No Way Out

For those condemned to a perpetual stream of American-centric financial media, I will continue pointing out the issues confronting Europe.

Ambrose Evans-Pritchard continues as one of the only remaining mainstream writers with a sense of journalistic integrity. Yesterday, he delved into the highly explosive issue of Latvia and how the centralized decision making in Brussels has doomed it to an ill fate. Unfortunately, AEP comes armed with the neoclassically fallacious idea that debt deflation is always and everywhere an evil, rather than a blessing, that "deflation" and "depression" are synonymous, and that government stimulus spending is a legitimate method of inducing economic recovery. Nevertheless, he manages to consistently turn over rocks in search of termites. And guess what, he finds them. Furthermore, he displays a rare ability to weight the significance of his findings through a causal-realistic interpretation of economic history.

From the Daily Telegraph:

Contrary to revisionist talk, Argentina was not a basket case. Its imbalances were no worse than those of the Baltics, Balkans, Spain, or Greece, and arguably better.

It ran a trade surplus in 1999 and 2000 until dollar revaluation against Brazil and Europe crushed exports. The economy shrank 5pc in 2001, mild compared to Latvia's 20pc slump this year.

Yet Argentina span out of control very fast in December 2001 when President Fernando de la Rua stopped cash withdrawals from banks. There was a national strike. Co-ordinated mobs stormed supermarkets.

On the 17th, de la Rua ordered a 20pc cut in public spending. (Like cuts just passed by Latvia's parliament). It set off three days of rioting fanned by Peronist agitators. De la Rua declared an emergency. The army refused to act without backing from congress. Police lost control. Some 27 people were killed on the 20th.

Trapped in the Casa Rosada by furious crowds, De la Rua fled in an air force helicopter. After five presidents in two weeks, Argentina ended a half-baked dollar union that had lured its people into a debt trap. Dollar mortgages − 90pc of home loans − were switched into pesos by decree. Foreign creditors received a 70pc haircut.

The country recovered, as countries do once suicidal policies of monetary deflation are halted. In a sense, Argentina did what Britain and America did in the 1930s by coming off gold. Creditors didn't like that either, but Anglo-Saxon democracies at least survived to save capitalism.

Latvia looks well-advanced in this political chain. As our Moscow correspondent reports, three of Latvia's eight Euro-MPs elected last week are pro-Kremlin. The Harvest Party of ex-Communist strongman Alfreds Rubiks came first in local elections, backed by both ethnic Russians and disgusted post-capitalist Latvians.

If the purpose of Baltic euro pegs is in part to keep Putin's Russia at bay by locking the region deeper into the EU Project, the strategic gamble has gone badly wrong. It has created a reservoir of Russian irredentism in both Latvia and Estonia that gives Moscow a pretext to intervene at any time. The Baltics are being offered to Putin on a platter.

Latvia is firing a third of its teachers. The welfare state is being dismantled. Pensions for those in work will be cut 70pc. The salaries of doctors, nurses, and police (nota bene) will be cut 20pc. Unemployment has risen from 6pc to 17pc in a year, and is still rising. Jobless benefits for most will run out in the autumn, reducing support to £40 a month. "It is time to take to the streets," said union leader Valdis Keris.

So why is Riga persisting with peg crucifixion? The central bank has burned a tenth of its reserves in a fortnight. Overnight rates have topped 200pc. Why go on? No doubt devaluation would be a shock for middle class Latvians with euro and Swiss franc mortgages, but they face punishment either way – slowly by debt deflation, fast by devaluation. Swedish banks with $75bn of exposure to the Baltics have already thrown in the towel, accepting that it might be better for all to lance the boil.
The usual IMF strategy in these cases is to devalue by 30pc or so, which allows boom-busters to export their way back to health. Further rescue loans change little without this liberating action. They add debt, and draw out the agony.

We know from leaked documents that the Fund advised Latvia to ditch the peg last year. IMF experts were overruled by Brussels. The reason, of course, was to prevent: 1) a chain of falling dominoes in Eastern Europe; 2) a default shock for West European banks with $1.6 trillion (£970bn) of exposure to the region; 3) leakage from Bulgaria across the EU line into Greece – euroland's Achilles heel.

Latvian society is being sacrificed to buy time for EMU's dysfunctional system. It is the designated martyr for the EU Project.
When Latvians wake up to what is being done to them, more than a wretched peg will go.

Pritchard gets it right in his comparison with Argentina. He could have used any number of other relevant examples such as Thailand 3 years earlier.

But what he has left out is that currency pegs never work. They always blow up because of the incentive governments and central banks have to juice the supply of money and credit to achieve political ends. In this case, Latvia experienced an enormous boom following its adoption into the EU. Foreign investment caused a boom that made Southern California look rational. The money supply expanded enormously, forcing the central bank to defend the peg that was imposed by the EMU as a precondition to eventual adoption of the Euro. The enormous cost of doing this put huge pressure on the government budget, causing fears that the government would not be able to make good on its claims. Those fears were realized when CDS spreads started blowing out, interest rates started rising and its sovereign credit rating was cut.

Latvia has no way out. The conditions AEP mentions above are precisely what needs to happen in order to correct the malinvestment made over the last decade. The debt, which is denominated primarily in Euros and Francs will be defaulted on, while the currency slowly erodes away to nothing - its true value.

It is with these kinds of conditions that hyperinflation is inevitable. However, for those currencies which have large amounts of their money supply outstanding as debt, the opposite is the case. The scramble to pay back debt combined with the default of yet more debt, first by frightened foreigners worried of their real debt burdens skyrocketing, followed by domestic investors who see asset prices falling, will experience the paradoxical phenomenon of their currencies rising. Paying back debt, defaulting on debt and saving are all theoretically synonymous. They are expressed the same way even though they appear characteristically opposite.

The currencies that will experience the most of this deflation are those which have the highest ratio of debt:money, for the demand for money to pay back the debt will be highest. Naturally, the currency that was granted "reserve status" was the one which had inflated credit the most during the boom and subsequently exported it to the world. It is for precisely this reason that Charles A Conant tirelessly agitated for American economic imperialism around the turn of the 20th C. And it is for precisely this reason that Montagu Norman did the same in England during the interwar period. The gold-exchange standard (not to be confused with a gold standard) that both of these men advocated, naturally collapsed due to the ever-increasing amounts of debt being sold and skepticism over the ability to repay in gold. But in the end, they both deflated relative to other currencies (like the franc, lira, mark, peso, etc).

This is the incentive for having a dollar reserve currency. They can issue as much debt as they want to foreigners and reap the apparent immediate benefits of an elastic money supply (ie. permanent inflation). Yet when the time comes for those debts to be either paid off or defaulted on, the lone adverse symptom (to the monetary imperialists) is an increased demand for dollars either via bank loan/loss additions or foreign exchange transactions.

This is where, it appears, the "hyperinflationist camp" seem to be missing the boat. They see the public debt owned by China, Japan, etc as looming supply, ready to be repatriated at any moment. Yet they ignore the many times greater private debt that is denominated in dollars, which represents looming demand for dollars and de facto looming supply of foreign currencies that need to be sold in order to pay off those debts.

To summarize, there appears to be three different types of situations present:

1) Foreign creditor nations (China, Japan, Oil exporters) who own dollar denominated public debt as currency reserves and therefore represent future demand for their own domestic currencies when the debts are repatriated to the US. The relevance of this debt is dependent on the amount of private debt denominated dollars that is in existence. For example, how many Chinese companies have obtained their financing for infrastructure projects in dollar denominated loans? Loans that are now sitting on the books of some foreign bank waiting to be paid back in dollars. The Chinese company would then have to collect its expected revenue in Yuan, convert those to dollars and pay back the debt. My question is not rhetorical. I do not have the answer, nor do I know where to find it. Perhaps such a practice is forbidden in China and only Yuan denominated debt is permitted. That would not surprise me. If this is the case, then China would appear to be facing its own deflationary pressures. But if there are private obligations outstanding in derivatives, mortgages and commercial paper that far exceed the $1.4 Trillion in US Treasury assets, then the opposite force should prove superior.

2) Foreign debtor nations (Latvia, Mexico, Hungary, Poland and dozens of others) who thought it more prudent to borrow money in foreign currencies because they either thought their own currencies would rise, or because obtaining a loan at a low rate of interest was far easier in Dollars or Euros than in their own domestic currencies. The collapsing export markets of these countries is putting massive pressure on government budgets and the perceived risk of insolvency is, in turn, putting downward pressure on the domestic currencies, and an increase on domestic borrowing rates. The accompanying skyrocketing unemployment and rising interest rates puts downward pressure on asset prices even while the currency inflates. This panics borrowers of foreign currency at both ends - 1) their purchasing power is falling and 2) their debt/equity ratio is getting smashed. The panicky borrowers in these countries will either a) scramble to pay back the debt, requiring the sale of their domestic currency and the purchase of the foreign currency in forex markets or b) default on the debt, pressuring domestic asset prices and requiring foreign lenders to boost loan/loss reserves. Both outcomes perpetuate the problem.

3) Imperial debtor nations (US, EU, UK, Switzerland) which have large public deficits which are visible, but have enormous private banks that act as creditors to developing nations. As mentioned above, the foreign private outstanding credit likely outsizes the public debt by a considerable margin. And that does not include derivative contracts which are a total wildcard. This private outstanding debt represents future demand for dollars/euros/pounds in the forex markets. In the event that it is defaulted on, the losses will either have to be monetized (which is contingent on an appetite for debt and the political ability to do it) or realized via balance sheet deleveraging to free up capital for loan/loss reserves. The case of the former is neutral to the total supply of money/credit, the latter is obviously very deflationary. The deflationary impact could be heightened in the event that one of these imperial debtors were to default on their public debt. This would decrease the looming supply of dollars/pounds further, while the private debt would still remain.

For each of the respective groups, I see no way out of the present situation. I am still trying to determine the implications for countries that don't really fit any of the descriptions (primarily Canada, Australia and New Zealand). None of these countries made much in the way of loans to foreigners, nor is much of their public debt owned by foreigners, while there was little incentive for their citizens to take out foreign denominated loans for domestic purposes.

This post has dragged on far longer than I originally intended. But perhaps my rambling will prove thought provoking enough to stimulate conversation on the matter. I scarcely have the resources at hand to try and quantify this, nor do I think that any attempts to do so would be extra-illuminating due to the lack of transparency in foreign capital flows. But I'm interested in knowing what my readers, who often prove smarter than I, think of this.

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