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A crash dummy has some of the physical characteristics of a human being. It is used to test the safety of the interior of a car that has suffered a major accident. A pair of dummies are strapped into the front seat of a car that is on a track. Then the car is run into a wall at high speed. The engineers then examine what happened to the dummies. If the dummies had been human beings, would they have been killed? Dismembered?
But what if the dummies were in charge? What if they strapped the engineers into the car and ran the test?
This is what is happening in Europe today.
The dummies are the bankers. The engineers are the politicians and EU bureaucrats. The observers in the back seat are stock market investors.
To understand the nature of the car, the track, and the wall, view the comedy sketch of Australian comics Clark and Dawe. This will prepare you for what follows.
EVALUATING THE EXPERTS IN CHARGE
The Eurozone is coming unglued, piece by piece. A Greek debt default is looking more likely every day. Intrade, the gambling site, on October 10 rated at 46% the likelihood of a Greek default before midnight December 31.
The European experts in charge of big bank bailouts keep insisting that the problem is manageable. There will soon be some sort of program that will solve the problem. It is due out any day now. There are no details at present.
Furthermore, Angela Merkel will approve of it. The German Parliament will also approve it. A majority of German voters will not, but who cares about them? Surely not the People Who Really Count.
The problem with the European Party Line regarding Greek debt is that it never changes. Let us not forget the words of Joaquin Almunia in 2010. But, before we read his forecast in 2010, you should know that he was then the Commissioner for Economic and Monetary Affairs of the European Union. At the time, he posted this on his official website.
The EU is the world’s largest market and the euro a powerful asset in our competitive global economy. But in the face of 21st century challenges, securing sustainable growth for the future of Europe will depend on making the right policy choices today. As Commissioner for Economic and Monetary Affairs, it is my goal to ensure that sound policies for economic stability and dynamism and a smooth functioning Economic and Monetary Union continue to deliver prosperity for the 490 million citizens of the EU.
With this in mind, read his forecast in January 2010 at the famous Davos conference, an annual closed meeting attended by the world’s elite. He was speaking of the potential crisis in Greece.
We have no plan B plan A is on the table. Next week at the commission level we will adopt public recommendations for Greece and for other economies to adjust their imbalances.
The London Telegraph went on to report on the background of Almunia’s statement.
Mr Almunia said those recommendations would centre on the adjustment of the public deficit within the deadlines announced by the Greek government, as well as improvement in the functioning of the public sector, the budgetary process, the statistical system, pensions, and the health system.
“These adjustments are required to overcome the present situation of the Greek economy,” he said in an interview with Bloomberg TV at the World Economic Forum in Davos. He was insistent that Greece would not default, despite concerns over its debt mountain which have led to a series of downgrades by credit ratings agencies.
“No, Greece will not default. In the euro area, the default does not exist,” he said. He suggested there was no question that a bailout would be necessary because Greece was a member of the single currency, which afforded it more funding options than would be the case if it was not a member of the euro.
“Default does not exist.” Surely these words should be on a plaque on his desk, the way that Harry Truman’s “The buck stops here” plaque sat on Truman’s desk.
Mr. Almunia no longer holds the high position that he did in 2010. He was quietly shunted off to a new position. He is now the European Commissioner for Competition. He offers these inspirational words:
As regards state aid control, the most pressing issue is to manage the financial crisis and its impact, but I will also examine to what extent it is possible to streamline state aid control procedures.
What’s this? A financial crisis? You mean the event for which there was no Plan B in 2010 and no need for one? THAT financial crisis?
Juaquin Almunia is an engineer. He is surrounded by engineers. They are developing Plan C or is it Plan D? for the imminent default by the Greek government.
THE FIRST DOMINO
How much money are we talking about? The Greek government has about u20AC350 billion euros in outstanding debt, of which 75% is owned by investors outside of Greece. Most of these investors are commercial banks.
The question is this: Which banks? Weak banks. Banks that cannot afford to take a major “haircut” write-down of Greek bond value due to a default. These banks are mainly in Portugal, Italy, Ireland, and Spain. The media have not yet understood this. If they did, we would see headlines about the PIIS banks.
Banks in Europe provide about 70% of the financing of consumers and businesses. It’s about 40% in the United States. So, if banks in the PIIS nations stop lending, those domestic economies will take a hit. But these nations are the weakest in Europe.
This presents a problem: partial default by these nations or their banks. The comparative size of the inter-European debts of these nations dwarfs Greek debts. The New York Times ran a graph of this in mid-2010.
This is the domino problem. It threatens the European economy.
The clearest statement of the threat came last week from the head of the Bank of England, Mervin King. I have never seen anything this frank from a high official regarding the possibility of an economic collapse. “This is the most serious financial crisis we’ve seen at least since the 1930s, if not ever.” This was reported widely in the British press.
King is not alone. The financial media feature pessimists who think that Europe is at the edge of an abyss. I do not recall anything like this.
WHEN IRELAND DEFAULTS
John Mauldin wrote a very revealing first-hand account of discussions that he had with Irish officials. There is a real possibility that Ireland’s government will default on its debt to the IMF and the European Union.
Michael Lewis noted from his time in Ireland that the Irish seemingly went along the Irish government taking on the bank debt. The large majority were not aware of the nature of the impending crisis. In the last few years, that has changed. I have written extensively in the past about how the Irish have figured out they are taking on debt for banks that no government should have touched. It was just too much. It’s simple arithmetic: the Irish cannot repay that debt under the current terms (even after the ECB and Europe gave them lower interest rates in July) and ever hope to get out of debt in the next 30 years. They have consigned themselves and their children to decades of toil to pay back English and German and French banks (among others).
And that fact dawned upon them. They voted out the government that allowed the debt to be assumed. It was a clear message, but the government has not yet done anything to rid itself of the debt.
There are those like McWilliams who simply want to repudiate the debt. “It should never have been done, so we will not pay it.” He is not alone; that view is becoming increasingly mainstream now.
When you press politicians and establishment types (and I did) who are against unilaterally disavowing the debt, a strange thing happens. I kept asking, “But the voters seem to want to forego the debt. And the math suggests that Ireland can’t pay back these foreign bankers without great sacrifices.” At first, they would point out that Ireland is doing what needs to be done: cutting spending and payrolls. We are not Greece, they say; there is a need for “respectability.” But when pressed, they would come around to admitting that, “Yes, Ireland will get a haircut.” Everyone I met expected it to happen. The difference was the path to the haircut. But while the politics matter, the destination is the same.
Why complain this late in the game? Because the government lied about the arrangement until the final hours.
He was, indeed.
For two years, he had publicly started that Ireland would not need a bailout. He did so as late as mid-November, within days of the IMF/EU bailout.
The incumbent party fell within weeks at the election. Too late.
Or was it? For a sovereign nation, it is never too late.
There is no question in my mind what a future government is going to do. It is going to default. The voters will elect it to do this, and if it pussyfoots around, it will be replaced.
Greece will default. It will be the first of a row of dominoes to fall. When it gets away with it, voters in other nations will be alerted to the fact that defaulting to the EU, the IMF, and the ECB is cheaper than being saddled with a generation of debt and slow growth.
The voters can be fooled for a long time, but not forever.
Dexia Bank, an obscure Belgian bank, was nationalized over the weekend. It was leveraged 74 to one. To cover all losses, the size of which is not yet known, the governments of France, Belgium, and Luxembourg ponied up u20AC90 billion ($120 billion) in loan guarantees. (By the way, Belgium has not had an operational government for 17 months by far the longest period of no government in the history of parliamentary government.) This bailout was announced on Sunday, October 9.
Then an emergency weekend meeting of French and German leaders pledged that their nations will come up with a rescue plan for all European banks in November. They offered no details. European stock markets soared on Monday, as did American stock markets.
The crash dummies are still in charge in Europe. The engineers who have been strapped into the front seat. They turned to the observers in the back seat. “Everything is just fine.” The back seat dummies used their cell phones to call their brokers to buy shares.
The crash dummies have a fund with about u20AC440 billion euros in it. Well, not actually in it. It has the right to sell bonds to raise the money. It is called the European Financial Stability Stabilization Facility (EFSF). On its site, we read:
The European Financial Stability Facility (EFSF) was created by the euro area member states following the decisions taken May 9, 2010 within the framework of the Ecofin Council.
As part of the overall rescue package of u20AC750 billion, EFSF is able to issue bonds guaranteed by EAMS for up to u20AC440 billion for on-lending to EAMS in difficulty, subject to conditions negotiated with the European Commission in liaison with the European Central Bank and International Monetary Fund and to be approved by the Eurogroup.
So, in a major crisis, in which (say) 30 Dexia-size banks are going bust, the EFSF has the right to sell bonds to investors.
How will investors buy these bonds? They will call their banks and say, “I am withdrawing money from my account.” You can imagine how this will cheer the hearts of the bankers whose banks very large banks get the calls from rich depositors.
You call this a bank run. So do I. But the crash dummies call it Europe’s #1 weapon in the arsenal against a rolling wave of bank bankruptcies.
Remember: the dummies are the bankers. The engineers are the politicians and EU bureaucrats. The observers in the back seat are stock market investors.
The dummies are running the test. They have strapped the engineers into the car. The engineers see a tremendous future. They are Keynesians. They know the car is safe. The wall will miraculously drop into the floor just before the car would otherwise have hit it.
The dummies in America have signed credit default swaps to bail out the European dummies in case of sovereign debt defaults.