The announcement by the European Central Bank of ‘unlimited bond buying’ has made recent Aussie price action more about the ECB than China. But I wouldn’t expect the ECB announcement to have much of a shelf life.
Breaking down the ECB’s ‘unlimited bond buying plan’ I realised this is just the latest play in a poker game between Germany and the ECB.
The ECB wants to find a way to directly buy Spanish and Italian government bonds so it can prevent a credit and banking crisis. Germany doesn’t want to throw good money after bad until national governments commit to structural economic reforms – and cede economic sovereignty to Germany.
Yes, it would have been much more exciting to talk about the four-year high on the S&P 500 and Europe finally putting a firewall between share markets and the debt crisis. But the entire ECB plan revolves around the idea of ‘conditionality’.
Asking the Impossible
It’s a bureaucratic way of saying that Spain and Italy are only eligible for unlimited ECB bond purchases (through secondary mechanisms) if they agree to austerity conditions imposed by the International Monetary Fund (IMF) and the European Union. What’s more, Spain would have to officially request a bailout.
Spain must redeem around €20 billion in bonds by October. That means it’s likely to request a bailout from the ECB in the next week or so, to reassure markets and prevent short- and long-term bond yields from spiking again. But there’s a small problem.
‘Conditionality’ means that bailout recipients must adhere to the austerity measures imposed by Brussels and Berlin. Politically, this is suicide for an elected politician. That’s why democratically elected politicians in Greece and Italy have been replaced by EU bureaucrats. Spain’s Prime Minister Mariano Rajoy must know that as soon as he formally requests a bailout, his career is over.
The bigger problem is that it’s almost economically impossible for European governments to meet austerity terms. Cuts in spending and the public sector are needed to bring budgets back into balance. But the cuts necessarily reduce the contribution government spending makes to GDP. Lower GDP growth results in lower tax revenues and higher-than-expected deficits.
It’s a cycle of misery that explains high youth unemployment, lower GDP growth, and an inability to reduce government deficits as a percentage of GDP. The only real benefit is political, to the power brokers in the EU, who slowly gain control of Europe’s economic and political life, and lord it over millions of people who face tougher economic times.
The Answer for Europe, A Solution for Investors
Austerity is the wrong word for what Europe needs. What Europe needs is less government, less integration, and more freedom. It’s going in the opposite direction, though. And for financial markets, that means the likelihood of a big credit accident or financial crisis in Europe is as high as ever.
Ultimately, all of the world’s politicians and central bankers know of only one-way out of their troubles: print more money.
I’m troubled by the implications of this for a large cash position, but in the meantime, look for gains in precious metals.
Dan Denning
Editor, Australian Wealth Gameplan
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