Disclaimer. After nearly 40 years managing money for some of the largest life offices and investment managers in the world, I think I have something to offer. These days I'm retired, and I can't by law give you advice. I do make mistakes, but I try hard to do my analysis thoroughly, and to make sure my data are correct. Remember: the unexpected sometimes happens. The expected does too, but all too often it takes longer than you thought it would.
The Goddess of Markets punishes (eventually) greed, folly, laziness and arrogance. No matter how many years you've served Her. Take care. Be humble. And don't blame me.
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Friday, November 18, 2011
The European Crisis
Everybody except the Germans can see that to stop the European and Euro crisis, the European Central Bank must stand behind the government bond markets in Europe. A Central Bank has unlimited capacity to create money. In the old old days it was printing presses, these days it's electronic funds transfer. The CB buys government stock in the open market and settles by drawing funds on itself. Only the Central Bank can do this. Everybody else in the system has to have the money first. The CB creates the funds it uses to buy the government stock. It can add to its assets (in this case, government stock) and its liabilities (bank at-sight deposits with it) to an unlimited extent. This is what Central Banks have been doing for well over 200 years. In a financial crisis they intervene in the bond and money markets to prevent a temporary panic becoming a major economic disaster.
But Germany refuses to allow the ECB to do this. The Germans are still fighting the last war, so to speak. After the first World War and the second, Germany suffered hyperinflation because of excessive use of the printing presses to finance government spending. The problem now, though, is the risk of deflation. You do not want to have falling prices in heavily indebted economies. You do not.
And Germany (rightly) maintains that the Greeks and Italians got themselves into this mess and must now do the hard yards to get themselves out of it. Well, yes. But if you live in the top storey of a a block of flats and a flat on the first floor starts burning, you don't refuse to help because its their own stupid fault. You provide unlimited water, because if the fire spreads your flat will burn too. Already fiscal tightening (raising taxes and cutting government spending) will cut 1 to 2% off Euro GDP next year. And the banks are contracting their balance sheets, to try and get their equity up to a "safe" percentage -- i.e., they're contracting lending.
The chart says it all. It shows Euro IP (Industrial production) and the PMI (Purchasing managers survey). The PMI leads by a couple of months. It's heading south fast.
The ECB should cut the discount rate, now, to 0%. It should announce that it will buy Italian government bonds to whatever extent necessary to keep yields at 6% or below. Of course, the ECB will eventually act. But will it move before Europe's "Lehman moment" or after?
Posted by Nikolaos at 7:15 AM