Stock markets in the northern hemisphere soared overnight on comments from European Central Bank head Mario Draghi. He said the ECB would do ‘whatever it takes’ to save the euro.
Well, ‘Go on then,’ would be our response.
But it’s not quite so simple. Banking is a con-game. Central banking is an even bigger con-game. Draghi knows that Spain’s economy is in deep trouble. It’s perhaps only weeks away from the capital markets cutting off its funding. Everyone knows it. So traders position themselves by taking bearish bets. They short Spanish debt and all related derivatives.
At the point of maximum bearishness, it doesn’t take much to see those bets reversed. Central bankers have the data…they know how the market is positioned. So a few comments to the effect that they will do ‘whatever it takes’ is enough to bring about a surge of ‘short-covering’. That’s the process whereby previously bearish traders buy back their positions.
As we wrote the other day on the topic:
‘Short selling can be looked upon as creating a reservoir of potential buying power that will ultimately work not to depress the market but to buoy it.’
So Draghi is conning the market. He’s trying to get the shorts to cover and, based on last night’s action, he’s done so successfully. But when you’ve banned short selling (as Spain and Italy have done) you can only rely on one big short squeeze to push prices up.
So where to from here?
Draghi will have to come up with more than just verbiage. But what? The Long Term Refinancing Operation (LTRO), Europe’s version of quantitative easing, has been a bit of a debacle. Other, more blatant inflationary measures are not within its mandate. Europe’s ‘saviour’, the European Stability Mechanism (ESM), is awaiting approval from the German Constitutional Court, and that won’t come until September at the earliest.
In short, Draghi’s comments are little more than an orchestrated short squeeze. He’s trying to buy some time up until September when more concrete measures might come into view. While the ‘we will do whatever it takes’ comment received all the attention, we recommend you read the speech in its entirety. It is quite strange. It talks of a bumblebee (the euro) turning into a real bee. It conveys a very strong political will to make the euro a lasting feature of the global landscape
This rhetoric, combined with Europe’s woes, does raise an interesting question. When there is too much unproductive debt in the system the solution to the problem is either deflation (politically and socially very difficult) or inflation (much more palatable). Throughout history inflation has ALWAYS been the default policy. Instances of deflation are few and far between.
Europe is pursuing a policy of deflation and, predictably, it’s not going all that well. So how long before Europe gets back on the historical path and turns to inflation? After all, they’re somewhat insulated from an inflationary policy by having the world’s largest stash of gold. Combined, the Eurozone nations hold over 10,000 tonnes of the yellow metal. The ECB itself has 346.8 million ounces, worth around €550 billion at today’s prices.
And did you know the ECB (unlike the Fed) marks its gold holdings to market on a quarterly basis? Gold is the only financial asset that can rise in price without an offsetting rise in liabilities. This means a rising gold price helps to increase equity in the ECB’s balance sheet.
At the current low gold price, it’s not really going to make much of a difference given the amount of central bank credit created in the past few years. But in a gold revaluation scenario (say to $10,000 an ounce) it could make a big difference to Europe’s finances.
After all, it’s happened before. When the Fed created a boom in the late 1920’s a debt deflation ensued. So they opted for inflation and raised the official price of gold from around US$20 to US$35, for a 75% nominal gain in the gold price. When things look grim, inflation is always the ‘answer’.
Read Draghi’s speech and think about Europe’s gold in the context of its current financial woes. It could become very useful in the years ahead.
for Markets and Money
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