More Noise

​As summer vacations have ended, noise in financial markets has become especially pronounced.​

Late last week, world central bankers gathered at their annual Jackson Hole, Wyoming meeting. The markets' obsession with whether the Federal Reserve would propose, or at least hint at, a third round of quantitative easing (QE3, whereby the Fed purchases US government bonds with newly created money) was once again clearly evident. As it turns out, Chairman Bernanke neither confirmed nor denied imminent action. But, at least in this writer's view, his focus on​ "the enormous suffering and waste of human talent" of still high unemployment does indicate a QE3 announcement, perhaps as early as the next Federal Open Market Committee meeting on September 13.

Notably absent from the Jackson Hole gathering was Mario Draghi, the head of the European Central Bank (ECB), who cancelled his scheduled attendance just prior to the meeting. This of course fueled greater speculation that he was assigning priority to another program of ECB purchases of European sovereign bonds - a "European" QE. (A quick primer - by buying bonds, a central bank increases demand for, and hence the price of, these instruments. In any bond market, as the bond price rises, the yield - the effective cost of financing - declines, facilitating further borrowing by governments to fund debt and current program spending.)​ Press reports just this morning are signalling that the program, possibly to be outlined following the ECB meeting tomorrow, will be one of "unlimited bond purchases". As a result, Spanish bond yields have dropped, after reaching record highs in July, as have similar Italian, Portuguese and Greek yields.

All this central bank activity in America and Europe is no doubt useful in calming markets. But, for the longer-run, it does not, and cannot, address the fundamental economic and fiscal issues - sluggish or no growth, unsustainable levels of government debt, record-high annual deficits in many countries, and ever-expanding entitlement expenditures that seem politically impossible to constrain. Italy, Spain, Portugal, Greece and Ireland are poster children of this debt/recession scenario, but the American economy is stressed similarly, albeit with no upward pressure yet on very low US bond yields.​

Such fiscal imbalances were years in the making, and fixes can occur only over several more years, assuming governments act now to restrain spending. Paul Ryan knows this (see my blog of August 14). It can be done - Canada's Liberal government in the 1990's is a remarkably successful example of political will that produced the transformation of an economy from debt-laden and crises-prone to productive and relatively balanced.​

Horn Instability

Something happened in Brussels last week that had nothing to do with Spanish bond yields, Greek pleadings, or even pomme frites. The Prime Minister of Ethiopia for twenty-one years, Meles Zenawi, died, reportedly in a Belgium hospital, following a yet unspecified illness.​

I admit it is arcane to note this death, given all else occurring in world markets.​ There are two reasons for this. One is personal, as this writer spent a (difficult) summer many years ago in Ethiopia as an economics research student. Tuft University's Fletcher School of International Affairs had established an outpost on the main campus of what was then called Haile Selassie I University in Addis Ababa. I was sent by my university, Strathclyde, in Glasgow to obtain empirical evidence of over-invoicing by multinational corporations trading with Ethiopia, a project I subsequently turned into a Masters' thesis.

Apart from this personal connection, Ethiopia is interesting to this writer as something of a tale of economic transformation, albeit at a still early stage, and of international political strategy and intrigue. Readers likely associate Ethiopia with recurring periods of wide-spread famine, stemming from drought, poverty, and government corruption and incompetence. Indeed, the country's GDP per capita, estimated at US$ 1,100, remains one of the lowest in the world (as a point of comparison, Canada's per capita figure is a little over $41,000).

But the much less-known story is the remarkable growth of the Ethiopian economy in recent years. One could almost characterize the country as a mini-China from twenty-five years ago, with its very repressive political regime, yet real economic expansion since 2004 that has averaged about 10 per cent per annum (adjusted for inflation). This is a rate that has easily exceeded that of most other ​non-oil producing African countries. The agricultural sector, key to feeding the populace, and which still accounts for nearly eighty per cent of employment, has wisely been a principal focus of government policy, particularly through the promotion of new seed technology to enhance crop yields, the expansion of rural infrastructure and cultivation area, and legal changes to improve land tenure security.

Much of this development and reform could be compromised, or even stopped, if the political vacuum left from Zenawi's death is not effectively filled. America must be concerned, as, under Zenawi, it has relied on Ethiopia as a friend, especially as a buffer to the failed, dangerous state of Somalia​. A power struggle among the tiny elite that surrounded Zenawi, including notably his widow, seems inevitable.

Instability in the horn of Africa is about to worsen, not exactly what we all need right now.​

More Europe

Further to my discussion about Greece at the beginning of this week, it appears that chances of the Greek government obtaining an easing of the terms of its austerity package this week are dimming. Chancellor Merkel noted yesterday that she will not agree to a time extension in her meeting tomorrow with Prime Minister Samaras. Rather, the "troika" report scheduled for early September (an updated audit of Greek finances by the European Central Bank, the EU and the IMF) will form the basis of any decision. So, the simmering continues.

In Spain, expectation has once again emerge​d that the country will ask for a government bail-out following its monthly Cabinet meeting tomorrow. After the July meeting​, Spanish Deputy Prime Minister Soraya Saenz de Santamaria felt compelled to indicate that "Spain will not ask for a bail-out and the bailout is not an option". The Spanish ten-year bond yield (what Spain pays to borrow long-term funds), which just prior to that meeting had reached an all-time high of 7.6%, declined significantly. However, that yield is on the rise again. It would seem the market, at least, is expecting a formal Spanish request to the EU, if not tomorrow, then soon.

The month of September will be an active one indeed in, among other cities,  Brussels and Berlin.​

On We Go.....

​Once again, it's a big week for Greece and Europe - and the rest of the world. Greek Prime Minister Antonis Samaras (an economist, and the new leader of Greece's fragile, right-left coalition government) travels to Berlin and Paris at the end of this week to meet with the German Chancellor, Angela Merkel, and the French President, Francois Hollande. In preparation, he meets in Athens mid-week with Jean-Claude Juncker, the Luxembourg prime minister and the head of the euro zone finance ministers. And the Greek foreign minister is meeting today in Berlin with his German counterpart.

Out of all this financial diplomacy, Greece has one short-term objective - to extend its current austerity program, from two to at least four years​, to mitigate the effects of severe economic contraction. (Here's a quick check of that contraction - the economy has shrunk by 33% since the end of 2008, with only one three-month period of growth, and is estimated to fall a further 7%  this year; unemployment is rising, from 22% of the labor force; budget and current account deficits are running at 7-8% of GDP; total outstanding public debt is equivalent to more than 160% of GDP; and the ten-year government bond yield is just under 25%.)

The immediate issue this week is whether Greece will receive the next tranche of US$39 billion of rescue funds, required urgently to complete the re-capitalization of its banks, and to pay some bond interest and some pensions and public-sector salaries. Samaras is hardly negotiating from strength for the extension - he opposed the first Greek bail-out while in opposition in 2010. And, the late-July interim assessment from the "troika" (officials from the EU, IMF and the European Central Bank) is emphasizing​ yet another shortfall in implementation of privatization and public-sector job cuts promised by two previous Athens governments.

On the other side of the negotiating table, as Greece sinks and most of the rest of southern Europe remains stressed, the northern creditor countries, most importantly Germany, are becoming increasingly impatient and fatigued with a seemingly open-ended commitment to Greece. Chancellor Merkel in particular must be exhausted by the constant need to balance the concerns of her own political coalition and electorate at home, while being looked to as the driver of new measures to save the euro and the European Union.​ Moreover, the German economy, regarded as Europe's locomotive, is stalling.

To simply let Greece go (the "Grexit" scenario) would be massively disruptive and expensive. The Economist magazine recently guessed that the cost could be nearly US$400 billion, with Germany's share equal to about 4% of the German economy. While a "Grexit" might be preferable to never-ending bailouts, the full economic and political cost would be much larger, with market panic ensuing in Spain, Portugal, Ireland and even Italy. Bond yields would soar, and capital would flee, as investors' belief in an unassailable European financial back-stop was shattered. Depression at least in Europe would loom.​

So, much is at stake this week. In this writer's view, however, the outcome by next weekend is not likely to be a dramatic one. Compromise may well be reached to allow the release of the next tranche of financial aid to Greece. And there is expectation right now in the markets that the European Central Bank will resume a sovereign bond-buying program, perhaps linked to a yield ceiling. But, it's the fundamental fixes - such as the issuance of European bonds to replace some individual country debt, and a banking union across Europe - that are unlikely to emerge now, or soon. Without such, Europe, with a common currency but little else in common, will continue to simmer, with flashes of periodic crises. A Greek implosion will remain imminent.​

Frankly, I hope I'm wrong. Let's check back early next week.

Mr. Ryan, and The Elephant in the Room

Well, it's summer. Most Europeans are away for the rest of this month. In the United States, the fiscal cliff looms, but Congress is on a break too. And, although the Presidential election is a mere three months away, the Romney/Obama battle has continued in a kind of denial mode, with both sides indulging in attack ads, mostly about social issues, while public deficits and debt continue to expand and threaten to overwhelm.​

At least in America, however, a change occurred this past weekend. Romney's choice of Congressman Paul Ryan as his running mate sends a clear signal that fiscal and economic issues - and in a broader context, the question of what role government should play - will be placed front and center in the campaign.​

Mr. Ryan, in his role as Chairman of the House Budget Committee, has distinguished himself as the principal author of The Path to Prosperity: A Blueprint for American Renewal, a ten-year proposal, intended to be sharply in contrast with President Obama's stance on health care, taxes, and on federal entitlement and discretionary spending.​ In the face of recent federal government deficits equivalent to 8-9% of gross domestic product ( compared with, for example, 3% prior to the onset of the financial crisis in 2008, and a surplus of 2.4% in 2000 ), Ryan's plan aims to restore fiscal balance over ten years - not through tax increases - but, rather, by restructuring entitlement programs like Medicare and Social Security, broadening the tax base, and more generally shrinking the size of government in the economy. Within such a framework, Ryan believes that economic growth and employment in the private sector will be stimulated, as a sounder financial base, and the ensuing restoration of confidence, lead to increased consumption and investment by individuals.

Agree or disagree with Mr. Ryan, but be ready for the elephant in the room - fiscal policy change - to be finally acknowledged and debated as the Presidential campaign proceeds.​