I know why central banks are expanding their balance sheets so recklessly. They’re desperately trying to counteract the profoundly deflationary balance sheet contraction and deleveraging occurring everywhere else in the economy.
This balance sheet expansion and what is called long-term refinancing operations (LTRO) by the ECB amounts to none-too-subtle money printing. The ECB creates electronic money. It then uses that money to buy government bonds from eurozone banks. Flush with new money, eurozone banks can then buy more government bonds!
If this sounds like a Ponzi scheme designed to rig the market for the prices and yields of eurozone government debt, that’s because it is.
The wrinkle in this scheme is what happens when a eurozone government is so over borrowed and with such a small chance of growing its economy that it defaults on its debts anyway (which looks increasingly likely for Greece, and possibly Portugal).
Rather worryingly for Europe’s banks, German chancellor Angela Merkel has vowed to demonstrate “the primacy of politics over the markets”. As Buttonwood writes in the Economist, this is sending an odd signal from eurozone governments that desperately need to borrow money from those same markets; it is as if Mrs Merkel and her fellow leaders are saying:
“We hate private sector creditors. We will penalise you by defaulting on your debts but not on debts to official creditors. [The ECB, which holds billions of their bonds, may well not participate in whatever mess Greece imposes on all its other bondholders. Nice position to be in.] We will endeavour to stop you protecting yourselves against our actions by making it difficult to collect on insurance in the credit-default-swaps market. Now, can we please borrow some money at a very cheap rate?”
European banks are looking very vulnerable
In the 1983 movie WarGames, a high school student accidentally hacks into the NORAD supercomputer. At the film’s conclusion, having run hundreds of simulations of a nuclear exchange between various superpowers, the computer concludes that sometimes, “the only winning move is not to play”.
Eurozone banks are extremely vulnerable. Take just two examples. Between them, Italy’s Intesa SanPaolo Bank and Spain’s Santander have lent a total of €122bn just to the governments of Portugal, Italy, Ireland, Greece and Spain – the troubled periphery of the eurozone. Take into account the private sector loans (to institutions, corporations, retail businesses, mortgages, commercial real estate and so forth), and those banks have lent a total of €828bn to the private sector of the eurozone peripheral economies (€428.3bn for Intesa, and €400bn for Santander).
Imagine a truckload containing €2bn in €100 euro bills. The length of Intesa San Paolo’s convoy of money trucks is 3.8 kilometres long, and that of Santander is 3.5 kilometres long. Forget too big to fail; how about too big to survive?
“Sometimes, the only winning move is not to play” – this is exactly how I feel about the eurozone banking sector. Like anyone else, I don’t have a crystal ball, but I don’t like what I’m seeing: massive politically-inspired distortion of markets, banks with colossal holdings of dodgy government debt that is by no means guaranteed to be paid back. I am particularly concerned about the implications of a final loss of confidence in a market like Greece, and of a disorderly run on that country’s banks (which has in any case been happening in slow motion for the past two years).
How will this play out? Well let me ask you a question: in a modern financial system, can the authorities simply put up some kind of firewall that prevents money from leaking across borders? Will they impose limits on individual cross-border travel, too? How much grief will the Greek people take before they revolt?
Another question: if Greece does default on its debts (and speaking as a former bond salesman, paying back bondholders anything less than 100% of the value of their nominal holdings is an act of default, whatever eurozone politicians say), what happens if the European Central Bank itself ends up needing to recapitalise itself? How much money will Europe’s taxpayers agree to sacrifice to pay for the follies of their politicians and central bankers? How long before European taxpayers hit the streets in protest?
How to protect yourself from the meltdown in Europe
Since I value the ability to sleep at night, I’d rather not have to worry about these questions. So notwithstanding the recent bullishness of stock market investors across Europe, here is what I think makes sense:
• Avoid euro denominated investments altogether. This is your own personal firewall against a flare-up in the European banking system, and possible contagion.
• For equity investments, favour defensively oriented businesses with no strong exposure to Europe or to the UK in isolation.
• Diversify your portfolio holdings into other assets, including ‘absolute return’ funds and particularly into real assets (non-financial, inflation- and currency-hedges such as gold).
The market is not always right
Successful investment is part art, part science. The scientific aspect comes from a rational analysis of all the various investment choices out there, and rating those against an admittedly subjective assessment of economic conditions, both current and prospective.
The art comes, in part, from trying to understand (and sometimes withstand) the psychology of the marketplace. The marketplace is not some kind of alien, mysterious construct. The marketplace is us, with all of our hopes, fears, ambitions and misconceptions about what the future might hold.
Category: Market updates