John Mauldin: Anne Elk’s Theory On Brontosauruses

A further reminder of just how perilous things were back in 2012 can be seen in the chart below, which shows the Eurostoxx European Banks Index through that crucial 2011/2012 period.

In the 12 months prior to Draghi’s soothing words, the index had halved in value. From the day Draghi spoke, the rot miraculously stopped and the banks began a climb that would see them appreciate in value by over 100%.

Did European banks become more sound institutions on July 27th, 2012? (That was a rhetorical question, people; put your hands down.)

The only really important happenings in Europe’s banking sector during the post Elk Theory speech period were the following:

Cyprus bail-in

Erste Bank made a tiny miscalculation in its bad loan provisions (which led to a small 25% fall in its share price).

Corporate Commercial Bank (the 4th largest bank in Bulgaria) was taken into protective custody by the Bulgarian Central Bank.

Banco Espirito Santo sort of kind of went a bit pear-shaped.

European banks loaded themselves to the gills with peripheral European debt as part of the quid pro quo with Draghi, but making free carry off the Elk Theory promise of a desperate central bank head is hardly what used to pass for banking.

Remember when banking used to be about things like making loans?

(Zerohedge): [The] ECB update on Monetary Developments in the Euro Area was as grim as always, with the all important series of loans to the private sector sliding once again by 2.0% Y/Y, worse even than April’s -1.8% contraction, driven by a €43 billion collapse in loans to households. This happened even as the now largely meaningless M3 rose by 1.0%, an increase to April’s 0.7% Y/Y change.

In other words, Europe is in bad a shape as pretty much ever, and loan creation is just fractions above its all-time low print of -2.3% from late 2013.

Never mind.

As long as Draghi’s Elk Theory promise is held up as good, there’s nothing to worry about.

When recently (finally) confronting the spectre of deflation, Draghi once again cleared his throat. Lo and behold, yet another Elk Theory tumbled forth. Grandstanding over a frankly ludicrous 10bp cut to an already ridiculous 25bp benchmark rate (as if it will make any difference), Draghi realised, no doubt, that it was time for yet more vague threats promises rhetoric. After imposing negative rates on European banks’ deposits, Mario Draghi (brackets “Mister,” close brackets) was put on the spot once more in the press conference:

This theory, which belongs to me, is as follows… (more throat clearing) This is how it goes… (clears throat) The next thing that I am going to say is my theory. (clears throat) Ready?

Are we finished? The answer is no. If required, we will act swiftly with further monetary policy easing. The Governing Council is unanimous in its commitment to using unconventional instruments within its mandate should it become necessary to further address risks of prolonged low inflation.

Now, let’s be serious for a moment, shall we?

Not only have the GIS (Greece, Italy & Spain) failed to recover, but the engine room of what’s left of Europe is also sputtering:

(Ambrose Evans-Pritchard): Europe’s economic recovery has stalled. The EMU policy elites took a fateful gamble that global growth alone would lift the eurozone off the reefs, without the need for serious monetary stimulus or a reflation package to ensure take-off velocity.

Their strategy has failed. The Bundesbank says German growth may have slumped to zero in the second quarter. French industrial output has fallen for three months in a row. French business surveys point to an outright contraction of GDP, with a high risk of a triple-dip recession.

Stagnation is automatically causing debt ratios to spiral upwards yet again across a large part of the currency bloc. The situation is doubly delicate since the European Central Bank is no longer able to serve as a lender of last resort for Italy, Portugal and Spain.

Germany’s top court has ruled that the ECB’s back-stop plan (OMT) “manifestly violates” the EU treaties, and is probably Ultra Vires. The political reality is that the OMT cannot be deployed, whatever the European Court says when it issues its own judgment long hence.

Any external economic shock at this stage risks exposing the fundamental incoherence of the EMU system, and therefore shattering the fragile truce in the markets.

Ambrose talks about the gamble taken by what he calls “EMU policy elites” but fails to mention the gamble taken by Draghi — that his Elk Theory would never be challenged.

So far, it hasn’t; but at some point Draghi’s going to have to stop clearing his throat and lay out some concrete steps — and THEN we’ll see just how effective he can be. My guess is that one of two things happen: the economies of Europe prove so weak that its politicians find a way around the “technicalities” of the Maastricht Treaty, which currently prevent them from printing money, and allow Draghi to unleash an inflationary blitz; or the market realizes that his words are hollow, and confidence in the ECB head (the only thing holding European markets together) is shattered.

That… would be ugly.

Already the pernicious effects of compounding are making their mark on the debt-to-GDP ratios of European governments, a point Ambrose makes quite clearly, using Italy as an example:

(Ambrose Evans-Pritchard ): Eurostat revealed this week that Italy’s debt rose to 135.6pc of GDP in the first quarter. This is near the point of no return for a country that borrows in what amounts to a foreign currency.

What is remarkable is that the ratio has jumped 5.4 percentage points over the past year despite austerity and even though Italy is running a primary budget surplus.

This is the toxic effect of near deflationary conditions on debt dynamics. Unless action is taken to boost nominal GDP, Italy must mathematically sink deeper into a compound interest trap.

Precisely, and it’s not just Italy that’s falling into this dreadful trap, as you can see from the chart below, which shows the YoY % change in debt-to-GDP ratios in Italy, Greece, France, and Spain:

There’s your austerity. Right there.

Greece didn’t waste any time getting back on the horse after their default restructuring wiped about 13% off their debt-to-GDP ratio in 2012, did they?

Make no mistake, folks, Europe is back — and not in the good way.

But it’s not just Draghi laying out Elk Theories.

Oh no.

Across the Atlantic, the continued narrative being spun by the Yellen Fed is one of “nothing to see here,” with a dab of “there’s no inflation,” a soupçon of “we will keep rates low for a very long time,” a dash of “everything bad that has happened can be put down to the weather,” and the merest suggestion of “these aren’t the droids you’re looking for.”

The Fed’s nemesis is inflation; and, over time, they (along with the BLS) have done everything in their power to paint a picture of benign inflation in order to further their agenda.

Take hedonics, for example.

For those of you unsure as to what hedonics (or “hedonic regression” to give it its full title) is, here’s the quick and boring dirty:

(Wikipedia): In economics, hedonic regression or hedonic demand theory is a revealed preference method of estimating demand or value. It decomposes the item being researched into its constituent characteristics, and obtains estimates of the contributory value of each characteristic. This requires that the composite good being valued can be reduced to its constituent parts and that the market values those constituent parts.

Bottom line?

If your new iPad has more features than your old one did, then even though the price went UP, the newer model is “technically” cheaper because of the extra memory/pixels/whatever. Look, it just is, OK?

In a NY Times article published in May, the miracle of hedonics was laid bare for the world to see, and the chart accompanying it (right) showed that the cost of a television set (thanks to hedonics) has somehow fallen 110% since 2005.

Remarkable.



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