Friday, December 03, 2010

Europe's Failure is Our Own

By Robert Romano

The European Union (EU) is on the brink of failure, and the lesson should be telling here across the pond.

The problems seem fairly straightforward. The debts of these EU member states are growing faster than their economies, and they are growing larger than their economies. The larger and faster the debt grows, the dimmer the prospects of debt repayment become to creditors, and so investors demand higher interest rates.

If things get really bad, then the nations cannot auction their debt off, and face a national default.

As the full scope of Greece's budget problems came into full view — it had lied about the actual size of its national debt by over €40 billion — it could no longer sell its debt. The result was a €110 billion EU bailout for Greece earlier this year to help paper over its debt.

Unfortunately, the crisis was not merely limited to a gargantuan Greek accounting scandal. Other European nations were also taking a pounding in the bond markets, like Spain, Ireland, Portugal, and others.

As a result, months later the EU has announced that it is guaranteeing all of its member states' debts. This effectively turned the continent's €750 billion "temporary" sovereign debt bailout fund by the European Central Bank (ECB) into a permanent debt monetization fund, as reported by the Wall Street Journal. Now, the EU has agreed to an €85 billion bailout for Ireland. As other states fail to sell their debts, they'll get bailouts, too.

The way the bailout essentially works is that when member states like Ireland, Greece, and others cannot sell their debt, the ECB agrees to print more euros to fill in the gaps. So shaky are the finances of these European states that the only way they can pay their bills is by printing the money needed.

The ostensible purpose of the money-printing has been to ease the borrowing costs of member states. The logic is that if the ECB agrees to prevent the nations from defaulting on their debts, the risk of failure is removed from the equation, therefore market demand for the bonds would be restored, and interest rates on sovereign debt should come down.

Except, the exact opposite has happened. Since the Irish bailout was announced on November 28th, yields on Italian, Portuguese, Spanish and Belgian debt have risen. What does this mean? That far from calming the bond markets, the central bank interventionism has sent a decidedly different message to creditors, warning that the value of their investments are being diluted with printed money.

Therefore, the more money a central bank prints to pay its nation's debts, the higher the interest rates the markets will demand for that debt to stave off inflation and the depreciation of their assets. If it gets really bad, nobody will even accept the currency as a means of payment. That's essentially what happened to the Weimar Republic in the 1920's, and we all saw how that turned out.

For the U.S., it will be even worse. As the caretaker of the world's reserve currency, a run on the dollar would likely level the entire global economy, leaving a new economic order in its place. The dollar run may have already begun, as China and Russia recently announced that bilateral trade relations would no longer be conducted with dollars. That could be a preemptive move by the Chinese and Russians to prepare for dumping their dollar holdings, which are considerable.

It is in this context that members of U.S. Congress must now view the current round of purchases by the Federal Reserve of U.S. treasuries. Now, the central bank is buying another $600 billion over the next many months. It already holds over $900 billion, more than either China or Japan held as recently as September.

That means the Federal Reserve has or very soon will become the top lender in the entire world of U.S. debt. If you count the government's off-balance sheet liabilities (i.e. those that do not appear on the federal budget), factoring in "Federal Agency Debt" puts the Fed's stake in the government at $1.05 trillion. It comes to $2.086 trillion if you factor in mortgage-backed securities.

And they bought it all with printed money. Which is exactly the model Europe has adopted. Make no mistake, they are copying us. Greece got into trouble because it did not count its off-balance sheet liabilities towards its national debt. The U.S. may not be far behind if the government's "investment" in Fannie Mae and Freddie Mac is counted towards the national debt.

Ostensibly, the Fed made its current round of purchases to ease the borrowing costs of the U.S. Except, like the Europe, the opposite has happened. Long-term treasuries yields have gone up since the Fed's November QE2 announcement.

As the Hoover Institution's Scott Powell warns, "Rolled out as positive stimulus for the U.S. economy, QE2 could be, in fact, a liquidity dodge necessary to monetize U.S. Government debt issuance the Chinese and foreigners are no longer willing to buy. In any case, unlike Greece and Ireland, which are being rescued by an infusion of capital from Germany and the European community, there is no one to bail out the U.S."

That means that the Treasury is insolvent. And when the sovereign debt bomb blows up, nobody will be able to bail us out. For now, the Treasury can only pay its bills by having the Fed print more money. To the extent that the Fed's action drives up borrowing costs, it becomes a zero-sum game, as the EU is quickly learning across the pond.

Above all, the EU is a monetary union, a debt union, and to the extent that it can fail, so can we. The U.S. is a federal union of states, but it is also a monetary union, a debt union. Leaders in Congress must be cognizant that the nation's balance sheet is not above close scrutiny — and even insolvency — in the new interdependent global economic system.

Robert Romano is the Senior Editor of Americans for Limited Government.

http://blog.getliberty.org/default.asp?Display=2861



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