Why am I holding Euros???

The most obvious question to oneself these days, especially if one's a fund or an institutional, is Why aren't we bailing out of Europe...If you're the client, the question to your advisor: Why are you holding on to Euros?  The obvious explanation is: cognitive dissonance. The hypothesis was advanced by  psychologist Leon Festinger (1957).It became popular among political pundits and business types quite rapidly when, years later,  Newell and Simon* integrated Festinger's insights into their own hypothesis concerning human problem-solving.

The Newell-Simon model as it is now labelled, named after Allen Newell and Herbert Simon,  describes how human beings make decisions, ie. solve problems. It becomes especially enlightening when it describes how people react during the intellectual logistics of problem-solving: the intelligence phase, design phase and choice phase.

How do investors react to conflicting attitudes: you hold Euros but everyone calls a crash.

Decision-makers, when in doubt,  will "listen" 'more' to information that supports their belief system than to information that disrupts or questions their belief system.  The underlying hypothesis is that the individual seeks to reduce dissonance or accompanying discomfort created by conflicting information that undermines his position. He will settle for 'satisficing' information without claim to making the optimal decision.

But in many cases, he will side with inputs that justify his original position. Of course, the more individuals are rationally bound (you don't have all the info) the more they will attempt to adjust in a timely satisficing way to the facts. If the former, You could be a die-hard and lose your pants and that of your clients, notwithstanding the information;  if the latter, you could be pragmatic, give yourself and others the benefit of the doubt, and bail-out. After all, the well-known economist and investor John Maynard Keynes evoked the perfect reaction to relieve the dissonance: "When the facts change, I change my mind. What do you do, sir?"

So why are some investors still holding on to the Euro securities...for the same reasons that some European leaders keep promoting austerity measures for public policy notwithstanding the adverse results being generated in  Greece, Spain and Italy.

The dissonance:
Firstly, even though things are difficult in Europe, they're difficult all-around the world. Some will argue that they're already overexposed in equities, in BRICs, in US and other sovereign currency-issuer securities, and even gold-it can collapse on a wind-shift....after which deliberation they move on and argue the next....

...Eurozone economies are not in as bad a condition as selected data suggest. It's quite reasonable to experience hiccups during 'policy transitions' after traveling over rocky roads. And Southern European roads are very rocky according to northern Europeans. Things will smooth themselves out over time. The worst case is if Greece defaults. Let it exit. Nudge Greece out gracefully. The Zone is saved.  This is the message that is being conveyed by European leadership as social tensions in certain countries become more forceful. If that doesn't work out as planned....they move on and argue the next....

...Europe is 'too big to fail'. (Remember Lehmann et al). The US and China won't let it happen- this is Europe, not some mismanaged bank. Some refer to this position as highly speculative; other would consider it quite realistic. Either way, their rationalization recalls Lord Byron's popular but mistranslated line found in his Childe Harolde's Pilgrimage :

   When falls the Coliseum, Rome shall fall;
   And when Rome falls--the World.'

The Eurozone rendition is "When falls the Euro, Europe shall fall; And when Europe falls---the World."

It would carry more credence if it was the US, however.

Here's my take:  If China's growth is projected downwards, if Germany's order book starts doesn't refill to 2010 levels (I don't think it will refill for a long while) and  growth in the US is revised downwards, then you should have bailed to liquid USD, until the facts change!!! If you didn't, think about it.

*I credit Fictional Reserve Barking, Oct 2, 2011, author (Circuit, ) and reader  (JHCraw) for the reference to Herbert Simon's work.

Europe! It's not too late to reverse austerity

Europe! It's not too late to reverse austerity 

The article is cross-posted on Fictional Reserve Barking.  We wish to thank the editor. Readers are invited to post comments on either blogs.

Months ago we outlined the challenges that presented themselves to Italy and Greece, and to Germany, France and the United Kingdom.  We opted against austerity, trusting that the technocratic appointments of Messrs Monti and Papademos could transform governments in Italy and Greece, and enable their respective legislatures to both recommend alternative and optimal public expenditure policies and to restrain policymakers from endorsing imposed fiscal restrictions while constraining budgets any further.

Unfortunately for the global economy and markets, Messrs Monti and Papademos initiatives did the contrary.  They aspired towards the heroic in adhering to a sub-optimal detriment and have now emerged as the scapegoats for political and investment désenchantées.

More ironic is that both men had very little to do with the original debacle.  They were recommended to their nation’s legislatures to clean up a mess.  Instead, as a result of attempting to implement austerity measures, they have generated more anxiety in world markets than expected.

Unfortunately, the recent economic deterioration and rising social tensions within their respective economies has become their responsibility, and the political disenchantment surfacing within the electorate is also their responsibility.  Worse still, the time for apologetics is long past and is now irrelevant.  At jeopardy is their leadership, the credibility they endorse for their visions of the future and the overall well-being of their citizenry.

Mr. Draghi and Mrs. Lagarde have voiced a redemptive message.  Both had professed that the worst was over.  For instance, in a speech on March 26 of this year, Mr. Draghi said the following:

“I would like to take this opportunity to provide you with my assessment of the current situation in the euro area and shed light on recent signs of improvements in the overall outlook.  I would particularly like to draw your attention to the effectiveness of the policy measures implemented by the Eurosystem, the EU institutions and national authorities.  And to remind you of the measures that we all must continue to pursue over the coming months and years with great diligence in order to continue on this path of stabilisation.”

As for Mme Lagarde, on March 18 of this year, the Managing Director of the IMF sought to reassure the audience of the 2012 China Development Forum with the following statement:

“There are signs that strong policy actions—especially in Europe—are making a difference. Financial markets have become a little calmer…”

Yet, Spanish yields are rising, as are those of Italy and Greece, and there is more and more talk of a potential third bailout for Greece although the IMF and the ECB have reassured the investment communities that changes in Greece are being introduced as promptly as possible and will be enacted effectively.

Any remnant stress in markets, according to the institutional duo is a result of the misperception by the interested communities that the consolidations proposed by the ailing economies cannot be achieved.

The emerging doubt on behalf of investment communities and investors in general should not be surprising.  After all, it’s their money and it’s their perception that underscores investment decisions.

One daresay that the investment community saw the collapse of the system much earlier than either the IMF or the ECB, although the leadership of the latter two has been proactive in attempting to stabilize investor sentiment and mitigate between some form of restraint and investment in growth and employment.  Notwithstanding, the reassessment that further bailouts will be necessary is now the swan song of European austerity politics.

Unfortunately, European policymaker perceptions of the bond markets are completely skewed as a result of their own biases.  What is difficult for them to appreciate is that there is no basis left for growth.  Unemployment is up, with Spain leading at 23.6% followed by Greece at 21.0%.  And in those Eurozone countries where unemployment rates are low, many of the employed are part-time workers and, as such, susceptible to labour volatility during these turbulent times.

Moreover, capacity utilization in the manufacturing sector over the last four quarters is dropping across the Eurozone at alarming rates.  Order books are not being filled as quickly as desirable, and their durations and size are shorter than required to support additional investments.  As a result, business investment is stalling as management constrains expenditures and saves its liquidity for dividends in lieu of growth to stabilize share values, foreboding that equity markets react adversely to this dilemma and possibly falter.

What most pundits expected from the emerging markets may not be realized: trusting that BRIC plug the slowdown in Europe, with China leading the way.  Unfortunately, there is no plug.  Most informed observers now mitigate between a slowdown and an ease in aggregate demand, with China’s future growth rates in question.  Projections for the region suggest that China’s growth potential could be in the midst of a major contraction with rates dropping to 7.5% from anticipated 8% and over.

Given the above, the most difficult challenge in domestic politics is for any Government to admit that it followed the wrong track.  There is no shame in being part of a bigger bloc of nations that propound fiscal consolidations even if austerity is showing itself as being the ineffective solution to the Eurozone’s financial crisis, a crisis which is now becoming an economic and political crisis.

It actually takes great courage in admitting that the austerity programs recommended may not work out.  The experiences of other nations in the matter, elicit danger signals that can’t be overlooked.  In such a case, the consolation is that if one’s admission is timely, the Government may come out of an unfortunate situation looking respectful and remarkably diligent.  There is still time for Europe to turn back its political agendas before turning the wrong corner.

Austerity Contracts Italy and in turn Germany

ISTAT, Italy's National Statistics Institute has had a busy December 2011-end.  ISTAT released October's monthly stats. The results are not good. In fact, the results were not good for any of the critical markings: the releases confirmed decreases in the Orders, Production in Construction, and Trade Balance. Then, ISTAT published Italy's quarterly GDP. 

Notwithstanding the bleak setting above-mentioned, Italy's national accounts are particularly alarming.

The decease in GDP suggests that the Austerity measures being promoted by the Euro-Area and traditionally recommended by the IMF for struggling economies are counterproductive: detrimental to the health and growth of the Italian economy. That's not new. The results are, however, significant because they offer the economist-Prime Minister Mario Monti an acid test that the austere remedy preferred by the markets, in the longer run, will weaken the economic infrastructure of the country, induce social tensions and may trigger social unrest thereby further stiffening Italy's already fragile capacity to access reasonably priced funds from future markets. After all, once reimbursement of capital is made, there is no obligation on the part of the investor to revisit and refinance a palliative patient.

For the obstinate, the position that austerity is not necessarily linked to contracting economies is a reasonable stance. In fact, for the majority of austerists, if one can coin the label, there is no necessary relationship between austerity measures and contracting economies, where contraction is usually defined as an economy in which gross domestic product weakens for two consecutive quarters.

Orders were down in October 2011 by 4.8% over the same month in the previous year 2010. In October 2011 the seasonally adjusted industrial new orders index decreased by 1.6% with respect to September 2011 (-1.0% in domestic market and -2.4% in non-domestic market). The percentage change of the average of the last three months compared to the previous three months was -2.3 (-0.7 in domestic market and -4.7 in non-domestic one). Although adjusted industrial turnover index, which measures current dollar sales was up by 1.1% for the same periods, the medium and longer term effect of orders is critical to the growth and stability of the country, whereas industrial turnover results are an historical metric that is already integrated into the fourth quarter's projections. Traditionally, orders underscore the basic fabric of small and medium business which constitute the majority of regional economies in central and southern Italy. The significant indicator to watch is the Order Book, especially for export orders since Eurozone orders will certainly decrease all around given the need to cut back on spending: consumer spending will drop and business will limit its investments in order to buffer cash for a 'transition' towards a better investment climate.

Germany, on the other hand appeared to be steering through the storm. Unfortunately, recent indicators, especially the Order Book for Exports is designing a pessimistic future. Counterbalance to a drop in export orders is a suggested increase in consumer spending. I think pundits are overly optimistic about Germany's population continuing to bear the load of a European economic stall. Not only is unemployment inching up in 2012, savings will also inch up and business investment will decrease quickly and for a prolonged period.

The lesson of Austerity is that its negative effects profuse through the system much more quickly than market reinvestment. Once markets realize that an economy is slowing down, they will forestall decisions to reinvest capital, which in turn will stall growth. Austerity leads to a vicious circle and insidious downturn,especially during a global slowdown. We said it in an earlier post:

Evidently, once investors realize that the longer term confidence required to justify purchasing Eurobond securities is not justified by output figures from the region's business sector, then even if your brand name is Germany, and even if the rating agencies mark you tops,  it won't help keep yields down. Germany is as susceptible to being dumped as is Italy and its next candidate France which witnessed its yields increase, and its yield gaps widen against the German counterparts. There is no Immune Boutique in this Shopping Mall. There isn't any vote of confidence for Germany; rather it signals that investor concern is becoming pandemic within the Euro-Area and no sovereign, especially a non-sovereign issuer, is immune.

and we will repeat again: Mrs. Merkel, like all others including Mr. Monti, is neither immune to the consequences of Austerity nor to the whims of the markets. It's time to change tune before the audience boos the performance or rather lack thereof.

Is the Euro-Area Collapsing?

Over the last week, there are three significant Euro-Area activity figures that merit the market's consideration.

September's Eurozone's industrial production dropped from a previous August +1.3% to -1.9%
September's construction production dropped from a previous months -0.4% to -1.3%;
New Industrial Orders for the four largest populated economies-Germany, France, Italy and Spain all dropped significantly to -4.4%, -6.2%.-9.2% and -5.3% respectively. For the reverent, the United Kingdom NIO's dropped to -1.9%.

Well, shuttered factories are not privy only to the UK; they seem to be the prospect of industrial Europe, especially if one considers that levels of capacity utilization in manufacturing is slipping everywhere with the exception of an anomalous month in United Kingdom.

Evidently, once investors realize that the longer term confidence required to justify purchasing Eurobond securities is not justified by output figures from the region's business sector, then even if your brand name is Germany, and even if the rating agencies mark you tops,  it won't help keep yields down. Germany is as susceptible to being dumped as is Italy and its next candidate France which witnessed its yields increase, and its yield gaps widen against the German counterparts. There is no Immune Boutique in this Shopping Mall. There isn't any vote of confidence for Germany; rather it signals that investor concern is becoming pandemic within the Euro-Area and no sovereign, especially a non-sovereign issuer, is immune. But the contagion on the financial front is not as great a deterrent in our opinion as the rapid weakening and dampening of economic activity within the area. Germany can certainly pull out, or welcome the unstable members' exit, but it can't deter the oncoming economic slowdown that will devastate its own regional economies.

The ECB is a lame-duck if Mr. Draghi continues to endorse without challenge its constitutional mandate. Signor Draghi deve sospendere 'Price Stability',  which is a moot predicament at the moment, and with the help from two oversea friends, act to stabilize the yield curves. The New Normal advocated by financial and portfolio managers should not be higher unemployment and softer growth, it should be lower Returns on Investment. The structural adjustment required by the global economy in order to survive the extending contagion of below-quality investments is to realign investor expectations in view of  de-stabilized and riskier investment scenarios.

Obviously, this goes contrary to the grain of conventional investment lore: the riskier the target, the higher the yield! Unfortunately, when available resources are numbered, and quality contaminated, there's not much choice. You buy into the mess,praying for a cure, or seek quarantined shelters. Are there any? You run to gold? Does anyone care? To SF, Yen or some other resource-constrained sovereign? Price those economies out of the market and over time, the original predicament only changed hands.

What is becoming clearer is that there are only a few viable Backstops in this Global economy, and the Classic is the United States Treasury, with a little help from a friend.

To the United States Treasuries-of course, and at most probably quasi-zeros, or cash the portfolio. If the latter is the soundest judgement  of the wise and enlightened investors, then why wait for the storm; shelter yourselves now.

How will the markets end? Not with a tumble but a crumble. The EU will fall apart unless Draghi and some confreres show their stuff...change the discourse from financial narratives about controlling deficits and imposing guarantees to a discourse with fiscal narratives about job creation, stabilizing growth engines and stimulating aggregate demand. Mr. Draghi will need support from Mr. Bernanke and gang. He knows it and the United States know it.

Thanks, but Sorry, your way won't work, so let's...

The past two weeks have witnessed major changes in the political and financial landscape of the European Union and the Euro area.  Two of the European region's most economically and politically unstable members have endorsed visions for new governments. An Italian  lawmakers' consensus has accorded Mr. Mario Monti the opportunity to form a transitional government that will empower Mr. Monti to negotiate and manage Italy's financial portfolio through turbulent waters; a Greek lawmakers' consensus has accorded Mr. Lucas Papademos the opportunity to form a transitional government that will empower Mr. Papademos to negotiate and manage Greece's financial portfolio through even more turbulent waters.

In the same European theatre during this year's summer and fall,  a new optic is also focusing the people and market's perspective on the political savoir-faire and competence of the region's traditional leadership.  According to many, Mrs. Merkel and Messrs Sarkozy and Cameron are demonstrating a lack of courage to make things happen. The situation is simply too overwhelming for that threesome.  To the boisterous three is the stage, but not History! History confirms that some leaders are made for good times and others, in the mold of Roosevelt and Churchill are made of a 'stuff' that captains the worst of storms.

Although premature and echoing the sound of fluttering feathers, we are nevertheless inspired by both Monti and Papademos, firstly because the respective country's lawmakers agreed to the appointment and secondly, because the national sentiment appears to be overall favorable. The fundamental criteria for success in bleak times is the support of the people-which, while it lasts tacitly transforms the leadership of a technocrat to leadership by charisma. The 'je ne sais quoi' that makes Monti and Papademos viable is exactly the opposite of 'je sais tres bien que' Mrs. Merkel and M. Sarkozy  are no longer comfortable to lead the EU nor the Eurozone out of this maelstrom. Mrs. Merkel whose economy is cruising through the turbulence seems confused about her directions and reads signals with great difficulty, she should possibly review her entourage for more capable resources. Mr Sarkozy should leave aside his political ambitions and rise to the European Region's challenge-it would probably guarantee him the undecided electorate. Finally, Mr. Cameron should abandon his economic platform and slowly steer towards fiscal accommodation before the country reaches the crevice.The economic indicators for the UK are in a sharp decline, and although inflation is for all intents and purposes non-problematic, unemployment is on the rise and capacity is in decline. The latter do not project good times.

In this maze of political ambiguity, Monti and Papademos, seconded by a  known entity Mr. Mario Draghi stand out quite remarkably. In fact, the rise of Monti may have been spurred by Mr. Draghi's reluctance to fully engage the ECB in support of the Italian auction sponsored under the last Berlusconi government. The politicization of the European Central Bank in this context is not acceptable-it mirrors the rise of a political elite beyond the legitimacy of elected representation. If the analysis of the ECB's undemocratic behavior is correct, then Mr. Draghi must explain the actions of his office towards the Italian electorate.

On the other hand, regardless of the origins of their rise, Messrs Monti and Papademos were well-trained to deal with the one concrete challenge of any political economy - to spur employment and extend economic growth. Mr. Monti, as a student of the keynesian Mr. James Tobin has the baggage and opportunity to challenge the austerity measures that are being imposed on the Italian economy. The discourse is not to settle on the terms for a refinancing but to convince markets that the conventional wisdom is not operative and will fail dramatically in the longer run. If markets do not want to be disrupted, then they must entertain the possibility that social unrest will certainly ensue a market's intransigence towards the plight of the unemployed. The matter does not involve a change in narratives, it requires a change in the essence of the discourse.

For Mr. Papademos, the measure of success lies in convincing the Greek electorate that unless there is some accommodation by the people, then there will be no accommodation by the markets. But this tradeoff is quite out-of-line with Mr. Papademos own dispositions. As a young economist, Mr. Papademos studied the accommodation of anti-inflation policy  in promoting employment.  If one considers that the whole segment of the public service is discontented about the market behavior towards Greece's dilemma, then Mr. Papademos must re-engage the early flirtations of his intellectual odyssey and abandon the ECB temple's aphorism of 'Price Stability'. One also hopes that he will challenge the skew towards privatization of public assets that seems to be permeating the ideological baggage of most European leaders in structuring refinancing.

Certainly, one of the critical errors of the ECB financial managers has been the concession to promote 'price stability' at the expense of employment. During two consecutive sessions in April and July, Mr. Trichet decided to boost interest rates when every economic indicator in Europe signaled that there was no inflationary threat imminent on the horizon. If anything, the rate increases intensified an already fragile economic landscape, tempering business investment, and disappointing any consumer initiative to spend. The initiatives certainly cast doubt on the sound judgement of European financial leadership.  One can forgive Mr. Papademos for the latter case in point,because obviously, Mr Papademos although a former member of ECB's executive directorship, and Vice-President to Mr. Trichet, had  left the ECB in 2010. What does that imply for Mr. Draghi who inherits the sequitor of that deepening crisis. On the one hand, Mr. Draghi has signaled his intentions to support any reasonable auctions in the market. If there is anything for Mr. Draghi to recall it is one of  his former teacher's Robert Solow's insight that persistent levels of unemployment adversely affect long term growth in productivity and a second caution that accelerating unemployment can have a disinflationary effect which, in our opinion, given the European context of the day translates into a tendency to affect adversely real wages more than prices, hence disposable income and consumer spending rather than corporate revenues.

Although both Messrs Monti and Papademos are highly capable and well-intentioned, the leap from technocracy to polity is not a matter of degrees. It involves a qualitative leap that resembles more a Kierkegaardian leap of faith that marks the end of innocence.  Although the scenario both men confront at the moment in their respective nations is reminiscent of  the High-Noon sheriff's duel with destiny, both men are certainly more equipped and better supported than the solitary Gary Cooper with his lone gun.

Nevertheless, we have faith that both men will succeed by cautiously pulling back from endorsing further austerity and inviting the markets to the table in order to embed the common sense of loosening up their exigencies. We also trust that Mr. Draghi will endorse a more accommodating stance towards national governments that confront onerous economic and financial challenges. There is no easy formula for success, but there are options that are more beneficial than tightening the coffers of an economy- put people back to work.