Debt to Break the Back of the Welfare State

Monday was the day the world’s capital markets turned into a giant fiat money casino. Consider yourself warned. You can trade your way to profits this in this market on the tide of easy money being printed now by the Federal Reserve and the European Central Bank. But the financial markets are now setting up for the mother of all collapses.

Up until Monday, we’ve seen the end of the super cycle in fiat money as a process that could take years to unfold. The piecemeal nationalisation of certain industries…the assumption of private sector liabilities on the public sector balance sheet…the abrogation of contract in the form of defaulted mortgages that are not foreclosed on…and higher-and-higher public debt-to-GDP ratios were all signs that the government everywhere was sucking the life out of the economy to preserve the status quo, and turning dozens of firms and institutions into zombies with no real productive economic future.

But Monday is the day that sent a bit of a chill down your editor’s spine. And it’s not because the €750 billion bailout package by the ECB caused a frisson here in St. Kilda. Granted, it did wonders everywhere else. The S&P 500 was up 4.4% in New York. Local stocks rallied. And most impressively, the spread between 10-year Greek debt and equivalent German bunds shrunk by a massive 570 basis points.

And if you’re a speculator — and especially a high-yield bond hunter — why not get on the gravy train? If the ECB is going to print money to buy public and private sector debts to “ensure depth and liquidity” in certain markets, it’s not a trend you want to fight. If the central banks are going to splurge on assets to support debt markets, bond yields will fall and asset prices will rise. For now.

But we reckon it is not for long. This really is Act V of the fiscal welfare state, in which monetary policy becomes the shameless handmaiden of fiscal policy in order to sustain an unsustainable kind of riskless society with massive benefits for everyone paid for by a few. That is an unaffordable illusion, the shattering of which leads to lower standards of living — a fact many in Europe find politically unacceptable (even if the fiscal facts speak for themselves).

To delay the day of reckoning, the ECB is offering European banks nearly unlimited amounts of cash for three and six month borrowing periods. You can imagine those banks — proud owners of heaps of sovereign debt from Greece, Spain, Italy, Ireland, and Portugal — are happy to sell that stuff to the ECB and borrow some short-term cash to lever up into an equity rebound. More privatised profits and socialised losses that favour the financial industry.

And why wouldn’t you play that game if you were playing with other people’s money? We’ll get to WHOSE money in just a moment.

The immediate question you might have is, “Will this work?” It depends on what you mean by “work”. By throwing wads of cash at stressed banks, the ECB alleviates the immediate threat in the market that bond yields spike and a liquidity crisis sets in. But enabling debt-laded countries to take on more debt hardly seems like a long term solution to the problem of living above your national means.

“You cannot make any nation that is unable to service its accumulated debts more creditworthy by extending more credit!” said Jeremy Batstone-Carr, analyst at Charles Stanley in today’s Wall Street Journal. “If the EU lends Greece money, the loan will increase that country’s public sector debt. The interest on the additional loan, whatever it eventually proves to be, will increase the public sector deficit. Total debt-servicing costs will rise, raising the burden on public sector cash flows. At some point in the future, the loan will have to be paid back.”

EU policy makers hope that by extending more credit now to sovereign governments, bond investors will just, you know, back off! It’s amazing to read how officials blame derivatives and a “wolf pack” of speculators for the crisis. As if it was the speculators who ran up huge debt-to-GDP ratios. As if the solution was to ban credit default swaps and remove the one market pricing mechanism which alerts investors to rising sovereign credit risk.

Incidentally, this is a minor trading point…but worth thinking about…who is on the other side of all the credit default swaps underwritten on European debt? Remember it was AIG that collected premia by writing default insurance against sub-prime mortgage backed securities and collateralized debt obligations. Goldman, among others, bought that insurance.

If you were a handy speculator right now, you’d find out who sold default insurance on Greek and Spanish debt. And then you might consider shorting the daylights out of them.

Of course maybe the ECB really has solved the problem by throwing a wall of fake money at it. But we reckon yesterday’s action gives you fair warning about what’s ahead and a bit of time to do something about it. A massive monetisation of debt and an increase in public sector liabilities has now been set in motion. The euro itself will soon, again, become a target of speculators once the next major tranche of sovereign debt must be rolled over and there’s no one but the ECB there to buy it.

How long can Europe pay its bills and creditors with money that doesn’t exist?

But the buried item in yesterday’s news reveals that the U.S. dollar might be on the hook too. The Fed re-opened its swap lines with major banks around the world. This means the Fed will be expanding its balance sheet again…and sending a flood of dollars out into the world to shore up banks that need them. The Fed had closed the swap line with the ECB in February, when everything was just fine.

To the barricades, dollar standard! But this really could be a kind of last stand for the dollar as the world’s reserve currency. Unbeknownst to the American taxpayer, the Bernanke Fed has now thrown the dollar once more into the breach of a liquidity and solvency crisis. It may not survive.

That’s what you should watch for, then: the expansion of the Fed’s balance sheet. It will be hard to keep your eyes on that target with so many green numbers on so many shares and indices. The ECB has invited the entire financial world to speculate on the house. The ECB’s monetisation — with the Fed’s cash — is going to lead to a quick reflation of some markets; that’s for sure.

The biggest inflation, though, could come in precious metals. In fact, as a hedge against the central bank monetisation strategy, precious metals are about the only sensible speculation in a market which has essentially been reduced to total speculation by the distortion of values from the flood of money.

Things that can’t be printed by a central bank and aren’t anybody else’s obligation to pay might be the best investments for the rest of this year. And beyond?

The Welfare State has met its great funding crisis with a fraud. And the fraud is going to cost a lot of people a lot of money. If you’re in markets now, be aware that markets no longer bear any relation to underlying risk or reality. It’s never been more dangerous. And given the last few years, that’s saying something.

Dan Denning
Daily Reckoning Australia
Whiskey & Gunpowder

May 13, 2010