Last week in Europe

Some thoughts on the ongoing crisis

by DETLEV SCHLICHTER

Last week was supposed to be a major week for Europe. We had the ECB meeting on Thursday and then another EU summit to ‘solve’ the eurozone debt crisis on Thursday and Friday. Of course, nothing has changed, nothing has been solved, and quite frankly, I do not see any reasons whatsoever for changing my analysis of what is going on and how all of this is likely to end – badly, that is. If anything, the events of last week confirm that authorities are adamant to continue travelling further on the road to complete currency destruction – not only in the eurozone but equally in the U.S. and the UK, although the latter two are managing to escape closer scrutiny by markets for the time being. As usual, I felt that most of the commentary in the media was missing the main points.

The problems around the world are essentially the same. After decades of ongoing and generous expansion of the fiat money supply, of artificially low interest rates and cheap credit, banks are hopelessly overextended, asset markets are distorted, and sovereign states are bust. I sometimes get pushback on the last point. Are they really bust? – Yes, most of them are. They have acquired debt loads and spending habits – now very deep-rooted and practically impossible to eradicate – that require constant new borrowing at fairly low interest rates – cheap credit forever. Obviously, that is not going to happen. The end of the forty-year credit boom has arrived. The private sector is no longer playing ball.

What needs to happen? The overextended credit edifice needs to be cut back to a size that is commensurate with the underlying pool of real voluntary savings and with underlying real income streams. Money printing and the constant attempt to manipulate lending rates down have to stop. The market has to finally be allowed to set interest rates that reflect the true cost of available savings, and to liquidate what is not sustainable. Deleveraging, default, and debt deflation are necessary to bring the economic structure back into balance. Is this painful? – You bet. It is also unavoidable. There is no other solution. Yet, the solution is deemed politically unacceptable and it is thus being fought tooth and nail. Not only in the US and the UK, also in Europe.

The entities that are most under stress in this scenario are the banks and the debt-addicted states. You know my forecast: the central banks will be asked to underwrite the states and the banks directly with the help of the printing press on an ever-larger scale, and this will ultimately lead to higher inflation and finally to paper money collapse: the end of our present fiat money system, the latest experiment in the sad history of unlimited and fully elastic state money systems.

While this is broadly a global story, many people question whether it really applies to Europe. Isn’t the ECB more conservative, more Bundesbank-like, and thus less prone to debt monetization than the other central banks? Is there not some real effort being made in Europe to sort out the fiscal problems? – No. Most of it is simply theatre that has no or little implication for the final outcome. Let me explain.

The EasyB.

Like the other major central banks around the world, the ECB played its role in setting the world up for the credit bust by providing the cheap credit for the preceding credit boom. The ECB’s balance sheet – or rather the consolidated statement of the Eurosystem as it is correctly termed – started out at less than €690 billion in 1999. On the eve of the present credit crunch, in the summer of 2007, the balance sheet had reached a size of €1.2 trillion. In fact, over this period the ECB’s balance sheet had grown faster than that of the Fed. Like all other central banks, the ECB has, since the crisis began, become the lender-of-last resort to ever more banks and also to state institutions. At the end of 2011, the ECB’s balance sheet will be more than €2.4 trillion – its largest size ever, and also more than 20% larger than at the start of the year!

And as Mr. Draghi, the ECB’s top central banker, told us on Thursday, the growth of the central bank’s balance sheet will continue. More than four years after the crisis started and more than three years after Lehman collapsed, none of the problems in the European banking community are fixed. This is evidently the case as the European banking sector is still in desperate need of ongoing and, this is important, growing central bank support. In fact, the ECB announced more ‘liquidity’ measures to prop up the banking system this week. It also stated that it would lend money against an even wider range of collateral than previously. These measures are similar to the ones announced a week earlier by the major central banks around the world, which were also designed to lessen funding pressures among the banks. We can only conclude that the state of the banking sector must be extremely precarious.

Can all these banks ultimately be ‘eased’ back into lasting health and operational independence by the central banks? Of course, not. A reduction in banking capacity via a shrinking of balance sheets and potentially via defaults is ultimately unavoidable. Again, the banking sector overdosed on years of cheap credit. The boom will not be extended forever. Rehab is inevitable. So are the present measures of the central banks aimed at slowing this process, at postponing it, at sabotaging it or even completely avoiding it? I fear that the key decision-makers don’t even know the answer themselves. They simply want to buy some time, I guess.

The ECB had by Thursday night also fully reversed its timid and tentative rate hikes from spring and summer and was thus back to record-low policy rates. Developments last week thus confirmed my outlook: None of these central banks have an exit strategy. If you believe that these so-called unconventional and extreme measures are temporary, and that policy will be normalized at some stage, you are mistaken, in my view. The biggest direct beneficiaries of cheap money from the central banks are now the ‘private’ banks and the sovereigns, and as the shrinkage and/or failure of these entities is deemed politically unacceptable, and as the states in particular cannot cut back their expenditures and thus their deficits meaningfully, the central banks will continue to print money.

It is somewhat astonishing that in financial market debate and in large parts of the media coverage of ECB policy, the idea is conveyed that the ECB was being particularly stringent. This is due to the fact that many now demand that the ECB provides not only ‘unlimited’ direct support to the banks but that it should also manipulate directly the prices of certain financial assets, in particular the prices of governments bonds of weaker eurozone states, to an unlimited degree, because many banks hold huge quantities of them and they struggle with the lower and, I would suggest, more appropriate market prices for these securities. ‘Unlimited’ bond buying, however, is something that the ECB struggles with, at least officially, and that hits some raw nerves in Germany. Draghi’s negative assessment of large-scale bond buying in the press conference made all the headlines last week, and this is what helped to give the impression of conservatism and policy tightness.

The whole affair is complete theatre, of course. The ECB has indeed been engaged in sizable price-fixing operations in the government bond market for quite some time and is still conducting these operations today. Every week, the ECB buys bonds of weaker eurozone states in an attempt to lift their prices above normal market-clearing levels. Such indirect funding of state spending via the printing press is against ECB-rules, as Mr. Draghi confirmed again in his press conference. However, it is being done continuously by the ECB and defended with the ridiculous excuse that these operations are needed to allow a proper transmission of ECB policy. This is a blatant lie, of course, but apparently all this money-printing, market manipulation and rule-breaking still doesn’t go far enough for many in the financial industry who now demand even more money printing and more market manipulation. Please remember that the ECB presently limits its bond buying to €20 billion per week. If it only continues at this pace, which I expect it to do until it will give up its faint resistance and accelerate bond buying, the present procedures will add up to more than another €1trillion by next Christmas, and thus mean that the ECB’s balance sheet has expanded by another 42% in a single year! But, according to financial market economists, that is not enough!

None of this is a solution but all that market participants (and politicians) want is apparently some peace and quiet, a little pause in this unfolding disaster. Of course, it is only a question of time and the ECB will accommodate the wishes for even more aggressive money-printing. Again, I consider most of the debate theater.

Inflation will rise

What will all this money-printing mean for the purchasing power of money? – The answer is clear in my view: it will mean rising inflation, then accelerating inflation when confidence in paper money erodes and when central banks will find it impossible to restore such confidence through tighter policy.

It is truly remarkable that four years into a major credit correction, none of the major economies has registered any deflation. Of course, those who have an irrational fear of deflation and declare it an evil to be avoided at all cost will consider this a success. The truth is, a deflationary correction would be the natural response at the end of an extended inflationary boom based on artificially cheap money. Deflation would be part of a necessary, if in many ways painful adjustment process. This process is aborted via aggressive money printing from the central banks. We can clearly see that nothing has been solved and that the channels through which money debasement occurs have simply changed but that it is still ongoing.

Inflation in the eurozone may not be very high at present but it is above target and it will, in my view, continue to rise. The idea that all this money printing is not only harmless but also positive because it avoids deflation is nonsense. In the case of Britain, we are told every month that the Bank of England needs to keep rates low and its balance sheet expanding to avoid deflation and economic contraction when inflation has continuously been above target and in fact rising. Something similar is now unfolding in Europe. Easy money is supposed to help the banks and the states but enough of it is leaking into the wider economy to continually debase the monetary unit, while failing to initiate another artificial boom in the wider economy. I consider what we are seeing in Britain a good blueprint of what will unfold elsewhere in coming quarters: rising inflation (now above 5 percent in the UK), ongoing central bank balance sheet expansion (whether labelled officially ‘quantitative easing’ or something else), an overall weak economy with rising unemployment, failure to reign in budget deficits.

Fiscal consolidation and fiscal integration

It can only be a sign of desperation that grown and otherwise intelligent people believe that the solution to Europe’s debt problem is fiscal integration or policy coordination. This is at a minimum naïve. Debt levels and budget deficits are not where they are today because of a lack of coordination or integration among the member states. They are where they are because NONE of the states can live within their means.

Fact is that all members of the club have been shown to be habitual over-spenders and fiscal-rule breakers for years. The risk that in a fiat-money union some members may run excessive deficits and then expect to get bailed out by the other states or via the printing press, thus being rescued by a process that involves taking from the tax-payers in other countries (via fiscal transfers) or by taking from their own savers and savers in other countries (via higher inflation), was understood and clearly seen from the start of EMU. That is why certain rules were implemented: budget deficits shouldn’t exceed 3 percent, overall debt levels not 60 percent, there was a no-bail-out provision, and the ECB was banned from bailing out states with the printing press. ALL of these rules have now been broken. Germany insisted on the Maastricht criteria which restricted overall state debt to 60 percent of GDP. Germany herself is now at 83 percent – and happily signing up to new commitments in bail-out-funds that should not be possible under EU rules to begin with.

All fiscal rules have by now been broken. Bail-outs have been implemented and the ECB is funding member states to the tune of €20 billion per week!

But now, these politicians tell us, now we can finally trust them. Because all these cheaters and fraudsters will now check on one another very thoroughly as part of ‘fiscal integration’ under a new set of self-imposed restrictions and with a new treaty, and this will turn a club of rogues and rascals into a group of prudent and trustworthy guardians of the public purse.

This whole idea only deserves ridicule. It is completely laughable. Of course, it will not work. Sadly, it is also presented to the public with that specifically distasteful ingredient of bureaucratic micro-management. Obviously, the member states only trust one another to obey the rules if all decision-making is minutely coordinated and policy-setting on everything from corporate tax laws to bank regulation carefully centralized under a new European super-state. We will get more state-interference, more centralization, more meddling in markets, more and higher taxes and more capital misallocation. What we will not get is less government spending. All power to the bureaucracy!

The endgame does not change because of any of this. The only question is this: Will this impress the markets and restore some stability for a while? I doubt it.

In the meantime, the debasement of paper money continues.