Japan - Miracles Happen, But They Don't Want To

The miracle of Japan's economy, as revealed by the set of charts in the Flow Essentials, is that things aren't much worse. Of course, the economy was hit broadside by the multiple catastrophes of all sorts which cascaded from the March 11 earthquake and tsunami. But that's not all – Japan's industrial economy has also been facing unprecedented headwinds from the rise of the yen. Consider this: since July 08, the yen has risen 39% against the dollar and 40.7% against the basket of currencies forming the SDR. Now compare it to what happened between the signing of the Plaza Accord at end-1985 and the collapse of Japan's bubble in January 1990: during that traumatic process the yen rose 39% against the dollar, but a mere 20% against the SDR. In other words, the rise of the yen over the last three and half years has been more extreme even than the Plaza Accord period.

At the same time, Japan's historic inability to price its exports continues to astonish, with the result that Japan's terms of trade have now slipped right back to their lowest reaches of 2008. So, since mid-2007, Japan's terms of trade have fallen around 20%, whilst its currency has risen about 40% against the SDR. 

And yet, we do not have collapse. Recent economic history shows Japan's return on capital (ROC) plateauing between 2004 and 2007 before collapsing back to mid-1990s levels during the onset of the financial crisis. Capital spending cuts were made rapidly, and by early 2009, Japan's stock of capital was falling, allowing asset turns and therefore ROC, to start its recovery. The catastrophes of 2011 checked that recovery, but the decline in ROC has been very minor, which in turn has meant the contraction of capital stock has barely accelerated.

The key to this recovery has been the way Japan's real labour productivity has clawed back virtually all of the productivity lost in the financial crisis – and by 3Q, it that productivity, deflated by changes in capital per worker, was still rising 1.6% a year.

Result? Household and corporate cashflows remain positive, and the private sector savings surplus has barely retreated from a high of 10.2% of GDP in 4Q10 to 8.9% in 3Q11. Those cashflows keep flooding into Japan's banks, who's loan/deposit ratios have retreated to 70%, whilst their net holdings of foreign assets leaped.

The problem with miracles, though, is that they fundamentally don't want to happen. Whilst genuinely marvelling at Japan's ability to keep this show on the road, the underlying truth is that the road is getting steeper and tougher all the time. Japan's ability to minimise the damage to ROC in the face of multiple disasters is astonishing – but even so, it is another very long step to rediscover the levels of ROC which seemed attainable in the early 2000s. The likelihood, surely, is that that new build-up of holdings of net foreign financial assets by Japan's banks will be parlayed into a new stock of real industrial assets overseas in the next few years. The ground is laid for a new wave of industrial hollowing out. 

Shocks and Surprises, Week Ending November 25th

To summarise:

• For the first time in six weeks, in aggregate the news this week from the US surprised on the downside, although we don't take it particularly seriously.
• The news from the Eurozone – and particularly its service sector – surprised on the upside, and we don't take that particularly seriously either.
• The news from Japan's domestic economy surprised on the upside, and wasn't noticed at all. 
• The news from China was balanced, with very strong trade numbers from Hong Kong being offset by weak business survey readings and revisions from the mainland.

After six weeks in which positive surprises outweighed negative shocks, the news from the US surprised on the downside again this week. This was not so much the shock of 3Q annualized GDP being revised down to 2% from 2.5% - although no-one had expected such a revision, on close inspection the revision was due to a cut in inventories which took 1.55pps off growth, compared to the original cut of 1.08pps. The likelihood is that any stabilization in underlying demand will rapidly reverse that inventory trajectory very rapidly. The surprisingly positive news from labour markets over the last six weeks should bolster underlying demand. However, this week also showed us some more headwinds: whilst personal incomes rose 0.4% MoM (at the top end of expectations), personal spending only inched up 0.1% MoM, which was far below the bottom end of expectations. What's happening is that the personal savings ratio, which hit a miserable low of 2.2% in September, rose back to 3.5% in October, cutting spending on goods to 0.12% MoM, and on services to just 0.05%.

We continued the run of positive news from the housing sector, with existing home sales again coming in sharply above the range of expectations, at an annualized 4.97m. Just to recap the run of data: in the previous week we had positive surprises from housing starts, building permits, and the National Association of House Builders Market Index (highest since May 2010); two weeks prior to that new home sales also surprised on the upside.

As horrified onlookers watched Europe tottering effortfully towards the precipice, ironically the balance of its data this week managed to arrive in slightly better shape than expected. In particular, Germany's collection of IFO surveys not only managed to beat expectations, but they actually showed an overall slight MoM improvement for readings on the Business Climate and Expectations, with improvements in readings from the construction and wholesale sectors which were quite unlooked for. But the better-than-expected news from the services sector were also echoed in PMI readings for services in both Germany (rising to 51.4 from 50.6) and France (rising to 49.3 from 44.6), and for the Eurozone as a whole (rising from 46.1 to 47.8). And this resilience in the services sector even allowed the Eurozone Composite PMI to manage to rise from 46.5 to 47.2.

But can this survive the continued shocks coming from Europe's industrial sector, where new orders collapsed as stunning 6.4% MoM in October? Germany fell 4.4%, France fell 6.2%, Spain fell 5.3% and Italy fell 9.3%! These are truly shocking readings.

In Asia, this was a week of unacknowledged – because genuinely unexpected – modestly positive surprises. There are no surveys taken for expectations of Japanese supermarket and convenience store sales, so it passed largely unnoticed that October's readings (down 0.9% YoY and up 14.1% YoY respectively) were far stronger than anyone should have expected. Supermarket sales were 1.3 standard deviations above seasonal sequential patterns; convenience store sales were 1.6 Sds above trend. In other words, these are signs that genuine consumer demand is surfacing unexpectedly in Japan. We saw the same factor showing up in import growth, which jumped 17.9% YoY in yen terms – far higher than consensus expected. Mind you, part of this is driven by the J-curve effect of the very strong yen: although the J-curve is the stuff of first-year economcs, practicing economists always get its timing and strength wrong (and I am no exception).

There was also unexpectedly good news out of China. Well, Hong Kong actually, where October trade data showed a very strong and very unexpected rebound, with exports rising 11.5% YoY (vs a fall of 3% YoY the month before), and imports rose 10.9% (2.3% the month before). Hong Kong's trade numbers simply can't improve like this without it reflecting something of a strengthening in the mainland. In fact, exports to China rose 11.9^ (vs a fall of 7.3%), and imports from China rose 8.4% (0.8%).

But this result confounded the set of negative expectations surrounding China right now, and so this genuinely positive signal was lost in the negative reaction the previous day to the HSBC China Manufacturing PMI Flash, which fell to 48 (from 51) as output, new orders, quantity of purchases and stocks of finished products all contracted. And the impression of a new weakness was amplified at the end of the week when the final reading of China's MNI Business Conditions survey was revised down to 54.6 from an initial 55.5. This is not seasonally adjusted data, and for what it's worth, the MoM decline in October 2011 was identical to that of October 2010.  

China' Dammed Banks

Throughout history, China's rulers have demonstrated their legitimacy by channelling and controlling the unruly and disruptive flow of water by damns, sluices, canals. Within the next 18 months, we'll see whether a similar command can be demonstrated over the cashflows into and out of China's financial system. Success is not guaranteed, but the financial damns, sluices and canals are at least in place.

So far, the two main observations one can draw from the Flow Essentials charts of the major economies are that:

1. in 2012 there is a risk of an upside 'growth shock' from the US, and
2. Europe's set of ratios increasingly resemble those of Japan. If its financial system could avoid implosion then the Eurozone would be able to look forward to a long period of minimal growth and demographic deterioration softened by continually rising public debt bought by a flow of private sector savings coralled by by fear and financial repression.

Actually, the chances of the Eurozone staying intact long enough to really discover its inner-Japan must be accounted slim. My guess is that Europe's ratios will look very different post-Euro, most likely with more sharply rising ROCs and, in parts, significant private sector savings deficits.

Meanwhile, China's charts record an economy in the early stages of working off the worst impacts of the huge credit-stimulus of 2009/10. In particular, from what one can tell, the misallocation of capital of that period has at least not been extended in 2011. Capital stock is probably still growing nearly an unfeasible 20% a year, but the slump in ROC indicated during 2009 and 2010 has probably been arrested in 2011. The estimates and calculations are uncertain, but they are echoed by the beginning of a recovery in monetary velocity (GDP/M2), which seems to be accelerating after 18 months' flat-lining.

This process is being helped by a stability in China's terms of trade experienced during 2011 for the first time since the end of 2007.

The key chart for China, though, is its private sector savings surplus, which is still positive, but also noticeably in retreat for the third successive year. This ratio peaked out at 11.5% of GDP in 1Q09, but had fallen to 8.7% by end-09, then to 6.8% by end-2010, and to 4.2% by 3Q11. At the current rate of deterioration, the surplus is due to disappear almost completely by the end of 2012. And of course, since this savings surplus is primarily generated by China's trade surplus, any sustained or dramatic worsening in world trading conditions will tend to accelerate the process.

(Though note, one need not necessarily concur with the expectation of a sharp slowdown in trade during 2012: inventory levels are extremely low, there is an upside growth risk in the US, and the current garotting of the Eurozone economy will be relieved one way or another.)

The importance of this ratio is that it measures the net cashflow in an economy between the private sector and the financial system. Periods when private savings surpluses turn into savings deficits tend to be marked by financial turbulence because banks suddenly discover their jobs is no longer to cope with the flood of cash coming through the doors, but rather, to find cash in order to maintain credit growth. When banks find they have to sell assets in order to generate a positive cashflow suddenly and newly demanded by the private sector, they get to discover which of their assets are correctly priced, and which aren't. Mistakes get found out.

China's financial system will discover it has made mistakes it hasn't even imagined yet. However, unlike in virtually every other financial system in which I've seen this reversal of cashflows take place, China's banking system already has a potential source of 'artificial' cashflow waiting to be deployed. Between mid-2007 and now, the PBOC raised reserve ratios from 11% of deposits to 21.5% - this was the principal way in which it drained liquidity from the banking system. Since the current level of deposits is about 167% of GDP, for every one percentage point that the required reserve ratio is lowered will release an amount equivalent to 1.67% of GDP in positive cashflow to China's banks. Taking reserve ratios back from 21.5% to 11%, then would represent an 'artificial' cashflow into China's banks equivalent to 17.5% of current GDP. Properly managed, China's financial system can live for years now without a significant private sector savings surplus. If it is to make the transition from an exogenous to an endogenous growth model, it will have to.

A final thought: cutting those reserve ratios will drag money out of Chinese government bond markets. For the foreseeable future, China's yield curve is likely only to steepen.  

London and the Doomsday Machine

When the UK's FSA takes to warning UK banks to think about the structure of their balance sheets, and how they might stand up to a systemic implosion in the Eurozone financial system, you know it is well past time to take cover. This body, after all, was happy to OK Northern Rock as its loan/deposit ratio soared past mere percentages and into actual multiples. The FSA and regulation? I'm reminded of Gandhi's reply to a journalist's questioning what he thought of Western civilization: 'It would be a good idea'.

Nonetheless, it's worth a trip over to the Bank of England to have a look at the balance sheets of EU financial institutions operating in the UK, and see what they might tell us about Britain's first-round exposure to the Doomsday Machine. And the news isn't all bad: Europe's banks in London have squared themselves off to a marginal net asset position in Sterling, have shorted the Euro, and built up a reasonable non-sterling, non-Euro long FX position. As defensive crouches go, it's quite compact. 

That's reasonable, because whatever else the history books will say about this crisis, no-one will be able to say it struck out of the blue. 

We've previously charted the way in which international banks in New York have this year changed from being net takers of liquidity from US interbank markets, to being net suppliers (here). And the same thing, albeit on a much smaller scale, has happened in London. We have the data to the end of September, at which date, EU banks had a very small marginal net asset position in sterling, with sterling assets of £670 billion (down £22.3 billion on the year), and sterling liabilities of £668 billion, (down £56.7 billion on the year). That's the good news.  

But, of course, if the Doomsday Machine really blows, it'll be about liquidity at least as much as balance sheet. And here the news is less good: unlike in New York, very little of the sterling assets are held in cash or deposits. Rather, just over 50% of the assets are held in the form of loans to UK residents, and a further 25% (ie £170 billion) is in the form of intergroup loans (uh-oh) and loans/advances to non-residents (yup). Meanwhile, 92% of these banks' sterling liabilities is in the form of deposits. Chances of a maturity mismatch? Extremely high.

What about the foreign currency element? Here again, the news is perhaps better than expected, with foreign currency assets and liabilities almost exactly matched, at 58% of the balance sheet. (In fact, there's a £1.7 billion net foreign currency liability). This represents an almost complete eradication of net FX exposure during the previous 12 months, since in September 2010 these banks had net FX assets worth £32.7 billion.

And mark how the currency positioning has changed! These European banks have over the last year switched from a net long position in Euro assets of £54 billion in September 2010 to a net short position of £23.7 billion in September 2011. Meanwhile, all other fx positions (ie, excluding both Euro and Sterling) have gone from a net short of £21.3 billion to a net long of £22 billion.

Conclusion: In truth, these are better results than I had expected. For all the brave talk of bold solutions to the Eurozone's problems, and for all that it (just about) remains heresy to publicly accept where this is likely to end, Europe's banks operating in London have prepared for the worst, just as they have in New York. 

ECBanker of Last Resort

Watching the weekly balance sheet of the ECB has become a thing of horrified fascination: the statements as presented are reasonably opaque, and don't directly answer the questions we all have in mind, such as to what extent the continuing functioning of banking markets in the Euro-periphery are now underpinned by the central bank. Nevertheless, watch closely and the patterns begin to reveal themselves.

Consider first, the build-up of deposits held by the ECB which are surplus to regulatory requirements. Since the beginning of the year, these have risen from a January average of Eu 135.6 bn to Eu 425 bn as of November 18^th. That rise of Eu290 bn in deposits voluntarily placed in ECB is absolutely startling in the context of European banks, which in the year to end-September saw a rise in total deposits of only Eu 255 bn. Put it this way: on a net basis, the only thing European banks have been doing with the deposits they have collected this year has been to hand them over for safe keeping to the ECB. Isn't that astounding?

Then consider what ECB has been doing with this flood of deposits: roughly half has been re-lent back to the Eurozone's financial institutions (Eu139.3 bn worth), and a similar amount has gone to buy eurozone bonds (Eu128.57 bn). In other words, the ECB is simply taking the financial risks that Europe's banks are no longer willing/capable of taking. Instead of the market, we have the ECB.

Well, one might argue (though perhaps not if one were German) that in times of great risk-aversion, that's precisely what a central bank should do – after all, if it loses its equity, it can have resort to the taxpayer's purse, can it not?

But there's a second, and contingent danger here. For the tide of deposits being banked in ECB means that they now effectively fund approximately 70% of the lending ECB is doing back into the banking system itself – a proportion which used to be fairly static at around 20%.  

It seems a neat arrangement: banks daren't do anything with deposits – and certainly not intra-Eurozone interbank lending - so they give them to the ECB, which in turn recycles the deposits back to those banking systems that really need them (Euro-periphery, presumably). But the neatness is purely contingent: the balance need not continue like this. In particular, banks may find they have use for those liabilities – for example, to offset a drain in foreign liabilities (which is happening – gross foreign liabilities of Eurozone's banks contracted by Eu 162 bn between January and September). If there is any significant acceleration in the drain of those foreign liabilities, banks may find, and urgently, that they no longer wish to retain those assets in the ECB.

At which point, the ECB will face the choice of cutting their Eu 625 bn in lending to those Eurozone banks which need it, or finding some other way to fund their position. And frankly, the choices at that point are rather limited: the only other liability which could be expanded so quickly would be . . . . the amount of currency in circulation.

Eurozone - Like Japan, not the US

The quarterly Flow Essentials booklet looks at the US, Eurozone, Japan and China, which encourages me to compare regions. When I do, it rapidly becomes apparent that in its delayed reaction to the crisis of western financial institutions of 2008/09, the Eurozone looks strikingly similar to Japan, rather than the US.

In both cases we see:

• Return on capital recovering very slowly since mid-2009, but so far to a level far below that which preceded the crisis of western financial institutions – in contrast to the US, where the ROC indicator is far higher now than in 2007.
• Although Eurozone real labour productivity (adjusted for changes in capital per worker) is now growing by around 1% a year, this barely scratches the surface of the problem, since this measure of labour productivity fell 4.3% in 2008, and 5.4% in 2009. In both the US and Japan, the loss of labour productivity seen in 2008/09 has subsequently been recouped. We should therefore expect Eurozone labour markets to be systemically more challenging for longer.
• International terms of trade in the Eurozone have fallen back to the worst lows of 2008, just as they have in Japan. In the US, they have fallen, but only to around the levels seen at the end of 2007, not the nadir of mid-2008.
• The Eurozone's banks are rapidly building up colossal net holdings of foreign assets, just as Japan's did in 2010, and 2011 prior to the March 11 disasters. It's a dramatic change, with net foreign assets jumping Eu467 billion between October 2010 and September 2011. Quite apart from anything else, this shift represents a massive net capital outflow from the Eurozone managed by its banks. What's responsible? Almost in equal measure, the withdrawal of foreign liabilities (foreign deposits, and lending to the Eurozone's banks) and pro-active build-up of foreign assets. I have previously drawn attention to how we're seeing the corollary to this in the US (see this). My reading of this is both that banks outside the Eurozone are protecting themselves as far as possible from the Euro Doomdsay machine; and that banks inside the Eurozone are protecting themselves from threatened expulsion from international interbank markets.

• They can do this because, like Japan (and the US) the Eurozone continues to run a major (but declining) private sector savings surplus, equivalent now to around 4.9% of GDP. This is down from a 1Q2010 peak of 6.5%, but continues to deliver a net positive flow of savings into the Eurozone's commercial banks. Or Germany's anyway.
• Finally, the Eurozone's relationship with money its is remarkably stable: both monetary velocity and liquidity preference have barely moved for 18 months.

What this adds up to is an underlying statis which is difficult to reconcile with the financial crisis which is slowly engulfing the Eurozone. Gallons of ink have been spilled comparing the likely trajectory of the US now to Japan post-1990 – wrongly in my view (see this, and this). For the Eurozone, though, the financial and economic response to what happened in 2008/09 are too similar to ignore.

Bigger conclusion: does anyone really expect the Eurozone to grow its way out of its debt problems?

Shocks and Surprises, Week Ending November 18th

The signature development of the week was the way in which the US numbers continue to arrive stronger than the market expect, whilst economists are finally getting to grips with the sharp deterioration in European numbers. More generally, the US and to a lesser extent Asia, are both managing to survive or even ignore the prospective collapse of Europe's economy. Global economists everywhere and always talk about 'decoupling', and they're almost always wrong. Expect this to be the latest iteration.

For the eighth week in succession, in aggregate data from the US came in surprisingly stronger than expectations. But this week, the sectoral range of positive surprises was positively comprehensive, notably encompassing those parts of the US economic picture which are most routinely written up, or written off, as structurally depressed:

• Real estate markets: Housing starts rose 3.9% MoM, whilst building permits jumped by 10.9% MoM, whilst, separately, the National Association of House Builders Index rose to its strongest level since May 2010.
• Labour markets: Initial unemployment retreated to their lowest levels for seven months. In this context we also have to remember that the previous week's JOLTs Job Openings gave its strongest reading since August 2008.
• Retail sales: Excluding auto sales, these rose 0.7% MoM, which was the strongest monthly reading March.
• Industrial sector: Capacity utilization ratios (the principal indicator of profitability) rose to 77.8%, which was not only a surprise, but also the best reading since July 08. Industrial production growth of 0.7% MoM (motor vehicles up 3.1% MoM) was also unexpectedly strong, as was the Leading Indicator which, at 0.9%, was the strongest reading since March.

There are strong fundamental reasons to prepare for an upside growth shock in the US in the coming six to nine months, and the high-frequency data is merely confirming that it is slowly emerging.

These days, a European economy has really go get to work hard to shock on the downside. Consider some of the data this week which managed to come within a consensus which now embraces spectacular collapse:

• Italy reported an 8.3% MoM contraction in industrial orders, yet still managed to stay within the consensus range of expectations!
• European new car registrations fell 1.8% YoY,
• Zew Survey of German economic expectations, which fell to minus 55.2

Nevertheless, even with economists' expectations so pessimistic, they are still more cheerful than other Europeans, which allowed several indicators to disappoint. My favourite was the Zew German survey of economic expectations of the Eurozone, which fell to minus 59.1 – Angela Merkel's warning that this is Europe's worst moment since World War 2 evidently didn't fall on deaf ears. The British too were similarly embracing the imminence of catastrophe, with the Nationwide consumer confidence survey collapsing to levels unseen even at the worst points of 2009.

By contrast, it was a quiet week for Asia, with only a mild bias towards disappointment. In China, both the MNI Business sentiment survey flash reading, and the Conference Board Leading Indicator (late – for Sept), are probably best classified as 'mildly disappointing' without being surprising. Both suggest moderating growth (no surprise there), with only the new orders index of the MNI survey showing actual contraction. In Japan, Tokyo condo sales (down 9.3% YoY) disappointed, as did readings of capacity utilization, but the more important readings of industrial production and machine tool orders passed much as expected.

Singapore, however, produced two shocks which suggest it continues to slow faster than expected: domestic non-oil exports fell 5.9% MoM sa, and fell 16.2% YoY, and retail sales rose only 0.3% MoM and 3.1% YoY. Singapore's data has consistently been weaker than economists' expectations since October now.

The Biggest Risk - An Upside US Growth Shock

The biggest unacknowledged risk to world markets right now is neither in the Eurozone nor in China. It is in the US, where cyclical indicators remains highly constructive, where credit growth is finally creeping back into the system, where M2 growth is nudging double digits, but where in 3Q monetary velocity collapsed to the lowest point it has ever recorded. Unless it keeps collapsing – and there's no historic precedent for that – then the numbers compel us to expect nominal GDP growth to at least double in the coming year. More likely, nominal growth will easily break into double digits.

Neither bond markets, nor currency markets, are remotely prepared.

Much of my week has been spent preparing my quarterly Flow Essentials booklet. I think of this exercise as a fencing-in of the economic imagination. Whereas economic forecasts attempt to describe the world as the forecaster believes it may become, the great ambition of my Flow Essentials is merely to outline the limits of the likely. For example, if return on capital is rising sharply, capital spending can be relied upon to respond. If real labour productivity is rising fast, it would be perverse to expect employment to contract. Coming down to a slightly finer grain, you are most unlikely to see bond yields rise if surplus private sector savings are pouring cash into the banking system.

But having now assembled these ratios and cashflows for the US, Eurozone, China and Japan, I realise that in each economy we now have anomalies sufficiently large and strange to be worth commenting on individually. With luck we might, after all, be able to start fencing in some of the wilder margins of our economic horizons.

Let's start with the US. The ratios tell us there's little to worry about in the US cycle – the main indicators all remain sharply constructive. My return on capital directional indicator continues to rise sharply, and is now at its highest since mid-2000, and in response my estimation of capital stock growth has finally broken into positive territory for the first time since mid-2009. (I estimate capital stock by depreciating all capital investment over a 10 year period.) Growth in real labour productivity (adjusted for capital stock per worker) is running at a little over 3%, down from a bounce-back peak of early 6% in 2010, but no longer declining. In response, employment growth is up around 1.3% and accelerating. Banks have cut their loan/deposit ratio to around 82%, but no longer seem hell-bent on driving it down further: at the margin banks have just started to wean themselves off bonds, and, very cautiously, are expanding their loan-books again. Cashflows remain immensely positive, with the private sector savings surplus stabilizing during 3Q at 4.3% of GDP.

So the cycle is secured? I believe so. Yet there is a risk which needs to be acknowledged – the risk of a sharp upside growth surprise in the coming six to nine months which may scramble the current structure of money markets (bonds selling off) and currencies (dollar strengthening unexpectedly). The problem is simply that in the third quarter we have seen the biggest disconnect between monetary aggregates and economic activity since. . . . . well, since records began. When we measure monetary velocity (GDP/M2), we find that it absolutely collapsed during 3Q to the lowest level on record – a level absolutely off the map in terms of numbers of standard deviations from long-term trends. Now, monetary velocity was already at near-record lows, but the decline seen during 3Q is basically unprecedented.  

Why did it happen? Normally, one would attempt to link such a fall in monetary velocity to a sharp decline in return on capital, which in turn you would expect to see echoed in cashflows and investment spending. But the rest of the readings from the economy absolutely close out any such interpretation. So perhaps something strange was happening in the M2 numbers – some response to shifts in the Fed's balance sheet perhaps? But again, when one searches in detail, there's no rogue explanation there either: during 3Q, the fed was a marginal seller of bonds. So one is left with what seems a rather feeble explanation: a collapse in economic confidence and financial risk appetite which accelerated a substitution of real assets for financial assets, driving up deposit growth far faster than the underlying growth of the economy.

Precisely why it happened is probably less important than understanding the utter extremity of the situation it has left the US economy in. Quite clearly, the risk is monetary velocity stops, or even reverses its unprecedented collapse in the near future. And if it does so, consider this: in the US M2 is currently growing at just under 10% YoY, whilst nominal GDP is growing at 4.1%. Unless we see a collapse in M2 growth (unlikely given that bank credit is finally beginning to expand), here are the alternatives:

• Mere stabilization of monetary velocity at 3Q levels would involve a doubling of the GDP growth rate over the next 12 months on average.
• If even half the collapse in the 3Q monetary velocity is regained and sustained, it implies a nominal GDP growth rate of just under 12%.
• If we return to the (still historically very-depressed) rate experienced in 2Q11, we'd be looking at nominal GDP growth of 13.7%.

The message is unambiguous: the biggest risk to US financial markets in the coming year is a growth shock for which bond and currency markets are utterly unprepared.  

How to Outperform the FTSE 100

I can time the real implosion of the Eurozone very easily : it happened on August 1^st, the first day of my summer holiday (see Holidays in Euro-Hell). Between July 28^th and now, the FTSE 100 has lost 8.5%.  De La Rue, (DLAR LN) ("the Company produces approximately 150 national currencies") , by contrast, has risen 11.0%. 

Just saying . . . 

A Reply to 'How to Dismantle the Euro. . . . '

I have received the following critique of the piece from Don Hanna, currently MD of Fortress Investment, and previously an economist with Goldman in Hong Kong during the 1990s. He has kindly given me permission to post it, for which I thank him. He also suggests reading this and this.  Don's words follow: 

Michael’s diagnosis of Italy’s problem isn’t right.  Italy did grow fast enough, at low spreads to Bunds, to lower net D/Y from 101% on entrance to 87% in 2007 (using IMF WEO numbers).  The subsequent rise back to 100 (net) is largely the recession.   Italy would be in much better shape if its GDP growth had been higher than the 1.5% it managed in the nine years before the crisis.  But the current problem is, given that growth rate, 100% in net debt and a nominal interest rate of 6.5% is unsustainable.

Nor is Michael’s solution.  Committing to a currency board after stiffing your creditors to the tune of the devaluation times their claims on you is inherently not credible.  A risk premium gets immediately priced into the yield curve of the currency-board country, slamming growth and undermining Michael’s logic.  It’s also not correct to envision a world in which the creditors have already written down their claims and are, therefore, glad to see the devaluation so long as it’s lower than current secondary market prices.  Many creditors won’t be fully provisioned or will continue to strive for restitution in full in the original currency (there is also a legal question of the jurisdiction of the original debt contract and, hence, the ability of Italy to arbitrarily recontract).

The simple analogy for moving from a currency union to a currency board that illustrates the logical flaw is the alcoholic who’s been on the wagon, but asks to go on a binge for old time’s sake after which he promises future sobriety.   

An economy that uses a devaluation as a solution to growth is unlikely to be able to foreswear using the same solution again in the future, which is what, in principle, a currency board requires.  As Michael himself notes, it’s not current excesses—monetary or fiscal—that are the basis for Italy’s woes.  Hence, the added discipline of a currency board isn’t the solution. 

The solution is a set of reforms:

·         that promotes factor market liberalization, so that resources can be used more effectively

·         that boosts the effectiveness of government through lowering corruption and enhancing the rule of law; and

·         that provides a “good housekeeping seal of approval” from the ECB as a buyer of last resort above a yield of say 4.5% (the planned nominal growth of Italy in the next three years) so that the new Italian government has the time (and still the incentive) to implement these growth-oriented measures. 

There is much in this with which I agree: notwithstanding his initial paragraph, it's plain our diagnosis  of Italy's problem is identical.  Also, I agree that  the supply-side reforms which he mentions are, without doubt, essential to raising the underlying sustainable growth rate of the Italian economy, without which Italy's debt problem will be unmanageable. Part of the attraction of putting in a currency board would be precisely that it would discipline to encourage those reforms. Devaluation is no replacement for those reforms. 

So what do I disagree with? Well first, there's a tedious question of data: Don is evidently working with a set of net debt data (IMF WEO) which calculates Italy's government debt/GDP at sharply lower levels than the one I'm using the gross government debt data provided by the European Commission (via Eurostat), used to calculate the (ignored) Maastricht criteria. The difference matters, since Don's data has Italy's debt a 87% of GDP in 2007, whereas Eurostat data shows it at 103.1%.  Since at the crux of the problem is Italy's ability to achieve regularly a level of growth equal to or greater than debt/GDP multiplied by the medium/long term interest rate,  Don's hurdle for Italy is rather lower than mine. 

Then there is Don's repeated critique that Italy adopting a currency board is 'inherently not credible.' This argument is repeated three times: i) a risk premium immediately gets priced; ii) Italy being 'unlikely to be able to foreswear using the same solution in the future' and iii) his analogy about a recovering alcoholic. 

Actually, Don's a lucky man, because he evidently has never been forced to find out how 'recovering alcoholics' are actually treated.  If he had, he'll know that generally alcoholics are not forced off 'cold turkey' because that 'treatment' is more likely to kill them than cure them.  They get alcohol until their system is well enough to foreswear it. 

And consider the proffered alternative. I have to say that planning to have the ECB buying all your bonds above 4.5% as a 'good housekeeping seal of approval' is a step towards dismantling pricing signals which I would have thought unlikely to improve the allocation of capital. Rather, it's state planning pure and simple. Indeed, the combination of the ECB/GdF's oversight (implementation of the ECB/GdF Plan), coupled with state control of bond yields wouldn't give me comfort as an investor (though I'd participate in the initial ramp). As for Italy sustaining  a 4.5% nominal growth any time soon. . . . . well, the last time Italy managed a single quarter of such growth was back in 2Q 2001, six months before the introduction of the Euro. 

Finally, Don's probably right about banks not welcoming  the devalue/peg/don't default strategy, and for the reasons he gives.  But I reckon whilst he's right de jure, if the Peg stuck, I'd be right de facto. Eventually. 

Shocks and Surprises, Week Ending Nov 11th

The pattern this week was quite clear: in both the US and China, quite heavy weeks for data produced plenty of positive surprises, and only a couple of negative shocks. In Europe, however, this was the week when monthly economic data finally began to slow fast in response to the exceptional financial and political crisis.

This raises a question which I suspect is going to be much-analysed over the coming weeks and months: can a combination of a slowly recovering US, and a slowing but financial secure Asia de-couple from a Eurozone rout?

We might as well get Europe's misery out of the way first. The following results were all far worse that the continent's economists had expected:

• Germany's industrial output fell 2.7%
• France's industrial output fell 1.7% MoM
• Italy's industrial output fell 4.8% MoM
• Germany's imports fell 0.8% MoM
• Eurozone retail sales fell 0.7% MoM, despite Germany rising 0.2% and France 2%.

Germany's trade data still had one positive surprise up its sleeve – exports rose 0.9% MoM, led by a 11.5% YoY rise in exports to the Eurozone. Here's something worth remembering about Germany's trade data for coming months: 40% of Germany's exports go to the Eurozone, but only 14.3% of its trade surplus is generated by trade with the Eurozone (data for Jan-Sept). The moral is that we could quite easily expect that as Eurozone demand shrivels in the coming months, Germany's export growth slows noticeably more sharply than its trade surplus dwindles.

If one is embroiled in the ongoing disaster in the Eurozone, it is sometimes difficult to recognize that the US and Asia is simply not in the same situation – rather, economic data continues to surprise economists by showing the US substandard recovery ever more obviously intact, and China's slowdown stubbornly not turning into a hard landing.

In previous work, I've noticed how in important measurable respects US household deleveraging is approaching a level at which some respite should be expected. However, "continued and sustained debt deleveraging by the US householder is based not on the discomfort of the current situation, but fears about deteriorating prospects. Jobs and job safety, in other words."  Over the last few weeks, labour market data and confidence indicators have both surprised positively. T'his week, for example, the JOLTs Job Openings surprised with a jump of 7.2% MoM to the best reach since August 2008, whilst the weekly initial unemployment claims also came in, once again, under the range of expectations. Much more positively surprising, however, were two sharp improvements in confidence indexes. First, the NFIB Small Business Optimism index gave its best reading since June, and later the University of Michigan Consumer Confidence Index held a similar surprise. In both cases what's improved are not assessments of what the US economy is currently experiencing, but rather expectations about what's to come.

In China, a lot of October's data landed around consensus: exports up 15.9% YoY; industrial production up 13.2%; retail sales up 17%; industrial productionM2 up 12.9%; CPI up 5.5%, HK GDP up 0.1% QoQ – none of this surprised.

However, a second raft of data turned out to be stronger than the range of analysts' expectations:

• China's imports, which rose 28.7%;
• China's Urban Fixed Asset Investment, which rose 24.9%;
• Taiwanese trade (exports rose 11.7% YoY, imports rose 11.7% - both easily stronger than expected);
• China's new bank lending, which rose to 586.8bn yuan.

Finally, there's one other trend which opened up fairly clearly this week: in response to a slowing economy, pricing pressures are falling fast. This is most welcome in China, where the PPI for October fell to 5% YoY, which means PPI inflation is now running below CPI (which came in at 5.5%): this is very rare in China, having been seen only in early 2001 and late 2008. It surely heralds further and probably sharper falls in CPI in the next few months. Something similar was seen in Japan, where Domestic Corporate Goods PI fell to 1.7% YoY (from 2.5% in September), on the back of raw materials and intermediates falling 0.9% MoM, and final goods falling 0.2%. This fall in Asian producer prices also showed up on the other side of the Pacific, where US import prices fell 0.6% MoM, allowing the YoY to retreat to 11% YoY – which was 50bps below the range of expectations.

At the moment, this sign of price weakness is almost wholly benign – neither Asia nor the US is in imminent danger of deflation. Meanwhile, over in Europe, price pressures are doing nothing unexpected: German WPI, French CPI and UK PPI all touched down in their expected landing zone.

Target2, Keinen Sinn, and the New Lira

Yesterday I suggested that the Eurozone could be safely and usefully dismantled by allowing the stressed economies to exit the Euro and launch new currencies tied to the Euro via currency board arrangements. This, I argued, would allow these countries to grow without setting off a monetary free-for-all, without losing many of the real benefits of a single market, and probably at a far lower cost to the rest of Europe's banking systems than the current death-march strategies promise.

Today I want to suggest one of the ways this could be implemented, technically, whilst preserving much of the current financial infrastructure of the Eurozone. But it also provides an opportunity to draw your attention to a really rather remarkable row which has been paddling along under the water for nearly six months now, and which finally broke surface in the November ECB Monthly Bulletin.

Although seemingly abstruse, this argument is dangerous, and – though I hope not – possibly symptomatic of a selective blindness among Germany economists and policymakers which we would be wise not to ignore. So far as I can trace, the row started in June this year with this piece, 'The ECB's Stealth Bailout' by Hans-Werner Sinn. Now Prof Sinn could scarcely be more august: he's the Professor of Economics and Public Finance at the University of Munich, and he's also President of Ifo Institute for Economic Research. One crosses him with great reluctance and considerable trepidation.  

His paper asserted:

• that a large (Eu326bn by end-2010) Bundesbank surplus with the Eurosystem's Target2 real-time settlement system, was a 'stealth bailout' of peripheral economies by Germany;
• that it financed continuing current account deficits in the peripheral economies;
• that it dwarfed the official bailout packages;
• that the size of the Bundesbank's position was crowding out lending that might be made to the German economy;
• and that essentially this represents a major unrealized risk to the Bundesbank.  

So august is Prof Sinn that in all likelihood he probably has momentarily forgotten more about economics than I actually know just now. And yet, his paper is . . . . . wrong. And wrong which suggests a blindness to the way banking markets work which I cannot imagine he would have encountered looking simply at Germany's banking system alone.

I'll try and explain in simple terms what the argument is about. However, there are other explanations here and here which you may find more satisfactory (and to which I am indebted).  

Probably the simplest way to understand the problem is to think for a moment about how a banking system works, and a central bank's role within that system. Every day, commercial banks receive and make payments between each other: those payments can be the result of current flows (me using my debit-card at the supermarket), or it can be the result of capital flows (me selling shares or a house, and depositing the proceeds in the bank). At the end of every day, imagine all the commercial banks sitting round and netting off the transactions. The resulting netted total is the net clearing balance (NCB), checksummed at their accounts with the central bank.

In a closed economy, the NCB should be fairly stable, (provided there has been no sudden major change in the real capital stock of an economy). If for some reason there is a significant unanticipated fluctuation in the NCB (ie, if short-term rates spike), the central bank will probably feel it is playing a useful and normal role in acting in the market to smooth it out by supplying short-term liquidity. Alternatively, if it intends to implement a monetary policy change, one of the ways it can do that is to use money market operations to try to expand (or contract) the NCB.

Note that within this system, there may be very serious imbalances between banks, which could develop either as a result of slow underlying market-share changes, or because of more dramatic and destabilizing market-share changes. For example, if in England deposits left Lloyds HBOS to enjoy the relative security of HSBC, then for a while HSBC could find itself having a sharply positive balance with the Bank of England, whilst Lloyds would have a sharply negative balance with the central bank. However, as far as overall monetary control of the system is concerned, what matters is not the composition of the bilateral balances, but rather the movement of the NCB.

Such a situation would certainly suggest trouble at Lloyds/HBOS, and ought to attract the attention of regulators (although, given the FSA's negligence on Northern Rock, who know what they were capable of sleeping through). Nonetheless, there are several conclusions it would be difficult to draw:

1. You wouldn't think that HSBC's ability to lend was being curtailed by its large surplus with the Bank of England. You'd assume very much the opposite, in fact – that they were having difficulting finding someething useful to do with all these deposits they have sudden acquired.
2. You wouldn't think that there's a 'stealth bailout' going on, being funded by the Bank of England. Far from it: you'd think the money markets were operating efficiently, and in a way which is rather uncomfortable for Lloyds/HBOS.
3. You wouldn't think HSBC is exposing itself to great risk in accumulating deposits in the Bank of England. Again, the opposite is likely to be the case – you'd assume these deposits in Bank of England would be the safest asset on their books.

Now consider the institutional set-up of the Eurozone. Essentially, it is a system in which the national central banks settle their fluctuating bilateral claims through their accounts at the European Central Bank. (Together, the collection of Eurozone national central banks, plus the European Central Bank, is known as the 'Eurosystem'.) The ECB, then, can be seen as the central bank for the Eurozone's central banks, and the backoffice system through which it (and many others) settles and establishes the net clearing balance of eurozone is called Target2 (a mercifully short acronym for Trans-European Automated Real-time Gross settlement Express Transfer system). It's a busy system: last year, Target2 saw an average daily turnover of about Eu2.3 trillion.

As the financial crisis in the Eurozone peripheral economies has developed, so, quite unsurprisingly, deposits have left banking systems deemed to be at risk, and fled to the ones that isn't. Deposits in Irish banks have transferred to German banks. And this has resulted in Germany's surplus with the Target2 system. Since the build-up of Germany's Target2 surpluses are greater than the cumulative peripheral current account deficits, it's clear that what's happening is a measure and response to predictable capital flight.

And as such, it is also very strange to assert that as German banks build up this surplus that this represents a 'stealth bailout' or a loss of lending capacity by German banks to the German economy. It also curious to see the Bundesbank being exposed by these surpluses, to the financial fragility of the peripheral economies – if there is a liability, it is to the ECB itself.

It has been reported that there's a certain amount of tut-tutting in Brussels these days about peripheral countries resenting German tutelage: 'But don't you know, this is what you signed up to!' And that is the answer also to Prof Sinn: this is precisely what Germany signed up to when it established the Eurozone and the ECB. This is how it's meant to work. Didn't you know?

This row, though, has at least this merit: that it alerts us to the possibility that the Target2 mechanism could precisely be used to institute and patrol the workings of Euro-linked currency board regimes established by Euro-peripherals needing to exit the Euro. For the fundamental point of the currency board is precisely that if the net clearing balance of a currency-board banking system is to expand, it must and can only be done so when a financial institution deposits the stipulated amount of Euros with whatever body is charged with operating the currency board.

Prof Sinn would be delighted to find that as the currency board re-established financial stability as a function both of predictable monetary discipline and of sharply improved medium-term growth  prospects, there would be every likelihood that the current Target2 imbalances would . . . . correct themselves naturally as deposits flowed back into the peripherals banking systems again. The way it would happen would be simplicity itself: since the capital attracted back into the currency-board financial systems could not, by definition, push up the value of the New Lira, more New Lira would have to be printed. And, under the rules of the currency board, this could only be done by depositing Euros at the declared rate, with the central bank. Which in turn would result in an exactly matching run-down in Germany's Target2 surplus and Peripheral Target2 deficit.

That's how it's meant to work.

How To Dismantle the Euro Without Blowing Up Europe

Yesterday I promised to sketch a way in which the Eurozone could be dismantled in a way which would deal with the immediate problems whilst preserving as many as possible of the benefits of the Eurozone.

And the first thing I want to stress is that, though the potential benefits are currently dwarfed by the imminence of its catastrophic failure, the Euro project wasn't begotten purely to cause financial mayhem, or to further the sinister Europa-building fantasies of the EU's visionaries. There is much to be said not just for a single market, but also for stable and predictable currencies within that single market. More, there's a great deal to be said for a conservatively German view of banking and central banking (though, in extremis, as we shall see in my next post, even some quite eminent German economists plainly don't understand the day-to-day back-office mechanics of what a central bank does). And there is also plainly merit in ensuring democratically elected governments are not cocooned from the discipline of the markets.

What little work to have been done on a breakup of the Eurozone assumes that all these benefits must be lost or foregone throughout the whole of Europe if the Eurozone breaks up. The locus classicus so far is a research paper by published in September by UBS, which warned that the consequences of a weak country leaving the Euro would include sovereign default, corporate default, collapse of the banking system and collapse of international trade. The paper estimated a weak Euro country leaving the Euro would incur a cost of around Eu 9,500 to Eu11,500 per person during the first year, with a further Ee3,000 to Eu4,000 per person per year over subsequent years.

Mind you, it would be no picnic for the Germans, either, if they left the Eurozone: Eu 6,000 to 8,000 for every German adult and child in the first year, and a range of Eu 3,500 to 4,500 per person per year thereafter. That's the equivalent of 20% to 25% GDP loss in the first year!

I have three comments to make on this. First, we're in 'spurious accuracy,' or 'magical realism' territory as far as the forecasts are concerned. Second, since the paper was unable to envisage how – short of a sort of confetti-producing monetary free-for-all – an exit might be achieved, the authors were free to colour in their favourite shade of lurid in all possible ways, economic, financial and political. Third, and notwithstanding these shortcomings, UBS is at least to be congratulated on having the balls to broach the subject at all – even if in the end it did little more than scaremonger.

The key to finding a solution is to understand very clearly what the underlying problem is. And Italy's case makes this absolutely crystal clear: Mr Berlusconi may not be your cup of espresso, but it is simply not true that he ran a regime of exceptional fiscal indulgence. During 2001-2007, Italy's fiscal deficit averaged 3.2% of GDP, which is hardly deeply differentiated from France's 2.9% average, or even Germany's 2.7%. Since 2008, Italy's deficit has averaged 4.9% of GDP, which is frankly conservative compared to France's 7.3% (though Germany confined itself to 3.8%). If moralizing of all sorts can be temporarily adjourned, it's plainly not Italy's current fiscal policies the market cannot stomach. Nor is it the debt burden, which, at around 120%, is only slightly higher than the average since 1995 of 111%. What really kills is the absolutely correct perception that whilst it has the Euro as a currency, Italy will never be able to grow sufficiently fast to contain its debt-burden.

So what we are looking for is an way to ensure that when a country exits the Eurozone,  it will both be in a position to grow, whilst at the same time retaining the financial and fiscal disciplines encouraged membership of the Eurozone. And, quite obviously, whatever exit route is achieved, it must also be built to re-win financial stability and confidence at the earliest possible opportunity.

Put in these terms, the solution is obvious. Currencies can and should exit the Euro by first redenominating all domestic assets and liabilities of the banking system in the new currency, and also redenominating all external government debt in the new currency, whilst at the same time committing to fully servicing the debt in the new currency. But second, and crucially, it should at the same time announce a currency-board arrangement which pegs the new currency to the Euro, and dissolve the national central bank at the same time.

For those who've spent time in Hong Kong, this solution will seem obvious. But, strangely, I've never heard it mentioned as a possibility.

A currency board is simplicity itself: its founding principal is that for every unit of the new currency to be issued (let's call it the New Lira), the note issuing institution must deposit the full stated amount of the currency to which it is pegged, with the currency board. If the New Lira currency board is declared at 60 Eurocents, if the note-issuing body is a private bank (and why not?), it is obliged to lodge 60 Eurocents with the currency board. The currency board accumulates the interest on that deposit, whilst the bank makes its money from the New Lira financial asset it subsequently creates/sells. Crucially, there is no central bank to intervene in money markets, which means that banks must carefully monitor the daily net clearing balance of the banking system. If that net clearing balance is negative, the rise in interest rates will persuade a bank somehow to scrape together the Euros needed to print more money in order to rectify the imbalance. Conversely, if the net clearing balance is positive, one would expect interest rates to shrink, at which point banks may (or may not) find it profitable to redeem the New Lira for Euros.

Clearly a currency board subcontracts the monetary policy of the country to the monetary policy of the Eurozone, and so also patrols the fiscal possibilities of that country to the underlying cashflows (and eventually capital flows) of the private economy operating within that monetary policy. Sometimes, such as in Hong Kong, this is seen as introducing a degree of monetary arbitrariness: at the fringes of the Eurozone, however, such linkage is entirely justifiable, and desirable on both sides of the monetary border.

In other words, establishing a currency board allows the absolutely necessary currency re-set as a precondition for renewed growth,  whilst reinforcing the medium and long-term financial disciplines which the Eurozone's architects and current members profess to value.

And what of those left holding suddenly devalued New Lira government bonds? Well, here the news is actually rather good: assuming that at the time of the declaration of the currency board, the Euro-denominated government bonds are trading at a deep discount to face value, the instantaneous re-establishment not only of monetary discipline but also the new prospect of renewed growth in the medium to longer term will surely result in the yields on those bonds falling in the short-to-medium term. (Since, after all, lack of growth was the problem, and constant monetary indiscipline the fear.) In those circumstances, one might expect to find buyers even of Greek debt at 25%+. In short, what a bank lost immediately on the currency could be expected to be made up in the short-to-medium term on capital gains as bond yields return to 'normal'.

Even French banks might survive.

At what level should the currency boards be declared? I haven't done the detailed work, but plainly, the depreciation needs to be sufficient to give an assurance that growth is possible. In the end, one should avoid spurious accuracy. I am reminded of a story told of the blessed John Greenwood, who when devising the (highly successful) Hong Kong currency board in 1983, carefully worked out that the correct value should be eight HK$ to one 1 US$. His calculations were rejected out of hand by Sir Edward Youde, the governor, as quite implausibly lucky (or so I am told). The Cantonese would simple never believe it. So he altered the valuation to 7.8 where it has stayed.


I understand Lord Woolfson has offered a prize of £250,000 for anyone explaining how to dismantle the Eurozone painlessly. Feel free to forward him this piece: the task is significantly easier than either he has been encouraged to believe. 

Eurozone / Killzone

Unless something truly astonishing happens, it's all over for the Eurozone, and probably for Europe too. One way or another, we will live with the aftermath, with political, financial and economic structures which, right now, we simply don't understand and probably can't imagine. 

So let's start trying, whilst keeping things as docile and non-lurid as possible. This will obviously not be accomplished in a single piece. But in one respect, there is good news: we are finally reaching a point where at least the correct questions are being asked - for example, how to dismantle the Eurozone with minimum chaos. That's a start. Indeed, once you start asking the right questions, we may find that the answers are not quite so daunting, nor the future quite so lurid necessarily, as they currently seem.  

The key point this week is that yields on Italian bonds have reached an impossible 7%+ not because of any recent fiscal or financial profligacy on Italy's part, but because whilst it's locked into the Euro, the nation can't grow nearly fast enough to stabilize and repay its debt, and the imposition of short, medium and long-term austerity will only compound the problem. After all, during the last decade Italy's averaged 2.9% growth pa, nominal! What's being priced isn't the failure of the current or recent past, but the expected future failure provoked by Italy having a mispriced currency and a counterproductive fiscal policy. It's a whistle being blown on the whole Euro-delusion.

For now, for an idle hour or month, as Italy's financial failure heaves itself over the horizon, we are invited to believe that the Eurozone's financial frailties can be rescued by some form of leveraging of the European Financial Stability Facility. One hardly knows whether to laugh or cry. In one iteration, the EFSF is expected to act as a sort of credit insurance issuer – that's right, an attempt to re-invent the CDS markets which have just been killed by the fiction  that Greece can forget more than 50% of its obligations without triggering CDS payouts. In another iteration, we are invited to believe China will stump up fund the thing . . . . even though CIC chairman Jin Liqun has responded by specifically decrying the moral effects of the European 'social model' that it can no longer afford.

(Incidentally, if Europe can't get a good hearing from Jin Liqun, it can't get a good hearing from anyone in China. Mr Jin is probably the most Europe-friendly senior Chinese official currently in office. This is a  man who first taught himself English during the Cultural Revolution in order to read Shakespeare and the classics of Victorian literature. After that he taught himself French so he could read Victor Hugo. His favourite book is 'Wuthering Heights': when he first read it in Maoist China, he found it very easy to understand the theme of an intense love gone horribly and destructively wrong.)

But by now, we know that last month's solution will be discredited in a matter of weeks. The key point, after all, is the EFSF's structure: the body's financial credibility is backed by guarantees from 14 of the 17 Eurozone members – Greece, Ireland and Portugal are excluded, of course. But there are really only four shareholders which matter: Germany (29.07%); France (21.83%); Italy (19.18%) and Spain (12.75%). So, unless something truly astonishing happens, we will probably have to count out both Italy and Spain as viable sovereign guarantors. The EFSF's financial standing will then effectively be guaranteed only by Germany and France.

They're both triple A, of course, and France is passing successive emergency budgets of ever-tightening austerity to try to maintain that rating. The markets, however, are pricing in unprecedented spreads between French and German 10yr bonds, however, so the austerity alone doesn't seem to be working yet.

And why should it? BNP Paribas and Credit Agricole between them hold US$416.4 bn worth of Italian debt. With major recaps probably necessary in France, do we really expect France also to be able to underwrite the financial restructuring of most of the rest of the Eurozone as well? Without compromising its AAA status? C'est magnifique, mais ce n'est pas la finance.

As Sherlock Holmes may have put it, had he been a great economist rather than a bumbling detective, when you exclude the impossible, the options that remain become if not inevitable, then at least clearly identifiable.

So, in my next posting I'll explain how one can dissolve the current Eurozone without destroying the European Union, or even Europe's banks, and without outraging German notions about central banking.

And in the one after that, I'll look at how the Eurozone's current crop of financial institutions, including the ECB, can and should continue to play a central coordinating role in the evolution of a post-delusional system of European currencies. That, happily, will include nailing a truly revealing misunderstanding about how banking systems actually work currently being perpetrated both by a high-profile German economist, and . . . . no surprise here, I suppose . . . by the sages of the FT.