Monday, March 28, 2011

A European Lost Decade?

Last week, I wrote that the ECB appears to be overly focused on inflation and was ignoring the fragility of their banking system in light of the economic risks of tightening monetary policy. Now HSBC's chief economist Stephen King has echoed my comments in this Bloomberg story:
European central bankers agitating for higher interest rates to quell inflation may be ignoring the lessons of Japan’s economic history.
As the European Central Bank and Bank of England consider tightening monetary policy, HSBC Holdings Plc and Fathom Financial Consulting warn officials risk misjudging the inflation threat and may end up hurting their recoveries. That’s what repeatedly happened in Japan in the past quarter century as policy makers constrained credit only to reverse within months when expansion faltered.
“The danger is of a policy mistake,” said Stephen King, HSBC’s London-based chief economist and a former U.K. Treasury official. “In an attempt to control inflation this year they could set the scene for more disappointing growth in the future as happened in Japan.”
Meanwhile, the Portguese government has collapsed over a proposed austerity package. It looks like it is in need of a bailout and its bond yields are blowing out. What's more Standard and Poor's reported that European banks would need another 250 billion of capital in a stress test scenario and the Irish Times reported that the ECB has planned an emergency €60 billion for Irish banks.

It's a balance sheet recession
It appears that Richard Koo is right about balance sheet recessions. Not only America, but Europe is doomed for an endless loop of stimulus-tighten boom-bust cycles that we saw in Japan's Lost Decades.

Under this kind of economic backdrop, investors who use buy-and-hold approaches to portfolio construction are likely to see disappointing returns. I would advocate the use of models that trade these intermediate term swings like the Inflation-Deflation Timer Model.

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