»The Daily Reckoning by Bill Borner

Everyone has begun to ask questions
18 NOVEMBER 2011

Baltimore, Maryland

Europe falls apart.

Dow down again - 134 points. Oil back below $100.

We're back in the USA after 5 months in Europe. What a delight it was to be in Europe. It's always a pleasure to watch something fall apart.

How far apart the Old World will fall, we don't know. But it looks as though big chunks of the continent must be cut adrift...or the whole of it will sink.

Sometimes things come together. Sometimes they fall apart. You make money, generally, when they come together. When they fall apart, it's harder. Because everyone begins to ask questions.

In a boom, question marks disappear. In a bust, they come back.

"What's this stock really worth," people want to know.

"Who's on the other side of the trade," they ask.

"When the check comes back marked 'insufficient funds,' who are they referring to, us...or them?

The bond holders want to know if the Euro-feds are going to bail them out...the Euro feds want to know if the Chinese are going to bail them out...and the taxpayers want to know how long their pension checks will keep coming.

Angela Merkel gave an answer yesterday.

"If politicians believe the ECB can solve the problem of the euro's weakness, then they're trying to convince themselves of something that won't happen," she said in a speech.

The question she was answering was when the ECB would step in to buy more bonds and bail out the bondholders. Apparently, that's not a question worth asking, she says.

What the Germans really want to know is whether the Greeks and Italians can act like Germans. What the Greeks and Italians want to know is when the Germans are going to stop acting like Germans.

And what the French want to know is where to get a good piece of fois gras and good bottle of Bordeaux.

And everybody is counting on something impossible happening. Government spending has to fall...or at least cease growing. While tax receipts have to rise...or at least, cease falling. And the economy has to grow at 6% per year so that tax receipts can increase enough to support the level of debt. How does the economy grow at three times today's rates with no boost from government spending...when everybody is cutting back, trimming debt and saving money? You tell us!

In America, there aren't quite so many questions. Nobody doubts the full faith and credit of the US government. Not yet anyway. And nobody doubts the Fed will backstop America's public debt...by printing as much money as it needs to.

Trouble is, the thing they count on to save them from having to ask questions comes with a whole bag of question marks too. When the Fed starts printing again, investors will begin to wonder how long it can continue...before all Hell breaks loose.

We don't have an opinion on it. And we don't need one. That's a question, as the judges say, that's not ripe for a decision.

So let's move on...

*** And here's another question. What gives? Bread...or circuses? Social Security, medicare, and other domestic spending. Or, the military circuses abroad? In order to bring federal deficits under control...and avoid the bankruptcy of the country...something has to go.

You'd think the military spending would give way. Who really cares what happens in Iraq? Or the South China Sea?

But here we have another unstoppable force running into another immoveable object. And we'll make a prediction. Neither will give way. Neither the bread nor the circuses. The super committee will not be willing to battle it out with the voters ...nor with the military contractors. And if it did, it would get no support from the President...or Congress.

Polls show more than 75% of Americans oppose any cuts to Social Security or Medicaid. Since it takes only a majority of voters to decide an election, the chances of any candidate winning on a "cut social spending" platform is nil.

But don't expect any candidate to win on a "cut the military" platform either. The social services may have the votes, but the military has the money. That's why major Republican candidates are trying to out-hawk each other with preposterous claims and absurd proposals. They're all Teddy Roosevelt mixed with Thomas Friedman...blowhards and dimwits, almost every one of them.

Small wonder. The campaign contributors demand it. The lobbyists insist on it. And the voters deserve it.

But won't the bond vigilantes stop them from borrowing a trillion dollars + a year? Won't the dollar's guardian angels prevent them from printing money to cover America's deficits?

Oh dear reader. How long have you been reading these chronicles? If you've been reading for a while you know that the gods - and Mr. Market too - are fun loving, mischief-makers. What kind of a trap could they set that didn't let their prey get in it? What kind of a flim-flam could they play if their mark always showed good judgment?

The Super Committee is considering budget cuts of between $330 and $400 billion per year over the next 10 years (you can bet that any cuts they come up with will be heavily loaded on the backend of the 10-year period). First, those sums are peanuts. The feds will probably run deficits in excess of a trillion a year even if they make those cuts. Second, the cuts are not from current levels of spending but from projected levels...higher levels, that is. And those projections are worthless. They systematically underestimate expenses and overestimate revenues. Third, they ain't gonna happen anyway.

This will leave the feds in need of lots of money. But with so many question marks in Europe, investors think they can sleep easy at night by moving their money to America. All things considered, the dollar and the US bond market looks like the best games in town. This makes it easy for the feds to continue borrowing at low rates...continuing going into debt...and keep their bread and circus program going almost indefinitely.

The end of this phase may be many years ahead. Japan has been at it for 20 years. The US could pile up debt for another 10 years. But when the end comes...it will be something to see!

---------------------------------------- Have an enriching Saturday! ----------------------------------------

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Center can't hold

Italy seems to have gone too far. Its 10 year bonds yields are back over 7%. It is "the beginning of the end" say analysts.

But the end of what?

When the going is good people have little patience for questions. They are too busy, earning and spending, buying and selling, and getting where they are going. But comes a major turnaround, all of a sudden, they develop the deep torments of a retarded poet in an unhappy marriage.

'What really matters?' they ask themselves. 'And what the hell am I doing here?'

In the US, the "War Between the States" settled the matter. "We will agree to have a single, centralized state," said Abraham Lincoln, or words to that effect, "or we will kill you." Later, the federal income tax, the direct election of senators (which ended individual states' participation in the federal government), interminable meddling, and numerous Supreme Court decisions further enlarged the power of the central government at the expense of "states' rights."

In Europe, several times, centralization was attempted. In his article in the Financial Times, on Wednesday, Martin Wolf called it "the dream of centuries." It took big dreamers to think they could put together so many different tribes. Caesar...Bonaparte... Hitler. (For some reason, perhaps it was a slip of memory, Wolfe does mention Adolf.) But the most recent centralization cycle was agreed voluntarily. Europeans saw it as a way to prevent war and stimulate their economies. They appeared to be right on both points, for a while. Europe's economies boomed during the "30 glorious years" following WWII. Then, when America turned to private debt, Europe financed further lifestyle enhancements with public debt, financed at low German rates. The periphery states flourished by borrowing and spending. Germany flourished by selling them things.

Now, they all must cut back. The rest is detail...and denial. Total un-payable debt may be in the trillions. Someone is going to suffer it. Whether it is the taxpayers or the lenders hardly matters, not the way the two are twined together. If the lenders are forced to take large haircuts, many collapse...and bring down Europe's sovereign bonds...and its economies. If the burden of loss is put directly onto the general public, the result is much the same. Whether the austerity is voluntary, or forced, is it inescapable.

The authorities struggle to remain on course - towards a more powerful, more centralized, more bountiful state. But they may be fighting the tides of history as well as economics. The last 300 years have been marked by further and further centralization, first, consolidating the kingdoms, duchies, and principalities of Western Europe in the 18th century. Then, building the nation states of the 19th century. Finally forming the European Union in the 20th. All over the world, local dialects, local money, local customs, and local military power gave way. By 2007, most of the major states of Europe - and quite a few minor ones - used the same currency (the euro)...paid the same interest rates (low)...worshipped the same god (mammon)...and spoke a common commercial and diplomatic language (mid-Atlantic English). Almost the entire world embraced modern credit-enhanced capitalism as taught in the leading business schools. Mario Draghi went to MIT and worked for Goldman Sachs. Mario Monti went to Yale and worked for Goldman Sachs. Lucas Papademos went to MIT and worked at the Federal Reserve Bank of Boston. They are interchangeable parts of the same machine.

What caused such homogenization? Was it the availability of modern communications, which made centralization easy and convenient? Was it merely a further elaboration of the division of labor, where each region could do what it did best and depend on the others for what it lacked? Was it the invention of modern artillery? No castle walls were strong enough to protect a local fiefdom. Some thought that modern, democratic government - combined with guided capitalism - was simply a better, more productive system, an evolutionary improvement on all that had gone before. We don't know.

But we know something. The worries that brought Europe together after WWII now pull it apart. Greek (and other) debtors can't pay. German (and other) creditors can't collect. The Germans call the Greeks layabouts and chiselers. The Greeks call the Germans 'nazis.'

And the centrifugal forces don't stop at the borders. Belgium has been without a central government for 16 months, and prospers. Thoughtful Italians of the North must resent Garibaldi as much as Monnet. And if the Germans of Hamburg are not willing to support the Greeks of Larisa, why would they want to support the Germans of Dresden?

Developed countries can't continue to pay for lifestyle enhancements with debt. Total debt-to-GDP ratios already exceed 250% for almost all of them. Britain and Japan are near 500%. At 5% interest, it would cost 25% of total output just to pay for past spending -- hamburgers eaten years ago...salaries paid in 1997...and bridges that already need repair! At Italy's current yields, nearly a third of GDP would be required. As the cost of the past increases, there is less and less money available for voters in the here and now. The center cannot hold. It doesn't even want to.

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