HOW THE EURO WAS (REALLY) SAVED / PRUDENTBEAR.COM

How the Euro was (Really) Saved

by Doug Noland

May 23, 2014  



The short squeeze was back. 

“To the astonishment of almost everyone in the room, Angela Merkel began to cry. ‘Das ist nicht fair.’ That is not fair, the German chancellor said angrily, tears welling in her eyes. ‘Ich bringe mich nicht selbst um.’ I am not going to commit suicide. For those who witnessed the breakdown in a small conference room in the French seaside resort of Cannes, it was shocking enough to watch Europe’s most powerful and emotionally controlled leader brought to tears. But the scene was even more remarkable, those present said, for the two objects of her ire: the man sitting next to her, French President Nicolas Sarkozy, and the other across the table, US President Barack Obama. It would be the low point in a brutal, recrimination-filled night, one many participants would recall as the nadir of the three-year eurozone crisis. Mr Sarkozy had hoped his leadership of the Group of 20 summit would cement his standing on the global stage en route to re-election. Instead, everything was falling apart. Greece was imploding politically; Italy, a country too big to bail out, appeared just days away from being cut off from global financial markets; and Ms Merkel, try as Mr Sarkozy and Mr Obama might, could not be convinced to increase German contributions to the eurozone’s ‘firewall’ – the ‘big bazooka’ or ‘all of money’ they believed had to grow dramatically to fend off attacks by panicking bond traders.”

“It Was the Point Where the Eurozone Could have Exploded,” read the headline for the first of Peter Spiegel’s terrific six-part Financial Times series “How the Euro was Saved.”

It’s an interesting juncture to revisit the 2011-2012 Eurozone crisis. Italian and Spanish sovereign bond yields are these days near record lows. Italy's 10-year yields ended the week at 3.16%, down from the crisis-period high of about 7.50%. Yields in Spain closed below 3%, after trading above 7% in 2012. European stock prices are generally not far from record highs. The bullish view is that sustainable recovery has taken hold and the threat posed to the euro and European integration has long passed. Meanwhile, Italy, with sovereign debt at 133% of GDP, has had one positive quarter of growth (0.1%) in the past 11. And despite extraordinary monetary stimulus and booming securities markets, the French economy has stagnated with unemployment above 10%.

I believe history will be written in a way that surprises most of today’s pundits and analysts. Things are not as commonly perceived (in our “money”-induced “Truman Show” World). Spiegel’s behind-the-scenes account confirms the dire Eurozone prognosis back in 2011/12 - that at the time was really downplayed in the media and by analysts. And from my perspective, the so-called “Draghi Plan” (unlimited ECB backstop support for troubled bond markets) gets too much Credit for resolving the crisis. I actually believe concerted global central bank liquidity operations were primarily responsible for reversing the destabilizing outflow of funds from periphery European bonds, banks and the euro.

Without Ben and Haruhiko, Mario’s “bazooka” would have lacked street credibility. Indeed, the flooding of the global system with central bank liquidity resuscitated Bubble Dynamics throughout the Eurozone – and global markets more generally. It’s premature to celebrate.

It was July 26, 2012 that Draghi stated his now famous “Within our mandate, the ECB is ready to do whatever it takes to preserve the euro. And believe me, it will be enough.” A week later, under the headline “Synchronized Central Banking?,” The Wall Street Journal’s Jon Hilsenrath and Kristina Peterson wrote: “On back-to-back days this week, U.S. Federal Reserve officials, followed by the head of the European Central Bank, signaled they were edging closer to taking new actions to support their slices of the global economy. So it’s a fair time to ask: How much do global central banks work together?”

Around the time the Bernanke Fed signaled an extraordinary round of “open-ended” QE, the Bank of Japan began their unprecedented “money” printing operation. Fed Credit has now expanded $1.466 TN, or 52%, since November 2012. And since the summer of 2012, Bank of Japan Credit has expanded 70%, or almost $1.0 TN, to $2.4 TN. It is as well worth noting that global central banks’ “international reserves” have surged $1.5 TN since the summer of 2012. The world has indeed been awash in central bank liquidity like never before. How this all plays out is anything but clear.

I believe central bank measures implemented in the summer of 2012 will go down in history as a catastrophic mistake – akin to Benjamin Strong’s infamous 1927 market “coup de whiskey.” These measures unleashed powerful “Terminal Phase” Bubble excess in U.S. stocks, Credit and assets markets; Japanese equities; Chinese Credit; European stocks and bonds; EM Credit, etc. Already destabilizing speculation was further stoked, while necessary global financial and economic adjustments were obstructed.

Importantly, Draghi’s “ready to do whatever it takes… And believe me, it will be enough” was a direct threat aimed at speculators that had accumulated large bets against European debt and the euro. It’s my view that the Fed and BOJ’s extraordinary measures to devalue the dollar and yen – as the ECB refrained from QE - were instrumental in bolstering the vulnerable euro. And with global central banks supporting the euro coupled with Draghi promising a bond backstop, suddenly European periphery bonds were transformed into an incredible opportunity for speculation - in a world awash in free-flowing speculative finance. Stated differently, the major central banks dictated that the hedge funds and speculators reverse their bearish euro-related bets and instead go leveraged long. This powerful Bubble flourishes to this day.

Call me a nut, but I’m convinced the world is a much more dangerous place today than back in 2012. I don’t believe serious structural issues can be resolved by central bank monetary inflation. And I don’t view central bank market backstops as conducive to financial stability. Quite the opposite: increase the scope of a market backstop and you’ll correspondingly increase the size of the speculative Bubble. From Spiegel’s reporting, we now know that it was the U.S. and Italy that first pressed for a big (Fed-like) ECB/Eurozone financial backstop. Germany balked.

Now viewed as “one of the most successful monetary policies” ever, I believe the ECB backstop ensured only more dangerous excess. Financial asset mispricing has gone to greater extremes and speculative excesses have intensified. Underlying debt fundamentals have continued to deteriorate. Yet complacency is only more deeply entrenched. This creates latent financial and economic fragility. Meanwhile, global Bubbles stoke inequality and animosity around the world.

Central to my current macro thesis is the precarious divergence between inflated global securities prices – versus mounting risks associated with a rapidly deteriorating geopolitical backdrop and weakened fundamental prospects. This week saw the imposition of martial law followed by military coup in Thailand. I can only cringe when I read the suggestion of an “Asian spring.” In Libya, an escalating civil war risks exacerbating already frightening regional instability. Crude oil prices jumped $2.33 this week to a near three-year high.

May 23 – AFP: “‘In the modern, interconnected world, economic sanctions as an instrument of political pressure can have a boomerang effect, and in the end they have an impact on the businesses and economies of the countries that initiated them,’ Putin told an economic forum in Saint Petersburg. He also lashed out at the global influence of the United States. ‘The model of a unipolar world has failed. Everyone can easily see it today, even those who try to act in the usual manner, to keep their monopoly, to dictate their rules of the game in politics, commerce and finance, to impose their cultural and behavioural norms,’ he said. ‘The world is multipolar, people want to decide their own destinies, preserve their cultural and historical identities and civilisations,’ Putin said.”

It will be an interesting weekend in Europe. The Ukraine presidential vote will be decided Sunday. Throughout the European Union elections are being held for the European Parliament. To ‘save’ the euro, a small group of individuals had to push rules and democratic principles aside. Central bankers gambled that their massive ‘money’ printing experiment and market intervention would jumpstart a self-sustaining recovery. There are steep costs associated with such desperate acts, certainly including an increasingly polarized Europe and world. It is quite possible that so-called ‘fringe’ parties will be the biggest winners in EU elections. The European parliament could face a powerful anti-euro, anti-establishment contingent.

May 23 - Washington Post (Griff Witte): “It’s an election like no other: One continent; 28 nations; 16,000 candidates; 350 million eligible voters. The European parliamentary elections only come around once every five years, and every time they do, the world reacts with a giant, collective shrug. As ever-lower turnout rates show, even Europeans seem indifferent to their one chance to directly choose the E.U.'s leaders… And yet, this year’s vote… could be far more interesting than most. It could also matter more… If fringe parties do especially well in the European vote, it could also give them momentum going into national elections. Britain’s vote, for instance, is now just a year away, and UKIP is positioning itself to play the spoiler. Vladimir is watching: Perhaps no one outside Europe is paying closer attention to the European elections than Russia’s president. Ukraine’s crisis has hardly been a blip in the election campaign, but it could become a major issue in parliament if the anti-establishment parties do well. That’s because those on both the far right and the far left are serious admirers of Putin, who they see as just the sort of nationalist, tradition-minded, Alpha male that Europe so sorely lacks. A strong showing by the fringe could drive a wedge through Europe at exactly the moment the continent’s leaders are trying to hold the line against Moscow.”

Financial Times (Peter Spiegel): “…Less than a year after that November 2011 night, the existential crisis for Europe’s single currency would, for all intents and purposes, be over. The markets that once threatened to tear the euro apart would be tamed… When the history of the eurozone crisis is written, the period from late 2011 through 2012 will be remembered as the months that forever changed the European project. Strict budget rules were made inviolable; banking oversight was stripped from national authorities; and the printing presses of the European Central Bank would become the lender of last resort for failing eurozone sovereigns.”

There’s a far-reaching contradiction that I fear is going to come back to bite Europe. To “save” the euro, a small cadre of officials, including President Obama, had to impose a more unified and uniform Europe. More rules, restraints and operations dictated from Brussels and Frankfurt; less individuality and sovereignty for citizens, politicians and governments throughout a diverse and unsettled continent. Yet powerful secular forces – in Europe and globally – are pulling persistently in the exact opposite direction: less integration and less cooperation – deeper animosities and separatist proclivities. The perception is of a shrinking economic pie – an unjust “zero sum game” world – which dictates a more determined struggle to procure one’s share. The jury remains out on European integration and the euro currency experiment – awaiting the outcome of the global monetary experiment.

Friday Putin gave another intriguing speech and responded to a series of pointed questions. Bloomberg went with the market-friendly headline “Putin Says Russia Will Work with Elected Ukrainian President.” I would instead focus on more substantive comments, including the quotes provided above. This man is emboldened and has a message that resonates much more around the world than most in the West are willing to accept. He clearly has friends in Beijing, with a number of “rogue” nations, and likely as well in Brasilia, New Delhi and elsewhere. Putin has his sights focused way beyond Ukraine. He thinks he’s in the process of changing the world. In the U.S., well, we seem overly preoccupied with one heck of a market Bubble.