Friday, November 28, 2014

Living Europe’s Nightmare

NEW YORK – Losing a long war is always hard to accept. Hemmed in by the Americans and the Russians in the final days of World War II, Hitler convinced himself that he had two armies in reserve to mount a counter-attack and win the war. Meanwhile, having lost the entire Pacific, Japan’s Imperial Cabinet believed that no enemy could set foot upon the country’s sacred soil. When the truth is unimaginable, human psychology finds an alternative reality in which to dwell.

That describes the global situation today. The entire planet seems to be in denial about what is about to occur in the eurozone. Pundits keep expecting Germany to pull a rabbit out of the hat and flood the continent with Eurobonds, or that Mario Draghi will mount a coup at the European Central Bank and buy up every deadbeat country’s bonds.

Either could happen, but both are extremely unlikely. Germany cannot guarantee the eurozone’s debt without control over the eurozone, which no one has offered, and Northern Europe will not permit the ECB to be hijacked by “Club Med” and turned into a charity organization. It is not just a matter of politics; it is also – as the Germans keep pointing out – a matter of law.

Europe has a Plan A, whereby each country would reform its economy, recapitalize its banks, and balance its budget. But Plan A is not working: its intended participants, most notably France, are rejecting it, and there is an emerging southern European consensus that austerity is not the solution.

Greece’s recent election has put it in the anti-austerity vanguard. Italy and Spain (which does not have enough money to bail out its banking system), have similarly called for an end to austerity, and Ireland will be voting on it soon. All have lost access to the bond market, and Portugal is so far beyond hope that its sovereign debt is trading for cents on the euro.

There is no well-thought-out plan for the orderly exit of the eurozone’s insolvent countries. There are no safeguards, no plans, no roadmap – nothing. The Maastricht Treaty, like the United States Constitution, did not provide for an exit mechanism. So, instead of realism and emergency planning, we get denial and more happy talk. But, just because something is “unthinkable” doesn’t mean that it can’t happen.

In fact, it already is happening. Greece is rapidly running out of money; its residents are withdrawing their deposits and have stopped paying their taxes and utility bills. Even if the country can stay afloat until the June 17 election, a disorderly eurozone exit, default, and currency redenomination will follow. Greece will be dependent upon foreign aid for essential imports such as petroleum and food. Civil order will be difficult to maintain, and the army may be forced to step in (again).

Once Greece goes, runs on bank deposits are likely to follow in Spain and Italy. There is nothing to stop Spanish and Italian depositors from wiring their euros from their local bank to one in Switzerland, Norway, or New York. At that point, the only thing still standing between the eurozone and financial chaos will be the ECB, which could buy government bonds and fund the bank runs. The scale of such an operation would be enormous, and would expose the ECB to huge credit risk. But it could, in principle, step in – if Northern Europe permitted.

If the ECB does not step in, Italy and Spain, too, will be forced to exit the eurozone, default on their euro-denominated sovereign and bank obligations, and redenominate into national currency. Massive losses would be imposed on the global financial system. Given the opacity of banks’ exposures, creditors would be unable to discriminate between the solvent and the insolvent (as was the case in September 2008).

The US banks most likely to be affected by such a scenario would be the globalists: Citigroup, Bank of America, JPMorgan Chase, Goldman Sachs, and Morgan Stanley. They would require a rescue package similar to the US Troubled Asset Relief Program, created after Lehman Brothers’ collapse in 2008. The US can afford a second TARP, but it would require Congressional legislation, which is not guaranteed (though the US Federal Reserve can, of course, keep the system funded no matter what).

Massive wealth destruction, combined with global financial chaos, would pose a challenge to monetary policymakers worldwide. Central banks would be tasked with preventing deflation, implying a major round of quantitative easing. But, since banks are the transmission mechanism for monetary stimulus, this presupposes functioning banking systems. Each country would need to restore confidence in its banks’ solvency, which would most likely require a blanket bank guarantee and a recapitalization scheme (such as TARP).

The US financial system can withstand any shock, because the US can print the money that it needs. The Fed can maintain nominal prices, nominal wages, and growth if it acts heroically, as it did in 2008. The stock market will react negatively to the level of uncertainty caused by the collapse of the European financial system (as it did in 1931), and the dollar, yen, and gold should benefit. The fate of the British pound and Swiss franc is impossible to say; they could benefit as safe havens, but their banks are highly exposed to the eurozone.

It is bad enough that the world is utterly unprepared for the future that can be foreseen. The unanticipated financial, economic, and political consequences of the coming crisis could be even worse.

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    1. CommentedMarten Klein

      The Bundesbank is independent, it is not controlled by the German people. That is your misconception. The German concept of a central bank is like Ulyssees at the Sirens, and they exported their model to the EU.

    2. CommentedWilliam Wallace

      Sorry, but in today's environment, I'd need a disclosure of any short positions on the euro in order to measure the value of comments from former executives of the ratings agencies which actively contributed to the financial crisis.

    3. CommentedJohnny (MoneyWonk)

      THE ECB CAN DO THE EXACT SAME THING! To quote Ezra Klein, Mario Draghi is holding Europe hostage. The ECB can add liquidity, guarantee deposits to curb the bank runs, and begin massive rounds of asset purchases. True the PIGS needs to reform their economies and learn to be a little more "German". But the ECB can do the same and learn a thing or two from the Fed and Bernanke. And what would be the consequence of such an action? Curbing a massive financial crisis and making all exports, including Germany's, more competitive. Again, the ECB is holding Europe hostage.

        Portrait of Christopher T. Mahoney

        CommentedChristopher T. Mahoney

        True, but the Bundesbank controls the ECB and the German people control the Bundesbank (indirectly). Those who wish for decisive action must make their case to the German voter. Good luck on that.

        CommentedGary Marshall

        Hello JJ,

        The ECB can do those things, but like any lender it takes great risks. Paying the near maximum price for bonds will leave it vulnerable should their be a sell off. And who will fund the ECB's losses?

        When the ECB lends, it adds vast amounts to its bank reserves. It acquires an asset, and it creates a liability. If Greek bonds, then it adds large amounts of reserves to the Greek central bank's account. The money is then used and dispersed. Because reserves have been added, market interest rates will artificially fall because there is a greater supply of reserves and less need to borrow.

        Just look at what the Fed has done in the US and the BofJ in Japan.

        Massive bond purchases mean massive additions to reserves, and great declines in savings interest rates. When the bond prices fall, then the ECB can only extinguish a portion of the artificially created reserves, leaving market interest rates artificially and irredeemably diminished. This is the Japan disease, and now the US disease.

        No growth, little or no borrowing, little savings earnings, and with high public expenditure, lots of inflation, making everyone poorer.


    4. CommentedAnna Syngellakis

      We have just filed our tax return online, we have paid all our utility bills and so have all our family and friends. Such overgeneralisations are simplistic and do not help a struggling country to survive.

    5. CommentedGary Marshall

      Here is a solution to the Greek problem. If anyone can find the flaw, I shall be more than happy to give him or her $50,000. I am just tired of doing this.


      The costs of borrowing for a nation to fund public expenditures, if it borrows solely from its resident citizens and in the nation's currency, is nil.

      Why? Because if, in adding a financial debt to a community, one adds an equivalent financial asset, the aggregate finances of the community will not in any way be altered. This is simple reasoning confirmed by
      simple arithmetic.

      The community is the source of the government's funds. The government taxes the community to pay for public services provided by the government.

      Cost of public services is $10 million.

      Scenario 1: The government taxes $10 million.

      Community finances: minus $10 million from community bank accounts for government expenditures.
      No community government debt, no community
      government IOU.

      Scenario 2: The government borrows $10 million from solely community lenders at a certain interest rate.

      Community finances: minus $10 million from community bank accounts for government expenditures.
      Community government debt: $10 million;
      Community government bond: $10 million.

      At x years in the future: the asset held by the community (lenders) will be $10 million + y interest. The deferred liability claimed against the community (taxpayers) will be $10 million + y interest.

      The value of all community government debts when combined with all community government IOUs or bonds is zero for the community. It is the same $0 combined worth whether the community pays its taxes immediately or never pays them at all.

      So if a community borrows from its own citizens to fund worthy public expenditures rather than taxes those citizens, it will not alter the aggregate finances of the community or the wealth of the community any
      more than taxation would have. Adding a financial debt and an equivalent financial asset to a community will cause the elimination of both when summed.

      Whatever financial benefit taxation possesses is nullified by the fact that borrowing instead of taxation places no greater financial burden on the community.

      However, the costs of Taxation are immense. By ridding the nation of Taxation and instituting borrowing to fund public expenditures, the nation will shed all those costs of Taxation for the negligible fee of borrowing in the financial markets and the administration of public

      Gary Marshall

        CommentedGary Marshall

        Hello Charles,

        The creation of money without purpose is always inflationary, whether by individual, business, or government.

        I won't deal with the detrimental effects of taxing for wasteful public expenditures. I shall just focus on borrowing for wasteful public expenditures.

        Suppose in some 1 man economy, a fellow produces 10 fridges per year with $100,000 circulating in the economy. Each fridge sells for $10,000.

        If the man borrows $100,000 and invests it in a new plant, he can now produce 25 fridges per year with $200,000 circulating. Each fridge will now cost $8000.

        This is not deflation, as some would believe. It is the markets at work. A new technique comes along that allows for a reduction in expenses and consequently price. Having to pay less for certain items means having more money, $2000, to spend on other items.

        The project enriches the nation.

        Let us say that 90% of the nation is employed and 10% are not. With idle capacity, the government institutes a program for the unemployed 10% to dig holes in the morning and fill them in the afternoon. The program consumes resources in shovels and other equipment and material. The enriched labourers now have money to purchase goods.

        Unfortunately, the government program produced no saleable good. So we have 100% of the nation now competing for saleable goods produced by only 90% of the nation. Without idle capacity to increase production, or only at great cost, producers just raise prices in the competition for diminished aggregate supply, or in other words, too much money chasing too few goods. Aka, inflation!

        The output gap in this instance is 10%. In an economy with government participation of about 40% or more, I cannot imagine how costly such an output gap must be.

        With borrowing, no one is forced to give the government money. Everyone will now focus on what government expends the nation's money on.

        Therefore, all those politically worthy, but economically worthless public expenditures will cease to be. Who shall lend money to a corrupt organization enriching its own at the expense of others? Who will fund subsidies to sugar producers or alternative energy producers?

        The only projects to be funded will be those that pass a test based upon solid cost and benefit analysis.

        Access to clean water could be accounted a worthy project with good returns. Dirty or disease laden water can cause a community grievous harm. The local hospital may be overrun with patients suffering all sorts of water borne maladies. The medical costs, lost work days, etc could be erased with a modest investment in purifying the water.

        An idle person will cost the community or nation in welfare costs. An annuity of $10,000 would require an initial investment of $200,000 with an interest rate of 5%. If a person collects $10,000 per year, the community or nation would be better off lending funds of say $50,000 for training or education up to amend the burden.

        Simple cost and benefit analysis. If the cost to the community of water borne diseases are $5 million, and construction costs of a water filtration plant $1 million with $1 million in annual expenditures, is this not a valued return to the community?

        Is it inflationary? No because the community now has $3 million per year to go and spend on other items, perhaps better healthcare, better education, a larger home.

        The first post I made shows that whatever liabilities are created and accrue will be covered by similarly created and accruing assets, if you borrow from resident lenders. The nation incurs a debt, and the nation, by way of the resident bondholder, acquires an equivalent financial asset. Similarly with the borrowed interest.

        In other words, if you add equal amounts to your assets and liabilities, are you any better off?

        No should be the answer. So if a nation borrowing for public expenditures leaves the nation's financial position unchanged, does Taxation have any financial benefit?

        Now when a nation can no longer take, and only borrow, how will the nation fare?

        Well, there is no constraint upon earnings or investment or any worthy activity. No penalty or punishment for productive enterprise. There will also be a great contraction in government expenditures as cost and benefit analysis springs into action. Both factors will create a far more productive and wealthy nation.

        I hope that answers your questions.


        CommentedCharles Cunningham

        Hello Gary

        I like the idea of government with out tax, but I don't think substituting borrowing for tax will work - the problem is that borrowing by governments, with out ever repaying, is very inflationary. The value of money would start to plummet as the government started to spend the money that it borrows. Why is this? Because when a government borrows it gives back a security - a bond. Sovereign bonds are good collateral and sovereign bonds are as good as cash. So for every £,$ or what not that the government borrows, it creates a new £,$ or what not in the form of a bond. Borrowing from the people and never paying the debt would have the same inflationary consequence as just printing the money would, namely lots of inflation.

        There is also the small detail of covering the cost of interest payments, these will grow ever larger by the year as the government borrows but never repays. This will mean that every year the government will need to borrow an increasing amount to cover both its current spending and also the accumulated interest.

        This could not go on for ever - in which case at some point the whole scheme would stop and the government would be broke - at this point the printing presses would be the only option - hence to hyper inflation.

        I think this is why governments levy tax and don't just borrow or print the money.


        CommentedGary Marshall

        Hello Eduardo,

        I read through your comment.

        No one is forced to lend to the government. Those who are in a position, will. Those who are not, will not.

        The government is currently taking large fractions of the financial resources of a nation by force. So with the abolition of Taxation, this will free up all the money currently being paid in taxes of all forms in any nation, even in Portugal. If money is sitting within bank accounts, it can easily be used to purchase government paper, which means it will transfer to other bank accounts.

        By revoking the right to tax, the government will have to wade into the financial markets like any other lender. As funds will now come with a capital charge, the government will be forced to justify its expenditures through novel cost/benefit analysis.

        With a people's direct control over government expenditures, can you imagine a government actually having to justify its expenditures? Government expenditure should contract drastically as all those politically enriching, but practically worthless and corrupt expenditures cease to be.

        There will also be the benefit of a nation not having to factor in Taxation into every economically worthy activity. There will be no constraint upon worthwhile economic activity. People and corporations will earn, save, invest, retire debt, expend without having to hand large fractions of that money to the ubiquitous tax man.

        The economy without the burden of intrusive and exacting government will soar.


        Commentededuardo rebelo

        I have a question: if the people from the many endangered countries are force to lend money to their governments that would mean a huge stress to the financial system since people would rush to the banks in order to take their deposits so they could use that money to help the government. Right now families and small companies are struggling to survive, they dont have the spare money to finance their states, being a portuguese I know that too well. Unless governments allow families the ability to lend money they dont really have (which is pretty much the foundation of our financial system) its impossible to get the amounts of money needed to cover both our current expenses and our public depths. I think your idea is really interesting but since we are in such a stressful situation we could be risking the collapse of european banks which is the scenario that all countries are trying to avoid at all costs

    6. CommentedFrank O'Callaghan

      The article points out the air of unreality that exists.

      Conventional economics does not always describe the reality clearly. In broad historical terms, the world is at a peak of productivity. We make more and better things at a lower unit cost than ever before. Our technology is of course at it's record level but next year it will have advanced further. Yet, we are in an economic crisis.

      We certainly have economic challenges. Energy depletion, loss of biodiversity, overpopulation and inefficient resource allocation are real threats. Economics and accounting can make a real contribution only if it focuses on the reality rather than the ephemera. The crisis in the currency and bond markets is a direct result of one factor: inequality. The great allocation of resources to a tiny minority over the past 30 to 40 years has destabilised our economies. Fortunately the rebalancing of this requires only the simplest and mildest of remedies. We must progressively tax global wealth and use the proceeds to deal with these accounting difficulties.

    7. CommentedZsolt Hermann

      Answer to Bakhtiyor Khujaev: I agree with you about human greed, but after Greece is "sorted" what happens to Spain, Italy and the other dominoes in Europe?
      What about "human greed" in other countries, like the US for example causing the vast social inequalities, Senate stand-offs among other things, or India, China, Argentina and so on the list is endless.
      You are right it is our human nature that is on trial now and this is what needs changing if we want solutions.

    8. CommentedZsolt Hermann

      It is not easy to be the messenger of bad news, or to be a whistle-blower, especially when the expected outcome is as severe as the article suggests.
      Indeed we are in very difficult times and I have to say that personally I think the article with all its severity is underestimating the problem.
      We still seem to zoom on this crisis as a European problem, and not looking at the Eurozone crisis as a symptom of a much deeper disease.
      The US markets for example, or any other global markets, nations are not only in danger because of the expected Euro collapse.
      All the nations and the whole system is in danger of collapsing in its own right, because we, all of us are stubbornly pushing on with the wrong system in the wrong time.
      The details are best seen in Europe but they could be projected to any other part of the globe.
      The daily arguments about stimulus vs. austerity are futile, because both sides of the argument are based on "return of quantitative growth". But infinite quantitative growth, especially the one we try - based on overproduction and over consumption of excessive and harmful products in order to accumulate profit for a small minority while practically "enslaving" the rest - is unsustainable, unnatural and now it has exhausted itself and became self destructive both within human society and between us and our environment.
      Additionally in today's global, interdependent human network we simply cannot continue making decisions based on self calculations ignoring everybody else, as with any negative action we influence the whole system and the effects come back to us multiplied as a boomerang.
      Basically our whole present lifestyle is based on bubbles and illusions which we are still not brave enough to see, but on the other hand there is nothing we can do to stop the inevitable collapse.
      We have to pull our heads out of the sand and start preparing for a transitional period and building a new human system that takes into consideration the global, integral system we live in and the natural laws governing it.

        CommentedBakhtiyor Khujaev

        There is one global problem in this situation - human greed which resulted in disproportion of eurozone financial system at the very beginning of EU's monetary system conception. I am sure there is a way out letting Greece use their own currency and isolating greece financial illness withing Greece.