Panic in the New World Order

by Gary North
Tea Party Economist

Recently by Gary North: Tariffs as Welfare State Economics

For the first time in my career, I see the international establishment, sometimes called the New World Order, facing a crisis so large that its very survival is at stake. For the first time, these people are scared.

There are not many of them. In his book, Superclass, author David Rothkopf estimates that there are only about 6000 people at the top of the pyramid of world power and influence. They are mostly males, and at least a third of them have attended America's most prestigious universities. Most of the others have attended comparable universities in Europe.

The crisis in Europe is clearly beyond anything that this generation of establishment leaders has ever seen. The last time that anything like this faced the European establishment, it led to World War II.

During the entire postwar period, the United States has been the dominant force in the West. The United States government through the Marshall Plan wrote the checks to keep the European governments afloat, and it funded most of NATO, the mutual defense system that was set up to constrain the expansion of the Soviet Union.

The United States is no longer in a position to bail out anybody. It is running a massive trade deficit, and is running a massive federal deficit. Europe realizes now that, from an economic standpoint, it is on its own. If there are solutions to the European economic crisis, these solutions are going to have to be generated inside the eurozone.

BANKS AT RISK

Today, the entire banking system of Europe is at risk. The banks are highly leveraged, and they have made enormous investments at low-interest rates in bonds issued by governments that are technically insolvent. There is no possibility that any of these bonds will ever be repaid. They were never designed to be repaid. They were designed to keep the taxpayers of all European countries in permanent bondage to the banking system.

Now, in a complete reversal of fortune, the banks are increasingly dependent on the governments. The governments are now the lenders of next-to-last resort to the commercial banks. The central bank, of course, is the lender of last resort. But today, the European Central Bank has moved into neutral. It does not want to take action to bail out Greece, Spain, or Italy.

The PIIGS governments that wrote the IOUs to the banks in northern Europe are technically insolvent. When Greece defaults, which it will, there will be enormous losses sustained by some northern European banks. When Spain defaults, which it will, these losses will get far worse. When Italy defaults, which it will, the entire banking system of Europe will be busted.

The only things that can save European banking system today are the European Central Bank, which has the power to create money out of nothing, and the taxpayers of Germany, whose national leaders are relentless in their desire to expand the power of the eurozone over all of Europe. These politicians are willing to write IOUs on behalf of German taxpayers in order to extend this consolidation.

A DAISY CHAIN OF DEBT

The problem is, the Northern European governments do not have any money to serve as lenders to Greece, Spain, or Italy. They are borrowing money at rates not seen before in peacetime Europe. These governments are expected to intervene and lend money to the Greek government. But every northern European government is now faced with the additional responsibility of being the lender of next-to-last resort to the large commercial banks inside its own borders.

Who is going to lend northern European governments enough money to bail out southern European governments? Which lenders think this is a good idea today? At today's rate of interest, not that many. That is why interest rates are going to rise. But when long-term interest rates rise, that will lower the present market value of all of the bonds in the portfolios of the lenders.

So, on the one hand, investors have to pony up the money to lend to the governments, and the governments need the money to recapitalize the banks in their own borders. This leads to the next problem: in order for the lenders to lend money to a government, they have to write checks on their bank accounts. What happens if their banks should go under? Who will lend money to the governments?

In this daisy chain of fiat money, credit, and debt, the European Central Bank is the lender of last resort. It is the lender of last resort because it has the legal authority to create money out of nothing. It can buy IOUs issued by governments, and it can lend money to banks, so that the banks can buy the IOUs of governments.

DAYS OF RECKONING

The entire political system that we know as the European Union is dependent upon a system of fractional reserve banking which has overextended itself, and now faces a day of reckoning. Actually, it faces two days of reckoning.

First, there is a day of reckoning in the PIIGS countries, when depositors withdraw funds. The second day of reckoning is going to be imposed by the insolvent governments who have been borrowing hundreds of billions of euros from the banks.

The arrival of a bank run threatens the ability of the Greek government to borrow money from anybody. The Greek government is dependent upon the Greek banking system to collect taxes. If the Greek banking system goes belly-up, the Greek government goes belly-up.

In this system, only the European Central Bank has the authority to bail out the system. Every other potential source of euros is dependent on the solvency of the European banking system. But that is exactly what is at risk today.

This is why all fractional reserve banking must ultimately rest on the monopoly granted by government to a central bank. The central bank, above all, is the guarantor of the solvency of the largest banks. The central bank is the economic agent of the owners of the largest commercial banks. These owners are now facing bankruptcy. They hold shares in multinational banks whose lending officers had no understanding of basic economics. They wrote checks to the PIIGS.

In this scenario, the only way to save the system is to risk destroying it. The only way to save the euro is to risk destroying it. This is because there are only two ways to save the largest commercial banks. The first way is by hyperinflation. This will enable the banks to keep their doors open, but the borrowers will be able to pay off their loans by selling a handful of hard assets, which will raise enough money to pay off the loans with worthless euros.

The second way to save the banks, which is what the European Central Bank is attempting to do, is to avoid hyperinflation, and to inflate the money supply only to the degree that the largest banks can be bailed out by making low-interest loans available to them. They in turn must lend out the money, if they can find solvent borrowers, and if those borrowers are willing to borrow.

If the European Central Bank adopts the second approach, this is going to lead to a depression. The bank has inflated. The commercial banks have lent money to insolvent governments. These governments are going to default if there is a recession, but by refusing to expand the money supply, the European Central Bank will produce a recession. The boom that it fostered in the Greenspan years has blown up on European banks, in the same way that the boom in the United States has blown up on America's banks.

There is no equivalent of the FDIC in the European banking system. There is no single government that has the assets or the legal authority to lend to any and all of the other governments. There is no common fiscal system, which means that all the governments can run massive deficits. This means that the governments are in constant competition with each other to borrow enough money to fund their deficits.

So, the system is stretched to the limits. The few remaining lenders with capital who have enough money in their banks to write checks to insolvent governments are now refusing to write the checks. This is why Spain is paying over 7% to get lenders to fork over their money. Lenders who do this are going to wind up like the saps who loaned money to the Greek government prior to 2010. They are going to see the value of their investments collapse as interest rates go to double digits in Spain, which they are going to do unless the European Central Bank intervenes and makes fiat money loans to Spain's government.

WEEKEND SUMMITS

There is now at least one monthly emergency weekend meeting of the political authorities, accompanied by their bureaucrats from the ministries of finance. They come together on a Saturday to talk about how they can save the system. They issue a press release on Sunday. The press release is always short on specifics. Within a month, the crisis has escalated again, and there is another weekend summit meeting.

Every time there is a summit meeting, the investing public that has sufficient money to invest waits with bated breath to see if there is some solution offered on Sunday afternoon. There never is a solution offered, so the stock market drops for the first day or two after the meeting.

It is clear by now to everybody that there is no solution forthcoming. There is no agreement politically, especially between Germany and France, as to who is going to write the checks to bail out the next PIIGS government to hit the brick wall.

I can remember almost 40 years ago listening to a speech by a young hotshot economist at Yale, who informed us that there would be a new currency system established in Europe by the year 2000. This was an accurate forecast. It was established in 1999. The hotshot later moved to Harvard. He has generally disappeared from public view. But it was clear from his enthusiastic speech that he was convinced that this new currency system would create a completely new economic order in Europe. Boy, was he right!

The new economic order in Europe is now disintegrating. The establishment politicians, bureaucrats, and spokesmen are looking in horror as the system which their predecessors designed to work permanently is disintegrating. Not to put too fine a point to it, but this is reminiscent of Adolf Hitler's promise about the thousand-year Reich. It lasted 13 years. This year, the euro had its 13th birthday. So far, it has not had a happy birthday.

NO FIREWALL

The leaders of the European establishment have never had to deal with any crisis on a scale like this one. They keep talking of the need for firewalls. Until they have firewalls, nobody is willing to yell "Fire!" Yet the fire is now raging.

What kind of firewall can be created that keeps a default by one government from becoming a default by another government? What firewall is there for a large multinational bank that has just lost half of the value of the bonds that it purchased at a rate of 3%, now that the interest rate is 7%? Every time the interest rate doubles, the market value of the bonds decreases by 50%, minimum.

There is no firewall. The financial system of Europe is interrelated by way of the euro. Everybody uses the same currency in 17 countries. Everybody is dependent upon the same central bank, and that bank is not exercising leadership. The head of the bank keeps saying that the governments have to step up to the plate and take responsibility. Every time he says this, I am reminded of what Ben Bernanke keeps telling Congress.

The heads of the two largest central banks in the world keep complaining that the politicians have got to take responsibility for solving the crisis. But this is exactly what the politicians do not want to do. The politicians have always understood that the central bank would bail them out of their crisis, merely by creating new money and buying the IOUs of the government. This has always been the public justification of central banking.

The politicians seem blind to the real reason for the existence of central banking, namely, to bail out the largest commercial banks under its jurisdiction. The European Central Bank faces an enormous problem: it has under its jurisdiction the largest banks in every country in the eurozone, other than Great Britain. It has to intervene to save any large bank that is under its jurisdiction, because if it does not, there will be bank runs in that nation.

A BANK RUN

Depositors can go down to their banks and have money transferred to a bank outside the country. Usually, this is going to be a German bank. Legally, the recipient bank can refuse to take a deposit, but what bank would dare not take deposits? Any bank that would say that it was not taking deposits from any other bank would be sending a signal to the media that the other bank is bordering on insolvency. That is the last thing that any bank in northern Europe wants to do with respect to any bank in Greece, Spain, or Italy.

The European Central Bank is sitting on a powder keg. The fuse has already been lit. That fuse is connected to the Greek banking system. If the Greek banking system blows up, by which I mean implodes, that will light another fuse. The other fuse leads to Spain. I could be wrong. There may be two fuses, one leading to Spain, and the other leading to Italy.

There is no firewall. The only firewall would be for banks in northern Europe to refuse to take new accounts from people who were closing out their accounts in southern Europe. But if they do not stop the bank runs from taking place in Greece, the Greek government is going to default on its debt and pull out of the eurozone. It will have no choice. If its banks are collapsing, how will it be able to fund its debt? How will it be able to collect taxes?

You can see what is at stake here. A small-scale bank run has been going on for at least a year in Greece, and it is now threatening to escalate into a full-scale run. Northern European banks could refuse to take new deposits in euros from existing depositors in Greece. But they would all have to do this at once. If only one or two major banks in northern Europe refuse to accept new accounts from Greeks, this will send a message to all the other Greeks: "You had better get your money out of your bank, fast, and get it into a northern European bank that has not yet closed off new deposits." The bank run escalates.

Because not all of the banks are under the same banking laws, and because no regulatory agency can tell them what to do, Europe has a system in which depositors in PIIGS nations can create massive bank runs against the banks in their own nations.

There is no firewall against this. The bank runs have begun in Greece. Banks outside of the eurozone can refuse to take on new deposits, but banks inside the eurozone cannot do this without threatening the survival of the entire banking system. Furthermore, if they do not create a firewall, the collapsed banks of Greece, Spain, and Italy will lead to the bankruptcy of their respective governments, and that in turn will lead to massive losses in northern European banks.

You do not see a detailed discussion of this in the mainstream press, for very good reason: the mainstream press is afraid of being blamed for triggering a bank run out of Greek banks. Everybody in authority knows a Greek bank run has begun, but this is not front page news. It is certainly not a story on the evening television news shows. Maybe "The PBS News Hour" will bring in two or three experts to discuss it, who will offer rival views, but the network news will not talk about the Greek bank run until it is in its terminal stage.

So, the people who run the new European order sit there, helpless, completely dependent upon decisions made by depositors in Greek banks. At any time, a wave of fear could spread through Greece, and a majority of depositors will start lining up to get their money. If they take out their money in currency, this collapses the local bank, which has to sell assets to buy the currency from the European Central Bank in order to hand the currency to the depositor. That kind of bank run is bad for a single bank, but usually depositors spend the money. When a depositor spends the money, the business that receives the money re-deposits the money in its bank. So, a bank run into currency is not a huge threat to the Greek banking system as a whole.

In contrast, however, is a bank run in the form of the transfer of digital money out of the country. All of the Greek banks are facing this threat today. Once the euros leave the Greek banking system, they are not redeposited in the Greek banking system.

What we are seeing is the collapse of the Greek banking system. Unless the European Central Bank intervenes again, by the end of the year, there is not going to be a Greek banking system. All of the banks will be busted.

There is nothing that the Eurocrats can do about this. The only agency that has the power to stop this is the European Central Bank, which can do whatever it wants to do, ultimately, which means lending money to Greek banks based on any collateral they want to put up, especially IOUs issued by the Greek government.

CONCLUSION

Angela Merkel can scream, yell, and hold her breath until she turns blue, but ultimately she has no power over the European Central Bank. Ultimately, no politician has any power over it. No politician really wants power over it. Why not? Because that politician would then be responsible for coming up with the money that the European Central Bank was about to come up with, but which was stymied by the politician.

This is why the European Central Bank is going to inflate, inflate, and inflate. The head of the bank can make all the comments he wants about the responsibility of politicians to intervene to keep the structure going, but he is ultimately the bagman of the system. He is the guy who has control over the printing press. He is the only person, along with his colleagues, who is in a position to keep the system afloat.

There is no firewall. There is only the ability of the European Central Bank to create money, and to do so by lending it to commercial banks or directly to governments. It does not matter what kind of rules and regulations are in place that were supposed to prohibit this back in 1999.

In the midst of a conflagration, nobody in power is going to point a finger at the European Central Bank when the bank intervenes to bail out a government that is about to default on its debt. The reason is clear, or at least is clear to me: no politician wants to be responsible for coming up with the money to bail out the largest banks in his country, all of which will be threatened with insolvency because of the default of Greece and Spain, because that will produce a domino effect by all of the PIIGS governments.

June 23, 2012

Gary North [send him mail] is the author of Mises on Money. Visit http://www.garynorth.com. He is also the author of a free 20-volume series, An Economic Commentary on the Bible.

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