EU Crisis Worsens as Money Printing Presses Rev Up

* The European Union decided over the weekend that they will not let the silly debt markets threaten the grand experiment they have concocted. One of the reasons behind the creation of the EU was create a globally competitive force to counterbalance the growing dominance of the US and the dollar. Each and every EU country was not large enough to be a global competitor to the US, but collectively, it was thought, they could give the US a run for its money. The EU was conceived during the bull market of the 1990s, and came into being in 1999/2000. The Euro quickly became a success, and the grand experiment in which all EU countries shared the same currency seemed to work. In fact, given the EU’s firm monetary policy, relative to the soft Fed policy, the Euro gained in value by 60%, at its 2008 peak. From this perspective, the European Monetary Union (EMU) was deemed to be almost too successful, as a strong currency was starting to hurt the competitiveness of its export dependent industries.


When the Greek crisis arose, the Euro weakened from 150 into the 130s. While no one in the EU elite officially embraced the cheapening Euro, cries of foul play by China disappeared (and their fixed exchange rate with the dollar), disappeared as the EU had what it wanted, a cheaper currency. Yet it is a fine line between wanting a cheaper currency and to understand why the market was selling it. In my mind, that explains why the EU was slow to respond to the Greek situation: they secretly liked the idea of a cheaper Euro. When it got down to understanding that the market thought the EMU was going to disintegrate, which was highlighted by last week’s market turmoil, is when the EU decided that they had better send a signal to the markets.


Ironically, it seems as if the jist of the EU’s response is analogous to that which the US did to stem the systematic risk in the US financial system in 2008/2009. In effect, the EU will defend the Euro currency against “the wolf-pack” as some EU officials seemed to refer to the market. In addition, the ECB, and the individual Central Banks of the EU will be in the market buying corporate and government bonds, something which the ECB said they did not even discuss at their meeting last Thursday. What the EU is effectively doing, is printing money, and buying its own debt securities. Sounds similar to the $1.7 trillion the US Fed purchased in 2009 to 2010. While this might be positive for the markets over the short term, it does not solve the dual problems of weak economies and a poor fiscal situation, which is still the general malaise for the EU sector as a whole. It was thedeficit spending which got Greece into the problems it is in, and will be so for Spain and Portugal as well. While Spain’s debt to GDP ratio is well below 100%, (Greece was 130%), their current deficit for 2010 is expected to run around 10%, while they have a 20% unemployment rate. How can they pull themselves out of this mess? As part of the EU’s response, Spain announced that they will cut an extra 0.5% off their fiscal deficit this year, and an extra 1.0% next year. How will this help a country with a 20% unemployment rate?


The bottom line is that the EU, and the US for that matter, has been relying on government debt to finance its deficits, and to a very large degree, the government has been empowering its Central banks, private banking sector and its GSE’s, to lend amongst itself. The cleanest example of this is the US treasury guaranteeing FNMA debt, which the Fed will then go and buy, and print money in the process.


There are a few details about this EU’s plans which I find disturbing:


1>  The US Fed will lend dollars against ECB eligible collateral, which means that junk rated Greek bonds could be pledged to the Fed, and


2>  The IMF will provide up to 220 billion Euros for the purposes of supporting Euro FX transactions. Where is the IMF getting 220 billion Euros from? And how much of this is the US, the largest contributor to the IMF, on the hook for?


As a US citizen, I find it rather disturbing that the US is putting a significant share of its capital behind the EU plan. I am not surprised by the acquiescence of the US, just bothered. I am getting used to being bothered. At some point in time, the chickens will have to come home to roost, debts will need to be repaid, by somebody, or there needs to be a way for governments to absorb the losses which are inevitable. How does one avoid these losses? One strategy has been for the Fed to keep interest rates real low, which in turn allows banks to earn a nice spread on their deposits, and hopefully, this spread provides enough money to allow the banks to realize losses in their loan portfolios. The folks who are paying for this are the thrifty and conservative savers, who are sitting on piles of cash earning zero percent. I am not saying it is fair, this is just what is happening. Does a positive interest spread solve all the problems? No, but it helps to a certain extent. With short term interest rates already at 1% in the EU, the ECB has been fostering a similar environment for their banks.


There was some mention that the ECB would sterilize money which they injected into the system. This means that the EU will issue debt, which will then be used to purchase debt of the weaker countries. The bottom line is that eventually these debts will need to be repaid. For the moment, the burden is clearly on the larger countries to use their credit rating to fund the debt burdens of the weaker countries. There is also a certain amount of press being given to the notion that the constituents in the well to do countries might not want to support the weaker countries, and that the actions of the EU this weekend, with the exception of ratifying the 110 billion Euro Greek rescue package, was done arbitrarily, and with weak constitutional support. In fact, in a regional election in Germany over the weekend, Angela Merkel, the head of the ruling German government, lost her majority in the upper house of the parliament. These plots and sub-plots will play itself out in the weeks and months to come.


In short, while today’s actions go a long ways to stabilizing the current market, I cannot envision that these measures are nothing than a replay of the US rescue of the US’s financial system in 2008/2009. Stabilizing the markets today does not insure their long run success, just that they will not implode today or in the next week.


* Chaos at hand, and what it means to the great Inflation/Deflation Debate – It is remarkable how stunned the world seemed to be at the intra-day collapse in stock prices last Thursday. On the one hand, I have to say that all the warning signs of a debt collapse have been in front of us for the last couple of years. Sovereign debt concerns are arising while debt deflation is ongoing in the US real estate markets. At this point in time, the world’s governments have been undertaking heroic efforts to keep the debt intact. 


The likely solution is that governments around the world are resorting to printing and borrowing money from the financial system to support spending (which supports the economy and the ability to service the debt). Printing money, which represents the low impact way to solve the “lack of money” problems, will come with the side effects of inflation, while continued borrowing from the financial markets will put stress on the finances of the borrowers. And ultimately, it will get down to a few large powers who will need to back-stop the debt of the world. It will be the way in which policy responses occur, which will determine the complexion of any recovery, in the context of the depression, which is still lurking in the wings. If governments around the world pro-actively act to pump up their economies through the creation of debt and money, which is what the preferred path seems to be so far, then the result will be an inflation aided recovery. The extent of the amount of debt creation and money printing will determine how much inflation is actually created. The adverse side of inflation is that despite how well you might seem to be doing in dollars (or local currency terms), the purchasing power of your life-style will suffer, either because of higher taxes, or lower purchasing power, or a combination of both. In addition, investments in real estate, which seem to be a pretty dominant part of America’s wealth, will lag far behind other investment vehicles, and inflation, creating a negative wealth effect, in real dollar terms.


This is why the inflation/deflation debate is so widely debated with major disagreements by very smart people. It is going to get down to policy decisions which will come as debt crises occur, and as the world’s economy does not seem to respond as many would hope. In summary, the inflation/deflation debate will be won by those who can accurately predict the extent to which the governments around the world act to prop up their economies through money and debt creation. To the extent that politicians let nature take its course, which seems unlikely, then deflation will rule. I’ll keep my gold and precious metals.


* US unemployment picture – did anyone notice, that the unemployment rate rose to 9.9% (from 9.7%) in the Friday’s employment report? This was despite the fact that payrolls increased by 290,000, of which 66,000 was census related hiring. Nonetheless, it is a positive trend, and the general view of economists, is that when employment starts to pick-up, that folks who had previously chose to not to look for work, entered the work-force, far in excess of those who actually found work.