Thursday, July 26, 2012

Proverb from Papa

The first panacea for a mismanaged nation is inflation of the currency; the second is war. Both bring a temporary prosperity; both bring a permanent ruin. But both are the refuge of political and economic opportunists. -- Hemingway

Perhaps Hemingway met Draghi's kinfolks.  In any case, the irrational exuberance, as Greenspan once intoned, of the markets looks to me like a "so far, so good" response.  What do people think Draghi is going to do to "save" the euro?  What options are left?  Basically, it comes down to the European Central Bank somehow buying into the Spanish and Italian bond markets and driving down the rates.  Direct intervention by the ECB in the way the Fed buys U.S. Treasuries is supposedly contrary to the law.  Not that laws ever stopped criminals -- by definition. 

Is Draghi threatening to drastically devalue the euro?  Will the Germans and the Finns stand by and allow themselves to be impoverished for the sake of the Eurozone?  I guess we will see. 

Hemingway's second option sounds laughable these days, but desperate people will do desperate things.


  1. Thanks once agin' for the understandable analysis. I think what makes it such a mystery for me are the perverse actions. Ok, lemme see... bond yields rise to attract investors. But the ECB is going to buy the bonds so the issuers don't have to raise the rates thereby keeping the cost of running the Spanish and Italian governments down.

    That right?

  2. You've got it. Like individuals, nations have credit scores. A person with a 780 can borrow money more cheaply because he is a better risk than someone with a 650. Spain and Italy are becoming likely candidates for default so their rates have increased. The consensus is that somewhere over 7% on a ten-year bond for Spain makes it impossible to service the debt. In other words, Spain cannot even pay the interest on its debt which is automatic default.

    Draghi cannot increase the tax revenues in Spain which has an unemployment rate around 25% now. A lot of the employed people are government workers. Government workers are, generally, a net negative even if you tax them at 50%. As tax revenues continue to decline in a recession/depression, Spain has to borrow just to avoid default.

    Draghi can use the central bank to lower the bond rates but not for long, certainly not indefinitely.

    Calling the market reaction perverse is correct. The markets are betting that inflation will infuse more cash into equities because devalued dollars have no place else to go in a zero-interest rate environment. I think that is a mistake. I think they will go into the mattress, metals, or other currencies -- U.S., Australian, Canadian dollars, Swiss francs, yen, etc.

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