Eric Fry

“Europe is in one of its toughest — perhaps the toughest — hours since World War II,” German Chancellor, Angela Merkel declared yesterday.

Who would argue with her?

The Second World War crippled the European economy. The victors suffered almost as much as the vanquished. Nearly ten years after the war ended, the British were still rationing sugar and meat.

Notwithstanding these hardships, however, the history of the post-WWII European economy is mostly a story of economic renaissance. From the rubble of war, the European Continent produced decades of economic growth.

Attempting to perpetuate and enhance that growth trajectory, the leading economies of Europe thought it best to pool their resources. So they formed the “European Union” and abandoned their national currencies in favor of the euro.

Nice idea. But the execution may have been flawed.

Just like a “group project” in junior high school, there’s usually an A-student in the mix…as well as an F-student. So what happens? The A-student does all the work to make sure he gets his habitual A. The F-student does nothing, but still receives the “A” he never could have earned on his own.

That’s the European Union.

Unfortunately, the F-student is on his own most of the time. He still has to get passing grades in his other courses…like “Tax-Collecting I” and “Remedial Budget-Balancing.” When the F-student fails to get a passing grade, there’s very little anyone can do to change the transcript…other than writing over the F’s to make them look like “B’s.”

That’s the European Union’s rescue plan. Every kid gets a passing grade, no matter how awful his homework may be.

But out in the school of hard knocks, an “F” is an “F.” Greece has failed already…and several of the other “students” are close to failing as well. The leaders of the euro zone are trying to change the transcripts. But that gambit will likely fail. A curriculum without absolute standards is a curriculum of no value.

The moment the EU began bailing out the Greeks, it abandoned the absolute standards that rendered the euro viable. If the EU had applied absolute standards and booted Greece out of the euro block, the euro’s credibility would have been validated. Without those standards, the euro’s value becomes as dubious as an online degree.

That’s why the Greek crisis has become a euro crisis. In fact, the entire system of currencies-backed-by-nothing may be lurching toward a crisis.

“If ideas could file for bankruptcy,” James Grant muses in the latest edition of Grant’s Interest Rate Observer, “the modern model of money and banking would have beaten MF Global Holdings to the courthouse. The concept of leveraged finance in a world of paper money and socialized risk deserves rehabilitation under an intellectual Chapter 11.”

The world’s monetary model is bankrupt — both intellectually and in fact. But if ever there were an institution that was too-big-to-fail, it is the institution of paper currencies. It is too-enormous-to-fail, which is why the world’s central bankers will stop at nothing to rescue it.

In general, the central banks are borrowing and/or printing money to buy “distressed assets.” By removing these distressed assets from the marketplace, the central banks hope to clear away some of the rot in order to “stabilize” the financial system and, by extension, the value of the currencies they print.

But since central banks are functionally outlawing bankruptcy for every large institution and government in the Western world — along with a few of those in the Eastern world, the rot remains…and it’s spreading. The rot is not only undermining economic activity, it is also undermining the entire global monetary system.

Throwing good money after bad — even newly printed, pretty good money — does not really clear away the rot; it merely smears it around…like a dry windshield-wiper smears bird-droppings.

Bankruptcy clears the rot away. Nothing else will do.

But since bankruptcy has become the ultimate non-option, the world’s largest central banks are all printing currency in the name of alleviating economic stresses. And they are swapping this currency for troubled assets.

For example, here in the States during the 2008-9 crisis, the Federal Reserve purchased hundreds of billions of dollars’ worth of mortgage-backed securities. It still owns them. Today, the European Central Bank is busy buying up the dodgy debts of Greece and Portugal.

Even the Chinese are in on the game. China’s sovereign wealth fund recently announced that it was “investing” in four of the largest state-owned banks in order to stabilize their share prices and support their operations.

The central banks dress their brutish market manipulations and backdoor bailouts in the elegant vernacular of ivory tower economics. Thus, “counterfeiting” becomes “quantitative easing,” while “using my influence at the Treasury Department to bail out my buddies at Goldman Sachs” becomes a “Troubled Asset Relief Program.”

But at the end of the day, the central bank manipulations are as clumsy, counter-productive and/or illegal as they appear at face value. And the worst of it is that these multi-trillion-dollar interventions do not remove the rot from the financial system; they merely relocate it from the private sector to the public sector.

The European Central Bank (ECB), for example, holds sub-AAA assets equal to 14 times its equity. Large portions of those sub-AAA assets are the very sub-AAA government bonds of Greece, Portugal, Italy and Ireland. If these assets, in the aggregate, were to lose 7% of their value, the ECB’s equity would be zero. (For perspective, the government bonds of Greece, Portugal, Italy and Ireland have already lost 30% to 60% of their values).

But don’t lose any sleep over the math; that’s what printing presses are for — to paper over the asset values the financial markets take away.

Observing these phenomena, Grant concludes: “There are better ports in a monetary storm than government securities denominated in paper money.”

Eric Fry
for The Daily Reckoning

Eric Fry

Eric J. Fry, Agora Financial's Editorial Director, has been a specialist in international equities for nearly two decades. He was a professional portfolio manager for more than 10 years, specializing in international investment strategies and short-selling.  Following his successes in professional money management, Mr. Fry joined the Wall Street-based publishing operations of James Grant, editor of the prestigious Grant's Interest Rate Observer. Working alongside Grant, Mr. Fry produced Grant's International and Apogee Research, institutional research products dedicated to international investment opportunities and short selling. 

Mr. Fry subsequently joined Agora Inc., as Editorial Director. In this role, Mr. Fry  supervises the editorial and research processes of numerous investment letters and services. Mr. Fry also publishes investment insights and commentary under his own byline as Editor of The Daily Reckoning. Mr. Fry authored the first comprehensive guide to investing internationally with American Depository Receipts.  His views and investment insights have appeared in numerous publications including Time, Barron's, Wall Street Journal, International Herald Tribune, Business Week, USA Today, Los Angeles Times and Money.

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