May 17, 2010
Two Choices: Restructure Debts or Debase Currencies
Last week, the European Central Bank pledged to spend as much as 750 billion euros (about a trillion US dollars) in an attempt to discourage market concerns about European debt, particularly that of Greece, Portugal and Spain. The intended message was to show the markets - particularly bond market "vigilantes" speculating against European debt - that the ECB has deep enough pockets to thwart the mounting pressure on European debt and the euro itself.
ECB President Jean-Claude Trichet has been quick to deny concerns that the move by the ECB will be inflationary, emphasizing that the intervention will be "sterilized" in order to prevent a major increase in the amount of euros outstanding. This is "totally different," he argued last week, from the massive increase in monetary base that has occurred as the U.S. Federal Reserve has bought up over $1.25 trillion in debt obligations of Fannie Mae and Freddie Mac. A "sterilized intervention" is one where the euros created through the purchase of distressed Euro-area debt will also be absorbed by selling other assets from the ECB's balance sheet, in order to take those euros back in.
In order to evaluate the arguments being made, it's helpful to understand the balance sheet of a typical central bank. Whether in the U.S., Europe, or elsewhere, the basic structure is the same. On the asset side, the central bank has government debt that it has purchased over time. A small proportion of total assets might be held in "hard" assets such as gold, but primarily, the assets of each central bank has traditionally represented government debt - mostly of its own nation (or in the case of the ECB, euro-area governments). As a central bank purchases these securities, it creates an equal amount of liabilities, in the form of "monetary base" (currency and bank reserves).
Notice, for example, that the pieces of paper in your wallet have the words "Federal Reserve Note" inscribed at the top. Currency is a liability of the Federal Reserve, against which it has traditionally held assets such as Treasury securities, and prior to 1971, at least fractional backing in gold.
In this context, consider the ECB's proposed 750 billion euro line of defense. Essentially the ECB is saying "We stand ready to buy as much as 750 billion euros of distressed Euro-area debt in order to defend the euro." Simultaneously, despite the fact that Euro area countries are running large fiscal deficits, the worst being in Greece, Portugal and Spain, the ECB is saying "However, we intend to sterilize this intervention, which will ultimately require that we sell Euro-area debt into the market in order to absorb the euros we create." The only way that both statements can be true is for the ECB to admit "Therefore, we are fundamentally promising to debase the quality of our balance sheet, by exchanging higher quality Euro-area debt with lower-quality debt of countries that are ultimately likely to default."
Far from being "totally different" from what the U.S. Federal Reserve has done, the ECB is essentially promising exactly the same thing - to corrupt its balance sheet and debase its currency in order to protect the worst stewards of capital from the consequences of bad lending and poor investment.
Over the shorter term, the Federal Reserve has promised to abet the ECB by entering currency swaps, essentially accepting euros from the ECB and providing U.S. dollars that the ECB can in turn use to buy up euros and European debt. The promise, of course, is that the ECB will reverse these swaps at a later date, at the same exchange rate at which they entered into the transaction. The problem here is that this is a very dangerous game for the ECB (not to mention the Fed). If the euro depreciates materially, the ECB will later be forced to sell euros into an already weak market (effectively creating new currency to cover the loss) in order to buy back enough dollars to reverse the swaps and make the Federal Reserve whole (assuming the Fed will ultimately be made whole).
Presumably, the ECB hoped that the 750 billion euro figure would inspire shock and awe, but after a quick rally on Monday, the markets were neither shocked, nor durably awed, as investors began figuring out that the ECB was essentially promising to buy Euro-debt with Euro-debt, and to defend euros with euros.
In the end, as I've argued repeatedly over the years, monetary policy is only as good as fiscal policy. A central bank does not have wealth of its own. It is a zero-sum entity that can only enrich those from whom it purchases debt by debasing the relative wealth of people who hold the existing stock of currency. If a government insists on running deficits, engaging in wasteful spending, and dissipating public resources to bail out private bondholders, it has to find somebody willing to buy its debt. If it does not, the central bank buys it, and dilutes the currency by doing so. The situation is particularly insidious when the central bank buys low-quality debt, because there is no taxing authority behind it to provide a basis for confidence in the currency.
The Euro-area has a special problem in this regard, because the bailouts represent clear country-to-country transfers of wealth, and risk creating inflation for all the members of the European Community in order to defend the deficit spending of countries that simply do not have enough flexibility to cut those deficits. Greece in particular is likely to experience so much loss of output that it will most likely lose on the revenue side much of what it cuts on the spending side. For that reason, the deficits are likely to come down much slower than expected. Germany, with its particularly strong aversion to inflation, is unlikely to accept the costs for long.
It is difficult to project the timing and events by which all of this will be resolved, but I increasingly suspect that the (relatively) stronger Euro-area countries will reject the prospect of providing continuing subsidies and accepting growing inflation risk as the cost of keeping deficit-prone member countries under the euro umbrella. In short, I don't expect that Greece or Portugal (Spain is more uncertain) will ultimately remain part of the euro.
At the point that Greek and Portugese debt has to be restructured (which seems inevitable given the negative revenue effects of austerity measures), departure from the euro will give these countries a better ability to depreciate their currencies to a level that re-aligns internal wages and prices with competitive levels. This will be a less disruptive solution than having to force - as austerity measures do - a massive internal deflation through wage reductions and spending cuts. The unpleasant alternative is to hold the line on wages and prices within Greece, Portugal and other high-deficit countries, and suffer inflation throughout the entire Euro-area as those debts are monetized. The only other alternative, which does not seem at all likely, is that other Euro-area countries will accept ongoing country-to-country transfers in order to finance the deficits of their neighbors.
Without a central taxing authority, the goal of a common European currency can only survive if the participating countries obey a rule that strictly controls the deficits of individual countries. Without that, the whole system is compromised. It should not be difficult to recognize that the confidence in any currency is tied to the confidence in the assets which stand behind it, and associated confidence in the restraint of fiscal and monetary authorities. The bureaucrats in both the U.S. and European central banks have chosen to betray that trust. It's fascinating that they seem genuinely surprised when their generosity with other people's wealth (and their assurance of greater betrayal) is met with contempt. While I expect that the euro will survive by the coordination of its stronger members, it risks being debased by the unwillingness to accept debt restructuring sooner rather than later.
On Monday of last week, the Market Climate re-established its overvalued, overbought, overbullish, rising-yields syndrome. Given the easing of interest rates in the preceding week, I had expected more latitude for upside before that syndrome reasserted itself, but yields shot back up on Monday, and investor sentiment did not ease nearly as much as anticipated. Not surprisingly, much of the gains from Monday evaporated as the week continued. The Strategic Growth Fund is effectively fully hedged here.
My impression is that the market remains in a tenuous state in that we have not meaningfully cleared the overextended syndrome that has been with us in recent months. Even so, we'll respond fractionally to any clearing that we do observe (with a growing responsiveness as we move through the year). We're certainly not inclined to "buy the dip" to a material extent, and I continue to anticipate a second wave of credit difficulties in the months immediately ahead. But I also believe that if we can move through 2010 without a second "crisis-level" wave of credit strains, we'll be more able to rely on post-1940 criteria in setting our investment positions, with less concern about the more hostile "post-crash" dataset.
Suffice it to say that we're not about to lift a significant portion of our hedges early in a selloff provoked by fresh credit strains, but that I also don't intend to specifically factor in concerns about a second-wave for an extended period if we don't observe them.
In bonds, the Market Climate was characterized last week by relatively neutral yields and neutral yield pressures. The Strategic Total Return Fund continues to hold a duration of just under 4 years, mostly in medium term Treasuries. In response to the move by the ECB, we also scratched on our sell a few weeks ago of precious metals shares, re-establishing those positions early this week at about the same level that we sold them. The Fund currently has about 3% of assets in that group, which is not much, but we're inclined to add exposure on weakness or retracement from last week's spike. We liquidated our small 1% holding the euro early in the week (same reason), shifting to the Swiss franc, which ominously continues to gain ground against the European currency. A spike in the euro/Swiss franc exchange ratio would be a sign of speculative pressure that one would observe in an escalating crisis, as would a spike in eurocurrency rates denominated in euros, versus other inter-bank deposit rates.
On the inflation question, we continue to observe a debate between those anticipating inflation and those anticipating deflation. From my perspective, this is a false dichotomy. Certainly, we can expect a continued relative deflation in real wages - elevated unemployment has a remarkably inconsistent relationship with overall price levels, but the true "Phillips Curve" relation is between unemployment and real wages. High unemployment is predictably associated with wage growth that falls short of growth in the general price level. Whatever happens with the general price level, we can expect wage growth to be uncomfortably tepid in the next several years.
With regard to the general price level, observers frequently make the mistake of equating inflation with demand growth, which effectively assumes that the quantity of money (or at least its marginal utility) is constant. This is a poor assumption in the present state of the world.
Think of it this way. If you were in an elementary school lunchroom, and the kid that always has the Chips Ahoy cookies suddenly starts bringing in three times as many, you could predict fairly accurately that the value of a cookie relative to just about everything else would fall (that is, the price of everything, in terms of cookies, would go up). Moreover, this would occur even if nobody else was a bit hungrier. When you substantially increase the quantity of something, you reduce its marginal value relative to everything else. You don't need strong demand for the price of goods and services to rise in terms of dollar bills. All you need to do is to debase the marginal value of dollar bills by creating too many.
Over the past year, Ben Bernanke has pushed a monstrous sack of Chips Ahoys into the cafeteria. In terms of general price inflation, the question is how eager people are for those Chips Ahoys. If there is a crisis that makes people fear that everything else they might eat will give them food poisoning, the kid's Chips Ahoys will hold their value even if he brings in three times as many. But over time, well after the food poisoning scare is past, those cookies will be worth much less.
The bottom line is that we can expect real wages to stagnate for several years, as a predictable reflection of slack capacity in the labor market. While credit concerns will be helpful in augmenting the demand for U.S. government liabilities as a default-(food poisoning)-free alternative to other assets, there is a continued prospect for significant price inflation beginning in the second half of this decade. With the ECB surrendering monetary discipline for the sake of short-term expedience, that prospect has become even more hostile.
I want to be clear that my concern about inflation is not very strong at present. This is important, because investors seem to be chasing precious metals a bit too avidly here. Commodities can experience extremely high levels of volatility. Corrections can be both abrupt and deep, which allow for multiple entry points. But it is important to recognize that this volatility can be quite painful, so very deliberate risk-management is important. We've generally found that chasing advances in commodities is unrewarding. Again, our own holdings are fairly restricted here. Reversing our recent sale simply maintains the very small exposure we've held for several months.
Longer term, in the name of defending the holders of bad debt, the world's major economies appear willing debase their currencies. Most likely, we've got several years (not weeks or months) before we observe a striking return of inflation, and there will be probably plenty of time in between where investors give up the concern entirely for a while. As always, we try to look ahead at the major risks facing the economy, even if those risks take a while to fully emerge. At present, I believe our monetary authorities are moving down an unfortunate path. This will create opportunities as well, but we'll move very deliberately.
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