European Versus American Debt
The currency market tends to shift back and forth between different ideas regularly. Before the summer it was all about Eurozone debt worries, and this pushed the euro down against other currencies. Since then it has been all about the Federal Reserve easing policies and the corresponding dollar weakness.
The euro has suffered some falls in the last couple of weeks as news is beginning to resurface about the debt problems in the Eurozone. Bond yields in peripheral countries are rising, raising fears of more bailouts or debt defaults to come. Most analysts are expecting that Ireland and Portugal will follow Greece and end up needed a bailout or having to restructure their debt.
The US also has
high levels of debt. The government is running a massive budget deficit, and individual states within the US are also facing large scale debt problems. Yet no one talks about the US defaulting on its debt, or needing to restructure or get bailed out. US bond yields are very low – meaning that investors have full confidence that they will repay their debts. Why is it that peripheral Eurozone countries are seeing rising bond yields and investors effectively pricing in some form of restructuring?
The answer to this question lies in the way that each is dealing with the debt problems. The US answer to this problem is to print more money. The Federal Reserve’s policy of quantitative easing is to print money to buy government bonds. Effectively this means printing money to fund its deficits. In Europe, nothing of this sort is occurring. There is no monetary easing by the ECB, and peripheral country debt problems have to be dealt with by cutting their deficits or risk facing default, restructuring, or needing a bailout.
Which approach is the correct one? Monetary easing is clearly easier to implement, and it tends to have good effects in the short term. US bond yields are much lower than peripheral Eurozone bond yields and this will allow them not to be overburdened by their debts. Contrast this to Europe, where countries will have to face significant falls in government spending, rises in taxes, and less economic activity to deal with the debt.
In the long term, it is much less clear. Too much monetary easing can lead to asset price bubbles, and eventually crashes. Arguably, the entire financial crisis of 2007-09 was a result of too much liquidity caused by the Federal Reserve having very loose monetary policies. On the European side, there is a bigger risk that they could spiral into recession again it would be a while before they came out of it.
The correct approach is some sort of combination of the two. In the short term, monetary easing is helpful because it prevents bond yields from going too high, and prevents deflation from occurring. This should also be accompanied with strong efforts to reduce deficits and bring down the level of debt. The US has certainly failed on this last point, and the result could easily be another stock market bubble that is just waiting to crash.
Asad is an Economics Graduate from The London School of Economics who has also been a part of the currency derivatives team of Deutsche Bank in London. Currently pursuing his PhD at the University of California San Diego where he's researching on Algorithmic Trading Strategies, Asad will be your direct line for answers to all the questions you might have on short-term investing. A part of the Equitymaster Team since 2010, Asad has been sharing his knowledge on short term trading strategies with our valued readers, like you, through our various services. In fact, at the last count, his weekly newsletter, Profit Hunter, was being delivered to more than 100,000 smart traders across the world!
More Views on News
Jun 10, 2017
Forty Indian investing gurus, as worthy of imitation as the legendary Peter Lynch, can help you get rich in the stock market.
Aug 19, 2017
Ever heard of Lindy Effect? Find out how you can use it to pick timeless stocks.
Aug 18, 2017
Buying the index now will hardly help make money in stocks even in ten years.
Aug 18, 2017
Donald J Trump, a wrasslin' fan, took a 'Holy Sh*t!' blow on Tuesday.
Aug 17, 2017
PersonalFN simplifies the mutual fund account statement for you.
More Views on News
Aug 7, 2017
The data tells us quite a different story from the one the government is trying to project.
Aug 10, 2017
Don't miss these proxy bets on growing companies or in a few years you will be looking back with regret.
Aug 8, 2017
Bharat-22 is one of the most diverse ETFs offered so far by the Government. Know here if you should invest...
Aug 12, 2017
The India VIX is up 36% in the last week. Fear has gone up but is still low by historical standards.
Aug 7, 2017
Raksha Bandhan signifies the brother-sister bond. Here are 7 thoughtful financial gifts for sisters...