German Pope, Italian Central Banker

by Gary North

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Conclusion: Europe is in bad shape. This is hedge fund manager Kyle Bass's assessment of the situation in Europe. He stated this in a rousing interview on the BBC's TV network. Here is the segment.

He made two crucial points – points that stock market investors are ignoring. First, over the last nine years, there has been an increase of world debt from $80 trillion to $210 trillion. These numbers are staggering. Global debt over the last nine years has grown at 12% per year, while GDP has grown at 4% per year.

While he did not verbally spell out the conclusion for the interviewer, it is this: when credit must grow by 12% per year in order to produce 4% GDP growth, at some point there will not be enough GDP to supply sufficient credit.

It is time once again to quote economist Herb Stein: "When something cannot go on forever, it has a tendency to stop."

Bass had a great metaphor: the PIIGS have "sailed into a zone of insolvency."

Second, he explained, the sovereign debts in Europe will be written down. There is no other solution.

The airhead interviewer with the Oxbridge accent seemed to be doing a college-skit imitation of Emma Thompson. She challenged him. What about Germany? Can't Germany continue to fund Europe's "southern neighbors"? Germany has "the earning power." (Note: this means German taxpayers.)

Bass responded instantly. First, the German court has determined that any further bailouts are unconstitutional. Second, Greece – and, by implication, the other "southern neighbors" – will spend every euro it borrows from Germany and then come back for more, threatening a default if its demands are not met – exactly what it has done so far. This goes on until the write-down takes place, which it will.

There are two ways of looking at this: the Bass way and the Bass-ackwards way. The airhead chose the latter.

He draws conclusions from the numbers. No one in the mainstream media and mainstream investment fund world seems to be willing to do this. They talk and invest as if the process can go on forever. Debts need not be repaid. This is ancient Keynesian dogma that goes back to the New Deal. "We owe it to ourselves." On the contrary, specific borrowers owe it to specific creditors. At some point, the specific borrowers are going to default, leaving specific creditors with huge losses.

How huge?

THREE TRILLION EUROS

Charles Hugh Smith agrees with Bass. He says that there will have to be a write-down. By "write-down" he means write-off. He estimates the losses at three trillion euros.

Someone will have to take the hit. The great political debate in Europe today is over who will take this hit, and how soon.

It will be investors. But, to forestall the day of reckoning, Europe's politicians pretend that taxpayers' credit lines can be used by superficially solvent Northern European governments in order to borrow more money from creditors in order to lend to the PIIGS's governments, so that the PIIGS's governments can continue to (1) delay real austerity measures, i.e., massive layoffs of government workers and massive cuts in welfare payments, and (2) make payments on what they owe to investors, mainly banks.

Smith admits that three trillion euros is a guess. Nobody knows how much bad sovereign debt there is, so we must start somewhere. In a world of $210 trillion worth of debt, his estimate seems reasonable to me.

Let's start with the most basic fact about all this uncollectible, impaired, bad debt: every euro of debt is somebody else's asset. Wipe out the debt and you wipe out the asset. That's why there's no willingness to accept the writedown of debt: somebody somewhere has to suck up 3 trillion euros of loss.

This is the source of Europe's present policy of "kick the can," or more accurately, "kick the can with press releases and summits." If there were a pain-free solution, it would have been implemented long ago.

There is no way Europe is going to "grow its way out of this debt." How much of the eurozone's "growth" was the result of rampant malinvestment and risky borrowing? More than anyone dares admit. It won't take austerity to crash the euroland economy, all it will take is turning off the debt spigot.

Europe is facing the problem that Bass raised when he spoke of 12% per year increases of credit and 4% increases per year of GDP. There is no way to grow your way out of this. This is not just Europe's problem. It is the world's problem. But Europe is facing it now because the debts are coming due now. They must be rolled over. Creditors must agree to re-lend. But why should they?

The Establishment world of crony capitalism speaks of "re-structuring" the debt. What does this mean? Smith does not pull any punches.

"Restructuring" is a code word for writeoffs. Here, let me "restructure" the euro bond you bought at a 4% coupon yield. Now you're going to get 2%, and you're going to like it. Bang, your bond just lost half its market value, but everyone gets to keep it on the books at full value. Nice, until you have to sell it to raise cash. Oops, the euro has slipped in value so you lost more than 50%.

The banks keep the assets on the books at face value. The underlying value is down by at least 50% for Greek bonds. The European experts admit this. (Why the debt is worth that high a percentage is beyond me.) The Greeks are going to default, one way or another.

Who will take the hit? Smith writes: ""There's a fundamental truth that everyone has to understand: what the government spends, the public will pay for sooner or later, whether in taxes or inflation or having their debt defaulted on." This is reality. But it's not precise enough.

WHO IS THE PUBLIC?

If there is hyperinflation – price inflation above 30% per year for a decade or more – the public that takes the hit will be almost everyone inside the eurocurrency zone. There will be almost universal hardship.

On the other hand, if monetary inflation ceases for more than a few months, there will be a depression. Big banks will fail. Their depositors will lose everything. The money supply will shrink. It will be 1930-38 all over again.

Central bankers do not allow such things. The European Central Bank will try to walk the tightrope, just as the national central banks in Europe did after World War II. The ECB will pursue boom-bust policies, refusing to capitulate either to a Great Depression or hyperinflation.

But how can it walk this tightrope? The losses will be huge for large banks. The politicians will try to transfer the cost of bailing out Europe's banks to Germany. But the debts are too large.

The politicians will try to do what the BBC interviewer suggested: get northern Europe to fund a never-ending series of rollover loans to the PIIGS. This is standard wisdom. But the numbers are too large.

Then what will happen? Europe will adopt the American solution. The ECB will not allow large banks to default. It will inflate to buy the bad assets or else buy the bonds of the governments, so they can make payments. Then the bankers will put this money into excess reserves. New lending to businesses will cease. The West will go into permanent recession or no-growth stasis. The governments will absorb an ever-larger percentage of the region's capital: bond sales. Private firms will not be able to borrow at low rates. Capital development will crease.

Europe is more dependent on bank financing than the USA is. Europe is therefore headed for a long era of very low growth or else recession. The governments will suck up the credit because they must keep the payments system alive. The banks will not be allowed to collapse. Neither will the money supply.

The ECB does not want hyperinflation or a Great Depression. The alternative is the transfer of capital to PIIGS on a long-term basis. The states will absorb the savings of the region.

MORAL HAZARD

Smith describes what has been done to voters by the bankers by way of the politicians. There is nothing new here. It goes back to Walter Bagehot's description of "moral hazard" in the mid-nineteenth century.

Those who made the risky bets have diverted the risk to others: taxpayers or the general public who holds currency. The gains from the bets are private, and theirs to keep, but all the losses are distributed to the public via government bailouts or money-printing. The first shifts the losses to the taxpayer, and the second shifts the losses to everyone holding the currency being devalued.

This has worked because all of the governments' bills have not come due. The rollovers have been sequential. The big debtor states – Spain and Italy – have not yet reached the edge of the abyss that Greece is staring at. But they are getting close.

Smith comments on the winners and the losers in all this.

Not only has the risk been palmed off onto unsuspecting chumps, the returns have been concentrated into the few hands that control the big bets. This is the ideal setup for the stupendous gains and zero risk that characterize crony-capitalism: make the big bets with leverage and borrowed money, and skim the vast profits. Then when the bets sour, demand a bailout from the Central State, the ECB, the Fed, etc., which promptly socializes the losses and distributes them over the entire populace of taxpayers or holders of currency.

Smith says that the only thing that can stop this is the rebellion of the new serfs: voters.

It works beautifully until the debt-serfs rebel. The EU's politicos are begging to start the printing presses, as that is the only way they can retain their power in the face of the debt-serfs' revolt. But at least one populace of tax-serfs (Germany) is rebelling against sucking all the losses via a massive reduction of purchasing power.

But the debt-serfs do not see it. They cannot stop their governments. They are not united against the bailouts. Each new government pursues business as usual.

Typical is the "Occupy Wall Street" movement. They are mostly socialists and welfare statists. They want more regulation and higher taxes on the rich – the New Deal extended. This program has not reduced inequality since 1933. The protesters are not demonstrating in front of the regional branches of the Federal Reserve. They still have no idea of how central banking is at the center of the economy, and has been in the USA ever since it opened its doors for business in 1914.

Smith offers a solution.

Those who made the bets should rightly lose everything – yes, be wiped out. If risk and return are actually causally linked, then this is the only result of a big bet that sours: those who placed the bets should be wiped out. That includes money managers, bank honchos, bond-fund gurus, and everyone else who foolishly bought all this debt without investigating the risks.

But that means the big banks. If they fold, the entire monetary system goes into mass deflation – of money first, then prices. The world goes back to 1930-33. There is no way to avoid this, according to Keynesians, monetarists, supply-siders, and even Austrians. Here is where there is universal agreement. If the large banks go under, then the Great Depression returns. Then the governments that have bailed out the PIIGS go under, too.

The Austrians recommend this in order to get back to true pricing of capital. All other schools of economic opinion want to prevent this by means of central bank inflation. The Austrians say "let the sucker go down." Then the recovery will begin. First pain, then joy: like a woman in childbirth. Politically, this is an impossible marketing job. It will not be allowed to happen. Governments will bail out the big banks. They will borrow to do this. If this requires a violation of the European treaties, either the treaties will be changed by parliaments or else they will be ignored.

This is moral hazard in action. It never changes in principle. The numbers just get larger. Economic interdependence gets larger. The division of labor is extended. The system relies more and more on fiat money and bookkeeping deceptions.

WHAT FIREWALL?

Smith assumes some sort of firewall for the bankers and the voters. The loss should be contained.

Who should not suck a loss are those who did not stand to gain: the taxpayers and holders of the currency. To repeat: the most basic fact about all this uncollectible, impaired, bad debt is that every euro of debt is somebody else's asset. Wipe out the debt and you wipe out the asset.

This means the assets of the largest and most leveraged banks will be wiped out. Then the banks will be wiped out. They will fail. This means failure at the heart of the European economy. The crash will spread around the world. There is no firewall other than fiat money.

There is no way to avoid the 3 trillion in losses. The only question is who should absorb those losses: those who stood to gain, or the innocent chumps whose only crime was being a taxpayer or owner of euros? If there is any justice (or classical Capitalism) at all in Euroland, then those who made the bets and invested capital in the bets to reap a return are the ones who should absorb the losses.

All true. But the masses have their money in commercial banks, pension funds, and mortgaged homes. Monetary deflation will impoverish them. The masses are trapped, one way or another.

He says, "Life will go on if the banks are wiped out and closed, pension funds and insurance companies take losses, etc." In a world with an extended division of labor, which is also a world regulated from the top by bureaucrats, if the big banks really do go down, life may not go on for millions. The division of labor depends on the money economy. The money economy is leveraged at 40 to 1. What if the money supply falls by (say) a factor of 40? This is the curse of moral hazard.

Smith draws a conclusion.

If those who made the bets for their own private gain aren't forced to absorb the risk, then we don't live in either capitalism or democracy; we live in a financial-fascist tyranny.

But this is exactly where we live. That was my point back in February 2009.

CONCLUSION

Europe's game of kick the can will continue. The best summary of the outcome was made by a Spanish government worker on Sunday, November 20, the day of national elections. The socialists were thrown out of office. He said this: "We can choose the sauce they will cook us in, but we're still going to be cooked."

The whole urban world is in the same pot. We get our choice of sauce.

November 24, 2011

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 20-volume series, An Economic Commentary on the Bible.

Copyright © 2011 Gary North

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