Today’s downgrade of Spain sealed the faith of Wall Street this week, posting the biggest weekly decline since 1940. The financial crisis seem to be back with full force, maybe even more. Some market participants are convinced that the recent economic events, particularly in Europe, is the damning evidence of a failed monetary policy.
“There’s nothing wrong with throwing a little money at a problem to make it go away. But what happens if you throw a lot of borrowed money at a problem, and the problem doesn’t go away?”
Eric Sprott/David Franklin
U.S. stocks tumbled, capping the worst May for the Dow Jones Industrial Average since 1940, while the euro slumped and Treasuries rose after the downgrade of Spain’s debt rating and escalating tensions in Korea.
The Dow Jones Index dipped 122.36 points, or 1.2 percent, to 10,136.63 Friday and have lost 7.9 percent so far this month. Standard & Poor’s 500 sank 1.2 percent to 1,089.41, led by financial shares after Fitch stripped Spain of its tripple-A rating.
“Spain’s downgrade just adds to more uncertainty,” Quincy Krosby, chief market strategist at Prudential Financial Inc., says in a commentary on Bloomberg News.
“There are too many geopolitical events. We have a three-day weekend in the U.S., and traders will definitely want to lighten their books.”
“A Busted Formula”
The more bearish side of the market are interpreting the latest events as more hard evidence of a failed economic policy – that the biggest fiscal experiment in modern history is about to become the biggest fiasco.
Siding with the political response in the early 1930’s that sent the global economy into severe depression, culminating in the world war 2.
There’s nothing wrong with throwing a little money at a problem to make it go away. There’s equally nothing wrong with throwing a little borrowed money at a problem to make it disappear, as long as you have the means to pay that borrowed money back.
But what happens if you throw a lot of borrowed money at a problem, and the problem doesn’t go away? If you’ve ever experienced a situation like that you can probably understand how Europe feels right now. It just unleashed a magnificent $1 trillion euro bailout and the market responded with a selloff by the end of the week! So what happened? That money was supposed to make the problem go away, after all. And it was a lot of money. Why did the market respond to it with such disdain?
We believe the market’s reaction is confirming what we have long suspected: that these bailouts provide next to no long-term value. They don’t produce real jobs. They don’t improve productivity. They just prolong the precarious leverage game played by the financial sector, and do so at tremendous cost to taxpayers. “Bailout and Stimulate” has been the rallying call for governments and central banks since the beginning of this financial crisis – and it has certainly had its impact over the last two years, but not the type of impact we need to propel real, sustainable growth. There are three recent, glaring examples of this busted “Bailout and Stimulate” formula in action:
Exhibit A: The
From the outset of this financial crisis, the US Government and Federal Reserve have spent prolific amounts of money to save its banks and stimulate its economy. According to Neil Barofsky, special investigator general for the Troubled Asset Relief Program, the United States has now spent approximately $3 trillion on various programs to stem the financial crisis.1 This figure is expected to be updated again in July.
This $3 trillion expenditure includes stimulus programs like ‘cash for clunkers’, the extension of unemployment benefits, infrastructure spending, the “Making Home Affordable” program, as well as the activities of the Federal Reserve. To measure what the fiscal stimulus has actually accomplished we looked to the US Federal budget outlays/receipts to gauge the impact of the stimulus on GDP.
Table A presents current dollar GDP increases year-over-year alongside current dollar budget deficits. Comparing the two in current dollars provides a sense of the hard dollar impact that stimulus spending has had on the economy. As the chart illustrates, the net impact of the stimulus contributions and promises made since 2008 have resulted in a combined budget deficit of close to $2.5 trillion dollars and an incremental net increase in GDP of $200 billion. A $200 billion return for a $2.5 trillion increase in debt represents a terrible return on investment. It implies that the net impact of the stimulus on GDP since 2008 has been a mere 9 cents for every deficit dollar spent. Buying dimes with dollars is bad business, government-funded or not.
Another troubling statistic relates to the cost of job creation for the American Recovery and Reinvestment Act (that’s the $787 billion program designed to produce real jobs in the United States). The White House estimates that it takes approximately $92,000 of government spending to create one job in the US. The White House justifies this exorbitant amount by stating that at the current employment level, each job in the US economy generates $105,000 in GDP, thus resulting in good “bang for the (taxpayer) buck”.5 Spending $92,000 to generate $105,000 in GDP seems justifiable on the surface. But further digging reveals that the actual cost to save or create one job in the US was $117,933 per job from February to December 2009.6 That’s well over $92,000, and more than the $105,000 “return” each job is supposed to provide in GDP. If this metric is correct, it means the US government is actually suffering a negative return from its job stimulus.
To further convolute the issue, one must also consider that the supposed $105,000 GDP return for each new job doesn’t incorporate the fact that the $92,000 (or $117,933) spent to create it was BORROWED. Why does this aspect of government expenditure never make it into the analysis? Spending $92,000 for a $105,000 pop in GDP represents bad logic when that $92,000 isn’t yours to spend. If we incorporate the interest costs required to borrow the $92,000, are we really producing value or just digging a deeper hole?
Numerical discrepancies aside, the fact remains that GDP is a terrible metric to measure the return of a job program. GDP is technically the value of all finished goods and services produced in an economy. From a business perspective, GDP is akin to revenue, which isn’t an asset, and is different from ‘earnings’ or ‘profits’. Businesses don’t hire additional workers for their marginal increase to ‘revenue’ – they hire to increase their marginal ‘profit’. The White House approach to job stimulus will maximize spending, not profit. Rather than maximize spending, why not maximize actual employment by finding a way to produce a job for less than $92,000? Surely some of the fifteen million unemployed workers in the US would appreciate some help in that area.
Exhibit B: The Latest Bailout Failure in Europe
In a show of force designed to impress the world markets, the European Union pieced together an unprecedented loan fund worth almost €1 trillion euros. The fund’s capital was made available to rescue euro zone countries in financial trouble. The European Central Bank announced it was ready to buy euro zone government and private bonds “to ensure depth and liquidity.” The US Federal Reserve, the Bank of Canada, the Bank of England, the European Central Bank and the Swiss National Bank announced that temporary US dollar swap facilities would be opened to provide liquidity. Never have so many organizations coordinated and contributed so much to a single bailout effort!
So what was the ultimate effect of this shock and awe campaign? After enjoying a short-lived obligatory rally, the market for stocks, bonds, and the euro (in terms of USD) traded lower by the end of the week. Gold, a barometer of fear, appreciated almost 6% in euro terms over that same week.
Which brings us to the crux of the problem…
Exhibit C: Over-Levered Banks
Banks are at the epicenter of this financial crisis. The reason? Leverage. We outlined our measurement of bank leverage in our article Don’t bank on the Banks in November 2009. As equity investors we worry about the impact a change in assets will have on a banks’ tangible common equity. Readers will note that the German financial regulator recently banned naked credit-default swaps of euro-area government bonds and banned naked short selling in ten German banks and insurers. It shouldn’t surprise you to learn that, according to their most recent filings, German banks are some of the most levered in the world. Table B shows the leverage calculation for each of the four largest banking institutions in Germany as of March 2010.
Commerzbank has the highest leverage of the German banks at 124:1. This means that if their assets drop in value by a mere 0.8%, their tangible shareholders equity is effectively wiped out. How many asset classes do you think have dropped by 0.8% since Commerzbank’s last filing in March? We would guess almost all of them have (except gold of course). Hence the recent ban on naked short selling of German bank shares. They’re too vulnerable to handle the market’s wrath.
The German banks are not alone. Most large banks around the globe are operating with too much leverage. The governments can keep the “Bailout and Stimulate” game going, but it won’t amount to much in the long-term unless the leverage issue is wrung out of the banking system. Until that happens, bailing out the banks is akin to pouring money down a bottomless pit.
The key point to remember with bailouts and stimulus is that it’s ultimately your money that the government is spending – and your children’s money. The numbers strongly suggest that your money isn’t being spent wisely. We need real jobs and real growth, not bigger, more leveraged banks. The market isn’t oblivious – it can see what’s happening. Gold’s recent strength in lieu of seemingly ‘deflationary’ economic data confirms the market’s doubts over government intervention in the financial system.
Needless to say, we remain bearish.
Eric Sprott and his colleagues have built an impressive track record over the last years, collected a numerous prestigious awards, and are currently ranked among the top 100 fund managers in the world.
The Thomson Reuters Lipper Award 2010 in the Precious Metals Equity Category.
Best Long/Short Hedge Fund Globally, 2008, and Best Canadian U.S Performance Awards, 2007, by HFM Week.
Ranked as the worlds best global hedge fund in 2002, and as number 49 last year by Barron’s.
Eric Sprott, Fund Manager of the Year 2007.
Eric Sprott, Entrepreneur of the Year, Ontario Region 2006.
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