Peter Tchir

Print, Rally, Then What?

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The demand that the ECB becomes the lender of last (and only) resort has reached a crescendo. Virtually everyone in the world is pleading with Germany to allow the ECB to print money and buy massive amounts of Spanish, Italian, Portuguese, Irish, Belgium, and possibly Austrian debt. But as far as I can tell, the analysis doesn’t go beyond buy and the problem will be solved.

Seriously, read the articles, look at the headlines, listen to the guests on TV and radio, and all you discover is that the ECB must be allowed to buy but nothing about what will happen once they do. That to is a huge problem. At every step of this crisis, the popular demand to avoid immediate pain has been followed and has NOT worked. Right from the start, a core of people thought the system could handle a Greek default. Too many people, most of them powerful with a lot at stake, convinced the politicians that letting Greece default would be a disaster and lead to contagion. We don’t know what would have happened had Greece been allowed to default, but we do KNOW that not letting Greece default HAS lead to disaster and contagion.

Too many decisions are being made on the “one and done” theory. Avoid default and all will be good. Create EFSF and ESM and all will be good. Enhance EFSF and all will be good. Why will ECB acting as lender/printer of last resort ensure that all is good? I am willing to believe that the initial reaction to the decision will be big and positive. Risk assets will rally strongly but then what?

What will the world look like after the printing press has been turned on? How will investors respond? Is it really all positive, or are there consequences, and is it possible that these consequences are far worse than not printing in the first place?

Some work has been done about what the world would look like if we don’t print. Again, most of the analysis is of the variety of “print or die”, but some have laid out the consequences of not printing. Most of that analysis is of the extreme doom and gloom variety (published by banks that will benefit the most from massive taxpayer funded printing) but as a whole, there will be some consequences from not printing. Banks will be under pressure, some will fail, the stock market will go down, fears of recession will grow and the Central Banks and governments will have to act. This is where I believe that people go too far in their doom and gloom analysis. I believe that once the initial shocks go through, the central banks and governments will be in a much stronger position to implement policies that can help. The problem of solvency will have been reduced through restructurings and write-offs, and then with assets cheap enough, and liquidity provided by central banks, a new, cleaner, less complicated, stronger financial system can be allowed to grow. The banks (and most will survive, and some will thrive) can be told that no matter what they want, derivatives will be exchange traded, and anything OTC will carry large capital and margin requirements.

So, we have some idea of what happens if the ECB doesn’t print. There is agreement that it will cause some short term pain, but from there, the views range from dire predictions, to ones that are more manageable and optimistic that it can be contained and used as a new base for growth.

We don’t know what will happen after the ECB opens the floodgates. After the initial rally what really happens? The FED mostly bought assets that had a low risk of default. The ECB will be buying bonds that are unlikely to be repaid other than by the ECB buying new issues to pay off the old bonds. Is there really no consequence for that? Will we really just rally and not get nervous about the ECB’s balance sheet or about Germany and France? Will inflation run rampant? I think the Euro might rise at first on the “all saved” theory, but won’t it then weaken? In fact, shouldn’t it weaken massively as trillions have to be printed, and it is being printed for debt that might otherwise have defaulted? And yes, it will be trillions. Anyone who thinks that just the threat of printing is enough is wrong. Banks are bloated and will need to sell. This printing will reduce their losses on sales, but they will need to sell. The rally will last only as long as the ECB buys unlimited amounts, and that will be tested. As the ECB prints and the Euro declines and inflation rises, then what?

Will Italy and Greece really cut back pensions when inflation is rising? Will Germany be forced to raise their social benefits to catch up to Greece and Italy? Printing takes off the pressure, and inflation ensures that the higher levels of benefits are necessary. Will this actually become self fulfilling inflation as the austere countries race to provide benefits similar to those frivolous countries? I don’t know, but I have seen ZERO analysis on the subject since people are just happy with the print and all must be good solution.

What will the Fed do? Will we have to embark on our own printing program to ensure that we can keep the exchange rate with Europe from getting too low? How will we export our way out, if the Euro is cheap? Oil is already above $100, where will it go if we embark on our own printing program? QE worked really well for stocks in the US. The Fed created money which found its way from the treasury market into risky assets and made the dollar weaker, helping exports and making our risky assets look cheap to foreigners. Will EU QE be good for US stocks? The consensus is that stocks in the US will rally if Europe embarks on a massive printing program. I’m not as convinced. First, the money created by selling bonds to the ECB is unlikely to find its way into riskier assets. These are already risky assets and the newly minted money will be used to reduce risk and leverage. Europe will use the printing to deleverage – which is good long term – but this may not give the same benefit to stocks we saw in the US where it was low risk assets being purchased and the banking system didn’t need to deleverage as desperately as European banks need to. Also, if the Euro gets cheaper, won’t that hurt US exports? Won’t our companies become less competitive? Won’t our stocks look expensive relative to European stocks if the Euro declines? Again, some argue that the Euro will rise, but that argument seems to involve some hand waving; whereas, saying massive printing will weaken the Euro makes more sense.

What will the BRIC’s do? If inflation starts to hit and Europe devalues, and the US rushes to keep pace with the devaluation on a global scale, what happens to the developing countries, where daily poverty is still a real problem? How much inflation could China or India sustain? Do they retaliate in some way we haven’t thought about? Do we see problems in the commodity world? Does this heighten the tensions in the mid-east? Does China take steps to secure supplies beyond the land and resource purchases they have already made in other countries? There is a reason Germany is so worried about printing.

Before taking the step to print, all that I can hope for is that someone will actually do some serious analysis of the potential consequences, beyond the immediate relief rally. We need to make a decision based on the risk/rewards of the various steps we can take. We need to give MORE weight to the longer term than the shorter term. Too much that has been done to avoid short term pain, has led to bigger problems down the road – and not as far down the road as initially thought. On Greece I was quite certain that default would have been better. On EFSF I was completely certain it wouldn’t work in the way they said it would. On printing, my gut feel is that it will actually turn out far worse than people expect, but I’m not convinced. I am open to the idea that it could work, in spite of my concerns, maybe the arguments are persuasive, but we need to have those arguments. We need to realistically look at potential outcomes of printing, including the bad ones, and see if they can be mitigated. It may be the best solution, but until I see some real analysis convincing me the consequences of printing have been thought out, I will remain in the camp that letting some defaults, break-ups, write-downs, is the best longer term solution in spite of short term pain.

Copyright © 2011 · Peter Tchir

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