Imagine you have some money to invest. You see the inflation is 2%, the risk insurance is 3% and your profit expectation is 3%. This means an expected income of your investment of 8%. You find such an asset (for instance Spanish or Italian government bonds) and put your money in. One day somehow the income of your bonds falls to 4%. The reason doesn't matter. It just falls to 4%. The inflation is still 2% and the risk on that bonds is the same. This means your investment needs 5% income just to be neutral - no profit, no loss. I.e. you are losing money with your bonds at 4% income from them...
What will be your reaction?
It is clear - you will sell your bonds and search for another and better investment opportunity...
The market equilibrium is a price level where buyers and sellers meet and both are glad of the deal. Any price not on equilibrium leads to either deficits of surpluses.
No let's go back to real world. The European Central Bank (ECB) is considering a cap on the yields of government bonds in Eurozone. This means that if the yield reaches the cap, the Bank will start buying bonds without limits. This way the yield will not pass the cap level.
But what does this administrative intervention mean?
When the yield is below market expectations the investors will not buy bonds or buy less. This will mean an increasing pressure up on yields. To fight it the Central bank will have to buy an enormous quantity of bonds - it will have to compensate all investors that had run off. In fact this decision will turn the Central bank in major, and in many cases - the only, buyer of bonds. Something similar has already happened with FED that now directly or indirectly is buying about two thirds of US government debt.
This situation is very risky as it does not return the confidence of markets, but additionally ruins it. Buying bonds by the Central bank is a money print strategy. Every money print leads to inflation expectations, that increase additionally the expected return on investment. I.e. it presses the interest rates up. The Central bank can keep the rates on bonds low, but the pressure will go to real economy. Investors will expect higher dividends on their shares and more interest on their corporate obligations. This will make the financing of the real economy more expensive.
If somehow this problem is solved (for instance the Central bank buying corporate bonds) then the investors will move money in other direction. The Bank will have to become the main investor in real business.
If too much assets are manipulated this way, the investors will entirely lose the confidence in every investment and will put money in safe havens to wait until the market madness ends. But moving too much money in safe havens is the trigger to a financial crash. If Gold becomes too expensive this will lead to market panic, because the Gold is the eternal competitor of government issued money. Going up, the Gold will destroy the confidence in fiat money.
Safe havens like Gold has one very decisive advantage - their price and income is very difficult to manipulate. The Central bank can not press the price of Gold down. It will have to sell real Gold, and the Gold reserves are limited.
Ruining the confidence in fiat money is the end of fiat money. Fiat money is only confidence and nothing else. Without confidence fiat money is nothing.
Printing money is a too easy decision to be real. It looks very well the ECB to implement a cap on government bonds yields. It looks very well to achieve this only using newly issued money. But this is not a cure. It is a disease. Lowering the yields artificially will confuse the market signals and create non logic and not economically backed decisions. The bond market is not isolated from other markets. Manipulating it will lead to a jumble in much other markets. And generally the money-print will influence all the economy via inflation.
The EU debt crisis is not a crisis of yields. It is a crisis of debt and confidence. Countries that are reliable have no high yields. And I mean not only Germany or Netherlands. For instance some weeks ago even Bulgaria has sold bonds at low yield. The problem with yields is consecutive to the general problems in budget and in economy. If we press just the yields down artificially, this will not solve the real problems. And these problems will find another way to create a headache...
The real decision is not easy. The problems are too long time accumulated to assume an easy decision is possible. Pain will be needed. Living standard must be sacrificed. It must be clear that the era of easy life, guaranteed by welfare state, is over. Trying to avoid this will only postpone the painful decisions and will require even more pain in future...
Dobri
August 20th 2012
