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.
2. See
here.
Martin Hutchinson is the author of Great Conservatives (Academica
Press, 2005) - details can be found on the website www.greatconservatives.com -
and co-author with Professor Kevin Dowd of Alchemists of Loss (Wiley,
2010). Both are now available on Amazon.com, Great Conservatives only in
a Kindle edition, Alchemists of Loss in both Kindle and print editions.
(Republished with permission from PrudentBear.com.
Copyright 2005-11 David W Tice & Associates.)
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