Gold News

The Papandreou Puzzle

Was calling a referendum a principled stand, or just a way of correcting a mistake...?

THREE CHEERS for democracy, writes Dan Denning, editor of the Daily Reckoning Australia.

From out of the blue, Greek president George Papandreou has called a referendum on the Greek debt situation and whether Greece should accept the terms of the financial and political surrender imposed on it by the "Troika" of interventionists from the International Monetary Fund (IMF), the European Union (EU), and the European Central Bank (ECB).

The idea that the Greek people will be given the right to reject their indentured servitude goes so much against the current of events that it makes us wonder, what is going on here? Is this a principled stand that gives people a voice in their financial future? Will people really cease voting themselves more money they don't have and voluntarily accept "austerity"?

How about a more direct explanation: the Greek referendum is a kind of "deus ex machina" that allows the Europeans to correct the great mistake they made last week. The mistake they made was not calling a 50% haircut in Greek government bonds a default. This prevented a "credit event" in which owners of Credit Default Swaps (CDS) on Greek debt would be paid. But it had the completely unintended consequence of undermining the entire European government debt market. Why bother buying government bonds at all if the insurance you purchase against default is worthless?

The simpler solution is to let the Greek's default, pay off the CDS investors' $4 billion, and then try to put the fire out in Italian bonds. But now nothing is simple. The referendum isn't scheduled until early January. And meanwhile, 10-year Italian bond yields traded as high as 6.3% yesterday.

The bond market is telling the ECB that it doesn't think Italy can pay its debts. The 10-year Italian bonds trade at a 45-basis-point spread to German debt. But you can expect that to get wider. And the higher it goes, the more difficult it will be for the Italian government to refinance its mountain of debt in 2012.

This clearly ends the two weeks of peace and prosperity we wrote about two weeks ago. Now that Italian Mario Draghi is in charge of the ECB, we are one step closer to money printing in Europe. If no one else will buy Italian government debt, the ECB will have to.

Draghi didn't say so in as many words last week. He said, "The Eurosystem (of central banks) is determined, with its non-conventional measures, to prevent malfunctioning in the money and financial markets creating an obstacle to monetary transmission."

That statement is nearly incomprehensible. But what we think it means is that the ECB will do whatever it takes to keep borrowing costs down for European governments, even if that means buying government bonds that no one else wants with money no one else has. The only way to do this, of course, is to print money.

Thus we have reached a point where the financial markets are stressed. If the world has too much debt – government debt and household debt – you'd expect deleveraging. The debt would be written down, defaulted on, or restructured. Asset prices that benefitted from lots of debt (houses, bonds, stocks) would fall too.

This is probably what should happen. But the people who benefit the most from the expansion of debt – financiers, bankers, government – are fighting it. They are fighting to preserve their free ride at the head of the easy money gravy train. They have lots of tools, one of which includes a printing press.

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Best-selling author of The Bull Hunter (Wiley & Sons) and formerly analyzing equities and publishing investment ideas from Baltimore, Paris, London and then Melbourne, Dan Denning is now co-author of The Bill Bonner Letter from Bonner & Partners.

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