Post by jeffolie on Dec 30, 2012 10:27:55 GMT -6
DECEMBER 29, 2012
Euro Crisis or World Collapse?
Economist Mike Astrachan describes the dark implications of the European debt crisis, amid its many names. He offers Barron's a cautionary view of the prospects for Spain, Italy, and France.
The European crisis used to be called the European sovereign-debt crisis. Later on, it was referred to as the European banking crisis. Recently, it's the continuing European crisis. But these are all the same.
Experience in Japan, the U.S., the U.K., Ireland, Spain, and numerous other countries revealed what always should have been understood: No developed economy can afford to have one of its large banks go under, and when the risk of that is severe, the local government is forced to take over the ailing bank or back its liabilities. And when the government cannot find buyers for its debt, the local banks must buy it, because if the government reneges on its debt, the local banks that normally own much of the existing government debt will fail.
And if the government and the banks go bankrupt, so will the whole economy.
What happens when the Germans call a halt to their support for Spain and other highly indebted countries in the euro zone?
Consider the evolving story of Spain. At present, no one but a domestic financial institution would buy Spanish government debt, except for an occasional large speculator who guesses he is buying these bonds cheap and will eventually be able to sell them (directly or indirectly) to the European Central Bank. Such a speculator probably heard the president of the ECB, Mario Draghi, say he will do whatever it takes to support the euro. Draghi also announced that the ECB will buy any amount of Spanish government debt necessary to support its prices and keep Spanish interest rates manageable. Draghi's only precondition was that Spain ask for German aid.
The German finance minister, Wolfgang Schäuble, has said he doesn't believe that the Bundestag will approve this aid to Spain so soon after €100 billion ($132 billion) was earmarked to support the Spanish banks.
But there could be another slight problem. If the German lawmakers are worried about a measly €100 billion, of which about half is allocated to specific banks, what will they say when they find out that the ECB has to finance all of Spain's maturing debt plus its budget deficits, over three years, and do the same for Italy and perhaps other countries, for a total of nearly €2 trillion?
When all of this becomes clear in the next few weeks or months, what will follow? Spanish and Italian banks have a strong incentive to hold their governments' debt, as long as the ECB lets them borrow 100% against it at only 1% interest and make a profit on the hefty rate spread. As Greek experience shows, this isn't riskless: Government bonds may be subjected to a 70% haircut, time and again. Nevertheless, the ECB is standing by to monetize much of the debt of Spain and Italy, whether the banks only borrow against their holdings of government debt or sell the bonds outright.
This flood of newly created money will come on top of €1 trillion in "liquidity" the ECB already injected several months ago and a few hundred billion injected into, or now expected by, the Spanish banks and the support programs for Greece, Portugal, Ireland, and Cyprus. But given the size of the needed aid for Spain and Italy, it is likely that all of this won't suffice, and the euro zone eventually will have to be taken apart. AT SOME POINT GERMANY will have to decide that the burden of keeping the euro intact is too heavy. When it comes, the decision may be made by the Bundestag, Chancellor Angela Merkel, the German courts, or the general public. (There are indications that the Bundesbank has already made the decision and is waiting for other sectors to see the light.)
After the Germans comes the deluge: Spain will default on its obligations, followed in short order by Italy and probably by France. Investors the world over will relearn that government obligations aren't "risk free," and neither are bank obligations.
There is no reason to believe that this lesson will be confined to Europe.
Savers in Japan may finally conclude that their government obligations are too large to be safe, and investors in U.S. federal debt securities may soon reach the conclusion that their positions are increasing too fast for comfort.
Obviously, there's a big difference between the euro-zone members who can't just print more euros on their own and the U.S., which has been printing dollars big-time in recent years. Therefore, the process in the U.S. will be different. As people lose confidence in government obligations, they will naturally also lose trust in those little government pieces of paper (or plastic, or computer files) called money. After all, a Benjamin is only different from a $100 bond in that the cash carries the words "In God We Trust."
As investors lose confidence in government paper and rush for real assets such as real estate or gold, or even stocks that carry a claim to some real-income stream, inflation will start rising.
The inflation will be akin to the hyperinflation experienced by Germany in the early 1920s, in that it will be caused by loss of confidence in government obligations. It is unlikely to reach anywhere near the levels seen then, but could reach levels not even imagined by most savers and investors, let alone by market analysts. Global inflation will be hard to fight, especially because some governments and central banks, including Germany, Japan, and the U.S., are trying to boost inflation for various reasons.
All of this doesn't have to happen, but it will take a lot of ingenuity and flexibility on the part of major decision makers to avoid it. Most would have to change their policies, and the chances of that are slim at best.
MIKE ASTRACHAN is chief economist and strategist of 4L Macro Opportunities in Tel Aviv, Israel.
Euro Crisis or World Collapse?
Economist Mike Astrachan describes the dark implications of the European debt crisis, amid its many names. He offers Barron's a cautionary view of the prospects for Spain, Italy, and France.
The European crisis used to be called the European sovereign-debt crisis. Later on, it was referred to as the European banking crisis. Recently, it's the continuing European crisis. But these are all the same.
Experience in Japan, the U.S., the U.K., Ireland, Spain, and numerous other countries revealed what always should have been understood: No developed economy can afford to have one of its large banks go under, and when the risk of that is severe, the local government is forced to take over the ailing bank or back its liabilities. And when the government cannot find buyers for its debt, the local banks must buy it, because if the government reneges on its debt, the local banks that normally own much of the existing government debt will fail.
And if the government and the banks go bankrupt, so will the whole economy.
What happens when the Germans call a halt to their support for Spain and other highly indebted countries in the euro zone?
Consider the evolving story of Spain. At present, no one but a domestic financial institution would buy Spanish government debt, except for an occasional large speculator who guesses he is buying these bonds cheap and will eventually be able to sell them (directly or indirectly) to the European Central Bank. Such a speculator probably heard the president of the ECB, Mario Draghi, say he will do whatever it takes to support the euro. Draghi also announced that the ECB will buy any amount of Spanish government debt necessary to support its prices and keep Spanish interest rates manageable. Draghi's only precondition was that Spain ask for German aid.
The German finance minister, Wolfgang Schäuble, has said he doesn't believe that the Bundestag will approve this aid to Spain so soon after €100 billion ($132 billion) was earmarked to support the Spanish banks.
But there could be another slight problem. If the German lawmakers are worried about a measly €100 billion, of which about half is allocated to specific banks, what will they say when they find out that the ECB has to finance all of Spain's maturing debt plus its budget deficits, over three years, and do the same for Italy and perhaps other countries, for a total of nearly €2 trillion?
When all of this becomes clear in the next few weeks or months, what will follow? Spanish and Italian banks have a strong incentive to hold their governments' debt, as long as the ECB lets them borrow 100% against it at only 1% interest and make a profit on the hefty rate spread. As Greek experience shows, this isn't riskless: Government bonds may be subjected to a 70% haircut, time and again. Nevertheless, the ECB is standing by to monetize much of the debt of Spain and Italy, whether the banks only borrow against their holdings of government debt or sell the bonds outright.
This flood of newly created money will come on top of €1 trillion in "liquidity" the ECB already injected several months ago and a few hundred billion injected into, or now expected by, the Spanish banks and the support programs for Greece, Portugal, Ireland, and Cyprus. But given the size of the needed aid for Spain and Italy, it is likely that all of this won't suffice, and the euro zone eventually will have to be taken apart. AT SOME POINT GERMANY will have to decide that the burden of keeping the euro intact is too heavy. When it comes, the decision may be made by the Bundestag, Chancellor Angela Merkel, the German courts, or the general public. (There are indications that the Bundesbank has already made the decision and is waiting for other sectors to see the light.)
After the Germans comes the deluge: Spain will default on its obligations, followed in short order by Italy and probably by France. Investors the world over will relearn that government obligations aren't "risk free," and neither are bank obligations.
There is no reason to believe that this lesson will be confined to Europe.
Savers in Japan may finally conclude that their government obligations are too large to be safe, and investors in U.S. federal debt securities may soon reach the conclusion that their positions are increasing too fast for comfort.
Obviously, there's a big difference between the euro-zone members who can't just print more euros on their own and the U.S., which has been printing dollars big-time in recent years. Therefore, the process in the U.S. will be different. As people lose confidence in government obligations, they will naturally also lose trust in those little government pieces of paper (or plastic, or computer files) called money. After all, a Benjamin is only different from a $100 bond in that the cash carries the words "In God We Trust."
As investors lose confidence in government paper and rush for real assets such as real estate or gold, or even stocks that carry a claim to some real-income stream, inflation will start rising.
The inflation will be akin to the hyperinflation experienced by Germany in the early 1920s, in that it will be caused by loss of confidence in government obligations. It is unlikely to reach anywhere near the levels seen then, but could reach levels not even imagined by most savers and investors, let alone by market analysts. Global inflation will be hard to fight, especially because some governments and central banks, including Germany, Japan, and the U.S., are trying to boost inflation for various reasons.
All of this doesn't have to happen, but it will take a lot of ingenuity and flexibility on the part of major decision makers to avoid it. Most would have to change their policies, and the chances of that are slim at best.
MIKE ASTRACHAN is chief economist and strategist of 4L Macro Opportunities in Tel Aviv, Israel.