The enthusiasm of investors about central-bank interventions has reached a pitch that is already well-reflected in market prices, and a level of confidence that with little doubt, investors will ultimately regret. In the face of this enthusiasm, one almost wonders why nations across the world and throughout recorded history have ever had to deal with economic recessions or fluctuations in the financial markets. The current, widely-embraced message is that there is no such thing as an economic problem, and no such thing as risk. Bernanke, Draghi and other central bankers have finally figured it out, and now, as a result, economic recessions and market downturns never have to happen again. They just won’t allow it, printing more money will solve everything, and that’s all that any of us need to understand. And if it doesn’t solve everything, they can just keep doing more until it works, because there is no consequence to doing so, and all historical evidence to the contrary can finally, thankfully, be ignored. How could anyone ever have believed, at any point in history, that economics was any more complicated than that?
Unfortunately, the full force of economic history suggests a different narrative. Up to a certain point, which seems to be about 100-120% debt-to-GDP, countries can pull themselves from the brink of sovereign crisis through a combination of austerity (spending reductions), restructuring (putting insolvent financial institutions into receivership and altering the terms of unworkable private and public debt), and monetization (relief of government debt through the permanent creation of currency). Austerity generally reduces economic growth (and corporate profits) in a way that delivers less debt reduction benefit than expected, restructuring is often stimulative to growth because good new capital no longer has to subsidize old misallocations, but is politically contentious, and monetization of bad debt produces clear but often quite delayed inflationary pressures. None of these choices is simple.
Moreover, once countries have created massive deficits and debt burdens beyond about 120% of GDP – typically not to accumulate productive assets and investments that service that debt, but instead to fund consumption, bail out insolvency, and compensate labor without output – austerity produces further economic depression, restructuring becomes disorderly and produces further economic depression, and attempts at monetization tend to be hyperinflationary.
Europe is fast approaching the point at which every solution will be disruptive, and remains urgently in need of debt restructuring, particularly across its banking system. It is a pleasant but time-consuming fantasy to believe that governments that are already approaching their own insolvency thresholds can effectively bail out a banking system that has already surpassed them. To expect the ECB to simply print money to solve the sovereign debt problems of Spain, Italy and other members is also dangerous. This hope prevents these nations from taking receivership of insolvent institutions now, and allows them to continue to operate in a way that threatens much more disorderly outcomes later. The reality is that Europe is not a unified economic and political entity with a single national character and obligations that are mutualized among its members. It is instead a geographic region where the economic, political and cultural differences remain very distinct. While each country is willing to cooperate in setting common rules and practices that are to their own benefit, they are unlikely to cooperate when it comes to decisions that require the stronger economies to interminably subsidize the insolvent ones through direct fiscal transfers or permanent money creation that has the same effect.
With regard to last week’s ebullience over the possibility of ECB buying of sovereign debt, my concern continues to be the danger of assuming that a solvency problem can simply be addressed as a liquidity problem. If the European Central Bank buys Spanish or Italian debt in volume, there is very little likelihood that it will ever be able to disgorge this debt. This is because: any eventual ECB sales of debt holdings – or failure to roll those holdings over - will have to be offset by private demand in the same amount, when Spanish and Italian debt/GDP ratios are unlikely to be smaller; the European banking system is already largely insolvent, and; the European continent is already in recession, which means that the volume of distressed sovereign debt is likely to expand even beyond the reasonable capacity of the ECB to absorb it. So major ECB purchases would effectively amount to money-printing, and Germany, Finland and other countries in opposition are fully aware of that. Reversible liquidity operations may be monetary policy, but non-reversible money-printing is quite simply fiscal policy.
For a review of some of the issues the ECB faces, see Why the ECB Won’t (and Shouldn’t) Just Print. In evaluating the repeated assurances that emerge out of Europe, keep in mind that details matter. For example, the phrase “Germany is prepared to do everything that is necessary to defend the Euro” has repeatedly meant “everything that is politically necessary” and “everything that is legally required.” It has also been demonstrated again and again that Germany (among other stronger European countries) has no intention of allowing a blank check for direct EFSF or ECB bailouts without a change in the EU law that imposes a surrender of fiscal sovereignty and centralized fiscal control of Euro member countries. Following Thursday’s assurances by ECB head Mario Draghi to protect the Euro (just after Germany’s Angela Merkel left on a hiking trip), it took until Saturday for the German finance minister to step into the void with the predictable, “No, these speculations are unfounded.” It was widely reported that Germany again tossed out the “everything that is necessary” bone on Sunday, but one had to read the French dispatch to find that this accord referred to nothing but an agreement between Germany and Italy to do everything necessary to quickly implement June’s plan for a plan to establish a centralized banking regulator: l'Allemagne et l'Italie sont d'accord pour “que les conclusions du conseil européen des 28 et 29 juin soient mises en oeuvre aussi rapidement que possible.”
In the U.S., quantitative easing has had the effect of helping oversold financial markets recover or slightly surpass the peak that the S&P 500 Index achieved over the preceding 6-month period, but there is much less evidence that it will do much for the financial markets when prices are already elevated and risk-premiums already deeply depressed (see What if the Fed Throws a QE3 and Nobody Comes?). The upper Bollinger band of the S&P 500 on both weekly and monthly resolutions is at about 1430. That level represents our best estimate for the market’s upside potential in the event that the Federal Reserve initiates a third program of quantitative easing. Given that our economic measures continue to indicate that the U.S. has entered a new recession, it is not clear that another round of QE will even achieve that effect.
In the event that another round of QE has a greater or more durable effect, we’ve introduced enough additional constraints on our staggered-strike hedges that we wouldn’t expect the decay in option premium that we experienced during QE2. The market reestablished an “overvalued, overbought, overbullish” syndrome last week, so another round of QE is unlikely to move us to a significantly constructive investment stance as long as that syndrome is in place. Still, we don’t expect to move our strike prices higher in the event of further improvement in market internals, so the “tight” character of our present hedge will moderate in the event the market advances from here. Suffice it to say that I’m not worried that another round of QE will create difficulties for our approach, though it should also be clear that such an event wouldn’t automatically prompt us to shift to a bullish investment stance.
