Inquiring minds are reading a post from Steen Jakobsen, Chief Economist at Saxo Bank in Denmark. Please consider Steen’s Chronicle: Consensus, buying time aren’t acceptable

There are three major themes this morning: the election in Portugal, Greece bail-out Part II, and confirmation of slowing US growth.


On the surface, the Portuguese election looks like a victory for change as the Social Democrats (PSD) secured 30 per cent of the vote and appear to have a solid majority of 126 seats in the 230-seat Parliament with the support of the Conservative Popular Party. The new prime minister, Passos Coelh, has promised austerity beyond the needed cuts of 3.5 per cent of GDP per annum layed out in the IMF plan.

But real change – what change?

Portugal has become the poster child of an Entitlement Society – the public sector has extended everywhere and private capital has been crowded out by the need to keep the public sector employment in place. The only solution to Portugal’s catch-22 is to create real private sector growth and to cut the public sector down in size. Portugal has one of the lowest GDP growth rates in Europe with a four-year average of -0.7%, and an outlook for -2.1% in 2011 and -1.5% for 2012, according to the ever too optimistic OECD. Even more importantly than GDP growth rates, unemployment will rise to 11.7% and then 12.7% over the next two years from present 10.8%! That’s a recipe for a social upheaval.

This is the huge national dilemma – Portugal has gone beyond the point of no return – the problems facing the country are not merely those of “challenges”, but massive, structural intractable problems. Even if Portugal did the “right thing” – curtailed the public sector, refinanced the banks, and created a pro-business, pro-growth agenda, it would take years, not months before Portugal again starts moving forward. My issue, as always, is not with the people or the individuals of Portugal, but with the system. The Portuguese entitlement society began collapsing years ago, and the only reason the situation has been allowed to limp along until this year was due to the artificially low rates generated by the ability to ride German credit rating for years.

Greece Bail-Out Part II

The Greek drama continues – basically no one has a clue how to solve the issue of giving Greece more money when the funding runs out next spring. The “re-profiling” of debt (extending duration and the like through a “soft restructuring”), the Vienna solution and the new path of creating ratings default but not a CDS default event are all too complicated for me. My mentor always told me: if it takes more than one minute to understand your arguments, you have no arguments. Clearly, using Greece as the benchmark for how the EU will face down the sovereign debt issue, the EU institution is critically challenged, and Greece is even more so.

For starters, we have to shake our heads at the fact that, the EUR 327 billion in outstanding Greek debt, more than 90 per cent is under Greek law (source: Citigroup), whereby Greek bonds have no collective action clause (CAC). This would mean that a voluntary debt restructuring requires 100 per cent of investors to accept the terms to avoid triggering a default.

Furthermore, the ECB continues to object to any sort of debt restructuring as it would blow a hole in their own portfolio and create a moral hazard. Good luck to EU trying to resolve this before the June 23-24 summit.

Slowing US Growth

How low can we go on US growth? The status quo is maintained and extended in the USA – as the fortunes for Main Street and Wall Street continue to head in opposite directions. The Bernanke cocktail of lower rates for longer has only made Wall Street richer and Main Street poorer.

Where from here? We have our most likely scenario as one called ‘QE to Infinity’ but it may need to be changed to QE and Operation Twist to Infinity.

Bernanke thinks it’s only a matter of size and objective to do what could not be achieved in the 1960s. As it happens, Operation Twist not only failed but became the Great Inflation of 1965-81. Fed rates were 3.0%, and were supposed to go back to 2.5% but ended at 6.0% before the Fed of the 1960s gave up.

We remain bearish the market as per my earlier note: “No more Silver Bullets” and I have increased the Crisis 2.0 odds from less than 10% to 25% as the amount of troublesome issues continue to rise day-by-day.

Operation Twist to Infinity

Steen cites a reference to “Operation Twist” in footnote 11 to Bernanke “famous” deflation speech from 2002: “Deflation: Making sure ‘It’ does not happen here” – the very same speech which was academic reasoning for QE and QE2.

An episode apparently less favorable to the view that the Fed can manipulate Treasury yields was the so-called Operation Twist of the 1960s, during which an attempt was made to raise short-term yields and lower long-term yields simultaneously by selling at the short end and buying at the long end. Academic opinion on the effectiveness of Operation Twist is divided. In any case, this episode was rather small in scale, did not involve explicit announcement of target rates, and occurred when interest rates were not close to zero.

Let’s Twist Again Unlikely For Now

QE2 did not stimulate employment or housing. However, it did stimulate risk taking in financial markets, and bubbles in commodities and junk bonds. In other words, QE2 was a total failure.

Will that stop Bernanke?

Of course not. However, “Let’s Twist Again” is unlikely for now given that Bernanke will not want the short end of the curve to rise just yet.

Nonetheless, I am in complete agreement with Steen on the critical point: “Bernanke thinks it’s only a matter of size and objective to do what could not be achieved in the 1960s.”

Bazooka Theory Revisited

Recall that Treasury Secretary Paulson’s failed “Bazooka” policy was based on the construct that size matters. The EU’s silly attempt of talking down problems in Greece was based on the same principle.

If you have a bazooka in your pocket and people know it, you probably won’t have to use it.” Paulson said at a July 15 Senate Banking Committee hearing in regards to Fannie Mae and Freddie Mac.

Bazoooka Theory vs. Actual Results

I discussed the ECB’s attempt at Bazooka policy on February 12, 2010 in EU Tries Paulson’s Bazooka Ploy; Bazooka Theory vs. Historical Results.

Did the EU’s ploy of talking down problems and threatening action work? No, it failed.

Did that stop Trichet? No, it didn’t. Indeed the ECB, IMF, and EU tried a basket of ideas that all failed. Then Trichet went on to buy a boatload of Greek debt believing it would cap yields on Greek bonds. That did not work either.

Now Trichet has upped the ante once again as noted in his Call for Creation of European “Nanny-State” and Fiscal “Nanny-Zone”

Cure Cannot be Same as the Disease

Keynesian and Monetarist clowns always think it’s just a matter of size. When proven wrong they simply grab more power and try again.

I discussed that idea just this morning in Fed Uncertainty Principle as Applied to ECB: Trichet’s Power Grab

The disgusting state of affairs is that bureaucratic fools in the EU, US and everywhere else, all believe the cure is the same as the disease if only done in big enough size.

Mike “Mish” Shedlock
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