Friday, April 28, 2017

Greece on Collision Course With Creditors

Greece is in the familiar position of needing more money. It must come up with about 7 billion euros ($7.5 billion) in July 2017 for debt payments on loans from three previous bailouts. If it defaults on these payments, it will be out of the European Union.

Since the three previous bailouts have failed to provide Greece with a sustainable economy, there is great reluctance by the previous creditors to provide a fourth bailout. These creditors include the International Monetary Fund, the European Central Bank, and various European countries

Currently operating under the third bailout, which runs into 2018, Greece was expecting to receive enough of that remaining bailout money to meet its obligations for the July payments. However, the trio of inspectors who periodically review Greece's performance, found that performance unsatisfactory, which halted the payments to Greece. The IMF has taken the position that it will not participate in any further funding for Greece until there are economic reforms, particularly regarding pensions, labor laws, and broadening the tax base, that will allow Greece to reduce its debt to sustainable levels. The IMF's analysis concludes Greece's debt-to-GPD ratio, currently 179 %, is “highly unsustainable” and without the economic restructuring it recommends, that ratio will balloon to 275 % by 2060. By comparison, the European Union requires its nations to have a debt-to-gross domestic product ratio of no more than 60 percent. Economist generally consider the limit of sustainable debt to be around 80 percent.

In 2016 a paper by the European Stability Mechanism, which manages the bailout program, proposed to ease Greece's debt load by extending some maturities and locking interest rates on some loans as protection against interest rate hikes. Even so, an official ESM paper projects Greece's debt-to-GDP will be 104.9 % percent in 2060, assuming Greece fully implements the IMF-recommended reform measures —probably an extravagant expectation given its performance under previous bailouts. After 43 years Greece will still not have a sustainable economy.

Germany, by far the largest economy in the EU, was the largest contributor to the three prior Greece bailouts. But Germany has stated it will not provide further funds to Greece unless the IMF also agrees to resume lending to Greece. Moreover, Germany and the Netherlands have promised their parliaments that they won't ask for more money for Greece unless the IMF participates, too.
 
In 2015 Greece pledged to achieve a primary surplus of 3.5 % of GDP—before debt payments—in 2018 and for an unspecified number of years in the future, but the current track for Greece is for a primary surplus of just 1.5 % . Moreover, the IMF believes a primary surplus of 3.5% is wholly implausible. Few countries have ever managed such a feat—and none with such a weak political system as Greece.

Because the enormous size of Greece's debt is such an obstacle to achieving sustainability, it has been suggested that the nation needs to have some debt reduction from its creditors. That is even more unlikely than another bailout. In 2012, private investors “voluntarily” accepted losses on Greek bonds that wiped 107 billion euros off the country's debt. The public sector followed with a reduction of the economic value of the loans. No country in the world has ever received greater debt reduction, but  Greece still faces a debt problem.

Greece has had many of these crises but has always managed to survive by somehow pulling a rabbit out of a hat. Compromises were made, terms were adjusted, political leaders were changed, and when all else seemed to fail, another bailout arrived in the nick of time. But now there is little room for any of the participants to maneuver. The IMF rules state it cannot make loans to countries whose economies are unsustainable or unlikely to attain sustainability in a reasonable period. So, after proclaiming Greece's debt is “highly unsustainable” and getting worse, how can it justify another IMF loan to it? Moreover, having put its name on two failed programs, it is leery of further damaging its institutional credibility by doing so again.

Chancellor Merkel's promise not to participate in further help to Greece unless the IMF is also on board is welcomed by the German people, who are strongly against having their tax money going to Greece. In addition, Merkel has recently announced she will run for a fourth term in the forthcoming September election. So she is not about to join, much less lead the charge, to save Greece. Meanwhile, it is questionable whether the Greek government—or any Greek government—will have the political will and public support for accepting the demands of the IMF for reforms that will mean further years of even more harsh austerity for the people. The country's “fiscal and structural reforms...pension reforms, tax reforms, are only a down payment,” said the IMF's Poul Thomsen recently. He said restoring the country's pre-crisis levels of unemployment and income levels will require “deep structural reforms, many of which are not on the books yet.” The unemployment rate is currently 22 percent.

Will Greece avoid disaster one more time by somehow pulling one more rabbit out of a hat? It seems unlikely, but we shall know fairly soon.

Friday, March 31, 2017

A New Way to Pick Supreme Court Justices

President Trump's nomination of Neil Gorsuch to the U.S. Supreme Court has brought to the fore a troublesome feature of our federal government, namely the selection of Supreme Court justices. The problem developed from the Senate's failure to approve the nomination of Robert Bork to the Court thirty years ago.

James Robertson, now a retired district judge, led a team of lawyers to oppose President Reagan's nomination of Bork to the Court. Recently he wrote, “I regret my part in what I now regard as a terrible political mistake... the treatment of Bork touched off a Thirty Years’ War on judicial appointments. We have politicized the judicial confirmation process far beyond historical norms and undermined public confidence in the judiciary.”

There is no question that Bork was highly qualified. Ralph E. Shaffer, a professor emeritus of history, wrote that during the Senate hearing for Bork's confirmation,

Americans were tuned to television and radio broadcasts of the most enlightening judicial give and take this country has ever witnessed." Bork met “each senators’ challenging questions with the brilliance of the law professor and attorney that he was.  When the questioning of Bork ended, observers and participants, whether for or against the nominee, expressed amazement at the high level of discourse that had just taken place....

Orrin Hatch, still on the judiciary committee thirty years later, told Bork,...that his analysis of how our charter works was unequaled by any commentator or television program.  Former Attorney General William Rogers called the proceedings an adult education class of the highest order, 'one that ought to be required reading for law students.'  To fellow Republican Alan Simpson the hearings were like a return to law school, with the sharpest kids in class debating the nation’s sharpest law professor. Patrick Leahy, who also serves on the Gorsuch committee, saw the Bork hearings as a graduate seminar in constitutional law. The country reveled in an intellectual feast. That had never happened before.

What made Bork’s interrogation so different from any other was the depth of questions and the forthright answers.... Via television and radio the nation enrolled in Rogers’ adult education class as Bork explained in detail ...[He] tackled every issue the committee raised...and presented a conservative analysis of the ninth and tenth amendments.”

But the Senate refused to confirm Bork's nomination. Why? Because he was a conservative. Democrats in the Senate wanted a liberal, or at least a nominee who was less conservative than Bork. Previously there had been, for the most part, a tendency in the Senate to go along with a president's judicial choices, regardless of whether conservative or liberal, so long at the nominee was qualified. The feeling was that a president who had won election should have the right to nominate judicial candidates of his own political persuasion. The republicans even provided Senate votes for Obama's supreme court nominees Sotomayor and Kagan. But—while it is uncertain at this point whether they will be able to defeat the Corsuch nomination—the democrats hope to do so, and Senator Chuck Schumer, senate minority leader, has said he will lead the drive for that effect. 

Antonin Scalia, whose death created the Court vacancy Gorsuch hopes to fill, believed the Constitution should be interpreted according to the meaning of words and phrases as they were understood in the times they were written. He scoffed at liberals who believed in a so-called “living” Constitution that changes with the times. Last year Gorsuch echoed Bork's idea of “originalism” in interpreting the Constitution when he wrote courts must “apply the law as it is, focusing backward, not forward, and looking to the text, structure and history to decide what a reasonable reader at the time of the events in question would have understood the law to be — not to decide cases based on their own moral convictions or policy consequences they believe might serve society best.”

Gorsuch's words on this are very much in keeping with the view of Thomas Jefferson, who wrote:
“On every question of construction [of the Constitution] let us carry ourselves back to the time when the Constitution was adopted, recollect the spirit manifested in the debates, and instead of trying what meaning my be squeezed out of the text, or invented against it, conform to the probable one in which it was passed.”

If the words of the Constitution do not mean what they meant when that document was written, then we don't have a constitution; we have a fake constitution, into which the justices can insert their own personal convictions or ideology to replace the original meaning of the words. This brings us to the fundamental problem of how we can select judges to conform to the Constitution rather than distort it or ignore it. To accomplish this, we need to take politics out of the process of selecting supreme court justices.

At the time the Constitution was written, there were no political parties, so the Framers couldn't foresee the problem of political partisanship undermining the Constitution. That document has very little to say about the process of selecting judges, only that the president “shall nominate, and by and with the advice and consent of the Senate, shall...appoint judges of the Supreme Court.”

Here is what I propose for a constitutional amendment to take partisan politics out of appointments to the Supreme Court.

When a vacancy occurs on the Court, the presiding judges of the highest court of each state and the chief judge in each of the thirteen U.S. Circuit Courts of Appeal shall within 30 days submit the names of two persons considered qualified for the vacancy on the high court, at least one of whom is not from the designator's home state or circuit court which he represents. The names of those chosen persons shall be submitted to the chief judge of the Superior Court of the District of Columbia. That judge shall then rank the submitted names according to the number of votes they have received, noting the names of those who have made the selections, and then convey this list to the judges so that they may verify the accuracy of their submissions as well as those of the other judges participating.

The president shall then nominate for the Supreme Court vacancy one of the top five persons on the list. If the Senate does not confirm this nominee, the president is then obligated to select another name from the top five. If the Senate fails similarly to confirm all five top names on the list, the procedure shall be repeated for the next five names on the list. If those five likewise are refused confirmation, the president shall then nominate the next name on the list, which shall be considered confirmed by the Senate unless a tie exists in the eleventh place. In the event of a tie of two or more persons in the eleventh place, the eldest shall be chosen and deemed to be confirmed. In the event that the list consists of fewer than eleven names, if the Senate fails to confirm all preceding names down to and including the next-to-last name on the list, the final name on the list shall be considered nominated and confirmed. For example, if the list contains only seven names and the first six all fail to win confirmation from the Senate, the seventh name on the list shall be considered nominated and confirmed.

The state chief judges and appeals court chief judges in this procedure are allowed to include their own names. It would be simpler not to allow their own names here, but these are highly knowledgeable, experienced individuals who have risen to the top of their court system and their opinions deserve to be included. This is part of the reason for allowing them to name two individuals, rather than only one and preventing them including themselves.

Another reason for having the state chief judges and appeals court judges contribute two names is that it allows a larger number of people to be considered, some of whom might well be in the top ten in the larger count—and would make very good members of the Supreme Court—but would be eliminated in the smaller count of only one name per state chief judge or appeals court chief judge. (Fifty states plus 13 appeals courts would mean 63 names on the District of Columbia list on the basis of one supplied by each chief judge, compared to twice that number if they are allowed two names.)

Still another reason for allotting two names per judge is the following. If judges are allowed to name only one and the results show one individual to be extremely popular, getting let's say, 48 of the 63 votes and the second-place finisher getting, say, 14 votes, that leaves only one vote left for all other candidates. That would make the system unworkable because there wouldn't be even 5 names on the list from which the president must make a choice. But if there are 126 possibilities for names, there will be no problem if one person gets 50 because there will still be 76 places for other names. In fact, if an individual got every vote possible, the most he would get would be 63, because no chief judge could name him twice. Each judge must submit two names for the list.

There is one other possibility which is extremely unlikely to ever occur but should be guarded against just in case. This is a situation in which the list contains a large number, say for example, 31 names getting only a single vote. This could happen in one of two ways. One, if 31 of the chief judges vote for themselves but receive no other votes. Two, if 31 of the chief judges vote for an individual other than themselves who gets no votes from any other chief judge. The whole system should not be thrown askew by a large number of names with extremely low support. Accordingly, any name on the list not supported by more than five state or appeals court chief judges should be eliminated from further consideration.

Finally, here is the oath that Supreme Court justices must take before they proceed to execute the duties of their new office:

"I, _________, do solemnly swear (or affirm) that I will administer justice without respect to persons, and do equal right to the poor and to the rich, and that I will faithfully and impartially discharge and perform all the duties incumbent upon me as _________ under the Constitution and laws of the United States.  So help me God."

I suggest this be changed as indicated in red:

"I, _________, do solemnly swear (or affirm) that I will administer justice without respect to persons, and do equal right to the poor and to the rich, and that I will faithfully and impartially discharge and perform all the duties incumbent upon me as _________ under the Constitution according to the meaning of its words as commonly understood at the time the Constitution was written and laws of the United States.  So help me God.

Wednesday, February 22, 2017

Calm Before the Financial Storm?

Widely watched statistics recently give the impression of modest growth in the economy. Nothing to worry about, it seems. Slight movements up or down in a number of statistical categories don't seem meaningful, but some very significant negative numbers aren't being mentioned at all. For example:

A growing number of U.S. companies are going bankrupt. In 2016 there were 37,823 of these. That's a whopping 26 percent more than in 2015. And American individuals are filing bankruptcies at the fastest rate in years. In January 2017, they filed 55,421 bankruptcies, 5.4 percent more than in January 2016. Those are not the kind of statistics you would expect from a healthy, growing economy. Another unhealthy statistic is median household income. It did not increase as all in 2016. In real dollar terms, it is now 2 percent (-$1,666) below its peak in 2008.

On January 13, 2017, the Education Department said it had overstated student loan repayment rates at most colleges and trade schools. The new numbers show that at 1,029 schools more than half of the students had already defaulted or failed to pay even one dollar down within seven years of leaving school. Student loan debt is growing at 20 percent per year, which is far higher than the economy or the rate inflation is growing. Student loans total more than auto loans or credit card debt and are almost 4 times larger than all the debts of Greece.

The stock market today is one of the few economic aspects widely viewed as positive because stock prices have held up, but this requires a closer look. The upsurge in stock prices has been fueled by mergers and acquisitions and buybacks. According to Goldman Sachs, buybacks have been the biggest driver of stock prices since the financial crisis, with companies spending $2.5 trillion on share buybacks. 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.

Earnings on the Standard & Poor's 500 peaked in 2014, but stock prices have kept on rising. The latest price-to-earnings ratio (cyclically-adjusted) of the S&P 500 is 28.6—which is its highest level since the “dot-com” bubble of 2000.

Another indication that stocks are overpriced is the fact that in the first quarter 2017, companies of 61 stocks in the S&P 500 gave negative estimates of future earnings while only 29 gave positive estimates. Rising stock prices correlate to higher earnings or the expectation of higher earnings; and if earnings are disappointing, stock prices will adjust accordingly.

Still another indication that stocks are overpriced is the growth in margin debt, which means stocks are increasingly purchased with borrowed money. This is usually a good indication of rising speculative interest associated with market tops. You can see in the following chart that stock market margins are higher now than at the peaks of the stock market in 2000 and 2007—just before sharp declines in the market.
 
Chart courtesy of dshort.com

The bursting of the housing/mortgage bubble precipitated not only a stock market crash and the Great Recession in the U.S. but had enormous repercussions on foreign banks and economies, particularly in Europe. Another U.S. stock market crash now will do the same. Conversely, foreign banking troubles now have the potential to create havoc not only in markets and banks in Europe but in the United States.

The center of the Italian banking crisis is Monte dei Paschi di Sienna, Italy's third largest bank and the oldest in the world, dating from 1472. Burdened by bad loans, it would be bankrupt in two or three months without external help. It was looking for a bailout, but the experience in recent years with bailouts—particularly in Greece—led to a change in European banking regulations. When Cyprus wanted a bailout, what it got instead was a “bail-in.” The difference is this: a “bailout” provides rescue funds from governments or foreign banks; a “bail-in” requires that bank owners, shareholders, junior bond holders, sometimes senior creditors and even depositors take a loss before public funds can be used for the rescue. This is what happened in Cyprus.

The bail-in approach was also tried last year with four small banks in Italy. The government is keen not to see a repeat of the protest demonstrations and two suicides which occurred. In one case a man who hanged himself left a suicide note that his entire life savings of €100,000 had been seized to rescue the bank, leaving him penniless. In the other case, Antonio Bedin put a bullet in his head after he lost his savings in the same manner. If banks' subordinated bonds are forced to take a hit in a bail-in, it will affect not just wealthy owners and other banks but an estimated 600,000 small savers like those two, many of whom were fraudulently sold these bonds as risk free.

However, an exception to the new banking rules was “found” (or perhaps “interpreted”) to allow a government bailout for Monte dei Pasche and other banks, and the Italian Parliament authorized 20 billion euros for this purpose in December 2016. The problem now is that it had been estimated Monte dei Pasche would require €2.8 billion, but the actual number is turning out to be closer to €6 billion. What would be left of the €20 billion would not be enough to cover the other troubled banks even under the most optimistic assumptions. Goldman Sachs estimates Italy's most fragile banks need €38 billion to be adequately capitalized. Italy’s banks hold double the amount of bad loans they held five years ago. In December 2016 a Forbes article estimated there is roughly €240 billion of Monte dei Pasche-type bank debt scattered around Italy. Italy's top 12 banks lost more than half their stock value in 2016. The sheer magnitude of Italy's banking problems rules out bailouts or bail-ins—but lack of a solution leads inevitably to the likelihood of Italy leaving the euro zone.

Otmar Issing is an economist who was brought in by the European Central Bank to design the monetary framework for a new currency, the euro. Known as the “Father of the Euro,” he now says the ECB has become “dangerously overextended” and is a “house of cards ready to collapse.” He said the ECB “betrayed the principles of the currency project by bailing Greece out in 2008,” and he condemns that action “as a bailout for French and German banks who had loaned to them.” [a point we had made in our book The Impending Monetary Revolution, the Dollar and Gold.

Issing goes on to state, “Market discipline is done away with by ECB interventions. So there is no fiscal control mechanism from markets or politics. This has all the elements to bring disaster for monetary union.”  

Economist Wolfgang Munchau is considered one of the world's foremost experts on the eurozone. He writes a regular column for Financial Times, in which he wrote: “An Italian exit from the single currency would trigger the total collapse of the eurozone within a very short period. It would probably lead to the most violent economic shock in history, dwarfing the Lehman Brothers bankruptcy in 2008 and the 1929 Wall Street crash.”

While the exact timing of the coming Italian banking collapse cannot be predicted, a likely timeline has emerged for another threat to the European Union—a threat which will accelerate the Italian exit from the EU if that hasn't already occurred. I'm speaking here of the situation in Greece. Under the terms of its third bailout, in 2015, Greece would allow periodic inspections of its progress in reducing its deficits under austerity measures and tax-and-spending policies that had been agreed upon. The inspections would be carried out by a Troika of officials from the ECB, the European Commission and the International Monetary fund. Their approval of the Greek government's progress would be necessary before the next tranche of funds from the 2015 bailout would be disbursed.

But in December 2016, after a year of relative calm, the Greek government issued a series of welfare benefits and suspended a sales tax increase that had been scheduled. Eurozone officials expressed surprise and frustration that Greece had taken these measures without notifying them in advance and said they appear to be “not in line with our agreements.” In retribution the European Stability Mechanism, the agency that provides the bailout loans, announced it would not honor an accord to ease the burden of repayment obligations on Greece's debts. The German ministry supported putting the debt relief on hold.

Germany has said it will not agree to any debt relief for Greece unless the International Monetary Fund participates. The IMF has said in two recent policy papers that it will not do so. The IMF has been criticized, both internally and by outside experts, for the role it took in earlier bailouts, which violated its own rules. But if the standoff is not resolved and Greece does not get the remaining funds from the last bailout, there is no way it is going to be able to make payment on the €6 billion that is due creditors in July 2017. And even if it is able to make the July payments, that is no assurance of a fourth bailout for Greece, because the IMF has insisted upon additional austerity measures that Greece cannot accept. So come July Greece could be out of the EU.

The pressure will then be on Italy to exit, too. As we pointed out, the ECB is already “dangerously overextended,” and the magnitude of Italy's needs is too big for a bailout or a bail-in. Remember that the initial bailout of Greece was undertaken to save French and German banks, which would likely go under if Greece wasn't rescued. If the bailout was a success, Greece would be able to pay back the French and German banks, which otherwise stood to lose heavily—perhaps everything—on their investments. But success never arrived for that bailout. Or the next one. Or the next one. Italy is now in a similar situation, only worse.  The total exposure of French banks and private investors alone to Italian government debt exceeds €250 billion. Germany holds €83.2 billion worth of Italian bonds; Deutsche bank alone, nearly €12 billion; Spain, €44.6 billion; the U.S., €42.3 billion; the UK, €29.8 billion; and Japan, €27.6 billion. Keep in mind that these are just the direct investments in government securities; they do not include corporate bonds or other financial paper denominated in euros, including banks which own them in addition to government securities.