Surely, the pressure has only piled on since I last wrote about this only a few days ago (see links above). The Financial Times' blog Alphaville in this case personified by Izabella Kaminska has steadily been supplying us with the latest on the unravelling in Latvia. A particularly good piece hammers down the point that it is not only freelance bloggers such as yours truly who are questioning the Baltic (Latvian) currency peg but also, now, most professional analysts close to the situation. This is a called a market discourse and although the commitment to maintain status quo may be there one cannot make the waters go back.

However and to be fair to all parties it does seem as if the Latvian authorities got the best of the discourse this week if, that is, being the last one to shout constitutes an upper hand in this case. Consequently, both the central bank and the premier minister Valdis Dombrovkis issued strong statements to suggest that the peg will hold simply because Latvia is committed to seeing this correction through.

Latvian Prime Minister Valdis Dombrovkis pledged to push through budget cuts and ensure the inflow of international loan payments as speculation grows the Baltic state may devalue, threatening the economy of Sweden. “These rumors and speculations should finally be stopped” about the devaluation of the lats, Dombrovskis, 37, said in an interview with Latvian Independent Television today. The currency will not be devalued, he said, and the country will pass budget cuts needed to get the next tranche of money.

This is of course all well and good, but one has the distinct feeling that all this merely constitutes the inevitable last launches before the opponent finally lands the kidney blow to send you crushing into the canvas.

In terms of a more thorough look at the Latvian situation which goes beyond the immediate plethora of market jitter you could do a lot worse than visit Edward's latest post on this issue. As he sets out pointing towards, overnight interbank rates rose to a record of 20% this week and it suggest more than anything the stress being levied on the system.

Another particular issue Edward deals with is the risk of contagion and essentially fallout from a devaluation in Latvia. Certainly, this is an important question in itself but I also agree with Edward [1] in the sense that the immediate plunge in other CEE currencies not to mention the Swedish Krona following a Latvian devaluation is not really the main issue here.

For the record, I see no decoupling and a Latvian devaluation would clearly force others to do the same, most notably I would think Lithuania and Estonia. As for the ripple effects towards the entire CEE edifice, they are likely to be substantial although not necessarily catastrophic. The real issue we need to understand I think is that that IMF program has problems and that this will become clearer and clearer as we move forward. Edward points to one very important data point in the form of a real effective exchange rate where numbers have just been published in 2008 format.

This gives a very clear image of the amount of down scaling the Baltics, and indeed many of the Eastern European Economies, need. It is important to understand that there is a level effect and relative effect here in the sense that one thing is to correct relative to one's own past level, and quite another to correct relative to others. Consequently, this is a chronic problem all across Eastern Europe and thus everybody has to correct. In this sense, the IMF are submitting those with pegged exchange rates to a dose of "medicine" which is simply too strong and which the domestic "system" cannot muster.

So, my feeling is that all this goes beyond whatever effect currency speculation would have in the wake of a Latvian devaluation/default. There are clear signs that the "exit strategy" from this crisis is not working and it is next to scandalous that the IMF/EU do not realize that while these countries certainly need a strong dose of "stick" to get themselves on the right track we need to ensure that they are not obliterated over the course of the next year. I mean, this talk about Euro adoption in 2012 is just so silly and counterproductive since who the heck knows where we are in 2012. Who knows, for example, where the Eurozone itself is in 2012. Really, I cannot stress enough how these road maps of convergence need to be rethought since there has been a structural break. We need a new plan and one which factors in the change in environment.

Moreover, I think we have established by now that the Eurozone is no magic potion and in fact faces a series of very severe tests on Spain, Italy not to mention the mental crush it will be when Germany does not recover because I can tell you; in terms of domestic demand she won't.  Basically as I see it, the option has always been to "let the CEE in", but that would also take a much stronger coordination on the fiscal side and essentially joint European financing through Euro bonds. At the moment, this is far to big a step for the gents in Frankfurt and Brussels to consider.

So, no decoupling in an immediate devaluation context, but more importantly, I tend to look at this more structurally than a simple question of how much the e.g. Forint and Leu will fall in the context of a Latvian devaluation.

At the end of day, this is a question of swallowing those camels and accepting the idea that the current solution being applied is out of touch with reality. Essentially, I don't think the parties involved quite understand the structural damage many of the CEE, and Latvia in particular, have suffered. As per usual I am implicitly referring to the importance of factoring in demographics but then again; it is absolutely amazing that none of the presumed experts here have not added this variable to the equation yet. As Edward says towards the end in his entry ...

That is, the simple fact of the matter is that there is no exit strategy. The programme simply doesn't work. It is "over determined", since whichever way you look at it, there is always one more problem than there is solution. Gentlemen. I think its time to give up. Honourably, but to give up. Come on out of the bunker, white flags and hands in the air will not be called for. There's a world out here waiting for you, it's on your side, and there will be a tomorrow.

I couldn't have put it much better myself, I really couldn't.

---

[1] - There is a surprise :)

The almost trivial outcome of today's council meeting in Frankfurt was actually the decision to push the main nominal interest rates down 25 basis points to 1%. If anything, risks to this decision seemed to come from the upside in the sense that all the talk of impending green shoots and second derivatives would make the ECB pause. What was always going to be much more interesting at this meeting would be whether the ECB would announce a series of those famous unconventional monetary measures, and if so; what they would be. In their comment leading up to today's decision, Danske Bank economist Frank Øland pointed out that he expected some form or measure of buying paper or assets. For my own part, I mused a bit on what the heck the ECB was saying in the first place conceding that talks about unconventional measures were indeed popping up in the statements of council members.

Consequently, the ECB brought three things to the table today in the form of longer term refinancing operations, the decision to let the European Investment Bank become eligible counterparty to the Eurosystem's monetary policy operations and most importantly a decision to, in principle, start buying covered bonds of which 60 billion euros was mentioned as the headline figure.

Now, all this about principles of course is open to a wide range of interpretations and Trichet certainly had to dodge a lot bullets at the press conference regarding whether this constituted quantitative easing or not. In the dying minutes of the conference Trichet himself used the words credit easing, and I will let be up to my readers to decide what this means. The president also snubbed FT reporter Ralph Atkins in his question of whether he was allowed to write that the ECB is printing money or, as it were, sterilizing the purchases. The more interesting bit here of course is why exactly the ECB would be buying covered bonds, of all assets. In order to understand this, you basically need to go to Spain and recount the story about cedulas hipotecarias, what they mean for the Spanish financial system and the stress her banks are currently suffering. Start with this one by Edward and then this, this, and this. And if that is not enough, you can go chew on the role of the German Phandbrief. Basically, I think there is a sound economic rational behind the ECB's decision to begins its asset purchase program on this front and whether we call it quantitative easing or not is of little matter I think. It will be most interesting next meeting to see what exactly the ECB is planning in the detail.

With respect to the economic outlook and the level of interest rates and its future change, we were served the regular bout of newspeak from the council which essentially is a reflection of the fact that the journalists were trying to get Trichet to pre-commit to an interest rate floor. Their endeavors were unsuccessful and in stead we got a rather conflicting message in the sense that while Trichet pointed out how 1% constituted no such thing as a floor, he also highlighted the idea that the current stance was appropriate and had also taken into account future weaker signals on the economy. In this light, we can only guess as to how forward looking the council believes the 1% nominal interest rate really is. Personally, I think that the extent to which the green shoots/second derivative punt continues the ECB will stand pat at its next meeting.

Economic Outlook

(click on graphs for better viewing)

Turning to the specifics of the economic situation the ECB rightfully recognised the severity of the situation in the introductory statement and pointed out that risks are still skewed to the downside even amidst green shoots.  It is rather obvious that the downturn is in full force and the recession is now also biting, as it were, on the real economy. This is most obvious from the quick deterioration on the labour market as well as the general slowdown in the real sector.

In terms of inflation, the message was a bit unclear in so far as I think the fundamental discourse is counter intuitive. There is a natural reason as to why this is though in the sense that the ECB would like to be worried about deflation at the same time as it wants to be adamant about anchoring inflation expectations and ever so pointing out that whatever unconventional measures taking are temporary.

There can be no doubt that the Eurozone is teetering on the brink of deflation but since this is also primarily a base effect from a very sharp reduction in commodity prices, the ECB is happy to stick with the standard argument that although inflation should turn negative in mid year it will rebound in subsequent quarters. The fact that headline inflation is adding negatively to the overall HICP can be seen from the negative sign of the graph plotting the spread between core and the main HICP index. it is interesting to observe how the ECB is now confident that energy prices won't lead to an entrenchment towards deflation when we all remember how the bank was terrified of second round effects from higher energy prices a year ago. Perhaps this asymmetry in the famed argument of nominal rigidities and how this may prevent the Eurozone from deflation is what disturbs me the most. Add to this of course that Trichet still maintains that the council is represent 329 million European citizens which apparently means that he does not see, or wants to mention, the fact that places such as Ireland and Spain are already well and truly bogged down in deflation. On the other hand of course, and given recent signs  that commodity prices are beginning to sneak back up, we should expect the ghost of second round effects to emerge once more.

Finally, it is interesting to look briefly at financing and credit conditions where it was noted by Trichet how lending to households and non-financial corporations are still falling. Also, if we look at the annual rate of growth in the much allured M3 measure it has also fallen back steadily. Now, just as I don't care much about the M3 when it running at 10+% I am not sure I care much now since the creation of money/deleveraging may have a life of its own beyond the M3.  Of course, as Danske Bank points out basing their analysis on the lending survey there may also be a second derivative here too, but this would only echo the general sentiment expressed by Trichet in the sense that whatever stabilization we are observing it is situated at very low if not negative levels.

Turning to the evolution of credit the picture is similar. The figure which is actually underestimating the trend because of the one year moving average clearly shows though how the flow as derived by the total stock is on a clear downtrend. In both Q4-08 and Q1-09, the evolution of the stock of household loans was negative. Moreover, Danske Bank's fine analysis of the lending survey suggests that a lot credit tightening is still clogged up in the pipeline even if the trough may have been reached. The interesing thing here will the extent to which the second quarter will see some improvement over a Q4-08 and Q1-09 which were clearly utterly abysmal. Note also that the chart to the right is an average which is of course ripe with generalizations. Basically, some economies such as Spain and Ireland are experiencing a much faster rate of contraction in credit than can be derived from this chart. Also and given the fact that this is after all a unique crisis, we really don't know much the overall stock needs to be capped before we are "done".

In summary, today was a quite significant meeting if there ever was one and the thing to watch is how the ECB will conduct itself in the covered bond market. As noted above, I am thinking cedulas and Spanish cajas as the main key words.

However, and with the recent rate meeting one is tempted to conclude that the ECB is now seriously committed to considering alternative measures and also, as it were, drastic measures along the lines of its peers at the Fed, the BOE and the BOJ who have all in their distinct way been engaged in QE for quite some time. In the recent print edition, the Economist provides a fine overview of global central banking in the midst of the current financial crisis; what has changed, whether there will be a "normal" again, and specifically whether central banks will emerge in new clothing, as it were, with new policy targets and objectives. I think these are some important questions since there is indeed a big risk that the edifice of central bank policy which has been built up during the financial crisis may turn out to be anything but temporary. And here I am not talking about the inflationist hobby horse that central bankers may be too slow to haul back the reigns when the economy picks up again, but more so about the fact that whatever trend we will observe in the aftermath won't be anything near the one markets and policy makers expect. Of course, the good old principle of falsification will help on this one as we move forward.

One way in which the ECB has so far differed from its peers can be seen from looking at the first figure in the Economist article where it shown how the ECB has certainly expanding its lending operations (and credit facilities), specifically in the interbank market, it has not yet entered the securities market to buy up debt and equity. Some of us has been surprised by this reluctance which, together with the fact that the ECB has been relatively shy in slashing nominal rates, means that the ECB has appeared lagging in its response. Now, there is nothing wrong with being different and there is certainly nothing wrong with applying different tools to a situation which you genuinely find different. However, as one friend to me pointed out a while back, the ECB's unique, and according to some brave and prudent, response to the crisis is now a liability rather than an asset, and one has to wonder whether that strategy hasn't been subject to revision for a while now.

Indeed, I would be unfair in omitting to mention the fact that the ECB has indeed continued to slash interest rates and that signs have emerged to indicate that the ECB may be more flexible towards non-traditional policy measures. However, if you look at the assessment of the central bank the risk of deflation is still not paramount. At the recent policy meeting where interest rates were lowered by 25 basis points to 1.25 Trichet consequently pointed towards risks being balanced and more specifically how he did not view dis-inflation as being the same thing as deflation. This suggests that the ECB is not yet ready to take steps similar to the ones being taken by the Fed, the BOE and the BOJ.

Trichet, a Man of Principles

The impending comparison in this relation is the one with the Fed and in a recent speech Trichet points towards three, well known, reasons why we should not compare the US and the Eurozone.

The first reason relates to the ECB's focus on the banking sector. Pointing to the fact that banking loans make up a substantially larger part in the Eurozone than in the US (as a percentage of GDP), the chairman defends the focus on easing bank credit issues. Moreover, and as a related point Trichet points towards the importance of small and medium sized companies in the Eurozone (SMEs) and how these companies rely heavily on banks. Far be it from me to disagree with an expert (and I do consider Trichet an expert here), but I would humbly submit the point this is not only a (credit) supply story. At this point it is very much a demand story and how those very same companies need to find investment opportunities beyond maintaining credit to smooth their short term expenses with whatever revenues they might have in prospect.

As a second reason Trichet points towards a higher risk associated with the housing market in the US and thus why the US' asset programs to purchase toxic housing assets should not be replicated in the US. Now, it is true that the wealth effect from housing is considerably higher in the US than in the Eurozone countries at large, but this is also as far as the argument goes. In essence, I really don't know what to say here, and quite frankly this is an embarrassing remark from the president. I mean, doesn't he know that Spain and Ireland are part of the Eurozone? Also the implicit narrative that Europe and the US differs because of the role of housing in the latter is extremely simplified. Take Eastern Europe for example not to mention my own country Denmark. In fact, if there ever was a call for a program to relinquish banks and credit institutions of bad mortgage assets it would be in the case of Spain. Add to this that the crisis exactly turned global the minute BNP Paripas revealed that they too would be suffering subprime related losses and after them a veritable tableau d'horreur has followed.

Thirdly and perhaps most popularly in this discourse, Trichet points to the mitigating effects of a relative high degree of price rigidities in a European context. The point goes that if prices are rigid on the downside, companies will have a harder time lowering wages and prices and thus provoking inflation. We could think of this as a structural hedge against a collapse into deflation and it is basically driven by the fact that if headline inflation did not spark core inflation growth on the up, it won't do it on the downside either. From the point of view of ECB policy however, this argument would be rather inconsistent since we all remember the horror of second round effects that the ECB tried to enshrine into markets as rates were raised back in 2006-07 to counter the increase in headline inflation. In this way, one would assume that such logic applied on the downside too and what is more, it is quite obvious that the deleveraging needed across the global economy need to be deflationary by very nature of the problem at hand. Trichet on the other hand is a man of principles and his remarks, in the context of inflation expectations, during an interview with Süddeutsche Zeitung brought a smile to my face.

But citizens can have full confidence that we will guarantee stable prices over the medium and long term. The 329 million citizens of the euro area are very clever. They would not improve their level of confidence and help restarting the economy if they had the sentiment that we were forgetting our primary medium term goal.

(...)

We should not confuse disinflation and deflation. At the moment I am speaking, we are experiencing very low inflation and in the months to come negative inflation due to the decrease of the prices of oil, energy and commodities, before it increases again at the end of the year. This is good for the purchasing power of households and is a correction of the high prices of the past.

It would be interesting to take a poll to see whether those 329 million souls really were as clever as Trichet thinks, whether they are imbued with the kind expectations assumed here, or whether they agree with the ECB overall main objective.

The ECB, a Hydra?

Meanwhile and although the President certainly seems to be keeping his discourse straight, it is not easy to get a handle of what exactly the ECB is planning as we move forward. One classic dichotomy in the context of ECB watching and one which is dearly loved by financial journalists is between Axel Weber, as a hawk, one the one side and e.g. Greek council member Athanasios Orphanides on the other. It is well known that the former on several occasions have argued against slashing the nominal interest rates below 1% whereas the latter has advocated for the ECB to engage in QE-like purchases of assets in the market place. Weber has even been quoted of arguing how the ECB should set a specific floor under how low the nominal interest rate could be slashed.

But, by no means is this only a Saxon-Hellenist skirmish.

Recently, Bloomberg ran a piece in which the Dutch and Belgian council members Noel Wellink and Guy Quaden were quoted of saying that the ECB could (potentially) serve up extraordinary measures as we move forward from the next meeting the 7th of May. On the economic outlook, it is also difficult to get a handle on what the council members think with some arguing how the economy is improving and some, on the other hand, voicing concern over downside risks to prices and economic momentum. Also, on the outlook for deflation, the opinions are many. Trichet is well known to hold the belief that we are not going to see deflation, but only dis-inflation which, in itself, is not detrimental and may even be good for households' disposable income. However, Wellink was also quoted by Bloomberg of saying that the longer this disinflationary process lingers, the higher the risk will be that we get into an unwanted situation.

Adding to the cacophony, executive board member Lorenzo Bini Smaghi recently pointed to the fact (get the speech here) that bringing interest rates close to the zero bound would risk distorting money markets as it could curtail interbank lending. Apart from constituting yet another voice in the wilderness of official ECB opinion makings, this is a point worth considering in the sense that financial institutions might swap what was otherwise a smoothly functioning interbank market for the soothing liquidity tap of the central bank. I think it is important to emphasise though that there is a big difference between short term and long term financing here, where one would assume the central bank to stay exclusively on the short end of the curve. In essence, Mr. Smaghi's speech is a well argued one, and I would not want to leave the impression that I am trying to present a picture of an ECB that is torn to a greater extent than is really the case.

However, it appears that I am not the only picking up the mixed discourses on the radar. Consequently, Bloomberg reporter Simone Meier has a piece which details how Trichet has decided to silence his fellow council members, at least as so far goes the measures taking during the next meeting the 7th of May.

European Central Bank President Jean-Claude Trichet has imposed a vow of silence on Governing Council members as they struggle to agree on what to do next to rescue the economy from recession.

Trichet asked council members last week to refrain from commenting on what new measures the ECB will unveil at its next policy meeting on May 7. Austria’s Ewald Nowotny confirmed the ban today, telling reporters in Vienna officials had been asked “in the name of the President not to talk about details before the May meeting.” Trichet said on April 27 that council members had agreed “not to give any further indications.”

Given the short overview above of the different voices, one can hardly fault the President for this initiative and as David Milleker, chief economist at Union Investment in Frankfurt is quoted of saying;

“They’ve created more confusion than clarity. The entire cacophony didn’t exactly give the picture of a united council in any case.”

This seems to be the point in a nutshell and in an environment where the uncertainty surrounding the ECB's strategy and play book is generally high, the confusion only increases.

Charting a Course

In many ways I think it is natural that the ECB, just as its peers, are finding it difficult to deal with the present circumstances. Nobody ever said that this was easy, but the ECB still leaves an impression that it really does not know what it wants and, more importantly, how it wants to get there. In the recent World Economic Outlook 09, the IMF heads of the description of the European economic edifice with the point that Europe is searching for a coherent policy response. The fund highlights how the severe stress that has built up in the financial system and in the real economy (especially in the context of the CEE) calls for coordination between fiscal and monetary policy. The niggle here is of course that, at present, this is difficulty achieved in Eurozone let alone European context. Moreover, the ECB's sole focus on price stability may be robbing it of looking at more flexible measures although of course, in relation to buying securities in the open market, it is not certain e.g. which countries' bonds it should buy. This is why I, and among others the IMF, have argued that Euro Bonds be considered.  

For me, there are two additional issues here. Firstly, I think the ECB is too dogmatic. Sure, you can call me excessively worried about deflation and you can argue that since we are currently sustaining a three month rally things are perhaps not as bad as they seem. However, I still believe that the myopic look on inflation expectations in the aggregate for the Eurozone as well as the idea that price stability in the long run follows naturally from anchoring these expectations constitute a severely miscalibrated compass to navigate the waters in which the economy finds itself at present. There is a fine balance between sticking to one's convention and adjusting to new circumstances, and the ECB is, in my opinion, leaning too much to former. Secondly, I think the ECB and the indeed Eurozone policy makers have a responsibility towards one the one hand, the CEE and on the other keeping the Eurozone in one piece.  I think that this responsibility should be conveyed very clearly in speech and action. You can always argue that measures already have been taking, but I think there is good chance (risk) that the whole European economic system needs a serious re-boot on the back of this crisis. Such re-structuring need to be intimately tuned to these two challenges which means that we need to be able to speak openly about them and not narrate anything in the context of one set of aggregate inflation expectations measures. If it is not, then we will truly be all at sea.

In response to my speculation that recession was impending, one reader wrote:

The yield curves are different today because so many central banks are buying long-term debt with their freshly created Yuan, Yen, etc. They do not express what they did in the past.

At that juncture, I was also pretty circumspect myself about the predictive power of the yield curve, given the conundrum, the "saving glut", and the Great Moderation. Ensuing events (e.g., worldwide recession) inspired Kavan Kucko and myself to write this paper (recently presented at this EABCN conference in Frankfurt). In the paper, we assay the predictive power of the yield curve for (i) growth of industrial production, and (ii) recession. Our key findings are:

• The term spread has significant predictive power when forecasting industrial production growth over a one-year time horizon.
• However, the predictive power for one-year growth is much weaker in the post-1997 period.
• Four out of six European models exhibited relatively high R-squared statistics when using data from 1998-2008 (and the adjusted R-squared actually increased in Italy and Sweden).
• The yield curve does have some predictive power for recessions (defined using ECRI criteria for non-US countries, and NBER criteria for the US).
• However, the predictive power is greatest for U.S., Germany, and Canada. Interestingly, in the latter case, the statistical significance of the term spread disappears when the short rate is included.
• We do not replicate Wright's (2006) finding that adding in the short rate improves the fit of the equation for predicting recessions.
• The yield curve is hopeless in terms of explaining Japanese recessions.

The detailed results are contained in the paper. Figure 1 depicts the slope coefficients estimated over the full sample period for each country, while Figure 2 depicts a goodness of fit statistics.

As remarked earlier, the probit models are not particularly successful in predicting recessions. Once again, recessions are best predicted in the U.S., Germany and Canada by the yield curve. But similarly, in the latter case, the significance of the yield curve is not robust to inclusion of the level of the short policy rate.

Unfortunately, given the small number of recessions in the latter subperiod, it's not possible to make clear conclusions regarding how the predictive power of the yield curve has changed over time.

Of course, these are preliminary results. In particular, it's not clear what lessons can be gleaned from the current yield curve for the US (and other countries) as the policy rates hit the zero lower bound. (On the other hand, Charles Goodhart argues that the yield curve has greatest power when uncertainty is high -- and I can't think of a time in the recent past where uncertainty has been higher.)

Moreover, as is obvious, we do not allow for some of the effects and complications laid out in this post by Jim.

Other current commentary on the yield curve: Cleveland Fed, [0] (!).

Update: 4/7 11:25am Pacific

My coauthor reminds me that it does appear that the probit models do better at predicting earlier in the full sample. Below are the estimated probabilities of recession in the succeeding 12 months, according the to yield curve (blue) and the yield curve augmented with the level of the 3 month interest rate (red).

Obviously, the discussion which we hope to initiate here comes in two phases. First, there is the question of whether or not the ECB should be considering QE at all? I am sure that there is plenty of people out there disagreeing with the sentiments expressed below. Secondly, there is then the issue of how exactly the ECB would conduct QE. Once again, I should warn you; this is a bugger and, at times, also somewhat technical.

---

Most sports coaches - irrespective of whether they work in soccer, baseball, rugby or even American football - have playbooks; small books or pads filled with notes, decision rules and strategies for each and every possible situation they can envision. Of course, in some cases the playbooks are mental rather than physical, but every good coach lives and dies by his ability to adapt and react to new and changing situations and in order to do this effectively what he needs above all is a good playbook.

So what has all this waffle about football, baseball and whatever got to do with the ECB and how it should respond to the Eurozone's "fluid and evolving" economic and financial crisis? Well, the point surely would be that whatever playbook the ECB works with (and it is sometimes pretty hard to see clearly which one it actually is) they do not seem to have included a section on what to do when interest rates finally hit the zero bound (not this month evidently, but maybe, or possibly the one after....as Bank President Trichet said after today's decision to reduce the rate to 1.5%: “We didn’t decide ex-ante that this was the lowest point that we could attain” ). Nor do the ECB seem to have a page which explicitly handles the currently fashionable state of the art set of tools known collectively as quantitative easing. And this omission may, as the zero bound looms and outright deflation threatens, turn out to be a rather large and unfortunate one. The question is, what exactly are we going to do if (or even when) the Eurozone as a whole enters a deflationary rather than a disinflationary dynamic, and even more importantly, what happens if price movements fall into deflation mode and stay there?

 But before we get ahead of ourselves, let's go straight to the horses mouth (as it were), and take a brief look at what it is exactly the ECB has been doing all this time in order to alleviate the credit crunch and reverse that depressing cycle of decline and deterioration which currently seems to hold the Eurozone economies so tightly in its grip. Speaking at the European American Press Club on the 20^th of February ECB President Jean Claude Trichet laid out in some detail the considerable variety of measures the bank has been taking since the crisis broke out in August 2007. Reading through the text of the speech, one major detail immediately strikes the eye, and depending on your point of view the omission is a more or less disturbing one.

The fact of the matter is that at no point in his entire speech does the Central Bank President get to mention (not even once) the effects the crisis has been having on the real economy. His entire attention is focused on measures that the bank has been taking in order to ease the crunch by improving funding conditions in the interbank market, and in particular he enumerates in some considerable detail all the various classes of credit the ECB has been making available to Europe's banks. Now, you could argue that this absence is hardly surprising given that Trichet was not invited to give a talk about the state of the European economy, but rather about the steps the bank was taking to address the impact of the financial crisis and the credit crunch. But this would be precisely the point, since at the present moment in time the two are inextricably intertwined, with the credit crunch driving the real economy down, even as the rising unemployment this produces sends risk sentiment in the banking sector to ever lower levels.

This being said, the more disturbing part of the whole speech is the sense of complacency it conveys, with the impression being given that Trichet by and large believes the ECB has things nicely under control with a nominal interest rate (then) running at 2% and that despite the awkward hurdles which may still lie out there in front of us, no extraordinary measures are needed. If this is the case, maybe someone needs to pick up the phone and give the gentlemen in Frankfurt Ivory Tower a call suggesting they take a long hard look out of their window to see just what is happening in the world that lies beyond.

Possibly some may feel that the dichotomy being made here is a false one since the ECB always held that the measures it was taking to normalize conditions in the interbank market were also de-facto intended to cushion the effects of the credit crunch on the real economy. However, using this argument in the current situation is not only misleading, it is also dangerously complacent. Put in more prosaic fashion; this is all soo pre H2 2008.

The facts of the matter are all now pretty much unequivocal, and really speak for themselves (or at least they should do).

• In the first place the problem in the banking sector and the wholesale money markets was never really the main issue. This, undoubtedly real, problem was merely the outward and evident symptom of a much deeper structural problem concerning how the whole (global) economy needed to deleverage, and how the systemic character of the money market breakdown would ultimately require government and institutional intervention on a large scale.

• Secondly the crisis has now very much become an economic and not simply a financial one. We won't belabour the reader here with all the gory economic details which you are all already so familiar with, but we would like to stress that it is now pretty evident that the global economy is taking a hit on the scale that has not been seen since the first half of the last century, and most specifically, since the years of The Great Depression. So this is not a matter to take lightly, even if some economies are hit worse than others. We should also not fail to take notice of the fact that, despite many early assurances to the contrary, while the United States is certainly busily fighting its own private economic demons, the locus of the crisis has now slowly but surely moved in Europe's direction, first via the Southern and Eastern periphery and then entering into that very bastion of the Eurozone itself - the German economy.


• This is not either the time or the place to examine all the chain-links and mechanisms through which crisis transmission operates, but we should all be aware that the force of the blast we are taking at the present time is such that the very foundations of our common economic edifice - of the Eurozone and even the European Union - are now at risk. When the simple act of transferring deposits from bank accounts in one member state to those in another (in order to speculate on the future stability of a currency) becomes (and by some multiples) a potentially more profitable investment opportunity than building a factory and creating employment then the seeds of financial crisis are well and truly sown, and action needs to be taken to prevent the implicit peril coming to fruition. We simply don’t understand how anyone can deny that this problem exists at the present juncture, and that something needs to be badly and urgently done to secure the foundations of our edifice before the worst is, by omission, allowed to happen. The economies of the EU and, in particular of the eurozone, need to see the return of profitable investment opportunities as an alternative to idle speculation, and the ECB has a key role to play in this process, by returning price stability, by stimulating growth possibilities, and above all by encouraging a return of confidence to our somewhat battered and beaten economic system.

In order to address the rather urgent task which now faces us we should not, in principal, exclude the use of extraordinary action and recourse to what have come to be known as "unconventional tools" on the part of the ECB. Indeed in the difficult battle which now confronts us, no door should be closed, and no stone left unturned. Yet, all of this still remains on the level of "in principle" and in theory. Since despite all the evidence, indeed the facts on the ground speak for themselves, which strongly suggests that the Eurozone now faces not only a strong disinflation process but the advent of outright deflation (as defined by a sustained period of price declines in the core HICP index, see here and again here) we are still wallowing around in hypothetical discussions with no one actually prepared to strongly push for a very rapid biting of the most badly needed bullet. Furthermore, a new problem now presents itself, since the wreckage which is rapidly piling up in Eastern Europe risks destabilizing the whole system through the deep financial linkages which exist between the banking system in the Eastern countries and those very Western banks which have already been beaten to pulp by equity losses and debt defaults in one corner of the globe after another.

Indeed, some of us would claim that once the wheels of the present train crash were set in motion a year or so ago it was not particularly difficult to see that the lions share of the problem would end up in Southern and Eastern Europe, and in this fashion would arrive beating and hammering at the doors of the ECB in the form of both a severe Eurozone recession and a near-systemic collapse in the economies of Eastern Europe. If there was a danger of a repeat of the 1990s Asian style contagion anywhere it was always going to be in Emerging Europe, as the Bank for International Settlements and those much maligned ratings agencies never ceased to point out.

However, if we come to look at the responses to date from the ECB, we find that these have in no way been either as drastic or as urgent as those initiated by counterparts like the Bank of Japan and the US Federal Reserve (or even, come to that, by the Bank of England and the Swedish Riksbank). In fact, far from reacting rapidly and vigorously, ECB council members have repeatedly voiced concerns about the dangers of letting interest rates drop too low too quickly, and even warned of the dangers of reproducing yet more bubbles. This "conjuring of demons" seems to us to be soo terribly Japan in the 1990s-ish.

In fact the whole crisis reponse and reaction process seems to have revealed more a feeling of confusion and disarray, than one of order and "everything under control". Back in December 2008, the councils self-proclaimed hawk, Axel Weber, was busy worrying us all with his discovery of the "horrifying fact" that lowering interest rates below 2% would have implied the application of negative real interest rates (citing the fact that inflation expectations at that point for the medium-to-short term were themselves hovering at around 2%. He seemed to be blissfully unaware that with economies like the German and Spanish ones registering annual contraction rates in the 5% region, negative interest rates might be just the recipe the doctor was ordering. Just over a month ago Greek council member George Provopoulos added his voice to the chorus, cautioning that there was only limited scope for further rate cuts (towards 1%), citing among other reasons his expectation that the Eurozone economy would begin to recover by the time we reached 2010. Specifically, he noted that while there was room for interest rates to go lower if the economy and inflation expectations were to deteriorate further, this would in no case imply a move towards 0%.

This view was reiterated some weeks later by Luxembourg's representative on the Council, Yves Mersch, when he stated that he was completely opposed to the idea of the ECB adopting a Japanese (or US) type policy of ZIRP (zero interest rates). The reasons normally cited for such continued caution were what one might call the "usual suspects" - namely that while inflation was expected to reach very low levels due to the drop in energy prices it would subsequently rebound in late 2009 (due to the so-called base effects), or that the economic outlook in the Eurozone was fundamentally different that in Japan and the US where the respective central banks had gone much further in the direction of aggressive monetary policy.

Most ECB watchers view the continuing cautious stance over on Kaiserstrasse with a growing sense of unease and bewilderment. In light of the daily slew of incoming bad news it has seemed pretty odd (to say the least) for the ECB to maintain its focus on measures which were clearly lagging the pace of economic development rather than trying to get out in front of the problem and head it off. In fairness, it does now seem that some members at least of the Governing Council may belatedly be moving closer to a recognition of the full scale of what we are up against. Recently, council member Guy Quaden pointed out that it was perfectly possible for the ECB to lower rates well beyond 2% and that, in his view, there were no taboos whatsoever. Such statements certainly constitute a starting point, but still perpetually create the feeling of "too little too late", and in fact have done little to persuade financial markets that the ECB is actually in control of the situation.

This problem was further highlighted at the February meeting when rates were kept on hold and where Trichet, in his usual charming manner, simply noted that ZIRP (and thus QE) had several inappropriate drawbacks, although he did not see fit (at that point) to go further, and elaborate on what he thought these were. The markets responded as might have been expected to such obfuscation, and the yield on two year German bunds was pushed to its lowest level since 1997. Symptomatic of the then prevailing "zeitgeist" was the statement of Austrian council member Ewald Nowotny to the FT that the ECB would not move into ZIRP as this would imply negative real interest rates, apparently not understanding that this may well be precisely what we needed given the strength of the contraction.

As BNP Paribas's senior economist in London, Ken Wattret, said at the time:

“We’re desperately spinning around to get a proper handle on the issue,” (...) “The worst-case scenario is that the ECB is hoping they don’t need to do things like this because the economy will pick up again. If that’s plan A, then that’s rather disturbing.”

Part of the problem here, of course and as ever, is that there is far from unanimity on the ECB Governing Council. With the stream of council members lining up to give their own personal views to Bloomberg in recent weeks, one might easily be let to utter that famous "would the real spokesperson for the ECB now stand up"! The latest "dissenter" in the long line who have been queuing up to expound on their "nuanced view" was Athanasios Orphanides, Governor of the Bank of Cyprus, who in a speech the 28th of January made plain his opinion that:

The suggestion that monetary policy becomes ineffective when rates are close to zero is a “dangerous” fallacy.

That this sounds vaguely reminiscent of the message which has long been coming across from the other side of the pond should not surprise us too much, since as Bloomberg reporter Ben Sils has pointed out, he is in fact a former Federal Reserve economist (who made a name for himself, apparently, by telling his superiors they were wrong, go to it Athanasios). Sils suggests that events are now moving rapidly on the Council (although not that rapidly, judging by this week's outcome), and that Orphanides might actually be the one emerging with the upper hand in the near term. And don't for a minute believe Orphanides is merely doing a bit of headline grabbing. There is a real theoretical argument behind his position, one which he, himself, elaborates in this paper which discusses how, in a deflationary situation, the central bank should attempt to steer expectations towards inflation by "promising" very low interest rates for an extended period of time. (For some considerably more wonkish material on all this, try the Lars E. O. Svensson paper from 2001 or Gauti Eggertsson and Jonathan D. Ostry's IMF paper on the importance of communicating clearly when you want to make a "credible threat of irresponsibility").

What are Others Doing Then?

With the ECB being so cautious and unsure about whether or not to engage in what has now become known as Quantitative Easing (QE to its friends, for a pretty detailed discussion of QE in Japan and the US try this post here) why don't we take a look and see just what the rest of them are doing.

Morgan Stanley's Stephen Jen had a very useful piece on the Federal Reserves' entry into QE in late November 2008. In the first place it is important to note that QE comes in two stages (although these will now need to be collapsed into one here in Europe given the looming deflation threat). The first stage is to attack the credit crunch, and when that attack fails (as it evidently has done, virtually everywhere) the second stage is to try to halt the slide into outright price (and then debt) deflation. In fact, for some time we have been operating a kind of modified version of QE in the Eurozone (without, of course, the presence of the "lower bound") based on a division of labour between the bank (which has ballooned its balance sheet in order to provide short term liquidity to the banking sector) and the national governments who (following the Paris meeting of October 12) have worked on the fiscal side with initiatives to try and move credit by guaranteeing bank loans or buying commercial paper. Now we are about to move into the second stage, which involves first and foremost trying to "steer" inflation expectations. According to Jen there are three key elements in any comprehensive system of QE.

• Communication policy is vital, in order to steer expectations and in particular in convincing market participants that short term interest rates will be held low for a prolonged period of time, even as governments print money on the fiscal side, and even at the risk of "monetising" the growing debt. The point here, naturally, is to try to thrust rather than jolt inflation expectations strongly into positive territory. Judging by all the yelps of pain we are hearing from US market participants about looming inflation Bernanke seems to be having some success here (at least for the moment), and it is a pity we are not able to say something similar about their European equivalents, who, it seems to us, are gradually being steered towards reluctantly accepting either deflation, or at the least very low inflation, as now more or less inevitable.


• The central bank can also increase the size of its balance sheet, and this is a tool that the Fed has been using extensively in an attempt to increase the money supply. For a visual illustration of the process, check out this graph . As for the mechanics, this piece by John Kemp is a good starting point. One significant way in which this can work is, as Kemp notes, by matching increased lending to financial institutions with an increase in deposits these same financial institutions hold with the Fed (a bit wonkish, but still).


• A central bank can also alter the composition of its balance sheet by purchasing securities in an attempt to directly affect the prices of financial assets. This measure is of course intimately connected with the previous point, since without the former there is no great likelihood that the latter will work. In fact, the ECB has already doing something like this for some time now, since it is not at all clear just how many of those assets currently parked over in Frankfurt (and which have been exchanged for liquidity) will ever actually get to leave again. In a general sense, there also seems to have been a rather radical change with respect to the kind of assets the central banks have been willing to accept as collateral for liquidity.

One of the basic cornerstones of QE that has so far been implemented both at the Federal Reserve and at the BOJ has been the aggressive expansion in the purchase of unconventional securities. This could for example be corporate debt as well as, in the US' case, agency and mortgage-backed securities (together with a veritable myriad of other assets). All of this marks a considerable evolution of the "traditional" QE measures (as practised during an earlier period in Japan) whereby the central bank engages in heavy purchasing of t-bills in order to "manage" the yield curve on the short end and thus allow the government to conduct fiscal expansion at lower cost. Effectively, what we have at the Fed and the BoJ is both an asset and a liability approach where the former takes the form of the central bank accepting the purchase of an ever broader range of assets while the latter takes the form of expanding excess reserves held by banks at positive interest rates.

So, What should and could the ECB do?

Well the answer to this question clearly depends on where you think the Eurozone's real economy is at right now. In particular, if you are willing to entertain the idea that the bank needs to bring interest rates near to zero and start operating a more aggressive version of QE then you also need to buy the idea that there is a significant and impending risk of deflation in the Eurozone. Basically, M. Trichet's recent comments to the effect that there is no present danger of deflation in the Eurozone seem to fly in the face of everything we have on the table in terms of economic data, and that we are still a long way from doing the necessary.

However, and in fairness to their point of view, we might start by taking a look at the various reasons which have been offered attempting to argue why it would be inappropriate for the ECB to engage in QE and why some continue to argue that the risk of inflation is still imminent. In order to get to grips with such arguments there is, of course, no better route than by listening to the ECB itself, but since its council members all too often simply offer us their own highly distinct form of newspeak, the following pieces (one by Robert Ophèle Deputy Director at La Banque de France, the other from Sylvester Eijffinger, professor at Tilburg University) are quite useful.

Ophèle rightly tries to highlight the distinction between deflation and disinflation, pointing to the fact that what we are currently experiencing is the latter and not the former. Judging by the recent data it is not certain that this view is entirely correct, but he does highlight an important issue in the sense that the key question here is the extent to which one expects rapid disinflation to turn into deflation.

Ophèle uses two arguments in defence of the idea that what we may currently be experiencing is disinflation and not deflation. The first is the fact that the current sharp drop in price levels mainly comes from energy and food prices, and are thus largely giving back the price gains that were so instrumental in driving global monetary policy only a year ago. The second is a much trickier issue, and concerns the degree to which nominal wage rigidity may actually be a virtue in the context of disinflation since it acts as a structural hedge against a collapse into deflation.

This is an extraordinarily powerful and, as it were, convenient argument for those who would defend the current posture of the ECB. In this context it is perhaps worth going back to all those endless disquisitions we were subjected to about the potential for those horrid second round effects as energy prices shot up ever higher and one might thus assume the argument to be a symmetrical one now that energy prices are dropping sharply. However, the presence of nominal wage and general core price ridigity might mean that wages and prices are not sent on a downward spiral by the negative energy proce shock and if one expects the downtrend in energy prices to be merely temporary then, arguably, the monetary stance should not be changed on this account alone.

However this argument may not be entirely valid in the current context. Firstly, it should by now be pretty obvious to everyone that the current correction will have to be deflationary in its consequences those economies in the Eurozone who have accumulated sizeable imbalances over the last eight years. This would then exactly suggest that whatever the trend in energy prices it is the forward looking trend in the core price index we should be looking at. However, Ophèle has an argument ready to hand even in this case:

We should recall that deflation is not possible while households and enterprises continue to expect price rises. This is incontrovertibly the case at the moment. Business surveys, measures derived from market rates, and forecasting experts surveyed by the ECB all point to five-year inflation expectations remaining anchored around 2% for the euro area as a whole.

Shall we run that one by again: deflation is not possible as long as inflation expectations remain positive? This is evidently wrong, since it is basically circular (since prices can't deflate because households don't expect them to, and households don't expect them to because they are running at x% a year), and it does serve to highlight the care one needs to take when interpreting those dreaded (rational?) expectations models. Basically, just because one expects inflation does not mean that you are going to get it and furthermore, expectations may change over time. It is a question here of which is the leading indicator and which the lagging one. There is much more evidence to support the idea that strong inflation expectations may, in some circumstances, be self fulfilling and fuel future price increases, than there is to support the idea that people always and everywhere don't get deflation because they are expecting inflation. That is, there is a certain asymmetry in the situation. During rapid economic contractions, where excess capacity tends to lead to sharp and unanticipated price reductions, it is far more plausible that expectations follow prices downwards, and this is what we suspect is happening now.

As ever when we have this discussion of expectations the time horizon is the problem. Ophèle is talking about 5 years horizons, and these implicitly embody a high level of uncertainty, especially in an environment like the current one. Quite simply, the key problem for the Eurozone is to keep the edifice together over the next 6 months, not to quibble over some kind of perceived steady state five years from now, and it is this much shorter time perspective which should be in the forefront of ECB thinking right now.

Turning to the case made by Sylvester Eijffinger, an even stronger argument is fielded against the deflation risk in the Eurozone since he not only believes the risk of deflation is slight, he actually thinks the risk of inflation is much higher than that of deflation. Like Ophèle, Eijffinger initially points towards the structural aspects of wage rigidity citing as authority European Union economy and Finance Commissioner Joaquim Almunia who has also advanced the idea that nominal downward wage and price rigidity constitutes a strong line of defense against deflation. This argument would seem to us to be a self defeating one, since if it is valid the future of countries liike Spain, Ireland and Greece within the Eurozone must come under an immediate question mark, since without such downward corrections it is impossible to see how they can ever hope to achieve the competitiveness their economies need in order to grow again. Further, it sees to us to be much more plausible that downward wage rigidity may be much more an issue than downward price rigidity, which means quite simply that as prices fall unemployment simply rises and rises as the recession deepens. In other words the difficulty people have in reducing wages simply means those very same people get sent home rather than working, and thew consequent drop in demand only serves accelerate deflation rather than avoid it. That it, this kind of argument, in a major recession like the one we have now, is totally and thoroughly false.

Basically, the whole problem here boils down to the tricky question of implementing a common monetary policy in the absence of a coordinated fiscal policy not to mention a unified treasury. In this sense and while it is straightforward to see that the Fed should buy US treasuries to conduct QE it is not entirely clear what exactly the ECB either can or should do. For one thing, it is strictly forbidden according to the ECB's own rules for the bank to enter the primary market to directly purchase securities (read print money) in order to finance fiscal deficits in any member country. Moreover, and if we assume that this small niggle could be dealt with; whose bonds should the ECB buy and how many from each country?

But what if, instead of directly purchasing individual country bonds the bank were to purchase EU bonds explicitly created for the purpose, and what if the produce of the same of those bonds were to be deployed by the commission across the Union to fulfil pre agreed objectives. But wouldn't those bonds be inflationary in their consequence? Of course, we would answer, that is precisely the objective.

Time to Add More Pages to the Playbook?

We realize that this has been somewhat of a whopper of a blog post and if you have made it this far then congratulations, since you obviously have a good deal more stamina than most. Our argument is fairly modest in its aims, since we are absolutely clear at this point that we do not have all the answers. What we have tried to do here is simply draw an initial tentative sketch of what the ECB might do to move forward towards a process of quantitative easing and we have offered some suggestions about how to do this. Clearly, not everyone will be ready to agree with the initial premise that the ECB should consider QE at all. Looking at the incoming data however this move does seem to be increasingly becoming a foregone conclusion even if the ECB itself is not ready to entertain the idea. As such we hope the ideas here expressed may contribute to a wider ongoing debate about what to do about Europe's present economic and financial crisis, and what kind of measures and tools we have available to deal with it.

Unfortunately, the ECB, and most recently and specifically bank President Jean-Claude Trichet, have been ardently defending a viewpoint based on the non-existence of deflation risk. Today's, decision to cut interest rates by 50 basis points constitutes nothing more than the expected (not even surprising us with a bold move down to 1%) and this on a day when the BoE seems to have accepted the severity of the UK situation as it bit the bullet and moved itself over to QE. We are not arguing here that the ECB should turn itself into some sort of a rubber stamping clone following blindly along a path laid down by its peers, but rather, that the ECB decision makers should reflect very carefully about the arguments which have lead others along the QE path, since quite frankly, at this point in time the ECBs "originality" is beginning to turn into a liability rather than an asset, and one really has to wonder just how much credibility the institution will have left as and when it really decides to jolt itself back into action. In particular, if it has through either inaction or negligence lead the countries in its charge into a negative deflation cycle, will it still have the credibility left to convince market participants that it has the ability to lead us back out of the mire, into the inflation and into the sun.

Towards a Common European Answer?

As I mentioned last week, Q4 was an absolute horror story in terms of European data with an aggregate Eurozone contraction of qoq GDP standing at -1.5% as well as cartoonish numbers from Eastern Europe. Unfortunately, the abyss does not seem to be any less daunting one week later and if anything, it seems that the chasm may have widened. Consider for example that Ukraine's economy contracted a full 20% yoy as measured by, an adimittedly dodgy, monthly GDP estimate. It should come as little surprise that the country is now being put into spotlight for a potential sovereign default. At least, the latest brief on Eastern Europe by Danske Bank goes a long way to convince me that the end may soon come for Ukraine. Not only do we have considerable insecurity about the proposed IMF package negotiated earlier this year, the rating agencies are also naturally on high alert. Here is Danske;

The ratings agency Standard & Poor's this week warned Ukraine it could face another ratings cut, saying it distrusted Ukraines ability to implement a crucial IMF deal. The agency said it could cut Ukraine's B foreign currency rating and B-plus local currency rating by one or more notches.

Hence Ukraine's commitment to adjust is wavering against a backdrop of contracting growth, es-pecially in the manufacturing sector (industrial production dropped an exorbitant 34.1% y/y in January), and the upcoming presidential elections in January 2010. Recently an IMF mission failed to sign off on a first review of Ukraine's performances under the USD 16.4bn IMF pro-gramme during a recent visit, sparking fears of non-implementation. Ukraine says it may approach other countries including Russia for additional financial help.

 

Yep, it does not sound good and the prospect of Ukraine betting on the whims of Mother Russia certainly cannot be accommodative for foreign investors' willingness to finance the ballooning current account deficit (well, they aren't of course which is also why the Hryvnia is collapsing).

Further afield in the context of Eastern Europe it seems as people are finally waking up to the fact that the unfolding mess will need a common European response. There are of course obvious political reasons for this, but also in economic ones since if something is not done to stop the whirlwind it is likely that the European banking sector will get dragged down too due to their exposure to Eastern European economies. Edward simply notes that we should let the east into the Eurozone now as well as he has forcefully argued why we need a common EU bond scheme to get to heart of the problem with the widening of financing conditions for Eurozone economies. And don't for a minute think that EU bonds to help Italy et al. issue bonds to pay to clean up the mess has nothing to do with the CEE. Basically, contagion works in mysterious ways sometimes and with the amount of direct exposure of European banks to Eastern Europe sovereign debt ratings and spreads could easily be hit by this.  Today, FT's correspondent Munchau chimes in with a similar point. Once again, I think it is important to point out that if we let things go their own way, the whole European economic system is at risk. This view is further given life by Morgan Stanley in their recent installment on the Polish economy which, as the biggest CE economy, is also riddled with the same weaknesses as its peers. I would especially note the following bit which is a general and important point ...

The notion that the euro area (mostly made up of Western European countries) can just ignore the issues ongoing in Eastern Europe is fundamentally flawed, in our view, for at least two reasons. First, Austrian (mainly), but also German, Italian and French banks have lent aggressively in the region, and have an interest in ensuring that CEE can see through the current downturn. Second, the trade linkages between the euro area and Central and Eastern Europe have expanded significantly over the recent years: the euro area now runs a €50 billion annual trade surplus with the CEE (CE + Baltics + Bulgaria), by our calculations.

Alas, how many times have I not hoped that Trichet and his fellow chums in Frankfurt would pay just a little bit attention to the unfolding tragedy to the East. So far, they have stayed firmly in the Ivory Tower, but I reckon that this will change.

And don't think for a minute that the clock is not ticking. Last week also brought the news that the Latvian government has chosen to resign. Now, apart from likely confirming Manuel Alvarez-Rivera's prediction that Latvia is headed for an early election it also brings up the question of where exactly that political stability and will the IMF called for in connection to their policy of maintaining the peg is. My feeling is that the IMF has its credibility firmly on the line here, and one has to wonder how this idea about the policies demanding a strong political consensus fits together with what we are observing.

And the going is getting increasingly tough in key areas;

Latvia, Estonia and Lithuania, facing a prolonged recession, say they will protect their currency pegs whatever the cost. That strategy may be as crippling as the alternative, economists say. The three-nation Baltic region is in its deepest crisis since breaking from the Soviet Union in 1991. Latvia, which spent $1.26 billion in 11 weeks defending the lats last year, was forced to turn to an International Monetary Fund-led group for a $9.6 billion bailout. Its economy may contract 12 percent this year, while Estonian gross domestic product may shrink by as much as 9 percent and Lithuania’s GDP by 4.9 percent.

Latvian Premier Ivars Godmanis resigned on Feb. 20 and Lithuania’s two-month-old cabinet is struggling to win over a skeptical electorate after the two nations suffered the largest street riots since independence last month. Keeping the peg “will likely mean a number of years of very low economic growth,” said Lars Christensen, chief economist at Danske Bank AS in Copenhagen. “Wages and prices will have to fall to reestablish competitiveness.”

One has to wonder why there is such asymmetry with respect to the economies in Eastern Europe? I mean, Ukraine and Russia has been devaluing like there is no tomorrow and also the Forint has taken a solid beating. Even though the two former might be outside the IMF's definition of political will and stability I think we should remember two things; one is that the economies who are now devaluing in nominal terms will be Baltics' main competitors for exports and secondly, the adverse effect of balloning debt and bankruptcies will also ensue in the context of deflation to restore competitiveness. No easy solutions here, but if the Baltics are not accepted de-facto into the Eurozone I still hold that they will need to devalue.

The coming week will be interesting not least in relation to how European leaders respond to the realization that this now actually, and without doubt, demands a solution in which nations just as banks may need to be bailed out.

Getting to the Heart of the Matter on the Global Economy

Leaving the travails of the Eurozone and her Eastern brethren for a minute I was also positively surprised by a couple of well put points by two of the big boys in relation to economic punditry. Let us begin with Martin Wolf writing about the lessons to be derived from Japan in a world of balance sheet deflation . Now, the first thing to dispense is obviously what a balance sheet recession is [1]. Well, the term originates from from economist Richard Koo and basically advocates that in situations like this, a strong fiscal stimulus is the most effective remedy. I tend to agree here, but I will leave that discussion for. Rather, I would like to turn the attention to one of Wolf's last remarks with respect to summing up the global situation (emphasis added);

It is, for this reason [see the article], fanciful to imagine a swift and strong return to global growth. Where is the demand to come from? From over-indebted western consumers? Hardly. From emerging country consumers? Unlikely. From fiscal expansion? Up to a point. But this still looks too weak and too unbalanced, with much coming from the US. China is helping, but the eurozone and Japan seem paralysed, while most emerging economies cannot now risk aggressive action.

Where indeed Mr. Wolf where indeed. Regular and perceptive readers will know that this is one of my main hobby horses in the context of the global economy. In fact, as recent as two months I, sort of, took the same Wolf to task on his piece on global imbalances in which he argued that credit worthy surplus nations should put into place measures to expand domestic demand. As I pointed out at the time this may be easier said than done especially because there are underlying structural reasons as to why surplus nations cannot easily ramp up demand to suck up excess global capacity. I am happy to see Wolf framing the situation as he does here because it means, in my humble opinion, that it brings us one step closer to the understanding of what the heck is going on here.

Adding to the choir Paul Krugman also joins in on Koo and Wolf and apart from the standard fiddle about the importance of fiscal policy (which I agree with, remember) Krugman also makes another point. Quite simply, Krugman points towards the well known fact that whatever recovery Japan has had since 2000 it has been all about exports (and foreign asset income); and at the end we get this:

And needless to say, we can’t all export ourselves out of a global slump.

So, how does this end?

Needless to say I cannot answer the last bit, but I do think that we are making progress here since apart from a poor little graduate student (in applied economics of all atrocities) some of the big ones are making some crucial points about what exactly the underlying structural dynamics are here (hint: demographics!) Here is to hoping that the thinking is being stimulated across the board.

[1] For some wonkish background on balance sheet recessions and where it comes from, Oxonomics has some further info here.

“October is at last ending - the worst month in commodity history,” Eugen Weinberg, an analyst at Commerzbank AG in Frankfurt, told Bloomberg. “Investors are expecting lower growth for the longer term and that is putting prices under pressure.”

The news came one day after the revelation that the U.S. economy shrank 0.3% in the third quarter, and on the very same day that the government announced consumer spending tumbled 0.3% in September - meaning the world’s largest economy is struggling…

Volkswagen’s Frankfurt-traded shares soared as high as $1,258 (1,005 euros) before closing at $1,186 (918 euros) yesterday.

On Monday, Porsche SE (PINK: POAHF) announced it had acquired options on 31.5% of Volkswagen’s stock, in addition to the 42.6% direct stake it already controlled. With the German state of Lower Saxony controlling another 20.2% of Volkswagen stock, that left a very small amount of shares available for short-sellers who had bet on a decline in Volkswagen’s share price - given the poor outlook for the global auto industry - to…

Austria, one of Europe’s stronger economies, cancelled a bond auction on Monday in the latest sign that European governments are facing increasing problems raising debt in the deepening credit crisis.

Market conditions have steadily deteriorated in recent days with the best gauge to credit sentiment, the iTraxx investment grade index, which measures the cost to protect bonds against default in Europe, widening to more than 180 basis points, or a cost of €180,000 to insure €10m of debt over five years, on Monday.

The eurozone countries will raise €925bn ($1,200bn) in 2009, according to Barclays Capital. The UK, which is expected to increase its bond issuance from the current €137.5bn in the 2008-09 financial year, will take the figure above €1,000bn.

``The resources of the IMF may not be sufficient for wider bailouts if needed,'' said Vivek Tawadey, head of credit strategy at BNP Paribas SA in London. ``If it can't raise the money, some of the more distressed emerging markets could end up defaulting.''

Gordon Brown on Tuesday spearheaded calls for a multi-billion pound "bail-out fund" to prevent the global crisis spreading to more countries, and warned of the need to stabilise economies "across eastern Europe".....

The prime minister on Tuesday urged the oil-rich Gulf states and China to provide "substantial" funding to the International Monetary Fund, before flying to France for talks on an increase to the European Union's bail-out fund. The government is keen to emphasise the link between global action and domestic voters' interests, as well as portraying Mr Brown as a world leader.

The prime minister said it was "in every nation's interests and the interests of hard-working families in our country and other countries that financial contagion does not spread". While he did not rule out the UK making a contribution, he insisted the "biggest part can be played by the countries that have got the biggest [balance of payments] surpluses".

The IMF's $250bn (£158bn) bail-out fund "may not be enough" to prevent the crisis destabilising more countries, Mr Brown said. His spokesman added the UK was "looking at a figure in the hundreds of billions of dollars" for the IMF. Mr Brown called for "action on this new fund immediately".

Germany plans to finance part of its 500 billion euro ($636 billion) bank rescue package by issuing bonds to banks in exchange for new preferred stock, according to Finance Agency head Carl Heinz Daube.

``The banks will not be allowed to sell the injected government bonds,'' Daube said in an interview in Tokyo today. ``So far there's obviously not a huge demand for any rescue measures, but this might change in the coming weeks.''

Germany's rescue plan, approved by lawmakers on Oct. 17, amounts to about 20 percent of the gross domestic product of Europe's biggest economy. Chancellor Angela Merkel's administration pledged 80 billion euros to recapitalize distressed banks, with the rest allocated to cover loan guarantees and losses.

....Hypo Real Estate Holding AG, the Munich-based lender that's already had a 50 billion euro bailout, today asked the Deutsche Bundesbank for 15 billion euros to cover short-term liquidity needs. ....Frankfurt-based Deutsche Bank AG may also need 8.9 billion euros of new capital, more than any bank in Europe, Merrill Lynch & Co. analysts Stuart Graham and Alexander Tsirigotis wrote on Oct. 20.

The bailout plan is still being discussed in Berlin and more information will probably be released at the end of this week, Daube said.

Germany may meet additional funding needs for its bank rescue by selling six-month bills before examining options for borrowing using longer-term securities, Daube said. The government plans to offer between 212 billion euros and 215 billion euros of debt through its 2009 program, about the same as the 213 billion euros scheduled for this year.

The debt-for-equity swap will probably have ``next to no effect'' on the country's yield curve because the notes offered to banks won't trade in the so-called secondary market, he said. The yield curve plots the rates of government bonds according to their maturities, and increases indicate higher borrowing costs.

``The government deficit of course will increase, the outstanding volume of bonds will increase as well,'' Daube said. ``The number of outstanding bonds available in the secondary market will stay exactly the same.''

Survey underlines grim outlook for eurozone

By Ralph Atkins in Frankfurt, Published: October 24 2008 11:23 | Last updated: October 24 2008 18:37

The eurozone economy contracted sharply in October as the global bank crisis slammed the brakes on business activity and blackened the outlook for the 15-country region, a closely watched survey indicated on Friday.

The steep fall in eurozone purchasing managers' indices, which showed private-sector output falling at the fastest rate since the launch of the euro in 1999, suggested the region was facing prolonged recession-like conditions, which could last well into next year.

But economists warned that the full effects of tighter credit conditions on business and consumers may have yet to feed through, and that expected cuts in European Central Bank interest rates could fail to revive growth.

The "composite" purchasing managers' index, covering manufacturing and services, slumped from 46.9 in September to 44.6 in October, the lowest since the survey began a decade ago.

"The financial crisis has developed rapidly into an economic crisis, with the eurozone economy contracting at the fastest rate for over 10 years," said Chris Williamson, chief economist at Markit, the research company that produces the survey. The indices are regarded as offering a good guide to trends in economic activity, providing a more up-to-date snapshot of activity than gross domestic product data. An index figure below 50 is taken to indicate a contraction in activity.

They showed eurozone manufacturers' new orders fell this month at the sharpest rate ever recorded, led by a slump in export orders. Service sector new business did not contract as fast but still saw the second steepest fall on record. Eurozone employment has fallen for four consecutive months.

The scale of the deterioration suggested several factors had combined into a lethal economic cocktail. Eurozone growth started to slow last year as a result of a stronger euro, higher official borrowing costs and then surging oil and commodity prices. "What I fear at the moment is that you have a natural progression from the downturn that was already in place with the extra hit from the financial market crisis ... It has exacerbated problems that were already there," said Mr Williamson.

...

The impact of this data can be seen in revisions to the outlook. I don't have access to consensus forecasts for Europe, but I can plot the outlook from DeutscheBank's forecast from yesterday, and from before the financial crisis.

So, it seems the world has re-coupled, partly because of common shocks emanating from the financial crisis.

Addressing the European Parliament, President Sarkozy implored his European contemporaries to embrace the current period of economic upheaval as an opportunity to restructure the global financial system. According to the Daily Telegraph, he also articulated the concern of many Western authorities that sovereign wealth funds, located primarily in Asia and the Middle East, could use their massive cash reserves to scoop up key foreign assets at extraordinarily…

"The Kazakh government is ready to step in,'' Kazakhstan's Prime Minister Karim Masimov said this morning in a telephone interview with Bloomberg "The Kazakh banking system with the support of the government and central bank will fulfill all obligations to international investors.....We have our own specific plan to survive without any external support....I don't think we need support from the International Monetary Fund or overseas.''

Ranked as the ninth largest country in the world by size, it is also the world's largest landlocked country, with a territory of some 2,727,300 km² (which is greater than the whole of Western Europe). It is bordered by Russia, Kyrgyzstan, Turkmenistan, Uzbekistan and China. On the other hand, and despite its enormous size, Kazakhstan has a comparatively small population. No one actually has an exact idea of the actual size of the Kazakhstan population (not to mention the thorny issue of just how many foreign migrants live and work there), but the US Census Bureau International Database list the current population of Kazakhstan as 16.763 million, while sources drawing their data from the United Nations (like the IMF which I have relied on for the chart below) give a 2008 estimate of 15.135 million. In any event the current population level, after falling in the early 1990s as ethnic Russians left, has now stabilised, and is virtually stationary. This virtually stagnant population constitutes, as we will see, a significant problem for a country with such a massive resource base, and such enormous economic and development potential as Kazakhstan would seem to have.

Record Oil Revenue Boom

Kazakhstan is the biggest energy producer in Central Asia and the country's $100 billion economy has in fact grown at an average of 10 percent a year rate since 2000 (see chart below), in particular as the price of oil has surged. This rapid GDP growth produced a rapid increase in per capita income as well as national creditworthiness, and these in turn sparked in their wake a substantial construction boom. Indeed it has precisely been the bursting of this boom in the autumn of 2007 - on the back of the seize-up in global wholesale money markets which followed August's financial turmoil in the USA - which lies at the heart of Kazakhstan's current growth slowdown. Kazakhstan's economy expanded at a 'mere' 5.3 percent rate in the first quarter of 2008, half the pace achieved in the same period a year earlier, following a dramatic curtailment in bank lending, and if Kazakhstan is still able, despite all the problems we will see below, to maintain some sort of growth momentum at this point it is undoubtedly the result of the oil and other commodity resources which the country has at its disposal, and indeed as part of its initial response to the present crisis the country increased crude production by an annual 6.3 percent in the first four months of the year, according to official government data.




Now one of the most curious details about the present slowdown in Kazakhstan, has been the fact that at the very same time as the economy started to lose velocity the central bank found itself busy struggling to curb an inflation rate which was steadily shooting onwards and upwards towards the outer stratosphere, as revenue from record oil prices pushed up domestic demand, and the resulting construction and consumption boom drove up wages far beyond normal "productivity-gain" rates of increase (remember, there are not THAT many people in the country, and much of the population is rural and unskilled in relation to the needs of a modern technological and services economy). In fact inflation hit year-on-year rates of increase approaching 20% in the autumn of last year (see chart below), although it had dropped by to an annual 18.2% by September.




So, as well as containing the property bust, the Kazakh authorities have also had to conduct an inflation fight (more details below). So far from lowering rates like the US Federal Reserve has been able to do, Karakhstan's central bank was forced to raise the key interest rate to 11 percent in December 2007, at a time when annual inflation was riding at almost 19 percent, the highest for the country in over eight years. The refinancing rate was then maintained at the 11% level until it was finally lowered to 10.5% at the last central bank meeting in July.



Not Just Energy - Vast Resource Potential

The fact that Kazakhstan's industrial output growth has lost a lot of momentum in 2008 as the slowdown in the building industry provoked a slump in cement and other materials production should not take our minds too far away from the fact that the underlying potential in Kazakhstan is enormous. In fact while industrial output growth was reduced to an annual 3.8 percent growth rate in the January-June period, it was at least still growing.

The low point seems to have been hit back in January, when cement production which, not surprisingly, was among the hardest hit sectors, was down 26 percent year on year, the sharpest January fall in five years, as growth in the construction industry stalled, brought to a halt by the fact that the Kazakh banks, who had been struggling to borrow from abroad following the collapse of the U.S. subprime mortgage market, virtually stopped lending to homebuyers and builders.

Copper and rolled-iron output also declined an annual 13 percent in January while output from oil refineries and manufacturing industry decreased an annual 2.9 percent as the problems rolled in. Thus there is evidence of a very sharp shock initially hitting the local economy. On the other hand, since the country is resource rich and the given that first half of 2008 saw a very significant global commodities boom, there were other economic sectors to fall back on, and mining production was up 6 percent from a year earlier in the first quarter, bolstered by an increase in natural gas and coal output, which climbed 15 percent and 11 percent respectively. At the same time crude oil production went up by an annual 5.4 percent.

Apart from oil and gas Kazakhstan has a huge array of potential resource reserves just waiting to be tapped. Among these there is copper. London-listed Kazakhmys accounts for the bulk of Kazakh copper output - and this was down 17.5 percent year-on-year in January-April. Industrial output in Karaganda region, home to Kazakhmys and Arcelor Mittal mines and smelters, declined 5.5 percent year-on-year in January-April.

Kazakhmys reported that their first-quarter output fell 9.9 percent on "severe winter weather'' and repairs at its Balkhash smelter. Production of finished copper plates, or cathodes, from the company's ore fell to 75,500 metric tons, from 83,800 tons a year earlier. These drops in output are, of course not entirely associated with the credit crunch, but they do give an idea of the challenging and volatile environment in which the mining and extraction industries work in Kazakhstan. Realistically speaking it seems quite likely that output in these sectors will return to more normal levels during the second-half of 2008, having alreadt rebounding significantly from the low point reached in the first-quarter.

On the other hand industrial output in capital Astana and commercial hub Almaty, where most construction activities are based, was down 13.2 percent and 8.6 percent, respectively, in January-April, and this activity may well take much longer to recover.

Kazakhstan has also had to cut its 2008 oil production forecast to 67.6 million tonnes (1.35 million barrels per day) from a previous estimate of 70 million tonnes citing maintenance works and transport bottlenecks. The country is able to produce a lot of oil, but it does have a large problem getting that oil to the places where people want it. Three major pipeline routes - the Atyrau-Samara and Caspian Pipeline Consortium (CPC) links to Russia, and the Atasu-Alashankou pipeline to China - carry Kazakh crude off towards its end destinations, but none of these are proving sufficient to the demands on them.

"It is impossible to transport crude out of Kazakhstan without some difficulties," Senior Associate Klara Nurgaziyeva from law firm Dewey & LeBoeuf told an oil and gas conference last week in the Kazakh financial capital Almaty.

In a smoke-filled bar in the Kazakh financial capital Almaty, the laughter of Scottish ex-pats is loud and boisterous. More than three thousand miles (5,491 km) separate the Scottish Highlands and the Central Asian steppe, but a mutual interest in oil and gas has created a surprising alliance. Residents estimate that around 400 Scots live in ex-Soviet Kazakhstan, a resource-rich country roughly the size of western Europe.

Most come from Aberdeen, Britain's northeastern oil hub, and they bring with them their technical expertise."We're going to try attract Kazakhs to Aberdeen over the next few years and look at initiatives, and create further investment in Scotland from Kazakhstan," Lord Provost Peter Stephen of the Aberdeen City Council told an energy conference last week in Almaty. He said over 100 companies from in and around Aberdeen are active in Kazakhstan, and the Scottish oil town even has a Kazakh consulate to serve the hundreds of Kazakhs who go to Scotland to train up for the oil business. The Kazakh-British technical university, set up by a group of Scottish universities seven years ago, occupies a grandiose columned building in the centre of leafy Almaty, which housed parliament before the capital was moved to Astana.

Prices for residential property soared 30.2 percent in 2007, reaching a record average mid-year high of 161,300 tenge ($1,338) per square meter, up from 123,900 tenge in 2006, according to the Astana-based state statistics agency. In the financial capital, Almaty, the average price was 345,200 tenge.

The drop in prices from these peaks and the sudden drying up of credit has caused numerous problems for would.be buyers, and Bank TuranAlem, Kazakhstan's second-biggest bank by assets, received $81.2 million last December from the state emergency investment program simply to finance the completion of unfinished construction projects.

The most recent government bailout of the construction sector was announced during the summer - just two weeks before the celebrations of Nazarbayev's 68th birthday and the 10th anniversary of the founding of the new capital Astana on July 6 - following the announcement by a group representing people who had purchased apartments in the unfinished buildings that they were planning a protest march to be held in Astana bang in the middle of the official festivities.

The Industry and Trade Ministry have said that there were 939 residential buildings, with 45,130 apartments pre-paid by homebuyers, under construction as of last January. Minister Edil Mamytbekov said in July that the cases of 4,558 homebuyers in 18 buildings "remain problematic'' because of conduct for which the builders in question had been "charged with crimes.'' The Kazakh Prosecutor General's Office said 123 construction companies that received 104 billion tenge ($865 million) in pre-payments from homebuyers were behind schedule or haven't even begun work on new apartment buildings.

Assets of "careless construction companies,'' including buildings and vehicles, have been seized to compensate lost investments of homebuyers and the government, according to the Prosecutor General's Office. Criminal investigations have been opened into eight companies. A total of 285 companies are building 407 residential projects in Kazakhstan and have received 231 billion tenge in pre-payments from more than 50,000 individuals and companies, prosecutors said. Of 200 ``problem'' projects delayed by at least six months, 110 are located in the capital Astana and 42 in Almaty.

The July rumpus was provoked by the fact that at the start of the summer the Kazakh government had spent only 51 billion tenge to complete stalled residential projects, a fraction of the bailouts promised by Prime Minister Karim Masimov in the autumn of 2007, according to data made public by the Ministry of Industry and Trade on June 23. The government had said on Nov. 14 2007 that it would spend $1 billion by the end of 2007 and another $3 billion in 2008 to "provide economic stability and growth'' by supporting the real estate market and small and medium-sized businesses. Following publication of this data, and some international press coverage, Masimov said that his original emergency investment program was in the process of being expanded, and his government announced plans to spend 17.2 billion tenge to complete residential projects in Astana.

President Nursultan Nazarbayev instructed the state to step in and finish projects, ``which have no source of financing,'' to ``help to reduce social tension,'' according to Edil Mamytbekov, a deputy minister of industry and trade, on June 20. President Nursultan Nazarbayev also said it was necessary to take ``tough measures against careless builders". As a result the Almaty mayors office announced on July 26 that another 46.4 billion tenge had been allocated to support residential projects in Almaty. The state had already invested 22.4 billion tenge and was going to spend the remaining 24 billion tenge by year's end, according to the announcement.

In April, however, the government had announced that the state development holding Kazyna would distribute 59 billion tenge to commercial banks during 2007 to finish 131 buildings in Almaty. Sergei Kuyanov, spokesman for Almaty Mayor Akhmetzhan Yesimov, declined to comment on the discrepancy between the numbers when question by journalists in July.

Whatever the complications of the present situation and the ins-and-outs of putting the construction and banking problems straight, we should not lose sight of the fact that Kazakhstan has, large financial resources which will surely help it weather the current situation. Official foreign currency assets totaled $46 billion in early June, comprising NBK reserves of $21 billion and oil fund (NFRK) assets of $25 billion. Commercial banks also have foreign assets of which about $3.5 billion are thought to be liquid. Total foreign assets broadly match foreign liabilities when the intracompany debt of the oil sector is excluded, while liquid foreign currency assets comfortably cover potential short-term foreign currency drains.


Favourable Demographics But Migrants Needed, And With Them Modern Citizenship Rights


The chart you will find below is known as a “heat chart”. It depicts the ongoing changes in Kazakhstan's age structure. Each dot represents the number of people in any given age group at any given point in time. A dark red dot represents the largest concentration of people, by age, in a particular year while deep blue dots show the lowest concentrations. A single dark red dot is the equivalent of almost 406,000 people while each deep blue dot represents nearly 23,000 people.


In the upper left-hand corner of the chart the bright reds and yellow areas depicts the population boom that started in the mid 1970s and lasted until the late 1990s. The remnants of that boom extend downward from left to right across the chart. The band also narrows as this population segment ages. This is simply a reflection of the reduction in the total numbers in the population bulge cohorts as out-migration has taken its toll.

Many ethnic Germans and Russians, for example, left Kazakhstan during the years following the end of the Cold War. In the lower left-hand side of the chart there is a preponderance of dark blue dots, indicating a relatively small number of people over the age of 60 years. Over time these dark blue dots are replaced by light blues and greens, a pattern reflecting a gradual but steady increase in the number of elderly people.

The strong budget position in Kazakhstan has provided scope for the government to use fiscal policy to support the economy as growth has slowed. We believe that the increase in spending in the recent supplementary budget is appropriate, and that the automatic fiscal stabilizers should be allowed to work, with any revenue shortfalls due to a weakening economy being accommodated in the near future rather than offset with expenditure cuts to meet budget targets. Going forward, the government's recently announced three-year budget plan maps out a transparent path for fiscal policy over the medium-term. We believe, however, that it is important that the government not commit to further large increases in public sector wages and pensions in future years given uncertainties about budget revenues—particularly from the oil sector—and the stage of the macroeconomic cycle in two or three years time.

Kazakhstan has large financial resources to help it weather the current situation, and medium-term economic prospects remain favorable. Official foreign currency assets, comprising central bank (NBK) reserves and oil fund (NFRK) assets, reached $48 billion at end-September, well above the mid-2007 level. The current account balance has strengthened significantly this year, and oil production is set to increase substantially in the years ahead.

As at the time of the Article IV consultation discussions in April, we believe that in the short-term policies should remain focused on managing risks to the outlook and setting the stage for the resumption of strong and sustained growth. Since our last visit, the authorities have continued to skillfully handle the difficulties the economy has faced, and we welcome the policy steps that are being taken in the monetary, fiscal, and supervisory areas to strengthen the resilience of the Kazakhstani economy. Nevertheless, considerable challenges remain, and these have been heightened by the renewed bout of global financial market volatility.

UniCredit SpA surged after Libyan investors including its central bank boosted their stake in Italy's biggest bank and said they will invest more. The shares gained as much as 12 percent to 2.42 euros in Milan, valuing the bank at 32.2 billion euros ($42.4 billion). Libya's investment is ``good,'' UniCredit Chief Executive Officer Alessandro Profumo told reporters in Milan. ``It's a confirmation of their interest in our company, which they also consider to be very attractive.''

The investment may be worth much as 1.3 billion euros, according to a note by Centrosim analyst Marco Sallustio published this morning. It could allow Libya to obtain a seat on the bank's board. Central Bank of Libya, Libyan Investment Authority and Libyan Foreign Bank bought shares to boost their holding to 4.2 percent, the investors said in a statement late yesterday. They intend to buy as much as 500 million euros of securities that UniCredit plans to sell over coming months.

- - UniCredit is one of Europe's top 10 banks by market value, with a capitalisation of about $39 billion. It is second to Intesa Sanpaolo SpA among Italian banks.

-- In a U-turn on Oct. 5 it announced plans to boost capital by 6.6 billion euros. It will ask investors for 3 billion euros in a capital increase and offer shares rather than a cash payout on 2008 results, putting 3.6 billion euros instead in its own coffers.

-- UniCredit on the same day boosted its target for Core Tier I to 6.7 percent at the end of 2008 based on Basel II requirements from its previous aim of 6.2 percent. The figure was 5.7 percent at the end of June.

-- It also slashed earnings per share forecasts for this year to 39 euro cents from around 52 euro cents previously.

-- It is the Italian bank with the most foreign exposure. UniCredit gets about half its revenue from outside Italy and its conservative lending market.

-- UniCredit, whose units include Germany's HVB, is among market leaders in Germany and Austria.

-- UniCredit's share price has dropped about 62 percent since the start of the year, pushing it second to Intesa Sanpaolo among Italian banks. The DJ Stoxx European banks index has lost about 52 percent.

-- First-half net profit was 2.9 billion euros on operating income of 14 billion euros. Deposits from customers and debt securities totalled 639.8 billion euros.

-- The bank traces its origins back to 15th century Bologna. The current UniCredit resulted from the merger of nine of Italy's biggest banks in 1998, as well as the purchase of HVB in 2005 and Italy's Capitalia last year.

-- The biggest shareholder is the Fondazione Cassa di Risparmio di Verona Vicenza Belluno e Ancona, at 5 percent.

-- Libya now comes second with its combined 4.23 percent, followed by:

Fondazione Cassa di Risparmio di Torino with 3.83 percent

Carimonte Holding with 3.35 percent

Gruppo Allianz with 2.37 percent

Fondi Barclays Global Investors UK Holdings Ltd with 2.01 percent.

-- UniCredit is the biggest shareholder in powerful investment bank Mediobanca SpA with an 8.7 percent stake.

Italian Prime Minister Silvio Berlusconi pledged $5 billion over 25 years to Libyan leader Muammar Qaddafi in compensation for the occupation of the country in the 30 years before World War II.

Italy will pay $200 million per year to Libya in the form of investments in infrastructure. The money will finance the construction of a coastline highway that runs about 1,600 kilometers (994 miles) between the Egyptian and Tunisian borders.

``It's a full moral recognition of the damage done to Libya during Italy's colonial period,'' Berlusconi said after arriving at the airport in the Libyan city of Benghazi, where the two leaders met to sign the accord. ``This will end 40 years of misunderstandings.''

In a deviation from the measures seen in France and Germany, Italy has not created a fund for its rescue plan, with Finance Minister Giulio Tremonti stating that, "As of today, we estimate that it's not necessary to have a predetermined figure."......Italy is in stark contrast to other European nations by providing no firm capital commitments; however, the government's reluctance to create a rescue fund could partly be a reflection of the restraints imposed by its substantial public debt, which stood at 104% of GDP in 2007.

The Bank of Italy will also engage in a 40-billion-euro debt swap, taking on inferior bank debt for government bonds that can then be used to obtain financing from the ECB.

Japan’s Nikkei 225 Index set a record one-day gain today, soaring 14.2%, or 1,171.14 points, to close at 9,447.57, after being closed Monday for a holiday. Hong Kong’s blue-chip Hang Seng Index extended its 10% rally from yesterday with a 3.2% gain this morning, adding another 520.72 points to close at 17,832.88.

Stock markets in the Philippines, South Korea and Australia also saw gains today.

“The U.S. and Europe now seem to be promising unlimited support to remove the deep-rooted disbelief in the financial system,” Yoo Byung Ok, who oversees the equivalent of $3 billion at Mirae Asset Investments Co. in Seoul, told Bloomberg News. “The key issue here is whether these market gains can be sustained or not. I believe more time is needed to dispel worries about the ripple effect on global economies.”

Europe enjoyed similar strong results, with the FTSEurofirst 300 Index closing up 2.8% for the day after earlier being up as much as 6.8%. The Paris-based CAC40, London’s FTSE 100, Madrid’s IBEX 35 and the Frankfurt-based DAX all posted triple-digit gains.

Russia’s Moscow Interbank Currency Exchange, or MICEX, where the bulk of Russian trading occurs, climbed 11.2% before regulators halted trading, The Associated Press reported.

These global gains were a response to international efforts to recapitalize banks, as well as some easing in the short-term credit markets. The dollar-denominated three-month London Interbank Offered Rate (LIBOR) fell slightly today, down 0.12% to 4.64%. LIBOR’s euro and pound counterparts also fell, albeit by slightly smaller amounts.

“We are now seeing solvency being dealt with, we are seeing huge amounts of liquidity being thrown at the market,” Simon Ballard, a senior portfolio manager at Fortis Investments, said in a Bloomberg Television interview. “Banks will little by little start to face one another in the interbank market.”

In Japan, the central bank pledged unlimited dollar funds to shore up capital positions, according to a Washington Post report.  The Japanese government will also relax rules that prevent companies from buying their own stock, Finance Minister Shoichi Nakagawa said. The government will immediately cease the sale of any of the $33 billion in bank stocks it acquired during that country’s “Lost Decade,” Nakagawa added.

Europe announced its bank recapitalization plan yesterday, while the United States announced its own $250 billion plan this morning.

Source: Strong Gains in Asia and Europe as Governments Act to Instill Confidence in Global Banks

More from Bill:

Each country controls its own money (with the exception of the countries of Europe, who have decided…perhaps temporarily…to use a common currency). Since this paper money can be created at negligible cost to the creator, countries are tempted to create more of it than they should - especially in times of war or financial crisis.

Historically, what has kept this from happening was that the paper currency was tied to gold.

More recently, currencies are tied to the dollar. And since countries trade with one another, a sin by one country -- printing too much money -- is punished by the others.

They mark down its money.

But now, all the world's major countries are conferring, colluding, and conspiring. They're all going to do the same thing. They're all going to take over their banking systems, support their financial industries, bail out important businesses and rescue their citizens from their own mistakes. Where will they get the money for all this? Will they borrow it from each other? Don't be silly; they will print it.

"They are in trouble in New York," said J.P. Morgan to Bishop Lawrence.

In October, 1907, J.P. Morgan was 70 years old…and attending a church meeting in Richmond when the importance of the sacred was disturbed by the urgency of the profane. Telegraphs kept arriving from New York; they warned of a disaster. According to Dun's Review, 8,090 companies had failed in the first 9 months of 1907. Then, a failed takeover of the United Copper Company caused a panic.

"A correction is equal and opposite to the deception that preceded it," Morgan would have said, if he'd thought of it. Since he didn't, it falls to us.

Morgan had been around the block when it came to money.

He had taken over his father's banking business decades ago. He'd seen panics, crashes, bankruptcies. And, now, it must have seemed that his whole life had been spent training for this one test. He returned to New York; crowds of investors looked to him to save the day.

And he did.

He put his own money on the line to help shore up troubled companies. He rallied friends, colleagues and competitors to do likewise. A trust was in trouble…then the New York Stock Exchange itself…then the City of New York…one after another, Morgan brought in the financiers…came up with the money…bullied and cajoled…until the storm had passed and they could all enjoy a good drink.

And when it was over, Senator Nelson W. Aldrich, realizing what Morgan had done said: "Something has got to be done. We may not always have Pierpont Morgan with us to meet a banking crisis. "

As it turned out, Pierpont Morgan was a ghost four years later. But in that same year -- 1913 -- the US Federal Reserve was set up to fill his big shoes.

This year, it's the Fed that is being tested.

Armageddon seemed to arrive in Manhattan on Monday. And not just in New York, but in Moscow, Hong Kong, London and Frankfurt too. Germany hastened to succor bank account holders. In Rejkavik the pandemonium was so hot it seemed to melt the ice.

Then, on Tuesday, all the plagues and locusts we've been warning about here in The Daily Reckoning were loosed on the world: The US stock market fell hard again. Japan was sinking into the sea. Brazil's market was down 51%, year to date. Central banks were cutting rates like pulpwood. Even so, unemployment was on still the rise. Consumer spending was falling. House prices were going down.

Of course, the world improvers were intervening in the usual clownish ways.

Short selling was blamed for more accidents than alcohol. And everywhere, the authorities were getting ready for show trials…perp walks…and public hangings.

Over on The Guardian's front page, for example, was an extended whine about how much Richard Fuld earned at Lehman Brothers (NYSE:LEH) before he bankrupted the 158-year institution. $480 million was the number given for the 8 years of disservice. "Is that fair?" asked Congressman Henry Waxman.

Congressman Waxman seemed to think that something needed fixing. But that just goes to show how little he appreciates the free market. Investors handed Fuld that money of their own free will; they got exactly what they deserved. The system was fixing itself.

Politics always lists to the port side. But markets are more exquisitely balanced, between fear and greed.

When investors had the wind at the backs, they were ready to believe the most outrageous things -- that the financial sector could get rich by lending money to people who couldn't pay it back…and that a whole economy could flourish by luring consumers to spend more than they could afford.

These hallucinations created an immense worldwide bubble of debt and dollars.

But now, the wind has swung around. A huge anti-bubble is forming -- equal and opposite, in true Newtonian form -- a financial whirlpool marked by exaggerated thrift, debt destruction and sweaty-palmed investors.

And where is Morgan when we need him? Where is the Fed?

Ten years ago, the giant hedge fund LTCM had overdone it. As in 1907, according to Roger Lowenstein's account, "Rushing for the exits…[traders] posed a danger not only to themselves, but to the entire world financial system."

So, the Federal Reserve Bank of New York called in the big financial houses to help with the rescue. It worked. The crisis was averted. LTCM's positions were liquidated in an orderly way, just the way Morgan would have wanted.

But this time, the fix doesn't seem to stay fixed. Bad positions can't be unwound in an orderly manner; there are too many of them.

And it's not just a handful of speculators who are getting whacked -- it's half the population of the United States of America and Great Britain.

Trillions of new cash and credit are being pumped in. The Fed is buying 'assets' you would throw out of your refrigerator. Her majesty's government is now proprietor of 50 billion pounds worth of banking shares; the government of George W. Bush is preparing to enter the banking business too.

But as trillions go in, trillions more leak out. So far this year, world equity markets have lost $20 trillion. US property markets alone have lost $6 trillion over the last two years.

It is not just a few investment decisions that are being corrected, in other words, it's the delusions of an entire generation.

"These prices make no logical sense," said a Wall Street trader, referring to mortgage backed derivatives at Wal-Mart Wal-Mart-style discounts, missing the point.

Markets are not scientific. They are poetic. After the liquidity comes the liquidation. After the outsized recklessness comes the appropriate regret.

Editor's Note: Bill Bonner is the founder and editor of The Daily Reckoning. He is also the author, with Addison Wiggin, of the national best sellers Financial Reckoning Day: Surviving the Soft Depression of the 21st Century and Empire of Debt: The Rise of an Epic Financial Crisis. Bill's latest book, Mobs, Messiahs and Markets: Surviving the Public Spectacle in Finance and Politics, written with co-author Lila Rajiva, is available now by clicking here: Mobs, Messiahs and Markets

Source: Him That Hath Has Less Than He Thought

Many of us in the US are focused on our own woes. But this is a global credit crisis. In today's Outside the Box, we take a look at the currency markets, which are in an historic upheaval and also look at what is going on in Europe. I suspect that Europe is in for a period of much distress, as the world begins to deleverage That is why one government after another will back the deposits of banks within their countries, for otherwise capital will flee to countries like Ireland and Germany which ARE guaranteeing the deposits for all banks in their borders. Many European banks are leveraged 50 to 1 (not a misprint). I suspect that more government will do like Belgium and the Netherlands and inject capital directly into their local banks deemed too big to fail.

First, from Dennis Gartman:The dollar and the Japanese yen reign absolutely supreme as the world continues the rush to exit from the EUR in whatever form it now holds them. Stock markets around the world are imploding it seems, and as they do, "risk" in any form is being unwound, forcing the Yen/EUR cross to move several "Big Figures" in the shortest span of time we have seen in our years of trading. Only in the "Russian/Emerging Markets Panic" in August of several years ago have we seen movements such as these. We stand in awe and we stand in fear.

Thus to begin, we say here this morning, mincing no words whatsoever, we are more frightened now for the future of the global capital markets than we have been at any time in our thirty+ years of watching, commenting upon and taking part in them. We are fearful... and we mean this fully... that we have passed the tipping point; that things are now spinning out of control; that forces have been unleashed that cannot be stopped without some truly massive, truly strong-handed, governmental action including the closure of markets and limits upon bank withdrawals, et al. These are troubling times, and our fear is palpable and growing. Worse, these concerns are giving rise to the likelihood that the Left shall be in ascension, and that manifestly left-of-centre, interventionist government lies ahead here in the US and in Europe. Higher, rather than lower taxes will be the end result. Greater... indeed very much greater... intervention in the capital markets lies ahead. Trade and act accordingly.

To put things into proper perspective, it is reasonable to see the Yen/EUR cross move within a 1 Yen range, high to low in any twenty four hour period of time. Beyond that, the situation becomes uncommon. 1.5 Yen movements, although not rare, are unusual, and 2 yen movements in the cross as "Black Swans" indeed. Now, it seems the world is filled with black swans, looking about for the few white ones that remain, for the Yen/EUR cross, having closed near 144.50:1 on Friday afternoon... which was already rather weak for the cross was trading 156 only a bit more than a week ago...is this morning trading 140.50!

We have long said that this cross relationship is the barometer of the relative health of the global capital markets, for over the course of the past several years as risk was embraced Mr. and Mrs. Watanabe would sell their Yen holdings and "swap" them for investments abroad that might return them more money. At the same time, foreign non-Japanese investors were very willing to borrow in Yen terms, take that low cost capital outside of Japan and invest elsewhere. This was the "Carry Trade" and it was one of the driving forced in the global capital market. Hedge funds around the world employed the "carry," borrowing cheap Yen and investing into anything, anywhere around the world where the returns were larger. Once confidence began to ebb, however, and once the losses on the carry trade itself began to wane, the pressure upon those exposed grew.

Now, not only are those who borrowed Yen and bought EURs, or Aussie dollars, or Russian Rubles, or gold, or equities anywhere around the world, or debt securities of almost any kind, finding that they are losing money on the "cross" itself, they are losing more and vast sums on the investments they made. It is horror story writ large and getting larger.

Is there any fundamental investment reason to be bullish of the Japanese Yen? No there is not. The demographics of Japan are horrid as her population ages and begins to actually decline. We have written often of this demographic time-bomb that is exploding consistently over time in Japan. The country's population is imploding and it continues to do so despite government policies aimed at changing that trend. However, once demographics as consequential as what is happening to Japan become entrenched, time... and very, very long periods of time,... decades certainly; centuries perhaps... are needed to reverse the course.

Thus, the only thing driving Yen higher is the panic liquidation of the "carry trade." This unwinding has been going on for several months, having begun in earnest in July when the cross touched 170:1 ever-so-briefly. It took years to build the trade up as Yen was borrowed and the EUR bought since the turn of the Millennium. It may take months yet to unwind these years of accumulation. The process is not pretty. The damage wrought is enormous. The panic lies still ahead.

Moving on, the unwinding of the long EUR/short Yen cross is being made all the more dramatic as investors find reason to shun the EUR and investments in Europe generally as confusion regarding the EUR's future has leaped dramatically to centre stage. As we pointed out last week, Dr. Milton Friedman once said regarding the EUR... in which he tended to have very little confidence...that he doubted it would last through its first real recession. His fears are being put to test today. The world is testing the very mettle of the European confederation experiment, and investors the world wide are watching to see just how well the officials in Brussels and Frankfurt can resolve their large and growing differences.

When the economic weather is mild, the "boat" that is a unified Europe runs pleasantly upon the water. The passengers may be a bit unruly, and they may argue amongst themselves, but their arguments rarely will tip the boat for at least the waters are calm. However, when the waters around the boat are riled, the least bit of unruly activity amongst the passengers is amplified and made serious. When the waters are riled, what would have passed for mere annoyance during periods of quiet become life-threatening instead. We are at that point.

But for investors with "a clear head and a keen eye for opportunity" boldness can pay big dividends.

Taipan Daily editor Justice Litle says there are five proven strategies for building wealth... regardless of whether the bulls or the bears are in charge. 

Strategy #1: Superior Information

One of the oldest and most successful wealth-building strategies hinges on superior information -- learning something important before everyone else.

In today's hyper-connected and heavily regulated markets, it is much harder to come by superior information (without a keen willingness to break the law). But back in the 18th and 19th centuries, no one played the superior information game better than the Rothschilds.

The Rothschilds were known for maintaining an extensive (and secretive) information network, connected by financial hubs in five European cities: London, Paris, Vienna, Naples and Frankfurt. Nathan Rothschild, a bullion dealer on the London Stock Exchange, made legendary use of this information network during the Napoleonic wars. This network laid the foundations of the Rothschild fortune.

Richard Bookstaber recounts the backstory in his book, A Demon of Our Own Design:

By the end of the final hour of the battle of Waterloo on June 17, 1815, just 10 hours after first contact, a quarter of the Duke of Wellington's troops lay dead. The French losses numbered nearly 30,000. Within the space of half a day, Waterloo claimed more casualties than any other battle in history.

Given the communications limitations of the period, Great Britain could not immediately know about the carnage of Waterloo or the swift victory... Wellington's Envoy, Major Henry Percy, was dispatched to send the news of the victory to the War Office in London, but he and his horse were affected by the physical toll of the battle.

Even with his best efforts, he did not arrive until late on the night of June 21. Until that time, all of Britain waited in suspense -- all of Britain but one man, Nathan Rothschild.

Because the Rothschilds were known for having superior information -- and because he had made a show of stopping by the prime minister's house on the way -- all eyes were on Nathan Rothschild as he took up his usual post at the London Exchange.

England's victory was a hugely bullish event. Nathan Rothschild knew this full well. But rather than buy British consols (the main trading vehicle of the day), Nathan began to sell.

The heavy selling was a very loud -- and very false -- signal. Rothschild's bearish actions fairly shouted, “Britain has lost! Napoleon has won! Abandon all hope...”

Of course, it was the exact opposite that had actually happened. So once everyone had panicked out of their positions, and the market hit rock bottom, Nathan Rothschild turned around and began to buy. And the family made a spectacular killing. Nathan Rothschild’s masterstroke was twofold: He knew how to acquire superior information, and he knew precisely how to use it.

Strategy #2: By Hook or by Crook

For a thousand years -- from roughly 800 AD to 1800 AD -- the Rhine River in Europe served as a revenue source for the Holy Roman Emperor and his minions. Cargo ships were required to pay tolls at various points along the Rhine, providing a sort of interstate tax revenue on traded goods.

The Raubritters, or robber barons, were originally renegade feudal lords who levied unjust tolls on these passing ships (to the great annoyance of the emperor and the church). The term “robber baron” was later resurrected in 19th-century United States and applied to the financiers and captains of industry who had amassed huge sums by ruthless means.

Few of the latter-day robber barrons were as successful, or as hated, as Jay Gould.

In the aftermath of a failed gold corner, which in turn led to the Panic of 1869, Gould was dubbed “the Mephistopheles of Wall Street.” In addition to being a railroad titan, Gould was known for being one of the most manipulative, cunning and creative financiers in history. His strategic maneuvering included bribery, bankruptcies, lawsuits, insider trading, stock manipulation and much more.

One of Gould's favorite techniques was the “bear raid,” in which a company's shares would be hammered into the ground with strategic selling. This allowed Gould to then step in at rock-bottom prices (precisely when the selling onslaught stopped), wrest control from the board, and establish himself as chairman or president. Many of the maneuvers Gould pioneered would inspire the formation of the Securities and Exchange Commission (SEC), created some 40-odd years after his death.

In his book Dark Genius of Wall Street, Edward Renahan describes how it was done:

Jay Gould would transact virtually all of his Wall Street business for the balance of his short life through a series of special partnerships with a variety of brokerage firms. This device allowed him the luxury of trading anonymously whenever he cared to, and of trading on both sides of a speculation through different brokers. Eventually, Jay would spread his business over so large a network of Wall Street houses that he became something of a phantom; ever present, but frequently invisible and always inscrutable.

In light of his larger-than-life reputation as a heartless crook (still stoked by books and news articles to this day!), Gould never really received credit for the positive things he achieved. Dirty dealings aside, Gould's business acumen greatly aided the expansion and development of America's railroads, thus aiding the dramatic long-term expansion that followed.

Even Mephistopheles had some good in him it seems...

“Free Money” From the Government? Follow the detailed instructions outlined in this letter and you’ll learn how to add $4,570 to $11,450 to your bank account every month, courtesy of the U.S. government. Sound too good to be true?Read on and learn how you can boost your bank account every month …

Strategy #3: Looking to the Future

Claude Shannon, the brilliant scientist of Bell Labs fame, was perhaps best known as the father of “information theory”... an idea so big it is almost impossible to overstate its influence. Wikipedia captures some of the magnitude:

[Information Theory] is at the crossroads of mathematics, statistics, computer science, physics, neurobiology, and electrical engineering. Its impact has been crucial to success of the Voyager missions to deep space, the invention of the CD, the feasibility of mobile phones, the development of the Internet, the study of linguistics and of human perception, the understanding of black holes, and numerous other fields.

As if being the father of information theory were not enough, Shannon did still more. In the late 1930s -- a decade before revealing his famous theory -- Shannon hit on the idea of the digital computer, using Boolean algebra to prove that any problem could be solved with electrical circuits. This led to the 1s and 0s system of binary computing in use today.

Shannon's discoveries meshed together beautifully. The 0s and 1s made digital computing possible, while information theory enabled the means of sending digital information across great distances without garbling the transmission.

As far as digital technology goes, Claude Shannon basically cracked the philosopher's stone. In terms of brilliance and influence, many rank Shannon above Einstein for this reason (plus the follow-on impact of Shannon's ideas on the everyday world).

Just as a great scientist should be, Shannon was deeply playful. He loved to tinker with Erector Sets and odd materials, and was known to juggle in the halls of Bell Labs while riding around on a unicycle. (He invented one of the first computer chess programs and one of the first artificial intelligence devices, among other things.)

One of his quirkier inventions was a cigar-shaped box with nothing but a switch on one side. On flipping the switch, a mechanical hand would come out, flip the switch off, and retreat back into the box again.

We mention Shannon here, though, because he was a wildly successful investor. In his book Fortune's Formula, William Poundstone recounts Claude Shannon's view of markets. “You know the economists talk about the efficient market where everything is equalized out and nobody can make any money really, it's all luck and so on,” Shannon once said. “I don't believe that's true at all.” (Hear, hear! Neither do we.)

Given his track record, Shannon had good reason to doubt the academics. Poundstone notes that Shannon’s performance even stacked up against the Oracle of Omaha’s:

When Warren Buffett bought Berkshire Hathaway in 1965, it was trading at $18 a share. By 1995 each share was worth $24,000. Over thirty years, that represents a return of 27 percent. From the late 1950s through 1986, Shannon's return on his stock portfolio was about 28 percent.

As of record books in the early ‘80s (just before the great equity bull market took off), Claude Shannon had the majority of his investment account in one stock, Teledyne, that he had purchased for just $1 per share. In 1981, this $1 stock was worth $194.38 per share... a nearly 200-fold return.

Even more impressive from an ROI (Return on Investment) standpoint were Shannon's returns on Hewlett Packard (HPQ) ... a stock he had purchased at just 13 cents per share. The Shannons had a 63,000% return on Hewlett Packard as of 1981. Given Shannon's deep aversion to selling companies he believed in, that return no doubt grew even more impressive in the years that followed.

Claude Shannon not only invented the future, he and Betty (his wife) invested heavily in it.

But rather than take a cerebral, formula-laden approach, as one might expect, the brainy Shannons were the type of common-sense investors who would, say, sample a piece of Kentucky Fried Chicken before buying stock in the company. (They actually did that.) The Shannons looked to the future, bought companies they believed in... and held on tight.

The Dow Jones Industrial Average careened below 10,000 points for the first time since 2004 yesterday, after plummeting 500 points in the first hour of trading. The Dow closed down 369.88 points, or 3.6%, on the day at 9,955.50, after earlier surrendering as much as 800 points.

The Standard & Poor’s 500 Index shed 42.38 points, or 3.95%, to 1,056.85 and the Nasdaq Composite Index tumbled 137.52, or 7%, to close at 1,809.

The Dow has shed more than 1,100 points, or about 10% in slightly more than a week, and the S&P 500 has lost more than 15% in the same period.

Indices around the world suffered similar declines. London’s FTSE 100 index closed down 5.6% yesterday. Germany’s DAX was down 5.2%, and the CAC-40 in Paris lost 5.9%. In Asia, the Nikkei 225 stock average in Tokyo fell 4.3%, the Hong Kong’s Hang Seng index slid 5%, and China’s CSI 300 Index slumped 5.1% coming off a one-week holiday.

The credit crisis that originated in the United States last year has clearly infiltrated economies in Europe and financial institutions throughout the region are beginning to topple.

France’s BNP Paribas SA (OTC: BNPQY) became the Eurozone’s largest bank by deposits after agreeing to buy Fortis NV’s Belgium and Luxembourg divisions, just days after it was partially nationalized by the government of the Netherlands as part of a $16.4 billion resuce plan.

Trading of Fortis shares was suspended Monday after falling to $7.50 on Friday. The company’s shares have plunged roughly 70% this year.

Sunday, the German government was forced into a $68 billion (50 billion euro) rescue of Hypo Real Estate Holding AG – the nation’s second-biggest commercial property lender.
HRE was torpedoed by short-term financing struggles within its Dublin-based subsidiary, Depfa Bank PLC.

Hypo Real Estate fell as much as 76% in Frankfurt trading.

In Italy, shares in bank giant UniCredit SpA were suspended several times yesterday, after the company announced its decision to raise 6.6 billion euros in fresh capital – something the UniCredit’s board previously said it would not do.

“We made some mistakes in evaluating the market scenario, that’s absolutely clear to us,” Chief Executive Officer Alessandro Profumo told Bloomberg News. The company said “waves of market turbulence,” as well as an “unprecedented lack of trust among financial institutions” forced management’s hand.

The fresh round of European collapses was the second domino to fall behind an American contagion that claimed The Bear Stearns Cos. Inc. and Lehman Bros. Holdings Inc. (OTC: LEHMQ), and forced a bailout of mortgage giants Fannie Mae (FNM), Freddie Mac (FRE) and American International Group (AIG).

"Everyone is losing confidence," Mark Tan, who helps manage about $20 billion of equities and bonds at UOB Asset Management in Singapore, told The Associated Press. "The problem now is that the lack of foreign confidence could affect the Asian consumer, which would lead to a bigger slowdown in Asia than expected."

Central Bank Panic

A round of chaotic collapses over the weekend spurred central banks and policymakers around the world into action.

German Chancellor Angela Merkel guaranteed private deposit accounts in a desperate bid to restore confidence after the rescue of Hypo Real Estate. Austria, Denmark, Ireland, and Sweden have all raised the limits on guaranteed savings, and there is growing speculation that the United Kingdom will soon join them.

However, Germany’s decision, in particular, came as a surprise as it came just one day after Chancellor Merkel joined French President Nicolas Sarkozy, U.K. Prime Minister Gordon Brown, and Italian Prime Minister Silvio Berlusconi in condemning Ireland’s decision to offer blanket protection for its deposits.

In fact, EU competition authorities had already agreed to challenge Ireland’s decision as a competition distorting measure.

“It would have been advisable to properly consult other EU authorities on the envisaged legislative plans,” the European Central Bank said yesterday. The ECB is also concerned the guarantee provides the lenders covered by the scheme with “preferential treatment.”

The ECB, the Bank of England and the Swiss National Bank offered more than $60 billion to markets yesterday, hoping to ensure that the financial sector remains well oiled.

The ECB offered $50 billion in overnight money, while the Bank of England offered $10 billion.

Financial institutions borrowed $33.9 billion (24.6 billion euros) on Oct. 3 – the most since February 2001.

Meanwhile, back across the pond, the U.S. Federal Reserve said it would make hundreds of billions of dollars more available through its Term Auction Facility (TAF). The Fed said it would expand its 28-day and 84-day TAF operations to $150 billion each. The central bank will also begin paying interest on bank reserves.

Source: Global Markets Nosedive as Credit Crisis Washes Over Europe

I've spent the last week visiting the European Central Bank in Frankfurt and Eurostat in Luxembourg. Europe is becoming a very exciting area for business cycle research, with a lot of bright and energetic people studying the nature of the new economic interactions among the European nations. One of the most interesting papers at the Eurostat conference I attended was by Gabriel Perez-Quiros, my former student who is now a well-known researcher at the Bank of Spain, and Maximo Camacho, one of Gabriel's former students (which makes Maximo my grandchild, Gabriel says) who is now at the University of Murcia.

Camacho and Perez-Quiros's paper sets out a state-space representation of the various data that arrive (or fail to arrive) during a given month and how they relate to an unobserved latent variable of interest such as a monthly factor driving euro-area GDP. Given a presumed structure of how each observed variable is related to the unobserved factor, Camacho and Perez-Quiros can then calculate the optimal forecast of quarterly GDP based on any arbitrary subset of the variables, such as the subset that is known as of some day d within a given month.

Source: Eurostat presentation by Gabriel Perez-Quiros.

The figure above illustrates how the procedure works in practice. The graph plots what the model expected the growth rate for euro-area real GDP for 2007:Q4 (quoted at a quarterly rate) as new information arrived during the second half of 2007 and beginning of 2008. The most important single piece of news was a bearish euro area purchasing managers index released in September. That signal was partly reversed by a more favorable number for the euro-area industrial production index the next month.

And what does their model say at the moment? It's pretty confident we're going to see negative real GDP growth for Europe for 2008:Q3.

They've also explored a version of their model with business-cycle phase shifts, along the lines of the multivariate model described in my paper with Marcelle Chauvet, a univariate GDP-based version of which forms the basis for our Econbrowser recession indicator index. Camacho and Perez-Quiros's model seems to send a clear signal that Europe began its current "growth recession" over a year ago:

Source: Eurostat presentation by Gabriel Perez-Quiros.

Technorati Tags: GDP, European economy, euro area GDP, recession, macroeconomics, economics

Russia's economic growth is obviously slowing quite quickly - and evidently far more rapidly than the government anticipated - largely due to the impact of the global credit crunch, the downward movement in oil prices and investor reaction to Russia's "go it alone" attitude in international disputes.

In the present environment inflation is likely to slow quite rapidly, and in September this easing in infaltion was noted in the prices that manufacturers pay and charge, as highlighted in the VTB report: "The rate of increase in prices charged by Russian manufacturers eased for the fifth straight month to its weakest' since at least January 2003".



Oil Output Down


And just to cap it all, Russia's oil production also fell in September as companies struggled with costs and maturing fields, effectively bringing the world's second-largest crude exporter closer to its first annual drop in output since 1998. Production fell to 9.83 million barrels of crude a day (40.2 million metric tons a month), 0.4 percent less than a year earlier, according to figures released by the Energy Ministry's CDU-TEK unit.

So What Can We Expect?

Well, in broad outline I don't think the outlook has changed that much from when I wrote my last analysis two weeks ago.

As I said at that point, Russia is hardly the Baltics, so we should not expect the economy to go into a complete nosedive. A lot depends on the view you take about the future of energy prices. While the global economy is now evidently set to slow considerably - in addition to the reduction in growth rates already seen so far this year -and especially in the aftermath of the most recent bout of financial turmoil. Cleary oil prices are set to drop even further - and this will only keep pushing Russian growth down - but at some point the market will find a floor, possibly in the region of $80 a barrel. More importantly when it comes to the future of oil prices, I would not be banking on some kind of long and deep global recession. Many of those developed economies who are significantly affected by the bursting of their construction booms (and the banking issues which have gone with it) will probably have weak domestic consumer demand for some time to come, but a solid core of emerging economies may well take off again quite rapidly as we move into 2009 -and especially if energy prices drop back, and the current near panic in the financial markets settles down (people do, after all, have to put their money somewhere). So the emergent (and numerous in population terms) emerging economies should give another strong shove to what may have become a rather listless global economy. As a knock on effect this should also serve to put some life back into export dependent economies like Germany and Japan (who by and large are not reeling under the impact of the construction bust, although their banks may have been lending to people who are).

So the bottom line here, I think, is be ready for a sharp slowdown in headline Russian GDP, but don't expect to see any imminent meltdown in the Russian financial system, one way or another they have the wherewithall at this point to keep limping forward. Of course, in the longer term, well, you know......