Q: So what the hell is up with the Europe banking whatever today? The market is up, so I guess it’s good news. But I’m just your typical American with a public school education … I’m lucky if I can find France on a map.
A: Actually, if you’re a typical American, there’s a chance you can’t even find America on a map (cue viral Miss Teen USA video). But let’s focus on ECB president Mario Draghi, not how cool Mario Lopez was in that disaster of a YouTube clip.
Here’s what happened: European Central Bank President Mario Draghi pulled back the curtain on a what he calls a “fully effective backstop” for the eurozone debt crisis. Namely, it’s an unlimited bond-buying program where the ECB will purchase debt from member states in the 17-member eurozone.
Q: No kidding, that headline is everywhere. Tell me what it means.
Well, the big problem is that countries like Spain and Italy could find few buyers for their bonds — and as a result, had to offer huge interest payments on their debt to entice investors to shoulder the risk. This summer, Spain was borrowing at rates above 7% — on par with what I pay for my personal credit card debt.
So troubled European nations were doubly at risk: First, they couldn’t find the money to pay all their bills. Second, when they did find money, they paid through the nose for it.
Here’s where the European Central Bank comes in. Other measures have been taken to prop up the EU bond market (that is, help finance government debts), including bailing out Spanish banks so they would in turn bail out the Spanish government. But all have been stopgaps or indirect solutions — until Draghi finally said that the central bank will step in, ensuring that there is decent demand for government bonds.
The phrase “lender of last resort” is a popular shorthand here.
Q: That sounds like cheating.
A: Well, to folks like Ron Paul, it certainly is because the central bank is messing with free markets. But in times of great crisis, most economists believe that leaving the free market to its own devices would ultimately cause more harm than good — such as the collapse of the U.S. financial system or the unraveling of the eurozone.
Consider that a similar thing happened as subprime mortgage debt in America got that pleasant label of “toxic assets.” Nobody wanted these things, and there wasn’t even a real market for the securities as buyers disappeared. Thus, rather than allow the credit markets to implode, the Fed stepped in as a lender of last resort for mortgage debt.
The European Union believes the crisis is so dire that it has no choice but to step in. Otherwise, the whole thing would unravel. We could debate whether Mario Draghi is getting dangerously loose with money or making a power grab for the ECB. But I assume you don’t give a hoot about European power politics.
Q: Obviously. OK, so in review: Stocks jumped because now Europe is fixed and governments won’t go bankrupt. Got it.
A: Well, that’s a gross oversimplification. For starters, the ECB hardly stroked a blank check. Draghi offered no specifics or immediate help or a clear date when the program will begin. (Read paragraphs four and five of this New York Times article … or better yet, just take my word for it). There’s also the sticky point that the bank left the next step to governments — demanding they formally ask for help and then follow a fiscal discipline checklist before the central bank would buy any of its bonds.
So the cavalry isn’t arriving immediately for Spain — and with interest rates still around 6% on its 10-year bonds even after this ruling caused dip of about 0.4 percentage points, every day counts. Consider that the U.S. borrows for 1.7% right now on its 10-year Treasuries.
And then there’s the bigger issue that long-term financial stability will never come from providing a debt backstop now. The economies in the eurozone need to improve to raise tax receipts, and governments need to be realistic about their spending habits.
Q: So … this move helps ensure Spain and Italy and whatever won’t go bankrupt. But things still suck over there.
A: Right. The bottom line is that the debt problem also is an economic growth problem because you need businesses and consumers generating tax revenue, or else this is all academic. The ECB also has been trying to kick-start the economy, with Draghi cutting interest rates three times since taking over less than a year ago, to a current record-low level of 0.75%.
But recession is here — and permabears like Dr. Doom Nouriel Roubini think it will get worsen into depression, considering some regions like Greece have staggering unemployment rates of 20%.
And the worst part is that Germany is pretty pissed about this whole thing because its primary concern is the ECB mandate to control prices. Unlike the U.S. Federal Reserve with a dual mandate to control inflation and maximize employment, it’s technically not the job of the European Central Bank to care about employment.
In short, it’s a mess because of high unemployment and governments spending more than they can afford.
Q: Man, that sounds a lot like America.
A: Yup. Except the irony is that right now we borrow for a ridiculously low rate because the world sees us as “safe.” Compared to alternatives like Europe or Australia or China, I guess we are. So our debt is not an immediate problem.
Just watch out if perceptions change, however, since it will wind up costing us — not just in interest on our debt, but in many other ways relating to trade and our economy.
Don’t worry, we won’t wind up like Zimbabwe. But there will be consequences.
Q: Crap. I thought this meant I could start buying stocks again …
A: Don’t be a moron — you certainly should be buying stocks if you’re a long-term investor. Because the bottom line is that with this backstop, Europe now has a much, much lower chance of falling apart. And if you wait for the fireworks and streamers, the recovery there will pass you by.
Besides, have you failed to notice that S&P is up 13% since Jan. 1? That we are challenging levels not seen since spring 2008 when unemployment was like, 5%?
Yes, Europe has a long way to go, and other global markets like China are seeing headwinds. Yes, America has not wholly gotten its swagger back. But unless you have a flux capacitor, you’ll never be able to perfectly sell a top and buy a bottom. So give it up.
Most long-term investors know to buy dips as well as tops — it’s called dollar cost averaging. Here’s the damn Wikipedia page for it if you’ve never heard the term.
Jeff Reeves is the editor of InvestorPlace.com and the author of “The Frugal Investor’s Guide to Finding Great Stocks.” Write him at email@example.com or follow him on Twitter via @JeffReevesIP. As of this writing, he did not own a position in any of the stocks named here.