The planets are aligning for another round of debt monetization in Europe, backed up by the United States. Mario Draghi, the president of the European Central Bank, is reportedly looking at expanding the amount of Spanish government debt he can buy. He is also said to be considering another LTRO – Long Term Refinancing Operation, which is the mechanism the central bank uses to buy debt from private sector banks.
That Spain needs help is beyond doubt. The global bond market has been fleeing Spanish government debt as rapidly as it can, forcing yields to the 7.3% area, which is beyond the point where the Spanish government can continue to pay interest from its own revenues without severely cutting back on domestic expenditures. The same situation is playing out at the local level in Spain: Andalusia and other provinces have been besieging Madrid for help in meeting the interest burden on their own debts. There is also talk that medium to small size Spanish commercial banks are out of liquid collateral, and are unable to meet further collateral calls on the global markets.
The markets went through this situation last October, with Spanish, Greek, and Italian banks all under pressure when yields on their debt soared. The first LTRO was the solution to that crisis, but apparently it was not enough. When that crisis occurred, the US Treasury announced it was back-stopping European governments by expanding its swap lines to these governments – meaning the Treasury took on European currencies that the market didn’t want, and provided these governments with much more liquid US dollars. It shouldn’t be a surprise, therefore, that the US Treasury announced this afternoon that Treasury Secretary Timothy Geithner is flying to Europe this weekend for a meeting with German Finance Minister Wolfgang Schauble. The topic of the meeting was not announced, but it is certainly suggestive of a grand announcement coming soon out of Europe and Washington, just like the announcement last October, which was meant to fix the European problem once and for all.
Mario Draghi’s hope is that by taking Spanish debt out of the public markets, interest rate pressures can be eased. He is probably right, but he is also expecting this will give the Spanish government room to institute austerity. Spain has not yet faced the types of austerity programs that have been imposed on Greece, so it would be interesting to see what the consequences would be if extensive cutbacks were enacted on social spending, government employee salaries and pensions, and infrastructure repairs. Spain announced this morning that official unemployment in the country is at an all-time high of 24.6%. What sort of unemployment would result from real governmental austerity, and when does the point come where social order breaks down? Already there have been enormous demonstrations in Madrid and elsewhere in Spain against any further cutbacks, but even though these demonstrations are similar in size to those seen in Greece, they are being given little international attention.
The point of imposed ECB austerity, in exchange for a bond purchase program, is not very clear if the alternative is imposed market austerity as a result of interest rates at 7.3%. About the only constituency that really welcomes all this austerity are the financial markets, because bond holders (meaning mostly banks) are being bailed out once again by the taxpayers. Stock markets in Europe and the US have rallied strongly since Thursday when hints first appeared of a grand deal in the making. The US markets were already excited by news from the Fed that the governors were thinking of getting back into the debt monetization business again, with a QE3 program.
The Fed would generally prefer to avoid deliberate easing so close to a general election, lest it be accused of favoring the party in power. The governors would prefer, therefore, to do their quantitative easing quietly, and better yet, as a result of some crisis in Europe that appears to force their hand. They do have legitimate economic reasons to take further easing actions. Most of the economic reports of the past three months have disappointed on the down side. Growth in GDP the past quarter was announced this morning at an anemic 1.5%, and retail sales have been awful in the US since May. Industrial production is lagging, and garbage shipments are back to their recessionary levels of 2009 (garbage shipments are a curiously accurate reflection of economic trends). About the only good news is that inflation has receded, with the fall-back in the price of oil below $100/bbl. The Fed can afford to ignore for the moment any potential food inflation due to the nationwide drought, because that won’t show up until 2013. In short, there are a lot of reasons to “do something” to save the economy.
During all the various incarnations of quantitative easing and support packages for Europe, the stock market had at least two legs to stand on: central bank liquidity, and record high corporate earnings. The second leg has disappeared quickly. We are now into the second straight quarter of declining corporate earnings, and it looks almost impossible for the S&P 500 to generate the expected average earnings of $100/share for the 500 companies in its index. At the start of the year, expectations were for $117/share earnings; now $85/share would be welcome.
US companies are hurting from declining sales in Europe, a slowdown in Asia (especially China), margin compression from inflation, and growing difficulties with the US consumer. There have been earnings disappointments this quarter from what had been market stalwarts: Apple, FedEx, Starbucks, McDonalds, Caterpillar, Cisco, and many others, especially in the technology sector. Another disaster has also befallen Facebook, which opened this morning at 10% down, triggering exchange freezes on short selling in the stock. Facebook’s growth in customer volume was an anemic 13% on an annual basis, which is hardly enough to call it a growth stock, and not enough to justify its $25/share price. This is a stock which debuted early in the year at an over-hyped $43/share, and now analysts are beginning to think fair value might be around $15/share.
All that’s left holding up the stock market is central bank liquidity and promises of more liquidity if necessary. That the central banks have now been obliged to take over for the global interbank market, and for the global bond market, is beyond question. There are hardly any private markets these days that are still functioning, or if they are, it is because of direct government support. Economies cannot create sustainable growth off government borrowing and central bank liquidity programs, which are stimulants every bit as healthy and addictive as illegal drugs.
One would think that men like Mario Draghi or Timothy Geithner would recognize this fact, or at the very least, get tired of going to the same meeting over and over, coming up with one rescue package after another promising endlessly to “do whatever it takes” to save the global economy, and finding themselves in the exact same situation six months later. Perhaps they do. On the other hand, both of these men are former executives at Goldman Sachs, as are many of their colleagues in government posts around the world (two of the principal candidates to replace Mervyn King as governor of the Bank of England are Goldman Sachs alumni). Perhaps they spend their moments together talking about old times in the private sector, and then conclude the meeting with five minutes of agreement on how to bail out the private sector once again. That is, after all, the practical effect of what is going on here.
However much money is going to be spent this time, you and I won’t see a penny of it. These bailouts stay within the banking system, which remains just as stingy as ever in granting loans, because it recognizes that most of its customers are broke or don’t have the collateral to support new credit. They recognize this because they themselves are broke and can’t find the collateral to support their own borrowings. In effect, the world continues to run out of money. The only people who have any money these days are the people who can create it out of thin air – the central banks. There comes a point, though, when even a central bank reaches its limit of money creation. Ask Greece, or ask Spain, who didn’t think it would happen to them. If the ECB or the Federal Reserve understood this, they wouldn’t be too eager to continue to debase their balance sheet and their currency with more money printing. But, after all, they have to “do something.” It’s in their mandate and thus in their genetic makeup, and they’ll continue to “do something” until interest rates for the euro and the dollar become prohibitive. That day is inevitable, and it is approaching closer and closer as this Greek tragedy continues to play out.