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Guest Post: No Wonder the Eurozone is Imploding

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Washington’s Blog

You might assume that the reason for the implosion in the Eurozone is a mystery.

But it’s not.

There Wouldn’t Be a Crisis Among Nations If Banks’ Toxic Gambling Debts Hadn’t Been Assumed by the World’s Central Banks

There wouldn’t be a crisis among nations if banks’ toxic gambling debts hadn’t been assumed by the world’s central banks.

As I pointed out in December 2008:

The Bank for International Settlements (BIS) is often called the “central banks’ central bank”, as it coordinates transactions between central banks.

BIS points out in a new report that the bank rescue packages have transferred significant risks onto government balance sheets, which is reflected in the corresponding widening of sovereign credit default swaps:

The scope and magnitude of the bank rescue packages also meant that significant risks had been transferred onto government balance sheets. This was particularly apparent in the market for CDS referencing sovereigns involved either in large individual bank rescues or in broad-based support packages for the financial sector, including the United States. While such CDS were thinly traded prior to the announced rescue packages, spreads widened suddenly on increased demand for credit protection, while corresponding financial sector spreads tightened.

In other words, by assuming huge portions of the risk from banks trading in toxic derivatives, and by spending trillions that they don’t have, central banks have put their countries at risk from default.

No wonder Greece, Portugal, Spain and many other European countries – as well as the U.S. and Japan – are facing serious debt crises.

But They Had No Choice … Did They?

But nations had no choice but to bail out their banks, did they?

Well, actually, they did.

The leading monetary economist told the Wall Street Journal that this was not a liquidity crisis, but an insolvency crisis. She said that Bernanke is fighting the last war, and is taking the wrong approach (as are other central bankers).

Nobel economist Paul Krugman and leading economist James Galbraith agree. They say that the government’s attempts to prop up the price of toxic assets no one wants is not helpful.

BIS slammed the easy credit policy of the Fed and other central banks, the failure to regulate the shadow banking system, “the use of gimmicks and palliatives”, and said that anything other than (1) letting asset prices fall to their true market value, (2) increasing savings rates, and (3) forcing companies to write off bad debts “will only make things worse”.

Remember, America wasn’t the only country with a housing bubble. The world’s central bankers let a global housing bubble development. As I noted in December 2008:

The price of Southern California homes is already down 41%, Southern California hasn’t fallen as fast as some other areas, and we’re nowhere near the bottom of the market.Moreover, the bubble was not confined to the U.S. There was a worldwide bubble in real estate.

Indeed, the Economist magazine wrote in 2005 that the worldwide boom in residential real estate prices in this decade was “the biggest bubble in history“. The Economist noted that – at that time – the total value of residential property in developed countries rose by more than $30 trillion, to $70 trillion, over the past five years – an increase equal to the combined GDPs of those nations.

Housing bubbles are now bursting in China, France, Spain, Ireland, the United Kingdom, Eastern Europe, and many other regions.

And the bubble in commercial real estate is also bursting world-wide. See this.


Moreover, the real estate bubble formed the base upon which a series of bubbles in derivatives were built. Specifically, mortgages were packaged in “collateralized debt obligations” (CDOs), which were sold in enormous volumes all over the world. Credit default swaps were then bet against the companies which bought and sold the CDOs.

Now, with housing prices crashing, the CDO bubble is crashing, as is the CDS bubble.

A series of other derivatives bubbles are also crashing. For example, the “collateralized fund obligations” – sort of like CDOs, but where the assets of a hedge fund are the asset being bet on – are getting creamed as hedge funds are forced to sell off many hundreds of billions in assets to cover margin calls.

As everyone knows, the size of the global derivatives bubble was almost 10 times the size of the world economy. And many areas of derivatives are still hidden and murky.

So the bust of the derivatives bubble could even be bigger than the bust of the housing bubble.

BIS also cautioned that bailouts could harm the economy (as did the former head of the Fed’s open market operations). Indeed, the bailouts create a climate of moral hazard which encourages more risky behavior. Nobel prize winning economist George Akerlof predicted in 1993 that credit default swaps would lead to a major crash, and that future crashes were guaranteed unless the government stopped letting big financial players loot by placing bets they could never pay off when things started to go wrong, and by continuing to bail out the gamblers.

These truths are as applicable in Europe as in America. The central bankers have done the wrong things. They haven’t fixed anything, but simply transferred the cancerous toxic derivatives and other financial bombs from the giant banks to the nations themselves.

Are Debt-Based Economies Sustainable?

Of course, Eurozone countries like Greece and Italy have been living beyond their means and masking their real debt levels for years (with a little help from Goldman Sachs, JP Morgan and the boys) – just like the U.S.

And of course, Eurozone central banks – like America’s Federal Reserve – create fiat money out of thin air. As I argued in March, one or the primary problems is that Europe and America have debt-based economies, and the debt-based ponzi scheme has reached it’s maximum limit:

Private banks don’t make loans because they have extra deposits lying around. The process is the exact opposite:

(1) Each private bank “creates” loans out of thin air by entering into binding loan commitments with borrowers (of course, corresponding liabilities are created on their books at the same time. But see below); then

(2) If the bank doesn’t have the required level of reserves, it simply borrows them after the fact from the central bank (or from another bank);

(3) The central bank, in turn, creates the money which it lends to the private banks out of thin air.

It’s not just Bernanke … the central banks and their owners – the private commercial banks – have been running the printing presses for hundreds of years.

Of course, as I pointed out Tuesday, Bernanke is pushing to eliminate all reserve requirements in the U.S. If Bernanke has his way, American banks won’t even have to borrow from the Fed or other banks after the fact to have reserves. Instead, they can just enter into as many loans as they want and create endless money out of thin air (within Basel I and Basel II’s capital requirements – but since governments are backstopping their giant banks by overtly and covertly throwing bailout money, guarantees and various insider opportunities at them, capital requirements are somewhat meaningless).

The system is no longer based on assets (and remember that the giant banks have repeatedly become insolvent) It is based on creating new debts, and then backfilling from there.
It is – in fact – a monopoly system. Specifically, only private banks and their wholly-owned central banks can run printing presses. Governments and people do not have access to the printing presses (with some limited exceptions, like North Dakota), and thus have to pay the monopolists to run them (in the form of interest on the loans).

See this and this.

At the very least, the system must be changed so that it is not – by definition – perched atop a mountain of debt, and the monetary base must be maintained by an authority that is accountable to the people.

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  1. mmckinl

    “It is – in fact – a monopoly system. Specifically, only private banks and their wholly-owned central banks can run printing presses.”

    Yep … and the tax payer gets the bill when they fail.

    Absolutely outstanding piece … if only people got “it”.

    1. Cullpepper

      True, true, but even that is a joke: the whole point is the outstanding debt load far exceeds the ability for anyone to pay, be it taxpayers, private investors, governments. It doesn’t matter.

      When this global bubble was smaller, it was still conceivable that the trade imbalances could be dumped on naive developing countries. (Hey China! We’ll trade you this AWESOME green paper for gigatons of industrial output! W00t!)

      But now, the game has gone to far. There’s nowhere left to push this debt. What “we’re” really doing is stalling for time until a clear monetized alternative to paper emerges, something the elite can try to preserve (some) measure of their (imaginary) wealth in. We’re way, way, way past the point of using actual commodity metals.

      My bet: we’ll see a couple of years of food riots as the global petroleum supply chain breaks down, and then the current sitting president will roll up the current banking system, retire the dollar and issue some sort of universal debt card. Hell-o neo-feudalism.

      Give a choice between preserving freedom for the people and power for the leadership what do you expect will happen?

  2. Gary Anderson

    The BIS stood by in 1997 and allowed off balance sheet banking at Basel 2. For the BIS to now want fiscal sanity is a joke. The BIS is NOT THE GOOD GUY. They kindled the mass ponzi.

    So, now, all we have left is to default and clean up the balance sheets. If insurance is not sufficient to pay for all the defaults, oh well.

  3. Someone Else

    Well, Yves (and CR too) was a cheerleader for bailouts, so it’s refreshing to see a different opinion on this blog.

    1. Gerald Muller

      If I remember correctly, Yves was in favour of in effect nationalizing the banks leading to a close to 100% haircut on bond and equity holders, getting rid of the dreck assets and “reselling” the banks to private parties after they had been cleaned out of the waste. Not mentioning firing all the top executives. This does not sound to me as a “cheeleader for bailouts”.

      1. call me ahab

        well . . .uh . . .what you describe didn’t seem to happenb either-

        bondholders were protected and stocks of the bankrupt companies are still trading- banks are larger and now have an implicit guarantee for federal assistance- because if one fails- it rocks the economy- so they know the USG “got their back”

        and now w/ zero interest rate policies that “bend over” the savers- it allows banks to make money risk free-

        what a great country

    2. RueTheDay

      “Well, Yves (and CR too) was a cheerleader for bailouts, so it’s refreshing to see a different opinion on this blog.”

      Oh come on. The “just let the banks fail” argument is completely brain dead. It’s like being faced with a nuclear reactor about to have a meltdown in a populated area and asserting that the government should not do anything because to intervene would interfere with voluntary free markets and would create moral hazard for future nuclear power plant operators. It’s an absurd argument.

      No sane politician would ever let a financial system fail and bring down the economy with it. The real question is one of HOW a bailout should have been conducted. The executive management team and board of directors should have been fired, the shareholders should have lost everything, and the bondholders should have taken a forced haircut and had their debt converted to new equity.

      There’s a huge difference between arguing that the bailout should have been conducted differently versus arguing we should have just let the whole thing implode.

      1. Mr. E

        Are libertarians even human? They look human, but they sure don’t have emotions like a real human.

        1. NotTimothyGeithner

          They are human. They just try to make the world “simpler” not “simple”

      2. liberal

        Love your comments, RTD. I used to see your stuff on sci.econ, which sadly no one really posts to these days (including you and Roy).

        I really liked your comment about bond insurance and how it underprices credit risk and linked to it a few times in various blog comment sections.

      3. Costard

        “The executive management team and board of directors should have been fired, the shareholders should have lost everything, and the bondholders should have taken a forced haircut and had their debt converted to new equity.”

        And this would have been grossly illegal – as it seems that much of the bailout process was. Is it the position of sanity that government should do what it wants, when it wants, violating law and constitution because some troop of perennial half-wits deems it necessary? Perhaps you should then seize a gun and take charge, because you are clearly, in your estimation, the voice of sanity and reason.

        Do you perchance have any basis for the claim that the financial system would have failed and “(brought) down the economy with it”? Or that the effects of bankruptcy and debt destruction are comparable to a nuclear meltdown? Do you in fact have anything to say that cannot be chalked up to hyperbole or an appeal to common opinion?

        Perhaps I’m not a libertarian, but I respect them because they represent the few who still believe that government’s guiding light should be justice, not pragmatism.

    3. Glen

      Greece is imploding, Portugal, and Spain are not far behind. Everybody’s worried about how the inter linkages will bring whole mess down. GS was just in a Senate hearing about how they scam their clients, and everybody knows that’s just the tip of the iceberg.

      So why are all the markets up today?

      Is it because all the TBTF banks are counting on another massive infusion of taxpayer bucks?

      So how does this cycle end? When all the countries go broke and the TBTF banks declare victory over civilization as we know it?

    4. KFritz

      1)This is slander. Is your idea to use the ‘Big Lie’ technique, tell the biggest whopper possible and then proceed on that basis?

      2)Please change your name to ‘Something’ Else. More appropriate.

  4. Thomasina Jefferson

    The subject of moral hazard is moot after the banks were very generously bailed out to allow for multi-billion dollar bonuses.
    Governments are systemically more important than banks. If banks could be bailed out – with citizens footing the bill- so can governments.

  5. mannfm11

    GW, this is pretty solid work. What is missing is the fact that reserves or no reserves, banks generally only need money to pay each other. Central bank money is bank money, not deposit money and technically not spendable in the economy at large. It is acquired by the bank forking over assets for central bank credit. This is why the transactions have had almost no effect on the money supply.

    I have contended since this mess started this was a solvency crisis, as that was going to be the end game. I can be broke as a church mouse, to use an old pun and if I have an account I can draw cash on, I have money and can appear to have money. My creditors may never know the difference.

    Once they start operations, banks are actually insolvent immediately. It is a ponzi scheme, one endowed with creditility by governments that could derive their own bonanza from the banks. Minksy said in his 1986 book, “Stabilizing an Unstable Economy” that the banking system in the US was pretty much out of collateral to take to the Fed in the early 1970′s and that was the cause of instability at that time going forward and the reason banks had stability prior to, due to the sizable amount of treasuries built up during World War II. They depended on financial innovation as a means to create more money. A credit crunch is when a sizable player or players in the banking circle cannot produce enough credit to pay for their excessive lending, to wit Citicorp and Bank of America to name a couple.

    The entire system is a bunch of smoke and mirrors, at least it is starting to appear. I am beginning to wonder how many balance sheets and income statements are not doctored by some kind of swap to produce the desired effect for the markets. It seems the system has reached a point where the truth serves no purpose.

  6. fresno dan

    There is a tremendous belief in keeping (take your pick) “assets” “housing” “bonds” at their “bubble” values.
    There seems to be a belief that sovreigns canNOT default. Whether it is a defacto or dejure default, they certainly have.

    Why this belief? A desire to have taxes on inflated asset values? The idea that deflation of any price is a disaster? I tend to think its inertia. Most government types I know are very, very statist – most believe that changing things can make things worse – which is true enough. But when the Titannic is sinking, staying on the ship, while the conservative course of action, is not the best course of action.
    Your standard of living can go down fast and sharp, or slow and drawn out. I have a tendency to believe a sharp knife cuts the quickest and hurts the least.

    1. NotTimothyGeithner

      Judging from the history of revolutions of any sort, the sharp cuts are more likely to inspire a revolution as opposed to a long drawn out process.

  7. Dan Duncan

    This post…”it’s all Greek to me.”

    Greece and Japan are not in the position they are in because their “private banks took on toxic gambling debts and they had to be bailed out.”

    Additionally, you need to separate the “Debt-Based” economies into “Public-Sector debt based economies” and “Private-Sector debt based economies”.

    Railing about Fat-Cat Bankers, while commenting on Greece and Japan misses the mark. These countries have a different sub-set of problems that each individual society must work out. As an “informed expert commenting on these issues”, you’re simply imposing the banker excesses of the UK and USA on Greece and Japan. Yes, at some point, there is some connection (ie, when Goldman gets involved)…but for the most part the issues dividing, for example, UK and USA on one side and Greece and Japan are distinct.

  8. aet

    “Global real estate bubble”?

    I don’t buy that, for the value of real estate = location, location, location.

    1. Thomasina Jefferson

      I think this might be true, especially for cities and suburbs where all the migrants settle that come to work in foreign countries. It is a bit less pronounced outside this areas, but still noticeable.
      It may not be a bubble everywhere yet, but certainly seems to go in that direction.

  9. Mr. E

    I don’t think this post is accurate. The problems in the Eurozone are stemming from the fact that their central banks cannot create enough money to inflate their way out of this crisis.

    The banks cannot just print money out of thin air. If you look at the process as commonly understood, it requires government securities to be purchased by the central bank. But what is happening in the Eurozone is they are restricting the supply of government securities below what I am going to call “inflation clearing prices”, and the ECB isn’t playing along anyway, so not enough money is being created to pay for all the loans coming due.

  10. Doc Holiday

    We are currently in a Recovery Bubble, and all the Central Banks are setting up synthetic foundations which will melt — they have simply switched their building materials from a house of paper cards, to houses of debt made from plastic coated cards — the initial engineering of the framework may look good to speculators, but the skyscraper they are building can’t deny the reality of gravity!

    So says the good book, amen…

  11. John Merryman

    Three hundred years ago, debt based currency was a pretty smart idea, since there were few economic measures to determine how much money was necessary and debt grows at roughly the same rate as productivity. It does create a problem in that productivity must constantly increase to service this debt, which goes a long way to explaining the inherent voraciousness of capitalism. The financial system has been allowed and frankly encouraged to turn the entire economy into a debt production machine to create the illusion of wealth far exceeding the productive capacity of the economy and often subverting actual production in the process.

    Since money is drawing rights to productivity, the question is how to formulate a viable and healthy production based currency system.

    Money serves as a store of value and a medium of exchange. As a store of value, it is private property, but as a medium of exchange, it is a public utility. As property, there is the desire to accumulate as much as possible, but as a medium of exchange, more money than productivity eventually destroys the value of the money. Money should only be treated as a public utility. In that way, it would be similar to a road system. You own your car, house, business, etc. but not the roads connecting them and no one seriously cries socialism over that. The fact is that money already is a government owned public utility. Just try printing some, if you think otherwise.

    The reason banks and government like us to think of money as property is because it encourages us to use it in all economic transactions, which makes them potentially taxable. Treating money as form of public commons would make people very careful what value they would take from social relations and environmental resources to convert into currency in the first place. This would be healthy for society, the environment and the monetary system. Of course, it would create a slower, but more sustainable economy. We all like having roads, but there is little inclination to pave more than we need. If we applied the same principle to money, life would be in better shape. Instead of valuing ourselves by how big our bank accounts are, our sense of worth would be on how strong our community is and how healthy our environment is. A much smaller money supply would go a long way to limiting the size of the government and the banking system.

    By the Federal Reserve’s own logic of reducing the money supply by selling bonds and retiring the money collected, a surplus of money is in the hands of those with a surplus of wealth. The people at the top can’t just keep much of the wealth and loan it out to everyone else forever, especially since its value depends on everyone participating in maintaining the system.

    The function of the central bank is to make maintaining the value of the currency a public responsibility, while leaving private banks to profit from managing it. Political power started as private enterprise and eventually became monarchy. When monarchs lost sight of the fact that their purpose was to guide their people, as opposed to simply exploiting them, they tended to be overthrown and eventually the whole system of hierarchal power was replaced by political power as a public trust. Democracy works by pushing power down to the level it is responsive. If we were to make banking a public function, it would also be bottom up. Local credit unions would use local deposits to loan to local enterprises and use the profits to fund local needs. They would then form regional banks for broader investments.

    With a debt based currency, there is an overwhelming need to create debt. A good example is government spending. The current system is designed to overspend by buying votes for enormous bills that can only be passed or vetoed. This serves to create debt in order to store capital, as government debt is the primary investment vehicle. In the spirit of actual budgeting, a possible solution would be to break the spending bills down to their constituent items and have every legislator assign a percentage value to each item and then re-assemble them in order of preference. The president would draw the line at what would be funded. This would divide responsibility, allowing the legislature to prioritize, while giving the president final authority over total spending. Since making the cut would be graded on a curve, there would be much less incentive to trade favors and the percentage system would allow legislators to fine tune their granting of favors to other legislators and lobbyists. Since this would likely reduce funding for local projects, a system of local public banks would fill this need.

    Another issue would be the variability of needs by different communities from their currencies, so possibly a system of various currencies could be developed, of different exchanges rates, inflationary expectations, etc. Then countries/banking collectives could join what most suits their needs and if necessary, switch from one to another, or start new ones. Obviously somewhat chaotic, but it would be an evolving system and would engender a deeper understanding of economics among the larger population, thus making them less vulnerable to financial predation.

    Then there is the question of how to introduce it into the economy. Currently it is by loaning it out at low enough interest rates to allow sufficient productive returns to pay interest back. This has proven to lead to speculative booms, when interest rates are lower than assets are appreciating, creating feedback loops that increase appreciation and thus more speculation.

    The reason debt worked so much better than precious metals, or kings/politicians issuing it, was because it did provide a rough approximation for economic growth, but that is not a problem anymore, as we have a lot of information on the economy. One method that has been put forward is for governments to issue it to pay for public works, but this tends to encourage more public works simply to get the economy moving, rather than necessary expenditures, as various applications of Keynesian theories show. Another might be to issue it as tax subsidies when prices decline and increase taxes when they are rising. This would inject it directly into the broad economy, yet still allow some sense of overall direction of promoting productive sustainability and providing basic needs. As well as simply taxing those with excess savings, as opposed to having to borrow it back in order to reduce money supply. Obviously most people’s incomes would still depend on earnings in the economy. There would hopefully remain the bias towards a limited money supply, since the tendency to save currency above useful limits would be discouraged and value would flow to tangible assets and stronger social connections.

  12. MyLessThanPrimeBeef

    It’s called the Conservation of Problem – you take the problem off one guy’s hands, it merely goes into another guy’s (or gal’s) hands. It doesn’t go away.

  13. Costard

    No. Just no. Greece’s sovereign debt has nothing to do with home prices in California, other than being a victim now of the same dearth of liquidity. It has everything to do with graft and entitlements and obliging debt markets. If you know something about bank bailouts in Greece, Spain, etc., say so. Otherwise it appears as though you’re merely trying to make topical a hobby horse of yours – one that I would agree with you on, in the right context.

    1. Vinny

      Yes, but home prices were inflated in Spain, Greece, and other EU nations as well. At least, in California most people earn a decent salary, but in Greece or Spain this is not the case. It really was hard to justify a 600,000 Euro for a tiny 2 bedroom condo in Barcelona, when the average Spaniard has to make ends meet on less than 20,000 Euros a year. In Greece the discrepancy is even greater than in Spain.


  14. KFritz

    Thanks for repeating the facts–yet again. If public figures keep repeating the facts, perhaps eventually something good may come of it.

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