March 20, 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
“To view…fund managers as immoral was a gross simplification of the world. And what was there to replace capitalism, anyway? Communism? Theocracy? Most of the Third World had already suffered nearly terminal bouts of idealism. It was the Communists, after all, who had littered the world with cheap AK-47s in order to ‘liberate’ the masses. But the only lasting effect was that every wall between Cairo and the Philippines had at least one bullet hole in it. But nothing changed. Nothing changed because these alternate belief systems flew in the face of human nature. Of even common sense. Anyone who has ever tried to share pizza with roommates knows that Communism cannot ever work. If Lenin and Marx had just shared an apartment, perhaps a hundred million lives might have been spared and put to productive use making sneakers and office furniture.”
Daniel Suarez, Daemon (2009)
There is a famous story attributed to the great British playwright George Bernard Shaw that in many respects describes what is happening in Europe today. Shaw was speaking with a woman at a party (apparently he attended a lot of parties) and told her that anybody would agree to do anything for money if the price was high enough. The woman disagreed, so Shaw asked her if she would sleep with him for £1 million. She said, “Well, I might for £1 million.” Shaw then asked, “Would you sleep with me for ten shillings?” The woman answered: “Certainly not! What do you take me for?” And Shaw replied, “We’ve already established what you are, Madame, now we are merely haggling over the price!”
Europe is little different than a woman who is willing to sleep with a man for £1 million but not for 10p. She knows what she is but wants to haggle over the price. In the case of Europe, she is insolvent, and hopelessly so. Her procurer – in this case the European Central Bank (ECB) – can front her some money for a while, but in the end she is either going to have to repay him or suffer a very rough consequence. In the meantime, however, she can continue to entertain her customers, in this case those willing to extend her credit in one form or another. Sooner rather than later, however, these creditors are going to grow tired of her tricks and turn their attention otherwise. At that point, she will be left to deal with the ECB because nobody else will have her.
The world eases
Over the past several months, the developed world’s central banks have shifted toward a decided easing mode through quantitative easing. The Federal Reserve adopted Operation Twist, the Bank of England engaged in a new round of bond purchases, and the ECB has been purchasing the bonds of its weak sisters and launched its LTRO program in December (another tranche is due this month). Even China, which has less room to ease given rapid credit expansion over the last three years, has loosened the monetary reins recently as well. Figure 1 below shows the increasingly dominant role played by these central banks (and the Swiss National Bank) in their respective economies. Central bank balance sheets are swelling to record levels as unsustainable private sector debt burdens are being shifted to the public sector.
Central banks rule
In the short term, central bank easing is producing improved funding conditions in the private markets. Weak European sovereigns such as Italy and Spain have thus far been able to fund themselves at lower rates. European banks are also seeing improved spreads although their access to capital markets remains limited. The covered bond market has been relatively hospitable to the strongest European banks, a promising sign. Important indicators such as the Euribor-OIS spread have rallied for four consecutive weeks and aggregate bank spreads have also tightened by almost 100 basis points. For the moment, the financial system has backed away from the precipice. While all of these are promising signs, they will go for naught if they are not accompanied by meaningful reform of the labor markets in southern Europe and other pro-growth changes throughout the European Union. But they are certainly better than the situation that we were facing at the end of the year.
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