The surprise of the week has undoubtedly been panic over Italy’s finances. Until this happened, it was commonly assumed that the PIIGS would fall in strict order, with Spain due to follow Portugal. The political response to this development amounts to total confusion among the Eurocrats. They recognise they must do something, but they do not know what, so they have meetings.
It is hard to have sympathy with these, the most statist of politicians, but there is in reality nothing they can do. The underlying problem is that western governments are nearly all running massive budget deficits, and the savings simply do not exist to fund them all, not even if interest rates doubled or tripled from current levels. In the funding queue some governments have precedence over others, either because they are seen as low-risk, or in the case of the US, because the dollar is the reserve currency. The propensity to save is important, which gives Germany and China, for example, a greater degree of funding security. This used to be true of Japan. The competition for savings leaves Euroland’s PIIGS shut out of capital markets.
Bond market analysts, the rating agencies, and organisations such as the OECD and the IMF, all produce optimistic forecasts of the funding requirements for these countries in the coming years. They are optimistic because economic recovery is assumed, when it is actually becoming impossible. And as the prospects for economic recovery are replaced by the near certainty of slump, these nations become locked into a cycle of raising taxes and cutting welfare, plunging them further into depression.
This may be a fatal blow to the European Project. It certainly puts the ECB in an impossible position. The central bank has done little to help the PIIGS governments with their financial difficulties, sticking mainly to keeping the eurozone banking system solvent. The ECB now faces the ultimate test: in the face of these escalating sovereign difficulties, will it continue to follow its relatively sound money policies? (Relative, that is, compared with the brazen money printers at the US Federal Reserve, Bank of England and Bank of Japan.) Sound money is bankrupting the PIIGS and will soon do the same for Belgium and France. Or will it cooperate by buying newly-minted PIIGS debt in a quantitative easing programme? If it does, the eurozone will live to fight another day. Though the ECB’s charter says no to QE, political reality says it is vital.
Any easing of the ECB’s stance against QE can be expected to fuel European demand for precious metals, and with gold hitting new highs this week, perhaps the smart money is ahead of it. And if the ECB starts its own QE programme, we can expect the Bank of England to consider QE2, and thus the Fed will have an excuse for QE3.
The reality is that the only way the large budget deficits of many developed countries can all be funded is by printing money to buy debt. The alternative is far higher bond yields for all but the very best credit ratings, yields that few governments can afford to pay.
No wonder gold is so strong. The penny is finally dropping in the slot machine that passes for the collective brains of the investment community.