James Saft

By James Saft

(Reuters) – It won’t be the American consumer who powers the economy and financial markets.

An examination of the Federal Reserve’s new tri-annual Survey of Consumer Finances goo.gl/AxYTJ shows we didn’t just suffer a debt bubble – we had an income drought.

The statistics are stark: in the three years through 2010 the median family saw its net worth fall by nearly 40 percent, wiping almost two decades of asset accumulation off of the books. The real source of concern was a 7.7 percent drop in real income in the period, leaving many families still struggling with intractable debts.

There are two really important takeaways from the survey.

First, U.S. households, far from being a source of real pent-up demand, are sailing into their retirement years with very little wriggle room. Saving has been deferred, yet again, and consumption will have a very difficult time driving growth.

Second, and unsurprisingly, the poor and volatile performance of equities during the bubble years has driven savers away from the asset class, setting them up for another potential disappointment.

The root cause of the financial crisis, it seems clear from the data, was the interplay between stagnating family income and the easy availability of debt. The debt not only bankrolled consumption by heavy debtors, it – and this is an important point – encouraged consumption by those who had manageable or no debt at all.

That’s because the flow of debt through society helped to elevate asset prices, both in housing and in stocks and bonds, allowing many more people to play at being wealthy types who live off of their investments. What we saw from 2007 to 2010 was this: as the air came out of the debt bubble, the impact spread, hitting asset prices and income.

It is this interplay that is key, and it is ongoing. In fact the loss of notional wealth, which was mostly due to the fall in the value of housing, really should be thought of as the lifting of an illusion.

Americans thought that somehow their houses and stocks could go up and up and finance lifestyles their earned income could not. What’s more, a lot of the earned income – think about sectors like finance, construction and real estate – were artificially raised by the debt bubble.

THE LONG STAGNATION

Wages and income in real terms have been stagnating for decades. Putting aside arguments about the justice of this, it presents a real problem for investors in an economy which relies on consumption for 70 percent of its activity. A loosening of lending standards allowed the economy to grow reasonably strongly until the crisis, but the math is now far less favorable.

Debt went down in absolute terms, according to the Fed study, but rose by the key comparison to net worth. For all families, the ratio of debt/net worth rose by 11 percent to 16.4 percent.

The good news was that the proportion of households where debt repayments account for more than 40 percent of family income – in other words those drowning in debt – fell.

That’s probably partly the result of borrowers defaulting on home loans. In aggregate, debt to family income levels continued to rise, despite falling interest rates and despite a huge wave of defaults.

The savings rate, as measured by the survey, also fell, raising questions about exactly how long retirement saving can be forestalled.

All in all it was a survey only a bond investor could love, pointing as it does to years of sub-par growth and little room for reflationary growth.

People’s faith in the stock market has been eroded by the bubble and bust pattern, as can be seen in the decline in the number of families with exposure to stocks, which declined to less than half from 52.3 percent in 2001. Direct ownership of stock declined by about 15 percent and ownership of stocks in a fund fell sharply – by almost a quarter to just 7.7 percent. Fewer people also own retirement accounts, presumably due to emergency liquidation and slow uptake among the young.

While it is hard to get excited about equities in this climate, I can’t help but worry that this kind of mass turning away from the asset class is a buying signal. It would be a terrible irony if investors learned the wrong lesson from the past 10 years. It may be true that investors rarely get a fair shake from financial markets, but it is also true that, correctly done, they represent the best game in town.

So, stay invested, cut costs but don’t count on a consumer renaissance to inflate us out of our problems.

(James Saft is a Reuters columnist. The opinions expressed are his own)

(At the time of publication, Reuters columnist James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund. For previous columns by James Saft, click on)

(Editing by James Dalgleish)

June 14 (Reuters) – It won’t be the American consumer who
powers the economy and financial markets.

An examination of the Federal Reserve’s new tri-annual
Survey of Consumer Financesshows we didn’t
just suffer a debt bubble – we had an income drought.

The statistics are stark: in the three years through 2010
the median family saw its net worth fall by nearly 40 percent,
wiping almost two decades of asset accumulation off of the
books. The real source of concern was a 7.7 percent drop in real
income in the period, leaving many families still struggling
with intractable debts.

There are two really important takeaways from the survey.

First, U.S. households, far from being a source of real
pent-up demand, are sailing into their retirement years with
very little wriggle room. Saving has been deferred, yet again,
and consumption will have a very difficult time driving growth.

Second, and unsurprisingly, the poor and volatile
performance of equities during the bubble years has driven
savers away from the asset class, setting them up for another
potential disappointment.

The root cause of the financial crisis, it seems clear from
the data, was the interplay between stagnating family income and
the easy availability of debt. The debt not only bankrolled
consumption by heavy debtors, it – and this is an important
point – encouraged consumption by those who had manageable or no
debt at all.

That’s because the flow of debt through society helped to
elevate asset prices, both in housing and in stocks and bonds,
allowing many more people to play at being wealthy types who
live off of their investments. What we saw from 2007 to 2010 was
this: as the air came out of the debt bubble, the impact spread,
hitting asset prices and income.

It is this interplay that is key, and it is ongoing. In fact
the loss of notional wealth, which was mostly due to the fall in
the value of housing, really should be thought of as the lifting
of an illusion.

Americans thought that somehow their houses and stocks could
go up and up and finance lifestyles their earned income could
not. What’s more, a lot of the earned income – think about
sectors like finance, construction and real estate – were
artificially raised by the debt bubble.

THE LONG STAGNATION

Wages and income in real terms have been stagnating for
decades. Putting aside arguments about the justice of this, it
presents a real problem for investors in an economy which relies
on consumption for 70 percent of its activity. A loosening of
lending standards allowed the economy to grow reasonably
strongly until the crisis, but the math is now far less
favorable.

Debt went down in absolute terms, according to the Fed
study, but rose by the key comparison to net worth. For all
families, the ratio of debt/net worth rose by 11 percent to 16.4
percent.

The good news was that the proportion of households where
debt repayments account for more than 40 percent of family
income – in other words those drowning in debt – fell.

That’s probably partly the result of borrowers defaulting on
home loans. In aggregate, debt to family income levels continued
to rise, despite falling interest rates and despite a huge wave
of defaults.

The savings rate, as measured by the survey, also fell,
raising questions about exactly how long retirement saving can
be forestalled.

All in all it was a survey only a bond investor could love,
pointing as it does to years of sub-par growth and little room
for reflationary growth.

People’s faith in the stock market has been eroded by the
bubble and bust pattern, as can be seen in the decline in the
number of families with exposure to stocks, which declined to
less than half from 52.3 percent in 2001. Direct ownership of
stock declined by about 15 percent and ownership of stocks in a
fund fell sharply – by almost a quarter to just 7.7 percent.
Fewer people also own retirement accounts, presumably due to
emergency liquidation and slow uptake among the young.

While it is hard to get excited about equities in this
climate, I can’t help but worry that this kind of mass turning
away from the asset class is a buying signal. It would be a
terrible irony if investors learned the wrong lesson from the
past 10 years. It may be true that investors rarely get a fair
shake from financial markets, but it is also true that,
correctly done, they represent the best game in town.

By James Saft

(Reuters) – The recent fall in German bunds is the most interesting development in markets in months, and may contain hints of the fate of the euro itself.

German bunds have sold off sharply in June, driving yields higher. In recent days they have also broken a longstanding relationship and are now falling along with Italian and Spanish bonds, rather than, as they have almost throughout the crisis, rising as things in the periphery get hairy.

Since June 1, benchmark German 10-year yields have risen by nearly a quarter to 1.42 percent. To be sure, German yields are still very low, and the rise in and of itself is meaningless to Germany’s ability to manage its debt and borrow.

Strikingly though, in recent days at least, what is bad for the debt of weak euro zone nations also seems to be bad for Germany.

This is either really good news or really bad news.

Since the beginning of the euro crisis investors have sought safe haven in German bonds. Some of this is, in essence, capital flight, as investors worried about being stuck with new drachmas or pesetas opt for the debt of one of the few euro zone states whose currency, were it ever to leave the euro, might actually rally.

The good news option is that investors are now waking up to the possibility that Germany may soon be a far, far worse credit. Germany, in other words, may soon blink and become the effective guarantor of the euro zone banking system and of the finances of its weakened members. That’s absolutely terrible news for Germany’s creditors, who will have no say in the matter, but excellent news for the rest of us.

A euro zone breakup, no matter how a soft exit or transitional period is spun, is terrible news. It would damage the European and global economy and might bring on yet another freeze in global capital markets. Therefore, if rising bund yields are signaling that it is becoming politically and practically possible for Germany to sign on as the euro zone’s backstop we all ought to give thanks.

A FINE LINE BETWEEN GREAT AND TERRIBLE

Sadly, a number of very terrible outcomes could also produce the same pattern of trading in markets, and at this point it is impossible to distinguish the good from the dire.

First off, the rise in bunds might just be good old-fashioned contagion. German banks’ assets dwarf German GDP, and include very large exposures to potentially dubious borrowers on Europe’s fringes. Moody’s on June 5 downgraded seven large German banks and some subsidiaries, citing high leverage and risks from the euro zone crisis. A review of Deutsche Bank, Germany’s largest bank, is ongoing, Moody’s said.

Perhaps more to the point, the continuing deterioration in the euro zone points to rising risk of break-up.

“Yesterday’s rise in Bund yields, which was accompanied by simultaneous rises in Italian and Spanish yields, was particularly scary, in that it seemed to signal that investors were developing a generalized fear for the euro’s continued existence, and hence were selling the debt of all euro countries – large or small, safe or precarious,” Saxo Capital Markets senior markets consultant Nick Beecroft wrote in a note to clients.

“In the case of a widespread break-up of the euro, what is the value even of Bunds, denominated as they are in euros? Even though they may come to be redenominated in Deutschemarks, who wants to go through the legal hell and uncertainty that would surely ensue?”

While you might be better off holding German rather than Italian or Spanish bonds in the event of a break-up, there are many more attractive places to be.

Germany has done, it must be pointed out, very well out of the euro, which has provided a market for its products and kept its currency cheaper than it would otherwise have been. If the euro breaks apart, Germany will likely have to recapitalize many of its banks. It will also find that its tax receipts are hit drastically as Europe, and likely the world, fall back into a deep recession.

There is also the possibility that Germany finds itself, like Spain and Greece before it, the subject of a financing crisis but not the possessor of the tools to fight it. If, for whatever reason, Germany finds its yields rising sharply, it too will suffer because it does not have its own central bank with the right and responsibility to print money to meet its obligations. This, to put it mildly, would be a bit of an irony.

It is impossible to know if we should cheer German yields higher or run for cover. For the next several months German 10-year yields might become the world’s most important number.

(James Saft is a Reuters columnist. The opinions expressed are his own)

(Editing by James Dalgleish)

(At the time of publication, Reuters columnist James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund. For previous columns by James Saft, click on)

By James Saft

(Reuters) – It is shaping up to be a vintage year for doing the same thing over and over again but expecting different results.

The latest: Europe’s attempt to bail out Spain’s banks but not, somehow, have it count against Spain. This is akin to a dieter eating a cookie and telling himself he’s feeding his arms and legs but not his belly.

And while there are different bells and whistles this time, the thread that connects all of the European crisis resolution efforts is an unwillingness, or inability, to address the issue of who will pay for the destruction of excess debt. All efforts, from the LTRO to the bailouts, successively, of Greece, Ireland and Portugal dissembled on this point.

The LTROs made borrowing money easy but did little to make paying it back any more possible, while the bailouts attempted to buy time by perpetuating the fiction that a debt-laden state can be brought to health by shrinking its economy and lumbering it with even more debt.

As a result, the relief brought on by successive “rescues” has been ever shorter and ever milder. This pattern appears to be reaching something approaching the end of the line: Monday’s rally in Spanish bonds didn’t last the day and, ominously, losses spread to Italian debt.

It is difficult to know where to start with what is wrong with the program, but a good place is the contention that this is a credit line to recapitalize Spanish banks, rather than a bailout of Spain. European policy-makers have become obsessed with the idea that they must break the mutual death-grip between banks and states, falsely reasoning that if only banks can be backstopped, mysteriously, credit will flow to states and make unnecessary further outright rescues by Germany.

There are only two ways to break this link – one is to substitute a new sovereign and the other is to cut the banks loose. You can create all the bad banks you want, but someone has to fund the bad assets.

The assumption of investors is that the new funds, equal to about 10 percent of Spanish GDP, will represent a further liability of the Kingdom, thereby making it a less good credit and even less able to both grow and repay.

UNCERTAINTY AND SUBORDINATION

The Eurogroup indicated that money for the bailout might come either from the EFSF, a temporary rescue fund, or the permanent ESM, slated to become effective next month. In either event, indications were that the loans would be senior to private creditors, and that bank bondholders further down the food chain would likely face losses.

Subordinating Spanish debt holders and forcing bank creditors to share losses is correct, but probably needed to be done on a pan-European basis. As of now both groups have had a lesson they may have learned in Greece reinforced: they are on the firing line.

Little wonder then that yields on 10-year bonds issued by Italy rose above the important 6 percent level. Not only is Italy now lumbered with about 20 percent of the liability for the loan to Spain, it was already very highly indebted at the national level. The read-across for other bank systems is similar. Who wants to fund French banks when the assumed rules of the game are changing?

This is not to say that the rules as they stood before, that Germany backed Europe and Europe backstopped its banks, were reasonable. They were unsustainable and an invitation to borrow and skim. If, however, we are changing those rules we need to anticipate the consequences.

For example, the bailout of Spain’s banks is founded on the idea that it will only be a few banks, probably regional lenders called cajas, which will fail. How do you force the weak banks to come clean about their dodgy collateral without affecting the so-called strong banks? ECB willingness to accept doubtful collateral from Spanish banks has kept them afloat but also prevented Spanish real estate from falling to a sustainable level. As a result Spanish real estate prices have only fallen 10 to 15 percent, despite suffering from over-supply akin to Ireland, Nevada or Florida.

Bank bondholders are working out that they will suffer losses as that bad collateral is recognized.

That’s right and proper, and will accelerate the healing process.

It will also make the 100-billion-euro bailout of the banks insufficient, which in turn will focus more attention on Spain’s weakened condition, probably forcing it to seek more aid as investors, outside of its own banks, desert its debt.

On to Italy, where the crisis has more rivers to cross.

(Editing by James Dalgleish)

(At the time of publication, Reuters columnist James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund. For previous columns by James Saft, click on)

By James Saft

(Reuters) – Quarter-by-quarter management and a compensation-driven obsession with company share prices may be impairing the long-term prospects of U.S. stocks as executives live off of their companies’ seed corn rather than disappoint a market obsessed with short-term results.

U.S. corporations are holding a record $1.74 trillion in liquid assets, according to the Federal Reserve’s quarterly “flow of funds” report released on Thursday.

That’s up 16 percent since the end of the last recession in June 2009. A variety of explanations has been posited for this – ranging from fear of regulation to a reluctance to repatriate gains and pay taxes.

The tax argument may play a role, but to judge by foreign companies’ headlong drive to invest in the United States and by the healthy return on net worth earned by non-financial corporations in recent years, it is tough to blame Washington or even the economy for this one.

Economist Andrew Smithers, of asset allocation adviser Smithers & Co in London, says changes in corporate behavior are part of a secular change over two decades, driven by executive compensation practices and the bonus culture.

As he notes, most executives get bonus payments, often in shares, based on metrics such as earnings per share, return on equity and return to shareholders. All of which can be gamed and all of which might encourage short-termism.

“A decision to allow profit margins to fall will almost certainly hit profits in the short term, but a decision to raise prices or cut costs in order to limit or prevent such a fall will increase the longer-term risks of losing market share,” Smithers writes in a note to clients.

Similarly, buying new equipment can cut profits short-term, but provide long-term benefits, he argues.

“As the calculations on which bonus payments are based depend on short-term changes, the growth of the business culture has naturally increased resistance to cuts in profit margins and has inhibited investment,” Smithers writes.

In other words, it seems likely that U.S. firms are hoarding cash and choosing not to invest – not because of economic and policy uncertainty, but because the managers are not paid to invest for the longer-term.

INVESTMENT AND THE CEO REVOLVING DOOR

Whereas CEO turnover at U.S. firms was at 12.5 percent annually in 1992, it increased by half to 18.5 by 2005 and was, at least anecdotally, much higher than in the 1950s and 60s. It is perhaps no coincidence that the bonus culture and high turnover developed alongside a much more gimlet-eyed view of long-term research and development.

The issue for equity holders is that, while this approach flatters profit margins in the short term, it reduces the scope for a firm’s long-term growth and health.

If you don’t maintain a car and run it into the ground it is indeed cheaper, and might be a viable strategy if you don’t own the car and only want to drive it so far.

That may well describe the strategy of a generation of chief executives, who quite naturally want to maximize the benefit they can extract during their time on the playing field. A manager who is sticking around for only 6 or 8 years has an incentive to cuts costs, goose profits and cash out her options.

Further evidence for this behavior is found in the fact that U.S. publicly traded firms hold more cash, and have been stockpiling it more quickly, than both their international and privately held peers over the past decade, according to a recent study by academics at Georgetown and Ohio State universities. www.nber.org/papers/w18120

This may be because the bonus culture is less embedded outside of the English-speaking world and among privately owned companies.

For U.S. industry generally this is troubling because it implies that, 20 years or so into this experiment, many companies and industries have been living off the investments made by previous generations, while not replenishing the stock.

While U.S. industry has produced wonders in recent decades, the innovation has been concentrated in technology start-ups and healthcare, which benefits from a parallel universe of publicly and charitably funded research.

A possible partial remedy would be to force CEOs to become long-term holders of the majority of the shares they are granted in their companies, perhaps by mandating a 30-year tapering schedule of allowable ex-CEO share sales.

To judge by the returns to shareholders in the past 15 years, the current system does investors no favors.

In theory, this problem will be self-limiting, as U.S. companies lose market share to foreign and private competitor. But the damage to pension funds and investors in the meantime will be huge.

(At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund. You can email him at jamessaft@jamessaft.com and find more columns atblogs.reuters.com/james-saft)

(James Saft is a Reuters columnist. The opinions expressed are his own.)

(Editing by Walden Siew; Editing by Dan Grebler)

June 7 (Reuters) – Quarter-by-quarter management and a
compensation-driven obsession with company share prices may be
impairing the long-term prospects of U.S. stocks as executives
live off of their companies’ seed corn rather than disappoint a
market obsessed with short-term results.

U.S. corporations are holding a record $1.74 trillion in
liquid assets, according to the Federal Reserve’s quarterly
“flow of funds” report released on Th ursday.

That’s up 16 percent since the end of the last recession in
June 2009. A variety of explanations has been posited for this -
ranging from fear of regulation to a reluctance to repatriate
gains and pay taxes.

The tax argument may play a role, but to judge by foreign
companies’ headlong drive to invest in the United States and by
the healthy return on net worth earned by non-financial
corporations in recent years, it is tough to blame Washington or
even the economy for this one.

Economist Andrew Smithers, of asset allocation adviser
Smithers & Co in London, says changes in corporate behavior are
part of a secular change over two decades, driven by executive
compensation practices and the bonus culture.

As he notes, most executives get bonus payments, often in
shares, based on metrics such as earnings per share, return on
equity and return to shareholders. All of which can be gamed and
all of which might encourage short-termism.

“A decision to allow profit margins to fall will almost
certainly hit profits in the short term, but a decision to raise
prices or cut costs in order to limit or prevent such a fall
will increase the longer-term risks of losing market share,”
Smithers writes in a note to clients.

Similarly, buying new equipment can cut profits short-term,
but provide long-term benefits, he argues.

“As the calculations on which bonus payments are based
depend on short-term changes, the growth of the business culture
has naturally increased resistance to cuts in profit margins and
has inhibited investment,” Smithers writes.

In other words, it seems likely that U.S. firms are hoarding
cash and choosing not to invest – not because of economic and
policy uncertainty, but because the managers are not paid to
invest for the longer-term.

INVESTMENT AND THE CEO REVOLVING DOOR

Whereas CEO turnover at U.S. firms was at 12.5 percent
annually in 1992, it increased by half to 18.5 by 2005 and was,
at least anecdotally, much higher than in the 1950s and 60s. It
is perhaps no coincidence that the bonus culture and high
turnover developed alongside a much more gimlet-eyed view of
long-term research and development.

The issue for equity holders is that, while this approach
flatters profit margins in the short term, it reduces the scope
for a firm’s long-term growth and health.

If you don’t maintain a car and run it into the ground it is
indeed cheaper, and might be a viable strategy if you don’t own
the car and only want to drive it so far.

That may well describe the strategy of a generation of chief
executives, who quite naturally want to maximize the benefit
they can extract during their time on the playing field. A
manager who is sticking around for only 6 or 8 years has an
incentive to cuts costs, goose profits and cash out her options.

Further evidence for this behavior is found in the fact that
U.S. publicly traded firms hold more cash, and have been
stockpiling it more quickly, than both their international and
privately held peers over the past decade, according to a recent
study by academics at Georgetown and Ohio State universities.

This may be because the bonus culture is less embedded
outside of the English-speaking world and among privately owned
companies.

For U.S. industry generally this is troubling because it
implies that, 20 years or so into this experiment, many
companies and industries have been living off the investments
made by previous generations, while not replenishing the stock.

While U.S. industry has produced wonders in recent decades,
the innovation has been concentrated in technology start-ups and
healthcare, which benefits from a parallel universe of publicly
and charitably funded research.

A possible partial remedy would be to force CEOs to become
long-term holders of the majority of the shares they are granted
in their companies, perhaps by mandating a 30-year tapering
schedule of allowable ex-CEO share sales.

To judge by the returns to shareholders in the past 15
years, the current system does investors no favors.

In theory, this problem will be self-limiting, as U.S.
companies lose market share to foreign and private competitor.
But the damage to pension funds and investors in the meantime
will be huge.

By James Saft

(Reuters) – Ben Bernanke and Mario Draghi are keeping their powder dry but may find, in the end, that there is a limit to the usefulness of monetary policy bullets.

The Federal Reserve and the European Central Bank are both keeping their options open as global economic conditions worsen and the euro zone looks, if anything, more fragile than in recent months.

The ECB did the absolute minimum at its meeting on Wednesday, leaving rates unchanged and extending some liquidity provisions until the end of the year. This despite clear signs of broad-based weakening in the euro zone economy and a widespread credit drought which looks very likely to worsen.

The Fed, for its part, is generally thought likely to temporize at its meeting this month, perhaps extending a reallocation of its bond portfolio intended to suppress short-term rates but, again, holding fire on any major new extraordinary monetary policy effort.

And yet investors mid-week pushed shares higher, partly wagering that Europe would get its institutions together but also in expectation that further distress would bring on further monetary policy medicine.

Well, it might, but it might not bring on the reaction many expect.

“It is truly hard to imagine that there is not enough monetary stimulus in the system with policy rates in most parts of the industrialized world at or close to zero and assets on central bank balance sheets tripling since the crisis began to an unheard-of 30-percent-plus share of GDP. But such indeed is the case and, frankly, is more a reason to be cautious,” David Rosenberg of Gluskin, Sheff wrote in a note to clients.

Quantitative easing has clearly had an impact on financial markets but the carry-through to economic activity is less clear. The first rounds in 2009 came as financial and lending markets were paralyzed by fear. The effect was electric, in part because investors reasoned that it would allow for time to rebuild capital and spark inflation and growth which would make debt proportionally easier to bear.

Clearly the U.S. did a good job rebuilding bank capital, but keeping a banking system going is necessary but not sufficient for growth. Instead you could argue, and JP Morgan’s derivatives misadventure supports this, that having very low rates and ample liquidity but in a low-growth, debt-heavy economy has only set up incentives for speculation rather than long-term investment.

Growth has been slow and borrowers who should have failed kept alive, more in service to bank capital than to themselves or the broader economy.

NOT 2009 ALL OVER AGAIN

And compared to 2009, the threat from the euro zone is both less tractable and larger. Europe’s banks, collectively, need a massive amount of capital, and that in an economy more reliant on bank lending. Moreover, there is no clear and workable chain of responsibility for European banks which leads to a solvent sovereign backstop. Spain’s banking system is small in proportion to Germany’s wealth, but one thing is different to another, and German voters don’t seem to want to use their money to support Spanish banks, at least without having Spanish fiscal policy brought under an integrated euro zone authority.

That conflict, not economic data, is the principal reason the ECB failed to ease. The central bank wants conditions to be tough enough to force action from political leaders. While both they and the Fed may be forced from the sidelines, monetary policy is not where the problem lies. It lies instead in Europe’s institutions and in Washington political maneuvering.

Europe needs to get on with integration and Washington with fiscal reform. Both powers need to provide credible plans which foment long-term investment and bring state and private debts back into line with the size of their economies. State debts can be managed slowly, but private debt should be allowed to go bad and be purged as quickly as possible.

None of that is likely any time soon, meaning we probably will see coordinated central bank action in coming months. The interesting question is what the reaction will be. We’ve seen a pattern of diminishing returns to extraordinary monetary policy efforts since 2009, with economic growth remaining subdued and periods of euphoria and relief in financial markets becoming ever shorter.

The ECB’s long-term refinancing options (LTRO) are an example: easing conditions for euro zone state and bank borrowers for less time on each successive occasion.

Surely, of course, central bankers can create as much money as they wish, and just as surely this must inevitably have an effect on prices, or rather on nominal prices. But the idea that monetary policy can, by itself, rekindle animal spirits may have reached something like the end of the line.

If the easing comes at a time when the euro zone and Washington cannot give a credible account of what they are doing to resolve the underlying issues, quantitative easing may this time drive money under mattresses or into electronic last resorts rather than productive investments.

(Editing by James Dalgleish)

(At the time of publication, Reuters columnist James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund. For previous columns by James Saft, click on)

By James Saft

(Reuters) – As events in Europe show, an unhappy marriage can be prolonged indefinitely but where there is life there is not always hope.

The two current arguments for enthusiasm about asset and risk markets seem to be these: that policy forbearance and the European Central Bank can keep the euro zone intact until someone thinks of something, and; that coordinated central bank and fiscal policy will rescue the global economy anyway.

Both are untrue but, like most untruths, both contain interesting elements of truth.

The latest focus of hope is a planned Tuesday emergency telephone meeting of the finance chiefs of the Group of Seven nations to discuss potential salves to the euro zone crisis. The meeting, not the first and certainly not the last of its kind, is being held as the idea of a Greek exit from the euro becomes almost mainstream. More troublingly, investors have suddenly realized what has long been clear: that Spain’s banks and its treasury have been propping each other up like two drunks at a bar.

“There’s a heightened sense of alarm over developments in Europe, particularly in Spain,” an anonymous G7 source told Reuters. “There is concern on whether there will be a bank run in Spain that could have repercussions beyond the euro zone.”

Well, yeah, I guess it would, but a telephone call ought to sort that bank run repercussion risk right out.

This sort of babble doesn’t make me feel much better but apparently it does serve to inspire some investors to believe that policy-makers can limit their downside. If not, we’d have lost far more than the 10 percent or more equities globally have fallen, and never would have scaled this spring’s peaks in the first place.

Part of this reasoning is correct. Germany and the ECB have both the firepower and reasonable incentive to keep the ailing south respirating. Despite all the angry words there isn’t a hard and fast trigger which will force dissolution. Bank runs can be stopped, expensively, by central banks. Despite the fact that it may be against the rules and an offense against the German idea of justice, a steady flow of cash southward is likely in coming months.

RESCUE DOES NOT REVIVE RISK

That does not mean that risky assets are attractive here. Europe’s solvent nations and the ECB may well keep things ticking over but while they do, the fundamental condition of the euro zone and global economy will continue to deteriorate.

Attempts to cut the knot between banks and their sovereign backers only underline the fact that one state must be replaced with another, in this case Spain and Greece have to be fully subsumed into a euro zone fiscal union, a process which will be long, difficult and no sure thing. Bank lending will be impaired, investment delayed and jobs lost. This implies that things will be considerably worse economically at the point at which some solution is reached. In other words, your risk isn’t just that something will force the euro zone to dissolve, but that world growth will melt while we wait.

This is not simply a euro zone issue; conditions are weakening most everywhere, from the U.S. to India to China. The jobs figures in the U.S. last week were poor, U.S. factories show signs of slowing and Chinese manufacturing is sliding rapidly towards contraction.

The inevitable riposte to this is that authorities will respond with liquidity, cash and stimulus. Governments and central banks are indeed eager to avoid a negative feedback loop, and we can expect more quantitative easing or extraordinary measures in coming months from the Federal Reserve, Bank of Japan, Bank of England and assorted others.

It is unclear, however, why four years into a global debt crisis this should make us eager to take on risk, to invest in capacity and to consume. We have had upwards of four years in which monetary policy has been fixated on the idea of tempting cash into risk, and yet here we find ourselves. Similarly, though the experiment with austerity looks to have failed, we have had a decent experiment with stimulus which also has returned mixed results.

The global economy has two fundamental problems: the wrong things got built and invested in and too much money was borrowed to finance it all. The bad investments of yesteryear are not just sunk costs but an ongoing problem. Policy may not be able to wave a wand over a brick-layer and make him an electrical engineer, but it can clearly tempt money from the pockets of that engineer into bubbles like Facebook.

It’s time to really start attacking the debt problem, not by skimping and repaying but by writing it off and starting all over again, no matter whose nose is bloodied in the process. (Editing by James Dalgleish) (At the time of publication, Reuters columnist James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund. For previous columns by James Saft, click on)

By James Saft

(Reuters) – A banking union, as espoused by the European Commission, is probably totally unworkable unless accompanied by a full fiscal union.

Which is to say a euro zone which features banking union is no different than the current state of affairs, the solution to which, short of a break-up, also almost certainly requires much greater centralization of taxing and spending.

The Commission, the European Union’s executive arm, on Wednesday floated the idea of a banking supervision union to run alongside the 17-nation currency zone.

“A closer integration among the euro area countries in supervisory structures and practices, in cross-border crisis management and burden sharing, towards a ‘banking union’, would be an important complement to the current structure,” the Commission said.

This could include a single deposit guarantee fund and allow greater flexibility to the European Stability Mechanism, a sort of permanent bailout fund set to take effect this July.

“In the same vein, to sever the link between banks and the sovereigns, direct recapitalization by the ESM might be envisaged,” the Commission added.

Of course, you are not severing the link between banks and the sovereigns; you are replacing one sovereign with another. Under the old arrangements, individual states could, with agreement, borrow from the ESM to recapitalize their banks, but the liability for the borrowed funds would lie with the state, as would the primary responsibility for supervision.

This plan still backstops banks with a sovereign, but rather than a state hamstrung by its euro zone arrangements, like Spain is now, you have an over-state in the form of the euro zone as the backstop. The euro zone, or that portion of it devoted to running the banking union, would be the effective ultimate guarantor of all banks in the union.

This will, at a stroke, solve many problems while creating more still, because it will, in essence, be transferring liability for Spanish, Italian, and, yes, French, banks partially to Germany. This will make it easier for Spain to borrow cheaply, because of course it will have shed this awful liability. It will also make it easier for Spanish banks, or at least those which aren’t in hideous distress, to borrow because they will enjoy support from a big, solvent parent: Germany.

THE PRIMACY OF THE BANKS

Doing this acknowledges the current reality – that states which license and insure banks almost inevitably become in some measure subject to them – without doing much about it.

This puts Germany in the position of accepting much of the liability for the last decade or so of loose supervision and poor banking practice. Germany would, at the same time, find itself on the hook for the hundreds of billions of euros of Spanish, Italian and Greek government bonds with which banks have stuffed their balance sheets, partly as a response to policy incentives set up by the ECB. That would allow Spain, just as an example, to run a ruinous deficit safe in the knowledge that Germany would have a massive incentive, as effective banking guarantor, to make sure it wasn’t forced to default.

Germany and the other stronger states could use their influence as part of the banking union supervision to force southern banks to divest themselves of government debt, but that too would prove ultimately self-defeating. The banking union authorities could try to force budget discipline on states by passing rules saying banks must give higher reserve risk weights to bonds of states with larger deficits. Germany would effectively be like China is to the U.S. – it could torpedo southern states by forcing sales of their bonds, but at the same time would suffer grievous wounds itself.

Far better, then, to make banking union, which is almost certainly a necessary reform, go alongside fiscal union. That would imply central control of all of the levers of spending, allowing for a gentle path of fiscal reform and the re-capitalization of banks without huge moral hazard.

Trying to do all that while dealing with the dire situations in Greece and now Spain is like trying to organize a group of fire fighters who’ve never met at the scene of the blaze – you’ll get there eventually but the structure may be a write-off.

It may be that banking union does happen, but if it does two things are at once abundantly clear. First, that Germany and the other stable states have agreed to pay for the errors of others. Second, that fiscal union will either happen within a very short stretch of time or the euro zone will face another, this time even larger, catastrophic break-up.

(Editing by James Dalgleish)

(James Saft is a Reuters columnist. The opinions expressed are his own)

(At the time of publication, Reuters columnist James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund. For previous columns by James Saft, click on)

By James Saft

(Reuters) – It is perhaps the single easiest rule of thumb in investment: favor the simple over the complex.

Complexity, whether it be in a strategy or in a financial product, makes investors vulnerable: to being overcharged, to misunderstanding risks and to being unable to exit the position easily and economically.

To understand why this is true, on so many levels, look no further than JP Morgan’s chief investment office disaster. It involves a trading position which, despite being put on and overseen by people who ought to be the best in the world, landed the bank with a loss that is almost literally unquantifiable.

The advice that Morgan shareholders wish the bank had followed holds true for individuals as well: don’t invest in anything you can’t understand.

In fact, take it a step further – if you have to even consider whether you understand an investment, just walk away.

On its face the appalling track record of complexity in the investment industry is a puzzle. After all, jet engines are more complex than what the Wright brothers used and a Prius more reliable than a Stanley Steamer.

The answer, of course, is that complexity favors those who structure and sell investments over those who merely commit capital to them, increasing the already dangerous lack of alignment between investors and their financial providers.

The rewards to the industry for pointless (for the investor) complexity far outstrip the rewards of actual outperformance.

“In finance we love to complicate. We love to over-complicate. We rely on complexity to baffle, bamboozle and generally thwart human understanding,” James Montier, of fund manager GMO, told a conference hosted by the CFA Institute earlier this month. goo.gl/qaERB

“Complexity impresses, it allows people to charge high fees, it keeps outsiders out,” Montier said.

Complexity when accompanied by its inevitable handmaiden, the “expert,” is even more dangerous, he says.

Subjects in a behavioral investing experiment were hooked up to a brain scan and asked to choose between a safe asset and a more complex one that was essentially a lottery.

Half the subjects had the “benefit” of having the choices explained by an expert. Inevitably, it was found that while the experts spoke, the parts of their brains that handle calculation and probability turned out like a light.

MANAGING RISK

Prime among the reasons for avoiding complex investments is that they make it much harder to understand the underlying risk. While Jamie Dimon believed, and still believes, that he can control complexity risk through sheer excellence, he was proven wrong. You, dear reader, are almost certainly both less well-resourced and less excellent than Mr. Dimon.

Secondly, of course, is the fact that complexity makes it easier for the experts to benefit themselves without cutting the owner of the capital sufficiently in on the benefits. Just as banks are forever getting burned by traders seeking big bonus payments, so fund holders are vulnerable to paying too much in fees when they choose complex products. It is far easier hiding an extra layer of fees in a complex options-based mutual fund than in a tracker.

Complexity breeds activity like a swamp breeds mosquitoes. Complex products, by their very nature, tend toward being active products, executing more trades more often. This may or may not benefit the investor, but definitely does create a stream of income for brokers.

There are very few things in investing that you actually control. What you pay for investment management products is one, and as such should probably be top of your list on what to concentrate on to improve your outcome. This is especially true in times of low returns, as an extra 1 or 2 percent in annual charges in an era of low inflation and low returns is all the more damaging.

Keeping it simple is one of the easiest ways to control costs. And, as there is absolutely no sustained record of evidence to support the idea that complexity produces better outcomes, sticking with a prejudice for the simple over the complex is one of the easiest ways to improve long-term outcomes.

Of course, the truth is, in Warren Buffett’s famous dictum, “Investing is simple, not easy.”

Just like losing weight, the issue is not the strategy but the execution. Keep costs down, favor companies that return capital and be disciplined about buying and selling based on valuation. All so simple, but so difficult.

(At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund. You can email him at jamessaft@jamessaft.com and find more columns atblogs.reuters.com/james-saft)

(James Saft is a Reuters columnist. The opinions expressed are his own.)

(Editing by Walden Siew and Dan Grebler)