Following the €750 billion emergency fund announcements from Europe, the Federal Reserve announced that it was going to reopen the dollar swap lines for the Bank of Canada, the Bank of England, the Bank of Japan, the European Central Bank and the Swiss National Bank. This measure is supposed to help alleviate short term liquidity needs of commercial banks, in effect providing liquidity to the whole financial system.

This is something one would expect to be cheered, but for some reason, that is not the case. One needs to understand the the Federal Reserve is not trying to help Greece or any other Club Med with their sovereign debt issues, it is simply trying to avoid contagion, id est a fire-sale of US dollar based assets. The last time non-US banks faced a dollar shortage, it resulted in a massive sale of everything and anything denominated in US dollars, including gold, which is regarded as a safe haven by many (including me). Back in the heyday of the dollar shortage of 2008-2009, the overnight lending markets literally fell to pieces – the charts of LIBOR and TED spread are a living witness to that. The Fed did its best to pick it up and it did a great job at it. The dollar shortage is the only reason the cyclical bear market that began in 2007 fell way off its downtrend channel. Anyone who is familiar with the 2007-2009 downtrend knows what I’m referring to. This time around, the Federal Reserve is trying to prevent the spread of the crisis to US markets. Remember, the sovereign debt crisis, as it stands now, is still only a European problem. The US with its massive national debt has not entered the stage yet and the Fed is doing its best to prevent this European problem from spreading to US markets.

Indeed, signs of a lack of liquidity have been all over the place recently. The previous swap lines were terminated in February (January-February sell-off, anyone?), the RMBS repurchases were halted in March and the LIBOR has been climbing a steep mountain along with TED spread. During all this time, the dollar has climbed to levels last seen during April of 2009 (also seen in October 2008). Indeed, the last time the US dollar climbed so fast was after the collapse of Lehman Brothers. One might even attribute last week’s intraday crash to problems with associated with liquidity, at least in part (more often than not, events like that need more than one catalyst).

All in all, it isn’t the least bit surprising to see the Fed reopen the swap window. One would take it for granted that the US government and the Federal Reserve wants to maintain the dollar’s position as the world’s reserve currency. If the dollar’s reserve status is indeed of concern to the Fed, it is only natural for them to open the swap lines. How would one expect the US to maintain that position if dollar based markets witnessed fire-sales every now and then? These dollar shortages wouldn’t be a concern if non-US banks weren’t so overly leveraged, but there isn’t anything the Fed can do about it, really. The only thing they can do is provide short term liquidity, which is exactly what they are doing. The advantages that come with being a reserve currency are numerous, but as this is not the issue at hand right now, I would rather not go into that right now.

Of course, with swap lines and other complicated measures directed at easing liquidity constraints, one can always expect to see a surge of uneducated claims from internet discussion boards as well as from politicians. One of the many claims floating around is that the American taxpayer has to pay for this. This is not the case as these dollars will be returned as the swap lines are terminated (the deadline for the new swap lines is January 2011). As per its name, a swap implies that something is given in return, in case of the ECB, the Fed receives euros and so with every central bank. More on that here.

Most of concerns, claims and accusations about the swap lines have been addressed in the FAQ sheet provided by the Federal Reserve, which can be accessed here. For additional information on swap lines, see my previous post and my free report on the previous dollar swap lines.

From the Federal Reserve:

In response to the re-emergence of strains in U.S. dollar short-term funding markets in Europe, the Bank of Canada, the Bank of England, the European Central Bank, the Federal Reserve, and the Swiss National Bank are announcing the re-establishment of temporary U.S. dollar liquidity swap facilities. These facilities are designed to help improve liquidity conditions in U.S. dollar funding markets and to prevent the spread of strains to other markets and financial centers. The Bank of Japan will be considering similar measures soon. Central banks will continue to work together closely as needed to address pressures in funding markets.

For more information on the dollar swap window, please see my research on the previous swaps:

Another Dollar Shortage? (blog post)

My dollar swap research on Scribd, available for download (full PDF)

For further information, please see the PDF for references to BIS working papers on the topic.

Some time ago, Obama suggested opting for pay-go, the implementation of which would require the Congress to find financing for new projects before writing a check – this way federal deficit would be capped at current levels. Needless to say, nobody really cared about that and new checks were written, which further added to the decifit. This chart really tells you everything, doesn’t it?

Unfortunately, there is no indication that this is about to change any time soon. Indeed, the President and the Congress are talking about deficits all the way into 2020. But what does this mean for the US economy and the US dollar?

1. Rising debt means bigger interest payments (currently around $250 billion), with higher interest rates, this could double in a matter of years. Interest payment goes into spending, but if they want to keep spending the way they have, the deficit will rise even further.

2. More debt means the US dollar will have to weaken – after all, they are ‘paying off’ old debt with new debt. This doesn’t have to happen overnight, but if deficits aren’t brought down to a manageable level, the US dollar will very likely fall like it did during 2000-2007 – slowly, but in a determined fashion.

3. More debt, more money printing and a falling dollar will lead to higher inflation numbers. Again, this is a process much like the weakening of the dollar. Don’t expect hyperinflation until you see the signs (you will know when you see it). But there will have to be at inflation, even amidst all the deleveraging and defaults.

4. US companies will find it increasingly harder to make money. Why? Because more spending and falling revenues always lead the politicians to raise taxes. Indeed, this has already been happening – states, cities and counties all over the US have raised taxes and fees for almost everything. The expiration of the Bush tax cuts further raises the tax burden and there are talks about carbon taxes and even VAT in the US. This should be a time of lowering tax rates, not increasing them. Go figure.

5. Living costs are going to go up, up and away. A falling dollar and higher tax rates can only mean one thing – the US will have to pay way more for its imports, especially staples that are in tight supply over the long term. I’m talking about oil and food. There doesn’t seem to be a shortage or a bottleneck right now, but it has been acknowledged that food supply is at a critical point (record low warehouse supplies and a growing population that eats more every day). Developing agricultural land is a tough one these days as there is less and less arable land every year. Combine that with water shortages and you have a problem. Oil supplies aren’t anything to cheer about either – you can argue all you want over peak oil, but the fact is that oil is getting harder and more expensive to get out of the ground. So, all in all, with the supplies of staples running almost below demand, you can be sure that food and energy will get a lot more expensive.

Quite a few members of European Union are eager to join the eurozone to boost confidence in the eyes of foreign creditors and investors. Any talk about ‘confidence’ and ‘the euro’ in the same sentence might raise a few eyebrows in the light of Greece’s problems and the recent fall of the euro exchange rate, but compared to sovereign currencies of the former Soviet-occupied bloc the euro is a big step forward. Sovereign currencies carry the risk of devaluation and rapid depreciation due to an aftershock flight of capital. Of course, the same can happen to the euro, but with smaller currencies with no reserve currency status (the euro is a reserve currency) the risks are much higher. Perceived risks, anyway. So in essence, the countries of Eastern Europe are eager to join the eurozone because they figure it makes more sense to stand among the strong, even if they themselves are weak, currency-wise at least.

One of the criteria that a country looking to join the eurozone has to fulfill is a debt to GDP ratio of less than 60%*. According to IMF data, Latvia’s debt to GDP ratio will reach a maximum of 89% in 2013, after which it will start a slow decline. This projection is made on the basis of a weak economic recovery (13.9% cumulative growth in 2010-2014), but even with a strong recovery, the outlook is gloomy indeed. The 2009 GDP data for Latvia is not out yet, but it’s very likely that Latvia will have breached the 60% threshold due a combination of rising government debt and contracting GDP. There is not telling whether IMF’s debt to GDP projection for Latvia is accurate in terms of the ratio reaching 90%, because the IMF has already made a number of missing projections due to nature of Latvia’s economic decline. However, there is a high probability that Latvia’s debt to GDP ratio will remain above or close to the threshold for an extended period. In any case, it looks likely that Latvia will have to work harder than ever before to join the eurozone. It might have to shift the date five or even ten years into the future.

The data and charts were taken from CEPR’s report on Latvia from February 2010: Latvia’s Recession: The Cost of Adjustment With An “Internal Devaluation”.

*Just to be clear on this, here is a link to the Maastricht criteria, also known as euro area convergence criteria.

As I was going through The New York Times in search of the article about Greece and the boys at Goldman, I stumbled upon an interesting, yet very misinformed article. The article was titled ‘Greece’s Woes May Give Pause to Euro Zone Candidates’, so I naively thought the article would discuss the different views toward the eurozone in countries such as Estonia, Latvia, Lithuania, Poland, the Czech Republic and so forth, all looking to join the eurozone. After reading the first paragraph, it was apparent to me that the journalist had yet again taken the path of least resistance and opted for the easy choice -  he took Latvia as a basis and extrapolated the results to come up with a very misinformative headline that has got nothing to do with the content of it.

“Countries like Estonia and Latvia were once desperate to get in,” said Alf Vanags, director of the Baltic International Center for Economic Policy Studies in Riga. “The euro is not looking so attractive now.”

Such were to words of Alf Vanags, the director of an obscure organization that comprises of him and 18 other members. Let me point out to international readers that in the Baltics, think tanks don’t have any say in public matters, they don’t every represent anyone but themselves. And more often than not, people don’t even know they exist. In any case, the (personal) opinion voiced by Mr. Vanags is far from the truth when it comes to Estonia. Estonia is very eager to join the eurozone. Being an Estonian, I would like to think that I know better than Mr. Vanags, who resides in Latvia.

Estonia and the eurozone

The eurozone is as attractive as ever for Estonia and there are no second thoughts (with the exception of a few populist politicians and a few communists such as Mr. Savisaar*). Why? Well, it’s because the Estonian national currency, the Estonian kroon has been linked the German Mark ever since its inception in 1992. According to the law, the exchange rate is one German Mark for 8 Estonian kroons. Germany is now using the euro, so the Estonian kroon is now linked to the euro at 15,64 kroons for one euro. The key point to understand here is that in Estonia, devaluation is a political decision de jure and de facto. Devaluation is a political decision de facto in most countries, but in Estonia, only the parliament can decide to devalue the kroon, making it a de jure political decision, which means that it cannot be done without serious political repercussions to follow. Political chaos is the last thing a country needs during a recession and politicians will surely do what it takes to avoid one. There is no reason for Estonia to put off joining the eurozone since our national currency isn’t floating anyway and there is nothing in it for us to devalue.

Moreover, it is important to understand that joining the eurozone is not an if question, it’s a when question. When Estonia joined the EU in 2004, we pledged to join the eurozone. We’ve even had to change the constitution to accommodate the euro. It is not only that we’ve given a promise to join the eurozone, we really do want it. The financial crisis has proved that foreign investors don’t trust the kroon as much as they do the euro, which is only natural. Against the backdrop of the crisis the imperative to join the common currency area has become even more pressing. We don’t have any childish illusions about the eurozone being a harbinger of great riches, but we realize that joining the eurozone means that we can cross perceived devaluation panics off the list of possible risks. Estonia has fulfilled every single criteria according to the central bank of Estonia and the Ministry of Finance.

The same might be said about Latvia, but they key point here is that Latvia hasn’t even fulfilled the Maastricht criteria, which it needs to do to join the eurozone. They might talk all they want, but there is not way they are going to join the eurozone any time soon. Even with Latvia being where it is right now, aiming to join the eurozone in the future is still a prudent goal to work toward. Being left out in the cold is not something Latvia wants.

“These governments have reason to fear that, like Athens, they will be caught in a vise: unable to pay for expensive social programs demanded by citizens while staying within the euro zone’s debt limits.”

Newsflash, Mr. Kramer, Estonia and Latvia are nothing like Greece. We don’t have elaborate social programs, in fact, we have the bare minimum that we’ve been able to provide for our citizens in the almost 20 years that we’ve been independent. We also don’t have a history of street riots. It would be advisable to study history before you start writing things you don’t know about. And unlike Greece, our sovereign debt is too small to cause a meltdown in big European banks.

“To keep a faltering country’s economy in line with the euro “is a tall and very unpleasant order,” Mr. Vanags said.”

I really don’t know who is the foolish one here, the journalist for not pointing out the obvious flaw in Mr. Vanags’ reasoning or Mr. Vanags for saying something so naive. Probably both. Here is what Mr. Kramer should’ve added: eurozone requirements aren’t something pulled out of thin air. The requirements are such that if any country were to follow these in the long run, it would do well. And that is precisely why the requirements are what they are – to ensure the stability of the eurozone.

How bad can one journalist get?

Mr. Wannabe Journalist tops the article off with another fallacy, a favorite of Western bankers who would like to see countries such as Latvia fail so they could cash in on their credit default swaps:

“Despite some negative effects, devaluations have helped many countries over the years, giving a lift to their economies by making foreign goods more expensive and domestic goods more attractive.”

I would really suggest reading a bit of history before making statements like that. Devaluation per se solves nothing unless the country whose currency is being devalued has either a huge manufacturing or a huge services sector that exports most of its production (Latvia doesn’t). It is a pity that journalists trust economists’ statements without actually making sure those statements are correct. The devaluation of Argentina, which is a favorite of journalists’, didn’t save Argentina. Argentina had pegged its currency and devaluation was just one part of the big overhaul that led to the stabilization of their economy. It didn’t save Argentina, but it was done to keep the central bank from bleeding out. Net exports played a boosting role during the first year of recovery, but what saved Argentina in the end was investments and personal consumption. In fact, after the first year of positive contribution to the GDP, net exports actually had a negative effect on Argentina’s GDP. And let me remind you that Argentina’s exports were mostly comprised (still are) of agricultural products, fuels and industrial products (something not found in large quantities in Latvia). Furthermore, Argentina had it easy because the rest of the world was not going through a recession, which meant strong demand for their exports. Devaluation is not a life saver. If it was, countries would be doing it all the time. For some odd reason devaluations are not that commonplace as mainstream media would suggest useful.

Before putting this issue to rest, let me just point out that this is not the only misinformed article written about Estonia, or the Baltics for that matter. I don’t want to spend my days looking for childish articles about the Baltics and ripping them to pieces, but I had to write one of these to point out the fact that not all information is of the same value. If you want correct information about the Baltics, turn to our experts and our statistical offices. They’re not magicians that play with numbers unlike the central planners of days gone by (there was once such a thing as the USSR and we were an unwilling part of it). For those that are interested in truly objective information, take a look at Swedbank’s financial statements. They’re one of the biggest banks in the Baltics and their results give a pretty good feel of the state of the economy in the three Baltic countries. Swedbank’s numbers are good for comparison too.

* Yes, dear fellow Estonians, I called him a communist. I call a spade a spade when I see it. Deal with it.