Back to 1693
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, [1] 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, [2] 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.
Notes
1. Laffer Curve - a theoretical representation of the
relationship between government revenue raised by taxation and all possible
rates of taxation.
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