March 13, 2012
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This essay is excerpted from a recent version of The Credit Strategist (formerly the HCM Market Letter). To obtain the complete issue, you must subscribe directly to this publication; Please go here. The Credit Strategist is on Twitter - @credstrategist
“In meritocracies, though, it’s the very intelligence of our leaders that creates the worst disasters. Convinced that their own skills are equal to any task or challenge, meritocrats take risks that lower-wattage elites would never even contemplate, embark on more hubristic projects, and become infatuated with statistical models that hold out the promise of a perfectly rational and frictionless world.”
Adam Smith is spoken of as the father of modern laissez faire capitalism, as well he should be. But the market system Smith described in The Wealth of Nations (1776) no longer exists. Instead, it has morphed into a system of fiat money that owes its existence to another man: the German printer and publisher Johannes Gensfleich zur Laden zum Gutenberg (1398-1468). Gutenberg was, of course, the inventor of movable type and the modern printing press, a device without which the modern economy could not function.
As commentators near and far speculate on what 2012 will bring to the global economy and markets, there is little question that one factor will be decisive: the central banks’ printing presses. As I recently said in an interview on MSNBC, both the Federal Reserve and the European Central Bank (ECB) will keep printing dollars and euros around the clock until their presses run out of ink.2 This vomitoria of paper currencies is the major force driving financial markets around the world. There may be a lot of “known unknowns” to worry about, but central bank money printing is one “known” that can be taken to the bank. The only question is whether the bank will still be able to cash the check when it is asked to.
Whatever the problem, the Federal Reserve has given the same answer over the past three decades – PRINT!! The stock market crashes in 1987? PRINT!! Computers might shut off at midnight on 12/31/99 (we should have been so lucky…)? PRINT!! The Internet Stock Bubble bursts in 2001? PRINT!! The housing bubble implodes in 2008? PRINT!! Europe got into the act during the 2008 financial crisis but is now taking the art of printing money to a new level. As of the end of 2011, the ECB’s balance sheet has swollen to €2.7 trillion ($3.4 trillion), even fatter than the Federal Reserve’s $2.7 trillion. Without exception, every proposed solution to the European debt crisis involves the printing of huge amounts of money in the form of debts that can never be repaid in real terms.
In their latest scheme, European leaders have decided in their infinite wisdom to further swell the ECB’s balance sheet through the LTRO (Long Term Refinancing Operation) program. In the week before Christmas, the ECB loaned €489 billion to European banks. Only €210 billion of these loans added to systemic liquidity; the other €279 billion was used by the banks to refinance existing debt obligations. This is only the first LTRO operation planned by the ECB; further loans will be issued under this program in 2012.
The LTRO provided much-needed liquidity to European banks, which were experiencing increasing difficulties in accessing short-term financing (especially in USDs – see Figure 1 below). This of course begs the question that the banks are suffering from an insolvency problem as much as a liquidity problem, but the authorities are trying to deal with one crisis at a time. The LTRO facility lends money at one percent in the hope that banks will relend this money at a higher rate and earn money on the spread. Some expect the new loans to be in the form of purchases of European sovereign debt. One can only hope that the banks will not be tempted to repeat their previous mistakes by further burdening their balance sheets in that manner.
The equity markets greeted this operation with glee, rallying sharply into the end of the year on the hope that the ECB was stepping up its market intervention. Previously, the ECB’s efforts had been limited to the repurchase of a bit more than €200 billion of European sovereign bonds. The LTRO was seen by many as a break-out move by the central bank, an admission that stronger measures were needed to prevent the crisis from truly becoming a systemic threat.
Intensifying Search for Dollars
Of course, the LTRO is nothing of the kind. It is does little more than put a small Band-Aid on a bleeding artery. A scheme that simply piles more debt on effectively insolvent European banks is doomed to failure. It would be surprising if the banks actually loaned out these additional funds; they are far more likely to retain them to prop up their liquidity. Further, it is difficult to see how the banks will be able to repay these funds when they are due in three years. During that period, they will be operating in contracting economies, hardly the type of environment that will enhance profitability or their ability to generate free cash to reduce debt. Instead, the banks will have to refinance these loans at higher interest rates (unless the program is extended) or restructure them (i.e. default). Moreover, a mere €210 billion of additional liquidity is a drop in the bucket in terms of the €2 to €3 trillion of capital that appears to be needed to return Europe to economic stability (these are not TCS’s numbers but numbers provided by outside sources that are, as it is said, “deemed to be reliable”). This program may have given hedge funds and other equity managers the chance to dress up their disappointing 2011 performance, but it did little to solve the European debt crisis.
1. Ross Douthad, The New York Times, Nov. 5, 2011.
2. The interview can be found at http://www.msnbc.msn.com/id/31510813/#45828718.
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