Waking up

A Band-Aid for a cancer patient

by DETLEV SCHLICHTER

This was another hectic week for financial markets, and nerves were calmed somewhat over the past 24 hours with another liquidity injection from the central banks – this time the provision of dollars from the U.S. Fed channelled through a few other central banks, most importantly the ECB. This is certainly not a solution but again the doctoring of symptoms. Pumping ever more fiat money into the system to avoid – or rather postpone – a much needed recalibration will not solve the underlying malaise. Four years into the crisis the banks still need emergency funding. That is a damning indictment that financial structures are far from sustainable.

Not a European problem

The euro debt crisis is not a specifically European problem but the European version of a global problem. Decades of constantly expanding fiat money have created a highly distorted global economy and a bloated and excessively indebted financial infrastructure. The fundamental problems are now the same the world over: weak banks, too much debt – now increasingly public sector debt – and a severe addiction to cheap credit.

As I explain in detail in my new book Paper Money Collapse – The Folly of Elastic Money and the Coming Monetary Breakdown, ongoing and persistent expansion of the money supply must disrupt the market process, it must lead to distortions in relative prices, to misallocations of capital and the accumulation of economic imbalances. The majority of observers ignore these effects. They just see the near-term boost to headline growth and the impact on the price level. Higher inflation is the only negative effect from money production that they can fathom. This is a grave intellectual error.

The key flaw in our system of constantly expanding fiat money – which only came into full bloom in 1971 when the last link to gold was severed – is that those in charge of the money franchise are always tempted to avoid liquidation and correction and to spur the system onward with ever more bank reserves, artificially lowered interest rates and more debt. This has been going on for decades but we have now reached the limit.

Default – painful, yes. Needed? – Definitely

A default of Greece now appears very likely. This is a positive development. Positive as it points toward shrinkage – toward smaller debt, toward a smaller Greek state, toward an important lesson for banks: Don’t think that lending to the state is without risk!

The exposure of European banks to European sovereigns is mind-boggling. It is indicative of a severely distorted and corrupt financial system. This has nothing to do with capitalism. This has nothing to do with free markets. This whole charade gives ‘capitalism’ a bad name. The sooner it ends the better.

Out now!

With the help of ‘lender-of-last-resort’ central banks and under implicit and explicit state protection, banks have been able to engage in fractional-reserve banking, and therefore money and credit creation, on an unprecedented scale – with many of the loans being in turn extended to the banks’ generous state protectors. Lending to sovereign borrowers used to be a low-yielding but supposedly safe business – very lucrative if you conduct it in size. You may give 5 million to an unstable capitalist enterprise and charge it a hefty interest rate, or you can give 5 billion to the state at a lower rate. What can go wrong?

Back to Greece. Default is now likely and that is a good development. I am not taking lightly the pain that this will cause for many individuals. It will involve hardship. But what is the alternative? The situation is simply beyond repair. The Greek state has maneuvered itself into an unsustainable position. And it is not alone – but probably the first in line.

Default is not the end of the world. It involves the acknowledgement of the debtor that he borrowed too much and the acknowledgement of the lender that he lent too much. Both take a hit.

No bailout

A full-fledged bailout of Greece seems no longer an option. The Germans are unwilling to do it – and let’s face it, they don’t have the money for it, contrary to the caricature in parts of the press of Germany as an economic powerhouse with unlimited resources. Of course, the German government could borrow the money at a lower rate than anybody else but this would set a dangerous precedent. Italy and Spain would be next in line.

The biggest risk to the euro is not a Greek default but the markets waking up to the bleak long-term outlook for the solvency of the core, Germany and France. The bizarre willingness with which the markets continue to treat German Bunds (and for that matter, U.S. Treasuries) as absolutely safe assets is one of those aspects of the crisis that feel surreal and unsustainable but that have thus far allowed the system to stagger on. The Germans would do nobody a favour by risking the standing of their bond market as a safe haven – however unfounded that standing may appear on closer inspection. The moment the market thinks the core is in trouble, the euro will be in trouble.

It also appears unlikely that the ECB can save Greece. Full-scale debt monetization – with disastrous consequences for the euro – still seems a very likely endgame. This, to me, is still the biggest risk, namely that a correction of the system’s excesses through default, balance sheet reduction and credit contraction will not be allowed to occur for political reasons as the short term impact on growth and employment would be considered unacceptable. But as the system will – sooner or later – contract, this could trigger a massive monetary expansion by the central banks. But not yet, I think, not for Greece.

The euro will not break up over Greece

The idea that Greece would have to leave the euro does not make sense to me at all. I don’t see any reason for it. Greece should default – in fact, the Greeks should just stop paying on their debt, period – and the debt should be restructured. None of this has anything to do with the euro.

What if California defaulted on its debt, or Illinois? Mind you, these are hardly improbable scenarios. Would that mean these states had to leave the United States of America? Or that they would have to issue their own currency? Would you take out the dollars in your New York bank account because one of these states had just declared bankruptcy? As long as others accept your dollars or euros in exchange for goods and services it doesn’t matter how solvent the state is under whose jurisdiction the money was issued.

Dollar and euro are paper money, irredeemable pieces of paper. They are backed by nothing. They do not constitute a claim against the state. They are not debt.

The Eurocracy fears the Greek default not because it means the end of the euro (it doesn’t) but because of what it means for the banks in the eurozone (and thus for near-term prospects for growth) and what it means for the market’s perception of the other sovereigns, in particular Italy and Spain, the heavyweights.

Of course, the banks will take a massive hit from Greece. This would be an opportunity to allow the sector to shrink. This is urgently needed but not wanted by the Eurocracy. Anything that involves another recession is deemed unacceptable.

After the massive credit boom that ended in 2007, the banks are too big. They should not be recapitalized but shrunk. Unfortunately, this will not be allowed to happen.

It will be easier for French and German politicians to bail out their banks than to bail out Greece. And it will be easier for the ECB to print money to keep the banks alive and prevent them from shrinking than to keep Greece from defaulting.

Thus, we will get some liquidation (Greek debt) but also some re-liquefying (big banks). It will not be the end of the euro – but not the end of the financial crisis either.