Yet Another "Historic" Mistake by the Feds

Paris, France

Europe has lost its head!

First, the weather is completely out-of-sync with the calendar. Perhaps it’s because the volcano in Iceland... The dust is blotting out the sun. There’s no sun here today. Instead, the sky is pale grey. And it’s raining. The calendar say’s May 11th, but it could easily pass for February.

The euro markets lost their heads too. On Monday, Europe exploded to the upside. Stocks went up. Bonds went up even more. Especially Greek bonds.

Why the good time? Because Europe decided to follow the US into full-scale combat with the future. Yes, the Europeans are as eager to prevent real change from happening as their American counterparts.

The change they most don’t want is what we’re calling ‘the Great Correction.’ It’s a combination of several corrections at once – including a correction of the welfare state.

Europeans live well. And thanks to so many transfer payments and so many government-provided services, they live well without really having much money to spend. Their incomes go to pay taxes and social charges.

Trouble is, they enjoy a standard of living that they can’t really afford.

This will sound familiar to Daily Reckoning readers. For many years, we pointed the finger at Americans, claiming that they spent too much money. Americans lived beyond their means. Individual households over-spent and went into debt. That over-leveraging in the private sector in the US is now being corrected. At least, we think it is being corrected. (Recent figures are mixed... with some indications that private households are up to their old habits, trying to increase their standards of living by going into debt.)

In Europe, the phenomenon is a little different. It’s the public sector that is living beyond its means. Military budgets are small. Most government spending is focused on services and transfer payments. This social spending is responsible for a big part of the GDP and a big part of living standards. But as in the US, living standards are higher than people can afford. Governments provide more employment, more transfer payments and more ‘services’ than they have tax revenue to pay for. The result is public debt, which is getting worse every year.

Europe, generally... excluding England, does not have high levels of private debt. The debt is the public sector. That said, government debt in Europe, on average, is no worse than it is in the US. The Eurozone, altogether, has government debt to GDP of 88%.

In terms of deficits, Europe is actually in better shape than the US. US deficits are running around 10% of GDP – or more. In Europe, the average deficit this year is expected to be 6.6%.

In Europe, the center is solid. But like the edges of a carpet, the periphery states tend to get a little worn. Greek public debt is expected to reach 150% of GDP next year. Its budget deficit is as large as that of the US...
You can’t sustain a debt of 150% of GDP – not unless you are Japanese. So, a correction was inevitable. Greece had to change course.

This is what caused a crisis last week, a ‘rescue’ over the weekend, and a sharp rally Monday. America rescued its private sector. Europe is rescuing its public sector. Both are actually making the situation worse... but that subject is for a different day.

Rather than permit problems to correct themselves, the euro feds stepped in to aggravate them. That is, the euro feds are following the same program as the Americans. If people get into trouble because they have too much debt, the feds come to their aid with more debt!

In the event, EU financial officials worried that the Greek illness could be catchy. They were afraid that Portugal, Spain and maybe Italy would get whatever the Greeks had. So, they decided to inoculate the whole Eurozone with a $1 trillion program.

Where will the money come from? Just as in the US, it will come from people who don’t have any. All the Euro states are borrowing money already. Now they will have to borrow more to pay for people who borrowed too much.

The plan calls for loan guarantees and money from the IMF too. Plus, the European Central Bank will do its part. It will go into public and private debt markets to buy troubled debt, the equivalent of the Fed’s ‘quantitative easing’ program.

Yes, dear reader, the Europeans threw in everything they had. Under no circumstances did they want anyone to say it was ‘too little, too late.’

It was a “historic” occasion for the European Union, said French finance minister Christine Lagarde.

On that point, she was surely right. Up until now, Europe had shown some dignity... some scepticism... and some good sense. It had intervened to protect speculators from their mistakes, but reluctantly. Now, it has thrown in the kitchen sink, the oven, the refrigerator... and everything else.

But what’s this?

Asian markets seemed to slough off the Euro miracle this morning. And even the euro seems to wondering if this rescue effort will be as smooth and effective as people thought. Markets are quite likely to continue second guessing today... and then third guessing tomorrow... The gains could prove very short-lived.

Why? Is it too little, too late?

No, it is not. It is too much... much too early.

More thoughts from our London team…

Does Monday ’s impressive stock market ascension from last week’s dip into hell mean that everything’s OK?

We won’t pretend that we know the answer to that one. But our best guess is that it’s not. The primary trend still feels like it’s down…

Sure, stock markets rallied as investors around the world figured the Great Eurozone Bailout will stop the rot in Europe.

But, don’t bet your life (or your wealth) on it. It looks like all they’ve done is put off the evil hour… like giving a chronic maxed-out debt junkie a new credit card. Some day it all has to be paid back… but how?

Jeremy Batstone-Carr, an analyst at Charles Stanley: “You cannot make any nation that is unable to service its accumulated debts more creditworthy by extending more credit! If the EU lends Greece money, the loan will increase that country’s public sector debt. The interest on the additional loan, whatever it eventually proves to be, will increase the public sector deficit. Total debt-servicing costs will rise, raising the burden on public sector cash flows. At some point in the future, the loan will have to be paid back.”

It’s early days yet. Let’s give the Great Eurozone Bailout a chance. On Monday, investors rejoiced. The FTSE 100 was up more than 4%. The Dow Jones up nearly 4% and some European indices up nearly 10%.

Meanwhile, the Dread Gauge (VIX index) got smashed. We looked at the VIX in Friday’s DR, seeing how it showed investors moving from complacency to fear to dread. On Monday it fell 29% as investors let some optimism back into their lives.

How quickly moods can swing when you’re in no man’s land. All it takes is for another scare… and you can be bet the VIX will be heading higher.

Where to put your money as the West melts down

Meanwhile, while all the fun is happening in Western, developed markets, you might consider putting your money out East.

Cris Heaton from MoneyWeek Asia:

“For anyone who remembers the Asian crisis in 1997, Greece’s troubles bring a strong sense of déjà vu. There are the politicians blaming speculators and markets rather than their own mistakes. There’s the endless series of failed interventions that make things worse. There’s even, sadly, rioting and now deaths.

“And looming over it all, the big question: who’s next once this one goes down? How far will the contagion spread?

“If there’s any good news, it’s that emerging Asia should be safe. Thanks to changes the region made after its own crisis, most countries are in good fiscal shape...”

Chris actually wrote his note at the tail end of last week… before the Great Eurozone Bailout. But his point is still on the money. Asia should be a better bet than Europe.

Why Asia’s finances are sounder than Europe’s

“Most of emerging Asia doesn’t suffer the same lethal combination of imbalances that has felled Greece… almost no emerging Asian economy has the combination of problems that are likely to bring about a crisis at the moment.

“In the medium term, this should be good for Asian currencies and government bonds. As awareness of Asia’s better fundamentals grows, more investors will want to hold their debt rather than that of distressed Western economies. Local currency debt is likely to grow in importance as an asset class.”

The shift of power and wealth from West to East – it’s a theme Cris is following closely. Look out for his ideas for how to play it…

More doubts about the rally…

Bengt Saelensminde is just as sceptical on the stock rally as we are:

“I’m sceptical about this stock market rally. The markets want to go down, yet the authorities are pumping them up. But the market always gets its way.

“These are unwinnable battles and taxpayers are the cannon fodder. The people of Germany don’t much like the idea of being press-ganged and sent to the front line.

“And neither should we. Why should the British public bail out a currency to which they’re neither a member, nor have any intention of joining.”

From’s Bengt’s point of view, now is the time to be defensive. He has recommended his readers take a look at the latest Price Report. It’s a sobering assessment by esteemed investor Tim Price on where the economy is now and the four investments to make before the next correction.

You can view the report by clicking here.

And more thoughts...

*** “More bullets to dodge on the road from ruin,” is a marvelous headline in the Financial Times. If they had just changed one word it would have been accurate too. Europe, like America, is still on the road TO ruin.

“Everyone has had a wake up call about limitations [to state borrowing,]” the paper quotes an economist with HSBC.

But when the wake up call sounded, Europe – like the USA, hit the snooze button, rolled over, and when back to sleep. That is the real meaning and real effect of the bailout. Instead of being forced to balance their budgets right away, the wobbly countries, will get to wobble some more before falling down.

What else could happen? If Europe’s fringe states are to avoid falling down, they will actually have to reduce their spending – drastically. And, to judge from the riots in Greece, that would mean dodging real bullets. We don’t think Europe has the stomach for it. Neither does the USA.

Until tomorrow,

Bill Bonner
For The Daily Reckoning

P.S. If you enjoyed this article you can find out more about our free email, The Right Side by clicking here.

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