Tuesday, November 1, 2011

Europe is Still Struggling

The debt deal cut in Europe last week apparently did not get out in front of the markets through its own actions.  Interest rates and interest rate spreads over the German 10-year bond rate remained at or near Euro-era highs. 

There were a lot of questions still floating around financial markets last Friday.  (See my post on Blogspot of October 28, 2011: http://maseportfolio.blogspot.com/.) But just where is the weak spot in last week’s deal…the write down of Greek debt?  The recapitalization of the banks?  Or, the European bailout fund?  Or, all of the above?

The point still remains that financial markets are not satisfied.

The yield on Italian 10-year bonds closed at 6.11 percent yesterday, a new euro era high and this was 411 basis points above the comparable German bond.  The yield on Portuguese bonds on Friday was almost 1200 basis points above the German bond, also a new euro era high.  And, yields on Greek bonds, Spanish bonds and other stay at lofty spreads above the German bond.

It is one thing when credit inflation pervades the financial system.  Credit inflation provides incentives to create debt, to speculate, to absorb more risk. 

When credit inflation is checked, as it is at the present time (although not through the explicit desire of a large number of governments) the fiscally and economically strong dominate.  That is why Germany is currently in such a strong position in Europe.

Credit inflation like we have experienced over the past fifty years encourages financial leverage, excessive risk taking, and cutting corners.  The incentives that exist at such times allow governments and businesses and banks to issue debt and leverage up…and the credit inflation buys them out. 

Speculation thrives in a time of credit inflation.  I read an article like that of Andrew Ross Sorkin in the New York Times this morning (http://dealbook.nytimes.com/2011/10/31/its-lonely-without-the-goldman-net/?ref=business),  an article that discusses the trading and “big bets” placed by such names as John Corzine, John Thain, Robert Rubin, and J. Chris Flowers.  These individuals benefitted by taking on more and more risk during the time of credit inflation and financing this risk taking with lots of leverage, and especially short term debt.

The morning papers are filled with the news of the latest bets placed by John Corzine at MF Global.  Unfortunately, the environment was not one that was conducive to the recently placed bets of Corzine.

Furthermore, a period of credit inflation is a time when people cut corners on the truth, push hiddenness a little more, and engage in schemes that are on the edge of being legal if they are legal.  Greece hid its financial condition for a long time before it had to “fess up.”  Italy has not been fully forthcoming concerning its financial affairs.  Citigroup hid mountains of questionable assets “off-balance sheet”.  And, of course, look at all the instances of insider trading and Ponzi-schemes that have surfaced over the past few years.

As Chuck Prince, former CEO of Citigroup so famously stated: As long as the music is playing, you have to keep dancing.

When the music stops…

Or, as Warren Buffet has said, you have to wait until the tide goes out before you find who is swimming without a bathing suit!

Well, the music has stopped…the tide has gone out…

And, we are observing those who where not wearing bathing suits and the scene is not very pretty.

The financial markets are saying that the officials of Europe have not gotten out ahead of the situation…they are still behind.  And, since the tide has gone out, there is no credit inflation to buy them out of their situation.  As a consequence, some time or another, they are going to have to finally address the insolvencies that exist. 

And, it will be the strong that control the situation. 

Germany will be one of the strong…maybe gaining a position in the twenty-first century that they could not achieve in two world wars in the twentieth century. 

Will America be one of the strong?  People are raising questions about the ability of the United States to lead in the twenty-first century.  See John Taylor’s op-ed piece in the Wall Street Journal this morning: http://professional.wsj.com/article/SB10001424052970204394804577009651207190754.html?mod=ITP_opinion_0&mg=reno-secaucus-wsj.

It does not appear that Europe has made it yet.  Consequently, there will still be financial market turmoil, social unrest, and political dislocation.  The European continent had its fun over the past fifty years financed by lots of debt.  Now, it must pay the debt collector…or default.

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