I hate to beat a dead horse, but the situation in Europe is dire, and two issues crossing my desk this afternoon only add to my angst. First, Karl Smith at Modeled Behavior sees that the ECB is losing all control of monetary policy:
Based on entirely different indicators this looks to be the point where the ECB’s control over Eurozone monetary policy began to come unmoored.
At the crux of the problem seems to be the inability to arbitrage away differences in funding costs between institutions and countries because of malfunctioning in the European Repo market.
This malfunctioning appears to be down right mechanical with trades regularly not settling on time, collateral not being delivered, awkward interventions by local regulatory agencies and a host of other deep, deep problems.
Very, very scary - remember that the ECB is the last great hope. But it can't be effective if the European banking system collapses, which looks more likely each day. A signal that the related rush to cash is severe is that the ECB is no longer able to fully sterilize its asset purchases. Stories at the Wall Street Journal and the Financial Times. Recognize the risk that even when the ECB switches to quantitative easing, the resulting cash just sits unused in bank reserves. Sound familiar? Europe has liquidity trap written all over it.
A second point comes from Edward Harrison, who spots a story which claims France and Germany are looking to impose a strict zero (!) percent budget deficit target by 2016. Harrison's take:
Note that an adjustment to balanced budgets throughout the euro zone requires either an exactly equivalent offset in private sector savings down or in the export sector up . So implicitly, Germany and France are calling for a massive private sector dissaving or a large reduction in the external value of the euro area currency. I see this as a pipe dream. It tells you that bad things are definitely going to happen in Euroland.
This is my fear - that Germany and France continue to press ahead with the "austerity first" plan, with the ECB cheering them along. Unequivocally, this is not going to work. It hasn't worked yet, and there is zero reason to believe that it will in the future. All Europe is doing is setting itself up for greater speculative attacks as each new turn toward austerity pushes the deficit targets further out of reach.
We are setting the stage for a massive counter-example to the US reaction to its financial crisis. The US allowed the fiscal deficit to swell while force-feeding capital to the banking sector (not enough, but that is another story). Europe is pushing for massive fiscal austerity and, to prevent additional fiscal borrowing, pretending that the banks can survive via "liability management exercises." If you think the US would have been better off shrinking the deficit while letting the banking system collapse, it is time for you to go long on Europe.
For the rest of us, enjoy the policy-driven market upturns while they last.
