by Gary North
by Gary North
Recently by Gary North: Washington's Snowfall Yesterday Was Nothing Compared to Bernanke's On-Line Snow Job
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 of Greece.
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 beneficiary?
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 Switzerland's GDP.
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 banks: 34%. 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 must 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: moral hazard.
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 standard advocate.
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 new Europe.
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 purse strings.
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 against default.
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 façade 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.
February 17, 2010
Copyright © 2010 Gary North