a. If you are going to bluff, do it big and do it early;
b. If you are going to panic, do it early and do it big. ....
By Chan Akya
The trick to flying is to fall ... and miss. Douglas Adams, Hitchhiker's Guide to the Galaxy
Douglas Adams should have been around now, but tragically died a few years ago aged in his late forties (rather than at '42'). If he had been around, perhaps he would have given some wise counsel to world leaders who all seem out at sea in attempting to handle a crisis that wasn't necessarily of their making but almost seems certain to be their undoing.
The weekend saw political parties in the United States failing to agree on a program to adjust let alone cut sharply the country's yawning budget deficit. Alongside, the seventh regime change since the beginning of 2010 in Europe after this week's booting out of Spain's prime minister Jose Luis Rodriguez Zapatero marks yet another chapter of voters throwing not just the baby out with the bathwater, but in this case also the midwife and the entire bedroom. (See The men without qualities, Asia Times Online, October 29, 2011).
Cue the markets pushing Spanish and Italian yields to record levels this week, and even "reassuring" statements from rating agencies about US creditworthiness being shrugged off. The talk in Europe is now when, not if, Italy and Greece leave the euro; speculation has even mounted about the tenability of the French fiscal position.
Meanwhile banks on both sides of the Atlantic are being pummeled into submission with eye-watering declines in share price which the banks are attempting to correct by shedding thousands of employees. The count this year so far is that over 200,000 banking jobs will be lost in the major financial centers of the West - in effect reversing the entire marginal hiring by the industry since 2008. Alongside business sentiment continues to fall, and as companies postpone indefinitely their plans to invest, the job market isn't going to bounce back anytime soon.
Then there is the economic data. European data is no surprise except to those who have been sleeping for a while, but the ugly numbers from US gross domestic product on Tuesday showed declining inventories - exactly the kind of multiplier effect on the negative end of the spectrum that predicts further and sharper economic pain.
Politicians in the US and Europe need to be aware of two basic tenets of government:
a. If you are going to bluff, do it big and do it early;
b. If you are going to panic, do it early and do it big.
The unsaid supplemental rule here is: don't do both. This is the reason for the opening quote from Douglas Adams.
Suspension of disbelief is an art form but apparently also broadly applicable to various aspects of modern life ranging from market sentiment to voter angst. There is very little certainty about any initiative, which basically calls for strong confidence in one's ability to achieve something and more importantly in one's ability to convince the other side of one's confidence in respect to the same. For the markets, the common thread is really one of credibility, not of credit worthiness.
Think about this broadly - if the European Union had stepped out and initiated a broad program to buy every unsubscribed bond from Greece, Italy, Spain et al in the beginning of 2010, would any of the problems really have gotten out of hand since then? Instead, they embarked on a series of "limited" interventions, which have been fruitless precisely because everyone knows they are limited.
It's a bit like walking into battle carrying a single revolver - everyone knows you only have six bullets, and once they dodge those you are the one in serious trouble. If on the other hand the other side has no clue about your weapons and ammunition, the battle is most likely won without firing a single shot.
In the end, this is the primary reason for the Keynesian policies of the past three years to have failed utterly. They were simply insufficient, vastly under-estimating the true economic damage wrought by the 2007-8 financial crisis (I really shouldn't be dating this financial crisis, given that it very much continues to this day). This was then a case of bluffing late and bluffing small time. I am of course happy with this failure because, as I argued before, the demographic necessity of the West was to embrace poverty either broadly through inflation or narrowly through significant write-offs in savings and investments.
So much about the Keynesian failures, but how did the Austrian School followers do in their neck of the woods? Not too well I am afraid. Austrian principles such as credit tightening in a crisis, allowing banks and companies to go bust without hesitation were observed in the exception (Lehman Brothers) rather than the rule (countless US and European banks).
Even in the case of sovereign debt, the demands for austerity (Greece) were trivial and the penalties for noncompliance, laughable ("You veel resign Mr Papanderou, ja?"). This isn't the way that free markets work.
If you really wanted to stem the moral hazard tide, the best way would have been to rescue depositors but let the banks go into administration. That would have ended up costing Ireland a fraction of what the country has spent on its banks since the beginning of 2008, primarily to mollify German bankers who had made incredibly stupid lending decisions (see (F)Ire and Ice", Asia Times Online, November 20, 2010) in the first place.
Even in the US, research has shown that in situations where private institutions purchased mortgages at deep discounts from the banks (or more likely from the Federal Deposit Insurance Corporation, which rescued the banks), the turnaround has been palpable. Mortgages have been quickly modified, some useless tenants kicked out while a majority see their payments adjusted to more affordable levels along which they also have upside participation. In contrast, the government-rescued banks still carry billions of zombie mortgages and have simply failed to address them adequately if at all.
This isn't a surprise as the banks invested government bailouts not into their decrepit operations but rather in punting across their fixed-income books, essentially loading up on a whole bunch of underpriced assets. Some of these assets rose in price, but some others have since fallen back over the course of this year.
"Those damn Europeans sold from summer," exclaimed an American banker by way of explanation of his horrific trading losses in the second half of this year. "Yes, but what were you doing with a 30x leverage position on your books in the first place?" I countered, to no avail. "What else could I do - everyone else was hiring in 2009 and management asked me why I wasn't" he replied. That is moral hazard in practice for you. A game of passing the parcel where everyone knows that the parcel contains an explosive device that may be set off by movement, time or just randomly.
The way forward
How do I expect this all to be resolved? This presupposes that I do expect this situation to be resolved in the first place, which I really can't see at this stage. Among all the worst body of options out there, it is my belief that the following combination is likely to produce the most acceptable solution from here on:
1. An unpopular Obama administration attempts to reverse the mollycoddling of US banks going toward the elections. This means a crackdown on banking system leverage, proprietary trading and a long look at jailing a bunch of bankers. This would also involve taking a couple of US banks (you know who you are) to the proverbial cleaners, in essence allowing a controlled bankruptcy of those institutions.
2. Meanwhile the Europeans simply go ahead and commit big time to Keynesian solutions, essentially overruling the German opposition. The European Central Bank indulges in significant and unlimited quantitative easing, while European governments turn their back on austerity.
In this combination, the following market impacts come through:
a. A significant decline in the value of the euro against the US dollar, perhaps approaching parity or worse;
b. A sharp decline in global stock prices followed by a sharp rally next year;
c. Rampant inflation in the Western world that helps to push up commodity prices after the initial decline;
d. Recovery in European sovereign bonds for the short-term.
In every possible way of looking at all this though, I cannot help but admit to a strong whiff of wishful thinking in all this. Oh well, it is Thanksgiving after all....
By Martin Hutchinson
The eurozone crisis, which could have been defused initially by allowing Greece to depart the euro, has now taken on a much more serious aspect. If, as seems possible, Italy, Spain and even France lose the confidence of the international debt markets and are forced to write down debt, then government debt of prime countries will no longer be considered a risk-free asset. That will take markets back beyond the traumas of the 20th century, beyond the relatively serene 19th century, beyond even the institution-forming 18th century.
It will undo the 1751 triumph of the forgotten financier Samson Gideon in forming the immortal Consols, will undo the sterling if self-serving 1721 work of Sir Robert Walpole in preventing the South Sea crash from destroying the British government bond market as the Mississippi crash did the French one, and will even undo the 1694 foundation of British credit, the formation of the Bank of England. Life for government bond dealers will revert to a primitive Hobbesian state of nature, nasty, brutish and short. But will the rest of us suffer, except in the short term?
Based on the bond market as we have known it over the last century or two, only Greece was bound to default. Its problem was not so much its starting ratio of debt to gross domestic product (GDP), but the fact that its GDP was over-inflated, being based on hopelessly unrealistic living standards for the Greek people.
Once the Greeks were paid at a level at which the country's economy would balance - no more than US$15,000 or so in GDP per capita compared to 2008's overinflated $32,000 - Greek GDP would be halved, and its debt/GDP ratio doubled to a level approaching 300%. That would have been beyond the highest levels ever successfully reduced without default - 250% of GDP by Britain after 1815 and again after 1945. Since Greece is a notoriously undisciplined society, with poor tax enforcement and an open economy whose citizens keep much of their wealth abroad, a Greek default was and is inevitable in the best of circumstances.
The same is not, however, true of Italy and Spain. Italy's competitiveness has declined by about 20% against Germany's in the last decade. However its debt level is only 120% of GDP, or say 150% of GDP if Italy's living standards and GDP declined by the necessary 20%. Since its budget deficit under the competent management of Silvio Berlusconi's finance minister Giulio Tremonti was only about 3-4% of GDP, Italy's position by the standards of the last two centuries is perfectly manageable without default being more than a distant threat.
Similarly Spain has a budget deficit of around 7% of GDP, and a housing finance sector that is a mass of bad debts, with house prices still to descend to market-clearing levels, but its official debt is only 61% of GDP, and its economically odious Zapatero government is on the way out.
The level of market panic about Italian and Spanish debt indicates that the comforting parameters of 19th and 20th century sovereign debt finance no longer hold. The principal reason for this is the determination by the eurozone authorities to break the rules by which debt markets have traditionally been governed. Instead of allowing Greece to default or rescuing it completely, they arranged an inadequate debt-financed bailout that simply postponed Greece's inevitable exit from the euro and increased its debt. Then they arranged a "voluntary" writedown of Greek private sector debt, which was subordinated in repayment to the monstrous institutional and government debt created by the bailout.
When the Greek government attempted to get referendum or electoral support for the "reforms" imposed by the eurozone authorities, the authorities replaced the Greek government with a eurozone stooge, without democratic legitimacy. Eurozone authorities repeated this stooge imposition process with the long-lasting and economically capable Italian government of Silvio Berlusconi, who they regarded as euro-skeptic and excessively devoted to free market and low-tax principles. Berlusconi was replaced with a government dominated by europhiles and the left, which had been decisively defeated in the previous election.
Finally, and most damagingly, the euro-zone authorities prevented the modest $3.5 billion of Greek credit default swaps (CDS) from paying out, thus drastically devaluing the CDS of Italy, Spain and France, whose volume is of the order of $40 billion each. They have thus called the entire CDS market into question, at least for sovereign names, and have badly shaken the security of international contracts. By doing this, according to Gillian Tett of the Financial Times, they removed the protection that Deutsche Bank, for example, thought it had obtained this year by buying CDS on $7 billion of its $8 billion Italian exposure.
Investors in PIIGS (Portugal, Ireland, Italy, Greece and Spain) debt thus now face the reality that they have been subordinated arbitrarily to the international and eurozone institutions. Their ability to protect themselves by CDS purchase has been removed. The security of their debt contracts themselves has been called into question.
Finally, investors' protection against coups and revolutions, that monetary and fiscal policy were being set by democratically elected governments acceptable to their people, has been removed by the imposition of governments wholly lacking in democratic legitimacy. If those governments impose policies that the populace finds intolerable, as is very likely, there is now far more chance of outright popular revolt or coup d'etat, since ordinary democratic change has been blocked.
In short, the protections given to government debt progressively in the last three centuries have been removed. The rationale for the Basel committee rating government debt at zero in banks' risk calculations has been exposed for the fraud it always was. Since government levels of taxation are close to the Laffer Curve yield peak in most countries,  the protection given to investors by the taxing power has also been rendered nugatory.
Investors are no longer in the position of investors in the solid, well-managed government debt of Walpole and Lord Liverpool, in which the phrase "as solid as the Bank of England" made British debt sell at the finest international rates. Instead, they are in the position of the goldsmiths lending to Charles II, charging 10% for their money and liable to be ruined at any point by a Great Stop of the Exchequer, like that of 1672.
I have written before in some detail about the likely effect on the global economy of the removal of government debt markets. In general, it should improve financial availability for the private sector, while starving profligate governments of the means to implement "Keynesian" stimulus and other wasteful policies. Thus it may well improve economic performance in the long run, certainly compared to the anemic growth and high unemployment suffered in most countries since 2009.
Needless to say, however, the 2010s will be a grim decade, because the transitional and wealth effects of eliminating the government debt markets that have formed the centerpiece of the last three centuries will be enormous - a Reinhart/Rogoff depression of spectacular severity.
However, there is another effect of transporting the world financial system back to 1693 - the year before the Bank of England was established. The European Central Bank will be bankrupt because of its holdings of worthless PIIGS debt, and it is most unlikely that German taxpayers will consent to recapitalize an institution that has failed so badly, after first eliminating their beloved deutschemark. The Bank of England, the Federal Reserve and the Bank of Japan will also be legally insolvent, since in their policies of quantitative easing they have acquired gigantic quantities of assets that will drop catastrophically in price once interest rates rise.
The Fed, for example, is leveraged 60-to-1, and it was recently calculated that a rise in long-term interest rates of only 40 basis points would be sufficient to wipe out its capital. Needless to say, a rise of 4-5% in long-term interest rates, back to a historically normal level 2-3% above the true level of inflation, would put a hole in the Fed's balance sheet that in current stringent budgetary conditions would be politically impossible for the US Treasury to fill.
Thus if a debt default in the eurozone spread even partially to the over-indebted economies of Britain, Japan and the United States, not only will government bond markets be wiped out, but central banks in their current form will disappear also.
In the long term, this should also prove a blessing. My colleague and co-author, Kevin Dowd, has been trying for some years to persuade me that the ideal monetary system is not only a gold standard, but one entirely without a central bank. I had always resisted this, believing in the positive qualities of the privately owned Bank of England of the 1797 Old Lady of Threadneedle Street Gillray cartoon,  the 1844 Bank Charter Act and the elegant inter-war Montagu Norman, the hero who removed the 1929-31 Labour government by omitting to tell that bunch of economic illiterates that leaving the gold standard was an available option.
However, lovers of central banks cannot deny that the Fed bears a substantial share of the responsibility for creating the Great Depression and an even greater share of the responsibility for creating the 2008 crash and the period of grindingly high unemployment that has followed. Thus the existence of a central bank is no longer a battle won and lost in 1694, but must be considered to have become a live question.
If government debt markets across Europe collapse and central banks worldwide are rendered insolvent, the fiat currencies of the world are no longer likely to command enough public confidence to be workable. Like successive generations of Argentine pesos and Ecuadorian sucres, they will have to be junked. Further, since there is unlikely to be a figure like Weimar Germany's Gustav Stresemann, able to create a new and workable fiat "rentenmark" out of a mythical monetization of land values, a return to a gold standard will be not only inevitable but irresistible, since it will have been imposed on the ruins of the current system by the global private sector.
With a gold standard, and central banks in ruins, a truly free banking system will also be inevitable. Most large existing banks will have failed along with their central banks, with no more money for bailouts and their regulatory institutions thoroughly discredited.
The new central bank-less gold standard banking system that arises from the ashes of the old will be perfectly workable, as in 18th century Scotland, 19th century Canada and the United States between 1837 and 1862. It will permit only minimal government, but will allow the private sector, particularly the small-scale private sector, to flourish as never before.
As after 1945, from the chaos of monetary ruin will emerge a new global economy that is stronger and healthier, provides better living standards for its citizens and imposes far fewer taxes, scams and state-aided rip-offs on their wealth than does the current system.
But the intervening decade is certainly not going to be easy or pleasant.
1. Laffer Curve - a theoretical representation of the relationship between government revenue raised by taxation and all possible rates of taxation.
2. See here.