Quarantining the Spanish Flu

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by Gary North Tea Party Economist

Recently by Gary North: Detours on the Road to Freedom: Where Milton Friedman Went Wrong

     

The Greek crisis was merely the warm-up act for the main show: the default of Spain and its much-denied departure from the euro.

That departure will leave holders of Spanish bonds with IOUs in euros that will be paid interest in pesetas.

These bond-holders include French banks, German banks, and assorted pension funds. The owners of those institutions will take significant hits on their net worth.

Mario Draghi, the head of the European Central Bank, bellied up to the bar on Thursday, July 26. “Within our mandate, the ECB is ready to do whatever it takes to preserve the euro. And believe me, it will be enough.”

He said this without clearing it with senior representatives of the ECB. They had never heard anything about a new policy. He made the statement at an informal meeting: Prince Charles, Prime Minister David Cameron, and other biggies the night before the Olympics opened. It was an off-the-cuff statement. It got worldwide coverage.

Investors all over the world believed him the next day. Stock markets soared, and the rate of interest on Spain’s 10-year bond fell from 7.6% to 6.7% in one day. Spain’s stock market rose by 5%.

But he must now deliver the goods. The goods are euros. He has to be able to provide enough money to the government of Spain to cover the massive deficits that are expected.

By Friday, there was talk of a plan to buy the bonds issued by Mediterranean PIIGS in the secondary market. Why there? To get around rules against buying them directly from the governments. The effects would be the same.

Here is reality: Draghi had no plan. The ECB is now scrambling to cobble together something. The four northern members are opposed: Germany, Netherlands, Finland, and Belgium.

This could split the ECB. If the PIIGS have the votes, the north has the capital. They can quit at any time. But, so far, they have merely mumbled their opposition. Grousing is not organized opposition.

It is turning out exactly as the critics predicted 15 years ago. The PIIGS have the votes. They will vote to inflate. Draghi, an Italian, is on their side.

HOW MUCH INFLATING?

In England, Ambrose Evans-Pritchard is the most determined defender of monetary inflation in the British financial community. He has been calling for years for a central bank program of monetary expansion. The ECB never inflates fast enough, high enough, or long enough to satisfy him.

He believes, as do most other commentators, that a quarter-point cut in the overnight inter-bank borrowing rate is not going to solve anything. He is correct. Banks are not lending. Excess reserves sop up monetary base inflation.

Also useless will be any limited expansion of purchases of government bonds, meaning PIIGS bonds. The time has come, he insists, for decisive action on the part of the ECB.

He sees matters, as do most of his peers, in terms of a battle between Germany’s Angela Merkel and Draghi. Merkel keeps saying, “Thus far, and no farther,” the Queen Canute of European policy-makers. He insists that Germany must now sit down, shut up, and let the ECB start cranking out euros like there is no tomorrow, which Evans-Pritchard thinks may be the case.

Germany must “let the ECB step up to its responsibility as a global central bank after two years of ideological posturing.” What will this involve? It must “take all risk of sovereign default in Spain and Italy off the table.” Really? And how can it do this? Inflate. This it can do “easily enough once it stops playing politics and obeys the ‘financial stability’ clause (Article 127) of the Lisbon Treaty.”

In short, it’s a showdown. The PIIGS’ representatives at the ECB must act. The question hinges on this:

That is to say, whether Latin states are willing to mobilize their majority power on the ECB’s council to force a change in policy over German protest, or lamely let themselves be picked off one by one in serial disasters like the death of the Gold Standard in 1931.

I see. Force a protest. Tell Germany to shape up or ship out.

But Mrs. Merkel can in fact ship out. She can take her stainless steel, high-tolerance, precision-ground German marbles and go home. She can take Germany out of the eurozone. She would have the backing of a majority of German voters.

She has resisted. But she has not been told by the ECB to sit down and shut up.

If Germany leaves, where will the PIIGS get the huge bailouts that they need, one by one? From the IMF? Hardly. The head of the IMF has said that the euro crisis has to be solved within three months. That was in mid-June.

Evans-Pritchard has listed the threats. Spain and Italy are facing a “full-blown debt debacle.” Meanwhile, China, India and Brazil are in the grip of a broken credit cycle. The USA is “on the cusp of a fresh recession.” The fiscal cliff will make it worse. He thinks the world will move into a downward spin like that of 2008.

He is not alone. The head of the IMF’s European Department and mission chief for the euro area has issued a clear warning.

The critical stage is indicated by the clear signs of very high levels of stress in a number of financial markets. Risk premia have recently reached a record euro area high in some countries, especially Spain and Italy. This applies to sovereigns as well as to corporate and household borrowers. This tells us that the adverse links between sovereigns, banks, and the real economy are stronger than ever. As a consequence, financial markets are increasingly fragmented across member countries. In other words, borrowing costs are very high for some countries, but at record lows for others, because capital within the euro area is moving away from the Southern periphery countries to safer havens in Northern Europe.

These developments are not consistent with a properly functioning economic union. They imply a breakdown in the monetary transmission mechanism. The common monetary policy is not working the way it was intended.

What does he have in mind? Simple: larger government deficits and quantitative easing by the central bank.

The common monetary policy in the euro area should stay accommodative for a longer period. There is room to reduce policy rates a little bit more. The European Central Bank should, in our view, consider more unconventional measures (for instance, quantitative easing) to support financial markets in countries undergoing severe stress. Demand can also be supported by fiscal policy. It’s true that fiscal adjustment is inevitable in many countries facing high deficit and debt levels. But in countries with less pressure, the pace of fiscal adjustment is appropriately more gradual.

This is what all Keynesians call for. It is what politicians and voters also want.

In Spain, unemployment is at least 24% overall, and over 50% for young adults. The recession is widely expected to drag on until 2014.

German political leaders have said they will not accept a common Eurobond system. They have drawn a line in the sand. If Merkel crosses this line, she and her party will face a revolt. She has a coalition government. Her partner party will not back her, its leader has said.

There is a rescue fund, Evans-Pritchard says: the ESM. But the ECB has already issued a legal opinion: it will require a new European Union treaty to raise the ESM’s authority before letting it issue more than 500bn. There is no way that the German Parliament will accept this, and there must be unanimity for a new treaty.

The ECB issued a trillion euros to bail out banks earlier this year. Nevertheless, Spain’s banks are still going under. The cause is declining sovereign debt value. He writes:

The ECB’s earlier purchases of Greek, Irish, Portuguese, Spanish and Italian bonds were a textbook case how not to proceed, violating the “Powell Doctrine” of overwhelming force: too timid to lower yields for long or reduce default risk, yet enough to push private investors down the creditor ladder.

The ECB announced that it will get paid back first if there is a default by Italy or Spain. This assumes that there is any value at all remaining in the bonds. This pushes private investors down the ladder. This raises the risk of loss, which raises interest rates. Capital flight out of Spain’s banks is in full force today. Credit Suisse Bank has estimated that Spain’s banks are losing 50bn a month. That is 5% of Spain’s GDP.

If you were living in Spain, you could call your bank and have euros transferred to a German bank. You would pay the German bank a fee for the privilege. The flood of euros into German institutions is so huge that they are charging a fee: negative interest. This is smart investing. Italians and Spaniards and Greeks are buying bank safety. If these nations go off the euro, their citizens who get out while the getting is good will wind up owning a valuable currency. Their home currencies will fall by 25% or more overnight.

So, how big a bailout will be required. Evans-Pritchard estimates 400bn. Why so high? Because private investing will stop overnight for Italy. Nomura Securities has estimated that it will take at least 1.1 trillion over three years to rescue Spain and Italy.

The money is not there. It cannot be raised in private markets. That leaves the ECB.

How soon will the ECB have to put up the money? Some experts say within weeks. The optimists say by late December. His conclusion: “Only the ECB has the firepower and speed to halt a catastrophic replay of 1931 before the year is out.”

LOSING ITS POLITICAL HAMMER

One problem that the ECB faces is this. In the past, its refusal to buy a government’s bonds has been a major hammer. It could veto national government policies. It refused to buy Italian bonds when Berlusconi’s government refused to impose spending cuts. That forced him to resign. More recently, it vetoed Spain’s idea to capitalize a failing bank by making available government bonds.

The bank then headed toward imminent bankruptcy. Then the weekend summit in late June provided a bailout of that bank. But it also transferred to the ECB the power to regulate national banks.

So, there has been a trade-off. The ECB has the power to control national economic policies by the threat of not buying a nation’s bonds, or by not accepting the bonds as collateral suitable for the commercial banks that get cheap ECB loans. But if it openly goes to another round of inflation to bail out Italy and Spain, it forfeits its political clout. In other words, the ECB can either save the governments or control the governments, but it is hard to see how it can do both.

THE DESPERATION OF NORTHERN EUROPEAN BANKERS

There is no question regarding which institutions will be hit hardest by a default by Italy and Spain: the commercial banks of Northern Europe. The bankers assumed that PIIGS bonds were almost as safe as German bonds. They loaded up, in order to get higher interest rates. Now they are sitting on top of hundreds of billions of euros in face value IOUs from Club Med PIIGS. The looming default will push them close to bankruptcy. They will have to write down PIIGS bonds.

Add to this the European recession. The governments will be hit by increasing demand for unemployment payments. Revenues will fall. The deficits will once again move higher across Europe in all but the safest countries. They want an ECB bailout of PIIGS’ governments. They want the flow of interest payments from the governments. But they also want money in reserve domestically in order to bail them out next time. Any depletion of domestic government funds today means less for them as direct bailouts in the recession.

The money that goes to PIIGS governments is diluted. It does not all go to making interest payments. Domestic big bank bailouts will go to commercial banks. So, the money being sent to PIIGS by governments is only indirect money. It will help delay a default, but it also absorbs capital.

This is why bankers prefer the ECB to put up the money. The domestic governments in the North can keep their credit lines open to big banks, so that the governments can provide money to save the big banks.

There is rationality undergirding this strange flow of funds. The source of the bank bailout money will be the northern European banking system. But bankers want middlemen to handle the money and offer IOUs: politicians.

Bankers don’t trust each other to pay off in a time of real crisis. They think that governments in the North will be able to raise loans from bankers and the public. The “full faith and credit” of the government is trusted by bankers far more than their peers’ full faith and credit.

CONCLUSION

The Establishment in Europe, like the Establishment in the United States, has one economic faith: the full faith and credit of central banks.

The European Establishment is desperate to get a new fiscal union, but it cannot do this without violating the Maastricht treaty, which created the European Union.

The voters are moving toward nationalism and against the European Union. There is no way that the Establishment can get over half of the voters in all 17 eurozone nations to vote in favor of fiscal union.

The ECB is the only European institution that can conceivably bail out the PIIGS. It can do this only by debasing the euro. Inflation is the only option. There will be no fiscal union, except one that is imposed illegally. In any case, it cannot come before the end of the year. It is unlikely to come by the end of 2013. But the eurozone’s banking system does not have until the end of the year. It must have a bailout now – one large enough to carry the banks and governments of Spain and Italy through the recession.

There must be a cessation of the flow of funds out of Italian and Spanish banks into Germany. But no one knows how to mandate this legally. On the other hand, if it is not stopped, the PIIGS banks will run out of liquid assets to sell in order to raise the euros to replace the withdrawn funds.

The trusting PIIGS citizens who have not yet sent their funds to German banks will wish they had by the end of 2013. All it will cost them are the higher interest rates of high-risk banks. Better to preserve capital than lose it. Better to buy a currency that will appreciate in relation to pesetas, lira, and drachmas.

Gary North [send him mail] is the author of Mises on Money. Visit http://www.garynorth.com. He is also the author of a free 31-volume series, An Economic Commentary on the Bible.

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