The European Central Bank Goes Nuclear: Cuts Rates, Announces QE

The ECB’s Keynesian “euthanasia of rentier” has gone nuclear. Aside from the negative deposit rates last June, the latest announcement includes a surprise paring down of interest rates by .1% to .05%, as well as, a QE based on Asset Backed Securities (ABS).

From the Wall Street Journal: (bold mine)

The European Central Bank surprised financial markets with a cut in interest rates and new stimulus plans despite opposition from Germany's powerful central bank, underscoring its urgency in keeping too-low inflation from derailing the eurozone's weak economy….

The ECB lowered its main lending rate by 0.10 percentage point to 0.05%. It cut a separate rate on bank deposits deeper into negative territory, to -0.2% from -0.1%. In June, the ECB became the largest central bank to experiment with a negative rate on bank deposits, a measure aimed at encouraging banks to lend surplus to other financial institutions rather than paying to park them at the ECB.

The central bank also announced it will purchase covered bank bonds and bundled loans known as asset-backed securities and said additional details will be released in October. Mr. Draghi didn't indicate a size for the program, but said the ECB's aim was to get its balance sheet, currently around €2 trillion, back to its size at the beginning of 2012, when it was €2.7 trillion.

A previous covered-bond program in 2011 didn't generate much interest from banks, but reviving it—with the new ABS program—sends a signal of the ECB's resolve to deploy its balance sheet to head off the threat of too-low inflation.

Deflation or “low inflation” amidst weak growth  has been made the bogeyman to justify such measures. The reality is that the Eurozone’s problem has been one of impaired household and institutional balance sheets, therefore the inability to expand credit. In short, the Eurozone needs to clean their finances for them to borrow again. Forcing people to borrow will only add to their existing woes.

Yet the other major obstacles in the real economy such as crushing taxes, various forms of interventions and welfarism have been disregarded. All these represent cumulative symptoms of government interventions. 

The Eurozone has already an amazing record low bond yields. Despite this, the much politically desired (debt financed) spending hasn’t emerged.

What all these interventions has done has been to muddy the investment climate.

Thus the capital investment has been flagging. Companies instead has been returning cash to investors. (chart from FT Alphaville)

And the natural consequence from low investments has been to diminish trading activities as evidenced by dwindling intra-EU trade.(chart from Zero Hedge). 

Reduced trade activities simply extrapolates to low economic growth.

Of course not everything has been bad. Zero bound and negative rates has signified a subsidy to government activities.

Political spending in the region has mostly increased (chart from Dan Mitchell).

And given the low growth environment, these has ballooned government debt-to gdp (Zero Hedge).

Government debt according to the Eurostat as of July has been at 93.9% of GDP

So subsidies via financial repression has not only kept government debt levels afloat, they have encouraged even more unproductive debt accumulation. Yet whatever government resources consumes means resources taken away from the private sector, hence the low investments and low economic growth environment

And there’s more. Because Keynesian dogma of the “euthanasia of rentier” have been designed to promote debt, companies have taken in on risk debt from capital markets to record levels. Here’s the Wall Street Journal: The prospect of quantitative easing in Europe is reviving the market for risky bank debt, with two European lenders testing the waters on so-called contingent capital, or CoCo, bonds after a monthslong drought. CoCos—which can convert to equity or be wiped out if the issuer's capital levels drop below a threshold—had a booming start to the year as banks took advantage of record low rates to bolster their balance sheets ahead of a banking-system health check this fall. Issuance surged to a record €33.6 billion ($44 billion) in the first half of the year, before the market ground to a halt in July when financial difficulties at Portugal's Banco Espírito Santo and U.S. Federal Reserve Chairwoman Janet Yellen's warning about the high price of risky debt prompted investors to pull back

And aside from the US Federal Reserve providing bridge finance to Eurozone companies via Overnight Interest Rate on Reserves, much of these borrowed money may have most likely been powering financial asset speculation. The Stoxx 600, a composite benchmark of 600 companies, has been levitating at multi-year highs. 

So the Eurozone has been experiencing a fantastic parallel universe; listless economic activities in the face of a financial asset markets boom

And with the Euro being clobbered, the likelihood is for the currency to be used as funding currency in potential carry trades which may further provide fuel to the amplification of global asset speculation orgy. And this is why many drool over the ECB's recent actions.

Meanwhile, a weak euro may spawn a reversal in the bond rallies in Eurozone's periphery economies as money flows elsewhere in search of higher returns.

At  the end of the day, the ECB’s euthanasia of rentier only adds to the imbalances to the Eurozone’s fragile economy which may spillover to the global economy via a global bubble cycle.

As the great Austrian economist Ludwig von Mises presciently warned: (bold mine)

Public opinion is prone to see in interest nothing but a merely institutional obstacle to the expansion of production. It does not realize that the discount of future goods as against present goods is a necessary and eternal category of human action and cannot be abolished by bank manipulation. In the eyes of cranks and demagogues, interest is a product of the sinister machinations of rugged exploiters. The age-old disapprobation of interest has been fully revived by modern interventionism. It clings to the dogma that it is one of the foremost duties of good government to lower the rate of interest as far as possible or to abolish it altogether. All present-day governments are fanatically committed to an easy money policy…Many governments, universities, and institutes of economic research lavishly subsidize publications whose main purpose is to praise the blessings of unbridled credit expansion and to slander all opponents as ill intentioned advocates of the selfish interests of usurers.

The wavelike movement affecting the economic system, the recurrence of periods of boom which are followed by periods of depression, is the unavoidable outcome of the attempts, repeated again and again, to lower the gross market rate of interest by means of credit expansion. There is no means of avoiding the final collapse of a boom brought about by credit expansion. The alternative is only whether the crisis should come sooner as the result of a voluntary abandonment of further credit expansion, or later as a final and total catastrophe of the currency system involved.

All these reckless experimentation for the sake of protecting the interests of politicians, bureaucrats and their cronies.

Yet the massive misallocation of resources from manipulation of interest rates paves way for a depression (soon).

The Euro Bailout And Market Pressures

``The problem is that the fundamentals of these economies are not right. People in those countries cannot maintain a decent standard of living because they are not producing enough in the private economy to keep the public-sector unions afloat. Unfortunately, these unions are so powerful that they can extort pay and work agreements that plunder the taxpayers, and now that the bailouts have arrived, look for the unions to be even more militant and violent. These countries don’t need more inflation, contra Keynesians. They need to stop feeding the monster of public-employee unions and permit business to operate without being smothered by rules and regulations. But after being bailed out, these governments will go back to doing things as they always have, and the malinvestment will continue.” William L. Anderson, Will the New Bailout Save Europe?

The ultimate question at present is whether the Greece crisis would escalate into a full-blown international sovereign debt crisis, in spite of the recent monster $1 trillion bailout[1] announced by an EU-IMF syndicate last Sunday or if the market stresses emanating from the Greece episode would lead to a cascading impact on the real economy. And for that matter the sequential question should be, what would be the attendant policy response if the markets continue to react negatively?

Bailouts Are Politically Motivated And Ballooning

It’s a silly notion to limit ourselves to only the economic aspects, when throughout the decade the policy response, when confronted with a crisis, has been mostly politically designed which eventually had political results, particularly boom bust cycles. And this is why political reactions[2] by global leaders have been like clockwork, which has seemingly validated us anew.

For instance, the nearly 10% plunge[3] in the US the other Friday, which was mostly pinned on computer error, has prompted authorities to conduct an investigation. Here is a very telling commentary, as quoted by the Financial Post[4], from a US lawmaker,

"We cannot allow a technological error to spook the markets and cause panic," Rep. Paul Kanjorski said late on Thursday. "This is unacceptable."

This only implies that US markets have been very much incorporated into the policy setting modules of US authorities, where falling stockmarkets for valid reasons or not, e.g. due to technological glitches, is like a taboo.

And there is little nuance when compared to the EU’s bailout of the Euro, where EU Commissioner Olli Rehn announced, ``We shall defend the euro whatever it takes”[5]

These are more than enough proofs that the guiding principle for global authorities is to shore up their markets as means to convey “confidence”. As we have been saying, the intuitive response by global governments has been to unceasingly throw money at the problem. And confidence in the market is likely to translate to financing for politicians running for elections, aside from a favourable image to the public.

And one would note that the cost of bailouts have been growing,

This from Bloomberg[6],

``The cost of saving the world from financial meltdown has been bloated by ‘hyperinflation’ since Long Term Capital Management LP’s rescue in 1998… rising price of bailouts since the $3.5 billion pledged to hedge fund LTCM after it was crushed by Russia’s default, and the almost $1 trillion committed to halt the European Union’s sovereign debt crisis this week. It cost just $29 billion to sooth markets in March 2008 when Bear Stearns Cos. was taken over, and $700 billion for the Federal Reserve to save the banking system with the Troubled Asset Relief Program in October that year. ‘We haven’t had any kind of normal inflation in the last decade, but we’ve had hyperinflation in writedowns and the magnitude of bailouts,’ said Jim Reid, head of fundamental strategy at Deutsche Bank… ‘You have to do more to get a similar effect every time.’”

As we earlier wrote[7], To paraphrase Senator Everett Dirksen ``A trillion here and a trillion there, and pretty soon you're talking real money; (gold as money)"

There seems to be no apparent end to the spate of bailouts.

QE In 4 Largest Economies And A Different Kind Of Carry Trade

Will global governments wake up to face reality recognizing the attendant risks by adapting policies that require stringent sacrifices to clear their respective markets of excesses or malinvestments? Or will they continue to flush the economic system by the massive use of their printing press as a short term fix or a nostrum?

For us, until they are faced with a crisis that forces their hands, the path dependency for authorities is for the latter.

Yet a genuine manifestation of an international sovereign crisis would be a surge in interest rates among nations afflicted by growing risks of debt default.

However this seems unlikely to occur yet, as governments would still be able to manipulate the bond markets for political expediency, particularly to finance existing deficit as incidences of inflation appear muted.

And part of such policies to suppress interest rates would be to buy government bonds from the financial markets or the banking system. And this apparently has been part of the measures that was packaged with the bailout of the Euro.

In essence, we have 4 of the world’s largest economies that have now engaged in “quantitative easing” (even if the ECB denies these, for the reasons that she would “sterilize” her purchases or offset bond purchases from banks/financial institutions with sale of EU bonds).

And these 4 economies constitute nearly 85% of the $83 trillion global bond markets as of 2009[8].

In short, world markets and the global economy would likely suffer from an unprecedented meltdown in a horrific scale, which would make 2008 a walk in the park, if any of the developed nation’s sovereign crisis transform into a full contagion.

However, I don’t believe that we have reached that point yet.

Figure 2: US Treasuries Index, EM Index, Yield Curve, US Dollar

The highly volatility in the markets have led a misimpression of a repeat scenario of carry trade circa 2008.

As we have pointed on last February, there is little evidence that a carry trade from the US dollar has been building among the global banking system[9].

Instead what the Euro crisis has been showing us is that the carry trade has been within the Eurozone system as seen by the interlocking[10] activities or the vastly intertwined network among private and national banks, EU member governments and the ECB. In short, it isn’t a foreign currency arbitrage, but a carry trade of government debts distributed among EU banks.

As we earlier quoted[11] Philipp Bagus[12],

(bold emphasis mine)

``The banks buy the Greek bonds because they know that the ECB will accept these bonds as collateral for new loans. As the interest rate paid to the ECB is lower than the interest received from Greece, there is a demand for these Greek bonds. Without the acceptance of Greek bonds by the ECB as collateral for its loans, Greece would have to pay much higher interest rates than it does now. Greece is, therefore, already being bailed out.

``The other countries of the eurozone pay the bill. New euros are, effectively, created by the ECB accepting Greek government bonds as collateral. Greek debts are monetized, and the Greek government spends the money it receives from the bonds to secure support among its population.”

And the existing regulations which mandate the banking system to hold government debt as a risk-free reserve has equally contributed to the current mess by introducing the moral hazard problem effectively channelled into subsidies to the subprime EU member states as Greece.

So the pressure seen in the Euro markets of late isn’t due to the unwinding of US dollar carry trades but a perceived rise in the default risks and possibly the consequent impact to the real economy from a perceived slowdown due to compliance to fiscal adjustments, or of the question of the European Union ability to survive the crisis without getting dismembered.

As shown above, US interest rates markets and the US dollar have been chief beneficiaries from the troubled Euro. The Morgan Stanley US Government Morgan Stanley Fund (USGAX), a fund where 80% of its assets are invested in Treasury bills, notes and bonds, has surged. Moreover, the US dollar Index where the Euro has the largest share of the basket, has continually spiked.

This, in essence, looks more of a rotation away from EU assets into US assets than a looming full blown international sovereign crisis.

In addition, we are seeing parts of that rotation away from the EU into Emerging Market Bonds as shown by rise in the Salomon Bros. Emerging Market Debt Funds (XESDX).

Likewise, the spread between the 3 month Bills and 30-year Bonds remains steep in spite of a relatively higher 3 month rates since the start of the year.

In a full scale sovereign crisis we are likely to see a faster surge of short term bills rather than bonds. And this will likely be triggered by a spike in inflation which sets about a self feeding mechanism that would force up rates. At this point, governments will have to choose to bring down interest rest rates by printing more money or by totally renouncing inflationism.

This Isn’t Lehman Of 2008; China’s Role And Slumping Commodities

Well obviously this isn’t 2008, where the disruptions in the interbank funding markets forced a seizure or a rapid system-wide contagion in the banking system.

Yes, we are seeing some volatility but this has been nowhere near the post Lehman episode as shown in the credit markets or in the interest spreads (see figure 3).

Figure 3 Danske Bank: Credit Markets Isn’t Manifesting Signs Anywhere Near 2008

The yields in US cash indices for different corporate bonds (left window) have largely been unscathed in spite of the current selling pressures.

And the 3 month Libor-OIS spread considered as a measure of the health of the banking system (in the US and Europe), hasn’t been suffering from the same degree of stress during the zenith of the Lehman days (right window).

And that’s also why EU officials have been quick to institute “buying of government bonds” or “quantitative easing” in response to signs of growing stress in Europe’s banking system.

By making sure of the ample liquidity of markets, these actions which work to suppress interest rates are meant to allow markets and the banking system continually finance EU’s bailout. In other words, the bailout is not only meant to politically uphold the Euro as the region’s currency, but to also keep intact the carry trade, unless overhauled by reforms-which appears to be nowhere in sight.

Morgan Stanley’s Joachim Fels sees the same view,

(bold highlights mine)

``More generally, with the establishment of a potentially large stabilisation fund, fiscal policy in the euro area is being effectively socialised. No country will be allowed to fail, and it seems that no country will be too big to bail. Ultimately, this creates an incentive for governments to run a looser policy than otherwise. If markets then refuse to fund a profligate government, it could turn to the fund, borrow at below-market interest rates and domestically blame the required fiscal tightening on the ‘diktat' from the euro area partners and the IMF. So, our bottom line on the implications of the European fiscal emergency plan is that, while it addresses the near-term liquidity problems, it does little to solve the underlying problem of fiscal sustainability and may even make things worse on this front over the medium term.”

Moreover, I’d like to add that while some have argued that the EU’s actions will not violate the principle of Maastricht treaty, which disallows for direct bailouts, the Special Purpose Vehicle (SPV) created to extend loans to troubled nations, for me, signifies as EU’s act to go around their self-imposed rule, or regulatory arbitrage, but this time by the EU government.

If governments would work to circumvent their rules in order to accommodate political expediency and likewise save particular interest groups in the context of the meme of saving the economy or the Union, then how else would this politically privileged group react when they knowingly feel protected? They are likely to engage in more reckless behaviour.

This reminds us of Hyman Minsky[13] who warned that bubbles emanate from government intervention, ``It should be noted that this stabilizing effect of big government has destabilizing implications in that once borrowers and lenders recognize that the downside instability of profits has decreased there will be an increase in the willingness and ability of business and bankers to debt-finance. If the cash flows to validate debt are virtually guaranteed by the profit implications of big government then debt-financing of positions in capital assets is encouraged. An inflationary consequence follows from the way the downside variability of aggregate profits is constrained by deficits.”

So its more than just inflating, it’s also a burgeoning moral hazards problem.

In addition, considering that the US is directly and indirectly involved, through the Federal Reserve via the currency swap lines and the IMF respectively, this can’t be seen as “beggar thy neighbour” approach considering that the US Federal Reserve sees the spillover risks from a banking contagion as possibly harmful to the sensitive state of her counterparts. In other words, the Fed isn’t causing a higher a US dollar for trade purposes but to ring fence the US banking system from a Euro based contagion.

Instead, such policy is more of a “beggar thy economy” genre where resources are being marshalled to save the banking system in the US and in Europe, at the expense of the real economy.

It’s not clear that the recent spate of falling oil or commodity prices are materially connected to the events in Greece or Europe, as they seem more correlated to the developments in China (figure 8).

Figure 4: China and commodities

As you can see the sharp drop in China’s Shanghai index (SSEC), which has been under constant assault from her government in an attempt to quash formative bubbles, has nearly been concurrent with the drop in oil (WTIC) and general commodities (CRB). Albeit the SSEC’s recent steep decline has also coincided with the fall of global markets from the Greece crisis the other week.

However, one bizarre development which seems moving in contrast to the current tide has been the Baltic Dry Index (BDI). The BDI appears headed towards the opposite direction almost as markets have been falling.

And with reports that consumer price inflation has been accelerating, it is quite likely that the Chinese yuan, could be expected to appreciate soon. And possibly, the rising BDI could possibly mean two things: one, a rising renmimbi means cheaper imports, which could reflect on the possibility of China’s positioning, and second, the falling prices could also be another factor for increased demand.

Unlikely Slump For Global Markets

So what does this tell us of the global markets?

First I am doubtful if this is the “inflection point” as expected by the permabears.

I see this more of a reprieve than a reversal. As said earlier, for as long as consumer price inflation rates are low, governments can continue to flood the economic system with newly printed money that may artificially contain interest rates levels.

Since money isn’t neutral, the impact from bailouts will have uneven effects to countries or specific sectors in particular economies. Even those expecting a deflation in Greece seem gravely mistaken[14].

Second, aside from the liquidity enhancement programs, policy rates by developed economy central banks are likely to stay at present levels for a longer period of time.

We even think that EM economies are likely to maintain rates at current levels, given the current conditions. In addition, rate increases enhances the risks of attracting more foreign capital in search of higher yields. Policymakers in EM nations will be in a fix.

Three, given the still steep yield curve, I have been expecting a pick-up in credit activities even in nations afflicted by over indebtedness. So far there have little signs of these (see figure 5)

Figure 5: St. Louis Federal Reserve: Consumer Loans at All Commercial Banks

Our basic premise has been that incentives provided for by the government to punish savers and reward debtors by suppressing rates will eventually force people to spend or speculate at the risk of blowing another bubble.

Besides, debt has been culturally ingrained in Western societies. It is an addiction problem[15] that will be hard to resist considering that the government itself is the main advocate of the use of addictive credit.

Fourth, economies of emerging markets have been performing strongly and are likely to maintain this momentum given the ultra loose liquidity backdrop.

Fifth, any slowdown or economic problems in any countries is likely to produce more bailouts from governments.

The trend has been set, therefore the chain of events are likely to follow. For instance, US participation in the bailout of Greece is likely to set a moral hazard precedent for financially troubled domestic states.

As Ganesh Rathnam argues[16], (bold highlights mine)

``The Federal Reserve's and IMF's participation in the eurozone bailout will not be lost on union members and politicians of heavily indebted US states such as California and Illinois. When the day of reckoning arrives for the US states who are unable to close their budget gaps and whose pension plans have huge funding gaps, they will be up in arms for their bailout as well. How could the US government politically defend its bailing out Greece via the IMF and the Federal Reserve and refusing the same for its own citizens? The idea that California would be allowed to default on its obligations when Greece wasn't is unthinkable. Therefore, the bailout of the PIIGS sets the stage for similar bailouts of bankrupt US states and cities.”

So governments worldwide will continuously pour freshly minted or digital money into the system. And yes this is going to be an ongoing battle between the markets and government armed with the printing presses.

Finally, Nassim Taleb in a recent interview[17] said, “No government wants solution to apply on themselves”.

And this only means that there will be even more government spending, bigger deficits and debts, higher inflation and missed fiscal targets or slippages from proposed austerity programs.

In the Eurozone, the EU circumvented existing rules to accommodate a bailout. These are signs that rules can flouted for political goals.

For the interim, this will all help. But at a heavy price in the future.

---

[1] see $1 Trillion Monster Bailout For The Euro!

[2] Stock Market Investing: Will Reading Political Tea Leaves Be A Better Gauge?

[3] See A Black Monday 1987 Redux?

[4] Financial Post, Obama says authorities probe cause of stock swoon

[5] see $1 Trillion Monster Bailout For The Euro!

[6] InvestorVillage/Bloomberg, Cost of Bailouts Keep on Rising

[7] See Are Record Gold Prices Signalling A Crack-Up Boom?

[8] The Asset Allocation Advisor, World Stock and Bond Markets and Portfolio Diversity; distribution share as follows US 37.9%, Euro 28.7%, Japan 13%, UK 4.9%

[9] See Does This Look Like A US Dollar Carry Bubble?

[10] See Was The Greece Bailout, A Bailout of The Euro System?

[11] See Why The Greece Episode Means More Inflationism

[12] Bagus, Philipp, The Bailout of Greece and the End of the Euro Mises.org

[13] Minsky, Hyman "Inflation, Recession and Economic Policy", 1982 (page 67) quoted earlier here More On Goldman Sachs: Moral Hazard And Regulatory Capture

[14] See Is Greece Suffering From Deflation?

[15] See Influences Of The Yield Curve On The Equity And Commodity Markets

[16] Rantham, Ganesh A Greek Tragedy in the Making

[17] See Nassim Taleb: Waking Up One Day To Perceptional Hyperinflation

Why The Greece Episode Means More Inflationism

``The European capital market institutions would not be able (or even willing) to step up to the plate and negotiate a restructuring. The ECB is not allowed to. And the EC is not up to it. There is an alternative -- the IMF has specific experience in this regard. But, allowing the IMF in would be an admission that the Euro area has not quite made it as currency union. The IMF, given its historical origin with exchange rate mechanisms, would convey a message that the big Euro players would not like to see. It would tar the reputation of the Euro even if there are no contagion effects on other PIIGS. Moreover, allowing Greece out of the Euro (or kicking) it out would be even worse. That is why, I think, the Germans will pay up. They will pay to maintain the reputation of the Euro. Americans underestimate the commitment to the Euro.” –Paul Wachtel Thoughts on Greece's debt problems

Prior to last week’s intermission, we noted that like the Dubai debt crisis, the Greek dilemma would seem like a political issue more than an economic one and therefore, as we suggested, would be resolved politically.

And by politically, we meant that arguments for sound policies or by imposing harsh or rigorous discipline against a wayward member of the EU would be subordinate to the practice of inflationism.

And as per the mainstream, the most recent volatility in the global markets had been mostly attributed to either the prospects of a contagion from the risks of a Greece default or from the attempts of China to wring out inflation out of its system.

Nevertheless, we have not been convinced by verity of the alleged cause.

While key benchmarks across asset markets have indeed broadly deteriorated then, which somewhat did raise some worries on my part, the correlation and the supposed causation did not seem to square [see Global Market Rout: One Market, Two Tales].

If indeed there had been a generalized anxiety over a contagion of rising default risks from sovereign debts, then sovereign CDS AND sovereign YIELDS, aside from corporate and bank lending rates would have spiked altogether!

In addition, considering the scenario of a run from sovereign securities, the contagion should have been largely a regional dynamic and paper currencies would not have been seen as the safe shelter, since the major currencies of the world have all similarly afflicted by the same disease!

What happened instead was a palpable shift to the currency (US dollar) of the lesser affected nation (the US) which somewhat resembled a “flight to safety” paradigm of 2008. With the trauma from the recent crisis along with automatic stimulus response [as discussed in What Has Pavlov’s Dogs And Posttraumatic Stress Got To Do With The Current Market Weakness?] some have mistakenly labeled the recent events as the unwinding US dollar carry trade.

Yet, as CDS and yields went on the opposite course, Baltic stock markets soared and gold plummeted validating our observation that the precious metal, which has served as man’s money throughout the ages, has been exhibiting a tight correlation with the Euro or a proxy thereof, instead of deflation or inflation signs [see When Politics Ruled The Market: A Week Of Market Jitters]. This tight correlation appears to have been broken last week! (see figure 3)

Figure 3: stockcharts.com: Gold-Euro Break, US 10 Year Yield, JP Morgan Emerging Debt Fund

The contour of the Euro and Gold trendlines has been the same over the 6 months up until last week!

Since gold has served as lead indicator of asset markets since the depths of 2008, including the recent selloffs, any resumption of an upward trend by gold is likely to be signs that asset markets will be headed higher soon.

Ergo, Gold above 1,120 should likely serve as my trigger for a buy on equity markets.

Moreover the major US sovereign benchmark, the 10 year Treasury yield (TNX), in spite of the recent stock market setback has remained stubbornly high. Also the JP Emerging Market Debt Fund (JEMDX), in spite of the recent China and Greek jitters, remains buoyant.

In other words, those expecting a repeat of 2008 or of a deflation scenario appear to be in a wrongheaded direction.

What seems to be in place is that the markets seem to be looking for a reason to retrench or has been reacting to the discordant tones from the mixed messages transmitted by the political and bureaucratic authorities. In short, if markets had been recently buoyant out of a flood of global liquidity then qualms over a liquidity rollback appear to be the major concern.

Inherent Defects In The Euro

Any major liquidity rollback for developed economies would most likely be deferred, with the Greek and the PIIGS issues signifying as one of the principal reasons.

Remember since the PIIGS is a political issue then any attempt to resolve the Greek crisis will be political.

Professor Paul Wachtel in a New York University forum captures it best, ``It is not Greece, it is the Euro. A troubled small country can be shrugged off but a currency area is either whole or not. The Germans will pay up to keep the Euro area in tact.”

True. A united Europe has been a longstanding project since the close of World War II. Monetary integration has been in the works through the European Monetary System since March of 1979.

So the Euro isn’t just a symbolical currency that can easily be jettisoned, instead it is a sense of pride for the major European economies that make up the core of the European Union. Hence it won’t be easy to dismantle a pet project for Europe’s social democrats.

However since the Euro is another monetary experiment it comes with inherent flaws in it.

For instance, the inclusion of Greece to the European Union has effectively bestowed subsidy privileges to her by the European Central Bank (ECB) even prior to this crisis via an intraregion carry trade.

Where the interest rate spread of Greek sovereign instruments had been wide relative to core Euro members, European banks bought Greek bonds and used them as collateral to extract additional loans from the ECB. Spendthrift socialist Greece, in turn, took advantage of this easy access to money to fund lavish public expenditures.

As Philip Bagus explains, ``The banks buy the Greek bonds because they know that the ECB will accept these bonds as collateral for new loans. As the interest rate paid to the ECB is lower than the interest received from Greece, there is a demand for these Greek bonds. Without the acceptance of Greek bonds by the ECB as collateral for its loans, Greece would have to pay much higher interest rates than it does now. Greece is, therefore, already being bailed out.

``The other countries of the eurozone pay the bill. New euros are, effectively, created by the ECB accepting Greek government bonds as collateral. Greek debts are monetized, and the Greek government spends the money it receives from the bonds to secure support among its population.”

The latest US centered bubble exacerbated the carry trade and the intraregion subsidies of the PIIGS which eventually rendered European banks as highly sensitive to a PIIGS default (see figure 4).

Figure 4: Bloomberg: Shot Gun Wedding

According to Bloomberg’s Chart of the Day, ``Banks in Germany and France alone have a combined exposure of $119 billion to Greece and $909 billion to the four countries, according to data from the Bank for International Settlements. Overall, European banks have $253 billion in Greece and $2.1 trillion in the so-called PIGS.”

So not unlike the US, the European Union will most likely persist in subsidizing subprime PIIGS and the European banking system at the expense of the rest of its society.

And also not different from the US, the risks of unsustainable welfare states will likely be a part of the currency and asset equation.

NYU’s Mario Rizzo bluntly writes, ``People like to deny reality when it is unpleasant. This is not just a problem of bad leadership. It is a problem that goes to the heart of the fantasy world the typical voter lives in. Buy reality bites. Let’s see how it does so in the next few years.” (bold highlight mine)

Moreover, the underlying systemic subsidies incent European member state beneficiaries to expand spending. Obviously such feedback loop mechanism of incremental subsidies and deficit spending will ultimately be untenable.

Again from Philip Bagus, ``For the member states in the eurozone, the costs of reckless fiscal behavior can also, to some extent, be externalized. Any government whose bonds are accepted as collateral by the ECB can use this printing press to finance its expenditures. The costs of this strategy are partly externalized to other countries when the newly created money bids up prices throughout the monetary union.

``Each government has an incentive to accumulate higher deficits than the rest of the eurozone, because its costs can be externalized. Consequently, in the Eurosystem there is an inbuilt tendency toward continual losses in purchasing power. This overexploitation may finally result in the collapse of the euro.” (bold emphasis mine)

So perhaps it wouldn’t be systemic rigidities that could undo the Euro, as preeminent monetarist Milton Friedman warned about [or the tradeoff between ``greater discipline and lower transaction costs outweigh the loss from dispensing with an effective adjustment mechanism”] but the untenable cross subsidies and systemic inflationism inherent within the system.

Easy Monetary Policies To Continue

And the political response has been as what we had expected.

An article from Bloomberg says Europe will use former US Treasury Secretary Hank Paulson’s “Bazooka” approach to deal with Greece, ``European leaders closed ranks to defend Greece from the punishment of investors in a pledge of support that may soon be tested. German Chancellor Angela Merkel and her counterparts yesterday pledged “determined and coordinated action” to support Greece’s efforts to regain control of its finances. They stopped short of providing taxpayers’ money or diluting their own demands for the country to cut the European Union’s biggest budget deficit.”

Like short selling, the blame has always been pinned on the markets. However, as discussed above, the woes of the PIIGS exhibits a structurally flawed monetary system.

The fact that Greece fudged its numbers to get into the Euro membership serves as damning evidence of EU’s incompetence. Investors don’t just punish nations without any basis. Investors get burned for making the wrong decisions.

On the other hand, bilking taxpayers, misrepresentation and mismanagement are enough justifications for punishment, not only from investors but from the resident political constituency. True, international sanctions won’t likely work as policymakers are too tied up rescuing each other.

Of course, tightening of monetary policies today won’t help the cause of the EU or the US from executing bailouts and rescues of their political patrons. Hence we can expect deferred “exit strategies” and even extended quantitative easing programs.

Oh, did I just mention the US as possibly help fund a Greece bailout? Yes, apparently. This according to Financial Times, `` European governments are expected to turn increasingly to US investors to help them meet their funding requirements as record levels of bond issuance make it harder to attract buyers.” (bold highlight mine)

So whether it be the IMF (where the US has the largest exposure representing 17% of voting rights) or direct participation from US investors we can expect somewhat the US to be a tacit part of the rescue team. Sssssssshhhhh.

Perhaps, some Asian nations as China may take part in it too.

What do you expect, it’s a paper money system! Government central banks can simply print money and channel them into sectors or economies in dire straits, in the hope that the money printing has neutral effects.

All the imbalances we’ve just spelled out here is a medium to long term perspective, which means they aren’t likely to unravel anytime soon.

But it is one of the risks that should be reckoned with overtime.

For the meantime, the triumphalism of the Philosopher’s Stone or the alchemy of turning lead into gold will likely still work its interim or immediate wonder. That’s why it has been the preferred du jour priority option by policymakers.

And importantly, that’s why it gives confidence to the global political authorities to do all their redistributive programs.

Meanwhile, expansionary policies from the EU and the US are likely to continue. And this should help support the asset markets.