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The European Bailout: A Week Later   May 14th, 2010
One week weaker, and in more trouble       


More observations...

It's been a week since Europe announced its trillion-dollar bailout of itself. So how about a preliminary review of its effectiveness.

As I wrote earlier this week, countries in the Eurozone hammered together a dealer that mostly amounted to a trillion-dollar bailout of itself. The bailout consisted of:

  • A promise by member countries to provide up to approximately a trillion dollars to guarantee the debt of all its member countries
  • The European Central Bank stated it would buy the debt of member countries (print Euros)
  • The U.S. Federal Reserve opened a dollar-borrowing window to a number of primarily European central banks (print dollars)

In the comments I wrote last Sunday, my prediction was "I bet we see the value of the Euro increase for awhile (after all, it's a shocking amount of money they just promised), and then decline once again as specific Euro countries continue to be tested by the bond market. Once the shock and awe wears off, Europe will be back where it started and we'll see if they live up to their promises."

Last Friday--the last business day before the bailout was announced--the Euro closed at 1.2752. On Monday, the first business day after the weekend bailout announcement, the Euro peaked at 1.3074 (a gain of 2.5%) when European markets opened. The Euro has been falling ever since. Five business days after the announcement the Euro is at 1.2358. That's a loss of 3% since the bailout was announced, and a drop of 5.5% in it's post-bailout peak in less than a week.

Likewise, the U.S. stock market rallied 400 points on Monday over its Friday close. However, aside from that one-day rally, the stock market was down 3 of the other 4 days and closed the week on a downward trajectory.

Based on the evidence of this week, so far I was right. The announced bailout provoked a one-day euphoric rally and both the Euro and the stock markets have been sliding down ever since.

The Euro's continued fall is the most impressive--and the most worrying.

As I also wrote last Sunday, "If the Euro doesn't increase in value over the next few days in response to this promise, Europe is in trouble--because that would mean the credit markets don't really put much faith in Europe's promise."

This is the situation Europe finds itself in. The Euro rally caused by the bailout lasted just one business day. It's in worse shape now than it was before the bailout announcement.

That's not surprising since the European Central Bank also announced that it was going to start printing Euros and devalue the currency--which is what it means when a central bank starts buying government debt.

In addition to the value of the Euro and the generally declining stock market, we have the issue of the price of U.S. bonds and the price of gold.

The price of gold has been reaching record highs even though the value of the dollar is also increasing (as compared to the Euro). Usually the value of the dollar and the price of gold move in opposite directions.

U.S. bonds are also increasing in price. This is what normally happens when the stock market falls--when investors get nervous and take their money out of the stock market, they invest it in "safe" U.S. bonds. So it's common to see the price of U.S. bonds and the stock market move in opposite directions.

What's interesting is both gold and U.S. bonds are increasing in price. These are both "safe haven" investments where investors park their money when they're nervous. But it wouldn't seem the stock market has dropped enough (yet) to create such a run-up in gold and such simultaneous demand for U.S. bonds.

This is just a guess, but I suspect what's happening is that Europeans are taking their money and parking it in gold in the face of a devaluing Euro. Americans are also nervous--and some are buying gold--but many have yet to fully recognize the sovereign debt crisis, and that America will soon be facing the same crisis itself. Those individuals are taking their money out of the stock market and parking it in the supposedly "safe" harbor of U.S. debt.

This conclusion would seem to be somewhat supported by this article:
Gold is experiencing strong demand from Europeans lately, as investors there worry the region's debt problems will persist and devalue the euro, said Adam Klopfenstein, senior market strategist at commodities brokerage firm Lind-Waldock.

"Gold is the market that Europeans want to own. Their money is going into gold because at some point, people who have already been burned by their own currency want to own something tangible," he said.

In other words, since Europeans have been burned by government debt in their continent and burned by the falling value of their own currency, they may very well be hesitant to buy something that isn't tangible--such as dollars or U.S. debt.

Recognizing that the empty promise of a self-funded trillion-dollar bailout wasn't impressing the markets, a number of European countries are announcing that they will move quickly to do the one thing that can turn things around: Fiscal conservatism. This week a number of European countries outside of Greece have started to announce that they will be making prompt reductions in government spending. Europe has realized that the markets aren't going to be fooled for long. The trillion-dollar bailout fooled the markets for exactly one day. What the markets are looking for now are real actions that address the structural problem, which is unsustainable overspending.

It will be very interesting to see over the days and weeks ahead if the current trends can be stopped. The trillion-dollar bailout promise didn't stop the trend. The announcement of plans to cut spending are welcome, but the markets so far have apparently discounted those promises, too.

Now that eurosocialism has apparently run out of other people's money, the markets are waiting to see fiscal conservatism deployed in Europe to save the day. And the Euro. And the economy.

    NOTE: It should be noted (and so I am) that presumably the European bailout's intent was not to prop up the value of the Euro. With the ECB's promise to print Euros they had to know it was going to devalue the currency. The intent of the bailout was to provide liquidity.

    What that means is that since fewer and fewer investors were willing to buy the debt of certain European countries, interest rates for those countries were increasing to the point that those countries couldn't borrow more money at rates they could afford.

    The European bailout did address that problem. Interest rates for debt of even the risky countries have fallen significantly. So now those heavily indebted countries will be able to get even further in debt.

    So the effect of the European bailout is that countries that aren't economically viable are being allowed to borrow more money.

    What an absolutely amazing and insightful economic policy. In fact, it reminds me of the Community Reinvestment Act in the U.S. that sparked lending to subprime borrowers whereby individuals that weren't economically viable were allowed to borrow more money.

    I suspect the Europeans are practicing the art of insanity: Doing the same thing over and over again, and expecting a different result.

    But maybe, just maybe, they'll practice the art of fiscal conservatism and break the vicious cycle that they find themselves in. That wouldn't be insanity. That'd be enlightenment.

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