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Incredible Draghi

Why it's hard to believe what the ECB's top man says...

AND NOW the World Bank has just turned up to the party, telling everyone they should go home and sober up, writes Greg Canavan for the Daily Reckoning Australia.

But with the music blaring and the booze flowing, no one is listening. Besides, the party only just started. 2012 is a new year. The 'January effect' – which says stocks usually enjoy a rally at the start of the year based on nothing more than blind optimism – is in full swing.

The front page of the Australian reports...:

The World Bank warned that the crisis in Europe could trigger a credit freeze that threatened to be worse than the 2008 crash that sent Wall Street investment bank Lehman Brothers bankrupt and ushered in the worse economic shock since the Great Depression.

We appreciate the insight. But everyone has known this for ages.

That's not to say it's wrong though. It's just nobody cares. With the European Central Bank joining the Fed in their own special version of quantitative easing – and the prospect of much more to come – the stock market wants to party.

The 'credit freeze' the World Bank mentioned is off the table for the time being. Mario Draghi, new ECB boss who completed his monetary apprenticeship at Goldman Sachs, has conjured up a sneaky way to print money while giving the impression he's doing nothing of the sort.

As soon as Draghi took the helm in November last year he began talking out of the corner of his mouth. Like all good central bankers, he believes words speak just as loud as actions. Here's a snippet of what he had to say at his first public appearance as ECB head:

Gaining credibility is a long and laborious process. Maintaining it is a permanent challenge. But losing credibility can happen quickly – and history shows that regaining it has huge economic and social costs.

Six weeks later he opens the ECB's balance sheet up for all of the European banking sector to dump their toxic debt into. And he handed out nearly €500 billion Euros in return. Rumor has it the next 'long term refinancing operation' will see the ECB's balance sheet take on another €1 trillion of garbage debt.

No wonder the market is in rally mode.

Given Draghi talks about credibility, but acts in an incredible manner, it's no wonder the Euro continues to sink. Look at the performance of the Euro against the Aussie Dollar...

A croissant and a café noir are as cheap as ever.

Which brings us to a question we received from a Daily Reckoning reader last week. He and 'the missus' are off to Italy in April and are a tad concerned. If they load up on Euros, what would happen if Italy went back to the Lira?

With Greece's return to the Drachma still a very real likelihood it's a good question. But maybe Greece and its fellow uncompetitive peripheral nations will stick with the Euro. Maybe the 'Northern League' nations, headed by Germany, will exit and form their own currency.

Here's our rationale. Forget for the moment Draghi's bank bonanza scheme. It's a time-buying exercise that does nothing to solve long-term imbalances. What it does do though is weaken the Euro. This is good for the peripheral nations' exports.

Germany might complain about money printing by the ECB. But as an export powerhouse it benefits from the weaker Euro even more so than its austerity (which is just a euphemism for living within one's means) drenched neighbors.

While a weaker Euro will help the Eurozone gain international competitiveness, it does nothing for intra-Eurozone competitiveness. This is the crux of the problem in Europe. The southern European nations are, by some reports, 30% less competitive than their northern trading partners. The policy of austerity is meant to correct this imbalance. But try cutting a nations cost base (wages etc.) by 30% without inciting a social revolution.

All the talk about cutting Greek debt and getting voluntary write-offs of much more than 50% is pointless. Even if it happens, the most optimistic scenario has Greece with a debt-to-GDP ratio of 120% by 2020. That's where Italy is now!

With handpicked EU puppet governments running Greece and Italy, expect them to stay with the Euro until an angry populace hauls them out of office. That could be some time away.

But Germany is no doubt watching Draghi closely and wondering how long they want to hang around with this wolf in sheep's clothing running the show.

It might not happen this year. But we can see a future where the Euro survives, managed by an ECB channeling Greenspan and Bernanke on steroids.

Short of reversing thousands of years of cultural evolution, this is the only way to restore the imbalances within the Eurozone.

Buying Gold?...

Greg Canavan is editorial director of Fat Tail Investment Research and has been a regular guest on CNBC, ABC and BoardRoomRadio, as well as a contributor to publications as diverse as and the Sydney Morning Herald.

See the full archive of Greg Canavan.

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