Has Europe Saved the Day?

May 10, 2010 · Posted in Weekly Posts

No…next question?

Seriously, the governments of the developed world are pumping up the balloon of debt bigger and bigger while postponing the inevitable pop for less and less time. European politicians, without asking their citizens, have now promised nearly $1 trillion for backstopping their member nations. They will accomplish this by buying up distressed sovereign debt - like Greece’s - and by doing so drive down the borrowing cost of issuing new debt. They state also that they will sterilize this by withdrawing liquidity from the system at the same time. So the net effect would be to drive down the cost of borrowing for countries like Greece while incrementally tightening credit conditions for everyone else. Should the loans fail, i.e. should Greece default and leave the ECB stuck holding a bad loan, then the EU governments, including those who are in debt trouble, are guaranteeing the loans.

A couple of points warrant mentioning. First, the people of those countries like Greece are still expected to endure severe belt tightening. As we have seen from the pictures of the activity in Athens this isn’t going down well. Expect that they will turf out the current government and replace it with one that refuses to continue with the plan and threatens to leave the EU.

Second, the German populace did not want to support Greece with aid in the first place and Merkel just lost the North -Rhine-Westphalia elections so she has lost control of the upper house. There will need to be votes taken in parliament on this and it is not clear they will pass. There also may be constitutional challenges. So beyond the initial pop it is unclear that this plan can actually be executed without the ECB being forced to simply print money to cover the bill. This is obviously inflationary.

While stock markets rallied strongly today the currencies, after an initial short covering spike did not move all that much. Bonds corrected but that was expected technically anyway. Gold was down but not a lot. So the flight to safety trade did not react to an extreme degree the way equities did. The equity rally in fact seemed very reminiscent of the bear market one-day-wonder rallies of 2008 - largely short covering.

The world has not seen a situation before with our current conditions. In the past, say Wiemar Germany, Germany and to a lesser extent Austria and some of their eastern neighbors suffered hyper inflation. But their main trading partners did not. Further, hyper inflation due to currency debasement was the primary problem. Debt was not, unemployment was low, the banks were solvent. What we have now is a global case of sick banks, high sovereign and personal debt, high unemployment in many developed nations, and a debasement of multiple, major currencies. Further the same nations debasing their currencies have aging populations. It is difficult to see then how we get a roaring stock market and booming economy out of this like Wiemar Germany had*. It seems more likely to us that we get high inflation without the benefits as an aging population seeks to preserve its money in gold and other tangibles and eschews paper assets.

Time will tell. For now we are exposed only to gold either directly or through ETFs. We own no stocks nor do we intend to for some time. Our view is that the equity markets are headed down and the EU’s actions will only further serve to drive people into something that they perceive as free form manipulation by politicians.

*See: “The Economics of Inflation - A study of Currency Depreciation in Post-War Germany” by Constantino Bresciani-Turroni, available on Amazon.

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