James Saft

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

On one point departing Kansas City Fed President Thomas Hoenig and the high-yield bond market agree: current monetary policy is not helping.

Bonds issued to highly indebted and riskier companies have suffered since the Federal Reserve last Wednesday introduced “Operation Twist,” its attempt to suppress longer-term rates and goose investment and speculation.

This should come as little surprise to Hoenig, who retires from the KC Fed on Oct. 1 after a long career as a central banker and banking supervisor, and who has decried the way monetary policy has encouraged the running up of debts.

“When you encourage consumption by inhibiting your interest rates from rising to their equilibrium level, you will in fact buy problems, and we have in fact bought problems,” Hoenig said on Wednesday in his farewell speech.
The cost of the debts, a drug that isn’t working any more, is becoming clear; from the utterly indifferent reaction in key markets to Fed policy initiatives and from the very poor performance of the economy since the bubble burst.

Hoenig predicts long-term U.S. GDP growth to average around 2.5 percent a year, down from the 3 percent plus the U.S. has enjoyed over the last quarter century. That may sound a slight difference, but if his prediction comes true it will have profound effects. For one thing the same low growth that has been caused by the amassing of debts will make those very debts harder to repay.

Considering that real wages for American workers have been essentially flat for the past 40 years, despite growth in the economy, it is hard to see strong gains in a more growth-starved environment. Something will have to give and neither will be good for risk assets; either the consumer economy suffers or workers will command a bigger slice of the corporate pie, thereby hitting profits and valuations.

The Fed’s new policy slate, under which it will sell shorter-dated Treasuries and buy longer ones as well as additional mortgage bonds, has so far had a decidedly mixed record. While 30-year mortgage rates are lower than they were a week ago, they’ve risen in recent days. That’s partly driven by bets that Europe will contain its financial crisis, but also a lesson in the limits of monetary policy.

HIGHER YIELDERS

The move higher in yields of bonds of sub-investment grade companies is striking. Investors are now getting 8.00 percentage points more than government debt to own high-yield bonds, according to a Bank of America Merrill Lynch index, up 0.40 percentage point since just before the policy was announced. That’s the highest they have been since October 2009.

That’s telling you that investors are worried about growth, worried about whether money will be there for debt refinancings and worried about market stability.

As analysts Bespoke Investment Group point out, high-yield spreads began to perform poorly in early August, just after the budget scare and Standard & Poor’s cut the U.S.’s long-term rating. This too fits in with Hoenig’s thesis, both about the impact of debt on growth and the inability of the Fed to wave a magic wand over things. Investors in corporate debt are recognizing that government spending will drop, which will hurt corporate profits. The further out on a limb a company is — and the high-yield borrowers are out there, the bigger the chance one will take a tumble.

The loss of the AAA rating, which is the result not just of the size of the debt but of the dysfunctional U.S. political system, has made debt investors very nervous. Now that we live in a world where nothing is truly safe or risk-free, investors are, ironically, buying newly downgraded Treasuries in preference to corporate debt. If nothing is safe, better to hold what is relatively safer. That is having, and will have, a far more profound impact on economic conditions than the Fed’s new $400 billion program of bond reallocation.

It may be that Hoenig’s critique of Fed policy is better than his suggested alternative of raising rates, at least if this is done in isolation.

Albert Einstein is supposed to have said “We can’t solve problems by using the same kind of thinking we used when we created them.”

That is exactly what the Fed has done, and largely what is being done in Europe; seeking to ease debts through time, low rates and inflation rather than seeking to destroy them.

That’s not the job of a central bank, it is the job of a government. Destroying debts can also be done by markets; we’re seeing it in Greece and we will see it again.

(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.)

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

The question isn’t “will Europe tip the world into recession?” but rather how much worse the euro crisis will make the recession that is already chugging down the tracks.

Markets have been transfixed by the European debt crisis, with its dozens of moving pieces, and its potential to reshape the monetary and political map, to topple banks and to deal a massive shock to the global economy, trade and confidence. High-level meetings in Washington over the weekend were, once again, inconclusive. Some hope for a euro super bazooka bailout vehicle, though such a fund faces obstacles and its chances for lasting success are far from clear.

Investors are right to worry about the unraveling of Europe, but wrong to conflate averting disaster there with a return to rude economic health.

The economic data globally tell a story of weakening demand and dwindling confidence, both in the main developed economies and in formerly fast-growing parts of the rest of the world. The extent to which this is driven by fears of European meltdown is open to debate, but it seems clear that it is far from being the world’s only problem.

In the U.S., the well-respected Economic Cycle Research Institute’s weekly index of leading economic indicators fell again last week, taking a four-week rolling average to -6.7 percent, the steepest such decline in almost a year. Housing is still a source of weakness, joblessness, at 9.1 percent threatens to grow and the Fed’s latest effort to sump pump the economy by driving longer-term interest rates lower fill few people with much confidence.

The Flash Markit Eurozone Services Purchasing Managers’ Index for Europe, a broad-based indicator for the most volatile and important part of the economy, fell to 49.1 this month from August’s 51.5, below the 50 level that is supposed to indicate contraction. Little wonder, given the turmoil and unease there, but still worse than economists’ expectations.

Perhaps even more tellingly, the HSBC China Flash PMI, this time measuring the manufacturing sector, fell to 49.4 from August’s final 49.9. That tells you that the weakness in the U.S. and Europe are really being felt in emerging markets. While a so-called global recession would for China only mean growth falls below the 8 percent benchmark, you can bet that kind of growth there will have knock-on and self-reinforcing effects elsewhere.

Copper futures, which are highly sensitive to growth, fell by about 2.5 percent on Monday in New York, heading for a 15 percent three-day fall, the biggest since the juddering days of October 2008.

THE FIRE THIS TIME

We could easily be looking at a recession in both Europe and the U.S., an outcome that would, in consequence, make dealing with the current agenda more difficult.

Corporate profits will be hit, and companies, already hoarding cash and slow to expand, will shrink further into their shells, delaying investment and perhaps shedding additional jobs.

Tax revenues too will slide, worsening the debt problems and credit profiles of sovereign borrowers and again potentially setting off a self-reinforcing round of budget cuts, layoffs and yet more revenue shortfalls. That could prompt further rating cuts, and will definitely cause the bonds of the more fiscally challenged nations to sell off. The U.S.’s place as safe haven may actually be reinforced, sparing the U.S. from a bond market rout, but deflation will again be part of the discussion.

It is hard to argue for higher equity market valuations under these circumstances, which either indicates further falls or more extreme central bank intervention, whichever is politically easier.

This is not to say what happens in Europe is not important; the next month had better include a comprehensive and credible plan to buy a couple of years’ grace.

“The outcome of the European debt crisis is probably pretty binary: either Europe lets Italy go bust, or Italy and Europe prevent such a disaster,” Berenberg Bank economist Holger Schmieding told clients.

“Once markets start to believe that Italy and Spain are safe, markets and the European economy could recover nicely. We see an 85 percent probability that the euro zone will get it right in the end.”

That 85 percent figure seems optimistic to me, but even if disaster is averted, the fundamental reasons for the global slowdown cum recession remain: balance sheets are being repaired, debt repaid and in consequence demand will be poor. That’s really not going to change until enough of the debt has been forgiven, defaulted or inflated away.

Europe, like Lehman Brothers before it, is an impetus that pushes that snowball downhill, but even without Europe the hill is just as steep and the snow is just as deep.

(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.)

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

HUNTSVILLE, Ala. – That much-anticipated global coordinated easing won’t be global, won’t be coordinated and won’t even be much of an easing.

In 2008 the world got global coordinated monetary easing, with contributions from central banks from Tokyo to Washington.

In 2009 virtually every member of the Group of 20 nations contributed to global coordinated fiscal easing, committing to a total of almost $700 billion in additional spending, or more than 1 percent of global GDP.

In 2011 we will get half measures, conflicting policy and self-preservation. This should be no surprise; not only has the crisis spread from being one about banks and houses to one about governments, it has also hardened the divisions between constituencies and interests.

Short of a not inconceivable breakup of the euro it’s hard to see this changing soon. The U.S. and Europe are riven by political and fundamental divisions, China is hardly poised to carry the water and the rest of the world is weak, small and looking to its own diverse interests. It is easier to see currency wars and protectionism rising than the linking of arms of 2008 and 2009.

The Federal Reserve on Wednesday said it would over the next year sell $400 billion of shorter term Treasuries already in its portfolio, using the proceeds to buy longer term Treasuries, a move intended to drive longer term interest rates lower.

This might buy the economy cheaper long-term interest rates of perhaps 20 basis points, but, considering that the Fed said there are now “significant downside risks to the economic outlook, including strains in global financial markets,” this is little more than a cold cup of coffee.

The Fed also threw in a splash of skim milk for that coffee, saying that it would now reinvest maturing mortgage securities it holds into new similar bonds.

Given that unemployment is 9.1 percent and the U.S. economy produced exactly no additional jobs in August, this hardly even qualifies as palliative care. That the Fed, which was split by a 7-3 vote on its decision, made the moves shortly after receiving a highly unusual letter from Congressional Republican leaders gives an indication of exactly how difficult its position has become.

House Speaker John Boehner, Senate Minority Leader Mitch McConnell, Senator John Kyl and Representative Eric Cantor asked Chairman Ben Bernanke to “resist further extraordinary intervention in the U.S. economy,” maintaining that it could worsen current problems or cause new ones.

President Obama’s $447 billion jobs plan will likely end up being less than half that size, if that, and could end up having far less impact on confidence and the economy than the discussions about cuts and the budget that will accompany it.

In the U.S., there is no consensus about what works and what should be done, only mutual cynicism about motives.

DISUNITED NATIONS

Expecting global coordination out of Europe seems a bit rich, given that it can barely coordinate policy internally. The parts of the euro zone that need stimulus most, Greece, Spain, Portugal, Ireland and Italy, are the ones the rest of the euro zone seem most bent on punishing with a self-defeating austerity.

After having led the European Central Bank into two disastrous rate hikes, Jean-Claude Trichet has toned down his rhetoric and the bank has cut its forecasts for growth and said the risks to inflation are now balanced, having previously been tilted higher. The ECB at least has room to cut, but continues to be deeply ambivalent about its real lever, its ability to buy up the bonds of countries like Spain and Italy.

While the Bank of Japan might be willing to add to a long-running program of buying assets, it is more likely to act to intervene to limit yen strength, effectively acting to send economic weakness back across the Pacific to the U.S.

Minutes from the Bank of England’s Monetary Policy Committee indicate that it may take another run at supporting demand through quantitative easing, a path stoutly advocated by member Adam Posen. Britain’s plans to cut its way to fiscal health are also under question, as weak growth caused it to record a modern all-time largest budget deficit in August. The IMF cut its forecast for British growth and said a policy reversal may be called for in the event of further weakness.

As for the Swiss, their signal contribution to coordinated policy has been to act unilaterally, pledging to cap the strength of the franc.

China’s economy will slow, but it remains constrained by inflation and high debt levels. To expect China to play along with a united U.S. and Europe is one thing, to expect it to lead and take extra risks onto itself is another.

While bond markets are preparing for disaster, the equity markets still appear to believe, at least a little, in the policy fairy. It may not take long to find out who is right.

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.

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

HUNTSVILLE, Ala. – Tim Geithner went a very long way on Friday to accomplish very little, flying to Poland to pitch to the assembled euro zone finance ministers the same tactics that have worked so poorly in the U.S.

Faced with another debt problem, Geithner once again proposed more debt as the solution, suggesting that Europe should leverage its EFSF bailout fund so it can have enough firepower to buy up the debts of weak euro zone nations. This mislabels a debt problem as a price problem, and is an almost exact analogue to the U.S.’s own tactics in addressing its own financial system problem — creating leveraged funds to buy up toxic debt and thereby massage the balance sheets of banks.

This is the deflationary equivalent of reacting to runaway inflation by deciding to lop a zero off the end of prices; things will appear better but the underlying issue is not resolved. This is borne out in the U.S., where private fortunes continue to be made in banking, but where the system is unable to play its role in capital intermediation. Many lenders are still wary, rightly, of funding U.S. banks and are unconvinced that the toxic debt problem is gone for good.

The Europeans don’t appear to be buyers either. “We are not discussing the expansion or increase of the EFSF with a nonmember of the euro area,” said Jean-Claude Juncker, the chairman of the Eurogroup.

He also ruled out any further fiscal stimulus, something Washington has also called for. “Fiscal consolidation remains a top priority for the euro area,” he said.

Austria’s Finance Minister Maria Fekter went further, describing how Geithner urged the group to commit more money to the rescue, but flat out rejected the idea of funding the bailout with a financial transaction tax.

“I found it peculiar that even though the Americans have significantly worse fundamental data than the euro zone, that they tell us what we should do and when we make a suggestion … that they say ‘no’ straight away.”

Remember, Geithner isn’t proposing borrowing more money so that the deeply destructive cuts the euro zone is requiring in Greece and elsewhere can be eased. It is not money for teachers, it is money to support bond prices, which in effect is money to support the capital positions of the banks which would be left broken if the true market price prevailed.

SOVEREIGN CREDIT RISK ROULETTE

The problem with this is that ultimately supporting the banks may swamp the sovereign’s credit rating. A massive increase in the size of the EFSF would surely call into question France’s AAA rating. While Europe has a problem over who is going to pay, with Germans unwilling to underwrite what they see as Mediterranean profligacy, it also has a profound problem with which lenders to make whole.

A look at a study from the Bank for International Settlements into the interaction of sovereign credit risk and bank funding really shows the limits of Geithner’s leverage-happy approach.

Released as part of its quarterly review, the central bank’s central bank described sovereign credit risk as posing “a significant and urgent challenge to banks.”

Bank are massive holders of sovereign debt; indeed bank regulation hard-wires holdings into their business model. That leaves banks open to losses on sovereign loans held on their balance sheets, and in turn those loans are worth less as collateral for loans from the market or from central banks. On top of that, as the state is the ultimate insurer of its banking system, downgrades to the sovereign are effectively downgrades to its banks, raising their funding costs.

In other words, buying up sovereign debt at inflated prices without properly restructuring the debt will result in an ongoing European bank funding crisis, with ever more leverage needed until the day comes that the sovereign is no longer credit worthy. The bank funding and sovereign credit dynamic is one that must ultimately be broken by sovereigns repairing the stability of their finances.

Banks can mitigate these risks by holding fewer government bonds, and by funding themselves more conservatively, but those steps will tend to make them less willing and able to provide credit to the economies they are supposed to support. That is probably the way banks need to be run, but operating a bank conservatively in an economy in which debts have already been properly written down will result in good solid growth. Doing it in a make-believe economy with make-believe asset prices will result in years of stagnation.

That is what the U.S. is seeing. Europe should choose a different path.

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.

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

HUNTSVILLE, Ala. — Don’t count on the euro zone getting a leg up from the giants of the emerging markets.

The idea that Brazil, Russia, India and China will use some of their massive foreign reserves to buy up the bonds of weak euro zone countries has a certain symmetry, but it is unlikely to happen and even more unlikely to work if it does.

Brazilian Finance Minister Guido Mantega on Tuesday confirmed that the so-called BRIC nations will discuss help for Europe when they meet next week in Washington in the run-up to the IMF meeting on Sept. 24.

The idea, which is internally consistent at least, is that the exporting BRICs can save themselves pain if they step in where private investors are unwilling to and help to stave off a monetary union and banking crisis.

While you can bet the BRICs will use this possibility as a bargaining chip, as well they should, this is a crisis of insufficient global demand and too much debt and this particular maneuver will do little to nothing to address those issues.

So far, only Brazil is indicating much enthusiasm for the idea. India was lukewarm, Russia pointed out that its reserves already include more than $250 billion of euro-denominated securities, giving it little headroom, and China managed to at the same time both pass the buck and plead for better trade status.

The BRICs are unlikely to bail out Italy, or Germany depending on how you view things, for many of the same reasons the Europeans seem unable to help themselves: self-interest and domestic political exigencies are trumping cooperation and the hope of a better overall outcome.

China and Russia are, with good reason, very concerned not just with what a euro explosion will do to demand for their exports, but also with the risk that they will see their own treasure wasted in a possibly futile attempt to bolster a system that is unable to take the decisions needed to ensure its own survival.

“We would like to know what actions will the European Union take itself, what scenario will they opt for: a default on Greek debt, default or no default? Whom will they help: banks or governments?” Arkady Dvorkovich, President Dmitry Medvedev’s chief economic adviser, told Reuters on Wednesday.

TREATING THE WRONG ILLNESS

As well, even though massive purchases of peripheral euro zone bonds may buy time for a solution to the essentially political issue of euro zone fiscal management, they could turn Europe from a capital exporter into a capital importer, turning its small trade surplus into a deficit.

“This means slower growth for Europe — Germany needs a trade surplus to generate growth and Spain’s trade deficit is so high that it cannot afford any further deterioration,” according to Michael Pettis, a professor at Peking University.

“Is it really a good idea to trade slower growth for another year or two in which Europe can further build up its debt burden?”

This is exactly the point: Europe needs to destroy its debts rather than build them up. This can be done through some form of default, or call it a jubilee if you like, or through inflation. More extending and pretending with the help of less well-off nations won’t address this, especially as it will only serve to make possible more programs of austerity in Europe. These will cut growth and make the debts that much more unwieldy.

Jerome Booth, Head of Research at Ashmore Investment Management, points out that the “BRICaid” idea, as he calls it, has things almost exactly back to front.

“The best way emerging markets can help developed countries is by boosting global aggregate demand,” he writes in a note to clients.

“The way to do this in a noninflationary way is through a massive set of infrastructure projects in emerging markets amounting to several trillion dollars. EU and U.S. funds should be encouraged to participate and could also help increase transparency and reduce inefficiencies. This appears not to be up for discussion though.”

What remains is for the euro zone to clearly define whom it is going to help, why and how. The best option might be a massive recapitalization of banks and a writedown of the debts of the bad borrowers, combined almost certainly with taking a number of banks into public administration.

The problem is that since the euro zone cannot seem to be able to agree to do this collectively, with Germany footing much of the bill, it may end up doing it individually, a process that almost certainly implies the currency zone will not survive in its current form.

(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.)

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

HUNTSVILLE, Ala. — It looks as if patriotism is the last refuge of bankers.

Jamie Dimon, chief executive of JP Morgan Chase, on Monday inveighed against new Basel III banking regulations which will impose higher minimum levels of capital adequacy on banks.

“I’m very close to thinking the United States shouldn’t be in Basel any more. I would not have agreed to rules that are blatantly anti-American,” Dimon told the Financial Times. “Our regulators should go there and say: ‘If it’s not in the interests of the United States, we’re not doing it’.”

Dimon objects to the imposition of an additional layer of capital of 2.5 percent, to rules which limit how banks can count income from collecting and distributing mortgage payment as capital, and to liquidity regulations which he said favor covered bonds, a type of fund-raising more prevalent in Europe.

“I think any American president, secretary of Treasury, regulator or other leader would want strong, healthy global financial firms and not think that somehow we should give up that position in the world and that would be good for your country,” said Dimon. “If they think that’s good for the country then we have a different view on how the economy operates, how the world operates.”

The amazing thing is that many bank shareholders may feel he is arguing their corner. He isn’t; shareholders are the other major victim of a financial system which is overly complicated and opaque and allows far too much of the profits to walk out the door in the pockets of employees at the end of every day. And because they are also presumably taxpayers, bank shareholders are doubly left holding the bag, first on an ongoing basis when revenues fail to compensate them adequately for their risks, and secondly every few years when the whole thing blows up, killing their share prices anew and socking them with liability for the government debt issued to clean things up.

Arguably equity investors who aren’t even bank shareholders also pay a price. Overly complex banks offering overly complex services serve as a tax on the rest of the economy, diverting money from where it could best be invested for growth and jobs, weighing down other sectors with unprofitable and unneeded financial services, and every few years hitting the entire market when the tent blows off the circus.

SIMPLICITY, TRANSPARENCY = PROFITS

While there can be no substitute for regulation, as implied government guarantees underwrite and subsidize much banking activity, there really is a need for shareholders to militate for simpler banks, and a shrinking financial services sector. Shareholders would benefit even as revenues fall, as more transparent banks would be easier to manage, making it easier for investors to see who really is adding value and who is simply arbitraging the bank’s balance sheet and government guarantee. Compensation would fall, allowing shareholders to capture more of the pie. Earnings and share price volatility would also fall, both in the short and long runs, allowing investors to pay a higher price for a more secure stream of income.

A smaller banking sector would also very likely allow the rest of the economy, and by extension the stock market, to do better over the long term. While there can be no doubt that higher bank equity and a shrinking financial sector will hurt growth during the transition period, it is very likely going to prove a good bargain over time.

Dimon’s line is very similar in cast to the argument advanced by British bankers against newly proposed regulations there which would force banks to carry higher capital and build moats between their boring, utility-like functions and riskier investment and wholesale banking. Arguably too weak, these regulations are far stricter than what Dimon has to contend with at home. Here too, industry advocates say that Britain will suffer, as banking goes offshore, and as economic growth is stifled.

Britain have been particularly badly served by its banks, which have enabled it to pile up an unsustainable level of debt (232 percent of GDP combined household and corporate) while charging too much in fees for services and, in the end, landing the public purse with a massive bill for implicit and explicit guarantees.

The argument that this is bad for Britain and the U.S. should be turned on its head; decline in financial services is inevitable, managed decline is by far the best route.

Shareholders, of all stripes, should wake up to this and push for it. If government does not oblige with tighter regulation and simpler structures, they should, as they have been doing, vote with their feet.

(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.)

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

HUNTSVILLE, Ala. — With European banks facing mounting funding problems, it is time once again for the tail to try to wag the dog.

Democracy or not, procedure or not, principles or not, a funding crisis could soon put euro zone policy makers in a position where they either take radical steps to resolve their debt crisis, or face having their decisions made for them by events which would overwhelm their banking systems.

That, at least, is the impression given by recent comments from leading bankers. I’d love to tell you they are bluffing, but I am not so sure.

First, chief executive of state-owned ABN Amro Group, Gerrit Zalm, a former Dutch finance minister, warned on Sunday both that funding markets were becoming difficult and of the catastrophic consequences of a break up of the euro zone.

“We will have a recession which makes the 1930s look like nothing,” he told Dutch television. “The whole of Europe will crumble.”

The connection between bank funding and euro zone breakup risks is clear. Many euro zone banks are not solvent if true market prices on their holdings of euro zone government debts are taken into account, and investors will only fund banks to the extent that they believe that those debts will never be marked to market, as they would be immediately for banks if their countries spun out of the euro.

“It’s stating the obvious that many European banks would not survive having to revalue sovereign debt held on the banking book at market levels,” Deutsche Bank Chief Executive Josef Ackermann said at a meeting of banking executives.

And yet, almost in the next breath, Ackermann scorned a call from IMF head Christine Lagarde for mandatory recapitalization of banks, saying that it would “threaten to send the signal that politics has lost faith in the ability of existing measures to succeed.”

Really what Ackermann is implying, and he is right, is that almost no amount of bank capital is enough to overcome a loss of faith in the sovereign states on which all banks in a fiat money system, by definition, rely. You can dilute the equity stakes of existing shareholders as much as you want, but banks will still fail if the sovereign fails, and that is exactly what is at risk if the euro zone disintegrates.

HANG TOGETHER OR HANG SEPARATELY?

The Ackermann-led bank lobby group, the Institute of International Finance said in a statement: “In a pattern echoing that of the 2007-09 financial crisis, there is a growing risk of the real economy and financial conditions being locked into a mutually-reinforcing downward spiral,” citing, in part, the impact on bank health of unsustainable levels of debt in some European countries.

“The situation for banks is more dramatic than it was in 2008,” said Ulrich Schroeder, head of German government-backed KFW, speaking at the same conference.

“In 2008, governments were still able to support their banks. Now this is simply no longer possible.”

The distinction here is between individual states supporting their banks, which for Italy or Greece would clearly not be possible in a euro exit, and of the euro zone as a whole supporting its members and thereby, hopefully, avoiding the whole nasty issue of bank capital.

Really though, this analysis only gets half of the story right. While it is true that many banks would be vaporized by a euro breakup, it is not therefore true that if you deal with the sovereign debt problem you needn’t bother with bank capital levels. The key is to do both at the same time, rather than pretending that doing one will mean you don’t need to do the other.

European banks need more capital not simply because they happen to be holding a lot of dubious paper issued by euro zone countries. They need more capital because they have been operating at levels where they cannot absorb even moderate losses and survive without implied and real government aid.

Even worse, euro zone banks, and those in the U.S. for that matter, continue to pretend that profits gained by government license have been created by existing employees and executives in a competitive market. Much of that money flying out the door as compensation should be retained to build up capital, thereby reducing dependence on the public purse. Euro zone reform, banking recapitalization and further regulation should come as a package.

We should be afraid that the euro zone will break up – that is both increasingly possible and would be a disaster. But we should not conflate keeping the euro zone intact with maintaining an unfair and debilitating status quo in its banking system.

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

HUNTSVILLE, Ala. — If you thought you’d found someplace that was insulated from the economic weakness coming from the U.S. and Europe, well, chances are you are wrong.

Around the world, manufacturing is taking a hit, and the rate of slowing and the suddenness of the move pose a threat not just to the economy, but to financial market valuations.

Take Canada, long held up as a model of economic and financial system management, and supposedly well positioned due to great demand from emerging markets for its natural resources.

Well, Canada’s economy actually shrank at an 0.4 percent annual clip in the three months to July, data on Wednesday showed, the first such fall since the last recession. Exports fell by 2.1 percent from the previous quarter.

While wildfires and an auto manufacturing slowdown linked to Japan’s recent natural disaster played a substantial role, that may not be the whole of the story. Growth returned in June, possibly because the automotive industry recovered, but manufacturing as a whole was down in the month.

Or look at India, one of the coming giants of the new global economy. India’s economy this week recorded growth in the last quarter of 7.7 percent, down from the 8.8 percent rate seen in the same period a year earlier. Manufacturing growth fell rapidly, expanding at a 7.2 percent clip compared to a previous 10.6 percent. Those figures still seem heady compared to the United States, but the rate of slowing, which may actually have been masked by a change in the way India calculates its growth, is also large.

China too is showing signs of weakness, with the HSBC/Markit survey of purchasing managers indicating two straight months of manufacturing decline. Market forecasts of future growth have been cut, with most analysts citing expectations of weaker exports to the U.S., Japan and Europe.

While China perhaps has more room for domestic stimulus, the unfortunate truth is that even a small decline in demand in the west has a large impact in China.

The common denominator across the three countries is slackening demand for manufactured goods, which considering that manufacturing led the world out of recession is a poor sign.

“Global growth since March 2009 has had a distinctly old-fashioned feel to it. Manufacturing has led the way, we would argue primarily because it fell the most in 2008 and because of policy in emerging markets and developed markets around government spending on infrastructure investment,” Nomura strategists Kevin Gaynor and Bob Janjuah wrote in a note to clients.

OLD-FASHIONED VOLATILITY

Gaynor and Janjuah make an excellent point: manufacturing is by its nature more cyclical than services. That has important implications for economic volatility, and, by extension, for financial market valuations.

Manufacturing works on a capital expenditure cycle and growth will generally ebb and rise more dramatically than services or consumption. After all, someone might buy a car only every five years, but needs medical care and uses a mobile phone on an ongoing basis.

That shift over time in the global economy towards more services, in particularly in the developed world economy, has tended to make economic growth less volatile. It was helped by increasing access to credit among consumers, who borrowed more when income fell. That smoother growth, what economists used to call the “Great Moderation,” while an illusion based on increasing use of debt, was manna to financial markets.

If consumers use debt less to smooth consumption, well then consumption, and manufacturing, will be more likely to bump up and down.

Investors hate volatility and penalize it by paying less for things which go up and down in performance violently. For a good example of this consider the stocks of what we used to call investment banks, which traded at very low multiples of earnings even before the crisis.

If we are living in a world more reliant on manufacturing to take up the slack, then we are looking at a more volatile world, with sudden drops into recession and surprising, if weak, recoveries. That’s not too far from how things worked in the 19th century. It also fits very well with the data we’ve seen, and with the sudden drop off in US economic data. That will translate into company performance, and via that, into the volatility and prices of stocks and bonds.

What’s left then, is for investors to figure this out. As they do, and they arguably are already doing this, they will be less willing to pay high prices for all sorts of assets, extracting better terms in compensation for holding things that are more likely to melt in their hands.

That process, of realization and repricing, is going to take a good long time, and will accentuate what already looks to be a bumpy ride.

(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.)