Social tension to end the macroprudential Ponzi scheme?

The buzz word among policy makers when they want to feel important is to talk about the “Macroprudential Framework”

Trust me, “prudential” really means: extend-and-pretend, and “macro” really means intervention and as for “framework” – that’s a golden oldie from communist five-year plans, isn’t it? The officially touted purpose of the macro-prudential framework is to “reduce the risk and macroeconomic costs of financial instability. It is recognized as a necessary ingredient to fill the gap between macroeconomic policy and the traditional microprudential regulation of the financial institution” (Source: Bank of England – 2009. The role of macroprudential policy. Bank of England Discussion Paper, November)

The Berlin Wall came down in 1989 but another wall, its economic equivalent, has been raised over the last two years. On one side of the Economic Berlin Wall we have the banks and governments (the old Eastern bloc) and on the other side, we have reality and the micro-economy (the Free World).

The zero interest rate policy and macroprudential framework – excuse me, money printing – stopped having an impact on the real economy two years ago, and I estimate it will stop having an impact on asset prices inside the next six months.
Here are two major reasons:

1. Social tension will likely rise from here. Austerity, higher taxes, lower pensions, higher pension ages, and historical trends have left wage earners with the lowest income and disposable income in decades.
2. Banks will have a hard time continuing to invest in the macroprudential framework as they have failed to deleverage and with Basel III coming fast and furious, reallocating to Risk Weighted Assets will increase their regulatory capital, but their funding needs will still be the same.

Social tension where is it?
Social tension will rise and to me the big surprise for 2012 is that it has not happened yet. The chart below shows why social tensions will rise if current trends continue or even stagnate.

Source: St. Louis Fed.

The wage component of GDP is at all-time low at 43.5 per cent of GDP according to the St. Louis Fed, down from 48.0 per cent before the crisis. Wage earners are taking the smallest amount home from their jobs in modern history, some of this is due to "evolutionary" reasons like off-shoring and automation, but it’s a dramatic change regardless.

The same wage earners are seeing their disposable income eroded by austerity, increased pension costs, tax increases and weak job markets. And in the US, there are the spiraling medical costs as well.

Finally, their purchasing power is diminished every time the Fed, BoJ, BoE or ECB starts the printing press. Don't forget that increasing the monetary base means that everything else needs to go up in price to compensate for the increase in the amount of money, even a Princeton Professor like Bernanke should know this.

Status on the downsizing of European banks
So, the middle-class and general wage earners are left to fight for themselves and have become the real losers in this financial crisis. This would probably be acceptable if banks where losing money and the stock market was down (sharing the pain….) but that’s not the case. Instead, banks are back to their pre-crisis game: expanding balance sheets, chasing yield and leveraging up. The proclaimed deleveraging of banks never really happened. Draghi (LTRO, etc.) put an end to that.

That’s right, the same old habits from 2007/2008 are back and most European banks have expanded rather than down-sized their balance sheets in 2012! The European banks promised to shrink their balance sheets by 1.2 trillion Euros according to this article by Bloomberg: European Banks postpone their diet.

Source: Bloomberg Businessweek

This expansion in bank balance sheets has happened despite independent analysts saying European banks need to reduce their balance sheets by 5 trillion Euros in the next five years to live up to Basel III demands. That’s what I call deleveraging: European banks gross balance sheets are three times the GDP of Europe!

The banks also started shifting their assets and liabilities around to satisfy the regulatory changes so everything needed to be: Risk Weighted Assets. The only problem being that although you can reduce the regulatory capital needed through this exercise, your funding will always be on the gross balance! Accounting sleight of hand does not help you finance your long-term debt.

The bottom line is that we now have more systemic risk in the European banks today than we had in 2011 or 2010. It’s predominantly in risk weighted assets but the gross balance is higher. I fail to understand why the market, regulators, shareholders, and analysts refuse to point this out.

The Italian and Spanish banks now have more government bonds than ever from their own country than before - the exact positions that got them into trouble in the first place. Furthermore, the banks have increased earnings by 10 billion Euros by funding governments with money funneled from the ECB. I rest my case - in prior economic cycles this would have been called a Ponzi scheme, but now it’s a “macroprudential framework”.

The impact on the market from this is gradual, but 300,000 people on the street in Lisbon is a red flag you can’t ignore. Furthermore, with Spain refusing to take its medicine – the bail-out that only comes with the “conditionality” of a formal request for such – the patient either needs to be force “drugged” monetarily or allowed to die (default).

Neither is an option for Germany, where Merkel increasingly is preparing her re-election campaign with an ardent desire for less, rather than more, noise from the Club Med. But you can’t always get what you want! This week will see a new round of austerity announced in Spain. Spain braced for further austerity as Madrid prepares for a bailout.

Meanwhile, back in the USA
Finally, the US Senate over the weekend approved the temporary measures for keeping the government open for another six months. No real changes, only, that’s right, more extend-and-pretend. For a more detailed analysis of why the “fiscal cliff” matters, turn to this piece on Seeking Alpha: Fiscal cliff: Will a 1937 repeat = 2013 Dead Meat? Where Mr. Wade Slome argues that in 1937 President FDR faced the same decisions on his budget after the 1933 New Deal stimulus began to fade away. (History lesson: the market turned way south in 1937 and didn’t make a sustainable comeback for years).
We remain with Trade-of-the-Day positions:

• Short S&P500 from 1472 
• Long Volatility
• Long US Natural Gas 
• Short AUDUSD 
• Long Apple 

Safe travels,
Steen