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Rescue-on/Rescue-off, Round Two

NEW YORK ( TheStreet) -- European Central Bank President Mario Draghi announced the bank's policy of Outright Monetary Transactions, or OMT, on Sept. 6.

Shortly after, upon hearing Spanish Prime Minister Mariano Rajoy denied he was considering making an application for rescue, I laid out this game plan:

Market assumes Spain will apply for rescue, Spanish debt yields go down.

Which reduces Spain's need for rescue and increases its bargaining power in easing the conditions for rescue.

As a result, Spanish debt yields shoot up.

Which increases Spain's need for rescue.

As a result, Spanish debt yields go down.

Go back to Step 2.

We are currently in Step 2 of the first iteration.

In theory, the loop can settle into an equilibrium, the yield premium based on the probabilities and risks of rescue/no-rescue scenarios. But this is an unstable steady-state, like a pencil standing on its tip.

One might say it has already been at equilibrium, only it's dynamic. But this dynamic "equilibrium" is poised to swing wildly each time it goes through the loop due to the inherent positive feedback mechanism, as explained below. (By the way, I have a gripe with people calling it "negative feedback," which makes the system stable. Just because the effect is bad, doesn't mean the feedback is "negative.")

The OMT Positive Feedback Loop

It continues to amaze me how people still think Portugal, Italy, Ireland, Greece and Spain (the PIIGS) want to avoid default. OK, maybe they do. But the point is there is no real incentive for them to do so. Austerity is the right (only?) solution in the long term, but it's painful.

At some point the people will cry out in pain and force their politicians to drop the pretension and take the easy way out.

It is perfectly rational and moral to demand the people endure painful austerity since it was they who reaped the benefits of overspending. But this is an external view, with no resonance inside the austerity zone, and therefore irrelevant unless forced on by an external power.

And who dreads the PIIGS default more, elites with the "United States of Europe" dream or people struggling to get by?
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