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07.12.2011 0

The Euro’s Last Gasp

DominoesBy Bill Wilson – While Obama sits here and plays rhetorical games with the $14.294 trillion debt ceiling, attempting to sucker Republicans into increasing taxes, there are strong headwinds from across the Atlantic that threaten the U.S. economy.

Greece’s default is inevitable. And the fate of the euro is in question.

The only real question currently facing policymakers in Brussels is whether banks foolish enough to lend money to a bankrupt socialist government will take losses, or if the European Central Bank (ECB) will simply print more money to bail out Greece’s creditors.

That decision will have major ripple effects. If bondholders take losses on Greek debt, American financial institutions like Bank of America, Goldman Sachs, and AIG are said to be on the hook for honoring credit default swaps sold to insure against Greece’s default on its €340 billion debt.

If, on the other hand, the banks are bailed out, and the ECB buys back the Greek bonds with printed money, then it is the central bank that is on the hook for any Greek default.

At that point, a Greek default would in principle lead to the ECB’s insolvency. The European Central Bank (ECB) is already on the hook directly for over €120 billion in Greek debt, including tens of billions of Greek debt it accepted as collateral when making other loans.

So, whether the ECB further intervenes at this point or not, a Greek default would hurt the ECB — and the euro — most of all.

Even if U.S. financial institutions foolish enough to insure against Greek default were still to be the ones on the hook to honor the swaps, nobody expects the global banking ruling class to really take any real losses on sovereign debt, no matter how richly deserved. The assumption is that these institutions cannot afford to honor the credit default swaps. So, who would bail them out?

The Federal Reserve, as usual. As in 2008 and 2009, the Fed’s emergency facilities would once again likely bail out financial institutions all over the world deemed too big to fail. Or, perhaps the newly minted, FDIC-operated, so-called “orderly liquidation fund” under Dodd-Frank — really, an unlimited bailout fund — would be invoked.

One way or another, institutions that purport to be private will be made whole by the public treasury, just as creditors of Greece, Portugal, and Ireland already have been. Soon too Italy’s creditors will try to get a piece of the action. They won’t lose a cent.

However, that does not make a Greek default any less damaging economically. Yields on Italian and Spanish debt are soaring, and Portugal, Ireland, and Greece are already dramatically high as the crisis continues. A default in Athens would force markets to price in potential defaults for the other states, which means punitively high interest rates.

This will place even more pressure on the ECB to paper over the debts of the other European states. Meanwhile, the crisis will claim new victims that have, as a matter of political choice, spent far beyond their means.

The ultimate casualty may be the euro itself. If the monetary union breaks up — How does Greece default and remain in the eurozone anway? How does the European Central Bank go bankrupt and the euro remain a viable currency? — gone will be a cushion the U.S. has relied on economically for the past two years.

As the financial crisis turned from bad to worse, there was a flight to safety in two havens: gold and U.S. treasuries. In 2010, the same flight occurred in the heels of the sovereign debt crisis in Europe. The euro plunged, and the dollar, treasuries, and gold went up.

Sadly, the exchange rate is only a matter of relative weakness. Both the euro and the dollar are racing to the bottom.

Without the euro, attention would be more centrally focused on the unsustainable U.S. Treasury bubble, where already the Fed is intervening to purchase trillions of U.S. debt with printed money. So heavy has the Fed’s hand been in treasuries markets that creditors have not yet begun pricing in a U.S. default.

When they do, watch out for the falling dominoes, even if Uncle Sam hasn’t.

Bill Wilson is the President of Americans for Limited Government. You can follow Bill on Twitter at @BillWilsonALG.

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