Why the Tobin Tax is a Bad Idea; Sweden's Experience With the Tax; Details of Sarkozy's Proposed Tax; Sarkozy Wants to "Provoke a Shock"

There is massive theoretical as well as actual real life evidence that financial transaction taxes will backfire, but that never stops politicians hell-bent on plowing ahead with "it's different this time" horrendous ideas.

Via Google Translate from Les Echos, please consider Sarkozy's stock exchange tax as of August 1

The 0.1% tax on financial transactions will apply from 1 August. In addition to equities, derivatives and high frequency trading are also covered.

Drawn up in haste, the tax on financial transactions is still the subject of intense discussions with the banking sector. A meeting has yet to take place on Monday to clarify the exact scope of covered products.

Many things are acquired, however: the tax will be paid by the people who buy a financial product, not by those who sell it. As reported Sunday, by the head of state, it will amount to 0.1% regardless of the nature of the product purchased (equities, derivatives) and will apply from 1 August, leaving a few months to Germany to eventually join the movement.

Three types of products involved

The law affects three different types of products: stocks, derivatives (including the famous' credit default swaps ", CDS) and high frequency trading-that is to say execution in microseconds of financial transactions by the only way of computing. This activity represents a huge chunk of transactions (about one-third). But most of the computers being located in London, the government will struggle to reach this activity. Still: he wants to show that tackles the most speculative operations.

Sarkozy Wants to "Provoke a Shock"

Bloomberg provides more details in Sarkozy Says France to Tax Financial Transactions From August

France plans to unilaterally impose a 0.1 percent tax on financial transactions starting in August, President Nicolas Sarkozy said, brushing aside opposition from the nation’s banks.

“What we want to do is provoke a shock, to set an example,” Sarkozy said late yesterday on French television from Paris. “There’s no reason why deregulated finance, which brought us to the current situation, can’t participate in the restoration of our accounts.”

“CDSs, which are speculative instruments against sovereign debt, will be taxed and online speculative purchases will be taxed,” he said.

Ernst & Young, an accounting company, has said in a report that while an EU transaction tax itself may raise as much as 37 billion euros, its net effect could be negative by between 2 billion euros and 116 billion euros by decreasing economic activity and reducing revenue from other taxes.

Socialist candidate Francois Hollande leads in the French presidential election polls. He has the support of 31 percent of voters in the first round, 6 points more than Sarkozy, and his second-round lead has risen to 20 points at 60 percent, according to a CSA poll published last week. Hollande, too, has pledged to impose a tax of financial transactions, if he’s elected.

Sweden’s Experience with the Tobin Tax

The Peterson Institute for International Economics presents Sweden’s Experience with the Tobin Tax

The Swedish Social Democratic government enacted a transaction tax on stocks, bonds, options, and some other securities in 1983. The tax, named after the economist James Tobin, was abolished by the new nonsocialist government in 1991.

The tax rates varied from 0.1 percent on ordinary stock trade to 0.15 percent on treasuries and 1 percent on options.

The Tobin tax in Sweden was a devastating failure that nobody would like to revive.

1. The expectation had been that the tax revenues would be 1.5 billion Swedish krona (SEK), but they stopped at SEK80 million.

2. Most Swedish trade in securities disappeared and went abroad, mainly to Oslo and London, and never returned. Soon after, the previously tiny Oslo stock exchange overtook the Stockholm stock exchange, and it is still the larger of the two stock exchanges.

There is no way that the current non-socialist Swedish government would accept a Tobin tax, as they know the security trade would leave the European Union.

In general, the Nordic and Baltic governments are amazed by what they view as a combination of arrogance, incompetence, madness, and slowness in Brussels, Paris, Berlin, and London. These sentiments are rather stronger in this region than in Washington. These countries are run by people who know how to handle crises, but they are effectively excluded from EU decision making.

Sarkozy's Pledge of Going it Alone

That discussion is all one should need to read to determine France would be acting very foolishly to implement such a tax.

Sarkozy thinks Germany would "soon" follow. As we have seen in the Eurozone, political decisions seldom if ever happen soon. Moreover, why would Germany act instead of watching France for a while?

Ironically, as soon as Germany saw the results in France (which likely would be soon), there is little chance they would implement such a foolish thing ever.

But what if all the European countries agreed to do it? We already know the UK opted out, but for the sake of argument, let's assume even the UK agreed.

The first that that would happen would be a mad scramble to execute transactions in the US, Switzerland, or Hong Kong. Nonetheless, let's assume the long arm of the law still managed to tax those transactions. What then?

Expect Increased Volatility, Decreased Trading Volumes, Lower Share Prices

The Adam Smith Institute offers a Comparative Study of the Potential Effects of a UK Tobin Tax. Here are some snips.

Sweden’s Experience with the Tobin tax

The rise and fall of the only case of a “pure” Tobin tax began in Sweden, when a 0.5% tax on the purchase of all equity securities (and stock options) was introduced on 1st January 1984. The tax applied to both domestic and foreign customers, and was levied directly on registered Swedish brokerage services.

Until 1987, inter-broker trades were considered intermediate (and hence exempt). ‘Round trip’ taxation effectively made the net taxation 1%, or 100 basis points. This was doubled in 1986, and later to include fixed income. Furthermore, a tax on stock options of 2% was introduced (1% relating to the premium, 1% upon exercise).

Understandably, investors devalued their assets to reflect the present value of future tax payments on the marginal share. The 2.2% average decrease in share prices on the announcement day added to the -5.35% index return over the 30 day period including the announcement. A further 1% share price reduction was seen in 1988 in reaction to the rate doubling.

Decreased Trading Volumes

Decreasing trading volumes led to secondary effects such as a reduction in capital gains taxes, almost entirely netting the (exceptionally low) tax revenue being generated.

Despite the tax being higher on equities, it was the fixed income market that suffered most. Despite the ‘low’ 0.003% tax levied on 5-year bonds, trading volumes dropped by 85% alone in the first week after implementation. Futures trading fell by 98%, and the options market was virtually non-existent.

Liquidity

All market participants would be subject to the tax; a Tobin tax is unable to discriminate between de-stabilising trades and those which provide liquidity, information and tradefinancing. With short-term trading providing invaluable liquidity to the market, an incapability to segregate individual trader motivations will therefore lead to a reduction in both liquidity and welfare-enhancing trade, in addition to increasing market susceptibility to individual shocks.

Robin Hood

Whilst the Tobin tax’s roots lie in economic theory, its current appeal is evidently political. The Robin Hood imagery drives the tax’s public support. It is its ‘stealing from the rich to give to the poor’ appeal that attracts many of its advocates, not the belief in its realistic economic capability. Understandably, some people are more-easily influenced by a well publicised, celebrity-endorsed Robin Hood Tax marketing campaign than by econometrical analysis or time series data.

Capital Flight

The experience of Sweden is one of capital flight. Odds are it would happen again.

The ATM Effect

The Adam Smith article contained an interesting analogy regarding ATM usage. When fees were zero, people would think nothing of doing an ATM transaction for $20. With fees of $2, you have to be pretty desperate to do an ATM transaction for $20. Instead, you would do one for your maximum limit. Some only use an ATM in an emergency and keep a pile of cash in their house instead.

In a falling market short-term traders provide liquidity (so do those shorting). Yet, Robin Hood proponents will drive those short-term traders away.

"In thinner markets, each trade would have a larger impact on price; resulting in less fluidity within the currency inventories of broker-dealers, the ‘liquidity providers’ of the market."

I fail to see how reduced liquidity and increased volatility will not be the result.

Four Reasons Tobin Tax is a Bad Idea

1. It would encourage capital flight (I know hedge funds that have contingency plans to move their entire operations to the Caribbean if such a tax is passed)
2. It would drive out short-term traders who provide much needed liquidity
3. Reduced liquidity would lead to increased volatility at the worst times
4. Pension plans  and mutual funds would bear much of the brunt of the tax. Rest assured market makers will find a way to pass their costs on.   

The results in Sweden are conclusive. A ‘low’ 0.003% tax levied on 5-year bonds caused trading volumes dropped by 85% in the first week after implementation.

Five-year US treasuries now yield .74%. Three-month treasuries yield .05%. Corporate bond yields are pathetic. How much of that do you want to take away?

Excluding bonds is not the answer. Liquidity and capital flight arguments suggests this idea should never get off the ground for any transactions.

By the way, buyers of CDS are often hedgers. Tax them heavily and there will be less interest in the underlying bonds. I would also point out that the speculators Sarkozy want to drive out of the market just happen to provide liquidity. Short sellers eventually cover, and provide fuel for rallies. Day traders will step into falling markets when others won't.

Sarkozy will "provoke a shock" alright, and it may crash the markets when he does.

Greek Bond Math (Assuming the Deal Goes Through) ; Merkel Faces Backlash Over Deal; Political Zugzwang

Rumors that a deal will be reached "soon" have gone on for weeks. Indeed announcements of an expected agreement today have already hit new snags.

For the sake of argument, let's assume a deal does go through, then crunch the latest numbers to see what the situation looks like from the point of view of Greece (and the lenders as well) before and after the deal.

The place to start is the current projection for the size of the next needed bailout.

Please consider Greece Needs EU145 Billion in Second Aid Package

Greece requires 145 billion euros ($192 billion) as part of a second aid package for the cash- strapped country, 15 billion euros more than was agreed in October 2011, Der Spiegel reported, citing an unidentified official from the so-called troika of European Commission, European Central Bank and International Monetary Fund.

Greece needs more money because the country’s economic situation is worsening, the German magazine cited the official as saying. The gap can’t be filled by contributions from private creditors alone, it said.

Bigger Bailout Needed

So, presuming a deal goes through, Greece is going to take on another 145 billion euros of debt, up from 130 billion last week.

Let's now turn our attention to the latest deal rumors.

Private Investors Near Deal on Greek Debt

Bloomberg reports Private Investors Near Deal on Greek Debt

Let's assume for the moment that "near" really means "near" and not five weeks from now when undoubtedly Greek conditions will have deteriorated further, requiring of course a bigger bailout. Here are the pertinent ideas from the article to consider.

• Investors holding euro206 billion in Greek bonds would exchange them for new bonds worth 60 percent less
• The new bonds' face value is half of the existing bonds. They would have a longer maturity and pay an average interest rate of slightly less than 4 percent.
• The deal would reduce Greece's annual interest expense on the bonds from about euro10 billion to about euro4 billion.
• When the bonds mature, instead of paying bondholders euro206 billion, Greece will have to pay only euro103 billion.
• The deal would reduce Greece's debt load by at least euro120 billion
• Greece faces a euro14.5 billion bond repayment on March 20, which it cannot afford without additional help

Three Essential Facts 

1. The new deal will reduce existing debt by 120 billion
2. The new bailout funds will take the debt load up by 145 billion
3. The net result is an increase in Greek debt of 25 billion

This is supposed to work? The reduced interest rate to 3.6% will of course help Greece. But what is the interest rate on new debt?

Regardless, given Greece's deteriorating financial condition, exactly how long will it take before the EU and IMF realize once again that Greece cannot possibly pay back the new 145 billion?

In whose best interest is this deal? I fail to see how it benefits anyone.

Merkel Faces Backlash Over Deal

The Financial Times reports Merkel faces backlash over EU pact

Angela Merkel, the German chancellor, is facing growing political pressure at home to demand stricter fiscal discipline from her eurozone partners at an extraordinary European Union summit in Brussels on Monday.

She also faces a potential revolt by conservative members of the German parliament over any call for more taxpayers’ money to bail out the ailing Greek economy.

“If the Greeks don’t put the reform programme into effect, there can be no more help,” said Horst Seehofer, leader of the Bavaria-based Christian Social Union, in an interview with Spiegel magazine.

Philipp Rösler, economy minister and leader of the liberal Free Democratic party, junior partners in Ms Merkel’s government, threw his weight behind the call for stricter control over the Greek programme. “If the Greeks cannot do it themselves, there must be stronger leadership and supervision from outside, for example from the EU,” he said.

On the eve of the EU summit, which is supposed to finalise a formal treaty on budget discipline, Ms Merkel’s supporters in the German Bundestag are also calling for those rules to be made tougher.

“As it stands, the draft treaty does not go far enough,” a senior official of the Christian Democratic Union in the parliament said on Sunday. He said the centre-right group wanted sanctions to be imposed more automatically for excess debt and deficits, and a tighter timetable for all 17 eurozone members to introduce a binding commitment to balanced budgets in their national constitutions.

Political Zugzwang

Zugzwang is a term in chess. A player has to make a move but every move weakens the position. Pass is not an option.

Merkel is in such a no-win position. Everything she does will put her under attack by someone. Doing nothing, is an option in politics but not chess. However, doing nothing also exposes Merkel to attack.

Attacks Fly

Check out this nonsense from former European Commission chief Jacques Delors who says Resistance to eurozone bailout boost 'scandalous'

Former European Commission chief Jacques Delors on Sunday blasted the reluctance of eurozone countries like Germany to boost the size of the Greek bailout and create a system of eurobonds to facilitate lending.

"It is scandalous. You cannot be a member of the euro cooperation and at the same time say no to elementary demands for solidarity with other members within the framework of existing agreements," the prominent European federalist said in an interview with Dagens Nyheter, Sweden's daily of reference.

"We have to save Greece together. What has been done so far is too little, too late," he added.

Delors, who was commission chief between 1985-95 and a key player in creating the framework for the euro's 1999 launch, said it was "out of the question" to push Greece out of the eurozone and insisted the solution was for "Greece to privatise more of its economy."

"The euro countries also must together introduce common eurobonds, ... not to finance the current debt but to create greater efficiency and connectivity in the financial and monetary system," the 86-year-old Frenchman said.

The creation of such a "eurobond," which would pool the debt of the entire monetary bloc in a bid to reassure markets and facilitate lending, has long been a contentious issue among top policymakers, with the European Commission and France being in favour of such an instrument but Germany strictly opposed for now.

"It is a mistake of German Chancellor Angela Merkel to refuse to go along with such bonds," Delors said.

Delors' Self-Serving Pomp

What's scandalous if for political hacks like Delors to assume the Eurozone is worth saving, then tell everyone else how to go about it without taking into consideration any restraints others may have.

I suggest the euro is not worth saving. For the sake of argument, however, let's assume the eurozone is worth saving, and start with a look at Merkel's options.


Merkel's Predicament

1. If Merkel proposed Eurobonds, her coalition would collapse and she would be ousted. Moreover, the German supreme court would certainly demand a referendum which would fail. The irony then, is if Merkel did what Delores asked, the eurozone would fly apart right here right now.
2. If Merkel proposed significantly more bailout money, her coalition would also collapse and once again the proposal would be at risk of a challenge from the German supreme court.
3. If Merkel does nothing, she takes heat from political dimwits like Delors and an entire gamut of other nanny-zone supporters. She also takes heat from her coalition.
4. If Merkel steps up the pressure on Greece she hears it from her political opposition, from Delors, and from a whole host of parties representing a myriad of political views.

That my friends is political zugzwang and that is precisely why she called for Greece to Cede Sovereignty to Eurozone "Budget Commissioner".

Her proposal elevated the ire of Greeks as well as the likes of political hacks like Delors. Yet, that option is the one that made the most sense.  It was her least-worst option, that also bought her and the eurozone the most time.

It is the only option that has any chance of working.

By making those demands, she has a chance of keeping her coalition together. Indeed, if her demand are met or if Greece exits the eurozone in response, she might even be viewed as a hero!

Simply put, she is doing everything she can to keep the eurozone together. For doing the best she possibly can under the circumstances, she gets nothing but grief.

I think the best thing for the Eurozone would be for Germany to exit. The irony is that would likely happen if Merkel embarked down the path demanded by eurofools like Jacques Delors.

Brussels Hit by First Coordinated Strike in Nearly Two Decades; Spain to Miss Deficit Reduction Goals; France Halved 2012 Growth Forecast to 0.5 Percent; Ten Things to Expect in Europe

The Financial Times reports Brussels hit by strike as EU leaders meet.

A general strike brought widespread disruption to Belgium on Monday, as European Union leaders arrived for a summit in Brussels with a focus on boosting employment across the region. Trains, shipping, air travel and public transport were all hit by the trade union action, called in response to reforms enacted hastily by the new government of Elio Di Rupo.

It is the first time in nearly two decades that unions from all sectors of the economy have co-ordinated a strike. As well as schools, the postal service and other branches of the public sector, some private enterprises were affected as unions flexed their muscles.

The strikes in the EU’s capital are a reflection of union discontent across the continent, worried that austerity measures will jeopardise the recovery. A Europe-wide “day of action”, bringing together unions from across the continent, is planned for February 29.

Voter distress and open dissent is no where close to peaking.

Spain to Miss Deficit Reduction Goals

Courtesy of Google Translate, please consider Spain deficit to Hit 6.8% in 2012 and 6.3% in 2013, according to IMF

6.8% is far from the 4.4% that the European Commission has imposed
IMF predicts two years of recession, with declines of 1.7 and 0.3% in 2012 and 2013

Spain will not meet deficit reduction goals of the European Commission in 2012 and 2013. Specifically, the IMF projects that the deficit will be within 6.8% of GDP in 2012 and 6.3% in 2013, when Brussels requires, at most, a deficit of 4.4% this year and 3% next.

The agency, predicts a recession of two years for the Spanish economy, ending the last three months of this year with a contraction of 2.1%. This indicates the organization in the latest update to its Global Growth Outlook, published today in Washington.

France Halved 2012 Growth Forecast to 0.5 Percent

Yahoo! Finance reports EU leaders struggle to reconcile austerity, growth

European leaders struggled to reconcile austerity with growth on Monday at a summit that approved a permanent rescue fund for the euro zone and was trying to put finishing touches to a German-driven pact for stricter budget discipline.

Officially, the half-day 27-nation summit was meant to focus on ways to revive growth and create jobs at a time when governments across Europe are having to cut public spending and raise taxes to tackle mountains of debt.

But disputes over the limits of austerity, and Greece's unfinished debt restructuring negotiations with private bondholders, hampered efforts to send a more optimistic message that Europe is getting on top of its debt crisis.

Spain's economy contracted in the last quarter of 2011 for the first time in two years and looks set to slip into a long recession.

France halved its 2012 growth forecast to a mere 0.5 percent in another potentially ominous sign for President Nicolas Sarkozy's troubled bid for re-election in May. Prime Minister Francois Fillon said the cut would not entail further budget saving measures.

Conservative Spanish Prime Minister Mariano Rajoy, attending his first EU summit, said Madrid was clearly not going to meet its target of 2.3 percent growth this year. That has raised big doubts about whether it can cut its budget deficit from around 8 percent of economic output in 2011 to 4.4 percent by the end of this year as promised.

European Commission President Jose Manuel Barroso hinted Brussels may ease Spain's near-unattainable 2012 deficit target after it updates EU growth forecasts on February 23.

Bickering Continues

It is quite rare, if not unprecedented, for the head of the European Parliament to criticize what Merkel and Sarkozy hailed as "progress", yet that is exactly what happened.

European Parliament President Martin Schulz told the leaders the new fiscal treaty was unnecessary and unbalanced, because it failed to combine budget rigor with necessary investment in public works to create jobs.

"To write into law a Germanic view of how one should run an economy and that essentially makes Keynesianism illegal is not something we would do," a British official said.

Merkel has said she will not discuss the issue of the ESM/EFSF's ceiling until the next EU summit in March. Meanwhile, financial markets will continue to worry that there may not be sufficient rescue funds available to help the likes of Italy and Spain if they run into renewed debt funding problems.

The sticking point is German public opinion which is tired of bailing out the euro zone's financially less prudent.

Portugal's Debt Will Be Restructured; 3-Year Government Bond Yield Tops 25%; CDS at Record High, Implies 72% Chance of Default

Inquiring minds are watching Portuguese government bonds soar into the stratosphere, with record-high bond yields across the entire yield curve.

In all the images below, the numbers are accurate but the charts reflect yesterday. I have mentioned this to Bloomberg a number of times to no avail.

Portugal 2-year Government Bonds



Portugal 3-year Government Bonds



Portugal 5-year Government Bonds



Portugal 10-year Government Bonds



Notice the opens and the lows in the charts above.

Bloomberg reports "The Frankfurt-based ECB bought Portuguese government bonds today, according to three people with knowledge of the transactions, who declined to be identified because the deals are confidential. A spokesman for the ECB declined to comment when contacted by phone."

My take is the ECB foolishly attempted to manipulate Portugal's bond market at the open, then was blown out of the water in the process. The ECB recklessly bought Greek bond and learned nothing from it.

Portugal's Debt Will Be Restructured

Adrian Miller, a fixed-income strategist at GMP Securities LLC, talks about the outlook for the European debt crisis. He speaks on Bloomberg Television's "InBusiness with Margaret Brennan."

You Ain't Seen Nothin' Yet; Another Trillion (or Two) Euro LTRO Coming Next Month

Last month, European banks tapped the ECB for €489bn in a long-term refinance operation dubbed LTRO. On February 29, another round of LTRO is coming up and expect banks to go for the gusto. Banks like cheap money to speculate and that is exactly what they will do.

The Financial Times reports Banks set to double crisis loans from ECB

European banks are preparing to tap the European Central Bank’s emergency funding scheme for up to twice as much as the ECB supplied in its debut €489bn auction last month, providing further evidence of the sector’s liquidity squeeze.

Several of the eurozone’s biggest banks have told the Financial Times that they could well double or triple their request for funds in the ECB’s three-year money auction on February 29.

“Banks are not going to be as shy second time round,” said the head of one eurozone bank at last week’s World Economic Forum in Davos. “We should have done more first time.”

Three bank chief executives, all of whom asked to remain anonymous, said they were planning to increase their participation twofold or threefold.

Unlimited Money for Three Years at One Percent

The ECB is offering unlimited money to banks for three years, at one percent. Banks are salivating because the first round went well.

The money is supposed to go for bank lending but it won't. Why should banks lend? They have a guaranteed profit by speculating in Spanish or Italian bonds, assuming of course Spain and Italy do not need bailouts coupled with a writedown on government debt.

However, that's quite a risk, and in my opinion Spain will need such a writedown. If so, Germany will be on the hook once again.

For a discussion about how futile this is, please see Premature Dollar Obituaries and Mainstream Economists' Monetary Insanity; Keynes-Inspired Great Depression; Lessons Not Learned

Money Supply Will Soar, Lending Won't

Don't expect the next LTRO to make it into the real economy. It won't. Rather the LTRO will fuel more bank speculation and more leverage in government bonds. Money supply will soar, lending won't and this rates to be good for gold.

Cherry Picking Timeframes on Alleged Leading Indicators; Big Change In LEI on January 26

Bob Bronson makes the claim on the Big Picture Blog that Initial Unemployment Claims Confirm Unfinished Market Rally

click on any chart in this post for a sharper image

Stock Market vs. Weekly Claims

In addition to other bullish coincident economic data reported yesterday, initial unemployment claims, which are a leading economic indicator, are especially noteworthy. They are a good precursor to the popularly-followed payroll, or jobs, report, a coincident economic indicator.

Really? No, Not Really!

This is a classic case of picking one tiny timeframe and extrapolating a coincident at best indicator (and possibly even a lagging indicator) into a leading one. Here is proof:

Weekly Claims vs. Recessions



Looking at longer-term trends, I count 4 instances in red where weekly-claims was more of a lagging indicator than anything else. A recession started 4 times with weekly claims at or very near the lows.

I count 3 recessions in green where a weak case can be made that claims are a leading indicator. However, I can also count six instances in which weekly claims turned up relatively sharply and there was no recession.

Unfortunately, Bronson cherry picked not only a timeframe for weekly claims but used it to make the claim that weekly claims are a leading indicator for the stock market which is also a leading indicator for the economy.

Stock Market Not a Leading Economic Indicator

The stock market is not a leading indicator of the economy. Rather, the stock market is a coincident indicator of sentiment towards equities.

S&P 500 vs. Recessions



Far from being a leading indicator, on an absolute basis the S&P has a perfect track record of peaking right before or just as a recession starts. This is just as one might expect from a gauge of equity sentiment which tends to peak right before a downturn in the economy (with everyone extrapolating good times forever into the future).

Annualized Percent Change in S&P 500 vs. Recessions



On a percentage change basis, the S&P 500 is not leading, not lagging, and not coincident. Instead it is completely useless mush.

Leading Indicators and the Risk of a Blindside Recession

John Hussman penned a must-read article on January 9th called Leading Indicators and the Risk of a Blindside Recession

Over the past few weeks, investors used to setting their economic expectations based on a "stream of anecdotes" approach have seen their economic views evolve roughly as follows:

"After a brief 'scare' during the third quarter, economic reports have come in better than expectations for weeks - a sign that the economy is on a gradual but predictable growth path; Purchasing managers reports out of China and Europe have firmed, and the U.S. Purchasing Managers Indices have advanced, albeit in the low 50's, but confirming a favorable positive trend, and indicating that the U.S. is strong enough to pull the global economy back to a growth path, or at least sidestep any downturn; New unemployment claims have trended gradually lower, and combined with a surprisingly robust December payroll gain of 200,000 jobs, provides a convincing signal that job growth is on track to improve further."

I can understand this view in the sense that the data points are correct - economic data has come in above expectations for several weeks, the Chinese, European and U.S. PMI's have all ticked higher in the latest reports, new unemployment claims have declined, and December payrolls grew by 200,000.

Unfortunately, in all of these cases, the inference being drawn from these data points is not supported by the data set of economic evidence that is presently available, which is instead historically associated with a much more difficult outcome. Specifically, the data set continues to imply a nearly immediate global economic downturn. Lakshman Achuthan of the Economic Cycle Research Institute (ECRI) has noted if the U.S. gets through the second quarter of this year without falling into recession, "then, we're wrong." Frankly, I'll be surprised if the U.S. gets through the first quarter without a downturn.

Let's examine the seemingly most "compelling" data point first - the fact that December payrolls grew by 200,000. Surely that sort of jobs number is inconsistent with an oncoming recession. Isn't it? Well, examining the past 10 U.S. recessions, it turns out that payroll employment growth was positive in 8 of those 10 recessions in the very month that the recession began.

Likewise, in 5 of the past 10 recessions, the ISM Purchasing Managers Index was greater than 50 just weeks before the recession began, and the new orders component of that index was greater than 50 in most cases, immediately prior to the recession.

New claims for unemployment have very slight short-leading usefulness, but new claims, the unemployment rate, and the slope of the yield curve (flattening) actually have much better lagging characteristics, so these should be used primarily to confirm an ongoing recession (particularly if the NBER hasn't made an official determination yet), rather than to anticipate a downturn. The yield curve generally flattens significantly coming into a recession, but the change in the yield curve (not plotted) is also most useful as a lagging indicator. Consumer confidence has mixed characteristics, with weak leading characteristics and somewhat greater usefulness as a lagging indicator, but in any case is too much of a "weak learner" to be used in isolation.

At present, our own recession ensembles, as well as ECRI's official views, remain firmly entrenched in the recession camp. This feels more than a little bit disconcerting, as the entire investment world appears to have the opposite view. My problem is that the data don't support that rosy "U.S. leads the world off the recession track" scenario. Leading data leads. Lagging data lags. Weak data is weak data. To anticipate a sustained economic upturn here would require us to place greater weight on weak, lagging data than we presently place on strong leading data. It's really that simple. If the evidence turns, we will shift our view - and frankly with some amount of relief. At present, though, we continue to expect a concerted economic downturn.

Our own recession ensembles remained unfavorable last week, and the ECRI Weekly Leading Index deteriorated to -8.2, from -7.6 the previous week. The 3 month growth rate of non-farm payroll employment - despite last month's employment gain - is among the lowest 13% of all historical observations. The 6-month change in the S&P 500 is among the lowest 20% of historical observations. The current value of ECRI's Weekly Leading Index is among the lowest 9% of all historical observations. We don't disregard the marginal improvement in various economic measures in recent weeks. It's just that those marginal improvements are either too small or too statistically uninformative to be helpful in shifting the evidence.

In sum, the balance of leading evidence continues to indicate a very high likelihood of an oncoming recession. We respect the various marginal improvements in the data in recent months, which do take the probability to less than 100%, but that is a far cry from suggesting that recession risk is anywhere close to being "off the table." Recession is not a certainty, but it remains the most probable outcome at present.

Warning About Using One Indicator in Isolation

Note the key difference between the approach of Hussman vs Bronson.

Brosnon extrapolated a coincident  (at best) indicator into a leading indicator for the stock market, alleged to be a leading indicator of the economy (which I clearly proved isn't).

In contrast, Hussman looks at a broad array of indicators, and the combined analysis in aggregate suggests we will soon be in recession territory.

Leading Indicator Battle

Here are a pair of charts courtesy of Doug Short and Advisor Perspectives regarding The Great Leading Indicator Smackdown

Conference Board LEI



ECRI WLI



ECRI and Hussman vs. LEI

I may be wrong, but I side with Hussman and the ECRI, not the LEI.

The LEI is way too dependent on the yield curve rather than the direction of the yield curve. The yield curve itself is useless because the lower end is zero-bound.

Hussman points out ...

Close to half of the weight in the LEI index goes to the two monetary components - the yield curve, and real M2. I suspect that this is a legacy of inflationary business cycles where monetary tightening in response to inflation was the typical event preceding recessions, but it adds noise in the present environment, where the primary economic risks are related to leverage and credit strains.

Remember that at present, monetary policy is way out on the "liquidity preference" curve, to an extent that is historically unprecedented (see Monetary Policy in 3D ). Normally, there is a general, if weak, linear relationship between monetary variables, interest rates and economic activity. But given the current scope of monetary policy, M2 velocity has collapsed (and moves as a perfect inverse of M2 itself), and interest rates are at the zero bound, so these variables are essentially detached from economic activity. So you've got two highly weighted variables in the index that have gone almost perfectly horizontal with respect to their effect on the economy. The crisis in Europe has triggered a flight of time deposits from European banks to U.S. banks, which shows up as a further boost to M2, which has driven much of the advance in the LEI.

Expect Big Change In LEI on January 26

Please consider Makeup of Leading Economic Indicators Index in U.S. to Change

For the first time since 1996, the components of the U.S. leading economic indicator index will change, according to the New York-based Conference Board.

Gone will be the inflation-adjusted money supply, the Institute for Supply Management’s supplier deliveries gauge, the Thomson Reuters/University of Michigan’s measure of consumer expectations and the Commerce Department’s orders for non- defense capital goods, the private research group said in a statement.

Replacing the money supply will be the Conference Board’s own Leading Credit Index, which aggregates measures of the yield curve, interest-rate swaps and the Federal Reserve’s senior loan officer survey. The ISM’s supplier deliveries gauge will give way to the group’s index of new orders.

Instead of using one measure of consumer confidence, the Conference Board will include an equally weighted average of the Michigan sentiment expectations reading and its own measure. Finally, the capital goods component will be replaced by the one that excludes commercial aircraft.

The new index will start with the December number coming out on Jan. 26, the group said, and readings will be revised retroactively to 1990.

At least a portion of the enormous discrepancy between the LEI and the ECRI weekly leading index (WLI) will be resolved to the downside of the LEI on January 26.

Absurd Threat by Greek Prime Minister: "Hand Over Your Wallet or I Will Give You a Million Dollars"

Hedge funds holding credit default swaps on Greek bonds are probably laughing out loud over statements made today by Greek Prime Minister Lucas Papademos.

The New York Times reports Greek Premier Says Creditors May Be Forced to Take Losses

Taking direct aim at hedge funds and other private holders of Greece’s debt, Prime Minister Lucas Papademos says he will consider legislation forcing the creditors to take losses on their holdings if no agreement can be reached in critical negotiations scheduled to resume Wednesday.

Mr. Papademos said that if Greece did not receive 100 percent participation in a program in which bondholders would voluntarily write down $130 billion from Greece’s unwieldy $450 billion debt, the country would consider passing a law to require holdouts to take losses.

“It is something that has to be considered in the light of expectations about the degree of the participation to be achieved,” Mr. Papademos said. “It cannot be excluded. It is contingent on the percentage.”

Laughable Bluff

I will post another snip below, but that is all you need to read to be laughing your head off. If you "force" creditors to take losses, the writedowns can hardly be considered "voluntary" can they?

In short, the moment Greece does what Papademos illogically threatens to do, there would be a "credit event" on Greek bonds, exactly what Papademos does not want, and exactly what hedge funds with CDS on Greek bonds do want.

Ideally a bluff should carry some measure of risk. Instead, hedge funds are praying Papademos does what he threatens to do. Thus, the Papademos threat is like a robber pointing a gun at you saying "hand over your wallet or I will give you a million dollars".

Absurd Statement of the Day

Papademos asked Greeks to put their sacrifices in perspective. If all goes well, he said, they could expect “an end to austerity” next year.

The only way austerity in Greece will end next year is if Greece defaults.

Greek Bond Talks Edge Toward 68% Haircut Deal; Will the Deal Be Accepted?

Former ECB president Jean Claude Trichet said there would be no haircuts. There were. The first Greek haircut was 21% and it was insufficient. The second Greek haircut deal was 50% and that too was insufficient. On each failed attempt, the ECB and EMU poured more money into Greece.

There is now about €200bn of Greek debt held by banks, hedge funds and other investors up from about €50bn a couple years ago.

A third renegotiation is now underway, rumored to be a 68% haircut. Clearly there would have been far fewer ramification on banks if Greece would have defaulted long ago.

Such is the stubborn arrogance of ECB, and EMU officials.

Unless another haircut is approved Greece, and still more money is poured into Greece, it will default on March 20 when a €14.5 billion bond repayment is due.

The Financial Times reports Greek bond talks edge closer to deal

Talks broke down last week with holders of close to €200bn of Greek debt after some eurozone officials called for a sharply lower coupon, or interest payment, on new bonds.

The latest proposal called for a step-up coupon starting at about 3 per cent and rising to 4.5 per cent as the bond approached maturity, one banker said. Another said the average interest paid during the life of the bond would be 4.25 per cent, a rate “that the banks would be happy with”.

The deal would amount to a 68 per cent loss for bondholders in net present value terms, according to people familiar with the talks.

Banks will be happy with a 68% loss? I rather doubt it.

Will the Deal Be Accepted?

Peter Tchir at TF Market Advisors had some interesting comments on the likelihood of the "success" of the PSI (private sector initiative) in his post Greek PSI - Headlines And Reality

The Greek PSI is once again (still) hitting the headlines. Here is what I think the most likely scenario is (80% likelihood).

Some form of an agreement will be announced. The IIF will announce that the “creditor committee has agreed in principle to a plan.” That plan will need to be “formalized” and final agreement from the individual institutions on the committee and those that weren’t part of the committee will need to be obtained. The headline will sound good, but will leave a month or so for details to come out. In the meantime every European and EU leader (or employee) with a press contact will say what a great deal it is. That it confirms that Europe is on the path of progress and that they are doing what they committed to at their summits.

The rating agencies will call it a DEFAULT, because it is. ISDA won’t call it a Credit Event because it isn’t. The EU leaders will call it a haircut or PSI, because they have an aversion to saying the word DEFAULT (and to the truth). There will be some concern that calling it a DEFAULT by the rating agencies will trigger some actions. It won’t. The ECB will allow banks to overrule the declaration of the rating agencies. They will say that Greece remains current on some bonds, that Greece will make payments on new bonds, so this DEFAULT situation is temporary and can be ignored for purposes of accounting, mark to market, collateral, etc.. It will avoid the chaos that would ensue, so they will go with the flow.

Then all talk will turn to Portugal. Why should Portugal continue to pay on their existing debt, when Greece just cut a great deal? And Ireland? The reality that Greece will NOT be an isolated case, but will be the norm will hit, and we will see the market give back the gains and sink lower on the realization that the banks recognizing losses is just beginning.

The key to understanding the negotiation mess is private investors (hedge funds) who bought bonds at a steep discount and at the same time bought credit default swaps for protection have everything to gain by forcing a credit event.

Tchir suggests they will be bought out. Certainly they will have to be bought out or the deal will collapse.

If they are bought out, everyone who does hold out is far better off than those who accept the deal straight up. This is what all the tension is about.

Greek deal disrupted by bondholders gambling on default

It is often hard to tell which article is more current when reading conflicting opinions, but please consider Greek deal disrupted by bondholders gambling on default

"Significant numbers" of Greek bonds may have migrated from financial institutions participating in the voluntary Private Sector Initiative (PSI) to others betting that the country will default, throwing the negotiations into peril, a senior economist has warned EurActiv.

It is also impossible to gauge how much of this ‘bond migration’ has taken place since the PSI negotiations began last year – because of a lack of transparency on the markets – according to Sony Kapoor, the managing director of economic think tank Re-Define.

The deal on the table involves persuading creditors to turn in their bonds and receive new ones that have half the face value and mature many years in the future. The Greek authorities say €206 billion of bonds are subject to the exchange; if all the creditors agree, they’d get €103 billion in new bonds back.

But there is a conflict between those bondholders – represented in the negotiations by the IIF – who are serious about accepting a voluntary write-down, and others betting on a default.

Kapoor said that the interests of bondholders who are hoping to free-ride on a voluntary agreement [some of whom hold credit default swaps] – is irking the bondholders willing to participate in the agreement, and was a major reason for the breakdown in negotiations last week.

“It is a classic collective action problem,” he said. “Collectively a voluntary agreement is in the interests of some of the bondholders. But if 90% of bonds were volunteered and 10% did not, Greece is not likely to default and these 10% may have a bumper payoff,” Kapoor added, explaining why those willing to join the agreement are exasperated with the others.

A spokesman for the IIF refused to comment to EurActiv on speculation that bonds were migrating in significant numbers to institutions hedged with credit default swaps. The spokesman said: “The first priority now for the negotiators representing major institutional investors is to see if it is at all possible to do a deal. If there is one, then the next phase is to see if as many as investors as possible can participate.”

Meanwhile, the Fitch ratings agency announced Tuesday that Greece would default on its debt, although it said that such a default was likely to take place in an orderly manner.

“It is going to happen. Greece is insolvent so it will default,” Edward Parker, the managing director of Fitch's sovereign group for Europe, the Middle East and Africa told Reuters on the sidelines of a conference in Stockholm.

Will the Third Haircut be Sufficient?

Whether the deal is accepted or not I side with that "Greece is insolvent so it will default". But did Fitch mean a "credit event" default or a "voluntary" non-credit event default?

Here is the deal.

The Greek economy is absolutely dead. Austerity measures are going to impart still more pain. Capital flight is underway. Few of the reforms Greece has agreed to have even been implemented. The idea that Greece will reduce its deficit under these circumstances seems silly.

Moreover Greek elections are coming up, possibly "sometime in April", according to the prime minister. Thus, whatever is agreed to now in terms of austerity measures, reforms, asset sales, privatizations etc. by this caretaker government will all have to be fought over yet another time.

Eventually, some politician or set of politicians will have had enough of this process.

Money Supply Figures Suggests Italy Headed Into Depression; Non-Performing Spanish Loans Hit 134 Billion Euros, 7.51% of All Loans, Highest in 17 Years; Eurozone Unemployment Charts

Ambrose Evans-Pritchard says The euro is pushing Italy into depression

Here is the latest money supply chart from the Banca d'Italia. Just look at M3. Horrendous.

Italy M1, M2, M3

click on chart for sharper image

This speaks for itself. There is no clearer indictment of the dysfunctional nature of monetary union. Italy is being pushed into depression. Criminal.

Obviously, Italy and Germany can no longer share the same monetary policy. Ergo, Germany should leave EMU, pronto.

The Banca said Italy's economy contracted by 0.5pc in the last quarter of 2011. It will shrink by a further 1.5pc this year, with no growth in 2013.

This is a direct result of the misguided pro-cyclical austerity policies imposed by Angela Merkel and the ECB – the infamous Trichet letter – without offsetting monetary and exchange stimulus.

This will of course play havoc with Italy's debt trajectory.

Non-Performing Spanish Loans Hit 134 Billion Euros, 7.51% of All Loans

Italy may be headed for depression, but Greece, Spain, and Portugal are already in depression. The most important country in that sad group is Spain, and the Spanish hit-parade keeps right on rolling.

Via Google Translate, please consider Non-Performing Spanish Loans Highest in 17 Years.

The NPL ratio of credit granted by banks, savings banks, cooperatives and credit institutions rose in November to 7.51%, the highest percentage for seventeen years due to increased volume of bad loans, which exceeded the 134,000 million euros. [134 billion]

According to provisional data published today by the Bank of Spain, this new increase of one tenth compared to 7.41% last month, is the fifth in a row after the small cuts that took place in June.

As the volume of bad loans, the loan portfolio of banks, savings banks, cooperatives and credit institutions rose in November to 1.785 billion euros [1.785 trillion euros in US notation], from 1.778 billion [trillion] in October.

Eurozone Unemployment Rates

click on chart for sharper image

Tax Hikes, Austerity Measures Will Backfire

Spain, Greece, Ireland, and Portugal and Italy already have high and rising unemployment rates. France unemployment rate is relatively stable near 10%.

In contrast, the unemployment rate in Germany is low and falling. Don't expect that condition to last. A European recession will affect the German export machine and Germany's unemployment more than most suspect.

Given various austerity measures in Spain, Portugal, France, and Italy coupled with high and rising taxes, expect eurozone economic conditions to get much worse. The sad thing is, four eurozone countries are already in depression.

Changing work rules, pension rates, retirement ages, is badly needed. Raising taxes in a harsh recession is inane.

Greece is going to default and Portugal will soon follow. The ECB is attempting to fence off Italy and Spain, but the only way it can do so is by buying massive quantities of Italian and Spanish debt (and doing so puts Germany and France at risk when the setup blows up).

How long the ECB can get away with this policy before the bond market focuses on France and Germany remains to be seen, but it sure will not be forever.

Chickens Come Home to Roost in Croatia

Thanks to massive propaganda, Croatia is foolishly about to join the EU. Chicken farmers (Croatians in general) are about to pay a steep price.

The New York Times reports As European Union Beckons, Allure Fades for Wary Croatia

Zoran Sluga has a small family farm here on the border with Slovenia, his 300-year-old barn filled with thousands of squawking chickens.

But if Croatians vote to join the European Union next Sunday, Mr. Sluga’s simple business will become a lot more complicated. The cages he keeps his hens in will not meet the group’s rules, requiring expensive upgrades. Italian egg producers, given access to Croatian markets, are likely to undercut his prices. Mr. Sluga believes that his very way of life is a stake. And for what? he asks.

“See what happened to Greece,” he said. “They got billions from the E.U. and it did not work out.”

Recent polls show that Croats are still likely to vote yes. Then, the 27 European Union countries are expected to ratify their membership and Croatia will become part of the group on July 1 — in all likelihood, the last new member for many years.

Srdjan Dumicic, the director of Ipsos Puls, a company that has conducted several polls on the subject in recent years, said that support had been dwindling in the past few weeks and could narrow, according to the latest poll that has not yet been published. Some Croatians joke, he said, that joining now is like arriving at the party at 2 a.m. Half the revelers are drunk. Half have gone home.

“It’s not the party it was at midnight,” Mr. Dumicic said.

“In the European Parliament, we would be 12 members out of more than 740; in the Council of Ministers, 7 votes out of more than 350,” said Marjan Bosnjak, secretary of the Council for Croatia, an association opposing European Union membership. “We will be a statistical error. Who will give a damn about what Croatians think?”

The reach of the European Union is often underestimated, as it tries to create an even playing field among its members. Take the egg business. No detail seems overlooked. The union’s rules say that the chicken cages must allow at least 750 square centimeters per hen and contain a nest, litter, perch and “clawing board.” These requirements are amusing to Mr. Sluga, the farmer. “The chickens have more rights than humans in the E.U.,” he joked.

Mr. Sluga estimates that he will have to spend $100,000 on new cages or $13,000 for used equipment. The alternative is to allow his chickens to roam free either indoors or out, something he finds bizarre because, he said, the hens can — and do — eat their own excrement under such conditions. And such an operation would require a lot more labor, he said. "Nothing Good is Coming"

Any country that joins the EU now instead of waiting a couple years to see the results of a Eurozone breakup, has mush for brains.

To understand why Croatia is likely to plow ahead anyway, please consider the following snip from the above New York Times article.

The campaign against European Union membership is being run from a cramped three-room office with no heating. The only visitor before 10 a.m. one recent morning was the landlord asking about the rent. Mr. Bosnjak, the secretary of the Council for Croatia, said the council represented about 25 small groups that together had just $4,000 to $5,000 to spend. (The government said it planned to spend about $800,000 on television spots and a pro-integration information campaign.)

Yet even opponents of European Union membership seem to think that the country has nowhere else to go. As he mulled what to do about his hen cages, Mr. Sluga said that he feared that his no vote would be in vain.

“I am aware that we will have to enter the E.U.,” he said, “but I also know that nothing good is coming.”

Chickens Come Home to Roost Expression

The chickens are about to come home to roost. To help those unfamiliar with the expression please consider Chickens Coming Home to Roost

As a proverbial expression it’s half a millennium old. The older fuller form was curses are like chickens; they always come home to roost, meaning that your offensive words or actions are likely at some point to rebound on you. The idea goes back to Chaucer, though he expressed it rather differently in The Parson’s Tale, around 1390, writing that curses are like “a bird that returns again to his own nest”.

Bureaucrats can and will cram this down the throats of Croatians, because they, not Croatia will benefit. Bigger salaries and benefits await representatives of the European Parliament.

There is absolutely no reason for Croatia to join now, especially as the UK ponders an EU exit. Nonetheless, if recent polls are correct, it seems likely.