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Comstock Partners, Inc.
Central Bank Action Not A Solution
December 01, 2011

The emergency action of the central banks led by the U.S. to ease the credit crunch on European banks came as the world was only days away from a crisis that would have brought the European----and perhaps global ----economic and financial systems to a near collapse.  Just as in the days leading up to the outbreak of World War I, European leaders were about to stumble into a dire situation that they didn't want, but were unlikely to prevent.  Fortunately, however, Fed Chairman Bernanke saw what was about to happen and coordinated the effort to step in and stop the coming train wreck. 

We know that some will say that all this accomplishes is to add to the "moral hazard" that has been accelerating since the bailout of Lockheed Aircraft in 1971, the first public bailout of a major corporation.  They have a point.  That was followed by the rescues of Penn Central (1974), Chrysler (1980), Continental Illinois Bank (1984), the savings & loan industry (early 1990s), Long Term Capital (1998), the dot-com bubble (2000) and the housing crisis (2008-09).  There's little doubt that each crisis led to the next one, and that the costs have been accelerating all along.  However, when a house is burning and the winds threaten the rest of the neighborhood, the fact that the fire was started by someone smoking in bed is no reason not to put out the fire.

Having said that, an emergency ejection of liquidity to prevent immediate Armageddon is not even a first step toward solving Europe's deep-seated problems.  It's more or less the equivalent of the proverbial doctor telling a patient to "take two aspirin and see me in the morning".  It treats the symptoms, but not the disease.  Since the European crisis started almost two years ago central banks have made numerous attempts at coordinated action.  All of these moves were followed by strong market rallies that faltered when investors realized that the core problems were not addressed. 

Whether the core problems will be addressed this time remains to be seen.  European leaders now recognize the severity of the problem, but are still uncertain as to how to proceed.  The ECB is unwilling to buy massive amounts of sovereign bonds without some assurances of fiscal reforms, but such reforms require changes in treaty provisions that are difficult to change.  Today, ECB President Mario Draghi hinted that the ECB would be willing to expand purchases of sovereign bonds if EU governments created a "new fiscal compact" to strengthen fiscal policies.  The goal would be to purchase massive amounts of government bonds in order to stabilize yields and give nations time to enact new rules to make deficit reduction legally binding and enforceable.

European leaders will meet again on December 9th in an attempt to come up with the solution.  The important point, though, is that the probable solution would call for European nations to surrender some sovereignty over fiscal policy to a higher authority dominated by the stronger EU nations, particularly Germany.  In addition, the new fiscal policy would amount to more austerity.  Given that the people in the weaker nations have already been rioting against the austerity programs proposed by their own governments, how will they feel when that austerity is imposed from the outside?  And even if these obstacles were overcome, the result would be highly restrictive.  As we have repeated ad nauseam, the overall problem is too much global debt.  The policy solutions are inherently deflationary and will result in slow growth and disappointing market returns for years to come.      




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