Recommended links

1. Rogoff: 80% chance that Greece will leave the euro (Bloomberg)

2. More Greece love from Sarkozy: Greece should have been denied euro (BBC)

3. Nominal GDP targeting is unlikely to work (INET)

4. World power swings back to America (Telegraph)

5. Hugh Hendry at LSE Alternative Investment Conference (Greshman's Law). My writeup on Hugh's Jan. 2011 interview at the AIC can be found here. Hugh has agreed to come back to the 2012 AIC conference, which I look forward to attending.

6. Portugal enters the 'Grecian vortex' (Telegraph). AEP has been on a roll lately.

7. Italian 10-Year Yield Tops 6% in Auction, Setting Record (CNBC)

Video: Kyle Bass on the Worldwide Problem of Too Much Debt

Link to Kyle's video presentation here.

Kyle, btw, is the protagonist in Michael Lewis' latest book, Boomerang. Zerohedge has posted some of the highlights about Kyle from the book here. 

Default Myth Busting: Sorry Simon and James, the U.S. is not a Default Virgin

Professor Simon Johnson and James Kwak of The Baseline Scenario have an article at Vanity Fair about the geopolitical importance of credit in late-18th century France, Great Britain, and (especially) the United States. Their article, however, fails to mention an important detail which also happens to contradict their claim that "the (U.S.) federal government would always honor its debt".

The consolidation/conversion of U.S. revolutionary state debt into federal debt, which took place in the early 1790s, and which the authors refer to in the paragraph prior to the above quote, represented a U.S. sovereign default. (For more on this event see Reinhart and Rogoff (click on the U.S. tab) or Sylla, et al, which describes the 'haircut' bondholders received (6% to 4%).)

The notion that the U.S. has never defaulted has unfortunately been repeated often enough that, like the incorrect claim that TARP was "profitable", otherwise well-informed people have come to believe it.

In terms of other U.S. defaults, Reinhart and Rogoff also count Franklin Roosevelt's 1933 prohibition on owning gold and the subsequent devaluation of the U.S. dollar vs. gold as a default.

It's not very surprising to see Vice President Biden promoting the myth that the U.S. has never defaulted (in his case following a visit to the U.S.'s largest creditor, China). Professor Johnson, however, should know better.

Video: The Teaching of Economics

Video: Carmen Reinhart on a Decade of Debt

Here is a link to audio only versions of Carmen's presentation and the Q&A.

Is the Bernanke Put Kaput?

As Barry suggests, have we just seen the end of the Bernanke put? Based on the way markets are trading today it would appear Ken Rogoff was right that Bernanke doesn't have the stock market's back.

However, in all likelihood Soros is right about how policymaking powers-that-be will be forced to bailout Too Big To Fail banks should the financial system begin to teeter again. In which case the only real question is for how long can the current central bank shell-game be sustained in a low-to-no growth economic environment?

No one -- not Ben Bernanke, not Alan Greenspan, not Milton Friedman if he were alive, nobody -- knows for sure just how much more room the Fed's balance sheet has before non-negligible inflation kicks in. However, former Fed Chair Paul Volcker for one is starting to get nervous.

Federal Reserve Total Assets ($s Trillions)

(click to enlarge)

Continue reading the full article at SeekingAlpha here.

Why the Vickers Report on Banking Reform Failed the UK and the World

Kotlikoff rips the Vickers commission's final recommendation:

The Independent Banking Commission’s final report is a grave disappointment. The ICB (chaired by Sir John Vickers) seeks to reinstate Glass-Steagall by ring-fencing good banks and letting bad banks do their thing and, if they get into trouble, suffer the consequences. This proposition was tested by the collapse of Lehman Brothers, whose failure nearly destroyed the global financial system. 

The commission retains the current system apart from some extra requirements primarily imposed on the good banks (the retail banks). The main impact of this is likely to be to foster more financial intermediation to run through the bad banks, i.e. if you impose more regulation on financial companies that call themselves X and less on companies that call themselves Y, companies that call themselves X will start to call themselves Y. In short, the commission has in effect taxed good banking while sanctifying shadow banking. The commission has also chosen to regulate based on what a bank calls itself, rather than on what it does.

A year back, Mervyn King, Bank of England governor, described the current banking system as the “worst possible.” In a speech, delivered at the Buttonwood Conference in New York, he called for the analysis of Limited Purpose Banking — a reform plan that I developed, which replaces traditional banking with mutual fund banking and makes no distinction between financial intermediaries.

At the end of last year, I travelled to London and met the commission staff to discuss Limited Purpose Banking. I had thought the commission would take the proposal and my discussion with them seriously. That was not to be. In fact, the commission spent very little space discussing the proposal, despite Mr King’s urging that it be carefully studied, and notwithstanding its remarkably strong endorsement by economics Nobel Laureates George Akerlof, Robert Lucas, Edmund Phelps, Edward Prescott, and Robert Fogel as well as by former US secretary of state and former US secretary of the treasury, George Shultz, by Jeff Sachs, Simon Johnson, Niall Ferguson, Ken Rogoff, Michael Boskin, Steve Ross, Jagdish Bhagwati, and many other prominent economists and policymakers.

Do the opinions of the governor of the Bank of England and all these prominent authorities on finance and economics deserve to be dismissed in seven sentences? For seven sentences is all the commission was able to spare when it came to discussing Limited Purpose Banking, notwithstanding the 358 page length of its report.

Full article here.

Reinhart and Rogoff on Why Heavily Indebted Economies Can't Grow

Coinciding with Moody's placing the U.S. debt rating on negative review, Carmen Reinhart and Ken Rogofff remind us that country's will high debt levels often struggle to grow (attention Paul Krugman, they're talking to you!):

Our empirical research on the history of financial crises and the relationship between growth and public liabilities supports the view that current debt trajectories are a risk to long-term growth and stability, with many advanced economies already reaching or exceeding the important marker of 90 percent of GDP. Nevertheless, many prominent public intellectuals continue to argue that debt phobia is wildly overblown. Countries such as the U.S., Japan and the U.K. aren’t like Greece, nor does the market treat them as such. 

Indeed, there is a growing perception that today’s low interest rates for the debt of advanced economies offer a compelling reason to begin another round of massive fiscal stimulus. If Asian nations are spinning off huge excess savings partly as a byproduct of measures that effectively force low- income savers to put their money in bank accounts with low government-imposed interest-rate ceilings -- why not take advantage of the cheap money? 

Although we agree that governments must exercise caution in gradually reducing crisis-response spending, we think it would be folly to take comfort in today’s low borrowing costs, much less to interpret them as an “all clear” signal for a further explosion of debt. 

Several studies of financial crises show that interest rates seldom indicate problems long in advance. In fact, we should probably be particularly concerned today because a growing share of advanced country debt is held by official creditors whose current willingness to forego short-term returns doesn’t guarantee there will be a captive audience for debt in perpetuity. 

Those who would point to low servicing costs should remember that market interest rates can change like the weather. Debt levels, by contrast, can’t be brought down quickly. Even though politicians everywhere like to argue that their country will expand its way out of debt, our historical research suggests that growth alone is rarely enough to achieve that with the debt levels we are experiencing today. 

The full Reinhart and Rogoff article can be found here.

Rogoff: Germany Must Construct a 'Firewall' Around Spanish and Italian Debt

Full post here; graphic below of what Germany and the 'troika' can afford.

Rogoff: 'Sovereignty and currency co-habitation do not mix'

Reflecting on the latest twists and turns in the Eurozone debt crisis here are some other choice quotes from Professor Rogoff's FT editorial:

• the euro is looking very much like a system that amplifies shocks rather than absorbs them
• even if the euro system was not at the heart of the crisis, it needs to be able to withstand two standard deviation shocks
• markets are more worried about the US’s lack of a plan A than Europe’s lack of plan B
• It is sometimes said that the euro is a creature of politics that would never be justified by economics. The present episode could well turn this statement on its head.

Full editorial here, and here is a recent Charlie Rose panel discussion he participated in with Paul Krugman and others.

Video: Bill Gross on U.S. Financial Repression

Econ Myth Busting: Sorry John Carney, the U.S. is Not a Default Virgin

I'm a big fan of American Public Media's Marketplace radio show, but Friday's show featured CNBC's John Carney and Fortune's Leigh Gallagher discussing the U.S. debt situation.

Both John and Leigh stated the oft-repeated myth that the U.S. has *never* defaulted.

If only that were true.

The above summary is from Carmen Reinhart's and Ken Rogoff's research in their superb book This Time is Different, which is available in the Good Books and Films section on the far right column of this blog.

As you can see from their research not only has the U.S. defaulted, but the U.S. has defaulted or 'restructured' (a partial-default) at least once every century since the founding of the republic. Details on each episode can be found in the book and at Carmen's website.

As Reinhart and Rogoff put it, the U.S. is definitely not a "default virgin".

Ken Rogoff to Investors: "The Fed Doesn't Have Your Back"

Interview with Ben Bernanke's close friend below:

The young chess grandmaster

Q: The U.S. hit the $14.3 trillion debt ceiling today, and now the Treasury is moving cash around to stave off default till August. What's that mean for markets?

A: I don't think it means anything immediately, but it doesn't seem like any way to run the government. I think they should raise the debt ceiling unconditionally, despite the fact that some reforms are desperately needed. When you're the world's biggest debtor there are repercussions when you take it to the brink and scare people (with the idea) that you just might consider a default.

Q: You're not in favor of the artificial cap, or debt ceiling, because it threatens creditors. But debt is still your biggest worry about the economy, yes?

A: The greatest concern at the moment is the huge debt overhang. All U.S. government debt, including state and local, is higher than at the end of World War II. But equally significantly, private debt (like mortgages and credit cards) is almost at its all-time high. If you combine the two, there's never been anything like it.

Q: What's the risk in the U.S. having so much debt? Other countries, like Japan, have larger debt burdens.

A: It doesn't automatically cause a crisis, but it certainly weighs on the recovery. Very roughly speaking, when a country has public debt over 90 percent of income, growth is about 1 percent lower for a very long time.

Q: A government can't increase spending as easily if it has too much debt, which you say makes a country vulnerable. How so?

A: That's the fundamental problem. You see it when a country loses tax revenues and needs to borrow money. They have wars and natural catastrophes and need to spend to pay for things, reconstruction, bridges. You don't want to be forced in the middle of a recession to raise tax rates (to pay for those things). That's a disaster.

Q: Politicians use your work to argue for deep spending cuts now to trim our debt. Do you agree?

A: If we tighten too fast, the economy will implode on itself. We didn't get here in two years, and we shouldn't try to get out of it in two years. But at the same time the idea that we can worry about the future later, that's false. It's not just about cutting spending. The tax take probably needs to go up. We need to clean up the tax system.

Q: Where would you start?

A: I'm one of many economists who favor scrapping the current system entirely in favor of some form of a flat tax, with a very high deductible for low-income earners. And you know what? The very wealthy would pay more. They pay less under the current system because there are these smoke and mirrors they can hide behind, all these deductions and all these ways of avoiding taxes.

Q: Your friend and former classmate Ben Bernanke has taken flak for the most recent quantitative easing program, known as QE 2. What do you make of the effort to keep prices from falling through pushing $600 billion into the economy?

A: I thought QE 2 was absolutely right when they did it. But the way quantitative easing works best is you announce a goal and then say you will do whatever it takes (to get there). If you don't have a blank check, it doesn't do much. Because of all the pushback from the Chinese, the Germans and Sarah Palin, they couldn't keep going. The Fed needed a free hand, and it doesn't have one. A second problem was the Fed was not careful enough to tell the market clearly, "This is not going to solve all your problems." The biggest mistake they made was the suggestion that part of the way quantitative easing operates is through the stock market. There are all these traders on Wall Street who said, "This means the Fed's got our back. The Fed is just determined to drive up the market."

Q: What's wrong with traders thinking that?

A: Well, the Fed doesn't have their back. The Fed cares about stable inflation. So the worry now is when these traders see that QE 2 is coming to an end, will they get really depressed and all their trades will unwind? That's the concern.

Q. At Bernanke's first press conference in April, he joked that playing chess with you was a "big mistake." Most people don't know you're an International Grandmaster. Did Bernanke ever ask for a rematch?

A: No. I went cold turkey after leaving graduate school. I teach my children how to play (chess) but that's it. I'm completely addicted and need to guard myself from playing. I still think about chess all the time.

Q: Has your expertise in chess helped inform your work?

A: Chess teaches you to think about what the other person is thinking. Obviously, there are other ways besides chess to come to that. Chess is just a disciplined approach. At the IMF, we had crises in Argentina, Brazil, Turkey and Lebanon. And it helped to put myself in their position: "What are they thinking."

Source: AP

What is Financial Repression and How Investors Can Protect Themselves

Carmen Reinhart

Financial repression, a subject last widely studied in development economics circles in the 1970s-80s, appears to be making a comeback. Bill Gross dedicated his May investment letter to financial repression, and an article by the FT's Gillian Tett describes how both policymakers and investors are having to refamiliarze themselves with its tenets.

Just what exactly is the ominous sounding 'financial repression'? Below is an abridged definition from Reinhart & Rogoff's This Time is Different:

Banks are vehicles that allow governments to squeeze more indirect tax revenue from citizens by monopolizing the entire savings and payment system. Governments force local residents to save in banks by giving them few, if any, other options. 

They then stuff debt into the banks via reserve requirements and other devices. This allows the government to finance a part of its debt at a very low interest rate; financial repression thus constitutes a form oftaxation. Governments frequently can and do make the financial repression tax even larger by maintaining interest rate caps while creating inflation.

The 'Era of Financial Repression'

Carmen Reinhart and M. Belen Sbrancia recently published a paper which analyses the extent of financial repression among advanced economies in the post-World War II period. Here's Reinhart's and Sbrancia's updated definition of financial repression, which now includes pension funds along with banks in their list of domestic captives:

A subtle type of debt restructuring takes the form of “financial repression.” Financial repression includes directed lending to government by captive domestic audiences (such as pension funds), explicit or implicit caps on interest rates, regulation of cross-border capital movements, and (generally) a tighter connection between government and banks.

They studied the post-WWII period:

In the heavily regulated financial markets of the Bretton Woods system, several restrictions facilitated a sharp and rapid reduction in public debt/GDP ratios from the late 1940s to the 1970s. Low nominal interest rates help reduce debt servicing costs while a high incidence of negative real interest rates liquidates or erodes the real value of government debt. 

And their key finding which has PIMCO's Bond King in a tizzy:

Continue reading the full article at SeekingAlpha here.

Video: Ken Rogoff on the Problem of Too Much Debt at Bretton Woods

Ken Rogoff Forecasts "Currency Chaos" in 2011

Continuing the 'chaos' theme, thoughts on how various currencies will fare in 2011 can be found here from Ferguson's Harvard colleague Professor Ken Rogoff, author of This Time is Different.

Note to U.S. dollar bears: Rogoff points out that the U.S. dollar's "purchasing power is already scraping along at a fairly low level globally – indeed, near an all-time low, according to the Fed’s broad dollar exchange-rate index. Thus, normal re-equilibration to “purchasing power parity” should give the dollar slight upward momentum."

Goldman Sachs Says Fed's Next Money Printing Move is Imminent: "No Point in Doing Anything Less Than $1 Trillion"

Goldman Sachs chief U.S. economist Jan Hatzius yesterday said that the Fed is going to have to eventually print more money to tune of $1 trillion+.

In other words, the Fed's recently announced 'QE Lite' simply won't cut it. Hatzius figures are in line with estimates for QE 2.0 (the term that has become attached to the next massive round of Fed money printing) that I've been pointing towards for awhile.

In terms of the timing of QE 2.0, Goldman Sachs Chief Global Economist Jim O’Neill said "September might be a little bit soon, but by October I would say for sure if the data carries on being as disappointing as it’s been."

Given that market confidence is clearly deteriorating, why won't the Fed act sooner? I've recently wrote about my ideas on timing here. Ken Rogoff, the Harvard economist and author of the only economic history bestseller This Time is Different, recently appeared on Charlie Rose. He suggests that the Fed is hesitating because they're "nervous about overshooting". Aiming for 3% inflation, the Fed may miss their target badly and wind up with 30% hyperinflation. However, Rogoff states the "Fed will have to take that chance".

The U.S. dollar has held its ground so far, but concerns are rising about ongoing record budget deficits and what the government will do about the massive mortgage market problem that is Fannie and Freddie. The terrible housing figures are coming in spite of record low mortgage rates, housing prices 33% off their peak, and federal government subsidized mortgages for even Manhattan condos that require only 3.5% down payment. Perhaps most importantly, the now all but certain QE 2.0 makes the future value of the dollar anything but certain.

From an investment perspective, any move by the Fed to print more money is bullish for gold.