03.15.2011 0

Europe’s Gathering Storm

By Bill Wilson

On Mar. 12, the European Union (EU) reached an agreement to create a permanent €440 billion bailout fund to support troubled sovereigns like Portugal, Ireland, Greece, and Spain (PIGS). Despite a lot of talk of making the “senior bondholders” pay part of the loss in government bonds from the PIGS, ultimately this was not included in the agreement.

The European Central Bank (ECB) and the elite insisted that these holders be protected and paid back everything. But why? Ultimately, the issue revolves around who these bond holders are: mostly German and French banks that have lent about $922.9 billion to these nations, according to a report by the Bank for International Settlements.

That represents 57 percent of the total $1.613 trillion foreign exposure to the PIGS nations. And it explains the outcome of this agreement lacking any apparent haircut for the bondholders.

It also explains why the newly elected Prime Minister of Ireland, Enda Kenny, was unable to secure a deal with the EU to have his nation’s 6 percent interest rate owed on €67.5 billion bailout loan lowered. Germany and France are insisting that Ireland increase its lowest-in-Europe corporate tax rate from 12.5 percent.

Since German and French banks are making the rules, they are not willing to accept getting paid less than was lent out, by taking a haircut on the bad loans through debt restructuring. They are not even willing to lower the interest rate on the debt owed — except in return for Ireland eliminating the one economic advantage it has in its corporate tax incentives.

Instead, the banks have gotten essentially everything they wanted, a permanent bailout fund so they can sell existing debts that cannot be rolled over to the European Central Bank.

In some cases, these are the same banks that have lent to the U.S. and other sovereigns throughout the world. So, if the banks take losses on anything, it limits the amount of money that can be lent to other states. It is for this reason that the astronomical debts being held by governments throughout the world pose the greatest systemic risk to the global economy — everyone has skin in this high stakes game of musical chairs.

Losses in one group of those bonds would lead inevitably to losses elsewhere, since the initial losses limit the funds available to for others to refinance existing debts. That is why the central banks are stepping up and just printing the money needed for the sovereigns to refinance their debts. Which is exactly what is happening now in Europe.

What the ECB and others are afraid of is that defaults or even just debt restructuring will result in a deleveraging of government debt not unlike what was seen with the housing bubble popping the U.S.

The goal therefore is to create a “soft” landing for these financial institutions, which can then reposition themselves and probably limit future purchases. Also, since the expansion of government debt has become the most efficient means of increasing the money supply, if losses start occurring, the central banks worry this will slow down money creation and velocity, leading to “deflation”.

If these banks are anything like the Federal Reserve, they are counting these debt securities on the assets side of their ledgers. Which means, adding to the risks posed, these major banks may have leveraged these bonds to back borrowing. It is also possible that these debts are held as part of their reserve, which the Fed does, which is just as bad.

Why wouldn’t they? These are supposed to be the “safest” investments in the world. If governments will just agree to monetize the debts if anything goes wrong, there is no risk in lending to even the most irresponsible of governments.

The only problem, of course, is that there is no such thing as a safe investment. That is the only reason why the German and French banks are so vehemently opposed to any restructuring occurring — it breaks the unspoken agreement between the banks and the governments. They cannot afford for the terms of that agreement to change.

Instead, the banks prefer that it is the citizens who are left holding the bag if these bills ever come due — in the form of inflation, higher prices, higher interest rates, and eventually, higher taxes. Unfortunately, these same banks are risking the collapse of whole currencies, like the euro and dollar, under the weight of these astronomical debts.

Such is the state of the social contract during the current sovereign debt crisis. No longer is the arrangement between the governed and the government, as the Irish people are quickly learning. Now it is between governments and their lenders. The governed, sadly, lack any representation in that arrangement.

Bill Wilson is the President of Americans for Limited Government.

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