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By Daniel R. Amerman, CFA,
To
“save” the euro, the European Central Bank (ECB) chose what some economists
were calling the “nuclear option”. That sounds dramatic, but for
non-economists: what does it mean? Why was Germany so strongly opposed? As we will review herein, the ECB’s choice of the “nuclear option” means: 1) the door has been opened for unlimited
direct monetary creation by the ECB; 2) the money will be effectively used to
pay for an outside-the-budget, unlimited bailout of major European and global
banks; 3) the inflationary effects of creating all this new money will be
contained by creating still more money out of the nothingness; and 4) as part
of their Faustian bargain, global banks will hollow out still more of their
balance sheets, growing ever economically weaker even while their regulatory
capital creates an illusion of ever greater strength.
The
European Central Bank had a blueprint from which to work: the parallel interventions by the Federal
Reserve in the United States. As it
happens, I've recently finished a series of articles that explain the Fed’s
blueprint for creating a financial nuclear device. In this article we will summarize the path
chosen by the ECB, and briefly discuss the key implications for investors. Each summary will also link to a full length
educational article on the particular implication in question.
There
are three powerful incentives for US readers to understand the contents of this
article. 1) In this tightly interlinked world, if the European economy plunges
down – so does the US economy. 2) We’re the blueprint, and face quite similar
risks. 3) There he goes again! Ben Bernanke just bravely stepped forward to
once again take on unlimited risks for the citizens of the United States, this
time in the form of currency swaps, thereby imperiling the value of our money
and savings.
The
starting point for deciphering what just happened in Europe is to understand
that we have not one, but two bailouts going on. There is the approximately $1
trillion (750 billion euro) loan package put together by European Monetary Union
members as well as the International Monetary Fund. Sometimes referred to as
the “shock and awe“ rescue package, it was unveiled at 3:15 AM in the morning,
after a marathon 14 hour meeting among European financial chiefs.
The
other bailout was (as in the United States) the real bailout, the one that
really matters, and there is no price tag put on it. There is no price tag because there is no
limit on what can be spent. "The European Central Bank said it will buy
government and private bonds as part of an historic bid to stave off a
sovereign debt crisis that threatens to destroy the euro" (Bloomberg). This type of purchase was prohibited when the
ECB was created – because of its potentially dire inflationary consequences.
To
understand the rescue, we need to understand who the beneficiaries are, and
Greece is arguably not the main beneficiary. For the European Central Bank is
not buying the securities directly from the governments or the private issuers
-- it's buying them from the banks. The banks are in deep trouble, so the
European Central Bank takes its power – which is the stewardship of the value
of money for the citizens of Europe – and uses this power to buy the banks out
at on an unlimited basis. The pricing
is more attractive than what the market offers (which is the point of the
intervention). So the banks either don’t
lose money at all, or they take much lower losses than they would through
selling to normal buyers. The ECB is
making an unlimited amount of banking losses disappear. As others have commented, the euro zone rescue
plan is not really a bailout of Greece, but rather, a bailout of Europe's (and
America's) banks.
For
more on the blueprint mechanics of how a central bank can pay for outside-of-the-budget
bank bailouts without limit, through the creation of money without limit,
please read the article linked below, “Creating A Trillion From Thin Air”.
http://danielamerman.com/articles/Trillions.htm
Of
course, creating money without limit to fund bank bailouts without limit would usually
have the nasty side effect of leading to immediate and powerful inflation. So the central bankers of Europe faced the
same dilemma as did the Fed in the US:
how do we spend unlimited money but contain the immediate inflationary effects?
Following
the lead of the Federal Reserve, what the European Central Bank will do is to
attempt to “sterilize” the money, by offering to purchase bonds without limits,
but keeping the money paid out from leaving the ECB and entering general
circulation. The particulars have yet to
be announced, but for a good guide to how “sterilization” works, please read
the article linked below: “Containing
Inflation Via Unlimited Money Creation”.
http://danielamerman.com/articles/Containment.htm
Banks
have the right to take the newly created money paid to them for the bonds, and go
lend it out at any time (which is what banks are supposed to do with their
money), but this would likely lead to immediate rampant inflation. To keep the
banks from doing so, as described in my article above, essentially a corral is
formed to keep the euros from leaving the central bank. The corral is created
of money, and consists of paying the
banks to not pull their balances out.
Because the European Central Bank has unlimited monetary creation
ability, it can pay however much money it needs to keep the bank money (that
was used to pay for the bonds) out of circulation. Even if a “horse” does succeed in jumping the
fence, and a bank takes its money out, there are a variety of lassos the
central bank can use to pull the money back out of the system, as described in
the article.
So
what the coldly clinical term “sterilization” means, effectively, is that unlimited
money can be created and passed to privileged insiders, keeping the major
investors from recognizing the losses from their bad investments, so long as
the central bank is willing to create unlimited additional money to keep the original
created money from “escaping". You
don’t need to be an economist to understand the hubris involved here, and how dangerous
this desperate strategy is for all of us.
The
initial response to the euro zone rescue was enthusiastic, and why shouldn't it
be? The banks of Europe and the world
had just been assured they would be the beneficiaries of a virtually unlimited
bailout, and that news was worth celebrating when compared to the alternatives
of paying the price for bad investment decisions. However, even within 24
hours, some of the enthusiasm was cooling off, and the reason is that the
fundamental problems haven't changed.
As
covered in my article linked below, “Futile Attempts To Reflate The Housing
Bubble”, the US has its own parallel fundamental issue with mortgages and the
housing market (as well as its even bigger “sovereign debt” problems). The consequences of dealing with that failure in
the housing market was something that the politicians and bankers were
unwilling to accept, as full acceptance of what is happening would likely
shorten all of their individual careers. Thus, desperate measures were taken, supposedly
to buy time. These measures do buy time
for politician and banker careers, but they don't buy society anything, as the “cure”
effectively risks the value of all of our savings in order to accomplish the
goal of creating a bookkeeping illusion.
http://danielamerman.com/articles/Reflatea.htm
The
creation of money without limit does not cure the fundamental issue of
governments making promises which they can't possibly afford to keep. Europe’s sovereign debt crisis is still
there. Greece hasn't cured anything.
Portugal, Spain, Ireland, and Italy all have their own oncoming issues. As do
the stronger European economic powers when we travel another 10 or 15 years
further out the demographic cycle.
In
Europe and the US, the central bankers rationalize their actions by saying that
they give time for normality to return.
With stability and time, so we are told, normal pricing will return, our
current global problems will go away like a bad dream, and as the US mortgages
and European bonds pay off, the “sterilized” trillions are removed from bank
balance sheets, until they have disappeared as completely as if they never they
existed. And we've all been bailed out at no cost to any of us, thanks to the
brilliance of our courageous central bankers.
It
is a lovely sounding fairy tale, but unless the governments of the world
somehow find the ability to cure their sovereign debt crises, the fairy tale will
not have a happy ending. Instead, the problems will just get worse and worse, which
will mean that government interventions must continue on a massive scale to
maintain an artificial market. Which will
mean more and more money must be created out of thin air -- until a breaking
point is reached.
What
has been little recognized is that in making their Faustian bargain with the
world's central banks, the global banking community has had to sell not their
souls – but their balance sheets. Yes,
the festering wound of government and private bonds that had been plunging in
value has been removed from the banks’ balance sheets, seemingly without cost
to the banks or society. However, as always in real life, there is a cost. The price can be found in that sterile place
known as central bank reserve balances, as explained in the article “Hollowing
Out America's Banks".
http://danielamerman.com/articles/Hollow.htm
From
an accounting and banking regulators’ perspective, balances held at a central
bank, whether it is the Federal Reserve or the European Central Bank, are about
the safest investments a bank can possibly have. However, these investments are,
in economic essence, investments in
nothing at all. There is no real economic activity. The source of security
is the central bank’s control over the money supply, its ability to create
money out of nothingness as needed. So what bailing out banks on a massive
basis with “sterilized” central bank money (which can’t actually be spent) truly
means is that distressed assets that represent investments in the real economy
are systematically swapped out for economically unreal claims on monetary
creation authority. In economic terms,
the banks become steadily weaker, even as their strength appears to grow when
viewed from a regulatory and accounting perspective.
This
next level is where the crisis in Europe becomes even more deeply intertwined
with the financial crisis in the United States. Part of the rationale for the
Federal Reserve's creating an entirely artificial $1.25 trillion mortgage
market, is that bank balances at the Federal Reserve are effectively
collateralized by all the (below market) mortgage securities it now owns. It is these valuable mortgages that will pay
off the bank reserve balances, or so the theory goes. Just as in theory, the cash flow from the
bonds that the ECB purchases will be used to eventually wind down the
“sterilized” reserve balances.
As
I explained in my article linked above, “Hollowing Out America's Banks”, the
problem with this theory is the multitude of other crises that the Federal
Reserve is taking on. The bank depositors and shareholders may have to wait
their place in line for whatever's left over after the Fed has also bailed out
the United States government, the state governments, the global derivatives
crisis, then whatever else the Federal Reserve decides is in need of fixing
with its unlimited monetary creation ability.
A
very significant demonstration of this problem can be found in the United State’s
role in the euro zone economic rescue. Ben Bernanke, chairman of the Federal
Reserve, has volunteered to enter into dollar swaps as needed, to help out the
European Central Bank. What this means
is if the ECB wants to buy distressed government and private bonds with dollars
instead of euros, the US central bank (the Fed) agrees to help them do so, by
swapping dollars and euros. So if the euro collapses – the Fed (and the US)
takes the hit on those swaps, instead of the ECB.
The
dollar amounts are unknown, but the last time this happened in 2008 and 2009,
the Federal Reserve ended up removing all limits, with a total swap volume that
ended up peaking at $583 billion in late 2008. If a similar volume occurs this
time (it could be less – or much more), that is half a trillion dollars of risk
that the Federal Reserve is agreeing to cover, in case the euro plunges in
value relative to the dollar.
This
is on top of all the other massive and unprecedented risks that the Federal
Reserve is taking now, or may take in the future. Thus, the cash flows from that trillion
dollars in below-market US mortgages just got another claimant. Even as the
risk of inflationary meltdown for the US dollar – with devastating damage for
US savers and investors – increased another notch.
Offering
a half trillion in help to a buddy in need may or may not be the correct
political and economic choice. But what needs to be clearly understood is that this
is yet another very real and massive risk that the Federal Reserve is taking,
without benefit of Congressional approval, or inclusion in the budget. The only
source of repayment is the Fed’s ability to create more dollars. Which means the ultimate value of the dollars
you and I have, is potentially significantly less today than it was last week.
Here’s
a quick summary of the Federal Reserve blueprint which the European Central
Bank is using for its own “rescue”:
1)
Invoke
emergency measures and do the opposite of what a central bank is supposed to
do: create great big of gobs of money
and throw the largesse around wherever you like. The obsolete term for this is “cranking up
the printing press”, but this goes far beyond any printing press capabilities,
as physically printing the hundreds of billions of euros or dollars at the
speed with which they are being created would likely melt down a press.
2)
Take
those vast sums of money, and use them to entirely bail the banks and bankers
out of their bad investments. There’s no
budget, no legislative hearings and no formal rescues or bailouts to be debated
or repaid. Just pay the banks more than
the market says the investments are worth, and let the bonuses continue to
flow!
3)
The
catch is that the new money can’t actually be spent, or the public might catch
on to what’s happening when the cost of bread goes through the roof. Being the ungrateful sort, however, the banks
are exactly the type who would take their rescue money and go spend it if there
was more money to be made that way. So unlimited
money is made available to bribe the banks, and keep the banks’ money safely
inside the corral (i.e. “sterilized”).
4)
The
more money the banks get, the less real economic investment assets they have,
and the bigger the portion of their assets that consist of nothing more than
the monetary creation ability of the central banks.
5)
Meanwhile,
the fundamental problems that led to the crisis in the first place are still
there, and the pain of dealing with them has been deferred into the future. At which time, they are likely to blow up
worse than ever because delaying action never does help these things – but the
focus of these emergency actions are about today. Tomorrow can take care of itself.
6)
If
you are a banker or politician, and if the fundamental problems do blow up much
worse down the road – so what? The end
result is the same, but you’ve kept what you think is one of the best jobs in
the world in the meantime.
7)
On
the other hand, if you are a member of the general public, and if there had
been no rescue packages, then there would have been a terrible price today, but
at least you would have had your savings to fall back on. Thanks to the brilliance of central bankers
and rescue packages however, this way when things do blow up, the economic
damage is worse than ever, job losses are bigger than ever, and the value of
your savings and retirement accounts just went “poof”, too.
8)
Good
thing the general public has no idea what these economists are really doing,
eh? (And the public never will know, unless articles
like this are circulated more widely… if
you find this outrageous, tell as many people
as you can about it.)
The
heart of the current battle is a series of frantic measures being taken by
desperate people who are in way in over their heads and are trying to preserve their
own privileged way of life. Their
collective greed and short-sighted pursuit of personal bonuses got us all into
this mess. They don’t know the way
out. But they are determined to use
their full power to try and save themselves, and that includes changing the very
nature of money itself. It is a high
risk attempt, and the risk involves everything you, I and our families have
worked for and built over our lifetimes.
A relatively tiny group of people taking massive risks for all of us in
the attempt to save themselves – is nothing more than human nature. The decision is particularly easy when the
people in question have spent their careers in the steadfast accumulation of
personal wealth and power.
As
is usually the case, there is also a silver lining, slim though it may be for
society as whole. When desperate people rush
into changing the world, changing the rules, and creating artificial trillion
dollar markets, they also do something else.
They leave a multitude of doors open.
All over the world through multiple asset (and liability) categories,
doors are being inadvertently left wide open for unparalleled personal
arbitrage opportunities. The open doors
are inadvertent because there is no master strategy, and nobody’s had a chance
to think through all the implications.
The
financial heads of Europe were up until 3:15 in the morning, and they were
desperate, so they did a “shock and awe” on the long-term value of their
nation’s own collective currency in their efforts to convince the banks that
there was no chance of banks taking a loss on bad investments in the short term. It is inevitable that with such radical and
comprehensive change – extraordinary but temporary opportunities opened up for
investors, that would not be there in a stable monetary and financial system.
Fundamental
opportunities are opening up in multiple ways for creating wealth. For highly
risk-averse investors, this may involve protecting what you have on an
after-tax and after inflation basis, and maybe even modestly growing it a
little. (Which is saying a lot for these times.) For those who understand risk
and don't mind taking it for the right reasons -- there are speculative
opportunities to create multi-generational wealth.
To
find those open doors requires doing something fundamental, which can be quite
uncomfortable for many people. It starts with accepting that the times truly
have changed and are continuing to change.
What
happened in Brussels over the weekend was that the nature of money changed. The
nature of the euro changed, as the nature of the US dollar has fundamentally
changed, as have many other currencies over the last couple of years. This in
combination with radical, trillion dollar government market interventions has also
fundamentally changed the very nature of the investment markets. The paradigm has changed, and everything most
of us have is at risk because of this. The paradigms that governed successful
investment – and the preservation of capital in the 1990s and the 2000s – are
now obsolete.
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Those who follow obsolete paradigms become victims. Those who understand the new
paradigms find extraordinary opportunities, until such time as the new paradigm
becomes widely understood and accepted. The difference between victim status
and seizing the opportunity is quite simply one of learning and education. If
you're going to build investment capital in these bizarre and terrifying times –
what you need before anything else is intellectual capital.
I
realize that for many people, reading fundamental articles that explain central
bank actions and investor implications is about as appealing as dental surgery.
For the sake of what you have built, and for your future – let me urge you to read (or re-read)
the linked articles. I have done my best to make them as understandable as I
could, and have received letters from around the world from people telling me
that for the first time they are truly understanding what is happening. Consider taking the time to learn what you need
to know.
Seek
education. Seek learning. Read widely.
Good luck to you in these perilous times.
Do you know how to Turn Inflation Into Wealth? To position yourself so that inflation will
redistribute real wealth to you, and the higher the rate of inflation – the
more your after-inflation net worth grows?
Do you know how to achieve these gains on a long-term and tax-advantaged
basis? Do you know how to potentially
triple your after-tax and after-inflation returns through Reversing The
Inflation Tax? So that instead
of paying real taxes on illusionary income, you are paying illusionary taxes on
real increases in net worth? These are
among the many topics covered in the free “Turning Inflation Into
Wealth” Mini-Course. Starting simple,
this course delivers a series of 10-15 minute readings, with each
reading building on the knowledge and information contained in previous
readings. More information on the course
is available at DanielAmerman.com or InflationIntoWealth.com .
Contact Information:
Daniel R. Amerman, CFA
Website: http://danielamerman.com/
E-mail: mail@the-great-retirement-experiment.com
This article contains the ideas and
opinions of the author. It is a conceptual exploration of financial
and general economic principles. As with any financial
discussion of the future, there cannot be any absolute certainty. What
this article does not contain is specific investment, legal, tax or any other
form of professional advice. If specific advice is
needed, it should be sought from an appropriate professional. Any
liability, responsibility or warranty for the results of the application of
principles contained in the article, website, readings, videos, DVDs, books and
related materials, either directly or indirectly, are expressly disclaimed
by the author.
Copyright 2010 by Daniel Amerman