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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
By Detlev Schlichter, on 17 June 11
The efforts of our political leaders to socialize the fallout from the financial crisis by means of the balance sheets of the government and the central bank, and to thereby sustain an illusion of normalcy, have guaranteed that the financial crisis is now morphing into a sovereign debt crisis – a process that is unfolding at different speeds globally but that in many places is well advanced already. On a long enough time line, everywhere is Greece.
Crises clarify things. When the cash runs out and the chimera of harmony and “shared ideals” can no longer be sustained with borrowed or printed money, the hard questions get asked – and clear and blunt answers are finally given. No more time for fuzzy logic.
Who Owes Government Debt?
Who owes government debt? Who do the lenders to governments ultimately hold a claim against? The answer is not as obvious as it is in the case of loans to private entities, such as individuals or corporations.
In the case of Greece, for example, many will consider the answer to this question obvious: The Greek “people” have an obligation to repay the loans that banks and bond investors have extended to the government of the Greek “people”. After all, the government represent “the people” and have thus borrowed in the name of “the people”. So “the people” of Greece have a collective obligation to pay.
This is nonsense. It is unjust and economically absurd. Also, it is simply not going to happen. Forget about it. Not only in Greece – forget about it almost everywhere. Once the debt load has reached a certain level the “people” won’t pay – and rightly so.
The loan from a banker or bond investor to a government is a contract, and many people will assert that contracts have to be honoured for the market economy to work. But most Greeks never contracted for this debt, their government officials did. The loan is between a lender (bank or bond investor) and the government – a political entity. That entity has seriously overspent and is now going broke.
I maintain that the vast majority of people do not consider the debt of their government to be the equivalent of their own personal debt, nor do they feel obligated morally to assume responsibility for any action that government officials undertake or any contract that they sign. This position is sensible. To have any real sense of personal responsibility one needs to have control over affairs. In a democratic nation state, no single voter has sufficient control over the borrowing and spending activities of the government, and it would thus be absurd to assume the citizen will readily forfeit a considerable part of his or her future income or property to honour debts incurred by those who are running the government.
The whole notion of democratic “representation” has been obscured by constant propaganda trying to tell us that the government qua democratically elected government represents “the people”, that it looks after the “national interest” (which is a convenient political fiction) and “society as a whole”. This is evidently not the case. The government is not a true representative of anybody.
If the government officials were my representatives – like, for example, the lawyer and tax account who I hire to work for me, or the shop manager or other employees who work in my business, and for whose actions I do in fact take considerable responsibility – I could direct their activities, and most importantly, I could release them from their duties at any moment. In a democracy, I get a chance to kick out my “representatives” only every four or five years even if I tire of their “representation” much earlier, or more precisely, I get a chance every four or five years to cast an individual vote of infinitesimally small importance in a process that may replace one group of politicians with another group of politicians. Whatever my “representatives” do in these four or five years, I have to take the consequences – and live with these consequences for years and decades. If the presently ruling group of politicians decide to bail out the entire banking industry – all with my best interests at heart, of course – I have to foot the bill.
So, a secretly elected official, who I may or may not have voted for, whose supporters largely remain anonymous to me (elections are secret – which further weakens accountability!), whose actions I cannot direct, and who I cannot relieve of his duties for a number of years, can sign loan contracts which will place a considerable burden on my future income and my property.
Not likely.
It gets even more absurd. While my children do not have to pay for my debt – debt, for which their father signed personally – and can thus control their financial future without being burdened by my financial extravagance, they will be on the hook for servicing and repaying the debt of governments that accumulated that debt while they were not yet allowed to vote or were not even born yet – and that not even their father ever voted for.
If this represents the currently accepted notion of what a government is rightfully allowed to do, it is clear that then the notion of private property has no meaning in our society. In such a system there can be no private property. If the government can tax my income and property and engage in loan contracts that create an everlasting and potentially unlimited claim on my future income and future property – then the phrase “private property” is a vacuous term.
The German anarchist philosopher, Max Stirner, saw this very clearly already 166 years ago when he wrote in his “Der Einzige und sein Eigentum” (“The Ego and Its Own”) that if there was a state, all property was owned by it. The individual can just borrow it for a fee – taxes. Or, as Doug Casey put it: Try not paying your real estate taxes for a year or two, and you find out who really owns your house.
Such clear thinking is sadly the exception today when most people happily declare that we need a state to protect private property. I would argue that today in all advanced democracies the state is almost certainly the largest threat to your property and future market income.
Continue reading at Paper Money Collapse.
By Dr Frank Shostak, on 25 May 11
U.S. Treasury Secretary Geithner said in a letter to Senator Michael Bennet, a Colorado Democrat, that a default arising from failing to raise the $14.29 trillion debt limit could cause “irrevocable damage” to the economy and risk a “double-dip” recession and increase unemployment.
Missing or delaying payments on various obligations, including those to businesses for goods and services and bond payments to investors, would result in a massive and abrupt cut in federal spending and aggregate demand, the letter warned.
‘The abrupt contraction would likely push us into a double-dip recession’, Geithner said. According to Geithner, he is currently using an emergency reallocation of funds so that the government can meet its obligations, including payments to Treasury bondholders.
Those measures are only expected to enable the government to operate normally until August 2 from when it will start defaulting on payments including those on Treasury debt, an event that could trigger chaos in world financial markets. Geithner is of the view that a default or any missed payments would not only increase borrowing costs for the U.S. government but also for average Americans, businesses and local governments.
Now, when a lender transfers his real savings to a borrower he expects to receive his real savings plus interest after an agreed period, i.e. on the maturity date. In order for the borrower to be able to honour his debt he must be able to generate real wealth that will be sufficient to cover the original debt plus the interest.
Government however, is not a wealth generator; it can only engage in a consumption of real wealth. How then does it repay the debt? – by borrowing again. It uses new borrowings to repay previous borrowings.
As long as the private sector is capable of supporting an expanding pool of real savings, this enables true real economic growth to stay in force. As long as this is the case, the government can engage in its endless borrowing game without ever being caught out – note that government borrowings result in the diversion of real savings from wealth generating activities, which in turn only weakens the economy. Obviously, then, if the ability of the government to borrow is curtailed this means that its ability to undermine the formation of real wealth is also curtailed – so what is wrong with this?
Once the ability of the government’s capacity to engage in non-productive activities is curtailed, various activities that are supported by government spending come under pressure – these activities cannot support themselves because they survive through a diversion of real savings from wealth generating activities. The emerging crisis then is not a crisis of the real economy as such, but a crisis of non-productive activities. On the contrary, now wealth generators will be able to retain more real savings at their disposal and expand the overall real pie.
The major threat to the economy is not failing to expand the debt limit but failing to arrest endless non-productive borrowings by the government.
By Anthony J. Evans, on 23 May 11
Consider this diagram showing the billions of euros that each of 8 EU countries owes the other.
Whilst the numbers are far from perfect, they give a clear understanding of the extent to which EU debt obligations are interlinked. But why try to raise money to pay someone off if they owe you even more? Why not cross cancel the debts and be left with the difference?
To see how this might work I recently ran a classroom simulation where students did precisely that. After three trading rounds they had managed to generate the following results:
- The countries can reduce their total debt by 64% through cross cancellation of interlinked debt, taking total debt from 40.47% of GDP to 14.58%
- Six countries – Ireland, Italy, Spain, Britain, France and Germany – can write off more than 50% of their outstanding debt
- Three countries – Ireland, Italy, and Germany – can reduce their obligations such that they owe more than €1bn to only 2 other countries
- Ireland can reduce its debt from almost 130% of GDP to under 20% of GDP
- France can virtually eliminate its debt – reducing it to just 0.06% of GDP
The final picture demonstrates the scope for cross cancellation. It is hard to see how such a policy would be possible, let alone desirable, but as a pedagogical exercise I think it is worth consideration. For those interested in more details I have set up a website: http://www.eudebtwriteoff.com. You can also download the full report: The Great EU Debt Write Off (.pdf)
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