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Issue 935 February 12, 2010
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BANKROLLING THE INCONTINENT SUBCONTINENT
The wicked borroweth, and payeth not again: but
the righteous sheweth mercy, and giveth (Psalm 37:21).
The question arises: How wise is it to lend to wicked
people? Not very.
What about lending to national governments, whose
representatives were elected in order to show mercy to
certain voting blocs with taxpayers' money? Not very.
Yet this is what has been done on a massive scale.
The European Central Bank now faces its moment of
truth: how to finance the European Union's rumored bailout
Why was the bailout agreed to -- assuming that the
details can be worked out? Because of the threat to the
commercial banks of Northern Europe. A default would have
busted some big banks all over Europe.
The issue did not turn on the issue of whether to help
the national treasuries of the profligate PIIGS: Portugal,
Italy, Ireland, Greece, and Spain. The European Central
Bank does not answer to, or have any concern for, the
elected governments of the PIIG nations. It answers to,
and has a great deal of concern for, the large commercial
banks of Northern Europe. That is to say, it is a central
bank. It feathers the nests of large commercial banks
under its jurisdiction.
Whenever we hear "bailout," we should follow the
money. Where does the money wind up? Who is the final
The Federal Reserve System and the Treasury bailed out
AIG in 2008. Who were the beneficiaries? AIG was helped;
this kept it from a well-deserved bankruptcy. But AIG did
not keep most of the money. Who got the money? The banks
that were owed billions of dollars by AIG because of AIG's
issuing of derivatives. The bailout money was pure profit
for the recipient banks, which were paid off at face value
for their preposterously high-risk leveraged investments.
The losers are the rest of us.
The EU and ECB have decided to fund the spendthrift
nations that ran up debts to European banks. The threat of
default still hangs over the banks that made the stupid,
supposedly low-risk loans to the PIIGs.
The money on the line is huge:
trillions of euros in a wave of defaults in a worst-case scenario.
The euro is the common currency unit in Europe,
although not for the United Kingdom and Switzerland.
Speaking of the UK and Switzerland, their banks are
holding lots of IOUs from the PIIGs. According to one
estimate, the money owed to British banks is the equivalent
of 16% of the UK's entire gross domestic product. British
financial columnist Edmund Conway has estimated Great
Britain's exposure as close to $350 billion in euros. Not
to be outdone, Swiss banks are holding the bag for 21% of
These are big numbers. They are not limited to just
two nations. Loans to PIIGs are in the range of 30% of
France's GDP. Germany's banks: 19%. Netherlands: 29%.
Then there are the PIIG nations themselves. Their banks
are also holding bags. Portugal's banks: 24%. Ireland's
For a table on which nation's banks are
holding the bag for what percentage of its nation's entire
GDP, click here:
THE CARRY TRADE
The carry trade is a variation of "buy low and sell
high." It is "borrow low and lend high." This is possible
because of a specific central bank policy: to stimulate the
economy with low short-term rates. Borrowers can then lend
long: buy high-rate bonds. They borrow short and lend long.
How did these banks get themselves into such trouble?
Simple: the ECB funded it.
The spendthrift nations ran up large debts. They
borrowed more money than lenders -- banks -- thought was
reasonable at low interest rates. So, the lenders demanded
higher rates. In the case of Greece, rates were as much as
three percentage points above German bonds of the same maturity.
The banks bought these bonds and then used them as
collateral to get ECB loans. They paid the ECB 1% per
annum. That rate point spread is worth billions of euros in profits.
Now economic reality is breaking through. Greece may
default. The risk factor is high. The commercial bankers
assumed that there would never be a default. They assumed
that the spread between Greek bond rates and German bond
rates was there for no good reason other than to make them
richer. They assumed that the ECB would never allow the
Greek government to default. After all, if the ECB really
was convinced that Greek debt was too risky, the ECB would
not have accepted the Greek bonds as collateral for its 1% loans.
This is the carry trade in action. It always comes to
this: a day of reckoning, when the debt-ridden borrower
cannot pay its debts. No one ever expects any government
to pay off all of its debts. They do expect it to meet its
interest payments in full and on time.
The risk of default is real. While governments never
pay off their debts, they can walk away from them at any
time. No one can prosecute them. This is what economists
call an asymmetric relationship: in this case, between
sovereign national borrowers and fractionally reserved
lenders. Lots of leverage means that a single national
default can take down a lot of banks.
The ECB, having funded this inverted pyramid of debt,
now must take action to see that a default does not take
down any large banks. It will have to intervene to save
the big banks. It wants to avoid this.
The fractionally reserved dominoes could easily have
toppled. The ECB knows this. It subsidized these high-
risk loans at low rates in order to save the European
economy from the recession, but now the policy has
backfired. The banks gorged themselves with IOU's from
PIIG governments. Now what?
In an economic sense, the ECB has been bailing out the
PIIG governments all along. It allowed their bonds to be
used as collateral. Now the inverted debt pyramid is
larger than when the bailout process began. If it topples,
the devastation will be much worse.
In 1802, a free market economic theorist and
successful banker, Henry Thornton, described what the ECB
is facing today. A central bank will be called upon to
provide emergency loans to bail out insolvent banks, in
order to avoid a wave of defaults and busted banks. Two
generations later, Walter Bagehot named this phenomenon:
It is a shame that Thornton did not come up with this
phrase, for it was Thornton, more than any banker in
history, who was most closely associated with morals. He
was William Wilberforce's cousin and a founder of the
Clapham Sect of evangelical Protestants, which promoted
moral reform and the abolition of slavery. He was a gold
Until this year, the moral hazard argument had been
confined to a discussion of government and central bank
bailouts of profit-seeking banks and brokerage firms. Now,
however, there has been a quantum leap. The moral hazard
argument has been extended to nations -- indeed, to a
subcontinent: southern Europe. It has been called Club
Med, because of its club-like spending habits and the nations'
location on the Mediterranean or close to it (Portugal).
Ireland is included, leading some wag to call it Club O'Med.
The amount of money at stake is astronomical.
Europe's entire experiment in the European Union and the
common currency is now facing destruction. Salaried
bureaucrats must now make decisions that could saddle
taxpayers with new debts for a generation. The central
bankers must decide how much fiat money will be required to
paper over (digit-over) the crisis.
This crisis goes far beyond domestic politics and
monetary policy. Beginning with Jean Monnet before World
War I, there has been a messianic push for a United Europe.
This goal has been a big part of the modern push toward
centralization and micro-management by governments.
The proponents of European union were relentless in
their efforts to move from a free trade zone (the matador's
red cape) to the creation of a new nation state (the sword
under the cape). As of December 1, 2009, they had
fulfilled their goal through the Lisbon Treaty. This had
to be substituted for a Constitution, which did not get
ratified by the voters of all the nations. There is now a
Then, without warning, the financial crisis has hit
this year. It is now apparent to everyone that the
recession has undermined the supposed guidelines for bank
capital and fiscal policy. No agency is enforcing high
bank capital requirements set by the Basel Accord I (1992).
No one is enforcing the less restrictive Basel II
guidelines (2004). No one is enforcing the low percentage
requirements set for national deficits in relation to GDP.
The only common agency of the New Europe that has the
authority to impose sanctions on the treasury departments
of the independent nations is the ECB. The central bank is
officially in control over monetary policy. It can legally
decide which banks and governments receive or do not
receive assistance in the form of newly created digital
money. It must back up any decisions made by the EU. It
holds the pursestrings.
The ECB still faces the threat of governments
defaulting on their debt. This was considered
inconceivable as recently as three months ago. The risk
factor has risen, as reflected in rising insurance rates
Any default could create a crisis for the commercial
banks in each nation. The major European nations are under
the ECB. Only Great Britain and Switzerland are outside
the euro zone, meaning outside the authority of the ECB.
So, a threat to any nation's commercial banks becomes a
threat to the euro zone as a whole. This means that the
ECB will have to take action, country by country to deal
with any domino effect of one or more national defaults.
The ECB must act on behalf of Europe as a whole, yet
it has no civil authority over the domestic policies of
individual member nations. It has only the power over the
monetary base that affects all of them. It holds the money
bag. Meanwhile, large commercial banks are holding bags
full of IOU's from struggling national governments.
The ECB must now use money as the only sanction
available within the euro zone that is a serious threat to
member national governments. There is no way that NATO
will be used to take over bankrupt member states. There is
no agency with police power that can enforce a decision by
any court to require member states to honor their IOU's.
An agency without any guns has become the agency with
the only available sanction: butter. It can intervene and
work out an arrangement by which technically bankrupt O'Med
national governments can preserve the legal facade that
they are solvent. The game of deceiving investors can continue.
The investors are the best and the brightest bankers
in Europe. They decided that there can be no default by a
member nation. What were they thinking of?
Maybe they thought that nations cannot default. That
was the standard textbook account in the good old days.
But, way back in the good old days (pre-2000), each
European nation had its own central bank. Not today.
Maybe they thought that the ECB would intervene in
order to prevent any default. A default could topple very
large banks all over Europe. That would force the ECB to
put the pieces back together. The ECB now has to face this
threat. Commercial bankers concluded that, in a showdown
between the ECB and a national treasury department, the ECB
would blink first and provide the government with newly created funds.
THE SHORT-TERM WAGES OF SIN
Let us review: "The wicked borroweth, and payeth not again."
Professor Philipp Bagus has written an enlightening
article on the threat to the euro. He identified the
origins of the euro carry-trade. He also identified the
political incentive to sin.
The incentives for irresponsible behavior for
these and other countries are clear. Why pay for
your expenditures by raising unpopular taxes? Why
not issue bonds that will be purchased by the
creation of new money, even if it finally
increases prices in the whole eurozone? Why not
externalize the costs of the government
expenditures that are so vital to securing political power?
When the New Europe's new central bank subsidized this
behavior, thereby providing huge profits to commercial
banks, sin increased. Economics teaches this: "When the
price falls, more is demanded." The price of fiscal
profligacy fell because of the policies of the ECB.
Greece got away with this. It will now get bailed out
by the ECB. This will send a message to voters and
politicians across Europe: "Gravy train!"
For the member states in the eurozone, the costs
of reckless fiscal behavior can also, to some
extent, be externalized. Any government whose
bonds are accepted as collateral by the ECB can
use this printing press to finance its
expenditures. The costs of this strategy are
partly externalized to other countries when the
newly created money bids up prices throughout the monetary union.
Each government has an incentive to accumulate
higher deficits than the rest of the eurozone,
because its costs can be externalized.
Consequently, in the Eurosystem there is a built-
in tendency toward continual losses in purchasing
power. This overexploitation may finally result
in the collapse of the euro.
To prevent such behavior, there must be negative
sanctions. There have been none. There have been
guidelines. But without negative sanctions, the guidelines
are enforced by a plea to act responsibly. This has been
about as effective as sex education in the tax-funded schools.
Such a regulation was installed for the European
Monetary Union. It is called the Stability and
Growth Pact, and it requires that each country's
annual budget deficit is below 3% and its gross
public debt not higher than 60% of its GDP.
Sanctions were defined to enforce these rules.
Yet the sanctions have never been enacted and the
pact is generally ignored. For 2010, all but one
member state is expected to have a budget deficit
higher than 3%; the general European debt ratio
is 88%. Germany, the main country that urged
these requirements, was among the first to refuse to fulfill them.
The ECB did not decide to let the Greek government go
without aid of any kind. That would have sent a message:
"No more Mr. Nice Guy." But the Greek government might
have defaulted. Greek voters would not have risen up to
demand that the government raise taxes and cut spending to
be able to pay foreign bankers.
If any other debt-laden government defaults, some
large commercial banks all over Europe will suffer huge
losses. Then the ECB will have to bail them out. So will
their own national governments.
For the first time in my lifetime, politicians in
Europe are having to consider the costs and benefits of
national default. The theology of the messianic welfare
state is being reconsidered. "A government need not
default" has always meant, "a government can stiff lenders
with fiat money." Today, that traditional avenue of
concealed default has been cut off in Western Europe. The
threat of real default has reappeared.
If the euro dies, the New Europe also dies.
That will be a funeral I hope to attend.