Friday, October 28, 2011
The stock markets were euphoric yesterday about the latest EU bailout/rescue deal. Is the euro-crisis over? Will euphoria, or even mild euro-optimism, continue for very long? I wouldn't bet on it.
The trillion Euro rescue commitment turns out to be highly "leveraged", that is, illusory or at least highly risky. It was leverage that helped precipitate the 2008 Lehman and housing crises. The risk that Wednesday's euro-salvation might make things even worse, rather than better, is very real.
Leverage, of course, means putting down less money than you are committed to. If the market goes up, you make far more than you would otherwise, since you gain the full value of the rise in your commitment, without your having put down - typically, without your possessing - what you committed. But if the market goes down, you lose dramatically - often, you lose everything - since if you put down, say, 30% of your commitment, and the market goes down 30%, then you lose not 30% but 100% of your actual investment. (The European governments seem to have put down about 30% of their trillion Euro "commitment", although given the slipperiness of their government accounting practices, it's all too likely they're really putting down even less than that.)
Here is Ambrose Evans-Pritchard on the European "rescue":
Albert Edwards from Société Générale said the ECB will have to act, over a German veto if necessary. "The increasingly frenzied attempts of eurozone governments to persuade financial markets that they can draw a line under this crisis will ultimately fail."
"The impending threat of a euro break-up will force the ECB to begin printing money, very reluctantly joining the global QE party. The question is whether Germany will leave the eurozone in the face of such monetary debauchery," he said.
Evans-Pritchard is a quirky man, to put it gently. (He is intellectually idiosyncratic in a very English, upper class contrarian way. His father was Edward Evan Evans-Pritchard, perhaps the greatest English anthropologist of his generation, and a sharply contrarian character himself.) But Ambrose Evans-Pritchard's scepticism in this case seems justified; probably more than justified. Read the whole article.
My first introduction to the concept of leverage, by the way, came from John Kenneth Galbraith's wry book about 1929, "The Great Crash". Galbraith was a deeply complacent liberal and a believer in Keynes as the last word in economics, but he wrote clearly and he could be quite funny, as he was in The Great Crash. Galbraith's writing is irritating too, of course, because he was so relentlessly pleased with himself. But credit where it's due: The Great Crash explains leverage unforgettably and with an amusing helping of irony.