December 15, 2011

Printing By Another Name

Why Have Rules?

When the Maastricht treaty was signed in 1992, limits were set on debt and deficits permitted to be carried by European Union (EU) member nations.[1]  Specifically, per country, deficits are supposed to be capped at 3% of Gross Domestic Product (GDP), and gross government debt is required to be no higher than 60% of GDP.[2]  Countries currently violating both limits include: Austria, Belgium, Cyprus, France, Germany (yes, that Germany), Greece, Hungary, Ireland, Italy, Malta, Netherlands, Portugal, Spain, and the UK.[3]  Violating at least one restriction are Bulgaria, Poland, Romania, Slovakia, and Slovenia.[4]  Countries violating neither criterion are Denmark, Estonia, Finland, Luxembourg, and Sweden.[5]  So the final tally is 14 out of 27 EU nations violating both criteria; 5 violating one criteria; and only 5 violating neither.  Of the 17 Eurozone/Euro Area nations that have actually adopted the Euro as their currency,[6] 12 are currently violating both criteria with an overall government deficit equal to 6% (double the supposed limit) of GDP, along with gross government debt equal to 85% of GDP (42% higher than the supposed limit).

European fiscal union was supposed to be based on rules, but they hardly seem to matter any more.  The difficulty governments have with fiscal restraint is once again evident.  The rules seemingly exist to be ignored.

This Time They Really Mean It (For Real)

On December 9 Europe agreed to draft a new treaty embracing deeper integration into the Euro Zone, along with agreeing to cultivate tougher budget discipline with automatic sanctions for countries who violate debt and deficit limits.[7]  To me it reads like comedy.  Gushed German Chancellor Angela Merkel, “This is a breakthrough to a union of stability… we will use the crisis as a chance for a new beginning.”[8]  ECB President Mario Draghi stated, “It’s going to be the basis for a good fiscal compact and more discipline in economic policy in the euro area members.”[9]  How do they say these things with a straight face?  Based on the abysmal European track record of fiscal discipline mentioned in the first paragraph of this commentary, why would anyone believe Merkel, Draghi, or any other Euro-crat?  How does one not laugh out loud?

Caving And Printing

Also on December 9, quite interestingly and seemingly under the radar, European Union leaders dropped their requirement that investors (i.e. banks making bad/risky investments which did not work out) share in the cost of bailouts.[10]  In other words, German Chancellor Angela Merkel’s desire to expose bondholders (i.e. banks making bad/risky investments which did not work out) to losses was overridden.  Once again, as in the United States, it seems large banks get to privatize their gains and socialize their losses.

And there is more.  ECB (European Central Bank) President Mario Draghi recently cut the key benchmark interest rate by 0.25% to 1.00%, while also lowering the lending credit rating threshold for acceptable bank collateral to “single-A,” also offered European banks perpetual three-year loans, and cut in half the reserve requirement ratios for European banks.[11]  While stating the ECB will not step up its purchases of shaky Euro sovereign debt – Draghi is effectively still providing banks the money to buy the same bad sovereign debt.  I see it as quantitative easing (QE) all the same.  And as with all QE, including that performed by the Federal Reserve Bank – the money is created out of thin air.  It’s simply printed.

Draghi may think he’s being sly, but I believe it’s just a matter of time before markets catch on.

As I’ve said numerous times previously, history shows us that overly indebted governments typically repudiate their debt by inflating away.  Large banks tend to get bailed out.  And the currency gets debased.  One should not get caught on the wrong side of that trade.  And I believe opportunity lies on the right side of it.

At Ernharth Group, we will continue to plan accordingly.

As always, I maintain my positive outlook.  That outlook is based on my belief a bear market in one thing is often a bull market in another.

As we enter this critical time – now, more than ever – I believe investors need to focus on their investment strategies. Those readers who are clients are fully aware of the strategies we’re implementing in light of unfolding economic circumstances.  Others may feel free to contact us to learn more.

Sincerely,

Stephan R. Ernharth, JD
Vice President
Ernharth Group
www.ernharth.com

Go to www.ernharth.com/economic-commentaries to read past articles from our Economic Commentary series.