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By Lewis Lehrman, on 2 January 12
A view from America, previously published at The American Spectator.
The super-committee of Congress is the latest group to confess abject defeat by the Treasury budget deficit. Who can be surprised by this total failure? During the past generation Congress has made as many as fifteen legislative attempts to control government spending — aimed ultimately at a balanced budget. The most notable efforts were those sponsored by the all-time budget hawk, Senator Phil Gramm of Texas. But every administrative and legislative effort by the authorities, no matter how well-intentioned, has collapsed. Why is this so?
Nobel economist Milton Friedman believed the solution to the budget deficit problem was to deny Congress tax revenues. So he advised Congressmen and Presidents to oppose all tax increases — thereby denying bloated government the funds with which to increase spending. But Friedman’s advice has failed, too. We know this because marginal tax rates have been reduced from as high as 70% in 1964 to 15-20-39% in 2011 — depending on the type of income. But congressional spending has nevertheless increased every year — such that, today, only 60% of the Federal budget is financed by taxes, the remainder by Treasury debt. Total direct Federal debt is now about equal to total U.S. output.
The intractable budget deficit and the inexorable rise of government spending has a simpler explanation. Congress and the Treasury are in possession of several open-ended charge accounts — “permanent credit card financing” — with no limits. With its charge cards the Treasury can borrow new credit (money) from the banking system — much of what it needs every year to finance the ever-rising budget deficit.
A look at the current Federal Reserve Balance Sheet shows that the Fed has created about $1.7 trillion of new credit (money) with which to purchase Treasury debt. Foreign central banks have created about $2.7 trillion of new credit to purchase U.S. Treasury bonds. This global, electronic, money-printing exercise has financed almost 30% of the total direct debt of the U.S. Treasury. In 2002, Ben Bernanke, now Chairman of the Fed, did not mince words to describe this process:
[U]nder a fiat (that is, paper) money system, a government (in practice, the central bank in cooperation with other agencies) should always be able to generate increased nominal spending and inflation, even when the short-term nominal interest rate is at zero…. [T]he U.S. government has a technology, called a printing press (or, today, its electronic equivalent), that allows it to produce as many U.S. dollars as it wishes at essentially no cost.
He might have added that these “no cost” dollars, printed by the Fed, are the enablers of the perennial U.S. budget deficit.
But the Fed is not the only credit card used by the Treasury to finance the budget deficit. Because the dollar is the world’s reserve currency, foreign central banks also finance U.S. budget deficits (as the custody account of the Fed balance sheet shows). Domestic and foreign commercial banks, too, supply vast amounts of new credit to the U.S. Treasury because domestic, foreign, and international bank regulators, such as the Basel authorities, define U.S. sovereign bonds as high quality assets for which bank reserves are not necessary. Therefore financial institutions can qualify their overleveraged balance sheets by loading up on Treasury Securities. Indeed, only 10-20% of the total direct debt of the U.S. Treasury is now owned by the non-bank, non-government private market. Given the reserve currency role of the dollar, the Federal Reserve and foreign central banks have been given every institutional incentive to finance the U.S. budget deficit. Beginning with World War I, every monetary discipline has been removed by domestic and international authorities, such that runaway government spending everywhere relies on the ultimate credit card — newly created money in the banking system.
The simplest solution to the government spending problem in Congress is “to tear up” its credit cards. The way to do this is not with ad hoc and unavailing administrative patchworks, all of which are nullified by world banking system credit made available to the U.S. Treasury. Instead, the effective democratic solution is authorized by the U.S. Constitution — in Article I, Sections 8 and 10: — whereby the control of the supply of dollars is entrusted to the hands of the people — where it stayed for most of American history, especially from 1792 to 1914. This was America’s longest period of rapid, non-inflationary, economic growth — almost 4% annually, with the budget under control except wartime.
Congress need only mobilize its unique, Article I, constitutional power “to coin money and regulate the value thereof.” From 1792 to 1971 Congress defined by law the gold value of the currency such that paper dollars and bank demand deposits were convertible to their gold equivalent — by the people (1792-1914) and/or by governments (1933-1971). Congress should exercise this constitutional power to restore dollar-gold convertibility, because of the proven budgetary and economic growth benefits of a dollar as good as gold.
First, the discipline of convertibility would automatically set the limit on Treasury access to its Federal Reserve credit card. If the Federal Reserve created more money than participants in the market wanted to hold, people would get rid of the inflationary excess by promptly exchanging paper and credit money for the gold equivalent. But under the true gold standard, the Fed and the commercial banks would be required by law to maintain dollar-gold convertibility at the statutory gold-dollar parity — or suffer insolvency. In order to maintain dollar convertibility to gold, the Fed and the commercial banks must reduce the quantity of money and credit, including credit to the Treasury — thus controlling government spending increases and inflation.
Second, the empirical evidence of American economic history also shows that convertibility to gold stabilizes the value of the dollar. The same evidence shows that a stable dollar also stabilizes the general price level over the long run. For example, under the gold standard, the price level in 1914 was at almost exactly the same level as it was in 1879 and in 1834. There was no long term inflation, even over an 80 year period! But from 1971 — Nixon’s termination of dollar-gold convertibility — until 2011, the purchasing power of the dollar (adjusted by the CPI) has fallen 85% in a 40 year period.
Third, gold convertibility of the dollar leads to a vast outpouring of savings from inflation hedges such as commodities, farmland, art, antiques — almost anything perceived to be a better store of value than depreciating paper currencies. Stable money also creates incentives to save from income. Combined with the global release of trillions of hoarded, inert, unproductive inflation hedges, convertibility triggers new savings which would pour into the productive investment market. The new investment would give rise to a general economic expansion — through new business, new products, new plant and equipment, creating thereby a renewed demand for labor to work the expanding production facilities.
The restoration of a dollar worth its weight in gold provides not only a missing and necessary brake on government spending, but a stable dollar supplies the missing steering wheel by which to guide the immense, hoarded savings into long-term productive investment. Dollar convertibility to gold is the simple, institutional financial reform which terminates the fear of rapid inflation — thus transforming unproductive, store-of-value hedges into real investment capital with which to inaugurate a new American era of rapid economic and employment growth.
By Steven Baker MP, on 20 December 11
Following his recent paper The law of opposites: Illusory profits in the financial sector, TCC Advisory Board member and founder of Cobden Partners Gordon Kerr appeared on Bloomberg. The video is here.
 Click for video Gordon dealt with the flaws in IFRS, the reasons for the debt crisis, the case for hardening money, the need for international money in support of trade and more.
Later in the day, I said in the Commons that the Government’s response to the ICB report seemed to take accounting for granted, asking the Chancellor to consider the issue seriously in the forthcoming white paper.
By Toby Baxendale, on 3 November 11
A good article from Brian Domitrovic on Forbes.com:
Let’s face it – we’ve seen what arbitrary government control and central bank manipulation can do. Namely, what the Federal Reserve has done since 2008. This is to scare everyone away from the currency such that there’s no investment, with inflation hedges (such as gold) shooting the moon, all the while stiffing the small defaulter and bailing out the biggest of the big.
This kind of anti-democratic monopolism is exactly what the gold standard forestalls, and The True Gold Standard explains why, among much else, in less than a hundred tidy pages.
Here’s another exquisite recommendation from the book: given gold, government bonds can’t count as bank reserves. This will do two things. First, dry up the market for government debt, an unqualified good in our age of trillion-dollar deficits. And second, release bank assets to be at the service of the real economy.
Read more.
By Nick Ottens, on 1 November 11
Eurozone leaders ordered their banks to raise additional capital last week to prepare for a partial Greek default. The continent’s banking industry didn’t yet receive a direct financial injection but will be allowed to appeal to national governments and the European bailout fund for assistance.
A recapitalization of Europe’s financial industry was championed by the International Monetary Fund and the United States as well as countries whose banks are excessively exposed to Greek debt, notably France. It is why President Nicolas Sarkozy liked to enable banks to tap into the European Financial Stability Facility that was set up last year to help countries, not companies, in financial distress so his fiscal challenges wouldn’t be aggravated. German Chancellor Angela Merkel insisted that banks raise capital from their own governments before raiding the bailout fund.
It’s a better plan, but one that will provide only temporary relief to Europe’s sovereign debt crises before making it worse.
Europe’s leaders agree that Greek debt levels have reached unsustainable heights. Its public debt is now worth 50 percent more than its entire economy and is projected to growth further in the coming years as Athens struggles to rein in spending substantially. Greek debt will be “restructured,” which means that roughly half won’t be paid back. European banks that have loaned to Greece could be in trouble. Even if they aren’t, other banks and investors might worry that they are, causing the market to tank. “Recapitalization” is designed to prevent that from happening.
In the short term, it could, but several weeks later markets would likely start wondering whether pumping billions of euros into a financial system that’s bloated with debt is really an intelligent strategy.
Western banks have been hesitant to loan money, to each other and to businesses, since the 2008 financial panic when the investment bank Lehman Brothers collapsed. American and European central banks lowered interest rates in response, allowing banks to borrow cheaply in the absence of private sector confidence.
The European Central Bank has been more prudent than its American counterpart, the Federal Reserve, and didn’t buy sovereign bonds, from Italy and Spain, until this summer. The Fed, by contrast, has been financing American deficit spending by printing trillions of dollars for more than two years. Both have supported banks in the expectation that they would continue to extend business loans and mortgages.
They haven’t really—not enough to stir an economic recovery, anyway, because they realize that the market is still full of dislocations and excesses.
If there weren’t central banks or if they hadn’t intervened, those dislocations and excesses, build up in an era of “cheap money” when financial institutions knew that they were “too big to fail,” would have been cleared out in 2008 when Lehman collapsed and threatened to sink half of Wall Street with it. Prices that did not reflect real demand, especially in housing, where government policy had encouraged people without sufficient income to apply for mortgages, would have deflated—considerably.
Default and deflation however, along with potentially huge losses in personal savings, are politically unacceptable. So instead of failing, the institutions that created the crisis are now on life support while the housing market in many Western countries, and construction with it, is stuck. Homeowners aren’t willing to lower their expectations while buyers aren’t able to purchase at the prices they charge.
Recapitalizing banks after they bought worthless Greek bonds when they should have known better isn’t just wrong; it’s not going to work. If writeoffs are also expected for Portugal and maybe Italy and Spain, investors will realize that no matter how big the EFSF is made to be, the solvent countries in the north of Europe can’t afford to compensate them for their losses indefinitely. If the ECB also turns on the printing presses (which it doesn’t want to), that will be the clarion call for investors to get out. Interest rates on peripheral bonds will skyrocket.
The political willingness to reform structurally rather than cut several billions of euros in annual spending is virtually nil in Greece and Italy. These states are already bankrupt and waiting for Germany to pull the plug. It is king in the land of the blind (or broke actually) but doesn’t have the cash on hand to bail out half of Europe. Some countries just won’t change until they’ve hit bottom. The sooner the better, for the longer banks have to wait for the inevitable, the longer they’ll avoid investing in enterprises and loaning to other banks — they don’t know which will survive the reckoning and which won’t. Recapitalization would thus make the problem worse by providing a false sense of security that cannot last.
This article is based on one previously published at Atlantic Sentinel
By Detlev Schlichter, on 28 October 11
As you know, my expectations were low to begin with. I did not expect the EU summit on the debt crisis to provide a solution. There is no solution. The situation is beyond repair and the crisis will continue to unravel.
What struck me most when reading the first responses to the EU summit was this: most of what you get from the mainstream media pundits or from the financial economists on Wall Street or in the City of London not only misses the relevant points, it usually gets things completely the wrong way round. What these analysts suggest is good policy and needs to be done is almost always bad policy and should be avoided under any circumstances.
Let’s go through the salient points:
1. Write-down of Greek debt to 50%
“Private sector involvement,” aptly abbreviated PIS, is one of those dreadful, perverted phrases that conceal more than they explain. The private sector here means of course the banks that were stupid enough to give billions of euros to Greek politicians.
We all know what happens under capitalism to lenders who give money to borrowers who end up being unable to pay: they lose their money. That is how it should be. That’ll teach them and hopefully make them more prudent lenders in the future. Alas, this is Europe, so there is no capitalism, and you can negotiate your losses with the political class and agree on the ‘appropriate’ haircut. In July, a 20 percent write-off was agreed, now this was upped to 50. Either number is entirely arbitrary.
The positively Orwellian phrase “private sector involvement” makes it sound as if these poor banks were just innocent bystanders – and respectable members of the private sector for that matter – who got dragged into this unfortunate business at no fault of their own.
For how much should the ‘private’ sector be ‘involved’? Well, I would say for exactly as much as it chose to involve itself in the first place by voluntarily lending money to the Greek government. I mean, have the risk managers and credit analysts at the likes of Credit Agricole and Societe Generale ever been to Athens and inspected the bottomless pit in which their loans were dumped? Or have they from the start assumed that the German taxpayer or the ECB would cover their losses?
Of course, a haircut of 50 percent, as now agreed in Brussels, is better than the ridiculous 20 percent, or so, ‘agreed’ in July. But looking at Greece’s dire financial situation the haircut should be at least 60 percent, or maybe 90, or 100. As I said here and here, there is no reason for the Greek citizens of this and future generations to suffer endlessly because of the corruption of their past governments and the stupidity of their bankers. Embrace default! Just stop paying, go bankrupt, shrink your government, role up your sleeves and start from scratch. After a complete and proper default the state will not get loans easily again, which coincidentally is an additional bonus of a complete government default, it keeps your future politicians honest. That would be the free-market solution. But again we are in Europe.
An even bigger haircut, one decided not by political horse-trading but by the market and Greece’s true ability to pay, would be more helpful for the Greeks and would conveniently discipline the bankers. Why is it not considered? Well, the politicians don’t like it because it would shut much of the government bond market down and make it difficult or impossible for them to keep running deficits of their own, and also because the banks have skilfully booby-trapped the entire financial system with explosive CDS (credit default swaps) that get triggered if the “private sector involvement” gets too big. The bankers resemble increasingly financial terrorists: If you don’t bail us out we blow the whole place up!
Bottom-line: A haircut of 50 percent is better than 20 but it is still too little for Greece, and the whole idea that the ‘private’ sector negotiates losses with the politicians doesn’t bode well for the future.
2. Fiscal coordination.
Nothing specific was agreed at the summit but this is where we are going, and the mainstream economists are cheering for it.
For years now we have heard this in endless macroeconomic research pamphlets and newspaper editorials: There can be no monetary union without a fiscal union. This is, of course, utter nonsense. Complete rubbish. And it doesn’t get any more right by repeating it at nauseam.
The money of capitalism, of the free market and global trade, has always been gold (or silver, but I will refer to gold here). A gold standard is the oldest and best currency union imaginable, and I would argue, the only one workable. Under a gold standard various countries and their governments use the same currency, gold. There is no central bank and no printing press. Governments have to make do with the income they generate from taxing their local population. In such a system, the state has to live, just like any other entity in society, within its means. Apparently, this is a truly fantastical notion for today’s politicians and mainstream economists. Under a gold standard, the state may also borrow from the market but it is clear to the lenders that they assume full risk of default. There is no lender of last resort. This is a powerful constraint on government largesse.
The Greek crisis was a good test to see how closely the European fiat money union could resemble the workings of a proper gold standard. In theory at least, and as intended by the original designs for EMU, there should have been no bailout and the whole mess should have been a local affair between the Greek government and its lenders, just as it would be under a gold standard.
All this nonsense about the falling apart of the euro was, of course, needless scaremongering, albeit politically motivated. When a government defaults under a gold standard, there is no reason why any other government should give up gold as a currency. Had the no-bailout provision been adhered to, there would equally have been no reason why a Greek default should have affected the acceptance and the usability of the euro in any of the other countries, nor for the Greeks themselves. A currency union does not require a fiscal union. Quod erat demonstrandum.
But EMU is no gold standard, and it already failed its first test of whether it could even be a currency union of some discipline. The gold standard was abandoned globally precisely so that governments would not have to live within their means. The euro is political paper money, fiat money, and issued to allow persistent fiscal irresponsibility, as is any other paper currency. Central banks have always been created to fund the state and the banks. The ECB is no different.
This is the global picture in 2011: After 40 years of complete paper money, public debt around the world has reached such momentous dimensions that the major central banks are now increasingly funding the state directly. This is what is happening in the U.S., the UK and increasingly the eurozone, and it is either accepted with suspicious equanimity or enthusiastically supported by bank economists and the inflationistas in the mainstream media. The trend is the same pretty much everywhere. It is only that within the eurozone it is less clear which government has first call on the printing press. In other paper money economies this can be done more straightforwardly.
To assume that some form of institutional framework for fiscal coordination will discipline the European governments and reduce the desire for ongoing central bank debt monetization is at least naïve, if not outright stupid. All governments in Europe are fiscally irresponsible, even the German one. In the run-up to EMU Germany imposed the Maastricht criteria on her European partners. Anyone remember the 60 percent debt to GDP limit? Laughable. Today Germany is at 83 percent and rising, which may look relatively prudent if compared to Belgium or Greece, but if Germany has to pay up on its already agreed upon commitments under the European Financial Stability Fund, she will go above 90 percent in one giant leap, roughly where Ireland was when her creditors said ‘no mas’! Germany may have the lowest unemployment rate in twenty years and, last year, had the highest GDP growth in twenty years, but she is still running deficits, accumulating debt every year, just like anybody else in Europe.
On a long enough time line, everywhere is Greece!
Bottom-line: We will see a plethora of treaty changes, top-level EU summits and other pointless boondoggles. All to no avail. To assume that governments will not collectively resort to the printing press and that they will instead discipline one another when all of them are long-standing, habitual and incorrigible fiscal offenders, is beyond ridiculous! If you believe it, call me, I may have something I want to sell you!
3. ‘Unlimited firepower’ courtesy of the central bank
I guess you might argue that it could have been worse. Merkel could have given in to demands by Sarkozy to use the ECB straight away to leverage the €440 billion bailout fund. Seems like she didn’t, and Sarkozy will have to go, hat in hand, to the Chinese and see if they have some change to spare. However, this is not a long-term solution and once Italy and Spain are in trouble, the bailout fund will be depleted.
One of the most shocking aspects of this crisis is how acceptable it has become for the mainstream economists and the pundits in the media to point towards the ‘unlimited resources’ of the ECB. True, a fiat money central bank can print unlimited amounts of paper and electronic money to bailout everybody, the government, the banks, the pension funds, etc. It is just that such a policy used to be advocated only by suicidal cranks, as it is a sure recipe for complete currency annihilation. Today, established and supposedly highly regarded economists point out the importance of ‘keeping the ECB engaged’ because only the ECB has the ‘unlimited’ resources to underwrite the boundless fiscal profligacy of modern democratic governments and their vote-buying political elites, and to underwrite the gargantuan debt pile.
As the hysterical calls by the inflationistas for a bold ECB policy get ever shriller, Mario Draghi, the new money-printer-in-chief for Europe, has already signalled his support for the ECB’s debt monetization policy, that is, ongoing buying of depressed and ultimately worthless government bonds with the help of the euro-printing press.
Anyone who has any savings stored in the euro-area should be extremely concerned about what is going on here, and in particular about the tone of the debate. When the mainstream speaks of ‘unlimited’ resources of the ECB, they do in fact mean unlimited. The creation of new euro-currency units will be without ANY LIMIT. And the remaining inflation will also be without limit.
Bottom-line: On the face of it, the German position has won: deeper haircuts and no use of the ECB for leveraging the EFSF for now. But where is the money for the larger EFSF going to come from? Italy and Spain will remain under pressure. Nobody has the money to save them or to recapitalize the banks again when the big deficit countries lose access to the market and fail. The ECB is not off the hook. Resorting to the printing press has become a global policy theme for the past three years, and sadly such thinking is now part of the mainstream. The balance sheet of the ECB will not shrink, it will grow. There is no exit strategy. Pressure for further and accelerated monetization of debt, of budget deficits and bank balance sheets will continue and intensify. The endgame will be inflation.
By Detlev Schlichter, on 21 October 11
When the tectonic plates underneath society shift, confusion reigns, together with wishful thinking.
It appears that financial markets have again managed to get themselves into a state of unrealistic expectation. The European summit this coming Sunday (or the follow-up summit on Wednesday) is now supposed to bring a “comprehensive plan” to solve the European debt crisis. Of course, nothing of the sort will happen, and for a simple reason: it is impossible. Those who cherish such fanciful hopes are naïve and will be disappointed.
Let’s step back and look at the problem, which in a nutshell is this: the dominant societal model of the second half of the twentieth century – the social democratic nation state with its high levels of taxation, regulation and stifling market intervention, and thus increasingly dependent on a constantly expanding fiat money supply and artificially cheap credit – is rapidly approaching its logical endpoint everywhere, not just in Europe: excessive and unmanageable piles of debt, systemic financial fragility and weak growth.
For many, including quite a few of those demonstrating under the ‘Occupy Wall Street’ banner, this whole mess deserves the label “crisis of capitalism”. That this is nonsense I explained here. What we are witnessing is not a crisis of capitalism but the failure of statism. The present system, certainly the financial system, has very little to do with true capitalism, and if financial markets are now being demonized for their failure to go on funding political Ponzi schemes, then this means shooting the messenger rather than addressing, or even understanding, the root causes of the malaise. As I said, this is also a time of great confusion.
Failure of statism
The monetary madness of recent decades was only made possible by the transition from apolitical and inflexible commodity money (free-market money) towards limitless, entirely discretionary fiat money (state money). This shift was completed on August 15, 1971, when this system was also made global. What does such a monetary system logically entail?
In a complete paper money system, banks cannot be private capitalist enterprises but must be extensions of the state because the state holds the monopoly of unrestricted money creation. The banking sector is cartelized under the state central bank. To operate a bank, you need a state license that requires that you open an account with the central bank.
In such a system, the central bank can create bank reserves out of thin air and without limit, and has thus full control over the level and the cost of such reserves. The central bank has therefore ultimate control over the funding of the banks and the availability of credit in the economy – which is now supposed to be magically freed from its natural constraint under capitalism: voluntary savings.
In such a system, it is generally assumed that the state cannot go bankrupt as it can always print more money to fund itself. It is equally assumed that the banks cannot fail and do not ever have to shrink, at least collectively, as ever more bank reserves can be made available to them – if need be at no cost, as has become – now that the system arrived at the point of ultimate excess – the global norm.
It can hardly be surprising that those who are in charge of the banks and those who are in charge of state finances have behaved for decades as if the Great Regulator of economic life, the threat of bankruptcy, was of no concern to them. Now that the system has finally overdosed on cheap credit and that the forty-year fiat-money-fed boom is over, reality is sinking in. And it comes as a shock.
There is a lot of talk of return to normality. The market has, of course, a way of returning to normality, which involves liquidating the excesses, clearing out the dislocations, defaulting what will not be repaid, and deflating prices that do not reflect real demand. Liquidation, default and deflation, however, are politically unacceptable, as they cut right to the core of our system of state-managed ‘capitalism’: the notion that the state is above the laws of economics and that it can bestow a similar immunity on its protectorates, most importantly the banks.
What’s €2 trillion among friends?
Back to the alternate reality of the policy debate in Europe. The hope of many financial market participants seems to be that the summit will reveal measures by Germany and France to erect a firewall around Greece in case it will default, that the banks will get ‘recapitalized’, and that steps will be taken toward further ‘fiscal integration’. The wish here is evidently that Big Daddy will finally step forward, that he draws a line in the sand, and says, hey, this stops here. Time out on the crisis.
There is only one problem: nobody has the money to do it.
Two days ago The Guardian broke the story, unconfirmed so far, that Germany and France had agreed to a €2 trillion bailout fund. In response, equity markets around the world enjoyed a brief rally. Finally, the big bazooka had arrived.
Really? I was wondering if nobody ever heard of Brian Cowen.
He was the hapless Irish chap who in 2008 played Big Daddy himself and implemented an official government back-stop for the Irish banks. And duly bankrupted his country.
If Merkel and Sarkozy were really stupid enough to launch a €2 trillion bailout fund, it would certainly pay to go short French BTANs and German Bunds right away. Germany and France have no money to bailout anyone. All they could do is pile on more debt on the already large and ever-growing debt pile of their own. It would not take the market as long as it did in 2008, in the case of Ireland, to figure out what the endgame must look like.
But surely, everyone involved must realize that the little boy in the crowd has already pointed out that Emperor Sarkozy and Empress Merkel have no clothes. Interest spreads on French bonds have already blown out, and Moody’s has warned that France’s AAA-rating (what? Triple-A?) might come under review. Credit-default spreads on German bunds have widened of late, and the cost of insuring against the bankruptcy of the Bundesrepublik Deutschland will most certainly only go one way: up. Have I mentioned that Bunds are the short of the century, and U.S. Treasuries, too?
The whole notion of ‘ring-fencing’ Greece is, of course, absurd, as if Greece had contracted some rare contagious disease from which healthier nations, such as Italy or Spain, had to be isolated. Ongoing, endless fiscal deterioration is, however, not a virus but a self-inflicted and ultimately fatal wound that all European states, and in fact, almost all modern social democratic states are already suffering from. The difference between Greece and Germany is one of degree, not principle.
For these reasons, the idea that some form of ‘fiscal integration’ could be the solution, is equally absurd, as if pooling the finances of the already-bankrupt and the almost-bankrupt will somehow give you a community of the fiscally strong. As if you could improve the financial standing of a trailer park community, in which some inhabitants are maxed out on their credit cards while others still have some borrowing capacity left, by giving all of them a joined bank account.
So does this mean that all political options are exhausted, that default, liquidation, and deflation are now unavoidable?
It will get worse
Not so fast. There are still some options left to governments. None of them will solve the problem, all of them will make the crisis worse. All of them are scarily ugly and destructive. Of course, I expect that all will be adopted by governments soon.
There is, of course, always the prospect of growing regulation and market intervention, of capital controls and the banning of short selling of government debt. I expect all of this to be enacted at some point in the not-too-distant future. Like all government intervention, it will make things worse and accelerate the demise of the system.
But the biggest of all policy mistakes is already being made, and we will get more of it, much more of it: printing ever more money ever faster.
The ECB will be forced/asked/convinced to support the market for government debt of ever more European states to an ever larger degree. Central banks and fiat money are not creations of the free market but of politics. Their role has always been to fund the state. We have already reached the point at which all major central banks are dominant buyers, frequently the largest marginal buyers, of their governments’ debt. The U.S. Fed is already the single largest holder of U.S. Treasuries, and when the just-announced second round of ‘quantitative easing’ in Britain will have been completed, the Bank of England will own almost a quarter of all outstanding Gilts. Funding the state directly with the printing press is the logical penultimate stage of the demise of the present global fiat money system, and all major economies are approaching it fast. The eurozone will be no exception. The ultimate step is loss of confidence in paper money and inflationary meltdown.
If there is one outcome from the European debt summit that I am most convinced about it is that another crucial step will be taken to accelerate the ongoing debasement of fiat money.
This article was previously published at Paper Money Collapse.
By David Howden, on 7 October 11
The original worry was whether Greece would default. Then it became a question whether it should it default. Now it is a question of how it will default. To hazard a guess, I should think that after the wizards of Brussels determine how much of a default is necessary to keep German (et al.) bail-out money forthcoming, the only remaining question will be when the default will occur. It is clear that the vast majority seem convinced that default is the only option, or that it is the best one, or, at the very least, that it is the most expedient one at this time.
Default is not a word to throw around casually. When an individual defaults on his mortgage, it involves great pain – he loses his house, his car, and whatever other assets he posted as collateral. Default does not mean that debts are forgiven and he starts afresh (although the vulgar form of default seems to imply this). Default causes our individual pain – it is something that he tries to avoid at all costs.
Before the Greek default occurs – which is increasingly becoming a foregone conclusion – we must look at two facets. First, what will this default mean? Second, is there a better way?
A nation can default two ways. Implicitly, by inflating the real value of its debt away by increasing the money supply, or explicitly, by not paying back the full value of its debts. If the eurozone is to continue to include Greece as a member, it is clear that an implicit inflationary default is impossible. (Some commentators seem to belabour this point, as if Greece exiting the euro and inflating away its problems would prove a panacea.) With this avenue gone the attention focuses on the explicit default, soon to be delivered.
Haircuts imposed on creditors form what seems to be the preferred planned default. In reality, a haircut only allows for one-half of a default to occur.
The half that we will see is the pain imposed on creditors. Lenders kind enough to loan their funds to the Greek government likely never expected that they would not be repaid. At least, they likely never expected the extent to which they would not be repaid (which could be as little as 20 to 50 cents on the euro). It is easy to take solace with caveat emptor, but that is only half the story.
If I default on my house, it is not only my bank that suffers a loss; I must as well. I must lose all available assets in an attempt to make my bank as whole as possible. There are not so many plans to sell Greek government assets to pay for its debts (of course, the related question is whether anybody would want such assets. I am sure that few creditors would rather take a union-saddled Greek government agency, complete with strike-induced headaches, rather than cut their losses at 100 percent).
If Greece wants to default, it must abide by the rules of the game. The current “default” plan for Greece is nothing of the sort; it is a gift. Few Greeks seem willing to sacrifice sovereign control to foreigners by relinquishing assets, and perhaps rightly so. But if assets will not be sold to try to cover its debts, Greece must look for a different avenue to default.
Cutting expenditures is one path. While Greeks strike at the very thought, if the choice was clear to them – lose sovereign assets to take a cut on your pension – their attitude might quickly change. Creditor nations avoid this trade-off by being ambiguous as to what a Greek default would actually mean to Greeks. This very ambiguity makes the game continue longer than it must. As excessively high expenditures are what got the country into the mess to begin with, it seems to be a logical place to start to try to exit recession. Austerity might be a dirty word, but it is a necessary one.
There is one other option left to the small Hellenic republic. It is not without precedent, but it too is a dirty word in some circles. Greece may not be able to pursue an external devaluation through inflation, but she can pursue an internal devaluation through price decreases. Deflation might cause some to run to the exits, but it is increasingly proving its worth. Ireland has recently started exiting its recession through deflation, and occurrence making it ever less likely that the country will default. Deflation is not necessarily easy – public and private workers will have to take salary cuts, austerity programs will have to be intensified (and fulfilled!) – but it allows the country to avoid the costs of losing national sovereignty and creditors taking losses on their loans. Some may think deflation is a dirty word, but no more than the alternatives. And it has already been successfully tested in other ailing European economies.
By Tim Price, on 4 October 11
Mises was infinitely patient and kind with even the most dim-witted of us, constantly tossing out research projects to inspire us, and always encouraging the shiest and most awestruck to speak. With a characteristic twinkle in his eye, Mises would assure them: “Don’t be afraid to speak up. Remember, whatever you say about the subject and however wrong it might be, the same thing has already been said by some eminent economist”.
- From “Ludwig von Mises: Scholar, Creator, Hero” by Murray N. Rothbard
There is hope for all of us in the news that an experiment at CERN may have challenged Einstein’s theory of relativity. It suggests that deep-seated and long-cherished ideas can still be knocked off the pedestal of conventional wisdom. The process may take an age, but as Max Planck observed, Science advances one funeral at a time. If only the study of economics could evolve as quickly. Sadly, the mouthpiece of conventional economic wisdom, the Financial Times, continues to provide the oxygen of relevance to commentators like Martin Wolf, who if his latest article is any guide (“Time to think the unthinkable and start printing again”) has simply gone mad.
Future historians will not look kindly on those who continually and repeatedly advocated the wrong remedies – inflationary money-printing, or the issuance of yet more debt – to a problem in large part caused by unsound money and inordinate debt. Einstein himself defined insanity as doing the same thing over and over again and expecting different results.
Unfortunately for those still toiling in the productive economy, there seems plenty of evidence that the lunatics have taken over the asylum. A small example: UK monetary policy committee member Adam Posen recommends a state-backed bank that could lend to small businesses. But we already have at least three, and they are called RBS, Lloyds TSB and HBOS.
As to why Martin Wolf‟s baffling addiction to inflationism is so gallingly wrong, consider Rothbard’s tribute to the Austrian economist Ludwig von Mises cited above:
An increase in the quantity of money only serves to dilute the exchange effectiveness of each franc or dollar [or pound]; it confers no social benefit whatever. In fact, the reason why the government and its controlled banking system tend to keep inflating the money supply, is precisely because the increase is not granted to everyone equally. Instead, the nodal point of initial increase is the government itself and its central bank; other early receivers of the new money are favoured new borrowers from the banks, contractors to the government, and government bureaucrats themselves. These early receivers of the new money, Mises pointed out, benefit at the expense of those down the line of the chain, or ripple effect, who get the new money last, or of people on fixed incomes who never receive the new influx of money. In a profound sense, then, monetary inflation is a hidden form of taxation or redistribution of wealth, to the government and its favoured groups, and from the rest of the population.. every change in the supply of money stimulated by government can only be pernicious.
Inflationists also tend to be stimulus fanatics. Mises had a suitable response:
The longer the boom of inflationary bank credit continues, the greater the scope of malinvestments in capital goods, and the greater the need for liquidation of these unsound investments. When the credit expansion stops, reverses, or even significantly slows down, the malinvestments are revealed. Mises demonstrated that the recession, far from being a strange, unexplainable aberration to be combated, is really a necessary process by which the market economy liquidates the unsound investments of the boom, and returns to the right consumption / investment proportions to satisfy consumers in the most efficient way.
Thus, in contrast to the interventionists and statists who believe that the government must intervene to combat the recession process caused by the inner workings of free-market capitalism, Mises demonstrated precisely the opposite: that the government must keep its hands off the recession, so that the recession process can quickly eliminate the distortions imposed by the government-created inflationary boom.
But as a fellow asset manager recently observed, we are not policy makers, we are stewards of other people’s capital and we are here to outperform. The quotation, or paraphrase, is from an outstanding recent article by Joshua Brown citing a lunch meeting with DoubleLine’s Jeffrey Gundlach. Other gems:
I don’t know what’s going to happen in Europe but there is one thing I am certain about – eventually, someone is going to take a big loss. As investors, the most important thing we can do is make sure that we aren’t the parties taking that loss.
This glass of water is more worthwhile than a government bond under 5-year duration.
On emerging market debt:
A secular improving credit story.. [emerging market debt trades at] twice the yield of developed market debt and triple the fundamentals.
And finally,
The bloodless verdict of the market – In the end, he who gets it right wins, there are no points awarded for being smart but wrong.
Never, ever take counterparty risk – It is the one risk you are almost never rewarded for taking. Unless you are running $800 billion, there is no need to use swaps, synthetics or baskets – trade cash markets and avoid any trades that require a counterparty.
Having spent the last two weeks in Italy, it is striking how what is portrayed as a grave and seemingly permanent crisis over here might as well not even exist over there. That said, we did come across quite a few Germans, who may or may not have comprised the advance guard.
As to the financial markets, it seems abundantly clear to us that any hopes of a resolution to the crisis remain just that – wishful thinking, notwithstanding the stylish nonchalance of our Italian cousins. The extraordinary oscillations of the stock market do not intuitively feel like anything good, but rather the convulsions and twitchings of a body anticipating an even larger shock. The one bit of good news is that we have an opportunity to buy back into the likes of gold and silver at levels that seem very attractive to us, given the ever-darkening clouds elsewhere.
This article was previously published at The Price of Everything.
By Tim Lucas, on 27 September 11
I came across this excellent report by Boone and Johnson from the Peterson Institute for International Economics on the mechanics of how the Eurozone sovereign debt crisis built up (hat-tip James Aitken of Aitken Advisors).
The report helpfully runs through the various policy options that the Eurozone leaders have, and runs through the likely consequences of default – interesting reading given the growing probability of some portion of this option being taken with respect to Greece at least. The writer at least believes that default and ‘an end to the moral hazard regime’ has now become the most likely option.
Cobden centre readers will enjoy the description of how it was the ECB’s repurchase operations that entrenched moral hazard throughout the Eurozone through the treatment of all sovereign paper as collateral from banks equally regardless of its creditworthiness.
There is also an up-to-date summary of the current net claims of all countries against each other, all guaranteed and monitored through the ECB, imbalances that are still building. Germany as of July was the largest creditor to the scheme at over Eur335bn. In gamblers’ parlance Germany’s decision over whether to throw good money after bad will determine the route the crisis will take next.
By Detlev Schlichter, on 16 September 11
This was another hectic week for financial markets, and nerves were calmed somewhat over the past 24 hours with another liquidity injection from the central banks – this time the provision of dollars from the U.S. Fed channelled through a few other central banks, most importantly the ECB. This is certainly not a solution but again the doctoring of symptoms. Pumping ever more fiat money into the system to avoid – or rather postpone – a much needed recalibration will not solve the underlying malaise. Four years into the crisis the banks still need emergency funding. That is a damning indictment that financial structures are far from sustainable.
Not a European problem
The euro debt crisis is not a specifically European problem but the European version of a global problem. Decades of constantly expanding fiat money have created a highly distorted global economy and a bloated and excessively indebted financial infrastructure. The fundamental problems are now the same the world over: weak banks, too much debt – now increasingly public sector debt – and a severe addiction to cheap credit.
As I explain in detail in my new book Paper Money Collapse – The Folly of Elastic Money and the Coming Monetary Breakdown, ongoing and persistent expansion of the money supply must disrupt the market process, it must lead to distortions in relative prices, to misallocations of capital and the accumulation of economic imbalances. The majority of observers ignore these effects. They just see the near-term boost to headline growth and the impact on the price level. Higher inflation is the only negative effect from money production that they can fathom. This is a grave intellectual error.
The key flaw in our system of constantly expanding fiat money – which only came into full bloom in 1971 when the last link to gold was severed – is that those in charge of the money franchise are always tempted to avoid liquidation and correction and to spur the system onward with ever more bank reserves, artificially lowered interest rates and more debt. This has been going on for decades but we have now reached the limit.
Default – painful, yes. Needed? – Definitely
A default of Greece now appears very likely. This is a positive development. Positive as it points toward shrinkage – toward smaller debt, toward a smaller Greek state, toward an important lesson for banks: Don’t think that lending to the state is without risk!
The exposure of European banks to European sovereigns is mind-boggling. It is indicative of a severely distorted and corrupt financial system. This has nothing to do with capitalism. This has nothing to do with free markets. This whole charade gives ‘capitalism’ a bad name. The sooner it ends the better.
With the help of ‘lender-of-last-resort’ central banks and under implicit and explicit state protection, banks have been able to engage in fractional-reserve banking, and therefore money and credit creation, on an unprecedented scale – with many of the loans being in turn extended to the banks’ generous state protectors. Lending to sovereign borrowers used to be a low-yielding but supposedly safe business – very lucrative if you conduct it in size. You may give 5 million to an unstable capitalist enterprise and charge it a hefty interest rate, or you can give 5 billion to the state at a lower rate. What can go wrong?
Back to Greece. Default is now likely and that is a good development. I am not taking lightly the pain that this will cause for many individuals. It will involve hardship. But what is the alternative? The situation is simply beyond repair. The Greek state has maneuvered itself into an unsustainable position. And it is not alone – but probably the first in line.
Default is not the end of the world. It involves the acknowledgement of the debtor that he borrowed too much and the acknowledgement of the lender that he lent too much. Both take a hit.
No bailout
A full-fledged bailout by Greece seems no longer an option. The Germans are unwilling to do it – and let’s face it, they don’t have the money for it, contrary to the caricature in parts of the press of Germany as an economic powerhouse with unlimited resources. Of course, the German government could borrow the money at a lower rate than anybody else but this would set a dangerous precedent. Italy and Spain would be next in line.
The biggest risk to the euro is not a Greek default but the markets waking up to the bleak long-term outlook for the solvency of the core, Germany and France. The bizarre willingness with which the markets continue to treat German Bunds (and for that matter, U.S. Treasuries) as absolutely safe assets is one of those aspects of the crisis that feels surreal and unsustainable but that have thus far allowed the system to stagger on. The Germans would do nobody a favour by risking the standing of their bond market as a safe haven – however unfounded that standing may appear on closer inspection. The moment the market thinks the core is in trouble, the euro will be in trouble.
It also appears unlikely that the ECB can save Greece. Full-scale debt monetization – with disastrous consequences for the euro – still seems a very likely endgame. This, to me, is still the biggest risk, namely that a correction of the system’s excesses through default, balance sheet reduction and credit contraction will not be allowed to occur for political reasons as the short term impact on growth and employment would be considered unacceptable. But as the system will – sooner or later – contract, this could trigger a massive monetary expansion by the central banks. But not yet, I think, not for Greece.
Continue reading at Paper Money Collapse
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