Flash Point: Europe is fixed! Not!

We received this note from our friend JR that echoes what appears to be a common sentiment.

This is simple. If the ECB sets rate caps on long-term rates then the solvency crisis is essentially over. This would essentially be a pseudo guarantee of bond markets with the ECB’s backing. This would almost certainly bring private investors back to these markets and help fund the governments. So we eliminate the solvency crisis. That’s a HUGE first step. http://pragcap.com/europe-a-policy-proposal-with-teeth

We will argue that the solvency issue is not resolved but simply kicked down the road. That in turn opens up a rarefied space we haven’t seen commentary or speculation on yet.

The Solvency Problem

The immediate problem is one of solvency. Being able to rollover debt or take on new debt at a capped rate does not address the solvency problem. It addresses a cash-flow problem. The debts are so large that any reasonable rate cap will still carry with it debilitating interest payments which will support large and worsening deficits. The only thing that a rate cap will do is shift national sovereign debt onto the ECB from the private sector if the private sector considers that the risk associated with a bond is greater than the cap. We have seen no discussion of the NEXT STEP. Everyone sees this as the final solution. It is in the sense that it is the last kick of the can.

The IMF as a supranational entity might be a candidate for an additional kick of the can taking all ECB debt onto its balance sheet. But saner countries like Canada and the US have refused to go along with this pathetic European plea of entitlement to give them money. And neither the Extraterrestrial Bank of the Solar System nor the Central Galactic Bank have given any indication that they are willing to intervene. So the buck – er, euro – stops with the ECB.

If this path is taken, markets will stabilize, possibly fairly quickly as the printing starts (today from Mike Shedlock: ECB Printing Press Door Is Open ). As the article notes, private investors – those not already burned by unilateral haircuts imposed by authorities on Greek debt, may feel it safe to hold PIIGS debt and acquire more. Since interest is largely a measure of risk and if the ECB effectively removes most of the risk, it may not have to actually buy that much. Just the occasional intervention to maintain the cap. Markets left to themselves are very efficient and we think would stabilize at some price just below the cap.

This would solve the cash-flow problem that governments face. This does nothing to solve the problem of excessive debt. The two solutions are economic growth greater than debt growth or default. The former is not possible, in part as noted in other posts, because the high level of debt restrains growth. Inflation as a means of default is not desirable in an economy suffering protracted and deep austerity. It would simply accelerate all the negative factors currently working in these economies. Without a hard default, these countries can only issue an accelerating amount of debt which a cap would facilitate.

Consider This Question

A country with its own central bank and currency registers the money as a liability on the central bank’s balance sheet offset by assets that were acquired in spending the newly created money into circulation. The value of the currency is backed by the central bank’s assets. Should these assets for whatever reason lose value, the country’s government then must provide the assets to restore the value of the currency.

The proposal we have been discussing is for the ECB to buy the sovereign debt of insolvent eurozone members to cap yields and stop the bleeding. The scenario is not that farfetched for the ECB to own virtually all the sovereign debt of a country if the market decides the interest rate cap has misprinted the risk. And this could happen very quickly. That transfers the entire sovereign debt onto the ECB through  a process that expands the supply of euros. The assets backing the euro at this point are sovereign debt instruments whose market value is considerably below its nominal value. In short, the ECB would lack the capital to support the euro’s value.

So the question is who backs up the ECB? In theory each country of the eurozone does so in proportion to its GDP. At present, Greece, Portugal and Ireland are essentially in receivership. They cannot contribute. Spain is at the point of joining this elite club and Italy may not be far behind. This is a dinner party of 17 people, most of whom find their pockets empty when the waiter brings the bill. The fear in Germany is that they will be stuck with the bill and this fear is well founded. If it comes to a crunch, will Germany pay? We doubt it.

The endgame is simply too enmeshed in complexity to discern a likely path and outcome. Fragmentation of the EU and the eurozone in any of a number of forms which have been widely speculated about is likely. The euro will undergo a great devaluation as sovereign debt implodes. Historically, no structure as large and complex as what the Europeans have built has been created before. We have no idea at all how ultimately it will fail. We have a firm belief that this house of cards will fail. Historians will look back and say: and great was the fall of it.

Addendum

Zero Hedge (ZH) just posted: What Happened After Europe’s Last Three Currency “Unions” Collapsed. Historically:

In the last century, Europe saw the collapse of three multi-nation currency zones, the Habsburg Empire, the Soviet Union, and Yugoslavia. They all ended in major disasters with hyperinflation.

ZH also posted an extensive Citibank analysis, Citi Sees Greek Exit As Soon As September, that offers these pessimistic viewpoints:

  • we expect that growth in periphery economies will undershoot official forecasts, leading to above-target and generally rising government debt/GDP ratios in coming years.
  • We continue to put the probability that Greece will exit the euro area (ie “Grexit”) in the next 12-18 months at about 90%and, … conceivably even as early as September/October
  • We think the EMU end-game is likely to be a mix of EMU exit (Greece), a significant amount of sovereign debt and bank debt restructuring (Portugal and, eventually, perhaps Ireland, Italy and Spain), with only limited official fiscal burden sharing (via the ESM, EFSF and ECB losses) and ongoing liquidity support from the ESM and the ECB.
  • We doubt that any of these countries will be able to sustain normal market access at a tolerable yield without the backstop of official support in coming years.
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