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David Miles Headshot

Europe's Dance Of Death

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"It's a Ponzi scheme, it's a fraud, it's a sham," observed Jim Rogers this week when interviewed on the BBC World Service. One of the world's most successful investors was, however, not giving his verdict on the dastardly deeds which have confined Bernard Madoff to prison for 150 years, but rather the current strategy of the European Central Bank (ECB) and European leaders in trying to solve the euro zone sovereign debt crisis. For Rogers, their approach is based more on Peter Pan than sound monetary policy.
Ever since euro zone banks snapped up almost half a trillion euros in very low interest three-year loans offered by the ECB last week, the question was to what extent these banks would do the sovereigns a favour, as Nicholas Sarkozy hoped, by buying the bonds of euro zone governments. The answer, based on the results of Italy's latest bond auction on Thursday, is not encouraging. Investors are simply not prepared to lend money to Italy on a long-term basis without a cripplingly high premium, which at 6.98% is barely below the 7% level that forced Ireland, Greece and Portugal to request international bailouts.
If investors in government bonds seem a little nervous at the prospect of buying what until recently were seen as virtually risk-free financial assets, the reason for this reticence, as Jim Rogers observed, is not hard to discern. Money, as Harvard historian Niall Ferguson notes, is about trust and over the last two years the euro zone's political leaders have been extraordinarily successful at blowing every opportunity to solve the debt crisis and restore trust in the single currency project. When ordinary citizens can borrow money at less interest than the Italian state, then it's clear just how serious this crisis has become. For Anthony Crescenzi, executive vice president at Pimco, the largest bond fund in the world, European sovereign debt is "toxic" with about the same status that subprime mortgage assets have had ever since the financial crisis of 2008.
What got rather less attention than the ECB handing out money last week was the news that a large number of euro zone banks actually deposited €452 billion ($589 billion) with the Frankfurt-based central bank at a paltry rate of interest, and for far less than they could earn making loans to other financial institutions. The reason? These banks are simply too nervous to lend at more profitable rates because they fear not being repaid. Across the euro zone there are zombie banks that have effectively failed and are only being kept alive with funds from the ECB. In this environment even healthy banks would sooner make next to nothing depositing their cash at the ECB, rather than risk lending to a competitor that might run into trouble as the Franco-Belgian bank Dexia did recently. Things wouldn't be so bad if the banks and bond investors had confidence that euro zone governments would step in to support their banking systems the way the UK did in 2008. But given the parlous state of government finances in most euro zone countries, underlined by the recent credit downgrade warnings, the capacity of sovereign states to ride to the rescue of their wounded banks is now heavily circumscribed.
If the markets were convinced that a credible government treasury like that of Germany was standing full square behind Europe's monetary union project, confidence could be restored, but every botched EU summit and failed rescue plan shows just how rickety the euro edifice has become. Resolving a systemic banking crisis requires that the politicians involved in finding a solution recognise that the markets do not move at the glacial pace of government. Investors in sovereign bonds will render judgements swiftly and ruthlessly if the measures taken are not seen as credible. Even as the ECB continues to inject money into the crippled banking system, the hope of its policymakers is that some of this liquidity will either find its way into the real economy or at least bring down the borrowing costs for the euro zone's governments. To paraphrase Jim Rogers, 'Welcome to Never Never Land'! Far more likely is that this suffocating embrace between indebted euro zone governments and their living dead banks will simply ensure that when the day of reckoning comes, when the bond markets finally say "No more money," the pain will be that much greater.