Losing Faith in the “Power” of Central Bankers

09/12/11 Laguna Beach, California – Global equity markets are sinking again today, as the euro zone credit crisis deepens.

According to the rumor mill, a default by the Greek government is not merely inevitable, it is imminent. As a result, the cowboys up in Germany and France are circling the wagons.

“Germany may be getting ready to give up on Greece,” Bloomberg News reports, “as the credit markets signal growing concern about the smaller nation’s ability to repay investors. Yields on Greek two-year notes rose above 60 percent today for the first time…

“After almost two years of fighting to contain the region’s debt crisis and providing the biggest share of three European bailouts [to Greece, Ireland and Portugal],” Bloomberg continues, “German Chancellor Angela Merkel is laying the groundwork for what markets say is almost a sure thing: a Greek default.”

Of course, a Greek default has been a sure thing ever since the European Union and IMF started shipping euros down to Athens more than a year ago. Bailouts, rescue packages and official protestations to the contrary are all part of the “Inevitable Default Playbook.”

Over the weekend, Greek Prime Minister, George Papandreou, vowed “to save the country from bankruptcy.” The Prime Minister promised, “We will remain in the euro.”

Ergo, a default is both inevitable and imminent.

“It feels like Germany is preparing itself for a debt default,” says Jacques Cailloux, chief European economist at Royal Bank of Scotland. “Fatigue is setting in.”

The threat of a Greek default is not exactly a new story. In fact, it is a very old story here at The Daily Reckoning. As early as February 2010, your editors began linking the words “Greece,” “default” and “inevitable.” Your editors would re-position these words from time to time, just to keep the story fresh. But the essential message never changed: This thing that cannot possibly last will not last. Greece will default. It’s inevitable.

But since inevitable is not the same thing as imminent, the financial markets of Europe and the US kept powering ahead for months, without worrying about the due date of inevitable.

Obviously, investors are worrying now. Stocks are suffering worldwide, and no stocks are suffering more than European bank stocks. The share prices of Europe’s largest banks are down 50% to 70% over the last three months. Here in the States, the financials are also performing dismally. Just today, the share price of Goldman Sachs dropped back below $100 for the first time since March 2009.

Somebody is worried…and that worry is also extending to the forex markets, where the euro has dropped to 6-month lows against the dollar and 10-year lows against the yen.

As investors scurry away from the risk of additional losses, they are also fleeing a delusion that has been condemning their capital to inevitable (there’s that word again) losses. This costly delusion is that central banks and other governmental agencies possess the power to improve economic conditions.

For several months, at least, investors have been able to see that government finances throughout the Western World were in shoddy shape…and becoming even shoddier as these governments catapulted billions of dollars and euros into their sluggish economies, hoping something good would happen.

Despite this obvious distress, however, global stock markets have been rallying for most of the last two years. Why? Because investors trusted the power of governments to overcome the forces of recession and debt liquidation. Investors placed their faith in the gospel of omnipotent central banking, just as they had always done since the days of Alan Greenspan.

But that faith is wavering. Investors are becoming disenchanted with their golden calf.

The long-running faith in the power of central banking traces its roots to the great American folktale, Maestro Alan Greenspan. Remember that delightful tale? Alan was the guy who could steer a massive $13 trillion economy just by tweaking one little bitty interest-rate. He was the guy who could produce a rally on Wall Street, simply by raising his eyebrows a certain way during congressional testimonies, or by clearing his throat a certain way when discussing Fed policy.

Alan was the guy who always had the right answer, even when there wasn’t one. He always knew exactly what to do, even when nothing should’ve been done. He was more than a Maestro; he was a wizard. No one doubted his power to improve the US economy. And he was also omniscient. He always knew what the proper level of interest rates should be, even when Mr. Market vehemently disagreed.

Whether by luck or genius, Greenspan played a hot hand for many years. His “masterful” monetary policy received credit for placing two chickens in every pot and an “affordable mortgage” in every household balance sheet.

As a result, investors not only placed their faith in Greenspan’s “power” to produce economic growth (and stock market rallies), they also came to believe that governments and central banks, in general, possessed the power to nurture economic growth and/or dampen the effects of recession.

But as it turned out, Greenspan did not have all the answers. In fact, he did not have any answers at all. He had gimmicks and quick-fix levers to pull — the one constant ingredient being EZ credit. Greenspan responded to every mini-crisis of his tenure by slashing short-term interest rates.

These quick fixes did not actually fix anything, but they did enable the US economy to lurch from bubble to bubble until the financial system had become so fatally levered that a large-scale credit crisis became inevitable.

The nation marveled at the Maestro’s golden touch, and revered his reputation…until about 2007, when the Greenspan legacy came under review for possible downgrade…outlook “negative.”

As the housing bubble burst, and the balance sheets of America’s largest financial institutions began melting faster than the Wicked Witch of the West, many American investors started to have second thoughts about the wizard-formally-known-as-Alan-Greenspan. They began to realize that Greenspan was merely human, and that central bankers do not possess superhuman powers.

And yet, vestiges of the “benign government intervention” delusion remain. Some investors still trust the European Union to “fix” the Greek debt problem, and clearly, some Americans still trust President Obama to “create jobs.”

Here at The Daily Reckoning, we do not.

We distrust central bankers to fix economies and we distrust politicians to create jobs. But that does not mean we lack a belief system. On the contrary, we possess a strong and enduring faith in politicians to borrow money and in central bankers to print it. That’s what they do; that’s what they have always done.

Trusting the power of central bankers and politicians may be a decent, short-term trade; but distrusting that power is a great, long-term investment.

Eric Fry
for The Daily Reckoning

Eric Fry

Eric J. Fry, Agora Financial’s Editorial Director, has been a specialist in international equities for nearly two decades. He was a professional portfolio manager for more than 10 years, specializing in international investment strategies and short-selling.  Following his successes in professional money management, Mr. Fry joined the Wall Street-based publishing operations of James Grant, editor of the prestigious Grant's Interest Rate Observer. Working alongside Grant, Mr. Fry produced Grant's International and Apogee Research —  institutional research products dedicated to international investment opportunities and short selling. 

Mr. Fry subsequently joined Agora Inc., as Editorial Director. In this role, Mr. Fry  supervises the editorial and research processes of numerous investment letters and services. Mr. Fry also publishes investment insights and commentary under his own byline as Editor of The Daily Reckoning. Mr. Fry authored the first comprehensive guide to investing internationally with American Depository Receipts.  His views and investment insights have appeared in numerous publications including Time, Barron's, Wall Street Journal, International Herald Tribune, Business Week, USA Today, Los Angeles Times and Money.

View articles by Eric Fry

Related Articles:

• March 5, 2012 -- What the Greek Rescue is Really About
• March 8, 2012 -- How Market Sentiment Moves With the Greek Debt Crisis
• March 6, 2012 -- Seeking to Explain the Market’s Dour Mood
• February 17, 2012 -- The Role of Youth Unemployment in Staving Off Default
• February 16, 2012 -- A Greek Debt Crisis Recap

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