A Spectre is Haunting Europe

by futurist Richard Worzel, C.F.A.

The spectre of Sir Thomas Gresham is stalking Europe, like a shambling, unstoppable zombie, straining to eat the heart out of its financial system and economy. And if Europe falls, the global markets and global economy won’t be far behind.

Gresham (1519-1579) is generally credited with formulating Gresham’s Law, which says that bad money forces out good. Suppose, for instance, that you have your life’s savings in a Greek bank account, denominated in euros, but that there are rumors that Greece is going to leave the euro. If that happens, then the government will force all its banks to convert their euro deposits into drachmas, including your savings. Further, suppose the press is speculating that if the drachma is re-issued, it will almost immediately drop in value by about 50%. What do you do if you want to preserve the value of your life’s savings?

Clearly, you either take your savings out of the bank and put euro notes under your mattress, or you open a euro-denominated account in a bank in some other country, beyond the reach of the Greek government’s greedy hands. You don’t want your life’s savings turned into zombie money.

But since all of your friends and neighbors are hearing and doing exactly the same thing, what happens is that there’s a run on Greek banks, as Gresham’s Law drives money out of Greece and into some safer haven, like Germany. Meanwhile, the EU and the Greek government both look for ways of stemming this outflow of money because a run on Greek banks makes it even harder for Greece to stay in the euro, and because a bank run is an unpredictable thing. Once a run starts, it can be very difficult to stop, and can spread to other jurisdictions.

Like Spain, for instance. In 2007, before all the troubles started, Spain’s ratio of debt to GDP was less than 40%, which was better than the U.S. or most of the EU, so they didn’t start out being profligate the way Greece has been profligate. But they did have (and encourage) a housing bubble, much like America’s. And, like America, when the bubble burst in 2008, Spanish banks (and others) were left with too many bum loans, and not enough capital to cover them. In response, the Spanish government borrowed money to provide a capital infusion to its banking system, much as America did in 2008-09. This increased their indebtedness to 68.5% of GDP in 2011, and then caused it to skyrocket to 89% of GDP so far this year. In turn, this caused the rating agencies to downgrade Spanish bonds by three notches at once, to a notch above junk bond status. So now Spanish bonds are suspect – and since Gresham’s Law applies to bonds as well as cash, investors now want to ditch Spanish bonds and find something more secure (like U.S. treasury bonds, or German bunds). In effect, there is now a run on Spanish debt – or rather, away from Spanish debt – because of Gresham’s Law.

And so it goes. The troubles in Spain have overshadowed similar problems in Portugal and Cypress. And if investors are scared of Spain (the fourth largest country in the EU), they might start to question the debt of Italy (the third largest country in the EU) – in fact, at time of writing, this has already started. A June 13th, 2012 Associated Press story quoted Nicholas Spiro, an expert on government debt, as saying “Contagion is back with a vengeance, and Italy is bearing the brunt of the fallout from Spain’s request for external assistance, which is a sign that panic has set in.” And France and its big deficits and debt load are looking none too secure right now either – and France is the second largest economy in the EU.

So Gresham’s Law moves from a small, weak, profligate country like Greece, to a stronger, larger, less profligate country like Spain, to an even stronger country (albeit with a large amount of debt outstanding) like Italy. Europeans (and others) may like the idea of the EU and the benefits of the euro, but when it comes to their own personal money, solidarity be damned and devil take the hindmost. That’s how Gresham’s Law works.

How the problem spreads

Spain’s pain illustrates perfectly why this game can’t continue forever. The Spanish government, per se, was not irresponsible, at least not directly, but their banks certainly were. When the Spanish government rode to the rescue of their banks (as well as other European and international banks holding Spanish housing debts), they took on the problems of their wobbly banks in order to prevent their banking system from collapsing. But while there’s no limit to human greed or stupidity, there’s a vague, poorly-defined limit to how much debt a country (and a people) can support. Spain is now approaching that limit, with the result that it is having trouble borrowing money to finance its deficit.

The recent bailout of Spain and Spain’s banks by the usual suspects (the IMF and various EU agencies) solved that problem, but only temporarily. And the capital infusion they received came from other EU countries and the IMF, which means that those countries have less money or borrowing capacity than they had before. In effect, Spain’s problems have been spread around.

But there are two problems with sharing your problems like that. Either countries get tired of bailing out people whose financial problems are of their own making (the grasshopper and ant parable writ large), or they get scared that if they give away some of their financial capacity to save you, then they won’t have enough to save themselves when the markets start applying Gresham’s Law to them. Either way, the subsidies eventually dry up.

And there’s another problem as well: the price that is being exacted for helping the profligate PIIGS (Portugal, Ireland, Italy, Greece, and Spain) is that they tighten their belts in order to get their fiscal affairs in order. This is being called “austerity”, and it brings us to the Black Hole that Gresham’s Law is creating that is eating Europe.

The Black Hole

Come back to Greece for a moment. Its economy was already weak, and its unemployment was high when the crisis started, almost three years ago. Greece has had billions of euros in emergency loans – effectively subsidies – and has given investors a “haircut”, which means they were forced to accept a big loss on their investments in Greek debt in order to try to keep the Greek government afloat. In return, Greece had to promise to reform its tax structure, by actually collecting taxes owed but not paid by Greeks, and by reducing overgenerous payments to civil servants, retirees, and other social welfare recipients. This is the austerity deal: we’ll bail you out if you’ll get your finances in order.

The only problem is that while getting you financial affairs in order is necessary in the long run, it can’t work in the short run. There are three groups that support economic growth: consumers, businesses, and government. With unemployment reaching an all-time high in excess of 22%, Greek consumers are not eager to spend money right now. And with consumers largely out of the market, businesses aren’t eager to spend or invest now either. So when you increase government austerity, it means the government is laying off more people, and spending less money. None of the three groups that constitute the economy are spending money – indeed, they are cutting back on their spending. And the more the government cuts, the faster the economy falls. And the faster the economy falls, the faster government tax revenues fall, which, in turn increases the deficit, which increases the need to borrow. So austerity, in the aid of deficit reduction, actually winds up increasing the deficit, making the situation worse. So cutting further, in the name of balancing the books and behaving responsibly, actually makes the situation worse in a vicious, downward spiral.

This actually repeats the mistakes made by governments during the Great Depression of the 1930s: cut spending to reduce deficits, which reduces employment, cutting economic growth, which causes tax revenues to drop, which increases the deficit. And we all know how well that policy worked out: it produced a 10-year global depression that ultimately ended when World War II came along.

So does that mean Greece should increase spending? No, because that immediately increases their deficit, which means they need to borrow money, which the markets don’t want to lend them, which leads to default. It also doesn’t help their economy very much, it just stops making it worse.

So what should Greece do? And the proper answer to that question is: What makes you think that every problem has a solution? Maybe it’s inevitable that Greece goes bankrupt.

And maybe Spain goes bankrupt. And Portugal, Ireland, and Italy. And perhaps France as well.

But if that happens, it definitely doesn’t end there. A remarkably candid June 14th report issued by the Bank of Canada said that given the excesses of the Canadian housing market, and the fact that the indebtedness of Canadian households now exceeds that of U.S. or U.K. households, a financial crisis that affected the financial markets in Europe would likewise shake the financial markets in North America, including Canada. The U.S. still hasn’t recovered from the Great Recession, and its banks seem not to have learned anything from the panic of 2008, so it’s not hard to imagine a financial crisis in Europe tipping the U.S. financial markets back into a renewed banking crisis – only this time I suspect that Congress tell the arrogant, unrepentant bankers of Wall Street to go f*ck themselves, with the result that the U.S. banking system would come tumbling down, bringing the rest of the world with it.

Global crisis and global depression, here we come – and all because of Gresham’s Law.

“That’s not going to happen; they’ll muddle through somehow!”

The only thing that’s keeping the financial markets from tanking right now is that not many people believe this can happen. Every time there’s a new crisis in Europe, there are hurried meetings, violent disagreements behind closed doors, then a triumphant public announcement, and the crisis is averted.

Except it’s not. This is not a series of crises, it’s one long, running crisis that is being repeatedly papered over but never resolved because the players involved don’t want to pay the cost of a real solution. The governments with money, like Germany, are trying to do as little as they possibly can to make this all go away so they can get on with what is, for them, a very pleasant life.

For Germany and Germans, the universe seems to be unfolding just as it should. The euro is weak because of the repeated crises, so German exports are under-priced and demand is strong. As a result, incomes are high, and unemployment is almost non-existent. Markets are scared of the debts of the PIIGS, and so are seeking a safe haven elsewhere. German bunds (bonds) seem to provide that safe haven, so demand for them is high, and interest costs on German borrowing are approaching zero, which is very comforting. And the German way of life is being shown as being superior – so clearly this means that Germans are superior. It’s all very satisfying, really.

As a result, the German public appetite for bailing out those lazy, spendthrift governments that don’t have the same level of competence as Germany is, perhaps understandably, very limited. Why should they put up their own hard-earned money to subsidize those shiftless, undisciplined southern Europeans? Austerity is what those louts need – let them tighten their belts, as Germany did 10 years ago.

The only problem with this smug, self-satisfied train of thought is it assumes that Germany wouldn’t be hurt by the massive crisis that is hurtling towards us, but they’re wrong. German banks invested heavily in the very tempting high interest rates that were offered by the PIIGS’ banks and sovereign debts, and they’re afraid to sell them now because it would force them to realize ruinous losses on their investments. But if these investments go sour, then German banks go to the wall, and suddenly Germany has the problem with its banks that Spain had with theirs. At that point, the German bubble of complacency gets pierced rather violently, but by that time it’s too late.

And then there’s the question of scale: Just how big is this problem if you look at Europe as a whole, rather than at a bunch of weak sisters? Well, if you consider that the fourth and third largest economies are already in crisis, that France, the second largest, seems to be sliding towards the precipice, and that the banks of the largest economy are hip-deep in debt that may be worth a lot less than they paid for it, it raises the question of: Who’s left to save us?

Captain America to the rescue!

Clearly, the answer has to be that America is the ultimate backstop, able to step in and shut down a crisis. But America ain’t what it used to be. The panic of 2008, precipitated by the deregulation of the financial markets under Bill Clinton and George W. Bush, coupled with the massive deficits created by Bush and continued by Obama, means that America has its own financial difficulties. Moreover, its economy is experiencing truly feeble growth, bumping along the bottom, with the result that the debt levels and deficits at state and federal level are remaining persistently high.

Then add the toxic, dysfunctional relationship between the few sane legislators left in Congress, and the “we won’t raise taxes even if it destroys America” folks in the wacko wing of the Republican Party, and we really do have a recipe for disaster. The Republicans and Democrats can’t agree on anything substantial, certainly nothing that involves deficits, debt, and taxes, leaving the American government stuck in gridlock.

And beyond that, under previous brain-dead agreements aimed at (temporarily) staving off earlier, self-inflicted financial crises, America is now facing a significant, automatic tax increase on January 1st, and a repeat of last July’s debt ceiling crisis sometime in the first few months of 2013. All told, unless a miracle happens, America is more likely to cause a crisis over the next 6-9 months than stop one.

Oh, and did I mention there’s a presidential election going on in America? That always brings out the best in American policy-makers.

The one remaining question

There’s really only one question left to consider: When? When will this house of cards collapse? When will the massive disaster hurtling towards us hit?

I don’t know. I’d be surprised if it didn’t happen within 9 months, but the trigger event could happen as soon as this Sunday, June 17th, following the elections in Greece. If the markets don’t like the choices Greek voters make, then Gresham’s Law takes over, and a panic stampede for the exits begins.

Meanwhile, politicians and policymakers will keep meeting, continue to come forth with brave, bold solutions that solve nothing except to try to sing the markets back to sleep for a while. Crises will come and go, the cracks will continue to be papered over, and everyone will pretend for a while longer.

But the root causes go untouched: too many governments and people borrowed too much money for bad reasons. Too many economies are too weak to support the levels of spending that voters demanded and got; the lure of apparently free money was too strong to resist. Too many banks got too greedy and stocked up on bad housing debts, bad sovereign bonds, and now have big holes in their balance sheets that they don’t know how to repair. And too many citizens are living longer, consuming more than they produce, and have become so used to their pension and health care entitlements that they will vote out anyone who threatens to adjust them.

These are fundamental things that should never have happened in the first place. But now that they have happened, they can’t be wished away, conferenced away, press-released away. They can’t be made to didn’t happen.

Sir Thomas Gresham’s spectre is haunting Europe – and can’t be stopped until all the bad debts and bad money are flushed out. And the process will be desperately painful.

© Copyright, IF Research, June 15th, 2012.