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German Pope, Italian Central Banker

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by Gary North
Posted November 24, 2011 

CONCLUSION: EUROPE IS IN BAD SHAPE. This is hedge fund manager Kyle Bass’s assessment of the situation in Europe. He stated this in a rousing interview on the BBC’s TV network. Here is the segment:

He made two crucial points – points that stock market investors are ignoring. First, over the last nine years, there has been an increase of world debt from $80 trillion to $210 trillion. These numbers are staggering. Global debt over the last nine years has grown at 12% per year, while GDP has grown at 4% per year.

While he did not verbally spell out the conclusion for the interviewer, it is this: when credit must grow by 12% per year in order to produce 4% GDP growth, at some point there will not be enough GDP to supply sufficient credit. It is time once again to quote economist Herb Stein: “When something cannot go on forever, it has a tendency to stop.”

Bass had a great metaphor: the PIIGS have “sailed into a zone of insolvency.” Second, he explained, the sovereign debts in Europe will be written down. There is no other solution. The airhead interviewer with the Oxbridge accent seemed to be doing a college-skit imitation of Emma Thompson. She challenged him. What about Germany? Can’t Germany continue to fund Europe’s “southern neighbors”? Germany has “the earning power.” (Note: this means German taxpayers.)

Bass responded instantly. First, the German court has determined that any further bailouts are unconstitutional. Second, Greece – and, by implication, the other “southern neighbors” – will spend every euro it borrows from Germany and then come back for more, threatening a default if its demands are not met – exactly what it has done so far. This goes on until the write-down takes place, which it will.

There are two ways of looking at this: the Bass way and the Bass-ackwards way. The airhead chose the latter.

He draws conclusions from the numbers. No one in the mainstream media and mainstream investment fund world seems to be willing to do this. They talk and invest as if the process can go on forever. Debts need not be repaid. This is ancient Keynesian dogma that goes back to the New Deal. “We owe it to ourselves.” On the contrary, specific borrowers owe it to specific creditors. At some point, the specific borrowers are going to default, leaving specific creditors with huge losses. How huge?

THREE TRILLION EUROS!

Charles Hugh Smith agrees with Bass. He says that there will have to be a write-down. By “write-down” he means write-off. He estimates the losses at three trillion euros. Someone will have to take the hit. The great political debate in Europe today is over who will take this hit, and how soon.

It will be investors. But, to forestall the day of reckoning, Europe’s politicians pretend that taxpayers’ credit lines can be used by superficially solvent Northern European governments in order to borrow more money from creditors in order to lend to the PIIGS’s governments, so that the PIIGS’s governments can continue to (1) delay real austerity measures, i.e., massive layoffs of government workers and massive cuts in welfare payments, and (2) make payments on what they owe to investors, mainly banks.

Smith admits that three trillion euros is a guess. Nobody knows how much bad sovereign debt there is, so we must start somewhere. In a world of $210 trillion worth of debt, his estimate seems reasonable to me.

Let’s start with the most basic fact about all this uncollectible, impaired, bad debt: every euro of debt is somebody else’s asset. Wipe out the debt and you wipe out the asset. That’s why there’s no willingness to accept the writedown of debt: somebody somewhere has to suck up 3 trillion euros of loss.

This is the source of Europe’s present policy of “kick the can,” or more accurately, “kick the can with press releases and summits.” If there were a pain-free solution, it would have been implemented long ago. There is no way Europe is going to “grow its way out of this debt.” How much of the eurozone’s “growth” was the result of rampant malinvestment and risky borrowing? More than anyone dares admit. It won’t take austerity to crash the euroland economy, all it will take is turning off the debt spigot.

Europe is facing the problem that Bass raised when he spoke of 12% per year increases of credit and 4% increases per year of GDP. There is no way to grow your way out of this. This is not just Europe’s problem. It is the world’s problem. But Europe is facing it now because the debts are coming due now. They must be rolled over. Creditors must agree to re-lend. But why should they?

The Establishment world of crony capitalism speaks of “re-structuring” the debt. What does this mean? Smith does not pull any punches.

“Restructuring” is a code word for writeoffs. Here, let me “restructure” the euro bond you bought at a 4% coupon yield. Now you’re going to get 2%, and you’re going to like it. Bang, your bond just lost half its market value, but everyone gets to keep it on the books at full value. Nice, until you have to sell it to raise cash. Oops, the euro has slipped in value so you lost more than 50%.

The banks keep the assets on the books at face value. The underlying value is down by at least 50% for Greek bonds. The European experts admit this. (Why the debt is worth that high a percentage is beyond me.) The Greeks are going to default, one way or another.

Who will take the hit? Smith writes: “There’s a fundamental truth that everyone has to understand: what the government spends, the public will pay for sooner or later, whether in taxes or inflation or having their debt defaulted on.” This is reality. But it’s not precise enough.

WHO IS THE PUBLIC?

If there is hyperinflation – price inflation above 30% per year for a decade or more – the public that takes the hit will be almost everyone inside the eurocurrency zone. There will be almost universal hardship.

On the other hand, if monetary inflation ceases for more than a few months, there will be a depression. Big banks will fail. Their depositors will lose everything. The money supply will shrink. It will be 1930-38 all over again.

Central bankers do not allow such things. The European Central Bank will try to walk the tightrope, just as the national central banks in Europe did after World War II. The ECB will pursue boom-bust policies, refusing to capitulate either to a Great Depression or hyperinflation.

But how can it walk this tightrope? The losses will be huge for large banks. The politicians will try to transfer the cost of bailing out Europe’s banks to Germany. But the debts are too large.

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