Permanent surplus is as bad as permanent deficit

Only fools and market absolutists [presuming these are separate categories] deny that financial excesses are killing the world economy.  Everyone has their pet theories as to why this is so.  Mine start with a rising tide of hot money roaming the planet at the flick of a few computer keys searching for short term gains.  This started with the vast surpluses generated by the two OPEC price revolutions of the 1970's and has grown from there.

Oil money first: The sums are vast but the problem has largely been dealt with.  The bulk of OPEC [and the other major oil exporters] spend their oil money as fast or faster than they get it.  The major surpluses are the GCC.  They have managed to transition as a whole to rentier nations that invest sensibly, have a stake in the system and at this point decades of experience in managing their wealth.  Also the KSA [the vastly largest GCC producer] increasingly spends its surplus on internal consumption.  The OPEC effect is more regional than global; they run surpluses with the rest of the world to spend in Europe and South Asia.

That leaves the twin problem children: Germany and East Asia Inc.  The German problem is the Euro project.  If Germany had its DM back, its currency would have shot into the stratosphere as the Swissie has.  This would depress exports and boost imports.  Instead the Euro gives Germany a favorable exchange rate at the cost of having to act as piggy bank for a collection of Club Med nations with severe structural and financial problems [Eire is a separate issue].  Europe as a whole has a reasonably balanced economy.  The problem is whether Europe is a whole or a collection of nations.

East Asia Inc. is the piece that will kill the current world system.  The various East Asian nations are not peas in an economic pod.  Chinese mercantilism is significantly different from Japanese which is significantly different from Korean...However net net East Asia runs huge surpluses with the rest of the world.  This gives them a pile of Dollars and Euros which they do not wish to spend.  Instead they want the US and Europe to both perpetually run trade deficits with them [the Asian economies are built around exports rather than internal consumption - there are structural and social reasons for this] while at the same time maintaining the value of their currencies.  These two goals are directly contradictory.  For the US to run consumption at 70% of its GDP it must run accomodative economic policies that require the dollar to continually depreciate.  Except the Asia Inc. nations game the supposed free floating F/X market to avoid dollar appreciation trying to put the entire adjustment burden on Europe which is part of what is killing the Club Med countries.

Essentially the entire world system is broken.  We can wait for a planetary Lehman moment when the entire Atlantic world defaults in a chain reaction or we can begin to divest from a global system that doesn't work into regional blocks that could work.  East Asia, Europe and Anglo North America use words like capitalism, markets etc. but mean different things by them.  An orderly retreat would do the least damage.  However it would require a clear headed look at the current mess which seems unlikely.  So my advice [for whatever that is worth] is to mentally prepare for a financial Armageddon that makes 2008 look like a walk in the park.  Indeed I have a book bet on this.  Will probably lose the bet - I am always better on what than on how fast.  However I was willing to roll the dice.  I can afford to lose a book at Amazon.  Whether the world can afford a total meltdown as the price of facing reality is a scarier notion.

A proposal for the Fed to save the world

How the Fed Can Save the World

It is a truism to say the world economy is in crisis and has been since the Lehman bankruptcy induced crash of 2008.  As in most such cases different experts offer different sets of causes, divided more by prior ideology than observed facts.  So let us put ideology aside and start with facts.  This is a financial or balance sheet crisis as happened in 1929, not a business cycle contraction as the world is more used to dealing with. 

This is the first such worldwide collapse since 1929.  There have been such implosions on a national level [Japan, Sweden, Mexico to name three of the most well known] since WW2 but this is the first global incident since the Great Depression.  Some causes of this year’s specific relapse are transitory and part of the nature of the world.  The Japanese Tsunami, the Arab spring’s run-up of oil prices, the BP oil spill of last summer are all the sort of one-offs that are part of the human condition.  There is no policy cure for them.  The best one can do is take actions at the margin to mitigate their effects.

In reverse the long term global structural problems [Asian mercantilism, a German economy geared to manufacturing exports, the worldwide flood of hot money that the perpetual export surpluses of these and OPEC produce, the over reliance of the Anglo-American economies on consumption and finance, the huge OPEC generated surpluses of a handful of oil exporting states, a neoliberal Washington consensus that at its core thinks the whole world can get rich running a trade surplus with the US, the gridlock in the US political system that precludes any serious budgetary relief from a medium term debt implosion] have no easy, fast solutions.  Experts different on the solutions and all possibilities are both painful in the short run and trample on established interests.  In the medium term all of these need attention but this has been true for a generation.

However there is one recurrent source of massive instability that can be dealt with.  The on-going collapse of the Euro project is destabilizing the world and risks another Lehman moment where the entire system freezes and implodes over counterparty risks.  It was obvious at the time of creation that the Euro project was a leap in the dark.  The ERM worked because the burden was on the other nations to match Germany’s fiscal and monetary policy.  The other ERM currencies became de facto DM’s by staying within the snake.  When this proved impossible [UK, Italy 1992] nations dropped out of the snake and suffered accordingly.  The Euro project reversed this.  Once in there was no visible mechanism to expel wayward members.  The so-called terms [on budget deficits, debt etc.] were near immediately shown to be bogus as France and Germany would not apply the terms to themselves.  This in itself could have be accepted if the Euro had been restricted to the Rhine 5.  For political reasons the French pushed the Euro project to fringe countries whose fiscal abilities were always suspect.  We now have a rolling series of implosions on the PIIGS.

These implosions expose the root problem of the Euro project.  There is neither a common treasury nor a central bank on the level of the US Federal Reserve.  Europe has near choked on dealing with tiny Greece and Portugal [a very good case can be made that Eire is different as the EU is engaged in a disguised bailout of its own banks who own most of the Irish bank debt that Eire nationalized and whose nationalization Is why Eire requires a bailout – absent such a nationalization Eire has both a budget and a trade/payments surplus].  All three of these are small and peripheral to the European project.  The next two targets of market speculation [Spain, Italy] are not.  They are two of the larger economies in the world.  Bailing these out will require heavy lifting, possibly more heavy lifting than the current European institutional structure [and the patience of the German voting public] will permit.  Yet a firewall is needed.

The analogy becomes the Mexican bailout of 1995, http://en.wikipedia.org/wiki/1994_economic_crisis_in_Mexico#Financial_assistance_package , http://en.wikipedia.org/wiki/Robert_Rubin#1990s_global_financial_crisis , where the USG created a firewall by keeping Mexico afloat.  Spain should be left to the EU to handle.  Its politics are more poisonous [including a looming national election, a fiscal civil war between the lame duck Socialist central government and the near bankrupt regional governments many of whom are now in the hands of the Popular Party opposition, and a property bust that dwarfs US real estate troubles].  Brussels, Frankfort and the Rhine axis should be left with this tar baby, as they have the most investment in the European project and indeed in a governable Spain that has not split into its component regions. 

Italy has a long term fiscal problem from mammoth national debt, a static rigid economy, an aging population and a political leader drowning in immense political, personal and financial scandals.  It has also shown an ability to service such sky high debt levels for a generation [1980’s].  Italy runs a primary budget surplus [public spending before interest payments].  It is on the road to a surplus net of interest within the next few years.  It has a de facto near two party system with both parties committed to fiscal rectitude, albeit with different formulas of how to reach the goal.  It has a set of technocratic financial experts who can guide this regardless of which coalition is in power. 

If the Fed undertook to make Italy a firewall the speculative attack on the Euro ends with Spain.  If the Feds stands ready to be buyer of last resort for Italian funding needs at an agreed rate of say 2% it will return large profits to the US treasury.  It will focus the EU institutions on saving or severing the other four PIGS [one less I for Italy being the firewall].  As long as Italy holds we probably avoid a Lehman moment where banks on both sides of the Atlantic suddenly discover how much counterparty risk they have. 

This plan would create a political firestorm in the US from the usual Paulite Fed haters.  Every option has political risks and Paul’s following while loud is also a fringe wing of the US right.  There is also the currency risk involved.  Italy would have to fund its needs in dollars to the Fed and then buy futures to limit its exposure.  In the context of a currency market that trades in trillions of dollars a day even a trillion dollars of such risk spread at maturities over a five year period [the probable need for the firewall] is handalable. 

For those who would say this is not the US’s problem, look at the effects each Euro crisis of the past two years has had on US financial markets.  Then compare the size of the Greek and Portuguese economies and foreign debt to that of Italy and Spain.  The two of them together might not crash the world system beyond hope of recovery.  Might not but does anyone like the size of the bet?  In 2008 the US authorities gave in to the orthodox claims of moral hazard and limits of legal authority.  They let Lehman fail.  We are still living in the wreckage of that decision.  This crash would probably be larger and the system being crashed is far more vulnerable.  QED.

The Failure of the Fairfax Primary

Part of the ongoing death of the GOP Establishment is the failure of the 'Fairfax Primary'.  'Fairfax Primary' was short hand for the Establishment having an Inside the Beltway voice is anointing who were 'serious' candidates for President.  The conservative media, think tanks and the usual DC hangers on would get favorable media for their anointed ones and disparage the rest.  The unanointed would be labeled unelectable and the combined media chatter would destroy their campaigns.

With the Ames Straw poll coming next week it seems to be a good time to review their results.  They anointed 3.5 candidates: Romney, Huntsman, Pawlenty and Gingrich.  Romney did not need them to anoint him.  He has been running since 2007 and was the provisional front runner by the usual GOP 'next in line' theory.  So far he remains a weak provisional front runner on a combination of name recognition and the support of the country club vote [upper income voters who care mostly about economic issues and governance].  Huntsman's campaign is sinking without a trace.  His campaign has even managed to misspell his name twice.  The latest is that more major figures are jumping ship as it becomes clear he is not willing to continue to self-finance a race that is going nowhere.  Pawlenty is at the do or die point with Ames.  He had an authentic story to tell [blue collar man from hard scrabble background makes good and becomes a 'Sam's Club Republican'].  He has trashed that authenticity trying to refashion himself as a Tea Party pseudo-Reagan clone.  Absent selling biography and a general nice guy feel he has no ecological niche to fill.  If he can finish in the top three in Ames he may linger on till Iowa next winter, but his campaign is reduced to trying to keep breathing long enough for Obamacare to kill Romney [which so far it isn't - Romney's core voters have forgiven him for that sin as they have essentially forgiven everything else he did to win Massachusetts elections].  Newt was always an unlikely Fairfax choice.  My personal guess is they felt compelled to take him seriously both from history [Gingrich Revolution of 94] and because Newt is an ideas man as opposed to an ideologue.  Didn't matter - once you get past name recognition the Gingrich campaign has gone nowhere.  Beyond refreshing his brand for commercial ventures his 'campaign' seems to be a mostly un-campaign with staff leaving, fund raising lagging and few actual campaign events in battle ground states.

In reverse none of the serious [double diget in the polls] candidates needed the Fairfax seal of approval.  Bachmann has become the Tea Party candidate.  She may be self-selected but that never stopped the lady before.  Paul has his cult following and will over-perform in straw polls where his groupies can pack the audience.  Perry has [for the moment] emerged as the stalking horse for everyone who look at the choice of Romney or Bachmann and asks for a third choice.  He's Tea Party enough.  He's Establishment enough [Trans-Texas Corridor].  He's actually been the governor of a major state [the last President from the House was Ford; the last President elected from the House was Garfield].  Whether his candidacy can survive the media spotlight once he announces remains to be seen. 

Yet the crazy part is that while the Fairfax Establishment would never have chosen Perry, he has in a real sense become their 'great white hope'.  Their nightmare is a contest of Romney v Bachmann with Paul as the least un-serious #3.  Establishment v Populist v Doctrinaire Libertarian.  If a Democrat were devising a formula to split the GOP into its components and possibly produce all three running for President in November this would be the formula.  Romney uses money and victories in blue states that will never vote GOP in November to beat the other two.  They pronounce him a RINO and run as two varieties of True Quill.  We live in interesting times.