THE BEAR'S
LAIR Confidence drains
away By Martin Hutchinson
The continual stream of bad news coming
out of Europe is causing a withdrawal of investor
confidence in the bonds of several European
countries, very reminiscent of the draining
confidence in housing-related bonds in 2007-08.
Thus there seems to be an increasing likelihood of
an extreme scenario in which confidence disappears
and insolvency events occur that were previously
unthinkable.
Such a collapse in confidence
would almost certainly produce a global depression
of 1930s magnitude. It's also pretty clear from
the 2008 experience that the authorities have
little idea of how to prevent this or of what to
do when it happens.
This can be easily
demonstrated by examining the authorities'
behavior in 2008. In monetary policy, Ben
Bernanke's Federal
Reserve and the Bank of
England both violated Walter Bagehot's famous
dictum that in a crisis the central bank should
make money readily available against first class
security at a very high rate.
The purpose
of doing this, as Bagehot and his contemporaries
well knew, was to prevent a liquidity crisis that
might destroy confidence and cause banks to be
forced into liquidation unnecessarily, while at
the same time providing a strong incentive for the
banking system to get its house in order,
foreclosing on loans with poor security,
liquidating positions even at a loss and freeing
up the banks' balance sheets for future
opportunities.
If the banks took large but
not fatal losses in doing this, so much the
better; it would prevent them from overextending
themselves so foolishly in the future, sharply
discouraging future bubbles.
In 2008 in
both the United States and Europe and again
earlier this year in Europe, the world's central
banks recklessly disregarded this dictum and
instead lent large amounts of money at very low
rates. The result was that banks piled back into
risky assets, buying mortgage debt in the US after
the housing market had collapsed (thereby
profiting from the artificially steep yield curve
gap between low short-term rates and higher medium
term rates).
In Europe this year, Italian
and Spanish banks bought more of their countries'
government bonds, thereby recklessly overloading
their balance sheets still further and weakening
at a crucial moment what should have been a
ferocious budget pruning in both countries.
Given the ability to postpone pain, the
Italian government of Mario Monti, installed
illegitimately by Brussels, wimped out on the
necessary labor law changes. The mostly admirable
Spanish government of Mariano Rajoy trimmed the
national budget adequately but failed to bring the
grossly overspending provinces to their senses.
As well as reckless lending at excessively
low rates, 2008 saw the creation of the Troubled
Asset Relief Program (TARP). Like the cheap loans,
this saw government taking an utterly
irresponsible attitude towards public money and
demonstrating a complete lack of forethought as to
what the bailout should achieve. Indeed, in its
first incarnation, TARP would have had taxpayers
buying the most toxic housing assets from the
banking system at prices determined by the banking
system; it would thus have guaranteed humongous
losses for taxpayers and achieved little.
With the massive liquidity injections from
the Federal Reserve, no bank bailout should have
been necessary. At worst, Citigroup, Merrill Lynch
and Washington Mutual might have failed because
being overleveraged and heavily concentrated in
the most worthless assets they would have lacked
sufficient collateral for a Fed loan program that
was run in an appropriate manner. AIG would
undoubtedly have failed and would have deserved to
do so because of its grossly inappropriate
activity in the gimcrack credit default swap
market.
However other banks would have
rescued themselves through Fed emergency funding,
with Wells Fargo buying Wachovia at a knockdown
price and Bank of America surviving, in spite of
its catastrophic previous purchase of Countrywide,
because it would only have had its own bad assets
to deal with and not those of Merrill Lynch.
The result would have been a very nasty
recession, a sharp contraction of credit, and a
further lurch downwards in house prices that would
have achieved 2012's depressed and
market-stabilizing price levels three years early.
The recovery from recession would however have
been robust, as it was for example in 1920-21,
which saw a similar period of mass liquidation
after the overextended bubble caused by World War
I.
Even if a bailout had been undertaken,
TARP's principles were precisely the reverse of
those that should have been used. Instead of
making TARP capital injections compulsory, they
should have been voluntary. TARP as it was
implemented cast a shadow over the credibility of
the entire US banking system, as well as
encouraging assets and business to flow even
further towards the largest banks, which were
thought "too big to fail".
A voluntary
TARP, on the other hand, in which banks took only
those capital injections that they felt truly
necessary, would have allowed those banks that
could survive without TARP, including many of the
larger regionals, to gain additional credibility
and lower market funding costs through doing so.
As for AIG, it should indeed have been
treated as a special case, being forced to default
altogether, thus ensuring that the wholly unsound
credit default swap market involved several of the
world's largest banks in painful losses,
strangling its further growth. Holders of genuine
AIG insurance policies might have had to wait for
their money, as did holders of assets in the
defaulting Reserve Primary Fund, but they would
have received most if not all of their legitimate
claims in the end.
Enough of history. We
are currently in the eurozone faced with a repeat
of 2007's mortgage market collapse, only on a
larger scale, potentially involving the public
debt of not only Greece and Portugal (Ireland
appears to have rescued itself) but Spain, Italy
and France, all countries so large as to be
impossible to bail out.
Just as in
2007-08, investor confidence drained from mortgage
bonds of all kinds, even though some of them
eventually proved of high quality, so today
investor confidence is draining from a number of
European countries whose prospects are very
different.
Should the authorities continue
pouring money into the market without the
necessary structural reforms taking place, we will
eventually experience another September 2008, with
the defaulters being countries rather than banks
(though their defaults will cause several banks to
default as well). In detail:
In Greece, a
further default is inevitable, whether or not the
country remains part of the euro. The deflation
required in order to force the witless Greeks back
to living standards that are sustainable - about a
third of their 2008 opulence - is simply too great
if Greece remains part of the euro, and the debt
Greece has already acquired, even after the
write-offs already taken, is too great to be
repaid from collapsing drachmas. Greece must exit
from the euro; the market has already priced this
in, and the principal objective should be to force
it out as quickly and in as orderly a manner as
possible, without pouring additional resources
down the Greek rat-hole. Those resources will be
needed elsewhere.
Spain, on the other
hand, is in trouble almost entirely because of
investor confidence. Its budget is well under
control and its debt is moderate. What's more, its
real estate problems were confined to the smaller
banks (Bankia being an amalgamation thereof). Its
problem now is that it is a decentralized polity,
and its provincial governments did not adopt
austerity quickly enough and are now cut off from
the market. If Spain were isolated, its problems
could be solved with a moderate-sized bailout; as
it is, it may very well have to leave the euro
although a full debt default remains unlikely.
Rationally, Spain has by no means the most
difficult problem to solve, but market confidence
in it has almost entirely departed.
Italy
has considerably worse problems than Spain, in
terms of its debt level, and much less capability
to solve them. If the EU were going to impose a
new government undemocratically, it had to ensure
its government would take the actions needed. As
it is, Monti has wimped out in face of Italy's
public sector unions, and Italy's budget and debt
problems are getting worse, not better.
Furthermore, Italy must have an election
next March (or lose democratic legitimacy
altogether). At that election, it now seems the
electorate will be offered three alternatives:
further pointless austerity with Monti, a clean
departure from the euro followed by an assault on
union privileges with Silvio Berlusconi or an
outright debt default with Beppe Grillo. Two out
of three of these alternatives would lead to debt
default, while all three would probably lead to
departure from the euro, since under Monti the
bailouts would get too great for the German people
to stand.
Finally, France is currently not
in investors' sights, with its 10-year bonds
yielding 2.2% rather than 6-7% as in the case of
Spain and Italy. Here investors are being
irrationally optimistic in not panicking. The new
French government has introduced a 75% tax rate,
plus a swingeing wealth tax, and has reversed most
of the very modest fiscal reforms introduced by
the previous government.
France's budget
and debt position are both worse than Spain's, and
the new measures will drive wealth out of the
country, cause economic decline and thereby worsen
France's debt and budget problems substantially.
When investors figure this out, probably toward
the end of this year, there will be hell to pay -
the French economy is far too big, and French
economic policy far too bad, for any bailout to be
feasible.
There are thus at least two
major confidence destroyers in France and Italy
beyond the current problem children of Greece and
Spain. Just as with the successive
bankruptcies/liquidation rescues of Northern Rock,
Bear Stearns, Fannie Mae/Freddie Mac, WaMu, Lehman
Brothers, Wachovia and AIG in 2007-08, successive
events will deal hammer blows to investor
confidence, eventually drying it up altogether. No
amount of further "liquidity support" and bailouts
will prevent this; the amounts of money involved
in the case of Italy and France are simply too
great.
Doom is not inevitable. If the euro
breaks up, each national currency can find its own
level, and national monies can be printed as
necessary to fund debt service and government
deficits. Inevitably, some countries, probably
Greece and France, will overdo the injections of
liquidity from their central banks and experience
a Weimar Republic-type inflation episode, followed
by a partial default on their debt. But that, and
the sharp decline in living standards that it will
produce, will be purely their problem.
In
Italy (probably) and Spain (almost certainly)
sufficient discipline will be maintained that the
crisis will be solved without default and without
further outside intervention. Globally, the
break-up of the euro will cause a short-lived
downturn, but the new strength in Germany,
Finland, the Netherlands and elsewhere, their
economies finally freed from the need to bail out
their weak sisters, will quickly restore global
growth.
In 2008, much subsequent economic
malaise could have been solved by the authorities
applying the principles of Adam Smith and Walter
Bagehot. The same principles can now be applied in
the eurozone, and the collapse of investor
confidence stopped in its tracks. To adapt a
famous Maynard Keynes aphorism, all it will take
is the euthanasia of the bureaucrat.
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 2005-12 David W Tice &
Associates.)
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