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Mark's Market Blog

6-17-12: Greek Elections

By Mark Lawrence

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Stocks fluctuated all week on news about the supposed Spanish bailout. It's happening, it's not enough, it will solve everything, it will lock Spain out of the markets, it will induce other countries to demand the same terms. . . it's like high school the week before the prom. Early results suggest a pro-bailout government being elected in Greece, so expect the market to celebrate for a bit until the reality - this current Greece, Spain, Italy crisis isn't resolved yet - sinks in. My oldest son just graduated from college and left on a several day vacation with his girlfriend. He's broke with no job - just like Europe - but a celebration is called for. Just like Europe.

S&P 500 December 22 2011 to June 15 2012

Soon we'll know how the Greek elections went. Exit polls seem to show a very narrow victory for the New Democrats, who would then be able to form a government with the help of the outgoing party Pasok. I expect they'll form a government, and it will last most of the rest of this year.

EU technocrats are continuing to prepare for a Greek exit from the Euro. They are discussing capital controls to keep money from fleeing Greece; limits on ATM withdrawals; and perhaps even border controls to keep Greeks in Greece. The Greek central bank said they were completely unaware of these discussions. If you're Greek and reading this, you perhaps have a couple more days to get your money out of a Greek bank and into something, anything else. Personally I like US, Singapore or Canadian dollars for a while. Greeks apparently agree with me, they're withdrawing money from Greek banks at a record rate.

Europe has a solvency problem - they spend money faster than they earn it, buying themselves early retirement, free health care and jobs where you can't be laid off. If they were a family, bankruptcy would be just a matter of time. We're getting to the point where no one wants to loan them money anymore, so they also have a liquidity problem: they have no cash, their banks are broke. Europeans hate the idea of banks failing, so they're willing to print money to keep their banks alive. This is like our nearly-bankrupt family continuing to find new credit cards and move their balances, except the EU doesn't need to borrow money, they can just print it. When will it end? Apparently not just yet, they printed enough money to get their Spanish credit card out of arrears. The EU is planning on selling low interest bonds to China to help fund this operation, but it turns out China has already said they're not very interested in EU bailout bonds.

In spite of the likely bailout, Spain's interest rate continues to go up, nearly to the 7% panic level by the end of the week. The markets aren't sold on this plan. Spain has a lot of bonds outstanding, and some include contracts that those bonds will be senior to all others - the first to be paid off. The money coming from the EU is supposedly going to be senior to all other debt, even the previously contracted bonds, so bondholders are getting nervous about holding Spanish bonds. If this continues, Spain will be effectively locked out of the bond market and the ECB will have to fund them indefinitely. Italy's interest rates are also continuing to increase for the same reason, hitting the 6% white knuckles point this week. It's widely believed Italy will also need a bailout. It's technically illegal for the European Central Bank to do such a bailout, but we're nearing the end of technicalities and approaching basic survival. Things in Europe are far from settled right now.

Why do we care about all this Greek / Spain / Italy stuff? Big banks have quietly invented a new business for themselves in the last couple of decades. They no longer make money on deposits and loans. Banks now write insurance policies on things like Spanish real estate loans and Greek debt. When Lehman bros went bankrupt the major issue was who had loaned them money and was now suspect. But a couple weeks later AIG looked bankrupt; they were holding nearly a trillion dollars of these financial insurance policies, and their inability to pay off brought most of the big banks in the world into question. The AIG fuse had to be stomped out instantly, there was simply no way the chain reaction from that little firecracker was going to be predictable or containable. This is the issue with Greece: they bring Spain and Italy into question, and if Spain and Italy go, big banks everywhere get caught up in the chain reaction. If Spain and Italy aren't contained, we could be looking at world trade stopping in its tracks, big international banks failing all over, and stock markets losing half their value in a couple weeks. And the worst part is no one knows what will happen, no one knows all the details of who owes whom what, so there's no predicting or preparing for this little judgement day. As Warren Buffet famously said, "When the economic tide goes out, you find out who is swimming naked."

Inflation is falling fast in China. In the US we like a low inflation rate, so low inflation is a good thing for China too, right? No. This brings the stability of the entire country into question. Inflation is part of the fuel that keeps China's kleptocratic engine running. We saw a couple months ago that in China the richest 70 politicians are worth over a billion dollars each. Since there's no social security in China, and the one child policy means each kid has four grandparents to support, people are forced to save their money for retirement. In China savings are about half of GDP, as compared to a couple percent in the US. By law Chinese banks only pay 1% on deposits, so at a 6.5% inflation rate Chinese are paying their banks 5.5% to hold onto their money. This negative real interest rate means Chinese want to buy apartments, so the Kleptocrats can borrow money from the bank at negative rates, build shoddy apartments, and sell them at inflated prices to the people they borrowed from. They borrow from the bank at negative 5% interest then buy US treasury bills that pay 2% and make an almost guaranteed 7% on their money. They borrow at negative 5% and buy gold, then sell that to the peasants as an always-and-ever-increasing asset. Or they borrow money, form a corporation, build some useless airports, cook the books and sell worthless stock back to the people who paid them to borrow their money - stock fraud is a huge part of the Chinese economy. But if inflation falls the better-than-free money party is over; the kleptocracy has to actually work to earn their money, they can't just steal it from the billion Chinese peasants. Below is a graph from a Chinese newspaper about Chinese inflation. You don't need to be able to read the text to figure out the blue line.

Who is the world's leading economic power? PEW research did a poll recently across several nations, it turns out it's pretty widely believed that China is #1. Well, it's not believed by me.

S&P issued a warning that as India slips into recession their bond rating could drop down to junk. There's been a lot of talk about India being the next dream growth story, the next China, but I've never believed it: India has an intrenched and recalcitrant bureaucracy, they can't feed their people, their water situation is reprehensible, and their people continue to breed at unsustainable rates. They have a handful of decent universities and some of their people are quite clever at math and engineering, but it's not nearly enough for their population size. I've thought for several years that India looked like a slow motion train wreck, and I still do.

Why is unemployment so high in the US and Europe? Paul Samuelson, whose economics text book ruled universities for 50 years, explained it 70 years ago. In the US 50 years ago we had surpluses of land and resources, but a shortage of labor. This resulted in the union movement which raised the price of labor dramatically. Contrast that with China, who has a surplus of labor but a shortage of land and water. Now add free trade and cheap cross ocean transportation into the equation. Who wins? People who have surpluses, like American farmers who are forced by their enormous productivity to sell food cheap, are big winners: they have huge new markets for their grains and meats. Chinese labor wins, they have huge new markets for their products. Who loses? American labor, where their shortage is suddenly over as a billion Chinese appear willing to work for $100 per week instead of $50 per hour, and Chinese farmers who are suddenly forced to compete with hugely productive American farms. This is called the Stolper-Samuelson Theorem, first published in 1941: the winners of free trade are people who own abundant assets, like US farm land, and the losers of free trade are people who own scarce resources, like US labor.

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