Quarantining the Spanish Flu
Tea Party Economist
by Gary North: Detours
on the Road to Freedom: Where Milton Friedman Went Wrong
The Greek crisis was merely the warm-up act for the main show: the
default of Spain and its much-denied departure from the euro.
will leave holders of Spanish bonds with IOUs in euros that will
be paid interest in pesetas.
include French banks, German banks, and assorted pension funds.
The owners of those institutions will take significant hits on their
the head of the European Central Bank, bellied up to the bar on
Thursday, July 26. "Within our mandate, the ECB is ready to do whatever
it takes to preserve the euro. And believe me, it will be enough."
He said this
without clearing it with senior representatives of the ECB. They
had never heard anything about a new policy. He made the statement
at an informal meeting: Prince Charles, Prime Minister David Cameron,
and other biggies the night before the Olympics opened. It was an
off-the-cuff statement. It got worldwide coverage.
all over the world believed him the next day. Stock markets soared,
and the rate of interest on Spain's 10-year bond fell from 7.6%
to 6.7% in one day. Spain's stock market rose by 5%.
But he must
now deliver the goods. The goods are euros. He has to be able to
provide enough money to the government of Spain to cover the massive
deficits that are expected.
there was talk of a plan to buy the bonds issued by Mediterranean
PIIGS in the secondary market. Why there? To get around rules against
buying them directly from the governments. The effects would be
is reality: Draghi had no plan. The ECB is now scrambling to
cobble together something. The four northern members are opposed:
Germany, Netherlands, Finland, and Belgium.
split the ECB. If the PIIGS have the votes, the north has the capital.
They can quit at any time. But, so far, they have merely mumbled
their opposition. Grousing is not organized opposition.
It is turning
out exactly as the critics predicted 15 years ago. The PIIGS have
the votes. They will vote to inflate. Draghi, an Italian, is on
Ambrose Evans-Pritchard is the most determined defender of monetary
inflation in the British financial community. He has been calling
for years for a central bank program of monetary expansion. The
ECB never inflates fast enough, high enough, or long enough to satisfy
as do most other commentators, that a quarter-point cut in the overnight
inter-bank borrowing rate is not going to solve anything. He is
correct. Banks are not lending. Excess reserves sop up monetary
will be any limited expansion of purchases of government bonds,
meaning PIIGS bonds. The time has come, he insists, for decisive
action on the part of the ECB.
He sees matters,
as do most of his peers, in terms of a battle between Germany's
Angela Merkel and Draghi. Merkel keeps saying, "Thus far, and no
farther," the Queen Canute of European policy-makers. He insists
that Germany must now sit down, shut up, and let the ECB start cranking
out euros like there is no tomorrow, which Evans-Pritchard thinks
may be the case.
"let the ECB step up to its responsibility as a global central bank
after two years of ideological posturing." What will this involve?
It must "take all risk of sovereign default in Spain and Italy off
the table." Really? And how can it do this? Inflate. This it can
do "easily enough once it stops playing politics and obeys the 'financial
stability' clause (Article 127) of the Lisbon Treaty."
it's a showdown. The PIIGS' representatives at the ECB must act.
The question hinges on this:
is to say, whether Latin states are willing to mobilize their majority
power on the ECB's council to force a change in policy over German
protest, or lamely let themselves be picked off one by one in serial
disasters like the death of the Gold Standard in 1931.
I see. Force
a protest. Tell Germany to shape up or ship out.
But Mrs. Merkel
can in fact ship out. She can take her stainless steel, high-tolerance,
precision-ground German marbles and go home. She can take Germany
out of the eurozone. She would have the backing of a majority of
She has resisted.
But she has not been told by the ECB to sit down and shut up.
leaves, where will the PIIGS get the huge bailouts that they need,
one by one? From the IMF? Hardly. The head of the IMF has said that
the euro crisis has to be solved within three months. That
was in mid-June.
has listed the threats. Spain and Italy are facing a "full-blown
debt debacle." Meanwhile, China, India and Brazil are in the grip
of a broken credit cycle. The USA is "on the cusp of a fresh recession."
The fiscal cliff will make it worse. He thinks the world will move
into a downward spin like that of 2008.
He is not
alone. The head of the IMF's European Department and mission chief
for the euro area has issued a clear warning.
critical stage is indicated by the clear signs of very high levels
of stress in a number of financial markets. Risk premia have recently
reached a record euro area high in some countries, especially Spain
and Italy. This applies to sovereigns as well as to corporate and
household borrowers. This tells us that the adverse links between
sovereigns, banks, and the real economy are stronger than ever.
As a consequence, financial markets are increasingly fragmented
across member countries. In other words, borrowing costs are very
high for some countries, but at record lows for others, because
capital within the euro area is moving away from the Southern periphery
countries to safer havens in Northern Europe.
are not consistent with a properly functioning economic union.
They imply a breakdown in the monetary transmission mechanism.
The common monetary policy is not working the way it was intended.
he have in mind? Simple:
larger government deficits and quantitative easing by the central
common monetary policy in the euro area should stay accommodative
for a longer period. There is room to reduce policy rates a little
bit more. The European Central Bank should, in our view, consider
more unconventional measures (for instance, quantitative easing)
to support financial markets in countries undergoing severe stress.
Demand can also be supported by fiscal policy. It's true that fiscal
adjustment is inevitable in many countries facing high deficit and
debt levels. But in countries with less pressure, the pace of fiscal
adjustment is appropriately more gradual.
This is what
all Keynesians call for. It is what politicians and voters also
unemployment is at least 24% overall, and over 50% for young adults.
The recession is widely expected to drag on until 2014.
leaders have said they will not accept a common Eurobond system.
They have drawn a line in the sand. If Merkel crosses this line,
she and her party will face a revolt. She has a coalition government.
Her partner party will not back her, its leader has said.
There is a
rescue fund, Evans-Pritchard says: the ESM. But the ECB has already
issued a legal opinion: it will require a new European Union treaty
to raise the ESM's authority before letting it issue more than 500bn.
There is no way that the German Parliament will accept this, and
there must be unanimity for a new treaty.
The ECB issued
a trillion euros to bail out banks earlier this year. Nevertheless,
Spain's banks are still going under. The cause is declining sovereign
debt value. He writes:
ECB's earlier purchases of Greek, Irish, Portuguese, Spanish and
Italian bonds were a textbook case how not to proceed, violating
the "Powell Doctrine" of overwhelming force: too timid to lower
yields for long or reduce default risk, yet enough to push private
investors down the creditor ladder.
The ECB announced
that it will get paid back first if there is a default by Italy
or Spain. This assumes that there is any value at all remaining
in the bonds. This pushes private investors down the ladder. This
raises the risk of loss, which raises interest rates. Capital flight
out of Spain's banks is in full force today. Credit Suisse Bank
has estimated that Spain's banks are losing 50bn a month. That is
5% of Spain's GDP.
If you were
living in Spain, you could call your bank and have euros transferred
to a German bank. You would pay the German bank a fee for the privilege.
The flood of euros into German institutions is so huge that they
are charging a fee: negative interest. This is smart investing.
Italians and Spaniards and Greeks are buying bank safety. If these
nations go off the euro, their citizens who get out while the getting
is good will wind up owning a valuable currency. Their home currencies
will fall by 25% or more overnight.
So, how big
a bailout will be required. Evans-Pritchard estimates 400bn. Why
so high? Because private investing will stop overnight for Italy.
Nomura Securities has estimated that it will take at least 1.1 trillion
over three years to rescue Spain and Italy.
is not there. It cannot be raised in private markets. That leaves
How soon will
the ECB have to put up the money? Some
experts say within weeks. The optimists say by late December.
His conclusion: "Only the ECB has the firepower and speed to halt
a catastrophic replay of 1931 before the year is out."
ITS POLITICAL HAMMER
that the ECB faces is this. In the past, its refusal to buy a government's
bonds has been a major hammer. It could veto national government
policies. It refused to buy Italian bonds when Berlusconi's government
refused to impose spending cuts. That forced him to resign. More
recently, it vetoed Spain's idea to capitalize a failing bank
by making available government bonds.
The bank then
headed toward imminent bankruptcy. Then the weekend summit in late
June provided a bailout of that bank. But it also transferred to
the ECB the power to regulate national banks.
has been a trade-off. The ECB has the power to control national
economic policies by the threat of not buying a nation's bonds,
or by not accepting the bonds as collateral suitable for the commercial
banks that get cheap ECB loans. But if it openly goes to another
round of inflation to bail out Italy and Spain, it forfeits its
political clout. In other words, the ECB can either save the governments
or control the governments, but it is hard to see how it can do
DESPERATION OF NORTHERN EUROPEAN BANKERS
There is no
question regarding which institutions will be hit hardest by a default
by Italy and Spain: the commercial banks of Northern Europe. The
bankers assumed that PIIGS bonds were almost as safe as German bonds.
They loaded up, in order to get higher interest rates. Now they
are sitting on top of hundreds of billions of euros in face value
IOUs from Club Med PIIGS. The looming default will push them close
to bankruptcy. They will have to write down PIIGS bonds.
Add to this
the European recession. The governments will be hit by increasing
demand for unemployment payments. Revenues will fall. The deficits
will once again move higher across Europe in all but the safest
countries. They want an ECB bailout of PIIGS' governments. They
want the flow of interest payments from the governments. But they
also want money in reserve domestically in order to bail them out
next time. Any depletion of domestic government funds today means
less for them as direct bailouts in the recession.
that goes to PIIGS governments is diluted. It does not all go to
making interest payments. Domestic big bank bailouts will go to
commercial banks. So, the money being sent to PIIGS by governments
is only indirect money. It will help delay a default, but it also
This is why
bankers prefer the ECB to put up the money. The domestic governments
in the North can keep their credit lines open to big banks, so that
the governments can provide money to save the big banks.
There is rationality
undergirding this strange flow of funds. The source of the bank
bailout money will be the northern European banking system. But
bankers want middlemen to handle the money and offer IOUs: politicians.
trust each other to pay off in a time of real crisis. They think
that governments in the North will be able to raise loans from bankers
and the public. The "full faith and credit" of the government is
trusted by bankers far more than their peers' full faith and credit.
in Europe, like the Establishment in the United States, has one
economic faith: the full faith and credit of central banks.
Establishment is desperate to get a new fiscal union, but it cannot
do this without violating the Maastricht treaty, which created the
are moving toward nationalism and against the European Union. There
is no way that the Establishment can get over half of the voters
in all 17 eurozone nations to vote in favor of fiscal union.
ECB is the only European institution that can conceivably bail out
the PIIGS. It can do this only by debasing the euro. Inflation is
the only option. There will be no fiscal union, except one that
is imposed illegally. In any case, it cannot come before the end
of the year. It is unlikely to come by the end of 2013. But the
eurozone's banking system does not have until the end of the year.
It must have a bailout now one large enough to carry the
banks and governments of Spain and Italy through the recession.
be a cessation of the flow of funds out of Italian and Spanish banks
into Germany. But no one knows how to mandate this legally. On the
other hand, if it is not stopped, the PIIGS banks will run out of
liquid assets to sell in order to raise the euros to replace the
PIIGS citizens who have not yet sent their funds to German banks
will wish they had by the end of 2013. All it will cost them are
the higher interest rates of high-risk banks. Better to preserve
capital than lose it. Better to buy a currency that will appreciate
in relation to pesetas, lira, and drachmas.
North [send him mail]
is the author of Mises
on Money. Visit http://www.garynorth.com.
He is also the author of a free 31-volume series, An
Economic Commentary on the Bible.
2012 Gary North
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