We’re on our way to a new global monetary system. The current one isn’t working, and each year, fewer parties have the incentive to keep it.
This summer will mark an acceleration of the move toward a new monetary system. If European leaders want to hold the euro together (they do), Europe has no alternative but the printing press. The cries for more printing will drown out the German elders’ warnings against using the printing press to finance government spending.
Reuters recently quoted a Spanish diplomat who likened the German cultural aversion to currency debasement to the Taliban: “It may go down to the wire; it may get very bad,” he said. “But Germany has to choose. With Greece, it did not have to choose. It could allow Greece to fail. But if Spain fails, Europe fails. So in the end, we have to believe that Merkel and the Taliban of the Bundesbank (German central bank) will change their minds and do what they need to do to save Europe.”
Which party is acting like a Taliban fanatic here? The parties arguing that central banks financing governments can set society on an inescapable road to hyperinflation, or the parties blackmailing the rest of Europe into unconditional bailouts (“if Spain fails, Europe fails”)?
This ultimately comes down to an ugly argument over which countries and institutions will suffer losses and lower standards of living. Lenders and borrowers should suffer the losses, but thanks to the printing press and bailout policies, losses are spread around to everyone holding currency — even if they were prudent and responsible during the bubble years.
Two Choices For The Eurozone…
Looking at the big picture, the eurozone crisis will keep pressure on politicians until it forces an important choice:
- Unite into a mediocre, fading welfare state. In this potential United States of Europe, Brussels plays the role of Washington, D.C., holding the power to tax and issue debt. No country fails or succeeds, and everyone waits as demographics and euro debasement slowly push the welfare state into bankruptcy, or
- Break up, force losses on banks and bondholders and start over in the aftermath with a series of currencies. In other words, restore a system in which the currency has meaning and living standards rise and fall based on productivity.
Below is how I expect this crisis to proceed, based on political incentives. But first, here is the backdrop to the choice Europe faces…
As expected, nothing concrete came out of the recent summit held by eurozone political leaders — the latest in a long line of summits dating back to early 2010. All of them deal with one key issue: Who will shoulder the losses from the past decade’s government debt bubble? And is the European Union destined for a full-blown “fiscal transfer” union, with richer countries spreading the wealth around to the periphery?
Many respected investors see a movement toward fiscal transfer union, with Brussels having the power to tax and issue debt guaranteed by every EU member country. Bridgewater CEO Ray Dalio, the world’s best macro hedge fund manager, recently told Barron’s that he sees a fiscal transfer union as inevitable. In Dalio’s view, it’s only a matter of how much pain European financial markets and economies must endure before forcing the wealthier EU countries into such an arrangement.
But at this point in the crisis, a transfer union looks like a long shot; it’s not politically acceptable to core countries like Germany. “Why,” the Germans ask, “should we subsidize the budgets of profligate governments that have shown no ability to restrain their spending? These countries can’t even foster conditions that allow for a competitive economy!”
That’s a valid question. You can sympathize with the seemingly cruel, miserly sentiment if you ask yourself the following: Imagine co-signing a luxury car loan for a free-spending, un-creditworthy neighbor, just so you can maintain a friendly relationship. You know you’ll be on the hook for the debt, yet the benefits of co-signing are tiny.
Aside from understandable objections to a fiscal transfer union, Germany and other core eurozone countries also want to prevent the European Central Bank (ECB) from behaving like it’s financing a banana republic. On the issue of ECB policy, however, Germany is not likely to get what it wants. The ECB will likely launch another round of printing and buying of PIIGS bonds, simply because the Greek and Spanish banking crises continue festering and there is little hope of any quick political resolution to these problems in the coming weeks and months.
More ECB printing would not solve the problems clearly on the horizon; printing simply buys more time ahead of a needed restructuring of government debts and banks.
Spain’s hidden and contingent liabilities are becoming all too real. For instance, the regional government of Catalonia, Spain’s wealthiest region, just asked the central government for help refinancing its debt: It must roll over €13 billion in debt through year-end, and has been shut out of international bonds markets for years.
As liabilities pile up at the central government, depositors continue running from Spanish banks. As we suspected, the recapitalization needs of Bankia keep growing. The Spanish press recently reported on Bankia’s request of €15 billion in cash from the government — money that the Spanish government doesn’t have, and which would, if granted, push its own bonds further into distress.
Prime Minister Mariano Rajoy’s response to the banking crisis has been erratic and incoherent. The Spanish public is losing confidence in their political leaders. It probably will fall to EU and ECB bureaucrats to decide how to restructure the Spanish banking system, especially since they have access to borrowing and printing options far beyond those of Spain.
I doubt many of the large banks can absorb the losses on Spanish loans and mortgages, because the interconnectedness of the system means the weak banks will drag down the stronger banks, both through the tightening of credit to the rest of the economy and through the liquidation of overmarked collateral, which pushes down collateral values backing loans at all the other banks.
For all the duplicity of his actions in 2008, Hank Paulson knew a successful bailout required all too-big-to-fail banks to take TARP money in 2008, even if they didn’t want it; he understood that the most-bankrupt banks would act in a manner that dragged down the supposed “fortress” balance sheets.
Remember, Spain doesn’t have the capacity to implement a TARP-like recapitalization of its banks. Spanish Prime Minister Mariano Rajoy at a recent summit resorted to begging the ECB to buy more Spanish bonds. More ECB buying would do nothing to solve the problem, and would only exacerbate the flight of private-sector bond investors from Spain.
At the end of this process, the losses will likely exceed the value of the Spanish banking system’s equity. Claims of subordinated, unsecured bondholders will likely get haircuts, too.
The ECB and EU need to act fast. Private deposits in Spain’s banks fell 2% in April, to €1.62 trillion, according to ECB data. The month of May must have been even worse. Continued runs at this pace would hollow out the banking system in a matter of months, leaving the ECB as the only entity supporting the towering edifice of bank liabilities.
The central bank reaction to debt crises is prompting large bond fund managers to ponder the future of the monetary system. Bill Gross, manager of the world’s largest bond fund, in his latest missive describes “a potential breaking point in our now 40-year-old global monetary system.” He sees that there is no way out of our current global debt problem other than continued printing and repression of returns for savers.
Spanish bank insolvency lies at the heart of the country’s crisis. Until it’s adequately restructured and recapitalized, Spain’s crisis won’t end. This recapitalization process is why I’ve instructed my readers to short two large Spanish banks — one of which we’re already up well over 10%.
In Greece, it’s more of the same. The chances of political and economic chaos are high. The Greek government is suffering from plummeting tax receipts, and is likely to run out of cash to fund its budget right around its June 17 elections. It faces the unpleasant choice of sticking with EU bailout terms and receiving the next bailout cash payment or defaulting and jumping into an uncertain economic abyss.
Putting myself in the shoes of Greek political leaders (even if the Syriza party wins the next round of elections), I expect they’ll decide to “accept” bailout terms for now, get the cash and then not adhere to the terms. Depositors and bond investors would see this scenario as more of the same, and the crisis would continue to boil.
Pressure on the ECB to ease will grow. It will cut interest rates. It will expand loan programs and printing operations. The ECB will feel compelled to announce a huge quantitative easing program — one much more similar to those of the Federal Reserve. Such printing could buy time for the European banking system as its political leaders decide how to allocate losses on items like bad Spanish loans and Greek government bonds.
At the end of this process, the euro will be even more debased, and many PIIGS countries and banks will still be insolvent. At that point, perhaps the core EU countries will decide to push toward a fiscal union. But until then, it will be more of the same.
Meanwhile, the ECB will ease further and likely gain support from the Fed and other central banks in a “coordinated” intervention. So the weakness in gold and gold stocks in early May was merely temporary. And the global middle class will continue to be squeezed by the inflationary policies of central banks that are increasingly becoming pawns of politicians.
More wealthy investors in the core of the eurozone will come to view the euro as trash and gold as money.
Hold your gold-related investments as we await the next deluge of money printing, likely to arrive soon…
Dan Amoss, CFA
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