Capital Markets Update

By Louis S. Barnes Wednesday, November 23, 2011
It is Thanksgiving week here, not over there, but given the sudden silence over there you'd think they were the ones on holiday.
Here we got the mild disappointment of 3rd quarter GDP revised down from 2.5% to 2.0%. Stock market pollyannas are already spinning: since inventories were not re-built in the 3rd, contributing to the downward revision, the 4th is going to be hot, hot, hot! Not, not, not. Richmond and Chicago Fed metrics, as nearly every real-time indicator, show slight forward motion but no acceleration.
The failure of the Supercommittee did no particular harm, as markets hold all politicians in contempt and expectations were already near zero.
Now, we'll talk turkey -- technical, central bank turkey. Europe is out of all options except one: the ECB with invented money can buy a couple of trillion euros' worth of Club Med debt. How would that be different from the Fed's "quantitative easing"?
QE1 here was announced three years ago this week. The Fed promised to buy $1.7 trillion in MBS and Treasurys (2/3rds the former) to bypass a broken banking system and inject credit directly into the economy. The focus on mortgages: those rates had risen near 7% in 2008, adding to housing distress jumping out of the Bubble Zones.
Cries of INFLATION!! rang throughout the land. MONEY-PRINTING!!! The same people still screech the same lines, but three years later, no inflation. Credit still contracting, no money reaching the economy, no inflation.
Europe's bond markets in the last 10 days have begun to fail. They are headed for a day in which markets open but must be closed, and cannot open the next day... or the next or the next. Huge pressure on and expectation from Germany that it will agree to co-sign for wayward Club Med is ridiculous. The combined GDP of Italy, Spain, and France is nearly double Germany's. All of the invented-financing euro-bailout schemes are dead for the same reason: Dad doesn't make enough money to co-sign for 14 kids.
All central banks are legal counterfeiters. The ECB could bid for Club Med bonds, and pay banks for them by making credit entries on their accounts at the ECB. Investors would presumably stop dumping, Club Med borrowing costs would fall to a sustainable level, and they could roll over maturing debt.
Why not?
The most popular answer: Germany's historical-hysterical fear of inflation forbids such money-printing. Another: the euro-creating treaty also forbids the buys.
Wrong and wrong. Here the Fed bought only government guaranteed paper issued by its own nation. The ECB's first problem would be, whose paper to buy, and how much of each? Very much worse, the ECB knows that the Club Med paper is bad-credit paper. Rising market interest rates has been a symptom, not a cause of the underlying troubles. Club Med has so over-borrowed that it will default, leaving the ECB holding a bag that all of Europe has tried to drop.
The second problem is worse. Germany believes that if austerity is adopted, then markets for Club Med debt will re-open, somehow ignoring the revenue-wrecking that austerity will inflict. And no matter what austerity is adopted, or what the ECB buys, Club Med cannot recover: those nations cannot compete with Germany if bolted to the euro, not if Germany proceeds as a mono-maniacal exporter to Club Med, refuses to import, refuses to goose internal consumption, and insists on clenched monetary policy.
Germany demands austerity and reforms in exchange for nothing. And the ECB knows. Markets know. Even if the ECB comes in, big, it will not restore the status quo 1999-2010 to which Germany feels so entitled.
Last, be careful what you wish for. If the ECB is in, big, the euro would fall from $1.35 to something far lower, which would put China in agony about what to peg, dollar or euro, and with whom to start a currency/trade war. Same for Japan. Same for us.
Despite the short-term chaos, I do hope that Europe will break up this experiment quickly, before more damage is done. It's the ECB's call, very soon.