declined more than 55%, and those of Credit Suisse and Barclays are down by half. Since the start of 2016, twenty of the world's bigger banks have lost about $455 billion, a quarter of their combined market value.

Bank leverage is the a proportion of a bank's debts to its equity/capital. Deutsche Bank has leverage of 40 times. By comparison, Lehman Bros. had leverage of only 31 times when it imploded in 2008, setting off the global banking crisis.

The European Central Bank has assets of $3.5 trillion on its balance sheet, according to Yardeni Research Inc.'s June 2016 Global Economic Briefing: Central Bank Balance Sheets. In addition, the ECB is committed to purchasing another 80 billion of euro assets every month until March 2017 (which might be extended) in European sovereign bonds and corporate bonds, including junk bonds. However, ECB's capital, which determines its solvency is a mere $12.2 billion. If the ECB were a “real” bank, its leverage would be almost 287.

Deutsche Bank's chief executive John Cryan has warned of the "fatal consequences" of the European Central Bank's negative interest rate policy, which he said  punishes savers and is “working against the goals of strengthening the economy and making the European banking system safer.” He said low interest rates have dire implications for savers and pension plans. In fact, according to insurance giant Swiss Re, the U.S. Federal Reserve's low interest rates cost savers $470 billion in forsaken interest income between 2008 and 2013. It calculates that by the end of 2016 savers, retirees and pension funds will be shortchanged $752 billion.

Since the ECB introduced negative interest rates in 2014, the euro has lost 18% of its value. Worldwide there are now $13 trillion of government bonds with negative interest rates. More than 90% of Japanese government bonds have negative yields, as do about 84% of German government bonds.

In a 12-page damning analysis, Deutsche Bank compared the European Central Bank's mistakes to those made by the German Reichsbank and the U.S. Federal Reserve in the 1920s, which eventually helped lead the U.S. into the Great Depression. "That was a hundred years ago,” the report said, “but mistakes keep happening despite all the supposed improvements to central banking, from independence to better data and more sophisticated theoretical and econometric models." 

The mistakes keep happening because those theoretical and econometric models are fundamentally wrong. They are based on Keynesian economics—which means they are not economic at all; they are anti-economic. As Professor Robert Barro—who has studied Keynesianism extensively—put it: “The Keynesian model asks one to turn economic common sense on its head in many ways.”

Hunter Lewis, author of the book Where Keynes Went Wrong writes: “Keynes suggested that the government could print new money. That money would flow into the economy in the form of debt, and that would take the place of savings, but there is just no evidence for that at all, there is no logic behind that. In fact, if you want a good economy, what you need is savings, and you need to invest savings in a wise way...Of course, Keynes completely ignores the issue of how you are investing. For him, not only is any investment equivalent to any other investment, but spending is equivalent to investment.” He believed, said Professor Barro, that “more government spending is good even if it goes to wasteful projects.” Of course, it is not promoted as wasteful spending; instead it is called stimulus spending. 
Keynes claimed government spending created a multiplier effect as that money was, in turn, spent over and over again throughout the economy. The Obama administration based its massive stimulus spending program on a multiplier of 1.5, meaning that every dollar of government spending would lead to a $1.5 increase in the GDP. But Lewis says, “There is just no evidence” that spending ever cured a recession, and Keynes “wasn't particularly interested in evidence.” Professor Barro says, "What few know is that there is no meaningful theoretical or empirical support for the Keynsian position.” In my book, second edition, I cite several academic studies proving this point. For example, a study by Barro and Charles Redlick found a multiplier effect of 0.4 to 0.7. A study by economics professor Gerald W. Scully covering sixty years of data found a multiplier of 0.46. When the multiplier is less than 1.0, it shows a negative effect: the benefits are less than their cost. I also include a graph (which I showed as Figure 2 here on this blog in June) showing the Obama stimulus act worsened—rather than reduced—the unemployment rate. The U.S. economy would have done better if the government had done nothing, rather than attempting to stimulate it.

There is extensive evidence that Keynsian policies of Franklin Roosevelt prolonged the Great Depression rather than curing it. And the same faulty doctrine has produced two “lost decades” of economic growth in Japan, which is now well into its third such substandard decade, while fear of a depression is growing. Nevertheless, Obama has been implementing the same failed doctrine throughout his presidency, and it has produced the weakest recovery from any U.S. recession since 1949.
The stock market today is one of the few economic aspects that some view as positive because stock prices have held up, but this requires further inspection. According to Goldman Sachs, buybacks have been the biggest driver of stock prices since the financial crisis. Companies have spent $2.5 trillion on “share buybacks” since then. A buyback is when a company buys back its stock from shareholders. This reduces the number of shares on the market and raises a company's earnings per share, which makes the company look good—it may pay a higher dividend—and may lift its stock price, but it doesn't make a company any more profitable. Low interest rates have allowed companies to borrow cheaply to buy their shares, as opposed to expending capital on business improvements, hiring and growing earnings.

Basically, rising stock prices correlate to higher earnings or the expectation of higher earnings; and if earnings are disappointing, stock prices will adjust accordingly. Here are some facts that indicate the high level of stock prices is out of whack with economic realities—and are due for a sharp downward adjustment:
  • The Standard & Poor's 500 index now has a P/E (price/earnings ratio) of 25. Only twice in history has this metric been this high: (1) at the top of the high-tech (“”) bubble that burst in 2000, and (2) in 2007 at the peak of the stock market before it and the housing/mortgage market collapsed into the Great Recession of 2008-09.
  • Earnings have moved in the opposite direction from stock prices. Earnings for the S&P 500 peaked in 2014 at $106 per share. Corporate earning for those same companies have declined for four straight quarters, and the end of the second quarter 2016 stood at $86.67 per share. This despite the fact that the Dow Industrials and the S&P 500 hit all-time highs in August.
  • Business investment fell 2.2% last quarter, the third straight quarterly decline in investments in property, plant and equipment, which hasn't happened since 2008-09.
  • U.S. companies are borrowing faster than they did during the dot-com bubble or housing boom.
  • Corporate leverage, which measures net debt against earnings, is twice as high as it was in 2007.
  • The real GDP growth rate for the year ending in June was a mere 1.2%—the weakest four-quarter rate since the Great Recession.
The stock market is thus very vulnerable in its own economic terms, but a major collapse here could also be triggered by an outside event such as a Frexit. Remember the 611 point drop in the Dow Industrials after the Brexist. After a Frexit, there won't be an immediate rebound as happened then, because there will still be the specter of an Italian banking crisis and the likelihood of Italy also exiting the EU. 

It is also possible that Italy will take the lead in exiting the euro zone rather than France, not just because of its banking problems but because of a referendum in October or November. The current prime minister Matteo Renzi, who has pursued reforms, is risking his future on a referendum over badly-needed constitutional changes. He says he will resign if the referendum fails. A “no”vote will not only bring about the downfall of his government but throw Italy's membership in the eurozone in doubt. If Renzi is gone, it is quite likely other parties will call for a vote on whether Italy should stay in the EU.

Another possible trigger for a stock market collapse and the fall of other economic dominoes could be the Fed instituting negative interest rates to try to “stimulate” (ha!) economic growth after a series of increasingly negative economic reports. That would be the final nail in the coffin of economic growth. It would reduce the available money supply in the banking system because people will simply withdraw money from their accounts and hide it under a mattress or equivalents. Even Commerzbank, the second largest bank in Germany, says it is considering storing cash in its own vaults to avoid paying the negative interest storage costs at the European Central Bank.

The aim of negative interest rates was to induce people to spend more and save less, on the faulty assumption this would improve the economy. It has produced the opposite effect. Central banks in Japan, Denmark, Sweden and Switzerland have adopted negative interest rates; but consumers in all those countries are saving more. They are looking out for their own future and want to replace lost interest income from savings and retirement accounts, not spend more. And banks in some countries, such as Switzerland, have responded to negative rates by making mortgage borrowing more expensive, not less as had been hoped.

Since the formation of the EU in the 1990s, there has been a concerted political effort to phase out gold in the international monetary system and replace it with a fiat currency, the euro. The euro experience has shown that an unlimited ability to print money with no backing cannot replace the effectiveness of a tangible monetary asset, gold. It may be useful, therefore, to look at the history of the EU's agreements on gold.

The first Central Bank Gold Agreement took place in 1999. At that time, central banks held nearly a quarter of all gold held above ground, about 33,000 tonnes. The second gold agreement (GBA2) took place in 2004. CBA3 and CBA4 followed in 2009 and 2014. The first clause in each of these four agreements began: “Gold will remain an important element of global monetary reserves.” In one of its first pronouncements, the ECB governing council decided the capital subscriptions of eurozone members would be paid 15% in gold and 85% in dollars or Japanese yen. (The capital subscriptions were based on population and GDP of the members.)

In a speech at Harvard's Kennedy School of Government in October 2013, Mario Draghi, head of the ECB and responsible for printing huge quantities of fiat euro, said, there are “several reasons” to own gold, among them “as a reserve of safety.” At the close of 2015, the world's centrals bank held about 31,400 tonnes of gold. The ECB held 503.2 tonnes, while national central banks held the rest. In 2014 the central banks bought 477 tonnes, the second highest amount in 50 years. In 2015 they bought 588 tonnes.

In the many centuries since the Chinese invented paper, there have been some 3,400 fiat paper currencies. All of them became worthless. There are no exceptions. The record is perfect failure: 100 per cent. The dollar will eventually become totally worthless, too. It may be a tossup whether the euro will get there first.

The rising gold price—and the fact that the central banks not only have thousands of tons of gold but are increasingly adding to it—shows a concern for safety and stability of money as a store of value. People throughout the world have the same concern and been increasing their buying of gold. Gold has answered the need for a store of value for 5,000 years. Quantitative easing and negative interest rates have never done so. Indeed, negative interest rates are unknown in 5,000 years of history.

However this issue plays out, gold will win in the end—because it best exemplifies the realities of the natural requirements of money—and its price will be much higher than it is today.