Friday, August 15, 2014 - Don't Worry

Don’t Worry

by Sinclair Noe

DOW – 50 = 16, 662
SPX – 0.12 = 1955
NAS + 11 = 4464
10 YR YLD - .06 = 2.35%
OIL + 1.49 = 97.07
GOLD – 8.40 = 1305.50
SILV - .31 = 19.65

For the week, the Dow rose 0.7%, the S&P 500 gained 1.2% and the Nasdaq climbed 2.2%.

The Federal Reserve said factory production jumped 1.0% last month after rising 0.3% in June. That was the largest gain since February and reflected increases across all major categories. Auto production surged 10.1%, the biggest rise since July 2009. There were also solid gains in the production of machinery and computers and electronic goods; yesterday we talked about the importance of capex and business spending; maybe we’re seeing signs of that.

Or not. In a separate report, the New York Fed said its "Empire State" general business conditions index fell to 14.69 this month from 25.60 in July.

A preliminary August reading on the University of Michigan/Thomson Reuters consumer-sentiment index fell to the lowest level in 9 months, 79.2 down from a final July level of 81.8.

Producer prices, or prices at the wholesale level increased 0.1% in July, with 0.5% growth for transportation and warehousing prices; goods prices were unchanged; food prices rose 0.4%; energy prices dropped 0.6%. Overall producer prices rose 1.7% over the 12 months that ended in July, down from June’s annual-growth rate of 1.9%.

But the economic news carried little weight today, as attention once again focused on geopolitics. That might not be totally accurate; Wall Street looks at geopolitical hotspots but it can’t hold their focus. A new survey of institutional money managers around the world by Bank of America Merrill Lynch has found a sudden surge in worry and fear, and a rise in the number buying “protection” against a crash; which means derivatives such as put options or credit default swaps.

Money managers are worried about the markets and the Fed raising interest rates and geopolitical events and the baggage retrieval system at Heathrow, and so, over the past month they have raised their cash positions from 4.5% to 5.1%. Which doesn’t sound very defensive; in fact, it sounds like money managers are still excessively bullish on stocks.

Yesterday Russian President Putin talked about how he wanted to avoid confrontation in Ukraine. Last night a Russian armored column crossed the border into Ukraine; they started firing artillery at Ukrainian forces, which exchanged shellfire. Ukrainian President Petro said a "significant" part of the Russian column had been destroyed. Russia's government denied its forces had crossed into Ukraine. NATO said there had been a Russian incursion into Ukraine but would not go so far as to call it an invasion.

After Ukraine reported the invasion, Russia's ruble weakened against both the dollar and the euro. Russian shares were also dragged lower. International markets moved lower. European Union governments warned they are ready to expand sanctions against Russia if the conflict in Ukraine intensifies.  US markets initially moved lower. The yield on the ten year treasury dropped 6 basis points to 2.35%; Treasuries are usually considered a safe haven. The yield on German bunds, or 10 year bonds, dropped under 1%. The escalating clash is now haunting the European economy, already on the brink of fresh recession, with a string of southern states in debt-deflation.

All of a sudden, the euro crisis is back, though in truth it never really went away. The latest economic figures from the eurozone make bleak reading. Across the eurozone, which is struggling to get banks lending to businesses, economic growth is expected to be 1.1% this year. All three of the euro area’s biggest economies — Germany, France and Italy — are failing. Germany’s output actually fell in the second quarter. Italy is suffering through a triple dip recession. The French economy has stagnated. Analysts expect it to grow by less than one per cent this year. Italy has dropped back into recession, or maybe it never got out of recession. The closest thing approximating good news was that Spain's dead-cat bounce recovery continued with 0.6% growth. But it still has 24.5% unemployment. The eurozone economy is still far smaller than six years ago, by about 1.9%; unemployment is in double figures and debt burdens in some areas are high.

In June, the ECB cut its key interest rates and introduced a new program of cheap loans to banks that are intended to be passed on to businesses. Some economists say the European Central Bank should go further and engage in large-scale purchases of public and private debt to reduce borrowing costs and add to the money supply. ECB President Mario Draghi is under fire to do more to resuscitate growth. He, in turn, argues that “monetary policy can only achieve so much, with government reform required to do the heavy lifting,” and he is probably right, but there doesn’t seem to be much appetite for reform. Monetary stimulus is simply not remotely an adequate substitute for government spending. Even the austerian IMF has been forced to acknowledge that fact.

The Ukraine crisis has drawn the EU into an economic confrontation with Russia, which is not only the principal supplier of energy to many eurozone countries but is also a significant trading partner and export market for European goods. This is hardly designed to improve the economic outlook, and the eurozone remains too weak to withstand external shocks. And Eurozone weakness was already in place before the most recent economic sanctions against Russia; the unfortunate reality is that nobody really knows how Russian sanctions will play out. There will be costs associated with sanctions; many of them unexpected.

Next week, the Federal Reserve will hold its annual Jackson Hole retreat. Janet Yellen will speak on labor markets. The labor market has improved but still looks weak. Various Fed officials have various theories on the labor markets, but not much in the way of solutions, and so, not surprisingly, they have different views on Fed policy.

Jeremy Stein left the Fed Board of Governors earlier in the year to return to a teaching gig at Harvard. Last week Stein said whatever the Fed does, we can expect less financial stability. Stein says that the process of exiting QE and raising interest rates has “no real precedent”. Yellen devoted an entire speech to the subject of financial stability last month at the IMF, where she said the Fed had devoted “substantially increased resources” to monitoring stability and acknowledged that the Fed’s low-interest rate policy had spurred “households and businesses to take on the risk of potentially productive investments.” But, she went on, “Such risk-taking can go too far, thereby contributing to fragility in the financial system.”

Yesterday, St. Louis Federal Reserve President James Bullard said he believes financial markets are probably mistaken if they’re counting on Fed interest rate increases to occur more slowly than policy makers forecast. Bullard says the Fed will raise the interest rate target in the first quarter of 2015. Bullard said: “We’re way ahead of where we expected to be” in terms of the Fed’s employment mandate, and “If that strength continues in the second half of the year here, then the conversation on a little more hawkish direction of monetary policy will heat up.”

Today, Minneapolis Fed President Narayana Kocherlakota offered a contrasting view, saying: “The FOMC is still a long way from meeting its targeted goal of price stability” because of excess slack in the job market, and “progress in the decline of the unemployment rate masks continued weakness in labor markets,” which would keep the inflation rate below the Fed’s 2% target until 2018. Kocherlakota pointed to the participation rate among people between the ages of 25 to 54, the prime working years; another especially significant” measure of slack is the “historically high” percentage of workers who would like full-time jobs but can only find part-time work. The U-6 unemployment rate, a broad measure of unemployment that includes people working part time because they can’t find full-time jobs rose to 12.2% in July after declining one percentage point over the first six months of the year.

One of the biggest changes in the US labor market over the past two decades has been the increasing number of people working over the age of 55. From the end of World War II until the early 1990s, a smaller and smaller share remained in the labor force but since the 1990s that trend reversed. In 1993, only 29% of people that age were in the labor force. The vast majority were retired. But participation has been rising and by 2012 more than 41% of people in that age group were still in the labor force, the highest since the early 1960s. Clearly, something has changed about people’s attitudes toward retirement. A survey from the Federal Reserve last week provided some clues. Around 21% of people said their plan for retirement is simply “to work as long as possible” and the number of people giving this response increases by age.

In addition to the Fed’s get-together in Jackson Hole, next week’s economic calendar includes minutes from the Fed’s July 30^th FOMC meeting; on Thursday we’ll get a report on July existing home sales from the National Association of Realtors; Tuesday brings an update on July housing starts. Housing starts tumbled 9.3% in June. The Labor Department will release the consumer price index report on Tuesday; the CPI measures inflation at the retail level; it’s been running near 2%, more or less.

Thursday, June 12, 2014 - The Beautiful Game

The Beautiful Game 

by Sinclair Noe

DOW – 109 = 16,734
SPX – 13 = 1930
NAS – 34 = 4297
10 YR YLD - .05 = 2.59%
OIL + 2.51 = 106.91
GOLD + 12.70 = 1274.30
SILV + .34 = 19.63

This is a big day for sports fans. In the US, many fans are thinking about the NBA playoffs or the start of the US Open golf championship, but those games are small potatoes compared to the World Cup. Over the next month, the World Cup will attract about 4 billion television viewers, maybe more when we consider all the digital devices that can replay the games; that’s more than the 3.6 billion viewers who watched the Beijing Olympic games; more than the 3.2 billion that watched the 2010 World Cup. By comparison, the Seahawks-Broncos Super Bowl managed a record 111 million viewers. The cumulative viewership for all the matches over the next month might top 35 billion. It’s a corporate marketing bonanza.

Over the next month, there will be countries across the globe that will quite literally shut down for 90 minutes intervals. Courts will delay hearing cases, hospitals will not schedule surgeries, offices and retail outlets and factories will shut down, the crime rate will drop, the streets will empty with almost zero traffic, planes stop flying, and trains stop running. I’ve seen it happen; and because I am blessed to be married to a lovely Brazilian woman, I have been caught up in the madness.

If you are still unclear, and most Americans are unclear on this subject, I’m talking about the beautiful game, futebol, or what we call soccer and the rest of the world calls futebol. The World Cup is the global championship in soccer and this year it is being played in Brazil, which is the greatest soccer team in the history of the World Cup. The first game was just a little earlier today, Brazil beat Croatia 3-1.

The whole thing was once strange to me as well, but I have a friend, Charles Oelfke, the Honorary Brazilian Consulate in Arizona; he is also an American married to a Brazilian, and when I talked with him about this World Cup thing, he pulled out an article he wrote back in 1994; that was the year the US hosted the World Cup; that was also the year Brazil won its fourth championship.

Here’s what I learned from Charles’ Gringo’s-eye view of the World Cup Extravaganza. Because of my marital affiliation, I will be required to watch all games involving my adopted country every four years. It’s a cultural thing. I will be required to record every game. I will be required to call Brazil immediately after each game to discuss why, for example, a 0-0 tie was such an exciting, logical, tactical display, clearly proving Brazil’s world dominance in the sport. I will be required to replay each game at least 3 times that same night, then twice weekly for the next four years. And apparently it also involves turning the TV room into a green and yellow shrine to Brazilian futebol.

I still don’t really understand the game and the rules, but Charlie explained that there is a certain methodology of the 22 men in plastic shorts and long hair who run around like decapitated chickens for 90 minutes making life miserable for the goleiros (the goalkeepers) who wear oversized sticky gloves while flying horizontally through the air. The goleiros can’t win games, but they’re so often blamed for losing them that volunteers for this position on the team are scarce and they are often hired from other countries.

Next question: just how large is a soccer field? I’ve learned from experts (of which Brazil now has more than 200 million) that it’s… oh…maybe… uh 70 or 80 meters wide by about maybe…, 100 meters… uh.. maybe 110 meters long; something like that. The regulation probably reads “the dimensions of which depend upon space available.” You have to respect the degree of precision in the world’s most popular sport.

My own travels in Brazil reveal that futebol, at least on the amateur level, can be played on almost any stretch of open field, or a street without too much traffic, or the beach, or even on a volleyball court. The only requirement is a ball, or something that looks like a ball.

I asked about the 1994 World Cup, which was in the US but for some reason I have almost no personal recollection of it. It was supposed to be the games that introduced soccer to the US, and the US to World soccer; but mainly it proved that we weren’t quite ready, with the possible exception of our ability to grow and mow grass.

And then I asked about the actual final, the championship game from ’94. Charlie explained that back then he and his wife Josefa had been inviting friends to watch the TV broadcasts at their home, and this usually involved a lot of yelling and screaming and copious overeating (and I’m guessing quite a few cervezas and caipairinhas), but the numbers grew too fast, and they ran out of chairs for everybody, and they had to set up in a restaurant (a steak house, of course) for the final game. About 300 Brazilians showed up, and about 3 very foolhardy Italians; and there was a lot of cheering and dancing and singing. It’s a cultural thing, he explained.

And about that final game in 1994, he said: “It was Brazil’s destiny. Everyone agrees, Brazil was the best team and I believe that, but…” the final of 52 games, of an every four year event, the showcase, the championship of the world’s most popular sport, between two tri-champion teams, the most important athletic competition in the universe with billions of spectators around the world ended in a 0-0 tie. And after 30 minutes of overtime, still a 0-0 tie.

So then it was decided by penalties, a shoot-out, a lottery. Why not just give the goleiros a last cigarette, put a blindfold on them? And … 4 years of preparation and 52 games and it all came down to individual luck. The experts called it a great game, a real cliff hanger, and justified the Brazil win because Brazil had 22 shots on goal compared to Italy’s 8.  That’s like saying Michael Jordan had a great game because he shot 22 air balls. Still, it will go down in history as Brazil Campeao 3-2 over Italy. It was also the first championship to be decided by penalty kicks. Something that still upsets Charlie 20 years later.

Brazil is the undisputed greatest national team in the history of futebol. They have 5 championships; their closest rivals have 3. And this year, Brazil, the most futebol crazy country in the world, is the host country for the World Cup; and most of the experts are picking Brazil as the favorite to win a sixth championship. This would seem to be a perfect, futebol dream come true. Not so fast.

Many Brazilians are angry about how much was spent preparing for the Cup and how the country still struggled to be ready. Anger about broken promises and the ballooning cost of soccer venues contributed to widespread protests that drew over a million Brazilians into the streets last year. Detractors say the World Cup has done more harm than good by taking funds away from social programs and investment projects. The Brazilian government has spent an estimated $11 billion on the World Cup, while protesters say the money should have gone to low income housing, hospitals, better roads, and better schools.

And as the games start today, Brazil is ill-prepared, with many projects over budget and behind schedule. The government spent nearly $300 million for a stadium in Manaus, a city that doesn’t have a major league soccer team, and is deep in the jungle along the Amazon River. It’s expected that after the World Cup, the stadium will sit empty for the most part. Building materials were shipped in by boat because you can’t drive to Manaus.

And to add insult to injury, the ticket prices for most games will price average Brazilians out of the stadiums, and the profits from the games don’t go to Brazil, they go to FIFA. And part of FIFA’s deal is complete tax exemption on all profits. Toss in some charges of bribery and FIFA is being compared to the mafia.

Part of the preparations for the World Cup involved what is known as pacification plans for the favelas, the massive shantytowns that are home to tens of millions of the urban poor. The police move in and after they enforce order, they are supposed to upgrade hospitals and schools. So far, it has been a police invasion without the benefits.

Last year, Brazil hosted the Confederation Cup, a trial run for the World Cup; that led to riots, and protests that drew hundreds of thousands to the streets. The protests continued today, with subway workers on strike in Sao Paolo, and protest camps set up just out of sight from the stadiums.  Two days ago, Joseph Blatter, the President of FIFA, the international football association that arranges the World Cup, kicked things off in Sao Paulo. Brazilian celebrities including President Dilma Rousseff as well as the governor of the state of Sao Paulo and the mayor of the megacity stayed away from the event. They didn’t want a repeat of last year, when Blatter and Rousseff were booed off the stage. Blatter’s solo performance in Sao Paulo speaks volumes about the mood in the country. The World Cup may be a fiasco, but if Brazil loses the World Cup Championship it could be a disaster for the government.

Brazil is the 5^th largest country in the world; it has the 6^th largest economy; Sao Paulo and Rio de Janeiro are major cosmopolitan cities with massive favelas; it is the 17^th worst country when it comes to inequality. When millions live in poverty, and corruption is rampant, and basic public services are denied, a sports extravaganza seems inappropriate, even if it is futebol on Brazilian soil. And so they play. Maybe this is Brazil’s destiny. 

Wednesday, March 27, 2013 - What Does That Mean?

Mark your Calendar, April 5 & 6 and make your reservations for the 2013 Wealth Protection Conference in Tempe, AZ. For conference information visit www.buysilvernow.com or click here or call 480-820-5877. This year's conference features Roger Weigand, Nathan Liles, David Smith, Mark Liebovit, Arch Crawford, Ian McAvity, Bill Tatro, and I will speak on Friday. There is an expanded Q&A session with all speakers on Saturday. I hope you can attend.

What Does That Mean?

By Sinclair Noe

DOW – 33 = 14,526
SPX – 0.92 = 1562
NAS + 4 = 3256
10 YR YLD - .05 = 1.85%
OIL + .35 = 96.69
GOLD + 5.90 = 1606.40
SILV - .07 = 28.79

With just a couple of trading days left in the first quarter, it looks like the S&P 500 will finish the quarter with its highest valuation in three years. At its current price, the S&P 500 has an LTM P/E of 16.1x; allow me to translate. The Price to earnings ratio, or P/E, over the last twelve months, (LTM) is 16.1. We get this number by taking the stock's current price divided by the company's 12 month earning per share. As an example, if a stock is priced at $10 and had earnings of $1, the P/E is 10. If they had earnings of $5 the P/E is 2; if they had earnings of 50 cents, the P/E would be 20. After gaining 9.2% year-to-date and growing its multiple, the S&P 500 will enter earnings season with high expectations. However, the current multiple is still low by long-term standards, so good earnings could sustain the rally. Maybe.

The Fed continues to throw money at Wall Street through its accommodative easing; Europe hasn't imploded yet; things could change and there could be a big event, but absent that, the stock markets will be paying attention to earnings. Forward looking P/E for the upcoming 12 months are expected to come in around 15.2. Now, in the past quarter the laggards have been technology companies, energy companies, and financials; while the leaders have been consumer companies and healthcare. One of the things to consider is whether the laggards can pick up the slack.

So, when we enter the first quarter earnings season, it will be interesting to see if there is a rotation to the energy or maybe the tech sectors. Tech should really be important when it comes to sustainability of the rally. Another area to watch is Emerging Markets, down more than 7% from the start of the year. If the markets are destined to move higher, the overseas equities would need to show strength, and might even represent an upside opportunity. Let me caution that I'm not making predictions here, just offering some thoughts on what might be important to watch.

Another thing to consider is that the US economy went flat-line in the fourth quarter; GDP was initially reported as negative and then revised to just barely positive, and in this environment, the stock market hits record highs. It won't be easy to turn in earnings numbers that support those new higher prices.

Lots of attention on Cyprus, especially tomorrow, when the banks are scheduled to reopen, with sharp restrictions; withdrawals will be limited to 300-euros per day. Big mess; lots of photo ops tomorrow. The Cypriot economy is struggling; they've gone almost two weeks with nothing but limited ATM withdrawals. Fitch just got around to downgrading the three biggest Cypriot banks.The banks are facing big losses and that is radiating out through the island economy. The private sector has already started cutting back.

When the banks reopen, they will confiscate deposits; nobody knows how much, but they will be taking from the accounts over 100,000-euro. The reversal of the decision to ‘tax’ insured depositors constitutes a last minute restoration of common sense. By forcing losses on uninsured depositors and the banks’ bondholders, taxpayers have to bear a smaller burden of the bailout loans; and this is a good thing.

One of the disturbing revelations is that the Euro-zone technocrats says this is the template for the future. It is now up to depositors to know the bad investments the banks hold, even if the banks themselves are withholding information or are clueless.

The Memorandum of Understanding, which is the deal that is supposed to explain how much the Troika will steal from bank depositors, has not been written up yet and, thus, the deal is utterly incomplete. In particular, we have no idea what degree and type of austerity will be imposed upon a collapsing social economy. And when a deal is reached, Cyprus is going to continue to be subject to the austerian predilections of the Eurozone, and we can see how well that is working out in Greece. A break, though more painful initially, might have been better in the long run. Cyprus should be “no big deal”, and it may still slip from memory, but it may also signal a turning point.

And with all that mess it's easy to forget about the mess in Italy. They had an election, with no clear winner, and today we learn they can't form a coalition government. The euro dropped below $1.28.

Remember the rest of Europe? Yesterday, S&P downgraded Bankia in Spain. They also cut their euro-zone gross domestic product forecast to negative 0.5% from the earlier estimate of a 0.1% decline.

The Bank of England’s Financial Policy Committee says British banks must come up with 25 billion-pounds in fresh capital by the end of the year to start plugging an estimated 50 billion-pounds ($75 billion) capital shortfall across the sector.

The largest US banks: Citigroup, JPMorgan Chase, Bank of America, and Wells Fargo, together have paid $61 billion to settle credit-crisis and mortgage claims over the past three years, according to SNL Financial. But wait, there's more! Research firm Compass Point Research estimates that U.S. banks will wind up owing a further $24 billion related to the repurchase of faulty mortgage loans.

At least eight federal agencies are investigating JPMorgan; federal prosecutors and the FBI in New York are also examining potential wrongdoing. A recent misstep points to the growing friction between JPMorgan and regulators as well as to the concerns within the bank. JPMorgan misstated how the bank may have harmed more than 5,000 homeowners in foreclosure. The bank’s primary regulator, the Office of the Comptroller of the Currency, is expected to collect a cash payment from the bank to remedy the flawed review of loans. The problems stem from January, when JPMorgan and other big banks agreed to a multi-billion dollar settlement over foreclosure abuses. As part of the pact, the bank agreed to comb through each loan file to spot potential errors, a process that the regulators will use to help determine the size of the payouts to homeowners. While assessing 880,000 mortgages, JPMorgan overstated the potential harm for more than 5,000 loans.

In April senior executives are expected to meet with investigators who are examining the London Whale trading loss. A handful of executives have already met with authorities, but the second round will include Mr. Dimon. While he is not suspected of any wrongdoing, the officials hope Mr. Dimon will help build a case against traders in London suspected of lowballing their losses.

Federal prosecutors in Manhattan are examining JPMorgan’s actions in the Madoff case, suspecting the bank may have violated a federal law that requires banks to alert authorities to suspicious transactions. The comptroller’s office is investigating similar issues.

Marketwatch reports that Bernie Madoff is speaking out from prison, claiming  the banks knew of his Ponzi scheme all along. Madoff says that ‘the banks must have known,’ and were complicit and contributing to my crime.” He specifically points out JPMorgan Chase, Bank of New York Mello, HSBC, and Citicorp.

Madoff wrote that “the trustee seems unwilling to act on my offer” to help and he is therefore “offering this information to the appropriate governmental committees in the hope that this information will prove helpful in future regulation of the appropriate institutions.” The House financial services committee and the Senate banking committee had no immediate comment on whether they had received any information from Madoff.

Madoff’s comments come as prosecutors are looking at whether J.P. Morgan failed to fully alert authorities to suspicions about Madoff’s finances. Madoff’s comments also come as JPMorgan Chase is reportedly embroiled in a squabble with regulators over a government probe into the institution’s relationship with Madoff. According to a January Reuters report, the OCC, JP Morgan’s chief regulator, has been unable to obtain documents it has requested from the big bank in connection with an investigation into its relationship with Madoff.

The report cites a letter from Treasury Department inspector general Eric Thorson to JPMorgan’s general counsel, Stephen Cutler, saying the OCC has been unable to obtain what it is seeking. Madoff had an account at JPMorgan Chase that he used to transfer funds between offices.

The headline of the day comes from the Economist, under a section titled Catholicism and economics, the story is headlined “The Poor Pope” and the subtitle is: “Francis wants to emphasise the church's teaching on poverty. What does that mean?”

I'm not surprised that the folks at The Economist don't know what religion teaches us about poverty; the surprising part is that they turned their ignorance, or at least their indifference, into a headline.

Wednesday, April 18, 2012 - Euro Debt, Iceland, the IMF, and Forgiveness

DOW – 82 = 13,032
SPX – 5 = 1385
NAS – 11 = 3031
10 YR YLD -.03 = 1.98%

OIL – 1.43 = 102.77
GOLD – 8.00 = 1643.00
SILV - .08 = 31.73
PLAT – 5.00 = 1581.00

Spain's non-performing loans as a proportion of total lending jumped to 8.16% in February, up from 7.91% in January and the highest level in 18 years. Data from the Bank of Spain show that Spanish banks are burdened with about 176 billion euros of "troubled" real estate assets and that 21% of the 298 billion euros of loans linked to property developers are non-performing. Despite the increase in the country's bad loans, the yield on Spain's 10-year bond fell to a 1-1/2 week low of 5.72% on optimism over tomorrows auctions of 2-year and 10-year Spanish securities.

Will Europe and its increasingly ugly currency, the euro, get out of the crisis in one piece? This is probably the biggest question for the global economy right now. There is increasing concern that Spain and Italy will eventually default. Maybe the euro will survive but nobody seems confident of that right now. And it appears Europe is facing an economic depression which will diminish living standards and create social unrest and take years to work though. A best case scenario is years of stagnation. Actually there is another solution and we'll get to that in a few moments.

The fate of the euro has global consequences. Europe is the largest marketplace in the world. When Euro-countries and companies and the general population pull back and stop spending and investing and buying, it won't take long for the effect to be felt in the United States.

The problems with the Euro are structural; a currency union without an accompanying political union. Seventeen individual states all share the same money, but still chart their own budgetary courses. Over the past few years that meant the global marketplace was expected to treat Greece and Germany as equals. The idea was that the risks were the same because the currency was the same. The currency masked the fundamental differences that distinguished the fiscal soundness of individual member states, giving less-disciplined governments access to too much credit. And now the PIIGS, (Portugal, Ireland, Italy, Greece, and Spain) are buried in debt.

One solution is to allow the European Central Bank to issue bonds for the entire Union backed by all members. Germany doesn't like the idea of putting its credit on the line. Maybe the Germans have a fear of inflation built on the hyper-inflationary past of the Weimar Republic. Maybe the Germans have some moralistic reason to think they are financially superior, more economically worthy. Whatever the reason, the response is to impose austerity. Tighten the belt. Put the brakes on the economy. Unfortunately the prescription for starvation is not a diet. Austerity ensures that Europe cannot grow robustly, enhancing the debt burdens of weaker states. The cure is as bad as the disease. Europe will not shrink its way to prosperity.

Italy’s prime minister has abandoned the notion that Italy can balance its budget during a deepening recession. Slow growth, not profligate public spending, is the No. 1 problem in Italy. And in Spain, where a recession is causing a wave of loan delinquencies and defaults. Investors are bailing out of Spanish government bonds for fear the government will be overstretched trying to save Spanish banks.

Italian Prime Minister Mario Monti is the technocrat who is supposed to get Italy’s finances back on the straight and narrow. After meeting in Rome today, his cabinet announced that it’s now projecting the federal budget to show a deficit equal to 0.5 percent of gross domestic product in 2013, worse than a previous forecast of a 0.1 percent deficit. Prices of Italian bonds dropped on the news.

The International Monetary Fund is starting to catch on. They realize that it is one thing to throw money at the wayward banks, but it is another matter to get the money moving through the economy. And they have come to realize that households burdened by debt will not go out and spend. Last week, the IMF targeted household debt reduction policies. You probably haven't heard much about it because it involve debt forgiveness and mortgage write-downs. The IMF issued a report using Iceland as an example. Iceland defaulted and they have recently forced banks to accept reductions in mortgage interest payments of up to 40% and many distressed households had a portion of the debt written off. The economy there has now recovered remarkably since its bank-led collapse in 2008.

It found that countries, like Ireland, that saw house prices and household borrowing skyrocket, saw a longer than average period of recession after the bursting of the housing bubble. A large part of this protracted recession it said is due to households trying to reduce their debt levels, which in turn leads to less spending in the economy, driving the recession deeper and further. In the case of Iceland the situation was more difficult, due in part to the much bigger proportion of the population that was affected, and to the wide presence of foreign currency mortgages.

The government and the newly constructed Icelandic banks developed a template to be used in case by case restructuring discussions between borrowers and lenders. The templates facilitated substantial debt write-downs designed to align secured debt with the supporting collateral (that is, bring the loan into line with the value of the house) and align debt service with the ability to repay.

The IMF found that such case by case negotiations safeguard property rights and reduce moral hazard, but they take time. As of January of this year, only 35% of the case by case restructuring applications had been processed. To speed things up, Iceland has introduced a debt forgiveness plan which writes down deeply underwater mortgages to 110% of the households' pledgeable assets.

It noted that only when a comprehensive framework was put in place and a clear expiration date for relief measures announced that debt write-downs finally took off. As of January 2012, 15 to 20% of all Icelandic mortgages have been or are in the process of being written down.

In the US in the 1930's the Roosevelt administration introduced the Home Owners Loan Corporation, which bought distressed mortgages from banks with government bonds, with federal guarantees on principal and interest. It then restructured these mortgages to make them more affordable to borrowers.

80% of the restructured loans (some 800,000) were protected from repossession by the measure, and the mortgages were subsequently sold on over time for a nominal profit at the time the program was brought to an end in 1951. The mortgage purchases amounted to 8.4% of 1933's GDP in the US.

The IMF said "a key feature of the HOLC was the effective transfer of funds to credit constrained households with distressed balance sheets and a high marginal propensity to consume, which mitigated the negative effects on aggregate demand" caused by the recession and need for household deleveraging.

The main mechanism to make loans more affordable was to extend the term of the mortgage - sometimes doubling the term - and converting it from a variable to a fixed rate. In a number of cases the HOLC also wrote off part of the principal to ensure that no loans exceeded 80% of the appraised value of the house.

Austerity is not the solution. Increasing debt to pay for unsustainable debt is not the answer. When debt is unsustainable you can't grow your way out of it and you certainly can't shrink your way out of it.

I've told you for a long time that when debt becomes unsustainable there are three outcomes: slow default, quick default, or default due to war or catastrophe. There is actually one more outcome – debt forgiveness. It is rare, but it might actually be the answer.