Friday, December 3, 2010

Italy Goes the Way of the PIIGS and Belgium Waffles

12/3/2010 Portland, Oregon – Pop in your mints…
Oh my, fellow taxpayer!  All of the action is in the Bond markets lately!  Specifically in Europe.  Our current working hypothesis as to what will unfold in Europe is that the financial crisis is serving the purpose of generally weakening the governments of the Euro zone to the point where they will be compelled to turn over most of their authority to a central government which is currently located in Brussels.  Whether it is premeditated or not is subject to a debate that we will not enter into at The Mint.  We are simply observing the data and following it to a logical conclusion.  And how entertaining the action is to watch!
The latest act in the drama of the emerging sovereign debt crisis is playing out with Italy and Belgium preparing to take center stage.  From the New York Times:
Italy and Belgium have a lot in common: both are less dependent on foreign creditors than Greece or Ireland. But each is plagued by severe political dysfunction, which has raised questions about whether they can ever repay a mountain of debt, respectively the second- and third-heaviest loads in the European monetary union after Greece.

Both countries have long histories of debt and political problems that contributed to economic downturns in the past. But no one seemed to pay attention during the current crisis until this week, when investors, transfixed by debt fears in other countries, drove borrowing costs in Italy and Belgium to near record highs.

Investors eased some of that pressure Wednesday after the European Central Bank signaled that it could take new steps to prevent the market contagion by buying more bonds of crisis-stricken countries. Stocks in Europe rose about 2 percent. And yields on government bonds fell after rising sharply in the past couple of weeks amid worries about the growing risk of repayment, although yields are still near their recent highs.
While the fact that governments all over the world are in disastrous financial straits should not be news to anyone who has been paying attention, what troubles us today is the way that these apparent revelations are being presented to the public as recent.  While the errors in presentation are understandable and typical, we are compelled to point out the errors in any popular analysis of the events of these days because the ideology that is being preached is detrimental to the general welfare of all mankind.  The general problem, as Henry Hazlitt brilliantly outlined in his book Economics in One Lesson is:
"The persistent tendency of men to see only the immediate effects of a given policy, or its effects only on a special group, and to neglect to inquire what the long-run effects of that policy will be not only on that special group but on all groups.  It is the fallacy of overlooking secondary consequences."
In the case of Italian and Flemish Bonds, we are inquiring into long term causes as well as effects.  Returning to the New York Times analysis, we see in the space of three paragraphs shades of the fallacy that Hazlitt wrote about.  In order of appearance, these countries are "plagued by severe political dysfunction", the villainous "investors are driving borrowing costs to near record highs," and that the ECB is coming to the rescue!  Case closed!  This is the obvious conclusion if you were to open the paper today and see interest rates rising on Italian and Flemish sovereign debt, is it not?  From one day to the next, interest rates just magically jumped!  What are those evil investors thinking?
Preparing to Replace National Flags in Throughout the Euro Zone!
But if you stop and take a sober look at events, you would see that the governments were already carrying a large debt load, which did not appear overnight.  What has appeared overnight is that, for some unknown reason, governments all over the world see it as their duty to bail out their banking sector at all costs.  Because this is a political and not economic decision, investors do not know, one day to the next, whether to include the liabilities of a countries banks as part of the government's potential liabilities or not.  They also do not know, because it is a decision political in nature, whether or not the ECB will rescue said government if it gets in over its head trying to rescue its drowning banking sector.
Policy actions DO ABSOLUTELY NOTHING to change economic fundamentals, more commonly known as REALITY.  Rather, they are simply another data point that an investor must take into account when calculating the risk/reward of any potential investment.  Policy outcomes can have a major impact on the attractiveness of any investment.  In the case of a sovereign government's outstanding bonds, it has a life or death impact as to the debtor's perceived solvency.
You see, it is policy uncertainty that causes sudden swings in markets, not a sudden epiphany, as the media would have us believe.  The simple answer to avoiding this sudden swings in sovereign debt financing costs is simply for the governments and central banks to behave in a predictable fashion.  It would be preferable if they did nothing.  But if do something they must, please do it on a consistent basis!
Is that too much to ask of them?
Stay Fresh!
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Key Indicators for Friday, December 3, 2010
*See FED Perceived Economic Effect Rate Chart at bottom of blog.  This rate is the FED Target rate with a 39 month lag, representing the time it takes for the FED Target rate changes to affect the real economy.  This is a 39 months head start that the FED member banks have on the rest of us on using the new money that is created.