by Doug Noland;
Global systemic stress has been gaining critical momentum, and markets last week were heartened that global policymakers were in the process of mustering meaningful responses. Scores of headlines offered encouragement that European officials were working diligently on a plan to help Spain resolve its banking crisis.
While reports were conflicting - and often contradictory - there was a general sense that circumstances had forced the Germans into a softer approach. And as global markets rallied, the fallback view again held sway that when global policymakers recognize the seriousness of a situation they will surely act accordingly - and, as such, "risk on" is alive if not well. Pavlovian.
Confidence in politicians may be rather shallow, yet there remains deep faith in the capacity of central bankers to rise to the occasion and bolster global risk markets. First came comments from European Central Bank (ECB) president Mario Draghi: "We monitor all developments closely and we stand ready to act."
Federal Reserve vice chair Janet Yellen made it clear the Fed was poised to do more: "There are a number of significant downside risks to the economic outlook, and hence it may well be appropriate to insure against adverse shocks that could push the economy into territory where self-reinforcing downward spiral of economic weakness would be difficult to arrest. ... I am convinced that scope remains for [the Federal Reserve] to provide further policy accommodation either through its forward guidance or through additional balance-sheet actions."
Yet on the policy response front, the biggest surprise of the week arrived courtesy of Beijing. The People's Bank of China reduced lending and deposit rates by 25 basis points (bps), the first cut in official rates since 2008. China's central bank also took measures to loosen lending standards, allowing banks additional flexibility to both discount loans and attract deposits.
There were also reports that Chinese bank regulators had delayed the implementation of more onerous bank capital requirements. From Bloomberg: "New draft rules from the China Banking Regulatory Commission aim to set 'reasonable' schedules for banks to meet capital targets in a way that helps 'maintain appropriate credit growth'."
Beijing confirmed the bullish consensus view that China's policymakers will ensure strong economic growth. Meanwhile, data continue to support the thesis that China's economic and credit engines are really sputtering.
In Europe, there were reports of special weekend meetings - and perhaps even Spain requesting emergency financial assistance. There are important French parliamentary elections Sunday. And, of course, there is the final countdown to Greece's June 17 national election, which may be disrupted by a municipal workers strike. Markets confront a minefield of issues, although attention for now seems fixated on renewed policymaker largesse.
In studying past monetary fiascos, I've often been struck by the predictable nature of credit inflations. Credit booms would be followed by busts - and the arduous downside of the credit cycle would invariably provoke aggressive policy responses. Historically, governments would resort to printing larger amounts of currency (or simply incorporate more zeros), in increasingly desperate attempts to support post-bubble faltering economic output, rising unemployment and sinking prices levels (goods and asset prices).
Often it would come down to a critical dynamic: policymakers would eventually recognize (admit) that their money printing operations were having deleterious effects. A consensus view would even develop that inflationary policies had to be wound down - if not scuttled altogether.
Throughout history, there have been many derivations of the typical pronouncement, "Be on notice, this will be the last time this government resorts to the printing press." And rarely would it ever work out that way. Indeed, not only would monetary inflations continue, the scope of the money printing would too often escalate to the point of being completely out of control. Once unleashed, monetary inflations take on a life of their own - and turn unwieldy on many levels. And this complex dynamic explains why monetary history is littered with worthless currencies.
Years of "activist" central banking have conditioned markets to envisage eager-to-please policymakers with flasks in hands at the fountain of everlasting market vigor. Meanwhile, policymakers at this point (four years into crisis management mode) more clearly appreciate both the limits of their monetary tools and the costs associated with ultra-loose monetary conditions and sure-fire market interventions. Markets were nonetheless content last week to cling firmly to the view that markets and policymakers remain on the same page.
Curiously, ECB president Draghi and Fed chairman Ben Bernanke last week seemed to be reading from similar scripts. While both, of course, assured market participants of their respective central banks' commitment to providing market backstops in times of crisis, each also seemed determined to try to signal to the markets that monetary policy has done about all it can do. Both seemed to recognize that ultra-loose monetary policy has played an integral role in political foot-dragging when it comes to implementing fiscal reform/responsibility. Both were measured in their comments, as if reluctant to incite market animal spirits (ie destabilizing speculation).
There is also a view that Drs Draghi and Bernanke are keen to save some of their central banks' depleted arsenals in the event of destabilizing fallout post the Greek election. And there is certainly the possibility that the Spanish debt crisis rapidly spirals out of control.
When I read a Reuter's report with sources claiming that Spain would request bailout aid on Saturday, I immediately assumed that capital flight must be turning unmanageable. But then a Financial Times article (Peter Spiegel) quoted "a senior European official": "It is essential that the other euro-area member states are pre-emptively and effectively ringfenced and protected from any possible Greek fallout, before the elections."
This explanation for why Spain would do an about face on European Union financial assistance - even before the completion of International Monetary Fund (IMF) and private audits of its banking system - seems as reasonable as problematic capital flight.
Spain and the EU face a serious dilemma. Several analysts have gone so far as to state that the euro will be made or lost in Spain. And while the markets seemed to welcome leaks of an imminent Spanish bailout, it might be one of those "be careful what you wish for" moments.
Spain - it's sovereign, banks, regional governments, corporations and economy - today suffers a market crisis of confidence. Estimates place (guess) the banking system's capital shortfall in the wide range of between 40 billion (US$50.5 billion) to 250 billion euros. A full-scale Spain IMF/EU bailout program could tally in the hundreds of billions. The chatter is of some "bailout light" strategy that would tide Spain over - at least through the Greek election and its immediate aftermath. Do too little and the plan lacks credibility; promise too much and the markets will question where the money is to come from.
The Telegraph's Ambrose Evans-Pritchard ("Spain too big for EU rescue fund as China recoils") reminded readers of potential problems associated with the EU's "firewall" facilities.
The European Financial Stability Facility (EFSF), for example, is backed by euro zone member/creditors. But once a country taps emergency funds it can longer back EFSF borrowings. So the firewall shrinks or the additional liabilities accrue to the other member states. There is also the issue of prospective market appetite for EFSF/ESM (European Stability Mechanism) debt. Mr Evans-Pritchard's article noted that China's sovereign wealth fund is backing away from European debt. Quoting the chairman of China Investment Corporation: "The risk is too big, and the return too low."
I have written previously that Europe's "firewall" was created with the hope/intention that it would never be deployed - a big bazooka that sits there with everyone just kind of assuming it's loaded and operational. Well, it's likely to be called upon in a big way and in a hurry. And when the headline crosses that Spain has requested aid, it might very well be seen as good news ("resolves uncertainty") in the marketplace.
I don't expect it to be long, however, before serious questions arise as to the credibility of the bailout structure. Is the bazooka legit? Will global investors be willing to buy hundreds of billions of euros of EFSF/ESM debt in an environment where the marketplace surely will have serious questions as to the sustainability of the euro currency regime? Can bailout bond and the euro credibility persevere through the failure of a "core" euro zone country?
There were reports that Greek government revenues during May were down 20-25% year on year. No matter the outcome of the Greek election - or even whether Greece stays or exits the euro - there is little to suggest that this deeply troubled little economy will anytime soon end its status as a quite formidable financial "blackhole".
This post-bubble dynamic makes one really fear for Spain - and the euro. I've believed that a preferred strategy - and perhaps the only hope for salvaging the euro - would have been to push the Greeks out of the euro to ensure that the full weight of policymaker attention and European resources could be deployed to "ring-fence" the euro zone's vulnerable "core."
Over the coming days and weeks we'll instead be faced with the spectacle of a failed periphery (Greece) and a failing core (Spain) perhaps working in concert to pull the fabric of the euro apart at the seams.
The view that last week provided only the opening policy response salvo is anything but unjustified. If things proceed in Europe (and globally) as I fear, we can expect the ECB to cut rates and implement additional liquidity measures, as the Fed moves forward with additional quantitative easing. The Chinese, Indians, Brazilians and others will stimulate in hope of sustaining faltering booms. And I expect all of these measures to have little, if any, constructive impact on deepening global credit and economic crises.
At the same time, the impact on financial markets is less clear. Even New York City taxi drivers are confident that policy measures are sure to bolster the markets. To what extent will the sophisticated operators now use generous market accommodation to head for the exits? It's traditionally been referred to as "distribution". Think ZIOCONNED CIA's Facebook IPO....or Apple, MSFT or Google's Hype....