Euro TARP

Risk taking is back with a vengeance this morning after a
spectacular bailout of the Eurozone was announced prior to markets
opening in Asia.  As such, we felt it was important to share a few
pieces of thoughtful commentary regarding Items Nine and Ten of our
recent Ten Reasons to Buy Bonds post:

Our
friends at Research Edge referred to this weekend’s announcement as The
Keynesian Elixir.  Wikipedia defines an elixir as “a
sweet flavored liquid used in compounding medicines to be taken orally
in order to mask an unpleasant taste and intended to cure one’s ills.
Elixir in the noun form means a drink which makes people last
forever.”  In this case, the Euro Elixir is masking the unpleasant
aftertaste of unintended consequences.  The cure will buy some time,
but will emphatically, not last forever.  Per John Hussman this AM:

Looking
at the current state of the world economy, the underlying reality
remains little changed: there is more debt outstanding than is capable
of being properly serviced. It’s certainly possible to issue government
debt in order to bail out one borrower or another (and prevent their
bondholders from taking a loss). However, this means that for every
dollar of bad debt that should have been wiped off the books, the world
economy is left with two – the initial dollar of debt that has been
bailed out and must continue to be serviced, and an additional dollar
of government debt that was issued to execute the bailout.

Notice
also that the capital that is used to provide the bailout goes from
the hands of savers into the hands of bondholders who made bad
investments. We are not only allocating global savings to governments.
We are further allocating global savings precisely to those who were
the worst stewards of the world’s capital. From a productivity
standpoint, this is a nightmare. New investment capital, properly
allocated, is almost invariably more productive than existing
investment, and is undoubtedly more productive than past bad
investment. By effectively re-capitalizing bad stewards of capital, at
the expense of good investments that could otherwise occur, the policy
of bailouts does violence to long-term prospects for growth. Looking
out to a future population that will increasingly rely on the
productivity of a smaller set of younger workers (and foreign labor) in
order to provide for an aging demographic, this is not a luxury that
our nation or the world can afford.

“Failure” and
“restructuring” mean only that bondholders don’t get 100 cents on the
dollar. We can continue to bail out the poor stewards of capital who
voluntarily made bad, unproductive investments, and waste our future
productivity in order to make those lenders whole, or we can turn the
debate toward deciding the best strategies for restructuring existing
debt.

And the skeptical David Rosenberg raises the
following concerns in his morning commentary:

Beyond
today’s knee-jerk reaction, there are issues left on the table. The
emergency measures just announced buys some time but should help take
some of the fear and illiquidity out of the market over the near-term.
However, what were not addressed are the intense structural fiscal
problems plaguing much of the Eurozone.

In the
final analysis, if the EU lends money to Greece or to any other problem
country in the zone, debt ratios (including contingent liabilities) in
the region will only rise further. It will be interesting to see how
the rating agencies end up handling this. It cannot be lost on them, or
the global investment community, that while loans, guarantees and
central bank provisioning can deal effectively with liquidity issues,
they are ineffective in addressing what’s really at stake here, which
are structural fiscal issues. So the deal over the weekend is only
going to be successful insofar as they are backed up by meaningful
reforms (it must be emphasized that the rescue package critically
hinges on the Club Med countries accepting deep budgetary retrenchment
notwithstanding their weak economic structures. Indeed, it will be
interesting to see how Spain can manage to meet EMU deficit
requirements at a time when the unemployment rate is currently at 20%,
just as one example.)

Since the ECB has come out
and said that it will buy both government and corporate bonds, then
what is clear is that any rally in the Euro should be faded because the
lines between fiscal and monetary policy has just become blurred.
The cost of the ECB helping drive long-term yields in the periphery
lower is jeopardizing the sanctity of the central bank balance sheet.
And, just as the Fed has ceased in expanding its balance sheet, the ECB
is set to expand its balance sheet, and this is a Euro-negative. Of
all the knee-jerk bounces today, the Euro is the one most vulnerable
to reversal.

Although the measures will help
mitigate the growing dangers of contagion in the Euro area, the IMF/EU
loans come with a “strong conditionality” with respect to intense
budgetary restraint and structural fiscal reforms. The massive package
of loans and guarantees buys time, but the issue of whether the
austerity package for Greece will be accepted by the public (almost
half do not approve) is still up in the air. Portugal and Spain are in
need of credible packages to cut their deficits. This will exert an
enormous fiscal squeeze across wide swaths of the Eurozone and require a
weaker Euro as an antidote.

Against this backdrop,
the threat of default and concerns over the future of the Euro will
not dissipate entirely. The region, especially the Club Med partners,
will be in for a long period of extremely weak economic growth.

Obviously, we agree.  The Euro dropped from about 1.33 to 1.25
since we suggested that investors Remain Calm – “the Euro still has a
ways to go before reaching fair value on a purchasing-power-parity
basis.  Given the prospects for an extended deflationary period ahead,
we think the odds of a downside overshoot are “strong to very strong.” 
We are not there yet.  Sell the bounce.

Disclosure: At the
time of publication, the author was short the Euro, although positions
may change at any time.

Comments

[Quantum Nucleonics]

Did anything really change with Sunday's "deal"??  No, the core of Europe's problem remains that workers like getting 13 or 14 monthly paychecks per year, plus free health care, early retirement with a sweet pension, and a boatload of vacation, BUT they don't want to pay for it.  More debt only puts off the day of reckoning.  You'll know the crisis has passed when they announce pay and pension cuts. [LOL]

Now that the PIIGS have some cash to spend courtesy you and me, is the UK now the slow zebra in the herd??

[Al Huxley]

We are further allocating global savings precisely to those who were the worst stewards of the world’s capital

This is the Central Bank equivalent of averaging down on an underwater equity position rather than just taking the loss and moving on.  Always a bad move in the stock market and I'm betting it will be a bad move here as well.

[naiverealist]

"We are further allocating global savings precisely to those who were the worst stewards of the world’s capital. From a productivity standpoint, this is a nightmare. New investment capital, properly allocated, is almost invariably more productive than existing investment, and is undoubtedly more productive than past bad investment. By effectively re-capitalizing bad stewards of capital, at the expense of good investments that could otherwise occur, the policy of bailouts does violence to long-term prospects for growth."

Bingo.  We are allocating current capital to meet the needs of today's corruption and greed, not to build tomorrow's productivity.

[williambanzai7]

We are further allocating global savings precisely to those who were the worst stewards of the world’s capital.

That says it all in a nutshell.

[tim73]

"However, what were not addressed are the intense structural fiscal problems plaguing much of the Eurozone."

Yeah, everything should be solved during a sunday afternoon. New York hour even better. They are addressing the problem but it will take some time. Typical Austrian groupbitchingfest. Everything will just be peachy after the mighty gold temple replaces the governments. Ponies for everybody and the gold in the temple will make us all honest and better persons all around. Or something like that, according to Austrian school propaganda.

Eurozone nations needing bailout will go through a lot of pain now. Otherwise, Germany would have not agreed to join the party.

[moneymishap]

according to Austrian school propaganda.

as opposed to the proven universal laws of Maynard.

[akak]

And did your nonsensical rant have some semblance of a point?  If so, it somehow managed to elude me.

[ColonelCooper]

I think what he was saying is that it takes a lot of time to fully recognize utter failure and foolishness.  Sometimes mistakes must be repeated again and again before their full effect is realized.  Since this trillion couldn't prop the Euro up for more than a few hours, we should probably just throw 10 trillion at it tomorrow.  Or something along those lines.

Then he went off into an inane rant about Austrian propaganda and a desire to molest a collie, where he lost me too.

[Dirtt]

Probably what he meant to say is that the NY Times is giving Krugman a little less space this week to make room for more advertisments brought to you by companies not disclosed by the NY FED.