Recently by Gary North: Europe’s Two Endgames
Ben Bernanke is in panic mode. The November 30 coordinated announcements of six central banks regarding their intervention into the currency markets was exactly that — coordinated.
As I shall argue, this was an action preliminary to (1) Angela Merkel’s December 2 speech to the German parliament, which is preliminary to (2) the next Eurozone summit, scheduled for the weekend of December 9, which is preliminary to (3) a coordinated violation of the two treaties that created the European Union, which is hoped will (4) pressure the European Central Bank to buy newly created Eurobonds issued illegally by the EU, in order to (5) raise enough euros fast enough to buy Italian government bonds before (6) the Italian government misses interest payments, which may (7) bankrupt the largest French banks, which could (8) trigger a worldwide financial panic.
In short, Bernanke and his peers are in a pre-panic panic.
DECIPHERING THE ANNOUNCEMENT
This was an announcement of a very specific kind. Ninety minutes before the American stock markets opened, the six central banks said that they would increase the availability of money.
The Bank of Canada, the Bank of England, the Bank of Japan, the European Central Bank, the Federal Reserve, and the Swiss National Bank are today announcing coordinated actions to enhance their capacity to provide liquidity support to the global financial system. The purpose of these actions is to ease strains in financial markets and thereby mitigate the effects of such strains on the supply of credit to households and businesses and so help foster economic activity.
In short, The FED assured us, they were acting on behalf of the best interests of common people around the world. They were doing this in the name of the People. “What’s good for the People is good for central bankers.”
The problem is, they were silent on why, exactly, the strains of the supply of credit was threatening the People. On November 29, the interest rate for 90-day U.S. Treasury bills was 0.01%, or one one-hundredth of a percent, which is the lowest it has been in history, basically. To be honest, I do not regard this as evidence of a strain in the financial markets.
This raises these questions: “Which financial markets? Paying what rates? Why?”
In the good old days, meaning earlier than November 30, “strain in the credit markets” meant a frantic rush by investors and speculators to purchase a financial asset. The asset’s price rises rapidly, which is what happens when there is greater demand than supply for any asset.
The U.S. dollar has been bumping around in relation to the euro all year. There has been no indication of a frantic rush to sell euros. On January 1, 2011, a euro bought $1.34. On November 29, a euro had fallen in price to $1.33. That was not what I would call a strain on the euro market. We are not talking even nickels and dimes here. We are talking pennies . . . in single digits.
So, the question arises: Why was it necessary for a coordinated intervention? The FED explained:
These central banks have agreed to lower the pricing on the existing temporary U.S. dollar liquidity swap arrangements by 50 basis points so that the new rate will be the U.S. dollar overnight index swap (OIS) rate plus 50 basis points. This pricing will be applied to all operations conducted from December 5, 2011. The authorization of these swap arrangements has been extended to February 1, 2013. In addition, the Bank of England, the Bank of Japan, the European Central Bank, and the Swiss National Bank will continue to offer three-month tenders until further notice.
This is central bank gibberish. It refers to the practice of lending U.S. dollars for a period of time. These are central bank loans to other central banks. They are called central bank liquidity swaps. For a description, see Wikipedia. Say that one central bank needs dollars. It can swap its assets for dollar-denominated assets for a fixed period of time. In this case, the deadline is February 1, 2013.
The five other central banks promised to supply liquidity, meaning their own currencies.
As a contingency measure, these central banks have also agreed to establish temporary bilateral liquidity swap arrangements so that liquidity can be provided in each jurisdiction in any of their currencies should market conditions so warrant. At present, there is no need to offer liquidity in non-domestic currencies other than the U.S. dollar, but the central banks judge it prudent to make the necessary arrangements so that liquidity support operations could be put into place quickly should the need arise. These swap lines are authorized through February 1, 2013. It can therefore supply dollars to those who demand them.
So, the problem is the dollar. Better put, it may soon be the dollar. But, just in case, the central banks are willing to inflate.
At this point, I can imagine an exchange between a confused caller and some call-in satellite radio investment show.
But won’t the free market do this? “Yes, but at a higher price.”
So, the coordinated action was a move to keep down the price of the dollar. “You’ve got it, Sherlock.”
So, the other five banks are working with the Federal Reserve to keep the dollar low, which will reduce their nations’ exports to America. “That’s one effect.”
But that means the central banks are acting to hurt their own export markets. “That is one effect.”
But central bankers never do this. “This time, they are.”
Why? “Because they are scared out of their wits.”
To get some indication of what the coordinated action is intended to accomplish, pay attention to this.
In addition, as a contingency measure, the Federal Open Market Committee has agreed to establish similar temporary swap arrangements with these five central banks to provide liquidity in any of their currencies if necessary. Further details on the revised arrangements will be available shortly.
So, the FED thinks there is a chance that there will be an increase in demand for dollars in other currencies: “to provide liquidity in any of their currencies if necessary.” So, more than one of them are afraid of a panic-driven sell-off of their currencies.
Are they all equally at risk? No. There has to be one targeted bank: the central bank of the currency that is being dumped by investors in order to buy any of the others. Which might that be?
It is obvious: the European Central Bank.
But the euro has been stable in relation to the dollar all year. It is obvious that Bernanke and five other central bankers think that this rosy scenario is about to end.
U.S. financial institutions currently do not face difficulty obtaining liquidity in short-term funding markets. However, were conditions to deteriorate, the Federal Reserve has a range of tools available to provide an effective liquidity backstop for such institutions and is prepared to use these tools as needed to support financial stability and to promote the extension of credit to U.S. households and businesses.
The FED said that U.S. financial institutions are not having problems getting access to dollars. Furthermore, the FED “has a range of tools available to provide an effective liquidity backstop for such institutions.” Then why the swaps? Why would five other central banks join in? Why should they need to worry about “such institutions”?
Simple: the central bankers are not worried about U.S. financial institutions. They are worried about their own financial institutions. They have good cause to be worried.
FRANCE’S BIG BANKS
With a useful interactive graph in the New York Times, we can see which nations owe how much money to which other nations’ commercial banks.
The chart reveals something ominous. French banks are sitting on top of a mountain of Italian bonds. What if Italy decides to create what I have elsewhere called an “Iceland event”? It could be a disaster!
Europe will then have French fried banks. Then the question arises: What will Sarkozy do? How will the French government get the money it needs to bail out its now-insolvent big banks? Who will lend it this money?
The money needed will be euros. But, under the present laws governing the European Union, the ECB is not allowed to buy bonds of nations that are considered poor credit risks. France will be a bad credit risk if Italy skips interest payments, let alone defaults.
Then what is the FED’s problem? This: if Merkel does not get her government to accept instant inflation by the ECB, but without a revision of the Maastricht and Lisbon treaties, then she will go into the December 9 summit as a barrier to a quick decision by the ECB. The summit will be stuck.
The threat of Italy’s default is imminent. If the ECB does not act, and act fast, then the Eurozone will be seen as approaching a break-up. This means the euro may not survive. That fear may trigger a run on the euro: a mad dash to sell it and buy U.S. dollars. If dollars are not available at a price people are willing to pay, then there will be a rush to buy other currencies.
This is the much-feared, long-denied domino effect. The orders to sell euros are placed by people with big money: hedge funds. They want instant conversion. They will also start looking for safe-haven banks located outside the Eurozone. They will fear a Lehman event. This is what an Iceland event can become if Italy defaults. It owes too much money.
At that point, the ECB will be pressured to intervene to prop up the euro. Question: Intervene with what? With U.S. dollars. Where will it get these dollars? From the FED.
This is what the coordinated announcement was designed to forestall. This is the “bazooka.”
What is the bazooka? It was the word used by then-Secretary of the Treasury Hank Paulson to describe his promise that the Treasury would provide funding for the two visibly tottering, over-leveraged mortgage companies, Fannie Mae and Freddie Mac. He told Congress: “If you’ve got a squirt gun in your pocket, you may have to take it out. If you’ve got a bazooka and people know you’ve got it, you may not have to take it out.” This has been identified as one of the 21 dumbest business moments in 2008. Two months later, both outfits went bust, and Paulson, on his own authority, nationalized them. The taxpayers picked up the tab. Michael Pento commented on this on November 14.
But years after Secretary Paulson fired his bazooka, those formerly thought of as “safe” investments are now trading at just pennies a share. And just last week the government — or more appropriately the taxpayer — was forced to throw an additional $7.8 billion at the GSEs for the last quarter’s losses. That was on top of the $169 billion they have already spent to rescue the black holes known as Fannie and Freddie since 2008.
Pento then commented on the newly installed head of the ECB: “Similarly, Draghi now believes that the problem with European debt is fear, not one of insolvency.”
And just like Hank, Mario will soon learn that offering to purchase an unlimited amount of Italian debt does nothing in the way of bringing down the debt to GDP ratio. In fact, it has the exact opposite effect. It encourages more profligate spending, just as it also lowers the growth of the economy by creating inflation. What’s even worse is that yields on Italian debt will reach much higher levels in the longer term. That’s because the purchasers of sovereign debt have now become aware that their principal will be repaid with a rapidly depreciating currency. Therefore, the yield they will require in the future must reflect the decision to use inflation as a means of paying off debt.
This is the first bazooka. The joint announcement of the six central banks is the second. This one tells the world that any rush out of euros into dollars will take place in an orderly way.
A PANIC-DRIVEN SELL-OFF
I assume that Prof. Bernanke understands the #1 principle of chapter 1 of any college-level economics 1 textbook: “When the price of any scarce resource falls, more is demanded (other things remaining equal).” This is described graphically in the famous intersecting S/Q supply and demand curves.
The economist assumes that the reason why demand increases faster than supply does is because speculators believe that the price of an asset will rise. So, they buy it now. In the case of currencies, they sell one and buy the other.
Why would speculators buy dollars and sell euros? Because they fear a major event that will threaten the euro as a currency. So far, the price of dollars in euros has not revealed any such imminent fear.
It is clear that the central bankers think this lull in the storm is unlikely to last much longer. So, they hauled out the bazooka.
What are they aiming at? They did not say. We can figure it out.
TIMING IS EVERYTHING
If French banks lose the value of Italy’s bonds on their balance sheets, some of them will face bank runs. This could easily cause a system-wide banking panic in France. That panic could spread to other nations’ commercial banks.
This will not be allowed by the Powers That Be. They will find some loophole to bail out the banks. But they would prefer to implement it soon, before the dominoes start falling.
Strategically, the public support of Italy is wiser. The Powers That Be don’t want to face an Iceland event. At that point, they would have to save France’s big banks. But the Powers That Be are the big banks. There will be panic, bank to bank, national banking system to national banking system. They want to forestall this.
The first bazooka — the ECB saving Italy — needs a legal cover. There has to be an annulment of the treaties. The ECB will be hesitant to fire the bazooka if it is not given authorization.
What if it isn’t? What if the crisis hits Italy before the annulment can be codified by some cooperative announcement by the summit — an announcement that the members can get their governments back home to agree on?
That’s where the second bazooka comes in. The FED will supply dollars to the ECB, which can then sell them to investors fleeing the euro.
Back to economics 1. If you can see that the supply of any asset will run out, and there is a rush to buy, it will do no good for the sellers to promise more of the sought-after asset. They will not be believed. The low price subsidizes skeptics to buy even more. At a lower price, more is demanded.
So, the central bankers have to hope that there will not be a panic run out of the euro into the dollar. They are buying time. They have a deadline: February, 2013. So, they think that the panic will be short-lived. A show of force — a bazooka — may cut it off before it begins.
Note: it didn’t work for Paulson.
They must assume that a panic will force the hand of the ECB to inflate and buy either Italian bonds (early) or the debt of the French government (late), which will lend money to the largest French banks. The second bazooka is supposed to lend credibility to the first one: the one the ECB could use to save Italy from default. The ECB’s managers at present are afraid to invoke it. “We are not going to use it.”
If the ECB fails to act fast enough, Italy could cease making payments. A run on large French banks could begin. That will force the hand of the ECB. The central banks have handed the ECB lots of bazooka ammunition.
Bernanke and his peers are in panic mode. They are taking steps to deal with a run out of French banks and maybe out of the euro. They are in effect subsidizing this run, assuming that the ECB sells dollars to all buyers who bid. I think the goal is to sell to big banks only — those being hit by runs. They will do this because they don’t think the panic will last beyond January 2013.
We shall see how much longer Italy continues to make its interest payments. Long-term, Italy will default. There will be an Iceland event. I think there will be more than one.
December 2, 2011
Copyright © 2011 Gary North