One thing about Paul Ryan’s nomination that really matters

I am reluctant to wade into the polarized waters of politics. But there is an important point about Paul Ryan’s nomination I haven’t seen made (hard to believe, I know).

We all know the next four years will be about fiscal issues. And the sense, increasingly, is the Democrats could be forced at gunpoint to compromise on entitlement spending. There are no indications, however, that the Tea Party Republicans would be willing to come off their ideological stance against raising revenue.

So, if Obama were to get reelected, it is hard to imagine that the more ideological elements in the Republican party would suddenly have a change of heart and soften their current stance.

We know as well that compromise, eventually, is the only way out. One of Romney’s strongest selling points to moderates has been that he would have a much better chance than would Obama of cracking the log-jam of the anti-tax right. Now, by bringing on board Ryan, Romney’s odds of dragging them into a compromise just went up a lot further.

Ryan knows this group of house member well, he carries enormous credibility on fiscal matters with this group, and he knows where the political bodies are buried on all the hot-button issues. This political reason, for me, is the most compelling one for Romney to bring Ryan on board, even if I personally think the supply-side baggage and excessive faith in efficient markets that he brings with him are ill-suited for the problems we face and are about three decades past their sell-by date.

Why are Global Macro hedge funds struggling?

The first hint: everybody is now a global macro investor (or wants to be).

Here’s the backdrop:

1.    Global Macro hedge funds performed poorly since about mid-2010. Performance continues to be lackluster (paragraph nine);

2.    The category is now in net redemption mode;

3.    Some, like Moore Capital, are preempting investor discontent by returning money to them;

4.    Most seem to be doing their best to milk the 2 percent management fee for as long as investors allow.

How did we get to this point?

First, a bit of history. Pre-crisis, there were three basic types of global macro players. There was Old School Macro. Think George Soros. There were many others. These guys placed massive, fundamentally-driven bets and would come back in X months’ time to see if they broke the Bank of England or whatever. They tolerated huge P&L swings. These were the guys who made global macro sexy.

Then came New School Macro. These guys mostly grew up in the investment banks, either as prop traders or flow traders, or both. Their motto is risk management über alles. These funds—though they are loath to admit it—are driven by risk management much more than by fundamental ideas. They have tended to inhabit the more liquid end of the investment spectrum and manage drawdowns aggressively.

Lastly, there has been the steady growth of Tourist Macro. These are the guys whose expertise was in another market sector, such as credit (e.g. John Paulson) or long-short equity (e.g. David Einhorn), who became enamored of a macro view (short Europe, long gold, short US Treasuries, etc.) and placed big bets, Old School style. The common denominator was that they were bottoms-up guys who got seduced by top-down ideas. And below these marquee managers there is no shortage of erstwhile bottoms-up guys who have been assiduously trying to rebrand themselves as global macro thinkers or strategists.

After the crisis, several things happened. One, Old School Macro quietly went away. Some blew up. Many discovered that the new class of hedge fund investor couldn’t stomach the P&L volatility that came with their style. Others converted to family offices to avoid, inter alia, the hassle of defending their positions to fund-of-fund MBAs armed with sharp ratios.

Two, New School Macro came into its own. Performance in the crisis was good, most of them didn’t “gate”, or lock-up investors when the crisis hit, and they held out the promise of managing drawdowns aggressively. All this, plus the strong instinct to chase returns, made New School Macro look pretty good when investors gazed at them through their rear view mirrors.

The inflows into New School Macro and the nature of the fundamental events unleashed by the crisis increased massively the popular focus on macro issues. This, in turn, fed the growing trend toward Tourist Macro. Everyone constantly talked global macro. Everyone wanted to be global macro.

Why does this matter today?

The attention on and inflows into global macro, coupled with the risk management style of the New School, has produced the choppy (rip, then air pocket; air pocket, then rip) market with high correlations across asset classes that we have come to know all too well in the past two years. Why? Because New School global macro feels enormous pressure to take risk and justify management fees. They need to be involved when the market is moving—especially when the S&P is going higher (“You are getting paid to take risk. So, take risk”). But they also have promised their investors that they will manage their downside aggressively if their positions turn against them.

Having to be in the market, but not being able to stomach drawdowns is what has led lots of large players to stop in at local highs and stop out at local lows; broadly the same positions, broadly at the same time. It has been hugely frustrating for them. But this is largely where the high-correlation choppy market has come from.

How can an investor take advantage of this?

This dynamic will persist until the strategy falls enough out of favor that the big inflows of 2009-2010 flow back out (which has started to happen), or other investors emerge that can “arbitrage” the herd.

The way to arbitrage the herd is to be able to keep your bat on your shoulder for months at a time if necessary, and deploy capital in the assets you fundamentally like when the dislocations from the global macro chop fest eventually materialize. And they will materialize. Then, when you do commit, widen your stops so as to increase your staying power.

It sounds simple, but any professional hedge fund manager will tell you (perhaps only after the application of sufficient sodium pentothal) that running less than say 30-40% of targeted VAR (or whatever your risk benchmark is) for any meaningful length of time is next to impossible if you are clipping 2 percent management fees.

(Lastly, a pro tip: When a global macro investor tells you he expects to see greater market “differentiation” going forward, he is really saying the global macro equivalent of “it’s a stock-picker’s market”.  Caveat emptor.)

Back in the Saddle

Apologies to interested readers for the extended absence. I have been self-indulgently enjoying the longest vacation I have ever dared to take, in my favorite place on the planet earth. And, guess what? It didn’t suck.

I did, however, continue to accumulate things I want to write about, and hopefully I will start to pump them out in the coming days.

I will start today with a piece on why Global Macro hedge funds are struggling. Stay tuned.

ECB, PBOC and Global Wheezing

A lot of heavy breathing for very little oxygen intake. This should be the take away from this morning’s flurry of central bank activity from the ECB, the BOE and the PBOC.

The market is finally coming around to the realization that risk appetite is more important to sustainable monetary stimulus than central bank actions. Absent risk appetite—and it is absent—there is little risk of inflation and efforts to reflate will eventually fall back to earth.

The US, Europe, the UK and, I would argue, China are in liquidity traps, and the effects of monetary policy have proven to be largely psychological. The market now gets this. I believe this is what the underperformance of gold and silver is trying to tell us.

This doesn’t mean there is no role for monetary policy. There is. I will circle back to that below. But first I want to run over the implications for China and the ECB of this morning’s actions.

China

The PBOC cut its one year lending and deposit rates. The important thing to know about China is that even under normal circumstances lending in China is driven quantitative credit targets and not by price. But even from a micro prospective pricing is next to irrelevant. Think about it: when nominal GDP is growing at 15 percent, borrowing at four percent or seven percent starts looking like the same number. It really doesn’t matter. You just borrow.

If, however, your firm is under pressure, and you are concerned economic growth is falling precipitously—which I suspect is currently the base case in China—four and seven percent still look like the same number, but no longer in a good way.

Right now, however, the micro view matters less. The dominant point is that macro credit targets will no longer produce the results we all have become accustomed to. In the first place, they will be pushed less aggressively. As a consequence of the credit boom in 2009-10, the absorptive capacity of the Chinese economy is now diminished. Everyone who could borrow, has, and time is needed to digest the rapid credit growth (Brazil, mutatis mutandis, has a similar situation, IMO). Second, an important source of collateral behind the boom, local government ‘land banks’, have essentially been taken away by the decline in property values. And, finally, the central government—always incremental and afraid of the law of unintended consequences—is going to be extra careful this year given the political turbulence and upcoming transition. Put all this together and it becomes hard to imagine that the 8-8.5 trillion Yuan credit target analysts had penciled in for the PBOC in 2012 will be hit.

Bottom line: If you are banking on policy to save a constructive view on Chinese growth, there is still much scope for disappointment.

The ECB: Anderson Cooper is not alone

Mario Draghi finally came out and said what most of us already knew: the binding constraint on the flow of credit is on the demand side. In other words, Europe is in a liquidity trap. Yes, there are still more supply issues than Draghi implied given the need to recapitalize a fair amount of the EZ banking system, but even if the system were already properly capitalized the weakness on the demand side would keep growth in check.

There are two implications from this. One, the lending dynamic in the EZ is not sensitive to price. Second, the ECB’s forecast for a gentle recovery in the second half of 2012, which as Draghi today came out and said was predicated on low interest rates eventually kicking in, is, to put it charitably, highly suspect.

So why cut rates if lending is price inelastic? The first reason is signaling. The ECB has long had a reputation for erring on the side of tightening and being overly mechanistic in its approach (remember the hikes of July 2008, April 2011 and July 2011?). Cutting now shows that they recognize the issues and are not asleep at the wheel. Some might also be tempted to argue that the gesture was a hat tip to the EU for the recent summit agreements.

But I think the market will gravitate towards a simpler interpretation, now that participants better understand lower rates aren’t likely to stimulate credit growth or risk inflation. The market will conclude that the ECB is trying to engineer a weaker euro.

There is something to this. I’m sure the ECB wouldn’t mind seeing a weaker euro—at long at it comes in an orderly way. But we have to be careful not to over interpret. I think we in the market make two mistakes when we think about FX policy and the ECB. The first is overestimating the extent to which a reserve currency central bank can control its FX rate. We do this regularly. Yes, lowering rates matters, and signaling intentions does too, but ultimately it comes down to the stock adjustments and financial imbalances of major financial actors much more than it does the flows from economic fundamentals. This is much of why the Japanese yen defies the country’s poor fundamentals and why the euro has been stubbornly strong for so long relative to the EZ’s deteriorating economic backdrop. Those who have argued the Fed has been trying since 2008 to debase the dollar by printing trillions should also be naturally sympathetic to this view.

The second mistake we make is overestimating the extent to which a weaker euro will help growth. The EZ is a closed economic block. Exports are roughly 10 percent of EZ GDP. Most EZ trade is with other EZ countries (and this is also where the imbalances are). As a result, it would take a monster boost in exports to turn the GDP dial in any discernible way.

In addition, exports from the EZ tend to be more price inelastic than those of other economic blocks. Europe is a high-cost producer. People often buy from the EZ when they can’t get the quality they need anywhere else. They are sensitive to quality, not price. If they were highly sensitive to price, it is likely that they would already be buying from China or another developing country.

So, if your economy is closed and the price elasticity of demand for your exports is low, your currency would have to be much, much weaker to generate the change in quantities necessary to support GDP.  And, guess what? This is likely where we are headed with the euro.

Final quick comment on monetary policy in the context of a liquidity trap

I don’t mean to suggest that monetary policy is useless in this environment. There are a couple ways in which it can still have a meaningful impact. Indeed, there is a fairly robust debate going on about the extent to which central banks can influence inflationary expectations if they were to really go all in. I remain skeptical of the argument, and I think going all in along the lines advocated by the most aggressive proponents is highly unlikely in all but the most dramatic of circumstances, but I understand that I may be wrong and that in certain circumstances it might be worth running the attendant risks. But what is more germane is that central bank action can still elicit a psychological response, even if only a diminishing one. It still has enough juice, in my view, to short circuit the periodic self-reinforcing negative feedback loops that markets have been stumbling into since the Great Deleveraging began. And this, still, can be a valuable card to keep up your sleeve.

Seems to be an expression of the fear of inflation, rather than an actual hedge for inflation

From “The Golden Dilemma”, by Claude Erb and Campbell Harvey (via @Jesse_Livermore)

A quick example on base money and money supply

A lot of people have a hard time understanding why base money growth (i.e. Fed printing) doesn’t necessarily lead to money supply growth. I’ve been beating this drum for a few years now, and I get the question a lot. So here’s a quick, non-technical answer:

Say base money is 10% of the money supply (close enough for illustrative purposes). Then, if the 90% portion is contracting because banks aren’t lending and consumers are deleveraging, it doesn’t take much contraction for this to more than offset almost any increase in the 10% (base money) portion. This is the basic concept.

Reality is a bit more complex because pre-crisis, much of the growth in credit came from the “shadow banks”, which were outside of the existing regulatory framework and weren’t part of the fractional reserve banking system. They financed their lending through the repo market. The shadow banking system has delevered/is delevering as well. In short, the increase in base money would have to offset both the reduction/contraction in bank lending and the reduction/contraction in the shadow banking system for there to be overall growth in the money supply.

So, even though the money supply of the banking system has returned to modest growth, the broader point is that there is no one-to-one correspondence between base money and the broader money supply. You can get rapid growth in the money supply when there is no base money growth (which happened pre-crisis), and you can get contraction in the overall money supply when base money is growing rapidly (which happened post-crisis). 

The main determinant, therefore, is really risk appetite: do banks and shadow banks want to lend and do others want to borrow. Do they feel secure in their wealth and their jobs? Do they see others around them making money? Do they see other banks gaining market share?  These questions drive money growth more than the interest rate and base money. And the fact that it is less about the price of money and more about the mental state of borrowers and lenders is something many people have a hard time wrapping their heads around–in large part because of what Econ 101 taught us about the primacy of price and rational actors. 

If you want to know what is happening in the money supply, look to the lending portions of the economy, not base money, to get the real story. Don’t let the shrill cries of the inflationistas throw you off course.

A Framework for thinking about Gold and Silver

Gold and silver have become very popular investments in recent years. I’m sure you’ve all seen the ads pitching it. The reaction to this last Fed policy meeting and press conference makes it a good time to go over the main reasons people have had for owning it, and how those factors have been evolving.

Low real rates. Commodities in general tend to do well in environments of low real interest rates. None more so than precious metals. The two reasons are (1) the opportunity cost of holding precious metals is low and (2) periods of low real rates often precede periods of inflation, for which precious metals historically have been used as hedges.

Systemic risk. The US banking system was on the verge of collapse back in 2008, counterparty risk had already broken down, and those living in the bowels of global money markets believed—with good reason—we were hours away from seeing lines of people in pajamas in front of ATM machines hoping there would be cash still in them. And history has seared into our collective memory the role of gold as a time-tested refuge in systemic crises.

Fear of high inflation. Central banks around the world have been expanding their balance sheets. Aggressively. When this started in late 2008, the consensus view was that this would cause inflation, perhaps hyperinflation. This led to a surge in the interest in precious metals, and to many high-profile hedge fund managers buying gold to protect against it. The list is long: John Paulson, David Einhorn, George Soros (though he has reportedly since sold), and countless others.

Fear of fiat currencies/gold as an alternative currency. “All currencies are in a race to zero” seemed the mantra for much of 2010-2011. The belief seemed widespread that in a desperate quest for growth there would be a no-holds-barred currency war, with the US as the instigator. If everyone was going to debauch their currencies, the word was holding gold–which many have come to view as an alternative currency–would be the natural place to go.

Diversification and the Dollar Overhang. The global financial system has been massively dollar centric for the past 60 years. Two things, around 2002, catalyzed a major diversification wave away from the dollar. The first was the plugging-into-the-grid of emerging markets (Brazil came back from the brink; China joined the WTO, etc). The newly found growth and macro-economic stability in these countries  led to them trusting their home currency more, and needing the dollar—in which they were all heavily loaded—a lot less. Dollar-denominated funds joined the BRIC party, intensifying the decline in dollar demand. I’ve written in greater detail on this subject, one of the most misunderstood in global macro investing, here, here, and twice here.

The second was the emergence of the euro. The euro came into existence as an exchange rate regime in 1999, but only in 2002 did it become a deliverable currency. With central banks around the world holding reserves almost exclusively denominated in dollars, a liquid currency that could reduce their concentration in US dollars and better reflect their patterns of trade was a godsend to many. This too put downward pressure on the dollar.

Once the diversification away from the dollar gained momentum, its decline boosted demand for precious metals, first because of the traditional correlations, but second because it also led to fears that something was wrong with the dollar (nothing brings out sellers like lower prices). This further reinforced the diversification bid for precious metals.

Income effects: China and India. China and India have grown spectacularly over the past 10 years. The past decade really was their coming-out party. But these economies have woefully underdeveloped financial systems. Savers and earners have had very few investment vehicles from which to choose. Capital controls have limited choices even further. As a result, Chinese and Indians have resorted to the time-tested investments their grandparents told them about: real estate and precious metals. As their incomes grew, so did demand for both. The fact that precious metals were going up in price only fed the fever. (Nothing brings out buyers like higher prices.)

Where do we stand today?

You can go over each of the above factors, assign weights to them, and decide for yourself if in the aggregate they are waxing or waning. But let’s run through them quickly:

The low real rate environment persists. This, ceteris paribus, will be supportive of precious metal prices. However, the fear that these rates are going to lead to rapid inflation has faded considerably, as investors (and, embarrassingly, many economists) are slowly coming around to a better understanding of the transmission mechanism of modern monetary policy and negative money multipliers. We’ve also seen the serial predictions of those promising that Zimbabwe or Argentina-like inflation was ‘just around the corner’ fall repeatedly flat. Even Peter Schiff must be getting tired by now.

Systemic risk is still an issue, with Europe far from resolved, but with much of global financial system having successfully delevered, it is much less of one. US banks have issues, but the focus is on earnings run-rates in the new environment, not (for most of us) sovlvency. Heavily levered carry-driven investment strategies (remember Peloton and its ilk?) are the exception rather than the rule as risk aversion has pushed aside the pre-crisis go-go mentality. Plus, the EU has a better understanding of the kinds of problems they are likely to run into in crisis, given the Lehman dress-rehearsal, as well as which measures will be required to fix them—even if they are so far reluctant to fully engage them. Lastly, the better understanding of the deleveraging process has led many to conclude deflation may be the greater risk, and it is not clear precious metals will be good hedges for this.

The fever surrounding the currency race to the bottom seems to have broken when the US dollar stopped its decline. As is often the case, the bottom in the US dollar was found exactly when the predictions of its crash became loudest. Investors are coming around to the realization that expanding base money is not the same as expanding the money supply. And, while the link between the money supply and currency rates may tickle investors’ memories of Econ 101, this relationship can’t be found in the data of financially developed countries over the past 20 years. As a result, to the extent the fear of fiat currencies abates, investors who have been holding precious metals on this basis will likely become more nervous and look to reduce (especially when prices go down). Indeed, this explains a lot of the price action in gold and silver over the past year.

The secular diversification away from the dollar should be supportive for precious metals, in theory. In the near term, however, this is somewhat irrelevant: the currency flows related to EU deleveraging and global risk aversion should keep the dollar well supported (NB: irrespective of where funds are domiciled, they are still overwhelmingly denominated in dollars). Longer term, diversification away from the dollar will persist, but whether the main beneficiary of this will be precious metals or other fiat currencies will depend on whether fear of the latter continues to subside.

China and India for their part will continue to grow. And it is unlikely that the development of financial markets there will be fast enough to divert savers, structurally, away from precious metals and real estate for a number of years. But for now, growth rates in both countries are slowing sharply, ahead of expectations, and their real estate markets are under pressure. This, plus declining precious metals prices, is putting China and India off their traditional zeal for gold. (Again, prices and demand are positively correlated. It amazes me we still put so much equilibrating faith in the price mechanism, but that is a post for a future date.)

In short, the reasons for owning precious metals are waning rather than waxing. Some of this is cyclical, but the main reasons for owning precious metals are being revealed as conceptually flawed. And this, to me, is significant. The growing recognition of the impotence of central banks when faced with deleveraging is finally, it seems, driving this point home. More ominously, positioning in gold and silver is still heavy, as macro tourists and retail investors are slow in giving up on their investment theses.

Precious metals are notoriously difficult to trade. Even if I turn out to be right, knowing when to place and press your bets won’t be easy. But I do know this: gold and silver are small, fairly illiquid markets relative to the kinds of positions the biggest macro tourists have on. And when they decide to leave, the escape hatch is going to look very, very narrow.

What if the Fed doesn’t throw a party and everyone comes? (market view)

I don’t write very often about market views, especially short-term ones. There’s excess supply of that already in the system, and my comparative advantage should be melding policy, economics and behavior to try explain things that I think are misunderstood. At least this is what I try and stick to. 

But I am a trader, and I follow markets very closely, even when I am running low risk. And I have been getting a lot of inquiries about my views at this juncture.  So, here they are. 

Prospectively, I think guys are salivating to short risk in run up to/aftermath of the Fed tomorrow. I think a selloff is likely and will be short lived. The short-term indicators are quite overbought, but the intermediate-term indicators are very oversold, still. (Helene Meisler over at RealMoney.com lays these indicators out very well; in fact, she’s the only reason I’ve kept my subscription.)

A selloff that sucks the shorts back in followed by a return to rally is my base case. I don’t think the rally lasts too long, but breaks of 1410 in S&P, 1.31 in the euro, 1.03 in AUD, 13.40 in MXN, as indicative levels, seem doable—even if for the way I trade I care much more about the dynamics and sentiment than the levels themselves.

Part of the reason I have this view is because everyone is asking “What if the Fed throws a party and nobody comes?” Increasingly, people have recognized QE is largely psychological and the psychological response is diminishing. Even the Fed has. So a lot of bearish traders would like to see the Fed do something and then have the market selloff anyway. This would be ‘the dream sequence’. It would validate the bearish market view, vindicate the “it’s all artificial” theory of monetary policy, AND cast the Fed in an unfavorable light. Hat trick.

But the bigger pain trade right now seems to me the opposite. It’s the question in the market that no one is asking: “What if the Fed DOESN’T throw a party and everyone comes anyway?” This would imply the Fed announces no balance sheet expansion, the market sells off at first, then, once the bears feel like they’re back in control, a rally.

Reinforcing this whipsaw is my fundamental view that the Fed will disappoint. Expectations seem unrealistic. As traders we often act as if our anxiety level should be the principal criterion in the Fed’s reaction function. That, and, of course, the most recent move in the S&P. And our anxiety level has been high.

We have a strong tendency to project onto others our own thinking and preferences. But the Fed doesn’t think the way we do. I think we in the markets are projecting a bit too much here. So, I expect Son of Twist, with commitment to lower rates forever, or something along those lines.

There is very little short-term paper left on the Fed’s balance sheet to sell for a continuance of the current Twist, so I’m guessing they might buy further out and sell a little further out to continue the program. A twist on Twist. Just to be doing something. And because it can’t hurt. It doesn’t matter that I think it is pointless.

There are three main reasons I don’t think there will be any balance sheet expansion at this point—though the Fed will almost certainly discuss options for expansion should they need it further down the road: 

1)  The bar to expanding the balance sheet is high given domestic politics, international politics, and the Fed’s recollection of the sharp market reaction to QE2. I think they are still chastened, despite their intellectual recognition of its diminishing psychological effect; 

2)  Inflation and inflation expectations are running higher than in August 2010, when they were low and falling off a cliff. And they have a clear trend since last year; 

  

3)  They need the optionality now. “Taking out insurance” is pre-emptive. The US economy is healing, albeit slowly. So insurance is less necessary. The bigger risk is that of an exogenous shock from Europe or from a fiscal cliff (or hostage-taking in the run up to a fiscal cliff). The timing of these events is uncertain. Thus, the optionality of holding off with warheads that have been losing throw-weight anyway seems the superior risk-adjusted strategy. Again, I think these policies at this point are not very useful. But they can still short circuit negative sentiment in extremis when it gets to the point where that sentiment starts to feed on itself.

A little longer-term, I think the EZ did buy more time with Spain than the market is recognizing, and there is plenty of scope for further announcements in the coming days/weeks that could hurt those short risk.

To get a good entry point for my fundamentally bearish worldview, I would like to see the bearish tone subside and the bulls to get some chirping chips, to use another poker expression. I would like to see analysts on TV again saying “buy any dip” with the kind of confidence we saw in March/early April. We are not there yet. Until then, my strategic bias is to keep my bat on my shoulder. Often the most profitable trade is the one where you sit on your hands.

The takeaway: Germany is pot committed

The short-term market reaction to the Spanish bank deal should not blind us to the important longer-term implications: Germany is now pot committed.

Most of you know the poker term, I suspect. Pot committed is when you have bet such a large percentage of your chips that you cannot fold your hand. You are not all-in yet, but you eventually will be unless the others fold. (“Crossing the Rubicon” has roughly the same meaning, but seemed a little too evocative in the present context).

The Spailout, as it is being called, is the biggest one-shot resource commitment the EZ has made in this crisis. In fact, the commitment seems somewhat open-ended. And it is the first one explicitly made (SMP purchases are really indirect) to a large EZ member state. Moreover, reading between the lines of the official statements from inside and outside the EZ indicates a fairly high degree of commitment to going further and forging a banking union. There are increased murmurings of fiscal union as well. Greece may be already outside the circle of trust, but all this suggests that the EZ—and Germany—very much wants the rest of the EZ to be indivisible.

I have serious doubts about the feasibility of these ambitions, but this is not germane to the point here. What is germane is this: If Germany is indeed pot committed, and you believe as I do that the other players are not going to fold (i.e. the crisis will continue), then we now know on whom the peripheral countries will default.

It will be the official sector and local banks, where the risk has been increasingly concentrated with each round of official intervention. The supranational institutions take down a lot of the bad assets, plus Spanish banks buy the Spanish debt, Greek banks the Greek debt, Italian banks the Italian debt, etc. This is, has been and, we now know, will be the dynamic.

Whether the bulk of default falls on the official sector and local banks, or the default falls on markets makes a big difference for contagion beyond the defaulting countries. If market participants are levered long troubled assets, or own troubled assets and are elsewhere leveraged—as was the case for markets pre-Lehman—contagion will be severe and collateral damage great. If, on the other hand, the official sector and the local banks (de facto official sector) own the bulk of the risk and market participants are not, in general, highly leveraged, the consequences—while still brutal for the defaulting countries—will not propagate through the rest of the financial system with anywhere near the same violence.

I am not arguing there will be decoupling. But for a number of months now I have been trying to gauge on whom EZ defaults will fall, the private sector or the official sector, because, ceteris paribus, the contagion implications are vastly different. And now I have my answer: Germany is pot committed, and the other players are not about to fold. This might not be fair or even efficient, but it matters a lot for eventual burden sharing, and on this count we just found out that markets are going to come out well ahead.