The Great Depression Online

Great Depression Online Archive Issue:

Why Inflation Will Prevail

Great Depression Online
Long Beach, CA
February 09, 2010

Inside This Issue You Will Discover…

*** The European Union’s Weakest Link
*** One Heck of a Speculation
*** Why Inflation Will Prevail
*** And More

The European Union’s Weakest Link

Over the weekend the top financial officials of the G7 industrial nations gathered in Canada and contemplated just what in the heck they should do to improve the world economy.  After all the hoopla this amounted to a renewed pledged to keep their respective stimulus plans in place.  This big idea to save the world form itself, regrettably, is the big problem that’s dragging it down.

What was amusing was that while everyone was holding hands and congratulating themselves on their greatness, Greece was being called out by financial markets for their inability to pay for their massive deficits.

Greece, ironically, has done what everyone else has done…and what the G7 nations are encouraging.  They’ve run up debt to stimulate their economies.  Yet their ability to pay back these debts is what now has markets bothered.

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For the rest of the 16 member European Union, the problems of Greece – and Portugal and Spain – are their problems too…they share the same currency.  To the chagrin of Germany and France – the economic powerhouses of the European Union – the euro is only as good as its weakest link.  As Greece sinks into the Mediterranean Sea, so goes the euro.

One Heck of a Speculation

Over the last two months the euro has fallen over 8 percent against the dollar.

“The key question rolling forward,” says David Rodriguez at DailyFX, “is whether or not Greece can contain its growing budget deficit and whether any problems in one country can cause contagion across the broader Euro Zone.

“Greece is in special danger not only due to the sheer size of the fiscal deficit as a percentage of GDP, but any political efforts to institute cuts in spending and rein in the deficit have been met with fierce popular opposition.  The political deadlock is especially troubling given that the Greek government will need significant funding in the months ahead as the deficit grows and interest rate payments skyrocket.  If markets are unwilling to purchase Greek debt, then it seems likely that the strongest EMU countries may need to bail-out the debt-ridden country.”

Who knows?  Loaning the Greek government money could be one heck of a speculation…if you’ve got the stomach for it.  A Greek debt default may be considered unacceptable to the European Union.  In this respect, Greek debt would be implicitly backed by the European Union.

The spread on 10-year Greek government bonds and the equivalent German bunds was nearly 400 basis points in late January.  Last week it narrowed to about 330 basis points.  Still, that means if German bunds are yielding 3 percent, Greek bond yield are about 6.3 percent. 

The spread is the risk premium that investors demand in exchange for Greek bonds because of their risk of default from rising budget deficits.  But if Greek debt is implicitly backed by the European Union, the risk premium may come with no risk at all.  If that’s truly the case, with a little foresight and guts, you can now buy Greek bonds at essentially the same risk of default of German bunds…with nearly double the yield.

Just an idea, of course.

Why Inflation Will Prevail

The United States, among others, has been tempting the fates of the god’s too.  In 2010 their deficit as a percent of GDP will be 10.6 compared to Greece’s deficit of 12.7 percent of GDP.

Remember, historically a deficit to GDP ratio of 7 percent is when international creditors jump ship.  For example, in 1994 Mexico was running a deficit that was 7 percent of GDP.  Then one day, late in the year, foreign investors panicked.  They dumped their holdings and the peso crashed in spectacular fashion.  In the space of one week the peso fell 44-percent against the dollar.  Mexico’s economy crashed too.

Last week President Obama announced his proposed budget for fiscal year 2011.  This budget proposal consists of $3.8 trillion in spending, of which $1.3 billion will be funded through debt.  This amounts to a deficit of 8.3 percent of GDP.

Yet by the end of the week we could hardly believe our eyes.  Remarkably, the markets embraced President Obama’s proposed budget…10-year Treasury yields went down; not up.  On Friday, 10-year Treasuries yielded just 3.55 percent; down from 3.70 percent on Wednesday.

For now foreign creditors are more than happy to keep extending credit to the U.S. government.  We’re not exactly sure why, but we don’t think it’s because they consider it a particularly good investment.  More likely, it’s because buying U.S. government bonds is less bad than buying other government paper.

Nonetheless, as far as we can tell, we’re still living in a world with consequences.  And one day foreign creditors will no longer fund the United States’ massive deficits.  That’s when interest rates will skyrocket.  But rather than an explicit default, the Federal Reserve will buy U.S. government debt.

Where the Federal Reserve will get the money from is, of course, the origin of the farce.  That’s why inflation will prevail.


M.N. Gordon
Great Depression Online

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