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The latest
round of optimism on display late last week from Wall Street was based upon
the supposed resolution--once again--of all Europe's problems. However, the
sad truth is the move upward only brought the S&P500 near the unchanged
mark on the year in nominal terms and much lower when adjusted for inflation.
What was the
cause for this optimism you ask? It was the speculation that an epiphany had
been reached on the part of the European Central Bank that they would arm
themselves with a bazooka to purchase all of the PIIGS distressed sovereign
debt. Under its Securities Markets Program (SMP), the ECB has already bought
billions of Euros worth of government bonds issued by Italy, Spain and other
troubled euro area economies. The global equity market has now assented to
the notion that the new ECB head, Mario Draghi, is
going to borrow Hank Paulson's bazooka, which was first deployed to rescue
FNM and FRE. But years after Secretary Paulson fired his bazooka, those
formerly thought of as "safe "investments are now trading at just
pennies a share. And just last week the government--or more appropriately the
taxpayer--was forced to throw an additional $7.8 billion at the GSEs for the
last quarter's losses. That was on top of the $169 billion they have already
spent to rescue the black holes known as Fannie and Freddie since 2008.
Nice bazooka
Hank! You see, the problem with arming any government with a bazooka is that
they are guaranteed to have the need to fire it. Mario Draghi
is making the same mistake as our former Treasury Secretary did during our
financial crisis. Paulson believed that the problem with the GSEs was a lack
of confidence. The thought process was that if he threatened to buy all of
the GSE obligations, he would never have to actually do it. However, the
truth was that the FNM and FRE owned or guaranteed mortgages that were
worthless. Offering to buy these garbage investments did nothing in the way
of solving the problem of people owning homes that they couldn't afford.
Similarly, Draghi now believes that the problem
with European debt is fear, not one of insolvency.
And just like
Hank, Mario will soon learn that offering to purchase an unlimited amount of
Italian debt does nothing in the way of bringing down the debt to GDP ratio.
In fact, it has the exact opposite effect. It encourages more profligate
spending, just as it also lowers the growth of the economy by creating
inflation. What's even worse is that yields on Italian debt will reach much
higher levels in the longer term. That's because the purchasers of sovereign
debt have now become aware that their principal will be repaid with a rapidly
depreciating currency. Therefore, the yield they will require in the future
must reflect the decision to use inflation as a means of paying off debt.
What is
unfortunately assured is that several countries in Europe are facing a
recession due to their overwhelming level of debt. One of the consequences of
having a debt to GDP ratio over 100% is that the economy ceases to grow. But
to make matters even worse, the ECB has decided to deploy their arsenal
against rising bond yields. Therefore, the significant downturn in the
economy will be also be accompanied by a high rate of inflation.
The situation
in Greece, and perhaps soon to be in other countries, is not that different
from an individual that is using nearly all of his or her income to pay the
minimum interest payment on their credit cards. Once the C.C. Company gets
wind of that, they are likely to pull in all lines of credit because the
chance of getting their principal back has become nil. However, unlike an
individual, a country with a fiat currency can counterfeit as much currency
as they please. But that is a temporary solution at best.
For now the
yield on the Italian 10 year note has declined from 7.3% on Wednesday the 9th
to 6.5% on Friday. But the ECB has a very short window in which they can
create inflation to bring down bond yields. That's because the main
determinants of how much it costs a country to borrow money in the
international markets are the credit, currency and inflation risks of their
debt. In pulling out his inflation bazooka, Mr Draghi is rapidly increasing all three risks and much
higher yields are virtually guaranteed in the near future
Of course,
not to be outdone Mr. Bernanke and his cadre of counterfeiters at the Fed
have sent oil prices back to $100 a barrel, M2 up 10% YOY and the Misery
Index to a 28 year high. The threat of yet more quantitative easing has sent
many commodity prices rising and gold in shouting distance of its record
nominal high. With central bankers around the globe consistently coming up
with plans to destroy paper currencies, can someone justify a reason not to
buy more gold and gold stocks!
Michael Pento
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