Monthly Archives: November 2010

Sovereign debt crisis worsening. Governments paralyzed. Solution too hard to swallow.

Despite all the governments’ efforts, or maybe because of them, the sovereign debt crisis is only getting worse. Marketwatch reports:

The euro zone’s sovereign-debt crisis intensified Tuesday, with yields on Spanish, Italian and other peripheral government bonds soaring in the wake of a weekend meeting of European Union finance ministers that failed to soothe fears of the potential for future defaults.

The yield on 10-year Spanish government bonds jumped to around 5.63%, strategists said, a day after surging to 5.43%.

The move sent the yield premium demanded by investors to hold 10-year Spanish debt over comparable German bunds to more than three full percentage points.

“Ireland’s bailout did nothing to ease the euro-zone debt crisis: it might have even made it worse,” said Steven Barrow, currency and fixed-income strategist at Standard Bank. “For now the market sees a pattern emerging and the next piece of the bailout puzzle seems to be Portugal, with Spain to follow after that.”

The yield on 10-year Italian bonds also rose for a second day to hit 4.77% from around 4.64% on Monday. Portuguese, Greek and Irish bond yields also rose. And outside the periphery, the Belgian 10-year bond yield continued to climb, hitting 3.97% versus around 3.86% on Monday.

How long before Europe realizes that bailing out the banks, announcing plans to cut their deficits to 3 percent in four years time, and getting bailouts from EU and IMF will not work? The sovereign debt crisis will continue until these European countries announce balanced budgets effective immediately (2011) or, at the worst case, next year (2012) and that they will never again bail out the banks. They also have to leave the Euro, which is partly responsible for the mess to start with.

Unfortunately, I doubt the European governments will implement these measures. And if they were to do so, the people would be in full revolution. The only easy way out I see is if the economy suddenly stages a huge recovery. Barring that, it looks like things will be getting worse, possibly much worse.

Government says it’s OK to break social security agreement, but not pension agreements.

Barack Obama’s debt commission proposed several changes to Social Security to help reduce the deficit. The New York Times reports:

The plan would reduce cost-of-living increases for all federal programs, including Social Security. It would reduce projected Social Security benefits to most retirees in later decades, though low-income people would get higher benefits. The retirement age for full benefits would be slowly raised to 69 from 67 by 2075, with a “hardship exemption” for people who physically cannot work past 62. And higher levels of income would be subject to payroll taxes.

I have no idea how much these measures will contribute to reducing the deficit or paying off the debt. My complaint is more ideological.

When employees contribute to social security, they are doing so with the understanding that they will receive certain benefits starting at a certain date. Currently, an American expects to pay a certain amount each year into the system, retire at age 67. and receive cost of living adjustments (COLA) each year. The proposals by the debt commission would violate this agreement, forcing people to pay more each year if they earn over a certain amount, retire at a later date than originally agreed to, and receive less in benefits than promised as the COLA is reduced. In effect, the government is unilaterally canceling its contract with each American and replacing it with a less attractive one.

In reality, I am not opposed to these changes, especially the retirement age which will not fully take effect for 65 years, thus having little effect on anybody working today. The reduction in COLA would have a much greater effect on everybody starting in the near future while the removal of the cap on social security taxes would have an even larger effect, but only the wealthy. But while these are necessary changes, contrast this with the government’s stance on pension funds.

In a Q&A titled The pension time bomb, The Week asks:

Can benefits be scaled back?

Only for future employees. New Jersey Gov. Chris Christie recently signed legislation reducing pension benefits for new state employees. In California this month, voters in nine municipalities approved ballot measures to limit benefits for future public employees. And governments are starting to take a harder line in collective bargaining with public unions. “I’ve seen a sea change in the local collective bargaining process,” said Dwight Stenbakken, deputy executive director of the League of California Cities. Some analysts recommend following the lead of Georgia, which requires that prior to being enacted, any changes to retiree benefits be studied for long-term impacts. According to the Pew Center on the States, the policy has helped Georgia avoid “costly and irreversible” mistakes.

These pension liabilities have already been promised to employees and retirees. The government has a contractual obligation to pay the pensions as promised.

So why are the pension obligations sacrosanct while money can be taken from Social Security beneficiaries? Social security is just as much a contractual obligation as public union pensions. If social security benefits are to be reduced for those who have already paid in, public union pension benefits should be as well.

* Though I have not yet read this (too busy writing my next book), Robert Graham discusses this topic in much more detail in his Job Killers: The American Dream in Reverse. How Labor Unions are Destroying American Jobs and the Economy. If you’ve read it, leave a comment here or send me an email, tweet, or facebook message letting me know what you think of it.

Ireland officially gets its bailout, market gods are displeased.

Ireland finally got its bailout on Sunday and the market is less than impressed. In fact, one could say it is outright disappointed. Marketwatch reports:

The cost of insuring Spanish and Portuguese government debt rose Monday as spreads on peripheral euro-zone sovereign credit default swaps, or CDS, widened to record levels in the wake of a lackluster Italian bond auction, analysts said. The five-year Spanish CDS spread widened by 25 basis points to 350 basis points, according to data provider Markit. That means it would now cost $350,000 a year to insure $10 million of Spanish debt against default, up from $325,000 on Friday. The Portuguese spread widened to 545 basis points from 502, Markit said, while the Italian spread widened to 231 basis points from 215. “Spain and Portugal are now at record wides, suggesting that contagion fears haven’t been assuaged by Ireland’s bailout,” said Gavan Nolan, vice president for credit research at Markit.

When Greece got its bailout, spreads narrowed and the market was happy. But then credit in Europe headed down and spreads hit new highs. Traders are acting smarter this time. If the bailout didn’t work for Greece, they are not going to assume that it will work for Ireland… or Portugal… or Spain.

And the sovereign debt crisis continues.

Ireland was no bastion of capitalism. Here’s what went wrong!

With Ireland sinking under a huge pile of debt, the socialist liberal left points out that Ireland, with its low taxes and supposedly unregulated banking system, is suffering from the excesses of capitalism. Liberals never waste an opportunity to convince you with pleasant-sounding lies.

I’ll give you a couple of examples of where the Irish and European governments, not capitalism, went wrong.

Minimum Wage

AP reports:

Ireland’s 140-page National Recovery Plan proposes to introduce property and water taxes, raise the sales tax from its current rate of 21 percent to 22 percent in 2013 and to 23 percent in 2014, and cut the minimum wage by euro1 to euro7.65 ($10.20).

So Ireland’s minimum wage was 8.65 Euros or $11.46. The minimum wage in the United States is just $7.25 with some states and cities imposing higher rates (the state of Washington has a $8.55 minimum wage, San Francisco is $9.79, and Santa Fe is $9.85) all of which are much lower than Ireland old $11.46 rate and its new $10.20 rate. With Purchasing Power nearly the same in Ireland as in the United States, the minimum wage there was 58 percent higher than in the US.

While everybody talks about Ireland’s extremely low corporate tax rate, much of that benefit was offset by this too high minimum wage. And the minimum wage did not just affect those at the low end of the wage scale. A minimum wage raises costs throughout the economy forcing employees to demand higher wages even at the higher end of the wage scale.

Liberals may argue that capitalism doomed Ireland to failure, but these high minimum wages are most certainly anti-capitalist.

Low interest rates

For years, the Irish economy was hot, earning the nickname Celtic Tiger. Wikipedia explains:

From 1995 to 2000 GNP rate growth ranged between 6 and 11% through 2001 and early 2002 to 2%. The rate then rose back to an average of about 5%. During that period the Irish GDP rose dramatically to equal then eventually surpass that of all but one state in Western Europe.

This economic growth led to speculative excess which led to inflation:

Inflation brushed 5% per annum towards the end of the ‘Tiger’ period, pushing Irish prices up to those of Nordic Europe, even though wage rates are roughly the same as in the UK.

Also:

Rising wages, inflation and excessive public spending led to a loss of competitiveness in the Irish economy. Irish wages are now substantially above the EU average, particularly in the Dublin region. These pressures primarily affect unskilled, semi-skilled, and manufacturing jobs. Outsourcing of professional jobs is also increasing, with Poland in 2008 gaining several hundred former Irish jobs from the accountancy division of Philips and Dell in January 2009 announced the transfer from Ireland, of 1700 manufacturing jobs, to Poland.

Much of this inflation and rising wages can be attributed to the high minimum wage discussed above. But where was the central bank to deal with this rising inflation?

When Ireland joined the Euro, it lost control of its monetary policy. Normally, a central bank would raise rates and decrease the money supply to fight inflation. But while Ireland was growing quickly, the rest of Europe struggled through most of the 1990s and 2000s with low growth rates and high unemployment. Thus, the European Central Bank (ECB) kept rates low in an attempt to promote growth. As a result, through no choice of its own, Ireland had a loose monetary policy at the exact time it needed a monetary tightening. Thus, Ireland’s economy, most notably its property market and banking system, experienced a huge bubble. We are now suffering the consequence of those previous excesses.

In a true free-market capitalist system, interest rates would have risen through investors’ demand and this would have slowed or stopped the Irish bubble. But the artificial government Euro system prevented this important market process from occurring.

Conclusion

Yes, Ireland was more capitalist than most. But errors like the above led the country to excess and then collapse.

Ireland agreed to a bailout already, but it’s still sinking.

Last weekend, Ireland agreed to an 85 billion Euro bailout ($112.5 billion), details of which should be announced this weekend. But that hasn’t stopped the turmoil. Today, Irish bond yields hit euro-era high, banks sink:

Yields on Ireland’s bonds reached a new euro-era high Friday as investors dumped the nation’s debt securities, and Irish bank shares also kept falling in expectation the banks are heading toward greater state ownership.

Analysts said Ireland’s bonds and banks are getting battered because deep skepticism remains that an international bailout loan – whose details are expected to be unveiled Sunday – will be enough for Ireland to resolve its debts.

The Irish Times said an agreement on an euro85 billion ($112.5 billion) IMF-EU loan for Ireland could be announced Sunday, one week after Ireland formally applied for a financial rescue. It would be used as a credit line by Ireland’s government and banks, which both have been priced out of the bond markets.

Yields on Ireland’s 10-year bonds rose to 9.22 percent from 9.02 percent Friday, a new high since Ireland joined the euro in 1999.

Wasn’t the whole point of the bailout to end or at least alleviate this crisis? But now, the crisis is getting even worse as traders/investors lose confidence in Ireland’s ability to resolve its debts and the Eurozone’s ability to help.

Now, the Eurozone and IMF are proposing a bailout of Portugal. Will that bailout fare any better than this one? As I’ve written previously:

And all the bailouts in the world won’t end this madness until these countries get their fiscal and monetary houses in order.

So far, the bailouts have been a reward to countries that behaved poorly by spending more than they had and making bad investment. Conversely, the bailouts are punishing those who successfully avoided the urge to over-leverage and over-spend.

Bailouts will only work when they reward those who made mistakes in the past but are now behaving well. However, all these at-risk countries are proposing to reduce their budget deficits to three percent of GDP. I do not call that behaving well. I call that behaving less badly than before. Until these countries propose balanced budgets and plans to pay off their debts, they should receive no bailout money. But that is unlikely to happen because those “strong” countries that are providing the bailout money, such as Germany and France, have no plans of their own to balance the budget and pay off debt. Thus, we are in a situation where countries needing to bailed out are providing money to those who are in even more desperate need of a bailout.

The blind leading the blind… And the sovereign debt crisis continues.

Portugal and Spain deny need for aid, but it doesn’t matter what they think or say.

Even if the MSM and government officials did not see this coming, you and I certainly did.  Marketwatch reports:

Portuguese and Spanish officials scrambling Friday to head off speculation that Lisbon or Madrid could soon be forced to seek help to meet their borrowing needs.

A spokesman for the Portuguese government said a report in the Financial Times Deutschland newspaper — that Lisbon was under pressure from the European Central Bank and a majority of euro-zone countries to seek a bailout in order to ease pressure on Spain — was “totally false,” news reports said.

Meanwhile, Spanish Prime Minister Jose Luis Rodriguez Zapatero said in a radio interview that he “absolutely” ruled out a rescue for Spain, saying the nation’s deficit-reduction measures were well under way and that the economy, while still weak, has touched bottom.

OK, so Portugal and Spain continue to deny their need for a bailout or loans from the EU or IMF. Nothing new there. But the market disagrees:

The yield premium demanded by investors to hold 10-year Spanish bonds over German bunds widened to a record 2.63 percentage points as Spain’s 10-year yield continued to climb above 5.10%.

The cost of protecting Portuguese and other peripheral euro-zone sovereign debt against default through credit default swaps, or CDS, continued to rise.

The spread on five-year Portuguese CDS widened by 20 basis points to 500 basis points, according to data provider Markit. That means it would cost $500,000 annually to insure $10 million of Portuguese debt against default for five years, up from $480,000 on Thursday.

The euro fell to a two-month low versus the dollar to change hands at $1.3236 in recent action.

Portugal, with 10-year bond yields above 7%, was long seen as the next most likely candidate to seek a bailout after Ireland. Borrowing costs under the EFSF are seen at around 5% to 6% over three years.

Uh oh! As I wrote in a previous post:

Spain, Portugal, and Italy may not be in trouble, but if people start thinking they are “at risk,” they’ll withdraw their funds and it will become a self-fulfilling prophecy.

Technically speaking, Portugal and Spain may not need help right now, but they will most certainly need help if interest rates rise too much. But the report continues:

News reports, meanwhile, said that Germany this week rejected a suggestion by the European Commission to double the size of Europe’s 440 billion euro ($588 billion) bailout fund for euro-zone governments. The euro-zone contribution is part of the total €750 billion rescue program put in place with the International Monetary Fund in the spring.

Will Europe be willing and able to bail out Spain if it comes to that? Germany appears to be having second thoughts. Why should Germany waste its money bailing out another country? More so, how much money did Spain contribute to the bailouts of Greece and Ireland as part of the EU, money it no longer has to fix its own problems? Germany may want to keep its cash just in case it needs it.

In fact, Germany is one of the best fiscal situations in the entire world. Yet even it is balking. As Margaret Thatcher reported said, “The trouble with socialism is that eventually you run out of other people’s money.” Ireland and Greece have used up much of Europe’s money and good will. Now, there is a lot less left for Portugal and Spain.

Good luck Europe.

Favorite Quotes from Aristotle’s Politics

More than 2000 years ago, Aristotle literally wrote the book on politics. Aristotle’s Politics most certainly rivals and probably exceeds Plato’s Republic and Machiavelli’s Prince in its understanding and explanation of political philosophy, though it seems to be less popular than those other works. Aristotle’s Politics was possibly the most influential political book until Montesquieu wrote his Spirit of the Laws, which our Founding Fathers relied on quite heavily in developing the United States Constitution.

In writing The Path to Tyranny: A History of Free Society’s Descent into Tyranny, I used Aristotle’s Politics as a prime source for information on ancient Greek politics and political philosophy in general. Here, I share some of my favorite quotes.

Aristotle’s principles of liberty:

One principle of liberty is for all to rule and be ruled in turn. [Politics Book 6 Part 2]

The majority must be supreme, and that whatever the majority approve must be the end and the just. Every citizen, it is said, must have equality. [Politics Book 6 Part 2]

A man should live as he likes. This, they say, is the privilege of a freeman, since, on the other hand, not to live as a man likes is the mark of a slave. This is the second characteristic of democracy, whence has arisen the claim of men to be ruled by none, if possible, or, if this is impossible, to rule and be ruled in turns; and so it contributes to the freedom based upon equality. [Politics Book 6 Part 2]

Aristotle’s definition of tyranny:

For tyranny is a kind of monarchy which has in view the interest of the monarch only. [Politics Book 3 Part 7]

Aristotle explains the motivations of tyrants:

A tyrant, as has often been repeated, has no regard to any public interest, except as conducive to his private ends; his aim is pleasure. [Politics Book 5 Part 10]

The idea of a king is to be a protector of the rich against unjust treatment, of the people against insult and oppression. Whereas a tyrant, as has often been repeated, has no regard to any public interest, except as conducive to his private ends; his aim is pleasure, the aim of a king, honor. Wherefore also in their desires they differ; the tyrant is desirous of riches, the king, of what brings honor. And the guards of a king are citizens, but of a tyrant mercenaries. [Politics Book 5 Part 10]

As of oligarchy so of tyranny, the end is wealth; (for by wealth only can the tyrant maintain either his guard or his luxury). [Politics Book 5 Part 10]

Aristotle explains how men became tyrants:

In any of these ways an ambitious man had no difficulty, if he desired, in creating a tyranny, since he had the power in his hands already, either as king or as one of the officers of state. Thus Pheidon at Argos and several others were originally kings, and ended by becoming tyrants; Phalaris, on the other hand, and the Ionian tyrants, acquired the tyranny by holding great offices. [Politics Book 5 Part 10]

Panaetius at Leontini, Cypselus at Corinth, Peisistratus at Athens, Dionysius at Syracuse, and several others who afterwards became tyrants, were at first demagogues. [Politics Book 5 Part 10]

History shows that almost all tyrants have been demagogues who gained the favor of the people by their accusation of the notables. At any rate this was the manner in which the tyrannies arose in the days when cities had increased in power. [Politics Book 5 Part 10]

Aristotle explains the ruthlessness of tyrants:

Another mark of a tyrant is that he likes foreigners better than citizens, and lives with them and invites them to his table; for the one are enemies, but the Others enter into no rivalry with him. [Politics Book 5 Part 11]

From democracy tyrants have borrowed the art of making war upon the notables and destroying them secretly or openly, or of exiling them because they are rivals and stand in the way of their power; and also because plots against them are contrived by men of this class, who either want to rule or to escape subjection. [Politics Book 5 Part 10]

Aristotle explains how tyrants oppress the people:

These are, (1) the humiliation of his subjects; he knows that a mean-spirited man will not conspire against anybody; (2) the creation of mistrust among them; for a tyrant is not overthrown until men begin to have confidence in one another; … (3) the tyrant desires that his subjects shall be incapable of action, for no one attempts what is impossible, and they will not attempt to overthrow a tyranny, if they are powerless. [Politics Book 5 Part 11]

Another practice of tyrants is to multiply taxes, after the manner of Dionysius at Syracuse, who contrived that within five years his subjects should bring into the treasury their whole property. [Politics Book 5 Part 11]

The people, having to keep hard at work, are prevented from conspiring. The Pyramids of Egypt afford an example of this policy; also the offerings of the family of Cypselus, and the building of the temple of Olympian Zeus by the Peisistratidae, and the great Polycratean monuments at Samos; all these works were alike intended to occupy the people and keep them poor. [Politics Book 5 Part 11]

The tyrant is also fond of making war in order that his subjects may have something to do and be always in want of a leader. [Politics Book 5 Part 11]

Adam Smith and Alexander Hamilton on income and sales taxes.

Back in the 1700s, income taxes were rare, yet more countries were adopting such revenue generating schemes. Adam Smith minced no words in attacking such “absurd and destructive” taxes. In a section of The Wealth of Nations titled “Taxes upon the Wages of Labour,” Adam Smith wonders why countries institute such income taxes:

Absurd and destructive as such taxes are, however, they take place in many countries.

Just a decade later, the Founding Fathers recognized that limits needed to be placed on government. One such limit would be to make it more difficult for government to raise our taxes. In Federalist #21, Alexander Hamilton argued that a consumption tax would effectively limit the size of government:

It is a signal advantage of taxes on articles of consumption, that they contain in their own nature a security against excess. They prescribe their own limit; which cannot be exceeded without defeating the end proposed, that is, an extension of the revenue. When applied to this object, the saying is as just as it is witty, that, “in political arithmetic, two and two do not always make four.” If duties are too high, they lessen the consumption; the collection is eluded; and the product to the treasury is not so great as when they are confined within proper and moderate bounds. This forms a complete barrier against any material oppression of the citizens by taxes of this class, and is itself a natural limitation of the power of imposing them.

We have seen how the income tax has accomplished the growth of government that duties were unable to do previously. I return to this chart of the size of government excluding defense dating back to 1910. Remember, the income tax amendment to the Constitution was ratified in 1913.

Click on image to zoom in:


Seeing the growth of government since the income tax appeared a century ago, Smith and Hamilton were correct in their assessments. Based on the above quotes and their other writings, Adam Smith and Alexander Hamilton would support a switch to a consumption tax, more commonly called a sales tax today or the proposed Fair Tax.

Favorite Polybius Quotes

Polybius on the evolution and de-evolution of political systems:

Monarchy first changes into its vicious allied form, tyranny; and next, the abolishment of both gives birth to aristocracy. Aristocracy by its very nature degenerates into oligarchy; and when the commons inflamed by anger take vengeance on this government for its unjust rule, democracy comes into being; and in due course the licence and lawlessness of this form of government produces mob-rule to complete the series. [The Histories 6.4.7-13]

Polybius describes how democracies kill themselves:

And hence when by their foolish thirst for reputation they have created among the masses an appetite for gifts and the habit of receiving them, democracy in its turn is abolished and changes into a rule of force and violence. For the people, having grown accustomed to feed at the expense of others and to depend for their livelihood on the property of others, as soon as they find a leader who is enterprising but is excluded from the houses of office by his penury, institute the rule of violence; and now uniting their forces massacre, banish, and plunder, until they degenerate again into perfect savages and find once more a master and monarch. [The Histories 6.9.7-9]

Polybius on checks and balances in government:

The constitution should remain for long in a state of equilibrium like a well-trimmed boat, kingship being guarded from arrogance by the fear of the commons, who were given a sufficient share in the government, and the commons on the other hand not venturing to treat the kings with contempt from fear of the elders, who being selected from the best citizens would be sure all of them to be always on the side of justice; so that that part of the state which was weakest owing to its subservience to traditional custom, acquired power and weight by the support and influence of the elders. [The Histories 6.10.6-10]

Polybius on how the Roman Republic created its “best of all existing constitutions” through trial and error:

The Romans while they have arrived at the same final result as regards their form of government, have not reached it by any process of reasoning, but by the discipline of many struggles and troubles, and always choosing the best by the light of the experience gained in disaster have thus reached…the best of all existing constitutions. [The Histories 6.10.13-14]

Polybius on the success of the Roman Republic’s system of checks and balances:

Such being the power that each part has of hampering the others or co-operating with them, their union is adequate to all emergencies, so that it is impossible to find a better political system than this… For when one part having grown out of proportion to the others aims at supremacy and tends to become too predominant, it is evident that…none of the three is absolute, but the purpose of the one can be counterworked and thwarted by the others, none of them will excessively outgrow the others or treat them with contempt. All in fact remains in statu quo, on the one hand, because any aggressive impulse is sure to be checked and from the outset each estate stands in dread of being interfered with by the others… [The Histories 6.18]

Am I really that smart? Or is the EU-IMF that stupid?

The EU and IMF had hoped that bailing out Ireland would end the sovereign debt crisis or at least forestall it for the time being. As I explained previously:

I don’t see how this changes anything. It may stave off immediate default, but Ireland is simply borrowing more money, exactly what got it into this mess in the first place. This simply buys them time to get their house in order, but will they?

I then compare the bailout to Dr. Evil:

These bailouts, loans, and austerity measures in Greece, Spain, Portugal, and Ireland are “an easily escapable situation involving an overly elaborate and exotic death.” Instead of eliminating the deficit immediately, they have convoluted plans to reduce it over a five-year period. Will these plans work? Nobody knows. But that’s okay because “we’ll just assume it all went to plan.”

It only took a few days to prove that I am correct. Marketwatch reports:

European government bond markets were in turmoil Tuesday, as Portuguese and Spanish yields followed Irish yields sharply higher on growing doubts about the ability of politicians to contain the euro zone’s sovereign-debt crisis.

Rising bond yields underline fears that the debt crisis, which has already forced Greece and Ireland to seek bailouts, will spread to other high-deficit countries, potentially shutting them out of credit markets.

The yield premium demanded by investors to hold Portuguese 10-year bonds versus German bunds widened to 4.34 percentage points from around 4.08 percentage points Monday.

The spread between Spanish and German yields widened to 2.32 percentage points, exceeding the spread of 2.27 percentage points seen earlier this month.

How could the EU and IMF really be so stupid to believe their bailout would work. They thought their bailout of Greece and 750 billion Euro backstop would end the crisis once and for all. That failed, but they didn’t let that stop them from making the same mistake again.

It is often said that insanity is “doing the same thing over and over again and expecting different results.” Supposedly, Einstein said as much.

This leaves us with three options:

  1. The EU and IMF are stupid.
  2. The EU and IMF are insane.
  3. The EU and IMF have some ulterior motive.

Which do you think it is?