COMMENTARY

Peter Burgess

The Biggest Bubble in History?

We are baffled by the analysis of the analyst community, some, of which, are not so analytical. They say that Europe’s fundamental problem is that it has a central bank which is unwilling to monetize sizeable debt maturities which bondholders are unwilling to refinance . They look to the Federal Reserve as a model and as proof that the U.S. does not and will not have a sovereign funding crisis.

Maybe that’s why the U.S. Congressional “Super Committee” is having trouble reaching an agreement on a fiscal program. Talk about the Fed creating moral hazard!

If a sovereign crisis is the result of an intransigent central bank that refuses to print money to refinance maturing bonds that the government can’t afford or is unwilling to pay, why in the world did the Russian government default on its local treasury securities in 1998?

Remember that crisis? It eventually led to the collapse of Long Term Capital Management and what President Clinton called the greatest economic crisis since the Great Depression. He was only about ten years early.

Why didn’t the Russian government simply monetize the existing treasury securities, known as GKOs? Couldn’t they hold rates down to say 10 percent instead of letting them soar to 200 percent?

We don’t know for sure and are too lazy to research it (impossible to prove a counterfactual!) but maybe it was because they didn’t want to inflict hyperinflation upon the Russian people. What would Russia be like today if they had monetized? Ironically, Russia chose to default on its local currency debt, much of it held by foreigners, including David Tepper, and decided to pay their hard currency Euro bonds. Go figure.

We’ll also never forget being in the Bulgarian central bank in 1996 just before some very large maturities of treasury bills were coming due. The market had lost confidence in the government and a high ranking central bank official looked us straight in the eye and said “we will not let the government default.”

We knew instantly a massive amount of liquidity was about to hit the local markets, the demand for the currency was going to collapse, and the country was headed for hyperinflation. Rioting broke out, the government fell, and the country eventually implemented a currency board, not too dissimilar from that of the Euro, in order to enforce fiscal discipline upon the government.

Here at the Global Macro Monitor we believe it is one thing to monetize the small debt maturities of Greece and, say, Portugal, but Italy, the third largest debtor in the world, is in a totally different league. Surprisingly, the markets don’t seem to make the distinction, but, no doubt, German policymakers do.

It doesn’t help that many of Italy’s bondholders are some of Europe’s largest banks who have been recently rewarded by the markets for reducing their sovereign bond holdings. Some of the French banks, for example, saw their stock prices soar after they announced sizeable reductions in their European sovereign exposure in the latest earnings releases. There is no question, at least in our mind, they’ll continue to be under pressure to sell down their sovereign exposure.

But to whom we ask? The ECB? More importantly will the ECB’s “bid of last resort” at a subsidized bond price for the seller result in Italy’s return to full market access at sustainable interest rates? This is the question Mario Draghi must be asking himself every minute of every day. The answer will largely depend on Mario Monti’s political ability to motivate Italians to swallow the necessary austerity measures to win back market confidence, which could take some time.

We’re not sure of the economic and political consequences of the monetization of Italy’s debt, but unlike many, we are sure there will be unintended consequences, both economic and political.

We just may be in the midst of the biggest bubble in history. The complacency that the accumulation of all the ills of the many and massive bubbles that have ripped through the global economy in the past twenty years can simply be resolved by quantitative easing, monetization, printing money or whatever you wish to call it is simply stunning to us.

The loss of confidence, to paraphrase Rudiger Dornbusch, takes longer to happen than you think it should and happens faster than you thought it could. Governments can finance themselves until they can’t. Risk free is risk free until it isn’t.

For more on the Russian Rouble crisis, see Russia, sovereign debt defaults, and fiat currency. For more on currency sovereignty and the European crisis, see On Creators of Currency and the Sovereign Debt Crisis.