Buying time on the tax-payer's dime
By now everybody has heard about the EU-IMF bail-out package, which evidently was sized to impress. All in all, the bail-out fund announced by the EU is valued at almost $1 trillion in tax payer funds, including guarantees (the whole package is a complex and complicated web of commitments). A massive transfer of wealth is underway. By necessity, the funding for this giant mother of all bail-outs must come from those in the euro area who produce wealth, so that those who have squandered wealth can be propped up.
The end result will be a further structural weakening of the euro area economies. Note also that the politicians have not asked the producers of wealth if they are giving permission for this cross-border theft. It has been presented as a fait accompli, and that's that. The Federal Reserve meanwhile has pledged to reopen the swap lines with European central banks that were employed in 'Crisis, Act 1' to relieve dollar funding pressures in the European banking system.
A recent sharp rise in LIBOR and OIS (overnight indexed swaps) spreads indicated that once again, banks in Europe have stopped trusting each other. This renewed rise in perceived counterparty risk was a direct result of European banks being large holders of 'PIIGS' debt, and was reflected in CDS on numerous euro area banks rising above the highs of 2008. This $1 trillion package is not counting the fact that the ECB has now relented on the issue of buying government debt of euro-area member nations directly.
Apparently, the German ECB board members were less than thrilled about the prospect of debt monetization, and so everybody was at pains to stress that these would be 'sterilized'. What we have here is obviously the European version of the Fed's collateral swaps of 2008.
The printing press is waiting in the wings
Let us briefly recall: in order to reliquefy the markets during the initial iteration of the crisis, the Fed instituted a program of exchanging 'liquid, safe assets' such as t-notes and t-bonds for 'illiquid and difficult to value assets', such as formerly AAA rated MBS that had turned into toxic waste without bids. This was done via the TSLF (term securities lending facility), which promptly cut the treasury holdings on the Fed's balance sheet in half. At the time I remarked that the US dollar's backing had come to resemble that of the Assignats of the French revolution. The Fed stressed back then (just as the ECB is doing now) that the reason for using these collateral swaps was that they didn't impinge on monetary policy, as no money printing would occur. It was all about shoring up the quality of bank balance sheets.
While the ECB's announced program is presented as something slightly different, it is in fact the very same thing in principle. The only way the ECB can 'sterilize' these interventions is if it sells as many securities as it buys under the program. Since the intent of the program is evidently to relieve banks from their current holdings of 'toxic sovereign waste', the only way this makes sense is if the ECB ultimately exchanges higher quality securities it currently holds for lower quality ones on the books of the euro area banks (i.e., sovereign PIIGS bonds, as well as bonds of suspect private issuers).
Now let us think back to the Fed's TSLF. Somehow, quite a few of those treasuries that were swapped out never seem to have made it back to the Fed. Instead, the Fed suddenly announced an outright quantitative easing program (less euphemistically known as 'money creation from thin air' or 'government debt monetization') that achieved exactly what the collateral swaps were designed to prevent: a giant inflation of the money supply. In the process, the Fed got to replenish its holding of treasury notes, while making it really easy for the US treasury to fund itself in spite of a vast increase in its fiscal deficit. Money TMS rose at an annualized rate of 15%, and the Fed's balance sheet exploded into the blue yonder, where it remains to this day.
This is why I conclude that the ECB's announcement to buy euro area government bonds amounts to the 'printing press waiting in the wings'. The ECB is about to stuff its balance sheet with what everybody knows is the debt of either utter deadbeats like Greece, or the debt of likely future deadbeats, i.e. the rest of the PIIGS, paper that has become a hot potato indeed. The sterilization effort then will reduce the amount of higher quality assets on its balance sheet. At the end of the day, it will find itself in the position the Fed found itself in in late 2008/early 2009. It will be unable to swap the toxic stuff back, because that would immediately undo the intended effect of the swaps, as the underlying solvency problems that have made certain sovereign debt toxic will likely remain unsolved. At the same time, it will then find it problematic to just continue to swap good assets for bad, since that would place it in the ridiculous situation of becoming a major central bank with a balance sheet that resembles a radioactive waste dump. So the next logical step will then be to emulate the Fed and begin outright monetization.
Of course we don't know for certain at this time if it will come to that. All we know for sure is that the bail-outs elsewhere (in the US and UK) have inexorably led to this outcome. Granted, the German board members will be miffed and likely voice their objections, as they have done already. For all its real and imagined faults, the post WW2 Germany has always been a fount of monetary rectitude – the trauma of the devastating Weimar inflation is deeply etched into the national psyche as something that must not be allowed to happen again. On the other hand, the inherently devaluation-friendly entire rest of the ECB board will be able to point to the fact that private credit growth in the euro area has collapsed, and urge the adoption of further Keynesian remedies (the Keynesian 'remedies' are fiscal spending and inflation – both are utterly ruinous for the economy, but a large contingent of economists in fealty to the State hold them to be good things, or at the very least 'necessary evils'). Lastly, even if the ECB strictly sterilizes all its government bond purchases, this activity will distort market prices – of course this is precisely the objective, but the economic effect will be a further misdirection of scarce resources.
Verbal attacks on 'speculators' reveal the politicians' and bureaucrats' disdain of the free market
Along with Mrs. Merkel declaring the European Union to be in battle with 'perfidious speculators', an entire smorgasboard of EU politicians and their bureaucratic lackeys have sounded the alarm over the impudence of financial market participants who dare to pay up for sovereign CDS and sell the bonds of fiscally unsound euro area nations. From French president Nicholas Sarkozy , to Greek prime minister Papandreou to Spain's prime minister Zapatero, to EU commission president Jose Barroso, to the internal market commissioner Michel Barnier (who like Sarkozy and Trichet, seems to be a typical product of the overbearing French State's bureaucrat factory), all 'vowed to fight speculators'.
A brief overview of Monday's press headlines shows that this is the tack the entire EU political class has decided to take in trying to sell its gigantic intervention to a reluctant public:
… and so on and so forth.
And there we naïvely thought the crisis was the fault of profligate and fibbing governments! It seems we were wrong – it's all the fault of some more or less mysterious 'speculators'.
Let me quote Barnier verbatim, as reported in the Wall Street Journal (link broke on August 5th 2010):
"We are ready to increase the sanctions against abnormal speculative action."
Abnormal speculative action? It simply leaves one speechless. One wonders though, do they like those speculators a tad better today?
5 year CDS on the major PIGS (sans Ireland) – today the market sold them vigorously in a first reaction to the bail-out announcement.
The Monday short squeeze in the SPX. Sometimes you just gotta love those speculators.
Those of you who have read my article on Hoover know that Hoover held the stock market in utter disdain. Throughout his presidency he blamed a shadowy Wall Street conspiracy for trying to destroy the country's economy and thwarting his valuable interventionist efforts. Politicians painting themselves to be in a heroic struggle with the markets, where 'evil speculators' are trying to undermine their well-meaning exertions, is a canard at least as old as the financial markets themselves. The reality is that economic dislocations, which are reflected in financial market dislocations, are invariably almost exclusively the work of the very governments shouting the loudest about the alleged misdeeds of investors whenever said investors are trying to save what they can.
As Ludwig von Mises writes in Human Action, chapter 18, 'Action in the Passing of Time', section 8, 'The Mobility of the Investor':
“Entrepreneurial profit and loss emanate from the dedication of factors of production to definite projects. Stock exchange speculation and analogous transactions outside the securities market determine on whom the incidence of these profits and losses shall fall. A tendency prevails to make a sharp distinction between such purely speculative ventures and genuinely sound investment. The distinction is one of degree only. There is no such thing as a non-speculative investment. In a changing economy action always involves speculation. Investments may be good or bad, but they are always speculative. A radical change in conditions may render bad even investments commonly considered perfectly safe. Stock speculation cannot undo past action and cannot change anything with regard to the limited convertibility of capital goods already in existence. What it can do is prevent additional investment in branches and enterprises in which, according to the opinion of the speculators, it would be misplaced. It points the specific way for a tendency, prevailing in the market economy, to expand profitable production ventures and to restrict the unprofitable. In this sense the stock exchange becomes simply "the market," the focal point of the market economy, the ultimate device to make the anticipated demand of the consumers supreme in the conduct of business.”
In other words, all entrepreneurial activity is in fact 'speculation'. If one regards the composition of profits reaped by entrepreneurs, if there were no entrepreneurial profit element – which can be said to be the result of 'correct speculation' – there would be no incentive to engage in the production of goods and services. If a putative entrepreneur were happy to just reap the interest on the capital he employs, he might as well offer it in the loanable funds market for the use of others. Wages he can earn elsewhere as well, by offering his labor to other entrepreneurs. So earning a wage and earning interest is not enough – there has to be a the possibility of reaping a speculative profit by producing what consumers want. The stock exchange in turn, as the venue where speculators express an opinion about various lines of business by driving up the prices of certain stocks while driving down those of others, renders valuable information about which lines of business are likely to be profitable (let us leave aside here for a moment that in an inflationary fiat money system, investment manias can distort these signals, just as inflation distorts other important market signals; in a truly free market, stock price signals would evidently be rather more reliable).
We can conclude that when politicians attack speculators, trying to scapegoat them for the messes they themselves have produced, they reveal an inherent disdain for free market processes.
One should therefore strongly guard against uncritically going along with such assertions.
On the road to perdition
As mentioned above, one immediate effect of these breathless bail-out announcements will be to buy the EU, and with it the euro, a little bit of time. To the extent that wealth is now transferred to prop up what are obviously unsound credits, the economies of the EU will suffer additional structural damage, on top of that already suffered over the past two years by the massive Keynesian government spending burden that has weighed down these economies in the wake of the initial crisis.
In short, there is absolutely no light at the end of the tunnel. It is probably pretty safe to assume that the countries on the receiving end of the bail-outs will end up not adhering to their austerity commitments, as that is politically extremely difficult. Wealth and resources are once again forcibly taken from where they are now profitably deployed to save bond holders who have taken undue risks. Once again a massive dose of interventionism is preferred over a free market solution and the liquidation of unsound investments. All of this has once more happened over the heads of those who are going to pay for it.
Obviously, there is a limit to these interventions. Once the destruction of wealth exceeds a certain threshold, further bail-outs will become impossible. Given that the burden on wealth producers is increasing ever more, we must expect economic growth to disappoint, which will make it all the more likely that the defaults will eventually escalate in spite of this massive bail-out (by the way, since the IMF is also forking over funds, tax payers of non-EU nations are likewise involuntarily involved in the exercise). Can the EU possibly pull off another bail-out if this one fails? The answer is clearly no. That will be impossible to finance, and what's more, it will invite a tax payer and voter revolt.
Incumbent European politicians are already facing electoral defeats – both Gordon Brown and Mrs. Merkel's CDU have just lost important elections (one national, one regional) over the weekend. This is the bearish social mood in action: it creates dissension and disharmony. 'Inclusionary' political projects such as the euro tend to lose more and more popular support, in accordance with Bob Prechter's socionomics theory.
The euro looks now very oversold and bearish speculative bets against it have become extremely one-sided, which normally results in at least short a term bounce. However, the long term forces arrayed against the euro are now formidable indeed. While the market's attention is currently still focused on the weakest links in the euro area, faith in the entire global monetary system could eventually be lost. After decades of 'papering over' every crisis with more and more debt and money from thin air, we seem to be coming ever closer to the moment where the greatest fiat money experiment in history finally fails and falls apart.
Charts: Bloomberg, stockcharts.com
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