Fed to intervene in Europe?

2011-NOV-28

Gold and silver prices had another down day last Friday, with the Comex November gold contract down 2.3% over last week. Percentage losses were greater in silver, platinum and palladium, with investors growing more and more scared of the possibility of a disorderly breakup of the eurozone. Friday saw the yield on three-year Italian government debt reach 8.3%, as the clamour for the European Central Bank to “do more” (a euphemism for print money) grows stronger by the day.

The vast majority of politicians, bankers, academics and financial analysts are all in favour of the ECB increasing its money-printing effort – with the Germans routinely castigated as “sado-fiscalists” and “neo-Calvinists” for daring to have reservations about this – and we are moving closer to some sort of effort to “paper over” the eurozone debt crisis. This is literally the only way the “show can be kept on the road”, as further sovereign debt defaults in Europe – inevitable without some increased form of debt monetisation – will cause serious damage to Europe’s overleveraged and undercapitalised banks. Bank failures in Europe would then spread to America and the rest of the world. It’s not overly dramatic to say that the entire world financial system could collapse as a result of chaotic sovereign debt defaults in the eurozone’s periphery.

With the stakes this high, it’s hardly surprising that US Treasury Secretary Tim Geithner is pressing the Europeans hard for increased ECB money printing. European Council President Herman Van Rompuy flew to America yesterday for consultations with US officials. Talk this morning is of the US Federal Reserve stepping in where the Germanic ECB fears to tread, and monetising vast amounts of eurozone debt.

Though any Fed intervention in Europe would guarantee a nice stock market rally into the New Year, it’s unlikely to occur. The Fed has already been stung by conservative criticism of its domestic quantitative easing policies, and with Republican primaries looming ahead of the presidential election in November 2012, moves by the Fed to support the European bond market by further debasing the dollar would be hugely controversial. Though the Fed propped up foreign financial institutions during the depths of the crisis in 2008, the lengths it went to to conceal this from the public shows that Bernanke and Co are well aware of the serious political risks that come – not surprisingly – from bailing out foreigners.

There are, moreover, issues with the Fed’s balance sheet. As Tangent Capital’s James Rickards points out in both his new book Currency Wars and in a piece for the King World News Blog, the Fed is leveraged by around 50 to 1. A mere 2% decline in the value of the Fed’s assets would be enough to wipe out its capital. Piling more leverage on to its books by printing money to buy European bonds would risk the remaining confidence financial markets have in the Federal Reserve System – and by extension, the US dollar itself.

Thus, it seems implausible to expect the Fed to act as a “white knight”, riding to the eurozone’s rescue. As Rickards has discussed on numerous occasions, and mentioned on this website previously, the IMF remains the eurozone’s best hope as far as any rescue deal is concerned. Indeed, reports at the weekend stated that that institution is drawing up a €600 billion euro rescue package for the continent.

It will be interesting to see how IMF involvement escalates. Stay tuned.