The Latest Ploy to End the Financial Crisis

Global markets took off on Thursday and Australia duly followed in Friday’s trade. Perhaps because economic growth returned to Europe? Or maybe America discovered the new internet? Nope, all it took was a carefully worded comment from the European Central Bank’s President:

‘Within our mandate, the ECB is ready to do whatever it takes to preserve the euro. And believe me, it will be enough. To the extent that the size of the sovereign premia (borrowing costs) hamper the functioning of the monetary policy transmission channels, they come within our mandate.’

Translated, that means, ‘We’re going to do something.’

But central banks were designed to prevent financial crises, not economic ones. There’s a crucial difference. One that is coming to the fore right now all around the world. Because world economies are slowing again. It’s not a shock this time around. It wasn’t really a shock in 2008 either, if you knew where to look. But this time around, even the mainstream indicators are flashing red.

We won’t go into what those indicators are. Mostly because they are a bit dodgy anyway. Instead let’s focus on whether the same duct tape fixes that worked last time will work again this time. Can a recession and financial crisis be averted around the world? Or will markets melt down even worse than last time?

A financial crisis is a crisis of confidence. In the sense of confidence men (known as con men) and their confidence schemes. A financial crisis is what happens when a fraud is exposed on an economy wide scale. The fraud is that banks don’t have the money depositors want to withdraw, because the banks lent it out. The confidence game is up when the depositor’s withdrawals overwhelm the banks reserves.

But the fraud can be maintained during a crisis with an inflow of money to the banks. That is what central banks were designed to do. It’s called the lender of last resort function. Any bank that is in trouble because of deposit withdrawals can ask for help from the money printers.

The idea that the central bank can manipulate the economy has grown from this (kind of like a brain tumour). But it doesn’t work. At least, not in a good way. Central banks can’t control the economy because the economy is, unlike fiat money, made up of real stuff. Money can be created out of thin air, but real stuff can’t.

The central banks’ inability to control the real economy doesn’t stop economists and politicians from trying, though. Still, they won’t be able to engineer a true economic recovery. The real question is whether the financial system confidence game is up or not.

Can policy makers cover up the instability of the financial system with more money? Will stock markets rally on the news of more intervention? Or will the markets figure out that the economy is immune to the drug of more money?

There’s a little logical riddle you must answer if you think that markets will rally the next time money printing and bailouts are announced. Because for markets to rally, two questions must be answered in your favour:

Will the stock market believe that the economists and politicians can save the banking system again? Will the stock market believe the banks will continue to save the politicians and economists?

The problem with those two questions is that both saviours are in need of saving from their savees. Let me explain. Banks need to buy government bonds so the government has money to bailout the banks.

And central banks need banks to lend the money they create (not just to governments) to make their policies effective. That’s something the banks won’t do while they need to fund withdrawals and give the rest to governments so governments can give it back to them.

It’s a three legged musical chair race. Everyone is tied to each other at the ankles, but not everyone can win because one chair is missing. And there’s no finish line in sight, you just keep going round and round.

Policy makers have resorted to their usual ploy to escape the cycle — change the rules. They’ve been a little more imaginative with their ideas than usual, though. According to the Austrian central banker Nowotny, policy makers are considering a classic con man tactic — make the fraud even bigger to hide its rotting foundations. Instead of preventing banks from lending out money their depositors have given them for safe keeping, why not allow other entities to engage in the same fraud?

Specifically, why not let the bailout funds of Europe become banks? That way, they will get access to the central banks’ lender of last resort function. And voila, we have an entity to break the three legged musical chair race deadlock by bailing out bankrupt governments with central bank money.

If this strikes you as a much ado about nothing, you’re more or less right. The Europeans have come up with a bizarrely arcane way of going about the age old practice of printing money for the government to use. They had to circumvent their own rules designed to stop them from doing just that. But they might get there in the end.

Remember, printing money and buying government bonds won’t help the real economy. The UK and US can both print money and buy bonds more or less directly already. And they’re in trouble themselves. All the Europeans will have done, if their plan works, is to keep the con going.

Is there any hope the spectacle will end well? Not really.

Usually, financial crises are triggered by poor private sector lending by the banks. Mortgages sour, depositors withdraw money in case the bank fails, and the central bank bails out the bank. But this time around, the dodgy lending decision that the banks made en masse was lending to governments. The same governments that make the rules.

This adds a whole new dimension and dynamic to the story of our 2008 experience. Imagine if all those subprime borrowers had banded together in 2008. Things could have gone down a little differently if they formed their own police force, army and legal system. Now that the politicians are the subprime borrowers, things will get interesting. They actually have a police force, army and legal system to do their bidding.

Politicians are much more difficult to predict than private borrowers because their incentives are hidden. In the private sector, people want to make money by selling stuff. Politicians like power, donations, votes and cushy jobs for when they get voted out.

It’s difficult to know what influences are playing out. And the possible outcomes are much more diverse. In 2008, we had some idea what we’d be in for because the issues were centred in the private sector. This time, it’s going to be much more difficult.

What does all this spell for Australia? Well, we definitely won’t be immune down under. But what are the chances of us being hit especially hard? We’ve got plenty of cobwebs and skeletons to clear out after so many years of growth. In fact, you have to wonder whether we have the worst of all worlds. A housing bubble, an oversized financial industry, resources curse and a super strong currency. The only thing we haven’t got is what everyone else has got – a sovereign debt crisis.

Of course, that could change if all the other problems take hold. Bank bailouts, falling tax revenue and overseas debt turmoil could turn Australia’s sovereign debt into a real problem pretty quickly. Then the question will be whether we are like Greece with its rising interest rates or the US with its record low rates. That’s a question for another day.

On Wednesday in our article about the Australian mining tax we pointed out that gold as a percent of global assets is currently tiny compared to historical norms. A return to normal would see gold based assets rally significantly. A reader kindly pointed out an alternative scenario:

‘Dear Nick,

‘The graph you posted – Destined to Grow – and your statement that “one of two things will have to happen” misses the third option. That is a massive drop in the value of global assets. Why is it so inconceivable that global assets could drop in nominal value by 80-90%? Of course it does not fit the Markets and Money belief/desire that gold will rise by an amount that would restore gold to the bracket around 20%+ of global assets. I think that is far less likely than my suggested scenario because it also implies that inflation will be rampant. What do you think will happen to every other asset (stocks, commodities and property) if inflation breaks out big time?

Yes, they will climb too.

‘The far more likely scenario is surely a deflation in which most assets including gold decline (but at different rates) and some currencies, including the US dollar, will rise. The breakdown is already happening because low interest rates are not sufficient incentive to grow the credit market. Total credit worldwide is dropping and that is deflation.

‘Yours sincerely,

Nick Marshall’

Choose your poison, dear reader: hyperdeflation or hyperinflation. One protects (or actually enhances) the value of paper currency. The other seeks to destroy the value of the currency to keep the system going for as long as possible.

Based on the long history of currency management, which outcome would you bet on?

Until next week,

Nickolai Hubble.
The Markets and Money Weekend Edition

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So where to for Europe from here?

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Nick Hubble
Nick Hubble is a feature editor of Markets and Money and editor of The Money for Life Letter. Having gained degrees in Finance, Economics and Law from the prestigious Bond University, Nick completed an internship at probably the most famous investment bank in the world, where he discovered what the financial world was really like. He then brought his youthful enthusiasm and energy to Port Phillip Publishing, where, instead of telling everyone about Markets and Money, he started writing for it. To follow Nick's financial world view more closely you can you can subscribe to Markets and Money for free here. If you’re already a Markets and Money subscriber, then we recommend you also join him on Google+. It's where he shares investment research, commentary and ideas that he can't always fit into his regular Markets and Money emails.

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I don’t focus too much on whether the consensus is on inflation or deflation. There is ample evidence of both happening dependent on product or asset what was overvalued, debt fuelled. Supply and demand issues and whether a product is elastic or inelastic in a particular economic climate will determine inflation and deflation on specific issues. The overwhealming force out there is debt deflation and the only outcome is Debt Default. I repeat DEBT DEFAULT. The FED reserve actions are buying some time but the defaults are on. Greece has already given out a default to bondholders and More to… Read more »
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