The Sovereign Debt Crisis is Sucking the Wind out of the Global Economy…. The “Can” Just Got Punted Down the Road!

By J.M. Hamilton (5-10-10)

Wow, what a difference a weekend makes.  Do you ever notice how central banks do their “wild and craziest” maneuvers on the weekends: whether it’s letting Lehman Bros slide into oblivion, or deciding to bailout AIG (or was that a weekday?), or in the case of Europe, bailing out PIIGS!   Looking into the future when it comes to bailing out the world’s fiat currency, one might imagine that happening on the weekend, too.

One of the words we heard thrown around Europe’s second bailout of the banks is “sterilization” of the expansion of money supply.   Simply put, “sterilization” means as money is pumped into the European central banks, if I have this correct, the banks will give up their toxic PIIGS debt in exchange for European or Euro debt, so that money supply is not increased.  What a relief! 

Either way you look at it folks, the Euro just got a little bit weaker with one trillion Euros magically appearing from no where, and toxic assets being moved on to yet another central bank’s balance sheet.

Why this special emphasis, by our European brethren, on money supply “sterilization?”

Well, because the Europeans remember very well (unlike some Americans) the Weimar Republic and how hyper inflation lead to the rise of a paper hanger/would-be artist, named Adolph Hitler, and the global calamity called World War II.  Europeans remember, all too well, particularly Germans, the whirring of the printing presses and currency created out of thin air, and the resulting madness.   And the German’s just to show the world that they remember their history voted resoundingly against Chancellor Merkel’s Christian Democrats…  and as of Sunday, her party is no longer holding down upper house of German Parliament, due to Merkel’s real or perceived support of the bailout that transpired this weekend.

Sure, this time, the world is a little more sophisticated… The major banks  - which are beholding to the politicians for their bailouts - have agreed, in their Japanese-Zombie state, to leverage up the free money they receive from their respective governments, and "hoover-up" the ever expanding national debt.  Heh, why not… after all, tax payer funded rates of return trump the vagaries of lending to the private sector any day.  Right? 

Except there’s one problem:  The crowding out effect is coming to fruition, as government borrowing takes precedence over providing credit to businesses in the private sector, which has a stifling effect on jobs creation and tax revenue.

What we are in right now, citizens of the world, is a vicious economic cycle, perhaps globally – certainly in the U.S. and Europe, where governments, who depend upon the private sector for jobs creation and a tax base, are literally destroying private sector opportunity – through the crowding out effect in the credit markets.  Check out the Shadow Banking web site, and the contraction of M3 or the money supply (http://www.shadowstats.com/charts/monetary-base-money-supply).

The cycle continues in that governments in turn have to borrow higher and higher amounts of money to provide benefits for the ever growing ranks of the unemployed, which leads to even greater private sector crowding out of the credit markets.  If we review our history further, the last country to crowd out the private sector, totally, this time at the barrel of a gun, was the former U.S.S.R.   And many of us remember how that story ended.

The Wall Street Banks, and their European Peers, were bailed out in 2008…. For making wild bets on speculative real estate, and real estate CDO’s and derivative products.  But now we can already see that European banks are being bailed out, less than two years later, for holding junk sovereign debt.   The worry of the major powers in Europe has not been avoided by this weekend’s events, that a chain of sovereign dominoes would fall (as the stronger nations attempted to bailout their weaker sister states); but rather, the thesis has been confirmed.

And now, the PIIG’s must anti-up with politically unpopular social benefit reductions, and tax increases – all contractionary economic policies – or dissolve in chaos, as governments are overrun and are overturned by their upset citizens.  We saw hints of social unrest in Greece just last week.  More than likely, those same citizens will be hitting the streets again, very soon.  Either that, or the Greek government will not enact the spending and tax reforms necessary, so that they will be back at the E.U., yet again, looking for additional bailouts.

Moral hazard affirmed once again… this time, among sovereigns and the banks that lend to them.

Unfortunately, few politicians have the political will to address these issues.  There’s always an excuse to kick the can down the road a little further:  say political expediency, an election around the corner, an economy that isn’t quite back on its feet, or wars to be fought and wars to be won.

The cold hard reality however, is that when a currency is weakened by over expansion, or inflation, subsequent bailouts become increasingly more expensive, and, possibly, more frequent, until such time as the currency is no longer viewed as holding any value.  World banks steeped in the U.S. dollar and euro holdings, in the long run, may be no better off than they were going into this weekend holding PIIGS’ debt.