Comstock Partners, Inc.December 08, 2011
Additional Liquidity Is Not A Solution
"More than any other time in history mankind faces a crossroads. One path leads to despair and utter hopelessness, the other, to total extinction. Let us pray we have the wisdom to choose correctly."
We begin this comment by warning that anything we say can be overtaken by swift-moving events, and may be moot by the time you read it. As everyone knows the EU is meeting today and tomorrow in what is being billed as a last-ditch effort to save the Euro Zone. It is, of course, impossible to come up with a lasting solution in two days after almost two years of a patchwork series of conferences that have spurred short market rallies followed by continued downturns. What has been happening this week is all about providing enough cover for the ECB, either alone or in combination with other financial institutions, to provide enough liquidity to satisfy the markets temporarily while a longer-term solution is being kicked down the road once again.
Prime Minister Sarkozy and Chancellor Merkel have proposed a plan to change the EU treaty forcing the 27 nations in the EU or, at least the 17 nations in the Euro Zone, to accept fiscal oversight of their national budgets from a higher authority in the EU. The plan would include automatic sanctions against nations violating the budget rules, meaning a transfer of sovereignty from national parliaments to an EU institution. Sarkozy warned that "The risk of explosion is looming if the decisions taken with Angela Merkel are not put into effect."
The problem with the proposed solution is that it requires the approval from the parliaments of at least every nation in the Euro Zone, in addition to whatever non-Euro Zone members of the EU join in the plan. Complicating the process even more, some countries require national referendums. It is likely that there will be strong opposition to giving up national sovereignty to an unelected super-authority. Past treaty changes have taken years to accomplish and some have been rejected in referendums. If the process of treaty changes is extended, renewed panic in the markets will probably ensue. Moreover, to the extent that all of this works, the fiscal austerity imposed on the weaker nations will throw their economies into deep and prolonged recessions with ever soaring budget deficits.
In the negotiating process leading up to the meeting it is hard to tell how much the various parties are bluffing and how much they really mean what they say. Earlier in the week ECB head Mario Draghi said an agreement to bind governments on fiscal policy would be "the most important element to start restoring credibility" with financial markets. "Other elements may follow, but the sequencing matters." Various observers interpreted this statement as meaning that if fiscal reforms were seriously put on the table the ECB would start a massive sovereign bond buying operation. Today Draghi contradicted this view, saying that he was misunderstood; that the ECB was bound by the European Treaty and that it was up to the EFSF to intervene in the government bond markets. This could be just a negotiating ploy to extract the most fiscal reforms possible, or he could actually mean what he says, thereby ruling out any massive government bond purchases by the ECB. Draghi, however, did announce that the ECB would provide banks with unlimited cash for three years in order to ease the strains on the European financial system in the short-run.
In sum, it seems clear that the next few days will not produce a long-term solution to the European debt crisis. However, the various nations and financial institutions realize the gravity of the situation, and it seems likely that they will make every effort to reassure the bond markets and stop interest rates from continuing to climb, at least temporarily. It therefore would not surprise us to see a combination of financial institutions inject massive doses of liquidity into the markets in an effort to buy some time. While markets profess not to like government interference, they do love liquidity, and another brief rally is quite possible. However, this treats the symptoms rather than the disease. A dose of liquidity does not cure insolvency, recessionary economies, massive budget deficits and huge debts. At best, this will be another case of kicking the can down the road. At worst----we don't even want to think about it.