Dance of Fireflies
David R. Kotok
August 22, 2012
The modern Greek odyssey continues with a dance of fireflies. This particular version is dedicated to a different Homer. We are speaking of the late Sidney Homer and his treatise on interest rates. His book, A History of Interest Rates, graces libraries around the world. Homer’s great contribution to the history of finance and economics is his study of interest rate movements and interest rate levels from antiquity to his death.
Were Sidney Homer alive today, he would be rewriting his book, and the new edition would incorporate the interest rates we see in Europe, particularly in the Eurozone. The latest movements of negotiations between the peripheral weak Eurozone member countries and the credit worthy strong Eurozone member countries, like Germany and Finland, are geared to interest rates. The absurdity of that policy is clear to anyone who has studied interest rates over the course of several millennia.
The European Central Bank discussed a proposal which is not official, but has been debated in the press. It argues that the central bank should target the level of interest rates on sovereign debt in the weaker peripheral countries. In other words, the ECB should determine what interest rates are appropriate for the government of Italy to pay. Then enter the market and buy unlimited quantities of bonds until such an interest rate is sustained. The same would be true for Spain and other countries.
Picture the debate that sets the level of interest rates which are determined by an institution under the present circumstances where a country, like Italy, has a debt-GDP ratio rising, an economy shrinking and deficits still not under control.
The US had such an interest rate policy during World War II. In order to finance the war, the Federal Reserve maintained interest rates on US treasury debt at a constant level for over four years. The short-term interest rate on 90 day treasury bills was three-eighths of one percent. The long-term interest rate on US treasury bonds was two percent. The Federal Reserve purchased unlimited quantities in order to maintain those interest rates. Its motivation was patriotic. Its policy implementation was necessary. Our country was at war and fighting for its survival.
The Federal Reserve ignored the inflation rate during this period. At its peak, the inflation rate was in double-digits. The Federal Reserve ignored the fiscal policy. During that time, it was huge. Money was being borrowed and financed by the central bank. Savings rose within the country in order to be spent on a military operation necessary for victory.
Now fast forward to the condition in the world today. Most countries are not at war. Politically motivated circumstances are driving the economic conditions of nearly all major economies. Patriotism is in short supply; unity of national purpose has been replaced with politically-driven acrimony. The financial system reeks of corrupt and distasteful behaviors. The short-term interest rate is being held by the major central banks close to zero. This is similar to what happened during World War II.
The ECB is discussing freezing, holding and stabilizing the longer-term interest rate and doing so in the weakest of its economies. In the US, we see the Federal Reserve using “Operation Twist” in order to hold, stabilize or determine longer-term interest rates. In Japan, the long-term interest rate has been so low for so long that it is becoming a basic assumption in ongoing life.
Greece is the ultimate firing line test now. The dance of the fireflies takes place between German cities, German government and German politicians trying to find ways to stop the bleeding that is feeding a Greek political system with unbalanced affairs. There is a trade-off. The German politician asks, “Do we draw a line in the sand and risk default?” Do we bend the terms, amend the agreement, alter the composition of the payments, accelerate certain benefits, and otherwise twist the structure so as to defer the inevitable?
We are witnessing a series of these questions that will take place in September. We are witnessing a troika determining whether to advance more money to Greece or not. We are witnessing the rolling refinance of Greek debt so that the debt held by institutions can be paid from advances from the same or sister institutions.
About €60 billion must roll soon. The IMF, ECB, etc. must contrive a mechanism to advance money to Greece. This allows Greece to make its payments to them or their financial siblings. This roll does not bring Greece any new money. Only a restructuring of Greek debt results in freeing up cash flow to use. But austerity requires Greece to tighten its belt while hunger rises. This is no easy task after years of economic contraction. European history is replete with failures after this approach was attempted.
The dance of fireflies continues in the Eurozone. The outcome is the ongoing increase of moral hazard.
Modern day Sidney Homer would have several new chapters in his book. The troika has replaced Troy of antiquity and the battle continues between the forces, including those that would introduce a deceptive horse into this mix. After Labor Day, the next round of Eurozone shock, anti-shock and market reaction will commence once again.
Cumberland is underweight in the Eurozone and takes a very hard view about getting paid.
The idea of extending credit to sovereigns, whether it is in Europe or in the US, is simple. If you loan your money to a government by purchasing one of their bonds, you want to be sure you are going to get paid interest and principal as agreed.
David R. Kotok, Chairman and Chief Investment Officer