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The Tower of Babel!

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TC_1013-tumb(Oct. 13, 2009 - Erwan Mahe) The longer this crisis drags on, the more I have the feeling that we are confronted with a genuine problem of understanding, not just between the various economic players, but also between central bankers themselves, some of whom seem to be deaf to the reality around them.

The other hypothesis simply one of bad faith, given the dogged attachment to the Austrian school principles of creative destruction (Schumpeter :  ‘Capitalism, Socialism and Democracy’, 1942), which delights in debt deflation whose Brüning or Mellon like damage we have already witness. I refuse to go along with this conclusion.


(Pieter Brueghel the Elder)

Just consider a few examples of our modern-day Tower of Babel in Frankfurt.

In Europe:

·        French CPI came out this morning, down 0.4% on an annual basis, worse than the consensus estimate of -0.2%. This serves as a new illustration of the stickiness of the deflationist trends with which European economies are confronted.

And yet, Mr Stark and Mr Weber continue to assert that there is no risk of deflation on the eurozone, and even Mr Moyer says he sees no deflationist risk, given the magnitude of the base effects. We all agree on the latter point, but he seems to be greatly underestimating the strength of the mechanism at work today.

·        Ditto for Iron-man Stark’s and Mr Pignon’s denial of credit crunch risk in Germany, despite again being contradicted, this time by the German Association of Engineers, VDMA, cited many times in this note, who assert that the economy is heading straight for a credit crunch.

·        Leaving the best for last, the comments by Mr Honohan this morning, from which I have quoted extensively, since they promise to provoke quality debates within the ECB board where he serves as member, given his presidency of the Irish Central Bank:

- falling prices are threatening the budgetary situation, both through adversely affecting the tax take if they result in higher real wages - thereby choking-off the recovery of employment - and generating an unintended increase in the real value of payments which are fixed in monetary amounts.

- Ireland needs to correct wage competitiveness

- There may need to be cuts in Irish nominal wages

- Ireland has never seen such falling prices

We can well understand the Irish Republic’s difficult situation, which cannot use currency devaluation as a means to restore a semblance of competitiveness, given its attachment to the euro, while it is confronted with a deflationist black hole, due to the continuous depreciation of the pound sterling.

·         As for the United Kingdom, we have a comment, just out, from the BoE’s Mr Posen:

- “A second dip in the global financial sector, driven by the failure of a bank, is possible. You don't usually have one dip and come right back and nothing else happen”.

In the US:

·         We continue to hear cries of alarm about the risks of (hyper) inflation due to the expansion of the Fed’s balance sheet, its ultra-accommodating monetary policy and the Federal government’s soaring deficits and debt load.

This sparked furious reactions from various Fed officials in the course of last week (Bullard, Lacker, Fisher, Bernanke), who reiterated that the central bank will do what’s needed (when needed), given the heavy cost of stabilising inflationary anticipations previously paid (thanks Mr Volcker) so necessary to the conduct of monetary policy.

·        These assurances were wrongly interpreted by certain observers as signalling a retightening of monetary policy, leading Mr Bullard (St Louis Fed) to issue a little correction. Just to avoid being accused of twisting his words, read them for yourself:

-some jobs growth and unemployment coming down is a prerequisite for an increase in interest rates

- I’m the north pole of inflation hawks, but we are trying to describe optimal policy, some optimal outcomes in an environment where inflation is below target -- we have an implicit target of 1.5 to 2 percent –

- And you have the spectre of a Japanese-style outcome, which I have worried about and some other members of the FOMC have worried about.

- The likelihood of a Japanese-style deflationary period has diminished but hasn’t been eliminated

- It is a little disappointing that private sector economists are thinking so much about when we are going to move our fed funds rate up. We are at zero. We are going to be there awhile.

- If you had a pretty robust recovery, then it is going to be a lot more of an issue. If you continue to get a lot of mixed news up until that time period, it wouldn’t be that reasonable.

It would hard indeed to be any clearer!

·        And Mr Krueger of the US Treasury added his own little dose of reality for those who are still wavering:

- the "real" unemployment rate is much higher than the Labor Department's official 9.8% if discouraged workers who have stopped looking for jobs and part-time workers who would like to have full-time jobs are counted.

- It's clear there is a lot of slack" in the labor market, adding, the evidence all points to considerable slack in the job market.

- Considering whether the administration is looking at additional stimulus, Krueger said, it is "always evaluating different options."

- But in an era when banks bundle and sell their loans to nonbanks -- or just as problematic -- in a period when the securitization market freezes and banks are unable to remove their loans from their balance sheets -- the growth in banks' outstanding loans gives a misleading picture of the amount of new credit being extended.

·         And let’s not forget Moody’s economist Mark Zandi:

- I don't think monetary policy is up to the task" of sustaining expansion.

- The current zero federal funds rate isn't (low) enough.....

- You need a very significantly negative federal funds rate to make up for all that's going on in the economy....

I feel no need to add anything today, but just consider the following instructive cases:

· Capmark Financial bankruptcy due soon. Former GMAC subsidiary in midst of debt to equity swap.

· CIT debt swap struggles, bankruptcy looms. Such a bankruptcy will cut off the credit market to American SMBs.

· Credit Tightens for Small Businesses. An illustration of the credit crunch hitting American SMBs.

· Dutch central bank seizes DSB. What debt?

Given all these factors, I see no reason to change our investment focus:

· positive bias toward government debt instruments, especially, on the eurozone 5-10 year segment, which benefits from the ECB's credibility;

· on stock markets, we prefer limiting hedging operations to small deltas, to theta and to minimum credit.

(With each market rebound, we can see the might of end buyers, who feel suffocated by 0% interest rates, and who will therefore continue to prop up stock indices for a while longer whenever they shows signs of weakness).

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