The Root of All Sovereign-Debt Crises

by Amar Bhidé and Edmund S. Phelps

The Greek debt crisis has prompted questions about whether the euro can survive without a nearly unimaginable centralization of fiscal policy. There is a simpler way. Irresponsible borrowing by governments in international credit markets requires irresponsible lending. Bank regulators should just say no to such lending by institutions that are already under their purview.

Lending to foreign governments is in many ways inherently riskier than unsecured private debt or junk bonds. Private borrowers often have to offer collateral, such as their houses. The collateral limits the lenders’ downside risk, and the fear of losing the pledged assets encourages borrowers to act prudently.

But governments offer no collateral, and their principal incentive to repay – the fear of being cut off by international credit markets – derives from a perverse addiction. Only governments that are chronically unable to finance their outlays with domestic taxes or domestic debt must keep borrowing large sums abroad. A deep craving for the favor of foreign lenders usually derives from some deeply engrained form of misgoverance.

Commercial debt usually has covenants that limit the borrower’s ability to roll the dice. Loan or bond covenants often require borrowers to agree to maintain a minimum level of equity capital or cash on hand. Government bonds, on the other hand, have no covenants.

Similarly, private borrowers can go to prison if they misrepresent their financial condition to secure bank loans. Securities laws require that issuers of corporate bonds spell out all possible risks. By contrast, governments pay no penalties for outrageous misrepresentation or fraudulent accounting, as the Greek debacle shows.

When private borrowers default, bankruptcy courts supervise a bankruptcy or reorganization process through which even unsecured creditors can hope to recover something. But there is no process for winding up a state and no legal venue for renegotiating its debts. Worse, the debt that states raise abroad is usually denominated in a currency whose value they cannot control. So a gradual, invisible reduction in the debt burden by debasing the currency is rarely an option.

The power to tax is thought to make government debt safer: private borrowers have no right to the profits or wages that they need to satisfy their obligations. But the power to tax has practical limits, and governments’ moral or legal right to bind future generations of citizens to repay foreign creditors is questionable.

Lending to states thus involves unfathomable risks that ought to be borne by specialized players who are willing to live with the consequences. Historically, sovereign lending was a job for a few intrepid financiers, who drove shrewd bargains and were adept at statecraft. Lending to governments against the collateral of a port or railroad – or the use of military force to secure repayment – was not unknown.

After the 1970’s, though, sovereign lending became institutionalized. Citibank – whose chief executive, Walter Wriston, famously declared that countries don’t go bust – led the charge, recycling a flood of petrodollars to dubious regimes. It was more lucrative business than traditional lending: a few bankers could lend enormous sums with little due diligence – except for the small detail that governments plied with easy credit do sometimes default.

Later, the Basel accords whetted banks’ appetite for more government bonds by ruling them virtually risk-free. Banks loaded up on the relatively high-yield debt of countries like Greece because they had to set aside very little capital. But, while the debt was highly rated, how could anyone objectively assess unsecured and virtually unenforceable obligations?

Bank lending to sovereign borrowers has been a double disaster, fostering over-indebtedness, especially in countries with irresponsible or corrupt governments. And, because much of the risk is borne by banks (rather than by, say, hedge funds), which play a central role in lubricating the payments system, a sovereign-debt crisis can cause widespread harm. The Greek debacle jeopardized the well-being of all of Europe, not only Greeks.

The solution to breaking the nexus between sovereign-debt crises and banking crises is straightforward: limit banks to lending where evaluation of borrowers’ willingness and ability to repay isn’t a great leap in the dark. This means no cross-border sovereign debt (or esoteric instruments, such as collateralized debt obligations).

This simple rule would require no complex reordering of European fiscal arrangements, nor would it require the creation of new supra-national entities. It would certainly make it difficult for governments to borrow abroad, but that would be a good outcome for their citizens, not an imposition. Moreover, curtailing governments’ access to international credit (and, by extension, inducing more fiscal responsibility) could actually help more enterprising and productive borrowers.

Such constraints wouldn’t solve the current crisis in Portugal, Ireland, Greece, or Spain. But it is high time that Europe, and the world, stopped lurching from one short-term fix to the next and addressed the real structural issues.

Amar Bhidé, author of A Call for Judgment, is a professor at the Fletcher School of Law and Diplomacy, Tufts University. Edmund Phelps, a Nobel laureate, is a professor at Columbia University. Both are founding members of Columbia’s Center on Capitalism and Society.

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A Bad Deal for America’s Future

by Michael Mandelbaum

The painfully negotiated US budget legislation that President Barack Obama signed on August 2 combines an increase in America’s government debt ceiling with reductions in federal spending, thus averting the prospect of the first default in the 224-year history of the United States. But the agreement has three major flaws. Two of them offset each other, but the third threatens what America needs most in the coming years: economic growth.

The first flaw is that the spending reductions are badly timed: coming as they do when the US economy is weak, they risk triggering another recession. The measure’s second shortcoming, however, is that the spending reductions that it mandates are modest. While the legislation does too little to address America’s problem of chronic and rising budget deficits, the damage that it inflicts on the economy in the short term is likely to be limited.

The third and most damaging flaw, however, is that the spending cuts come in the wrong places. Because the Democrats in Congress have an almost religious commitment to preserving, intact, America’s principal welfare programs for senior citizens, Social Security and Medicare, the legislation does not touch either of them. These programs’ costs will rise sharply as the 78-million-strong baby-boom generation – those born between 1946 and 1964 – retires and collects benefits, accounting for the largest increase in government spending and prospective deficits in the years ahead. And, because the Republicans in Congress have an equally strong allergy to raising any taxes, any time, under any circumstances, the bill does not rely at all on tax increases – not even for the wealthiest Americans – for the deficit reduction that it provides.

All of the spending cuts come from the “discretionary” part of the federal budget, which excludes Social Security, Medicare, the Medicaid program for the poor, and interest on the national debt. That leaves only about one-third of total federal spending from which to cut, and much of that goes to the defense budget, which Republicans will attempt to protect in the future. So the structure established by the August 2 law concentrates deficit reduction on the “discretionary non-defense” part of the federal budget, which is only about 10% of it.

This is too small a pool of money from which to achieve deficit reduction on the scale that the US will need in the years ahead. Worse yet, discretionary non-defense spending includes programs that are indispensable for economic growth – and economic growth is indispensable for America’s future prosperity and global standing.

Growth is, in the first place, the best way to reduce the country’s budget deficits. The higher the growth rate, the more revenues the government will collect without raising tax rates; and higher revenues enable smaller deficits.

Moreover, economic growth is necessary to keep the promise – enormously important to individual Americans – that each generation will have the opportunity to become more prosperous than the preceding one, the popular term for which is “the American dream.” Just as important for non-Americans, only robust economic growth can ensure that the US sustains its expansive role in the world, which supports the global economy and contributes to stability in Europe, East Asia, and the Middle East.

As Thomas L. Friedman and I explain in our forthcoming book That Used To Be Us: How America Fell Behind in the World It Invented and How We Can Come Back, a crucial factor in America's economic success has been an ongoing public-private partnership, which dates back to the founding of the country, that is imperiled by the pattern of budget cuts established by the August 2 legislation.

That partnership has five components: wider opportunities for education in order to produce a workforce with cutting-edge skills; investment in infrastructure – roads, power plants, and ports – that supports commerce; funds for research and development to expand the frontiers of knowledge in ways that generate new products; an immigration policy that attracts and retains talented people from beyond America’s borders; and business regulations strong enough to prevent disasters such as the near-meltdown of the financial system in 2008 but not so stringent as to stifle the risk-taking and innovation that produce growth.

The first three elements of the American formula for growth cost money, and that money is included in the “discretionary non-defense” part of the federal budget now targeted by the debt-ceiling legislation. Cutting these programs will lower American economic growth in the long term, with negative consequences both at home and abroad. Reducing the deficit by cutting funds for education, infrastructure, and research and development is akin to trying to lose weight by cutting off three fingers. Most of the weight will remain, and one’s life prospects will have worsened significantly.

Reducing deficits in order to raise the debt ceiling was the right thing to do, but the August 2 law does it in the wrong way. Unless more deficit reduction, which is inevitable, comes from curbing entitlement benefits and increasing revenues, and less from programs vital for economic growth, the result will be a poorer, weaker US – and a more uncertain, if not unstable, world.

Michael Mandelbaum is Professor of American Foreign Policy at The Johns Hopkins School of Advanced International Studies, and the co-author, with Thomas L. Friedman, of the forthcoming book That Used To Be Us: How America Fell Behind in the World It Invented and How We Can Come Back.

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America’s First Debt Crisis

by Mark Roe

The West is ensnared in a debt crisis. The United States, as everyone knows, came perilously close to defaulting on August 2, and Standard & Poor’s downgraded US debt from AAA on August 5. In Europe, the outgoing head of the European Central Bank recommends more centralized fiscal authority in Europe in order to deal with likely defaults by one or more of Greece, Portugal, and Spain.

Both Europe and America can learn a lesson hidden in American history, for, lost in the haze of patriotic veneration of America’s founders is the fact that they created a new country during – and largely because of – a crippling debt crisis. Today’s crises, one hopes, could be turned into a similar moment of political creativity.

After independence from Britain in 1783, America’s states refused to repay their Revolutionary War debts. Some were unable; others were unwilling. The country as a whole operated as a loose confederation that, like the European Union today, lacked taxing and other authority. It could not solve its financial problems, and eventually those problems – largely recurring defaults – catalyzed the 1787 Philadelphia convention to create a new United States.

And then, in 1790-1791, Alexander Hamilton, America’s first treasury secretary, resolved the crisis in one of history’s nation-building successes. Hamilton turned America’s financial wreckage of the 1780’s into prosperity and political coherence in the 1790’s.

To understand Hamilton’s achievement – and thus to appreciate its significance for our own times – we need to understand the scale of the Revolutionary War debt crisis. Some states lacked the resources to pay. Others tried to pay but would not levy the taxes needed to do so. Others, like Massachusetts, tried to levy taxes, but its citizens refused to pay them.

Indeed, some tax collectors were met with violence. Indebted farmers physically disabled the repayment machinery in many states, most famously in Shay’s Rebellion in Massachusetts.

Even private debt-payment mechanisms via courts didn’t work. James Madison, who would become the Constitution’s principal author, couldn’t borrow to buy land in frontier Virginia, because lenders lacked confidence that Virginia courts could enforce repayment. George Washington bemoaned that America was not a “respectable country.” He found Shays Rebellion so worrisome that he came out of his first retirement to preside over the 1787 convention.

Today, the US Constitution’s most noted features are its allocation of power between Congress and the presidency, and its guarantee of individual rights via its first ten amendments. But, at the time, its key role was as a government-debt-repayment mechanism. The Constitution would create a new national government that could coin stable money, borrow, and repay debts, including the states’ defaulted Revolutionary War borrowings.

With the Constitution ratified by 1789, Washington became President and appointed Hamilton – still in his thirties – to head the Treasury. Hamilton had not been a finance person. He was Washington’s Chief of Staff during the Revolutionary War and a quick study: when it was time to learn battlefield tactics, he read military manuals; when it was time to become a national leader who understood finance, he read finance books.

Yet, it was no accident that two military men were key to making the US a “respectable nation” in financial terms. Both thought that only a fiscally strong US could have the military prowess needed to defend itself from the European powers, whose return to American soil both men expected.

But getting the dollars to repay the debt was not easy. There were no entitlements to cut or government funds to re-direct. Hamilton knew that the wrong kind of taxes would weaken the already-fragile economy. He focused taxation on imports and nonessential goods, like whiskey.

And Hamilton needed Congress to approve the federal government’s assumption of the states’ debts, which at first seemed unlikely. Some states, like Virginia, had already paid much of their debt, and others saw their debt as having become a financial game for New York speculators. As a result, many states feared federal assumption would mean that their taxes would go to pay northern speculators or to retire the debt of big borrowers, like Massachusetts.

Virginia and several other southern states that owed little or had repaid what they owed voted against Hamilton’s first assumption bill and defeated it. They were expected to be adamant – an outcome that could well have brought about the young country’s demise.

Jefferson and Madison, the southern leaders, opposed Hamilton’s assumption plan, and Madison was critical in blocking it in Congress. But then the three met for dinner and cut a deal. Jefferson and Madison did not want the country’s capital to be in the north, and Hamilton reluctantly agreed to support moving it to an area carved out of Virginia or Maryland. They, in turn, would secure the votes for the federal government to assume and repay the states’ defaulted debts.

A responsible fiscal state emerged from that grand compromise. Despite the enormous cost – more than half of the fledgling government’s expenditures in early years went to debt service – the economy shook off the 1780’s depression and entered a growth boom.

Hamilton’s task was both easier and harder than ours is today. It was easier, because there were few choices: no income-tax rates to adjust or entitlements to cut. And it was harder, because the US was an unknown entity, and there was little reason for confidence in the American non-nation.
Today’s trajectory is the reverse of that of the 1780’s and 1790’s. It is hard today for America (and, until recently, the world) to imagine a US default, because there has been no strong reason to fear one since the 1790’s.

Americans today know what must be done: some combination of entitlement cuts and tax increases. Europeans, too, know a new balance that needs to be struck. But, until Europe and the US find leaders with the authority and willingness to repeat a modern version of the deal-making example set by Hamilton, Jefferson, and Madison 200 years ago, their debt problems will continue to weaken their national foundations.

Mark Roe is a professor at Harvard Law School.

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Stagnant and Paralyzed

by Michael Spence

The recent dramatic declines in equity markets worldwide are a response to the interaction of two factors: economic fundamentals and policy responses – or, rather, the lack of policy responses.
First, the fundamentals. Economic growth rates in the United States and Europe are low – and well below even recent expectations. Slow growth has hit equity valuations hard, and both economies are at risk of a major downturn.

A slowdown in one is bound to produce a slowdown in the other – and in the major emerging economies, which, until now, could sustain high growth in the face of sluggish performance in the advanced economies. Emerging countries’ resilience will not extend to double-dip recessions in America and Europe: they cannot offset sharp falls in advanced-country demand by themselves, notwithstanding their healthy public-sector balance sheets.

America’s domestic-demand shortfall reflects rising savings, balance-sheet damage in the household sector, unemployment, and fiscal distress. As a result, the large non-tradable sector and the domestic-demand portion of the tradable sector cannot serve as engines of growth and employment. That leaves exports – goods and services sold to the global economy’s growth regions (mostly the emerging economies) – to carry the load. And strengthening the US export sector requires overcoming some significant structural and competitive barriers.

What the world is witnessing is a correlated growth slowdown across the advanced countries (with a few exceptions), and across all of the systemically important parts of the global economy, possibly including the emerging economies. And equity values’ decline toward a more realistic reflection of economic fundamentals will further weaken aggregate demand and growth. Hence the rising risk of a major downturn – and additional fiscal distress. Combined, these factors should produce a correction in asset prices that brings them into line with revised expectations of the global economy’s medium-term prospects.

But the situation is more foreboding than a major correction. Even as expectations adjust, there is a growing loss of confidence among investors in the adequacy of official policy responses in Europe and the US (and to a lesser extent in emerging economies). It now seems clear that the structural and balance-sheet impediments to growth have been persistently underestimated, but it is far less clear whether officials have the capacity to identify the critical issues and the political will to address them.

In Europe, risks spreads are rising on Italian and Spanish sovereign debt. Yields are in the 6-7% range (generally viewed as a danger zone) for both countries. Combined with their low and declining GDP growth prospects, their debt burdens are becoming sufficiently onerous to raise questions about whether they can stabilize the situation and restore growth on their own.

Italy and Spain expose the full extent of Europe’s vulnerability. Like Greece, Ireland, and Portugal, membership in the euro denies Italy and Spain devaluation and inflation as policy tools. But the declining value of their sovereign debt – and the size of that debt relative to that of Europe’s smaller distressed countries – implies much greater erosion of banks’ capital base, raising the additional risk of liquidity problems and further economic damage.

The domestic policy focus in Europe has been to cut deficits, with scant attention to reforms or investments aimed at boosting medium-term growth. At the EU level, there is not yet a complementary policy response designed to halt the vicious cycle of rising yields and growth impairment now faced by Italy and Spain.

Credible domestic and EU-wide policies are needed to stabilize the situation. Neither is forthcoming. Recent market volatility has been partly a response to the apparent rise in the downside risk of policy paralysis or denial.
In the US side, the integrity of sovereign debt was kept in question for too long. During those months of political dithering, US treasuries became a riskier asset. Then, with the immediate default risk removed, money stormed out of risky assets into Treasuries to wait out the economic bad news – mainly feeble and declining growth, employment stagnation, and falling equity prices.

Little in America’s domestic policy debates hints at a viable growth and employment-oriented strategy. In fairness, some believe that cutting the budget is a sufficient growth strategy. But that is neither the majority view, nor the view reflected by the markets.

Structural and competitive impediments to growth have been largely ignored. There is little recognition that domestic aggregate demand cannot be restored to its pre-crisis levels except through growth. In fact, the household savings rate continues to rise.

The details may elude voters and some investors, but the focus of policy is not on restoring medium- and long-term growth and employment. Indeed, there is profound uncertainty about whether and when these imperatives will move to the center of the agenda.

In the emerging economies, by contrast, inflation is a challenge, but the main risk to growth stems from the advanced countries’ problems. In addition, reforms and major structural changes are needed to sustain growth, and these could be postponed, or run into delays, in a decelerating global economy.

The resetting of asset values in line with realistic growth prospects is probably not a bad outcome, though it will add to the demand shortfall in the short run. But uncertainty, lack of confidence, and policy paralysis or gridlock could easily cause value destruction to overshoot, inflicting extensive damage on all parts of the global economy.

This somewhat bleak picture could change, though probably not in the short run. Stability can return, but not until domestic policy in the advanced countries, together with international policy coordination, credibly shifts to restoring a pattern of inclusive growth, with fiscal stabilization carried out in a way that supports growth and employment.

In short, we confront two interacting problems: a global economy losing the struggle to restore growth and the absence of any credible policy response. Too many countries seem to be focused more on political outcomes than on economic performance. Markets are simply holding up a mirror to these flaws and risks.

Michael Spence, a Nobel laureate in economics, is Professor of Economics at New York University’s Stern School of Business, Distinguished Visiting Fellow at the Council on Foreign Relations, and Senior Fellow at the Hoover Institution, Stanford University. His latest book is The Next Convergence – The Future of Economic Growth in a Multispeed World (www.thenextconvergence.com).

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Evening markets: crop futures hurt by Wall Street collapse

by Agrimoney.com

Nightmare on Wall Street Part 10 (the number of trading days out of the last 12 that New York shares have fallen) had a leading role for agricultural commodities.

Sure, there was some support around for the idea that crop and livestock futures might continue to outperform, ie fall less quickly, than other risk assets, shielded by their defensive qualities – we always need to eat – besides the underlying tightness in supplies.

But farm commodities sustained painful losses nonetheless, with many shedding as much as, or more than, the average 2.8% decline in raw material prices (according to the CRB index) - if less than the 4.8% wound that Wall Street shares were nursing in late deals.

The major catalyst to all this, if a reminder is necessary, was Standard & Poor's downgrade late on Friday of America's credit rating, to AA+ from AAA, with a negative outlook (implying more cuts could be on their way), with worries about eurozone debt doing their bit too.

"The downgrade is the first ever downgrade of US credit ratings and has sent shock waves through the global markets as investors run to safe haven assets such as gold," Benson Quinn Commodities noted.

Or as Jurgens Bauer, at PitGuru, put it: "The turmoil facing traders is obvious. The environment is ripe with margin calls and as such for risk to be taken off the table."

'Concern is on the demand side'

And, however relatively safe crops may appear, their credentials are deeply undermined by, say, the 6.8% slump in prices of West Texas Intermediate crude in late deals to just over $81 a barrel.

Lower oil prices mean lower prices of ethanol too, as made from corn, sugar and, less so, wheat.

"The concern is on the demand side of the equation today, not the supply side," Darrell Holaday at Country Futures said.

"Today's action should remind all that the ethanol industry drives corn use and if you believe that crude oil will go to $70 and it will not hurt the value of corn, no matter what the size of the US crop" -well, "redo your analysis".

Disappointing exports

And even if external markets were in better condition, there was enough bad karma around to make life difficult for farm commodities.

In the US, weekly export inspections were disappointing for corn, at 31.7m bushels, and soybeans, at 5.6m bushels, both in line with the previous week's figures, and confirming "the fact that corn and soybean stocks at the end of this crop year will be higher than the current USDA estimate", Mr Holaday said.

They took the shine off the announcement of a 120,000-tonne purchase by Egypt of US corn.

'Heatwave has broken'

Furthermore, weather was hardly so threatening.

"The heatwave for now has broken," US Commodities said.

Benson Quinn said: "Weather remains favourable with cooler temperatures moving into the northern Plains and pushing rains into the drier regions of the central US."

The outlook appears favourable "to soybeans with crop heading into key pod-filling phase over next couple weeks".

Soybeans for November dipped 1.8% to $13.11 ½ a bushel, ending pretty much at the day low and with its weakest finish since late June, while corn for December shed 2.4% to $6.86 a bushel.

... but more heat to come?

Wheat in terms of the days' fundamental terms had more going for it, with US export sales of 25.2m tones, up more than 50% week on week, and 100,000 tonnes of hard red winter (the type traded in Kansas) sold to an unknown destination.

Furthermore, US Commodities noted that the extended weather forecast "places a ridge in the southern Plains and western Midwest after August 20", a factor "of most concern to the planting of hard red winter wheat".

Still, with corn, the main prop to the grain complex, failing, wheat, whose supplies on a global scale are pretty abundant, closed down 3.3% at $6.56 ½ a bushel for September delivery in Chicago.

'Little else supporting wheat'

Kansas wheat dipped nearly as much, ending down 3.2% at $7.55 ¼ a bushel for September, despite the export order.

And European wheats fell too.

Sure rains "continued to hinder cutting across Germany, France, Poland and the Czech Republic over the weekend and more rain is forecast for the coming three days", Jaime Nolan at FCStone's Dublin office said.

But, "other than quality concerns, there is little else supporting current wheat values" than corn, he noted.

As an extra hurdle to bulls, Strategie Grains upped its estimate for the UK wheat crop to 15.08m tonnes, after better-than-expected results from the early harvest.

Paris wheat for November shed 2.7% to E190.25 a tonne, while London's November lot fell 1.5% to £157.25 a tonne.

Softs soft

Among soft commodities, it was little surprise that cotton was notably weak, shedding 3.9% to 97.72 cents a pound.

The fibre, as a non-food farm commodity, lacks the "everyone has to eat" defence, and, with clothing as more of a discretionary purchase, is seen as more susceptible to changes in economic outlook.

Even coffee, which had fundamental support from frost in Minas Gerais, could not dodge the bullet, closing down 1.6% at 234.20 cents a pound in New York for September delivery, the lowest close for a spot contract since January.

Also in New York, raw sugar at least managed a bit of a bounce from an intraday low of 26.38 cents a pound, but only to 26.98 cents a pound for October, down 2.0% on the day, and the weakest finish for a spot lot since late June.

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U.S. Debt Downgraded, Now What?

By Ilene

On Friday, August 5, Standard and Poor’s downgraded U.S. debt from AAA to AA+, and assigned a negative outlook to U.S. debt. In its press release, S&P directly addressed the contentious squabbling on Capitol Hill, and the clumsy spectacle of Obama, Boehner and the upstart Tea Party faction of the Republican party wrangling over the raising of the debt ceiling, a process that had previously been routinely approved as a matter of course.

Bruce Krasting asked and answered,

“What to make of the move by S&P? I will tell you that I was surprised that it happened this weekend. I expected that S&P would have given the US till November to sort things out. From the news reports, it appears that the White House and Treasury were equally unprepared for this to happen now. Some thoughts:

“It looks as if the US is going to have a split rating. (AAA {equivalent} by Fitch/Moody’s, and AA+ by S&P.) If this were a high-grade corporate credit, the split rating status would make no difference in how the underlying bonds trade. I doubt that the S&P action will have a different (lasting) consequence.”

China is the largest holder of U.S. debt, and the S&P’s downgrade presented an opportunity for the Chinese government to sharply admonish the U.S. government through the state-run Xinhua News Agency:

“The U.S. government has to come to term with the painful fact that the good old days when it could just borrow its way out of messes of its own making are finally gone... China, the largest creditor of the world’s sole superpower, has every right now to demand the United States to address its structural debt problems and ensure the safety of China’s Dollar assets.”

Xinhua suggested that the U.S. slash its “gigantic military expenditure and bloated social welfare costs” and accept international supervision over U.S. Dollar issues.

Theoretically, the downgrade might make U.S. debt less attractive to the rest of the world, and might cause China to stop buying so much of it. However, Michael Pettis, finance professor at Peking University’s Guanghua School of Management, argues that this is very unlikely.

“Is the PBoC going to stop buying USG bonds? ...if the US defaults, it will be mainly a technical default that will certainly be made good one way or the other. Since the PBoC doesn’t have to worry about mark-to-market losses, unlike mutual funds, I think for China this is largely an economic nonevent.

"Remember that the PBoC does not purchase huge amounts of USG bonds because it has a lot of money lying around and doesn’t know what to do with it. Its purchase of USG bonds is simply a function of its trade policy.”

In examining the S&P's move, it's natural to wonder about its motives - politics, money, or just a desire to (finally) do the right thing? A separate question is whether the U.S. deserves an AAA rating or not. Those who find fault with the S&P's downgrade, should consider that second question as well.

Lee Adler of the Wall Street Examiner discussed the overall health of the economy, as measured uniquely in food stamps.

“Total food stamp recipients rose by 1.1 million in May. That represented a dramatic acceleration from the recent rate. Enough QE2 had trickled down from December to April to slow the growth rate of people entering the program to about 100,000 per month. The last time we saw an acceleration of this magnitude was in September 2008. That was at the beginning of the 2008 crash in the stock market and economy.

“This rise in food stamp use,...... [and] a sharp drop in government withholding tax receipts in May, suggesting the return of the recession that had been hidden by the government’s propping of the markets and economy. I had repeatedly warned that it appeared that the economy had suddenly gone into free fall beginning in May. This data on the food stamp program tends to confirm that.” (See chart below, note the number of people on food stamps is inverted.)

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Why the U.S. Credit Rating Downgrade Could Cause a Full-Fledged Market Crash

By Jason Simpkins

That Standard & Poor's finally downgraded its U.S. credit rating surprised no one - the agency said weeks ago that it would require a deficit-reduction agreement of around $4 trillion to affirm its AAA rating on the United States.

But what the ratings agency doesn't realize is that it's playing with fire. Because what we've seen over the past few weeks has been a massive sell-off in the stock market that suggests Wall Street's biggest players are scrambling to bolster their net capital positions.

And it's entirely possible that this already-stiff correction will snowball into a full-blown market crash.

For months, years even, many of these firms have leveraged their Treasury securities to borrow more money to buy more government bonds and other - more speculative - investments. But since Treasury bills, notes, and bonds can no longer be considered "risk free," institutions are being forced to recalculate their net capital positions to accommodate the added risk.

In industry parlance, this is called a "haircut," and it's exactly what Money Morning Contributing Editor Shah Gilani warned about back in July.

"After studying everything that could happen due to a downgrade of the United States' top-tier AAA credit rating, and the potential default on its debt, we found a scenario that would result in forced asset sales that are so widespread that global stock-and-bond markets would plunge -- and economies around the world would crash," said Gilani.

Gilani now says that we could be seeing the beginning of a "global margin call" that will continue to ravish global markets.

The Dow Jones Industrial Average plunged more than 631 points, or 5.52%, yesterday (Monday), after falling 6% last week.

"The sell-off itself got uglier later in the day as margin calls likely triggered more liquidations when there was no bounce after the opening downdraft," Gilani said in an interview. "This is very worrisome. If we don't get a bounce Tuesday morning, but instead see a bad opening, margin calls will ramp up and the effect of rolling collateral and margin calls could turn this correction into a full-fledged crash."

Market Mechanics

Gilani says what happens next boils down to margin mechanics and counterparty risk.

"It's the market's ‘mechanics' that presents the greatest danger, which 98% of investors, including professionals, aren't seeing. The focus now has to be on margin mechanics," says Gilani. "More margin calls mean more pain and much, much longer recovery from wherever the markets bottom out. The next few days are super important."

Gilani says this was made evident yesterday by the downgrades of several major clearinghouses and government-related entities.

Companies downgraded to double-A-plus with a negative outlook were: Knights of Columbus, New York Life Insurance Co., Northwestern Mutual, Teachers Insurance & Annuity Association of America, and United Services Automobile Association.

Companies affirmed at AA-plus with their outlook lowered to negative were: Assured Guaranty Corp., Berkshire Hathaway Inc. (BRK.A, BRK.B), Massachusetts Mutual Life Insurance Co., Guardian and Western & Southern Financial Group Inc.

"Any panic grab for collateral, and principally I'm fearful of this happening in thederivatives marketplace, would engender counterparty fears," Gilani said. "We've seen insurance company downgrades today, so the questions are being asked: What's the real level and quality of their capital, and do they have skeletons in the closet?"

With so much risk abounding, it's important that investors not panic, but rather prepare. They can do that in a number of ways, including:

• Buying gold: Gold prices hit a record high of $1,718 an ounce in intraday trading yesterday (Monday) in response to Standard & Poor's downgrade of the U.S. credit rating, and the continuing drumbeat of dreary global economic news will keep pushing the yellow metal higher.

• Investing in high-yielding, large-cap stocks: Large multinational companies that pay juicy dividends will be less susceptible to a market downturn, and could even prove to be bargains during a rebound.

• Employ inverse funds: Exchange-traded funds like the Rydex Inverse S&P 500 fund (MUTF: RYURX) move up as the market goes down, making them a viable hedge.

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by Tyler Durden

For today's preview of the FOMC rate decision (which should really be called a QE3 decision), we go to RanSquawk which highlights the push and pull mechanics of today's events, and to Goldman which once again makes the explicit clarification that it needs QE3 with the statement that "A bit more easing might be needed in the near term." Yes Goldie, we know you want another year of record bonuses.

From RanSquawk:

PREVIEW: FOMC rate-decision due at 1915 BST (1315 CDT)

Today’s FOMC rate-decision comes in the backdrop of a long-term sovereign rating downgrade of the US by S&P to AA+ from AAA, with a negative outlook. The latest move by the S&P may force policymakers to debate the viability of further monetary easing, as the downgrade could see a rise in the long-term interest rates. Moreover, a sustained reaction from the present crisis could translate into a slowdown in growth, which together with sluggish personal income/spending in the US, and fading temporary factors supporting prices may weigh upon the country’s core inflation further, and in turn force the Fed to act. Although, in its latest communiqué, the Fed said that S&P’s ratings downgrade does not affect the operation of its emergency lending window or its buying and selling of Treasury securities to conduct monetary policy.

The Fed is likely to keep its “exceptionally low” borrowing cost for “an extended period” language, although it may be tempted to use the “extended period” phrase with respect to reinvesting principal payments. A more aggressive approach would be for the Fed to alter its reinvestment policy so as to extend the average maturity of its security portfolio, which currently stands at around 6.1 years. However, this is unlikely to be a favourable option as it may hinder a smooth exit from Fed’s current loose monetary policy. The Fed could signal another round of quantitative easing, although it would be reluctant to do so as this may raise questions about whether the Fed is simply monetising the US debt, which could undermine confidence in the USD and drive interest rates higher.

Some policymakers may opt to slash the interest paid on excess reserves and thus in effect encourage enhanced lending by the country’s financial institutions. However, in Bernanke’s own words, this approach would have little effect on overall financial conditions. A more desirable approach may be for the Fed to open a new lending facility to increase credit availability for targeted sectors of the economy those that need help. The Fed could reduce the secondary credit rate in its discount window or alternatively start to accept a wider range of collateral in exchange for loans offered. This may help the access of funds to a wider economy, and may prevent the danger of big institutions strengthening their own balance sheets as opposed to lending.

Bernanke has been a prominent supporter of an explicit inflation target, and it would be interesting to see any comments along these lines. By setting a higher inflation target the Fed can give itself more room for further monetary easing. Elsewhere, the Fed could lower its 2011 growth forecast for a third consecutive time, which currently stands at 2.7%-2.9%. It may also surprise the market by lowering its core PCE inflation target, which currently stands at 1.5%-1.8%, citing fading temporary factors supporting prices. In terms of market reaction, any indication of further easing would potentially see weakness in the USD, and is likely to support Treasuries and equities. However, if the Fed cuts its growth/inflation forecast, that may exert downward pressure on the currency and equities, and in turn support T-Notes.

It is also worth noting that the FOMC rate-decision is due at 1915 BST (1315 CDT) and there is no press-conference from Fed’s Bernanke following the rate-decision. According to the press-release by the Fed, dated March 24th 2011, the next press-conference by the Chairman will be on November 2nd 2011.

And here is Goldman which makes it 3rd consecutive push for QE3, saying "A bit more easing may be needed in the near term."

Last Friday we lowered our growth forecast further and now expect real GDP to increase just 2%-2½% (annualized) through the end of 2012. Since this pace is slightly below the US economy’s potential, we now expect the unemployment rate to be at 9¼% by the end of 2012. Given the large—and now growing—amount of slack in the economy, we expect the year-on-year rate of core inflation to fall from a peak of around 2% in late 2011 to 1¼% in late 2012. (For details see Jan Hatzius, "Subpar Growth Brings the Fed Back into Play," US Economics Analyst, 11/31.)

What are the implications of these forecast changes for the Fed outlook? Our preferred tool for thinking about this question is our forward-looking Taylor-type rule, which describes how Fed officials have historically set the funds rate using their four-quarter-ahead forecasts of core PCE inflation as well as the expected unemployment gap (actual less “structural” unemployment). (For details see Jan Hatzius and Sven Jari Stehn, “The "Warranted" Funds Rate: Is It Really Negative?” US Daily, March 10, 2010.) Moreover, we have constructed a "QE-adjusted" version of our Taylor rule to take into account the Fed’s unconventional policies—including its “extended period” language and its asset purchase programs (“QE1” and “QE2”). (For details see Jan Hatzius and Sven Jari Stehn,"QE2: How Much is Needed?" US Economics Analyst, October 22, 2010.)

Plugging our new forecasts into our Taylor rule has two implications for our Fed outlook (see exhibit below):

1. A bit more easing might be needed in the near term. Under our new forecasts our QE-adjusted Taylor rule implies that the “warranted” funds rate is currently -1.7%. (This figure is obtained by adjusting the funds rate implied by our baseline Taylor rule, -3.7%, with our estimate of the effectiveness of the Fed's unconventional policies, equal to 2%. For details, see US Economics Analyst, October 22, 2010.) Given a current funds rate of 0.1%, the "policy gap" between the actual and appropriate funds rate is therefore about 180 basis points. Does this gap mean that the Federal Open Market Committee (FOMC) will adopt a third round of quantitative easing? Our answer is “probably not”, unless the economy falls back into recession.

The reason is that the committee perceives asset purchases as cosiderably more costly than an equivalent amount of conventional monetary stimulus, and is therefore not likely to close this policy gap fully. Taking a view on the perceived costs of returning to unconventional easing--and thus on the threshold for the warranted funds rate below which Fed officials might adopt QE3--is difficult. Prior to QE2, we estimated that because of these costs the FOMC was willing to accept a gap between the warranted and actual policy stance worth 100bps in the funds rate. (See US Economics Analyst, October 22, 2010.) Given the backlash against QE2 since then, we believe that the threshold for further quantitative easing has risen, perhaps to something like 150bps.

Unless the economic outlook deteriorates further, we therefore expect that Fed officials will only take two small steps to close some of the policy gap. (Given a 150bp easing threshold, our calculations imply that they might close 30bp of the current 180bp policy gap.) First, we expect them to expand the scope of their “extended period” language to cover not only the exceptionally low funds rate but also the exceptionally large balance sheet. For example, they could rewrite the current forward-looking language in the statement to say that economic conditions “…are likely to warrant exceptionally low levels for the federal funds rate and exceptionally large asset holdings for an extended period” (our suggested change in italics).

New York Fed estimates, for example, suggest that pushing out the expectation for the start of balance-sheet run-off by one year would narrow the policy gap by 25bp. We expect that this change will occur in tomorrow's FOMC meeting. Second, we expect the composition of the Fed’s balance sheet to shift toward longer maturities. This could happen via an increase in the average maturity of its reinvestment of MBS paydowns and/or a change in the reinvestment policy for its Treasury portfolio. Although such a change is possible tomorrow, we think it is more likely to occur at a later date.

2. The Fed is likely to exit even later. Our new forecasts reinforce our long-held call for no funds rate hikes until 2013, and suggest that it could be even later. Indeed, our Taylor rule suggests that it could be as long as late 2014 before the first funds rate hike becomes appropriate--around 18 months later than before. This prediction is close to that from a rule estimated by Glenn Rudebusch of the San Francisco Fed (see "The Fed's Exit Strategy for Monetary Policy," FRBSF Economic Letter, 2010-18). Feeding our new forecasts into his rule suggests that the first rate hike might take place in mid-2014.

Judging by the offerless surge in futures (at least for the time being), either we have a massive short squeeze on overnight positions, or someone has already selectively lifted the Fed embargo.

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Stunning Pictures of Senseless London Riots; Conflagration and Carnage in the Capital and Beyond; London Riots: Live Blog

by Mike Shedlock

Boston.Com, The Telegraph, and The Guardian have stunning images of massive riots in the UK.

Sources report the exact cause for massive riots, now in their third day in London, is unknown. While the trigger may be a deadly shooting by police, I believe the cause is social-breakdown fueled by rising unemployment, loss of dignity, and a desperate realization that hope for a better future and for government to do something responsible about jobs and rising food prices is fruitless.

Boston.Com reports on London Riots.

Two nights of rioting in London's Tottenham neighborhood erupted following protests over the shooting death by police of a local man, Mark Duggan. Police were arresting him when the shooting occurred. Over 170 people were arrested over the two nights of rioting, and fires gutted several stores, buildings, and cars. The disorder spread to other neighborhoods as well, with shops being looted in the chaos. Collected here are images from the rioting and the aftermath.

The article displays 26 stunning images. Here are a few of them.



Fire fighters and riot police survey the area as fire rages through a building in Tottenham, north London on Aug. 7, 2011. A demonstration against the death of a local man turned violent and cars and shops were set ablaze. (Lewis Whyld/PA/AP)



A double decker bus burns as riot police try to contain a large group of people on a main road in Tottenham on August 6, 2011. (Leon Neal/AFP/Getty Images)



Fire rages through a building in Tottenham on Aug. 7, 2011. (Lewis Whyld/PA/AP)



Buildings burn on Tottenham High Road in London during protests on August 6, 2011. (Matthew Lloyd/Getty Images)



A shop and police car burn as riot police try to contain a large group of people on a main road in Tottenham on August 6, 2011. (Leon Neal/AFP/Getty Images)

There are 26 images in the article. It is worth a closer look.

London riots: conflagration and carnage in the capital and beyond

The Guardian reports London riots: conflagration and carnage in the capital and beyond

Riot police charge past burning buildings on a residential street in Croydon. Photograph: Dylan Martinez/Reuters



Several large fires engulfed the centre of Croydon on Monday night as the unrest that has gripped London spread to one of the capital's most southerly boroughs.

Residents said the trouble started in outlying neighbourhoods at about 7pm with 200 to 300 youths rampaging through the streets looting and setting fire to shops.

At about 9pm, the trouble had spread to the centre of Croydon where the hundred-year-old Reeves furniture shop was set alight sending flames high into the night. Croydon Central MP Gavin Barwell said: "I'm sickened to see this happening in my town. My first instinct is sympathy for the businesses and residents who have been directly affected by what's happened.

"I have never seen anything like it," said Mary Wright standing on her doorstep watching a burning car at the bottom of her street. "It started at around 7pm and has not stopped since."

By 10.30pm the main fires in the centre of Croydon appeared to be under control although helicopters still hovered over the town and police vans with sirens wailing continued to criss cross the town as the unrest continued.

On London Road just north of the centre, several shops had been smashed and looted and two burning cars were left in the middle of the road.

Groups of young men many with their faces covered with masks and scarf pelted police vans with bottles and rocks as they sped past.

Some had collected mounds of rubble to use against the police, others had armfuls of goods they had taken from looted shops.

Riot police were out in force blockading some roads but did not attempt to stop people attacking shops or setting fire to cars.

The above text was regarding Croydon. The Guardian also highligted major riots in Birmingham, Battersea, Lewisham, Kilburn, and isolated outbreaks in Liverpool.

London Riots: Live

The Telegraph has rolling coverage of London riots: live

Rolling coverage of the third night of violent disturbances in London, Bristol, Liverpool and Birmingham, with widespread arson and looting reported across the capital.



People loot a shop in Hackney

The Telegraph article has numerous video is a "live blog" scrolling format.

Rule of the Mob
Tomorrow's Daily Telegraph Front Page


Fuel for these riots has been building up for some time, and it finally erupted. One has to wonder in a Spring/Summer of riots, what country is next.

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What Happens to Gold if the Markets Crash?

By: Clive_Maund

This is the question that many would like an answer to, as it is looking rather likely after the announcement, conveniently made after the markets closed on Friday, that Standard and Poor were lowering their rating for US debt.

Actually the markets started to crash on Thursday, with major indices breaking down from a large Head-and-Shoulders top, as we can see on our 1-year chart for the S&P500 index chart below. By Friday's close the markets had become deeply oversold, and while this could lead to a technical rebound towards the neckline, it would very likely be followed by renewed decline, but because the breakdown was such a seriously negative technical development there may be no rebound at all - instead the markets could accelerate away to the downside. Banking and financial stocks in particular look truly awful with major support levels having just been breached and little but air beneath most of them. 

To answer the question regarding the outlook for gold we will start by looking at the longer-term 6-year chart. On this chart we can see that gold is certainly not a bubble commodity as some like to claim. Instead it has been plodding steadily higher in response to the concerted worldwide attack on the value of fiat by politicians, which shows no signs of ending. The 2008 crash pushed gold lower sufficient to turn its 200-day moving average down, but notice that it did not result in gold breaching the zone of support at the top of the 2006 - 2007 consolidation pattern and gold certainly held up better than most asset classes. Could a general market crash result in it breaking down from its current orderly uptrend and entering a period of more severe decline as in 2008? Well, it could, and if it should break down from the channel it would constitute a trading sell signal, but remember, things are different this time round, as especially after the ratings downgrade on Friday, investors might be less keen to flee into Treasuries and the US dollar, although we should be careful not to underestimate their capacity for stupidity - it doesn't seem to cross the minds of most of them that they would be far better off in bear ETFs. Long-term the outlook for gold remains super bullish, especially as it is still a long way from being a bubble. 

The shorter-term 4-month chart for gold certainly does give grounds for caution, especially for shorter-term traders. For on this chart we can see that it is definitely looking overbought after its strong run of the past 5 weeks or so that has taken it to new highs, and attracted the attention of the mainstream media (it's only taken them 10 years to start to cotton on to gold as an investment, better late than never I suppose). Gold has been running a critically overbought condition on its RSI indicator for a couple of weeks now and is very overbought on its MACD indicator, in addition to which it has opened up a significant gap with its moving averages, although it can get larger as we can see on the 6-year chart. The big move up last Tuesday looks like a blowoff move and it was followed by short-term bearish looking candlesticks. All of this suggests that a reaction is likely soon that could carry gold back to the channel support line shown on the 6-year chart, and possibly lower. 

The contention that a reaction back soon by gold is likely is certainly supported by the latest COT chart which looks bearish for the near-term. On this chart we can see that the Large Specs have gotten themselves worked up again, and are foaming at the mouth, which usually happens at or near a top. Meanwhile the Commercials are running large short positions again. 

Many PM stock investors are of course wondering if a market crash will drag down PM stocks. We got the answer to this question on Thursday when the HUI index plunged along with the broad market, although it has not yet broken down below the support at the bottom of the menacing potential Head-and-Shoulders top that we can see on the 3-year chart for this index shown below. If this support fails it will open the door to a brutal selloff as in 2008, so if it does fail it will be viewed as a general sell signal and investors in the sector will want to stand aside if this happens. 

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Where Is This Market Going?

by Macro Story

“He observed that human emotions collectively had major impacts on the movement of stock prices and Markets in general, ultimately creating patterns that kept repeating.”

- From a book on Jesse Livermore’s trading style.

Markets at major inflection points are more a function of investor psychology and less technicals and or macro data. The struggle between bull and bear, greed and fear will always play a major role in the success and failure of investors. As Jesse Livermore discusses these struggles are a reflection of human emotions and since human emotion never changes they leave patterns that are repeated.

Up until now the 2007 topping pattern was a spot on comparison. It was ominous in terms of daily candlesticks through last Friday. In fact Friday was probably the most ominous of repeated candlesticks considering the massive swings during the day. Then today came and the market showed its hand. The market showed that great levels of fear and leverage still exist. Buyers are not stepping in and until the supply demand imbalance is resolved this market will move lower.

Over the weekend I began studying the fall of 2008 charts to see if any other patterns developed. What I found was a similarity between the late 2007 market and the fall of 2008 as shown below. The pattern is a series of rallies some rather substantial leading to subsequent selloffs before one final and move lower.

Perhaps the reason for this is that many traders miss the first move whether they fail to initiate a short or fail to get out of longs. I believe this is what sets up the next few rallies until the market finally moves lower and puts in a longer term tradable bottom. A few points regarding the chart below.

In early 2008 the initial selloff which I had been tracking was 15.3% and until today we were right at those levels.

In the fall of 2008 the selloff lasted two months and was 36%. In fact the ultimate trading bottom of March 2009 was almost reached in the fall of 2008 when the SPX touched 835.

I believe the fall of 2008 is more comparable in terms of this initial move lower. In the fall of 2008 there was Lehman, Fannie and Freddie and AIG all collapsing. Today we have Bank Of America, Citi and sovereign nations like Greece, Ireland, Italy, Portugal and Spain.

Notice the similarities between the three rallies and subsequent selloffs as highlighted below. That is the emotional pattern I believe will repeat after this initial selloff ends.

Long Term Divergence VS SPX

Both the long and short term IV skew charts show no signs of selling pressure letting up.

Short Term Divergence VS SPX

As I’ve stated before I wish I could be more definitive here. This market really showed its hand today. The late day selloff was a sign of funds and or individual investors waiting for a chance to sell into strength to meet margin and or redemption calls only to find lower prices and forced to sell at the close. Bank Of America remains a wild card as well and the companies statement today basically said the market had it wrong. Not the calming words long investors want to hear.

What the fall 2008 pattern shows us is this market can remain oversold for a very long time. Initiating short positions at these levels is very difficult unless one is using hedged option trades such as vertical spreads. The volatility could easily turn a winning trade into a losing one.

Lastly, remember it is human nature for others to relay their fears and limitations upon an event beyond their control. I’m listening to Carl Icahn right now say how this selloff is way overdone. He doesn’t see it lastly any longer but what basis does he have for saying that? Other than talking his book he has none. Don’t be greedy and don’t be a hero. There may very well be more selling ahead of this market.

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