The Euro must fall. If the Euro is to be saved, and if there is not to be some messy bank default with a side order of contagion, the ECB will be engaged in debt monetization very soon. All the Germans are seeking before they will let loose the printing presses is some assurance that they will not be forever subsidizing the siesta in the Southern provinces of Europe. They should rest assured that they will not, not forever anyway. History has shown that the Fates are fair, if a little perverted. The day will come when Germany will be the one in need of some slack. In fact, what the Germans plan to do to the PIIGS is what the Allies did to the old Weimar Republic that forced it into depression.

This week will be the fourth time the Euro group meet to formulate a comprehensive plan for the Euro. I don’t see what else they can pull out of the hat. What are the hard constraints? Well, the Eurozone needs to find some 3 trillion EUR to recapitalize the banking system. They need to find this from somewhere, either by borrowing it from some unsuspecting developing nation or by printing it. Earning it is ideal but that could take decades and these chaps have a few days left. That leaves printing it. But the Germans have conditions which they want met before they will allow the ECB to print.

Note that the ECB has already primed its printing presses. All Mario Draghi is waiting for is the go ahead from Angela and then its happy days. The only risk is that the German conditions are not met. So what are these conditions? They have not been clearly specified but you can bet on a stronger form of the Maastricht Criteria embedded in the EU Treaty. Well that’s a relief then. These criteria were pretty much violated by every member of the Euro including Germany.

However, it is now so crucial that the ECB be allowed to monetize debt that there will likely be brinksmanship and a grubby political bargain in the establishment of Maastricht II. Angela’s hand is not as strong as one might imagine.

When the printing presses start to roll, you can bet that the Euro will be on a path of weakness. Just like the USD. But knowing how rational investors behave, that weakness is likely to be prefaced by a sharp spike up for no good reason.

There is no economic rationale for Europe having a common currency. The USD works in the US because there is a common treasury on top of the state governments and Federal taxes and benefits unite the US. Also, labor mobility is high, and the national identity is at least as strong as the state or regional identity.

Any economist of basic competence would have struggled to find an economic rationale for the Euro. Yet it went ahead 12 years ago as a work in progress with a weak or incipient form of fiscal alignment if not union in the form of the Maastricht criteria. It was recognized by the European leaders of the day that Maastricht was but a first step towards a closer fiscal union which would be necessary if the Euro were to survive. As it turned Maastricht was breached by every member including Germany and was allowed to lapse in 2010, probably when it was clear to all that fiscal union was a bridge too far.

While the Euro makes no economic sense, we have to realize that it was the product of political and not economic will. When Euro notes and coins were initially introduced, those who lived in Europe will recall the rise in inflation which was foreseen by many economists in the day, but who unfortunately were shouted down by the politicians. Beware the politicians and the loud. Human beings are susceptible to decibels and smart suits, and less accepting of logic unless it is suitably embellished by a silver or a forked tongue.

Pity the Germans. Since they were locked out of the embryonic European Union immediately following World War II they have paid dearly to be part of the Europe they once tried to conquer. And so with the implementation of the Euro sovereignty over monetary policy was transferred from the Bundesbank to the ECB. This came as a second blow to Germany which was only a few years into absorbing the East German economy and in need of a weaker currency and lower interest rates. Instead the Germans got chronic unemployment and higher inflation. This was the bargain for inclusion into the Euro club.

More than memories of the Great War, the Weimar Republic, World War II, more than a Teutonic tendency to eschew indebtedness and to require its repayment all else be damned, more than all this is the more recent memory of the price of Euro membership to Germany some twenty years ago, a price which Southern Europe seeks now not to pay. This is hard for the German to understand or bear. Germany is being asked again to pay.

More immediately and more topically, France and Germany are working desperately to avert a crisis in the Eurozone. Each has paid a price to have the Euro and are now likely to throw good money after bad to save a currency union which has no economic underpinnings. If it did, the world would have a single currency. Europe needs the Euro as much as Asia needs a common currency. While the risks to a Euro break up are high, the immediate damage in its wake to the banking system is too much to contemplate and so it is expected that some compromise solution will be hammered out which will allow the ECB to begin monetizing sovereign debt. The Germans will only allow this if there is a binding framework for centralized fiscal management of the Union and its members. A partial union has not worked, perhaps a more complete one might. This is misguided.

Fiscal union is only necessary to maintain monetary union. It is predicated on the logic of monetary union which is flawed. Be that as it may, fiscal union will indeed allow the Euro to survive. But years hence as countries look back to their subjugation to both a European Central Bank and possibly a European Central Treasury, how will they judge their investment? A central fiscal planner suffers from the same illogic as a central monetary planner. Countries in Europe will at different times require different fiscal policy. What is profligate for one may be thrifty for another. We give up efficiency for no good reason.

The sum of outcomes of separate individual optimizations is greater than or equal to the optimization of a sum of outcomes. This is a mathematical truism that is clearly overlooked by anyone seeking monetary or fiscal union.

The future is a wonderful place. Because you can borrow from it.

Nobody really owns a house, not normal people anyway. They only rent it. They either rent it from a landlord or they rent it from a bank, through something called a mortgage. Some landlords actually rent their real estate from the bank and then sublet it to some hapless tenant. Renting from a landlord is less risky. Renting from a bank means that you are likely to either make a colossal amount of money if property prices rise, as they have in places like Hong Kong or Singapore, or you might lose more than everything including your pet cat, if property prices slump, as in places like Florida or Nevada.

But you don’t really have a choice. Cheap housing doesn’t really exist in cities where the jobs are. Jobs are only available where expensive real estate is on hand to relieve you of your hard earned wages. Cheap real estate is only available where jobs are cruelly scarce.

So it makes sense to be a landlord or homeowner, but only if property prices are rising or if you don’t have to rent your real estate from a bank.

A long time ago you would buy a house with a mortgage and would have had a good chance of paying off this mortgage before having to move into a pine box carried by six of your best friends. There was a point in time when the bank would hand you back the keys and the deeds to the property. These days you’re more likely to refinance and rollover your mortgage and home equity debt until a point in time when you handed the keys to the house over to the bank or the bailiffs. It is a sad state of affairs, and it is not exclusively American or Western.

Debt is not bad. It enables and it facilitates. Problems arise when we start taking it for granted and lose sight of the obligations to repay it. So ingrained is debt and how it is regarded that it has become a cultural phenomenon.

Whereas debt used to be a good thing that allowed you to enjoy something today which you envisaged being able and willing to pay for in the future, today debt is just something that allows you to enjoy something today, period. The obligation and the ability to repay has been relegated to a mere irritation.

Soon households began to repay credit card debt with other credit cards, cycling their debit balances whenever they came due. This practice while initially frowned upon has become standard practice for even high grade corporate issuers and indeed has been turned into an art form by sovereign issuers. It seems today that even sovereign bonds are PIKs (Payment In Kind bonds, kinda like junk, usually worse.)

So ingrained in our society has this practice been that it is the de facto financing mechanism for buying cars in the UK from a Toyota to a Porsche. White Bentleys with mirrored glass tend to be paid for in used hundred dollar bills with non sequential serial numbers in patent croc carryalls borne by big men in dark suits…

Installment plans can be found for everything from luxury watches to designer clothes. Store credit cards continue to be dealt out by croupiers in the basement of Harrods or the fifth floor of Harvey Nichols. And everyone seems happy to rent their clothes, cars, mobile phones and iPads.

All we need is time. It will be better tomorrow. This time next year we’ll be rich.

Pensions. A defined benefit pension defies the concept of responsibility and quite frankly is naïve. A defined contribution pension is fairer and more practical. Even that, however, can be gamed. If the trustee of a defined contribution scheme exposes the scheme to credit risk in a conflicted or cavalier fashion, what recourse is there? What preventive or preemptive action can be taken? Some of the arguments and proposed solutions to pension underfunding have an unmistakable kleptocratic logic to them. ‘Raise the pension age’ really means don’t pay the old codgers so soon and let’s see if we get lucky and some of them die. ‘There’s no problem, they have home equity’ really means, let them eat cake, they seem to have money anyway, how dare they take back what they’ve paid into over the last 40 years. Countenancing an arithmetic that involves an arbitrary and mandatory cash transfer between generations is institutionalized theft. Besides, pensions discourage discretionary saving, and a misplaced belief in the promises of companies and states. Ultimately, we are on our own and if you don’t believe that then trust your pension, your bank, your banker, your accountant, your member of parliament, prime minister, president, generalissimo et al.

I would honestly like to know what happens when a corporate or a state is no longer able to meet its pension liabilities. An employee provides their services on 30 day credit to their employer and on 30 year credit to their employee pension fund. What happens when companies just cannot hire anymore? What does that say for the structure of business organization? Already the British public sector workers have woken up to the fact that their easy ride has run away.

The human race is great at depleting things. Just as we deplete all the stuff in the ground that powers our planes, trains and automobiles, and holds up our glass and steel towers, we deplete our future leaving a massive burden of debt.

This is a consequence of living beyond our means and getting ahead of ourselves. Yes it makes sense to borrow to buy today what we can pay for tomorrow. But it is not alright to borrow to consume today and expect future generations to pay for it. There are limits to profligacy and we have stepped well over the limit. We laugh at the thrift and inefficiency of some of the more backward nations, nations from whom the Europeans now hope to obtain a loan, and then have discovered to their surprise and dismay that these nations actually have some sophisticated underwriting standards. They actually expect to be repaid in money that’s worth something in cold hard stuff.

Chapter 11 is good in that it allows companies to get back on track to profitability. Personal bankruptcy gives people a second chance to rebuild what has been lost, or spent. But safety nets have two sides, one that saves and another that encourages irresponsible behaviour.

Another broad phenomenon has been the fall of communism and the lack of a counterbalancing force to capitalism. Without a dual, capitalism has evolved in a perverted way. Where once the system would reward and punish decisions in equal measure, the type of capitalism practiced today rewards but does not punish. At least it tries at each turn to bail out investors, to entrench management, to enrich the powerful. How can the price signal work if its distribution is deliberately skewed to the upside? The system attempts to blunt the punishment to inefficient resource allocation and poor decisions. The spectre of moral hazard hangs above every market and economy, holding policy and governments hostage to the concept of ‘too big too fail.’ Without an alternative regime, a competing model, there is no incentive to refine, improve or keep the capitalist model honest. Even the communists have adopted capitalism, albeit without democracy. This unbridled form may be even more cutthroat than the original model where minority rights actually meant something, instead of being swept away in a torrent of economic growth.

The perversions of capitalism have led to excessive debt without the recognition of responsibility and hence an absence of a credible long term solution, also moral hazard writ large which have policymakers doing what the market wants, and price distortions the result of asymmetrical efforts to support special interests. These make the current trajectory of economic development u
nsustainable and unstable.

Already the degree of intervention in markets and the economy has reached unprecedented levels. Central banks have bloated their balance sheets monetizing debt issued to finance Keynesian fiscal policies. Fictional bank stress tests are applied to signal strength where there is weakness. Regulators require more conservative practices from banks while governments require credit profligacy. Central banks extend credit to one another in a kaleidoscope of capital they hope no one can trace or fathom. And accounting standards have developed, or degenerated, depending on your point of view, to the point that they can no longer be considered generally accepted.

Something has to give and suddenly the future is not so wonderful a place. Because we’ve borrowed the living daylights out of it.

I first looked for an export led recovery in the US in June in my article Investment Strategy: The New Macro. It was my view at the time that the US economy had been in recession for the last 12 months, despite a 2 year long liquidity and emerging market driven bull market in the S&P500, and that no recovery had yet taken place, at least in real terms. My base scenario was that the US was becoming an export economy.

In July I sought signs for a recovery in the US economy in my article Looking For A Recovery In The US. Still Looking. And ISM Numbers That Don’t Stack Up but to no avail. Exports were a bright spot though and reinforced my thesis that the US economy would recover on the back of exports towards the latter half of the year.

In mid October I wrote about The Seeds of a US Economic Recovery. By this time it was clear that an indirect export route had been established and that exports were taking hold.

The latest ISM numbers for November are encouraging. Where previous ISM numbers north of 50 suffered from strong inventory accumulation, the current numbers do not. New orders are up from 52.4 to 56.7, Production is up from 50.1 to 56.6, and Inventories although they have risen are 48.3. Customer’s Inventories are up 6.5 to 50, but this shows a static position and perhaps reflects improved sentiment. Employment continues to be a problem slipping from 53.5 to 51.8. Exports rose from 50 to 52 and imports fell from 49.5 to 49.0. Taken together with US trade balance and export numbers they paint an encouraging picture of an economy in recovery. US exports in nominal terms have now exceeded 2008 levels (from which they fell precipitously in 2009.)

The US continues to make stuff people the world over want. Accounting issues mean that the data is more likely to show up in corporate cash flow and income statements than in the national income accounts but they are real.

The big risk to all of this is China. Much of the export demand that the US sees comes either directly from the Asia Pacific or indirectly through capital goods demand from resource rich countries with the Americas. Canada, Mexico and Latin America are big exporters of resources to China which has until recently had a voracious appetite for infrastructure. If China slows or stalls, the knock on effects could easily derail the recovery in the US.

Yesterday the Fed and 5 other major central banks announced measures to shore up liquidity in the global banking system. In the past 6 months LIBOR OIS spreads, the TED spread, swap spreads and LIBOR had been rising steadily as money markets slowly seized up. Obviously the Fed felt that conditions had deteriorated to a level at which it had to act. The swap lines that the Fed would extend are due to expire Aug 2012. This has been extended a further 6 months to Feb 2013. So the announcement was regarding swap lines already in place and which are currently well under-utilized (about 2.5 billion USD) compared with the whole of 2008 and 2009 utilization (ranging between 100 – 600 billion USD). The cost of borrowing would also be reduced from OIS + 100 bps to OIS + 50 bps. This signals a possible reduction in the Fed primary discount rate from the current 75 bps. Absent such an adjustment, it would be cheaper for a European bank to borrow USD from the ECB than for a US bank to borrow at the Fed’s discount window. But that’s all academic. These swap lines are simply not being drawn down.

Since 2008, the knee jerk reaction has been for banks to sell down their loan books and to replace their balance sheets with sovereign debt. Why? Because sovereigns carry a zero risk weighting under Basel 2. Since corporates were at the same time shoring up their balance sheets just as sovereigns were bailing out private balance sheets by buying their toxic assets, risk was being transferred away from corporates to sovereigns just as banks were substituting away from corporates to sovereigns. A strong Tier 1 capital ratio has become a red flag lest the zero weighting was not due to cash and near cash assets. Now that banks are replete with sovereigns, very much eligible for repo with central banks, the cheaper source of funding has been to repo these assets at single digit basis points costs with the central banks and deposit the cash back with the same central banks for a thin but positive spread. Domestic banks, for example in the US, have to pay a small cost of insurance to the FDIC, pretty much destroying the arb spread, but foreign banks do not pay this cost. For them, it is entirely viable to repo their sovereign bonds and earn a spread on their reserves with the central bank.

So the Fed swap lines are currently not any where close to fully drawn and are not nearly as cheap as the repo market for which the banks have ample collateral. How interesting. At the same time, TED spreads and LIBOR OIS spreads have continued to widen even as equity markets have rallied. OK, so its been less than 24 hours and we are talking about the relative intelligence between fixed income and equity traders. No contest. My tendency is to go short the equity markets if the technicals even show a peep of weakness.

The cynic in me asks why the Fed is prepping the morphine when the patient is in a critical but stable condition.