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The Monthly Banker: 28 May 2010
Another Minsky Moment!
A Minsky* moment occurs when over-indebted agents collectively drowned in their own mountain of debts. Unable to satisfy creditors with existing cash flow, debtors sell whatever assets they’ve got – good and bad. The last major Minsky moment erupted in 2008 when Bears Stearns and Lehman Brothers went belly-up six months apart. Then, government bonds were deemed to be the safe-haven.
But no longer.
In fact, a violent Minsky moment has erupted in places where people previously deemed as “safe”: the PIIGS government bonds (Portugal, Ireland, Italy, Greece and Spain). Having refinanced their deficits for years, investors are now questioning whether this process can be sustained. Alarmed by Greek’s swelling deficit, investors naturally demanded more compensation for bearing the risk of default. This caused Greek bonds to plummet. Unfortunately, because Greece is locked inside the Eurozone, it set about a market fire that spread rapidly throughout the Eurozone – a fire that was only put out with a weekend inspired €750 billion package. Euro was saved from a break up – for now.
Figure 1. “The Euro is in danger.” Angela Merkel (20 May, 2010)
However, doubts about the deal have quickly re-surfaced:
1. How will EU governments pay for loan guarantees worth a staggering €440 billion?
2. How will the PIIGS economies adjust without a currency devaluation and interest rate adjustments?
3. Why do the frugal Germans have to pay for Greek’s profligacy?
4. What would happen if a big economy like Italy gets into trouble?
Questions, questions, and questions, but no clear answer. But one thing is at least more certain now: Europe will face huge deflationary pressures in the next couple of years. Politicians are realizing the grave danger of deficits to the society (a big contrast to Dick Cheney mantra, “Deficits don’t matter”). The twin forces of increased budget cuts and higher taxes, from Greece to Spain to the UK, will ensure that the aggregate spending is reduced, thus forces prices to adjust lower.
“This is not true,” argue the gold bugs. Because the current levels of debts are already so huge, they predict ECB is likely to monetize these government debts and bring about a massive inflation in the process. The fact the gold rallied on the day the €750 billion package was announced confirmed their analysis. The Financial Times, too, reported that Germans were frantically buying physical gold on fears of Weimar-type hyperinflation. Demand for gold ETFs reached record peaks.
We concur with the gold bugs. But then, this hyperinflationary process is some time away because the ECB has not abandoned its ‘prudent’ monetary policy. Over the next few months, the risk is still deflationary because of (1) the ongoing cuts in government spending, (2) weak job markets, and (3) fragile financial markets. In the US alone, unemployment is still more than 10%. In Spain, it is closer to depression levels. Without jobs, spending can’t go far. This global recovery will be soft and punctuated with recurring financial crisis. Deep deflationary pressures are also another reason why Mervyn King was not overly concerned by the recent surge in UK inflation. The broad economic stats support this stance.
Against this backdrop, interest rates in US, UK and Europe are likely to stay low. Talks of a collapse of bond prices could be premature.
But having said these, we would continue to buy gold because the issue of debt crisis is still with us. Government debts have not got much lower; they have merely been replaced.