January 3, 2012
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This essay is excerpted from a recent version of The Credit Strategist (formerly the HCM Market Letter). To obtain the complete issue, you must subscribe directly to this publication; Please go here. The Credit Strategist is on Twitter - @credstrategist
“What is most important is that the systems of immediate concern – currencies, capital markets and derivatives – are social inventions and therefore can be changed by society. The worst-case dynamics are daunting, but they are not inevitable. It is not too late to step back from the brink of collapse and restore some margin of safety in the global dollar-based monetary system. Unfortunately, the deck is stacked against commonsense solutions by the elites who control the system. Diminishing marginal returns are bad for society, but they feel great for those on the receiving end of the inputs – at least until the inputs run dry. Today, the financial resources being extracted from society and directed toward elites take the form of taxes, bailout costs, mortgage frauds, usurious consumer rates and fees, deceptive derivatives and bonuses. As citizens are crushed under the weight of this rent extraction, collapse grows more likely. Finance must be returned to its proper role as the facilitator of commerce rather than a grotesque end in itself.”
James Rickards, Currency Wars (2011)
The ghosts of Christmas past are haunting Western economies this year. These ghosts lurk around the landscape in two forms. First, they assume the guise of the discredited economic policies that have failed abysmally and left these economies choking on debt and bereft of growth. Second, they parade around in the form of the financial and political elites who have spent years enriching themselves at the expense of the rest of society through the promotion of these bankrupt economic policies. As more information leaks out about the 2008 bailouts (the most egregious recent example being the MF Global debacle), and an increasing number of post hoc justifications are delivered by bailout participants to justify their actions, it becomes increasingly clear just how corrupt the system has become. Ben Bernanke argues that the Federal Reserve did not contribute to the housing bubble while members of the media laud him for allegedly saving the Western world from a disaster to which he was a main contributor through easy money policies. Just this week he was lauded by some for leading the latest bailout of Europe by the world’s central banks (more on this below). While Europe desperately needs the liquidity that this scheme provides, nobody should mistake liquidity for solvency and think for a moment that the crisis is over. Much more work is needed to heal the wounds that European policy makers and business leaders have inflicted on their societies since the European Union was formed.
While Alan Greenspan played his own part in fomenting the investment bubble from which the world is still recovering, at least he had the courage to admit that he was operating under incorrect assumptions about human nature and markets. Mr. Greenspan believed that economic actors would act in their own interest was correct, but he failed to realize that these actors’ individual profit-seeking would lead to unhealthy doses of collective risk-taking that would almost destroy the system. For some reason, Mr. Bernanke still appears to be clinging to the flawed belief that economic actors will wisely react to low interest rates as he tries to boost the value of financial assets. But unless he receives some serious assistance from fiscal policy, all he will accomplish is delay the day of reckoning. Mr. Bernanke needs to insist that his monetary promiscuity be coupled with genuine regulatory and fiscal chastity. Without those changes, the system will merely indiscriminately ejaculate liquidity around without targeting it to productive areas. The result is those areas that propagate risk – like derivatives trading – will suck up all of the seeds and spawn monsters. The system cannot foster any more monsters, as the Europeans are learning to their dismay.
Those of us who warned of the 2008 crisis are haunted by the ghosts of Ben Bernanke and Tim Geithner and Barney Frank and Larry Summers and others who – well-intentioned or not - have inflicted enormous harm on the global economy. These men tread down the hallways of our minds dragging heavy chains behind them, chains that are heavy and rusty and ugly. We can only hope that by next Christmas these ghosts will be laid to rest.
Europe – Will The Latest Bailout Work?
On November 30, the world’s central banks banded together and announced joint action to boost global liquidity. Specifically, they announced that they would lower the pricing on existing temporary U.S. dollar liquidity swap arrangements by 50 basis points to the U.S. dollar overnight swap (OIS) plus 50 basis points and extend these swap arrangements from August 1, 2012 to February 1, 2013. Clearly this was in reaction to deteriorating funding conditions that were reaching the point-of-no-return in Europe, particularly with respect to dollar funding. For several weeks, funding conditions had been deteriorating sharply: the Euribor-Libor spread kept widening through November as banks grew increasingly reluctant to lend to each other; European banks were encountering increasing difficulties accessing U.S. dollar funding; and Germany experienced an almost unheard-of failed bond during Thanksgiving week, which led the Bundesbank to engage in the even more unheard-of purchasing of a couple of billion Bunds.
Europe’s Credit Deteriorates
While nobody is saying anything, one has to suspect that one or more large European banks were on the cusp of failure (most likely a French one). Since the world is generally awash in liquidity, it is apparent that the authorities were aware that funds were not finding their way to places where they were needed, posing a systemic threat. All of the world’s banks are interconnected through complex webs of derivatives, and the failure of one may not be containable despite the assurances of regulators and the banks themselves (the latter of whom are the last ones whose words should be believed). It is a fact that many European banks are on the brink of insolvency, and it is also a fact that this move by the central banks will help their liquidity but do little to address their solvency issues. TCS would like to be encouraging and say that this move by the central banks was an important first step, but it may just as likely turn out to be another diversion on the road to disaster. It is just too early to tell despite the stock market’s jubilant reaction, and the ultimate outcome will depend on what is done to deal with the underlying solvency issues facing both Europe’s banks and its sovereigns.
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