Losing Faith in the “Power” of Central Bankers

Global equity markets are sinking again today, as the euro zone credit crisis  deepens.

According to the rumor mill, a default by the Greek government is not merely  inevitable, it is imminent. As a result, the cowboys up in Germany and France  are circling the wagons.

“Germany may be getting ready to give up on Greece,” Bloomberg News  reports, “as the credit markets signal growing concern about the smaller  nation’s ability to repay investors. Yields on Greek two-year notes rose above  60 percent today for the first time…

“After almost two years of fighting to contain the region’s debt crisis and  providing the biggest share of three European bailouts [to Greece, Ireland and  Portugal],” Bloomberg continues, “German Chancellor Angela Merkel is  laying the groundwork for what markets say is almost a sure thing: a Greek  default.”

Of course, a Greek default has been a sure thing ever since the European  Union and IMF started shipping euros down to Athens more than a year ago.  Bailouts, rescue packages and official protestations to the contrary are all  part of the “Inevitable Default Playbook.”

Over the weekend, Greek Prime Minister, George Papandreou, vowed “to save the  country from bankruptcy.” The Prime Minister promised, “We will remain in the  euro.”

Ergo, a default is both inevitable and imminent.

“It feels like Germany is preparing itself for a debt default,” says Jacques  Cailloux, chief European economist at Royal Bank of Scotland. “Fatigue is  setting in.”

The threat of a Greek default is not exactly a new story. In fact, it is a  very old story here at The Daily Reckoning. As early as February 2010,  your editors began linking the words “Greece,” “default” and “inevitable.” Your  editors would re-position these words from time to time, just to keep the story  fresh. But the essential message never changed: This thing that cannot possibly  last will not last. Greece will default. It’s inevitable.

But since inevitable is not the same thing as imminent, the financial markets  of Europe and the US kept powering ahead for months, without worrying about the  due date of inevitable.

Obviously, investors are worrying now. Stocks are suffering worldwide, and no  stocks are suffering more than European bank stocks. The share prices of  Europe’s largest banks are down 50% to 70% over the last three months. Here in  the States, the financials are also performing dismally. Just today, the share  price of Goldman Sachs dropped back below $100 for the first time since March  2009.

Somebody is worried…and that worry is also extending to the forex markets,  where the euro has dropped to 6-month lows against the dollar and 10-year lows  against the yen.

As investors scurry away from the risk of additional losses, they are also  fleeing a delusion that has been condemning their capital to inevitable (there’s  that word again) losses. This costly delusion is that central banks and other  governmental agencies possess the power to improve economic conditions.

For several months, at least, investors have been able to see that government  finances throughout the Western World were in shoddy shape…and becoming even  shoddier as these governments catapulted billions of dollars and euros into  their sluggish economies, hoping something good would happen.

Despite this obvious distress, however, global stock markets have been  rallying for most of the last two years. Why? Because investors trusted the  power of governments to overcome the forces of recession and debt liquidation.  Investors placed their faith in the gospel of omnipotent central banking, just  as they had always done since the days of Alan Greenspan.

But that faith is wavering. Investors are becoming disenchanted with their  golden calf.

The long-running faith in the power of central banking traces its roots to  the great American folktale, Maestro Alan Greenspan. Remember that  delightful tale? Alan was the guy who could steer a massive $13 trillion economy  just by tweaking one little bitty interest-rate. He was the guy who could  produce a rally on Wall Street, simply by raising his eyebrows a certain way  during congressional testimonies, or by clearing his throat a certain way when  discussing Fed policy.

Alan was the guy who always had the right answer, even when there wasn’t one.  He always knew exactly what to do, even when nothing should’ve been done. He was  more than a Maestro; he was a wizard. No one doubted his power to improve the US  economy. And he was also omniscient. He always knew what the proper level of  interest rates should be, even when Mr. Market vehemently disagreed.

Whether by luck or genius, Greenspan played a hot hand for many years. His “masterful” monetary policy received credit for placing two chickens in every  pot and an “affordable mortgage” in every household balance sheet.

As a result, investors not only placed their faith in Greenspan’s “power” to  produce economic growth (and stock market rallies), they also came to believe  that governments and central banks, in general, possessed the power to nurture  economic growth and/or dampen the effects of recession.

But as it turned out, Greenspan did not have all the answers. In fact, he did  not have any answers at all. He had gimmicks and quick-fix levers to pull — the  one constant ingredient being EZ credit. Greenspan responded to every  mini-crisis of his tenure by slashing short-term interest rates.

These quick fixes did not actually fix anything, but they did enable the US  economy to lurch from bubble to bubble until the financial system had become so  fatally levered that a large-scale credit crisis became inevitable.

The nation marveled at the Maestro’s golden touch, and revered his  reputation…until about 2007, when the Greenspan legacy came under review for  possible downgrade…outlook “negative.”

As the housing bubble burst, and the balance sheets of America’s largest  financial institutions began melting faster than the Wicked Witch of the West,  many American investors started to have second thoughts about the  wizard-formally-known-as-Alan-Greenspan. They began to realize that Greenspan  was merely human, and that central bankers do not possess superhuman powers.

And yet, vestiges of the “benign government intervention” delusion remain.  Some investors still trust the European Union to “fix” the Greek debt problem,  and clearly, some Americans still trust President Obama to “create jobs.”

Here at The Daily Reckoning, we do not.

We distrust central bankers to fix economies and we distrust politicians to  create jobs. But that does not mean we lack a belief system. On the contrary, we  possess a strong and enduring faith in politicians to borrow money and in  central bankers to print it. That’s what they do; that’s what they have always  done.

Trusting the power of central bankers and politicians may be a decent,  short-term trade; but distrusting that power is a great, long-term  investment.

Eric Fry
for The Daily Reckoning